Tag: Private Equity

Private Equity in India

Posted on by Rebecca Targan

Since the enactment of economic reforms in the early 1990s, India has experienced a period of rapid economic growth.[1] On average, GDP has grown over 7% per year since 1997,[2] making India one of the world’s fastest growing economies. In 2004, investors began seeing opportunities for private equity investment,[3] and the market grew from $6.6 billion in 2005 to $55.8 billion in 2007.[4] Despite taking a major hit in response to the economic crisis, investment grew back steadily through early 2011,[5] at which point India had the fastest growing private equity market in Asia.[6] However, towards the end of 2011, investment began trending downward and has languished ever since.[7] Unfortunately, this is due at least in part to the Indian government’s inconsistent policies, which have created regulatory uncertainty among foreign investors.

In January of 2012, the Supreme Court of India held that the Indian government may not tax capital gains from indirect transfers of capital assets located in India, an issue over which there had been much confusion.[8] The suit began after Vodafone, a Netherlands company, had purchased CGP Investments Ltd. (CGP), a company based in the Cayman Islands.[9] CGP’s main asset was an interest in Hutchison Essar Limited (HEL), based in India.[10] Under Section 9 of India’s Income Tax Act, a non-resident must pay tax on income arising through “transfer of a capital asset situate[d] in India.”[11] India’s tax authorities contended that this section applied to Vodafone, claiming that Vodafone’s acquisition of CGP was equivalent to a transfer of shares of HEL to Vodafone. Therefore, the government insisted that Vodafone owed taxes on capital gains derived from the acquisition of HEL.[12] The Supreme Court disagreed, holding that Section 9 did not cover indirect transfers of capital assets situated in India.[13] The case set an important precedent for a number of foreign investors whose deals were structured similarly to Vodafone’s, and provided clarity for others who were hesitant to invest due to the legal uncertainty of the pending case.[14] Unfortunately, the issue was once again opened in March of 2012, thanks to the Indian Financial Minister’s proposal of new tax rules. The proposal would enact General Anti-Avoidance Rules (GAAR),[15] making transactions between international companies with Indian subsidiaries liable for a domestic capital gains tax.[16] GAAR would “effectively overturn[]” the Supreme Court’s decision in the Vodafone case.[17]

The Financial Ministry’s proposal sparked massive uncertainty. GAAR would be retroactive through April 1st, 1962, creating the potential for many cases, including Vodafone’s, to be re-examined.[18] In addition, the outcome of several pending cases regarding M&A deals between international companies that hold Indian subsidiaries is once again uncertain.[19] Moreover, GAAR created further uncertainty among those who might have been planning to invest in Indian companies through deals structured similarly to Vodafone’s.[20] To assuage investor concerns, India’s Prime Minister issued a statement in June of 2012 saying GAAR would not be finalized without his approval.[21] The Prime Minister is expected to soften GAAR’s impact on investors, but exactly how he will do so is still unclear.[22]

The recent actions of the Government of India are problematic for two reasons. First, they re-open the issue of whether the Indian government may tax capital gains from indirect transfers of capital assets situated in India. Hopefully, the Indian government will soon clarify what GAAR’s practical effects will be, and resolve the matter once and for all. Second, even if the Indian Government resolves the GAAR issue in favor of investors, they have now set an example to the world that the law of India is volatile. Private equity deals are carefully structured to gain benefits from whatever legal systems they are subject to, so the fact that India’s laws seem to be constantly in flux is highly discouraging to anyone looking to acquire Indian companies. If the country wants any sort of private equity market, it must find a way to rebuild investors’ confidence in the stability of India’s laws. At any rate, it will not be easy to do so before Indian private equity investment falls even further.

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[1] Central Intelligence Agency, Economy: INDIA, The World Factbook, https://www.cia.gov/library/publications/the-world-factbook/geos/in.html#Econ (last visited Oct. 27, 2012). See also T.C.A. Anant & N.L. Mitra, The Role of Law and Legal Institutions in Asian Economic Development: The Case of India 4, 57 (Harvard Institute for International Development 1998).

[2] Central Intelligence Agency, supra note 1.

[3] Malini Goyal, PE: The story of greed, boom and the fall of private equity in India, The Econ. Times (May 17, 2012), http://articles.economictimes.indiatimes.com/2012-05-17/news/31749390_1_pe-firms-pe-investments-subbu-subramaniam.

[4] Deloitte, Private Equity: Fueling India’s Growth 6 (2012), available at http://www.deloitte.com/assets/Dcom-India/Local%20Assets/Documents/Thoughtware/Private%20Equity.pdf.

[5] Id.

[6] Id. at 4.

[7] Id. at 6.

[8] Vodafone International Holdings B.V. v. Union of India & Anr., (2012) __ S.C.R. __ (India), available at http://judis.nic.in/supremecourt/imgs.aspx.

[9] Id. at ¶ 2 (India), available at http://judis.nic.in/supremecourt/imgs.aspx.

[10] Id.

[11] Id. at ¶70.

[12] Id. at ¶ 71.

[13] Id.

[14] Amol Sharma and R. Jai Krishna, Vodafone Overturns Tax Bill in India, Wall St. J. (Jan. 21, 2012), http://online.wsj.com/article/SB10001424052970204616504577172152700710334.html.

[15] 5 Facts About the General Anti-Avoidance Rule (GAAR), NDTV Profit, http://profit.ndtv.com/news/market/article-5-facts-about-the-general-anti-avoidance-rule-gaar-300693 (last updated May 14, 2012, 19:27 (IST)).

[16] James Crabtree, India to Change Tax Law After Vodafone Case, Fin. Times, http://www.ft.com/intl/cms/s/0/d9d96cde-6f59-11e1-9c57-00144feab49a.html#axzz2ASEttu4q (last. updated Mar. 16, 2012 8:32 PM). Language in the amendments seems to be specifically targeted at the Vodafone decision. One of the explanatory notes reads, “[A]n asset or a capital asset being any share or interest in a company or entity registered or incorporated outside India shall be deemed to be and shall always be deemed to have been situated in India.” Crabtree, supra.

[17] Crabtree, supra note 15.

[18] Crabtree, supra note 15.

[19] Crabtree, supra note 15.

[20] After Vodafone, GAAR; PM Takes Charge of Finance Ministry, The Times of India (June 30, 2012, 2:16 AM IST), http://timesofindia.indiatimes.com/business/india-business/After-Vodafone-GAAR-PM-takes-charge-of-finance-ministry/articleshow/14513903.cms.

[21] Id.

[22] FE Bureau, PM Moves to Soften GAAR, Vodafone Blow, Fin. Express (June 29, 2012, 32:00 IST), http://www.financialexpress.com/news/pm-moves-to-soften-gaar-vodafone-blow/968019/0 See .also FinMin May Amend GAAR Rules to Boost Investor Confidence, Firstpost (Oct. 2, 2012), http://www.firstpost.com/economy/finmin-may-amend-gaar-rules-to-boost-investor-confidence-476521.html

Private Equity Funds in China: Structures, Opportunities and Challenges

Posted on by Chenhao Zhu

Private equity (PE) funds formed to make investments in the People’s Republic of China (PRC) come within three main types of structures. This post identifies and analyzes the characteristics, advantages and disadvantages of each structure, and highlights recent legal developments pertaining to how international investors can build or sponsor an onshore RMB funds.

