In August 2022 the FCA issued a letter to the Chief Executives of firms in the FCA’s “Alternatives” portfolio. The letter set out the FCA’s supervisory strategy and priorities for the alternatives sector, and stated areas where the FCA believes improvements can be made. This article summarises the key takeaways from that letter.
Who should pay attention?
The letter outlines the FCA’s updated strategy and priorities for firms managing alternative portfolios. It is addressed to the chief executives of firms that predominantly manage alternative investment vehicles (such as hedge funds or private equity funds) or manage or advise alternatives assets directly. It is important for those firms to read this letter as the FCA states it will take action against firms where it sees shortcomings.
The FCA observed that market abuse controls across the sector need improving and that it will consider criminal, civil or supervisory sanctions as deterrents. The FCA also said that where inadequate management of conflicts has a role in harming investors, it will consider appropriate enforcement action.
In the coming months, the FCA will be issuing a questionnaire asking firms for information about their business model, products, investor categorisations and associated control frameworks. In the forthcoming supervisory cycle, the FCA will also look at how senior managers and firm policies influence culture, noting that evidence of staff being unable to speak up is an area of particular concern.
What are the FCA’s priority areas?
The FCA’s priority areas are consistent with its 2022 Business Plan commitments. Integrity of the markets and market abuse, ESG and consumer needs are all priority areas. Where these areas apply, firms must ensure their actions and culture support and promote these initiatives.
The FCA Business Plan also focuses on promoting competition, prioritising strengthening the UK’s position in Global wholesale markets and attracting new capital. It sees alternative firms as having a vital role to play in achieving that.
What should firms be doing in relation to putting consumers’ needs first?
The FCA’s concerns
What should firms do?
Investment strategies that carry inappropriate levels of risk for target clients
Firms should consider the appropriateness or suitability of the investments they offer for their target customers, whether those customers are retail or elective professionals.
Firms that onboard retail or elective professional customers should review their processes to ensure these are effective, including the procedures for checking that elective professional investors meet the quantitative and qualitative tests in COBS 3.5. Where firms market non-mainstream pooled investments, firms must comply with COBS 4.12.
Firms can reduce the risk of consumers with limited investment knowledge or risk appetite being exposed to inappropriate investment strategies by conducting investor assessments. To achieve this, firms should:
Ensure alternative investments are only offered to appropriate investor types, and that investments meet client’s needs,
Recognise not all alternative products are suitable for all investors,
Consider the application of relevant marketing restrictions to retail investors when communicating/approving a financial promotion for alternative products,
Undertake an adequate assessment of the suitability of alternative investments for retail investors, as this is an essential mitigant in the reduction of potential harm, and
Clearly outline target markets for distribution channels to ensure a clear understanding of in-scope investors is in place.
The FCA also expects firms to be aware of upcoming regulatory changes including:
The new financial promotion rules for high-risk investments coming in at the end of this year and beginning of next year,
Rules for the promotion of cryptoassets when HM Treasury formalises legislation to bring these into its remit, and
Their obligations under the new Consumer Duty.
Conflicts of interest
Poor management of conflicted positions can encourage market manipulation or improper fund performance reporting and, in turn, produce poor consumer outcomes and loss of market integrity.
Where the FCA identifies harm to investors, it will assess the extent to which inadequate management of conflicts played a role and will consider the need for enforcement action. It draws firms’ attention to recent fines levied because of inadequate management of conflicts.
Giving some examples of conflicts of interest, the FCA says it has seen situations where firms have bypassed their own processes to make sales or increase assets under management (AUM). These are examples of conflicts that lead to investor detriment.
Further, the FCA says internal firm conflicts can cause indirect harm to investors and that situations where dominant shareholders make material decisions independent of the firms’ governance structure can also lead to conflicts and increase the risk of poor outcomes for investors.
The FCA says that firms should consider the impact of their shareholder structure and the potential implications this has on the effective governance of their organisation (noting also that the FCA is concerned about firm cultures where staff cannot speak up).
Firms are reminded that they must manage conflicts of interest fairly per Principle 8 of the FCA Handbook, as well as the rules in SYSC 10 and the on-shored MiFID Org Reg.
Firms’ boards should carefully review their procedures to ensure conflicts are avoided, managed or disclosed in a way that minimises harm to investors and markets.
What should firms be doing to strengthen the UK’s position in global wholesale markets?
The FCA’s concerns
What should firms do?
Market integrity and disruption
The FCA notes that part of an investment manager’s role is to harness and manage risk with investor capital to generate returns. For some alternative funds, risks can be significant.
The FCA reminds firms that its rules (including SYSC 4.1.2) set out that firms’ governance arrangements must be proportionate to the nature, scale and complexity of the risks inherent in the business model. Firm boards should ensure that risk functions are appropriately resourced, contemporaneous and commensurate with the levels of portfolio and business risk being taken.
The FCA is particularly concerned about funds employing high leverage or exposing investors to elevated levels of risk, noting that firms with concentrated or leveraged investment strategies can negatively impact liquidity during adverse market conditions.
The FCA says that robust risk and liquidity management is especially important given the current increased market volatility and rising interest rates, which is leading to several coexistent risks for alternative asset managers.
The FCA will continue to conduct assessments of alternative asset managers’ risk controls where market footprints imply a higher inherent risk of contagion or harm.
Market abuse
The FCA expects firms to have strong prevention cultures and effective systems and controls to enable them to discharge their obligations under the UK’s Market Abuse Regulation.
Firms must ensure their UK MAR controls are tailored to their business models.
Where firms do not comply, it will consider the need for criminal, civil or supervisory sanctions to provide effective deterrents
Culture
Understanding a firm’s culture is central to the FCA’s supervisory approach, with the regulator taking the view that a firm’s corporate culture has a direct influence on business practices.
The FCA reminds firms subject to MIFIDPRU Remuneration Code that they are required to apply the relevant rules from the performance period on or after 1 January 2022, but generally makes the point that where employees are inappropriately incentivised, this can increase conflicts of interest and the potential for harm.
In the forthcoming supervisory cycle, the FCA will be looking at how senior managers and firm policies influence an organisation’s culture. It says that evidence of staff being unable to speak up is an area of particular concern.
The FCA expects firms’ boards to fully consider diversity and inclusion, noting that it published Discussion Paper 21/2 in July last year, and plans to produce a Consultation Paper later in the year.
What should firms be doing in relation to ESG?
The FCA notes that it has seen a growth of ESG investments in the Alternatives sector. Where firms are ESG-focused with investment strategies benchmarked against ESG themes, those firms should ensure documentation of those products is clear, not misleading, and that firms’ actions match their stated claims. Firms offering such products should expect to be subject to review to ensure their marketing materials accurately describe their product.
The FCA also expects those AIFMs, that will be subject to new FCA rules mandating TCFD disclosures at the entity and product level, to consider what steps they need to take to make these disclosures from 2023 as required.
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Next steps
As mentioned above, the letter suggests various workstreams for firms to undertake. The FCA states numerous times that it could take action against firms where it sees shortcomings in its priority areas. It is therefore particularly important that firms review their processes and procedures in relation to the FCA’s priority areas and make any changes that they need to make as a result of those reviews.
If you require further information about anything covered in this briefing, please contact Andy Peterkin, Kya Fear or your usual contact at the firm on +44 (0)20 3375 7000.
This publication is a general summary of the law. It should not replace legal advice tailored to your specific circumstances.
