This INDOS Financial article was first published by HFM Week and can be viewed by subscribers at www.hfmweek.com/comment
Many EU hedge fund managers will need to comply with new requirements under the Alternative Investment Fund Managers Directive (AIFMD) to appoint a depositary. The exact requirements will depend on a combination of the domicile of the managers, their hedge funds and how they are being marketed. The requirements can be broadly summarised as follows
1. All EU-domiciled Alternative Investment Funds (AIF) managed by EU Alternative Investment Fund Managers (AIFM) are required to appoint a single depositary (Article 21);
2. EU-AIFM managing non-EU AIF must comply with the ‘depositary-lite regime’ (Article 36) if the AIF is being marketed to EU investors through private placement; and
3. Non EU-AIFM managing either EU or non-EU AIF are subject to Article 42. Whilst Article 42 does not impose any depositary requirements, some countries (including Germany and Denmark) are imposing a depositary-lite requirement in order to market these funds into their countries.
Regardless of the regime which will apply, hedge fund managers will need to undertake due-diligence over their depositary providers. In particular, UK managers will need to provide a summary of the due diligence undertaken in their AIFMD Variation of Permission applications to the Financial Conduct Authority, and be in a position to share further details of the due diligence undertaken on request by the FCA.
Very little has been written about what AIFMD depositary due diligence will involve. We set out below a number of factors which hedge fund managers, particularly those seeking to comply with the depositary-lite requirements, can consider.
Regulatory Authorisation. Any UK firms undertaking AIFMD depositary duties will need to hold a authorisation, whereas overseas firms may not be subject to regulation. We suggest that investors and managers will be more comfortable with a regulated firm.
Experience of complex strategies. Many depositaries are experienced in long-only strategies but what experience do they have over complex derivatives and more complex hedge fund strategies.
Financial strength. Financial strength is of primary importance for EU funds where the depositary is required to take on the strict liability for loss of financial instruments. This does not apply in depositary-lite but nevertheless if things go wrong and depositaries are found to have been negligent, can the depositary foot the bill? Depositaries which form part of broader financial services group will be perceived to offer ‘deep pockets’ protection, but how is the depositary unit capitalised and what parent guarantees exist to back up the depositary in the event of their negligence? Independent providers may not have the same deep pockets, but if regulated, will be required to maintain minimum levels of regulatory capital and should maintain adequate professional indemnity insurance.
Legal and commercial terms. Depositary agreements are not new and firms should be prepared to share their standard terms. Depositaries should be operating to a negligence standard and not seek to cap their liability.
Operating models and Service levels. Different depositaries will have different operating models and service levels and different regulators have different expectations. Key areas include the frequency of reviews around investment guideline monitoring, fund valuations and how depositaries meet the enhanced AIFMD cash flow monitoring requirements. Depositaries should be transparent about the procedures they will perform and their frequency (daily/ weekly/ monthly/ quarterly or annually).
Depositaries which take a flexible and pragmatic approach (particularly in the depo-lite context) should not have a significant operational impact on managers since they should simply work closely with existing service providers. Will the depositary establish a service level agreement which will govern the information flow between the depositary, manager and administrator?
Systems and Controls Assurance. What systems does the depositary employ and will it provide a regular independent controls assurance report such as a SOC1 or ISA3402 report? Review the exceptions in the most recent report.
Independent vs. Affiliate model. Where the depositary provider will oversee an affiliated fund administrator, how does it manage the potential conflict of interest presented by this model?
Value Proposition. Whilst the primary responsibility of the depositary is to act fairly and in the best interests of investors, depositaries should be able to articulate how their activities will add value to the manager and the fund. In so doing, depositaries turn this aspect of the AIFMD into a positive for managers and investors in return for the costs incurred.
Transparency and Reporting. Like any other service provider, depositaries should be held accountable for their work. As a minimum, depositaries should provide a summary of their findings each month to the manager and a formal written service report on a quarterly basis to the manager and board of the fund. This should be part and parcel of the core service. Reports should be transparent about the work undertaken and the results.
Past Claims. Has the depositary been subject to any past claims where the depositary was found to have been negligent? What circumstances gave rise to the claims and have procedures been enhanced as result?
Escalation Process. How will issues be escalated and in what kind of circumstances would issues be escalated to the board of the fund and potentially regulators?
Cost. Are the proposed depositary fees competitive? Will the depositary consider fee caps or fixed fees depending on complexity of strategy?
In conclusion, whilst this may seem like a long list of points to consider, all depositaries should be prepared to provide clear responses. Only then can managers compare and contrast different providers and make decisions that are in their best interests and, since the fund is paying for the service, their investors. INDOS has prepared a detailed due diligence questionnaire to enable managers assess providers. Please click here to download.
