Combine an Irish regulated fund trustee with a Japanese trust bank, and what do you get? A solution to the AIFMD depositary problem that is surprisingly compelling.
“It would be wrong to say that managers are in denial,” says David O’Keeffe, CEO of SMT Trustees (Ireland) Ltd a Trustee & Custodian subsidiary of Sumitomo Mitsui Trust Group (SuMi TRUST) in Dublin. “Most are trying to grasp as quickly as they can exactly what it is they have to do, and by when.” He refers, of course, to the deadline set by the European Securities and Markets Authority (ESMA) for fund managers to appoint a single depositary to each and every EU domiciled fund captured by the Alternative Investment Fund Managers Directive (AIFMD). This obligation has to be fulfilled no later than 22 July 2014, if a fund that falls within the scope of AIFMD is not to find itself unable to market to European investors. That challenge confronts all managers running money out of an office inside the European Union (EU), or with funds domiciled in the EU, or which are either marketing or intend to market alternative investment funds to investors based in the EU. It applies to all funds not regulated by the Undertakings for Collective Investment in Transferable Securities (UCITS) regime, including hedge funds, private equity funds, real estate funds and investment trusts, provided they are managing at least €100 million or private equity funds with assets of up to €500 million (excluding leverage,). But even funds below these thresholds face
marketing restrictions, and funds that are not domiciled in the EU can market to investors by private placement only.
As David O’Keeffe suggests, there was a worry for some with regard to the shortage of time in order they had to comply with the deadline of 22 July 2014. The Financial Conduct Authority (FCA), originally told managers to submit their Variation of Permission (VoP) applications, which would enable them to become authorised AIFMs, by January 22, 2014 if they wanted to ensure that they secured regulatory approval by July 22, 2014. However, in December 2013, the FCA told managers they would be allowed to trade after that
deadline even if they had not been authorised. This, in effect, then permitted managers to consider the submission of their VoP, as late as July 21, 2014. Managers all over Europe have since been turning to the European regulator that knows them best to secure permission to manage alternative funds in Europe or on behalf of European investors. Not all regulators are as advanced as the FCA. When EY surveyed AIFMD implementation in Europe, it found that as at the end of August 2013 just 15 out of 28 member-states of the EU had transposed the AIFMD into their own national legislation. Four more were at the drafting stage of transposition, while the rest had either implemented AIFMD in part or were still at the early stage of transposition. Even EY was unable to determine which of the 15 states had turned the AIFMD into a detailed set of local compliance requirements. Deadlines varied too. Norway, which is not even in the EU but is always enthusiastic to implement its directives, had originally set a deadline of 1 January 2014 but this was put back further to July 1, 2014. The Central Bank of Ireland had also set a deadline for receipt of applications of 21 February 2014. To be sure of receiving a license to continue to market to
European investors before the final deadline of 22 July 2014, a duly authorised AIFM was to demonstrate full compliance with the requirements of the AIFMD. One of those requirements was to have in place an EU credit institution or a MiFID investment firm or a UCITS approved depositary pursuant to the UCITS IV Directive as depositary for each fund. The duties of the depositary is defined as monitoring all the cash flows into and out of the fund; safe custody of all financial assets, in segregated accounts, and verification of the ownership by the fund of all other assets it holds; and an “oversight” function that obliges the depositary to ensure that investment restrictions, redemptions, valuations, payments, income and instructions affecting the fund comply with its own articles of incorporation and with any applicable national laws and regulations. Any alternative fund domiciled in the EU is subject to the full depositary requirements of the AIFMD, as specified in Article 21 of the Directive. In these cases, the depositary has a strict liability for the safety of any of the funds’ financial assets in its custody, which it can escape only in exceptional circumstances. Funds domiciled outside the EU and marketing to EU investors by private placement, on the other hand, do not have to appoint a single depositary. Instead, they are allowed to appoint “one or more entities” as their delegates to carry out the same key duties as that of a single full depositary required for an EU AIF. An Article 36 depositary of this kind does not bear strict liability for the loss of assets in custody, and is liable to make investors whole only if assets are lost through its own negligence. Since there is no strict liability and no single depositary – the work can be shared between “one or more entities” - the Article 36 regime is commonly referred to as “depositary lite.”
