Ready and waiting

The prospect of a regulatory shift loomed large in January against the backdrop of a change of guard at the White House and the UK’s vote to leave the EU. In the US there was promise of deregulation, while in Europe it seemed the UK would have to decide whether to maintain the status quo with Europe, or loosen the rules to attract managers from across the pond after Brexit. But although the stage seemed to be set for a big shift, it was tax that emerged as the biggest story of the year.

Over the past few months US managers have been drip-fed clues as to what Republican tax reform will look like for them. Changes to carried interest tax were put on the table and quickly removed, while a shift towards a more territorial system through the introduction of a border tax has been both on and off the agenda. It wasn’t until November that more firm plans were introduced, and with them a proposal to eliminate interest deductibility, seemingly the biggest consequence of the reform for our friends in private fund management.

Carry rulings

In Europe, Swedish managers are lobbying against a judgment that carry will be taxed as salary at 60 percent, potentially with retrospective effect, while in Spain a tax ruling found carried interest should be taxed as fee income. The industry there is campaigning for something in line with the French and new Italian systems, which allow carry to be taxed as profit provided certain conditions are satisfied. No conclusions have been reached yet, so it seems tax will remain in the headlines as we transition into 2018.

Of course, it’s not just the finances of a private fund firm that are affected by tax change, it also impacts their operations. Our survey of CFOs, conducted with EisnerAmper, found accountants to be the most in-demand staff at firms. More than one-third of those surveyed plan to make at least one addition to their finance team over the coming year, with a further 15 percent planning to boost their tax expertise. Others are increasingly outsourcing tax matters: “Tax is such an interesting and complicated component in the alternatives world,” a participant at a recent pfm roundtable said.

Back-office pressures

Tax isn’t the only factor fuelling the growth in outsourcing among US managers; a general increase in demands on the back office has led managers to turn to external advisors with increased frequency, a practice that had typically been the reserve of their European peers. The lack of internal tech expertise has been among the most common drivers of the increase as cybersecurity remained in the headlines. Two consecutive global attacks that hit high profile businesses and private equity service providers were followed by news the Securities and Exchange Commission, which has taken a hard stance on cybersecurity, had itself been hacked in 2016.

After the incident, new SEC chairman Jay Clayton made what has probably been his only detailed speech about the direction of the agency under his lead, and re-iterated its focus on cybersecurity and advised regulated firms to do the same. Business as usual was very much the implication, as appears to have been the case in other areas of its oversight. Enforcement action has continued apace and a spate of cases were published towards the end of the summer. The usual suspects – fees and expenses and conflicts of interest – were the order of the day. Whether this continues into 2018 remains to be seen; a decision on whether to give power back to enforcement staff to issue subpoenas on their own authority – which was removed by acting chairman Michael Piwowar in February – is yet to be made.

While US fund managers are safe in the knowledge that their supervision will not be altered in the near future, their compatriots in the UK were dealt a shock blow in June. The Financial Conduct Authority told them they would be subject to greater regulatory oversight from 2018, and will be obliged to report fees to their investors using a standardised template. Chris Sier, the man drawing up these templates, told pfm “honest managers have nothing to fear,” and nor should they face the same battle as GPs adopting the extensive Institutional Limited Partners’ Association’s fee reporting template either, as both asset class and investor type specific templates will be drawn up.

There may be clarity on the new reporting rules, but in other regards, UK managers are very much in the dark. They have been almost starved of the details of how Brexit will impact them, and many are still pondering how they will tackle the eventual outcome of the UK’s departure from the EU. One of the most memorable quotes to have made its way into pfm this year came from KPMG’s head of regulatory change Julie Patterson. She said in September that there are “no answers at all” on how UK managers will market their funds in Europe in the increasingly likely scenario that the country leaves the single market. At the time of going to press that remains the case, and while there are a number of options to consider, most managers are not taking action until things become a bit clearer.

An overview of the year would be incomplete without a nod to fund finance and specifically the growing scrutiny of it by investors. Since Oaktree’s Howard Marks sounded the alarm on subscription line credit, criticism has rained down on the product. The SEC has flagged IRR calculation as an area of focus, warning managers in June that they should review their calculations, while global head of private equity at Indosuez Wealth Management, Oliver Carcy, told pfm that some managers are “abusing credit lines.”

Transparency call

But there has also been a tide of support for its use and GPs argue, and many investors agree, that they help to smooth cashflow. “In some cases GPs have a significant number of LPs in the funds, so it doesn’t make sense to make these individual capital calls which would be very modest – or as some people call them ‘nuisance level,’” one infrastructure GP said. London-based Silverfleet Capital’s Neil MacDougall said transparency around their use is crucial, as is the period of time for which the facility is outstanding. “The longer you build up the stock of undrawn capital, the more Marks is correct,” he said, noting that his firm typically clean down facilities every 12 months. Its growing popularity and increased scrutiny will ensure that the topic remains at the fore long into 2018.

It’s safe to say that 2017 has in general created a number of loose ends that, hopefully will be tied up over the course of the next 12 months. US tax reform and progress on Brexit are likely to be the big headline grabbers, but the ongoing debate around fund finance and changes  to tax on carry in a number of European countries will also demand airtime. As ever, pfm will stay abreast of developments, and we are looking forward to the start of what promises to be an interesting and news-packed year.