By Arnaud Bon, Partner – Consulting Alternatives Leader and Philippe Theissen, Senior Manager at Deloitte as featured in Insight Out Magazine #26
In response to concerns over undue costs being recharged to the funds (i.e. fees charged to the funds which are considered excessive or unjustified), the United States has emerged as a catalyst for transparency and investor protection.
Over the past decade, these principles have gained traction as they made their way across the Atlantic to Europe. European policy makers, driven by both investor protection and the belief that the overall cost of third-party money management could be decreased across the industry, have decided to take action. After an initial supervisory briefing in 2020, the European Securities and Markets Authority (ESMA) published its report in 2022 on the common supervisory action conducted by national competent authorities, followed by a CSSF publication dated October 2022, under which Luxembourg based fund managers were requested to put in place the adequate governance by end of March 2023 to ensure compliance with a number of principles.
Further steps towards a harmonized and stringent framework across the E.U. are underway, but fund managers themselves had already embraced fund and internal cost reviews in order to get more insight when considering and assessing their internal organization, governance and overall efficiency.
What is required?
Within regulatory language, implementing “proper action” essentially revolves around adopting a clear pricing framework, robust governance, appropriate controls to be performed to ensure compliance with the pricing model implemented, and a thorough and recurring assessment of fund costs charged, which is typically executed through the performance of a market benchmarking exercise. All considerations need to be clearly addressed in the pricing policy of the fund manager, which details the fee calculation process, the management of potential conflicts of interest, reporting towards third parties and the established governance framework for ongoing fee monitoring.
A robust pricing governance framework facilitates the execution of proper fee and cost monitoring processes by implementing the right toolbox. A proper fee mapping template and related control framework covers:
- Identification of all fees directly / indirectly charged to investors
- Fee levy and level identification
- Mapping of data sources
- Control performed and costs classification (e.g. nature, counterparty)
By having rigorous monitoring in place, potential errors or inconsistencies in fee calculations can be identified and rectified, preventing investors from incurring undue costs. Additionally, the pricing policy should facilitate periodic market assessments to ensure fair fee structures aligned with market standards and expected product return, while also outlining the process for communicating changes or updates to investors in a timely manner.
Three types of fee/cost market benchmarks commonly observed
In a perfect world, a cost benchmark at product level, integrating all type of costs from management fees to operating costs charged or recharged to the fund, would be the ideal scenario to best address current regulatory expectations. However, due to the lack of publicly available data on alternative product costs, such exercise can prove challenging if not impossible. Management fees and a number of asset management related remuneration elements can be benchmarked relatively easily. They however tend to be pretty standard (though specific to each strategy and sub-strategy) across the alternative industry, hence contributing little value to the objective. Operating costs instead vary generally largely from one fund to the other. Add the fact that most of such costs are not charged at fund level but at underlying SPV or asset levels, benchmarking between products becomes impossible. An alternative solution is to benchmark such costs with what third-party service providers would be charging for a similar product. Where such costs relate to services already provided by service providers, this allows for adjustment of the pricing level. Where such costs relate to activities performed by an affiliate of the manager, and eventually recharged to the funds, this enables managers to demonstrate that they are not over-charging despite a potential conflict of interest.
Several methodologies may be used in this context depending on the operating model and cost model of a specific product – from platform cost benchmarking to service-by-service benchmarking. But all would require, at one point of time, for some simulations to be run over time.
Such type of exercise also helps fund managers address other elements on top of regulatory expectations. The platform cost benchmarking would typically provide a fund manager with view on their total cost for running their platform against prices charged by third-party services providers. This can help managers assess the competitiveness of their internal costs and operations in relation to industry standards, which would help them justify a possible operating model where functions/services are performed in-house rather than delegated to specialized third-party service providers, or on the contrary justify more outsourcing.
Cost monitoring efforts and granularity should be driven by a risk-based approach, taking into account the level for potential conflict of interests for each cost item, with fees and expenses charged or recharged by the manager bearing more risk of conflict of interest. Third-party service providers related costs should generally be considered lower risk. As a result, cost monitoring for these services may generally be conducted less frequently.
Observed challenges to run market benchmarks
Benchmarking, especially in the alternative fund management industry, is however not a straight forward process and comes with its fair share of tailwinds that fund managers need to navigate effectively.
One of the primary challenges is the need for access to recent and relevant data. Using historical or outdated data for benchmarking purposes can result in misleading or inaccurate comparisons, especially with the recent market environment where high inflation has considerably affected prices charged by third party service providers. To ensure the validity of benchmarks, fund managers must gather and analyse data that reflects the current market conditions and fee structures.
Another factor that needs to be considered lies in selecting the appropriate benchmark data that is asset class /investment strategy specific. Maintaining consistency in the scope of service delivered as well as comparing prices charged for similar types of investments is crucial to ensure meaningful and relevant results.
Geographical relevance is also crucial when performing a benchmarking exercise, as different regions or markets may have unique fee structures and market conditions. Therefore, it is important to ensure that the benchmarking data used is relevant to the specific geographical area of analysis.
Insight and related benefits generated trough implementation of regulatory requirements
From an operating model perspective, the regulation prompts fund managers to critically assess their current operating model. By mapping and analysing their costs, fund managers can identify areas for optimization and cost reduction, enhancing their operational efficiency. This evaluation offers an opportunity to optimize processes, streamline operations, and potentially leverage external – sometimes more efficient – expertise where useful.
Moreover, the regulation fosters improved transparency towards investors, which, in turn, instils a sense of confidence and trust. This transparency on costs not only meets the ESMA regulatory requirements but also enhances the overall investor experience and strengthens the investor-manager relationship.
In summary, the regulation does indeed come with certain challenges that fund managers need to address, such as the access to proper data and the implementation of robust controls over their pricing model. However, it also brings significant benefits to the fund management industry and fund managers alike. It provides a clearer understanding of operating costs, improves transparency with investors, and encourages a thorough evaluation of the operating model. By embracing these changes, fund managers can enhance their competitiveness, build stronger investor relationships, and drive operational excellence in the dynamic landscape of the investment fund industry.