AIFMD Implementation Challenges: Part 2
Since the Alternative Investment Fund Managers Directive (AIFMD) (2011/61/EC) went into effect on 21st July 2011, Alternative Investment Fund Managers (AIFMs) (i.e. hedge funds, private equity funds, real estate funds, and institutional funds) have faced a number of significant operational AIFMD implementation challenges.
Risk Management
Under the AIFMD, AIFMs are required to functionally and hierarchically separate the risk management function from operational units (including any Portfolio Management Function (PMF)), in order to ensure independent performance of risk management activities.[1] AIFMs must put in place specific safeguards against conflicts of interest[2], and ensure adequate risk management systems to appropriately identify, measure, manage, and monitor all risks to which each Alternative Investment Fund (AIF) is exposed (including investment strategy). The new AIFMD risk management system must establish, implement, and maintain:
(1) a permanent risk management function (RMF);
(2) an adequate and documented Risk Management Policy (RMP)[3]; and
(3) quantitative or qualitative risk limits[4] (or both) for each managed AIF (taking into account all relevant risks, AIF strategies and assets employed, and national AIF rules).
AIFMs must also adopt adequate and effective arrangements, processes, and techniques to identify, measure, manage, and monitor risks to which managed AIFs are or might be exposed, including periodic back-testing, periodic stress testing, and scenario analyses relating to adverse market risks. These risk management systems must be assessed, monitored, and periodically (at least once a year) reviewed, in order to review the degree of AIFM RMP compliance and to ensure the adequacy and effectiveness of:
(1) the RMP;
(2) the performance of the RMF;
(3) measures taken to address risk management deficiencies; and
(4) measures aiming to ensure functional and hierarchical separation.
Liquidity Management
In order to address liquidity concerns, AIFMs must employ an appropriate Liquidity Management System (LMS) for each managed AIF, and must also adopt procedures that allow AIFMs to monitor AIF liquidity risk, and to ensure that the liquidity profile of an AIF’s investments complies with the AIF’s underlying obligations.[5] AIFMs are also required to ensure that the investment strategy, liquidity profile, and redemption policy of each managed AIF are consistent[6], and must conduct regular stress testing (under normal and exceptional liquidity conditions) in order to assess and monitor AIF liquidity risk. The LMF should at a minimum ensure that the AIFM:
(1) maintains AIF liquidity at a level appropriate to underlying obligations[7];
(2) monitors the liquidity profile of the AIF’s portfolio of assets[8];
(3) implements and maintains appropriate liquidity measurements arrangements and procedures to assess quantitative and qualitative risks of positions, in order to enable their effects on the overall liquidity profile to be appropriately measured[9]; and
(4) considers and puts into effect tools and arrangements[10] (including special arrangements[11]) necessary to manage the liquidity risk of each managed AIF under normal and exceptional circumstances.
Whilst this provides a high-level overview of the new AIFMD risk management and liquidity management operational requirements, there are more detailed requirements stipulated in the AIFMD Delegated Regulation (No 231/2013). AIFMDs will likely find it highly challenging to implement proportional and cost-effective risk and liquidity management systems that can effectively address the new and stringent AIFMD requirements.
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AIFMD IV Reporting
[1] AIFMs must ensure that: (1) RMF employees are not supervised by those responsible for operating unit performance (operating units include PMF); (2) RMF employees are not engaged in the performance of operating unit activities; (3) RMF employees are compensated in accordance with achieving RMF objectives, and (4) RMF senior officer remuneration is directly overseen by the remuneration committee (where such a committee has been established).
[2] These should ensure that: (1) RMF decisions are based on reliable data and subject to an appropriate degree of control; (2) RMF remuneration reflects RMF objectives (independently of the performance of business areas in which they are engaged); (3) RMF is subject to appropriate independent review (with independent decisions); (4) RMF is represented by a governing body (or supervisory function); and (5) any conflicting duties are properly segregated.
[3] This should identify all relevant risks to which managed AIFs are or may be exposed.
[4] Risk limits must at a minimum cover: (1) market risks; (2) credit risks; (3) liquidity risks; (4) counterparty risks; and (5) operational risks.
[5] This applies to each managed AIF that is not an unleveraged closed-ended AIF.
[6] These are consistent and aligned when AIF investors are able to redeem their investments in a manner that is consistent with the fair treatment of all AIF investors, in accordance with the AIF’s redemption policy and its obligations.
[7] This should be based on an assessment of relative liquidity of AIF assets in the market, their sensitivity to other market risks or factors, and taking into account liquidation timeframes and liquidation prices or values.
[8] The AIFM should have regard to: (1) the marginal contribution of individual assets which may have a material impact on liquidity; (2) material liabilities and commitments (contingent or otherwise) an AIF may have in relation to underlying obligations; and (3) the AIF’s investor base profile (i.e., type of investors, relative size of investments, redemption terms).
[9] This also includes intended investments which have a material impact on the liquidity profile of the portfolio of the AIF’s assets.
[10] For example, gates, temporary borrowings, or partial redemptions.
[11] For example, side pockets, gates, or other similar arrangements.