Depositaries under the AIFMD. Oversight duties and cash flow monitoring

Depositaries under the AIFMD Oversight duties and cash flow monitoring

Contents Introduction 3 1 Role and liability of the depositary 4 a. Prevention and detection 5 b. Increased liability 5 2 Organizational challenges 6 3 Oversight obligations 8 a. General approach to conducting oversight 9 b. Initial and periodic assessment 10 c. Ex-post controls 10 4 Cash flow monitoring and cash reconciliations 12 a. Cash flow monitoring for significant and inconsistent transactions 13 b. Frequency of cash flow monitoring 14 c. Volume of cash flows to be monitored 15 d. IT systems and automation of cash flow monitoring 16 e. Cash flow reconciliation 16 f. Reconciliation of cash positions 17 Conclusion 19

Introduction One of the primary aims of the Alternative Investment Fund Managers Directive (AIFMD) was to increase investor protection. A key step in this regard was the requirement for each Alternative Investment Fund Manager (AIFM) to appoint a single depositary for each authorized Alternative Investment Fund (AIF) it manages. The depositary s traditional role in the investment fund industry mainly consisted in executing safekeeping duties for traditional custodial assets as well as other assets which include noncustodial assets such as private equity (PE), real estate (RE), infrastructure, debt and over-the-counter (OTC) derivatives. With the AIFMD, depositaries saw themselves propelled from simple custodian banks to policemen supervising the AIFM s activities in a much broader way. Their initial role was supplemented by additional oversight obligations relating to: Depositaries were furthermore required to monitor and reconcile AIF s cash flows by obtaining a full overview of the cash positions and cash movements of the fund. Given this context, in February 2016 EY invited 14 representatives of depositaries to discuss their current organizational and operational set-up as well as benchmark their interpretation of the AIFMD requirements against current market practice. 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 in light of oversight and cash flow monitoring obligations under the AIFMD. i. The valuation of assets ii. The subscription and redemption of shares or units iii. The carrying out of the AIFM s instructions iv. The timely settlement of transactions v. The income distribution of AIF. Depositaries under the AIFMD 3

1 Role and liability of the depositary 4 Depositaries under the AIFMD

a. Prevention and detection Although depositary banks have seen their obligations and liability significantly increase, their fundamental role has remained unchanged. Participants agreed that in layman s terms, the main role of the depositary is still to prevent anybody from taking money that belongs to the fund. The first opportunity for depositories to prevent breaches (including fraud) starts with the onboarding process where depositaries perform due diligences and analyze the models or the approach of the AIFM. Furthermore, building a good relationship with clients and asking the relevant questions to understand their controls as well as having the client understand the depositary s role under the AIFMD, has been identified as a key step in the prevention mechanism. Finally, understanding the clients business and knowing the patterns of cash flows can help in preventing any type of fraud. Prevention however has its limits where the depositary no longer has any control over transactions. For instance, in the PE area, funds often benefit from bridge financing facilities with third party banks and as such have access to cash even before the first investor drawdowns have been received by the depositary. In real estate, a significant number of transactions take place at the level of the property company under the control of property managers. In such cases, the role of the depositary can no longer be to prevent any breaches, but is to detect them as soon as possible in order to allow the AIF, the AIFM or the depositary itself to initiate remedial action. b. Increased liability From a legal perspective, the depositary s liability will be triggered if it does not act with the diligence expected from a professional of the financial sector. In case a potential liability triggering event is detected, discussions would typically be conducted between the AIFM, the fund and possibly investors to identify its origin and whether the depositary should have prevented or detected it at an earlier stage. In such cases, depositaries would be asked to cover at least part of any financial loss to the extent that it is partly due to a lack of diligence by the depositary and not entirely due to the non-execution of an obligation by another party (e.g., the AIFM which could have failed its obligation to provide the depositary with all required information) The participants also agreed that the oversight functions and cash flow monitoring obligations do not present the biggest risk for depositaries, although frauds relating to cash flows are the most likely to happen. From a financial and reputational point of view, the biggest risk still remains the ownership verification. The consequences for depositaries when failing to fully complete ownership verifications will still largely outweigh any consequences in an incorrect execution of oversight obligations. However, the enhanced role that the depositary has been given by the AIFMD has also lead to a general increased exposure of depositaries. In the past, investors would have mainly looked towards the AIFM to seek compensation in case of a loss due to an improper execution of obligations or even fraud. Nowadays investors along with AIFMs are increasingly looking at the depositary when it comes to funding possible compensations. In view of this new environment and ultimately the increased liability, depositaries had to adapt their internal organization, as well as their policies and procedures in order to reinforce their operations. Depositaries under the AIFMD 5

