Private Equity Law Review : New York Private Equity Lawyer & Attorney : Geoffrey Parnass : Corporate & Business Law

In acquisitions of public companies, private equity sponsors often seek to retain members of the target’s management to run the day-to-day operations of the portfolio company after closing. Almost invariably, the sponsors will offer management shares in the surviving company in order to align the managers’ interests in improving the company’s profitability with those of the private equity fund. Sponsors may offer managers an equity interest in the surviving company in proportion to their existing equity interests in the target company (known as “roll over” equity). Alternatively, they may allow managers to invest their own funds to purchase equity in the surviving company alongside the private equity fund (a deal structure known as a “buy-in management buyout” or “bimbo”). When management is offered equity in the acquiring company without having to take out loan notes to finance their buy-in, their shares are known as “sweet equity.”  Such equity interests may be offered either in addition to or in lieu of equity options that vest over time or upon meeting certain financial milestones (referred to as “promote equity”). 

When private equity sponsors issue equity interests in the surviving company to a public target’s current management, the managers may be considered “affiliates” of the target company who are “engaged” in a transaction subject to the Securities Exchange Act’s Rule 13e-3 “going private” filing requirements. Although the Staff of the Division of Corporation Finance of the Securities Exchange Commission as a policy does not provide guidance on whether or not a particular party should be deemed an “affiliate” for purposes of this rule, Compliance and Disclosure Interpretations (C&DIs) released by the Staff on January 26, 2009 together with the Staff’s interpretive releases provide practitioners guidance on what types of deal structures may require Schedule 13E-3 filings. For an overview of Rule 13e-3’s definitions of a “going private” transaction and “affiliate,” please see Part 1 of this post.     

Management as “Affiliates” in Private Equity Buyouts

The SEC has maintained that the determination of a person’s status as an affiliate is a factual question that only may be determined by considering all the relevant circumstances of a given transaction. Nevertheless, the Staff’s C&DIs provide some insight into the factors considered by the Staff to be determinative of a person’s affiliate status. Judging whether or not officers or directors of a publicly traded target company are affiliates of the company under Rule 13e-3 generally turns on whether or not they have the power to direct or cause the direction of the management and policies of the target company. According to the Staff’s interpretive releases and C&DIs, the continuity of management or directors of the target before and after the transaction in question likely indicates that the deal requires compliance with Rule 13e-3.

In the interpretive release adopting Rule 13e-3 (Release No. 34-16075), the Staff suggested that even if an unaffiliated private equity sponsor engages in arm’s-length negotiations regarding the acquisition of a target, yet intends to keep the target’s management in place after the purchase is completed, the parties engaged in the transaction may be required to file Schedule 13E-3. Among the factors the Staff takes into consideration are:

• an increase in consideration received by management;
• any alterations in management’s executive agreements that are favorable to management;
• equity participation of management in the acquiring or surviving entity; and
• the representation of management on the board of directors of the acquiring or surviving entity. 

The Staff has consistently held that members of senior management of a public corporation that is “going private” are affiliates of the company. In deals where a transaction is accomplished by way of a merger, the Staff has concluded that senior managers are required to file Schedule 13E-3, even though: 

• management’s involvement in the target’s negotiations with the buyer was limited to the terms of each manager’s future employment with or equity participation in the acquiring or surviving company; and
• the target’s board of directors appointed a special committee of outside directors to negotiate all other terms of the transaction except management’s role in the acquiring or surviving entity. 

Measures taken by a public company’s board of directors to protect shareholders from the possibility that its officers or directors may collude with a buyer do not alone obviate the need for a Schedule 13E-3 filing.  Factors considered by the Staff include: whether management would hold a material amount of the surviving company’s outstanding equity securities, occupy seats on the company’s board of directors in addition to having senior management positions, or would otherwise be in a position to “control” the surviving company. 

Although the Staff has not defined what constitutes a “material” equity interest in a company, historically it has determined that a 10% ownership interest is sufficient to cross the materiality threshold. Nevertheless, this 10% figure should not be taken as a bright-line rule, as even a smaller equity interest in a public target may trigger Rule 13e-3 if other evidence of “control” is present.  

Private Equity Funds as “Affiliates” of the Target and its Management

In one of the January 2009 CD&Is, the Staff specifically addressed the situation where a financial buyer, previously unaffiliated with the target, intended to enter into separate agreements with members of the target’s senior management resulting in management’s ownership of 20% of the surviving entity after the deal closed. Although the managers neither negotiated the merger agreement with the private equity sponsors nor executed any documents regarding their future equity participation, the Staff held that “where there exists a general understanding that a target’s senior management will receive equity in a surviving equity, whether derived from unexecuted documents or otherwise, Rule 13e-3 may apply.” The Staff reasoned that because senior management understood they would be equity holders in the surviving entity, the financial buyer in effect straddled both sides of the transaction (i.e. as both acquirer and target). Owing to the substantial equity participation in the transaction by senior management, each of whom would remain in a position to influence the policies of the target, the financial buyer could be in “control” of the target before the deal closed.

As the previous CD&I demonstrates, where management of the target company is effectively “on both sides” of the transaction, the private equity funds (and any acquisition vehicles formed for the deal) may also be deemed to be affiliates of the target company engaged in the transaction and thus be required to file Schedule 13E-3. In Release No. 34-16075, the Staff stated that “affiliates of the seller often become affiliates of the purchaser through means other than equity ownership, and thereby are in control of the seller’s business both before and after the transaction. In such cases the sale, in substance and effect, is being made to an affiliate of the issuer.”

A recent example of this scenario may be found in the July acquisition of Bankrate, Inc. by funds advised by Apax Partners in which the Apax funds, the holding companies set up by Apax to complete the deal, members of senior management, and Bankrate jointly filed a Schedule 13E-3. 

