Actually, some time ago I participated in a discussion among CAIA committee members. One participant questioned whether regulators should not focus on protecting unsophisticated investors from venturing into alternative assets. He observed that regulatory philosophy is unfortunately not developing in this direction. The thrust of regulation like the AIFMD is to make alternative assets “safe,” which is almost comparable to the attempt to increase safety standards in Formula One by requiring to put a first aid kit and a spare tire on board of every racing car. This approach to regulate risk out of alternatives is counterproductive and almost absurd. Risks will continue to exist regardless, and this will just lead to a spiral of ever-tightening regulation. In my opinion, the right approach would be making sure that the investors in this asset class have the right skills, profile, processes, systems, experienced staff, and resources – to stay with the analogy, are qualified Formula One drivers instead of somebody with my driving skills.

Other participants feel very uncomfortable with regulating the kinds of investors who can access various investment products and saw this as a kind of discrimination. Because of their risk characteristics, strategies embraced by allegedly “sophisticated investors” would be off-limits to retail investors. Regulating differently according to type of investors does not strike me as radical as you see comparable approaches in many strands of life (for instance, driver licenses). My own bias is clearly private equity where attempts to make this asset class liquid and attract retail investors have arguably not met with great success. It is not about denying retail investors exposure to this asset class but about making sure that they involve intermediaries who know what they are doing and have sufficient skills, experience, and systems to deal with the risks. In any case, for the AIFMD and comparable regulatory initiatives it is still early days and the jury is still out.

To maintain the integrity of the financial system does not seem convincing as a reason to regulate private equity as this asset class is hardly systemic. However, having grown from a few hundred private equity firms in the 1990s to by now about 10,000 private equity firms, more caution is clearly in order. Moreover, the financial industry is extremely innovative in finding loopholes and could certainly find ways to jump over the boundary to more liquid and systemic asset classes like hedge funds. So, it is sound to close all avenues to regulatory arbitrage and in this respect I personally welcome all-encompassing and sound regulation.

On the other hand, private equity as a niche area of the financial system never was the focus of regulation and more the troublesome exception. As a consequence, rules suitable to hedge funds are difficult to apply to private equity. Regulation also appears too much a reaction to the latest (perceived) scandal. Various regulatory initiatives overlap and there is no real architecture. For instance, in regard to private equity institutional investors are subject to Solvency II and Basel III, whereas the fund managers need to comply with the AIFMD, but these regulations do not talk to each other (or about the same thing).

I interpret many aspects of regulatory initiatives as the result of a crisis of trust where suspicion about financial actors has become routine. However, private equity is operating in environments where information is difficult to get, non-standardized, and difficult to understand and where its interpretation requires professional judgment and experience. Any disclosure is likely to trigger a cycle of follow-on questions and increasing suspicion. As the philosopher Onora O'Neill observed, public distrust had grown in the “very years in which transparency and accountability had been so avidly pursued.”

One could also interpret this as relying on “regulated” LPs. During my work for the EIF in the early 2000s we were continuously asked by policymakers to promote practices and push for investor protection clauses with the VC funds under EIF management. Many of the practices we developed and introduced later resurfaced in the AIFMD. In my interpretation at the time, EIF, due to its domineering position in the European VC market, acted as a “quasi-regulator,” giving confidence to less experienced LPs to follow EIF's lead. This would be in line with a model for alternative assets where it is rather the LPs who have to meet standards and as experienced investors need to exercise proper care.

At a certain point investors find this cheaper to diversify the impact of such risks away than paying higher management fees to funds in order to further reduce the probability of adverse events. This is what was reflected in a comment a managing director of a highly respected VC fund-of-funds made at a conference pre-2008 (those were the days…): “If we hear a GP talk about risk management, we walk away from the deal.” Two caveats: First, also compliance and operational risk–related events can be correlated, for instance, in cases where flawed valuation or risk models are widely accepted in the industry. To tackle this, regulators should avoid being too prescriptive – strict adherence to regulatory requirements can also result in complacency, lack of attention, and systemic risk. Second, high diversification leads to higher probability that potentially embarrassing compliance failures happen, like the proverbial terrorist that is getting through. However, rather than aiming for funds being failsafe, investors should find ways to deal with public anger, admittedly not an easy task nowadays.

Having said this, finding value and pricing it is the business GPs are in and if they would be always right in their assessments, the private equity asset class would be without any risk. Arguably, the valuation is more of an issue for auditors, regulators, and investors who are concerned about financial reporting errors and fair-value measurements that cannot be supported. But a value is not equivalent to a price and valuations are by definition subjective, even more so in the thin market that characterizes private equity. In my various publications I put forward as one argument why in private equity and particularly in venture capital we mainly see self-liquidating fund structures is because valuations relate to a large degree to intangibles and can only be proven as “true” by exiting the investments and turning them into liquidity. My concern is that with recent regulatory initiatives related to valuation we will see allegations of misbehavior in fair-value measurements where actually no wrong-doing happened.

Moreover, there are often conflicting objectives associated with “fair” valuations. The IPEV Guidelines see fair value as the “price that would be received to sell an asset in an Orderly Transaction between Market Participants at the Measurement Date,” which is certainly the perspective GPs would take. LPs may be more interested in understanding how the investments are developing, that is, consistency of valuations over time. Here I have heard the argument that practices before 2000 (keeping values at cost and only writing them up after new capital rounds) made this easier for LPs as this disregarded market noise. Auditors and regulators, on the other hand, tend to have a conservative bias, but LPs are also concerned about safeguarding their assets and would certainly object to assets being exited at low prices in line with a conservative valuation but that jump in value subsequently.

Finally, as a previous risk manager I (and several others in the industry) disagree with the IPEV Guidelines view that the fair value of fund interests is based (as described in the Guidelines essentially equivalent) on the fund's attributable net asset value. An in-depth discussion of this point goes beyond the scope of this interview. Just one aspect: LPs are exposed to the uncertainty regarding timing and amounts of the fund's cash flow. From their perspective also, the fund's undrawn capital forms part of their exposure. When LPs commit to a fund, the fund has no net-asset-value (NAV) but forms a risk.