SBAI warns of potential conflicts of interest between parallel investment funds

The Standards Board for Alternative Investments (SBAI) has published a new memo that may be of interest to the insurance-linked securities (ILS) fund managers community, regarding the potential for their to be a conflict of interest between parallel fund strategies.

It is a relatively common practice for alternative investment managers to operate parallel investment funds or strategies that have virtually identical strategies, but for some reason cannot be managed together or on a co-mingled basis.

In insurance-linked securities (ILS) and reinsurance linked investing this could be because ILS funds are at different stages of their investment lifecycle, are funds of one established for a single enc-investor, or have different ancillary restrictions, are illiquid, or one is less fully invested than another.

In fact there are many valid reasons for operating parallel investment funds in the ILS and reinsurance world.

We can also see this in private quota share arrangements, where a single investor may have entered into a quota share directly with a large reinsurance firm, but that firm also operates a sidecar that has numerous investors in it and all are accessing a share of the same book of normally catastrophe risks.

The SBAI, which endeavours to set standards for alternative investment managers and their investors, highlights the potential for this to result in conflicts of interest.

Concerns could arise regarding the fair treatment of investors in different funds, including over preferential allocation to one or the other, something incredibly relevant in reinsurance.

In addition, fees and how they are paid and structured across different funds is another area where conflicts could arise.

So too can allocation to different parts of an issuers capital structure, meaning that different funds run in parallel could end up on opposite sides if the issuer became distressed.

Finally, governance could be another conflict point, as funds in different jurisdictions may have different governance rules, but otherwise be following the same strategies.

In the ILS and reinsurance market, this reminds us of the conflict question that is often asked of reinsurers with their own ILS management entities or fund units.

These may manage third-party capital in a fund structure which is invested in their underwriting, may also have a reinsurance sidecar, plus private quota shares, but also have a balance-sheet backed by shareholders, all doing the same. As a result there can be clear conflict of interest questions that such reinsurers need to be prepared and able to answer.

The memo published by the SBAI highlights how its Alternative Investment Standards helps to address issues related to conflicts of interest and offers examples for additional measures managers can take to strengthen their approach.

It also provides detail on where investors should spend time assessing managers as part of their due diligence on how potential conflicts of interest are addressed.

Commenting on the launch of the memo, Jamie Wise, CEO of Periscope Capital and a member of the Standards Board’s Governance Working Group, said, “Parallel funds with similar investment strategies can give rise to conflicts of interest among different investors and it is important that managers have a robust approach. The memo sets out additional measures managers can take specifically to address conflicts of interest between parallel funds, including documenting allocation decisions in trading/compliance reporting systems, audit of allocations by the chief compliance officer or conflicts of interest committee, review by an independent third party and reporting to fund governing body.”

Kai Rimpi, Head of Hedge Funds at Varma Mutual Pension Insurance Company, also a member of the Working Group, added, “This topic of conflicts of interest remains important to investors. A robust approach to mitigating these conflicts properly plays an important role in improving investor confidence. This memo provides a real-life case study with practical solutions to addressing conflicts of interest. We are very pleased that the Standards Board continues to demonstrate its commitment to improving practices in various areas, including fund governance and management of conflicts of interest.”