2 Organizational challenges 6 Depositaries under the AIFMD

Depositaries are, among other things, required to identify the target investments within a given fund structure, perform ownership verification, understand the valuation of assets including any holding structures, monitor cash flows and oversee the net asset value (NAV) calculation. In simple words, they need to comprehend the big picture in order to answer the question whether it all makes sense. In this context, we asked participants how they have organized themselves in order to get that big picture; the outcome was diversified feedback. One participant indicated that they put all controls together as part of the NAV oversight on a quarterly basis. Within their organization, someone is responsible for signing off significant movements and the valuation which is quite easy for consolidated accounts of RE funds. In the case of joint ventures or minority interests however, it is more difficult to perform these controls meaning they have to rely more on queries to the AIFM. On a similar note, another participant indicated that they have a dedicated team supervising oversight activities who have full responsibility of the controls. Inevitably, an organizational setup where one individual is tasked with all obligations for a portfolio of funds, including the responsibility to have a clear overall picture was presented to the round table. Although there were quite some notable differences between the approaches chosen by the participants, they all agreed that it is difficult to have the same evidence for liquid and illiquid products. What should be avoided in any case is installing a tick-the-box mentality where people gather required information and tick the relevant box without trying to understand the overall picture. Gaining a good view on the overall fund structure is not only a question of having the right controls and organization in place, it is also a question of communication between different service providers, especially in cases where the depositary does not also act as the central administration agent. After having set the general stage for further discussions, the depositary oversight obligations as well as cash flow monitoring and reconciliation duties were discussed in more detail. A third participant, nonetheless, commented that they have: i. A dedicated team for relationship management (PE and other) ii. A dedicated cash flow management and oversight team dealing both with non-liquid and liquid assets. They are all responsible for one point of the control framework. Good escalation procedures ensure that they maintain a view on the big picture Depositaries under the AIFMD 7

3 Oversight obligations 8 Depositaries under the AIFMD

With the entry into force of AIFMD, depositaries did not only face extensive levels of additional work, they also had to build up entirely new competencies within their depositary operations, mainly to comply with the oversight obligations. Some participants shared their experiences in how they chose to deal with this challenge and all agreed that the solutions were mainly based on i. The legacy structure of each organization ii. Available expertise, both in-house and within the group as a whole a. General approach to conducting oversight With the introduction of the requirements regarding oversight duties, depositaries first of all had to cope with the lack in resources and knowledge. The approach taken by the majority of attendees was to set up a dedicated team while building on existing expertise or resources from other teams, such as fund compliance teams. Support was received at group level or by external advisors. Providing trainings to these newly established teams was a key element as well. The internal organization of oversight and safekeeping teams may however vary from one depositary to another. In fact, several attendees illustrated that every team member is responsible for several funds and thus needs to perform the whole range of required oversight duties as well as liaises with experts if needed. Another approach mentioned was to have dedicated people for every oversight duty who is in charge of all the funds for that specific duty. No matter how different the teams of participants were structured, they all followed the guidelines and recommendations for depositaries on oversight duties and cash monitoring for AIFs published by The Association of the Luxembourg Fund Industry (ALFI) and The Luxembourg Bankers Association (ABBL) in 2013. In this document, the authors recommend to start with an initial assessment of the risks associated with the nature, scale and complexity of the fund s strategy and the organization of the AIFM. Based on this analysis, the depositary is able to decide on the level of due diligence to implement and the number and frequency of periodic controls that should be undertaken. The depositary should furthermore perform ex-post controls through a sequence of actions, as shown in the following graph. Initial and periodic assessment of policies and procedures Periodic control Independent external control report reliance Due diligence and on site visits When it comes to gathering information in order to perform periodic controls, depositaries may rely on independent external control reports. 77% of attendees indicated that they prefer to rely on and review information provided by the AIFM or independent external control reports when conducting oversight. Only a small stake (8%) signified to re-perform checks of the control environment or the quality of services performed. What is your preferred approach in conducting oversight? 77% 15% 8% Reliance on/review of information provided by the AIFM and any delegates or independent external control reports Re-performance of checks of the control environment/quality of the services performed Mixed model depending on the oversight duty Depositaries under the AIFMD 9

