LP handcuffs

Regulators have been trying to crack down on the activities of private equity managers for months, but now they have turned their attention to controlling which limited partners should have access to the private equity markets. 

Draft legislation in the US Senate as well as the European Union would have the effect of locking some LPs out of the private equity industry.

In Europe, the Solvency II Directive would create a more stringent capital adequacy regime for insurers and reinsurers, with the goal of preventing those institutions from taking on overly risky investments.

The directive calls for a standard stress factor of 55 percent for insurance companies that invest in unlisted equities, an increase from the 45 percent level originally proposed by the directive. This will lead to higher capital charges against unlisted assets, and could cause insurance companies to invest less money in private equity and more money in the types of liquid assets that attract lower capital requirements.

The directive is rather unsophisticated as written, as it lumps private equity in with other asset classes with very different risk profiles. It also doesn’t take into account the fact that LPs use private equity commitments in a variety of ways – some to diversify their portfolios, reducing risk rather than adding it. 

In the US, the National Venture Capital Association and the Angel Capital Association sent a letter to Congress this week rejecting a provision in Senator Christopher Dodd’s financial reform bill that would raise the threshold of personal assets required to be an “accredited investor”. Currently, investors need to have $1 million in assets, or report an income of $200,000 per year or $300,000 per year for joint filers. These numbers haven’t changed since 1982, and Dodd has suggested subjecting the thresholds to periodic inflation adjustments. 

It isn’t clear how much the thresholds would rise in the short-term should the bill pass, nor how often the inflation adjustments would occur. The thresholds would certainly be a blow to the angel investment community, and could also create problems for those venture funds that allow entrepreneurs at their portfolio companies to invest smaller amounts in their funds. “Friends and family” contributions could also be at risk for both private equity and venture capital funds. 

If passed, the changes to the thresholds could certainly create a compliance headache for fund managers. Managers relying on the 3(c)1 exemption from the Investment Company Act of 1940 are subject to strict rules on who can invest in their funds: they can’t market to anyone who doesn’t meet the “accredited investor” thresholds. Private equity fund lives are long, and someone who is “accredited” when they first commit to a fund might not be able to retain this status until the final exit, if regulators adjust the threshold every few years.

Angel investors are already a scarce commodity in the US after the financial crisis, and the venture capital industry relies on them to fill a crucial funding gap in the very early stages of new companies’ development. Thinning their ranks even further would very tangibly dampen innovation and job creation in the US.

At a time when GPs must struggle to find capital for their funds, regulators in the US and Europe are diligently trying to create ways to tighten the liquidity tap even further for GPs thirsty for capital.