PEGCC Comments to the Financial Stability Oversight Council on the “Second Notice of Proposed Rulemaking Regarding Authority to Require Supervision and Regulation of Certain Nonbank Financial Companies”
SUBMITTED ELECTRONICALLY
Re: Financial Stability Oversight Council (the “FSOC”) Second Notice of Proposed Rulemaking Regarding Authority to Require Supervision and Regulation of Certain Nonbank Financial Companies (the “Second NPR”) – FSOC-2011-0001
Dear Secretary Geithner:
These comments are submitted by the Private Equity Growth Capital Council (the “PEGCC”). The PEGCC is an advocacy, communications and research organization established to develop, analyze and distribute information about the private equity and growth capital investment industry and its contributions to the national and global economy. Established in 2007 and formerly known as the Private Equity Council, the PEGCC is based in Washington, D.C. The members of the PEGCC are 36 of the world’s leading private equity and growth capital firms united by their commitment to growing and strengthening the businesses in which they invest.[1]
The PEGCC has supported and continues to support efforts to identify potential systemic risks before they arise and, where appropriate, to require enhanced regulation of systemically significant nonbank financial companies. The PEGCC previously submitted comment letters (copies of which are attached) in response to the FSOC Advance Notice of Proposed Rulemaking Regarding Authority to Require Supervision and Regulation of Certain Nonbank Financial Companies and in response to the FSOC Notice of Proposed Rulemaking Regarding Authority to Require Supervision and Regulation of Certain Nonbank Financial Companies (the “NPR”).
I. Private Equity Firms and Funds Do Not Present Systemic Risks.
In the PEGCC’s comment letters, the PEGCC reviewed each of the statutory factors that the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) requires the FSOC to consider in determining whether a nonbank financial company should be designated for enhanced supervision, as such considerations apply to private equity and growth capital firms (“private equity firms”) and the private equity and growth capital funds managed by those firms (“private equity funds”).[2] The PEGCC concluded—and continues to believe—that private equity firms and private equity funds, as a class and individually, do not present systemic risk concerns under any or all of the considerations set forth in Section 113 of the Dodd-Frank Act or the NPR. This conclusion was based on the fact that (i) private equity firms and private equity funds are not meaningfully interconnected with other financial system participants, with very limited counterparty exposure in the form of swaps, derivatives, borrowings or otherwise; (ii) while there are operational relationships between them, there are no meaningful financial interconnections (such as cross-collateralization) between a private equity firm, the funds that it manages and the companies in which those funds invest (“portfolio companies”), and therefore the material financial distress or failure of a private equity firm, a private equity fund or a portfolio company would not cause the material financial distress or failure of an affiliated firm, fund or portfolio company; (iii) private equity funds typically engage in little or no borrowing; (iv) private equity firms and funds are too small in size to present systemic risk concerns; (v) private equity funds pursue long-term investing strategies focused on acquiring primarily illiquid securities, which cannot be “dumped” in the public markets and thereby affect market valuations; and (vi) the sophisticated investors in private equity funds are prohibited from redeeming their interests for the life of the fund, making a “run” on the fund impossible.
II. The Proposed Six Factor Framework is Appropriate.
The PEGCC believes that the proposed six factor framework set out in the NPR and the Second NPR correctly identifies the appropriate criteria for analyzing and designating nonbank financial companies. As discussed in detail in our letters attached hereto, the PEGCC continues to believe that the application of those criteria demonstrates that private equity firms and private equity funds, individually and as a class, do not present systemic risk concerns. Applying the six factor framework, the PEGCC believes that private equity firms and funds (i) are too small in size to present systemic risk concerns; (ii) do not provide financial products or services that cannot be replaced; (iii) are not deeply interconnected with other financial institutions; (iv) generally are not leveraged, and portfolio company leverage does not present more risk than other operating company leverage; (v) generally have long-term assets and liabilities; and (vi) are and will be subject to significant scrutiny from and reporting to the Securities and Exchange Commission (the “SEC”).
III. The Proposed Quantitative Thresholds Are Appropriate.
The PEGCC believes that the quantitative thresholds proposed in the Second NPR are also appropriate for private equity firms and funds, with two qualifications expressed in Sections III.A and III.B below. Assuming that the term “consolidated total assets” is properly defined as a private equity firm’s own assets that are at risk, the PEGCC believes that the $50 billion consolidated assets test is an adequate Stage 1 screen for private equity firms and funds for the reasons outlined in our previous letters[3] and in Section II above. (Indeed, a much higher assets test, we believe, would be more than sufficient for purposes of a Stage 1 analysis of private equity firms and funds, in view of their structures, operations and investors.) In addition, the PEGCC believes that the Second NPR takes the correct approach by only subjecting a nonbank financial company to Stage 2 analysis if it meets both the assets test and at least one other quantitative threshold, such as leverage.
