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What has happened?

In August 2022, the FCA issued a Dear CEO letter to firms operating in the alternatives sector that outlines its updated supervisory strategy and priorities for these firms as well as identifying certain areas where it believes that improvements can be made.

What are the key points in regard to FCA authorised firms?

The FCA’s alternatives portfolio consists of FCA authorised firms that predominately manage alternative investment vehicles such as hedge funds or private equity funds, or which manage and advise alternative assets directly. The asset management portfolio is comprised of FCA authorised firms that predominantly manage mainstream investment vehicles, or which advise on investments, excluding wealth managers and financial advisers.

In the letter, the FCA outlines its view of the main risks of harm that alternative investment firms, and the markets in which they operate, pose to their customers, which in turn shape supervisory priorities. Firms’ Boards or Executive Committees are asked in the letter to consider which of the risks outlined by the FCA are applicable to their business and whether they have the appropriate strategies in place to address them. The FCA expects alternative asset firms to take the actions considered necessary to mitigate the risks and ensure that the firm meets FCA requirements.

The FCA’s supervisory priorities in this area are summarised below.

Investment Risk

When the FCA last wrote to this group of firms in January 2020, it stated its concern that investors could be exposed to inappropriate products or levels of investment risk. While the ban on the mass marketing of speculative investments to retail clients has led to a reduction in harm, inappropriate distribution and marketing practices by firms targeting mainstream investors remain a concern.

The FCA has seen examples of informal governance processes within firms, compounded by poor due diligence and inadequate investor categorisation leading to investors with a lower risk appetite accessing high risk products that may not match their objectives. Firms should consider the appropriateness or suitability of the investments they offer for their target customers, whether they are retail clients or elective professionals.

Firms can reduce the risk to consumers with limited investment knowledge or risk appetite being exposed to inappropriate investment strategies by conducting thorough investor assessments. In order to achieve this, firms should:

• ensure that alternative investments are only offered to appropriate investor types, and that the investments meet client needs and recognise that not all alternative products are suitable for all investors,
• consider the application of relevant marketing restrictions to retail investors when communicating or approving financial promotions for alternative products,
• recognise that an adequate assessment of the suitability of alternative investments for retail investors is an essential mitigant in the reduction of potential harm, and
• make sure that target markets are clearly outlined for distribution channels to ensure a clear understanding of in scope investors is in place.

Following receipt of this letter, firms that onboard retail or elective professional customers are asked to review their processes to ensure they are effective, including the procedures for checking that elective professional investors meet the quantitative and qualitative tests required under COBS 3.5. Where firms market non-mainstream pooled investments, their procedures must comply with COBS 4.12.

Consumer Duty

Firms should also consider their obligations under the Consumer Duty (see https://www.fca.org.uk/publications/consultation-papers/cp21-13-new-consumer-duty), which is intended to set high standards of consumer protection by requiring firms to put their customers’ needs first. The rules and guidance being introduced for new and existing products or services open to sale or renewal will come into force on 31 July 2023, and on 31 July 2024 for closed products or services.

In the coming months, the FCA will be issuing a questionnaire asking all portfolio firms for information about their business model, products, investor categorisations and associated control framework. It will follow up with firms exhibiting characteristics that increase the potential for consumer harm. As part of this supervisory work, firms will need to evidence the reasonable steps taken to ensure their target market is appropriately defined and is not exposed to an unsuitable level of risk.

Conflicts of Interest

Firms are required to manage conflicts of interest fairly. Poor management of conflicted positions can encourage market manipulation or improper fund performance reporting, in turn producing poor consumer outcomes and loss of market integrity. The FCA has also seen situations where firms have bypassed their own processes to make sales or increase assets under management, these being examples of conflicts that may lead to investor detriment. Furthermore, internal firm conflicts can cause indirect harm to investors.

Situations, where dominant shareholders make material decisions independently of the firm’s governance structure, can also lead to conflicts and increase the risk of poor outcomes for investors.

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. Firms should also consider the impact of their shareholder structure and the potential implications this has on the effective governance of their organisation.

Market integrity and disruption

Part of an investment manager’s role is to harness and manage risk with investor capital to generate returns. The FCA’s rules set out that firms’ arrangements must be proportionate to the nature, scale and complexity of the risks inherent in the business model. Where funds employ high leverage or expose investors to elevated levels of risk, the FCA expects firms to ensure their risk management systems, controls and resources are fit for purpose.

Firms’ Boards should ensure that risk functions are appropriately resourced and commensurate with the levels of portfolio and business risk being taken. During the last two years, the FCA has conducted assessments of alternative firms’ risk controls and it will continue to do so where market footprints imply a higher inherent risk of contagion or harm.

Market abuse undermines confidence in, and the integrity of financial markets. Established, robust systems and controls are crucial in mitigating this risk, with firms providing a vital first line of defence. The FCA has previously observed that market abuse controls across the sector need to be improved. It expects firms to have strong prevention cultures and effective systems and controls to enable them to discharge their obligations under the UK Market Abuse Regulation (UK MAR). Firms must ensure UK MAR controls are tailored to their individual business models. Where firms do not comply, the FCA will consider the need for criminal, civil or supervisory sanctions to provide effective deterrents.

Culture

The FCA takes the view that a firm’s corporate culture has a direct influence on its business practices, with a healthy culture seen as critical for consumer protection. Understanding regulated firms’ culture is therefore central to the FCA’s supervisory approach. A firm’s approach to remunerating and incentivising staff contributes to its organisational culture and remuneration policies can help ensure appropriate outcomes for customers and markets and reduce the likelihood of harm. Where employees are inappropriately incentivised, this can increase conflicts of interest and the potential for harm.

Firms that are subject to the MIFIDPRU Remuneration Code are required to apply the relevant rules from the performance period on or after 1 January 2022. During the forthcoming supervisory cycle, the FCA will look at how senior managers and firm policies influence an organisation’s culture. Evidence of staff being unable to speak up is an area of particular concern. Furthermore, the FCA is interested to understand how healthy cultures are embedded in firms where founders or other senior individuals occupy a dominant role.

ESG

The FCA has seen a growth of ESG investments in the alternatives sector, with increases in the number of AIF registrations that have a stated focus on these themes. Firms should ensure that documentation of such products is clear and not misleading and that firms’ actions match the stated claims. The FCA continues to assess authorised fund applications with an ESG or sustainability focus and firms should note that ESG remains a priority area in the Asset Management department.

How can we help you?

If you’d like to know more about how we can help you with your alternative investment or AIFM arrangements, or any other regulatory compliance issues, our specialist team is here to help. Contact us today on 0207 436 0630 – or email info@thistleinitiatives.co.uk.