AIF Club. Risk and liquidity management for Private Equity and Real Estate Funds

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1 AIF Club Risk and liquidity management for Private Equity and Real Estate Funds

2 B AIF Club Risk and liquidity management for Private Equity and Real Estate Funds

3 Introduction Risk management is one of the two core functions required by the Alternative Investment Fund Manager Directive (AIFMD) together with portfolio management. Provided that portfolio managers of alternative investment funds (AIFs) are typically domiciled outside of the Grand Duchy, Luxembourg alternative investment fund managers (AIFM) have predominantly put a focus on risk management as their backbone for ensuring governance and providing substance to local management companies. Given the importance of the topic, EY invited 12 risk managers of local AIFM in the context of its AIF Club to discuss their governance models, systems and processes as well as current trends and needs for improvement during a roundtable discussion. Among the participants were several of the large Luxembourg domiciled real estate and private equity managers along with representatives from third party management companies who service mainly illiquid asset classes. In addition, some players from Super ManCo s participated in the discussion which allowed for a comparison to UCITS and the more liquid investment world. This paper summarizes the outcome of the roundtable discussion and aims at providing insights into current market practices in Luxembourg when it comes to risk management under the AIFMD. AIF Club Risk and liquidity management for Private Equity and Real Estate Funds 3

4 1 Risk management governance and internal controls 1.1) Organization of the risk management function and interaction with other functions Organizational structure Risk management teams are generally a distinct part of the AIFM and usually consist of highly specialized people working in groups of one to four people. In general, risk managers are not specialized with regard to specific asset classes. When it came to reporting lines, 71% of the attendees indicated that they report to a conducting/officer/senior manager in charge of risk and in 29% of the cases to the board of directors. Additionally, for global players, the report of the risk management function is also provided to the board at group level. Moreover, several risk managers also report to the board of the managed AIFs, hence, there is often a direct relationship between the board of the AIF and the risk management function at AIFM level. Reporting at AIF level helps to increase the awareness of the risk management function as well as its influence with regard to investment management teams which is an argument used especially in the context of third party AIFMs. Interaction with the compliance function The compliance and risk management functions are generally separated, with the compliance function concentrating mainly on legal aspects of the business. The two functions are complementary; however, nearly three quarters of respondents argued that overlaps occur in terms of roles and responsibilities, since the role of a risk manager is not yet clearly defined. Interaction with the valuation function The risk management function is closely connected to the valuation function, with an overwhelming majority of attendees (89%) indicating that a formal regular relationship between the two functions exist, and that 67% stated that the valuation function is mainly set-up as a committee. One third of attendees indicated though that they make use of an external valuation function. Overall, there is large consensus that there are difficulties when gathering the necessary data for risk management purposes. This is especially true for third party AIFMs. 4 AIF Club Risk and liquidity management for Private Equity and Real Estate Funds

5 1.2) Influence of risk managers Over the past years, there has been a gradual increase in the importance of the risk management function as well as the level of influence it exercises over the decision processes within the company. There are several ways in which the power of risk managers can manifest itself. First of all, though still relatively uncommon, the risk manager may have a veto right with regard to portfolio transactions. However, attendees argued that if set up properly, the risk management framework should be able to discard inappropriate transactions at an early stage without making use of a veto right and thus have a preventive approach. Secondly, risk managers can have significant influence with regard to the level of leverage. They may even take on the role of an intermediary between investors and portfolio managers, for instance, investors may seek a high leverage in accordance with their risk appetite. This can be taken into account by developing adequate risk frameworks. Finally, concerning the operating platform, the risk management is closely involved in the analysis of weaknesses of processes in order to raise efficiency. Typically, the compliance function is also involved at this level. 1.3) Risk management knowledge The level of risk management knowledge in Luxembourg is still maturing, even though a strong improvement can be seen over the past two years. It is therefore vital to continue the investments into growing local know-how and expertise. A deeper pool of high level education and training, which would be available locally, is essential in order to improve the effectiveness of risk management. What is the priority of focus with regards to the risk management industry? 20% 10% 70% Completeness and relevance of industry guidelines and best pratices Qualified people Access to peer networks and risk management communities Additionally, risk managers look at financial authorities for relevant guidance. This demonstrates that the risk management function is not yet clearly defined and the exact roles and responsibilities of risk managers are not identical across the industry. There is a demand for more standardized processes and best practices to help clearly outline the main requirements from risk management in the private equity and real estate sector. Furthermore, a fifth of respondents argued that there is a lack of qualified people in risk management. AIF Club Risk and liquidity management for Private Equity and Real Estate Funds 5

