AIFMD Annex IV Reporting: Risk Scrutiny on Deadline

The Alternative Investment Fund Manager Directive Annex IV.

The long phrase describes at least three hundred points of reference data and other risk metrics alternative fund managers must provide regulators if they want to grab a “passport” to market their funds across European borders.

That passport allows them to operate by a single set of rules, rather than accommodate the discrepancies of onerous private placement requirements in each market or risk reverse-solicitation sanctions. All alternative fund managers have to do is register with a  single local regulatory body, which will offer them a green light to sell in other European countries. As is the case with sister regulation UCITS for traditional investment fund managers, Ireland and Luxembourg remain the most common European fund domiciles and markets to register.

That’s the good news. The bad news: Annex IV is about so much more than just about finding the right data that is conjures headaches and heartaches for those fund managers scrambling to complete and submit their first report to a national European regulator by the end of January 2015, or looking at their next Annex IV reporting hurdle.

As with other regulatory reporting requirements, some fund managers are attempting to outsource the work to fund administrators and other third parties, hoping they will be able to do a far better job than they can in-house. In fact, at this late date they are counting on it.

Understandable feelings, but bad idea acknowledge fund managers and even service providers. As is the case with any outsourcing agreement, fund managers had better plan on doing a lot of work on their own and verifying the work of their external helpers. It’s the only way fund managers, on the hook with regulators for any mistakes, know whether or not the information they are providing is accurate.

In a nutshell, national European regulatory bodies and their supernational overseer the European Securities and Markets Association (ESMA) want to ensure that investors — as well as the overall European market — are protected from alternative fund managers who don’t have a handle on their active marketm counterparty risk, liquidity risk and leverage of each alterntive fund. Annex IV documentation is required by ESMA to be collected by local regulators and akin to the US Securities and Exchange Commission’s Form PF, the required depth of information and reporting frequency depends on the fund’s total assets under management. As a rule of thumb, the largest fund management firms must submit the Annex IV report on a quarterly basis, instead of only semiannually or annually, and  the clock is ticking.

“Fund management firms which have won regulatory approval to operate under the AIFMD might have filed the Annex IV report in January 2014,” explains Melvin Jayawardana, European market manager for data management automation and regulatory reporting software provider Confluence in Luxembourg. “Others might have asked for extensions and have filed their report in October, but the vast majority will likely be filing at the end of January.”

No Silver Bullet

Fund administrators may seem like the obvious choice for fund managers looking for help, but in touting their AIFMD Annex IV reporting services, those service providers could accidentally be leading fund management firms to think they can simply hand over the burden of completing the AIFMD Annex IV documentation.

Delegating the whole job would be an attractive scenario for alternative fund management firms that want to stick to what they do best — ensuring a higher return for their investors which might well increase their changes to raise more assets. After all, that’s what they are in business for.

Right idea. Wrong strategy, say some consultants. “Fund administrators do the best job they can, but their services should be used carefully,” cautions Samuel Won, managing director of Global Risk Management Advisors, a New York-based advisory firm specializing in managed risk services, including risk-related regulatory reporting.

Fund administrators shouldn’t be viewed as a one-stop solution when it comes to regulatory reporting such as for Annex IV and Form PF. Instead, fund managers should understand what fund administrators typically can provide, and what they can’t.

Fund administrators don’t have all of the data necessary in-house and may have to rely on other fund administrators, prime brokers, risk measurement providers and the fund manager itself,” explains Mario Mantrisi, senior advisor and a member of the executive board for regulatory reporting specialist Kneip in Luxembourg. “Fund administrators also may not have the knowledge to provide the necessary interpretations to some of the questions.” Even worse, a fund manager overseeing multiple funds may also be using several fund administrators, making the project that much more complicated.

According to several fund management compliance managers speaking to FinOps Report, at least a third of the information requested by regulators could be considered “interpretative” or subject to error. “Just what the error is depends on not only the data, but also the methodology and assumptions used to make calculations,” explains Mantrisi.

Matter of Interpretation

Even the word “error” is a bit subjective. The fund management firm and fund administrator could easily come up with different answers in good faith. However, it is what regulators think which counts the most. Common areas of disagreement are which MIC should be used to report on portfolio concentrations when a stock is traded on multiple exchanges, or the basis for risk calculations for a fund of funds if there is no “look through” to the underlying fund.

Of course, it stands to reason that reporting firms and external consultants have a vested interest in pointing out the downside of using fund administrators for help. After all, wouldn’t fund management firms know that their fund administrators are far from a silver bullet?

