Travers Smith's Venture Insights: Emerging Managers and the UK AR Regime

Key Insights

Pro-competition: The UK appointed representative (or AR) regime provides a quick solution to market entry for VC emerging managers, allowing them to operate without obtaining authorisation to carry out regulated activities in the UK. However, that flexibility may now be curtailed.

The AR regime is being retained: After coming under increasing scrutiny, the AR regime will be retained, with some modifications.

Changes to the AR regime: There will be two key changes. Of most significance to the VC sector is the need for third-party providers under the AR regime to get advance permission from the FCA. This is likely to reduce flexibility which, in turn, could have an impact on the number of providers in the market.

The UK government is committed to using private capital to boost innovation and productivity. The UK's finance minister, Rachel Reeves, has recognised the importance of British venture capital to that mission and the government insisted that the regulators take steps to align their rulebooks with the policy goal of competitiveness and growth.

But what happens when the rubber hits the road? Proposed reforms to one of the industry's core regulatory advantages – the "appointed representative" (or AR) regime – may put these well-intentioned pledges to the test.

The AR regime really does matter. It is pro-business and pro-competition. For decades, it has helped first time fund managers get to market quickly and has reduced their up-front costs. Early suggestions of its abolition were met with consternation and the latest proposals suggest that the UK regulator, the FCA, is listening to feedback.

Usually, a person who carries on regulated activities in the UK must be authorised by the FCA. The AR regime is an exception to this rule because an already authorised firm (the Principal) accepts responsibility for the AR's regulated activities. The AR carries on its activities relatively independently from the Principal, but the Principal must oversee the AR in line with FCA rules and guidance. That Principal oversight has been enhanced in recent years.

Communicating with LPs is likely to involve a regulated activity and so VC managers need regulatory cover in order to raise and market a fund in the UK. However, VC emerging managers launching their first fund may not have the bandwidth for the cost and time involved with obtaining FCA authorisation so they often rely on the AR regime. This enhances their speed to market for their first fund and is a useful temporary platform while they build up the resources should they wish to apply for FCA authorisation.

Under the AR arrangement, a VC emerging manager would only be able to provide transaction arrangement and investment advisory services and would not be authorised to manage and run their funds. The AR regime doesn't extend to these activities and so the VC emerging manager will usually appoint an authorised third-party (a "host") to act as the fund manager, with the VC emerging manager providing investment advice to that host in reliance on the AR exemption. Nine times out of ten, the Principal and the host are part of the same third-party provider's business.

The AR regime really does matter. It is pro-business and pro-competition.

The AR regime has come under scrutiny because of a perceived tension between the ease of market entry that it provides vs consumer protection. The UK government's economic and finance ministry, HM Treasury, confirmed in its recent policy statement that there will be two key changes to the regime:

A new requirement for Principals to obtain FCA permission before they can appoint ARs (firms which act as Principals for ARs already will not need to apply for the new permission).
The UK Financial Ombudsman Service (FOS) will have new powers to investigate cases where the AR acts outside the scope of its AR agreement and carries on other (non-covered) regulated activities, and the Principal wasn't at fault.

The first change raises a few potential issues for VC emerging managers. By requiring authorised firms to get advance permission to act as Principal, it will reduce some existing flexibility because – currently – any authorised firm can provide an ad hoc hosting solution. This is likely to drive emerging managers and other firms towards established providers, concentrating ARs within a smaller number of principal firms. This could, in turn, cause capacity issues, with a knock-on effect on timing and pricing.

In addition, the FCA will be able to impose conditions on the grant of any permission (which could, for example, limit the type of clients or business for which the Principal can accept responsibility). The FCA will also be able to vary or revoke the permission and, depending on how it exercises these powers, this could further limit the capacity of existing service providers to act as a Principal.

The second change is generally less relevant to emerging managers when they operate a sub-advisory model (like the one mentioned above), as they would normally not be providing services directly to clients who are eligible to complain to the FOS.

We don't expect the primary legislation to come into force until next year at the earliest. The UK government intends to consult on the detail of the changes and it's also likely that the FCA (and the FOS) will need to consult on changes to their rulebooks, so we'll need to wait and see what the outcome of those consultations are and how far the government's well-intentioned pledges are put to the test.

These reforms won't be a game-changer, but will result in some loss of flexibility. How much that matters to the VC sector depends on what the FCA decides to do now – and how much weight they give to the government's core growth mission when they perform their difficult balancing act.