The Dodd-Frank Bill is set in motion to transform the money industry in July 2011. Meanwhile, there is plenty of time for private equity firms and their advisers to lobby and petition Congress to ensure the current business model is not completely disrupted. As members of the private equity industry, we should protect the capital flow to businesses that is vital to the global marketplace.
The Volcker Rule
The Volcker Rule’s intent is to reduce taxpayer’s exposure to high-risk, high-reward vehicles such as private equity funds. The desire of Dodd-Frank is to prevent another bailout of an overexposed banking entity that is ‘too big to fail’. We understand that; however, coming after private equity is not the answer. A banking entity can establish a fund with “sufficient initial equity for investment so as to attract unaffiliated investors.” What does sufficient mean and who determines when initial funding has reached sufficient levels?
In any event, the banking entity must, within one year, reduce its investment to not more than 3% of the total ownership interests in the fund, and the aggregate of all permitted investments by the banking entity must not exceed 3% of the banking entity’s Tier 1 capital. This is worrisome to private equity investors because it will significantly limit funding options and lengthen fund raising periods.
Adviser Registration
Dodd-Frank’s new requirements will bring private equity funds under the auspices of the Securities and Exchange Commission. Any entity that has assets of at least $150 million is subject to record keeping and disclosure requirements pursuant to the SEC and Commodity Futures Trading Commission (CFTC). So how should private equity avoid this? Smaller deals. A firm can simply create different fund structures to have multiple funds that have no more than $125 million each and do not have similar ownership structures in order to evade Dodd-Frank.
Who is going to escape this regulation? Venture capital.
Venture capital funds are exempt from Dodd-Frank. The reason for this is because Congress feels that the majority of risk is self contained in the fund. Once again, how can private equity avoid being treated negatively for doing essentially the same thing? Depending on how Congress defines venture capital, some private equity managers may simply be able to categorize their deals as venture capital in order to avoid restrictions.
Growth Capital firms lean more towards the later stage plays than the typical Venture Capital firm focused on early stage start-ups. Shall we leave it to Congress to categorize where the embedded risk is in each fund? Each deal? Each structure? Where do we draw the line, and let investors make decisions with their own money?
New requirements will create a level of transparency that has not been seen before in private equity. In private equity, transparency is good when it is restricted only to concerned parties. One of the attractive things about private equity deals is that the public is not at risk and therefore has no reason to know the details of a deal arrangement. If all things within the private equity world become truly transparent, then we run the risk of having something close to an efficiently priced private equity market.
Nobody benefits from such a market. If private equity assets are bought and sold in an efficient market, then getting 7x-10x returns on your deal becomes much more difficult to obtain since everyone else will have access to the same information as you do.
As we know, private equity’s real currency is information and part of the allure of private equity is the opportunity to make big gains for your risks taken and unique access to information and clients.
Reporting and Record Keeping
Private equity will be subject to new SEC regulations and required to report a variety of trade secrets it will not want exposed, including valuation policies and trading practices. Furthermore, any confidentiality provisions do not authorize the SEC to withhold information from Congress and information disclosed must be “necessary in an enforcement proceeding or investigation.” That’s code for: You have no confidentiality with us and if we need to use it we will.
We are accustomed to politics’ having a fall guy, however, making private equity the scapegoat is not the answer. If the government really wants to make a difference it should start with itself and the lending practices in this country; not with the people who make the industries that create jobs.
About the Authors
Kareem G. Nakshbendi, M.B.A. candidate, and Averell H. Sutton, J.D./M.B.A candidate, are from the American University and members of the Kogod Private Equity and Venture Capital Club. They would like to thank the following for assisting in the creation of this article: Mr. Hamed Meshki: Partner, Kirkland & Ellis LLP; Dr. Ghiyath Nakshbendi, Kogod School of Business, American University; Mr. David Peyman, Partner, Miller Barondess; Professor Nancy Sachs, Kogod School of Business, American University; and friends at some of the top 10 private equity firms who could not be mentioned due to compliance reasons but nonetheless provided invaluable insight.
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