The monitoring & delegation of the risk management function under AIFMD Yves de Naurois

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

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? Copyright Arkus Financial Services The monitoring & delegation of the risk management function under AIFMD Page 2

3 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? Copyright Arkus Financial Services The monitoring & delegation of the risk management function under AIFMD

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 Copyright Arkus Financial Services The monitoring & delegation of the risk management function under AIFMD Page 4

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 Copyright Arkus Financial Services The monitoring & delegation of the risk management function under AIFMD Page 5

6 OUTPUT CONTENT MODULE 2. AIFM Risk Reporting VALUE CHAIN OF 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 Draft/ review of existing Risk Management Policy (RMP) This include s documenting governance, key risks and KRIs, limits, monitoring and reporting Based on key risks identified, to implement a practical risk management monitoring tool. Specific risk monitoring reports Regular board reporting on risk; alert summaries etc. Prepare regulatory risk reporting compliant with AIFMD Annex 4 reporting template Systematized scaling (probability and impact resulting in criticality score) Individual AIF risk profile summary AIFMD compliant RMP yet meaningful to a specific investment strategy based on a thorough understanding of illiquid assets investment process Risk dashboard Liquidity risk and stress testing reports IRR at risk and stress testing Individual risk management sheet Board packs risk report Regulatory risk reporting Annex 4 Copyright Arkus Financial Services The monitoring & delegation of the risk management function under AIFMD Page 6

7 INTERNAL 2. AIFM Risk Reporting - Overview IN CHARGE RECIPIENTS KEY DOCUMENTS REFERENCE Senior Management AIF Risk Profile (including limits) Art AIFMD Art. 39 CDR Art. 44 CDR Permanent Risk Management Function AIFM Board AIFM RMP Art. 40 CDR Art. 47 CDR 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. Art. 39 CDR Art. 45 CDR Documented due diligences Art. 18 CDR Art. 19 CDR Copyright Arkus Financial Services The monitoring & delegation of the risk management function under AIFMD Page 7

8 EXTERNAL 2. AIFM Risk Reporting - Overview IN CHARGE RECIPIENTS KEY DOCUMENTS REFERENCE Permanent Risk Management Function Investors AIF Risk Profile Art. 15 Art Art. 39 CDR AIFM Investors 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) Annual Reports Art. 23 Art. 22 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. Art. 105 CDR Art. 23 Art. 108 CDR AIFM Regulator AIF RMP Risk Management process and techniques (any material change) 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) Art. 16 Art. 46 CDR Art. 41 CDR Art. 24 Art. 110 CDR Art. 111 CDR Copyright Arkus Financial Services The monitoring & delegation of the risk management function under AIFMD Page 8

9 2. AIFM Risk Reporting Annex IV 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. 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 Copyright Arkus Financial Services The monitoring & delegation of the risk management function under AIFMD Page 9

10 Data sourcing 2. AIFM Risk Reporting - Schematic flow REFORMATING ENRICHMENT QUALITY CONTROLS $ DATA MANAGEMENT SENT TO REGULATOR AIFM REPORTING TOOL REGULATOR CUSTODIAN PRIME BROKER PORTFOLIO MANAGER CENTRAL ADMIN. RISK DEPARTMENT Copyright Arkus Financial Services The monitoring & delegation of the risk management function under AIFMD Page 10

11 Historical RP Risk Profile of AIF 2. AIFM Risk Reporting - Annex IV 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 BLOCK FIELD SPECTRUM DESCRIPTION DATA NEEDED DATA SOURCE APPLICABLE FOR NON-TRADABLE ASSETS MODELLING REQUIRED IRR Cash Flow Projections Portfolio Manager YES (YES) CS01/DV01/ Delta/Vega + repartition into buckets Portfolio positions, yield curves/termsheets etc. Admin/Broker NO YES , 302 VaR Portfolio Positions (e.g. contract size, strike price, maturity date etc.) Admin NO YES CCP/Regulated Market/Repos/Cash Collateral Portfolio Positions+ related information on Counterparty Admin NO NO Counterparty (BIC codes etc.) Portfolio Positions, (BIC of counterparties codes etc.) Admin/Counterparty NO NO 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 Stress Tests Portfolio Positions Admin YES YES Leverage Portfolio Positions Admin NO YES TOTAL FIELDS CONCERNED: 28% Copyright Arkus Financial Services The monitoring & delegation of the risk management function under AIFMD Page 11

12 2. AIFM Risk Reporting - Annex IV example RISK MEASURE TYPE RISK MEASURE VALUE RISK MEASURE DESCRIPTION Leverage - Sum of Notionals % AIFMD Leverage still to be implemented - the shown value is the Gross Leverage - SON IRR % Expected annual investment return/irr in normal market conditions. CS Dollar change in the Portfolio NAV if credit spreads rise by 1 basis point. Net CS01 value for bucket < 5 years Net CS01 value for bucket 5-15 years Net CS01 value for bucket > 15 years - Dollar change in the Portfolio NAV if credit spreads of securities with maturity less than 5 years rise by 1 basis point. (input parameters: Floating leg, Fixed leg, rates, issuer information,, Maturity, Yield curves) Dollar change in the Portfolio NAV if credit spreads of securities with maturity between 5 and 15 years rise by 1 basis point. Dollar change in the Portfolio NAV if credit spreads of securities with maturity greater than 15 years rise by 1 basis point. DV Dollar change in the Portfolio NAV if yield curves rise by 1 basis point. Net DV01 value for bucket < 5 years Net DV01 value for bucket 5-15 years Net DV01 value for bucket > 15 years - Dollar change in the Portfolio NAV if yield curves of securities with maturity less than 5 years rise by 1 (input parameters: Maturity date, Coupon, Callabilty properties, basis point. information, Rating, Yield curves) Dollar change in the Portfolio NAV if yield curves of securities with maturity between 5 and 15 years rise by 1 basis point. 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 Dollar change in Portfolio NAV if all equities rise by 1%. Vega Exposure 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 % E.g. Calculated using the Pricing algorithm suggested by ISDA Using standard bond pricing methods (e.g. DCF) Obtained through a risk model (input parameters: Model data, detailed position information) 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 Copyright Arkus Financial Services The monitoring & delegation of the risk management function under AIFMD Page 12

