Private Equity Regulation: 2023 Changes and Impact on Finance Careers

Private equity was viewed as a “lightly regulated” industry for a long time.

Only wealthy individuals and institutions could invest, so governments cared less about PE firms than commercial banks and brokerages.

But that is changing as of 2023, as the U.S. government has become more aggressive about regulating all “private funds” (private equity, hedge funds, venture capital, etc.) and reviewing M&A deals.

If you’re not familiar with these recent developments, I’ll summarize them below and explain how they could impact your career.

I don’t think anything the government has proposed will “kill” these industries, but the new regulations will make them less appealing:

Private Equity Regulation: What’s Changing? And Why?

You can read all ~660 pages of the new “Private Fund Rule,” but the SEC’s summary is more than enough. Dentons also has a good summary with more details on some rules.

In short:

• Quarterly Financial Statements: All “private funds” must now issue quarterly statements to investors with the fund’s performance, fees, and expenses.
• Liquid vs. Illiquid Funds: “Illiquid funds” (most private equity firms) have more reporting requirements than “liquid funds” (most hedge funds) and must present metrics such as the IRR, MOIC, and contributions and distributions.
• Annual Audits: Each private fund must receive an annual audit.
• Preferential Treatment: Firms cannot use “side letters” to give certain investors materially better terms unless they disclose them to all the other investors.
• Secondary Transactions: If there’s a “secondary transaction,” i.e., an existing investor sells its stake in the fund, the fund must get a Fairness Opinion or valuation opinion to demonstrate that the price and terms are reasonable.
• Restrictions on Certain Practices: Finally, certain activities, such as charging for regulatory/compliance fees as part of the fund expenses, are now restricted unless everything is disclosed to all the investors.

These rules were watered down from the original version the SEC proposed last year.

The original version also had provisions around the limited liability for “negligence” that would have made it easier for investors to sue PE firms for bad performance.

The changes above may sound small, but they are the most significant new rules for the industry in 10+ years, and they will affect firms’ operations.

Just as one example, private equity firms often use “side letters” to offer better redemption terms to win anchor investors for their new funds.

If they can win a well-known Limited Partner with these terms, they can use this LP’s commitment to persuade other investors and raise more capital.

Technically, they could still do this under these new rules, but later investors might demand similar redemption terms since they’ll know about the sweetened deals now.

As a result, it could become even more difficult to start a private equity firm, and you’ll likely need more time, capital, and experience.

The other new rules above will result in higher compliance costs, which firms could use as an excuse to limit compensation increases.

The private equity and hedge fund industries have sued the SEC to block these rules, but I doubt they will win.

Why Does the U.S. Government Suddenly Care So Much About Private Equity Regulation?

The main issues here are:

1) The “private funds” industry has grown tremendously since 2008 and has over $25 trillion in assets, more than the entire commercial banking sector in the U.S.

This WSJ article has a good summary graph:

2) Many teacher, firefighter, and other pensions have invested in PE firms and hedge funds, and regulators are concerned that they may be paying exorbitant fees for overstated performance.

The Biden administration has taken a much more aggressive approach toward antitrust and financial regulation, and these new rules are extensions of that.

Other Changes Related to Private Equity Regulation

Another other significant change is a revision of the HSR filing process.

In the U.S., the Hart-Scott-Rodino (HSR) Act requires firms that complete a merger to report the deal to the government, assuming they have revenue or assets above certain thresholds.

This filing isn’t required for small deals, such as $20 million acqui-hires, but it’s part of the process for almost all M&A deals that bulge bracket and elite boutique banks advise on.

Up until now, the HSR filing has mostly been a formality.

In theory, the government takes 30 days to review the deal for “potential competition issues,” but in practice, almost all deals get approved without questions.

The Federal Trade Commission and Department of Justice have proposed major changes to this process that will require acquirers to disclose points such as:

• The transaction rationale, the acquirer and target’s existing relationships, and the potential synergies.
• Details about how the firms’ products and services will be affected and how the key supplier relationships might change.
• Information about previous acquisitions, which could affect many PE firms using “roll-up” strategies to complete bolt-on acquisitions.
• The major creditors and investors in the deal, any foreign governments and PE firms that might be involved, and relevant subsidiaries and Board members.

These are only the proposed rules, so the final version could be watered down.

But even if only some of these requirements go into effect, lawyers will have to spend a few extra weeks drafting documents for deals.

Matt Stoller has a great overview and commentary about these changes if you want more details.

The large corporate law firms started freaking out months ago when the FTC and DOJ announced these changes and requested outside comments.

Yes, these new rules mean more billable hours – but they also make deals less likely to happen, which hurts their overall business.

So, How Bad Are These Regulatory Changes?

As I said at the top, I don’t think anything proposed here will “kill” industries like private equity, venture capital, or investment banking, but they certainly won’t help.

The macro environment continues to be quite bad due to higher interest rates, inflation, poor demographics, and everything else I’ve covered previously.

These new regulations will make it more difficult and expensive to execute deals and make many firms think twice before pursuing an M&A growth strategy.

I expect that fewer PE firms and hedge funds will launch, and when they do, they’ll need to raise more capital to pay for these higher expenses.

Banks might get additional business because of the Fairness Opinions required in secondary deals and the new HSR filing requirements, but none of that matters if fewer deals occur.

In short, these changes make an uptick in deal activity less likely, even if the macro environment improves.

What Does This New Private Equity Regulation Mean for Finance Careers?

I expect the following changes:

• Starting your own private equity firm, hedge fund, or venture capital firm will become even more expensive and time-consuming; expect fewer VPs, Directors, and MDs to follow this path.
• Small funds will be affected more than large ones because they are more resource-constrained, and even a few additional compliance hires will make an impact. Unlike what I previously predicted, smaller/startup firms might not offer better long-term prospects.
• There may be more of a divergence in private equity and hedge fund compensation over time because of how these new rules distinguish between “liquid” and “illiquid” funds. There is already more variance in HF pay, but it could become even more variable if the SEC continues to make separate rules.
• M&A investment banking is unlikely to recover anytime soon because deals will become more difficult to close. There may be a shift from always favoring M&A experience to preferring more diversified deals.

I still believe that the poor macro environment is the biggest problem, but these new rules do not help things.

It’s the “death by a thousand cuts” model, where each rule itself is not that bad, but when taken together, they dampen activity, slow down deals, and make it harder to do everything.

But that’s the goal of most government rules, and private equity regulation is no different.