The new EU PRIIPs Regulation
Many private equity and venture capital managers (Managers) may have overlooked the forthcoming EU PRIIP Regulation (the Regulation)1 assuming that, because they do not generally raise money from retail investors, the Regulation is not relevant to them. However, the definition of "retail investors" for these purposes is unexpectedly broad, meaning the Regulation will apply where Managers raise money for their funds from high-net-worth or sophisticated investors, from local authorities, or from their "friends and family". It may also apply in relation to staff co-investment and / or carried interest arrangements.
What is a PRIIP?
A "PRIIP" is a packaged retail and insurance-based investment product and includes any investment where the amount payable to a retail investor is subject to fluctuations due to the performance of assets which are not directly purchased by the retail investor. This is a wide-ranging definition (the Regulation is designed to apply to all products regardless of form or construction) that will therefore cover all types of private equity and venture capital funds, as well as listed investment trusts and venture capital trusts. It also potentially covers co-investment and carried interest vehicles.
What is the aim of the Regulation?
The Regulation aims to help retail investors better understand and compare key features, risks, rewards and costs of PRIIPs by proving them with a uniform three page standard key information document (KID) prior to investment.
To whom does the Regulation apply?
The Regulation applies to PRIIPs "manufacturers" and also to those distributing PRIIPs. It will therefore apply to Managers who raise and establish funds and also potentially to placement agents engaged by Managers to assist with fundraisings.
When does it apply?
The Regulation only applies to PRIIPs that are "made available" to retail investors. This phrase is undefined in the Regulation. The logical conclusion is that if any retail investor can subscribe for an interest in the PRIIP, it has been made available to retail investors.
The Regulation does not distinguish between PRIIPs sold with or without advice provided to the retail investor, or acquired by the retail investor on its own initiative or otherwise. A KID will be required in all instances.
What is a retail investor?
The definition of "retail investor" encompasses anyone who is not a professional client as defined in MiFID2. Under MiFID, investors that are not automatically considered "per se professional clients" must meet certain requirements set out in two tests (a qualitative test and a quantitative test) in order to elect to be able to be treated as "elective professional clients", and not as retail investors. Under MiFID II (which comes into force on 3 January 2018) local government pension schemes must be treated as retail investors unless they can be "opted up" to an elective professional client.
The qualitative test
UK Managers will be familiar with the qualitative test as this is the test used by them under the UK rules to "opt up" their executives and "friends and family" to elective professional client status. This is the only "opt up" test which needs to be met in such circumstances because operating a private equity or venture capital fund is non-MiFID business under the UK’s FCA rules. Under the qualitative test, the Manager must undertake an adequate assessment of the expertise, experience and knowledge of the individual that gives reasonable assurance, in light of the nature of the transactions or services envisaged, that the individual is capable of making his / her own investment decisions and understanding the risks involved. Certain disclosures must also be provided. It is generally a fairly straightforward test for a Manager to operate.
The quantitative test
For the purposes of the Regulation (which follows the MiFID tests), the qualitative test alone is not enough. Investors must also meet a more onerous quantitative test, by satisfying at least two of the following criteria:
- the investor has carried out transactions, in significant size, on the relevant market at an average frequency of 10 per quarter over the previous four quarters (very few, if any, investors in private equity and venture capital funds will be investing in 40 funds per annum);
- the size of the investor’s financial instrument portfolio, cash deposits and financial instruments, exceeds €500,000 (a number of investors will likely meet this test); and
- the investor works or has worked in the financial sector for at least one year in a professional position, which requires knowledge of the transactions or services envisaged (this test will likely be met by some of the Manager’s investment staff but friends, family, high-net-worth investors and sophisticated investors will not necessarily have worked in the private equity or venture capital industry).
The FCA is implementing a different, more tailored, quantitative test for local government pension schemes which, it is expected, the larger local government pension schemes will be able to meet. This is as follows:
- the size of the investor’s financial instrument portfolio, cash deposits and financial instruments, exceeds £10m; and
- the investor has carried out transactions, in significant size, on the relevant market at an average frequency of 10 per quarter over the previous four quarters; or
- the person authorised to carry out the transaction on behalf of the investor works or has worked in the financial sector for at least one year in a professional position, which requires knowledge of the provision of services envisaged; or
- the investor as an "administering authority" of the Local Government Pension Scheme (in accordance with the relevant regulations) is acting in that capacity.
As it can be hard to meet the quantitative test, a number of investors in private equity and venture capital funds previously treated as "professional clients" (including smaller local government pension schemes) will likely be considered retail investors for the purposes of the Regulation. As such, Managers may well be in the position of marketing to investors that meet the qualitative test and can therefore be considered "elective professional clients" for the purposes of being eligible to invest in the fund under current FCA rules, but that nonetheless will be considered retail investors for the purposes of the Regulation because they do not meet the quantitative test.
What if staff members are the only retail investors in my funds?
A product whose acquisition does not require payment by the retail investor, meaning that there is neither an initial payment nor any risk of future financial commitments by the retail investor, is not considered an investment for the purposes of the Regulation and therefore, does not require a KID to be produced. This suggests that a KID is not required for a carried interest scheme where no payment is required to participate and the carried interest partners include retail investors. However, a KID would be required for any retail investor in a co-investment vehicle, which can often include staff members, as there is an initial payment and the risk of future financial commitments.
The above would equally apply to "friends and family" or other high-net-worth or sophisticated investors who might invest in a co-investment vehicle where commitments are made and drawn down.
My fund is established outside the EEA (e.g. in the Cayman Islands or Channel Islands). Do I need to worry?
