Private Equity Investment: Increasing Investor Diversification Benefits - Essay Sample

Introduction

In the recent past, private equity investment has increasingly gained importance as an asset category due to the increasing investor diversification benefits compared to bond holdings and traditional stock. As such, large investors such as insurance companies are now allocating more significant parts of their overall investment portfolio to private equity (Demaria, 2015). The entry, management and exiting the direct private investments demands expertise and experience, and therefore most of the investments are intermediated through funds. For private equity, the risk is inherent, and the challenge persists beyond unpredictable business cycles alongside volatile markets (Demaria, 2015). Operational, strategic, as well as external threats, are major potential disruptive forces in private equity investments. Private equity investments for many firms are experiencing risks such as from disruptive technology, fraud, cybercrime and regulatory compliance. In the modern world, which has been dominated by dynamic technology, these threats are increasing at an increasing speed. Although in many firms the focus and budgets are not consistent with managing the escalating risks, it is crucial that investment firms monitor and develop management strategies for the growing threats. Regulatory compliance is a critical component in any private equity firm and continues to permeate every element of private equity operations by firms. As such, the study aims to explain what is a regulatory risk in private equity investment.

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In the US, the private equity funds have not been subjects to much or any regulatory scrutiny historically. However, the past few years have been a shock to the investor community as they face the challenge to acclimate to operations in a new regulated environment (Demaria, 2015). Due to the increased regulation, private equity investors are now forced to invest more of their time and resources in compliance matters. This has created several challenges which include the need to have sufficient resources in carrying out compliance programs which have been structured to avoid violations of applicable laws (Demaria, 2015). Again, private equity investors are taking compliance considerations in their decision-making process at an increasing rate. Although compliance has been reported to be expensive and painful at the moment, the long term effects of regulation will be positive for this industry.

Private equity investments and their managers have in the recent past moved to increase regulations due to rising risks resulting from overleveraged transactions alongside potential investors costs induced by insider trading and price fixing by mega funds which capture the most substantial portion of the net capital flows (Demaria, 2015). However, there has been a rift in opinion concerning if the private equity investment should be subjected to regulations which have been structured to protect workers and curb asset stripping behaviors. According to Demaria (2015), the proponents of regulation argue that there is a negative image of the private equity investment such as the decisions to cut jobs at industries. The private equity investments, in this case, are solely interested in own enrichment at the cost of other interested within the sector (Demaria, 2015). Demaria (2015) suggested that evidence has decried the regulatory interference by reporting a positive association between firm performance and private equity investments.

The global turbulence experienced in credit markets ended no regulatory regime in private equity investments and have slowed down the private equity activity (McCahery & Vermeulen, 2012). Besides, there has been an increase in scrutiny from policymakers, regulators and judiciary. A variety of regulatory options such as self-regulation and government intervention continue to be considered in lowering the risk level and counter the balance between private equity firms and investors. Other reasons that have been identified for the demand for regulatory interventions include the need to reduce buyouts incidences (McCahery & Vermeulen, 2012).

In general, private equity funds are governed by a contract (McCahery & Vermeulen, 2012). These funds are mainly formed as limited (partnerships, liability partnerships of liability companies) and are in a position to be exempted and excluded from exemptions and exclusions outlined by the regulatory framework (McCahery & Vermeulen, 2012). The various business forms are therefore an advantage as the businesses are treated as transparent entities for tax reasons which permits the funds to avid taxation and thus pass through tax liabilities and finally to the fund investor (McCahery & Vermeulen, 2012). These contracts also enable investors and managers to set an agreement and schemes which align incentives and lower agency costs (McCahery & Vermeulen, 2012).

