asset managers and the libor transition · creates additional uncertainty in the net asset value of...

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Asset Managers and the LIBOR transition

© 2019 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. The KPMG name and logo are registered trademarks or trademarks of KPMG International. NDPPS 897502

The future of the London Interbank Offer Rate (LIBOR) has become highly uncertain since the UK’s Financial Conduct Authority announced in 2017 that it would not compel or persuade panel banks to make LIBOR submissions after 2021.

LIBOR is currently used within a broad range of financial instruments involving trillions in notional value, so institutions can expect the LIBOR transition to significantly impact a number of their functions and businesses. As efforts continue worldwide to develop alternative risk-free rates (RFR), individual firms must assess and plan for how their products, infrastructures, and customers could be affected by the transition away from LIBOR.

This paper discusses domestic U.S. challenges, their potential impacts, and how asset managers should begin to prepare now despite uncertainty. Asset managers face a number of sector-specific challenges and risks in this environment.

1Asset Managers and the LIBOR transition© 2019 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. The KPMG name and logo are registered trademarks or trademarks of KPMG International. NDPPS 897502

Specific challenges for asset managersValue transfers

Issue: The transition to RFRs will lead to changes in the value of existing positions, which may be more or less favorable to counterparties. The “value transfer” occurs when there is a difference between the original expected rates of return and the replacement rates of return over the life of the contract. Because the LIBOR curve has an embedded credit component, a credit event will be somewhat muted creating advantage to one party in the transaction. In the current environment, it is uncertain how capital market participants—including dealers, end-users, issuers and investors—will consider the value transfer when pricing transactions. This creates additional uncertainty in the net asset value of the funds under management.

Impact: Value transfers represent a significant risk. Asset managers will need to identify LIBOR indexed fund holdings in order to analyze the risks associated with legal, valuation, technology, operations and investor communications. Accordingly, asset managers should enact a formal enterprise governance structure to inventory and analyze firm-wide key decisions, related impacts and initiate a formal program to manage the LIBOR transition. In addition, asset managers need to recalibrate their internal valuation, forecasting, or scenario models for replacement RFRs in order to isolate the value transfer and reduce the risk to investors. As the value transfer is analyzed, asset managers must know their legal rights and obligations associated with fund holdings, investment agreements and other contracts with LIBOR references.


Legacy Contract Documentation

Issue: References to LIBOR in legacy contracts and other documentation will require revision to reflect the replacement RFRs—a substantial undertaking. Legacy contracts include fund holdings, investment agreements, corporate debt and associated fund documentation. In addition, investment management agreements and fund documentation may reference LIBORs for benchmark purposes. Other contracts with LIBOR references (both direct and indirect) include credit agreements, bond indentures, offering circulars, and derivative confirmations.

Impact: Firms will need to analyze their cash bonds, syndicated lending, middle market credit agreements, and corporate debt for current fallback terms, which provide interim-period rates should LIBOR be eliminated. The next step is to review contracts based on their fallback language, prioritizing those with the least favorable terms. As current holdings mature and are replaced, fallback terms should explicitly reference alternative methods, or rates that can substitute for LIBOR and acceptable to relevant parties. Firms will need to be flexible, perhaps making changes in documentation over time, as language becomes available, rather than forgoing any changes until all revisions are certain.

Revising so much language accurately and consistently will require significant effort and resources. Asset managers should consider using automated intelligence solutions that ingest, identify, read, report on and manage the workflow associated with legacy contract language—steps that would normally require significant efforts to manage manually.

As investment management agreements are updated for LIBOR change, compliance engines that reference these rules need to be updated in accordance with the contract changes. Otherwise, the portfolio managers and traders managing the portfolios can be exposed to 3rd party fines as a result of non-compliant investing activities.


