Select Committee on Treasury Written Evidence

Memorandum submitted by the Financial Services Authority

  1.  This Memorandum is submitted by the Financial Services Authority in response to the Committee's inquiry into private equity.

  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), are:

    Consumer protection;

    Market confidence;

    Public awareness; and

    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 equity market;

    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.


  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.


  6.  Private equity firms can conduct a number of activities which require authorisation under FSMA. These include:

    —  establishing and operating collective investment schemes;

    —  managing investments;

    —  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 management operations.

  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).


  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 funds suitable?

  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 overseas—highlighting the significant variation in national regulatory regimes;

    —  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 below.
Market abuse
Conflicts of interest High
Excessive leverage
Unclear ownership of economic risk Medium High
Market access
Market opacityMedium Low
Reduction in overall capital market efficiency Low

  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 stakeholders—regulated 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 regulators.

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 decisions.

  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 UK.

  24.  This view has been supported by the recent release of an ECB report[1] 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.

May 2007

1   ECB Report-Large banks and private equity-sponsored leveraged buyouts in the EU (April 2007). Back

previous page contents next page

House of Commons home page Parliament home page House of Lords home page search page enquiries index

© Parliamentary copyright 2007
Prepared 22 August 2007