Fund Governance

What to make of the AFM review

6 minute read time

A review by the FCA has set in motion broad but uncertain changes among firms that underpin huge amounts of fund activity.

A specialist group of fund management firms that plays a crucial role in the investment industry are in for a shakeup after a regulatory review that identified structural flaws at the core of the funds sector.

Experts say the Financial Conduct Authority (FCA) review of ‘host’ authorised fund management firms (AFMs) could lead to higher fees for many investment managers. Perhaps, more crucially, it may lead to a consolidation of the AFM sector and a shift in the balance of power between three key parties: host AFMs; the often high-profile third-party investment managers who use their services; and the depositaries who provide oversight.

The background

When the FCA released its review in June 2021 it demanded drastic change in the next 12 – 18 months to address serious “weaknesses in governance structures, conflicts of interest management and operational controls” by host AFMs, which are also known as authorised corporate directors (ACDs).

AFMs are legally responsible for operating a fund and ensuring it complies with FCA regulations but they delegate investment decisions to outside investment managers, who the regulator fears are not being properly scrutinised through due diligence and ongoing monitoring.

So, the regulator is demanding more active and independent oversight by AFMs and a greater commitment of resources and skilled personnel to protect investors. But sector expert Ryan Johnson says AFM fees and profit margins have been squeezed so much over the past decade that not all of the active operators in the sector will be able to adjust. 

“There is definitely a consolidation that’s going to happen with a number of them,” says Johnson, a financial services expert at Lloyd Expert Consultancy, currently the only firm that specialises in AFM/ACD selection and review.

“We know for a fact that two ACDs are up for sale; they’ve decided it’s no longer for them as there is already too much regulation and too many capital adequacy requirements.”

Nikki Wells, a senior director in the relationship management team of NatWest Trustee and Depositary Services (NatWest TDS), agrees and says that “some smaller host AFMs might either be taken over or consolidate with others because if more resources are needed to meet the FCA’s requirements, some of the smaller players in the industry might find that they can’t actually survive”.

“The rules as they stand are sufficient but the way they are applied is a touch weak, so it’s the application of the rules that needs to improve and you can do that by getting more robust guidance” Elizabeth Budd, partner, Pinsent Masons

Wells explains that NatWest TDS is working with its host AFM clients to understand how they will respond to the FCA’s demands “because as a depositary we are driving best-in-class governance in the sector”.

She adds: “Talking to our clients, quite a lot of them have already started to make changes to address the points the FCA has raised, such as ensuring that their management team are sufficiently well organised to undertake robust oversight of investment managers by making new hires or creating specific roles within the business which focus on this."

Shifts in power

Elizabeth Budd, a partner in the financial regulation and funds practice of law firm Pinsent Masons, says the basic problem with how the host model has operated is that the regulatory regime assumes a certain cascade of power that is at odds with the commercial reality and actual cascade of power.

“Quite often the host is a smaller operation being used by a very large investment manager who doesn’t want the hassle of setting up its own internal AFM, and when you’ve got a very large entity dealing with a very small entity the balance of power is not what the regulator would like.

“From a regulator’s point of view, the AFM owns the fund and outsources the investment management activity,” she says, but the true power dynamic is that the fund’s sponsor has most power and has chosen to outsource its regulatory duties to the host AFM.

“From the investment manager’s point of view, they are just buying in a service that they are not able to do themselves,” Budd adds.

“We’ve had a huge amount of FCA guidance and regulations around what you have to do on outsourcing, but I don’t think anybody really regarded this as outsourcing previously.

“Having the host model is very useful for the industry, so if the industry wants to keep it, it has to shift its attitude and allow the model to work properly,” she adds. “The investment manager has to allow the host AFM to do strong due diligence, strong monitoring and if unpalatable things are uncovered the investment manager has to acknowledge that, and not ignore it.”

Budd argues that “the rules as they stand are sufficient but the way they are applied is a touch weak, so it’s the application of the rules that needs to improve and you can do that by getting more robust guidance”.

The power of oversight

Ryan Johnson of Lloyd Expert Consultancy insists that much more sweeping reform is required, saying the FCA needs to rip up its current rule book and provide much clearer and simpler guidance.

“The findings of its review are absolutely solid in terms of identifying the problems with governance and conflicts of interest, and recognising that the system is not fit for purpose, but it hasn’t actually come up with a solution,” he adds.

Johnson says host AFMs are not only commercially beholden to fund sponsors, who he calls “their real paymasters”, they have also been weakened over time as tighter profit margins have seen them lose expertise and resources.

The best solution, he says, would be to rely more heavily on the oversight of depositaries, on the proviso that they provide a standalone service, rather than also selling a range of other services to host AFMs.

“The depositary has the deepest pockets, not the ACD, so you now need to move the balance of accountability and responsibility from the ACD to the depositary. The depositary should be there to fix it as quickly and swiftly as possible on behalf of investors,” he says.

“The industry is looking for transparency and clear lines. In my view the role of the depositary should increase and really take a grip of the industry in terms of fund oversight, so I just think it’s a better model to have a separate entity as the depositary.”

It’s a view supported by Wells: “A depositary is the cornerstone of good governance and we want the industry to see the importance of them being independent.”