Bill Prew, INDOS Financial Limited founder and CEO, believes that the AIFMD depositary fulfils a utility function of benefit to the whole financial community, policing funds from many angles on a daily basis, and alerting administrators, managers, fund boards and where appropriate regulators to concerns. Prew argues that a properly assiduous AIFMD depositary would have blown the whistle on the Weavering fraud. Of course, the whole industry has raised its game since the credit crisis, but INDOS identify many issues through their fund oversight. Some have led to NAV restatements, and to administrators compensating funds for processing errors.
Depositary services are nearly always bundled with administration or custody (or both) as current market practice encourages this. Some asset managers want a “one-stop shop” including all three services, and the “inertia factor” meant that using the incumbent provider was the line of least resistance when AIFMD required some AIFs to have a depositary. Very few independent depositaries exist, and some providers may be reluctant to offer depositary on a standalone basis. As part of a depositary mandate, one global custodian demanded custody of assets, Prew said. This was not a viable option as taking assets away from prime brokers could have severed the fund’s prime broking relationships.
INDOS claims to be the UK’s only independent depositary for alternative investment funds, defined as depositary being its sole function. The same is true in Ireland, judging by a list of seventeen depositaries from the Monterey Research Ireland 2017 report: all are affiliated with either banks or administrators or both. UCITS funds are required to use a credit institution as depositary, but AIFs have more choice.
INDOS was the first non-bank entity to be authorised as a full UK AIFMD depositary in 2017, having been the first FCA regulated AIFMD depositary in January 2014.
INDOS is gathering momentum, with $26.2 billion of client assets under oversight as of July 2018. $22.6 billion relates to 79 hedge funds from 57 hedge fund clients; and $3.6 billion relates to 36 private equity or real estate funds from 20 clients, of which $1.9 billion is represented by eight listed UK investment trusts. The growth has been all organic. When one administrator ceased offering depositary services in 2016, nine of its ten clients selected INDOS, in what was an entirely arms-length transaction.
INDOS carries out depositary lite (depo-lite) – cash flow monitoring, asset verification and oversight but not safekeeping – for EU and non-EU AIFMs managing non-EU domiciled funds, including Cayman, Bermuda, and Channel Islands funds. INDOS also acts for some non-EU managers of non-EU real estate and private equity funds, who need a depo-lite to market in Germany and Denmark, which “gold-plated” article 42 of AIFMD. INDOS has a growing list of full depositary mandates, including custody, for UK AIFMs investing in the core CSD (Centralised Securities Depositary) markets including US, Canada and Europe, and also for UK private equity and real estate AIFs. INDOS plans to obtain a regulatory authorisation for its well established Irish office to act for certain Irish domiciled funds.
As banks can have rigid pricing structures, INDOS may be able to offer better value. A $1 billion fund is not 10 times the work or risk of a $100 million fund.
Bill Prew, CEO
“Such switches can be effected within a month or two and are much more seamless than those involving some other service providers, such as administrators. The FCA requires only a month of notification, and our due diligence on-boarding process takes another month,” says Head of Client and Business Development, Jon Masters. INDOS has connectivity with 16 administrators, and 17 prime brokers and custodians. “File Transfer Protocol (FTP) files enable a smooth transfer, so that we hit the ground running on day one with cash-flow and NAV information. We do all of the heavy lifting,” says Masters. “It was very easy to switch. INDOS did everything, it was seamless,” says Indar Capital COO, Raza Khan, who switched a previous fund from an administrator-affiliated depositary, to INDOS.
INDOS’ due diligence process occasionally results in it declining to act for a potential client. One instance was a fund with unusual related party transactions and borrowings, which was later sanctioned by the FCA. Another mandate turned down was a Singapore-based manager, which had no independent fund directors at the time (but has subsequently taken steps to add independent directors). In a third case, the prospective client was deemed to be unreasonably inquisitive about competitors that are clients of INDOS. In a fourth, there were no issues with the manager – but INDOS was not confident that a fund administrator had a sufficient critical mass of relevant clients to warrant the costs of forging a relationship, which would have included overseas site visits; the model is not 100% open architecture.
