The new normal

Governments around the world are finalising rules to mitigate private equity's future potential risk to the global economy.

Private equity was not responsible for the economic collapse. But the industry was indeed caught up in legislators’ efforts to mitigate future risks to the global financial system. As a result, a flurry of bills was passed in 2010 that demanded increased transparency and reporting requirements for private equity firms.

In the US, the Dodd-Frank Wall Street Reform and Consumer Protection Act mandates that domestic firms register with the US Securities and Exchange Commission. The law also require foreign private equity firms with more than 15 US-based LPs, at least one office in the US and more than $25 million in combined US investor assets to register. This will mean firms – both based in or out of the US – will need to establish formal compliance policies to outline how they would deal with potential conflicts of interest. Registration also means firms need to designate a compliance officer, and face regular inspections by the Securities and Exchange Commission.

The act also sets new limits on banks’ involvement with private equity firms. The so-called “Volcker rule”, named after former Federal Reserve chairman Paul Volcker, will impose restrictions on banks’ abilities to invest in or sponsor private equity and hedge funds based both within the US and abroad.

Unlike the White House’s campaign for a complete ban on proprietary trading and sponsorship, Congress passed softer language which allows banks to invest up to 3 percent of their Tier 1 capital in private equity, with an additional restriction on acquiring more than a 3 percent ownership stake in any fund.

Furthermore, the signed bill is not the end of the reform process as the legislation provides only a framework for the new regulatory landscape. US financial supervisory agencies are expected to interpret and implement further regulations at the behest of Congress over the coming months and years. The Volcker rule’s precise impact on global markets is as yet unquantifiable, but any restriction on bank holdings suggests grim news for bank sponsored private equity investment.

Tilted risk scales

Banks are also being targeted on a more global scale. The Basel Committee on Banking Supervision is in the process of creating new international standards – dubbed “Basel III” – which are the latest global agreements on capital requirements for banks following the financial crisis. The rules, which were endorsed in November by nations at the G20 summit, will introduce higher capital requirements and liquidity measures for banks.

Final rules for Basel III, scheduled to go into effect between 2015 and 2018, will increase the minimum common equity requirement banks must hold from the current 2 percent to 4.5 percent and will further introduce a capital conservation buffer of 2.5 percent, bringing the total common equity requirement to 7 percent. Depending on how private equity assets are risk-weighted, the provisions could result in banks decreasing their holdings in the asset class as a way of complying with capital requirements.

Or perhaps more likely, Basel III may result in a number of banks spinning out in-house firms to be compliant. Global banking giant HSBC, for example, agreed in September to sell an 80.1 percent stake of its Asian private equity business HSBC Private Equity Asia to the firm’s management team, while retaining the remaining share. It has indicated plans to do the same with other in-house private equity groups, as have other banks.

Likewise, a process is also underway in the European Union that would affect investment activities by the insurance industry. The Solvency II directive, scheduled to be introduced in November of 2012, will introduce risk-based solvency requirements for insurance and re-insurance groups.

It looks likely that the capital a European insurer would need to hold against its private equity assets will increase. Indeed, insurers are likely to “reduce appreciably” their private equity holdings, perhaps even stopping investments in the asset class altogether, according to a study carried out by the EDHEC Financial Analysis and Accounting Research Centre in April.

Dodging the taxman

Some private equity managers thought they could breathe a sigh of relief that new taxes were not pushed through in 2010. Think again.

In early October, the European Commission proposed new taxes on the financial services industry, arguing the sector “needs to make a fair contribution” to cash-strapped governments. The commission called for a globally applied financial transaction tax, which would tax each financial transaction based upon its value. At the EU level, the commission is calling for member states to implement a financial activities tax, which would be applied to the profits and remunerations of companies in the financial services sector.

The EFAMA, Europe’s representative association for the investment management industry, expressed “serious concerns” over the proposals, arguing the proposals make “no acknowledgement of the fact that the funds industry has not benefited from government support and would not expect to rely on state bailout as a safety net”.

In the US, similar worries are taking place over taxes on carried interest. A package of tax reforms introduced by Democratic chairman of the Senate Finance Committee Max Baucus in September would prevent GPs from paying taxes entirely at the capital gains rate on carried interest. If passed, the proposal is estimated to raise approximately $14 billion in revenue over the next decade.

Baucus’ amendment would have decreased the percentage of carried interest characterised as ordinary income to 65 percent from the House of Representatives proposal of 75 percent.

