Regulators moving in on private equity

Securities regulators worldwide are taking a closer look at the private equity industry. The Technical Committee of the International Organization of Securities Commissions (IOSCO) has published an incisive report earlier this month on conflicts of interest in the private equity industry.

With the private equity industry growing bigger and more complex, and accessing funds from a wider base of public high net-worth individual investors, regulators seem to be keeping a close tab on issues that the industry could throw up for them.

The IOSCO report focuses on conflicts of interest that are involved in the industry – it does not cover issues around investee companies and general “business tensions” that are not peculiar to the private equity industry.

The report classifies the conflicts across various stages of a private equity fund’s life – fund-raising stage, investment stage, management stage and the exit stage. The risks identified by the IOSCO underlines how closely regulators are studying this largely-contract-driven-unregulated industry. Among the issues identified by the IOSCO report are:

# the conflict between the charge of transaction fees from investee companies, and the general interest of investors in the fund to keep costs incurred by the investee companies to the minimum;

# conflict between an equity fund having invested in the equity capital an investee company, and an affiliated fund having invested in the debt capital of the investee, particularly when the investee company is in financial distress;

# conflicts between allocation of opportunities between an existing fund, and a newly raised fund;

# usage of resources from a newly raised fund to bail out an investee in which an earlier fund has invested;

# discretionary allocation of co-investment opportunities to affiliates of the fund manager firm, and investors in the fund;

# receipt of fees by the fund manager firm from investee companies, including fees earned by directors nominated to the fund;

# fees received by affiliates of the fund manager firm from investee companies, such as consulting arrangements between such affiliates and the investee companies;

# conflicts in the minds of directors nominated by the fund manager firm between the interests of the nominating shareholder and the interests of the investee company;

# issues arising out of access to information arising out of a board seat after listing of an investee company, and the resultant inability of the fund to avail of divestment opportunities owing to possession of such information;

# allocation of management resources across funds managed – the propensity to move people away from monitoring investments made by poorly performing funds to funds that are better performing, particularly when the poorly performing fund has no chance of delivering a “carried interest” (share of profit for the fund manager firm);

# timing of divestment of assets by multiple funds managed by the same fund manager firm – the ideal timing for one fund may not be the ideal timing for another fund, where two funds from the same firm have investments in the same investee company;

# propensity for larger investors in the private equity fund, getting more access to portfolio companies and their information, as compared to smaller investors in the fund; and

# conflict between the desire of an investor in a private equity fund to sell, and the fund manager firm’s desire not have the proposed transferee as part of the fund.

The IOSCO report discusses various practices in the industry, and the inherent mitigating factors, and concludes with eight principles. These are generic “good conduct” principles, which, indeed, any self-respecting private equity fund would have advice on from its lawyers in order to mitigate the risk of litigation initiated by investors. It is the interest of the regulators and the level of detail that is interesting, and perhaps indicative of future direction of the legal environment for the industry.

In India, the environment is even more interesting, with private equity firms increasing in number. Some of the funds are also being distributed across high networth individual investors, looking at expanding their asset classes.

The Indian capital market regulator has been a bit ambivalent but at times aggressive about whet-her fund raising of such a nature would constitute a collective investment scheme (the approach to art funds, and the reasoning adopted in the case of unit-linked insurance plans, are cases in point).

The mantra of investor protection can indeed catch up soon. That a significant component of private equity investment ultimately finds its way into listed securities is also an aspect that would nudge the regulator closer to writing regulations seeking to protect investors in private equity funds. (The author is a partner of JSA, Advocates & Solicitors. The views expressed herein are his own.)

Email: somasekhar@jsalaw.com