The Good, the Hedge and the UCITS:

why funds are different and what it means for EU policies

Executive Summary

Private equity and funds are among the “alternative structures” which, because they are not mutual funds covered under UCITS, fall under the Alternative Investment Fund Managers Directive (AIFMD). There is a wide variety of “AIFMD funds” across Europe, from hedge funds to real estate and credit funds.

Despite often subject to the same or similar rules, these funds do not share the same characteristics and purpose, nor do they bear the same risks. Contrary to UCITS and hedge funds, private equity: - make direct and active investments into businesses (as opposed to indirectly managing a basket of securities based on a reading of indexes) - are set up as long-term, illiquid, closed-ended and unleveraged structures, which cannot be regularly traded - are vehicles of choice to institutional investors looking for long-term yield and are generally not marketed to retail clients

Understanding the differences and distinctions between those asset managers, irrespective of their current regulatory classification, is essential to appropriately calibrate EU financial services law.

A lot of attention will be devoted over the next few years to the regulatory treatment of asset managers under EU law. On top of the initiatives developed as part of the CMU agenda, such as the review of ELTIF or the recategorization of investors under MiFID, the European Commission is considering whether to introduce changes to the AIFMD framework, with a likely impact on managers operating under this regime.

In that context, this paper will help you understand what lies behind the name “private equity” and why its features require a calibrated regulatory treatment for this industry to fulfil its two main purposes: - providing investment opportunities to long-term investors, such as pension funds or insurers, which are seeking returns for the citizens that rely on them - funnelling equity capital into companies in all industry sectors, from start-ups to well established businesses, that require funding to face their day-to-day challenges.

As such, this paper aims at providing you with the appropriate tools to build a legislative framework that incentivise long-term equity investments in Europe and support the objectives set in the Capital Markets Union agenda.

Our 9 suggestions

1. Review the ELTIF regime to make it more workable 2. Avoid reopening the currently efficient AIFMD regime 3. Take into consideration the long-term nature of equity investments in prudential frameworks (Solvency II, CRR) 4. Prepare rules that are tailored to all types of managers 5. Protect as a best-interest mechanism 6. Maintain existing delegation rules 7. Do not require investors in long-term, illiquid assets to present daily reporting values 8. Do not apply liquidity requirements to closed-ended funds 9. Redefine the concept of a “professional investor”

See more details on these different suggestions in the paper and in its Annex

The private equity industry is composed of managers: I- investing into businesses with a potential to grow II- through long-term, closed-ended equity funds III- with the capital of institutional and sophisticated investors

In this paper we will detail each of the different steps shown in the graph above.

I. From start-ups to turnarounds: in which companies does private equity invest?

It is easy to forget the core role the financial services industry is supposed to play in providing funding to people and businesses that are either looking to grow or manage crises, such as the one we are currently facing.

In the financial market you will find all kinds of operators offering a variety of services, where the connection to the underlying real assets or activities can sometimes seem opaque. That is not the case for private equity. Investing in real businesses is still very much what private equity is about.

Private equity managers will commit capital to a wide range of companies in all sectors of the economy and all stages of development, from the smallest start-ups to the largest conglomerates, from promising scale-ups to businesses in distress

There are several types of private equity investments (venture, growth, infrastructure, turnaround, etc.), with no distinction between these from an operating perspective. They will all invest patiently (for five years on average) and actively in the businesses to ensure they become successful. In other words, private equity managers do not only choose the companies in which they invest after a long due diligence process, they also take minority or majority equity ownership and are actively involved in their running for several years.

In numbers

10.5 million employees ; 4.5% of Europe’s total 234 million workforce

Private equity is also often a solution for companies which are most likely to show potential but which require time to grow and/or evolve to reach such potential.

To read more: Private Equity at Work, September 2020

N.B.: Dark blue: Buy-out backed jobs; Green: Growth funds-backed jobs ; Blue: Venture-backed jobs ; Light Blue: Others

As markets evolve, private equity is becoming an increasingly essential alternative to more traditional forms of financing, such as: • banks and other debt lenders, which, first and foremost, provide debt to their clients; they are understandably not focused on the way companies operate once credit has been granted • public markets, which can be too volatile for companies that require long-term stability and too large for smaller market players.

