The monitoring & delegation of the risk management function under AIFMD

The monitoring & delegation of the risk management function under AIFMD
Yves de Naurois
The 4th Annual Malta Fund Conference – AIFMD one year after
Malta, 19th September 2014

Copyright © Arkus Financial Services - 2014
Page 2
Content
►Is AIFMD really bringing something new to risk management function?
►Insourcing/Outsourcing: should RM or PM be outsourced? The various operating models – What we see in practice
►And what about illiquid assets?

Is AIFM really bringing something new to risk management function?
►1. The risk manager function under AIFMD
►2. AIFM Risk Reporting
►3. The risk manager responsibilities and liabilities – what are the practical consequences?
►4. How is independence from PM secured? Does independence mean no relationship?
►5. Practical challenges
►6. To conclude: What is new with AIFM for RM?

Page 4
1. The risk manager function under AIFMD
Organisation Requirements
►Personnel with the necessary skills, knowledge and expertise
►Includes a permanent risk management function
Functionally and hierarchically separate from operating units
►Safeguards against conflicts of interest Operational Conditions
►Risk Management standards/processes
►Due diligence conditions with respect to investment selection and on-going monitoring of investments
►Appropriate liquidity management system Transparency (Disclosure & Reporting)
►Reporting obligations to AIFM’s Competent Authorities
►Disclosure to investors
Either via prospectus or separately pre-investment
For each AIF managed by the AIFM and
For each AIF it markets in the EU

Page 5
1. The risk manager function under AIFMD
Risk Management Function
►Identifies measures, monitors and manages all relevant risks
►Provides regular updates to the governing body and senior management
►Functionally and hierarchically separate from operating units Risk Management Policy
►Documents the procedures, techniques and tools employed
►Takes into account nature scale & complexity Assessment and Review of Risk Systems
►Performs a periodical assessment of the policy, performance of the function
►Corrective action to be taken in case of specific deficiencies Risk Reporting
►To provide both on-going and ad-hoc risk reporting to management
►Reporting obligations to AIFM’s Competent Authorities
►Risk figures and stress tests to cover all risks including market and liquidity risk Risk Limits
►Quantitative and qualitative risk limits covering all relevant risks
►Limits to be aligned with the strategy, risk profile and risk appetite of the AIF

Page 6
2. AIFM Risk Reporting
AIF’S RISK PROFILING
AIFM RMP REVIEW/ DRAFTING
RISK MONITORING
RISK REPORTING
►Identification and formalization of all risks inherent to an AIF’s specific strategy by creating a risk hierarchy
►Provide guidance as to how to interpret proportionality
MODULE
CONTENT
OUTPUT
►Systematized scaling (probability and impact resulting in criticality score)
►Individual AIF risk profile summary
VALUE CHAIN OF REPORTING
►Draft/ review of existing Risk Management Policy (RMP)
►This include s documenting governance, key risks and KRIs, limits , monitoring and reporting
►Risk dashboard
►Liquidity risk and stress testing reports
►IRR at risk and stress testing
►AIFMD compliant RMP yet meaningful to a specific investment strategy based on a thorough understanding of illiquid assets investment process
►Based on key risks identified , to implement a practical risk management monitoring tool.
►Specific risk monitoring reports
►Individual risk management sheet
►Board packs risk report
►Regulatory risk reporting Annex 4
►Regular board reporting on risk; alert summaries etc.
►Prepare regulatory risk reporting compliant with AIFMD Annex 4 reporting template

Page 7
2. AIFM Risk Reporting - Overview
INTERNAL
IN CHARGE
RECIPIENTS
KEY DOCUMENTS
REFERENCE
Permanent Risk Management Function
Senior Management
AIFM Board
AIF Risk Profile
(including limits)
Internal risk reports (produced internally or with the help of a specialised service provider) to document the identification, measurement and management of all risks managed AIFS are or may be exposed to.
Documented due diligences
►Art. 15-16 AIFMD
►Art. 39 CDR
►Art. 44 CDR
►Art. 40 CDR
►Art. 47 CDR
AIFM RMP
►Art. 39 CDR
►Art. 45 CDR
►Art. 18 CDR
►Art. 19 CDR

