Private funds regulatory update
The Brexit effect
Brexit took effect at the start of the year with the EU and the UK achieving the Trade and Cooperation Agreement before the 31 December deadline. The economic effects of the agreement are beginning to be felt, particularly in respect of customs arrangements, and this has put immediate pressure on some portfolio companies. Nonetheless many are relieved that the acrimony that would have resulted from no agreement has been avoided.
The Prime Minister acknowledged that the deal “probably does not go as far as we would like” on financial services, although the parties did announce their intention to agree a Memorandum of Understanding (MoU) on financial services by the end of March. Hopes have been pinned on the MoU to detail equivalence agreements that might facilitate UK firms’ access to the single market and vice versa. As discussed in our review of the draft MoU, this seems increasingly unlikely. It appears that the MoU will outline the institutional arrangements for future discussions about regulation, based on the EU/US Financial Services Forum. This model does not compel the parties to reach agreement. The smart money, then, is that equivalence will not be agreed soon or on any wide-spread basis. The EU’s Commissioner for Financial Services, Mairead McGuinness, recently said as much, stating that the absence of cliff-edge risks means that the EU can take its time on equivalence to “get it right”. Given that, even if granted, equivalence can be withdrawn by the EU with little notice, many firms have restructured their businesses to continue to operate under the current circumstances, which is effectively “no deal” for financial services. Equivalence agreements will be welcomed but as time goes on, their value will be a diminishing return.
If true, this would make regulatory divergence more likely over time. The UK is already floating ideas about dropping parts of MiFID II. We recently published a report entitled “Big Bang 2.0” that details the UK’s options for divergence, the benefits and costs. Managers might be interested in the possibility that the UK might adopt a dual regime for AIFs, like the Channel Island’s approach, scaling back undesirable rules such as the AIFMD’s remuneration requirements for some firms. The UK is also exploring the possibilities of trade deals with other countries. Some, such as the pan-Asian CPTPP, have financial services chapters. Trade-offs will be involved.
Restricting delegation: another try?
Meanwhile the EU is considering another attempt at restricting the ability of managers to delegate portfolio management outside of the EU. ESMA initially recommended quantitative limits on the amount of business that can be delegated, but the rhetoric has softened lately. Natasha Cazenove, newly announced as ESMA’s Executive Director-designate, addressed a Politico conference. She suggested that the European Commission (EC) should ban name-plate entities, investigate suspect business models and tightening the UCITS and AIFMD rules to align with ESMA’s tougher supervisory guidelines. These are all laudable aims, although there was no mention of quantitative limits being imposed. However, at the political level, discussions about changes to delegation got underway this month. Perhaps regulators will try to moderate some of the stronger and more damaging proposals, although the trend continues towards more “substance” required within the EU. We will know more when the EC is expected to announce its intentions for the AIFMD Review around the middle of this year.
More EU marketing rules
Managers are facing the introduction of new rules for the cross-border marketing of AIFs and UCITS in the EU from August. There are several problems resulting from the current uncertainty in these rules. We present a deep dive into the issues in this update.
The Investment Firms Prudential Regime
The Investment Firm Prudential Regime (IFPR) will overhaul the prudential regime that applies to investment firms when it comes into effect on its planned date of 1 January 2022. We also look at the effect which the proposed rules set out in the FCA’s most recent consultation paper, CP20/24 (CP1) could have on private fund managers in this update.
The onward march of ESG rules
The first phase of the new ESG rules for fund managers and advisers, the Sustainable Finance Disclosure Regulation (SFDR), took effect for funds from 10 March. The regulation poses tricky issues, such as how to classify funds and whether and how the rules apply to non-EU managers. You might find it helpful to refer to our Q&A which sets out our views on some of the key interpretation questions raised most frequently by our clients.
The SFDR has also raised questions about how managers obtain the ESG data that they need to comply with the regulations and to meet their investors’ requirements. The next wave of ESG regulations will focus on investee company disclosures and on the quality of ESG ratings and scores. Investors in private markets will wish to know whether private and unlisted companies will be mandated to make ESG disclosures or whether only large publicly listed companies will be subject to the requirements. In addition, regulators will be scrutinising ESG fund labels. These labels typically help retail investors gain certainty about what they are investing in (like the environmental labels on white goods to help non-experts know that they are buying a “green” product). Although if regulators are serious about tackling green-washing, private funds might also be in the regulators’ crosshairs.
For more on our thoughts relating to ESG, visit our hubpage.
