Monday, December 12, 2011

European Commission Proposes EU-Wide Passport for Venture Capital Funds

An EU-wide regulatory regime for venture capital fund managers has been proposed by the European Commission in an effort to allow the funds to more easily raise cross-border capital and so better invest in European small and medium-sized companies. Instead of having to comply with 27 national laws, the fund managers will be subject to a single and simplified regime. Under the proposed Regulation, managers of venture capital funds will need to register in the country where they are established. They will have to comply with some key requirements on how to organize and conduct themselves and on how to inform their investors about their activities and investment policies. The country where they are located will be responsible for making sure these rules are complied with.

Venture capital funds are specialized financial institutions that typically collect money from other financial bodies (such as pension funds) or wealthy individuals, in order to re-invest it in firms with a high growth potential. Because investing in venture capital funds can be risky, the Commission proposes to restrict the option of investing in EU venture capital funds to professional investors. At this stage it is not envisaged that this option will be made available to retail investors.

The Commission's proposal is to simplify matters by governing the marketing of funds under the European Venture Capital Funds designation. Venture capital funds can earn this designation if they satisfy three requirements. First, they must invest 70 percent of the capital committed by its sponsors into unlisted small and medium-sized companies. The 70 percent threshold represents a balanced approach between investor confidence and risk spreading. Second, the venture capital fund must provide equity or quasi-equity to these companies. Third, the funds must not employ leverage so that they do not invest more capital than that committed by investors. The home Member State regulator will only register venture capital funds that comply with the essential requirements of the framework. Once registered, the manager has access to the EU-wide passport.

The essential function of venture capital is to invest in equity that is directly issued by the start-up company. This is why the venture capital fund manager has to invest at least 70 percent of the capital received from investors into equity directly issued by small and medium-sized companies. In order to enhance liquidity management and risk spreading, the fund manager is not subjected to any further limitation as to the use of the remaining 30 percent of the fund's capital commitments. Thus, the fund manager can trade shares of other financial instruments.

Broadly, the Commission is acting because, compared with competing global financial centers, most notably the United States, the European venture capital industry is fragmented and dispersed, which has chilled investor interest in venture capital funds. Because of such fragmentation, potential venture capital investors such as wealthy individuals and pension funds, find it difficult and costly to embark on channeling some of their investments toward venture capital. Regulatory fragmentation also impedes specialized venture capital funds from raising significant amount of capital from abroad.

Currently, investors prefer private equity over venture capital investments. As long as this bias in favor of private equity investment in mature companies and organized leveraged buy-outs persists, reasoned the Commission, available funds are not channeled to equity finance start-up ventures. The lack of financial resources that are currently directed towards venture capital is directly responsible for the sub-optimal size of the average European venture capital fund.

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