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February 18, 2020

Stroock Special Bulletin

By: Robert Abrams, André B. Nance, Eric Requenez, Samantha D. van der Bunt, Deborah L. Bernstein, John J. Sottile

On January 14, 2020, the Securities and Exchange Commission (the SEC) held the inaugural meeting of its newly formed Asset Management Advisory Committee (the AMAC). The meeting was attended by various industry participants, including SEC Commissioners and staff, as well as individuals representing consulting firms, investment advisory firms, fund sponsors and regulatory organizations with legal, regulatory and business backgrounds.

The AMAC was created with the intention of facilitating discussion and providing the SEC with diverse perspectives on asset management and related advice and recommendations, in order to ensure that the SEC’s regulatory approach to the asset management industry meets the needs of retail investors and market participants. Specifically, it is intended that the main focus of the AMAC will be considerations surrounding the ability of Main Street investors to access private capital markets.

Introduction

SEC Chairman Jay Clayton opened the introductory session by emphasizing that the SEC has prioritized in its regulatory agenda the need to promote access and choice for Main Street investors while also ensuring appropriate investor protections. Chairman Clayton also stressed the important role that the asset management industry plays in helping Main Street investors achieve their financial goals and the importance of Main Street investors to the asset management industry and capital markets on a macroeconomic level.

During the introductory session, each of the SEC Commissioners — Elad Roisman, Hester Peirce, Allison Herren Lee and Robert Jackson — briefly identified issues they felt were most worthy of the attention of the AMAC. Commissioner Roisman highlighted the importance of investors’ ability to maximize investment choices while ensuring access to information and advice that would enable them to make sound investment decisions, as well as removing barriers and alleviating regulatory burdens and costs. Commissioner Peirce advocated that the AMAC address customer privacy and data protection issues and the unique challenges these issues pose to asset managers, including the difficulty of complying with GDPR and various state privacy and data protection laws. Commissioner Lee highlighted as an area for focus providing Main Street investors with a clearer framework in which to accurately assess, compare and invest in companies with sound policies on sustainability, ethical business practices and good governance, including what it means when a fund identifies itself as an ESG fund. Commissioner Jackson highlighted closed-end mutual funds as a crucial vehicle for ordinary investors.

Ed Bernard, Senior Advisor and Retired Vice Chairman at T. Rowe Price and Chairman of the AMAC, concluded the introductory session by noting that the AMAC was designed with broad representation to create balanced dialogue and showcase market perspectives. Over a two-year period, the AMAC will prioritize issues via sub-committee work and public discussion. This inaugural meeting featured sessions on the following three topics: The Evolution of Asset Management and Value Proposition, the Evolution of Public and Private Securities Offerings and the Globalization of Asset Management. Key discussion points from each of these panels are described below.

Panel 1 – The Evolution of Asset Management and Value Proposition

This panel discussion focused on historical trends of the asset management industry and highlighted the current changes the industry is facing that managers must consider. The contributors consisted of Michael Goldstein, Managing Partner of Empirical Research Partners LLC and Benjamin Phillips, Investment Management Chief Strategist with the Casey Quirk practice of Deloitte Consulting LLP.

Mr. Goldstein observed how “advice” in the industry has evolved, including in response to changing investor demographics and the increased use of technology, with:

  • The rise of indexing, investor price sensitivity and the nature of “advice” in the industry.
  • A decline in certain traditional institutional clients occupying the industry, which has resulted in a significant shift in the industry’s landscape.
  • The millennial generation representing a different type of consumer base, one with less wealth and different consumer demands, such as a preference for technological platforms, than prior, waning generations of consumers.
  • Current popular investments like ETFs and private equity being two examples of boom investments that help shape the industry, with the current trend showing a decline in investment in public markets.
  • An evolution of “advice” in the industry, as indexing has helped the price of advice decline while competition from both individuals and computer-driven “robo-advisors” has put even more pressure on pricing.

Mr. Phillips in turn observed how paradigm shifts and increased competition have affected the industry:

  • The asset management industry has seen a shift from a manufacturing/product paradigm to a service paradigm, and the contributing factors to this change include demographics, customized investor needs, outcome-oriented advice, consolidation of intermediaries, fee sensitivity and low growth.
  • The new needs and wants of younger generations, pointing to a growing trend for “outcome-driven” investment advice for specific benchmarks, as well as new profitability and research challenges presented by this trend, as the technological and data accumulation capabilities of funds will need to constantly improve, and managers may find consolidation necessary to meet investors’ needs.
  • Competition has driven fees to an all-time low, while continued low growth of 1%-2% and a saturated market combined with rising research and technological costs place increasing pressures on profits.
  • The increased value of outcome-driven advice, the importance of data collection to provide this advice and rising cost concerns will mean a shift to automation in many areas, and managers will need to constantly adapt to meet client expectations and remain competitive.

