Private Equity firms to face increased scrutiny of their AML procedures and how they deal with AML issues

Introduction

The UK Financial Conduct Authority’s (FCA) recent announcements indicate that private equity firms (PE Firms) will see increased regulatory scrutiny over their anti-money laundering (AML) systems and controls.

Earlier this year, the FCA issued a “Dear CEO” letter outlining its Alternatives Supervision Strategy, including its view of the key risks of harm that PE and other alternative investment funds pose to their customers or the markets in which they operate.^1 2 This followed a series of spot checks conducted by the FCA during the course of 2019 to assess firms’ policies and practices in relation to AML.³

PE Firms with links to the UK face two key risks in relation to money laundering:

1. Being used to facilitate financial crime, including money laundering in the context of fundraising (the Dear CEO letter states that the FCA intends to review firms’ systems and controls in these areas).
2. Risks in transactional activity (and, in particular, the risk of criminal money laundering offences under the UK Proceeds of Crime Act 2002 (POCA)).

These risks may give rise to criminal and/or regulatory issues. This article outlines the key AML-related risks faced by PE Firms in these areas and explains the key practical steps that can be taken to manage these risks.

Fundraising

An investment into a PE fund would normally be considered to be a low risk product.⁴ In addition, institutional fund investors are generally lower risk customers who tend to undergo thorough due diligence processes, including AML-related know your customer, before being accepted as investors.⁵ Nevertheless, prospective investors based in, or with funds based in, a higher-risk third country should be subject to more stringent due diligence measures.

If a PE Firm fails to take appropriate steps to identify and assess the AML risk to which it is subject, or to establish and maintain policies, controls and procedures to mitigate and manage those risks effectively, it could risk committing a criminal offence for breaching a “relevant requirement” under the Money Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer) Regulations 2017 (as amended by the Money Laundering and Terrorist Financing (Amendment) Regulations 2019).⁶

Non-institutional investors (such as family offices) are likely to pose a greater risk to PE Firms from an AML perspective due to their more complicated ownership structures and the presence of trust arrangements.  The key challenge for PE Firms is in identifying the ultimate beneficial owners, and in particular the beneficiaries of any trust arrangements.  The extent to which PE Firms are subsequently able to accept such investors is likely to be informed by their own risk-based approach, which will dictate how much comfort they can take from third-party sources for the purposes of completing their customer due diligence (i.e. reliance on family offices/trustees for information on the ultimate beneficial owners).

As such, the amount and type of documentation that a PE Firm may need to collect for the purposes of its customer due diligence will be dependent on the nature of that investor (i.e. institutional/non-institutional, high risk factors), the reliability and reputation of the sources of the information provided, and the PE Firm’s own risk-based approach to compliance with AML requirements.

Transactions

PE Firms are likely to encounter AML issues in transactional activity.  These risks arise not only at the time of an original investment, but also throughout its ongoing ownership and its exit.

Money laundering offences under POCA fall into two main categories:

1. Substantive offences, i.e. acquiring, dealing with, or being involved in a transaction which facilitates the movement of “criminal property”.
2. Failure to report offences or tipping off offences (which will apply to many employees and officers of UK PE Firms).

These offences are extremely broad because: (i) criminal property is defined as property obtained as a result of conduct which is illegal or would be if it took place in the UK (including where only part of the property, e.g. money within a bank account, is obtained in connection with criminal activity); and (ii) knowledge of money laundering is not required (but only suspicion, which has a very low bar).  Essentially, issues may arise wherever a PE Firm suspects criminal activity, for example:

• A PE Firm wishes to invest in a target which has historically underpaid tax (the benefit of saving money can constitute criminal property).
• A PE Firm learns that  a portfolio company has inadvertently failed to renew a licence where operating without a licence is a criminal offence.
• Allegations arise that the agent of a portfolio company has paid bribes in order to win contracts.
• A portfolio company is engaged in a business activity which is legal where it is operating, but illegal in the UK (e.g. recreational cannabis) – there is no exception unless the activity would lead to a maximum custodial sentence in the UK of less than 12 months.
• A nominee director becomes aware of criminal activity in a portfolio company and is involved in decisions in relation to the movement of funds or other property that is wholly or partially the result of that criminal activity.
• A PE Firm learns that employees of a target have potentially received kickbacks.

Where there is a suspicion that a portfolio company or its employees have been engaged in criminal activity (or dealt with the proceeds of their or another person’s criminal activity), there is likely to be an AML issue.

The good news for PE Firms is that the UK, unlike many other jurisdictions, has a mechanism whereby a defence (i.e. consent) to substantive money laundering offences can be obtained from the UK National Crime Agency (NCA) through the submission of a suspicious activity report (SAR).

The issue with this (aside from the time delay that consent requests may cause) is that PE Firms are essentially required to self-report criminal activity by their investee companies, which could lead to criminal or regulatory investigations (and if consent is refused, to a delay in the transaction beyond the normal seven working day period).

PE Firms may also consider taking advantage of the mechanism for information sharing between POCA regulated entities under the Criminal Finances Act 2017.  This could enable PE Firms to, for example, share information about suspected money laundering with other regulated parties to a transaction before submitting a joint disclosure report (otherwise known as a “super SAR”) to the NCA.⁷

Looking ahead

In light of the FCA’s recent announcements, PE Firms should consider reviewing and, if necessary, enhancing their AML systems and controls to address risks arising in the context of fundraising and transactional activity.

Proportionate and risk-based evaluations of potential investors, their beneficial owners and the source of funds to be invested should continue to be an integral part of the process of marketing and raising capital.  A PE Firm’s AML approach to investments in prospective portfolio companies should similarly be tailored according to the risk profile of the entity or corporate group that will be receiving the PE investment.

The mitigation of POCA-related risk arising from a PE Firm’s transactional activity should involve, for example, training: (i) employees to identify key issues and to escalate suspected criminal activity early; and (ii) nominee directors to conduct ongoing monitoring through board participation and regular involvement in a portfolio company’s activities.

Reviewing and enhancing existing AML systems and controls, and measures in place to identify and report suspected criminal activity at the portfolio company level, would leave PE Firms well placed to respond should the FCA follow-up on its stated intention to increase scrutiny over firms’ AML systems and controls.