Page 8
IN CHARGE
RECIPIENTS
KEY DOCUMENTS
REFERENCE
Permanent Risk Management Function
AIF Risk Profile
Annual Reports
►Art. 15
►Art. 23.4
►Art. 39 CDR
►Art. 23
AIF Prospectus (description of liquidity risk management - description of terms and timing of communication for special treatment of liquidity risk management, AIF Risk Profile, and the risk management systems of the AIFM)
►Art. 23
►Art. 108 CDR
AIFM
Investors
Management Report (overview of investment activity, performance of the AIF, any material change concerning information disclosed in the prospectus and not already present in the financial statements, principal risks of the AIF)
Regular reporting to investors*(% of the AIF’s assets subject to special treatment because of their illiquid nature - Any new provisions for managing the AIF’s liquidity - current risk profile of the AIF and risk management systems used by AIF or its management company - If the limits are exceeded, a description of the circumstances and remedial measures taken - Changes in risk management systems and anticipated impact on the AIF and the investors. For AIF using leverage, any change in the maximum level of leverage and the amount of leverage that the AIF used.) * To be included in the regular reporting to investors, as provided by the articles of incorporation of the AIF or in conjunction with the prospectus and at minimum when the annual report is available.
Investors
►Art. 22
►Art. 105 CDR
2. AIFM Risk Reporting - Overview
AIF RMP – Risk Management process and techniques
(any material change)
►Art. 16
►Art. 46 CDR
►Art. 41 CDR
►Art. 24
►Art. 110 CDR
►Art. 111 CDR
Annex IV (risk profile of the AIF with a focus on the market risk profile and liquidity risk - arrangements for managing liquidity - stress test results - RM system)
AIFM
Regulator
EXTERNAL

Page 9
2. AIFM Risk Reporting – Annex IV
301 fields to be filled in at AIFM and AIF level*
►Identification fields;
►Principal exposure and concentration;
►Risk figures;
►Main categories of asset used;
►Trading activities. * Some end of period/Some on an historical basis
Frequency Criteria
►Half yearly (if between threshold and € 1Bn);
►Quarterly (if AUM > € 1Bn);
►Quarterly if illiquid asset and AUM > € 500M;
►Yearly if non leveraged in non-listed company.

Page 10
2. AIFM Risk Reporting - Schematic flow
AIFM
CUSTODIAN
Data sourcing
PRIME BROKER
PORTFOLIO MANAGER
RISK DEPARTMENT
CENTRAL ADMIN.
REPORTING TOOL
REGULATOR
DATA MANAGEMENT
SENT TO REGULATOR
$
REFORMATING
ENRICHMENT
QUALITY CONTROLS

Page 11
2. AIFM Risk Reporting - Annex IV
1
2
3
4
5
6
7
8
9
Historical RP
Risk Profile of AIF
BLOCK
FIELD SPECTRUM
DESCRIPTION
DATA NEEDED
DATA SOURCE
APPLICABLE FOR NON-TRADABLE ASSETS
MODELLING
REQUIRED
137
IRR
Cash Flow Projections
Portfolio Manager
YES
(YES)
138 – 145
CS01/DV01/ Delta/Vega + repartition into buckets
Portfolio positions, yield curves/termsheets etc.
Admin/Broker
NO
YES
146 – 147, 302
VaR
Portfolio Positions (e.g. contract size,
strike price, maturity date etc.)
Admin
NO
YES
148 – 159
CCP/Regulated Market/Repos/Cash Collateral
Portfolio Positions+ related information on Counterparty
Admin
NO
NO
160 – 177
Counterparty (BIC codes etc.)
Portfolio Positions, (BIC of counterparties codes etc.)
Admin/Counterparty
NO
NO
178 – 217
Liquidity (Asset and Liability side)
Portfolio Positions + investor profiles
Admin/PM/GP
YES
NO
218
Total number of open positions
Portfolio Positions
Admin
NO
NO
279 – 280
Stress Tests
Portfolio Positions
Admin
YES
YES
294 – 295
Leverage
Portfolio Positions
Admin
NO
YES
TOTAL FIELDS CONCERNED:
28%
“To be efficient, it is necessary to integrate the requirements of necessary risk data to complete parts of the risk sections of Annex IV at the design stage”