13 3. The risk manager responsibilities and liabilities what are the practical consequences? Need for adequate monitoring tools Need for adequate support services Copyright Arkus Financial Services The monitoring & delegation of the risk management function under AIFMD Page 13

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. Copyright Arkus Financial Services The monitoring & delegation of the risk management function under AIFMD Page 14

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. Copyright Arkus Financial Services The monitoring & delegation of the risk management function under AIFMD Page 15

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 Copyright Arkus Financial Services The monitoring & delegation of the risk management function under AIFMD Page 16

17 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 Copyright Arkus Financial Services The monitoring & delegation of the risk management function under AIFMD

18 1. No one size fits all. Different models available MODEL 1 ALL DONE INTERNALLY MODEL 2 PARTIAL OUTSOURCING MODEL 3 FULL DELEGATION OF PM OR RM AIFM AIFM AIFM $ $ $ Relies on Delegates the permanent RM function 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. Copyright Arkus Financial Services The monitoring & delegation of the risk management function under AIFMD Page 18

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. Copyright Arkus Financial Services The monitoring & delegation of the risk management function under AIFMD Page 19

20 3. Insights from a practitioner Discussion? Copyright Arkus Financial Services The monitoring & delegation of the risk management function under AIFMD Page 20

21 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? Copyright Arkus Financial Services The monitoring & delegation of the risk management function under AIFMD

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. Copyright Arkus Financial Services The monitoring & delegation of the risk management function under AIFMD Page 22

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

24 1. Risk management for illiquid assets Operational risks: a key element to understand and report The criticality concept Vulnerability, risk monitoring and risk rating Farmer curves Copyright Arkus Financial Services The monitoring & delegation of the risk management function under AIFMD Page 24

25 1. Risk management for illiquid assets Inherent and mitigated risk Scale Probability 1 Very improbable 2 Isolated rare event Risk id : xx Category : Operational risk Plant damage 3 Repetitive- possible event 4 Recurring probable event 5 Common - very probable event Risk description: Accidental or intentional destruction Inherent Probability Impact Reputational Operational Legal Financial Criticality Rationale: Environmental group may object to the construction of the plant etc Controls/Mitigation factors: Insurance; remote guard surveillance; fencing Mitigated Probability Strategic response (accept/reduce): Accept Corrective actions: Impact Reputational Operational Legal Financial Criticality Expected Probability After corrective actions Impact Reputational Operational Legal Financial Criticality 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 Copyright Arkus Financial Services The monitoring & delegation of the risk management function under AIFMD Page 25

26 1. Risk management for illiquid assets Private Equity and Real Estate assets Case study - Renewable energy fund 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 Technology risk Reliability & bankability : controls/mitigation factors Technical due diligence; market intelligence; track record Technology risk Reliability & bankability : after corrective actions Operational risk Localisation/engineering Refusal from local constituencies; reversal of authorizations granted; strikes/blockades 2.3 Operational risk Theft/Plant damage Accidental or intentional destruction, vandalism, theft Environmental group may object to the construction of the plant; local authorities reverse a previously granted approval, etc. Certain items of the plants (e.g. PV modules) can be removed. Environmental group may object to the construction of the plant, etc 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 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 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 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 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 Market risk Financing risk : controls/mitigation factors 4.2 Market risk Electricity rates risk 4.2 Market risk Electricity rates risk : controls/mitigation factors Hedging strategies may be implemented. Alternative funding may be available Revenues may be negatively impacted by a reduction in electricity rates Sale prices for grid-connected plants are relatively inelastic; electricity is normally sold at regulated rates 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 Market risk Valuation risk : controls/mitigation factors Interest rates can be fixed and/or risk can be hedged Market risk Valuation risk : after corrective actions 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 Market risk Leverage risk : controls/mitigation factors No leverage through derivatives, close monitoring of leverage level 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 Credit risk Counterparty default : after corrective actions 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 Liquidity Risk Asset liquidity : controls/mitigation factors Focus on cash flow generation Liquidity Risk Asset liquidity : after corrective actions Liquidity Risk Liability risk Mismatching asset/liability profile Assets are relatively illiquid while liabilities may have different duration Liquidity Risk Liability risk : controls/mitigation factors Focus on cash flow generation; maintain a reserve liquidity; manage overall duration Liquidity Risk Liability risk : after corrective actions Copyright Arkus Financial Services The monitoring & delegation of the risk management function under AIFMD Page 26

27 1. Risk management for illiquid assets 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 For closed-ended PE funds, no liquidity risk on the liability side Limited risk on the assets side Liquidity risk Y N 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 Copyright Arkus Financial Services The monitoring & delegation of the risk management function under AIFMD Page 27

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) Copyright Arkus Financial Services The monitoring & delegation of the risk management function under AIFMD Page 28

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. Copyright Arkus Financial Services The monitoring & delegation of the risk management function under AIFMD Page 29

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

31 Questions? Copyright Arkus Financial Services The monitoring & delegation of the risk management function under AIFMD Page 31

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