The dawn of 2018 heralds the 10-year anniversary of one of the worst financial crises the world has ever seen.
The aftermath brought legislation that would change the face of the private equity industry in the US: the Dodd-Frank Wall Street Reform and Consumer Protection Act, which meant private funds had to register with the Securities and Exchange Commission.
“Although the Dodd-Frank legislation was passed in 2010, it really came out of the ashes of the financial crisis in 2008, so arguably this is the 10-year anniversary of the beginning of the largest shift in regulation of the US financial institutions since the Great Depression,” says Kelly Riera, director of compliance at Boston-headquartered TA Associates.
“Arguably this is the 10-year anniversary of the beginning of the largest shift in regulation of the US financial institutions since the Great Depression”
Riera joined the firm from Bain Capital in 2010 to start its compliance programme in response to the act. Firms were required to have a chief compliance officer, as well as formal and specific compliance policies and procedures. This affected every part of the firm, from marketing to IT to investment.
Unsurprisingly, the industry did not welcome this change with open arms. In fact, Riera remembers insiders wondering, “Why me?”
“I think there was hope it would be exempted similar to venture capital firms for the same reasons: many private equity firms see themselves as helping to grow businesses and not necessarily creating the types of risks that some of the other industry types were creating. So there was the feeling of, ‘Why are we being targeted? Do we really create the type of financial risk that resulted in the 2008 crisis?’” she says.
The introduction of the registration requirement changed the dynamics of the GP community, Joshua Cherry-Seto, chief financial officer and chief compliance officer at mid-market firm Blue Wolf Capital, tells PEI. Most small and mid-sized GPs had been carved out from large operators or banks, and had a culture of entrepreneurship.
“Each one of them ended up being an island unto itself. They accumulated a set of investors who bought into them, they went out and operated, and there wasn’t a lot of transparency, certainly outside of their investor group. There wasn’t a lot of focus on compliance, disclosure and reporting because they were wholly focused on returns and part of their pitch was not having time and resources bogged down in excessive institutional compliance,” he says. “Dodd-Frank flipped that mentality on its head.”
A focus on leverage and other risks after the crisis also meant there was “more of a groundswell from investors saying that solely-focused-on-return model in our maturing market is not enough – fulsome disclosures are now a market requirement.”
Steadying the ship
In 2018, the industry takes a more sanguine view of regulation.
“After almost six years [after the act was implemented] we’ve now developed strong compliance systems and practices. We are disciplined about monitoring developments and trends and believe we have the elements of a sound compliance programme in place,” says John Malfettone, senior managing director and chief compliance officer at Clayton, Dubilier and Rice.
“While the environment is always subject to change, the major issues have been identified and addressed.”
And many now feel the industry is better for regulation.
“I think you’ve levelled the playing field in many cases, because people are required to make the same disclosures where before they might be hidden here or there”
“You’ve gotten rid of some of the fringe players, bad actors. I think you’ve levelled the playing field in many cases, because people are required to make the same disclosures where before they might be hidden here or there,” he adds.
Cherry-Seto agrees: “Regulation is a good thing, as it levels the playing field and creates a baseline of compliance. It’s a good thing to be part of a framework which gives investors more confidence just as regulated capital markets encourage more participation.”
Bruce Karpati, the global chief compliance officer at KKR, who co-founded the SEC’s asset management unit, concurs.
“From a compliance perspective, I certainly think the industry is better off. While it has been a process to adapt to a new regulatory environment, I have real confidence that our stakeholders – including investors, the public and regulators – have more confidence in the private equity industry as a result.”
One family office investor who invests on both sides of the Atlantic tells PEI that although there is a significant risk that “endless waves of new regulation” are a distraction from delivering higher returns, SEC registration is a marginal net positive, as it “removes some risk for LPs by submitting all managers to minimum standards”.
He adds the Form ADV, which all US managers must file, is also helpful. “The fact that these are available equally to all LPs and again include minimum levels of disclosure is broadly positive.”
Firms know the SEC is prepared to audit aspects like accelerated monitoring fees or the allocation of transaction fees in co-investments, which means these are addressed to the highest possible standard.
“This is important as these issues are virtually impossible for LPs to audit themselves and therefore rely on a level of trust. Other positive areas for LPs have been the emphasis on reporting net performance and greater transparency in allocating co-investment opportunities.” The attention paid to private equity by the SEC, given the breadth of its scope and the seemingly disproportionate penalties, is more controversial. “However, the fact that the highest profile cases have tended to find in favour of LPs, particularly with respect to the charging of fees, has broadly been positive for LPs,” the investor says.
Some larger firms say they have turned regulation to their advantage. The legal and compliance team at Blackstone has more than doubled since chief legal officer John Finley arrived at the firm in 2010, growing “at a little bit faster rate than the firm”, which has more than tripled its AUM in the same period.
“It really is quite an investment of resources to be able to meet all the regulatory needs and demands and to do everything the right way, not only from a substantive way but the process that regulators expect to see. That investment can be burdensome for the smaller firms and is a way of setting apart competitively the bigger firms,” Finley says.
