A seller-pays regime in response to new rules for how super funds manage their operational due diligence has been lauded as a cost saver for both fund managers and asset owners. Scrutiny over compliance is tipped to ramp up towards the end of the 2017 calendar year.
In this context, ‘operational due diligence’ (ODD) refers to how super funds review the back-office administration and trading execution systems of their external fund managers, as distinct from due diligence on their investment strategies.
In late 2014, the Australian Prudential Regulation Authority (APRA) warned super funds that it was set to intensify scrutiny of their processes for managing both investment and operational risk when appointing investment managers or investing in external products.
Over the three years since, the Australian Institute of Superannuation Trustees (AIST) has been co-ordinating an industry-led response to the question of how super funds can comply with the new ODD requirements.
In March 2017, AIST produced the result. It released new guidance for ODD of investment managers that outlines a ‘seller-pays’ arrangement, whereby fund managers would engage an independent ODD provider to review their processes and produce a report that can be provided to any super fund considering investing with them.
A ‘ticket to ride’
Members of the AIST working group who developed the seller-pays model have likened it to when an individual who wants to sell a second-hand car foots the bill for a roadworthiness report to show to potential buyers.
At a seminar hosted by the Australian chapter of the Investment Management Consultants Association (IMCA), held in Sydney on June 23, 2017, working group members outlined the expected benefits of the seller-pays model.
“We think it will reduce costs for both asset owners and managers in the end,” Maritime Super general manager investments and finance Grant Harslett said. “These are hidden costs that will grow beyond the current level if an industry standard isn’t provided. Who pays for it upfront shouldn’t be a concern; in the end, it’s a savings for the industry and fund members.”
The model is particularly appealing for smaller super funds, like Maritime Super, that do not have the internal resources to undertake extended operational due diligence on all of their external fund managers. Outsourcing annual reviews of all managers would lead to “substantial costs”, Harslett said.
Former CareSuper general manager investments and current Labour Union Co-Operative Retirement Fund investment committee member Greg Nolan, who has also been part of the AIST-led industry working group that developed the new guidance, said larger funds also stand to benefit.
Nolan said he hopes the seller-pays model will give fund managers a “ticket to ride” and avoid the creation of a new and costly ODD industry.
“[Without a new model] if an investment manager has 10 clients, then that would mean they’d need to provide 10 separate ODD reports. We are trying to save everyone time and money and minimise the risk of growing a new industry,” Nolan said. “We are aware some larger funds have teams doing this. We don’t want to replace those teams. This model will form a base of about 80 per cent of what they require. They may do their own work to cover the other 20 per cent. It could mean a larger fund spends one day instead of three conducting due diligence.”
Widespread support despite concerns
A number of industry players in the audience at the IMCA seminar questioned whether investment managers would be happy to foot the bill, noting examples of overseas markets where asset owners fork out for ODD reviews, instead of investment managers providing them.
Harslett said, however, that a number of investment managers in Australia had already agreed to the model and that most of the larger super funds were “very supportive” of it.
“The Australian industry is far more prudentially controlled than overseas,” Harslett said. “We did consider if funds could pull together and pay for one provider. But that doesn’t work beyond one moment in time.”
There was also concern among audience members that investment managers might end up paying for multiple ODD reports due to provider inconsistencies and quality. Harslett said big super funds would drive quality control and set the standard.
“Managers already provide us with details about their auditors and accountants,” he said. “We don’t see this being any different. If a fund manager gives us a third-party report, we should rely on it.”
Nolan stressed that the model – which suggests investment managers undertake an ODD review every three years peppered by light reviews – was in no way perfect or final.
“There are two models: one is auditor based and the other is advisory based. We are working with the providers to come up with one model that accounts for advisory and control factors,” Nolan said.
Nolan said the APRA is supportive of the model. He expects the regulator to start questioning asset owners about their ODD processes in the second half of the year.
“We understand APRA wants to see this ODD process started by asset owners within the next six months, as opposed to the next month,” he said.
Speaking to Investment Magazine earlier this year, former AIST chief executive Tom Garcia nominated the ODD arrangement as one of the proudest achievements of his four years leading the peak body for non-profit funds.
“The benefit for our funds is that they don’t have to go pay for 40 or 50 of these reports, while the big advantage for the fund managers is that they don’t have to deal with 50 requests coming at them from different funds,” Garcia said at the time. “It sounds like a boring achievement but that little project will save tens of millions of dollars for members over time.”