Regulation Tomorrow: Asset Management series - The role of host AFMs and appointed representatives

Sure, thanks Anita and hi everyone. There are a few different versions of the regulatory hosting model in the UK asset management industry, but the general principle is the same.

The model would be used where an individual portfolio manager (or PM) wants to carry out services for a fund they have created – such as discretionary portfolio and risk management – without the fund or the PM needing to seek FCA authorisation themselves. To achieve this, the PM can set up a new UK entity, or alternatively the existing entity that the PM is employed by can act as the fund’s sponsor. For these purposes, let’s call that sponsor or new entity the ‘PM Company’.

The PM Company and the PM would then enter into an agreement with the host AFM (which would already have the requisite FCA authorisation to act as an authorised fund manager for the fund). Under that agreement, the AFM would be appointed as the fund’s manager and the PM would be seconded from the PM Company to the AFM, so that the PM can carry out portfolio management activities for the fund using the host AFM’s regulatory license.

The PM Company will usually be appointed as the host AFM’s Appointed Representative, and in that capacity it can provide investment advice and arrange deals in regulated investments in the fund without needing its own FCA authorisation to carry out such regulated activities. However just to note that while the PM Company is the Appointed Rep in this model, the individual PM is the one managing the strategy and the fund and all the investments that are going to be made.

It is also important to note that the host AFM is the operator / manager of the fund, meaning that it is responsible for the overall management of the fund, including managing the investments made for and on behalf of the fund. The host AFM can delegate some of the functions involved in operating the fund to other parties, such as investment managers, investment advisers or administrators, but its responsibility from a regulatory perspective for those functions is unaffected and can’t be delegated entirely. In simple terms, the host AFM will be ‘on the hook’ for any breaches that occur in relation to the fund’s management, such as the fund’s reporting or liquidity management obligations.

The term ‘host’ in the regulatory hosting model has no defined meaning under the FCA rules but it typically refers to an AFM that agrees to operate a fund for a fund ‘sponsor’ or an investment manager that has significant influence over the fund’s design, distribution and management. 

Thanks Taher – and we’ve seen a number of clients using regulatory hosting structures in the context of AIFMD as well. Hannah, maybe you could give another example that is tailored to a UK alternative investment fund?

Yes, of course. An example of this would be where a new entrant in the market decides to set up an AIF, but that new entrant is not a traditional asset manager or ‘fund house’. As the new entrant does not currently have the FCA permissions to manage an AIF (which is a regulated activity in the UK), to be able to operate the AIF (and carry out portfolio management and risk management activities) the new entrant would need to either obtain the requisite FCA authorisation to manage the AIF (i.e. the Part 4A permission) or appoint a host AFM to act as the fund’s manager. There are some exemptions, such as when the fund is small enough to be ‘self-managed’ without authorisation, but for the purposes of this discussion we won’t go into this as the recent discussion paper is focused on the hosting model specifically.

If the new entrant chooses to appoint an external manager for the fund whilst wishing to retain its participation in making decisions for the fund, they would appoint a host AFM which has the regulatory permissions to act as the alternative investment fund manager for the AIF. The host AFM would enter into an agreement with the new entrant to:

• Firstly, enable the new entrant to become an Appointed Representative of the host AFM to allow it to provide advice or arrange investments into the fund; and
• Secondly, incorporate the relevant portfolio managers into the host AFM’s governance model (usually as a customer dealing function i.e. CF30) to allow the nominated PMs to carry out the portfolio management and risk management activities of the fund, which include things like choosing the investments for the fund in line with the set investment guidelines under the host AFM’s license.

There are benefits to these arrangements, which include significantly lower fees than the PM Company obtaining authorisation itself or complying with the various regulatory obligations that stem from managing a fund. Plus, where the PM Company is a new entrant, it would benefit from having the experience of a host AFM to better understand the regulatory framework for operating these types of vehicles. Due to its benefits, the regulatory hosting model has been used in asset management for years, but more recently the FCA has raised various concerns with the use of this model.

Thanks Hannah. You mentioned the FCA’s concerns with the model – back in Q4 of 2019 the FCA began its review of host AFM firms, aimed at testing the viability of the regulatory hosting model and assessing whether conflicts of interest were being effectively managed. Taher, what were some of the concerns they raised?

