FCA sets out its supervisory priorities for the alternatives sector

The FCA has published a Dear CEO Letter (the Letter), which it has sent to CEOs of firms in its ‘alternatives portfolio’ (ie, “FCA authorised firms that predominately manage alternative investment vehicles - hedge funds or private equity funds - or manage and advise alternatives assets directly”).

What does the Letter say?

The Letter

• outlines the FCA’s updated supervisory strategy and priorities for portfolio firms
• points out areas where improvements can be made
• sets out the FCA’s view of the main risks that alternative investment firms, and the markets in which they operate, pose to their customers and
• recommends that the CEOs discuss the Letter with their Board or Executive Committee Board, which should then consider which of the risks are applicable to the firm and whether it has the appropriate strategies in place to address them.

The FCA expects Boards to “take the actions that are considered necessary to mitigate risks and ensure that your firm meets our requirements”.

Firms with any queries about the Letter are asked to contact the FCA’s Supervision Hub on 0300 500 0597.

The FCA’s supervisory priorities

The Letter follows one sent to the Alternatives portfolio in January 2020.

The FCA accepts that since then, several significant events (COVID, Brexit and cessation of LIBOR) have impacted the priorities for the sector. Even so, several of the risks outlined in 2020 continue to be relevant and firms will see some commonality in terms of the priorities described in the two Letters.

1. Putting consumers’ needs first

Investment strategies that carry inappropriate levels of risk for their target client

Inappropriate distribution and marketing practices by firms targeting mainstream investors remains a concern despite the FCA’s ban on the mass marketing of speculative investments to retail clients.

Informal governance processes, poor due diligence and inadequate investor categorisation have resulted in investors accessing products that may not match their objectives. Firms should consider the appropriateness or suitability of the investments they offer for their target customers, whether retail or elective professionals.

Ways in which a firm can reduce the risk of consumers being exposed to inappropriate investment strategies include

• ensuring that alternative investments are only offered to appropriate investor types, and that the investments meet client needs.
• considering the application of relevant marketing restrictions to retail investors when communicating or approving financial promotions for alternative products.
• recognising that an adequate assessment of the suitability of alternative investments for retail investors is an essential mitigant in the reduction of potential harm.
• making sure that target markets are clearly outlined for distribution channels to ensure a clear understanding of in scope investors is in place.

The Letter recommends, where a firm onboards retail or elective professional customers, it should review its processes to ensure their effectiveness – this includes the procedures for checking that elective professional investors meet the quantitative and qualitative tests required under COBS 3.5.

Following publication of PS22/10 on the financial promotions rules for high-risk investments (see our summary here), the FCA expects firms to amend their business practices in line with the new obligations. The main risk warning rules come into force on 1 December 2022, the other rules on 1 February 2023.

Firms also need to consider their new obligations under the Consumer Duty - rules and guidance for new and existing products and services which are open to sale or renewal come into force on 31 July 2023, those for closed products or services on 31 July 2024.

All portfolio firms will receive an FCA questionnaire in the next few months, asking about their business model, products, investor categorisations and associated control framework. Firms will need to evidence the reasonable steps taken to ensure your firm’s target market is both appropriately defined and not exposed to an unsuitable level of risk.

Conflicts of interest

Principle 8 of the FCA’s Principles for Businesses requires firms to manage conflicts of interest fairly.

The FCA notes that it has seen instances of firms bypassing their own processes to make sales or increase Assets under Management (AuM) and draws firms' attention to recent fines levied because of inadequate management of conflicts.

The Letter advises Boards to

• carefully review their procedures to ensure conflicts are avoided, managed, or disclosed in a way that minimises harm to investors and markets and
• consider the impact that their shareholder structure may have on the effective governance of their organisation.

2. Strengthening the UK’s position in global wholesale markets

Market integrity and disruption

Firm Boards should ensure that risk functions are appropriately resourced, contemporaneous, and commensurate with the levels of portfolio and business risk being taken – the FCA will continue to conduct assessments of alternatives firms’ risk controls “where market footprints imply a higher inherent risk of contagion or harm”.

Market abuse

The FCA’s view is that market abuse controls across the alternatives sector need to be improved – firms should have strong prevention cultures and effective systems and controls which enable them to discharge their obligations under the UK Market Abuse Regulation, with controls tailored to their individual business models.

Culture

How a firm approaches the remuneration and incentivisation of its staff contributes to organisational culture. Firms subject to the MIFIDPRU Remuneration Code must apply the relevant rules from the performance period on or after 1 January 2022.

The Letter flags that the FCA will be looking at how senior managers and firm policies influence an organisation’s culture, with an area of particular concern being the ability of staff to speak up.

In terms of diversity and inclusivity, DP21/2 outlined the issues and the benefits that can be brought to the sector alongside potential policy interventions. A Consultation Paper will be published later in 2022 and the FCA expects Boards to fully consider this aspect of their organisation.

3. ESG, a strategy for positive change

The Letter notes the growth of ESG investments in the Alternatives sector and the increase in the number of AIF registrations with a stated focus on these themes.

Investor confidence in the products being offered has specific relevance for products labelled as being ESG focussed and with investment strategies benchmarked against ESG themes.

ESG remains a priority area in the Asset Management department and firms which offer ESG products should expect to be subject to review to ensure marketing materials accurately describe their product, with funds offering clear and consistent disclosure.

In December 2021, the FCA published new rules requiring asset managers (including authorised AIFMs) to make disclosures in line with the recommended Taskforce on Climate-related Financial Disclosures.

These rules initially apply to the largest AIFMs only but will apply to AIFMs with AuM of over £5bn from 2023.

The disclosures have both qualitative and quantitative elements at both entity and product level and in scope firms should be considering what steps they need to take in order to be compliant with the new rules from 2023.