During the freefall of the U.S. economy of 2008 and 2009, there has been a continuing discussion among politicians, lamenting the need for more federal regulations and enforcement of existing regulations on the financial sector.
While much of Washington’s attention has turned to health care in recent months, the talk of new financial legislation hasn’t gone away.
“We should never again have to face potential calamity because of the reckless speculation and deceptive practices and short-sightedness and self-interested-ness from a few,” President Barack Obama said recently at a New York City Democratic party fundraiser, according to the Los Angeles Times.
Last week, the Federal Reserve announced plans to eliminate pay packages that encourage bankers to take financial risks, according to a report in the New York Times. Also recently, the White House announced plans to dramatically cut executive pay at banks that have accepted Troubled Asset Relief Program (TARP) funds.
While no firm proposals for new restrictions on the mergers and acquisition market have emerged to date, any change to the financial landscape will likely affect M&A throughout the country. Investment bankers are concerned about how federal financial industry reform will affect their industry and their companies.
“It’s pretty clear that the financial regulation topic is going to continue to make progress,” said Doug Marconnet, managing director with Mertz Associates Inc., a Waukesha-based investment banking firm. “In general, the government tends to overreach and that will slow down business and add costs, like the Sarbanes-Oxley (Act of 2002) which make the U.S. less competitive in a global environment.”
“My scare is that there is no such thing as little government today,” said Doug Mittman, managing director with Grace Matthews Inc., a Milwaukee investment banking firm. “They already have oversight with agencies like the SEC (Securities and Exchange Commission) and they dropped the ball with a number of fund situations. I’m a huge believer in capitalism. As soon as you have government intervention, it becomes a slippery slope – how far does it really go?”
Tax changes
Federal tax policy is likely to change in the next few years, which could have an adverse effect on the M&A market, said Mark Witt, an attorney with the Milwaukee-based law firm Godfrey & Kahn S.C., who specializes in M&A, private equity and venture capital.
“There’s been talk of raising capital gains rates to 20 percent or more and of eliminating the Bush tax cuts,” he said. “And any time you lower the returns for invested capital, you dis-incentive it. To me, that is not good tax policy in this environment from an M&A standpoint.”
The Bush administration was known for its lax anti-trust policies, and if the Obama administration ratchets up on anti-trust and monopoly enforcement, it could slow M&A activity in the upper level of the market.
“That will be another level of analysis with lawyers and analysts and government intervention,” Witt said. “Any time you have that, it makes things slower and more expensive, which will make fewer transactions close.”
Ron Miller, managing director with Milwaukee-based Cleary Gull Inc., said increased regulations governing the financial industry need to focus on the banking industry.
“There needs to be more regulation on banking, not necessarily investment banking,” he said. “There’s an absolute consensus that the system failed and that regulation and the free market participants did not self-regulate properly. A huge part of it was the lack of transparency and undue complexity.”
“The best thing (the government) can do for the M&A marketplace is to continue to follow through with the things it’s doing in the banking industry,” said Greg Myers, managing director with the Milwaukee-based private equity firm Mason Wells. “It’s been flat on its back for a while and is starting to show signs of life. The better (the banking industry) does, the better it will be for the M&A marketplace.”
Unintended consequences
In passing new legislation on some financial sectors, federal officials could adversely affect other financial markets.
Several politicians have proposed increasing regulations on hedge funds, and because those funds share similar legal documents and operational procedures with private equity investors, new regulations affecting hedge funds could impact the private equity industry.
“There will be unintended consequences in the buyout and venture capital industry if they pass on (regulations applying to) hedge funds,” said Paul Stewart, partner at PS Capital Partners LLC, a Milwaukee private equity investment firm.
“Any time you add regulation of that nature, you slow down the velocity of the capital markets, making them more inefficient,” Stewart said.
Over the last several years, other officials have suggested changing the way that carried interest is taxed for private equity investors, which could significantly increase taxes on private equity firms and their investors.
“It’s a double whammy,” Miller said. “Carried interest is likely to get taxed as ordinary income. The regulatory burden is going to go up. And those are not particularly constructive for those organizations.”
“For funds like ours that are focused on the lower end of the middle market, I don’t see the benefit of that (tax burden) and reporting,” Myers said. “Most of our investors are institutional, and the few individual investors we have are accredited. They aren’t the ones that the reporting regime was created to protect.”
If private equity funds that operate on the lower end of the middle market are required to adhere to more stringent reporting requirements to the SEC, some firms could be put out of business, said John Reinke, director with the Milwaukee-based private equity group Generation Growth Capital Inc.
“The reporting requirements could require a full time position and the costs that could go along with that would make it very difficult to run smaller private equity funds,” he said. “By applying these rules to these (smaller) funds, you’ll be making them into a scarce commodity.”
The majority of the private equity community is already holding itself to a relatively high reporting standard because of its reliance on investors for new capital, Reinke said, and if the government wanted to apply standards for the industry, it should examine what the industry is already reporting.
“To just move to full-scale SEC reporting is a little egregious,” Reinke said. “That’s more of a knee-jerk reaction to problems that were not driven by the private equity industry. I think the government needs to take a step back and ask itself what it is really trying to do. When you start talking about changing the taxes on carried interest or capital gains rules, the government probably didn’t conceive what they would create when it made those rules.”
Federal officials need to be careful with new regulations on private equity investors because of the large amounts of money many PE firms are now holding and will likely invest in the next several years, said Victoria Fox, managing director with Milwaukee-based Emory & Co.
“There are billions of dollars in there, but it is not an overly regulated industry,” she said. “I think it is a very efficient one and they should leave it alone. These firms are relatively transparent already because of their need to report to investors.”
More importantly, PE firms will play an important role in what will be a booming buy-sell market in the next 10 years, Fox said.
“I think it will be the biggest cycle I’ve seen in my career,” she said. “It’s the combination of the billions that private equity has raised and not invested and the (wave of businesses that will be sold by) baby boomers, which hasn’t really started yet – the combination of money and more business owners at the age of retirement.”