Based on two contracts that fund management firms provided to FinOps, the fund administrators in question did indicate explicitly they would not be responsible for any mistakes, nor were they responsible for “interpretations.” Despite these caveats, both of the fund management firms used the fund administrator services. The reason: They were convinced they could do the work based on their “prestigious brand names.” In one case, the fund management firm found several questions unanswered. In the other case, the fund management firm uncovered incorrect answers. Just how did it discover they were incorrect? It was advised by a regulator to review some of the answers to its Annex IV documentation.

What do fund administrators have to say? Several contacted by FinOps Report were eager to describe what they offered, but didn’t want to specify their limitations. They also refused to elaborate on the generic operational workflow set up with fund manager clients to ensure accuracy on the grounds the information was “proprietary.”

Filling in the Gaps

So what should fund management firms do? For one, they shouldn’t scrap the idea of using a fund administrator for AIFMD Annex IV reporting altogether. “Fund administrators can be a good option for many funds needing assistance with risk-related regulatory reporting,” says Won. However, fund administrators should not be relied upon for interpretative guidance and in many cases are not able to assist a fund with needed risk calculations.

So what can fund administrators be best used for? For one thing, data aggregation and mapping once a fund manager is certain about the interpretations and assumptions it wants to use for AIFMD Annex IV reporting, recommends Won. It might not sound like an onerous task but it could well save the time and cost of doing it internally.

Even if a fund manager considers doing all the work internally, it might still need some external help. That is where a risk management advisory firm comes into the equation. “The fund manager doesn’t need us to help answer questions such as the descriptions of the fund, its investment strategy,” asserts Won. However, advisory firms can help with interpretations and assumptions, complex risk calculations such as VaR, stess test values, and finally reviewing and validating the filing to ensure there are no regulatory “red flags.”

Fund management firms that want to keep the work in house may also need a tool to collect all of the data from multiple internal and external sources. Data aggregation and reporting firms, such as Confluence, serve in such a technology role, but stop short of doing the number crunching involved with risk metrics or providing answers to any questions requiring interpretation. That is where risk analytics vendors and advisory firms come into the equation.

For fund management firms that prefer delegating the work to third parties, Dublin headquartered software provider ViClarity offers yet another option in conjunction with fund services provider Trinity Fund Administration and risk management software provider MSCI RiskMetrics. The service will collect trade and position data from the fund manager, any external administrators, custodians and prime brokers; validate, map and calculate risk liquidity and stress test data using MSCI Risk Metrics; capture qualitative data; verify and populate the template for AIFMD reporting provided by the ESMA; and complete the report to be submitted to the fund manager for final approval.

Such a scenario, explains ViClarity’s manager Tom Faraday, offers fund managers the benefits of outsourcing while retaining oversight and accountability. Workflow questions have been designed to map directly into ESMA’s template to help ensure the correct data is collected from the outset. Trinity’s technology also provides automated error checking of quantitative data several times throughout the process and the fund management firm always has access to draft copies of the Annex IV report to review at any time before submission.

Unsettled Requirements

Naturally, the first time a fund management firm completes the Annex IV reporting requirement will be the most challenging. It has to decide just how much work it wants to do in-house, what part it wants to outsource, and who will do the work. Ideally, the fund management firm will appoint a dedicated internal project manager to oversee third-party providers, technology, verification and deadlines. Giving the job to an already overworked operations manager is likely not a good idea, several tell FinOps. logically, the project manager be in the regulatory reporting unit, they say.

Even if all the work is set up correctly and validations take place, hiccups can still occur. Annex IV reporting is apparently a work in progress for regulators. “Local regulators are still finetuning what information they want and fund management firms which have already forwarded the AIFMD Annex IV reports are finding they might still have gaps,” says Faraday. “Information which was listed as optional to provide by the ESMA might be considered mandatory by a particular regulator.” Cases in point: ESMA says that providing data on high frequency trading, geographical focus, hedging and some risk metrics is optional, while the Central Bank of Ireland ultimately ruled that fund managers should fill in those blanks.

For fund managers staggering under the workload of their first Annex IV reporting, there is a silver lining. If they think long-term, that is. Simply filling in the questions as an exercise in regulatory compliance may not equate to having a full-blown risk management regime in house, but it certainly offers a good idea of exactly what investors are going to be looking for as the conduct their own pre-investment due diligence.

“Completing Annex IV is just a small portion of the larger risk management requirements that funds which fall fully under AIFMD must do now,” warns Won. Asset managers will also need to demonstrate to regulators and investors that they have solid and sustainable risk management processes, controls and governance. The post-crash investor cohort may not be totally risk averse, but they are likely to expect demonstrated competence in risk management.