Under the Alternative Investment Fund Managers Directive 2011/61 (AIFMD), the main regulatory framework for non-retail fund managers operating in the European Union, depositaries play a key role in safeguarding investors’ rights and interests.

Fund stakeholders depend on depositaries to safekeep funds’ assets, monitor cash flows and provide oversight of activities carried out by Alternative Investment Fund Managers (AIFMs) or their administrators. Whilst depositaries may have initially struggled with operational constraints associated with their independent oversight and control function, the market has evolved and reshaped the way in which depositaries fulfil their duties. The CSSF, in its circular 18/697, formalised the established market practices that had emerged under its supervision.

To shed light on recent developments, and to discuss what could be done to further streamline operations, PWC Luxembourg invited representatives from over 20 depositary to its “Alternatives Hub”, a roundtable event held in November 2019.

Other than to discuss operational and organisational changes, and to reflect on residual challenges, the goal of the Alternatives Hub is to create a community for Alternatives stakeholders and promote knowledge sharing. Areas of discussion covered safekeeping duties, application of the look-through principle, laying the groundwork for operational efficiency and digitalisation, and fostering collaboration with other parties in the fund value chain.

This paper summarises the outcomes of the depositary roundtable discussion. It aims to provide insights into how depositaries are gearing up to respond to market trends and challenges.

Roundtable participants affirmed that whereas depositary services transformations were initially driven by regulatory and client requirements around safekeeping and oversight, current operational changes are motivated by the need to drive scalability and increase efficiency through optimisation.

Proposed ways to achieve scalability included standardising de-facto market level procedures and operations, leveraging technology and increasing collaboration with others in the fund servicing value chain.

Whereas depositary services transformations were initially driven by regulatory and client requirements around safekeeping and oversight, current operational changes are motivated by the need to drive scalability and increase efficiency through optimisation.”

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Insights to the practical application of look-through and the overall depositary landscape for alternatives: 2020 and beyond

Specifying safekeeping duties and the application of the look-through principleThe CSSF Circular 18/697 on non-UCITS depositaries has achieved its principal objectives of (i) codifying best practices in relation to safekeeping duties and the application of the look-through principle, and (ii) ensuring standardisation and alignment of depositary activities in the market.

However, depositaries are still plagued with operational challenges, related to document exchange and applying the look-through principle, that date back to the early days of the AIFMD.

In our attendee survey, related to safekeeping duties addressed under Circular 18/697, the most demanding/challenging aspects from a practical point of view were considered to be the following:

44%

33%

11%

11%

Obtaining documentation/evidence for ownership verification

Application of the look through basis for certain asset classes

Record keeping

Formalisation of the service level agreement with relevant third parties

Look-through: How is it applied today?

The look-through principle serves to determine whether a depositary’s safekeeping, verification and record keeping practices meet the requirements to address assets that are held by an AIF or its underlying investment structures.

Following the introduction of AIFMD, discussions on the application of the look-through principle primarily revolved around the notion of control, i.e. verifying whether the AIFM directly or indirectly controls the investment vehicle.

Case studies, assessed during the roundtable, confirmed the market’s increased comfort in interpreting and applying the look-through principle and control test. Attendees even referred to the direct control test as being “easy”, except in rare and complex cases. However, depositaries acknowledged that they have to go beyond just the strict application of look-through based on the control test.

To effectively perform their depositary duties, depositaries apply look-through to target investments; even in instances where the control test is not satisfied. This is illustrated in the following cases:

i. Depositaries of a Real Estate fund would conduct an ownership verification on the entire investment structure and the target Real Estate asset even if one entity in the entire ownership structure is not controlled by the AIFM to ensure compliance with the investment policy.

ii. The depositary of a Luxembourg parallel fund would look-through to the target investments even if the Luxembourg fund only takes minority stakes in the investment vehicles of the main fund.

To ensure consistency in their operations, depositaries often have internal guidelines and procedures to help define and scope ownership verification.

