IM&W: Navigating FCA scrutiny through the M&A process

Investors into the UK Investment Management & Wealth (IMW) sector have in the past commonly used third-country entities as an efficient investment vehicle to raise debt and to purchase the equity of UK regulated firms. The use of an offshore acquisition structure was viewed as providing greater financial flexibility and more favourable deal economics for investors, with goodwill (which would ordinarily result in a capital deduction) falling outside the UK regulatory perimeter. The use of such structures became the favoured approach, particularly for Private Equity (PE) investors.

Following the FCA’s introduction of the Investment Firm Prudential Regime (IFPR) in 2022 and perhaps the popularity of these offshore structures, our experience of recent Change-in-Control (CiC) applications has highlighted that the viability of this structure is coming under increased FCA scrutiny.

This blog shares insights from where we have supported clients through recent transactions and regulatory approvals. Our insights are relevant to regulated entities and PE investors, specifically those considering further M&A or divestments.

Current FCA areas of scrutiny

From our experience gained from supporting clients in recent CiC applications, the FCA appears to be placing more scrutiny on the proposed acquisition structures and deal economics. This is particularly relevant to deals, often backed by PE houses, that use a chain of holding companies based overseas (‘BidCo’, ‘MidCo’, ‘TopCo’) to facilitate debt and equity investments in UK regulated entities. Areas of FCA challenge has included:

• Whether the offshore holding companies are in fact within the scope of the FCA’s supervision under the ‘principal place of business’ requirement;
• Whether goodwill created as a result of the deal is booked onshore or offshore;
• How the structure meets the requirements in Section 143J of FSMA to maintain a single UK parent;
• Whether the structure of any debt obligations in the chain could place a strain on the UK regulated entities to upstream cash via dividends or loans, particularly under stressed conditions; and
• Whether firms have correctly identified connected undertakings and the prudential consolidation perimeter.

We have now seen the FCA raise questions related to any of the above five areas on a regular basis, including very late on in the CiC process when just a few days remained on the statutory clock. This has resulted in some firms being required to change their planned acquisition structure or take alternative mitigation, including injecting more equity in some cases, late in the process to ensure successful FCA approval.

Any group which includes multiple FCA regulated firms as direct subsidiaries of an overseas holding company (i.e. without a single UK parent) should carefully consider the FCA’s evolving expectations ahead of their next CiC application.

Emerging risk

Whilst in previous years the FCA has focused its attention on investment management firms with discretionary management permissions under the MIFIDPRU regime, there is a chance that the prudential expectations of the FCA will start to increase for the wealth management sector. The FCA is currently reviewing the industry feedback to Consultation Paper 23/24 (CP23/24) and they plan to publish a Policy Statement before the end of this year. There are two fundamental issues for wealth managers/ personal investment firms (PIFs) to be aware of:

• The FCA has consulted on an additional requirement for in scope firms (those subject to IPRU-INV Chapter 13) to hold additional capital for potential redress claims based on a prescribed methodology. If the FCA proceeds as per CP23/24, PIFs may be required to comply with the requirement to hold additional capital as early as H1 2025.
• However, the chapter within CP23/24 with the greatest potential impact to this sector is the Discussion Chapter where the FCA has signalled that they are considering moving towards a more comprehensive prudential regime with an explicit reference to the IFPR. Although Finalised Guidance 20/1 (FG20/1) already applies to all FCA solo-regulated firms, it appears that the FCA is considering introducing in due course formal requirements in the following areas:
  • Risk and/or activity-based capital requirements: Potential recalibration of capital requirements for PIFs to a more risk-based approach as the FCA indicated that the prudential capital requirements for PIFs are relatively low compared to other regulated sectors.
  • Basic and activity-based liquidity requirements: Although already expected under FG20/1, the FCA is considering the merits of introducing formal liquidity requirements for the first time for PIFs.
  • Improved risk management: The FCA is raised the potential to rollout a similar requirement to the Internal Capital Adequacy and Risk Assessment (ICARA) for this sector to bring it in line with the IFPR.
  • Wind-down analysis: Similar to the ICARA, the FCA is also considering the introduction of a formal Wind-Down Plan (WDP) requirement which would build upon expectations already in FG20/1.

