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Changes in the American private equity industry in the aftermath of the crisis.

JEL Classification: G01; G24; G28

INTRODUCTION

On the eve of the financial crisis, the US private equity industry was enjoying a second boom phase in its young life. With a large domestic market and developed financial settings, it had reached the height of its development--by far the world leader in the sector. Not only did US management companies amass and manage substantial investments, but they also undertook ever larger transactions and moved internationally to diversify their businesses. Furthermore, similar to most alternative asset management industries, US private equity management was unregulated, and its business environment was incredibly favorable, marked by bullish financial markets, cheap and abundant debt, investors hungry for high yields and structured products, and so on.

However, the boom was short in duration, lasting only from 2004 to 2008. The financial crisis sparked a sudden and massive downturn in both transactions and fundraising. A major crisis of any kind offers an opportunity to rethink current practices and challenges. In the US private equity market, these thoughts mainly focused on the potential risk that large-scale transactions created for the stability of the financial system, as well as the relationships between investors and fund managers.

Five years after the most acute phase of the financial crisis, a new landscape is emerging for private equity. Few actual defaults of leveraged buyouts (LBOs) occurred, yet the sector underwent profound changes, in response to the combined impacts of considerable business declines and disappointing results. This balance of forces emerged as unfavorable to management companies in their relations with investors but highly favorable for the introduction of new regulations.

By addressing this situation, this article seeks to analyze the various modifications at work in the US private equity industry and their likely outcomes. For this analysis, venture capital constitutes a different business than other forms of non-listed equity investments (eg, LBO, mezzanine, real estate) and thus falls outside the scope. In the next section, the state of the industry, both before and after the crisis is briefly described. This description leads into an analysis of the evolving landscape, focusing mainly on the changing balance of power between management companies and investors and the impacts of new regulations, on both investors' protections and systemic risk. The final section is dedicated to a discussion of the ongoing consequences of these significant changes in the private equity industry.

A BUOYANT BUSINESS, SUNK BY THE FINANCIAL CRISIS

The current form of the private equity industry in the United States arose during the 1980s, with the first massive wave of LBOs. At that time, most major management companies that remain active today came into being; also during this period, the industry borrowed and adapted management forms from the venture capital industry, creating the overall framework for institutional investments. In less than 30 years, US private equity also has experienced two boom-and-bust cycles: 1982-1990 and 2004-2008. In both cases, the same economic forces were at work, though they also were marked by considerable differences.

Some of the key similarities included a favorable capital market context, characterized by soaring equity prices and plenty of available debt, combined with massive influxes of capital. The management companies also shifted their usual operations from midsize companies to public to private transactions (1) of major listed firms. In the fiercely competitive climates, the funds' transactions ran up very high prices (eg, 10 times the EBITDA in 2007), with considerable leverage (eg, up to 80% of the acquisition price). Both boom phases abruptly came to an end with a stock market crash.

In terms of their differences, the second boom phase exhibited some distinctive characteristics. The massive influx of capital into private equity funds (PEFs) occurred after the burst of the Internet financial bubble and the ensuing stock market crash. At that point, the Federal Reserve had lowered interest rates to avoid a major economic downturn. Disappointed by 3 years of negative returns on public equity, investors began looking for alternative, more profitable investments around 2004, as exhibited by a massive shift of approximately US$1 trillion from liquid markets to PEFs.

The Fed's monetary policy also increased the availability of huge amounts of cheap debt to finance LBO operations. In the 1980s, financing for transactions came mainly from debt provided by banks (bank loans) and bond markets (junk bonds). Between 2004 and 2008 though, leverage operations were fueled mostly by shadow banking, using sophisticated, structured products (eg, collateralized loan obligations (CLO)), underwritten by hedge funds and money market mutual funds (Rizzi, 2009; Demiroglu and James, 2010). The massive increases in the use of shadow banking, promoted by the banks' 'originate to distribute' strategy, allowed management companies to find plenty of debt, which combined with conditions that favored moral hazard to produce a significant deterioration in the level of protection of covenants and relaxed monitoring of borrowers (Acharya et al., 2007; Committee on the Global Financial System [CGFS], 2008; Demiroglu and James, 2010).

