Building a Capital Markets Union (CMU) The AIC response to the Green Paper

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1 Building a Capital Markets Union (CMU) The AIC response to the Green Paper CMU should seek to utilise investment companies to deliver its key objectives of securing long term investment via EU capital markets, creating alternatives to bank finance and providing capital for SMEs and infrastructure projects. What are investment companies? Investment companies are closed-ended funds which hold a diversified portfolio of assets, including listed and unlisted equity and debt, venture capital, property and infrastructure. They aim to provide shareholders with capital or income returns or a mixture of the two. Unlike open-ended structures, such as UCITs, which issue units that can be redeemed via a manager, investment companies issue quoted securities. Investors customarily enter and exit the fund by trading shares on a public stock market. (N.B. for the purposes of this paper, all references to investment companies are to closed-ended, quoted funds.) Investment companies are an established funds structure (with assets under management of 135 billion) that could play an important role in delivering Capital Markets Union (CMU). The sector is currently primarily UK based with a few companies located in other Member States. Investment companies are overseen by an independent board with legal duties to protect the interests of shareholders. Where they are domiciled in the EU with their shares admitted to trading on regulated markets they are governed by EU company law, the Prospectus Directive, the Transparency Directive, the Shareholder Rights Directive, applicable accounting standards and the AIFM Directive. How can investment companies help deliver CMU? Investment companies are uniquely able to help deliver CMU as they: use EU stock markets to pool capital which is then allocated to investment opportunities according to the company s investment mandate. mitigate systemic risks that arise in other fund structures. The IMF has warned that open-ended funds create risks of herding and excessive risk taking, particularly where investors cannot observe or oversee the portfolio manager. These issues are mitigated in investment companies by the oversight of the manager provided by the board on behalf of shareholders. Concerns that redemptions can cause the sale of liquid assets in falling markets do not arise as these funds do not offer redemptions. deliver more effective capital allocation than open-ended funds, particularly when investing in illiquid assets (such as infrastructure). Open-ended funds hold cash or liquid assets to ensure they can meet redemptions. This limits their capacity to be fully invested in illiquid assets. This consideration does not arise for investment companies. 1

2 Building a Capital Markets Union attract capital from a wider range of sources for investment in assets such as unquoted SME securities or infrastructure. UCITS are unable to hold these assets directly. Investment companies can. Also, unlike structures such as limited partnerships, they are well suited to direct investment by retail investors, pension funds with listed securities only mandates, and global investors already familiar with investing via EU stock markets. This capacity to attract a wide range of investors to less traditional assets is exemplified by Venture Capital Trusts (VCTs). VCTs provide an alternative to bank finance for UK SMEs. They are held almost exclusively by retail investors and are an important conduit of funds to businesses which would otherwise struggle to secure development capital. offer a competitive investment proposition with lower charges and the potential to outperform other funds. Investment companies can maintain long-term holdings without any need for the underlying portfolio to be disrupted by asset sales required to satisfy redemption requests. The independent board oversees the portfolio manager to optimise performance and secure value for money. The cumulative impact of each element of the investment company structure which delivers incremental performance improvements has the potential to deliver significantly enhanced investor outcomes over the longer-term. CMU should seek to develop a balanced funds market which utilises these benefits more widely. This would substantially enhance the capacity of EU stock markets to act as a credible alternative to bank finance to attract and effectively allocate investment capital. What stops investment companies being launched across the EU? The foundations to build a pan-european investment company sector are in place. The EU has an established framework of company law and shareholder rights. It has an internationally recognised system of regulation of the markets themselves and for the admission and trading of shares. Nonetheless, there are impediments to developing the investment company sector across the EU. These include: cultural barriers. The huge success of UCITS has focussed the attention of investors, product developers and regulators on open-ended or quasi open-ended structures that offer redemption. Competing approaches (such as closed-ended investment companies) have been less able to make their mark. potential for double taxation of investment returns. The UK has tax rules designed to support various types of investment companies. The investment trust rules have traditionally enabled the launch of companies focussed on investment in shares and securities. The Venture Capital Trust rules support investment in smaller businesses. The UK REIT regime is tailored to the needs of investment companies holding property. Where similar rules do not exist in other Member States, the incentives to launch investment companies are reduced. lack of regulatory incentives. Since 2008 EU policymakers have focussed on regulation to prevent the emergence of systemic risks and to enhance consumer protection. While necessary, this process has increased the level of regulation applying to structures such as investment companies, which were already robustly regulated. For example, the AIFM Directive imposes additional rules on the sector, overlaying company law and market rules. This adds a layer of complexity and compliance risk. 2