Depositary “lite” offers managers of non-EU funds a range of options not open to funds subject to full depositary requirements, of which the most obvious is to retain existing custodians and prime brokers (to custody assets) and fund administrators (to monitor cash flows) while bolting on a trustee function of the kind familiar to UCITS funds to provide the “oversight” functions. Understandably, to the London-based managers using Cayman-domiciled funds and marketing by private placement to EU investors, depositary “lite” is an attractive option It offers a less onerous, less disruptive and more cost-effective remedy to the AIFMD compliance challenge than appointing a full depositary bank under Article 21. “A lot of the hedge funds are domiciled offshore, mainly in Cayman, so depositary lite is of keen interest to them,” says David O’Keeffe. “Depositary “lite” meets the negligence standard in relation to the assets, but the manager does not need to appoint a single depositary bank. Instead, it can delegate to its existing custodian/prime broker and fund administrator the roles of safekeeping and cash flow monitoring. It reduces the impact on their business and their existing relationships, and helps to keep the costs down.” That lower cost reflects chiefly the fact that depositary “lite” escapes strict liability for any assets that are lost. Unlike full depositaries, that also means the depositary “lite” does not have to develop potentially antagonistic relationships with custodians/prime brokers and fund administrators. Any bank liable for the full amount of any loss of cash and securities handled by third parties is duty-bound to take a keen interest in how those third parties look after those assets, and is likely to charge a premium for insuring investors against loss.
In providing managers with lower cost depositary lite services, David O’Keeffe reckons Dublin headquartered SuMi TRUST starts with an advantage. It has provided trustee and custodial services to UCITS and other regulated funds since 1994. This is because any fund domiciled and regulated in Ireland, including non-UCITS funds, has long had to appoint a trustee/custodian to protect the interests of investors. Irish regulation even insists that the trustee and custody functions are entirely separate from the fund accounting role in terms of both the corporate entities performing those functions and the management of those entities. As a result, SuMi TRUST finds it is “grandfathered” into being approved by the Irish Central Bank as an AIFMD-compliant depositary as a result of its trustee work over the last 20 years. “As a completely separate, self-managed entity, independent of the fund administration business, SuMi TRUST as a fiduciary can and does presently work with many other administrators as well,” says Charles Bathurst, an advisor to the Board of SuMi TRUST. “The trust business is not just an add-on to SuMi TRUST fund services. It is a completely independent business with its own offices, board, staffing, etc. We as the administrator are just one of its customers.” Indeed, the best evidence of the independence of SuMi TRUST is the fact that the firm is presently working with five other hedge fund administrators in Ireland in addition to SMT Fund Services, and oversees multiple non group related sub-custodians and prime brokers acting as sub-custodians to its hedge fund clients.
In its role as trustee to UCITS funds invested in markets and asset classes all over the world, SuMi TRUST has for many years undertaken due diligence on custodians and prime brokers. It routinely checks their procedures against a list of requirements, including counterparty credit risk, local market risk, segregation of assets, verification of the ownership of assets, collateral movements, documentation of sub-custody agreements, account-holding methods, and back-up plans in an event of default by a custodian to name but a few. “In a UCITS fund, the assets are held by us on trust,” explains David O’Keeffe. “We hold them on behalf of the investors. We open up the custody accounts, and decide the account-naming convention, and are clearly recognised as having an authority over the account. We monitor credit ratings on all our sub-custodians and prime brokers, keep abreast of market developments to see what we can learn about what is happening in their business, and ask fund managers to share with us any concerns which they may have about a provider. Our sub-custody agreements give us an entitlement to step in and remove assets from an account on our instruction alone, so we can remove assets to another provider at short notice if necessary. We do not require the fund manager to issue the instruction. It is critical we act quickly to move assets if a custodian or prime broker gets into trouble. If an institution does go under, it is often the clients who get in first that lose the least.”
