Private equity is posting a strong finish to the decade, continuing the trend
of the past several years. Fundraising remains healthy, and both terms and
interest rates remain favorable to borrowers for leveraged deals. And while
some Brexit-related uncertainty remains, the recent Conservative victory
seems to be bringing that long-running drama to an end.
To be sure, there are challenges as well: valuation multiples remain high
and there is growing concern that we may be nearing the top of the
economic cycle. Notably, the market has responded not by downshifting,
but by creating new types of opportunities structured to meet evolving
investor priorities. Neither ongoing trade wars nor the political tensions in
the United States and the UK have dampened the market’s fundamental
outlook. The tax and regulatory situation for private equity is generally
stable as well, although there are several areas that will undergo increased
regulatory and enforcement scrutiny.
Our 2019/2020 Private Equity Review and Outlook offers our
perspective on the year behind us and highlights some of the trends
and developments to watch for in the year ahead.
Global fundraising activity in 2019 has remained steady after the record-breaking levels
achieved in recent years. With nearly $200 billion of capital raised through the third
quarter, we expect this year’s total to match, if not exceed, the amount raised in 2018.
While changing economic, political and regulatory landscapes may affect the private
equity fundraising markets as we head into 2020, investor appetite generally remains
strong, and so we anticipate this long-running fundraising strength to continue.
One of the most notable trends in the private equity fundraising space is the growing
desire of investors to diversify their portfolios. LPs are expanding their mandates to include
more jurisdictions and strategies. Sponsors are responding by diversifying their businesses
both geographically and across asset classes, increasing the number of product lines they
offer and pursuing new types of strategies. Over the past year, we saw multiple firms that
historically focused on raising traditional buyout funds expand their businesses to include
more specialized strategies, including infrastructure, emerging markets and growth equity.
With many of the view that we are at or close to a market peak, we expect to see further
diversification next year with firms increasingly pursuing distressed debt, special situations
and credit strategies.
Another trend we are seeing is a notable increase in the role of private equity sponsors as
managers of insurance company assets, including both significant acquisitions by private
equity sponsors and funds of insurance businesses as well as fund, managed account and
other specialized investment arrangements such as “collateralized fund obligation,” ICOLI
and rated note structures. As these products and structures are refined and continue to
gain prominence, we expect sponsors to be able to offer an increasingly sophisticated set of
options to insurers that are seeking less liquid assets in exchange for the potentially higher
yields sought by core private equity strategies.
Finally, we are also seeing a growing desire by investors to participate in co-investment
opportunities and invest in alternative fund structures, including permanent capital vehicles
and other long-dated funds. These types of investment activities provide LPs with several
benefits. For example, investing in longer-term and permanent capital vehicles offers a
stable and low-risk investment opportunity with regular cash flows and a lower fee burden.
Investors also are attracted to long-dated asset classes because of the flexibility they provide
to invest in companies that may require a longer time horizon to deliver returns. As more
investors begin to recognize the benefits of these new structures, we expect demand for
them will increase, with sponsors in return providing more such opportunities in the
Collateralized Fund Obligations
The groundbreaking development in fund financing for 2019 was the growing use of
collateralized fund obligations (CFOs) to help sponsors raise capital for their private funds.
These structures are particularly appealing to insurance companies investing in funds on
a risk-based capital-efficient basis. CFOs can be structured as investments in a diversified
portfolio of funds or used in a single commingled fund. During 2019, we advised on several
of these transactions, as sponsors and investors sought to find innovative and effective
ways to structure investments in funds.
While environmental, social and governance (ESG) criteria have been part of the investing
landscape for some time, in the past year we have begun to see sponsors increase their
prioritizing of ESG in fund finance transactions. One novel and interesting approach has
been to vary the margin on fund-level subscription facilities by referencing the fund’s ESG
performance. The parties to a financing agree to set the margin at an initial level and, on
each anniversary of the facility, adjust the margin to reflect the fund’s ESG performance
against certain key performance indicators.
