AIFMD Depositary-Lite: Exploring the Benefits of Depositary Oversight
When most people think of AIFMD depository requirements they think of depositories being required to take on the strict liability for loss of financial instruments.
Many hedge fund managers do not see the value in the depository requirements for investors and view them as just another cost that will be passed on to the investor. There are some arguments why this is the case, not least because of the way the depository requirements for EU AIFs are being implemented (noting these are the only funds, when managed by an EU alternative investment fund manager, where the strict liability requirements of Article 21 of AIFMD applies). Assets will frequently continue to be held by prime brokers that will provide an indemnity to depositories. In some cases, the depository will seek to discharge its liability in addition to holding the indemnity. As a result some would argue that, particularly where a depository discharges its liability to the prime brokers, in the event of another major default of a prime broker such as Lehman Brothers, the AIFMD objective for restitution of assets by the depository may not be achieved.
Beyond the safekeeping of assets and strict liability provisions, there are two other core duties of a depository. They are required to perform daily cashflow monitoring and a range of oversight duties that include oversight of the valuation of the fund and compliance with investment restrictions. For most hedge funds, the cashflow monitoring aspects will not add much value because independent administrators perform daily cash reconciliations. The oversight duties, on the other hand, if implemented well should add real value to investors and managers. Some investors and managers are starting to realise this, and as a result, are giving serious consideration to the providers selected to perform this function.
Whilst it is true most European hedge fund managers already appoint an independent administrator, the monitoring and oversight of the administrator is generally undertaken by the manager themselves. In some cases, managers and funds appoint a shadow administrator to gain comfort that the administrator is undertaking its duties to the required standard but a more common model is one whereby managers have dedicated individuals performing net asset valuation (NAV) oversight. They do this because they recognise that NAV accuracy is a key operational risk area and investors expect an effective oversight model to be in place. Managers also need to ensure there are no pricing errors since a history of errors is a red flag to investors when performing operational due diligence.
Guideline compliance is another key operational risk area for managers and investors. Very few, if any, European administration agreements encompass guideline monitoring. In a typical hedge fund the manager is the only party monitoring compliance with investment restrictions and some are more sophisticated than others. Many hedge fund boards will look to the manager to provide assurance that the fund has been managed in accordance with the prospectus.
Depository oversight should therefore provide additional comfort to investors, managers and fund boards over two key risk areas. The question then becomes how and by whom is it undertaken. Common sense suggests that as much independence between the firm performing the oversight and the firm subject to oversight is a good thing. With the increasing focus in the industry on conflicts of interest and governance, independence neatly fits within this agenda. However, the majority of depositories will only act where an affiliate performs fund administration. There is an obvious potential conflict of interest in this model but, particularly in the hedge fund space, managers and funds face very little choice.
It is also interesting that, despite the non-EU (largely Cayman Islands) hedge fund market representing more than 75% of the funds managed by EU-domiciled hedge fund managers, AIFMD does not prescribe any requirements in terms of capital or regulatory requirements for any firms wishing to undertake depository oversight duties. The Financial Conduct Authority took the lead in Europe and established a new regulatory permission which it requires UK firms to hold in order to perform these duties. Many other regulators have not issued clear guidance. As a result, it will therefore be left to managers and the boards of the funds to ensure appropriate firms are appointed.
The debate will continue about whether the AIFMD depository provisions will add value to investors. Practices such as discharge of depository liability may be challenged and established prime broker operating models and their relationship with depositories will evolve. But one immediate benefit to investors should be the comfort they can take from a well-implemented depository oversight model.
This article by INDOS Financial was first published by the Hedge Funds Review in January 2014 (subscription required).
INDOS Financial talks to Waters Technology
Waters Technology published an article “Fund Managers Gear Up for AIFMD” which looks at how managers are preparing to comply with AIFMD, in what is now the “homestretch” to the final date for compliance, 22 July 2014. The article features comments from a number of leading law firms and service providers and covers some background to the original objectives of the AIFMD, investor protection and the depositary requirements, marketing, risk management, and reporting.
INDOS Financial sets out a number of considerations for managers when selecting a depository, Managers should consider the regulatory status of the depository, its breadth of experience and financial strength, its legal position on liability, its degree of independence from the fund accounting function over which the depository will have oversight, operational requirements, its on-boarding process, reporting and transparency, and, of course, costs.
INDOS has developed an on-boarding checklist to facilitate a manager’s due diligence.
The full Waters Technology article can be read by clicking here (subscription required).
AIFMD: A case of one step forward, two steps back?
By the end of 2013, with a little over six months to go until the 22 July 2014 AIFMD compliance deadline, many managers had grasped the nettle and made good progress in their efforts to meet the requirements of the directive. In particular, with the then 22 January 2014 FCA ‘deadline’ looming, managers were generally well prepared to submit their variation of permission (“VoP”) applications by this date. Whilst some managers had already submitted their applications by the end of 2013, the majority of managers appeared to be aiming for the 22 January deadline.
