12 March 2015

Mixed blessings: German and US regulatory developments

Two recent regulatory announcements offer some welcome relief to the private equity industry, even though in both cases it would be hard to characterise them as good news.  Restrictions on the ability of German insurance companies and some pension funds to invest in private equity and venture capital funds, and rules that make it much harder for international banks to do so, could hardly be welcomed.  But, in both cases, the final form of the rules will not have as much impact on European fund managers as had been feared, and so they feel like a reprieve.

The German rules, unveiled (at last) earlier this month, have made changes to the conditions that enable assets to sit in the "equity quota".  It is this quota which allows insurance companies and many pension funds to allocate up to 15% of their "restricted assets" to private equity, infrastructure and similar investments, and without it allocations to private equity would certainly fall.  It had been expected that the changes to the rules would be severe: the early drafts would have made it almost impossible for these important investors to commit to any fund that was not authorised under the Alternative Investment Fund Managers Directive (and even among authorised funds, they would have only been permitted to invest in those that only made equity investments - which would have raised question marks over those using shareholder loans). And funds of funds would have been hit particularly hard, having to meet the requirement at both the top and underlying fund level. 

However, positive engagement with the regulators by the industry has mitigated the impact of the changes significantly.  There are still tighter rules for funds that want to qualify for the 15% equity quota, but most European venture capital and private equity funds – even those who are below the size thresholds for full AIFMD authorisation – should qualify (as should many outside the EU if they can show that they are regulated to "comparable" standards in an OECD country).  The final rules also allow the underlying funds to invest in subordinated shareholder loans, and funds of funds only need to qualify at the fund of funds level.  There is also a new alternative funds quota, which allows an allocation of 7.5% of restricted assets for other types of EU fund, which is most likely to be helpful for some types of infrastructure, debt and other "non-equity" funds.  The final rules, which for insurance companies will be replaced with pan-EU rules in January 2016, also grandfather existing investments.

Meanwhile, in the US, regulators offered some further relief to European funds at the end of last month.  It had been widely believed that the "Volcker rule", which restricts US banks from sponsoring or investing in certain funds, had a significant extra-territorial effect on non-US entities that are affiliated to an insured depository bank in the US, and prohibited such entities from investing in any private equity fund that is marketed to the United States.  Although it has generally been possible to structure around this prohibition by setting up parallel vehicles, a recent clarification issued by regulators indicates that the marketing restriction will not apply when a Volcker-sensitive investor (that is not located in the United States, and not controlled, directly or indirectly, by a US banking entity) invests in the fund, and is not a sponsor, manager or adviser of that fund. This is a helpful clarification, which makes marketing funds to a mix of US and European investors a little easier. 

It is hard to argue that more restrictions on the ability of key investors to invest in private equity is good news.  But the industry can console itself that, at least in part due to the work of its industry associations, the changes will not have as much impact as many had feared.

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We explore the key issues being considered by clients looking to unlock investment opportunities in the People’s Republic of China.

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