Four letters that spell responsibility

The Senior Managers and Certification Regime will revamp the structure and culture of private equity firms in many ways, valuations being one

If MiFID was the acronym of 2018 for UK-focused asset managers, 2019 is likely to be the year of SMCR, the Senior Managers Certification Regime. This replacement for the Approved Persons Regime, set to be introduced toward the end of the year by the UK’s Financial Conduct Authority, will introduce a regime defined by personal responsibility and, if things go badly awry, culpability.

In practice this means that if an asset manager finds itself under investigation for fraud or malpractice, the regulator will want to know who is responsible and whether that individual took the steps required to remedy the situation, possibly resulting in jail time for that individual. Systemic failure will no longer be a valid excuse.

Firms might try to kick the can down the road. After all, it’s difficult to remember a new regulation that was implemented on time and in full. But the FCA has said repeatedly that this is not a box-ticking exercise and, in its annual report, put the implementation of SMCR among its top priorities for 2018-19.

What does it mean for PE?

The regulations are three-tiered, depending on seniority: there’s the Senior Management regime for the top brass, the Certification regime for middle managers and Conduct Rules for virtually every other member of the organization.

Their application is also three-tiered at a corporate level. There are core firms, a category which encompasses a majority of private equity firms; limited scope firms, which do little regulated activity and therefore have a lighter regulatory load; and enhanced firms, the most burdensome category reserved for the very largest asset managers, which make up only 1 percent of the UK total by number.

In the context of private equity, the spotlight could be shone on any area of operation. But given that in the event of a crisis regulators are invariably quick to scrutinize valuations and the process that led to them, this area is one of the most significant.

There is a contradiction at play. To accurately value portfolio companies requires input from a lot of people, very few of whom are likely to carry the can under the SMCR regime. While the deal team might have the best idea of how portfolio companies are really performing, responsibility understandably gravitates toward the C-suite, particularly the chief financial officer.

According to an October conference poll carried out by third-party valuations provider Duff & Phelps, only 23 percent of valuation professionals are willing to take personal responsibility for valuations, 39 percent were not, and 39 percent said they needed more information on SMCR. Given that your success in the role is dependent on the good faith and practice of others, this reticence is understandable.

In reality, managers with good processes in place should be fine. Clear lines of sight are required between the team and the person responsible. The need for general partners to carry out thorough, regular audits of their portfolio companies to ensure the information from the deal team is within the bounds of expectation.

CFOs need to be more aware than ever of pro-forma modifications, for example, attempts by investment managers to alter EBITDA based on unjustifiable assumptions. To be certain, firms could bring in a firm to do third-party valuation, though no strong uptick is evident as yet. To use a cliché, to be forewarned is to be forearmed.

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