Introduction

PRC’s economic growth has created a steady flow of investment opportunities. Especially after the global financial crisis, more and more global PE funds seek to deploy capital in this region. The financial crisis turns out to be a starting point for PRC to usher in a completely new phase for its opening-up and become one of the favorite investment destinations. To date, PE industry enjoyed a steady growth as can be seen in the chart below.

chartone

Chart 1 Annual Fundraising Amount by PE Funds focusing on Greater China between 2002 and 2011 Source: Preqin as of 2012

PE funds could be formed in PRC in one of the three structures:

1) offshore US Dollar-denominated funds;

2) onshore domestic-invested RMB-denominated funds;

3) onshore foreign-invested RMB-denominated funds.

Offshore US Dollar-denominated Funds

Offshore US Dollar-denominated funds are formed in non-PRC jurisdictions, most commonly in the Cayman Islands or British Virgin Islands.

Advantages:

· As offshore funds are typically organized as limited partnership, investors enjoy two typical advantages of partnership compared to corporations: greater flexibility of commercial terms and the availability of pass-through tax treatment, i.e. it avoids dividend tax and double taxation because only owners or investors are taxed on the revenue.

· As offshore funds are organized under laws of Cayman Islands or British Virgin Islands, there are greater certainty and predictability pertaining to the legal enforceability of contracts and limited liability protection of limited partners than entities governed by PRC law.

Disadvantages:

Offshore funds are not governed by PRC law, but their investments made in PRC will be. As they are registered in non-PRC jurisdictions and funded by foreign investors, offshore funds are classified as foreign investors under PRC’s regulatory regime pertaining to foreign investment, and thus are subject to many special restrictions.

According to Foreign Investment Industrial Guidance Catalogue enacted by PRC’s State Council, many sectors and industries are closed to foreign investment. Even for accessible industries, every investment needs government approval. While not difficult to obtain, the great latitude of administrative authorities has generated huge space for rent-seeking. Moreover, the application process can be time-consuming since it involves extensive negotiations with various approval authorities. For example, a large factory may have serious land use or environmental issues. Thus, the exact time frame for approval is never certain. It depends on the type of project and the location. Foreign investors must be prepared for this uncertainty from the outset.
· Since offshore funds are denominated in USD yet invest in RMB, government approvals are also required for the conversion of USD into RMB and associated repatriation.

· As there are no PRC tax rules specifically ensuring pass-through tax treatment for offshore funds, investors must be very cautious to make sure that a “permanent establishment” is not created in PRC as the tax exposure of both general partners and limited partners could be adversely affected.

It should be noted that offshore funds used to be able to circumvent the restrictions stated above through “round-trip investment”: typically a PRC national established or controlled an offshore holding company to control a Chinese domestic company by captive contractual arrangement. The Chinese domestic company makes investment in China as a domestic investor while the international investors invest at the offshore level. However, the “round-trip investment” is no longer an easy shortcut as PRC had made significant policy changes in recent years to close related regulatory loopholes.

Since then, more and more PE funds prioritize setting up RMB funds. As can be seen in the graph below, most of the newly-raised funds are denominated in RMB.

charttwo

Chart 2 PRC Private Equity Fundraising. USD Funds vs. RMB Funds, denominated in $US Billons Source: Preqin as of 2012

Onshore Domestic-Invested RMB-Denominated Funds

Onshore domestic-invested RMB-Denominated funds are registered in PRC, comprising exclusively of domestic source of capital. The vast increase in its popularity in recent years could be partially attributed to the corresponding growth of Chinese sources of capital available to onshore RMB funds, including, among others, 1) PRC’s National Social Security Foundation; 2) local government funds held by several provincial and municipal authorities, such as Beijing, Shanghai, Tianjin and Jiangsu; 3) an increasing number of wealthy Chinese entrepreneurs.

It is crucial to note that onshore domestic-invested RMB-Denominated funds are closed to foreign capital, but not to foreign investors. In other words, international investors could sponsor an onshore domestic-invested RMB-Denominated fund as its general partner. First, they should register a management entity in PRC to raise and manage the RMB fund as its general partner. Then, they would raise limited partner capital from domestic Chinese investors. Specific regulations pertaining to such type of transaction vary across provinces and municipalities, as there is not yet a unified set of rules governing investor solicitation and private offering on a national level.

Advantages:

· As onshore funds are typically organized as limited partnership under PRC’s Partnership Enterprise Law, investors enjoy two typical advantages of partnership compared to corporations: greater flexibility of commercial terms and the exemption from double taxation.

· As onshore funds are classified as “domestic investors” under PRC law, government approval for investment and currency conversion could be avoided, so as the associated lag-time and rent-seeking, resulting in greater efficiency and lower cost.

· As domestic investors, onshore funds can invest in industries restricted to foreigners like television stations and publishing, thus have access to more deals in a broader share of PRC’s economy.

Disadvantages:

· Onshore domestic-invested RMB-Denominated funds are by its nature inaccessible to foreign sources of capital, and thus very difficult to scale their business. As of now, most of them are relatively small in size, with whole funding below US$100 Million.

· Compared to Cayman Island and BritishVirginIsland, there are less certainty and predictability in PRC’s legal matrix, especially pertaining to enforcing contracts in PRC courts. PRC has a lot of capital, but not a large group of seasoned investors. It could be tricky when dispute arise between foreign sponsors and domestic investors, who are unfamiliar with private equity, regarding terms such as capital calls and years-long commitment.

Onshore Foreign-Invested RMB-Denominated Funds

Onshore foreign-invested RMB-Denominated funds are registered in PRC, comprising at least partially of foreign source of capital. They could be organized either as foreign-invested venture capital enterprises (FIVCEs) or foreign-invested limited partnerships (FILPs).

With respect to regulatory framework, of particular importance are the passage of Waishang Touzi Chuanye Touzi Qiye Guanli Guiding (外商投资创业投资企业管理规定) [Administrative Rules on Foreign-Invested Venture Capital Enterprises] (the “FIVCE Rules”) on March 1, 2003, [1] and the Waishang Touzi Hehuo Qiye Dengji Guanli Guiding (外商投资合伙企业登记管理规定) [Administrative Measures on Establishment of Partnership Enterprises by Foreign Enterprises or Individuals in China] (the “FILP Measures”) on March 1, 2010. [2]

According to FIVCE Rules, the scope of investment of FIVCEs is limited to high-tech or new-tech industries. Additionally, FIVCEs are forbidden to make investment by borrowed funds. Thus FIVCE can be a very ineffective model for making PE investment in PRC.

FILPs, as a new investment avenue opened in 2010, offers another promising option for international investors to engage in PE investments in the foreseeable future. The Carlyle-Fosun RMB fund, registered in March 3, 2010, is the first reported FILP. With initial investment of US$100 million, the co-branded fund is a 50/50 joint venture between Carlyle and Fosun, both of which are general partners [3]. Afterwards, Blackstone formed the Shanghai Blackstone Equity Investment Partnership, while TPG launched the TPG Shanghai RMB Fund and the TPG Western China Growth Partners I. Goldman Sachs and Morgan Stanley also reportedly have RMB funds in the pipeline.

Advantages:

· As onshore RMB funds are typically organized as limited partnership under PRC’s Partnership Enterprise Law, investors enjoy two typical advantages of partnership compared to corporations: greater flexibility of commercial terms and the exemption from double taxation.

· Capital contribution could be made in cash or in kind, subject to valuation and filing requirements.

· Previously, PE investments by foreign investments are subject to approval of Ministry of Commerce (MOFCOM), which could be very intrusive, paper-intensive and time-consuming. But according to FILP Measures, FILPs could be set up by registration with State Administration of Industry and Commerce only, thus bypassing the burdensome process of MOFCOM approval.

