Very Public New Regulations for a Very Private Industry

For many years, private equity (PE) relied on light-touch regulation and self-governance, which kept the industry out of the limelight. Those halcyon days now seem to be over.

The passage of a wave of new regulations has opened the door for a new era of post-crisis scrutiny on the once-opaque PE industry. The net effect has placed PE more in the spotlight, in the same way that hedge funds and the big Wall Street banks have garnered more attention.

Demands for enhanced transparency have grown louder over time, bolstered by the media blitz of the last election cycle, increasing allocations from public pension funds and Main Street’s growing exposure to PE via financial sponsor IPOs.

A look back at developments over the last few years sheds some light on this new world of scrutiny and provides more information about the efficacy, efficiency and continuing evolution of regulatory actions.

Transformative Rules and Regulations

PE’s protective shell first began to wear thin in September 2006, when the U.S. Financial Accounting Standards Board adopted the Statement of Financial Accounting Standards No. 157 (SFAS 157), which clarified the meaning of fair value in generally accepted accounting principles (GAAP) as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement data.”

This was a huge change: It directed PE firms to mark-to-market their portfolio holdings instead of holding them at cost. The mechanisms around fair valuation were further outlined in May 2011 with Accounting Standards Update 2011-04, which sought to increase transparency by requiring funds to provide detailed disclosures of the estimates, assumptions and supporting documentation used in all fair value models.

In what now looks like a clear foreshadowing of future actions, the Securities and Exchange Commission (SEC) announced in August 2009 the eventual reorganization of its Division of Enforcement into five specialized units designed to enhance the its ability to protect investors. The largest of the newly specialized units, the Asset Management Unit (AMU), focuses on investment advisers and companies, including PE funds. The AMU is staffed with 75 full-time employees, including PE industry experts, and uses advanced risk analytics to detect problematic fund conduct.

The Dodd-Frank Wall Street Reform and Consumer Protection Act, signed into law in July 2010, brought sweeping changes across many areas of the financial services landscape, including PE. Dodd-Frank eliminated the private adviser exemption, requiring most PE firms to register with the SEC by March 2012. Dodd-Frank also included the Volcker Rule, which limited banking entities to owning no more than 3% total interest in alternative asset funds, in addition to limiting their investment in alternative asset classes to no more than 3% of the bank’s Tier 1 capital.

The full force of these regulatory actions was revealed in September 2011, the first complete fiscal year under the SEC’s finalized restructured enforcement program, when the agency filed a record 146 enforcement actions against investment advisers, a 30% increase over the prior year and a 92% increase over 2009. This marked the beginning of the end for PE’s private persona.

Taking to the National Stage

With Mitt Romney’s ascension in late 2011 as a leading candidate for the Republican nomination for President, his background as chief of Bain Capital served as a lightning rod of criticism against the PE industry from both Democrats and competing Republicans. The popular critiques portraying PE managers as tax-avoiding corporate raiders who profit via massive lay-offs, cost cutting, and over-leveraging, gained widespread media attention for the first time.

In December 2011, as media attention on Romney’s candidacy intensified, the SEC’s enforcement unit sent letters to several leading PE firms as part of an informal inquiry into the industry. The SEC’s stated goal was to investigate possible violations of federal securities laws as well as to deepen the commission’s understanding of myriad issues related to the industry, including how PE firms value investments, impose fees and allocate costs.

The enforcement unit had been heavily criticized in the past for its ineffectiveness in regulating the financial services industry in the period leading to the worldwide economic downturn, and has since taken a more aggressive, public stance in its vow to eradicate corruption and impropriety on Wall Street.

The AMU’s co-chief, Robert Kaplan, explicitly put the PE industry on notice at a conference in January 2012 when he said that “Private equity law enforcement today is where hedge fund law enforcement was five or six years ago.” This was a warning for the industry to expect increased attention and enforcement going forward.

Armed with a clear focus, the requisite manpower and powerful new analytical tools, Kaplan and the AMU set upon a mission to police the previously self-regulated industry. The AMU used the Aberrational Performance Inquiry (API), a proprietary risk analytics engine, to highlight areas for further review. The API helped analyze funds’ investment strategies and other benchmarks to evaluate returns and highlight inconsistent performance. By December 2011, the API had already been credited with six enforcement cases.

In the months that followed, more inquiries and enforcement actions would take place pertaining to a host of private equity activities, including overstatement of portfolio fair value, insider trading, cherry picking, price collusion, misallocation of transaction and portfolio expenses and misstatements made to limited partners.

In October 2012, the SEC announced that newly registered private fund advisers would have to conduct a series of “presence exams” administered through the commission’s National Exam Program. According to the SEC, the exams would review certain high-risk areas. Focus areas included valuation, marketing, security of client assets and portfolio management. Any serious deficiencies would result in an examination summary letter and potential action by the Division of Enforcement.

It does not take a massive leap of faith to believe that the recent increase in the carried interest tax rate was facilitated by this new era of PE scrutiny. Carried interest is the share in profits that PE managers take as compensation when their investments perform well, and is classified as a long-term capital gain, which is taxed at a significantly lower rate than the ordinary income tax rate. In the recent budget deal, lawmakers increased the top rate on long-term capital gains from 15% to 20%. It is still very possible that capital gains may eventually be taxed as ordinary income. According to the Joint Committee on Taxation, such a rate change would result in additional government income of $16.8 billion over 10 years.

What’s Next for the Industry?

It does not seem that the tide of media attention, regulatory scrutiny, and public speculation directed at PE will abate anytime soon. This sentiment was affirmed by AMU co-chief Bruce Karpati, who in January 2013 at the Private Equity International Conference said, “It’s not unreasonable to think that the number of cases involving private equity will increase.”

A near-term focus for the AMU will be identifying “zombie managers,” defined as fund managers who have been unable to raise follow-on investments. The SEC’s thesis is that while most “zombie managers” will continue to act in the best interest of their investors, there will be others who will be incentivized to shift priorities and focus far too much on maximizing their own revenue to the detriment of others, leading to problematic conduct and possible regulatory violations.

This “new normal” of increased regulatory oversight and media scrutiny will lead many PE managers to wonder how to conduct themselves and their businesses in the future.

Robert Rapp, a partner at the law firm Calfee, Halter & Griswold LLP, explains that, “going forward, it will be up to private equity managers to look through the lens of fiduciary duty to understand expectations, identify and resolve conflicts of interest, and know what drives enforcement.”

PE firms must strive to have well-documented, consistent, and transparent policies and procedures, while bracing themselves for the tangled web of uncertainty, disagreement and frustration that comes with an evolving regulatory landscape.

This article was written by John Daly, a member of the Wharton MBA Class of 2013.

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