The end of the AIFMD depositary derogation and other market developments

The Alternative Investment Fund Managers Directive (AIFMD) is entrenched but evolutions are taking place in its development.

Continued focus on the independence of the depositary

Increasingly, alternative investment funds (AIFs) are favouring the appointment of independent depositary providers, as managers, institutional investors and fund directors become more circumspect about the potential conflicts of interests occurring in the oversight role if the depositary is affiliated to an administrator.

The AIFMD is a benchmark for investor protection, and it is crucial that a depositary, which should represent the interests of investors and perform a valuable fiduciary oversight role, adopts an unbiased and thorough approach towards monitoring the processes at an administrator. Such impartiality may not always be guaranteed if the depositary is part of the same overarching corporate structure as the administrator.

July 22, 2017 end date of the depositary derogation

Article 61(5) of AIFMD contains a derogation permitting an EU credit institution to act as depositary to an AIF located in another member state. This clause was inserted at the behest of smaller fund domiciles, who argued that any requirement forcing EU funds to select a depositary in their home domicile could be problematic, particularly if service providers were in finite supply.

This derogation, however, expires on July 22, 2017. Managers of EU funds – where the depositary is located in another EU member state – will shortly receive service termination notices from their depositary outlining they will be unable to continue to act after this date. Managers will need to start making arrangements to select depositaries located in the same jurisdiction as their fund.

This is a particular problem for UK managers of UK alternative funds, several of whom use depositaries out of Luxembourg or Ireland, which lack a UK presence. The uncertainty arising as a consequence of Brexit has meant few depositaries are contemplating expanding their UK operations. This creates an opportunity for UK-based independent depositaries with the right mix of regulatory permissions to win market share.

Commitment of service providers to the market

Banks and fund administrators that operate depositary units are also facing challenges. Banks continue to face balance sheet capital pressure, and many, non-core businesses are being sacrificed or scaled down. Depositary consumes a lot of time and carries risks but is often revenue light and many banks are unwilling to on-board smaller or sub $500 million managers for depositary services exclusively.

While non-bank fund administrators are not facing the same regulations as banks, they face other business challenges. A subdued market for new fund launches and lack of growth in underlying assets hinder growth at administrators. This lack of activity has resulted in several administrators focusing their marketing efforts on winning private equity business as they look to diversify revenue sources.

One large provider exited the depositary market in 2016 to focus on its core fund administration business, and these on-going strategic challenges could result in other organisations deciding to follow its lead and exit the depositary market.

The continuing role of the depositary post Brexit

UK depositaries may also end up becoming beneficiaries of Brexit. It is unlikely the UK will abrogate depositary rules for fund managers, not least if it wants to obtain EU equivalence. The UK has also been careful to articulate that EU rules will apply until Brexit is fully signed off. While some firms anticipate the UK could pursue policies exhorting deregulatory zeal, we expect the reality will be quite different and the UK will continue to be the gold standard for funds regulation.

Given this backdrop, it seems unfeasible depositary – which is being increasing recognised as enhancing investor protection – will go away. In fact, it is highly plausible that depositary will continue to play a role in the UK fund management industry, and may yet be expanded further.