INDOS has never lost a client due to its performance. There is some natural turnover of the client base as funds or managers close down or lose seed investors. On one occasion, INDOS exited a client that provided insufficient information.
The modus operandi for declining to act is to recommend that a client or potential client engages another depositary and make introductions where possible.
INDOS has some appetite for start-up and smaller managers and has recently secured the mandate for Indar Capital, which has an anchor seed investment from Tages Capital. INDOS works for some sub-AIFMD threshold managers (open ended funds with gross assets under EUR 100 million, or closed end funds with lock ups of at least five years running below EUR 500 million) that are not required to have a depositary. “Smaller managers really appreciate the added value provided by INDOS, such as a NAV restatement that a third party AIFMD platform did not spot,” says Prew. However, he realises that INDOS’ minimum annual fee (of USD 30,000) may be too high for some small funds, which might be paying as little as USD 50,000 a year for administration. INDOS is paid by funds, but an expense cap can in effect mean that a small manager would have to forego some management fees to accommodate the depositary cost within the expense ratio ceiling.
INDOS’ growth is increasingly coming from seasoned funds with track records beyond five years, and ten figure assets: seven manager clients have an underlying NAV overseen by INDOS over $1 billion. They are switching from bundled providers to INDOS’ standalone offering.
One motivation for moving to an independent depositary is the perception that some affiliated offerings can entail potential conflicts of interest. Granted, AIFMD contains some provisions around “functional and hierarchical separation” of the depositary but these are not focused on separation from fund administration which forms a large part of the depositary oversight function. Instead EU regulators have adopted different approaches to regulation of depositaries, which generally have separate management, governance, and other policies to mitigate potential conflicts. Notwithstanding this, Prew believes that the revenue disparity between administration and depositary is an overriding and inherent source of conflicts. Administration pays 8-12 basis points versus 2 or 3 for depositary, so his concern is that depositaries are “pulling punches” because they do not want to risk jeopardising the more lucrative administration business. The lack of issues being reported by affiliated depositaries, suggests some are doing little more than rubber stamping the work of their administrator “siblings”, and are failing to pick up and report errors, according to Prew and some INDOS clients.
“What distinguishes us is the thorough approach we take to our duties covering cash-flow monitoring, oversight, recordkeeping and verification, and custody of assets. We understand what funds do, perform daily reconciliations, meeting managers and administrators, and flush out anything that does not fit. We are carrying out a real-time audit function, touching a fund 220 times a year,” says Masters. Both Prew and Masters have been COOs of hedge funds before – and so are on the same wavelength as other COOs. INDOS has also obtained some quality assurance certifications: Type II SOC1/ISAE3402, and Cyber Essentials Plus. “We have invested in systems and process to carry out depositary duties in an efficient and cyber-secure way,” says Prew.
Valuation of level 2 and 3 assets can be contentious and has attracted the attention and ire of regulators. It is one of multiple areas under the depositary’s oversight umbrella, which can be used to illustrate INDOS’ approach. INDOS is not an arbiter of level 3 valuations per se, but rather monitors the quality of the process. INDOS ascertains “that processes are being consistently applied in terms of governance, pricing committees, documentation, and in some cases back-testing marks versus exit prices. For level 2 assets, we will obtain copies of broker quotes to check that administrators are consistently applying processes,” says Prew. INDOS has picked up stale pricing of level 3 assets.
The three INDOS clients we interviewed highlight various facets of the INDOS service.
Says Fraser McIntyre: “They are very detailed, and we have proper questioning and analysis of our processes. Coverage is thorough and well presented. We meet twice a year to assess how the relationship is going. They are very professional in all of our undertakings”.
INDOS has $26.2 billion of client assets under oversight as of July 2018.
