The Alternative Investment Fund Managers Directive (AIFMD) is the most cumbersome piece of regulation ever to affect the private equity industry, and it comes in to effect remarkably soon: 22 July 2014. Those private equity managers obliged to comply with its provisions – namely, any fund managing more than €500 million unleveraged or more than €100 million leveraged – face a host of new regulatory requirements. These include the appointment of a depositary to “custody” the assets of the funds they manage, restrictions on the remuneration of executives, and new regulatory reporting and risk management responsibilities. The depositary in particular is charged not only with safekeeping the assets, but with overseeing the processes and procedures of the manager and monitoring cash flows of the fund. This level of intrusion is a seachange for private equity fund managers, which have historically operated without custodians. To discuss the impact of the AIFMD on the private equity industry, PEConnect invited David Bailey, chief executive officer of Augentius Depositary Company; Gerry Warwick, director of Heritage Administration Services Limited and Heritage Depositary Company (UK) Limited; and Iain Stokes, the former group managing director of Mourant International Finance Administration and now a non-executive director of a number of fund management and fund investment companies, to join founder Dominic Hobson at a round table discussion in London

Hobson: There is a view that AIFMD is last year’s story. Is it?

Bailey: It is for those who have registered and put in place a depositary in time for 22 July this year. But the vast majority of the industry has spent a good deal of time and effort trying to avoid that. Next time they go out fund-raising in Europe, they too will need a depositary. So it is going to take another three to four years to get everybody on board with a depositary. That applies not just to EU managers, but managers from outside the EU that want to come and market their funds in Europe. Most of our clients that need to be ready are ready. As a depositary, part of our role is to carry out a risk assessment of all our clients, looking at their procedures, and where they are, so that we can properly assess them. To date all of those we have looked at are ready. They have procedures in place. They have taken it seriously, and they are in a good place.

Stokes: Of the over €500 million market, I would suggest that only 30-40 per cent have actually had to secure a depositary now for the simple reason that either they are not marketing. Most of the sub-€500 million funds have obviously avoided it. But it is going to affect them going forward, so they cannot avoid it completely. Over the next three to four years, they are going to get involved.

Warwick: Among our UK clients those that need a depositary and those that do not are split more or less 50:50. Some people have come to us, who are not our administration clients, to ask: “Will you be our depositary?” They have come late to the game and they are now looking for a depositary. There are a number of AIFMs out there who are not as far along as they probably should be.

Hobson: Does it make sense for you to offer depositary alone, or will you insist that you are doing the administration as well?

Warwick: We do not on the whole insist on doing the administration. It is certainly more cost-effective if you are the administrator, but a number of firms which will be caught either have administrators who do not wish to provide depositary services or do their own administration in-house and need a depositary. They have to come somewhere. The smaller businesses which have come to market for depositary services may in future outsource their administration services as well, and that is something Heritage hopes to provide in due course.

Bailey: Augentius said right from the outset that we would be happy to provide depositary services on a stand-alone basis and we are doing so. We completely understand that some managers will wish to continue to do their own administration, although given the level of increasing legislation, the trend to outsourcing continues.

Hobson: Is there a risk that funds below the threshold start drifting above the threshold as they draw down capital?

Bailey: Yes, it is a risk. But there are detailed rules on it. There is also a risk, as assets are sold, that a fund falls below the threshold as well. But we will have to see how the regulators apply the rules in practice once AIFMD is live after July.

Stokes: Quite. In fact, the conclusion the industry has come to - and certainly the conclusion I have come to, as a non-executive director - is that the Directive is largely a procedural matter now. We have had time to understand it, and to grapple with it, and to ask ourselves, “Is it truly relevant to our industry irrespective of our thoughts on it?” It is here and it is here to stay. We have all spent a lot of time to make a determination as to how it impacts our particular circumstances and, the more that we have looked into that, the more we have realised that we are doing a lot of the work anyway, particularly from a reporting perspective. AIFMD is just another procedural layer that we need to deal with

Bailey: We have seen this as a European problem or a European issue. But we have been appointed depositary by a Canadian fund because they want to go marketing in Germany, and the German private placement regime under AIFMD requires the appointment of a depositary. We have also been appointed as a quasi-depositary by a Cayman-domiciled fund that is being run out of our Singapore office that is investing in India, at the request of a substantial European institutional investor. So what is happening is that that the investor is saying, “Well, in Europe we have this concept of depositary and security of assets, and actually we want to see this happen with some of the other funds that we invest in as well.”

Hobson: It sounds as if the AIFMD depositary concept is spreading to the Asian and North American markets, and becoming international best practice. Is it?

Bailey: It’s very early days but some managers are following the Directive as ‘‘best practice.’’

