In early May the European Commission, under the guidance of Internal Market Commissioner Charlie McGreevy, issued its “Directive on Alternative Investment Fund Managers”, a proposal to create a comprehensive regulatory framework for hedge and private equity fund managers in the European Union. Reactions to the directive varied widely: the Financial Times called it a “crowd pleaser”, while the European Private Equity and Venture Capital Association said it would “punish the middle market”.
The proposals would apply to leveraged fund managers with more than €100 million in assets, or, for non-leveraged managers whose funds have at least a five-year lock up period, more than €500 million in assets. For the most part, private equity funds will fall into this latter category. The European Commission has estimated that this would cover around 30 percent of hedge fund managers and 90 percent of the assets of EU domiciled hedge funds.
All fund managers who fall into those categories would be required to prove their qualifications to provide investment management services, and would be subject to significant disclosure requirements. To investors, the managers would have to provide information on the investment strategy, limitations, and risk management of the fund; the process by which the fund can change that strategy; the identity of all the service providers to the fund; the fund’s valuation procedures and pricing models; a description of the fund’s fees, charges and expenses; and any favourable arrangements with specific clients. Where the fund employs high levels of leverage – defined as combined leverage from all sources that exceeds the value of the equity on two out of the last four quarters – the manager must disclose the total amount of leverage used by each fund in the preceding quarter, along with any right of re-use of collateral or any guarantee arrangements relating to the leverage.
Fund managers would have to provide a similar type of disclosure to regulators, with more extensive detail of their use of leverage: managers would have to identify their major lenders and describe the breakdown of leverage arising from borrowing versus leverage from entering into derivatives.
Managers would also have to maintain minimum capital of €125,000. Those who manage more than €250,000 would be required to maintain an additional 0.02 percent of the excess amount. There is no cap on the capital required, so large fund managers could potentially need to keep millions of euros on hand to satisfy capital requirements.
The draft also requires that the covered fund managers have a depositary, independent from the manager, to safeguard the assets and cash of the funds. These depositaries must be European Union incorporated credit institutions, unless the fund is established in an outside country, in which case the depositary can be incorporated in that country only if it has local legislation that is equivalent to that laid out in the directive. As law firm Clifford Chance points out in a client briefing, that last stipulation could be difficult to satisfy.
Of particular interest to private equity firms is the set of provisions requiring disclosures when an alternative investment fund takes a 30 percent or more stake in the shares of an unlisted company with more than 250 employees, an annual turnover of more than €50 million and/or has a balance sheet total of more than €43 million. Upon acquisition of the stake, the fund must inform the company and the company’s other shareholders of the identity of the fund, the fund’s policies for avoiding conflicts of interest among board members, the fund’s development plans for the company and the fund’s policies for communicating with employees at the company.
Finally, the directive lists new information about portfolio companies that funds will be required to include in their annual reports: operational and financial developments, financial risks, employee turnover or recruitment and any significant divestitures of assets.
Beyond the increased disclosure requirements, the directive also proposes stricter rules governing the ability of non-EU fund managers to market their funds in the EU, starting in 2014. Foreign funds can only do so if their country of origin has legislation that is equivalent to that described in the directive, and grants EU fund managers comparable market access; and if the foreign fund manager provides EU authorities with all of the disclosures described above, and the foreign fund’s country of origin has signed an agreement with an EU member state that guarantees its compliance with tax transparency standards.
Reactions from the market
Private equity firms and trade bodies, as well as industry experts, expressed dismay over various parts of the EC regulatory plan.
The European Private Equity and Venture Capital Association (EVCA) voiced its concern over the impact on the mid-market. “While we welcome the Commission’s distinction between hedge funds and private equity, we are deeply concerned that the thresholds set out today punish middle-market companies, which lie at the heart of corporate Europe,” said EVCA chairman Jonathan Russell. The EVCA estimates that under the proposed directive around 5000 portfolio companies will be subject to “costly and unwarranted” reporting rules.
Increased disclosure rules would “do nothing to attenuate the perceived risks of the asset class, while creating a huge amount of additional cost in the wrong place,” said Charles Ind, managing partner of Bowmark Capital, a mid-market UK private equity firm with £700 million under management.
Martin Calderbank, partner at Stirling Square Capital Partners, also a London-based mid-market investor, said: “At the very time that the European economy needs the skills of private equity investors to kick-start a recovery, the Commission risks sending out a clear message that it wants to stifle, not encourage, this proven form of entrepreneurism.”
James Greig, a partner a PricewaterhouseCoopers, said: “We echo the concerns of the key trade bodies in their criticism of the catch-all effect and unintended consequences it appears to have on sectors of business where no material systemic issues have been identified or which are already subject to perfectly adequate schemes of regulation. We are also concerned that funds caught by this Directive will be made subject to significant disclosure and transparency obligations and will, as investors, be at a competitive disadvantage to, for example, the Sovereign Wealth Funds and other investors expressly excluded from its ambit.”
The EU missive will now be debated by members of the European Parliament. If political approval on the proposal is reached by the end of 2009, the directive could come into force in 2011, according to the Commission.
The silver lining
Toby Mitchenall, of sister publication PEI, looks at how the EC regulatory proposals could have been worse.
In the grand scheme of things – and despite valid industry complaints that mid-market portfolio companies could be saddled with a regulatory burden when they need it least – private equity can look at the proposed Directive on Alternative Investment Fund Managers and think it has got off lightly.
The European Commission’s proposed regulatory regime for private equity and hedge funds operating in the European Union has been stoutly criticised by private equity firms as being potentially costly and pointless.
But as acknowledged by the European Venture Capital and Private Equity Association, private equity funds, by merit of the fact that they do not use leverage at fund level and their investors are typically locked in for more than five years, are being treated differently from hedge funds.
Private equity funds need to have €500 million under management before they fall under the directive, while other alternatives managers – namely hedge funds – only need €100 million.
The task force mandated by the industry to argue private equity’s corner in the regulatory debate had placed a lot of importance on the difference between the asset classes, and the Commission listened.
The contents of the proposed directive, broadly speaking, require private equity fund managers to register with a regulator, demonstrate they are operating responsibly in terms of risk management, outline what their funds will do and report in detail on the assets and markets to which their funds are exposed.
There is no talk of limiting a fund’s activity, just keeping the regulator informed. Given that self-regulation – regardless of how successfully it could have been implemented – was never going to be a viable option in the political environment, this can be considered the next best thing.
There may be costs involved in compliance, but – and this may not be a popular line to take amongst the mid-market community – is this level of portfolio company reporting not already in place for the sake of limited partners? It may not be cripplingly expensive to adapt this to standardised regulatory reporting. There is still a lot of detail to be hammered out and the directive has yet to be debated in the European Parliament before being either passed or amended.
If the heavy hand of the regulator was an inevitability, and most feel that the political momentum behind this debate made it so, then private equity can count itself lucky. It could have been a lot worse.
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