Minister for Superannuation and Corporate Law
3 December 2007 - 8 June 2009
Regulation of Private Equity: Getting the Balance Right
Speech to the IBA-LCA Private Equity Conference
8 APRIL 2008
Thank you to both the International Bar Association and the Law Council of Australia for this opportunity to speak on Private equity: the sub prime crisis and beyond.
Before I begin, I would like to acknowledge the Honourable Justices Lindgren of the Federal Court of Australia, Austin of the Supreme Court of New South Wales and Jacobs of the Supreme Court of Delaware, who are in the audience this afternoon. I am delighted that you are able to join us.
I will reflect today on the dramatic changes in the market environment for private equity and alternative investment classes more generally in the last four to five years, as well as examine the near to medium term outlook.
I would also like to share the Government's views on 'getting the balance right' when it comes to looking out for that complex matrix of considerations that constitutes the national interest.
It is of great importance that we strike the right balance between the key objectives of investor protection … prudential integrity … and high quality domestic markets, while maintaining and promoting Australia as an attractive investment destination.
I will begin by laying out the context of the international and domestic economies and their respective outlooks … as well as the state of international and Australian financial markets.
As you would recognise, the economic outlook and access to capital funding on commercially viable terms are key determinants of the prospects for the private equity industry and companies more generally.
The International Economy
In recent months, the outlook for the US economy has sharply deteriorated. Downside risks to growth have increased considerably, and the potential for a deeper and more protracted slowdown has increased.
The outlook for other major advanced economies has weakened somewhat, with growth expected to slow in the UK, the euro area and Japan.
On a brighter note, the outlook for emerging market economies, remains more positive. The strong growth performances of countries like China and India are expected to continue to underpin robust global growth, even in the face of weakness in the major advanced economies.
A key uncertainty is the extent to which strong domestic demand in emerging economies can offset the negative impacts of a weaker external environment.
State of International Financial Markets
In terms of financial markets, it is quite apparent that, after a prolonged period of low global interest rates and rapid financial innovation, the international financial system is facing a significant challenge.
The current turmoil in global financial markets was triggered by falling US house prices coupled with a dramatic weakening of lending standards for US sub-prime mortgages. Markets came to the sobering realisation that many of the world's financial institutions were heavily exposed to securities backed by these mortgages.
Despite concerted central bank action, large losses on these and other structured credit products have put significant pressure on banks' balance sheet positions. These losses have also led to an erosion of confidence and widening spreads in inter-bank lending markets.
In addition to this, global equity markets have fallen in response to ongoing disruptions in debt markets. And, of course, there are increasing concerns over the implications for economic growth in the US and several other major advanced economies.
So far, central banks in the major advanced economies have demonstrated that they are alert to the seriousness of the situation. They have taken a series of policy actions to address liquidity shortages in key funding markets and to maintain financial system stability.
The Australian Economy
On the Australian economic front, the short-term outlook is somewhat different.
The Australian economy faces conflicting currents, with increasing uncertainty about the global outlook combined with quite firm domestic demand growth.
Strong international demand for resources is expected to sustain high commodity prices over the forecast horizon, supporting domestic demand and income growth.
These pressures create a challenging macroeconomic environment for Australia in maintaining output growth while keeping prices in check.
Indeed, with the domestic economy facing capacity constraints, the RBA expects inflation to remain elevated this year and next.
The Australian market success story
We are also facing challenges in Australian markets as a result of the global turmoil.
The securitisation market here is now attenuated, and credit spreads are markedly higher than they were.
But our financial institutions are sound, and we have not seen any substantial increase in mortgage defaults.
We are helped by a strong prudential framework, and by the fact that our financial markets have been among the largest, fastest growing and most sophisticated in Asia.
For example, turnover in the nation's equity, debt, foreign exchange and derivatives markets has more than doubled in size in the last four years to exceed $120 trillion in 2006-07.