Stokes: I am resident in the Channel Islands, so the majority of funds that I am involved with are non-EU. We have had to go through a thought process which asks, `Are we captured or not captured?” We have had to go through a very detailed process of identifying the AIF, and identifying the manager who sits above the AIF. In the vast majority of cases that I am involved with, it is a non-EU AIFM which is in any event ineligible for a European passport until, at the earliest, 2015. So we then said to ourselves, “Fine, so we do not have access to the European passport, so how are we going to market into the EU?” We are very reliant upon national private placement rules and we have really struggled to identify those articles in AIFMD which will in fact have an impact on us. The private placement regimes vary, and that has been a very significant and very expensive problem for us to solve, because we have had to take legal advice.

Hobson: Of the 28 markets in Europe, how many are serious fund-raising possibilities for private equity managers?

Bailey: There is a major sub-set. Choosing between them has been made more complicated by the fact that some of the countries have not completed changing their rules. You have to remember that this is the first time that the individual local regulators have themselves been regulated – they are now regulated by the European Securities and Markets Authority (ESMA) – so they are paying much more attention to private equity managers getting on an aeroplane and coming to Germany or France for the day. and fund-raising. If it is found that the local regulators are in breach of the European rules and regulations, they are liable to €3.5 million fine and an awful lot of adverse publicity. Local regulators have never been regulated before. All of a sudden they are paying attention to their own rules and regulations. They are looking at them, changing them, and making sure that they are compliant. As a consequence, they are also looking for people coming marketing in their country.

Stokes: From a practical point of view, you have a new product that you want to get out there, and you want investors to invest in it, and so you are having to grapple with those local regulatory uncertainties on a day-to-day basis. Are you able to rely upon the national private placement rules in, say, Italy and France? What about Norway and Finland and Belgium and Austria and Denmark? You as a manager are seeking to market into the EU, and you have all these uncertainties to deal with. We need to get authorised in each of those countries. It is a major administrative effort. It is do-able but it is a big effort, and it is deflecting you away from your core job, which is to raise new monies into your new products. It is very costly, and very time consuming and, ultimately, there is no certainty until those anomalies have worked their way through the system. As we said earlier, we are on a three to four year timeline here until it starts to settle down.

Bailey: Absolutely. You cannot rely on reverse solicitation either. Six to 12 months ago a lot of the legal fraternity were suggesting that reverse solicitation was potentially the way forward. The general advice now is that you cannot rely on reverse solicitation. What is reverse solicitation anyway? The true definition of reverse solicitation is contested.

Hobson: What about investment discretion? Does AIFMD put any kind of constraint on the discretion of managers to invest as they choose?

Bailey: I am not aware of any concerns. Certainly, from the depositary point of view, we are not looking to pre-approve any investments. Investment clauses in private equity agreements tend to be very wide anyway. But if I am a depositary and a fund is empowered to invest across continental Europe, and it invests in Turkey, then we might have a debate as to whether Turkey is in continental Europe or not. It could be an issue, and a manager will not want to reverse out of a transaction. Most managers that we act for have actually said to us, “Well, if we have got any issues like that then we would like to come and talk to you in advance before we actually do the transaction to make sure that we do not have any issues.

Warwick: We are in exactly the same boat in the way that our depositary has approached the situation. There are constraints imposed on the managers in the AIFMD, including constraints on leverage, which has to be published. But whether those are concerns or not is another story. Most private equity managers are living with those sorts of regulatory constraints at the moment anyway. Managers have to stick to what they say they are going to invest in.

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Bailey: While the directive is drawn to accommodate hedge as well as private equity and real estate funds, strategy drift is a lot easier within the hedge environment. Private equity is different. It means doing four or five deals a year, and reporting to investors every three or four months. The deals are done, and they are very visible to investors. Private equity funds are unlikely to stray from their mandate..

Hobson: Are funds that fall below the threshold able to just carry on as before, marketing throughout Europe?

Bailey: No. They have got two options. If they are sub- €500 million, and they have not gone for the full passport, then they have got to comply with all the local placement regimes. If they decide to go for full registration, which they are perfectly entitled to do, and get the full passport, then they can go and market their funds across Europe. So although lots of people have been using that €500 million number to avoid having to appoint a depositary and deal with all the other aspects of the directive, over the coming months and years someone who has got three €200 million funds is probably going to want to go for a full registration. That is why I say, in three to four years, everybody will be pretty much caught.

Stokes: You are right about that. AIFMD was always going to become a brand in its own right, and it will become almost prescriptive to tick the AIFMD box. There is a certain air of inevitability about the direction we are moving in. We should not be overly concerned because actually it is largely procedural.

