The Markets in Financial Instruments Directive (MiFID), which has been in force since 2007, is being replaced by MiFID II. MiFID II will be effective from 3 January 2018.
The extent to which MiFID II will impact private equity firms will depend on each firm’s regulatory classification. All private equity firms will however be impacted to some extent. Some private equity firms will be directly within the scope of MiFID II, whilst others will be impacted as a result of “gold plating” by the Financial Conduct Authority (FCA). This note looks at the specifics of MiFID II and why it is relevant for private equity firms.
Key provisions of MiFID II1
MiFID II has a broad scope, impacting the following key areas:
- Organisational requirements: corporate governance; systems and controls, compliance, risk management and internal audit; conflicts of interest; outsourcing; record-keeping; telephone recording and electronic communications; safeguarding client assets; and complaints-handling.
- Conduct of business: information to clients; product governance; investment advice; inducements; remuneration; bundled services and cross-selling practices; suitability and appropriateness; best execution; client order handling; tied agents; client classification; client agreements; and reporting to clients.
- Transparency: transaction reporting; clock synchronisation; and post-trade transparency (trade reporting).
The devil is in the detail: individual firms' operating models will determine how MiFID II affects them:
- Full scope Alternative Investment Fund Managers (AIFMs). These are firms authorised under the Alternative Investment Fund Managers Directive (AIFMD). Full scope AIFMs which do not have any permissions other than those for the purpose of managing collective investment undertakings are categorised by the FCA as collective portfolio management (CPM) firms. CPM firms are exempt from MiFID. This means that they are only affected by MiFID II to the extent that the FCA chooses to “gold plate” MiFID II. The FCA has “gold plated” aspects of MiFID II such that certain aspects of the following areas will apply to full scope AIFMs: telephone recording; inducements and research; client categorisation; and (potentially, although hopefully to a more limited extent) product governance.
- Full scope AIFMs with “top up” permissions. These AIFMs are authorised under AIFMD and have "top up" permissions which enable them to carry out certain additional MiFID services including individual portfolio management. These firms are categorised by the FCA as collective portfolio management investment (CPMI) firms. A CPMI firm will need to comply with MiFID II in respect of the MiFID services it provides. A CPMI firm will also be impacted in its Alternative Investment Fund (AIF) management activities where the FCA has “gold plated” MiFID II activities for non-MiFID firms.
- Small authorised AIFMs. Small authorised AIFMs, which do not perform additional activities other than managing an AIF, will be affected by MiFID II to the extent that the FCA chooses to extend MiFID II requirements to these firms. Where small authorised AIFMs have additional permissions, for example as an adviser / arranger or for individual portfolio management (including separately managed accounts), they will be subject to MiFID II requirements as they apply to these additional services. The FCA has “gold plated” aspects of MiFID II such that they will apply to small authorised AIFMs in the following areas: telephone recording; inducements and research; client categorisation; and (potentially, although hopefully to a more limited extent) product governance.
- MiFID investment firms (other than Exempt CAD firms). These are investment managers and other firms authorised as MiFID investment firms. In a private equity context, these are typically firms acting as an investment manager (but not an AIFM). These firms will be subject to the entirety of MiFID II. Firms within this category include onshore UK investment managers to whom some or all of the day-to-day portfolio management of a fund is delegated where the fund itself is resident and managed offshore by an offshore AIFM. A firm which manages separately managed accounts (but is not an AIFM with “top-up” permissions) would also fall within this category.
- Exempt CAD firms. These are firms whose FCA permission is limited to acting as an “adviser / arranger”. Under MiFID II, European member states will continue to be able to apply an optional exemption for Exempt CAD firms, provided they are not permitted to hold client money. However, to apply the exemption, member states must ensure that national rules apply at least analogous requirements to the authorisation, conduct of business and organisational requirements of firms subject to MiFID II. In a private equity context, Exempt CAD firms are usually advisers to fund managers typically located offshore. However, they may also include venture capital firms and corporate finance firms. Firms which are Exempt CAD will be subject to the entirety of MiFID II. However, as the activities of these firms are more limited, they will be impacted to a lesser extent than investment managers which are MiFID investment firms.
