The Power of Private Funds

01 March 2007

Jason Glover, Clifford Chance and Tom Bell, Simpson Thacher & Bartlett LLP 

Reflecting the strong performance of private equity investments (both absolutely and relative to market benchmarks) and the high level of capital distributed to investors and now in need of reinvestment, a record US$401 billion was raised globally by private equity funds in 2006, according to Private Equity Intelligence. Almost US$ 100 billion of this amount came from just 10 funds, including nearly $20 billion from Blackstone Capital Partners V, the largest private equity fund raised so far. Assuming an average leverage ratio of 3:1 on this pool of capital, that means that equity capital for over US$1.5 trillion of additional private equity transactions became available in 2006, a fact that is doubtless of great interest to M&A and financing lawyers and which underscores the enormous strategic value of a funds practice to a law firm’s overall corporate practice these days. 

Similarly, hedge funds pulled in a record $126.5 billion of new capital in 2006 (nearly triple the amount raised in 2005). Net assets in the industry now stand at $1.43 trillion, according to Hedge Fund Research. Interestingly, the spectacular collapse of the $9 billion hedge fund Amaranth at the end of the third quarter, while slowing new investment down to a ‘mere’ $16 billion in the fourth quarter, did not lead to the absolute decline in industry assets that many expected. Institutional demand for hedge funds remains robust, even amid a trend toward weak performance from hedge funds both absolutely and relative to market benchmarks. The recent change in ERISA legislation to significantly liberalise the “under 25 per cent” ERISA exemption for hedge funds should further spur investment by pension plans in hedge funds and reinforce the pressure toward greater transparency and greater adoption of institutional quality standards of reporting, risk management and governance. 

The unprecedented level of investor demand for private equity funds means that many fundraisings are now oversubscribed from the outset, even before commercial terms have been finalised. This creates significant challenges for private funds lawyers on the investor side, as the scope for negotiation of terms is very limited. In these circumstances it is vital for fund investors to instruct knowledgeable lawyers who appreciate that a hard line ‘one size fits all’ approach to negotiating terms is inappropriate. At a time when successful private equity managers are typically unable to accommodate all proffered commitments from potential investors, one of the major criteria being used in deciding between investors is the negotiating position taken by investors and their counsel. The practitioners identified in the following pages are all experts in the field of private funds and therefore appreciate the need to be discerning as regards the positions taken on ‘hot’ funds. Put simply, these practitioners can provide the skills necessary to secure a place for their client in an oversubscribed fund while protecting their clients’ key interests. 

The advent of the ‘mega fund’ (for these purposes meaning private equity funds with over $10 billion of commitments) means that many large undervalued or undermanaged businesses which were previously immune from potential private equity acquisition are now subject to market speculation as to their attractiveness as a takeover target by a private equity firm. Consequently, private equity funds are being seen as a threat in some parts of the traditional corporate world, either as competitors to the traditional trade acquirers or as aggressive bidders who might seek to make hostile approaches to publicly listed companies (many private equity funds are seeking to loosen the traditional contractual restrictions which forbid hostile activity). Indeed many bids have been unwelcome; a notable number of boards (HMV, VNU, Nordic Telephone Company etc) have refused or resisted large private equity sponsored takeovers for their businesses. Additionally, trade unions and their political allies are perceiving private funds as ‘locusts’ (to use one politician’s phrase) whose investment approach is not driven by a desire to build stronger long-term businesses but to pull out profits as quickly as possible through either leveraged recapitalisations that saddle businesses with competitively damaging debt, restructurings that bring layoffs and asset sales or ‘quick flips’ of businesses. 

Consequently, many have questioned whether the industry has become too powerful and therefore needs to be subject to greater regulation. Inevitably, this speculation as to the perceived negative impact of private equity funds upon the general economy is bringing private equity under increasing scrutiny by legislators and regulators around the world. As a result, practitioners are having to expand their knowledge beyond the relatively limited regulatory environment to which the private equity industry has historically been subject. Practitioners are being asked to guide their clients as well as legislators and regulators through the potential consequences of greater regulation of the private equity industry and the adverse impact that this may bring to various economies. 

