A recent survey conducted by HFM Week revealed that hedge fund managers are placing increasing importance on AIFMD compliance and the role of the depositary. Surprisingly the survey revealed around 50% of hedge fund managers were dissatisfied with the service they have been receiving from their depositary since the introduction of AIFMD in July 2014. Almost a quarter of respondents said that, whilst they were dissatisfied, they weren’t sure if it was worth the ‘hassle’ of switching.
Why managers should be taking action
Investors, regulators, and fund directors are placing an increasing level of focus on the role of the depositary. This trend will continue as stakeholders become more aware of the value of the depositary function and develop their understanding of what constitutes best practice.
Operational due diligence teams have the benefit of being able to compare different depositary models they see across the funds in which they invest. They will want to understand the reasons why a particular firm was appointed, the level of service they provide and the interaction they have with the manager. Dissatisfied managers need to address the performance concerns they cite with their depositary and, if the depositary is unwilling or unable to change, managers should seriously consider changing providers. Managers that are not proactive in addressing these issues risk standing out versus their peers and are potentially open to regulatory or other challenge for poor service provider oversight.
What managers should expect from their depositary
We set out below the service managers should expect from a depositary and what we regard as best practice.
There should be regular interaction between the depositary and the manager. The depositary must use its judgement to strike a balance between raising trivial queries and the communication of true exceptions. Examples of regular interaction include queries in relation to daily cash flow monitoring exceptions, or queries arising from the monthly NAV review.
Depositaries should perform their own independent review rather than simply relying on assurances from the manager or the administrator. This is particularly relevant in areas such as AIFMD leverage monitoring and review of compliance with investment mandates.
Managers should have access to senior management at the depositary who should keep abreast of the fund and the work undertaken.
Regular reporting should form part of the depositary service delivery to managers and the board of directors of the fund. A good depositary will deliver monthly client reports and quarterly fund board reports as well as ad hoc reporting when breaches or errors are notified to or identified by the depositary. The content of monthly client reports should be tailored to the fund and not just a generic report where the fund name is being changed from one client report to the next. The report should be transparent about all activities carried out and the results. It should also contain details of where cash and assets are held and the naming convention used on the accounts.
Fund directors are responsible for ensuring that the fund is being managed appropriately and a key element in discharging this duty is the review of service provider performance. Board reports should be comprehensive covering all depositary duties. The report should contain details of all breaches and errors notified or identified by the depositary as well as any operational issues that arose in the period under review. The depositary should be available to present the report and address any questions arising.
Depositaries should remain fully independent of the administrator and should not be subject to internal corporate pressures to dilute issues or not report them at all. Managers should expect a certain level of queries to be raised on a regular basis by the depositary and should seek assurances that the depositary is completing its duties fully where there is a lack of reporting or queries being raised. The depositary should be able to clearly demonstrate the work it has completed to discharge its duties.
The depositary should conduct a periodic service level review with the manager which could be quarterly or six-monthly depending on the nature of the fund and the relationship. This provides a forum for any ongoing issues to be raised by the manager or the depositary and also to discuss any regulatory updates that may impact the business.
The depositary should be willing to engage with investor operational due diligence teams in an open and transparent manner.
Changing depositary service provider
The main inhibitor from changing a provider is the fear that the change of depositary will not make a difference to the service levels being provided and the perceived effort of changing will not bring any rewards.
The process of changing depositary is relatively straight forward compared to changing a fund administrator particularly because there is no requirement to build trade files or other operational interfaces with the depositary.
A good depositary will manage the process in a timely and un-intrusive manner meaning the manager should not need to do any heavy lifting nor incur any significant cost. In our experience the client on-boarding process can take as little as two weeks but four to six weeks is more typical, comfortably within the three months notice period of most depositary service contracts.
In the main part the depositary should interact seamlessly with the fund’s existing administrator and custodians/ prime brokers. The manager will need to approve data access on behalf of the new depositary.
The new depositary will need to complete due diligence on the manager and the depositary should provide the manager with a detailed due diligence questionnaire covering its operations.
In the UK there is a requirement to notify thy FCA of a change of depositary via the completion of a simple material change notification form (which requires one month’s notice).
Agreeing a new contract should be a straightforward process given depositary contracts are now becoming more market standard. Depositaries should contract to a negligence standard, not require indemnities from the manager nor seek to cap their liability.
Finally a small addendum will be required to the offering document detailing the change in service provider.
There is no reason to accept poor performance from your depositary. To do so could be costly and managers are advised to seek change or consider moving to an alternative provider. To quote Charles Kettering “The world hates change, yet it is the only thing that has brought progress”.