U.K.-domiciled private equity funds fall outside of the EU regulatory framework that allows general partners to market to investors across the bloc following Brexit, creating complexity for firms that previously relied on these rules.
The Alternative Investment Fund Managers Directive, or AIFMD, is the main piece of regulation that governs how managers market their funds in Europe.
Since its introduction in 2013, Europe-domiciled funds "have had to comply with this big piece of regulation" and get a passport to market across Europe freely, while their non-European counterparts had to comply with individual country regulations known as National Private Placement Regimes, or NPPRs, Ed Hall, private equity funds partner at law firm Goodwin, said in an interview.
U.K. managers with U.K. funds "were previously in bucket one, and now they are in bucket two," Hall said. They're now treated like a U.S. fund manager that's outside Europe, for example, and must now decide whether they are happy accessing the bloc "through this patchwork of different rules and different states" or whether to set up operations in Europe, either in a financial hub like Frankfurt or Paris, or in private equity-focused jurisdictions like Luxembourg or Ireland, Hall said.
Their decision is likely to depend on who a firm's investors are, rather than the way it invests. Those with more non-EU investors may find U.K. fund structures more attractive. "You might have a few German investors, but you just deal with the German rules in that case," Hall added.
"If, on the other hand, your investor base is 75% France, Germany, Italy, Spain, then you want to find a solution that allows you to stay within that European net," Hall said, adding that people have been thinking about this for a while but now need to make a final decision.
Whether it is building out a presence in another jurisdiction or bringing in a third party, which is probably shadowing their abilities and presence in the U.K., it is adding a layer of cost in an environment and industry where there are massive pressure on fees, Alan Keating, managing director in Duff & Phelps' Compliance and Regulatory Consulting practice said. "I think it's just another challenge for the industry to try and solve," he said.
Markus Golser, managing partner at U.K.-focused mid-market manager Graphite Capital Management LLP, said fund domiciles are not an "acute issue" for the firm as it is not fundraising, but added it was "pretty obvious that there are AIFMD complexities." Trade bodies BVCA and Invest Europe are working to get to an industrywide position. "It will be an evolving kind of universe really, and I think one with great complexity," Golser said.
By the time the firm raises its next fund, Golser said he hopes there will be clarity, but it is not yet obvious whether U.K. firms will continue to trade with EU investors as they have done in the past. "I really don't believe there is any form of certainty over that yet," he added.
A spokesperson for the BVCA was unable to provide comment at press time "given it's an ongoing area of work," they said in an email. Invest Europe has submitted its views on the European Commission's consultation on a broader AIFMD review. Public Affairs Director Martin Bresson said in an emailed statement the trade body has "made it very clear to the European Commission that as far as the AIFMD goes we prioritize regulatory stability above anything else, that evidently includes rules about delegation arrangements, NPPRs and the so-called third country regimes."
Some managers are having to re-think their investor base because of the implications of Brexit.
Duff & Phelps has had conversations with individuals "maybe U.S.-based investors that have a presence in the U.K., or U.K. firms who are thinking about what to do in terms of post-Brexit strategies" over the past couple of years, and in some cases "there is a sort of dotted line being drawn down the address book in terms of existing and future investors," Hannah Rossiter, its Compliance and Regulatory Consulting lead said.
On the investor side, the European Investment Fund, or EIF, the investment arm of the European Investment Bank owned by EU member states, pushed the breaks on U.K.-focused commitments following the Brexit vote. The EIF is a cornerstone — or early-stage — investor for U.K.-focused funds, and such support can also be a sign of approval for other investors who are considering backing a fund.
"There's a whole host of blue-chip, low mid-market investors that you recognize that the European Investment Fund supports, and they're all buyout funds. And that investor, that early cornerstone investor, is no longer there," Guy Davies, managing partner of U.K.-focused lower-mid-market manager WestBridge Capital LLP, which counts the EIF as a cornerstone limited partner in its two funds, said in an interview.
WestBridge, which plans to raise its third vehicle shortly, has become more attractive to a wider pool of investors because it has grown out an established team on the back of its emerging funds, Davies said. But others may not be afforded the same opportunity with the EIF as a cornerstone investor. The U.K.'s state-owned economic development bank British Business Bank PLC launched British Patient Capital in 2018 to support long-term investment in high growth potential companies, but it does not have funds it can deploy into U.K. buyout strategies, Davies said.
"One of the unintended consequences of Brexit will be a shortage of funding for new, emerging, and maturing managers," Davies said, adding that "it's always good to have new managers coming through." Transition capital — capital used to exit a founder and bring in a more professional team to accelerate growth — is "really important in terms of U.K. growth." There will be a "really big hole" across the next four to six years as "emerging managers don't emerge" because raising a debut fund becomes increasingly harder "and your current lower mid-market investors raise bigger funds and migrate up in size."
Davies believes the EIF may find a way to invest in U.K.-only funds, where it has produced attractive returns for the investment arm, but any announcement would not be imminent.
In an email, a spokesperson for the EIF said the EIB Group's response "remains the same" following a Brexit statement released on Jan. 31, 2020: "No discussion has taken place concerning the future engagement of the EIB Group in the U.K. during the financial settlement. The European Union notes the U.K.’s desire to explore possibilities," the 2020 release said.
Attraction has not dwindled
But generally, demand for U.K.-focused funds has not dropped off as a result of Brexit. Most limited partners, whose primary aim is returning value for their own investors, are still as attracted to the U.K. as a jurisdiction for investment as they ever were, and they will continue to be, Goodwin's Hall said.
"It's always the case that over time, people have different views on the economic outlook for different jurisdictions. But broadly, I haven't seen any kind of drop down in interest in the U.K. there."
Hall's colleague, private investment funds partner Ravi Chopra, said the firm's practice remained busy over Christmas. "We know that there hasn't really been that dip that you could point to and say, 'Oh, well, the funds lawyers are half on holiday and interest has waned.' I think quite the contrary, equal or perhaps there's even more focus than ever on investment opportunities at the moment."
Initial fears about not being able to raise any capital at all have been replaced by, if anything, nervousness about whether funds will get through all the work required to raise all the capital that seems to be coming in, he added.