Following Dodd-Frank legislation, the SEC is going to require private equity fund advisers to register with the SEC, which broadens the registration requirements that currently apply to financial advisers Several members of Congress are complaining (see their letter here) and asking the SEC to not require registration by advisers to funds that are not highly leveraged. They argue that the typical private equity fund investor is “highly sophisticated” and making illiquid investments. My response: sure, the typical one is. I expect the typical adviser-investor relationship is not a concern. That does not mean that we do not want to keep track and be able to find the relationships/advisers that are problematic. The other argument is that private equity does not post systemic risk issues. This is silly. As the letter notes “private equity has a key role to play in our economic recovery.” A hit to the equity in private equity firms could easily be a systemic problem, like a hit to the equity of investment banks. Finally, the issue of leverage seems misguided. A fund can use zero leverage, but by holding equity in a venture with a lot debt, it is in effect leveraged. The exemption could incentivize funds to be less levered and individual start-ups or private firms to become more levered. And the SEC could not track advisers who advised funds that invested in highly levered private firms. The big question: why the big fuss? Who is it that is trying to keep this information out of the SEC and out of the market?
Everything Finance 
Jonathan –
As somebody in the throes of adopting all of the Dodd-Frank regulations at a middle-market private equity (P/E) fund, let me rebut a few of your points.
Regulation is harmless. Not true – the harm from needless registration and regulation is wasted resources – both the money spent (which ranges from several hundred thousand dollars to several million depending on fund size) and the countless man-hours required to review and adopt hundreds of pages of regulations that use a “one-size fits all” approach to every type of financial institution. What tangible benefits are created by forcing private citizens and taxpayers to spend billions of dollars for “information to be free”? Are these really worth the resources required?
We need to protect P/E investors. I would first ask whether a government agency can really protect sophisticated investors better than those investors can protect themselves? Investors in private equity fund are all institutional investors or accredited investors. The do not include “main street” investors. Even if P/E funds wanted “retail investors” (and I assure you they do not), it would be impossible for the average citizen on Main Street to invest in a private equity fund or in its (privately-owned) portfolio companies because of the monies involved, the existing regulations requiring accredited investors, and the narrow windows/opportunities to invest in each fund. Further, the big P/E investors (ILPA) bandied together a few years ago to establish a set of operating principles they wanted to implement to improve alignment of interests, governance, and transparency across the P/E industry. Nowhere in the document did they ask for more governement regulation to help them out. Who is this regulation trying to protect?
P/E funds are systemically important. Private equity funds that invest are not involved in the monetary system – they do not offer anything approaching fractional reserve banking. Your analogy with investment banks is inappropriate – investment banks act as “shadow banks” by using leverage at the entity level to create credit or credit-like instruments in which they trade (e.g. credit default swaps, repos, and margined trades). Hedge funds will do this; CLO/CDO funds will do this; but P/E funds do not. Further, there can be no “runs” on a P/E fund because investments are illiquid and not subject to investor-driven withdrawal. The LP investors understand they are making an investment in an illiquid asset class and as such, they do not view it as a source of liquid funds for their operating needs. (This is very different from revolving credit lines or deposits at banks, or even collateral and deposits at other financial institutions). The failure of a P/E fund does not reduce aggregate monetary bases or credit levels in the system. How is something “systemically important” if it cannot affect the system? A number of P/E funds very likely failed during the Great Recession due to poor performance of their investments. Do you recall reading anything about any of them needing to be bailed out, threatening the economy with their failure, and/or ruining the savings of middle America? Neither do I.
P/E funds may not affect the monetary and banking system, but the can still be systemically important to the economy by causing mass failure of their portfolio companies. Again, this is not the case. P/E funds are not leveraged at the fund level, and while their portfolio companies are indeed leveraged (at about $1.50 of debt for every $1 of equity), P/E funds do not offer guarantees or cross-collaterlization of their holdings. As a result, the failure of a single portfolio company does not cause an immediate failure of the parent fund or a risk of failure in the other portfolio companies under that same fund. The investments are structured to be independent of one another. Also, when a P/E portfolio company “fails” it typically has some form of restructuring (bankrtupcy, foreclosure, out-of-court agreement) that leaves the basic operating company standing but in the hands of new owners who had claims more senior in the capital structure. Again, how does this threaten the general economy?
Poorly designed, ill-thought-out regulation wastes resources – both taxpayers’ (monies used to pay regulators to regulate unimportant things) and the private sectors’. We should not be so quick to embrace all-encompassing, one-size fits all mandates by bureaucrats and politicians attempting to inject themselves into private contracts between sophisticated parties. A little critical thinking and skepticism is warranted here.
Great comment, thanks. Lots to think about.
Jonathan A. Parker
Donald C. Clark/HSBC Professor of Consumer Finance Kellogg School of Management Northwestern University 2001 Sheridan Road Evanston, IL 60208-2001
http://www.Kellogg.Northwestern.edu/faculty/parker/htm
Phone: (847) 491-4113 Fax: (847) 491-5719