Direct and indirect regulatory developments affecting private equity firms – Ashley Coups, private equity assurance leader, Ernst & Young
By Ashley Coups (pictured) – As private equity assurance leader, my main relationships within private equity houses are with CFOs and COOs. When it comes to working through the impact of regulatory issues, however, one tends to deal with a variety of people. Whereas most of the large US and UK firms have full-time compliance officers and teams, inside the smaller and mid-market firms - of which there are around 100 in the UK – compliance is often one of several roles performed by the COO.
There are several direct regulatory impacts affecting the private equity industry today, the most pertinent of which remains the European AIFM Directive. There’s been a degree of lethargy over the last couple of years and whilst there are details that still need clarification, people are starting to take onboard the implications of the Directive more proactively now.
Not that AIFMD is the only direct regulatory impact. The Dodd-Frank Act and FATCA in the US are often occupying just as much time in PE houses.
The AIFM Directive is due to be implemented into national law by July for a go-live date in just over a year’s time. One of the challenges I think everyone’s been dealing with is how to set in place an implementation plan. How do you do your gap analysis in terms of where you are, versus where you need to be, when there are so many moving parts around finalisation of the Directive?
Another salient point that PE houses are dealing with is the issue of depositaries and how to implement their use effectively under AIFMD. Details on this remain unclear. If they have to use an independent bank depositary how much is the bank going to charge? Will it be a case of administrators stepping into the breach and providing a solution that bolts on to the administration/accounting service they provide to GPs? One other option being discussed that warrants further investigation is whether the PE houses can do it themselves.
Regulators have expressed some sympathy towards the possibility of having a subsidiary of the organisation that is able to perform that depositary function. Not enough time has yet gone into looking at the practical implications of doing this however. What would be the implications on the firm’s structure, contractual arrangements and the capital they’d need to hold to perform that function?
I think you’ll see people looking at this much more seriously over the next six months.
When you consider that a PE house manages itself on no more than a 2 per cent management fee, or priority profit share, the prospect of using an external depositary or custodian who could, potentially, charge up to 80 basis points, would have a significant impact and change the overall economics of the business model.
Another area of the AIFMD that PE houses are having to think about is whether or not to adopt the passporting option in full compliance with the Directive, or stick with the private placement regime which is scheduled to remain in place until 2018.
One issue that perhaps people haven’t considered is that those private placement regimes may not stay the same between now and 2018. I think there’s always been an implicit assumption of stability with the private placement regime, but that assumption is not necessarily valid anymore.
Again, there’s uncertainty as to how those regimes could change. It could come down to local, national views. Are they happy just to leave it [private placement] as it is? What’s driving the national agenda? These political nuances have the potential to influence PE houses when it comes to being early adopters of the passporting regime, or not.
The US is facing just as much regulatory upheaval in the guise of FATCA and Dodd-Frank. FATCA, when it’s introduced in 2013, is going to present a potentially burdensome task. The PE executives that I’ve spoken to are all taking it very seriously; at the end of the day, any regulatory interaction with the US has to be treated with the highest priority.
With respect to FATCA, people probably haven’t done huge amounts of work on this and are likely viewing year-end before they commence with KYC (know your customer) work and get all the relevant documentation ready in-house to enable them to identify US individuals. This won’t be easy; some PE houses have over 100 investors and run multiple funds.
FATCA has no European equivalent unlike Dodd-Frank, which came out when AIFMD was firmly on the European table. It too contains a lot of rule uncertainty although as we head into the second half of 2012 we should start to see more clarity on provisions.
Many PE houses are now registered with the SEC. What’s worth emphasizing here is that these managers will need to be prepared for a potential visit by the SEC who have indicated they’ll be making European trips.
This could be at short notice, perhaps two or three weeks prior to the intended visit. The FSA have carried out more thematic visits, rather than look to cover everyone; but that’s exactly what the SEC intend to do. Firms can expect to be visited on a rotational basis, perhaps every seven years or so. The point here is that, unlike with the FSA, it’s a question of when, not if.
The majority of hedge funds use external administrators who can assist with SEC filings. In PE houses probably only about 30 per cent use an external administrator; the other 70 per cent do it in-house. There’s a clear operational burden on them and it’s something they can’t afford to get wrong.
As for the indirect impact of regulation, the obvious issue is Basel III and Solvency II, which will make it harder for financial institutions to invest in private equity because of the increased costs of capital. Under Basel III and Solvency II, it will become more expensive for institutions to invest in private equity funds because they will attract more regulatory capital due to their lower liquidity profile. This in turn will impact the cost of leverage used by PE houses when building their portfolios.
Another potential indirect impact is whether equivalent regulation is placed on pension funds. There is discussion related to what the capital environment for pension funds might look like. Were an equivalent Solvency II-type regime to be applied that would present another significant challenge.
In the UK, pension funds are the single largest investors in private equity (around 20 per cent of portfolio AUM). Roughly 60 per cent of the money raised in the UK comes from European investors, 40 per cent from the US. Of that capital, roughly 40 per cent is invested in the UK and a similar amount gets invested into continental Europe: that clearly underlines what the UK means to private equity investors.
The last thing PE houses will want is for that significant funding channel to be closed off.
Ashley Coups is a partner at Ernst & Young where he runs the private equity assurance practice, overseeing a team of approximately 50 people. Prior to joining the firm in 2011, Coups spent 16 years at PricewaterhouseCoopers, the last four years of which involved running PwC’s private equity assurance business. One of the key strengths of Ernst & Young is that it operates an EMEIA practice as opposed to single territory practices. The benefit to this is that it replicates how Ernst & Young’s private equity clients do business; many of which are large US and European buyout houses that invest across Europe, the Middle East, India and Africa. Coups has been working with private equity houses for over 13 years.
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