'A Properly and Effectively Supervised Private Equity Market' - Colm Kincaid, Director of Securities & Markets Supervision

Remarks delivered to the SuperReturn CFO/COO Regulation and Compliance Summit

Good afternoon ladies and gentlemen.

It is my pleasure to join you today and I would like to thank the organisers of the SuperReturn CFO/COO Conference for the opportunity to say a few words that I hope will inform your discussions over the course of this important event. Private equity plays a critical role in our economy and the topics you are discussing over the course of these three days have a profound impact on the welfare and prospects of businesses and investors.

The Central Bank Mandate

Before turning to the topic of what constitutes a properly and effectively supervised private equity market, I want to say a few words to introduce myself and the Central Bank of Ireland, for those of you who may be unfamiliar with us.

The Central Bank of Ireland has one of the widest mandates amongst financial regulatory authorities, being both a central bank within the Eurosystem and the prudential and conduct regulator of financial services provided in and from Ireland, including under the various EU mandates with which you will be familiar such as MiFID II, UCITS and AIFMD. Sitting within our Financial Conduct pillar, my own area within the Central Bank of Securities and Markets Supervision includes the authorisation and supervision of regulated investment funds as well as other capital market supervisory mandates such as the approval of prospectuses and the supervision of market conduct (including for compliance with rules against market abuse). Guided in the performance of all of these duties by our overarching mission to safeguard stability and protect consumers, our vision is of a trusted financial system supporting the wider economy, where firms and individuals adhere to a culture of fairness and high standards. We contribute to the fulfilment of this vision through an assertive risk-based approach to supervision underpinned by a credible threat of enforcement.

While we are of course a national competent authority in Ireland, we work within the regulatory framework of the European Union, including through our active participation on the governing boards and committees of each of the three European Supervisory Authorities, including of course ESMA. As evidenced by our work at international bodies such as IOSCO, we also recognise the importance of international standards and cooperation in the field of securities and markets supervision, not least because of the important contribution Ireland makes to international financial services generally.

The role of Private Equity

So, at its heart, the Central Bank of Ireland’s perspective places an importance on real economic outcomes that serve the best interests of users of financial services and the wider economy over time, from both a national, EU and international perspective.

Private equity serves an important purpose in this context. In particular, private equity has a significant role to play in driving economic growth by creating jobs, generating returns for its investors and building better businesses by creating real value. There has been a steady flow into private equity in the period since the financial crisis and its growth and scale, both at a global level and in Europe is evident. A recently published report by Invest Europe¹ revealed that in 2017, private equity investment in European companies reached its highest level in a decade at €71.7 billion, representing a 29 per cent year-on-year increase. Almost 7,000 companies in Europe were the beneficiaries of this investment and 87 per cent of these companies were small and medium-sized enterprises, representing around 1,000 more companies than a year ago. Notwithstanding this, European businesses remain heavily reliant on banks for funding and relatively less so on capital markets. The contribution private equity can make in widening the range of options, particularly for small and medium sized enterprises, has been firmly recognised in initiatives such as the EU Capital Markets Union. We have also seen this demonstrated in a domestic context in Ireland, where for example the Enterprise Ireland Seed and Venture Capital Scheme continues to provide key investment support to the development of Irish high-growth companies. The scheme, which is operated by the Irish Government organisation with responsibility for the development and growth of Irish enterprises in world markets in partnership with the private sector, has invested over €1 billion in 605 companies since 1994.²

Reflecting these global and European growth trends, 2017 also saw the highest level of capital invested in private equity in Ireland in over a decade, with an estimated €11.9 billion invested across 39 deals³. 

