Europe’s markets have had a torrid few years but while many investors have run for the exits, others have recognised the moment to be a major buying opportunity. For foreign private equity managers looking to invest in Europe, the Channel Islands provide a tried and tested route
Despite the constant stream of negative news from Europe, the unrelenting threat of downgrades from the rating agencies, the attention of the IMF and social unrest, Europe remains an attractive place for international investors.
The single biggest reason for this is valuations: markets are often known to overshoot on bad news, and there has been plenty of bad news to overshoot in Europe. After years of pummelling in the equity markets, valuations in Europe now look cheap and private equity managers with an eye for an opportunity are moving in to pick up companies that could look real bargains once sentiment turns.
Private equity has proved to be a safe haven for international investors and continues to perform strongly. This combined with the relative strength of the U.S. dollar against currencies, provides U.S. dollar investors with an opportunity to diversify their portfolios to include U.K. and European assets.
Analysis of price-to-earnings ratios either side of the Atlantic support this claim. European price-to-earnings ratios are about 75% of U.S. ratios. Relative valuation over the decade has oscillated between 60% 130%.
The Preqin All private Equity Index showed that private equity as a whole had considerably outperformed the S&P500 index since the 2007 fi nancial crisis. Preqin further reported that “the majority of LPs expect returns in excess of 400 basis points over the public markets”. With Europe selling at a discount from the U.S., historical patterns suggest that sooner or later, it will outperform its American counterpart, diminishing the valuation gap.
Add in the funding crisis and regulatory tightening of capital adequacy requirements for European banks and it is likely that some existing leveraged structures will be sold at a discount to intrinsic value. As European banks continue to be under pressure to shrink their balance sheets, well-funded purchasers with access to equity or debt fi nance will be well placed to take advantage of opportunities in the U.K. and Europe.
This all suggests that managers willing to take a long-term view, who are able to ride out some short term volatility, should be – and are – looking at Europe. Having taken that decision, the question is how to structure the fund to ensure the best blend of effi ciency and protection.
Non-European managers looking at Europe will be struck by the Alternative Investment Fund Manager Directive, and the magnitude of cost and time associated with compliance.
When it comes to fund domicile and administration, the Channel Islands offer the best of both worlds to funds looking to invest in Europe: the comfort of a well regulated, familiar jurisdiction, without being technically onshore. For the purposes of the onerous AIFMD the Channel Islands are regarded as third country, non-E.U. jurisdictions.
Funds operating out of the traditional European centres of Dublin or Luxembourg will need to be fully compliant with AIFMD by 2013, but those operating outside “onshore” Europe have more flexibility. By basing a fund in the Channel Islands a manager can continue to be regulated with the light touch, pre-AIFMD regulation beyond 2013, and perhaps until 2018.
There are various advantages in deferring full AIFMD compliance, but perhaps the biggest is the risk that the rules will continue to change within the first few years following initial implementation, as specific issues arise showing certain rules to be unworkable or to have unintended consequences.
This will lead to additional costs for those that comply early, but are then forced to modify their systems again when the rules are refined.
A wait-and-see approach gives managers a better chance that when they do comply the creases will have been ironed out of the regulations, meaning no further changes in the rules. For now, Jersey is widely regarded as being well placed to be able to also offer fully passported funds under the AIFMD from 2105, while still allowing the flexibility of private placement up until 2018.
There is no doubt that for investors coming to Europe from the U.S. and elsewhere, the ability to continue using familiar, time-tested fund structures and practises has considerable appeal, especially with managers already wrestling with the demands of the Foreign Account Tax Compliance Act ( FATCA).
No doubt some investors will prefer to gravitate to fully compliant, onshore structures, but according to research conducted by Jersey Finance, 71% of alternative asset advisers would not replace non-E.U. managers and funds with onshore solutions.
With their strong relationships with the European Securities and Markets Authority and other European financial authorities, Channel Islands jurisdictions offer the best opportunity for using the familiar, traditional structures in Europe over the coming years. Basing a fund in the Channel Islands, in other words, will provide the least disruption to managers wishing to continue running their funds as they have previously.
This will leave them free to turn their attention to the many other challenges currently facing fund managers. Obviously times of extreme market stress and dislocation, as well as presenting buying opportunities, present equally numerous risks.
It has been much debated what additional service costs the AIFMD will bring; the operational structural changes the managers may need to make; the compliance and reporting changes; and the additional cost of depositories.
As the costs of operating an asset management firm increases, many firms will revise their business model. New fee structures and products will emerge and they may also choose to outsource certain middle and back office functions such as portfolio accounting and investor reporting.
Traditionally, investors have chosen a classic closed ended structure to gain exposure to private equity. However, many are increasingly taking advantage of direct or co-investment and secondary opportunities to add value to their portfolio’s and reduce the cost of investing. While co-investing alongside a fund increases capital risk, it includes the potential to enhance returns and lower fees.
Fund managers are under siege from all sides. Investor expectations are high while market confidence is low. Funds must generate strong returns or die, and for all its problems Europe is the place with the best opportunities for picking up under valued assets.
Yet Europe is also seeing regulatory retrenchment, making it harder to do business there than it has been for years. The answer, for many, is a compromise solution: the Channel Islands offer the advantages of Europe, with reduced regulatory risks and, therefore, costs.