b. Initial and periodic assessment Performing on-site visits seems to be key when initially assessing policies and procedures. In fact, attendees predominantly use on-site visits to gain an understanding and insight of the AIFM. In order to gain a high-level understanding, plausibility checks can be performed as well. Ultimately, depositaries send out due diligence questionnaires and review the due diligence reports of the AIFM. The written report on the initial and periodic assessment is usually sent to the AIFM. The latter also requests reports from the depositary in order to perform its due diligence. c. Ex-post controls The ex-post controls performed by the depositary take into account all procedures put in place by the AIFM. First of all, the depositaries analyze the procedures in order to assess whether they are sufficient with regard to the requirements. In a second step, they assess whether they have been applied appropriately. In order to get supplied with all the relevant information necessary to perform these types of controls, the depositaries typically rely on operating memorandi and the service line agreements (SLA). Several attendees argued that, while analyzing and assessing the correct execution of procedures, depositaries can get involved in discussions regarding their initial set-up and implementation. The risk at this point is to get too deeply involved in AIFM s processes and thus take on additional liability. When looking at the approach used in conducting control checks, it becomes clear that depositaries are not in a pure ex-post mind-set, as only 25% of attendees use this approach. The way how control checks are performed depends, on a large extend, to the complexity of the fund and the type of transactions it performs. In fact, for PE or RE funds, performing ex-ante controls is deemed mandatory given the illiquid nature of the assets. What is your approach in conducting control checks? 15% 77% 15% 8% Purely ex-post Ex-ante review and ex-post validation Depending on the complexity of the fund Other 10 Depositaries under the AIFMD

When it comes to cash payments, attendees indicated that they could, in theory, not release a payment if information is missing, however, this is almost never the case as depositaries feel that they have completed their task when communicating concerns to the AIFM. Only in extreme cases where fraud is a major risk, depositaries will in fact block payments. Does your client onboarding assessment (e.g., combined risk rating) have an impact on the frequency and types of ex-post checks performed? The depositaries attending our roundtable stated that every on-boarding of a new AIFM constitutes a high risk and hence the set-up of an appropriate control framework is time consuming. Accordingly, the assessment of the client during the on-boarding process has an impact on the frequency and types of ex-post checks performed, as shown in the graph above. 14% 7% When it comes to the reviews of procedures and processes under the responsibility of the delegates of the AIFs, depositaries largely agree on performing reviews on a yearly basis. Only 23% of attendees review them upon material changes only. 79% Yes, Always Yes, on a case by case basis as qualitative opinion No, never Other How often are you reviewing the processes and procedures that are under the responsibility of the delegates of the AIFs? 23% 77% Anually Biannually Quarterly Upon material Changes Other Depositaries under the AIFMD 11