Related Post: Going Private: Rule 13e-3 and the Acquisition of Public Companies – Part 1

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In debates over public policy, the first battle often involves a contest over narrative. If others adopt your story, you can gain an early advantage by having lawmakers solve the problems you define for them. In this month’s hearings on “Enhancing Oversight of Private Pools of Capital” before the House Financial Services Committee, Douglas Lowenstein, President of the Private Equity Council (PEC), told a familiar tale: Twin brothers, both productive and contributive to the common good, unjustly subjected to different standards. Why should Abel’s gifts be accepted, while Cain’s gifts are rejected? Mr. Lowenstein did not invoke our shared concept of justice, but instead turned to the pragmatist’s supreme value: practicability. In his criticism of Congressman Paul Kanjorski’s (D-PA) draft amendments to the Investment Advisers Act of 1940 (IAA), Mr. Lowenstein claimed the bill’s venture capital exemption may “prove impossible to implement” because private equity and venture capital funds “have virtually the same business model, skill set, and compensation structure.” But how accurate is this statement?         

Private Equity vs. Venture Capital

In his own testimony before the Committee, Terry McGuire of the National Association of Venture Capitalists drew a distinction between venture capital’s investments in young enterprises and private equity’s buyouts of mature companies:

Importantly, the capital supplied to a venture capital fund consists entirely of equity commitments provided as cash from investors in installments on an as-needed basis. Venture capital funds do not use debt to make investments in excess of the partner’s capital commitments or “lever up” the fund in a manner that would expose the fund to losses in excess of the committed capital or that would result in losses to counter parties requiring a rescue infusion from the government.

Venture capital’s “straightforward equity investment,” Mr. McGuire concluded, meant that venture capital “risk is contained and measured,” thereby distinguishing it from the systemic risk Rep. Kanjorski’s draft legislation seeks to monitor.

When describing private equity investments, however, Mr. Lowenstein spoke only of “adding managerial expertise, making capital and R&D expenditures, expanding into new markets and developing new products, and making strategic acquisitions to create the scale required to compete and become market leaders.” Nowhere did he discuss the centrality of restructuring the balance sheet, or leverage recapitalization, to PEC members’ strategy for increasing the rate of return on their investments. On the contrary, most of Mr. Lowenstein’s discussion of private equity practices focused on the limited partnerships at the fund level rather than delving into an explanation of how such funds finance their portfolio company acquisitions. When he touched upon borrowings by portfolio companies, he did so only to note that such loans constituted “a small portion of the overall credit market.” 

In spite of the striking similarity between the PEC’s remarks on October 7 with those delivered to the same Committee on July 17, the PEC tellingly dropped any reference to the 3:1 to 4:1 Debt/Equity ratio carried by private equity fund investments. Back in July, the PEC cited the ratio to compare it to the 32:1 Debt/Equity ratio of failed investment bank Lehman Brothers, a favorable foil, to be sure. Even then, the PEC stressed that Lehman’s parent company carried the debt, thus exposing “the entire bank to collateral calls.” Limited partners in private equity funds, on the other hand, have no such exposure because their organizational documents preclude follow-on equity infusions into existing investments. 

By concentrating on the risks to LPs of any single portfolio company capsizing, the PEC may have lost the forest for the trees. After all, the Obama administration, the Federal Reserve, and Congress have made it clear that the impetus behind regulatory reform is “to monitor and identify emerging risks to financial stability across the entire financial system.” In this context, any assessment of private equity funds must take into account all stakeholders in their portfolio company investments, including banks and bondholders.   

Leveraged Recapitalization (or Restructuring the Balance Sheet)

To begin with, “private equity” is somewhat of a misnomer; a more apt name would be “private levered equity,” a term that would at least acknowledge the critical role of leveraged buyouts (LBOs) in private equity’s investment strategy. Until the credit markets dried up over the last 12 months, equity investments by LBO funds have always been supplemented by a healthy dose of debt financing. Historically, private equity buyouts have been largely funded by acquisition debt, usually comprising senior term and revolving loan facilities paired with a post-acquisition high-yield bond offering, which was occasionally backstopped by mezzanine financing. (In addition to high interest rates, mezzanine loans usually require warrants attached, allowing lenders to roll over into a shareholder’s position upon the occurrence of certain adverse events.) 

What’s the advantage of using relatively small amounts of equity in an investment? Part of the answer may be found in the implications of what is known in modern portfolio theory as the Modigliani-Miller theorem. Nobel Laureates Franco Modigliani and Merton Miller showed that – at least in “perfect capital markets” – the composition of a firm’s securities does not change the total value of a firm’s assets. That is, a firm may divide its cash flows into dividends to shareholders and interest payments to creditors without decreasing the value of its underlying business operations. Without getting into the way in which real-world market imperfections affect the implementation of the Modigliani-Miller theorem, we’ll summarize its influence on the structure of LBOs.    

The expected rate of return on an investment increases in proportion to a company’s Debt/Equity ratio.  (The basic principle is the same as mortgaging the purchase of a house.) In practice, the portion of a portfolio company’s cash flows available for dividend payments to the LBO fund actually is decreased for several reasons. An increased Debt/Equity ratio results in a commensurate increase in the risk that a company will go bankrupt because it fails to make timely interest payments on its debt obligations. For deeply subordinated high-yield debt, for example, some of this risk is borne by bondholders, who accordingly demand higher interest rates, thus siphoning off some of the company’s cash flows that would otherwise go to shareholders. But the cost of servicing debt in turn is reduced by an important provision of the U.S. corporate tax code: interest payments by a company on its debt are tax-deductible (whereas dividend payments are not). So every dollar paid to the company’s senior lenders and bondholders in fact only costs the company a fraction of that amount; the benefits of this tax shield ultimately accrue to the LBO fund that owns the company. (It should be noted that the Wall Street Journal reported this week that a presidential tax-policy panel headed by Paul Volcker is currently examining whether to eliminate the “tax code’s bias toward raising money from tax-deductible debt issues rather than from stock sales.”)

