Private funds regulatory update
In this edition, we:
- analyse recent UK and EU developments which indicate that the regulatory direction of travel is a renewed focus on ensuring that firms maintain adequate financial resources;
- focus on the ability of private fund managers to manage, and otherwise provide investment services to, fund vehicles in two key fund jurisdictions (Ireland and Luxembourg) post-Brexit; and
- provide a timeline of key upcoming UK and EU regulatory developments impacting private fund managers.
1. Increased UK and EU regulatory focus on regulatory capital
Recent UK and EU developments indicate that the regulatory direction of travel is a renewed focus on ensuring that firms maintain adequate financial resources. In particular, private fund managers should be aware, and assess the potential impact, of:
- the EU proposed prudential requirements for MiFID investment firms as contained in the Investment Firms Regulation (IFR) and Investment Firms Directive (the IFD) (together, the EU Prudential Proposals); and
- the Financial Conduct Authority’s (FCA) consultation paper on assessing adequate financial resources (CP19/20).
EU Prudential Proposals
What is the purpose of the EU Prudential Proposals?
The EU Prudential Proposals are intended to create a common prudential framework that takes into account the particular risks faced by investment firms in contrast to the current regime imposed by the Capital Requirements Regulation (CRR) and Capital Requirements Directive (CRD) IV Directive. Significantly the EU Prudential Proposals will apply a more stringent regulatory capital regime to many private fund managers.
Do the changes apply to adviser/arrangers?
Many private fund managers (including private equity firms and credit fund managers) are structured as “adviser/arranger firms”. For example, this includes those firms that have a UK-based adviser that provides investment advice to a fund manager that it often located outside of the EEA which takes the discretionary investment management decision with respect to the investment portfolio.
The EU Prudential Proposals will have a significant impact on adviser/arranger firms. Such firms currently benefit from a lighter touch regulatory capital regime (with some firms currently able to hold as little as £5,000 in regulatory capital). Most adviser/arranger firms are likely to have to hold significantly higher amounts of capital under the new proposals (see What changes are there to how firms calculate capital requirements?).
Do the EU Prudential Proposals apply to Alternative Investment Fund Managers (AIFMs)?
Private fund managers are also often subject to the Alternative Investment Fund Managers Directive (AIFMD) as AIFMs. However, the EU Prudential Proposals apply to MiFID investment firms and do not directly impact AIFMs authorised under AIFMD. Nevertheless, such firms could be impacted if the EU adopts a similar approach to certain issues when undertaking the upcoming AIFMD review.
Some private fund managers are authorised under the AIFMD but are also permitted to undertake certain MiFID investment services. This would include a private equity firm that can manage alternative investment funds (AIFs) but can also provide portfolio management services to, for example, other AIFMs on a delegated basis. From an FCA perspective, such firms are categorised as collective portfolio management investment (CPMI) firms. It is unclear at this stage how the EU Prudential Proposals will apply to CPMI firms and it will depend whether the FCA chooses to apply the requirements to such firms.
Other private fund managers are subject to a lighter application of the AIFMD due to the level of their assets under management. The EU proposals will also likely apply to the MiFID business of sub-threshold AIFMs.
Do the EU Prudential Proposals apply to delegated portfolio managers?
Certain private fund managers are not AIFMs but are authorised by the FCA to provide portfolio management services, often on a delegated basis by a fund manager in the same group that is authorised in the EEA (for example by the CSSF in Luxembourg). Some private fund managers have structured their operations in this manner in anticipation of Brexit. The new regime will apply to private fund managers that are delegated portfolio managers.
How do the EU Prudential Proposals categorise investment firms?
The EU Prudential Proposals apply to the three categories of investment firm.
- Class 1 firms – “Systemically important investment firms” that are to be treated as credit institutions and “large investment firms” that are not treated as credit institutions that will continue to be subject to the CRR/CRD IV regime. This category will apply to a very small number of investment firms.
- Class 2 firms – Investment firms that do not fall within Class 1 or Class 3 and will, therefore, be subject to the full application of the EU Prudential Proposals.
- Class 3 firms – Small and non-interconnected investment firms that are subject to a partial application of the new regime. A series of quantitative tests are applied to determine whether a firm is a Class 3 firm. All of the tests must be satisfied in order to benefit from a lighter application of the regime. Of particular relevance to private fund managers is that assets under management (which includes non-discretionary arrangements involving investment advice of an ongoing nature) must be less than €1.2bn.
It is unlikely that many, if any, private fund managers will be categorised as Class 1 firms. The majority will be categorised as Class 2 firms, therefore, this bulletin focuses on the impact of the EU Prudential Proposals on Class 2 firms. Some smaller private fund managers may be able to avail themselves of the regime for Class 3 firms – firms will need to undertake an assessment on a case-by-case basis to determine this.
