Europe to Private Equity: Drop Dead

Europe is trying to destroy the global private equity market.

Actually, that’s a bit hyperbolic. Let’s go with this instead: European Union regulators are trying to destroy the global private equity market.

At issue is the EU’s Directive on Alternative Investment Fund Managers, which could effectively prevent European institutions and individuals from investing in non-European funds. No more raising fund capital from that Dutch pension system or that British corporation or that wealthy family in Germany. Buh and bye.

You know all that talk about how the Volcker Role could kick U.S. banks out of the limited partner biz? Well, in terms of fundraising impact, Volcker is Lamar Odom and the EU is Kevin Garnett.

The European proposals — there are two, currently being reconciled — cover all types of alternative investments (hedge, private equity, venture capital, real estate, etc.). They were drafted in response to the financial meltdown, despite explicit acknowledgment that alternatives themselves were not to blame (save for hedge funds, just a little bit).

Before continuing, let me say that private equity’s lack of culpability is, to a large extent, irrelevant. After all, subprime mortgage bundling did not cause the Great Depression, nor subsequent recessions until 2008. New rules should be judged on their own merit, and there can be valor in thinking ahead.

But these new rules fail the test miserably. Not because they attempt to preempt future over-leveraging that could lead to systemic illiquidity, nor because they will make it more costly for non-European firms to raise money from European investors (although both are true). No, they fail because they insist that non-European home countries of private equity funds adopt the new European standards.

For example, imagine you’re a private equity firm domiciled in New York City, which wants to raise money from European investors. Following a three-year “transitional” period (i.e., status quo), you could only secure European fund commitments if U.S. regulators mimeograph the new EU standards. The chance of that happening, of course, is nearly the same as Vatican City’s soccer team winning the World Cup.

How come? Well, one proposal would maintain public reporting requirements on a company taken private (for two years after the acquisition). Another would restrict the amount of fund-level leverage in the case of “exceptional circumstances” (think distressed debt/hedge), while a competing draft would include deal-level leverage restrictions (LBOs). Another would require PE firms to provide an annual disclosure of “investment strategy and objectives” on any company in which is acquired a control position (VC-backed companies would be excluded). Finally, there are a whole host of annual reporting requirements.

In short: The U.S. won’t go for it.

Complicating matters even further, there is the portability issue. Basically, one draft would require non-EU fund managers to register and provide disclosures to each and every country from which they raise money. The other draft would provide a so-called “passport,” via which you could register in one European country and be copasetic in all the others.

Of course, if the EU doesn’t drop its “you must play by our rules” demand, then the issue of portability is largely irrelevant. If it does blink, then a passport would be required to keep down compliance costs.

I spoke with a bunch of European sources over the weekend — all of whom believe that the EU will come to its senses before it’s too late. They say some additional disclosures will be unavoidable, but that the most absurd proposals are being driven by politicians who want credit for “driving private equity locusts out of [pick a European country].”

I hope my sources are correct but, for now, it looks like the demagogues might just get their wish.

Here is a copy of the more modest of the two proposed directives:
LexUriServ