European Fund Regulation – Just Like London Buses?
It is often said that you wait a considerable amount of time for a London bus to arrive, and then three turn up at once. If they are all going in the same direction, then (barring a breakdown) your choice should be relatively easy – but what if the route is a mysterious acronym that could set you down a path that might not get you to your destination, or only get you there in a roundabout way?
Until very recently – UCITS apart – it was left to individual European Union (“EU”) member states to determine whether and how alternative investment funds were regulated and marketed. 22 July 2013 saw not just one new regime come into force – and much has been written elsewhere about the Alternative Investment Fund Managers Directive (“AIFMD”) – but two additional, lesser-known regimes that certain investment managers may want to consider using. So what is behind those other two acronyms, EuVECA and EuSEF, when compared with the better-known AIFMD?
Note that another European initiative in the field of investment law is the creation of European Long-Term Investment Funds (ELTIFs), discussed in a separate article in this Quarterly Report.
EuVECA – A Eureka Moment for European VC Investing?
The European Venture Capital (“EuVECA”) fund label is a more lightly regulated alternative to the AIFMD regime. Two political issues have shaped the creation of the EuVECA regime. First, following the onset of the global financial crisis, the amount of financing made available by the banking sector to early stage businesses decreased markedly and, in turn, increased the importance of venture capital funds and other alternative sources of growth and development capital. Secondly, it was felt that the AIFMD regime was both politically and financially too great a burden to bear for the venture capital industry, which typically invests smaller amounts of capital in a larger number of portfolio companies with no, or very low, attendant systemic risks.1
The EuVECA label attaches (if the manager so wishes) to the funds of those asset managers that are not required to become authorised under the AIFMD because they are sub-threshold managers – that is, they manage unleveraged closed-ended funds with less than €500 million of total assets under management. A key benefit of the EuVECA regime is that it offers those managers a pan-European marketing passport in much the same way as the AIFMD does2 and removes the need to rely on the patchwork of national private placement regimes. The categories of individuals to whom EuVECA funds may be marketed is wider than under the AIFMD, as the passport permits marketing not only to MiFID professional investors, but also to (i) investors who commit a minimum of €100,000 and provide a written risk acknowledgment (this is intended to capture, for instance, “business angels”); and (ii) executives, directors and employees of the EuVECA manager.
EuSEF – Championing the Social Impact Fund?
The regulations governing European Social Entrepreneurship Funds (“EuSEF”) were created as a way of encouraging the “smart, sustainable and inclusive growth” of the EU’s social economy by fostering a more beneficial climate for social enterprises that, because of the way they seek to create both a positive impact on society and financial returns, might not otherwise easily attract investment.
As with the EuVECA regime, the EuSEF regime is a voluntary regime open to EuSEF managers that manage unleveraged closed-ended funds with less than €500 million of total assets under management and that wish to benefit from a pan-European marketing passport. An EuSEF can be marketed to the same types of investors as an EuVECA fund (and works in the same way as the EuVECA passport) and an EuSEF manager can be authorised under both the EuSEF regime and the AIFMD.
Key Differences from the AIFMD Regime
The EuVECA and EuSEF regimes are based on a similar statutory footing, and it therefore follows that the ways in which those two regimes distinguish themselves from the AIFMD regime are much the same. The key differences can be summed up as follows:
- The EuVECA and EuSEF regimes are voluntary, rather than mandatory – that is, managers of EuVECA funds or EuSEFs can continue to market outside the AIFMD, EuVECA and EuSEF regimes if they do not want to take advantage of the marketing passports, provided they are not required to become authorised under the AIFMD. The voluntary nature extends to the ability of a manager to choose to affix the EuVECA or EuSEF label to some, but not all, of its funds if it so wishes.
- The EuVECA and EuSEF regimes are only available to EU managers established in the EU. This will be partially reviewed in 2015, raising the possibility that, for instance, Channel Islands funds managed by EU managers could attract the EuVECA or EuSEF label. However, there is no current scope for non-EU managers to be able to use the EuVECA or EuSEF labels.