Yes. If a fund is made available to retail investors anywhere in the EEA, then the Regulation will apply. However, if an EEA fund or non-EEA fund is only made available to retail investors outside the EEA, then the Regulation will not apply.
If the Regulation applies, what next?
The Manager is responsible for producing a KID. The Regulation prescribes the KID format and contents. The KID should be:
- a maximum of three sides in length (A4 size);
- in the standardised form and with content as set out in the Regulations;
- provided to investors free of charge;
- provided to an investor in good time before they invest;
- available to investors on a website or in hard copy; and
- referred to in marketing communications such as the PPM.
If KIDs are required, a Manager will need to produce a template KID and then set up appropriate systems to ensure that relevant data is captured and presented in the right way.
Alternatively there are many outsourced KID providers who can help. Outsourcing KID production will not significantly dilute the infrastructure required as data will still need to be collated and transmitted to the chosen service provider.
The Regulation requires KIDs to be reviewed regularly and kept up-to-date. However, the Regulation does not address how this requirement should be applied in the context of closed-ended funds (which are no longer "made available" to investors after their final closing and from which investors typically cannot withdraw or redeem once they have invested). Logic suggests that this requirement should not apply following the final closing of a closed-ended fund (especially as the purpose of the KID is to help retail investors before they take their investment decision) but as yet no regulator has confirmed this interpretation. Where updated KIDs are produced, these should be made available to retail investors promptly, either on the Manager’s website or in hard copy.
Do we need to provide KIDs to investors that have already invested in our existing funds?
No. Only to retail investors to whom a fund is made available after the Regulation becomes effective, on 1 January 2018.
What needs to be included in a KID?
The following table sets out the structure and summary of content requirements of a KID:
|1. Title||‘Key Information Document’ should appear prominently at the top of the first page|
|2. Purpose||A mandatory explanatory statement describing the purpose of the KID|
|3. Comprehension Alert||(where applicable) An alert to investors if the product may be difficult to understand|
4. What is this product?
|Type, objective, intended investor, details of insurance benefits (if any) and term of the PRIIP|
|5. What are the risks and what could I get in return?||Risk indicator and performance scenarios|
|6. What happens if the manager is unable to pay out?||Information on whether there is a guarantee scheme, e.g. FSCS|
|7. What are the costs?||Specific details on costs to be borne by the investor|
|8. How long should I hold it and can I take money out early?||Details including a recommended minimum holding period|
|9. How can I complain?||How and to whom can a complaint be made|
|10. Other relevant information|
What are the most challenging parts of the content requirements?
The content requirements look relatively simple, however, there is a significant amount of data to be gathered and a number of calculations to be carried out in order to produce the information in the format required. Some potentially more challenging aspects are:
Past performance is not included in the KID. Future expected performance, i.e. average return per year after costs, should be estimated and presented in four different scenarios (unfavourable, moderate, favourable and stress), determined in each case in accordance with a prescribed methodology), at one year, at half the recommended holding period, and at the recommended holding period. The holding period for a private equity or venture capital fund will be the life of the fund.
All direct and indirect costs incurred by an investor in the fund must be included, but they must be presented by their impact on returns averaged over the holding period (known as “reduction in yield”). The total costs take into account one off, ongoing and incidental costs. Transaction costs must be included. This can be particularly challenging for fund of funds when details of direct and indirect costs relating to underlying funds need to be factored in. Details of the methodology for the calculation of costs is set out in Annex VI of the RTS (as defined below).
The Manager will need to assign a “summary risk indicator” to the PRIIP by giving it a number on a scale from 1 (being the lowest risk) and 7 (being the highest risk). The methodology to determine the relevant number is based on onerous market risk and credit risk calculations. It is likely that many private equity and venture capital funds will be assigned a summary risk indicator of 7.
Regulatory Technical Standards
The European Commission on European Supervisory Authorities produced regulatory technical standards which were adopted on 8 March 2017 (the RTS). The RTS sets out the detailed methodology for applying market risk and credit risk calculations and will need to be applied as Managers complete their KIDs.
What if the retail investors are outside of the UK?
The KID must be translated into the official language of each EEA country where the PRIIP is distributed or in another language accepted by the regulator of that country. The mere fact that the website of a person advising on, or selling a PRIIP, may be accessed by retail investors from member states other than the member states in which the PRIIP is distributed, does not imply a requirement to provide the KID in a language prescribed by those other member states.
What if we do not produce KIDs or do not produce them correctly?
Managers failing to produce KIDs will be subject to a standard range of regulatory sanctions. These include fines, public warnings or an order prohibiting the marketing of the PRIIP. In addition, Managers may face damages claims from investors for loss caused by reliance on inaccurate or misleading KIDs.
Interaction with other regimes
Certain elements of the Regulation are not currently aligned with the UCITS Directive key investor information document or the disclosure of costs and charges required by MiFID II. This is unhelpful for firms subject to more than one regime who may need to collate and present data in several different ways and in different types of documents in order to comply with the different regimes.
When does the Regulation take effect?
After some initial delays, it has been confirmed by the European Commission that the Regulation will take effect from 1 January 2018.
Managers should analyse their investor base to see if they are likely to have retail investors in their funds and therefore need to produce KIDs. If they make their funds available to retail investors, they should either revisit their systems and controls to prevent retail investors from being able to invest in their products (if practicable), or should start looking at required content and any systems needed to be able to collect and present data in a Regulation-compliant manner.
1 Regulation (EU) No 1286/2014
2 Markets in Financial Investments Directive (2014/65/EC)