Pillar III ICAAP

 

1. Executive Summary

Adelio Partners Limited (“the Firm”) is regulated as a stand-alone entity in the UK and is not part of a group for regulatory purposes.  Overall we have a straight forward business model, acting as an investment manager to a Luxembourg domiciled UCITS fund (at the time of writing the fund is not yet launched but it is expected to do so in the next few months).  Adelio Partners Limited is a BIPRU Firm with a MiFID activity restriction, i.e. unable to place financial instruments without a firm commitment basis.  It may control but not hold client money and assets.

The main purpose of this report is to identify the key risks facing the Firm, how well these risks are managed and to conclude whether the current controls are sufficient mitigation or whether it is necessary to hold additional capital. To ensure this has been carried out diligently and completely, stress scenario tests have been conducted to ensure that the processes, strategies and systems are comprehensive and robust. In determining the risks faced by the Firm, reference has been made to the guidance in BIPRU 2.2.25G (it is considered that the activities of the firm are simple); and in BIPRU 2.2.61 to 2.2.65 (risks associated with an asset management firm).

The regulatory capital resources available to the Firm are the initial capital contributions, plus any further contributions made by the founders.   As at December 2020, the Firm’s capital totals £573,680.

Our firm is categorised by the FCA as a BIPRU €50,000 limited licence firm. As a consequence of this, the regulatory capital rules we must adhere to are that the regulatory capital that the Firm must hold as a minimum is the higher of:

o             €50,000; or

o             The sum of our market & credit risk requirements; or

o             The fixed overhead requirement (‘FOR’) which is 1/4 of the Firm’s operating expenses less certain variable costs.

The FOR is based on our projected 2021/22 expenditure and produces a sum of £213,935.  This forms the minimum level of regulatory capital we must hold in our business (often referred to as the ‘Pillar 1’ capital amount).

Our liquidity will be measured by the amount of cash we hold at the bank and the additional assets we hold which are readily realizable.  As at 31 December 2020, these currently comprise of £593,856.

The results of our analysis are that, no additional capital (‘quantitative’ mitigation) is required under Pillar 2 capital to mitigate risks faced by the business. We discuss, in sections 5-8 of the ICAAP, the ‘qualitative’ measures taken to mitigate the risks we face.

Our total capital requirement is therefore £213,935 and with regulatory capital of £573,680 as of 31 December 2020, we hold sufficient financial resources to match the firm’s activities and the risks to which they give rise.  

The capital in our business is therefore primarily to protect against operational, credit and market risks/losses which we may encounter and the business risk of no longer being a viable concern.

We do not operate a formal capital allocation process; instead our capital is used concurrently to mitigate all of the risks faced by our business.

Our capital requirements for each of the risk areas identified can be summarised as follows:

Base capital requirement            €50,000

Fixed overhead requirement      £213,935

Additional capital required for specified risks:     

Operational Risk*                                                             £0

Business Risk*                                                                   £0

Credit Risk*                                                                        £2,741

Market Risk                                                                        £0

Total additional capital required for Pillar 2                 £0

Total Capital required:                                                     £213,935

Current Capital:                                                                £573,680

2. Background to the ICAAP and Risk Assessment Process

To complete our assessment we considered the risks that the Firm is exposed to (including liquidity), articulating the risk, the impact if the risk were to crystallise, and the likelihood of it doing so.  We also considered whether the residual risk, after our controls and governance are taken into account, necessitated holding additional capital to protect the businesses in the event the risk crystallises. We believe that our capital adequacy is not placed in jeopardy due to the existence of the risks outlined in sections 5 and 6 below.

Our business is fundamentally dependent upon receipt of cash management fees from the Fund to meet our overheads. Therefore, we have done further analysis to identify our current and forecast financial position, and run appropriate scenario tests to stress the forecasts according to differing scenarios. This is explored further in section 7.

The results of our analysis are articulated in this document and have been challenged and adopted by the senior management of the Firm.

3. Statement of risk appetite

When considering the details and analysis throughout the ICAAP and when running our business, we have been and will continue to be cautious with regard to risks. We want the business to grow and prosper but in seeking to achieve growth we will not put the business itself, or a material amount of its capital, at risk. 

We take a similar approach to the operational management of the business. Our responsibilities to the investors in the fund that we will operate (once launched) demand high levels of internal control and risk management.  We therefore place a high priority in our internal control processes, and seek to mitigate risks through adherence to these by the employees of the Firm rather than through holding additional capital. The crystallisation of risks we are exposed to may impact the profitability of our firm.  On this basis we have arrangements in places to identify and report all operational risk failings. 