When performing their independent analysis on the application of the look-through principle, the majority of the participants defer to fund documentation, in particular the investment policy. In simple terms: If the fund documentation states the fund invests into Real Estate, depositaries tend to look-through to the level of the actual building. However, as external auditors increasingly use annual ownership confirmations in their year-end audits, we notice a growing cooperation between audit firms and depositaries.

The roundtable consensus was to “look-through unless you can prove otherwise”. As the burden of proof is incumbent on the depositary, instances where they do not look through are generally limited to cases where the asset is in the safekeeping of another depositary.

Even then, they must carefully consider the equivalence of the depositary regime as not all countries have the same requirements when it comes to non-liquid assets and/or derivatives (e.g. US). With this in mind, depositaries are aware of potential challenges when onboarding funds investing in complex assets for which they have difficulties to reasonably verify ownership, such as timberland, farmland and movable assets.

56%Do not consult

any 3rd party

11%Partially rely on

information provided by the AIFM

33%Consult with the

auditors

On performing independent analysis on the application of the look-through principle, the most frequently sought assistance/support was as follows:

Operational challenges relating to safekeeping, ownership verification and record keeping

Depositaries are heavily dependent on third parties. When it comes to collecting relevant information and documentation, depositaries need to juggle significant time and volume constraints. Ownership confirmations can involve several hundreds of assets. In addition, some jurisdictions, especially in the real estate industry, can face delays in accessing relevant registers. In cases where information is not updated regularly such as investment structures, depositaries become dependent on AIFMs to confirm that nothing has changed.

Most surveyed participants conduct a complete in-house ownership verification on an annual basis. For funds with a larger volume of assets, depositaries defer to a risk-based approach by rotating assets over two to three years. In such cases, depositaries ensure that all assets in question are reflected in the annual valuation report to demonstrate that they still belong to the fund.

Depositaries can also manage high volumes by distributing their workload throughout the year, performing reviews in batches and leveraging their global network to execute preparatory tasks.

They however continue to be confronted by situations where they are not provided all the information that they need (e.g. omission of agreements relating to pledges, loans and incumbrances) and can even experience resistance due to duplicate controls and information requests from themselves and auditors. AIFMs could also help depositaries by using Service Level Agreements (SLAs) in their instructions to third parties requiring information to be provided in a timely manner.

Market players are evidently capitalising on new technologies and tools to achieve scalability. Their in-house solutions are geared to meet operational needs and reduce error-prone Manual Touch Points (MTPs). Most (80%) of those surveyed had dedicated IT systems that were, in equal proportion, either developed in-house (50%) or vendor provided (50%).

Gearing up for operational efficiency and digitalisationDepositaries recognise that they have a need to scale and are on the alert to manage growing volumes in a more cost-efficient manner.

Historically, depositaries for alternative investment funds have been the least amenable to emerging technologies. This is due in part to the manual nature of certain processes (e.g. review of shareholder registers) and the bespoke character of the AIFs serviced.

Although safekeeping duties have long been excluded from the digitalisation agenda, trade settling, cash-flow monitoring and certain oversight duties (e.g. NAV checks) are strong first contenders.

Strong focus on digitalisation

Participants acknowledged that there are substantial opportunities to promote automation, reduce operational risks and scale operations by introducing new technologies in the depositary service offering. They also conjecture that some processing will continue to be done in Excel spreadsheets.

The degree to which safekeeping operations are currently digitalised are

43%

14%

29%

14%

Using dedicated tool including reporting capabilities

Using dedicated tool

Using excel but actively looking for a solution

Using dedicated tool and document management system including third party upload capabilities

Organisations have further adapted and added functionality to their available tools or are using a combination of solutions to get the results they need. The underlying concern about home-grown tools is whether they will scale sufficiently to handle future volumes or adapt to changes in regulations.

Examples of such tools include:

• Workflow management tools (including customisable checklists, alerts, visibility and monitoring of status, interfaces with other tools…)

• Document management tools (including natural language processing, digital signature, secure file transfer, management of outdated documentation…)

• Reporting tools (including customisable reporting templates, interfaces with other tools…)

• Asset record keeping tools (including digital registers, links to supporting documents, extracts…)

In addition to achieving scalability through automating repetitive and voluminous tasks, digital solutions provide better audit trails and evidence of controls.

