Depositaries under the AIFMD - EY - United States

Depositaries under the AIFMD Safekeeping of non-custodial assets and look through principle

Contents Introduction 3 1. Organizational and functional set-up of depositaries

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2. Safekeeping duties for non-custodial assets

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a. Legal establishment b. IT systems c. Outsourcing arrangements

a. b. c. d. e.

Register of assets Periodic ownership supervision Reliance on information provided by the AIF/AIFM Frequency of monitoring PE/RE investments Volume of ownership verification

5 5 6

8 8 9 10 10

3. Depositary lite regime and business opportunities

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4. Case studies on application of look-through principle

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a. b. c. d. e. f.

Direct investment Investing in regulated fund PE/RE fund – control over underlying asset PE/RE fund – joint control over underlying asset Fund of Funds Master Fund

15 15 15 15 15 15

Conclusion 17

Introduction The Alternative Investment Fund Managers Directive (AIFMD) has introduced a new regulatory environment for the alternative fund industry with the overarching aim to enhance investor protection. One of the pillars of protection put in place by the regulation is the depositary. The AIFMD stipulates that an Alternative Investment Fund Manager (AIFM) must appoint a single depositary for each authorized Alternative Investment Fund (AIF) it manages. The depositary must comply with a prescribed set of requirements and is obliged to execute safekeeping duties not only for traditional custodial assets but also for other assets which include non-custodial assets such as private equity (PE), real estate (RE), infrastructure and overthe-counter (OTC) derivatives. Those safekeeping obligations extend to cover investments of an AIF on a look-through basis, i.e., target investments held by an underlying structure

controlled directly or indirectly by an AIF. Application of the look-through principle introduces another level of complexity for safekeeping of non-custodial assets and is a widely discussed topic on the market. Given this context, in February 2016 EY invited 16 representatives of depositaries to discuss their current organizational and operational set-up and to benchmark their interpretation of the AIFMD requirements. Among the participants were local banks, global banks and special depositaries with global assets under custody (AUC) ranging from €11 billion to €20 trillion. This paper summarizes the outcome of this roundtable discussion and aims at providing insights into the current market practice for depositaries in Luxembourg when it comes to safekeeping of other assets under the AIFMD.

Depositaries under the AIFMD |

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1

Organizational and functional set-up of depositaries 4

| Depositaries under the AIFMD

a. Legal establishment

b. IT systems

Depositaries are required to functionally and hierarchically separate the performance of the depositary function and other conflicting functions performed within the group (notably fund administration, transfer agency and prime brokerage). In order to comply with this requirement the depositaries have been looking at their organizational and functional set-up in Luxembourg and in other EU jurisdictions as part of their AIFMD implementation. The roundtable demonstrated that over 56% of the respondents have a separate legal entity for depositary services versus fund administration. The rest addressed functional and hierarchical separation of depositary and fund administration services within the same legal entity through diligent segregation of duties and reporting lines. There were no particular trends or preferred operating models identified between large global depositary banks and smaller local players in Luxembourg. As the AIFMD does not prescribe legal separation per se, the differences in the organizational set-up of depositaries are predominantly based on legacy. The depositaries that chose to operate depositary and fund administration out of the same legal entity were typically already established in such a way prior to the AIFMD. Notwithstanding the organizational approach taken, the separation of duties must be accompanied by diligent management of conflicts of interests. Any potential conflicts of interests must be identified, managed, monitored and disclosed to the AIF’s investors.

When it comes to the IT systems that can support depositary duties for safe-keeping of non-custodial assets, only one quarter of the respondents indicated that they have an appropriate IT solution in place. Half of the respondents are currently looking for available IT systems to support their operations. The general consensus is that there is currently no single IT system on the market that would fit the safekeeping requirements for all non-custodial asset classes. The depositaries have to work with several tools, including Microsoft Excel, to capture data for OTC derivative transactions, performing look-through ownership verification for PE/RE assets and reviewing contractual arrangements for loan transactions. Additionally to the IT systems for safekeeping of non-custodial assets, the attendees confirmed that it would be beneficial to employ a workflow tool in order to manage every step of the depositary value chain. Such tool would ideally track the work performed through a completion stage, identify and flag any outstanding tasks and have an escalation and sign-off functionality. Several attendees indicated that they already started to develop such tool internally and/or are looking to invest in external solutions.