In Ireland, Irish regulated private equity funds are subject to extensive regulatory requirements by way of the AIFMD and the Central Bank’s rulebook for alternative investment funds, known as the ‘AIF Rulebook’. The Central Bank currently has a workstream underway which is converting the AIF Rulebook into Central Bank regulations that will put these requirements on a statutory footing. These funds are established as Qualifying Investor Alternative Investment Funds (“QIAIFs”), which are authorised and regulated by the Central Bank of Ireland under national Irish legislation. They can take the legal form of a unit trust; an investment company; an ICAV; a common contractual fund or an investment limited partnership under the Investment Limited Partnership Act 1994. QIAIFs are targeted at sophisticated and institutional investors who meet the minimum subscription per investor of €100,000. Once authorised, an Irish QIAIF can market its units to professional investors across Europe under the AIFMD distribution passport.

QIAIF applications are subject to a 24-hour authorisation process by the Central Bank of Ireland. Currently, there are 2,384 QIAIFs domiciled in Ireland with a combined NAV of €565 billion.⁴ Notwithstanding the fast turnaround time for authorisation, it should be noted of course that following authorisation, all QIAIFs are subject to extensive regulatory, supervisory and reporting requirements.

Benefits and Risks

The unique characteristics of private equity create investor benefits. As an asset class it can offer investor returns that outperform those of more conventional investments though that is balanced with the risk profile of such investments. It can also provide investors with exposure to unique market segments and early stage businesses that may not be accessible through listed vehicles. The long-term horizon of private equity can offer investors a less volatile investment opportunity than public equity and match the long-term orientation of investors who are focused on steady and sustainable performance. Done properly, the equity ownership model of private equity funds can also result in an alignment of interest between investors and the investment manager.

However with these benefits come risks. Since private equity usually involves longer-term investments in companies rather than securities, it can result in highly illiquid investments. Should the need arise for investors to withdraw their capital from a private equity fund investment or transfer their interest, it can prove difficult for them to do so. There are also risks associated with the lack of transparency with private equity when compared to publicly listed investments, particularly in the valuation of illiquid assets and the operations of portfolio companies. Moreover, since the active nature of private equity investment requires particular skills and expertise, the management of portfolio companies may have information advantages and possess the ability to control portfolio companies in a way that is not transparent to investors.

Rules to mitigate Private Equity risks

So, if private equity is to take its proper place in developing our economy, investors need to be able to have confidence that if they invest in a regulated private equity fund their best interests are protected. First and foremost, it is the managers and promoters of private equity funds and those firms providing advice to investors who are responsible for this outcome. Nevertheless, this needs to be underpinned by a regulatory framework that is robust where investors have confidence that the regulatory requirements and accepted standards are being met.

Of course, regulation comes at a cost. This places a responsibility on rule makers to be proportionate and on regulators to be efficient and effective in our gatekeeper and supervisory approach. A proportionate regulatory approach only works when those in industry act responsibly and drive high standards in behaviour. It also requires that, where firms or individuals fall below the standards required by the rules or those of their peers, regulators hold those firms and individuals to account.

At the Central Bank of Ireland, this is a responsibility we take seriously, including as an EU competent authority looking at the discharge of our role from an EU perspective. As well as our representation on the Management Board and Board of Supervisors of ESMA, we engage with up to 30 committees set up under ESMA to examine and develop standards and guidance in relevant areas relating to securities market regulation. We fully support ESMA’s progression from rule writing to implementation and EU supervisory convergence, and we work hard at both ESMA and through our domestic supervisory work to deliver on these goals. 

A properly and effectively supervised private equity market

So, what does a properly and effectively supervised private equity market look like? At the Central Bank of Ireland we apply five principles to securities market regulation which I believe apply equally to private equity:

• A high level of protection for investors and market participants.
• Transparency as to the features of products and their market price.
• The market must be well governed (and comprise firms that are well governed).
• The market must be trusted, by both those using the market to raise funds and those seeking to invest.
• The market must be resilient enough to continue to operate its core functions in stressed conditions and to innovate appropriately as markets evolve.

