Private Capital: Regulatory horizons
Geoff Cook, Chair of Mourant Consulting in Jersey, looks at regulatory horizons affecting private capital in the United States, Europe and Asia.
These turbulent times focus the minds of regulators just as much as the private sector, given the increased risks that market disruption poses. Regulatory styles and approaches differ according to geopolitical and cultural norms worldwide, with significant actors such as the US, the EU, Britain and China tending to lean into rulemaking, while smaller, nimbler players are often rule takers.
Still, smaller countries must grapple with the policy innovations of their larger neighbours if they are to retain market access and equivalence recognition. Fold in the activities of the international standard setters such as the OECD, FATF and IOSCO, and there is ample material for the watchful to monitor. Small may be beautiful but small states, particularly IFCs, need to be agile and alert from a regulatory standpoint.
The US has increased its scrutiny on the private equity industry. The perennial subject of carried interest featured in the Build Back Better Act but was later migrated to the Inflation Reduction Act. However, but for the intervention of Senator Kyrsten Sinema, the capital gains tax treatment currently applied would have changed to income tax, levied in the US and most other countries at a higher rate.
There are sound arguments for treating performance fees as capital gains as they reflect the growth and added value created in the underlying investments in a private equity fund. That said, the migration of the very largest private equity groups to a corporate listed status means that much of the industry is now taxed at corporation tax rates.
Another recent innovation has been the introduction of a Book Minimum Tax of 15% that companies are expected to apply to their financial statement income. The book tax will have the effect of increasing the overall effective rate of corporation tax. Harmonisation with the global tax deal promoted by the OECD looks problematic as that initiative is stalled, having failed to clear legislative hurdles in the US and the EU.
Policing private capital
The focus hasn’t just been on tax. The Biden administration has taken full advantage of the political appointee system by recruiting several key figures sympathetic to a more robust policing of private capital activities, and they have begun to make their mark.
Given the Biden administration’s leanings toward a more interventionist approach and the American system where political appointees to regulatory boards are far more common, Lina Kahn, an associate professor at Columbia Law School, who as an academic proposed the break-up of Amazon, has been appointed to Chair the Federal Trade Commission (FTC).
The FTC’s principal responsibilities are enforcing US civil anti-trust laws and promoting consumer protection. In early communications, Khan has expressed clear concerns regarding ‘roll up’, in other words, market consolidation. A quote from her early staff memo is instructive:
“Meanwhile, the growing role of private equity and other investment vehicles invites us to examine how these business models may distort ordinary incentives in ways that strip productive capacity and may facilitate unfair methods of competition and consumer protection violations. Evidence suggests that many of these abuses target marginalised communities and combatting practices that prey on these communities will be a key priority.”
This approach is mirrored elsewhere. Department of Justice Anti-Trust Unit head, Jonathan Kanter, in recent testimony delivered on 20th September 2022, at the Senate Judiciary Committee Hearing on competition policy, anti-trust and consumer rights, confirmed:
“We will litigate more merger trials this year than in any fiscal year on record. Notably, this litigation occurs against a backdrop of nearly 3,000 notified transactions in FY2022 – which follows FY 2021 as the largest number of filings any year since the reporting thresholds were adjusted in 2000.”
‘Buy, strip and flip’
Concerns expressed by the anti-trust regulatory community and President Biden’s own special advisor on competition, Professor Tim Wu (also of Columbia Law School), around consolidation and a ‘buy, strip and flip’ model, signal a clear intent to place private equity under much closer scrutiny. Given the commitments of the entire industry to ESG factors and the evolution of the patient capital model, these developments should be a cause of concern. Further investment in education, transparency and disclosure will be needed.
The new regulatory tone maps across earlier moves by the SEC Chair, Gary Gensler, another Biden appointee, who set his stall out following his appointment in 2021, with initiatives relating to climate change and cyber security assuming a new prominence. Common themes are enhanced reporting requirements and more significant regulatory intervention at an individual deal level, an example being more rapid disclosure of beneficial ownership and the disclosing of substantial positions.
There are implications for this new and more strident regulatory approach, with great care required to comply with reporting requirements regarding target investments and, increasingly, disposals. These requirements will impact service providers such as the legal profession and due diligence arrangements. Fund boards and administrators may have to adjust to more protracted timescales in the acquisition and sale of companies, and more complex due diligence and reporting processes will be required to support anti-trust reviews that look set to grow in number.
Europe – tax
European standard setters such as the European Commission, ESMA and the ECB have shown themselves more than capable of devising sophisticated directives and regulations that shape not only the EU markets but, through an extra-territorial application, also significantly influence the actions and standards of third countries who seek access to the EU market. The EU has been particularly adept at wielding this soft power by placing great emphasis on investor protection, competition and high regulatory standards.
While the EU has its priorities, themes that surfaced in the US are also evident in Europe. On tax, the EU has failed to reach unanimity on the Global Business Tax with several countries now trying to build a coalition of early adopters, independent of a full-blown directive, with Hungary under considerable pressure to come onside.
Ireland has been lobbied to join the Member States Coalition for Global Business tax adoption by the European Parliament Tax FISC Committee delegation on a recent visit to Dublin. At this moment, the prospects of a deal remain unclear.
