AIMA Journal - Edition 117
AIMA Journal - Edition 117
Message from AIMA's CEO
Jack Inglis, CEO, AIMA
A warm welcome to the latest edition of the AIMA Journal. As always, the level of expertise and quality of commentary in this edition remains at the highest standard and demonstrates the great depth of insight that our membership possesses. We would like to express our thanks to all those who contributed to this edition.
Readers will benefit greatly from a variety of articles ranging from developing trends impacting industry regulation, the latest thoughts on the consequences of Brexit, understanding co-investment, global enforcement trends relating to crypto-asset investigations, managing event risk, integrating Natural Language Processing (NLP) into investment analysis, computer vision technology and autonomous investment learning strategies (ALIS) and more.
Allen and Overy explores how important an issue sexual misconduct is for the FCA and how this can impact firms from a regulatory perspective. Robert Quinn Consulting outlines its considerations on the extension to the Senior Managers and Certification Regime (SMCR) scheduled to go live in December. Dechert explores the role of private fund side letters, offering an overview of common side letter terms, including the regulatory context and practical guidance for managers navigating the restrictions and obligations that come with using multiple side letters.
On Brexit, Cappitech offers its latest thoughts, examining whether EMIR and MiFIR delegated reporting for asset managers will survive the UK’s divorce from the EU, while DRS offers an insightful article on why considering upcoming initial margin regulations is something AIMA members should consider sooner rather than later.
Things to consider when raising co-investment vehicles including structuring, key terms, offering issues and regulatory issues are covered in an insightful piece by Kleinberg Kaplan. CME Group discusses three phases of event risk and what is needed to manage them. It also looks ahead to analyse different event risk debates that are currently at the forefront of market attention.
It seems like no AIMA journal is complete these days without contributions to the debate regarding the increasingly disruptive influence of technology and ESG on the hedge fund sector.
Deloitte offers an interesting article on integrating natural language processing and natural language generation into analytical models to augment research for investment managers. Staying with technology, Citco Fund Services explains how SaaS solutions can enable fund managers to concentrate on alpha-generating activities while leaving logistics and software development to a third party. Mov37 considers the burgeoning role that computer vision technology, both with and without the latest Artificial Intelligence techniques, is already serving in financial services and situate this trend within the larger movement toward computer automation in investment practice.
On the cryptoasset front, Clifford Chance shares data obtained from the FCA by a freedom of information request relating to cryptoasset investigations, and analyses global enforcement trends.
On ESG and sustainable investment, Société Generale discusses barriers to implementation and generating financial outperformance. State Street outlines the development of infrastructure as an asset class, its composition and popularity with institutional investors.
Elsewhere, Maritime Super appraises the ‘manager model’ of Operational Due Diligence. The piece includes an explanation of how the process provides the foundation for investors to make their operational risk assessments and, by doing so, saves the duplication of ODD groundwork common to all investors.
Finally, Bernadette King of haysmacintyre provides her thoughts on her career to date, including how the accounting profession has become more diverse and the need to remain dynamic in order to keep with a rapidly changing industry.
We hope you enjoy reading edition 117 and wish you well for the year ahead.
What topics would you like to see in future editions?
- Diversity & inclusivity
- Latest policy & regulatory themes
- Investment strategy overviews
- Private credit
- Macro-economic and related commentary
- Operational due diligence and industry sound practices
- Digital assets and blockchain
#Metoo in asset management
by Sarah Hitchins and Robbie Sinclair, Allen & Overy
Senior Associate, Allen & Overy
Senior Associate, Allen & Overy
If there is one thing that we have learnt from the #metoo fallout, it is that no sector is immune from this type of misconduct. And it is telling that a range of industry bodies in sectors such as law, charities, construction and entertainment have been quick to issue guidance on dealing with these issues.
The Financial Conduct Authority (FCA) has made it clear that it views sexual harassment as an important issue. Its interest in allegations and findings of sexual harassment or other sexual misconduct about individuals who work for the firms it regulates is part of the FCA’s broader focus on culture within the UK financial services industry.
The FCA’s interest in this area is not new. Many firms (especially banks and building societies that are already subject to the FCA’s Senior Managers and Certification Regime (SMCR)) have been taking a more holistic view of misconduct for some time, recognising that non-financial misconduct (including sexual harassment and other sexual misconduct) can have regulatory implications. However, the issue has received considerably more public attention following the recent publication of a letter written by the Executive Director of Supervision at the FCA, Megan Butler, to the Women and Equalities Committee which emphasised the interest that the FCA is taking in relation to ‘poor personal misconduct, including allegations of sexual misconduct’.
It therefore comes as no surprise that we find ourselves being asked with increasing regularity how allegations and findings of sexual harassment or other sexual misconduct impacts firms and individuals from a regulatory perspective.
How will things look after the implementation of the SMCR?
The spotlight on individual accountability and overall culture will be intensified following the implementation of SMCR for FCA-only authorised firms, which will include alternative investment managers, on 9 December 2019. From this date firms will be turned into mini-regulators with responsibility for assessing the fitness and propriety of their Senior Managers and Certified Persons, as well as assessing potential breaches of the FCA’s Code of Conduct for almost all employees as and when issues arise. The FCA has made it clear that firms’ responsibilities in relation to these matters will extend to allegations of sexual harassment or other sexual misconduct.
