Hedge fund managers exasperated by the cost and operational disruption of appointing an AIFMD depositary saw depositary “lite” as offering the ideal combination of compliance and the status quo. But expectations of its durability as a solution to AIFMD are not high.

The Alternative Investment Fund Managers Directive (AIFMD) posed a number of challenges for hedge fund managers in particular. Lacking the extensive resources of the established institutional managers, few decided to opt for full compliance. Some elected to abandon the European Union (EU) as a source of capital. Those that were unable to take such a drastic step sought either to postpone full compliance, or to find a way around it. Chief among the solutions found was so-called depositary “lite,” by which hedge fund managers with European investors could postpone, if not escape, their obligations to appoint a depositary bank to safeguard the asset of investors.

The depositary bank is charged by the AIFMD with the safekeeping of the assets of the fund, the monitoring of cash flows into and out of the fund, and oversight of the managers of the fund, to ensure they manage its assets in ways consistent with the obligations laid on them in the offering memorandum. To ensure they take the work seriously, Article 21 of the AIFMD imposes strict liability on depositaries to reimburse investors in full for any assets which go missing through either fraud or negligence.

The initial assessments of the scale of the risk imposed by strict liability sent estimates of the cost of covering it to astonishingly high levels. The global custodians that were the natural inheritors of the liability let it be known that they would have to add another 30 to 40 basis points to their ad valorem, fees on top of existing custody fees. Funds invested in exotic markets or esoteric or illiquid asset classes would have to pay even more. The hedge fund industry association, the Alternative Investment Management Association (AIMA), issued a statement in 2011 warning that depositary services alone would add $6 billion to the costs of the hedge fund industry.

The number was dismissed as hyperbolic at the time, and later proved to be so. In October 2013, a study jointly sponsored by AIMA, the Washington-based Managed Funds Association (MFA) and consultants KPMG put the total expenditure by hedge fund managers worldwide on all regulatory compliance at $3 billion. The global custodians also became less indignant, slowly revising their estimates of the cost of the liability to 10 to 15 basis points in the summer of 2013, and to low single digits by the time they actually started taking their first AIFMD depositary clients in the winter of 2013-14. Some universal banks, which can offer depositary services as part of a package encompassing prime brokerage, fund administration and (occasionally) third party collateral management, are even reported to be throwing the service in for free.

However, agreeing terms with hedge fund managers to cover strict liability under the full AIFMD depositary regime proved harder than these reports suggest. Every hedge fund manager has relationships with one or more prime brokers, and those that borrow from them have traditionally not only collateralised the loans but left even unencumbered assets in custody with their prime brokers. While title to encumbered assets passes to the prime brokers (except in those few jurisdictions where assets can merely be pledged) unencumbered assets continue to belong to the fund. This means the depositary bank is liable for them. But the ability of the prime broker to borrow or on-lend - or re-hypothecate, as the jargon has it – those assets was an important part of the commercial economics of the prime brokerage industry.Unsurprisingly, by the summer of 2013, somewhat testy negotiations were in train between the prime brokerage arms of the investment banks and the nascent depositary businesses of the global custodian banks. Just weeks before the AIFMD compliance deadline of 22 July 2014, many of these negotiations were still unfinished. However, a default solution did emerge by late 2013, as a form of triple insurance for the depositary banks. First, the depositary banks have agreed to work with a limited number of prime brokers only. Secondly, those prime brokers will indemnify the depositary banks against any unencumbered assets which go missing. Thirdly, depositary banks will be discharged from their liability to make investors whole where an “objective reason” can be identified for relieving them of this responsibility. Such reasons include having no option but to delegate custody of assets to a third party, as in the case of a prime broker (see the box for a list of such reasons from Article 102 of the AIFMD).

