Alternative Investment Management Association Representing the global hedge fund industry
UBS Fund Services
Ever since the Alternative Investment Fund Managers Directive (AIFMD) was first conceived in 2009, it has precipitated intense lobbying and legislative argument. But with a July 2014 deadline now agreed and rapidly approaching, attention is now focused on implementing the right solutions to achieve compliance.
Of particular interest is the Directive’s treatment of depositary services – the strict liability regimes and the effect on pricing, the different models available, the different guidance issued by respective national regulators and the emergence of the so-called ‘depositary lite’.
A key tenet of the Directive is the differentiation between EEA (European Economic Area) and non-EEA funds and this has created different needs for both categories. Consequently, European-based depositaries and administrators have been busy designing solutions across all alternative asset classes and for use within and outside the EEA.
Within the hedge fund world, depositaries have been grappling with the choice of offering a full service model where they offer all three functions (safe-keeping of assets, cash flow monitoring and oversight) or a split service model where a prime broker may look after some of the functions. I believe the latter approach offers the most benefit to AIFs for a number of reasons. Firstly, it gives managers the ability to diversify the assets of their AIFs across multiple counterparties. Secondly it is the least disruptive approach allowing managers to continue with their existing prime brokers and depositaries. Finally, it keeps the prime broker competitive, thereby keeping costs down.
That said, the legal agreements that must be struck between prime brokers and depositaries within the shared service model will have an impact on price. Due to the full liability clause on the Directive, depositaries will look to work with external prime brokers with a full discharge of liability, however this is not a straight-forward discussion and it may have an impact on costs.
One benefit of the AIFMD and the finalisation of the level II measures is that the responsibilities for depositaries are now more prescriptive. The difficulty, however, is the broad scope of these responsibilities and depositaries must work out how they will develop a solution for all types of alternative structures – from private equity funds to fund of funds.
The major question for a custodian assuming the responsibility for the safe keeping of assets is how the strict liability clause (and thereby the price they will charge) is affected by the depositary set-up. In the private equity industry, assets are generally registered in the name of the fund and therefore the strict liability clause will not apply. For fund of hedge fund positions, these products are generally registered in the name of the depositary and so could be deemed to be financial instruments and the strict liability clause will apply.
In order to dispel any uncertainty, AIFMs should engage with their depositary to understand exactly how their AIF assets will be registered and to make sure the price charged is appropriate.
Another complication with the AIFMD has been the inconsistency in the approach of different national regulators, many of which are still to provide further guidance on implementation of depositary or depositary lite requirements. The UK regulator, the Financial Conduct Authority (FCA), has been one of the most active in giving guidance on the practical implementation of AIFMD.
For example, the majority of managers were relieved to discover at the end of 2013 that the AIFM Variation of Permission (VoP) form does not need to be completed in full by 21 January 2014, and AIFMs only need to submit their form before 22 July 2014, although the AIFM and the service providers are still required to be compliant by the July deadline. The FCA is still encouraging AIFMs to complete their VoP form as a priority and we have found that managers are taking their heed. This means the depositary of the AIF needs to be documented in the form and the AIFM must notify the FCA if it has carried out appropriate due diligence on the service provider.
One additional benefit the FCA has offered clients is the opportunity for AIFs to appoint another EEA depositary to carry out the depositary duties for UK 'unauthorised' AIFs up until 2017, commonly known as the Malta Clause. This gives EEA depositaries an opportunity to provide services to UK AIFs without being authorised in the UK, however they will still need to be conscious of their local regulator’s requirements in order to carry out these duties.
A significant implication of the AIFMD is the requirement for EEA-based AIFMs to appoint an entity or entities to carry out cash flow monitoring, safekeeping and general oversight to non EEA-based AIFs marketed within the EEA, commonly referred to as 'depositary lite'. As EEA-based AIFMs will not have the ability to ‘passport’ non EEA-based AIFs until at least 2015, the only option currently available is to market these funds to individual member states, typically referred to as national private placement.
Additionally some Member States have 'gold plated' the Directive and have applied similar conditions to Article 36 for non EEA AIFMs marketing non-EEA AIFs in Member States. The following table gives a summary of the difference between the full and lite depositary regimes.
As can be seen from the table above, there is a lot more flexibility in the depositary lite model versus the full depositary model. Managers considering a depositary lite are, in general, looking for the simplest and most cost-effective solution that will involve the minimum amount of disruption. In order to do so, AIFMs are discussing with their current AIF service providers to see which of the three functions they can provide. As with the full depositary model, these functions can be provided by a single entity or a combination of providers and it is the latter multi-entity approach that seems to be the model of choice for UK AIFMs.
Whatever depositary lite model a manager decides on, there are some issues to consider. In the UK, as part of the AIFMs application for authorisation, the FCA requires the AIFM to name each entity that will be providing the three functions and carry out appropriate due diligence. It is possible for more than one entity to provide each service, for example two separate prime brokers providing the safekeeping function of financial instruments.
Additionally, there are a number of independent providers who are in the process of receiving their authorisation to provide the oversight service. While these entities will offer managers the benefit of an independent review of the services they receive, there will be an additional cost. With regard to the oversight service being provided by current fund service providers (administrators and depositaries), they will need to mitigate any conflicts of interest in order to give comfort to investors.
One complication around the depositary lite regime is the uncertainty of its future. For example, is it just a temporary stopgap that could become obsolete by 2018? Where does this leave independent providers of depositary lite? At the moment managers are just looking to meet the requirements due to the tight deadlines but some key developments will impact on this service. Primarily there is the decision on whether non EEA-based AIFs will have the ability to avail of the passport in 2015. This option will not be attractive for all managers, many of whom will find it more sensible to use a European product to sell to European investors, but time will tell. Secondly, there is the future of private placement after 2018, a key issue that should be followed closely by AIFMs.
One asset class where depositary services for non EEA-based AIFs may have a longer future is in providing services to private equity funds. Similar to the depositary requirements for EEA-based AIFs, private equity investments are deemed non-financial instruments and therefore the strict liability clause does not apply. In an industry where depositary services were not prevalent in a pre AIFMD world, depositary lite services may continue for private equity funds well after it has disappeared in the hedge fund world.
Amid all of these individual issues there is one general certainty. Depositaries are going to be far busier in the future, as well as carrying out their safekeeping and oversight duties they will have to implement effective and regular cash flow monitoring procedures, review and monitor more complex valuation policies, and be accountable for financial instruments in an external sub custody network.
In order to meet these responsibilities and fulfil a more broad ranging service proposition, depositaries will first and foremost need to enhance their operating model. Data management must be bolstered so that they can capture the relevant data points and regulatory requirements must be monitored in a timely manner. Finally, depositaries must be able to meet a more stringent due diligence process when appointed by clients and ensure that they understand the risks and liability they are assuming and have priced it accordingly.
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