Under their thumbs

Ten regulators around the world who matter to the private equity industry, and why.

Ten regulators who matter

Charles Grassley Hector Sants
Senator CEO, Financial Services Authority
United States United Kingdom
Chuck Schumer Charlie McCreevy
Senator Commissioner of Internal Market and Services
United States European Commission
Barney Frank Christine Lagarde
Member, House of Representatives Minister of Finance
United States France
Christopher Cox Alexa Lam
Chairman, Securities and Exchange Commission Executive Director,
Securities and Futures Commission
Hong Kong
Alistair Darling Bo xilai
Chancellor of the Exchequer Minister of Commerce
United Kingdom China

All populism is local
The summer of 2007 may well be remembered as the season the US Congress discovered alternative assets. Both houses of the legislative branch held hearings on the industry, resulting in proposals that included redefining carried interest within the tax code as ordinary income, not capital gains. Ordinary income is taxed currently at 35 percent, compared to 15 percent for capital gains. However, the fate of the industry's tax status may reside in the hands of two lawmakers in particular, and their ability to make their case for their constituents, an advocacy that veers sharply from their party lines.

Charles Grassley, a Republican senator from Iowa, co-sponsored a bill with Max Baucus, a Montana Democrat, that would tax the income of certain publicly traded partnerships as corporations, nearly doubling the tax rate for publicly traded private equity firms and hedge funds. As a ranking member of the Senate Finance Committee, Grassley is well positioned to press his agenda, especially as his contrarian stance falls in step with the current Democratic majority in Congress.

?Some have inaccurately described this bill as an attack on capital formation and as a tax increase on a single industry,? Grassley says in a statement on his web site. ?But this issue is about closing a loophole, not raising taxes. Our bill merely clarifies that firms that manage private equity funds and hedge funds will be treated no differently than their competitors or any other active business that goes public.?

Grassley's role as a sponsor of the bill bestows that treasured quality of ?bipartisan? support at a time when many Democrats remain sensitive to charges of being tax-and-spend liberals. However, much as the senator may be breaking ranks from his party to support the tax change, he's risking little of his homegrown support.

While supporting closing the loophole on public traded partnerships, Grassley is also advocating tax credits for alternative fuels, including corn-based ethanol (there's a lot of corn in Iowa). Having been elected by wider margins in each subsequent campaign, Grassley demonstrates he knows his voters' priorities: higher taxes may be far more palpable for alternative asset managers in New York than local farmers.

Shaking the hand that feeds him
If the bill from Senators Grassley and Baucus enjoys bipartisan support, it also suffers from bipartisan criticism. There was little surprise when Republicans in the US Senate were quick to express misgivings about the bill, but when an influential Democrat like Chuck Schumer from New York urged caution, the words had weight.

Much as Grassley may safely suggest revising the tax code for businesses operating well outside his state, Schumer can't ignore the fact that New York is a hub for the financial services sector. According to the website of nonprofit, nonpartisan research group opensecrets.org, the securities and investment industry contributed more to Schumer than any other sector, totaling roughly $2.5 million in support. The New York senator also sits on the Senate Finance Committee which ensures he'll have his say. But Baucus, who introduced the tax change, is chairman of that committee.

Schumer's influence in the carry tax debate is far less official than the other two Senators, but still substantial. Widely credited as the Democrat's most successful fundraiser in the Senate, Schumer is viewed as one of the primary architects of his party's electoral victory in 2006. Few within his party would cavalierly disregard the misgivings of someone who could tap Wall Street support in 2008.

Furthermore, Schumer is critiquing the proposal with some savvy. When he expressed his reservations, he explained that it singled out private equity firms and hedge funds exclusively. He suggested that other publicly traded partnerships be included as well, from real estate, to oil and gas, to timber and agricultural investment vehicles. If the proposal widens beyond financial services, observers expect greater opposition to the bill. Schumer explained to Dow Jones, ?My state may depend more on financial services, and Texas may depend more on oil and gas ? it's unfair to treat one region differently than another.?

First up, carried interest
Barney Frank, a Democrat from Massachusetts, serves as the chairman of the Financial Services Committee in the US House of Representatives. His language concerning alternative assets has been far softer than many of his fellow Democrats, but he has co-sponsored a bill that would treat fund managers' carried interest as ordinary income, not capital gains.

