Secondaries: Playing by the rules

Seven years on from the collapse of Lehman Brothers and the start of the global financial crisis the rules surrounding the holding of private equity seem to be growing steadily tighter.

Frameworks such as the Volcker Rule and Basel III have seen financial institutions sell off the bulk of their stakes and today many are increasingly using the seconda-ries market as a portfolio management tool.

“It’s not just the investment funds but asset managers generally, and even the banks. People are weary of the increasing regulatory burden,” says David Harris, a partner at law firm Dechert in Washington DC. “Every time you turn around it seems like there’s a new regulation to deal with.”

Since the financial crisis, banks including Bank of America, Standard Chartered and Italy’s Intesa Sanpaolo have reduced their exposure to private equity as regulatory changes have either prohibited financial institutions from holding the asset class or made it prohibitively expensive.

In 2011, Barclays sold a $740 million portfolio of fund interests to Ardian, then known as AXA Private Equity, while this year Standard Chartered is reported to have sold a $700 million portfolio of assets to Goldman Sachs Asset Management and LGT Capital Partners.

In the first half of 2015, financial institutions accounted for around 10 percent of sellers of private equity assets, a drop from 19 percent for the same period a year earlier, according to advisory firm Greenhill Cogent. Although banks still hold north of $100 billion in private equity assets, some of which they plan to keep on their books, the main reason they have had to sell private equity assets is the regulatory pressure to clean up their balance sheets and increase the amount of capital they hold under the reformed capital adequacy requirements.

As of January 2014, banks in the EU have been subject to Capital Requirements Directive IV (CRD IV), part of the Basel III global banking reforms. CRD IV focuses on capital ratios with the aim of helping raise the resilience of individual banking institutions during periods of stress, making it considerably more expensive for banks to hold private equity.

“The cost of holding private equity is going to go up for the European institutions, so banks may each have their own view as to whether it’s worth incurring that cost when you compare these assets to the returns on other assets,” says Michael Gerstenzang, a lawyer for Cleary Gottlieb Steen & Hamilton in New York who has advised large private equity firms on secondaries deals.

THE VOLCKER EFFECT

In the US, the Volcker Rule came into effect in 2014 as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act. In essence it prohibits banks from investing in private equity with their own funds and aims to prevent the institutions from making the sorts of risky investments that preceded the financial crisis.

Developments surrounding Volcker, which can affect any bank with US operations, are still having an impact on the secondaries market – last December, a large non-US bank cancelled the bidding process on the disposal of its private equity assets after a two-year extension was granted for legacy covered funds under Volcker, according to industry sources.

Another piece of framework primary and secondaries market participants must contend with is the Alternative Investment Fund Managers Directive (AIFMD). This regulation covers the management, administration and marketing of alternative investment funds within the EU and includes private equity as well as hedge funds and retail investment funds, among others.

AIFMD is a compulsory framework implemented by the regulator in each EU jurisdiction. It means fund managers must have been authorised with passports if they want to market funds cross-border. The European Securities and Markets Authority has recommended Switzerland and the Channel Islands should be awarded pan-European Union marketing passports, but three other domiciles – Singapore, Hong Kong and the US – still await a decision. In addition to giving private equity participants another regulatory regime to deal with, some experts say AIFMD has deterred US firms from marketing to European investors, and that includes on the secondaries market.

“It’s kind of a bureaucratic monster that has been created,” says Dominik Meyer, managing director at Swiss advisory firm Axon Partners. “LPs in the industry concur that it’s hard to see any benefit for anybody out of the regulations. If you look on the placement side, the consequences of AIFMD are still being worked through. Some US GPs that are very sought after are not bothering to take European LPs anymore, and that’s a big concern.”

SOLVENCY II

Yet another regulatory framework is Solvency II, the equivalent of Basel III for the insurance industry. Coming into full effect in January 2016, many insurance companies are already making quarterly calculations around whether they can make new commitments to private equity, or in some cases whether they must sell, under the new framework.
Some industry participants have expressed frustration at the raft of regulations the industry has had to deal with.

“Investors making commitments to private equity are sophisticated, they know what they’re doing,” says the managing director of one European firm. “You don’t need to protect them from themselves. The only thing you’re doing is preventing them from making good investment decisions.”

Financial institutions have often bought and sold private equity as crises and regulations have forced them to adjust the allocation to the asset class, but this time things seem different. Banks, in particular, may have been removed from the picture altogether, leaving other investors to take their place.

“You’ve taken out some players from the playing field,” says Meyer. “The impact on the secondaries market is that the volume return from financial sellers may significantly decrease over time, and the only thing that could compensate for that is if other holders use the secondaries market in a more active way.”

The banks that are still active within private equity are now seeing the secondaries market as a portfolio management tool, much like other sellers in the market, but the private equity interests that many banks now hold are niche assets that are trickier to sell and may not have a natural buyer.

“Tighter regulation of financial institutions is one driver of deal flow, but the main driver now is strategy,” says Philipp Patschkowski, a principal at Coller Capital. “We are seeing some banks that want to run asset-light balance sheets. If you want to do asset-light, private equity is clearly not the right thing to have on your balance sheet.”

One European banking analyst agreed that banks are increasingly heading toward this asset-light model.

“Banks are becoming simpler and trying to get rid of all these complicated assets they’ve built up or acquired externally,” says Shailesh Raikundlia, an analyst at investment bank BESI in London. “They are becoming much leaner and simpler, and things can only continue that way.”