Risk Management under AIFMD
The Alternative Investment Fund Manager (AIFM) Directive, in combination with the according national laws, introduces unprecedented requirements on risk management at the level of the AIFM and the alternative investment funds (AIFs) they manage. Areas to be addressed by risk management cover the constant monitoring of the risk profile of the AIF, including the level of leverage and the consistency of the fund’s risk profile with its investment strategy, the identification and monitoring of any conflicts of interests potentially causing damage to investors as well as the proper management of liquidity risk potentially affecting the AIF. To manage risks effectively, the AIFM is required to employ adequate risk management systems. These are not limited to the set-up of the risk management function and its related policies and procedures, but embrace further relevant elements of the AIFM’s organizational and governance structure, including provisions concerning remuneration, conflicts of interest and valuation. As such, risk management is not limited to actual risk management analytics, but has to be understood and set up as a crosssectional control function.
The context The alternative investment asset management industry is a highly competitive environment. Going forward, some categories of investors may grant a preference to the managers who are able to display the AIFM Directive “quality and transparency” label or at least to provide clear evidence that they have taken the necessary steps to comply with best practices standards. The AIFMs that used the requirements of the Directive to rethink the way they are organized and align their governance structure and risk management processes to the risk profile of their products will be the clear winners. This compliance exercise has proven to be an opportunity to streamline the risk management and control structures and to rethink the delegation arrangements. It is moreover an opportunity to produce internal control information that can be used as a marketing tool, for example, through implementation of Service Organizations Control (SOC) reporting. By implementing sound and well-documented risk management systems and procedures, emphasizing on quality and transparency, alternative asset managers will be able to maintain their investors’ trust and to benefit from first mover advantages, placing themselves among the leading edge of the industry.
The challenges For many alternative asset managers, meeting the organizational requirements as imposed by the AIFM Directive and the respective delegated regulation will be challenging since this will mean, inter alia, establishing, implementing and maintaining: • A documented organizational structure defining decision making procedures and reporting lines as well as allocating functions and responsibilities (including delegated tasks) • Adequate internal control mechanisms, with permanent compliance, internal audit and risk management functions, which will have to be functionally and hierarchically separated from other functions of the AIFM at least to the extent required when applying the principle of proportionality • Policies and procedures covering, inter alia, the areas of risk management, liquidity management, leverage, remuneration, conflict of interest and valuation • The necessary methodology, processes and tools to assess, measure and monitor risks, including the regular performance of stress tests and scenario analyses • Escalation, reporting and disclosure frameworks Compliance with the AIFM Directive is certain to cause increased administrative burden to alternative fund managers and thus higher costs to investors. It is therefore critical that AIFMs create additional value by employing efficient and coherent risk management processes and by providing meaningful and transparent risk reporting. Information concerning risk management provided to investors should give additional comfort and lower their due diligence cost. The respective reports should contain sufficient detail to facilitate decision making and allow investors to monitor compliance with their investment restrictions while investing in an AIF.
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Our approach We analyzed the implications on risk management provisions resulting from the AIFM Directive at the level of the AIFM and the AIF in detail. Based on this analysis, we have developed a five-step approach which addresses those requirements and provides for an efficient process. This approach takes into account the links to the overall organizational and governance structure as well as to related functions such as liquidity management and reporting. In addition, it embeds leading practices and provides a standardized methodology to set up and implement comprehensive cross-sectional risk management procedures. Risk management provisions have to be based on sound organizational and governance structures.
Permanent Risk Management function
Reporting to investors decide and ks RMS ris te tes to da
nd sa s 4 . M o n it o r r is k u lt re s r e p o rt c r i t i c a l
Remuneration Conflict of Interest Risk Management Liquidity Management Leverage Valuation
Reporting to the competent authorities
1. Re -/D efi for ris ne km ea a s
• Identification • Measurement • Monitoring and reporting
Risk profile
ch roa pp ment e ur
Policies & Procedure
Identification, measure-ment, monitoring and mitigation of risks
Reporting
2 an . G at her ag ris k em e nt i n p u t d at a
Roles & responsibilities Independence Delegation & oversight
Risk Management System & Process
5. M on itiga up
Governance & Organizational Structure
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Meaningful results generated by the risk management system are a precondition of a sound reporting process.
