Memorandum submitted by the Financial
1. This Memorandum is submitted by the Financial
Services Authority in response to the Committee's inquiry into
2. The FSA is the single statutory regulator
for most financial services in the UK. Our statutory objectives,
set out in the Financial Services and Markets Act 2000 (FSMA),
Reducing financial crime.
Our work in the private equity sector touches
on all four of these objectives.
3. This Memorandum:
outlines the function and nature of the private
provides an overview of our regulatory regime
for private equity; and
addresses the specific questions raised in this
inquiry's terms of reference relevant to our regulatory responsibilities.
A. THE PRIVATE
4. The function of the private equity market
is to provide medium- to long-term capital to companies which
are not quoted on a public equity market and which would benefit
from financing to fund growth, development or business improvement.
This capital takes the form of both equity and debt. The equity
elements are typically provided by private equity funds, which
in turn raise their capital from investors such as pension funds,
investment funds, endowments and high net worth individuals. The
debt is typically provided by investment, commercial and retail
banks. The banks concerned often distribute large proportions
of this debt to other entities, either other banks who were not
the primary finance provider or institutional debt market participants.
As well as supplying capital, the private equity sector also typically
provides specific strategic and management advice to the privately
owned companies in their portfolio.
5. The private equity market is highly diverse.
It encompasses the funding of new company start-ups, helping existing
companies grow and develop, public to private transactions, increasing
the operating potential of mature companies, and turning failing
companies round. Private equity firms typically characterise their
funds as venture capital, expansion, buyout or distressed funds,
according to the position of the companies in which they invest.
B. OUR REGULATION
6. Private equity firms can conduct a number
of activities which require authorisation under FSMA. These include:
establishing and operating collective
arranging deals in investments; and
advising on transactions in investments.
Many private equity firms are also authorised
to undertake dealing activities in connection with their fund
Private equity firms are subject to relevant
FSA regulatory requirements covering issues such as capital, systems
and controls and conduct of business standards (including the
Code of Market Conduct).
C. SPECIFIC QUESTIONS
7. We now turn to the specific questions
raised by the Committee about the current regulatory environment
for private equity.
Is the current regulatory regime for private equity
8. Recognising the growth of private equity
in the UK and its increasing influence and importance in the financial
services industry, in 2006 we conducted a wide-ranging review
of our regulation of the private equity market. In carrying out
this review we sought the views of the full range of stakeholders
in the private equity sector.
9. Our review sought to define the optimal
level of regulation for the private equity market by identifying
risks posed by this sector to our statutory objectives. We set
out our thinking in November 2006 in a discussion paper, "Private
equity: a discussion of risk and regulatory engagement".
10. Through this paper we aimed to:
stimulate informed discussion among
public policy makers and industry participants about the development
of the private equity market;
clarify our current assessment of
the risks posed by the private equity market to our statutory
objectives, and more broadly;
inform key stakeholders about actions
to mitigate these risks that are already in place, in the UK and
overseashighlighting the significant variation in national
identify further proportionate risk-mitigation
steps we could consider taking; and
invite views from stakeholders that
would help us decide whether to take these steps.
11. In the paper we outlined seven key risks
to our statutory objectives, and we set out our provisional assessment
of the significance of these risks, taking into account both impact
(the potential harm that could be caused) and probability (how
likely the event is to occur). These are outlined in the table
|Conflicts of interest ||High
|Unclear ownership of economic risk ||Medium High
|Market opacity||Medium Low
|Reduction in overall capital market efficiency
12. Our paper describes in detail each of these risks
and outlines the current regulatory regime and the changes we
propose in order to mitigate effectively against the crystallisation
of these risks.
13. We received a substantial number of responses to
our Discussion Paper, from a wide range of stakeholdersregulated
firms, trade associations, academic research institutions, trade
unions, investors and members of the public. Most respondents
were in broad agreement with the approach set out in our paper.
We will publish a feedback statement in June summarising the responses
received and setting out the further steps we plan to take.
14. We have already taken one step to enhance our supervision
of this sector. In our Wholesale Markets Business Unit we have
established an alternative investments centre of expertise. This
specialist supervision team manages our relationship with all
higher impact hedge and private equity fund managers/advisers
and carries out relevant thematic work. We believe that this change
will significantly improve the breadth and depth of our supervision
of these sectors.
15. We have also enhanced our monitoring capabilities
with respect to credit markets. These capabilities will be further
enhanced by the implementation of a new transaction monitoring
system later this year. In addition, we undertook a number of
visits to private equity firms to discuss the potential for market
abuse. These discussions indicated that there is considerable
potential for market abuse and insider dealing within the private
equity market. We will take the issues raised into account in
our future monitoring work.
16. Our Discussion Paper also aimed to engage overseas
regulatory colleagues on these issues. We are working closely
with a number of international standard-setting bodies to achieve
as proportionate and consistent an approach globally as possible.
This includes contributing to work in the International Organisation
of Securities Commissions, the Financial Stability Forum, the
European Central Bank, as well as bilateral contact with individual
Is there sufficient transparency on the activities, objectives
and structure of private equity funds for all interested parties?
