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Legislative procedures cast their shadows

11 April 2019

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Revision of the AIFM Directive and Solvency II as well as Environmental Social and Governance (ESG) concerns and cross-border fund sales do not allow the private equity and venture capital funds any regulatory break.

It is not just the adjustments to the, unfortunately still unclear, effects of Brexit that are currently driving the private equity (PE) and venture capital (VC) funds sector in Europe. Other legislative procedures of relevance for the PE and VC sectors are casting their shadows.

These include the forthcoming revision of the Alternative Investment Fund Manager Directive (AIFMD) based on the recently completed review by the European Commission. In this context, the article also refers to, from the PE and VC sectors point of view, the draft Commission Transparency Regulation on ESG themes, the drafts on the cross-border sales of funds and the recently published Commission proposal for a regulation on the revision of the Solvency II rules (advanced insurance solvency requirements).

The AIFMD has been controversial since its introduction by the PE and VC sectors. Not only because did one see the sector being, from their point of view, wrongly accused of (jointly) causing systemic risk.

Unlike hedge funds, which typically use leverage of the capital raised for investment (synthetic) purposes, and thus – according to the authors of the Directive – could potentially be systemically relevant, such leverage in PE and VC Funds is neither necessary nor desired.

In that regard, the leverage rules of the AIFMD are at least not precisely suitable for the PE and VC sectors. Furthermore, one was also critical of the asset stripping rules and sceptical as to whether the benefits identified when the marketing passport was introduced would also benefit the PE and VC sectors.

In the framework of the Commission’s review of the Directive, with a view to a forthcoming revision, the sector has now, at least partially, been able to make its voice heard. The review has had as its object, based on the mandate of Article 69 (1) of the Directive, inter alia, assessment of the management as well as the marketing passport, examination of the question of any impact of leverage financing, experience and assessments of investor reporting.

It is pleasing that the Commission’s review also seems to confirm that – with the exception of open-ended real estate funds – AIFs (alternative investment funds) or PE or VC funds are generally exposed to little liquidity risk due to the use of third-party capital or leverage. Any systemic risks to financial market stability in general would therefore not have been caused at least not by the fund sector, and certainly not by PE and VC funds, which generally do not use such leverage. This does not mean, however, that the review will lead, for example, to the abolition of leverage rules, for example for PE and VC funds.

The Commission proposes to wait for the report from IOSCO (the International Organization of Securities Commissions) on leverage in mutual funds and alternative investment funds before proposing any adjustments to the leverage rules of the AIFMD to overcome and mitigate any leverage or liquidity management risk.

By contrast, the ERSB (European Systemic Risk Board) had already noted in a separate report, which appeared before the review of the AIFMD, that general abstract legislative measures were needed to avoid leverage or the consequentially-arising systemic risk, regardless of the issue whether such risks can really be evoked by funds and, specifically, the PE and VC funds. In that regard, the Commission’s proposal to give overriding priority to IOSCO and not to follow the ESRB recommendations without further ado is to be assessed positively from the point of view of the PE and VC sectors.

The management passport was generally assessed as positive in the review and is also widely used, for example, for Luxembourg funds (at least insofar as the cross-border administration does not create a permanent taxable establishment for the fund in the manager’s country of residence).

The marketing passport, according to many market participants, has not (yet) met the expectations that have been placed in it by the PE and VC sectors that have responded in the framework of the review. Ambiguity in the definition of what “marketing” means and differences in the national interpretation of the term as well as a number of additional national measures and fees, which turned out to be an additional “trade barrier”, especially for the Luxembourg funds reliant on cross-border sales, have made the application much more cumbersome than expected on the occasion of the entry into force of the Directive.

In addition, it has not been helpful in translating the functioning of mutual fund sales to alternative investment funds, as the latter is structurally different in type and manner of sales, i.e. where a finished product is not sold directly to a large number of retail investors through an existing sales network but often a small number of institutional investors are addressed and only if their prospective commitment is real will a fund product be created. From the ranks of the PE and VC sector, the demand for a time limit of the passport was also loud, because here – unlike mutual funds – the phase of raising funds is usually only a fraction of the term of the fund.

As part of the measures initiated by the Commission on cross-border sales, some of the experience described above has been included. Thus the Commission’s proposal now includes a common definition of ‘pre-marketing’, which should allow the interest of potential investors in an AIF to be established to be tested in advance. For this purpose, the AIFM acting for the respective fund must then inform the Member State informally in advance. The Commission also proposes a mechanism for funds to end sales notices.

It remains to be seen

Whether these measures in the proposed form will prove practicable (for example, the European definition of “pre-marketing” perhaps being more restrictive than other definitions used so far in different Member States) remains to be seen. It is also noteworthy that the Commission also explicitly provides for a study on the so-called “phenomenon” of “reverse solicitation” and the use of EU-AIF by third-country investors in order to address perceived circumvention risks in this context.

Another topic that was the subject of the review is investor reporting. Here participants of the study were critical of the fact that the “one size fits all approach” in particular of Article 23 of the AIFMD is implemented by market participants very differently (the range goes from an implementation, for example, in the context of a partnership contract up to the production of a separate discharge document) and that moreover sector or asset class specifics cannot be sufficiently taken into account.

However, it seems unlikely that the Commission will react with an obligation of this requirement. By way of example, the draft ESG Transparency Regulation sets out to extend the requirement of Article 23 for statements on ESG risks of all types of funds, including PE and VC funds, if only to highlight the sustainability risks of the investment or whether these funds pursue a sustainable investment goal.

By contrast, the Commission had good news for the private equity and venture capital sector as part of a proposal for a regulation published on 8 March 2019 to revise the Solvency II rules. Insurance companies that do not choose their own internal valuation model for the capital adequacy of their investments but rather the Standardised Approach can likely use reduced equity ratios (potentially only 22%, depending on the application) for depositing their investments in a new category of “Long Term Equity Investments” introduced by Article 171a of the draft Regulation.

In addition, the question of classification can be assessed at the fund level itself and not at the level of the portfolio companies. The measure is currently only a Commission proposal and Parliament and Council approval are still pending. If, on the other hand, the Commission takes its proposal through, it will expand the potential investor base for private equity and venture capital funds and provide these investors with a welcome diversification of their investment path from low-yielding government bonds for the benefit of those entities which they insure.

Authors: Anja Grenner, Director Funds, Intertrust and Arne Bolch, Partner, GSK Stockmann.

Originally published in Börsen-Zeitung on 27 March 2019.