INDOS Financial, the UK independent AIFMD depositary, has been named Best Depositary Solution for the second consecutive year at the 2017 HFM European Services Awards.
INDOS won the award in recognition of its continued innovation as an independent depositary in a market otherwise dominated by depositaries affiliated to the fund administrator, exceptional client focussed service delivery and impressive client growth over the past 12 months.
Bill Prew, CEO of INDOS Financial, said “We are thrilled that INDOS has once again been recognised as the leading depositary servicing the hedge fund industry. As the only specialist independent depositary in the market, the award recognises the inherent benefits of an independent solution that delivers value to investors, fund boards and managers. We would like to thank all our clients and other industry stakeholders that supported our application and our entire team for their incredibly hard work over the past year.”
The Alternative Investment Fund Managers Directive (AIFMD) is entrenched but evolutions are taking place in its development.
Continued focus on the independence of the depositary
Increasingly, alternative investment funds (AIFs) are favouring the appointment of independent depositary providers, as managers, institutional investors and fund directors become more circumspect about the potential conflicts of interests occurring in the oversight role if the depositary is affiliated to an administrator.
The AIFMD is a benchmark for investor protection, and it is crucial that a depositary, which should represent the interests of investors and perform a valuable fiduciary oversight role, adopts an unbiased and thorough approach towards monitoring the processes at an administrator. Such impartiality may not always be guaranteed if the depositary is part of the same overarching corporate structure as the administrator.
July 22, 2017 end date of the depositary derogation
Article 61(5) of AIFMD contains a derogation permitting an EU credit institution to act as depositary to an AIF located in another member state. This clause was inserted at the behest of smaller fund domiciles, who argued that any requirement forcing EU funds to select a depositary in their home domicile could be problematic, particularly if service providers were in finite supply.
This derogation, however, expires on July 22, 2017. Managers of EU funds – where the depositary is located in another EU member state – will shortly receive service termination notices from their depositary outlining they will be unable to continue to act after this date. Managers will need to start making arrangements to select depositaries located in the same jurisdiction as their fund.
This is a particular problem for UK managers of UK alternative funds, several of whom use depositaries out of Luxembourg or Ireland, which lack a UK presence. The uncertainty arising as a consequence of Brexit has meant few depositaries are contemplating expanding their UK operations. This creates an opportunity for UK-based independent depositaries with the right mix of regulatory permissions to win market share.
Commitment of service providers to the market
Banks and fund administrators that operate depositary units are also facing challenges. Banks continue to face balance sheet capital pressure, and many, non-core businesses are being sacrificed or scaled down. Depositary consumes a lot of time and carries risks but is often revenue light and many banks are unwilling to on-board smaller or sub $500 million managers for depositary services exclusively.
While non-bank fund administrators are not facing the same regulations as banks, they face other business challenges. A subdued market for new fund launches and lack of growth in underlying assets hinder growth at administrators. This lack of activity has resulted in several administrators focusing their marketing efforts on winning private equity business as they look to diversify revenue sources.
One large provider exited the depositary market in 2016 to focus on its core fund administration business, and these on-going strategic challenges could result in other organisations deciding to follow its lead and exit the depositary market.
The continuing role of the depositary post Brexit
UK depositaries may also end up becoming beneficiaries of Brexit. It is unlikely the UK will abrogate depositary rules for fund managers, not least if it wants to obtain EU equivalence. The UK has also been careful to articulate that EU rules will apply until Brexit is fully signed off. While some firms anticipate the UK could pursue policies exhorting deregulatory zeal, we expect the reality will be quite different and the UK will continue to be the gold standard for funds regulation.
Given this backdrop, it seems unfeasible depositary – which is being increasing recognised as enhancing investor protection – will go away. In fact, it is highly plausible that depositary will continue to play a role in the UK fund management industry, and may yet be expanded further.
The EU’s Alternative Investment Fund Managers Directive (AIFMD) has gone through numerous rewrites and development phases since the acronym first entered the public domain way back in 2009.
AIFMD originally included a requirement that it must be reviewed by the European Commission by 22 July 2017. The Commission is now reportedly looking for experts to undertake an evidence-based study, to ascertain whether AIFMD’s initial objectives have been met, but also to qualify its impact on the alternatives industry and its institutional client base.
