As regulators scamper to introduce regulation into the world of alternatives one cannot help but wonder whether another opportunity is about to be lost.
The problem with regulation is that it is often a political knee jerk reaction to events. I had for example viewed with some excitement the opportunity the FSA had with the consultations on side letters to address some of the issues that gave rise to the need for such agreements – but the result was a disappointment of weak compromise and the current European regulatory effort seems destined to a similar fate.
Regulation will never save investors from themselves. Investors will forgive almost anything with performance. So what should regulation be designed to address? I prefer a variation to the FSA’s eleven principles as my starting point:
- Integrity
- Fairness
- Transparency
- Appropriate business structures and governance
- Balance of interests
- Protection of interests
- Verifiability
- Skill and due care
How would these apply to the world of alternatives? I believe it is possible to have a regulatory framework that does not stifle the investment manager but has sufficient clout to bring a manager to heel or to its knees if it misuses the privileges granted to it.
Integrity is a broad over arching starting point and does not require much discussion. Skill and due care whilst clearly important are intentionally placed last on my list – what chance for example does a regulator or an investor have when market participants/managers themselves have no idea of the effects of re-hypothecation in financing transactions – and that is not to condone any of the three groups for that lack of knowledge.
Fairness is central to any financial services transaction – whether in relation to investment terms, fees, manager’s intellectual property or otherwise. When one looks at existing terms and risks that could at least technically be mitigated such as in relation to cross class liability between classes and different levels of leverage then I don’t believe that enough is done by managers to protect investors. I don’t think it is enough simply to disclose the existence of cross class liability – I think the manager needs to be obliged to justify why maintaining that risk is fair to investors. The manager’s argument is that once disclosed it is a matter for investors to determine whether the risk is an acceptable one that of itself is not an unreasonable position until one looks at the rationale applied and the level of due diligence really done by investors. However applying the concept of fairness the manager would need to have taken reasonable steps to protect the classes from cross class liability rather than simply disclosing the existence of the risk and will have explained to the investor why from their point of view the existence of such a risk is fair to the different classes of investors. This argument is important as it is often confused with the principle of transparency – it is never enough in my view simply to disclose – although disclosure is an important step. To go back to my example of re-hypothecation – this was clearly disclosed to those who bothered to read the contractual terms – but its impact was assumed to be known which it clearly was not. I am not advocating that the investment manager needs to become nanny to the investor but I think disclosure needs to go beyond the familiar generic risks that one sees spouted with such regularity in any prospectus that one might care to pick up.
The business and governance structures too are generally constructed from the managers point of view. Managed accounts are often created to address specific issues – whether it is in relation to ownership and control of assets or transparency to trades. Managers could do much more to protect the interests of investors – but lawyers are remunerated to protect managers – as is so clearly set out in the disclaimers in the prospectus. The obligations in that respect need to be balanced and that can only be done by an independent party making sure that there is a proper balance of interests – which should protect the manager as much as the investor.
Whose interests need protection? Everyone has a stake – the manager its intellectual property and investment edge, the investor its capital, the service provider protection of its profits and reputation. The balance of interests and the protection of interests is very skewed in favour of the manager – that needs to change as it is linked to bringing fairness back into the balance without destroying commercial opportunities.
There is no investment house today that does not proclaim its adherence to best practice. Unique selling points gradually blur as everyone claims to adopt practices of virtue – operational due diligence being no exception to such claims. The reality however is quite different – few do so properly whilst many play at the periphery of what should be best practice. This is what makes verifiability so important – whether it is in relation to best execution, due diligence or risk management. If it is possible to verify the claims of an investment house whether through ISO standards, SAS70/FRAG21 reports or independent valuation reviews and where such information is provided to investors – then that would make a significant change to the investment landscape that we currently observe.
Principle based regulation that addresses the roots of the problems that we have experienced in the industry in the last decade would go a long way to rebuilding foundations of trust – but in finding the appropriate balance to encourage the industry to flourish is an opportunity that would be a great pity to miss.
©Jaitly LLP