Financial advice is one of the keys to the government strategy to drive investment into the real economy including from retail consumers.
However, regulation has been more focused on reducing the risk that consumers come to harm. In this case, the FCA’s approach, in our view, has for many years been so focused on reducing the risk of poor advice with onerous regulation that a sizeable gap in the provision of advice has emerged. The problem for growth in the economy is that consumers need that missing advice if they are to channel funds safely into productive investments. The FCA has therefore tried to row back on the regulation by trying to encourage a form of advice with less regulatory risk – so-called targeted advice.
That is fine and commendable progress in striking a better balance between risk aversion and growth enabling. However, another trend in the wealth management sector has re-triggered the FCA’s risk aversion: the consolidation of wealth management firms backed by Private Equity capital. On Friday last week, after many months of data collection and thought, the FCA finally published its findings of its review of “Consolidation in the financial advice and wealth management sector”. It makes for interesting and essential reading especially if you are a PE firm or a wealth management firm.
The FCA has found much that it is unhappy with that is strategic for consolidators. The FCA hasn’t found a new problem or created new expectations on firms. But it has identified issues that it wants firms to address. Now that it has found these issues it will not let go. Failure to address the issues yourselves will, as usual, be costly in money and time for firms. The threat to derail acquisitions is implicit. Indeed, the FCA wrote that the “attributes” it is looking for “are likely to support timely change in control processes”.
The answer is not yet another round of the tick-box compliance with 3rd party support. Even the FCA was dismissive of “due diligence exercises [that] appeared to be to be “tick box” in nature”. What makes more sense is to look at the fundamental and strategic principles that underly the regulation and the value-creation theses of consolidators. At Prysm Global, we call that a critical friend approach. As a critical friend we bring insight into the fundamental principles (and mindset) of the FCA and how that interacts with the strategy and business model of firms.
The wealth management sector presents several challenges for the regulator. It is a very fragmented sector with more than 5,000 mostly small firms where the financial consequences of (and cost of putting right) poor advice is very significant relative to the finances of the firm. Supervising a lot of small firms, knowing what they are up to and ensuring that they have the resources to make redress is the stuff of nightmares for a risk averse regulator.
The consolidation of the sector is thus an opportunity for the regulator. Supervising a relatively small number of well managed and well capitalised firms should be attractive to them. But firms need to recognise that their growth will lead to greater scrutiny and expectations. At Prysm Global we believe that the business strategy and investment theses of the firm should fully integrate the principles underlying the FCA approach.
In theory, larger firms should be able to afford better leadership; stronger and more independent Boards; more robust and scalable risk management; and greater capital efficiency. These benefits of scale are part of the investment theses for many firms. However, the challenge is often that these attributes are not there in smaller companies that are acquired and investment will be needed to bring acquisitions up to the mark – potentially creating “negative synergies”. Furthermore, the FCA has made very clear that they expect firms to scale systems and controls in line with their growth; to ensure leadership with sufficient knowledge and experience to deal with increasingly large and complex issues; and to have regulated Boards that have the power to challenge on material decisions and use it. These attributes are judgement-based and are well suited to a critical friend approach that draws on both strategic commercial and regulatory expertise. They are not well suited to a tick-box approach.
The FCA doesn’t just want to know that firms are managed well. It also wants to know that they have enough of a capital buffer to get them through the business cycle and if worst-comes-to-worst they have the funds to meet operational costs for an orderly run off and the cost of customer redress. Again, having large well-managed and capitalised firms should be a plus for the regulator compared to a history of small firms that gave poor advice, went bust and had their customers bailed out by the FSCS.
In banking, there are models and formulae for determining this capital. In wealth management, there are also formulae, but the FCA are clear that the formulaic capital requirement is the bare minimum. The FCA has written rules to require firms to assess all their risks – including through stress-testing, the potential financial implications of those risks, and the size of the relevant capital buffer. Unsurprisingly, this process has much in common with the financial modelling undertaken by PE-backed firms to assess their financial risks and their resilience taking into account leverage.
As the FCA contemplates PE-backed consolidators it sees some important attributes of their typical strategy, structure and modus operandi that raise red flags. The FCA insists that they are taken into account in controlling risk and calculating the capital needed as a buffer against the risk:
- High financial leverage and financial engineering is a red-flag – even if it sits elsewhere in the group. The FCA therefore demands that capital adequacy be assessed at a group level as well as for the regulated entity. Anything which compromises the value of (net) assets in a distressed situation is a no-no: e.g., good will from acquisitions doesn’t count, amounts owing from other parts of the group don’t count; guarantees of other parts of the group. Anything that might compromise the ability of the firm to wind-down in an orderly manner is a red-flag – e.g., lack of funding to deliver operational, technology and control services from other entities.
- Synergies and value-creation theses that risk poor customer outcomes are red flags:
- Cross-sell, pricing of services and migration to new platforms which raise red flags around conflicts of interest and poor Consumer Duty outcomesCentralisation of operations and technology functions to unregulated entities elsewhere in the group – especially when the entities are offshore or otherwise outside the reach of the regulator.
- Efficiencies in overhead/control functions which might compromise the ability to identify and control risk
The FCA required process is called the Internal Capital Adequacy and Risk Assessment – ICARA. The FCA may well want to see the ICARA – especially when determining a change of control application.
A critical friend review of the ICARA which clearly integrates the investment thesis for acquisitions and the regulatory capital principles could go a long way towards avoiding problems later. This is going to be especially important during an acquisition process. The FCA has looked into the due diligence approaches for acquisitions and highlighted the benefits for ‘all stakeholders” of having a clear acquisition strategy with “defined commercial, cultural and client acquisition targets”, and a flexible approach to due diligence tailored to the specific targets. They also seem to recognise that success with post-merger integration from a regulatory perspective as well as a commercial perspective starts with integration of post-merger planning into target assessment, negotiation and investment thesis development
The FCA work and publication is important to the industry, and they expect firms to take action even if it is only to step back and review their approach. At Prysm Global, we know how to craft a strategic approach to value-creation and regulation which meets the needs of the regulator, of investors and of customers.
Written by Jonathan Davidson, Founding Partner, Prysm Global
