The Alternative Investment Fund Managers Directive (AIFMD) has been in effect for nearly two years now. While the alternative asset management industry has broadly coped well with the challenges presented by AIFMD, service providers such as fund administrators that also provide depositary services now face some difficult questions.
While alternative investment fund managers (AIFMs) managing EU alternative investment funds (AIFs) utilising the pan-EU AIFMD marketing passport have had to appoint a full scope depositary, those AIFMs managing non-EU AIFs marketing through various EU national private placement regimes (NPPR) have had to comply with the so-called depositary-lite regime.
The overall services of a depositary and depositary-lite are similar although under the depositary-lite regime prime brokers will typically undertake the role of safekeeping financial instruments and there is no strict liability for loss of financial instruments.
AIFMD initially prompted several independent fund administrators to establish affiliated depositary-lite businesses largely as a defensive play. They were concerned that competitors with existing depositaries would pose a threat to their core administration business because the majority of depositaries will only act where an affiliate undertakes the fund administration. In some cases, this was even actively encouraged by administration clients.
18 months on, such depositary-lite businesses face some difficult decisions.
Firms have found the duties of the depositary to be more involved and labour intensive than they expected. Coupled with the relatively low fees, depositary has not been a profitable business for many firms, especially those that have failed to attain scale or critical mass.
There has also been an increasing focus from investors and managers on the role being undertaken by depositaries, with particular attention around independence. Some investors and managers have expressed reservations whether a depositary would be truly independent and unbiased if issues were to arise at the affiliated fund administration business.
As such, the common affiliated depositary model is coming under scrutiny and a number of high profile billion-plus funds have already switched depositary mandates to a depositary which is independent of the fund administrator.
Regulators are also focussed on the level of independence between the depositary and the fund administrator so as to ensure investors’ interests are looked after.
Private placement may also be a temporary phenomenon. The European Securities and Markets Authority (ESMA) is assessing which non-EU ‘third countries’ meet equivalence under AIFMD to enable AIFMs or AIFs domiciled in those jurisdictions to market to EU member states through the AIFMD passport.
The increasing prospect of the AIFMD passport being extended means that depositary-lites need to carefully consider their future strategy. Any AIFs which are marketed through the passport must comply with the full depositary requirements of the AIFMD. Existing depositary-lite businesses will no longer be able to act unless they become a full depositary. As a result some managers are starting to question their depositary about future strategy.
While many managers running non-EU funds may not wish to market their funds via the passport and be happy to rely on NPPR, it is possible NPPR could be phased out altogether making depositary-lite obsolete. At the outset of AIFMD this could have happened by 2018 but it is now more likely to occur around 2020 since NPPR can only be phased out three years after the extension of the passport, which could now conceivably be introduced in 2017.
Becoming a full depositary is a long process and has a number of significant consequences for firms. Firms either need to become EU credit institutions or MiFID investment firms which undertake the ancillary activity of safe keeping of financial instruments. Both involve significantly greater regulatory capital and regulatory scrutiny than what depositary-lite businesses are subject to at present.
As full depositaries need to contractually take responsibility for all of the depositary duties, including the safekeeping of financial instruments (undertaken directly by custodians and prime brokers under the depositary lite model), the operational complexity and expertise required to act as a depositary will increase. Firms will need to establish sub-custody relationships and also invest in systems and people with knowledge around prime brokerage, custody and network management.
The risk profile will change too for firms since they will become subject to strict liability for loss of financial instruments. While steps can be employed to mitigate this risk, it is not possible to completely contract out of this liability. Some administration groups may question whether they are prepared to take on this greater level of risk which ultimately could place their entire core business at risk.
The challenge is even greater for depositary-lite businesses located outside of the UK because there is no depositary passport at present. This means an Irish depositary-lite, for example, will not be able to act for a UK AIFM that wishes to market a non-EU AIF in the EU via the AIFMD passport, should the passport be extended. As it stands, the depositary will need to be in the domicile of the AIFM or the non-EU AIF provided the depositary in the AIF’s domicile meets equivalence standards. Some Irish depositaries are now preparing to submit depositary applications to the UK FCA as a result. In so doing, these firms will be subjecting their overall businesses to FCA regulation for the first time.
The regulatory process in the UK will likely take anywhere from nine to 12 months and will require all depositaries to have substance on the ground in the UK.
With the passport potentially around the corner in 2017, this push towards full-scope depositary needs to start happening and standalone fund administrators need to decide whether it is viable for them to go down that path or leave the business altogether. Given all these challenges, some independent administrators may doubt it is worth the effort and it could result in administrators exiting or offloading their depositary units altogether.