Do you have a specific IT system in place supporting your non-custodial assets?

Do you have a separate legal entity for your depositary (vs. your Administration)? 25%

50%

44% 56%

25%

Yes No

Yes

Currently looking into solutions

No


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c. Outsourcing arrangements In executing its safekeeping function, the depositary may utilize to a certain degree outsourcing/shared services arrangements with other parts of the group. This becomes particularly relevant when the depositary is part of a global banking group. Typically global players rely on their own custody network (for custodial assets) where the network management is centralized. Other supporting tasks such as reconciliation and data collection (both for custodial and other assets) may also be grouped in one location and provided by means of shared service arrangements. The attendees confirmed this trend, with a majority (over 85%) of representatives from large global depositary banks (global AUC more than US$ 500 million) stating that they benefit from the outsourcing arrangements within the group, whereas the same proportion of smaller players typically perform all activities in-house from Luxembourg. In instances where certain tasks are outsourced to other group entities, the depositary is required to establish appropriate internal controls to monitor the performance of these tasks (either through key performance indicators or other measures) and perform periodic due diligence assessment on its delegates.

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Do you perform outsourcing to service hubs within the group? (e.g., network management, reconciliation, data collection) 100% 80% 60% 40% 20% 0%

Yes No

2

Safekeeping duties for non-custodial assets Depositaries under the AIFMD |

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a. Register of assets

b. Periodic ownership supervision

The depositary must ensure that all transactions on the AIF accounts are accurate, complete and recorded on a timely basis. The depositary can rely on the information provided by the authorized service provides, however, such information must be verified on a sample basis and accompanied by regular due diligence performed on these services providers. Based on the roundtable discussion, the general consensus is that the majority of participants keep their independent asset register for non-custodial assets such as OTC derivatives and PE/RE assets and independently reconcile this register with external sources (fund administration inventory of assets, broker statements) on a periodic basis. The maintenance of an independent asset register is considered to be best practice in the industry and is one of the reasons why the majority of participants are looking to invest in an appropriate IT system to support different non-custodial asset classes.

Ownership verification comes hand in hand with maintenance of the asset register of an AIF. The depositary shall maintain the register of AIF’s assets for which it is satisfied that the AIF or the AIFM acting on behalf of the AIF holds the ownership of such assets. Ownership must be verified periodically and, where applicable, on a look-through basis. When it comes to physical assets, the depositaries often perform regular onsite visits to confirm ownership. This activity is typically supported by other group entities and/or external service providers. The majority of attendees (67%) indicated that the core analysis of ownership verification is not outsourced. However, supporting tasks such as data collection from different jurisdictions (including notary confirmations, trade register extracts etc.) are typically performed locally where the asset is located either by utilizing the depositary branch in the relevant jurisdiction (for the banks with global presence) or by appointing external service providers (e.g., local notary/law firm/big four).

What is your model when performing periodic ownership supervision/look through on local markets to ensure safekeeping of non-liquid assets in different locations?

7% 6%

20%

67%

Performed in-house (Luxembourg) Performed within the group Performed by a (local) third party service provider Other model

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c. Reliance on information provided by the AIF/AIFM In the context of its safekeeping duties, the depositary is required to look-through the AIF’s portfolio until target investment. In practical terms this means that the depositary must perform a detailed assessment of the AIF’s structure to review any fund structures/special purpose vehicles (SPVs) that need to be looked through and identify the underlying target investments for which the depositary has its safekeeping obligations. The AIFM maintains the primary responsibility to provide the depositary with all necessary documentation, including a full picture of the overall structure of the AIF, in order for the depositary to perform its assessment in the context of the look-through principle. When enquired, none of the respondents indicated that they fully rely on the information provided by the AIFM. Notwithstanding the size and the global presence of the depositary, all of the participants perform to a certain extent an independent analysis of the AIF’s structure. The look-through analysis is primarily performed at the outset of the client relationship during the client acceptance phase and then reviewed on a periodic basis as part of the client continuance process as well as on an ad-hoc basis when necessary (e.g., acquisition/disposal). Additionally, the periodic look-through analysis is essential to understand fund cash flows as part of monitoring and cash safekeeping responsibilities of the depositary. Cash flows up or down the AIF’s structure can be supporting evidence for the existence of a target investment. Also, a broad understanding of the structure is essential in analyzing how the components of the fund net asset value (NAV) roll up in the valuation process. This is another responsibility of the depositary.

