There are two things that every alternative investment fund (AIF) manager – whether EU-based or not – should know about risk management: it is central to achieving AIFMD compliance; and it must be kept independent of portfolio management.
The reality is that risk management is a critical pillar of AIFMD for a number of reasons. For one, the function is closely interconnected with other key functions such as valuation, reporting and operations and, as such, is a key component of ensuring the longer term sustainability and performance of the AIF and AIFM. The European Commission also hopes that stronger risk management will help to improve the stability of the sector overall while enhancing investor protection.
But the increased focus on risk management also reflects the increasing recognition that AIFs, in particular, are exposed to a wide range of risks including market risk, credit risk, business risk, counterparty risk and liquidity risk, just to name a few. AIFMD will, for instance, force the boards of AIFMs to define a risk appetite for each fund and put in place the appropriate mechanisms to measure these risks on a continual basis.
For some managers, one of the most difficult challenges related to AIFMD will be in ensuring – and demonstrating – that their risk management and portfolio management functions are independent of one another. So where, historically, fund managers have traditionally provided both portfolio and risk management services, much activity is now underway to separate and delegate one or the other of these functions.
This has created significant challenges for managers. Those based within the EU are understandably focused on structuring their governance in a way that not only demonstrates independence, but also shows that the board is getting the right management information to make the right decisions in order to properly manage the risks of the fund. The big question, however, is how to demonstrate independence without hiring a significant number of new risk managers (or one risk manager for each entity).
Equally understandably, non-EU managers are putting most of their effort in this area towards demonstrating that their risk management happens outside of the EU and, therefore, is outside of the scope of AIFMD.
AIFMs looking to design and implement a robust and high-quality risk management framework as part of AIFMD will need to first identify and qualify the risk landscape associated with each individual AIF (as different investment strategies will often lead to different risk profiles).
Next, they will need to define the qualitative and quantitative risk appetite for each fund. As part of this approach, the AIFMs will use risk reports and ‘dashboards’ to monitor and compare actual risk to the pre-established appetite.
And finally, AIFMs will need to structure the appropriate mechanisms and monitoring systems as part of an ongoing risk management approach as a way of demonstrating that they have implemented sufficiently strong risk management processes.
The biggest take-away about risk management for AIFMD, however, is that it is not simply a ‘tick-box’ exercise. Indeed, if the activities, processes and governance that support your risk management policy don’t come together and actively work on a day-to-day basis for your organization, then the entire exercise is largely pointless.
And the time is now, as the risk management framework must be in place when applying for authorization.
By Sven Muehlenbrock, KPMG in Luxembourg