The European Venture Capital Funds Regulation: will a new fund label arise?
September 2013 | SPECIAL REPORT: PRIVATE EQUITY
Financier Worldwide Magazine
The 22 July 2013 marked the deadline for the transposition of the Alternative Investment Fund Managers (AIFM) Directive in Member States. On that same date another European legislation became applicable that impacts directly the venture capital industry: the European Venture Capital (EuVECA) Funds Regulation.
With this Regulation, the EU aims to encourage investments by venture capital funds in small and innovative companies in order to boost economic growth.
This article examines the expected impact of the Regulation on the European venture capital industry and whether the optional regime offered by the Regulation may succeed in attracting managers and investors, thus giving rise to another new fund label.
Venture capital funds can contribute to economic growth
The EuVECA Funds Regulation was released as part of an EU action plan (‘Europe 2020 Strategy’) to improve access to finance for small and innovative businesses and in turn to stimulate economic growth. Indeed, SMEs often face difficulties in accessing bank loans or listing on stock exchanges. They therefore increasingly need to turn to alternative sources of financing, in particular venture capital funds.
However, the EU venture capital industry is fragmented and dispersed. Because of the diversity of rules in the Member States, venture capital managers bear high costs in raising funds across Europe. The result is that EU venture capital funds are still very small – according the European Commission they are five times smaller than US funds – and do not contribute to the financing of the economy as much as they could.
The primary aim of the Regulation is to make it easier for venture capital funds to raise capital across Europe and enable fund managers to market EuVECA in all Member States without having to comply with 28 different national rules.
Venture capital funds should benefit from a passport
In the aftermath of the financial crisis, European legislators resolved to regulate hedge funds and private equity funds through the AIFMD, subjecting them to obligations aimed at monitoring systemic risk and enhancing investor protection. In return, AIFMs are granted a passport allowing the management or marketing of their funds throughout the EU. The AIFMD, however, sets out thresholds exempting ‘small’ managers from many of its obligations, in the meantime depriving them from the benefits of the passport.
Considering that 98 percent of the managers of venture capital funds are below the AIFMD thresholds, European legislators decided to introduce a new EuVECA designation which would allow venture capital fund managers to nevertheless benefit from a marketing passport outside the AIMFD framework, provided that they comply with requirements that are globally lighter than those set out by the AIFMD.
The legislative process that led to the adoption of the EuVECA Funds Regulation was swift. The European Commission launched a consultation in June 2011, which was followed by a Regulation proposal in December 2011. The EuVECA Funds Regulation was adopted on 17 April 2013 and became applicable concomitantly to the AIFMD on 22 July 2013.
An optional regime for managers below the AIFMD thresholds
The aim of the EuVECA Regulation is to make it easier for venture capital fund managers that are below the AIFMD thresholds to raise funds across Europe. The key elements of the Regulation provide for the use of a EuVECA designation and for the introduction of a European ‘product’ passport allowing funds to be marketed throughout the EU without having to comply with 28 different sets of rules.
AIFMs whose assets under management do not exceed the following thresholds are exempt from the requirement to seek authorisation under the AIFMD and from many of the provisions of Directive: (i) AIFMs that manage portfolios of AIFs whose assets under management in total do not exceed a threshold of €100m; and (ii) AIFMs that manage portfolios of AIFs whose assets under management in total do not exceed a threshold of €500m when the portfolios of AIFs consist of AIFs that are unleveraged and have no redemption rights exercisable during a period of five years following the date of initial investment in each AIF.
It should be noted here that managers that benefit from these exemptions are, however, required to comply with certain minimum registration and reporting requirements under the AIFMD, such as registration with the relevant Member State’s competent authority, notification of the investment strategies employed and periodic updates with regard to the main instruments they use. The EuVECA Regulation should in no way be considered as a means to circumvent the AIFMD.
The EuVECA Regulation offers managers below the AIMFD thresholds that are located in the EU the option to identify their funds as EuVECA and passport them across the EU. Managers that subsequently exceed the AIFMD thresholds are allowed keep the EuVECA designation – provided of course that they comply with the AIFMD and the relevant provisions of the Regulation.