Warwick: Most of the people currently avoiding AIFMD are making a mistake. They have got to come into the fold eventually.

Hobson: You can avoid AIFMD by avoiding Europe. Is anybody saying “We have just had it with Europe”?

Warwick: Anecdotally, rather than through personal experience, I have heard of a few private equity managers who have decided they may buy in Europe but they will not seek capital in Europe because of the AIFMD. They are cutting themselves off from European capital.

Bailey: I have spoken to a number of US managers. In the US fraternity, the jury is out. The US is a very big place, and it is perfectly able to raise its own capital. But about 33 per cent of the industry’s total investor capital comes from Europe. So it is an important source of funds.

Stokes: We have got to be careful that the tail is not wagging the dog, but there has been a movement anyway post-crisis for investment strategies to be much more specialised. Investors are much more rigorous in their own investment process. If people make a decision that they are going to stay outside Europe, there is plenty of opportunity for them to do that. But the European numbers are too big to ignore Europe completely if Europe is part of the delta in your investment strategy.

Hobson: What impact will AIFMD have on private equity investment in Europe? Will European money stay at home?

Bailey: Private equity managers tend to invest where they live. They invest in the markets that they are close to, and that they know. Very large funds have multi-jurisdictional investment operations but they have the form and substance to set up their own AIFMs within Europe. Smaller fund managers do tend to invest in their home environments. So is a US manager managing €500 million likely to be investing in continental Europe? Probably not, unless they are doing a buy-and-build and trying to bolt a European operation on to a US operation, which is not going to be a substantial investment. The flows are restricted as to where the managers are. There is not much continental flow from European managers into Asia and North America.

Stokes: If the question is, “Is the AIFMD going to change behaviour patterns in European private equity?” the answer is, `I do not think so.” Behaviour patterns are embedded and we will just learn how to deal with AIFMD. There are things about it which are going to be problematic. The rules on asset stripping, for example, are going to impact how some exits are structured, and indeed how the deals themselves are structured. So there are some specific considerations but fundamentally this is not going to change behaviour patterns.

Hobson: Behaviour might be affected by the remuneration provisions of the AIFMD. What effects are they going to have inside private management houses?

Stokes: AIFMD has this concept of proportionality, which gives you some degree of flexibility as to how the remuneration rules are interpreted. It gives you the opportunity to argue your case. Internally, organisations need to put in place a remuneration policy that addresses this point. It is about effective risk management, the alignment of interests, and detailing how the internal procedures of the firm measure proportionality and avoid conflicts of interest. How is the remuneration policy overseen? How often do you review it? There is a whole raft of detail that sits around that.

Hobson: Do we have a good fix on exactly who is affected?

Stokes: Again, there is a degree of interpretation. Certainly, senior management, including the directors and the managers, are affected. AIFMD also has this concept of the risk-takers, and there is a degree of interpretation of that. You have the control functions too, so those staff who are responsible for risk management and compliance, and certain senior back office figures such as the head of HR, may also be captured. Other employees who are in the same remuneration bracket as the senior management and the risk takers will be affected. So it is actually quite a wide, prescriptive set of guidelines as to exactly who is going to be captured by this.

Hobson: The remuneration measures aim to ensure the general partners continue to bear risk. Will the private equity concept of carried interest not fit rather well into that approach?

Warwick: Yes. It is going to fit fairly well. As you say, carried interest sits squarely in line with the deferment of remuneration. These rules are all principles-based. They certainly have some rather prescriptive parts, but they are generally all principles-based, and my view is that carried interest will fit into deferred remuneration without difficulty.

Stokes: The private equity model is a long term model, and the Directive is aimed at short term investment vehicles. The guidelines are nevertheless specific, and they talk about whole fund carried interest rather than deal by deal carried interest. So the big conclusion that we are coming to is that, where you pay out carried interest only after all the investors are paid and have claw back provisions, we will actually be excluded from the short-term remuneration provisions. Claw back is very common already. If it is a whole fund carry arrangement, and it is subject to claw back, the remuneration provisions are not a problem.

Bailey: It is interesting that the American market is slowly moving towards an all fund carry rather than a deal by deal carry. Private equity has one of the fairest bases for remuneration across the whole fund management industry, because no one shares any profits until profits are actually made and taken. And nothing is distributed to anybody until the investors have had all their money back plus the interest. It is only then, at the end of the day, that the pie is divided up. It is a very fair method of doing things and I do not really see what is written in the directive changing it very much.

Hobson: So your clients are no changing their behaviour in relation to the remuneration provisions of AIFMD because they do not actually have to?