Increasing retail access
Finally, some good news: the drive to “retailisation” is underway. The aim is to get retail investors into illiquid assets, providing more funds for infrastructure, small businesses and to support the economy’s emergence from the pandemic. Policymakers are targeting the large amounts of capital sitting in DC pension schemes and mass affluent investors. The UK’s Chancellor, Rishi Sunak, has made it his aim to launch the first Long Term Asset Fund by the end of this year and the EU is looking at improvements to make the ELTIF more attractive. The lure of growing AuM and achieving greater yield for a wider pool of investors will be appealing to managers, provided that the regulations can prevent a Woodford-type situation happening again. In the longer term, the weakening boundary between retail and private funds could shake up the industry’s structure.
The new rules for marketing of funds in the EU will take effect on 2 August 2021. While the reforms are helpful to managers by making it clearer and perhaps easier to obtain approval to market a fund in a member state, the legislation is unclear in some respects. This presents uncertainty to managers that wish to go to market during the implementation phase and perhaps afterwards too. It is hoped that national implementation of the legislation before August might resolve some of the uncertainty in the provisions, but perhaps not in a way that managers would find desirable. Furthermore, the new regime will compel managers to decide whether to actively promote a new fund to potential investors or whether to rely on reverse enquiries from interested investors, but not to exercise both options. Successor funds could face severe restrictions too.
The Cross-Border Marketing Directive and Regulation became legislation in August 2019. EU policymakers’ intention was to make it easier to market AIFs and UCITS throughout the single market, removing national barriers to marketing and harmonising some rules.
There had been hopes that the EU might introduce a marketing passport for funds, in parallel to the authorisation passport for funds, by which approval in one member state would have the effect of approval in all member states. However, this proved to be politically impossible. The result is legislation that standardises some of the processes pertaining to regulatory approvals to market a fund, but which does not go so far as to fully harmonise the rules, to introduce a marketing passport or to centralise the approval process under ESMA.
National competent authorities will continue to consider and approve applications from managers to market a fund in their member state. However, the Regulation standardises the templates by which managers provide information to regulators to support their application to market a fund. It is envisaged that a single template will reduce some of the costs associated with researching each member state’s application process and to streamline the process of making multiple applications to market a fund across two or more member states.
The fees that regulators charge in respect of marketing applications vary markedly across member states. These regulatory fees will continue to be set and charged at the national level. However, national competent authorities will be required to publicly disclose the fees that they charge. It is hoped that the transparency might help the level of fees charged converge across Europe as regulators seek to make their jurisdictions more attractive for the marketing of new funds.
The reforms clarify that managers must maintain local facilities in the jurisdictions in which their funds are marketed. These facilities include the ability to process transactions with and provide information to local investors. Helpfully the legislation does not require managers to retain a physical presence in the country. This could reduce costs for some managers that have previously been required to have a physical local office in some countries and it could help the transition to better digital provision of services to investors.
More importantly, the legislation provides a harmonised definition of “pre-marketing” activities. Pre-marketing comprises promotional activities to professional investors in respect of a fund where there is no offer or placement of the fund to those investors. An inducement beyond this – for instance, presenting an investor with a subscription form – would by implication constitute marketing and trigger the requirement on the manager to notify the relevant regulator.
The introduction of pre-marketing is important for two reasons. First, it aims to provide much needed clarity to managers to enable them to assess the potential demand for a fund in a jurisdiction without fully committing to marketing the fund there and complying with the associated requirements. Second, the definition helps to resolve some of the variance in the treatment of marketing across the EU.
So far, so good, but here the problems begin to arise.
The legislation introduces an unhelpful provision: if an investor subscribes in the fund within an 18-month period after pre-marketing begins, this will be deemed to constitute marketing and trigger the notification requirements. This effectively means that managers are subject to an 18-month ban on reverse solicitation if they choose to undertake pre-marketing.
A further complication is the uncertainty as to whether the ban applies only within the member state in which pre-marketing took place or whether managers will not be permitted to accept reverse enquiries anywhere within the EU in respect of the fund in question. ESMA is not required to provide clarification of this provision. National transposition of the rules might offer some clarity, but even so, it is possible that national interpretations might conflict, and member states are not empowered to legislate on behalf of other member states. This suggests that the ban is likely to apply nationally, at least at first, unless all member states agree that it should apply across the EU. Otherwise, ESMA and the European Commission would need to correct member states’ transposition after the event if the EU authorities believe that the ban should apply on an EU-wide basis.
