Regulatory rumbles

Under FSA regulations, UK-based private equity firms have to adhere to rules that were originally designed to protect retail investors in liquid securities markets. Not an easy undertaking. By Philip Borel, Managing Editor

To most private equity practitioners active in the UK, the rules and regulations imposed on their industry by the Financial Services Authority (FSA) are a necessary evil.

From an industry perspective, the FSA rule book is flawed. Compliance officers at private equity firms say that identifying and interpreting the relevant regulations accurately and making sure that their firms are doing business without breaking the rules can be cumbersome and costly.

More importantly none of the FSAs regulations were written with the practicalities of private equity fund investment in mind. Instead, the industry was lumped together with the rest of the general investment management industry and is therefore having to operate within a framework designed primarily for finance professionals dealing with retail clients and investing in liquid securities.

As a result, for UK private equity and venture capital firms to comply with the FSA rule book is to follow a set of rules that are often irrelevant and sometimes even hindering.

On the other hand, the benefits of being watched over by a regulator at all are widely appreciated in industry circles. FSA supervision bestows credibility on private equity as an asset class and provides a barrier to entry that dilettantes and conmen are unlikely to clear, hence keeping reputational hazards to those regulated at bay.

Established in 2001 under the Financial Ser-vices and Markets Act, the FSA is an independent non-governmental body accountable to

Britain's Treasury, the entity that appoints its board. Its statutory objectives include maintaining confidence in the financial system, protecting consumers and reducing white collar crime.

The FSA keeps Britain's private equity industry on a shorter lead than financial services regulators in other countries. Approximately 200 private equity firms are currently being supervised by the watchdog.

So far, the organization has never taken what it calls ?public enforcement action against a private equity firm, though harsh penalties including steep fines and even imprisonment are among the possible consequences facing anyone violating the UK's Financial Services and Markets Act. Unsurprisingly one would be hard pressed to find many UK private equity fund managers taking FSA provisions in any way lightly.

Because of the aforementioned lack of private equity specificity underpinning the FSA rules, developing an understanding of what is considered appropriate conduct for private equity firms isn't easy. The FSA Handbook is vast, and the organization's website does not offer any guidance as to which sections are relevant to private equity managers and which ones are not. (Neither, it is worth pointing out, does the British Venture Capital Association provide any primer or reference document to help prospective or existing members navigate through the regulatory maze.)

To avoid any missteps, practitioners intent on establishing a new private equity investment business in the UK are advised to seek professional advice from specialist lawyers and accountants.

?To be fair to the regulator, its remit is to service the UK's entire financial services industry, which obviously makes it difficult to cohesively deal with a subset such as private equity, notes Blair Thompson, a partner at London-headquartered law firm SJ Berwin. ?But as a result, there is no simple way of approaching FSA rules and regulations and applying them to private equity in a tailor-made way. What you're doing is interpreting general rules, which can be hugely difficult.?

What is more, for a new manager to go through the process of obtaining FSA clearance is a major undertaking. Any private equity practitioner who has gone through it will tell you that completion of the FSAs application pack invariably results in several ring-binders full of paperwork detailing a firm's proposed business plan, budgets and operating procedures. Producing the documentation typically takes weeks. Thereafter the FSA will take between four and six months to review the submitted documentation.

Also worth noting is that investment professionals joining a new or existing private equity firm are required to pass a series of FSA examinations. These exams require significant preparation but according to industry practitioners are not particularly well suited to testing whether or not a candidate is qualified to operate as a private equity investment manager.

?At the moment there isn't an industry-recognized exam for private equity managers and advisers in the same way that there is for example for other managers through the Investment Management Certificate, says James Perry a corporate partner at European law firm Ashurst in London. ?Any such exam tailored to work done by the industry would be a positive step.?

Once a firm is entitled to print the coveted ?Regulated by the FSA strapline on its marketing literature and business cards, the next challenge is comply with the watchdog's requirements. To be sure, no one interviewed for this article described compliance with FSA regulations as desperately onerous. However, practitioners do tend to point out that while larger firms with dedicated compliance personnel on the payroll have less difficulty dealing with regulation, smaller outfits are finding it tough.

