‘Risk Management? What’s that?'

PE Manager revisits some of its best guest articles of 2013: In October, with much confusion about what risk management under the AIFMD means for private equity funds, compliance specialists Elisa Perna (pic) and Joe Vittoria shared their thoughts.

Initially, AIFMD was not really on the radar of the private equity industry, which had been led to believe that this legislation would pass it by. After all, it was hardly designed with private equity in mind. However, AIFMD is now a reality, and most existing private equity management and advisory firms are using the one year transitional period to assess their options.

Compliance presents a serious challenge for the sector. One of the key aspects of AIFMD is that risk management is now as important to the regulators as portfolio management. But private equity firms typically do not face the sort of risks that the directive seeks to mitigate. The risk management function has a long history as a distinct activity in other areas of finance; however, it is still relatively unknown to private equity management teams. This is because many of the concepts traditionally employed in risk management elsewhere do not apply to the private equity model.

While listed equity long/short funds, for example, are familiar with the risk diversification benefits of a portfolio of perhaps 30-70 stocks, a typical private equity fund might hold a more focused portfolio of, for example, four to six companies. Another key principle for diversifying risk in listed equity portfolios is to spread exposure across different sectors, private equity funds very often specialize in investing in companies in the same or related sectors.

As such, there is understandably some confusion as to what risk management means for private equity funds. AIFMD recognizes that risk management for private equity is different from other asset classes. So what does risk management look like for the private equity industry? In order to conform, firms need to address:

Governance: Ensuring a functional and hierarchical separation of the risk management and portfolio management functions.

Risk profiling: Identifying and measuring the risk profile of the fund’s market, liquidity, leverage, credit risks, and the manager’s operational risks.

Risk process: Establishing risk management systems to identify, measure, manage and monitor the risks of each fund’s investment strategy.

Liquidity: Adopting an appropriate and stressed liquidity management process.
Leverage:Monitoring leverage levels and ensuring the manager calculates leverage according to AIFMD.

Due diligence documentation: Making sure that when investing, the due diligence process is adequate, documented, and regularly updated

The lack of a clear definition of how the above translates into the private equity sphere, or of what methodologies and tools exist, are problems that are being urgently reviewed by market participants. Nonetheless some of these areas will clearly pose a challenge for certain private equity players. Smaller firms may lack the resources to achieve functional separation between portfolio and risk management. Unless the firm can commit to a dedicated risk professional, designating the CFO as the risk officer is one option, as is delegating the responsibility to a regulated third party.

And whereas due diligence, valuation models and risk parameters are currently largely a matter of professional judgment for private equity companies, AIFMD requires they be formalized into a structure and documented for each and every deal. The emphasis on transparency will also mean making far more disclosures, qualitative and quantitative, which threatens to consume valuable internal resources.

All this means that service providers are expected to play a critical role in helping private equity firms achieve the AIFMD standard, whether this is by engaging risk consultants or more radical solutions such as delegating therisk management function. There is also the lesser known ‘hosted AIFM’ solution, whereby funds appoint a third-party to be the AIFM, which would then delegate the portfolio management back to the current manager who would not have to become an AIFM.

There are various options out of there for private equity firms. In the coming months this list of options will likely grow even larger, as service providers continue to innovate to adapt AIFMD to the particular demands of the industry. Managers would do well to keep their ear to the ground for developments. However time is passing, and for many in the market there is much to be done; whereas for many organizations AIFMD will involve updating and improving risk management systems, for private equity firms it will largely mean starting from scratch.

Elisa Perna is head of risk management at Cordium, a compliance consulting service provider. Joe Vittoria is head of Mirabella, a wholly owned Cordium subsidiary and regulatory hosting provider.