The new proposal would have meant that only 35 percent of carried interest would continue to be taxed as capital gains, which enjoys a low 15 percent tax rate. Ordinary income in the US is taxed as high as a 39 percent rate.

However, Republicans – who have been able to thus far block any attempts to further increase tax on carry – retook control of the US House of Representatives in the November elections, meaning the issue is likely to be buried until political winds once again shift. 

Put up or shut up

In the UK, new rules may also make it easier for target companies to shake off a takeover attempt by a private equity firm. The independent Panel on Takeovers and Mergers unveiled the new proposals in late October, arguing bidding firms have too much of a “tactical advantage”, and it was necessary to rebalance the playing field more in favour of target companies.

Arguably the proposals’ biggest impact on the private equity industry would be a revamp of the “put up or shut up” regime, which forces bidders to either make a formal offer for control of a company or walk away from doing so for six months. Bidders that make a “virtual bid” – whereby a firm announces consideration of making an offer without any actual legal commitment to do so – must now do so within four weeks of making an offer announcement.

The new rule provides target companies more certainty over how long the offer process would last and addresses situations in which bidders would attempt to put pressure on a target company’s board of directors through long lasting discussion with shareholders.

Private equity firms have always been heavily involved in virtual bids, said Norton Rose partner Paul Whitelock. “These new rules will mean firms will have to be much more prepared before approaching a target or making a possible offer announcement,” added Whitelock, who specialises in public and private company M&A deals.

Other likely changes include the abolishment of inducement payments, or break-up fees, which target companies must pay if they walk away from an agreed offer; and greater disclosure requirements in relation to advisor fees and the financing of a takeover or merger.

Taming the AIFM monster

None of the aforementioned issues, however, compare to the private equity industry’s concerns about the Alternative Investment Fund Manager’s directive. The 210-page text, which lays out a host of regulations for Europe’s private equity industry, passed the EU Parliament on a vote of 513 to 92 in mid-November.

The long-anticipated directive will impose rules on general partners’ pay, fund transparency, restrictions on asset stripping, but most notably, the rules will allow non-EU funds marketing access to the 27-member bloc.

Until recently, discussions have been deadlocked between the EU Parliament – arguing for stricter regulation of fund managers – and the more GP-friendly EU Council.

The directive ultimately underwent 17 compromise proposals, the latest being in late October under the Belgian presidency of the EU Council, when EU finance ministers played their part in approving the negotiated text.

Under the directive, non-EU managers have been permitted access to European investors. However, this will be under the condition the non-EU country has in place sufficient regulatory standards and information sharing agreements with member states.

The AIFM directive also introduces rules on manager remuneration, fund transparency, asset stripping and depositaries, among other things.

GPs will face rules on pay and bonuses, similar to those imposed on bankers under the Capital Requirements Directive. Remuneration policies will have to ultimately be put in place for any staff whose work will have a material impact on the risk profile of a fund.

GPs will also be subject to restrictions on the amount of capital they can distribute following the takeover of a non-listed or public company. In the first two years following an acquisition, fund managers must use their “best efforts” in preventing “distribution, capital reduction, share redemption and/or acquisition of own shares by the company”.

Indirect effect

And it isn’t just legislation targeting the broader financial industry that will impact private equity. Private equity houses have closely followed the Carbon Reduction Commitment scheme first put into effect by the UK government this past April, for example. The initiative will monitor compliance on a group-wide basis, meaning if one portfolio company falls under the basic qualification criteria, the private equity fund and all other portfolio companies held by it – including those outside the UK – will be jointly responsible for CRC compliance.

Or, take for example, anticorruption legislation in the US and UK. Under the UK’s recently passed Bribery Act, a “commercial organisation” will become criminally liable should any “associated person” offer or conduct a bribe designed to provide a business advantage for the commercial organisation. Expected to come into force in April of next year, the act makes no distinction between bribes paid in the UK or anywhere else in the world, nor does it matter if foreign authorities do not interpret a UK firm’s activity in its home district as bribery.

Likewise, the US has been ramping up investigations against foreign firms under the Foreign Corrupt Practices Act, says Chris Leahy, managing director of greater China and Southeast Asia at risk consultancy company Kroll.

The FCPA echoes a number of provisions included in the UK’s Bribery Act, including the responsibility of firms to implement compliance programs and conduct due diligence on deals in foreign countries, all of which makes commercial relations between foreign nations and the US more scrutinized and less attractive.

The past couple of years have thus been a watershed moment in the world of private equity. And as new laws take effect, and secondary rule-making processes kick-off, it will become increasingly important fund managers keep abreast of the new regulatory landscape.