Why firms will need to change how they market AIFs and fundraise.

The FCA have released a consultation paper (CP25/36) and discussion paper (DP25/23) which signal  rule changes that will impact how firms market AIFs and fundraise in the UK. The FCA will utilise the Consumer Duty and clarify current rules, but clarification does not necessarily mean less work.

The following quote is significant for understanding what the changes are and why they are coming:

“We still see significant consumer harm from investment scams and inappropriate high-risk investments, and we want to mitigate that…” (CP25/36).

This is the lens firms should view the changes proposed by the FCA.

The FCA are not trying to create unnecessary barriers. They are driven by the potential risks of harm posed to consumers by marketing products which are higher risk than “plain vanilla” UCITS funds or other “safer” investments. Changes to rules on opting up retail clients to professional status, financial promotions (including FPO), the appropriateness test and application of the Consumer Duty should be seen through this FCA lens. The changes are designed to address this obvious risk.

Most firms have a good understanding of their target market, and which investors should have access to their products. Most firms in this space avoid working with individuals with limited funds and limited understanding of the investment landscape and instead work. This enables them to work with those already in the ecosystem, such as entrepreneurs, founders, and angel investors. However, the approaches adopted can sometimes lack structure and documentation, making it difficult to justify the work conducted on marketing a product after the event, if challenged. For instance, without records of phone calls and face to face discussions talking through the product, the detail can be lost.

Firms offering such products will need to adjust to these rule changes, and pivot to a better approach. Technology will likely play a decisive role: it can be the catalyst or obstacle for future compliance. Firms already complain that slow, cumbersome processes hinder ability to raise funds, and these challenges will be amplified if workflows are not modernised.

The FCA endorse ”frictions” during onboarding (it is embedded in the rules for promoting higher risk products). but this is designed to provide opportunities for investors to consider their investment decisions. The FCA are not inherently interested in rules which result in unnecessary paperwork, enforced delays, and repeated deliberation which may discourage investors from following up or proceeding with investments (which may be appropriate for them). FCA agree inappropriate frictions do not work for firms or regulators in delivering the right outcomes.

Arguably, wealthy, sophisticated investors often expect barriers to be removed for them, as they are in other aspects of life and they do not want to spend hours of time “ticking boxes” or wading through forms when they understand what they are doing and the risks involved.

It is clear from DP25/23 that the FCA understand this dynamic:

·       ”Over the same period, innovation and market developments have made investing easier. For example, opening investment accounts and accessing trading platforms without advice has become simpler. The breadth of investment opportunities has also changed, with emerging opportunities for ownership through fractionalisation and fund tokenisation. The range of wholesale products now available to retail consumers has grown. Future developments such as open finance may further change how consumers access investments” (DP25/23).

Of course, FCA’s focus is on ensuring that consumers are well protected, rather than making the investment process easier. They state, “we support innovations which improve access and make it easier for consumers to engage with investments that meet their risk appetite and needs”. In our view, there is every reason to believe that a simple, robust and well-meaning marketing and onboarding service can align to the needs of both firms and regulators. However, firms need to be willing to instigate the requirements and protections with the necessary clarity delivered by proposed rule changes.  

Of course, ”simple” is not necessarily easy. By understanding the broad changes, it is possible to consider how this could work in practice. There are always different ways to cut it but thinking through how it could work is the first step.

The expected rule changes

The consultation paper (CP25/36) on client categorisation has already proposed a clear change in how persons can be categorised as elective professional, based on changes to the quantitative and qualitative thresholds:

·       Net investable assets (defined as a portfolio of designated investments or cash) in excess of £10 million.

·       A qualitative assessment of the expertise, experience and knowledge of the client and satisfaction on reasonable grounds, that the client is capable of (a) making their own investment decisions, and (b) understanding the risks.

Firms need to understand FCA’s concerns: once a person is ‘opted up’ they are not given retail protections and Consumer Duty will not apply. This can enhance information asymmetry, and potential losses were conducted without relevant controls.

The regulator’s expectations are not absolutely clear as yet. However, regardless of whether a person qualifies because of wealth, or sophistication, it is expected that there will need to be a verification exercise that takes place to qualify persons. Firms will not be allowed to rely solely on information provided; therefore, a reasonableness test will be needed. The old adage” trust but verify” is probably a succinct summary of the required approach. Or, to put it bluntly, if it is not written down it didn’t happen…

This verification process can be built into an onboarding process; however, timing is key. If the firm is relying on the ability to promote a high-risk product to a person because they are an elective professional investor it is misguided to think you can promote the higher risk investment to them before conducting this assessment. Marketing in this way is unlikely to be aligned to Consumer Duty or other FCA rules, particularly as it may look like the firm are encouraging a potential investor to opt up and lose retail protections.

Alongside the proposed changes to the elective professional regime, it is chapter 3 of DP25/23 (‘How can we rebalance risk through our regulatory framework’) which signals future changes to marketing procedures.

This Discussion Paper considers the impact of:

·       Financial promotion rules (including reliance on the FPO, pushing for the UK Government to amend legislation to align with FCA requirements)

·       The appropriateness test (when it should apply, and the effectiveness of it)

·       Application of the Consumer Duty (i.e., how does this apply during the marketing and onboarding process and how does it apply to elective professionals)

As this covers initial communications with potential investors, what documents can be provided and when, and what data is required to assess whether an investor falls within the appropriate target market, as well as the checks required before onboarding them - it may be reasonable for firms to consider the overall relationship with the potential investor. This includes considering how they are contacted, what discussions are held with them and how the firm know they fit within the target market. Firms should also consider how dealing with these regulatory issues at an earlier stage will align with a firm needs to understand the investor, and how technology can support this process.

As a high-level summary of proposed FCA rule changes, it suggests firms should:

·       Create specific groups of investors based on wealth or sophistication, only those individuals clearly passing these ‘higher bars’ should be recipients of marketing for higher risk products.

·       This dovetails with the changes to the client categorisation rules (i.e., introducing a higher bar, but also clarity on how they are applied so that the industry can consider how this aligns to their business model and processes instead of distinctions based on detailed product categories, MiFID/Non-MiFID provisions and so on)

·       Ensure there is a proportionate evidence-based approach, moving away from the more relaxed approach to ensure there is a robust ‘barrier’ for non-sophisticated, less wealthy investors to access higher risk products.

·       Ensuring marketing rules (whether FCA rules or legislation such as the Financial Promotion Order) create relevant frictions, and clear communication on potential risks.

·       Describe how the Consumer Duty applies in these scenarios; what are the key risks and areas firms should consider to ‘avoid foreseeable harm’, for example, without creating disproportionate requirements.

This should be achievable; however, firms should consider how they work with the FCA to understand how these protections for retail consumers can be embedded within a firm’s marketing process practically and without putting off the right investors.

Despite the new rules increasing the work required, they may also increase the money raised from the right type of investors. This is, of course, if the regulator and firms get this right (which clearly the Government is pushing for: making sure capital is put to use in the right place).

To support the FCA get these rules right, firms should engage with the regulator and/or their trade bodies and respond to the consultations and discussion papers.

If you would like to discuss what these changes could mean for your firm in more detail, get in touch.