Long ReadSep 7 2022

Alternatives sector coming under FCA scrutiny again

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Alternatives sector coming under FCA scrutiny again
(Bloomberg)

The Financial Conduct Authority routinely reaches out to the wider financial industry through a variety of different mechanisms, and one such method is of course the 'Dear CEO' letter.

This appears to be the method of choice now for the FCA to give a general steer on what they are looking for in a collegial tone rather than setting out specific targets in the more formal annual business plan or regulatory initiatives grid. 

Now, more than two years since the last 'Dear CEO' letter was sent to the alternatives portfolio, which in FCA parlance is the hedge fund and private equity sectors, the regulator has reached out to note that Covid-19, Brexit and the cessation of Libor have caused them to reassess their supervisory priorities for the sector.

A brief skim of the headline terms does not actually suggest much of a reassessment, however closer reading indicates a broadening of considerations.

In this latest correspondence, the FCA’s view of the main risks of harm that alternative investment firms pose to their customers are as follows:

Putting consumers’ needs first 

A staple of almost every FCA correspondence and central to the conduct rules governing those working in the industry is putting consumers’ needs first (or treating customers fairly). The FCA clearly feels there is a substantial risk that inappropriate investment opportunities are being presented to investors. 

The FCA notes that within the alternatives portfolio there are firms that deal with retail clients and elective professional clients. Both of these categories of clients can be considered consumers from an FCA perspective.

The regulator will be issuing a questionnaire to all its alternatives portfolio firms.

Investment products/services such as Seed Enterprise Investment Schemes, Enterprise Investment Schemes and venture capital trusts are among the retail investments that may fall into the FCA’s scope of concern that firms within the alternatives portfolio are selling high-risk investments to, but which do not match those investors’ risk profiles or investment objectives. 

The FCA is introducing new marketing rules, coming into force from December 1 2022 around high-risk investments and the additional obligations under the consumer duty may also have some impact on firms within the alternative investments sector.

Furthermore, the regulator will be issuing a questionnaire to all its alternatives portfolio firms about their business model, products, investor categorisations and associated control framework. Firms must have clearly defined their target markets and not have exposed investors to an unsuitable level of risk.

How this warning balances against the current proposal to expand the long-term asset funds to more retail investors will be interesting to watch, though interest in those products is less than the regulator and government would have hoped.

Conflicts of interest

The FCA has committed to assessing the extent to which inadequate management of conflicts of interest has played a role whenever harm to investors (all categories of clients) has been identified. 

The FCA observes that market abuse controls across the sector need to be improved.

Following some very hefty fines levied by the FCA at recipients – including a £41mn fine to a British-American hedge fund and a £9.1mn fine to a European headquartered asset management firm – the FCA warns that it will consider enforcement action against firms that have failed to ensure conflicts are avoided, managed, or disclosed in a way that minimises harm to investors and markets.

Whereas most firms would consider their conflicts of interest to be centred around topics such as asset allocation or competing funds, the FCA notes that behaviour of individuals may also be viewed as a conflict of interest, having seen situations where processes were bypassed to make sales or increase assets under management.

Dominant shareholders making decisions contrary to internal governance are also noted.

Given the potential harm these conflicts may cause, the FCA draws attention to the aforementioned enforcement cases in what can only be described as a none too subtle hint.

Market integrity and disruption

The FCA is focused on alternatives firms’ risk functions, viewing a manager’s role as harnessing and managing risk. This in turn plays into the new requirement of the regulator to strengthen the UK’s financial sector and to promote growth.

Increased market volatility and rising interest rates have caused the FCA concern, particularly for firms with highly concentrated or leveraged investment strategies, which can negatively impact liquidity and wider market stability, which has led the regulator to warn that the boards of regulated firms should ensure their risk management functions are appropriately resourced.

Market abuse

The FCA observes that market abuse controls across the sector need to be improved.

In previous publications, such as the FCA Market Watch 69, the regulator comments on the need for firms to tailor market abuse monitoring to their individual business models to ensure that surveillance alert parameters and logic are properly established and reviewed and that market abuse policies are sufficiently detailed.

In this letter, the FCA warns that where firms do not comply, it will consider the need for criminal, civil or supervisory sanctions.

Culture

The FCA reminds firms that corporate culture is at the heart of business practices; that inappropriate remuneration practices incentivise conflicts of interest and the potential for harm; and that Mifid Pru firms have been subject to a new remuneration code since January 1 2022.

The alternatives sector will have to be prepared for some targeted questions.

The FCA will look for evidence of staff being unable to speak up as a particular area of concern and firms should encourage a healthy culture of diversity and inclusion.

ESG: a strategy for positive change

Firms should ensure that environmental, social, and governance products are clear, fair, not misleading, and that firms’ actions match the stated claims.

Rules that require asset managers to make disclosures in line with the Task Force on Climate-Related Financial Disclosures will apply to alternative investment fund managers with ,ore than £5bn from 2023. 

While overall tone remains consistent, I would encourage firms to note the more targeted mentions of certain areas. I consider conflicts of interest to be a growing area of focus for the FCA, and the cases in the early part of 2022 demonstrate this.

Obviously Covid-19 hindered the FCA's ability to conduct further investigations, but as some form of normality takes place, I anticipate this picking up once again. 

What is more, political pressures to open the private markets to a wider pool of investors will inevitably lead to issues around suitability, while culture and governance are central to the senior managers and certification regime.

Could this 'Dear CEO' letter represent a subtle changing of approach from a regulator facing increased pressures both internally and from governmental changes?

If so, the alternatives sector will have to be prepared for some targeted questions. 

Andrew Poole is director and James Read is a Consultant, UK regulatory advisory, at ACA Group