Regulating Private Equity

The term private equity or alternative asset can encompass a lot of different types of firms, including venture capital firms and hedge funds. Private equity, in this context, mainly refers to leveraged buyouts, where private equity firms buy companies by loading them up with debt. In these private equity transactions, debt is commonly employed to acquire a business. This debt creates obligations of interest and principal payments that are due on a timely basis. When the debtor misses payments, creditors can take action to recover sums borrowed by the company.

The private equity industry has seen tremendous growth over the last two decades, increasing from less than $10 billion raised worldwide in 1991, to over $180 billion in 2000, and nearly $6 trillion in 2020. Even during a pandemic, where businesses are collapsing and millions of Americans are out of work, private equity deals are on pace to raise more money than any year since 2008. Despite this rapid growth and recent public scrutiny, the alternative asset sector has successfully avoided the scrutiny of regulators and lawmakers for years, which contributes to its success in attracting investors. Yet, with concerns arising from the increased risk due to over-leveraged transactions and the potential costs to investors from insider trading and price fixing, regulation of private equity funds and their managers has seen an increase over recent years. In this context, there is a division of opinion regarding whether private equity funds and their investments should be subject to regulation designed to protect workers and to discourage asset-stripping practices.

Theory of Private Equity

Normally, when someone borrows money, it is the responsibility of that person to pay back the debt. For instance, when you purchase a car and receive a loan, if you do not pay that loan back may lose the vehicle. Playing by leveraged buyout rules, a private equity firm buys a car with a loan, puts a certain amount towards the loan, but the rest of the money is the responsibility of the car, not the firm. Of course, this is antithetical to common sense, but in the world of private equity, the car owes the money and its parts are assets.

The theory behind these rules is that it will be worth it for both the car owner (private equity) and the car (the company). The private equity organization is buying a company that is struggling or has growth potential and reorganizes them, accelerating their growth, and making them “work better.” In reality, because the companies are often overly saddled with debt and interest payments on that debt are so high, they can not make the investments necessary to compete or even survive. Additionally, these companies are often forced to take out even more loans to pay the private equity investor dividends or fees when it is sold.

Private Equity Controversy

A major controversy surrounding this business model is that regardless of what happens to the acquired company and its employees, the private equity investor makes money. Firms generally have a two-twenty fee structure, which means they get a two percent management fee from their investors and then a twenty percent performance fee on the money they make from their deals. Basically, if an investment goes well, they get twenty percent of it. But regardless of what happens, they get two percent of the money they are managing altogether, which can be a sizable sum, considering the value of global private equity in 2020. Moreover, private equity firms can take out additional loans through their leveraged companies to pay dividends to themselves and their investors, and the companies are on the hook for those loans too. The share of profits private equity managers earn carries interest, gets special tax treatment, and is taxed at a lower rate than regular income. It is an industry with seemingly unlimited money, begging to be regulated, but is still free to profit off the closure of companies and job loss.

Regulation v. Self-Regulation

Proponents of special regulation point to a negative image of private equity – from decisions to cut jobs, strip assets, and allow companies to fail-as was seen with Toys R Us, Payless, Shopko, and Radioshack, while still taking in profits for themselves. It is easy to characterize private equity funds as vultures interested only in their own enrichment at the expense of others. However, proponents of self-regulated private equity suggest a positive correlation between private equity investments and overall economic prosperity and performance. Economic studies show that private equity investment routinely surpasses the Standard & Poor’s index, enhances new product and market development, and increases the levels of employment and Research & Development expenditure.

The major regulatory agency that covers private equity is the Securities and Exchange Commission (“SEC”). The SEC monitors private equity funds and has the power to bring enforcement actions against them for violations of SEC regulations, but is limited by the lack of transparency common in the private equity field. This is a major concern for the SEC, as much of the improper conduct in private equity funds results from conflicts of interest, lack of transparency, and failure to disclose managerial interest in transactions.

