Private funds regulatory update

The private funds regulatory update provides a practical overview of recent UK and EU financial services regulatory developments impacting private fund focused investment managers.

In this edition, we:

  • review the FCA’s recent pronouncements and publications and how they relate to private fund managers;
  • provide an overview of European regulatory developments and how they apply to private fund managers active in the EU; and
  • analyse how the FCA’s actions taken as a result of the ongoing Covid-19 pandemic have an impact on private funds focused investment managers.

FCA updates

FCA business plan 2020/2021


The FCA has released its business priorities for the year, specifically focusing on the challenges presented by the Covid-19 pandemic. While Covid-19 has unsurprisingly altered the FCA’s approach to regulation, most of the regulatory priorities for alternative fund managers which we identified in our briefing in early February remain relevant, albeit that timelines for compliance may have shifted.

In the short term, to face challenges posed by the Covid-19 pandemic, the FCA will focus on ensuring that, amongst other priorities:

  • markets function well;
  • the impact of firm failure is minimised; and
  • consumers and small firms are treated fairly.

The FCA says it may amend the business plan if significant changes are required due to the pandemic. We have considered the FCA expectations for asset managers in connection with Covid-19 and the impact on private fund managers in other briefings.

Culture, governance and SMCR

In our February briefing, we discussed some areas of focus for alternative fund managers in 2020 and noted that there needs to be a focus on governance. In particular, we noted that Senior Managers and Certification Regime (SMCR) implementation for solo-regulated firms remains important and it should not be treated as a separate compliance project. This is still the case.

The FCA has increasingly focused on culture in financial services. The business plan echoes this and notes that the FCA’s aim is to assess and address the drivers of culture. This includes a focus on the four key culture drivers in firms – purpose, leadership, approach to rewarding and managing employees and governance.

Critically, the FCA expects all solo-regulated firms (which includes the majority of private fund managers) to comply with the requirements of the SMCR. It reiterates that the regime aims for financial services firms to foster cultures where conduct and fair customer outcomes are at the forefront of their business.

The FCA has also specifically identified cases of poor governance as a key cause of harm in the investment management sector. As a result, the FCA continues to prioritise effective governance and expects firms to implement the SMCR properly to help deliver this.

The FCA, in its business plan, states that it will “move swiftly to enforcement action” against firms that do not meet FCA rules and principles and so cause harm. Given this potentially renewed regulatory focus, private fund managers ought to consider how they have implemented the SMCR and their governance structures, and whether any changes are necessary to ensure compliance.

Exposing alternative funds to retail investors and investor decision-making

In our February briefing, we explained that it is important for managers, including private fund managers, offering products and managing investments with exposure to alternative assets and strategies to consider the appropriateness or suitability of those investments for their target investors.

We also set out a number of questions managers should consider to ensure investors are only exposed to appropriate products and levels of risk. In light of the business plan, managers should continue to consider these questions.

In its business plan, the FCA notes that it hopes to address continuing harm by ensuring that:

  • investment products are appropriate for consumer needs by ensuring that they are designed to meet consumers’ needs, deliver value for money and are marketed in a fair, clear and not misleading way;
  • consumers make effective decisions about their investments by consulting on a proposal to undertake a consumer harm campaign to help consumers make better-informed investment decisions; and
  • firms and individuals operate under high regulatory standards and act in consumers’ interests, ensuring that firms have high standards of governance.

The FCA points out that one of the causes of harm in the investment management sector is an insufficient focus on delivering good value. As a result, the FCA wants to ensure that, in this sector, consumers are able to access and choose from a range of products that are fair value and meet their investment needs.

The FCA will also continue to assess the impact of remedies from its Asset Management Market Study in 2017 and is exploring what effective disclosure looks like in supporting consumer investment decisions. While this is of more relevance to authorised fund managers than private fund managers, where authorised funds have exposure to private funds, private fund managers will need to be aware of these requirements.


The FCA states that it continues to assess asset managers’ exposure to LIBOR risk. The FCA wants to ensure that asset managers, including private fund managers, have strategies to manage the risks, including conduct risks, and will monitor how firms implement these plans. This is consistent with the FCA’s letter to asset managers on LIBOR risks which we reported on.

Operational resilience

The FCA states that harm in the investment management sector is also caused by a lack of investment in technology and operational resilience.

In our February briefing, we noted that private fund managers need to ask: have the contents of the FCA consultation on operational resilience been considered and responded to and, where appropriate, have the proposed changes been implemented? Along with a number of other publications, the FCA consultation on operational resilience has been delayed, with the consultation period now open until 1 October 2020.

