For those wishing to set up a standalone Alternative Investment Fund, getting the right service providers in place is crucial to the manager's long-term success and reputation. The following sections detail what to look for when it comes to appointing four key service providers:
• The Fund Administrator
• The third party AIFM
• The depositary
• The Prime Broker (for hedge funds).
Onshore depositary
"An AIFMD Depositary Bank is tasked with: oversight of assets, activity, and the manager; safekeeping of assets (where required); cash flow monitoring; strict liability for restoration of lost financial assets and reporting breaches. In short, the depositary has a fiscal responsibility to investors and a regulatory duty to carry out that oversight," explains Owain McNeill, Business Development Director, CACEIS, one of Europe's leading depositary banks.
Where a manager chooses to use a prime broker broker and/or administrator separate to that of the appointed depositary, the depositary has to conduct a robust risk assessment of the AIF.
Under this arrangement – referred to as an open architecture arrangement – the cost impact to the manager will be higher because the depositary will be required to enter into a discharge of liability arrangement with the prime broker charged with safekeeping the AIF's assets (less unencumbered assets).
Alternatively, by using an integrated model, much of the risk can be internalised and the cost impact to the manager is reduced. In this arrangement, a single counterparty acts as the administrator and depositary to carry out the cash monitoring and oversight functions.
Some depositaries require unencumbered assets to be held in their own custody network. Only then will they accept strict liability over the financial assets. It should be pointed out, however, that strict liability does not apply to non-financial assets or assets encumbered/re-hypothecated by the prime broker under a discharge of liability arrangement.
"Some clients take advantage of our depositary services across multiple locations, including the UK. Our ability to offer services flexibly (i.e. as a standalone depositary) is valued by managers that wish to maintain specialist relationships with other service providers. Other clients, such as those using CACEIS' Private Equity, Real Estate and Securitisation services, partner with us to provide a fully outsourced asset service covering everything from Equity Bridge Financing, Custody, AIFMD Depositary, and Fund Administration," explains McNeill.
In his view, some of the key criteria for selecting an onshore depositary should include:
Balance sheet strength of the bank
Since the purpose of the depositary is to oversee, safekeep and provide liability over financial assets lost, the bank's robustness should be a consideration.
CACEIS, for example, is a strong independent bank backed by two of the largest European banking institutions, Credit Agricole and Groupe BPCE (via Natixis).
"Our A/A-1 credit rating is a reflection of strong solvency ratio and shareholder equity," adds McNeill.
Brand Recognition
As the primary duty of the depositary is to protect investors' interests, having a strong European bank behind the fund is an important selling point for the manager.
Flexibility
A manager may well have identified its prime broker and/or fund administrator already. As such, the ability to work with a depositary willing to offer modular services is important.
Location
Is the depositary part of banking group that is operating in the location of the fund? Is the banking group close to the manager? This helps with local market and regulatory knowledge. Is the banking group also in the location of the investors? This will help with local market understanding, distribution, and generating potential new capital.
Operationally fit
Does the depositary have an established relationship with the managers' prime broker? If not, it's very unlikely that that relationship will work, as new depositary/prime brokerage contracts are notoriously difficult to put in place.
"We are one of few UK depositaries covering any UK-domiciled AIF with the requisite skill to handle the nuances of private equity and real estate funds," says McNeill. He adds that a few common misconceptions when it comes to appointing a depositary include:
• Misunderstanding the purpose of a depositary. To investors and the regulator it is an important safety net in the event of another financial crisis or other events.
• Not knowing the benefits of a bank and its financial strength versus a professional firm offering `Depositary Lite' services.
• Recognising the value of the depositary brand and reputation as a fund selling point.
Fund administrator
Suryanshu Mishra is Head of Hedge Fund Administration, Fund Services at Deutsche Bank. In his view, the ideal administrator for a start-up can be summed up in three words: robust, adaptive and global.
Robust
This comes from having a proven track record servicing various aspects of the fund spectrum. A good quality administrator is one that supports large established asset managers, mid-tier asset managers and start-ups as it allows the administrator to build in-house technical expertise to handle any types of complexities.
