Hot on the heels of its recent “Dear CEO” Letter addressed to asset managers generally, on 20 January 2020 the UK Financial Conduct Authority (“FCA”) penned a further “Dear CEO” Letter specifically addressed to managers and advisors in the “alternatives” sector, covering, amongst others, hedge funds and private equity funds. (Click here for a copy of the letter.)
FCA Concerns with the “alternatives” sector
This appears to be the first time the FCA has specifically addressed the “alternatives” sector of asset management. The letter identifies a number of sector specific concerns overlaying the FCA’s general thematic asset management concerns described in the “Dear CEO” Letter addressed to all asset managers (click here for our report on this).
Reiterating its general observation that standards of governance fall below expectations, the FCA went on to state that:
Far too often, the appropriateness of investment products for investors is not adequately considered. In particular, this presents a significant risk of harm where high risk alternative investments are made available to less-sophisticated investors.
Client asset and custody controls and processes were judged to be “not always robust”, creating a risk of loss to client money and custody assets.
Systems and Controls against Market Abuse and Financial Crime
Weak systems and controls were identified which could lead to the risks of market abuse, financial crime and harm or disruption to market integrity not being effectively mitigated.
The FCA set out its supervision strategy to address these concerns.
Investor exposure to inappropriate products or levels of investment risk
By their nature, alternative investments can carry significant levels of investment risk. It is important that, where relevant, firms offering products and managing investments with exposure to alternative assets and strategies consider the appropriateness or suitability of those investments for their target investors.
Firms were urged to:
- Identify the client type and investment need for any particular product at both the product development and distribution stages – Firms should recognise that alternative products may only be appropriate for a niche market.
- Adequately assess the appropriateness (for non-advised investors) or suitability (in the case of advised investors or those who have given discretionary mandates) of alternative investments for retail investors more generally.
- Comply with restrictions on marketing to retail investors when communicating or approving financial promotions for alternative products. The FCA also made it clear that firms allowing investors to ‘opt up’ to elective professional status, must robustly assess a client’s knowledge and experience of the relevant market, as well as the relevant quantitative tests.
The FCA gave warning that they will be testing that firms are aware of who their customers are and that they are placing a clear focus on acting in the best interests of their clients and funds. They will be scrutinising measures taken to ensure that investors adequately understand the risks they are exposed to through their investments, and are not inappropriately exposed to risk beyond their risk profiles.
Client assets and custody
The FCA plans to test whether firms that have permission to hold client money and safeguard custody assets are exercising those permissions under “robust control frameworks”. It will be looking at levels of oversight of client money and custody operations, record-keeping; and general compliance.
Market abuse, market integrity and financial crime
The FCA stressed that firms must make sure their policies and procedures are sufficiently comprehensive and tailored to their individual business models so as to be effective.
Firms are expected to operate robust risk management controls to avoid excessive risk-taking and mitigate the potential for market harm or disruption. The FCA clearly expects the quality and nature of risk control to reflect the levels of risk taken.
The FCA stressed the importance of appropriate due diligence on third parties and Know Your Client (“KYC”) checks. It will be reviewing firms’ systems and controls to mitigate such risks.
What should Firms be doing in response to these concerns?
Firms should be:
- Considering their investment disclosures and marketing materials – do these give a clear and fair picture of the risks of their products?
- Reviewing their marketing strategies – are these sufficiently targeted to investors for whom their products make sense?
- Reviewing their client classification, opt up and KYC procedures. Are these thorough and are decisions clearly justified and their basis recorded?
- Looking at their book keeping and record keeping arrangements and how they are dealing with client assets. Many alternative firms will not have a permission to hold client money – only to control it. They should ensure they are acting within the scope of their permissions; and
- Critically reviewing their compliance procedures and internal systems and controls in light of the market information they receive, and the specific risks of their investment and risk strategies.
On January 29, 2020