Fitness and propriety
Some firms may have viewed #metoo type allegations as ‘HR issues’. That is not the FCA’s view. Even though this type of misconduct may not appear as relevant to FCA’s traditional areas of regulation in the same way as financial misconduct (e.g. misstating the value of a position), it is misconduct which the FCA still expects firms to consider from a regulatory perspective.
Even before the SMCR comes into force for alternative investment managers, allegations of sexual misconduct should be considered in light of the fitness and propriety requirements that apply to approved persons and the FCA’s Statement of Principle and Code of Conduct for Approved Persons (APER). With the introduction of SMCR, however, one of the factors that firms are required to consider when assessing the fitness and propriety of an individual is their ‘personal characteristics’. This criterion has led to firms taking a more holistic view of an individual’s suitability to perform a particular role, and has led to firms considering the fitness and propriety implications of some individuals’ ‘strong’ or ‘robust’ management styles, as well as allegations of bullying and non-sexual harassment. In the wake of the #metoo movement, allegations or findings of sexual harassment or other sexual misconduct now fall to be considered within an individual’s ‘personal characteristics’.
While the FCA has been clear that issues of sexual harassment should be considered from a fitness and propriety perspective, its guidance has been less clear on the action firms should take in relation to individuals who are implicated or potentially implicated in these situations.
Invariably, each allegation or finding of sexual misconduct has to be assessed on a case by case basis looking at all the circumstances including the individual’s role and relationship with the victim, the surrounding evidence and any explanation given. Bear in mind that, when looking at the factual matrix, the relevance of the misconduct to the role that an individual performs for a firm may be critical, given that a number of allegations made about #metoo type behaviour relates to the alleged abuse of power by a senior individual over a more junior individual. For example, take a senior male in a firm who holds a Significant Influence Function (under the current approved persons regime) or holds a Senior Manager or Certified Person role (under the SMCR) who manages numerous women. If he acted towards one or more of these women in a way that was sexually inappropriate, the FCA may view this behaviour as undermining his supervisory responsibilities, thereby calling into question his competence and capability and potentially also his integrity to carry out his role.
Obviously, the more serious the misconduct, the more likely that it will impact on an individual’s fitness and propriety and, in particular, their honesty and integrity. For example, committing sexual assault is a clear example of conduct that impacts an individual’s fitness and propriety, whereas a one-off comment made by an individual that includes sexual innuendo is likely to be less clear-cut. When misconduct arises (including but not limited to #metoo type misconduct), firms will often need to make nuanced judgement calls based on the specific facts. Developing a robust and consistent approach to assessing fitness and propriety in these situations is an issue with which banks and building societies are still grappling, almost three years after the SMCR came into force for them.
Wherever a firm comes out in relation to the fitness and propriety of an individual who is implicated in a #metoo complaint, it is important for a firm to carefully record the thought process followed in reaching that decision and the rationale for it.
APER and the FCA’s Code of Conduct
#metoo type misconduct which raises fitness and propriety issues will not, however, always amount to a breach of one or more of the Conduct Rules set out in the FCA’s Code of Conduct (which will come into force for alternative investment managers with the SMCR in December 2019). This is because, unlike fitness and propriety (which can take into account any conduct engaged in by a person), the scope of the Code of Conduct is narrower. It will apply to (among other things) activities that have, or might reasonably have, a negative effect on the integrity of the UK financial system or the ability of a firm to meet its own fitness and proprietary requirements. Although the FCA does not specifically refer to #metoo type misconduct when it defines the scope of activities to which the Code of Conduct will apply, the Individual Conduct Rules are sufficiently broad to capture this type of misconduct in some circumstances. The FCA has publicly reinforced that this could be the case. In her recent letter, Megan Butler confirmed that: ‘[s]exual harassment and other forms of non-financial misconduct can amount to a breach of [the FCA’s] Conduct Rules’.
From the starting point that #metoo type misconduct can fall within the scope of the Code of Conduct, the next question firms will need to answer is which (if any) of the Conduct Rules have potentially been engaged in a particular case. The FCA’s general and specific guidance relating to the Code of Conduct does not specifically refer to how conduct such as bullying, harassment and #metoo type misconduct should be interpreted under the Code of Conduct. However, the FCA’s guidance in this area is not intended to be exhaustive and, as a result, firms are left to come to their own views about which of the Conduct Rules may be engaged by #metoo type misconduct. The most obvious candidates are Individual Conduct Rule 1 (acting with integrity) and Individual Conduct Rule 2 (acting with due skill, care and diligence).
The activities that fall within the scope of APER are narrower than the activities that will fall within the scope of the Code of Conduct from December 2019 onwards. APER applies to the performance by an approved person of their controlled functions or in relation to the carrying on of regulated activities, whereas the Code of Conduct applies to a much broader scope of conduct, including unregulated activities. In light of this narrower scope, it is less likely that #metoo type misconduct could fall within the scope of APER.
What is clear though is that the FCA expects firms to consider whether misconduct (including #metoo type misconduct) falls within the scope of APER or the Code of Conduct and, if not, to record the reasons why. While firms may conclude for a variety of reasons that some (but not necessarily all) #metoo type complaints which concern events that took place outside of work fall outside the scope of APER or the Code of Conduct, it will be important for firms’ records to show how these decisions were reached and that a robust process was following in reaching them.
Linking tolerance of sexual harassment to a poor culture
We can now say categorically that the FCA is interested in allegations and findings of sexual misconduct, and that such misconduct (as well as other forms of non-financial misconduct) may form the basis for an adverse finding in relation to an individual’s fitness and propriety and potentially also their compliance with the Code of Conduct. #metoo misconduct can no longer be considered an ‘HR issue’ within financial services firms.