Australia's equity market, with a total value of $1.28 trillion as at the end of February, is one of the largest in Asia by free-float market capitalisation.
The Australian and US dollars are the fourth most traded currency pair by global turnover.
Australia has one of the world's largest funds management pools, which provides considerable investment demand.
Many global investment banks … wealth managers … hedge funds … and private equity specialist firms have established operations in Australia in recent years.
We have become an attractive centre for financial services activity, with a reputation as a major capital markets centre in the Asian region. The Rudd Government is committed to securing Australia's place in the Asia-Pacific and delivering on an election commitment to situate Australia as the pre-eminent financial service hub centre in the region.
The Government's Policy Responses
In light of the current international uncertainties, how will the Government secure prosperity?
The global turbulence in financial markets and inflationary pressures have placed additional stresses on hard working Australian families.
The Government understands that many Australians are experiencing an increased cost of living burden. We are committed to taking action to ease these pressures and address this serious legacy of the previous Government.
A few moments ago, I identified the significance of the inflationary, capacity building and productivity challenges that are faced by the Australian economy.
In response to this array of challenges, the Government has set out a broad, five point plan to fight against inflation. The plan addresses both demand and supply side pressures on inflation.
The elements of that plan are:
- a hardline attitude to fiscal restraint, including a comprehensive review of government spending;
- fostering a culture of private saving;
- tackling chronic skills shortages, addressing the economy's skills deficit with targeted investments in training;
- national leadership to tackle infrastructure bottlenecks; and
- lifting workforce participation and thereby the productive capacity of the economy.
The Government has already announced a number of initiatives against each of the elements of our inflation fighting plan.
Enhancing the productive capacity of the economy will enhance its non-inflationary growth prospects and, thereby, the wellbeing of the Australian people.
Furthermore, when Australians are able to feel confident about their wellbeing, this will improve prospects for Australian businesses and markets.
Recent markets and financial services policy measures
Notwithstanding the reputation of our markets, the Government is not complacent.
While the current regulatory system has performed well under pressure, recent issues have highlighted the need for some fine-tuning to ensure the integrity and systemic stability of our markets.
To this end, the Government has initiated or is leading policy responses in a number of key areas.
One issue of significant interest is the work being carried out to progress national financial services regulation. Regulation of the industry is currently a three-way split between the Australian Government, the States and Territories and industry self‑regulation.
This system imposes an unnecessary regulatory burden on the providers of financial services.
The financial services industry is increasingly global in both scope and nature. It is constantly crossing jurisdictional boundaries. Issues in the financial services sector, for example mortgage market, tend to be national in nature.
A single national regime for the main types of financial services provided to consumers is a logical evolution of the regulatory environment.
The Government plans to ensure that mortgages and margin loans will be regulated under uniform national legislation. The establishment of a single regulator will reduced the level of red-tape facing businesses and increase the level of protection for consumers.
We will also pursue a legislative change to the Corporations Act to address an ambiguity around the disclosure of covered short selling. This will provide the market with access to information about the level of short selling, covered and naked, and thereby promote transparency in the marketplace.
These initiatives will improve the transparency of its financial markets to further protect mum and dad shareholders and make Australia's financial market more attractive to international investors.
Private equity and hedge funds
This brings me to the economic and financial roles of private equity and hedge funds in the well regulated Australian market economy.
Economic and financial market role
Private equity investment in Australia has grown steadily over the past four years. In particular, we witnessed rapid expansion of activity in 2006 and early 2007.
This investment sector has developed in response to demand from investors looking for higher returns — albeit with correspondingly higher risks.
However, it is important to remember that, overall, it is still a relatively small sector within Australia.
Regardless of this small size, private equity investors are an important element of dynamic and efficient capital markets. They contribute significantly to the market objective of ensuring that capital is allocated to the most productive purposes.
Indeed, the potential for the investment of private equity funds in publicly owned companies should encourage company directors and management to remain focused on maximising returns on invested capital. This is, of course, widely considered to be a good corporate governance outcome.