6 2 Risk management systems and processes 2.1) Methodologies and risk management standards Due to the fact that standardized processes and best practices have not yet fully emerged, risk managers apply various risk management methodologies across the industry, even though there is a trend for using certain key risk indicators (KRI). The risks of private equity (PE) and real estate (RE) funds are not yet clearly identified and categorized, which creates demand for more guidelines to be published by relevant authorities and associations. This is especially the case for operational risk. Common standards for defining risks and risk management processes with regard to PE and RE are among the most important priorities for risk managers. The majority of attendees indicated that they apply a consistent risk management approach to all investment vehicles irrespective of their regulatory status. However, approximately one fifth indicated that the formal risk management processes are only applied to AIFs whereas non-regulated products are assessed using a different risk management platform. Do you apply a consistent risk management approach to all investment vehicles irrespective of their regulatory status? 22% 11% 67% Yes, we have one RM platform across the organization No, we only apply formal RM processes to AIFs Yes, but only if this is driven by investors Risk managers overwhelmingly use a balanced combination of qualitative and quantitative risk measurements (80%). Using benchmarking for measuring risk is not a common practice, since appropriate benchmarks may not always be available or might not be truly representative. It has been indicated that the practice of benchmarking is used more for strategic purposes, rather than for day-to-day risk management. Value at Risk (VaR) is not a common metric used among alternative investment funds to evaluate market risk, and is only applied to certain portfolios for which the necessary data is available. 6 AIF Club Risk and liquidity management for Private Equity and Real Estate Funds

7 2.2) IT systems and tools There are currently two main IT systems in use by the market, one is the preferred solution for real estate, the other is mostly used for private equity. However, there has been an overall consensus that the developments in terms of IT systems and tools to support the risk management function today could be further enhanced. The two areas which could most benefit from new IT systems were identified as Workflow Tools and Risk Reporting. Approximately half of the attendees specified that they had a program to invest in specific risk management systems. What are the areas that could most benefit from such IT tools and resources? 22% 45% 33% Workflow tools Risk reporting Mathematical models AIF Club Risk and liquidity management for Private Equity and Real Estate Funds 7

8 3 Liquidity management approaches Risk managers use detailed forward looking models to manage liquidity risk, mainly based on cash flow models. Stress tests are most commonly performed using hypothetical scenarios or actual historical crises. 78% implied that both quantitative and qualitative risk indicators are employed when measuring liquidity risks. A quarter of participants (22%) use exclusively quantitative indicators. Based on which scenarios are stress tests performed? 11% 33% 56% Hypothetical scenario Historical crisis Other 8 AIF Club Risk and liquidity management for Private Equity and Real Estate Funds

9 4 Transparency and investor reporting Risk managers generally do not employ specific IT systems for performing risk reporting to investors, which is partly also due to the lack of platforms offering such a service. There is an overall consensus that the risk management requirements imposed by the current regulation represent a benefit for the investors, with a majority citing higher transparency as the main benefit, while the rest indicated better understanding of the risk exposure. Do you consider the risk management requirements imposed by the current regulation a benefit for the investors? 22% 78% Yes, better understanding of the risk exposure Yes, higher transparency No = N/A AIF Club Risk and liquidity management for Private Equity and Real Estate Funds 9

10 10 AIF Club Risk and liquidity management for Private Equity and Real Estate Funds

11 Conclusion While there is still a requirement to further define the roles and responsibilities of risk managers as well as establish industry guidance on certain aspects of the risk management function, this first roundtable clearly demonstrated that Luxembourg s risk community is on a very good track in embracing the AIFMD. At the same time, risk managers have a clear understanding of the areas to be improved and a good drive to tackle them. AIF Club Risk and liquidity management for Private Equity and Real Estate Funds 11

12 EY Assurance Tax Transactions Advisory About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com Ernst & Young S.A. All Rights Reserved. ED None This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax, or other professional advice. Please refer to your advisors for specific advice. ey.com/luxembourg Contacts Kai Braun Partner, Luxembourg Alternatives Advisory Leader, EY Luxembourg T: E: kai.braun@lu.ey.com Michael Hornsby Partner, EMEIA Real Estate Funds Leader, EY Luxembourg T: E: michael.hornsby@lu.ey.com