· It could use RMB to invest more easily in domestic companies in PRC, thus help take them public in PRC, on the Shanghai or Shenzhen stock markets. By contrast, offshore USD funds typically made investment into companies that were structured for a public listing outside PRC. Since IPO valuations are at least twice as high in PRC as they are in Hong Kong or USA, investment through RMB funds leading to a Chinese IPO can earn foreign investors a much higher return, likely over 300% higher, than otherwise.

Disadvantages:

· When organized as offshore funds governed by Cayman law, the general partner and the fund manager are typically exempted from taxation. But as the general partner and the fund manager of FILP are treated as PRC tax resident, the carried interest and management fee payments are taxed at the PRC corporate income tax rate at 25%.

· FILPs are still subject to the previously mentioned Foreign Investment Industry Guidance Catalogue, thus could not invest in industries restricted to foreigners like television stations and publishing.

· The local limited partners may not be as sophisticated as the international investors. Their lack of experience and unrealistic expectation of high yields may possibly damage the business cooperation.

Recent Regulatory Developments

In 2011, the four direct-controlled municipalities of PRC: Beijing [4], Shanghai[5] , Tianjin [6] and Chongqing [7], initiated significant pilot programs as to RMB funds organized as FILP. Under these programs, certain FILP could avoid more regulatory hurdles. For example, foreign capital contribution by foreign general partners and qualified limited partners may not be subject tot foreign currency conversion approval.

Indeed PRC is taking cautious steps to further open up its PE market. On November 23, 2011, PRC’s National Development and Reform Committee (NDRC) promulgated the first nationwide regulation of PE industry: Guojia Fazhan Gaigewei Bangongting Guanyu Cujin Guquan Touzi Qiye Guifan Fazhan De Tongzhi (国家发展改革委办公厅关于促进股权投资企业规范发展的通知) [The Notice on Promoting the Standardized Development of Equity Investment Enterprises]. [8] On one hand, it tightens regulation of PE funds by requiring that all the PE funds shall register with NDRC or its counterparts at provincial level. On the other hand, the notice further opens PRC’s PE market to international participation as it does not reverse or limit any of the pilot programs’ initiatives to circumvent the foreign current regulations. In other words, this state-level regulation’s “hands-off” approach implicitly encourages local authorities to offer new incentives to attract international capital, and implicitly encourages international investors to continue forum shopping among these competing programs.

Summary

To sum up, the PE industry in PRC is blessed, as nowhere else is, with abundant capital, stellar investment opportunities and favorable IPO markets. With respect to investment avenues, the advantages of onshore RMB funds are clear: they can make investment without foreign exchange controls, they face much less red tape and they can raise funds from PRC’s local sources. Carlyle, TPG and Blackstone, as the earliest market entrants in this regard, have each launched their own RMB funds in partnership with leading PRC private company, and point the way forward for many of its peers in US. As PRC authorities gradually opens up its PE market to foreign capital, an increasing number of PRC’s strong private enterprises will get growth capital from international PE investors with the know-how and pools of RMB to build great public companies.

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*Chenhao Zhu received a JSM (Master of Science of Law) from Stanford University in 2011, where he was the recipient of Franklin Family Fellowship and an editor of Stanford Journal of International Law. He is now an associate in the Palo Alto office of K&L Gates LLP, focusing on US-China business transactions, especially venture capital and private equity investments.

[1] Promulgated by the Ministry of Commerce (formerly, Ministry of Foreign Trade and Economic Cooperation), Ministry of Science and Technology, State Administration of Industry and Commerce, State Administration of Taxation and State Administration of Foreign Exchange on Jan. 30, 2003, effective on Mar. 1, 2003.

[2] Promulgated by the State Administration of Industry and Commerce on Jan. 29, 2010, effective on Mar. 1, 2010.

[3] See Shanghai Approves Carlyle and Fosun Joint RMB Fund; First Business License Granted to Foreign-Funded Equity Investment Partnership Enterprise. http://thecarlylegroup.com/news-room/news-release-archive/shanghai-approves-carlyle-and-fosun-joint-rmb-fund-first-business-license- (last visited Oct. 13, 2012)

[4] See Beijing Shi Guanyu Benshi Kaizhan Guquan Touzi Jijin Jiqi Guanli Qiye Zuohao Liyong Waizi Gongzuo Shidian De Zanxing Banfa (北京市关于本市开展股权投资基金及其管理企业做好利用外资工作试点的暂行办法) [Interim Measure on Pilot Program of Utilization of Foreign Capital By Equity Investment Fund and Its Management Entity of Beijing Municipality] (promulgated by Beijing Bureau of Finance, Beijing Commission of Commerce and Beijing Administration of Industry and Commerce on Feb. 28, 2011, effective on Feb. 28, 2011).

[5] See Shangha Shi Guanyu Benshi Kaizhan Waishang Touzi Guquan Touzi Qiye Shidian Glongzuo De Shishi Banfa (上海市关于本市开展外商投资股权投资企业试点工作的实施办法) [Implementation Measures for Foreign-Invested Equity Investment Enterprises Pilot Programs of Shanghai Municipality] (promulgated by Shanghai Financial Service Office, Shanghai Commission of Commerce and Shanghai Administration of Industry and Commerce on Dec. 24, 2010, effective on Jan. 23, 2011.

[6] See Tianjin Shi Guanyu Benshi Kaizhan Waishang Touzi Guquan Touzi Qiye Jiqi Guanli Jigou Shidian Gongzuo De Zanxing Banfa (天津市关于本市开展外商投资股权投资企业及其管理机构试点工作的暂行办法) [Interim Measure on Pilot Program of Foreign-Invested Equity Investment Enterprises and Its Management Entity of Tianjin Municipality] (jointly promulgated by Tianjin Development and Reform Committee, Tianjin Financial Service Office, Tianjin Commission of Commerce and Tianjin Administration of Industry and Commerce on Oct. 14, 2011, effectively on Dec. 13, 2011.

[7] See Chongqing Shi Guanyu Kaizhan Waishang Touzi Guquan Touzi Qiye Shidian Gongzuo De Yijian (重庆市关于开展外商投资股权投资企业试点工作的意见) [Implementation Measures for Foreign-Invested Equity Investment Enterprises Pilot Programs of Chongqing Municipality] (promulgated by Chongqing Administration of Industry and Commerce, Chongqing Foreign Economics and Trade Commission and Chongqing Office of Finance on Mar. 31, 2011, effectively on Mar. 31, 2011.

[8] Promulgated by the Office of Staff of National Development and Reform Commission on Nov. 23, 2011, effectively on Nov. 23, 2011.

Presidential Politics and Private Equity

Posted on by Todd Bullion

This election season there has been a good deal of discussion over Mitt Romney’s time spent at Bain Capital. The Romney Campaign has sought to highlight that experience as a qualification to lead the country to a better economic future. The Obama Campaign and other groups affiliated with it have made the argument that Romney eliminated and outsourced jobs during his time at Bain Capital. [1]

Concerns exist that this election could bring increased public attention to the Private Equity industry, and give politicians extra incentive to regulate the industry. [2] In a recent survey of Tech Industry executives, where the Tech executives were questioned on the Presidential election, “78% say that the campaign’s focus on Romney’s roots in private equity have “damaged” the reputation of private equity and venture capital”; [3] and, “65% worry that there could be new regulation of private equity and venture capital investing”. [4] However, there is little reason to be concerned that the election will give politicians an impetus to further regulate the private equity industry.

