PRINT THIS PAGE

Fundraising from institutional investors in light of legal regulations

The European venture capital industry has been subjected to several important regulatory changes in recent years that have aimed to promote the industry among institutional investors. The Hungarian Venture Capital Association discusses the legal changes that are expected to facilitate investments in private equity by pension funds in the region.

On the basis of the significant experience of the venture capital industry in the US and for the purposes of improving the competitiveness of the European risk capital sector, the Lisbon European Council in 1998 developed a Risk Capital Action Plan (RCAP) to be implemented by 2003 and a Financial Services Action Plan (FSAP) to be implemented by 2005.

The purpose of the RCAP is to facilitate cross-border activity - within the EEA - to make it easier and cheaper to raise capital, to strengthen prudential regulations and standards, to improve transparency and to provide for faster and more effective financial legislation.

The European Private Equity and Venture Capital Association (EVCA), representing the interest of the European private equity industry, proposed to the European Commission to extend the general principles of the RCAP to the promotion of entrepreneurial activities through the development of long-term capital resources to support the capitalisation demands of early stage and innovative enterprises who do not wish to raise capital on any stock exchange or other recognised capital market. In this context, the involvement of the EVCA is essential, as private equity and venture capital corporations are the main channels of raising risk capital funds.

Within the framework of the above proposal, the issue has been raised that in most European countries, it is not legally possible for pension funds to place their assets for a long term into risk capital funds or to directly invest in target enterprises. Or, if such would be legally possible, the opportunity is not utilised, as tax laws do not properly support investments in growing enterprises, or institutional investors have little confidence in early stage enterprises, or it is difficult to find the target enterprises. To eliminate such concerns, some progress in the EU has been made, aiming at harmonising expectations and principles with respect to the proper institutional and tax legislation.

In the course of assessing the achievements of the RCAP, at the end of 2001 it was pointed out that since 1998, venture capital has multiplied by a factor of four and that early-stage funding is more widely available.

The lessening of investment limitations applicable to pension fund assets is also an objective of the FSAP, providing that although the security of pensions is of prime importance, attention must also be paid to the costs of pensions (e.g.: administrative constraints, low returns on safe investments). If pension benefits are too expensive, pensioners might end up receiving smaller benefits.

The challenge for the legislation and the market is, therefore, to balance the requirements relating to providing security for pensions (prudent standards), with the costs for pension fund asset management and the maximisation of returns in a prudent manner.

On the heels of EVCA, the Hungarian Private Equity and Venture
Capital Association (HVCA) has also focused its program for 2002 on the possible inclusion of private pension fund assets into the Hungarian private equity and venture capital flow, extending such analysis to other institutional investors, such as insurance companies and credit institutions.

Therefore, it is useful to review the legal regulations (and to highlight the recent amendments) limiting the investment of assets by institutional investors into equity not floated on the stock exchange or other recognised markets.

Hungarian law, apart from the fact that it actually follows the principles incorporated in EU directives and proposals for directives seeking to authorise risk capital investments, contains such limitations with respect to which the presidency of the HVCA has already expressed certain concerns.

Some of those concerns shall be presented in this article.

1)  Private pension funds

The asset management rules of Act LXXXII of 1997 on Private Pensions and Private Pension Funds (PfAct) reflect the EU principles concerning the requirements relating to prudent investment standards and the management of a diversified investment portfolio.

On such basis the investment portfolio rules of the PfAct require that to reduce risks and to prevent unwarranted dependence on any particular investment, the fund shall in all cases diversify its investments according to various types of investments available. Investments shall be chosen in such a manner that the rate of return on any particular investment shall depend on the rate of return from other types of investments to the smallest possible extent.

The allocation of the investments may not jeopardise the continuous liquidity of a fund and compliance with its obligations. Such risk management rules for example set forth the requirements pursuant to which a fund may, with the exception of government securities and investment fund units issued by open-ended investment funds, invest a maximum ten per cent of its assets in securities issued by any single issuer, and may not, with the exception of government securities, acquire more than ten per cent of the securities issued by any single issuer.

Investments made by a fund shall be in line with the fund's short-term (within one year) and long-term (longer than one year) liabilities, and thereby ensuring the continuous solvency of the fund. Currently, therefore, the PfAct requires - which does not address long-term investments at all - that the fund shall not directly own more than ten per cent of the registered capital of an economic organisation for a period longer than one year, except for organisations owned by a fund itself and responsible for the fund's asset management, record keeping, benefit provisions, administration and debt collection.