Protection for investors and market participants

Investors and market participants need to know that there is a regulatory regime in place that is effective and appropriately tailored to ensure that their best interests are protected within the context of the financial service they are availing of and their individual characteristics and circumstances. This includes bearing in mind the financial cost of regulation that is typically borne by the end user. Extensive progress has been made at an EU level to both raise and harmonise levels of protection for investors and market participants. This includes the requirements of the AIFMD that the valuation of fund investments be functionally independent from the portfolio management and the implementation of measures to mitigate conflicts of interest⁵, all of which are key protections in a private equity context. Under the Central Bank of Ireland’s AIF Rulebook⁶, a QIAIF is required to specify in its constitutional document the rules for the valuation of its assets and these rules must clearly and unambiguously define an expected valuation and set out a framework for variation from this method of valuation. You will also be aware of the AIFMD measures that have a particular relevance to private equity funds, such as the asset stripping restrictions⁷, notification of acquisition of significant interests and notification of acquisition of control.⁸

The rulebook is tailored to take account of sector specific considerations. For example, it is generally not permitted for an alternative investment fund or its management company or general partner to acquire any shares carrying voting rights which would enable it to exercise significant influence over the management of an issuing body. However, the Central Bank of Ireland’s rulebook permits private equity funds to exercise some element of legal or management control over the issuer where the Central Bank is satisfied that the management of the fund has the necessary experience and expertise, and there must be detailed disclosure in the prospectus. Also, our domestic Investment Limited Partnership legislation is currently under review and the Central Bank is providing technical advice to the Irish Department of Finance in this regard. The aim of the review is to improve the operation of investment limited partnerships and we will scrutinise these measures to assess their impact on our regulatory framework.

Transparency

Private equity investors have a particular need for transparency when one considers the length of time their capital is committed and the difficulty there may be in withdrawing this capital before the end of the term. The long duration of investment brings with it the risk of diminishing investor engagement and oversight over their investment over time. Therefore it is vital that sufficient information is provided to investors at the outset and over the course of their investment. For funds that hold investments with limited liquidity, the AIFMD for example requires that a process be put in place regarding how these assets should be managed¹⁰. To address transparency risks, a certain minimum level of information is required to be made available to investors, including disclosure of remuneration paid by the AIFM to its staff.¹¹

The nature of private equity investment, and in particular the lack of transparency, increases the risk of failings and problematic practices around allocation of expenses, hidden fees and issues concerning marketing and valuation¹². It is also apparent that the increased awareness on these topics brought about by enforcement actions by regulatory authorities has fostered the beginning of a healthy dialogue between investors and advisers on the appropriateness of certain fees and the rightful beneficiaries of those fees.¹³

The subject of fees and incentives is of course a cross-cutting theme of our conduct supervision, evidenced most recently in our thematic review of performance fees in UCITS, the findings of which we published last week¹⁴.

Well Governed

It almost goes without saying that good governance is central to the effectiveness of any market or firm. However, there are three particular aspects of governance that I want to highlight in the context of your discussions.

The first is the role and responsibility of individuals in positions of significant influence to be vigilant to ensure that the best interests of investors and market participants are being protected, and to take seriously their responsibility to do so. At the Central Bank of Ireland, we treat individual accountability very seriously at both the gatekeeper and supervisory stages. This is underpinned by a statutory fitness and probity regime and powers of investigation and enforcement. Moreover, we have proposed reforms to this regime, including a statutory Senior Executive Accountability Regime, or “SEAR”, similar to the senior manager regime in the UK, which seeks to ensure clearer accountability by placing obligations on firms and senior individuals within them to set out clearly where responsibility and decision-making lies for their business.¹⁵

Secondly, there is the need to ensure sufficient substance and resources within the regulated entity to manage the business on a day-to-day basis including proper oversight of outsourced activities. With effect from 1 July this year, the Central Bank of Ireland requires fund management companies to comply in full with the Central Bank’s Fund Management Companies Guidance. This body of work to enhance fund management company effectiveness was carried out over a three-year period and represents a significant part of the evolution of the fund industry in Ireland and the requirements for the day-to-day management of investment funds. Consistent with the principle of proportionality these requirements are commensurate with the nature, scale and complexity of the management company but place particular focus on delegate oversight, organisational effectiveness and directors’ time commitments. Firms and applicants for authorisation must demonstrate to our satisfaction that they meet these requirements in the context of their specific business model and risk profile.