There is evidence that political advertisements based on Romney’s Bain record have been effective; a Super PAC running political advertisements attacking Romney’s Bain record claim that their internal polling shows that “a decisive plurality of voters said Mitt Romney’s record as Bain CEO makes them less likely to vote for him.”[5] These advertisements highlight negative consequences of pursuing a strategy of profit maximization with a special focus on outsourcing, downsizing, and reducing employee benefits.[6]

However, the persuasive thrust of these advertisements could be effectively applied to all profit-maximizing business, particularly large businesses. In a recent PEW Research poll over 50% of respondents said businesses make too much profit. [7] In the same poll slightly less than 50% of respondents said that Wall Street hurts the economy more than it helps it. [8] And perhaps most significant, 67% of respondents claimed that Wall Street only cares about making money for themselves. [9]

It is a well-known fact that manufacturing companies pursue strategies of profit maximization as a rule of thumb. To maximize profits manufacturing companies have outsourced jobs, downsized workforces and when possible reduced employee benefits. However, manufacturing companies are not facing the same negative press as private equity firms. Consider for a moment that instead of working at Bain Capital Mitt Romney had become the CEO of General Motors. I suspect in this hypothetical world where Mr. Romney was CEO of General Motors – never having worked in private equity – we would see almost all of the same political advertisements currently on the air criticizing Mr. Romney’s Bain record, but with the word’s GM in place of Bain Capital.

In short, I posit that the public does not hold a special grudge for the private equity industry. That while the election may have certainly put private equity in the spotlight nothing of consequence will come from it because criticisms of the private equity industry are both general in nature and very similar to criticisms made of profit maximizing institutions in general. Consequently, concerns that new private equity or venture capital regulations may be coming as a result of the Presidential election are likely overblown.

[1] See , Michael Shear, A Final Push in Swing States, in a Bid to Break the Stalemate, N.Y. Times (Oct. 23, 2012) http://www.nytimes.com/2012/10/24/us/politics/a-tight-focus-on-battleground-states-as-campaigning-time-dwindles.html (describing Priorities USA plan to spend several million dollars on adds that tell the stories of people who lost their jobs after Bain Capital acquired the companies which employed them).

[2] Eric Savitz, Tech Execs Mostly Back Romney, But Expect Obama to Win, Forbes (Oct. 8, 2012, 8:04 PM) http://www.forbes.com/sites/ericsavitz/2012/10/08/tech-execs-mostly-back-romney-but-expect-obama-to-win/

[3] Id.

[4] Id .

[5] Alex Pappas, Democratic Super PAC to Revive Attacks on Romney’s Bain Record, The Daily Caller (Oct. 20, 2012, 9:41 AM) http://dailycaller.com/2012/10/20/democratic-super-pac-to-revive-attacks-on-romneys-bain-record/

[6] Shear, supra note 1.

[7] ‘Staunch Conservatives’ Are Warry of Wall Street , Pew Research Center (May 26, 2011) http://pewresearch.org/pubs/2003/poll-wall-street-business-financial-crisis

[8] Id .

[9] Id .

Russia and the WTO: The Private Equity Outlook

Posted on by Nikolai Karetnyi

Russia’s ascension into the World Trade Organization signaled an expected, but nonetheless major, opening of the Russian economy. Russian membership in the WTO will dramatically lower tariffs for both Russian exports and imports into Russia. These developments, coupled with Russia’s growing middle class, global engagement through the 2014 Winter Olympics and 2018 World Cup, and market reforms, seemingly transform Russia into a hotspot for private equity investment.[1] However, the actual picture is far from rosy. Despite ending its holdout as the last G20 nation not in the WTO, Russia will continue to challenge private equity investors through both structural and legal barriers.

Many forecast the effects of Russian membership to be similar to those of China’s. After joining in 2001, China’s exports rapidly grew and its economy adjusted to meet the rising global demand for cheap Chinese exports. But simply put, Russia is not China. Though Russia’s economy is also based on exports, these exports are often commodities rather than cheap products buoyed by low wage costs. Additionally, state ownership and interventionism remains the norm in the attractive commodity sectors, meaning that Russia will be slower to adapt new reforms to compensate for the opening of its markets. [2]

This is particularly significant for private equity companies aiming to invest in Russia. While barriers to foreign investment in the crown jewels of the Russian economy (oil and gas companies) are unlikely to be removed, more foreign investment could flow into Russia’s manufacturing sector. Between 2007 and 2011, the manufacturing sector accounted for 51% of investment projects and 92% of job creation. Other similar sectors, such as the industrial and food sectors, also attracted a high number of projects and significant foreign investors. With newfound access to European markets, these sectors should experience an influx of private equity investment in the near future. [3]

Despite Russia’s economic structural limitations, private equity investors remain confident in Russia’s future growth. [4] The main reason for this confidence is Russia’s growing domestic market. Due to rising wealth levels, about 25% of Russia’s population now calls itself middle class. [5] This is a stark contrast to the oligarch-driven wealth gap that typified Russian society in the 1990’s and early 2000’s. Russian companies, already experiencing a trade surplus, will look to capitalize on the growing middle class rather than exporting to new markets. However, the specter of European competition in Russia’s markets will necessitate expansion and an influx of both domestic and foreign private equity.

While economic forces have seemingly aligned to attract investors, Russia’s culture of bureaucratization and corruption continues to ward off private equity. Additionally, the politicization of Russia’s economy also creates a major barrier for American companies. Currently, the US and Russia do not have normal trade relations due to the Jackson-Vanik Amendment, thus the US is precluded from using WTO mechanism to challenge Russia’s higher tariffs on American goods. Strict government regulation of foreign investment and corruption at all administrative levels further complicates private equity investment in Russian companies. However, investors who have already successfully navigated these barriers remain confident in future growth. For new investors, the risks may be justified by the increasing rewards of Russian companies expanding inward to a robust domestic market.

[1] Positive Outlook for Russian Investment as it Joins WTO , Ernst & Young Emerging Markets Center (Sep. 7, 2012), http://emergingmarkets.ey.com/positive-outlook-for-russian-inward-investment-as-it-joins-wto/

[2] Matthew Philips, Don’t Get Too Excited About Russia’s WTO Deal, Bloomberg Businessweek (Aug. 22, 2012), http://www.businessweek.com/articles/2012-08-22/dont-get-too-excited-about-russias-wto-deal

[3] See note 1, supra.

[4] Lena Smirova, Russia Climbs Up Investment and Business Climate Rankings, The Moscow Times (October 25, 2012), http://indrus.in/articles/2012/10/25/russia_climbs_up_investment_and_business_climate_rankings_18629.html

[5] See note 1, supra.

Minority Shareholder Freeze Outs

Posted on by Aaron Schneff

Issues surrounding arbitration are now front and center in the business and legal worlds. In January 2012, news concerning Carlyle Group’s initial public offering surfaced when it proposed “the most shareholder-unfriendly corporate governance structure in modern history.” [1] In its proposal, Carlyle required that public shareholders arbitrate all claims against the company. Moreover, the arbitration must be confidential and precludes class-action lawsuits.[2] With the Supreme Court practically removing all barriers to arbitration in cases like AT&T Mobility v. Concepcion[3] orCompuCredit v. Greenwood, [4] Carlyle’s proposed governance structure seems poised to withstand legal challenge.

