Private equity is facing an avalanche of new rules. Not only are the size and scale of latest regulations unprecedented for the industry, they are of an entirely different nature.
Several are more specific to private equity – MIFID II, PRIIPS, SMCR, proposed changes to EuVECA supervision, the long-awaited AIFMD review – while others are so ambitious and expansive in their reach, no industry is immune from major legislation such as GDPR, AML and tax evasion.
Underlining this new wave of regulation is personal accountability. Discontent towards the financial services sector has festered since the global financial crisis, with only a handful of individuals since held to account for the major and widespread irresponsible behaviour that dragged the global economy onto its knees.
While much of the post-crash regulation has focused on preventing another meltdown, the current regulatory tactic is to delve deeper into organisational structures – to remove loopholes and protections previously exploited, and to strike fear into the hearts and minds of practitioners.
For many private equity firms, particularly those operating on the continent, the fresh rules mark their first brush with regulation. But it is not simply a case of reading up on new requirements and obediently tweaking systems and processes; this major shift is far from isolated – it comes at a time when the operational burden for PE is mounting. Investors are more demanding, reputational risk is growing, technology is displacing all manner of jobs and industries, attracting and retaining talent is harder than ever, while the pressure to be transparent, as well as environmentally and socially minded continues to build.
Within private equity houses, COOs (or most likely CFOs wearing two hats) are now tasked with solving all of these issues. Given the overwhelming burden they face, many will be tempted to find shortcuts; to ascertain what the bare minimum is; to seek the lowest cost and least time consuming solutions.
“When I’m speaking to PE firms, they always ask: how do I prioritise? What’s the most I need to do? What’s the least I need to do?” says Eoin O’Shea, CEO of Temple Grange Partners, a startup focused on regulation risk and compliance:
It’s wholly understandable for CFOs and COOs to find themselves in this mindset. Speaking privately to a CFO of a mid-market GP, today’s regulatory challenge is mindboggling: “Where compliance is most challenging is having responsibility for portfolio companies – how do you effectively communicate all of this to them? It’s about figuring out how to interface all of the compliance. And it’s the same with the LP base. We’re spending so much time speaking about regulations; we have four people working fulltime dealing with compliance.”
Asked if any GP is prepared for the new rules, Patricia Volhard, partner at Debevoise & Plimpton, notes the distinction between UK and French firms relatively well-versed in dealing with regulation and those operating in other jurisdictions with lighter interpretations of European rules. “Probably no one is really 100% ready; at the least they might be more used to dealing with it, but on the continent many people haven’t quite realised how much is coming.”
One new regulation cited by many as being particularly worrisome for private equity is PRIIPS (the European Regulation on Packaged Retail Investment and Insurance Based-Products). “Private equity isn’t ready at all, in a large part because there has been no guidance,” notes Volhard.
Chris Dearie, partner at MJ Hudson explains: “For smaller PE firms, they may not have the tech to deal with PRIIPs. Larger firms are more likely to have in-house capability, but smaller firms won’t. As such, they are at the mercy of providers of outsourced solutions…which may be costly. On the face of it, producing PRIIPS should be straightforward, but for smaller managers it may be anything but.”
Beyond the frustration of having yet another rule to deal with, PRIIPs comes with a particular sting for private equity as it will likely see friends and family, as well as non-senior team members no longer able to participate in fundraises and locked out of carry vehicles.
On top of the lack of guidance around PRIIPs, the sense of unfairness brought on by the regulation could see COOs and general counsels hesitate to act. This sentiment is compounded by the way in which regulations typically evolve overtime. By the 2014 implementation period, AIFMD had been significantly watered down from its first proposals in 2011 – thanks to successful industry lobbying – setting a precedent for the industry to assume adjustments of regulations will be made to suit private equity in time.
“There needs to be a lot of education on both sides, within private equity as it becomes more regulated and on the side of the regulators – explaining PE to them and finding a way together to ensure regulation works,” says Volhard.
