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Regulation in 2016: what private equity needs to know

As we move into the new year, there are plenty of new regulations that are coming in for private equity which we all need to be aware of. Here is a breakdown of what you need to know regarding the regulations in 2016.

Alternative Investment Fund Managers Directive

The EU’s Alternative Investment Fund Managers Directive (AIFMD) has been in train since July 2014. The cost impact on alternative investment managers such as private equity has not been as significant as many predicted but a number of challenges remain. While fully-compliant, AIFMs are permitted to market freely to institutional investors across the EU, EU managers of non-EU funds and non-EU managers of non-EU funds must continue to utilise national private placement regimes (NPPR), many of which vary across the EU.

Those firms hoping to avoid the compliance obligations of AIFMD are electing to use reverse solicitation, a mechanism whereby managers are wholly reliant on investors actively contacting the private equity firm rather than other way round. This is fraught with risk as the precise definition of what constitutes reverse solicitation is up for debate. As such, firms must thoroughly document all interactions with prospective EU institutional investors.

“Some US private equity firms are requiring institutional clients to confirm in side-letters that they are happy to receive information about a private equity manager’s next new fund,” said Eamon Devlin, managing partner at MJ Hudson. Lawyers routinely warn that different EU regulators will enforce breaches of the marketing rules differently. Some point out jurisdictions which have adopted a stringent stance on AIFMD such as France, Italy and Germany may be harsher than more liberal regimes such as the UK and The Netherlands. Nonetheless, the UK’s Financial Conduct Authority (FCA) announced in January 2015 that it was investigating 67 AIFMs for AIFMD breaches although little has been heard since.

Going forward, the European Securities and Markets Authority (ESMA) is analysing which third countries should attain regulatory equivalence, which would enable managers in those jurisdictions to take advantage of the pan-EU marketing passport. ESMA has so far said Guernsey, Jersey and Switzerland meet equivalence although it added more time needed to be spent assessing the US, Hong Kong and Singapore. Offshore jurisdictions are also being reviewed although this is likely to be a protracted process. Devlin said the uncertainty over whether the US would be granted equivalence was resulting in some US private equity managers holding off marketing to EU investors. “The delays will ultimately hurt the smaller private equity managers hoping to obtain a foothold among EU investors. The larger private equity firms already have those EU investors, so this is not so much an issue for them,” he said.

“We are getting more positive attention from policymakers because they are slowly starting to realise that our industry can actually be part of the solution which puts Europe back on track to growth,” said Dörte Höppner of EVCA at SuperInvestor. How are your relationships with regulators today?

Foreign Account Tax Compliance Act and Common Reporting Standard

Most private equity managers point out the main challenges around the US Foreign Account Tax Compliance Act (FATCA) was not the implementation itself but understanding the law. FATCA seeks to clamp down on wealthy US citizens not paying income tax by requiring Financial Institutions and Foreign Financial Institutions (FFIs) to report either directly to the Internal Revenue Service (IRS) or indirectly to the IRS via their own local tax authority information pertaining to US accountholders. Should recalcitrant investors be present in the fund, the fund can be subject to a 30% withholding tax on all US source payments and dividends. As such, private equity managers have been forced to identify whether their investors are US persons – a not entirely straightforward task given the broad definition of what constitutes a US person, as well the complexity of certain holding structures, like family offices.

Private equity firms must now deal with the Organisation of Economic Co-operation and Development’s (OECD) Common Reporting Standard (CRS). This is a global FATCA and has been christened GATCA and it will take effect over 2016 and 2017. This is a global exchange of tax information, and it will be shared among all signatory countries, which includes a number of financial centres. The sheer volume of work required under the CRS will be far greater than FATCA. Most significantly, different signatory countries will have varying degrees of punishment for non-compliance. Irrespective of the financial punishments, private equity managers must attain compliance with these tax requirements as institutional investors will shun firms which are in breach of the rules.

Fees

Scrutiny around private equity fee structures has been on the agenda since 2014 when Andrew Bowden, former director of the Office of Compliance Inspections and Examinations (OCIE) at the Securities and Exchange Commission (SEC), said there had been violations of law and weaknesses in controls around fees and expense allocations in over 50% of the private equity houses inspected by the US regulator. It was inevitable regulatory sanctions for breaches or conflicts of interest around fees would follow. Blackstone settled with the SEC to tune of $39 million following SEC charges that it failed to inform investors about the benefits advisers had obtained from accelerated monitoring fees and discounts on legal fees. Another high profile settlement involved KKR. KKR paid a $17 million settlement to the SEC amid accusations it charged broken deal costs such as due diligence to its funds but not to investment vehicles established on behalf of KKR executives.

Institutional investors are also taking note. CALPERS, the Californian pension fund, demanded enhanced transparency around private equity performance fees. Some state legislators in the US are reportedly introducing laws requiring external money managers to disclose their fee structures to pension trustees. “It is almost inevitable that reporting on fees will be made obligatory in the next 12 months to 24 months. This is not just in the US. The UK’s FCA is reviewing retail fund practices and their conflicts of interest. I suspect this could be extended to private equity vehicles too,” commented Devlin.

Going forward

The regulatory landscape has changed markedly for private equity. Managers need to be cognizant of the existing rules and what is expected, and prepare for new regulation potentially around their fee structures.