Lighter requirements for using the EuVECA designation and marketing passport
Managers that elect to use the EuVECA designation and passport have to comply with requirements that are globally lighter than those set out by the AIFMD. The main obligations they are subject to are as follows. First, managers and funds should both be located in the EU. Second, funds should fulfil a number of criteria applying to the assets in their portfolio: in particular, they should intend to spend a high percentage of their investments (70 percent of capital contributions and uncalled committed capital) in supporting young and innovative companies. Such ‘qualifying investments’ are described by the Regulation as equity or quasi-equity instruments issued by ‘qualifying portfolio undertakings’, located in the EU or not (in which case some agreements on anti-money laundering and terrorist financing and taxation need to be in place), defined as unlisted organisations with fewer than 250 employees and an annual turnover under €50m or a balance sheet of less than €43m. Third, funds may not employ any method to increase their exposure beyond their committed capital, whether by borrowing, through the use of derivatives or any other means. Finally, funds must abide by uniform standards (including rules on governance, conflicts policy and reporting to regulators) and rules on delegations (in particular, managers may not become a letter box entity).
It should be noted here that, unlike AIFs subject to the AIFMD, EuVECA funds are not required to have a depositary. This may be seen as a significant advantage in terms of costs. However, on the other hand, this may constitute a significant flaw in terms of investor protection and might hamper investor confidence in EuVECA funds.
Expected benefits of the passport and potential development of a recognised label
The passport introduced by the Regulation is based on the same principle as the UCITS or AIFM ‘product’ passport, i.e., marketing of a fund across the EU through a notification procedure. Managers who wish to use the EuVECA designation are required to apply for registration with the competent authority of their home Member State. Once the competent authority grants authorisation, it is required to notify the registration to the Member States listed on the manager’s application as target jurisdictions for marketing. EuVECA may be marketed in all EU Member States without being required to comply with the national rules of those Member States.
It should, however, be highlighted that target investors are defined differently than in the AIFM Directive framework. Indeed, the EuVECA passport applies, in addition to professional clients, to investors who make a minimum investment of €100,000 and who state in writing that they are aware of the risks associated with the investment in the fund as well as executives, directors or employees of the manager.
In the same way the AIFM passport will allow managers to benefit from an enhanced market, it is expected that the EuVECA Funds Regulation, harmonising rules at European level, will reduce the compliance costs attached to raising funds across the EU.
Will a new fund label arise complementary to AIF and UCITS?
As the Regulation is not compulsory, managers will have to perform a careful assessment of the pros and cons of using the EuVECA designation for each of the funds they manage.
It might be a concern that rules on ‘qualifying investments’ might prove too prescriptive and reduce the types of investments that a fund is able to make. This would in turn narrow the structuring options available to managers and generate reduced returns.
In addition, the absence of a compulsory depositary for EuVECA funds may constitute a major deterrent to the development of a new fund label. Indeed, there is a risk that investors might not trust their assets in funds that do not ensure their expected level of protection. It remains to be seen whether this new EU stamp of approval will provide investors with the required confidence.
Furthermore, a review of the Regulation scheduled by July 2015 could see the Regulation expanded to non EU domiciled funds. Is there a risk that such an extension might dilute the label and confuse investors? A later review scheduled by July 2017 should include a general survey of the functioning of the Regulation and consider in particular the extension of the marketing of EuVECA funds to retail investors as well as the introduction of a depositary regime. Would this allow building a label recognised by professional and retail investors alike?
At this very early stage, it is hard to tell the extent to which the Regulation will appeal to the venture capital industry and whether a fund label will arise complementary to AIF and UCITS. In other words, it is difficult to assess the willingness of managers to subject to the Regulation and the appetite of investors for EuVECA funds.
The Regulation puts in place useful tools that venture capital fund managers will hopefully employ wisely in order to serve their clients better and in turn contribute to the economic growth of the EU.
This year we celebrated the 25th anniversary of UCITS, as the fifth version of the Directive is under way. The AIFMD is still in the process of being transposed by Member States. In this context it is to be expected that EuVECA will take some time to develop into a fully-fledged fund label.
Carine Delfrayssi is Deputy Head of International Affairs at AFG – French Asset Management Association. She can be contacted on +33 1 4494 9658 or by email: email@example.com.
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AFG – French Asset Management Association