Regulation gold rush?

Incoming regulations on both sides of the Atlantic are expected to fuel a global secondaries bonanza. Nicholas Donato and Toby Mitchenall ask whether the hype is justified.

As governments across the globe propose new rules and regulations in reaction to the worst recession in generations, private equity secondaries investors are looking on hungrily.

Policy-makers have yet to hammer out the exact details of reform packages to be introduced across the US and Europe, but changes to solvency rules, permissible banking activity, and capital reserves in the banking and insurance markets will undoubtedly have a significant trickle-down effect on the secondary market, as institutions with substantial private equity interests are pushed – or at least encouraged – to rethink their private equity holdings.

In the United States, the recently signed, “Dodd-Frank Wall Street Reform and Consumer Protection Act”, sets new limits on banks’ involvement with private equity firms. The so-called “Volcker Rule”, named after former Federal Reserve chairman and current chair of President Obama’s Economic Recovery Advisory Board, Paul Volcker, will impose new restrictions on the ability of banks to invest in or sponsor private equity and hedge funds.

Unlike the White House’s campaign for a complete ban on proprietary trading and sponsorship, Congress has passed softer language which allows banks to invest up to 3 percent of their Tier 1 capital in private equity and hedge funds, with an additional restriction from acquiring more than a 3 percent ownership stake in any private equity group or hedge fund.


Volcker and Obama: juicing up the secondaries market?

For the world’s top banks, the Tier I capital measure, which is essentially equity capital and disclosed reserves, would largely allow proprietary trading to continue as normal. Bank of America alone reported $155 billion in Tier 1 capital based on a Q1-2010 financial statement. With that much in reserve, the banking giant would be able to legally trade over $4.6 billion from its own accounts.  According to analysts, the bank expected to be most significantly affected from the change in rules is Goldman Sachs, which reportedly generates roughly 10 percent of its revenue from proprietary trading.

Even so, language in the bill allows a comfortable lapse-time for banks to sell or unwind assets should the 3 percent threshold be breached. The restrictions would come into effect over the next 18 months, and full compliance with the rule may not ultimately be required for between 10 and 12 years.

However, the signed bill is not the end of the reform process as the bill provides only a framework for the new regulatory landscape. The Securities and Exchange Commission is expected to interpret and implement further rules and regulations at the behest of Congress over the coming months and years. The Volcker Rule’s precise impact on the secondary market is as yet unquantifiable, but any restriction on bank holdings suggests a coming opportunity for secondaries buyers.

Until there is clarity on the rules, therefore, banks will be able to continue monitoring the upcoming regulations, putting any rush to sell swathes of LP fund interests in the secondaries market on pause until full details of the law become available. “Some banks may choose to start to use the secondary market to pare back their portfolio or trim it down while they let the remainder of their portfolio unwind itself. Other banks may, over time, choose to sell down their portfolio completely,’’ says Harvey Lambert of PineBridge Investments, an alternative-asset manager.


A much bigger impact on secondaries will likely stem from the new restrictions on a bank’s ability to sponsor in-house private equity programmes. In-house private equity management teams may accelerate spin-out plans rather than face an uncertain future as a bank captive. This presents its own complications, says Pinebridge’s Lambert, who notes that bank-sponsored funds rely on their sponsoring parent in more ways than just as a capital source. “One of the reasons [LPs] invest in [bank sponsored] funds is the fact that the banks put up a lot of their own money inside of the fund, not to mention the network the bank provides the GP.  If, as a result of regulatory issues, the bank decides to spin out the GP and sell down all or part of its LP commitment, then the investment thesis of the fund has radically changed,” Lambert added.

One of the reasons [LPs] invest in [bank-sponsored] funds is the fact that banks put up a lot of their own money.

Harvey Lambert

On a global level, the Basel Committee on Banking Supervision is in the process of creating new international standards – dubbed “Basel III” – to “increase the quality, quantity, and international consistency of capital, to strengthen liquidity standards, to discourage excessive leverage and risk taking, and reduce procyclicality”, the committee said in a statement in July. Scheduled for full implementation by the end of 2012, Basel III’s mandate of increased liquidity and capital reserves will likely result in decreased investment in alternative investments and other asset classes.

A similar process is underway in the European Union to bring in regulation affecting the insurance industry. The Solvency II directive will introduce risk-based solvency requirements for insurance and re-insurance groups. As it stands it looks likely that the capital that a European insurer would need to hold against its private equity will increase.

