As we reported
at the beginning of last year, a new prudential regime for investment firms is set to raise the minimum capital requirements for many UK-based private equity firms. Although these changes have been brewing for some time and will be phased in over a relatively lengthy period, the impact is potentially very significant and affected firms should start preparing.
The changes will affect firms regulated in the European Union by the Markets in Financial Instruments Directive (MiFID) and, possibly, some firms wanting to gain access to the European single market from outside by relying on a future “equivalence” determination.
At the moment, the most important category of European private equity firms who could be affected are those that give investment advice to another firm on private equity or venture capital matters (usually called “adviser/arrangers”) or those who undertake portfolio management. Firms in the latter category are becoming more numerous as Brexit-proof structures are put in place, and management of segregated mandates (alongside, or instead of, funds) becomes more prevalent. The changes will have no direct impact on Alternative Investment Fund Managers regulated by the AIFMD.
In fact, most of the affected private equity firms will be based in the UK. That’s because many non-UK-based investment advisers fall within the group exemption and are not classified as MiFID firms. And, even though the UK is currently scheduled to fully leave the EU before the expected implementation date for these changes, UK firms cannot assume they are immune: the date of the UK’s departure (and the end of any transitional period) remains uncertain, and, in any case, the UK seems to be committed to implementing the new regime whether it is obliged to do so by European law or not.
The headline change is that affected firms will have to move from a capital requirement which tends to be quite low (for most private equity adviser/arrangers it is €50,000) to one set by reference to fixed overheads. Although larger firms may have to maintain even more than that, based on the assets they have under management or advice, most firms are likely to find that the new requirement equates to one-quarter of their annual fixed overheads – primarily staff and office costs (other than any that are profit related) and fees paid to service providers. In addition, unless they are “small and non-interconnected” (and their national regulator chooses to exempt them), firms will also need to hold one third of regulatory capital (generally the equivalent of one months’ fixed overhead) in liquid capital.
These changes could make a huge difference, and do not seem to be justified by any significant market risk given the business model of most of those firms. Larger firms will also be subject to additional remuneration and governance regulation and will be required to make public disclosures on risk management and remuneration, among other things.
There will be time to adjust to the capital increase – during a five-year transitional period, capital will be limited to twice its current level – and some discretions for national regulators that are built into the rules could further cushion the impact on the sector. However, in time, the impact will be significant, and there are good reasons to urge national regulators to do what they can to minimise the disruption – especially in the UK, where further barriers to private equity are likely to be particularly unwelcome.