Private equity fundraising is riding high with unprecedented levels of institutional capital rushing into the asset class, frequently due to portfolio reallocations from other fund sub-sets like fixed income and hedge strategies.
The investors are institutional and highly sophisticated. Institutions of this calibre expect their managers to adopt best practices around fund governance, a key element of which is the appointment of an effective depositary that must act in the interests of investors and perform oversight of the fund during its life-cycle.
Having historically been subject to limited regulatory scrutiny, private equity is now facing far greater oversight following the implementation of the Alternative Investment Fund Managers Directive (AIFMD) in July 2014. AIFMD introduced the concept of depositary to private equity, whereby a third-party provider is responsible for ensuring the ownership and title to fund assets are verified; monitoring cash-flows in and out of the fund; and providing a qualified assessment as to whether the manager is compliant with its fund rules.
Some institutions are starting to question the potential conflict of interest risk at some providers. Many organisations will offer depositary as a bundled service with private equity fund administration, leading sceptics to ask whether these firms are properly incentivised to report oversight issues, particularly if it takes place under the same corporate umbrella. An independent depositary offering unbiased oversight has clear advantages for investors over an affiliated model.
A lack of proper engagement by some depositary providers is also leading to rudimentary errors and mistakes on the fund administration side of their business being missed. As awareness of the role and benefits of the depositary increases, more institutional investors will exert pressure on managers to appoint an independent depositary provider instead of relying on the bundled model.
Depositaries that adopt a minimalist approach to oversight could find themselves being black-listed by some investors. As such, private equity managers are being encouraged to hire proactive depositaries that will independently scrutinise their activities and flag concerns where appropriate.
Appointing an independent depositary serves private equity managers well during investor due diligence examinations. Unlike conventional financial instruments, real assets are held by the manager and not safe-kept at a custodian or prime broker, making it difficult to qualify asset ownership and existence. A private equity manager using a fully engaged, independent depositary will be able to demonstrate that the portfolio assets are legitimately owned thereby expediting the due diligence process.
Tax reform is also indirectly having an impact on the role of the independent depositary in private equity. Corporate governance is one area where private equity has been making material improvements, although some of these enhancements are being driven by rule-changes such as the OECD’s BEPS (Base Erosion and Profit Shifting) provisions, which seek to clamp down on tax avoidance and places the onus on organisations to show they have substance in the jurisdictions they are located in.
BEPS is aimed at rooting out domiciliation abuse, and preventing companies from establishing themselves in low-tax jurisdictions with limited substance on the ground.
Substance comes in many forms, but it is likely to result in directors having to prove that they are fulfilling their fiduciary obligations and that the fund is not simply based in an offshore location for tax purposes with no palpable business in the country.
One way directors can demonstrate BEPS adherence is through regular interactions with an independent depositary, which will be providing them with a steady flow of information on the underlying funds.
Fund managers looking to passport post-Brexit will also need to satisfy EU regulators that they have substance within the Single Market. ESMA has repeatedly warned that letterbox entities will not be acceptable, so managers will need to ensure their EU-27 directors are actually making meaningful decisions and reviewing operational processes.
Again, the role of the independent depositary in providing directors with the necessary information will be critical if firms are to prove that they are not running letterbox entities as and when the UK loses its Single Market access.
While it is relatively straightforward for an investor to withdraw capital from a poorly managed hedge fund offering quarterly liquidity, it is significantly harder to exit a private equity vehicle with a ten-year lock-up period. It is therefore critical for investors to ensure that their private equity managers are subject to thorough and regular oversight by an independent and well-versed depositary, especially as regulatory changes such as BEPS and Brexit begin to take effect.