- The authorisation process for prospective EuVECA or EuSEF managers appears more straightforward than is the case under the AIFMD, reflecting the fact that EuVECA and EuSEF managers will likely be smaller managers. Rather than setting out a detailed list of prescriptive requirements, the regulations require an EuVECA or EuSEF manager to comply with a set of principles in relation to each of the EuVECA funds or EuSEFs that it manages. These principles cover issues such as acting with certain standards of care, treating investors equally and selecting and monitoring investments with a “high level of diligence”.
- Unlike under the AIFMD, there is no need to appoint a depositary in relation to EuVECA funds or EuSEFs. Unlike under the AIFMD, existing national private placement regimes are not intended to be turned off in relation to EuVECA funds or EuSEFs in the near or medium term. The pre-sale marketing information that is required to be provided to investors in an EuVECA fund or an EuSEF is less extensive than is required under the AIFMD and corresponds broadly with what would typically be included in a market standard fund private placement or information memorandum. The ongoing (post-sale) disclosure obligations are intended to mirror what has been agreed with investors, although there is a requirement that both types of funds be audited annually, and a requirement under the EuSEF regime to disclose to investors the type and impact of work that the EuSEF is undertaking.
- Leverage at the level of the EuVECA fund or EuSEF is restricted to amounts that can be covered by uncalled commitments (and is therefore intended to deal principally with bridge financing).
- One of the key factors that will determine whether managers want to proceed down the EuVECA or EuSEF, as opposed to the AIFMD, route is whether the investment strategy that they intend to pursue is permitted under the relevant regimes. Perhaps not altogether unsurprisingly, the investment focus for both EuVECA-labelled funds and EuSEFs is intended to be on smaller enterprises, but managers will want to ensure that any investment strategy that they intend to pursue, and the likely target investment pipeline, falls squarely within the restrictions described below. The EuVECA regulations go so far as to state expressly that the EuVECA regime is not intended to be used for buyout strategies or “speculative” real estate investments.
An EuVECA fund must invest at least 70% of its capital contributions and uncalled capital in “qualifying investments”.
“Qualifying investments”, in turn, are:
- equity or quasi-equity instruments3 issued by “qualifying portfolio undertakings”;
- loans, of up to 30% of capital contributions and uncalled capital, to qualifying portfolio undertakings in which the EuVECA already holds a qualifying investment (although there does not appear to be a minimum holding requirement); and
- interests in other EuVECAs, provided that those underlying EuVECAs have not themselves invested more than 10% of their capital contributions and uncalled capital in other EuVECAs (i.e., a bar on creating cascading fund of fund EuVECAs).
“Qualifying portfolio undertakings” are:
- unlisted small or medium enterprises (“SMEs”);4 and
- certain types of SME holding companies;
that are established either in EU member states or in third countries that: (i) have entered into appropriate tax information exchange agreements with each EU member state in which the manager is established and in which the EuVECA in question is being marketed; and (ii) are FATF compliant.
Collective investment undertakings and certain types of credit, investment and insurance institutions are not treated as qualifying portfolio undertakings.
An EuSEF must invest at least 70% of its capital contributions and uncalled capital in “qualifying investments”.
“Qualifying investments” for the purposes of an EuSEF are:
- equity or quasi-equity instruments issued by “qualifying portfolio undertakings”;
- securitised and un-securitised debt instruments issued by “qualifying portfolio undertakings”;
- interests in other EuSEFs, provided that those underlying EuSEFs have not themselves invested more than 10% of their capital contributions and uncalled capital in other EuSEFs (again, a bar on creating cascading fund of fund EuSEFs);
- secured or unsecured loans granted by the EuSEF to a “qualifying portfolio undertaking”; and
- any other type of participation in a qualifying portfolio undertaking (it is worth noting that the range of permitted instruments is broader than under the EuVECA regime).
