INDOS Financial updated the Hedge Fund Journal (January/ February 2014 edition) on developments in the AIFMD depositary-lite market. The full article can be read by HFJ subscribers at http://www.thehedgefundjournal.com/node/9183.
Recap of the depositary regime
One of the principal objectives of the AIFMD is to increase investor protection. Fundamental to achievement of this is an obligation placed on EU alternative investment fund managers (“AIFM”) to appoint a depositary for each alternative investment fund (“AIF”) managed, or marketed, in Europe. The main 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 which include oversight over the valuation of the AIF, subscriptions and redemptions, and monitoring compliance with laws and regulations including investment restrictions and AIFMD leverage limits.
EU AIFMs managing EU AIFs are required to appoint a single depositary to perform all these duties and take on the strict liability for loss of financial instruments. Non-EU AIFs managed by EU AIFMs are only caught by the depositary requirements if they market those funds to EU investors through private placement. In this situation, the AIFM must ensure one to more entities are appointed to perform the depositary duties but the strict liability provisions do not apply. This has become known as the ‘depositary-lite’ regime.
It has now also become clear non-EU AIFM marketing to certain EU investors (notably in Germany and Denmark) will also be subject to a depositary-lite requirement even though the AIFMD itself does not impose such a requirement.
Evolving depositary-lite models
Different depositary-lite models are evolving:
Model 1 – Single depositary performs all the depositary-lite duties and delegates safe keeping of financial instruments to prime brokers.
Model 2 – Prime brokers perform safe keeping of financial instruments but the depositary performs the cash flow monitoring, verification of other assets, and oversight duties.
Model 3 – Prime brokers perform safe keeping of financial instruments, administrators perform cash flow monitoring and verification of other assets and a depositary performs the oversight duties.
Different administrators and depositaries support different models. Given the choice, many managers would prefer model 3 since this should be lower cost and result in the least duplication of effort (particularly in terms of cash flow monitoring given daily cash reconciliations are generally performed today by fund administrators).
Very few depositaries are insisting on Model 1 – the single depositary model, whereas most support model 2. Costs (paid by the fund) can range anywhere from 2bps to 5bps and minimum fees apply. AIFs with less than around $200m of net assets are likely to be within scope of a minimum fee and the basis point impact will be higher.
Some uncertainty remains whether the Central Bank of Ireland (“CBI”) regards the verification of other assets duty as requiring a safe keeping authorisation under the Irish Investment Intermediaries Act, something which Administrators do not generally hold today. It may possibly mean model 2 becomes the principal option for most managers unless they want to appoint a single depositary under model 1.
Over the past few months, a number of independent hedge fund administrators have announced they intend to launch AIFMD depositary-lite operations, whereas others have no plans 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 CBI.
Unlike the depositary requirements for EU AIFM managing EU AIF, where the depositary needs to be an EU credit institution or equivalent non-EU entity, the directive does not prescribe that depositary-lite providers need to be regulated. However, given the fiduciary nature of the duties, the UK Financial Conduct Authority (“FCA”) requires UK businesses performing these duties to be regulated. The Malta FSA takes a similar stance. A notable exception is the CBI which only announced in December last year it did not intend to regulate Irish entities undertaking two of the three depositary-lite duties (cash flow monitoring and oversight) but would regulate entities performing safe keeping duties (entities require a safe keeping/ custody authorisation).
Of the administrators seeking to launch depositary-lite businesses, one is seeking FCA authorisation (and two more are rumored to be planning to seek the same) as an Article 36 Custodian, the UK’s regulatory authorisation for any UK firm, such as INDOS Financial, undertaking any of the depositary-lite duties. One administrator has established an unregulated Irish sister entity to its existing administration business in Ireland. This entity will only be able to perform the depositary-lite cash flow monitoring and oversight duties, only two of the three depositary-lite duties.
Firms seeking authorisation in the UK may reflect the lack of clarity which until recently existed, and still exists in relation to the safe keeping duties, in Ireland. It may also reflect the fact that in future, if the AIFMD passport is extended to non-EU AIF (considered later), 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 managers themselves with comfort they are selecting a provider which holds a recognised regulatory authorisation.
A case for provider regulation?
We believe there is a strong argument to require any firm undertaking depositary-lite duties to be regulated, and that there is a risk the CBI may 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, for example if there were another fraud such as Weavering and an unregulated Irish depositary-lite business was found to have not performed appropriate oversight. 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 could be magnified where depositary-lite businesses are not subjected to appropriate regulatory oversight.