The role of private equity within domestic economies should not be overlooked. For example, it is estimated that in the UK more than 20 per cent of all private sector workers are now employed by businesses owned by private equity funds. The significance of the private equity industry on UK plc is not being underestimated by the regulators, who have been keen to engage in extensive dialogue with the industry in advance of any legislative change. Specifically, the UK Financial Services Authority (FSA) has been keen to stress that its discussion paper ‘Private equity: a discussion of risk and regulatory engagement’ (published toward the end of 2006) is not a precursor to greater regulation. The FSA concludes in the paper that “the current regulatory architecture [for private equity] is effective, proportionate and adequately resourced”. Not surprisingly, the British Venture Capital Association has welcomed the paper as “a useful contribution to the understanding of the industry which will form the basis of ongoing discussions between the BVCA and the FSA”. Unfortunately, not all governmental or regulatory authorities elsewhere have expressed the same view on the constructive role of private equity. 

In response to negative publicity and increased governmental and regulatory scrutiny, 10 of the world’s largest private equity firms have formed the Private Equity Council, a trade association whose purpose is to promote broader understanding and appreciation of the nature and benefits of the international private equity fund industry and to advocate on behalf of the industry before regulatory and legislative bodies. One suspects it has a major task at hand. 

Some of those who have been arguably the major beneficiaries of private equity activity, namely the shareholders of ‘target’ businesses, are now arguing that in fact the private equity industry has sought to frustrate market dynamics by acting in an anti-competitive manner. This accusation has led the US Department of Justice (DoJ) to carry out an investigation into the activities of several major US private equity firms. Specifically, the DoJ is reportedly seeking comprehensive data relating to the involvement of various houses in competitive auction ‘club’ deals going back to 2003. The DoJ appears to be looking at the possibility that there may have been co-operation, “tacit agreements” or even collusion between private equity firms ostensibly bidding against one another. Allegedly fuelling the DoJ’s concerns is the fact that the largest consortia deals in the US in recent years did not witness a private equity led counter-bid following announcement and that in certain instances members of a losing consortium have subsequently joined the winning group. 

While the attention of the world’s media on private equity and hedge fund managers has led to a greater focus on regulation, it has at the same time resulted in the asset class increasing its appeal to individual investors. The consequential demand from high net worth individuals for these products has led a number of private banks to package products for their private wealth clients. Such products result in a number of challenges for the private funds practitioner: in particular, products need to be structured which are both tax efficient and capable of being marketed in compliance with regulatory rules across multiple jurisdictions. With a continued lack of harmonisation of taxation and legislation regarding the promotion of products to individuals (and therefore a necessary complexity with the resulting structure), such products are often only viable if they have sufficient critical mass. 

Many private equity and hedge fund managers are considering how best to capture the relatively untapped demand from quasiretail investors, particularly given that the return requirements of such investors are generally lower than those of institutional investors and other traditional private equity investors. However, the imposing regulatory challenges and burden required to tap a retail or quasiretail investor base have meant that the most successful firms have traditionally steered clear of structuring funds that appeal to these investors – at least, that is, until now. 

In the second quarter of 2006, KKR successfully launched KKR Private Equity Investors, a private equity fund that raised $5 billion and is publicly traded on the Euronext Amsterdam exchange. This landmark transaction provided broad public investor access to KKR’s private equity funds and related transactions in the form of a publicly listed security, while providing KKR with management over a permanent pool of capital. Following that transaction, Apollo raised over $2 billion in a similar Euronext Amsterdam-listed offering. Similarly, on the hedge fund side, Marshall Wace raised €1.5 billion in December 2006 for MW Tops on Euronext Amsterdam in the largest initial public offering ever of a hedge fund. These offerings are in addition to smaller capital raises for other alternative asset vehicles sponsored by Goldman Sachs, CMA, Dexion and Boussard. Taking due note of these developments, the FSA announced a change in the LSE listing guidelines that will effectively permit single manager hedge funds, activist funds and private equity funds to be listed on the LSE’s main market, which is expected to further increase the availability of these ‘permanent capital vehicles’ to retail investors. 

