Selecting an AIFMD Depositary, Considerations for Alternative Investment Managers
Reassuringly, given the fast approaching target date of the 22nd January 2014 for firms to submit their AIFMD application to the FCA, the majority of firms who participated in our AIFMD survey indicated that they are now clear on the AIFMD depositary requirements. However, so far a relatively small proportion of the respondents have actually appointed a depositary. Three quarters have indicated that they are in the process of selecting a depositary with the majority still at the RFI stage. Given that managers are required to identify their depositary providers on their FCA Variation of Permission application, one can foresee that there will be a flurry of activity as firms look to finalise their selection and carry out the required due diligence and contract negotiations in the remaining weeks before the target submission date. It would, therefore, seem like a good time to take a look at how the AIFMD depositary landscape has developed and how both the depositaries and the alternative investment managers are approaching the challenge of meeting the AIFMD depositary requirements.
Functions and duties
A key activity of the AIFMs is to appoint a depositary to bring AIFMD compliant funds in line with UCITS by having independent oversight and challenge of activities, with AIFM depositaries also having extra liability and oversight responsibilities. AIFMD depositaries are required to support the following duties and functions:
- Monitor all AIF cash flows
- Keep AIF assets safe with an obligation to return financial instruments held in custody
- Oversee (control and audit) AIFM responsibility in terms of subscription/redemption, valuation of shares/units, AIFM's instructions, timely settlement of transactions, income distribution)
In respect of the above, the depositary must act independently, honestly, fairly, and professionally in the best interest of the AIF, protecting the investors whilst ensuring they do not carry out activities with regards to the AIF that may create conflict of interests.
Whilst the broad duties and functions of an AIFMD depositary are well defined, the precise blend and detail of the duties that a depositary will undertake is determined by the depositary requirements of the AIF. These are driven by a combination of the domicile of the AIF, AIFM and marketing practices. These can be summarised as follows:
- Full depositary requirements (EU AIFM of EU AIF).
- Lighter depositary regime or "Depositary- Lite" (EU AIFM of non EU AIF marketing via private placement).
- No depositary requirements (non EU AIFM of EU or Non EU AIF except if potentially marketing into certain countries).
For AIFs subject to the full depositary regime, the AIFM must appoint a single depositary per AIF to undertake safekeeping, cash monitoring and other oversight duties. For AIFs subject to the lighter depositary regime ("Depositary-Lite"), an AIFM can appoint one or more entities to carry out these duties. Until the passport is available, a Non EU AIFS managed by a non EU AIFM is not required to have a depositary appointed.
The asset class in which an AIF is invested will also have a bearing on the type of organisation that can be appointed as a depositary and the functions performed. AIFs whose investors have no redemption rights for five years from the date of their initial investment (typically, funds investing in real estate, private equity and venture capital strategies) can appoint a depositary that meets reduced capital requirements, for example lawyers or registrars. Furthermore, as these asset classes are not held in custody, the depositary does not need to provide a custody function in order to fulfil its safe keeping duties and, consequently, the onerous liability of a regime of strict liability for the loss of financial instruments held in custody does not apply. This translates to a potentially a lighter depositary regime for AIFs investing in these asset classes.
Another factor that shapes the scope of the functions under- taken by a depositary is the ability of a depositary under the regulations to delegate its safe- keeping function to a sub-custodian subject to certain conditions being met including rigorous due diligence. Given that the sub-custodian is unlikely to accept the transfer of strict liability from the depositary as part of the contractual terms, one would expect that due diligence will need to be very comprehensive if there is to be any chance of a depositary proving, should loss occur, that it could not have been prevented.
The highly nuanced nature of the depositary rules has al- lowed different types of organisations to make a play for the AIFMD depositary market. The lighter depositary regime avail- able to non EU AIFs managed by EU AIFs, the reduced capital requirements for depositaries servicing AIFs with restricted investor liquidity, and the fact that that strict liability does not apply to "other as- sets", has resulted in the emergence of specialist depositaries alongside depositaries owned by large banking and custody groups. There are at least five new firms, either authorised or seeking to become authorised AIFM depositaries, in the private equity and real estate market.
Furthermore, the "Depositary- Lite" regime provides the flexibility for a non EU AIF managed by an EU AIFM to appoint multiple providers to support the depositary duties. As a result, there have been new entrants focusing on oversight as their core service with the existing prime broker/custodian and administrator undertaking the AIFMD requirements for safe keeping and cash monitoring, respectively. The justification given for this model is that it negates the risk of conflict of interest and minimises the disruption to AIFMs' existing relationships.
However, the majority of depositary businesses today are divisions of large banks that are looking to broaden their service offering to existing clients to whom administration and / or custody services are currently being provided. For many, this appears to be a largely defensive move with the depositary service only being offered to existing clients. How- ever, there are undoubtedly some "big players" who are looking at AIFMD as an opportunity to win new clients. One can foresee that the large trustees that do not offer custody will be vulnerable unless they can establish a robust solution to allow them to fulfil the AIFMD asset safekeeping du- ties and can competitively price the risk associated with strict liability.