By contrast, private equity managers offer operational guidance and assistance to the businesses they own until the very last moment of the investment period. As the success of the company in which they have invested will make the success of the fund, managers need to spend a significant amount of time with businesses.

Did you know ? - Risk takers

Private equity is risky. Often active in disruptive markets, especially in the venture capital context, some of the portfolio companies, when selling their products or services, may fail.

But risk is mitigated. This is why investments are made indirectly through funds, which have dozens of companies in their portfolio. The (often great) success of one portfolio company can compensate for the failure of others, as such diversification is a key feature of the industry. And yet, despite this, EU prudential frameworks, such as CRR or Solvency II, rarely make a distinction between direct investments in businesses and investments through funds.

Why are we different?

As seen above, the private equity investment targets are not at all the same as for other types of AIFs, such as UCITS and hedge funds.

UCITS Hedge funds Private equity

Stocks of listed businesses

Bonds

Derivatives

Active investments in unlisted businesses

What does this mean from a legislative perspective?

Today more than ever, policy makers need to reflect on whether the EU has the right environment to incentivise further investments in unlisted businesses.

Assessing this will require looking at recent legislative initiatives – for example the recent development of a European voluntary passport for venture funds (the “EuVECA”) and for long-term investment funds committing capital into real assets (the “ELTIF”).

It also means looking at the EU prudential frameworks – which have the tendency to base their risk assessment on liquid markets and often fail to appropriately assess the real risk of long-term assets.

Invest Europe Recommendations:

1. Review the ELTIF regime to make it more workable for managers who operate such funds 2. Avoid reopening the currently efficient AIFMD regime and keep the current €500 million de minimis threshold above which the Directive applies to protect smaller market players such as venture capital firms 3. Develop prudential frameworks (Solvency II, CRR) that take into consideration the long- term nature of equity investments

II. Illiquid and closed-ended: how are private equity funds set up?

Enabling invested companies to have sufficient time to grow and develop requires funds to be structured in a certain way. This has shaped how managers are marketing to their investors. This in itself makes private equity a very special asset class.

While there is no definition of private equity in EU law, the proxy that has been used in various EU laws (“closed-ended and unleveraged funds”1) is a good indication of the industry’s particularity. Private equity funds indeed have the following characteristics: 1) they are long-term and closed-ended: funds are typically set up for a 10-year period, renewable by two years 2) they are illiquid: all capital is committed at the beginning of the fund and cannot be redeemed 3) they are unleveraged: funds are typically not authorised to borrow more than the capital committed 4) they are international: managers very often operate cross-border

1) Long-term and closed-ended

The long-term and closed-ended nature of private equity funds has a series of implications from a regulatory perspective: i) it is difficult to assess the funds’ success during the life of the fund in the same way as liquid assets ii) funds have no history and as such, they are unable to present past performance iii) it allows for specific variable remuneration models based on long-term performance

In numbers OUTPERFORMING European buy-outs delivered a net IRR Private equity performance Public benchmark of 15.00% versus 5.84% for the MSCI

15% Europe

13.28% Private equity is a well-performing asset class,

generally outperforming public markets. The 9.77% performance of private equity fund managers is one of

8.39% the main reasons behind the rapid growth of the 7.32% industry over the past few years. But assessing the 5.84% performance of portfolio companies after 2 or 3 years would not make sense – it is highly likely they will still be loss-making. This is a phenomenon called the “J- Curve”.

To read more: The Performance of European BUY - O U T G R O W T H V E N T U R E FUNDS FUNDS FUNDS Private Equity Benchmark Report, October 2020 (request it here)

1 For example, exposures to these funds are granted a lower risk weight under Article 168, paragraph 2 of the Solvency II Delegated Acts (Delegated Regulation EU/2015/35). Aside from a of around 2% per annum of the funds’ committed capital over the investment period of the fund, a typical incentive for the manager to make the fund successful is “carried interest”, a model specific to closed-ended funds which is designed to align the interests of fund managers with those of investors. Fund managers may also co-invest alongside the fund, which is an additional way for them to have “skin in the game”. These mechanisms are designed to ensure professionals remain focused on the success of the fund even over several years.

Did you know ? - You can carry it with you

Carried interest, or “carry” as it is known in the industry, is a profit share mechanism decided at the outset of the fund. The fund manager is entitled to receive part of the fund’s profits (typically 20%) once the investors have received their initial capital back, plus an agreed return (typically 8% p.a.). In the vast majority of cases, carry will therefore only be received at the very end of the fund.