Consequently, the size and nature of the transactions implemented by the private equity industry changed dramatically in the second boom phase. Compared with the 1980s, the industry focused more on 'mega-buyouts' of listed companies; many acquisitions even were in excess of $10 billion. Finally, the business sectors in which LBO funds were invested expanded, particularly into health care and utilities. For example, the largest transaction of the time was an acquisition, initiated by KKR and TPG, of Texas Utilities for $44.4 billion in June 2007.

Unprecedented levels of activity, concentrated on very large transactions

After more than a decade during which annual investment levels were significantly below $100 billion, in the second boom phase, US private equity registered a record volume of business, mainly driven by very large transactions of more than $1 billion (Table 1).

This surge in investment by PEFs was both sudden and rapidly growing. Of the $1,896 billion worth of transactions that took place between 2001 and 2011, more than 60% of them occurred during 2004-2008. In 2007 alone, investments amounted to $571 billion, equivalent to 30% of the value for the entire decade. These funds overwhelmingly invested in 'upper market' segments, through transactions worth more than $1 billion ($438 billion for 2007). Although other market segments involving smaller transactions also recorded significant increases, their share of the total value was relatively smaller.

The market abruptly collapsed to a value of just $62 billion in 2009, but it increased again quickly, to nearly $161 billion in 2010, then stabilized at $147 billion in 2011. These levels--still considerably higher than those of the early 2000s--may reflect the amount of capital raised during the period of euphoria, which left funds available for investment.

Rising investments, supported by a massive influx of capital

From 2001 to 2011, the US private equity industry raised nearly $1,600 billion from investors. Similar to the investments, the fundraising numbers were concentrated in time: $991 billion from 2005 to 2008 (Table 2). Correspondingly dramatic increases appeared in the number and size of PEFs being created. In total, 63 funds larger than $1 billion arose from 2001 to 2011, 17 of them in 2007 alone. The largest, or 'mega funds', all launched between 2006 and 2008, including Blackstone Capital Partners V (valued at $21.7 billion), GS Capital Partners VI ($20.3 billion), TPG Partners VI ($18.9 billion), KKR 2006 Fund ($17.6 billion), and TPG Partners V ($15.3 billion).

Investors in these funds, still known as limited partners (2) (LPs), were mainly pension funds and insurance companies. According to Meerkatt and Liechtenstein (2009), the investment breakdown was as follows: public pension funds (30%), insurance companies (17%), private pension funds (16%), financial institutions (15%), sovereign and government wealth funds (10%), family offices and foundations (6%), and university endowment foundations (6%).

Even when the fundraising flow dried up in 2009, considerable amounts of cash remained available to invest, left over from the unprecedented rate of fundraising in previous years. At the end of 2011, these assets were estimated at $425 billion, of which $120 billion was raised in 2008 and $84 billion in 2007 (PitchBook, 2012). Because of the way these funds operate and the incentives for management companies to invest, this abundance of capital has become a problem though.

Very large, diversified management companies

The rapid growth of transactions and assets occurred together with the emergence of very large management companies (general partners (GPs)). Most GPs, including the most successful, were created in the 1980s during the launch of the market, then expanded as the market grew, creating mega-funds. American management companies are by far the largest in the world in terms of asset management: Of the 10 main private equity management companies globally, eight are American (Table 3).

However, these companies also have evolved considerably since the 1980s. The largest employs hundreds of people, often located in offices in the United States, Europe, Asia, and Africa. These employees were mostly financial experts in the 1980s, but their skills have grown far more industrial, including the management team. Furthermore, most of these companies have set up alternative management businesses, beyond their private equity management, to deal with funds of funds, real estate funds, hedge funds, and unlisted debt funds, among others. In some cases, private equity assets no longer represent the largest component in the total assets managed (eg, at Carlyle, of the $150 billion it managed overall in 2011, less than $40 billion was strictly private equity). This portfolio of managed assets helps GPs spot advantageous complementarities (eg, equity and debt) to initiate LBOs.

