Alternative Insight – November 2016

FCA Deliver Crystal Ball (and just in time for Christmas)

Overdue and much anticipated, the FCA issued its Interim Report on the Asset Management Market (Report) on 18 November. The FCA identified a series of issues and proposed a number of fixes, including recommendations aimed at enhancing transparency around fees, charges and fund governance.

Private equity funds were not within the scope of its study, however the FCA draws parallels within its Report to private equity managers, observing that some of the issues raised are also issues that will need to be addressed with private equity managers. The FCA notes that private equity is a particularly opaque part of the asset management sector.

The industry has the opportunity to comment on its findings before the final report is released in the second quarter of 2017.
Asset managers should carefully read the Report as the key identified issues are likely to indicate future areas which the FCA will seek to regulate. The industry has been warned.

The following key issues are most likely to be relevant to private equity fund managers and influence future market practices and regulation. This is an early Christmas present to UK asset managers – an early warning sign of where and how they will wield their power

Reinforced Duty of Care

Authorised fund managers (AFMs) are already under a duty to act in the best interests of investors. However, the FCA want to go further by having an express legal obligation to seek value for money for those investors.

The FCA suggests that it may be appropriate to impose a duty on asset managers to demonstrate how their funds deliver value for money for investors and to implement enhanced governance standards for authorised funds to hold their managers to account in this area, with an eye on the US model.  The FCA’s view is that AFMs do not robustly consider value for money for fund investors.

This would include UCITS managers, as well as managers of other authorised funds. Recommendations proposed by the FCA include:

  • Imposing duties on fund governance bodies to consider the fees and charges imposed by the fund with reference to specified criteria, including reasonableness
  • Performing an annual arm’s length reassessment of the investment management agreement with the fund manager
  • Imposing specific duties on senior managers of the AFM to consider value for money
  • Clarifying the duties of the board of an AFM so as to require it to demonstrate how the AFM has complied with the enhanced duty to act in the investors’ best interests.

Past Performance

The Report confirms that past performance is an important metric for investors when deciding on what fund to invest in.  When ranking factors important to institutional investors, past performance ranked third behind management fee and fund manager reputation, and was identified as the second most common influential factor behind retail investors’ decision-making. The Report scrutinises past performance metrics as being misleading to investors, noting that:

  • Past performance data is always presented net of transaction and other costs, which provides an over inflated indication of investor return
  • Research has shown that past performance is not an accurate indicator of future performance
  • It can be hard to compare past performance information and time periods vary, along with how often performance is reported, leading to inconsistent and misleading information.

The Report argues that past performance does not help investors, as the majority of fund managers do not consistently outperform.

In order to assist investors in developing more accurate expectations in relation to the performance of funds, the FCA is considering requiring fund managers to:

  • Provide a timeframe over which the performance of the fund should be measured;
  • Set clearer and more specific objectives for the fund
  • Provide information to allow investors to assess whether the performance objectives are being met, including disclosing any benchmarks used by the fund manager
  • Requiring managers to explain the performance of funds that have merged/closed.

Transparency and Investor Outcomes

The FCA holds strong views that:

  • Overall, after costs, actively managed funds do not outperform their benchmark
  • Fund investment objectives are unclear to investors
  • Fee breakdowns are also murky to investors.

Certain charges, in particular transaction costs, are not disclosed to investors, or not often not even estimated in advance.

Regarding any investment vehicle which are available to UK retail investors, including insurance investments, investment trusts and UCITS funds, the FCA is considering requiring more clear communication of charges both at the entry point and in ongoing communications. In particular, it is considering:

  • Insisting on greater use of pounds / pence numbers to allow investors to understand the holistic impact of charges in a more user-friendly way
  • The introduction of an “all-in” fee – i.e., a single charge esigned to make the charges taken from the fund more visible to investors
  • Requiring ongoing communications to investors explaining the impact of charges on actual gross returns.

