May 2009

           Cost management in a more
           regulated asset management industry
Cost reduction activity – the crude,                                           create a robust operating model that could ...
The directive proposes minimum capital requirements                       Conclusion – desperate times call for
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Viewpoint - Cost management in a more regulated asset ...

  1. 1. May 2009 Viewpoint Cost management in a more regulated asset management industry This paper reviews some of the current cost reduction activity in the asset management industry, some familiar and some not seen so often in the past. It also considers the most recent indicator for the future of regulation of the industry, issued by the European Commission, and looks at the impact that this, and other regulation in the pipeline, is likely to have on the cost base of an asset manager.
  2. 2. Cost reduction activity – the crude, create a robust operating model that could cope with precisely this sort of downturn. This ‘weatherproofing’ may have resulted the painful and the constructive in a more expensive operating model paying a fee to outsource Cost is a measure that tumbles down the priority list when providers based on a percentage of assets under management. markets are buoyant and investors are abundant. However, However, it is currently being proven to be more robust as the cost when the sun stops shining, the issue of cost is promoted, of the operating model drops with the AUM. almost overnight, to the top of the asset management executive agenda. Large outflows of funds and markets that have fallen significantly from their levels 18 months ago have led to a Who will regulation affect the most? contraction of the asset management industry (the European The alternative asset management sector is, unsurprisingly, asset management industry shrunk by €2.9tn in 20081). This has likely to be the target of much of the expected new regulation. placed increasing pressure on profit margins. Although some asset At the time of writing, the most recent document released on managers entered the financial crisis in better shape than others, future regulation was the EU framework proposal for managers all are now in a period where cost reduction and cost management of alternative investment funds, issued by the European are in the minds of senior management. Commission (EC). This draft legislation is the next step in an EU program designed to ensure financial markets across Europe As has been the case in other downturns where asset managers are secure and that market actors operate responsibly. The focus on cost, their first reaction is to stop or significantly reduce EC believes that the oversight and supervision of activities of discretionary spend. Only business critical projects are not iced managers of alternative investment funds (AIFs) across Europe overnight. The second reaction is redundancy or ‘right-sizing’ need closer regulatory engagement and supervision. The key as the industry would prefer to have it. Non-revenue generating principles include an increase in the focus on what the EC believes and non-business critical business areas are usually the first to to be the sources of systemic and operations risk, enhanced be targeted; more recently, with globalization, firms are looking investor protection and regulatory disclosure. at their business models and stripping out layers of management that they deem superfluous. For example, some are questioning Highlighted below are the elements of the recent proposed whether they need a business head in each region in which they directive on alternative investment fund managers (AIFMs) that operate. It is of course important that resource cuts are not will have greatest impact on the cost base. made too deep, preventing the organization from reacting The most eye-catching element of the operating requirements quickly to gain market share when the industry eventually starts for AIFMs is the requirement for the assets of the fund to be to recover. It remains to be seen who got ‘right-sizing’ right and valued by a valuator that is independent of the AIFM. While third- who got it wrong. party pricing sources of market and private trades is common, Asset managers are also reducing cost through less familiar and this appears to be a requirement for the annual valuation to be perhaps more constructive activity. First, it is widely recognized struck independently. The Commission will in due course define that product proliferation has led to far more products in the the conditions for determining independence. The organizational marketplace than is either necessary or desirable, which is design is a common theme throughout the proposed directive. leading to product rationalization. Asset managers are taking the It requires independent depositaries and custodians to be opportunity to consolidate products that have accumulated as the appointed to the AIF – EU credit institutions subject to prudential result of earlier mergers or to close products that have failed or regulation – which is a significant change in practice and a become inefficient to manage. Secondly, many asset managers challenge for the existing prime brokerage and private equity are reviewing their third-party service providers with a view to models. The AIFM shall have a structure to prevent, identify and consolidating and thereby reducing cost through scale or, at the disclose conflicts of interest. There is also a requirement to have very least, to renegotiating contracts. Thirdly, many are a functionally separate portfolio risk management function, reviewing how the money managers and traders in the although again it is unclear how independence should be achieved. organization are rewarded. Re-aligning the remuneration of Other requirements include measures regarding: managers with the risk profile of the fund and incentivizing ► liquidity management, stress testing and redemption policies them in a way that is in line with the investment interests of clients is a tricky balance to strike, although also long overdue. ► procedures to ensure that short positions are covered at Fourthly, asset managers are analyzing the operating model to delivery date identify opportunities to reduce fixed costs and build a more ► requirements that must be met before an AIFM can invest in variable cost base. Ideally this redesign of the operating model securitized investments should have been completed in the years prior to the financial crisis. We have encouraged our clients to review their operating ► authorization by local regulators of the delegation of model on a periodic basis, one of the principle reasons being to activities and apparent anti-avoidance provisions to prevent excessive outsourcing. 1 European Fund and Asset Management Association (EFAMA) 2 Viewpoint Cost management in a more regulated asset management industry
