Challenges and open questions

PE Manager revisits some of the year's best guest articles: In March Thomas Meyer of the European Private Equity & Venture Capital Association discussed the increased regulation of private equity funds.

Investments into private equity have been booming over the last few decades. Against the background of the financial crisis, the large amount of capital invested in this asset class is attracting ever-increasing attention from industry regulators across a range of jurisdictions.

The Walker Report in the UK, which called for more stakeholder transparency with respect to large buyouts, and the European Union’s Alternative Investment Fund Manager Directive, which addresses potential systemic risks arising from the alternative investment space, are both examples of increased regulatory scrutiny. The Basel Committee on Banking Supervision is issuing recommendations for banking regulation and is currently working on an updated version of the Basel II Capital Accord. The Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) is addressing regulation of the insurance industry within the framework of its Solvency II project.

The private equity boom of recent years has been matched by huge advances in financial risk management. Nevertheless, Bongaerts & Charlier (2006) found “the academic literature on the intersection of the two is very close to an empty set”. While there is an abundance of papers on banking regulation, there was “curiously enough”, hardly any on the treatment of private equity under the Basel II Capital Accord for the banking industry. At the time of writing, the situation has not significantly changed, however new regulation is likely to have an adverse impact on this asset class.

One example of such incoming regulation is Solvency II, the updated set of regulatory requirements for insurance firms that operate in the European Union. Solvency II foresees significantly higher risk weights for alternative assets such as private equity compared to public equity. While pension schemes still fall outside Solvency II it appears to be just a question of time before a comparable regulatory regime is put in place. The Netherlands has already introduced a more risk-based supervision for pension funds in the shape of Financieel Toetsingskader.

All of these regulatory regimes place greater emphasis on risk measurement and promote the use of internal models. It is now widely feared that regulated financial institutions will reduce their private equity exposures in order to minimise overall capital requirements for investment risk. Under-allocation of regulatory capital gives the appearance that an investment is attractive and can lead to overly risky investments that could destroy capital, whereas over-allocation might lead to foregoing investment opportunities that appear unexciting but in fact could increase economic value.

As private equity only represents a small part of a typical financial institution’s capital, it has not been high on the regulators’ agenda. As these new financial regulations are still being implemented, or discussed, and are at different stages of maturity, this chapter cannot be the final word on this subject. Its objective is to highlight areas for increased analysis and discussion, develop solutions and provide an opportunity for the industry to engage with various regulatory bodies.

This chapter takes Basel II as a representative example of how risk weights under financial regulation for banking, insurance or pension schemes will affect the amount of capital required to be allocated when investing into the private equity asset class.

The Basel II Capital Accord describes the risk weights to be applied to private equity investments using the standardised Internal Ratings-Based (IRB) approach for credit risk and the Internal Models (IM) approach for market risk. Under the standardised approach the risk weight for ‘other assets’ like private equity is 150 percent, resulting in a capital requirement of 12 percent compared to 8 percent for public equity. This does not look conservative, but banks that have decided to implement an IRB approach for their loans cannot follow the standard approach for their other assets anymore.

In August 2001, the Basel Committee published its Working Paper on Risk Sensitive Approaches for Equity Exposures in the Banking Book for IRB Banks3, envisaging a significant increase in the minimum risk weighting for private equity investments. Banks can follow three approaches to calculate the capital requirements for such exposures:

1. Banks that do not have a qualifying internal model for equity exposures or choose not to use such a model must use the Simple Risk Weight (SRW) approach. Under the
SRW approach, capital requirements for private equity are 32 percent compared to 24 percent for public equity.

2. Under the IM approach, a 99 percent three-month Value-at-Risk (VaR) quantile should be established for the returns on the private equity investments in excess of an appropriate long-term risk-free rate. The IM approach allows banks to use their own models, subject to approval by the regulators, for estimating the risk of loss on equity exposures.

However, there are minimum risk weights, i.e. ‘floors’ set under Basel II: the floor of 300 percent translates into a minimum capital requirement of 24 percent for private equity exposures. For public equity the floor is 200 percent.

3. In cases where the bank has a debt exposure to the same firm, private equity investments can also be treated within the Probability of Default/Loss Given Default (PD/LGD) approach. For example, in the case of corporate bonds using a 90 percent LGD and a maturity of five years, banks must determine the PD. Applying the PD/LGD approach is subject to certain qualifying criteria4, and Bongaerts & Charlier (2008) see it as less advantageous compared to an internal model. The IM approach is based on a shorter horizon of three months instead of one year, and the lower confidence level of 99 percent versus 99.9 percent.

Under both the IM and IRB approaches, banks have to apply a capital charge of at least 24 percent for their private equity exposures under Basel II.

This partial chapter is one of 36 in Inside the Limited Partner: A compendium of investor attitudes to private equity, a new book from PEI Media.