How Private Is Private Equity? Securities Law Hurts the Private Capital Markets
Spindler, James C., Regulation
The financial reform plan of Obama Treasury Secretary Timothy Geithner includes measures to rein in private equity and other forms of private capital formation that have been, up until now, largely exempt from the federal securities laws. Geithner and the Obama administration would require registration and reporting from these otherwise private entities, bringing them under the discretion of the Securities and Exchange Commission (or whatever regulator might take its place).
A commonplace justification for this sort of registration and reporting program is that disclosure does not place a great burden on companies--all they need to do is not lie. But this begs several questions: What does it mean to say that private equity is "private"? What are the advantages of being private in this sense? And if there are benefits to being private, why is it that not everyone does it?
In answering those questions, I will make two related points in this essay: First, disclosure is not a costless activity and the benefit of being private is that private firms can limit their disclosures and avoid those costs. Because of the uncertainty regarding the future and the inherent subjectivity of reporting (even of ostensibly historical information), imperfectly enforced disclosure rules can have the effect of placing a great deal of risk on firms and managers--risk that is better borne by a firm's diversified security holders. The securities laws essentially impose mandatory contract terms that would unwind the optimal risk-sharing arrangements that firms, their shareholders, and their managers would prefer. Maintaining exemption from the securities laws is then a form of regulatory arbitrage: by structuring one's capital formation in a certain way, much of the regulatory apparatus applicable to public companies may be bypassed. The benefits of such a strategy are especially appealing where, as in the realm of private equity, managers and entrepreneurs tend to have large personal investments in the firm and are particularly vulnerable to the securities laws' imposition of risk. Bringing private firms under the regulatory radar would largely eliminate these benefits of regulatory arbitrage without offering much in the way of offsetting value, as there is very little reason to think that private equity investors are unable to bargain for joint welfare-maximizing contractual provisions.
Second, this regulatory arbitrage process is neither painless nor free. Opting out of the federal securities regime requires considerable distortions of behavior. The relationship between the private equity fund and its investors, the limited partners, is severely constrained. To opt out of securities law liability, funds must be structured to provide limited partners with little or no disclosure, few or no control rights, and artificially reduced liquidity of limited partnership interests. While such a complement of contractual provisions avoids much of the securities laws' reach, it imposes the cost of greatly reducing the accountability of the general partner and exacerbating agency costs in the management of the private equity firm. One manifestation of these agency costs is the dramatic performance-based compensation (the customary 20 percent "carried interest" that general partners receive) required to align incentives between general and limited partners. While there is a tendency to view the general partner's 20 percent cut as a market wage for extraordinary talent, it is more properly attributable to the massive agency costs that the typical private equity structure creates. It is also a measure of the extent to which the public capital markets have been degraded with regulatory over-reaching: while the costs of being private are large, the costs of being public are greater still.
Put another way, the negative impact of the U.S. securities laws are not limited to the public company sphere. In the world of private equity, the constraints of compliance with securities law exemptions create a situation in which limited partner investors must give up much or all of their ability to monitor their investments and to hold fund managers accountable by controlling or exiting the fund. …