AIFMD Depositary Lite: Placing investors and managers first

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As part of our professional network, we have the benefit of receiving valuable industry updates from various firms and individuals. Bill Prew, a former Hedge Fund COO and founder of Indos Financial Limited, has prepared a useful briefing which we believe will be of interest to you:

Most UK based hedge fund managers, particularly those managing non-EU funds, are taking advantage of the Alternative Investment Managers Directive (AIFMD) transitional year up to 22 July 2014. However, in recent guidance issued by the Financial Conduct Authority (FCA), managers have been advised to submit their ‘variation of permission’ application, or VOP as it is now commonly referred to, by 22 January 2014 in order to be certain to receive authorisation as an ‘AIFM’ by 22 July. Many managers we speak to are taking this guidance seriously and working towards submission around that date. Given the choice, the majority of UK managers of non-EU hedge funds would like to delay their actual authorisation to the last possible date, 22 July 2014, something which the FCA has just announced it will be possible to request. However, managers that intend to comply with the depositary-lite regime are required to identify their depositary-lite provider or providers in the VOP, even if they only need to have a solution implemented by July. The remainder of 2013 is therefore a very important time for managers to assess the appropriate depositary-lite solution for their business.

Two fundamentally different depositary-lite models have emerged – the single vs. multiple firm approach. We will summarise these models and highlight a number of considerations for hedge fund managers to help them make informed decisions which are in the best interests of the fund, investors and the manager. We see clear advantages of a multiple-firm model over the single model, and believe many managers will have a strong preference for the multiple model. Yet the signs are many established depositary businesses are focussing on the single firm model which will be more expensive for funds. We believe that service providers should provide a choice of model and let managers decide for themselves what is in the best interests of their funds and, ultimately, the investors.

What is depositary-lite?

Following the introduction of the AIFMD, UK and other EU hedge fund managers that wish to market their non-EU, offshore hedge funds to EU investors through private placement will need to comply with the so-called depositary-lite regime. This requires managers to ensure one or more firms are appointed to perform the depositary duties of safe keeping of assets, cash flow monitoring and oversight (principally the oversight of the valuation process, subscriptions and redemptions, compliance with laws and regulations, investment restrictions and leverage). It is a common misconception that firms undertaking these duties need to be ‘depositaries’. This is not the case although, for example, the Financial Conduct Authority does require a UK firm performing any of these duties to hold an appropriate regulatory authorisation.

Industry readiness

Before we focus on the emerging models, it is worth reflecting on the current state of readiness of the industry. To date, the primary focus of depositaries and prime brokers has been to agree the single depositary model that needs to be implemented for EU funds managed by EU managers. Given the potential liabilities depositaries are being required to take on where, unlike the depositary-lite model, the directive requires depositaries to take on the strict liability for loss of financial instruments, this is perhaps not entirely surprising. Even today, almost three months after the 22 July 2013 AIFMD transposition date, these negotiations are not completely resolved. Against this backdrop, depositary-lite has not received the attention it deserves. This is disappointing given the significance of the non-EU hedge fund sector in the context of the overall industry.

Managers, many of whom are starting to focus on this area of AIFMD, have reported real frustration about the lack of clarity from many service providers in terms of their depositary-lite solutions, fees and contractual terms.

The depositary-lite models

Two depositary-lite models have emerged.

Many existing depositaries are proposing a ‘one stop’ solution whereby they will perform all three depositary-lite duties. In reality for these firms, the depositary model for EU and non-EU funds doesn’t differ greatly except for the potential increased liabilities they face from EU funds. There are obvious benefits to depositaries from offering the single model including consistency of operations and higher potential revenues.

The second model is where the duties are performed by a combination of the existing prime brokers and custodians (safe keeping of financial instruments), existing administrators (cash flow monitoring and record keeping of other fund assets such as derivatives) and an oversight provider performing the oversight duties. Today, the prime brokers and administrators broadly perform the safe keeping and cash flow monitoring duties required under the directive. The main action for managers is to identify an appropriate firm to perform the oversight duties. Depositary-lite compliance should largely be a pragmatic, flexible and cost effective ‘plug and play’ solution.

Whilst many depositaries are offering the single model, by far the majority of managers will have a strong preference for the multiple-firm model. At Indos we have met with over 40 London based hedge fund managers, large and small, over the past six weeks and we have yet to meet a firm which prefers the single model.

From a managers perspective let’s consider the advantages and disadvantages of the single model vs. the multiple-firm model.

Advantages

Since managers are responsible for ensuring compliance with the AIFMD, the single firm depositary-lite model reduces the risk of non-compliance. The single firm will take on all the necessary depositary-lite duties and nothing should fall between the cracks. At Indos Financial we recognise this and are prepared to assist managers’ co-ordinate with PB’s, custodians and administrators to ensure the model is implemented appropriately and prime brokers and administrators perform the duties required of them, hold the necessary regulatory authorisations and these duties are reflected in their contracts with the fund.

Another advantage of the single model is managers will become more used to working with a single depositary, and be more prepared, if the AIFMD marketing ‘passport’ (currently only available to EU managers managing EU funds) is extended post 2015 to non-EU funds. In this event, the non-EU fund would need to appoint a single depositary to access the passport. A counter-argument to this is that many hedge fund depositaries (more often than not Irish regulated entities) do not currently meet the FCA requirements for depositaries for a non-EU fund marketed through the passport to EU investors. In these circumstances, the depositary (under the current FCA FUND rule book) would need to be domiciled in the country of the manager (mostly the UK) or the fund (most commonly the Cayman Islands).

Disadvantages

Put simply, many managers don’t want to pay for duplication of functions already performed today. With investor focus on fund expenses and in a challenging return environment, the issue of cost-effectiveness is key. In the multiple-firm model, funds really ought to only pay for the oversight function. This should start at 2 basis points which reduces as assets grow, with strong arguments to cap fees at a certain level depending on the complexity of the strategy, fund structure and terms.

The single model is naturally going to cost more since the depositary is taking responsibility for safe keeping and daily cash flow monitoring. By comparison, some reports suggest the costs for the single model could start as high as 5 basis points – if true, this is a significant drag on fund performance and high relative to fees already paid for administration. That’s why it could be more expensive to be ‘single’. Managers are sceptical and several have commented they view this as an attempt to use AIFMD to increase margins and reverse the fee compression seen in the administration industry over recent years. Other reports suggest some depositaries have expressed surprise that firms are even considering the multiple firm model and, further still, an independent provider and will seek to impose additional fees to perform cash flow monitoring despite the administrator performing daily cash reconciliations today. A cynic would argue this is simply to discourage firms from selecting another provider and make the single affiliate model more financially attractive.

In addition, faced with many other AIFMD and other regulatory challenges, managers prefer a model which requires the least amount of operational change. They also want to retain flexibility and the maximum level of competition between service providers, both of which are achieved by the multiple model.

Summary

In summary, imposing a single depositary into an offshore fund structure when it is unnecessary doesn’t make operational or commercial sense. It will be interesting to see whether many of the established depositaries become more flexible in this regard since the revenue opportunity will be lower if they just perform the oversight duties.

Depositary-lite should be straight forward to implement and doesn’t need to be a major challenge for managers.

The right thing is to offer managers the choice and let them and their independent fund boards decide what is in the best interests of their funds and investors.

Should you have any questions relating to the above, please do not hesitate to contact Bill at billprew@indosgroup.com.

Responsibility for the information and views set out in this article lies entirely with the author and do not necessarily reflect the opinion of Throgmorton. Throgmorton cannot be held responsible for the use of information contained herein. 



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