Leveraged Buyouts & the 2006-2007 Credit Bubble

In arguing against the need to disclose information to the SEC, Mr. Lowenstein insisted that “third parties that privately negotiate with PE funds,” including creditors, “are all highly-sophisticated market participants with the leverage to bargain with the fund at the time that the counterparty or creditor relationship is first established.” Yet, the experience of the past four years has demonstrated that even sophisticated lenders are subject to market forces and may sacrifice their negotiating leverage in order to capture fees in a highly competitive environment. As Professors Colin Blaydon and Fred Wainwright of Dartmouth’s Tuck School of Business described the situation in a 2006 article, “The Balance Between Debt and Added Value,” before the credit bubble burst:

Banks and other lenders are aggressively competing with each other for deals to generate fees and interest income in the midst of a relatively low interest rate environment. The result has been a steady expansion of the amount of debt available for leveraged acquisitions and a relaxation of lenders’ terms and conditions. This expansion of debt availability has permitted investors to quickly recapitalize their acquired companies and make large dividend payments to themselves and other equity owners.

In previous posts, we’ve covered the advent of so-called “covenant lite” senior loan agreements (which eliminated or reduced maintenance covenants requiring companies to meet certain financial ratios) and “payment-in-kind,” or PIK notes, to bondholders (which permit a company to issue additional notes to bondholders in lieu of cash interest payments). Declining interest rates over the course of 2006 and 2007 coupled with banks’ eagerness to generate underwriting fees from bond issues enabled private equity funds to generate immediate returns for their investors through financial engineering.

According to a New York Times story on the bankruptcy filing of the Simmons Bedding Company, the company’s private equity owners Thomas H. Lee Partners paid itself and its limited partners a $375 million dividend with the proceeds of post-acquisition debt issuances, allowing it to recover all of its initial equity investment. This sort of recapitalization through additional borrowing serves two purposes: it puts cash directly in the hands of an LBO fund’s LPs and GP and it decreases the fund’s exposure to the portfolio company’s risk profile. Even though portfolio companies generally were able to lock in their debt obligations at low interest rates, these highly leveraged companies were vulnerable to a general economic turndown. Ironically, many of the institutional investors who as limited partners in private equity funds benefited from leverage recapitalization also suffered as portfolio company bondholders when they were only able to recover cents on the dollar, if anything at all.

Private Equity Firms & the Banks

Although senior term and revolver loans for acquisitions are initially funded by a consortium of lead banks, the banks seek to syndicate interests in the loans to other counterparties in an attempt to decrease their risk exposure to any single portfolio company’s financial performance. Similarly, banks underwriting post-acquisition high-yield offerings privately place the bonds with a large number of institutional investors, many of whom later sell interests in these notes to other qualified institutional buyers in the secondary market. A single LBO investment, in other words, has many stakeholders other than the private equity fund itself. 

What happens when the market for LBO senior loan syndication or private placements of high-yield bonds suddenly dries up? Usually, the banks are left holding the debt. Foretelling things to come, Bloomberg reported in July 2007 that “banks have had to dig into their own pockets to finance parts of at least five leveraged buyouts over the past month because of the worst bear market in high-yield debt in more than two years.”   

In late 2006, when private equity funds eyed larger prey, both on their own and in concert with others in “club deals,” banks began to offer buyout firms “equity bridge loans” for the first time since the late 1980s. When banks issued equity bridge loans, they intended them to serve as temporary advances of credit to a private equity fund to facilitate the acquisition of a company. After the deal closed, the banks would then seek to find buyers for the equity stake they had taken in the portfolio company. Although such loans carried a high degree of risk, the competition among banks during the years 2006 and 2007 for the high fees they earned from LBOs provided them with sufficient incentive. After all, according to Dealogic, private equity firms generated 22% of investment banking fees during the period from mid-2006 through mid-2007. In August 2007, BusinessWeek reported that banks were “on the hook for billions of dollars,” although none of the banks would reveal their exposure.

Leveraged Buyouts & Systemic Risk Regulation

As far back as May 2007, Federal Reserve Chairman Ben Bernanke warned that the LBO model resulted in banks’ sharing a significant amount of risk in private equity investments:

There are some significant risks associated with the financing of private equity including bridge loans. ... We are looking at that….. I urge banks to closely evaluate the risk that they’re taking not only in the context of a highly liquid, benign financial environment, but in one that might conceivably be less liquid and benign.

As Chairman Bernanke recognized over two years ago, the institutional investors constituting private equity funds’ limited partners are not the only stakeholders in LBOs. 

None of this should be misconstrued as a call to arms for the regulation of all private equity funds. But unless Congress takes into account the nature of private equity’s leveraged buyouts – especially ones conducted by billion-dollar mega funds like those managed by the PEC’s members – regulatory reform will most likely fail.      

In closing, it’s worth reading the Wall Street Journal’s coverage of Terry McGuire’s interview with founder and chairman of global private equity firm Advent International, Peter Brooke: 

The people that over-leveraged their companies, the people that did these dividend recapitalizations and the things of that nature, have done no one any good…We have to face the fact that there is going to be some form of restrictive legislation on private equity managers…The bad guys deserve it, the good guys don’t deserve it, but I’ll tell you, they’re all tarred with the same brush.