3 CMU should tackle these barriers by balancing regulatory protection with measures to enhance the commercial attractions of launching alternatives to UCITS, such as investment companies. This will encourage providers to consider a wider range of product options, including investment companies, and help break-down cultural barriers to developing these funds. It will also incentivise Member States to address any local barriers arising. Seeding the sector in Member States across the EU will in turn help create a cross-border market for investment via this structure as familiarity increases and attractive investment options emerge. How should CMU seek to create a favourable regulatory environment? The AIC recommends that CMU should prioritise: supporting the development of a balanced funds market (including investment companies) across the EU when considering the introduction of financial services regulation. This should be a priority for regulatory initiatives already underway as well as new proposals. For example, the consumer protection elements of MiFID II threaten to categorise all non- UCITS as automatically complex. Treating all non-ucits the same way irrespective of their basic product features will erect unnecessary barriers to the development and distribution of these funds. Implementing MiFID II in this way risks encouraging the development of an unbalanced funds market, dominated by UCITS to the detriment of other funds structures. This will raise the EU s vulnerability to the systemic risks identified by the IMF arising from open-ended funds, reduce consumer choice and limit the EU s capacity to develop products best placed to use capital markets to deliver benefits for the real economy. The development of a balanced funds market should also be considered in relation to implementing the PRIIPs regime. The introduction of the PRIIPS KID (Key Information Document) must ensure that the disclosures enable non-ucits funds, including investment companies, to compete on a fair basis. reducing unnecessary compliance obligations that act as a barrier to accessing capital markets. With this in mind, the AIC welcomes the Commission s review of the Prospectus Directive. This initiative offers an opportunity to significantly reduce unnecessary compliance burdens by streamlining issuers disclosure requirements. The AIC recommends that a priority should be removing the obligation to provide a prospectus for a secondary issue of shares already admitted to trading on a regulated market. This would significantly increase the commercial attractions of launching listed fund structures. It would also reduce barriers to trading companies accessing capital markets. No regulatory risk would arise as market disclosures are already required by the Transparency Directive and Market Abuse Directive. The AIC is preparing a full submission to the Commission consultation on the Prospectus Directive which will explore this recommendation in detail. reviewing existing rules to remove unnecessary constraints on non-ucits funds, particularly where their securities are admitted to trading on regulated markets. For example, one objective of CMU is to increase take-up of ELTIFs. This could be achieved by streamlining aspects of the ELTIF regime for closed-ended corporate AIFs with their 3

4 Building a Capital Markets Union securities admitted to trading on regulated markets. These AIFs are already subject to a wide range of regulatory obligations (including EU company law and markets rules) and do not raise regulatory concerns regarding redemption, investor access etc. This could allow the ELTIF rules on asset exposure, portfolio composition and concentration, borrowing, redemption policy and life of the ELTIF, disposal of assets, distribution of proceeds and capital, transparency and the marketing of the fund (including to retail investors) to be simplified (or removed) for these funds. Similarly, there is a case for reviewing the small AIFM exemptions set out in Article 3 of the AIFM Directive. The current exemption for unleveraged AIFMs with assets under 500million imposes conditions which could be re-examined. For example, the rules currently categorise overdrafts as leverage. Overdraft facilities would not normally be considered as such where the facility is used to manage the expenses of the AIF (rather than to finance long term investment). A review could also consider the possibility of increasing the level of the size thresholds included in Article 3. An increase could be considered appropriate as non-eu AIFM are able to market into the EU without a passport, on similar terms to the conditions of Article 3, but without limit to their size. The current rules therefore increase compliance burdens on EU providers where their international competitors do not face the same obligations. Questions raised by the Green Paper 1) Beyond the five priority areas identified for short term action, what other areas should be prioritised? The AIC recommends that CMU should seek to maximise the competitiveness of EU capital markets by streamlining regulation and deregulating to remove overlaps. This objective is implicit in the review of the prospectus regime. It should be made an explicit element in CMU to help focus the attention of stakeholders and policymakers on options to achieve a more flexible and responsive commercial environment for EU funds and capital markets. 2) What further steps around the availability and standardisation of SME credit information could support a deeper market in SME and start-up finance and a wider investor base? Investment companies are able to mobilise capital for investment in unquoted SMEs. Encouraging the development of this model across Member States could provide an invaluable new source of finance for these companies (see introductory comments and our response to question 15 for further discussion of SME funding). 3) What support can be given to ELTIFs to encourage their take up? A number of the requirements in the ELTIF rules are designed to address regulatory issues arising from offering redemption. Investment companies (closed-ended corporate AIFs with their shares traded on public stock markets that do not offer redemption) do not raise these regulatory issues. This creates options to simplify the rules on asset exposure, portfolio composition and concentration, borrowing, redemption policy and life of the ELTIF, disposal 4

