Proposals for Better Management of Non-Financial Risks within the European Fund Management Industry

Proposals for Better Management of Non-Financial Risks within the European Fund Management Industry - December 2012

1. Regulation and Non-Financial Risks

Only months later, the effects of the crisis were rippling through the fund management industry, and regulators allowed funds to isolate illiquid assets whose disposal would not be in the interest of their investors in separate accounts or “side-pockets” (Amenc and Sender, 2010). That redemptions caused so much disruption in the aforementioned markets and to asset managers underscores the vagueness of the practical definition of liquidity requirements for UCITS funds and the limits of liquidity risk management. Following these sorry episodes, the implementing of the UCITS IV Directive created an explicit obligation for UCITS asset managers to “employ an appropriate liquidity risk management process” (Article 40 (3) of 2010/43/EU) to safeguard the fund’s ability to “repurchase or redeem its units at the request of any unit-holder” (Article 37 of the original UCITS Directive (85/611/EEC) recast as Article 84 of UCITS IV (2009/65/EC); no guidelines have been provided. As we have previously observed (in Amenc and Sender, 2010), asset managers and parent groups acted not because regulation required them to do so, but simply to safeguard their reputations. That the shareholders of investment firms had to bear losses as a result of risks they did not know they were taking highlights the importance of transparency, not only towards investors but also towards shareholders of investment firms (which may also be distributors or sponsors of funds). If regulators’ classifications and asset managers’ promises lead investors to believe that they are investing in safe assets and kept in the dark about the risks they are actually taking, it is reasonable

a downward spiral. At the time, the move was highly unusual and compared to a 1996 fund rescue by Morgan Grenfell Asset Management (Burgess, 2007). 10 In July and August 2007, a raft of French and German domiciled enhanced MMFs froze, switched to internal models to value illiquid securities, imposed liquidity haircuts on redemptions, or closed. 11 As the first phase of the crisis continued to unfold, asset managers and their parents supported their MMFs with partial or total guarantees extended to investors or by purchasing troubled assets from the funds to allow redemptions to continue, eventually taking losses on these positions. In the second phase of the crisis, support continued, leading to further losses for asset managers and their parents. Equity Funds On 23 January 2008, French mid and small capitalisation equity specialist, Richelieu Finance, and KBL European Private Bankers announced a tie-up with the private banking unit of Belgian group KBC, taking 100% of the shares of the theretofore independent asset manager. While the CEO of Richelieu Finance denied any plan to freeze or close down the company’s open-ended flagship fund, he admitted the tie-up had been prompted by a “relative illiquidity problem” which he attributed to the extension of the crisis to the mid and small segment of the equity markets, and a desire to release the selling pressure on the fund’s holdings. The partial liquidation of the fund’s high conviction (i.e. highly concentrated) portfolio of relatively illiquid securities had led to punishing falls, which were fuelling a vicious circle.

10 - Amenc and Sender (2010) review the Morgan Grenfell Asset Management (MGAM) precedent: in September 1996, dealing in three MGAM funds was suspended after the discovery of irregularities. Following a change of management, the nature of these funds had started evolving and their portfolios had gradually become concentrated in high-risk holdings of unlisted securities, to the extent that legal limits were exceeded. Deutsche Bank, the parent company, injected GBP180 million into the funds to solve the problem. Both the trustee and the asset manager had failed to verify the compliance of the funds with the statutes and with regulation. Verification had been made more complex by investments in structured bonds that hid the nature of the underlying investments. 11 - For a detailed account, see Bengtsson (2011).

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An EDHEC-Risk Institute Publication