M&A feels the cold wind of regulation

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Slowly and stealthily a regulatory net is closing in on M&A in Europe. Many of the measures looming over the horizon have little direct connection with M&A but collectively they could significantly alter the climate in which deals are done, the tactics employed and ultimately the costs and complexity of deals.

Mergers and acquisitions practitioners may be feeling a little smug that their corner of the financial forest has escaped the regulatory onslaught the financial crisis unleashed. But they should not be so confident. Slowly and stealthily a regulatory net is closing in on M&A in Europe. Many of the measures looming over the horizon have little direct connection with M&A but collectively they could significantly alter the climate in which deals are done, the tactics employed and ultimately the costs and complexity of deals.

Without doubt, the political climate has changed. Many of the measures – such as the introduction of a new pan-European regulatory structure and the Alternative Investment Fund Managers directive governing hedge funds and private equity, among others – are essentially political. They are a reaction to the perceived causes of the crisis and voters’ demands for action. They are also seen in London as the continuation of a long-running Franco-German campaign to clip the City’s wings.

This is a bit paranoid, but given that London is the financial capital of Europe the City is right to look closely at the small print of, and motives behind, the avalanche of regulatory measures crashing down on it.

Take the proposed European System of Financial Supervisors, which the European parliament recently approved. There will be three bodies: the European Banking Authority; the European Securities and Markets Authority; and the European Insurance and Occupational Pension Authority. In addition, there will be a European Systemic Risk Board.

National supervisors will be represented on all these bodies. But the centre of decision-making is inexorably shifting to the European Union level.

This can be justified by arguing that it improves the functioning of the internal market – a desirable outcome to which all EU members are supposedly committed. However, the new structure will increase the chances of EU level intervention in all types of financial activity at the national level, including M&A. Whether or not this is part of a Continental, Eurozone strategy, that is likely to be the result.

The same point applies to the more technical, but no less pertinent, planned changes to rules governing derivatives trading and shorting stock. By forcing most derivative trading on to exchanges and into the light of day, and greatly restricting the use of opaque over-the-counter instruments, Michel Barnier, the French EU internal market commissioner, believes he is addressing a cause of the crisis. Similar thinking underlies plans to make market operators disclose to regulators net short positions once they reach 0.2% of issued share capital, and make public positions of more than 0.5%.

Changing M&A practices is not the stated intention – and to be fair, is probably not the unstated intention. But derivatives and shorting have long lurked in the investment banker’s armoury.

Not long ago, concealing a potential position in a target company by, for example, buying call options on its stock was quite common. The rules were tightened in London to make disclosure of complete consequential holdings mandatory, but derivatives are still a useful way of finessing exposure to a stock.

Shorting has been a chosen tactic of hedge funds, so much so that it was temporarily banned during the crisis. The ban has been lifted in London and shorting is back. In practice, 0.5% of a large company whose capitalisation is measured in tens of billions is a bigger exposure than some funds would risk.

However, it is within the capacity of the leading funds, which might find the need to go public a deterrent. Investors might even feel that reporting to the regulators once the 0.2% threshold is reached is a deterrent as well. After all, what might the regulators do, especially in this more interventionist climate?

Another example of perverse consequences is the more stringent capital requirements being placed on banks. Strengthening bank balance sheets may reduce the amount of funding available for M&A – which is a little ironic when interest rates remain so low.

In some ways, that is no bad thing. In the boom years, readily available financing fuelled deals that might otherwise have been hard to justify, not least by private equity houses. But restructuring will become more important as economic activity picks up and banks may not be able to play their full part.

The collective consequence of all these and other regulatory changes could be to make M&A more complex and costly. Whatever Europe’s regulators and politicians aim to do, that is a poor outcome for the EU. M&A will not escape the regulatory embrace.

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