The European private equity industry looks to be fighting a losing battle against regulators. The introduction of a new regulatory framework, that will most likely undermine the recovery in PE activity just as it has started to gather traction, is set to go to a vote in the European Parliament this week. While my colleagues at Corporate Financing Week, BMI’s weekly financial publication, have long been highlighting the risk of tightening regulation to PE’s recovery, it seems this risk is now becoming increasingly acute. The Directive on Alternative Investment Fund Managers is designed to target firms seen to pose systemic risk, and it is in this respect that private equity finds itself in the firing line. Worryingly, however, it seems that regulators are not content with stopping at an expansion of powers to further regulate banks, securities firms and insurance companies. Indeed, Risk Watchdog understands that a strengthening band of European leaders are now stepping up their regulatory rhetoric to target credit default swaps, (CDSs) – with talk of banning the market for them altogether.

Global Private Equity Financing (US$bn)

In my view, should the regulation be passed in its current format, the impact stands to be predominantly threefold. First, Europe will see international funds slashing their funding allocation to European-based PE funds. Second, this may serve to push European funds away from eurozone soil altogether and into offshore locations exempt from such rules. And finally, the first two factors combined will likely serve to hit the volume of PE deal making hard. This all serves to pose a threat to BMI’s core view that the private sector will continue to take up the slack from the public sector in corporate financing, as stimuli is reigned in. While the impending heightening of regulation does not necessarily change this view, Risk Watchdog, however, sees PE’s role within this as becoming increasingly muted.

The component of the Alternative Investment (AI) regulation which has been the subject of the most controversy has been the so-called PE passport. This requires funds from ‘third countries’ (those based outside the Union) to comply with European regulation if they wish to market themselves in the 27-nation trading bloc. One part of this legislation is that EU-based funds will be forced to use locally-based banks as depositories. While in principle the passport is an attempt to facilitate EU-wide marketing by fund-managers, in practice, such regulation is no less than protectionist, as it discriminates against firms attempting to access the EU market. Essentially it gives the EU ability to pick and choose which funds it will allow to enter Europe.

So, who stands to be the biggest loser in all of this? You guessed it: the UK, which is home to around 60% of Europe’s PE funds and which has been the regional stalwart in the industry’s recovery in the year-to-date. PE M&A is up an astonishing 516% y-o-y so far in 2010, totalling US$6.3bn of deals, according to Thomson Reuters data. Indeed the new British coalition government is hoping that the application of EU regulation will be left to the discretion of individual countries – in this respect, the classic EU principle of ‘subsidiarity’, whereby the Union does not take action unless it is more effective than action taken at the national level, would come in very handy. It seem that the passing of EU-wide legislation is based on an assumption that the eurozone is a unified decisions making bloc, rather than the almost non-existent politician union that is it is often viewed as from this side of the English channel.