On 29 May 2018, the European Commission published a draft Delegated Regulation amending several of the AIFMD Delegated Regulations relating to the safe-keeping duties of depositaries and their delegates. Equivalent amendments are proposed to the UCITS regulations.

Publication of the draft Delegated Regulation follows ESMA’s opinion on asset segregation, in which ESMA asked the Commission to clarify certain obligations of depositaries where they delegate safe-keeping functions to third parties. The consultation paper was covered in previous INDOS updates:

http://www.indosgroup.com/2017/08/esma-opinion-on-asset-segregation-and-application-of-depositary-delegation-rules-to-csds/

The AIFMD Delegated Regulation sets out the depositaries’ duties with regard to the safe-keeping of alternative investment fund (AIF) clients’ assets. Article 21(11)(d)(iii) of the AIFMD requires that where a depositary delegates safe-keeping functions to third parties (i.e. custodians or prime brokers acting as custodians), the assets also need to be segregated at the delegate.

Article 99 of the Delegated Regulation sets out the obligations but the European Commission notes that experience gained since 22 July 2013 (the AIFMD implementation date) has shown that further clarification is needed on the requirements laid down in Article 21(11)(d)(iii). The Commission also notes securities and insolvency laws are not harmonised at the EU level but considers it important to have common rules to ensure the protection of assets safe-kept by depositaries or custodians for their clients. The proposals therefore seek to ensure the clear identification of assets belonging to a particular AIF, and to the protection of these assets in the case of insolvency of the depositary or the custodian.

The Commission also notes that diverging applications by European regulators and market participants of depositaries’ obligations as regards safe-keeping of AIF clients’ assets. As a result, it is proposing amendments to Articles 89(1)(c), 89(2), 98 and 99 of the Delegated Regulation to clarify the requirements in this area.

To allow depositaries time to adapt to the new requirements, the application of the Delegated Regulation will be deferred for six months after publication in the Official Journal of the EU.

In summary, the amendments are as follows:

• Article 89(1)(c) is amended to provide for the factors that should determine the frequency of reconciliation between the depositary’s financial securities accounts and internal records and those of the third parties to which safe-keeping functions have been delegated. The trading frequency of the depositary’s AIF client and also the trades carried out by other clients, whose assets are held in the same omnibus account, must be taken into account.
• Article 89(2) is amended to require that the depositary maintains a record in its financial instruments account opened in the name of an AIF client or in the name of the AIFM acting on behalf of the AIF showing that the assets kept in custody by a third party belong to a particular AIF client. The depository must at all times have a complete overview of the assets of its AIF clients where the custody of assets has been delegated to a third party.
• Article 98 is enhanced to prescribe the minimum details that should feature in the contract between a depositary and a third party on delegation of custody of assets of the depositary’s AIF clients. The depositary must be able to identify all the entities in the custody chain and secure access to all the relevant information in the third party’s possession to be able to verify the quantity of the identified financial instruments kept in custody by the third party. Should the third party need to delegate the custody function to another third party, the proposed provision requires the delegating third party to contractually secure equivalent rights from that another third party, as itself granted to the depositary.
• Article 99 is amended to clarify the asset segregation requirements for the third parties (custodians) to which the custody of AIFs assets has been entrusted. A custodian can hold assets of UCITS and AIFs clients and other clients of one depositary in the same omnibus account, provided its own assets, proprietary assets of the depositary and assets belonging to other clients of the third party are held in segregated financial instruments accounts. To ensure increased asset protection and facilitate the depositary’s duty of the oversight of the entrusted assets, custodians must issue depositories with a statement whenever a change relating to the safe-kept assets occurs. Factors to determine the frequency of reconciliation mirrors those set out in the amendment to Article 89(1)(c) of the Delegated Regulation.
• Article 99 is also amended to introduce new obligations for depositaries which delegate the custody of assets to third parties located outside the EU. Legal advice from independent parties on the insolvency laws of the third country is required. The depositaries should also ensure that the third party complies with their national laws securing the benefits of asset segregation and that the third party communicates any changes to the insolvency laws which are a part of the legal system in which they are operating.

INDOS will be considering the implications of these changes as they relate to its EU AIF depositary business and sub-custodial relationships.

INDOS Financial Limited, the independent UK depositary, has been appointed as depositary to four alternative investment funds (“AIFs”) managed by Gresham House, the specialist alternative asset manager which manages a range of alternative investment strategies with assets under management in excess of £1.5 billion.

The AIFs are Gresham House Strategic plc, an AIM quoted investment company, Gresham House Strategic Public Equity LP and Gresham House British Strategic Investment Fund LP, both Guernsey Limited Partnerships, and Gresham House Forestry Fund LP, a Scottish Limited Partnership.

Bill Prew, CEO of INDOS, said “We are delighted to have been appointed as depositary to the Gresham House funds. The appointment leverages our expertise as an independent depositary across a number of disciplines, including private and public equity, real estate, infrastructure, and custody, and UK listed and other UK and non-EU fund structures.”

