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Private Equity and Its Regulation in Europe

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Abstract

In the fifteen year period to 2008, the private equity industry grew enormously in Europe, to the point where it began to be seen as a rival to the public markets. This gave rise to concerns and calls for the private equity industry to be regulated. The financial crisis, and in particular the contraction of the market for debt prompted by the collapse of Lehman Brothers in September 2008, has led to a significant reduction in the number and value of private equity deals. However, if anything, the financial crisis has led to increased calls for regulation of the industry. This paper examines the development of private equity transactions in Europe, and analyses the nature of these transactions. It then considers whether the concerns raised in relation to private equity are justified. Broadly, the arguments in favour of regulation of private equity may be divided into two kinds: the need to increase transparency in the industry by imposing disclosure obligations, and systemic risk concerns. These arguments are considered, and the terms of the Alternative Investment Fund Managers Directive (AIFMD) are examined in the light of these issues. It is argued that the arguments in favour of regulation of private equity are weaker than has been suggested and that this Directive does not adequately differentiate between hedge funds and private equity when imposing this regulatory regime.

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References

  1. Private equity really took off in the 1970s, following the founding of the buyout firm Kohlberg Kravis Roberts and the development of the leveraged buyout (LBO) model: G.P. Baker and G.D. Smith, The New Financial Capitalists: Kohlberg Kravis Roberts and the Creation of Corporate Value (Cambridge, Cambridge University Press 1998).

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  2. E.g., private equity has existed in the UK in some form for 70 years or more: HM Treasury, Institutional Investment in the United Kingdom: A Review (the Myners Report) (2001) para. 12.23; E. Ferran, ‘Regulation of Private Equity-backed Leveraged Buyout Activity in Europe’, ECGI Law Working Paper No 84/2007 (May 2007).

  3. European Venture Capital Association (EVCA), Buyout Report 2010, An EVCA Research Paper (October 2010), at p. 9 (figures for 2007). The UK is a major player in the European private equity market, accounting for the majority of the funds raised (at p. 17) and dominating the market in terms of the number of deals done and the value of those deals: Centre for Management Buy-out Research (CMBOR), European Private Equity: Country Trends, available at: <http://www.cmbor.org>. In 2010, the UK remained by far the largest country by value, at €22.1bn, while France recorded €7.9bn and Germany €4.8bn. The number of buyouts in the UK remained extremely low in 2010, at 380. In France, deal numbers rose by 38%, to 138, but German deal flow continues at a low rate, with just 76 buyouts in 2010.

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  9. In 2009, the level of funds raised fell to €10.5bn (EVCA, supra n. 3, at p. 17) but the debt side of the market was hit hardest and in 2009 senior loan volumes in LBO transactions fell to just €4.7bn. The number of buyouts also fell considerably, from around 1,500 in 2007 to 846 in 2009 (CMBOR, European Private Equity Summary: Annual Trends, available at: <http://www.nottingham.ac.uk/business/cmbor/CEsummary.html>). However, there are signs that the private equity market may be starting to recover (see, e.g., the purchase of the RAC by US private equity firm Carlyle Group for £1bn in June 2011).

  10. Directive 2011/61/EU of the European Parliament and of the Council of 8 June 2011 on Alternative Investment Fund Managers and amending Directives 2003/41/EC and 2009/65/EC and Regulations (EC) No 1060/2009 and (EU) No 1095/2010, OJ 2011 L 174/1.

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  13. In contrast to the traditional model of private equity, some private equity houses (e.g., 3i) have also looked to the public markets for funding.

  14. One of the significant considerations when structuring a private equity fund is to ensure that it is tax efficient. Generally, limited partnerships are tax transparent.

  15. This alignment of interests may break down, however, if staff investment is not fully aligned with that of the investors, e.g., if staff are able to under- or over-commit to specific transactions — effectively cherry picking. Alternatively, a conflict may arise where a fund manager acts for several different private equity funds. For a discussion of the conflicts of interest that can arise in private equity transactions, see FSA, supra n. 5, at pp. 72–76; IOSCO Technical Committee, Private Equity Conflicts of Interest, supra n. 11.

