By James Williams – Now that the AIFM Directive has been codified and formally unveiled across the European Union the next stage is seeing how effective individual Member States will be at embracing it. How will they cope with the demands of regulating alternative investment funds (AIFs)? Will they have the requisite service provider infrastructure in place to cope with the enhanced monitoring, reporting and risk management demands under the Directive?
In this context, Luxembourg certainly appears to be well positioned. As Europe’s leading onshore funds domicile – EUR2.4trillion in assets under management as of 31 August 2013 according to ALFI and home to some 3,894 funds – and the world’s second largest funds domicile, it has built its expertise substantially over the last decade. With such a strong track record in servicing UCITS funds, it’s business as usual for the Grand Duchy under the Directive.
“Relative to other jurisdictions like the UK and the Channel Islands, Luxembourg is where we expect to see the least change under the Directive. Some of the AIFMD’s provisions regarding supervision and risk management have come out of the UCITS Directive whose market in Luxembourg has grown substantially over the last 10 years,” says Justin Partington, Commercial Director at Ipes, one of Europe’s leading private equity fund administrators.
Aside from UCITS, Luxembourg’s service provider community has had time to hone its expertise in handling other regulated fund structures such as the SICAR and SIF, introduced in 2004 and 2007 respectively.
“When they were introduced we established a fund administration function here in Luxembourg,” says Alan Dundon, a director at Alter Domus, one of the world’s leading providers of corporate and fund services to the private equity community. “In that respect the AIFMD is not particularly new for us. That’s reassuring for the private equity community because they see in Luxembourg the presence of key players such as ourselves who have been servicing them in various ways for many years.”
Not that private equity managers are bolting out of the stable door to become compliant. Many will take full advantage of the grandfathering period that runs until next July and even then, certainly among non-European managers, the choice of whether to opt in or continue with private placement will need to be based on careful cost-benefit analysis.
Pascal Hernalsteen, Head of Private Equity and Real Estate at CACEIS Bank Luxembourg, believes that next summer the number of AIFMs will start to gain traction, even among smaller managers who fall below the EUR100million threshold: “They understand it will benefit their image in the market and give them more leverage in terms of raising capital. Broadly speaking, we expect the AIFMD to potentially bring the same benefits as the UCITS Directive brought to Luxembourg. As Luxembourg already has a significant market share in UCITS funds we hope to attract more alternative investment funds here.
“We can’t rest on our laurels however. Luxembourg’s position has always been to adjust and adapt to the market,” states Hernalsteen.
Depositary services under the AIFMD
One of the major focuses for both financial and non-financial firms is ensuring that they become AIFMD-compliant with respect to depositary services and the enhanced regulatory reporting requirements, which will require firms to file within 30 days post quarter end as opposed to 60 days for quarterly Form PF filers.
With respect to depositary services, Credit Suisse is already fully compliant. As Jean-Daniel Zandona, Director, Sales Management at Credit Suisse Fund Services (Luxembourg) explains: “We have been investing over the last 24 months to adapt our servicing model to cope with increased depositary liabilities and to take a stance regarding the new duties imposed by the Directive. For instance, vis-à-vis our relationship with prime brokers, our look-through duties on multiple layer private equity deal structures etc.
“Beyond pure back-office services, our clients seek more and more upstream AIFMD solutions and guidance. In this respect, Credit Suisse has proudly obtained the very first AIFM authorisation in Luxembourg. In the future, our clients will profit from our “AIFM for rent” solution by using a separate “SuperManco” for which we are currently waiting final approval. This will allow our private equity, and more broadly, our alternative clients, to focus on deal sourcing and execution, while we do the heavy lifting in terms of AIFMD obligations.”
Partington adds that setting up a ManCo service could well be an important growth area for Ipes as well as providing depository services: “We are looking at ManCo services and are also actively seeking to add an acquisition in Luxembourg. This is an attractive area for us going forward.