While digitalisation initiatives are key priorities for depositaries in their quest for scalability, many still feel handicapped by budgetary constraints and being unable to find suitable tools. Participants confirmed that tools tend to be costly (especially fund accounting tools of which depositaries would use only dedicated modules) and there is no fully-functioning dedicated solution on the market.

Data management as a future value driver

At the same time as depositaries are looking into multiple systems to support their digitalisation journey, they are focusing their efforts on delivering data in a secured and centralised environment.

Digitalisation will without a doubt accelerate the depositary’s search for greater efficiency and scalability. However, to best leverage the benefits of automation and avoid inefficiencies related to duplication of tasks, depositaries should target greater standardisation in the service offering and processing, which can only be achieved by further aligning with other service providers in the fund value chain.

To-date, the key organisational barriers to technology are:

33%Lack of suitable tools in the

market offering required functionalities

33%Budget and cost

considerations

11%Security concerns

11%Other: No barriers!

11%Insufficient time and resources to drive digitalisation projects

Fostering collaboration with other parties in the fund value chainFor fund servicing to scale and become more efficient, players all along the value chain should clearly delineate and understand the scope of their respective responsibilities and interdependencies.

Although the depositary plays a crucial part in this value chain by independently monitoring fund operations and guaranteeing investor protection, it’s role and related obligations remain (at least partially) unclear to some other actors. Participants stated that especially non-EU asset managers often required further education around AIFMD and Circular 18/697-driven depositary obligations.

Participants also expressed the need for additional guidance from the regulators to help depositaries gain more clarity around best practices and expectations relating to the record keeping of notional amounts of the AIF’s assets, in particular across different strategies (Fund of Funds, Real Estate, Private Equity, etc.).

These unclarities and diverging approaches are particularly challenging where depositaries work with multiple audit teams and AIFMs and fail to find a common approach. Discussions and practical examples have highlighted that depositaries are eager to seek further collaboration and efficiency with all actors in the value chain and are looking for further regulatory guidance to address these issues.

While doing so, depositaries recognise that “increased collaboration should not dilute the role of the depositary as a gatekeeper, or compromise it as being independent protector of the investor.”

Although safekeeping duties have long been excluded from the digitalisation agenda, trade settling, cash-flow monitoring and certain oversight duties (e.g. NAV checks) are strong first contenders”

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ConclusionDiscussions with depositary representatives confirmed that great progress had been made with respect to the convergence of best practices, particularly around interpreting the look-through principle. Case studies illustrated that the market has standardised answers and consensus around how to approach “standard cases”. Differences in interpretation and operational challenges mostly pertain to isolated cases including, for instance, pledged assets. Such cases will require further deliberation and guidance to ensure consistent understanding and application.

Practical examples further highlighted that the regulatory interpretation of look-through (test of control) is increasingly used as only one of several guiding factors in determining how far in the investment structure depositaries should reach. Indeed, to further protect investors, depositaries were found to increasingly look all the way to underlying investments held via non-controlled vehicles due to the scope of the investment policy and the possible risk of fraudulent cash flows disappearing in the structure.

Whilst depositaries act as independent watchdogs of the AIFM and as such play a key role in ensuring investor protection, effective collaboration and information sharing with other parties in the fund value chain, including auditors and fund administrators is required to warrant this. In this context, further guidance is expected from the regulators as to how responsibilities and independence requirements can clearly be allocated amongst the parties.

For a fully functioning fund ecosystem, key actors need to cultivate more efficient and collaborative ways of collecting, disseminating and sharing information to reduce the duplication of tasks and burden of day-to-day activities.

There was consensus amongst participants that improving operational efficiency and boosting scalability is on top of their strategic agenda for the coming year(s) with a focus on outsourcing support tasks and digitalising repetitive and low value-added activities.

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Philippe Belche Alternatives Advisory Partner, PwC Luxembourg

T: +352 49 48 48 2082 E: philippe.belche@pwc.lu.com

Kai Braun Alternatives Advisory Leader, PwC Luxembourg

T: +352 49 48 48 2085 E: kai.braun@pwc.lu.com