We entered 2017 with the twin unknowns of a Trump presidency and Brexit and they continue to cast shadows of uncertainty and risk. European and UK anxiety is centred around the lack of clarity and progress with respect to Brexit and its transition. Nevertheless, the commercial world doesn’t stop and neither does regulation; it just gets more complicated and more expensive to implement, especially when trying to provide suitable options for an unknown EU future. The behavioural aspect of this cannot be underestimated as participants are concerned that valuable resources are being expended on systems, controls, planning and administration for regulation that might be redundant or have little real value in a European context in a comparatively short period of time. One also has to have sympathy for the UK regulators at this very difficult time.

Private equity continues to be an attractive asset class

According to current estimates, global fundraising in 2017 recorded the largest annual amount of private equity raised, with $453bn closed into 921 funds. Not surprisingly, North America raised the larger proportion with $256bn. This represents a substantial increase over the $310bn closed into 755 funds in 2016, with the average fund size increasing from $384 to $535m (all estimates are from Preqin Jan 2018). For each of the past five years, fundraising has been over $300bn, and the estimated assets under management for private equity stands at just under $3tn, with dry powder [undrawn cash available] to deploy at over $1tn. This weight of money has led to concerns that too much money is chasing deals which, together with aggressive debt financing available, is resulting in prices paid for assets that are too high. What is also evident is that there is very much a two-tier environment, with the large or mega funds raising ever more amounts quickly and investors having to fight very hard to get into those funds, while the rest of the pack are finding fundraising hard. This bifurcation in the market is not totally reflected in the scope of regulation, whereby small firms feel they do not always get their fair share of proportionality of application. Smaller firms and funds are using outsourced compliance firms or their fund administration service providers to cover this function – of course responsibility lies with the firm and individuals. However, first time funds are seeing the attraction of being structured as an appointed representative of one of the umbrella firms that provide full fund, administration and Alternative Investment Fund Managers Directive (AIFMD) services. This is now on the FCA radar.

ESMA principles on relocation from the UK

Private equity that raises funds from European investors and invests in Europe, the prospect of third country passports notwithstanding, is taking precautionary measures and starting to open or move parts of operations to other EU jurisdictions, with Dublin and Luxembourg being popular. Firms pursuing this course will have to bear in mind that during 2017, the European Securities and Markets Authority (ESMA) issued principles on relocations from the UK, with a focus on the investment management sector. Amongst these are no automatic recognition of existing authorisations; regulators’ ability to verify objective reasons for relocation; substance requirements; avoidance of letter box entities; outsourcing; and delegation under strict criteria/principles. The final advice from ESMA on extending the marketing passport to non-European managers (so called ‘third country passport’) was issued in mid-2016 with no further progress since. This has been clearly impacted by Brexit and political manoeuvring from the EU. Thus, for non-AIFMD firms, the only avenue that remains for managers and funds located in these third countries to market in Europe remains the National Private Placement Regime (NPPR) and all its problems and inconsistencies.

Implementing all the legislation

The amount of legislation that continues to be issued is diverse and it would be impossible to round up all the relevant pieces, but it goes without saying that the updated Markets in Financial Instruments Directive/Regulation (MiFID II/MIFIR) and the FCA’s gold plating are extensive pieces of regulation which have been time consuming in their implementation. Although not directly caught, private equity firms will have been snared by some aspects. This legislation was effective on Jan 3, 2018, although the FCA has acknowledged some leniency if firms were not completely compliant by this date, but firms would have to show that they have been diligent in meeting the requirements and are in the process of completing necessary steps to ensure best compliance. Firms authorised under AIFMD were in a better position. Those firms who have a traditional or ‘Back to the future’ structure of onshore advisor to an offshore manager/fund might have been caught and subject to the telephone call recording provisions. The British Private Equity & Venture Capital Association (BVCA) lobbied and a position has been agreed that recording should only be needed to record communications that are intended to result in the conclusion of a transaction. For example, if the investment committee was offshore or geographically spread, then its decision, if taken during that meeting, would need to be recorded. For those firms caught by MiFID II, some other aspects that would need adjustment include: product governance (identifying target markets and product compatibility); categorisation of local authorities as retail, not professional clients unless appropriately opted up; and transaction reporting. While non-EU managers and firms are not the focus of this legislation, if conducting business with a EU customer or investment firm/service provider they will need to assess the degree of interaction and potential areas of being caught. They should consider the need to obtain Legal Entity Identifier codes (LEI).

The FCA issued various changes to guidance and Annex IV reporting for AIFMD, including non-EEA AIFMs that market alternative funds via a feeder structure. Both the master AIF and feeder need to be reported quarterly.

