FCA Dear CEO letter: Alternatives Supervision Strategy August 2022

The FCA has updated its supervisory strategy and priorities for firms within its ‘Alternatives’ portfolio in a Dear CEO letter published on 9 August 2022.  The letter provides an update on the FCA's view of the key risks of harm that alternative investment firms, and the markets in which they operate, pose to customers (which in turn shape the FCA’s supervisory priorities), noting that several of the risks outlined in its previous letter of January 2020 continue to be relevant.

The FCA’s alternatives portfolio encompasses a broad range of business models, and 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.

Action points for firms

The FCA expects the boards of these firms to consider which of the risks identified in the letter are applicable to their business and to take the actions considered necessary to mitigate them and meet the FCA requirements. 

FCA Supervisory Priorities:

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 an FCA concern. It reminds firms that they must consider the appropriateness or suitability of the investments they offer for their target customers, be they retail or elective professionals, and that they 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.

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 reminds firms to 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, and will follow up with firms exhibiting characteristics which increase the potential of consumer harm.  Firms will be expected to evidence the reasonable steps taken to ensure that their target market is both appropriately defined and not exposed to unsuitable risk levels.

Conflicts of interest

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 requests that  firms consider the impact of their shareholder structure and the potential implications this has on the effective governance of their organisation.

Strengthening the UK’s position in global wholesale markets

Market integrity and disruption 

The FCA has identified that firms with concentrated or leveraged investment strategies can negatively impact liquidity during adverse market conditions leading to wider market instability and contagion risks, and has identified circumstances of firms overestimating liquidity in the context of stressed markets.  It emphasises 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. The FCA therefore directs firms’ boards to ensure that risk functions are appropriately resourced, contemporaneous, and commensurate with the levels of portfolio and business risk being taken.

Market abuse

The FCA reminds firms of its expectations that firms should 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.

Culture

The FCA highlights that understanding the culture of the firms it regulates is central to its supervisory approach.  As such, 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.

D&I remains a focus, and building on Discussion Paper 21/2 published in July 2021 (which outlines the issues and benefits that D&I would bring to the sector), later this year the FCA will publish a Consultation Paper.  The FCA will expect firms’ boards to fully consider this aspect of their organisation.

ESG – a strategy for positive change

Noting the growth of ESG investments in the Alternatives sector, with increases in the number of AIF registrations which a stated focus on ESG, the FCA highlights that:

• Firms should ensure that where products are labelled as being ESG focussed, documentation is clear, not misleading and that firms’ actions match the stated aims.
• Firms offering products with an ESG or sustainability focus 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 the FCA’s December 2021 TCFD disclosure rules for asset managers and owners should already be considering what steps they will need to take to be able to make these disclosures from 2023 as required.