Private equity firms are facing the prospect of bank-style regulation
Following a string of new regulations, private equity executives could be forgiven for thinking that the industry had been subject to a case of mistaken identity. Since the financial crisis, the most complex and onerous regulation has tended to be reserved for banks. However, as policymakers and regulators have started to become more concerned about other types of financial services firms falling prey to some of the problems that have affected banks, bank-style regulation has been extended to apply to new sectors, such as asset management and private equity.
For private equity, regulation coming down the track includes increased regulatory capital requirements and remuneration rules, and the EU Sustainable Finance Package, as well as the recent expansion of the Senior Managers and Certification Regime (SMCR) to private equity firms. The implementation of the new EU regulatory capital requirements and the Sustainable Finance Package in the UK after the end of the Brexit transition period will depend on the extent to which the government decides to adopt them.
The Prime Minister has described regulatory divergence as one of the “key attractions” of Brexit, meaning that the UK could seek to diverge from EU rules. On the other hand, some degree of alignment is likely to be necessary for UK financial services firms to have access to EU markets after the end of the transition period. That means a lot could depend on the trade deal negotiations between the EU and the UK.
Additional regulatory capital requirements for private equity firms
New EU regulation will see EU-based private equity firms face potentially large increases in their regulatory capital requirements, along with strengthened rules on remuneration. Currently, such firms are generally subject to much more limited regulatory capital and remuneration requirements than banks.
Since 2015, the EU has been working towards reforming the prudential regime applicable to investment firms, dubbed the “Investment Firms Review”. This has recently resulted in agreement in the EU of an Investment Firms Regulation (IFR) and Investment Firms Directive (IFD) which will start to apply in mid-2021, subject to phase-in provisions.
The new rules will introduce a classification system for prudential requirements for MiFID investment firms, with some private equity firms likely to fall into ‘Class 2’ categorisation and generally becoming subject to a permanent minimum capital requirement of up to €150,000. Additionally, much more complex and potentially higher variable capital requirements apply to Class 2 firms, as well as a number of other prudential requirements that were initially developed for banks, such as liquidity rules. Class 2 firms will also be subject to remuneration requirements similar to some of the requirements that apply to investment bankers, such as pay deferral requirements for high earners and material risk takers. Where private equity firms have portfolio companies that are investment firms there is the potential for consolidation requirements to capture the private equity houses.
Extension of the Senior Managers Regime to private equity firms
Another recent regulatory requirement is the extension of the SMCR to private equity firms which took effect on 9th December 2019. The SMCR is not quite being applied wholesale to private equity firms in the same way that it applies to banks, although for “enhanced” firms, such as firms with AUM of £50 billion or more, the regime will be very similar.
For UK private equity firms, the SMCR represents a major remodelling of its predecessor, the “approved persons regime”. Under the SMCR, firms must provide regulators with a “statement of responsibilities” for every Senior Manager and assign “prescribed responsibilities” to senior managers. Additional requirements apply to enhanced firms, such as having a “responsibilities map” setting out the management and governance arrangements for the firm.
New Senior Manager Conduct Rules and a new “duty of responsibility” are intended to spell out more clearly Senior Managers’ personal liability when things go wrong. While there is an increased focus on the most senior individuals, some individuals that were previously an “approved person” but who are capable of causing significant harm to the firm or its clients, will no longer be approved by the regulator. Instead they will be subject to a “certification regime” where firms must identify such persons and certify that they are fit and proper to perform their roles. The final part of the SCMR is the conduct rules. In addition to the Senior Manager Conduct Rules referred to above, “Individual Conduct Rules” are broadly framed standards of conduct (e.g. acting with integrity) that apply to almost all staff. Firms must train staff on the conduct rules and report disciplinary action taken for breaches of the rules to the regulators. Enhanced regulatory reference obligations also require firms to provide more detailed information to new employers.
The SMCR is an entirely home-grown regulatory regime and is therefore not likely to be directly impacted by Brexit.
New sustainability duties and disclosures for private equity firms
The EU’s Sustainable Finance Package will apply significant new requirements to private equity aimed at promoting “sustainable” investing. This will include in particular requirements regarding disclosing how sustainability factors are integrated into private equity firm’s processes (including in respect of investment decision making and remuneration policies), as well as restrictions around which financial products can be presented as being “sustainable” to investors – with an explicit aim of preventing “green-washing” by firms. Firms will also be required to capture and reflect clients’ ESG preferences where suitability assessments are required under MiFID II.
ESG is a key priority for the FCA and the government also launched a green finance strategy which was supportive of integrating ESG factors into financial decision making, so many expect that the UK will look to align with the EU’s approach after the end of the Brexit transition period, although nothing has been confirmed on this.
As ever, Brexit has presented challenges for the financial services industry. While private equity firms will need to prepare to implement the new regulations that are in the pipeline, they should also expect twists and turns along the way.
Sebastian Barling is a Partner and Omar Salem is a Managing Associate in the Financial Regulation Group at Linklaters
“This article (Subscription only) was originally published by Thomson Reuters Regulatory Intelligence”