Fighting Accountability: Financial Intermediaries Resist Regulation
In yesterday’s New York Times Gretchen Mergenson makes the case for regulating private equity firms as broker-dealers (see, “Private Equity’s Free Pass”). As Ms. Mergenson details, many private equity firms engage in exactly the same types of activities as investment banks in structuring deals, collecting fees, raising capital and doling out advice. Since its inception, private equity has attempted to operate under exceptions to the securities laws. In fact, most of the founding fathers of private equity began their careers in broker-dealers before abandoning them for the freedom and profit of private equity. In the beginning, PE deserved the exemption. They derived their capital from a small group of high net worth individuals and institutions and earned their profits from management fees and carry. They also had a significant portion of their net worth tied up in their funds.
Two things changed. First, the private equity business institutionalized and began to offer many more products to a wider audience. Second, the industry became greedy. Not only did they want to earn fees and carry, they decided there were additional profits to be made in providing portfolio companies with a variety of products and services. To be fair, all of these types of practices, as well as the potential conflicts of interest, are disclosed and acknowledged in the legal documents signed by investors. As the SEC has pointed out, all too many PE firms have taken gross advantage of these situations. There are probably many smaller PE shops that deserve to remain exempt from registration as broker-dealers. However, investment banks and large PE firms are indistinguishable, except that the former are regulated and the latter are not.
Although some PE firms have acknowledged the inherent conflicts and formed broker-dealers, the industry will fight any attempt to subject them to the costs and requirements of regulation. Broker-dealers would probably like to see the playing field leveled and would support greater oversight of the PE industry.
However, broker-dealers are fighting their own battle. For many years the
SEC and the US Department of Labor have been attempting to subject broker-dealers to a fiduciary standard of care when they provide customized advice to clients. At present, brokers act under the looser suitability standard even though they are providing the same services as financial advisors. The brokerage community claims that it wouldn’t be able to offer their clients as wide a variety of financial products if it were subject to a fiduciary standard of conduct. That’s hardly the issue. The brokerage community fears that the higher standard of conduct would lower their profits and subject them to greater liability. They are right. Appropriate accountability would cost them, just as it would cost the private equity industry.
It’s time to rein in private equity and broker-dealers. Private equity no longer deserves its wholesale exemption, and broker-dealers don’t merit the suitability standard. Greater responsibility is more than warranted. I’m not holding my breath.