We previously highlighted the growing popularity of net asset value facilities and hybrid
facilities (where the borrowing base is a combination of uncalled investor commitments
and fund investments). This trend continues, with NAV facilities increasingly no longer
raised only by credit and secondaries funds (which have liquid assets), but also by private
equity funds (with less liquid underlying assets).
M&A and Leveraged Finance (U.S./Europe)
After a slow start to 2019 following equity market turbulence at the end of 2018, private
equity deal volume picked up considerably in the second quarter and has stayed strong
through the end of the year.
In the face of continuing high valuation multiples, we have seen sponsors continue to
look beyond traditional leveraged buy-outs to deploy capital, pursuing growth equity
investments, joint ventures and minority investments.
This past year saw a robust number of sponsor sale auction processes, perhaps driven by
valuation multiples and perceptions regarding where we sit in the economic cycle, and
we expect sponsor sale processes to continue to come online as we enter 2020.
For now, deal volume shows no signs of slowing. To be sure, uncertainty around the 2020
U.S. presidential election looms large, though we expect any effect to be most pronounced
in industries such as healthcare, which have the potential to be directly affected by a
change in government policy. Concerns regarding the U.S./China trade dispute also persist,
though, to date, we have not seen a direct impact on overall deal activity.
U.S. Leveraged Finance
The leveraged finance market experienced a credit quality bifurcation in 2019 of the type
that we have not seen in a number of years. Significant outflows of retail investors from
leveraged loans funds, together with trade issues, increased pressure on yield and concerns
over the possibility that we are reaching the peak of the current economic cycle all
precipitated a flight to quality, with high-quality credits able to obtain syndicated financing
on peak terms. On the other hand, credits with any hint of blemishes or question marks
(especially involving EBITDA adjustments) struggled to obtain commitments and in
syndication, with most such deals being fully flexed, some even pricing beyond the flex.
These factors led to a record year for the private debt markets, with sponsors looking
for transaction financing, ranging from large-cap deals to lower-middle market deals, an
area where private capital has been an important source of capital for many years. This
development reflects the maturation of the private debt market, which has experienced
record fundraising almost every year during the last half of the decade. That growth has
allowed funds to provide ever-increasing commitments, which in 2019 facilitated several $1
billion-plus unitranche deals for companies with EBITDA in excess of $100 million. Sponsors
have benefited from the availability of this capital, which provides certainty of term, the
absence of flex and the ability to execute quickly with no marketing or ratings requirements.
As we look forward to 2020, we expect that sponsors, particularly in the middle market,
will continue to test the bounds of investor appetite for aggressive syndicated loan
terms. They will also continue to explore the availability of alternative sources of capital
in the private debt markets as traditional financing markets continue to fluctuate in the
face of investor uncertainty regarding the longer-term economic outlook.
As in the United States, creative deployment of capital in Europe is likely to remain decisive
for strong returns in the context of an oversubscribed European buyout market. Take-privates
are increasingly popular in spite of high premiums, as public targets become comparatively
more affordable relative to the high multiples seen in private M&A transactions.
Traditional buyout specialists are also turning their attention to minority stakes in an attempt
to create diversified portfolios that address investors’ concerns over Brexit and recessionary
signals. In light of the current industry-wide stabilization trend, risk-distributing acquisition
structures such as partnerships with strategic buyers, co-investments and joint ventures have
also become more attractive in the face of market volatility and macroeconomic uncertainty.
Europe Leveraged Finance
We are continuing to see loan documents that are very friendly to sponsors and borrowers,
with “cov-lite” now the norm. Sponsors continue to push for and obtain increased covenant
flexibility with additional add-backs to EBITDA (including cost savings and synergies, often
in unlimited amounts). Sponsors are also obtaining restrictions on loan transferability, which
inhibits the lender’s ability to transfer to the secondary market without obtaining borrower
consent. There continues to be a downward pressure on interest rates. New alternative
lenders are appearing on the growing non-bank direct lending market, with direct lenders
increasingly able to move beyond small to mid-market deals to fund larger transactions.
