The re-engineering of the risk management function under the Alternative Investment Fund Managers Directive (AIFMD) brings its share of challenges, especially in the case of real assets. With strong requirements but little concrete guidance, alternative investment fund managers are facing multiple implementation issues at each step of the risk management process. Innovative solutions and best practices are starting to emerge, one construction site at a time.
The re-engineering of the risk management function under the Alternative Investment Fund Managers Directive (AIFMD) brings its share of challenges, especially in the case of real assets. With strong requirements but little concrete guidance, alternative investment fund managers are facing multiple implementation issues at each step of the risk management process. Innovative solutions and best practices are starting to emerge, one construction site at a time.
Risk management oversight in the context of AIFMD is complex because of the very nature of the asset classes and strategies it aims to regulate. This is particularly true for illiquid and real assets such as private equity, real estate, infrastructure and securitisation. A one-size-fits-all approach fails to capture the specific characteristics of these asset classes, while there is a definite lack of principles and guidelines for a concrete implementation.
So, where to start? AIFMD is rather clear in its fundamental requirements. Alternative investment fund managers have to set up an independent and permanent risk management function. The risk profile of each underlying manger has to be precisely assessed and monitored.
In the absence of definitive guidelines, shortcuts and misunderstandings are common. One of them is linked to the regulatory filing of the AIFMD Annex IV Report. This particular element has drawn the attention in the fund industry recently, not necessarily because of its novelty or relative complexity, but mainly because it represents one of the few well-defined requirements. However, this periodic filing, at best on a quarterly basis, can hardly cater for the permanent nature of the risk management function.
Another issue is the actual information available in the report, which will only provide limited insights on the actual risk profile of the alternative investment fund , and none when it comes to illiquid assets. This is essentially because the Annex IV report is at the crossroad of risk and compliance requirements.
The blurred line between compliance and risk is a recurring theme when it comes to real assets. This is often caused by the absence of specific risk measures, which are sometimes limited to investment policy compliance checks. While this is not advisable from a pure risk management perspective, it also raises a number of issues from a governance standpoint. In this respect, second level measures provide clear guidelines at Article 61(3(c)): the risk management function has to be distinct and separated from the compliance function.
This clearly implies that specific risk measures and reports will have to be implemented, in order for the risk manager to demonstrate ongoing, independent monitoring of the alternative investment fund. Of course the regulation provides a number of exceptions, especially for small structures where the proportionality principle should be applicable. While this provides useful flexibility to regroup compliance and risk under the same umbrella for practical and cost efficiency reasons, the principle of two distinct functional requirements remains clear.
As requirements are clarified, and common shortcuts and misunderstandings put aside, it is time to turn to concrete implementation solutions.
The first challenge is the independence of the risk management function. In the context of real assets, data is sparse and difficult to obtain. In practice, a significant part of the information will come from third parties and portfolio management, potentially under the form of already shaped reports. It is therefore key to identify and document the relationships between the various stakeholders including portfolio management, fund administration and custodian, to prevent conflicts of interests.
Potential solutions could also come from using dedicated technology, with innovative data-centric platforms to ensure that the different functions within the alternative investment fund manager can all access and share the same fundamental data for the various funds.
The second idea is that the risk management process of real assets is definitely more efficient when it evolves and follows the lifecycle of the investments. This implies that the risk manager of the alternative investment fund manager should enter into a round of discussions with the portfolio managers as soon as business plans or investment strategies are drafted, and prior to their approval.
The idea is that the risk manager of the alternative investment fund manager should be in the position to intervene before it is already too late, which in the context of illiquid assets sometimes means before the investments are committed. A typical control point would be to verify that the investment considered is in line with the policy and risk profile of the alternative investment fund.
After operational workflow and governance, the third pillar would be the risk measurement itself. The endless debate between qualitative and quantitative approaches seems rather pointless, as common sense dictates that both should be used in the most appropriate way. Illiquid and real assets as an asset class covers a wide variety of strategies, but they all share in common the fact that they are so-called cash-flow assets.
The pitfall is precisely to place too much attention on NAV. The standard risk management approach, as developed for UCITS, is anchored in a world where the price of the asset conveys the most useful information. It is important to keep in mind that NAV and price are two different things. Using NAV as a proxy for asset price requires a leap of faith. Illiquid and real assets are in turn better characterised by the statistical properties of their cash-flows, the uncertainty on their amount and their timing. Of course, this means that specific risk measures and risk frameworks are required to monitor cash-flow assets.
The risk management oversight in the context of AIFMD for illiquid and real assets requires a significant effort, at least for its initial set-up. With the right skills and technology, this does not necessarily translate into heavy costs. The benefits could go well beyond the simple compliance with the latest regulatory requirements. It could be the opportunity for many alternative investment fund managers to demonstrate a more robust and transparent process, with concrete structure and controls in place. This should be relevant to all investors, also because it will make their due diligence process more efficient and less expensive.
And if common sense is not enough, one can always count on other regulations affecting institutional investors, from Basel III to Solvency II, to be the definitive driver.
