Storm brewing in the West

A slew of new financial regulations and proposals from the US and Europe are extending their reach into Asia, potentially damaging international investment between the regions.

 Though Asian markets have a long history of notoriety for their seemingly arbitrary and often obstructive regulatory environments, the frameworks that are currently being finalised in the US and Europe could put the strict into restrictive.

Lawmakers in the West typically admit private equity shares little blame in the recent financial crisis, but nonetheless want increased transparency and reporting requirements on firms to decrease the industry’s potential for evolving into a future systematic risk in the economy.

Rules, however, aren’t being crafted with only domestic markets in mind. Instead, a number of laws written by national governments are set to impact private equity markets on a global basis. 

In the private equity industry’s largest market, the US, the recently signed, “Dodd-Frank Wall Street Reform and Consumer Protection Act”, will require foreign private equity firms with more than 15 US-based LPs, at least one office in the US and more than $25 million in combined US investor assets to register with the US Securities and Exchange Commission. This will mean Asian firms need to establish formal compliance policies to outline how they would deal with potential conflicts of interest. Registration also means firms need to designate or hire a compliance officer, as well as face regular inspections by the SEC.

The act also sets new limits on banks’ involvement with private equity firms. The so-called “Volcker Rule”, named after former Federal Reserve chairman and current chair of President Obama’s Economic Recovery Advisory Board, Paul Volcker, will impose new restrictions on the ability of banks to invest in or sponsor private equity and hedge funds based both within the US and abroad.

Unlike the White House’s campaign for a complete ban on proprietary trading and sponsorship, Congress has passed softer language which allows banks to invest up to 3 percent of their Tier 1 capital in private equity and hedge funds, with an additional restriction from acquiring more than a 3 percent ownership stake in any fund.

Furthermore, the signed bill is not the end of the reform process as the legislation provides only a framework for the new regulatory landscape. The Securities and Exchange Commission is expected to interpret and implement further rules and regulations at the behest of Congress over the coming months and years. The Volcker Rule’s precise impact on global markets is as yet unquantifiable, but any restriction on bank holdings suggests grim news for bank sponsored private equity investment in Asia.

Tilted Risk Scales

Banks are also being targeted on a more global level. The Basel Committee on Banking Supervision is in the process of creating new international standards – dubbed “Basel III” – to “increase the quality, quantity, and international consistency of capital, to strengthen liquidity standards, to discourage excessive leverage and risk taking, and reduce procyclicality”, the committee said in a statement in July. Scheduled for full implementation by the end of 2012, Basel III’s mandate of increased liquidity and capital reserves will also likely result in decreased investment in alternative investments and other asset classes.

Or perhaps more likely, the new banking rules may result in a number of banks spinning out in-house firms completely in order to reach compliance. Global banking giant HSBC, for example, agreed this past September to sell an 80.1 percent stake of its Asian private equity business HSBC Private Equity Asia (HPEA) to the firm’s management team, while retaining the remaining share. Other banks have expressed similar plans for the near-future.

Likewise, a process is also underway in the European Union to bring in regulation affecting the insurance industry. The Solvency II directive will introduce risk-based solvency requirements for insurance and re-insurance groups. As it stands it looks likely that the capital that a European insurer would need to hold against its private equity assets will increase. Thus it isn’t just banks feeling the pressure to shy away from private equity firms, but also large institutional investors as well.

Taming The AIFM Monster

None of the aforementioned concerns, however, may match the amount of resistance put up by the industry towards the pending Alternative Investment Fund Manager’s directive in Europe. The long anticipated European law may restrict Asian fund managers or domiciled funds from accessing the sophisticated European Union (EU) market.

First introduced in April 2009, and currently still tied up in negotiations, the directive is expected to pass within the next few months. The EU parliament originally advocated rules which would have effectively shut out Asia’s private equity industry from Europe, but current talks suggest a framework which would allow foreign access into the EU under certain conditions.

At the time of writing, market sources have revealed the EU directive is most likely to offer select Asian countries a dual approach to so-called third country rules that regulate foreign managers and funds. The proposal permits both a passport system, allowing full EU market access with the approval of one member state, or through an individual EU member state’s private placement system.

If passed, the new proposal will go through a five-year trial period following the directive’s implementation, after which the EU Commission will launch a review of the directive that includes consultation with the private equity industry.

Should the Commission determine the more industry lenient passporting framework has no negative effects, such as on “investor protection, market disruption, competition and monitoring of systemic risk“, the passporting framework would then apply exclusively, the proposal stated.

For Asian fund managers wanting to market or manage funds in the EU under the passport system, the proposal calls for different requirements depending on whether the fund is EU domiciled. In either instance, GPs will need to meet all the directive’s requirements, disclose the fund’s marketing strategy and ensure sufficient tax and regulatory information exchange agreements are in place between their home country and any relevant EU member states.

Likewise, Asian fund managers are permitted to market both non-EU and EU funds under each member state’s domestic private placement rules as long as the GP complies with transparency and other private equity fund provisions. The managers also must have sufficient cooperation arrangements “relating to systemic risk oversight and information exchange” between the manager’s home state, and any member state the fund is marketed in.

Indirect Effect

And it isn’t just legislation targeting the financial industry that will carry a reach into Asia. Policy to reduce carbon emissions in the UK, for example, will apply to private equity firm portfolio companies including those outside the UK. Known as the Carbon Reduction Commitment (CRC) scheme, under certain conditions an Asian portfolio company majority owned by a UK private equity firm will be subject to the scheme’s carbon reduction requirements.

Or, take for example, anticorruption legislation in the US and UK. Under the UK’s recently passed Bribery Act, a “commercial organisation” will become criminally liable should any “associated person” offer or conduct a bribe designed to provide a business advantage for the commercial organisation.

Expected to come into force in April of next year, the act makes no distinction between bribes paid in the UK or anywhere else in the world, nor does it matter if Asian authorities do not interpret a UK firm’s activity in Asia as bribery.

Likewise, the US has been ramping up investigations against foreign firms under the Foreign Corrupt Practices Act, says Chris Leahy, managing director of greater China & South East Asia at risk consultancy company Kroll.

“Some Asian regions in particular have a bad reputation in Europe and the US, meaning regulators may keep a closer eye on deals simply based on where they are sourced from,” added Melvin Glapion, head of business intelligence at Kroll, who added cultural differences may result in western regulators interpreting some deals which would be innocuous in Asia as corrupt.

The FCPA echoes a number of provisions included in the UK’s Bribery Act, including the responsibility of firms to implement compliance programs and conduct due diligence on deals in foreign countries, all of which makes commercial relations between Asia and the west more scrutinized and less attractive.

Leahy explained a lot of Asian firms are going to have to tackle these anti-corruption laws partially as a result of government wanting to flex some muscle in light of abuses taken place prior to the financial crisis, which are no longer as easily tolerated in today’s economic climate.

With the western world looking to tack on further rules when entering their markets, “a lot of Asian private equity funds are figuring things out as they go,” said Leahy, adding this may mean “Asian private equity funds may just continue investing primarily in their own backyard where they’re more familiar”.