All Change

01 January 2008

However, the second half brought a sharp downturn in industry conditions and heralds what another industry leader, David Rubenstein of Carlyle, believes will be a ‘purgatory age’ for private equity over the next couple of years, but one that ultimately will be followed by a ‘platinum age’.

The implosion of the subprime and CDO markets in the second half of 2007, the dramatic increase in spreads and reduction in availability of debt financing and the emerging threat of a recession in the US have changed the landscape for private equity dealmakers. Predictions in 2008 are for fewer large buyout transactions, with significantly less debt and therefore greater equity amounts being used to finance transactions, all raising questions about how the enormous amount of capital raised in the past few years can be invested without diluting returns. In addition, there is expected to be an increase in strategic minority investments as well as growth capital investments and an increased focus on the emerging markets where robust economic growth is still expected and private equity transactions are much less reliant on debt financing. The current cycle is also expected to produce distressed and turnaround investment opportunities.

FUNDRAISING TOTALS
Against that backdrop of change, how were fundraising totals affected in 2007? In private equity, 2007 saw fundraising totals jump to new heights in the US, where a record US$302 billion was raised in 2007 (including the largest private equity fund ever, Blackstone’s US$21.7 billion Blackstone Capital Partners V) compared to US$255 billion in 2006. In Europe, preliminary indications are that fundraising was just short of the record-breaking year in 2006 with around US$114 billion raised. Preliminary totals indicate that well over US$500 billion was raised globally in 2007. As in 2006, buyout funds represented the vast majority of funds raised (an estimated 75 per cent of total funds in the US) with the ‘mega-funds’ dominating fundraising (just 12 funds representing 28 per cent of overall fundraising in the US). However, reflecting the mid-year change in events, an estimated 59 per cent of 2007’s capital was raised in the first half, and the second half showed a marked downturn in fundraising activity.

Private equity fundraising has proved to be cyclical in the past and, with a lag, has often been closely correlated with trends in levels of underlying investment activity. For example, in the 2000-2003 period, fundraising declined by approximately 85 per cent. With projected slowdowns in the deployment of new capital and in exits that generate distributions for investors needing reinvestment, many fund practitioners are preparing for leaner times in 2008.

Yet the very same adverse circumstances that may dampen fundraising activity for some types of private funds may also create a demand for others. For example, the second half of 2007 saw the launch of a number of ‘credit opportunities’ funds designed to capitalise on the dislocations in the credit markets, and managers of distressed funds and mezzanine funds have seen a surge in investor interest. Part of the appeal of a private funds practice to a law firm is that, whatever the investment climate, there is almost always some investment strategy designed to capitalise on that climate and a fund to be launched to pursue that strategy. As one practitioner has put it, ‘If the markets are making lemons, we are raising lemonade funds’.
On the hedge fund front, inflows set another record in 2007. According to Hedge Fund Research, the hedge fund industry attracted US$194.5 billion in new investor capital in 2007, a startling 54 per cent increase over 2006’s previous record of US$126.5 billion. As a result, total assets under management in the industry now stand at $1.87 trillion. Of considerable note, despite the collapse of several mortgage and CDO-focused hedge funds during 2007, hedge funds overall performed impressively both on an absolute and a relative basis. For example, Hedge Fund Research’s Fund Weighted Index returned 10.24 per cent during 2007, compared to a 5.50 per cent increase in the S&P 500 and a 6.49 per cent increase in the MSCI World Equity Index. Similar outperformance was reported by the other major hedge fund aggregate indices.

Supported by strong performance, hedge funds continue to see increasing institutional demand. The recent change in ERISA legislation in the US to significantly liberalise the ‘under 25 per cent’ ERISA exemption for hedge funds has further spurred investment by all kinds of pension plans in hedge funds. This, in turn, has increased pressure for greater transparency and greater adoption of institutional-quality standards of terms, governance, reporting and conflicts resolution among hedge funds, and many practices prevalent in private equity fundraisings, such as extensive investor negotiations and side letters, are becoming more commonplace in hedge fundraisings. As a result, in contrast to private equity (where many practitioners expect a downturn in activity levels in 2008), practitioners with active hedge fund practices generally anticipate robust prospects for the next year.