John-Paul Preston, Head of Corporate Advisory for Gresham House plc, commented “We selected INDOS because we required a depositary with the breadth of experience and regulatory permissions to support our continued growth and diverse requirements. The INDOS team were pro-active and professional to work with and provided valuable guidance throughout.”

This INDOS Financial article was first published by HFM Week and can be read here.

The latter half of 2018 will be a period of relative contemplation for the fund management industry, having spent the last few years priming itself for compliance with MiFID II and GDPR, both of which have been labour and cost-intensive exercises. The volume of regulations introduced following the crisis has diverted managers’ stretched resources, and deterred them from reassessing or revisiting historic service provider relationships and outsourcing arrangements, but the coming legislative hiatus could change all of that.

In a world of reduced margins, cost sensitivities are high at many managers and they are looking for operational efficiencies and ways to manage costs more effectively across their businesses. Competition for business in fund administration remains high, while market rates for services have reduced, even despite the M&A activity that has taken place in the sector. The range of outsourced services on offer is also much broader.

In areas such as depositary, managers typically accepted the pricing proposed by providers in 2014 when AIFMD was introduced.  While administrators typically scale down their fees as clients’ Assets under Management (AuM) grow, depositary costs were frequently fixed at around two basis points. This means a $250 million fund will pay $50,000 per year in depositary fees, but if it were to increase its AuM to $1 billion, those costs would shoot up to $200,000. This has prompted some managers to question the value of the service received.

A May 2017 study by Preqin found that 55% of hedge funds who changed service providers did so because of costs. Cost is not the sole reason for shifting business, with a growing number of smaller managers changing providers because they require a more focused service delivery versus what they are receiving already. Larger firms, or those whose AuM has grown significantly in recent years, are looking for more tailored fee structures that reflect the current size of their business.

Service provider change could also be driven by the recent Financial Conduct Authority’s (FCA) Asset Management Market Study final report, which despite targeting traditional UK asset management companies, may permeate into the alternative funds’ sector. The FCA wants to see firms focus on value for money as part of their duty to act in the best interests of their investors.

The same FCA report also put a lot of emphasis on fund governance, acknowledging it was an area that required substantive improvements. The regulator will require managers of UK authorised funds to appoint a minimum of two independent directors, and for them to comprise at least 25% of the total board membership. While these rules do not currently affect hedge funds, it is reflective of the continued focus being placed by regulators generally on strong independent boards and fund governance more generally.

Some providers have come under criticism for inactivity or poor service delivery. The Preqin study also found that 41% of hedge funds who switched provider did so because the service was inadequate.  Over the past year, INDOS has seen managers and independent fund board members ask more questions about the value and quality of service provided by third party vendors. This has led to several managers transitioning a variety of business to different providers across fund administration, depositary, or audit.

Robust governance will continue to lead to more unbundling of depositary and administration for fears that that these consolidated offerings are vulnerable to conflict of interest risk. A strong, independent depositary and administrator can help complement governance practices, by providing regular and detailed information flows about the funds’ operations and assets to directors.

Inefficiencies or poor service provider delivery have frequently been tolerated by managers, often because they incorrectly assume that switching fund administrator is a disruptive and expensive process, and one that could be viewed negatively by investors. While it used to be quite operationally onerous to change providers, improvements in technology and transition management have made the process more straight forward and investors now recognise a change in service provider relationships can also be in their best interests.

This rare regulatory interlude is an excellent opportunity for managers to scrutinise their providers and identify whether they are getting the service and value that is expected. During the remainder of 2018 and 2019, there is likely to be more movement as managers start issuing RFPs.

Managers increase emphasis on independent services

Depositary assets at INDOS Financial have grown past $25bn only three months since the service provider passed the $20bn milestone on 1^st February.

According to Bill Prew, CEO of INDOS Financial, this continuing, rapid rate of growth is partially a function of INDOS’ competitive and tailored fee structure where, in contrast to the fixed rates charged by many providers of depositary services, rates decline as managers’ assets grow.

“More generally,” said Mr Prew, “our message about the virtues of independence is getting through. INDOS firmly believes that depositary services are more effective and will add value when handled by an independent provider rather than bundled with fund administration and managers across the alternative investment space appear increasingly to agree.”

Underscoring this assertion, Mr Prew pointed out that while the majority of INDOS’ depositary assets arise from new/developing investment funds, over 45%, representing over $11bn (17 funds), have transferred from other service providers in the last three years.

“It would be wrong to infer that INDOS is carrying all before it given that we’re a $25bn participant in a $1 trillion+ European alternatives industry and furthermore, some clients have transferred from administrators who have chosen to withdraw from the depositary space.

“Nonetheless,” Mr Prew continued, “the importance to managers of regular engagement with their depositary service provider cannot be overstated given that one of the key roles of a depositary is to oversee the output of the administrative function and flag up issues. Many managers who transfer business to us say that formerly, extant problems went either unidentified or unreported and therefore recognise the value our independent service provides”.