New regulations in Europe: the perils of painting with a broad brush

Officially, that’s because the European Parliament has gone into recess for the summer, with the next trialogue discussion among the European Commission, the Council of Ministers and the European Parliament scheduled for August 30. But the fact is, so far, nine similar ‘discussions’ have already occurred without agreement on a single issue. Some say it will be October (at the earliest) before anything will be resolved.

Not surprisingly, there are a number of contentious issues in play, with the so-called ‘third – country regime’ topping the list. This refers to conditions under which non-European-based fund managers – such as Asia Pacific GPs – will be able to market their non-European funds to European investors.

But there are a daunting number of additional issues also in need of resolution, such as new disclosure and capital requirements, use of leverage, remuneration, grandfathering and the treatment of secondary private equity assets to name a few. Taxation is of course in the mix, though unlike in Australia, most market onlookers don’t see it as critical at this stage.

Dissolving confidence

Amanda McCrystal, a Vice President with HarbourVest Partners in London, and co-captain of the Listed Private Equity Forum’s Industry Affairs Committee and participant in EVCA’s Technical Committee, told AVCJ, “The biggest concern I have is the uncertainty all this is now creating. Nothing worries investors more. There’s a growing sense of hiatus because there is nothing anybody can sensibly yet do to plan for what may or may not be required when this AIFM Directive is finally resolved.”
Unfortunately, ‘wait and see’ is not an option.

“For those significant institutional investors that have big investment programs to carry on, this is problematic, not only because the shape of the coming regulation remains obscure, but also because the timetable under which it’s likely to be enforced is another unknown.”

McCrystal continues, “That said, I think it is nonetheless important to recognize that many alternative investment managers, including HarbourVest Partners, their trade bodies and professional investors are supportive of the goals of the directive, to avoid financial crisis and to protect investors. Established and well-governed managers are not concerned about being regulated, they are concerned about unnecessary or onerous regulation that does not bring benefits for investors and fails to achieve its original objectives.”

Key sticking points

Perhaps the most prominent specific issue is the third-country issue. Under the current European Parliament text, managers domiciled in third countries would be able to market their funds to European investors if their country of domicile meets certain equivalency criteria. In other words, the country where the fund is located would have to have high enough standards to combat money laundering and terrorist financing, while granting reciprocal access to the marketing of EU funds on its territory.

Furthermore, it would have to have agreements in place with (European) member states where such marketing is intended, on the exchange of information related to taxation and monitoring. Fund managers must also agree with ESMA (the supervisory regime being created) to comply with the directive.

Simon Walker, CEO of the British Venture Capital Association (BVCA), the prime industry lobby group in the UK, told AVCJ:

“While we support the principle of granting a ‘passport’ on a pan-European basis, any passport/restriction on national regimes – which is, according to the parliamentary and commission text, dependent on individual member states entering into agreements with the alternative investment fund’s (AIF) local regulator – is not a true passport.

Individual member states will be able to refuse to enter into agreements with the AIFs locally. And a failure to provide third countries with a level-playing-field mechanism could spark tit-for-tat retaliation, particularly from the US. And since about 60% of European venture capital and 40% of the buyout funds come from outside the EU, it is critical that our trading partners feel that they are being treated fairly.”

A bureaucratic dream come true

As to how all this might play out in a European private equity context, HarbourVest’s McCrystal offers the following simplified snapshot:

Assuming, she says, that you are a fund domiciled in the EU, managed by a European fund manager, in theory such a fund would be regulated under the new regime and European investors would be free to invest in them. But there could still be restrictions, including what the fund itself could invest in, if it is to be compliant. Still, if the European fund manager and European fund has an end-to-end onshore European structure, the manager could apply for authorization under the directive and be off on their way.

That becomes more complicated, however, if they have a fund which is based outside the EU – as with any Asia Pacific fund. In such cases there would be additional regulatory obligations as to how they would be able to market that fund to European investors.

As well, if a fund is based outside the EU, such as HarbourVest itself, this extra burden would likewise apply.

“The original attempt appears to have been to encourage as many alternative fund managers as possible to bring everything they do within the confines of the EU,” she explains. “But that’s unlikely to happen for a number of reasons, not least the taxation considerations. But there could well be a sort of staggered process, depending on your particular structure, governing what a manager can do in Europe and when.

Disclosure and capital requirements

Bearing in mind that it is all speculation at this point, the disclosure requirements in the European Parliament’s text, wherein only companies with 50 employees or less are exempted from the requirements, would be damning to the venture capital industry. They put onerous burdens on small companies in terms of both their competitive and administrative capacity, effectively rendering them unattractive to entrepreneurs using venture capital as a means to fund growth.

Additionally, the European parliamentary text sets the threshold for a controlling interest at a mere 10%. This despite the fact that shareholders with 10% voting rights in a privately-owned business can exert no influence vis-à-vis that company, its management or the other 90% shareholders.

Similarly, the BVCA says, under the Commission’s original draft, the capital adequacy would have been “incredibly onerous” for the venture capital community, to the extent that they would served only as a major deterrent to new VC managers.

“It is therefore encouraging, under the parliament’s latest text, that a degree of tailoring has been recommended, ensuring that private equity and venture capital firms are exempted from these requirements,” Walker explains. “After all, they do little to provide additional investor protection, which is one of the aims of the directive.”

Another iffy area growing out of an amiguous text concerns leverage.

The BVCA position is that leverage should be regulated at the fund level. By contrast, debt regulation at the portfolio company level would reduce a company’s capacity to develop solely due to the nature of its shareholder. Thus it too would be discriminatory. As well, sustainable leverage at the portfolio company level will vary a good deal from one company to another, depending on the sector, the cycle and the company itself. And these are in no way linked to the AIF.

Secondaries, grandfathering and bleak prospects

HarbourVest’s McCrystal points to secondary assets, specifically the conditions under which they can be sold, as yet another potentially problematic area.

“This issue is significant because secondaries are completely embedded in the whole fabric of the private equity industry,” she told AVCJ. “So to have restrictions over what investors might be able to sell in the secondary market – and to whom – would again make life quite challenging, for all market participants.”

In terms of the grandfathering regime, McCrystal reckons the whole issue has yet to be properly considered. All three drafts of the directive to date are silent as to the treatment of existing GP investments and LP commitments.

“None of us needs to be a financial genius to work out the implications of a vast divestment program being forced upon the private equity industry,” she says. “But as things stand at the moment, there is no guidance as to what Brussels is planning for existing funds and existing investments that have been made by those funds. Nor has any signal been sent that indicates this issue is being addressed. My view is that it’s dangerous to assume that silence in the draft texts means everything will be OK. This is why we’ve been doing our best to draw it to the attention of the European finance ministers and policy makers. It’s too important to be left to chance.”

Finally, both sources share the view that the changes ushered in by the directive (if there is not a substantial change) will have a very marked effect on emerging market fund managers, and therefore the businesses they invest in.

“Asian interests could potentially end up starved for capital, to the degree that they look to Europe for economic support,” Walker says. “And I’d reckon that over a comparatively short period of time that will have a marked impact on the viability of managers and fledgling businesses there.

“Overall, however, in trying to be so overarching in its scope, the directive may ultimately fail to achieve its goals. But let’s see where it ends up. It is still certainly possible that the eventual draft could be sufficiently re-shaped to address the plethora of concerns voiced from all corners of the world. But there is a long way still to go.”  

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• Topics
• Regulation
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• HarbourVest Partners