Page 12
RISK MEASURE TYPE
RISK MEASURE VALUE
RISK MEASURE DESCRIPTION
Leverage - Sum of Notionals
136.47%
AIFMD Leverage still to be implemented - the shown value is the Gross Leverage - SON
IRR
12.0340%
Expected annual investment return/IRR in normal market conditions.
CS01
12548.25
Dollar change in the Portfolio NAV if credit spreads rise by 1 basis point.
Net CS01 value for bucket < 5 years
-5874.36
Dollar change in the Portfolio NAV if credit spreads of securities with maturity less than 5 years rise by 1 basis point.
Net CS01 value for bucket 5-15 years
-6673.89
Dollar change in the Portfolio NAV if credit spreads of securities with maturity between 5 and 15 years rise by 1 basis point.
Net CS01 value for bucket > 15 years
-
Dollar change in the Portfolio NAV if credit spreads of securities with maturity greater than 15 years rise by 1 basis point.
DV01
3.8236
Dollar change in the Portfolio NAV if yield curves rise by 1 basis point.
Net DV01 value for bucket < 5 years
0.4087
Dollar change in the Portfolio NAV if yield curves of securities with maturity less than 5 years rise by 1 basis point.
Net DV01 value for bucket 5-15 years
3.4149
Dollar change in the Portfolio NAV if yield curves of securities with maturity between 5 and 15 years rise by 1 basis point.
Net DV01 value for bucket > 15 years
-
Dollar change in the Portfolio NAV if yield curves of securities with maturity greater than 15 years rise by 1 basis point.
Net Equity Delta
- 1 234.41
Dollar change in Portfolio NAV if all equities rise by 1%.
Vega Exposure
- 226 62
Dollar change in portfolio NAV if the implied volatility of securIties rise by 1%.
Vega Exposure at markets 10% lower
-
The Vega exposure with market 10% lower.
Vega Exposure at markets 10% higher
-
The Vega exposure with market 10% higher.
Net Commodity Delta
-
Dollar change in portfolio NAV if commodity prices rise by 1%.
Net FX Delta
-
Dollar change in portfolio NAV if FX rates rise by 1%.
VaR
5.7500%
Threshold value such that the probability that the mark-to-market loss on the portfolio over the given time horizon exceeds this value is the given probability level.
VaR Calculation Method Code Type
CARLO
Scenarios are generated from a log-normal distribution and revaluing all positions in a portfolio for each trial
2. AIFM Risk Reporting - Annex IV example
E.g. Calculated using the Pricing algorithm suggested by ISDA
(input parameters: Floating leg, Fixed leg, rates, issuer information,, Maturity , Yield curves)
Using standard bond pricing methods (e.g. DCF) (input parameters: Maturity date, Coupon, Callabilty properties, information, Rating, Yield curves)
Obtained through a risk model
(input parameters: Model data, detailed position information)

Page 13
3. The risk manager responsibilities and liabilities – what are the practical consequences?
Need for adequate monitoring tools
Need for adequate support services

Page 14
4. How is independence from PM secured? Does independence mean no relationship?
No interdependence does not mean no relationship and RM needs to work closely with PM.
However RM is clearly a ‘second line of defence function’ under AIFMD with oversight responsibility – The idea is not to duplicate what PM does already.
“
”

Page 15
5. Practical challenges
AIFMD requirements
►Appoint a permanent risk management function functionally and hierarchically separated from the operating units;
►Formalize the risk management framework (including governance structure and policies);
►Implement robust risk management systems (techniques and tools);
►Ensure that the risks associated to each investment position of an AIF and its overall effect on the AIF’s portfolio can be properly identified, measured managed and monitored on an ongoing basis;
►Periodically, at least once a year, review their risk management system. Review the alignment of the investment strategy, liquidity and redemption policy;
►Implement stress tests (including investment ones) and disclose the results of the test to their competent authorities.
Practical challenges
►Document the independence of the risk management function when
Teams are small;
The risks are intrinsically linked to the investment and management of projects invested in and managed through a structured evaluation and fundamental analysis of each investment opportunity.
►Formalize and document the risk management framework
Formalize RMP, including AIFs risk profile;
Formalize tools to monitor relevant risks and stress test them in a meaningful and proportionate way.
►Report on risk management;
To the AIFM senior management and the board
To investors and the regulator.

