The European Commission has published a consultation paper looking at methods for creating an Internal Market for venture capital funds. Exemption from AIFMD is one option under consideration. Responses are due by 10 August 2011.

Impetus for Change

Venture capital is recognised as a particularly important source of early-stage funding for small and medium enterprises (SMEs) in the Community, which in turn form a vital source of innovative, high-quality, job-creating businesses. However, the number and size of venture capital investments have fallen over the last two years, exacerbating the difficulties of many start-up and early stage companies in obtaining funding. Venture capital organisations typically provide not only capital but also valuable expertise to the companies in which they invest.

The EU venture capital market is fragmented along national lines, with 27 different regulatory regimes, no real internal market and, in certain cases, the problem of double taxation on international investments. The difficulties faced by venture capital managers in this regard lead to additional costs and serve to limit the total sum of venture capital available to SMEs. The Commission considers this market fragmentation to be an issue that requires immediate action, with the priority being to enlarge the geographical base in which venture capital funds can raise and invest capital, whilst also reducing tax barriers to the greatest extent possible.

Present Regulation

Managers of venture capital funds are presently within the scope of the Directive on Alternative Investment Fund Managers (AIFMD), which takes effect in 2013. Managers of funds with over Euro 100m of assets under management (or over Euro 500m if the fund is unleveraged and subject to a five-year non-redemption policy) are currently due to become subject to the AIFMD regime and its burdensome requirements. Managers of smaller venture capital funds will, if they wish, be able to opt in to the full Directive regime (for example, to take advantage of the EU management and marketing passport). Please see our AIFMD overview for a full description of the proposed regime.

Options to Create an Internal Market for Venture Capital in the EU

Encouragement has previously been given for mutual recognition of existing national frameworks governing venture capital funds, on the basis of directly applicable Treaty provisions on the free provision of services and the free movement of capital, but the Commission report concludes that little progress has been made with that initiative.

Two further options are therefore examined, either the adaptation of the AIFMD framework to make it more suitable for venture capital firms or the creation of a tailor-made system as a stand-alone initiative, involving only light-touch regulation. It is envisaged that such a stand-alone regime would involve voluntary registration with a competent national authority, perhaps with a specific ‘European registration’ for those wishing to obtain a European passport. Such registration would then have to be recognised automatically by authorities in other Member States, although some notification requirements would be imposed. In order to benefit from this regime, venture capital funds could only be offered to professional investors. This proposal to restrict investment to professional investors only under the simplified regime may be controversial, since many UK private investors get significant tax breaks on VCT investments.

Consultation

The consultation addresses the following key issues, amongst others, asking whether respondents agree with the propositions specified:

  • is there agreement with the proposal for single home-state registration with notification elsewhere?
  • is there a need to impose operating conditions on venture capital firms, such as rules governing conduct or levels of resources held by venture capital managers?
  • how should the investment focus and strategy of the venture capital firms be specified, in order to ensure that only those funds that invest predominantly in SMEs and are committed to the long-term development and viability of the companies in which they invest can benefit from this light-touch regime?
  • how are venture capital funds to be defined - by scope of activities, stage of investment and/or by the investments that are excluded?
  • what financial information should venture capital managers provide, and how often? Would an audited annual report suffice?
  • is it right for the new legislative framework for venture capital to impose only very light obligations on venture capital managers?

Conclusions

Venture capital fund managers will no doubt welcome the consultation paper, which may represent an opportunity to obtain a carve-out from the onerous requirements of the AIFMD that will otherwise apply from 2013 onwards. Implicitly, the consultation also amounts to recognition by the Commission that the one-size-fits-all approach adopted by the AIFMD is not an appropriate means of regulating managers of all types of non-UCITS fund, and it may provide ammunition to other managers or self-managed funds to argue for similar carve-outs as the ongoing AIFMD Level 2 legislative process evolves.

Whereas the primary aim of the Commission is to improve access to funding for SMEs, with more cost-efficient operation of venture capital funds a subsidiary benefit rather than the prime motivation, the method of achieving this objective is the minimisation of impediments to cross-border raising and investing of venture capital funds. Compliance costs for managers operating across different EU jurisdictions should be significantly reduced if the proposals on which the Commission is consulting are adopted.

As always, much of the devil will be in the detail, particularly with respect to the definition of venture capital funds, criteria for qualification or exclusion, any real impact on double taxation and the level of information disclosure required.

Those likely to be affected by changes to the regime should take advantage of the opportunity to comment on the ideas within this consultation paper and provide their responses prior to the 10 August deadline.