Most regulators around the world are of two minds about private equity as an asset class. They'd like to woo more private equity onshore to expand successful enterprises and nurture ailing sectors back to health, just so long as foreigners don't control prized assets and no local citizens ever lose a job. Naturally, this often leads to fickle regulatory machinations.
GPs tend to get nervous any time regulators set their sights on private equity. All too often the goal of these regulators is to “do something” about private equity, which often ends with more regulatory red tape, higher taxes, off-limits investment targets, or all of the above.
Not all regulators are scolds of the asset class. This past summer, US Federal Reserve Chairman Ben Bernanke testified that private equity could play a useful role in the country's banking crisis, and there is word that US banking regulations may be relaxed to allow buyout funds to take meaningful stakes in the sector for the first time.
Private equity is most welcome where its presence is seen as making a positive contribution to the local economy. Sadly, only centers of offshore services are uniformly rolling out the red regulatory carpet, so to speak. A number of jurisdictions like the Channel Islands and Luxembourg are improving their tax regimes as they compete for more private equity funds to be domiciled there. However, such competition doesn't escape the attention of tax authorities; more than ever before, they are requiring firms demonstrate real “boots on the ground” in such places to enjoy the benefits of any tax treaty.
What follows is hardly an exhaustive list of the regulatory changes concerning the asset class, but simply those that may have the most impact in the year to come. To be sure, some legislation may give a dealmaker pause, but there's plenty of good news as well. The nice thing about mixed messages from regulators is there remains room for interpretation, so GPs can decide for themselves if the glass is half-full after all.
The US Department of Treasury recently proposed regulations that would expand the types of activities subject to potential review by the Committee on Foreign Investment in the United States (CFIUS) and, among other things, require wider, more stringent, disclosure requirements in response to Committee requests. This may affect how private equity firms operate in the US.
CFIUS gauges the national security implications of foreign investments in US companies or operations, and includes representatives from nine federal agencies, including the departments of Defense, State and Homeland Security, but is chaired by the Secretary of the Treasury.
The Foreign Investment and National Security Act of 2007 demanded a stricter oversight from CFIUS as the bill was largely introduced after the political fallout from the DP World controversy, when a company based in Dubai was about to acquire six major US seaports.
Under the Act, the President of the US can suspend or prohibit any transaction that falls under CFIUS review based on credible evidence that a foreign person exercising control over a US enterprise could impair US national security.
The newly proposed regulations reflect an expansive concept of “control” and less-than-complete acquisitions are now subject to review by CFIUS, including minority investments and joint ventures. The proposed regulations also appear to require more information regarding ownership vehicles to determine who, in fact, has a true controlling interest.
These new regulations are causing some concern in private equity circles for a few reasons. “The new CFIUS guidelines spark two main concerns within [the private equity] the industry,” explains Jim De-Graw, a partner at the law firm Ropes & Gray, based in Tokyo. “For transactions where private equity firms may receive funding from, or team with, a foreign entity, CFIUS considerations will at least need to be taken into account, as these activities may now fall under the jurisdiction of the committee.”
The second concern is that the new regulations may change the nature of foreign LPs' involvement with US-based funds. “Structuring, governance and control considerations [with foreign LPs] may need to be made with CFIUS in mind if the regulations are adopted,” says DeGraw. This added complexity won't be welcome as the LPs most flush with the capital of late hail from countries in Asia and the Middle East – precisely the geographies that make for popular targets by US politicians.
Some critics of the proposed regulations cite a lack of objective criteria in the process, leaving sufficient room for protectionist tendencies to play out. It remains to be seen how proactive CFIUS will be in the future, but many attorneys are exploring ways to comply with the new requirements.
Supporters of the new regulations note that many other countries like China, Japan and Canada gave similar regimes, and these are not unique in their rigor. “A number of firms, including Carlyle, Steel Partners, and TCI, have run into difficulties completing proposed transactions in these countries as a result of regulatory review,” says DeGraw. Though the fact that the US now has a regime reminiscent of China's is hardly a comfort to those trying to raise funds and close deals.