To raise capital, some companies have used the financial market and launched listed investment vehicles, such as KKR, which listed KKR Private Equity in 2006 on the Euronext-Amsterdam Stock Exchange, then later added KKR Financial Holdings LLC, an investment fund specializing in debt, which it listed on the New York Stock Exchange. (3) In some cases, the listings of big management companies anticipated the retirement of their 'founding fathers'. For example, initial private offerings (IPOs) by management companies such as Blackstone in 2007, KKR (KKR and Co. LP) in 2010, Apollo Management in 2011, and Carlyle in 2012 clearly reflected the wishes of their founders to dispose of some of their assets for inheritance issues. Furthermore, the IPOs by Blackstone, Carlyle, and Apollo Management were preceded by an opening of their capital to investors, such that the IPOs simply provided the founders with a more liquid market.

CHALLENGES STEMMING FROM THE CRISIS

Even before the onset of the global financial crisis, the vast amount of capital raised and the development of mega-buyouts had prompted some questions and concern. The high prices of transactions and the massive leverage involved led primarily to worries about the viability of these transactions, in the event of an economic downturn. Other concerns focused on potential systemic risk, because the scale and nature of the debt amplified moral hazard and the spread of risk. Moreover, the organizational structure of the industry, including the nature of the relationship between GPs and LPs, was being strained by the colossal size of the largest funds.

Although systemic risk directly related to LBOs has not materialized thus far, the crisis exposed other shortcomings attributable to the operations of private equity firms. In response, many LPs have tried to impose greater transparency in operating modes, as well as more balanced relationships with GPs. At the same time, the US Dodd-Frank Wall Street Reform and Consumer Protection Act (2010) imposed parallel regulations on GPs, placing the biggest players under threat of being treated as systemically important institutions. By prohibiting banks from investing in private equity, Dodd-Frank also will alter the balance within the equity sector.

Systemic risk

Despite numerous warnings and predictions of large-scale LBO shakeouts starting in 2009 (eg, Meerkatt and Liechtenstein, 2008), no such results have emerged, though the economic recession prompted bankruptcies, including those of some of the largest operations. This apparent resilience to economic and financial crises might reflect the GPs' capacity to convince portfolio companies to adopt protective measures, such as by managing working capital needs and setting up a 'cash kit' to deal with liquidity problems. PEF managers specialize in debt management and have considerable skill in dealing with unforeseen circumstances. As investments remain held in the portfolio for several years, financial packages are designed accordingly, and the amount of debt in the LBO holding depends on a business plan, designed with careful attention to its sensitivity to the economic situation. In this regard, the losses experienced by LBOs, on average, are no better or worse than those of other companies, even if they appear slightly higher during crisis periods (CGFS, 2008; Kaplan and Stromberg, 2008; Lopez-de-Silanes et al., 2011).

The resilience also can be explained by the flexibility provided by the debt instruments used in the packages before the crisis though. Through the adoption of structured finance, funds could load their LBO packages with a wide variety of debt securities, designed to defer payments to lenders. (4) Then the portfolio companies were able to honor these longer maturities because of widespread assumptions of their business growth and/or hopes of resale at higher prices. Furthermore, a significant portion of the debts were known as covenant-lite, citing their minimal creditor protection clauses (Demiroglu and James, 2010). In the event of an economic downturn, the companies enjoyed relatively strong shelter from onerous debt-servicing settlement dates, at least for the early years.

Yet it also would be folly to claim that the sector has completely succeeded in escaping the worst outcomes. In the next 2-3 years, the debt transactions from 2004-2008 will reach maturity, at which point PEFs will confront a serious 'refinancing wall'. More than $670 billion of LBO debt has to be refinanced between 2011 and 2016, some $200 billion in 2014 alone (KPMG, 2011). This refinancing, necessary because of companies' inability to repay their acquisition debt, also will take place in difficult regulatory conditions that will limit CLO issues and bank loans.

Thus it is too early to say that LBO companies have made it through the crisis without major problems or systemic repercussions. Yet the opacity of debt assets and their private ownership also has contributed to freezing the capital market in 2008, in collaboration with the securitized debt for this period, regardless of its origin.

