The importance of implementing an institutional-quality infrastructure for Marketplace Loan Funds

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[Editor’s note: This is a guest post from Jeremy Christensen, Director of Private Fund Custody and Meg Zwick, Director of Alternative Custody Services from Millennium Trust Company. Millennium Trust Company is a bronze sponsor and will be in attendance at LendIt USA 2015 on April 13-15. In this post, they talk about the importance of implementing an institutional-quality infrastructure for marketplace lending loans.]

A WATERSHED MOMENT FOR MARKETPLACE LENDING

For a lot of the folks involved in the marketplace lending industry, last year’s Lending Club IPO was a watershed moment. The industry had ‘arrived’. No longer viewed as a fringe business idea but a mainstream success, marketplace lending is continuing its evolution. For some of us (largely service providers), the watershed moment actually happened back in 2008 & 2009, when both Lending Club and Prosper reopened after registering with the SEC. Not only did this signal a maturing industry and set the stage for further institutionalization, but with SEC registration, came the need for a more ‘institutional-quality’ mindset. Innovation tempered by a need to meet regulatory requirements and focus on operational soundness.

NO GOING BACK: THE TRANSFORMING LANDSCAPE

Not only did lending platforms begin registering as advisors with the SEC, but the loans themselves were now being registered as securities. Individual investors were already exploring ways to invest in these loans, putting the ‘peer’ in ‘peer-to-peer’ lending (often via self-directed IRAs or standard taxable accounts), and interest from institutional investors and other registered investment advisors (RIAs) accelerated.

It didn’t take long for investment managers to begin structuring private funds or separately managed accounts (SMAs) that invest in marketplace loans, and the first securitizations of these loans occurred roughly one year ago. All signs of a developing asset class; and for fixed income or high-yield investors, a short leap from the types of investments in which they are already well versed. More recently, investors have been exploring opportunities to further diversify their marketplace loan holdings by not only spreading their investment risk across multiple platforms and credit qualities but across regions as well.

OPERATIONS FOR MARKETPLACE LOAN FUNDS

In order to take advantage of the opportunities this emerging asset class may offer, fund managers need to focus on more than the strategies they intend to execute. They need to consider how to effectively structure their funds and organizations in ways that address both increasing regulation and investors’ concerns about the safekeeping of assets. To paraphrase something we’ve heard from clients on multiple occasions, custodians provide an essential service you don’t know you need, until you find out you need it. And from our perspective, it is better you find out that you need a custodian for your investments from us, rather than the SEC, during an examination.

REGULATORY SCRUTINY OF REGISTERED INVESTMENT ADVISORS

In recent years, an outbreak of issues related to RIAs  misunderstandings about the SEC Custody Rule has landed some advisors in the headlines. The problem has been so pronounced that the SEC issued a Risk Alert in March 2013 related to compliance with the SEC Custody Rule. It put RIAs on notice. The SEC Office of Compliance Inspections and Examinations announced it had found significant deficiencies in custody-related issues at more than one-third of the firms it had examined. Custody continues to be a priority for SEC examiners this year.

In some cases, investment advisors ran into trouble because they thought that the functions performed by their administrators satisfied the requirements of the Custody Rule when, in fact, they did not.

RESPONSIBILITY OF CUSTODIANS AND ADMINISTRATORS

Custodians and fund administrators provide services that are utilized in day-to-day fund operations. However, their roles are not interchangeable and certain tasks fall squarely under the purview of qualified custodians as per the Custody Rule. The exact nature of the relationship between qualified custodians and administrators can vary from manager to manager, as it can be crafted by them based on the needs of the firm, its funds, and its investors. In some cases, the roles are flexible; in others, they are not. When the custodian is initially engaged, part of the challenge is to remain sensitive to the rhythm the fund manager has established with the administrator. Understanding the differences can help fund managers not only meet the requirements of the Custody Rule—the current focus of many SEC examinations—but meet investors’ expectations for independence and checks and balances.

INVESTORS AND OPERATIONAL DUE DILIGENCE

Investors are not content to accept assurances that operational systems are sound without confirming for themselves through a dedicated operational due diligence process. If a fund manager’s ambition is to grow and attract larger individual or institutional investors, having the right components in place to meet investors’ operational due diligence standards is critical and can give RIAs a strategic advantage when it comes to winning new business. Funds engaged with an independent, qualified custodian in tandem with an administrator can help create checks and balances, as well as operational efficiencies that provide additional oversight and benefits to investors.

FOR 2015 AND ON

It’s been exciting to be involved in this industry and to lend our service and expertise to help it grow. As investors become more sophisticated in their evaluation of alternative investments (committing significant time and resources to dedicated operational due diligence processes) and regulators step up their examinations (paying particular attention to the custody of investor assets), it is important for fund managers to keep pace with industry standards by adopting a best-practices approach to fund operations. For fund managers, putting an institutional-quality infrastructure in place at the fund’s inception will increase operational expenses. However, addressing regulatory and investor concerns about the safekeeping of client assets from the start helps to position them for growth and can increase the chances of successful capital-raising campaigns. As Marketplace Lending continues to mature and attract investors, it is best served when all parties work together to help fund managers deliver high-quality offerings.

About Millennium Trust Company

Founded in 2000, Millennium Trust celebrates 15 years of providing its clients with innovative and cutting-edge custody solutions. Millennium Trust Company is a leading financial services company offering niche alternative custody solutions to institutions, advisors and individuals. The firm serves as a complement to services offered by other custodians. Millennium’s innovative solutions include rollover solutions, alternative asset custody, private fund custody and advisor support solutions. Millennium Trust performs the duties of a directed custodian.  As such, it does not provide due diligence on prospective investments, sponsors or service providers and does not sell investments or provide investment, tax or legal advice.

 

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