Capital requirements for private equity firms

A recent change of direction in the ongoing debate of the Basel Committe on capital adequacy is good news for UK-based private equity fund managers. Comment from SJ Berwin.

The Basel Committee, the group of global banking regulators charged with overhauling capital requirements for banks, has got its work cut out. The existing rules – which establish the amount which banks have to set aside to cover default risk – are clearly in need of an overhaul, but striking the right balance is proving tricky.

It is vital that they do get it right, and listen to the 'special pleading' of affected groups. Otherwise, the knock-on effects will be felt way beyond the banking sector. Crucially, the private equity industry (while not directly affected by the proposals) will suffer if more restricted lending makes leveraged buyouts harder, and if banks become more reluctant to invest in funds.

But in one respect, at least, the deliberations of the Basel Committee have proved helpful to UK-based fund managers. They have helped to deliver a reprieve – perhaps even a full release – from proposed rules which would have had very significant consequences for their own regulatory capital requirements.

The UK’s Financial Services Authority – which regulates fund mangers operating in Britain – has been looking at its rulebook. It wants an integrated approach to capital for all firms, including private equity fund managers, and issued some worrying proposals in 2001. Although no doubt right in principle, the draft rules failed to recognise the different risk profile of those running private equity funds. In particular, they suggested an 'income based' requirement which would have established disproportionate burdens. Capital of 5 per cent of managers’ income was proposed as a yardstick, which would have been a very significant increase for most.

Those proposals have been put on hold while negotiations continue on the Basel Accord and the related European capital adequacy framework. It now seems unlikely that the income based requirement will survive in either the European or the UK’s final draft rules, and fund managers can breath a sigh of relief, at least for the moment. Nothing is now likely to change until 2006 at the earliest.

A watching brief remains essential, though. Integrated approaches to regulation have a number of attractions – but are also fraught with difficulty. The regulatory environment for private equity fund managers must reflect the risks which they face: that is part of a coherent approach, not special pleading.

SJ Berwin is a European law firm with a particular focus on private equity. The above comment is taken from the firm's weekly e-bulletin, Private Equity Comment, which provides commentary on legal and tax developments which affect the European private equity community. For comment or to subscribe to these bulletins, please email sjbnetworks@sjberwin.com.