A few days after welcoming a US government proposal to appeal for private capital to purchase up to $1 trillion in toxic assets, GPs received a taste of bitter medicine from US Treasury Secretary Timothy Geithner.
As part of his testimony to the House Financial Services Committee, Geithner outlined a set of guidelines that would impose substantial government oversight of private equity and hedge funds for the first time.
Under the proposal, leveraged private investment funds with assets under management over a certain threshold would be required to register with the Securities and Exchange Commission (SEC), including reporting any information “necessary to assess whether the fund or fund family is so large or highly leveraged that it poses a threat to financial stability”. Such information would include names of investors, trading partners and details as to how much firms borrow to leverage investments.
The data would be shared by the SEC with a new “systemic risk regulator” that would determine whether a firm's failure would pose a risk to the economy and thus allow the government to seize control, as was the case when the government decided to intervene in saving AIG from bankruptcy last September. Although Geithner hasn't yet provided details as to the new proposed regulatory body, it would have the power to impose stricter capital requirements on firms deemed “at risk”.
“There is no reliable, comprehensive data available to assess whether such funds individually or collectively pose a threat to financial stability,” he said. “In the wake of the Madoff episode it is clear that, in order to protect investors, we must close gaps and weaknesses in regulation of investment advisors and the funds they manage.”
Following Geithner's speech, Washington DC-based lobbying group the Private Equity Council released a statement saying it would seek to ensure any new legislation does not impose undue burdens on the industry. “We believe that private equity investments do not create systemic risk. Private equity firms invest in companies, not exotic securities and their investors are long-term investors, eliminating the “run on the bank” type of risk that helped create the current financial crisis.”
Even before Geithner's proposal, the issue of increased SEC oversight had been brought up in the Senate. In February, the Senate introduced a bill that would require private funds with $50 million or more in assets – including hedge funds, private equity funds and venture capital funds – to register with the SEC.
But while the managing partner of one large firm said he didn't expect the new proposals to be too burdensome, Lerner says if Geithner's assets under management threshold ends up falling somewhere under $50 million, smaller firms may not be able to handle the cost as easily. “We don't think that any fund with assets under management of under $50 million can afford to register, the costs are just too high,” says David Lerner, a partner at law firm Morrison Cohen. “You need at least two additional people on top of your other infrastructure just to manage regulatory compliance issues. Under $50 million, forget it, they'll simply have to shut down.”
The Treasury's reforms still have to win the approval of powerful Congressional members such as New York Senator Chuck Schumer, whose Wall Street constituents include many private equity players. It also remains to be seen how top industry players will react, with The Blackstone Group recently refusing an SEC request to publicly disclose performance aspects of its buyout and hedge funds, while Fortress Investment Group complied.
However, with the regulatory tide showing no sign of receding, more GPs will likely recognise that, as Carlyle Group co-founder and managing director David Rubenstein said during the recent PEI Emerging Markets Forum, “additional regulation is inevitable”.