As private equity groups in Europe prepare to push back against new regulatory proposals coming up for debate in the European Parliament, there are a few issues they will likely focus on trying to eliminate or water down.
The industry-wide effort comes in response to the European Commission’s issuance in May of the “Directive on Alternative Investment Fund Managers”, which if passed would create a comprehensive regulatory framework for hedge and private equity fund managers in the European Union. The new disclosure rules would apply to leveraged fund managers with more than €100 million in assets, and more than €500 million in assets for unleveraged funds with a lock-in period of more than five years.
The biggest points of contention that private equity firms and lobbyists will likely try to remove or water down in the final draft are:
- A broad definition of leverage that would draw more firms into the regulation.
- Changes in how professional investors are designated that may make some LPs off limits
- Potential hurdles that could bar non-Europeans from fundraising in the continent
The directive would also require managers to provide detailed information on their funds’ activity, governance, internal risk management, valuation, asset safe-keeping arrangements and audit arrangements. Fund managers would also be required to hold and retain a minimum level of capital of €125,000.
The European Commission has estimated that the rules would cover around 30 percent of hedge fund managers and 90 percent of assets of EU domiciled hedge funds, while the European Venture Capital Association (EVCA) said shortly after the directive’s release that around 5,000 portfolio companies will be burdened by costly reporting rules. In addition to the EVCA’s concerns in late May, the Alternative Investment Management Association (AIMA), a global hedge fund trade association with about 1,100 members, called the proposals “unworkable” and said they added an unnecessary layer of bureaucracy.
The AIMA also vowed to fight against the new rules, while the Association of Investment Companies (AIC) more recently responded with a position paper proposing that all EU companies trading on an EU-regulated market should be completely exempt from the scope of the directive. “The Directive does not take account of the closed nature of investment companies, the supervisory and legal responsibilities of the board and the existence of European directives which already regulate their activities,” the group said in a statement. “If the Directive is not significantly amended, investment companies will face serious problems which will compromise their ability to operate effectively.”
In the run-up to the debate over the proposal, the EVCA, AIMA and British Venture Capital Association are all preparing to release their own position papers outlining their views and recommendations. Such groups will have to counter the efforts of Poul Nyrup Rasmussen, leader of the Party of Socialists, who has been the driving force for having a European regulation.
Playing politics
The draft legislation could be enacted by 2011 if it receives the approval of a majority of the 27-member EU, as well as the assent of the European Parliament. However, while the socialist groups maintain a large and hostile bloc inside the parliament, private equity groups may have received a boost in recent elections: centre-right political parties gained significant ground in Germany, France, Italy, Belgium and Spain.
In fact the main centre-right bloc was expected to have the biggest presence in parliament with 263 seats. “There has been a change in the political landscape toward groupings who may be philosophically less inclined to regulate so strongly,” said James Ford, a partner in the Investment Funds and Securitisation practice of O’Melveny & Meyers. “To some extent that may be helpful when this directive gets to be debated in front of the European Parliament probably in the last quarter of this year.”
However private equity groups won’t be taking any chances, and will likely be engaging in an all-out push to get their view out about the benefits of private equity and the damage the regulations could do, not just to their industry but to economies throughout the continent.
Points of contention
One of the areas that the industry will focus on in trying to change the draft is its definition of leverage, which is considered too broad in how it designates which firms qualify for regulation as part of the assets under management threshold.
On the marketing side, European- and non-European-authorised managers will be limited to only being able to market to professional investors. But to qualify as a professional investor one must demonstrate that they have done a number of transactions in the relevant asset space within a certain period.
“Private equity by its nature is an asset class in which the biggest LPs don’t make a huge number of investments in one year, and there are already a number of conversations about how it is going to be difficult to qualify the smaller, less frequent investors within that professional investor bracket,” Ford said.
The rules would have an impact outside of Europe as well, restricting US-based alternatives managers from raising and managing assets in the European Union. Foreigners trying to market in Europe as the directive stands at the moment will have to demonstrate to the relevant authorities that they are subject to the equivalent regulation in their home jurisdiction.
“As things stand, and for so long as we are waiting for proposals from the US government, I don’t think that anyone can be comfortable that US managers would be able to demonstrate that,” Ford said. “There is a very clear risk that European investors could have a very serious loss of access to top-performing alternative investment managers who are not based in the EU.”
Other issues of contention will likely include the high capital threshold requirements for independent valuations and an independent depository or custodian.
Best case scenario
While some of the more aggressive opponents may think they can get the industry out of these regulations, the best case scenario is that there will be some regulation, but an effective lobbying effort will turn into something acceptable to the industry.
“My belief is that we will end up with something sensible, but my fear is that to an extent that gets slightly derailed by overaggressive lobbying rather than a more constructive engagement,” Ford said. “There is going to be compulsory regulation and the key is going to be engaging with the national member state governments as well as the European trade associations.”
The EVCA recently proposed changes to its governance structure to better align it with national associations around Europe and counteract the threat of increased regulation. The move is intended to help the whole European industry speak with “one clear voice”. Ford says of the relevant bodies, the EVCA has taken the most “intelligent and reasonable” approach.
Such groups can look to the recent voluntary Walker reporting guidelines in the UK as an example to follow in carving out regulations the industry can live with. However, they should not think they can talk the industry out of having to adjust to some form of oversight.
Other key recommendations of the Association of Investment Companies’ position paper:
- Investment companies must be allowed to continue to issue shares and manage their capital structure. Failure would prevent existing companies from meeting commercial needs such as implementing discount control policies.
- Remove requirements for redemption on demand for investment companies.
- Limit obligations to funds with potential regulatory significance. The threshold determining whether alternative investment fund managers have to comply should be increased.
- Any requirement for independent valuation should refer to accepted best practice and not be set in relation to country laws or the alternative investment fund’s best practices. Independent valuation should not be required of assets where there is a readily available market price.
- If investment companies remain within the scope of the directive, the UK government should formally confirm that it intends to allow alternative investment funds to be marketed to retail investors within its jurisdiction.
- Provisions regarding short selling should be removed from the directive. Instead a full consultation should be undertaken with a view to introducing suitable provisions into the Transparency Directive, which will then apply to all relevant market participants.
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