Proposed European Union regulations have U.S. private-equity players buzzing.
Most private-equity players acknowledge that if the rules to restrict the use of leverage are enacted, their own activities abroad will be crimped. They also fear that U.S. regulators may follow suit — raising a host of other concerns.
The proposed rules, known as the European Union's Alternative Investment Fund Managers Directive, will be debated by the European Parliament this month. Part of a series of measures EU regulators put forth after the global financial crisis to manage systemic risk, the rules would likely affect any U.S. firms raising money and putting it to work in Europe. Whether their influence extends further is an open question.
In the U.S., there have been periodic calls for greater oversight of private-equity and other alternative asset managers, but none have taken root. If the European rules are adopted in the U.S., they could make certain leveraged buyouts less palatable and make managing portfolio companies more costly.
"Whatever regulation is passed in Europe, it is likely to influence regulations in the U.S.," said Raj Marphatia, a partner at Ropes & Gray LLP, a law firm that advises the Boston private-equity firm Bain Capital. "If the EU makes it difficult for U.S. managers to operate in the EU, I think the U.S. will apply similarly stringent standards to EU managers operating in the U.S."
"There is no doubt that the U.S. private-equity industry has been and will continue to be under real political pressure at home — the recent carried-interest debates and underpinnings of the Volcker rule make it clear that private equity has very little obvious political constituency," said Justin Abelow, a managing director at Houlihan Lokey responsible for sponsor coverage on the East Coast and in Europe. "Over a certain size threshold — probably somewhere around $3 billion of the latest fund size — there is no such thing as a purely U.S. private-equity firm, and all the U.S. fund managers above that size range are keeping an eye on shifting regulations across the ocean," he said.
Abelow said the added regulations would burden an industry that could be a significant source of job creation. Firms that routinely raise money in Europe and invest it in the region include Kohlberg Kravis Roberts, Bain Capital, Blackstone Group and Carlyle Group.
U.S. private-equity funds raised $16.5 billion in Europe last year, while European funds raised $77.5 billion.
Blackstone has had a long history of investing in European companies and managing funds dedicated to doing deals on the Continent. Last year it raised more than $4.2 billion (€3.1 billion) for its third Europe real estate fund.
"We are concerned that [the proposed regulations] will restrict our ability to raise funds within Europe and serve our clients," said Peter Rose, a spokesman for Blackstone.
The rules being considered in Europe would require private-equity firms with a portfolio valued at €500 million ($685 million) or more to meet a host of requirements in order to do business in Europe. Hedge funds with a portfolio valued at more than €100 million, or $137 million, also would face tighter restrictions.
The EU rules also would require that PE portfolio companies with more than 250 employees and revenue exceeding €50 million, or $68 million, to file an annual report with European regulators; no regulatory agency was specified. PE firms also would be required to maintain minimum capital requirements much like banks.
"There is a concern that the [EU's] directive will make it difficult for alternative-investment fund managers to market non-EU alternative investment funds in Europe, thereby restricting their access to capital," said Robert Duggan, head of the investment funds group in London at the law firm Walkers, which advises PE firms on the creation of funds.
Limits on the amount of leverage fund managers can take on for transactions are sure to affect leveraged buyouts and may reduce bank lending activity. Between 2000 and 2005 the amount of debt used in buyout transactions ranged from 59% to 68% of a company's purchase price. That leverage amplified returns for the funds and their investors.
"Private equity has never been subjected to governmentally imposed and substantive limits on leverage," said Marphatia, adding that regulations on leverage are "novel."
The amount of debt used in private-equity deals, of course, varies widely by LBO firms. So, an approach that embodies a one-size-fits-all regulation isn't the best way to go about creating a regulatory framework for alternative fund managers, according to a recent report published by the U.K. Parliament's House of Lords, which has taken interest in the issue because proposed EU regulations stand to affect U.K. fund managers, whose deals account for roughly 60% of private-equity activity in Europe. The alternative asset management industry employs 40,000 professionals in the U.K.
The House of Lords was critical of the proposed regulations in a 79-page report published this week. Specifically, the report warned that a one-size-fits-all approach to regulation of private equity was not a good method.
"We concluded that the details were poorly thought through. We have said to the British government that they should not agree to the directive as it's currently framed, and that a balanced and sensible level of regulation is achieved," said Lord Woolmer of Leeds, who serves on the House of Lords subcommittee on economic and financial affairs.
Woolmer acknowledges that a comprehensive regulatory framework is needed for the private fund industry, but he said the directive unfairly discriminates against those funds that are domiciled outside the EU, like U.S. buyout firms in New York.
The directive is also misleading, he said, because it incorrectly relates the financial crisis to the alternative-investment business. "We want to give a wake-up call to politicians across the EU that these industries did not cause the financial crisis," Woolmer said. "They are very important in providing liquidity to the markets."
Meanwhile, some industry groups — many of them with U.S. PE fund managers as members — have raised warning flags about the planned European regulations. The British Venture Capital Association, the European Private Equity Roundtable and the European Venture Capital Association voiced opposition to the regulations.
The EVCA objected to proposed disclosure rules.
"Requiring greater disclosure from portfolio companies of private-equity funds than from portfolio companies of other investors excluded from the scope of the directive would discriminate against private-equity-backed companies and distort competition among private capital investors competing for investment opportunities," the group said.