Indos: hedge funds switch from depositories affiliated to administrators

A conflict of interest could raise operational risk if one part of a group oversees its affiliate, writes Bill Prew of Indos Financial

Bill Prew, founder and CEO, Indos Financial

The European fund management industry is at a crossroads. Since the aftermath of the financial crisis, firms have been inundated with a host of regulatory initiatives and demands from institutional investors for increased transparency and improvements in governance and operational processes. Most managers have successfully navigated these dual challenges from regulators and investors. For the first time since early 2009, managers are experiencing a brief regulatory lull.

In general, firms appear to have successfully navigated implementation of the Alternative Investment Fund Managers Directive (AIFMD). Notwithstanding a laborious regulatory authorisation process, the directive has not proven to be as ruinous to the industry as some had predicted. Appointing a depository has not been a huge cost burden, while Annex IV regulatory filings are becoming more straightforward with experience.

The worst of the remuneration rules can be disapplied by the majority of managers and the risk management provisions, despite general disbelief about the usefulness of the required leverage measures, have not caused too much trouble either. As a result, many managers feel AIFMD compliance has involved a lot of repapering of legal documentation and amendments to policies and procedures, but has not had a material impact on how they conduct their business.

The regulatory lull may not last long. Further significant change lays ahead, most notably the Markets in Financial Instruments Directive II (Mifid II), which is due to be implemented from the beginning of January 2017 although there are increasing signs it could be delayed. The remit of Mifid II is significant and, unlike AIFMD, the provisions it contains will bring about significant changes for affected fund managers in terms of how they conduct their investment management business and further operational and compliance burdens.

In the interim before the impact of Mifid II is fully felt, a number of managers are addressing potential shortcomings on the operational sides of their businesses. One particular area is a review of their depository arrangements, leading to a growing trend of managers switching their depository away from providers affiliated to the fund administrator to an independent firm.

As a specialist independent AIFMD depository, Indos has already taken over the depository service for one billion-dollar hedge fund from a large global fund administration group, and two more managers with assets in excess of $3 billion are in the process of migrating their business from well-known providers. In all these cases the managers have retained the same fund administrator despite moving to an independent depository model.

There are various reasons for this growing trend.

Many managers acknowledge they initially opted to appoint a depository that was an affiliate of their fund administrator, because they felt it would make AIFMD compliance a simpler process. Some managers had little choice, since the majority of depositories that act for hedge funds only do so where an affiliate is the fund administrator. There are only a few firms that are able and prepared to act in an entirely independent capacity. Managers now possess practical experience of the depository service and some are actively revisiting their depository arrangements.

A number of managers have expressed disappointment with the level and quality of service from their depositories. These managers complain they have had little interaction, with very few enquiries being raised and template style reports not highlighting any issues. This has caused managers to question the role being performed by their depositories, which they have subsequently found to be lacking.

Since few issues are being raised by depositories, managers are sceptical about the independence and Chinese walls between the fund administrator and depository entity. They are questioning how the depository can demonstrate it is acting independently and managing the inherent conflict of interest presented by one part of a group overseeing another affiliated entity.

Managers are increasingly finding they need to justify their depository strategy to investors. Operational due diligence teams have been increasing their understanding and focus on the depository service and probing managers on the service provided by the depository. Managers feel that independence between the depository and the administrator will be viewed more positively by investors.

There is an increasing recognition of the benefits an independent depository solution can bring, as it provides an additional level of oversight over the fund administrator's processes. Industry peers are attesting they have benefited from the appointment of an independent provider. If depositories are truly acting independently and performing a rigorous review, it is implausible some issues would not be identified and reported.

As an independent depository, Indos has identified a broad range of issues that reveal control weaknesses across a range of administrators, such as reconciliation or pricing errors, as well as managers, such as investment restriction breaches. Managers take comfort from issues being identified since it enables them to tighten up areas of potential control weaknesses.

It is interesting to note that the benefits of improved service, transparency and independence have so far outweighed financial motives such as cost reduction. Some firms also see benefits by diversifying their service providers thereby reducing exposure and reliance on any one provider.

We are confident other managers will join those that have already decided to move to an independent depository model. It is disappointing that there are not more depositories willing to act entirely independently of the administrator. However, affiliated depositories will continue to come under pressure to add value and demonstrate how they manage the conflict of interests that is inherent in this model.

Bill Prew is founder and CEO of Indos Financial.