INDOS has attended several compliance conferences and briefings over recent months. Common themes arising include the regulatory focus being applied to fund operational resilience, cyber security and manager and fund governance.

Operational resilience is currently being heavily tested by the extreme pressures on businesses resulting from the significant measures which have been implemented to tackle COVID-19.

Cyber security is becoming more challenging given the significant growth in cyber attacks and therefore the high level of disruption risk posed to markets and businesses.

Under the new Senior Managers Certification Regime (SMCR), which came into effect in December 2019, the FCA has delivered a clear message that senior management will be held accountable for weakness in procedures in these and other business areas.

It is important that firms document and stress test their contingency plans to deal with major events including assessment of operational risk and the firm’s ability to continue to operate effectively to serve and support their clients.

Away from the immediate operational challenges currently faced by firms, there are a wide range of other regulatory changes and areas of focus, including:

• Product disclosure regulations come into force in March 2021, where there will be focus on sustainability and sustainability risk. Large firms will be expected to review the impact of their investments on the globe.
• FCA review of implementation of research rules has shown most firms have a clean bill of health, however, FCA reviews are likely to continue into research and inducements.
• Product and fund governance is another key area of focus as there are concerns that some products are not in the best interests of investors and also how product and fund governance and compliance responsibilities are being undertaken.
• SMCR – the aim of which is to deliver a cultural transformation. The FCA can take action if they believe a firm has not taken reasonable steps to avoid a breach. The burden on a firm is greater now with the onus on certification staff to demonstrate their responsibilities through documentation and a proper audit trail. We are likely to see testing as the quality of firms’ statement of responsibilities varies across the industry. It is essential that there is a full firm buy-in to SMCR so that it is not just seen as a compliance project.
• Compliance monitoring has moved away from being a tick box exercise, firms need to explain what effective controls they have in place for monitoring and documenting meaningful evidence to support the effectiveness of controls is key.

Good governance in firms is key in order to enable a firm to address these challenges.

To many readers of the financial press it might appear that ESG (Environmental, Social, Governance) is a trending phenomenon. It might have attracted a lot of attention recently, but in fact ESG was introduced almost 15 years ago, in 2006 by the UN PRI (Principles for Responsible Investment). For most of the time since then ESG has been a sideshow. However, during 2020, starting with Greta Thunberg taking on President Trump in Davos, ESG and climate change in particular has been the main show.  Indeed, sometimes it feels as if the investment world has been hit by an ESG tsunami.

The current narrative is that hedge funds and ESG are not necessarily natural bedfellows. ESG is about long term investing: the “E” for example is concerned about how the global economy transitions to a low carbon economy over the next 10 to 30 years and the risks surrounding that transition. Meanwhile, hedge funds are perceived to have, and in many cases do have a much shorter investment time horizon.

I would present an alternative view: that ESG enables an opportunity for the hedge fund industry, not only to improve its public perception; but to also help turn the tide of negative net hedge fund flows, amounting to about $100bn in 2019.

The general perception is that hedge funds are behind the curve and this is certainly supported by my own experience through discussion with many managers. As it stands, the long only world has been grappling with ESG for many years now and in a few exceptional cases since before 2006, when the PRI introduced the concept.

There are reasons that hedge funds have remained behind the curve. First of all, there is confusion around terminology and language which has not helped. Apart from questions regarding terminology, including differences between ethical investing, responsible investing, socially responsible investing, impact investing and ESG, the ESG world is literally littered with acronyms. The PRI and ESG acronyms are just for starters. At a recent conference I was asked what I thought about the TCFD, the CPD, the GRI and SASB. You need an “acronym bible” to negotiate your way through an ESG conference these days.

As well as confusion, there is also cynicism with regards to ESG ratings. A whole industry has grown up around ESG ratings, a simple answer to a complex problem, which tries to address how good companies are according to a variety of ESG factors. But it’s not clear how meaningful these corporate ratings are.  Ultimately it is a subjective view which tries to aggregate apples, oranges and bananas.  It is no surprise therefore that there can be little correlation between ESG data providers.

