Friday Letter Beware the regulator

Friday Letter: Beware the regulator 2009-03-20 Private equity investing is a long-term business that uses patient capital, but it’s still hard for a lot of GPs to shake that “just can't win” feeling in the short term. Credit remains scarce, industries and markets across the globe have contra

Private equity investing is a long-term business that uses patient capital, but it’s still hard for a lot of GPs to shake that “just can't win” feeling in the short term. Credit remains scarce, industries and markets across the globe have contracted, limited partners lack liquidity and politicians in the US and Europe seem determined to enact anti-private equity regulations. It is arguably this last issue that has the industry as a whole feeling most besieged.

“Regulation is not the holy grail politicians think it is,” one European GP recently complained. Yet it continues to be a priority for various legislators.

For example, earlier this month, private equity once again found its way into US Senator Carl Levin’s crosshairs. He introduced a bill bluntly titled the ”Stop Tax Haven Abuse Act”, which is aimed at constraining offshore tax havens and would pose problems for private equity firms with a significant investor base of non-US limited partners and US tax-exempt limited partners. Investors who rely on non-US “blocker” corporations to invest in US funds, ensuring their share of fund income does not incur US tax, would see their worldwide income become subject to US tax. The resulting tax costs would “certainly outweigh any benefits of the feeder or blocker corporation”, law firm Proskauer Rose confirmed in a client memo.

The proposed bill would also expand the reporting requirements relating to passive foreign investment companies (PFICs) to include US citizens who (deep breath) “directly or indirectly form, transfer assets to, are a beneficiary of, have a beneficiary interest in, or receive assets from” a PFIC. It would require that unregistered funds – including private equity funds – establish anti-money laundering programmes and submit reports on any suspicious activity. Among other measures, the bill imposes special measures against non-US jurisdictions and financial institutions that are seen to be impeding US tax enforcement, and it allows for increased time for investigations involving accounts in offshore jurisdictions. It also strengthens the “economic substance doctrine” to invalidate transactions that have no business purpose other than tax evasion, and it strengthens tax shelter penalties. Little surprise therefore that private equity CFOs for one were wincing at the prospect of the dead hand of such legislation thudding on their table.

Senator Levin last month also introduced a transparency bill that would require all private funds (not firms, but funds) to publicly disclose the identities of their LPs, as well as the value of their assets under management. 

“Anyone who thinks for one minute that increased regulation is not going to happen hasn’t been paying attention,” Cindy Scotland, managing director of the Cayman Islands Monetary Authority, said at an Ernst & Young symposium in January.

It’s likely these proposed bills will be amended significantly before being passed by the Senate, and then sent on to the House for approval –  assuming they make it that far. PEO readers are sure to recall the buzz on Capital Hill in summer 2007 that surrounded proposed bills on publicly traded partnerships (the so-called Blackstone Bill) and carried interest taxation (again, a Levin-led initiative). Those ultimately went nowhere, thanks in part to a massive lobbying effort by private equity firms. Mel Schwarz, legislative affairs partner in the US National Tax Office of global accounting firm Grant Thornton, told PEO at the time, “Once one of these things comes on the table, it's very difficult to get it off the table.”

European politicians, meanwhile, continue to debate proposals on enhanced cross-border private equity regulation, calls for which have been driven mainly by a group of socialist members of European Parliament led by Poul Nyrup Rasmussen, president of the Party of European Socialists and former Danish prime minister.

And it’s not just elected politicians pursuing private equity regulation: earlier this month, an International Monetary Fund policy report grouped private funds in a “shadow banking system” of financial institutions that falls outside the regulatory system and, it was argued, should be subjected to greater scrutiny in the future.  The IMF also said the “intrinsic procyclicality” imparted by fair value accounting standards, while to blame for much of the severity of the financial crisis, should remain in place. “The problem is not too much transparency but too little, and the clock should not be turned back on fair value accounting just to address the issue of temporary market illiquidity,” the study said. That some have likened these kind of declarations to having the lunatics take over the asylum illustrates the depth of concern many practitioners feel at present.

With all this in mind therefore, GPs should be cheered to learn that one of the regulatory bodies responsible for imposing mark-to-market rules has had a change of heart. Just this week, the US’ Financial Accounting Standards Board (FASB) extended an olive branch that could stave off the seemingly endless stream of portfolio company write-downs. FASB has released a list of seven indicators of inactive markets and proposed an amendment to Statement No. 157, the fair value accounting rule, so that firms may use their own valuation methodologies when quoted prices are unreliable.

It is to be celebrated that regulators can evidence the ability to modify – and most would say improve – their regulations, although the negative impact of the original FASB 157 can not be overestimated. Asked if further regulation of their industry was needed or not GPs would likely deliver a unanimous negative. But today that choice has gone: instead the question to private equity is what kind of regulation do you want? And implicit in that is the need for practitioners to stay deeply engaged with regulations' passage to enactment. Otherwise you'll get given the regulations others want.