Praise lavished, problems flagged

With bated breath, UK private equity professionals last month pored over a near 100-page report from the Financial Services Authority (FSA) to see whether the regulator was delivering to the industry a pat on the back or a slap in the face. In the aftermath, opinion was divided.

?Private equity: a discussion of risk and regulatory engagement? was billed by the FSA as a report that aimed to ?stimulate informed discussion? and ?clarify our current assessment of the risks posed by the private equity market.?

A number of subsequent press dispatches suggested that the report's authors were alarmed at the level of risk they discovered. ?FSA turns up the heat on private equity? was the interpretation of leading business daily the Financial Times, for example. It focused on the report's warning that ?the default of a large private equity-backed company, or a cluster of smaller private equity-backed companies, seems inevitable.?

As buyout debt continues to skyrocket, so the risk of default is growing in tandem. The argument that a high-profile failure is likely to arise sooner rather than later would probably meet with little disagreement, even within the industry. Nonetheless, it's a long way from acknowledgement of this unsettling prospect to devising punitive new regulations – and the prospect of the latter does not appear to be on the immediate agenda.

By contrast, the FSA went out of its way to stress that the report would not be a precursor to formal regulation and concluded that the existence of private equity did not raise systemic risks. It even went so far as to acknowledge that the private equity industry was now one of London's key strengths as a financial center.

Conclusions such as these unsurprisingly drew praise from industry spokespeople. Peter Linthwaite, chief executive of the British Venture Capital Association (BVCA) proclaimed: ?The report?is a useful contribution to the understanding of the industry. It also explicitly highlights how important the industry has become to keeping the UK economy dynamic and competitive.?

The report was also applauded by the EVCA, the industry body for European private equity. Javier Echarri said the FSA was taking ?a very down-to-earth and constructive principles-based approach to regulating? and expressed the hope that ?this will encourage a similar approach from continental European regulators.?

Only two areas were identified by the report as high risk and therefore meriting further formal investigation: conflicts of interest (such as when the director of a fund manager is also the director of a portfolio company) and market abuse (potentially an issue in large public-to-private auctions where, in some cases, hundreds of people get access to privileged information under confidentiality agreements).

In both of these areas, there is a view that private equity houses have already taken considerable steps to ensure their houses are in order. James Perry, a partner and regulatory specialist at London-based law firm Ashurst, says fund documents relating to potential conflicts ?actually go further than is required by law? while firms adhere to solid compliance procedures designed to mitigate against market abuse.

Perry says the reason for the FSA highlighting these areas is that they are particularly important and it wants to underline how seriously it is taking its obligation to monitor them. ?The FSA is simply saying ?we're keeping an eye on things? and, as the industry regulator, it's their job to do that,? he says.

In many ways, the report smacked of a regulator determined to tread very carefully in a market where the activities of private equity firms are arguably already more tightly governed than in the US and most of Europe. Nonetheless, by drawing attention to the frothy debt market, the report – however unwittingly – made its own contribution to the harsh media spotlight to which private equity has recently been subjected. It's a sobering thought that not everyone will read beneath the headlines.

Sarbanes Oxley to ease somewhat
SEC chairman Christopher Cox has indicated that key provision of the Sarbanes Oxley Act will be clarified, a move that is expected to ease the burden of being a publicly traded company in the US. The most complained-about provision in Sarbanes Oxley is Section 404, which requires companies to self-certify that their corporate governance systems are sound before hiring an outside audit firm to test the system. SEC chairman Christopher Cox last month sent a letter to the Public company Accounting Oversight Board urging it to include the SEC's impending recommendations.

Novak Biddle promotes CFO to partner
Bethesda, Maryland-based venture capital firm Novak Biddle Venture Partners has closed its most recent fund and announced a string of promotions, including the promotion of chief financial officer Joy Binford to general partner. The firm recently closed its fifth fund on $227 million (€178.5 million). Other promotions included the naming of Philip Bronner, Andrea Kaufman and Tom Scholl to general partner. Prior to joining Novak Biddle, Binford worked for InterCAP Graphics, a producer of technical illustrations. She received a Bachelor of Arts from The American University. The firm was co-founded by E. Rogers Novak, a former investment banker and entrepreneur, and AGW Biddle, the former CEO of software company InterCAP Graphics Systems.

Clock ticks away on Section 470 reform
The National Venture Capital Association is lobbying for the Tax Technical Corrections Act of 2006, which would narrow the scope of Section 470 of the Internal Revenue Code, a tax loss deferral rule that would affect several VC funds. The rule was first proposed to prevent ?sale-in, lease out? (SILO) transactions that were viewed as tax abusive. Due to concerns that partnerships could be used as SILOs, the rule was expanded to apply to any partnership that has both taxable and tax-exempt, or foreign, partners, and has income or loss allocations that are not strictly proportional or ?straight-up? allocations. Given the number of foreign and tax exempt LPs, and the allocations required to implement a GP's ?carried interest,? almost all venture capital organizations fall within the rule's jurisdiction. The Treasury Department has already postponed the effective date of Section 470 for such partnerships twice, but without further relief, calendar-year VC funds would have to comply for the 2006 tax year. This would demand that VC funds incur the costs of discovering if any tax losses, and what portions of those losses, would be deferred in any taxable year.

UK Company Law as vague as ever
According to a client memo from London-based law firm SJ Berwin, the UK's new Company Law, soon to be passed by Parliament, leaves major questions unanswered as to what duties a British director owes his or her company. The legislation aims, among other things, to codify a director's current responsibilities under the law in a clear and concise fashion. The question of particular interest to private equity pertains to conflicts of interest. While assurances abound that the new law simply re-states laws already on the books, many find a new rigor towards any ?situation in which he (the director) has, or can have, a direct or indirect interest that conflicts, or possibly may conflict, with the interests of the Company.? Most non-executive directors, as in the kind appointed by private equity firms, don't believe they have any responsibility to avoid these conflicts, simply manage them. The new law provides exceptions where independent directors have ?authorized? the conflict. But such exceptions are ill-de-fined, leaving the private equity appointed director to cross their fingers and hope they're standing on the right side of the law.