Private Equity Funds - A Changing Regulatory and Negotiating Landscape
Jason Glover
Tom Bell
Two of the most highly regarded private funds practitioners worldwide give thier view of the recent changes in regulation and the fundraising environment and how these will affect the daily reality of professionals active in this area.
Jason Glover and Thomas Bell
In previous editions of The International Who’s Who of Private Funds Lawyers, we have sought to provide a review of key changes that we believe will affect the private equity funds industry and therefore the day-to-day practices of private equity funds practitioners. In that regard, this year is no different; yet unlike previous editions we have felt compelled to focus our attention on just two topics. The first is regulation. Legislative responses to the financial crisis have resulted in what are arguably the most significant changes ever to private equity regulation both in the US and in Europe (even though it is generally acknowledged that the industry did not play any meaningful role in causing the crisis). The second topic is the fundraising environment, which can be described as patchy at best. This in turn has led to a rebalancing of power between fund managers and investors, with investors seeking to heavily negotiate the terms of private equity funds and private equity managers needing to become ever more creative in ensuring that their funds proceed to a successful first close.
The Impact of the Dodd-Frank Act
Among the most significant recent legal developments in the United States for the private equity industry is the enactment of the Dodd–Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act), especially its investment adviser registration provisions. The Dodd-Frank Act is a comprehensive reform of the United States’ financial regulatory system that, among other things, effectively requires registration with the US Securities and Exchange Commission (SEC) of the vast majority of US (and a great many non-US) advisers to private equity funds.
Previously, advisers to private equity funds and other private funds were generally not required to register with the SEC under the US Investment Advisers Act of 1940 (the Advisers Act), in reliance on the “private adviser” exemption under the Advisers Act. The principal requirement of this exemption was that the adviser had fewer than 15 clients during the preceding 12 months (each fund vehicle generally being treated as a single client for this purpose). The Dodd-Frank Act, however, repealed the private adviser exemption and established a general requirement (subject to very limited exemptions) for US private equity advisers (non-US advisers having a different standard, as noted below) to register with the SEC if the funds that they advise together with other client accounts have US$150 million or more in assets under management.
The new registration obligations become effective on 21 July 2011. Private equity firms that need to register as a result of the Dodd-Frank Act should start preparing well in advance of this date since fairly complex and robust compliance systems must be put in place as a consequence of registration, and the service providers (ie, law firms and regulatory compliance consulting firms) with expertise in this area are likely to face bottlenecks in their resources as the effective date approaches. Many US law firms are beefing up their Advisers Act practices in anticipation of a surge in activity resulting from new registrations.
Of particular consequence to the global private equity industry is the treatment of non-US advisers under the Dodd-Frank Act’s registration provisions. The SEC previously took the position that in the case of non-US advisers, only US clients counted towards the “fewer than 15” client cap under the private adviser exemption (there being no limit on the number of non-US clients).
In addition, under a doctrine sometimes characterised as “registration lite”, even if a non-US adviser was required to register, the substantive provisions of the Advisers Act generally only applied to the non-US adviser’s dealings with US clients (although the adviser needed to comply with many of the Advisers Act’s record-keeping requirements for both US and non-US clients) and a fund organised under non-US law generally was treated as a non-US client for this purpose. The result was that under prior law most non-US private equity firms could operate without registration under the Advisers Act and, even if required to register, could do so in a way that was relatively unburdensome to the adviser’s overall business.
The Dodd-Frank Act establishes a dramatically more limited exemption from registration for “foreign private advisers”. This foreign private adviser exemption will not be available if the adviser meets any of the following criteria: it has a place of business in the United States; it has 15 or more clients and investors in the United States in private funds advised by the adviser; or it has aggregate assets under management attributable to clients in the United States and investors in the United States in private funds advised by the adviser of US$25 million or more. Since the exemption is so narrowly crafted relative to prior law, it will significantly expand the extra-territorial application of the Advisers Act’s registration provisions for non-US advisers, that manage capital on behalf of US investors. This may, in turn, have the unintended result of restricting access by US investors to the services of non-US advisers, especially advisers in emerging markets where assets under management are smaller and the burden of US registration would be greater.
