In response to the 2008 credit crisis, the EU pursued a successful initiative to regulate alternative investment funds (AIFs) registered, managed, or marketed within its borders. The aim of supervisory measures adopted was twofold: avert a repetition of the destabilising effect the sector had on the global financial system, and strengthen the level of investor protection. The body of documentation supporting this new supervisory framework is extensive, as is also the breadth and depth to which it goes, often breaking new ground (e.g. on remuneration practices of AIF Managers (AIFMs), or the duties of Depositaries).
In this brief article we focus solely on a particular aspect of investor protection, namely, AIFM governance requirements1. We begin with an overview of regulatory provisions and then proceed to express a view on their sufficiency. We conclude with practical steps AIF sponsors might adopt to maximise the value added by participants in the AIF’s governance.
AIFM Governance Requirements
EU Regulation 213/2013 specifies in detail the obligations of AIFMs to apply high standards of diligence in the selection and monitoring of investments, act honestly, fairly, and with due skill, employ sufficient and competent personnel, manage and disclose conflicts of interest, etc. In terms of governance provisions, worth highlighting are:
1. Definition of Risks to be Managed
The AIFM is required to operate a risk management framework covering each separate AIF it manages. A key component of this framework is the setting of limits covering the following risk types: market, credit, liquidity, counterparty, and operational. At first sight this may not sound as much, until one realises that it took the financial industry the best part of 30 years (starting with Basel I in 1988)to arrive at common definitions and boundaries between risk types and produce a taxonomy of sub- types within each category.
2. Duties of the Depositary
Without doubt a key pillar of the new supervisory framework is the spelling out of the duties of the Depositary which extend beyond traditional custody and safekeeping of AIF assets to cover also regular monitoring of its cash flows, as well as oversight of the transfer agency, fund administration, and accounting functions, including NAV calculation. Furthermore, the Depositary needs to be independent from both the AIFM and prime brokers acting as counterparties to the AIF.
3. The Three Lines of Defence
In line with regulatory best practice, the primary responsibility for designing and implementing risk management and internal control procedures rests with line management and staff. Permanent risk and compliance functions, independent from line staff need to be in place to act as a second line of defence, with internal audit serving as a third one. The AIFM’s Board of Directors is also required to review reports prepared by these three control functions.
How Robust is the New Framework?
The definition of an AIF under the new rules was deliberately drafted in such a way as to capture virtually all non-UCITS funds. Merely bringing the sector under the purview of regulators can act as a deterrent against excessive risk taking, being entangled in conflict of interest situations, or plain fraud. The same can be said of the scrutiny imposed by regulations through the work of control functions, the obligations imposed on the governing body, as well as onsite examinations by supervisors. Of course deterrence does not equate complete eradication of all such incidents though one could argue that their frequency, duration, and magnitude will on average over a full economic cycle be reduced compared to the past.
Extracting Value from Governance Participants
At the risk of stating the obvious a governance framework is only as good as the people operating it. For this reason, AIF sponsors are well-advised not to neglect to carry out so-called operational due diligence on shortlisted AIFMs and Depositaries. Besides requesting sight of credentials they should make a point of meeting in person the heads of AIFM control functions (risk, compliance, and internal audit), fund administration, as well as Board members. Things to look out for include:
- fielding of the necessary skillset to effectively carry out the job at hand
- an independent spirit not shying away from challenging management
- a genuinely risk-based method of work rather than a box-ticking one.
Prior to its introduction, AIF regulation was greeted with scepticism by the industry on account of associated compliance costs. Four years on, while no consensus has emerged amongst industry participants it seems that investors have voted with their feet, as testified by the steady annual growth in both the number of EU AIFs and the value of assets under management which reached 28,327 and €5,7 trillion at the end of June 2017. The perceived increased level of investor protection has certainly played a part in this success.
Author: Mr. Kypros Georgakis, Manager Funds Unit, Amicorp (Cyprus) Ltd
Mr. Kypros Georgakis is a Manager at Amicorp (Cyprus) Ltd assisting clients with licensing and operation of regulated funds. He has over 25 years financial industry experience including investment management of a €0,5 billion multi-asset portfolio, financial control, risk management, and internal audit. He holds an MSc in Theoretical Physics from Imperial College, and is a Chartered Accountant and CFA Charter holder.