The depositaries that we have spoken to have advised, unsurprisingly, that they are operationally ready for AIFMD. Whilst there is anecdotal evidence to suggest that services will initially lack the breadth and sophistication that is required to fully support AIFMD, it is premature to judge if this is the case as the majority of depositaries have either no, or very few, "live" clients. Again, this is not surprising in light of the fact that the FCA had only authorised 15 or so AIFMs up until a few weeks ago.
However, it is highly probable that depositaries will have capacity issues in the scramble to on-board clients in the 6 months leading-up to the 22nd July 2014, despite the fact that most firms appear to be augmenting their transition teams to address this issue. Being as close to the front of the on- boarding queue is probably prudent.
Whilst implementing the technical architecture in the time remaining will be challenging for many depositaries, finding appropriately skilled staff to re- source the service is likely to prove even more difficult. The UK trustee / depositary re- source pool is relatively small so attracting and retaining staff with the specialist knowledge that is required for AIFMD is a pre-requisite for a successful operation. Following on from a number of high profile moves between competing trustees / depositaries, the focus has now turned to staffing-up the operational teams.
Choosing a Depositary
The high level choice facing AIFMs is whether or not to go with a depository which is the division of a bank, and with which there is likely to be an existing custody and / or fund administration arrangement, or to appoint an independent depositary. The former has the advantage of critical mass and a group balance sheet that provides confidence that they can fulfil their obligations arising from the "strict liability" requirements. As they have the custody and administration infrastructure in place, providing the information required by the depositary should be seamless and the operating model should be more robust as a consequence. These factors, plus experience of providing trustee like services amounts to a powerful proposition, especially where there is an existing relationship.
But are they truly independent, even with "Chinese Walls "and do they have the subject matter expertise and operational flexibility to support the smaller and more complex AIFs?
The independent depositaries are arguing the case that best practice demands that a fund receives genuine "arm's length" oversight which only they can provide. They are also positioning themselves as special- ist providers with more subject matter expertise in the sectors of the fund market that they are servicing, for example, hedge fund practitioner experience.
But are they adequately capitalised if there is an issue and how well positioned are they to deal with the operational challenges arising from the need to interface with multiple third parties?
Not all investment managers, especially the larger AIFMs operating a UCITS equivalent level of oversight, accept the 'lack' of independent oversight argument given that the activities of the investment manager, administrator and custodian are already being overseen by an independent Fund Board with guaranteed access to the relevant MI generated by all parties.
Significantly, three quarters of respondents to our survey are looking to appoint an existing service provider to support their depositary requirements with the remaining quarter looking to use an independent depositary. Furthermore, none of the respondents are using AIFMD as a driver to review their wider third party service arrangements. This would suggest that the aggressive time scales to become AIFMD compliant has left firms with a fundamental unwillingness to go beyond the letter of the regulation and with little opportunity to look beyond their existing providers for a solution. This also raises t of the depositaries to support the AIFMD oversight regime is largely unproven and as such, cannot be evaluated in the same way as an existing service. One suspects that usual evaluation criteria such as cost, client references and on-boarding capability are secondary to the need to have a depositary identified on the VoP application and up and running by the 22nd July 2014.
Another peculiarity of the depositary selection process is that with the deadline fast approaching, it appears to be "a sellers' market with AIFMs that have an existing relationship or attractive scale being targeted by depositaries, leaving smaller AIFMs or those with complexities, at risk of not being able to find a suitable partner.
Finally, it is worth noting that the pricing models are highly variable across depositaries, reflecting the fact that there is no real benchmark for the service at this point. Pricing models seem to be highly complex, based on multiple factors including AUM, legal structure and domicile of the fund, AIFM entity and domicile, AIFM corporate governance structure, service model, identity of dele- gates and other counterparties, asset classes invested and risk policy. However, a small number, typically the independents, do have simpler (and more transparent) pricing models based on a basis point fee on AUM. Market commentators have suggested that there will be 2-5 bps charge for depositary services. At this point in time it is not possible to con- firm if this prediction will hold true and how it will apply to different types of AIF and service models.
It is clear that the AIFMD requirements represent a significant challenge to both alternative investment managers and depositaries and, ultimately, investors, through increased compliance and le- gal costs, and will potentially require many existing business and structural relationships to be re-engineered.
That said, for depositary businesses, the potential to expand one's client base is real and could be exploited to great advantage. However, this opportunity appears to be con- strained in the short term as investment managers choose to go the route of least resistance and appoint an existing service provider to meet their depositary requirements.
The highly nuanced nature of the AIFMD regulatory requirements has seen the emergence of number of smaller, specialist independent depositaries enter the market along- side the larger depositaries affiliated to the banking groups. These businesses have a key role to play and will be attractive to those mangers that are looking for a more agile and specialist service and value the independent oversight they offer.
The immediate focus for investment managers is to identify a depositary in order to allow the VoP application to be completed and to "on-board". Consequently, the next six months will be frantically busy for both depositaries and AIFMs alike.
Having achieved the 22nd July target date, one envisages that there will then be a period of stability as both parties con- tend with the reality of complying with the regulation followed by more activity as contracts come up for renewal in 3-5 years from now. By then the market should have a bench- mark for costs that more accurately reflects the AIFMD depositary operating model(s) and the pricing of the risk associated with strict liability, allowing the investment manager to make a much better informed decision as to what provider represents the best AIFMD depositary solution for their business.