No insurance for private equity

Though private equity managers are currently focused on fighting the draft AIFM directive, a campaign to force insurance companies to hold more capital against their investments could be just as harmful to the private equity industry.

Proposed regulations that aim to create a level playing field for insurers across the EU could also result in those insurers reducing or freezing their commitment to private equity, leading to a tougher fundraising environment over the next few years.

The Solvency II Directive is intended to create a more stringent capital adequacy regime so that the capital requirements for insurers and reinsurers in the EU are better aligned with their risk profiles, according to SJ Berwin partner Simon Witney. However, private equity firms and lobbying groups have argued that the current draft does not take into account the differences between private equity and other types of investment.

“The details are still being worked out, and the point I’d make at this stage is that it is critically important that the regulators are quite sophisticated in the way that they analyse the level of risk and therefore the capital requirements that are needed to support an investment in a private equity fund,” Witney said. “I think there is concern about a simplistic approach being adopted and that private equity funds are all lumped in together no matter what kind of deal they are doing. It is also clearly not appropriate that they are all lumped together with any kind of unlisted investment holding.”

As Witney points out, the risk profile for an investment in a fund for the purposes of diversifying a portfolio is different from the risk profile of an investment in a single company, as is the risk profile for an investment in a fund that does leveraged buyouts versus one that does early stage venture deals. 

“The question is not whether changes to capital requirements are necessary – they are – the question is whether regulators are being sophisticated enough in the approach they are adopting when it comes to assessing the risk associated with private equity-style assets,” he said.

As it stands now, 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 in less risky and more liquid assets that attract lower capital requirements.

Thomas Meyer, director at the European Venture Capital Association (EVCA), said Solvency II could make it harder for insurance companies to invest in private equity down the line, and has heard that firms in some countries fear that local insurance companies will freeze allocations to private equity if the directive is passed with the current capital requirements. He said the EVCA has put together a task force that is intended to work with regulators to better explain the risk of private equity and move toward a more advanced approach to risk management.

He adds that some of the details of the directive are still unclear, such as the exposure the 55 percent rate relates to for private equity investments. Meanwhile, the European Commission is also examining whether suitable solvency requirements should be developed for pension funds as well.

As pension funds are the largest source of capital for the European private equity industry, providing more than a quarter of all investment, such requirements – combined with the restrictions on insurers – could further restrict investment and make fundraising tougher over the next several years.

According to SJ Berwin, the impact of this directive could be even more consequential to the industry than the European Commission’s proposed “Directive on Alternative Investment Fund Managers”, which is posed to reduce managers’ access to foreign investors, as well as local investors’ access to foreign funds.