That’s right – between Q4 2019 and Q4 2020, the FCA visited a sample of host AFMs to review the effectiveness of their governance, controls and monitoring, and it also asked them questions about the risks in their business models. The results of the review were published in June 2021 and the FCA grouped its observations into 4 main areas – due diligence over delegated third-party investment managers and funds; oversight of those entities; governance and oversight of the AFM itself; and financial resources.

Due diligence was an area where the FCA found that firms performed particularly poorly. There were various concerns – for example, the FCA noted that firms did not gather the level of detailed knowledge required, through their due diligence, to adequately understand the funds they would be responsible for, and where firms did identify risks or inconsistencies they were often addressed inadequately.

In relation to AFMs’ oversight of delegated third-party investment managers and funds, the FCA found that a number of firms displayed poor oversight. Some firms did not have enough appropriately skilled and experienced staff at the AFM to carry out the oversight needed, so there was a lack of in-depth understanding of investment management activities and investment strategies by key people carrying out the oversight function.

A number of the AFMs in the review were unable to show evidence of robust governance procedures, with a lack of effective challenge by independent non-exec directors. The FCA highlighted particular concerns around how conflicts of interest were managed by AFMs and also how they carried out their value assessments – which they are required to do at least annually to check whether the charges paid out of a fund are justified.

The fourth area covered by the review findings was financial resources. AFMs are required under Principle 4 to maintain adequate financial resources, but the FCA found that several firms were operating at relatively low margins and seemed to lack appropriate investment in systems, controls and people to execute their role as host AFM effectively. There were also issues with over-reliance on professional indemnity insurance and/or parent support, insufficient stress testing and wind-down planning, and errors in regulatory reporting.

Finally, just to note that an overarching concern for the FCA was an apparent misunderstanding of the relationship between AFMs and PMs, with some AFMs incorrectly referring to their delegated third-party investment manager as a ‘client’.

Thanks Taher. So, quite a lot of issues identified by the FCA there – and in December 2021 it published a consultation paper, CP21/34, which proposed improvements to the Appointed Representatives regime which impact the regulatory hosting model. A subsequent policy statement, PS22/11, was then published in August 2022 setting out the final rules for the new Appointed Reps regime. Those rules took effect on the 8th of December 2022. Hannah, could you run us through those changes and explain how they addressed some of the concerns raised in the FCA’s review?

Yes of course. Among the measures introduced through PS22/11 was a requirement for principal firms to notify the FCA if they are currently providing, or intend to provide, regulatory hosting services. This notification is in addition to a requirement for firms to notify the FCA of their appointment of an Appointed Rep and to provide their details. The aim of this requirement is to ensure the FCA is aware of all firms that are using this business model – any principal firm with a business model that falls in scope of “regulatory hosting” must notify the FCA of its intention to provide that service, at least 60 days before commencing the hosting services.

The FCA didn’t impose any specific additional rules or restrictions on firms providing those services, although it did leave open the possibility that it might make “further interventions” in the future, and this new notification requirement clearly gives the FCA more visibility of where the regulatory hosting model is being used.

The new measures the FCA introduced through PS22/11 also require principal firms to collect and report additional information on their Appointed Reps (for example in relation to complaints and revenue), and clarify and strengthen the responsibilities and expectations of those principal firms – including enhanced oversight requirements and taking more effective responsibility for Appointed Reps. In the regulatory hosting model, this increases the oversight the AFM has to have over the Portfolio Manager (i.e. its Appointed Rep) for both regulated activities and financial non-regulated activities, which should address some of the oversight concerns the FCA has raised.

In PS22/11, the FCA also gave a summary of the responses it received to some discussion questions in its consultation, covering potential areas of further change. One of those areas was the regulatory hosting model. The FCA said there were mixed views on the topic, with most respondents feeling there was harm associated with the model and that regulation should be tightened – although others (largely firms that use these models or practices) considered it to be a viable and stable model and felt confident that they could effectively oversee their Appointed Reps and manage any challenges those business models might present.

