This INDOS Financial article was first published by Risk.net / Hedge Funds Review and can also be read here (subscription required).
The European Union’s (EU’s) alternative investment fund managers directive (AIFMD) has been in effect for more than four months now, yet a number of issues still remain unresolved. At the heart of these matters is how to address some of the unexpected conflicts of interest that are emerging out of the directive.
The most obvious relates to the decision by a number of standalone fund administrators to create depository-lite entities as permitted under Article 36 of the directive. These entities are generally separate from the parent group but are required to perform oversight over the net asset value (NAV) calculation and other operational functions performed for funds by their affiliated administration arm. The core challenge is proving to managers and end investors that the depository-lite entity is sufficiently independent to act in the best interests of the fund and report mistakes made by the administrator, as opposed to sweeping issues under the carpet. The spirit of AIFMD and its reputation will be irreparably damaged should the latter scenario prevail. Banks face similar questions about the veracity of their Chinese walls partitioning fund administration and depository business units but, given their sheer size, these organisations are arguably better placed to manage the conflict than the smaller standalone administrators.
The problem is not just confined to administrators and depositories. A number of AIFMD management companies, offering delegated and hierarchically separate risk management to alternative investment fund managers have entered the fray and are proving reasonably popular as they permit non-EU managers to market across the EU without having to invest in people and infrastructure on the ground in Europe. While a number of management companies are standalone businesses, there are others that also provide fund administration and, in some cases, depository services to managers. These bundled offerings can represent attractive pricing to managers at a time when the costs of doing business are rapidly rising, but they also present a material conflict of interest risk. Again, the issue therein lies as to whether the different units are suitably independent of each other to ensure any errors are challenged and dealt with in an appropriate manner. As such, managers and investors should be conducting thorough operational due diligence on these bundled offerings to make sure the Chinese walls between multiple business arms are sufficiently robust and the conflicts of interest are appropriately managed.
Another problem lies with concentration risk. Some investors have made no secret of the fact that managers who have all their eggs in one basket can be a source of concern. Compared with a multi-provider model, a single group providing a range of core services to a manager presents a greater counterparty risk were it to enter into default or suffer a major credit event. The capitalisation of management companies is also a source of contention. Under AIFMD, management companies are required to hold capital worth just 0.02% of their assets under management. While management companies will undoubtedly hold professional indemnity insurance, litigation arising through fraud or negligence could stretch this coverage. For firms providing multiple services, this could have a spillover effect into the administration and depository arms. Likewise, litigation against the depository or the administrator could have similar repercussions. Were a management company or depository to cease functioning, potentially all of the managers it worked with would be prohibited from marketing or trading within Europe. This could prove fatal to managers and funds, and would hurt investors.
Regulators are taking note of this. Ucits V requires that both the Ucits management company and its depository act independently. A recent consultation paper published in September 2014 by the European Securities and Markets Authority seeks to reduce potential conflicts between management company and depository in situations where there is “common management” or “cross-shareholdings” between both units.
In March 2014, the Central Bank of Ireland confirmed that depository-lites providing cash-flow monitoring and oversight will not be subject to regulation but stressed that conflicts of interest must be managed where fund administration and depository arms are part of the same group. The UK’s Financial Conduct Authority (FCA), as part of its ongoing thematic review into the asset management industry, has frequently highlighted management of conflicts of interest as a key area of focus. The FCA has also warned fund managers about their outsourcing arrangements, with a particular focus on how firms would port assets or operations to another service provider should their provider run into difficulty. There is speculation that outsourcing to technology vendors may also be on the FCA’s radar. It is not unreasonable that the independence between depositories, administrators and management companies could also become a target of scrutiny.
The overheads of initial set-up and ongoing compliance with AIFMD are not small. While a bundled service offering can help manage costs, managers need to be aware of the conflicts presented by these models. Investors are also becoming increasingly aware about the independence of service providers operating under the same management umbrella. Ignoring conflicts of interest could prove costly if managers are to succeed in attracting institutional capital.
ESMA consults on asset segregation under AIFMD
This INDOS Financial article was first published by HFM Week and can also be read here (subscription required).