Subject to transitional measures, investments firms will be required to hold at all times own funds at least equal to the highest of its: (1) fixed overheads requirement (FOR); (2) permanent minimum requirement; and (3) K-factor requirement.
The FOR is at least one quarter of fixed overheads based on the previous year. The calculation is likely to be similar to the CRR calculation. The permanent minimum requirement is a fixed sum that a firm must always hold as a floor to its regulatory capital requirements. For most adviser/arranger firms this will be €75,000.
The K-factor requirement is a series of quantitative factors to determine the risks posed by the activities of an investment firm. The K-factors are divided into three groups.
- Risk-to-Customer (RtC) K-factors – These K-factors relate to assets under management (including non-discretionary arrangements constituting investment advice of an ongoing nature), client money held, assets safeguarded and administered and client orders handled. Each must be calculated on a rolling average basis and multiplied by a coefficient.
- Risk-to-Market (RtM) K-factors – These K-factors relate to clearing member guarantee and net position risk. These K-factors are only relevant for the trading book positions of an investment firm with permission to deal on own account.
- Risk-to-Firm (RtF) K-factors – These K-factors relate to concentration risk, daily trading flow and trading counterparty default risk. The calculation requires the aggregation of these components and, as applicable, the application of a coefficient.
Investment firms will also be subject to provisions on concentration risk, liquidity requirements, disclosures and regulatory reporting.
The new regime will be particularly onerous for firms that have not previously been subject to a regulatory capital regime applying a fixed overheads requirement. This will include private fund managers that are “exempt CAD” firms and currently benefit from a lighter touch regulatory capital regime.
What do the EU Prudential Proposals mean for remuneration and governance?
The EU Prudential Proposals contain a modified version of the requirements contained in the CRD IV Directive. The IFD introduces requirements relating to internal governance, country-by-country reporting, treatment of risk, remuneration policies, variable remuneration, remuneration committees and oversight of remuneration policies. These provisions will not apply to all Class 2 firms. However, it will subject some private fund managers to a detailed remuneration code when previously they were only subject to overarching principles including a duty not to promote excessive risk taking.
Do the EU Prudential Proposals contain consolidation provisions?
Yes – a parent investment firm, parent investment holding company or parent mixed financial holding company in the EU must comply on an individual and consolidated basis with the new regime as to own funds composition, capital requirements calculations, concentration risk, liquidity requirements, disclosure and reporting.
However, there is some limited scope for national competent authorities to apply a lighter touch regime where it regards that there are no significant risks to clients or the market by not applying consolidated supervision. Importantly, where prudential consolidation applies, requirements relating to internal governance, transparency, treatment of risks and remuneration apply on a solo and consolidated basis. The application of consolidation requirements will be new to some private fund managers that were not subject to consolidation provisions previously.
This could particularly impact firms where debt has been injected at the level of an onshore holding company.
When do the EU Prudential Proposals come into force?
The EU Prudential Proposals have been passed by the European Parliament and will become law, subject to adoption by the European Council. Although there are some transitional provisions, it is likely that the new regime will apply in late 2020 or early 2021.
What is the likely impact of Brexit on the EU Prudential Proposals?
The UK government has indicated that it intends to implement the EU Prudential Proposals even if there is a no-deal Brexit. The FCA noted in its 2019/2020 business plan that it will publish a consultation paper on implementing the new regime in Q4 2019.
What should private fund managers do now?
Private fund managers should undertake a gap analysis and impact assessment of the EU Prudential Proposals having regard to the nature of the business undertaken by the private funds manager and the particular business model it operates. The EU Prudential Proposals contain transitional provisions that will need to be taken into account by private funds managers when undertaken their impact assessments. If you have any questions regarding the detailed application of the EU Prudential Proposals, we would be happy to assist.
FCA Consultation Paper CP19/20
What does the consultation paper address?
The FCA has recently published a consultation paper regarding its expectations of firms when assessing whether firms have adequate financial resources. Although the consultation paper is not addressed directly at the private funds industry, it includes important practical questions that private fund managers can ask themselves when assessing their financial resources.
The FCA states that the consultation paper seeks to provide more clarity to the industry on:
- the role of adequate financial resources in minimising harm;
- the practices firms can adopt when assessing adequate financial resources; and
- how the FCA assesses the adequacy of a firm’s financial resources.
The FCA states that its intention is not to increase general levels of financial resources across financial services firm's but to take a proportionate and risk-based approach to the supervision of firms. Nevertheless, at the level of individual firms this could lead to increased regulatory capital requirements or the imposition of individual capital guidance by the regulator. Accordingly, firms would be well-advised to consider the possible implications of the consultation paper for their business and take appropriate action to ensure that their financial structure and level of financial resources would pass regulatory scrutiny (we discuss this further below under “What practical steps can private funds managers take now?” and in Appendix A).
