Hoping to Buy or Sell a Regulated Financial Business? Don’t Miss Out on a Critical Prudential Health Check

Whether you are exploring a potential sale, securing funding for your company or an acquisition of a regulated business, a robust due diligence exercise may make or break the deal.

Most firms regulated by the Financial Conduct Authority (FCA) are, at the very least, obliged to have appropriate resources (as per Threshold Condition 2.4), which means having financial and non-financial resources that are adequate for the nature, size and risks of the business it undertakes on. FCA Finalised Guidance 20/1 (FG20/1 - Our framework: Assessing adequate financial resources) describes how firms should assess and meet their appropriate resources with a view to minimising potential harm while they continue to provide services, and/or in a situation, where they need to leave the market in an orderly manner¹.

In addition, many regulated firms such as investment firms and asset managers, are subject to prescriptive prudential rules that describe minimum regulatory capital and liquidity requirements, with which they must always comply.

Understandably, clients seek quality due diligence reports that tend to focus on several key areas.  Reports relating to regulatory risks typically include core areas arrangements such as governance, compliance oversight, financial crime and risk management. Notably, an assessment of the prudential component has not historically received quite the same level of attention as other areas or can be superficially included as part of (a separate) undertaking of financial due diligence (FDD).

Why Commission a Prudential Review Within the Scope of Your Due Diligence Exercise?

A typical due diligence exercise of a regulated financial institution aims to establish the material risk exposures that a prospective investor ought to be aware of ahead of the transaction. 

As outlined above, it is often the case that FDD does not fully explore prudential risk that arises from the operations and regulated activities of the target, nor does it explore potential consequences post-acquisition, on the capital and liquidity resources and requirements. Additionally, a review of a firm’s potential consolidated situation and its consequences can get overlooked.

For example, as part of an acquisition, an issue of regulatory consolidation may arise whereby the target entity may be within the scope of a consolidated situation. It means that the targeted firm will be included in an Investment Firm Group which will have to calculate its minimum capital requirements, as if they all form a single investment firm. Careful analysis of the prudential risk should be carried out before making changes to the groups’ structure. We note particularly the increasing focus from the FCA to restructuring processes and the broad reach of the consolidation group requirements to cover “connected undertakings² which are firms within the same financial group that are connected by links beyond direct ownership, i.e., majority common management, significant influence and/or single management.

Another common issue arising from acquisitions or sale of firms is the creation of goodwill. The structuring aspect of the transaction is essential to ensure efficient management and holding of financial resources. Goodwill is an intangible asset and as such must be deducted from capital resources. Special consideration must be given to the size of the goodwill asset and the subsequent impact on financial resources. Also, identifying which entity will record the goodwill asset and its role within the group is fundamental to developing the most efficient group structure for the management of financial resources.

A review of a firm’s financial resources that focuses on the minimum criteria, an incorrectly identified consolidated situation, among other aspects of the post-transaction situation, could result in tangible and expensive outcomes with material repercussions of negative investment, lost trust and reputation in the market.

How Can We Help?

Kroll has undertaken numerous due diligence reviews and has a wealth of experience in assessing all areas of a firm’s operations. Our expertise includes a specialist team of prudential experts who can provide a full review of prudential elements of a regulated firm with an expert opinion on the adequacy of the firms' financial risk management. 

Our prudential due diligence output will be tailored to your needs. A typical review would include identification of any potential gaps or focusing on development areas in the management of a firm’s financial resources, the accuracy of financial regulatory returns, the adequacy of an ICARA process, including the appropriateness of stress scenarios and wind down planning. 

Please connect with us if you need any help with the prudential component of your due diligence review. Know more about our service here. 

Sources
¹ Further FCA guidance on Wind-down requirements can be found here:Wind-down planning guide
IFPR implementation observations: initial observations, concluding report.
TR22/1: Observations on wind-down planning: liquidity, triggers & intragroup dependencies.
Assessing liquidity for orderly wind-down: good and poor practices from general insurance brokers.
Payment Services and Electronic Money – Our Approach.
² As mentioned in the FCA Consultation Paper 23/23 or PRA Consultation Paper 25/23, and IFPR newsletter November 2023.