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By Douglas Lowenstein
President & CEO, Private Equity Growth Capital Council


2011: The Public Policy Agenda for Private Equity

For the last four years, the public policy issue which consumed the private equity world was whether or not to tax carried interest as ordinary income. The debate ebbed and flowed, first cresting in 2007 and then receding in 2008-09. It seemed as if every conference and every journal had a panel or article on the topic. Then, last spring, carried interest returned to the endangered list as part of an effort to extend a wide range of business tax breaks, such as the Research and Development Tax Credit.

But as the summer wore on, resistance to the proposal grew. Commentators identified a wide array of unintended consequences triggered by the legislation, Republicans remained opposed to it, and some moderate Senate Democrats also expressed increasing concern about the adverse effects the proposed carried interest tax increase would have on investment, small businesses, and jobs creation. Moreover, the inclusion in the bill of a provision subjecting ownership interests in investment partnerships to the higher carried interest rates (the so-called enterprise value tax), stirred opposition even from lawmakers who actually supported the original carried interest proposal. By the fall, with the political and substantive case against higher taxes on carried interest strengthening, and with general anti-tax, anti-spending, and anti-big government sentiments emerging as voter concerns, Senate Democrats fell three votes short of the sixty votes required to send the carried interest package to President Obama.

But while the carried interest debate consumed much of the oxygen in the corridors of private equity (PE) firms, other issues with far reaching and long-term potential for PE firms of all sizes were lurking. Indeed, at the same time that the battle over carried interest reached aturning point in 2010, the two-year legislative drive to enact a financial services reform package culminated when President Obama singed the Dodd-Frank Act (DFA) into law.

While many in our industry are breathing a sigh of relief over the diminished enthusiasm for raising taxes on carried interest in the new Congress, continued vigilance is required. Pressure on both parties to address fundamental and structural budget and tax policy flaws will intensify in the next two years and many issues could return to the table if momentum develops for a grand compromise on fiscal policy. Meanwhile, though, PE firms should focus their attention on the DFA implementation process, which is filled with potential risks for buyout and growth capital firms.

Throughout the legislative debate on financial regulatory reform, going all the way back to 2008, our goal was to persuade lawmakers and the Obama Administration that private equity firms do not pose systemic risk. Thus, it was extremely gratifying that the criteria included in the bill to determine if a nonbank financial company poses a systemic risk are not criteria that generally apply to private equity. Specifically, among other elements of systemic risk, the bill identifies interdependency, criticality for providing credit to households, businesses or underserved communities, reliance on short-term funding, leverage, and the extent and nature of off balance sheet exposure. The absence of a presumption in the Dodd–Frank Act that private equity firms pose a systemic risk is a major victory for the industry, establishing the probability that private equity firms will not fall under the supervision of the new systemic risk regulator (the Financial Stability Oversight Council or FSOC). This is no academic exercise as FSOC coordinated oversight could carry with it limits on leverage, capital requirements, and more.

That said, the statute itself is not the end of the matter because it granted regulators some flexibility to more precisely interpret systemic risk criteria. Thus, in late 2010, regulators solicited comments on systemic risk criteria and how best to apply them in the new regulatory regime. PEGCC filed comments reiterating why private equity firms and funds do not present systemic risk concerns, but PE firms should closely watch the outcome of this proceeding in 2011.

Another major new regulatory issue PE firms face in 2011 is the law’s requirement that advisers to private equity funds with more than $150 million of AUM in the United States register with the SEC as investment advisers by July 2011 ( venture capital funds will be exempt from the registration requirements, but the reach of that exemption is subject to additional rulemaking). The SEC will soon issue draft regulations governing aspects of the registration requirement, including the scope of the record retention and reporting requirements. (We were pleased that lawmakers deleted from the final bill a provision that would have authorized the SEC to require investment advisers to disclose “documents, records and reports” to “investors, prospective investors, creditors and counterparties.” This sweeping grant at worst could have resulted in disclosure of trade secrets and business confidential information, and at best could have opened the door to mischief-making by critics of private equity.)

Federal regulators are also sorting through the scope of the so-called Volcker Rule which requires many financial institutions to shed their private equity operations. One especially important issue is ensuring that the Volcker Rule regulations do not prohibit bank-affiliated feeder funds, bank-affiliated pension plans, insurance company general accounts, insurance company separate accounts, and non-U.S. banking entities from investing as limited partners in PE funds. The PEGCC has filed comments urging regulators to clarify that such investmentsremain permissible, and to stress the critical importance from a market stability standpoint of building in a transition period for compliance with the Volcker Rule which is as long and flexible as possible.

Yet another issue PE firms must watch is requirements related to independent compensation committees: Under Section 952 of the DFA, issuers of listed equity securities will be required to have independent directors on their compensation committees. PEGCC was able to persuade lawmakers to create an exemption for controlled companies (publicly listed firms where the PE firm owns more than 50% of the outstanding equity securities). The SEC plans to release proposed regulations on Section 952 in the first quarter of 2011 providing additional guidance as to what “independence” means in the compensation committee context. Of special importance to private equity firms is ensuring that the additional regulations related to independence of compensation committees do not prevent PE GPs from sitting on portfolio companies’ compensation committees when the private equity firms control 50% or less of the company’s stock.

The DFA also required the U.S. Government Accountability Office (GAO) to conduct a study on whether a self regulatory organization (SRO) should be created for private funds of capital. Needless to say, creation of any new regulatory regime could have a profound impact on the way PE firms do business in the years ahead.

The systemic risk rules, the Volcker Rule scope, the Investment Adviser Act registration issues, and the independent compensation committee issues are just a few of the 17 separate rulemakings and studies that could impact private equity firms in the post-DFA world. It should be clear that Washington is going to have an impact on the private equity business and this is no time for PE firms to crawl back under a rock. To the contrary, it is more critical than ever beforefor firms to step into the public policy arena to explain to those who shape public perceptions, and those who make public policy, the ways private equity strengthens companies and U.S. competitiveness. The PEGCC is committed to making strides in 2011 to build a national network of PE advocates, small, medium, and large, local, regional, national, and international. This is not a task which can be completed in a few months or even a few years. It requires a sustained commitment and no one should remain on the sidelines.

About the Author

Douglas Lowenstein

Douglas Lowenstein
President & CEO, Private Equity Growth Capital Council

Doug Lowenstein is the founding president and CEO of the Private Equity Growth Capital Council.

Before joining the organization in February 2007, Lowenstein founded and served as president of the Entertainment Software Association (ESA). In his 13 years at that organization, Lowenstein built the ESA into the most influential and important worldwide trade body representing the $30 billion computer and video game software industry.

Earlier, Lowenstein was an executive vice president in the Washington and New York strategic communications firm Robinson Lake Sawyer Miller, Inc. From 1986-1991, Lowenstein was a Principal in National Strategies, Inc., a Washington DC public policy consulting firm.

From 1982 through 1986, Lowenstein worked for U.S. Senator Howard Metzenbaum (D-OH), spending the last two years as legislative director.

Lowenstein spent the first eight years of his career as a newspaper reporter, starting with the Buffalo Courier Express, followed by two years at the Capitol Hill News Service. From 1976-82, he was a correspondent in the Cox Newspapers Washington Bureau.

In 1982, he authored a biography of his late uncle, Allard K. Lowenstein, a member of Congress and anti-war, civil rights and human rights activist, who was killed in 1980. Entitled, “Lowenstein: Acts of Courage and Belief,” the book was published by Harcourt Brace Jovanovich. Douglas Lowenstein received a B.A. degree in Political Science in 1973 from Washington University in St. Louis.