AIFMD Depositary compliance under the spotlight

With the end of the AIFMD transitional period on 22 July approaching, the Hedge Fund Journal spoke to Bill Prew, CEO of FCA authorised independent AIFMD Depositary INDOS Financial and Shane Brett CEO, of Global Perspectives, a consultancy to the alternatives industry that has been working closely with a number of depositaries and administrators to plan for AIFMD, about the challenges depositaries and managers have faced preparing for compliance with the AIFMD.

The article can be read on the Hedge Fund Journal by clicking here and can also be read below.

To recap, the AIFMD introduces a range of depositary requirements. The core duties of the depositary are to perform safekeeping of financial instruments, record keeping and ownership verification of ‘other assets’, cash-flow monitoring and a number of oversight duties. The depositary regime which applies depends on a combination of the domicile of the alternative investment fund manager (AIFM) and alternative investment fund (AIF):

  • EU AIFM managing EU AIFs are required to appoint a single depositary. The depositary is generally required to be domiciled in the domicile of the AIF.
  • EU AIFM managing non-EU AIFs are caught by the depositary requirements only if they market those funds to EU investors through private placement. The AIFM must ensure one or more entities are appointed to perform the depositary duties in what has become known as the ‘depositary-lite’ regime.
  • Non-EU AIFM managing EU or non-EU AIFs are not subject to any depositary requirements under the AIFMD, except where countries ‘gold plate’ the AIFMD and impose certain depositary requirements for these types of AIF to be marketed in each country.

What issues are you seeing for Depositaries implementing their new service?

[Shane Brett] Depositaries are currently busy expanding and recruiting their new operational teams. A large amount of training is taking place at most depositaries and new controls and systems are being introduced, as depositaries seek to interpret the practical implementation of the AIFMD rules.

Most depositaries are also in the process of setting up data and reporting linkages with their administrators. This process has proceeded fairly well where the custody and administration is performed in-house. It has been more of a challenge where the fund’s administration is performed by a different organisation. To date most depositaries have concentrated on bedding down links to their internal administrators, rather than linking in with external  providers. We expect that to happen over the next year or so.

[Bill Prew] As an independent depositary, INDOS Financial has experienced first hand the challenges associated with establishing information flows with unaffiliated fund administrators. INDOS is only one of handful of depositaries that are willing to take on business where an unrelated third-party acts as the fund administrator. We strongly believe that all service providers should facilitate an ‘open architecture’ model allowing managers to select and appoint specialist service providers that are independent of their administrator. Given the resource pressure all firms in the industry face, we recognised early on we would need to be flexible in terms of data delivery formats since administrators would be reluctant to perform any custom builds. On the whole, administrators (and we are currently working with ten) have engaged positively with INDOS to enable their clients to appoint an independent depositary provider. Prime brokers, which typically perform the safe keeping of financial instruments duties in the depositary-lite model, have also been co-operative establishing data reporting lines.

Open architecture will also be important when managers assess how they plan to comply with AIFMD’s regulatory reporting obligations, the so-called Annex IV reporting, since specialist independent firms will also require data linkages to the administrator.

How are Fund Managers finding the launch of their new depositary service?

[SB] Many (but no means all) AIFMs have now applied for authorisation from their home regulator. Their focus has moved to ensuring they are fully AIFMD compliant by the imminent 22 July deadline.

AIFMs are working closely with their service providers and prime brokers to put new relationships in place and ensure a successful on-time depositary implementation.

Part of this process involves the AIFM making sure the depositary gets the access they need to the administrator’s shareholder records, NAV details and cash reporting. It is the AIFM’s responsibility under the Directive to ensure this access takes place.

The amount of the work involved in on-boarding a new depositary should not be underestimated – by either the depositary or fund manager. Our clients have reported being surprised by the scale of the work involved. In many instances it has been akin to the on-boarding of a brand new client or fund.

The further into the implementation process, the more managers have been surprised by the amount of legal, technical and operational work required to take the depositary service live. The key message here for managers is to start early and not underestimate the amount of work involved.

[BP] The on-boarding process, whether in the full depositary or depositary-lite model, takes time. Most depositaries have enhanced the level of due diligence performed over the manager. Depositaries are taking on real risk in both the full and depositary-lite models and need to ensure they understand the business they are being asked to undertake and design appropriate procedures to mitigate the risks. Operationally however, there should not be a significant impact on managers themselves – the depositary providers should simply plug-in and interact closely with a fund’s existing service providers.

