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Regulators are rebuilding | Due Governance

The Regulators are rebuilding

APRA an ASIC are currently in the process of rebuilding their teams in order to meet the increased surveillance and oversight expectations that the Federal Government and general population are now placing on them.

One of the surprising ways they are doing this is by hiring talented individuals with skillsets parallel to, but outside of finance.  This is a deliberate strategy to ensure their people are neither tainted or captured by the existing mindsets that the Hayne Royal Commission uncovered. 

While this will dramatically help regulators remain fiercely independent in their thinking, it will come at the cost of subject matter expertise.  We think it is therefore imperative that organisations that want to do the right thing are able to sit alongside regulators and genuinely help them understand how their subsector of the industry operates – both in the members/customers best interest but also in terms of revenue generation for the organisation.

We also believe that organisations need to very clearly enunciate how the various layers of governance within the organisation work.  It used to be sufficient to show that the organisation had ‘Three lines of defence’ that started with individual departments and ended with the Trustees/Directors.  Post the Royal Commission a lot more work will need to be done to demonstrate that there is a two-way street of information flowing from the coalface of the organisation right up to the fiduciaries and back down again.

Given that regulators are going to be taking an ‘outsiders’ perspective on our industry.  It will be worthwhile for us to take a moment to stand back and look at our own activities from an outsider’s point of view. Just because a process has always been done a particular way does not mean it will make sense to an outsider. 

A good place to start might be to consider how an investment organisation manages its risks.  It seems odd to me that most investment risks are managed quite differently to the corporate risks that that same organisation is taking.  At the governance level, the risks that are being overseen by an investment committee are usually handled differently to those risks that are being overseen by the board.

Let’s look at an example.  Let’s say the executive management team of a super fund has identified a particular middle-office challenge as one of the key risks it needs to manage.  It will show up on a risk register and so long as this middle-office challenge is seen as a risk, it will stay on the risk register where directors will be able to keep an eye on it every month.  This also gives the directors an appropriate opportunity to ask management for any updates as time progresses.

Now let’s say this super fund recently appointed a new fund manager for an Australian Small Cap Equities mandate.  The investment team making the appointment had several different managers they could select from.  A normal due diligence process would unearth a range of pros and cons for each manager.  The investment team weighs up which of those strengths they wanted the most without also introducing unwanted risks. Usually the investment team will consider what can be done to mitigate those risks and make their selection based on what best balances the benefits with the mitigated or otherwise acceptable risks. 

But once that investment has been made, the investment team will almost exclusively look at the return fundamentals of that fund going forward, and managers are usually required to advise if any of their key staff have changed.  But the Investment Committee may not be furnished with a continually updated register of the individual fund manager level risks and how they change through time.   Other than an Investment Committee having a little less tangible hands on information relating to the original due diligence findings of the fund manager, we might think this shouldn’t cause any real issues.  And initially it won’t. Experienced investment teams typically offer an exceptional ability to weigh up the various complex factors that go into making a decision.  If any issues are to creep in, it will usually occur as time marches on, more so if there is staff turnover within the investment team as new investment staff are less likely to have the same history with these ‘legacy’ investments.

Let’s get back to our Small Cap Equities manager example.  Let’s say during the initial due diligence phase of the process, the team realised that one of the ways their preferred fund manager was able to maintain high returns while also smoothing out the volatility was by combining a mix of growth companies with a portfolio of low-volatility companies.  While an understanding of this strategy helped give the super fund’s investment team confidence that its historical returns were no accident, there would be times in the future where this particular strategy would temporarily perform poorly.  Given this background, it might cause a level of self-harm if some years later a new investment team fired this fund manager in a year where both high growth companies fell and volatility levels rose across the rest of their portfolio.   

Treating risk and strategy as two sides of the same coin is part of good governance for both investment teams as well as management executives and their directors.  Ultimately we think that features from an investment due diligence process can be added to a board governance framework, just as we think a good corporate risk management framework can be added to a traditional investment process.  

While we think outsiders such as regulators will start asking questions that we never asked ourselves will be challenging, this also presents an opportunity for efficiency gains and improved governance oversight.

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