A second complication arising from the new legislation is in respect of de-notification of a fund. If a manager wishes to cease marketing a fund in a member state, the manager must notify the national competent authority of the relevant country. De-notification will trigger a 36-month ban on pre-marketing of the de-notified fund within the member state. This poses problems for managers that wish to launch a successor fund because the legislation appears to capture structures that use the same or similar investment strategy, branding and other product features. The rule seems unnecessarily punitive and it is possible that member states might seek to interpret the provision in as narrow a manner as is possible in order to permit successor funds to continue to be marketed within their jurisdiction. Nonetheless it is true that the uncertainty around this restrictive rule is hindering some managers’ longer-term fundraising plans and it could be negative for investment in the EU.
Over the coming months we should see the Directive being implemented in member state laws and regulations. The markets will hope that regulators take the narrowest possible view of the bans on reverse solicitation in respect of pre-marketing and on pre-marketing activities in respect of de-notification. However, it is possible that EU policymakers will need to revisit the rules to resolve ongoing confusion or damage to investment.
The Investment Firm Prudential Regime (IFPR) will overhaul the prudential regime applicable to MiFID investment firms when it comes into effect on 1 January 2022. We look at the effect which the proposed rules set out in the FCA’s most recent consultation paper, CP20/24 (CP1) could have on private fund managers.
Which firms does the IFPR apply to?
The IFPR will, broadly speaking, apply under the proposed rules to MiFID investment firms in the UK which are authorised and regulated by the FCA (FCA investment firms). In the private funds context, this would encompass private fund managers which are currently:
- delegated portfolio managers subject to the BIPRU and GENPRU sourcebooks in the FCA Handbook; and
- exempt CAD firms (often known as “adviser/arranger” firms).
The IFPR will also impose requirements on regulated and unregulated holding companies in the same group as an FCA investment firm. For more detail on this, please see “Prudential consolidation” below.
Instead of the relative complexity of the current prudential classifications, the IFPR will divide UK investment firms (and by extension private fund managers) into two categories:
- small and non-interconnected FCA investment firms (otherwise known as SNIs); and
- non-SNI FCA investment firms (non-SNIs).
We have published a briefing on SNIs and the thresholds which private fund managers must meet to be deemed an SNI. However, in short, FCA investment firms will need to ensure that, in order to be an SNI it:
- does not have permission to deal on own account, whether for itself or on behalf of clients; and
- meets specific thresholds.
In practice, this SNI classification could capture a number of smaller private fund managers whose assets managed/advised is below £1.2bn and which are currently categorised as either BIPRU firms or exempt CAD firms. A firm which wishes to explore whether or not it will be categorised as an SNI under the IFPR should not hesitate to contact us in order to use our scoping tool, which results in a tailored programme plan for the implementation of the IFPR.
It is anticipated that SNIs will be subject to a less rigorous prudential regime. Whilst the full benefits of being an SNI will only be known when the FCA publishes its additional consultation papers and follow-up policy statements, CP1 suggests that SNIs will benefit from a simpler calculation for its own funds requirement. This will involve SNIs having an own funds requirement of the higher of its permanent minimum capital requirement (PMR) and its fixed overheads requirement (FOR). It is likely therefore that a number of private fund managers which are SNIs will calculate their own funds requirement by reference to their FOR. The FCA notes in CP1 that details on how to calculate firms’ FORs will follow in a subsequent consultation.
What are the key differences under the IFPR which private fund managers should be thinking about?
There are three major differences which private fund managers should be thinking about now.
1. Higher own funds requirements
As noted above, the PMR for a number of private fund managers is likely to stand at £75,000 which is the lowest PMR figure possible under the IFPR. This represents a notable increase on the base capital resources requirement for investment firms which are currently categorised as BIPRU firm or exempt CAD firms. The FCA does plan to introduce transitional provisions for the PMR (as set out in Chapter 6 of CP1) over the course of five years, but this nonetheless represents a substantial increase in the PMR for a number of private fund managers.
In addition, firms will have to maintain own funds which are the higher of their:
- FOR; and
- (for non-SNIs), their K-factor requirements.
Given that, in CP1, the FCA did not consult on the FOR and only consulted on the K-factor requirements which apply to FCA investment firms which deal as principal, it remains to be seen how the FOR and the K-factor requirements will impact private fund managers’ own funds requirements in practice. We dealt with the IFPR’s impact on the capital structure of investment firms in more detail in our February briefing.