And yet ESG provides the active fund management world and hedge funds an incredible opportunity to fight back against the inexorable rise of indexation.

From an investment perspective, hedge funds have an opportunity to short those companies failing to properly adapt to climate change.  Shorting is no longer a dirty word, partly responsible for the financial crisis in 2008; instead it can be seen as a smart strategy, helping to accelerate the transition to a low carbon economy. Equity hedge funds have the opportunity to create carbon neutral, even carbon negative portfolios.  For those pension funds and insurance companies looking to reduce their carbon footprint, this could be an interesting additional source of diversification.

And for once hedge funds have had a positive portrayal in the general media. Reporting on Hedge Fund Manager, Sir Christopher Hohn, Founder of the TCI, the Children’s Investment Fund, who came out publicly with details of TCI’s ESG policy, and its focus on climate risk. Mr Hohn recommended that all investment managers should engage with the companies that they are invested with on climate risk and, more controversially, he suggested that asset owners should fire any investment managers who aren’t doing so. Therefore, ESG can help to reverse the negative image of hedge funds in the general media.

Looking now into the crystal ball, what does 2020 have in store? Well, firstly the rising tide of enthusiasm for ESG is not going to slow down. 2020 will be the year when ESG continues to dominate the news. Culminating with the UN COP 26 meeting in Glasgow in November, the most important meeting on climate change since Paris in 2015.

A lot of the coverage around ESG investing has so far focused on millennials and rightly so. In 2020, however, I believe that the big story will be how the UK pension fund industry adapts to the ESG revolution.  The interpretation of fiduciary duty has been turned upside down in the ESG space. And now there is over a trillion dollars of assets which need to consider ESG and provide evidence of how this is done.

A couple of examples: the Brunel Partnership, which manages assets of around £30 billion for local authority pension funds, has announced their intention to remove non-ESG compliant fund managers from their portfolios. NEST, the largest UK Defined Contribution pension fund, with 8.9m members, wants its investment managers to be aware of ESG risks and opportunities; and, furthermore, that ESG is part of the culture of the firm and that this should start right from the top.

So, with this in mind I suggest a simple “ESG action plan” which can apply to both hedge fund managers and service providers: to become carbon neutral in 2020.  The UK has set a target of becoming carbon neutral by 2050; BP recently hit the headlines when it set the same target of becoming carbon neutral by 2050.  If the hedge fund industry becomes carbon neutral in 2020, then it would be 30 years ahead of the ESG curve.

3 things are required:

• Firstly, calculate your company carbon footprint, which comes mainly from air travel
• Secondly, get your calculation approved and there are several certification agents; and
• Finally, offset your carbon footprint. In this respect there are various offset programs, including those supplied by the certification agents.

There are various parties who do care: employees; families; and perhaps most important, investors. 2020 will be the year when “Who cares wins”.

Although limited partners (LPs) have historically exercised less pressure on private equity managers to integrate ESG (environment, social, governance) into their portfolio choices than say – for example – public equities or real estate firms,[1] this is slowly changing. INDOS Financial attended Super Return International in Berlin last month, where it discovered the private equity industry is becoming increasingly receptive to the principle of ESG investing.

GPs embrace ESG

Until recently, private equity managers were not entirely convinced by the merits of ESG investing, seeing it as something that could potentially impede returns. This has largely been disproven. For example, the University of Hamburg found 63% of studies indicated there was a largely positive correlation between ESG investing and returns, while only 8% said the contrary. [2] Aside from the commercial advantages of incorporating ESG, investors at Super Return made it clear that a failure to take it seriously opened managers up to various risks.

