Regulatory Issues of Private Equity

In November 2007 IOSCO published a report on its review of private equity markets. This report identified seven specific issues relating to private equity markets that have been raised as potential risks to financial markets.

Increasing Leverage

• Growth in lending associated with leveraged buyout (LBO) activity may enhance the chance of financial distress and default, creating potential detriment to the secondary marktes if the debt is traded.

Market Abuse

• Flow of price sensitive information in relation to private equity trnsactions, creates potential for market abuse (like insider dealing).

Conflicts of Interest

• Private equity transactions involve a number of parties including private equity firms, investors, target portfolio companies and market intermediaries. Some parties can take on multiple roles with respect to the same transactions, presenting material conflicts of interest.

Transparency

• Industry standards (e.g. International Private Equity and Venture Capital Guidelines) have been widely used but not adopted consistently across the industry, making investors difficult to make objective comparisons among private equity firms.
• The wider market receive relatively little information on the activities and performance of funds, portfolio companies and private equity firms.

Overall Market Efficiency

• Public investors may lose access to firms during their development period with maximum growth before they are returned to public ownership.
• Existence of private equity investors may ensure that management of public companies are competent and seek to maximize shareholder value.
• High volumes of private equity activity may have a detrimental effect on the quality, size, depth and even fair and efficient operation of public markets.
• Governance in public firms may focus on short term share price levels, rather than long term strategic growth, in order to protect against becoming a takeover target.

Diverse Ownership of Economic Exposure

• Extensive use of opaque and complex risk transfer practices, such as assignment, sub-participation and credit derivatives, could damage the timeliness and effectiveness of workouts following credit event or downturn.

Market Access

• Some investment entities have sought public listings, providing some retail exposure to the market risks these firms undertake.

In HK, there is basically no securities regulation covering the private equity market because it has not approached retail investors. Similar to the case of hedge funds, I don't think HK retail investors are sufficiently sophisticated to invest in private equity products.