The same regulatory and tax topics are trotted out year after year in relation to private equity. However, this year, cue the threatening music from the film Jaws. Just when you thought it was safe to go back in the water, not one but two dark shapes have appeared in the sea. The question is: are they great white sharks or harmless whales which, with judicious monitoring, can be navigated around without too much anxiety? Of course, the dark shapes represent Brexit and the new US President Donald Trump. However, while concentrating on these large dark shapes are we missing more deadly creatures lurking in the deep?

Some commentators and investors might think Jaws is an appropriate analogy for private equity (PE) as its participants display similar characteristics! Unfortunately, the sentiment in that joke is reflective – or appears so in the minds of PE participants – of a reality impacted by frequent regulatory developments.

A brief recap of history provides suitable background. Thirty years ago, private equity as an asset class was a very small niche product. Fund sizes were in the tens of millions and investments were typically, although not exclusively, early stage. Managers were (and theoretically are) remunerated on the 2/20 basis: 2% management fee and 20% of fund profits, known as carried interest, after return of capital, expenses and preferred return either on a deal-by-deal basis or whole of fund. The managers put their own money into the fund as ‘skin in the game’* and saw themselves as entrepreneurs. The memorandum of understanding with HMRC in 1987 provided for carried interest to be taxed at capital gains tax (CGT) rates after adjustment – base cost shift – which increased the capital gains base and reduced the effective tax charge. Inevitably, participants also started to structure management fees as capital gains (disguised management fees).

The industry has grown, with a sizeable number of managers routinely raising a billion dollars and the mega funds significantly more. This has attracted more entrants: in 1980 there were approximately 25 firms and now there are over 6000. Today the size of monies committed yet undrawn and available for investment is reckoned to be over a trillion dollars. The industry has matured.

This scale has produced significant sums and wealth for the industry and many managers. When it started, it was aspirational to be a millionaire or multi-millionaire. Now individual partners in the very large managers want to be billionaires. A select number achieve this, and their behaviour and publicised spending has attracted adverse attention and reaction which has trickled down through an industry where there are funds that still raise in the tens of millions. There are all types of sizes and investment strategies, but there is a feeling of bifurcation, which in any industry is difficult to legislate for. There is a ‘private equity privilege’ (hedge funds are similarly classified) which is reinforced when senior politicians refer to ‘society’s lottery winners’ to formulate their policy. In the past, private equity firms in Germany have been referred to as ‘locusts’, as they buy companies with high leverage, maximising their interest deductibility, cutting costs dramatically – including staff costs, and then exiting in three to four years.

High returns and high risk

So given this type of reaction, why is private equity a popular investment class and why haven’t governments become even stricter in their policy and treatment? The answer lies in the fact that governments around the world recognise the benefits of private equity, as they invest in start-ups and help identify or create potential commercial champions. Private equity is also growing to become a large asset class, as well as an established part of diversified portfolios of institutions and large investors. In an era of low investment yields and increasing pension deficits, investing in private equity funds yield higher returns, albeit with higher risk.

The history and the caricature painted above leads very interestingly and in a readily understood way to the current state of the compliance and tax arrangements of the industry. Broadly, what are the key regulatory, legal and tax issues that keep coming up? These include taxation of both individuals (particularly carried interest and management fees) and portfolio structures, expenses allocation and fees, transparency, quality of reporting, conflicts of interest, and marketing.

What happened in these key areas in 2016?

Carried interest

The treatment of carried interest is continually being reviewed in many jurisdictions around the world. However, one does sense that a harmonised approach – or watch/copy me – is prevalent, with desires to tighten the tax rules and widen the tax net. In the UK, the government recognises the benefit of investment manager rewards that are investor aligned in longer-term investment funds, and has made such statements in new legislation introduced in respect of the taxation of carried interest. In the latest comprehensive tax rules introduced in 2016’s Budget, it continued to treat carried interest under CGT rules, but with stricter criteria. CGT is levied at a special rate of 28% as opposed to the general rate of 20%. Additionally, the average investment holding period must be at least 40 months, if not then it will be taxed as trading income at 45%. There are a raft of complex rules and guidance for various types of funds issued by HMRC, which need careful understanding. In the 2015 Budget, base cost shift was eliminated and rules introduced to ensure disguised management fees are treated as income.

Fees and expenses

The US Securities and Exchange Commission (SEC) has been in the vanguard of examining and investigating the allocation of expenses and fees being charged between the fund and the manager, as well as between various funds and co-investors. The SEC has ignored the concept of market practice to see what was specifically allowed in the Limited Partnership Agreement which governs the investment fund, and whether these expense allocations were adequately disclosed at the time of the investment decision. Do not be surprised if the FCA decides to review this topic.

Reporting

The Walker Guidelines – a set of voluntary guidelines for FCA-authorised firms that undertake large buyouts of UK public and private companies – issued its eighth annual report at the beginning of 2016, commenting that the new higher benchmark of FTSE 350 reporting resulted in the decline of relevant private equity backed portfolio companies with a good or excellent rating. Areas of underachievement were board composition, business models, and gender diversity. Improvements in reporting were noted in key performance indicators and environment, social and governance (ESG) matters. The willingness of firms and the industry to emulate listed company reporting is a strong positive.

