Capital adequacy and private equity in the EU
September 2013 | SPECIAL REPORT: PRIVATE EQUITY
Financier Worldwide Magazine
This September marks the five-year anniversary of Lehman Brothers’ filing for Chapter 11 bankruptcy protection – the event widely seen as precipitating the financial crash. Five years on and we continue to grapple with the fallout of a crisis unprecedented in modern times and which has generated a considerable regulatory backlash. In Europe this has manifested itself in numerous dossiers hitting all manner of financial institutions such as banks, insurers, hedge funds and private equity. The name of the game has been to increase macro-prudential stability and accountability following the excess of the pre-crisis era.
Legislation affecting the financial sector always entails a trade-off, however. Too light-touch and you risk laying the foundations of future crises; too heavy-handed and we will have moribund financial activity. Unfortunately, politicians and regulators, at both domestic and European level, have adopted an approach that is tantamount to using a sledgehammer to crack a nut. This will have a profound effect on the competiveness of the European economy.
One of the most prominent legislative files to emerge from the European Union (EU) in this regard has been the fourth iteration of the Capital Requirements Directive (CRD IV) which will be applied across the bloc’s 28 member states from 2014. This dossier implements the Basel III agreement in the region and will mandate European banks hold greater levels of capital, in more liquid form, against their investments. This should ensure they are better able to withstand market stress of the kind we saw in 2008. This is a laudable objective, but somewhat predictably the devil is in the detail.
Banks put capital to work in all manner of financial institutions that provide alternative finance to the real economy, such as private equity. This could be jeopardised under CRD IV. The premium on liquidity does not square with the provision of long-term investment for which private equity is synonymous as funds are closed-ended and usually offer limited redemption rights for investors. As such, banks may shy away from investing in the industry, despite its proven track record: over the last 10 years annual returns generated for pensions funds and other investors by UK private equity and venture capital has been 14 percent, three times those generated by public markets.
Of even greater concern over the last 18 months was the stated ambition of the European Commission to introduce risk-weighted capital charges for pension funds under a revised Institutions for Occupational Retirement Provision (IORP) Directive (which regulates pension fund activity at EU-level). These would have been heavily modelled on those set to be implemented under the Solvency II Directive – covering insurers – which requires a 49 percent charge be held against every investment into private equity. To do so would have severely limited the availability of long-term finance in the real economy both directly and indirectly (via investments into long-term investment vehicles). For every euro that is held in reserve as a capital charge, one that could be put to work to foster the recovery is lost.
Fortunately, the Commission recently revised its view on pension funds and capital charges will no longer be included in the upcoming proposal – due this autumn. The situation remains static for insurers under Solvency II however, with anecdotal evidence suggesting that up to 50 percent of the industry could refrain from investing in private equity due to the new regulatory requirements. Again, this would be to the detriment of the end users of private equity investment – European SMEs.
Capital charges, if introduced, must reflect underlying risk and the suggestion (as indicated under Solvency II) that there is a 1 out of 200 chance of a private equity asset losing 49 percent of its Net Asset Value over the course of a year (under a 99.5 percent Value at Risk calculation) does not reflect reality. Independent research suggests this figure should be closer to the 30 percent mark.
Furthermore, two seminal ‘post-Lehman’ reports examining the causes of the financial crisis by former FSA chair Adair Turner and the High-Level Group on Financial Supervision in the EU, led by Jacques de Larosiere, both accept that private equity activity is not in any way, shape or form systemically risky. Of course, this does not mean that the industry has been impervious to regulatory scrutiny however, and nor should it be. July saw the implementation of the Alternative Investment Fund Managers Directive which introduces new rules for the managers of private equity funds relating to remuneration, delegation, capital requirements and depositaries. As an EU-regulated industry, investors can have even more confidence in the underlying risk-reward profile on offer, and this should be reflected in associated regulation.
Banks, pension funds, insurers, private equity – these financial institutions need to be firing on all cylinders if the engine of economic recovery is to ignite. Debt finance provided by banks is of pivotal importance to European business, but the Barclays, BNP Paribas, Prudential, and CalPERS of this world also serve a key economic function by investing in and facilitating the providers of equity finance. Crude banker-bashing reflected in heavy-handed legislation is not the right response to the mistakes of the past. Regulation should of course shield both taxpayers and investors from undue risk, but it must also serve as an enabler of new economic activity and growth. There has been precious little evidence of such an approach from the EU to date, however, which should be of significant concern to all those who want to see strong, sustainable growth return to the Continent.
Tim Hames is Director General of the British Private Equity & Venture Capital Association (BVCA). He can be contacted by email: firstname.lastname@example.org.
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