2) Illiquid

Investors will subscribe to a private equity fund at the beginning of its life – during a short subscription period – and will not be in a position to redeem their investment for the entire life of the fund. While investors must be careful to have sufficient liquidity in their portfolio to honour their commitments, there is no liquidity risk from a fund perspective.

3) Unleveraged

Private equity funds do not use leverage in the same way as hedge funds do to increase the potential return on the investment. Even if it needs to borrow temporarily (for example, to buy a company quickly before being in a position to call the capital committed by the investors), the fund will not exceed the ratio of 1:1 between exposures/loans and committed capital. In the private equity model, investors are simply not pushed to take on extra risk beyond the capital they have committed.

Did you know ? - Ring fencing

Some private equity strategies may involve leverage at the portfolio company level. However, the borrowing at the level of the portfolio company will have no bearing on the leverage of the fund (if any). The debt held by each of its individual portfolio companies is ring-fenced from any debt of the fund itself and of any other portfolio company controlled by the fund. This legal and economic separation is an essential feature of the private equity model and distinguishes it from corporate ownership that can be seen within trade groups.

4) International

In numbers

€39.9bn of cross-border investment flows in 2019

Private equity is an international industry by nature, with funds managers raising capital from across the globe to invest it into companies based in all corners of Europe. What matters to a private equity manager is not the location of a company but its ability to thrive.

To read more: Private Equity Activity Report, May 2020

Private equity funds by nature almost always operate on a cross-border basis: investments are usually made all over Europe; teams are very often located in different countries; and investors will also be dispersed across Europe and the wider world.

Within such an international context, delegation arrangements are fundamental to how the industry functions as they are aimed to improve efficiency and to facilitate fund managers’ access to the relevant investment professionals and portfolio management expertise (e.g. in the country where they are investing).

Concretely, delegation and advisory arrangements are deployed to enable fund managers to be close to the assets / the portfolio company and to access the skills, knowhow and expertise they need, wherever they are based, in the most efficient manner possible, allowing them to provide better returns to their investors and their ultimate beneficiaries.

Why are we different?

UCITS Hedge funds Private equity

Illiquid

Unleveraged

What does this mean from a legislative perspective?

The structure of private equity funds makes them different from other market players. Harmonised requirements for all types of funds (including UCITS) have their merits but they often do not acknowledge the nature of the relationship between investors and managers in the private equity world.

Invest Europe Recommendations: 1. Resist the general temptation to present harmonised, untailored rules for all types of managers, especially when these have an impact on the way funds are structured and managers operate 2. Protect mechanisms, such as carried interest, that incentivise the fund manager to act in the best interest of its investors over the entire length of the closed-ended fund’s life 3. Maintain existing delegation rules, recognising established market practice and the specific characteristics of the private equity industry 4. Do not require daily reporting values from investors in long-term, illiquid assets(as these are simply irrelevant from a market perspective)

III. Investors of a third kind: who commits capital to private equity?

As mentioned earlier, private equity is easily distinguishable from other classes as the products it offers are long-term and illiquid. Although a secondary market in fund interests can exist, the terms under which an investor could sell their position on the secondary market to another investor are very limited. This has implications for the way they provide investment opportunities to investors across Europe and globally and on their ability to sell their stakes in the fund, as the capital committed will serve supporting businesses over the entire length of their growth.

This model has a direct consequence: committing capital to a private equity fund requires careful consideration and a strong liquidity profile from investors in the asset class. Typically, private equity has been reserved to knowledgeable investors able to commit larger sums of capitals.

Did you know ? - I can’t get no redemption

Redemption during the life of the fund is typically expressly excluded by the legal agreement which governs the management of the fund. Overall, private equity funds are not designed to be traded like a liquid asset.

The typical composition of a private equity fund investor base will be: • 70% of institutional investors: pension funds, insurers, banks, sovereign wealth funds, fund- of-funds • 30% of other experienced investors: family offices, entrepreneurs

The vast majority of direct investors into private equity funds are therefore clients (i) with an expertise of the market (ii) who invest large sums of capital after having negotiated their entry in the fund with the manager. Situations where private equity managers market to individuals committing smaller tickets (typically less than €100,000) are rare and even in those cases these “mass-affluent” investors will commit larger tickets than typical retail investors. The ELTIF regime has been considered a vehicle of choice for this type of investors.