17. There are many stakeholders with a strong interest
in private equity firms and companies owned by private equity
funds. Our specific regulatory responsibility is to ensure an
appropriate level of transparency in order to promote efficient,
orderly and fair markets. In the context of private equity funds
we are concerned to ensure the provision of appropriate transparency
to private equity investors, in order to facilitate informed investment
18. The review which we conducted in 2006 found that
transparency is currently extensive for existing and potential
investors in private equity funds, Such investors frequently demand,
and receive, far more comprehensive and detailed disclosures than
investors in public companies, both on the fund in which they
have invested and on the companies represented in the fund's portfolio.
19. Industry standards relating to performance reporting
and investor disclosure exist, such as the International Private
Equity and Venture Capital Valuation Guidelines developed by,
among others, the British and European Venture Capital Associations.
However, as we acknowledged in our paper, methodologies for disclosure,
valuation and performance reporting used in the private equity
market are not always applied consistently. This can create difficulties
for investors in comparing investment opportunities and in facilitating
wider research and analysis of the private equity market. We are
mindful of this, but recognise that private equity within the
UK is predominantly a wholesale market. Investors should therefore
have the appropriate level of sophistication to assess information
given to them by funds in which they plan to invest or have invested.
20. Direct access to private equity markets by retail
investors is currently limited to venture capital trusts and a
relatively small number of private equity investment trusts. If
funds were to target retail investors directly, which they currently
do not, we would expect them to provide information in a suitable
format. Indirect access is also limited as few UK pension or insurance
funds have committed significant capital to private equity. We
will keep this issue under review but, as we said in our Discussion
Paper, we do not currently consider it appropriate to impose any
further transparency requirements on this market.
21. The important issue of transparency of private equity
markets to a wider group of stakeholders, including the employees
of private equity-owned companies, goes beyond the remit of the
FSA. We welcome the establishment of an independent working group,
chaired by Sir David Walker, which aims to establish a code of
conduct for disclosure and valuation within private equity businesses.
We will keep in touch with the development of this Code and will
consider regulatory implications it may have.
Has there been evidence of excessive leverage in recent transactions
and what systemic risks arise in consequence?
22. In our Discussion Paper, we assessed as medium high
the risk of leverage levels increasing to excessive levels. In
order to monitor market developments we conducted a survey, in
conjunction with the European Central Bank, of exposure to leveraged
buyout activity among a large number of major UK-authorised investment
banks. The results indicated that average leverage levels are
increasing in the largest transactions. Our paper highlighted
a number of potential explanations for this. We do, however, acknowledge
that each transaction is unique and the appropriate level of leverage
varies according to the underlying business and economic conditions
prevailing at the time.
23. As we said to the Committee earlier this year, in
the context of its hearing on financial stability, increasingly
aggressive financing of private equity transactions creates a
greater probability of financial distress and default within individual
transactions. This would, most likely, lead to losses for investors
in the private equity fund and for owners of a defaulting company's
debt. However, the failure of individual transactions does not,
in our view, pose a threat to overall financial stability in the
24. This view has been supported by the recent release
of an ECB report on
leveraged buyout activity in the EU which concluded that "the
materialisation of systemic risks for the banking sector from
LBO (leveraged buyout) activity appears remote at the EU level".
25. In order to understand trends and developments in
the leverage and complexity of leveraged buyout transactions,
we plan periodically to survey leveraged lending in the UK. We
believe that this, taken together with our continuing prudential
supervision of leveraged finance providers, will provide proportionate
mitigation of risks in this sector.
What are the effects of the current corporate status of private
equity funds, including both their domicile and ownership structure?
26. Private equity funds and their investors and managers
exist in a variety of legal forms. We outlined a variety of these
in our Discussion Paper. As a matter of policy, we are indifferent
to the structure and domicile of a private equity fund, provided
that, if it requires FSA authorisation, it is able to demonstrate
a continuing ability to meet our regulatory standards.
27. Some private equity firms are publicly listed. Such
firms will be affected by our current review of the listing regime
for all investment entities. One of the principal objectives of
this review is to modernise our rules in this area and produce
a durable, principles-based regime which will facilitate the listing
of entities with more modern investment strategies, such as private
equity and hedge funds, while providing appropriate levels of
investor protection. When we make rules in our capacity as UK
Listing Authority we have a duty to have regard to the international
character of capital markets and the desirability of maintaining
the competitive position of the UK. Currently overseas companies
are able to list under the "directive minimum" requirements
set out in Chapter 14 of the Listing Rules. Domestic funds are
required to list under the more onerous Chapter 15.
28. Throughout this review we have been conscious of
our responsibility to protect investors while having regard to
the competitiveness of the UK capital markets. Following earlier
consultations, as we announced on 4 April, we intend to proceed
on the basis of a single platform for all listed closed-ended
investment funds, irrespective of domicile. We will publish a
consultation paper, outlining possible implementation measures,
in June. Depending on the outcome of the next round of consultation,
we envisage that the single platform should be in place in the
first quarter of 2008.
29. As we noted earlier, in June we will publish a feedback
statement on private equity, summarising responses to our Discussion
Paper and outlining next steps. We will provide the Committee
with a copy.
ECB Report-Large banks and private equity-sponsored leveraged
buyouts in the EU (April 2007). Back