Addressing the Women and Equalities Committee in relation to their work on sexual harassment in the workplace on behalf of the FCA, Megan Butler felt confident in making a link between a culture where sexual harassment is tolerated and one ‘which would not encourage people to speak up and be heard, or to challenge decisions’. For the FCA, tolerance of sexual harassment is not only ‘a driver of poor culture’ but also a barrier to ensuring that firms retain their best talent and make the best business decisions and risk decisions.
Walking the walk
Not only is the FCA talking the talk in this area, it is walking the walk. Through Megan Butler’s letter, the FCA has made it clear that it has a number of tools to ensure that firms take allegations of sexual harassment and misconduct seriously. Her comments are very helpful as they give a degree of clarity in an area in which the FCA had previously been silent, particularly in the following:
• Fitness and propriety: Sexual misconduct may have an adverse impact on an individual’s honesty, integrity and reputation for the purposes of assessing their fitness and propriety, in the same way that a criminal conviction can. Interestingly, findings of discrimination and harassment more generally may also have a similar impact on an individual’s fitness and propriety.
• Code of Conduct: Sexual misconduct can amount to a breach of the FCA’s Code of Conduct when it comes into force for alternative investment managers from December 2019 (for Senior Managers and Certified Persons) and December 2020 (for all other in-scope employees). If a breach of the Code of Conduct is established, that breach must be reported to the FCA (within seven days in the case of Senior Managers). Whether sexual misconduct can amount to a breach of APER is less clear-cut, given its narrower scope.
• Regulatory references: If a disciplinary sanction has been imposed on an individual in relation to sexual misconduct (or if an individual resigns when allegations have been made) this is something that a firm is likely to need to include on any regulatory reference provided in respect of that individual, regardless of what (if any) decision is taken about that individual’s fitness and propriety or compliance with the Code of Conduct or APER.
• Whistleblowing: In addition to using a firm’s internal whistleblowing procedures to report allegations of sexual misconduct, the FCA has expressly invited individuals to raise such allegations directly with it through its whistleblowing procedure. The FCA said in Megan Butler’s letter that it would be particularly interested in any reports that indicated that a firm was ‘systematically mishandling allegations or incubating a culture of sexual harassment’.
And there’s more…
If necessary, the FCA has said that it will discuss allegations of sexual harassment and how such allegations are handled by firms in the course of its supervisory work, and that it will continue to focus on the issue in its strategic planning as well as its day-to-day operational work. So we should not expect #metoo to slip down the regulatory agenda for the FCA in 2019.
For more information please visit our website.
Saas: The Next Frontier in Fund Outsourcing
By Albert Bauer, Citco
Head of Products, Citco Fund Services (USA) Inc.
Software as a Service is a subscription-based approach that can deliver unlimited scalability, unprecedented flexibility and increased accessibility for fund operations.
It is no secret that fund managers are constantly looking for ways to do more with less. Their problem has always been that improving efficiency in fund operations also increases operational risk. For example, installing new technology increases the risk of system downtime and data loss. It may also require the installation of new and unfamiliar hardware.
But there is now a more effective way for managers to implement better tools within their organizations and access just the services they need. It’s called Software as a Service – SaaS.
SaaS solutions enable managers to use complete outsourced, managed services – or they can simply implement a better tool for a specific job within their organization. Whichever approach they take, SaaS solutions enable managers to concentrate on alpha-generating activities while leaving operational logistics and software development to a third-party.
The Citco group of companies’ (“Citco”) new Æxeo Treasury system is an example of a tool that can either be fully used by a manager’s operations team or provided as an outsourced managed service. That managed service can be anything from simply providing help with processing third-party invoices all the way to having Citco manage all cash movements to fund counterparties.
SaaS solutions use cloud-based software. This means that the hard work of running applications is carried out on centrally-hosted systems that are specifically designed for this task, and there are dedicated teams that keep the applications secure and up-to-date.
As a result, the SaaS approach offers lower up-front costs, reduced roll-out time and a near-endless capability for scalability and integration, compared to traditional inflexible models of software installation. Moreover, because SaaS applications are hosted and managed in the cloud, the software is always up-to-date, with state-of-the-art solutions for security and the changing regulatory environment rolled out to all users as soon as they are ready.
Where the installation of traditional fund administration systems required huge upfront effort and cost, SaaS is scalable, so funds can begin by using just a small subset of the total tools on offer. Instead of receiving a large initial bill, managers pay by subscription for the services they actually use.
The development of SaaS systems in fund administration can be seen as an evolution of outsourcing. For some years, the traditional one-size-fits-all model of running operations internally has not been suitable for all managers. Depending on where a manager is in his/her lifecycle, the full internal model can be less effective and costlier. As a result, many asset managers are choosing to outsource some or all of their middle and back office operations. Outsourcing ensures that those best equipped to handle tasks are delegated exclusive responsibility for them, and thus can dedicate all their resources to guaranteeing utmost efficiency.
Providers of outsourced solutions, such as Citco, have always been at the forefront of developing and delivering technological solutions that can manage the growing complexities of fund administration. One benefit of being a third-party vendor is that we have the capability and resources to innovate specifically for operational processes, which is the crux of our service for clients. As a result, the last decade has seen a broad adoption of emerging technology in fund outsourcing.