“Qualifying portfolio undertakings” for the purposes of an EuSEF are unlisted undertakings that:
- aim to produce a measurable, positive social impact by: providing goods or services to vulnerable or marginalised, disadvantaged or excluded persons; employing a method of production of goods or services that embodies their social objective; or providing financial support exclusively to social undertakings that carry out the above;
- are managed in an accountable and transparent way, in particular by involving workers, customers and stakeholders;
- use their profits primarily to achieve their primary social objective (which appears to need to be embedded in the constitutional documents) and whose constitutional documents determine the circumstances in which profits are distributed to owners to ensure that any such distribution does not undermine their primary social objective; and
- are established either in EU member states or in third countries that: (i) have entered into appropriate tax information exchange agreements with each EU member state in which the manager is established and in which the EuSEF in question is being marketed; and (ii) are FATF compliant.
The EuSEF regulations contain some detail on how the above characteristics are to be measured, although the missing piece here is some additional European Commission-level guidance.
It is worth noting that the letterbox test (i.e., the test to determine who, following any delegation by the entity that is claiming to be the EuVECA fund or EuSEF manager, is actually (capable of) exercising the management of the EuVECA fund or EuSEF) applies in relation to the EuVECA fund and EuSEF manager as it does under the AIFMD (albeit that there has been much less discussion on the application of the test in the context of the EuVECA and EuSEF regimes).
Disclosure Requirements Under the EuSEF Regime – Social Transparency
Prior to an investor’s investment in an EuSEF, the EuSEF manager must disclose to the investor information regarding: (i) the positive social impact being targeted by the investment policy of the EuSEF; (ii) the methodologies used to measure the social impact; and (iii) a description of the assets (other than other EuSEFs) in which the EuSEF may invest and the process and the criteria used for selecting such assets.
Additionally, an EuSEF must produce an annual report for existing investors which includes the following disclosures:
- details of the overall social outcomes achieved by its investment policy and the method(s) used to measure those outcomes;
- a statement of any qualifying portfolio undertaking divestments made;
- a description of whether non-qualifying portfolio undertaking divestments were made in accordance with the process and the criteria set out in the EuSEF’s marketing materials;
- a summary of the activities that the EuSEF manager has undertaken in relation to the qualifying portfolio undertakings; and
- information on the nature and purpose of the investments other than “qualifying investments”.
In light of the European Commission’s aim to boost investor confidence in social enterprise funds by removing the confusion around what a “social enterprise fund” actually does, the additional disclosure requirements are an unsurprising and sensible addition.
The EuVECA and the EuSEF regimes are welcome additions – and indeed alternatives – to the AIFMD regime and give those managers that intend to invest only in the closely defined types of permitted investments access to a European marketing passport without much of the burden of the AIFMD (including, notably, the private equity rules relating to transparency and asset stripping). It is early days, of course, but the balance of comparatively light regulation and access to capital that the regimes offer is to be welcomed – and may just mean that investment capital finds a home much more quickly.
1) The EuVECA and the EuSEF regimes were created on the basis of very similar regulations (Regulation (EU) No. 345/2013 of 17 April 2013 and Regulation (EU) No. 346/2013 of 17 April 2013) that have direct effect as a matter of EU law in each of the EU member states, without the need for any national implementation steps to be taken.
2) A manager of an EuVECA-labelled fund that subsequently manages more than €500 million can continue to make use of the EuVECA label, but will also be required to comply with the AIFMD regime and is required to provide a limited amount of information to its home regulator as a precondition to using the marketing passport.
3) “Equity” is an ownership interest in the capital of the qualifying portfolio undertaking; “quasi-equity” is a combination of equity and debt where the return is linked to the profit or loss of the qualifying portfolio undertaking and repayment is not fully secured.
4) An SME has fewer than 250 employees and either (i) annual turnover of €50 million or less or (ii) an annual balance sheet not exceeding €43 million.