A Changing Landscape for Private Equity Firms

In the world of alternatives, hedge fund managers have had their fair share of attention and scrutiny from politicians, the media, and the public in general.More recently, joining the ranks of hedge funds are their close brethren: Private Equity Firms. Unlike hedge funds, private equity firms have traditionally avoided the limelight, but that is all changing.

So how exactly is the landscape changing for private equity firms?First, due primarily to an argument of overall fairness, there is a threat of higher tax rates to be paid by these buyout executives on profit rewards that they earn from the current 15% tax rate to possibly more than double that.The global landscape and less profitable deal flow available also threaten the profits of private equity firms. Additionally, besides new registration requirements with the Securities and Exchange Commission (“SEC”) for certain private equity funds under the Dodd-Frank Wall Street Reform and Consumer Protection Act, the SEC has recently announced that they will likely step-up their oversight and actions against private equity firms over the next few years. Further, there is a continued push by investors for lower fees and revised fee structures. Another change we’re seeing is with public pensions; at the end of the day, public pensions are responsible as fiduciaries to answer to everyday workers, so the public pensions that invest in private equity funds may ask for more details on job creation from private equity fund managers.Lastly, the current administration and law makers in both houses are also evaluating the elimination or restructuring of a key interest expense deduction that is important to private equity firms related to their leveraged buyout strategies.
In order to best navigate this changing landscape, here are some important points for private equity firms to keep in mind:

• Valuation methodologies of a fund’s assets should be well documented, consistent, and comparable;
• Performance reported to current fund investors, or in marketing materials, is strengthened if verified by a reputable and qualified third party, like a public accounting firm registered with the PCAOB;
• A robust and tailored compliance program offers good protection against government investigations and litigations, where a compliance audit of current policies is imperative in order to determine where gaps may exist in a private equity firm’s current policies;
• Undergoing a review of current insurance policies for continued relevance and applicability is important to ensure correct and appropriate insurance protection is in place for the firm and its executives; and
• For those firms that receive investment dollars from public pensions, such firms should be proactive and start to compile job creation and related statistics now and in advance of an investor requesting such data. This preparation is imperative for two primary reasons 1) it will take some time to compile this type of data, since it is likely such data has not previously been analyzed in any formalized manner, and 2) such data could be an important differentiator for a private equity firm seeking investor dollars; regardless if the investor is a public pension fund or not. This data should also be verified by a reputable and qualified third party, like a public accounting firm registered with the PCAOB.

While some industry experts are going so far as to say that given this new landscape, especially given the prospect of lower profits and higher taxes, private equity firms’ ability to attract the top talent in the industry is at risk and that the golden days for private equity firms may be over, other experts argue that many sectors of the industry do not show any immediate signs of a slowdown. In fact, creativity and entrepreneurship seems to be at heightened levels for such sectors. For example, some funds are taking advantage of programs offered by the U.S. Small Business Administration in order to leverage their fund with cheap debt, others are taking advantage of programs outside of the U.S. to launch and leverage their funds also with inexpensive debt, while others are being innovative with their ability to make money, without charging any fees to their investors.Moreover, private equity firms are working with hedge funds that have illiquid assets they want to dump; hence we are seeing a switching of problem assets between sectors within the world of the alternatives. Lastly, Latin America (excluding Brazil) promises new potential deal flow, presenting an attractive emerging market investment opportunity for private equity firms.

There is no doubt the landscape is changing significantly for private equity firms and most industry experts agree that private equity will look much different in the future than it does today. This change, however, does not discount the hugely important role that private equity plays in relation to our overall economy and capital markets, from funding innovation and new technology to providing a platform for an entrepreneur to monetize and exit their business. As John F. Kennedy said “For time and the world do not stand still. Change is the law of life. And those who look only to the past or the present are certain to miss the future.” (Address in the Assembly Hall at Paulskirche in Frankfurt. June 25, 1963)