The regulation roundabout

There’s no jurisdiction to run to, and no jurisdiction to hide in; regulation continues to close in on fund managers regardless of where they base their operations.

Over the past six years, private fund firms have adapted well to regulatory oversight, be it increased scrutiny from the Securities and Exchange Commission, compliance with the Alternative Investment Fund Managers Directive or global initiatives like the Organisation for Economic Co-operation and Development Common Reporting Standards.
Speaking to pfm in April, former chairwoman of the SEC Mary Jo White said the industry has responded diligently to the changing environment and corrected the practices the agency found to be problematic. But a compliance officer’s job is never done. Political change, particularly in the US and Europe, is likely to affect existing regulation and could herald a new era in oversight of the private funds world – for better or for worse.

The US: Regulatory seesaw

President Donald Trump has made his thoughts on regulation clear – there’s too much of it, and it’s hurting the US economy. He has vowed to strip back the Dodd-Frank Act, which includes the Volcker Rule restricting the amount of capital banks can invest in private equity.

The administration plans to replace this with the Financial Choice Act, which is currently making its way to the Senate. The draft bill proposes both the elimination of the Volcker Rule and SEC registration requirements for private fund firms.

But even if the bill does pass, its provisions may change significantly as it passes through the political system. As such, lawyers are quick to rule out extensive roll backs on regulatory obligations for managers.

“Nobody should be firing their CCO or ditching their compliance policies,” David Winter, co-head of global fund formation at law firm Hogan Lovells, tells pfm. “The compliance landscape in the US is driven as much at the staff level of the SEC as at the political level, and our operating assumption is that changes, if any, will be modest and gradual. That being said, some practical change might occur simply owing to expected SEC resource constraints.”

Then there’s changes within the SEC. Under the stewardship of private equity lawyer Jay Clayton there was talk that the agency may be more lenient toward private fund firms.
“Regarding the new administrations at the SEC and the White House, the market may hope for less vigor in examinations and a reduction in enforcement actions,” says Rob Goldstein, a private equity transactions partner at McDermott Will & Emery. “There may also be a slowdown in SEC activity as the chairman will have to make appointments, and that will delay some of their work.”

Clayton has yet to provide clear direction for the SEC, but with his background, he may view private equity as a more mature market, Goldstein says.

“The LPs are sophisticated and may not need as much regulatory protection,” he adds.
The opposing view is that the SEC’s scrutiny of the private funds industry may increase as it tries to get a better understanding of the market.

“Some of the rules are more difficult for private equity to adopt and implement, because SEC rules are generally expected to be applied across all asset classes,” says Frederick Shaw, chief compliance officer at global private equity firm Hamilton Lane.

“There are aspects of private equity investing – including private debt or fund of funds – that are fundamentally different from public market investing.”

The challenges of standardizing regulation for private equity mean the SEC has been reliant on tacit rule making, but Shaw says this is understandable, given the complexities of the industry. In some cases the SEC has provided clarifying commentary in the form of FAQ documents to private equity firms around some of the rules and expectations.

“It would be great if there was a specific ‘private equity playbook’, but this wouldn’t be practical, because we operate so differently even within this industry. Outside of this we use market news and external counsel to stay on top of regulation. Any more clarity the SEC could give on their expectations would really benefit us,” he adds.

Europe: A chip off the old bloc

Just over a year after the UK voted to leave the EU, it’s still unclear what its trade relationship with the rest of Europe will be after Brexit. What we do know is that once the UK leaves the union it will become a third country, meaning managers will be unable to automatically market their funds to European investors.

Some UK managers, including BC Partners and EQT have set up operations in Luxembourg, while managers including Carlyle and Blackstone are reportedly eyeing the country as a new European base so they can continue marketing its funds to investors. Hamilton Lane is also pondering its European future.

“We’ve seen news of managers making moves out of the UK. At Hamilton Lane, we’re not waiting to see where the wind blows,” says Shaw. “We’re reviewing which locations would make sense to operate from, though I don’t anticipate we’ll move wholesale from London.”
Managers that opt to remain in the UK without a European base will join other offshore managers already grappling with the uncertainty of how to market funds into the EU. Currently, they can market alternative investment funds to EU investors only where permitted by National Private Placement Regimes and subject to compliance with certain AIFMD disclosure and transparency obligations. Technically, the NPPR is due to be replaced by a passporting scheme in 2018. Whether this will happen is another unknown. While the European regulator has carried out assessments of countries that have applied for a passport – some of which it recommended received one – it has also said that the scheme is flawed.

The chairman of the European Securities and Markets Authority told the European Parliament its framework was a “patchwork of arrangements” lacking consensus on how to consistently implement the passporting rights across all EU member states.

There is also little enthusiasm for the passport among the funds industry.

“There is plenty of capital available inside the EU, and plenty of EU funds to commit to. [Passports] will be nice to have, but it’s not going to account for the bulk of business,” Fabio Galli, director-general of the Italian asset management society told delegates at a conference in November.

What is more certain is that few changes will emerge from a wholesale review of the AIFMD. Originally scheduled to take place in 2017, this review has been pushed back to 2018 and this year the European Commission will review the directive’s efficacy, and whether or not it has created barriers to entry for cross-border fund distribution.
The anticipated status quo is good news for fund managers that are regulated under the AIFMD; following initial skepticism, most have embraced the regulation and view it as a good framework within which to run a fund.

Asia: External control

Region-specific regulation is of less concern for managers in Asia, but global initiatives such as the OECD’s Base Erosion and Profit Sharing initiative and Common Reporting Standards pose regulatory challenges.

“This year we’ve had the introduction of CRS, which has been a big undertaking for Asian fund managers. They’ve had to go back to investors collect more information on their taxes, regardless of where they are based,” says Andrew Read, partner and head of Asia, at fund administrator Langham Hall.

Compliance has been difficult for many Asian firms; the requirement to open an account with banks that don’t necessarily understand private equity capabilities has been a challenge.

“Some of the obstacles can appear unsurmountable, but firms must persevere. Deals can still get done, they just may take longer,” Read says.

Luckily for firms in the regions, it’s unlikely the regulatory burden will increase over the coming 12 months, BEPS and ongoing CRS compliance aside.

“[Asian managers are] well informed on CRS and taking action,” says Read. “We don’t know how BEPS will work yet, so there’s no point taking action now, potentially overreacting, and then incurring unnecessary costs.”

With so many political issues still up in the air, it’s too early for anyone to advise firms on the best course of action to take to prepare for regulatory change. But, if the past is anything to go by, they will be well equipped to deal with anything that comes their way once the starting gun is fired. ?