It’s been 10 years since the darkest days of the financial crisis. The events of that period fundamentally changed the private equity industry, in many cases for the better.
One key outcome was bringing the industry under the purview of regulators. Among the wide-ranging 2010 Dodd-Frank Reform and Consumer Protection Act was the Volcker Rule. The rule – which didn’t actually fully come into force until 2015 – forces banks to limit their investments in private funds to no more than three percent of Tier 1 capital.
As soon as Dodd-Frank was signed into law in 2010 many of the big banks began offloading their private equity assets in anticipation of the rule, spinning out or selling their in-house direct investment arms. We have Volcker in part to thank for One Equity Partners (JPMorgan), Equistone Partners Europe (Barclays) and Graycliff Partners (HSBC). In 2014 divestments by banks accounted for a quarter of secondaries deal volume, according to Setter Capital.
Now it looks like some of those banks may have been too quick to act. The Securities and Exchange Commission is seeking comment on proposals to ease restrictions that prohibit banks from investing in private equity funds.
The proposal raises numerous questions concerning what counts as a ‘covered fund’ – the definition of which is at the heart of the private fund investment prohibitions under the Volcker Rule. As it stands, ‘covered fund’ refers to both hedge and private equity funds; the SEC asks whether the agencies should separately define ‘hedge fund’ and ‘private equity fund’ or restrict the definition of a ‘covered fund’ to one or the other.
“Would such an approach more effectively implement the statute? If so, how should the agencies define these terms and why?”
What’s more, the SEC suggests it’s open to the idea of scrapping restrictions on banks backing private funds, asking whether there are funds included in the ‘covered fund’ definition that do not in fact engage in prohibited investment activities, and therefore should be excluded from the definition.
In a July article, lawyers from Debevoise & Plimpton explained that current regulations limit banking entities’ investment in funds that make long-term investments in portfolio companies, despite the fact banking entities may invest directly on their balance sheet in portfolio companies under various authorities.
“This is an incongruous result and an example of the over breadth of the covered fund definition,” the Debevoise lawyers wrote. “To resolve this incongruity, the agencies could revise the regulations to provide banking entities flexibility to engage in permissible long-term investing, whether through a private fund structure or otherwise.”
One firm surely quietly congratulating itself that it didn’t move too fast is Goldman Sachs. The bank – which had roughly $4 billion fair value of private investments as of March – secured a five-year extension on divestment obligations included in the Volcker Rule last May. On the bank’s second-quarter earnings call last year, chief financial officer Martin Chavez said he was expecting a “recalibration” of the rule.
The future not just of the Volcker Rule but the whole of Dodd-Frank has been uncertain since President Trump took office; in a first definitive step toward rollback, earlier this year Congress approved a bill relaxing federal oversight of banks with assets of less than $250 billion.
Significant changes to the Volcker Rule that would allow banks to re-enter private equity in a meaningful way would open up a huge pool of capital to general partners – that is, if those banks that paid the cost to comply with Volcker could stomach the thought of potential regulatory yo-yoing in the future.
The Debevoise lawyers note the SEC proposal includes “few specific modifications to the covered fund provisions”, instead asking “open-ended questions”, suggesting the agencies are “relying on the industry to provide feedback on how to revise the implementing regulations both to reduce unnecessary complexity and to implement the underlying statue appropriately”.
The comment period has been extended until October 17. So, now’s your chance.
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