Page 16
6. To conclude: What is new with AIFM for RM?
►Two essential and separate functions:
Portfolio Management
Risk Management
►Risk profile communicated to investors
►Detailed documented investment due diligence
►Detailed reporting prescription for regulatory consolidated market supervision

Insourcing/Outsourcing: should RM or PM be outsourced?
The various operating models – What we see in practice
►1. No one size fits all. Different models available
►2. Challenges and pitfalls when delegating the risk management function
►3. Insights from a practitioner

Page 18
1. No one size fits all. Different models available
MODEL 1
ALL DONE INTERNALLY
AIFM
$
AIFM
$
AIFM
$
MODEL 2
PARTIAL OUTSOURCING
MODEL 3
FULL DELEGATION OF PM OR RM
Risk monitoring support services
To discharge his/her duties the permanent RM function may rely on risk reports and risk data produced internally or externally.
Relies on
Delegates the permanent RM function

Page 19
2. Challenges and pitfalls when delegating the risk management function
►Challenges and pitfalls for the AIFM delegating the function:
AIFM still remains responsible => controls in place with KPIs in order to ensure not only initial due diligence but ongoing monitoring.
►Challenges and pitfalls for the delegate performing the function:
Access to data and information;
Communication with AIFM;
Communication with other CPs if in a position to be CP.

Page 20
3. Insights from a practitioner
Discussion
►…
►…
►…
?

And what about illiquid assets?
►1. Risk management for illiquid assets
►2. Particulars of the RMP
►3. How to monitor risks for illiquid assets? Is a quantitative approach feasible/desirable?

Page 22
1. Risk management for illiquid assets
How risk management differs for liquid and illiquid assets: in a nutshell
Liquid assets
►In funds investing in assets for which there is an organized market, the process focuses on:
The active management of the exposure
Principally through an ongoing measurement of the potential downside risk and related internal limits
Illiquid assets
►For funds investing in illiquid assets such as real estate and private equity, for which there are no organized market, the exposures cannot be readily decreased.
►For such funds the risk management process relies on:
Initial due diligence on investment;
Thorough risk mapping;
Monitoring of impact and frequencies internally but also access to external data;
Where the resulting criticalities pass over an internal acceptability threshold, further corrective actions need to be implemented.

Page 23
Operational risk mapping for a Management Company
THEME
EXAMPLE OF ASSOCIATED OPERATIONAL RISKS
Investment policy
-Non adherence to the documented strategy
-Non adherence to documented policies (market, dealing, operations)
-Style drift
-Contradictory documents (Prospectus vs. Marketing presentations
Management of operational risk
-Lack of pertinent and extensive data
Market risk
-Inadequate capture of data
-Data errors in valuation tools
-Failure to validate/review model
Counterparty risk
-Erroneous estimation of risk (non consolidated data)
-Inadequate frequency of reviews
Credit risk
-Complex structured instrument: collateral gaps
Liquidity risk
-Faulty estimation of potential redemptions
-Faulty estimation of market liquidity
Portfolio management
-Unauthorised transactions
-Attribution of consolidated orders
-PM resignation
Hedging management
-Faulty information regarding net exposures
-Roll over process
Annual report
-Significant errors in annual accounts or management report
Reporting to investors
-Reporting errors
-Delayed reporting

Page 24
Operational risks: a key element to understand and report
The criticality concept
Vulnerability, risk monitoring and risk rating
Farmer curves