For hedge fund managers, the indemnity-plus-discharge model does at least allow them to continue to work with their chosen prime brokers. However, a second – and almost certainly temporary - alternative is available which allows them to maintain existing prime brokerage relationships and comply with the AIFMD but without appointing a depositary bank that carries the burden of strict liability to make investors whole if assets go missing. Under Article 36 of AIFMD, managers of funds domiciled outside the European Union (EU) that market their funds to investors inside the EU via national private placement regimes do not need to appoint a depositary with strict liability. However, they do need to appoint a third party service provider – which does not even have to be a bank – to perform safekeeping, cash flow monitoring and oversight duties. Known throughout the industry as “depositary lite,” this role is akin to that of a trustee.

For fund managers, the attraction of a depositary “lite” service is not only that it allows the firm to continue to work with existing fund administrators and prime brokers. It is also much cheaper. “Managers with Cayman Islands-domiciled funds wishing to continue to market to Europe through private placement in most instances will appoint a depo-lite,” says Mark Mannion, head of sales and relationship management for EMEA at BNY Mellon Alternative Investment Services (AIS). “In some jurisdictions, such as Germany, the appointment of a depo-lite is now a requirement rather than a ‘nice to have.’” A survey of 50 fund managers across Asia, North America, Latin America and Europe by BNY Mellon AIS in conjunction with FTI Consulting, published in January 2014, found 60 per cent of alternative fund managers had either appointed or were in the process of appointing a full depositary provider, while 17 per cent were planning to appoint a depositary “lite” provider.“The number of managers expressing an interest in using depositary-lite is low because of a geographical bias in the survey,” explained Mannion at the time. “If we focus on the London-based hedge fund market alone, a significant proportion is electing to appoint a depo-lite and we are fielding a lot of calls from managers expressing an interest in our depo-lite offering. While we have had some inquiries from the United States, most managers in North America are simply waiting for more clarity around the rules before they commit.” Many of the American managers that wished to maintain relationships with sophisticated European investors did eventually opt for depositary “lite”.

This was welcome news to a number of hedge fund administrators in Europe, many of which had assumed their lack of a banking licence would condemn them to a slow extinction as full AIFMD depositary service providers gradually aggrandised the marketplace. Several had already contacted global custodian banks to offer strategic partnerships by the time the depositary “lite” option hardened into a realistic alternative last year. These were not destined to succeed. The global custodians were understandably reluctant to assume strict liability for loss of assets when they did not also own the relationship. In this sense, Article 36 of the AIFMD has prolonged the life of the stand-alone hedge fund administrators in Europe by allowing them to offer clients a depositary “lite” service.

SS&C GlobeOp submitted an application to provide a depositary “lite” service to the United Kingdom regulator, the Financial Conduct Authority (FCA) in December 2013, and it received regulatory approval in July 2014. “We decided to establish a depo-lite to enable an easy transition for our clients into an AIFMD regime,” explains Des Pierce, director for strategic markets at SS&C GlobeOp. “The business is wholly separate from our fund administration business and will ensure EU clients with non-EU funds can continue to market to EU investors through private placement should they wish to.” Likewise, Dublin-based Centaur Fund Services applied for a licence to provide a depositary “lite” service from Ireland. “Our decision to launch Centaur Financial Limited (CFL) was a client-driven one,” says Ronan Daly, founding partner at Centaur. “We presently look after over 30 hedge fund groups, and most of these companies want to market towards EU investors through national private placement regimes. Our clients turned to us as their fund administrator to help them with their AIFMD compliance requirements. CFL was established to help our clients transition towards AIFMD compliance in a seamless way. CFL will undertake cash-flow monitoring and provide oversight services.”

The challenge for the fund administrators, as Des Pierce indicates, is to demonstrate the independence of the depositary “lite” service from the fund administration service which the depositary will have to supervise in its role as safekeeper, cash flow monitor, and provider of oversight services. It is difficult to imagine, for example, that the depositary “lite” arm of a fund administrator would report to the regulator malpractice by colleagues in the fund accounting arm of the same firm. Martin Maloney, head of markets policy at the Central Bank of Ireland, speaking at the GAIM Ops International conference in Paris in November 2013, actually reminded stand-alone administrators that they needed to demonstrate they could adequately manage conflicts of interests.