Since 2008, fund managers have increasingly adopted cloud-based solutions, commoditized data subscription services, and a hybrid mix of cyber security and reporting applications. The direct benefits of this adoption have been increased flexibility, data accuracy, team collaboration, transaction expediency, compliance management and improvements across all workflows.
At Citco, Saas is simply the next step on this journey. As our clients’ needs change, so too do our solutions. We partner continually with our clients to deliver innovative technology and will soon introduce the next generation of born-on-the-cloud SaaS solutions. Our goal is to develop these solutions in the most flexible manner possible to suit our clients’ varied demands, while always enabling quick onboarding for new clients and the ability to roll out additional functionality. This approach will continue to enhance fund managers’ operations and improve resiliency across all administrative functions.
SaaS is the ultimate solution for outdated traditional software models because it improves on legacy inefficiencies while retaining the highest levels of security and control. Without a doubt, the future for financial services is SaaS-based.
Cryptoasset Enforcement - where are we at the end of 2018? What to expect in 2019?
by Robert Rice, Steven Gatti, Kelwin Nicholls, Oliver Pegden and Ben Peacock, Clifford Chance
Partner, Clifford Chance
Partner, Clifford Chance
Partner, Clifford Chance
Senior Associate, Clifford Chance
Senior Associate, Clifford Chance
On 11 December 2018, Andrew Bailey, Chief Executive of the UK FCA, speaking to an audience in London, praised the enforcement action taken by the SEC in relation to initial coin offerings (ICOs) and said that European regulators could learn from the SEC's strong interventions. The FCA is expected to consult on the regulation of cryptoassets early in 2019 but has not yet taken any enforcement action.
In this briefing, we share data obtained from the FCA by freedom of information request relating to current cryptoasset investigations and analyse enforcement trends globally.
UK investigative activity
In October, the Cryptoasset Taskforce (HMT, FCA and Bank of England) published its Final Report which identified the main risks associated with cryptoassets as financial crime, risks to consumers, risks to market integrity and risks to financial stability.
Subsequently, we made a freedom of information request to the FCA asking for detailed information regarding the FCA's investigations or enquiries relating to cryptoassets (broadly defined to include: cryptocurrencies, derivative instruments referencing cryptocurrencies, investment assets in cryptocurrencies, security tokens and utility tokens).
As at November 2018, there were no current cryptoasset-related FCA enforcement investigations (the same position as existed in May 2018). However, the FCA was conducting 21 separate enquiries in relation cryptoasset perimeter issues (i.e. whether firms that are involved in some form of cryptoasset business might be carrying on regulated activities without appropriate authorisation). These enquiries were not solely focused on issuers - they included enquiries into firms who may be conducting regulated activities through advising and/or arranging deals in cryptoasset investments.
There were two ongoing enquiries into authorised firms in relation to cryptoasset activities. One enquiry related to the potential misappropriation of client funds, the other related to providing account services to a cryptocurrency exchange. There were two open enquiries relating to the money laundering risks associated with cryptoassets.
There were no market abuse enquiries relating to cryptoassets and, perhaps surprisingly given the reports of manipulation in cryptocurrency derivative markets, the FCA was unable to find any record of having received any Suspicious Transaction and Order Reports (STOR) relating to cryptocurrency derivatives over the last two years.
Wider enforcement trends
It is unsurprising to see the FCA focused on perimeter issues.
The past two years have been characterised by uncertainty as to whether cryptoassets, particularly tokens issued as part of ICOs, constitute securities falling within existing regulatory perimeters.
During this period, enforcement investigations globally have focused heavily on perimeter issues, playing an important role in enabling authorities to develop their understanding of cryptoasset businesses and products and to signal interpretations of the perimeter.
As Andrew Bailey indicated, the US has led the way. Prior to 2017, publicly-announced SEC actions focused on products that clearly qualified as U.S. securities, such as offerings of shares in bitcoin investment trusts or tokens that purported to represent shares in a company. The SEC's enforcement efforts broadened in 2017 beginning with the publication of the Slock.it Decentralized Autonomous Organization (DAO) Report which concluded that the tokens issued by the DAO constituted investment contracts, and therefore securities. The SEC declined to penalise Slock.it because the DAO Report was the first instance in which the SEC asserted broad authority to regulate ICOs, but since then the SEC has settled multiple enforcement actions related to ICOs and is actively investigating additional ICOs. Most recently in November 2018, the SEC announced that it settled charges against two firms for securities offering registration violations in connection with ICOs. These were the first occasions on which the SEC has imposed civil penalties against ICO issuers for securities offering registration violations only (a prior enforcement action for securities offering registration violation in connection with an ICO was settled without imposition of a penalty after the issuer voluntarily refunded all proceeds of the ICO).
Elsewhere in the world, enforcement activity has been more limited, but has also focused on perimeter issues.
In May 2018, the Singapore MAS, in its strongest public reprimand over digital tokens, stopped an issuer of an ICO from continuing with its fund-raising bid as its tokens represented equity ownership in a company and therefore would be considered securities. The MAS also warned eight unnamed digital token exchanges in Singapore not to facilitate trading in digital tokens that are securities or futures contracts without the MAS' authorisation.
The Hong Kong SFC has not yet taken any formal enforcement action against any cryptocurrency exchanges or issuers of ICOs. However, in February 2018, the SFC issued letters to various cryptocurrency exchanges and ICO issuers warning them that they should not trade or issue cryptocurrencies that are "securities" under the SFO without authorisation. In March 2018, ICO issuer Black Cell Technology Limited (Black Cell) halted its ICO to the Hong Kong public and agreed to unwind ICO transactions for Hong Kong investors after the SFC had expressed concerns that Black Cell had engaged in potential unauthorised promotional activities and unlicensed regulated activities. We see a similar pattern elsewhere.