This is of course exactly the kind of asset safety risk management and monitoring work an AIFMD depositary is expected to perform. As it happens, SuMi TRUST has so far had to exercise its right to move assets from one custodian to another once only. This was during the Greek meltdown, and on that occasion it was with the full agreement of the fund manager. But by bringing powers of that magnitude to alternative funds, AIFMD creates obvious scope to complicate and even disrupt the relationship between managers and prime brokers in particular. Under AIFMD, a prime broker is not permitted to act as a depositary unless (as Article 21 4 (b) of the AIFMD puts it) they have “functionally and hierarchically separated the performance of its depositary functions from its tasks as prime broker and the potential conflicts of interest are properly identified, managed, monitored and disclosed to the investors.” The prime broker as custodian is unlikely to be regarded as best practice and, in most cases, investors are bound to prefer an entirely separate depositary bank. This means that prime brokers that are financing or lending assets on behalf of managers will act as sub-custodians to the depositary, creating potential for tension between them.
Neither prime brokers nor managers relish the idea of trades being second-guessed by a depositary bank acting for investors on the narrow front of asset safety. Yet it is a dynamic that regulated fund managers, some of them working with prime brokers, have lived with for decades. “Under UCITS, a fundamental duty of the trustee is to monitor where and how the assets of the fund are held,” explains David O’Keeffe. “We constantly ask how assets are held, request and review statements regularly, and seek wherever possible to ensure assets are held in individually segregated rather than omnibus accounts. Before we engage with a fund manager as a client we are also obligated to undertake a risk assessment, and to consider arrangements we may require in regards to safe havens, in the shape of alternative custodians, for the assets of the fund. We work on UCITS and non-UCITS funds with over a dozen sub-custodian and prime brokers already. Over the years, we have had many conversations with them about how assets are held, and we seek assurances not only from them that assets continue to be held in ways that make us comfortable, but also look to seek independent verification that this is the case. We have in the past had to ask prime brokers to hold assets in a market in a different manner than they had expected. If we have not dealt with a prime broker or sub-custodian before, we have to do a full due diligence, and draw up and agree a sub-custody agreement. Funds may have different prime brokers, but those prime brokers may also use the same sub-custodian in a market, and we need to ascertain whether the assets, for which we take liability, are then concentrated at a single custodian in a particular market. To mitigate that concentration risk, we can put in place an agreement with a second sub-custodian to ensure we can move assets promptly if a problem develops with the sub-custodian to the prime brokers. The risk assessments can be extremely intricate, and often may need to be considered before a manager can send in his variation of permission submission, because we look to have each of the sub-custodians agree to the requirements of the depositary.”
These are critical requirements, as they must be where a depositary is accepting strict liability for losses of financial assets in custody. In fact, the AIFMD has initiated a series of awkward negotiations between custodian banks that wish to provide depositary services and prime brokers, which finance and re-hypothecate assets on behalf of fund managers. Custodians are understandably reluctant to accept strict liability for assets which they neither custody nor control. Prime brokers are equally reluctant to indemnify custodians against the possibility of loss. “We may seek an indemnification if assets are of a particular type, or held in a market or in a manner we are not comfortable with, including our level of comfort with assets held by sub-custodians appointed by the prime broker rather than in our own sub-custodian network,” says David O’Keeffe. “Unfortunately, I do not see a lot of traction with the prime brokers in terms of their willingness to go along with that approach.” The AIFMD does permit a depositary to discharge itself of liability to the fund (under Article 21, paragraphs 13 (a) to (c)) if it can prove there is an “objective reason” (Article 21, paragraph 11 (b)) for placing the initial responsibility to a properly regulated third party, and it chooses that third party only after careful due diligence, continues to monitor its ability to absorb the risk, and ensures the assets are appropriately segregated, and never re-used without the permission of the fund or the manager
With negotiations between custodians and prime brokers still on-going and at such an intricate level – they are looking at risks market by market, and instrument by instrument within those markets - managers have another reason to adopt a quicker and simpler solution that effectively preserves the status quo: depositary “lite”. “It is a faster and cheaper way of complying with the AIFMD,” explains David O’Keeffe. “After all, the prime broker is already doing the custody, or safekeeping, and it is relatively straightforward for a fund administrator that is doing the cash account reconciliation every day to add cash flow monitoring to its duties. There is less value in bringing in a third party to replicate what is being done already. The critical new service is oversight.”