The five-step model helps you implement a state-of-the-art risk management that addresses the extensive requirements established by the AIFM Directive. We support you in updating your risk management policies, procedures and systems in line with leading practices and in accordance with the relevant legislation. The model entrenches assessment and monitoring tools to run, on an ongoing basis, risk management processes and stress tests. In addition, it contains meaningful reporting and disclosure frameworks that can easily be customized to your organization and the types of AIFs you manage. Before applying our model, we start with a high-level review (gap analysis), establishing which components of risk management required under the AIFM Directive are already in place and to which extent these need to be amended in order to achieve compliance. This step will also include an analysis of your existing risk management and related policies to ensure that your governance structure and risk management provisions (functional and hierarchical separation, allocation of responsibilities, escalation lines, etc.) are properly aligned. The review will allow us to identify gaps between your current situation and the requirements of the Directive, which will help us quantify the extent of efforts to be undertaken and tailor our services to your needs.
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Risk Management under AIFMD
Specific considerations for alternative investment fund asset classes Although the generic structure of the risk management framework will be substantially the same for all asset classes across the alternative investment fund sectors, there are, nevertheless, important differences between alternative asset classes and investment and financing strategies that will directly impact the practical approach (models) applied, the frequency, sources of information and tools used in the risk management process. Sometimes alternative funds (e.g., Infrastructure and development funds) combine the attributes of the different generic asset classes described below.
Hedge funds
Private equity
Real estate
In general, the objective of risk management is to identify and mitigate the financial impacts of macro and microeconomic changes on the investment strategy and portfolio’s assets. Unlike physical assets, hedge funds investments will be characterized by the following: • Centralized risk management process embedded in daily portfolio management activity • Multiple investment strategies crossgeography correlated with large assets under management (AuM), posing systemic risk concerns • Diverse leverage calculation methodologies cross-jurisdiction • The risk management activity may be independent of the financial and NAV reporting (i.e., active trading strategies may require intraday calculations) • Delegation of most key functions • Mix of liquid and illiquid assets • Potential mismatches between underlying assets and frequency of redemptions in stressed situations, use of liquidity management measures • Issues related to rehypothecation, collateral and its use, sub-custodians and prime brokers
In general, the key overall objective of the risk management process applicable to private equity is to guarantee the protection or enhancement of the earnings capacity of target assets and repositioning of investee companies over the lifecycle of the fund. Private equity investments can be characterized by the following qualities relevant to the risk management process: • Significant but infrequent cash flows relating to acquisitions and disposals • Generally, a limited number of complex assets following a particular investment strategy or geographic approach • Use of complex hybrid instruments to finance acquisitions • The underlying investments are unique corporate assets, generally presenting very asset specific information, which is often qualitative in nature • Focus on earning capacity data to measure and monitor market risk • The risk management activity tends to follow the cycle of the financial and NAV reporting
In general, key overall objectives of the risk management process applicable to real estate are to guarantee the stability of income generated from real estate assets and protect the long term asset value. Real estate investments can be characterized by the following qualities, relevant to the risk management process: • Significant cash flows circulating in the fund structure over the life of the fund • A limited number of assets spread over several geographies • A limited number of moderately complex transactions • Generally simple financing structures secured by real estate assets • The use of asset specific data, such as tenancy schedules, yields and lease information as well as other contractual arrangements to measure and monitor market risk • The risk management activity tends to follow the cycle of the financial and NAV reporting
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Implementing a risk management system Our risk management service model represents a practical process adapted to the various needs of AIFMs which, in today’s challenging regulatory and business environment, require robust and pragmatic solutions.
The risk management framework comprises three major elements:
Onboarding Define Risk Profile of the AIF
Acceptance of the AIF by the AIFM
Assessment of material risks of the AIF
Evaluate impact on AIFM strategy
Definition of risks limits
Assessment of risks to the AIFM Evaluate AIFM competencies Identify conflicts of interest
1. “Onboarding”; this is the accommodation of a new fund into the manager’s overall risk management platform and strategy
The risk management process will be substantially driven by the risk profile and specificities of the asset class managed in the fund.
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4.1. Define/implement risk monitoring model 4.2. Compile report and analyze results 4.3 Report/escalate according to defined processes 4.4. Propose/consult on mitigating action
5. M on itiga up
decide and s k RMS ris te tes to da
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3. The risk management process; this is the recurring cycle for the identification, measurement, monitoring and reporting of risks, including the following activities: • Re-evaluation of models to measure risk • Gather relevant risk input data • Analyze and consolidate data • Measure risks and compare against risk limits • Escalate results, if necessary, and report to stakeholders
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5 5.1. Execute mitigating action 5.2. Draw conclusions from risk reporting results and decide on risk management system (RMS) amendments
1. Re -/D efi for ris ne km ea a s
ch roa pp ment e ur
2. The review and adaptation, if necessary, of: • The existing governance framework • The organization of the risk management function • The development of specific risk policies to match the profile of the AIF
Risk profile
2 an . G at her ag ris k em e nt i n p u t d at a
At EY we have developed a simple and practical framework to operate risk management activities for alternative funds. This can be applied at a high level to meet the requirements of the AIFM Directive.
