Solvency II may herald fundraising dark age

Investors in England, France, Germany and several other European states have long been vital sources of capital for the private equity industry. But, an updated regulatory framework covering European insurance companies may spur one of the private equity industry’s biggest supporters to pull back future fund commitments.

The heart of the issue rests in how European insurance firms will need to set aside emergency capital for their investments. The Solvency II Directive, expected to enter effect in 2013, requires insurers to hold varying levels of capital based on the riskiness of an asset. For private equity, insurance firms will need to set aside €49 for every €100 invested.

In all, European insurers hold some €7 trillion in assets, according to Fitch, a credit rating agency. And while hard numbers are difficult to come by and vary by country, sources tell PE Manager that insurance firms typically allocate between 1 to 2 percent of their portfolio to private equity – translating to roughly €70 billion to €140 billion at stake.

Oddly, in deriving a sizeable 49 percent “shock buffer”, regulators analysed historical data from the LPX 50 – an index of 50 quoted private equity firms. However the LPX 50 index is an inappropriate starting point for the asset class, argues Michael Studer, the head of portfolio and risk management at Partners Group. “The composition of the index is not representative of a typical institutional private equity portfolio. For example, 20 percent of the index is comprised of asset managers such as Partners Group which pull revenues made from management fees that do not reflect the risk characteristics of private equity.”

Additionally, “listed firms do not provide a genuine risk profile of unlisted firms because of differences in liquidity and strategy,” he continues. The end result is a private equity benchmark showing greater correlation (and thus risk) to other investment strategies than what is actually the case.

Studer discusses a Partners Group study which found a more appropriate stress factor for private equity would be no more than 30 percent when taking into account its long term holding strategy through time series models. The firm also names Thomson Reuters as a suitable alternative in providing a more accurate index of unlisted private equity while others have suggested the European Private Equity and Venture Capital Association (EVCA) provide the benchmark.

In an email exchange the European Insurance and Occupational Pensions Authority (EIOPA), the market watchdog responsible for supervising the new insurance rules, says it was “not considering using a different benchmark” from LPEQ.

A tangled web 

Perhaps more cumbersome is that Solvency II lumps private equity in with hedge funds, commodities and equities listed on emerging market exchanges as part of an “Other Equity” subcategory within its standard risk model. Insurers’ capital holding requirements are relaxed if it can be shown certain subcategories within the model exhibit diversification benefits, thus reducing the insurer’s portfolio risk. By commingling private equity with other asset classes, insurers lose the opportunity to show the diversification benefits of assets within their own subcategory and measured against others, says Amanda McCrystal, the head of strategic business development at fund of funds HarbourVest Partners.

“Some studies show that there can in fact be negative correlation between certain private equity strategies, such a venture capital, and public equities, but the current proposals do not accommodate such an outcome,” McCrystal adds.

EIOPA says private equity was grouped with other asset classes because the potential diversification benefits between them were too “low and difficult to calibrate” therefore assigning every investment grouped in the “other equity” risk bucket “an implicit correlation of one”.

A side effect of the model’s risk groupings is better treatment for listed private equity firms. While assets (including private equity) sitting under the “other equity” umbrella are assigned a 49 percent stress factor, listed private equity was categorised under the “global equity” umbrella which receives a lower 39 percent stress factor. Some reports have argued this could split the industry into two, but multiple sources told PE Manager these concerns were overblown due to volatility and holding strategy differences between the two investment models.

Fundraising straightjacket 

The model’s inflexible treatment is particularly detrimental for insurers and certain pension funds which are best able to utilise private equity’s long-term holding strategy, elaborates McCrystal. And the problem may not be limited to EU insurers. Solvency II requires non-EU insurers and reinsurers to meet an “equivalency test” to gain certain privileges, including most importantly lower capital holding requirements.

Moreover, the European Commission is currently seeking advice on how it could transpose Solvency II capital requirement rules to EU pension funds, says Lesley Browning, a partner at law firm Norton Rose, who adds the move has sparked backlash from European pensions potentially affected by the changes. Danish pension funds, due to their unique legal structure, will already be captured by the new insurance rules. Separate regulations covering banks will further constrain fundraising. Basel III, which from 2013 will be phased in over six years, will force banks to hold more capital against their private equity investments.

Fortunately, an escape clause exists within Solvency II. Insurers may adopt their own internal risk models should they find the standard model provided by regulators too cumbersome.

However, doing so requires significant time and expense, say sources. And even if an internal model were developed it would have to first be approved by EIOPA before it could be put into practice.

Sources say EIOPA is currently experiencing a backlog of approval requests, many of which will remain idle past the January 2013 deadline.

EIOPA responded in its email that “preapplications are in progress to ensure that industry and supervisors can prepare as much as possible before the application of Solvency II”, adding they are “aware of the challenges the model approval process is posing” to insurers. EIOPA intends on issuing guidelines “which should help in assessing the application and quality” of an internal model submission.

Looking forward, EIOPA is waiting for the European Commission and Parliament to complete work on an “Omnibus II” directive which will provide the legal basis for EIOPA to complete its Solvency II reforms. This is expected to be completed in early 2012.

For this, and other reasons, says McCrystal, “There is current debate about whether the implementation date may be delayed by 12 months to January 2014; either way there will follow an 18 month implementation transition period for insurers.” Though, for some fund managers, that may not be enough time.