The monitoring and control of real estate assets will benefit from increased competition thanks to AIFMD. Those providing services in this area must take note of considerable infrastructure requirements. Pierre Welmerskirch and Michael Hornsby report
The principle of the Alternative Investment Fund Managers Directive (AIFMD) is to ensure the stability of the financial sector and to provide better protection for investors. In this respect it lays out a burdensome list of rules for the managers concerned come 2013. A number of these rules also touch on the funds themselves, with one of the biggest changes at fund level concerning the obligation to appoint a depositary.
To date, only a few countries in the EU, such as Luxembourg and France, require a depositary. This new regulation therefore provides banks with a big opportunity to offer custody and depositary services for managers across Europe. This will inevitably reshape the depositary landscape in the EU as the Directive also opens the door for non-credit institutions to act as depositaries, while at the same time setting very stringent requirements for them. These include:
• Broadened duties: all financial instruments that can be registered within segregated accounts must be held in custody by the depositary. For other assets that cannot be held in custody, ie, private equity, property or other physical assets, the depositary's duty is limited to the oversight of those assets. Moreover, the depositary has to ensure that the manager's cash flows are properly booked and monitored at all times;
• Extended liability: first, the depositary is strictly liable for any loss by the depositary, or a third party, of financial instruments held in custody, and for all other losses suffered as a result of the depositary's negligent or intentional failure to perform its duties. The depositary must restitute the financial instruments in due time. Moreover, the depositary is responsible for demonstrating and providing evidence that it has complied with all duties and regulations in case of loss (inverted burden of proof).
These rules and regulations reach deep into depositary organisation and how depositaries operate in future. As the Directive will have ramifications far beyond achieving basic compliance, depositaries should ask themselves how their operating model will be impacted and how they will have to react to the new obligations and risks introduced by the Directive.
From 2013 depositaries will hold a more fiduciary role similar to a trustee when it comes to the oversight function of the assets. Depositaries will need to pay particular attention to asset ownership verification and monitoring, the review of the calculation of net asset value and the valuation procedure as well as compliance with legal requirements and the requirements of incorporation documents. In particular depositaries have to understand and verify how assets are owned. This is for the most part challenging for non-financial assets, which cannot be held in custody. Since most of the risk is centred on ownership, significant time has to be spent understanding and examining ownership structure. As assets are held in different countries in many different ways, there is no standard approach.
In certain situations, the depositary might need to send teams to evidence asset ownership titles and ensure they are held in the name of the fund. Due to the increased monitoring responsibilities, depositaries will be required to put more rigorous control procedures in place; the scope of the controls will depend on the risk profile of the client and the asset type. The depositary therefore has to have sufficient experience to assess the risks in order to determine the appropriate level of control procedures. For the execution of its tasks, the depositary calls on a network of sub-custodians and depositaries. The depositary's liability is however unaffected by any delegation and highlights the importance of a thorough due diligence and third party monitoring procedures.
Furthermore, the extended set of duties and liability require an increased degree of expertise by the depositary. The depositary has to review the appropriateness of its operating model and readjust it. Post AIFMD, depositaries will need to employ an increased number of people with a relevant sector background and have experience with typical alternative investment structures. However, depositaries need to strike a balance between hiring these specialists and staying efficient.
An appropriate model to cope with this balance is to set up an organisation in the form of a centre of excellence. This means that the depositary would set up excellence centres on a sector basis and operate along a hub and spoke model through different countries. The technology, administration and deep sector expertise would be centralised in the hubs. Such a model will help the depositary to realize economies of scale and scope.
Although 2013 seems far away, by now custody and depositary banks should be asking themselves if they are committed to the alternative investment fund sector and ready to embrace the change the Directive is bringing. Some banks might come to the conclusion that they do not want to do so, either because their business model is not aligned with the new obligations or they do not have the capabilities. Banks should already be thinking about their future strategy on how they want to service the industry and what an appropriate operating model would be.
Pierre Weimerskirch (left) and Michael Hornsby are partners at Ernst & Young, Luxembourg