However, depositary “lite” is possibly only a stop-gap solution. It may be unlikely to survive more than two years, and no more than five at the most. How long it persists will be decided by ESMA within the next two years. If the regulator rules against depositary “lite”, even non-EU funds sold by private placement to European investors will be obliged to switch to full depositary. Some individual regulators such as the German regulator is already insisting upon this. “Depositary ‘lite’ may be the cheapest fix for the investment managers, with least impact on them, right now,” says David O’Keeffe. “But they may be required to have a full depositary in a couple of years’ time, so the solutions offered by some depositary ‘lite’ service providers may not be future-proofed. At SuMi TRUST, we can future-proof out depositary ‘lite’ service, by continuing with depositary ‘lite’ until a full depositary requirement is necessary. In fact, we want to do that, because we want to form long term relationships with investment managers. By the time the manager needs to switch to full depositary, we will know them and they will know us, we will have good working relationships with each other, and we will know where their assets are held too. So the switch to full depositary should be simpler and less impact for SuMi TRUST clients, whenever ESMA may demand that.”
Naturally, as a bank-owned trustee company, SuMi TRUST already offers a full depositary service which includes strict liability for the safety of any financial assets in its custody to European onshore funds, and is finding stand-alone fund administrators eager to work with the firm to offer the same to their clients. Article 21 of the AIFMD requires full depositories to be regulated “credit institutions,” which is Euro-jargon for banks. This puts independent hedge fund administrators without banking licences in a difficult position once clients demand or require a full depositary service, and eliminates them from the market completely if and when ESMA rules out depositary “lite”. Investors also favour banks, and for the same reason as regulators. Despite repeated disappointment, investors believe banks with large balance sheets are more likely to make them whole in the event of loss. O’Keeffe says SuMi TRUST has worked for more than three years with a number of independent fund administrators that are either looking after a UCITS fund that requires a trustee/custodian of the kind that AIFMD is bringing to the alternative investment management markets, or whose clients demand the independent support of a bank, but which baulk at the idea of working with a major competitor. ”They can often prefer to work with a bank which, while it can compete for the same business through a sister company, is seen to be upfront and open with the other administrators when it does.” explains O’Keeffe.
Full depositary can occasionally include a premium for the additional risk, though David O’Keeffe says it adjusts to take account of the nature of the assets and the riskiness of the banks and markets where they are held. “We have to price full depositary on a client by client, market by market, instrument by instrument basis,” he explains. “We have over 100 markets in our sub-custody network. We do not include Belarus in our network, for example, but the assets may not actually be traded or held in Belarus. They may just be linked to economic developments in Belarus.” In other words, assets whose value is determined by the performance of the economy in Belarus, but which are not held by a sub-custodian in Minsk, will attract a lower premium than, say, treasury bills issued by the government of Belarus and held in custody at the central bank in Minsk. For now, however, judgments of this kind are less fraught. The majority of existing and potential SuMi TRUST clients with non-EU funds are talking to the firm about buying a depositary ‘lite’ service only. O’Keeffe says clients can contract for all three duties delegated under Article 36 – safekeeping, cash flow monitoring and oversight - from SuMi TRUST (what he calls “Model A”); or safekeeping and oversight only, while leaving cash flow monitoring with their existing fund administrator (“Model B”); or appoint oversight only, leaving safekeeping with the existing prime broker and cash flow monitoring with the existing fund administrator (“Model C”). “Model C is proving of particular interest to managers, especially on such a dwindling timescale,” says O’Keeffe. “They see it as the quickest way to put in place the depositary they need to secure a variation in their regulatory permissions, with least impact on their business, and likely requiring no more than an addendum to their prime brokerage and administration agreements and a relatively simple depositary “lite” agreement.” SuMi TRUST calls Models B and C “depositary ‘lite’ break out,” not because it offers managers an ability to reduce their obligations, but because it enables them to choose to keep as many existing relationships intact as they desire.