  16. The general partner will receive an annual management fee, commonly 1.5–2.5% of funds committed, and a share (or ‘carry’) of profits made by the fund as a whole (commonly 20%) although this latter payment will be subject to a minimum hurdle level of return to investors, usually about 8%: FSA, supra n. 5, para. 3.16.

  17. However, it is invariably an essential condition of this immunity that a limited partner shall not take part in the management of the business and has no power to bind the firm. See, in relation to English limited partnerships, Limited Partnership Act 1907, s. 6(1).

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  20. Some doubt has been cast on whether superior returns do actually result: L. Phallipou and O. Gottschalg, ‘The Performance of Private Equity Funds’, 22 The Review of Financial Studies (2009) p. 1747, who find that the performance of private equity funds as reported by industry associations and previous research is overstated. They find an average net-of-fees fund performance of 3% per year below that of the S&P 500.

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  21. Myners Report, supra n. 2, para. 12.50.

  22. Over the ten years to 2001, for example, the report noted that while the performance of the better funds (the top 10th percentile of private equity) had been outstanding (46.8% per year), across private equity funds in the bottom 10th percentile the figures were significantly lower (6.6% per year) (ibid., para. 12.55). In the same period, ten-year annual returns from the FTSE All-Share stood at 14.9% and UK bonds at just over 10% (ibid., para. 12.59).

  23. Initially, many private equity organisations were wholly owned subsidiaries of large financial institutions. These organisations, known as ‘captives’, therefore obtained their funding from the parent institution. More recently, many of these organisations have become independent, or at least semi-captive, and therefore raise some or all of their funding from external sources.

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  25. EVCA, Annual Survey 2010: Fundraising Statistics (June 2011).

  26. FSA, supra n. 5, para. 3.10.

  27. There is a limited secondary market for the stakes of limited partners in private equity funds, but this does not materially detract from the view that assets held by limited partners are illiquid.

  28. EVCA, supra n. 3, at pp. 45–46.

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  40. FSA, supra n. 5, paras. 3.77–3.78.

  41. One method which hedge funds have evolved to deal with this issue is to include ‘side pockets’ in a fund, i.e., different classes of shares within the hedge fund that are subject to a different (lesser) liquidity profile. Lock-up periods, during which time the investor cannot dispose of its investment, are used for this purpose, and gates, which place an upper limit on the absolute amount of money that can be redeemed at any one time, can be added: FSA, supra n. 5, paras. 3.26–3.27.

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  45. A survey conducted by the FSA revealed that equity represented just 21% of the capital base of the 5 largest transactions to which each bank in the survey committed capital: see FSA, supra n. 5, para. 3.65.

  46. See EVCA, supra n. 3, at pp. 13–14 (for transactions of more than €100m, the share of equity jumped from an average of 32% from 2004 to 2007 to almost 70% in the first half of 2010. The equity share in sub-€100m deals also increased, although less sharply, from an average of 44% from 2004 to 2007 to 67% in the first two quarters of 2010).

  47. H. Croke, ‘Equity Finance’, in C. Hale, ed., Private Equity: A Transactional Analysis, 2nd edn. (Globe Business Publishing Ltd 2010) p. 56.

  48. lbid.

  49. The management’s minority stake in the portfolio company is often referred to as ‘sweet equity’, because the amount of return the management can receive on their investment can be disproportionate to the amount invested.

  50. For discussion, see Sir David Walker, supra n. 18.

  51. Another alternative would be for the fund to invest via preference shares.

  52. It is estimated that in 2006, for example, $302 billion of leverage loans were made to US and European borrowers owned by private equity sponsors: Standard & Poor’s Leveraged Commentary and Data (2006).

  53. See, generally, C. Morgan, ‘Debt Finance’, in Hale, ed., supra n. 47. Generally, the senior debt will be used to purchase the target company, to provide the company with the working capital it needs following the acquisition, and perhaps also to provide financing for any capital expenditure that the company needs to engage in following acquisition.

