A regular briefing for the alternative asset management industry - Issue 34Towards the end of last year, many private fund managers began reviewing their approach to interest rate risks. Although private funds are often heavily exposed to movements in interest rates – most obviously in relation to leveraged portfolio investments, but also for fund-level facilities and manager-level liquidity – low and stable rates have been the norm for the past 10 years, making interest rate risk a relatively low priority. That has clearly changed: central bank announcements warning of phased increases in interest rates, along with governmental pressure to combat rising inflation, have prompted many funds to consider how to hedge against future rises.A firm's review of its approach to interest rate risks is likely to start with an assessment of its own knowledge and skills. Fund managers – and portfolio company finance teams – clearly need to model the impact of expected future rate rises on returns and liquidity needs, but also need to understand the tools that are available to manage the risks, and the circumstances in which they can be deployed.That is partly about making sure the firm has the right expertise (internally or externally) to identify, and then negotiate terms for, the instruments that can ensure that risks are appropriately hedged. It will also be important for the firm to analyse the regulatory framework that applies to the use of any derivatives for hedging – including restrictions and additional reporting requirements imposed by both specific derivatives rules such as EMIR, and by more general pan-European legislation, most obviously the AIFMD and MiFID (and their UK equivalents). Any provisions on hedging (or related aspects, such as fund guarantees) in the fund's Limited Partnership Agreement (LPA) will need to be navigated, and the impact of hedging at fund-level on the borrowing base under a fund-level facility fully understood.Managers seeking interest rate protection by accessing the bank and broker-led markets will need to put in place appropriate legal agreements, so an understanding of current ISDA terms and model documents is needed. These are specialist documents, and a firm's regular fund formation or fund finance counsel may not be familiar with the detailed provisions or market practices. Therefore, managers should not underestimate the time that it can take to agree them, especially because they should be tailored to the specific fund.Establishing or reviewing policies and procedures for interest rate risk management will require firms to address questions of responsibility and accountability among the portfolio management, legal and compliance and finance teams.It is likely that some of these required skill sets and advisory relationships will need refreshing. Establishing or reviewing policies and procedures for interest rate risk management and the use of derivatives will flush out gaps and will require firms to address questions of responsibility and accountability among the portfolio management, legal and compliance and finance teams. Such clear procedures are vital and, indeed, investors may be expected to ask more questions about them as we enter a higher interest rate environment.Some managers, recognising the specialist skills needed, have sought to implement systematic interest rate risk management on a centralised basis across their portfolio. This marks a change to the more traditional approach where interest rate risk management was delegated to the underlying investee companies and portfolio manager, rather than being subject to centralised modelling and oversight. While centralisation does bring some advantages,...

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