The ever-increasing scale of assets under management in private equity has come with greater regulatory oversight and a fast-growing compliance burden. In 21 years, private equity has gone from an asset class largely misunderstood by overseers to one firmly in their sights, with the Alternative Investment Fund Managers Directive in Europe and the Dodd-Frank Act in the US as seminal pieces of legislation that changed the face of the market.

“The regulatory changes of the past two decades stand out more as punctuation marks in a broader story,” says Robert Sutton, a partner in the private funds group at Proskauer. “The larger the industry gets, the more it impacts society, the more different stakeholders in society have views on how it should be conducted and then the more it is subject to regulation.

“The Securities and Exchange Commission, as the primary US regulator, started to pay more attention to private fund managers back in the early 2000s, and at that point their primary focus was on hedge funds. In 2004, they were of the view that private equity and venture capital fund managers were not perceived to pose significant risks.”

The arrival of AIFMD

In the UK, the Financial Services Authority – which has since been replaced by the Financial Conduct Authority and the Prudential Regulatory Authority – consolidated the responsibilities of several predecessor regulators under one roof in December 2001 and began regulating all UK private equity firms for the first time. But it was not until the arrival of AIFMD as the pivotal piece of European regulation that the industry was really subject to rules specifically drafted with private equity in mind.

AIFMD was borne out of the global financial crisis and was part of a wider regulatory effort to increase oversight of private funds, which had by that point become significant actors in the European financial system, managing large quantities of assets. First coming into force in 2011, EU member states were required to write the directive into national law by 2013, with some providing a one-year transition period before managers became subject to its requirements in 2014.

The regulatory changes of the past two decades stand out more as punctuation marks in a broader story”

Robert Sutton

Tim Lewis, head of financial services and markets at Travers Smith, says: “AIFMD was the first piece of pan-European regulation that focused on private equity and hedge fund managers. It allowed the larger funds to market on a cross-border basis for the first time using AIFMD passporting, creating more of a single market in the EU for at least the bigger private equity funds.

“One of the drivers for AIFMD was the desire to create a single European market for institutional investor funds to match the existing UCITS market for retail funds, which policymakers regarded as a great success. Another was the desire to improve investor protection following the activities of Bernard Madoff, the American hedge fund manager who orchestrated the largest Ponzi scheme in history and defrauded investors of billions. It was the perception that Europe needed more laws for private funds as a result of that which led to the introduction of a single market across Europe.”

While AIFMD represented a harmonisation of rules in Europe, it affected the private equity industry globally, says Owen Lysak, a partner at Simpson Thacher & Bartlett, where he leads the European financial services and funds regulatory practice. This was because “it introduced marketing rules that applied no matter where you were in the world when you were talking to EU LPs”, Lysak explains.

In the years that have followed, many of the largest US fund managers have moved to set up EU-based funds. John Verwey, a partner in Proskauer’s private funds group, says: “Following AIFMD, non-EU fund sponsors found that they were effectively shut out from marketing their funds in some EU member states owing to how these member states had implemented AIFMD into their domestic regulatory regimes.

“People were concerned that the regulatory compliance burden on private fund managers would be too heavy to operate efficiently in Europe”

Patricia Volhard
Debevoise & Plimpton

“This led such non-EU sponsors to establish EU funds with EU fund managers, predominantly out of Luxembourg, and with these EU fund managers either delegating portfolio management to the non-EU fund sponsor or receiving advisory services from the non-EU sponsor. This arrangement allowed the funds to be marketed in all EU member states under the AIFMD passport. With this development, Luxembourg became – particularly post-Brexit – the hub for private equity in Europe as people moved to set up vehicles there to get access to the whole European market.”

Patricia Volhard, a partner at Debevoise & Plimpton, says the upheaval wrought by the regulation was significant for private equity, but nevertheless proved to be short-lived. She notes that AIFMD was a significant change that caused uneasiness in the market at the time, but the industry quickly adapted. “If you listened to the initial reaction, people were concerned that the regulatory compliance burden on private fund managers would be too heavy to operate efficiently in Europe, and that this would have a negative impact on investments into Europe.

