Written by Partner Geoff Sanders and Senior Associate Stephanie Malon
With the release of an ASFA Best Practice Paper on insourcing investment management, we look at some of the challenges and opportunities for in-house legal teams that come with the seemingly inexorable move in the superannuation industry towards insourcing investment management functions.
If those in the Australian superannuation industry needed any further confirmation that the trend of industry and public sector funds insourcing investment management is now becoming more than merely the domain of our very largest funds, the release of ASFA Best Practice Paper No. 36 on that very topic is surely confirmation enough. As the Paper notes, a number of funds in Australia (the Paper lists at least nine, and there are probably more) now manage at least some of their assets internally – that is, with investment professionals sitting within the trustee's own structure, rather than in an external investment manager. It's a trend that is being replicated around the world, particularly for funds with greater than A$50 billion in assets.
The Paper is the result of some detailed research and interviews by ASFA and focuses on the very important – and in some cases challenging – strategic, process and practical issues that trustees should consider when embarking (or, indeed, choosing not to embark) on a journey involving the insourcing of some or all of their investment management functions.
While an excellent resource for trustees on the issues it covers, the Paper also got us thinking about some of the challenges and opportunities the insourcing trend brings to legal and compliance teams within trustees – something the Paper touches on but, understandably given its broad remit, doesn't dwell on in any great detail.
We've been very fortunate to have a close relationship over a long period of time with many of the funds which have, in small or large part, started on the insourcing journey. While they've all taken quite different paths in some respects, one of the constants in all cases has been the dramatic change in the size and role of the internal investment-facing legal department.
Some of the key challenges (and opportunities) we've witnessed are:
- Size of the team: Perhaps the most obvious issue, but also one of the more challenging ones – it seems inevitable that the increased investment team that comes with insourcing also leads to a significant increase in the size of (and, in most cases, the creation of a stand-alone) legal and compliance team focused on investments. While the considerations will depend in large part on the types of assets being managed internally, a range of practical issues arise when trying to build that team including, importantly:
- how quickly you try to build the team – the workload may well increase very quickly (and, indeed, ahead of any actual insourcing), but building a good team takes time;
- what type of lawyers are you looking for – do you want superannuation regulatory specialists (a valuable skill set in dealing with any tricky regulatory issues that arise in an investment context); funds lawyers (the thinking being that even if you're investing directly, many of the acquisitions will be non-controlling stakes and the structures used will closely resemble wholesale fund and club-deal structures funds lawyers are well versed in dealing with); general corporate/M&A lawyers (much is to be said for their versatility and project management skills) and/or specialist lawyers in the asset classes you're insourcing (eg, property, projects or infrastructure lawyers, on the basis they'll focus on that type of work).
- Role of the team: A related issue to size is the expected role of the in-house team. We see a range of approaches (which often work as well as each other) but, in our mind, the fundamental question to consider is whether the team is expected to replace external advisers (ie, by running transactions internally) or whether the role of the team is predominantly to better manage the external legal relationships of the fund.
- New skills: As you'd expect, legal and compliance teams are faced with a wide array of legal and compliance issues to deal with, which will in part depend on the asset classes being managed internally. As just one example, funds that manage Australian equities internally might have to grapple with issues such as insider trading risks arising from interactions with external managers and other internal asset class teams, the Australian rules on short selling, the new SIS regulations on charges associated with securities lending and OTC transactions and so on. Given it would be near impossible for any in-house team (at least initially) to be across all of those issues, it emphasises the importance on having close relationships with the right external legal advisers that understand the fund, the industry and are able to get the right parts of their firm involved for the right issues.
- No specific APRA guidance: As the ASFA Paper notes, there is currently no specific APRA (or ASIC) regulation or guidance on investment management insourcing. As such, while some of the APRA guidance can be (and is intended to be able to be) scaled to insourced-heavy organisations, it's fair to say that there is very little concrete regulatory guidance available to trustees and in-house departments in working through some of the legal, risk and compliance issues created by insourcing. This doesn't mean, however, that in-house teams are alone on their journey – on the contrary, we have found that other super funds who have been through (or are going through) the same journey have been very generous with their time with others in the industry. Similarly, it should be recognised that external investment managers have a wealth of knowledge on many topics – after all, they've been essentially dealing with many of these 'new' risks as part of their core business as agents for trustees.
- Build a risk and compliance function: Of course, it's not just the internal legal function that needs to grow and adapt – there will also be a huge range of investment risk and compliance functions that will need to be enhanced (or in many cases created), which will depend on the asset classes managed internally. You only need to think about the sophisticated risk and compliance systems that investment banks and equities managers have in place to manage risks as diverse as insider trading risks to counterparty exposure management to start to appreciate the types of issues that super funds need to consider when building internal teams (particularly equities and fixed interest teams). Again, one of the initial structural questions to consider is how that internal compliance function will be arranged – for example, whether they sit as part of the legal function or whether it will be staffed (and supervised) by non-legal risk and compliance professionals.
- Role of the Board, Investment Committee and delegations: A bigger investment department will almost certainly require a more streamlined approach to the role of the Board and the Investment Committee and, therefore, the delegations that are in place to senior investment management personnel within the trustee – it will simply not be possible for the Board or Investment Committee to handle the volume of day-to-day investment and other decisions that come with an internal equities, property or infrastructure portfolio. A large role of the legal and compliance teams will be in establishing and managing the internal investment decision making processes and procedures needed to effectively manage decision making.
As the ASFA Paper notes, investment management insourcing will eventually impact all aspects of a fund and the list above shows that legal and compliance teams are in no way immune, but, ultimately, the trend is part of an exciting new chapter in the continuing evolution of superannuation funds in this country.