In the last decade, turbulence in the credit markets, triggered by the subprime mortgage market in the United States in 2007, arguably should have ended the private equity boom as well as the laissez-faire era in the private equity industry. During this period, a credit squeeze momentarily slowed down the level of private equity activity and resulted in increased scrutiny from regulators, policymakers, and the judiciary. However, as the 2020 numbers indicate, the increased scrutiny had little effect in slowing the growth of private equity. As was the case following the 2007 downturn, a wide range of regulatory options, from industry self-regulation to governmental intervention, are still being considered in order to lower risk and redress the balance, not only between investors and private equity firms, but also between these firms and society. Despite the absence of major collapses in the buyout market, even during a pandemic, regulators are considering a number of governmental measures designed to reduce the incidence of buyouts, including caps on leverage limits or limits on the levels of interest payments that are tax-deductible. These regulatory changes were a central point in both Senator Warren’s and Sanders’s most recent presidential campaigns. There may, however, be other motivations that can explain the demand for regulatory intervention other than to protect investors from manipulation and to promote regulatory responsibility; such as, the ever-increasing wage gap, and devastating job loss.

In addition to the SEC’s attempts at regulation, private equity funds are regulated by contract. These funds, predominantly formed as limited partnerships, limited liability partnerships, or limited liability companies, are able to take advantage of various exemptions and exclusions explicitly provided within the regulatory framework. These business forms are treated as transparent entities for tax purposes, allowing funds to avoid taxation at fund level and to ‘pass-through’ tax liabilities to the fund investors. More importantly, the contractual flexibility of the limited partnership, limited liability partnership, or limited liability company allows the managers and investors to enter into covenants and schemes that align incentives and reduce agency costs. As an example, the investors are usually permitted to vote on important issues, such as amendments of the contractual provisions, dissolution issues, removal of managers, and sometimes even the valuation of the portfolio. At the same time, the private placement business arrangements are oriented and structured for large and sophisticated investors, making it possible to be exempted from the securities regulation framework. These funds rely on the exemptions from treatment under the Securities Act of 1933, the Investment Company Act of 1940, and the Investment Advisers Act of 1940.

Still, there are important issues that confront the world of private equity. The industry must face the dilemma of identifying well-suited techniques to increase transparency and reduce the level of risk without substantially damaging the flexibility and the benefits of the business models that have prospered with limited intervention. The contractual basis for the funds is usually adequate to address the agency problems among the people who benefit most from its existence. However, as wealth becomes further consolidated, the economy gets weaker, and the performances of buyouts are jeopardized because of over-aggressive capital structures, lawmakers should intervene without analyzing the contractual structure of the funds. In this respect, more attention should be directed to the reliability of private equity funds in justifying their contribution in the strategic performance delivered. Additionally, the lack of regulation and oversight can lead to market abuse, conflicts of interest, and a lack of market transparency.

The level of regulatory risk will increase substantially should a high profile buyout fail, as experienced by the 30,000 former employees of Toys R Us. Hence, as the risk becomes more critical for companies and their employees, we should expect more direct government intervention at the expense of the system of private ordering, employed by the funds and their investors. However, financial considerations invariably prevent lawmakers from simply introducing new legislation that could alter the balance of benefits and gains for the sector. Besides, mandating legal rules that are inflexible can have uncertain consequences on the industry. These consequences will remain uncertain as long as the industry lacks transparency. Although private equity funds have become an essential part of the global financial system, there is insufficient information about their governance, impact and strategies, and, as the SEC knows, regulation without transparency is extremely difficult.

It is often tempting to conclude that self-regulation is the optimal strategy, and concerns about the negative impact of special regulation on the financial industry are always present. Self-regulation can involve complex conflicts of interests, which may have detrimental effects on the confidence that investors have in the industry standards. Moreover, the non-compliance with and enforcement of these regulations is yet another concern. To be sure, the effectiveness of self-regulation is closely connected to the incentives of the firms that are providing the measures and the quality of their efforts to monitor compliance. Industry players are not indifferent to the possibility of ineffective or misdirected policies, but rather assume that the private equity industry has a stake in establishing a good reputation for compliance with industry standards. It is clear that current regulation is not sufficient to deal with all the risks of private equity funds or illegal conduct, and consequently some kind of response is needed. Self-regulation serves the top, but the top are not the victims of leveraged buyouts. The victims are the 597,000 retail employees who have been “reorganized” out the door in the last ten years when a company, saddled with debt, goes bankrupt.

If you would like to speak to one of the legal professionals at West & Dunn about this or any other legal issue, please feel free to contact us by phone at (608) 975-3042  or reach out online.