But Carlyle goes beyond merely requiring disputes to be arbitrated. Additionally, many Carlyle shareholders will have no ability to elect directors. If public shareholders hold less than ten percent of the company, Carlyle reserves the right to summarily repurchase all of those shares. [5] Perhaps most interestingly, Carlyle has supplanted fiduciary duties with a partnership agreement that grants the board to act in its sole discretion without good faith. A committee of independent directors appointed by Carlyle deals with conflicts of interest.

However, minority shareholder freeze out is not an entirely new concept in the private equity sphere. Other public private equity firms including Apollo Global Management, the Blackstone Group, and Kohlberg Kravis Roberts contain similar corporate governance structures. [6] Some commentators view these provisions as designed to “eliminate any ability of shareholders to sue the board for even the most egregious acts.” [7]

The first challenge the Carlyle Group will face is the approval from the Securities and Exchange Commission. The question will likely center on whether a public company can force arbitration in cases involving federal securities law. In support of its proposed corporate governance structure, Carlyle will find solace in recent Supreme Court decisions like AT&T Mobility and CompuCredit.

Arguments favoring the arbitration clause focus on the division between the company and shareholder interest. Some commentators believe that shareholder interests and incentives tend to be short term, while companies should be run by boards of directors who are incentivized to focus on the company’s long-term interests.[8] By limiting shareholder rights, the board of directors can avoid the pitfall of focusing on short-term profits.

Another advantage is that arbitration clauses reduce transaction costs. When private equity firms primarily operate through acquiring companies, shareholder litigation significantly increases the cost of doing business. According to a report released by Cornerstone Research in cooperation with Stanford Law School, 91% of acquisitions valued over $100 million in 2011 were subject to shareholder litigation. [9] According to the same study, the number of lawsuits per deal averaged 5.1. [10] Of the 565 legal challenges to acquisitions in 2010-2011, 27% were voluntarily dismissed, 4% were dismissed by the court with prejudice, and 69% settled. [11] With the cost of legal representation on the rise, the increase of lawsuits per deal becomes increasingly burdensome for publicly traded private equity firms.

While it is unclear whether firms can require arbitration for claims of federal security violations, the Supreme Court’s decision in CompuCredit seems to support the use of arbitration in any setting not directly prohibiting it. Further, the use of arbitration clauses may be necessary to support the central business model of publicly traded private equity firms. Finally, the market is the best place to regulate corporate governance structures: if investors are not satisfied with shareholder rights, they can simply choose not to invest. As long as adequate disclosure is provided to potential shareholders, arbitration provisions like that proposed by Carlyle Group should be held valid.

[1] Steven Davidoff, Carlyle Readies an Unfriendly I.P.O. for Shareholders, DealBook (Jan. 18, 2012), http://dealbook.nytimes.com/2012/01/18/carlyle-readies-an-unfriendly-i-p-o-for-shareholders/

[2] Id.

[3] AT&T Mobility LLC., v. Concepcion, 131 S.Ct. 1740 (2012) (Under Federal Arbitration Act, California must enforce mandatory arbitration clause that precludes class-action arbitration)

[4] Compucredit Co. v. Greenwood, 132 S.Ct. 665 (2012) (holding where federal statute is silent on arbitration, Federal Arbitration Act requires arbitration agreement to be enforced according to terms)

[5] Id.

[6] Id.

[7] Steven Davidoff, Carlyle Readies an Unfriendly I.P.O. for Shareholders, DealBook (Jan. 18, 2012), http://dealbook.nytimes.com/2012/01/18/carlyle-readies-an-unfriendly-i-p-o-for-shareholders/

[8] Id.

[9] John Gould, Developments in M&A Shareholder Litigation, Harvard Law School Forum on Corporate Governance and Financial Regulation (Mar. 4, 2012), http://blogs.law.harvard.edu/corpgov/2012/03/04/developments-in-ma-shareholder-litigation/

[10] Id.

[11] Id.

A Look Into the Growing Trend of Family Offices

Posted on by Taylor Webb

Private equity firms were reluctant to make deals in the first half of 2012, as the number of deals dropped 15 percent from last year. [1] A lack of large deals could create negative repercussions going forward, as firms address the need to deploy the large amount of cash that they have built-up. Firms currently hold about $1 trillion in cash, $200 billion of which will be handed back to investors if firms are unable to find large deals within the next year. [2] The increased need to find large deals will lift multiples for the larger target companies, providing less upside potential going forward. [3] Although well priced deals may be harder to find for some of the major private equity firms, some wealthy investors are beginning to seek out alternative ways to invest their capital. A growing number of wealthy families are beginning to make direct investments in companies, rather than investing in large private equity firms. [4]

As wealthy individuals look for new ways to invest after experiencing a period of low returns, some wealthy families have begun to hire top Wall Street talent to manage their investments.[5] Between 2006 and 2010, the share of private equity investments in multifamily investment portfolios rose from 3.8% to 10%. [6] Moreover, the current environment is ripe for investors who want more control over their investments because of the pressure some of the major funds are facing. [7] Not only does the idea of being closer to their investments appeal to wealthy investors, but it opens the door to numerous investments that may not be readily available when investing in large private equity firms. Investing in a family office allows investors to make investments with longer time horizons. Managers within family offices have found success in making long-term investments in a few platform companies with the aim of growing the companies through smaller acquisitions. [8] This holding company approach is just one example of the ability of family offices to be flexible in the type of strategies they employ.

Although family offices usually do not have the same amount of resources at their disposal as some of the major private equity firms, the resources they do have are streamlined.[9] The number of individual investors in any given family office is relatively small, with some offices starting out with only one family. [10] At the same time, some managers are drawn by the opportunity to work closely with clients, while being relived of worrying about marketing or spending time doing client development and have left large investment houses to work with these family offices. [11]

Running a family office also has the advantage of flexibility when it comes to the type of investments that are available for managers to consider. [12] Simply put, the size of many of these family offices allows managers to consider a broad spectrum of investments that may not be as appealing to many of the large private equity firms. Many of the family offices are able to invest in young, promising startups because they are dealing with a smaller pool of money. [13] In fact, some family offices seem to focus mostly on young startup companies, almost acting as a venture capital fund. [14]

As the industry continues to face challenges, investors continue to adjust their actions to seek out better rates of return. For those who seek greater control and a more personal atmosphere, investing in a multifamily office is an attractive alternative to investing with a major firm. At the same time, managers in family offices will also benefit from the small amount of investors they will be communicating with and the greater flexibility in the investments that are available to them. With the advantages of size, flexibility, and greater control, it is easy to see why family offices have become a favored alternative for wealthy investors and managers alike.

[1] Mohammed Aly Sergie, Survey Says: PE Flat in First Half, Eyes Carve-Outs in Second, Wall St. J. Blog (July 2, 2012, 4:57 PM) http://blogs.wsj.com/privateequity/2012/07/02/survey-says-pe-flat-in-first-half-of-2012-eyes-carve-outs-in-second-half/.

[2] Andrew Ross Sorkin, More Money Than They Know What to do With, N.Y. Times Dealbook (Oct. 1, 2012, 8:42 PM) http://dealbook.nytimes.com/2012/10/01/more-money-than-they-know-what-to-do-with/.

[3] Id.

[4] Azam Ahmed, Family Investment Funds Go Hunting for Wall St. Expertise, N.Y. Times DealBook (Apr. 4, 2012, 3:50 PM), http://dealbook.nytimes.com/2012/04/04/family-investment-funds-go-hunting-for-wall-st-expertise/.

