Operating private equity funds in Europe has become disproportionately expensive because, following 2008, stakeholders across Europe have failed to recognise that the term ‘fund’ means different things in different contexts. It can have a narrow legal meaning under specific product laws or it can have a broader commercial meaning where it is used to control the promotion of ‘investment schemes’. Brexit provides Britain with an ideal opportunity to revisit this mistake at the heart of the Alternative Investment Fund Managers Directive and restore the competitive position of its private equity funds’ industry.
Following 31 December 2020, Britain is no longer part of the Single Market and its industry must compete for international capital. Sponsors can adopt one of two operating models:
The European rulebook envisages a universe of UCI’s (or legal funds) comprising UCI’s investing in transferable securities (UCITS) and UCI’s that raise capital from investors to invest in alternative assets. To the extent that Level 1 or 2 of the AIFMD is unclear, ESMA explicitly identifies the key characteristic of an AIF as the common pool comprising the subscription proceeds of securities sold, which is actively managed by a regulated asset management business and supervised by a depositary institution.
US co-investment on the other hand, is simply a static co-ownership agreement between partners to invest directly alongside management teams in investment opportunities. These private equity funds are ‘funds’ in a commercial sense only and lack almost all the features of a legal fund. There is no securities’ offering, there is no pooling of interests insofar as partners maintain separate capital accounts, there is no asset management or asset management fee and there is no need for a depositary. Common law limited partnerships should not be understood as an actively managed AIF, but rather as capital conduits supplying equity funding from investors to finance deals. Value is generated by the portfolio management teams.
The key difference between the two operating models though, is cost. If we compare the annual costs of operating a £500m private equity fund, the results are as follows:
European AIFs are at least four times more expensive to operate than comparative US funds and this cost differential is only expected to increase with additional social reporting costs. The EU sustains this pricing differential through strictly controlling access to its market and a complex framework of regulation that subsidises European investors to invest through EU-based products. This all changes now for Britain, and the UK industry must consider whether the European rulebook remains a realistic operating model outside the Single Market.
Diverging from the European rulebook need not be complex. This is because, unlike civil law partnerships on the Continent, common law limited partnerships never really fell within the legal scope of the AIFMD. While Limited Partners are managed on a collective basis under UK regulation, partnership interests were never pooled in the manner required by European jurisprudence. The AIFMD was mis-applied to limited partnerships in the UK though, because, the Treasury felt bound by its political commitments as a Member State and could not acknowledge the correct legal position in the FCA’s perimeter guidance. Obviously, the position is now very different.
If the AIFM Regulations were no longer applicable in the UK, the costs of managing British private equity funds would immediately collapse offsetting the difficulties of operating outside the Single Market and putting the UK back on an equal footing with the US. The British industry would continue to be able to access European markets through the establishment of parallel funds that have the advantages of side-stepping delegation issues and ringfencing the higher costs applicable to EU-based investors. This is the approach that the UK historically relied upon and US sponsors still use.
The Treasury has recently published the Review of the UK funds regime: a call for input providing industry with an unique opportunity to correct the AIFMD mistake and significantly improve the operational efficiency and integrity of British private equity funds. In preparing responses, we very much hope that all stakeholders consider including this Modest Proposal.
Our team has a proven track record in assisting clients and entities administered through new fund and compliance requirements. We take pride in our ability to deliver the solutions required by our clients to support their investment structures, in an ever-evolving industry. Should you require our expert team to advise on any of our services available, we would be delighted to speak with you. To discuss how Sanne can assist, please contact Chris Warnes, Head of Sanne United Kingdom.