As European private equity firms look forward to another busy year for fund-raising and investment activity – albeit with the threat of a slowdown or correction hanging in the air – European legal and compliance teams will be planning their 2020 projects. There are a number of ongoing and new work streams that will keep those teams busy throughout the year. At the same time, there is a little more clarity than there was this time last year on a number of fronts, and some welcome breathing space.

2019 saw successive extensions to the date on which the United Kingdom will leave the European Union, but it is now almost certain that it will do so on 31 January – although, if all goes according to plan, nothing much will change then. However, the transition period – which is likely to end on 31 December 2020 – may lead the UK and the EU to a hard landing at the beginning of 2021 if a new free trade agreement cannot be agreed in time. Furthermore, it is very unlikely that any such trade agreement will deal extensively with financial services, meaning that “passporting” will probably be lost when the transition ends. Most firms are now familiar with the risks that Brexit entails (including the tax consequences) and are as prepared as it is possible to be, but 2020 will see them looking at their longer term plans once again.

In the regulatory sphere, the focus has been on any restriction that Brexit will impose on a UK firm’s ability to approach EU investors during fund-raising. Working on the assumption that UK-managed funds will no longer have the benefit of the EU AIFMD marketing “passport” (which would depend on extension of the “third-country” passport to the UK – not likely in the short term), Luxembourg and (to a lesser extent) Ireland are now firmly established as the EU hubs for private equity fund management. Many managers intend to continue their portfolio management and fund-raising activities from a UK office, often with authority delegated by a manager in Luxembourg or Ireland. However, such an arrangement will need to satisfy regulators scrutinising the “substance” of the EU office and its ability to supervise the UK team’s activities. Work on these structures will continue throughout 2020 so that firms can continue to raise funds seamlessly from 1 January 2021. UK firms that do not intend to establish an EU structure will need to have a Plan B.

While the UK government’s expected approach to Brexit – establishing the UK’s autonomy over its rulebook, leaving it free to diverge from EU rules – will inevitably lead to more friction in many sectors, it will allow the UK regulator to take a different approach to the future regulatory framework. We already know the direction of travel: Andrew Bailey, currently Chief Executive of the Financial Conduct Authority (FCA) and the next Governor of the Bank of England, has talked about a “same outcome, lower burden” approach. There are both benefits and downsides to regulatory divergence, and the industry will have an important role to play in shaping the UK’s path.

Brexit aside, many fund managers are finding the regulatory aspects of EU fund-raising increasingly complex, having to navigate a complex set of “hard” and “soft” preferences of EU investors. Faced with these challenges, more managers outside the EU are giving serious consideration to an EU structure either in parallel with or even in place of their traditional non-EU structure. In addition, while the European Commission’s forthcoming changes to AIFMD under the Cross-Border Marketing Directive are intended to harmonise the definition of “pre-marketing” across jurisdictions, the market widely regards a tightening of the conditions for “reverse solicitation” as the regulatory quid pro quo, increasing the likelihood of enforcement activity in an area that has attracted little such attention to date.

In the UK, FCA continues to place a very modest focus on the private equity industry, showing little desire to interfere with arrangements negotiated between investors and funds or to question the sufficiency of managers’ fiduciary duties. Private equity firms have, however, been caught by much broader initiatives. Most notably, all FCA-authorised private equity firms began to implement the Senior Managers and Certification Regime in December 2019, and the new accountability requirements put internal governance arrangements on a clearer and more formal footing. Work will continue on phase 2 of that project this year, especially as firms start to certify their professional staff and make important changes to recruitment and appraisal processes. In addition, the FCA-supported initiative to improve cost reporting to investors across the asset management industry led to the publication of template reports in 2019 by the Cost Transparency Initiative, which private equity firms and UK-based investors have been considering alongside the already widely adopted ILPA template. This initiative chimes well with an increasing push for greater transparency from a number of influential investors.

UK portfolio companies will have to make sure they are prepared for new corporate governance disclosures that will apply this year, and firms may also want to take account of a Debevoise & Plimpton memorandum (commissioned by the UN-backed Principles for Responsible Investment) on the fiduciary duties of UK company directors. Meanwhile, the PRI’s commitment to expel non-compliant signatories may also force a refocus on PRI annual reporting.

The European Commission, meanwhile, is re-doubling its efforts on environmental, social and governance (ESG) matters. The key parts of the financial services initiatives launched by the European Commission in 2018 are now agreed and will come into force in the coming years. These will have an important impact on all firms in the EU (including the UK) and those raising funds from European investors. Firms should begin preparations in the coming months. For example, the forthcoming European Disclosure Regulation will require most private equity managers to disclose how they have considered sustainability issues that affect the value of an investment and to state whether they have taken account of societal impacts more broadly.

However, subject to the detailed rules that are now being written, the Disclosure Regulation seems unlikely to impose unworkable new burdens on the many firms that are already ahead of the curve on sustainability issues. Indeed, the greater focus on ESG across the financial services industry presents an important opportunity for many private equity firms, and the fact that the UK is playing host to a hugely important climate change summit, so-called COP 26, in November of this year will only add to the pressure among European investors for “sustainable” investment products.

At the same time, some firms (broadly, those acting as EU-based advisers) will be preparing for increasing capital requirements, although those will not bite this year, and others will continue their push to market new products to individual, even retail, investors. Behind the scenes, the industry will continue to prepare for the anticipated review of AIFMD, following publication of a report prepared for the European Commission by KPMG this time last year. And who knows, 2020 might also be the year when Ireland finally reforms its limited partnership law.

As always, there is a packed regulatory agenda – although firms have some time to prepare for these important changes. Perhaps the first half of the year will be a good time to get ahead of the curve.

This week’s European Funds Comment is an edited version of a note that appeared in our 2019/2020 Private Equity Year-End Review and Outlook. To read the full publication, click here.