"Take accounting complexities. There could be a lot of nuances depending on the fund structures such as unusual bucketing of expenses, innovative fee models that need specific accounting treatment and so on. You can't have errors on these things. They are fundamental to the governance of the fund. As such, managers need an experienced administrator," says Mishra.
Another aspect of being `robust' is investor relations. When out on the road raising assets, having an administrator that understands the end investors is key; a good administrator is responsive and help showcase the pedigree of the manager.
Straight through processing of data is another criterion. The administrator should demonstrate that various asset types and transaction types can be processed on a trade file quickly and accurately.
"A strong AML regime is also important. You need your administrator to provide the safety and soundness of the investor AML environment the fund needs to operate in. Managers shouldn't be expected to understand all the various nuances of AML laws in the US, Cayman, Ireland, Luxembourg and so on.
"A final point about robustness is for the administrator to show that they can be independent. If they can ask questions about the Offering Memorandum before the fund launches, that shows they are thinking carefully about how they can support the fund and are not just a dummy provider who simply relies on the manager's instructions. An administrator that is willing to question the manager is a good sign," stresses Mishra.
Adaptive
This is important if one assumes that the fund manager is going to grow and become successful. The fund administrator needs to be adaptive in two ways.
Firstly, with respect to flexibility of technology; as the fund grows and takes on more investors there will be more reporting requirements, additional data points. Some start-ups will launch funds even before they've got PMS and OMS systems in place and decided on their own internal technology stack. When they do, it's important that the administrator is flexible enough to handle it without issue. Technology agnosticism and flexibility are extremely important. The first year or two, start-ups will often change their technology systems.
"Secondly, listen to clients. Things change for managers and a good administrator is one who listens and can adapt by understanding their clients," says Mishra.
Global
Any start-up manager launching a fund with long-term aspirations needs to have in place an administrator with the connectivity and thought leadership in multiple markets. Understanding different jurisdictions is key – if the administrator lacks the depth of expertise to handle different regulatory requirements in different domiciles it could impact a manager's business.
"Managers should look for an administrator with good connectivity to global third parties, especially custodians and prime brokers – and when I refer to connectivity I mean both from a technology and relationship perspective. Things should `happen by themselves' and resolved with little or no intervention needed by the manager. A good administrator is also one that has relationships with local regulators to potentially influence market regulation before it comes into play.
"Finally, is the administrator able to provide coverage in all time zones? Can they provide end of day reporting to ensure that the fund is up to date the minute the fund manager walks into the office the next day?" says Mishra in conclusion.
Outsourced AIFM
There are three models for managers to consider when it comes to operating as an alternative investment fund manager (AIFM), under AIFMD.
Full outsourcing
This is where the investment manager appoints a third party AIFM who bears the risk management function internally and sub-delegates the portfolio function back to the investment manager. Under this arrangement, the AIFM takes care of 15 of the 16 core requirements of AIFMD, the 16th being portfolio management.
Full insourcing
This is where the investment manager becomes their own AIFM, keeping the risk management and portfolio management functions internal with no delegation to a third party AIFM.
Partial outsourcing
This can best be thought of as a hybrid of models 1 and 2, whereby the manager does partial outsourcing. They may, in this instance, become a registered AIFM in the UK, for example, and outsource the risk management, compliance and regulatory reporting function with respect to Annex IV.
Cordium offers a version of this model with the Cordium Total AIFM Solution or `CTAS'. In this arrangement, the manager retains full ownership of the AIFM, which Cordium establishes in Malta, and at the same time Cordium handles all the operational and compliance demands. This provides the best of both worlds; full ownership of the AIFM with none of the heavy lifting of operating it internally.
Alan Picone is the Managing Director and Member of the Board of Directors of Duff & Phelps' (Luxembourg) Management Company and Global Head of Risk and Management Company Solutions at Duff & Phelps. He says that if managers planning on having a wide distribution strategy for the AIF then the full outsourcing model is probably the best option.
Cost will also play an important factor. Managers of a certain size will benefit from full insourcing or partial outsourcing, where they own the AIFM; but this typically will only apply to large billion-dollar managers with an established brand pedigree.
