Homer Simpson first uttered his immortal signature exclamation of ‘Doh!’ on a short edition called ‘Punching Bag’ aired on 27 November 1988. He was hit by a punching bag with his face drawn on it. ASIC’s new Design and Distribution Obligations (DDO) feel a bit like that and some funds are closing to new investors rather than face the increasing administrative and compliance burden.
DDO will even change the way banks market some products directly, such as when bank hybrids are offered by mail or email letters to existing investors or shareholders.
Brief fundamentals of the DDO regime
ASIC is imposing principles-based design and distribution obligations for financial products. Issuers and distributors must introduce a product governance framework to ensure funds target the right people. It covers products which currently require disclosures to investors including issuing a Product Disclosure Statement (PDS).
The DDO regime is designed to ensure that product providers only sell their product to appropriate consumers. This means that your 86-year-old grandmother won’t be subject to someone trying to sell her an inappropriate 10-year leveraged structured product. Product providers now need to provide a Target Market Determination or TMD to explain who the product is appropriate for and not engage in retail distribution without such determination.
There are some exceptions, but DDO will cover ‘financial products’ such as insurance, asset management, superannuation (not MySuper) and derivatives.
Many smaller funds do not have the compliance and administrative resources to satisfy these requirements, and techniques used by large issuers will also need to change.
Following are two examples of funds closing to new investors partly as a result of the DDO regime.
Third Link Growth Fund
As many readers of Firstlinks know from previous articles, such as here and here, I manage the Third Link Growth Fund, an Australian equity fund that donates all its fees to charity. Here is an extract from the letter we have sent to our investors. In short, we will close the Fund to new investors from the end of September 2021.
“Dear investor
When I first launched Third Link Growth Fund in 2008, I did so with the stated aim of closing the Fund when it reached $150m in size, which I later extended to $200m. Through the generosity of the fund managers and service providers who offer their services to the Fund pro bono, a $200m balance would allow the Fund to donate over two million dollars to charity every year without diluting investors’ returns.
The time is now right to close the Fund for two critical reasons. Firstly, the Fund’s balance is close to our target of $200m ($197.48m at 30 June 2021). Secondly, ASIC’s strict Design and Distribution Obligation (DDO) regulations are due to come into effect on 5 October 2021. They will add a costly layer of compliance protocols to the management of the Fund.
While we broadly welcome regulation that makes investing easier and more transparent for consumers, Third Link Growth Fund is designed to run as leanly as possible to maximise donations to charity. The DDO compliance burden will increase our costs and decrease the amount we can donate to charity.
Until the end of September 2021, Third Link Growth Fund will accept applications from new investors and additional amounts from existing investors. The Fund will close to new inflows on 1 October 2021 but continue to operate.”
EGP Concentrated Value Fund
On closing his fund, Tony Hansen (Founder and Portfolio Manager, EGP Capital) advised his investors with his usual dry humour:
“We are a retail fund and as such, the burden of compliance was already high, but in the last couple of years, ASIC has continuously added layer after layer of additional process and documentation. The latest creation by ASIC is the “Design and Distribution Obligations” (DDO), which has ostensibly been created to “assist consumers select appropriate financial products by requiring issuers and distributors to appropriately market and distribute financial products.”
For some reason, ASIC seems convinced that almost every consumer of financial products is an imbecile incapable of anything resembling coherent thought when they seek to select financial products. Many might well fit this description, but if we continuously legislate for the lowest common denominator, we might as well appoint Douglas Adams’ Vogons to rule over us.
Ben Franklin once said, “an ounce of prevention is worth a pound of cure” and I’m sure it is this noble aim ASIC pursue when they design these compliance obligations. We suspect a noble distortion of Franklin’s axiom would be “an ounce of enforcement is worth a pound of compliance”. Start gaoling wrongdoers for lengthy periods using the laws that currently exist and half the current red tape could be repealed.
The burden of these costs falls to the fund, and we thought it unfair to burden the investors with layers of cost we are so philosophically opposed to. Furthermore, the time associated with complying with these rules eats into time your fund manager views as better spent reviewing investment opportunities.”
And as Elstree Investment Management points out, DDO may also have a material impact on the hybrid market. Quoting from their latest newsletter:
“Banks used to shotgun their hybrid PDS’s. Shareholders, customers, and the general public would all be sent a PDS in the post or by email. This particular cohort typically provided between 10% - 40% of funding per issue. It was a really good way of raising funds, and banks didn’t have to pay fees to advisors in this cohort.
We think there is no way that the DDO marketing process to the public at large will be compliant with DDO by October 5 (when DDO becomes operative) so the potential IPO market for hybrids may become smaller after October 5. We’re also unsure as to whether DDO will affect how banks distribute hybrids to customers who are advised. Is, for example, a bank hybrid an appropriate investment for all customers with advisors (who knows)? and ASIC hasn’t provided much guidance on how a target market is determined.
If we put ourselves in the position of bank and corporate treasurers, we can see them thinking; “It’s going to be more difficult to issue hybrids next year and you may not be able to issue as much as you want to. In the worst case, unless we can get a reasonable outcome on our Target Market Determination, we may have material difficulties in issuing in 2022. Maybe, we should bring our issuance forward and do it pretty soon.”
We have seen a number of issues being brought forward. The Treasurers of Suncorp and Westpac both stated that DDO was not a reason for them to bring forward their scheduled issues but:
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- Macquarie was first out of the block last month with a $650 million new issue that was not replacing a maturing issue. They accepted all ‘general/shareholder’ applications.
- Suncorp had a hybrid due in June 2022. They announced a $375 million+ issue last week.
- Westpac has a hybrid which is due to be reset/redeemed in December 2021. We would usually expect an announcement around results time in mid-October. Westpac announced a $1.45 billion+ issue last week.
- CBA has an issue resetting in October 2021 and $4.5 billion of hybrids that need refinancing in 2022. They have already done one issue this year and maybe they will upsize the October 2021 refinancing.
- Latitude Financial Services announced an issue this week.
- NAB has a $1.5 billion June 2022 issue that needs refinancing. They haven’t yet announced whether they will be attempting to issue before the October 5 DDO deadline.
The upshot is we think there might be a lot of supply coming and it’s already looking like the biggest three-month issuance surge we’ve seen.”
There is another side to the DDO regime - investor confusion and inconvenience. Many in our industry are now franticly adding questions to their application forms, as if they were not already long enough. Questions like "Is this a satellite or core investment" are guaranteed to cause confusion and angst. Not that ASIC forces product issuers to ask these questions (far from it in fact) but many will do so in an effort to show they are attempting to comply.
In the end, this legislation tilts the playing field even further towards the listed environment. Why is it that an investor with a CommSec, nabtrade or SuperHero account is deemed to be so much more discerning than their unlisted brethren?
Chris Cuffe was the Co-Founder of Cuffelinks, the predecessor to Firstlinks. He is Chairman of Australian Philanthropic Services as well as Portfolio Manager of the APS Foundation. Chris is involved with many other groups as a director, chairman and investment professional. This article is general information and does not consider the circumstances of any investors. Anyone wishing to know more about issues mentioned in this article should do their own further research.