“The choice managers make is not just down to them, but has to reflect what their investors require also,” adds David O’Keeffe. “Investors like the extra vigilance and oversight that AIFMD brings to bear. If a manager chooses Model C, investors might well ask, ‘What is different?’ In fact, we have had substantial clients only wishing to consider Model A, even though Model C would work equally well for them. They have insisted on Model A because it is what they think their investors require.” O’Keeffe is aware that competitors are offering variants of this modular approach, but SuMi TRUST’s combination of flexibility on price and service plus financial strength, brand name, Asian brand recognition and counterparty diversification often differentiates it from others. He also points out that the apparently competitive pricing set by some banks reflects an insistence fund managers buy a bundle of services that includes prime brokerage, fund administration and custody of assets as well as depositary duties. Bundled offerings entail some awkward risks he adds. “There is always the possibility that items which might be of concern to a genuinely independent depositary might not be as apparent, or as likely to be considered, by a depositary that is part of the same group that provides prime brokerage and fund administration,” says O’Keeffe. “Issues may not be addressed as promptly or appropriately by a depositary that is not truly independent. The independent provider has nothing to lose, and everything to gain, from being forthright.”
SuMi TRUST justifies the initially meagre revenues from depositary “lite” and even oversight-only clients – to say nothing of the far from nugatory negligence risks – as an inventive way to develop new and lasting relationships with fund managers. Charles Bathurst reckons a Japanese trust bank is an increasingly appealing counterparty. “Managers are concerned about concentration risk, and not only because their investors dislike it,” he says. “If they were to adopt a bundled service from a universal bank, they would be buying fund administration, prime brokerage and custody from the same bank as they are buying depositary services. It means the manager and the fund are at the mercy of the balance sheet of the bank. What managers like about SuMi TRUST is that fiduciary services, trust and oversight are in its DNA, but it does not provide prime brokerage services, yet it is still a bank, and a bank that is completely independent of any of the large international banking groups.” Certainly, the security of working with an administrator owned by an independent Japanese bank, is proving effective in recruiting business from managers concerned about concentration risk.
The parent of SuMi TRUST - Sumitomo Mitsui Trust Bank (SMTB) - is a Japanese trust bank safekeeping trillions in custody, largely on behalf of Japanese pension funds. It also manages more than $600 billion of assets on behalf of the same funds, making it the largest fund manager in Asia, and has until recently relied on third party fund administrators to value and service the assets on behalf of their investors. Its knowledge of the hedge fund industry, gleaned through its interests in entities such as Nikko Asset Management, FRM Asset Management and NewSmith LLP, etc is extensive. The decision made by the bank in June 2012 to acquire Daiwas’ Global Asset Services (GAS) – the deal actually closed in November 2012 – marks a decision by SMTB to internalise its alternative fund administration needs. But it also signifies an ambition to grow its third party custody and fund administration businesses on a global scale. Certainly it has a largely Asian flavour, but even that appeals to managers looking to attract investors in Asia. “SMTB is a great parent for us to have,” says David O’Keeffe. “The Trustee company is an Irish subsidiary but is 100 per cent guaranteed by SMTB Tokyo directly. The guarantee was a requirement to secure the approval of the Irish Central Bank for the acquisition, but it is also an important point for our clients. They value the reassurance coming from Tokyo. They are encouraged by the fact we are owned by an A+ rated institution, and especially one which can mitigate their concentration risk, because they do not have a wider relationship with SMTB as a counterparty, or as a service provider, and nor do they often own any of the securities issued by SMTB.”