Questioning the relationship between GPs and LPs

When the US private equity industry began in the early 1980s, the total value of funds was a few hundred million dollars, and transactions mainly involved mid-sized companies. The industry structure delegated the management of funds contributed by investors (LPs) to management companies (GPs), which have complete decision-making power. This highly specific form of management reflects several key principles:

First, closed funds have a specified lifetime, usually 10 years with the option to extend it for up to 2 years, subject to agreement by the investors. The lifespan of funds thus includes an investment period of 4-5 years, followed by a similar disinvestment period, which ends with the fund's maturity and liquidation. Furthermore, GPs are required to invest in the funds.

Second, financial flows limit the duration that capital remains tied up for investors. When the fund is created, investors make an irrevocable commitment to invest a certain amount of capital. These sums then get called on, sequentially, by the management company as it makes more investments. Once a holding is sold though, the fund immediately returns the proceeds from the sale to the investors.

Third, the remuneration of GPs consists of a flat fee based on the value of the assets they manage, plus a performance-related fee (carried interest) that corresponds to a fraction of the capital gains earned, above a minimum rate of return (hurdle rate) for investors. The carried interest mechanism seeks to align the financial interests of GPs and LPs. In addition, GPs charge portfolio companies transaction fees and annual monitoring fees.

The wide application of this management system partly explains the growth of private equity. It has enabled investors to gain access to a new asset class and earn gross returns (excluding fees) similar to that of fund transactions, through the cash flow mechanisms in place between the fund and investors. However, this mechanism also suffers shortcomings, especially with regard to aligning the interests of investors and managers (Harris, 2010; Jones and Rhodes-Kropf, 2003; Klausner and Litvak, 2001; Phalippou, 2007). In the buoyant market of 2004-2008, latent conflicts of interest between GPs and LPs continued to be largely disregarded, because performance was great and managers made effective promises. However, with the onset of the financial crisis, managers sought capital to sustain their business, (5) even as investors tried to draw back. The imperfections and shortcomings of the system thus became clear in several manifest issues as follows:

Fees: In the flat fees, heterogeneity was the rule, despite some standardization towards the '2 and 20' model (ie, flat fees at 2 % of the assets managed and carried interest at 20% of the capital gains above the hurdle rate). However, the multiplicity and complexity of the calculation methods and payments made comparisons across funds difficult (Litvak, 2009). The growing size of the funds also altered the situation, because in dollar terms, 2 % of a $200 million fund is hardly comparable to 2% of a fund of $10 billion or more. The increased size of management companies alone could not justify such astronomical fees. Furthermore, the transaction and monitoring fees often were mostly paid to the management companies, which relied on them as sources of substantial profits. Finally, the fees that accrued when secondary LBOs were implemented by management companies or secondary funds also were subject to dispute.

Commitment and long-term lock-in: With the initiation of a PEF, investors agree to pay substantial amounts on a multi-annual basis (commitment), even though its investments have not been identified at the outset and are determined by the GPs alone. Commitment is a peculiarity of private equity that continues to raise questions. The arguments justifying this practice cite reduced transaction costs (Ippolito, 2007) and the demand for investors with 'deep pockets', who are not subject to liquidity requirements but instead can respond to calls for funds from the management company and maintain their participation in the fund over time, regardless of what happens (Lerner and Schoar, 2004). Capital provided to the fund thus remains locked in for an average of 5 years; fund shares also are difficult to sell, because of the informational asymmetries associated with non-listed investments. Yet, the magnitude of the financial crisis made deep-pocketed investors very rare. Instead, fund investors were left holding illiquid fund shares, having been lured in by high returns and then discovering suddenly that they could not sell except at a fire sale price--if at all. Moreover, investors remained bound by their commitment to respond to appeals from the funds, even as they sought to reorient their own investment strategies completely. Many LPs tried to sell off their commitment and their shares, even at a discount.

Investment decisions and policy: For most GPs, flat fees decline in absolute value after the first few years of the fund's lifetime. At the end of the contractual period (usually 5 years), the calculation of fees generally depends on the portfolio assets, not commitments. To maintain their fee income and perpetuate their viability, GPs therefore have strong incentives to invest as much as possible, potentially to the detriment of the selected investments. The difficulty of selling in times of crisis--when merger and acquisition activity declines and there are fewer IPOs--can also lead to secondary LBOs, implemented mainly to maintain the fees.

