News that the Financial Services Authority (FSA) has been making visits to private equity houses and other players, such as debt providers, as part of a “themed” inquiry into the market has raised concerns in some quarters.
Fears centre on issues such as whether the FSA could try and increase transparency and disclosure relating to funds or whether they may try and bring in new regulation relating to levels of leverage.
One fund director says: “I don’t see private equity as destabilising financial markets and although we are a meaningful sub-sector of the economy now the private equity community, including banks and advisers, is pretty reputable and isn’t sailing close to the wind.”
But what are the areas the FSA is looking at? The authority describes its inquiry as a “fact-finding” or “market-mapping” exercise, which will help it better understand this increasingly important market.
“There’s been huge growth in private equity in the last few years and as we regulate private equity and venture capital we thought it was the right time to try and improve our understanding,” says FSA spokesman David Cliffe.
He adds that the authority’s approach to private equity regulation has been “light touch”, as it is a wholesale rather than a retail market, but that the market has changed due to factors including the explosive growth in funds, the increasing size of the public-to-private market, an increasingly institutional investor base and the dominance of later-stage buyouts and buyins.
The authority, in its Financial Risk Outlook 2006, notes that lending in Europe’s LBO market reached a record £64bn in 2004, up nearly 50% on the previous year.
This growth has brought up several issues, says the FSA, including “the effect that continued growth in the private equity market relative to the public market may have on the efficiency of the overall capital markets and whether the leverage and illiquidity inherent in private equity structures may increase the risks to financial stability.”
Other issues include, “whether market standards, including those related to transparency and disclosure, remain appropriate given the increasing, albeit indirect, interest of retail investors.”
David Cliffe says that visits to private equity houses and other players will probably continue until the end of this quarter and then the FSA will feed back its findings to the private equity industry. This feedback will include what, if anything, the authority intends to act on as a result.
Kathryn Brown, a partner at law firm Paul Hastings, says: “Whenever there is an inquiry like this it makes people nervous because they worry about new regulation.” She adds that the FSA’s probe is a reflection of the maturing of the private equity industry and that it has become a mainstream asset class that is attracting huge institutional sums and investing significantly in public companies.
“It has a much bigger profile and is attracting a broader range of investor, so the FSA is doing its job in trying to understand the broader effects on the economy and capital markets.”
Possibly the more controversial issue, says Brown, is the question of disclosure and transparency, as there has been increasing pressure in recent years from some LPs to get more financial information on funds and, more particularly, on their performance and valuations of portfolio companies.
“One of the traditional strengths of the private equity industry has been that private equity houses can acquire a business and turn it around away from the pressure of public markets or public scrutiny,” says Brown: “If you take that away you’re removing one of the benefits of the way private equity works.”
Others agree that this is a potentially tricky area, as evidenced in the USA by freedom of information legislation that has put pressure on some public-sector LPs to release information about agreements with private equity funds.
Justin Perrettson, regulatory affairs manager at the European Venture Capital Association (EVCA), says that it has done significant work on developing industry standards and issued guidelines last year, as well as putting out to consultation its work on achieving more consistent approaches to valuations.
“Private equity in Europe has probably one of the most advanced professional standards of any alternative asset in the world,” he says. Perrettson acknowledges that there is an issue around information on the underlying portfolio investments if, for example, a pension fund wanted to provide such information to policy holders.
“Disclosing such information can damage investments and we would want to keep a division there otherwise there is not a level playing field on disclosure between private equity-owned private companies and other private companies.”
Generally, however, Perrettson says he does not expect any “rush to further regulation” by the FSA. “My impression is the FSA has an open mind and wants to keep the industry on shore not destroy it,” says Perrettson, adding that some of the press reports on the inquiry have probably exaggerated fears.
A director at one private equity house that has been visited by the FSA says: “They came for a day to talk about financial crime, including money laundering but also fraud and whether someone at the house could take investors for a ride. They actually seemed like sensible people who did not have an axe to grind but were genuinely trying to find out more about how we operated.”
He says he does not expect the FSA to call for more transparency and disclosure: “Apart from venture capital trusts it’s pretty much an institutional investor market and the banks, insurance companies and pension funds know what they’re doing.”
On the issue of whether high levels of leverage are potentially destabilising for the financial sector the director says: “There always have been and always will be some deals that go wrong and if debt levels are high then those deals may go wrong more quickly and be harder to rescue, but I don’t agree that they are making the financial markets less stable.”
Peter Linthwaite, chief executive of the BVCA, says that even though there has been an increase in debt levels in private equity deals, it is still a relatively small part of overall debt especially when compared with consumer debt. “Also, these days the banks are generally not exposed to very high debt in a particular transaction, because of syndication.”
EVCA’s Perrettson recognises that there has been an increase in leverage in European buyouts but says the increase has been lower than many people realise and that there is no “domino effect” waiting to happen. According to Thomson Financial figures, he says, average debt-Ebidta ratios on those deals that disclosed debt levels only increased from 4.1 to 4.9 in the last two years. Other research, on exit prospects, has actually showed that portfolio write-offs fell between 2001 and 2005.
“When you dig down into the facts it’s clear that there’s no bubble of debt waiting to burst,” says Perrettson.
Peter Linthwaite appears relaxed about the FSA probe and says he understands how, with the growth in private equity and its high media profile, the authority felt it needed to increase its knowledge.
“They want to understand how the private equity model works and the inter-relationship between private equity, debt and the public markets – it’s a kind of cross-market review to ensure that they’re meeting their aim of financial market stability.”
The increasing trend of private equity investors to acquire listed companies has triggered the FSA’s interest in the relationship between the two markets and whether there is any negative impact on the public market.
Linthwaite says the two markets operate in a mutually beneficial way and that private equity actually benefits from a strong public market. In any case, he says, the influence of private equity over the public markets waxes and wanes: “If you opened up a newspaper six months ago there were endless stories about how private equity was aiming to take over this or that public company, but in the last month the same articles have been talking about how private equity bids are being rebuffed.”
There will always be opportunities for private equity investors to identify opportunities in listed companies, which those companies’ shareholders may not see, and that that is how it should be, says Linthwaite.
Tom Whelan, a partner at law firm DLA Piper, says that any FSA increase in regulation in order to protect the public market could end up having the opposite effect.
Shareholders of a listed company who decide to sell to private equity get what they see as a good price, he says: “If the FSA ends up increasing regulation on issues like gearing, so that it’s harder for private equity houses to acquire public companies then there will be less demand for those companies and therefore lower returns for the shareholders in the public market.”
What the FSA ends up proposing remains to be seen, although it seems likely that some changes will be proposed if only to justify the effort of such an inquiry. “The FSA will draw together its conclusions from meetings with private equity houses, intermediaries and debt providers and will then flag up the issues, if there are any, that it believes warrant further study,” says Linthwaite.
Some believe that the most likely area where the FSA could seek change is in the transparency and disclosure area, although clearly the FSA would need to be very careful in any increase in regulation so as not to jeopardise private equity in the UK, which many see as one of the most dynamic areas of the UK economy.
Paul Hastings’ Kathryn Brown says: “There is a tension between how much information a private equity fund should release to LPs, or the public, in the interests of transparency, and how much information the fund should be allowed to retain in the interests of commercial performance. It will be interesting to see what view the FSA takes on striking the right balance between the two.”
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