Although it didn’t give its feedback on those views at that stage, the FCA did say it would consider its next steps on how best to reduce the potential harm in the regulatory hosting model.

Thanks Hannah. And it seems the FCA did indeed consider its next steps in this area, as it then published discussion paper DP23/2 in February this year, which is of course an asset management focused paper, and which included proposals relating to host AFMs and the business model they use.

Now as we discussed in the first of this series of asset management podcasts - which is available on our website for anyone who hasn’t listened to it yet – the FCA set out in DP23/2 quite a range of ideas for reforming the UK asset management regime, and not all of those will make the cut and be implemented. But it is worth discussing the proposals in that paper on the host AFM rules, as the FCA is looking to be guided by the industry on which proposals to pursue, and if there is enough backing for these rules, they could become a reality.

Taher, perhaps you could explain what the FCA is proposing in the discussion paper in relation to host AFMs?

Yes – thanks Anita. There are three main areas really where the FCA is proposing to make changes in relation to host AFMs – they relate to the responsibilities of host AFMs, liquidity management, and investment due diligence. These cover some of the areas we have just been discussing, as areas the FCA is concerned about.

Firstly, the FCA is proposing to clarify the responsibilities of the host AFM and of the Portfolio Manager, respectively, by amending its fund rules or adding guidance to either make the requirements on Portfolio Managers of funds clearer, or to set minimum contractual requirements between host AFMs and PMs. The rationale for this is that some of the FCA’s concerns about the regulatory hosting model are caused by misunderstandings by some PMs about the division of responsibilities between themselves and the host AFM – the aim is to reduce the risk of those misunderstandings through clearly articulated contractual provisions, or perhaps through industry guidance and standards for host AFMs if there is the appetite from a trade body or other group to develop them, or through new rules and guidance that make clearer the expectations on the Portfolio Manager.

On liquidity management, there are already rules around this in the UK regulatory framework, which aim to ensure that funds pass on appropriately the costs of dealing in investments and that all unit holders are treated fairly. However, the FCA emphasises in the DP the importance of liquidity management in funds for the good functioning of the market, given the growth of the fund industry, and on that basis proposes to amend the existing rules and guidance around liquidity stress testing. This includes adding rules and guidance that reflect the liquidity stress testing guidelines issued for the EU by ESMA, removing or significantly restricting the limitation around liquidity stress testing in COLL 6.12.11, clarifying the current rules on swing pricing and other anti-dilution mechanisms, and enhancing reporting requirements around liquidity including potentially requiring public disclosures of fund liquidity.

Finally, on investment due diligence, the FCA is considering making its expectations clearer for all asset managers. It highlights in the discussion paper that it has found practice to be inconsistent – for example it has seen investments made in illiquid or complex securities without significant due diligence, and in some cases material risks seem to have been overlooked, with consumers suffering losses as a result. So, rather than the current rules – which for portfolio managers focus on suitability with an emphasis on what the PM needs to know about the client rather than about the investment, and for fund managers are generally high-level rules on due diligence – the proposed changes would set out the FCA’s regulatory expectations around investment due diligence for all types of asset management activity.

Thanks Hannah. Taher, any concluding thoughts? 

Yes – thanks Anita. There are a lot of considerations and the ideas proposed by the FCA in the discussion paper are likely to be just the start of a bigger conversation about how practices can be improved in the host AFM model. The FCA does, though, see clear benefits in the use of this model – for example its ability to reduce barriers to entry, facilitate competition, offer choice for consumers, and enable access to a wide range of investment expertise in an efficient manner. Efforts to improve the model are likely to continue, whether in the form set out in the discussion paper or through other changes.

Additionally, the use of a host AFM as opposed to applying for direct authorisation enables unregulated firms to benefit from the host AFM’s license, expertise and knowledge in the sector if they are not as familiar with the framework and rules. Many new entrants will start with using this model to build a track record and familiarise themselves with the regulatory framework before opting to apply for direct authorisation from the FCA later on. Of course, from a commercial perspective, the sooner a firm builds a track record in fund investments, the more likely a firm will be to attract potential investors so the use of this model enables new entrants to enter the market and offer their products sooner rather than later.