Nov 07 2006 Peter Elstob
The Financial Services Authority has published a discussion paper on the regulatory challenges posed by the rapidly growing private equity market, which has this year raised more primary capital than the public listed market. The DP seeks industry and policymaker feedback on whether the regulator has correctly identified the various systemic risks posed by this growth, and the suitability of its approach to these.
In the first half of 2006, UK-based PE fund managers raised £11.2bn of capital, exceeding the £10.4bn of public equity raised through initial public offerings on the London Stock Exchange, despite the fact that IPOs also grew in the same period.
The FSA believed its current approach was effective, proportionate and adequately resourced, and that risk-based supervision, supplemented by targeted thematic work, constituted an effective response to the PE market. The market was stratified into three main groups: around 14 major firms doing large, highly leveraged and often complex domestic and international deals; a much larger group of firms focusing on mid-size, predominantly domestic deals; and a large group of firms focusing on smaller domestic deals.
The FSA currently maintains what it calls "a close and continuous supervisory relationship" with the largest PE/venture capital managers to address the key sources of these risks. It lists these as: excessive leverage, unclear ownership of economic risk, reduction in overall capital market efficiency, market abuse, conflicts of interest, market access constraints, and market opacity.
The FSA said it was responding to these key risks as follows:
Excessive leverage: The FSA recently asked banks for information on their credit exposure to leveraged buyouts by PE firms. The 13 banks that responded reported a combined exposure at June 2006 of €67.9bn, up 17 per cent from one year earlier. The regulator pointed out that system-wide exposures were substantially greater than this, however, because banks were selling around 80 per cent of their exposures to investors, such as hedge funds, and managers of collateralised loan obligations and collateralised debt obligations.
This large and growing supply of debt finance, along with the rise of club deals, in which a number of PE managers cooperate, was leading to larger PE transactions, enabling major public companies to be taken private in huge deals, like the recent €12.9bn acquisition of Danish telecoms group TDC by five PE funds. That deal, one of Europe's biggest, would have been dwarfed if last week's offer of €40bn by US buyout firm Kohlberg Kravis Roberts for French media and telecoms company Vivendi had been accepted.
In addition to its normal prudential supervision of banks, the FSA recently carried out a survey of leveraged buy-out activity, as part of a wider European Central Bank initiative. This found that equity represented just 21 per cent of the capital structures of the five largest deals done by the surveyed banks in the 12 months to June 2006. While UK banks' leverage levels were found to be historically high and rising, however, they might have begun to peak. The regulator was considering conducting similar surveys on a regular basis.
Unclear ownership of economic risk: The FSA found that the extensive use of opaque, complex and time-consuming risk transfer practices such as assignment and sub-participation, together with the increased use of credit derivatives, was making it harder to identify who ultimately owned the economic risk associated with an LBO. In times of distress, the confusion such factors caused could damage the timeliness and effectiveness of work-outs, and might even undermine otherwise viable restructurings.
In response, the FSA would, as a priority, consult trade bodies and market practitioners to increase its understanding of the issues and risks that firms would face in the event of default by a heavily traded issuer, or multiple concurrent defaults. It would explore whether an industry code of practice on preparing for such events would be beneficial, and it would make this issue a key focus over the next 18 months.
Reduction in overall capital market efficiency: The development of secondary PE markets — in both individual investor commitments to PE funds and PE funds' holdings in companies — certainly enhanced liquidity, and probably contributed to improved capital market efficiency, both private and public, the FSA believed. But it might also reduce capital flows to the public markets. The regulator cited Citigroup research which found that UK public equity market capitalisation shrank by a net £46.9bn in the first half of this year, reflecting the impact of public-to-private deals, widespread use of share buy-backs and special dividends (often as a defence against a PE bid), and diminished private-to-public capital flows.
As a result of this development of a secondary private equity market, an increasing proportion of companies with growth potential was being taken private, and fewer private companies were going public.
The FSA would continue to maintain a watching brief on overall market quality. Its statutory objectives did not differentiate between public and private markets. The regulatory burden of the UK listing regime should be neutral between the two sectors and the FSA as listing authority would continue to review its rules to ensure this. It was also alerting other public bodies to PE issues and risks, including those risks outside its own statutory objectives.
Market abuse: The FSA said it was monitoring the credit market proactively; an enhanced transaction monitoring system was under development and it had recently acquired a new source of credit trading information. It would take appropriate action if it identified any incidences of market abuse by PE firms or in relation to PE deals.
It was also monitoring industry initiatives to establish principles and recommendations for the handling of material non-public information by credit market participants.
Conflicts of interest: The main conflicts of interest arose between the fund manager itself, the investors in the separate funds it managed and the companies owned by the funds. Advisers and banks providing leveraged finance also faced significant conflicts, particularly where they took on multiple roles.
One year ago the FSA issued a "Dear CEO" letter on senior management responsibilities in relation to conflicts of interest and non-standard transactions, and published an article in the UK Listing Authority newsletter highlighting the potential for conflicts of interest in competitive IPOs. Management of conflicts by PE managers was likely to be the subject of a future thematic exercise.
Constraints on market access: Retail investor access, both direct and indirect, is currently restricted by a number of regulatory and technical factors. The FSA will publish a CP in December, drawing on the feedback to CP06/4, published in March, which proposed changes to the listing rules for investment entities such as PE investment trusts to address some of these constraints. The December CP will, for example, propose removing the prohibition in the current listing rules on primary listed investment entities taking control of the companies they invest in.
Market opacity: Valuation and other methodologies often vary, making it hard for professional investors to compare relative performance. The FSA did not intend to impose transparency requirements on the PE market, but was watching industry initiatives to raise standards in this area, recognising that the level and form of transparency needed to be appropriate to the PE market's relatively sophisticated investor base.
The views and the opinions expressed in 'hot topics' are that of the individual authors and not necessarily those of the Securities & Investment Institute.
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