Last week’s UK election handed the Conservative party a decisive mandate to form a majority
government to “Get Brexit Done.” While that vote provided a sense of direction, plenty
of uncertainties remain. For example, the Conservative election manifesto was curiously
silent on changes to UK tax policy that might be needed to help cover funding gaps and
improve the UK’s post-Brexit global competitiveness. In any event, private equity firms whose
investment structures include UK companies should plan for the fact that they will soon no
longer benefit from the EU Directives that currently remove withholding taxes on interest
and withholding taxes and income tax on dividends, in each case paid between a UK company
and a group company in an EU member state. In addition, the EU Directive that facilitates the
tax-neutral treatment of cross-border mergers between a UK company and a group company
in an EU member state will no longer apply. However, it appears that there will be no material
changes (other than administrative) to the UK’s VAT regime, even though this is an EU-mandated
tax. We’ve previously commented, in some depth, on these tax aspects of Brexit.
Brexit-related tax questions aside, the new Conservative government’s intention appears to
be to keep much of UK taxation the same as it is, although there will be changes in some
areas. For private equity firms holding UK businesses in their portfolio, the following three
points in particular should be kept in mind:
The UK’s corporation tax rate will remain at 19 percent (rather than be reduced to 17
percent, as previously proposed).
Entrepreneur’s relief, which can lower a UK seller’s effective UK capital gains tax rate on
disposal of an interest in a trading business from 20 percent to 10 percent, will be reviewed.
Tackling tax avoidance and evasion will be the subject of renewed focus, in part by
implementing the controversial digital services tax, which is most likely to affect UKinbound
multinational enterprises with material UK sales.
Early 2020 should also bring long-awaited final guidance from HM Revenue & Customs
regarding the rules covering carried interest and disguised investment management fees.
The extent to which the final guidance deviates from prior draft guidance remains to be seen.
Once the final guidance has been published, private equity firms may wish to review their
UK principals’ remuneration with their advisers.
Separately from the new UK tax developments described above, private equity firms that
invest in Europe may find themselves directing significant resources in 2020 toward dealing
with a number of tax initiatives that had surfaced previously.
Despite what appears now to be its departure from the EU, the UK has committed to
implementing “DAC6,” an EU disclosure regime that will require taxpayers and their advisers
to report to EU tax authorities cross-border transactions that touch the EU and include
certain “hallmarks.” Because some of these hallmarks are not tax-related, they may expand
the universe of reportable transactions in unexpected ways. As we’ve discussed previously,
the UK’s draft regulations implementing the regime, published in July, suggest that
these reporting obligations could be very onerous for private equity firms, their portfolio
companies and their advisers. In particular, there is some uncertainty as to whether common
fund transactions involving tax-exempt investors or hybrid entities may become routinely
reportable. However these issues are resolved, firms should prepare well in advance of
the first reporting deadline in August 2020, which will cover all reportable arrangements
implemented since 25 June 2018. The final UK regulations are expected in early 2020.
Over the past few years, the UK and EU have sent increasingly clear signals that UK and
European tax authorities will no longer tolerate private equity investment holding structures
that lack sufficient substance in their jurisdiction of establishment. One such signal came
in February, with the judgment handed down by the senior court of the EU in the so-called
“Danish cases.” The court’s ruling indicated that a Luxembourg company, which held a
European investment that was ultimately owned by a non-EU private equity fund, had to be
the “beneficial owner” of investment proceeds in a broad sense (i.e., not bound to pass on all
such proceeds to its owners) in order to benefit from a reduced rate of withholding tax on
interest under an EU Directive.
This scrutiny of holding structures is also reflected in the recent ratification by the UK and
many other jurisdictions (including Luxembourg) of the BEPS multilateral instrument
(“MLI”). Under the MLI, starting in 2020, certain of the UK tax treaties most commonly
used in the private equity context will no longer allow the granting of treaty benefits to an
arrangement in which obtaining those benefits was “one of the principal purposes” of that
arrangement. Private equity firms should carefully assess the integrity of their European
investment structures so that they do not fall foul of these changes. For further
background, see our notes on the MLI and the introduction of the BEPS Action 6
“principal purpose” test.
