Bill Prew, CEO of independent AIFMD depositary INDOS Financial Limited, was recently interviewed by Albourne TV about the benefits of the AIFMD depositary function to investors in alternative investment funds.
Drawing on practical experience over the past 18 months since AIFMD was introduced and many funds appointed a depositary for the first time, Bill highlighted the broad range of issues which have been identified by the depositary. These issues highlight how the depositary has delivered a valuable additional layer of control and oversight over a fund’s operations.
Here is a summary of the interview performed for Albourne clients (www.albourne.com).
Could you recap the role performed by the depositary?
The depositary is an independent service provider that is appointed by the fund and has a fiduciary duty to act in the best interests of investors. The depositary’s duties fall into three main categories:
• safe keeping of the fund’s assets and ensuring the existence of, and title to, those assets;
• monitoring of the fund’s cash and cash flows; and
• a range of oversight duties to ensure the fund is being managed in compliance with its offering document, including oversight over the valuation of the fund and the fund’s compliance with its investment mandate.
What types of issues has your depositary oversight identified?
Issues have broadly fallen into two categories:
• Fund administration related issues; and
• Manager related issues.
Examples of fund administration issues include:
• Securities which are not priced in accordance with the pricing policy.
• Expenses not being accrued accurately, or outside the fund’s range of permitted expenses.
• Position reconciliation errors, such as duplicate trades processed and recorded in the NAV.
• Aged or material cash reconciliation items requiring further explanation.
• Incorrect P&L allocation between share classes.
• Anti-money laundering control weaknesses (around investor screening).
• Shareholder transactions not processed correctly.
• Cash control weaknesses (e.g. expenses paid out of the wrong fund bank account).
Examples of manager related issues include:
• Breaches of investment mandate restrictions.
• Breaches of AIFMD or other leverage restrictions.
• General compliance gaps around the AIFMD rules.
When issues do arise how are they dealt with?
AIFMD requires depositaries to put in place a clear escalation path to ensure that are issues are dealt with promptly and appropriately.
In the first instance an issue would typically be brought to the attention of the COO of the fund and there would be a discussion about any remedial action to be taken.
Depending on the nature of the issue, the issue may also be escalated and reported to the board of the fund.
Ultimately if the depositary felt appropriate action was not being taken the matter may be escalated to the FCA as the depositary’s regulator.
All issues are reported in writing in a monthly report to the manager, and a quarterly report to the board of the fund. Increasingly INDOS has found that the fund board expects to be promptly advised of any issues which arise, and not wait until the next quarterly board meeting, particularly where the issue highlights control weaknesses.
This INDOS Financial article was first published in HFM Week and can be read here (subscription required).
Many alternative investment fund managers have not traditionally subjected themselves in their fund offering documents to specific investment restrictions unless required to by regulation or other rules. Managers prefer this approach since it provides them with maximum flexibility to manage the fund as they deem appropriate.
Despite the introduction of AIFMD, which requires managers to make prior disclosure of a range of information to investors, including a description of the investment strategy, fund objectives and investment restrictions, there has not been a noticeable change in practice. Some investors suggest there is a trend towards disclosing less rather than more restrictions, which they feel is not a positive industry development.
Regulators are also placing more emphasis on mandate compliance. In its 2015/6 Business Plan, the FCA stated it would focus on whether UK authorised investment funds are operating in line with their marketing materials and investment mandates. Whilst this review focusses on UK authorised funds, it sends a message to all managers to ensure they monitor their mandate compliance. In the US, there have been several cases of SEC enforcement action against registered investment advisors for failure to comply with or disclose changes in investment strategy.
Some investors would no doubt welcome more specific restrictions which are tailored to a fund’s strategy. These would include restrictions around the types of products and markets in which the fund normally expects to trade, counterparty risk management restrictions and portfolio concentration restrictions. This would result in reduced potential for scope creep which is a specific area of concern to them. In this respect, the conditions for listing a fund on the Irish Stock Exchange offer an example of a sensible starting point. These include concentration limits of 20% in a single issuer, as well as counterparty exposure limits of 20% to a single counterparty. There are also requirements to ensure counterparties are appropriately regulated and hold minimum financial resources.
Arguably, more specific disclosure would also enable better oversight over a fund’s compliance with its mandate. Fund boards and depositaries would be able to more effectively discharge their duties and protect the interests of investors. A key role of a fund board is to ensure the investment manager operates within its mandate. For many alternative funds, it has traditionally been the board of the fund and the manager itself overseeing a fund’s compliance with its mandate since administrators do not to take any contractual responsibility for doing so and auditors generally rely on representations from the fund board. AIFMD introduced the role of the depositary for non-EU alternative investment funds being marketed in the EU. One of the more valuable duties performed by depositaries is oversight over a fund’s compliance with its investment restrictions.
When it comes to funds which contain restrictions, there are a wide variety of approaches taken. Some funds include a list of several specific restrictions but it is more common to see documents refer to ‘guidelines’ rather than restrictions. In some respects guidelines are neither fish nor fowl and could be difficult to enforce were a manager to stray outside of them. We have also seen instances where language could be tightened up to avoid ambiguity or to accommodate practices such as placing unencumbered cash into money market funds, which can inadvertently lead to a breach in counterparty limit restrictions.
Even when there are restrictions in place, they need to be appropriately monitored. A good example is the Weavering Macro Fund fraud. Its offering memorandum contained a number of representations, investment guidelines and restrictions including that all counterparties to the fund would be ‘major banks’ and no more than 20% of the fund’s gross assets would be exposed to the creditworthiness of any one counterparty. At the time of the fund’s collapse, exposure to a related party counterparty had increased to over 90% of the net asset value. We have often argued that, had a depositary been in place, the whistle would have been blown on the fraud a long time before the fund’s eventual collapse.
More specific disclosure may also be beneficial to defend any claims against breach of mandate. One leading insurance broker noted that claims for breach of mandate are low-frequency (around 5% of claims by volume), but they account for over 30% in value of all claims. There are different views as to whether managers would be in a stronger position to defend claims if they had published very clear restrictions which they can demonstrate they have subsequently complied with.
In summary, now may be a good time for managers to review their documentation and strategy for defining and disclosing investment restrictions and looking at their controls and procedures for ensuring on-going mandate compliance, given the current increased regulatory interest and investor transparency demands.