This INDOS Financial article was first published by Risk.net and can be read by clicking here (registration required).
The European fund management industry is at a crossroads. Since the aftermath of the financial crisis, firms have been inundated with a host of regulatory initiatives and demands from institutional investors for increased transparency and improvements in governance and operational processes.
Most managers have successfully navigated these dual challenges from regulators and investors. For the first time since early 2009, managers are experiencing a brief regulatory lull. In general, firms appear to have successfully navigated implementation of the Alternative Investment Fund Managers Directive (AIFMD). Notwithstanding a laborious regulatory authorisation process, the directive has not proven to be as ruinous to the industry as some had predicted. Appointing a depositary has not been a huge cost burden, while Annex IV regulatory filings are becoming more straightforward with experience.
The worst of the remuneration rules can be dis-applied by the majority of managers and the risk management provisions, despite general disbelief about the usefulness of the required leverage measures, have not caused too much trouble either. As a result, many managers feel AIFMD compliance has involved a lot of re-papering of legal documentation and amendments to policies and procedures, but has not had a material impact on how they conduct their business.
The regulatory lull may not last long. Further significant change lays ahead, most notably the Markets in Financial Instruments Directive II (MiFID II), which is due to be implemented from the beginning of January 2017 although there are increasing signs it could be delayed. The remit of MiFID II is significant and, unlike AIFMD, the provisions it contains will bring about significant changes for affected fund managers in terms of how they conduct their investment management business and further operational and compliance burdens.
In the interim before the impact of MiFID II is fully felt, a number of managers are addressing potential shortcomings on the operational side of their businesses. One particular area is a review of their depositary arrangements, leading to a growing trend of managers switching depositary away from providers affiliated to the fund administrator to an independent firm.
As a specialist independent AIFMD depositary, Indos has already taken over the depositary service for one billion dollar hedge fund from a large global fund administration group, and two more managers with assets in excess of $3bn are in the process of migrating their business from well-known providers. In all these cases the managers have retained the same fund administrator despite moving to an independent depositary model.
There are various reasons for this growing trend:
Many managers acknowledge they initially opted to appoint a depositary which was an affiliate of their fund administrator because they felt it would make AIFMD compliance a simpler process. Some managers had little choice, since the majority of depositaries that act for hedge funds only do so where an affiliate is the fund administrator. There are only a few firms that are able and prepared to act in an entirely independent capacity. Managers now possess practical experience of the depositary service and some are actively revisiting their depositary arrangements.
A number of managers have expressed disappointment with the level and quality of service from their depositaries. These managers complain they have had little interaction with their depositary, with very few enquiries being raised and template style reports not highlighting any issues. This has caused managers to question the role being performed by their depositaries, which they have subsequently found to be lacking.
Since few issues are being raised by depositaries, managers are sceptical about the independence and Chinese Walls between the fund administrator and depositary entity. They are questioning how the depositary can demonstrate it is acting independently and managing the inherent conflict of interest presented by one part of a group overseeing another affiliated entity.
Managers are increasingly finding they need to justify their depositary strategy to investors. Operational due diligence teams have been increasing their understanding and focus on the depositary service and probing managers on the service provided by the depositary. Managers feel that independence between the depositary and the administrator will be viewed more positively by investors.
There is an increasing recognition of the benefits an independent depositary solution can bring as it provides an additional level of oversight over the fund administrator’s processes. Industry peers are attesting they have benefited from the appointment of an independent provider. If depositaries are truly acting independently and performing a rigorous review, it is implausible some issues would not be identified and reported.
As an independent depositary, Indos has identified a broad range of issues which reveal control weaknesses across a range of administrators (such as reconciliation or pricing errors) as well as managers (such as investment restriction breaches). Managers take comfort from issues being identified since it enables them to tighten up areas of potential control weaknesses.
It is interesting to note that the benefits of improved service, transparency and independence have so far outweighed financial motives such as cost reduction. Some firms also see benefits by diversifying their service providers thereby reducing exposure and reliance on any one provider.
We are confident other managers will join those that have already decided to move to an independent depositary model. It is disappointing that there are not more depositaries willing to act entirely independently of the administrator. However, affiliated depositaries will continue to come under pressure to add value and demonstrate how they manage the conflict of interests that is inherent in this model.