FSA encourages private equity firms to improve management of conflicts of interest

The FSA's recently published Capital Markets Bulletin reports on its thematic review of the management of conflicts of interest in private equity firms, setting out examples of good practice as well as key concerns. While the Bulletin does not constitute formal FSA guidance, the FSA is clearly encouraging firms, particularly non-relationship managed firms, to undertake a benchmarking exercise against its findings in order to identify any gaps and, where relevant, implement necessary changes.

Background

The effective management of conflicts of interest by wholesale market participants is an FSA supervisory priority. The FSA committed to carrying out thematic work on the management of conflicts within private equity firms in its feedback statement to DP06/6: Private equity: a discussion of risk and regulatory engagement. Unlike DP06/6, which carried out a broad review of the private equity industry, the FSA's thematic work focused on the key conflicts of interest that arise between private equity firms and the underlying investors in the funds that they operate, manage and advise. In particular, the review explored the extent to which the private equity business model demonstrates an alignment of interests with fund investors, and the adequacy and formalisation of firms' approach to conflict management. The review, which involved a questionnaire and FSA visits, looked at a wide range of private equity firms: investment banks with private equity businesses as well as specialist private equity firms such as fund operators, managers and advisers.


Key findings and concerns

The FSA found that the majority of firms visited operated business models with a high degree of alignment between the interests of managers and fund investors; however, a small but significant number of firms carried out practices which could undermine such alignment, for example, offering preferential co-investment terms to affiliated cornerstone investors. Unsurprisingly, the FSA observed that there was an increased risk of conflicts of interest within broad-based firms such as investment banks.

While the FSA acknowledges that most firms maintained a broadly adequate approach to conflict management, its key concern relates to the lack of formal conflict policies and procedures; the FSA found that significant improvements in this area were required at 40% of firms visited. In particular, the FSA observed a lack of:

• documentation to formalise firms' approach to conflict management;
• staff training to address conflict management, with an apparent over-reliance on firm reputation and culture as a means of influencing staff behaviour;
• ongoing review of conflict policies and procedures; and
• proactive compliance monitoring.

The FSA also observed that firms appeared to be placing primary reliance on the investment process and fund documentation to address potential conflicts of interest. This finding sits uncomfortably with the MiFID conflict requirements in SYSC 10, which provide that disclosure should be more of a last resort for conflict management; the FSA is looking at this issue more generally in the context of its MiFID supervisory review work.

As a result of its visits, the FSA has concluded that a significant number of firms ought to consider formalising their approach to the management of conflicts.

Examples of good practice

The FSA also identified examples of good practice during its visits, including the following:

• Formal compliance reviews developed in-house with input from business heads and external advisers, and signed-off by senior management.
• Annual declarations by staff covering, for example, knowledge of the firm's conflict policy and adherence to the firm's code of conduct and ethical standards.
• Proactive disclosure on a deal by deal basis of conflicts to all fund investors.
• The use of committees to address potential conflicts, for example, a Valuations Committee to review fair valuations of illiquid securities.
• Regular and proactive monitoring mechanisms, for example, a formalised compliance monitoring plan and a "live" risk map.

MiFID and conflicts of interest

The FSA found that most firms had a good grasp of the new common platform requirements in SYSC 10, although the FSA remarked that firms had generally codified their existing conflict practices rather than changed their approach to conflict management. The FSA also found that some firms may have incorrectly classified themselves as MiFID-exempt due to a misunderstanding of the exemption for operators of collective investment schemes; the exemption does not extend to the provision of investment advice or portfolio management to a fund where the firm is not the designated fund manager.

Most of the exempt MiFID firms visited by the FSA suggested that they would be able to comply with the extension of the common platform requirements, including SYSC 10, proposed in CP07/23: Organisational systems and controls - extending the common platform; this finding may influence the outcome of the FSA's consultation, on which it intends to report in September.

Next steps

The FSA encourages private equity firms to undertake a benchmarking exercise against the findings of its thematic work, with a view to identifying gaps between current practices and good practices and implementing any necessary changes. In particular, firms may wish to focus on training programmes, the development and review of formal conflict policies and procedures in conjunction with senior management, compliance with SYSC 10 where relevant, compliance monitoring and investor disclosure.

The FSA reminds firms that conflict management remains a supervisory priority. Accordingly, the FSA will continue to visit private equity firms, focusing on non-relationship managed firms, and may consider comparing firms against the findings of its thematic review.

Comment

Although the Bulletin is couched in fairly moderate terms, firms should take note of the FSA's findings; thematic reviews are often a prelude to further action, in particular, where the FSA believes that its concerns are not being addressed. It is worthwhile noting, in this context, that while the Bulletin does not constitute formal FSA guidance, it is soft guidance and may be used against firms in enforcement action. In this case, the tone of the Bulletin suggests that the FSA's next steps may stop short of enforcement, for example, issuing further soft guidance. Comparisons can be drawn with Market Watch 24, which reported on the FSA's review of market abuse controls at UK based hedge fund managers; this publication adopted a harder line, implying that continued failings could result in enforcement action.

While the Bulletin is directed at private equity firms, other wholesale firms should consider whether the FSA's findings are relevant to them: the FSA is interested in conflict management by all wholesale market participants and expects firms to consider whether guidance directed at another sector may also apply to them by way of analogy. Whether it is fair to require firms to carry out this type of lateral analysis, given the proliferation of guidance and firms' often limited resources to monitor it, is debatable. It is arguable that where the FSA intends its guidance to apply to firms more generally, it may not be appropriate to publish such guidance in a sector-specific newsletter.

It is somewhat regrettable that the Bulletin focuses on conflicts of interest between private equity firms and underlying investors: under FSA rules and the common law, the client of a private equity firm is generally the fund rather than the investors. However, this is probably an academic point, as many of the conflicts described in the Bulletin also arise between private equity firms and funds, for example, in relation to co-investment and preferential terms.

The FSA makes clear in the Bulletin that conflict management will remain a priority and that it will continue to visit private equity firms, in particular, non-relationship managed firms. Firms which are currently MiFID-exempt may also receive FSA visits in due course if the common platform requirements are extended as proposed in CP07/23. More generally, given the FSA's findings and its focus on conflicts as part of its MiFID supervisory review, it may be prudent for MiFID firms to review their conflict arrangements to ensure that disclosure is more of a last resort for managing conflicts of interest.

The content of this article does not constitute legal advice and should not be relied on as such. Specific advice should be sought about your specific circumstances.

Herbert Smith LLP, Gleiss Lutz and Stibbe are three independent firms which have a formal alliance.

© Herbert Smith LLP 2008