Shifting sands

A decade ago, it would have been unheard of for private equity firms to hire public policy teams, engage closely with governments around the world, and work with lobbyists as a matter of course. But today even midmarket buyout shops, wherever they are based, must keep abreast of sentiment in Washington and at the European Union; they must make their voices heard on the implementation of tax changes; and they must engage with evermore active regulators. Being able to influence policymakers, or at least get a view on the direction they may be heading, has become a key priority for private equity. Here are five of the biggest challenges facing the industry in the coming year.


In mid-September, the US and the European Union expanded their sanctions against Russia to target Arctic and shaleoil projects and further limit financing to Russian state-controlled companies. The energy sanctions prevent Western energy firms from providing services to many Russian majors’ projects, while Sberbank, Russia’s biggest bank, was added to the list of financial institutions to which Western companies are banned from lending in the short term.

For private equity firms, simply keeping abreast of the ongoing development of the sanctions regime is a weighty task. But keeping close to decision-makers, in order to get some idea of what might come next, also makes a big difference – especially when firms are given as little as two weeks to comply. While some firms will have encountered sanctions regimes before, the impact of the Russian programme on the buyout industry is unprecedented.

Wynn Segall, a partner advising GPs on international trade at the law firm Akin Gump Strauss Hauer & Feld in Washington, says: “The sanctions programmes for Iran and other countries involve smaller economies that have been isolated by many years of sanctions, so geographically they have less entanglement and cross-border investment than we see in connection with Russia. Russia is an enormous economy, whose trade and investment ties with the rest of the world are deep and substantial.”

The challenge for private equity firms is partly about managing their existing portfolio of assets, and partly about their approach to fund formation and new transactions. Says Segall: “Funds need to engage in thorough diligence for new investment opportunities and to take stock of their established holdings, their established relationships with investors, and their potential risk exposure through direct and indirect links to Russian companies in private equity or capital markets holdings.”

Many firms are checking through their portfolios and looking closely at relationships with vendors, suppliers, customers, joint venture partners, co-investors and investors.

Other issues that need to be considered include the level of due diligence required on new deals. Jessica Gladstone, international counsel at Debevoise & Plimpton in London, says: “We are looking at the extra checks involved, and ensuring firms have compliance procedures and policies that are robust enough and also flexible enough to adapt to changing regulations.”

Funds also need to be mindful of the different risk appetites of their investors and the banks they deal with, who may adopt responses to sanctions regimes that impose even further constraints.


At the end of July, the transitional period allowed for European Union managers of alternative investment funds to apply for authorisation under the Alternative Investment Fund Managers Directive finally expired. Now, private equity firms across Europe and beyond are wrestling with the practical compliance requirements.

Numerous areas of ambiguity remain, one of which is around raising new funds. The rules require national regulators periods, to oversee what is being marketed to investors, such that a firm has to give details to the FCA of each new partnership it is looking to raise. The FCA is meant to have details one month ahead of the fund launch, which creates issues for fundraisings involving a number of partnerships, forcing firms to form those partnerships much earlier than they would have done in the past.

The FCA should also receive one month’s notice before a GP can implement a material change to the information it is taking to investors. As such, if certain terms are knocked back by potential LPs, a firm may have to go back to the FCA and re-file before returning to the marketing trail.

James Gee, head of private funds regulation at Weil Gotshal & Manges in London, adds: “For a lot of our clients who are not in Europe already, we have advised them not to step in any sooner than is necessary, because people need to work out how these things are going to operate in practice. We are now a couple of months past the transitional period and there remain a surprising number of areas of uncertainty, even around some pretty fundamental areas.”


A few issues have been keeping managers busy on the taxation side, the biggest being the Foreign Account Tax Compliance Act (FATCA) and all its associated tax information exchange agreements. Effective as of July, FATCA – which is intended to close tax loopholes and fight tax avoidance – requires a huge compliance effort for all businesses. It requires foreign financial institutions to report to the US tax authorities about accounts held by US clients, and many countries have already signed intergovernmental agreements (IGAs) with the US to cooperate.

Debevoise tax international counsel Cécile Beurrier says: “The challenge for private equity clients is that they typically have portfolio companies and operations in many jurisdictions. Since there are differences in the way FATCA is being implemented in each jurisdiction, they have to comply with different frameworks in different markets.”

