Depositary lite is the ideal solution to AIFMD for some

15 Jul, 2013

In June this year, it was announced that a former hedge fund chief operating officer (COO) was seeking approval from the Financial Conduct Authority (FCA), the UK regulator, to set up a so-called “depositary lite” service for EU hedge fund managers of non-EU domiciled hedge funds affected by the Alternative Investment Fund Managers Directive (AIFMD) that comes into effect on 22 July. If the application is successful, it could provide a pragmatic and cost-effective solution to some managers needing to comply with the new requirements in order to continue marketing to European investors.

Since it may come as a surprise to some, it is worth remembering that EU hedge fund managers running offshore funds based outside the EU are affected by some of the depositary provisions of the AIFMD if they market their funds to European investors via national private placement rules.

Those private placement rules are of course in flux. Each member-state of the EU is setting its own version, forcing managers to understand the regime in every country where they have investors. Private placement is also being retained as an option until 2018 only, when the European Securities and Markets Authority (ESMA) might eradicate it completely and force any fund manager selling to European investors to be wholly compliant with the AIFMD. So private placement may be a temporary window into the European marketplace only.

Temporary or not, managers with European investors have plenty of other things to worry about, so a “depositary lite” route into AIFMD is likely to prove attractive. Certainly the FCA interpretation of AIFMD has created an opportunity for offshore fund managers with investors in the UK - provided they have approached them via the private placement regime - to substantially reduce the cost of compliance and operational upheaval associated with the AIFMD.

Under Article 36 of the Directive, managers running privately placed European money have to comply with only three sections of the full depositary regime of Article 21: the custody or safekeeping of assets by a third party custodian, daily cash flow monitoring and reconciliation (which naturally includes subscriptions and redemptions) and “oversight.” Unlike the full depositary function under Article 21 of the AIFMD, there is no strict liability on the depositary to cover all the costs of lost financial assets.

The beauty of Article 36 and the FCA regime is that it frees offshore managers to continue to entrust the custody function to their prime brokers, and the fund accounting function to their existing fund administrator. All they need in addition is a third party to provide the “oversight” function.

The “oversight” requirement, which would be familiar to any European mutual fund manager, is essentially a trustee function. It requires an independent party to verify the Net Asset Value (NAV) calculation and ensure the fund is in compliance with relevant regulations and any investment restrictions set by the investors. This is the role which that former hedge fund COO has applied to the FCA for a licence to perform.  So far, it could be the only application the regulator has received.

The reason for that is not hard to discern. The global custodian banks (such as BNY Mellon and State Street) that are expecting to win the majority of the full, Article 21-compliant business created by the AIFMD are not interested in earning a couple of basis points for providing oversight only. Naturally, they want clients that award them the custody and fund accounting business as well. For managers running privately placed European capital, that could entail incurring the cost and hassle of transferring two relationships that are probably working perfectly well.  It also entails running the risk that either the custody or the fund accounting is done badly, or that the “oversight” trustee decides not to report adversely on the failings of the affiliated fund accounting arm.

Similarly, stand-alone fund administrators will want the fund accounting and investor relations contract as well. If they were to assume the “oversight” role they would likely have to establish a separate subsidiary to avoid the conflict of interest inherent to a fund administrator checking its own NAV calculations. In addition, most European hedge fund administrators are based in Ireland, and the Irish regulator - unlike the FCA – have yet to clarify their Article 36 regime. Chances are that most independent administrators will opt to work with an independent trustee rather than go to the trouble and expense of doing it themselves, especially since they may struggle to find an independent custodian bank prepared to work with them.

Nonetheless, the success of “depositary lite” services is not guaranteed. The window is likely to be temporary. Article 21 full depositary-compliant managers will be inclined to buy an integrated custody, fund administration, “oversight” and even prime brokerage service from the likes of J.P. Morgan. Exemptions from stringent liability for losses also do not insulate depositary lite providers from being sued for negligence. As several independent fund administrators have discovered over the last decade, litigation can prove expensive. Managers who worry about deep pockets (or, more likely, managers with investors who worry about deep pockets) might well look to hire a bank instead but the choice for many could be limited and the cost and operational impact greater.

Charles Gubert

AIFMDEUFCAdepositary-liteESMABNY MellonJ.P. Morganprivate placement

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