Private Equity gathering clouds?

Transcription

1 Private Equity gathering clouds? Introduction The FSA has recently undertaken a wide-ranging review of the private equity market to ensure that the overall level and form of regulatory engagement is, in its opinion, optimal. It published its findings on 6 th November in Discussion Paper DP06/6. The consultation paper received widespread coverage in the financial press heralding a move by the regulator against the private equity industry. But in fact the paper is generally cautious, with a whole chapter representing an attempt to corroborate the FSA s understanding of the nature of the industry and the perceived risks. Some commentators view the paper as an attempt to set some parameters for principle based regulation of the private equity industry in the face of more aggressive posturing from continental European politicians and regulators. The FSA identifies seven reasons why it feels that it is appropriate to publish a paper specifically on the subject of private equity: 1) There has been significant growth in the capital flowing into private equity funds; 2) Currently the FSA believes that in the UK the capital raising of private equity funds outstrips that of the public market; 3) The FSA believes that leveraged finance provision to private equity transactions has increased significantly; 4) Private equity s reach has extended to involve significant sized transactions through the raising of larger individual funds, the increased availability of debt finance and development of club deals where private equity fund managers cooperate on a single transaction; 5) The FSA is concerned to understand more about the impact on secondary markets and the capital flows to the public markets; 6) The contribution of public to private transactions, share buy backs and /or payment of special dividends in a defence against a private equity bid to reducing capital flows from the private market; and 7) A perceived lack of understanding amongst public policy makers, potential future investors and commentators with respect to the nature of private equity business models and their inherent risk. Areas of regulatory concern The FSA highlights, and has provisionally rated, six areas of regulatory concern in the private equity market. HIGH - Market abuse: The FSA considers that the significant flow of price sensitive information in relation to private equity transactions and the number of participants create considerable potential for market abuse. The involvement of participants in both public and private markets and the development of related products traded in different

2 markets, e.g. Concern that Credit Default Swaps ( CDS ) on leveraged loans, have increased the potential for abuse. FSA s proposed response: The FSA considers that market abuse risk exists because of the large number of individuals involved in private equity deals and because not all participants will be successful in their proposed participation. FSA believe it is essential that participants in the private equity market, including small firms understand their obligations in respect of the market abuse regime, and establish an appropriate control environment The FSA undertakes regular transaction monitoring and is in the process of developing an enhanced transaction monitoring system covering credit trading and markets. It threatens to take disciplinary action against market abuse it observes by private equity firms or against others in relation to private equity deals. The FSA is also monitoring the progress of industry initiatives to establish principles and recommendations regarding the handling of material non-public information by credit market participants. HIGH - Conflicts of interest: The FSA considers that material conflicts arise in private equity fund management between the responsibilities the fund manager has to itself (including its owners/staff), the investors in the separate funds/share classes it manages and the companies owned by the funds, including those invested with a Joint Venture partner. Advisers and leveraged finance providers also face significant conflicts (particularly where they take on multiple roles in relation to an individual transaction) between their proprietary and advisory activities and between their different clients. FSA s proposed response: The FSA continues to give priority to conflict of interest issues within its risk-based approach to supervision. Its 2005 Dear CEO letter raised awareness of its concerns. In addition the FSA has also highlighted the increased potential for conflicts of interest in competitive IPOs. Conflicts of interest management in private equity fund managers is likely to be the subject of a FSA thematic exercise in 2006/07. MEDIUM HIGH - Excessive leverage: The FSA is concerned that the default of a large private equity backed company, or a cluster of smaller private equity backed companies, now seems inevitable. It considers that this has negative implications for lenders, purchasers of the debt, orderly markets and conceivably, in extreme circumstances, financial stability and elements of the UK economy. FSA s proposed response: The FSA has participated in UK and EU-wide surveys of the leveraged lending market that has increased its understanding of the scale of such lending and plans to repeat these surveys on a regular basis. MEDIUM HIGH - Unclear ownership of economic risk: The FSA is concerned that operational issues, which make it difficult to identify who ultimately owns the economic risk associated with a leveraged buy out and how these owners will react in a crisis, could exacerbate the duration and potential impact of any credit event. These operational issues arise out of the extensive use of opaque, complex and time consuming risk transfer practices such as assignment and sub-participation, together with the increased use of credit derivatives. The entrance of new types of market

