In a “Dear CEO” letter sent in early August 2022, the FCA outlined the robust approach it will take to the supervision of firms in its alternative asset management portfolio – namely FCA authorised hedge funds, private equity firms and firms that manage and advise alternative assets directly. Relevant firms can expect the FCA to focus on excessive investment risks to retail and elective professional investors, conflicts of interest, inadequate mitigation against ongoing market disruption, poor market abuse controls, and culture, as well as ESG disclosures.
The FCA acknowledged that most firms in the alternatives space deal with professional clients, and those firms should expect the FCA to supervise them proportionately. However, there are firms which deal with retail and elective professionals and as such the FCA will check these firms’ business models and approach to consumer protection – a particular focus for the regulator at the moment with the upcoming introduction of the new Consumer Duty.
The letter sets out what the FCA considers are the main risks relating to these firms and noted that these are consistent with the business plan commitments around customer needs, strengthening the UK position in global wholesale markets and ESG. While the letter provides a useful summary of the focus of the FCA for firms in this sector, the key themes should be familiar to those firms which have been paying attention to the mood music coming out of the regulator for some time, as well as its previous update from January 2020.
The first set of supervisory priorities related to customer needs:
- Level of consumer risk
- The FCA is concerned that the targeting of mainstream investors, informal governance, and inadequate investor categorisation at certain firms can mean that some retail and elective professional investors may access high risk products which are not appropriate or suitable.
- Firms were asked to ensure that proper investor assessments were conducted (and firms onboarding retail and elective professional customers were required to review their processes for efficacy), and only appropriate investors were offered certain investments, with marketing restrictions and target markets clearly defined and applied.
- Firms were also reminded of a number of relevant regulatory developments – including the marketing restrictions and higher standards relating to high risk investments which are coming into force in December 2022 and February 2023, the new obligations under the Consumer Duty coming into force in July 2023 and July 2024, and the anticipated final rules on the promotion of crypto assets.
- The FCA also explained that it would be requiring all alternative firms to complete a questionnaire about their business model, products, investor categorisation, controls, target market and how customers are protected from unsuitable levels of risk – with a risk for firms where there are concerns about consumer harm of further regulatory scrutiny.
- Conflicts of interest
- Firms were reminded of the requirement in Principle 8 to manage conflicts of interest fairly, and the letter noted that failure to do so posed risks of poor customer outcomes and damage to market integrity – as well as damage to shareholders.
- The letter also emphasised the need for firms to consider the risks and conflicts arising from dominant shareholders overruling processes, and to consider the impact of its shareholder structures.
- The letter referenced recent high profile financial penalties which it had imposed on Bluecrest and GAM for failure to adequately manage conflicts.
The next set of priorities were grouped around strengthening the position of the UK in global wholesale markets:
- Market integrity and disruption
- The letter noted that investment managers need to manage risks to investors, and that for some alternative funds these risks can be significant. Arrangements must be proportionate to the nature of the business and where these risks are higher to investors, or funds are highly leveraged, (e.g. for larger hedge funds) firms must ensure their systems, controls and resources are fit for purpose.
- Current risks arising from recent increased market volatility and rising interest rates mean that firms must have particularly robust risk and liquidity management and should ensure that their risk functions are appropriately resourced. The FCA has been assessing alternative firms’ risk controls and will carry on doing so where there is a higher risk of contagion.
- Market abuse
- The FCA has previously noted that controls across the sector need to be improved. Controls must be tailored to individual business models – with the threat of sanction as a deterrent.
- The FCA emphasised the importance of a healthy firm culture. In particular, firms must ensure that employees are appropriately incentivised in a manner that does not increase conflicts of interest, and the potential for harm.
- The FCA has also noted that it will be looking at how senior managers and firm policies influence culture – including a particular concern about speak up culture, as well as the importance of diversity and inclusion – with a Consultation Paper due later this year.
- Firms which have founders or other senior individuals in dominant roles should expect to receive particular attention on their cultures in the upcoming supervisory cycle.
The final topic set out in the letter is ESG – which has been a recent hot topic for the FCA given the number of firms that increasingly state that they will focus on ESG assets – with a particular focus on funds having accurate marketing materials and clear and consistent disclosure. The letter referenced the fact that relevant firms must comply with the current phasing-in of requirements for larger Alternative Investment Fund Managers to make disclosures in line with those recommended by the Taskforce on Climate-related Financial Disclosures.
Nothing in the letter should be a surprise to firms – consumer protection has remained a focus of the FCA for years, the management of conflicts has been reiterated by the regulator in both Supervision and Enforcement contexts, and ESG disclosures are a focus of global regulators at the moment. That said, this letter should focus the minds of senior managers in alternative firms to properly articulate how they are dealing with these issues, and to address any inadequacies that they identify.