For these reasons, regulatory responses should be considered and balanced.
There is agreement that hedge funds play a useful role in enhancing the efficiency of financial markets, notwithstanding concerns about the risks.
Recently, there has been significant speculation and accusation about the market conduct of hedge fund investors. While it is not appropriate for me to comment on the details of any investigations that may be underway in relation to such speculation, it should go without saying that the Government takes these market concerns seriously. We will support the regulators in their vigorous enforcement of the law.
More generally, Australian regulation of hedge funds is directed at disclosure requirements, along with their licensing and registration as managed investment schemes.
Such an approach seeks to ensure that there is sufficient disclosure by these funds to allow all investors — particularly the more unsophisticated investors — to make informed decisions about the risks involved.
We need to be constantly vigilant to ensure that our regulation keeps pace with the most recent financial market developments. One of the recent developments in financial markets relates to the substantial growth in equity derivative products.
Because the owners of these instruments only have indirect economic ownership over the underlying securities, these equity derivatives have enabled market participants, including speculators and hedge funds, to avoid the disclosure requirements associated with direct stakes.
The use of these instruments have created uncertainty and facilitated speculative trading which puts individual shareholders at risk. Companies don't know who the ineffective owners are … investors suffer from volatility as stock prices can be manipulated.
To address these concerns, Australia intends to take a lead in increasing the transparency of its financial markets. The Prime Minister recently announced that Australian Treasury would undertake an immediate review of the current disclosure requirements of equity derivatives.
While the Government is examining the disclosure requirements of financial instruments that are used by hedge funds, we do not try to dictate investment strategies or place undue limitations on hedge fund activities and their leveraging. Doing so may result in unintended and possibly less efficient outcomes, which may be undesirable.
On the other hand, the investment strategies of hedge funds have associated risks, which can influence the performance of prudentially regulated institutions such as banks and superannuation funds.
For this reason, hedge funds need to provide a high level of transparency to their investors, particularly those that are prudentially regulated and of systemic importance, so that exposures to market risks can be accurately assessed and managed by those investors.
Compliance with these expectations continues to be closely monitored by the relevant regulators and the Government.
Private equity and hedge funds have increasingly attracted a wider range of investors. These investors have sought to diversify investment returns from traditional asset classes such as equities, debentures and cash.
These diversifiers, if you will, include insurance companies … intermediaries … corporations … pension funds … wealthy individuals … and endowments and foundations.
Of particular relevance to my portfolio responsibilities is the pension fund or superannuation fund category.
In its March 2007 report on Private Equity in Australia, the RBA observed that, since 2003, nearly fifty per cent of all funds committed to Australian private equity investment vehicles were ultimately from superannuation funds.
Available evidence at that time also suggested that more than half of the largest superannuation funds had some portfolio allocation to private equity, with an average allocation of around five per cent.
Superannuation funds – policy implications
While direct exposure to private equity by retail investors was relatively limited, the Australian Council of Financial Regulators acknowledged in March 2007 that retail investors have indirect exposure through superannuation funds.
The Council considered that superannuation fund trustees need to consider — and be able to document and justify — that investments made are consistent with the disclosed investment strategy.
They must also prove that they have achieved a level of diversification reasonable, having regard to the circumstances of the fund.
Of course, Labor Governments have a long history of championing the cause of superannuation for all hard working Australians. It was a Labor Government that introduced compulsory superannuation.
We strongly feel that compulsion must be accompanied by a strong "duty of care" by the Government.
We emphatically concur with the Council's expectations … and will be monitoring developments accordingly.
Renewed importance of internal growth and return drivers
Given my comments so far, it is reasonable to then ask what the short to medium term outlook is for private equity investment activity.
The capital market environment has changed significantly. By the second half of 2007, reduced investor appetite for corporate debt had led to the cancellation or postponement of a number of leveraged buyout debt issues.
Internationally, banks and other debt investors also began to impose stricter terms and conditions on the debt packages to leveraged buyout deals.
