Taking the 'private' out of private equity

As the US Securities and Exchange Commission scrutinises the way some general partners value their assets, particularly in connection with fundraising, an important question to ask is whether the information available to LPs is adequate and accurate for them to make informed decisions about committing to a fund.

I would argue the answer is yes. The private nature in which private equity capital is raised allows for an iterative conversation with investors, where, if they have questions, they can get answers. If you call Schwab to buy a share of Apple, you can’t ask Apple a question and expect to get an answer. When a private equity fund is out raising, you can ask the principals a question and decide whether or not you’re comfortable with the answer. It’s that fundamental difference in the capital raising aspect of private equity which, together with the sophistication of the investors, I would argue, is what really mitigates against the need for a lot of the formulaic protections that the SEC has determined are necessary in the public market.

But the SEC’s recent inquiries into private equity are really just part of a larger trend that is increasingly taking the “private” element out of private equity. The increased scrutiny will not be a passing issue, and has been amplified by the Dodd Frank registration requirements and even the press coverage from the presidential election.

Andrew McCune

Hopefully, it will turn out that the SEC is seeking information in part to determine whether or not there is an issue they think requires rule-making. I’ll put my bias on the table right now. I hope that determination is that there is not a need for rule-making.

While diminishing  private equity’s private element will not necessarily be a fatal blow to the industry – private equity hasn’t been successful simply because it’s private – the fact that it has been private has reduced the costs in that part of the equity market, and that’s one of the reasons people gravitated toward deploying capital in private equity: the costs were lower.

If the SEC concludes market practices have been such that the private equity market has become too large and too established for it not to be more regulated (whether regulation may or may not be worthwhile being a separate question), it will invariably add costs. And costs create barriers to entry, reduce returns, etc. If there is a correct determination that there are abuses in the market and that increased regulation can fix or prevent those abuses, then people can debate whether or not the added costs are worthwhile.

As a result of new or anticipated regulation, we’ve seen in-house fund of funds operations at commercial banks spun-out based upon an expectation they will get swept up in the Volcker rule as a use by a commercial bank of its proprietary capital for trading strategies. That’s one of the areas where I think the remedy was broader than the area for possible abuse. I question the effect of running a fund of funds on the risk to or volatility of a bank’s financial condition. That’s different than a bank using its capital for proprietary trading, but they fall in the same bucket in large part.

There was a reason why those in-house fund of funds came to be in the first place and were successful. If you think that such an offering was in response to a market demand – and I think you have to because most large commercial banks had them and had substantial ones – you are taking away something that the market otherwise is saying it wanted and attached value to. Obviously most of those investment professionals are going to try and replicate, to the extent they can, those models outside of the commercial banks.

Will they be as successful? That’s a question that has yet to be answered.

Andrew McCune is a partner at McDermott Will & Emery.