Until recently, authorities themselves have defined the regulatory perimeter through published guidance and settled enforcement cases. Recently, however, enforcement actions have started to arrive in the courts, providing an opportunity for judicial guidance.
In September 2018, a Federal Judge in the Eastern District of New York, in the context of the criminal prosecution of Maksim Zaslavisky for securities fraud in connection with two ICOs, ruled that a reasonable jury could conclude that the ICO tokens in question were investment contracts falling with the scope of securities laws.
Meanwhile, also in September 2018, the Higher Regional Court of Berlin held in a criminal enforcement case, that Bitcoins are neither a financial instrument nor units of account within the meaning of the German Banking Act and that therefore operating a Bitcoin trading platform does not require a German banking licence. The German government is currently investigating whether the German Banking Act needs to be amended to support BaFin's current administrative practice of defining the scope of licensable activities and deciding whether an activity is licensable under the German Banking Act.
In recent months we have seen US perimeter enforcement activity expand focus beyond issuers. On 11 September, the SEC announced two settled actions against non-issuers, TokenLot and Crypto Asset Management. These cases marked the SEC's first cryptocurrency enforcement actions against non-issuers for failing to register as broker-dealers and investment companies. TokenLot operated as a broker by facilitating sales of digital tokens offered by nine ICO issuers. CAM managed Crypto Asset Fund, a pooled investment vehicle formed for investing in digital assets. On 8 November, the SEC announced a settlement with the founder of EtherDelta, a trading platform for digital assets, for operating as an unregistered national securities exchange. We expect enforcement authorities elsewhere to expand the focus of their perimeter investigations similarly.
Looking ahead in enforcement
We expect to see continued enforcement activity in relation to perimeter issues as authorities gain confidence in the conduct of these types of investigations and anticipate hardening of the rules. But we also expect that, as changes in law take effect and the perimeter is better defined, authorities will expand enforcement activities to other issues.
We expect, in particular, to see a growth of enforcement activity relating to market misconduct, anti-money laundering and investor protection (within the regulatory perimeter).
As regards market misconduct, we expect to see an increase in enforcement focused on market manipulation of cryptoassets. To-date publicly-announced enforcement activity in this area has been largely confined to action taken by the CFTC in the US. This has focused exclusively on fraud related to bitcoin. Now that bitcoin futures contracts are trading on U.S. exchanges (with bitcoin options scheduled to begin trading soon), it is likely that the CFTC will increase its efforts to police bitcoin manipulation. In summer 2018, it was widely reported that the CFTC was taking aggressive action to obtain trading data from cryptocurrency spot exchanges whose prices are components of the reference rate used to price the CME's Bitcoin futures contract. We expect similar trends elsewhere, particularly in the UK where the FCA has been increasingly focused on market manipulation since 2015.
As regards anti-money laundering risks connected with cryptoassets, whilst we have not seen any public enforcement outcomes, authorities are already focusing on the specific obligations that established regulated firms have in relation to these risks. In June 2018, the UK FCA wrote to bank Chief Executives highlighting the obligations that regulated firms have to prevent and detect financial crime connected with cryptoassets, citing examples of where a regulated firm offers services to cryptoasset exchanges, arranges an ICO, or serves clients whose wealth derives from cryptoassets. Regulatory initiatives to bring cryptoasset exchanges into the anti-money laundering regulations are underway in the EU. The Fifth European AML Directive will extend AML and Counter-Terrorist Financing rules to virtual currencies, such that rules will now apply to entities which provide services holding, storing and transferring virtual currencies. In future, these entities will have to identify their customers and report any suspicious activity to relevant regulators and authorities.
Although cryptoassets may present particular cross-border enforcement issues, particularly concerning where activities take place, we have not yet seen significant examples of large-scale cross-border collaboration and co-ordination in relation to enforcement activity such as that seen in recent years in relation to other forms of conduct. We expect that to change too.
Why sustainability matters?
by Yannick Ouaknine, Societe Generale
Head of Sustainability Research, Societe Generale
Sustainability matters differently for different entities. For listed corporations and multi-national companies, it mainly revolves around Corporate Social Responsibility (CSR) or Corporate Sustainability where companies demonstrate accountability through environmental and social efforts that go beyond regulatory requirements. For entities in the sustainability research or investment space; Environmental, Social and Corporate Governance (ESG) research of companies could be a good proxy to better grasp and anticipate future financial risks and/or opportunities. This brings us to the broad concept of “Sustainable investment”, an area which has been evolving rapidly for the past few decades.
Sustainable Investment has been described in many ways based on diverse cultural and historical interpretations of the term; a universally accepted definition is yet to be formulated. What started as an exclusionary approach of avoiding investments in tobacco or gambling companies has now matured into integrating ESG factors in the selection of stocks/securities to build up an investment portfolio.
Investors are “pragmatic”
In theory, it might be difficult for investors to apply this kind of strategy, as wealth maximization and protection are typically the main purpose of investing.
In truth, hedge funds (as other types of investors) have been very “sceptical” about ESG for various reasons (i.e. challenging their ethical, religious or philosophical roots / lack of commonly-agreed definition / lack of common set of indicators / cultural biases…). But the reality is now much different, as increasing transparency and recent controversies moved ESG to the center of investment-making decisions.
