ESMA Consultation on AIFMD Level 2. Submission by: Ipes (Guernsey) Limited. About Ipes. About the authors:

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1 ESMA Consultation on AIFMD Level 2 Submission by: Ipes (Guernsey) Limited About Ipes Ipes is a leading European provider of fund administration and outsourcing services to the private equity ( PE ) industry. Our team of over 130 skilled professionals manages in excess of $43bn of funds on behalf of our diverse client base from offices in London, Luxembourg, Jersey and Guernsey. Established in 1998, we have an outstanding track record in the private equity industry working for more than 90 clients with over 300 funds and 5,000 investors. Ipes is the winner of multiple industry awards and is ranked 5 th globally for PE assets by ICFA magazine. For further details, please refer to About the authors: Justin Partington Commercial Director Justin Partington joined Ipes in March 2010 as the Group's Commercial Director. As Commercial Director, Justin is responsible for delivering the group marketing strategy to expand Ipes' profile in key markets, diversify its product range, and grow the revenue base. Justin joined Ipes from a London based Fund Administrator, where he headed the Private Equity department. Prior to that, Justin progressed from Fund accountant to Director at UBS Fund Services overseeing portfolios of hedge funds, fund of funds, and private equity funds over a 5 year period in the Cayman Islands and Toronto where he was Deputy Head. Before UBS, Justin was the Financial Controller for the Cayman back office of Swiss Life Private Equity Partners and spent 5 years with Deloitte and PwC. Justin is a qualified Chartered Accountant (Canada), a CFA charter holder and a full member of the Chartered Institute for Securities and Investment. In June 2011, Justin authored a chapter on Depositaries under the AIFMD for PEI Publications European Compliance Guide.

2 Barry McClay Chief Operations Officer Barry joined Ipes in November 2004 and is currently Chief Operating Officer. As Chief Operating Officer, Barry is responsible for service delivery across the group including; establishing and maintaining operational procedures; reviewing and developing the Ipes IT platform; and performing service reviews with clients. In addition, he is a director on a number of general partner boards of leading private equity funds. These funds represent some of the major names from the UK, Europe, USA, Asia and Russia. Prior to joining Ipes, Barry worked in the private equity administration department of Northern Trust for five years. He is a Chartered Accountant (ICAI), having undertaken his training in an Irish audit firm, and holds an MBA from the University of Manchester. Contact details For further details or questions, please contact Justin Partington by telephone on or at justin.partington@ipes.com or Barry McClay by telephone on or at barry.mcclay@ipes.com. We would be pleased to discuss any aspects of this paper with you.

3 Introduction This reply to ESMA s consultation does not address all of the questions posed by ESMA. Instead, our reply is focused only on those significant points where our relatively long history, extensive PE market coverage and experience as a practitioner support our opinions. Depositaries General comments Private Equity AIFs do not benefit from depositaries. Investors generally do not wish to pay for it given that the Other Assets held by PE AIF typically cannot be transferred without the signoff of many parties including transaction lawyers and their illiquid nature means that PE assets are rarely subject to fraud or loss in the definition under the AIFMD. With regard to cash, PE AIFs do not keep any on hand, other than a small amount to pay fees. PE AIFs call specific amounts from investors and these amounts immediately pay for investments or are returned back to the investors. Since the method of measuring PE returns causes cash balances to reduce the AIF s performance widely known as cash drag on IRR PE AIFMs get paid higher performance fees by holding the absolute minimum cash on hand. This greatly reduces the need for cash balance monitoring, reconciliation and cash fraud protections. While large EU banks support the depositary requirement and cynically view it as a revenue generating opportunity, we do not. Our view formed by being close to our client concerns is that it adds unnecessary cost burden and at already difficult time for PE fund returns, with minimal investor protection as the work duplicates that performed by fund administrators, auditors and lawyers. While the consultation rightly acknowledges the cost benefit question and duplication, it is relatively quiet with regard to reliance on regulated and experienced expert parties. Fund administrators are regulated and are reliable partners in maintaining accounting records, reconciling accounts and monitoring cash flows. Lawyers usually are on both buy and sell side when a PE asset transfers ownership and the assets and cash consideration do not move until lawyers are satisfied on all aspects. Auditors check ownership, completeness, accuracy and control procedures. While mistakes or errors happen, the industry widely acknowledges that the failure rate is extremely small. The ESMA draft appears to potentially create a negative burden of proof with regard to liability. This could cause independent administrators and accountant s not to become depositaries, and concentrate the risk with 5 or 6 European banks. The result would be a massive increase in systemic risk as BNY, BNP, Caceis and others all have either retail or institutional assets under management. We applaud the Level 1 text and the ESMA consultation s move to permit quasi depositaries for 5 year closed ended and unleveraged funds as partially recognising that PE is different. The goals of ESMA s consultation are more likely to be met by staying within its bounds and not overregulating beyond the Level 1 draft, by focusing on ex post verification rather than duplication of all effort,