[5] Id.

[6] Steven R. Strahler, Families Jump Into the PE Pool, Crain’s Chicago Business (May 28, 2012) http://www.chicagobusiness.com/article/20120526/ISSUE02/305269999/families-jump-into-the-pe-pool.

[7] Id.

[8] Id.

[9] Ahmed, Supra note 3.

[10] Strahler, Supra note 6.

[11] Ahmed, Supra note 3.

[12] Id.

[13] Id.

[14] Id.

Re-defining the Line between Public and Private

Posted on by Zach Paterick

In his new article, Revisiting “Truth in Securities Revisited”: Abolishing IPOs and Harnessing Private Markets in the Public Good, Adam Pritchard argues that the current transition between private and public company status is awkward and inefficient.[1] Pritchard suggests that these inefficiencies can be reduced through the implementation of a two-tier market system for transitioning from private to public status.[2] In this blog, I analyze the implications of Pritchard’s suggested system on the Private Equity Community.

Background

Pritchard argues that the separate enactment of the Securities Act and the Exchange Act created a mismatched dividing line between public and private status.[3] The Securities Act draws the line in a manner that focuses explicitly on investor protection, while the dividing line under the Exchange Act reflects the attempt to balance investor protection, interests in capital formation, and practical ease of application.[4] Congress has shifted the point at which companies must go public through the JOBS Act, which gave the SEC new authority to exempt offerings from the requirements for registered offerings and authorized the SEC to adopt less demanding periodic disclosure from companies who benefit from this new offering exemption.[5] Pritchard contends that the JOBS Act reforms have the potential to create a lower tier of public companies and to blur the line between private and public companies.[6]

The Two-Tier System

Pritchard offers a different solution; one he believes unifies the public/private dividing line under the Securities Act and Exchange Act. Pritchard’s solution involves a two-tier market for both primary and secondary transactions, where the primary market would be limited to accredited investors, while the public market would be accessible to all.[7] Under this regime, all public offerings would be seasoned offerings with a price informed both by full disclosure and a pre-existing trading market. Issuers would be able to choose whether to sell in the primary or secondary market and companies would become eligible for the primary market after reaching a certain quantitative benchmark (he suggests $75 million in market capitalization, the threshold currently used by the SEC for shelf registration).[8]

Under this system, issuers below the quantitative benchmark would be limited to selling their securities to accredited investors. However, contrary to the current system, those securities could not be freely resold after a minimum holding period, but would instead be sold to other accredited investors on an established secondary market (similar to SecondMarket or SharesPost except expanding eligible purchasers from Qualified Institutional Buyers to all accredited investors).[9]

Elevation to the public market would be completely voluntary.[10] Issuers unable or unwilling to meet the obligations associated with access to the public market would be allowed to remain private. Once a company chose to go public, a seasoning period would follow with the filing of requisite 10-Q’s during which the shares would continue to be traded in the private market.[11] This seasoning period would allow the trading price in the public market to be informed by the prior trading in the private market as well as the new information required to initiate the “going public” process.[12] Only after the company graduated to having its shares traded in the public market would the company be free to sell equity to public investors.[13] This two-tier system relies on the pricing efficiency of the markets.

Impact on Private Equity

Pritchard’s suggested model would impact the private equity market in multiple dimensions. First, companies looking for late stage investment to expand their brand could continue to seek private capital, without having to cross the public divide. Consequently, the amount of firms seeking private equity would likely expand, creating more opportunities for private investment.

Additionally, Pritchard’s plan would essentially create a liquid market for private equity investors. While similar markets already exist, see SecondMarket and SharesPost, these markets are limited to “qualified institutional buyers” (investors with more than $100 million under management). Pritchard’s secondary markets would include accredited investors, individuals with at least $200,000 in annual income or $1 million in assets. This increased participation in the secondary market would allow the market to establish a trading price.

Lastly, Pritchard’s plan would eliminate the need for marketers to create demand when a firm decides to go public. Instead, the secondary market, supplemented by the required filings to go public, would establish a trading price. The underpricing dilemma of IPOs would essentially disappear. Thus, private equity holders participating in the company’s transition from private to public would receive greater returns.

In summary, Pritchard’s two-tier market plan would create new opportunities for private equity investment, create a liquid trading platform, and help ensure that investors exiting the market when a firm elects to go public receive proper returns. Such a market system would be advantageous to private equity investors; it should be given serious consideration.

________________________________________
[1] Adam C. Pritchard, Revisiting “Truth in Securities Revisited”: Abolishing IPOs and Harnessing Private Markets in the Public Good (University of Michigan Law & Econ Research, Paper No. 12-010, 2012), available at http://ssrn.com/abstract=2103246 .

[2] See id. at 5.

[3] Id. at 3.

[4] Id.

[5] See Revisiting “Truth in Securities Revisited” at 4.

[6] Id.

[7] See id. at 30.

[8] See id.

[9] See id. at 31.

[10] Id. at 33.

[11] Id.

[12] Id. at 34.

[13] See id.

Regulatory Oversight in Private Equity

Posted on by Kail Jethmalani

Late last year, the Securities and Exchange Commission (SEC) announced an informal inquiry [1] into private equity funds. This investigation has at least three goals: (1) understanding alleged systemic risks posed by private equity funds; [2] (2) ascertaining whether valuation, due diligence, and related compliance controls are in place and adequate; [3] and (3) rooting out potential fraud. [4] However, some commentators have expressed the belief that the SEC is concerned with the valuation and compliance processes in place at smaller funds and so called “zombie”[5] funds, as opposed to the major players. [6] Indeed, neither the Blackstone Group nor KKR—both major players and publically traded—received the SEC’s first wave of informal inquiry requests in February, [7] and it is unclear if they have since received a request in a subsequent wave. Comments by the Bruce Karpati of the SEC’s enforcement division confirm this narrow view: “[the agency] is looking at zombielike funds that have potentially stale valuations.” [8]

The SEC’s espoused goals thus seem inconsistent: in contrast to large funds, small funds or zombie funds are unlikely to cause the systemic risks that would warrant investigation. Although valuations for zombie funds might raise concerns of fraud, [9] systemic fraud in private equity valuations seems unlikely due to countervailing incentives: private equity funds might want to overvalue assets to attract new investors, [10] but they want to maximize the difference between purchase and sale price [11] which could incentivize undervaluing assets. Reputation, which directly affects investor confidence, is another check on fraud. [12] Additionally, private equity investments involve sophisticated investors, [13] and as a matter of policy the SEC limits oversight of sophisticated investors. Increased regulatory oversight chips away at the notion that sophisticated investors can and should bear the economic risks of their investments themselves.

Therefore, to even investigate zombie funds is a marked policy shift for the SEC. By subjecting zombie funds to regulatory oversight, as opposed to leaving them to private resolution, the SEC has imposed not-insignificant regulatory compliance costs onto all private equity funds. [14] Simply put, the industry-wide costs imposed by the SEC’s new regulatory scheme could substantially outweigh the costs [15] associated with private resolution of zombie funds. Although investors might face significant losses through private resolution, private equity is a field for sophisticated investors that are capable of bearing investment risk. Consider a hypothetical pension fund that has invested into what has become a zombie fund. The fund must only take steps to leave the investment and absorb the associated losses. [16] In contrast, the SEC must first identify the zombie fund by reviewing valuation and compliance procedures, likely a costly and inefficient endeavor. Every private equity fund subject to SEC oversight must thus bear the cost of regulatory compliance, rather than limiting the costs to investors in zombie funds. A more efficient solution might be to work directly with aggrieved investors to investigate only particular funds. Upon receiving a complaint from an investor, the SEC can launch a targeted investigation that does not impose unnecessary costs onto the industry. The SEC already maintains a complaint reporting system, and expanding that system to include zombie funds is potentially a better use of the Commission’s finite resources.

