Third-Party ManCos: Oversight and Independency in Fund Management and future scenarios

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In the fund sector, the use of third-party ManCos is increasing, a trend expected to continue in the coming years. Over the past three years, the escalation of costs, regulatory fees, and stringent substance requirements have made more asset managers consider leaving the ManCo business and relying on third-party ManCos. This article examines why relying on third-party ManCos can be a benefit for leader asset managers and fund sector itself, by improving investor protection, introducing an additional layer of oversight and minimize potential conflicts of interest.

According to CSSF data, the total number of Super ManCos (AIFM & ManCo licenses) has been decreasing since 2019. Moreover, a strong decrease in the number of UCITS licenses has been registered, from 206 in 2018 to 171 in 2023, indicating market consolidation and the increasing challenges of maintaining a standalone operation in a complex regulatory environment and raising of operational costs.

As a result, over the past four years, there has been a reduction in the overall number of ManCos with leading asset managers increasingly shifting from in-house ManCos to third-party solutions or possibly the moving on the alternative investment fund structures.

As asset managers seek to optimize operations and concentrate on their core strengths, such as Investment Strategy, Research and Portfolio Management, the role of independent ManCos in providing specialized oversight and governance becomes increasingly important. In this context, preserving the independence of the ManCos is crucial. Regulators, during onsite visits, are increasingly focus on verifying framework that ensure true independence and strong governance in place. This trend highlights the significance of third-party ManCos in ensuring efficient fund management and compliance with regulatory standards.

The key concept of the independency lies in the third-party ManCo operating autonomously and separately from the main actors and in particular from Portfolio Manager and the Fund Initiator. This independence is critical because it ensures that the ManCo can make decisions solely in the best interest of the fund and its investors, rather than being influenced by the needs or desires of the asset manager or initiator of the fund.
Typically, a ManCo's client, the fund sponsor, is often acting as the fund's Portfolio Management itself. An independent ManCo ensures that its risk management functions can operate autonomously, despite the potential for the Portfolio Management to be, in essence, the client.
The independence of a third-party ManCo allows it to carry out its risk management functions autonomously. This means that even though the Portfolio Management (possibly operated by the fund initiator) might technically be the client of the ManCo, the ManCo has the freedom and authority to implement risk controls, investment compliance checks, and oversight mechanisms without undue influence. This setup ensures that the ManCo can objectively assess and manage risks, maintain compliance with regulatory requirements, and protect investor interests.
The potential conflict of interest arises when the entity managing the fund's investments (the fund sponsor as Portfolio Manager) could make decisions that benefit itself at the expense of the fund's investors. For example, it might choose investments that carry higher fees or are riskier than suitable for the fund's objectives. By having a third-party ManCo, this risk is mitigated because the ManCo's sole focus is on the governance, compliance, and risk management of the fund, separate from the investment decisions. The concept of the third-party Management Company significantly diminishes the risk of conflict of interest, as it operates independently from the asset manager or fund sponsor.

Another critical element is the Central Administration & Transfer Agent function. It's important for the integrity of the fund's operations that the TA is not mixed within the ownership structure of the Super ManCo. Although the TA function is often delegated to a third-party provider (with the fund signing an agreement directly with the TA instead of through the ManCo), its operations, risk appetite, policies remain independent and separate by the Fund Initiator and AIFM/Management Company. The TA conducts its Anti-Money Laundering controls based on internal policies, in coordination with the fund and the Super ManCo's policies, adding an extra layer of independence. This structure ensures that there is no conflict of interest between the Super ManCo, the TA, and the Fund initiator allowing for the impartial assessment on investors on on-boarding and periodical review phase.

Another aspect to consider, for a fully independent Super ManCo, represents the depositary activities. Even though the CSSF Circular 18/698, specifically in Sub-chapter 4.4, mandates the independence of the Investment Fund Manager's bodies from the depositary, and the necessity of maintaining separate management and, where applicable, risks may still exist. This regulation addresses scenarios where a group link between the Management Company (ManCo) and the depositary exists, particularly when assets of Undertakings for Collective Investment in Transferable Securities (UCITS) managed by the ManCo are deposited with the linked depositary. Despite these clear stipulations for operational independence and oversight to safeguard against conflicts of interest and ensure the integrity of asset management and custody, inherent challenges remain and they do not eliminate the potential for systemic risks. These risks are partly due to the complexities involved in maintaining absolute segregation and independence within the interconnected structures of financial groups. Consequently, while regulatory frameworks like CSSF Circular 18/698 aim to mitigate such risks through stringent governance and oversight mechanisms, the realities of operational interdependencies within group structures necessitate ongoing controls and robust compliance measures to maintain the principles of independence against potential conflicts of interest or oversight failures.

A standard Third-Party ManCo, according to a KPMG survey, oversees 97 delegates, highlighting its primary activity on robust oversight over delegates and service providers. It's a misconception to view Third-Party ManCos merely as the back office for leading asset management firms; in reality, they serve as a fundamental pillar in overseeing the fund's activities, and investor protection. This network of oversight ensures that the management and operational practices of the fund meet regulatory and ethical standards. The third-party ManCo acts as a layer of objective oversight. It is tasked with ensuring that the fund operates within the regulatory framework, adheres to its stated investment objectives, and protects investor interests. In few words, this separation of duties helps prevent any single entity from having too much control or influence over the fund, thereby safeguarding against conflicts of interest.

As we were mentioning at the beginning of the article, given the current scenario of escalating costs associated with reporting and staffing, many lead asset managers are exiting and shifting to Third-Party ManCos. Also Super ManCos need to reduce costs, and achieve economies of scale by servicing more clients with approximately the same number of staff and reduce costs.

In this context, we might anticipate a rise in merger and acquisition activity within the sector, with smaller players more inclined to exit the market, and a future dominated by fewer but larger Super ManCos. These larger entities would ideally demonstrate superior Operating and Management Efficiency Ratios, highlighting their ability to manage costs and assets more effectively, thus positioning themselves more favorably in the competitive market. The focus on these ratios not only helps in internal performance management but also makes these entities more attractive in the eyes of investors and potential merger or acquisition partners, signaling their capability to navigate the challenges of escalating costs and the need for economies of scale.

Efficiency and cost reduction can be achieved through digitalization and the use of AI softwares that reinforces compliance and oversight of investment funds. With digital transformation and Artificial Intelligence becoming increasingly important, reflecting the sector's investment in technology to enhance operational efficiency. This not only enhances efficiency and reduces costs but also ensures that clients can effectively manage compliance with current and future anti-money laundering regulations. AIFMs today face the necessity to select from a wide spectrum of solutions, taking into account the scalability or the ability to adapt to future regulatory changes, as well as the speed of deployment.

In conclusion, the increasing adoption of third-party ManCos reflects a strategic evolution in the fund sector, one that prioritizes operational excellence, regulatory compliance, and the safeguarding of investor interests. As the sector continues to evolve, the importance of independent ManCos is set to grow.

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The views and opinions expressed in this article are my own and do not reflect the official policy, position, or opinions of any financial institution, or other organization.
The content of this article is based on personal research of the author and understanding of AML (Anti-Money Laundering) and compliance topics.