May 23, 2013
Interviewed by: David Snow
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GPs Under Attack: Fundraising and Regulation

Dodd-Frank has placed private equity under increased scrutiny. Richard Jaffe of Duane Morris says that many of the reforms inappropriately target the asset class and are “burdensome and costly.” What kinds of changes can LPs and GPs expect and what’s being done to dampen the impacts?

Dodd-Frank has placed private equity under increased scrutiny. Richard Jaffe of Duane Morris says that many of the reforms inappropriately target the asset class and are “burdensome and costly.” What kinds of changes can LPs and GPs expect and what’s being done to dampen the impacts?

GPs Under Attack: The Regulating and Fundraising Reality
A Privcap Conversation with Richard Jaffe of Duane Morris

Dodd-Frank has significant implications for finance in general, but what about private equity specifically?

Jaffe: One of the issues and probably the most significant issue that private equity funds face under Dodd Frank and continue to face is the obligation to register as an investment advisor under the Investment Advisor’s Act of 1940. Now, the form itself, ADV, is a very simple form, very straightforward. But the obligations under that and the changes in the way you have to operate are burdensome and costly. And it requires you to have a series of manuals, new policies, email policies, policies on what you can talk about, when you can talk about things. It also requires you to have a chief compliance officer. So, there’s a significant increase in the expense that’s an obligation of having to register. So, that’s one issue.

And what we in the industry questioned was when this was enacted, it was designed to control those issues that would have that or create a systemic risk to the financial institutions. And that’s important. But when it was enacted, venture funds, which were structured the same way that buy-out funds are/were exempted. And what happened was private equity funds were lumped in with hedge funds. And as such, were obligated to register if they had 150 million or more under management. So, we think that this is a burden that, one, there is no systemic risk to financial institutions or the financial condition of the country as a result of these funds because they don’t have capital. They call capital. And when a subscriber signs up, he or it commits to invest; whereas a hedge fund actually manages money. And we think there was a need for more education of congress, the policymakers and the policy shapers before this was enacted. Fortunately, Representative Hurt from Virginia has introduced a bill that would exempt those private equity funds that do not have more than two times the leverage of their equity. And we think that’s a very positive thing. It’s now bipartisan. And although it was introduced last year, it did come out of committee but wasn’t brought onto the floor. This year, we think it will be. And we think that’s important because that will enable the private equity funds to use those dollars to invest in companies, rather than to pay these costs that are incurred to comply with Dodd Frank. So, that’s on one side. That’s the registration side.

What else should private equity firms be looking out for, but may not be aware of?


There are also issues that the Securities and Exchange Commission is now focusing on. So, one of them is they are starting to look at the offering material that these funds use when they raise their funds and they seek commitments from limited partners. They have actually instituted an action against the fund for having inflated the value of its portfolio companies. And that’s a very standard kind of issue when you sell securities. It’s a section 10B5 issue. And so that, the SEC is now back on track looking at.

The other issue is the individuals who are offering these securities. You have to be registered in order to be paid if you sell a security. So, if there is compensation that’s based on success, you have to register as a brokered dealer. And some people said, well, I’m not really selling security. I’m just making introduction. So, I’m a finder. So, I shouldn’t have to register as a broker dealer. And some of us in the practice used to rely on that. But the SEC is saying, no, you can’t be a finder if you can do it on a continual basis.

So, the issue this creates is if I’m a private equity fund and I use an unlicensed person to sell securities, the buyer of that security has a rescission right and can get his or her money back. So, it affects not only me, but also, the person who sold it. So, that’s a real issue. A more esoteric issue that the SEC is starting to talk about again is if I’m a private equity fund and I’m selling one of my portfolio companies and I’m being compensated, do I have to register as a brokered dealer? And a speech was given by one of the attorneys at the SEC talking about that issue. So, I think that’s going to be a more prominent issue in the future, that private equity funds have to be sensitive to and are generally not aware of.

LPs have clearly gained more leverage in fundraising negotiations. What are some of the more significant changes for GPs?


So, one of the important ones is the waterfall issue and whether limited partners will have European or the American style. And America is a deal-by-deal procedure where at the end of each deal, a transaction occurs and an exit happens. Once the LP receives a return of his or its capital, there’s a sharing, an 80/20 sharing. Under the European model, the LPs have to receive the entire return of their capital before there’s an 80/20 split. And this is obviously favored by the limited partners. It avoids claw back issues, things like that. But the limited partners are also interested in co-investment rights, separate accounts. And they’re doing that to reduce their expenses.

Some of us think that the co-investment rights are really illusory because generally, there isn’t a sufficient amount of time for the LP to really do the kind of due diligence that has to be done in order to determine whether or not who wants to co-invest. So, yes, there is an opportunity avoid carrier management fee. But within the timeframe, I haven’t seen that many LPs really take advantage of it.

Separate accounts is a different issue. And LPs are looking at that. And I think we’ll see more of that issue. Alignment of interest, LPs are looking to GPs to commit more. One percent is just not enough. And they want to know that you’ve got more skin in the game. And sophisticated GPs recognize this. They’ve got their capital invested alongside of the LPs. So, in addition to the carry, they get a return on their capital.

What changes are you seeing related to management and other fees?


So, we’re seeing these kinds of discussions happen on a more regular basis. The offset of fees from the outside to the GP as an offset against management fees, it used to be zero, went to 50 percent, 80 percent. Now, for most funds, it’s 100 percent. So, that there isn’t a double dip and GPs, again, stay much more focused on I will benefit. I’m not trying to make anything out here. I’m focused solely on how I can maximize the value for the LP. And then, I will benefit, too.

So, it’s been an evolution. And it’s more important for middle-market funds because there is a trend where the large investors are reducing the number of managers and increasing the check size. So, this creates more of an issue for the lower middle market and the middle market funds. And what we’re seeing is, in response to that, they’ve got to adhere more to ILPA principles to make them more attractive to the LPs. We’re also seeing other kinds of LPs come in. Family offices are playing a larger role now. And will in the future. So, there’s a change there. But even though most of the large investors are seeking fewer relationships, we are also seeing, for the right funds with track records in the lower middle market and middle market, carve-outs so that there are still investors that are interested in that sector.

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