AIFMD: No Pain, No Gain for Fund Managers

Alternative fund managers who might have been initially hot to take advantage of the new European Alternative Investment Fund Managers Directive (AIFMD) to more easily market their investment funds cross-border are quickly waking up to a cold reality: they might be ill-prepared to comply.

With so little time left, they will need to warm up to their middle and back-office operations teams, third-party administrators, software vendors and other service providers fast. Alternative fund managers may be pretty sophisticated when it comes to understanding and implementing trading strategies and front-office technology. Not so with other post-trade requirements. Out of sight, out of mind is the mantra when it comes to dealing with middle and back-room operational issues they may feel are unrelated to generating alpha.

Akin to the UCITS legislation for traditional investment fund managers, AIFMD aims to provide their alternative fund brethren with an “EU- passport.” They can use the authorization provided by one national regulatory body to gain access to investors in as many European Union markets as they want. No longer will alternative fund managers have to go through the rigorous process of setting up separate legal structures and winning regulatory approval in each country which has specific private placement rules.

Yet, there is a catch and a big one: fund managers wanting to become AIFMD-compliant will have to track down lots of data located in disparate internal applications and external sources. And they will have to do it quickly enough to forward new more detailed reports to national regulatory organizations, either on an annual, semi-annual or even quarterly basis depending on the value of assets under their belts. Those with more than € 1 billion in total assets under management, or serving an individual fund with assets valued at over € 500 million, must file quarterly.

The reports are due either 30 days from quarter-end or 45 days in the case of a fund of funds. With so many alternative fund managers waiting until the very last minute to win regulatory approval, the first round of documents will likely be delivered between August 2014 and January 2015. The handful of fund managers which won regulatory approval — or authorization — as alternative investment fund managers late last year, either should already have filed, or will be doing so any minute.

In addition to their new more detailed reporting duties, all AIFMs must also come up with a sturdy, independent  risk management policy, separate from other operational functions. The legislation is a bit vague when it comes to the exact requirements for testing risk management capabilities, leaving room for interpretation. Expectations are that larger fund managers will go the extra mile with more rigorous metrics and oversight.

The new regulatory landscape is apparently creating plenty of angst among alternative fund managers and even fund administrators, according to a new survey,  just released by Pittsburgh, Penn.-headquartered regulatory reporting solutions specialist Confluence. Although 95 percent of the 21 specialists at alternative fund managers and 39 from fund administration shops interviewed say they are aware of the AIFMD’s provisions, a full two thirds are concerned about meeting the reporting requirements. The next most worrisome thought — implementing risk management procedures, as indicated by fifty-two percent of respondents.

With the final deadlines for applying to become a recognized alternative investment manager either already passed or close at hand — by July 22 — fund managers might not have sufficient time to prepare for AIFMD given the extra workflow management and policies they will need to implement.

Complex Reporting 

“Fund managers and third-party administrators are facing one of the most complex regulatory reporting challenges the industry has had to manage to date,” says Melvin Jayawardana, European market manager at Confluence’s Luxembourg office. “At the heart of their concern is AIFMD’s requirement for reports to be validated, formatted and posted as quickly as 30 days after the end of the reviewed period. This is a major hurdle for an industry that has not implemented methods for handling such reporting granularity or frequency in a very narrow window before now.”

Alternative fund managers wanting to leverage their experience with US Form PF required by the Securities and Exchange Commission will soon find out that AIFMD’s reporting requirements are far more stringent, say European regulatory experts. Only 30 percent of the data is similar and, unlike Form PF, AIFMD-compliant reports require extra detailed information — about 20 data fields — on leverage, if the fund is highly leveraged.

Those wanting to benefit from AIFMD’s EU passport do have choices in how they can fulfill the reporting task. Alternative fund managers can take on all of the data aggregation, number crunching, and reporting work on their own either using proprietary or third-party software; rely on a third-party firm to do the reporting through a managed service, or outsource some or all of the chore to a fund administrator. But none of those options absolve them from legal liability in case of error. They just have to hope they — or their third party providers — can live up to the more rigorous informational requirements.

Staying Ahead of Deadlines

“Doing the work on their own, requires them to source data internally and from their fund administrators, ensure its accuracy, perform complex calculations, format the regulatory report, and then forward it to a regulator,” says Jayawardana, whose firm offers a reporting package for AIFMD-compliant managers. “The timetable for tracking down the data will be harrowing if they don’t start to collect the data on a monthly basis already.”

Using a repeatable data management process could go a long way to easing the reporting pains down the road. About 60 percent to 70 percent of the information European regulators want, typically basic descriptive data on the fund, its terms for subscriptions and redemptions, its holdings, and portfolio and transaction data, will be held by fund administrators and prime brokers, predicts Pete Townsend, head of hedge fund solutions for BNP Paribas Securities Services in Dublin.

That data won’t be hard to find if a fund manager has only one administrator, but will take a bit of work to gather if it has more than one administrator and prime broker, as is often the case with larger alternative fund managers. Reconciliation of data from disparate sources will become critical.

