On 8 March 2019, the European Commission published a draft amendment to the Solvency II Regulation that will establish revised prudential capital requirements for EU-regulated insurance companies holding long-term investments in European companies—including holdings in certain European private equity and venture capital funds. Insurance companies taking advantage of the newly introduced capital charge for long-term equity investments could, under certain circumstances, slice their capital requirements in half: the Regulation will introduce a stress factor of 22% for long term investments, which could apply instead of either 39% or 49% that would normally apply to private funds under the standard formula at present. This is a very welcome step and an important victory for the European private equity industry associations after a lengthy campaign. The change should herald a boost to private equity and venture capital funding.
Prudential Capital under Solvency II
In 2016, unlisted equity investments only represented 3% of insurance companies’ total investments. That is in part because investing in private equity or venture capital comes with a hefty capital charge for insurance companies as a result of the calculation method for the prudential capital required to cover the market risk inherent in those investments as set out in the Solvency II Regulation. To protect insurance companies from insolvency, they are required to hold enough prudential capital to absorb potential losses from their business activities. This includes the insurance company’s investments and the market risks they are exposed to. Solvency II provides a standard formula to calculate the required prudential capital to reduce the likelihood of insolvency over the next year to 0.5% or below. To cover the market risk in the insurance company’s investment portfolio, the market value of each asset is taken as the starting point and multiplied by a stress factor set out in the Solvency II Regulation to simulate potential losses. When the Solvency II Regulation was drawn up, equities listed on a regulated market (type-1 equity) were given a stress factor of 39%. Unlisted equity investments (type-2 equity) drew the short straw: they were allocated a stress factor of 49% along with any other investments that could not be allocated to any other risk module set out in the standard formula. On the other hand, a considerably better stress factor of 22% was allocated to the insurance company’s “strategic” equity investments. To capture the actual economic risk, Solvency II follows a “substance over form” principle exemplified by the “look-through” approach. This means that insurance companies are generally required to treat investment funds as transparent and to calculate their prudential capital by looking through the funds they are invested in and treating the underlying portfolio assets as if they were direct investments.
Funding the European Real Economy
Since the original rules were formulated, European legislators have made several changes to mitigate this harsh treatment of unlisted equity investments. Those changes followed studies that showed that there is less volatility for certain sub-sets of investments, justifying preferred treatment. The changes were also motivated by policy objectives: it is the declared goal of the European Commission, set out in the Action Plan on building a Capital Markets Union and reaffirmed in the Mid-term Review ’17, to channel funds from institutional investors to projects that will boost the European real economy, including the funding of small- and medium-sized enterprises (SMEs). A first step towards that goal was the establishment, in 2013, of two new European fund products, EuVECA and EuSEF, focused on venture capital and social entrepreneurship funds respectively, lowering the bar of entry to the European marketing passport for private equity managers.
Preferential treatment was subsequently offered to insurance companies investing in those fund products and, following discussions with the European private equity industry, also to those investing in closed-ended, unleveraged alternative investment funds domiciled in the European Economic Area (EEA). As a consequence of those discussions, an exemption was introduced pursuant to which equity investments held by those funds are reclassified as type-1 equity and receive a 39% shock factor under the standard formula. Investments by insurers in non-EU investment funds are, however, not yet eligible for this reduced capital charge and may only become eligible in the future if they avail themselves of the Alternative Investment Fund Managers Directive’s (AIFMD) third-country passport when it is introduced. Any such third-country passport will require the fund manager to opt in to full compliance with the AIFMD and is unlikely to be widely adopted. This reduced capital charge therefore creates an incentive for EU-regulated insurance companies to invest in European private equity funds, rather than those established elsewhere.
Now, the forthcoming changes to the Solvency II Regulation envisage a further reduction in the capital charge for two sub-sets of equity investments in European companies. This will further incentivise investment in venture capital and private equity funds by this potentially huge source of capital, but will also increase the incentive for fund managers to use EU structures.
Long-Term Equity Investments
Under the proposed change, a portfolio of long-term equity investments will be able to benefit from a stress factor of 22%, similar to that already now applicable for strategic holdings.
Although the policy intent was uncontroversial, the approach taken in the original draft rules that were published by the Commission was widely criticised. These drafts would have established conditions that would have been onerous for direct investments held by an insurance company and virtually impossible for investments made through private equity and venture capital funds. After intense lobbying by the European private equity industry associations, the provisions were amended so that the 22% stress factor can be applied to a portfolio of equity investments that meet the following requirements:
the equity investments in the portfolio and their holding period must be clearly identified;
the portfolio must be ring-fenced, separately managed, assigned to the obligations arising from a subset of the insurance company’s activities and remain assigned for the life of those obligations;
the insurance company’s solvency and liquidity position and asset-liability management ensures that there will be no forced sales of the portfolio’s equity investments for at least 10 years;
the equity investments are listed in the EEA or are unlisted equities in EEA headquartered companies; and
the average holding period of the equity investments exceeds five years.
Helpfully, if the equity investments are held in a portfolio of a qualifying EU investment fund, as described above, the underlying investments do not have to meet these criteria themselves as long as they are met at the level of the fund. This last-minute addition to the rules took account of criticism that applying the criteria asset by asset was almost impossible if the insurance company was investing in a third-party-managed private equity fund. There remains the question if and to what extent the underlying portfolio companies would also have to meet at least some of the requirements (e.g. being headquartered in the EEA). The wording does not suggest so.
An additional improvement is the reclassification of the diversified EEA based private equity portfolio.
In addition, to the introduction of a new stress factor for long term investments, the Commission has also introduced an option to reclassify a diversified portfolio of common shares of unlisted companies with their headquarters and the majority of their workforce in the EEA as type-1 equity with a stress factor of 39%. To qualify the portfolio’s beta must not exceed a certain threshold, and the companies must meet the following requirements:
they must have a majority of revenue denominated in EEA or OECD currencies, and
they must meet either of the following two requirements for the last three years:
(i) the annual turnover or balance sheet total of the companies must exceed EUR 10 million, or
(ii) they must have had more than 50 employees.
For European fund sponsors, this may be of limited relevance, as assets held by closed-ended unleveraged EEA private equity funds are already treated as type-1 equity. However, insurance companies investing in some non-EU funds, or those employing leverage may find this new capital charge helpful.
This draft amendment is still subject to review by the European Council and the European Parliament. However, it is not expected that there will be significant changes.
With trillions of assets under management, and relatively low levels of unlisted equity investments, the European insurance sector remains a large untapped source of funding. The revised stress factor of 22% is more aligned with the risk profile of longer-term equity investments and an important step in encouraging insurance companies to invest more in European private equity funds.
Any incentive to make EEA investments or to use EEA structures has particular significance for UK fund sponsors ahead of the UK’s (potentially) imminent departure from the EU. From the date of departure (or, if there is a transitional period, from the end of any such period), it would seem likely that UK companies or structures will not qualify (unless, for example, the UK pivots towards a Norway-style long-term relationship with the EU). That could be a particular issue for any UK funds which have traditionally sought capital from EU-based insurers. Subject to the reservations set out above, they may be able to avail themselves of the preferential treatment later on if and when the AIFMD’s third-country regime is introduced.
On the other hand, if the UK proceeds to “onshore” European law in the way it currently intends, it is quite possible that UK-based insurance companies will only get a 22% preferential capital weighting if they invest in UK funds or those with a UK-investment focus.
The Private Equity Report Spring, 2019, Vol 19, No 1