At a roundtable hosted in late September in London by Debevoise & Plimpton, investment bankers, private equity deal professionals and representatives of other financial institutions assembled to discuss the investment opportunities resulting from the post-financial crisis restructuring of insurers and banks in the European Union. The principal speakers included: Jacques Aigrain, Chairman of LCH Group and Senior Adviser of Warburg Pincus; Eric Dinallo, Debevoise partner and former Superintendent of Insurance for the State of New York; Jeremy Hill, Debevoise partner and co-chair of the firm’s Financial Institutions Group; Gregory Lyons, Debevoise partner and chair of the firm’s Global M&A Banking Practice; and Richard Ward, Debevoise partner and chair of the firm’s U.K. tax practice.
The roundtable participants first discussed the post-2008 investment opportunities for private equity and strategic acquirers; then turned to the specific regulatory and market issues driving these opportunities; and finally addressed the key structuring considerations for deal professionals considering a potential investment in an E.U. insurer or bank, or in its assets.
The Evolving Opportunity
The investment bankers and deal professionals participating in the Debevoise roundtable identified three phases of crisis/post-crisis financial institution M&A activity. Phase 1, largely at the outset of the financial crisis, was characterized by nationalizations and recapitalizations. Phase 2, in the early-to-mid post-crisis period, saw fire sales of distressed assets to enable institutions to weather the crisis. In Phase 3, which is now beginning in earnest, banks, insurers and other financial services players are: evaluating the new regulatory landscape that is coming into focus and the associated costs; identifying their core and non-core activities based on a variety of criteria; and engaging in strategic sales and other transactions accordingly.
Private equity firms and other non-financial services players will have the opportunity to play a prominent role in Phase 3, whether: acquiring divested assets; purchasing business lines that were de-emphasized or terminated by financial institutions as a result of prohibitions and costs imposed by new regulation or due to inadequate returns given the new constraints; or investing in or with strategic acquirers.
The financial services industry in the E.U., particularly in the Eurozone, is experiencing a major phase of transition and regulatory change. For example, from November 4, 2014, after the latest stress test results are released, the European Central Bank (the ECB) will be the regulator of the 120 largest banks in the Eurozone (and other member states that opt in), representing 85% of banking assets, and will be responsible for the Single Supervisory Mechanism (SSM) within the Eurozone. In addition to the SSM, the Single Resolution Mechanism (SRM) – a single set of rules across the Eurozone to allow for the timely and effective resolution of cross-border and domestic banks – is expected to be operational from January 1, 2016. Additional regulatory initiatives, such as the Solvency II framework for insurers, which is due to come into force in January 2016, and the Basel III framework for banks, which will continue to phase in through 2019, will increase investment opportunities for private equity firms and other less regulated entities.
The above and other factors driving restructurings of insurers and banks in the E.U. are discussed below. Notably, while insurers and banks have distinct regulatory and business concerns, in many regulatory areas (e.g., new capital requirements and resolution planning) the rules, and the stresses they create, are or are anticipated to be similar for both. Experience and expertise with respect to both the banking and insurance regulatory frameworks will best position banks, insurers and private equity firm acquirers to succeed as Phase 3 plays out over the next several years.
Principal Drivers of E.U. Insurance Restructuring
Two key factors have driven restructuring in the insurance sector over the past several years, specifically: (1) state forced sales, some of which have taken the form of public share offerings (ING is a good example of this) and (2) the expected implementation of Solvency II in 2016, which will include more onerous capital, financial modelling and supervisory requirements.
In addition to these two factors, developing and increasingly onerous new global capital standards, along with coming resolution plans and other regulatory initiatives discussed below, are expected to drive additional restructurings. These new drivers provide substantial incentives for insurers to consider carefully which assets/business lines are strategic, and which they should dispose of to increase profitability and/or reduce capital and regulatory complexity.
