Prior to the global financial crisis (GFC), risk management and reporting commonly formed part of the investment management function, says Max Hilton (pictured) of Clarus Risk.
Where risk staff report in to the portfolio management team, there is a potential conflict of interest within the application of risk policy and, as a result, the effective implementation of risk management. In the ‘low volatility, high return environment’ prevalent prior to the GFC, weak risk management structures were not tested and the concerns resulting from a portfolio manager being the sole arbiter of risk and reward less appreciated.
Investor interests
Following the GFC, there was a reactionary demand from investors for greater transparency within alternative funds. This demand has continued to evolve along with a greater awareness of investor liability. This has been further reinforced, for institutional investors, by specific new regulatory requirements for insurance, wealth management and pension investors. Nowadays, it is not uncommon for an investor to make ongoing transparency of fund positions a condition to investment. Many alternative investment firms have operational and informational concerns around providing position-level transparency, and in turn can benefit from the development of an independent and credible risk management function. Finally, given the failures of risk management during the GFC, recent academic and industry research shows that evaluating fund risk solely on returns-based analysis such as the Sharpe ratio, and correlation with market indices, is insufficient at best and misleading at worst. As a result, due diligence demands are now significantly greater.
Regulatory requirements
While investor demands was the greater force for independent risk management in the aftermath of the GFC, in more recent years financial re-regulation has become the main driver. Drafting new legislation has required significant international coordination as well as consistency across differing financial services geographies, which explains why the Alternative Investment Fund Managers Directive (AIFMD), for example, has been slow to come into effect.
A fundamental requirement of the AIFMD includes a functional and hierarchal separation of investment management and risk management; and for the manager (the AIFM) to retain at least one of these functions. This separation represents a cultural issue for some alternative investment managers and an operational issue for some smaller managers. For AIFMs that delegate a function, it is important that they can demonstrate that they have the necessary expertise and resources to supervise the delegation and to retain the function for which they are responsible. Failure to do so puts the AIFM at risk of being deemed a ‘letterbox entity’.
The development of the AIFMD has presented Guernsey with an opportunity to offer alternative investment managers and funds the choice to either ‘opt in or out’. To date ‘opt in’ has relied on utilising the private placement rules of each European country to access their domestic markets, so far this has proved a viable and appealing option. ‘Opt out’ remains an option for managers and funds that are out of scope of the directive.
During 2015, the timetable for Guernsey AIFMs to use the AIFMD ‘passporting’ regime directly into member countries will become clearer. In July, ESMA is due to update on the timetable for third country AIFMs, such as Guernsey. It seems likely that this will place further scrutiny on substance and the need for physical presence tied to the investment management or risk management functions. In this regard, Guernsey is relatively well stocked with qualified and experienced financial services personnel, in particular within real estate and fund of fund asset classes. Furthermore, Guernsey’s proximity to European financial centres, in particular London, facilitates hierarchal and functional separation without compromising operational efficiency and communication.
Key considerations within risk management
Hierarchy and roles. The AIFMD requires that “persons engaged in the performance of the risk management function are not supervised by those responsible for the performance of the operating units, including the portfolio management function, of the AIFM”.
This is further reinforced by the functional requirement for the AIFM to ensure that risk measurement is based on “sound and reliable data”, i.e., an independent risk function, rather than the portfolio management team.
Within the risk function there is a distinction between the tasks associated with risk measurement and those which are risk management. Risk measurement is a highly technical discipline and for less liquid strategies (such as private equity real estate) or more sophisticated financial strategies (such as multi-strategy hedge funds) highly complex. The AIFMD requires a significant amount of risk data to be reported to national regulators and for many service providers and fund boards this is an entirely new experience.
Technology. A risk measurement function should provide an independent warehouse of positions and risk exposures, often sourced and aggregated from numerous counterparties. Technology also enables flexibility: to measure risk in a manner appropriate for the investment strategy; and, to monitor compliance with fund specific investment restrictions. Reporting must not only address the needs of the risk management function, which may be a committee or a single director, but also facilitate regulatory risk reporting demands.
Future trends in risk management
Over the last year there has been increased interest and attention of the demands of the AIFMD on less liquid asset classes such as private equity and securitisation assets. These asset classes are extremely challenging from a risk measurement perspective, but more conservative strategies and funds within these markets have recovered strongly and there is robust investor demand. Risk measurement for these asset classes is very much an emerging discipline.
We expect that there will continue to be growing specialisation within both risk management and risk measurement as financial regulation such as the AIFMD stipulates structure and reporting requirements. For third county AIFMs, risk management as a separate discipline will continue to evolve to meet regulatory and investor requirements and during 2015 there will be greater focus on the requirements of the AIFMD relating to personnel and risk systems as ESMA provides more detail on the AIFMD passport regime.
Max Hilton is the Managing Director of Clarus Risk.
An original version of this article was first published in Financier Worldwide, March 2015
