The Assessment of Value You Didn’t Know You Needed
Unlock Real Value: How the UK’s Governance Rules Are Transforming Fund Management Accountability. (Actionable insights in italics)
With the Asset Management Market Study dated 2017 and the ensuing package of measures introduced in 2018, the UK pioneered the paradigm shift towards greater accountability for fund managers. The findings of the study had showed weak price competition in the industry, due in part to non-existing negotiating power of retail investors vis-à-vis fund managers. At the same time, fund governance bodies lacked any focus on the assessment of value that customers received for the money spent to purchase asset management services.
The package of measures introduced further to the Asset Management Market Study was originally conceived free from extraterritorial effects as an obligation incumbent on UK authorised fund managers only, including the ones managing UCITS. The recent introduction of the UK Overseas Fund regime questions this original approach. Recent guidance issued by the UK FCA confirms our expectation that EEA UCITS applying for marketing recognition under the new UK Overseas Fund Regime will have to comply with local rules on assessment of value and undue costs.
A Matter of [Good] Governance
The assessment of value and its disclosure in the UK is essentially chalked up to a matter of [good] governance. Rules existed already, well before the Asset Management Market Study, that required fund managers to act in the best interest of their shareholders. Including rules to prevent that undue costs are charged to them.
However, the fact that fund governance entities were not sufficiently focussed on issues of value for money was also a function of their lack of authority to challenge overall commercial strategies of fund promoters or initiators. The extremely weak competition on price in asset management was confirmation though that the libertarian approach adopted thus far had failed. Additional rules were required to ensure that consumers received value for their money when purchasing asset management services.
The governance model adopted in the UK envisages that authorised collective investment schemes are required to appoint an authorised fund manager. This body becomes responsible for the fund, both for statutory and regulatory purposes, irrespective of its legal structure. The authorised fund manager usually acts as the sole corporate director of UK authorised funds. Authorised fund managers typically either manage their own funds or act as host for third party managers or promoters. Either way, their fund board attracts different sets of conflicts of interest, which inherently undermine their ability to ensure that shareholders receive value for the money spent to purchase the specific asset management services. In case authorised fund managers only deal with proprietary funds, their board members are most typically either in a direct employment relationship with the portfolio manager or are members of the ultimate parent company of the group. Thus, biased in their role for this very reason. In the case of authorised fund managers acting as hosts of third party funds, in a fashion very similar to independent management companies in Europe, the conflict of interest is driven by the commercial relationship with the third party fund manager or promoter.
Without completely altering existing governance arrangements to morph them on the ones introduced in Europe, the solution adopted in the UK revolves around not only more robust governance but accountability of the board of authorised fund managers. On the one hand, introducing a new rule to require that authorised fund managers assess whether value for money has been provided to fund investors. On the other, making the board accountable to respect this rule and introducing a share of independent directors within fund boards.
A Parallel on the Notion of Undue Costs
The UK FCA provides guidance on what constitutes undue costs for funds in the COLL Handbook. More namely, COLL 6.6.A.2.R(5) states that an authorised fund manager must act in a way to prevent undue costs being charged to any scheme it manages and its unitholders. An indication of what could be considered undue costs is contained under COLL 6.6A.3G(2), where undue costs are meant to include unreasonable charges and excessive trading, taking into account the scheme's investment objectives and policy. Existing rules from the FCA emphasize that costs should be reasonable and justified relative to the strategy of a fund.
As part of a broader package of measures part of the so-called retail investment strategy, both the UCITS directive and AIFMD will soon include a definition of undue costs, so far missing piece of the equation. The rationale followed by the European authorities revolved around the idea that introducing such a definition would have made existing undue costs prevention obligations on fund management companies more effective. Under the proposed new rules, all costs not in line with fund disclosures, not necessary for funds to operate in line with their investment strategies or objectives, nor to fulfil regulatory requirements, will be considered undue.
