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The Most Dangerous Asset Management Client
Regulatory scrutiny, conflicts of interest, opaque fees: few investment firms know what they’re getting into with outsourced CIOs, warns one consulting group.
Outsourced chief investment officer mandates are one of the fastest growth areas in asset management, but business consultants urge managers to beware of reputational and regulatory risks.
Outsourced CIOs run portfolios on institutions’ behalf for fees, typically with discretion over the hiring and firing of managers and daily investment decisions. According to consultancy Chestnut Advisory Group, OCIOs oversee $1.6 trillion in assets at present, and that figure is expected to approach $3 trillion by 2022.
[II Deep Dive: Fear and Loathing in the Outsourced CIO Market]
Chestnut — a business adviser to asset managers — suggests that OCIO introduces unique and complex risks that investment shops likely have not encountered before, according to forthcoming research obtained by Institutional Investor.
“The risks are all about the transparency of the decision-making and pricing to the client,” says Amanda Tepper, Chestnut’s founder and CEO. “With OCIO, you as an asset manager have no direct contact with clients anymore.” That disintermediation requires managers to be on alert.
For example, an asset manager might accept $500 million into its emerging markets fund from a consultant’s OCIO program, in exchange for a discounted fee. But the asset manager doesn’t know what the consultant is charging its clients, the structure of the program, or if other managers are offering the investments at similar or wildly different prices. Tepper recommends that, at a minimum, asset managers must understand what the end client is paying. “Transparency right now is all over the place.”
Chestnut also suggests managers protect against conflicts of interest when the OCIO is run by a consultant. Tepper said a consultant might get $400 million into an oversubscribed private equity fund, but then has to choose how to allocate the capacity among its different channels. Consultants may be tempted to allocate more of the $400 million reservation to its discretionary OCIO programs, where fees can be double or triple non-discretionary channels.
The asset manager needs to know how the consultant firm allocates capacity to its various clients, explains Tepper. “If it’s not done right, the asset manager’s name — even if its funds were not involved — will be dragged through the mud. It was part of that OCIO program and that’s enough.”
Tepper says that the growing OCIO market is attracting regulators’ attention, which should signal asset managers to ensure their processes are airtight. Last fall, U.K. regulator the Financial Conduct Authority said it will review consulting firms with OCIO programs through March. Tepper, who predicts U.S. regulators eventually homing in on the sector, says the FCA is concerned about transparency, including pay-to-play schemes. “Providing special treatment to managers who pay extra fees for educational and consulting services – or ‘pay to play’,”as the report defined it. “This could potentially be extended to include managers who agree to special discounted fee structures with certain consultants in order to be included in OCIO and other proprietary comingled consultant funds.”
Tepper says asset managers need to be aware of these investigations and potential conflicts. “For example, one implication in any pay-to-play investigation would be that the manager isn’t really best in class,” the report said.
Chestnut also outlines best practices for asset managers when dealing with OCIO providers. Among them are investing significant resources, including staff, into supporting the programs and recognizing how much they differ from other distribution channels. Chestnut also suggests they focus only on their best products and be candid about near-term performance expectations. “Helping the OCIO look good by giving them the heads-up to cycle out of a certain product ahead of a rough patch will serve any manager extremely well in the long run with that OCIO relationship.”