Building AIFMD risk structures in a Euro storm

In the run up to the introduction of the Alternative Investment Fund Manager Directive (AIFMD) over the next year, Europe’s hedge, private equity and real estate managers will have to start revolutionising their risk management. As financial markets have lurched from one crisis to the next – from sub-prime, to banking, to Eurozone – having a reliable risk management framework has hardly ever been so important.

The AIFMD requires most asset managers who were not previously regulated to create risk management functions that are independent of portfolio management. What’s more, it requires managers to review risk across their investment processes and to introduce risk controls accordingly.

Coming at a time when failure to resolve the Euro crisis over the past two years has led to a situation where drastic outcomes can no longer be ignored, a number of alternatives managers are planning their new risk management frameworks just as they also act to mitigate the risks of a Eurozone break up. Having a strong risk management framework is no longer simply a matter of regulatory compliance.

Revolution, not evolution

The final countdown to July 2013, when EU Member States must transpose AIFMD into national law, is happening against a background of deepening crisis. While few managers have started to make the directive’s required changes to risk management yet, they’ll have to start soon in order to meet the deadline of July 2014 for being fully compliant.

Unlike the evolution of risk management for UCITS funds, the AIFMD represents a revolution for the alternative investment sector, which previously faced no regulatory risk management requirements. Applying a broad set of risk management principles to all of the alternative investment asset classes, the AIFMD requires managers to totally re-evaluate how they control risk.

All managers impacted by AIFMD will have to describe the processes that they’ve put in place to identify, measure, manage and monitor all the risks to which the fund is materially exposed, or could be exposed, considering, at the minimum:

  • Market risk (including leverage)
  • Counterparty risk
  • Credit risk
  • Liquidity risk
  • Operational risk.

Simply transposing existing risk management approaches at portfolio level is not an option, partly due to the wide variety of asset classes involved (e.g. the Value at Risk approach is not relevant for private equity funds). AIFMD’s decrees mean that asset managers will have to build new risk management frameworks, through first defining their risk appetites and then conducting detailed risk profiling exercises. Also, and especially for non-traded instruments, they’ll have to analyse risk across the investment value chain (i.e. from sourcing to exit) in order to cover the full scope of risk exposures.

The Euro stress test

This introduction of new risk management systems for AIFMD is, coincidentally, happening against the background of the Eurozone crisis – arguably the most formidable stress test ever. As the focus of the crisis has shifted from Greece alone to the highly indebted Spanish banking sector and the Spanish sovereign itself, so the stakes are rising.

Recognising the fact that the consequences of one or several countries leaving the Eurozone could have devastating impacts on multiple levels, many organisations have decided to identify potential exposures and are moving to mitigate them.

We have identified a number of ways in which the Eurozone crisis could play out, depending on the mix of policy responses over the next year or two. We present four possible, though not necessarily exhaustive, scenarios below that represent a range of potential resolutions to the crisis in 2012:

  • Scenario 1: Successive phases of monetary and fiscal action hold the Eurozone together at the cost of inflation
  • Scenario 2: Voluntary defaults for highly-indebted sovereigns
  • Scenario 3: Greece exits the Eurozone and a firewall is built around other economies
  • Scenario 4: A new currency union is formed by the stronger economies.

Each scenario varies in its likelihood and impact. Whichever comes to pass, the Eurozone that emerges from the crisis is likely to be very different to the one we know today, with 2012 being dominated by uncertainty and high volatility. There is a wide range of potential outcomes.

Planning for a break-up

On top of setting up an appropriate risk management framework, covering the whole investment process as well as ongoing portfolio management, risk managers face the challenge of establishing stress testing programmes which could cope with a Eurozone break-up. Even though break-up scenarios would need to be modelled at portfolio level, their impact on the different key players in the value chain would also have to be reviewed. Risk managers would need to anticipate all potential material impacts, as well as the related damage-limitation decisions, in order to limit negative results as much as possible.

Four key players need to play a part in this exercise: the investment manager, the depositary/custodian (required under AIFMD), the management company/the board of directors and the fund administrator. Each of these actors will need to address critical questions. For example:

  • Investment manager:
    • Investment policies: Is the asset manager required to stick to an inflexible investment strategy or does it have some flexibility and opportunity to hedge/revise portfolio allocation?
    • Geographic allocation: What is the geographic allocation/concentration of the investments?
    • Liquidity risk: How would a break-up affect market liquidity? How would the fund meet investors’ redemption requests? How could the fund limit these risks?
  • Depositary/custodian:
    • Geographical location of investments: Are the investments for which the bank is liable located in countries that would be impacted by the Eurozone break-up?
    • Sub-custody network: Where are the sub-custodians located and how would they be affected by a Eurozone break-up? Could a break-up lead to losses for which the main custodian would be liable?
  • ManCo/board:
    • Delegation: What are the services that have been delegated by the ManCo / Board (e.g. transfer agency, fund accounting etc.) and how ready are the different actors for a potential Eurozone break-up?
    • Investment strategy: Will the previously defined investment strategy still meet Board members’/investors’ expectations?
  • Fund administrator:
    • Time management: If there were significant changes to the Eurozone (including all their related market impacts), would fund administrators be able to meet their tight deadlines for computing NAV? Would it be technically possible to compute the NAV?

More than just a regulatory requirement

As said earlier, AIFMD will require a large proportion of Europe’s asset management community to upgrade its risk management practices. But, beyond being an AIFMD requirement, this is a sensible reaction to the turmoil of recent years.

Considering the Euro’s uncertain fate, having a sound and reliable risk management framework appears no longer just a matter of regulatory compliance.