Bailey: There has been a bit of re-shuffling internally within the organisations as to who does what and how they do it to accommodate the remuneration policy, particularly in respect of senior management. But the initial shock and horror when the Directive came out has dissipated. Everybody has had the chance to read it and understand it. I completely concur with the view that everyone is saying, “Well, we pretty much fit in.”

Stokes: You could argue about the merits of the directive but it is here to stay. We should acknowledge the contribution of the individuals and the groups and the trade associations who lobbied on behalf of the industry in order to get the directive to where the directive has ended up, which is certainly not where it might have been once upon a time. So, in terms of the practicalities of AIFMD, it is costing us money; it is a nuisance; it is intrusive; and it is arguable as to what the merits are in terms of investor protection and in terms of the information that the regulator will get to help manage future systemic risk. Leaving all of that aside, AIFMD is here, and it is largely procedural. And, when you scratch below the surface, most firms are doing a lot of it anyway.

Hobson: Costly, intrusive and of dubious merit is exactly what many would say depositary services offer the private equity industry. How are your clients going about choosing depositaries?

Warwick: We have seen a range. One is working with consultants that have put together a due diligence questionnaire for the manager. The manager has approached us with that, and with their consultant. We have engaged solidly with them, not just by filling in the questionnaire but by hosting visits and having good, long dialogues with them. Each time that we have due diligence performed on us by managers they mostly want to know the same thing but from different angles. It helps us formulate our own due diligence profile, if you like. We can then provide that to the managers in advance of them actually asking the questions. In a sense, we help them do their due diligence by helping them with the types of questions they should think about asking.

Bailey: We are not seeing that many consultants, but then we have been publicly involved with the depositary business for a long time. We had a lot of involvement with ESMA and the Financial Conduct Authority (FCA) when the Directive was being drawn up. As a consequence, a lot of people have come to us directly rather than through the consultancy profession. There has been a lot of dialogue helping managers understand what is going to be like having a depositary involved in their business, and helping them to make it as efficient and as painless as possible, so it just works in the background. It has really been more been more of an educational process. Certainly all managers are talking to more than one depositary. They have not just picked the organisation that is doing their administration. They have gone about it in a sensible and professional manner, as I would have expected.

Stokes: As someone who has appointed depositaries, what you want is a depositary that is in compliance with the Directive; that is non-intrusive on your operations; that has no involvement in investment transactions until after the event; which is pragmatic and responsive, fits in with your needs as a client; and which is economically viable. It is like anything. When you make your appointment it is down to process, people and systems, and you have to satisfy yourself that each of those boxes can be ticked.

Hobson: Given that some of your funds are actually working with depositaries already, can you tell us a little bit about how it works, especially in terms of information transfer?

Stokes: It is still early days. In some cases, there is an administrative relationship in place already, and depositary services are tacked on to a process that is already there. There are other situations where the depositary is segregated from the administration. But the cardinal rule is to de-duplicate any process. If you can have a banking interface where transactions are fired straight into the depositary’s systems that is clearly helpful, when it comes to monitoring capital movements, investment transactions, and other cash movements. Systems are a very important consideration. As I keep saying, we are moving towards a largely procedural accommodation of AIFMD, in which, 80 per cent of the reporting to the depositary is done to a template, with the remaining 20 per cent bespoke. Making the relationship with a depositary work is really about de-duplication and systems efficiency, but we are not talking about huge volumes of transactions anyway.

Hobson: Monitoring cash movements is one thing, but what of the actual assets? Is that not more onerous?

Bailey: It is a different job. The vast majority of the assets that are purchased are purchased in major markets. Those major markets have the appropriate Companies House-type registration organisations, so much of the information is available through the appropriate authorities online. It is not a particularly onerous task. It requires specialist people who know what they are doing. Importantly, being a depositary requires different roles and different mentalities from those required of an administrator. In our view, the two businesses have to be segregated by quite a thick Chinese wall. You cannot have people carrying out fund administration tasks in the morning, and then putting a different hat on and moving across into the depositary in the afternoon, as one or two firms started off doing. That cannot be allowed to happen because the depositary has oversight over the functions that are being carried out, including the administration part and, if the manager is consistently getting it wrong, ultimately the depositary has to report that to the regulator.

Warwick: David is right. Heritage did have to build thick Chinese walls to segregate the work of the administrator from the depositary. The regulator did push us and a number of other firms on exactly that point. Under AIFMD, the depositary and administration services have to be organisationally and hierarchically separate from each other.

Hobson: Is there an argument for preferring a bank owned administrator to an independent one like our colleagues here?

