Outlook 2013: Compliance

Gone are the days of expenditure only in crisis. Increasing regulatory and investor-led requirements now present significant non-deal costs and risks for sponsors. Compliance reporting and auditing is an emerging business for advisors and there is debate as between them and their portfolio companies as to where these costs should sit.
 
Private equity sponsors are facing ever-increasing challenges and suffering a greater compliance burden as a result of the changing regulatory landscape. Much of this new regulation is not aimed specifically at the private equity industry, but has had the effect of moving the point of liability for the actions of portfolio companies to the sponsor level, increasing the accountability of the private equity sponsor.

Examples include the Carbon Reduction Credits and FATCA which is aimed at all financial institutions. Additionally there are liabilities which can pierce the corporate veil of the portfolio company e.g. environmental and pensions liabilities can be attributed to sponsor owners or sponsors. In addition as a result of the increased political focus on alternative investment sectors such as private equity posing a perceived risk to the financial system, there is also specific regulation of the industry coming in the form of the AIFM directive which will impose for the first time sponsor-level restrictions and requirements on portfolio company disposals and reporting of portfolio company information.
 
Separately, investors, who are increasingly conservative and institutional, have their own ethical and, in the case of sovereign wealth funds, cultural standards which, given increased investor power in the current fundraising environment, they are seeking to work into fund terms and investor specific side letters. As a result they are seeking to impose compliance obligations on sponsors to address ESG issues and general compliance (anti-corruption, anti-trust and sector-specific regulation) as a condition for receiving investors’ funds. Investor requirements include limitations on investment in geographies and sectors of investment, requirements to follow a socially responsible investment policy or comply with specified ethical standards and expectations of mature compliance cultures and systems in portfolio companies. Accordingly, sponsors now implement forensic compliance due diligence on new deals and have on going periodic reporting obligations to investors regarding compliance issues at sponsor and portfolio company levels.
 
The stakes are high as falling foul of compliance covenants with investors through, for example, the inadvertent grease payment made by a portfolio company’s agent or the over-zealous salesman who attracts the interests of competition authorities, harms not just PR and financial returns but can lead to contractual liability to investors and investor excuse rights as the vicious cycle of PR continues. Whilst the political environment remains hostile towards private equity the impact of these increasing regulations and investor demands presents such significant risks and corresponding cost to the sponsor’s business that it will sit at the heart of operations going forward.

Based in London, Ian Bagshaw is the co-head of Linklaters' private equity practice.