Clarity sought in PE rulemaking

Some years after the financial crisis that set in in 2008, and after a considerable back and forth lobbying effort, the unprecedented rules and regulations crafted to supervise GPs are inching closer to (or already have reached) their implementation dates. Nonetheless, many private equity firms are still undecided on how to tackle this regulatory challenge.

“The biggest issue is not only the regulation itself but the uncertainty of how the regulation comes out,” says Philippe Bucher, chief financial officer of European fund of funds Adveq. When asked to identify which particular provisions or incoming laws are most troubling, Bucher said most were still too undefined at this point in time to name specifics.  

A prime example is the US Foreign Accounts Tax Compliance Act (FATCA). Passed by Congress in 2010, FATCA requires foreign firms to provide US tax authorities the name, address, tax identification number, and other key financial details of their US investors or suffer a 30 percent withholding tax on certain US-connected payments.

Critics have slammed the law as overstepping its jurisdictional reach, requiring firms to implement new reporting and payment systems to meet US standards and possibly violate local data privacy laws. However the US Internal Revenue Service, which is in the process of revising its reporting forms, still hasn’t made clear exactly what information will be required.

Perhaps as a result of this uncertainty firms have yet to complete a huge amount of work to comply with FATCA, noted Ernst & Young partner Ashley Coups in a client memo. Instead firms are likely waiting until the end of the year before they start with any “know your customer” work that would enable them to identify US individuals for reporting purposes.

“The process may be burdensome for a fund manager with many investors, or one who doesn’t keep centralised information or have retrieval systems for its existing processes,” adds Peter Schuur, a tax partner at law firm Debevoise and Plimpton.

Peter Schuur

For those without such systems and processes Schuur advises managers start evaluating what information they do have and what systems they can put in place to collect and organise this extra data.

Another consideration for managers is whether or not to start gathering extra data from investors now, or whether to wait until the forms have been finalised before potentially annoying investors with extra questions that might not be pertinent.

In Europe the main regulatory priority for GPs has been the Alternative Investment Fund Managers Directive (AIFM), a pan EU-marketing regime for private fund managers that is still in the rulemaking process. However, despite the uncertainty in how the directive will look once it enters effect in July 2013, GPs will not for the most part experience significant stress in complying with its provisions says Sue Woodman, general counsel at Equistone Partners, formerly Barclays Private Equity.

Adveq’s Bucher doesn’t see much more work to follow if a firm is already regulated within its own jurisdiction. He adds the reporting requirements for the AIFM are not expected to be difficult to file. 

“What the directive requires is additional administration that of course can be done,” says Woodman.

The real challenge of the AIFM centres on how to set in place an implementation plan, says Coups. He addresses the test of completing a gap analysis which measures where firms are, versus where they need to be – a process made even more difficult by a directive that has yet to be finalised.

There’s been a degree of lethargy over the last couple of years concerning the Directive’s requirements but with details emerging GPs now appear to be taking the law’s implications more seriously, added Coups.

One aspect of the AIFM causing significant concern is the need for EU firms to register their private placement memorandums with their home regulator. Before the memorandum can be issued to potential investors it will have to be sent to the country regulator, such as the Financial Services Authority (FSA) in the UK, who has ten days to approve it before marketing is permitted.

However, terms of the registration are not yet known and questions surround the capacity of regulators to handle the process.

“If they receive several on consecutive days will they have the manpower to do anything meaningful in terms of approval?” wonders Woodman.

Any changes after registration will then have to be notified to the FSA, or other regulator, who will consider the changes. This has led to concerns that the amount of time needed to close commitments on agreed terms will lengthen.  

Rules affecting fundraising are also being felt in the US with the Dodd-Frank Act forcing firms to disclose greater information to the Securities and Exchange Commission (SEC).

“SEC examiners will be spending a lot of time reviewing disclosure and marketing materials, especially any material that includes information on prior performance,” says Ken Berman, US –based partner at law firm Debevoise & Plimpton.

Another important area for the SEC is how GP’s are valuing their portfolio companies. “Valuations are easy if you have realisations, but if certain portfolio positions have not been realised, and the performance numbers are based in part on the current values of unrealised portfolio positions, the SEC is going to want to look at that process used to arrive at those valuations,” notes Berman.

And “if you look at the valuation cases that the agency has historically investigated, the staff tend to look at not only if your policies are reasonable but whether you materially deviated from them in arriving at your portfolio valuations” says Rob Kaplan, partner at Debevoise & Plimpton and former co-chief of the SEC’s unit responsible for investigating private fund managers.

“The [SEC] can and has brought fraud cases against advisors that have deviated from their valuation policies and procedures, and is of the view that a case doesn’t necessarily have to prove that the valuations were materially incorrect, just that the investment advisor made certain representations about their valuation processes to investors, and that those representations proved to be inaccurate,” Kaplan adds.   

This is not just an issue for US firms however. Registration with the SEC under the Dodd-Frank Act is a requirement of many overseas firms. There is of course the “private fund adviser exemption”, which foreign firms with US investors qualify for, but Woodman argues this is no exemption at all.

“It means that they are exempt from registration under the US Investment Advisers Act but they will not be exempt from, and will have to comply with, the reporting requirements of the SEC which can investigate and check on firms when necessary. So, many UK firms [for example] now fall within the remit of the SEC as well as the FSA – not necessarily a happy position,” says Woodman. 

Another daunting regulatory challenge for US firms will be Form PF: a rule that requires firms to disclose information on counterparty dealings, leverage and investment so that regulators could spot any brewing systemic risks within the industry. 

Smaller firms will escape this challenge but SEC-registered firms with $150 million or more in assets under management (AUM) will be required to file annually starting from next April. Very large private equity firms should be aware, however, of falling foul of the “large hedge fund manager” classification which could come with quarterly filing duties starting as early as this August.

The SEC stated that a private fund would not fall under this classification as long as it doesn’t “borrow an amount in excess of one half of its net asset value” or sell securities or other assets short (with an exception for hedging exposure to interest rates or currency risks). But some are still likely to fall within this classification, warn legal sources, who as an example point to firms that sell short to hedge a position in a publicly traded portfolio company.

Some of the daunting filing obligations awaiting private equity firms with more than $2 billion in assets under management include information on the indebtedness of certain portfolio companies. They would also need to break down by location and sector each portfolio company in a fund and provide certain financial data for any portfolio company in the financial services sector. 

“They should start the process by considering how they are going to pull all the information together. For private equity firms some of that data is going to have to come from portfolio companies and this may prove difficult to get from some companies on a timely basis,” warns Berman.

For those that haven’t made inroads into their Form PF preparation Berman advises they first assemble a team from different divisions of the firm. “They need their compliance people, their financial and accounting people, their investor relations people and the people who generate the data for performance reports.”

“It is fair to say that advisors need to take Form PF seriously, and that completing the Form accurately and completely may require the advisor to engage a number of employees to assemble the data from multiple sources,” adds Kaplan.

Indeed with implementation of many new regulations already here or looming, GPs still without clarity should be regularly keeping track of updates but also reviewing their current information and systems.  Preparing for the unknown is difficult but increased focus on the regulations now will put them in the best position to ride what has become a tsunami of new rules.