LP handcuffs

New rules being mulled in both the US and Europe would shrink the universe of LPs allowed to invest in private equity funds.

Draft legislation in the European Union and the US Senate could have the effect of locking some LPs out of the private equity asset class. 

In Europe, the draft Solvency II Directive – scheduled to be introduced in 2012 – would create a more stringent capital adequacy regime for insurers and reinsurers, with the goal of preventing those institutions from taking on overly risky investments. The directive calls for higher capital adequacy requirements, leading to higher capital charges against unlisted assets. Ultimately this could cause insurance companies to invest less money in private equity and more money in the types of liquid assets that attract lower capital requirements.

Experts have raised concerns that the directive takes an overly simplistic approach in grouping private equity with other unlisted asset classes with different risk profiles, and ignores the fact that LPs use private equity commitments in a variety of ways – some to diversify their portfolios, reducing risk rather than adding it.

“The details are still being worked out, and the point I’d make at this stage is that it is critically important that the regulators are quite sophisticated in the way that they analyse the level of risk and therefore the capital requirements that are needed to support an investment in a private equity fund,” says Simon Witney, a partner at international law firm SJ Berwin. 

“I think there is concern about a simplistic approach being adopted and that private equity funds are all lumped in together no matter what kind of deal they are doing,” he says. “It is also clearly not appropriate that they are all lumped together with any kind of unlisted investment holding.”

In the US, meanwhile, industry associations are rallying against a reform bill that could potentially shut some individuals out of the asset class. The National Venture Capital Association and the Angel Capital Association have sent a letter to Congress rejecting a provision in Senator Christopher Dodd’s financial reform bill that would raise the threshold of personal assets required for an individual to be eligible to invest in private equity limited partnerships: to be an “accredited investor”. 

Currently, investors need to have $1 million in assets, or report an income of $200,000 per year or $300,000 per year for joint filers. These numbers haven’t changed since 1982, and Dodd has suggested subjecting the thresholds to periodic inflation adjustments.

It isn’t clear how much the thresholds would rise in the short-term should the bill pass, nor how often the inflation adjustments would occur. The thresholds would certainly be a blow to the angel investment community, and could also create problems for those venture funds that allow entrepreneurs at their portfolio companies to invest smaller amounts in their funds. “Friends and family” contributions could also be at risk for both private equity and venture capital funds.

“We’ve just gone through (are still going through?) an economic period where many people of high net worth have lost, well, a lot of net worth,” blogs  William Carleton, a startup-focused lawyer at Seattle-based firm McNaul Ebel Nawrot & Helgren. “As the shock of this wears off, many are not necessarily going to entrust Wall Street with their wealth in the same way they did before. This could be a good thing for entrepreneurs seeking capital. Is this really the right time to be knocking many potential angels out of the game altogether?”

Angel investors are already a scarce commodity in the US after the financial crisis, yet the venture capital industry relies on them to fill a crucial funding gap in the very early stages of new companies’ development. Thinning their ranks even further would very tangibly dampen innovation and job creation in the US.