The regulation is in its early stages. It was adopted in principle in November 2009 and is currently being subjected to a quantitative impact study run by the Committee of European Insurers & Occupational Pensions Supervisors (CEIOPS). The study is scheduled to run until the end of October, after which detailed implementation measures will be introduced in 2011. The directive will be formally introduced in 2013.


It is not yet clear how much more “expensive” Solvency II will make it for insurers to hold private equity interests. “The major concern for the private equity industry is if the solvency capital requirement is increased in respect of private equity holdings of insurers from current local requirements,” said a client note from law firm Ashurst in July.  This, the note continued, would make the asset class less attractive: “European insurance groups might as a result exit holdings and decrease future exposure.”

A research report from Swiss private equity investor Partners Group reaches a similar conclusion: “While most insurers are expected to have sufficient solvency capital, the new rules might either cause insurers with low surplus capital to consider reducing their asset allocations to private equity investments or potentially limit the ability of insurers to further increase their allocation to private equity.”

The fact is, an accurate assessment of Solvency II’s effect on the private equity market is impossible at this early stage. “There still seems to be considerable disagreement about some of the major issues surrounding Basel III and Solvency II, such as capital rules, before even turning to the granular – yet vital – discussions affecting individual sectors such as private equity,” says Andrew Milligan, head of global strategy at FTSE 100-listed insurer Standard Life. “Not only will the devil be in the final detail of any regulations, but also the other worry for investors is the length of time which it looks to be taking to reach agreement, with the technical committees hard at work until well into 2011.”


With detail still scant, there is a feeling that a worst case scenario – unlikely as it may be – could be shocking. Says one sardonic source at a secondaries firm: “If all the different initiatives in the European Parliament and Commission were to get passed, there would be no one left in Europe at all allowed to hold private equity. Hopefully a lot of this stuff will get thrown out.”

While the details of Solvency II and Basel III have yet to be hammered out, and the full effect of the Volcker Rule is as yet unclear, secondaries players are confident that the combined force of the legislation will provide plenty of deal flow to be getting on with.

Daniel Green, an investment director at secondaries specialist Green Park Capital, says his firm enjoyed “great” deal flow in both the build-up to and aftermath of the Basel II banking regulations in 2003. “The market was still recovering and we saw some very good deals sourced from banks all around the world,” he says, adding that he is expecting much the same from this round of banking regulation.

The insurance industry’s reaction to Solvency II seems less predictable. “Insurance companies have also historically been big sellers [of secondaries],” says Green, “although there has as yet been no trigger – such as Basel II for banks.”

Solvency has attracted less attention than the upcoming banking regulations, but, says Green, “there will inevitably be an impact”. “It is definitely something to keep an eye on: something we will be following closely.”


Despite the incoming regulatory codes being at various intial stages of definition, the industry has already seen a number of significant secondaries transactions emerging from the banking and insurance sectors. It should be noted, however, that there are other more pressing demands on some banks and insurers. In the case of one of Europe’s most significant recent deals – the sale by Lloyds Banking Group of a portfolio of direct portfolio companies to secondaries specialist Coller Capital – the state-backed bank was under pressure from the European Commission to sell off assets. Coller paid £332 million (€406 million; $515 million) for a 70 percent stake in a new venture named Cavendish Square Partners, which would manage 40 assets formerly owned by Bank of Scotland Integrated Finance (BOSIF).

In the US, Bank of America has been making strong headway in shedding its private equity assets in advance of Basel III. The bank has so far spun out two groups: one which will manage around $1.4 billion of the bank’s legacy private equity assets and another which will help run a $1.9 billion portfolio of fund interests sold earlier in the year to AXA Private Equity. “We haven’t seen the formal language under Basel III. [The proposed law] has requirements to hold capital against unfunded commitments. We have to evaluate that now and decide if that’s an appropriate use of capital,” a spokesperson for Bank of America told PEI at the time in July.

While it is possible to pinpoint some significant deals emanating from both the banking and insurance industries, it is unlikely that they are all symptomatic of a wider trend of institutions getting “ahead of the curve” by winding down their exposure. Indeed some market participants suggest that incoming regulation is a convenient excuse to either terminate relationships with some GPs or to get out of the asset class for other – less forward-thinking – reasons. Regardless of whether or not this is the case, it is clear that actors in the secondaries market expect deals from banks and insurers to eat up a significant chunk of the pile of dry powder waiting to be deployed into the niche.