Submission of the VoP would tick off a major part of the AIFMD preparations. But the job isn’t complete then and there is work still to do for many managers to be operationally ready and compliant by 22 July 2014. These include areas such as appointing and on-boarding depositaries, finalising amendments to offering and disclosure documents, ensuring risk management policies and procedures are compliant, and so on.
Following concerns raised by a wide range of stakeholders, HM Treasury (“HMT”) announced just prior to the Christmas break that it intended to amend the AIFMD Regulations to provide that, if a transitional manager’s application for authorisation or registration is submitted without sufficient time for the FCA to determine the application by 22 July 2014, that manager will be able to continue managing its funds until the FCA has determined the application. The requirement to submit an application before 22 July would remain in place and managers will need to be in AIFMD compliance from 22 July 2014, even if their application has not yet been determined.
HMT advised it is working out certain details; in particular the status of managers whose applications are yet to be determined after 22 July. HMT nevertheless encouraged all transitional managers to make their applications for authorisation in good time. The FCA followed up the announcement with a statement stating it was considering the impact of HMT’s announcement but it encouraged firms to submit applications in line with previously stated guidance. The FCA has more recently issued further guidance on a ‘triage’ review process which will take place on all applications to assess their completeness prior to assignment of a case officer.
Since the HMT announcement, there appears to be a sense within the manager community of the pressure being off and that firms have more time. This is probably not the response HMT and in particular the FCA wanted. The FCA is still expecting in the region of 800 AIFMD applications. It will still have up to 6 months to consider an application and therefore if managers delay their applications they run the risk of not receiving authorisation by 22 July 2014. It is clearly better for the industry as a whole to have a situation whereby it is the norm, rather than the exception, for managers to have been authorised by 22 July 2014. In some senses, therefore, the announcement could have been handled differently i.e. a coordinate announcement from HMT and the FCA stressing that managers are strongly encouraged to submit their VoP applications by the previously stated deadlines but simply providing re-assurance that a manager may continue to conduct business after 22 July 2014, as long as they are AIFMD compliant, whilst their application is pending.
From a managers’ perspective, there were always business and reputational risks to consider if they did not obtain authorisation by 22 July 2014. Whilst the amended AIFMD Regulations will now allow for authorisation after 22 July, I expect most managers would prefer to have the certainty of authorisation by this date. If the majority of firms still achieve this deadline it could shine a spotlight on those that don’t. It may even invite questions from investors about what it says about a manager’s commitment to compliance. Questions are also being asked whether there could be implications for a manager’s ability to market their funds to EU investors through private placement without being authorised.
Many commentators are advising managers not to delay their applications. Often they have vested interests but in this case they are right. Managers would be wise to continue to focus on AIFMD and finish the job they have started.
This article was first published by HFMWeek and can be accessed here (subscription required).
INDOS Financial to speak at Global Fund Domiciles & Governance Forum 2014
INDOS Financial’s Bill Prew will be speaking at the Global Fund Domiciles & Governance Forum 2014 being held on 30th January 2014 in London. We will be discussing risk management in the post AIFMD era in what should be an interesting debate. The Forum will also cover developments in fund governance, the impact of regulation such as AIFMD on choice of fund domicile, and conflicts of interest. For further details or to register for the event, please visit this link.
FCA Updates on AIFMD Application Process
The FCA has updated its website to provide more details of the process it will employ to review variation of permission applications submitted by UK alternative investment fund managers. Applications will be reviewed through a triage process to assess their completeness in order to be assigned to a case officer.
Despite HM Treasury making an announcement before Christmas that it planned to make changes to the AIFMD Regulations to allow for situations where managers have not received AIFMD authorization by 22 July 2014, the FCA is still encouraging managers to submit their applications as soon as possible. The industry awaits further clarification from the FCA and HMT but in the meantime advisors are also recommending managers continue to focus on submission of their VoPs.
The law firm Akin Gump has issued a very interesting bulletin on this change which is relevant to any managers seeking to comply with the AIFMD depositary-lite requirements in order to continue to market their funds to EU funds from the end of the transitional period, 22 July 2014. The bulletin which can be found by clicking here, confirms what we hear from many managers about their discussions with established depositary firms or administrators seeking to provide depositary-lite solutions – that is many are not yet ready to provide draft contractual terms and are unable to clearly articulate how depositary-lite will be implemented in practice. This continually surprises us and we encourage any managers frustrated in their efforts to date to agree terms and operating models with a depositary lite provider to contact us.
We offer a very pragmatic and transparent depositary-lite solution. We have balanced contractual terms and detailed due diligence materials which will enable you to make an informed decision. Selecting Indos does not involve any significant operational burden on your business (no trade file builds for example) – we simply work alongside your existing administrator and prime brokers and managers and their fund boards benefit from the independent oversight and reporting we provide.
To visit the FCA website click here and scroll down to “The Application Process”