Which is why a truly independent depositary “lite” service provider found its approach was popular. Established by Bill Prew, a former chief operating officer at James Caird Asset 35Management, INDOS Financial secured regulatory approval from the FCA in January 2014. As the AIFMD deadline approached, the firm’s depositary “lite” service was set to go live with more than 20 clients. The Central Bank of Ireland also adopted a relatively laissez-faire approach towards firms offering cash flow monitoring and oversight only, while insisting only regulated firms undertake safekeeping. “It remains to be seen whether unregulated firms will seek to enter this market,” explained Bill Prew at the beginning of 2014. There is a risk that if another offshore fund fraud such as Weavering were to occur, and an unregulated entity did not detect the fraud because they failed to perform their oversight or other depositary duties to an appropriate standard, this could present a significant risk to the reputation of the Irish industry.”As Prew points out, that is more likely to happen if the depositary “lite” provider is not fully independent and free of conflicts of interest. “In most cases fund administrators are establishing depo-lites as a separate legal entity in an effort to demonstrate some independence from the fund administration function over which the depositary will have oversight,” he explains. “This also appears to be partly a defensive measure to protect the core fund administration business on the basis that most depositaries - with the exception of a handful of independents - will only act where an affiliate entity performs the fund administration. In each case the administrator will need to demonstrate how it manages the potential conflict of interest associated with performing oversight over an affiliated entity. Some managers and commentators are sceptical this can be achieved except by the largest administration groups and, as a result, are looking to depositaries which are independent from the administrator and will perform genuine arms-length oversight.”

But if investors are sceptical that administrator-owned depositary “lites” can be truly independent, the same is even more true of universal banks offering bundled prime brokerage, fund administration, custody and depositary services. What is different about the universal banks is that they have balance sheets. Even if the security of its funding is almost always exaggerated, a large bank balance sheet funded by equity, debt and deposits offers at least the hope that a depositary will make good on its promise to make investors whole if assets go missing. Even without strict liability, depositary “lites” offer no serious form of insurance – and even they will be liable if loss of assets can be ascribed to their negligence.

This can happen. In 2009, for example, the then-independent GlobeOp was forced to pay $43.5 million to settle a suit brought by Regents Park Capital Management. Regents Park, a hedge fund which went out of business in 2006, claimed that GlobeOp had made errors in the valuation of assets in its portfolio. Banks, of course, do not hesitate to make this point, and some (though far from all) do have a track record of swallowing losses on behalf of clients. In any event, there is a widespread assumption that banks are better equipped than stand-alone administrators to absorb losses.

This is a problem for stand-alone depositary “lite” providers, but not a lethal one. They argue that they have sufficient safeguards in place to mitigate the risk of being sued into extinction. Bill Prew points out that INDOS Financial is still subject to FCA capital requirements, and maintains significant professional indemnity (PI) insurance coverage. Des Pierce highlights the fact that SS&C GlobeOp is actually a $3 billion-plus company in terms of market capitalisation. Unlike universal banks offering depositary services as part of a package that includes prime brokerage, stand-alone depositary “lite” providers are not at risk of cross-contamination from trading businesses. After all, those large balance sheets testify to the fact that banks and investment banks are engaged in activities which can put the entire organisation at risk of failure. With even Basel III demanding banks maintain minimal amounts of equity capital, there is not one bank that can truly claim its balance sheet is impregnable.

“There would be a serious counterparty risk issue if a manager had a single counterparty relationship with one entity,” says Phillip Chapple, managing director at KB Associates, a hedge fund consultancy in London. “It is essential managers use multiple service providers. Admittedly, it would take time to port business if your administrator or depositary failed, but if that provider is also your prime broker, the manager would be in serious trouble.” Dividing even the three functions of an AIFMD depositary – safekeeping, cash flow monitoring and oversight - between different service providers, as depositary “lite” providers tend to do, reduces that risk. Furthermore, if a depositary “lite” provider ran into difficulty or was offering a sub-par service, a manager can easily shift its business elsewhere.

