12 November 2015

Improving the EU's venture capital regulation

The pan-EU regulatory regime for European venture capital funds (or EuVECA) was introduced alongside the AIFMD as a voluntary, proportionate regime for smaller fund managers (broadly, those with portfolios of less than €500 million) focussed on "venture capital" investing. When the regulation was first proposed in 2011, Michel Barnier, then Internal Market Commissioner, made clear its objective: "We need more venture capital in Europe. By helping companies become more innovative and competitive, venture capital will create Europe's companies of the future. In order to support the most promising start-ups, venture capital funds must become bigger and more diversified in their investments." However, since 2013, only 34 funds throughout the EU have registered as EuVECA funds and - as part of its Capital Markets Union Action Plan – the European Commission wants to know why take-up has not been higher. Part of the answer to that question lies in the unnecessary complexity of the entry requirements, and part in the deliberately narrow scope of the regime. It is timely to review both.

First, though, it is fair to point out that the venture capital regime is still relatively young.  Funds take many years to plan and to raise, and it is too early to tell whether the regime will gain momentum and help to deliver the larger and more diversified European funds that the Commission says it would like. However, it is also clear that some managers have been put off by the regime's detailed qualifying criteria, and others are ruled out because their strategy does not fit.

The benefit of accepting the additional regulatory burdens imposed by the EuVECA rules, which fall well short of the detailed authorisation requirements set out in the AIFMD, is that the manager gets a marketing passport for the fund, similar to that given by AIFMD (although EuVECA funds can also market to high net worth individuals who commit more than €100,000). However, the passport is not without its problems, and therefore not quite the benefit that the Commission promised. Many countries have imposed additional fees and cumbersome bureaucracy on the venture firms that have attempted to passport their funds, and the Commission has so far declined to stamp out what would appear to be an illegal practice.

But even to get this "passport" requires a firm to believe that its fund, when raised and invested, will pass several tests.  At least 70% of the fund's investments should be in "qualifying portfolio undertakings", which are unlisted companies with less than 250 employees and a maximum annual turnover of €50m, or an annual balance sheet of €43m or less. Managers may reasonably take the view that – at the time of fundraising – they cannot guarantee that there will be enough deal opportunities to meet this threshold, nor might they be willing to accept the restrictions on the types of financing instruments they can use. In addition, 70% of investments must be into companies located in countries that have signed a "Relevant Tax Agreement" with each EU Member State in which the fund is marketed. The problem is that there are many member states that have only entered into a few of these agreements, so again managers may shy away from EuVECA, particularly when they may not know which countries their portfolio companies may be based in at the time that they are raising their fund.

Another issue is that, as funds grow, they may well exceed the threshold that will then require the manager to seek authorisation under AIFMD, and any manager who also runs other funds and is therefore already AIFMD authorised cannot market an EuVECA fund. And only European managers can use the regime, which seems both odd (given that European managers using it can invest the funds outside the EU) and damaging (because European investors would find it easier to put money to work across a diversified venture portfolio, which could stimulate increased allocations to the asset class as a whole). Last month's consultation paper asks a number of questions, including whether to relax these restrictions, and is welcome if it leads to a more inclusive regime.

However, the Commission could be much bolder. There is a strong argument that the EuVECA passport (or an equivalent) should be made available to all venture capital and private equity fund managers who do not need to be authorised under AIFMD. If the goal of the European Commission is to complete the European single market, there is no reason only to offer the advantages of a passport to a sub-set of fund managers. It is clear that smaller buyout funds are also catalysts for growth in Europe, and it is hard to see a principled reason to exclude them from the advantages offered to venture funds.  It is true that these fund managers could opt-in to AIFMD and get the benefit of a passport to market to professional investors, but that would require them to accept disproportionate and unnecessary regulation. In the meantime, the only alternative for such managers is to muddle along using unsatisfactory national private placement regimes (which differ from country to country, and require at least a state-by-state registration).

This consultation (which seeks feedback by 6 January 2016) is welcome and offers a real chance for the entire industry to engage with the Commission to shape a wider regime that can be of real benefit to funds, investors and companies throughout Europe. But the Commission (and the co-legislators, including a previously sceptical Parliament) will need to be open to quite radical change if the benefits of a single capital market are to be made available to more than just a select few.

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