Further, some commentators also question whether the SEC should devote any resources to valuation methods. [17] Conventional wisdom holds that valuing a private entity is an art, not a science; there is inherent uncertainty in valuation. [18] Industry groups argue that valuations are not as important to private equity funds as they are to other alternative investments. [19] Hedge funds, for example, charge fees based on changes in valuation, whereas the majority of fees due to private equity firms are based on the difference between the entrance and exit prices. [20] Although the SEC contends that smaller private equity funds might be incentivized to overvalue assets to attract greater investment and management fees, [21] they also face the countervailing incentive to minimize their asset valuation to maximize the delta between entrance and exit price. As previously noted, the private equity industry serves sophisticated investors capable of bearing investment risk, and the SEC’s resources might be better used to protect lay investors rather than to regulating an uncertain-by-nature practice.

This is not to suggest that greater regulatory oversight does not lead to benefits for the firms themselves. For example, some small and midmarket funds have retained outside firms to analyze and test their compliance practices, with the goal of understanding vulnerabilities. [22] Funds have already seen benefits from these reviews, by discovering that their internal controls with regard to data security were not up to SEC standards. [23] Nevertheless, these benefits must be weighed against the broad inefficiencies imposed by the regulatory scheme. Small and midmarket funds must already consider how to efficiently use their relatively limited resources. Rather than imposing costs across the industry, a much narrower regulatory scheme implemented through the existing complaint system is more likely to limit costs. Risk aversion will still lead to the creation of elaborate compliance schemes and mock reviews given that many compliance groups have “little or no experience with an SEC inquiry[,]” [24] or may not understand how to handle an SEC investigation. However, because fewer funds will be in the spotlight at any given time through the use of the complaint system—there at least 200 zombie funds, compared to more than 10,000 private equity funds generally— [25] it will be easier to contain industry-wide costs.

______________________________________________________

[1] Letter from Securities and Exchange Commission to Certain Private Equity Funds (Dec. 8, 2011), available at http://online.wsj.com/public/resources/documents/SECInquiry.pdf.

[2] Shaun Gittleman, U.S. SEC Set to Monitor Private Equity Funds, Official Says, Reuters (May 8, 2012), http://blogs.reuters.com/financial-regulatory-forum/2012/05/08/u-s-sec-set-to-monitor-private-equity-funds-official-says/ (due to new regulations implemented under Dodd-Frank, private fund advisers must report potentially systemic risks through the SEC and Commodity Futures Trading Commission).

[3] Carlo V. di Florio, Director, Office of Compliance Inspections and Examinations, U.S. Securities and Exchange Commission, Address at the Private Equity International Private Fund Compliance Forum (May 2, 2012), available at http://www.sec.gov/news/speech/2012/spch050212cvd.htm.

[4] Id .

[5] Zombie funds are those where investors must continue to pay management fees, even though the funds are inactive or not actively managed. Often, the zombie fund’s assets are difficult to value or sell. Thus, investors are locked into these funds—which continue to accrue management fees—without the prospect of future payoff. According to one estimate, as much as $100 billion is tied up in zombie funds, and investors stand to lose substantially if they try to sell their stake: private markets value those investments at 30-40% of the stated value. See David P. Abel, Investors Beware of Zombie Funds, Motley Rice Blog (June 7, 2012),http://blog.motleyrice.com/investors-beware-of-zombie-funds/; see also Susan Pulliam and Jean Eaglesham, Investor Hazard: ‘Zombie Funds’, Wall St. J. (May 31, 2012), http://online.wsj.com/article/SB10001424052702304444604577339843949806370.html .

[6] See Dan Loeser, SEC Investigates Private Equity Valuation Methods, Colum. Bus. L. Rev. (Feb. 27, 2012), http://cblr.columbia.edu/archives/11980.

[7] Joshua Gallu and Cristina Alesci, SEC Review of Private Equity Said to Focus on Smaller Firms, Bloomberg Bus. Wk. (Feb. 14, 2012), http://www.businessweek.com/news/2012-02-14/sec-review-of-private-equity-said-to-focus-on-smaller-firms.html .

[8] Pulliam & Eaglesham, supra note 5.

[9] Abel, supra note 5 (there is “concern about the possibility of private equity firms manipulating the value of investments to prop up these zombies.”)

[10] See Gallu & Alesci, supra note 6; see also Jonathan E. Green and Lindsay S. Moilanen, SEC Scrutiny Focuses on Asset Valuation and Private Equity Funds, Inv. Funds Group Newsletter (Kaye Scholer, New York, N.Y.), Summer 2012, at 8, available at http://www.kayescholer.com/news/client_alerts/Investment-Funds-Newsletter-Summer2012/_res/id=sa_File1/Investment-Funds-Group-Newsletter-Summer2012.pdf .
[11] See Loeser, supra note 6.

[12] Id.

[13] See Gallu & Alesci, supra note 7; see also Loeser, supra note 5.

[14] See Loeser, supra note 6.

[15] Which are perhaps more accurately characterized as investment losses.

[16] Private resolution is likely to lead to losses upon exiting the investment. See Abel, supra note 5 for a description of some potential private remedies.

[17] See, e.g. , Loeser, supra note 6 (discussing the inefficiencies arising from greater SEC oversight in the context of the Commission’s already overextended resources).

[18] Id . (citing European Private Equity and Venture Capital Ass’n, Int’l Private Equity and Venture Capital Valuation Guidelines (2006)).

[19] Gregory Zuckerman, How Scared Should Private Equity Be Under SEC Microscope?, Wall St. J. (Feb. 27, 2012), http://blogs.wsj.com/deals/2012/02/27/how-scared-should-private-equity-be-under-sec-microscope/ .

[20] Id . Note, however, that private equity funds do derive some fees from fund valuation (typically 2%) but receive far greater fees from profits or “carry” (typically 20%). This fee arrangement is commonly referred to as “2 and 20.”

[21] See supra note 10.

[22] Laura Kreutzer, PE Firms Learn to Live with Dodd-Frank, Dow Jones Private Equity Analyst (Aug. 27, 2012), available at http://pevc.dowjones.com/article?an=DJFPEA0020120827e88refmxe&from=alert&pid=22

[23] Id .

[24] Id.

[25] Pulliam & Eaglesham, supra note 5.

The Legitimacy of the Entrepreneur

Posted on by DJ Hill

It certainly seems like a special thing that our modern world has reached a turning point in which all stereotypes (regardless of their occasional accuracy) are generally considered offensive and are a simple indication of poor social posture. For the most part, this is good news. Be that as it may, obviously this was not always a familiar attitude. There is no question that prejudice and unjust group classifications used to be entirely acceptable modes of thought, even in our own recent past. In spite of this new war on labels, however, there is still one group upon whom an unofficial “open season” has been declared: the entrepreneur. Specifically the private equity community, who not long ago was likened to a “swarm of locusts.”1 This seems to be a shared sentiment among many.