Furthermore, the slow and bureaucratic nature of European policy-making could increase the temptation to do as little as possible and wait it out. After all, it was the previous European Commission that wanted to punish the investment industry following the GFC. “In our view, the European Commission’s current agenda has changed significantly to the previous one,” says Anna Lekston, head of public affairs at Invest Europe. “The previous Commission was in place in the aftermath of the crash and the focus was mainly on prudential rules and financial stability. Now the focus is on growth and jobs, and that’s very positive from our point of view. The Commission has realised how PE contributes to growth, jobs and the real economy.”
The expectation for better-fitting rules is strengthened by the frenzy of lobbying efforts. According to Invest Europe’s Lekston, the trade body is currently working on a long list of ongoing policies, including the current review of the European supervisory framework; the proposal on cross-border distribution of funds; the Sustainable Finance Initiative; and of course the AIFMD review.
“But, the devil is in the detail,” warns Lekston. “It remains to be seen if any of this is truly helpful to PE. The Commission might be tempted to create a one size fits all solution. If it’s not appropriately tailored, it could be just another layer of regulation.”
Asked if the current Commission’s positivity towards private equity will protect the industry against ill-fitting and cumbersome new rules, Lekston is cautious. “It remains to be seen. The current Commission is positive for our industry but the AIFMD review will fall under the new Commission and new EU parliament. It depends on who is elected to parliament and their agenda.”
To the drawing board
Combining the new and markedly different style of rules coming into effect, the uncertainty around attitudes towards the industry from the next European Commission and parliament, and the burgeoning challenges faced by operational leaders, how should CFOs and COOs attempt to create sensible strategies to deal with these multiple headwinds?
Developing a clear picture of ideal outcomes is a good place to start. Private equity has reached its current level of success through its ability to be agile – running lean teams and keeping costs to a minimum. The challenge today is to maintain nimbleness while also complying with the oncoming plethora of new requirements.
However, that may require a major rethink. “A prominent issue for private equity is the common mistake of getting the COO to constantly map new rules against existing businesses. But you cannot assume your business model is always fit for the new rules,” says Temple Grange’s O’Shea.
Genuine business decisions must now be made: forever trying to cut corners and battle against the tide, or embracing new ethical standards?
Take GDPR – every private equity firm collects data on companies targeted via origination efforts. But sweeping up information in this manner will no longer be an option; any company gathering data will need consent, and be able to respond to information requests about the data the hold, as well as erase records where necessary. Could firms leverage the push for data security as a means of attracting potential targets?
“Private equity needs to ask: am I starting at the right point? Should I adapt, not just react. It is not just about mapping new rules to an old business, they should use the opportunity to challenge the business model to make sure it still works within the new regulatory landscape,” advises O’Shea, who advocates that COOs are well positioned to lead the charge. “I really encourage PE to use the COO as a channel of proactive communication at the board level, and to move the conversation away from minimum requirements and technical issues, and instead talk about the potential strategic impact of rule changes on the business model.”
There are already private equity houses that have created new models fit for purpose. One stand out example is Summa Equity, founded in 2016 by former Altor partner Reynir Indahl. Summa’s future-proofed set-up is most clearly understood by its investment strategy, rooted in megatrends including resource scarcity, energy efficiency, changing demographics and technology. But its operational approach has been built for tomorrow’s business landscape.
Jenny Keisu, partner and COO of Summa was brought into the founding team – she was previously general counsel of Nordic Capital. “Running a PE firm today with all of the legal and regulatory requirements, talent management, IR demands and so on, Reynir realised if he set this up with only other investment professionals who don’t know the operational piece, it becomes very time consuming to learn or outsource.” The inclusion of operational expertise within a founding team has so far been a rarity in private equity.
This is a clear sign of how deeply regulation and compliance handling is already reshaping the industry. Other houses are starting to comprehend it is no longer a case of meeting regulatory requirements, rather, the new game is about changing attitudes and embracing the rules. “Compliance handling is at its most effective when it is seen as a business partner; when it collaborates with the business,” says Tracy Diamond, head of compliance EMEA and APAC at Pantheon. “As a compliance head I see rules coming down the pipeline; it has to be considered as part of the business strategy. In my view, you can’t think about strategy without compliance.”
