The Evolving Role of Compliance and Risk Management Among Alternative Asset Managers

By Shyam Prakash and Steven Richard, Gravitas  

Chief Compliance Officers (CCOs) at alternative asset management firms are facing increasing challenges overseeing and monitoring compliance with respect to investment guidelines and portfolio compliance mandates. To meet the new and growing challenges of effective compliance and risk management, a new trend is emerging among CCOs—namely, an expansion of the role to include greater involvement than ever with the investment process and, at the same time, expanded monitoring of portfolio compliance risk. Compliance risk can be broadly defined as monitoring compliance of investment style, portfolio construction and investment risk management, where these and other key areas relate to investment mandates, risk management guidelines and investor disclosures.

Several Factors Behind Heightened Oversight

CCOs are also introducing a wider regulatory focus on matters that reach beyond traditional “hot topics,” such as code of ethics and insider trading. These additional areas include investigating the control structure of the firm’s investment management practices and adhering to investor disclosures. Collectively, this heightened scrutiny stems from several contributing factors, including:

- Market events over the last several years have forced fund managers to meet investor demands for greater visibility into risk management policies and practices. As a result, there has been an increase in the level of investor disclosures surrounding portfolio strategy risk and compliance (e.g., control over “style drift” and concentration risk).

- Many larger, more experienced investors have been turning to separately managed accounts to gain access to prominent alternative investment managers. In doing so, these investors have been able to secure increased transparency and risk monitoring with respect to investment managers’ trading strategies, portfolio construction, risk metrics and portfolio performance.

- Additionally, with the implementation of Dodd-Frank, there has been a significant increase in the sheer number of SEC-registered advisors. This brings with it the attendant burdens of demonstrating and documenting appropriate compliance with investment policies, procedures, and other elements that comprise fund offering memorandums, external marketing materials and internal operating manuals.

To meet these and other new dimensions of external scrutiny, CCOs are more acutely focused on thoroughly understanding their firm’s investment and risk management environment in order to measure, monitor and report on portfolio risk against established investment policies and limits. While the extent and involvement of the CCO will vary by firm, “best in class” CCOs will focus on closer interaction and collaboration with risk managers in learning both the qualitative and quantitative dimensions of investment styles and strategies, portfolio construction processes, risk management framework, pre- and post-trade limit monitoring, periodic portfolio compliance reviews and testing.

Larger alternative asset management firms have responded to these demands by formalizing the risk management function through the addition of an independent Chief Risk Officer (CRO) to assist the Chief Investment Officer (CIO) and portfolio managers in making sound investment decisions. CROs are also playing the role of policing investment guidelines and risk management rules. To support the CRO and the risk management function, firms are making significant investments in building a comprehensive and integrated risk management framework. This may include establishing the proper governance to define appropriate measurements based upon investment guidelines and investor disclosures, defining policies and procedures to properly monitor compliance with such measurements, implementing advanced risk technology to measure risk limits and portfolio performance, and conducting stress testing and scenario analyses. Even with the sufficient levels of risk management experience and resources available at larger firms, implementing risk frameworks remains a challenging and time-consuming task and an even bigger challenge for smaller firms.

New Hedge Fund Launches Spur Scrutiny

As reported recently, new hedge fund launches during the first quarter of 2012 reached the highest level since the fourth quarter of 2007. At the same time, we are seeing a significantly sharpened focus on newly registered alternative asset managers by regulators. The SEC’s short term strategy includes examinations of a significantly large number of newly registered managers and reviews of marketing materials as well as all compliance policies and procedures, among other materials.

Although start-up funds typically lack the budget and resources of larger, more established firms, they still bear the same “burden of proof” in terms of fulfilling their fiduciary responsibilities and contractual obligations. For this reason, newly launched alternative managers are facing major challenges in the area of compliance risk monitoring. Whether they bite the bullet and invest in advanced risk technology and staff resources or leverage third-party service providers with the necessary scale and risk-management experience, newly launched alternative asset managers must ultimately check the same compliance and risk boxes as their largest, more seasoned rivals.

To be precise, firms are not looking to outsource the risk management function, which is the mandate and responsibility of the portfolio management team. What they seek are experienced risk professionals along with the risk technology needed to help them meet the demands of investors and regulatory requirements. This can range from establishing a sound risk governance framework and designing customized risk reporting to advising on customized stress testing and scenarios analyses, and more.

While they face fierce competition for investor allocations and must closely manage costs, firms increasingly view operational, compliance and risk infrastructure as a competitive advantage. Sustaining that competitive advantage while continually adapting to a dynamic regulatory environment has led to ever-widening demands for complex, cross-functional capabilities, intelligence, analytics and intensified reporting horsepower. It is in the midst of this historic transformation that firms need to be thinking pro-actively about the solutions they are implementing in the course of managing formalized risk management and compliance practices within a continually evolving alternative asset management industry.

Shyam Prakash is Director of Risk and Steven Richard is Managing Director of Risk at Gravitas Risk Analytics & Advisory Services, a provider of co-sourcing solutions for technology, investment operations, risk and research support to the alternative investment and financial services industry. Gravitas is based in New York with offices in Chicago, Greenwich, Mumbai and Ahmedabad, India. 

Click Here for PDF