Important questions remain open regarding the Advisers Act registration and compliance provisions for non-US advisers. For example, it is unclear whether the SEC will treat as “private funds” those non-US funds that do not offer or sell their securities to US persons (even though US persons may acquire such securities in secondary market transactions not arranged by the adviser). In addition, it is unclear to what extent the SEC will continue to follow its “registration lite” practices under prior law. The SEC is expected to propose rules for implementing the registration provisions of the Dodd-Frank Act by the end of 2010, which should provide guidance on these and other issues relevant to registration.
The Volcker Rule
Another important aspect of the Dodd-Frank Act for the private equity industry is the Volcker Rule. Named after Paul Volcker – the former chairman of the Federal Reserve and a prominent economic adviser to President Obama – the Volcker Rule will, subject to limited exceptions, ban banking organisations from sponsoring or investing in private equity and hedge funds. The Volcker Rule does not prohibit a banking organisation from merely acting as an investment adviser to a private equity fund so long as the banking organisation does not “sponsor” or invest in the fund. Similarly, the Volcker Rule does not modify the existing “merchant banking” authority of a banking organisation that qualifies as a financial holding company to make private equity investments so long as these investments are not made through a vehicle that is treated as a private equity or hedge fund. Finally, a banking entity may sponsor and invest in a private equity or hedge fund if it does not own more than 3 per cent of the fund and its aggregate investments in such funds do not exceed 3 per cent of its capital.
However, the Volcker Rule appears to prohibit a banking organisation from investing in a private equity or hedge fund that it does not sponsor. Banking organisations subject to the Volcker Rule include any US-insured depository institution, any company that controls a US-insured depository institution and any affiliate or subsidiary of any of these entities. Foreign banks with US branches, agencies or banking subsidiaries are also subject to aspects of the Volcker Rule and may sponsor and invest in a fund outside the US but may not offer or sell the fund to US investors.
Compliance with the Volcker Rule’s prohibitions is subject to a long phase-in period under a complex set of transition rules. The basic conformance period is four years from the date of enactment (or 2014). The Federal Reserve may extend the period, one year at a time, for up to three additional years (ie, seven years from enactment, or 2014). In the case of commitments and investments to private equity and other illiquid funds in effect as of 1 May 2010, the Federal Reserve is authorised to grant additional extensions up to an additional five years (or 2022).
Again, important questions remain open regarding many aspects of the Volcker Rule, including the scope of the hedge fund and private equity fund-type vehicles that are subject to the Volcker Rule, the ability of a banking organisation’s employees to invest in funds it sponsors, the application of the Volcker Rule to non-US banks with US banking operations and the availability of extended conformance periods. The relevant US regulatory authorities have considerable discretion to adopt regulations implementing the Volcker Rule, and much will depend upon the policy views they take in their implementing regulations and administrative practice.
The Volcker Rule has strengthened a trend, already arising from balance sheet pressures and increased capital requirements, toward the spin-off of private equity and hedge fund operations from US banks. Citigroup, Morgan Stanley, Bank of America and Goldman Sachs are among the banks that have announced restructurings, spin-offs and divestitures of parts of their alternative asset operations and fund commitments due in part to the Volcker Rule. These types of transactions will present both new business opportunities and client retention challenges to practitioners.
Restrictions on Political Contributions
In June 2010, the SEC adopted a rule for advisers in response to scandals in the US over “pay to play” practices by investment advisers involving campaign contributions and other payments (sometimes filtered through placement agents and “finders”) to government officials able to exert influence on the selection of advisers by government pension plans. The rule prohibits an investment adviser from providing advisory services for compensation to a government client for two years (a “two-year time out”), subject to very limited exceptions, after the investment adviser, its senior executives or its personnel involved in soliciting investments from government entities make contributions to certain candidates and officials who are in a position to influence the hiring of an investment adviser by such government client. In addition, the rule prohibits making payments to any person (eg, a placement agent or finder) to solicit a government entity on behalf of such adviser unless such person either is registered with the SEC as an investment adviser or is registered with the SEC as a broker-dealer and is a member of a registered national securities association that has adopted substantially equivalent rules addressing political contributions and “pay to play” practices. Finally, the rule prohibits registered advisers from engaging in “bundling”, which is a practice of soliciting or coordinating contributions from others to elected officials or candidates who are able to exert influence on the selection of an investment adviser or to political parties of a state or locality where the adviser is seeking to provide advisory services to a government entity.
