New regulation will substantially alter the landscape for service providers to alternative investment funds, especially depositories, say Michael Hornsby and Andreia Camara, of Ernst & Young, Luxembourg.
A key challenge for depositories is to anticipate the strategies of European alternative investment fund managers – in particular to understand where their future alternative product ranges will be domiciled.
From July 2013 onwards, investors in alternative investment funds will have the choice between products from managers that are compliant with the Alternative Investment Fund Managers (Aifm) Directive, and other products. From 2018 onwards, European investors may face limitations on their investments in non-Aifm Directive-compliant products.
All this will drive changes in the product ranges and operating models of alternative fund managers.
The Aifm Directive will also offer new business opportunities to some depositories. For example, existing alternative funds, particularly private equity and real estate structures that do not currently have a depository appointed, will be required to appoint one.
The onerous provisions of the directive will change the risk profile of the depository business and may lead to restructuring and concentration in the depository space. Only those depositories with a higher risk-bearing capacity – or “deep pockets” – may be able to accommodate high risk while offering a full range of services, but will also be better placed to grasp the opportunity to run a business on a European-wide scale. Moreover, the directive will open certain niche opportunities; for example, in some markets non-credit institutions will be able to provide depository services to certain alternative investment funds.
The convergence of requirements applicable to alternative funds and Ucits, and the convergence in the service requirements of alternative managers cross-Europe, will allow depositories to benefit from economies of scale through the harmonisation of their processes, and the implementation of hub-and-spoke organisational models; depositories would set up sector centres of excellence as hubs, with spokes in various countries. The hub will centralise the technology, fund administration, and deep sector expertise, while the spokes assist with the sales process, the on-boarding, and the development and management of clients. The hub-and-spoke model gives depositories the opportunity to offer their clients harmonised services across all jurisdictions, while taking into account the specificities of certain jurisdictions.
In view of the liability regime, depositories may be reluctant to entrust the safekeeping of assets outside their trusted network of sub-custodians and prime brokers, or even to serve certain products or jurisdictions. The Aifm Directive will therefore result in managers limiting the investment strategies of some types of alternative funds in addition to a new co-operation model between service providers and funds.
The additional or enhanced depository tasks will drive depositories and other alternative fund service providers to upgrade systems, improve reconciliation processes and enhance communication channels.
All these processes will be closely monitored by all players within the alternative space. Depositories will have to rethink their due diligence on delegates, clients and third parties, but will also have to prepare for greater due diligence carried out on them by alternative investment managers and by other service providers.
The Aifm Directive’s depository requirements represent a significant incremental cost in operating alternative investment vehicles, due to the need to meet their obligations and cover liability under the directive. These costs will ultimately be passed onto current and future investors; depositories may therefore have to reconsider their fee structures.
The bigger challenge for depositories is demonstrating their added value, and not duplicating work already performed by other service providers. Depositories may also consider offering added value services to differentiate themselves.
In order to reduce their risk exposure, some depositories may no longer offer depository services that are not bundled together with administration.
Some depositories will move towards a one-stop-shop service model covering. For example, depository, prime brokerage and administration; in such cases, conflict of interests must be adequately managed.
New depository tasks
Depositories are currently working under several regimes in Europe; the impact of the directive will vary depending on the depository’s jurisdiction. The obligations of the depository under the directive can be grouped as follows:
• To ensure proper monitoring of cash-flows
• To perform the safekeeping of financial instruments and other assets belonging to the alternative investment fund
• To carry out a number of oversight tasks
The depository is permitted to delegate safekeeping duties, but not any other duty. The depository remains liable in case of delegation, with limited exemptions. Many depositories need to enhance their capabilities to meet their increased obligations.
In terms of cash-flow monitoring, industry best practice still requires development on what proper cash-flow monitoring entails.
In relation to safekeeping, there are still a number of concerns in relation to financial instruments that “can be registered in a financial instruments account” and, therefore, are subject to the directive’s onerous liability provisions. Where safekeeping of financial instruments is delegated, the depository must perform adequate due diligence and monitoring of the sub-custody network, including ensuring that appropriate segregation is implemented.
The safekeeping duties of other assets belonging to the alternative investment fund consist of the verification of ownership and maintenance of an inventory of those assets.
These safekeeping duties should be applied on a look-through basis to underlying assets. Unlike safekeeping of financial instruments, safekeeping of other assets is a monitoring task that is subject to a lighter liability regime. The industry should develop best practice guidelines in this respect.
On the oversight duties requirement, the directive is generally aligned with current Ucits requirements – depositories should, in many cases, leverage existing procedures.
Reinforced liability regime
The directive harmonises the liability regime across Europe and limits the delegation of liability. For many countries, this means a stricter liability regime than the current one.
As a general rule, the depository is liable to an alternative investment fund or its investors for the loss of financial instruments held in custody by the depository itself, or by a third party to whom custody had been delegated, or sub-delegated. The depository is also liable to the fund, or its investors, for all other losses incurred as a result of negligent or intentional failure to properly perform its obligations pursuant to the directive.
The Aifm Directive changes the market for alternative funds, the operating models of their managers and, in some cases, the characteristics of the fund. Depositories should analyse their future market and rethink which clients they want to serve, with which partners they want to work and how to adapt their operating models effectively.
Michael Hornsby is a partner, Emeia real estate funds leader, and Andreia Camara is senior manager, alternative investment funds, advisory services, at Ernst & Young, Luxembourg
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