Over recent weeks, a number of independent hedge fund administrators have announced they intend to launch AIFMD depositary-lite operations, whereas others do not plan to follow suit. Those that have announced plans share one thing in common – they currently perform hedge fund administration services mainly from Ireland where they are regulated by the Central Bank of Ireland (CBI).
To date, the only guidance issued by the CBI about the regulatory requirements for Irish firms wishing to undertake depositary-lite duties is set out in an AIFMD Q&A document from May 2013. It states that, whilst Article 36 of the AIFMD does not set out eligibility criteria for entities performing the depositary-lite duties, if an Irish entity proposes to provide such services it must determine whether authorisation under the Irish Investment Intermediaries Act 1995 might be necessary. Since May, there has been no official update from the CBI. Speaking at the GAIM Ops International conference in Paris in November, the head of markets policy at the CBI was reported to have said standalone fund administrators would have to provide comfort to regulators that they can manage any conflicts of interest or capacity issues should they provide depositary-lite activities and that it was considering the situation.
Of the administrators seeking to launch depositary-lite businesses, one has decided to seek FCA authorisation as an Article 36 Custodian, the UK’s regulatory authorisation for any UK firm undertaking any of the depositary-lite duties. We understand a second firm is also planning to take this route. One administrator has established an unregulated sister entity to its existing administration business in Ireland to perform the depositary-lite cash flow monitoring and oversight duties (two of the three depositary-lite duties).
No doubt the firms seeking authorisation in the UK partly reflects the lack of clarity in Ireland, but also the fact that in future, if the AIFMD passport is extended to non-EU AIF, the depositary must be domiciled in the domicile of the manager (most likely the UK) or the fund (most likely the Cayman Islands). As it stands, an Irish entity would not be able to act as the depositary. One major established depositary is also planning to provide depositary-lite services to non-EU firms from the UK, even though they have a long-established Irish operation. Establishing a UK authorised firm therefore not only sets a depositary firm on the path to enable compliance with this future requirement, but it also provides hedge fund managers themselves with certainty they are selecting a provider which holds the necessary regulatory authorisation rather than asking them to bear the risk of regulatory challenge or change in Ireland.
Given the 22 January 2014 deadline set by the FCA for managers to submit their AIFMD variation of permission (VOP) applications, time is running out for managers to identify a shortlist of providers that are operationally ready and willing to act as depositary-lite providers. The FCA has recently issued a Q&A and a separate guidance note (the most recent can be found by clicking here) which clarifies its expectations around the identification of depositary providers in section 9 of the VOP applications. The FCA recommends that firms should consider depositary arrangements, and as a minimum provide a shortlist of prospective depositaries, before applying for authorisation. With over 750 offshore hedge funds alone expected to require a depositary-lite solution in order to continue to be marketed post 22 July 2014, there will be capacity constraints in the depositary market and delaying decisions could mean managers run up against these constraints and also run the risk that the FCA will reject VOP applications which do not meet expectations. Given the pressure to make decisions, many managers are becoming frustrated by the lack of clarity and preparedness on the part of firms that have only recently decided to develop a depositary-lite service.
Back to the subject of regulation of depositary-lite businesses, ultimately we believe there is a real risk the CBI will in time require Irish firms to be regulated to undertake depositary-lite duties. Given there is over $1 trillion of non-Irish, non-EU alternative investment fund Assets under Management administered by Irish administrators, there must be concerns about unregulated Irish entities undertaking fiduciary activities over this level of assets. There are clearly reputational risks to the Irish industry and without regulating these activities, how can appropriate standards be set and enforced? There are already differences between regulatory standards for trustee or depository activities across Europe (and consequently different service standards particularly around frequency of NAV review and monitoring of compliance with investment guidelines) and these will be magnified where depositary-lite businesses are not subjected to appropriate regulatory oversight.
AIFMD itself places the onus squarely on managers to ensure appropriate firms are appointed to perform the depositary lite duties. We expect many managers and their directors and investors will ultimately question the suitability of unregulated firms performing an important fiduciary function.
Managers wishing to perform due diligence over depositary-lite providers may find our Hedge Fund Manager Depositary Selection Checklist useful.