Key changes affecting private equity firms
Currently, most private equity firms are exempt from the requirements to record calls and other electronic communications because they are able to rely on an exemption for discretionary investment managers. This exemption enables discretionary investment managers not to record communications with firms which the discretionary investment manager reasonably believes are subject to the recording obligation.
As a result of MiFID II implementation, the FCA has removed the current exemption for discretionary investment managers and applied the recording requirements to all communications that relate to activities including (as relevant to this article):
- arranging deals in investments;
- dealing in investments as agent;
- managing investments; and
- managing an AIF to the extent that this comprises the function of portfolio management (each an In-Scope Activity).
However, the extent to which the telephone recording requirements apply to these activities varies depending on a firm’s regulatory classification.
For MiFID investment firms (including CPMI firms), the recording obligation will apply to all In-Scope Activities carried out in respect of MiFID instruments (rather than, as under the current domestic regime, qualifying (i.e. listed) instruments). This means telephone recording obligations will apply to CPMI firms undertaking transactions in non-listed shares when performing MiFID services.
The FCA has clarified that the focus of the In-Scope Activity of “managing an AIF” is on the transactional side of portfolio management where conversations relate to transactions undertaken or intended to be undertaken. In the context of private equity transactions, communications relating to potential transactions often take place over a long period of time. This means that communications that relate to managing an AIF could be construed as requiring firms to record all internal and external communications undertaken by a firm’s investment professionals. Firms will also need to consider the extent of calls which take place with investors leading up to investing in an AIF and the extent to which investment negotiations need to be recorded. In practice, for private equity firms within the scope of the recording obligation, this is likely to mean that all individuals who are approved persons for the customer function (CF30) will need to have their lines recorded.
For private equity firms which are not MiFID investment firms (such as CPM firms), and CPMI firms when not carrying out MiFID services, the FCA proposes a more proportionate approach to the telephone recording requirements. The outcome for these firms is that the recording obligation will apply to the same In-Scope Activities, but in respect of a more limited range of financial instruments (broadly, financial instruments traded on a trading venue or for which a request for admission has been made). This is similar to the current regime, albeit that the discretionary manager exemption will no longer be available.
Whilst the more limited application for CPM firms means that such firms can breathe a slight sigh of relief, the devil remains in the detail. CPM firms will still need to assess whether any transactions are undertaken in traded instruments. In particular, the recording requirements apply to the activity of managing an AIF where the instruments are traded or for which a request for admission to trading has been made. This will capture communications where an investment is exited by way of an IPO. For any in-scope transactions, such firms will need to ensure that the recording obligations are complied with even where such transactions are infrequent.
Inducements and research
Some of the most controversial rules under MiFID II relate to changes to the inducements rules and restrictions on how investment managers may pay for research. Currently in the UK, the payment or receipt of a fee, commission or non-monetary benefit (i.e. an inducement) to or from a third party is not allowed unless it:
- is designed to enhance the quality of the service to the client;
- does not impair the firm’s compliance with its duty to act honestly, fairly and professionally;
- is in accordance with the best interests of its client; and
- is clearly disclosed to the client.
The requirements to be satisfied for inducements in respect of non-MiFID business are less onerous.
Under MiFID II, firms carrying out MiFID business comprising portfolio management (including CPMI firms) or advice on an independent basis are restricted from accepting fees, commissions or any monetary or non-monetary benefits paid or provided by a third party in relation to the provision of services to clients. However, MiFID II permits minor non-monetary benefits that are capable of enhancing the quality of service to the client, provided that: (i) these do not impact a firm's compliance with its duty to act in the best interests of the client; and (ii) the benefits are disclosed to the firm’s clients. Minor non-monetary benefits are narrowly defined and do not include research.
