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.
