Within Europe, most countries do not directly regulate private equity and venture capital fund managers. The UK is one (but not the only) exception: Britain's financial services laws do generally require those who manage such funds from within the UK (or who arrange private equity deals) to be authorised by the country's financial services regulator – the Financial Services Authority (FSA).
Although the need for regulation in the UK is not new, the rules regulating financial services activities did change quite radically last year and the process of reform is continuing, as the new regulator sorts out its rulebooks. One proposal which emerged last year is for an overhaul of the regulatory capital requirements for authorised firms in the UK. For private equity fund managers, these proposals are concerning.
Until now, the regulatory capital requirements – the amount firms are required to keep available in case of solvency issues – have been relatively light for most venture capital managers. That recognises the relatively low level of risk they face. One can understand why other types of financial services firm are required to keep quite high levels of cash available. Firms that hold client money or assets, or which have obligations to deliver or pay for securities (whether as agents or as principals) need to protect against default and other types of risk. But (apart from using a nominee company to hold client assets, which are illiquid and therefore less likely to give rise to misappropriation risks) venture capital fund managers do not operate in that way, and the likelihood of them taking on an obligation directly and then not being able to deliver is usually remote.
Many firms in the sector have therefore been operating on a low level of regulatory capital, which was previously permitted by IMRO. Those whose business activities take them into the sphere of the European Investment Services Directive (but only to the limited extent that they arrange transactions for people other than funds they run) are required to maintain a fixed capital overhead of EUR50,000, and those to whom the ISD does not apply (which includes many leading fund managers in the sector) are subject to the even lower capital requirement of £5,000. But under the new proposals, these requirements would increase to one based on projected income. Inevitably, this will involve a much higher capital provision for many firms.
All of this is apparent from a consultation initiated in 2001, which is intended to lead to integrated rules that will address capital and other prudential issues for all of the firms and businesses that the FSA now regulates. Laudable though this aim may be, it is hard to see any compelling rationale for increasing the regulatory burden in the UK's private equity sector. Moreover, this approach is very much out of line with the intention of the regulator (and the UK Government) to encourage private equity to flourish and reduce the regulatory burden on venture capital managers.
There is still time for the proposals to change, and the industry is making its views know through various channels. However, more concerted lobbying is needed to point out the inappropriate nature of the proposed capital rules for the private equity industry.
There is also a wider point: many believe that the requirement for private equity fund managers to be regulated might spread to other European countries, and the European Commission is also involved in a re-examination of the capital regime for European investment firms generally. It is important for regulators across Europe to understand that the private equity industry has its own particular features and it is welcome that the European Private Equity and Venture Capital Association is already preparing the ground for the education and lobbying which will have to accompany any such moves toward greater regulation. Hopefully that will help to avoid 'one size fits all' regulations – which we have seen in so many other fields, and which often lead to inappropriate rules. The last thing the industry needs at the moment is a disproportionate increase in the expense of regulation engineered through an inappropriately heavy-handed attitude to regulatory capital.
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 email@example.com.