Says Raza Khan “The quality of reporting and work was a huge improvement. They look at things in a more comprehensive, detailed manner, using technology effectively. Whereas some other depositaries only carry out reviews for quarterly board meetings, INDOS provides more frequent reviews. The work is performed to a really high standard with a more hands on service”.
Says Nick Gaze: “They totally understand all AIFMD requirements, have put in place the infrastructure to deal with all the main administrators and prime brokers and have continued to bring on knowledgeable staff as the business has expanded. They have a good working relationship with the administrators and prime brokers whilst also maintaining good independent oversight”.
Unlike UCITS, AIFMD does not require the striking of daily NAVs, but does require monitoring of cash-flows on a daily basis, to identify “significant or unusual transactions” which can take many forms. Reviewing the issues identified by INDOS reveals how much detail is involved in their duties.
INDOS’ monitoring has identified dozens of issues of varying degrees of gravity – in both full depositary and depo lite mandates. The errors found by INDOS illustrate the complexity of fund accounting, which involves coordinating many moving parts that run at different periodicities and subject to their own rules. One cog askew can throw the whole NAV out of kilter – and apparently does from time to time.
INDOS has enumerated issues identified, under three categories from the articles of AIFMD as follows:
Subscription and redemption related errors have included: share class registers being misaligned through time and space; delayed processing of share class transfer requests; and incorrectly applied redemption holdbacks.
INDOS has also spotted breaches of investment restrictions, re-hypothecation indebtedness and AIFMD and other leverage restrictions, and consequently breaches of stock exchange listing rules.
INDOS has, as well, found managers not doing Annex IV regulatory reporting as often as required; lacking adequately documented and controlled risk management, and inadequately documenting side letter fee arrangements.
These errors and omissions have been shared with one or more of administrators, boards and in one case the regulator, but sometimes not appeared in administrators’ reports. Some of these errors have required multiple NAV restatements, and sometimes administrators have made a fund whole for processing errors.
Some of the issues have been flagged up by INDOS’ in house technology. “We felt that third party software had room for improvement and so we have spent over two years developing DEPOcheck, in conjunction with Centigen, as an integrated workflow management and depositary oversight tool that carries out automated, daily cash flow monitoring and position record keeping, as well as position reconciliation, pricing and investment restriction checks at each NAV date using data from prime brokers, administrators and market data sources,” says Prew.
INDOS has been investing in technology to scale and build efficiency into its process but will always retain a high human touch and understanding of the funds its services. Homing in on the reviews, “cash wires are prioritised as they carry a higher risk of misappropriation whereas delivery versus payment does not,” says Prew. Over time, artificial intelligence enhancements to DEPOcheck will help identify unusual transactions and reduce the need for human inputs.
Says Khan “When I was working for the Canosa macro fund, partnered with Brummer and Partners, we met INDOS from the start, liked the pitch, and asked Bill Prew to present to the board of the Fund to get them comfortable with the idea before we decided to switch”.
Says fund director Gaze, of Danesmead: “We don’t insist on managers appointing an independent depositary, though we do encourage managers to talk to INDOS in their depositary RFP process, rather than just opting automatically for the administrator-affiliated depositary. In our opinion and experience, there is less added value from having an administrator-affiliated depositary, than there is from having an independent depositary”. He adds “There is a definite value add to investors from having additional independent oversight. I have had three occasions as a fund director where an issue has been picked up by the depositary, all have been by INDOS, where none to date have been raised by an administrator-affiliated depositary”.
Says Cantab Capital COO, Fraser McIntyre: “I was uncomfortable about having the administrator as admin and depo-lite provider. It felt like they were “marking their own homework.” By that I mean they rarely queried the manager and any probing felt light. They would source answers internally”. Cantab directors also helped to make the decision: “a couple of the Cantab fund directors have other clients who use INDOS and they said that they had been impressed with them too,” adds McIntyre. “So we feel we get a more thorough service and for a lower fee. This is a win-win for our investors, says McIntyre”.
