3rd Party AIFMs: Why they are right to bother with Risk Management

The market for 3rd party AIFM services is taking shape across the European Union. The business model of 3r Party AIFMs authorized under the Alternative Investment Fund Managers Directive (AIFMD - 2011/61/EU) is to offer to their clients a turnkey solution – or platform - to operate their funds in the European Union (to be more precise in the European Economic Area or EEA). The supplier offers to the client a regulated entity able to perform the portfolio management and/or risk management functions for his/her fund (the Alternative Investment Fund or AIF) accepted on the platform - meaning that the fund can then be marketed across the EEA.

This can represent the best route to the market for entities located outside the EEA (such as the US and potentially the UK depending on the outcome of the Brexit) but also for initiators of projects who want to test their concept before establishing their own fully-fledged AIFM.

Those [still] following the debate on Brexit will be aware that the decision to grant equivalence to countries outside the EU is suspected of being easily reversible and therefore the 3rd Party AIFM's option is also a compelling alternative when the initiator is located in a country benefiting from the equivalence regime.

The main source of income for the 3rd Party AIFM is a management fee representing a percentage of the fund's size that can significantly be lower than the usual figures benefiting to mainstream fund managers. Covering the cost of running a regulated entity with relatively modest management fees points towards two basic business models:

1. Attracting a sufficient volume by accepting on the platform few funds but with large sizes; or

2. Accepting a large number of funds with more modest sizes

The first model is the most straightforward to secure that the 3rd Party AIFM is not exposed to the regulatory risk of being considered by the competent authorities as a letter box entity – and therefore not as the manager of the AIF. As this check on substance is conducted for each AIF, a degree of specialization regarding the investment strategies of the funds accepted on the platform of any 3rd Party AIFM gives confidence regarding his/her ability to perform the portfolio or the risk management function under the AIFMD.

Our experience in the market shows that 'large' funds can afford to have their proprietary structure in the form of an AIFM, meaning that 3rd Party AIFMs are more biased towards attracting a sufficient high number of 'small' funds with potentially a relatively diversified panel of investment strategies.

The question is then for the 3rd Party AIFM – in light of his/her resources and experience – to determine to which degree the investment strategies can differ one from the other without being rightfully considered as a letter box entity by the regulator.

The answer to the question above is dependent on whether the 3rd Party AIFM decides to delegate either the portfolio management or the risk management function. Conceptually, delegating one of these two functions should allow for a larger variety of investment strategies successfully accepted on a platform.

Keeping the portfolio management function internally and delegating the risk management function is according to us the less likely option to produce the needed economies of scale as the portfolio management function requires deal making skills which, depending on the strategy of the fund, can be extremely expensive.

On the contrary, keeping in-house the risk management function and delegating the portfolio management function is more promising for producing the required economies of scale and increasing the substance needed to perform the duties of an AIFM while at the same time expanding the bandwidth of investment strategies of a specific platform.

However, this can only be achieved if the risk management function is adequately structured by abiding to the following basic principles:

    • Recognizing that the risks of liquid assets cannot be identified, measured and managed in a similar manner as the ones of illiquid assets
    • Managing the risks through the support of dedicated on-line tools using various indices is probably a good starting point for liquid assets, but much less so for illiquid assets
    • Identifying from the start that the challenges of managing the risks related to illiquid assets lie in the ability to access the right information in due time, collect and use this information in a structured manner to quantify the risks and initiate early corrective actions if necessary
    • The previous point must be discussed during the contractual negotiations with the entity that will perform the portfolio management function and the corresponding information exchange system should be structured ex-ante
    • Staffing appropriately the risk management function

While this option keeps the risk management function in-house, the tools and methodologies need to be up to standard in order to withstand the reported increasing scrutiny of the regulator. LDS Partners has put in place a fully-fledged service which provides the 3rd party AIFMs with the necessary reports and analyses to be able to fully cover the risk management function. The responsibility remains with the 3rd party AIFM but he/she disposes of all necessary input to be able to assume the risk management function while having access to specialists' know-how and up to date regulatory requirements.

For any question or comment about this post please contact us at LDS Partners: contact@ldspartners.com

LDS Partners - This email address is being protected from spambots. You need JavaScript enabled to view it. - T +352 277 61 234
website by mijim