One of the many requirements found in the EU Alternative Investment Fund Managers Directive, which took effect in July, is for GPs to create a dedicated risk management team that is “functionally and hierarchically” separate from the portfolio management team. Not exactly an easy achievement.
That’s because the partners leading the deal are arguably best placed to identify and report on its risks. Nonetheless EU regulators see a conflict of interest when the people who are responsible for investing dollars, and stand to benefit when certain investments pay off, are also calling the shots on managing the portfolio’s risk.
So with the directive now in effect, how have GPs gone about creating this new risk unit? The answer to that question could serve as a blueprint for other managers planning to embark on the AIFMD-authorization process. It also allows GPs to compare how their peers are trying to meet what’s proven to be one of the directive’s more confusing requirements.
One of the first challenges here, market sources tell pfm, is finding a senior enough person in the firm to lead the risk management operation – someone who has enough stature to challenge dealmakers when they feel too much risk is being absorbed.
“They cannot be viewed as having no teeth or being significantly under control of the portfolio management,” says Jake Green, senior associate in the regulatory team at law firm Ashurst.
Some firms wonder if that means necessarily appointing someone with partnership status at the firm, and if so, how to go about finding that person, adds Elisa Perna, global head of risk at compliance consultancy Cordium. That’s mostly because GPs typically have “partners as the governing body of the AIFM and they are involved in portfolio management,” she explains. “They make the investment decisions and have discretion over these decisions.”
Market sources say the chief financial officer can be the best candidate for the role – after tweaking some of his or her responsibilities. “We are giving the CFO veto power on investment decisions because you have to prove this function has bite,” says one UK-based lower mid-market CFO.
Another firm says the responsibility was given to its chief executive, which worked because his focus was on investor relations and not dealmaking.
“He used to sit on the investment committee but won’t any longer for future funds,” said the firm’s CFO, who said the group’s financial controller and chief compliance officer will sit alongside the CEO on the newly-created risk management board.
At HarbourVest, a Boston-based fund of funds, the firm’s managing director George Anson took on the risk management role. But appointing a senior partner to the role comes with risk: you might fall foul of the directive’s rules on pay.
The directive states that those performing the risk management function must be paid in a way that isn’t tied to performance – a problem then for senior partners allocated carry dollars who take on a risk monitoring role. The aforementioned UK-based firm got around this because its chief executive is paid a fixed amount, with any variable amounts linked to his performance on fundraising, and not on the success of the portfolio. “I think this is a bigger issue at some funds because CFOs tend to have a participation in the carry; we didn’t have to grapple with that fortunately,” says the CFO.
But is it an absolute no-no for the risk officer to be allocated carried interest? Perna says their remuneration should be a fixed fee with any variable component tied to “the general success of the business, meaning its overall carry, but not directly to a particular fund.” (UK regulator the Financial Conduct Authority didn’t return a request for comment to clarify the matter.)
Other firms are tackling the challenge by setting up new committees to handle risk management decisions. Some even include dealmakers but are chaired by a member of the finance or compliance function, say legal sources.
Risk management committees have proven especially popular for larger firms. One reason for this in the UK is that preexisting regulations already required large asset managers to set up independent risk management functions, notes Nick Styman, head of compliance at real estate firm TIAA Henderson Real Estate.
TIAA Henderson uses a committee structure comprised of members from the compliance, legal and finance team who invite portfolio businesses to make presentations that can be used to identify bubbling risks; these are later reported to their colleagues.
No ‘one size fits all’ solution
Helpfully for smaller firms the AIFMD’s risk management requirements are subject to the principle of “proportionality”. This means firms with less staff and resources can disapply some of the requirements so long as that they can demonstrate the right safeguards are still in place.
“The UK is extremely au fait with exercising discretion based on proportionality,” says Green. “In the nature and scale of the business and to the extent you had an existing three man ship operating fine pre-AIFMD, you don’t need to reinvent the wheel and have seven all of a sudden – you might want a fourth doing a bit more risk management, but that is not a necessity.”
Another solution for smaller firms is to have a deal partner remove him or herself from the investment decision-making process and serve as the risk officer for that particular deal.
A source close to the FCA’s thinking on the matter said: “The FCA expects [the separation] to reflect the minimum requirements set out in the relevant technical standards, but a firm could chose not to adopt functional separation, although the FCA would expect it to explain how its alternative proposal meets the objectives in the regulation.”
GPs still baffled by the complexity of splitting the risk management and portfolio management functions also have the option of outsourcing the risk management entirely.
A host of service providers have set-up third-party AIFMs which will become the fund manager, to conduct all the back office work the directive requires, but which delegates the portfolio management responsibilities back to the GP.
Ultimately though, whatever path a GP takes to create a new risk management function, they need to be able to explain their thought process to regulators.
“We had two rounds of comments [from the FCA], they were quite formalistic and lengthy, about 20 detailed questions for the first round,” says HarbourVest’s head of compliance Nick du Cros. “The FCA wanted to really see us prove and explain things, especially around valuation, risk management, and leverage.”
What remains to be seen now is whether all this additional risk monitoring will translate into regulated funds becoming a safer bet for private fund investors.