 Related Post: House Hearing on Private Equity and Venture Capital Regulation - Part 1: The Private Equity Council

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Everybody likes a fight. So it came as no surprise that the media dredged up some hackneyed headlines to describe the House Financial Services Committee’s hearings on regulating hedge funds, venture capital, and private equity earlier this month. Whether they dodged bullets at a “Showdown at the VC Corral” or witnessed bloodlust as “PE lobbyists throw VCs under the bus,” journalists let us know that – surprise! – the private equity community trashed the venture capital exemption in Congressman Paul Kanjorski’s (D-PA) draft bill on amendments to the Investment Advisers Act of 1940 (IAA). Even so, it was somewhat disappointing that nobody offered any details about the testimony of Douglas Lowenstein of the Private Equity Council (PEC). True, details don’t always make for compelling news copy, but the PEC’s testimony seems to warrant a second look. Part 1 of this post first asks the questions: “On behalf of whom does the PEC speak?” and “What weight should Congress give to their opinions?” We then review some of the PEC’s specific complaints about Rep. Kanjorski’s draft bill. In Part 2, we’ll analyze the PEC’s arguments for eliminating the bill’s venture capital exemption, especially its facile equation of private equity acquisitions with venture capital financing.    

How Representative is the Private Equity Council?

What is the Private Equity Council? It’s a D.C.-based trade group formed in February 2007 to lobby public policy makers on behalf of some of the largest private equity firms in the U.S., including Blackstone, KKR, Carlyle, Bain, Apollo, Apax, and Madison Dearborn, each of which has over $10 billion in assets under management. By its own admission, the PEC represents only a dozen large private equity firms, even though it estimates that there are over 2,000 private equity firms based in the U.S. By comparison, the National Venture Capital Association (NVCA) has over 450 members, more than half of the approximately 740 U.S. venture capital companies, representing more than 90% of the venture capital industry’s assets under management. The PEC’s presence at the Committee’s hearing on “Enhancing Oversight of Private Pools of Capital” probably speaks more to its members’ influence on Wall Street and K Street than it does to its suitability as an advocate for the private equity industry as a whole. 

To be sure, the PEC’s members will be among those most affected by any regulation of alternative investment vehicles and consequently deserve to have their voices heard by Congressional lawmakers. They are also most likely to be scrutinized by any governmental body charged with the duties of a “systemic risk regulator.” At the same time, the Committee should not take the opinions of Mr. Lowenstein on Rep. Kanjorski’s bill as representative of the some 1,900 other private equity firms, who apparently don’t merit a seat at the bargaining table. It should be borne in mind that some of the PEC’s members either already are, or soon will be, subject to SEC registration and reporting requirements. The Blackstone Group LP (BX) currently trades on the New York Stock Exchange (NYSE), while KKR’s recently completed reverse merger with its Euronext Amsterdam-listed affiliate KKR Private Equity Investors positions it for a planned NYSE listing in the spring of 2010. Meanwhile, the PEC’s other members tend to target acquisitions of relatively mature companies, many of whose securities are publicly traded. In the process of taking such companies private, private equity funds must comply with various SEC requirements, including the Securities Exchange Act’s Rule 13e-3 “going private” disclosures for affiliates of equity issuers, the Williams Act’s regulations governing tender offers, Regulation 13D filings on beneficial ownership, and Section 16’s insider trading rules.

In his prepared testimony, Mr. Lowenstein tacitly acknowledged that many of the investment and fundraising activities of the PEC’s members already fall within the purview of governmental authorities. He seemed resigned that more stringent regulation was inevitable when he gave his lukewarm endorsement: “we are generally supportive of requiring registration of advisers to private pools of capital.” As expected, Mr. Lowenstein’s criticisms of specific provisions in the Kanjorski bill relate the objections of the PEC’s members. It would be foolish to ignore the obvious fact that small- to midsized private equity firms have no trade association that the Committee could have summoned to the Hill. Aside from these firms’ limited resources, the “lone wolf” investment style of private equity firms discourages the formation of a nationwide trade association. After all, the PEC itself was formed only after its members began to club together in mega deals for large corporations. But it would be even more foolish for Congress to disregard how the Kanjorski bills regulatory reforms will impact the vast majority of private equity firms.         

Big Private Equity’s Need for a Competitive Advantage

A close reading of Mr. Lowenstein’s October 6 testimony before the Committee indicates that the PEC’s members are most concerned with the prospect that the draft legislation’s “broad disclosures to third parties” would put its constituents at a “serious competitive disadvantage.” By contrast, the testimony of Terry McGuire of the NVCA focused on how the onerous regulatory burdens of the IAA would interfere with venture capital firms’ ability to “start and grow new companies.” Mr. McGuire pointed out that even relatively large venture capital firms – such as his own Polaris Venture Partners – run on skeleton crews ill-equipped to shoulder heavy administrative burdens. Compliance with the requirements imposed on IAA registered advisers would not only hamper the investment activities of big VC firms, but venture capital firms of all types and sizes.   

Mr. Lowenstein took particular issue with Section 204(b)(7) of the discussion draft, which would grant the SEC broad rulemaking authority to require IAA registrants to provide reports, records, and other information to “investors, prospective investors, counterparties, and creditors” of private funds. For private equity firms to comply with these requirements, Mr. Lowenstein contended, “is potentially destructive of normal commercial relationships and could expose proprietary information and trade secrets to those with whom we compete.” The PEC’s members appear to fear a scenario in which they are compelled by the SEC to disclose certain information to one of their senior lenders, such as JPMorgan or Goldman Sachs, which could then pass on such information to the banks’ respective private equity affiliates, like JPMorgan Partners or Goldman Sachs Private Equity Group. Averring that keeping such information confidential is crucial to retaining a private equity fund’s competitive advantage, Mr. Lowenstein exhorted the Committee to eliminate the provision from any final legislation. Such concerns more likely represent those of the PEC’s membership than of the typical private equity fund, which is unlikely to be able to convince banking behemoths like JPMorgan or Goldman Sachs to provide debt financing on a $50-$150 million leveraged buyout of a midmarket company. 

Moreover, for reasons we’ll explore in more detail in Part 2, Mr. Lowenstein’s argument that creditors and investors that negotiate with private equity funds “are all highly-sophisticated market participants with the leverage to bargain with the fund at the time that the . . . relationship is first established” rings hollow. Does anyone who witnessed the lending frenzy of 2006 – 2007 honestly believe that banks in such a competitive landscape would “simply refuse to lend to the fund if the lender is not satisfied that it has received sufficient upfront information about that fund and its investments?”