Among them is stranded asset risk, whereby managers are left holding assets whose value has been eroded by a failure to adapt to climate change. For institutions with long-term liabilities such as pension funds and insurance companies, this is an unacceptable risk, especially in light of the recent PG&E bankruptcy, the world’s first climate change related insolvency. For instance, ATP, the $133 billion Danish pension plan said earlier this month it would stop putting money into external funds – namely private equity and credit funds – which have investments in fossil fuels, citing stranded asset risk as being its overriding concern.[3]

Other pension funds have made similar pledges to rein in their exposures to fossil fuels, including ABP in The Netherlands. With more investors appointing sustainability heads, ESG is now an integral part of the fund manager due diligence process. However, one LP told Super Return that it was not an automatic red flag if a private equity firm is invested in a non-ESG company, conscious that some firms may be behind the curve. However, the LP said they will fail managers on due diligence grounds if they are reluctant to have an ongoing, constructive dialogue about ESG with clients.

The role of governance in ESG

Traditional asset managers – as we saw at Fund Forum International last year – acknowledged that ESG can be exceptionally subjective in public markets, a problem not helped by the abundance of different ESG methodologies at ratings agencies; divergent investor sensibilities; and the sheer volume of industry standards. One expert said the situation is more complicated in private markets where access to information – not least ESG data – is far more limited. Private equity – arguably – is therefore more susceptible to greenwashing than public markets, and this is something investors must be vigilant about.

Proposals including the taxonomy and reporting guidelines as envisaged under the EU’s Action Plan on Sustainable Finance could help solve some of these challenges, but there is unlikely to be wider regulatory standardisation. Moreover, the EU’s proposals are primarily focused on the environmental criteria of ESG as opposed to the social elements, which are notoriously difficult to quantify because the calculations are more subjective. While ESG data standards are critical for assuaging investors, independent ESG oversight/monitoring will become an increasingly important aspect of fund governance. Such oversight will be critical to ensuring that private equity firms are compliant with their ESG mandates and do not greenwash their portfolios.

[1] Bain & Co (February 24, 2020) Investing with impact: Today’s ESG mandate in private equity

[2] Bain & Co (February 24, 2020) Investing with impact: Today’s ESG mandate in private equity

[3] Reuters (February 4, 2020) Danish pension provider ATP to halt fossil fuel investments via external funds

European regulators are spending a lot of time scrutinising the liquidity risk management practices at investment firms following a number of high-profile fund suspensions last year. That such liquidity issues were allowed to happen raises questions about the effectiveness of fund governance practices as a whole. If asset managers are to retain the trust of investors, higher standards of governance are required within areas of the funds’ industry.

FCA is pushing up standards

The UK’s Financial Conduct Authority (FCA) is taking a lead on governance, having introduced the Senior Managers & Certification Regime (SMCR) in December 2019, which imposed heightened accountability criteria on asset managers. The importance of SMCR and robust fund governance were the central messages in two “Dear CEO” letters sent by the FCA to both retail and alternative asset managers at the beginning of 2020.

In the letters, the FCA said SMCR was not to be treated as a “discrete compliance project” but “as an opportunity to deliver high standards of governance.” The FCA’s message was clear: “Overall standards of governance, particularly at the level of the regulated entity, generally fall below our expectations”. The FCA has told firms it wants them to have “refreshed [their] approach to governance and taken the necessary steps to improve it”.

The letters were also clear in stating the FCA will be actively examining the retail asset management and alternatives sectors during 2020, so firms should expect increased scrutiny. As a result, managers have been put on notice meaning they will need to demonstrate how they have adapted their governance frameworks as a result of SMCR.

 Building blocks of strong fund governance

 SMCR focuses mostly on culture, conduct and accountability at asset managers. However, effective fund governance, which ensures a fund is operated in the best interests of its investors, requires a broader system of checks and balances. These are performed collectively by the fund board, the depositary and auditor, and must be done to a high standard. These three functions are essentially the building blocks of good fund governance. However, they are often treated as a box ticking exercise or worse they are vulnerable to conflicts of interest. This can result in subpar service much to the detriment of investors.

Examples of such deficiencies include fund directors not being genuinely independent of the asset manager, or depositaries overseeing fund administrators which they are affiliated with. In these circumstances, depositary is not seen as a core business but one born out of a need to enable clients to comply with a regulatory requirement. As such, there is little incentive for these depositaries to shine a spotlight on poor performance or errors made by the parent fund administration group.