That is not an option for managers buying bundled packages of complex, cross-subsidised services from universal banks. In the end, the preference of institutional investors for household name banks rests not on a belief that they are any more secure than smaller firms but on a confidence regulators are working hard to dispel: that they are Too Big to Fail. According to Ronan Daly of Centaur, even that is not a problem for firms such as his. “We do not see any bias among institutional investors in terms of appointing a bank or a stand-alone administrator,” he says. “We receive huge support from consultants and institutions. Often-times, the level of service at the banks can be very poor, whereas we pay huge attention to detail in what we do.”

Besides, investors concerned about the financial strength of depositary “lite” providers can always insist their managers appoint a major bank as a depositary “lite” provider, since most of them offer the service in addition to full depositary. The rationale for offering a choice is simple. Pete Townsend, head of hedge fund solutions at BNP Paribas Securities Services, predicts the European Securities and Markets Authority (ESMA) will make a number of changes to depositary responsibilities in its promised review of AIFMD in 2015. There is a widespread expectation that the national private placement regime loophole which is driving the adoption of depositary “lite” services will be closed, forcing all fund managers approaching investors of any kind within the EU to adopt a full depositary service. This will render depositary “lite” obsolete."“We offer a full depositary service to clients and a depo-lite model as well,” says Ian Headon, head of product development at Northern Trust Hedge Fund Services. “It is very likely that ESMA will require fund managers to appoint a full service depositary in due course, so our product makes it easier for clients to transition from a depo-lite to full depositary and means they can avoid the hassle of changing service providers.” Charles Bathurst, a board adviser at SuMi Trust, an arm of the Sumitomo Mitsui Banking Corporation, agrees. “SuMi Trust is simply future-proofing the requirements,” he says. “We believe depo-lite will only be around for a few years before ESMA requires managers to appoint a full depositary. We offer depo-lite now but, when the transition comes into play, we have the advantage that we know the clients and their strategies and can easily integrate them into a full depositary relationship in a way that is less invasive on the clients and their primes.”

However, other observers are confident depositary “lite” will survive for longer, and perhaps beyond the July 2018 threshold originally set by ESMA to terminate the national private placement regime. “Depositary `lites’ will exist until at least 2018 when private placement regimes may be closed off entirely,” says Michael Regan, general counsel at Citco Fund Services. “However, certain countries may lobby ESMA to retain flexibility so that individual member-states are free to determine whether or not they will permit non-EU hedge funds to continue marketing to investors in their countries via private placement and use depositary `lites’ beyond July 2018.” If depositary “lite” is effectively abolished by ESMA in 2015, a number of stand-alone fund administrators will struggle to retain some of their relationships, and might be forced into mergers with banks as the only alternative to extinction. “Depositary `lite’ is not guaranteed but at the moment, we are dealing with the rules as they are today,” says Ronan Daly of Centaur. “In 2018, if the depositary `lite’ regime comes to an end, we might have to find a bank partner or enter into a joint venture.”

As the 22 July 2014 deadline approached, it became evident that some managers that were considering a depositary “lite” service had decided to go for full depositary instead, having persuaded themselves that the costs and obligations were not as onerous as they had initially feared. This was especially true in the light of the possibility that they might have to adopt a full depositary service as early as 2015 anyway. But the real challenge facing depositary “lite” providers between now and then is to convince investors as well as fund managers that they can fulfil the duties of a depositary to a sufficiently high standard to warrant survival. They are up against major banks which now understand that AIFMD depositary services are not that different from the trustee or depositary services they have supplied to mutual funds for decades. But even convincing clients and defeating competitors may not be enough to persuade ESMA that depositary “lite” services provide enough protection for European investors. The life (or half-life) of depositary “lite” may turn out to be relatively brief.