Originally published on FT Adviser
29th October 2024
https://www.ftadviser.com/regulation/2024/10/29/scale-may-be-what-industry-wants-but-isn-t-always-what-the-customer-needs/
It has been a while since the Financial Conduct Authority last talked in depth about consolidation, but its recent ‘Dear CEO’ letter means that this activity is once again in its sights.
Earlier this month the FCA announced its plan to carry out a multi-firm review of consolidation within the market. The FCA also sent a strong signal about how seriously it intends to take any rule-breaking.
Over the past two years there has been an increase in the acquisition of firms or their assets, while the world of advice has gotten more complex.
And while scaling up a business by making acquisitions might be an attractive proposition because of the efficiencies it brings, the FCA is concerned it may not always be good for the customer.
Chris McCullam, investments director at Altus Consulting, recollects that for some of the advisers he has worked with who have sold up and retired, only 40 per cent of their previous customers were retained by the consolidator.
“And even with those that are left behind, there are stories of those needing active advice support being left unattended, likely leading to poor customer outcomes,” McCullam adds. “Scale may be what industry wants but it isn’t always what the customer needs.”
The FCA has said where it receives notifications from individuals or firms to acquire or increase control in regulated firms, it will assess and challenge their suitability and the financial soundness of the acquisition.
As McCullam explains, currently the regulator requires firms to submit a regulatory business plan when they are seeking new or additional permissions, so a similar approach could be used for a material change in ownership or control.
Where the needs of clients are not front and centre of any transaction, they may not benefit from the change of ownership.
The regulatory business plan already includes sections on business model, governance, and capitalisation, which would contribute to an assessment of suitability and financial soundness.
Roderic Rennison, a partner at M&A firm Catalyst Partners, says: “The FCA is likely to develop a standard set of questions to ask acquiring firms, and will be focused on financial resources, especially funding, and they will also be interested to understand the process for integration of each acquisition and the level of resources available.”
Where acquisitions complete without prior regulatory approval, the FCA warned it may use its enforcement powers to object to the transaction or initiate criminal proceedings.
McCullam says: “This is a clear signal that the regulator is serious about ensuring overall firm ownership clearly demonstrates that a firm is a responsible entity that carries a commitment to its customers and position in the overall market.”
Rennison adds: “Our experience is that share transactions nearly always take place with the section 178 change in control process being followed appropriately. We have only ever seen one instance where it wasn’t, involving an overseas acquirer who acted out of ignorance without taking professional advice.
“The FCA is, in our view, reminding acquiring firms and individuals to follow the laid down requirements.”
Notifications for changes in control are known as section 178 notices. Firms must let the FCA know when they have made a decision to acquire or increase control in an authorised firm.
Clare Whittle, counsel – financial regulation group at Linklaters, says: “Prospective controllers of regulated firms are already subject to a robust assessment from the FCA through its change in control application process, which scrutinises, among other things, the suitability of the controller, the rationale and financing of the transaction and the impacts to the firm and its customers going forward.
“The FCA appears to be signalling to the market, however, that it wants applicants to ensure that their levels of due diligence on the target and resulting plans are adequate.”
The regulator’s message is against the backdrop of the consumer duty regime, under which firms must act to deliver good outcomes for retail customers.
Since summer 2023, the FCA’s forms for prospective controllers have been updated to ask potential acquirers specific questions on its consumer duty due diligence, any compliance issues identified and remediation measures. Acquirers are expected to disclose their due diligence report/board pack.
A number of factors have been driving the acquisition and consolidation trend:
The increasing cost of regulation and maintaining technological currency will also be a factor as firms look to gain economies of scale as they combine.
McCullam says: “This is one of the key factors for investment business, especially in the platform market, where narrow margins and constant cost pressures suggest the need for scale to drive profitability.”
The lower deal multiples in the UK compared to the US makes it more advantageous to do deals in this country, which means private equity remains one of the most prevalent buyers in the advice and investment sector.
The more capacity there is, the more potential there is for things to go wrong.
McCullam adds: “The financial advice sector has been largely resilient and generates consistent cash flow and profit for many firms, within a largely fragmented market made up of smaller firms, so the opportunity is there for PE to bring together these firms, enable scale economies and improve growth.
“Although there are concerns about fulfilling the needs of the end customers – the customer doesn’t figure that highly on the agenda of the PE house – and it is understandable that the regulator is questioning this type of move.
“Large corporates and product providers have also made a play in this space to establish vertical integration where advice is tied to the provider products and investments, however, the change in business model for many advice firms does not necessarily make this an attractive or easy route to accelerate product sales.”
The regulator recognises that while consolidation can provide benefits, various types of harm can occur where this is not done, it says, in a prudent manner with effective controls to promote good outcomes.
Ben Hammond, managing director – consulting and insight at the Lang Cat, says the FCA is concerned about the importance of operational resilience and the potential risks if large consolidators fail.
He adds: “If you’ve got a consolidator who goes out and buys 10, 15, 20 firms this year at £100mn each, all of a sudden they’ve got a couple of extra billion quid in AUM with relatively large portfolio sizes.
“How do you keep track of all that and the data that sits behind it, and the consolidation of systems and everything else? The more capacity there is, the more potential there is for things to go wrong.”
With consolidation and a more standard model to support a wide array of clients, comes a reduction in client centricity.
Whittle says the potential for harm can vary by acquisition structure but prudential considerations are key, adding that the regulator tends to scrutinise deals heavily to understand whether the regulated entity – and resulting group – will have the necessary resources to carry on its regulated business and be able to meet its applicable regulatory capital and liquidity requirements post-acquisition.
Whittle adds: “The rules relating to regulatory consolidation will need to be considered and will have a fundamental impact on the structuring of a deal.
“The impacts of an acquisition on the existing governance of a firm will also need to be considered, and where there are changes there is the possibility of more FCA-approval filings for approved person/ senior managers.”
As they grow in size consolidators can become quite complex models, leading to a challenge in managing large numbers of firms and customers in a consolidated environment.
Hammond says: “We’ve got these firms that are growing at an increased rate of knots, and they’re getting to a large size, in terms of assets, advisers and staff.
“If one of them fails, or the backers decide to pull out, what’s the backup there?”
Hammond adds that negative news stories about client charges increasing may also be prompting the FCA to step in to take a better look at the market.
This review comes at a time when the FCA has expressed concerns about ongoing advice arrangements, after the regulator found that 231 firms had charged for ongoing advice but not delivered.
The issue affected 6,108 clients out of a total of 213,128 (2.9 per cent) who had paid for, but did not receive, an annual review in 2022.
Around 90 per cent of new clients are placed into ongoing advice arrangements. For the sector, ongoing advice is 80 per cent of all advice revenue, up from 60 per cent in 2016.
It is not uncommon for a business looking for a sale to go through a process of reducing its cost base to appear more attractive to investors.