By Vincent Reilly, Audit Partner, Head of Alternative Investments (KPMG in Ireland) and Jorge Fernandez Revilla, Director (KPMG in Ireland) 

By Vincent Reilly, Audit Partner, Head of Alternative Investments (KPMG in Ireland) and Jorge Fernandez Revilla, Director (KPMG in Ireland) 

The Alternative Investment Fund Managers Directive (AIFMD) is having a significant re-shaping effect on the alternative investment fund industry in Europe and beyond. The measures imposed by AIFMD are designed to curb systemic risk within the industry, with wide ranging implications for; the governance structure for Alternative Investment Funds (“AIFs”), the responsibilities for the Boards of AIFMs, and requirement to establish appropriate risk management oversight functions in manager (AIFM). The question that remains for AIFMs and AIFs is to what extent these extra regulatory compliance requirements can be turned into a real competitive advantage and deliver value to the investors in the AIFs.  

Scope of AIFMD and areas impacted

The broad scope of the Directive captures many managers of hedge funds, private equity funds, real estate funds and infrastructure funds that are marketed, managed or domiciled in the EU, a significant portion of whom have been either lightly regulated or unregulated in the past. There will be substantial effort required to adapt their operations to comply with the new requirements, all of which will have corporate governance aspects. The main impacts from the Directive will centre on the areas of; risk monitoring, regulation, process, delegation and monitoring of the processes, with the primary benefit of the greater regulation will likely be the passport to manage and market AIFs throughout the EU.

Impact of AIFMD on Corporate Governance and Risk Management

In implementing the Directive, boards need to be aware of how these changes impact on the principles of effective governance and their oversight role, while walking the fine line between robust corporate governance and maintenance of strong relationships with all parties to achieve that aim, within the expense constants the fund is facing. Throughout this process of change for both the AIFMs and AIFs, the roll of the directors will be vital in establishing and defining the new governance structures and in achieving the significant oversight that will be required under the Directive.  Effective governance and risk management is organisation wide and starts with the ‘tone at the top’ that cascades through every level of the organisation and hence the board will have a key role to play. The process of creating the corporate governance and risk management culture may be a particular challenge in well established entities, in circumstances where there is a need to challenge the existing culture. A number of critical decisions will need to be made by the boards on the corporate governance structures of the AIFMs and AIFs going forward due to the new regulation:

• delegation - while the Directive recognises that AIFMs may choose to delegate their functions to third parties, the issue arises as to what extent the AIF will delegate out these functions, how the board will perform its due diligence prior to engaging with the third party and its processes for ongoing monitoring of the delegate. There will be a challenge for the boards to find the right balance between outsourcing certain functions while keeping the substance and majority of the activities in-house;
• risk management – the board needs to consider how to set up the reporting lines for a segregated risk management department with sufficient resources to accomplish their required tasks allowing the board to quantify, monitor and manage all risks independently of the portfolio manager;
• valuation - previously for Irish funds, the board had ultimate responsibility for the valuation of a fund. However, under the Directive the AIFM will now have responsibility for the valuation. To the extent that the AIFM is not the board this will represent a change in the current practice. Connected with this, the Directive requires the AIFM to document the valuation procedures and process at an asset class level, with the review and escalation process and this policy should be reviewed on an ongoing basis. This documentation and review will likely pose a challenge to the board in circumstances where the valuation function is outsourced; 
• flow of information - the board needs to ensure it receives the necessary reporting from the valuation, risk management and other related functions along with any outsourced functions to allow them to comply with their oversight role.  The board will need to be able to identify the individuals who are responsible for these functions and hold them accountable for their decisions;  
• documented procedures - the Directive requires that the AIFM will have documented procedures, especially around valuation, risk management, and due diligence over new investments and operational procedures for the board. Additionally the Directive requires that the AIFM regularly reviews the procedures and updates them as necessary. For most AIFMs and AIFs this will be a new requirement and require extra time and resources; 
• focus of the board – the focus of the board should revolve around the key decisions that need to be made by the AIFM to ultimately deliver value to the AIFs.

Benefits of effective Corporate Governance and Risk Management

In addition to the challenges resulting from the Directive, there are also a number of potential benefits arising from the changes made to corporate governance beyond simply reducing regulatory risk from non-compliance.  Additional comfort can be provided to the different stake holders (e.g., investors, potential investors, regulators, tax authorities, etc.) through compliance, helping the AIFMs to retain and attract new investors to the AIFs. There are opportunities presented by the process re-engineering that is required to help ensure compliance with the Directive and give AIFMs a chance to streamline work and decision making processes to help minimise inefficiencies, while helping reduce the risk of rogue behaviour and mismanagement.  The Directive gives both the opportunity and requirement for AIFMs to hold their staff accountable for the successes and failures of the AIFs. To the extent that AIFMs are successful in marketing, their improved corporate governance, this could be preserved as a competitive advantage, impacting positively on the share price of the AIFs if listed. 

Expectations and challenges

The industry expectations for the responsibilities of the board in the context of the Directive are likely to be the overall role of ensuring compliance with the Directive for their entities and reviewing the policies, processes and delegation arrangements required. The board is expected to continue in the established role of considering the investment strategy and how this is implemented through policies. There will also likely be a very clear role in supervising the newly delegated functions post due diligence, and helping ensure that the service level is maintained as well and that the AIFMs documented procedures match up with the reality of the activities at the delegate level. The practical outworking of the above is expected to be the responsibility of the service providers to the funds, but the boards will still need to have an active role in their supervision, and ultimately take ownership for compliance.  

The challenge posed to AIFMs and AIFs and to the directors sitting on their respective boards is whether they can turn what could potentially be seen as a regulatory burden increasing their total expenses ratio, into a competitive advantage that can contribute to growth ultimately to return through better risk management and general processes. What is certain is that processes and activities will be changing, making this change not only compliant but the driver of returns and competitive advantage will likely be the mark of a successful AIFM. 
 

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Contacts

Vincent Reilly

Vincent.reilly@kpmg.ie

Jorge Revilla

Jorge.revilla@kpmg.ie