Three commercial impacts of MiFID II on alternative investment managers
MiFID II will be effective from 3 January 2018 and will have a wide ranging effect on the financial sector generally and alternative investment managers in particular.
The original MiFID (the EU Markets in Financial Institutions Directive, which came in to force in 2007) sought to harmonise European financial markets in an efficient manner and to protect investors. Ten years on and MiFID II now seeks to update and expand this regulatory regime. Almost all participants in the financial sector with some form of EU nexus can expect to be affected to some degree by MiFID II.
Highlighted below are what we consider to be three of the most commercially significant and potentially disruptive effects of MiFID II to the day-to-day business of alternative investment managers.
(1) Payment for investment research
Post-MiFID II, UK based investment managers will have to either: (i) pay for investment research they receive out of their own pocket; or (ii) obtain investors' prior permission to charge such research costs to a portfolio (or fund). Several of the largest investment houses have recently announced that they will be paying "hard" for research, rather than charging investors. However, much (possibly a majority) of the market has been trying to finalise their approach to research costs under MiFID II.
There seems to be an expectation that investors will vote with their feet if asked to consent to research costs being paid by a portfolio (or fund). However, investment managers may feel that margins are already so squeezed that they simply cannot afford to pay for research costs out of their own pocket and conclude that investors ought to pay for some or all of such costs. The elephant in the room (and has been since these measures were first mooted) is how much research desks will charge for their offerings. Whilst this "price discovery" has been a long time coming, it has picked up pace as deadline day approaches, enabling managers to negotiate an agreeable price point.
As this process unfolds, confidentiality is an utmost concern whilst managers seek to negotiate the lowest fees from research providers before going to investors to ascertain whether there can be any chance for portfolios to bear research costs. Some investors may have a pre-formulated house view on this issue. However, others may be able to appreciate that it could be reasonable for certain types of strategies (and existing fund fee structures) to charge research costs to the portfolio, especially where research is an essential part of the investment manager's process and margins from management fees cannot sustain the manager paying "hard" for research. In addition to the two extremes of managers or investors bearing research costs, there is also some scope for a middle ground (or hybrid model) to emerge, and it will be interesting to see if this becomes a practical option as opposed to a theoretical exercise. It will also be interesting to monitor the extent to which investors genuinely understand the strategy and product in which they are invested such that there can be a genuine discussion and informed debate on this issue between managers and investors based on the relative merits of each situation.
Payment for research also raises consequential issues. With the exception of the UK, MiFID II rules on unbundling of research charges only apply where managers are engaging in MiFID business (e.g. managed accounts) and not managing funds (governed by AIFMD or UCITS rules). However, the FCA has gold plated these specific rules, applying them to AIFMs and UCITS management companies as well as pure MiFID business. In addition, US rules permit use of "soft dollars" within existing "safe harbor" provisions. Thus: (i) EU investment managers will be disadvantaged toward their US counterparts; (ii) UK investment managers will be at a (further) disadvantage to their continental counterparts to the extent they manage funds and not only managed accounts; and (iii) any US manager seeking a point of entry in to the EU to manage EU based funds or assets, may prefer Luxembourg or Dublin rather than the UK to avoid the FCA's gold plating in this area.
2) Changes to best execution
Under the FCA's implementation of MiFID II in the UK, MiFID investment managers and UCITS management companies would be required to take "all sufficient steps" to obtain best execution of client orders. This would replace the current regime, which requires investment managers to take "all reasonable steps" to obtain best execution of client orders. This one word change heightens the extent to which such investment managers are going to need to review, monitor, analyse and address best execution issues. (AIFMs will be unaffected by MiFID II in the UK in relation to best execution and will continue to be subject to the existing "reasonable" standard.)
Whilst it may have been reasonable to apply some form of statistical analysis and random sample testing of trades in the past; the new expectation is that monitoring will need to be tailored to the nature of the portfolio and trading patterns (for example, VWAP may simply not be a suitable analysis tool for a strategy). Equally, greater internal structure will be needed to demonstrate trades have been reviewed, monitored and then analysed robustly, and that the analysis generates meaningful outcomes when issues are flagged.
This change to best execution is a positive step and should result in effective oversight and feedback. However, this change also introduces further infrastructure, time and resource burdens to the bottom line of the manager. In addition, the manager's operations and practice on this topic will be a key focus for new and existing investors in operational due diligence. As such, work needs to be underway now to ensure a robust solution is in place for year end.
3) Additional responsibilities, repapering and outsourcing
Changes to regulations around transaction reporting, post-trade reporting, client (re)categorisation and complaints handling (to name a few) are giving rise to a massive repapering programme across the industry. Myriad documents need to be reviewed and amendments agreed, new protocols need to be adopted and new procedures implemented.
Amongst new provisions under MiFID II are enhanced record keeping and phone recording requirements. The existing carve-outs for investment managers are being removed, and managers will need to have in place systems to record, monitor and keep communications. In addition to finding a suitable recording solution for voice (including mobile), communications will need to be monitored, checked and stored. The feedback loop here will be similar to that for best execution. And as with best execution, to ensure the requisite systems are in place by year end, services will need to be engaged now.In other cases, new services need to be undertaken or retained. Against this background, some managers may consider either outsourcing discrete work streams or outsourcing a portion of their operations. Outsourcing may be attractive where the outsourcer can bring subject matter expertise, and charging structures may be flexible enough to enable incremental fees with low minima thus reducing the immediate economic effect on the manager.