Finally, private equity firms with UK real estate investments should note an important
deadline, in April 2020, in the rollout of the UK’s “NRCGT” capital gains tax charge for
non-UK resident investors on direct and indirect disposals of UK real estate. One of the
major NRCGT structuring tools available to widely held funds is an “exemption election,”
which can exempt certain gains from taxation provided that the election is made within 12
months following its effective date. Given that the NRCGT rules came into effect in April
2019 (as previewed in the 2018-2019 YERO), firms that are planning on using the exemption
election should aim to make the election, or at least discuss their plans with their advisers
and HMRC, by April 2020 (with an effective date of April 2019) in order to reduce the risk of
investors bearing preventable tax costs and a reduction in firms’ carried interest returns.
Although 2019 saw successive extensions to the date on which the United Kingdom
will leave the European Union, it is now almost certain that it will do so by the end of
January. However, as it turns out, preparations for the possibility of a “no-deal” Brexit
may still prove to be useful. The transition period – which seems likely to end on 31
December 2020 – may lead to a cliff-edge Brexit, if a new free trade agreement cannot
be agreed in time. Furthermore, it is very unlikely that any such trade agreement will
deal extensively with financial services, meaning that “passporting” will probably be lost
when the transition ends. Most firms are now familiar with the risks that a hard Brexit
entails, and are as prepared as it is possible to be, but 2020 will see them looking at their
contingency plans once again.
In the private equity sphere, Brexit risk has focused on any restriction that Brexit will
impose on a UK firm’s ability to approach EU investors during fund-raising. Working on
the general assumption that UK-managed funds will no longer have the benefit of the EU
AIFMD marketing “passport” (which would depend on extension of the “third country”
passport to the UK – not likely in the short term), Luxembourg and (to a lesser extent)
Ireland are now firmly established as the EU hubs for private equity fund management.
Many managers intend to continue their portfolio management and fund-raising activities
from a UK office, often with authority delegated by a manager in Luxembourg or Ireland.
However, such an arrangement will need to satisfy regulators scrutinizing the “substance”
of the EU office and its ability to supervise the UK team’s activities.
Brexit aside, many fund managers are finding the regulatory aspects of EU fundraising
more and more complex, having to navigate a complex set of “hard” and “soft”
preferences of EU investors. Faced with these challenges, an increasing number of
managers outside the EU are giving serious consideration to an EU structure, either in
parallel with or even in place of their traditional non-EU structure. In addition, while
the European Commission’s forthcoming changes to AIFMD under the Cross-Border
Marketing Directive are intended to harmonize the definition of “pre-marketing” across
jurisdictions, the market widely regards a tightening of the conditions for “reverse
solicitation” as the regulatory quid pro quo, bringing the possibility of increased
enforcement activity to an area that has attracted little such attention to date.
In the UK, the FCA continues to place a very modest focus on the private equity
industry, having little desire to interfere with arrangements negotiated between
investors and funds or to question the sufficiency of managers’ fiduciary duties. All
FCA-authorized private equity firms implemented the Senior Managers Regime by 9
December 2019, with the new accountability requirements putting internal governance
arrangements on a clearer and more formal footing. In addition, the FCA initiative to
improve cost reporting to investors across the asset management industry led to the
publication of template reports in 2019, which were largely adopted by the industry.
The European Commission, meanwhile, is re-doubling its efforts on environmental,
social and governance (ESG) matters. The forthcoming European Disclosure Regulation will
require most private equity managers to disclose how they have considered sustainability
issues that affect the value of an investment and to state whether they have taken
account of societal impacts more broadly. But, since many private equity firms have
become further engaged with ESG issues in recent years, the Disclosure Regulation
seems unlikely to impose unworkable new burdens on the industry, and is largely moving
in sync with increasing investor requirements.
The Securities and Exchange Commission (SEC) is likely to continue its focus on
retail investors. Consistent with recent years, the priorities of the Office of Compliance
and Examinations (OCIE) in 2019 were primarily directed toward protecting retail
investors. However, private fund sponsors continue to receive attention as well, with
disclosures concerning conflicts of interest and fees and expenses being of particular
concern. We expect these trends to continue in 2020.