“For Ipes, the key is to ensure that we deal with the main issues of risk management and depositary services. We are reviewing the timing of our depositary offering in Luxembourg. Part of the reason we have not yet set up is that all fund managers that need a depository already have one. We’re not in the business of chasing other people’s clients to switch. If clients look for a change, they usually approach us directly.
“We haven’t therefore decided upon the exact timing of our depositary service in Luxembourg, suffice to say we expect to establish in Luxembourg within the next 12 to 18 months.”
There’s no doubt that regulation is playing to the hands of service providers. The ability for non-financial firms like Alter Domus, who already work with 12 of the 20 largest global private equity houses, to combine depositary services with fund administration represents a compelling growth avenue over the coming years. According to Dundon, developing its depositary function has been an exciting evolution for the firm over the last couple of years.
“For private equity clients, even though today they may be using unregulated structures they can see the potential of non-financial depositaries and our ability to fulfil that role,” explains Dundon.
“In the past when you had specialist fund administrators working with a financial institution as depositary it was accepted that most of the work was done by the administrator who had access to the asset manager and the fund’s assets themselves. So we saw ourselves as an ideal candidate and our application is currently subject to approval by the CSSF.”
At the same time Alter Domus has applied for a depositary license in the UK to support its UK clients and is currently under review by the FCA.
What this shows is that both financial and non-financial firms will look to leverage on the ability to provide custodian services. This makes logical sense. After all, monitoring the activities of a private equity fund is a completely different beast to monitoring other funds. Their assets are not market-traded securities but companies, land assets etc. This presents much more of a challenge to traditional bank-owned custodians and explains why firms like Alter Domus are well positioned. It will no doubt result in synergies between financial and non-financial firms and as Dundon adds:
“If you look at every one of our non-regulated structures they all have bank accounts so we are used to working with banks for cash management, for example.”
Costs of depositories
Everybody it seems has a different answer when it comes to assessing the potential costs of AIFMs appointing independent depositaries. In simple terms, the more service providers can provide an integrated solution the lower the frictional costs will be to funds. That is because more of a fund’s risks will be contained within one institution; the more service providers (fund administrators, prime brokers) a custodian has to deal with the more costly it will be to a manager because the custodian is, after all, on the hook for any potential liabilities incurred by the AIF.
In Hernalsteen’s opinion, the cost impact will be on service providers. The onus is on firms like CACEIS to improve their operational efficiency to better cope with these regulatory constraints:
“We are looking to offer a bundled service – fund accounting and custodian bank services. When you maintain a portfolio for accounting and for the depository bank there are clear synergies to doing this yourself. The best way to mitigate fixed costs is to increase volume,” says Hernalsteen, meaning that the more firms can achieve economies of scale, the lower the cost will be to managers.
“If you can set up a model that allows the private equity manager to come into the fund administrator who then also provides depository services and who manages that whole process, you cut out a huge level of duplication work. You keep the same level of controls but you simplify the process to the maximum extent. The reason we went into this was not necessarily because it’s a great new product, it’s because clients need access to an integrated solution using the most efficient model possible,” says Dundon.
Partington confirms that Ipes has an automated service that oversees all the cash monitoring and transactions “using a SWIFT-enabled bank portal that takes feeds on a daily basis for our clients. This avoids exchanging hundreds of emails; it’s a pragmatic unobtrusive approach for a depositary.”
On the reporting side, there is probably less of a burden on fund administrators but nevertheless firms like Credit Suisse are evolving to cope with the additional demands of the Directive.
Zandona says that Credit Suisse offers customisable operations reporting thanks to having the right systems in place and good people but he goes on further to explain that in the context of the AIFMD, traditional reporting on portfolio transactions or on capital activity “is not enough”.
“To fulfil their increased oversight and governance duties, private equity AIFMs need to rely on more sophisticated providers, able to support the initial risk framework definition, and the ongoing reporting that comes along with it. This is where we can help third party managers going forward, producing amongst other things, conducting officers’ reports, or Key Performance and Risk Indicators.”
