Robust fund governance and proper oversight play an integral role in safeguarding the fiduciary interests of investors. Shortfalls in fund governance standards were well-documented during the 2008 financial crisis – and while there have been material improvements, events at the Woodford Equity Income Fund and H20 Asset Management illustrate there is still more work to be done. Nonetheless, a combination of intense global regulatory and institutional investor pressure is prompting more asset managers to further enhance their internal operational processes and fund governance practices.
Regulators turn the screws on fund governance
Across the world, regulators are pursuing a fiercely proactive crusade against substandard corporate governance. The EU is widely seen as being the bellwether on governance reform, having introduced the Alternative Investment Fund Managers Directive (AIFMD) in 2014, which imposed heightened risk management and oversight provisions on EU asset managers. Among the AIFMD’s requirements included an obligation that funds appoint a depositary to oversee their operations. In recent years, some depositaries have been recognised for providing pertinent information and views to fund boards enabling them to fulfil their fiduciary duties. On a local level, EU member states have also legislated on governance. For example, the Central Bank of Ireland (CBI) pushed through the CP86 framework, which insists that managers appoint at least two, independent resident directors to their boards.
Elsewhere, the UK’s Senior Managers & Certification Regime (SMCR) imposes strict accountability requirements on financial institutions including asset managers and their boards. It is not just the EU that is focussed on weak governance practices.. The US Securities and Exchange Commission’s (SEC) Office of Compliance Inspections and Examinations (OCIE) regularly issues risk alerts outlining its concerns following routine examinations of investment advisers. Its most recent alert warned about the conflicts of interests at private funds, identifying examples of preferential client treatment and erroneous fee and expense practices. This blunt OCIE briefing should serve as a reminder to private funds that improvements are needed in their governance and compliance processes. Similarly, offshore fund centres are also taking meaningful action on the issue of fund governance. The Cayman Islands Private Funds Law – introduced in August 2020 – subjects private equity firms to added regulatory registration requirements and depositary provisions largely mirroring the AIFMD.
Investors prioritise governance
Having initially remained on the side-lines in the early stages of the COVID-19 pandemic, institutional investors are once again beginning to allocate capital into alternative funds. While inflows have picked up since the nadir of the crisis, institutions are being highly selective when making their investment decisions. Simply having a solid performance track record is not enough to win mandates. Investors want assurances that fund houses have best of breed operational and compliance processes in place, including strong governance, especially in light of the issues at Woodford and H20. In this competitive market, asset managers are at risk of missing out on mandates if they cannot demonstrate that their governance and oversight measures are robust.
An external, independent provider makes the difference
Even though the appointment of a depositary is a legal requirement under the AIFMD and best practice under the Cayman Islands Private Funds Law, it could potentially become more ubiquitous even in jurisdictions where it is not mandated, especially if investors – having observed the benefits depositary confers – start asking for it.
Historically, depositary has been seen by many managers as a routine tick the box exercise, but these attitudes are gradually beginning to shift. The best asset managers are those that take a smarter approach to regulatory compliance and think holistically about governance and compliance across their businesses and address multiple regulatory requirements. They view functions such as depositary as something that should add value to their business and clients, thereby creating efficiencies and enabling them to better manage compliance and regulatory risk.
Moreover, asset managers need to take a more thoughtful approach when appointing a depositary. While a one stop shop provider (i.e. a service provider offering custody, fund administration, depositary, and other services) is often seen as a cost-effective and simple solution, it also has significant weaknesses. Not only does the bundled model create heightened counterparty risk, but there are inherent conflicts of interest and a lack of independent oversight and challenge. There is no guarantee, for instance, that a depositary affiliated to a fund administrator will flag operational issues as readily relative to an independent provider. As a result, the affiliated model is not always in the best interests of investors to whom managers and fund boards have a fiduciary duty to protect.
By Bill Prew, CEO, INDOS Financial