LPs feel the heat too

Fund managers aren’t the only ones undergoing an unprecedented level of scrutiny from regulators. LPs too are facing a blowback from the financial crisis in the form of greater risk capital rules. And few other asset classes are being pegged as a greater risk than private equity in the minds of policymakers.

That’s a troubling situation at a time when the fundraising trail is becoming increasingly crowded due to what some might call a glut in the buyout industry. Forcing LPs to set aside a large cushion of capital for their private equity investments will only increase GPs' challenge to secure commitments. 

Nowhere is this issue more pronounced than in Europe. Already European banks and insurance firms will need to set aside emergency capital for private equity assets under Basel III and Solvency II respectively. But now pensions, a third pillar of the LP community, appear to be under the crosshairs.

The European Insurance and Occupational Pensions Authority (EIOPA) is considering copying and pasting its Solvency II directive to the continent’s pension fund system. As we reported last week, the buyout industry is sounding the alarm on why that would be a costly mistake for Europe’s ongoing economic recovery.

For starters, Solvency II presents a poor understanding of private equity risk. The directive’s default risk model makes a confused distinction between listed and unlisted private equity; or for that matter, even its difference from hedge funds. Other shortcomings relate to the model’s heavy preference for liquidity over capital at risk, a point stressed strenuously by Europe’s buyout industry. A short dated BBB rated bond, for example, requires less capital than a longer term AAA bond under Solvency II – an odd result in regulators’ attempt to reduce risk.

And pensions (perhaps more so than other institutional investors) fully appreciate the rewards of long-term investment in meeting liabilities as they fall due. A set of rules pushing pensions exclusively towards short-term assets would only increase their funds’ portfolio risk.

Wisely, Europe’s private equity community is diligently raising these concerns with government. In different conversations we’ve had with stakeholders, lobbyists and policymakers themselves, the apparent consensus is government will take a sympathetic view to these concerns as pension rules are crafted over the next two years.

EIOPA is due to submit its advice to the EU Commission next month. Let’s hope the appeal and diversification benefits of long-term investment is given its due by then, before final rules begin to take shape next year. Because for some fund managers time is of the essence, and speaking with pension officials is difficult enough without a regulatory elephant in the room.