The core responsibilities of a depositary to an AIF are to custody the assets, monitor the cash flows and oversee its compliance with the stated objective of the fund, on pain of having to make good any losses which occur. But there are several variations of the basic model.
The Alternative Investment Fund Managers Directive (AIFMD) obliges alternative investment fund managers, such as hedge fund, private equity and real estate fund managers, to appoint a depositary bank to safeguard the assets of the fund they manage on behalf of investors. Under Article 21 of the Directive, depositaries have a variety of duties toward investors (see the accompanying box), but the most important are to safekeep the assets of the fund, monitor cash flowing into and out of the fund, and assume the role of overseer of the compliance of the fund with its obligations as stated in its offering memorandum.
If assets are lost, depositaries have a strict liability to, in the words of Article 21, “return a financial instrument of identical type or the corresponding amount to the AIF or the AIFM acting on behalf of the AIF without undue delay.” There are only two circumstances under which a depositary can escape liability. The first is if it can prove that the loss was caused by an external event it could not reasonably have controlled and “the consequences of which would have been unavoidable despite all reasonable efforts to the contrary.” The second is where assets of the AIF are unavoidably in the custody of a third party (most obviously, a prime broker) and the agreement with that third party stipulates an “objective reason” why the depositary should be discharged from its liability.
Understandably, the stiff language of the AIFMD dismayed the global custodians which are taking on the bulk of the full depositary business on behalf of fund managers. They are currently charging one and a half to two basis points on top of their usual custody fees to cover the additional risk.Almost all global custodians are also offering a so-called depositary “lite” service in which they continue to provide safekeeping, cash flow monitoring and oversight services but do not assume strict liability for any assets which are lost. The depositary “lite” option has appealed mainly to managers of AIFs domiciled outside the European Union (EU), which are permitted under Article 36 of the AIFMD to market their funds to professional investors if the private placement regime of the relevant member-state of the EU allows them to do so (member-states are free to impose stricter rules, and Germany and France are doing so).
The Article 36 exemption, which is not expected to survive beyond 2018, also allows AIFs to appoint “one or more entities” to fulfil the three duties of safekeeping, cash flow monitoring and oversight. This enables the managers to continue working with their existing prime brokers and fund administrators, while appointing a third party to perform oversight functions only. Although the majority of Cayman-domiciled funds were expected to opt for depositary “lite,a larger number than expected chose full compliance, partly because they expect the Article 36 exemption to be short-lived. As the 22 July 2014 deadline drew near, and full depositary obligations became more concrete, they also appeared less alien than many had at first assumed.In fact, a full depositary service is not unlike the trustee role performed by British banks on behalf of investors in mutual funds, or the depositary role played by banks in UCITS funds. “The depositary is effectively fulfilling a quasi-regulatory role,” says Richard Frase, a partner at Dechert. “The custody function is more or less the same, albeit with much more liability. One of the big challenges for depositaries surrounds cash-flow monitoring. This has to be done on a daily basis and it is not something custodians have done in the past. It is certainly more operationally onerous than simply holding pension fund assets.”
One obviously unusual challenge is assuming strict liability for the safekeeping of off-the-run assets, such as real estate, fine art and wines, holdings in funds and funds of funds, bank loans, precious metals, some types of OTC derivatives and even third party cash deposits. The Autorité des marchés financiers (AMF), the French national regulator, has acknowledged this could be awkward for some depositaries. Speaking in November 2013, Xavier Parain, deputy executive director in the asset management directorate at the AMF, said depositaries might struggle to confirm the ownership of investments such as wine, ships, fine art or forestry. “Verifying the existence of some private equity-type investments is going to be a challenge,” agrees Frase. “The depositary might be required to obtain copies of share certificates or hire experts or external advisers to check ownership and existence of some hard-to-value assets.”
In fact, lobbyists on behalf of private equity fund managers, which were surprised to be caught by the depositary provisions of the AIFMD at all, used the unusual status of private equity assets to secure an exemption from strictly liable depositaries in Article 21. Since their investments largely take the form of equity stakes in private companies that they hold for many years, it is impossible for the assets to be safekept in the same manner as listed or traded financial instruments. As Article 21 puts it, “AIFs which … generally do not invest in assets that must be held in custody … or generally invest in issuers or non- listed companies in order to potentially acquire control over such companies … the depositary may be an entity which carries out depositary functions as part of its professional or business activities.” A group of specialist private equity fund administrators have developed to supply just such depositary services to private equity managers .