‘Depositary Lite’

Simple as the theory sounds?

Originally published in the February 2013 issue

What do you think of when you hear the word ‘depositary’ in the context of AIFMD? I am sure many will answer ‘additional cost’. Well, you are probably not far off the mark, given the widely reported requirements for a depositary to take on strict liability for the loss of financial assets. But this only applies to EEA alternative investment funds (AIFs). The reality is that, for the majority of alternative investment fund managers (AIFMs) managing offshore AIFs in locations such as the Cayman Islands, this won’t be an issue.

AIFMs of non-EEA AIFs do not need to comply with AIFMD Article 21 (Depositaries). However, if a non-EEA AIF is marketed to European investors via “National Private Placement” rules, as opposed to reliance on passive marketing/reverse solicitation, an AIFM needs to comply with Article 36. This requires the AIFM to “ensure that one or more entities are appointed to carry out” the depositary duties of 1) safe custody; 2) cash flow monitoring; and 3) oversight. Strict liability does not apply. This has therefore been dubbedthe ‘depositary lite’ model. It is surprising that, given its much greater size relative to the EEA AIF market, these reduced depositary requirements which apply to non-EEA AIFs have received far less attention.

Until the FSA’s first AIFMD Consultation Paper (CP1), many considered that the appointment of an AIF’s existing prime broker(s), in the role as custodian, and existing third-party administrator, would meet requirements (1) and (2). These entities already substantially perform the functions required under the AIFMD. The theory was an AIFM would then just need to identify a provider to perform the oversight function. This combination of service providers would enable full compliance with Article 36. No significant changes would be required to current operating models and there would be no material additional cost. An AIFM would be free to focus on other AIFMD challenges. CP1 changed this. It states that when an AIF is being marketed in the UK and any of the three duties is performed by a UK firm, a single UK depositary must perform all three. Given a significant number of prime brokers to non-EEA AIFs managed by UK-based AIFMs are UK entities, it follows that, under the draft rules, a single depositary would be required.

This requirement goes beyond the AIFMD and represents a ‘gold plating’ of the directive. The appointment of a single depositary, relative to the approach outlined previously, would require significant changes to current operating models, duplicate effort and increase the costs to the AIF. As a condition of appointment, depositaries could insist on the transfer of assets from the prime broker’s sub-custody network to their own network. Given the potential number of funds this would impact, a migration of assets on such a scale would be unprecedented and the execution risk should not be underestimated.

It remains to be seen whether the FSA will amend its approach, but many hope they will. Other EEA regulators have yet to clarify their position in relation to Article 36. Regardless of the final approaches taken, there are a number of factors which managers should be thinking about when considering how to comply with Article 36.

The principle question is which entities will offer oversight services. A limited number of large financial services groups already provide trustee or depositary services to non-UCITS funds such as Irish QIFs. However, they frequently only do so where they also provide custody or fund administration services to the same AIF. I expect they will provide a full depositary service to EU AIFs, but will have much less incentive to provide stand-alone oversight services where offshore AIFs, particularly small to medium-sized funds, are concerned. Possible reasons for this include:

  • Limited capacity. Depositaries will prioritise the on-boarding of EU AIFs and existing resources will be stretched. This capacity constraint may also be exacerbated by more onerous trustee requirements of AIFMD: for example the requirements around cash flow monitoring, relative to existing services.
  • Low fees. A typical trustee fee is around 2 basis points. For many funds (for example those with AUM of up to $250m) a modest minimum fee will apply. The potential revenue opportunity from providing oversight services on a stand-alone basis, without also providing higher value custody or administration services is not significant.
  • Risk management. Without oversight of custody and/or the assurance that performing fund administration provides, trustees may not be prepared to accept the reputational risk (relative to low fees) when things go wrong – for example another Weavering or Madoff.

As a result, small to medium-sized AIFMs may find themselves in a perverse situation – on the one hand, they are probably the managers that need the ability to access EU investors through private placement the most, but on the other hand, theymay find it hardest to appoint the necessary providers to meet the AIFMD requirements to enable them to market their funds.

I expect AIFMs will be reluctant to change existing prime broker/custody or administration service providers to attract trustees to act for their AIF. Many non-EU AIFs appoint independent administrators. As a general observation, relative to many of their larger bank competitors, these firms pride themselves on providing a more tailored service offering, superior client service and importantly, a no-nonsense approach to liability. They take on full responsibility for the calculation of the net asset value (NAV), hold themselves to a straightforward negligence standard and don’t seek to limit their liability. There has already been consolidation in the administration market but I hope for the industry’s sake that depositary lite solutions will become available enabling these administrators to remain independent and provide an alternative to the large banks. Another perverse consequence of the AIFMD could be reduced competition and choice which cannot be in the best interest of stakeholders.

Managers may also want to think about the inherent conflict of interest presented by the model where a depositary forms part of the same group as the administrator, particularly in the area of oversight of the fund valuation function. With a greater focus on management of conflicts of interest (a key element of the AIFMD in its own right, and also the focus of the recent FSA report on the subject) it will be interesting to see how depositaries demonstrate that they manage this conflict appropriately.

It also seems clear that the AIFMD requires depositaries to oversee certain activities of the AIFM itself. This is not something that hedge fund managers are used to and they will no doubt take some time to adjust! This is particularly the case for the valuation function, where most AIFMs will be viewed under the AIFMD as being the valuer, and also a specific requirement for the depositary to identify and challenge unusual cash flows.

In conclusion, ‘depositary lite’ might not be as simple as it sounds or the theory suggests. The industry urgently needs clarity on the final approach the FSA will take. Managers will need to monitor the implementation of Article 36 into national law throughout the EEA and, given the looming AIFMD implementation date, depositaries urgently need to confirm their service offerings. ‘Depositary lite’ does, however, need to finally take its position centre stage alongside other key areas of the directive in a manager’s implementation plans.

Bill Prew is the founder of INDOS Financial Limited, an AIFMD related business which will formally launch later in 2013.