Posted on Euroweek:
The International Organisation of Securities Commissions has published guidance on due diligence for investment in structured finance instruments (SFIs) by collective investment schemes.
The guidelines are based on three central principles, which IOSCO says should form the basis of an iterative process of due diligence, with the results of each step informing the others.
These steps involve understanding the underlying assets of an SFI, the structure, and how it fits into the investment mandate. Due diligence should not be a one-off event, according to IOSCO, but should involve regular monitoring.
The guidelines are presented as best practice rather than new obligations, but are likely to exceed the capability of some investors,
"For smaller institutions it’s going to get very difficult," said Ian Falconer, a partner at Freshfields in London. "The smaller credit institutions and fund managers are just not going to have the analytical resources or the legal resources to analyse some of the more complex products.
"Either they will have to narrow the range of investments which they can sensibly invest in, or somehow outsource the analysis to somebody else — although it’s clear that they can’t absolve themselves of the ultimate responsibility for the credit decisions."
On the asset side, IOSCO stresses the importance of assessing the "availability, reliability and relevance" of data for the market as a whole and the specific asset pool, and not assuming that a given pool shares the characteristics of the asset class. Loan level analysis may be required in some cases, with senior tranches of US subprime RMBS given as an example.
In structural analysis, fund managers should identify all relevant risks in both normal and stressed circumstances, and understand the cashflow. Managers should ensure they have access to the right legal expertise to perform the analysis.
The third step involves acknowledging that the risks of SFIs are different to vanilla products and ensuring that any investments are consistent with the mandate and with disclosures to investors about the fund’s objectives, strategy and risk profile.
IOSCO prioritises valuation and liquidity concerns — funds with short redemption notice periods should make sure they will be able to obtain accurate valuations on a regular basis even in illiquid markets where dealers are no longer providing prices.
Managers should also have a formal new product approval process before investing in a new class of SFIs.
"There is clearly a lot of inconsistency among jurisdictions as to what kind of fiduciary duties fund managers have and how those fiduciary duties are discharged," said Falconer.
"These principles are providing a pretty clear statement that performing appropriate due diligence when investing in a transaction and performing an ongoing monitoring role — which can be onerous if you’re investing in complex products — are important components in determining whether you’ve discharged your fiduciary duties as a fund manager."