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Specialised Depositary Q&A

Insight 15 April 2021

Specialised Depositary Q&A

All your questions about specialised depositary answered by Sanne's Dermot Mockler.

Before explaining the difference, it is important to understand the reasons for, and the role of a depositary.

The requirement for EU fund managers of alternative investment funds (AIF’s) to appoint depositaries was introduced in the AIFM Directive (AIFMD), to further strengthen the regulatory framework and to offer additional protection to investors.

EU regulators introduced a requirement that managers (AIFMs) engage a depositary to act as an independent ‘watchdog’, essentially to make sure that the AIFM and the AIF itself was following the rules.

The primary reason was to add a layer of independent oversight to AIF’s, with the ultimate objective to give better protection to investors. This was necessary despite AIF’s being restricted to professional or qualified investors, investors not previously afforded the same protections as retail investors. Such investors are experienced in making informed investment decisions and would be familiar in the risks associated with investing. Despite this experience, both European regulators and relevant national competent authorities recognised the need to provide this additional, independent layer of oversight.

A high-level description of the role of a depositary is that it oversees the AIF to ensure that it is being managed in accordance with all its legal and regulatory obligations and in accordance with its own constitutive and offering documents. A depositary adds oversight that should ensure that the AIF is being managed in the manner on which investors made the decision to invest in the AIF.

There are three core depositary functions - cash flow monitoring, fund oversight and safekeeping of assets. The first two of these are both self-explanatory and apply equally to all AIF’s.

Turning to the question of the difference between a regular and a specialised depositary, we look at the third obligation, asset safekeeping. To understand the difference the starting point is to understand that there are essentially two types of assets that an AIF can hold, financial instruments such as equity, corporate and government bonds, which are typically safekept by a custodian, and other assets, such as private equity and real estate, that are not safekept by a custodian.

For a typical, open-ended AIF, such as hedge funds, the assets traded will largely be financial instruments that would be held by a custodian. For such AIF’s a custodian, particularly if it also provides administration services, is well placed to provide regular depositary services.

However, when AIFMD was being drafted it was acknowledged that this would not suit all AIF’s, particularly those that invest in assets not held within a custody network. The Directive makes specific reference to these AIF’s and describes an alternative depositary arrangement, commonly referred to as ‘specialised’, or real asset, depositary.

For a depositary, the key difference is that the assets are not held by a custodian and the obligation for asset safekeeping does not apply. Instead, the depositary must carry out what is known as asset verification, effectively to confirm that the assets are properly acquired and owned by the AIF. This has the same net benefit for investors, giving them assurance that the assets are properly vested with the AIF.

A number of factors have led to its introduction, not least the fact that other EU countries introduced similar regulations over the past few years and it is very important that Ireland has a regulatory framework that puts it in a strong a competitive position.

The regulation must also be seen in the context of the growth in the importance of funds that invest in real assets, assets that often underpin the real economy. The growth in the public/private partnership model of investing is seeing private money being increasingly invested into our economic infrastructure, and assets ranging from roads and telecommunications infrastructure, social housing and ESG projects such as wind farms are now increasingly seen as attractive investment opportunities.

This type of investment is, by its nature, a long-term commitment and the liquidity profile of these funds must be aligned to the liquidity of the underlying assets. This has led to the growth of closed-ended investment funds, where the investors understand that the investments are long term in nature, with terms of five to 10 years being the norm.

From an investor perspective

These closed-ended funds are not designed to replace the more liquid open-ended funds but rather complement them. They offer a different risk vs reward / return dynamic and as such should be an important element of an investor’s portfolio. The different liquidity profile associated with such investments really makes such funds a separate asset class and one that can be very useful, particularly in volatile market conditions. They would not, for obvious reasons, suit the short-term, liquidity conscious, investor but, in many cases, should form a part of a balanced portfolio.

Given this the new regulation adds an important addition to the Irish regulatory framework, as such funds can now be serviced by depositaries that specialise in, and have a deep understanding of, the attributes associated with these funds and the assets that they invest in.

Finally, Ireland has also introduced significantly updated partnership legislation, specifically aimed at the investment fund community. Similar to the above this has been done to bring Ireland in line with a number of European competitors and the new legislation, commonly referred to as ILP legislation, will make Ireland a very attractive domicile for managers that prefer a partnership over a corporate or other structure. This is particularly important to attract US managers as this is the preferred legal form for most US funds.

The first, key point to highlight is that specialised, or real asset, depositaries will only service a specific type of AIF, namely one that:

  • Has no redemption rights for five years from the date of initial investment, and
  • Generally, do not invest in assets that must be held in custody.

At a granular level the duties of a specialised depositary are prescriptively detailed in AIFMD, and outline obligations in the areas of cash flow monitoring, asset safekeeping and / or verification and general fund oversight.

The specialised depositary must obtain the details of all bank accounts opened, which should be opened in the name of the AIF or the AIFM on behalf of the AIF.

The specialised depositary must then monitor all the bank accounts and must reconcile all cash movements. A particular emphasis is given to the need to monitor investor subscriptions to confirm that money is received in the correct account in a timely manner.

Similar oversight is required for cash movements related to asset acquisitions and disposals. For both investor and asset activity the depositary must also monitor the ‘suitability’ of each investor and asset against regulatory restrictions and relevant fund rules. This forms part of the fund oversight obligation discussed later.

In a traditional open-ended AIF, that invests in financial instruments, the assets are typically ‘safekept’ by a custodian. For closed-ended funds, that often invest in other assets, the Directive establishes a different obligation in relation to how these assets are ‘protected’ and it is known as asset verification. The specialised depositary must have access to relevant documentation to confirm ownership.

As well as verifying asset ownership the specialised depositary will also confirm both correct and timely settlement and that the acquisition is in line with regulatory obligations and the fund’s constitutive and offering materials.

The high-level obligation of a specialised depositary is to monitor a fund’s compliance with all its obligations, and it is this ‘fund oversight’ function that is central to this. It involves overseeing the actions of the AIFM in its management of the AIF and at other key aspects of how the AIF is administered.

The Directive outlines five specific areas for oversight:

  • All investor transactions are carried out in accordance with legal and fund rules,
  • The valuation is calculated in accordance with legal and fund rules,
  • Investor and asset transactions are settled in a timely manner,
  • All income is applied in a manner consistent with legal and fund rules, and
  • The instructions of the AIFM are carried out unless they conflict with legal or fund rules.

The oversight of all these activities is designed to give investors a degree of comfort that the AIF is being properly managed. The depositary will recognise activity not in line with ‘the rules’ very quickly and take appropriate action.

In conclusion, the three depositary obligations are designed to protect the interests of investors, overseeing the AIFM and other service providers to confirm that are complying with legal and fund rules and escalating non-compliance quickly and effectively.

In doing this the specialised depositary provides a key role in providing enhanced investor protection.

Sanne recently became the first to obtain a specialised depositary services licence in Ireland. To find out how Sanne can assist you and your business, please reach out to Philip or Dermot directly.

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Depositary Services
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Dermot Mockler Head of Depositary Services, Ireland - Ireland
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