Pursuant to the new provisions of the PfAct (Section 67/A) which came into force on January 1,2002 - as amended by Act CXX on Capital Markets, a fund except for organisations owned by the fund and responsible for the fund's asset management, etc. may only invest the assets of such fund - except for securities (shares and investment fund units) listed on a recognised exchange - in the following investments:

(i) equity securities, the issuer of which undertook to introduce the security within six months on a stock exchange or other recognised market, and no legal obstacles hinder the IPO,

(ii) such equity securities not satisfying the conditions under (i) with respect to which during the proceeding 30 days, two investment services companies have continuously quoted a market price with an irrevocable undertaking to purchase same, and

(iii) investment fund units.

The PfAct also sets forth investment limitations with respect to equity securities and investment fund units issued abroad which we do not herein describe in detail.

The investment limitation frames established in the PfAct are supplemented by additional rules specified in Government Decree No. 282/2001.(XII.26.) on Investment and Business Activity of Private Pension Funds (Decree).

The government has been authorised by the PfAct in its Section 68 (2) to allow funds to set in their asset management rules different rules diverging from the investment limitation thresholds rules specified in the PfAct for investments in investment fund units. The Decree, however, does not set forth different investment rules when regulating the investment limitations in investment fund units. As a consequence, the joint share of investment fund units (including units issued in Hungary or abroad) in the investment portfolio of a fund may not exceed 50 per cent of the assets of the fund, provided that the investment in the investment fund units of a single investment fund may not exceed ten per cent of the assets of the pension fund, and the joint share of investment units of different funds managed by the same investment fund manager may not exceed 30 per cent of the assets of the fund.
 
Pursuant to the Decree, the joint percentage of equity securities listed or non-listed on a stock exchange in the investment portfolio of the fund may not exceed 50 per cent of the assets of the fund, provided that from among this the percentage of non-listed securities may not exceed ten per cent of the assets of the fund. It should be noted, however, that the fund shall not be obligated to sell any shareholding which is delisted from the stock exchange in order to comply with these investment limitation thresholds in the particular investment category. The percentage of such equity securities may, however, not exceed five per cent of the assets of the fund.

It is a continuous shortfall of the PfAct, that even following the amendments effective as of January 2002, the PfAct still does not authorise funds to invest in quotas of limited liability companies, i.e. in equity instruments not incorporated into the form of a share. This gives rise to certain concerns such as the possibility that a private equity or venture capital fund was established in the form of limited liability company, however, the pension fund would not be allowed to carry out investments in target companies which operate as a limited liability company. The PfAct does not regulate the investment possibilities in risk capital fund units. Nevertheless, the latter is of less concern, as in practice risk capital funds and risk capital corporations regulated by Act XXXIV of 1998 are not very popular forms of institutions operating venture capital due to very strict institutional regulations and equity placement rules, although the intent to regulate such forms of institutions was for the purposes of supporting the equity capitalisation demands of small and medium-sized enterprises.

It is a welcome development that the PfAct abrogated an investment rule, which previously stipulated that with the exception of service providers established or partly owned by the fund, the fund would have only been able to invest its assets exclusively in securities traded on recognised stock exchanges.

According to the conflict of interest rule set forth in the PfAct - the principles of which are in line with EU norms - a fund may not, except for service providers founded by or partly owned by the fund, have ownership in economic organisations in which the founders of the fund, the employers of the fund's members, the investors or service providers of the fund own more than ten per cent of the registered capital.

On the basis of the above investment limitation thresholds it may be implied that the assets of the funds may be included in risk capital investments, however, such investments may not be made for a long term and the possibility of the exit conditions require substantial guarantees.

2) Insurance companies

Act XCVI of 1995 on Insurance Institutions and the Insurance Business (Insurance Act) also sets forth the basic requirement that insurance companies shall maintain continuous liquidity, as well as the rules for creating diversified portfolios.

With respect to the rules on investments, pursuant to the official commentary of the Insurance Act, the purpose for limiting investment by acquiring ownership in other undertakings is to ensure that the liquidity of the insurance company shall not be dependent on the financial status of certain other undertakings. However, the investment restrictions shall not apply to an enterprise subject to an outsourcing contract with an insurance company if at least 75 per cent of its activities are committed to insurance companies.

The insurance company shall not hold in another joint-stock company more than 75 per cent of the subscribed capital of that joint-stock company, unless it is another institutional investor.

