Private Equity - A discussion of risk and regulatory engagement
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Briefing Note 028/06
06 November 2006
The FSA has published a Discussion Paper (DP) "Private Equity: A Discussion of Risk and Regulatory Engagement". The DP is the culmination of a programme of work, prompted by the growing move from the public markets to the private equity market, designed to assess whether the FSA's current approach to the regulation of this market sector is appropriate.
The FSA believes that private equity is an important part of the financial markets and can significantly enhance capital market efficiency. Private equity can widen the availability of capital, increase the effectiveness of company valuations, identify companies with significant growth potential and facilitate their transformation. This belief guides the FSA's overall regulatory response to the private equity market.
Bearing in mind the significant variation in the level and form of regulation of private equity in different jurisdictions around the globe and within the EU, the FSA is very conscious of the need to ensure that its regime is effective and proportionate. Too much regulation can be detrimental to capital market efficiency, but too little regulation can damage market confidence. The FSA wishes to maintain the competitive position of UK capital markets, of which the private equity market is an important integral part, and its therefore asking for industry views on its proposed ongoing regulatory approach.
The FSA is seeking feedback from the industry and public policy makers on whether it has correctly identified the risks posed by the growth of the private equity market and the suitability of its regulatory approach in addressing these risks.
Current Regulatory Approach
The FSA already seeks, through its regulation of private equity firms, to mitigate the risks identified below in a number of ways. These include a close and continuous supervisory relationship with 14 of the biggest private equity/venture capital managers; developing risk mitigation programmes for the relationship managed firms; it engages in frequent dialogue with market participants on private equity sector issues; and including private equity firms in its thematic reviews on market issues.
Key risks
The risks identified by the FSA can be summarised as follows:
Excessive leverage: The amount of credit that lenders are willing to extend on private equity transactions has risen substantially. This lending may not, in some circumstances, be entirely prudent. Given current leverage levels and recent developments in the economic/credit cycle, the default of a large private equity backed company or a cluster of smaller private equity backed companies seems inevitable. This has negative implications for lenders, purchasers of the debt, orderly markets and conceivably, in extreme circumstances, financial stability and elements of the UK economy.
Unclear ownership of economic risk: The duration and potential impact of any credit event may be exacerbated by operational issues which make it difficult to identify who ultimately owns the economic risk associated with a leveraged buy out and how these owners will react in a crisis. These operational issues arise out of the extensive use of opaque, complex and time consuming risk transfer practices such as assignment and sub-participation, together with the increased use of credit derivatives. These credit derivatives may not be confirmed in a timely manner and the amount traded may substantially exceed the amount of the underlying assets. The entrance of new types of market participant with business models that may not favour the survival of distressed companies adds further complexities. These factors may create confusion which could damage the timeliness and effectiveness of work outs following credit events and could, in an extreme scenario, undermine an otherwise viable restructuring.
Reduction in overall capital market efficiency: The substantial inflows of capital into private equity funds combined with the considerable appetite of the debt market for leveraged finance products is fuelling a significant expansion of the private equity market. The quality, size and depth of the public markets may be damaged by the expansion of the private equity market. An increasing proportion of companies with growth potential are being taken private and fewer private companies are going public. Also, the growth potential of those companies that do go public may already have been fully exploited. These factors need to be considered against the backdrop of the enhancements private equity practices can make to capital market efficiency (including with respect to public market efficiency). These enhancements include widening the availability and sources of capital, increasing the accuracy of company valuations (factoring in their growth potential), enhancing the efficiency of corporate capital structures, facilitating corporate development and transformation etc.
Market abuse: The significant flow of price sensitive information in relation to private equity transactions creates considerable potential for market abuse. This flow is increasing as the complexity of the transactions grows and more parties become involved. The involvement of participants in both public and private markets and the development of related products traded in different markets, e.g. CDS (Credit Default Swaps) on leveraged loans, increases the potential for abuse.
Conflicts of interest: Material conflicts arise in private equity fund management between the responsibilities the fund manager has to itself (including its owners/staff), the investors in the separate funds/share classes it manages and the companies owned by the funds. Advisers and leveraged finance providers also face significant conflicts (particularly where they take on multiple roles in relation to an individual transaction) between their proprietary and advisory activities and between their different clients.
Market access constraints: UK retail investors currently only have limited access to the private market via venture capital trusts (which offer access to arguably the riskiest part of the market) and a small number of private equity investment trusts. Indirect access is also limited as few UK pension or insurance vehicles have committed significant capital to private equity. This is partly because of the need for frequent re-negotiation of limited partnership agreements and the substantial delays before committed capital is drawn down. These factors enhance the perceived complexity and reduce the internal rate of return associated with private equity investing. The UK aims to have broad, deep and liquid capital markets. There may, however, be a gap in UK markets as there is no market listing certain types of private equity related vehicle, which are consequently seeking a listing in other EU jurisdictions instead.
Market opacity: Although transparency to existing investors is extensive, transparency to the wider market is limited and is subject to significant variation in methodology (e.g. with respect to valuation, fee disclosure etc) and format. This makes relative performance assessment and comparison complex, which may deter investment by various professional investors who may not be comfortable interpreting the information. It could also lead to ill-informed investment decisions by such investors.
Risk Mitigation
As a result of its recent work it is planning some immediate action and is seeking views from industry on a range of other initiatives. These are set out below.
Planned additional risk mitigation actions:
Reorganisation of resources to establish an FSA alternative investments centre of expertise by integrating private equity firms and supervision staff into the existing hedge fund managers supervision team within the Wholesale Markets Business Unit. The team will relationship manage high impact firms and lead more thematic supervision of private equity/venture capital firms;
Undertaking increased proactive market surveillance targeting the credit markets;
Potential additional risk mitigation actions on which FSA is seeking industry views:
Requesting one additional data point (committed capital) from private equity firms to identify better the higher impact firms and therefore target supervisory resources more effectively;
Regularly surveying leveraged lending and distribution;
Engaging in a targeted fact-finding exercise with trade associations and experienced market practitioners to understand the issues and risks inherent in dealing with corporate defaults;
Undertaking targeted thematic reviews responding to identified risks, such as the significant conflicts of interest arising in private equity structures;
Removing provisions in the Listing Regime which were perceived to create a barrier to the listing of private equity funds.