Take my bank, please
This past July, Bernanke praised private equity as a “very good source of capital” for banks suffering liquidity problems in testimony before the House Financial Services Committee. The Committee asked Bernanke about the recent spate of private equity activity in the financial sector, and he affirmed the position of Treasury Secretary Henry Paulson.
“We have encouraged financial institutions to recognize losses and to raise capital,” Treasury Secretary Henry Paulson said at the same hearing. “Because capital is available, [private equity is] a much better alternative than shrinking their balance sheets” or curbing other activities, he said.
The Fed is reportedly considering changing regulations that make it difficult for non-banks entities, such as private equity groups, to take meaningful stakes in bank holding companies. In his testimony, Bernanke pushed for a clarification of a key regulatory hurdle concerning the ownership limits that private equity firms can acquire in banks, saying the Fed is “looking at what constitutes effective control.”
The current limits prohibit investors from acquiring more than a 9.9 percent stake in a bank without incurring stricter regulatory supervision, and should an investor own more 24.9 percent of bank it becomes a bank holding company, which restricts investments outside the banking sector. Given the diversity of industries in most GPs' portfolios, this is a real obstacle. According to Reuters, the Fed has already reached out to The Carlyle Group to discern what hurdles they face when investing in the banking sector.
Critics of the trend worry that private equity firms may be more inclined to engage in reckless behavior to satisfy the demands of their limited partners, possibly endangering the health of the financial institutions they own. The other criticism is that private equity is trying to profit from a crisis they created. Steve Patton of Madison, Wisconsin-based Patton Investments wrote in a letter to The Wall Street Journal that “…Irresponsible private equity LBOs were a cause in the current banking crisis – perhaps not the biggest cause, but a significant one. And now private equity wants to be the solution by buying the banks at fire-sale prices.” It remains to be seen which perception will take hold in the coming months.
Walker fails to satisfy
Sir David Walker's first attempt to create a self-imposed standard of transparency among buyout firms has failed to please UK unions or politicians, dashing hopes for a self-imposed standard that would serve as a model to be adopted throughout Europe. Critics say that Walker's standard applies to too few firms, and still leaves too much of the industry's dealings private. The sustained criticism has led many observers to believe the government will revisit the issue of private equity transparency, with the aim to establish a far stricter code than the one developed by Walker.
“For transactions where private equity firms may receive funding from, or team with, a foreign entity, CFIUS considerations will at least need to be taken into account, as these activities may now fall under the jurisdiction of the committee.”
The British Venture Capital Association (BVCA) asked Walker, the former chairman of Morgan Stanley, to develop the standard in 2007 . When his recommendations were published in November, government and union officials were quick to find fault with the code. John McFall, the chairman of the UK Parliament's Treasury Select Committee, expressed reservations to the BBC about the voluntary nature of the reforms, and the fact that much portfolio company data would remain private. A month later, he called Walker to testify before the committee where Walker defended the standard.
The Trades Union Congress (TUX), which represents many of the employees of private equity-funded businesses, was likewise unimpressed with the code, saying it failed to meet “already low expectations.” The general secretary of the TUX demanded that the government either pressure the industry to revise the standard, adding “bite” to the code or develop statuary regulation for transparency. This past June, Walker himself told Financial News he should have lowered the threshold for which firms would have to adhere to the new standard, but stopped short of suggesting it lacked “teeth.”
Large firms like Terra Firma Capital Partners and Permira have already produced comprehensive annual reports, but few of their smaller peers have followed suit, giving fodder to critics who feel the code is too voluntary. However, some observers expect the controversy over transparency may cool in the coming year. “[UK] regulators' concerns were driven by the megadeals that saw large British companies going private, with the expected decrease in public disclosure and tax revenue,” says David Lakhdhir, an attorney at the London office of Paul, Weiss. “Now, these concerns may well die down, with fewer deals in the spotlight.” Large firms like Terra Firma Capital Partners and Permira have already produced comprehensive annual reports, but few of their smaller peers have followed suit, giving fodder to critics who feel the code is too voluntary. However, some observers expect the controversy over transparency may cool in the coming year. “[UK] regulators' concerns were driven by the megadeals that saw large British companies going private, with the expected decrease in public disclosure and tax revenue,” says David Lakhdhir, an attorney at the London office of Paul, Weiss. “Now, these concerns may well die down, with fewer deals in the spotlight.”
