This article was first published in Hedgeweek.
Navigating the increased regulatory requirements of AIFMD has been a costly and resource-intensive exercise for many investment managers over the past few years. Now that the dust has settled on AIFMD, fund managers need to decide on, and implement, the most efficient operating models that allow them to manage assets and raise new capital.
Last month, SEI hosted a panel session in London in conjunction with Duff & Phelps, EFA and leading alternative investment managers entitled “Practical AIFM Management Company Operating Models for Investment Managers”, to specifically address the ways in which managers might wish to establish new European fund platforms or streamline their existing operations.
Since AIFMD officially went live two years ago, much advice and guidance has been proffered on how to approach the issue of establishing an AIFM or management company presence in Europe. Of course, non-EU managers can still choose to avail of national private placement regimes to market their funds, but those looking for a long term advantage are giving careful consideration as to whether to set up the AIFM internally, to outsource specific functions of the ManCo, or to go down the full outsourcing route and appoint a third party ManCo.
Arriving at such a decision can be complex depending on the nature of the fund manager’s existing business activities and expectations for the future, specifically as they relate to Europe.
Choosing the most appropriate operating model will depend on a number of factors.
Firstly, which should not be taken for granted, the investment manager needs to have a clear idea of what their investment plans are for Europe. Does it have a well-thought out distribution strategy? If yes, and Europe is an important market in which to grow the business, then the second important factor is to what extent does the investment manager want to outsource or take on regulatory risk?
“When looking at the AIFMD, it is a collection of rules on risk management, oversight of delegates, on remuneration, distribution, disclosures etc. The question is, does the investment manager feel comfortable taking on these regulatory risks? And if so, to what extent can it handle all the requirements internally?” asks Alan Picone, Managing Director at Duff & Phelps; the firm’s authorized third-party management company, one of the first firms to obtain a third party AIFM license in Luxembourg, now serves AIFM and UCITS clients across all jurisdictions and asset classes around the globe.
As part of the panel, Picone went on to explain that the next important factor is judging one’s operational robustness.
To what extent can the investment manager leverage its existing infrastructure? Does it require having to find new service providers to keep abreast of AIFMD, and if so how will the investment manager monitor and oversee those service providers objectively?
“The way that information is shared and the way that the manager interacts with service providers is important to assess. Could it become a potential distraction to the way they run the business as opposed to a seamless plug-in? In other words, could it become a more cumbersome process operating the management company internally?
“The overall efficacy of the operating model is a key consideration, without doubt,” Picone tells Hedgeweek.
The third factor is cost.
If an investment manager wants to build its own AIFM, it will need to put aside regulatory capital in the order of EUR300,000. It must also put in place professional indemnity insurance or, alternatively, have sufficient funds in place to cover any costs that arise from professional negligence. Piece by piece, the costs to setting up a self-managed AIFM soon rise.
As such, it is important to design the operating model in such a way that is not necessarily systematically driven by cost reduction, but rather incorporates costs that could be amortised along the way; one of those costs is selecting the right service providers with the appropriate systems, technology and expert skill-sets. “This is a very important element of regulatory risk that one can mitigate. The initial costs pay off as the fund evolves,” adds Picone.
Expanding on how managers can ensure they have an efficient operating model, Giles Travers (pictured), Director, Alternative Investment Funds at SEI Investment Manager Services, says that managers should look to technology to help “conduct the orchestra” of the various workflows, data requirements and service providers that comes with building a robust AIFMD compliant fund platform.
“AIFMD brings with it an additional set of reporting and requirements to an already complex operating environment for alternative asset managers. Whether you choose to insource or outsource the Manco functions, a COO or CFO will need to ensure they retain transparency over the operating model and deliverables. If you try to do this based on Excel spreadsheets, you’ll soon find yourself failing to keep up with the work-streams, data elements and audit trail necessary to meet regulatory requirements. A robust and scalable technology platform that provides a clear line of sight on all the different workflows, whether from a risk or reporting perspective, is essential,” says Travers.
The whole concept of using a separate, regulated management company is entirely novel for alternative fund managers who have never operated UCITS funds in Europe. As such, there is still a lot of conceptual work involved when it comes to establishing an AIFM, particularly for non-EU managers.
One of the main issues relates to control. If the fund manager decides to go down the third-party route, they are effectively electing to hand over 15 of the 16 key requirements of the Directive, operationally speaking, which includes risk management. The only function they retain would be portfolio management.
“One of the key factors that will influence the decision-making process will inevitably be the extent to which controls can be performed on the ground,” says Picone. “The experience that we, at Duff & Phelps, have as a management company is that it is, in effect, a case of operational risk management mitigation; that’s what you are getting when you go down the outsourced route,” explains Picone.
