Wed, 02/11/2011 - 11:19
By Simon Gray – From a jittery market environment plagued by investor fears over the creditworthiness of European sovereign debt, the solidity of banks and the possibility of double-dip recession to the uncertainty surrounding a raft of impending regulation on both sides of the Atlantic, the private equity industry is confronting multiple hurdles as it looks to bounce back from the effects of the 2008-09 financial crisis.
Despite signs of an improving outlook, exits remain hard to achieve and initial public offerings have dried up again after a brief surge earlier this year; fundraising remains difficult for all but the largest, most established and best connected private equity houses; and rumours about potential changes to the taxation of carried interest continue to circulate as governments seek to boost fiscal receipts as well as to impress on voters that the burdens imposed by the crisis will be fairly shared around.
But for Guernsey, arguably Europe’s premier private equity jurisdiction, there is much in the current environment, however stormy, offering hope that when the economic climate does improve, it will be one of the prime beneficiaries. In the meantime the island’s two decades of private equity experience and embedded expertise, coupled with a readiness to embrace international standards on regulation, tax transparency and measures to combat financial crime, seem to be protecting it from the worst of the weather.
Some of the island’s success as a private equity fund domicile and servicing centre is down to the good fortune of first-mover advantage, according to Gavin Farrell, a partner and head of funds in Guernsey at law firm Mourant Ozannes. “At least part of our success in developing into a platform for the private equity world is purely and simply because nearly two decades ago we managed to attract some of the early industry players at a time when other offshore jurisdictions were not interested in or did not understand this business,” he says.
“We were happy to provide a home and structure for alternative investments, whereas some of our competitors did not then look past what they considered blue-chip and retail products. That has meant that over the past 20 years we have been able to create and build up a body of experience and expertise, not just in administration but in developing the legal and regulatory environment for private equity funds amid the massive growth in the industry over the past two decades, and certainly up to 2008.”
Today private equity accounts for just over a quarter of Guernsey’s fund services industry as measured by assets, some GBP70bn out of a total of GBP275bn at the end of June this year. The strength of the rebound in the sector is demonstrated by the fact that private equity assets have risen by around 40 per cent year on year, from GBP50bn in mid-2010, compared with about half that for the fund industry as a whole.
“We’re not doing too badly in that sector, even though it’s been a very difficult time,” says Peter Niven, chief executive of the island’s promotional body for the financial industry, Guernsey Finance. He points to the impact of high-profile industry names such as Jon Moulton (pictured), once head of Alchemy and now of Better Capital, and Terra Firma’s Guy Hands, who have taken not only their businesses but themselves to Guernsey and have been ready to trumpet its attractions in international forums. “Their efforts have helped to keep the focus of industry players worldwide on the island.”
William Simpson, the managing partner of law firm Ogier in Guernsey, says the island has made itself the premier offshore jurisdiction for private equity in the same way that the Cayman Islands dominate the hedge fund sector and Luxembourg is head and shoulders above the competition as a domicile for Ucits funds. “The sector provides a lot of work for both law firms and administrators,” he says. “The first funds arrived in the early 1990s, but it is really in the past 10 years that private equity has become a major area of activity.”
The island’s readiness to comply with what over the past few years have become rather more demanding international standards in areas such as tax transparency and regulatory co-operation has been an important factor in Guernsey’s ability to hold onto existing clients and win new ones at a time when not only has the overall economic environment been unfavourable but offshore jurisdictions have had to defend their very role within the fund industry.
Arguably, Guernsey and some of its peers have done more than justify their existence and have demonstrated that in a number of areas onshore countries have something to learn from the offshore world. “Maybe because they are politically sensitive, the Channel Islands are better regulated than EU countries,” contends James Bermingham, a director and group general counsel of fund administrator Aztec Group.
“This notion that onshore EU means better regulation is a bit farcical. Take the issue of a fund having a depositary. We have a depository in Guernsey under the designated manager regime, but in the EU having a depositary means custody banking, which involves giving control of the fund over to a bank and requiring it to pay for all kinds of different services such as administration, foreign exchange and cash management. Arguing that custody banking equals regulation is just disingenuous.
“In fact there are far higher standards of regulation offshore. The spotlight is on them in terms of anti-money laundering measures and customer due diligence, and the regulator has come down hard on firms that haven’t obtained the right paperwork from their clients. There is regulation of funds, regulation of managers and extremely well drafted AML handbooks in both in Jersey and Guernsey. The islands are way ahead of many European countries.”
The key is a mix of robust regulation with the flexibility necessary to accommodate an industry that defies a production line, cookie-cutter approach, according to Barney Lee, a group partner in the corporate and commercial department of law firm Appleby. “Some years ago firms such as Partners Group, Permira and BC Partners decided that Guernsey had the right combination of regulatory reputation and flexibility that suited them,” he says. “The island has tried to maintain that balance over the years, even in the recent period when all regulators have been seeking to tighten up, and it has enabled Guernsey to maintain an edge over its competitors.”
One factor in maintaining that balance has been Guernsey’s unwillingness to follow Jersey down the path of establishing an unregulated funds regime, which its neighbour did in February 2008, even though there has been some use of these by the real estate financing sector over the past couple of years. “Guernsey has taken a deliberate decision not to go down the route of an unregulated vehicle of any sort that can be used for a fund or in a fund context,” says Andrew Boyce, a corporate and finance partner with law firm Carey Olsen.
“Jersey’s creation of an unregulated fund regime was possibly an attempt to win business away from Cayman, but with the financial crisis and consequential faltering investor confidence, there has been a flight to quality that includes pragmatic but robust regulation. As the leader of the two Channel Islands in the sector, Guernsey has always attracted private equity houses whose investors tend to be primarily large pension funds and financial institutions. That type of investor, while more than capable of protecting itself, wants some level of regulation, meeting international standards but not impractically onerous, so as to satisfy their own stakeholders.”
