SMCR for private equity

  • October 1, 2019

The ubiquitous and transformative rules come into play in just a few months; but what do they mean for private equity?

The Senior Management & Certification Regime (SMCR) is hitting private equity firms in December 2019. In some respects, the new rules shouldn’t dramatically alter processes and structures if robust corporate governance has been implemented and maintained. However, in terms of magnitude, ubiquity and paradigm shift, SMCR is a game changer.

The extension of the SMCR regime will see every FCA regulated investment firm - more than 58,000 financial services organisations - fall into its scope. Given the colossal reach of the regulation, some comfort can be taken. “The FCA is sensible, they don’t want to create chaos. The rules have to be practicable, useable and adoptable,” assures Leonard Ng, partner at law firm Sidley.

Furthermore, SMCR has already been road-tested on UK banks, but first step to readiness is via the creation of a work plan, which involves mapping out the organisational structure. “The work plan should be along the lines of getting basic governance prepared and in good shape before anything else,” says Ng.

As part of this, firms need to identify who is and who isn’t a senior manager under the new classifications. Says Sani Jackson, partner at compliance consultancy Optima Partners, “The most important place to start is the first pillar: senior managers and statements of responsibility. Find out who on the FCA register could fall under the senior manager function. These are CF4s for LLP structures, CF1s for limited companies, or CF3s as CEOs, as well as CF10/CF11 for the Compliance and MLRO function. Look at what they actually do and draft statements of responsibility.”

Don’t delay

While there are a few months until the rules come into play, plus a bedding-in period, firms ought to act sooner rather than later. First, to avoid a repeat the GDPR rules onset, which spawned a fleet of “specialists” capitalising on confusion.

Second, where the rules become interesting for private equity is in the meeting of corporate governance structures and tax treatments. PE houses are typically set up as LLPs for tax transparency, resulting in a high volume of team members as partners. Because of this structure, several years ago HMRC implemented the salaried member rules to test if partners are really partners, or rather just employees.

“The FCA will look at the register, and if for example A Capital has 15 partners who are all performing CF4, on December 9 the switch is flipped, and all 15 partners immediately become partner function SMF27. A number of those individuals become senior managers because of the tax test, but in reality they don’t have any influence,” points out Ng.

PE houses ought to be thinking now about whether those CF4s are really senior managers who are rightly transitioning to SMF27. To make changes to the partnership structure later down the line risks alarming the FCA. 

This time it’s personal

The second pillar to these rules is the Certification Regime, which changes the onus of approving a team member’s ‘fit and proper’ status from the regulator to firms’ themselves.

While most PE houses will likely have robust hiring processes, these rules seek far more depth than one’s ability to perform their job.

The FCA has made it clear they’re focusing on more than just financial misconduct. In May 2018, the FCA’s director of investment, wholesale and specialist supervision, Megan Butler, said at the UK Parliament’s committee hearings, that sexual harassment in the workplace falls into scope. “From our perspective, misconduct is misconduct, whether it is financial or non-financial.”

“Now it’s up to managers to look at all aspects of an individual’s history, including a person’s non-financial history, in considering whether the individual is ‘fit and proper’. This is broad,” remarks Ng. Indeed, if a firm were to hire someone with a blemished record, and that person then behaves unfavourably, the FCA could question the initial decision to hire that individual and speak to the senior manager who made the fitness and propriety assessment.  

Self-certification focuses on those classified as CF30 with the FCA. For many houses, there are typically large numbers of CF30s. Says one head of legal and compliance at a UK-focused private equity firm, “We’ve used CF30 as a proxy to approve team members to sit on portfolio company boards, which could mean that we’re heavily weighted in terms of those classified as senior managers under the new rules.” 

Bottom line

How private equity firms adapt to the new rules will of course be highly dependent on size and structure, but most of all on culture. Managers who have always had an eye fixed on accountability and corporate governance should find this transition fairly smooth. They will likely have organisational charts detailing individual’s responsibilities as part of their duty of care to investors. They will also likely have formal procedures in place that safeguard decision making processes, which are documented and evidenced.

However, there will also be a considerable number of firms sitting at the other end of the spectrum; those that have grown in an entrepreneurial manner, that may have hired investment staff without rigorous checks, who operate flat structures, who know how decisions are made but have not implemented formal processes. These firms will have more to prepare ahead of December, but there will be benefits in doing so: “This is a good mechanism to improve; this is a catalyst,” believes Jackson.

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