The Alternative Investment Fund Managers Directive (AIFMD) forced fund managers including hedge funds and private equity firms to appoint either a depositary institution or depositary-lite (depo-lite) to provide independent oversight of asset safekeeping, cash-flow monitoring and fund manager compliance. The “lite” moniker is assigned to a service provider undertaking the depositary role but which is excused from strict liability for any loss of assets in custody. A full depositary will face strict liability if losses occur at custodians or sub-custodians.
All managers that have structured themselves as EU AIFMs and make use of the pan-EU marketing passport must appoint a depositary. Those managers which continue to privately place into certain countries such as Germany and Denmark can appoint a depositary-lite under Article 36 of AIFMD. Fund administrators who did not have a large bank-balance sheet at their disposal to incur strict liability sensed an opportunity and set up depositary-lites.
Some organisations appear to be retreating from the depositary business. As Global Custodian reported last week, fund administrator HedgeServ is exiting the depositary-lite business. Reports elsewhere said that clients of HedgeServ were being ported to Indos Financial, an independent depositary-lite.
The depositary-lite model has faced some challenges. Firstly, the commercials can occasionally be tricky. Some fund administrators have seen clients’ assets drop amid market volatility, which in turn has impacted their own profitability. Culling a low margin product offering such as depositary/depositary-lite makes sense in such uncertain times, although it is crucial those fund administrators ensure clients have business continuity.
The impact of Brexit on UK-based depositary-lites/depositaries is an issue too. Depositary institutions must be located within the EU, and should a full Brexit occur, their model will need to evolve. “If the UK were to leave the EU, it is possible depositaries and depositary-lites would have to relocate to an EU member state or restructure their businesses out of an established fund servicing jurisdiction such as Ireland or Luxembourg. However, this is obviously contingent on the negotiations and how they conclude,” said Neil Robson, partner at Katten Muchin Rosenman in London.
Another factor is the on-going confusion about the status of national private placement regimes (NPPR). NPPR is a temporary arrangement under AIFMD. The European Securities and Markets Authority (ESMA) is conducting individual assessments of third countries to determine whether they meet AIFMD equivalence, which would give their fund managers access to the AIFMD passport. A handful of jurisdictions have been told they meet the criteria without impediment such as Guernsey, Jersey, Switzerland, Canada and Japan.
Other countries including the US, Australia, Hong Kong and Singapore have been told by ESMA they see no major reasons why the passport cannot be extended although the European regulator has advised minor policy changes be initiated in those countries. The recommendations by ESMA are certainly manageable. However, this is merely ESMA advice and it must be signed off by EU policymakers before it becomes law. If all of these countries obtain passporting rights, then their fund managers will need to appoint a full-depositary and not a depositary-lite if they are to use the passport. This is a challenge which depositary-lites may face down the line.
Fortunately, there is a lifeline for depositary-lites. Major fund domiciles such as the Cayman Islands and Bermuda have been notified by ESMA that it has yet to make a decision on whether they meet AIFMD equivalence. While the Cayman Islands has made material progress in creating a dual funds regime, many criticise the country for implementing this legislative action so late in the day. Jurisdictions such as Jersey, Guernsey and Switzerland established regulatory regimes equivalent to AIFMD very early on and have been rewarded accordingly by ESMA. Some feel the Cayman Islands should have made similar efforts given its pre-eminence as a fund domicile.
Why does this matter? It matters because the AIFMD passport cannot be enjoyed by managers whose fund is domiciled in a non-equivalent jurisdiction. The country-base of the manager and fund domicile must both be equivalent under AIFMD for firms to qualify for the passport. In short, very little has changed because of the ESMA advice and depositary-lites have some time yet before the migration to full depositary becomes mandatory for managers.
Assuming Cayman Islands attains equivalence in the next 18 months, depositary-lite could be in place until the early 2020s. Again, this is a big “if”. Offshore centres are facing enormous scrutiny following the Panama Papers’ leak, while the Cayman Islands’ constitutional set up with the UK may put it at a disadvantage post-Brexit. “The status of depositary-lite will be determined when ESMA extends the passport. This could be a long process, so for the time-being, the status of EU depositary-lites is fairly assured, at least for the next three to four years,” said Robson.
This gives depositary-lites time to reassess their businesses and evolve accordingly. Impacted firms can certainly apply for a full depositary license as and when they need to. The drawback is they will be subject to the strict liability clauses within AIFMD although affected firms can discharge liability and indemnify themselves against losses through agreements with sub-custodians. This is what bank depositaries have been doing since AIFMD was introduced and standalone fund administrators ought to be no different.
Furthermore, firms servicing AIFMs can obtain insurance to minimise this risk. However, UCITS V does not allow for such arrangements so strict liability could be a problem for standalone administrators minus a meaningful balance sheet with UCITS clientele. Depositary-lites should not be written off entirely. While some firms may reassess their models, many depositary-lites are likely to evolve with AIFMD.