Stokes: It was and will continue to be a discussion point, but it is much more important to have in the depositary all those attributes I mentioned earlier, such as being non-intrusive, acting on a ex post basis, and being pragmatic and responsive. It is also important the depositary has people who understand what your fund is and how it operates. That inevitably draws you towards the smaller, more independent providers of depositary services because they have a degree of flexibility inherent in their business model. That is not in any way to spurn the opportunity to be with one of the big banks, with access to other services, a bigger balance sheet, and scalability, if that fits your model better. The key issue, whether the depositary is independent or part of a large corporate bank, is your approach to liability. You have to consider the indemnities being sought and the indemnities being given.

Hobson: Do the investors have strong views about whether you go with an independent or a bank?

Stokes: I am not even sure it is even on the investors’ radar.

Bailey: There have actually been very few large banks in the market. There are large banks which currently play in the private equity space, and they have been providing appropriate services for their existing clients, but they have not been to my knowledge going out and actively seeking clients for private equity depositary services. I feel quite sorry for them because, to be perfectly honest, they have much bigger issues within the hedge fund industry and with their hedge fund clients with this concept. It makes no sense for them to dive into a whole new market in private equity. The sort of work that is involved in verifying private assets and such like is completely foreign to what the big custodial banks do anyway. They have not necessarily got the capabilities. If I was sitting round the board table at a large custodian bank, I would be saying, “It is probably not economically worth my while to set it up.”

Stokes: That is probably true. There is a very different approach to risk, and how risk is managed, between the big institutions and the smaller independents. Inevitably, that has a knock-on effect on pricing as well. At the end of the day, this is a cost which is borne by the investor, and we have a fiduciary responsibility to manage it.

Warwick: It is good to know that you are coming down on the side of the smaller depositary. Our flexibility can give us an edge. There is always serious engagement with a manager up-front. We ask for a lot of his time initially in order to fully understand his operations, especially if we do not already have the administration mandate. We then seek to provide, as economically and unobtrusively as possible, a service which lets the manager get on with the job of making the decisions and making money.

Hobson: Is the choice between depositary “heavy” and depositary “lite” irrelevant to private equity managers?

Bailey: Yes, because the only real differences between depositary heavy and depositary lite is the level of compliance oversight across procedures. There is still cash monitoring, and asset verification, but we are not obliged to make people whole if assets go missing as long as we have carried out our duty and can prove that we have carried out our duty to the extent that we should have done under the Directive. It is completely different to the hedge fund sector, for example, and a very important concession that was made to the economic realities of the private equity industry. The European Venture Capital Association (EVCA) and the British Venture Capital Association (BVCA) were very keen that the provision of depositary services did not end up in the control of three or four major banks. They wanted to see an open market place with a range of providers.

Hobson: How often do you expect people to review their depositary relationship?

Bailey: It is too early to say. Basically, the manager does not want to hear that much from the depositary. They just want it to be safe to assume that it is going on in the background. They want to receive some reports with appropriate regularity so they know that things are ticking over in the background. Other than that, they do not really want to get involved. For our clients that want one, we are putting an appropriate certification into the annual report and accounts saying that we have acted as depositary and that everything worked and is reconciled and nothing has gone missing. We will have to wait two or three years to see how often managers decide to review the relationship. At the end of the day, the cost is not enormous and it is not taking up too much of the manager’s time. If it was me, I would be saying, “Well it is working. I will have a quick look around but …” It is a matter of good corporate governance that you do that with all the professional bodies that you use, be they the auditors, the lawyers, the administrator, or the depositary. I do not see depositary services in a different light. There are also costs in changing.

Hobson: What do depositary services cost?

Bailey: In terms of a number, if you had asked me four or five years ago, there would have been a range of basis points. Depositaries generally are not charging basis points. They are looking at the assets, and at the manager, and at the way the manager works. They are looking at the way the relationship will work and putting pricing around that. Again, it is different to hedge and other assets. The manager may have €200 million of capital commitments, but he is not investing that €200 million on day one. It will take him five years to invest that capital. So the portfolio will build up and, as that particular fund reaches maturity, so the assets under management will decrease. The depositary fees and charges need to be in line with that.

Stokes: We have got to a place where basis points are not appropriate in this industry, so either it will be a fixed fee or on a transactions basis or on time spent. I think the pricing will be largely driven by the efficiency of the process, and especially by the extent to which you can de-duplicate the processes. As the managers and the depositaries get to know each other better, that process will itself get better, which will have a beneficial impact on pricing. There is a very strong preference on the part of managers for a clear line of sight, so that there are no nasty surprises on pricing, whatever the mechanism is.

Hobson: In terms of what you are getting paid for, what are you liable for as a depositary in relation to a private equity fund?