The rational of the global momentum around sustainable investment can be summarized as follows:
- the fiduciary duty principle,
- recognition that ESG factors play a “material” role in determining risk and return,
- rising concern about the impact of short-termism on company performance, investment returns and market behaviour,
- regulatory requirements (leading to more transparency),
- new appetite from end-investors to align convictions and investment ideas,
- the proven financial performance attached to those metrics,
- and finally, avoiding reputational risks from issues such as climate change, tax ethics…
From theory to practice: Leveraging on corporate governance to create financial outperformance
It seems (that) ESG gains more and more traction but how to demonstrate the value creation of adding ESG metrics in the investment process? And how to combine metrics the right way to demonstrate long-term value creation? At Société Generale Corporate & Investment Banking (SG CIB), we believe we have found a way to do this applying the following metrics which incorporates corporate governance as a differentiating factor (considering a mix of quantitative, qualitative financial parameters).
Investment philosophy: Underpinning our CEO Value stock selection is the idea that a company that has relatively sound corporate governance principles but that has underperformed peers over four years should see a turnaround in its share performance. Sound corporate governance principles should enable a company to address its weaknesses, or at least prevent deterioration, either by changing its strategy or management – or both.
Stock selection process: Our CEO Value proprietary screening tool (launched in April 2006) is built using a bottom-up approach. We apply this screening tool to the Stoxx 600 index to obtain a list of European companies that we think can deliver a positive message to investors over the following two years, and which are thereby likely to outperform – and in this we also have a clear large cap bias.
If you would like to know more about our product (that has more than ten years of a real track record), please do not hesitate to contact us.
Young, illiquid and…irresistible?
by Cesar Estrada, State Street
Senior Managing Director, Private Equity and Real Assets Services, State Street Corporation
What do a busy airport, an offshore wind farm project and a city parking meter system have in common? All have garnered billions of dollars from institutional investors increasingly turning to a young, evolving asset class: infrastructure.
As stewards of long-term capital, institutional investors are wired to see opportunity. But it’s not always easy to capture. State Street’s annual Growth Readiness Study shows an industry caught between the push of opportunities for growth and the pull of factors threatening it. More than two-thirds (68 percent)1 of institutional investors say they’re concerned about hitting their growth objectives in the current market environment.
Against this backdrop, there has been a significant shift in how investors are adapting. Proponents of infrastructure assets note that the class, by and large, boasts yields high enough to be attractive in a low-interest rate environment, while also providing exposure to stable, predictable cash flows. This hasn't escaped the notice of fund managers as well as institutional investors who have been making generous infrastructure allocations as of late.
"The growth has been twofold," explains Kyle Alexander, a managing director focusing on infrastructure within State Street's Alternative Investment Solutions group. "Fund managers who have been working in the space for years are seeing more interest from investors and are successfully fundraising larger funds. Further, the biggest fund managers have adopted a more intensive focus on infrastructure assets, making headlines with record breaking fund launches."
The political environment is an important factor that’s expected to help play a role in keeping this momentum going. With many differing feelings following the mid-term elections in the United States, Democrats and Republicans may finally begin to agree on something: infrastructure. In December, the U.S Department of Transportation announced that it will spend $1.5 billion to fund 91 infrastructure projects around the country.2 It comes at a much needed time. In fact, in 2017, the American Society of Civil Engineers gave the country’s infrastructure a grade of a D+.3 With bridges, roads, public transportation and more in need of major upgrades, bipartisan agreement will be especially beneficial to helping improve the country’s infrastructure.
That being said, a government infrastructure bill is not the only way to keep capital moving into the asset class. 2018 is on pace to be a record for total fundraising. For the first three-quarters of the year, private equity firms have already raised $68.2 billion in infrastructure funds.4 That compares to the record $66 billion set in 2016 and the $65 billion raised in 2017, according to the alternative asset data firm Preqin.5 Unlocking private capital in greater scale will require the Federal government to be transparent, stay consistent in their process for awarding projects and maintain a strong push when permissioning those projects.
The rise of infrastructure in some ways mirrors the growth of the real estate asset class some two decades earlier. Whereas most buildings in metropolitan areas around the world were once owned by corporations, governments or universities, many are now in the hands of pension funds, insurance companies, foundations and other institutions. It's likely that in just a few years, much of the world's infrastructure - now mainly owned by municipalities, state and federal governments, and corporations - will also find new homes in the portfolios of institutional investors and infrastructure funds.
Arguably, a key difference between real estate and infrastructure is the remarkable diversity of the latter class. While infrastructure traditionally brings to mind images of toll roads and bridges, energy and telecom are two sectors that are in the midst of transformation. Oil and gas projects, like pipelines, once dominated investor dollars. Today, renewable energy has ruled the fundraising roost. In 2017, for the first time, investors poured more money into renewable energy funds than into their conventional energy counterparts, according to Preqin. The explosion of data is also quickly creating a more prominent need for telecom structures in areas such as social care, battery storage and InfraTech. This includes the infrastructure used in developing the Internet of Things, facial recognition technology and airports.
The buzz around infrastructure assets stem, in part, from the widespread understanding that global infrastructure needs are intensifying. The world will have to spend between $3 and $5 trillion a year on infrastructure to keep up with demand, according to Global Infrastructure Hub, a G20 initiative. On its own, need isn't enough to justify an investment. Funds only consider assets that are expected to meet targeted rates of return and many may not pass muster. For instance, Olympic host cities are known for infrastructure building booms ahead of the games, but funds mulling investments must question how assets will perform after the Olympic flame burns out.