Are you relying on the information provided by the AIF/AIFM to decide on the application of the look-through principle?

43% 57%

Yes, fully rely on information provided Yes, partially rely on information provided and challenge work performed No, performing an own depositary analysis Other model


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d. Frequency of monitoring PE/RE investments When it comes to the frequency of monitoring PE/RE investments in the context of the depositary safekeeping obligations, the majority of respondents specified that they employ a tailored approach whereby the investments are monitored on a NAV frequency basis (e.g., 31 December for AIFs with year-end NAV closure) and certain level of checks are performed throughout the NAV cycle, e.g., on acquisitions/disposals, income distribution and asset restructuring. Furthermore, many participants indicated that periodic investment monitoring is performed throughout the year in order to avoid a backlog of work at year-end. In determining the frequency of the asset monitoring, contrary to EY’s expectations, the depositaries do not generally employ a risk based approach (e.g., there is typically no differentiation between open-ended and close-ended AIFs). Practically speaking, it would be possible to adapt the frequency of the asset monitoring to the AIF’s risk profile and client continuance process, prioritizing the higher risk investments and performing less frequent checks on the lower risk investments.

e. Volume of ownership verification The volume of ownership verification performed by participants for all of their AIF clients in Luxembourg varied greatly with over 35% of the attendees performing ownership verification for more than 500 assets and 7% for less than 10. The volume of ownership verification primarily can be linked to the size and the global presence of the depositary banks.

Looking at all your AIF clients, for how many target investments do you currently have to perform ownership verification? 50% 40% 30% 20% 10% 0%

Less than 10

Between 10 and 50

Between 50 and 100

Between 100 and 250

Depositaries with global AUC < EUR 500bn Depositaries with global AUC> EUR 500bn

10


Between 250 and 500

More than 500


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Depositary lite regime and business opportunities 12


Following the introduction of the AIFMD, EU managers that wish to market their non-EU AIFs to EU investors through private placement must appoint one or more firms to perform the depositary duties of safekeeping, cash flow monitoring and oversight, i.e., the so called depositary lite regime. Unlike the full depositary regime, the depositary lite does not provide for strict liability in case of loss of custodial assets. Going forward, the potential extension of the AIFMD marketing passport to third countries ( earliest in 2018 for most jurisdictions) would mean that those EU managers that now use depositary lite providers for their non-EU AIFs, would be required to appoint a single depositary compliant with the full scope of the AIFMD depositary provisions. The majority of participants viewed the introduction of the third country passport as having no meaningful impact on their operations in Luxembourg. They argued that, unlike the United Kingdom or Ireland, Luxembourg is not a major hub for depositary lite services and as such will not experience demand for full depositary services from the AIFs transitioning from depositary lite providers. The remaining participants were equally divided between those considering the third country passport to have a positive impact (17% of participants) and those considering this development to present a threat to their operations (16% of participants). The proponents of positive impact argued that, once the third country passport comes into force, they may see, in most cases on a group level, an inflow of new non-EU AIF clients. To the contrary, the latter participants were concerned about potential loss of business in certain EU jurisdictions where they currently provide depositary lite services. This threat concerns primarily firms that do not hold a full banking license and do not operate a proprietary custody network. In order to keep their non-EU AIF clients after the depositary lite is phased out they would need to obtain an additional authorization. Moreover, taking on the strict liability for custodial assets in instances where custody is provided by a third party is an additional concern for these market players.

Do you consider 2018 (or whenever the third country passport comes into force in a widespread way) as a threat, positive impact or neutral?

16%

17% 67%

Threat Positive impact Neutral


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4

Case studies on application of look-through principle

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As previously discussed in this paper, the application of the lookthrough principle is not a straightforward process. The AIFMD prescribes certain general rules for the identification of the target investment, including: • Depositaries’ safekeeping obligations extend to all target investments of the AIF controlled directly or indirectly (e.g., through SPV or other fund vehicles) by the AIF/AIFM • The look-through provisions do not apply to fund of funds or master-feeder structures provided that they have a depositary which provides ownership verification and record-keeping functions for this fund’s assets. However, the application of the above rules is often subjective especially with regards to the notion of control. In this context, several practical examples of AIF structures were put forward and the participants were invited to share their views with regard to the application of the look-through principle. The outcome of this discussion is clear. Depositaries are in agreement about one basic principle: look-through does not necessarily end just because the direct percentage of ownership between two entities (e.g., the fund and an SPV) does not qualify as control. Safekeeping rules are rather applied based on an understanding of a fund’s structure and its overall economic purpose for the manager or advisor. Also, depositaries focused on the description of the investment scope in the relevant prospectus or offering memorandum in order to take into consideration the investors’ view on what the target investment would be (e.g., an operating company rather than an SPV in the case of a private equity fund).

