Regulating Private Equity by Aligning PE Fund and Stakeholder Interests? A Look at Senator Warren’s Proposal

Nicholas Pokas

Democratic presidential candidate Senator Elizabeth Warren has put renegotiating the relationship between workers and capital at the fore of her campaign. She wrote that her plan to rein in Wall Street “start[s] by transforming the private equity industry” and she has proposed the Stop Wall Street Looting Act of 2019 (“the Act”) to that end.[1] The Act proposes changes, small and large, to the industry, from minor changes in regulatory oversight to provisions that would fundamentally reshape industry practices and even corporate law. 

It is little surprise that Senator Warren has targeted the private equity industry with such vigor. While precise measurements are open to debate—the industry is definitionally lightly regulated—private equity funds have seen substantial growth by nearly any metric over recent years. Funds have more than $2 trillion in dry powder, uncalled and uninvested capital commitments, globally in 2018, compared to under $1 trillion in 2012.[2] More than eleven million Americans are employed by private equity-owned businesses.[3] With this growth and the direct effect on American jobs, the industry has come under increasing scrutiny from politicians and academics.[4] In response to the scrutiny, the Act has five key provisions requiring private equity firms to have skin in the game—to share in the losses of their portfolio companies, to limit monetary transfers from portfolio companies to funds, to prioritize workers and community stakeholders in the case of bankruptcy, to increase transparency in fees and returns, and for debt arrangers to retain some of the risk in securitization.[5] The first and last proposals attempt to align the incentives of key decisionmakers in private equity deals with those of the underlying portfolio company, and are the two proposals that will be considered together below.

Joint and Several Firm Liability for the Fund

The Act is designed to address the critique that funds do not internalize the downside risk of their leveraged buyouts. While private equity funds benefit from well-performing portfolio companies, critics point out that the downside costs are borne by lenders and other stakeholders, while, even in an under-performing company, the sponsor is able to collect, at minimum, a management fee. In the archetypal buyout deal, a sponsor will purchase a portfolio company through debt financing—oftentimes more than six times the equity.[6] This leveraging offers tax benefits—though the deductibility of interest payments is also reduced in the Act—and gives the equity stake held by the fund returns at a higher multiple when compared to a transaction financed with less debt. While the gains are multiplied, the downside risk for the fund is limited. In the event of a bankruptcy, the fund’s losses are generally capped at its equity investment while the lenders and other stakeholders bear the bulk of the losses.[7]

In response, the Act requires funds to share in the liabilities of the portfolio company—including debt, legal judgments, and pensions obligations—so that funds internalize the downside risk beyond their equity holding.[8] The law would, therefore, vitiate limited liability in the context of private equity, by making the fund jointly and severally liable for the obligations of the portfolio company, and by extending this liability to beneficial owners of the fund under § 102 of the Act. This would put private equity at a significant disadvantage in comparison to other potential equity holders of a firm who continue to benefit from limited liability. While over time, insurance markets may develop once regulatory and case law interpretations of the provision develop,[9] this provision could severely curtail the ability of private equity funds to be competitive in the market for corporate control.

601—Risk Retention

The Act also provides that the parties arranging the debt used to finance a buyout deal retain an interest in the debt after it is securitized. This so-called risk retention rule would apply to a substantial portion of the debt arrangers of private equity deals. The collateralized loan obligation (“CLO”) market has grown to over $700 billion worth of product securitized globally every year, and over sixty percent of leveraged loans—the type of loans used to finance the purchase of portfolio companies of buyout funds—are securitized in CLOs.[10] Risk retention aligns the incentive of the CLO manager with the buyers of the securitized product, and at least in the residential mortgage backed securities (“RMBS”) market—where a 5% retention rule has taken effect—has resulted in tighter lending standards marked by stronger observable loan characteristics and mortgages less likely to become troubled, but at the cost to borrowers of higher interest rates.[11] The proposed regulation would counter the deteriorating lending standards that have typified these markets. In 2010, less than ten percent of institutional loan issuance was ‘covenant light,’ meaning that it offered fewer protections for creditors. In 2018, over eighty percent of debt issued was covenant light, and Federal Reserve Chair Janet Yellen stated she was worried by the “huge deterioration” in lending standards, particularly for leveraged loans.[12] By requiring debt arrangers to retain an economic interest in even the riskiest tranches of their CLOs, the Act may help address the perceived market imbalance created by the search for higher yields in the current low-interest rate environment.

Risk retention for debt arrangers was first included in the Dodd-Frank Act. However, an unappealed D.C. Circuit ruling held that the rule does not apply to open market CLOs, the main source of debt for private equity funds.[13] Open market CLO managers are those who do not hold the debt placed in the CLO they manage on their balance sheets prior to securitization. The court interpreted the Dodd-Frank Act to exclude open market CLO managers from the risk retention provision, since, according to the language of the statute, it required securitizers to retain an economic interest in the debt it held, and, as open market CLO managers never held the debt, they were unable to retain an economic interest.[14] The Act would amend Dodd-Frank and explicitly subject all managers of CLOs to the risk retention rule and require that managers who never held the underlying debt acquire the relevant tranches of the CLO to satisfy the risk retention rule.[15] Thus, debt arrangers for buyout deals would be required to retain an interest in the debt, so long as the loans for the deal are securitized. 