Issue: No RFR replacement will match 1:1 to LIBOR, which introduces basis risk and the potential for gains or losses. Firms will need to know which entity, government or private, is responsible for setting a replacement RFR, what will be defined as a conforming product by government sponsored entities such as Fannie Mae and Freddie Mac, how third-party pricing services will treat fallback language or amend associated agreements and report the change in value. For example, asset managers rely on a number of third party providers such as custodians, fund administrators, depositories, brokers, sub-advisors and others to provide investment services to their clients. There are dependencies on these third party service providers to facilitate LIBOR transition such as NAV per share. NAV per share will be calculated by the fund administrator and disclosed to investors through a number of methods as set out in the offering document of the relevant fund. Therefore, coordination across these service providers will be required to identify any risks to a firm’s LIBOR transition plans.

Market Pricing

Impact: Despite the change in value, firms will need to isolate and explain the basis risk to investors. They can do so with an attribute analysis, which may involve the use of internal models to isolate the change in value attributable to the transition. An example of a direct approach is to calculate the discounted difference in position cash flows, given the last reported LIBOR plus the spread and the replacement spread and index. An indirect approach may include (1) rolling forward the position over the transition period, (2) deducting current-period interest accrual, cash collections, and other observable changes such as any applicable foreign currency difference, and (3) assuming the remainder of the change in value is attributable to the transition. The reported change in price will help firms and fund investors understand the aggregate change in net asset value and accept the results accordingly.

Asset managers will need to understand this information to avoid overstating fund performance assuming a net positive value transfer to the fund. Otherwise, investors may perceive conflicts of interest or improper conduct associated with higher fees directly attributable to LIBOR transition.

As part of the ongoing due diligence, asset managers will need to verify the investment service providers have the necessary skills, expertise and resources to carry out their valuation functions. Asset managers may update service level agreements to include reporting on progress changes impacted by the LIBOR transition. Replacement RFR need to be reflected in each third party system to ensure all valuations are accurately calculated and reported. Any discrepancies will result in reconciliation mismatches.

As the models are calibrated for replacement RFR and LIBOR transition attribution analysis, asset managers and third party service providers need to update valuation policies and procedures associated with fund holdings, including hard to price investments, relative to their LIBOR transition plans. The updated valuation policies and procedures will need to be shared with the fund administrators for Net Asset Value (NAV) calculations and related investor disclosures.


Derivatives

Impact: Overall ineffectiveness, or the difference in fair value change, can be managed with coordinated negotiations between derivative counterparties and issuers to reach agreement by hedging risk with appropriate replacement terms that replicate the current risk profile. It is critical to involve departments including risk, accounting, trading, portfolio management, and legal to understand and mitigate risks and ensure the lowest impact to a fund’s net asset value.

Issue: Often a derivative’s fallback language conflicts with the underlying contracts associated with the hedged risk. For example, a single mortgage could have fallback language instructing the use of the prime rate if LIBOR isn’t available. That mortgage could be bundled into a security that instructs use of a Treasuries-based rate in absence of LIBOR. In these cases, ineffective hedging results are possible. Knowing if and where these conflicts could occur is essential to mitigating risks in a derivative portfolio.


Operations

Issue: The shift away from periodic LIBOR updates may require reevaluating existing processes, especially where those processes have been executed manually. If firms intend, for example, to continue a manual process with a daily (vs. quarterly) rate, new process controls will be needed (e.g. requiring two signatures on checks) to ensure the integrity of the new calculation process. Furthermore, risk, finance and other operations personnel need to track and monitor their LIBOR related exposures at the fund, aggregate portfolio and counterparty levels using quantitative and qualitative measures. This information is critical in assessing the risks and progress of the transition going forward.

Impact: Firms may start with identifying and inventorying their existing processes associated with LIBOR data processing, valuations, calculations, and reporting. Then next activity is to prioritize those LIBOR processes deemed critical under a predefined governance methodology. The goal is to ensure that in the transition from LIBOR to a replacement RFR (e.g., daily rate), critical processes required for day-to-day investing decisions and business operations are in place.