Assets under Management Threshold

It’s true that elsewhere in his testimony Mr. Lowenstein championed the concept of “calibrated reporting requirements for different types of funds,” an argument that on its face promotes the interests of smaller private equity funds. A good argument could – and should – be made that the IAA’s $30 million threshold is too low for advisers to private funds, many of whose deals, whether structured as leveraged buyouts or pure equity buyouts, could not arguably pose a systemic risk to the financial system. But even here, where Mr. Lowenstein appears to stand up for most private equity firms, he subsequently undermines this position by demanding that “the language [of the bill] base calibration not just on the type and size of the fund, but on their potential to cause systemic risk.” The problem with this argument is that nowhere does Mr. Lowenstein propose another way for Congress to devise a metric for determining systemic risk.   

Once again, this proposition only serves the interests of the PEC’s members. As Part 2 will show, Mr. Lowenstein’s insistence that the size and type of fund bears no relation to whether or not its investment activities pose a systemic risk relies on his attempt to equate venture capital financing with private equity LBOs. According to the PEC, the two are merely different species of the same genus. But the history of large LBOs over the past three years tells another story. Remember, as recently as this past April French banks seriously considered quarantining their LBO debt in a “bad bank” lest their liabilities metastasize.   

Related Post: House Hearing on Private Equity and Venture Capital Regulation - Part 2: Leveraged Buyouts

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At the end of last week, the House Financial Services Committee focused on regulatory reform measures designed to mitigate systemic risk to the financial system and to regulate hedge funds and private equity. Federal Reserve Chairman Ben Bernanke offered his advice on what steps Congress should take to reform U.S. financial regulation. Congressman Paul Kanjorski introduced draft legislation that would require all private equity and hedge funds that manage assets in excess of $30 million to register with the Securities Exchange Commission, but would exempt venture capital funds from SEC registration. This week, the Committee expects to be just as busy. Tomorrow, October 6, the Financial Services Committee plans to hear testimony from representatives of the venture capital, hedge fund, and private equity industries. In today’s post, we’ll summarize Mr. Bernanke’s recommendations for managing systemic risk, dissect Rep. Kanjorski’s draft bill, and provide you a brief preview of tomorrow’s hearing.

Bernanke’s Testimony on the Oversight of Systemic Risk

The Chairman of the Federal Reserve, Ben Bernanke, journeyed to Capitol Hill last Thursday to offer the House Financial Services Committee his perspective on proposed financial regulatory reforms. Like Treasury Secretary Timothy Geithner, who appeared before the same Committee back in March, Mr. Bernanke emphasized the current regime’s deficiencies in managing systemic risks to U.S. financial markets. Single agencies may be well suited to oversee a single firm or financial sector, Mr. Bernanke pointed out, but have neither the resources nor the expertise to oversee divers types of market players, let alone to anticipate the ways in which their dealings with one another may threaten the financial system as a whole. 

As a remedy to this regulatory malady, Mr. Bernanke highlighted two areas for reform. First, he advised Congress to establish an “oversight council” empowered “to monitor and identify emerging risks to financial stability across the entire financial system, to identify regulatory gaps, and to coordinate the agencies’ response to potential systemic risks.” As conceived by Mr. Bernanke, the oversight council would comprise representatives from governmental agencies tasked with supervising the financial sector. In order to fulfill its mandate, the oversight council would need to have access to a wide range of information from various agencies regarding the institutions and markets they supervise as well as the authority to collect information on its own.

Second, Mr. Bernanke recommended the “reorientation of individual agency mandates to include . . . the responsibility to try to identify and respond to the risks” posed by the firms and markets within each agency’s purview. While Mr. Bernanke acknowledged that each agency individually could take on this challenge, he suggested that they would be aided or advised by the oversight council as well. Although individual agencies could adapt their responses to systemic threats arising in the areas over which they have authority, Mr. Bernanke considered it probable that many systemic risks would cross traditional regulatory boundaries. In such situations, the oversight council would be best positioned to intervene. 

Mr. Bernanke’s proposed “oversight council” fleshed out the bare bones of Mr. Geithner’s “systemic risk regulator.” The Board of the Federal Reserve, it appears, lined up behind President Obama’s prescriptions for regulatory reform. It therefore was not surprising when Congressman Paul Kanjorski (D-PA), Chairman of the House Financial Services Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises released draft legislation mirroring a model bill issued by the Obama administration in July. 

Private Fund Investment Advisers Registration Act of 2009

Late in the day on October 1, Rep. Kanjorski circulated a “discussion draft” of the Private Fund Investment Advisers Registration Act of 2009, which would eliminate the Investment Advisers Act of 1940's “private fund adviser” exemption. Under the draft bill, all hedge funds and private equity funds with assets under management in excess of $30 million would be required to register with the SEC. The text of the bill introduces a definition of the term “private fund” into the Advisers Act. In its proposed formulation, a private fund would mean an investment fund that would qualify as an investment company under the Investment Company Act of 1940 were it not for the exceptions provided by §3(c)(1) or §3(c)(7) of the Company Act and that either (i) is organized under the laws of the United States or (ii) has 10% or more of its outstanding securities by value owned by United States persons. Under the Company Act, Section 3(c)(1) excludes funds beneficially owned by 100 persons or less and Section 3(c)(7) excludes funds whose securities are owned by certain “qualified purchasers” from the definition of an investment fund.  