4 and through acknowledging the role and professionalism of expert third parties including lawyers, administrators and auditors to the PE industry. In the spirit of constructive engagement, we respectfully wish to provide some comments below to support our views and also to try and reduce operational burdens and unnecessary costs to investors. Specific comments Box 75 the sentence commencing with Where the depositary does not receive... appears to reach beyond the initial Level I draft and is unnecessary given that the remainder of the text already requires the AIFM to ensure that the depositary has all information related to the cash accounts. We propose that this sentence be deleted. Q25 It would be easy to open general operating accounts and subscription / redemption accounts to be opened with the depositary. However we do not recommend this approach for two reasons. First, due the liability wording many institutions may decline the opportunity to become depositaries under AIFMD and the result would be further concentration of assets in a few banks, thus greatly increasing systemic risk. Second, PE funds commonly operate one account for all activity including operating and subscriptions / redemptions since the latter only occur a few times annually. This requirement would lead AIFs to open new bank accounts that they rarely use and investors would incur additional banking costs to do so. Instead, investors might gain comfort, risk diversification, and lower banking fees by allowing AIFs to choose a bank separately from the depositary as this would increase the availability and competition among banking providers. Further, it is noted that depositaries for closed ended and non leveraged AIFs under Article 21.3.c are not credit institutions, and it would not be possible to bank with such entities. The alternate solution is already addressed in draft Level II in that the depositary is made aware of all accounts that are opened. Q26 For PE AIFs, quarterly in the same frequency as the investor reports or net asset value calculation is the best option. The frequency depends entirely on the asset class. Some derivative products including CFDs, swaps, and margin products are reconciled daily, exchanged traded equities, bonds and other liquid products are typically reconciled weekly or monthly, but can be daily for an open ended fund trading each day. However, the accounts are monitored as often as daily for PE funds, and particularly when adhoc activity moves through the bank account. Cash reconciliation is irrelevant for PE funds. Reconciliation is performed primarily due to either the standard 1 to 3 business day settlement delay or corporate actions on traded securities (see further detail in Q28 below). Cash monitoring is relevant and is done frequently.

5 Q29 Option 2 is preferred. Option 1 is would not work and would hurt investors and AIFM. The discussion also appears to be beyond the intended scope of Level 1, and risks confusing monitoring with duplication and concentrates responsibility with a few institutions that increases systemic risk and increases cost to investors. Option 1 would cripple the investment process if Depositary pre approval was required for all cash flows, and would result in significant in duplication and cost to investors. The mirroring of cash transactions and reconciliations already recorded in the AIF s accounting records is clearly duplication of effort and cost to investors. Further it is noted that PE funds do not have cash reconciliation issues since Cash at Bank equals the accounting ledger. PE funds do not experience 1 to 3 business day settlement periods or corporate actions including receipt of dividends or interest payment s associated with exchange traded securities including stocks and bonds. For example, the most common corporate actions are dividends or interest declared and paid on equities that the AIF may not be expecting, or potentially spinoffs, rights issues and similar transactions that result in cash moving into and out of the AIFs bank account sometimes without prior knowledge of the AIF. PE AIFs do not have this issue. As a result, PE AIFs account books equal the bank with few or no reconciling items. Option 2 is the practical solution. The depositary should be permitted to rely on procedures and work done by experienced lawyers, administrators and auditors ( expert third parties ). Investors already bear the cost of auditors duplicating work by reviewing the reconciliations provided by administrators, and it adds no value to have yet another party doing the same work. The expert third parties should be regulated where applicable, and /or work to professional guidelines for their respective industries, and should be independent of the AIFM. Independence could be defined by being deemed arm s length controlled entities as already defined in Generally Accepted Accounting Standards. The expert third parties could provide either formal written representations, or such representations could be built into the depositary agreement, in which it would be stated that the depositary may rely upon the work done by the expert third parties and that appropriate controls are in place. Option 2 para. 2 should indicate that cash balances and not cash flows are reconciled since reconciliations require a starting and end point which is the cash balance. The cash flows are checked to reconcile the cash balance. Option 2 para.5 is vague and it is not clear what specific actions are required. We suggest a change to refer to monitoring as a result of any errors or discrepancies identified by the reconciliation procedures. Q30