THE IMPACT OF SOVEREIGN WEALTH FUNDS
While pension funds and insurance companies remain the bedrock source of funding for the private funds industry, ‘sovereign wealth funds’ (or ‘SWFs’), which are the investment arms of foreign governments and their controlled enterprises and entities, have come into prominence in 2007. Among the more visible entities in 2007 were several arms of the governments of Abu Dhabi, Singapore and China. These governments are flush with capital to invest, typically resulting from rising energy prices and foreign trade surpluses.

Many of these entities (such as those of the Government of Singapore and the Abu Dhabi Investment Authority) have been influential participants for many years in the financial markets, often as major investors in private equity funds. What is new is both the amounts that the SWFs are now seeking to invest and the aggressive direct participation in private equity that they are now pursuing.

Their traditional role as a fund investor continues and for the most part has not sparked controversy. While some other investors worry that there may be a crowding out effect from the large commitments being made by the SWFs and that the SWFs may be receiving preferential terms, such as access to coinvestment opportunities, these issues are not fundamentally new.

However, SWFs have also taken strategic stakes in several private equity and hedge fund managers (eg, Blackstone/CIC, Carlyle/Mubadala, Apollo/ADIA, and Och-Ziff/DIC). These transactions have generally been carefully structured to be ostensibly passive non-controlling stakes. They typically have been defended by selling firms as providing needed working capital to support expansion of the firms’ businesses and as giving the firms valuable relationships to enhance deal flow and geographic reach. But many outsiders wonder whether such large and important investors with strategic stakes can truly be expected to be ‘passive’ in practice. If, in fact, such investors do have influence over their firms’ activities, serious conflict issues may arise with other investors. In addition, there are important overarching public policy issues about whether SWFs will use their influence to pursue rational financial objectives or support ulterior political objectives of their sovereign owners, especially given the lack of transparency over the operation of SWFs.
Over the longer term, private equity firms must give thought to whether ultimately SWFs will prove to be competitors rather than sources of capital. In many of their recent transactions with private equity firms, SWFs have made it clear that they expect to receive, among other things, ‘technology transfer’ and training in return for their capital. While one can be skeptical that the technology of private equity dealmaking is as transferable as, say, the technology of silicon chip design, it is apparent that some SWFs aspire to one day disintermediate their private equity managers. Even now, in some recent privately negotiated transactions (eg the infusions of capital into Morgan Stanley, Merrill Lynch and Citibank), private equity investors were reportedly outbid for the investment opportunities by SWFs. Indeed, SWFs may hold a competitive advantage over private equity firms for certain kinds of situations, given the SWFs’ lower return requirements and longer time frames for holding investments.

INCREASED POLITICAL SCRUTINY
If 2006 was the year that politicians were awakened to private equity, 2007 was the year that politicians, faced with media and union pressure, chose to take action in response to the rise of private equity. In the UK, the bid for Alliance Boots by Kohlberg Kravis Roberts faced opposition from an alliance of doctors, pharmacists and MPs concerned about the possible impact on public health. The revelation that the £1.75 billion takeover of AA led to an equivalent of 34 per cent of the workforce losing their jobs led to union hostility, with Britain’s GMB union branding the private equity industry as ‘buccaneering asset-strippers’. As political scrutiny increased, the House of Commons Treasury Select Committee launched an inquiry into private equity, publishing its interim report in July 2007. The report focused on the advantages and disadvantages of the private equity and public limited company model, the apparent lack of regulation and transparency in relation to both private equity firms and investee companies, the levels of taxation of both the investee companies and the founder and carried interest partners, and the tax treatment of debt and equity. Similar debates in the US had previously led 10 of the largest buyout groups to move to contain the political damage by creating an industry lobbying group (the Private Equity Council), which was charged with the task of explaining to Congress and the public why the industry’s activities benefit the economy.

