Miffed about MIFID

A new EC Directive is likely to make extensive and costly demands.

European private equity firms are, it seems, forever being besieged by threats of new and painful regulations. Consequently, there is a danger that the European Commission's Markets in Financial Instruments Directive (MIFID) will be seen as just one of many potential black clouds on the horizon – a matter of concern, certainly, but no more so than many other missives of a similar hue.

Such complacency may be seriously misplaced. Says Carole Collier of global investment management and fund administration business Northern Trust: ?Some people are beginning to say MIFID represents the biggest change to the European financial industry for the last five years. And the more I look at it, the more that seems to be true.?

As is normal with roads to hell, MIFID is paved with good intentions. According to EC internal market commissioner Frits Bolkestein, the Directive will allow ?reputable investment firms to work anywhere in the European Union (EU) with a minimum of red tape while bolstering our defences against dodgy operators.?

Many private equity firms initially considered – and some may still – that the Directive would not be applicable to the industry. The initial interpretation was that only stock exchanges, investment banks and broker/dealers were in the regulatory firing line. Octavio Marenzi, founder and CEO of Boston-based research and consulting firm Celent, is keen to disabuse people of that notion, should they still hold it: ?Firms that regularly undertake portfolio management, or simply offer investment advice, are covered by the definition and are therefore subject to the Directive,? he says.

What is more, time to put in place the necessary measures is running short. MIFID is currently only in draft form, but has a final implementation date of November 2007. For firms based in the already well-regulated UK, says Collier, many of MIFID's demands are already covered by existing legislation drawn up by that country's Financial Services Authority. But for European countries with a lighter regulatory touch, much work lies ahead – and the clock is ticking ever louder.

UK Budget cuts VCT tax relief
Changes to rules regarding venture capital trusts (VCTs) were announced in UK Chancellor of the Exchequer Gordon Brown's Budget. In his Budget speech, the Chancellor announced that income tax relief on VCTs will be decreased by 10 percent to 30 percent for the 2006/2007 tax year and onwards. Brown announced the original increase of income tax relief on VCTs from 20 percent to 40 percent in his 2004 Budget in order to provide a boost to the VCT industry, which was seen to be struggling at the time. There had been fears that the rate would be cut back to the original 20 percent in light of stronger performance since. Brown said in his speech: ?Growing companies need venture capital. So I will refocus tax incentives for venture capital, with a 30 percent relief for investments in venture capital trusts.? There were also changes to the minimum investment period for VCTs, intended to encourage more long-term investment in small companies. The holding period for investors to gain tax relief on VCTs has been extended from three years to five years. In addition, the maximum size of companies that are eligible for VCT investment has been reduced from £15 million (€22 million; $26 million) in gross assets currently to £7 million. Peter Linthwaite, chief executive of the British Venture Capital Association (BVCA), said in a statement that the BVCA welcomed the Chancellor's decision to only reduce tax relief on VCTs by 10 percent to 30 percent, as it showed that the Treasury had ?listened to the BVCA about the important role VCTs play in bringing investment to the smaller, entrepreneurial sector of the market.?

Coke unveils PE-like incentives for board
The Coca-Cola Company has adopted an innovative incentive structure for its outside directors that bears similarities to carried interest. The new scheme rewards board members with $175,000 in stock options each year over a three-year period. But if, at the end of three years, Coke's earnings per share have not increased at an annualized rate of 8 percent, the directors must forfeit the options. Outside directors on the board will receive no additional compensation. In the private equity industry, a standard term in partnerships is the ?hurdle rate,? which is typically set at 8 percent. General partners who do not deliver returns of more than 8 percent per year do not receive carried interest. In a published report, famed investor and Coca-Cola shareholder Warren Buffett said of the new scheme, ?I can't think of anything else that more directly aligns director interests with shareholder interests.? Coke had previously paid outside directors $125,000 per year in cash and stock, regardless of the company's performance.

South Korean authorities raid Lone Star
South Korean authorities have reportedly raided the Seoul office of Lone Star Funds, seeking evidence of tax evasion and embezzlement. South Korean regulators are reportedly blocking 10 people from leaving the country as part of the investigation, and are planning to seek extradition for Steven Lee, the former head of Lone Star Funds Korea, who left the country in September. The investigation by Korean authorities delves into whether Lone Star owes taxes on its substantial windfall from its investment in Korea Exchange Bank. Lone Star acquired a 50.5 percent stake in the bank in 2003 for $1.2 billion, and recently agreed to unload the position to publicly held Kookmin Bankat a substantial profit. Many of the US firms that have pursued deals in South Korea have been subject to similar scrutiny. The Carlyle Group, in 2005, had files removed from its South Korean offices by the National Tax Service, and others such as Newbridge Capital and Citigroupwere also reported to have been investigated by Korea's tax authority. A spokesman for Lone Star issued a statement to PEO saying, ?Lone Star is cooperating with the authorities and looking forward to the end of the investigation.?

The rules of the game
According to an internal briefing circulated at a private equity firm and seen by Private Equity Manager, these are understood to be among the key demands made by MIFID:

Compliance, internal audit and risk: There is an increased focus on the ?functional independence? of these control areas and an evidential review to prove such independence will need to be undertaken. MIFID requires the company to have a documented risk management policy. The policy should set out the business risk based on activity and mitigation of those risks.

Action: Review reporting lines and responsibilities of governance structures; review independence and objectivity of compliance, risk management and internal audit; write and implement a risk management policy; review arrangements for risk identification and assessment.

Outsourcing: MIFID requires a review of the regulatory environment and status of any service providers in non-EU countries. Action: Identify service providers in non-EU countries. Review the regulatory status of those providers. Determine if any notifications should be made.

Conflicts of interest: The Directive requires a conflicts policy to be established and implemented. A conflicts log must also be maintained and appropriate disclosures made to clients where necessary.

Action: Review the conflicts identification and control procedures. Write and implement a conflicts policy and ensure it is disclosed to clients. Design and maintain a conflicts register.

Client classification: MIFID distinguishes between three types of client that are similar but not the same as current FSA categories. There will be a need to examine the differences between the existing and new classifications.

Action:Write and implement new client classification procedures. Review the classifications of existing market counterparties and intermediate customers, and re-classify them where necessary. Ensure clients are made aware of new classifications. Make appropriate disclosures.

Client ?take-on? and client agreements: MIFID will lead to requirements governing information about the firm and its services that must be provided to a client. The Directive also requires firms to keep a record of client agreements.

Action: Formulate procedures and processes for collating and providing the necessary information to clients.

Suitability and ?know your customer?: The MIFID requirements apply to investment advice and discretionary portfolio management and are likely to be broadly the same as the FSA's current requirements.

Action: Review the current processes and systems.