a. Direct investment The look-through principle applies for direct target investments held by fund or SPV structures which an AIF controls. The general consensus among the participants was that the notion of control is interpreted differently among the market peers ranging from (i) control based on established accounting terms (e.g., voting control, majority ownership) to (ii) the right to exercise dominant influence over the underlying fund/SPV. Some market players are using defined set of rules/checklists to determine the level of control of an AIF over the underlying investments whereas others are primarily focused on the investment strategy of the AIF arguing that the target investments of the AIF, as presented to the AIF’s investors (and not interim SPV/fund structures, whether controlled or not) fall under the safekeeping obligations of the depositary.

c. PE/RE fund – control over underlying asset Where an investment is held indirectly through a chain of SPV structures established and controlled by an AIF for the purpose of investing in underlying assets, participants agreed that the safekeeping obligations of the depositary extend to the underlying assets held by the SPVs.

d. PE/RE fund – joint control over underlying asset Where two funds jointly control an investment, through an SPV or a master fund structure (no EU depositary appointed), participants agreed that for both funds the depositary shall look-through up to the underlying asset as this represents the target investment.

e. Fund of Funds Where a Fund of Funds (FoF) invests in several funds with the purpose of risk diversification, the emphasis is primarily on selection of investment strategies and tapping into the expertise of different fund managers. The FoF does not exercise any control over fund managers’ investment decisions for the underlying funds. The participants agreed that in this case the depositary will not be required to look-through to the assets of the underlying funds, as the funds in which the FoF invests are themselves the target investments. It was also noted during our roundtable that special attention shall be made to the cases where a FoF is essentially a master feeder structure where the look-through principle applies as illustrated in the following example.

f. Master Fund In instances of master/feeder fund structure, the depositary of the feeder should look-through up to the target investment of the feeder which would typically be the assets of the master. The feeder structure only gives access to the investors to invest in the master fund, thus, in substance, the target investments are still the underlying assets of the master. In instances, where there is a depositary at the level of the master that meets the requirements of AIFMD, no look-through principle applies.

b. Investing in regulated fund Where an AIF invests in a regulated fund and this fund has its own depositary that is responsible for the ownership verification and record-keeping duties in the meaning of the AIFMD, the participants unanimously agreed that the depositary is not required to lookthrough to the target fund’s investments. Depositaries under the AIFMD |

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Conclusion Ever since the AIFMD came into force, the broad scope of the depositaries’ responsibilities precipitated intense market discussions. The depositaries have been busy refining their operating models and designing the AIFMD compliant solutions for all alternative asset classes. While many AIFMD requirements are now considered as industry norm, our roundtable clearly demonstrated that some AIFMD concepts, such as application of the look-through principle, record-keeping of non-custodial assets and the level of reliance on the information provided by the AIFM/its service providers are still subject to different interpretation among the industry peers. However, while depositaries have more or less aligned their positions over the past years on the points mentioned above, it was noted that some of their clients, i.e. asset managers, do not yet have the same understanding of what is required by a depositary and often take a more literal interpretation of the regulation. This can lead to conflicts in the exchange of information and thus render day-to-day operations more difficult. Furthermore, it is yet to be seen how the market will evolve following the termination of depositary lite regime in the coming years.


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Notes

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EY | Assurance | Tax | Transactions | Advisory About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com. © 2016 Ernst & Young S.A. All Rights Reserved. ED None This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax, or other professional advice. Please refer to your advisors for specific advice.

ey.com/luxembourg

Contacts Kai Braun Partner, Luxembourg Alternatives Advisory Leader, EY Luxembourg T: +352 42 124 8800 E: [email protected] Michael Hornsby Partner, EMEIA Real Estate Funds Leader, EY Luxembourg T: +352 42 124 8310 E: [email protected]

Depositaries under the AIFMD - EY - United States

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