What’s the Alternative?

FCA’s recent Dear CEO letter sets out its supervision strategy to address the key risks of harm that alternatives investment firms pose to their customers and markets.

The regulator says its alternatives portfolio comprises authorised firms that predominately manage alternative investment vehicles (hedge funds or private equity) or alternatives assets directly, or advise on these types of investments or investment vehicles. Amongst this group, the FCA identifies the key risks as mis-selling, controls and oversight over client money and assets, market abuse, market integrity and risk management, money Laundering and financial crime and the impact of EU withdrawal.

This is a fairly sweeping set of risks and alternative investment firms should consider how far they are relevant both directly and indirectly in their business models. Whilst alternative investment managers do not typically provide services to retail investors or hold client monies and assets, they might want to look outside the box of their own businesses and consider what risks their practical and contractual interaction with distributors, advisers and administrators pose. This is a principles-based approach consistent with Product Governance and the FCA’s focus on supervisory “outcomes”.

But there is also a question for the FCA to answer. How will it regulate the alternatives sector post BREXIT? ESMA recently published its Annual Statistical Report EU Alternative Investment Funds 2020. Based on over 30,000 Annex IV reports from AIFs managed and/or marketed by authorised EU and sub-threshold AIFMs, the report is heavy on detail statistics and light on interpretive analysis – intriguing for a regulatory reporting regime established to assess systemic risk.

Yet the analysis does show that the UK is the largest EU state for marketing on non-EU AIFs and where 80% of hedge fund managers measured by NAV have established themselves. Hedge funds make relatively lower use of the EU passport, are highly leveraged and have a low level of retail investors compared to other types of alternative funds. Meanwhile, private equity is the more likely sector to need to establish an EU presence post BREXIT because of its wider use of EU passports for marketing purposes and for access to EU investments. It too has a relatively low retail exposure. From a market integrity perspective, significant proportions of fund of funds (11.1%), other AIFS (16.9%) (a meaningful-sized mix of funds that include commodity, infrastructure and conventional non-UCITS strategies) and real estate funds (8.2%) contained liquidity mis-matches but also lacked contractual arrangements to manage these, yet, across the EU, these were the types of alternative funds more likely to contain retail investors.

The FCA acknowledges its review of retail exposure will need to cover a broad spectrum of alternative investment products and strategies, but the ESMA data suggests the FCA looks at the wide-range of “Other AIFs” managed or distributed from the UK and that there is a lower risk of mis-selling hedge or private equity funds.

ESMA used data collected from 2018 and we are limited to what it chose to report; but what it has published shows a highly diversified, heterogeneous alternatives sector with a preponderance of hedge fund managers based in the UK. Assuming the BREXIT transitional period ends on or before 31 December 2020, the FCA will need to establish its own arrangements to source the data it needs to assess the risks posed by UK alternatives and support its strategic objectives.

Otherwise, despite the substantial volume of data the regulators collect from alternative managers, we can expect more broad swipes at the alternatives sector without furthering our understanding as to where the risks might actually reside.