The primary duty of a third-party custodian is loss prevention by safeguarding assets. All registered funds, even those with alternative strategies, are required by law to use a custodian, who ‘sit between’ the investment manager and the assets themselves, for everyone’s protection.
Many unregistered alternative funds—such as hedge funds and limited partnerships—also use a custodian, often at the request of one or more large investors who want the strong controls provided by third-party oversight such as compliance with anti-money laundering (AML) requirements. Or, because the ancillary services provided by a custodian support efficiency in their cash management and investor onboarding efforts.
The word “custodian” can be a bit confusing, especially in the context of alternative asset classes. The role I’m addressing here is different from the services a manager’s prime broker may provide. Private fund custody, in this case, refers to third-party oversight and processing services sometimes known as “bank custody” or “institutional custody.”
That said, like prime brokers, private fund custodians can provide a suite of services that complement the primary function. For prime brokers, sales and trading is the primary function, complemented by ancillary services such as financing.
For institutional custodians, risk reduction is the primary function, complemented by services such as servicing and settling trades, managing overnight cash, providing real-time reporting on cash availability, enabling straight-through processing on cash movements, tax reporting, managing proxy and corporate actions, handling FX needs, segregating collateral, and registering and opening foreign accounts.
Not surprisingly, these private fund custody services relate to either or both securities themselves or the cash transacted for them. That intersection of securities and cash is precisely a custodian’s domain—and where it applies rigorous controls to avoid mistakes and fraud.
Investor-related services
Private fund custody services can extend even further to areas relating closely to the investor base of an alternative fund. These investor-related services can end up making a huge difference in managers’ operational efficiency. One such area is online reporting, via an investor portal that allows investors self-service access to account information.
Another investor-related area—one which we’ve seen significant interest—is help completing alternative investment subscription documents on a manager’s behalf. This can include completing the core offering documents as well as AML and KYC requirements for each investor.
Financing arrangements and more
Although prime brokers are more associated with financing than custodians, managers should know the role private fund custodians can play in supporting their financing strategy. At UMB, for example, we work strategically with both our customers and their existing lenders to create tri-party collateral agreements.
Bank custodians like UMB may also be able to support alternative managers even further throughout the investment lifecycle with traditional banking and escrow services, investor servicing and fund administration.
Ultimately, our work as custodian is to keep all parties secure and provide the client service that helps managers run their businesses as efficiently as possible.