On 7 December 2011, the European Commission published a proposal for a Regulation introducing a new EU-wide fund structure: the "European Social Entrepreneurship Fund" ("EuSEF").
Prompted by the Single Market Act in 2011, and following a two month consultation over the summer of 2011, the new regime is the brainchild of the Commission's Social Business Initiative, which recognises "social business" as an important emerging sector within the broader investment context. The initiative defines social business as one of the twelve key levers for an effective relaunch of the single market, and identifies as a priority the setting up of a European framework facilitating the development of social investment funds.
The December 2011 proposal by the Commission draws on, and develops, the consultation which it published in July 2011, which invited feedback from stakeholders and investors regarding the viability and desirability of a bespoke social investment vehicle. A range of bodies including the Investment Management Association in the United Kingdom (the "IMA") submitted responses, aspects of which are also reflected in the proposal.
The Consultation defines a "social business" as an undertaking the primary objective of which is the achievement of a positive social impact, rather than financial gain. Essentially hybrid structures, combining aspects of the for-profit and philanthropic sectors, their key features include:
- the achievement of social, ethical or environmental outcomes as a key corporate aim;
- reinvestment of profits and no, or only limited, profit distributions to investors; and
- adherence to specific governance arrangements, for example, by addressing social goals in their internal organisation.
Part of the value of social businesses lies in their ability to bridge the divide between mainstream businesses and charitable activities, combining commercial and philanthropic principles to provide innovative solutions to social problems, whilst also yielding a partial financial return. Social businesses can also play an important role in bringing together the public and private sectors, complementing State provision and furthering public policy goals through private investment and management.
However, the hybrid nature of a social enterprise fund brings challenges for social businesses too. Social businesses can face difficulties accessing either conventional or philanthropic funding precisely because they do not conform to recognised for-profit or not-for-profit structures.
The Commission's consultation noted that at present social businesses have very limited access to mainstream capital markets. The majority of such businesses are unlisted, and whilst investment funds are theoretically able to invest in them, the diversification and liquidity requirements imposed by existing regimes make these regimes suboptimal as a means of channelling capital towards social investment. UCITS funds are currently limited to 10 per cent investment in non-listed shares and NURS funds to 20 per cent. Both require liquidity levels that funds dedicated to social investment may find it difficult to achieve.
The Commission further recognised that the regulation of private placements is not currently tailored to meet the needs of social investment. Cross-border fundraising for non-listed entities is a complex and expensive process, and despite keen investor interest, regulatory obstacles have stunted the growth of larger, more efficient social investment funds.
In addition, there is confusion in the market concerning social investment, with competing structures claiming social or ethical credentials. The absence of a shared, coherent vision of what constitutes a social business has, in the view of the Commission, undermined investor confidence and inhibited investment in this sector.
A Bespoke Funds Regime?
The Commission consulted on a range of possible options which could be implemented either supplementary to, or independent of, a bespoke fund structure and regime. In particular, measures to enhance and standardise disclosure regarding social impact and returns, and the development of a common approach to defining and rating funds, with regulation and oversight being delegated to independent social assessment agencies, were considered.
The Consultation also noted that tax incentives could be used to achieve the desired outcome. This suggestion was particularly welcomed in the United Kingdom by the IMA, whose response identified tax benefits for investors, and exemptions for the funds themselves, as central to stimulating and sustaining investor interest in the sector. The IMA also identified a range of existing specialised funds and tax reliefs which can be targeted at social business: in particular, Venture Capital Trusts with an ethical focus, Enterprise Investment Schemes for smaller unquoted trading companies, and Community Investment Tax Relief Schemes for investing in accredited community development finance institutions. The IMA's response also noted proposals for the introduction of a "Green ISA" for stimulating environmental investment. However, the IMA acknowledged that take-up has been disappointing for many of these schemes so far.
The conclusion of the Commission was that an over-arching, high visibility framework implemented and endorsed at EU level is now required. In the view of the Commission, favourable tax rules will play an important part in facilitating the flow of capital to EuSEFs. However, action at the EU level is necessary to enable funds to access investors across all markets. It is hoped that this will lead to greater consistency and clarity for investors.
Outline of the Proposed Regime
The EuSEF "Brand"
Uniformity is the byword of the Commission's proposals. The Commission sees the establishment of a "trusted, safe and legally stable marketing environment" as key to building investor confidence in an EuSEF brand, and is keen to ensure that uniform conditions and standards are enforced across all jurisdictions.
The Commission's proposal identifies three key objectives:
- improving clarity and comparability through the development of a trusted brand;
- improving the tools for assessing and analysing social impact; and
- enabling greater ease of movement across Europe and better reflecting the needs of social funds in the rules applied to them.
