Basel II: A doubled edged sword for European private equity?

With its implementation not due until 2006 it is perhaps unsurprising that the second Basel Capital Accord hardly registers on the radar of most of Europe’s private equity firms. Yet as it currently stands the proposed Accord is likely to jeopardise the availability of debt, crucial in supporting many deals, and the willingness of banks to invest in private equity. Confusingly, some research suggests that private equity firms could also benefit from the new regulations

if they can cash in on the predicted wave of M&A activity. With the deadline for the final draft drawing closer EVCJ considers what Basel II might mean for the future of the industry. Louise Cowley reports.

Banks and private equity under Basel II

The SME-debt issue has received a lot of attention but there has not been much attention to the impact on equity yet,” says Didier Guennoc, EVCA research and public affairs director. He adds that the issue does not draw support from the people it should, for example governments. Governments have appreciated the role private equity plays in the economy and have otherwise supported private equity with an increasingly friendly regulatory environment. As far back as February this year the EVCA issued a position statement on the matter pointing out that the proposed Accord might have an adverse impact not only on the financings of SMEs through credit but also on equity investments.

With the issue of debt for SMEs at least partially addressed, for private equity the most severe consequence of the introduction of the second Accord will now be its impact on how banks invest in the asset class. As American private equity funds rely more heavily on pension funds than their European counterparts when it comes to fund raising the issue remains predominantly a European one. According to EVCA figures, banks were the second largest contributors to private equity fund raising in Europe in 2001 (see table). They invested 24 per cent of the EURO38.2 billion raised last year (a total of EURO9.2 billion) compared to pension funds, which committed 26.8 per cent of the total, or EURO10.2 billion. If the Basel Accord is introduced as it stands now, this level of bank involvement in the industry will be under threat. EVCA fears that the introduction of Basel II will reduce both the role of banks as investors in independent funds and reduce their direct involvement via private equity subsidiaries. “What Basel is trying to achieve is positive; trying to balance the risks of banks. But it should not impede the activity of private equity investors,” says Guennoc.

The cause for concern is the likely increase in the required level of regulatory capital for banks investing in private equity. Under the current Basel Accord a bank’s private equity activities require the minimum capital standard of eight per cent. In practise, if a bank invests EURO100 million in a private equity fund it must underwrite it to the level of EURO8 million. Under the proposed details of Basel II this will rise to at least double this level, if not higher. According to Guennoc it is possible that the regulatory capital requirement for private equity could rise to 100 per cent. Even more alarming than this is the typical response of bank-funded private equity funds when EVCJ asked about their preparations for Basel – “We haven’t even thought about it yet.”

However, at this point in time there is much that remains uncertain. “The picture is not entirely clear at the moment as the proposals that will affect private equity are not at as final a stage as those relating to other issues,” says Monika Mars, a senior manager with PricewaterhouseCoopers global risk management solutions team. For example, the risk assessment method to be used by banks has not yet been decided. Although both of the risk assessment approaches being considered will categorise private equity as high risk, the affect they will have on banks’ private equity commitments differs. At present it is up to banks how they assess risk, although national regulatory bodies may clarify this later. Either the standardised or internal ratings-based approach can be used. The market approach looks at historical data to see how much can be lost through private equity investing. According to Guennoc, this does not take the upside of private equity into account: “There has not been much thought of private equity as a profitable enterprise,” he says. The internal ratings-based method assesses risk according to the ratings of the underlying assets, or investee companies. Exact details of how this would work are still vague but at the moment it is the favoured approach and is also the one likely to have the direst repercussions.

This increase in the underwriting of private equity investments is obviously going to make private equity less attractive to banks but the exact impact can only be guessed at for the time being. Funds that are 100 per cent subsidiaries of banks are going to be the worst affected, as their parent organisations are likely to balk at the prospect of increased regulatory capital. According to Dr Holger Frommann, managing director of the German Venture Capital Association, BVK, these funds, of which there are many in Germany, may face closure. Other options include independence possibly via MBO, a tried and tested route that has been taken by some of Europe’s leading firms. Independence will bring fresh challenges for formerly captive funds as, even with a proven track record, they will have to fight it out in a crowded and competitive fund raising market. Funds that rely on banks as cornerstone investors or sponsors may also find that they have lost some of this support.