Bailey: If the asset disappears, and you have not carried out your duties, you are responsible for the asset. It is incredibly difficult for private equity assets to disappear, but cash could be siphoned off. If you are not doing your cash monitoring on a daily basis and making sure that the cash actually goes to the place it was intended to go to, or the investors were told it was going to, then obviously you have got that risk. But it is extremely difficult for an unquoted asset to be sold without anyone knowing about it, and for the proceeds to disappear

Warwick: I agree and, if you accept that premise, then the principal liability for the depositary is ongoing compliance with the Directive and relevant law because, if the underlying asset is lost, it will be lost for reasons other than any action taken or not taken by the depositary.

Bailey: You would really be on the line if you could be proven to be negligent in the execution of your duties and cash or an asset has gone missing. That really is the story.

Hobson: However small the risk, depositaries are still doing a real job. What are the risk indicators you look at in doing the job of a depositary to a private equity manager?

Warwick: We look first at the relationship with the manager.

Bailey: That is certainly the initial part of the process. After that it is cash monitoring. Cash monitoring is what we are doing on a daily basis. If all of a sudden the manager stops telling you what it is doing, or suddenly you are no longer able to reconcile the accounts, you are going to go back to the manager and say, “My cash is not reconciling. Why are you not telling me about this? What is going on?” It is when you start to experience things like that that you become uneasy. Cash is also the first thing that can start disappearing from the portfolio without too much difficulty. If people are carrying out fraudulent transactions - in other words, if they are executing drawdowns from the investors that are not going through to transactions - substantial sums of money are not going to be accounted for. That is when alarm bells start going off.

Hobson: In terms of practical measures, what do you do next?

Bailey: In our case, that will be completely documented in our agreement with the client. The client is made very aware of that up-front. But if you start to see things that are not reconciling, you go back to the manager. You give the manager a defined period of time to communicate details of those transactions. If the manager is not providing you with that information, you will then go through to the board. But ultimately you will go to the regulator.

Warwick: Every depositary will have their escalation procedures, and most will be exactly as David has outlined. The conversations begin at one level, move to the next level, and ultimately take place with the regulator, if necessary.

Hobson: What will private equity managers find most disagreeable about their obligation to report to regulators?

Bailey: Their obligations are clearly defined, but not straightforward. The guidance notes on how to fill in the regulatory reports run to 73 pages. The reports ask for details on the manager, the assets they have got under management and how they are invested, their investors, the value of the different types of assets that they have, the risk measures they take and the stress tests that they have carried out, counterparty details, liquidity profile, and valuations.

Hobson: And is this work you will be doing for them as administrator or depositary?

Bailey: Absolutely. Where the depositary is administering the fund they will have the majority of the information. Where the depositary is acting as a depositary only, they will have a good proportion of the information but will require further information from the manager.

Hobson: Would you welcome that information being made publicly available by the regulators so that private sector firms and industry associations can help regulators understand it?

Warwick: All of us have said individually today that we do genuinely believe the private equity market is a long term business, and there is nothing to hide, and nothing untoward going on. For the first time you have got regulators across multiple domiciles being expected to work in tandem and to exchange information with each other. If the information is available, and we are perfectly capable of filing it, it is a purely procedural matter. But once it is filed, what do regulators actually do with it? What actually happens to it? Has the regulator got time, and the capability, to make sense of the information?

Bailey: The reporting is to local regulators. It then gets consolidated up into ESMA. So if information is going to be consolidated and subsequently published it has to be published by ESMA and not by local regulators. The industry already collects information about its own activities on an aggregate basis. The BVCA publishes a quarterly report covering size of assets under management, types of fund transactions, sources of investor funds, and so on. It is a very detailed and extensive report.

Hobson: Would it be worth mapping what the BVCA collects against what the AIFMD reporting asks for?

Bailey: No, not really. There is a massive amount of information being collected, and which is being submitted to local regulators. They were already struggling to be able to approve AIFMs or approve depositaries in a timely fashion. They are under financial constraints already, and yet they are going over the rest of this year to receive a deluge of information which, through no fault of their own, they do not necessarily understand. They are going to have to consolidate it and make sense out of all the numbers. That is not going to happen overnight. The regulators are going to have to get used to seeing this information, get used to comparing it against what is going on in the market, and then potentially identify some red lights. But it is going to take time. We are talking about a massive amount of information that the regulators have never seen before.

Hobson: If data has to be submitted to local regulators, some managers are going to have to report to more than one. How many and how often for the average fund?

Bailey: Once a year, the majority, and wherever the fund is raising money by the private placement regimes. I would imagine seven or eight different countries.