Insurers in the E.U. are increasingly facing the question of whether to keep smaller subsidiaries burdened by significant regulatory requirements or to sell those subsidiaries. In the U.K., insurance business can be transferred as provided in Part VII of the Financial Services and Markets Act 2000; this is a Court-sanctioned transfer of the assets and liabilities of a particular book of business to a new owner. Similar arrangements exist in most other E.U. member states in respect of both insurance and banking business transfers.
New Global Capital and Regulatory Requirements—G-SII Designation. Potential additional drivers of restructurings include the Financial Stability Board’s (the FSB’s) designation of Globally Systemically Important Insurers (G-SIIs). In July 2013 the FSB designated nine insurers as G-SIIs, of which five were E.U.-domiciled. G-SIIs (like the bank analogue, Globally Systemically Important Banks, or G-SIBs, first designated in 2011) are the insurers determined by the FSB to be the internationally active insurance groups (IAIGs) most critical to a healthy global economy. The FSB will conduct its first annual update of the G-SII list in November 2014, and may expand this list further to include several global re-insurers. As discussed below, designation as a G-SII involves the imposition of additional regulation, oversight and costs, which could lead those insurers to restructure.
New Global Capital and Regulatory Requirements—Basic Capital Framework. Many observers expect a new, consolidated capital framework (the Basic Capital Requirements) to be finalized for G-SIIs at the Brisbane Summit in November 2014, with capital surcharges (again, similar to G-SIBs being imposed upon G-SIIs in 2015. Debevoise explained how detailed analysis it had performed of the Basic Capital Requirements shows that many elements of that framework are similar to the Basel III capital framework for banks. U.S. insurers designated as non-bank Systemically Important Financial Institutions (or SIFIs) (and thus potentially subject to the U.S. bank capital framework) have stated strongly that these bank-like rules are not compatible with their industry.
New Global Capital and Regulatory Requirements—ComFrame. For large IAIGs not designated as G-SIIs, the International Association of Insurance Supervisors (IAIS), a multi-lateral regulatory body for the insurance industry, is expected to discuss at its late October 2014 meeting in Amsterdam, and to finalize in 2016, a common supervisory framework (ComFrame). While not as burdensome as the rules applicable to G-SIIs, ComFrame is nonetheless expected to have a significant impact on affected insurers.
Required Recovery and Resolution Plans. In addition to the capital and supervisory rules mentioned above, FSB standards contemplate that G-SIIs will complete recovery and resolution plans. Such plans would detail how G-SIIs should be wound up in times of severe stress so as to minimize damage to the economy. Debevoise participants in the roundtable discussed how they assisted a U.S. non-bank SIFI to complete its first recovery and resolution plan this year. The several thousand-page plan (also based in large part on banking law principles) involved significant fact finding, strategic thinking to reduce complexity and extensive discussions with regulators.
Resolution planning is on the agenda for the IAIS late October meetings in Amsterdam. Debevoise will be hosting a dinner there to discuss resolution planning with G-SII and IAIG representatives.
For both G-SIIs and IAIGs, all these developing and increasingly onerous global capital standards and the coming resolution plans and other regulatory initiatives are expected to drive additional E.U. restructurings of insurers, leading to increased investment opportunities for private equity and other non-financial services investors.
Principal Drivers of E.U. Bank Restructuring
Global banks have been seeking to adapt to increasing regulatory burdens for several years longer than their insurance counterparts, and thus the response of the banks provides a window not only onto the evolving banking landscape, but also useful insights for insurance dealmakers seeking to predict future trends. According to a 2013 survey of large banks conducted by Ernst & Young and the Institute of International Finance, 81% of bank respondents are evaluating their assets mix and 44% are considering exiting business lines. Subsequent surveys and studies suggest that this trend will continue. For example, a 2014 impact study by European banking regulators stated that the banking industry shortfall to Basel III capital ratio requirements could be as high as € 36.3 billion. Similarly, liquidity rules could result in a shortfall of high-quality liquid assets for banks as high as € 262 billion. According to 64% of large bank respondents to this 2014 survey, together these rules will have a “significant” effect on the cost of doing business.