• Identification • Measurement • Monitoring and reporting
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3.A n al ze a n d y co n s o li d ate d at a
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1.1. Re-/Define the approach for measuring risks and establishing risk limits 1.2. Define risk monitoring and re-assessment frequency 1.3. Define triggering events to launch escalation process
2.1. Determine necessary information 2.2. Identify information owners and sources 2.3. Set up instructions and templates 2.4. Establish communication protocols
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3.1. Check quality of input data 3.2. Consolidate gathered data
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Align governance structure and policies of the manager Aligning governance structure
Risk management policies
Assign roles and responsibilities
Risk Management policy
Interaction with compliance and Internal Audit
Remuneration policy
Set up delegation and oversight structure
Conflict of interest policy
Investment approval process
Valuation policy
Management independence
Escalation procedures
IT tools and systems
Due diligence procedures
Risk Management under AIFMD
Steps 1 and 2
Subsequently, in steps one and two, we support you in identifying and assessing key risks relevant at the level of the AIFs and the AIFM as well as defining information requirements and formalizing communication between relevant internal and external information providers. At the level of the AIFM and the AIF, risks may be relevant that are difficult to quantify with certainty or to limit adequately. Together with you we define qualitative and quantitative metrics to measure those risks. Simultaneously, we ensure that the defined risk limits are aligned with and properly reflect the risk profile of the concerned AIFs. This step will mainly be conducted through workshops, facilitated by our respective tools and enablers. Key risks to be monitored as per the delegated regulation will include market risks, liquidity risks, credit risks, counterparty risks and operational risks. We are able to support you in implementing processes, systems and measurement techniques for each of these risk categories.
Steps 3 and 4
In steps three and four, we will assist you in defining processes to perform checks on the input data needed for your risk management system and consolidating the data efficiently to allow a meaningful measurement and monitoring of risks. Accordingly, step four will embrace the set-up and implementation of a customized risk monitoring tool which contains all relevant information and provides a comprehensive overview of the limit status and current risk profile of the respective AIF. The tool will further indicate anomalies (limit breaches/critical situations), help you define mitigating action and facilitate reporting and escalation.
Step 5
The result of steps one and two is a comprehensive system of key risk indicators and adequate risk limits that provides you with an overview of your AIFs’ risk profile and allows you to monitor and manage your risks efficiently.
In step five we will assist you in defining formalized processes to take mitigating action in case of limit breaches or other critical events and help you identify events that would require an amendment of the risk management system. In this step, we can also perform a high-level review of your respective external reporting processes and formats to assess compliance with the Directive, should you want us to do so.
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Our services to support you Our service model represents a practical process adapted to the various needs of AIFM wanting a robust but pragmatic approach in today’s challenging business environment. 1. Risk strategy of the AIFM
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Identification of material risks to the AIFM
Assessment of risk profile
2. Risk profile of the AIF
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3. Governance structure and policies
Assessment of material risks to the AIF
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Definition of risk limits
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Definition of risk metrics
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4. Risk management process
Guiding principles Governance structure • Roles and responsibilities • Independence • Delegation and oversight
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Remuneration policy
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Conflict of interest policy (identification, measures to manage them and circumstances of disclosure)
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Business strategy
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Valuation policy
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Risk policy maintenance procedures (distribution, review, frequency and approval)
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Aligning risk management framework with risk profile
Ongoing risk assessment and measurement • Risk identification frequency/trigger events • Risk measurement methodology, modeling and stress testing
5. Reporting and remediation
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Escalation procedures and follow-up of remediation measures
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Terms, content and frequency of reporting to BoD and senior management
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Reporting material changes of the risk management processess to the competent authorities
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Offering documents disclosures
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Update of annual disclosures framework to investors
Ongoing risk monitoring Monitoring tools, frequency and owners
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Risk management policy Our approach addresses the extensive requirements for appropriate and modern risk management as established by the AIFM Directive. We support you in updating your risk management processes and systems in line with results from recent research and in compliance with the relevant legislation. We start with an initial strategic review (QuickScan). This is a high level but insightful diagnostic which allows us to identify the gaps between your current situation and the requirements of the Directive, and the effort in reaching the desired outcome. In phases one and two we identify and assess the key risks at your level and at the level of the funds you manage. On the level of the AIF and the AIFM, risks may be relevant that cannot be quantified with certainty or limited adequately (e.g., market risk, counterparty risk). Together with you we will define qualitative and