Stokes: I would say more. To take advantage of the national private placement regimes, you need to get authorised by each regulator in each country. It is very time consuming, costly and frustrating. Once you have got authorised, and marketed your fund, you then need to report to each of those local regulators annually. You just have to multiply one firm by 20 EU countries to see that it becomes very onerous very quickly. How difficult is it going to be to be consistent? You might easily end up saying one thing to the French regulator and another to the Italian. One of the challenges is to ensure that you report to each regulator exactly the same information.

Hobson: In meeting the multi-national reporting challenge, which service provider - the administrator, the depositary, a consultant – do you expect to be most helpful?

Stokes: From a practical point of view, your own staff are the most valuable. As a fund director, ultimately it is my responsibility to make sure my manager is in compliance with the Directive. To do that, I have got to ensure we have effective internal procedures. Information to populate the reports will also come from the administrator but, in order to be certain of getting it right, you cannot expect the administrator to substitute for your own responsibilities.

Hobson: Can administrators get paid properly for contributing to regulatory reporting or is it just something you have to do?

Warwick: Yes, probably you can. Reporting starts off as an administrative duty, and then you can come back to it as a service. Consultants are not necessary for the job. Lawyers will be a part of it, as will IT people. But most of the reporting will be come from the independent administrator and the independent accountants. The administrator will lead.

Bailey: AIFMD is just the beginning of a massive amount of regulatory reporting that is being brought in. We have got FATCA coming up, for example. We have the technology to process high volumes of data. Whether the regulators have the same systems and capabilities is another question. Over time, we are becoming an information-bound society and every industry, no matter what it does, will be required to collect and process information. So this is just the beginning. There is going to be lots more of this, and it is going to fall more and more on the administrator and the depositary, as the organisations that have all the information available, to become the central point of collection.

Stokes: I agree completely. From a directional perspective, there is only one direction that we are going in, and that is into this information-driven world, be it compliance with a European directive or American tax reporting. Anything that is information-driven needs to be system-driven. Which means we are going to have to create a common reporting template. In terms of the AIFM Directive alone, it is a marginal procedural challenge, and we can cope with that. But the scale of the regulatory reporting challenge can only increase.

Hobson: Can managers escape these reporting obligations by being below the threshold or is everyone caught?

Bailey: Once you are registered, you have to report. As we discussed earlier, within two or three years everybody is going to be caught because everybody will be registered.

Warwick: The obligation to report is in the AIFMD, but it is not really a shock to the system. Reputable funds are already doing all this.

Stokes: The analysis we have done of the funds I am involved with suggests we are actually doing 75 per cent of this already. We just need to package and present it in a different way to a different audience.

Hobson: What will happen if a regulator decides a fund has completed a form incorrectly or finds something in a report that worries them? What evidence are the regulators looking for?

Bailey: That is a very interesting question. I would question whether the European regulators actually have the resources to do anything. However, if you look at what is going on in the US and the actions that the Securities and Exchange Commission (SEC) has taken, in terms of the volume of people that they have recruited and the inspections that they are carrying out in the private equity industry in the US, then the threat of a regulatory investigation is substantial. Whether Europe will follow that example, I have no idea. There have been over the last three or four years some inspections of private equity firms by the Financial Conduct Authority (FCA) and its predecessor, which have resulted in letters to CEOs and things like that on different topics, such as AML and KYC. As to what regulators can actually do, the answer is that, when they wrote the Directive somebody at ESMA said, “Oh my goodness, how are we going to police all this?” Someone else said, “Well, let us give the role to the depositary.” It is my strong belief that that is what happened, because a large part of the role of the depositary is to make sure that the manager plays by the rules of the game. In a way, policing the industry has been delegated to the depositary.

Hobson: Our members report that an on-the-spot SEC inspection is extremely demanding, in terms of finding answers to a large number of questions in a short period.

Bailey: Absolutely. And, depending on the quality of your responses and the quality of the people that the SEC have employed to carry out those initial inquiries, people further up the chain decide whether they should have a more detailed look at the organisation. The SEC is being very pro-active in this area. We are not seeing that in Europe yet.

Hobson: What is likely to trigger an investigation?

Bailey: You have to look at the role of the regulator and the resources they have got. Look at the issues that were experienced in a supposedly highly regulated industry like retail banking over the last five years. The private equity and real estate sectors have not experienced anything like that, or anything like Madoff. You simply do not see the number of fraudulent cases within private equity that you do even in hedge funds.

Hobson: What about Fern Advisers?

Bailey: It does happen, but it is difficult for it to happen, and it happens extremely infrequently. All I am suggesting is that, if I was a regulator, I would be asking “Where is the risk? Where do I need to concentrate my resources?” Historically, private equity and real estate have presented an extremely low risk by comparison with other sectors.

