Nate Silver, in his book ‘The Signal and the Noise’, explains the art of discerning trends from a mass of contradictory and uncorrelated data. This skill led him to predict the winner in 49 out of 50 states in the 2008 US presidential elections. Given the volume of unrelated information and initiatives in the private equity arena, this skill would be useful in discerning where the industry is headed.
In Europe, the deadline for compliance with the Alternative Investment Fund Managers Directive finally arrived on 22 July 2014. Implementation of this directive has been far from smooth, with some reports suggesting that many private equity managers will not have received authorisation from the regulators by that deadline. But this widely criticised one-size-fits-all piece of legislation aimed at regulating managers of private equity, real estate, hedge, infrastructure and other investment funds has in many cases brought GPs and LPs closer together. The investor protection measures in the legislation have led to situations where GPs are unable to market to potential LPs who are willing to invest in their funds, and who consider themselves sufficiently experienced to decide for themselves whether those funds are suitable. For LPs able to access funds, the introduction of rules requiring the appointment of custodians, widely acknowledged as unnecessary in the private equity context, is seen as adding an unnecessary tier of expenses that will eat into fund performance and LP returns. Similar issues arise in the US with the increased regulation of fund managers arising from Dodd-Frank, including the Form PF filing requirements and other compliance burdens.
That said, the increased transparency requirements of the Directive are by no means unwelcome to many LPs. Additional information around remuneration, the treatment of other investors and in relation to the operation of the fund’s constitutional documents is generally welcome. One question being asked, though, is whether it is focused in the right direction. That question may have been answered by the US SEC, which found in a recent investigation that over half of 200 fund managers surveyed were guilty of “violations of law or material weaknesses in controls”. The question on LPs’ lips is, “which half?” That said, while the SEC has taken enforcement action in what it considers to be egregious cases, it is possible that many of the issues relate to inadvertent overcharging, and in the context of the complex multi-jurisdictional fund structures that constitute many investment funds there will always be borderline judgement calls and inadvertent mistakes. It is worth noting that the SEC referred to “material weaknesses in controls” which does not necessarily mean that fees were overcharged in fact. The SEC’s concern appears to be that LPs are diligent going into funds, but might relax oversight on a day-to-day basis, assuming that GPs are always compliant. The increased roles of administrators and custodians in this area will no doubt improve the transparency drive that began, at least in the UK, with the Walker Review and resulting Guidelines for Disclosure and Transparency in Private Equity, and also reassure LPs that all is above board.
But that comes at a cost, and at a time when LPs continue their search for outsized returns. The recent surge of European IPOs of private equity-backed companies has allowed managers to return money to LPs, laying the foundations for an uptick in fundraising activity. Fears of the euro’s imminent demise have also receded, resulting in increased fundraising for deployment in the eurozone. The middle market appears to be resolving its overcrowding issue through natural selection, and investors are increasingly turning to what were until recently more niche, specialist sectors such as lending, following the banks’ retreat, restructuring, and secondaries, all of which are becoming recognised asset classes. GPs are also seeking to create centres of excellence around operational improvements in a bid to increase returns, implementing 100-day plans following acquisition of target companies.
Investors, often lightly resourced, struggled to maintain the relationships struck up before the global financial crisis with myriad GPs, and are concentrating on fewer, deeper relationships. That can favour the multi-strategy managers, and in turn has led to increased negotiation of fund documents which is taking longer to achieve than it has done previously, as LPs seek to address the wider potential conflicts of interest inherent in managing multiple, potentially overlapping strategies, and also to address lessons learned through the financial crisis.
Intriguingly, at a time when regulators are looking to police fairly micro-level issues, there has been growing recognition of the benefits of private equity. This does not just relate to the obvious role of private equity funds in rescuing many household name businesses, and their employees, when faced with their imminent collapse, but extends to wider positive attributes. The long term nature of private equity, aligning interests of GPs and LPs to deliver long term superior returns, was recognised by ESMA when it came to producing the AIFMD’s remuneration guidelines, and long termism has found a fanbase in UK government initiatives such as the Kay Review of UK Equity Markets and Long-Term Decision Making.
That said, headwinds remain. The industry continues to go through a generational shift, with the founders of many GPs making way for their successors, leading one industry insider to bemoan their replacement with “administrators rather than daredevils”. LPs’ diligence into GP management teams is increasing and it will be interesting to see whether the recent court cases involving disputes between GP executives were a one-off or the beginnings of a trend and, if so, whether the drivers are based around succession or other factors. This ties into the concern that the increasing tide of expensive regulation will stifle the creation of new GPs, or restrict them from accessing some of the more usual sources of capital in the US and Europe. That in turn can open the door for some of the other sources of financing for private equity funds and deals, including family offices and sovereign wealth funds which have been growing their private equity programs with mixed success. The tax treatment of carried interest continues to attract occasional criticism, but GPs are flexible and attempts to introduce penal rates of taxation are likely to result in GPs relocating to more welcoming jurisdictions.
The secondaries market continues to grow apace, also driven by a combination of regulatory initiatives aimed at de-risking banks, insurance companies and other significant financial institutions. The size of the secondary funds being raised is notable, but the frequency at which they are being raised by GPs is increasing, with a significant number of large portfolios changing hands recently.
So where does that leave the industry? LPs still have significant amounts of cash to deploy, bank regulations around remuneration are pushing the best executives into private equity and other alternative investment funds, and financial services regulations continue to drive investment opportunities. Politicians’ appreciation of the benefits of private equity continues to grow, and so while there has been a shakeout in recent years, there is every reason to believe that the coming years may prove to be attractive vintages for private equity fund GPs and LPs across a widening asset class.
Stephen Sims is European Practice Leader of the Investment Management Group, and Greg Norman is an associate, at Skadden, Arps, Slate, Meagher & Flom (UK) LLP. Mr Sims can be contacted on +44 (0)20 7519 7127 or by email: firstname.lastname@example.org. Mr Norman can be contacted on +44 (0)20 7519 7192 or by email: email@example.com.
© Financier Worldwide
Stephen Sims and Greg Norman
Skadden, Arps, Slate, Meagher & Flom (UK) LLP