Banking Sector And Alternative Investment Funds
Banks’ involvement in private equity is an important economic phenomenon. Between 1983 and 2009, 30% of all US private equity investments (over $700 billion) were sponsored by the private equity arm of a large bank. In the aftermath of the 2008 financial crisis, the passing of the ‘Volcker Rule’ as part of the Dodd-Frank Act required banks to limit their exposure to private equity and hedge funds to no more than 3% of their Tier 1 capital. In 2021, large banks in America invested around $250 billion in private equity funds. Goldman Sachs and JPMorgan Chase were the largest investors, with investments of $27.8 billion and $5.6 billion, respectively.
A bank does enjoy synergies from combining lending activities and equity investments that provide possibilities for upside benefits as opposed to debt instruments yielding only interest income. However, equity investments also expose a bank to much higher risks and seriously undermines fiduciary responsibility it owes to its depositors.
Given the higher risk nature of these transactions and based on the experiences, the US authorities chose to regulate PEVC investment activities of the banks.
US Regulations restricting banks from acting as general partners
The Volcker Rule, which was part of the Dodd-Frank Wall Street Reform and Consumer Protection Act, restricts banks from owning or controlling private equity funds or other covered funds. As a result, banks are not allowed to act as General Partners in PEVC funds. The idea is to discourage banks from taking on too much risk by not allowing them to engage in investment activities which are purely for their own benefit and which shift potential risk to their depositors or insurers.
The regulations that restrict banks from acting as General Partners in PEVC funds are designed to protect depositors and the broader financial system from excessive risk-taking by banks. By limiting banks’ involvement in these funds, regulators hope to prevent banks from engaging in proprietary trading and taking excessive risks with depositor funds. This is seen as a way to promote financial stability and prevent another financial crisis.
However, the rule does allow banks to invest in PEVC funds as Limited Partners, subject to certain restrictions and conditions. As Limited Partners, banks have a passive investment role and do not have control over the operations or management of the fund. Banks are also subject to regulatory restrictions on their investments in these funds, including limits on the amount of investment and the types of investments that can be made.
Also, in June 2020, regulators recognised the negative effects of overly broad application of the Volcker Rule’s covered funds section and decided to exclude venture capital funds from the definition, enabling banks to invest in qualifying venture capital funds. If a bank elects to invest in venture capital funds, it still must comply with limitations on conflicts of interest, investment risk, and safety and soundness. And the rules are stricter if the bank sponsors a venture fund, meaning the bank has more involvement and control in the fund, such as serving as a General Partner or controlling a majority of directors or managers.
Nepali Context
Following issuance of Specialised Investment Fund (SIF) rules approved by Securities Board of Nepal in 2019, a number of fund manager licences have been issued to entities, most of which are merchant banking subsidiaries of or are significantly owned by commercial banks. A few of them have launched their first funds and are at different stages of fundraise and deployment. By virtue of their significant ownership in the fund manager and the sponsorship role assigned to them per the regulations, banks have indirectly assumed the role of General Partners of the funds.
Majority of investments made by funds under SIF appear to have been directed toward IPO bound companies with a view to exiting through the stock market taking advantage of the shorter lock-in period. This approach is understandable in the current context as most SIF fund managers are merchant banking firms and they are building on their experience of managing mutual funds successfully over the years. The funds will in all likelihood diversify their portfolios as they gain experience.
Whilst bank sponsored funds may help Nepal’s nascent PEVC industry achieve more depth, banks must be cognizant of potential for conflict of interest and resulting ill effects. For example, banks providing debt facilities to entities where their funds hold equity positions would not be prudent as these are two different asset classes ideally requiring different types of sources of funds. Likewise, a sponsor bank’s client relationship with entities who subscribe to the fund as limited partners may create conflicting situations. Same concern applies for downstream investments promoted by the bank’s significant shareholders.
Paying attention to potential pitfalls as above by fund managers and the regulators will go a long way in helping our budding alternative investments space grow meaningfully.
