The importance of administration to the funds industry in Ireland has led to allegations that the regulator is soft on administrators which provide “depositary lite” services. The reality is a complex regulatory compromise, in which banks are winning most of the business but administrators are keeping enough to survive.
A study by PricewaterhouseCoopers (PwC) reckons more than 40 per cent of hedge funds are in serviced in some way from Ireland. The island is home not only to fund administrators, but also custodian banks and even prime brokerage operations. Given that heritage, the depositary provisions of the Alternative Investment Fund Managers Directive (AIFMD) ought to rank as a gift. After all, it makes compulsory the services custodians and administrators provide. In fact, it is has proved testing for the Irish hedge fund administration industry.
Although AIFMD obliges alternative investment fund managers - including hedge, private equity and real estate managers - to appoint a depositary to safeguard the assets of the fund they manage on behalf of investors, this does not necessarily have to be a bank. However, banks are best placed to provide full depositary services under Article 21 of AIFMD. This requires depositaries to provide safekeeping of assets as well as offer cash flow monitoring and oversight of the fund, to ensure it remains in compliance with the terms of its offering memorandum.
Most importantly, Article 21 subjects full depositary banks to strict liability for loss of assets belonging to investors. To become a fully compliant AIFM with all of the benefits of a pan-European passport, firms must appoint a depositary. AIFMD stipulates the depositary must be a regulated European bank or a firm entitled to act as a depositary under UCITS. This does not restrict full depositary services to the largest banks. Both Citco (in Malta) and SEI (in Ireland) are stand-alone administrators that have chosen to offer a full depositary service.
Stand-alone administrators have a second opportunity as well. Under Article 36 of the AIFMD, managers of AIFs domiciled outside the European Union (EU) but marketing to EU institutional investors through national private placement regimes are permitted to appoint what is known as a “depositary-lite.” Depositary lite providers can offer safekeeping, cash flow monitoring and oversight services, but do not assume the strict liability for loss of assets.
This exemption from strict liability is unlikely to last beyond 2018, and may disappear as early as 2015, when the European Securities and Markets Authority (ESMA) is scheduled to conduct its first review of the workings of the AIFMD. This risk has encouraged fund managers to select large banks even as depositary-lites, to minimise disruption if they are obliged to switch to full depositary services in 2015 or 2018.
A January 2014 survey by global custodian BNY Mellon, conducted six months ahead of the AIFMD compliance deadline by the bank in conjunction with FTI Consulting, found 60 per cent of alternative fund managers had appointed or were in the process of appointing a full-scope depositary. Just 17 per cent were planning to appoint a depositary-lite.
“Firms, by and large, are appointing full-scope banks to act as depositary-lite or depositary under AIFMD so they can migrate business from the former to the latter once the private placement regime expires,” explains David O’ Keeffe, chief executive officer at SMT Trustees in Dublin, a subsidiary of SuMI Trust.
Irish service providers certainly seem well placed to provide both depositary-lite and full depositary services to AIFMs. “On the full-scope depositary side, Ireland is well-ahead of the game, and certainly ahead of competing jurisdictions such as Luxembourg,” says Sean Tuffy, senior vice president at Brown Brothers Harriman (BBH) in Dublin. “Ireland has had the concept of the trustee for many years now, servicing UCITS funds and non-UCITS funds such as Qualifying Investor Funds (QIFs) and their successor, the Qualifying Investor Alternative Investment Funds (QIAIFs). The infrastructure for trustees already exists and has been tested, so we as a domicile did not need to do as much preparation as Luxembourg. It was therefore easier for Ireland to adopt the full-scope depositary to service our funds industry.”
The Irish experience may not be as helpful when it comes to depositary-lite. The model itself has faced numerous challenges. First, there is the obvious risk of a short shelf-life. The stand-alone fund administrators offering depositary-lite services are not well positioned to maintain their market share beyond 2015 or 2018.
Secondly, as large banks never tire of pointing out, the independence of depositary lites from the fund administration arm of the same firm is open to question. Although fund administrators are always careful to establish depositary lites as wholly separate businesses, with different reporting lines and boards of directors, they remain vulnerable to the insinuation that a depositary-lite reporting on the valuation work of a sister company will be loath to report malpractice to the regulator.
Thirdly, in Ireland in particular, depositary lites face the further disadvantage that Ireland, while a world-leading fund administration centre, is not a world-leading fund-raising centre. “This is the biggest challenge for Ireland in regards to building up a depositary lite industry,” explains Sean Tuffy of BBH. “ESMA has made it clear that asset managers must appoint a depositary-lite in the jurisdiction or jurisdictions where the fund is being distributed or the AIFM is domiciled. Given the depth of the UK institutional investor market, I believe more firms will use UK-based depositaries. I believe this to be particularly true of UK managers with Cayman Islands-domiciled fund vehicles.”
That said, the Central Bank of Ireland (CBI) is adopting a light-touch approach to regulating depositary lites. In a Question and Answer (Q&A) paper on AIFMD published in December 2013, the CBI said only that it expected stand-alone Irish fund administrators with depositary lites to demonstrate that they are in no way conflicted and that they will not be detrimentally impacted by capacity issues. This was reaffirmed in July 2014, when the CBI published its response to consultation paper CP78 of March 2014, which outlined the duties of Irish depositaries in accordance with Article 36 of AIFMD.
The CBI confirmed in that document that firms providing safekeeping of “other” assets will be subject to regulatory supervision but those offering cash-flow monitoring and oversight only – namely, depositary lites - will not be. In effect, the CBI by this means barred depositary lites from looking after over-the-counter (OTC) derivatives without obtaining , under Article 21(8)(b) of the Directive, a custody licence.
That insistence may have frustrated depositary lites which hoped to provide a full service, but it proved a clever way of defusing allegations that the CBO was going easy on fund administrators because they are such an important component of the Irish funds industry. It is predicted to encourage AIFMs with “other” assets in their portfolios to appoint stand-alone banks with a custodial license as their depositary lite in Ireland.
Not everybody is convinced the compromise is good one. “The primary focus of the consultation paper was on the management of conflicts of interest where a party connected to the fund administrator performs the depositary oversight function,” says Bill Prew, founder of INDOS Financial, an independent depositary lite based in London. “Indeed, the CBI notes these conflicts may be substantial. Notwithstanding this focus, a number of the responses to the consultation argued that the oversight duties should be undertaken by a regulated entity, given firms providing trustee services in Ireland, of which oversight is a major aspect, are subject to CBI supervision. The Financial Conduct Authority (FCA) in the UK requires depositary-lite entities to be regulated and I am sure some investors and managers will view the UK regime as more robust. Some have warned the CBI’s reputation could be tarnished if an unregulated Irish depository-lite failed to spot a fraud or blow-up.”
The CBI maintains its approach to regulating depositary lites is rigorous. “One of the key issues for fund administrators providing Article 36 depositary services is that they make sure conflicts of interest are avoided between the side of the business carrying out depositary functions and the fund administration units,” says Patricia Dunne, deputy head of investment service provider supervision at the CBI. “Furthermore, all administrators in Ireland are already subject to CBI regulation.”