Private Equity Policy Horizon 2018

With the daily churn of headlines emanating from global capitals, private equity investors can be forgiven for having a tweet-induced policy whiplash. Putting aside personality politics and wider political narratives, there are a host of coming policy changes – both big and small – that have direct implications for the private capital industry.

Here we take a look at some of the immediate changes in store for investors. We have kept the analysis mostly focused on US regulations, but there are a few with global applicability (GDPR) which are pertinent for GPs and LPs everywhere.

Known / Proposed Policy Changes

The following have been announced, are effective, or are currently under active consideration by the relevant regulatory authority:

Tax Cuts and Jobs Act of 2017

Effective Date: January 1, 2018

In short: Discussed ad nauseum, this is the largest piece of US tax legislation passed in more than 30 years. Changes to nearly all facets of the 1986 Internal Revenue Code, impacting individuals, families, business, and institutions.

Private Equity Implications:

• Carried interest taxed as income if exited in less than 3 years will mean fewer ‘quick flip’ exits, slightly lower total fund IRRs, less opportunity for early venture exits to strategics.
• Changes to interest deduction will mean less leverage and opportunities for financial engineering, translating to lower returns if not priced in to transaction values.
• Large university endowments facing a tax of 1.4% on net investment income will likely use more distributions to pay for operating expenses to offset capital gains, re-invest dividends less frequently, and rotate into more passive strategies to lessen tax complexities.
• More listed general partnerships follow the lead of Ares and KKR in converting to a C-Corp to enable mutual funds and ETFs to trade shares.

EU General Data Protection Regulation (GDPR)

Effective Date: May 25, 2018

In short: “GDPR is a new set of rules designed to give EU citizens more control over their personal data. It aims to simplify the regulatory environment for business so both citizens and businesses in the European Union can fully benefit from the digital economy.” Fines for improper handling of information: up to 4% of global revenues.

Private equity implications:

• Applies to any organization that is in digital contact with a citizen of the EU, hence any global business. In some cases, GDPR will require expensive upgrades of databases and / or consulting fees to ensure proper handling of personal information, increasing costs.
• Potentially significant impacts on e-retail companies – some of which generate of the majority of their revenue from email marketing. US websites that are not compliant may go dark for EU users, decreasing total addressable market.

Senate Bill 2155 (Dodd Frank Rollback)

Effective Date: May 24, 2018

In short: The ‘Bank Systemically Important Financial Institution (SIFI)’ threshold, which determines the size at which a bank is subject to enhanced regulation by the Federal Reserve, is increased to $250 billion from the $50 billion threshold established by Dodd-Frank. Includes a caveat that the Federal Reserve retains the discretion to apply enhanced regulatory standards to any specific bank greater than $100 billion. Exempts firms with less than $10 billion in assets from the Volcker Rule.

Private equity implications:

• Unclear. While the loosening of regulations for smaller banks will translate into higher profits – and backers of the bill argued that it will lead to more lending – neither have immediate implications for most private equity investors. More than anything, it will likely further reinforce business confidence around continued deregulation.

Repeal of Professional And Amateur Sports Protection Act (PASPA) / NJ Bill 3911 (Legal Sports Betting)

Effective Date: May 14, 2018

In short: The U.S. Supreme Court ruled that New Jersey can legalize sports betting – setting precedent for other states to follow suit. Officially, this was the repeal of the Professional and Amateur Sports Protection Act, which banned gambling on sports events.

Private equity implications:

• New gaming and leisure opportunities nationwide, more early stage opportunities in the space, and new exit paths for owners of real estate and gaming brands: FanDuel immediately began talks to merge with Paddy Power Betfair’s US branch, potentially setting up a nice exit for investors KKR, Google Capital, and TWC Investments

Rescission of the International Entrepreneur Rule (82 FR 5238)

Proposed: May 25, 2018

In short: The Department of Homeland Security (DHS) is proposing to end a program that allows certain foreign entrepreneurs to be considered for temporary visas to come to the United States to build and develop a start-up businesses here, known as the International Entrepreneur Rule (IE Final Rule).

