Regulation has been a hot topic in the private equity world over the past few years, from the controversial Alternative Investment Fund Managers’ Directive, which came into effect in July 2013, to the SEC’s Andrew Bowden revealing that the agency had discovered “violations of law or material weaknesses in controls” in more than 50 percent of private equity firms examined with regard to collection of fees and allocation of expenses.
Yet private equity fund managers have had to grapple with another concern this year, which will likely continue well into 2015. Tom Evans, partner in the private equity practice at Latham & Watkins, believes that GPs are facing increased risk in dealing with government sanctioned persons – an issue that has become more prevalent for the industry as political tensions with Russia continue.
In response to increasing unrest in Ukraine, both the US and the EU announced sanctions in March against individuals and companies that are thought to be directly involved in inflaming the ongoing conflict. These sanctions expanded over the ensuing months, with US president Barack Obama adding Russian flagship oil giant Rosneft to the list in July and announcing in September that the US would “deepen and broaden” the sanctions against Russia’s financial, energy and defence sectors.
It’s a complex issue, and one which impacts the private equity model at several levels, Evans explains.
“When investors are raising new funds or co-investments for particular deals, we are now helping them run through increased due diligence to test the beneficial ownership of investors to make sure there aren’t any sanctioned persons amongst those investors,” he said. “That can be time consuming.”
GPs also need to identify sanctioned people among the sellers of potential portfolio companies, a process so involved that it often becomes a separate work stream itself, said Evans. Additionally, firms must figure out whether the target company is also doing business with any sanctioned country or people.
“In some deals that means that you don’t do the deal, in other deals it means that there are covenants in the sale and purchase agreement to bring the particular part of the business into compliance pre-closing,” Evans said.
Taking an active approach toward sanctions is likely to stand firms in good stead, according to Evans.
“The clients that are investing now to put in place compliance procedures that will cope with the waxing and the waning of these sanctions as global political events move on, they’re the ones who we think will be best placed for the future,” Evans said.
He adds that despite regulatory uncertainties, 2014 has been a particularly seller-friendly year in Europe due to the increase in competition globally.
“There’s more dry powder globally this year than certainly in the last five years, and consistent with the trend there are likely to be fewer deals this year in the EU,” Evans said. “What that means is that deals are getting very, very competitive.”
In the 30 months to July 2014 almost three-quarters of deals in UK-based transactions that Latham & Watkins looked at used a locked-box or fixed priced purchase price mechanism, which are favourable to sellers.
“Post the credit crunch we thought we would see an explosion of things like deferred consideration mechanisms, loan notes and earn outs to bridge the gap between sellers’ expectations and buyers’ expectations,” Evans said.
“The reality is that based on our research to date we have seen those mechanisms being used on only a few European deals.”
Sellers are generally taking a bullish view of what might happen in the next 12 months, Evans said, with buyers taking a much more cautious approach as we head into the new year.