In the Summer 2013 edition of COO Connect’s COO Magazine, Bill Prew was interviewed about AIFMD and the opportunities he sees for INDOS Financial’s independent depositary oversight business. The article is set out below:
Bill Prew is that least likely of characters. He is a former hedge fund COO at James Caird Asset Management and European CFO at Barclays Global Investors who thinks an upside to the Alternative Investment Fund Managers Directive (AIFMD) is about to disclose itself. As he points out, AIFMD differs from some other regulations affecting the fund management industry – such as FATCA – in keeping to its advertised schedule, and attaining some degree of clarity in terms of implementation at the local level. In fact, Prew likens AIFMD to the UCITS directive of 1985 in terms of its potential to spark the growth of a genuine single market in alternative funds throughout Europe. “It is not a popular view, but I do try to take a more positive view of AIFMD,” he says. “AIFMD is clearly here to stay, and there is not much more we can do to change it, so why not try and make the most of it? For example, the European marketing passport could, in time, turn out to be a good thing. In addition, institutional investors may value the enhanced operational standards in areas such as risk management.” But there is a more direct reason why Bill Prew is enthusiastic about AIFMD. He sees an opportunity in providing what mutual fund managers would recognise as a trustee function.
To take advantage of it, he has set up a new business. Called INDOS Financial – the name stands for Independent Depository Oversight Services – the company will specialise in the provision of what Prew calls “independent, genuinely arm’s length AIFMD depositary oversight services to offshore hedge funds. INDOS Financial recently applied to the Financial Conduct Authority – the United Kingdom regulator – for authorisation to do exactly that. It coincided with the coming into effect of the AIFMD throughout Europe on 22 July this year. “For many managers, 22 July 2013 did not mean anything, except that the clock started ticking on the one year transitional period,” he says. “The real drop-dead date is when everybody has to comply in some shape or form, and that is 22 July 2014. Many regulators have been pretty flexible in their interpretation of the transitional rules.” American managers of Cayman funds that do not market to European investors are outside the scope of the AIFMD in its entirety. European managers do have to comply, whether or not they have European investors and wherever their funds are domiciled, but even they do not have to comply immediately.
Nevertheless, European managers of funds domiciled in Europe that have European investors have an obvious incentive to comply immediately because they are the only managers that can acquire immediately a “passport” to market to investors throughout the European Union on the basis of authorisation in one country (a non-European manager, even with a European fund, is not eligible for a passport until 2015 at the earliest). But many London-based managers of Cayman funds – the group that, conservatively estimated, make up more than 80 per cent of the classic European hedge fund industry – are largely unaffected by the 22 July 2013 date. The chief exception is a manager that wants to be an early adopter of AIFMD in order to continue to market to institutional investors by private placement in certain European countries that are taking a less than flexible approach during the transitional year to 22 July 2014.
Though the European Securities and Markets Authority (ESMA) has urged member-states to ensure fund managers comply on a “best efforts” basis from 22 July 2013, sceptics question the enforceability of this suggestion. A number of countries in Europe have yet to publish their detailed regulations for local compliance with AIFMD, though the main fund administration centres – Ireland, Luxembourg and now Malta – have. So has the United Kingdom, the most important hedge fund market in Europe, where the “best efforts” language of ESMA is conspicuous by its absence from the text of the AIFMD Regulations. What managers based in Europe have to do by 22 July 2014 is register with their local regulator as an “alternative investment fund manager” under the AIFMD. In the United Kingdom, the Financial Conduct Authority (FCA) has already issued a “Variation of Permission” form to enable existing authorised managers to comply with this requirement. The form is not short. It asks a lot of impertinent questions about the regulatory status of the principals of the firm, the number and nature of funds managed, financial statements including profit and loss accounts and balance sheets, insurance cover, compliance manuals, how client assets are held, regulatory business plans, disclosures to investors, liquidity management, risk management, leverage, prime brokerage relationships, valuation policies, marketing and delegation of functions, including portfolio management. A fee of £2,500 is payable too.
Needless to say, compliance consultants such as Kinetic Partners and IMS Consulting (now Cordium) are using the form as a major marketing opportunity. The purpose of the form, as the questions indicate, is to assess whether and how managers intend to comply with the detailed requirements of the AIFMD. Though the form does not have to be submitted until 22 July 2014, managers are starting to apply now on grounds the sheer weight of applications is bound to lead to delays in approvals by the FCA, and last-minute submissions risk missing the deadline. “I do not think it is sensible for managers to wait until July next year to submit their applications,” says Prew. “The FCA will receive a large number of applications, and may not get through them very quickly. You need to be compliant by 22 July 2014, and therefore there is a real business risk if your application is rejected for some reason after this date.”
