DCG Luxembourg managing director Daniela Klasén-Martin (pictured) says the new risk management requirements introduced by this year’s revision of the grand duchy’s SIF law are only the start for asset managers that fall within the scope of the EU’s AIFM Directive…
On March 26 Luxembourg’s parliament passed legislation amending the Specialised Investment Funds Law of February 13, 2007. Among other changes, the new law has introduced the requirement to develop and implement a risk management process and a conflict of interest policy, pre-empting some of the requirements that are further set out within the Alternative Investment Fund Managers Directive.
The SIF revision legislation came into force on April 1. Luxembourg’s regulator, the Commission de Surveillance du Secteur Financier, clarified the risk management requirements in a press release of April 20, followed by regulation 12-01 published on August 13.
What are the regulation’s main requirements regarding risk management?
Under the new rules, all existing SIFs had until June 30 to communicate to the CSSF a description of the systems implemented to identify, measure, monitor and manage all the risks to which the SIF could be materially exposed.
This description covers, among other things, the risk management function (including the allocation of responsibilities), its independence or specific measures implemented to avoid conflicts of interest and ultimately allowing independent execution of activities or procedures, processes and methods to appropriately measure and manage the risks arising from the investment strategies and the risk profile of the fund or its individual compartments.
The CSSF further clarifies in regulation 12-01 that the risk management function should be independent from the other operational units.
What has this meant in practice?
The extent to which this exercise has been challenging for asset managers depends on the size of their operations and on the existence (or otherwise) of risk management processes and procedures and the availability of internal resources to document these procedures.
Lawyers and consultants have been busy supporting their clients to write a description of their risk management process, and the Luxembourg fund industry association, ALFI, has produced guidelines to support asset managers in carrying out this exercise.
Putting aside the effort that asset managers have had to put into documenting their procedures and the associated costs, the main challenge is on one hand to ensure that appropriate resources are in place to maintain these procedures and processes and that limits are regularly reviewed and breaches escalated, and on the other to ensure that appropriate segregation of duties is applied to ensure that the risk management function is truly independent.
The latter remains an issue, in particular for smaller asset managers that do not have sufficient internal resources to ensure that the risk management function is a truly independent one.
What solutions are available?
Under the principle of proportionality, for smaller organisations it remains possible to appoint a member of the board of directors to wear the risk management hat. However, such a director must be truly independent and able to demonstrate the skills necessary to ensure proper oversight of the risk management process for the particular asset classes in which the portfolio invests.
Outsourcing is also an option, either to a specialist risk management service provider or to a third-party management company. The latter could be an interesting option to cover additional measures set out by the new law, such as the requirement for a regulated investment manager, or as a possible solution to comply with the AIFMD, if the asset manager expects to be in scope.
What does this bring to the industry?
The independent risk management function and the requirement to document the risk management process provide additional investor protection. Risk management is very much embedded in the fund’s investment management process, which makes it difficult for asset managers to consider independent and/or outsourced risk management as adding value.
However, it is important to stress that the real value of an independent risk management function, being responsible for developing a holistic risk management framework, is that it will not only oversee the financial risk associated with the investment process, but perform ongoing oversight of all material risks that the fund is exposed to, including operational risk and oversight of delegation of functions.
The independent risk management function will therefore play a role comprising co-ordination, analysis, issue management and escalation that can hardly be performed by a portfolio manager, whose main focus is the immediate risk linked to performance of the underlying assets.
Implications of AIFMD implementation
On August 24 the government laid before parliament draft legislation to transpose the AIFMD into Luxembourg law. SIFs that are within the scope of the directive will have to comply with its full rules, while those that are out of scope will continue to comply with the SIF law.
This means that the SIF will remain a highly attractive vehicle for the structuring of alternative investments in Europe, since asset managers that do not fall within the scope of the directive will continue to benefit from the ability to use a flexible but now more robust vehicle offering increased investor protection.
For those that are in scope, the SIF has the advantage of being a fully regulated product, incorporation most of the features that will be required under the AIFMD.
What additional challenges will the AIFMD bring?
For asset managers that are in scope of the AIFM Directive the challenge is more substantial, as additional requirements will be introduced. Whilst the SIF law and its regulations leave the content of the risk management process relatively flexible, the AIFMD requirements on risk are much more prescriptive, introducing monitoring of leverage limits and reporting to the regulator as well as enhanced investor disclosure.
The level of control is more demanding, since in addition to the independent risk management function, independent compliance and internal audit functions are also required. These additional requirements, which also include regulatory rules, can constitute a significant challenge for smaller asset managers.
The latter have available different solutions ranging from partial outsourcing to an experienced professional or full outsourcing to an AIFMD-compliant third-party management company.