FCA fees consultation

The FCA is consulting on its proposed regulatory fees and levies for the financial year, 1 April 2020 to 31 March 2021.

The business plan refers to the 2020/21 consultation on fees and explains that, given the impact of Covid-19, the FCA has aimed to ensure that it protects the smallest firms by proposing a freezing of minimum fees. This means that the 71% of firms that are small enough to pay only minimum fees will see no change in the fees they pay. However, the FCA’s annual funding requirement is nevertheless increasing for 2020/21 by 5.9% for portfolio managers (fee block A.7) and by 1.6% for advisory arrangers, dealers and brokers (fee block A.13). This may increase the fees payable by private fund managers where they have an FCA entity authorised as either as a portfolio manager or as an adviser/arranger firm.

Nonetheless, to help medium and smaller firms, the FCA has also proposed to extend the period for paying their fees by two months to 90 days. This means that 89% of firms will have until the end of 2020 to pay their fees and levies. Larger firms will be expected to pay their fees under the usual payment terms.

Finally, the FCA has invited views on the review it is undertaking of its authorisation fees. It notes that its objective is to simplify their structure and, at least, bring them into line with inflation.

The consultation period closes on 19 May 2020.

FCA webpage on delayed activities and regulatory change

On 30 April, the FCA published a webpage on delayed activities and regulatory change in light of Covid-19, which may impact the timeline to which private fund managers will be expected to comply with new regulatory requirements. The FCA states that it is reviewing its work plans to delay or postpone activity that is not critical to protecting consumers and market integrity. In particular, the webpage sets out three tables containing information covering:

  • delayed consultation papers and calls for input which have been delayed until 1 October 2020 – for example, the FCA’s consultation on operational resilience, as detailed above;
  • delayed publications and other activity which have been delayed until Q2 or Q3 2020 – this includes the discussion paper on “Prudential requirements for MiFID Investment Firms” as referred to below; and
  • delayed implementation of certain rules, which have been delayed until 2021.

European developments

MiFID/MiFIR review

Following two years of the application of Directive 2014/65/EU (the MiFID II Directive) and Regulation (EU) 600/2014 (MiFIR and, together with the MiFID II Directive, MiFID II), the European Commission, earlier this year, launched a review of MiFID II in the form of an open consultation.

Notable points for private fund managers

  • Investor protection – The European Commission asked for input on whether:
    • the access to ex-ante cost information on execution services should apply equally (as they do currently) to professional clients and eligible counterparties (ECPs) as well as to retail clients, and whether professional clients and ECPs should be able to opt-out of these requirements;
    •  an additional category of client (“semi-professional investors” or “high net worth” investors) should be created in order to encourage “wealthy or knowledgeable” investors to participate in the capital markets; and
    •  MiFID II/MiFIR product governance requirements should be simplified especially because, as the European Commission acknowledges, there is a “debate around the efficacy of these requirements”.

Bullets 1 and 2 above have the potential to impact private fund managers’ obligations in respect of “family and friends” investors but also individual, high net worth investors who may have been classified as professional investors. The potential changes to the product governance rules would be another welcome change, hopefully lessening the regulatory burden on private fund managers who may find themselves as manufacturers and/or distributors.

  • Research unbundling – Input has been requested on the overall effect of the onerous MiFID II research unbundling rules, in particular on how this has led to a decline in the research coverage of SMEs. The European Commission has mooted many options, including permitting bundling exclusively for providers of SME research or clarifying what is meant by “research” for MiFID II purposes. ESMA has also separately addressed the issue of research coverage for SMEs in a recent consultation paper on SME Growth Markets.
  • Spot foreign exchange – Section 2 of the consultation paper ends with a consideration of whether national competent authorities (NCAs) should be granted supervisory powers over spot foreign exchange, which is currently not within the MiFID II regulatory perimeter. Whilst the consultation does not appear to suggest that spot foreign exchange will fall under MiFID II, private fund managers should nonetheless watch this space.

ESMA draft guidelines on leverage risk

ESMA has published a consultation on draft guidelines aiming to set out a framework for NCAs to exercise their powers under article 25 of Directive 2011/61/EU (the AIFMD).

Article 25 AIFMD, broadly speaking, enables NCAs to monitor, assess and then set limits in respect of leverage used by alternative investment funds (AIFs) which may lead either to systemic risk in the wider financial system or to risks to the orderliness of markets or the long-term growth of the economy.