If you are an EU AIFM of a non-EU AIF, and you happen to want to market to a country where you have to be an authorised AIFM to do so, you will also want to apply early. Alternatively, some managers may want to differentiate themselves with investors from other managers through early compliance. On the other hand, some managers will want to delay their application, because it is becoming an authorised AIFM that subjects the management company to the AIFMD remuneration guidelines, which could require them to defer 40-60 per cent of their variable remuneration for a minimum period of at least three years and subject performance bonuses to claw backs. Importantly, any third party advisers to which the management company has delegated all or part of its portfolio management might also be subject to equivalent restrictions, potentially ensnaring complex groups with intra-company arrangements in remuneration constraints. Local regulators are obliged to implement the remuneration guidelines or explain why they have not. In the United Kingdom, where fund managers are already subject to the Remuneration Code laid down by the FCA, remuneration is the one aspect of AIFMD on which the FCA has still to consult the market.
The British outlook is further clouded by the publication in May of a consultation paper by Her Majesty’s Revenue and Customs (HMRC) on the taxation of limited liability partnerships, which are the most common form of corporate organisation in the hedge fund industry and tax partners on their annual profit allocations. If profits have to be deferred, and potentially clawed back, the partners will be taxed on profits they may never receive. “Deferred compensation does not sit well with taxation of LLPs,” as Prew points out. “There is a disconnect between regulation requiring deferral, and tax policy in terms of how partnerships can legitimately facilitate deferral in a tax-efficient manner.” Malta, predictably, senses an opportunity in all this. It has announced it will not comply with the remuneration guidelines in full. Needless to say, managers hope other regulators, including the FCA, will take a similar view. Whenever a manager decides to register as an AIFM, it makes sense to prepare operationally now. One reason is that the regulatory reporting burden under AIFMD will be much heavier than current reporting requirements. For EU managers this means reporting to the home state regulator on a minimum six monthly basis, while non-EU managers will need to report to regulators in every country into which a fund is privately placed or marketed for private placement (which is why the AIFMD passport is so attractive by comparison).
In the United Kingdom, non-compliance with the private placement rules is now a criminal offence. “The risks of non-compliance with the private placement rules are greater than they were before AIFMD, because marketing is now more strictly defined, there is more regulatory focus on it, and regulators in every jurisdiction are having to work out how to apply the private placement rules in their jurisdiction,” explains Prew. “There is a large amount of data to report every six months, or quarterly for larger funds and managers, and the reports have to be delivered within 30 days of the period end. Some managers will find it hard to put the systems and procedures in place to gather the data, especially within that 30 day time-frame.” European regulatory reports under the AIFMD have similarities to Form PF (the Securities and Exchange Commission reporting form) and Form CP-PQR (the Commodity Futures Trading Commission equivalent of Form PF) but there are enough differences to entail more work, and many European managers have no prior experience of regulatory reporting of that kind beyond “voluntary” submissions to the semi-annual FCA survey of the industry. Annex 4 of the AIFMD, which contains the reporting templates, will necessitate reporting breakdowns of investment portfolios, the notional value of derivatives exposures, leverage ratios, counterparty risk analyses, clearing and custody arrangements and other intrusive and hard-to obtain disclosures.
This too is developing into a marketing opportunity for lawyers – whose web sites are awash with country-by-country analyses of the status of private placement rules in every member-state of the European Union – and for fund administrators, IT vendors and consultants that are offering to help managers cope with their AIFMD reporting requirements. However, Prew believes many managers may choose to retain reporting in-house. “You can outsource it, but you still have to understand and take responsibility for it, and a lot of the data is only held by the manager,” he says. “So I think many managers will retain reporting in-house in the first instance, and consider outsourcing over time.”
But potentially the most challenging compliance issue is the appointment of a depository. True, non-European managers, irrespective of whether they have privately placed European investors or market private placements to European investors, are not subject to any of the depository provisions of the AIFMD until 2015 at the earliest, provided they fulfil the reporting requirements in each jurisdiction where the fund is marketed. A European manager of a European fund, on the other hand, needs to comply with Article 21 of the AIFMD, which obliges managers to appoint a single depository that will take on the strict liability for any losses of assets. No depository has yet declared exactly how it intends to price and manage that risk, so uncertainty remains. One reason for that is the reluctance of custodians to take responsibility for assets that are not in custody with them, such as encumbered assets with a prime broker or within the sub-custody network of a prime broker. Since assets tend to be held by prime brokers in omnibus accounts, segregating or earmarking investor assets at or for the account of a particular depository represents a daunting operational challenge to the prime brokerage industry. Depositories are seeking indemnities from prime brokers to cover the potential loss of assets they do not control, and some are angling to discharge themselves from any liability if the prime broker fails. “To my mind, the discharge of liability by a depository drives a coach and horses through the intentions of the depository requirements of the Directive,” says Prew. “Having said that, prime brokers want to preserve current operating models and manage their operational risk, and I expect they are somewhat indifferent between an indemnity and discharge of liability by the depository, if it allows them to retain something close to the status quo.”
