Fund Governance Insights

An alternative watchdog

6 minute read time

Depositaries play a crucial role in improving governance at alternative funds


  • As well as reviewing funds’ governance, depositaries help monitor cash flows, act as custodians for listed securities, and check legal ownership of alternative assets
  • While retail funds must appoint an independent depositary in all contexts, the rules are different for professional investor funds who fall within scope of AIFMD regulation
  • Today’s investor is also focused on governance, and prepared to ask questions about the service providers appointed by the fund manager

In its ‘Dear CEO’ letter sent to alternative fund managers last year, the Financial Conduct Authority called out low standards of governance as an issue that the sector needs to address. To this end, a fund must act in the best interests of investors by protecting and growing their capital over the long term.

The letter makes clear that governance is not a standalone issue. Rather, the FCA sees the way an alternative fund manager approaches governance as an indication of how effective they are at everything from assessing investment appropriateness to having secure controls over client assets and money, as well as diligence on anti-money laundering.

A key element of good fund governance rests with the depositary, which provides independent oversight to make sure that decisions at the fund are made in investors’ interests, scrutinising the fund managers and the functions that they delegate.

Depositaries are obliged to hold fund managers to account, ensuring that they and the services they use are showing the right behaviour and demonstrating a strong focus on governance, says Matthew Hiscock, Head of Alternative Investment Funds at NatWest Trustee and Depositary Services (TDS).

“The depositary needs to be prepared to ask hard questions and not stop until they get satisfactory and robust answers,” he says. “Having an independent depositary removes any real or perceived conflicts that may exist with a ‘bundled provider’ and we are noticing investors and independent directors becoming increasingly diligent when it comes to challenging fund managers on their control environment and responsibilities.”

Dual role and multiple challenges

A depositary has two main roles. First is to oversee the actions of the fund management company by regularly reviewing the fund’s policies, processes and governance arrangements. They are also tasked with safeguarding the fund’s assets, which they do by monitoring cash flows, acting as custodians for listed securities, and checking legal ownership of alternative assets.

Alternative funds present different challenges to depositaries compared with retail funds. The alternatives sector is generally characterised by more sophisticated investors who are prepared to take on higher levels of risk. Many alternative funds are private, unlisted and close-ended, with irregular inflows and outflows.

“We are noticing investors and independent directors becoming increasingly diligent when it comes to challenging fund managers on their control environment and responsibilities”

Matthew Hiscock, Head of Alternative Investment Funds, NatWest TDS

Any depositary needs to be aware of the challenges these factors bring, such as underlying issues in valuing assets and ensuring liquidity – which can be of particular pertinence in times of high market volatility, such as during the current pandemic.

It can be difficult to get true market valuations of investments such as unlisted companies and infrastructure, says Andrew Henderson, a partner at law firm Macfarlanes. “The rules are clear about the valuation process, but process and outcome are two different things and this could be an area for challenge. Depositaries scrutinise the processes and look at the assumptions and quality of information very carefully, considering the expertise of those making the assessments.”

The importance of attitudes

While all retail funds need to appoint an independent depositary, the rules are slightly different for professional investor funds. Under the terms of the Alternative Investment Fund Managers Directive (AIFMD), only funds that meet certain conditions must appoint a depositary that is not in the same group as the fund manager. But for those that don’t meet this threshold, the depositary still needs to be hierarchically and functionally independent. Julie Patterson of KPMG’s financial services regulatory insight centre says: “The FCA wants evidence of proper independence and establishes this by asking tough questions.”

Hiscock says that appointing an independent depositary gives a clear indication to the market that the fund manager is working to ensure that investor outcomes remain paramount. “This is a crucial part of ESG – with ‘G’ being governance – and gives investors comfort that the fund managers are taking the right steps to protect their investment,” he says.

NatWest TDS is seeing changes in behaviour towards depositary appointments, with tick-box attitudes being replaced by higher levels of engagement. Independent non-executive directors of alternative funds increasingly want to know more about the fund’s depositary selection process, the track record of their chosen provider and its independence, says Hiscock.

Alternative investors are also starting to ask some of these questions. In the past, many were concerned mainly with knowing who the fund manager was and whether they liked that manager’s investment style. Now, the investors are becoming more focused on governance and ensuring that the service providers appointed by the fund manager are doing their jobs properly.

Reputation management

Once the legal and regulatory requirements are understood, Henderson says alternative fund managers turn to the business and risk management issues. “A lot of factors will come into play around the reputation and experience of that depositary,” he says. “If a depositary serviced a lot of your peers, or those who you aspire to be peers of, then that would be a driving factor in deciding who to appoint.”

Much rests on the quality of the depositary, says Patterson. “Independence comes down to how the entity behaves, to the people in it and its management, and the importance of utter independence of thought and challenge.”

As alternative investment fund managers start taking on increasing amounts of business – such as investing in new asset classes and contemplating the extent to which their funds will be bought by retail investors, albeit indirectly – they start resembling institutional fund managers more than traditional private fund managers. 

With that increased size and complexity comes increased risk, says Henderson, at which point questions around the type and size of depositary become more important. “At a higher level, there is an increasing move for a lot of private fund managers to look more like institutions. And if they look like institutions, they have to behave more like institutions. At which point the justification for not appointing an independent depositary becomes more difficult.”

By Caroline Biebuyck