“It really is quite an investment of resources to be able to meet all the regulatory needs and demands and to do everything the right way”
“That investment can also be attractive for LPs in terms of a comfort level with the size and scale of our compliance effort.”
And in Europe, where the Alternative Investment Fund Managers Directive has presented a significant challenge for GPs, Blackstone has “been able to create incremental fundraising by virtue of substantially diminishing our reliance on reverse inquiries and avoid some of the burdensome aspects of private placement timing and administration”.
“Regardless, rather than look at it as, ‘How do I deal with this burden,’ we think about, ‘How can we be astute and use the change in the compliance landscape to our advantage?’” Finley says.
Larger firms’ ability to absorb the impact of the increased burden could be one of the factors playing into a dynamic that has characterised the industry in the last 10 years: capital consolidation. Money has been flowing to fewer firms, with the average fund size reaching $754 million in 2017, up from $508 million in 2014.
Footing the bill
There has inevitably been a cost attached to more regulation.
“It was pretty burdensome for the industry,” Riera says of Dodd-Frank. “If you didn’t hire a staff you had to at least hire consultants that could help you figure out the rules and implement the regulations.”
The requirements make it “undoubtedly harder for new firms to launch… as firms are obliged to have an increasing large and expensive compliance apparatus”, the family office investor tells PEI.
When Jason Ment joined StepStone as general counsel and chief compliance officer in 2010, he was the only lawyer, and he shared an additional resource with the finance team. Today the legal team is 10 people, although the firm itself is significantly larger.
“If our firm were the same size as it were then, the legal group would still be bigger than one and a half people now, but probably it would be three and not 10.”
Many GPs have chosen a combination of internal and external resources. For example, CD&R supplements its in-house resources with outside counsel and consultants.
“What you don’t want to do from a compliance perspective is build this big infrastructure because as a manager, we don’t have a big infrastructure,” says Malfettone.
“We have found external support can be very helpful in providing a second pair of eyes. For example, with our annual review process, we partner with both our internal audit team and an outside firm to make sure we’re capturing the right items in that process,” KKR’s Karpati adds.
His firm also found the size and make up of its compliance team evolved over the years to meet regulatory challenges.
“We now have more specialised expertise on our compliance team covering more ground in order to address the increased regulatory obligations, as well as the enforcement and exam priorities that we need to adhere to.”
While in the US, the lion’s share of regulation-related expenses fall to managers, with AIFMD in Europe it is a different story. In 2016, law firm Proskauer compared limited partner agreement terms of 30 funds raised in the preceding 18 months with the terms in the previous fund. It found both Foreign Account Tax Compliance Act and AIFMD compliance costs specific to the fund were being allocated to the fund.
Fund formation expenses are higher than they were before as a result of increased regulation
“Fund formation expenses are higher than they were before as a result of increased regulation. Legal bills to form a fund before AIFMD [when US managers marketed a Cayman fund in Europe versus an AIFMD passport structure] is suddenly way more, and that is being borne by investors,” Ment says.
“AIFMD has had little or no benefit for LPs,” the family office investor adds. “As an example, the additional reports produced by GPs are not available to LPs, unlike the US ADV reports. Furthermore, marketing rules have made it harder for European LPs to gain access to oversubscribed US managers and have led some US and Asian managers to abandon European LPs entirely.”
A new status
But just as US GPs made peace with regulation, a potential rollback reared its head. When Donald Trump was on the campaign trail in 2016, he pledged to dismantle parts of Dodd-Frank, calling it a “disaster”. In June, the House of Representatives voted to approve the Financial CHOICE Act, which would repeal key parts of the legislation, although it has yet to pass the Senate.
Consensus within the industry, however, is that a complete rollback of private funds legislation is highly unlikely. Furthermore, whether aspects of Dodd-Frank are rolled back is immaterial, PEI’s sources agreed, because investors are used to the new normal and will not accept less information.
“Whether private equity remains as intense a focus for the regulators, the industry standards that have evolved have set a bar that’s now going to be applicable regardless,” says Finley. “LPs have certain expectations as to the way in which the industry operates, and that’s not really going to change.”
StepStone’s Ment also doesn’t see LPs letting the industry off the hook on things they have come to expect, such as using the Institutional Limited Partners Assocation fees and expenses template and disclosing net returns as well as gross.
“Most of the larger LPs now have an operational due diligence team, which focuses on various non-investment functions, including compliance; five years ago that wasn’t the case,” Malfettone says. “We just finished a fundraise last year, and I probably had three or four dozen meetings with LPs.”
LPs also regularly conduct operational monitory reviews to make sure managers are following their policies. “Because you only get examined once every few years, you spend a lot more time on compliance with your limited partners than you do with the SEC and that’s probably the way it should be,” Malfettone says.
And the regulator appears to be shifting its focus to be more balanced across hedge funds, private equity and other private funds, according to a client note from Proskauer. In several recent speeches, chairman Jay Clayton has highlighted retail investor protections as a particular emphasis for the agency.
“In the industry itself we’ve shown that we accept being registered as a reality, and we are at the front line of trying to have more dialogue with investors and regulators to continually improve the current framework – not completely tear it down,” says Cherry-Seto.