Independence, independence, independence

Truly effective fund governance requires independent and conflict free oversight, which always places the interests of investors first.  As a consequence of SMCR and the follow up Dear CEO messages, more managers are expected to review the effectiveness of their fund governance arrangements. They will assess all aspects of their operations and recognise that independent, conflict free services represent a stronger governance model.

Tick the box approaches towards compliance should no longer be tolerated.  Managers must review conflicted service models and demonstrate that fund directors and depositaries are subjecting them (or their affiliates) to appropriate challenge. Managers will benefit from being able to demonstrate to their clients that they have embraced effective fund governance and depositary oversight.

Where do we go next?

As the end of the Brexit transitional period looms and calls from the industry grow for the UK to adopt its own unique, internationally accepted fund structure, the case for more effective fund governance is becoming stronger.

If the UK is to preserve its reputation as a leading asset management hub, regulators need to ensure that governance is robust. The role of the fund depositary is likely to grow in importance and this could be an excellent opportunity for the UK to lead the way on insisting that depositary oversight be strengthened and become more independent.

This INDOS Financial article was first published by HFM Week and can be read here.

The great and the good met at Davos in January but the event will be most widely remembered for the confrontation between Greta Thunberg and President Donald Trump: a dispute that transcended politics (USA vs Europe), gender (male vs female) and age (old vs young).  It made for good press and reflected the dominant theme of the conference which was of course climate change.

Every year the World Economic Forum (WEF) releases its Global Risks report highlighting the five biggest risks currently facing the world, broadly split into the following categories – economic, environmental, geopolitical, societal and technological. In previous years, these risk outlooks tended to be quite varied (e.g. WMD, cyber-crime, unemployment, asset price collapse), but in 2020, the list was dominated by environmental risks, chiefly climate change. Financial institutions are taking note.

So how has the investment management industry reacted to the challenges posed by climate change? Slowly is the simple answer. In 2004 the UN started to develop a responsible investment initiative focusing on the importance of environmental, social and governance (ESG) factors.  Over 15 years, this initiative has slowly developed momentum paving the way for the establishment of a new ESG analysis industry, evaluating and ranking companies on the basis of their ESG criteria.

Hedge Funds – barring a few notable exceptions – have been criticised for being slow to address ESG. The financial crisis in 2008 did not help as some investments designed to mitigate climate change, for example in renewable energy, went bust as credit for longer term projects dried up.

There is also a cynicism (in part justified) about the ESG rankings developed by various data providers and their ability to predict future price movements. For instance, how can an ESG ranking make sense as it tries to aggregate such different “non-financial” information?  In contrast, equity hedge fund managers – in particular activists with concentrated portfolios – argue they have a much better appreciation of the material financial risks related to ESG than the ESG data providers themselves. ESG is an implicit, not explicit part of their decision making.

One of the major advances made by the responsible investment movement has been to encourage companies to disclose their carbon footprints. Enabling this have been initiatives such as the Carbon Disclosure Project (CDP), a private, not for profit organisation launched in 2002. At its inception, there were 35 investors and 245 companies adhering to its reporting guidelines. Since then, that has grown significantly with more than 500 investor signatories (with $100 trillion in supporting assets) and over 8,000 companies disclosing details about their carbon footprints. As a result of this scheme (plus efforts by some ESG data providers), investment managers can now estimate the carbon footprint of their portfolios.

As such, it can be viewed as a simple proxy to the climate risk within the portfolio. Hedge funds who go long and short equities to create a market neutral portfolio could in theory create a carbon neutral portfolio by using the information provided by CDP.  By disclosing the carbon footprint of their portfolios, they would also provide transparency to investors around climate risk.

This enhanced transparency would also help change the negative media perception of the hedge fund industry. A few hedge funds are leading the way on governance and climate risk. There is now an opportunity for hedge funds more broadly to join in by disclosing the carbon footprint of their portfolios. By being pro-actively transparent, the hedge fund industry can get ahead of the ESG regulatory curve and start to play a leading role in the fight against climate change.