Defending a Fund

Nitin Khanapurkar, Global Head of Governance, Apex Fund Services, in an interview with HFM discusses an administrator’s lines of defence for funds.

HFMWeek (HFM):   What are the key lines of defence for funds?

Nitin Khanapurkar (NK): From an administrator’s standpoint, ensuring the protection of its clients is best addressed via a three-pronged approach. The first line of defence comes in the form of the administrator’s ‘operational controls’. These are embedded into the firm’s day to day processes and no matter what strategy the fund has, operational controls need to be solidly embedded in the set-up to subsequently form the basis for the first line of defence.

The second line of defence is compliance; a practice necessary for adhering to both external regulation and internal compliance frameworks. Compliance has its own array of monitoring controls that act to ensure the operational controls are functioning effectively, while simultaneously acting to fulfil regulatory requirements.

The third line of defence is the internal audit. Internal audits independently assess whether each of the aforementioned controls are operating effectively. This process is carried out independently from the general operations of the firm and subsequently reports directly to the company’s board. In my experience these are the three key lines of defence.

HFM: What factors must an effective internal audit address?

NK: When you look at the funds industry, there are both regulated and unregulated jurisdictions, each of which requires a specific control environment. The increasingly globalised nature of the investment management industry makes this an ever more complex landscape for funds to navigate. For example, a fund may be run in a regulated jurisdiction while the investment manager is set-up in a separate unregulated jurisdiction.

The performance of an internal audit may only address the first factor – the fund’s domicile and its overall structure. As a result, in many cases what we see is that a deeper dive into the fund’s day to day operational controls is somewhat lacking. The internal audit should really focus more on such matters to optimise its effectiveness, including the reference to multiple checklists for each action point performed. This process should be adhered to from the point of inception/on-boarding, all the way to fund liquidation or winding down. This standardisation is critical as it ensures that any fund accountant performing audits for the fund knows exactly what protocols they are required to follow. The internal auditor is responsible for safeguarding the appropriate design of control procedures and operating effectiveness. Essentially this person’s role is to ensure that the controls put in place are commensurate of the scale and nature of the operation and they may design various checklists to regularly test these controls are performing correctly. It is important that a) the checklists are followed consistently and b) that these checklists are comprehensive and regularly updated. In today’s world, most documents are ‘live documents’ that will become quickly outdated given the dynamic nature of businesses and the frequent changes to regulation. The checklists should typically be assessed and adapted on an annual basis, or if there has been a major regulatory change.

HFM: What governance and risk management responsibilities exist at the admin level?

NK: Interestingly, there does not seem to be a consistent regulatory framework at a global level when it comes to addressing risk management. From a control standpoint, the fund often has a very small number of people who control it directly; for this reason, governance is always a challenge.

Having said that, if we take a look at the majority of local regulators, we can see that they are increasingly adopting the same path as seen in the banking industry, as regulators now call for the administrator, as well as the fund manager, to evidence that they have proper governance and risk management procedures in place.

Again it’s the three-pronged approach. For example, at Apex we operate in 26 jurisdictions worldwide so it is imperative that we maintain proper governance and controls at all levels. We need full oversight and understanding of how our staff and offices operate and must ensure that a proper screening process is in place on a local level. We ask ourselves questions such as: are they performing as required? Are their risk appetites consistent? Are we holding board meetings within the stipulated timeframe? Do we have our own risk framework in place? Do we have our own risk and audit committees?

In many cases, the way in which funds are operating may be a challenge due to fragmentation and the lack of a well-established central governance or risk management framework. The second piece around risk management is the hidden underlying risks a fund may have. One way to mitigate this is to perform a risk assessment of the client, both during the on-boarding process and on an ongoing basis.

As previously mentioned, at the time of on-boarding, a risk profile of the client must be performed. This is then further subdivided into a risk management assessment of the fund manager and the fund itself. Following that, a certain set of questions need to be asked in order to classify whether the manager is a risk – this will be largely dependent on the domicile of the fund and the prior experience of the manager in question.

As far as the fund is concerned, the risk level will depend on a few factors: strategy, domicile, the size of investment and the type of investor the fund is likely to involve. Once these risks are identified, other parameters must be continually looked into for each fund administered – regulation and compliance, liquidity issues, negative press and more.

HFM: How do you safely navigate changing product and investment strategies?

NK: I want to place an emphasis on cryptocurrency – a contemporary topic that is a key challenge with respect to changing product and investment strategies. Traditionally, most funds have looked at listed securities as a key asset. However over time multiple different asset classes are emerging and cryptocurrency is the latest addition.

When it comes to the net asset valuation, the main challenge lies within the independent and fair valuation of assets – especially when those are not listed, such as with real estate and private equity investments. Administrators need to ensure that all investments are valued independently as a matter of best practice, and, on the basis of prescribed models, are vetted and verified by independent agencies. If this process is not adhered to, it will impact the underlying interests of the investor. The nature of the product is changing, too. Cryptocurrency today is extremely important to a lot of new and emerging funds. Yet as it is relatively uncharted territory, there are decisions to be made around identifying emergent risks, on-boarding bitcoin funds and how this type of fund should be evaluated. Newer asset classes will keep coming and this is something that needs to be prepared for.

HFM: Are there any gaps in best practice that you would like to see evolve in future?

NK: I would like to see a common risk management framework across all jurisdictions, including parameters to be considered for risk classification and risk ratings of the fund. This would be a really valuable resource as currently there is a lack of clarity over certain products. The lack of clarity is a problem for administrators when it comes to on-boarding funds working with new asset classes and product lines.

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