Making sense of European regulation

A regulatory tsunami is washing over Europe at the moment.  Banks, insurance companies and other regulated investors find themselves confronted with new European regulatory regimes under Basel III and Solvency II.  These new regimes will affect both European banks in their role as lenders as well as European insurance companies’ choice of investments in the future.

Basel III imposes stricter capital adequacy requirements on banks.  As a result of these new capital adequacy requirements, banks are increasingly cutting back on their lending activities and are not extending credit, either in the form of new loans or follow-up financing.  The result is a painful credit crunch.

Insurance companies have their own new solvency regime to deal with – Solvency II.  This new regime, which will have an impact on the insurance companies’ capital requirements and risk management systems, will determine the type of investments insurance companies will hold in the future.  Certain investments, such as direct investments in real estate, will require a higher capital reserve, while other investments, such as debt instruments, will require a far more lower and agreeable capital reserve.  Naturally, European insurance companies are eager to find and hold profitable investments that require a lower capital reserve.

One of the unexpected consequences of these new European regulatory regimes is the rise of a fairly new type of fund – the private debt fund.  This fund satisfies two needs in the market.  On the one hand, it originates new loans and offers follow-up financing, thus taking over the banks’ vital role of lender in the market. The market has access to financing and the credit crunch is thereby lessened.  On the other hand, European insurance companies, as investors, have shown an increasing interest in debt funds as such an investment would potentially require lower capital reserves, provided that debt funds are treated similarly to bonds for capital reserve purposes under Solvency II.  It seems that debt funds have the potential to make everyone happy.

The European insurance industry is the largest in the world and European insurance companies collectively hold €7,444 billion in their investment portfolios according to PwC’s 2012 report, ‘European Institutional Investors’.  Of these, French insurance companies are the largest European institutional investors, while German insurance companies are the third largest in Europe.  Debt funds sponsors would be well advised to target these potential investors.  However, careful consideration should be given to the tax issues and regulatory requirements faced by German and French insurance companies and other regulated investors when structuring a debt fund.


The Devil in the details

French and German insurance companies each have their own set of complex insurance regulations and tax issues that need to be addressed when subscribing to an investment. 

One of the main issues when structuring an investment fund for German insurance companies is whether an investment is eligible for a German insurance company’s so-called ‘Restricted Assets’.  Restricted assets represent approximately 90 percent of a German insurance company’s assets.    Investments out of the restricted assets basket are governed by the Ordinance on the Investment of Restricted Assets of Insurance Undertakings (Anlageverordnung, or ‘Investment Ordinance’).  The Investment Ordinance contains strict rules and requirements on assets classes, quantitative diversification, spread thresholds and asset-liability matching.  In order to be eligible for the Restricted Assets provision, the insurance company’s investment of choice must satisfy said rules and requirements.

The Investment Ordinance includes a catalogue of 18 investment items that are deemed eligible for the Restricted Assets.  Each of these catalogue items demands that certain requirements specific to that item be satisfied by the investment.  An investment is eligible for the Restricted Assets under the Investment Ordinance if the investment satisfies all of the requirements set forth for one of the investment items and can thus be assigned to one of these investments in the catalogue.

An investment in a debt fund could potentially be assigned to two categories in the Investment Ordinance.  The first category includes investments in regulated funds.  Such investments are eligible provided that, inter alia, the investment guidelines of such regulated open-ended funds restrict investments in loans (i.e. non-securitized debt) to 30 percent of the NAV.  The granting of loans is not permitted, i.e. the fund may only purchase loans from a third party (originator or seller).

The other category to which a debt fund investment may be assigned is found in Section 2(1) No. 13 of the Investment Ordinance.  This catalogue item is reserved for investments in limited partnerships or corporate entities and can be briefly described as “private equity”.  However, the German legislator fairly recently introduced a new requirement to Section 2(1) No. 13, namely the requirement that the entity issuing the shares or partnership interests has a business model and bears entrepreneurial risks.  One of the fund’s possibilities of proving the existence of a business model and entrepreneurial risk is by directly offering debt financing to third parties.  However, it is precisely this activity that may get a fund into trouble with other German laws, specifically German banking laws, as the fund may be required to apply and obtain a German banking license.  While German insurance regulations are at odds with German banking laws in this instance, it is our opinion that this contradiction can nonetheless be resolved.

In addition to the Investment Ordinance, the German regulatory authority supervising German insurance companies, the Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht, or ‘BaFin’) has issued various Circulars providing additional guidance and requirements for investments by German insurance companies out of their Restricted Assets.  These Circulars contain additional requirements that need to be met by all investments made out of the Restricted Assets, regardless of the assigned catalogue item, such as the requirement that the fund units be freely transferable without any third party consent, the exclusion of the transferor’s secondary liability following a transfer and the inclusion of a so-called trustee blocking note in the relevant documents.