  54. One development that emerged during the 2004–2007 period when there were very extensive levels of debt available to private equity firms, were ‘covenant lite’ financing deals. In these deals the covenants are only tested when an event occurs rather than being continuously tested. M. Campbell and S. Hughes, ‘Leveraged Finance — Financial Covenants under Stress’, 22 Journal of International Banking and Financial Law (2007) p. 353; J. Markland, ‘Cov-lite — The New Cutting Edge in Acquisition Finance’, 22 Journal of International Banking and Financial Law (2007) p. 379. These types of covenant-lite financing deals have disappeared in the wake of the financial crisis.

  55. Morgan, in Hale, supra n. 47, at pp. 81–82. In contrast to senior debt, which is typically provided by the traditional lending banks, second-lien debt was originally dominated by hedge funds, although subsequently all kinds of institutional investors became involved in providing this form of financing, and even the banks got involved and started lending in this category as well.

  56. Ibid., at pp. 82–84.

  57. For a discussion of why public to private transactions became so widespread, see L. Gullifer and J. Payne, Corporate Finance Law: Principles and Policy (Hart Publishing 2011), ch. 14.6. See also C. Hale, in Hale, ed., supra n. 47: ‘It has been said that private equity made its money by leverage in the 1980s, by price/earnings arbitrage in the 1990s and since then by genuinely changing companies. In fact all three components have always played their part’ (at p. 8).

  58. Jensen, supra n. 34.

  59. IOSCO Technical Committee, Private Equity (May 2008), at p. 11.

  60. See, e.g., Armour and Cheffins, supra n. 4.

  61. Jensen, supra n. 34, at p. 5.

  62. See City Code on Takeovers and Mergers, r. 25.1, esp. note 4. For discussion, see Gullifer and Payne, supra n. 57, ch. 14.5.

  63. See Sir David Walker, supra n. 18, at p. 3.

  64. Ibid.

  65. Ibid., at p. 6.

  66. For a discussion of the corporate governance concerns regarding private equity, see Ferran, supra n. 2, at pp. 9–10.

  67. Speech by the then Economic Secretary to the Treasury, Ed Balls MP, to the London Business School (March 2007).

  68. Financial Stability Board, Guidance to Assess the Systemic Importance of Financial Institutions, Markets and Instruments: Initial Considerations (October 2009), at p. 2.

  69. For a discussion of the systemic risks posed by hedge funds, see N. Chan, M. Getmansky, S. Haas and A. Lo, ‘Systemic Risk in Hedge Funds’, in M. Carey and R. Stulz, eds., The Risks of Financial Institutions (Chicago, University of Chicago Press 2007); see FSA, supra n. 43 (the FSA identifies two channels through which hedge funds can cause systemic risk: the ‘credit channel’, which is concerned with credit counterparties’ exposure, and the ‘market channel’, which is concerned with the high volume and often highly correlated strategies of hedge funds).

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  71. FSA, supra n. 43, at p. 3.

  72. FSA, Assessing the Possible Sources of Systemic Risk from Hedge Funds: A Report on the Findings of the Hedge Fund Survey and the Hedge Funds as Counterparties Survey (July 2011).

  73. Ibid., at p. 12.

  74. ECB, Large Banks and Private Equity-Sponsored Leveraged Buyouts in the EU (April 2007).

  75. EVCA, Code of Conduct (October 2008) and EVCA, Private Equity and Venture Capital in the European Economy: An Industry Response to the European Parliament and European Commission (25 February 2009), available at: <http://www.evca.eu>.

  76. Ibid.

  77. Sir David Walker, Guidelines for Disclosure and Transparency in Private Equity, November 2007. A Guidelines Monitoring Group has subsequently been established to review the private equity industry’s conformity with the Walker Guidelines: see <http://www.walker-gmg.co.uk>.

