In recent months, a handful of Canadian wealth managers have run into problems with their proprietary funds dealing in private market investments. These problems include restricted redemption privileges, valuation difficulties and outright gating.
Some of this is unavoidable. When liquidity dries up, investors redeem and everyone must scramble to facilitate clients’ need for cash.
But a large part of the problem is avoidable. The material conflicts of interest that arise when wealth managers own their own fund companies are too often ignored or poorly managed, undermining an industry built on integrity and fair dealing. This remains one of the biggest blind spots in Canada’s regulatory landscape.
So, is this really so bad? Yes.
Let’s take a not-so-hypothetical example: Imagine there’s a wealth management firm, WealthMGMT, where the portfolio managers on staff want to expose their clients to some private market investments. But instead of approving existing third-party funds, WealthMGMT gets the idea to spark up their own fund management firm, Alts R Us, to manufacture a suite of funds, offering various types of private market investments to their team.
One of these funds is a private debt fund (let’s call it PD Fund) that makes direct loans to businesses, secured by assets like property, equipment and real estate. One day, PD Fund finds it is having trouble sourcing enough investment opportunities. So, to put the extra cash to work, Alts R Us puts 10 per cent of its assets into a sister fund, VenCap, which makes concentrated venture capital bets. Perfectly legal under the fund’s offering documents, let’s assume.
Everything mentioned above may seem innocuous, but we have inadvertently waded into a governance swamp.
Conflict #1: Falling down on the job.
The portfolio managers at WealthMGMT may want to deliver private asset investments to their clients, but who is to say that the PD Fund is the best private debt fund for their clients? These portfolio managers have a fiduciary duty to their clients, and to just believe that their very own Alts R Us fund is the best one for their clients is an abdication of their duty.
The problem gets worse when the wealth manager restricts their product shelf to only include their own proprietary funds. How is it possible for a portfolio manager to perform their fiduciary duty when the only investment option for their client involves self-dealing? Or, to rephrase the question: When a portfolio manager is told what to buy for their clients, are they not just a salesperson at that point?
Conflict #2: The double-dip.
Regulators take a dim view of clients paying twice for the same services, and that could be happening here. If the WealthMGMT client is paying a fee for managing their account, sister company Alts R Us should not earn a management fee for managing the funds that have been allocated to it. The best actors in this space will rebate one of these two fees, but that practice is not as common as it should be, and enforcement seems spotty.
Conflict #3: Double counting of assets.
To appear more stable and to attract new clients, financial services firms always like to inflate their assets, and investing in your own products works like a charm. Here’s how the accounting game works: A client gives WealthMGMT $1 million. WealthMGMT invests half in the PD Fund. Suddenly, the parent company reports a $1.5-million increase in assets under management—the original million at WealthMGMT, plus the $500,000 “new” assets at PD Fund. It gets worse when PD Fund makes an investment in its VenCap sister fund. New assets appear again out of thin air.
Conflict #4: When things go bad.
Think about what happens if one of VenCap’s biggest holdings is revealed to be a fraud. In the absence of self-dealing, the VenCap fund would simply get marked down, the PD Fund would take a hit, and everyone would move on. Painful, but routine. But this isn’t routine—the VenCap asset is being marked down by the same firm that must absorb the loss at PD Fund. So, the question is, how hard do they mark it down?
An aggressive markdown serves the interest of PD Fund best. Any perception that the fund valuation doesn’t reflect reality will cause investors to flee. But the more they mark down the VenCap fund, the worse it is for the VenCap fund’s track record and the firm’s assets under management. The managers face a nasty conflict: Mark the losses honestly and watch assets crater across the firm, or “take a sunny view” to buy time and protect the house.
None of these problems are far-fetched. Investments run into trouble all the time, and when conflicts like the ones above are baked in, even well-meaning professionals are forced into impossible corners. Simply disclosing these conflicts in the firms’ documentation doesn’t make them go away.
So why do they continue unchecked, without a clear and enforceable framework for managing them? One reason is that investor advocacy groups tend to focus elsewhere. And to be fair, conflicts of interest can sometimes feel like a dry “gotcha” game. Tiny and technical conflicts of interest getting blown out of proportion.
Another reason seems to be regulatory capture. In July, the Canadian Investment Regulatory Organization and the Ontario Securities Commission (OSC) put out a report scolding the bank fund channel for “rampant conflicts of interest.” All good and accurate. The only disappointment was their solution: Ask the firms to “conduct an assessment” of their sales environment.
That’s it. Not a rule change. Not an enforcement action. Just a self-assessment.
Possibly encouraging is that just recently, on Oct. 9, the OSC revealed that it was conducting doing compliance exams at the Big 5 fund dealers related to this very issue. Time will tell whether material changes will flow from those inquiries.
It’s no wonder regulators seem to always pull back from harsh punishment. Self-dealing is central to the big dealers’ strategies. Their empires have been built on getting a bigger share of wallet by, among other things, cross-referring—moving the client money around the house, from brokerage to fund management company to bank to trust to capital markets, keeping every dollar in the family.
This is all very unfortunate, because Canadian investors deserve to be able to assume that if their portfolio manager selects a fund for them, it’s the very best to be found, and that even the appearance of a conflict is too high a price to pay for selecting the product of a related company.
Failing to deal with these issues detracts from the real strides Canada has made in recent years, upping proficiency and continuing education requirements for advisors, improving disclosure and easing the regulatory burden on untraditional strategies. But when it comes to self-dealing between wealth management and fund manufacturing, clearly a bit more water needs to be drained from the swamp.
Christopher Foster is Chief Executive Officer and Portfolio Manager at Foster & Associates and the founding client of the firm’s Family Office Group.
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