Perhaps even more telling is Diamond’s background – she joined Pantheon only six months ago and was previously head of compliance UK for HSBC Securities Services. With much of the new regulation now encroaching the private equity industry being first applied to banks – notably SMCR – bringing in this expertise may well form a larger hiring trend.
Increasing headcount was cited by firms of all sizes as the main strategy for tackling regulation, according to EY’s 2018 Global Private Equity Survey. “We’ve been investing in our compliance function since 2011, and we’re currently hiring,” acknowledges Diamond. “We’re also looking at what activities we can potentially outsource. And we’re looking at efficiency advantages that can be had from software.”
Outsourcing is of course another option to ensure compliance. Says O’Shea: “My experience of working with PE is that many see compliance as something to outsource; necessary and important of course, but non-core.”
But for him, the new breed of rules and regulatory expectations coming into effect mean simply tasking another firm to do the work will no longer suffice. “We are entering a new space where there are significantly heightened expectations of substantive internal understanding. To get there, private equity should reach out to spaces in other industries that have already been through that pain.”
O’Shea asserts bringing in existing experience from other sectors doesn’t necessarily have to come at a high cost. “Given how quickly the landscape is changing, the next acid test will be at the end of H1 this year: PE leadership will need to ask if it is comfortable that the COO and compliance officer can speak intelligently about new rules and evolving compliance challenges for the business. Good PE compliance officers need to be fit for purpose, they need integrity, judgement and relevant experience, but by leveraging deep pools of experience in other industries, they don’t have to be incredibly senior or expensive.”
A nascent role is emerging in reaction to the growing pressures facing compliance team; the legal operations head. “They’re not really doing law, they’re more focused on managing the team, the law firm relationships and procurement of software and systems,” explains Nicholas d’Adhemar, founder and CEO of legal software provider Apperio. “These people can be lawyers or people with more technical skills. Is the GC the best person to evaluate software? Is the COO? Or can a legal operations professional do the review process and bring in the GC when it makes sense?”
Eats strategy for tech-fast
The advent of a legal operations role also highlights the increased prominence of tech solutions in compliance efforts. Says d’Adhemar: “Today’s private equity COOs have more to do in their days than ever before; regulation and compliance, accounting and legal, operations and human resources. They have to simplify components. Tech can automate some of that worry – it can provide an early warning system.”
But given the market opportunity offered by private equity compared with say the banking industry, there are few tech solutions on offer tailored to its specific needs. “Having previously worked within the banking sector, I’ve seen some great regtech solutions, but none that are tailor-made for PE,” says Pantheon’s Diamond.
However, one technological development no private equity can afford to ignore is centralised data warehouses. “Centralised data is very important for compliance,” says Pantheon’s Diamond. “Especially for responding to the regulator’s requests; you need to respond immediately – a same day response is not good enough – you cannot waste time trailing through emails – it needs to be readily accessible.”
Rethinking operational agility is not just an effective tool for dealing with regulation and compliance, it will become a firm’s most important weapon for success. “We had some investors, those who typically are unable to invest in first time funds because of lack of operations, where we were able to go through their operational due diligence process. Around 10-15% of our LPs have very burdensome ODD, who wouldn’t have normally been able to invest in us. The way we have set up Summa was a great sales pitch – that investment people can focus their time on deals. It’s also about streamlining the operations; by having someone that can do both, we’re more efficient and we don’t need as many people centrally,” says Summa’s Keisu.
The three pillars of operational resource – people, outsourcing and technology – remain valuable and effective tools for dealing with today’s regulatory headwinds. But, the changing spirit of the oncoming rules and regulators’ heightened enforcement activities require more meaningful action.
This wave of regulation is a manifestation of exasperation and indignation towards the financial services’ irresponsibility. Private equity, as a long-term player, and an industry consistently promoting its responsible credentials – for any GP to make it through another fundraising cycle, it must understand the direction of travel, listen clearly, and embrace the objective wholeheartedly.
This requires a willingness to change but most of all, heightened creativity. For private equity to remain agile; to become future-proof – innovative hiring, outsourcing and tech solutions are vital. Rather than bemoaning restrictive and burdensome rules, they can be a catalyst for change led by operational pioneers, propelling private equity to the crest of this major cultural shift.