Standalone fund administrators considering setting up depo-lites

Fund Administration
22 Aug, 2013

Standalone fund administrators could create depositary-lite subsidiaries to help them comply with AIFMD instead of having to partner with a custodian bank.

A number of the larger independent fund administrators which do not possess the banking license required under AIFMD to serve as a full depositary for EU alternative investment funds have reportedly been reaching out to global custodians in efforts to form partnerships, although many custodians have balked at the concept of helping competitors at their own risk and liability.

“Some independent fund administrators have naturally been considering creating a depo-lite business to provide the oversight role for their existing administration clients. Given the low fees, I doubt this is for revenue reasons but rather something they are considering because they are under pressure to provide solutions to their clients,” said one industry expert.

The depo lite model is something at least one major fund administrator is reportedly exploring. It is an approach also being pursued by INDOS Financial, an independent depo-lite business currently awaiting approval from the UK’s Financial Conduct Authority, and established by Bill Prew, the former chief operating officer at James Caird Asset Management.

The rationale behind the concept of depo-lites is contained in Article 36 of AIFMD, which states managers of non-EU hedge funds marketing through private placement to EU investors will be subject to less onerous depositary arrangements whereby strict liability for loss of assets does not apply to the depositary. This has been dubbed the “depo-lite” model. Depo-lite requires the appointment of one or more firms to oversee the safe keeping of assets, cash flow monitoring and oversight in what is effectively a trustee role.

If a fund administrator did get regulatory approval and launch a depo-lite business as a separate subsidiary in order to oversee its affiliate, it would present a conflict of interest not too dissimilar to the challenges facing depositaries overseeing their own administration businesses. One difference however is that most existing depositaries are wholly different divisions of large banking groups and there is a clear separation of the depositary from the administration business.

“A large fund administrator could probably create a depo-lite business that provided genuine oversight and would have effective Chinese walls. However, a smaller fund administrator may struggle to convince institutional investors the Chinese walls were effective and I know some managers are concerned about this,” said the expert.

While depo-lites are shielded from the strict liability provisions of AIFMD under Article 21, this does not exempt them from liability through negligence. Nonetheless, the FCA does force these firms to adhere to basic capital requirements and maintain extensive insurance coverage. Despite this, institutional investors would probably feel more comfortable with a bank-backed depositary equipped with a sizeable balance sheet.

Furthermore, there is a future possibility the European Securities and Markets Authority (ESMA) could force all non-EU hedge funds marketing to EU investors to be compliant with the full depositary regime under Article 21, which would threaten the depo-lite model.