Over the last five years, banks and insurers have invested around €65 billion into private equity. That represents 15% of the overall investment in that asset class, which was then committed by these funds into companies of all sizes, from small start-ups to large established businesses.
While these numbers may appear impressive, the share of banks and insurance firms’ investment into the overall private equity fundraising has been decreasing over the past years compared to other funding sources, such as family offices or pension funds (pension funds’ commitments alone represent twice as much as the two combined). Most worryingly, despite banks and insurers handling trillions of assets, only a very small proportion of these (less than 1% in both cases) is committed into these long-term equity funds.
The inability of banks and insurers to commit capital over several years has not gone unnoticed. The second Capital Markets Union Action Plan, already published a year ago, made it a priority for the European Commission to tackle existing regulatory barriers by introducing changes to prudential regulation that, for nearly a decade, made it comparatively more expensive to invest in the long term.
“The participation of insurers in long-term investments, in particular equity, can be supported by ensuring that the prudential framework appropriately reflects the long-term nature of the insurance business”, Action Plan on the Capital Markets Union, September 2020
The recognition that long-term investment is crucial to a large variety of businesses was an important step. Companies receiving funding from venture capital and private equity know that without the long-term commitments of these funds they would not be able to develop innovative products or to grow to a size that makes it possible for them to face international competition. A long-term investment is also crucial as significant financing gaps remain in the infrastructure sector. And this does not even account for the resources countries across the world will need to mobilise to make the climate transition a success.
The publication of the Solvency II review last Wednesday marked the first test to determine whether the Commission will be in a position to transform the general ideas of the CMU Action Plan into concrete legislative changes.
Insurance Europe, the association representing insurers across the continent, has highlighted the need for the review to correct measurement problems that result in excessive capital requirements and artificial volatility in solvency ratios, especially for long-term business. Key elements of the framework such as the “risk margin” and “volatility adjustment” are vital in order to remove the barriers to greater long-term investments in equities and other investments.
Deputy director-general of Insurance Europe, Olav Jones, said: “The right set of corrections to Solvency II will better reflect the real risks and result in a justified overall reduction in the artificial volatility and excessive capital requirements for long-term investments, including equities. As insurers must plan and invest based on long-term considerations, only a significant and permanent reduction of capital requirements will allow insurers to increase their contribution to financing the recovery and supporting the EU’s Green Deal and Capital Markets Union.”
One of the most crucial challenges for EU policymakers will be to make improvements to the already existing “long-term equity” category, which allows insurers to set up long-term portfolios subject to a preferential risk weight. The revision of the category’s criteria will be part of the review of the Directive’s Delegated Regulation, on which discussions are expected to start in the coming months.
Invest Europe, the association representing private equity and venture capital managers as well as their investors (including banks and insurance firms), found that current criteria are too complex and burdensome for insurers to take the step to set up these voluntary portfolios. Martin Bresson, Director of Public Affairs at the association, noted that “the immediate consequence of this is that long-term equity remains subject to a higher risk weight compared to the actual risk of investing in closed-ended funds like private equity”
The second test for the development of an ecosystem favourable to long-term equity will be the review of the Capital Requirements Regulation, expected next month. While details of that proposal have not yet been announced, the implementation of Basel rules into EU law – and the increase of risk weights for banks’ exposures to equity – would go in the opposite direction as the one favoured by the CMU agenda. Not giving long-term exposures a preferential treatment would make it even harder for banks to contribute to the EU recovery.
As the European Parliament and the Council duly furbish their weapons for the upcoming legislative battle on these two prudential reviews, they may ask themselves this trillion-euro question: are strict capital charges (designed to protect investors) and more relaxed prudential rules (designed to foster investment) mutually exclusive?
The manner in which both bodies will respond to this question may have a significant impact on the role large institutional investors will play in driving the long-term recovery of the European continent.