A. Separate Metrics for Private Equity Firms and Funds Are Not Necessary.
The PEGCC does not believe that it is necessary or appropriate to develop separate quantitative thresholds for private equity firms and funds, as discussed in the Second NPR. The PEGCC believes, for example, that a lower assets test would capture private equity firms and funds that could not conceivably present systemic risks, creating uncertainty for those firms and additional burdens on the FSOC, with no discernible benefit to regulators or the public. To the extent, however, that regulators believe that separate quantitative thresholds are necessary or appropriate for certain asset managers, these thresholds should reflect the lower systemic risks presented by private equity firms and funds.[4] The PEGCC believes that an inappropriately low threshold that includes more private equity firms and funds would unnecessarily waste the time and efforts of both the FSOC and the private equity firms in what is almost certain to be a fruitless Stage 2 analysis.
B. The Quantitative Thresholds Should Not Apply to Groups of Companies If They Are Not Financially Interconnected.
The PEGCC believes that the quantitative thresholds set forth in the Second NPR must not be applied to affiliated or associated entities as a group if those entities are not financially interconnected in a meaningful way, but only to individual entities in the group or a subset of entities in the group, if any, that are interconnected. For example, the assets of private equity funds managed by a private equity firm and the assets of the firm should not be added together (whether or not those entities are consolidated for financial reporting purposes) as long as those entities are not meaningfully financially interconnected with one another.[5]
In several of the quantitative thresholds, the FSOC appropriately recognized that separate accounts should be excluded since “separate accounts are not available to claims by general creditors of a nonbank financial company.” The PEGCC believes that this principle should be applied to private equity firms and their private equity funds for the same reason. Private equity firms and the funds that they manage are not meaningfully financially interconnected with each other, i.e., those entities are not responsible for each other’s obligations (for example, because they do not guarantee each other’s obligations and any borrowings are not cross-collateralized). The assets of a private equity fund are not available to claims by general creditors of the private equity firm or another private equity fund, and vice versa, as further discussed below.
1. Private Equity Firms Should Be Analyzed Independently of the Funds and Accounts that They Manage, and Vice Versa.
The PEGCC believes that the quantitative thresholds should be applied to a private equity firm independently of the funds and accounts that it manages, except to the extent that they are proprietary funds or accounts. As the PEGCC has stated in its prior comment letters, the proper metric for measuring the size and interconnectedness of a private equity firm with the funds that it manages is the amount of the firm’s own assets that are at risk. Using a private equity firm’s total consolidated assets on its balance sheet, which in some cases would include third-party managed assets, rather than assets that are owned by the private equity firm, would provide a misleading view of the size and interconnectedness of the private equity firm. Indeed, a private equity firm’s ability to acquire, hold and dispose of third-party managed assets is strictly limited by contract, regulation and other legal arrangements. The obligations of a private equity firm are not guaranteed by, or secured by pledges of the assets of, any of the private equity funds or accounts managed by the firm, and vice versa. Similar to separate accounts, neither a private equity firm nor any creditor of the firm can use third-party managed assets held in a fund structure to gain access to liquidity or to settle a debt of the firm, and vice versa.
Accordingly, the failure of a private equity firm would not cause material financial distress at, or the failure of, the private equity funds and accounts advised by that firm. Similarly, the poor performance of a private equity fund or account managed by a private equity firm would not cause material financial distress at, or the failure of, the firm, except that the firm will receive reduced management fees and carried interest and may not be able to raise capital for new funds or accounts in the future.
For example, while the extraordinary decision by the principals of a private equity firm to dissolve the firm would impose costs on the private equity funds that it advises related to the search for a new investment adviser, this decision would not significantly impact the funds’ investments and, therefore, would not significantly impact the ongoing viability of the funds.
2. Private Equity Funds Should Be Analyzed Independently of the Other Funds and Accounts Advised by the Same Private Equity Firm.
The PEGCC believes that the quantitative thresholds should be applied to each private equity fund and account independently of the other private equity funds and accounts advised by the same private equity firm. The obligations of a private equity fund or account are not guaranteed by, or secured by pledges of the assets of, another private equity fund or account, and vice versa. So, the failure of one private equity fund or account advised by a private equity firm should have no impact on the other funds and accounts advised by that firm.[6]
For example, in the highly unlikely event that all of the portfolio companies of a private equity fund go bankrupt and the fund loses all of its value, none of the other funds advised by the same private equity firm would be impacted, since there is no guarantee or other financial connection between the funds.
3. Private Equity Funds Should Be Analyzed Independently of their Portfolio Companies.
The PEGCC believes that the quantitative thresholds should be applied to each private equity fund without regard to the assets or borrowings of its portfolio companies. Except for a pledge by a private equity fund of the shares of a portfolio company that it owns as security for that portfolio company’s borrowings and in other limited circumstances, the borrowings or other obligations of a portfolio company are not guaranteed by, or secured by pledges of the assets of, the fund or any other portfolio company. This has been industry practice since the 1970s and a private equity fund’s governing documents severely limit this type of exposure. As a result, the failure of one portfolio company should not impact a fund’s other portfolio companies. The fund and its investors may lose their investment in the failed portfolio company, but not in other investments held by the fund.