  3. 3. The directive proposes minimum capital requirements Conclusion – desperate times call for calculated as €125k plus 0.02% of the value of the assets under management, subject to a €250m hurdle. Therefore, the manager responsible and considered measures with €5bn in assets under management will need to hold an Asset managers are digging deeper for cost saving than they additional €1m of capital – not an insignificant amount. have done in the past and they are undertaking a wide range of activities to achieve the cost reduction objectives. What will be the incremental cost? The inevitable increase in regulation as a result of this financial crisis will increase cost and will impact the asset managers on Increased regulation will inevitably mean more cost to the a scale inversely proportional to size, to the extent that it may manager. However, this will vary significantly, depending on the make operating in the new environment too costly for some small degree to which the operational infrastructure has the resource alternative managers to continue. and data required to undertake the additional regulatory overhead. For example, the cost implications on AIFMs complying When the new wave of regulation is clear, it is important for with the proposed EU directive will vary significantly depending these managers to take the opportunity to address the on the size of the organization. The largest managers will, however demands of the regulator and the investor from an reluctantly, be able to comply with the proposed directive. Many enterprise-wide perspective and to resist the temptation to of the proposals embody business best practice, even if shoe- address each requirement (e.g., risk, compliance, control) or horned into a one size fits all approach. The data is likely to be source (e.g., investor, regulator) in a silo. By looking at the available albeit in disparate systems and records, but reporting in spectrum of reporting requirements, asset managers will be a timely and accurate fashion whilst managing confidentiality and able to effectively comply with the demands whilst minimizing commercial pressure will be more challenging. For those areas that incremental cost. are different – for example, mandating independent valuations, independent risk management and custody arrangements – it The views reflected in this article are the views of the will be challenging to translate high-level principles into practical, author(s) and do not necessarily reflect the views of other commercially viable guidance. Other provisions, such as notifying members of the global Ernst & Young organization. regulators of delegations, or periodic reporting to authorities of leverage, fund profiles or controlling interests, will be burdensome and require improvements in internal reporting systems. The larger AIFMs that have evolved with the industry over the last few years have implemented an operational infrastructure that can cope with the increased regulation with an acceptable incremental cost increase. This legislation will however apply to AIFMs with total assets under management greater than €100 million. This is a low threshold and will catch many small AIFMs who are less likely to have the entire infrastructure that will be required by this directive. This required investment may question the viability of the business itself. Traditional asset managers, as opposed to the AIFMs, are used to complying with the voluntary and involuntary demands of investors and regulators and should be in good shape for when the additional regulation that applies to them becomes clearer. They have also come to recognize the additional benefits and good business sense of complying with some voluntary self regulation; for example, the SAS 70 report has evolved to be a globally recognized method of demonstrating transparency and control in the organization and therefore an important and effective marketing tool. These asset managers will already understand whether they have adequate and efficient data architecture to provide accurate and timely reporting on the aspects of any new regulation. If they do not, it will be a familiar question that they face: whether to invest and upgrade the operational infrastructure to create a more efficient platform or to continue with the current environment and continue to bear the cost implications of the inefficiency. Viewpoint Cost management in a more regulated asset management industry 3
  4. 4. Ernst & Young Assurance | Tax | Transactions | Advisory Contacts: About Ernst & Young Crispin Rolt Ernst & Young is a global leader in Global Markets Director assurance, tax, transaction and advisory Phone: +45 3587 2535 services. Worldwide, our 135,000 people are united by our shared values and an unwavering commitment to quality. We make a difference by helping our people, Julian Young our clients and our wider communities Partner achieve their potential. Phone: +44 (0) 20 7951 2295 For more information, please visit Ernst & Young refers to the global Gillian Lofts organization of member firms of Ernst Partner & Young Global Limited, each of which Phone: +44 (0) 20 7951 5131 is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. EYG no. EH0027 © 2009 EYGM Limited. All Rights Reserved. In line with Ernst & Young’s commitment to minimise its impact on the environment, this document has been printed on paper with a high recycled content. This publication contains information in summary form and is therefore intended for general guidance only. It is not intended to be a substitute for detailed research or the exercise of professional judgment. Neither EYGM Limited nor any other member of the global Ernst & Young organization can accept any responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this publication. On any specific matter, reference should be made to the appropriate advisor. DPD11748.indd (UK) 05/09. Artwork by London DPD. Viewpoint Cost management in a more regulated asset management industry