After a prolonged period of rising investment markets, the economic outlook is dimming, with rising inflation and markets that seem much less likely to grow in the near term. The fee income cushion that has come from upwards investment performance seems unlikely to be a reliable contributor to investment managers in 2022. Indeed, repositioning investments for a period of higher inflation and increasing interest rates is arguably the biggest decision managers will need to make this year – not whether to reposition, but when and by how much. There will, as ever, be winners and losers in this process.
Geopolitics has reasserted itself with force and adds another challenge for managers to address. Other political and regulatory interventions are also rising up the agenda, including environmental, social and governance (ESG) issues, and embedding new rules on regulatory capital and liquidity.
Meanwhile, unprecedented consolidation activity in the sector continues apace. Businesses are seeking scale or the revenue benefit of vertical integration (or both). And banks now keen to buy scale in investment management after several years of appearing to be less than committed to their wealth and asset management business lines.
We've identified seven key areas that the investment management industry will need to take into consideration for the remainder of 2022.
Geopolitical tensions are adding impetus to the supply chain and fiscal driven inflation begun during the pandemic. Inflation now seems here to stay for at least this year. Equity markets seem to have taken this on board with several markets entering bear market territory, confidence is low. Even if market growth takes place, if it falls below a rate of inflation which is clearly above 5%, then it will still represent an erosion of the value of investments for most clients. Also, for the first time in over 20 years the potential exists for managers to have to make their investment decisions in a (relatively) high interest rate environment.
How, when, and to what degree managers respond to the new economic reality will arguably be the most important commercial decisions they make in 2022. As other economic and market turns have proved over the years, there will be some winners and some losers. Managers that are seen to have ‘called it right’ will have helped their clients to outperform, and such performance has almost always been the basis for client inflows and growth. The opposite holds true for managers who systematically underperform when the same decisions go against them.
Margin pressure on managers has not gone away. Active management fees are still trending down in the face of passive competition. And, in retail funds, there's considerable pressure from the Financial Conduct Authority (FCA) to justify, or reduce, fees through an increasingly forensic Assessment of value process.
The fee drivers alone could explain the past two years of industry consolidation. But the addition of significant outside capital seeking to build wealth and investment management businesses at scale has pushed the sale price multiples for managers to levels at which it has never been a better time to sell up. There doesn't appear to be any indication that the pace of consolidation will slow in 2022. Indeed, deals at every level of the market seem certain to continue.
Consolidation is taking several forms. The biggest deals are generally where a large bank has decided to re-invigorate its investment management business with a significant acquisition – an interesting turn of events after several years of those same banks being happy to neglect or even sell off their investment management businesses. Mid-tier and smaller-tier deals have often involved building businesses on a vertical integration model, such as managers that have added or expanded an investment platform and a financial advice offering. Many of these deals have been funded in whole or part by private equity (PE) investors. Along with the banks, PE is the other significant source of new capital into the sector.
The challenge that consolidation poses is the traditional one of how to make the newly formed business perform better than the sum of its parts.
Merged organisations that can realise significant cost synergies will go some way to achieving their goals. But most of the consolidation taking place is also intended to realise growth opportunities through improved propositions and client reach. Achieving those growth objectives requires a major focus on operating models and business culture to ensure they're not lost in the inevitable friction between newly merged businesses.
Replatforming – often described by investment managers as a once-in-a-generation change – is the replacement of core technology systems supporting the operations of the manager. By definition these projects are rare but the combination of industry consolidation and the wider pressure on margins is causing an above-average number of these ambitious projects to take place now.
Most investment managers are on order management and fund accounting solutions they installed in the early 2000s or prior. The attraction of newer systems with high levels of data, reporting, and compliance functionality is strong. Overwhelmingly, these are third-party solutions which managers need to customise and configure, but the scale of that exercise will make this easily the largest change project for any manager that pursues it.
Replatforming will rightly absorb a high level of management attention. Successful delivery may in part be measured by the extent to which it detracts from or slows progress on other initiatives.
The countless approaches to achieving ESG objectives in funds has come to a head this year, and the wide-ranging variety in how those objectives are described to investors is also coming under scrutiny. That scrutiny is coming from the FCA, who are actively enquiring how managers control and oversee the execution of their ESG philosophy. It's also coming from institutional clients, who are asking for granular information on how their assets are being managed.