The fourth Anti Money Laundering Directive (MLD4) came into effect in 2017 through the specific UK legislation of Money Laundering, Terrorist Financing and Transfer of Funds Regulation. A key requirement is that firms should adopt a more risk-based methodology to their AML procedures and this will require they conduct a risk assessment exercise for the types of business they undertake and types of customers. The FCA also published final guidance on politically exposed persons’ (PEPs). policies.

To conform with MLD4, the ‘persons with significant control’ requirements has been expanded and now catches Scottish limited partnerships and Scottish general partnerships where the partners are corporate entities. These types of partnerships are frequently used as part of private fund structuring. There is also enhanced disclosure for UK companies and UK LLPs already subject to reporting.

Changes to limited partnerships

There have been reforms to the UK limited partnership regulation. The UK limited partnership is a popular investment and fund vehicle for private funds and has undergone changes over recent years as it improves its attractiveness versus similar vehicles in other fund establishment jurisdictions. The latest reform is that a limited partnership can be designated as a private fund limited partnership (PFLP) if it can fulfil two conditions: that it is constituted in writing and it is a collective investments scheme under s235 FSMA. It has the benefits versus other limited partnerships of introducing a ‘White List’ of activities that limited partners can undertake without losing their limited liability status, removing the requirement for a limited partner to contribute capital as well as other administration and filing benefits. Clearly this has been introduced to simplify law, reduce administration burden, flexibility, and keep both the vehicle and the UK as an attractive jurisdiction to locate Funds. Existing limited partnerships can convert.

However, competition doesn’t stand still and the UK is not alone in development of its investment vehicles. The BVI is developing its limited partnership and Guernsey and Jersey have introduced their Private Fund initiatives which have the benefit of a fast track regulatory authorisation process for an offering or private placement to 50 or fewer professional investors and has a lighter touch regulatory regime.

Similarly, the EU commission reviewed the European Venture Capital Funds Regulation (EuVECA) and the changes apply from March 1, 2018. It allows registered managers under EuVECA and European Social Entrepreneurship Fund managers (EuSEF) to market their funds across the EU as well as broadening the types of managers that can set up such a fund and the types of companies to invest in. Fund managers with AUM greater than €500m are also now eligible.

The Institutional Limited Partners Association (ILPA) as part of its mission to represent limited partners and standardise reporting launched its second phase of the Reporting Template following the template it released in 2016 in respect of fees, expenses and carried interest. While take-up has been slow, general partners are completing it when requested. ILPA has also issued a model subscription agreement for private equity funds and more contentiously has also published guidance on the use of credit facilities. Credit facilities are used to finance/ bridge a deal or management fees prior to the calling of capital from investors. While this form of short-term financing is highly practical, it has been felt that it has transformed into something that benefits the general partner (GP) with the risks to limited partners not properly disclosed and the full benefits of reduced preferred return are not shared with the investors but benefits the GP. Clear down periods with institutions providing these facilities typically range from three to 12 months but with longer periods being available – three years is not unheard of – this topic has been pushed up investors’ agenda. Part of an ongoing trend of limited partners at ensuring all aspects of costs and revenue are transparent and appropriately apportioned between them and the fund manager.

In terms of reporting, the tenth annual report by the Private Equity Reporting Group (PERG) set up to monitor the private equity sector’s compliance with the Walker Guidelines, notes that compliance fell from 86% to 79%. It says that the decline stemmed from firms and their portfolio companies not incorporating the 2014 guidelines which mirrored the increased reporting standards of FTSE 350 companies, which is the benchmark for comparison.

Death and taxes

One piece of legislation from September 2017 that might have gone relatively unnoticed is the new UK corporate criminal offence of failure to prevent the facilitation of tax evasion. A general piece of legislation but nevertheless the financial services and asset management is considered a high-risk area. If breached, the only defence is that the firm had reasonable prevention procedures in place. Unlimited financial penalties and sanctions for this one and foreign businesses also caught as it is extra-territorial. Businesses should review their procedures and a risk review of service providers / suppliers, as well as offshore relationships in high risk jurisdictions. This review and identified controls should be tied into a firm’s anti-bribery and corruption policies.

The only two certainties in life are death and taxes. Taxes we have mentioned above, now death! When a fund come to the end of its life it is not unusual for the general partner to be the liquidating trustee under the terms of the limited partnership agreement and with very little other detail provided except for how to deal with in specie distributions. While there will be some statutory responsibilities, guidance has been thin on the ground. Now, helpfully, IOSCO in November issued its final report on Good practices for the termination of investment funds. There are 14 good practices and they provide a useful guide in the absence of documentary provision at the inception of the fund. They also serve as a template for what should be there at inception!

Views expressed in this article are those of the author alone and do not necessarily represent the views of the CISI.