Ethical Investment

The new European fund structure for social business

JAMES CAMPBELL, SHEARMAN & STERLING LLP

The European Parliament is due to vote upon the draft Regulation on European Social Entrepreneurship Funds on 12 March 2013. The Regulation proposes to create a new EU-wide investment fund framework for investment in “social businesses”, which aims to address obstacles – both regulatory and practical – to investors wishing to invest in social businesses, and to social businesses who need investment to grow. EU members are keen to capitalise on the ability of social businesses to contribute to social cohesion, employment and to reducing social inequalities.

Social business (SB) refers to the wide class of undertakings who aim to achieve social objectives as their primary purpose. SBs may take a variety of legal forms, including limited company and charity, and operate in areas such as access to housing, healthcare, assistance for the disabled and access to employment and training. An example of a SB might include, for example, a company which relies on a range of income sources including sales of products and grants to provide work-based training for youth in an area of high unemployment. Theability of SBs to distribute some profits – albeit secondarily to their primary objective – coupled with rapid growth of the sector in recent years has led many investment funds to identify SBs as a target for investment.

The regulatory environment, however, has long been described as unfit for the needs of SBs and investors. Firstly, investors who wish to raise cross-border finance must negotiate complex and inconsistent national rules on private placements. Secondly, existing fund structures do not take into account the unique characteristics of SBs. For example, most SBs are unlisted and many funds, such as funds designated under the Undertakings for Collective Investment in Transferable Securities (UCITS) regime, are restricted to a relatively limited investment in non-listed shares. Further, existing fund structures often come attached with onerous requirements with respect to diversification and eligibility of assets which were not drafted with SBs in mind. Thirdly, confusion in the market as to what a SB is, and how to separate it from other businesses, has undermined confidence and inhibited investment in the sector.

The Regulation – creating a bespoke financial regulatory framework for SBs – appears to tackle these issues directly.

Criteria
The Regulation creates a voluntary regulatory regime for fund managers who choose to market funds investing in SBs, under the European Social Entrepreneurship Fund (ESEF) label. To qualify for the regime, ESEF managers must have less than €500 million of ESEF-qualifying funds under management, and may market ESEFs across the EU to sophisticated investors who are either “professional investors”, or who otherwise commit to invest a minimum of €100,000. ESEFs are defined in the Regulation as collective investment undertakings which invest at least 70% of their aggregate capital contributions and uncalled capital in “qualifying investments”. The key type of qualifying investment is an equity instrument, such as a share, that is issued by, or in limited circumstances on behalf of, a qualifying portfolio undertaking. Qualifying portfolio undertakings – which may be read to mean “social businesses” – are non-listed undertakings which have an annual turnover of no more than €50 million or an annual balance sheet total of no more than €43 million, and whose primary objective is to achieve measurable, positive social impacts.

ESEF managers may not increase the exposure of the ESEF and may not borrow, issue debt obligations, provide guarantees or engage in derivative positions at the level of the fund. For defined short-term liquidity purposes, a carefully circumscribed exception exists for non-renewable borrowings of no longer than 120 calendar days. ESEFs are supervised by competent authorities of the member states in which they are based – in the UK, this will be the new Financial Conduct Authority – with oversight by the European Securities and Markets Authority. Once the ESEF is registered at member state level, the registration is valid for the entire EU and the manager may market the fund immediately.

Comment
Firstly, the absence of a list of specified “social business” or detailed criteria, save that they must have a “positive social impact” is to be welcomed. An inclusive approach is necessary to capture the variety of social business at both national and local level. Subjectivity as to what constitutes a “positive” social business is tempered by the requirement that the Charter of Fundamental Rights of the EU must be respected – an avowedly “anti-immigration” charity which seeks to market itself as a SB would not be able to gain the benefit of ESEF designation.

Secondly, eligibility requirements for managers (such as the €500 million cap on investment in ESEF assets), investors (who must be either professional investors or have more than €100,000 to commit), and SBs (who must have a €50 million annual turnover or less) – while arguably sufficient for the vast majority of SBs which resemble small and medium enterprises – may not adequately take into account expectations for growth in the sector and a need for bigger investment in the future.

Thirdly, the creation of a trusted brand is central to the Commission’s objectives. There is a danger that this may be undermined by marketplace confusion caused by the unquestionably high 30% element of the ESEF portfolio which may be applied to another, non-SB, purpose. However, various requirements for reporting achievement of social objectives on an ongoing basis, such as in the annual report, may – subject to appropriate enforcement of the Regulation by national regulators – successfully mitigate this risk.

Finally, the proposals allow investors to extract some profits from the ESEF – albeit in a way which is consistent with the primary social objective. There are, however, few rules as to how this is achieved. The main principle is that, where profits are distributed to shareholders, “pre-defined procedures and rules” are agreed. Investors must not misinterpret the spirit of the legislation by imposing onerous investment terms on SBs – the spirit of the primary social objective will need to be complied with.

Notwithstanding the risks outlined above, it is clear that the Regulation goes a long way towards creating a distinct investment brand for SBs. Despite initial compliance costs, fund managers will benefit from easier marketability of SB-focused funds. Crucially, the Regulation is not mandatory – if the requirements do not suit, fund managers may choose an alternative regime. As noted above, the state has an interest in promoting investment in SBs – the Recitals to the Regulation note the ability of SBs to offer “innovative solutions to social problems”. Fund managers will hope that the existence of a tailored regulatory framework for SBs may influence the choices of investors who would not otherwise consider SB investment. At the very least, SBs will welcome the potential for a leveling of the playing field with more traditional business structures as more sources of funding become available.

James Campbell is an Associate in the Financial Institutions Advisory & Financial Regulatory Team at Shearman & Sterling LLP.