With regard to the investment of technical reserves and the minimum working capital, the shareholding of an insurance company in another enterprise shall not exceed 25 per cent of the subscribed capital of that enterprise.

Insurance companies may not invest their assets used to cover actuarial reserves in an enterprise, belonging to an owner of the insurance company which owner has an influential holding, that is not engaged in the insurance business unless its activities are directly related to the activities of the insurance company to a degree of at least 75 per cent.

An insurance company shall not invest in the shares or other monetary and capital instruments issued by the same enterprise in excess of per cent of its technical reserves. However, such limit may be increased to a maximum of ten per cent if the aggregate amount of such investments does not exceed 40 per cent of the gross technical reserves.

According to the rules on investments, the technical reserves and the working capital of an insurance company may be held in the following assets:

(i) shares issued by economic organisations; either listed on recognised stock exchanges or shares of institutional investors, further, shares issued by a foreign company established in an OECD member state, not traded on a recognised securities exchanges,

(ii) investment fund units and other collective investment securities; either investment fund units issued by Hungarian close-ended investment funds registered by the Hungarian Financial Supervisory Authority (HFSA) and traded on recognised securities exchanges, further, close-ended collective investment fund units traded on approved securities exchanges in an OECD member state, investment fund units issued by Hungarian open-ended investment fund registered by HFSA, and open-ended collective investment fund units issued and traded in an OECD member state.

It shall be emphasised that any asset that is encumbered or the disposition thereof is restricted in any way shall not be included in the cover for technical reserves or working capital of the insurance company.

According to the investment rules, with respect to the assets used to cover actuarial reserves and the working capital maximum:

(i) altogether five per cent shall be invested in shares of institutional investors, and shares issued by economic organisations seated in OECD member state and not traded on approved securities exchanges, and

(ii) altogether ten per cent shall be invested in assets set forth in Section (ii) above.

To sum up, it can be concluded that although in the case of insurance companies the investment rules relating to a portfolio's potential assets of portfolio are broader and without time-limits, the applicable investment thresholds are narrower.

3) Credit institutions and financial enterprises

Act CXII of 1996 on Credit Institutions and Financial Enterprises (Act on Credit Institutions)contains mandatory provisions relating to compliance with rules on prudent operations in order to ensure the maintenance of liquidity and solvency in the course of the managing of its own and external resources and also sets forth investment limitations.

A credit institution may not acquire or hold investments constituting direct or indirect ownership shareholding in a company, the net value of which is in excess of 15 per cent of its guarantee capital, with the exception of other institutional investors.

A credit institution may not acquire or hold any direct or indirect ownership shareholding in any company to an extent exceeding 51 per cent of its subscribed capital, with the exception of shareholdings in other institutional investors.

The total net amount of the credit institution's direct control in enterprises other than institutional investors may not exceed 60 per cent of its guarantee capital.

With respect to the above restrictions, a shareholding - registered and managed separately - shall not be taken into consideration which was acquired by the credit institution for a temporary period of not more than three years, for the purpose of reducing losses deriving from financial services or acquired as a result of a conversion of debt to equity transactions or in the course of a liquidation procedure. Further, the credit institution may  exceed the limits described above if it is able to maintain the capital adequacy index of eight per cent with respect to its guarantee capital reduced by the amounts in excess of such limits, and if it is able to comply with other restricting requirements on the guarantee capital.

Pursuant to the official commentary to the Act on Credit Institutions, the purpose of such provisions is to facilitate capital investments for securities trading purposes, aiming the generation of profits from buying and selling securities in the short-term, and not by keeping shares for a long period of time. However, such approach is not favourable for those enterprises which do not need credit, but capital investments.

Summary

On the basis of the trends in the European Union, a further elimination of restrictions on the investments may be anticipated. On the other hand, on the basis of prior experiences in the EU, the confidence of investors is expected to increase vis-á-vis such risk capital funds which concentrate on start-up or early stage enterprises and invest directly or indirectly - on the basis of appropriate exit rules - in the hope for higher long-term returns as compared to investments made on stock exchanges.

Copyright © 2002 HVCA

Hungarian Venture Capital and Private Equity Association (HVCA) represents virtually all major sources of venture capital and private equity in Hungary and is dedicated to promoting the industry for the benefit of entrepreneurs, investors, its practitioners and the economy as a whole. For more information please visit www.hvca.hu