Basel could present less of a problem for fully independent firms, although ultimately it may deter banks from stepping up PE allocations and cause them to reduce, or even end, their commitments to private equity funds. Frommann suggests independent funds could benefit from the introduction of Basel, he cites a proposed condition of the Accord where only bank commitments that make up more than 20 per cent of the total size of a fund would qualify for the increase in regulatory capital. If included in the final draft of the Accord this would allow banks to maintain their private equity investing provided it was not concentrated in a small number of funds. In the same way fund-of-funds managers could also benefit if their funds are structured to accommodate such conditions.

Roger Bendisch is managing director of IBB Beteiligungsgesellschaft, a venture capital fund 100 per cent financed by Investitionsbank Berlin, and vice chairman of the BVK board. He says: “The problem is that no one in Germany knows how the Accord will finally be written. There’s a lot of over-reaction at the moment.” According to Bendisch some bank subsidiary funds will come under greater pressure than others, depending on how the parent has structured its financing of the fund. He says the introduction of new risk management systems at Investitionsbank Berlin resulted in a new equity-based structure for IBB so it will avoid most of the repercussions of Basel. Mars at PricewaterhouseCoopers says the accounting treatment of banks’ investments in private equity might allow them to avoid increases in regulatory capital but only if a bank can actually reduce the risk by changing the way its investment is structured. She emphasises that banks will have to prove it’s not just regulatory arbitrage.

However, Mars points out that there are a number of cases in which banks will qualify for exemptions from Basel’s increase in regulatory capital. If all of a bank’s equity investments fall below a materiality threshold, i.e. account for less than 10 per cent of its total portfolio, they may not be subject to increased underwriting. Also, some existing equity investments by banks will qualify for grandfathering into the new regime, although eligibility, to be decided by national regulatory bodies, has not been defined. Government-sponsored programmes run by banks may also be excluded. She says the EU is engaged in a consultation process parallel to Basel, looking at special cases such as small national and niche market banks, which may be granted concessions. There is pressure from the EU to ensure a level playing field is created for cross-border markets, such as private equity.

Ultimately Mars warns: “Where there is an impact it will be quite a big one. Risk weighting is likely to be at least double or maybe three times as high as it is now if none of the exclusions apply to the bank.” Crucially it is still unknown exactly what proportion of the market will be affected. The quantitative impact study being launched in October and to be completed by the end of the year should shed some more light on this question and depending on the results further exclusions may be included in the next draft, due in May 2003. In the meantime the EVCA is continuing discussions with the Basel committee and working to raise awareness in the industry. There will be another consultative period after the May draft and an EU paper on the Accord is expected in June 2003. However, there is unlikely to be much change to the second Basel Capital Accord after May next year when the clock starts to tick towards compliance.

Banks and debt under Basel II

Much of the controversy generated by the new Accord has focused on the implications it could have for bank lending to small- and medium-sized enterprises. The terms set out in the initial draft of the new Accord would have led to higher capital requirements for lending to SMEs, meaning banks would have to increase the capital they held against these loans to compensate for the risk. The effect of this would have been to restrict the credit available to SMEs or to increase the cost of financing them, something that would have dire consequences for many venture-backed companies. SMEs and private equity are mutually reliant on each other to prosper. According to the EVCA in 2001, 81 per cent of private equity investments were in companies employing less than 100 people.

The legislative efforts of the European Union, such as the Risk Capital Action Plan, to encourage the financing of SMEs is one reason it has proved such a contentious point within the proposed Accord. In a statement made in June last year to welcome the new timetable for the revision of the Accord, the EU stated: “SMEs are a vital component of the European economy. It is accordingly important that the capital charges for lending to such businesses are proportionate and fair.”

