Central Bank Issues Guiding Principles on Alternative Investments - International Law Office

Introduction
Guiding Principles
Consequences for Market Parties

Introduction

The Dutch supervisory authority for the prudential supervision of financial institutions, the Netherlands Central Bank NV, has announced its intention to monitor alternative investments closely and has recently issued a set of guiding principles for the risk assessment of alternative investments. The Central Bank's goal is to increase awareness and improve risk management with respect to alternative investments and to involve the financial sector in the development of the principles based on knowledge sharing.

Institutional investors allocate an increasing percentage of their capital to alternative investments - that is, (more or less) illiquid and non-transparent high-risk investments, such as (umbrella) hedge funds and private equity. The Central Bank is of the view that the increasing activity of institutional investors in alternative investments and the potential risks that arise from such products justify the specific attention of the supervisory authority.

The guiding principles are intended to make the supervision of the Central Bank transparent. The principles are directed towards pension funds, insurance companies and credit institutions, which are subject to the Central Bank's prudential supervision.

The Central Bank's supervision is principle-based - that is, the financial institutions must pursue a responsible course of conduct in respect of alternative investments. The guiding principles issued by the Central Bank are a result of this line of policy and should not be seen as an extension of regulatory measures. The guiding principles do not impose specific requirements on financial institutions. The Central Bank will use the guiding principles (which contain points of attention and best practice provisions) to assess whether financial institutions have implemented risk management in respect of alternative investments. The financial institutions must convince the Central Bank that their risk management is sound and, if not, that the applicable requirements will be met as soon as possible.

Guiding Principles

Characteristics of alternative investments
The assessment of financial institutions in respect of alternative investments should include specific risk and performance criteria. Since alternative investments have a deviating, asymmetric risk profile and limited transparency and illiquidity, traditional risk criteria are inadequate to assess the investment risks.

Portfolio management
Alternative investments should fit in the overall strategy of the financial institution, which shall take into account the ratio between alternative investments and the whole investment portfolio. Furthermore, financial institutions must periodically assess whether the investment portfolio is still spread evenly and whether there are no undesired concentrations.

Due diligence
Alternative investment funds are often situated offshore and are not - or barely - subject to supervision. Therefore, the Central Bank is of the view that an extensive due diligence investigation is necessary before making an alternative investment. Furthermore, financial institutions must periodically analyze the risk profile of the investment strategy and the capability of the fund managers. Points of attention in respect of the due diligence investigation are what the Central Bank calls the 'three Ps': people, process and performance. The evaluation of persons should involve management and other members of the organization; integrity risk is a significant aspect. The assessment of umbrella funds must also contain an opinion on the manager's quality of risk management, standards and principles of conduct.

Terms of contract and monitoring
Alternative investments should have adequate terms of contract. In general, these include:

• a clear limitation of risk;
  
  
• the measures to be taken where these limitations are exceeded;
  
  
• adequate information;
  
  
• a clear description of the lock-up periods; and
  
  
• the conditions for termination and/or dissolution of the agreement.

In terms of monitoring, alternative investments cannot be considered to be passive investments. The performance of fund managers should be monitored frequently; whether agreements are complied with should be verified.

Communication
The operation of alternative investment funds has been subject to debate. Therefore, adequate control of the reputation risk of a financial institution is impossible without explaining the policy and goals in respect of alternative investments to the financial institution's stakeholders.

Consequences for Market Parties

The guiding principles may have consequences for the internal organization of alternative investment funds, since the guidelines include management and transparency requirements, among other things. A good organization of alternative investment funds or private equity houses and transparency of performance will help to attract investment from financial institutions; in contrast, the absence of organization and transparency may lead to a decrease in the interest of financial institutions or, in extreme cases, to a discontinuation of investment.

Market parties have been given the opportunity to comment on the guiding principles. The results of the consultation will be made public on the Central Bank's website at www.dnb.nl.

For further information on this topic please contact Lous Vervuurt at Bird & Bird by telephone (+31 70 353 8800) or by fax (+31 70 353 8811) or by email (lous.vervuurt@twobirds.com).