For example, the bankruptcy of a portfolio company of a private equity fund would not have any impact on the other portfolio companies of that fund since there is no guarantee or other financial connection between the portfolio companies. The only effect on the fund would be the loss of its investment in the portfolio company.
IV. Process Recommendations
The PEGCC believes that there are several important procedural changes that could be beneficial to the FSOC and to nonbank financial companies, including private equity firms and funds.
First, all notifications during the process until the final designation should be confidential. Notifications that are made public even after the fact may have adverse effects on nonbank financial companies, even if they are not ultimately designated as systemically significant. For example, a private equity firm may face difficulty raising capital for a new fund if potential investors believe the firm may be designated as systemically significant.
Second, a nonbank financial company should be notified if the FSOC determines that the company or an affiliate meets the Stage 1 quantitative thresholds. Notification at this stage would allow the company, if it chooses, to prepare and submit its views, data and supporting materials more quickly if and when requested by the FSOC. Allowing earlier participation could save the FSOC time if, for example, the standard regulatory reporting forms create a misleading impression of the nonbank financial company’s business.
Finally, the FSOC should clarify the schedule on which it expects to review the application of the Stage 1 quantitative thresholds to nonbank financial companies in the ordinary course. In the case of private equity firms and funds, for example, the FSOC could clarify that, in the absence of unusual circumstances, it does not expect to review private equity firms and funds more often than annually, or every other year, and that such review ordinarily would take place within 90 days after those firms report information on Form ADV and Form PF.
* * * * * *
The PEGCC appreciates the FSOC’s consideration of this letter and is available to discuss any questions that the FSOC may have concerning the private equity industry.
Respectfully submitted,
Steve Judge
Interim President and CEO
Private Equity Growth Capital Council
cc: Mr. Alastair Fitzpayne
Executive Secretary
United States Department of the Treasury
[1] The members of the PEGCC are: American Securities; Apax Partners; Apollo Global Management LLC; ArcLight Capital Partners; The Blackstone Group; Brockway Moran & Partners; The Carlyle Group; CCMP Capital Advisors, LLC; Crestview Partners; Francisco Partners; General Atlantic; Genstar Capital; Global Environment Fund; GTCR; Hellman & Friedman LLC; Irving Place Capital; The Jordan Company; Kelso & Company; Kohlberg Kravis Roberts & Co.; KPS Capital Partners; Levine Leichtman Capital Partners; Madison Dearborn Partners; MidOcean Partners; New Mountain Capital; Permira; Providence Equity Partners; The Riverside Company; Silver Lake; Sterling Partners; Sun Capital Partners; TA Associates; Thoma Bravo; Thomas H. Lee Partners; TPG Capital (formerly Texas Pacific Group); Vector Capital; and Welsh, Carson, Anderson & Stowe.
[2] For the avoidance of doubt, for purposes of this letter we do not include in the definition of private equity funds the following: private investment funds sponsored by banks or insurance companies, even if some of those funds make private equity-type investments; any private investment fund that is open-ended; funds of funds (funds that invest in private equity funds or other private investment funds); and hedge funds.
[3] See, e.g., PEGCC Comment Letter Re: Proposed Rule: Definitions of “Predominantly Engaged in Financial Activities” and “Significant” Nonbank Financial Company and Bank Holding Company (Mar. 30, 2011) (copy attached).
[4] Private equity firms and funds are subject to different regulatory tests than other nonbank financial companies in other contexts. For example, they are subject to lower reporting burdens on Form PF. The SEC justified this lower burden (correctly, we believe) by stating: “The SEC acknowledges that several potentially mitigating factors suggest that private equity funds may have less potential to pose systemic risk than some other types of private funds…”. Reporting by Investment Advisers to Private Funds and Certain Commodity Pool Operators and Commodity Trading Advisors on Form PF, SEC Release No. IA-3308 (Oct. 31, 2011) at p. 100.
[5] Ordinarily, a private equity firm’s only economic connection to a private equity fund that it manages is the firm’s investment in the fund and the fund’s obligation to pay management fees and carried interest to the firm and/or the firm’s employees. For a detailed discussion of the typical private equity firm and fund structure, please see the PEGCC’s comment letter on the NPR, attached hereto.
[6] The FSOC has indicated that it may treat separate private funds together “if their investments are identical or roughly similar.” The PEGCC believes that, in the absence of interconnectedness, systemic risk analysis does not require that separate private equity funds be analyzed together. Therefore, the PEGCC believes strongly that two separate funds must be analyzed separately if they have differing portfolios, even if those portfolios overlap to some degree.
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