Hobson: What about risk management? The AIFMD insists that managers now separate this function from portfolio management. With most private equity firms being relatively small, how can they comply?

Bailey: Ask what actually is risk management within a private equity firm. It is making sure that the investments are in line with the investment strategy of the fund. It is making sure that any cash assets that you have are not necessarily with one institution, especially if it is a substantial amount of cash. That is what risk management in a private equity firm amounts to. Of course, you have the actual management of the portfolio itself, which is completely different to the risk management process. It is carried out by professionals, who sit on the boards of the underlying companies, and manage the assets.The risk management function, when you are doing four or five transactions a year, is not enormous.

Stokes: We have all had to look hard at how we report our activities, so actually we have always been doing risk management separately.

Bailey: There is a depositary component to this, because the depositary will usually be the risk manager. I had a conversation recently with a relatively small manager - there are 15 or 20 people in the entire organisation – and I asked how they would provide a depositary with the evidence to prove that the investment they were making was in line with the investment strategy agreed with the investors. Their answer was, “Well, we have always really just known. We know. We have always just done it.” Actually they have now put an extra stage in their investment approval process which asks the question, “Does this comply with our agreement with our investors?”

Stokes: That is a microcosm of what we have been doing with our managers. I am not sure that anything fundamental has changed in risk management as a result of AIFMD. It is really about being more overt about how it works. It is about evidencing in a more structured way that these activities are being monitored. You need to be able to reach down into the detail and show why an investment is in line with policy at the micro-level.

Hobson: So none of the managers you work with have appointed a chief risk officer and set up a risk committee?

Stokes: It is a good question to put to larger managers. They need to prove to the depositary that risk management and portfolio management are hierarchically and functionally separate activities.

Bailey: From the depositary point of view, that is a big change. The manager is required to have a whole bunch of procedures in place under the AIFMD. Risk management is one. The role of the depositary is to make sure that they have those procedures in place, that those procedures are adequate for that particular business, and produce evidence that they have followed them. This is the big change for the manager.They do actually have to document the fact that they have followed their procedures. In general, most of our clients are documenting their procedures and policies to ensure that they comply.

Warwick: I am seeing clients start to employ compliance managers. It is a substantial cost. This is an industry that has, up until now, been pretty much unregulated. Yes, they have had in Europe to register with regulators and do some reporting. But there has not been too much else. Now, people are having to develop formal procedures, follow them, and make sure that everything is in place on an ongoing basis. This increased regulatory burden is not going to get any lighter, with measures like FATCA following the AIFMD. The whole industry is becoming more regulated. So there is more work to be done within the average private equity house. They are already busy, so they are saying, “We need an extra person to do this. Let us get a proper compliance person.”

Hobson: Are administrators sharing with private equity managers knowledge of what other clients are doing? Are you becoming compliance “consultants”?

Bailey: The feedback from the depositary naturally feeds back into the compliance process and procedures. Effectively, the depositary is providing a lot of compliance oversight.

Stokes: Administrators are in a fantastic position to advise. They see a wide range of clients and they can take the best practices across their client bases.

Hobson: You have said a number of times that the best managers are doing most of what is in AIFMD already. But is that true of risk assessments and stress tests?

Stokes: What I have said is that, when it comes to compliance with the AIFMD, firms are distilling it down to procedure so they do not make mistakes or have to think about it again and again. On risk assessments and stress tests we are at a transitional stage. It is an iterative journey. There is no magic bullet. We are on a journey. As long as we are accountable to stakeholders, we have to produce evidence that we are taking actions to ensure we are compliant.

Hobson: Do you think the regulators will be relatively indulgent providing you can show evidence that you are making progress towards full compliance?

Bailey: The regulator is on this journey with us as well. We are all learning together and we are all sharing knowledge and information together.

Stokes: I think that the view I have always taken of the regulators is that there must be no surprises. You need to be open. You need to embrace. You need to produce evidence which says, “This is what I have done and this is why I have done it.” If you are not able to do that, then you do need to change or do things in a different way that will make it easier.

Hobson: Are any of your clients worrying about the capital requirement?

Stokes: No. It is what it is. It is a cost of doing business. The capital comes out of the fund, which means it is one of the costs of investment.

Hobson: Administrators acting as depositaries creates some obvious conflicts of interest. How are you managing those?

Warwick: The administrator and the depositary have to be hierarchically and managerially separated so that depositary services are a truly independent function. If we did not have that separation, there would be serious situations in the boardroom over conflicts of interest. Think of the conflict, for example, if the administrator performed a valuation which the depositary thought unreasonable.

Bailey: Augentius Depositary Company Limited is a completely “stand-alone” company, segregated from our fund administration business, with separate resources, board and staff.