RegTech Intelligence 
JWG analysis.
“This regulation has the possibility to create a strong ecosystem for social enterprises across the union”
In December 2011, the European Commission issued a press release highlighting the problems that businesses face when seeking conventional sources of funding due to the confusion surrounding their mix of social goals and business techniques. Responses from an ESMA consultation paper indicated that the socially-oriented investment funds are also often caught up and confused with normal investment funds, obscuring the distinction between the two in terms of purpose and, hence, making the former appear less attractive.
Consequently, a proposal was made for a sound and trusted brand for socially-oriented investment funds that spanned the union.
In July 2013, following the introduction of Alternative Investment Fund Managers Directive (AIFMD), the EU simultaneously published regulation for venture capitalists (EuVECA) and, specific to this article, for social entrepreneurship funds (EuSEF). EuSEF sets out a key framework for managers of Social Entrepreneurship Funds (SEFs) to operate within the EEA under a single designated name, unlocking a pool of potential investors that were hitherto inaccessible.
Here the authorisation process is a lot more straightforward than it was for AIFMD. EuSEF (and EuVECA) is typically aimed at managers of smaller, more specific investment funds – those presiding over assets worth less than €500 million – and is not obligatory. Allowing managers to voluntarily switch to the designation ‘EuSEF’ will reduce the burden for these more specific funds and create a mode of transport for accelerating social investment. With less obscurity, fundraising can be concentrated much more easily under the designated investment funds and, by operating with the same rules across the union, investor confidence will be boosted and competitive distortions eliminated.
It’s not all fun and games though. Safeguards have been put in place to ensure security and consistency for investors, fund managers and the businesses they support.
Fund managers
When looking at the new requirements under EuSEF, fund managers will have quite a lot on their plate to maintain a balanced diet of transparency, responsibility and integrity to their cause. Profits must not be distributed to owners or shareholders unless there is a case where it is deemed justifiable, and managers cannot invest in undertakings that could potentially compromise their ethical mission, for example, investing in the weapons industry.
In terms of a SEF’s portfolio composition, at least 70% of the fund’s capital should be invested in social undertakings, with no more than 30% on unqualified assets[1]. Managers cannot contribute to systemic risk by using high risk borrowing techniques; however, they are permitted to borrow in the short term to meet liquidity requirements, of which these borrowing/debt obligations/guarantees should be covered by the 30% that is not reserved for social undertakings. As a quick refresher, a social undertaking is defined by EuSEF as “an operator in the social economy, the main objective of which is to have a social impact rather than to make a profit for its owners or shareholders”.
If managers wish to delegate functions of their funds’ operational services to third parties, their liabilities will remain unchanged.
Investors
The safeguards on investors are even more specific. For reasons of security, managers should only market to professional investors, with the exception of high net-worth individuals who can be marketed to for reasons of creating a broad investor base, provided that they meet a certain range of appropriate safeguards themselves. Those that are marketed to should be prepared to commit a minimum of €100,000 and be able to commit to an agreement that they are aware of the risks associated with the investment.
Alongside the serious big-money investors, employees and managers of the SEF are allowed to invest in their own fund, due to the sufficient level of knowledge they will have on their undertakings.
Reporting and operational requirements strike with a meticulous-as-usual fashion. Managers who wish for their investment funds to be designated as EuSEFs should report all the relevant information chronologically (e.g., identity of manager, Member States where the manager intends to market or establish SEFs, etc.) to their home Member State. And they should keep hold of all that information too. Once qualified, annual reports will be required containing full disclosure of portfolio composition, activities of the previous year and the social outcomes and profits made together with where they were distributed. Investors will be needing all this information too when marketing.
By far the hardest, most intangible requirement will be creating a method of valuing the qualifying undertakings in terms of social impact. ESMA has been onto this and, earlier this year, published their final report draft technical advice with this and three other areas of the regulation that are similarly difficulty to classify:
- Specifying the types of goods and services – ESMA has ultimately provided a non-exhaustive list of circumstances where the social enterprise may be a qualifying undertaking, but the manager will decide on a case by case basis whether the business meets the requirements
- Guidance on managing conflicts of interest – a policy will be written up by the manager which is appropriate to their business and the potential conflicts
- Procedures for measuring social impact – a methodology appropriate to the size and complexity of the business should be used, involving all relevant stakeholders in the process (such as the social business itself)
- Process to disclose information on investments to investors – specific information will be required surrounding the nature of the asset and the strategy of the SEF with regards to this specific investment (i.e., how they intend to fund this investment).
The report inevitably leaves a lot of the remit to the managers to decide on what’s right and wrong for their specific business model, but that by no means provides an excuse to be laid back on requirements.
Which leads us to the fun part. Administrative penalties will be dealt out mainly for failure to comply with:
- Portfolio composition requirements
- General operational requirements (such as applying policies that discourage malpractice)
- Safeguards on eligible investors
- The use of the designated term EuSEF.
In short, this is a boost to all stakeholders on the social impact side of the economy. For investors, you get clarity and distinction; for EuSEFs, you get recognition and privilege; for social businesses, you get the funding that, prior to EuSEF, had been an incredible struggle to acquire.
Next up in the timeline …
On 22 July 2017 the European Commission are to review and report to the European Parliament and Council of the EU on the EuVECA and EuSEF Regulation, the interactions between them and other rules on collective investment undertakings and their managers. The main aims of the upcoming reviews will be to assess the market of the qualifying SEFs, to compare those affected by EuSEF regulation to those affected by the collective investment undertakings regulation (UCITS), to look at how to make EuSEF more inclusive, identify any possible tax obstacles or incentives and further remove barriers to investment.
With this in mind, keep an eye out for further progression down the SEF line. We certainly will be.
[1] In debating the correct threshold, it was decided that 50% would be too low for the more cause-dedicated investors and 90% would significantly remove the procedures to mitigate risk (i.e., not putting all the eggs in one basket, maintaining liquidity).