The EU Commission published its latest proposals on Friday relating to solvency requirements for insurers. These aim to facilitate insurance companies’ equities investments by introducing two new risk categories with reduced capital charges. Jegor Tokarevich of alternative investments consultancy Substance Over Form and Frank Dornseifer of the German Association for Alternative Investments were involved in the consultation process and summarise the key points for Solvency II investors.
How are private equity investments currently treated under the standard formula?
Direct and indirect private equity investments are generally classified as type 2 equities and are subject to a basic capital charge of 49 percent. An exception are private equity investments acquired via so-called type 1 AIF that are generally closed-ended, unlevered EU-AIF managed by a licensed AIFM. Private equity investments in type 1 AIF are subject to a basic capital charge of 39 percent.
What are the new equity risk categories suggested by the European Commission?
The new proposal introduces two different risk categories: qualifying unlisted equity portfolios (“QUEP”); and long-term equity investments (“LTE”). While the first category generally applies to unlisted equities, the second is supposed to capture listed and unlisted equities. Both are therefore of relevance for private equity. A comparison of capital charges between equity categories is summarised in the following table:
What is the SCR treatment for ‘qualifying unlisted equity portfolios’?
QUEP in the meaning of the Article 168a of the Draft Delegated Regulation acquired directly or via funds would be subject to the type 1 capital charge of 39 percent. Therefore, qualifying PE would benefit from a lower capital charge compared to the regular type 2 treatment and have the same treatment as PE acquired via type 1 AIF.
Which private equity investments would classify as QUEP?
QUEP would have to fulfil a rather impressive number of quantitative and qualitative criteria on the level of each portfolio company in accordance with the look-through principle. QUEP has to be comprised of ordinary shares of unlisted portfolio companies fulfilling the following criteria:
- Head offices of each company in the EEA
- >50 percent of the staff of each company with a principal place of work in the EEA
- >50 percent of the annual revenue of each company in currencies from EEA or OECD
- Size criterion (revenues and/or balance sheet and/or staff size) fulfilled in the last three years
- No financial sector company
- Diversification criterion, ie, each company contributes max. 10 percent to the QUEP
Besides a quantitative beta criterion has to be fulfilled. For this purpose a hypothetical beta has to be calculated for each portfolio company based on the following indicators derived from a linear regression model applied to public market data:
- average gross margin over the last five years
- total debt at the year end
- average net cashflow from operations (“CFO”) over the last five years
- return on common equity (“ROCE”) over the last five years
It is highly likely that existing reporting processes won’t fulfil the granular data requirements as proposed by the EU Commission. Even if all data are available, the majority of private equity portfolios might still not qualify since their hypothetical betas, which is the key parameter in the concept proposed by EIOPA, usually exceed the threshold value of 0.796 as confirmed by our earlier research based on real private equity data.
The above-mentioned reservations show the new module could become relevant for a rather small portion of PE investments, especially as the existing requirement for type 1 AIF – which is rather simple and straightforward – already leads to the capital charge that is now proposed for QUEP. This is a shortcoming of the new concept of QUEP.
What is the SCR treatment for ‘long-term equity investments’ (LET)?
LET fulfilling the criteria of Article 171a of the Draft Delegated Regulation will benefit from an all-in capital charge of 22 percent. Therefore, the capital charge for LET would be significantly lower than capital charges for type 2 equities, type 1 equities, QUEP and even qualifying infrastructure corporates and qualifying infrastructure project. In fact LET would benefit from the lowest capital charge currently introduced for the equity module.
Which private equity investments would classify as LET?
As opposed to QUEP the LET criteria were designed by the European Commission without a detailed technical advice provided by EIOPA, which is clear evidence of the Commission’s political intention to encourage long-term investments by insurers. The following criteria are suggested on different levels such as the portfolio level, the portfolio company level and the investor level:
- the LET portfolio must be part of a ring-fenced insurance business, ie, it has to be clearly attributed to certain insurance liabilities
- the average holding period of the LET portfolio has to (i) exceed 12 years and also (ii) exceed the average holding period of the ring-fenced insurance
- head offices of each LET company in the EEA
- holding ability based on the asset liability management
- holding intention based on the strategic asset allocation
Some asset classes such as long-term equity investments in the European infrastructure, real estate or other sectors without a trading intention might strongly benefit from the new proposal. While it is not entirely clear if and how indirect investments in such equities are also captured by the LET category, we assume that it should be possible due to the overarching look-through principle.
Typical private equity portfolios might not be captured by the new category because of their holding periods that are usually significantly lower than 12 years. However, if other equities in the LET portfolio have significantly higher holding periods, they might compensate for the shorter holding periods of private equity. Therefore, we would expect private equity to be included to a rather minor extent in LET portfolios. However, as the draft is published for consultation there might be further amendments or clarifications dealing with this issue.
What could be the next regulatory steps?
Since we don’t expect that the QUEP and the LET modules will become major drivers for private equity, further regulatory measures might become necessary in order to achieve the EU political goals pursued by the Capital Market Union. Increasing the beta threshold for QUEP or reducing the holding period for LET could be appropriate measures to further encourage PE investments. In any case it would make sense to use the available real PE data for the analysis of PE risk profiles instead of liquid proxies (eg, equity indices) as was the case until now.
There is still time to provide the EU Commission with feedback until 7 December, so there might be a chance that some of the considerations above will be considered in the final provisions. Otherwise the Solvency II Review 2020 will probably be the next date where changes could be addressed.
Jegor Tokarevich is managing director of the London-based consultancy boutique Substance Over Form, specialising in alternative investments. Frank Dornseifer is managing director of the German Association for Alternative Investments.