The task is not small: firms need to determine the full extent to which LIBOR processes impact critical investments and business needs, leveraging existing process maps or creating them when necessary. For example, existing regulatory reporting schemas and engines (e.g., Form PF) can be leveraged to monitor reported LIBOR transition exposure. Risk, finance and compliance groups can use these reports to view legacy positions and understand valuation and investment fee changes. Once processes are prioritized, a carefully coordinated change management effort is needed to establish a controlled re-design and re-purposed process, including thorough testing and sign-off. As new processes are implemented, an assessment of net new risks and compensating controls is required to prevent or detect operational and financial errors after the transition from LIBOR.

Finally, Operations personnel have engineered manual processes including reconciliation and remediation of financial differences with external parties. As industry adopts replacement RFR, there is a higher likelihood of reconciliation differences from internal systems to investment issuers, calculation agents and custodians. Middle and back office operations will have to update its processes, procedures and controls to reflect the replacement RFR in order to mitigate reporting valuation errors.


Technology

Issue: Many asset managers maintain legacy systems designed around monthly, or longer, updates to LIBOR based on the reset frequency specified in the contract. Moving to an overnight rate, such as the secured funds overnight rate (“SOFR”) or other alternative RFR, may require a daily interest accrual and reconciliation with a calculation agent. Otherwise, there may be a difference between collected and reported interest income.

Impact: Asset managers must assess their legacy investment accounting systems for overnight rate interest accruals and reporting to facilitate reconciliation with the interest accrual determined by a calculation agent. If the investment accounting system and market index data imports are not designed for overnight rate interest accrual, firms may need to create workarounds or discuss potential enhancements with their system vendors and data providers. At a minimum, firms will need to identify and document their data feed and system functionality requirements at the beginning to facilitate the technology change. This effort depends on the replacement terms, including renegotiated alternative RFRs and associated spreads.

Asset management firms often have large and complex technology architecture including legacy internal applications, vendor solutions and spreadsheet based end user computing functionality. Impacted systems may include trade order management systems, compliance systems, accounting platforms, enterprise data management platforms and enterprise risk platforms. A coordinated effort to ensure all platforms are in synchronicity is complex and may result in incorrect or inconsistent data processing across the organization. As such, there is an increased risk of NAV presentation and financial performance errors to management or external reporting.


Issue: Asset managers need to ensure that internal stakeholders and end investors are made aware of the LIBOR transition and the impact this could have to existing and new positions. Asset managers have a wide and varied investor community, and the communications will need to be customized accordingly.

Investor engagement and communication

Impact: It will be imperative to ensure that investors are being treated fairly through the transition and there are consistent messages provided to investors. Firms will need to develop an investor communication strategy and plan to their investors, fund boards, third party service providers and regulators. Firms need to educate client-facing staff on the LIBOR transition implications so they can guide external stakeholders transparently and fairly through the process. Investor communications will need to be supported by changes to risk statements in fund offering documents, financial statements and ongoing communications.


How KPMG can helpKPMG professionals are currently guiding numerous firms in structuring initial 90-day LIBOR transition plans that encompass enterprise-wide governance, contract identification, strategic planning, and the inventory of systems, infrastructure, and functions that require change. We understand the critical need for the use of cognitive technologies (including natural language processing, machine learning, and other capabilities enabled by artificial intelligence) in parallel with a flexible approach that keeps end-users and customers at the forefront of transition planning.

Choosing the right partner to help navigate the LIBOR transition is key to your firm’s success. KPMG has the experience to help make it a smooth journey.


Contact usChristopher DiasPrincipal, AdvisoryT: 212-954-8625 E: [email protected]

Christopher BoylesPartner, AdvisoryT: 213-955-8484 E: [email protected]

Sonia SoniDirector, AdvisoryT: 929-293-3718 E: [email protected]

Some or all of the services described herein may not be permissible for KPMG audit clients and their affiliates or related entities.

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The following information is not intended to be “written advice concerning one or more Federal tax matters” subject to the requirements of section 10.37(a)(2) of Treasury Department Circular 230.

The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.


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asset managers and the libor transition · creates additional uncertainty in the net asset value of...

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