Elsewhere the focus on ESG continues with delegated regulation now released for consultation following the introduction of the Sustainable Finance Disclosures Regulation (SFDR) adopted on 6 April 2022. The EU Commission has confirmed:
“Delegated Regulation specifies the exact content, methodology and presentation of the information to be disclosed, thereby improving its quality and comparability. Under these rules, financial market participants will provide detailed information about how they tackle and reduce any possible negative impacts their investments may have on the environment and society in general.”
The commission has announced plans to incorporate elements of the SFDR into a new Corporate Sustainability Reporting Directive (CSRD). The new directive is expected to increase the level of sustainability reporting by corporates in their financial statements.
Work on the EU taxonomy, a classification system for establishing lists of environmentally sustainable activities, continues in its journey to set a ‘common green standard’. According to a recent Goldman Sachs bulletin, the taxonomy is already shaping asset management research and decisions around capital allocation, cost of capital and company valuations.
A focus on substance and actual economic activity continues as the ATAD III ‘Unshell’ legislation progresses. The directive has proved controversial, with concerns that it will cast the net too wide and ensnare funds business that was not the original target of the legislation. ECON, the Committee on Economic and Monetary Affairs, has proposed amendments that would provide some comfort around outsourcing activities to ‘associated enterprises’ in the same jurisdiction.
ECON has further proposed to exclude AIFMs, supervised AIFs and UCITs, given their status as ‘regulated financial undertakings’. The relevant committee will review in November, and entry into effect has been put back one year to 1 January 2025, lowering fears over the potentially retrospective impacts of a two-year look-back period.
UK post-Brexit adjustment
Clearly the recent political turmoil in the UK has dominated the news headlines. However, the work of regulatory adjustment post-Brexit goes on. Much attention has focused on the Financial Services and Markets Bill and the Treasury committee’s second special report looking at the future of financial services regulation in a post-Brexit world. After recent events, it seems unlikely that the UK will see a Big Bang 2.0 programme and the degree to which regulatory divergence will remain a realistic goal will be moderated by market access equivalence requirements.
Financial Crime remained very much to the fore with the Economic Crime and Financial Transparency Bill introduced into Parliament for its first reading in the House of Commons. The Bill provides for a wide range of reforms that include changes to Companies House, a new regime for identity verification, and a strengthening of the anti-money laundering regime.
Given the recent volatility in UK financial markets, it seems reasonable to conclude that regulatory attention will focus on stability and market events for a time. However, the introduction of the Consumer Duty initiative by the FCA does bear the hallmarks of a more robust and potentially more directive approach to outcomes-focused investor protection, which, while targeted at a different investor community, chimes very much with the more robust positioning in the US.
China continues to dominate developments in Asia, and as with its trade policy, the regulatory focus of recent times has turned inward. The Xi administration’s goal seeks to reduce its dependence on international markets with a renewed focus on domestic enterprises and internally generated economic activity in pursuit of its social market goals. Regulatory action has aligned with this new approach. Firms will increasingly be required to account for their contribution to furthering the Chinese Communist Party’s aims in terms of the cultural and economic prosperity of the nation.
Firms will also be encouraged to partner with private equity and other private capital providers in ventures that may lead to an IPO in China instead of relying on external exchanges. Compliance with the relevant securities and conduct laws and regulations will remain imperative. There is an expectation that firms will need to demonstrate how they contribute to the long-term goals of the leadership in the country. ‘Internal circulation’ (for which read domestic activity) will receive much greater attention although China will remain engaged in ‘external circulation’ and the activities of Chinese companies overseas.
Hong Kong and Singapore continue to bolster their reputations as innovative centres in wider Asia. Each jurisdiction is actively developing climate and related ESG and disclosures regulation. Climate-related reporting is expected in Singapore in 2023, and both Hong Kong and Singapore aspire to establish voluntary carbon credit markets. In addition, digital innovation and its regulation have progressed in Singapore.
Trends and themes
Convergent regulatory trends have emerged across a range of areas. Transparency, disclosures, climate change and sustainability are all driving regulatory agendas and the introduction of new and heightened requirements. Competition issues and conflicts of interest are being addressed across most jurisdictions but with very different goals in mind when the US and China are contrasted, for example. The immediate post-financial crisis era saw a big focus on financial stability which has ebbed somewhat. Still, the recent market turmoil in the UK and the fragile nature of energy and food security worldwide may bring this up the agenda again. And given the enduring conflict in Ukraine, it seems that sanctions may be an issue that centres must grapple with for some years to come.
What can small state IFCs learn from these developments?
It’s clear that engaging with the ESG agenda and climate change are essential no-regret moves that align with responsible investment principles. Realistically given the huge capital investments involved and the limitations of size, and international influence, enjoyed by small state IFCs, a supportive fast-follower approach would appear to be the optimum policy choice.
A further area that merits reflection is how IFC firms can support the ever-increasing demands on private capital by regulators for data and information, particularly concerning competition and anti-trust matters. Investment in secure and increasingly sophisticated information gateways that counter concerns around anti-competitive practices through an evidence-led approach and robust cyber protection will be rewarded.
And as regulators make progress in these areas, we should not forget that social taxonomies will follow, with the impacts of private capital on human capital likely receiving increased policy attention.