The proposed bill would also eliminate the “private fund adviser” exemption under §203(b) of the Advisers Act, which presently is available to any adviser that has fewer than 15 clients and does not generally hold itself out to the public as an investment adviser. As we explained in an earlier post, the SEC historically has interpreted the term “client” in §203(b)(3) to refer to the limited partnerships advised by hedge fund managers and private equity firms rather than to the investors constituting their limited partners. Rep. Kanjorski’s draft legislation vests the SEC with broad rulemaking authority, including the power to change the definition of the term “client” under the Advisers Act. This provision pointedly overturns the 2006 ruling by the D.C. Circuit Court of Appeals in Phillip Goldstein v. SEC that vacated the SEC’s “Hedge Fund Rule,” which allowed the agency to “look through” a limited partnership’s legal structure to count each limited partner as a client.  

The Private Fund Investment Advisers Registration Act would require all SEC-registered hedge fund managers and private equity firms to maintain records or file reports disclosing:

• the amount of assets under management;
• the use of leverage (including off-balance sheet leverage);
• counterparty credit risk exposures;
• trading and investment positions;
• trading practices; and
• such other information as the SEC (in consultation with the Federal Reserve) determines necessary or appropriate for the assessment of systemic risk.

The draft bill also empowers the SEC to share information about hedge funds and private equity firms with either the Federal Reserve or any other government agency tasked with monitoring systemic risk to the financial system. 

Rep. Kanjorski’s proposed legislation exempts advisers to venture capital funds from registering with the SEC. In its current draft, the bill vests the power to identify and define the term “venture capital fund” with the Commission. This exemption has been heralded by many as a victory for the venture capital community, which has contended that its investments do not pose any viable threat to the financial system. Prior to the release of Rep. Kanjorski’s draft legislation, Barney Frank (D-MA), Chairman of the House Financial Services Committee, explained: “We are supportive of the role of venture capital, we are working in consultation with venture capital, and I don’t think there will be anything in there for venture-capital firms.” 

Aside from the discussion draft’s close tracking of the Treasury Department’s own proposal for the regulation of hedge funds and private equity, the House Financial Services Committee’s alignment with the Obama Administration on this issue is perhaps best exemplified by Rep. Kanjorski’s adoption of one of Mr. Geithner’s favorite metaphors for hedge funds and private equity firms. In his press release accompanying the distribution of the bill, Rep. Kanjorski observed: “[W]e need to ensure that everyone who swims in our capital markets has an annual pool pass.”

Capital Markets Regulatory Reform Hearing

Last Wednesday, representatives of the hedge fund industry’s main lobbying group, the Managed Funds Association, met with Mr. Geithner, Mr. Bernanke, and Mary L. Schapiro, chairwoman of the SEC, to voice their opinions on President Obama’s plans for overhauling the financial regulatory system. We expect to hear more from representatives of the hedge fund and private equity community at tomorrow’s Financial Services Committee’s hearing on “Capital Markets Regulatory Reform.” The following individuals are scheduled to testify before the full committee:

• The Honorable Richard H. Baker, President, Managed Funds Association
• Mr. Douglas Lowenstein, President, Private Equity Council
• Mr. James S. Chanos, Chairman, Coalition of Private Investment Companies
• Mr. Terry McGuire, Co-Founder and General Partner, Polaris Venture Partners, and Chairman, National Venture Capital Association

You can watch a live webcast of the hearing on the House Financial Services Committee’s website.

Hedge Fund and Private Equity Regulation Series

For other posts in our series on U.S. regulatory proposals for private equity and hedge funds, see:

Regulation of Private Funds: Senator Reed and the Congressional Hearings

• Senator Jack Reed's (D-RI) bill, the Private Fund Transparency Act of 2009 (S.1276), was referred to the Senate Committee on Banking, Housing, and Urban Affairs on June 16, 2009.

Geithner Calls for a Lifeguard to Monitor “Private Pools of Capital”

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When a private equity fund buys substantially all of a public company’s outstanding shares in a cash offering, the acquisition may be described colloquially as “taking the company private.” From the perspective of the Securities Exchange Commission, however, the term “going private” applies specifically to situations where either the issuer of an equity security or one of its affiliates purchases the shares. When this occurs, Rule 13e-3 under the Securities Exchange Act of 1934 requires the issuer and any of its affiliates participating in the transaction to file detailed disclosures on Schedule 13E-3. At first blush, it would appear that the buyout of a public company by an unaffiliated private equity firm wouldn’t implicate Rule 13e-3. Nevertheless, as we’ll explain in Part 2 of this post, the structure of leveraged buyouts by private equity firms often triggers the additional disclosure obligations mandated by the Rule.

More often than not, private equity buyers seek to retain a public company’s executive officers to manage the company’s business operations after the transaction has closed. Private equity firms typically offer these managers so-called “sweet equity,” or shares in the new holding company that will own the public company’s business operations post-closing, as an enticement for them to remain.  Owing to the way in which Rule 13e-3 defines the term “affiliate,” the issuance of equity interests to these executives frequently requires both them and the private equity fund to comply with Rule 13e-3. In today’s post, we’ll review the general requirements of Rule 13e-3. In Part 2, we’ll examine how the Rule applies to private equity buyouts where a public company’s existing managers stay on to run the business after closing.

“Going Private” Transactions 

The SEC adopted Rule 13e-3 over concerns that a “going private” transaction conducted by an issuer or its affiliates may be designed to favor its own interests rather than those of unaffiliated shareholders. When a public company launches a tender offer to purchase substantially all of its own outstanding equity securities, it plays a unique role. Unlike third-party buyers who must conduct arm’s-length negotiations over the terms and conditions of an acquisition, an issuer may abuse its insider position to dictate terms – including the proposed purchase price – unilaterally. 

Going private transactions tendered by an issuer or its affiliates present complex agency problems. Directors and managers of a company charged with representing the interests of a company’s shareholders may instead promote the interests of the entity acquiring the securities. The directors, for example, could choose to launch the tender offer during a period of depressed market prices, resulting in a loss to unaffiliated selling shareholders. In addition, directors and officers of the company could use coercive practices in order to secure shareholder votes approving the transaction. To protect shareholders from manipulative tactics, the SEC requires issuers and its affiliates to provide investors with extensive information about the transaction.      