Simpson says: “People occasionally ask whether we have unregulated funds, but we usually send them to our colleagues in Jersey. An unregulated fund industry sounded like a really good idea in the early 2000s, when people could get funds incorporated in Cayman in two days flat. However, although the financial crisis had nothing to do with offshore funds, it has made investors keen to be sure that their fund has some degree of regulation, and people want to know that service providers are properly licensed.”
He emphasises that that amount of business Guernsey may be turning away is tiny. “Over the first nine months of this year we might have referred on people wanting non-regulated funds perhaps once,” Simpson says. “This is no criticism of Jersey – they are set up differently to us and can perhaps handle unregulated business better than we can, but for us reputation is absolutely everything. We may not have every option that we could have on the regulatory side, but we have everything that we want.”
Niven notes that Guernsey Finance maintains a watching brief on developments in rival jurisdictions but he perceives no appetite for unregulated funds among either the regulator or industry members. “It just doesn’t sound right in the current climate,” he says. “There’s no sign that we need to compromise our standards – indeed, quite the contrary. We have set our stall out, and that’s how we work. We don’t need a regime like that to bring in business.”
In any case, Guernsey has more important things to focus on – not least the European Union’s Alternative Investment Fund Managers Directive, which promises to transform the regulation and marketing of alternative investments across the continent when adopted into law by the EU’s 27 member states. Although the legislative deadline is July 21, 2013, the crucial ‘level 2’ implementation measures, which will be enacted by the European Commission on the basis of advice from the European Securities and Markets Authority, are still in the process of being finalised.
The directive has a range of implications, few of them especially positive, for the private equity industry, notably so-called asset-stripping rules aimed squarely at the sector that include additional reporting and transparency requirements and restrictions on payments by portfolio companies, as well as measures governing remuneration, leverage and the role of depositary institutions.
For Guernsey the crucial area of the directive governs access to the European market for funds and managers based outside the EU, whether through existing national private placement arrangements or the planned extension to third-country jurisdictions some time after mid-2015 of the ‘passport’ that is designed to create a single market for funds aimed at sophisticated investors.
There is some doubt across the offshore world as to whether non-EU funds and managers really will gain effective access to passporting rights throughout the union, or whether private placement regimes will be terminated, as the directive stipulates, in 2018 or thereafter, but practitioners in Guernsey are cautiously confident that if the requirements placed on offshore jurisdictions are halfway reasonable, the island will be able to meet them.
“I’m not alarmed, which is a good place to be,” says Ernst & Young partner Mike Bane. “So far developments have been relatively favourable for the islands, but what happens next is important in the development of the impact of the directive on the industry here, and we have to wait and see how the rules develop further. There’s nothing in there that really frightens me, and the debate seems to be heading in the right direction. However, there is still a race to be run.”
Bane believes that efforts by industry bodies, regulators and politicians have succeeded in tempering an instinctive distrust of offshore jurisdiction among EU decision-makers that was manifest in early drafts of the directive but that now has given way to a more considered and pragmatic approach.
“Earlier some of the onshore jurisdictions managed to drum up a great deal of anti-offshore momentum,” he says. “However, in the end we got our case across thanks to an enormous amount of behind-the-scenes activity involving promotional agencies, governments, industry members and regulators. There is a huge commitment here to making sure the outcome is fair and reasonable.”
Boyce argues that however the legislative progress of the directive develops, Guernsey (and Jersey) will remain well placed to serve the private equity industry. “We have managed to combine the extreme demands for regulation from the international community with an element of practicality, so that our regulatory regime is well placed to be considered equivalent, making funds domiciled here eligible for passporting,” he says. “Clearly there were initially major concerns that the AIFMD would effectively regulate the offshore jurisdictions out of existence as far as Europe was concerned, but where Guernsey sits from a regulatory perspective seems to have averted that threat.”
The fact that Guernsey funds and managers will not be eligible for an AIFM Directive passport until 2015 at the earliest, compared with 2013 in EU countries, should not be a problem for two reasons, Boyce believes. “First, the private placement regimes will continue, and that entry requirement fits well with the institutional-type investors that go into Guernsey funds,” he says.
“Secondly, funds domiciled here tend to be marketed to a single European country. For example, funds from one of our big French clients tend to have mostly French investors, so the private placement regime is fine because we just deal with France. Clearly a passport will open the funds up to a potentially wider investor base which could be of benefit, but at the moment maintaining the status quo is equally beneficial.”
In any case, Farrell notes, the discussions on level 2 measures are leaning toward reliance on the appraisals of international organisations that have already expressed their satisfaction with the Channel Islands, such as the Financial Action Task Force on measures to counter money laundering and terrorist financing, the Organization for Economic Co-operation and Development’s campaign to curb harmful tax practices and promote exchange of tax information, and the International Organization of Securities Commissions’ template for co-operation between financial supervisors.
“We have carried out a lot of education in Brussels, especially among in convincing members of the European Parliament that we do not encourage, nor tolerate, dodgy business,” he says. “We already have in place a large number of measures required by international organisations such as anti-money laundering requirements, we are a member of Iosco and an affiliate member of the OECD, and we have always complied with the recommendations of the International Monetary Fund’s regular assessments.
“I believe we have now reversed the initial knee-jerk impression that the Channel Islands were tax havens. We have explained the role we play in the financial services industry, and that we comply with international obligations not only on money laundering but tax information disclosure. In fact Guernsey was the first jurisdiction to have the requisite number of tax information exchange agreements to satisfy the IMF and therefore the EU.”
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