The third item I want to highlight is the issue of diversity, including as to gender, experience and background. Diversity within management bodies has an important role to play in ensuring good governance and sound decision-making and there is still some distance to go in this regard. Last year the Central Bank of Ireland analysed fitness and probity related applications for certain regulated firms submitted to it between 2012 and 2016 (31% of which related to the securities and markets sector)¹⁶.

The data demonstrated significant gender imbalance in the submitted applications (less than one in four were female) and was indicative of a continued lack of diversity at the most senior levels of regulated firms. This year’s analysis of over 3,600 applications received in 2017¹⁷ found that while asset management and some other sectors had shown an increase in the proportion of female applicants in 2017 compared with the average for the period 2012-2016, funds applications did not (in fact there was a decrease from 20% to 19%).

Diversity of views and experience, and independence within management bodies, including the necessary rotation of membership to achieve this, forms an essential safeguard against the emergence of industry practices that restrict the investment potential of firms and in some cases, puts managers’ interests ahead of those of investors. It is encouraging to see the work underway to improve the level of diversity in the private equity industry. I note for instance the work of the Private Equity Women’s Initiative¹⁸ and the support that SuperReturn itself gives to gender diversity at its events.¹⁹

Trust in the market

With a long investment horizon, limited liquidity and the kind of transparency challenges that are particular to this asset class, private equity investors place a great deal of trust in those who are managing their investments. But there is a degree of concern that investors can become passive over such a long timeframe and undertake less monitoring of their investment, notwithstanding that they may be institutional investors. Where there is diminished investor engagement and oversight there is a particular risk that poor behaviours will develop and go unchecked. This risk is especially acute in circumstances where a fund has become loss-making with no realistic prospect of recovery. Where the management fee is based on the size of the portfolio, managers can stand to gain from holding on to investments as long as possible. Their incentives may consequently shift from maintaining good relationships with investors to maximising their own revenue using assets they have. Given your particular roles as COOs and CFOs, it is your responsibility to ensure that your businesses are managed in a trustworthy manner and to contribute to the reputation of the private equity market generally. I wholeheartedly agree with the remarks of Bruce Karpati, the former Chief of the SEC’s Enforcement Division Asset Management Unit²⁰, on the role of private equity COOs and CFOs to detect and correct conduct that may not comply with the fiduciary duty standard.

Resilience to stress and market evolution

A properly and effectively supervised securities market should be sufficiently resilient to continue to operate its core functions in stressed conditions and to innovate appropriately as markets evolve. Recent research conducted by Stanford Institute found that the private equity industry showed particular resilience in the last downturn²¹. Researchers found that private-equity backed companies managed to invest and grow more rapidly during the financial crisis than their non-private equity backed peers. The researchers attributed this to the longer time horizon of private equity firms’ funds, which allowed private equity investors to support their portfolio companies and the non-deployed capital that was available to private equity firms. They also noted the strength and quality of the relationship that existed between private equity firms and the banking sector, which allowed them to raise debt for their portfolio companies. The need for continued resilience must remain to the forefront of your outlook however. There is no basis for complacency.

Regulatory systems overseeing the market need to evolve also. To serve their purpose in the economy, there is a need to enable alternative investment funds, particularly private equity funds, to assess the potential interest of investors without having to undergo the full marketing notification process under AIFMD. The intention to introduce a definition of pre-marketing in AIFMD is therefore a positive step, provided there are appropriate safeguards and mechanisms to ensure this does not become a way to circumvent the protections potential investors need before they make their investment decision.

We all need also to keep pace with the developments of technology. At the Central Bank of Ireland, we have made it a priority to develop our data analytics capabilities and related technology infrastructure to support our supervisory engagement and inform our judgements and decisions. We expect the firms we regulate to also invest in technology to allow them to harness data to proactively monitor, identify, and correct situations that can lead to poor outcomes for investors.