In essence, AIFMD’s key focus areas are investor protection and the application of sensible risk management. It was framed by policymakers less than one year after the Bernard Madoff fraud became public and the collapse of Lehman Brothers, but how much progress has AIFMD made in redressing such issues, and what could be improved?
Recognising the role of the depositary
AIFMD outlines the framework by which an impacted fund manager and alternative investment fund (AIF) should appoint a depositary to provide oversight of the fund. The depositary’s responsibilities include ensuring that financial instruments and assets are held appropriately throughout the custody chain, verifying ownership of assets, daily monitoring of cash flows and a broad range of oversight duties to ensure the fund is being managed in accordance with its prospectus.
The Madoff fraud, which some investigators believe occurred over a period of around 30 years, could perpetuate itself as there was limited – if any – external scrutiny over where assets were held or if they even existed in the first place. Meanwhile, Lehman Brothers’ bankruptcy revealed failings in asset safekeeping principles with non-existent segregation policies while managers found their assets trapped due to the bank’s re-hypothecation practices.
An engaged AIFMD depositary should flag these issues to the manager, fund boards, and if necessary the regulator. Unlike the annual fund audit, the depositary reviews fund activity daily and thus develops a solid understanding of the fund’s operations allowing the depositary to identify issues in a timely fashion. In this sense, the depositary requirements are positive for the industry as they provide valuable, objective oversight of operations thereby complementing the work at the manager and fund boards.
The requirement to appoint a depositary caused concern at managers at first as they assumed it would significantly increase costs, but service provider fees turned out to be modest relative to other fund costs. Institutional investors are recognising the value of the added protections, particularly relative to the costs.
In addition, depositaries will not work with managers if they feel there are poor operational processes and controls at the fund, given the risks they face taking on such business. An inability by a manager to find a willing depositary to work with them may prove to be an impetus to strengthen their internal governance since they will otherwise be unable to market their fund. Again, this is a positive development for the industry, and one which should be recognised by the European Commission in its AIFMD review.
Other suggested areas of focus in AIFMD 2
AIFMD may be much improved following multiple redrafts and amendments, but it is still shy of being a finished product. Any Directive or Regulation will have costs associated with it and AIFMD does not disappoint.
Uniform Annex IV reporting
Annex IV reporting for managers privately placing their products in EU markets is suffering from creeping regulatory arbitrage, and this is something the EU needs to monitor. For example, some EU regulators demand non-EU managers marketing feeder products include data points on the master fund in Annex IV filings even if the latter is not sold into the country, whereas others do not. Inconsistent approaches to Annex IV filings therefore need to be ironed out, and this should be raised in the study.
The third country marketing passport, continuation of private placement and review of gold plating
The process to extend the AIFMD marketing passport to “third country” managers and funds has stalled reportedly due to Brexit and the Commission not wishing to establish any precedent for third country access to the EU until Brexit negotiations are concluded. As a result, the existing national private placement regimes will continue for the foreseeable future and certainly beyond the original 2018 AIFMD phase out date.
However, different regulatory approaches and ‘gold plating’ continue to frustrate pan-EU AIFM distribution whether this be via the marketing passport which was introduced by AIFMD for EU funds, or private placement for non-EU funds. This is a complaint that urgently needs to be resolved, as different cross-border practices and processes add to managers’ costs and ultimately reduce choice for European investors.
A more meaningful measure of leverage
Equally, there is a strong case to reassess how leverage is calculated under AIFMD. ESMA’s methodology for leverage calculations requires any notional values of derivatives to be added to the overall balance sheet before being divided by the net asset value. This can inflate leverage reporting, and there are calls for an alternative risk-weighted exposure methodology to be permitted to present a more meaningful measurement. This is also something that should be considered by the Commission.
These recommendations should be adopted by the EU, as it will make life easier for managers looking to export their fund products to EU investors. The EU funds’ industry is going through a period of change and transitioning, which has been made much more difficult due to Brexit. Intelligent appraisal of AIFMD is required if the European funds industry is to remain strong and successful at this sensitive juncture of EU change.