5 Trends and Developments in Private Equity
I Heard it Through the Grapevine: 5 Trends and Developments in Private Equity
By Sean Hill and Kerry Fitzgerald, Proskauer
While not quite time to sing Auld Lang Syne, 2015 has proven to be an active year for private equity. But the activity has not been limited to the record volumes in exits and consistent positive trends in fundraising – the ever-evolving legal and regulatory overlay has also kept lawyers and CCOs on their toes. Here are five things to keep in mind as we speed towards the New Year.
1) I’ll Be Watching You. Newly registered investment advisers are now faced with specter of their first a potential SEC exam, and long registered advisers are waiting for the doorbell to ring. While the SEC has publicly indicated several main focus areas, if you have to narrow it down to one it would be disclosure (and its conjoined twin, transparency). As we approach year end, fund managers would be well-advised to holistically review all disclosure materials (including Form ADV) and the relevant provisions of fund agreements in light of their current practices to focus on proper disclosure of fees and expenses charged to or otherwise borne by advisory clients (including allocation of expenses among related vehicles), deal allocation practices, particularly with respect to co-investments, and conflicts of interest generally.
2) Another Brick in the Wall. Cybersecurity has become an increasingly prominent focus of the industry, and regulators are taking a strong interest in firms’ vulnerability to cyber-attacks. While indicating there is no one-size fits all approach to managing these threats, the SEC’s Office of Compliance Inspections and Examinations published its Investment Management Cyber Security Guidance in April 2015, which focuses on the measures firms may consider, including (i) periodic assessment of sensitivity/location of information, technology systems, internal and external threats, security controls, impact of breaches, effectiveness of governance arrangements, and (ii) written policies and procedures and training as a part of its strategy to prevent and detect cyber-attacks. In addition, OCIE has stated that there will be more testing of procedures and controls in exams, and explicitly mentions protection of customer information as an area of focus.
3) The Best is Yet to Come. While we don’t yet have a full year of data, 2015 continues the positive fundraising trend. However, in order to be part of that success story managers are refining fund terms to address the current primary concerns of investors, including conflicts of interest, LP governance rights and clawback protections. Investors are also seeking to reduce their fee burden through co-investments, separate accounts, co-sponsorships and direct investments. Limited partners have many choices about with whom to entrust their capital, and the firms that listen to the marketplace are better suited to attract and retain those investors over the long term.
4) Won’t Get Fooled Again. These days, investors are just as concerned about the “headline risk” of investing with a manager that has its name in the paper for the wrong reasons, as they are about investing on attractive economic terms. Yes, investors want lower fees, but they also want predictability, stability and transparency. This trend has become very evident in the much broader and more detailed due diligence performed on the individual managers themselves, and of the compliance and control safeguards that are in place at their firms. No longer are “re-ups” rubber stamped. As you go to market with new funds, be prepared for multiple rounds of tough questions, and to have your operations and personnel examined as much as your investment performance.
5) Money for Nothing. Much has been said on the topic of management fees over the years, and in July the U.S. Department of the Treasury and the IRS proposed new partnership tax regulations under Section 707(a)(2)(A) of the Code addressing payments and allocations of income for services. The proposed regulations create a facts and circumstances test designed to identify whether arrangements between partnerships and partners (including fee waiver arrangements) will be treated as disguised payments for services for U.S. federal income tax purposes, resulting in ordinary income treatment (and possibly significant penalties under deferred compensation rules). The most important factor in such facts and circumstances test is the entrepreneurial risk of the arrangement — an arrangement that lacks significant entrepreneurial risk is treated as a payment for services without regard to any other factor. The industry response to the proposed regulations is varied and will continue to develop over the coming months.
Proskauer is a PEGCC Associate Member.
