Elections Over, Regulatory Fog Begins To Lift

Are buyout firms shadowy organizations whose highly-leveraged companies and affinity for cost-cutting and outsourcing put our economy further at risk of collapse? Or are they patient and responsible stewards, a source of innovation and job creation, a potential savior to shaky companies desperate for private capital, a big part of the answer to getting our economy back on track?

Each description carries a measure of truth. Both represent caricatures of an industry too large and complex for all-or-none characterizations.

But crises beget simplifications, and whether the new administration and Congress come to view buyout firms largely as villains or heroes will help determine their legislative, regulatory and tax fates in the months ahead. Much remains unsettled, such as who President-elect Barack Obama will name to his cabinet. (Andy Stern, president of the Service Employees International Union, a remarkably acerbic foe of private equity, is considered a possibility for Labor Secretary, according to the Associated Press.) The uncertainty itself has an impact on the buyout market, as firms and their lenders remain less likely to make loans, invest in initiatives, or make acquisitions, until they know more about the regulatory landscape to come.

One thing is clear, though. Just as Sarbanes-Oxley was enacted to ensure no repeat of Enron-like excesses, so Congress is almost certain to craft a regulatory framework to prevent another financial meltdown vintage 2008. Among the early culprits that could come under the government’s thumb: credit default swaps, mortgage-backed securities, and other exotica whose risks were either obfuscated or not fully appreciated by investors. Another are the hedge fund managers who traded in these securities, and who engaged in other practices, such as naked short-selling and buying securities on margin, that arguably pose risks to our entire financial system.

At a minimum, buyout firms should anticipate the enactment of regulations that discourage the rampant risk-taking—“frothiness” was our industry’s favored term for it—that led to the credit boom years of 2006 and 2007. “I think they’re going to use everything at their disposal to try to make banks behave more conservatively in all facets of lending,” wrote Dominick DeChiara, chair of the private equity practice at law firm Nixon Peabody LLP, in an e-mail to Buyouts. “This, in turn, may have an impact on lending into LBOs, especially big LBOs, once banks have decided to turn on the leveraged loan spigot.” At worst, though, buyout firms could find themselves lumped in with all those things that Congress feels it needs to understand better, and perhaps regulate more tightly, to prevent systemic risks to the economy.

Last month, at a hearing hosted by the House Financial Services Committee, Rep. Paul E. Kanjorski, the Democratic chairman of the subcommittee on capital markets, called for “genuine transparency in the new regulatory regime,” and said that both “hedge funds and private equity firms must disclose more about their activities.”

Should others in power agree, the upshot could be everything from requirements for buyout shops to expose detailed information on their investments all the way to limits on debt-to-equity ratios that impact the application of leverage on deals. Here are some other legislative and regulator areas to keep an eye on:

• Buyout shops should anticipate that the U.S. Justice Department and Federal Trade Commission will return to a “more aggressive application” of anti-trust laws, particularly in the communications and Internet markets, according to Frank Reddick, the Los Angeles-based co-chair of the corporate practice at law firm Akin Gump Strauss Hauer & Feld LLP. That could make it more difficult for buyout firms to pursue consolidation strategies, or, in some cases, to sell their companies to strategic acquirers. Reddick pointed in particular to the sale this year of DoubleClick Inc. by Hellman & Friedman to Google Inc. as one that might have been more difficult to complete in an Obama administration.

• Moving factories and other operations overseas has been a central prong of cost-cutting strategies by buyout firms and their consultants over the past decade. Such moves could become more expensive under the Obama administration. On his campaign Web site you can find Obama’s belief “that companies should not get billions of dollars in tax deductions for moving their operations overseas.”

• Obama also views the treatment of carried interest as capital gains as a tax “loophole” that needs to be closed. And, given ballooning budget deficits, his proposal to tax carried interest as ordinary income instead should be an “easy one to get passed,” said Tom Keck, chief investment officer at StepStone Group LLC, an advisor to institutional investors. Obama would also like to raise the top two tax brackets to 36 percent and 39.6 percent, resulting in a possible double-whammy that would make the buyout business a lot less lucrative in the years ahead.