The regulatory risk in private equity investments can, therefore, be defined as the associated risks resulting from regulatory intervention in the market to redress the investors and private equity firms balance and also lower the level of risk (McCahery & Vermeulen, 2012). Such risks resulting from regulatory intervention include the dilemma faced by private equity firms in identifying suitable techniques which target to increase transparency and also reduce the risk level without the subsequential damages to flexibility and advantages of business models thriving on limited interventions in the contractual relations (McCahery & Vermeulen, 2012). For example, when private equity flourishes, the contractual basis are usually adequate any agency problems in the industry in the given period. However, in cases of a weaker economy and jeopardized buyouts performance, regulatory interventions are likely to be applied regardless of the contractual basis of the investments. In this regard, the reliability of private equity funds in contributing to strategic performance has been questioned. Besides, criticism exists concerning conflict of interests, market abuse and market opacity which raise questions for the suitability of the current regulatory systems in addressing these challenges. McCahery and Vermeulen (2012) highlighted that the regulatory risks levels increase significantly during the failure of a high profile buy-out, which leaves employees and selling stakeholders in distress. At this point, it would be expected that the government intervenes at the cost of private ordering structures adopted by the investors and the funds.

Pedretti (2013) argued the private equity investments are exposed to several regulatory risks and obligations which have a substantial impact on the operation and financial rate of return for the firm. Examples of operational, regulatory risks experienced by private equity investments include:

Tax Problems

Private equity firms have been reported to convert fees charged investors for managing their assets into fund investments (Pedretti, 2013). This is known as management fee waiver also the fee-waiver conversion and occurs when investors are granted an exemption by private equity firms in their management fee so that they can use the capital as part of their own investment income in the fund (Pedretti, 2013).

Accounting and Valuation Problems

This regulatory risk occurs when private equity funds which are held by publicly listed companies inflate its value improperly (Pedretti, 2013). This necessitates the need for continued scrutiny of valuation practices for a money manager.

Fund Fees and Expenses Problems

The regulatory intervention may lead to scrutiny for the fairness and adequate disclosure of fees and expenses charged to investors by private equity firms (Pedretti, 2013).

Antitrust Problems

This results when there is a need to probe identified private equity firms for their possible collusion with "club deals" in lowering the leveraged buyout targets purchase price (Pedretti, 2013).

Foreign Corrupt Practices Act (FCPA) Problems

Private equity firms that violate FCPA through unlawful payments in obtaining sovereign wealth funds investment may be investigated. For bribery committed in portfolio companies, private equity companies may face likely FCPA liability (parent-subsidiary) regardless if the bribed transpired before the acquisition or whether the portfolio is privately held or publicly traded (Pedretti, 2013).

Fundraising Problems

The manager may face charges for fraud and misuse of money raised for an investor for other use without investors knowledge (Pedretti, 2013).

Conclusion

In the recent past, private equity investment has increasingly gained importance as an asset category due to the increasing investor diversification benefits compared to bond holdings and traditional stock. As such, large investors continue to invest more substantial portions in private equity. However, there are inherent risks in private equity investments such as regulatory risks which include trade problems, accounting and valuation systems and a loss of trust among involved stakeholders. However, research has supported that regulatory risks are in support of the fact that equity investments are subject to relatively minimal regulatory oversight since they are classified as an alternative investment. Again, since private equity investments do not take part in debt issuing or securities, they remain free of regulatory oversight in most jurisdictions. Besides, private equity investments may continue free from regulatory oversight and risks since fund managers contract with sophisticated institutional investors and individuals who constitute their investment through partnership and contractual arrangements which protect investors. Overall in minimizing risk levels, regulatory intervention is unavoidable in some cases, and there are risks associated with regulatory intervention.

References

Demaria C. (2015) Introduction. In: Private Equity Fund Investments. Global Financial Markets. Palgrave Macmillan, London doi https://doi.org/10.1057/9781137400390_1

McCahery, J. A., & Vermeulen, E. P. (2012). Private equity regulation: a comparative analysis. Journal of Management & Governance, 16(2), 197-233.

Pedretti, M. (2013). Operational Regulatory Risks Facing Private Equity Firms | Perspectives | Reed Smith LLP. Retrieved from https://www.reedsmith.com/en/perspectives/2013/07/operational-regulatory-risks-facing-private-equity