Returns and transparency: The financial crisis and ensuing economic crisis jeopardized the anticipated returns of investors, because most investments they made in the years prior to the crisis will no longer be profitable. In the absence of industry standards applied universally by all GPs, and because the companies held by funds are private, little public information is available, such that the LPs depend on GPs to learn the quality of reporting and evaluate funds. The profession has a reputation for opaque assessments, which GPs can exploit. The actual returns from funds thus remain a matter of controversy, though a general agreement implies that the best performing GPs consistently outperform the market over time (Gottschlag and Phalippou, 2008; Phalippou, 2009, 2011; Lopez-de-Silanes et al., 2011).

A changing balance of forces unfavorable to GPs

Unlike their European counterparts, actors in the US market, particularly GPs, did not belong to professional organizations that would define best practices or defend the interests of the profession. (6) In February 2007, the Private Equity Council (7) was established, and its members included the largest US GPs, yet this body has acted mainly as a lobbyist, seeking to protect members' fiscal interests, especially those involving carried interest taxation.

Faced with diverse market conditions and a general lack of transparency, US LPs responded in 2007 by reactivating (8) the International Limited Partners Association (ILPA), which they dominate (65% of the membership in 2011, compared with 16% for Europeans). In 2009, the ILPA published a first version of its 'Private Equity Principles', revised in 2011. This document contains rules that seek to establish the best practices for the industry. For example, it suggests that all transaction and monitoring fees be paid to the funds, not to the management companies. It also recommends means for LPs to extricate themselves from prior commitments in the event of glaring errors by GPs. Finally, it promotes consistent methods for calculating and paying carried interest. The ILPA also has published a standardized reporting model and rules to cover the procedures for calls for commitments by GPs and procedures for distributing funds to LPs.

Considering the current state of the market, and the need for GPs to raise new funds to survive, LPs are trying to impose levels of standardization and transparency that have been structurally absent from the industry thus far. Market information can support such efforts. In turn, KKR and Carlyle recently agreed to adhere to the ILPA principles, which represents a substantial change. (9) These initiatives by LPs also may be strengthened by the provisions of the Dodd-Frank Act, which mandates greater transparency by management companies.

The entry of private equity into the scope of regulation

Regarded as similar to hedge funds, with the same speculative, predatory finance image, PEFs gained a prominent reputation among non-regulated financial organizations. After intense debate, US legislators gave up trying to regulate the industry directly (10) and focused instead on two main issues: (1) sound information and investor security, by mandating that most GPs must register with the Securities and Exchange Commission (SEC) as investments advisors, and (2) the dangers of systemic risk, by making compulsory the disclosure of debt-related information by the biggest PEFs.

In the former case, existing private equity management companies faced the requirement to register with the SEC by 30 March 2012, as registered investment advisors. (11) Although some companies, especially the largest, already had adopted this status, most took advantage of an exemption granted to companies with no more than 14 clients (each fund is considered one client) to avoid this regulation. This mandatory registration has brought the GP profession under the control of the SEC. (12) In becoming fiduciaries, GPs take on the fundamental obligation to act in the exclusive interest of their clients and to respect the principles of 'disclosure' and 'compliance'. Furthermore, GPs must periodically divulge information and data about their activities to the SEC, using adviser public disclosure (ADV) forms, which require information about funds advised, the GP's business, and other activities if applicable. Some of these data then become public. A new private fund (PF) form also attempts to assess the systemic risk of investment advisers, whom I discuss subsequently. Together with the periodic provision of information, registered investment adviser status obliges GPs to comply with a series of rules and procedures, including adherence to the Compliance Rule (13) and the Custody Rule, (14) adoption of a code of ethics, and the use of written methods for evaluating investments. They also must be vigilant in detecting and reporting potential conflicts of interest with their investors. With regard to marketing, GPs must commit to providing truthful information, particularly in relation to past performance. The profession thus has left the deregulated world, in which its duties and obligations were largely determined by Delaware law and contracts (Gibbons and Stone, 2011). Still, most of the required information pertains to the managing company, rather than the operations of the managed funds (cf. the biggest funds).