6 Option 1 The costs can be derived by combining the transaction recording done by the existing back office with the audit review and checks of the cash reconciliations. For a typical PE AIF with 100M to 500M in about 10 investments for 25 investors, the cash bookkeeping and monitoring costs a range from 10 to 20K per annum. Duplicating the investor flows and capital calls / distribution notices to monitor those flows would cost about 10K per annum. Duplicating the investment flows on new deals and sales of existing investments would cost about 2k per investment per annum, or 8 to 10K yearly including time for queries and explanations which are inevitable given the bespoke structure and terms for each investment by a PE AIF. The uncertainty in the liability clause would have to be priced in, and insurance for such situations and size of fund can be estimated at between 30 and 50K per annum. If the depositary regime and liability deter new entrants and accountants, administrators and law firms from entering the space, the creation of an oligopoly would add an unknown further premium. Total estimated cost range of Option 1 = 30K to 40K plus both the insurance and lack of competition premiums which would see the estimate likely to exceed 100K annually. Option 2 The cost estimate can be derived by combining transaction recording done by the AIF back office or administrator with the audit review and checks of the cash reconciliations. Confirming the bank accounts, checking cash monitoring and reconciliation procedures, and taking further action regarding errors or discrepancies in the reconciliation process are all currently performed by audits from which the cost can be estimated. The cash section of audits for AIFs depends on the activity involved. For the typical PE AIF described above, the cost of such audit sections averages a range of 1 to 3K per annum, with a further one off cost primarily around control testing in the first year of 2K. Total estimated cost range of Option 2 = approximately 5K with minimal insurance needed and no lack of competition premium. Q31 per above reply in Q30, in excess of 30 to 40K per annum for an average PE AIF. Q32 Option 2 since it more closely describes assets that can be held by a depositary. This section should be limited to assets such as exchange traded securities that can be held in custody settlement systems. Shares of private companies and privately negotiated loans cannot fit this description. We do not understand Option 1 as custody securities or Other Assets are not held in the name of the depositary, even if that depositary acts as nominee. Box 81

7 Option 1 part i. could imply legal control over transactions or assets that likely contradicts asset transfer laws. This section should be changed such that the depositary is to ensure that assets cannot be moved without the knowledge of those that control the fund i.e. the Directors with ex post reporting to the depositary for periodic verification. The key here is that the Directors of the Fund and expert third parties obey the AIF rules previously agreed with investors and as filed with local regulators. The wording could state: Option 1 i. ensure there are procedures in place so that assets so registered cannot be assigned, transferred exchanged or delivered without the AIFM and the Directors or operators of the AIF duly approving the transaction in accordance with the AIF s formation documents.the depositary or its delegate is to be informed of such transactions on a timely basis with full access to the documentation; or Option 1 part ii. Is more practical and works if the documentation is provided on an ex post basis. Option 2 is impractical, prohibitively expensive, operationally near impossible and not considered further. Q35 In practice, banks and fund administrators are best placed to handle the safekeeping duties other than custody tasks. These groups have the technology, experience and are currently already performing the safekeeping function for AIFs. With Other Assets, full delegation of the recordkeeping and monitoring should be permitted. Q36 We do not understand this question. The depositary does not own the asset since the assets belong to the AIF. Registering assets in the name of the depositary to create an illusion of additional control only serves to impede the operations of the AIF, adds unnecessary additional cost, and perhaps may also risk cross contamination of client assets held by in the name of a depositary. Other Assets should only be registered in the name of the AIF directly. Paragraph 43 of the Explanatory Text refers to the feasibility of depositaries having prior information with infrequent transactions of Other Assets. We strongly disagree. The intense and detailed negotiations behind every Other Asset transaction hinges on extensive due diligence, the contribution of many advisers, with continually refined terms. Activity increases as the deadlines approach which are often set late into the evenings. Ipes acts as Directors for many of its clients, and could provide many examples of managers and staff working late into evenings to complete and signoff on client deals, with papers circulated at 2230 hours on a Sunday night in one case, and in another recent mid week case, the deal closed at 0430 hours as Ipes Directors signed off. Institutional banks in the EU where depositaries are currently required are rarely available past 1800 hours, with one client relaying an