2. Concentration risk
The IFPR introduces requirements concerning ‘concentration risk’, defined as the risks arising from the strength or extent of a firm’s relationships with, or direct exposure to, a single client or a group of connected clients. For the vast majority of private fund managers, a number of the requirements will not apply as they will not be dealing on own account. However, private fund managers will be subject to an obligation to monitor and control concentration risk in a number of different areas, including:
- exposures in a trading book;
- assets not recorded in a trading book (the example given by the FCA is trade debts);
- off-balance sheet items;
- the location of client money;
- the location of client assets;
- the location of its own cash deposits; and
- the sources of its earnings.
3. Prudential consolidation
The IFPR introduces comparatively strict rules on prudential consolidation for “FCA investment firm groups” which is a group which comprises a UK parent undertaking and its “relevant subsidiaries” where one of those companies is an FCA investment firm and the group does not contain a UK credit institution such as a bank.
“Connected undertakings” will also be included in the scope of consolidation, which can include companies connected by, for example, majority common management with one or more of the companies referred to above.
Once an FCA investment firm group has been identified, the firms which will be included within the scope of consolidation will be:
- FCA investment firms;
- financial institutions (such as AIFMS and UCITS management companies);
- ancillary services undertakings (such as group service companies); and
- tied agents (appointed representatives).
The effect of this will be to treat the UK parent undertaking along with all of the relevant entities in the FCA investment firm group as if it were a single entity. On the basis of this “consolidated situation”, the UK parent undertaking will need to comply with requirements in relation to:
- composition of own funds;
- own funds requirements;
- concentration risk;
- disclosure; and
Whilst a number of the items above are yet to be consulted on by the FCA, it is anticipated that these new prudential consolidation rules will have the following impacts for private fund managers.
- At the level of the private fund manager – Careful consideration will need to be given as to how these requirements impact holding structures for private fund managers, especially for many firms currently categorised as exempt CAD firms for which these prudential consolidation rules will be new. We dealt with the impact of the IFPR on exempt CAD firms in more details in our October briefing.
In particular, for many private fund managers, thought will need to be given as to how the prudential consolidation rules apply to a delegated portfolio manager or an adviser / arranger firm where its regulatory client is the AIFM of a private fund which is within the same group.
- At the investment level – To the extent that a private fund makes an investment into an FCA investment firm group, consideration will need to be given as to how this investment is structured and how the new prudential consolidation rules will impact returns to the private fund but also the manner in which the FCA investment firm group is run during the period of investment.
What does CP1 not deal with?
As already noted, CP1 is only the first of the FCA’s consultation papers on the IFPR. There are therefore a number of topics on which the FCA has not yet opined. Perhaps the most important of these is the exact application of the IFPR to CPMIs which is a common regulatory structure for a number of private fund managers. In addition, the FCA is yet to consult on the following topics which will be of interest to private fund managers:
- remuneration requirements;
- risk management and governance (e.g. ICARAs); and
Nonetheless, given the looming 1 January 2022 implementation date, it is important that private fund managers begin, or continue, preparation for IFPR implementation now.
The regulated nature of consumer finance arrangements can sometimes be overlooked, with the result that unanticipated issues arise for private fund managers. This article explores what constitutes a regulated consumer credit agreement, the key regulated activities which exist in relation to such agreements, and circumstances where private funds should remain alive to the danger of inadvertently falling within the scope of the regulations.
It is crucial to ensure that you do not inadvertently stray into the provision of regulated consumer credit services, as this would constitute a contravention of the general prohibition, and is therefore a criminal offence. Separately, where the lender of a regulated consumer credit agreement is not authorised they are required to apply to the FCA for permission to enforce the loan.
What is a consumer credit agreement?
Under article 60B(3) of the Regulated Actives Order (the RAO), a regulated credit agreement (in relation to an agreement other than a green deal plan) that is entered into on or after 1 April 2014, must have all of the following elements:
- be a credit agreement between an individual or relevant recipient of credit (A), and any other person (B);
- under which B provides A with credit of any amount; and
- that is not an exempt agreement.
A relevant recipient of credit means either:
- a partnership consisting of two or three persons not all of whom are bodies corporate; or
- an unincorporated body of persons that does not consist entirely of bodies corporate and is not a partnership.
Credit for these purposes includes a cash loan and any other form of financial accommodation.
What constitutes an exempt agreement?
