AIFMs & their Risk Management Framework

In the aftermath of the global financial crisis in 2008 and the European debt crisis that followed, the Alternative Investment Fund Manager Directive (AIFMD) Law was introduced by the European Commission in 2013. The primary aim of the European Commission and the national competent authorities (NCAs) was to ensure investor protection and transparency in the asset management industry. This continues to be the aim today and as the investment fund sector across Europe and in jurisdictions like Cyprus is growing steadily, CySEC and NCAs in other member states adopted the AIFMD, aiming to enhance their legal and regulatory framework.

Within the AIFMD law 2013, a new era in risk management attitude and culture was introduced for the fund managers. Among others, the upgraded AIFMD Law required a functionally independent risk management function. The risk management function must establish specific safeguards and provisions for remuneration and conflicts of interest.

Within this commentary, SALVUS risk management specialists discuss the AIFMs risk management framework, including the

  1. separation of the risk management and portfolio management functions,
  2. creation of a robust risk management framework,
  3. upcoming regulatory framework and the Liquidity Stress Testing

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1. The separation of the risk management and portfolio management functions

One of the most notable requirements of the AIFMD law is that the AIFM must ensure that the risk management and portfolio management functions are independent of one another. This was a major change mostly for the fund managers managing real estate and private equity funds, as the risk management was performed, inter alia, by the portfolio management function.

To ensure the independence of the risk management function, specific safeguards must be in place. The AIFM is required to establish

  1. adequate provisions on the composition of the senior management and the board of directors.
  2. segregation of duties and responsibilities on the governance structure within the
    1. remuneration policy, which must follow the remuneration guidelines and contractual arrangements,
      1. for example, the remuneration for personnel in control functions must be separated from the employees in the operational units.
    2. conflicts of interest policy in order to identify, prevent, manage, and monitor all conflicts of interest may arise
      1. internally,
      2. between the managed AIFs, and/or
      3. between investors of the AIF.

Therefore, a precondition for a compliant Risk Management function for an AIFM, is to implement an organisational and governance structure in line with the above safeguards.

2. The creation of a robust risk management framework

In order to create an AIFMD compliant Risk Management function, the AIFM must have in place adequate risk management systems and procedures, including

  1. risk management policy, detailing the procedures in place, as well as,
  2. risk management tools, to identify and monitor all risks.

The AIFMD and its delegated regulation (Level 2) oblige an AIFM to identify, document, measure and monitor all risks relevant to each AIF’s investment strategy and with the adequate frequency. Additionally, the AIFM must ensure the risk profile of each AIF corresponds to the size, portfolio structure and investment strategies and objectives of the AIF, as per the prospectus and offering documents to the investors.

Setting up an effective Risk Management framework for each AIF

The AIFM is required to understand the meaning and implications of the respective risks for each individual AIF, including the market, credit, liquidity, counterparty, and operational risks.

Providing an example of market risk
– for a real estate fund, the risk may be defined along the lines of the investment market and the micro-location developments whereas,
– for a private equity fund investing in companies producing goods, the risk may relate to developments within target customer groups or competitor movements.

As a result, it is necessary for the AIFM to identify all risk categories and indicators that allow measuring (quantitative) of the respective risks, as well as, the qualitative risks which must be justified with objective reasons. Those risks may arise

  • at the level of the AIF,
  • at the level of the asset itself, and/or
  • at the level of the AIFM.

The establishment of a sound liquidity management and stress testing exercises are necessary for the creation of an AIFMD compliant Risk Management function.

3. Upcoming regulatory framework for the Liquidity Stress Testing

The new ESMA regulatory framework for liquidity stress testing (LST) will take effect on the 30th of September 2020. In a previous commentary the team at SALVUS discussed

  • The objectives of the liquidity stress testing
  • Who is in the scope of the new guidelines,
  • The fund managers’ obligations,
  • The depositaries and NCA’s (and CySEC) obligations.

The liquidity stress testing (LST) framework shall be implemented by a fund manager with the aim of improving the operational capacity of the fund and its contingency planning during a liquidity crisis. In a nutshell, beyond ensuring compliance with the regulation, the LST implementation will be there to allow the fund manager to

  1. ensure that the fund is sufficiently liquid,
  2. manage fund liquidity in the best interests of the investors,
  3. to identify potential liquidity weaknesses of an investment strategy,
  4. perform risk monitoring and decision making.

In concluding, the AIFMs must ensure they have appropriate mechanisms and monitoring systems in place and an ongoing risk management monitoring program to be compliant. They must demonstrate to the investors and to the regulators that they implement sufficiently strong risk management processes.

SALVUS risk management specialists are at your disposal and can assist you in

  • Performing a gap-analysis of your current risk management framework,
  • Designing and implementing a risk management framework,
  • Drafting or updating your existing policies,
  • Reviewing, validating, and/or implementing your LST models and assumptions.

Talk to us. Do not hesitate to contact us if you require further information. We will be glad to support you in finding an appropriate solution or answering your questions.


Should you be interested to read about relevant topics on the funds sector, feel free to visit our earlier articles:

The information provided in this article is for general information purposes only. You should always seek professional advice suitable to your needs.

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