Picone is keen to stress that the above models are all quite fluid and flexible. A manager might start with the full outsourcing route, build the strategy and AUM over a number of years, and then, potentially, become their own AIFM.
"We always clearly articulate the various options to clients. We don't believe in a static AIFM model. Our product is designed to accompany start-up managers and allow them to evolve. We can delegate the portfolio management if they are already regulated. If they are not regulated, we can run the portfolio management function ourselves and accompany the manager through their FCA or CSSF license. Once the manager receives their license, we can then sub-delegate the portfolio management function back to them," explains Picone.
AIFM: Key criteria
Firstly, look at the nature of the AIFM business within the group. Is this purely a tactical decision? Look at the shareholder structure. At Duff & Phelps, for example, its biggest shareholders are Carlyle Group and the University of California. Knowing that the AIFM is in the business for the long haul is critical.
Secondly, look at the AIFM's expertise. Do they understand the manager's portfolio management process, the investment mandate? This should be a detailed exercise, not simply a check the box exercise.
"Thirdly, the AIFM should have an advisory mindset. We do not believe in the AIFM being a commoditised product. It needs to be a tailored service, especially to those managers who go down the full outsourcing route. The AIFM should operate as an extension of the manager's operations team in a partnership arrangement.
"We are able to apply a full range of expertise to support our clients at Duff & Phelps," says Picone.
Another consideration would be financial stability; does the AIFM have a strong balance sheet? The last thing a manager wants to do is appoint a third party AIFM only for them to disappear 12 or 24 months later because of cash flow issues.
"Exactly right. That is what I mean when I say that managers have to be certain that they are appointing an AIFM with long-term objectives, not just short-term tactical objectives. The AIFM is required to provide the necessary regulatory capital under AIFMD so check that the AIFM is well capitalised at the due diligence stage," concludes Picone.
Prime broker
Bank-owned prime brokers are becoming increasingly less well equipped to service small hedge funds because of the impact of Basel 3 regulations. This has led to increased costs of using balance sheet, requiring bank-owned primes to generate sufficient return on equity to justify keeping a hedge fund on their books.
"A small hedge fund generating USD150,000 a year in fees would mean that your average bank-owned prime would probably need 10 clients just to break even, 20 clients to make a profit. So the numbers don't work," says Jerry Lees, Chairman of Linear Investments, a London-based boutique prime broker.
It is much easier to service one USD500 million hedge fund than 20 hedge funds each with USD25 million in AUM, to generate the same return on capital.
For start-ups who might only have USD10 million in assets, unless the strategy is going to have a high volume of trades and employ lots of leverage, it is becoming more sensible to partner with a boutique prime.
"It's not so much that small hedge funds are spoilt for choice; many of them have no choice but to look at alternative prime brokerage solutions," says Lees. He points out that aside from the usual prime brokerage services – stock lending, financing arrangements, capital introduction services – Linear has built out its internal infrastructure to prepare for MiFID II regulation, due to come into play in 2018.
One key part element of its service offering is an outsourced trading desk.
"With MiFID II coming down the line, managers are going to have to prove statistically that they are getting best execution on their trades. We have a full trading desk covering equities with connection to multiple brokers, and a fixed income trading desk with a current team of 10 people, so we can achieve best execution on behalf of clients. We have also just expanded the office to include another 40 desks for start-ups who wish to come and operate under our MiFID regulatory umbrella," says Lees.
The cost of having three traders with respect to salaries and bonuses, Bloomberg terminals and so on, is close to GBP1 million a year. That's a lot of money, even for an established fund manager.
"By using an outsourced trading solution you just pay us commission. We can get managers a reduction on commission rates based on the right volume and remove the need for sourcing talent and building their own trading team. That's a GBP1 million saving, straight away," adds Lees.
Although there is a degree of kudos attached to appointing a big name prime broker like Goldman Sachs, many of the bank-owned primes simply cannot dedicate the same level of resources as one gets with boutique primes.
As Lees concludes: "Start-ups don't need an investor relations team, they don't need a trading team, they don't need a compliance officer, they don't need an IT team; we provide it all for them.