Each country entering into an IGA with the US has tended to treat private equity funds and their holding companies differently – such that the holding company of a private equity fund might have to report under FATCA regulations, but not under certain IGAs. Certain jurisdictions (like the UK) have put them within the scope of FATCA under domestic law.

Beurrier says: “Each jurisdiction must implement FATCA in its domestic legislation, which means a patchwork of legislations and systems.”

In the US (and in other jurisdictions), there’s been much debate about taxing the carried interest earned by private equity managers as ordinary income instead of capital gains. President Obama has put taxation of carry on his agenda for legislation every year; so far nothing has materialised, but that could all change if a bill like congressman Dave
Camp’s tax plan was to go forward. Under this bill, fees to fund managers would be taxed as straight income, not capital gains or carry.

Finally, there is the Organisation for Economic Cooperation and Development’s so-called BEPS project, which targets base erosion and profit shifting by multinationals – a response to public concerns that companies may be avoiding tax by shifting their earnings between jurisdictions. Many GPs have holding companies in places like Luxembourg, and while the BEPS proposals are yet to be finalised, the result could be that those cross-border structures become less efficient, reducing returns to investors.

Robert Gaut, a tax partner in the London office of law firm Proskauer, says: “People like the EVCA and the BVCA have been campaigning hard to make sure collective investment vehicles are properly considered as part of the BEPS reforms, as they could have a big impact.”


In May, at the PEI Private Fund Compliance Forum, Securities and Exchange Commission (SEC) director Andrew Bowden delivered a speech revealing the commision’s serious concerns about a lack of transparency and investor protections
within private equity.

The speech put advisers’ collection of fees and allocation of expenses firmly in the spotlight: “When we have examined how fees and expenses are handled by advisers to private equity funds, we have identified what we believe are violations of the law or material weaknesses in controls over 50 percent of the time,” Bowden claimed.

Potential issues include the payment of operating partners by portfolio companies; funds not disclosing sufficient disclosure to investors; and managers shifting expenses from themselves to their clients. The charging of hidden fees, and the way co-investment opportunities are allocated, are also high on the agenda.

In the four months since the speech, LPs have made a swathe of requests to managers about fees and expenses, and the SEC has continued its investigations.

Nabil Sabki, a private equity partner at law firm Latham & Watkins in Chicago, says: “The Bowden speech has already had an impact on disclosure and is going to have an impact in the long term. Many private equity firms are taking a close look at their current disclosures with respect to fees, expenses and other areas, and are making additional disclosures – because they realise that the clearer the disclosure, the better.”

Lawyers are now waiting to see if enforcement cases will follow, he adds. “I would find it hard to believe that the SEC didn’t have actions to come, and we would expect to see those by the end of the year.”


A year ago, the SEC made another speech that put the wind up private equity. In April 2013, David Blass, then chief counsel for the Division of Trading and Markets, warned that GPs might have to re ister as broker-dealers because of their fundraising activities, and because they charge transaction-related fees to their portfolio companies.

Broker-dealers are subject to a whole swathe of SEC rules that are aimed at reining in excesses and making sure advice is appropriate. Moreover, if their standards slip, broker-dealers face hefty regulatory and legal penalties.

Blass contended that managers should be registered if they employ full-time marketing staff whose compensation is directly tied to their fundraising success. He also pointed out that funds who charge portfolio companies transaction-related fees for acquisitions, disposals and recaps could be engaging in traditional investment banking activity, and therefore crossing the line.

Lawyers say that since the speech the SEC has been making systematic enquiries to establish the scale of any problem. Heather Traeger, a partner with O’Melveny & Myers in Washington DC, says: “My understanding is that there have been discussions about whether there is any kind of no-action relief that could be provided broadly – to recognise that even if an entity seems to meet the definition of a brokerdealer, if they are really a private equity firm – which is itself a term that is not defined – then they could have relief from the regulation’s requirements, provided they meet certain criteria.”

Blass left the SEC in July, but Traeger says this issue will not disappear. “Whether it gets left, slotted into some new rulemaking, or dealt with via some kind of exemption, this is really the elephant in the room currently. And people are in limbo.”

Traeger’s advice is that GPs should look at their fund documents to ensure there is appropriate disclosure related to fees, and review any fees that may be seen to suggest transaction-based compensation.