In order for a transaction to be considered “going private,” Rule 13e-3 demands that it meet three criteria. Specifically, it must:  

1. be a transaction or series of transactions resulting in the purchase of a security by the issuer or one of its affiliates, that
2. has either a reasonable likelihood or the purpose of producing, either directly or indirectly,
3. the effect of causing a class of equity securities of an issuer subject to Section 12(g) or Section 15(d) of the Exchange Act (a) to be held by fewer than 300 persons or (b) to be delisted or no longer authorized to be quoted on an inter-dealer quotation system of a registered national securities association (such as NASDAQ).

Rule 13e-3’s Definition of “Affiliate” and “Control”

In the context of buyouts of public companies by private equity funds, the determination of whether or not Rule 13e-3 applies turns on whether an affiliate of the issuer (that is, the public company that is the target of the acquisition) is considered to be a buyer of the target’s equity securities. Rule 13e-3 defines an affiliate of an issuer as “a person that directly or indirectly through one or more intermediaries controls, is controlled by, or is under common control of such issuer.” Although Rule 13e-3 does not specify what constitutes “control,” Rule 12b-2 of the Exchange Act, which applies generally to rules under the Exchange Act, defines “control” as “the possession, direct or indirect, or power to direct or cause the direction of the management and policies of a person, whether through ownership of voting securities, by contract or otherwise.” 

This broad definition of control creates an unsettling degree of uncertainty as to who or what may be considered an “affiliate” of an issuer in a transaction involving the acquisition of a public company’s shares. In some situations, the SEC may decide that a person indeed exercises such control where he has the power to influence a company’s management and policies, even if the person holds a low percentage of the company’s voting securities.

Schedule 13E-3

Rule 13e-3’s filing and disclosure requirements apply to both the issuer and any of its affiliates engaged in the “going private” transaction. According to the SEC, the rule is designed to ensure that all holders of the class of securities subject to the transaction receive information regarding the issuer and each of its affiliates engaged in the transaction. To that end, Schedule 13E-3 requires a discussion of the purposes of the transaction, any alternatives that the company considered, and whether the transaction is fair to all shareholders. The Schedule also must inform investors whether and why any of its directors disagreed with the transaction or abstained from voting on the deal. Moreover, Schedule 13E-3 must indicate whether a majority of directors who are not company employees approved the transaction.

In Part 2 of this post, we’ll analyze the application of Rule 13e-3 in buyouts by private equity funds in which managers of the public company are offered “sweet equity” in the new holding company. 

Related Post: Going Private: Rule 13e-3 and Private Equity Buyouts - Part 2

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Judge Sotomayor’s Senate confirmation hearings may have overshadowed other proceedings on Capitol Hill last week, but members of the private equity community kept a watchful eye on what could turn out to have been landmark hearings on government regulation of private equity and hedge funds. Representatives from the private investment advisory community and institutional investors gathered to testify before the Subcommittee on Securities, Insurance, and Investment of the U.S. Senate Committee on Banking, Housing, and Urban Development. The hearing was convened about a month after the Subcommittee’s chairman Senator Jack Reed (D – RI) introduced his own bill in the Senate, “The Private Fund Transparency Act of 2009.” Senator Reed’s proposed legislation would amend the Investment Advisers Act of 1940 to require investment advisers to private funds who manage assets in excess of $30 million to register with the Securities Exchange Commission. The SEC could in turn require registered investment advisers to submit records and reports to a federal systemic risk regulator.

Private Funds and the Investment Advisers Act

Before taking a look at last week’s hearings and Senator Reed’s bill, it’s instructive to place them in their historical context. The Supreme Court identified one of the fundamental purposes behind Congress’s passage of the Investment Advisers Act of 1940 as the substitution of “a philosophy of full disclosure for the philosophy of caveat emptor” in the securities industry. Under the Advisers Act and its implementing regulations, non-exempt investment advisers are required to register with the Securities Exchange Commission, and all advisers – registered and unregistered alike – are forbidden to engage in fraudulent or deceptive practices. 

Hedge funds (and private equity funds) are typically structured as limited partnerships, with the general partner managing the fund for a fixed fee and a percentage of the fund’s gross profits. Although hedge fund general partners meet the statutory definition of “investment advisor,” they generally qualify for the “private adviser” exemption from SEC registration under §203(b)(3) of the Advisers Act. The private adviser exemption is available to any adviser that has fewer than 15 clients and does not generally hold itself out to the public as an investment adviser. With respect to hedge funds organized as limited partnerships, the SEC historically interpreted the term “client” in §203(b)(3) to refer to the limited partnership itself rather than to the investors constituting its limited partners. 

In 1998, Long-Term Capital Management, a Connecticut-based hedge fund that managed over $125 billion in assets during its heyday, imploded. With many of the country’s major financial institutions at risk because of their credit exposure to Long-Term, the Federal Reserve Bank of New York stepped in to orchestrate the fund’s financial resurrection to avert a national financial crisis. Shortly thereafter, a joint working group of the country’s leading financial regulators embarked on a comprehensive study of the U.S. hedge fund industry. 

Prompted by the working group’s findings, the Securities Exchange Commission adopted the so-called “Hedge Fund Rule” in 2004. The Hedge Fund Rule required most hedge fund advisers to register with the SEC if the funds they managed had more than 15 “shareholders, limited partners, members, or beneficiaries.” In other words, the SEC reinterpreted the definition of “client” under the Advisers Act so that general partners of hedge funds had to “pierce the veil” of their fund to reach its beneficial owners in order to determine how many clients they advised. The D.C. Circuit Court of Appeals vacated the “Hedge Fund Rule” in 2006, dismissing it as “arbitrary.” Consequently, many general partners of hedge funds (and other private funds) still rely on §203(b)(3) to claim an exemption from registration under the Advisers Act.

