Maturing very nicely

appeared in JEP Funds Review 2010

Introduction

The last three years have seen a sea change in relationships between private equity managers, their investors and regulators and, judging by the continuing wave of regulation emerging globally, the process is by no means over.  For managers, the challenge is to ensure that their business models continue to be viable economically; are compliant with regulatory and investor demands and are flexible enough to encompass any necessary changes imposed by extrinsic forces.

What are the key drivers of change?

Even if not the fault of the private equity industry, the alternatives industry has been tarred with partial responsibility for the current economic crisis.  Policy makers and the public are seized by the belief that the alternatives industry is an unregulated "wild west", where secretive managers make significant personal fortunes and conduct their business behind closed doors.  The political solution is regulation and the imposition of transparency, coupled with, at least in the US, an increased intervention through SEC inspections.

Investor attitudes, too, are changing.  Where previously much was taken on trust, managers are increasingly being required by investors to be open, to underpin valuations with external oversight and control and to demonstrate that e.g. institutional conflicts are properly identified, understood and managed.

Regulatory changes

On the regulatory side, EU based managers, or managers with funds raised or committed to by EU investors will be well aware of the Alternative Investment Fund Managers Directive (‘AIFMD’).  They will have seen the AIFMD debate progress and retrace as discussions remain ongoing between the European Parliament and the European Council.

Accordingly, the managers accessing EU institutional capital will be faced with the possible imposition of material regulatory requirements in the areas of maintaining high levels of regulatory capital, adoption of detailed internal policies and procedures to deal with e.g. liquidity management; the need to appoint a depository to hold financial assets (though private equity may be exempted from this requirement) and monitor various aspects of the managers' business, the requirement to appoint an external valuator, or to have an independent valuation function, and, finally, the necessity to install mechanisms to report to investors and regulators significant amounts of information regarding positions in investee companies, much of which would legitimately be regarded as confidential and commercially sensitive, as well as reporting significant amounts of information regarding remuneration and carry.

The industry is also confronted with material equivalence tests to enable the continued marketing of non-EU domiciled funds to EU based investors or to operate through non-EU domiciled vehicles which, for reasons of stability and tax efficiency for investors, have been a fundamental component of structures.  The AIFMD may create significant restrictions on the ability to market non-EU domiciled funds into the EU unless the jurisdiction in which the fund is established has met certain equivalence criteria.

At the time of writing, the AIMFD remains in a state of extreme flux with a raft of proposed changes from all parties involved.  However, the political drive behind the AIFMD means any delays are likely to be short and agreement is likely by Autumn at the latest.

In the US, the regulatory change is manifesting itself on two fronts.  Firstly, there is legislation working its way through Washington which is designed to bring into the regulatory net many alternative asset managers who have not previously been regulated, although possible exemptions for private equity have been discussed.  It is not clear how this is going to work for non-US domiciled managers and there is a material risk that non-US managers with US based investors will be required to register with the SEC and comply with the relevant rules and legislation.  It is also entirely possible that the SEC will not accept proposals which would result in "registration lite" for non-US managers who are already subject to regulation by e.g. the FSA.

In addition to proposed changes to registration requirements, the SEC, prompted by the Madoff scandal, has proposed changes which will directly affect the custodial activities of registered investment advisors.  The custody rule changes will impose additional operational burdens on managers, particularly in the private equity space, where the custodial relationship is much less central to the business model.

Changing regulation is only one manifestation of increased regulator focus.  What is also clear in the US is that the enforcement division of the SEC now also has the alternative asset management industry in general in its sights and does not exclude the private equity industry from its targeting.  With an investor protection mandate, the SEC has re-organised itself to create 5 specialised units in enforcement and asset management is the exclusive interest of one of these units.

The signs are also that the FSA is increasingly approaching enforcement in the same way.  Certainly, the most recent announcements from the FSA's chief executive and head of enforcement would imply that this is their position, as "light touch" regulation has been replaced by "outcome driven supervision", coupled with enforcement as the tool for "credible deterrence".

It could quite plausibly be argued that the regulatory shift is no more than a direct and sensible corollary to changes which investors themselves are driving. Managers are increasingly discovering, when they start negotiations with investors for new funds, that the old days of light touch investor involvement and investor tolerance of manager autonomy are substantially gone.  The recent Institutional Limited Partners Association guidelines, which although they are still a work in progress and do not yet have industry wide endorsement, are evidence of a collegiate move towards investor driven best practice.

What should managers conclude and what steps should they take?   It is clear that the environment is changing fundamentally.  Transparency, disclosure and robust processes are the order of the day.  Accessing capital is likely to be harder, or at least more process driven and the expectations of investors are higher.  For some, this may prove a challenge they do not wish to face.  However, the need for private equity investment has almost never been greater and the opportunities for significant returns are still there.  If processes and controls need to be more robust, the balance of power is more equally divided and regulatory scrutiny more educated and focused, this may be a sign that the industry is reaching a much greater level of sophistication and maturity, which may not be a bad thing.