  78. For discussion, see Gullifer and Payne, supra n. 57, ch. 14.6.5.

  79. Proposal for a Directive of the European Parliament and of the Council on Alternative Investment Fund Managers, Brussels, 30.4.2009, COM(2009) 207 final.

  80. Executive Summary of the Impact Assessment of the proposed Directive, Brussels, 29.4.09, SEC(2009) 577, at p. 3.

  81. Directive 2011/61/EU, supra n. 10.

  82. For discussion of the differences, see European Parliament, Background Note on the Alternative Investment Fund Managers Directive. Differences between Commission, Parliament and Council Texts, available at: <http://www.europarl.europa.eu>.

  83. For a detailed discussion of EU regulatory policy in this context, see E. Ferran, ‘After the Crisis: The Regulation of Hedge Funds and Private Equity in the EU’, 12 European Business Organization Law Review (2011) 379.

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  84. ESMA, Discussion Paper on ESMA’s Policy Orientations on Possible Implementing Measures under Article 3 of the Alternative Investment Fund Managers Directive, ESMA 2011/121 (15 April 2011); ESMA Consultation Paper: ESMA’s Draft Technical Advice to the European Commission on Possible Implementing Measures of the Alternative Investment Fund Managers Directive, ESMA 2011/209 (13 July 2011) (the comments received by ESMA as a result of this consultation are published on ESMA’s website: <http://www.esma.europa.eu>); ESMA Consultation Paper, ESMA’s Draft Technical Advice to the European Commission on Possible Implementing Measures of the Alternative Investment Fund Managers Directive in Relation to Supervision and Third Countries, ESMA 2011/270 (August 2011).

  85. The Directive defines AIF as any collective investment scheme which does not require authorisation under the Undertakings for Collective Investments in Transferable Securities (UCITS) Directive: Art. 4(1)(a).

  86. For the geographical reach of the Directive, see Art. 2.

  87. The treatment of non-EU AIFM was one of the most controversial issues in the drafting of the AIFMD. The final text is intended to create a level playing field between EU and non-EU AIFM, but the regime permitting non-EU AIFM to register under the AIFMD and enjoy the same EU-market access as EU AIFM is only scheduled to become available from 2015.

  88. See Arts. 6–8. As a precondition of authorisation AIFM will be required to provide the competent authorities with detailed information regarding such matters as the identity of the owners and the characteristics of the AIF they intend to manage, as well as satisfying the competent authorities that they will be able to comply with the substantive requirements of the Directive.

  89. If it is a non-EU AIFM, the competent authority will be in the AIFM’s Member State of reference (see Art. 37(4)).

  90. See Art. 32.

  91. As defined in Annex II of the Markets in Financial Instruments Directive (MiFID).

  92. See Art. 31.

  93. There are grandfathering clauses in place to deal with the transition period. For example, AIFM managing existing closed-ended funds that do not make any additional investments after the final date of transposition by Member States (early 2013) will be allowed to continue to manage such funds without authorisation under the Directive.

  94. Art. 3(2). Member States must still impose registration and simplified disclosure obligations on these smaller funds: Art. 3(3).

  95. Art. 9(2).

  96. Art. 9(1). There is also an own funds requirement where the fund is managed by external AIFM, being the higher of (i) one quarter of fixed annual overheads and (ii) 0.02% of the amount by which the total value of portfolios under management exceeds €250 million, subject to a cap of €10 million (Art. 9(3)). Own funds must be invested with a view to short-term availability and may not be invested speculatively.

  97. Art. 20. Specific additional restrictions apply when delegating portfolio management risk or risk management functions.

  98. Art. 21(1). ESMA has made detailed suggestions regarding depositories, including their functions and duties and the liability regime to which they should be subject: see ESMA 2011/209, supra n. 84, Part V.

  99. Art. 19.

  100. Art. 13(1). ESMA is required to issue guidance on the application of the remuneration provisions: Art. 13(2).

  101. See Art. 12.

  102. Arts. 12(1)(a) and 12(1)(b).

  103. Art. 15(2).

  104. Art. 15(1).

  105. Art. 14(1).

  106. Art. 16(1).

  107. The Directive provides that competent authorities may, in exceptional circumstances, provide leverage limits in respect of individual funds or fund managers if necessary to deal with systemic risk concerns: Art. 25(3).