In terms of the expected uptake among private equity firms to comply with the Directive, much will depend on their LPs, or potential LPs. Hernalsteen believes that the pendulum has swung the other way: whereas previously the focus among institutions was chiefly on performance, now the focus is much more on the safety of investments.
“We see a lot of debt funds such as LBO funds now starting to invest in primary and secondary market debt. These are quite closely aligned to the private equity market and whether they are private equity or debt fund managers looking to appeal to institutional investors, the investor committees at big pension funds are looking much more closely at the safety of these investments.
“Managers need to demonstrate that they are compliant. So to that extent, even though the AIFMD brings no value to the manager, it brings value to their investors,” says Hernalsteen, adding that those who don’t adapt will likely disappear in this Darwinian environment that regulation has created.
“Depending on which kind of investors and asset classes they target, and on how they are organised from a corporate and substance standpoint, PE firms have diverging agendas. For managers placing their illiquid funds (i.e. Private Equity but also Real Estate or Hedge Funds) towards onshore regulated investors, in Europe or beyond, such as pension plans, funds of funds, HNWI or other professional investors, the Luxembourg SIF regime under AIFMD is a must,” states Zandona.
Technology developments under the Directive
One of the biggest technology challenges facing fund administrators is how to deliver an effective valuation solution in order to support the reporting and – if they are also offering depository services – general oversight function of private equity funds. This has never needed to be done until now. The vast majority of private equity houses staunchly adhere to customised internal valuation models that they have developed over many years. The idea that this needs to be handled by external parties is a potentially unsettling scenario.
KPMG is well aware of this and has engaged in discussions with a number of private equity houses to explore how they could improve their valuation reporting either for internal purposes or for investor/regulator reporting purposes.
“This has led to us this year developing a solution that automates valuation using Visual Basic Excel programming as well as external financial data sources which can plug in to it. The approach we take is to tailor the model according to the existing cash flow streams that each GP receives,” comments Yves Courtois, partner of KPMG in Luxembourg.
The solution was first implemented this January and the response seems to have been favourable thus far.
“In terms of expected cost efficiencies it will depend on the individual GP. Once we have a robust process in place, unless there are significant developments taking place in one of the portfolio companies or there’s a change in the business model for example, we expect to achieve substantial cost reductions for managers.
“The valuation solution we’ve developed is a demonstration of how to use technology to achieve the maximum level of efficiency and quality of the valuation process,” states Courtois.
Advent Software has been equally responsive to supporting private equity managers. As they prepare to deal with regulatory reporting under the Directive, the need for system consolidation is perhaps greater than ever. Operational efficiency is key. The last thing GPs need is to be pulling data from five different accounting engines.
This has led Advent to create Geneva World Investor, the firm’s integrated solution for portfolio management, investor accounting and servicing.
At its heart lies flexibility; something that Advent paid close attention to when speaking with private equity managers and administrators. To accommodate a variety of fund structures the platform incorporated an n-Tier fund structure function. This allows for the unlimited creation of entities within a structure including multiple masters, multiple feeders, blockers, AIV’s, SPV’s.
“The purpose of Geneva World Investor is to provide firms with system consolidation. We can support firms across all fund structures. Whereas other firms tend to focus purely on the mutual fund side or the hedge fund side or the private equity side, we focus on the whole suite,” says Jesper Steiness, director of sales in EMEA at Advent.
“Advent gives firms the ability to leverage greater efficiencies across asset classes and manage deep, complex workflows. This in turn allows firms to penetrate new markets and greatly increase revenue opportunities while consolidating disparate systems and lowering total cost of ownership,” adds Eddie Russo, solutions consultant at Advent Software, who continues: “Firms can now competently manage hedge funds, private equity funds, fund of hedge funds, limited partnership funds & hybrid funds in a single platform.”
Courtois concludes by saying that there’s a clear motivation by Luxembourg’s regulator to grow the private equity fund space over the next five years: “There’s probably something quite unique happening here in the sense that everyone seems to be on the same page from the politicians through to managers and service providers; they are all geared towards the same objective, and that community objective will likely contribute to the success of Luxembourg.”