Sixteen of the 29 G-SIBs have their primary banking operations in the E.U. Like G-SIIs, these banking institutions are subject to the most burdensome capital, liquidity and other regulatory burdens. As a result, these 16 E.U. banks are on track for € 100 billion in asset sales this year, according to a report in the Financial Times, which also noted that € 2.4 trillion of non-core assets remain on their balance sheets.
Particularly given that ECB stress test results are due at the end of October 2014, and that the ECB has declared that it will enforce stricter prudential oversight, these banks can be expected to provide substantial deal opportunities. Rules still to come fully into force, such as the Net Stable Funding Ratio, the Volcker Rule and the regulations enacting the recommendations in the Liikanen and Vickers reports, in the E.U. and U.K., respectively, as well as pending resolution plans (which already have had an impact on U.S. banks) will further accelerate the necessary re-positioning of these banks. The roundtable participants discussed how private equity firms and other non-financial services sector investors, which are outside the scope of these regulations and additional burdens, can benefit substantially from these developments.
Finally the conversation turned to the best way to approach acquisitions of these assets and operations by private equity firms or other acquirers.
Non-Tax Structuring Considerations. A potential buyer of insurers or banks or their assets will have to ensure, among other things, that:
- the relevant regulator is satisfied that policyholder/depositor interests will not be prejudiced as a result of the sale (for example, particularly in the case of private equity and other potential investment firms, the relevant regulator may require the structure of the target board to be altered to ensure that policyholder/depositor interests are adequately protected);
- there is a regulated entity in a suitable jurisdiction that will take over the carrying on of the regulated activity in question (the establishment of a branch or a subsidiary and E.U. passporting rules will need to be considered); and
- in the case of sales of state-owned assets, limitations on due diligence, representations, warranties and indemnities must be duly considered and reflected, as appropriate, in the price and deal documents.
A financial buyer should also be mindful of the requirements of the E.U. Acquisitions Directive, which applies to transactions involving banks and insurers whenever 10% or more of the shares or voting power of the regulated entity or its parent is proposed to be acquired. The Acquisitions Directive imposes extensive disclosure obligations on the potential acquirer, which include disclosure of the owners of the acquirer. In the private investment funds context, this may involve looking at the fund’s general partner and anyone who exercises significant influence over the general partner, and even could involve limited partners. The buyer will also need to satisfy the relevant regulator that it is adequately capitalised to provide sufficient policyholder/depositor protection on an on-going basis.
Tax Structuring Considerations. Tax analysis should focus on tax optimisation for the acquisition itself, the taxation of the ongoing operations of the business to be acquired (including the distribution of profits) and the tax treatment of any exit (whether partial or complete). This analysis is complex and fact-specific in a cross-border context. In the E.U., dividends can flow up holding company structures without tax liabilities across multiple jurisdictions. Holding companies are conventionally incorporated in Luxembourg or Ireland although other jurisdictions (including the U.K.) are also being used, all of which have participation exemption regimes for dividends and capital gains (the U.K. is also unusual in having no withholding tax under domestic law for dividends). Luxembourg is still largely the preferred jurisdiction for incorporating holding companies, given its tax authorities’ flexible approach to rulings.
From a tax perspective, it is often easier to control profits within a group via a subsidiary rather than a branch structure, which may be somewhat at odds with the regulatory preference for operations within the E.U. (although a branch structure may be less disadvantageous where the local businesses operate on a standalone basis). Transaction taxes in the context of insurance restructuring may focus on VAT issues, because the incidence of VAT on any business sale may give rise to significant tax leakage: this may force any restructuring to take the form of reinsurance (rather than an asset sale).
The roundtable discussion concluded with an interactive discussion between private equity firms, investment banks and the other participants about the foregoing and with the general consensus that this is a time of potentially significant opportunities for private equity and other investors in the insurance and banking sectors which merit careful analysis and evaluation.