Depending on the scope of the changes and the circumstances of individual firms, this sector may be required to meet higher capital and liquidity requirements in due course. Therefore, any firm going through the M&A process in the wealth management sector should be aware of the growing possibility of these firms being required to hold higher levels of capital and consider any appropriate price adjustments.

Common pitfalls

Aside from the FCA hot topics that we have explained above, we have noticed a number of common pitfalls that do not always receive adequate consideration by some firms during the M&A due diligence process. Without adequate consideration of the prudential requirements of the enlarged regulatory group, some buyers identify potential issues only at a late stage in the process. Conversely, sellers should also consider these key prudential requirements and expectations to help facilitate a smoother sale process. Particular issues that we have observed include:

• A lack of consideration as to whether conditions for the Group Capital Test or other regulatory waivers would continue to apply following the acquisition (or whether a new application would be required);
• A lack of assessment of the increased requirements that may apply to the enlarged group associated with exceeding regulatory thresholds, such as the Small and Non-Interconnected threshold, the significant SYSC definition or the MIFIDPRU remuneration code;
• An underappreciation of the potential impact to regulatory capital resources if previous audit exemptions are no longer applicable when an entity becomes part of a larger/different group;
• A lack of planning for the future integration of the separate ICARA processes into a single group/consolidated ICARA process with a robust assessment of integration and group risks;
• Insufficient challenge to the WDP of target entities that rely on material inter-company balances to fund an orderly wind-down; and
• An existing legal entity structure that does not support an M&A strategy or the integration of multiple acquisitions, resulting in the duplication of regulated entities/permissions and capital inefficiencies. In this regard, developing a Legal Entity Integration Policy can help provide firms with a post-merger integration blueprint to follow that is supported by the appropriate governance and risk management. Additionally, achieving an efficient legal entity structure can also help facilitate an effective future sale (if future exit is part of the business strategy).
  
  

For broader regulatory insights, please see these previous blogs relating to the ICARA and WDP requirements.

Why does this matter

The areas of regulatory scrutiny highlighted in this blog are not just a tick-box checklist of regulatory requirements that need to be met with no wider significance. Instead, depending on the approach taken by firms, they can make a material impact to the M&A deal, the firm’s business strategy and future regulatory engagement. For example:

• Where we have identified regulatory issues at an early stage, acquirers have been able to secure appropriate pricing adjustments to cover the anticipated costs of additional regulatory capital or other requirements. It can also help avoid the need to raise additional funding at a late stage of the process or even after the deal has closed.
• By being sighted and prepared for areas of regulatory scrutiny before the CiC application is submitted, firms are typically much better prepared to respond to FCA information requests and questions during the process. Being able to provide comprehensive responses to the FCA in a timely manner can help expediate the CiC process and, ultimately, increase the chance of success.
• If the FCA considers that their supervisory objectives are not being met on an ongoing basis, we have observed the regulator apply restrictions to some firms. This could include a higher capital requirement, a restriction on new business or a request to pause any further M&A until a remediation plan is completed. Regulatory action of that nature could have a material impact to a firm’s business strategy.
  
  

Ultimately, being sighted on evolving areas of FCA scrutiny whilst also having a legal entity structure that supports a long-term M&A strategy will be beneficial to reduce capital, regulatory, operating, tax and other inefficiencies that can occur with each new transaction.

Next steps

Firms currently in the process of an M&A transaction or planning further M&A in the future should take the opportunity to consider their planned acquisition structure against the FCA’s evolving expectations. Many firms do not have a dedicated FCA supervisor, so the CiC process will represent a period of much closer and more intense regulatory scrutiny. It is also an opportunity for the FCA to set out its expectations clearly and make an intervention if deemed appropriate. Therefore, firms should look to be as prepared as possible to facilitate a smooth CiC process and set themselves up for ongoing success in the future.

If you would like to discuss any item of this blog further or to hear wider sector insights, please contact any author of this blog.