Protecting Private Equity Investors: A Revolution Underway?

The desire for standardization still clashes with the realities of an industry that resists any form of “one-size-fits-all” approach.

Investors are increasingly concerned about their protection

It is well known that the private equity industry (PE) is booming. The strong entrepreneurial dynamic and the excellent performance in the past have convinced a circle of investors that is constantly expanding. This phenomenon of democratization has attracted many investors used to standardized assets from the post-subprime crisis regulations (Dodd-Franck Act in the US; UCITS, AIFMD and MiFID in the EU; LPCC and LSFin in Switzerland). Landed in a non-standard investment universe, these “Limited Partners” (LP) were sometimes surprised to find they had to hire lawyers to negotiate their protection. For many LPs, GP-LP bilateralism, side letter writing and contractual freedom reflect a fragmented industry that is not fully able to guarantee LPs an adequate level of protection due to a lack of standardization.

ILPA’s Contribution: Transparency, Investor Protection and ESG Standards

Based on the principle that there is no protection without standardized standards, calls for the standardization of PE arose very early on in the United States. As early as 2002, the professional association ILPA spoke out in favor of defending the interests of LPs. With its 500 members, collectively representing more than $2 trillion in PE investments, it fulfills its mission by publishing “guiding principles” and model contracts. ILPA emphasizes increased transparency of fees and costs, better information for LPs through the publication of detailed quarterly reports and strengthened fund administration. Recently, ILPA has also ensured that GPs show a genuine commitment to the ESG standards issued by international benchmark organizations (e.g. PRI or AIC guidelines). The approach of ILPA and its counterparts in Europe and Switzerland has shown tangible results. This is illustrated by the results of a study recently published by Preqin in September 2021.1 According to this, 57% of the players surveyed say that they rejected investments because of contractual conditions that they found to be unfavorable.

A long standardization process

Despite some investor awareness of the challenges, the desire for standardization still clashes with the realities of an industry that resists any sort of “one-size-fits-all” approach. According to a 2020 study published by ILPA2, only 8% of investors have received from GPs that they commit to financing agreements to use ILPA standards. The study states that such a commitment comes about in 75% of cases in the form of bilateral “side letters”. The efforts of these associations to change the course of events make the skeptics smile. ILPA and its sister organizations remain private law associations with no supervisory powers. They enact “soft law” standards without binding effect. General practitioners can therefore withdraw from their application without having to fear any consequences other than seeing that an interested party leaves.

The SEC, the new arm of the pro-LP lobby?

Given the opacity of so-called “private” funds, on February 9 the SEC announced a proposal to revise the Investment Advisers Act of 1940.3. This project largely takes up the previous goals of ILPA. This includes the obligation to publish detailed quarterly reports. It also allows itself to attack this totem that justifies the confidentiality of the “supplementary letters” and prohibits the invoicing with the means of many expenses, especially those related to conformity. The American regulator even took the opportunity to ban the widespread practice of liability limitation clauses. Since the consultation period ended on April 25, it is still too early to know whether this reform proposal will get through there. However, we know that GP lobbies have mobilized heavily to denounce intrusive hubris on the part of the regulator. In their opinion, such a project will lead to an unstoppable explosion in compliance costs and significantly affect the profitability of PE funds. Whatever the outcome, it’s clear that regulatory pressure is hitting hard on an industry that had previously eluded it. It is therefore appropriate to take an interest in this reform as, if adopted in its current form, it could bring about profound changes for the PE industry. European regulators would likely be tempted to imitate the SEC. Then we would be faced with a regulatory bump that the Swiss PE industry could hardly escape.

1 The 2021 Preqin Private Capital Fund Terms Advisor
2 ILPA Industry Intelligence Private Market Fund Terms Survey, June 2020

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