Prew believes that INDOS should command premium pricing but the reality is that INDOS may in some situations be able to save funds money. “As banks can have rigid pricing structures, INDOS may be able to offer better value. A $1 billion fund is not 10 times the work or risk of a $100 million fund,” says Prew. INDOS can offer a lower percentage charge for larger assets whereas some others may charge fixed rates. A typical headline pricing figure is two basis points, though it can be lower for depo lite and higher for full depositary. Other factors that can influence pricing include complexity, such as the number of prime brokers and ISDAs.
Custody risk per se is not in practice that relevant for the pricing of INDOS’ full depositary mandates. Though a UCITS depositary cannot discharge liability to sub-custodians, “for AIFs in the hedge fund market, it is customary for a full depositary of an EU fund to discharge liability to sub-custodians (often prime brokers) and have a contractual indemnity, disclosed to investors. We are also acting for funds with straightforward assets and requirements, but in some cases lack the scale to be attractive clients to the bank owned depositaries,” says Prew. Still, INDOS has a quantum of professional indemnity (PI) insurance (GBP 20 million, which it regularly reviews and increases in line with underlying growth of assets under depositary) that is larger than that held by some administrators, according to Prew.
INDOS is not acting as depositary for assets in certain emerging and frontier markets, such as Russia, that have historically been flagged up as posing higher custody risks.
On top of its hard core operational drills, INDOS can share some market intelligence. “At a time when some prime brokers have cut back on PB consulting, we also like to offer some informal consulting and market colour when meeting clients. We have a good view of market practice and can act as a sounding board for benchmarking different administrators and prime brokers on metrics such as their reporting and operational processes,” says Prew.
INDOS also has a long history of paying close attention to regulation. During AIFMD’s long and delayed gestation, Prew got up to speed on the directive and garnered some goodwill by briefing over 100 COO’s from the London hedge fund community on it. INDOS are members of AIMA and try to stay ahead of the curve by keeping abreast of new regulation.
There is a definite value add to investors from having additional independent oversight. I have had three occasions as a fund director where an issue has been picked up by the depositary, all have been by INDOS, where none to date have been raised by an administrator-affiliated depositary.
Nick Gaze, Fund Director, Danesmead
Via its affiliate membership of the Depositary and Trustee Association (DATA) trade body for UK depositaries, INDOS has contributed to ESMA’s consultation on asset segregation, which is potentially germane to some of INDOS’ full AIFMD depositary instructions. In fact, it is not relevant to most impacted INDOS clients as they have segregated accounts, rather than omnibus accounts. Still, INDOS has ascertained that one probably impacted client should be compliant with the rules that should be finalised in 2019.
“We were early to issue our GDPR addendum in March 2018, highlighting the approach taken with full data mapping, identifying key service providers, providing clients transparency and enhanced contract wording. There was no commercial benefit to INDOS in taking on these extra contractual obligations,” says Masters, but INDOS was keen to be proactive and pre-emptive in creating an audit trail for data and helping its clients comply with the new requirements.
Another new 2018 regulation, MiFID II, has no direct impact on INDOS but is tangentially relevant in creating extra cash wires, payments and budgets for INDOS to monitor, where research is being charged to the fund.
In July 2016, a few weeks after the Brexit referendum vote, Prew was quick off the mark in contributing an article to The Hedge Fund Journal on Brexit and depositaries (The Implications of Brexit on Depositaries, in Issue 115), mapping out potential impacts on different combinations of EU and non-EU managers; EU and non-EU funds; being marketed inside and outside the EU.
INDOS’ base case is that post-Brexit, the UK will continue to access EU markets through equivalence, which will require an AIFMD regime including depositaries. The FCA is clearly committed to the depositary concept and Prew believes regards the depositary as a cornerstone of good fund governance: the regulator chose to gold-plate AIFMD by regulating the depo-lite function that is not for example regulated in Ireland. Prew thinks that the FCA was wise to regulate depo-lite and has found clients like the fact that INDOS is regulated.