An even more cumbersome challenge: blending the basic easily accessible data with additional internally-held complex information on asset concentration, counterparty exposure, leverage, expected returns, and collateral. Hopefully, the information will already be stored within portfolio accounting, middle-office, and risk management systems. If not, it will need to be generated manually by already overworked operations specialists.

“The fund manager will need to provide that internal information on its own as it is subject to some interpretation,” explains Townsend.

Delegating Work, Not Liability

Alternative fund managers can use the data given by fund administrators to fill in the regulatory reports by themselves or they can rely on web-portals set up by fund administrators, such as BNP Paribas Securities Services, to share data and work on the reports jointly. Even so, based on Confluence’s survey, more than half of the fund administrators, which say they will offer “AIFMD transparency reporting” as service, won’t accept legal responsibility for any errors.

Such a shortcoming, albeit understandable, might just dissuade some larger fund managers with deeper pockets from outsourcing the reporting work. Often reliant on multiple fund administrators and prime brokers, they could decide to rely on a home-grown or commercial software package or even a managed service. However, not all software providers or managed service providers can come up with some of the complicated risk metrics required.

Disclosure of leverage could be one of the most difficult tasks under AIFMD’s reporting regime. Alternative fund managers must calculate their overall leverage using a simple gross approach and a more complicated commitment approach, which even the most experienced market risk analysts had trouble explaining to FinOps Report in simple terms. “The math is pretty mindboggling,” says one.

Alternative fund managers relying on plain vanilla long-short strategies will have a far easier time than those using derivatives for hedging purposes. Hedgers must rely on specific quantitative methodologies to make their calculations, which incorporate netting of exposures.

“Leverage is viewed by regulators as a fundamental risk indicator for the alternative fund manager which could lead to systemic risk,” explains Dario Cintioli, global product manager in Milan for portfolio risk analytics firm StatPro. “An alternative fund manager must monitor commitment exposure every day and if that figure is too high — over three times the market value of the fund — a regulator could require the manager to report the figure more frequently.” StatPro recently incorporated commitment leverage into its software package for risk calculations.

Heavy Governance

In going beyond the reporting requirements mandated by the SEC under US Form PF, European regulators have come up with additional more subjective guidelines for AIFMD-compliant managers. Regardless of the amount of detailed information they provide regulators, all AIFMD-compliant alternative fund managers will be required to revisit their entire risk management governance and oversight process to ensure an effective independent approach — a task which could be far too cumbersome and costly for many small to mid-sized managers to address. “Too often, the risk management process is simply embedded within the trading or portfolio management department which takes a seat of the pants approach,” says one operations director at a UK-based alternative investment fund. “That means reactive, instead of proactive.”

In their documented risk policy, alternative fund managers will set quantitative or qualitative risk limits on market risk, credit risk, counterparty risk and operational risk. Although not explicitly required for all alternative fund managers, backtesting and stress testing is encouraged for larger fund managers. Regardless of the size of assets under management, risk management systems must be subject to annual review by management.

The AIFMD makes no specific mention of how operational risk should be measured, let along monitored. Current practice is pretty qualitative and leaves plenty of room for interpretation, worry some European fund management operations specialists.

Rather than separate risk management into different categories, each with a different expert, alternative fund managers will likely delegate oversight of the entire process to a single expert or department. Regardless, they must find experienced specialists, if they don’t have them in-house and they don’t come cheap, European recruitment managers tell FinOps. The most qualified candidates have likely worked for large sell-side shops and are accustomed to hefty compensation rates.

To ensure their decisions won’t be unduly influenced by bottom-line profits, the compensation of risk management specialists for AIFMD-compliant management shops, can’t be linked to the performance of business lines they supervise. Likewise, the experts should not work or be supervised by the operating units they oversee.

“It all sounds great on paper, but wait until the time comes to put the risk management policy into practice,” predicts one operations director at a European alternative fund management shop. “No internal staffer will want the thankless task of taking on the risk management role and when it comes to writing down oversight obligations, there will be plenty of dissent between operating units and C-level management.” Obviously, he adds, trading desks and portfolio managers will want to dominate the decisionmaking process.

Is It Worth It?

The result: auditing firms, accountancies and consultants could end up making a lot of money at the expense of investors who will ultimately foot the bill. “We will need to call in external help to mediate,” another European alternative investment fund operations manager tells FinOps. “I dread to think of how much it will cost.”

The handful of European fund management firms contacted by FinOps for this article declined to provide any estimates of the costs of AIFMD compliance on the grounds such a disclosure could highlight their shortcomings.What is clear, says another operations director, is that deciding whether or not become AIFMD-compliant is generating plenty of internal debate.

“We’re now doing an intense cost-benefit analysis on the merits of meeting the new legislation,” he says. “It will likely come down to the number of markets in which we want to distribute.”

Those who want to expand into a broader market of pan-European investors may be more willing to invest heavily to comply with AIFMD than those who just want to distribute in one or two additional countries. The decision could be affected by concerns that the room to maneuver through private placement rules could become tightened or even abolished in some countries.

Regardless, as one European alternative fund management operations director notes, there are always a lot of funds chasing investors’ money. “Competitive factors may ultimately trump cost concerns,” he says.