4. Business strategy

The Firm’s business currently consists of one core service:

•             Investment management.

Our business strategy is to grow our funds under management, and therefore revenue, organically, by achieving good investment returns and attracting additional investors. At present our planning takes into account expected growth in current business lines, but does not include any potential other activities.  Before any such further opportunities are entered into they would be considered in detail and this ICAAP assessment will be updated to identify any further risks, capital requirements or liquidity issues they presented.

5. Significant Risks:

There are a number of risks that our business faces. However, we believe that each operational risk is well controlled and we have no history of operational losses that would give rise to the suggestion that further capital should be held.  The material risks that we face are essentially:

5.1 Key Risks for Asset Managers as identified by the FCA

BIPRU 2.2.61 determines operational risk and reputational risk as primary risks for asset management firms.

Like any asset management firm we are subject to the possibility of operational losses. These would potentially be caused by trading errors. However, we have strong controls in this area.

The Firm’s reputation could potentially be damaged by internal failings such as poor investment management decisions, unethical behaviour by the Firm’s representatives and significant underperformance.  Should the fund suffer from poor performance, the fees generated would be significantly reduced and the receipt of performance fees would be unlikely.  In this instance, the Firm should expect significant redemptions and there is the potential for disgruntled investors to bring legal action against the firm to recover their losses.   However, the firm will have a robust stock selection process informed by fundamental research and quantitative analysis.  Unethical behaviour by the firm’s staff could result in regulatory censure, fines and/or removal from the register of approved persons.  The firm carefully vets new staff and the Compliance Officer maintains oversight of discretionary investment decisions. 

5.2 Large Scale Redemptions

Large scale applications from investors to redeem their investments could jeopardise the business’s continuing viability.  In this instance, the fund, when launched, may not generate sufficient income from management and performance fees to cover the costs of administering the fund, or exceed the costs to the fund manager. This risk is true for any business and is closely monitored by the Firm’s senior management. However, if for any reason our business were to become un-viable at any point, the Senior Management would take appropriate management actions to reduce costs and possibly cease regulated activities. If even after such actions the business remained unviable we would need to consider whether the business should be closed down and the fund liquidated. All of this is relatively straightforward and could be achieved in a relatively short order without causing any customer detriment.

5.3 Key Person Risk

Adelio Partners Limited is a small firm comprising five executive directors, including a CIO and COO. There is more than one member of the investment team such that once the fund is launched they could cover each other if one of them was incapacitated. If the CIO was long term incapacitated this could have serious consequences for the fund. In this situation the portfolio managers would liquidate the fund’s investments so that it held 100% cash.  Depending on the severity of the CIO’s incapacity, widespread redemptions would be anticipated. 

    1. Breach of Investment Management Agreement

The investment team would breach the mandate if they invest outside the investment restrictions, which form part of the terms of the legal agreement.  Passive breaches, which are caused by circumstances outside the control of the investment team such as price fluctuation, may also cause the fund to breach its investment restrictions.  As the Firm will only have one fund, the likelihood of active breaches are minimal as the investment team knows the restrictions that will apply very well.  The firm also has procedures to record and check transactions which helps any potential breaches to be identified and rectified swiftly, reducing any potential detriment to investors.  If any breaches caused material detriment to customers, these would be remedied and the customer compensated for any losses.

The firm has not received any claims or legal action with regard to breaches of mandate, nor has it agreed to any out of court settlements. The fund has not yet launched in any case.

6. Other Risks

6.1 Market downturn

The effect of a market downturn may impact on the performance of the fund and affect the market value of the fund’s assets.  It may also hamper the Firm’s ability to attract new customers who may be wary of another recession or long-term falls in share prices.  This may also lead to large scale redemptions (see 5.2 above).  The Firm could mitigate some of the effects of a downturn by reducing operating costs and declining to renew the freelance agreements with contract workers.

6.2. Launching new products

There may be an impact on a Firm’s capital where it considers launching a new product or enters a market in which it lacks expertise.  Currently Adelio Partners Limited has no plans to launch any new products/services except the UCITS fund which was the purpose of its authorisation with the FCA.

6.3 Business risk

More generally, our business, like any other, is dependent upon undertaking sufficient commercial activity to meet our cost base and the amount of capital we are prepared to spend on maintaining the business. If for any reason our business became unviable, we would carefully consider our business strategy and model to determine if there were activities we should stop, costs we should cut, or other opportunities that we should take advantage of.  However, in the event that there were not credible opportunities to turn the business around, the senior management of the business would make a conscious decision to cease our current business activity while there was still sufficient capital to cease our regulated activity and resign our FCA authorisation in a controlled fashion without causing detriment to our customers.