“All of that didn’t happen, at least not as dramatically as envisaged by some, and the regulation has proven to be manageable in the end. However, it has [clearly become] more difficult for European investors to get access to non-EU funds due to the marketing restrictions imposed by AIFMD.”

Dealing with Dodd-Frank

Running alongside AIFMD implementation in Europe was the arrival of the Dodd-Frank Act in the US – a similarly substantive piece of post-crisis legislation that required private funds to register with the SEC for the first time.

“The Dodd-Frank Act resulted in two actions from a regulatory perspective that really transformed the regulation of private equity,” says David Blass, a partner in Simpson Thacher’s investment funds practice. “First, it brought the asset class very clearly into the oversight powers of the SEC, and then that was followed by fairly aggressive enforcement action by the SEC in the 2013/2014 timeframe.

“During that period, the SEC pursued enforcement action against many of the private equity fund managers of significance, with the pivotal themes being around the clarity of disclosures of conflicts of interest and the clarity of disclosures around expenses and fund reimbursements. The combination of all of those actions really transformed the approach to the regulation of private equity fund managers for the long term.”

The Volcker Rule that was included in the Dodd-Frank Act was in many ways just as transformative in its impact, prohibiting banks from engaging in proprietary trading and from acquiring or retaining ownership interests in private equity funds. That effectively forced banks to spin out their private equity funds, leading to a flurry of new fund launches and a dissemination of private equity talent into a next generation of market players.

The regulation keeps coming

In the past five years, the pace of regulatory change has continued unabated on both sides of the Atlantic, as regulators continue to tighten their grip on the private equity asset class.

The impact of Brexit cannot be overlooked. “Since then, firms have really been developing workarounds to address the political fragmentation of the market in Europe,” says Lewis. “It means the UK has been taken off the table for many US managers as a potential location for a European fund, for the sole reason that if you are not in the EU you have to deal with all the barriers to access that are put up around it.

“SFDR has really moved us into a new world in terms of how people are describing and positioning themselves from an ESG perspective”

Owen Lysak
Simpson Thacher & Bartlett

“There hasn’t been a huge departure of personnel from London, as was feared, and in fact there is still a lot of growth in London among private equity firms. But there has been a growth in headcount and expertise in other jurisdictions in the EU that wasn’t really there a decade ago.”

Most recently has come the advent of the Sustainable Finance Disclosure Regulation, a seminal piece of legislation that has seen the EU take the lead in global efforts to avoid greenwashing in the marketing of private funds.

“What is amazing about SFDR is the huge amount of time already spent on it when we have not yet got to the hard stuff, which is the ongoing disclosures,” says Lysak. “Fund managers have been struggling with the labelling aspects of SFDR and how to categorise their funds. The focus from European investors as to what category under SFDR a fund is and whether they will commit money on that basis is so significant that even managers outside the EU are now voluntarily categorising themselves and complying because that is what European LPs are asking for.

“There is now potentially a UK version of the regulation coming forward, and the SEC has brought forward proposals that are broadly similar in being product category inspired. SFDR has really moved us into a new world in terms of how people are describing and positioning themselves from an ESG perspective, and that’s creating a lot of tension in the market.”

In the US, the SEC’s latest proposals to enhance private fund investor protections go much further in their efforts to dictate the way in which private equity firms can behave. Marc Ponchione, partner in the investment management group at Debevoise, says: “The next phase is the SEC in February proposed a new set of regulations specifically applicable to private fund managers that would again reshape the industry in ways we have not seen before.

“This new phase of regulation would effectively result in the SEC putting its thumb on the scales of commercial negotiations between sophisticated private parties, because it will require private fund sponsors to use certain terms and refrain from using other terms that have until now been subject only to bilateral negotiations between the parties. That is a pretty drastic development, and many are questioning whether the SEC has the authority to do it.”

The new rules would prohibit various economic arrangements that have become market standard, including certain fees and expenses and some preferential side letter terms.
“We expect the proposals to go through with most of these problematic aspects intact,” says Ponchione, “and they will have a material effect on the processes by which investors negotiate with private fund sponsors, and will increase the cost of compliance and insurance, possibly to such an extent so as to price small and emerging managers out of the markets.”

Private equity has come from the outskirts of regulatory attention two decades ago to now find itself in the eye of the storm.