This past July, Frank chaired a hearing on hedge funds that shied away from committing to any particular legislative action, while noting the market risk posed by hedge funds. Frank said, ?We have a kind of uneasy consensus that there is a potential problem here? and expressed his wish to know more about how to solve them.

Frank may have his doubts about stiffer regulations for hedge funds, but he has introduced formal legislation to change the tax treatment of carried interest. The Senate proposal concerning publicly traded partnerships has not evolved into a formal law to be voted on, but Frank's proposed amendment to the IRS Code of 1986 is far farther along the legislative process.

This summer's House hearing on the carried interest question did feature a great deal of testimony in support of the current tax treatment for carried interest. However, Frank began the session by noting the purpose of the hearing was to explore if the buyout industry is ?exacerbating what is already an unfortunate trend? in US income equality.

With a watchful eye
Christopher Cox, chairman of the Securities and Exchange Commission, is poised to play an increasingly pivotal role in the regulation of private equity funds in the US, in lieu of the industry's tapping public markets for both acquisitions and a permanent source of capital. However, he remains sphinx-like as to how oversight might evolve.

Cox has made public his plans to launch a special unit within the SEC's enforcement division dedicated to alternative assets. The purpose, as Cox explained, is to better monitor insider trading issues with hedge funds and private equity firms. But while that may hint at greater oversight or more formal regulation, Cox hasn't indicated any other further moves. When pressed on the issue of The Blackstone Group's IPO, Cox told reporters the offering was undergoing the ?normal process? of review by staff of the SEC's corporate finance division.

During a recent hearing before the Senate Banking Committee, Senator Dodd, the committee chairman, asked Cox if he felt the tax proposals on publicly traded partnerships may adversely effect capital formation. Cox responded that it is entirely possible that tax legislation targeting public companies could ?have the unintended consequence of fewer public companies and decline in capital formation.?

Tempering the rhetoric
The UK's new Prime Minister Gordon Brown appointed Alistair Darling the new Chancellor of the Exchequer this past June, and since then, Darling has shown every sign of continuing in the moderate New Labour fashion. Despite public criticism of buyout groups as lightly taxed asset strippers, Darling has resisted calls for swift and severe reforms of the government's regulatory stance.

Although the new Chancellor has warned of ?unintended consequences? of a ?knee-jerk reaction? to criticisms from unions and politicos, he has also given little indication as to what the longer term may hold. He has deflected any inquiries into specifics by stating that all such questions will be answered in his tax and spend review before Parliament slated to take place on October 17.

He has already broken with tradition once, by merging the review into a single statement, when it is normally delivered in two reports. Many view the decision as simply a way for Darling to articulate his broader vision for the economy, while others think combining the reports might be a harbinger of major changes. Until then, the new Chancellor stresses ?that the government is committed to ensuring a fair and consistent tax system, and ensuring everyone pays their fair share of tax.?

Friendly so far
This past July, Hector Sants was appointed the new chief of the UK's Financial Services Authority, where he was previously the managing director of wholesale and institutional markets. As a former investment banker with Credit Suisse First Boston, Sants' appointment didn't set well with those that felt the FSA does too little to protect the individual investor. For those working with financial services, however, his appointment was welcome news.

Sants publicly admitted that the quality of UK markets could improve, a note of particular relevance given some changes already discussed by the body. The FSA is currently exploring relaxing rules on the listing of vehicles on the London Stock Exchange's main market in an effort to better compete for private equity and hedge funds business that has been lost to Euronext in Amsterdam. He even proved genial towards private equity during the recent parliamentary hearings into the asset class.

Sants said during the hearings that the dispersion of economic risk made it particularly difficult to determine where the said risk resided in the system, though whether he remains so friendly to the industry while facing its many critics in the UK remains to be seen.

The lone cheerleader
Charlie McCreevy serves as the European Commissioner of Internal Markets and Services and has proven since his appointment in 2004 one of the most vocal champions of private equity in the European Union. The Irish minister often refers to the ?constructive destruction? of private equity and hedge funds and is one of the few regulators not advocating tougher transparency laws.