European hedge fund managers welcoming a Japanese trust bank as a counterparty is not a development many predicted five years ago, but it is a measure of the changed nature of hedge fund investors, and of their heightened sensitivity to risk. But the absorption by the industry of AIFMD is an even greater change. There is a growing sense among managers that the directive is merely the start of a long regulatory journey for alternative investment managers active in Europe. Their conventional cousins are already awaiting the commencement of the fifth version of the original UCITS directive of 1985, and are already discussing the contents of a sixth. Expectations of an AIFMD II and III are built on the well-founded belief that ESMA and the European Commission will want to update the original directive in the light of experience.
David O’Keeffe predicts that the appointment of a depositary will not be an ”appoint-and-forget” decision for managers either. Just as the trustees to UCITS funds - or indeed any regulated onshore fund - are required to report regularly to the directors of the funds they act for, and to the regulators, the depositaries to alternative funds will sometimes have to place their fiduciary duty above the value of the commercial relationship with the fund manager. “AIFMD may have jumped ahead of UCITS in some respects, but it is also adopting a lot of the good things from UCITS, one of which is regular reporting by the depositary to the board of the fund,” explains David O’Keeffe. “This requires the custodian or depositary to attest to the fact that the fund has been managed in all material aspects to the standards required by the regulation, and to bring to the attention of the Board any instances where this was not the case, such as late or missing subscriptions, or NAV miscalculations, or advertent breaches of the investment mandate. There are also completely separate requirements laid on the depositary to report any breaches it finds to the regulator, even if that puts the depositary at odds with the manager in terms of what is reported by them to the regulator. The regulator expects that we would take a similar view to it should issues arise and, as such, we are required to report issues to it independently of any other party to the fund. For example the Central Bank of Ireland requires that a trustee submit reporting directly into their own on-line system. We are obliged to report advertent breaches immediately. The regulator may write to the Board of a fund as a result of what we have reported, in order to satisfy themselves that the issue was resolved, and steps taken to ensure it does not happen again. Many of these practices will feed into AIFMD. The AIFMD will in effect adopt many of the practices we see every day in UCITS. There will be regular dialogue between depositaries and alternative investment managers. The alternative investment manager appoints the depositary, but they do have the responsibility to check that we are doing a good job. It is not a one-off opportunity to appoint us, and then not hear from us again until the annual accounts. It will be an ongoing relationship, in which the depositary will report to the manager monthly and fund board at least quarterly.”
Inevitably, of course, the ‘quis custodiet ipsos custodes’ question arises. Depositories have to be approved by regulators. They are also monitored by regulators, which are expected to visit them regularly, and insist they meet minimum standards of capitalisation, competence, probity and governance. However, the regulatory record of un-success in identifying banks on the cusp of failure is extensive enough to suggest that managers and investors would be ill-advised to count on a regulatory blessing as a guarantee of financial strength. Its balance sheet matters when it comes to making investors whole which SuMi TRUST has through its’ parent, Sumitomo Mitsui Trust and Banking. SuMi TRUST early on, looked to affirm itself as being an AIFMD-compliant depositary in Ireland to meet the depositary requirements for Irish regulated funds and for those funds qualified to use the depositary “lite” model. But the real value of the firm to both managers and investors probably lies more in the quality of the work that its trustee subsidiary does in investigating the credentials and procedures of the multitude of global custodians, sub-custodians, prime brokers and fund administrators through which the cash and securities and other assets of investors must pass and its experience of providing similar services to UCITS funds since 1995.
Guide type:
aifmd