5 of assets, distribution of proceeds and capital, transparency and the marketing of the fund (including to retail investors) for ELTIFs structured as investment companies. The AIC recommends that the ELTIF regime be reviewed with a view to creating a streamlined version for closed-ended corporate AIFs which do not offer redemption but instead have shares admitted to trading on a regulated market. This streamlined version would ideally be made available on a passported basis, but could be limited to national regimes if this is considered more appropriate. 4) Is any action by the EU needed to support the development of private placement markets other than supporting market-led efforts to agree common standards? 5) What further measures could help to increase access to funding and channelling of funds to those who need them? 6) Should measures be taken to promote greater liquidity in corporate bond markets, such as standardisation? If so, which measures are needed and can these be achieved by the market, or is regulatory action required? 7) Is any action by the EU needed to facilitate the development of standardised, transparent and accountable ESG (Environment, Social and Governance) investment, including green bonds, other than supporting the development of guidelines by the market? The case for EU intervention to facilitate the development of standardised ESG investment products is unconvincing. Market led initiatives offer the most potential to develop this sector. Investors will have different views of what practices/investments represent their preferred ESG investment approach. The risk of EU intervention is that it will stifle the development of a variety of approaches designed to suit different investor needs. 8) Is there value in developing a common EU level accounting standard for small and medium-sized companies listed on MTFs? Should such a standard become a feature of SME Growth Markets? If so, under which conditions? No. Currently SMEs are able to report in accordance with national standards. These support disclosures which are understood within national markets and provide local investors (the main likely source of capital) with sufficient information. Where SMEs consider that their reports should be prepared in accordance to a standard which is internationally understood they are able to prepare IFRS accounts. We see no value in creating an additional tier of reporting standards. 5

6 Building a Capital Markets Union 9) Are there barriers to the development of appropriately regulated crowd funding or peer to peer platforms including on a cross border basis? If so, how should they be addressed? 10) What policy measures could incentivise institutional investors to raise and invest larger amounts and in a broader range of assets, in particular long-term projects, SMEs and innovative and high growth start-ups? Stimulating investor demand for long term projects, SMEs and start-ups is an important consideration for CMU. That said, the benefits of encouraging demand will be limited if the channels to satisfy this demand are unnecessarily constrained. To this end the AIC recommends that the Commission must also consider reducing barriers to establishing funds structures, such as investment companies, which are able to invest in these asset classes (see introductory comments for more detail). 11) What steps could be taken to reduce the costs to fund managers of setting up and marketing funds across the EU? What barriers are there to funds benefiting from economies of scale? The current Prospectus Directive requirement obliging an investment company to publish a prospectus when issuing shares identical to others already admitted to trading on a regulated market creates compliance costs for no benefit. This obligation restricts the capacity of investment companies to grow and channel capital into the EU economy. This, and other regulatory streamlining, would remove unnecessary barriers to investment companies successfully utilising EU capital markets and achieving economies of scale (see introductory comments for further discussion of proposed prospectus reforms). 12) Should work on the tailored treatment of infrastructure investments target certain clearly identifiable sub-classes of assets? If so, which of these should the Commission prioritise in future reviews of the prudential rules such as CRDIV/CRR and Solvency II? There should be no tailored treatment for infrastructure, or asset classes. This will introduce further complication into the rules for limited benefit. However, it is important to ensure that any flexibility allowed within the rules is applied effectively, irrespective of the asset class involved. For example, the introduction of Solvency II could make it more difficult for insurance companies to hold investment company securities if the regime is not sympathetically applied. This would affect the ability of these investors to access assets such as infrastructure and unlisted equities via the investment company structure. In turn this could reduce the amount of capital available for investment in unquoted securities and infrastructure. It also enhances the EU s vulnerability to systemic risks in the funds market by reducing its capacity to develop a balanced funds market (see introductory comments for further discussion). The AIC is seeking to address these issues with the appropriate classification of investment company securities under Solvency II. The AIC has made representations to EIOPA on this 6