Unfortunately, regulatory trends in the United States seem to be heading in the opposite direction to providing greater public access to private equity and hedge funds. In late December 2006, the SEC proposed amending the definition of an accredited investor for individuals to limit participation in private funds to individuals with a minimum of $2.5 million of investment assets, excluding the value of their primary residence. This action appears consistent with other regulatory developments within the United States (eg, Sarbanes-Oxley) that have generated concern domestically that US regulation is too restrictive and is resulting in a fundamental shift of business overseas, which threatens the competitive position of US capital markets (and US lawyers). 

As an alternative to raising capital in the public markets for funds, several managers have been exploring the option of taking the firm itself public. The recent stunning success of the Fortress IPO is expected to lead other marquee rivals to go public too. The Fortress IPO illustrates the tremendous wealth that has been created by successful managers who are able to create diversified product platforms with ‘brand’ franchise value. 

2006 was a year in which private funds generating long term income yields became increasingly popular vehicles for investors. The principal reason for this is that insurance companies, pension funds and similar investors are keen to acquire assets whose cash flow profiles match their liabilities. Witness the huge appeal in the last 12 months of infrastructure funds that are in many cases acquiring income-producing assets under long term concessions with either central or local governmental authorities. To the extent that such investments provide a suitable and sustainable margin on yields from fixed income securities, they represent attractive investment opportunities – notwithstanding that they do not possess the ‘growth’ potential of private equity. This shift towards a classic ‘value’ investing strategy is clearly attractive to those investors willing to accept a lower risk/ return profile. There is a considerable supply of opportunities to meet the demand for such investments; an estimated over €40 billion in infrastructure projects were available in Europe in 2006. Indeed, many governments see such interest as an opportunity to improve and update infrastructure via funding from the private sector. One challenge for the structuring of such funds is how to align a desire to receive a traditional carry payment against the fact that the assets are income producing but, in many cases, capital depreciating. In addition, such funds are likely to be in existence for a period significantly exceeding the lifespan of private equity funds. The challenge here is to ensure that the product meets the needs of those investors seeking long term yields while at the same time ensuring liquidity for investors. Interestingly, a few infrastructure funds have sought listings on the public markets to counteract such illiquidity. 

The attractions of income-producing assets is also attracting significant interest in the real estate sector with approximately US$55 billion being raised for real estate opportunity funds in 2006. As Blackstone’s recent acquisition of Equity Office Properties for $39 billion shows, these funds have assumed an importance in the real estate markets comparable to their private equity counterparts. 

Private equity and hedge fund managers continue to expand their global platforms. Responding to intense competition for investment opportunities in the developed markets of the United States and Europe and to high levels of economic growth in many emerging market economies, many private equity firms are opening new offices and seeking to source investment opportunities in new markets, especially in Asia. As a result, fundraising for private equity funds targeting markets such as Asia and Latin America are seeing an explosion in activity levels not experienced since before the Asian crisis of 1997. This in turn is challenging law firms to further globalise their fund and transactional capabilities to keep up with the expanding scope of their clients’ business activities. 

Conclusion 

Private equity funds and hedge funds have become mainstream investment products, and private fund practices have emerged as no longer ‘niche’ practices at many leading law firms but as key engines to a broad range of M&A, acquisition finance, capital markets, real estate and other activities. However, the very success of the private equity and hedge fund industries is creating new challenges for private funds practitioners. With these developments as a backdrop, the publication of this edition of the International Who’s Who of Private Funds Lawyers remains an extremely timely and valuable service to the industry.

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