To limit and control for the dangers of systemic risk, the Dodd-Frank Act requires that companies managing PEFs worth more than $2 billion provide even more information about the indebtedness of their funds and portfolio companies, including the outstanding balance of their borrowings and guarantees; the average, minimum, and maximum debt-to-equity ratio of the portfolio companies they control; aggregate borrowings of their portfolio companies (current, long term, payment-in-kind and zero coupon); defaults by portfolio companies; portfolio companies with bridge loans and the identity of their loan providers; and co-investments by related persons in portfolio companies. These reports are required quarterly, using a PF form submitted to the SEC. The SEC then transmits the information to the Financial Stability Oversight Council (FSOC), which has the power to decide whether a non-banking financial company is a threat to systemic stability, such that it should be regarded as a bank and supervised by the Fed. To assess this risk, the FSOC particularly attends to the degree of indebtedness, type of financial assets held, sources of financing, and links with other financial institutions and their significance as a source of credit and liquidity. If some big GPs become systemically important, they likely would be forced to break up into smaller units if they wanted to avoid controls imposed on them if they attain 'bank status'. Another provision of the Dodd-Frank Act entails 'major swap participants', (15) such that PEFs that regularly engage in debt swaps are liable to supervision by the SEC and subject to the rules that apply to actors in such markets.

The Volcker Rule and banks' exit from private equity

To limit systemic risk due to operations carried out by banks, the Dodd-Frank Act contains provisions, known as the Volcker Rule, that prohibit banks from proprietary trading and holding investments in PFs.

As a result, US banks and their subsidiaries are barred from sponsoring (16) and subject to limits on their investments in PEFs (and hedge funds). Specifically, banks may not hold (1) more than 3% of the total amount of a fund and (2) more than a total of 3% of their tier-one capital in funds of this type. Banks can still act as independent fund managers, provided that no entity within the group to which they belong grants credit to the fund, buys its assets, provides guarantees for it, or carries out similar transactions with it, except as expressly permitted by the regulations.

The effective date of the Rule was 21 July 2012, but the details of its implementation were not ready by that date. The Fed has thus provided each banking entity with a conformance period of 2 years after that date (ie, until 21 July 2014), 'in which to fully conform its activities and investments to the prohibitions and requirements (...) and the final implementing rules unless that period is extended by the Board'. (17) Moreover, the Fed has the right to grant extensions, depending on the facts and circumstances, such that some assets conceivably might be kept through 21 July 2022. Yet compliance by the US banking sector with the Volcker Rule, if enforced as intended, is likely to lead to the sale of tens of billions of dollars worth of illiquid assets of various kinds. The private equity assets held by the six largest US banks in excess of the 3% limit are estimated to have amounted to at least $21 billion in 2010 (Dow Jones, 2010). Furthermore, many banks already have begun to sell their portfolios (eg, Bank of America Corp., Citigroup Inc.). The secondary market, which is making steady progress in this sector, seemingly could reach record transaction levels by 2015, especially as the refinancing of existing funds gets added. The size of the secondary market already has increased dramatically since 2010, as the amount of capital raised by secondary funds has reached $11.4 billion in 2009, $10 billion in 2010, and $5.5 billion in 2011 (Dow Jones, 2012).

However, some banks may try to use the extensions and wait to liquidate their invested funds. Furthermore, as the Rule may not be finalized before the end of 2013, some banks may also hope that their active lobbying will result in a final text much less restrictive than intended.

SUBSTANTIAL CHANGES IN THE INDUSTRY AND ITS FUNCTIONING

Even after it emerged from the collapse of its first bubble at the end of the 1980s, considerably weakened by business declines, the US private equity industry made few changes to its practices and remained largely opaque to those outside the profession--as well as to many of its investors. In this respect, it has continued to cultivate and maintain a cult of secrecy. However, in light of current developments and new constraints, the industry is undergoing several deep changes:

* Downsizing, with sustained contraction in the level of activity, far below the peaks of 2007 and 2008, due to significant reductions in the amount of capital being managed, as well as lesser availability of the debt needed to finance LBOs. The amounts of investment of the industry have declined sharply since 2008 (to one-third their previous size).