This risk is particularly significant for infrastructure assets because they're mostly illiquid; a toll road can't just be traded away. Yet the assets' illiquidity is something institutional investors, like pension funds, are often willing to bear for the sake of long-term exposures that match their long-term liabilities. The lack of liquidity may also present opportunities for the largest infrastructure-focused funds, which can afford to take on bigger projects than smaller investors, especially when they form joint ventures with other funds. It's a valuable advantage, as investors today often must compete with one another for stakes in the most promising infrastructure assets.
The heated competition has naturally led to higher valuations, raising concerns that investors and funds might wind up overpaying for some of the most sought-after assets. But for now, institutional capital continues to chase infrastructure, with investors betting that assets like wind farms will keep blowing good returns their way.
The views expressed in this material are the views of Cesar Estrada, through the period ended 31 December 2018 and are subject to change based on market and other conditions.
Investing involves risk including the risk of loss of principal.
The information provided does not constitute investment advice and it should not be relied on as such.
All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed.
There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.
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- State Street Growth Readiness Study, 2018
- Transportation.gov, U.S. Transportation Secretary Elaine L. Chao Announces $1.5 Billion in BUILD Transportation Grants to Revitalize Infrastructure Nationwide, December 2018.
- American Society of Civil Engineers, 2017 Infrastructure Report Card, March 2017
- Preqin, Preqin Q3 Quarterly Updates Webinar, November 2018
- Preqin. 2018 Preqin Global Infrastructure Report, February 2018
Will artificial intelligence transform investment research?
By Rohit Kataria, Deloitte
Senior analyst, Deloitte Support Services India Private Limited
Investment research and analysis are evolving rapidly, with proliferating data sources and expansion of artificial intelligence (AI) applications. Portfolio managers and analysts rely on financial statements, earnings call transcripts, press releases, investor presentations, blogs, news articles and sell-side reports for investment research. Synthesizing information originating from multiple sources and building proprietary quantitative models takes enormous human effort and time. AI tools not only enable large-scale data processing at a rapid rate but also integrate traditional data sources with new ones such as web traffic, web search trends, and social media data. Application of AI to these data helps portfolio managers and analysts save time and uncover hidden signals, contributing to improvements in forecasting, investment decision-making, and idea generation.
Natural language processing (NLP) and natural language generation (NLG) are the branches of machine learning that enable computers to understand and generate natural human language. NLP processes natural language by transforming text into structured data, while NLG interprets and analyzes structured data and converts it into readable format. Application of these technologies results in a machine-generated report that conveys insight from computation of the data.1 It is able to make sense of spoken and written language. This approach overcomes some inherent limitations associated with rule-based algorithms, which struggle with processing unstructured data and lack the intelligence built from thousands of corrective iterations that machine learning conducts. Traditional rules-based algorithms don’t self correct.
Augmenting research with NLP
Investment managers are integrating NLP capabilities into their analytics platforms. NLP tools can augment investment research in the following ways, among others:2
- By interpreting management sentiment during earnings calls to predict a company’s future performance. By parsing sell-side reports for wording to gauge changes in analysts’ projections.
- By sifting through volumes of unstructured data sources, such as blogs, news reports, and social media and sentiment data to identify trends and potential investment ideas.
Some investment management (IM) firms are trialing NLP technology for investment decision-making. They are using NLP technology to score each piece of information a portfolio manager consumes into positive and negative groups. A positive score indicates the likelihood of a rise in company performance or corporate value, and a negative score means it is unlikely to rise. Trials also translate textual data from websites and blogs into quantitative scores. The goal is to augment the investment decision-making ability of portfolio managers by increasing throughput and reducing bias and other errors prone to humans.
Considerations before implementing NLP/NLG
NLP can also be used to generate investment ideas. Using NLP enables firms to reduce the time spent conducting initial research on one company the current average of four to five hours to 30 to 45 minutes.3
Margin compression and regulatory mandates are driving investment managers to pay for research directly, meaning the buy-side investment research landscape is likely to undergo a profound change.4 Investment managers may expand in-house research and analysis capabilities by making long-term investments in advanced technologies like NLP and NLG to reduce their dependency on external research. The pace at which the natural language application of AI is accelerating. Automation of the investment research and analysis function at scale could soon be a possibility. Business leaders at IM firms may need to take the following factors into consideration before starting an NLP/NLG implementation:
Piloting - undertaking pilot projects/proofs of concept before full implementation to test whether desired results can be achieved.
Deployment - integrating NLP and NLG tools into the data analytics platforms accessed by analysts and portfolio managers to enable widespread deployment across the firm.
Data format - data sourced from a vendor in a structured form can be fed directly into an NLG process. while NLP is required as a preliminary step for unstructured data.
Talent - assigning a team of domain experts, or hiring external specialists to champion implementation.
In the coming years, computers will likely be able to process text and speech, enabling them to generate narratives about potential investments based on thousands of times more information than analysts alone can read. This development could completely transform the investment research and analysis function at IM firms.
Has your firm started exploring NLP and NLG-based tools or other forms of AI for investment decision making?
- Ben Dickson, “What is natural language processing and generation (NLP/NLG)?,” TechTalks, February 20, 2018.
- Katherine Pearce, “Why big data and AI is the future for asset managers,” SS&C, April 23, 2018.
- Anthony Malakian, “Inside Look at How NLP is Used in the Capital Markets,” Waters Technology, 17 January 2017.