Fund management companies will also be required to maintain, operate and review for each fund they manage, from inception and throughout its lifecycle, a pricing process. This will ensure that costs charged to fund shareholders are justified and proportionate, considering the specific features of the funds, including investment objective, strategy, expected returns, level of risks and other relevant characteristics. Management companies will also be held accountable for their pricing process.
The Seven Pillars of the Assessment of Value
When it comes at the UK style assessment of value, authorised fund managers shall carry out their assessment based on the following seven pillars.
Quality of service
Performance
AFM costs
Economies of scale
Comparable market rates
Comparable services
Classes of units
From a methodological perspective, despite interconnectedness amongst them, authorised fund managers shall carry out their analysis on each of the pillars independently. Individual funds shall be reviewed and scored against these pillars. The analysis shall include a separate discussion and conclusion for each of the pillar and a conclusion as to whether fund fees are justified in the context of the overall value delivered to investors. Especially in case of poor performance, fund managers will have to explain remedies deployed to address specific situations.
For what concerns the pillar themselves, these look at different aspects of the overall asset management service offered. The pillar related to performance will have necessarily a closer connection with aspects related to fund investment objectives, policies and strategies, which will not necessarily be as relevant for other pillars. Some of the pillars like economies of scale, comparable market rates and services will be instead more naturally linked to cost and price considerations.
Lastly, quality of service is the only pillar divorced from performance and cost considerations, hence capable of encompassing other aspects of the asset management service, some of which neglected thus far. These include communications with investors and general customer services offered by the funds.
Transparency of the Assessment of Value
The assessment of value is not a one-and-done on a yearly basis, despite the requirement in the new rules only for a yearly publication of the related report. The expectation on authorised fund managers is to have the value process alive on an ongoing basis throughout the life cycle of their funds. The assessment of value shall be seen more as an additional layer of awareness about the way authorised fund managers carry out their business rather than a mere reporting obligation. In the words of the FCA, transparency of this assessment serves different purposes, including additional scrutiny and broader comparison across the industry.
From a more practical perspective, whilst it is possible to deliver the report on the assessment of value as part of the long form yearly financial reports of a fund, authorised fund managers are at liberty to provide it also on a standalone basis. This seems to be the widespread approach adopted across the industry. General rules on communications to investors having to be fair, clear and not misleading will apply to assessment of value reports.
Beyond Mere Pricing
The debate on undue costs in Europe was based also on the premise that the relevance of costs has always been a function of assets under management as well as performance. The larger the assets the more marginal the impacts of costs. At the same time, good performance is undoubtedly associated with value for an investment. Funds that can ensure that type of profile are usually less subject to criticisms about their pricing model.
The recent position from the UK FCA on the applicability of the UK principles on the assessment of value also to OFR UCITS will create different sets of challenges for different managers. UK UCITS managers will clearly be in a better position than both their European and American colleagues. Part of the problem is that European fund managers do not have in their tradition yet the habit to look at investment propositions they offer from the lenses of having to deliver value. In addition to that, the actual European rules on value for money might differ from the ones in the UK and lead to an output on the assessment of the value that is not necessarily identical. Without going into the details of the broader discussion on the forthcoming value for money rules in Europe, the approach there seems to be myopically focussed on costs only.
Whilst the UK rules on value assessment are essentially based on the US Gartenberg principles, the assessment of value in the US is slightly different in nature, focussed on fiduciary duties of investment managers and carried out in occasion of renewing related agreements. Like the ones to be introduced in Europe, they will lack necessarily one important dimension of the value of the overall asset management service offered to investors.
Conclusions
As UCITS managers are considering a marketing recognition under the UK Overseas Fund regime, it is no longer speculative to ensure that there is a demonstrable process in place relative to the assessment of value of their funds.
The time required to establish an internal process shall be factored in the timeline to prepare to apply for a marketing recognition under the UK Overseas Fund regime. The FCA has signalled on this point that a withdrawal of an application for recognition under the UK Overseas Fund Regime might be suggested in cases where dealing with their feedback might require a longer time. Establishing a process for the assessment of value does not happen overnight or certainly in one day.