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Understanding fund custody: private vs publicly offered fund vehicles

When managers of private funds decide to launch a strategy as a registered mutual fund–such as an interval fund, tender fund, or a daily NAV fund, the topic of custody can sometimes lead to confusion. Private fund managers are typically familiar with custody services provided by their prime brokers as part of a suite of services to support their private funds. However, registered fund custody for funds such as interval, tender, or daily NAV funds—typically provided by a bank custodian—is quite different in both the nature of services and fees.

Institutional custody for registered fund assets

Custody requirements for registered funds are governed by the Investment Company Act of 1940, commonly known as the ’40 Act, which requires a third-party entity—a bank or a limited-purpose trust company—to safekeep investors’ assets to minimize the risk of theft or loss. This is the first and foremost purpose of a custodian.

In addition, bank custodians provide transactional processing, including facilitating trade settlement, collecting income, processing corporate actions, executing foreign exchange transactions, and providing daily cash investment options. The custodian may also calculate fees to be paid to the manager from investors in a fund.

In the private-fund space, prime brokers typically provide a subset of these services—but the business model revolves around the broker charging for that service as part of a spread. Because custody is bundled into that spread, some managers aren’t accustomed to thinking of custody among the costs of doing business.

How and why registered fund custodians are compensated

In the context of funds registered under the 1940 Act, custody services may be based around transactional volume. The custodian is compensated for processing those transactions (and the operational risk created by doing so) while also holding the fund’s assets in safekeeping.

In this case, a custodian takes on significant operational risk because of the high volume of transactions processed daily. Errors in mutual fund trading, corporate action, trade settlement, foreign exchange (FX), and cash processing are potential causes of material losses for a custodian. Understanding these risks along with proper controls (procedure, technology) can help mitigate these errors.

Why private funds benefit from a bank custodian, even when not required

Alternative funds not regulated under the ‘40 Act may still wish to partner with a qualified custodian other than their prime broker depending on the needs of their portfolio or investor demand.

Institutional and other qualified investors may prompt a manager to ensure their assets are safeguarded. A bank custodian, like UMB, has standardized, proven processes for handling assets that make investors more confident about their investment decisions.

Also, custodians have further branched out into complementary financial services, such as investment accounting, administration, tax services, foreign exchange services, treasury services and investment management. More recently, custodians have become providers of data to their clients. Using straight-through processing capabilities, a custodian is able to take in multiple data sources related to their customer’s investments, repackage that data, and transmit it to customers and their agents. Bank custodians like UMB may also be able to support alternative managers even further throughout the investment lifecycle with traditional banking & escrow services, investor servicing and fund administration.

As I outlined in a recent podcast with Real Assets Advisor, as alternative managers adapt to market conditions, investor demand, digital assets and more, they will continue to seek solutions to ensure the safe handling of client assets.

UMB’s is among the nation’s leading institutional custodians. Our team offers a complete range of domestic and global custody services with a high-touch service model. Visit umb.com to learn how we  can support your firm’s institutional custody needs, or contact us to be connected with a custody team member.

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