Panel 2 – The Evolution of Public and Private Securities Offerings

The second panel discussion focused on recent trends in public and private markets and the variances that exist in the investment goals and experiences of retail versus institutional or high net worth investors. The contributors consisted of Stephanie Drescher, Senior Partner and Global Head of Client and Product Solutions at Apollo Global Management, John Finley, Senior Managing Director and Chief Legal Officer at The Blackstone Group, and Colby Penzone, Head of Investment Product at Fidelity Investments.

Ms. Drescher observed an increased interest in private markets and investors’ desire to increase exposure to alternative investments:

  • Recent trends in public and private markets, the shift of capital from active managers to passive, the growth of alternative investment products, investment in private versus public companies and the relative performance of such investments.
  • The decline in the number of public companies, an increase in the percentage of private debt raised as compared to total debt raised annually and higher risk- adjusted returns in private markets than general market benchmarks.
  • A meaningful outperformance of private equity and credit investments relative to public counterparts over the last 23 years, including the five worst performing years within that range.
  • Strong flows of capital to alternative managers, including the fact that over 90% of pension plans in the U.S. allocate to private equity and across asset classes.
  • A continued desire and interest to continue to add to investor exposure to alternative investments.

Mr. Finley similarly identified increased investor interest in opportunities to increase their exposure to less liquid investments:

  • The shrinking of public markets, offering less correlated returns and more volatility.
  • Strong retail demand for alternatives and a decline in demand for mutual funds and money market funds.
  • Lower allocations to alternatives for individual investors than for pensions and endowments, which makes it harder for individual investors to match the returns of such institutions.
  • Several key items which would enable retail investors access to private markets: eliminating accredited investor requirements, easing liquidity restraints for certain types of funds which limit investment in illiquid securities and permitting carried interest compensation in additional types of funds.

Mr. Penzone reminded the panel of the meaningful investor protections that continue to be available to investors in public market investments, and the continued investor interest in such products:

  • The benefits of a mutual fund structure, including daily liquidity, professional active management by market participants, no minimum investment amounts and retail direct to consumer platforms that have access to liquid alternative investment options.
  • Dedicated interest in private equity vehicles in the market generally, but noting that he has not historically observed a high demand from non-qualified purchasers or non-accredited investors, though he acknowledges that this lack of demand could also be related to the lack of ability for such investors to invest in private equity vehicles historically.
  • The gravitation of retail investors toward goal-based, outcome-oriented investment solutions that help them meet life needs.
  • Further exploration about allocation, diversification, fees and access is necessary when offering private markets beyond traditional qualified purchasers or accredited investors.
  • The ability to deliver a streamlined, transparent, digestible and affordable end-to-end experience for retail investor as crucial to determining if it is appropriate to broaden access to private markets for retail investors.

Panel 3 – The Globalization of Asset Management

This panel discussion focused on current and future trends in the industry, including challenges like costs and popular investment strategies, and current and future trends in regulation, such as a greater focus on investor liquidity and actual outcomes. The panel also analyzed the requirements and effects of the European Union’s Markets in Financial Instruments Directive (MiFID II) legislation. The contributors consisted of Alex D’Amico, Partner, Financial Institutions Practice and Wealth Management and Retirement Practice of McKinsey & Company; Raquel Fox, Director of the Office of International Affairs of the SEC; Dan Waters, Independent Director and Consultant; Paul Roye, Senior Vice President of The Capital Group Companies; and Jason Vedder, Director of Trading and Operations of Driehaus Capital Management.

Mr. D’Amico identified key challenges faced by fund managers pursuing asset management strategies globally:

  • Managers are facing current cost structure issues, as the cost of technology is seeing the most significant growth in a variety of applications, including investment technology, data analytics and technology designed to facilitate customer engagement.
  • A coming shift is expected over the next five years toward less liquid strategies and alternative investments, coupled with declining global organic growth to about 2% per annum and North America facing anemic growth. Specifically, the “barbelling” investment strategy — pairing traditionally safe investments with much riskier, highly leveraged and speculative investments — is a growing trend, especially from risk-driven investors.
  • The persisting longevity issues in markets around the world coupled with a lack of innovation have led to a failure to improve on retirement-focused investment issues.
  • The profile of a successful fund detailed a focus on strong and safe passive investment strategies like retail-oriented mutual funds, sustained alpha generators to meet demand for increased returns while minimizing risk and a renewed focus on outcome-oriented funds.