A priority action we are seeing play out in many firms is the ‘stocktake’ of their current position and infrastructure regarding environmental, social and governance issues. Often different approaches have evolved over time in different asset classes or for different client groups. Sometimes supporting analytical tools are not up to achieving the claimed approach. Or it may be that measurement of the actual impact isn't robust enough to confidently say that investment decisions have had the intended effect. These issues almost always require an investment in a thorough ESG reporting framework for defining, delivering and measuring ESG goals.
The FCA’s landmark revision of its rules in 2022 is the Consumer Duty – a top-to-bottom re-definition of its expectations for any regulated firm that serves retail customers (including via an intermediary, such as an investment platform). Final rules are due in summer 2022, with implementation in April 2023, but the draft rules already published are more than sufficient to understand the scope and scale of the change.
While the principles in play will all be familiar – good customer outcomes, providing value for the fee charged, understanding and catering to the intended consumer of the service – their application significantly expands the effort required to demonstrably comply. In particular, there's the need to apply those principles to all points in the customer journey and to have both management information and assurance activity in place to allow the board to attest to compliance with the Consumer Duty. The FCA itself has estimated that the industry will need to spend approaching £4 billion to achieve compliance.
While the Consumer Duty will mark a significant compliance challenge for many firms, the FCA is also strengthening other consumer protection initiatives. For example, it's tightening the rules on what is a high-risk investment and how it can be promoted.
Another area of challenge is the FCA’s thematic feedback on the assessments of value produced by managers with a retail fund range. That feedback has highlighted the regulator’s view that almost all managers needed to go much further in demonstrating that the fees being charged to investors are a fair reflection of both the service being provided and the true underlying cost of providing that service.
Making such a clearly delineated assessment at not only the fund level, but at the individual share class level, as is required by the FCA, poses a major challenge to most managers. This is because few understand their cost base in a sufficiently granular way to be able to determine the actual cost of operation of a single share class within a fund. Building the analytical tools to perform this evaluation will take a significant effort, one which may have only limited benefits to the business unless it also becomes a driver for both setting pricing and reviewing the viability of new and existing funds.
It's clear that managers will need to invest significant time and effort in meeting these compliance challenges in the year ahead.
From 1 January 2022, the regulatory capital and liquidity rules for every investment manager in the UK changed with the implementation of the MIFIDPRU rule book. For most managers, the immediate impact on the capital that they're now required to hold is small, although almost every part of the calculation they need to perform to determine that level of capital is changed by the new rules.
A more significant impact is that for the first time the new rules require a minimum level of liquidity to be maintained “at all times”. The assessments that are required to arrive at this liquidity level are complex and entirely new, hence managers are having to work their way through how the new rules work. It's quite possible for a manager to generate a significant liquidity obligation which can force a change in the way it manages its working capital. Combined with other changes – particularly the removal of a ‘group liquidity waiver’ with a non-UK parent, which prevents a UK subsidiary pooling its liquidity with group companies outside of the UK – there are some firms whose business model will need revision unless significant extra liquid resources are transferred to the UK business.
During 2022 managers will also need to produce their first ICARA document. At least in the first year, this will absorb significantly more effort to complete than would a simple update of the ICAAP (which it replaces). For managers with an existing individual capital guidance from the FCA (a mandated capital floor imposed by the regulator after a firm-specific review), completion of their ICARA will then trigger a review exercise by the FCA to re-base their capital floor. This process will expose the firm to extra scrutiny with uncertain results for their capital requirements.
The rest of 2022 is set to be a demanding time for pension providers, pension schemes, and pension advisers. There are a number of initiatives coming into effect, such as the enhanced regime of supervision that The Pensions Regulator is introducing for workplace pensions.
There's also the ongoing work being undertaken by the FCA on defined benefit pension transfer advice. For example, a special redress scheme is to be introduced for pension transfers which took place from the British Steel Pension Scheme, with approximately 300 wealth managers being required to review all such advice cases and pay redress where that advice is deemed unsuitable. Given redress in pension transfer cases routinely exceeds £100,000 per case the potential costs of this exercise may be significant.
Wealth managers undertook large amounts of pension transfer activity in the years following the 'pensions freedoms' introduced in 2015, it being a highly effective means of moving assets from occupational schemes into discretionary wealth portfolios. While some managers will have carried out these transfers with care, FCA thematic work suggests that a significant number will not have, leaving a back book liability for suitability issues that could materially damage the profitability, and possibly even the viability, of some firms.
For support with meeting challenges for the investment management industry, get in touch with David Morrey.