Release date
16 January 2023
Author
By Andreas Charidemou, CFA, Executive Director, Head of Risk Management, Resolute Investment Management (Cyprus) Ltd
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Evaluating Counterparties – A Fund Manager’s Point of View

Evaluating Counterparties – A Fund Manager’s Point of View

A common practice in the Fund Management industry is the delegation of various operational functions to service providers. Specifically, some Alternative Investment Fund Managers (‘AIFMs’ or ‘Management Companies’) tend to delegate various functions to access the expertise of professionals in specific fields. While AIFMs can perform the various functions in-house, subject to meeting certain organisational requirements, they choose not to and proceed to delegate the function as it might be a more cost-efficient option for both the AIFMs and the Funds they manage. Building an in-house team of individuals to cover the specific function that would otherwise be delegated, might be much more expensive and time-consuming. It also comes with operational risk, specifically, that no matter how thorough the interview process is, a person appointed to carry out the function may turn out to lack the relevant skills and experience required for the role or simply be a cultural mismatch.

In cases of such delegations, the AIFMs always remain fully responsible for discharging all of their obligations under the regulation. It is important to understand that delegating is not without risks and in some cases it might result in the relationship and the obligations towards the investors being deteriorated.  As a result, it is important to develop an internal counterparty evaluation policy that will help in assessing the counterparties to whom functions are delegated. Suitable counterparties for AIFMs that should be continuously evaluated include Depositaries, External Auditors, External Valuers, Financial Institutions, Fund Administrators and Legal Advisors.

The Regulation

The AIFM Directive (‘AIFMD’) states that AIFMs that intend to delegate to third parties need to notify their competent authorities before the delegation arrangements become effective.

In addition, some of the provisions included in the AIFMD, amongst others include that:

  • “AIFMs must be able to explain the entire delegation structure on objective reasons;”
  • “The third party, that the function is being delegated to, must obtain sufficient resources to perform the tasks, and its employees involved must be of good repute and obtain sufficient experience;”
  • “The delegation does not prevent the effectiveness of the supervision of the AIFMs, and it does not prevent the AIFMs from acting, or the Alternative Investment Funds (‘AIFs’) from being managed, in the best interests of their investors;”
  •  “AIFMs must be able to prove that the Delegate is qualified and able of undertaking the functions to be delegated;”
  • “AIFMs must also show that the Delegate was selected with the appropriate due diligence and that the AIFMs are in a position to monitor effectively at any time the delegated activity;”
  • “AIFMs can give at any time further instructions to the delegate and to withdraw the delegation with immediate effect when this is in the best interest of the investors;”
  • “AIFMs need to review the services provided by each delegate on an ongoing basis;” and
  • “If the function being delegated is either portfolio management or risk management, it must be granted only on assets which are authorised for asset management and are subject to supervision. If the above condition cannot be met, one of the two functions can be delegated only by prior approval by the competent authorities of the AIFMs.”

Delegating Process and Evaluation of a Counterparty

In general, a typical procedure for outsourcing is as per the following order:

  1. Identification of functions to be delegated
  2. Service Provider Selection
  3. Counterparty Evaluation & Due Diligence
  4. Transition
  5. Continuous Monitoring

To comply with all of the above, a counterparty evaluation policy is essential in helping the AIFMs carry out their obligations under the AIFMD.

Specifically, a counterparty evaluation policy may contain, for each delegated Function, a specific set of factors that must be assessed. Specific factors depend on the nature and the function being delegated. For example, when assessing a depositary, a specific factor might include access to foreign bank accounts.

Each factor can be included in a scoring mechanism and depending on the importance of each factor, it should have a relevant weighting in the score. Counterparties that their score is below or equal to the average in each category should be carefully considered before being appointed. The scores of various counterparties for each service shall be carefully compared with each other and a decision shall be made as to which counterparty should be appointed for each service.

Finally, the Senior Management of the AIFMs is responsible for the ongoing monitoring of the delegates and the delegated functions. The results of the monitoring processes should be reviewed and relevant minutes along with related documentation shall be kept and provided to the Board of Directors.

Replacement of a Counterparty

If several issues are identified during the ongoing monitoring process, they should be subsequently reported to the Board of Directors and as appropriate further investigation and actions should be performed.

The Board of Directors should further assess whether the escalation above is justified and needs to decide to either rebuke the service provider and request corrective measures to be taken instantly or to terminate the agreement which is subject to the approval of the replacement by the Regulator. Should the Board of Directors decide to delegate the function in question to another service provider instead of performing the same in-house, then the steps outlined above for the “Delegating Process” must be followed.

Conclusion

Having an internal counterparty evaluation policy is of critical importance. Despite the fact that it is not a legal requirement, having the best possible counterparties is an ethical responsibility of all AIFMs towards their investors, which will also contribute towards the proper functioning of the Alternative Investment Funds.

Whether the AIFMs choose to delegate some of their functions or perform them in-house, it must always be undertaken according to the latest regulatory requirements and the provisions under the AIFMD and other prevailing legislation. In order for the AIFMs to provide effective control of the management of the AIFs, it is crucial that the delegation of various operational functions to service providers is done according to the prevailing rules and regulations. Management companies always remain fully responsible for discharging all of their obligations under the regulation, despite the fact that the function is being delegated.

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