Page 25
Inherent and mitigated risk
Scale
Probability
1
Very improbable
2
Isolated –rare event
3
Repetitive- possible event
4
Recurring – probable event
5
Common - very probable event
Scale
Reputational Impact
1
Rumours
2
Local Coverage-Information requests from Investors
3
Special press coverage- some redemptions
4
National press coverage – significant redemptions
5
Broad International coverage – Mass redemptions
Scale
Operational Impact
1
Minor incident without impact
2
Isolated incident with manageable impact
3
Isolated incident with significant impact
4
Systemic incident with partial stop of activities
5
Complete stop of activities
Scale
Regulatory – legal Impact
1
CSSF reminder – minor complaints
2
Deficiency letter and request to sate position – commercial dispute
3
Injunction from the CSSF – Isolated civil case
4
Serious breach / fine – mass litigation
5
Authorisation withdrawal - liquidation
Scale
Regulatory – Financial /Performance Impact
1
Minor loss
2
Moderate loss impacting yearly performance
3
Loss impacting return and minor capital loss
4
Major loss resulting in capital loss
5
Irrevocable loss with major capital loss
Risk id : xx
Category : Operational risk
Plant damage
Inherent
Probability
Impact
Criticality
Reputational
Operational
Legal
Financial
3
2
2
-
3
9
►Risk description: Accidental or intentional destruction
Rationale: Environmental group may object to the construction of the plant etc…
►Controls/Mitigation factors: Insurance; remote guard surveillance; fencing
Strategic response (accept/reduce): Accept
►Corrective actions:
Mitigated
Probability
Impact
Criticality
Reputational
Operational
Legal
Financial
2
2
2
-
1
6
Expected
Probability
After corrective actions
Impact
Criticality
Reputational
Operational
Legal
Financial

Page 26
Private Equity and Real Estate assets
ID
CATEGORY
THEME
DESCRIPTION
RATIONALE
INHERENT PROBABILITY
REPUTATIONAL IMPACT
OPERATIONAL IMPACT
LEGAL IMPACT
FINANCIAL IMPACT
CRITICALITY
1.1
Technology risk
Reliability & bankability
Plant proves not to be working correctly; project is not approved for financing
The technology is not reliable; the track record not strong enough; negative technical due diligence
2
0
4
0
4
8
1.1
Technology risk
Reliability & bankability : controls/mitigation factors
Technical due diligence; market intelligence; track record
2
0
3
0
2
6
1.1
Technology risk
Reliability & bankability : after corrective actions
0
0
0
0
0
0
2.1
Operational risk
Localisation/engineering
Refusal from local constituencies; reversal of authorizations granted; strikes/blockades
Environmental group may object to the construction of the plant; local authorities reverse a previously granted approval, etc.
1
2
1
0
5
5
2.3
Operational risk
Theft/Plant damage
Accidental or intentional destruction, vandalism, theft
Certain items of the plants (e.g. PV modules) can be removed. Environmental group may object to the construction of the plant, etc.
3
2
2
0
3
9
2.4
Operational risk
Fraud risk
Risk of fraud over the valuation of underlying asset or the financing of these assets
Risk of financing without real assets to finance/influence on valuation
2
3
1
3
3
6
2.8
Operational risk
Grid reliability risk
Lack or interruption of grid connection
Instable power network nationally or locally; glitches with plant connection to the grid, etc.
2
0
2
0
3
6
2.8
Operational risk
Grid reliability risk : controls/mitigation factors
Preliminary analysis on grid capabilities; interviews with local grid managers; due diligence on connection points/capacity; etc.
1
0
2
0
2
2
3.1
Regulatory and legal risks
Authorisation risk
Withdrawal of any authorisations to operate the plant
The authorisation process at the time of construction may have been inaccurate or the operation of the plant may not abide by the laws and regulations
2
2
3
0
3
6
4.1
Market risk
Financing risk
Financing may not be available or terms may be or become costly
Financial markets may be instable from time to time
3
0
1
0
2
6
4.1
Market risk
Financing risk : controls/mitigation factors
Hedging strategies may be implemented. Alternative funding may be available
2
0
1
0
2
4
4.2
Market risk
Electricity rates risk
Revenues may be negatively impacted by a reduction in electricity rates
Market price of electricity is subject to fluctuations
3
0
0
0
2
6
4.2
Market risk
Electricity rates risk : controls/mitigation factors
Sale prices for grid-connected plants are relatively inelastic; electricity is normally sold at regulated rates
2
0
0
0
2
4
4.3
Market risk
Valuation risk
The value of the assets may be reduced
The market value of the assets is highly dependent on interest rates and demand for those assets
2
2
0
0
3
6
4.3
Market risk
Valuation risk : controls/mitigation factors
Interest rates can be fixed and/or risk can be hedged
1
1
0
0
2
2
4.3
Market risk
Valuation risk : after corrective actions
0
0
0
0
0
0
4.4
Market risk
Leverage risk
Increase of losses due to the use of leverage
The sub-fund may leverage its capital by borrowing directly at Fund level up to 100% of the Total Commitment of the sub-fund, for investment purposes.
3
0
0
0
3
9
4.4
Market risk
Leverage risk : controls/mitigation factors
No leverage through derivatives, close monitoring of leverage level
2
0
0
0
2
4
4.4
Market risk
Leverage risk : after corrective actions
5.1
Credit risk
Counterparty default
Exposure to the creditworthiness of its business counterparties
Ability to trade and generate revenues is dependent upon contractual arrangements
2
1
0
0
3
6
5.1
Credit risk
Counterparty default : after corrective actions
0
0
0
0
0
0
6.1
Liquidity Risk
Asset liquidity
The value of the assets that can be realised may be materially different from acquisition costs
Assets may not be sold in the expected timeframe and at the expected values
3
0
0
0
3
9
6.1
Liquidity Risk
Asset liquidity : controls/mitigation factors
Focus on cash flow generation
2
0
0
0
2
4
6.1
Liquidity Risk
Asset liquidity : after corrective actions
0
0
0
0
0
0
6.2
Liquidity Risk
Liability risk
Mismatching asset/liability profile
Assets are relatively illiquid while liabilities may have different duration
3
0
0
0
3
9
6.2
Liquidity Risk
Liability risk : controls/mitigation factors
Focus on cash flow generation; maintain a reserve liquidity; manage overall duration
2
0
0
0
2
4
6.2
Liquidity Risk
Liability risk : after corrective actions
0
0
0
0
0
0
Case study - Renewable energy fund
8
9
9
9
9
0
0
0
0
2
2
0
5
6
6
6
6
6
6
6
6
4
4
4
4
4