TAXATION
The UK media hit a frenzy in summer 2007 when Nick Ferguson, the highly respected chairman of the SVG, a major PE fund of funds investor, declared that ‘any common-sense person would say that [it can’t be right for] a highly paid private equity executive [to be] paying less tax than a cleaning lady or other low paid workers’. Subsequently, the system of taxation in the UK of capital gains was completely overhauled as a direct consequence of the adverse publicity surrounding the tax paid by private equity executives and successful management buyout teams. The overhaul resulted in the removal of the concept of taper relief, one of the Labour government’s major tax innovations when coming to power in 1997. Taper relief enabled carried interest to be taxed at a rate as low as 10 per cent in certain circumstances. That regime has now been abolished in favour of an 18 per cent flat rate of capital gains tax. In addition there is now speculation that the UK Treasury has opened a new front in its investigation into private equity taxation, turning its attention to avoidance measures used by the industry in relation to management fees.

In the US, a similar debate has led to tax legislation being pushed in Congress to treat carried interest as ordinary income, taxed at rates as high as 35 per cent, rather than as an allocation of underlying fund income, potentially taxed at 15 per cent where it is derived from long-term capital gains. Legislation was also proposed to prevent alternative investment firms from using deferred compensation techniques with offshore funds to prevent current taxation of fees and from claiming partnership tax treatment when going public and thereby avoiding the payment of corporate tax on certain types of their investment income (the ‘Blackstone bill’). While prospects for these legislative proposals appear weak in 2008 (especially since 2008 is an election year in the US), a new Congress and a new (perhaps Democratic) President may present a far more favourable environment for their adoption.

Similar moves to increase taxation of the private equity industry have been seen in other jurisdictions too, with Germany increasing the effective tax burden of carried interest as part of its company tax reforms.

SELF-REGULATORY EFFORTS
The political pressure being applied to the private equity industry in the UK led to the British Private Equity and Venture Capital Association (BVCA) undertaking a review led by Sir David Walker of the adequacy of disclosure and transparency in the private equity industry. The review was broadly welcomed by private equity houses who saw self-regulation as a better alternative to government-imposed regulation.

The Walker report seeks to impose public reporting requirements on private companies of a certain size. Such reporting would not only embrace the standards applicable to UK public companies but also calls on firms to reveal factors that will affect their future business as well as information on employees, environmental matters and a review of financial risk. Perhaps unsurprisingly the recommendations have failed to placate politicians and the unions, who have vigorously criticised the reforms for not going far enough.

It is worth noting that hedge funds have not escaped the attention of the politicians either, especially in Continental Europe, for their sometimes aggressive approach to listed companies, their opaque and secretive processes and the perceived threat they pose to financial stability. In the UK a group of the biggest hedge fund managers have outlined plans to bolster standards on disclosure, valuation and risk management in an attempt to improve the image of the industry. After seven months of consultation led by former Bank of England deputy governor, Andrew Large, the Hedge Fund Working Group recently released proposals that will encourage fund managers to have their portfolios independently valued and set out clearly for investors all the risks that their investments carry. The guidelines, the most ambitious attempt yet in Europe to codify best practice for the industry, have attracted praise from investors and regulators.
In the US, similar self-regulatory efforts for the adoption of best practices are under way in the hedge fund industry. The Managed Funds Association, the leading hedge fund industry association in the US, published this past Autumn its fourth edition of Sound Practices for Hedge Fund Managers, which sets forth a comprehensive set of recommendations for both managers and investors and is well worth careful reading by practitioners with an active hedge funds practice.

CONCLUSION
It is clear that the private funds industry is going through a critical period of uncertainty. Both managers and investors will be challenged to prosper amid the myriad forces for change affecting the industry. Practitioners and their clients will need to ‘think outside of the box’ and consider fresh approaches to their businesses. As Guy Hands of Terra Firma recently said ‘Darwin did not say that the strong survive, he said that those who adapt survive’. It will be interesting to see how industry participants adapt to such changing times.

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