Friday Letter Fighting for the future

 “If these folks want a fight, it’s a fight I’m ready to have,” President Barack Obama declared immediately after shocking the US financial markets with strict regulatory plans to prevent banks and financial institutions from profiting from owning, investing in and sponsoring private equity and hedge funds.

It looks like Obama will get just that fight, following widespread skepticism about his proposals. (One private equity real estate professional even described them as being downright “crazy”.)

Whether or not that label is appropriate, Obama’s plans – if eventually backed by the US Congress – need to be seriously challenged, not only because they indirectly blame private equity and hedge funds as one of the causes of the credit crisis in the first place, but also because the new rules would fundamentally alter what banks can do in private equity. For one thing, it is difficult to see how they could continue to operate their own private equity funds.

Private equity funds, including those investing in real estate, operate on the understanding there is an alignment of interest between the investors and the fund sponsors. As part of that alignment, GPs are expected to commit a portion of their own money to ensure they have “skin in the game”. For limited partners, this co-investment is an essential ingredient in the private equity fund structure. Indeed, after the events of the past 18 months, LPs are keen to see co-investments grow rather than decrease.

However, under Obama’s plans, GP co-investment capital in bank-sponsored vehicles could be eliminated completely.

Presenting his ideas yesterday, Obama said banks would no longer be allowed to “own, invest, or sponsor hedge funds, private equity funds, or proprietary trading operations for their own profit, unrelated to serving their customers”. If a financial firm wanted to trade for profit, he said, fine. But “these firms should not be allowed to run these hedge funds and private equities funds” while also benefitting from “the safety net that taxpayers provide, which includes lower-cost capital”.

Although vague, industry professionals told PERE the rules would likely prevent banks from investing in, and potentially profiting from, private equity funds, rather than prohibiting banks from actually managing funds on behalf of investors. In essence, it would put an end to a bank stumping up the GP co-investment. As one real estate banking veteran said: “Banks would probably be allowed to continue as GP, they just wouldn’t be able to invest alongside their LPs. It’s something we’re all watching closely.”

Without GP co-investment though, how would bank-sponsored platforms survive? Will the burden for GP co-investment fall directly on the shoulders of senior (and even junior) management teams?

Granted, the bank-sponsored model has taken a beating in the wake of the credit crisis already. Merrill Lynch and Citigroup have both put up for sale the management companies of their property platforms as they attempt to shed businesses perceived risky post-2008; while Capmark Investments, the private equity real estate and separate account arm of Capmark Financial, which has filed for Chapter 11 bankruptcy protection, is in the process of selling its funds, according to people familiar with the matter. Yet without the ability for GP co-investment, bank-sponsored private equity funds would face an even tougher time attracting third party commitments. They would, in fact, face extinction.

Little though is ever certain in politics. What lies before the industry is not necessarily what will be placed before the US Congress, let alone enacted into law. The industry needs to use this time to ensure private equity, and its cousin private equity real estate, doesn’t become the scapegoat of populist rhetoric. If Obama is prepared for a fight, so should private equity.

PS: Voting closes today in the PERE Awards 2009. There are just a few hours left. See story below for the latest contenders and for how to cast your vote.