Depositary services to alternative investment funds investing in emerging markets

5th September 2016

In the private equity and real estate sectors, we see managers increasingly looking to emerging markets for attractive investments and growth opportunities, such as Asia and Africa. This trend has increased with the low interest rate environment of recent years and the difficulties of finding attractive assets in the traditional markets. These potentially attractive returns often bring with them a higher level of risk.

When assessing the risks of investing in a particular emerging market, a manager will consider its political stability, how well the rule of law is enforced, levels of corruption and standards for controlling money flows, and then they will determine if the potential rewards are worthwhile.  The depositary has to do exactly the same and needs, therefore, to perform an initial risk assessment before agreeing to act, and this should be done during the acceptance process. Following this, based on the increased level of risk, it will implement an appropriate monitoring plan.

It is a crucial step which not only impacts the acceptance itself and the ongoing monitoring plan but also the terms of the depositary agreement and the level of fees with any associated risk premium.

Country risk
Risks are usually specific to each country, with both its political and economic structures influencing the general exposure to financial crime and money laundering. Ascertaining the level of risk of a particular country could be complex. There is a lot of available information and country risk indices from various public sources (OECD, FATF, the World Bank, Transparency International and the World Economic Forum), but there is no exact science and no universally agreed methodological approach that clearly defines whether a particular country represents too great a risk.

Whatever the information and country rankings the depositary is using, its assessment should be based on credible sources and the information needs to be analysed independently without the influence of profitability aspects. In that respect, the involvement of the compliance officer could be useful as this is also something he/she needs to monitor on a regular basis.

Asset risk
For private equity investments, the depositary should also pay attention to the business in which the target companies are operating.  For example, statistics suggest industries more susceptible to   corruption include oil and gas, defence, logistics, telecommunications and pharmaceuticals. Gaining access to, or staying in, these industries often involves public procurement and licences issued by state authorities, with obvious susceptibility to corrupt practices.

In real estate, the most common risks for a depositary revolve around title and expropriation, in particular in countries where freehold and its associated resources are the property of the State, and where real estate assets are “acquired” on a leasehold basis. This risk could be also applicable for infrastructure assets which are frequently state-owned as well.
Understanding of the governance structure
The next element to be considered during the acceptance process is fund governance. For any investor, a robust governance structure is a critical factor in any fund, but particularly for funds investing in emerging markets. Governance is a form of investor protection especially in the context of emerging markets where familiar and trusted service providers that typically give comfort to investors in more developed markets may not be fully present.

Fund governance is often linked to corporate governance. Although some principles and practices appear similar, there are important differences. Investment funds operate by appointing service providers under terms contained in service agreements with the fund, and each service provider is governed by its own governing body independently of the fund. This means that fund directors do not have any authority to direct the affairs of the service providers to the fund other than under the contractual responsibilities set out in the service agreement. Day-to-day managerial responsibilities are typically delegated to the investment manager.

From this, we can infer that the reliability of the fund’s governance structure is dependent on the quality and the reputation of the service providers involved. Therefore, as part of its assessment of a fund’s governance, the depositary should undertake discussions with the key service providers, in particular the auditor, who is also performing similar acceptance/reacceptance procedures in accordance with the International Auditing Standards.

For an existing fund, it will be appropriate for any incoming depositary to contact the retiring depositary to obtain an understanding as to the reasons for the change of depositary and any pending issues. This will particularly help the successor depositary to assess issues such as management integrity. Obviously, permission from the prospective client will be necessary but, in case of refusal, the successor depositary may consider the implications of that refusal in deciding whether to accept the client.

As part of the AML/KYC procedures, checks on the shareholders and beneficial owners of the fund will be performed using internet search engine or electronic databases like World-Check. In the case of joint ventures or minority interests in underlying investments, it is also necessary to perform some of this checking on the co-investor(s). When a third party lender is involved in the financing of the project, it will have to review the investment activity of the fund and its governance structure.

Testing the flow of information
To perform its duties properly and on a timely basis, the depositary is heavily dependent on reports and data provided by the fund managers and the other service providers. For an existing fund, depending on the assessment of the country risk and fund governance, the depositary should test the protocols and controls in place to ensure that it can access to the fund data it needs. For a new investment fund, the review of the operating memorandum and a general understanding of the manager’s governance infrastructure is a good starting point.
According to article 90(2) of the Commission Delegated Regulation (EU) No231/2013 (“AIFMD-CDR”), “the depositary shall be able to provide at any time a comprehensive and up-to-date inventory of the fund’s assets”. This testing is, therefore, particularly relevant for the asset safekeeping to ensure that all information regarding the chain of ownership is available wherever the investment is located, and translated where necessary.

Testing the flow of information will also enable the depositary to customise the depositary agreement (in accordance with articles 83(b) and 83(g) of AIFMD-CDR) and/or the operating memorandum by incorporating the specific obligations of the fund manager with regards to the information it needs to provide to the depositary.

The jurisdiction of the fund’s underlying investments has risk implications not only for investors but for the depositary and the other service providers. The fees of the depositary will, in part, depend on the perceived overall level of risk. This analysis stresses again[1] the importance to apply the right level of technical knowledge and experience in the corresponding asset class and in the investment fund industry. Country and industry knowledge is also important in performing depositary duties in funds investing in non-traditional or emerging markets. Applying a “tick box, compliance based” approach is unlikely to be sufficient.  

For some clients, the acceptance process could take some time depending also on the AML/KYC procedures. It is, therefore, important that the depositary clearly communicates to the fund manager, at an early stage, the different procedures that the depositary intends to perform in order to avoid misunderstanding and frustration. On one hand, the acceptance process enables the depositary to understand the fund’s activity and its associated risks. Thanks to this understanding, the depositary can better determine whether it has sufficient resources and expertise to execute the mandate. On the other hand, this ensures that the client business is conducted transparently and with integrity.

At the depositary level, it is also important to follow the “four eyes” principle during the whole acceptance process. In the context of an investment fund investing in emerging markets, the final decision may require a high level of professional judgement and, in such a case, having a second opinion is always valuable.
Langham Hall has depositary licences in the UK, Luxembourg and Jersey. It is the market leader for PE AIF depositaries in the UK with over US$40bn of commitments under supervision. The depositary department at Langham Hall Luxembourg received its CSSF licence in December 2015, and is led by Antoine Bonte and Clive Griffiths. Both have extensive audit backgrounds and have significant experience in the alternative investment fund industry (private equity and real estate). Such experience and expertise are essential to properly manage the acceptance process and raise the right questions on timely basis.

[1] Refer to our article: Control and the look-through approach for depositaries in Luxembourg

Antoine Bonte 
Director of Depositary Services – Luxembourg Office

T. +352 27 85 15 29
M. +352 661 332 034