In recognition of the importance of research for investment firms, MiFID II provides a limited exemption which permits investment firms to receive third party research without contravening the inducements rules. The exemption provides that the provision of research by third parties will not be an inducement where it is paid for directly by the investment firm from its own resources or from a separate research payment account controlled by the investment firm which satisfies a number of requirements.
Although the FCA has “gold plated” the MiFID II inducements requirements by applying these to non-MiFID firms, the FCA has specifically exempted private equity business from these requirements. In particular, the rules on inducements and research will not apply in relation to an AIF or collective investment scheme, which generally invests in issuers or non-listed companies in order to acquire control over such companies. This means that due diligence received by private equity firms within the exemption will not be subject to the new research payment requirements.
Currently under MiFID local public authorities (Local Authorities) are permitted to be treated as per se professional clients where they satisfy the "MiFID large undertakings test". Under MiFID II, Local Authorities will be classified as retail clients, with the ability to request (where they meet qualifying criteria) to opt-up to become elective professional clients. The FCA has implemented revised opt-up procedures.
Under the FCA’s revised rules, firms will be required to apply the following tests and procedural steps when opting-up UK local authority clients to professional client status:
- the qualitative test – firms must undertake an adequate assessment of the expertise, experience and knowledge of the client to give reasonable assurance in light of the nature of the transactions or services envisaged, that the client is capable of making his own investment decisions and understanding the risks involved;
- a re-calibrated quantitative test which requires that the size of the client’s financial instrument portfolio, defined as including cash deposits and financial instruments, exceeds £10m and one of the following criteria are additionally satisfied:
- the client has carried out transactions, in significant size, on the relevant market at an average frequency of 10 per quarter over the previous four quarters;
- the person authorised to carry out transactions on behalf of the client works or has worked in the financial sector for at least one year in a professional position, which requires knowledge of the provision of services envisages; and / or
- the client is an administering authority of the Local Government Pension Scheme within the meaning of the version of Schedule 3 of the Local Government Pensions Scheme Regulations 2013 or, (in relation to Scotland) within the mean of the version of Schedule 3 of The Local Government Pension Scheme (Scotland) Regulations 2014, and acting in that capacity.
Where firms wish to opt-up non-UK local authority clients in other EEA states, firms will need to classify the local authority taking into account an alternative recalibrated test as well as local law opt-up criteria.
As the FCA has applied the MiFID II Local Authority client categorisation rules to non-MiFID business, there are repercussions for private equity fund managers for which Local Authorities are significant investors in their funds. In particular, this may be problematic for smaller Local Authorities, which are less likely to be able to satisfy the final limb of the quantitative test.
A further issue that arises is that under the new rules, firms will have to categorise Local Authorities according to whether they are exercising their treasury management or pension fund administration function. Therefore, the financial instrument portfolio limb of the quantitative test will only take into account the cash deposits and financial instruments of the particular function of the Local Authority they are dealing with. Again, this may lead to fewer local authority clients being able to opt-up.
If Local Authorities cannot satisfy the FCA’s opt-up procedures, firms will need to assess if their permissions enable them to continue providing services to such entities or if additional retail permissions are required. Many private equity firms have historically sought to avoid the need for retail client permissions because of the increased regulatory profile associated with it; the need for investment managers to have sat exams approved by the FCA; and because having retail client permission removes a firm’s ability to disapply certain execution related obligations under Chapter 18 of the COBS sourcebook of the FCA Rules.
Although MiFID II does not significantly alter the best execution requirements, there are some additional requirements, including in relation to reporting. Currently under MiFID, the best execution obligation applies to firms which execute a client order or receive and transmit a client order to (or as portfolio manager place a client order with), another entity for execution. Firms are required to take “all reasonable steps” to achieve the best possible result for the customer.
