Last month, The Basel Committee on Banking Supervision issued a revised policy framework making it “more expensive” for banks to hold equity in private funds, legal sources tell PE Manager.
The policy change presents three different ways for banks to calculate how much regulatory capital they would need to hold for private equity fund commitments. Similar to the impact of Solvency II on EU insurers, banks need to hold emergency capital based on an asset’s riskiness, as determined by the Basel standards, with the latest version, Basel III, due to come in sometime in or before 2018.
Up until now banks have been able to sign up to default rules under Basel II that requires a bank to hold a set amount of capital in reserve based on the Basel Committee’s perceived riskiness of the asset class, with private equity falling into an “other” category with a risk weight of 100 percent. Alternatively, banks can come up with their own models for storing emergency risk capital that must first be approved by regulators (if it is a globally systemic bank). That has enabled banks to come up with their own models to risk weight what they have exposure to, according to Paul Ellison, regulatory attorney at Macfarlanes.
However, the three new approaches put forward by the Basel committee require banks to hold more regulatory capital against investments in private equity funds than they have in the past, say legal sources. There is the “look through” approach, the “mandate-based” approach , and the “fall-back approach”.
The look through approach is the one that requires probably the least regulatory capital to be held, according to experts. However, it requires fund advisors to deliver significant amounts of portfolio level data to the bank for risk assessment purposes, as the fund’s investments would be calculated using the same risk-weights that would apply if those assets were held directly by the bank. For instance, a fund’s investment in a US corporate would result in a 100 percent risk-weight for the bank. This means the bank would multiply its fund commitment by 100 percent to work out how much capital it must hold in reserve.
However, banks can only take advantage of this approach if funds issue financial reports at the same frequency as the bank prepares its own reports. Because of the perceived greater risk of less frequent reporting, banks have to take a slightly more risk-averse approach in calculating their exposure to a fund. In other words, if a private equity firm is only reporting quarterly and the bank reports more regularly than that, the bank will have to hold more risk capital against the exposure.
By contrast, the mandate-based approach means looking at the level of exposure at the fund level, rather than at its underlying investments. This approach takes into account risk weightings based on the fund’s permissible investments as set out in its mandate. The banking entity would carry the highest risk-weight the fund could create through its potential investments.
The third approach – what sources describe as the fall-back option – is the most stringent in terms of regulatory capital required. It is used when neither of the other two approaches – “look through” or “mandate based” – would be feasible. In this case, a 1,250 percent risk-weighting to a bank’s investment in a fund is applied.
This approach, according to Ellison, “could be seen as somewhat punitive, with a message to banks: ‘If you don’t (or are unable to) assess the risks to which this exposes you, then it could become a rather painful investment’.”
The reforms come at a time when other regulations have threatened GPs’ chances on the fundraising trail. The Volcker rule in the US restricts banks from trading off their own accounts as well as limiting their investments in private investment funds to no more than 3 percent of any one fund’s capital. Many private equity firms feared that they would lose banks as investors due to the rule.
Meanwhile, regulations in Europe, specifically the Solvency II directive for EU insurers, and the proposed pensions directive for EU pension plans, will require some of the industry’s biggest backers to hold more capital for private equity investments, potentially pushing LPs away from alternatives.