Cost management in a more regulated asset management industry

This paper reviews some of the current cost reduction activities in the asset management industry, some familiar and some not seen so often in the past. It also considers the most recent indicators 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, are likely to have on the cost base of an asset manager.

by Crispin Rolt, Director Ernst & Young

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Cost is a measure that tumbles down the priority list when markets are buoyant and investors are abundant. However, when the sun stops shining, the issue of cost is promoted, 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 contraction of the asset management industry. The european asset management industry shrunk by €2.9 trillion in 2008.

This has placed increasing pressure on profit margins. Although some asset managers entered the financial crisis in better shape than others, all are now in a period where cost reduction and cost management are in the minds of senior management. As has been the case in other downturns where asset managers focus on cost, their first reaction is to stop or significantly reduce discretionary spend. Only business critical projects are not put on ice overnight. The second reaction is redundancy or ‘right-sizing’ as the industry would prefer to have it. Non-revenue generating and non-business critical business areas are usually the first to be targeted. More recently, with globalisation, firms are looking at their business models and stripping out layers of management that they deem superfluous. For example, some are questioning whether they need a business head in each region in which they operate. It is of course important that resource cuts are not made too deep, preventing the organisation from reacting quickly to gain market share when the industry eventually starts to recover. It remains to be seen who got ‘right-sizing’ right and who got it wrong.

Asset managers are also reducing cost through less familiar and perhaps more constructive activity. First, it is widely recognised that product proliferation has led to far more products in the marketplace than is either necessary or desirable, which is leading to product rationalisation. Asset managers are taking the opportunity to consolidate products that have accumulated as the result of earlier mergers or to close products that have failed or become inefficient to manage.

Secondly, many asset managers are reviewing their third-party service providers with a view to consolidating and thereby reducing cost through scale or, at the very least, to renegotiating contracts.

Thirdly, many are reviewing how the money managers and traders in the organisation are rewarded. Realigning the remuneration of managers with the risk profile of the fund and incentivising them in a way that is in line with the investment interests of clients is a tricky balance to strike, although also long overdue.

Fourthly, asset managers are analysing the operating model to identify opportunities to reduce fixed costs and build a more variable cost base. Ideally this redesign of the operating model should have been completed in the years prior to the financial crisis. We have encouraged our clients to review their operating model on a periodic basis, one of the principle reasons being to create a robust operating model that could cope with precisely this sort of downturn. This ‘weatherproofing’ may have resulted in a more expensive operating model, paying a fee to outsource providers based on a percentage of assets under management. However, it is currently being proven to be more robust as the cost of the operating model drops with the AUM.

Who Will Regulation Affect The Most?

The alternative asset management sector is, unsurprisingly, likely to be the target of much of the expected new regulation. At the time of writing, the most recent document released on future regulation was the EU framework proposal for managers of alternative investment funds, issued by the European Commission (EC). This draft legislation is the next step in an EU program designed to ensure financial markets across europe are secure and that market actors operate responsibly. The EC believes that the oversight and supervision of the activities of managers of Alternative Investment Funds (AIFs) across Europe need closer regulatory engagement and supervision. The key principles include an increase in the focus on what the EC believes to be the sources of systemic and operational risk, enhanced investor protection and regulatory disclosure.

Highlighted below are the elements of the recently proposed directive on alternative investment fund managers (AIFMs) that will have greatest impact on the cost base.

The most eye-catching element of the operating requirements for AIFMs is the requirement for the assets of a fund to be valued by a valuer that is independent of the AIFM. While third-party pricing sources of market and private trades is common, this appears to be a requirement for the annual valuation to be struck independently. The Commission will in due course define the conditions for determining independence. The organisational design is a common theme throughout the proposed directive. It requires independent depositaries and custodians to be appointed to the AIF – EU credit institutions subject to prudential regulation – which is a significant change in practice and a challenge for the existing prime brokerage and private equity models. The AIFM is required to have a structure to identify, prevent, and disclose conflicts of interest. There is also a requirement to have an operationally separate portfolio risk management function, although again it is unclear how independence should be achieved. Other requirements include measures regarding:

• liquidity management, stress testing and redemption policies;
• procedures to ensure that short positions are covered at delivery date;
• requirements that must be met before an AIFM can invest in securitised investments;
• authorisation by local regulators of the delegation of activities and apparent anti-avoidance provisions to prevent excessive outsourcing.

The directive proposes minimum capital requirements calculated as €125k plus 0.02% of the value of the assets under management, subject to a €250m hurdle. Therefore, the manager with €5bn in assets under management will need to hold an additional €1m of capital – not an insignificant amount.

What Will Be The Incremental Cost?

Increased regulation will inevitably mean more cost to the manager. However, this will vary significantly, depending on the degree to which the operational infrastructure has the resource and data required to undertake the additional regulatory compliance. For example, the cost implications on AIFMs complying with the proposed EU directive will vary significantly depending on the size of the organisation. The largest managers will, however reluctantly, be able to comply with the proposed directive. Many of the proposals embody business best practice, even if shoehorned into a one size fits all approach. The data is likely to be available albeit in disparate systems and records, but reporting in a timely and accurate fashion whilst managing confidentiality and commercial pressure will be more challenging. For those areas that are different – for example, mandating independent valuations, independent risk management and custody arrangements – it will be challenging to translate high-level principles into practical, commercially viable guidance. Other provisions, such as notifying 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 within 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 recognise 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 recognised method of demonstrating transparency and control in the organisation 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.

Conclusion – Desperate Times Call for Responsible and Considered Measures

Asset managers are digging deeper for cost saving than they have done in the past and they are undertaking a wide range of activities to achieve the cost reduction objectives.

The inevitable increase in regulation as a result of this financial crisis will increase cost and will impact the asset managers on a scale inversely proportional to size, to the extent that it may make operating in the new environment too costly for some small alternative managers to continue.

When the new wave of regulation is clear, it is important for these managers to take the opportunity to address the demands of the regulator and the investor from an enterprise-wide perspective and to resist the temptation to address each requirement (e.g., risk, compliance and control) or source (e.g., investor and regulator) in a silo. By looking at the spectrum of reporting requirements, asset managers will be able to effectively comply with the demands whilst minimising incremental cost.

Crispin Rolt is a Director and Global Markets Leader in Ernst & Young’s Global Asset Management practice. Crispin has 12 years’ experience delivering business change in the asset management industry. He has worked for both global asset managers and leading providers of advisory services.