8 anecdote of the depositary closing the office on the night of one deal at 1630 hours sharp. The deal was delayed and could have fallen through. Q38 Option 1 On PE deals there can be many rounds of negotiation and documents produced and reviewed since it is not known which round is the last until the final conclusion. This process would increase the cost of the depositary if required to review and signoff before each deal is made. An ex post verification and review as described and verification of control procedures with regular testing would be significantly less costly as only one round of final documents would need to be reviewed. The current cost of ex post verification on an average PE AIF with about 4 investments / divestments annually could be broadly assumed to be in line with procedures currently performed by the Directors of offshore funds and by the auditors. These costs for an average fund would be approximately 10 to 20K a year by administrators plus about 5 to 10K by auditors for a total range of 15 to 30K. Option 1 would likely result in an average review by the depositary of at least the final 3 rounds of negotiated documents, and thus would effectively triple the cost. There would likely be a further risk premium and hassle factor for the late evenings and staff overtime cost for the late hours worked. We would estimate based on current EU depositary rates a range of 50K to 80K annually under Option 1. Transaction mirroring requires both staff time and also IT systems would need to be developed. Many depositaries systems are not currently setup to handle the record keeping and statement records for Other Assets. This development involves building a detailed data warehouse, asset level segregation, report design, web portals, access control and security features. Given Ipes own development cost, the depositaries would look to recover system costs of between 1M to 3M over a few years for even a modest system. The system costs, staff time and data entry and reconciliation would at least double the above estimated range to an approximate range of 100K to 150K annually. Q40 In order to avoid duplication and conflict, depositaries oversight role should limited to ensure that instructions from the AIFM and control procedures in place comply with the AIF s rules and applicable laws.

9 Leverage General comments The ESMA draft appears to recognise that PE AIFs are not typically leveraged for the purposes of the AIFMD, however it should further explicitly clarify this intention where AIFs hold only long equity and / or debt positions and 1) all FDIs held are recognised and treated by the audited financial statements as effective fair value or cash flow hedges, and 2) that all AIF borrowing and guarantees are covered by the investors capital comments and permitted in the AIFs formation documents, that in such cases that the leverage provisions of the AIFMD are not intended to apply. Specific comments Q57 Yes, contingent liabilities rules are well established under Generally Accepted Accounting Principles, and to avoid duplication and inconsistency, we recommend that the contingent liability sections refer to the amounts recorded in the AIFs Balance Sheet in accordance with the AIFs accounting rules stated in their formation documents. Q59 Options 1 and 2 both rely on expectations that are difficult to determine and measure as both options recognise that such actions could happen even if not legally bound to do so. One solution could be to select Option 2, but to the extent that such obligations are not covered by capital commitments from investors. A fund that spends its total investor commitments should not be considered levered as this is simply the agreed capital committed by investors. Q60 No, the AIF should only include leverage in the calculation where that AIFs liability increases due to an obligation. To include this definition of leverage would appear to contradict the intentions of the Level I AIFMD draft.

10 Transparency and Reporting General comments Industry bodies for PE have produced extensive reporting guidelines that have greatly improved information provided to investors. Over the past decade, investor reports have grown from 3 pages to 30 pages each quarter with an exponential increase in useful and transparent portfolio and AIF information. The reporting improvements are largely due to the reporting templates produced in the mid 2000s by the EVCA and BVCA due in part to the Walker guidelines in the UK and in our view, more consideration of these already established templates with which investors are familiar would be helpful. Specific comments Q69 No, annual reporting is sufficient for investors. Aspects of the investments important to investors are already reported quarterly and other information and discussion is provided annually. Revaluation of the Other Assets that are illiquid, infrequently traded, with little market price information more frequently than currently recommended by leading industry bodies has not been requested nor is required by investors. Doing so would add significant cost and reduce investor returns. Q70 A reporting template would need to be tailored for each unique AIF type otherwise investors will receive less useful information than is currently the case. Also, as practitioners, we respectfully recommend that ESMA refer to the established industry guidelines for such reporting. For example, the EVCA produced a detailed set of guidelines and reporting templates designed in part by PE investors. Most of our clients produce their reports to EVCA, BVCA or similar reporting guidelines. In terms of cost, a proxy would be the time taken to setup the risk section of audited financial statements under IFRS where IFRS 7 includes many of the risk disclosures and stress tests, then add in the additional performance, remuneration, and other disclosures. For a typical PE AIF with 100M to 500M in assets, this could be a range of 15 to 20K annually with about the same one off cost for the first year setup. If the quarterly reporting were implemented, there would be a less than quadruple change due ironically to the lack of portfolio change quarter on quarter and we would guess at 30 to 40K annually. This depends on meeting the industry s recommended AIFMD Level 2 disclosure levels re: leverage, remuneration, etc.. This cost estimate could more than double if the widest possible disclosures and calculations considered in the Level 2 draft are required. Q71 In our view, very few AIFs would meet a one month deadline. In our experience, investors are more interested in receiving accurate information than rushed reports that contain inaccurate estimates. To produce PE AIF reports typically requires 30 to 45 days, with 120 days by Fund of Funds since it takes at least 60 days to receive most of the underlying reports, and in some cases 90 days to do so.

11 In our experience, figures can be compiled earlier based on best guesses and then checked as reports are received subsequently however this can frustrate investors with future revisions if actual reports from the underlying funds of funds vary significantly from estimates.