Investment advisers have a transition period to come into compliance with the rule by 14 March 2011, with the limitations on the use of third-party solicitors described above effective as of 13 September 2011. The rule applies to a wide category of investment advisers (including, apparently, foreign advisers to private funds), both those registered with the SEC and those currently relying on the private adviser exemption that expires in July 2011.
Complementing the SEC’s rule, a number of states and localities have required disclosure of, or prohibited, political contributions by advisers and their employees to candidates for public office who can influence the selection of advisers. Other states have adopted bans on the use of placement agents to solicit governmental plans or have required placement agents soliciting governmental plans to register as lobbyists and forgo contingent fee compensation for their services. Given the broad application and complexity of the SEC’s rule and the significant economic exposure associated with a two-year time out, advisers will need to establish strong internal compliance procedures and policies to implement the rule. In addition, the SEC’s rule and similar state or local restrictions will warrant amendments to engagement agreements with placement agents to ensure compliance.
The AIFM
As in the US, the financial crisis has sparked efforts to impose greater regulation on the private equity industry in Europe, principally through the proposed EU Directive on Alternative Investment Fund Managers (the AIFM Directive). As we write this article in late October 2010, the legislation still remains to be finalised (with the legislation’s progress having been the subject of vehement debate for well over a year between the UK on the one hand and France and Germany on the other). However, it would appear that the most contentious part of the legislation (namely the third-country manager marketing issues) has just reached a compromise agreement (the details of which remain unclear) involving a transition period in which the existing private placement regimes of individual member states will remain in place for non-EU managers through 2018 but may then be withdrawn by the European Commission if it has by that time adopted a passport scheme available for non-EU managers.
Impact of Increased Regulation
As we suggested in our article in the previous edition of The International Who’s Who of Private Funds Lawyers, to the extent that increased regulation does not, inadvertently or otherwise, kill the private equity industry, it should provide an expanse of new work for private funds practitioners. In return, those practitioners will need to become (to the extent to which they aren’t already) experts in the regulatory rules affecting their clients (meaning that knowledge of both US and EU law will be essential) and adept at structuring funds to minimise any regulatory impediments that might otherwise threaten the success of a fundraising. These practice needs should reinforce the trend within law firms towards developing greater international multi-jurisdictional capabilities in their private fund practice groups.
The GP/LP Negotiating Landscape
The past year has seen one of the most challenging private equity fundraising markets in our respective careers, as the market has experienced a severe decline in the supply of new capital from investors while the demand from sponsors has been relatively steady. For example, according to Preqin, private equity funds only raised US$101 billion globally in the first half of 2010 compared with US$362 billion during the first half of 2008 (a 72 per cent decline). For the full year 2009, global private equity fundraising declined to US$281 billion (or by 57 per cent) from US$647 billion in 2008.
The causes of the fundraising decline reflect an investor community that is more risk averse, in search of greater liquidity and more capital constrained. Significantly, very few traditional private equity investors have turned their backs on the asset class (indeed, target allocations seem, if anything, to have somewhat increased overall), but as their portfolios have shrunk in the financial crisis and distributions from realisations have dried up, many investors have found themselves over-allocated and have sought to significantly cut back on their unfunded private equity commitments. Some have sought to reduce their unfunded exposure through extensive secondary sales programmes, but in many cases the secondary market has only offered liquidity at an unacceptably high discount to market value. Consequently, many investors have sought to reduce their private equity exposure instead through reductions in the size of their commitments to future funds.
As a result, private equity fundraisings are taking considerably longer, with a series of rolling closings being very much the norm (typically extending a year or more beyond the date of first closing) and with a degree of uncertainty surrounding the ultimate success of the fundraising. Investors have sought to exploit the enormous supply/demand imbalance by making significant demands on terms, the most notable being those relating to the economic package being offered. Terms that were once regarded as being non-negotiable have come under attack, with significant concessions being made on transaction fee offsets and on management fees. Investors have also continued to voice concerns over misalignment of interests and have sought to attack certain clawback provisions and carry models on this basis. Going forward, the ability of fund managers to withstand these economic pressures will be a function of both the demand/supply balance for their particular fund and their own desire to maintain terms at the expense of commitment levels, if necessary.