As an indication of the Commission's commitment to a dedicated, homogenous regime for social investment, and in contrast to the AIFM and UCITS Directives, the proposed framework has been drafted as a Regulation, and as such will not require national transposition in order to have legal effect.
The Commission's consultation acknowledged that funds investing in social business are likely to differ from mainstream investment vehicles in various important respects. In particular, characteristics such as lower liquidity, less frequent valuations, more flexible reporting, limits on redemption, more distant investment horizons and alternative remuneration structures were identified in this context.
The consultation further suggested that, in order to maintain acceptable liquidity levels, social funds may need to consider diversification across a range of social businesses, or alternatively hybridisation, whereby illiquid, "slow-burn" social investments are offset against highly liquid transferable assets. Having consulted on a minimum investment in social business of 60 per cent, the Commission's proposal now increases this to a minimum investment of 70 per cent of the funds under management.
The proposal also sets out uniform quality criteria for funds operating under the EuSEF designation, including specific requirements regarding portfolio composition, qualifying investment tools, qualifying investment targets, eligible investors and the internal organisation of fund managers. In recognition of the sector's diverse funding sources, the range of qualifying investment tools will be broad, including public and private finance, debt instruments, investment in other EuSEFs and small and medium term loans. The Regulation will also set out rules for EuSEF managers relating to conduct of business, relationships with investors and conflict of interest policies (which it is assumed will be broadly modelled on UCITS Directive requirements).
Providing reliable data on social impact will be particularly important for funds producing lower financial returns. So the Commission's consultation also sought advice on how best to quantify social returns. It acknowledged that asset valuation and reporting may be expensive and imprecise, and invited input on other reliable methods of assessment.
The IMA's response agreed with the Commission's approach, stressing the importance of transparency, and suggesting that clear information about risk, liquidity and reduced redemption rights should be provided in an equivalent to the prospectus or the KIID of an authorised investment fund.
The Commission's proposal reflects these concerns by requiring an EuSEF to provide key information to its investors in a standardised format, including the social objectives of the fund, the businesses it invests in and how the fund plans to assess their success. As with UCITS funds, EuSEFs will be required to make pre-contractual general disclosures, and supply information on costs and charges and associated risk/reward profiles. Regarding quantification of social impact, provision is made in the proposal for further research on the best methods of measuring non-financial returns from different portfolio undertakings.
Regulation and Passporting
In line with the IMA's recommendation that fund managers should not be subject to additional burdens, especially in the light of the existing complex regimes such as UCITS, MiFID and the AIFMD, the EuSEF regime is to be elective rather than mandatory. Funds wishing to use the new designation will be required to register with the competent national authority in their home State, and will thereafter be regulated by that authority, which will have the power to strip them of the EuSEF label if they fail meet appropriate investment and transparency standards. ESMA will also play a role in coordinating regulation between competent national authorities, and maintaining a central database of all registered EuSEFs.
In return, EuSEF funds will be granted the same passporting rights as existing fund structures, enabling managers to market them across Europe, and to overcome the uneven distribution of capital available for social investment. In that regard, the proposal also answers concerns raised by the IMA regarding the lack of investible propositions offering equity in the social business sector, which, it cautioned, may make it hard for funds to meet appropriate diversity requirements while at the same time maintaining a strong social investment focus.
The Commission's consultation envisaged retail investors being involved from the outset. By contrast, its latest proposal now specifically limits eligible investors to professional investors and a small group of traditional investors in social enterprise (high net worth individuals, family offices, angel investors and philanthropists). Investors from the latter group must be willing to commit a minimum of €100,000. This restriction is presumably intended to limit risk and build consumer confidence in the brand before it is rolled out into the retail market at a later date.
The EuSEF designation will also only available to funds with less than €500 million under management.
The advent of a new fund structure to stimulate social investment is in many ways an innovative and interesting development for the investment sector as a whole, opening up new opportunities for the inflow of capital to social business and social entrepreneurs, albeit that it will necessitate a fourth EU regulatory regime for investment funds (i.e., in addition to UCITs, NURSs and Alternative Investment Funds and a proposed new regime for venture capital funds).
The Commission's decision to require a high minimum investment in social business, the initial restriction to professional and business investors, and the emphasis placed on uniformity and quality throughout the proposal, all point towards a broader intention to establish a distinct, identifiable and trustworthy brand that will raise the profile of social investment and build investor confidence in the sector. However, these restrictions also limit the pool of potential investors, and possibly also the number of EuSEF funds that the social business sector can sustain.
It remains to be seen whether the Commission's cautious, quality-conscious approach will foster the kind of focussed brand awareness it hopes to create, or limit take-up to a small number of particularly committed investors.
The proposal will now be reviewed by the Council of the European Council and the European Parliament, but it is anticipated that EuSEFs
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.