There are a variety of exemptions which may apply to render a consumer credit agreement exempt. A summary of each possible exemption is beyond the scope of this note and we would recommend seeking advice in relation to specific agreements, but some of the particularly useful exemptions are as follows:
- agreements for over £25,000, which are borrowed for business purposes (pursuant to Article 60C(3) RAO);
- agreements where the lender is an investment firm, and the agreement is entered into for the purpose of allowing the borrower to carry out a transaction relating to one or more financial instruments (pursuant to Article 60E(6) RAO);
- agreements for 12 months or less requiring no more than 12 repayments – such agreements must be interest and fee free (pursuant to Article 60F RAO); and
- agreements in respect of a loan to a high net worth individual, where the credit is secured on land, or is for more than £62,260 (pursuant to Article 60HA RAO).
What are the regulated activities?
There are several regulated activities relating to regulated consumer credit agreements. A full list is beyond the scope of this note, but the key ones for these purposes are:
- entering into a regulated credit agreement as lender (which is regulated pursuant to Article 60B(1) RAO); and
- exercising, or having the right to exercise, the lender’s rights and duties under a regulated credit agreement (which is regulated pursuant to Article 60B(2) RAO)
Some common pitfalls with consumer credit
There are a couple of common pitfalls to be wary of in respect of consumer credit, in order to ensure that an entity does not inadvertently fall within the scope of the regulated activities detailed above.
Loans to employees
Entering into loans to employees can constitute a regulated activity in the context of consumer credit agreements. Where an entity provides loans to its employees, which do not fall within an exemption as detailed above, this may constitute entering into a regulated credit agreement as lender and would therefore be a regulated activity.
Therefore, in circumstances where loans are provided to employees, it is important to consider whether the loans fall within one of the exemptions. One such exemption which may be benefitted from in these circumstances is the one detailed above where the lender is an investment firm. However, as noted above, this is only effective where the agreement is entered into to allow the borrower to carry out a transaction relating to one or more financial instruments.
It is typically possible to ensure that loans to employees can be made to fall within an exemption, but in practice this is not always considered in great detail, with the result that the arrangements constitute regulated consumer credit agreements. Other common exemptions which may work for these purposes are low interest rate agreements, and interest free loans with a limited number of repayments (as described above).
It should be noted in this context that, whilst carrying on a consumer credit business without a licence is an offence, where the loans are only provided occasionally, such as a one-off loan or loans to a few senior executives, this is unlikely to constitute carrying on a business. It is where the loans are made to the entire workforce, or more frequently, that this may be engaged, and criminal liability may arise. However, in any case, the requirements to form and content, and the need to seek FCA approval to enforce the loan would still apply irrespective of the scale or frequency with which the loans are entered into.
Purchasing consumer credit agreements
Regulated consumer credit agreements which are transferred from one entity to another, possibly as a result of the purchase of a business, can be problematic from a regulated activities perspective. Where the legal title to the loans is transferred, the acquirer will become the lender under the regulated credit agreements. As a result, the acquirer will need to be authorised and regulated by the FCA, and have the requisite permissions to perform the consumer credit regulated activities described above.
There is an exemption (at Article 60J RAO) which allows an unauthorised person to carry out the Article 60B(2) activity, described above, provided that the unauthorised person has entered into an agreement with a person who does have permission to carry out the Article 60B(2) activity. However, where the purchaser of the loans becomes the legal title holder and lender of record, it will also be carrying out the Article 60B(1) activity described above. This potential exemption does not apply in respect of this regulated activity, and therefore the acquirer would require permission to perform the Article 60B(1) regulated activity.
The circumstances may be different where the loan receivables, and not the full legal title as lender in respect of the loans is transferred. In this case, the exemption contained within Article 60J RAO may be sufficient to allow the acquirer to be unauthorised, where it is simply exercising, or has the right to exercise, the lender’s rights and duties under the regulated credit agreement.
Long trailed and now confirmed: the FCA has announced the future cessation or loss of representativeness of all LIBOR currency-tenor settings on the previously indicated timeline. That is:
- immediately after publication on 31 December 2021: GBP LIBOR, EUR LIBOR, CHF LIBOR, JPY LIBOR and one week and two month USD LIBOR (subject to consultation on one, three and six month GBP LIBOR and JPY LIBOR continuing on a “synthetic” basis for limited use); and
- immediately after publication on 30 June 2023: the remaining USD tenor settings (subject to consultation on one, three and six month USD LIBOR continuing on a “synthetic” basis for limited use).
A few key implications of the announcement can be viewed in our blog post.