Alternative Investment Fund Managers Directive (AIFMD)

This complex, onerous and controversial piece of EU legislation, which applies to private equity and hedge fund managers that operate in the EU, imposes stricter reporting obligations, capital requirements and remuneration policies, but provides ‘a golden ticket’ (or passport) to market funds in the EU. The passport is not pure gold, as different countries have differing views of what the passport and single market means by charging fees and further administration. However, it does make raising funds easier than the alternative approaches in the form of the National Private Placement Regimes (NPPR). Managers outside the EU or sub-scale can either use NPPR or try to meet the criteria for EU’s venture capital regimes. Alternatively, the AIFMD has provisions for a ‘third country’ passport for non-EU managers who comply. While some countries have already been approved, the timetable for issuing this passport has fallen behind. Much of the practical detail is still to be finalised and the final issuance to qualifying countries is subject to EU Council and Parliament processes. This is now a political issue and smacks of preserving one’s patch as marketing in the EU without it is very difficult. A situation that has been made even more complex with Brexit - don’t hold your breath!

Litigation risk

As investment funds want to be seen as business owners to secure benefits, they increasingly come with a litigation risk that owners have to bear. However, investors as limited partners would like to be certain that they will not lose more than the money they put into an investment. More importantly, they normally benefit from a veil of protection from investment liabilities beneath the fund. However, being shielded behind an investment vehicle is becoming harder. There is a legal case in the US, Sun Capital, relating to the acquisition of the liability for a pension deficit. It involves two parallel investment funds that invested alongside each other. Neither fund was above the 80% ownership required for assumption of the liability. Additionally, they were a financial investor. On appeal the district court held that the funds were carrying on a trade and business as they were a controlled group, and had created a partnership – and were thus liable for the unfunded pension liability. The court looked at factors such as Sun Capital executives being on the board, and the general partner of the funds receiving management and consulting fees. There is a similar situation in Europe with the EU commission holding that Goldman Sachs is liable for the anti-competitive behaviour of one of its investments.

Interest deductibility

The OECD, in trying to reduce tax avoidance or treaty shopping by large multinationals, has been pursuing a project over recent years known as ‘base erosion and profit shifting’ (BEPS). In terms of interest deductions from profits, it made a recommendation to limit this to between 10 and 30% of earnings before interest, tax, depreciation and amortisation (EBITDA). In the 2016 Autumn Statement, the UK Government announced that with effect from 1 April 2017 it will cap interest relief to 30% of a group’s UK EBITDA. There is a group ratio for a worldwide group which could be of assistance to private equity firms. The devil will be in the detail.

Other items

Besides specific private equity regulation, general legal and compliance issues continue to bite and in 2016 firms dealt with:

• UK government transparency legislation regarding public registration at Companies House for persons with significant control, ie, persons with more than 25% of shares or voting rights
• Cyber security – a strong SEC initiative which is gaining momentum in the UK
• Implementing the Foreign Account Tax Compliance Act and the Common Reporting Standard
• Preparing for the FCA’s Senior Managers Regime, which will be replacing the authorised people’s regime in 2018 and will be applicable to all but the smaller firms.

Brexit

This really splits into two aspects: first, the impact on portfolio companies and second, the investment management firm’s own position. The most important of these is the portfolio impact. For a UK portfolio with domestic revenue and a relatively isolated sterling cost base, the real issue is around potential GDP decline. For those with extensive imports/exports or European operations, trade restrictions and foreign exchange become a more serious issue. For a private equity firm, the question of how to raise money in Europe, the extent of European investor base and how to operate when the third country passport (see above) arrangements are not finalised will be exacting. One can hardly see the EU rushing through that piece of the AIFMD to accommodate the UK in what undoubtedly will be a difficult set of negotiations. All of this is set against a background of several European countries wanting to take commercial advantage of the UK situation. Firms will inevitably review all this and most likely look for a fall-back solution of a European base with substance.

Trump

What one can infer from new US President Trump’s various comments is that he will look to repeal overly burdensome financial regulation. Clearly Dodd-Frank is looking fragile. He also intended to reduce and simplify taxation. However, the biggest concern for private equity is his intention to eliminate carried interest and other special loopholes. Whether this means that this will be taxed as ordinary income at the higher rates is unknown. This would send a big message to the industry as it would go further than the current UK position.

What lies ahead in 2017?

Repeats of course! Because good rules and regulation in financial services require time for consideration and need measured introduction to assess their impact. For an industry that has grown as rapidly as private equity has, the changing dynamics demands that the legal and regulatory regime evolve with it.

It is an industry which has matured and has largely accepted that it plays an important part in financial services and can no longer be treated as a fledgling industry. The changing regulatory, legal and tax environment – and hostility from certain quarters – will persist. There is no terminus! Private equity’s underlying characteristic of ingenuity will help it thrive and perform regardless of the specific legislation it faces. Remember, even though Jaws was vanquished in the first film – there were sequels!