What does the FCA expect of firms when assessing financial resources?
- Proportionate and regular assessment of risks – A firm’s assessment of adequate financial resources should be proportionate to the nature, scale and complexity of its activities. The assessment should be forward-looking and happen at least annually, reflecting the fact that the business environment is dynamic so the assessments of risk and harm should be dynamic too.
- Understand the business model and strategy – Firms should understand and articulate how changes in operational and economic circumstances might affect the risks to which they are exposed and their ability to generate acceptable returns.
- Prevent harm from occurring – Firms should be able to detect, identify, and rectify problems themselves by ensuring that their systems and controls, governance and culture enable them to prevent harm from occurring.
- Put things right when they go wrong – Firms should consider risks that may stop them putting things right when they go wrong including assessing the circumstances leading to financial stress and the potential depletion of financial resources, and the inability to convert assets into “cash” in time to pay for obligations as they fall due.
- Minimise harm in failure – Firms should consider the scenarios leading to financial stress, explore recovery options and, as a last resort, wind down its business.
Although the FCA is currently consulting on this topic, we consider that the consultation paper provides useful practical guidance for firms.
The consultation paper does not focus specifically on private fund managers, therefore, any guidance should be applied in a proportionate manner having regard to the nature and scale of a private fund manager’s business.
We set out in Appendix A some key practical questions for firms to consider to benchmark themselves against FCA expectations in this area. Although these questions are not exhaustive, they are indicative of the questions that the FCA would expect firms to consider.
2. Focus on private fund managers providing services into Ireland and Luxembourg post-Brexit1
With 31 October 2019 fast approaching, many private fund managers are taking the opportunity to refresh their Brexit contingency plans, in particular, those with Irish or Luxembourg structures. We consider below the regulatory consequences of a “no-deal” Brexit for these fund managers.
The general position
Full-scope UK AIFMs
Full-scope UK AIFMs will lose the management passport to manage EEA AIFs, but will continue to be able to manage EEA AIFs if the national law of the member state of the AIF permits. A full-scope UK AIFM will also lose access to the AIFMD marketing passport for any EU AIFs or UK AIFs it manages. As the timing of the extension of the AIFMD marketing passport to non-EEA AIFMs is unclear, UK AIFMs will therefore have to rely on the national private placement regimes of different member states to market in those member states.
EEA AIFMs delegating portfolio management to UK managers
Certain UK private fund managers are structured so that they provide delegated portfolio management services to an EU AIFM with respect to an EU AIF. The delegation of portfolio management by a EEA AIFM to a non-EEA firm requires, amongst other things, that there are appropriate cooperation agreements in place between the relevant regulators. The European Securities and Markets Authority (ESMA) and the FCA have now agreed a memorandum of understanding (MoU) under which EEA AIFMs will continue to be able to delegate portfolio management to a UK delegated portfolio manager following a "no-deal" Brexit.
UK firms providing investments services into EEA member states
Although EEA AIFMs will be able to delegate portfolio management services to UK managers, UK managers will still need to be able to provide investment services to EU AIFMs where they act as delegated portfolio manager (i.e. the MiFID investment service of portfolio management). Similarly, UK adviser/arranger firms will need to be able to provide investment advice cross-border into the EEA to service EEA-based clients (for example, where a UK firm provides investment advice to an EEA AIFM but does not take the discretionary investment management decision). Although the Markets in Financial Instruments Regulation contains provisions for a third country cross-border passport, this passport has restrictions which may limit its practical value and is unlikely to be available by 31 October. It is therefore necessary to assess the ability to provide investment services cross-border into the EEA on a jurisdiction-by-jurisdiction basis.
UK firms providing investment services into Ireland
We understand that non-EEA firms can benefit from a “safe harbour” from the need to be authorised by the Central Bank of Ireland (CBI). The “safe harbour” allows non-EEA firms, without establishing a branch in Ireland, to provide MiFID investment services to Irish per-se professional clients and eligible counterparties. It does not allow non-EEA firms to provide services to retail clients.
In order to benefit from the safe harbour the non-EEA firm’s head or registered office must be in a non-EEA member state and it must not have a branch in Ireland and the co-operation arrangements must be in place between the competent authorities of the non-EEA firm and the CBI. The latter requirement is satisfied by the ESMA/FCA MoU referred to above. We also understand that the CBI has previously confirmed that the IOSCO multi-lateral MoU, of which the CBI and the FCA are signatories, also satisfies this requirement.
This “safe harbour” should therefore enable UK firms to continue to provide investment services such as portfolio management and investment advice to Irish AIFMs and AIFs.
UK AIFMs managing Irish AIFs
We understand that the CBI has confirmed that an Irish Qualifying Investor AIF (QIAIF) will be permitted to designate a UK AIFM as its AIFM. However, as is currently the case, non-EEA AIFMs are unable to manage Irish retail investor AIFs (RIAIFs), so UK AIFMs currently managing Irish RIAIFs will not be able to continue to do so.