The SEC adopted an interpretation of the fiduciary duty applicable to investment
advisers—including private fund managers—under the Advisers Act. The final
interpretative release includes several notable clarifications made in response to comments
to the interpretation that the SEC initially proposed in April 2018. Among other things, it
emphasizes the differences between retail and institutional clients and provides guidance
on disclosures regarding conflicts, including on the allocation of investment opportunities.
We expect that this interpretive guidance will inform future SEC regulatory initiatives
and OCIE examination findings. Investment advisers should continue to review their
disclosures, particularly with respect to conflicts of interest, to determine whether they
need to be supplemented or clarified to keep pace with this guidance.
The SEC has proposed significant amendments to modernize the Advertising Rule
under the Advisers Act. The proposed amendments to the Advisers Act Advertising
Rule (Rule 206(4)-1) would expand the definition of “advertisement” to capture more
modern communications and expand the Rule’s general prohibitions while removing
some of its more specific prohibitions. In addition, the proposed amendments would
impose new requirements regarding performance presentations. The SEC also proposed
amendments to the Cash Solicitation Rule (Rule 206(4)-3) that would extend the
application of the Rule to persons who solicit investors for private funds. Finally,
reflecting its focus on retail investors, the SEC recently re-proposed a rule governing
mutual fund investments in derivatives.
The SEC is expected to propose amendments to the Custody Rule in 2020. In March
2019, the SEC Division of Investment of Management (DIM) solicited feedback on the
Custody Rule (Rule 206(4)-2) regarding non-delivery-versus-payment settlements and digital
assets. However, the proposed amendments are expected to go beyond these two issues.
Federal agencies approved certain amendments to the Volcker regulation
addressing the proprietary trading prohibition, with more changes expected. The
agencies adopted certain existing guidance regarding covered funds provisions; however,
the bulk of the issues pertaining to covered funds will be the subject of a future proposed
The legislative environment remains uncertain. Several pieces of congressional
legislation have been recently proposed that could affect the private equity industry. While
none of this legislation appears close to being adopted, the U.S. House of Representatives
did hold a hearing focused on the private equity industry on November 19.
Upcoming action by both the U.S. Supreme Court and Congress may impact the
SEC’s ability to seek disgorgement in federal district court. In early November,
the Supreme Court agreed to hear an appeal challenging whether courts possess the
authority to order disgorgement in SEC enforcement proceedings. The case, Liu v. S.E.C.,
follows on the heels of the Supreme Court’s 2017 decision in Kokesh v. S.E.C., which
found that disgorgement is a penalty and therefore subject to a five-year statute of
limitations. In Kokesh, the Court expressly declined to address the same issue—judicial
authority to order disgorgement in SEC proceedings—that Liu will now directly address.
Meanwhile, the U.S. House of Representatives in November passed with bipartisan
support H.R. 4344, a so-called “Kokesh fix” that would amend the Securities Exchange
Act of 1934 to allow the SEC to seek disgorgement of ill-gotten gains for a period of 14
years. Although similar legislation has been introduced in the U.S. Senate and referred to
the Senate Banking Committee, no further action has been taken. Such a “fix,” were it
to pass, would moot the potential significance of the Liu appeal.
The SEC’s Division of Enforcement Annual Report for 2019 showed a continued
focus on asset managers. In addition, the Report showed overall enforcement numbers
(both monetary remedies and total cases brought) increasing modestly from FY 2018.
In FY 2019, the SEC brought 181 cases related to investment advisers and investment
companies, the most of any category reported, and a 77 percent increase in the same
category from the prior year. That said, the majority of those cases stemmed from SEC’s
retail-focused Share Class Selection Disclosure Initiative. But even with its ongoing
focus on retail advisers, the SEC continued to scrutinize private equity firms in 2019
and brought several enforcement actions against them involving conflicts of interest,
valuation, and compliance with the Custody Rule. Asset managers should expect the
SEC to bring cases on similar issues in the coming year, as well on the continuing hotbutton
matters of virtual currencies and cybersecurity.
