EU alternatives directive creates new yardstick for funds
AIFMD is pushing fund managers to improve risk management and to use external valuers – it’s a model all funds should follow
The Alternative Investment Fund Managers Directive (AIFMD) is an EU directive that will place hedge funds, private equity and other alternative investment firms in a regulated framework, in order to monitor and regulate their activity.
It covers aspects such as remuneration policy, depositary, capital requirements, valuation, reporting requirements and risk management. For many hedge funds, complying with AIFMD in a timely manner can be daunting. But the advantages of the new processes in risk management and valuation are becoming apparent.
More rigorous risk management
The directive requires funds managers to have a permanent risk management function, independent of portfolio management. This risk management function will take responsibility for identifying, measuring, monitoring and managing various risks relevant to the fund. A fund’s risk management policy sets controls for market risk, counterparty risk, liquidity risk and operational risk.
Historically, the risk management function within many hedge funds has been limited to identifying and measuring risks for the fund. But AIFMD makes limits monitoring and management of risk a mandatory role of the risk management function.
Limits monitoring involves setting limits against various risks relevant to the fund and logging any breaches. The remediation performed (for example, reducing positions or adding hedges) needs to be documented and back-tested. Limits monitoring is a powerful tool that extends the risk management function from its traditional risk measurement role to one that really has the ability to control risk.
Effective implementation of AIFMD risk requirements will lead to an evolution of market standards around areas that have traditionally lacked clarity and consistency. For example, liquidity measurement for nonexchange traded instruments, treatment of hedging/netting arrangements and leverage calculations will all likely be improved.
All alternative fund managers that fall under the directive are required to ensure that appropriate and consistent procedures are in place for independent valuation of their portfolio. Managers are allowed to value the portfolios in-house as long as they can demonstrate the independence of the valuation process from portfolio managers. Alternatively, managers can appoint one or more external valuers to price their portfolios.
In the past, many hedge funds have chosen to price their portfolios in-house. They have often believed this route would give them greater control over the process and greater accuracy. But AIFMD places strict controls around the valuation process, and the advantages of external valuers are becoming clearer.
External valuers need to take responsibility for their prices and are prohibited from sub-delegating the pricing responsibility. Accordingly, firms intending to act as external valuers will need to implement robust processes and controls before they take on this binding responsibility.
These controls will in turn lend the figures supplied by external valuers great credibility; it is likely they will become the standard for comparison across the entire hedge fund industry.
Improving all hedge funds
Overall, the changes that AIFMD requires to risk management and valuation will improve the infrastructure of all funds involved. The adoption of a rigorous approach to risk management, the emergence of new industry standards and the arrival of more credible valuations, which are performed externally, will be a clear advantage for AIFMD funds in the eyes of all investors.
In fact, at Citco, we think that the changes brought about by AIFMD will have such an impact on the perception of alternative funds that even those funds not subject to AIFMD will embrace these concepts – either on their own or under pressure from investors.