FCA says conflicts frameworks in private markets should reflect business reality

Laura Dobie and Elizabeth Budd of Pinsent Masons were commenting on the FCA’s findings of its in-depth review into how asset management firms and investment advisers operating in private markets identify, manage, mitigate and disclose conflicts of interest.

The review covered firms whose UK activities included managing funds or providing portfolio management, and advisory services involving private equity, private credit and real estate assets.

The FCA said many of the participating firms were able to demonstrate “effective governance, strong conflict identification processes and a clear focus on investor outcomes”. However, it found that some firms were not proportionally scaling up their control frameworks to meet the increasing complexities of their business models as they grew.

The FCA expects firms to reflect on the findings, identify gaps in their frameworks and consider whether they need to take action to keep conflict identification processes agile and “responsive to changes in their business, such as group structures, ownership arrangements, product offerings, investment strategies and operating models”.

The FCA also highlighted several other "recurring weaknesses and areas of concern", including examples of firms handling cross-fund transfers and continuation transactions that had weak governance and conflicts frameworks in place.

Cross-fund transactions and continuation vehicles, which are becoming increasingly prominent in the private markets, including in the private equity space, are identified as a particularly ripe area for potential conflict. The Institutional Limited Partners Association (ILPA) recently published updated guidance to establish clearer expectations for general partners (GPs) and limited partners (LPs) on how to evaluate and conflict manage these types of transactions more effectively.

In respect of gifts and entertainment, the FCA said its “principal concern” was whether some firms were able to demonstrate that their policies and controls operate effectively.

Separately, it identified certain firms as relying overly on staff training and informal safeguards to restrict confidential information-sharing, rather than deploying effective monitoring “to demonstrate that confidential information was being effectively contained”.

The FCA noted that many firms consulted limited partner advisory committees (LPACs), or equivalent investor bodies, to help manage conflicts of interest. However, it recognised certain limitations of LPACs in its findings and cautioned that LPACs were not "always effective as a conflict-management tool", noting that investor consultation should not be used in isolation, but "should operate alongside strong governance, oversight and conflicts-management arrangements”.

In terms of disclosure, the FCA recognised “proactive and timely” disclosure of conflicts, where appropriate, and the engagement of both investors and LPACs “early enough to provide meaningful challenge and influence outcomes” as good practice, while noting stronger arrangements “treated disclosure as a supplementary control rather than a substitute for conflict management”, and “prioritised avoiding conflicts or if not possible, taking steps to mitigate and manage them before considering disclosure”.

The regulator noted that most-favoured nation (MFN) clauses and side letters were helpful for allowing “eligible investors to access equivalent rights to those available to other comparable investors”, offering potential to lower the risk of certain investors being treated preferentially at the expense of others. However, it recognised that governance of the use of MFNs and side letters by some firms could be improved with stronger oversight and systematic assessment of their cumulative impact on other investors.

The review should give private markets firms considerable pause for thought in how they manage conflicts of interest. In particular, the FCA cautioned firms against applying a form over substance approach to conflicts, identifying operating “frameworks that reflect the substance of their activity and the conflicts arising from them, not merely their legal form” as an example of good practice. It observed in some instances firms’ UK activities – not necessarily illegitimately – structured as “advisory-only” but actually involving “key investment-lifecycle activities” and noted that conflicts governance frameworks should reflect the reality of that.

Although the FCA acknowledged that not all findings would be relevant to every firm and stated it was not seeking to be prescriptive as to business model, ownership structure or level of inherent conflicts risk, the review provides firms with an ideal opportunity to re-examine their existing conflicts frameworks and practices, identify any gaps and ensure proportionate controls are in place that are appropriate to their business and its conflict risks.

The review also reinforces the regulator’s previously expressed views that financial services firms, specifically high-growth firms and asset management firms, must adopt governance frameworks that are tailored to their business model, proportionate and in step with their activities and growth.

Commenting on the findings, Budd, a specialist in financial services regulation, said: “FCA commentary on how its rules should be applied is becoming increasingly important. What this review helps to highlight is that conflicts assessment is not simply a single point in time but can ebb and flow throughout the lifetime of the investment.”

The FCA said the review was “conducted against a backdrop of increasing regulatory and industry focus on governance, transparency and standards across the sector”. Dobie, an investment funds and asset management specialist with Pinsent Masons, added: “The FCA’s findings will be of interest to GPs and LPs alike as they offer commentary on the place of commonplace mechanisms like LPACs and MFN clauses in conflicts management frameworks and their potential to support investor fairness and the limitations of relying on them. Firms should review their conflicts of interest management frameworks against the FCA’s relevant findings and look to remedy any shortcomings.”