Prime brokers do, however, have an alternative for the majority of their existing business – namely, offshore funds. This is to continue to provide asset safekeeping services under Article 36 of the AIFMD, instead of Article 21. A European manager of a non-European fund can adopt less onerous depository arrangements under Article 36 of the AIFMD which apply if – and only if – it markets to European investors by private placement. Article 36 says that an AIFMD-authorised manager needs to ensure that one or more firms is appointed to perform the basic depository duties of safekeeping of assets, monitoring of subscriptions, redemptions and other cash flows in and out of the fund, and oversight to ensure the administrators are doing the valuation work properly and that the fund complies with investment restrictions and laws and regulations. Strict liability for losses of assets does not apply in this case, and there is no requirement (unlike Article 21) to have a single depository performing all three of these duties. This enables prime brokers to continue to act as safe-keepers of assets, just as they do today. It has also enabled Bill Prew and his colleagues at INDOS to apply to the FCA for permission to act as an Article 36 custodian. “Under Article 36 requirements, which have become known as `depository-lite,’ we can help managers comply with the AIFMD without undergoing an unnecessary operational upheaval and the expense of paying a single depository to duplicate duties already performed by the prime brokers and administrators today,” explains Prew. “A typical London-based hedge fund manager will have one or more prime brokers, an administrator, and perhaps a third party cash custodian to manage counterparty risk. The prime brokers and the cash custodian are already fulfilling the safekeeping of assets duty, and they can simply carry on doing what they do today. Similarly, the cash flow monitoring is a daily cash flow reconciliation requirement, most of which is already being done by the fund administrator.
The only function which is entirely new is oversight, which is layering a trustee function on to an offshore hedge fund. “In effect, INDOS is offering to hedge funds what RBS and NatWest have offered orthodox mutual funds in the United Kingdom for years: an independent trustee service to look after the interests of the investors. Inevitably some of the established depositaries have questioned the depositary-lite model and the ability for a comparatively thinly-capitalised new entrant to take on this role. “I accept nobody would appoint a start-up without a large balance sheet as a depository to an EU fund,” says Prew. “But I see no reason why a regulated firm subject to regulatory capital requirements, and which maintains significant professional indemnity insurance, should not be well positioned to undertake the oversight duties for offshore funds. As an independent firm needing to manage our risk, I would also argue we are more likely to question what we see at the administrator than we might were we affiliated to the same administrator.” It might be asked why INDOS needs a custodial licence, since it is not providing any custodial services. Initially, the FCA interpreted Article 36 to mean that, if any one United Kingdom firm fulfilled any one of the three duties under Article 36 it must perform all three. In a subsequent revision of that interpretation of the Article 36, the FCA insisted only that any UK firm performing any one of the three duties must obtain an “Article 36 Custodian” authorisation. INDOS does not plan to safe-keep assets, or monitor cash flows, but only to ally itself with prime brokers and fund administrators to provide a “depository lite” oversight service that offers fund managers the precious gift of an economical and non-disruptive means of complying with the AIFMD.
INDOS expects to charge most funds no more than three basis points for providing the oversight function, subject to a minimum fee. Prew says he does not expect prime brokers or fund administrators to charge a material amount more, if any, for providing safekeeping and cash flow monitoring services under Article 36, since they are doing the job already. Nor does he expect either prime brokers or fund administrators to be enthusiastic about taking on the oversight function, especially if the revenue prospects are low. They are naturally focused on the larger accounts and higher value functions. Independent fund administrators without the affiliated trustee functions of their banking competitors should also value an independent oversight partner such as INDOS, argues Prew. “There is a competitive tension between the independent administrators and the big banks with trustee functions,” he says. “The big banks are already out there pitching for new business on the basis they offer a one stop shop. Independent administrators focused mainly on Cayman funds, which require no trustee function today, need a solution. To do it themselves, they would have to set up a separate legal entity, and obtain a separate regulatory authorisation, and demonstrate how the oversight function is independent of the fund administration function.” Fund managers, on the other hand, ought to find the relatively simple solution of adding a trustee function to existing prime brokerage and fund administration relationships appealing. With estimates of Article 21-compliant services for EU funds, where the depository takes on strict liability for loss of assets, running at 15 basis points in developed markets and 30 or more basis points in emerging markets, an additional two or three basis points plus preservation of the status quo ought to look like a bargain for offshore funds. Furthermore, with managers taking on responsibility for valuation errors post-AIFMD, a few basis points charged by an independent firm such as INDOS performing genuine arms-length oversight over the valuation function, might provide the manager with comfort and help them mitigate that risk. The obvious target audience is a London-based manager of a Cayman fund with assets under management of up to $1 billion, and using an independent fund administrator, but equally INDOS plans to provide an independent alternative to the affiliated administrator-trustee model that operates today. That is a sizeable opportunity. But it is of course limited to funds with privately placed assets, and it could be a temporary one too.
“Potentially it is temporary, if the European regulators switch off the private placement regime after 2018, and say everybody needs to comply with the Directive in full,” says Prew. “The question is how we turn a business initially focusing on oversight into a one stop shop that covers safekeeping and cash flow monitoring as well. We clearly need to reassure potential clients they can continue to use us come 2018, and that will likely entail re-capitalising the business in due course. While recognising that possibility is around the corner, for the next 12 months we are focussing on providing a pragmatic solution to the large number of hedge funds seeking to comply with the Directive.”