Profits generated by private equity are of course made at the benefit of the direct investors in the fund (the “limited partners”) which are seeking these returns to manage the expectations of their clients. The success of private equity funds therefore helps institutional investors such as insurers or pension funds meet their liabilities, at the ultimate benefit of pensioners and individuals with plans at a time where low interest rates represent an essential threat to these long-term schemes.

Why are we different?

As can be seen above, the private equity investor base fundamentally differs from that of UCITS and hedge funds which also target traditional retail clients.

UCITS Hedge funds Private equity

Institutional

Sophisticated

Mass-affluent

Other retail investors

What does this mean from a legislative perspective?

With different types of investors and a mostly illiquid profile, private equity differs significantly from other asset classes. This means that retail-like issues and liquidity concerns will be much less prevalent in the asset class.

Invest Europe Recommendations

1. Apply liquidity requirements only to open-ended funds that may be subject to liquidity concerns (as opposed to harmonised requirements that apply across the board) 2. Redefine the concept of a “professional investor” within MiFID to better take into account the level of sophistication of large and knowledgeable investors into illiquid funds

Conclusion: the good, the hedge and the UCITS?

As shown above, the private equity model is built on a three-step process: i) commitments received from investors are pooled into a fund ii) the capital collected will over the years be invested in the portfolio companies. iii) once an investment in a portfolio company is divested, the capital is returned to the investor, along with the overall profits that have been made.

Hence, private equity funds are set up in a fundamentally different way from liquid funds, such as UCITS and hedge funds. To deliver effective protection to the investors and to allow asset managers to commit the capital businesses require to finance themselves, it is important that regulatory frameworks are sufficiently tailored to the realities of each of these asset classes. This is why we prepared 9 recommendations for EU policymakers to take into consideration (see details in Annex)

This is all the more true as private equity funds will have a key role to play in allowing European businesses to overcome the recapitalisation challenges they are likely to face in the coming months.

UCITS Hedge funds Private equity

Investors

Institutional

Sophisticated

Mass-affluent

Other retail investors

Fund characteristics

Illiquid

Unleveraged

Investments

Stocks of listed

businesses Bonds

Derivatives

Active investments in

unlisted businesses

ANNEX: Our 9 Key Recommendations and relevant legislative provisions

N° Recommendation Relevant file

1 Review the ELTIF regime to make it more workable for ELTIF review (Q3 2021) managers who operate such funds

2 Avoid reopening the currently efficient AIFMD regime AIFMD (Q3 2021), in particular and keep the current €500 million de minimis threshold Article 3 above which the Directive applies to protect smaller market players such as venture capital firms 3 Develop prudential frameworks (Solvency II, CRR) that Solvency II Delegated take into consideration the long-term nature of equity Regulation, Art 171a (review investments Q3 2021), CRR, Articles 128 and 132 (review Q2 2021) 4 Resist the general temptation to present harmonised, AIFMD (review Q3 2021), KID- untailored rules for all types of managers, especially PRIIPS, SFDR, … when these have an impact on the way funds are structured and managers operate

5 Protect mechanisms, such as carried interest, that AIFMD, Article 13 and Annex II; incentivise the fund manager to act in the best Guidelines on sound variable interest of its investors over the entire length of the remuneration closed-ended fund’s life

6 Maintain existing delegation rules, recognising AIFMD, Section 3, Article 20 + established market practice and the specific AIFMD Delegated Regulation, characteristics of the private equity industry Section 8, Articles 75-82

7 Do not require daily reporting values from investors in CRR, Article 132, 132a and long-term, illiquid assets (as these are simply irrelevant accompanying delegated from a market perspective) Regulation (Q2 2021)

8 Apply liquidity requirements only to open-ended AIFMD, Article 16 + AIFMD funds that may be subject to liquidity concerns (as Delegated Regulation, Section opposed to harmonised requirements that apply across 4, Articles 46-49 the board)

9 Redefine the concept of a “professional investor” to MiFID II, Annex II (Q4 2021 or better take into account the level of sophistication of 2022) large and knowledgeable investors into illiquid funds