The other directive

The threat presented by Solvency II should not be underestimated.

Within weeks of this magazine hitting desks across Europe, the EU Directive on Alternative Investment Fund Managers will be one step closer to being written into European law. Since it started gathering momentum around two years ago, this movement to regulate the alternative fund industry on a pan-European basis has shaken the private equity and venture capital industries into a unified lobbying effort, the likes of which it has never before mustered.

But while the AIFM Directive is a current focal point for the industry’s regulatory fear, there are other ongoing legislative changes in Europe and beyond which could be just as damaging to the industry.

The draft Solvency II Directive – scheduled to be introduced in 2012 – would create a more stringent capital adequacy regime for insurers and reinsurers, with the goal of preventing these institutions from taking on overly “risky” investments. The directive calls for higher capital adequacy requirements, leading to higher capital charges against unlisted assets. Criticisms at this stage centre on the fact that all unlisted holdings are treated as being equally risky, when in fact risk profiles vary between asset classes (hedge vs. private equity) and strategies (buyout vs. venture capital).

At the same time the Basel Committee on Banking Supervision is due to vote later this year on new capital adequacy proposals – dubbed “Basel III” – which would enforce similarly stringent capital adequacy requirements on the banking sector.

Any noise around the effects of these two regimes has been drowned out by the rumbling juggernaut that is the AIFM directive.

But the “double whammy” effect of these two changes must not be ignored. Insurers and banks are two of the largest sources of European private equity capital in the institutional investment space, along with pension funds and funds of funds. If the supply of capital from these groups is staunched, then it will certainly be felt by private equity firms when they return to the fundraising trail.

GPs will feel the effects more keenly in some countries than others. While firms in the US and UK have leant heavily on pension funds and funds of funds, it is a different story on the continent. According to data compiled by accountancy group Grant Thornton, in the three years to the end of 2008, French private equity firms raised on average around 20 percent of their capital from banks and 18 percent from insurance companies. Italy’s GPs were more heavily reliant on banks, which provided 38 percent of the country’s private equity capital during the same period (insurance companies accounted for 19 percent). The banking sector was similarly prominent in Spain, providing around 28 percent of private equity capital.

PEI’s recent trips to the continent suggest that anecdotally Basel III and Solvency II are already having an effect. In Munich LPs and GPs showed frustration that, at a time when German banks and insurers are waking up to the need for private equity in their portfolios, they are now being discouraged from committing to the asset class. In Paris one GP went as far as suggesting that Basel III was specifically designed as an attack on French banks, a big source of capital for mid-market private equity in the country.

The advance effects of Basel III can also be seen in the swathe of banks currently working on spin-outs of their private equity units: HSBC being one of the most recent examples.

The European Private Equity and Venture Capital Association has over the last two years grown in stature from a straightforward industry service provider to a potent lobbying machine. The change was largely driven by the debate around the AIFM Directive, but as EVCA’s newly instituted LP platform convenes for its first meeting in the first week of July, Solvency II and Basel III will be high up the agenda. Two of the platform’s members – insurance group Allianz and bank-owned fund of funds Danske Private Equity – will no doubt ensure their voices are heard.

Risk profiles and benchmarking are very poorly understood areas, says Klaus Bjørn Rühne, a partner at ATP Private Equity Partners who is chairing the LP platform. He adds that this is a “real concern” for institutions wishing to make allocations today. Elsewhere among EVCA’s members, a risk management working group was established at the beginning of 2010 and is currently working on guidelines to help clarify what modelling assumptions should be used when assessing risk in private equity investments.

Javier Echarri, the long-time EVCA secretary general, said in June that he will step down from the position once the debate around the AIFM Directive is over. Over the next few months Echarri will work with the incoming EVCA chairwoman, Uli Fricke, to arrange his succession. Whoever ends up filling his shoes will no doubt be aware that, while the talking may soon be over on the AIFM Directive, the regulatory debate goes on.