Australia has not been immune to changes in the global capital market environment.
In the six months to June 2007, the total value of such deals completed was around $2 billion, down from $9 billion in the second half of 2006, with a number of major proposed buyouts not proceeding.
There are a number of possible reasons for this decline. The main ones include the less receptive funding environment … and the closure of the gap between the cost of debt and the return on equity that was one of the main drivers of leveraged buyout activity in 2006.
One might then ask what prospects should be held for the private equity industry into the future. Realistically, what measures will need to be taken to sustain its historical investment returns?
Clearly, changes in capital markets and the reduced attractiveness and availability of debt funding may mean that new investments will be funded with lower relative levels of debt.
Private equity funds may also have to be more selective with their investments. They may need to take a renewed focus on the quality and stability of investee company returns.
For existing investments, there will clearly need to be an increased focus on internal measures to improve company performance. It is here that private equity investors consider that they have an edge.
It is often reported by the private equity industry that focused ownership, and the enhanced corporate governance that it offers, permits the industry to better understand, manage and control its investments.
In the current economic and financial environment, these disciplines will undoubtedly be more important than ever and should serve the industry well.
Notwithstanding these potential benefits with regard to capital market and corporate efficiency, the private equity industry attracted some adverse public comment in 2006 and 2007.
With the emergence of private equity in the broader public conscience in 2006, a number of regulatory, institutional and parliamentary assessments of such activity were initiated. These assessments sought to look at the adequacy of existing corporate, prudential and taxation frameworks.
In many cases, these reviews did not recommend wholesale changes to domestic or international regulatory frameworks.
Australian Council of Financial Regulators
The Council of Financial Regulators established a working group in December 2006 to look at private equity investment and its attendant risks.
The report assessed that existing Australian regulatory frameworks were sufficiently well established to manage each of the identified issues.
The Government considers that the Council presented a balanced review of the economic contribution of private equity and its risks. However, regardless of the recent decline in new buyout activity, we will closely monitor the corporate developments as a way of validating those assessments. We will also continue to develop our policy approach to private equity.
UK Walker Review on industry transparency and disclosure
An important development in the UK has been in the area of transparency and disclosure, with the rollout of a set of voluntary industry-based guidelines for standardised public reporting by private equity portfolio companies, private equity firms and aggregate whole-of-industry reporting.
The first round of industry wide reporting, to be coordinated by the British Venture Capital Association, will be eagerly anticipated by investors, regulators, the public and governments alike.
While the Government continues to consider that existing disclosure frameworks are adequate, we will monitor the success or otherwise of the UK's initiative as well as any moves by industry bodies in other jurisdictions to adopt similar standards of disclosure.
Summary of Government policy and concluding remarks
I would like to conclude my address with a few remarks about the Government policy approach to private equity investment.
Australia has well established frameworks for the regulation of companies and financial markets. These frameworks are internationally regarded for their principles-based foundations and robustness.
It is from this position of underlying strength that the Government can approach the regulation of private equity investment activity and get the balance right.
I have identified for you today the key outcomes of reviews of the private equity industry conducted by regulatory institutions and even by the industry itself.
On the whole, the reviews have concluded that the industry is adequately regulated and contributes to the economies in which it operates.
Both the Government and our financial regulators will continue to monitor closely the central issues identified in the RBA's 2007 report. We will also monitor the success of international and domestic initiatives that potentially enhance the transparency and understanding of the industry in the broader community.
As financial markets become more global and assets are traded more quickly between nations, regulation and supervision must become more internationally uniform. To this end, the Prime Minister has outlined that the Australian Treasury work with the world's principal financial policy makers and regulators to identify reforms that will boost transparency of our financial markets.
In developing a balanced approach to private equity, the Government recognises that the sector is highly mobile. We will give due consideration to the need to maintain Australia's attractiveness as an investment destination.
Thank you once again for the opportunity to address you here today.