4 Cash flow monitoring and cash reconciliations 12 Depositaries under the AIFMD

a. Cash flow monitoring for significant and inconsistent transactions As part of its obligations relating to cash flow monitoring, depositaries must implement appropriate procedures to identify at the close of each business day significant cash flows, and in particular those which could be inconsistent with the AIF s operations. It should be noted that the AIFMD solely requires cash flow monitoring to be performed at the level of the AIF, i.e., no look-through principle applies for the cash flow monitoring duties of the depositary. Having said that, the depositary should have an understanding of the full AIF s structure, including cash accounts at the level of special purpose vehicles (SPVs) (cash safekeeping obligations apply on the look-through basis), investment/ disinvestment cash flows up or down the AIF s structure and any applicable financing options of the AIF. This is why many market participants choose to monitor significant cash movements not only on the level of the AIF as prescribed by the Directive, but also closely look at significant cash movements up or down the AIF s structure at the frequency practical and deemed appropriate taking in account the risk profile of the AIF. This approach was confirmed by the attendees of the roundtable. When it comes to setting up the threshold level for identifying significant cash flows, all participants confirmed that they use a pre-defined quantitative criterion, nevertheless the approach for setting up the significance level varied. Typically, a low absolute fixed amount is set up at the outset of the client relationship, which is then reviewed and adjusted as necessary, based on the nature of the AIF s cash flows and the volume of transactions. Regarding this, half the participants (50%) employ a hybrid model, whereby a minimum value threshold is set up in addition to the percentage of NAV to ensure all significant cash flows are captured. How did you establish your thresholds of significant cash flows within your organization? 7% 50% 7% 14% 22% Fix percentage of NAV Fix amount Fix percentage per type of cash flow Fix amount per type of cash flow Hybrid Other The roundtable demonstrated that some participants (14%) are using a fixed percentage of NAV and applying it to the whole population of cash flows in order to identify those that are significant. Other participants set a fixed amount, either for all cash flows (22% of the participants) or per type of the cash flow (7%), and disregard the NAV approach, arguing that even the cash flows that can be insignificant for the AIF based on the proportionality to its NAV, in many instances, may still be significant to the investors of the AIF (e.g., subscription/redemption transactions are largely significant to the AIF s investors even though they may constitute a negligible amount as a proportion of the NAV). Depositaries under the AIFMD 13

b. Frequency of cash flow monitoring Since the introduction of the AIFMD, the frequency of cash flow monitoring obligations of the depositary was widely debated on the market. The depositary is obliged to perform cash flow monitoring on a daily basis, or in case of infrequent cash flow movements, on occurrence, notwithstanding the nature and complexity of the AIF. The majority of the respondents (65%) confirmed that even for AIFs with non-daily cash flows, they perform cash flow monitoring on daily basis as stipulated by the Directive. How often do you perform cash flow monitoring for non-daily funds? 14% 7% When looking at the frequency of cash flow reconciliation specifically for non-daily funds where the depositary uses a fund administrator s (FA s) cash ledger for its reconciliation, the FA records would not necessarily reflect daily cash account information. The FA would typically perform cash reconciliation on the NAV calculation basis. In these instances, where the depositary intends to use the cash reconciliation of the FA for its own independent daily review, the list of outstanding records will be collected each day and unmatched items will be reconciled at the NAV basis. This means the full cash flow monitoring review in these cases, including cash flow reconciliation, can only be performed on a NAV basis. 14% 65% Daily Weekly Monthly Other 14 Depositaries under the AIFMD

c. Volume of cash flows to be monitored When inquired on the volume of the cash flow movements monitored, nearly one third of the respondents have a significant volume of cash flows to review on a daily basis (between 500 and 1000 cash flows per day). Typically, where the volumes are high, the depositaries employ a cash flow monitoring tool. However, even then manual intervention/ interpretation of the cash flows that are not automatically treated are inevitable in many instances. As depicted in the chart, 36% of the participants indicated that manual intervention is required, on average, for 20 50 cash flows on a daily basis. How many cash flows do you have to monitor per day in Luxembourg for all of your AIF clients? How many of the daily cash flows require manual intervention/are not automatically treated? 36% 14% 29% 21% Less than 10 Between 10 and 20 Between 20 and 50 Between 50 and 100 More than 100 8% 15% 23% 15% 31% 8% less than 50 Between 50 and 100 Between 100 and 250 Between 250 and 500 Between 500 and 1,000 More than 1,000 Depositaries under the AIFMD 15