McCreevy has even gone on to defend the compensation practices of the industry, so long as they are ?properly performance driven,? comparing pay at private equity firms to the performance fees of pro golfers or the transfer payments to soccer players. This bullish attitude has won him the ire of his fellow regulators.

On announcing its 250-page study into hedge funds and private equity, the European Socialist Party named McCreevy specifically, with reference to his support of the industry. The report called for greater transparency of the funds, along with better regulations at the national and EU level.

Some see McCreevy's influence waning, pointing out his plan to open the EU's postal industry up for competition has been postponed from 2009 to 2010.

Translating Sarkozy
The honeymoon for Christine Lagarde, the first woman finance minister of France, will likely be brief. Given the ?economic revolution? President Nicholas Sarkozy is planning, Lagarde will have no small amount of diplomacy to do. She will have to convince the French that tax breaks won't come at the expense of the country's poor, that the sanctity of the 35-hour work week can't be sustained, and that unions must come to the negotiating table willing to negotiate, not simply demand. Selling these reforms to her countrymen will be one hurdle, while selling reform to the rest of the EU may be yet another.

Among the biggest complaints private equity GPs have about the French market have to do with convoluted partnership laws, voting right laws, bankruptcy laws and employment laws.

Despite not being an elected official, Lagarde may be more than capable of the task at hand. She rose through the ranks of the US law firm Baker & McKenzie to join the firm's executive committee in 1995, eventually becoming chairman four years later. Her time defending the interest of internationals appeared to serve her well when she became trade minister in 2005, increasing exports by a large margin during her tenure.

It would be a mistake to consider her an internationalist exclusively, as she held firm in protecting French farm interests in the case of an agricultural brief she was tapped to handle. Some observers worry that she's too green of a politico to sell the reforms to the country, but Sarkozy might be politician enough for both of them. He'd better be, if he hopes to realize his vision for a newly dynamic French economy, an economy that may prove all the more welcoming to the buyout class.

Stepping up oversight
Retail investors in alternative investment funds in Hong Kong have a guardian. She is Alexa Lam, executive director of the Intermediaries and Investment Products Division of the Securities and Futures Commission.

Since Lam's appointment in 2001, the SFC has refined its regulations of fund managers. Lam, who has called hedge funds ?exciting,? wants to make them available to retail investors. But she is concerned about ?unfairness and conflicts of interest? in the use of side letters, which can lead to preferential treatment given by managers to certain investors, without adequate disclosure to other investors; and valuation for complex and illiquid products.

Lam wants greater disclosure from the managers who operate in Hong Kong, which are growing in interest due to the region's relationship with China. Increasingly, the SFC is also looking into regulating real estate investment trusts.

She is also working on simplifying licensing requirements for overseas managers in Hong Kong, who have complained that the licensing exam is too difficult compared to Asia's other hedge fund destination, Singapore. But Lam has brushed off the competition, insisting that the Hong Kong label should be one of quality. ?[The initiatives] are not intended to lower our regulatory requirements,? she reportedly reportedly said.

Before joining the SFC, Lam taught at the University of Hong Kong and was in private practice in New York and Hong Kong, specializing in corporate commercial work and China investments.

Gathering steam
When it comes to the nuts and bolts of doing a deal or raising a fund in China, the most important authority for private equity funds and investments may be the Ministry of Commerce (Mofcom). Led by Bo Xilai, the ministry is responsible for and regulates all foreign direct investments into, and within, China.

Last September, Mofcom clamped down on investors using offshore vehicles to purchase and list mainland firms. The ministry has also tightened merger and acquisition rules for foreign firms in China; it is in the process of enacting a comprehensive set of antitrust rules for foreign acquisitions of local companies.

The ministry's power can perhaps be best illustrated in The Carlyle Group's attempt to acquire Xugong Machinery. Mofcom wanted Carlyle to reduce its original 80 percent bid to 40 percent, while the central government's top planning agency was content to settle for a 50-50 stake. Construction machinery, deems Mofcom, is of ?strategic? importance to the country; the deal has dragged on for two years.

Now venture capital is coming under the ministry's purview. Mofcom is revising rules to allow foreign venture capital firms to team up with local partners to set up a joint venture fund which is then treated as a local entity. This bypasses the need for foreign investment approval.

Bo has led the ministry since 2004, and was previously governor of Liaoning province.