UK firms providing investment services into Luxembourg
Luxembourg has created a transitional regime that will allow UK investment firms to continue to provide cross-border services into Luxembourg following a "no-deal" Brexit. UK firms to which this transitional regime will be relevant include those that currently use the MiFID passport to provide portfolio management services and/or investment advice to Luxembourg clients.
Importantly, the transitional regime is only available to UK firms in respect of existing mandates – i.e. contracts in place before Brexit. UK firms will not be able to rely on the transitional regime to enter into new mandates after Brexit.
In a recent press release2, the Luxembourg regulator (CSSF) confirmed two critical aspects of the transitional regime:
- the regime will last for 12 months (so, assuming the UK leaves the EU on 31 October 2019, the transitional regime will expire on 31 October 2020); and
- a UK firm wanting to rely on the transitional regime must actively opt in to the regime by making a notification filing with the CSSF by 15 September 2019. The CSSF will assess the notification and then inform the UK firm as to whether it can benefit from the transitional regime or not. As part of this assessment, the CSSF will investigate whether the UK firm has been using the MiFID passport to provide its services into Luxembourg.
The first step for UK firms is to determine what services they currently provide cross-border into Luxembourg and whether they are using the MiFID passport to do so, or whether they are relying on an exemption (e.g. reverse solicitation).
Some firms may, on review, conclude that they are not currently using the passport to provide their services into Luxembourg, but ought to be; those firms will need to submit a passport application to the FCA first, before they can make use of the Luxembourg transitional regime.
Firms using the passport should then prepare to make the notification filing with the CSSF by 15 September 2019. The CSSF will set up an online notification portal for firms to use; the portal is not yet available and there is no clarity yet on how much information firms will need to provide as part of this process.
Once the CSSF confirms a UK firm’s eligibility to use the transitional regime, the firm can continue to service existing mandates for 12 months following a “no-deal” Brexit.
The firm should then consider using this 12-month period to submit a further application to the CSSF to make use of Luxembourg’s domestic “third country regime”, which enables non-EU entities to provide investment services cross-border to Luxembourg per-se professional clients and eligible counterparties.
A successful switch from the transitional regime to the third country regime would then allow a UK firm to continue to be able to provide services into Luxembourg beyond the 12-month limit provided for by the transitional period.
On the other hand, a UK firm whose notification to the CSSF to use the transitional regime is rejected will immediately have to cease providing services with effect from the date of a “no-deal” Brexit (unless it can make use of any other exemptions under Luxembourg law).
UK AIFMs managing Luxembourg AIFs
The Luxembourg transitional regime also covers UK AIFMs that manage Luxembourg AIFs under the AIFMD management passport. The CSSF has confirmed in a separate press release3 that, under the transitional regime, a UK AIFM will continue to be able to manage a Luxembourg AIF for 12 months after a “no-deal” Brexit, so long as:
- it makes a notification filing with the CSSF by 15 September 2019;
- it submits to the CSSF, as soon as possible but no later than 31 October 2019, either: (i) an application for authorisation as a Luxembourg AIFM; or (ii) a notification of the actions taken by the UK AIFM to cater for the loss of the AIFMD management passport (this could be, for example, steps taken to appoint an EEA AIFM to replace the UK AIFM); and
- the CSSF, having considered each notification on a case-by-case basis, grants the UK AIFM transitional relief on the basis that it is necessary to ensure the continuity of existing contracts and the protection of AIF investors. The CSSF will notify a UK AIFM of the result of its notification within 10 business days of all required information having been submitted.
UK AIFMs who do currently manage Luxembourg AIFs on the basis of the AIFMD management passport should therefore:
- prepare to make the initial notification filing with the CSSF by 15 September 2019 (as with the transitional regime for UK investment firms, the CSSF will set up an online notification portal for UK AIFMs – but this is not yet available); and
- start to finalise their contingency planning for a “no-deal” scenario – it is clear that the CSSF wants UK AIFMs to front-load their preparations, rather than waiting until after a “no-deal” Brexit has occurred.
3. Timeline of key upcoming UK and EU regulatory developments impacting private fund managers
We have prepared a timeline which covers upcoming UK and EU regulatory developments to be aware of.
1 Please note that this section provides an overview of the regimes in Ireland and Luxembourg and is not intended to be relied on or constitute legal advice. If you would like to obtain legal advice in relation to Ireland or Luxembourg, we would be happy to arrange this.
2 Press release 19/33, “Mandatory notification for UK firms in the context of Brexit”, 15 July 2019.
3 Press release 19/34, “Mandatory Brexit notification for undertakings for collective investment and their managers in the context of Brexit”, 15 July 2019.