Summary of ESMA’s draft guidelines

  • The assessment of leverage-related systemic risk – ESMA has split this into two steps for NCAs:
    •  step 1 – identification of certain types of leveraged funds – this includes those AIFs deemed to employ leverage on a substantial basis under Commission Delegated Regulation (EU) 231/2013 (the AIFMD Level 2 Regulation), which is defined as where exposure, as calculated under the commitment method, is three times net asset value. This category also includes leveraged AIFs with an AUM of more than €500m and other AIFs whose unusually high leverage poses risks to financial stability; and
    • step 2 – evaluation of leverage-related systemic risks – NCAs will be required to assess whether the leverage of those AIFs identified in Step 1 poses a systemic risk and to identify for which AIFs they should set leverage limits. ESMA has set out a number of factors for NCAs to consider under four headings: (a) risk of market impact; (b) risk of fire sale; (c) risk of direct spill over to financial institutions; and (d) risk of interruption in direct credit intermediation.

For private credit funds, it is notable that ESMA has included the final factor (d) in step 2. In their draft guidelines, ESMA has stated that the indicator for this factor is the relevant AIF’s investment in credit instruments of non-financial institutions. The practical implications of this are not yet clear, but this could potentially lead to private credit funds being more likely to be deemed to pose leverage-related systemic risks by NCAs and hence be more likely to be subjected to leverage limits.

  • Leverage limits – Assuming that NCAs have identified AIFs which pose systemic leverage-related risks, ESMA states that NCAs should impose leverage limits on those AIFs. Whilst ESMA does not specify any specific limits, it does note the following:
    • NCAs may apply leverage limits to a group of AIFs of the same type (private equity, real estate etc.) and similar risk profile where that group “may collectively pose leverage-related systemic risks”. This suggests that AIFs which may not necessarily fall within the scope of 1) above may nonetheless be subject to leverage limits as a result of being deemed to be part of a group in which there are deemed to be leverage-related systemic risks;
    • NCAs should implement leverage limits progressively as part of a “phased-in period” to avoid procyclicality; and
    • NCAs are able to consider additional restrictions on the management of the AIF in order to limit systemic risks (for example, restrictions on investment policy, redemption policy or risk policy) where:
      • imposing leverage limits may not reduce the systemic risk identified because AIFs can adjust their strategy to maintain the same level of risk; or
      • imposing leverage limits may result in an increase in risk due to the sale by an alternative investment fund manager (AIFM) of lower risk assets to meet the new leverage limit.

The consultation closes on 1 September 2020. Whilst the guidelines may change as a result of the consultation responses, private fund managers should be conscious that these potentially wide-ranging guidelines may affect the leverage their private funds are able to take on going forward.

The cross-border distribution of funds

Last year, Directive (EU) 2019/1160 (the Directive) and Regulation (EU) 2019/1156 (the Regulation) were published which aimed to facilitate the cross-border distribution of a number of different funds, including private funds, within the EU. Whilst a number of the provisions in the Regulation applied from 1 August 2019, the key requirements in respect of marketing communications in the Regulation and the provisions in the Directive apply from 2 August 2021.

The aim of both the Regulation and the Directive is to harmonise the distribution of funds, including private funds, within the EU and to enhance protections for investors. In order to achieve this, the Directive and the Regulation in particular:

  • introduce new requirements for an AIF’s marketing communications – marketing communications for AIFs must be identifiable as such, describe the risks and rewards of purchasing shares or units in the relevant AIF and be fair, clear and not misleading. AIFMs are required to ensure that marketing communications which comprise an invitation to purchase shares or units in an AIF do not contradict other information disclosed to investors and do not diminish their significance; and
  • introduce a concept of the “pre-marketing” of AIFs – a new definition of pre-marketing has been inserted into the AIFMD:

“pre-marketing” means provision of information or communication, direct or indirect, on investment strategies or investment ideas by an EU AIFM or on its behalf, to potential professional investors domiciled or with a registered office in the Union in order to test their interest in an AIF or a compartment which is not yet established, or which is established, but not yet notified for marketing in accordance with Article 31 or 32, in that Member State where the potential investors are domiciled or have their registered office, and which in each case does not amount to an offer or placement to the potential investor to invest in the units or shares of that AIF or compartment.

This definition limits pre-marketing activity to potential professional investors and to investment strategies or investment ideas by an EU AIFM in order to test investor interest. Recital (10) of the Directive makes clear that, as part of any pre-marketing, it should not be possible for investors to subscribe to units or shares in the relevant AIF and that the distribution of subscription forms, or similar documents, is not permitted.

