Competitive Aspects of Registration of Advisors to Private Equity Fund
By Michael J. Macaluso, DLA Piper LLP, March 6, 2012, originally published by Thomson Reuters Business Law Currents.
March 30, 2012 is less than a month away. On that day the exemption of advisers to private equity funds and other private funds from the requirement to register with the U.S. Securities and Exchange Commission expires, as a result of the Dodd-Frank Wall Street Reform and Consumer Protection Act.
In announcing the new rules under Dodd-Frank on June 22, 2011, Mary Schapiro, SEC Chairman, was quoted as saying: “These rules will fill a key gap in the regulatory landscape. In particular, our proposal will give the [SEC], and the public, insight into hedge fund and other private fund managers who previously conducted their work under the radar and outside the vision of regulators.”1
Meanwhile, in a letter2 which stands out in the increasingly polarized world of Washington for its signatories from both parties, 17 members of the House of Representatives (“Members”) asked for delay of the implementation of the rules as they apply to advisors to private equity funds.
The Members of the House who signed the letter make the argument that the SEC’s “registration requirement [does] not sufficiently consider the nature of private equity funds and the significant differences between private equity and other types of investors.” These differences were pointed out to be the employment of long-term investment strategies, locked in capital and the relative sophistication of private equity investors. In addition, according to the letter, Chairman Schapiro herself stated on October 26, 2011 that the private equity business model is working with a select group of companies and working with management to strengthen them over time.” These are not “systemic risks” but “investments that endure market fluctuations,” the Members point out.
The concerns raised by the Members relating to the regulation of private equity funds deserve wider discussion. Fundamentally, what constitutes a “gap” in the regulatory landscape is not a question the answer to which will be without consequences.
Insufficient attention to such matters in the aftermath of the Enron fraud led to Sarbanes-Oxley3. While one can debate the merits of that legislation, one of its unintended consequences has been a continually decreasing share of US listed IPOs. According to Ernst & Young, the US raised just 15% of global capital in 2011, well below its past 10-year average levels of 28%4 despite the fact that global IPO volume has returned to pre-crisis levels. Another unintended consequence is that some companies choose to remain private to escape the regulatory burdens and associated costs of a listing despite attempts by Congress to lighten those burdens5. Neither consequence is particularly helpful to the capital formation process at a time when private capital should be encouraged to do more of the heavy lifting to return the economy to growth.
Fund managers preparing portfolio companies for listing on an exchange, and the companies themselves, are increasingly sophisticated consumers of a given country’s regulatory attitude, which translates into what this author calls the country’s “regulatory burden efficiency index.” Such an index could easily be constructed by taking into account the cumulative financial and non-financial regulatory burden a company faces in a particular jurisdiction, adjusted for how efficient such regulation actually is in achieving its necessary goals, the transparency of the process, and the cost of navigating the regulatory regime. A good example of how this plays out in practice is the actual case of a specific client attempting to determine the appropriate exchange for listing one of its portfolio companies. Although based in the United States, the manager eliminated the various US exchanges early in the process. What is clear is that clients already engage in a regulatory burden cost/benefit analysis to approximate such an index. To be fair, there are other factors that are taken into account in making this determination, such as how other companies of a similar type have fared in particular markets and the potential valuations achievable in particular markets, among others. However, it is also clear after many meetings in a number of countries with this particular client that the regulatory burden is a non-trivial consideration.
With the March 30 date approaching for private equity advisor registration, it might be useful to take another look at the Members’ letter as it is fundamental to determine whether adding a regulatory burden to a particular segment of an industry is necessary in the first place or would lead to more unintended consequences mitigating against capital formation and the global attractiveness of the US capital markets.
If things remain as they are relative to private equity advisor registrations, private equity funds will have to expend substantial resources to establish and maintain a compliance program. The Members who signed the letter fundamentally understand the issues. In the letter they note that “[s]ubjecting private equity firms to excessive regulation risks hindering our nation’s economic growth.”
In a continuously globalizing world, the old notion that US managers forming new funds groups would automatically form them in the United States also appears to be eroding. This can no longer be taken for granted. US private equity managers seeking to form a new funds group are now having their counsel perform a comparative analysis of the regulatory burden efficiency index in various jurisdictions in addition to the United States, again demonstrating that the US as the situs for the funds company is no longer the going-in assumption for these managers.
The Members rightly point out in the letter that an unnecessary regulatory burden not only misdirects resources the regulated parties have to deploy in order to comply, but also misdirects the resources of the regulator and adds to the cost of government.
In their letter, the Members ask the SEC to adopt a more streamlined registration process for private equity funds. While such a process is certainly welcome, the Members do not go far enough. There is precedent in Dodd-Frank for exceptional treatment of entities that are not deemed to pose systemic risks, particularly venture capital funds. It is time for the Members to consider adding private equity funds to that list by amending Dodd-Frank itself.
Michael Macaluso is a partner in DLA Piper’s global Corporate Finance, Capital Markets and Investment Funds practices. He has a long track record for successfully managing large, innovative and complex matters for some of the world’s leading institutions. Experience includes several hundred billion dollars of completed transactions. He has served as outside treasury counsel and outside general counsel for both financial institutions and funds. In addition, Mr. Macaluso has broad experience representing companies, funds and financial institutions in domestic and cross-border transactions. He has been deeply involved in assisting clients through the capital markets liquidity crises in 1998, 2001 and 2007-9.
Mr. Macaluso is currently an active member of the Thomson Reuters’ Partner Advisory Board.
1“SEC Adopts Dodd-Frank Act Amendments to Investment Advisers Act” US Securities and Exchange Commission Press Release 2011-133, June 23, 2011.
2Letter to Mary L. Schapiro, Chairman, Securities and Exchange Commission, from Scott Garrett and 16 other Members of the House of Representatives dated January 30, 2012
3The Sarbanes–Oxley Act of 2002 (Pub.L. 107-204, 116 Stat. 745, enacted July 30, 2002).
4Ernst & Young Global IPO Trends 2011.
5On July 21, 2011 the SEC adopted rules to implement exemptions from the registration requirements of the Investment Advisers Act of 1940 for advisers to venture capital funds as required by Title IV Dodd-Frank.