The proposals will have a significant impact on prime brokers and depositaries but also managers and ultimately investors as well. Fundamental questions are being asked whether the changes enhance investor protection or simply put yet more pressure and cost on an industry feeling the burden of increased regulation.
The AIFMD requires EU alternative investment fund managers to appoint a single depositary for each EU domiciled alternative investment fund (AIF) they manage. Financial instruments held in custody should be held with the depositary in segregated accounts but depositaries may delegate the safe-keeping duty. Because most hedge funds depend on financing and asset servicing provided by prime brokers (PB), safe-keeping is delegated to the PB(s). The depositary must ensure that the PB segregates the assets of the depositary’s clients from its own assets, and maintains records and accounts to distinguish between assets of the depositary’s clients, its own assets and assets of its other clients.
ESMA recognises that a PB can maintain a common ‘omnibus’ account for multiple AIFs. PBs typically operate a single client omnibus account for all clients. Under UK client asset rules, the assets held in the omnibus account must be kept separate from the PB’s own assets. There is no physical segregation of assets but PBs maintain books and records to distinguish the assets belonging to each AIF. To date, PBs and depositaries have been operating on the basisthat these books and records satisfy the AIFMD requirements.
ESMA main focus is the extent to which assets held in an omnibus account should either be only AIF client assets of the same delegating depositary or whether the omnibus account can hold AIF assets of different delegating depositaries. Either option would be a significant change for PBs because it would require treating AIF assets differently from other client assets, and managing multiple omnibus accounts. ESMA appears to have ruled out several other options including full segregation. It is unclear whether the proposals only relate to EU AIFs (full depositary) or whether they impact non-EU AIFs (depositary-lite).
What could this mean for investors, managers, prime brokers and depositaries?
The proposals are aimed at improving investor protection, yet the paper offers no analysis as to how they would have this effect. There appears to be widespread scepticism they will. Instead we are likely to see a significant increase in costs and operational risk, restrictions on market access, reduced operational efficiency, reduced competition and further pull-back from Europe by US managers and investors.
The most obvious impact will be on prime brokers – firms already under increased capital and business pressure from regulations such as Basel III. Multiple omnibus accounts will reduce operational efficiency and result in increased operational risk particularly around failed trades. The changes are likely to have an effect on a PB’s ability to re-hypothecate assets and the financing it is able to offer hedge funds because of the dilution of the pool of available assets. PBs could move to synthetic product access only in certain markets. Depending on which option is required, there is a risk PBs will restrict the number of depositaries they work with. This would result in reduced competition between depositaries and more concentration risk in the industry.
Managers will also be impacted. The guidelines will apply to managers as well as depositaries since the manager is responsible for ensuring compliance with AIFMD. Firms could see increased transaction and financing costs, restrictions on the markets and instruments in which they can trade, inability to place block trades and more operational complexity generally.
Depositaries may feel intuitively that the proposals provide a greater level of protection but in reality assets will still not be held under their control. It has taken a long time to agree terms between PBs and depositaries around indemnities and the discharge of liability. It is likely PBs would want to re-negotiate these terms and it may put pressure on the arguments used by depositaries to defend liability discharge.
The deadline for responses to the consultation paper is 31 January 2015 with final guidelines expected by the end of March. There is no mention of a transitional period but it could take some time for prime brokers to implement the changes.
Given the potential impact of the proposals on the industry, more clarity on how investor protection will be enhanced would be welcome to weigh up against the increase in costs which industry participants and ultimately investors will bear.
AIFMD: Small Authorised UK AIFM – a practical guide
INDOS Financial and Robert Quinn Consulting, the financial compliance consultancy, have produced a practical briefing paper for UK alternative investment fund managers that are currently Small Authorised UK AIFM. The paper covers a range of topics including:
The calculation of AUM used to measure assets against the €100m threshold;
On-going obligations to monitor AUM and required action should the threshold be breached;
Reasons why managers may wish to consider opting up to Full Scope AIFM status;
AIFMD Annex IV regulatory reporting obligations for Small AIFMs;
A summary of the FCA Variation of Permission process for firms that no longer meet the Small AIFM exemptions; and