Magazine Issues » July-August 2014

INSIDE VIEW: New challenges facing alternative funds

Human pyramidCorporate governance challenges are forcing managers to make significant changes, says Michael Hornsby, of EY in Luxembourg.

The Alternative Investment Fund Managers Directive (AIFMD) has raised the bar substantially for alternative investment fund managers and the funds they manage. Managers are required to make significant changes to their organisational models and structures, corporate governance and remuneration practices, and many other aspects of operations. 

The impact of AIFMD has to be reconciled with the impact of other regulations, such as Dodd-Frank in the US and the European Markets Infrastructure Regulation (EMIR), and changes in tax regimes, such as the EU Savings Directive, OECD Common Reporting Standards and Base Erosion and Profit Shifting.

In the middle of this are the governing bodies (generally boards of directors) of alternative funds and of managers.

Board members should fully understand fund structures and their roles and duties therein. The role of the governing body will depend on factors such as the asset class and the group organisational model. 

Examples of fund models include:
• Internally-managed
• Group manager with multiple funds in one or more asset classes
• Group management company and alternative manager – the “super ManCo”
• Independent external manager.

In order to obtain a clear understanding of their role, members of governing bodies should ask questions such as:
• What roles do a governing body of the manager or fund have?
• What are applicable regulatory requirements?
• What corporate governance codes apply?
• How can I obtain a clear understanding of the organisational model of the fund (including its often complex underlying holding structures), the manager and asset management group, sponsor, or initiator?
•  How do the key decision-making processes work?

Under AIFMD, most of the challenges faced by boards in the alternatives world are not new; however, the new AIFMD requirements mean that boards must devote more time to their roles, and ensure that there is a greater level of formalisation at manager and board level. 

Boards must maintain appropriate board composition in order to respond to complex challenges. All board members must have appropriate knowledge, skills, experience, reputation, integrity and independence, and commit sufficient time to their mandate, especially as manager and fund activities evolve.

Typically, the manager will provide infrastructure not only to the board, but also to the fund and any underlying holding structures (special purpose vehicles, or SPVs) to support all relevant boards in their activities.

There is a wide range of different models, some of which are more formalised than others, relying on the resources of the manager including staff, processes and systems.

Considering the oversight responsibilities of the manager, and its role in coordinating the board processes of the fund and the SPVs across multiple fund structures, a well-designed workflow tool may be appropriate.

There are many types of potential conflicts of interest. Some are inherent in the operation of fund structures, such as investment transactions with related parties or appointment of a related party portfolio manager, investment adviser or service provider.

Boards must make sure that managers take all reasonable steps to identify, prevent, manage and monitor conflicts of interest in order to prevent them from adversely affecting the interests of funds and their investors. 

The biggest challenge is to identify any potential conflicts of interest.

Managers under the AIFMD are required to ensure that risk management is functionally and hierarchically separate of the portfolio management function and that any internal valuation function is functionally independent of it, too.

The independence of the risk management function and the valuation function from the portfolio management function does not imply that they should not work together. 

On the contrary, both the risk management and valuation functions should often work together closely with the portfolio manager, for example, to understand the portfolio management process and decisions, obtain the data needed to perform the risk and valuation functions and coordinate the due diligence process.

There are a number of practical measures which can be taken to avoid becoming a letter box entity and to maintain adequate substance. These include:
• Ensuring that the manager is adequately staffed
• Formalising the manager’s roles and responsibilities
• Formalising the roles and responsibilities of delegates (such as the portfolio manager), advisers (such as the investment adviser) and service providers, through contractual arrangements
• Ensuring that all formal communication respects the general organisational arrangements of the manager and the contractual arrangements
• Ensuring that formal meetings of senior management take place on a regular basis

If the manager or the fund performs marketing itself, then it is responsible for complying with the applicable marketing requirements. 

If distributors or placement agents are appointed, then they will generally ensure that the applicable marketing rules are complied with. 

In this case, the fund and/or manager should perform initial and ongoing due diligence on distributors or placement agents. 

The marketing arrangements should be formalised in a marketing policy. In practice, the marketing policy is often elaborated by the initiator or asset manager at group level.

The manager should always be in a position to understand the marketing arrangements for each fund it manages.

It should understand the distribution strategy, be the owner of – or be informed of – the marketing policy, perform due diligence on the distributors or ensure that appropriate due diligence is performed, and monitor the marketing on an ongoing basis.

Once the AIFMD has been embraced, and a new or enhanced manager has been authorised, boards need to get ready for their next challenges. The most pressing one is “walking the talk”: operating effectively in the new post-AIFMD environment. 

Looking further ahead, I see another key challenge emerging for many alternative managers: responding effectively to both the regulatory and tax agendas by aligning regulatory and tax substance.

Michael Hornsby is EY Luxembourg real estate leader and AIF Club chairman

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