Private equity firms are simply not seen as innovators. They are not seen as providers of capital. They are “greedy” because they own or control a disproportionate share of “society’s” wealth. There are dozens of obvious examples of this lazy characterization.2 The common joke, of course, is that “business ethics” is an oxymoron and the two concepts – business and ethics – are at a fundamental tension with one another. This confusion in moral and economic thinking can be seen by the fact that little moral sanction is granted to private equity firms, and many of the individuals are often accused of carrying around “more guilt” than the average person.

In fact, the two concepts are not mutually exclusive, but rather they have a very special ability to go hand in hand. The quest for success and knowledge is a simple, ontological desire, and an undeniable part of our human constitution. Regardless of a person’s skills, interests, or occupation, the pursuit of excellence is always a motivating force. While private equity firms don’t deserve unfair criticism, it’s important to note that they also don’t deserve to be treated like victims of unfair discrimination. That being said, their chosen profession certainly deserves to be legitimized by the people. The only way this can be accomplished is by acknowledging the value of private equity firms, the talent it takes to be a part of one, and the tangible benefits that are conferred onto society by them.

If private equity firms are indeed valuable, why the powerful divide? How is it that well meaning, generally “moral” people have difficulty grasping the moral fortitude or basic principles of a free economy? Most likely it is due to an alarming lack of economics training. Private equity is about producing wealth, not redistributing it. There is no zero-sum game. Entrepreneurs make money – they don’t simply collect it. The only way this can happen, though, is for them to offer something of value in exchange for payment. In other words, some party upstream has to actually pay them. “Greed” alone is nothing more than an attitude and can’t add even one cent to a person’s income. And even though it’s probably more accurate to characterize private equity investment as wealth creation rather than job creation, the obvious reason for this is that no business could survive with the chief goal of creating jobs. For example, Mitt Romney was recently criticized for only seeking net profits rather than job creation, and that “any job creation [at Bain Capital] was accidental.”3 Indeed, he amassed great wealth for Bain Capital, but isn’t it the goal of every single commercial enterprise to be profitable?

Another likely reason for the vitriol toward wealth is the unavoidable mass-media exposure to the terrible poverty that exists here and around the world. Strong emotional reactions to poverty are entirely proper, and morally incumbent on those who have the ability to assist. A problem develops, however, when this good sentiment is combined with the economic ignorance explained above to fabricate a sort of cause and effect relationship between the wealthy class and existing poverty. This reaction is understandable but mistaken. People who react this way fail to recognize that the most successful method for bringing people out of poverty is through a free market and wealth production.4

Moreover, private equity deals are never a guaranteed success. These firms put their money, time, and property on the line to ensure security for their investors and the companies they are creating efficiency for. These benefits necessarily run through to the entire market they are being supplied to, which includes individual consumers and employees. Only people with the competence, creativity, and guts to undertake such massive risks succeed.

As a free people, we have a moral obligation to attack uncertainty in an enterprising way. The private equity entrepreneur is a shining example. They look courageously into the future with a great sense of opportunity. They create newer, more efficient enterprises which allow more people to choose the way the earn income and develop their skills. Immoral behavior is at least as prevalent, if not more so, in any other industry. What’s important, though, is that categories of immoral behavior aren’t applied to the private equity community with more fervor than any other industry or trade. Particularly, the assertion that private equity firms are motivated by nothing more than “greed.”

_____________________________
1 Op-Ed, Marx or Markets: German Politicians Debate the Dangers of Capitalism, SEIGEL ONLINE, May 5, 2005, http://www.spiegel.de/international/anti-capitalism-debate-marx-or-markets-german-politicians-debate-the-dangers-of-capitalism-a-354733-druck.html.
2 See, e.g., WALL STREET (Twentieth Century Fox 1987), AMERICAN PSYCHO (Lions Gate Films 2000), Dallas (Warner Horizon Television 2012).
3 Steven Rattner, Tall Tales About Private Equity, N.Y. TIMES, May 22, 2012, at A23.
4 Mary Tupy, Capitalism Will Eliminate Poverty In Africa, CATO INSTITUTE, Apr. 20, 2012 http://www.cato.org/publications/commentary/capitalism-will-eliminate-poverty-africa

The National Hockey League and Private Equity

Posted on by Kevin Badgley

For the second time in seven years, there is a real possibility that an ongoing labor dispute will prevent the puck from ever being dropped on the National Hockey League season. Hockey has become an afterthought, a professional sport that is lucky to receive a minute of airtime on the nightly Sportscenter broadcast. While reports have estimated that the NHL has lost as much as $240 million in the last two seasons,1 diehard hockey fans do still exist. And while they would probably rather spend their time smuggling octopi into Joe Louis Arena, they may find hope in reading a recently published piece by Bloomberg Businessweek that asks, “Could Private Equity Solve Pro Hockey’s Problems?”

The article lays out a number of qualities that would make the NHL attractive to private equity firms. Among the qualities listed are:

• “Weak management
• Underachieving revenue
• Opportunities to expand while taking on debt
• Problems that are driving down value, but could be solved by a fresh set of outside managers.”2

These undesirable characteristics have plagued the NHL for years, and PE firms have taken notice. In 2005, Bain Capital surprised many with an offer to buy the entire league for $3.5 billion.3 Bain’s proposal reflected the classic PE business-model: by combining all 30 teams into a single business entity, it would be possible to streamline operations, boost TV revenue, and slash player salary from a position of absolute leverage.4 This single ownership strategy is the model that Major League Soccer, a league that started as an afterthought in the crowded American sports market, has employed (to at least limited success).5

As a dispassionate third party, Bain would focus solely on making money—it would not be blindsided by the emotions that undoubtedly come with owning a pro sports team. Yet those emotions are what ultimately doomed the deal, as Bain failed to muster the required majority approval from team owners.6 Given that most of these owners are independently wealthy and are not in the business for the money, it is unlikely that this type of transaction would ever be agreed upon.

Even if a firm like Bain were somehow able to overcome this hurdle, they would still be faced with an even larger issue: the players themselves. During a PE takeover, labor is often one of the first areas in which costs are cut. Technological improvements or cheaper workers typically replace longtime employees. However, sports are unique in that the laborers are the products. The NHL could recruit inexpensive, second-rate talent, but it certainly would not improve economic conditions considering that the league currently employs the top players in the world and still struggles to make a profit. The alternative—convincing the current players to take a significant pay cut—is extremely unrealistic given the lucrative contracts that foreign franchises would assuredly offer the NHL’s stars.

At first glance, the NHL and PE may seem like a perfect match. However, a closer look reveals that some major issues would have to be resolved in order for the relationship to be profitable. But still, if an entire season is lost and teams continue to operate in the red, the league would be wise to at least reconsider a PE model that has helped save so many similarly distressed companies in the past.

_______________________________________
1 Dirk Hoag, NHL CBA 2012: How can the league, as a whole, be losing money?, ON THE FORECHECK (Sept. 4, 2012, 4:55 PM), http://www.ontheforecheck.com/2012/9/4/3292168/nhl-cba-2012-league-losing-money-ha-ha-ha.
2 Nick Summers, Could Private Equity Solve Pro Hockey’s Problems?, BLOOMBERG BUSINESSWEEK (Sept. 11, 2012), http://www.businessweek.com/articles/2012-09-11/could-private-equity-solve-pro-hockey-s-problems.
3 Id.
4 Id.
5 See http://majorleaguesoccertalk.com/2009/11/27/mls-and-its-players-third-party-ownership-player-and-club-rights-non-existent/; see also, Fraser v. Major League Soccer, 284 F.3d 47 (1st Cir. 2002) (MLS central-ownership structure not an anti-trust violation).
6 Id.