Under MiFID II, a higher standard is imposed. Firms are required to take “all sufficient steps” to obtain the best possible result when executing orders. More is required of firms to demonstrate that the processes and procedures they have in place meet the best execution standard. In particular, firms are required to satisfy greatly enhanced disclosure obligations. This includes providing information to be published annually on their top five execution venues and brokers in volume and on the quality of the execution obtained specific to each class of instrument.
Full scope AIFMs are already subject to best execution requirements under the AIFMD. The FCA initially proposed to extend the best execution reporting requirements to full scope AIFMs but has now confirmed that this will not go ahead. Instead, the FCA has stated that it may still consider extending MiFID II standards at a later date if there is evidence of poor outcomes. The FCA has similarly confirmed that it will not apply MiFID II best execution standards to small authorised AIFMs and will retain the current exemption to switch off best execution for small authorised AIFMs which manage funds with only professional clients.
We understand that it is the FCA’s intention that where AIFMs which are CPMI firms are conducting MiFID business, the MiFID II best execution obligations will apply with respect to that business.
The best execution requirements should not greatly impact private equity firms which are undertaking pure private equity transactions. This is on the basis that such transactions are bilaterally negotiated, do not take place on an execution venue and there is no client order. Private equity firms within the scope of the new requirements will need however to ensure that where they execute client orders, they are able to satisfy the new requirements.
Product governance requirements will be new to most private equity firms. This is because the current product governance regime in the UK focuses on firms providing products or services to retail customers. Under MiFID II, the product governance requirements are extended to all client types.
The MiFID II product governance requirements apply to full scope AIFMs which are also authorised to provide MiFID investment services (i.e. CPMI firms) but only in connection with the performance of such MiFID investment services.
For non-MiFID firms (such as AIFMs which are CPM firms) that manufacture or distribute MiFID financial instruments, the FCA has applied the MiFID II product governance requirements as if it is guidance on the application of the FCA’s Principles for Businesses. As private equity funds constitute collective investment schemes and the units in collective investment schemes are MiFID financial instruments, an AIFM which establishes and / or markets such funds will be subject to this guidance.
The MiFID II product governance regime requires firms to comply with granular rules which legislate for the whole of a product’s lifecycle. These include (amongst others) requirements to ensure management body oversight; a product approval process; compliance oversight; review processes; and clear identification of a target market.
For private equity firms, the product is the private equity fund itself. This means that private equity firms will need to consider implementing governance processes around fundraising and throughout the life of the fund. Documented processes will need to be implemented including (amongst others) requirements for fund approval, setting out the fund strategy and the target market. This will result in an additional compliance burden for firms.
We understand that the industry hopes that the FCA may issue guidance allowing private equity firms to apply the MiFID II product governance requirements proportionately to their business models especially in light of their wholesale investor base.
Whilst we await further clarification from the FCA, firms must begin considering how to comply with these requirements. Given the nature of private equity funds and the market of professional investors, a proportionate approach should be able to be taken in order to comply with the rules in a more simple way. We set out some simple practical steps that firms may wish to take below.
What can private equity firms do now to prepare?
As a preliminary step, private equity firms must first determine which aspects of MiFID II they will be subject to (see our assessment of the impact on different private equity business models above) and consider which will have the greatest impact. In respect of the key potential areas of impact, we set out below key practical steps for firms to begin undertaking now.
Additional clarity as to how some of these issues will impact private equity firms may emerge with time. However, given that MiFID II takes effect in the UK from 3 January 2018, in our view, private equity firms would be well advised to commence this preparation exercise now, if they have not done so already. Aspects of MiFID II implementation may need significant development time (for example, establishing telephone recording systems and implementing changes to operating procedures).
|Telephone recording: extension of MiFID II requirements to private equity firms||
|Inducements and research: extension of MiFID II requirements to private equity firms and classification of due diligence as research||
|Client categorisation: categorisation of Local Authorities as retail clients||
|Best execution: extension of MiFID II requirements to private equity firms||
|Product governance: extension of MiFID II requirements to private equity firms||