This month we focus on some of the key legal and structuring flashpoints encountered in UK financial services M&A. Financial services has long been a popular sector for private equity and corporates alike, but in the last two to three years the rise of Fintech companies, particularly in the personal finance and payments sub-sector, has boosted activity levels. Combine this with continued consolidation of financial brokers and asset managers, and the outlook for FS M&A looks healthy.
1. You, me and the regulator
While the principal parties to any FS M&A transaction are still buyer and seller, there is arguably a third party whose interests need to be borne in mind at each stage of the transaction – the regulator (in the UK context the Financial Conduct Authority, or FCA).
Any business that offers or promotes financial products or services to consumers or businesses will likely fall within the UK regulatory framework, overseen and enforced by the FCA. Banking, insurance and large investment firms may fall within the regulatory purview of the PRA (Prudential Regulation Authority) instead, or as in addition to being regulated by the FCA. The regulatory framework applicable to the business can impact on transaction structure, financing and timetable. For the purposes of this article we will assume the FCA is the sole relevant regulator.
2. Change of control approval
Assuming the business is regulated by the FCA (see also due diligence section below), any acquisition of a significant stake in a financial services business will require prior FCA consent. This is not an approval of the transaction as such (so is unlike competition/anti-trust clearance), but is an approval of those persons who will become 'controllers' of the regulated business after the transaction completes.
Applying for this approval requires considerable work and advance planning, and the FCA has up to 60 working days to assess the application (starting from the date on which the regulator considers the application is complete). This can have a significant impact on transaction timing and, if any difficulties are encountered obtaining this approval, on the viability of the transaction itself. Further details are provided in our earlier article " Acquiring a Regulated Business – Change in Control Regime"
3. Structuring factors
Potential impacts of the regulatory regime on transaction structuring can include:
- Asset transfer vs share sale: in some cases, e.g. where the buyer already has sufficient regulatory permissions to conduct the target business – such as IFA consolidations – we have seen some innovative structuring, such as the target company relinquishing its regulatory approvals and then transferring its clients and assets into the regulated consolidator
- Financing structure: consider if the target business would need to fall within security arrangements that might complicate the change of control application, for example by creating a perception that the financial position/risk profile of the target business could be weakened post-acquisition
- Transitional services: if the transaction involves any transitional services (as is common, particularly if the business is spinning-out of a larger group), check if those services would amount to outsourcing under the relevant FCA rules. If so, those arrangements will need to be properly assessed (e.g. would the business still be able to monitor and control its operational risk and regulatory compliance), supervised and potentially disclosed to the FCA
4. Purchase price
Buyers often have three key concerns when agreeing a purchase price for financial services companies:
- the effect of 'client attrition' (clients who leave the target following the acquisition) on earnings
- the operational and financial implications of regulatory change
- the risk of departure of key individuals
We typically see the following mechanisms employed to address these concerns:
- earn-outs based on future revenues or profits (also commonly seen in non-FS deals to bridge the gap between seller and buyer pricing expectations)
- purchase price payments deferred and paid in tranches after completion, with a corresponding right of offset for warranty/indemnity claims (with warranties covering areas such client complaints, cancellation or non-renewal notifications, regulatory compliance and relationship with the regulator)
- consideration linked to assets under management (to address concerns about client attrition)
- revisions to key individuals' service (employment) agreements, e.g. ensuring notice periods reflect seniority and importance to business
- completion accounts adjustments to the purchase price, linked to the target's verified regulatory capital
5. LEGAL DUE DILIGENCE
As with any M&A deal, the focus of due diligence will depend on the transaction structure – whether a share or asset sale, or a public or private process. Where access to the relevant data is reasonable, due diligence is likely to target the following areas:
- the contractual basis of client agreements and whether the acquisition will adversely affect them (whether by change of control clauses, or assignment restrictions)
- analysing whether the firm's authorisations are sufficient in scope
- the history of the target's
relationship with the relevant regulator(s) including
authorisations, fines and enforcement, along with the target's
in-house compliance arrangements, including reviewing:
- internal and external compliance reports;
- material correspondence with the regulator;
- compliance and risk board and committee meetings; and
- complaints and breaches registers.
- regulatory capital – would the buyer or post-completion holding company meet applicable regulatory capital requirements?
- consideration of any forthcoming regulatory changes
- employment and incentive structures relating to key members of the target's team
Financial services and asset management businesses often rely on the skills of a few key individuals, along with their business relationships and reputation. As a result the value of the target business is often linked to those key individuals, and a buyer will want to ensure their continued involvement following the acquisition.
In addition, a regulated business will need to have individuals who are approved to carry out relevant 'controlled functions'; in brief, roles critical to ensuring the business complies with its regulatory obligations, such as acting as the director of a regulated firm or overseeing the firm's compliance processes. If those approved persons leave the business, they will have to be replaced without interruption in order to ensure continued compliance with the applicable regulations.
Typical mechanisms used to 'lock in' key individuals include:
- making a portion of the purchase consideration available to the target's employees on an incentive basis
- using deferred or contingent consideration – both buyer and seller (especially if an earn-out is used) will be incentivised to ensure that key employees stay
- to the extent permitted by regulation, linking bonuses or other awards to the success of the transaction and/or the migration of clients.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.