7 issue and would be happy to share its reasoning with the Commission if that would be helpful. 13) Would the introduction of a standardised product, or removing the existing obstacles to cross-border access, strengthen the single market in pension provision? While there may be a role for developing standardised products, the AIC does not consider that this should be a key priority for CMU. The EU has already legislated to create ELTIFs and EuVECAs to assist in the allocation of capital to infrastructure and unquoted companies. It is unclear that further product development will do more to deliver the desired outcome. A higher priority should be to ensure that structures able to deliver investment in infrastructure and unquoted equities, such as investment companies, are not unduly restricted by regulation. The removal of unnecessary restrictions, and streamlining of required obligations, will help focus commercial attention on the potential of these funds to deliver attractive investment propositions. This offers the best means for CMU to encourage the launch of products suited to institutional investors which allows capital to be allocated to relevant asset classes. 14) Would changes to the EuVECA and EuSEF Regulations make it easier for larger EU fund managers to run these types of funds? What other changes if any should be made to increase the number of these types of fund? Reviewing these regulations to identify where it might be possible to streamline the obligations they impose should be a priority. This should include considering options to revise the rules according to the structure of the AIF. For example, the AIC considers that there is potential to revise the requirements for investment companies, that is, closed-ended funds with their securities admitted to trading on regulated markets. 15) How can the EU further develop private equity and venture capital as an alternative source of finance for the economy? In particular, what measures could boost the scale of venture capital funds and enhance the exit opportunities for venture capital investors? The Green Paper highlights the 2014 modification of the State Aid rules on the provision of risk capital. The AIC welcomed this initiative. In particular, the Commission s intention that the State Aid regime should be better focussed on delivering growth, concentrating enforcement on the most significant issues and streamlining administrative complexity of the rules. The actual outcome of this process has fallen far short of these objectives. The AIC recommends that the Commission should review whether or not its goals are being delivered in practice and what action might need to be taken to ensure they are secured. Venture Capital Trusts (VCTs) are UK investment companies which receive State Aid in the form of tax incentives provided to retail investors. These incentives are provided because VCTs are required to invest in small and growing businesses (with gross assets of under 15million). The State Aid compensates for the risks retail investors face in devoting their savings to this inherently risky asset class. 7

8 Building a Capital Markets Union VCTs are designed to address a structural finance gap which arises because banks and other traditional investors (such as conventional private equity funds) do not serve this part of the market well. The VCT scheme previously received State Aid approval under the State Aid rules in It is currently seeking re-approval under the revised Risk Capital Guidelines. The structural finance gap facing SMEs has not changed since the 2012 approval. Identifying ways to support SMEs as a mechanism to deliver growth remains a policy priority for the EU. The AIC is therefore very disappointed that the current approval process is expected to increase compliance burdens on VCTs and restrict their investment options (within the overall requirement that qualifying investments must be made in companies with less than 15million of assets). These compliance obligations are expected to include restrictions on investing in SMEs according to how long they have been operating, when this consideration has no relevance to whether or not these businesses face a finance gap. The Commission is also imposing investment restrictions based on the number of employees which VCT backed firms can employ. This headcount test means that, except in very limited circumstances, a business employing over 250 staff will not be a qualifying investment for a VCT even if they otherwise meet the relevant conditions. This policy position is perverse given the Commission s broader goal of supporting employment. It is also unnecessary in the context of protecting the EU from inappropriate State Aid. The AIC recognises that State Aid must be controlled to ensure the effective functioning of the single market. However, the Commission s current approach (both in the construction of the Risk Capital Guidelines themselves and its interpretation of their requirements) are contrary to its broader policy objectives of supporting growth and employment. The AIC recommends that the approach to State Aid approval should be reviewed to ensure that it does not create unnecessary impediments to achieving the objectives of CMU and the provision of venture capital for SMEs. The AIC would be pleased to provide further insight into this issue if that would be of assistance. 16) Are there impediments to increasing both bank and non-bank direct lending safely to companies that need finance? 17) How can cross border retail participation in UCITS be increased? 18) How can the ESAs further contribute to ensuring consumer and investor protection? The role of the ESAs should be to set a baseline of investor protection. The specific rules required in different Member States are likely to be informed by the distinct characteristics of the local market. For example, the UK has allowed retail purchase of AIFs. This reflects the long-standing role that products, such as investment companies, have played in this market. The AIC understands that other Member States have taken a different view on allowing retail 8