Regardless of the position taken by the CBI and possibly other EU regulators in future, 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 AIF directors and investors will ultimately question the suitability of unregulated firms performing an important fiduciary function.
2015 and beyond
It is possible, but by no means certain, the AIFMD passport will be extended to non-EU funds post 2015, and ultimately lead to the phasing out of private placement regimes in 2018. If the passport is extended depositary-lite businesses will need to expand their range of services to include the safe keeping of financial instruments and quite possibly be re-capitalised in order to act as a single depositary. Whilst they would be required to take on the strict liability for loss of financial instruments, they would likely delegate the actual safe keeping duties to prime brokers and they may be able to argue (like many other depositaries acting for EU funds are doing today) there is an objective reason to discharge this liability. Regardless, at present, few managers appear to be opting for the single depositary model now and most are simply looking for a credible and cost-effective depositary-lite solution, even if that may turn out to be an interim one.
Independence and Conflicts of Interest
AIFMD requires that an AIFM conducts a due diligence review of any entity it proposes to appoint to perform depositary duties on behalf of the AIF. There are also various references throughout the AIFMD to avoidance and management of conflicts of interest.
Most depositaries will only act where an affiliate is the AIF’s fund administrator. There are potential conflicts created by the affiliated administrator/ depositary model, particularly given a key element of the depositary’s duties is to perform oversight over the valuation of the AIF. The potential conflict of interest is likely to be greatest within an administration business now seeking to provide depositary services for the first time. In such cases, the administrator will need to demonstrate how it manages the potential conflict of interest associated with performing oversight over an affiliated entity.
Some commentators believe the minimum requirement to ensure a level of independence in order to perform the depositary oversight function over an affiliated administrator is to establish a separate legal entity with a separate independent board. Some managers and commentators are sceptical this can be achieved except by the largest administration groups and as a result are looking to depositaries which are independent from the administrator and will perform genuine arm’s-length oversight.
Best practice for provider selection
A thorough assessment by the AIFM of a number of different depositary options will ensure the AIF (and its investors) receive the best solution. Managers should conduct a thorough due diligence review over a depositary including a conflicts assessment. There may be advantages from selecting an independent firm, for example increased flexibility, more favourable legal terms, and greater transparency over key operational due diligence risk areas of valuation and compliance with mandate restrictions. The independent model also fits well with industry best practice around corporate governance and management of conflicts of interest and increasing regulatory focus on managers’ placing reliance on single providers. On the other hand, most existing depositaries are members of large financial groups and therefore managers may take comfort from the ‘deep pockets’ protection if things go wrong and a more recognised brand. There are pros and cons to each model and AIFMs are well advised to compare and contrast independent vs. affiliate providers rather than simply defaulting to the affiliate model.
Operational impact on the AIFM
Depositary-lite should not have a significant operational impact on the AIFM. The depositary should, in the main part, work closely with the AIFM and AIF’s existing administrator and prime brokers to obtain the necessary information to perform its duties. No trade files or operational builds are required. Some AIFM appear concerned that the appointment of an entirely new party (as opposed to the affiliate of the administrator) will result in more work on an ongoing basis from a relationship management perspective. In some respects this is true, but you could also argue if an affiliated depositary is truly acting in an independent capacity from the administrator, there should be little difference over than a similar name above the door.
Don’t delay decision-making
For managers looking to select and on-board depositary providers in good time for the end of the AIFMD transitional period time is passing quickly. It is too early to say whether there will be capacity constraints in the depositary market. Anecdotal feedback from lawyers, prime brokers and consultants suggests approximately two-thirds of managers may opt for depositary-lite rather than seeking to rely on reverse solicitation. Feedback from several of the managers opting for depositary-lite suggests the decision is partly due to risk appetite and concern about their firms’ ability to rely on reverse solicitation all the time and the risk of overstepping what will probably be a grey line and potentially be viewed as marketing in some countries.
Given the number of managers seeking to comply with depositary-lite, there could be upwards of 750 funds needing to on-board depositaries in less than six months. Several managers are reporting frustration that, even at this late stage, some depositaries and administrators seeking to provide depositary-lite services are not yet able to clarify operating models, are being selective in terms of the type of the business they are willing to support, and do not have contractual terms to share with them or in some cases contain liability provisions which are squarely in favour of the depositary.
Depositary-lite should not be overly complex to implement and there is no reason why on-boarding should not take place in a controlled manner in good time before 22 July 2014, but managers need to make depositary-lite provider decisions soon and providers need to step up and make it possible for them to do so.