Concluding remarks

In conclusion, the particular characteristics of private equity make it an important catalyst for economic growth, boosting economic activity and providing a means for injecting capital into the real economy. While these features bring benefits, they also come with distinct risks that must be recognised and mitigated by private equity funds and those individuals managing and marketing them. CFOs and COOs play a key role here, underpinned by an appropriate and robust regulatory regime and supervisory framework. I hope that the principles of a properly and effectively supervised private equity market that I have outlined today will assist you in your discussions. I also hope you will take these remarks forward into your own endeavours to ensure private equity performs its proper role of providing a trusted service supporting the wider economy, where firms and individuals adhere to a culture of fairness and high standards.

I once again thank SuperReturn for the opportunity to speak to you today.

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I wish to thank Stephanie Kearns and James O’Sullivan for their assistance with this speech.

¹ Invest Europe (2017) 2017 European Private Equity Activity. See also Espinoza, J. (2018) Private equity investment in Europe reaches decade high, Financial Times 1 May 2018

² Source: Enterprise Ireland (2017) Seed and Venture Capital 2017 Report

³ Source: Irish private equity activity hits new €11.9bn high, Irish Times 19 March 2018

⁴ Source: Central Bank of Ireland. Figures as of August 2018

⁵ European Union (Alternative Investment Fund Managers) Regulations 2013, Part 3, Chapter 2, Valuation, section 20 (8)(b)

⁶ Central Bank of Ireland AIF Rulebook (January 2017),Chapter 2, Part 1 section 1 (iii)  Valuation, section 1, page 106

⁷ European Union (Alternative Investment Fund Managers) Regulations 2013, Chapter 6, Division 2 Obligations for AIFMS managing AIFS which acquire control of non-listed companies and issuers, section 31(1) Asset stripping.

⁸ European Union (Alternative Investment Fund Managers) Regulations 2013, Chapter 6, Division 2, Obligations for AIFMS managing AIFS which acquire control of non-listed companies and issuers, section 28 and section 29.

⁹ Central Bank of Ireland AIF Rulebook (January 2017), Chapter 2, Part 1, section 1 (i) 8 General Restrictions at page 103

¹⁰ European Union (Alternative Investment Fund Managers) Regulations 2013, Part 3 Chapter 1, General Requirements, General Principles, section 18 (1) Liquidity management

¹¹ European Union (Alternative Investment Fund Managers) Regulations 2013, Chapter 5 Transparency Requirements, Annual Report, section 23(1)(e)

¹² See for example Andrew Ceresney: Private Equity Enforcement, Securities Enforcement Forum West, San Francisco, California, 12 May 2016. 

¹³ Andrew Ceresney: Private Equity Enforcement, Securities Enforcement Forum West, San Francisco, California, 12 May 2016. 

¹⁴ Central Bank of Ireland: Review of UCITS Performance Fees highlights instances of non-compliance with Guidance (4 September 2018).

¹⁵ Central Bank of Ireland: Behaviour and Culture Report into Irish retail banks (July 2018)

¹⁶ Central Bank of Ireland: Gender breakdown of applications received for certain roles in regulated firms 2012 - 2016 (PDF 0.96MB) (2017)

¹⁷ Central Bank of Ireland: Demographic analysis – Applications for Pre-Approval Controlled Functions (PCF) roles in regulated firms – 2017 (PDF 1.01MB) (7 March 2018)

¹⁸ PR Newswire: Private Equity Leaders Working to Increase Gender Diversity in the Industry (9 February 2018)

¹⁹ KNect 365 Finance: Women in private equity: why diversity is the key to improving performance (8 March 2018)

²⁰ Bruce Karpati: Private Equity Enforcement Concerns, Private Equity International Conference, New York, (23 January 2013)

²¹ Shai Bernstein, J Lerner and F Mezzanotti: Private Equity an Financial Fragility during the Crisis (PDF 1MB), Harvard Business School Working Paper 18-005 (18 July 2017)