FSA targets ‘conflicts’
In July of this year, the UK's Financial Services Authority (FSA) called for the private equity industry to improve its management of conflicts of interest between the various funds under their management. A Dow Jones News report states that the FSA flagged a number of areas of risk where investors in separate funds managed by the same firm receive unequal treatment, and many managers fail to disclose “adequately” how profits and fees are allocated between various funds.
The FSA polled 250 firms in their review of conflict management programs, visiting several of them. The review found preferential treatment of some investors through the use of side letters, with offers for co-investment and reduced fees. The regulator also highlighted the chance for the private equity firm to co-invest along the fund, at preferential terms. While not suggesting any impropriety in such arrangements, the FSA called for better disclosure of such arrangements to allow LPs to make more informed decisions.
The FSA recommends that better disclosure to all investors would address many of their concerns about such conflicts. The regulator suggested, as an example, that when a GP earns fees for sitting on the board of a company, the firm disclose whether those fees get paid to the firm or the fund, or what the split between the two may be. No formal guidelines were proposed but the FSA said that firms should have policies and procedures in place to address such conflicts, while indicating that 80 percent of those polled had no such process in place.
Channel Islands flee ‘blacklists’
The Channel Islands is moving aggressively to compete with other offshore jurisdictions, and working with tax authorities around the world to avoid tax “blacklists.” Jersey launched a new Unregulated Eligible Investor Funds (UEIF's) regime, with light regulations and few requirements. The Channel Islands also signed Tax Information Exchange Agreements (TIEAs) with a number of countries, which assures prompt cooperation during investigations for tax evasion.
The Islands most recent regulatory initiative is the UEIF's regime. UEIFs need only be limited to sophisticated “eligible investors” defined as those who make an initial minimum investment equivalent to $1 million; persons whose ordinary business or professional activity includes acquiring, managing or giving advice on investments; and individuals whose property has a total market value of not less than $10 million. The UEIFs may be open or closed ended and may take the form of a Jersey company, limited partnership or unit trust. And finally, UEIFs may be listed but only on exchanges or markets that permit transfer restrictions to ensure that only “eligible investors” may acquire the securities or interests.
Aside from the eligible investor criteria, the UEIF's regime merely requires that a company have a registered office in Jersey, a limited partnership have its registered office in Jersey, and a unit trust or a Jersey limited partnership have a Jersey company as a trustee or general partner. “While the minimum investment is higher than in the Cayman Islands, there is no requirement for local audit sign-off and government charges are lower,” argues Ben Robins, a partner in the law firm Mourant du Feu & Jeune, based in the Channel Islands. Aside from the eligible investor criteria, the UEIF's regime merely requires that a company have a registered office in Jersey, a limited partnership have its registered office in Jersey, and a unit trust or a Jersey limited partnership have a Jersey company as a trustee or general partner. “While the minimum investment is higher than in the Cayman Islands, there is no requirement for local audit sign-off and government charges are lower,” argues Ben Robins, a partner in the law firm Mourant du Feu & Jeune, based in the Channel Islands.
Guernsey is taking a wait-and-see approach to offering a similar regime, but several observers expect one sooner rather than later.
One local deal attorney explained that in addition to the new regime, the Islands are acting to avoid blacklists that would make such reforms irrelevant. So the Islands signed TIEAs with Canada, Holland, a number of Nordic countries and France, so there would be a free exchange of information in cases where they may be investigating some ill-gotten gains in tax evasion cases.
“The Islands have shown that they are a location that acts with integrity and they recognize the importance of maintaining strong relationships with regulators and governments throughout the world,” says Brendan McMahon, a partner at PricewaterhouseCoopers CI in Jersey, with responsibility for private equity within the global Investment management leadership team at PwC. “Onshore jurisdictions, such as Holland, recognize that they have equivalent regulatory regimes for investment products.”
