Geithner Calls for a Lifeguard to Monitor "Private Pools of Capital"
Before jetting off to the G-20 meeting in London, Treasury Secretary Geithner warned House members that investors should no longer be allowed to swim in large “private pools of capital” at their own risk. Mr. Geithner’s message to the House Financial Services Committee was clear: the nation’s deep private investment pools need a lifeguard on duty. What the duties of this lifeguard would be remain somewhat murky. Mr. Geithner sketched the outlines of a regulatory regime in which an independent “systemic risk regulator” would work in tandem with the SEC to oversee hedge funds, private equity funds, and venture capital funds with assets under management above an – as of yet – unspecified threshold. Such large, privately managed funds would have to submit confidential reports to the SEC, which in turn would funnel the information to the systemic risk regulator. It would then be up to the systemic risk regulator to determine whether a fund is “so large or highly leveraged that it poses a threat to financial stability” and should be subject to stringent regulatory controls designed to mitigate risks to the financial system.
The new oversight and reporting requirements proposed by Geithner would substantially alter the regulatory world in which private equity funds operate; they would also inaugurate some of the most sweeping reforms in the regulation of financial markets since the 1930s. Congress passed the Securities Act and the Securities Exchange Act largely based on the sunshine principle. Financial markets would work efficiently, it was thought, if investors had access to reliable, timely information about companies that issued publicly traded securities. The SEC would act as the market’s “sunshine sheriff” by monitoring disclosure and regulatory compliance and taking enforcement actions against the insubordinate. By contrast, Geithner’s newly conceived systemic risk regulator would act as a “shadow sheriff” – making decisions based on non-public information behind closed doors.
If implemented, Geithner’s plan for regulating large private investment funds would create a two-tiered private equity community, with large funds subject to quasi-public company reporting requirements and small to midsized funds continuing to operate largely outside of the government’s regulatory reach. Funds subject to SEC reporting requirements - especially those subject to the more conservative standards imposed on financial institutions deemed “too big to fail” by the systemic risk regulator – may find their investment and management activities significantly curtailed. There will likely be fewer (if any) opportunities for large, highly leveraged deals, higher transaction costs for M&A activity, and increased costs related to the management of portfolio companies. For private equity funds registered with the SEC, the LBO buyout model that defined private equity for the past several decades may no longer be viable.
Small and midsized private equity funds, on the other hand, may find themselves more agile and better positioned to seize investment opportunities as they arise. When credit markets return to health, midsized funds may have greater access to both senior bank financing and subordinated financing from investors in high-yield and other corporate debt. Indeed, if the management and investment activities of the big private equity players become straitjacketed by so-called “prudential” regulatory requirements, small and midsized private equity firms may become our only barometer for telling whether or not private equity’s LBO acquisition model can continue to generate high enough returns to ensure its survival.
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