d. IT systems and automation of cash flow monitoring When it comes to IT systems that can support depositary duties for identifying significant and inconsistent cash flows, two thirds of the respondents indicated that they have an appropriate IT solution in place. Several attendees indicated that they are in the process of developing cash flow monitoring tool internally and/or are looking to invest in external solutions. Considering the volume of the cash movements and the frequency of monitoring, the level of automation varied among participants. For illiquid funds with infrequent cash movements, some participants indicated that they still rely heavily on manual reviews. Even when a dedicated IT system is deployed for monitoring significant and inconsistent cash flows, human intervention is necessary in many cases to identify those cash flows that are inconsistent and the depositary should ensure that personnel with a sufficient understanding of the AIF and its investment strategy is involved in detecting those inconsistent cash flows. Do you use a dedicated IT system for identifying significant and inconsistent cash flows? e. Cash flow reconciliation For cash flow reconciliation, there are mainly three models that are considered by the depositaries: i. The depositary performs its own transaction-based reconciliation by reconciling depositary cash records versus cash records received directly from various counterparties where the AIF s cash is held; ii. The depositary performs its own cash flow reconciliation by reconciling depositary cash records versus FA s cash records; and iii. The depositary relies on the cash flow reconciliation performed at the FA (based on an initial due diligence and ongoing supervision) and receives the cash flow reconciliation report from the FA and reviews the reconciliation breaks identified. The models to be adopted for cash flow reconciliation will significantly depend on the specific national requirements. In Luxembourg, model 3 is deemed to be generally accepted and is in accordance with ABBL/ALFI Guidelines and Recommendations for Depositaries. Provided that the control environment at the FA is checked by the depositary, using the FA records and/or the reliance on the reconciliation performed at the FA deemed to be sufficient. 29% of participants revealed that they use FA reconciliation to a certain degree, especially where an internal FA 36% 64% Yes No 16 Depositaries under the AIFMD

is appointed. However, the majority of participants (71%) chose to perform the cash flow reconciliation within the depositary (model 1 or model 2 above), stating the approach to be more prudent and closely aligned with the regulatory requirements. Some participants pointed out that, in order to avoid duplication of work, they have now established a separate functional unit that is outside the depositary and FA operations that performs the cash flow reconciliation for both depositary and FA. Who performs reconciliation within your cash flow monitoring process? 29% f. Reconciliation of cash positions In addition to reconciliation of cash flows, the depositary shall check the consistency of its own records of cash positions with those of the AIFM while the frequency of reconciliations between the accounts should be proportionate to the nature, scale and complexity of the AIF. The attendees confirmed that they perform reconciliation of cash positions as part of their cash safekeeping responsibilities. As cash is considered to be an other asset in accordance with the AIFMD, the requirement to maintain a consistent record of cash shall follow the look-through principle for safekeeping of other assets and extend to the underlying cash accounts held at financial or legal structures established and/or controlled by the AIF. The outcomes and actions taken as a result of any discrepancies identified shall be communicated to the AIFM and/or the AIF as per established escalation procedures if an anomaly has not been rectified without undue delay. 71% Depositary itself Central Administrator Others Depositaries under the AIFMD 17

18 Depositaries under the AIFMD

Conclusion For the past five years, depositaries have been forced to considerably revamp their operating models for alternative asset classes to comply with AIFMD requirements. Our roundtable has clearly shown that a market practice has crystalized for the implementation of a number of AIFMD topics such as: i. The preferred approach to conduct oversight is clearly the reliance on information provided by the AIFM, any delegates or independent external control reports ii. Processes and procedures under the responsibility of the AIF delegates are typically reviewed on an annual basis iii. Most depositaries have set up dedicated IT systems to implement cash flow monitoring requirements iv. Employ a hybrid model composed of a minimum value threshold and a percentage of the NAV to detect significant cash flows The roundtable participants also confirmed that optimizations and refinements are still required, particularly considering the upcoming implementation of UCITS V which will be a major scalability test for cash flow monitoring operating models. Depositaries under the AIFMD 19

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: kai.braun@lu.ey.com Michael Hornsby Partner, EMEIA Real Estate Funds Leader, EY Luxembourg T: +352 42 124 8310 E: michael.hornsby@lu.ey.com