The powerful House Financial Services Committee on Tuesday approved legislation that would give US regulators the power to force private equity and venture capital funds, among other financial institutions, to disclose the structure of incentive compensation including management fees, transaction fees and carried interest.
This is the first time that US legislators have proposed to regulate compensation at private investment funds.
The House of Representatives is expected to vote on the bill Friday, but it is unlikely to come before the full Senate until after Congressional recess in August. Both the House and Senate must approve the bill for it to become law.
“The Corporate and Financial Institution Compensation Fairness Act” would give regulators the power to set rules prohibiting certain structures that could “threaten the safety and soundness of covered financial institutions or could have serious adverse effects on economic conditions or financial stability”. The rules would not require that firms disclose individuals’ compensation, however.
House Financial Services Committee Chairman Barney Frank authored the bill, which would give the Securities and Exchange Commission and the Federal Reserve the power to regulate incentive compensation at banks, credit unions, registered broker dealers, and investment advisors with assets of at least $1 billion. The final category includes private equity, hedge, and venture capital funds, whether they are registered investment advisors or not.
In its current form, the $1 billion figure refers to the firm’s assets, not the firm’s assets under management, said Ropes & Gray partner Dan Evans, who noted this would exclude almost all private equity firms, since the firms themselves do not hold large amounts of capital. But he said it’s likely that the bill’s authors do in fact intend to target assets under management, and the text of the bill will eventually be revised.
The purpose of the regulation would be to give regulators enough information to analyse the extent to which incentive structures encourage undue risk-taking. Traditionally, private equity compensation arrangements have not been seen as encouraging excessive risk-taking because of its long-term nature. Evans says he can’t imagine that regulators are too likely to view current compensation structures as presenting a systemic risk to the financial markets.
“It would certainly seem to a reasonable observer that it would be a stretch to conclude that these compensation structures incent people to take undue risks,” Evans says.
He adds that the portions of the bill that deal with public companies are concerned with ensuring that shareholders are aware of incentive compensation structures and have the chance to vote on them. “In the fund world the equivalent of shareholders – the investors – know exactly what these compensation structures are because it’s critical to the fundraising process. It’s negotiated and completely understood, and all of these sophisticated investors have invested knowing what these compensation structures are.”
If you take undue risk and lose money [for LPs], you aren't going to get another fund.
But in recent weeks some critics have pointed out that carried interest, when not properly structured, can have the effect of incenting managers to take on too much risk, especially through the application of leverage.
“It’s certainly something [the bill's authors] need to think about,” said Evans. “I guess you could say that if you’re going to get compensated if you make money for the limited partners, but you aren’t going to lose money if you lose money for them, then you’ll be incented to take risks. The question is does it provide incentive to take undue risk. If you take undue risk and you lose a lot of money, you won’t get another fund.”
It’s important to note that the SEC already routinely asserts its authority to review compensation of registered investment advisers, said Evans, so the new bill won’t be an “earth shattering” change if passed. The rule making element is new however.