Private equity firms fear broker-dealer registration

Once a loosely regulated bunch, private equity firms might have to register as broker-dealers or find their ability to charge transaction fees or provide bank-like services impaired. These are the very services that help them attract portfolio companies.

The Securities and Exchange Commission rocked the private equity world last month when agency officials settled with private equity firm Blackstreet Capital Management for $3.1 million, signaling in a three-page agreement that if private equity firms want to charge transaction fees, they might have to register. According to the June 1 settlement, Blackstreet ran afoul of regulators by engaging in brokerage activity related to the acquisition and disposition of portfolio companies without registering as a broker-dealer.

Private equity firms perform a number of services for their portfolio companies, such as help them raise capital and assist with mergers and acquisitions.

Registration as a broker-dealer is not something private equity firms are eager to do because it is an expensive process and opens these firms up to another set of regulations and regulators, industry insiders and lawyers say. In order to avoid broker-dealer registration, many private equity firms have been offsetting as much as 100% of transaction fees against the management fees and/or carried interest.

“The new concern arising from Blackstreet is that private equity firms may need to become registered as broker-dealers if they engage in investment banking activities for their portfolio companies,” said David Fann, president and CEO of San Diego-based private equity consultant TorreyCove Capital Partners LLC. “This could be a new chapter of regulatory oversight for some private equity firms.”

The issue of registration first came up in a 2013 speech to the American Bar Association by David Blass, then chief counsel in the SEC's division of trading and markets who mentioned that private equity firms were charging transaction fees for investment banking and other banking services. In 2014, the SEC released a no-action letter on the issue, which provided limited relief only for brokers that solely worked on mergers and acquisitions, making relief generally unavailable to most private equity firms, according to a June 21 memo on the issue by law firm Winston & Strawn LLP.

What has gotten the private equity world rattled is that the Blackstreet settlement involves charges that the private equity firm had acted as an unregistered broker-dealer. It shows the broker-dealer issue, which seemed dormant, is still top of mind at the SEC.

Judith A. Burns, an SEC spokeswoman, declined to comment.

The SEC has been delving into the world of private equity since the financial crisis. In recent years, the SEC has brought actions against private equity firms for lack of disclosure on fee streams from portfolio companies, such as fees charged to the private equity funds for payments to operating partners and operational resources, Mr. Fann explained.

Now, it seems the SEC is considering whether private equity firms are acting as brokers for providing portfolio companies services that once were provided by investment banks. Indeed, some private equity firms tout these capabilities as a part of the value they add to portfolio companies, and most private equity firms aren't registered as broker-dealers, Mr. Fann said.

“Being a broker-dealer necessitates a different, and perhaps higher, degree of compliance, firm oversight and regulatory sensitivity than being a registered investment adviser,” he said.

Officials at the American Investment Council, a Washington-based private equity trade group, are in talks with the SEC regarding the broker-dealer issue, said James Maloney, council vice president, public affairs.

“We have discussed this issue with the SEC for some time and will continue to do so,” Mr. Maloney said in an e-mail. “Private equity investment advisers are not broker-dealers and should not have to register as such.”

Private equity managers provide investment advisory services and expertise for their funds and portfolio companies, Mr. Maloney stated.

“Layering broker-dealer regulations on private equity would levy unnecessary and significant costs on the firms,” he said.

Many asset owners are unsure what the impact would be on their private equity portfolios if private equity firms are required to register as broker-dealers.

“While CalSTRS is following the SEC settlements, we ... don't yet have enough information to comment on the impact to our partners or portfolio,” said Ricardo Duran, spokesman for the $188.8 billion California State Teachers' Retirement System, West Sacramento.

The managers in CalSTRS' $16.8 billion private equity portfolio charged an average of 1% of the transaction size in deal fees or success fees as of Dec. 31, 2014. CalSTRS did not report transaction and brokerage fees in its latest annual investment cost report dated Nov. 4, 2015.

Until the Blackstreet Capital settlement, executives at private equity firms believed they could avoid registering as a broker-dealer if they refund 100% of transaction fees to investors. However, the Blackstreet Capital settlement seems to signal that private equity firms might have to register anyway, or at least throws that assumption into question, said Zachary Barnett, Chicago-based partner and head of law firm Mayer Brown's fund finance practice.

Registration is an expensive process and would subject private equity firms to broker-dealer regulations, which are even stricter than the investment adviser rules to which they are now subject, Mr. Barnett said.

What made private equity insiders take notice about the Blackstreet settlement is that the limited partnership agreements for Blackstreet's two private equity funds allowed Blackstreet to charge transaction or brokerage fees. Blackstreet Capital was registered with the SEC as an investment adviser, but not as a broker-dealer. In exchange for charging transaction fees, Blackstreet executives solicited deals, identified buyers or sellers, negotiated transactions and arranged financing. The settlement said Blackstreet received approximately $1.8 million in transaction-based compensation for providing these services.

However, the SEC's Blackstreet order is skimpy on details, including whether the firm had offset any portion of the transaction fees, the Winston & Strawn memo on the settlement noted.

For private equity firms, these services are a source of fee revenue. The total amount of how much asset owners pay each year in transaction fees is hard to calculate, however, because investors sometimes receive credits against some fees.

For example, KKR & Co. LP earned $97.3 million in transaction fees in the first quarter, its second highest source of fee revenue after management fees of $156.3 million. Credits against fees including transaction and monitoring fees, were $22.4 million. Plus, while fee credits generally amount to 80% or 100% after expenses, the actual percentage varies among funds and classes of fund investors, KKR's latest 10-Q filing showed.

Adding to the concern about the Blackstreet enforcement action is the knowledge that the private equity universe is changing. Not only are private equity firms the buyers in deals, but some of the larger private credit firms now have sales forces to help them syndicate portions of the loans to other investors, sources said.

“Some of the larger non-bank lenders are now underwriting and syndicating middle market loans which were traditionally done by investment banks,” said Arthur H. Penn, founder, CEO and chairman of New York-based private equity firm PennantPark Investment Advisers LLC. “These alternative lenders may also need to set up broker dealer subsidiaries as a result.”

Executives at some of the larger private equity firms agree.

KKR, Apollo Global Management LLC, TPG and The Blackstone Group all have registered as broker-dealers. While none would comment for this article, most of them registered when they launched capital market businesses.