Nonetheless, this should bring some much-needed clarity to what does and does not fall within EU AIFMD marketing regimes.

Crucially, however, for private fund managers looking to make use of this regime, there are number of conditions for pre-marketing which have already been highlighted in our article, New AIFMD pre-marketing rules to take effect in 2021. In particular:

  •  information provided to potential investors must:
    • not be sufficient to allow investors to take an investment decision;
    • amount to subscription forms or similar forms, whether in draft or in final form; or
  • amount to constitutional documents, a prospectus or offering documents of a not-yet-established AIF in a final form,

seemingly limiting quite severely what can be provided to potential investors by means of pre-marketing.

The rules appear to be drafted in such a manner that it will be impossible to rely on reverse solicitation for a period of 18 months following the beginning of pre-marketing, seemingly making it much more difficult for private fund managers to rely on reverse solicitation.

Reminder on IFR/IFD

In a previous private funds regulatory update, we discussed the new EU Prudential Proposals. These Proposals potentially have a wide-ranging impact on private fund managers, including by:

  • potentially increasing the regulatory capital which will need to be held by private fund managers classified as “exempt CAD” firms, otherwise known as adviser/arranger firms;
  • expanding the number of firms which are subject to regulatory capital consolidation which may have implications for private fund managers with onshore holding companies; and
  • increasing the number of private fund managers subject to a detailed remuneration code where previously a large number were subject to overarching principles.

The FCA has indicated that it is expecting to introduce a more risk-sensitive prudential regime for investment firms in 2021. The FCA has also mentioned that, on its Covid-19 response webpage, it is delaying publication of a discussion paper on “Prudential requirements for MiFID Investment Firms” (as mentioned above). Whilst this seems to point towards a delay in the implementation of the EU Prudential Proposals, private fund managers, especially exempt CAD firms, should keep an eye on developments in this area given the potentially wide-ranging effects of these Proposals on such private fund managers.

Covid-19 developments

FCA’s expectations on the SMCR for FCA solo-regulated firms

The FCA recently published a statement setting out its expectations of FCA solo-regulated firms, which include the majority of private fund managers, in respect of the SMCR given the Covid-19 pandemic. It recognises that firms will need to keep their governance arrangements under review and make appropriate changes as circumstances change.

Nonetheless, private fund managers are required to ensure that the necessary steps are taken to satisfy the FCA’s expectations by allocating senior management responsibilities in a way that best enables firms to manage the risks they face.

Considerations for private fund managers

  • Senior management responsibilities – Regulated firms, such as private fund managers, are not required to have a single senior manager responsible for their Covid-19 response. However, senior managers should consider circumstances where the current situation might lead to emerging risks, and how it affects existing risks, along with the controls used to manage them.
  • Statements of responsibilities and significant changes to senior manager responsibilities – The FCA does not intend to enforce the requirement on firms to submit updated statements of responsibilities if there is a temporary change to responsibilities as a result of Covid-19. However, firms will still be expected to:
    • maintain clear internal records of these temporary changes;
    • provide the FCA with timely detail of the changes; and
    • keep a “running commentary” of their senior managers’ responsibilities (including by, for example, keeping statements of responsibilities up-to-date).
  • Furloughed staff – Unless a furloughed senior manager is permanently leaving their role, they will retain their approval during their absence and will not need FCA re-approval when they return.
  • Reallocating prescribed responsibilities – Firms should reallocate the prescribed responsibilities of a furloughed senior manager to another senior manager. Individuals performing required functions (for example, the Compliance Oversight Function) should only be furloughed as a last resort.

In conjunction with this, the FCA has issued a modification by consent which extends the period for which a replacement may stand in for a senior manager, as a result of a temporary or unforeseen change, from 12 weeks to 36 weeks. Firms, such as private fund managers, will also be able to allocate the prescribed responsibilities of the absent senior manager to the replacement so long as that replacement is an employee of the firm. This modification should give private fund managers additional flexibility in complying with the SMCR when dealing with temporary or unforeseen absences.

FCA statement on financial resilience for FCA solo-regulated firms

The FCA has set out its expectations on financial resilience for FCA solo-regulated firms, in response to Covid-19. Firms are expected to plan ahead to ensure the sound management of their financial resources. For private fund managers, this means taking appropriate steps to conserve capital, and planning how to meet potential demands on liquidity.