Ms. Fox described the SEC’s efforts to coordinate with foreign regulators and adopt similar approaches to soliciting public input:

  • The major aspects of her work at the Office of International Affairs, which involves engagement with SEC staff on crafting policy and engagement with stakeholders to deliver concrete and relevant data to help inform investors on policy.
  • The Office of International Affairs engages in daily contact with foreign regulators to advance the SEC’s regulatory interests.
  • International organizations like the Financial Stability Board (the FSB) and the International Organization of Securities Commissions (the IOSCO) are constantly releasing reports and studying new global trends and developments. Similar to the steps taken by FSB and IOSCO, the SEC is increasingly open to public consultation and public comment, and welcomes the submission of research and reports from the public.

Mr. Waters focused on key drivers of existing and proposed regulations at a global level:

  • The rationale and motivations behind the regulation of the investment funds industry, such as the current focus on protecting investors’ liquidity, stems from the view regulators have often taken that there has been a large disconnect between the expectation and actual entitlement of investors to redeem investments. Individual funds will likely face increased pressure to mandate liquidity risk management through regulations such as system-wide stress testing.
  • Future regulation will likely be focused on protecting retail investors, with much greater weight placed on actual outcomes and returns, and less reliance on mere disclosure as sufficient protection. A concern exists here in differentiating between products that are actively mis-sold and products whose investment strategies just didn’t work.
  • Regulations based on these concerns will likely create new challenges such as rising costs and technological adoption capabilities.
  • Sustainability is expected to be a major fund driver at the global level throughout the 2020s. Funds are rapidly responding to increased investor demand, and conflicting or vague regulations across jurisdictions could create significant challenges for managers to meet this demand. The European Securities and Markets Authority (ESMA) has taken the first steps at the global level, and the EU’s sustainability requirements can quickly develop into the global baseline.

Mr. Roye spoke on the impact of MiFID II and its conflict with U.S. regulations:

  • MiFID II, a 2018 update on legislation passed in 2007, requires asset managers located or domiciled in the EU, or otherwise contracted to comply with EU regulations, to pay for research services separately from trade execution services.
    • Firms must either charge clients transparently through a separate research payment account, the costs of which would be negotiated with clients, or pay their own research costs themselves out of their own resources.
    • The EU aimed to improve accountability over the costs funds typically passed onto clients, improve pricing transparency for research and execution services and reduce conflicts of interest for asset managers by unbundling research buying decisions from trade execution services.
  • In response to MiFID II, the SEC issued several No-Action Letters to address conflicts with existing U.S. regulations.
    • Specifically, one letter gave temporary relief to broker-dealers, allowing them to accept hard dollar payments or payments from a research payment account for research services without being required to register as investment advisors under the Investment Advisers Act of 1940 (the Advisers Act). This addressed concerns that payments under MiFID II could be considered “special compensation” under the Advisers Act, and force broker-dealers to register as investment advisors, an undesirable outcome given the additional burdens and restrictions such registration would impose.
  • The response of fund managers in the UK to MiFID II was mixed, with many fund managers opting to simply pay the research costs themselves. Other firms, especially international ones, viewed the regulation as creating an unfair subsidization of costs where only certain clients might benefit from a particular manager’s willingness to pay for the expense of research.

Mr. Vedder expressed concerns about the barriers to entry into the market created by regulations like MiFID II:

  • There are concerns with the practical effects of regulations like MiFID II, which can create significant competitive disadvantages for smaller firms.
  • The initial response by large U.S. based global asset managers subject to MiFID II to simply pay the research costs out of their own resources threatened small and mid-size firms that could not easily absorb these costs. Specifically, many of these firms’ business models depended on the type of commission-sharing agreements and accrual of soft dollar credits that MiFID II now prohibited.
  • The outcomes that a regulation like MiFID II produce could include significant reduction of profitability, which could negatively affect strategic plans, reinvestment of profits, firm expansion and the hiring of new employees, and the creation and development of new products. The most immediate and logical business step to reduce the costs associated with sell-side research would almost certainly lead to inferior results over time.

Discussion of Committee: Agenda Items, Next Steps, Future Meeting Topics, and Subcommittees

The meeting concluded by briefly laying out what the members felt were the most important issues. Many members identified similar problems and questions posed by the topics that were discussed, with recurring issues, including the need to improve transparency in the costs of asset management, the need to provide full-service solutions to investors and the newly increased focus by regulators on investor outcomes, the benefits and disruptions posed by the integration of new and future technology, the competitive disadvantages that well-intentioned regulations can create, and the present and future opportunities of Environmental, Social, and Governance (ESG) investment as the most significant and interesting topics. The committee expressed hope that over its two-year mandate, the AMAC will be able to advance industry discussions on a broad and diverse set of problems and issues.

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For More Information:

André B. Nance

Eric Requenez

Samantha D. van der Bunt

Deborah L. Bernstein

John J. Sottile

This article is for general information purposes only. It is not intended as legal advice, and you should not consider it as such.