We have considered the wind down of our business and have determined the Firms regulatory activity could cease in a short period of time. It would take an estimated 3 months to liquidate the fund (once launched) and complete the close down period. In assessing the time needed to liquidate the fund, we have been mindful of the liquidity of the markets we invest in. 

6.4  Liquidity Risk

The Firm is subject to the FCA’s Liquidity Rules at BIPRU 12.  The Firm is classified as a Non-ILAS Firm and, hence, is subject to the Overall Liquidity Adequacy Rule (BIPRU 12.2.1) and, hence, has in place Liquidity Systems and Controls which include the management of Liquidity Risk via scenario and stress testing of the Firm’s Cash Flow Forecast and the establishment of management actions and contingency funding plans.  These Liquidity Systems and Controls and a “Liquidity Risk Tolerance” under BIPRU 12.3.8R are set out in the Firm’s “Liquidity Risk Management Framework and Policy”. However, the Firm holds its cash at a reputable banking partner and it does not consider liquidity risk to be an issue.

The Firm is also obliged, as a consequence of SUP 16.12, to report annually to the FCA that it has adequate “Liquidity Systems and Controls”.

7. Capital planning and Stress and Scenario tests

The Firm operates a relatively straightforward business model as already explained. We receive fees from our regulated activity, and our expenditure is primarily on staff, IT, premises and other normal business costs.

Our base case for planning purposes is a financial projection, projected over a 12 month period to December 2021. We regard this planning horizon to be appropriate given the markets that we operate in.

These projections are periodically updated and discussed by our senior management as an intrinsic part of the governance of our business. Furthermore, we monitor our financial projections, the level of surplus capital and regulatory capital requirements, and cash flow, on a continuous basis, in order to ensure we remain capitally adequate at all times.  

Using the base case as a starting point we have also considered how the business would perform under stressed conditions. The stressed conditions we select should meet the FCA's definition of a severe recession or relevant business downturn / event, i.e. of a severity that occurs once in a 25-year period.

  1. Scenario 1 – decrease in management fees due to loss of clients, and
  2. Scenario 2 – large one-off expense due to fraud, theft or customer claim that the investment manager has failed to adhere to mandate.

We have discussed both of these scenarios at 5.1 and 5.2 above.

  1. Scenario 3 – loss of all cash because our bank fails. We are at risk of our counterparty banking providers failing and loosing all cash however we only select banking providers after completing due diligence and we monitor the creditworthiness of our providers on an ongoing basis. In the event that all cash generated was lost management would assess what action to take, including whether it was necessary to inject more cash into the business in order to ensure the firm could continue to meet its liabilities as they fall due. This would depend on the management fees owed to us and timeliness of payment, but it is likely some injection of additional liquidity resources would be required to cover a short-term shortfall.  

In addition to considering the impact of an economic catastrophe the FCA requires firms to consider what impact a 200bps shock to interest rates would have on the economic value of the business. The Firm does not have any complex instruments on its balance sheet and is not reliant on interest rates to any material extent for its projected revenue. Therefore, the Senior Management believes that such a shock would have no material impact on its economic value.

8.  Wind Down Analysis & Stress Testing

The Firm has assessed the capital that may be required to cover risks crystallising over the next 12 months. Its greatest risks are Business and Operational Risk. For Business Risk, the Firm has assessed Business Risks by modelling the effect on its capital planning forecasts and setting out actions to ensure it has sufficient Regulatory Capital.  For Operational Risk, the Firm has assessed if a Pillar 2 capital requirement is needed taking into account its mitigation.

Minimum Capital required to Wind-Down the Business

In the event of a business wind down, in a scenario where the fund has launched, the Firm estimates that within 3 months substantially all client assets will have been returned or new investment managers found.  The Liquidator costs are based on the average estimated costs to wind up the Firm given its activities and fixed costs. 

Operational Risk Stress Test approach

For Operational Risk, the Firm has assessed if a Pillar 2 capital requirement is needed taking into account its mitigation. The assessment covers risks crystallising over the next 12 months. The stress test is being used as a means of quantifying how much capital might be absorbed if an adverse event or events occurred.

The Firm operates a simple reduction is assets approach to estimating exposures to risks. 

Business Risk scenario test approach

For Business Risk, the Firm has assessed Business Risks by modelling the effect on its capital planning forecasts and setting out actions to ensure it has sufficient Regulatory Capital.  This includes scenario analysis of more than one parameter to explore the sensitivities in the business plan and how capital needs change over time. The existing financial planning process has been integrated into the ICAAP to develop forward looking financial forecasts.