* Sharp decreases of funds available to the industry, which will continue to change the nature of investing LPs. Only the true long-term investors will remain to provide funds to management companies. Many investors, attracted solely by the anticipated returns during the boom, exited the market because they were not fit to take on the risks of this asset class or the long-term lock-in demanded by private equity investments. As a result, the remaining LPs (mainly institutional investors) likely will be more long-term oriented and more professional.

* Fewer players, due to the threefold effects of scarce capital, banks exiting the business, and declining profitability. The sale of private equity bank portfolios will mostly benefit large companies with sufficient size and capacity to create, purchase, and manage new funds. To offset shrinkage in their main market (LBO) and sustain their turnover, management companies have functioned flexibly and opportunistically, by extending the scope of their activities, launching funds dedicated to new types of assets (eg, distressed debt, natural resources, infrastructure, special situations), and entering new realms of activity (eg, corporate finance advisory, underwriting). However, the success of such strategies are far from guaranteed.

* Persistent reductions in the profitability of management companies. The fee rebalances have been to the advantage of LPs. According to Preqin (2012), for buy-out funds, average management fees declined from 2.04% in 2006 to 1.92% in 2012; on average, 85% of the monitoring and transaction costs (cf. 69%) are now rebated to LPs by the funds. The profitability decreases also may be accentuated by additional costs, incurred by the need to respond to regulatory requirements and registering as investment advisors. Another pending issue is the question of whether carried interest should be taxed as income, rather than as capital gains.

* The lingering effects of past performance on profitability. The best performing GPs seem able to sustain a high level of fees, because many investors are willing to invest in their funds. Other companies have had no choice but to lower their overall fees. Along with their decreasing number, the GP profession appears likely to split into two categories: strong performers that attract major flows of funds and poor performers with less capital to manage and minimal profitability.

* Improved governance and greater practice standardization. The rebalance in the relationship between investors and GPs and the required registration of investment advisers with the SEC are inducing notable changes. Investors have succeeded in convincing most GPs to accept many of their best practice demands (eg, fees, reporting, explicit portfolio valuations). As registered investment advisers, GPs will have to disclose some of their business practices publicly. Entering a regulatory framework, in combination with investors' pressures, probably will bring US private equity gradually into the financial mainstream, similar to the trends in the mutual funds industry. The rents and practices that it managed to impose on LPs and sustain for 30 years--including fees, firm and final commitments, and obscure methods for calculating and paying carried interest--are unlikely to persist. Furthermore, investment management is evolving, by incorporating some socially responsible investing practices.

* Scrutiny of the FSOC. This body receives information about the amount and degree of leverage of the capital the large firms manage on a quarterly basis, which should induce them to seek to avoid being classified as a threat to financial stability. Nevertheless, the Dodd-Frank Act allows most information regarding the operations of private equity firms to remain private. Most of what must be disclosed pertains to the management companies, not the funds. This important limitation of this new regulation prevents full transparency or risk spreading, because present or future counterparties of funds or companies managed by LBO funds still offer no public information.

As an atypical industry, in terms of the nature of the assets it manages, the US private equity industry, 30 years after its birth and in the aftermath of a massive financial crisis, faces a new combination of challenges. It will undoubtedly experience further periods of boom and expansion, similar to any financial business. However, the demands of investors and the increasing scope of regulation will substantially alter its contours and likely lead to a more mature industry, with increasingly standardized practices.

Acknowledgements

The author thanks an anonymous referee for valuable comments that substantially improved this article.

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XAVIER MAHIEUX

Department of Finance, INSEEC, 27 avenue Claude Vellefaux, Paris 75010, France.

E-mail: xmahieux@groupeinseec.com

(1) Public to private acquisitions of listed companies by LBO funds accounted for 15% of the volume in 2003 and 45% in 2007 (Rizzi, 2009).

(2) PEFs are run by management companies, known as GPs, and financed by investors, known as LPs. If a PEF or a holding in a fund encounters financial difficulties, LPs have a limited legal responsibility, because they are not responsible for fund management decisions, which instead are the responsibility of GPs.

(3) Both funds merged in 2009 and mainly invested in private debt securities.

