IOSCO publishes due diligence good practices for investment managers

It seems intuitive enough, but the International Organization of Securities Commissions’ (IOSCO) latest guidelines for investment managers and regulatory bodies lists this sage advice among the top items in its latest report, IOSCO Good Practices in Relation to Investment Managers’ Due Diligence When Investing in Structured Finance Instruments. While it may seem pedestrian, considering what’s happened over the past 11 months, IOSCO makes a good case for getting back to basics.

Five pillars
According to the report, the Investment Manager Due Diligence Practices are based on five key messages that should inform any review, development or reconsideration of due diligence policies and procedures.

• Investing in a structured finance instrument (SFI) is different from investing in a traditional “plain vanilla” instrument. The risks are different and call for a tailored due diligence process;
• If you do not understand an SFI, do not buy it;
• Due diligence is and must remain a value-added process. It is not and must never become a plain box-ticking process;
• Due diligence is generally a three-step iterative process, which is structured around the understanding of the underlying assets of the SFI, of its structure and of how it fits into the collective investment schemes (CIS) mandate; and
• Due diligence is not a static process. It is an ongoing process that starts when the initial investment in the SFI is contemplated and ends when the SFI matures or is divested.

Good practices
IOSCO also presents three good practices aimed at assisting industry and regulators in their understanding, assessment and monitoring of investments in SFIs on behalf of CIS.

1. Analyzing the underlying assets of the SFI
When assessing an SFI, investment managers should assess the availability, reliability and relevance of information available both on the market and on the underlying assets. IOSCO warns against assuming that the unique properties of the specific pool of assets are to be identical to the broader asset category. Instead, investment managers should ensure that their analysis of the underlying assets is based on information that is relevant for those specific types of underlying assets.

2. Analyzing the structure of the SFI
The analysis of the structure of the SFI should be conducted both in “normal” and in “stress” scenarios, and the investment manager should also ensure access to the right expertise to conduct an analysis of a particular SFI, including legal expertise. The asset manager should understand how cash flows will be allocated to the different tranches of the SFI, and he or she should use IOSCO’s good practices to build an opinion on the SFI as to whether the price is right for the risks taken on behalf of the investors.

3. Fitting the SFI into the CIS mandate
The investment manager should check that investing in the SFI on behalf of the CIS is consistent with the disclosures, mandate and internal operations of the CIS.

With regard to third parties, the investment manager should understand the methodology, parameters and basis on which the opinion of a third party was produced It should also have adequate means and expertise to challenge the methodology and parameters.

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