No one is quite sure how significant of a force banks are as limited partners in private equity and real estate funds. Certainly, they are not as much of a force as pension plans, foundations, endowments or even sovereign wealth funds.
In the past, banks used to account for about 20 percent of total LP capital, but this ratio has been falling for a number of reasons, not just regulation. Still, banks might be as large as insurance companies, with some data suggesting each make up about six percent of the universal investor base of private funds. If that is the case, practitioners concerned with fundraising and perhaps those also involved in the secondary market should take heed of regulations affecting how banks should account for investments in funds.
In December, the Basel Committee on Banking Supervision issued a revised policy framework adding more detail. This revision, however, has done nothing but add to the opinion that Basel regulations are making it more expensive for banks to hold equity in private funds. “It may lead banks to think about alternative ways of investing in private equity other than using their own balance sheets,” says Paul Ellison, a lawyer at Macfarlanes in London.
Similar to the way Solvency II affects how insurance companies should treat their investments in alternatives, banks are governed in this respect by the Basel standards, with the latest version – Basel III – due to come into effect sometime in or before 2018. A voluntary global regulation designed in response to the banking chaos of 2008 and 2009, Basel III is intended to ensure banks’ capital is strengthened and risk is weighted properly.
Lawyers say Basel III, as conceived today, requires banks to hold more regulatory capital against equity investments in private funds. This is particularly the case for funds that do not issue financial reports at the same frequency as the bank prepares its own reports. Because of the perceived greater risk of less frequent reporting, banks would need to take a slightly more risk-adverse approach in calculating their exposure to such funds. In other words, if a private equity firm is only reporting quarterly and the bank reports more regularly than that, the bank might have to hold more risk capital against that exposure.
The revised policy framework from the Basel Committee on Banking Supervision presents three different approaches for calculating the amount of regulatory capital a bank needs to hold in respect to private funds (including real estate). “This hierarchy of approaches provides varying degrees of risk sensitivity and has been adopted to incentivize due diligence by banks and transparent reporting by the funds in which they invest,” the Basel Committee states in its missive accompanying the detail.
Experts that spoke with PERE simplify the three approaches by interpreting them according to how much regulatory capital each might require a bank to put aside. They are known as the ‘look-through’ approach, the ‘mandate-based’ approach and the ‘fall-back’ approach.
The look-through approach is the one that, at the end of the calculation, probably requires the least regulatory capital to be held. However, it requires there to be a lot of information from the fund to the bank, such that the bank can look through to its underlying exposure to the fund’s investments rather than just the exposure to the fund itself.
By contrast, the mandate-based approach means looking at the level of exposure of the bank to the fund rather than to its underlying investments. This approach takes into account risk weightings based on various information.
The third approach – the ‘fall-back’ – is the most painful in terms of regulatory capital required. It is used when neither of the other two approaches are feasible. In this case, a 1,250 percent risk weighting is applied to the bank’s equity investment.
This approach, says Macfarlanes’ Ellison, “could be seen as somewhat punitive. The message to banks is: ‘If you don’t (or are unable to) assess the risks to which this exposes you, then it could become a rather painful investment’.”
Clearly, applying a 1,250 percent charge would end up being a large number and could make banks reluctant to invest in funds when they are forced to adopt this approach. According to Ellison, this change may come as something of a surprise to banks that are invested in funds because, up until now, they have been able to use either the standardized approach under the existing regime, which in some cases allows them to adopt a lighter risk weighting, or they have used an advanced approach if they are a globally systemic bank. The latter scenario has enabled such banks to come up with their own models to weigh risk.
While the new regulations only apply to holdings in funds that are not on a bank’s trading books, the Basel Committee on Banking Supervision has stated that it is mindful of the need to avoid a disparate treatment between the banking book and trading book, implying that a similar regime may be applied to the trading book in the future.
So, just how significant are banks’ balance sheets in the universe of private equity and real estate investors? It is a question for which there doesn’t seem to be a ready answer, although new rules auger the pool of banks as LPs shrinking.