  108. Art. 15(4).

  109. Art. 25(3).

  110. Art. 23(1)(a).

  111. The Commission asked ESMA to consider how to define what is meant by ‘on a substantial basis’. ESMA’s view is that ‘leverage is a complex measure to calculate for the heterogeneous population of AIF covered by the AIFMD. As such, it is not deemed to be appropriate to seek to specify a quantitative threshold at which leverage would be considered to be employed on a substantial basis, as this may not always be the most insightful from the perspective of identifying systemic risk. Instead, it is proposed that a distinction is drawn based on whether the degree of leverage employed could contribute to the build-up of systemic risk in the financial system or the risk of disorderly markets’: see ESMA 2011/209, supra n. 84, at p. 232.

  112. Art. 24(4).

  113. Art. 25(3).

  114. Arts. 25(6) and 25(7).

  115. Art. 20(1).

  116. Art. 22. This should be provided no later than six months following the end of the financial year, or four months if the fund is subject to the Transparency Directive (e.g., listed funds): Art. 22(1).

  117. Arts. 23(4) and 24(2).

  118. Art. 24(1).

  119. Disclosure of acquisition of a major holding is also required. Disclosure must be made if the proportion of shares held reaches, exceeds or falls below the thresholds of 10%, 20%, 30%, 50% or 75%: Art. 27(1). This obligation does not apply where the fund acquires or disposes of shares in an SME within the meaning of Commission Recommendation 2003/361/EC: Art. 26(2).

  120. The Directive’s provisions apply in relation to one or more AIFM where control is acquired by: (a) a single fund; (b) multiple funds under an agreement aimed at acquiring control; or (c) multiple AIFM cooperating on the basis of an agreement under which their AIF jointly acquire control: Art. 26(1).

  121. For a non-listed company, control is defined as more than 50% of the voting rights of the company: Art. 26(5). Control of an entity whose securities are traded on an EU-regulated market (‘an issuer’) refers to the threshold for a mandatory bid under the Takeovers Directive. This will vary between Member States. In the UK, it is currently set at 30% of voting rights.

  122. Arts. 27 and 28.

  123. Art. 28(2).

  124. Art. 29.

  125. Art. 29(1).

  126. Art. 29(2).

  127. Art. 30. An earlier version of the Directive had proposed lock-in periods for AIF investments, but these provisions were dropped by EU legislators and do not appear in the final version of the Directive.

  128. See Ferran, supra n. 83, at pp. 404–405: the effect of these provisions ‘is to narrow the range of options that may be used to return value to shareholders in a tax-efficient way’. However, Professor Ferran points out that it should still be possible for acquirers to make use of more relaxed regimes governing financial assistance by private companies, provided no capital reduction is involved.

  129. D. Awrey, ‘The Limits of Hedge Fund Regulation’, 5 Law and Financial Markets Review (2011) p. 119.

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  130. EVCA, Response to the Proposed Directive of the European Parliament and Council on AIFM, Brussels (26 June 2009).

  131. I am indebted to my colleague, Dan Awrey, for these points. For further discussion, see Awrey, supra n. 129.

  132. Art. 21(3).

  133. See Commission Staff Working Document accompanying the AIFM Proposal (30 April 2009) 2009/576 (Impact Assessment).

  134. Directive 2004/25/EC, Art. 6.

  135. Kaplan and Strömberg, supra n. 44.

  136. Ben Jenkins, co-head of Blackstone’s corporate private equity business in Asia, in a speech at the International Financial Law Review’s (IFLR) Private Equity Forum (September 2009).

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    Jennifer Payne (Reader in Corporate Finance Law)

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Payne, J. Private Equity and Its Regulation in Europe. Eur Bus Org Law Rev 12, 559–585 (2011). https://doi.org/10.1017/S1566752911400021

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