Julie Kenny Investigates the New Regulatory Considerations for Venture Capital and Private Equity Firms
When it comes to regulations in Private Equity and Venture Capital, it pays to stay diligent. Many national and international regulations, treaties and multi-national agreements regularly change and are likely to affect Private Equity and Venture Capital firms. While not specifically targeted by the regulations, the impacts on the industries firms may be fewer product options, increased regulatory compliance and the erosion of confidentiality norms. Let’s consider three major issues facing the industry: Basel III, KYC & AML, and FATCA.
The BASEL III Requirements and Access to REPO
On January 1, 2014, Basel III regulations come into effect for banks with more than EUR 250 B in total consolidated assets or greater than EUR 10 B in foreign exposure. Such large banks are significant issuers of repurchase agreements, which in turn are the primary investment vehicle for excess funds in Private Equity and Venture Capital firms. In principal, collateral used in these transactions are securities issued or guaranteed by the respective governments or governmental bodies, and the agreements reset each day. The new Basel III capital requirements potentially make listing these securities as collateral – and therefore facilitating REPO transactions – more difficult, as banks generally hold on their own account these government guaranteed securities due to their low risk profile (and therefore lower capital requirements) they carry under Basel III. Moreover, the traditionally abundant supply of such high quality collateral has decreased due to the respective country central bank’s asset purchase plan. Consequently, the availability of higher quality collateral and low risk securities may decline over the short to medium term, resulting in an upward trend to the use of lower-quality, higher risk collateral in the longer term.
It is a possibility that we may find a development of alternative interest bearing investment products as a consequence of this potential shortfall in REPO inventory. The use of alternatives currently are limited given UBTI is a concern for many Private Equity and Venture Capital firms.
Know Your Customers (KYC) and Anti-Money Laundering (AML)
KYC and AML regulations have existed in most European countries and the United States since the early 1970s. The purpose largely to combat weapon trafficking, the drug trade and money laundering. With the enactment of the US PATRIOT Act, the scope of these regulations expanded to include terrorist financing, and spread internationally to a multitude of countries. Now Banks and other corporate financial services providers are required to act as enforcement agents under these rules, and those that fail to comply receive significant fines. AML violations are attracting the attention of regulators – a GBP 960 million fine was levied against UBS in 2012 and – looking east – India has fined 22 of their finance institutions this year. It is therefore logical and reasonable to expect that banks will be tightening their KYC and AML procedures.
Presently the consequences to Private Equity and Venture Capital firms can be felt primarily at the stage of account opening (brokerage accounts, etc.). Most banks -particularly larger banks- already require firms opening accounts to be able to provide identifying information down to the “natural person” – or “two legs” – level. For Private Equity and Venture Capital firms, this means lifting the veil down to the Limited Partner level. For large and institutional LPs, this may be very straightforward. For small to mid size Private Equity, Fund of Funds or Family Office LPs, this may become more onerous. If the Firm has implemented its own AML system and procedure in line with existing KYC and AML regulations, this may suffice meeting these banks’ requirements. Traditionally Private Equity and Venture Capital firms and their respective general partners have traditionally operated at a very high level of investor confidentiality. These KYC and AML changes could result in a dramatic and significant philosophical and operational shift.
Some other correlating trends also need regular monitoring. Some countries Act’s lifting of the general solicitation ban for Private Equity firms also may elevate the need for heightened KYC requirements, as many will pursue a different, unknown population of individual investors. Questions remain about how much due diligence may be required when acquiring the securities of a portfolio company to ensure there are no AML issues at the individual investor level. Additionally, how will such portfolio companies receiving investments be required to gather KYC documentation and information from their investors? Will they need to know the LPs in the funds investing in them? Retrospective changes could end in breaches of contract and ultimately pull the carpet out from under their feet. One wonders where the chain really ends. Regulatory changes will inevitably continue, and so must the systems and procedures adopted change to comply with the changing regulatory environment. Interestingly pols done on investors suggest that they too are focusing more on due diligence than in previous years.
Foreign Account Tax Compliance Act (FATCA)
US is spreading its regulatory web to virtually all countries registered Private Equity and Venture Capital Firms with US investors, clients or beneficiaries. FATCA requires Foreign Financial Entities to register with the IRS, starting in July 2014, though the effective date has been pushed back since the final ruling. The focus is on the reporting of US taxpayers for foreign financial accounts and offshore assets as well as foreign entities in which US taxpayers own an interest or a beneficiary interest. Private Equity and Venture Capital firms with foreign LPs and/or foreign Limited Partnerships must register with the IRS or be subject to withholding of 30% on any income, which may include any proceeds from the liquidation of any fund investments. We have addressed this issue in other papers and the industry has been discussing this since 2010. We shall continue monitoring FATCA to see how it ultimately effects Private Equity and Venture Capital Firms. Those requiring more information or wishing to register, the registration with the IRS is now available at www.irs.gov/Businesses/Corporations/Foreign-Account-Tax-Compliance-Act-(FATCA) . Details regarding which payments or movement of money will require withholding can be found at www.irs.gov/pub/irs-drop/n-13-43.pdf .
So yes, it does pay or cost less (whatever your point of view), to stay diligent in an environment of complex and interrelated regulations, the most effective protection is to stay diligent and prepare for what those changes mean in practical application to the industry.
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