Managing Risks of Alternative Investment Funds

The debilitating effects of the recent financial crisis have been particularly difficult on alternative investment funds, which
include hedge funds, private equity funds, commodity funds, real estate funds and infrastructure funds. In several countries,
these alternative investments have been used as a scapegoat in the global financial markets due to their alleged impact on
market stability. The volatility of hedge funds alone, which account for nearly $2 trillion in managed assets, as well as the
sharp decline in real estate funds, exposed the vulnerabilities in the financial system. Together with new regulations, this
crisis has caused alternative investments funds to reassess the best ways to attract new business, as well as implement
proactive risk management practices. Improving the robustness of their risk management investigations on their business
partners helps.

Last November, the U.S. Securities and Exchange Commission (SEC) voted to propose new rules to strengthen its oversight
of investment advisers and fill key gaps in the regulatory landscape, notably by bringing managers of hedge funds and other
alternative investments under its supervision. The SEC's proposed rules would implement provisions of the Dodd-Frank Act.

At the same time, the European Parliament adopted a similar directive on managers of alternative investment funds (AIFM) –
with particular emphasis on regulating hedge funds and private equity funds, but also affecting the supervision of all
investments in real estate funds, equity funds and funds of funds.

Financial institutions have shown a growing interest in requesting prudent risk management investigation policies for
business partners in investment funds, especially when these funds operate in a high-risk market such as real estate.
Regulators also recognized that the financial crisis exposed the vulnerabilities of real estate investments and confirmed the
need for stricter supervision. Risk management investigations of business partners will increasingly become a key element
in the investment decision-making process.

Developing Checks and Balances

Several decades ago, legislation was passed to combat money laundering (U.S. Bank Secrecy Act and First EU AML
Directive). These initial regulations required financial institutions to identify clients, keep records and file reports on
transactions that could be useful in prosecuting most financial crimes.

Laws were eventually revised to include accountants, tax advisers, real estate brokers, notaries, lawyers and other legal
professionals to address anti-money laundering issues. The addition of the U.S. Patriot Act of 2001 and the third EU Money
Laundering Directive of 2005 broadened the range of financial institutions and added a focus on terrorist financing. This
addition has great implications on risk management investigations, since it prompted the need for an understanding of the
purpose and origin of funds. Regulators now recommend a different approach to customer oversight – from “rule-based” to
“risk-based”– and require the acknowledgement of country, customer and services risks.

With the AIFM and the addition of the U.S. Patriot Act, parties with a fiduciary responsibility are required to adopt (specific
parts of) the required risk management investigation policies for financial institutions. Subsequently, investment funds are
starting to favor similar policies for potential investments and for business partners, especially in high-risk markets such as
real estate.

Risk Management Investigations and Alternative Investment Funds

With the current regulations for alternative investment funds and the emphasis on volatile market conditions, real estate
fund managers are developing compliance requirements for business partners, as well as investment partners, as a critical
element in protecting reputation. Going forward, real estate funds will be able to uncover potential risks to their investment
and business partners (e.g., developer, broker, real estate manager) to the business or to ultimate investors (e.g., financial
institution, pension funds). Based on the risk level for country, customer, transaction and services, the appropriate actions
can be taken.

In some countries, all real estate-related transactions are currently considered, prompting enhanced risk management
investigation to determine whether risks are present. An investigation is performed on the entity, as well as on its directors,
and includes bad press research, PEP checks and a review of presence on sanctions, watch and warning lists. In addition, a
check is performed to verify whether the person representing the company is authorized to act on behalf of the firm. The
origin of the funds (for investments), and the Ultimate Beneficial Owner are determined. If the results raise additional
questions, a more detailed investigation must be performed.

Often, after the initial analysis is conducted, an additional investigation is required for 30 percent of all business partners
rated as “normal risk,” and for nearly 90 percent of all business partners rated as “high risk.” In five percent of these cases,
the findings lead to a deal’s termination due to the discovery of fraud, sanctions from regulators or bad press.
Conclusion

Some alternative investments funds might consider these new regulations an additional burden to their business, but many
more are seeing the benefits from following these procedures. If you have ever been involved with a bad investment due to
fraud or a criminal act, you will never overlook risk management investigations again. These procedures can help to
minimize the risk profile of your investments.

Alternative investment funds can also use these procedures as an extra differentiator to attract new investors and funds.

Author

Michel Grummel
Managing Director
Amsterdam
+31 20.30.17.441
| Profile

Professional Spotlight

Martin Hunter
Managing Director
London

Martin specializes in serving as an adviser and expert witness in construction-related disputes that span four continents. He
also has significant experience in energy-related projects, testifying in oil and gas pipeline disputes in Central Asia, Europe
and the Middle East.
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