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Of grandmothers and serial entrepreneurs

03 Jul 2020

Or: Why the EU investor categorisation is preventing a real Capital Markets Union.


For the past few years, private equity has been a very attractive asset class for investors. Due to the long-term and closed-ended nature of private equity funds, a majority of the capital PE managers were able to raise, came from institutional investors such as pension funds, insurers, or sovereign wealth funds.

In parallel high net worth individuals, either directly or through family offices, have been increasingly keen to allocate resources to our industry. This is especially true for venture capital, where these investors represent nearly 40% of the overall fundraising in 2019.

Successful tech entrepreneurs, business angels or university endowments are an integral part of the venture financing ecosystem. But it is also the case for the rest of the private equity asset class. Private individuals and family offices committed no less than €26 billion of financing into buy-out funds over the past five years.

Looking good, so what is the problem?

Well… these high numbers from a private equity perspective are actually relatively small when looking at the amount of capital high net worth individuals should be able to deploy.

If the rules were changed and high net worth individuals would then add only a fraction of their wealth, say an additional 1% into the asset class, this could represent €130 billion of investment in the asset class. Considering funds have a ten-year life, this would effectively represent an additional €13 billion per year into businesses through venture and private equity funds – 3 times more than what is currently invested by private individual and family offices today.

But tapping into this fount of potential investments to European companies is ridiculously difficult. These investors are actually considered “retail-investors” under EU law. The MiFID II rules, which have been copy-pasted across EU legislation, is based on a series of criteria that are more – if not exclusively – apt for average trading clients than long-term sophisticated investors.

Particularly problematic is the concept of “frequency” as one of the ways to determine whether an investor can be deemed professional. For a trading client, it seems logical that you have to do a thing “frequently” if you are supposed to be good at it, but no private equity investor is able to meet this criteria, irrespective of her or his level of sophistication. Instead, they usually invest large sums of capital much less frequently, but always following intense negotiation with the fund manager, showcasing knowledge and securing high-level of information.​

Retail or not retail…

EU retail-investor rules are of profound importance to ensure that European grandmothers, orphans, and average-Joes (like me) can feel comfortable investing in capital markets. The level of these rules must to a great extend be maintained. Discomfort with the level of protection by a too wide segment of existing or potential retail investors could have wide-ranging implications on the ability of many European companies to access this broader pool to finance themselves through equity funding.

But the protection of average (and then some) investors should not lead to situations where experienced and sophisticated investors are prevented from investing. The binary distinction between retail and professional clients overshoots the aim – justified as it may be. It really doesn’t make sense to continue to give the same label to both grandmothers and average-Janes as well as serial entrepreneurs with deep knowledge of their own sector. It does not make sense to give the same standardised document to someone buying her/his first shares and to a family office representative, who has already prior to this information spent two weeks in intense negotiations with the fund manager.

While no rule can obviously cater to every single person's needs, rules still need to be sufficiently balanced to capture the relevant specificities to serve the greater good.

From that perspective, the current MiFID categorisation, although tailored to an extent, still misses many of the players in the alternative financing space. And to add insult to injury: it misses the long-term equity investors that are at the very heart of the CMU project.

New capital for new businesses

The retail categorisation of sophisticated investors has many implications. The EU marketing passport does not allow investment funds to market cross-border to these investors. This makes it much harder for fund managers to access these sources of capital in other EU countries. And marketing to these investors would still have to happen with the regulated marketing documents, such as the Key Information Document, which was clearly only designed with frequently traded, liquid products sold to average-Janes in mind.

Fortunately, this is not something that has gone under the radar of the European Commission. Already in 2013, it recognised the importance of these investors for the venture capital community by allowing managers to market to sophisticated investors, described as investing more than € 100.000 into the fund, under the voluntary EuVECA regime. But only allowing it for EuVECA is stopping short of the right solution.

The question of the treatment of sophisticated investors should be one key priority in delivering on the “CMU 2.0” agenda.

No time to lose

Much debate is already taking place on whether the MiFID “quick-fix” review should contain a revision of the investor categorisation. Indeed now (!!) is for all intent and purposes the right moment to reconsider the existing categorisation. In fact, addressing with urgency a new and better regulatory balance and giving access to a deep pool of additional equity financing for Europe’s struggling companies, particularly SMEs, should be the very definition of a relevant ‘’quick-fix”.

This is not for the sake of these investors themselves, nor of the managers – but for the numerous companies that will struggle in the coming years to attract financing from banks, as their lending capacities are expected to be reduced in the upcoming crisis.

Ensuring that as much capital from high net worth individuals can be channeled into businesses - without reducing the real and relevant investor protection - will not be a luxury for the companies our members support: it may soon become a matter of whether the business survives at all.

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