Every UK-registered alternative investment fund manager (AIFM) on July 22 chose the independent depositary offshoot of a fund administrator.
This confounds predictions of the end of the independent sector and its replacement by a custodian-bank model. What equilibrium can be glimpsed in this nascent market for depositary services to alternative funds and how will this impact the choices of AIFMs and service providers?
Investment managers have been consolidated since 2008 as liquidity has fallen while regulation, the Alternative Investment Fund Managers Directive (AIFMD) being the latest, has increased. The consequent shake-out of under-performing managers has seen the demise or rebranding of several noted houses. Some survivors have functionalised, either internally or by outsourcing their administration activities to save the cost and hassle of staff, systems and the control environment that surrounds them. Others continue to perform all functions in-house. The net effect, however, of more effort relative to committed capital, plus the greater procedural emphasis of regulation, is to reduce the subset of larger managers for whom a fully in-house administration and depositary model is efficient.
Many managers fear that a rigid, Ucits-based application of the AIFMD will fatally compromise their efficiency. Investing in a private company, for example, is a completely different process to a listed transaction through Crest and consequently requires a different depositary approach. The ex-ante controls from a Ucits world cannot be transplanted to private equity, while complex investment transactions cannot simply be unwound in the case of a defect as they might under the listed model. Such distinctions are reflected in the legal debate over the definition of the word “loss” which, while simple in the case of listed share record, is completely different when applied to private holdings. Managers and depositaries alike, therefore, find their existing models challenged by the AIFMD and lessons may now be drawn from the initial AIF-depositary response.
AIF-depositaries must evidence: investment in expertise; risk appetite; and pragmatism.
Expertise is required in proceduralising legislation, training knowledgeable staff and the legal and insurance framework with AIFMs and suppliers. Smart technology can also smooth the interaction of all parties. Cloud-based depositary portals can allow managers and depositaries to automate their payments and verification over Swift and thus improve efficiency. Such expertise is costly and forms the first hurdle for depositaries.
The risk hurdle reflects the depositary’s requirement to restore the value of “losses” on alternative assets caused by their negligent or intentional failure. Considerable thought from legal and insurance providers is producing a balanced and insured approach to the market. Meanwhile, the minority of financial instruments within a portfolio encourages partnerships between custodian banks and AIF-depositaries, which allow banks to extend their reach without administering unknown asset classes.
Pragmatism then depends on expertise to manage the depositary’s risk within the directive. Depositaries must work within the AIFM’s cash, investment and capital processes without duplication or delay. Ambiguities in the directive must be applied with judgement rather than knee-jerk caution.
AIFMs must measure their depositary partner’s expertise, risk management and pragmatic approach to the asset class. Thus far, independent depositaries have demonstrated the most popular response. Where these relationships succeed the additional responsibilities of the AIFMD may be smartly managed as all parties step up their game to succeed.
The winners in this process will be those who find a matching partner with smart technology.
Tim Andrews is director of development at Ipes
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