Private fund managers should therefore:

  • utilise capital and liquidity buffers to support the continuation of the firm’s activities;
  • revisit wind-down plans where necessary to take into consideration the impact of the Covid-19 crisis and activate these if they intend to exit the market;
  • revisit the firm’s recovery plan to ensure that this plan is up-to-date and activate this plan where the recovery indicators are being triggered;
  • satisfy themselves that distribution decisions are prudent and consistent with their risk appetite when considering whether to make a discretionary distribution of capital to fund a share buy-back, fund a dividend, upstream cash or meet a variable remuneration decision; and
  • be proactive in their communication with the FCA.

The FCA has reminded private fund managers which may be acting as non-bank lenders (such as private credit funds) that IFRS9 requires that the forward-looking information used in expected credit loss estimates is both reasonable and supportable. The FCA notes that it is essential that the standard is implemented in a consistent and well-balanced way which reflects not only the potential impact of the Covid-19 crisis, but also the support provided by governments and central banks to protect the economy.

Mortgages and Covid-19: FCA guidance for firms

The FCA has published guidance to support mortgage lenders, mortgage administrators, home purchase providers and home purchase administrators as the Covid-19 situation develops. For private fund managers with investments in the mortgage/consumer credit sector, this guidance will be particularly relevant at portfolio level. The guidance provides that firms should:

  • grant customers a payment holiday for an initial period of three months, where they may experience payment difficulties as a result of Covid-19;
  • ensure that there is no additional fee or charge (other than additional interest) as a result of the payment holiday; and
  • take steps to ensure that the payment holiday does not have a negative impact on the customer’s credit score.

Importantly for private fund managers managing portfolios which have direct or indirect exposure to mortgages:

  • the FCA has stated that its guidance applies regardless of whether a customer was already in payment shortfall prior to Covid-19, noting that customers in payment shortfall should not receive any less favourable treatment than other customers. This widens, potentially considerably, the number of mortgages in respect of which payment holidays may be offered; and
  • the FCA has also made it clear that repossession proceedings should not be commenced or, notably, continued unless the firm can demonstrate that there are exceptional circumstances (such as a customer requesting that the proceedings continue).

In general terms, firms will have to ensure that they continue to comply with Principle 6 (“A firm must pay due regard to the interests of its customers and treat them fairly”) and MCOB 2.5A.1R (“A firm must act honestly, fairly and professionally in accordance with the best interests of its customer”). This will, then, further limit the action which mortgage creditors can take, in turn affecting private fund managers managing portfolios with exposures to mortgages or mortgage-backed securities.

Covid-19 and AIF reporting

We summarise below important areas of FCA guidance for private fund managers in respect of fund reporting given the ongoing Covid-19 pandemic.

  • Delaying annual reports – The FCA has agreed to provide full-scope UK AIFMs an additional two months to publish annual reports. AIFMs wishing to make use of this extension period should:
    • promptly inform the fund’s depositary and auditors;
    • provide the FCA with details of the funds to which this will apply and the intended new date of publication; and
    • publish a prominent statement on their website by no later than the original publishing date of the annual report explaining the logic behind the AIFM’s decision and state the revised publication date.
  • MiFID 10% depreciation portfolio value reporting – Under current MiFID II rules, portfolio managers must inform investors where the value of their investment falls by 10% or more, in value, from the last periodic statement. However, until 1 October 2020, the FCA does not intend to take enforcement action where a firm ceases to provide 10% depreciation reports to professional clients.

ESMA’s position on telephone call recordings under MiFID II

Under MiFID II, investment firms are required to record telephone conversations or electronic communications, as well as take minutes of face-to-face meetings, where these relate to dealing on own account or the reception, transmission and execution of orders on behalf of clients.

ESMA has issued a public statement to clarify its position on the application of these MiFID II requirements, providing relief for MiFID investment firms (such as private fund managers structured as discretionary investment managers).

ESMA recognises that some scenarios may emerge where, as a result of the Covid-19 outbreak, the recording of relevant conversations may not be practical. If firms are unable to record voice communications, ESMA expects them to consider what alternative steps they could take to mitigate the risks related to the lack of recording, for example, the use of written minutes or notes of telephone conversations with clients. However, this is on the condition that the firm:

  • gives the client prior notice that it is impossible to record the call and that written minutes of notes of the call will be taken; and
  • ensures enhanced monitoring and ex-post review of relevant orders and transactions.

In any event, ESMA expects firms to deploy all possible efforts to ensure that these measures remain temporary and that recording of telephone conversations is restored as soon as possible.

The FCA has adopted a similar approach to the recording of voice communications and firms are expected to notify the FCA where they are unable to record telephone calls. For more information, please see our Passle ‘Telephone recording and Covid-19: some relief for FCA authorised firms?’.