Evolving perspectives

The great and the good of private fund finance and compliance gathered first in New York, and then in San Francisco, to discuss the most pressing fund operations and regulation issues of the moment, and to look at what awaits them in 2018. By Claire Wilson

This year’s edition of the annual Private Equity International CFOs and COOs Forum in New York last January attracted around 500 delegates and included discussions about US tax reform, adoption of technology by private fund firms and ongoing challenges such as maintaining Securities and Exchange Commission-proof valuation, fees and cybersecurity policies. In October, on the West Coast, a more intimate gathering took place in San Francisco. Once again delegates swapped ideas on how to keep the regulators from knocking on the door. Here’s a round-up of the issues covered at the events, and how things will progress into 2018.

Tax reform

Unsurprisingly changes to the US tax system were top of the agenda at both events. In January, much of the talk centered around a proposed change to tax on carried interest; during his presidential campaign Donald Trump hit the headlines when he said he would subject carry to the higher income tax rate, rather than continuing to tax it at the capital gains rate. Delegates were dubious the change would materialize.

“It isn’t in the house blueprint, maybe it was just happy talk,” one compliance officer said, referring to the policy reform proposals published a few weeks earlier.

By the time they reconvened in San Francisco in October, the outlook was less certain. Tax experts said that while the reform framework, published in September, said only hedge funds will be subject to a tax hike on carry, a similar change could still emerge for private equity firms as the policy is finalized.

“Both candidates promised to change the tax rate on carried interest, which is widely considered a loophole, so I feel it will be discussed. It could be used as a bargaining chip,” a tax partner at an accounting firm said.

A second added that they believed the issues was still on the horizon, it had simply been “kicked down the road” for the time being.

Interest deductibility, or the removal thereof, was also a key concern. The house blueprint replaced net interest deductibility, which allows firms to exclude the interest they pay on loans from their taxable income, with an immediate write-off of new equipment in the first year of ownership. While this would free up cash to re-invest in the business and encourage spending, it was considered “a huge blow” to the debt equation for private equity firms.

Since then, Blackstone said in its annual report that a change to the rule could force it to adjust its funds’ investment strategies and potentially lower returns for investors, adding it could hit profitability of portfolio companies. The tax reform framework said the deduction for net interest expenses will be “partially limited.” Congressional tax-writing committees have to decide by how much, but 30 percent is the widely touted figure.

Panelists in San Francisco said they were aware of firms that have already started to look at recapitalizing in order to benefit from the grandfathering of the law.

“Our firm may accelerate any new loans that we take out to avoid being affected by the interest deductibility tax,” a CFO said during the discussion.

Deadlines for the reform package to be passed depend on who is asked, but it can only be passed through the political system after a fiscal-year budget. This is because the former includes a legislative tool that would let the Republicans pass a tax bill by a simple majority vote in the Senate, where they hold 52 of the 100 seats. This will allow them to bypass the Democrats that are expected to vote against it.

While the impact of tax reform on private equity operations is not yet clear, widespread changes will be made in 2018 and firms were advised to stay in close contact with their tax partners.

Regulation

They didn’t agree with his policies, but just under half of delegates in New York said President Trump will have a positive impact on the private funds industry. SEC enforcement actions and examinations were expected to continue, but attendees thought private equity would be under less scrutiny.

“It’s important to keep focusing on what the SEC wants us to do; we’re not going back to 2005,” one CFO said. “But I think the environment will be more favorable for private funds.”

Delegates polled said having private equity lawyer Jay Clayton at the helm of the SEC would also be beneficial for the industry. Around 57 percent said he was well-equipped to head the regulator.

By the fall the predictions had materialized, at least in part. About eight firms settled cases over the summer, according to reports, but a panel of regulation experts in San Francisco said this was “significantly fewer” than a year earlier. The SEC has otherwise continued its private funds examination program apace and frontline agency staff are as active as ever.

Elsewhere in the regulation space, the possibility of a rollback of the Dodd-Frank Act was discussed at length in New York. Although most delegates agreed they would like to see the regulation dismantled, they accepted it would be very difficult to achieve.

“It would be hard to do. A filibuster would be possible, but a full rollback is unrealistic,” one said.

The Financial Choice Act, pushed by Republican congressman Jeb Hensarling, has since emerged as a way of reversing many Dodd-Frank provisions, and a bill is currently passing through the US legislature. Among its proposals is one that removes the need for private fund firms to register with the SEC, and a second to eliminate the Volcker rule.

At the time of going to press, several regulatory agencies had committed to examining the efficacy of the rule and expressed a desire to clarify its requirements, potentially removing the bank restriction on private equity investments.

Fees and expenses

Discussions at both conferences suggested that fees and expenses remain the biggest thorn in the private fund manager’s side. In New York, delegates were keen to discuss policies and what they could do to ensure theirs were SEC-proof. In San Francisco, it was made clear by regulatory experts they were right to do so because the matter remained high on the agency’s watch list.

Two-thirds of delegates polled in New York said they have revised their expenses policies since the SEC began publishing details of enforcement action, largely to improve consistency and clarity.

“We made some amendments, which were previewed by investors and created more consistency in the language [within the documentation] across all funds. If the SEC sees the same thing over and over, they’re likely to stop looking,” a CFO said during a panel discussion on the matter.

A second panelist said many LPAs pre-date registration with the SEC, and often require clarification rather than wholesale change.

The fees and expenses discussion in San Francisco revealed that there is still some uncertainty over what is and isn’t a reasonable fund expense. Almost one-fifth of delegates said they did not allocate travel or insurance expenses to their funds – something which came as a great surprise to the majority.

“They must have some seriously hard negotiators among their LPs,” the compliance officer of a small fund said during a panel discussion.

Just under two-thirds of delegates – 63 percent – and all four panelists said both these costs were allocated to the fund. In these cases, it was stressed, Limited Partnership Agreements must be explicit.

During a subsequent discussion, a panel of regulation experts said around 80 percent of the feedback firms receive after an SEC examination is about fees and expenses. While emerging compliance issues may be a concern, firms should ensure that they continue to keep an eye on the core SEC focus areas.