The FCA is recommending an “all-in fee”; the terms of this “all-in fee” are still being debated, and vary from a flexible position where managers would be responsible for covering the difference between the fees estimate and the actual fees, and a more stringent position where managers would be bound by a single pre-set charge to cover all costs. An all-in fee could present a considerable risk to managers, as they would have to bear the costs of any difference between all-in fee and the actual fees charged. They are also recommending greater and clearer disclosure of fiduciary management fees and performance fees.

In short, asset managers who are not crystal clear on costs and related transparency will be in the firing line of the FCA.

Fees

The FCA is concerned that there is very little publicly available information about, or scrutiny of, the fees charged by fiduciary managers and their performance.  In this context, the FCA defines fiduciary management to mean circumstances where a service provider advises clients on how to invest their assets and then makes investments on behalf of the client in relation to all or some of their assets. The duties delegated to fiduciary managers may include selecting other asset managers and determining strategic asset allocations. The FCA has particular concerns about the lack of consistency and comparability between the fees of different managers.

The FCA has not put forward specific initial proposals in relation to this aspect of the interim report, but is seeking views on the sort of information that fiduciary managers could be required to disclose, or whether there could be other alternative solutions to the problems it has identified.

Management Fees

Management fees are generally charged as a percentage of assets under management (AUM) the FCA is critical of this ‘ad valorem’ fee structure as it claims that this:

  • Encourages fund managers to focus on growing AUM, rather that improving investor returns
  • Deprives investors from taking advantage of economies of scale while managers benefit
  • If the growth in assets under management reduces the ability of a fund’s manager to generate higher returns, the manager may have a conflict of interest with investors.

The Report also notes that investors for the most part are not price sensitive when it comes to management fees charged and that many investors invest with funds with higher management fees with the expectation that this will lead to greater returns. The FCA suggest that the rate of management fees does not reflect fund performance.

Uniform Template

In seeking to promote broader transparency and standardisation of costs across the industry, the FCA aims to promote a standardised disclosure framework for asset managers to disclose investment costs. The FCA supports efforts by the Investment Association to develop a standardised “Comprehensive Disclosure Code” for managers and suggests that it will work with industry to set out its expectations as to what a standard template would include. That template would be provided to all institutional investors as a matter of course. The FCA’s primary belief is that the template could cover hedge funds, multi-manager products, and fund of funds. Subject to industry feedback, private equity funds may also be included.

Investment Management Innovation

Questions were also raised of innovation in the investment management industry. It is evident that the FCA would like to encourage innovation by investment managers to provide better service and returns. Examples included improving the quality and quantity of client reporting, Big Data, custody and clearing using block chain technology, and new analytical tools for investors.  Innovation is likely to improve many of the issues mentioned in this article especially when it comes to transparency for investors. In addition, the FCA is interested in promoting innovation in pricing models and is interested in exploring models which involve a greater element of risk sharing and the sharing of the benefits of economies of scale.

MFN

The FCA raised a possible concern that most favoured nation-type clauses between asset managers and investors could prevent some investors from getting better deals by preventing price transparency or by making asset managers less willing to grant concessions due to the fear of those concessions then being offered to all investors.

That said, it was noted by the FCA that such clauses may also have a positive impact in strengthening the negotiating positions of some investors.This remains an open point, and is attracting increased scrutiny from a competition law perspective.

Final thoughts

Managing almost £7 trillion of assets, the Report recognise that the UK’s asset management industry is the second largest in the world.  Plus that over 75% of UK households with pensions plans utilise the services offered by asset managers.

The Report will lead to long-lasting changes in the UK asset management industry.  The FCA seems serious about ensuring that asset managers deliver value for money.  Listed asset managers should be most concerned about the Report but this can, and should be, seen as a precursor to implementing serious changes in the way private equity is regulated.  PE has been warned (and just in time for Christmas).


 

Alternative Insight is produced by MJ Hudson’s private funds lawyers. We provide expert legal advice to fund managers, other financial sponsors, investors and advisers on the formation, structuring, investment into and regulation of private funds, managed accounts and similar vehicles. Our practice covers the full spectrum of alternative assets, including private equity, venture capital, hedge funds, private debt, real estate and infrastructure. Clients praise our entrepreneurial approach, commercial outlook and dedication to helping them achieve their objectives, regardless of the obstacles.