When it comes to sanctions, PE firms must proceed with great caution – TechCrunch

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.

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