Eight things we learned in 2019

The Securities and Exchange Commission appeared to take a more lenient stance towards enforcement in the first years of the Trump administration. But the regulator swung back into action in fiscal year 2019, bringing 191 cases against investment advisors and investment companies. This represents a 77 percent increase on the previous year.

77%

Increase in enforcement actions against investment advisors and investment companies

The SEC is most likely to target private funds over their misallocation of fees and expenses. Several firms settled enforcement actions in the past year, including two cases where firms paid close to $3 million to the SEC. The need for firms to ensure proper compliance structures and procedures are in place has never been greater, with the SEC particularly active in targeting firms where the chief compliance officer wears one or more hats. Meanwhile, the fallout from the Abraaj scandal continued in 2019. Founder Arif Naqvi is now facing criminal charges.

And the enforcement landscape will get even more interesting if the SEC pursues its plans to open private markets to retail investors. For the plan to work, regulators will have to be ever more rigorous in scrutinizing managers to ensure individual retirement funds are adequately protected.

Politics has not always been kind to private equity in 2019. Things could get more difficult in 2020, especially if a more radical candidate such as Elizabeth Warren wins the Democratic nomination for president.

The Massachusetts senator has been at the forefront of raising concerns about the way the industry operates, following a series of business failures at PE-owned companies. Her Stop Wall Street Looting Act proposes reforms that would drastically alter the regulatory ecosystem. Carried interest would count as regular income for tax purposes and fund managers would be financially liable for failed investments.

The chances of the Warren bill becoming law are effectively zero in 2020, given that Republicans control both the Senate and the White House. Even if Warren (or another progressive candidate such as Bernie Sanders) wins the presidency, they are unlikely have the votes to push the legislation through Congress. Even so, the danger of public opinion turning against the industry is a long-term concern for private equity.

Many fear that the anticipated AI revolution will result in massive job losses. But artificial intelligence and robotic process automation are only just beginning to make an impact in the private equity industry. And we found in our June issue that technologies that can be readily applied should allow professionals to devote more time to creative and client-facing tasks. We heard from a PE firm that had automated its invoice processing function. This saved 2-3 hours a week – and far from making someone redundant, it freed up time consumed by a low-value task.

“Artificial intelligence and robotic process automation are only just beginning to make an impact”

Relatively few firms have seriously engaged with AI. Our annual Private Funds CFO Insights Survey shows that 70 percent have not even reviewed its application. Part of the challenge is that AI requires a major investment in acquiring and restructuring data, when the payback may not be felt for years.

The potential for private funds to reduce costs and improve processes through automation means the CFO is increasingly focused on tech projects.

Our case studies of three firms that have implemented new technologies reveal a number of common themes. While it is routine for firms to outsource technology functions, a successful project relies on the firm knowing what it wants to achieve before turning to an external partner. Staying focused on the problem and the solution is crucial if you are to avoid being distracted by fashionable technology.

CFOs also face dilemmas in how to strike a balance between pushing projects forward while also achieving widespread adoption throughout the firm. Restricting a project team to a few individuals may help rapid implementation; but can come at the expense of widespread buy-in.

The GDPR, the EU’s data protection behemoth, has become a notorious compliance burden. Private funds (especially those headquartered outside Europe) are still confused over whether they are subject to the regulation and, if so, what they need to do to comply.

“The enforcement landscape will get even more interesting if the SEC pursues its plans to open private markets to retail investors”

The looming introduction of data privacy measures in California, the CCPA, will further complicate the picture. It appears the US is heading toward state-by-state data privacy regulation, a model that is inconvenient to private funds (and countless other industries) that have customers across many states. In practice, complying with the strictest state requirements is the most viable strategy to ensure firms do not fall foul of regulatory standards.

Although private equity firms do not typically collect huge amounts of customer data, protecting the data they do hold is of paramount importance. This is causing firms to focus intently on their cybersecurity infrastructure. Indeed, the CCPA imposes fines of up to $7,500 per violation – so if a database containing thousands of pieces of personal data was hacked, the firm could face fines running into millions of dollars.

GP-led secondaries deals are becoming increasingly popular. Out of $42 billion in secondaries transactions that closed in the first half of 2019, GP-led deals accounted for some $14 billion. This might be surprising to those who remember the days when a GP-led secondaries deal was normally a last-ditch attempt to resuscitate a fund that had gone badly wrong. But in recent years, as PE firms have looked for ways to efficiently manage an investment that still has room to grow beyond the 10-plus-two-years period, they have found that a GP-led secondaries deal can be the ideal solution.

$14bn

Value of GP-led secondaries deals in H1 2019

The biggest challenge is to manage conflicts of interest. The SEC takes a dim view of firms that do not adhere to the highest standards of transparency when in the delicate position of being responsible for selling assets, managing a transaction and possibly even buying a share in the same assets.

What do you do when your firm needs a capital injection to power the next phase of growth?

Very few are now finding that the answer lies in issuing shares on the public markets. It is far more common to enter into a private transaction, often with the biggest players in the industry.

Typically, a firm will sell a minority stake of no more than 20 percent. In some cases, the founding partners look to monetize their shares in the firm, allowing a leadership transition to take place. But in the majority of these deals, the bulk of the capital is reinvested into the firm. This can often fuel new strategies and power expansion into new markets.

Undertaking the transaction itself is far from straightforward. Many industry insiders doubt there is a ‘typical’ way to structure a deal. Methods of valuing private equity firms are shrouded in opacity, although a best guess suggests that a firm may be worth around 10 percent of its AUM.

Our domicile survey revealed, unsurprisingly, that Delaware retains its status as the heartland of private equity. Some 45 percent of survey respondents said it was one of the jurisdictions they would select for their next fund launch.

“Much of Luxembourg’s growth has come at the expense of the UK and Channel Islands”

Next on the list, level with the Cayman Islands, is Luxembourg. Both jurisdictions were the choice of 36 percent of respondents. The Grand Duchy is highly rated for its tax and regulatory frameworks and its business environment.

Much of Luxembourg’s growth has come at the expense of the UK and Channel Islands, as investors seek a European domicile post-Brexit and LPs express concern over offshore funds. Luxembourg has also been proactive in establishing limited partnership regulations that mirror those in Delaware or the UK, thereby offering reassurance to investors. This has given it an edge in its quest to be a hub for funds seeking to comply with the AIFMD.