Given the forthcoming 22 July deadline, many managers have left the depositary on-boarding process very late. Depositaries are reporting capacity issues and imposing deadlines on managers to make decisions about the services they require to complete the take-on ahead of July 22.

In a manager’s defence, there is still a lot of uncertainty about the regulatory position of firms that plan to provide depositary services. There are believed to be around 25 firms seeking authorisation from the FCA as an AIFMD Depositary yet, to date, only two firms have been authorised. Managers that have yet to identify and commence the on-boarding process with depositaries should do so in the near future or run a very real risk that they will not be able to market their funds from 22 July.

How is the implementation of Depositary Lite proceeding?

[SB] It is interesting that until recently the Depositary Lite requirements – despite impacting a large number of funds – has received much less attention than the full depositary rules.

Some AIFMs have been surprised at the relatively small cost differential between the full depositary and depositary-lite models. However we would point out that the day-to-day depositary service to AIFM’s is basically the same – regardless of the depositary model. The key difference is in the level of depositary liability.

What is also really interesting is the move by a number of countries including Germany, France, Austria and Denmark to ‘gold plate’ their Private Placement requirements for all non-EU managers that wish to market their funds into Europe. As well as having to complete the annual Annex IV reporting, these countries are also insisting that non-EU managers appoint a Depositary Lite for their funds.

We expect this to result in a major fall off in non-EU managers bringing their marketing road shows to Paris and Frankfurt in the next couple of years.

[BP] The main focus of the industry has been on the depositary model for EU AIFs since the depositary is required to take on the strict liability for loss of assets held in custody. In reality the majority of the industry is making use of a provision in the AIFMD which allows a depositary to discharge its liability to the entity performing the custody function on ‘objective reason’ grounds. This discharge, and other related matters, continues to be the subject of much debate. Costs between the models are not materially different in instances where the depositary seeks to discharge liability.

Initially many managers believed they would seek to rely on reverse solicitation and thereby avoid the depositary-lite requirements altogether. We have seen a noticeable trend away from this as managers have realised reliance on reverse solicitation is not a viable strategy, both in terms of flexibility for raising capital to grow their business and to mitigate the risks of non-compliance. This will contribute to a last-minute rush for depositary-lite services. In practice we expect many managers will simply not be able to on-board providers by 22 July and will have to defer implementation until after the summer.

The gold plating by certain countries which impacts non-EU managers is certainly an additional hurdle and cost for managers. Many larger US managers are understood to have undertaken a cost/ benefit analysis and a small number have taken the plunge and successfully obtained authorisation to market into Germany. One of the challenges the non-EU managers have faced is navigating their existing service providers since the non-EU teams are not as familiar with the AIFMD as their European counterparts.

What additional Depositary guidance would you like to see from the regulators?

More implementation guidance from the main fund regulators would be particularly welcome – specifically in cases of complex fund structures, where there may be multiple providers of custody services – and where potentially multiple parties could be named as providing the depositary-lite service.

Global Perspectives would also welcome more guidance regarding how national regulators view managing potential conflicts of interest. This might occur where the same large organisation is providing depositary, custody and administration services to an AIFM (i.e. a “One-Stop Shop” model).

The regulator in Ireland has recently launched a consultation process to examine this very issue and provide guidance as to how these potential risks should be managed.

They are also examining who should be allowed to provide the depositary lite services to a fund. Their early guidance suggests that while the monitoring of AIF cash flows (Article 21(7)) and oversight of the AIFM’s operations (Article 21(9)) can be completed by an administrator, the safe-keeping of an AIF’s assets (Article 21(8)) will require the possession of a custody license.

We think this is a pragmatic and sensible approach.

[BP] It is probably fair to say all depositaries would welcome more regulatory guidance on the application of the depositary requirements. Industry bodies have generally been quite active in seeking to develop ‘industry standards’ but almost all regulators have issued little guidance.

INDOS strongly advocates independence and provider choice. We believe there should be an alternative to the traditional affiliated depositary / fund administrator options that many managers are presented with. The Central Bank of Ireland consultation was welcome in this regard although having just closed on 31 May 2014 it will be difficult for firms to react to the outcome for 22 July.

We understand the FCA when assessing depositary applications is also focussed on management of conflicts of interest and in particular is seeking assurances that the duties and interests of the depositary business remain paramount when in conflict with a firm’s larger affiliated fund administration business.

It will be interesting to see how this develops. Many predict AIFMD will ultimately lead to more concentration amongst a handful of large banking groups that offer a bundled service. This will suit some managers looking at economics alone but not those that value independence and other benefits of a multiple-firm model.