Investors have sought to apply further pressure through the adoption of the Institutional Limited Partners Association (ILPA) guidelines, which purport to seek greater alignment of economic interest, greater transparency and better corporate governance. The first of these objectives has been contentious, but the latter two objectives have not been strongly resisted by private equity managers who have generally accepted the need for changed standards.
For private equity firms, the net effect of a decline in fundraising, a deterioration in terms and an increase in regulatory and reporting burdens (along with reduced carried interest from fewer realisations and lower valuations) is that both from a revenue and a cost point of view, margins are being compressed and the business looks to be less profitable going forward. Practitioners should not be surprised if clients seek to share some of their pain with their counsel! In addition, the pressure on profit margins will spur a trend that has already been under way for some time, namely the consolidation of assets under management at those firms that are able to be successful in the face of these pressures. Practitioners will need to give consideration to the competitiveness of their clients in developing business strategies for their practices.
The largest investors, such as sovereign wealth funds (which have become a powerful and perhaps dominant force in the fundraising market) and public pension plans, have used their leverage to negotiate special terms, often as part of bespoke “managed account” arrangements operating alongside more traditional fund structures. Sometimes these special terms have been positive or at least neutral from the perspective of other investors (as in fee breaks for investors with larger commitments), but in some cases (as with preferential co-investment rights) the special terms have been viewed negatively by other investors and have introduced friction among LPs in the fundraising process.
For the private equity fund practitioner, the challenging fundraising environment, the ILPA guidelines and the demand by the largest investors for special terms have meant that negotiations between GPs and LPs are more dynamic than for many years. Those practitioners that are likely to be the most successful are those who not only understand where the market currently stands on terms but also can apply commercial arguments to support their clients’ positions. Practitioners who seek to argue that terms should be changed – simply because they are not “market standard” or not in compliance with the ILPA guidelines – are missing the point. Private equity has never been a standardised product, and nor will be the terms applicable to it. There will always be subtleties and nuances that distinguish one private equity firm and its strategy from another; as such, we would suggest that there is rarely such thing as a market norm for all funds. The skill of the private funds practitioner is to know what terms are appropriate for a particular manager, fund and strategy, which in turn requires a depth of knowledge of the market and a clear commercial understanding of the product being offered and its sponsor. The practitioners featured in this edition of The International Who’s Who of Private Funds Lawyers possess that depth of knowledge and commercial understanding.
Getting To a First Closing
In this challenging fundraising environment, practitioners have had to be more creative to support their clients’ fundraising efforts. This creativity has manifested itself in a number of ways, including the creation of incentives to gain participation of investors in first closings. Historically, investors were keen to participate in first closings for a variety of reasons – to do so would enable them to have a greater say over the terms of the fund as well as to ensure that they received their full allocation of commitments.
In the current fundraising environment, neither of these reasons is applicable to the vast majority of private equity fundraisings. Instead, funds are typically undersubscribed at the initial closing and investors are just as able to negotiate the terms of their participation at second and subsequent closings. Moreover, the traditional “penalty” for participating at a subsequent closing, namely paying an interest charge on prior investments at a modest premium to EURIBOR or US Prime rates, fails to serve as an incentive to participate in a first closing. Indeed, with EURIBOR/US Prime being at historic low levels, one may well argue that the “penalty” rate charged is significantly less than the risk-adjusted rate of return appropriate for rebalancing private equity investments among investors at a subsequent closing. As such, investors have little incentive to participate at a first closing, especially since later investors have the advantage of being able to diligently examine any prior investments they are buying into. Such disincentives are potentially fatal to any fundraising; without first closing investors, there can be no fund.
Consequently, private funds practitioners are being asked by their clients to come up with various ways to create incentives for investors to participate in first closings. These are very much early days, and no clear preferred mechanism has yet arisen. However, it is clear that those practitioners who can think “out of the box” and be creative with their structuring of terms will thrive in the current fundraising environment.
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The key changes that we have highlighted will test the skills of even the very best private funds practitioners. Their technical skills will need to be honed on regulatory developments, not just in their home jurisdiction but in foreign jurisdictions too, while their commercial skills will be tested in the new fundraising environment and the newly combative arena of GP/LP negotiations. The successful practitioner will be that rare breed who demonstrates both the highest technical and commercial skills. In that regard, we commend to the reader those practitioners who feature in this edition of The International Who’s Who of Private Funds Lawyers.