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quantitative metrics to measure those risks and ensure the alignment of the risk profile of the AIFs and their business model with your risk limits and appetite. This step will mainly be conducted through workshops. The result of phases one and two is a comprehensive system of key risk indicators and adequate risk limits that provides you with an overview of your risk profile and allows you to monitor and manage your risks efficiently. Phase three consists of an objective review and analysis of the governance structure and policies. We will help you write your governance guidelines and structure and your remuneration, conflict of interests, valuation and investment policy. We could furthermore assist you in documenting your risk maintenance procedures. In phase four we analyze the alignment of the risk profile of the funds you manage with your risk framework. We focus on
Risk Management under AIFMD
the analysis of the scoring tools and mathematical models to assess and measure risks and build stress testing scenarios. We evaluate their capability to produce meaningful information for your stakeholders. EY has developed its own mathematical models for the AIF industry. These tools can be customized to your organization or used as a comparative while evaluating the features and information provided by the models already in place in your organization. In phase five we look through your lines of escalation and analyze your current risk reporting framework, adapting it to the requirements of the Directive. In parallel we can adapt your reporting framework to a SOC report, which is an examination of your description of the system(s) you operate on behalf of your funds and are relevant to their internal control process.
Leverage
In the context of liquidity management, apart from integrating its key aspects into your risk management system, we can help you design your policies, procedures and processes so as to link liquidity and risk management and ensure frictionless reporting and escalation lines. We can further advise you in defining suitable stress-testing methodologies and techniques to be applied and support you in either creating adequate cash-flow models or amending your existing models for the purpose of stress-testing and scenario analysis. The calculation and monitoring of leverage is closely related to liquidity management. We can provide advice on how to interpret and apply the respective requirements established by the AIFM Directive and its delegated regulation. We can further help you set up calculation models as well as design and implement state-of-the-art leverage reporting processes and formats.
Operation and reporting
How EY can help
Liquidity management
Although implementing a practical and comprehensive risk management that is in line with the requirements of the Directive will constitute the major effort for AIFMs in this regard, running the systems and processes will still require substantial time and resources. Moreover, an effective risk management will also depend on the quality of the interfaces with related functions and the integration of associated tasks. Anticipating these factors, we have designed specific service solutions that will help you set up related operations and establish effective links with the risk management function:
Apart from supporting you during the integration of related functions into your risk management framework, we can help you perform your day-today risk management tasks, thus reducing your operational burden. Our support can cover gathering information required for the risk management and limit systems from the various internal and external providers, verifying data inputs and processing of your data, linking it to your risk limit system. We can further generate the required internal and external risk management reports as well as support you with regard to required regulatory reporting.
The benefit to you EY Luxembourg has made the alternative investment industry its priority for many years. Accordingly, we recognized the impact of the AIFM Directive early and were among the pioneers developing AIFMD-related service solutions, assisting our clients in addressing the upcoming changes. As a result, our clients can benefit from our extensive experience and market insight gained in numerous AIFMD-related projects. Our model will help you implement a lean but comprehensive risk management framework, taking into account the extent to which the Directive’s requirements need to be met considering proportionality, and thus keep compliance costs at an efficient level. Risk management tools and templates already developed by us are flexible and can easily be customized to your specific needs. This will facilitate your implementation process. Our rich portfolio of solutions relating to various aspects covered by the AIFM Directive will further allow us to provide a complete service package, also covering areas such as liquidity management, stress-testing, leverage calculation and reporting, should you want us to do so.
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Our related thought leadership EY has published a number of thought leadership materials related to this topic that are available on our website or from one of our representatives. We plan to include this topic in our EY Alternative Investment Fund (AIF) Club events in the near future.
Investment Funds in Luxembourg - A technical guide, September 2014
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The Luxembourg Financial Connection, September 2014
Valuation on the radar, March 2014
Risk Management under AIFMD
An American in AIFMD land, April 2014
Contacts Kai Braun Executive Director, Luxembourg Alternatives Advisory Leader +352 42 124 8800
[email protected] Michael Hornsby Partner, EMEIA Real Estate Funds Leader +352 42 124 8310
[email protected] Désirée Springmann Manager, Luxembourg Alternatives Advisory +352 42 124 8025
[email protected]
EY | Assurance | Tax | Transactions | Advisory About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com. © 2014 EYGM Limited All Rights Reserved. ED none This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax, or other professional advice. Please refer to your advisors for specific advice.
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