Still, Prew acknowledges that uncertainties remain over Brexit, and is anyway now seeking authorisation for depositary functions that are regulated in Ireland. Having hitherto supported INDOS’ depo lite services from the Ireland office, in Enniscorthy, County Wexford, INDOS believes there is a gap in the Irish market for a specialist, independent depositary particularly for private equity and real estate funds. Irrespective of Brexit, it makes sense for INDOS to expand the Irish office in order to provide full depositary services for Irish domiciled funds and it plans to apply for a specialised depositary license from the Central Bank of Ireland.
INDOS Irish office co-heads, Micheal Reddy and Padhraic McLaughlin, had each spent more than a decade working at big administrators in Dublin, before deciding to seek a new challenge with a smaller firm. Eight of the sixteen staff in the Irish office are former colleagues of Reddy and McLaughlin, who say “knowing them from a previous job is a huge bonus”. Fourteen of the sixteen staff live locally, so save time on commuting into Dublin and also avoid high capital city housing costs. Over half are women and some of whom have returned to work after multi-year spells out of the workplace. There has been no specific drive to hire women, but INDOS has attracted applications from well qualified women. As a firm, INDOS offers flexibility to employees where possible. Most of the staff hold the title of analyst or senior analyst, and some more junior ones have been hired fresh from a local university. Turnover has been low; only two staff have left in three years. INDOS plans to expand the Irish office headcount to 30 to fill the new office over the next few years, to handle the ramp-up of new clients.
INDOS became profitable in 2016 and is exploring the potential for offering complementary services.
In response to new Cayman Islands AML requirements, INDOS is planning to offer Money Laundering Reporting Officer (MLRO) services to certain depositary clients. INDOS has on one occasion alerted a manager to a Politically Exposed Person (PEP) not identified by an administrator, as well as AML screening processes at another administrator which were off-market compared to industry best practice. Prew believes that depositaries, who already have oversight of a fund’s activities and good knowledge of the manager’s operations are in the best position to carry out the MLRO function and is keen to persuade other depositaries to offer MLRO services. INDOS is using an independent screening system called Spear Watch, which Prew believes gives the firm an advantage, because it is different to the systems most commonly used by administrators and includes alias identity checks and screens against multiple data sources. Masters argues that typical market pricing of $5,000 to $10,000 for an MLRO service is not sufficient to cover the work involved in doing thorough MLRO checks, which should in his opinion involve minimum six-monthly site visits to fund administrators. One manager told us they were not comfortable with an administrator’s MLRO officers double-checking its own AML processes, because they would look at it in the same way philosophically and culturally. Prew also points out that many banks have faced AML sanctions, and several bank owned administrators will not be offering the MLRO services.
INDOS has for 18 months or so been considering potential depositary and custody models for digital assets, in discussions with law firms and administrators, but has not accepted any such mandates, and is not aware of any cryptocurrency funds that have been structured under the scope of AIFMD and therefore required a depositary. This is early stage: Prew explains that it is not clear if crypto assets would be classified as “financial instruments” and therefore be subject to depositary liability in an EU legal context (some US regulators have said they are securities). However, “with the right firms, network, infrastructure and operational models involving tier one providers, we would look at digital asset custody and oversight and we continue to explore,” he says.
Environmental, social and governance (ESG) investing is rapidly growing amongst alternative asset managers, and Prew sees potential for depositaries to monitor ESG compliance. He distinguishes between the quantitative and qualitative elements of ESG: “Clearly the quantitative aspects are easier to implement – for example a fund could have an investment restriction to not invest in certain sectors or to ensure it has minimum x % of a portfolio in an MSCI ESG index. This could just be built into our DEPOcheck system like any other restriction. The qualitative aspects would be based on an on-going review of an investment manager’s investment processes which implement their ESG policies. We would visit managers and review their policies and processes to form a view in order to independently report to the fund board etc. We are working with a firm called Prime Advocates who have a lot of experience advising managers on ESG strategy implementation and will leverage this knowledge and experience where appropriate”.