- Beatrice Lo, MiFID II Research Unbundling 6 Months on – what are we seeing in the market? Latham & Watkins LLP, July 2, 2018.
Private fund side letters: common terms, themes and practical considerations
by Christopher Gardner and Mikhaelle Schiappacasse, Dechert
Partner, Financial Services and Investment Management
Partner, Financial Services and Investment Management
Side letters are an (increasingly) common way of formalising negotiated arrangements between a private fund and an investor.1 Whilst used more widely in the closed-ended fund context (given the limited withdrawal rights associated with such funds, the typically higher level of negotiation and greater structural complexity), they are also a feature of open-ended funds, for instance where there is a seed or cornerstone investor investing significant capital or an investor subject to specific tax or regulatory regimes that require bespoke terms.
A side letter supplements and, where the fund takes contractual form (such as a partnership), can override the terms of the fund’s constitutional documents and is typically required where an investor has specific commercial, legal, regulatory, taxation or operational concerns with respect to its investment in the fund. In many instances it is easier to agree concessions in these separate agreements rather than amend the fund’s constituting documents (being the private placement memorandum and the constitutional documents such as the partnership agreement or articles), especially as the latter approach would mean the rights agreed would generally then be available to all investors. Some rights are also most practically recorded in a side letter (for example confirmation of an advisory committee seat for a closed-ended fund).2
This article provides an overview of common side letter terms and current themes in the private fund market. It also considers the regulatory context and practical points for managers navigating the restrictions and obligations of multiple side letters.
Most favoured nations ("MFN") rights
Where a manager is willing to provide an MFN right, these rights are generally reserved for more significant investors as they can have wide-ranging implications for the fund, especially if they are not managed effectively.
An MFN right allows an investor to elect to receive the side letter provisions negotiated by other investors.3 However, MFN provisions can be drafted in a number of ways, meaning that what the investor may actually be entitled to elect to receive can vary widely. For example, the drafting may vary in respect of: (i) whether the MFN applies to all side letter provisions or just, for example, to the fee provisions, (ii) the MFN only applying in respect of those provisions negotiated by other investors with an equal or smaller investment in the fund (typically affiliated investors will be aggregated), and (iii) whether the investor can see all side letter provisions negotiated (regardless of whether it is allowed to elect to receive them) or just those it may elect to receive. It is also common to carve out certain terms from the MFN, for example, rights granted to first closing or seed investors, rights granted due to an investor’s specific legal, regulatory or taxation concerns and the right to an advisory committee seat. However, even with careful drafting, an MFN right can significantly extend the fund’s (or the manager’s) obligations; managers should therefore carefully consider which investors’ terms are likely to be captured by the MFN when negotiating these (and other) side letter provisions.
Transfer rights are particularly relevant in the closed-ended fund context where an investor cannot redeem from the fund should it wish to. Managers negotiating side letters on behalf of a fund should ensure that a transfer right provides them with sufficient comfort with respect to the identity and nature of the transferee (this is particularly the case where the fund has a credit facility and does not want to jeopardise its borrowing base) and that appropriate customer due diligence information will be provided in connection with any transfer. A blanket consent is therefore not advisable. Transferability is particularly important to certain investors, for example certain German pension funds,4 who may need to be able to demonstrate free transferability (or as near to free transferability as the fund can practically offer) for regulatory reasons.
The constitutional documents of closed-ended funds typically include a mechanism whereby an investor can be excused from participating in particular types of investments (generally due to regulatory or other internal constraints). Often an investor must notify the fund of any restrictions before it invests and/or require the opinion of external legal counsel to confirm that it is so restricted. If a fund is willing to negotiate excusal rights, it should try to limit the amount of investor discretion in determining what an excused investment is as the emphasis should be on using the investor’s full commitment rather than allowing it to cherry pick deals. If the scope of the prohibited investments is stated in the side letter itself, it is generally helpful to state why they are prohibited in order to increase the chance that the provision is taken outside the scope of any relevant MFN right.
Enhanced reporting and information rights
These side letter requests can come in many guises, including requests to vary the frequency, format and content of reporting. Some investors may have genuine tax related concerns (for example, the need to be supplied with K-1 schedules in order to prepare their US tax returns) or regulatory reporting issues (such as the need to comply with the Solvency II Directive (2009/138/EC)). Any such terms should be both commercially appropriate and operationally practical for the fund and its manager. For example, a request for portfolio level information should not result in the investor holding information it could use to its competitive advantage or to the detriment of other investors. This is an area of particular sensitivity in the open-ended fund context where portfolio level information should generally only be provided when stale, e.g., after further trading of the portfolio so that its then-current composition is not selectively shared.
Other common provisions
The table is a summary of common side letter requests. Whether it is appropriate to grant such requests should be considered on a case by case basis.
Set out below are some current themes that are relevant to negotiating side letter terms.
Co-investments and other alternative ways of investing
In recent years there has been growing interest in co-investment vehicles, separately managed accounts and other alternatives to classic commingled funds. While investors commonly seek an acknowledgement in a side letter that they are interested in co-investment opportunities (or a similar election right), the range of alternative investment structures currently in vogue introduces new side letter concerns, particularly in relation to strategy and allocation issues (for example strategy caps and successor fund provisions). Typically it is more appropriate for the manager rather than the fund to sign up to these requests. If these issues arise, managers should ensure that the concessions are achievable, do not unduly limit their firm’s growth and development strategy and that they can be effectively monitored.