Sara Benwell: To what extent are conflicts of interest in parallel funds a concern and why is that of particular interest now?

Maria Long: Parallel funds, where a manager operates the same or a similar strategy across multiple fund vehicles, occur for many genuine reasons.

This could be separately managed accounts (SMAs) run alongside commingled funds for reasons such as ESG exclusions, transparency, and capital efficiency, or could be different fund structures within the same strategy such as UCITs and Cayman Fund structures aimed at different investor bases.

"There have been high profile regulatory enforcement actions, particularly in the case of employee only accounts being managed alongside commingled funds."

Conflicts of interest in these parallel funds have been a concern for investors and regulators for some time, and there have been high profile regulatory enforcement actions relating to this, particularly in the case of employee only accounts being managed alongside commingled funds.

The reason this is a concern and covered during investor due diligence is that, in some cases, there may be an incentive for managers to give preference to one account over another for various reasons.

It is therefore important for asset managers to have plans in place to mitigate these conflicts and demonstrate these controls to both investors and regulators.

Sara: Can you give an example of the kinds of conflicts that are common to asset managers / fund operators?

Maria: The most common conflict when an asset manager runs parallel funds is to do with the fair allocation of trades between the accounts.

Where these parallel funds are running predominantly the same strategy, any trade opportunities need to be allocated (typically on a pro-rata basis) to all the accounts unless there are genuine reasons not to do so such as investment restrictions on one account that are not applicable to the other.

Trade allocation can present a potential conflict of interest where the accounts have different fee structures or different beneficial owners (in particular where these are employee only accounts).

The risk is that the asset manager “cherry picks” the best trade ideas to be allocated disproportionally to one account over another in its own favour, i.e., due to being invested in that account or the potential to earn better fees from the performance on the account that has higher fees.

"Asset managers who still run employee only accounts would need to have strong reasons for doing so"

Differing fee structures in parallel funds are not uncommon and are a function of negotiation between the investor and the asset manager and the size of investment amongst other things.

It’s important the asset manager understands this as a potential source of conflict of interest and has steps in place to mitigate this conflict.

Employee only accounts seem to have fallen out of favour in recent years following high profile enforcement actions.

Investors typically have a preference for employees to invest directly into the commingled vehicle to properly align interests.

Asset managers who still run employee only accounts would need to have strong reasons for doing so and be especially transparent with investors in this area.

Sara: How do the Alternative Investment Standards address conflicts of interest?

Maria: In 2015 and 2016 the SBAI held an open consultation on its Alternative Investment Standards specifically to address these conflicts.

This led to the enhancement to the Standards in several areas including: disclosure of any parallel accounts, disclosure of trade allocation policies to investors, and internal arrangements to be put in place to mitigate conflicts of interest.

As an example, Standard 2.4 requires the disclosure of any parallel accounts, any adverse material effects these accounts could cause, the aggregate AUM managed within the same strategy, the size of employee investment within the strategy, and details of any employee only accounts.

The consultation also resulted in additional standards requiring managers to have, and disclose, a trade allocation policy and have internal arrangements to manage and mitigate conflicts including reporting, recording, and escalation.

"Asset managers should make sure their trade allocation policies clearly detail situations where allocations can differ between these funds"

In addition to the Standards, the SBAI’s Toolbox Memo on Conflicts of Interest in Parallel Funds contains further guidance on mitigating these conflicts.

Asset managers should make sure their trade allocation policies clearly detail situations where allocations can differ between these funds, and require records to be kept of rationales where allocations do differ from those outlined in allocation policy.

These allocations and rationales should be reviewed by compliance on a regular basis and be reviewed at meetings of the fund’s governing body.

"These allocations and rationales should be reviewed by compliance on a regular basis"

Conflicts of interest is a key focus area within the SBAI and we have also produced a memo that provides guidance to mitigating conflicts of interest that may be present in alternative credit strategies.

Essentially the requirements are to understand and document the conflicts, document how they will be managed, and disclose both the conflicts and the controls to investors.

These standards and guidance can help an asset manager mitigate the conflicts and provide investors with information on what to assess during their due diligence processes.

Sara: What additional due diligence should fund ops be doing to ensure that conflicts are spotted and managed?

Maria: This is an important part of the due diligence process and investors should be discussing this with asset managers.  SBAI’s Toolbox memo contains a list of areas that investors should assess relating to this topic.

This includes initial steps such as comparing total strategy AUM with the AUM of the fund to identify any additional accounts that may not have been disclosed and explicitly asking asset managers about accounts that run pari-passu or run a carve out of the strategy.

"Investors should be discussing this with asset managers"

Once identified additional work should be completed to understand how potential conflicts are being managed.

This includes reviewing the trade allocation policy in detail, understanding and reviewing the compliance oversight of exceptions and reviewing how these exceptions are input into trading systems (this could be completed as part of a trade walkthrough).

Where investors are allocating through SMAs, they can request reporting from the asset manager detailing any differences in positions and any tracking error between the accounts that will assist in the ongoing monitoring of these conflicts.

Sara: What are some of the operational challenges to managing conflicts and how can they be overcome?

Maria: Managing these conflicts requires a carefully managed and governed process. It will add some operational complexity, for example having to record rationales where trade allocations differ from those stated in the trade allocation policy and regular compliance reviews of these exceptions.

"The more automated this process can be the easier it is to manage. "

The simplest way to do this is to build this process systematically into the trading process either via a pre-determined allocation that needs authorisation to override or via the systematically enforced input of trade rationales where this allocation is different.

The more automated this process can be the easier it is to manage. Non-automated processes will be more operationally challenging and compliance teams may be required to review all allocations rather than just exceptions in this case.

Sara: Looking to the future, are we likely to see more conflicts as a result of mergers and acquisitions across the sector? How can ops departments ensure that M&A activity doesn’t introduce conflicts.

Maria: Mergers and acquisitions between asset managers do have the potential to raise these conflicts, particularly where there are different funds in both entities running the same or similar strategies.

But for the most part, it is the rise in the use of SMAs that will lead to these conflicts. As institutional investors’ requirements for full portfolio transparency increases, along with capital efficiency or responsible investment reasons, the use of SMAs has also increased.

In some instances, these SMAs may be much larger in AUM terms than the commingled funds and as such it will be important for investors to understand how these conflicts are managed.

Maria Long is Research and Content Director for the Standards Board for Alternative Investments (SBAI) an active alliance of investors and asset managers dedicated to responsible practice, partnership, and knowledge.

 

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