Page 27
Other risks, examples and measures
TYPE OF RISK
QUALITATIVE LIMIT IN PLACE?
QUANTITATIVE LIMIT IN PLACE?
COMMENT
Market risk
Y
Y
►Level of interest rates and of the risk-free rate impact assessment
►Also impact the performance of the target companies, as well as the level of inflation
Credit risk
N
N
►N/A in the case of non leveraged PE fund at the AIF level and investing only in equity
►However, developments in the credit markets may affect the level of earnings and cash flow of the target companies, to monitor
Liquidity risk
Y
N
►For closed-ended PE funds, no liquidity risk on the liability side
►Limited risk on the assets side
►However, the liquidity risk is especially marked at the time of exit and exits must be adequately planned and the state of the market in terms of liquidity, monitored closely (analysis of comparable transactions in listed and unlisted structures, multiple etc. ).
►Investment phase capital calls : risk that an investor will default during a capital call.
Counterparty risk
Y
Y
►Risk associated with the use of derivative instruments, including hedging instruments

Page 28
2. Particulars of the RMP
►Art 18 and 19 for illiquid assets – Investment process is key
►Operational risks focus (as above but at AIFM level)

Page 29
3. How to monitor risks for illiquid assets? Is a quantitative approach feasible/desirable?
►Probability distribution for systematic shocks on the fund’s portfolio valuation can be derived from:
-The distribution of a public listed index historical returns.
-Public data on operational incidents
-Monte Carlo simulations
►The distribution of shocks is the building block for key risk indicators:
-IRR-at-Risk: Systematic shocks are applied to the current NAV, building a distribution of NAV for a given time horizon. A distribution of IRR can then be derived, from which IRR-at-Risk can be computed for a given confidence interval.
-Stress Testing: Apply a given level of shock on the systematic risk factor (the index) to the fund NAV, and derive a stressed IRR.
-Target IRR Analysis: Define targeted IRRs for the fund and derive the corresponding shocks on NAV required to achieve these targets.

Page 30
3. How to monitor risks for illiquid assets? Is a quantitative approach feasible/desirable?
*numbers are for illustration purposes only
Target IRR
0%
8%
15%
Scenario
-30%
-10%
+10%
Probability
0%
8%
23%
STRESS TEST
95%
Shock
-25%
IRR
5.9%
NAV
$117m
Stress Tests at 95% confidence based on the 1Y-distribution of FTSE- EPRA NAREIT Emerging index.
Scenario on NAV to obtain pre-specified target IRR levels for the fund:
STRESS TESTS
IRR-AT-RISK
Mark-to-Market IRR
Probability

Page 31
Questions?

The monitoring & delegation of the risk management function under AIFMD

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