The prominence of the German Mittlestand meant the SME aspect of Basel faced strong competition from the country. The Mittlestand enjoys vocal political support and as a result of the threat Basel is perceived to pose to SMEs, awareness of the possible implications of the new Accord is high in the country. Debt finance, often provided by state-owned banks, is the route typically taken by expanding young German businesses. This contrasts with the UK, which operates very much within an equity culture. Having tuned in to the probable impact Basel will have on the availability of debt to SMEs there is also greater appreciation in Germany of the repercussions for private equity. At a BVK meeting in August the new Accord was firmly on the agenda. Frommann said: “Two million smaller Mittlestand companies will face problems securing debt, they are too small to be of interest to private equity firms, even public funds, which have also moved upmarket to larger deals. They will have to find their own way.”

However, some private equity firms believe they will benefit from the debt-squeeze SMEs may suffer under Basel II. If debt is a rarer and a more expensive commodity it is possible more businesses will turn to private equity to help fund their growth. According to research carried out in Germany by Deloitte & Touche for its June 2002 Venture Capital and Private Equity Study, on average surveyed firms anticipate an increase in investment activity of 21 per cent after the new Accord comes in to force. Of 29 early stage investors and 24 buyout houses surveyed for the study 40 expected to see an increase in investing and only two firms expected a decrease. Egon Sachsalber, of Deloitte & Touche’s corporate finance and transactions team in Frankfurt, says further questions are needed on the issue of Basel.

EVCA joined banks, governments and SME-focused credit institutions in lobbying the Basel Committee on the issue of debt financing for SMEs. Their efforts were rewarded this July when, following an earlier announcement that the committee would focus on the “appropriate treatment of credit to SMEs,” it announced a concession. The committee has agreed that banks will be permitted to separately distinguish loans to SMEs, defined as those with less than EURO50 million in annual sales, from those to larger firms. Exposures to SMEs will be able to receive a lower capital requirement than exposures to larger firms.

Simon Witney, partner and head of knowledge management at SJ Berwin, comments: “The committee accepts that the risk management procedures are different when banks are lending to smaller companies, and that the capital requirements ought to reflect this.” While this decision has undoubtedly and deservedly been welcomed as a breakthrough Guennoc remains cautious saying that the impact of the recently announced improved treatment of SMEs is still being gauged.

Guennoc says the problems facing SMEs are only part of the story. He raises the question of how Basel might also affect other venture capital investments such as large buyouts and another private equity favourite: turnaround investing. Private equity firms and banks investing in and lending to distressed companies are likely to be penalised in terms of regulatory capital because of the adverse risk ratings of businesses in a turnaround situation. Another issue EVCA is looking into at the moment is how the risk ratings of buyout candidates compare to those of other companies and how this is likely to affect banks’ ability and willingness to lend to them.

Basel II: Background and timetable

The Basel Committee on Banking Supervision was established in 1974 and comprises representatives of the central banks of Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain,Sweden, Switzerland, the UK and the US. The committee formulates broad supervisory standards and guidelines of best practise for the banking community, its conclusions do not have legal force but are implemented through national regulatory bodies, such as the Financial Services Authority (FSA) in the UK or the Bundesanstalt fur Finanzdienstleistungsaufsicht (BAFin) in Germany.

In 1988 it introduced a capital measurement system known as the Basel Capital Accord. This set down an agreement to measure credit risk, the main risk incurred by banks, and applied a common minimum capital standard of eight per cent. In 1999, after several amendments of the Accord the committee decided to replace it. In January 2001 it issued a proposal for a new Accord that is based on three pillars:

* Minimum capital requirements to refine the measurement framework set out in 1988;

* A supervisory review of institutions’ internal assessment process; and

* Market discipline to encourage safe and sound banking practices.

The committee received more than 250 comments on

its consultative paper for the proposed Accord and extended the deadline for finalising its details. Implementation was set back from 2004 to 2005. There have been two Quantitative Impact Studies and a third will be launched in October this year allowing banks to assess the impact of the proposed Accord. Details of the new Capital Accord should be finalised in the fourth quarter of 2003, allowing for its implementation by the end of 2006.