(4) As many securities allow settlements in fine (up to 8 years), the possibilities exist to capitalize the interest, rather than paying in case of need (ie, pay as you can), or paying interest in shares or other securities (ie, payment in kind).

(5) The life cycle of PEFs requires management companies to raise a new fund every 3 or 4 years on average, to maintain their sales and market presence.

(6) The British Venture Capital Association was founded in 1983; the Association francaise des investisseurs de croissance came into being in 1985; and the European Venture Capital Association began in 1992. All three bodies treat GPs in venture capital and private equity similarly.

(7) It has since been judiciously renamed the Private Equity Growth Capital Council (PEGCC).

(8) The ILPA was created in the early 1990s but became fully active only after 2007.

(9) According to popular media. KKR has agreed, for the first time, to introduce a hurdle rate in calculating the carried interest of a new fund (The Deal Magazine, 2011).

(10) Legislators accounted for the specificities of PEFs, especially in relation to those of hedge funds. In particular, they noted the retention of investments in portfolios for several years, the use of financial packages conceived with a medium-term perspective, funds themselves that were not in debt, and the lack of financial solidarity among investors in the same fund.

(11) This status was created by the Investment Advisors Act of 1940.

(12) Only companies specializing in venture capital and some companies managing less than $150 million have the option of not registering.

(13) The Compliance Rule requires registered advisers to designate a chief compliance officer, responsible for administering policies and procedures; to adopt and implement written policies and procedures; and, no less than annually, to conduct a review of the adequacy of those policies and procedures.

(14) This rule demands the use of qualified custodians subject to internal monitoring, an annual review of operations conducted by an independent auditor, and so forth.

(15) These participants are entities (1) that hold substantial swap positions for reasons other than covering or managing commercial risk, (2) for which the size of the swaps creates substantial counterparty positions that could result in systemic risk, or (3) that are highly indebted but not subject to regulatory capital constraints and hold substantial swap positions, for whatever reasons.

(16) They are barred when banks act as a GP of a fund, control the majority of the board, or when the fund and the bank have the same name.

(17) Federal Register/Vol. 77, No. 111/Friday, June 8, 2012/Rules and Regulations.
Table 1: Private equity investments 2001-2011 ($ billion)

 LM market M market U market Total

2001 12 10 9 31
2002 16 15 8 39
2003 27 28 28 83
2004 36 40 49 125
2005 38 51 85 174
2006 44 69 192 305
2007 46 87 438 571
2008 32 39 127 198
2009 18 22 22 62
2010 28 64 69 161
2011 23 44 80 147
Total 320 469 1,107 1,896

Source: PitchBook

LM Market: Lower middle market-investments<$250 million.

M Market: Middle market--investments between $250 million and $ 1
billion.

U Market: Upper market--investments>$1 billion.

Table 2: Private equity fundraising 2001-2011

 Amount raised ($ billion) Number of funds

2001 56 147
2002 79 142
2003 44 117
2004 90 161
2005 142 252
2006 224 261
2007 313 314
2008 312 273
2009 152 136
2010 89 138
2011 93 141
Total 1,594 2,082

Source: PitchBook--Annual Private Equity Breakdown 2012

Table 3: Main PEF managers

Rank GP Nationality Creation
 date

1 Kohlberg Kravis Roberts US 1976
2 TPG US 1992
3 Blackstone Group US 1985
4 Carlyle Group US 1987
5 CVC Capital Partners UK 1981
6 Apollo Global Management US 1990
7 Bain Capital US 1984
8 Goldman Sachs Merchant Bank US
9 Apax Partners UK 1981
10 Advent International US 1984

Rank Diversified International PEFs raised
 (a) 2000-2010
 (in $
 billion)

1 x x 46.7
2 x 46.5
3 x x 41.7
4 x x 40.6
5 x x 37.0
6 x x 30.6
7 x x 29.1
8 x x 28.8
9 x 24.8
10 x 21.7

(a) Management of other assets: Real estate, hedge funds, and so on.

Source: Preqin and others
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Title Annotation:Symposium Article
Author:Mahieux, Xavier
Publication:Comparative Economic Studies
Article Type:Industry overview
Date:Sep 1, 2013
Words:6950
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