3 participant with business models that may not favour the survival of distressed companies adds further complexities. These factors may create confusion which could damage the timeliness and effectiveness of work outs following credit events and could undermine an otherwise viable restructuring. FSA s proposed response: FSA intends to undertake, as a matter of priority, a factfinding exercise, involving trade associations and experienced market practitioners, to increase its understanding of: The specific issues and risks firms would face in handling the default of a heavily traded corporate body or multiple concurrent defaults; Firms preparations for such events; and Whether an industry code of practice would be beneficial. This initiative is likely to have a broader scope than private equity backed transactions and is likely to spill over to the trading of banks and hedge fund managers it will focus on companies whose debt/credit is heavily traded and is anticipated to be a key area of the FSA s focus during the next 18 months. MEDIUM LOW - Market access constraints: UK retail investors currently only have limited access to the private equity market via venture capital trusts and a small number of private equity investment trusts. Indirect access is also limited as few UK pension or insurance vehicles have committed significant capital to private equity. There may, however, be a gap in UK markets as there is no market listing certain types of private equity related vehicle, which are consequently seeking a listing in other EU jurisdictions instead. FSA s proposed response: The FSA will publish a second consultation paper on revisions to the listing regime that will Propose removing the prohibition in the Listing Rules on primary listed investment entities taking control of the companies in which they invest; and Remove the restriction on overseas investment companies from taking up the directive minimum regime currently embodied in Chapter 14 of the Listing Rules (LR14). MEDIUM LOW - Market opacity: Although transparency to existing investors is extensive, transparency to the wider market is limited and is subject to significant variation in methodology (e.g. with respect to valuation, fee disclosure etc) and format. This makes relative performance assessment and comparison complex, which may deter investment by various professional investors who may not be comfortable interpreting the information. It could also lead to ill-informed investment decisions by such investors. FSA s proposed response: The FSA says it is maintaining a watching brief to observe the progress of industry initiatives to raise standards, such as the adoption of the International Private Equity and Venture Capital Valuation Guidelines and the development of Global Investment Performance Standards provisions on private equity. The appropriate level and form of transparency is linked to the nature of the investor base and will be considered in the light of any enhanced retail involvement in private equity. LOW - Reduction in overall capital market efficiency: The substantial inflows of capital into private equity funds combined with the considerable appetite of the debt market for

4 leveraged finance products is fuelling a significant expansion of the private equity market. The quality, size and depth of the public markets may be damaged by the expansion of the private equity market. On the other hand private equity has had the effect of widening the availability and source of capital, increasing the accuracy of company valuations (factoring in their growth potential), enhancing the efficiency of corporate capital structures, facilitating corporate development and transformation etc. FSA s proposed response: A watching brief will be maintained on the overall market quality (both public and private), identifying and analysing potential issues and risks on a case by case basis. It will continue to review the Listing Regime to ensure that the Rules are proportionate and respond to any identified risk such that there are no regulatory requirements which unduly influence firms to be either publicly or privately owned. Committed capital information will be requested from firms to establish who the high impact players are. In terms of its industry wide response, the FSA plans to establish an alternative centre of expertise by integrating private equity firms and supervision staff into the existing hedge fund managers supervision team to relationship manage high impact firms and lead thematic supervision. Other operational impacts on private equity firms Delegated Functions The FSA highlights that private equity firms use service providers for fund raising, and outsourced accounting and administration providers,which the paper refers to in its background discussion of the sector. Their concerns here would relate to the clarity of outsourced functions and the firm s continuing ability to demonstrate effective responsibility for delegated functions. MIFID Private equity firms are reminded that investment advice falls within the scope of MIFID. More private equity firms may be MIFID firms than ISD firms and they are advised to identify the impact this may have on their capital requirements. Permissions The paper identifies that many firms will have grandfathered their business permissions under N2 and that others may not have kept pace with business developments such that these permission may be inappropriate given firm s current activities. The FSA will be reminding firms through generic risk mitigation programmes, to ensure they have appropriate permissions for the business they undertake. Training and Competence The paper contains a reminder that this will be limited to firms with private customers from November 2007 and so will not generally be applicable to private equity firms.

5 Feedback The FSA will provide feedback on responses to the discussion paper in January Impact on compliance arrangements Press coverage concentrated on the levels of gearing in private equity transactions and the role of banks in this process but the FSA has classified market abuse and conflict of interests as the areas of High concern. It looks reasonable that these will be subject to FSA thematic visits in IMS can arrange to design a mock theme visit for you, covering the controls firms have in place to prevent market abuse and manage conflicts of interest, the firms policy towards gearing levels and issues affecting the transparency of the funds valuation and administration. These visits would prepare you for the thematic approach and questioning of the FSA, In addition all private equity firms will need to review their permissions in relation to MIFID to identify where a change to your permissions could bring benefit under MIFID / CRD or simply align these with current activities. Disclaimer This memorandum should not be construed as a recommendation or advice by IMS Consulting about the merits of particular course of action or its consequences. Specific advice and recommendations are only provided to clients in accordance with their consultancy agreement with IMS Consulting. IMS Consulting does not make any warranty, express or implied, as to such the accuracy or completeness of any news or regulatory update information or commentary and shall not be liable for, any losses, damages, costs or expenses, of any kind or description. Any persons wishing to act on the subject of this memorandum should take professional advice about the merits of their action. IMS Consulting is the trading name of, IMS Consulting (IB) LLP, IMS Consulting Partners Inc.