9 investors to purchase AIFs. The development of the role of the ESAs must not be allowed to prevent different approaches being taken where this is justified by local circumstances. Too much standardisation would risk stifling the development and continued offering of competing investment models able to meet local consumer needs. These different approaches can also act as pathfinders for approaches that can be more widely adopted by other EU Member States if and when their benefits become more widely recognised. Any suggestion that only EU mandated models, such as UCITS, are appropriate for retail investors risks reducing choice and competition able to lower costs and improve service standards. Concentration of retail (and institutional) investment in certain product structures could also increase the systemic risks identified by the IMF posed by an inappropriate focus on openended funds (see introductory comments). 19) What policy measures could increase retail investment? What else could be done to empower and protect EU citizens accessing capital markets? 20) Are there national best practices in the development of simple and transparent investment products for consumers which can be shared? The AIC considers that investment companies provide an exemplar of an investment product which is transparent and well suited to meeting retail investors long term needs. Aside from their high levels of transparency, one characteristic which makes these products particularly attractive from a consumer s perspective is the independent oversight provided by the investment company board. The directors of investment companies have legal duties to protect the interests of shareholders. Their scrutiny of the performance of the portfolio manager and securing their services on suitable terms delivers material benefits for shareholders. The role played by the board, alongside other benefits of the structure, has allowed the sector to deliver strong long term performance. It also allows retail investors exposure to a broad range of asset classes which helps diversify their risk (see introductory comments for further discussion). 21) Are there additional actions in the field of financial services regulation that could be taken ensure that the EU is internationally competitive and an attractive place in which to invest? A substantial amount of legislation has been introduced in recent years. A priority of CMU should be to review the current rulebook to establish if there are gaps and, critically, to identify areas where streamlining of the requirements would maintain investor protection while increasing commercial flexibility. 9

10 Building a Capital Markets Union 22) What measures can be taken to facilitate the access of EU firms to investors and capital markets in third countries? 23) Are there mechanisms to improve the functioning and efficiency of markets not covered in this paper, particularly in the areas of equity and bond market functioning and liquidity? 24) In your view, are there areas where the single rulebook remains insufficiently developed? No. The AIC is cautious about extending the scope of the single rulebook. Further consolidation increases the risk that EU rules will restrict diversity in the provision of financial services. While not all innovation is necessarily beneficial, it is important that different models are allowed to emerge to allow best practice to develop and, in time, to be spread across the EU. 25) Do you think that the powers of the ESAs to ensure consistent supervision are sufficient? What additional measures relating to EU level supervision would materially contribute to developing a capital markets union? While it is important for EU rules to be applied consistently, policymakers should recognise the limits to convergence. The activity of the ESAs must recognise the principle of subsidiarity and that Member States should be allowed the capacity to tailor the rules to the differing characteristics of their local markets. While divergence in standards may limit the creation of a single market, other issues (such as cultural and tax barriers) are arguably more significant. On the other hand, too much standardisation in the regulatory approach adopted may also create problems. For example, this could include focussing the EU funds market on a more limited range of investment structures which increases the systemic risk posed by the funds industry (see introduction for further discussion). 26) Taking into account past experience, are there targeted changes to securities ownership rules that could contribute to more integrated capital markets within the EU? 27) What measures could be taken to improve the cross-border flow of collateral? Should work be undertaken to improve the legal enforceability of collateral and closeout netting arrangements cross-border? 10

11 28) What are the main obstacles to integrated capital markets arising from company law, including corporate governance? Are there targeted measures which could contribute to overcoming them? The AIC is currently engaged in the debate on the Shareholder Rights Directive. One issue of concern has been proposals that long-term shareholding should be incentivised through requiring investors to be granted multiple votes or tax benefits if they are long-term holders of shares. The AIC is opposed to the imposition of such measures. They have the potential to create significant distortions in capital markets and detriment to companies and investors. CMU should seek to ensure that such initiatives are not imposed at an EU level. 29) What specific aspects of insolvency laws would need to be harmonised in order to support the emergence of a pan-european capital market? 30) What barriers are there around taxation that should be looked at as a matter of priority to contribute to more integrated capital markets within the EU and a more robust funding structure at company level and through which instruments? See introductory comments. 31) How can the EU best support the development by the market of new technologies and business models, to the benefit of integrated and efficient capital markets? 32) Are there other issues, not identified in this Green Paper, which in your view require action to achieve a Capital Markets Union? If so, what are they and what form could such action take? See introductory comments. To discuss the issues raised in this paper please contact: Guy Rainbird, Public Affairs Director. guy.rainbird@theaic.co.uk (0) May