Senator Reed’s Proposal for Regulating Private Funds

The Private Fund Transparency Act of 2009 (S. 1276), introduced by Senator Reed in June, would amend the Advisers Act to require investment advisers to private funds who manage assets in excess of $30 million to register with the SEC. The text of the bill restricts the private adviser exemption under §203(b)(3) to apply only to a narrowly defined group of “foreign private advisers.” Under Senator Reed’s proposal, all registered private fund advisers – including advisers to hedge funds, private equity funds, and venture capital firms – would be subject to the Advisers Act’s existing regulations regarding disclosures to the SEC, maintenance of books and records, custody of fund assets, compliance policies and procedures, advertising, and the examination of financial and other records by the SEC. (Last week, the Obama administration proposed parallel legislation that would create a new class of “private funds” subject to registration under the Investment Company Act of 1940 and require advisers to private funds to register with the SEC under the Advisers Act). 

In a recent interview with the Wall Street Journal, Senator Reed emphasized the need for transparency and government oversight to ensure what he called “fair dealing with customers.” Andrew J. Donohue, Director of Investment Management for the SEC, advised the Senate Subcommittee that registration of investment advisers with the SEC was essential to giving teeth to the Advisers Act’s anti-fraud provisions by providing the SEC “an opportunity to determine facts that most investors in private funds cannot discern for themselves,” and speculated that registration might deter unscrupulous advisers from committing fraud.  Mr. Donohue also called for (and Senator Reed’s proposed legislation contemplates) granting additional rulemaking authority to the SEC to enforce its broadened jurisdiction under the Advisers Act. 

In addition to protecting investors, Senator Reed described the other goal of his bill as devising a regulatory regime capable of aggregating information about various financial industries “in a meaningful way so that systemic regulators could get a sense if there is a possibility of risk in a particular market.” Back in April, we wrote about Treasury Secretary Geithner’s outline for a reporting system in which the SEC would work in tandem with a systemic risk regulator to ferret out privately managed funds deemed to pose a systemic risk to U.S. financial markets. The Private Fund Transparency Act specifically authorizes the SEC to require any registered investment advisor to “maintain such records and submit such reports as are necessary or appropriate in the public interest of the supervision of a systemic risk by any Federal department or agency.” In a press release posted on the Treasury Department’s website today, Mr. Geithner announced: “There exists today a national mandate, not seen in years, to reform our outdated and ineffective regulatory system.”   

Private Equity’s Response

Lobbyists and representatives from the private equity industry have been clamoring that the private equity industry is not too big to fail, yet have been conciliatory with regard to oversight. Perhaps this is not surprising. A number of private equity’s largest players, including the Carlyle Group, the Blackstone Group, and Kohlberg, Kravis, Roberts & Company, are already registered with the SEC. Mark Tresnowski, general counsel of private equity firm Madison Dearborn Partners, who spoke on behalf of the Private Equity Council, warned the Senate Subcommittee that although the private equity community supported registration of advisers in principle, any reporting and other requirements should be tailored to the type and size of the firm so as to reduce the inevitable increased administrative costs for funds. He concluded: “Private equity contains none of these systemic risk factors and thus should pose little concern for policy makers seeking to develop a new regime to guard against catastrophic, cascading financial shocks.” Private Equity Council President Douglas Lowenstein echoed Tresnowski’s opinions in testimony before the House’s Financial Services Committee two days later. 

This week, the Obama administration followed up last week’s hearings by sending a plan for a systemic risk regulator to Congress. The proposal would establish a Financial Services Oversight Council comprising bank and securities regulators that would be tasked with collecting information on systemic risk and would give the Federal Reserve authority to act as a systemic risk regulator. Both Senator Reed’s and the Obama administration’s proposals for registering private investment funds and/or their advisers would grant widespread authority to the SEC to determine what information should be shared with a systemic risk regulator.

One has to wonder whether the private equity industry’s tactic of conceding on SEC oversight while trying to persuade federal legislators that its business model does not pose a systemic threat to the U.S. financial markets will undermine its longer term strategic interests. Once a substantial portion of the private equity industry falls under the umbrella of the SEC’s regulatory authority, there may be little lobbyists and other industry representatives can do to persuade the systemic risk regulator – be it the Federal Reserve or another government agency – that private equity funds do not pose system-wide financial risks. At that point, leveraged buyout firms may have lost their negotiating leverage.

Related Posts:

House Financial Services Committee Proposes Hedge Fund & Private Equity Regulation

Geithner Calls for a Lifeguard to Monitor "Private Pools of Capital"

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The recent tax proposal submitted by the two top lawmakers on the Senate Finance Committee "closes a loophole" in the treatment of publicly traded partnerships. 

Years ago, 1987 to be exact, Congress passed legislation treating publicly traded partnerships as corporations.  It excluded however partnerships that derived at least 90% of their income from interest, dividends, and gains from the disposition of a capital asset.  Blackstone and other private equity firms that are flocking to go public have relied on this exemption since most of their income qualifies for the exclusion.  The exemption is huge -- corporations pay up to 35% of their income to Uncle Sam.

The new bill provides that the exception from corporate treatment for a publicly traded partnership, 90 percent or more of whose gross income is qualifying income, does not apply in the case of a partnership that derives income from investment adviser services or related asset management services.  Such a partnership is treated as a corporation for Federal tax purposes and is subject to the corporate income tax.

This strikes at the heart of the private equity firm, which receives fees and carried interests from investment adviser services.  As such, the legislation is pointed directly at firms such as Blackstone that hoped to be publicly traded partnerships without paying a corporate tax.

Reflecting, however, the strong connections that Blackstone must have in Washington, the new bill contains a 5-year exception for any private equity firm that is already public or that has an IPO registration statement already on file with the SEC.  As my tax colleague Stephen Foley notes, Blackstone may have successfully lobbied for the ability to be one of the few private equity firms that can ever go public.

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