More and more closed-ended private equity and real estate (PERE) funds are choosing to use a third party alternative investment fund manager (AIFM) for the entire length of the fund. This is largely due to the robust oversight, due diligence processes and compliance with regulatory requirements that such a provider can deliver. Here, I explore in more depth the drivers behind this growing trend.
Managing risk without relinquishing control
When the Alternative Investment Fund Managers Directive (AIFMD) came into play in 2013 it presented specific challenges for PERE funds because the regulatory measures and authorisation processes it mandated were completely new. While traditional financial asset classes were already used to implementing such measures, pure alternative players such as those in private equity and real estate were not. Moreover, the new obligations required expert judgement that could not easily be managed through common quantitative risk indicators.
PERE fund managers have since realised that appointing an external AIFM can fulfil this need and alleviate the burden of risk management without necessarily relinquishing too much control. Appointing an external AIFM can free up the fund manager to focus on portfolio management as a delegate, knowing that governance is being handled and the fund remains compliant with AIFMD.
Navigating regulatory changes
Crucially, a third party AIFM can help PERE managers navigate ever-changing regulations, including the AIFMD itself (which is due to change its parameters again as the 2017 review clause comes into play, with final revisions expected in 2020.) as well as market-specific regulation such as the Dodd-Frank Act in the US.
The proposed changes to pre-marketing rules under AIFMD provide a good example of impact on PERE funds. In December 2018, the Economic and Monetary Affairs Committee (ECON) of the European Parliament voted on legislative proposals for a directive and regulation on the cross-border distribution of collective investment schemes, with the aim of making pre-marketing possible while preventing it from being used to invoke reverse solicitation. Many PERE managers enter an EU country for marketing to one or two investors, whom they may or may not use, and so utilising a third party AIFM would be a more efficient way of navigating these pre-marketing restrictions.
Notably, a 2018 survey of PE fund managers by Private Equity Wire found that 67% of respondents believed regulatory compliance demands would be a key driver for outsourcing in the private equity space in the next five years.
The looming prospect of a no-deal Brexit is also likely to have an impact on the use of third party AIFMs among UK-based PERE managers. Many may choose to have a Luxembourg AIFM for EU distribution, keeping risk management in Luxembourg and delegating the portfolio management back to the UK to cause the minimal amount of disruption.
AIFMs and the investment committee process
Managers operating in the PERE space are also increasingly considering using a licensed AIFM for portfolio management internally, with the PE or RE manager then becoming part of the AIFM’s investment committee. For illiquid asset classes, these delegation arrangements are becoming more common – as long as the AIFM representatives within the investment committee have the relevant expertise within the specific asset class to challenge the portfolio manager.
Harnessing technology through a third party AIFM
A big part of the attraction of using a third party AIFM is the enhanced technology that comes with it. The complexity of the AIFMD requires a clear line of sight for risk management and reporting and this is particularly important for illiquid asset classes such as private equity and real estate. Such funds require more comprehensive valuations than other asset classes, which can only be achieved with a solid tech infrastructure.
Unfortunately, given the wide variation in the way each fund management group operates, there is only so much standardisation that can take place. However, there are a number of processes that can be automated through technologies such as robotic process automation, and using a third party AIFM provides access to a robust, scalable technology platform that can simplify processes and reporting requirements.
Transparent and dynamic reporting
Another driver for outsourcing among closed-end PE funds, again related to technology, is the rising demand from investors for more information. Limited partners are looking for much greater levels of transparency, even with illiquid PERE funds. Indeed, PERE funds are subject to additional risk and are therefore under greater scrutiny when it comes to governance. This is managed more efficiently with the use of a third party AIFM, which can monitor the entire fund structure, including SPVs, thus providing a much more comprehensive level of governance.
Further, using a third party AIFM grants access to a suitably customisable and responsive reporting platform without having to invest heavily in an in-house solution. It’s fair to say that the increasing use of such technology is transforming the way that PERE funds are managed, as higher quality data also helps improve decision-making.
A trend that’s set to continue
In the aforementioned Private Equity Wire survey, a whopping 96% of respondents saw outsourcing their administration function as advantageous. Capitalising on specialist regulatory expertise and technology to provide greater transparency to investors in a more effective and cost-efficient manner were the key drivers. In the current climate of uncertainty and fast-paced regulatory change, coupled with the fast growth of the PERE sector over the last 12 months, it is likely that the trend of utilising a third party AIFM well beyond the fund’s initial set-up phase will continue.
IQ-EQ and Lawson Conner
As a third party AIFM, IQ-EQ provides a range of AIFMD services to alternative fund managers (both EU and non-EU) from multiple leading European fund centres including Luxembourg, Paris and London.
Part of the IQ-EQ group, Lawson Conner is an award-winning provider of outsourced regulatory hosting and compliance solutions, including IQ-EQ’s UK-based third party AIFM offering. To find out more, please don’t hesitate to get in touch:
T: +44 207 305 5810
E: [email protected]