Under the Act, all debt arrangers must retain a 5% interest in their securitized products, generally 5% of each tranche of the securitized product.[16] The CLO manager is forbidden from transferring this 5% interest to an entity not controlled by the manager, and is also forbidden from hedging the debt.[17] LSTA, a trade group for both lenders and sponsors in the syndicated loan market, argues that open market CLO managers do not have the same misaligned incentives of balance sheet managers. Balance sheet managers may have an incentive to transfer bad assets to a securitized product in which they seek to retain no interest, thus transferring the risk to the buyers of the product. This phenomenon was at play in the RMBS market, where many managers were sourcing assets to include in the securitized product from their balance sheet.  In its risk retention ruling, the D.C. Circuit noted that CLOs, unlike other debt instruments, did not see greatly deteriorated performance in the Great Recession, and thus there is limited evidence that such a malign incentive plays a substantial role in the open market CLO market.[18] Nonetheless, the Act would reapply risk retention rules to these open market CLO managers to ensure that the possibility of misaligned incentives is limited. 

Conclusion

Taken together, the two reviewed provisions would partially align the incentives of debt arrangers and private equity funds with the lenders, who finance over eighty percent of many portfolio company deals.[19] To the extent that the misaligned incentives decrease overall economic welfare—e.g. by decreasing the likelihood that the sponsor fund takes into account the full cost of bankruptcy—these two proposals may serve to curb some of the perceived excesses of the private equity industry. The risk retention rule may slightly increase the cost of debt capital, as studies suggest it did in the RMBS market, without severely impairing the industry. The joint and severability requirement applied to funds, though, fundamentally alters the nature of the investment, and vitiate long-established principles of limited liability. This would put private equity funds at a disadvantage vis-a-vis other equity holders, and, depending on how the proposal is threshed out, pose a significant existential risk to the industry. Since the Act is unlikely to pass in its current form, a policy more narrowly tailored to require funds to internalize some of the risk of failure of portfolio companies than a broad joint and severability requirement is worthy of consideration.

 

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[1] Elizabeth Warren, End Wall Street’s Stranglehold on Our Economy, Medium (July 18, 2019), https://medium.com/@teamwarren/end-wall-streets-stranglehold-on-our-economy-70cf038bac76.

[2] McKinsey & Company, 2018 Private Markets Annual Review 18 (2018).

[3] Additionally, eight of the largest private equity firms are estimated to employ more people through their portfolio companies than any private-sector American employer except Walmart. Gillian Tett, Private Equity and Donald Trump’s Quest For Jobs, Fin. Times (May 4, 2017), https://www.ft.com/content/3be3acba-2ff7-11e7-9555-23ef563ecf9a?o=os.

[4] See, e.g. Carried Interest Fairness Act, H.R. 1735, 116th Cong. (2019); Steven J. Davis et al., The Economic Effects of Private Equity Buyouts (Becker Friedman Inst., Working Paper No. 2019-122, 2019) (finding buyouts are associated with higher worker productivity yet also lower employment and lower wages at target firms).

[5] Stop Wall Street Looting Act, S. 2155, 116th Cong. (2019), available at: https://www.congress.gov/bill/116th-congress/senate-bill/2155/text.

[6] Eric Platt & Mark Vandevelde, Credit Boom: Private Equity Bounces Back on Cheap Debt Bubble, Fin. Times (Nov. 16, 2018), https://www.ft.com/content/49950dba-e98a-11e8-885c-e64da4c0f981.

[7] In fact—as discussed below—with the growth of covenant light loans, the equity stake is oftentimes not wiped out even as lenders take a haircut.

[8] S. 2155 § 101.

[9] If such insurance is permitted—the law in its current form only bans indemnification by the portfolio company itself. Id. at § 103.

[10] Andrew Park, Those $700B in US CLOs: Who Holds Them, What Risk They Pose, S&P Global Mkt. Intelligence (June 21, 2019), https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/leveraged-loan-news/those-700b-in-us-clos-who-holds-them-what-risk-they-pose.

[11] Craig Furfine, The Impact of Risk Retention Regulation on the Underwriting of Securitized Mortgages, J. Fin. Serv. Res. 3–4 (2019).

[12] Editorial, Janet Yellen Is Rightly Worried About US Loan Standards, Fin. Times (Oct. 31, 2018), https://www.ft.com/content/23fd57c8-dc39-11e8-9f04-38d397e6661c.

[13] Loan Syndications & Trading Ass’n v. S.E.C, 882 F.3d 220 (D.C. Cir. 2018).

[14] Id. at 222–23. For the language the court interpreted, see 15 U.S.C.A. § 78o-11(b)(1) (2019).

[15] S. 2155 § 601(i)(1).

[16] Id. at § 601; Andrew Faulkner, Regulators Adopt Final Risk Retention Rules for Asset-Backed Securities, Skadden (Jan. 2015) https://www.skadden.com/insights/publications/2015/01/regulators-adopt-final-risk-retention-rules-for-as.

[17] Brandon Coleman et al., Deloite, Collateralized Loan Obligation Overview 22 (2018) https://www2.deloitte.com/content/dam/Deloitte/us/Documents/risk/us-rfa-collateralized-loan-obligations.pdf; 15 U.S.C. §78o-11(c)(1)(A) (2019).

[18] Loan Syndications & Trading Ass’n, 882 F.3d at 229.

[19] A six to one debt to equity ratio would mean nearly 86% of the funding comes from those with debt rather than equity stakes.