The Alternative Investment Fund Manager Directive (AIFMD) which had to be implemented by EU member states by 22 July 2013 introduces numerous changes for alternative investment fund managers (AIFMs) marketing funds in the EU. The effects are far-reaching and affect not only the organisational and governance structures of AIFMs but also day-to-day operations.
With the end of the transitional period approaching, risk management has recently become a major concern for real estate (RE) and private equity (PE) fund managers. These have traditionally performed risk management tasks within their portfolio-management function, with respective processes and procedures being less formalised and documented.
With the AIFMD now requiring AIFMs to implement a functionally and hierarchically independent risk management function and setting up a documented risk management process, RE and PE fund managers have to familiarise themselves with a new operating model. To ensure the independence of the risk-management function, specific safeguards have to be established. These involve adequate provisions on the composition of senior management and the board, remuneration, and conflicts of interest. As an example, the oversight of risk management cannot be performed by the conducting officer in charge of portfolio management. Similarly, remuneration for personnel in control functions has to be separated from that of employees in operational units. The precondition for an AIFMD-compliant risk-management function is thus the implementation of an according organisational and governance structure.
This, in itself, will frequently be challenging for existing fund managers, since established processes and structures will have to be pried open and replaced by new models. Apart from that, finding appropriate personnel to oversee and perform risk management tasks may prove difficult since the job profile in its required form was not prevalent in the market until now.
In order to operate risk management as required by the AIFMD, AIFMs have to implement the respective risk management systems. These comprise a risk management policy as well as measurement and management tools. The AIFMD and its delegated regulation (Level 2) oblige an AIFM to identify, document, measure and monitor all risks that are relevant for each of its AIFs with adequate frequency. Risks that have to be monitored generally include market, credit, liquidity, counterparty and operational risks.
To set up an effective risk-management framework for its AIFs, an AIFM has to understand the meaning and implications of the respective risks for each individual AIF. As an example, market risk for a RE fund may be defined along the lines of investment market and micro-location developments, whereas for a PE fund investing in companies producing goods it may rather relate to developments within target customer groups or competitor movements.
Based on this understanding of risk in the specific context of the AIF, the AIFM should elaborate a meaningful and distinct definition for each of the identified risk categories. This definition can then be used to identify indicators that allow measuring of the respective risk.
When identifying relevant risks, AIFMs should consider the level at which the risk arises. Some risks will arise at the level of the AIF, but others will arise at the level of the AIFM, or at the level of the asset itself.
For a risk-management framework to be accurate and effective, it is important that risks are addressed and monitored at the level of their origin. This should also be reflected when determining indicators for the identified risks. Indicators should be meaningful in the way that they properly measure the relevant risk component at the respective level. The number of indicators used should be limited but should allow capturing the risk and may depend on the risk’s priority. The priority of a risk for an AIF should be determined based on its potential impact and the probability of that risk materialising for the AIF.
Level 2 requires AIFMs to define limits for the identified risks, which are in line with the risk profile of the AIF. At this, the regulation states a clear preference for quantitative measurement. The use of qualitative limits, where considered more appropriate, should thus be justified with objective reasons.
Risk limits, especially when quantitative, should allow for regular fluctuations of the respective parameter but reliably detect irregularities. In order to ensure efficient detection and to be able to take proactive action, especially for high priority risks, AIFMs may consider setting risk limits for early warning and for immediate mitigation. Once set up, the risk management function will have to address and interact with various areas and functions covered by the AIFMD. Accordingly, AIFMs should carefully consider how they want to integrate risk management into their overall organisation. Processes for the coordination with adjacent areas, such as liquidity management, leverage, valuation and reporting need to be established and implemented.
Especially for liquidity management, AIFMs need to decide on where the respective tasks shall be performed. Liquidity stress-testing, for example, could either be performed directly by risk management or by portfolio management, with risk management validating the applied parameters, models and scenarios. In addition, sufficient thought should be given to what appropriate stress-testing means for the respective AIF and at which levels within the structure liquidity risks arise. As an example, a closed-ended PE fund investing in a single company is likely to require less extensive and sophisticated stress-testing than an open-ended RE fund investing in a large, internationally diversified portfolio including various property types at different stages in their lifecycle. Also, when stressing the liquidity of an AIF, to the extent feasible based on available data, scenarios used should be comprehensive and should take into account knock-on and feedback effects throughout the entire structure, starting from the asset level.
Overall, requirements on and implications of establishing AIFMD-compliant risk management are manifold and complex. Applicant AIFMs are thus advised to reflect on their business model and intended organisational structure before setting up the function and framework. AIFMs should spend thorough thought on the composition of their senior management and board, including the allocation of responsibilities for the oversight of operational and control functions, and the extent to which they might benefit from the proportionality principle. In addition, AIFMs may consider outsourcing part or all of the risk management operations. With this regard, several options, including the outsourcing of more ‘mechanical’ tasks, such as data collection and report writing are currently discussed within the alternative investment industry.
Kai Braun is an executive director and leader in Luxembourg Alternatives Advisory, and Désirée Springmann is a manager in Advisory Services, at Ernst & Young Luxembourg