?We don't have any particular problems with the current rules as they apply, and we seek to comply with them as they stand, says Adrian Johnson, chief executive of London-based mid-market investor Legal & General Ventures. ?It just depends on how geared up you are to deal with them.?

Smaller houses typically cannot afford a full-time compliance officer on the team. An increasingly popular alternative, short of small firm general partners doing the compliance work themselves, is to bring in external compliance consultants on a part-time basis to ensure all bases are covered.

One area that the FSA is currently taking a particularly keen interest in is money laundering. According to a bulletin published by SJ

Berwin in September, the FSA recently conducted unexpected visits to 11 private equity firms in the UK and found a number of them not wholly on top of their compliance game. Specifically, it lamented that regulated firms were not sufficiently familiar with anti-money laundering (AML) rules in Britain and the European Union or didn't have adequate procedures in place to abide by them. (Other complaints included wanting compliance documentation, insufficient resources devoted to compliance procedures generally and lax controls over outsourced business processes.) On the back of its findings, the FSA informed the BVCA that more visits will take place in the near future.

Industry professionals cite the FSAs anti-money laundering provisions as a typical area where a more private equity-specific set of rules would be preferable to the current requirements. ?AML is obviously important, private equity managers must be clear about where the money in their funds comes from and be certain that it hasn't been sourced illegally, says a general partner. ?But doing checks on every underlying investor when receiving a commitment from a fund of funds for example is obviously impossible, regardless of what the rules say. What we can do is look at the fund of funds manager's processes and get covenants that they have complied properly.?

So, while dealing with AML under the FSAs current rules isn't causing UK private equity firms intolerable levels of pain, practitioners would still very much welcome a different regime being put in place, one that gave explicit consideration to the ways in which private equity firms procure capital for investment.

Led by the BVCA's regulatory committee, a 12-strong group chaired by Margaret Chamberlain, head of financial services and markets at law firm Travers Smith, the industry has long been making efforts to encourage the FSA to take more of an interest in private equity, develop a better understanding of how it operates and adjust regulatory requirements accordingly. According to sources close to the committee, the BVCA's lobbying efforts have started to bear fruit, with a number of FSA officials having developed specialist knowledge about the industry recently.

The problem is that recent progress in terms of building a rapport with the UK watchdog is in danger of becoming irrelevant if new European Commission directives currently being worked on in Brussels will be implemented as they currently stand.

Specifically, there is a concern that Mifid, the markets in financial instruments directive due to be implemented in April 2007, is going to add yet another layer of regulation to private equity that once again ignores the fact that the industry is not part of the consumer-facing, public-market investment management mainstream. ?Mifid has the potential to undo all the work that has gone into building a dialogue with the FSA, says a UK venture capitalist. ?This is a genuine concern.?

If Mifid goes ahead as currently planned, it will touch private equity in numerous ways. For instance, the directive currently envisages capital adequacy rules that would require general partners to retain much larger amounts of capital on the balance sheets of their management companies than they currently do. For big, established groups this wouldn't necessarily be a problem, but new partnerships attempting to come to market may well struggle to comply with this particular requirement.

Another Mifid-related threat being taken seriously by private equity practitioners at the moment is the prospect of having to adhere to the principle of best execution, which requires brokers, market makers and anyone else acting on behalf of an investor to execute a trade at the best possible price. ?Again, in the public markets, best execution makes perfect sense, but how you would apply it in private equity just isn't clear, says a critic.

These and other areas of new regulation currently being discussed in Brussels have the potential to make life significantly more difficult for private equity investors in Britain and across Europe. Both the BVCA and the EVCA, its pan-European equivalent, are lobbying hard with various counter parties to avoid implementation of anything overly punishing. The lobbyists hope that engaging the relevant institutions in dialogue will eventually result in better regulation for private equity. Given what the European Commission has been saying so far, this is by no means a fore-gone conclusion.