AIFMD Depositary-Lite: Exploring the Benefits of Depositary Oversight

When most people think of AIFMD depository requirements they think of depositories being required to take on the strict liability for loss of financial instruments.

Many hedge fund managers do not see the value in the depository requirements for investors and view them as just another cost that will be passed on to the investor. There are some arguments why this is the case, not least because of the way the depository requirements for EU AIFs are being implemented (noting these are the only funds, when managed by an EU alternative investment fund manager, where the strict liability requirements of Article 21 of AIFMD applies). Assets will frequently continue to be held by prime brokers that will provide an indemnity to depositories. In some cases, the depository will seek to discharge its liability in addition to holding the indemnity. As a result some would argue that, particularly where a depository discharges its liability to the prime brokers, in the event of another major default of a prime broker such as Lehman Brothers, the AIFMD objective for restitution of assets by the depository may not be achieved.

Beyond the safekeeping of assets and strict liability provisions, there are two other core duties of a depository. They are required to perform daily cashflow monitoring and a range of oversight duties that include oversight of the valuation of the fund and compliance with investment restrictions. For most hedge funds, the cashflow monitoring aspects will not add much value because independent administrators perform daily cash reconciliations. The oversight duties, on the other hand, if implemented well should add real value to investors and managers. Some investors and managers are starting to realise this, and as a result, are giving serious consideration to the providers selected to perform this function.

Whilst it is true most European hedge fund managers already appoint an independent administrator, the monitoring and oversight of the administrator is generally undertaken by the manager themselves. In some cases, managers and funds appoint a shadow administrator to gain comfort that the administrator is undertaking its duties to the required standard but a more common model is one whereby managers have dedicated individuals performing net asset valuation (NAV) oversight. They do this because they recognise that NAV accuracy is a key operational risk area and investors expect an effective oversight model to be in place. Managers also need to ensure there are no pricing errors since a history of errors is a red flag to investors when performing operational due diligence.

Guideline compliance is another key operational risk area for managers and investors. Very few, if any, European administration agreements encompass guideline monitoring. In a typical hedge fund the manager is the only party monitoring compliance with investment restrictions and some are more sophisticated than others. Many hedge fund boards will look to the manager to provide assurance that the fund has been managed in accordance with the prospectus.

Depository oversight should therefore provide additional comfort to investors, managers and fund boards over two key risk areas. The question then becomes how and by whom is it undertaken. Common sense suggests that as much independence between the firm performing the oversight and the firm subject to oversight is a good thing. With the increasing focus in the industry on conflicts of interest and governance, independence neatly fits within this agenda. However, the majority of depositories will only act where an affiliate performs fund administration. There is an obvious potential conflict of interest in this model but, particularly in the hedge fund space, managers and funds face very little choice.

It is also interesting that, despite the non-EU (largely Cayman Islands) hedge fund market representing more than 75% of the funds managed by EU-domiciled hedge fund managers, AIFMD does not prescribe any requirements in terms of capital or regulatory requirements for any firms wishing to undertake depository oversight duties. The Financial Conduct Authority took the lead in Europe and established a new regulatory permission which it requires UK firms to hold in order to perform these duties. Many other regulators have not issued clear guidance. As a result, it will therefore be left to managers and the boards of the funds to ensure appropriate firms are appointed.

The debate will continue about whether the AIFMD depository provisions will add value to investors. Practices such as discharge of depository liability may be challenged and established prime broker operating models and their relationship with depositories will evolve. But one immediate benefit to investors should be the comfort they can take from a well-implemented depository oversight model.

This article by INDOS Financial was first published by the Hedge Funds Review in January 2014 (subscription required).