On 9 August 2022, the FCA published a portfolio letter on its Alternatives Supervisory Strategy.
The letter outlines the FCA’s updated supervisory strategy and priorities for firms within its ‘Alternatives’ portfolio together with firms that are predominantly active in the alternative investment sector (together firms). The FCA’s alternatives portfolio is comprised of FCA authorised firms that predominantly manage alternative investment vehicles (i.e. hedge funds or private equity funds) or manage and advise alternatives assets directly. The FCA’s asset management portfolio is comprised of FCA authorised firms that predominantly manage mainstream investment vehicles, or advise on investments, excluding wealth managers and financial advisers.
Main risks of harm
The letter outlines the FCA’s view of the main risks of harm that alternative investment firms, and the markets in which they operate, pose to their customers – which in turn shape the FCA’s supervisory priorities. The main risks of harm and supervisory priorities, which are consistent with the FCA’s 2022 business plan commitments, include:
- Investment strategies that carry inappropriate levels of risk for their target client.
- Conflicts of interest.
- Market integrity and disruption.
- Market abuse.
- Environmental, Social and Governance (ESG).
Investment strategies that carry inappropriate levels of risk for their target client
The FCA reports that it is still has concerns regarding inappropriate distribution and marketing practices by firms targeting mainstream investors.
It reminds firms that they:
- Should consider the appropriateness or suitability of the investments they offer for their target customers, be they retail or elective professionals.
- Can reduce the risk to consumers with limited investment knowledge or risk appetite being exposed to inappropriate investment strategies by conducting thorough investor assessments. In order to achieve this firms should:
- ensure that alternative investments are only offered to appropriate investor types, and that the investments meet client needs. Firms should recognise that not all alternative products are suitable for all investors;
- consider the application of relevant marketing restrictions to retail investors when communicating or approving financial promotions for alternative products;
- recognise that an adequate assessment of the suitability of alternative investments for retail investors is an essential mitigant in the reduction of potential harm; and
- make sure that target markets are clearly outlined for distribution channels to ensure a clear understanding of in scope investors is in place.
The FCA states that firms that onboard retail or elective professional customers should review their processes to ensure they are effective, including the procedures for checking that elective professional investors meet the quantitive and qualitative tests required under COBS 3.5. The FCA also adds that such firms should also consider their new obligations under the new Consumer Duty.
In the coming months, the FCA will be issuing a questionnaire asking firms for information about their business model, products, investor categorisations and associated control framework.
Conflicts of interest
The FCA draws firms’ attention to the fines it has recently issued because of inadequate management of conflicts. Boards are asked to review their procedures to ensure that conflicts are avoided, managed or disclosed in a way that minimises harm to investors and markets. The FCA also asks firms to consider the impact of their shareholder structure and the potential implications this has on the effective governance of their organisation.
Market integrity and disruption
The FCA warns that robust risk and liquidity management is essential at any time, but especially so given increased market volatility and rising interest rates which is leading to several new coexistent risks for alternative asset managers. It calls on firms’ boards to ensure that risk functions are appropriately resourced, contemporaneous, and commensurate with the levels of portfolio and business risk being taken.
The FCA reminds firms that it expects them to have strong prevention cultures, effective systems and controls to enable them to discharge their obligations under the UK Market Abuse Regulation (UK MAR). Firms must ensure UK MAR controls are tailored to their individual business models.
The FCA reports that during the forthcoming supervisory cycle, it will look at how senior managers and firm policies influence an organisation’s culture. Furthermore, the FCA is interested to understand how healthy cultures are embedded in firms where founders or other senior individuals occupy a dominant role. Later this year the FCA will publish a Consultation Paper which will follow up on its earlier Discussion Paper in July last year. The FCA will expect firms’ boards to fully consider this aspect of their organisation.
The FCA states that:
- Firms should ensure that documentation of products labelled as being ESG focussed are clear, not misleading and that firms’ actions match the stated aims.
- Firms offering products labelled as ESG should expect to be subject to review to ensure marketing materials accurately describe their product, with funds offering clear and consistent disclosure.
- Firms in-scope of its December 2021 rules requiring asset managers, including authorised alternative investment fund managers, to make disclosures in line with those recommended by the Taskforce on Climate-related Financial Disclosures, should consider what steps they will need to take to be able to make these disclosures from 2023 as required.
Steps firms should take
The boards of firms should consider which of the risks are applicable to their business and whether they have the appropriate strategies in place to address them.