Willkommen, venture capitalists
From the current tax proposals on the table, Germany still views private equity firms as “locusts,” as Franz Müntefering, then chairman of the Social Democratic Party of Germany, infamously labeled them in 2005. This past winter, the country was expected to introduce legislation that would revise a 1998 law that treated venture capital and private equity equally for tax purposes. The reform would lighten the taxation on venture funds, while increasing the burden on buyout funds. One version of the law has passed in the lower house of the German parliament, and the legislation is currently up for debate in the upper house.
Should the law pass, the German Federal Banking Authority will view regulated venture funds that are less than 10 years old and invest less than €20 million as untaxable, according to a client memo from the Munich office of the law firm SJ Berwin. However, if buyout funds are deemed to be acting “commercially” they will remain subject to a trading tax.
SJ Berwin gauges that the rule change essentially raises the tax rate on carried interest to 30 percent from 25 percent.
The legislation that already passed in the lower house of the German parliament addresses the transparency of buyout activity, as well. Investors with more than 10 percent of an enterprise have to provide more information about their business goals, according to the bill. The measure also requires greater disclosure in the resale of mortgages and other debts with a focus on making more risk data available to consumers. The law may change as it progresses from the lower house to the upper house of parliament, but the changes may not break the way of buyout firms.
Germany was expected to introduce legislation this year that would revise a 1998 law that treated venture capital and private equity equally for tax purposes. The reform would lighten the taxation on venture funds, while increasing the burden on buyout funds.
‘Lucrative interests’ in the Netherlands
This past June, Netherlands postponed voting on a bill that would raise the maximum tax rate on GPs' profits to 52 percent, the highest rate in Europe. The vote was postponed as critics charged the bill was too vague. The vote is now slated for September after the summer recess.
The current version proposes the 52 percent rate for what are deemed as “lucrative interests,” such as certain shares or receivables. The issue is that the definition of those “interests” was unclear. Not all private equity managers would be taxed at that rate, however. Some may be taxed at 25 percent should they meet certain criteria such as holding a substantial interest in the entity.
One tax advisor told local reporters that the current tax rate on carried interest can be as negligible as 1.2 percent, so the increase to 52 percent would prove a staggering tax hike on GPs' profits. Local critics of the bill support the 25 percent rate across the board, as a way to bring the country in line with other European nations such as France and Germany. If the bill passes in September, it would take effect on January 1st, but some carried interest may be taxed retroactively.
Luxembourg SIFs prove all the rage
Last year, Luxembourg adopted a new law governing special investment funds (SIFs) that created one of the most attractive structures for private equity firms to use in fund formation. “I'd have to say that Luxembourg is the market leader [for European fund structures] at this point,” says Daniel Dunn, a partner in the New York office of the global law firm Dechert.
In addition, Dunn explains that the since the law was adopted on February 13, 2007, many GPs have taken advantage of the new structure's efficiencies in a locale known for its experienced fund administrators. The key reforms include an expanded definition of eligible investors; easier approval process; lighter disclosure requirements; and no shortage of favorable tax provisions. “We've seen plenty of SIFs formed in the last year,” says Dunn.
The popularity of SIFs is easy to explain. According to a recent client memo from Dechert, the legislation enlarges the category of “well informed investors” eligible to invest in SIFs to include professional and institutional investors, as well as anyone who signs a declaration that he or she complies with the status of a “well informed investor,” invests at least €125,000 and has been assessed by an approved credit institution, investment firm or management company to verify that the investor understands the risks involved with SIFs.
Among the other recently added features of the SIF is one that speeds the approval process. Promoters of other “undertakings for collective investment” (UCIs) require approval from Luxembourg's regulatory authority CSSF, but SIF promoters do not. This frees a GP from having to secure substantial share capital, financial means, track record, experience or size before launching an SIF. There are lighter disclosure requirements as well, as the law demands that the SIF merely produce an issuing document, but with no minimum requirement besides allowing for an adequate assessment of the risk.
Last but not least, SIFs pay no tax on capital gains and income received by the fund. SIFs are only subject to the subscription tax and the capital duty of €1,250 levied upon incorporation of the fund or the management company of a SIF. The subscription tax is 0.01 percent calculated on the basis of the total net assets at the end of each calendar quarter. However the law exempts the portion of the SIF assets invested in other UCIs already subject to the subscription tax, certain money market funds and certain pension pooling funds.
