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Ladies and Gentlemen,
It is one year since the Walker guidelines were issued. How times have changed. Fears that buy-outs and public to private deals could unravel the fabric of European corporate governance now seem fanciful. Nevertheless, the Walker guidelines remain a far-sighted and significant step on the road to defining a new contract between private equity managers, their investors and other stakeholders including governments. The guidelines may have been introduced in a different context – when the private equity boom was at its peak. But they are even more relevant today as we face into leaner times.
I would like to structure my remarks in the following way. First, I will make some general remarks about the backdrop against which the unfolding European debate on private equity will be conducted. Second, I would like to explain how I see the charge-sheet against private equity. More particularly, I would like to explain why private equity should not be lumped together with other systemically relevant financial sectors. But we need to look at issues where private equity industry may have to front up. Lastly, I will comment on how I propose to steer the EU policy debate on private equity over the coming months.
The Economic and Political Environment
The financial crisis has led to a frantic search for corrective actions to address vulnerabilities in our financial system. This is a natural and proper response. We have stared into the abyss. And few people want to repeat the experience.
The intense focus on the adequacy of the financial regulatory system will not abate any time soon. There will be no return to the status quo ante. The decisions that we take over the coming months will shape our financial markets and economies for decades. We need to make sure that our regulatory response addresses the right issues – that regulators do not try to win the last war, but that they draw the right conclusions on what is needed to police the new market structures that are already starting to emerge.
We also have to act decisively when this is required. At EU level, we have already tabled a number of important legislative proposals to tackle some of the failings that contributed to the crisis – deficient liquidity management and due diligence by banks, misaligned incentives and conflicts of interest in credit rating agencies. We are also looking at structural solutions to the build up of counterparty risk through OTC credit derivatives markets.
How does this relate to the private equity industry? There is a push to extend the reach of financial regulation to previously unregulated or lightly regulated sectors. A strong body of opinion holds that the uncontrolled build-up of leverage through off balance sheet bank-controlled structures and the shadow banking system was an accident waiting to happen. This is leading to a renewed focus on the use of leverage by banks, investment banks and the alternative investment industry.
The recent G20 declaration confirms this all-encompassing approach to regulatory reform of the financial sector. It says that 'all financial markets, products and participants are regulated or subject to oversight, as appropriate to their circumstances'. There is a risk that private equity gets swept up in a wide-ranging and indiscriminate regulatory rethink. I want to avoid this distinctly sub-optimal outcome.
What policy issues does private equity raise that warrant further investigation?
My starting point is that private equity does not give rise to the macro-prudential or systemic concerns which are the driving force behind much of the post-crisis regulatory agenda. Failure of private equity funds will lead to painful losses for investors – but there should be no knock-on consequences for the wider financial system. Banks and other financial institutions have lent money to finance private equity portfolio companies – but these exposures are relatively limited. Therefore, I do not believe that private equity funds are systemically relevant and should not be lumped together with other categories of leveraged financial institutions. We must not shackle the private equity industry with regulatory constraints that are neither necessary nor productive. Otherwise, we will deprive capital-starved industries of much needed equity capital. I think that this message is increasingly understood.
This does not mean that private equity is entirely off the hook. Private equity industry needs to be attentive to the impact of buy-out activity on the social economy – and better management of its relationships with key stakeholders. Perceived failure to manage these relationships in the context of buy-outs has fuelled pressure to regulate private equity activities. These pressures found their most vocal expression in the Rasmussen and Lehne reports of the European Parliament in September.
There are concerns relating particularly to corporate governance, transparency and reporting that warrant further attention. I also consider that, with hindsight, some private equity deals have been over-leveraged.
How do I see the European debate on private equity funds evolving?
Where do we go from here? How do we deal with those issues where private equity has to raise its game?
In some of the areas where I believe that there are issues to be addressed – notably transparency of (minority) stake-building to investee companies – the Commission will review the Transparency Directive in 2009/2010. This will provide an opportunity to look at issues such as notification thresholds, investment policy disclosure and identification of shareholders. In addition, the Commission will also address next year the issue of remuneration in the financial sector and in particular the need for reward structures to be more closely aligned to the real medium term benefits accruing to companies.
In general though, I believe that the types of policy issue raised by private equity do not lend themselves to a regulatory solution. The concerns relate to the way in which private equity funds manage their relationships with investors and stakeholders in portfolio companies. Regulation cannot prescriptively define the type of conduct or behaviour that private equity managers should follow when initiating, implementing and managing deals. It also risks being disproportionate – taking a sledgehammer to crack a nut.
Self-regulation has lost some credibility in recent times. Politicians and policy-makers are less willing to accept the proposition that enlightened self-interest will lead market participants to act in a disciplined manner. However, I still believe that self-regulation represents the most promising avenue for promoting the desired behaviour by private equity managers.
I am comforted in this view by the G20 declaration. The G20 declaration calls on regulators to first look to the industry codes and best practices before considering the need for any regulatory intervention. This is the approach that I propose to follow in Europe insofar as private equity is concerned.
I will therefore press ahead with a review of the scope, content and performance of the relevant codes of practice that the European private equity industry has introduced – at European or national level. I will report on my initial findings to the European Parliament in March 2009 and continue to work on any outstanding issues with all interested stakeholders after that report.
The types of issue that we will want to focus on include:
- coverage of codes: when we look at the numbers, we can quickly see that there is a distance to travel. The number of BVCA firms that have signed up to the Walker guidelines is a case in point. According to certain reports only 32 out of a possible 200 members would be currently signatories. The limited reach of the Walker guidelines is also apparent when we look at the number of portfolio companies covered by the guidelines. Only 56, out of about 1,300 portfolio companies in the UK that are targeted by private equity investments, are reported to comply with the disclosure and transparency rules. These kinds of statistics are not going to impress any trigger-happy regulators;
- monitoring and mechanisms for promoting compliance: most of the standards are voluntary in nature and it is therefore difficult to determine the level of compliance with these standards in the absence of credible enforcement mechanism. There is scope for greater ambition ('comply or explain') and more active/independent monitoring of compliance;
- consistency across Member States: the European private equity market is now characterised by a series of different industry codes – which differ significantly in their content. At a certain stage, it may be possible to codify the common elements. Rather than a proliferation of separate, and possibly inconsistent national codes, there may be a need for consolidation on a set of widely understood and widely upheld guidelines.
This review will not be a white-wash. We will undertake a thorough and critical review. The yard-stick will be the impact and effectiveness of codes. Policy-makers and regulators will want to see evidence that these codes are influencing behaviour and avoiding undesirable outcomes.
We are open to input from the private equity industry on the scope and application of these codes across the board, and on ideas on how to give them teeth. However, we will also need to validate our views and findings with other relevant stakeholders – institutional investors, labour organisations - who are impacted by the activities of the private equity industry.
I would like to thank the private equity industry for the contribution that they are already making to our work. The establishment of the EVCA Task Force has already proved effective in mobilising a coherent, pan-European perspective.
Ladies and gentlemen,
Let me conclude.
I am confident that the industry will rebound form this crisis and cement its role in the European financial and economic system. That is why it is worth investing in durable and sound solutions for governing the interaction between private equity industry and the wider economic system.
I would urge the private equity industry to contribute constructively and positively to defining such solutions. This will entail commitment and cost. But it may lead us towards more effective solutions than regulatory approaches.