In his view, the issue of control should not be overly obsessed over. Taking regulatory risk out of the equation for a moment, over the lifetime of the fund the management team will spend a lot of time focusing on, and managing, market risk, liquidity risk etc., which is a fundamental exercise. In reality, however, unless the hedge fund or PERE fund is using excessive leverage, then the chances are the management of market risk is not going to require sophisticated risk engines.
“My view is that operational risk matters the most when it comes to supervising what is happening at the fund level. Interestingly enough, that is the one risk where you have the least impact (on control) as a fund manager based in the UK for example who might be using Luxembourg-based service providers as part of an outsourced solution,” says Picone.
Who’s conducting the orchestra?
This is why it is important that the fund manager, when thinking about the operating platform, has someone in place that can be the point person to not only coordinate the various providers, but view the outsource arrangement holistically and, much like the conductor of an orchestra, ensure all parts are working symbiotically. What that means is engaging with service providers, having a thorough cartography of the operational risks, enquiring during the due diligence process about the incidents/challenges that service providers have faced and how they mitigate them to avoid repeat episodes, and so on.
It’s about looking in detail at the flow of operations that needs to be deployed. When the manager has that in place, they end up with an operational risk matrix and, says Picone, is a key aspect of what Duff & Phelps’ management company team does.
“We are structured in a way that allows for close interactions between risk and operations teams, which, when combined, makes for an effective operational risk management team.
“The extent to which operational risk can become detrimental has been underestimated. When it comes to risk management, people often over-simplify it or tend to have clichés in mind. They think that risk is merely about calculating exposures or that operations is just about filling in due diligence questionnaires. That’s certainly not our mindset. We look at operational risk management at a deeper level. In my opinion, that’s the key challenge for any fund manager to consider when thinking about the best AIFM operating model,” opines Picone.
Indeed, the issue of ‘control’ should not only be thought about from an outsourcing perspective. Even if the manager decides to become a standalone AIFM, there is still an element of giving up control, more so for non-EU managers, to the European compliance officer and other local operations staff that run the AIFM. “The risk of creating your own AIFM is that if you hire the wrong people, cannot keep pace with technology and system requirements or are not on top of regulatory and market developments, whereas managers who look at a third party option are better able to benefit from the ManCo’s economy of scale from working with multiple funds,” says Travers. He adds that the technology platforms that SEI has built are able to assuage concerns that US managers might have in terms of ensuring that they see the same level of transparency both in the US and Europe.
“SEI has been providing regulatory and compliance services to investment managers since the 1980s. The lessons we have learnt with respect to data management, data governance and how to provide managers with the right interface to allow them to drill down into the detail were fully leveraged when it came to then providing a reporting solution for AIFMD. Managers can get a consolidated regulatory reporting view across their funds in multiple jurisdictions. Transparency is key, from a trust and control perspective, even if they are using a third party AIFM,” adds Travers.
It is worth pointing out that nothing is set in stone. Operating models are fluid and evolve as market conditions and the regulatory pipeline changes. Even if a manager makes the initial decision to use a fully outsourced AIFM model, there’s nothing to stop them from eventually becoming their own internal AIFM a year or two down the line. In many ways, this may be the most sensible route for managers as it allows them to test out a fund in Europe; if it works and they raise a good level of AUM, they might decide to become an AIFM. If it doesn’t work as well as expected, at least they haven’t spent a significant amount trying to build a footprint.
Asserts Picone, “Asset managers should look at a phased approach and to use a third party ManCo as an interim solution. My view is that while you cannot – and should not - simply wash your hands clean of the AIFMD, you should at some stage in the future envisage becoming your own AIFM. Clearly, given the complexity and intricacies of operating a management company, it’s certainly a good strategy, early on, to allocate that role to a third party ManCo. They can share the necessary knowledge and experience, the main regulatory and operational risks, which will help the fund manager get up to speed with AIFMD.
“We work hand in hand with clients to help them develop their own AIFM,” continues Picone. “We can host them on our ManCo and then develop a plan to eventually allow them to operate on a standalone basis. There’s no forced retention.”
Not only are operating models fluid, they also need to be customized - no fund manager is the same. None have the same operational infrastructure, talent base in-house, investor base, assets under management, or indeed future growth aspirations. While there are certain approaches to AIFMD that have proven to be successful, it is important that the solution addresses the fund manager’s unique nuances and take into account the absolute certainly of a fluid market.
As a final word of advice, Travers suggests that regardless of which management company operating model fund managers choose to adopt, at the back of their mind they should be considering their investors and how their chosen route will stack up under due diligence.
“One anecdote I heard recently was that a fund manager had selected a particular third party ManCo. They then presented the ManCo’s details to their investors, one of which said that they were unhappy with the selection and suggested that the manager go back and re-think their operating model accordingly.
“As such, understanding your potential market, your investor profile and how your European platform will evolve, should be considered when assessing the various operating platform options available,” concludes Travers.