For all those benefits, one deal attorney notes that such structures are scrutinized more than ever as regulators in the UK, the US and Japan are vetting such structures to ensure such funds have real decision makers in Luxembourg, not just a brass plate.
“Given the popularity of the Luxembourg and Dutch PE holding company structures, along with criticism in EU circles of abusive cross-border tax structuring, local authorities in these countries are still considering what local tax charges and local presence should be required for firms establishing holding companies in these jurisdictions,” says Lakhdhir. “They know that the best way to avoid charges of state aid or tax haven status is to ensure there is a meaningful local tax burden and/or operational presence, but if the requirements become too onerous you can sap the regime of the its popularity, so at this point they're exploring how to strike the right balance.”
Korea relaxes rules on bank bids
Korea's Financial Services Commission (FSC) introduced a deregulation plan this year for the banking industry that would allow private equity firms and pension funds to exceed the current cap that bans any non-financial company from owning more than 4 percent of a domestic bank. The proposal requires approval from the National Assembly and the timetable remains in flux for when the reforms will take place.
The FSC announced the three-stage deregulation proposal as part of its policy report to President Lee Myung-Bak on March 31st. The first stage of the plan is devoted to easing rules that restrict private equity firms and pension funds from owning more than a 4 percent stake in the bank. Both groups are considered non-financial parties due to their heavy reliance on capital committed by non-banks. Under the current law, if a non-financial company owns more than 10 percent of a private equity limited partnership, the fund is considered a non-financial firm. The regulator is currently reviewing the possibility of raising the cap to 20 percent.
“The government plans to permit non-financial firms to expand their investments in banks through private equity funds or pension funds to beef up competitiveness and speed up the privatization of state-owned lenders,” the FSC said in the report.
A second stage of the Korean deregulation plan involves lifting bank-ownership cap for non-financial firms, beyond private equity and pension fund bidders, from 4 percent to 10 percent. The third stage will remove the ownership restrictions altogether, with parties applying to FSC for consideration to be a major shareholder in a bank.
Local commentators suggest these latest reforms are driven by FSC's aim to sell a 49 percent stake of the state-run Korea Development Bank (KDB) by 2012. “We will turn KDB and its affiliates into a holding company system this year and enter selling procedures next year,” Jun Kwang-Woo, chairman of the FSC, announced in a press conference on March 20. In response to the report, President Lee was supportive of the deregulation plans and called for the FSC to pursue such initiatives aggressively. “Our top policy priority is to ensure the private sector drives the development of the financial industry,” Lee said.
India seeks to level playing field for locals
This past August, KP Krishnan, the joint secretary of India's finance ministry, announced plans to reform how private equity and venture capital funds are regulated. The reforms may include a registration of funds, tax proposals to encourage investment in high-risk sectors, and revisions to tax treaties that are viewed as favoring foreign GPs at the expense of local firms.
Another finance minister told the Financial Express, a local media outlet, that discussions were already under way between the finance ministry and the market regulator the Securities Exchange Board of India (Sebi) to propose a series of reforms of how the country regulates private capital.
Krishnan indicated that the government was going to help protect local venture and buyout funds from foreign competition. “What we need cannot be gained from foreign venture capital alone. The bulk will come from domestic venture capital,” Krishnan added. Currently many foreign funds registered in Mauritius and Cyprus do not pay any tax on the capital gains earned from their investments in the country. Krishnan explains that the new initiative would strive to ensure that both foreign and domestic funds face the same level of taxation.
One Sebi official spoke of a proposal that may make it mandatory to register venture capital and private equity funds with the regulator, after it had compiled sufficient data about venture and private equity activity in sectors such as real estate, IT and education. At the moment of the announcement, 97 out of the 111 firms active the country are already voluntarily registered with Sebi, so the official stressed that the industry was not plotting overly strict procedures to do so.
Krishnan also said that it would take time for the new regulatory mechanism to be developed along with the tax incentives for those firms intending to invest in high-risk areas, though he did not define what those areas would be. He also suggested that the government may restrict specific sectors, such as real estate, from receiving capital the regulator would prefer to be placed in more neglected industries.