The economic sanctions that have been imposed following the war in Ukraine pose an intricate set of challenges for private equity (PE). Sanctions are driven by foreign policy and national security officials rather than regulators, so the landscape can change quickly and in the most unpredictable ways.
Given the multiple waves of sanctions imposed in recent months, PE firms need to be especially vigilant about ensuring their investors have not become subjects of the newly imposed sanctions. If it happens to be so, PE firms will have to navigate the complexities involved in removing sanctioned investors from their funds.
After 9/11, the U.S. passed sweeping anti-money laundering (AML) legislation, requiring all financial institutions to understand who their customers really are. Shortly thereafter, the Treasury Department granted exemptions to certain categories of financial institutions, including hedge funds and PE. These exemptions were meant to be temporary, but remain in place even today.
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While financial institutions are subject to stringent know your customer (KYC) requirements, PE funds are not required to identify the source of customer funds or to alert regulators with respect to suspicious activities — a loophole in the law.
The effective management of sanctions risks at portfolio companies must begin at the pre-investment phase.
Exploiting the loophole
Over the past two decades, many oligarchs and kleptocrats have exploited this loophole and parked billions of dollars with “no questions asked” about the source of that wealth. Using shell corporations to move money through tax heavens, they ultimately placed the funds with PE firms. Oligarchs and kleptocrats routinely rely on complex corporate structures to shield their wealth and bank on proxies to manage it.
Untangling the ownership of a limited partner (LP) to determine sanctions exposure can sometimes be a challenging process and requires deep due diligence. In the current environment, there is little to no margin for error. Moreover, the typical tools that a financial institution relies upon in an AML context are not sufficient to determine exposure.
Having expert knowledge of the most commonly used jurisdictions and structures, as well as experience in unraveling beneficial ownership will be critical in determining whether an LP has sanctions exposure.
Despite the absence of a strict legal requirement, many PE funds are conducting due diligence of their LPs, largely with the objective of managing reputation risks for the fund and other LPs. In response to the rapidly evolving sanctions landscape, PE funds have started to implement sanction-specific risk mitigation strategies, which include building or improving existing sanction compliance frameworks, conducting sanction risk assessments across their investor base and executing deep-dive diligence on high-risk LPs.
If it turns out that there is a sanctions violation after programs and controls are implemented, this will be helpful in minimizing penalties from regulators.
General partners (GPs) have also started reviewing their limited partnership agreements. There is at least one known example of GPs proactively liquidating the stakes of exposed LPs to avoid the prospect of a regulator freezing the interests of the sanctioned investor.
PEs must proceed with great caution in these instances because the disposal of a stake itself may constitute a violation. Instead, blocking and reporting the interest to the authorities has become the recommended course of action.
Examining both ends of a deal: The investment
In addition to facing sanction exposure risks through their investor base, PE firms may also encounter sanctions violations through their investments. Compliance with complex sanctions regimes requires a fluent understanding of the rapidly changing sanctions landscape as well as current knowledge of how regulators think and act on enforcement.
In order to effectively mitigate sanction risks, PEs are investing in the close management of compliance programs, policies and procedures at each of their portfolio companies.
The effective management of sanctions risks at portfolio companies must begin at the pre-investment phase. PEs have started to conduct more thorough, investigative due diligence on investment targets to ensure that the company does not have any undisclosed or hidden relationships with sanctioned entities and individuals or does business in a sanctioned country. Such fact patterns are more common than many think and could trigger considerable reputation and legal liability for both the investment target, and in turn, the PE firm.
PE funds also require that the investment target has an adequate compliance framework in place that incorporates sanction exposure mitigation strategies and controls. At minimum, this will include a formal set of policies and procedures, transparent screening protocols for potential partners and customers to identify sanctions risk and a process for conducting enhanced due diligence of high-risk relationships and transactions. Where compliance frameworks are not as robust, PEs are making their enhancement a condition for proceeding with investments.
Despite the substantial liability and risks that economic sanctions inflict on private equity, they also create opportunities. Having deep understanding of sanctions and staying on top of policy developments can also represent first advantage for making investments in markets where sanctions are lifting.