Appointed representatives (ARs) are allowed to carry out a limited range of regulated activities under the regulatory cover of a principal – an authorised firm which accepts responsibility for the activities of its AR and must supervise the AR accordingly. This is a model we see being used increasingly by first-time fund managers looking to get started without having to go through the time-consuming process of obtaining upfront their own FCA authorisation and to allow for a period of learning under the umbrella of a more experienced firm. This is usually done in combination with the principal firm acting as a “host” alternative investment fund manager (AIFM), as described below.
In May 2019, the FCA published its review of principal firms in the investment management sector accompanied by a “Dear CEO” letter. The findings were far from a clean bill of health. The FCA identified significant weaknesses in the control and oversight of ARs and most principal firms surveyed were found to have weak or under-developed governance arrangements in place including a lack of effective risk frameworks, internal controls and resources. The FCA also identified what it labels the “host AIFM models” involving ARs as a particular area of concern.
The FCA separated its main findings into concerns over:
- The AR on-boarding process – with particular concern over the failure of principals to fully assess their ability to oversee prospective ARs effectively and the quality of due diligence.
- Ongoing monitoring of ARs – chiefly, a lack of appropriate control frameworks to monitor the activities of ARs, little evidence of active steps such as file reviews, testing or challenge and a failure to manage conflicts of interest.
- Capital and liquidity assessment – a failure to assess risks to the principal arising from the AR’s activities and to consider what financial resources are appropriate to meet the principal’s obligations.
Host AIFM models
While the review is relevant to a range of investment-management business models, the FCA drew particular attention to the promotion and management of AIFs with a discrete section on the host AIFM model.
The FCA has in mind here situations where a principal firm is appointed as AIFM to an AIF, often as part of a packaged regulatory cover solution, with the fund sponsor in the role of the principal firm’s AR and usually appointed as adviser to the AIF. This typically arises where a fund sponsor does not want the burden of being FCA regulated and, instead, uses the regulatory cover of an authorised firm to carry on activities such as advising and arranging (although not portfolio management) as that firm’s AR, and leaves the burden of AIFMD compliance to the host AIFM. It can be distinguished from a host AIFM model where an AIFM delegates either the portfolio management function or the risk management function under AIFMD to a delegate itself authorised or registered for the purpose of asset management (often used in a cross-jurisdictional context).
The FCA is particularly concerned by instances where an individual from the AR is seconded to the principal, where they are approved to perform the customer-dealing function on behalf of the principal and undertake portfolio-management activity. The FCA highlights as a cause for concern instances under this arrangement where the AR, rather than the AIFM as principal, claims to be the fund manager.
The FCA’s review found examples of the following deficiencies in cases where the host AIFM model was being used:
- Failures to identify and manage conflicts of interest where employees of an AR are appointed to carry out controlled functions for the principal.
- Evidence that some firms had failed to put in place appropriate control and risk management frameworks, including experienced people, to oversee the AIFs and the activities of the seconded portfolio managers.
- Failures to maintain effective arrangements, systems and procedures to prevent and detect market abuse.
- Failures to report changes such as ceasing to be the AIFM of a particular AIF.
The FCA stated that it has significant concerns regarding the host AIFM model and that it will continue to assess the risks associated with it.
Osborne Clarke comment
The warning from the FCA in the Dear CEO letter that it will be conducting further work, including visits to principal firms, and that it expects to see that firms have acted on the findings of the review, is a shot across the bow for authorised firms in the investment management sector that take a light-touch approach to the supervision of their ARs.
Principals, in particular those offering AIFM services and regulatory cover to fund sponsors, should review the systems and processes they have in place to monitor their ARs. Meanwhile, fund sponsors who are ARs, or who are considering using a host AIFM model of the kind described by the FCA, should be aware of a potential increase in scrutiny from the AIFM (with possible knock-on effects on costs).