From self- to over-regulation

The reaction of the European private equity and venture capital community to the directive is best illustrated by the words of Jonathan Russell, EVCA Chairman: "The Commission's proposals hit the wrong people, at the wrong time, in the wrong way."

Compared to other European countries where national regulatory regimes are already in place, German private equity fund managers will have to adjust even more since currently there is no national legal framework for private equity investment funds in general (currently only certain types of special funds are regulated to a certain extent). However, the German private equity community has a strong commitment to self-regulation in order to enhance investors' confidence and its reputation in the German business environment. In the mid 1990s the German Private Equity and Venture Capital Association (BVK) adopted a code of conduct for its members which has been brought in line with the code of conduct of the European Private Equity and Venture Capital Association (EVCA). Once the directive has been implemented into national law, self-regulation of the private equity industry will become less relevant.

Over the last few decades, private equity has become an important means of finance for the German "mittelstand" (SMEs). One major concern is that the proposed thresholds of EUR100m and EUR500m have been set too low and thereby impose quite complex burdens in relation to valuation, risk and liquidity management and capital reserve requirements on managers of "middle market" funds, which will have the effect of increasing the cost of investment for end-investors. Since the higher threshold of EUR500m applies to fund managers not using leverage and having at least five years lock-in period for their investors, it is to be expected that some fund managers may change their investment strategy (for example by using less leverage and increasing their general investment periods) to ensure that they fall into this category.

Furthermore, the proposed ongoing disclosure and transparency requirements are quite onerous and in some cases may even exceed those obligations placed on listed companies. It is feared that this will lead to a disadvantage of private equity-invested companies in relation to their market competitors that use other means of finance. It also is quite likely that banks providing loans in the context of private equity investments would ask for access to the same level of information as is available to the investors and the supervisory authority. This may impact on the underlying loan documentation (for example, additional covenants).

Of particular relevance are certain proposed disclosure and notification requirements that will apply if the fund acquires a controlling interest (that is, more than 30% of the voting rights) in a non-listed company (although exceptions apply for SMEs). This may lead to private equity investments being kept just below this threshold. Also, under the proposed directive, private equity-invested companies that are delisted will continue to be subject to ongoing reporting obligations for listed companies for two years. This may impact on the decision of taking portfolio companies private.

The proposed registration, ongoing supervision and transparency requirements will result in a necessity for more complex internal compliance and risk management structures. The German popular legal form of GmbH & Co KG (limited liability partnership) for private equity investments does not generally provide for a suitable corporate governance structure (for example, no compulsory supervisory board). As a consequence of the proposed directive, funds may choose to adopt voluntary supervisory boards.

Even though ideally the directive should differentiate more between the different types of funds, the concept of having an EU-wide harmonised regulatory framework bears certain advantages and, in particular, facilitates investments across borders on a level playing field.

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• Topics
• Regulation
• DACH