Private equity implications:

• In the words of Dan Primack, this “would be the most counterproductive piece of economic policy in recent memory.” IEP provides temporary visas for foreign nationals who have raised at least $250,000 from U.S. investors, with extensions dependent on their startups demonstrating growth via metrics like new hiring, revenue and follow-on investment. While no immediate implications beyond very early stage VC-investors, it signals a broader hostility to migration (even talent-driven migration) that will have long term implications for ongoing US innovation. In combination with additional restrictions of H1-B visa issuance, global investors may have a more difficult time moving staff between international offices.

EU Benchmark Regulation (Regulation (EU) 2016/1011)

Effective Date: January 1, 2018

In short: The regulation introduces a common framework and consistent approach to index and benchmark regulation across the EU. It aims to ensure benchmarks are robust and reliable, and to minimise conflicts of interest in benchmark-setting processes. An index will be regulated as a “benchmark” where it determines amounts payable under or sets the value of financial instruments or financial contracts.

Private equity implications:

• While the purposes of this new regulation are beyond simple private equity quartiling (or, the many other comparative analyses available on Chronograph), investors will have to learn new terms for understanding the underlying mechanics of certain reference benchmarks used in setting floating interest rates, as well as spend higher amounts on compliance where portfolio companies are reliant on (or providing) a regulated benchmark.
• Supervised entities under EU legislation, including banks, investment firms, insurance companies, UCITS and pension funds, fund managers, and consumer lenders, will also be subject to restrictions on using benchmarks unless they are produced by an EU administrator authorised or registered under the regulation or are non-EU benchmarks that have been qualified for use in the EU under the regulation’s third country regime.
• EU administrators must require all contributors to their benchmarks to comply with a code of conduct and the Regulation will directly require supervised entities that contribute to EU benchmarks to maintain systems and controls to ensure the integrity and reliability of their input data.
• The new EU regime will replace the current UK framework regulating the administrators of LIBOR and other specified benchmarks. It takes a very different approach from those jurisdictions, such as Japan and Singapore, that – like the UK – have so far chosen to regulate a limited range of critical benchmarks and those jurisdictions, such as the US, that are relying on self-regulation and robust enforcement action to achieve the objectives of the IOSCO Principles.

Ongoing Policy Concerns

Beyond the specific policy changes announced above, the following thematic issues are likely to impact investor thinking in the coming years:

NAFTA uncertainty / political headwinds for free-trade in general

In short: It is worth remember that in the 2016 US presidential election race, both Trump and Clinton vowed to scrap or water down the TPP, NAFTA, and other free trade agreements. Senator Bernie Sanders even threatened to leave the WTO. With Trump in office, he has been most consistent on free trade.

Private equity implications:

• Public markets have begun to price in increased volatility resulting from NAFTA uncertainty, Chinese tariffs, and other proposed changes (including the threatening of the recently renegotiated U.S.-Korea free trade agreement (“KORUS FTA”). Inevitably, these market dislocations will find their way to private markets, and at a minimum, make investors revisit prior assumptions about ongoing market access, free capital movement, and elevated political risks in this new environment.
• Should these more protectionist policies become law, US based portfolio companies will have to be prepared to comply with the stricter rules regarding the production and sale of their products.

Fed interest rate hikes

In short: The Federal Reserve has raised interest rates 6 times since the financial crisis. The general expectation is that the Fed will raise rates 3 – 4 times in 2018.

Private equity implications:

• Higher interest rates, combined with the new limits on interest rate deductions under tax reform, will lead to lower levels of leverage and possibly lower returns (all of this in combination with unprecedented valuation and margin levels).

Cryptocurrency regulation

In short: With the value and use of cryptocurrencies skyrocketing over the past year, authorities have begun to regulate the industry.

Private equity implications:

• ‘Initial coin offerings’ and other new forms of exotic usage are likely to see new restrictions. While still a nascent ‘asset class’, many VCs have placed large bets on the future of cryptocurrencies. Whether the fundamental underlying blockchain technology becomes subject to certain regulations remains to be seen, but with corporate giants like JPMorgan, UBS, Santander, BNY Mellon, and many others backing offshoots like Ethereum, investors are likely to continue to be gradually exposed to the concepts, assets, and regulations of this new market.