UK Business Integrity
Recent Developments in the Law on Parent Company Liability in the UK
Environmental, social and governance (ESG) issues have become increasingly pressing
for private equity and venture capital firms, with responsible investors taking care to
ensure that their portfolio companies comply with applicable legal rules and adopt
relevant best practices. However, recent developments in UK domestic law have brought
into focus the risks associated with greater involvement by parent companies (and, by
extension, investors) in the policies and operations of their subsidiaries or underlying
Although the parent-subsidiary relationship cannot in itself give rise to a duty of care for
parent companies as a matter of UK law, several cases have explored the circumstances
in which a parent company can nevertheless assume responsibility for the wrongdoing
of subsidiaries. For example, a number of significant UK Court of Appeal cases in 2018
appeared to confirm that parent companies could not assume responsibility merely
through the imposition of mandatory group-wide policies. In those cases, the relevant
test was said to be one of “control”: Did the parent company exercise a sufficient level of
control over the business operations of the subsidiary? The Court of Appeal generally
took the view that group-wide policies by themselves did not meet this criterion.
The test was revisited this year by the UK Supreme Court in Vedanta Resources PLC
v. Lungowe, a case which involved a claim brought by a large number of individuals
in Zambia against a Zambian copper mining company and its UK-based parent
company. The Supreme Court confirmed that the key question is the level of control or
intervention exercised by the parent company in the management of the subsidiary’s
operations. By way of illustration, the Supreme Court drew a distinction between passive
investors and vertically integrated corporate groups whose business is carried on “as
if they were a single commercial undertaking, with boundaries of legal personality
and ownership within the group becoming irrelevant, until the onset of insolvency, as
happened with the Lehman Brothers group.”
In this respect, the Supreme Court merely reiterated the test that had been applied by
the Court of Appeal. However, the Supreme Court then went further and opined that
group-wide policies may also give rise to a duty of care in certain situations. Lord Briggs
gave the following examples of situations where group-wide policies might result in
liability for a parent company:
Where the group-wide policies concern the environmental impact of inherently
dangerous activities and are shown to contain systemic errors which, when
implemented by a particular subsidiary, then cause harm to third parties.
Where the parent company does more than merely proclaim the group-wide policies
by, for example, taking active steps such as training, supervision and enforcement in
order to ensure that they are implemented by subsidiaries.
Where the parent company holds itself out in published materials as exercising a
degree of supervision and control over its subsidiaries, even if it does not in fact do so.
Although this new guidance appears to introduce the possibility of far-reaching liability
based on high-level statements, it is important to bear in mind that it was given in the
context of the overriding test, which remains one of control or intervention. In other
words, the examples set out above still relate to the degree of control exercised by a
parent company over its subsidiaries. Moreover, the Supreme Court did not technically
decide the duty of care question on the merits, and so the precise scope of parent
company responsibility remains to be determined.
This state of affairs may be of little comfort to investors who want clarity on exactly
where the “control threshold” lies. However, while that clarity will have to wait for
future cases, the key takeaway is that the criterion used in determining liability remains
the parent’s degree of control over the subsidiary’s operations. Further, the Supreme
Court took the view that “passive” investors in separate businesses (i.e. separate to their
own) are unlikely to cross the requisite control threshold. This category of investors
would appear to include investment funds and even, possibly, private equity portfolios—
in other words, equity investors that do not form part of an overarching, vertically
integrated corporate group.
So private equity fund managers and the funds that they manage are not in exactly the
same position as parent companies. Nevertheless, managers should exercise some degree
of caution in relation to their public statements regarding the actual level of control they
exercise over portfolio companies, since the underlying legal principles are the same as for
parent companies—and those principles are not yet settled.
That could change next year: There are a number of cases on the horizon that should
provide the Supreme Court and the lower courts with an opportunity to throw further
light on the issue of parent company liability. In 2020, the Supreme Court will hear the
appeal from the Court of Appeal decision in the Okpabi case, involving Royal Dutch
Shell and the Shell group of companies. In any event, there are similar cases waiting in
the wings and the UK courts will have to grapple with parent company liability again
Debevoise & Plimpton represented Royal Dutch Shell in the case His Royal Highness
Okpabi v Royal Dutch Shell Plc referred to above.