Alternative model in an alternative world

It seems clear in everyone’s mind that the depository concept is borrowed from the EU’s retail fund (UCITS) legislation. And considering all the comments from the private equity industry, this concept was neither expected by the General Partners (GPs) nor by the Limited Partners (LPs). 

On this, the view of the industry has always been that the need to have a depositary would represent a significant, unnecessary, and potentially costly, change for private equity management in many EU jurisdictions.

Indeed GPs perform a significant amount of tasks when acquiring a new piece of business running through legal diligences, financial audit, and management screening of the target companies. GPs also engage high end service providers such as international reputable lawyers, chartered accountants, investment bankers to help them in negotiating, closing deals and confirming the final ownership of the portfolio companies. Finally, GPs elect board members at the level of the portfolio companies to ensure a proper follow-up on a regular basis.

Alexandre Prost-Gargoz

The European Private Equity and Venture Capital Association (EVCA) even quoted in one of its comment letters: “Policymakers justified this additional (unquantified) cost as necessary to protect investors against losses arising from fraud by the AIFM, citing the losses incurred by investors in Madoff funds as an example despite the fact that the EU Madoff funds were supposed to apply existing UCITS rules, including with regards to the depositary”.

The reason behind this reluctance arose principally because depositaries were mainly useful for hedge funds and not as beneficial for private equity funds. Hedge funds more actively trade in financial instruments and derivatives that could benefit from a depository’s safekeeping. However, the same principle was applied to the private equity sector which at times uses these instruments in the long-term participation of private companies. 

The safekeeping of financial instruments is a commoditised service that a large number of credit institutions offer and is strongly related with the settlement of any purchase and sales of such securities. This service is principally system-driven as it relates to automated deals, high volumes of transactions and is built around large IT infrastructures.

The safekeeping of unquoted securities is just as complex but in a totally different way as it requires specific and dedicated knowledge. Nothing is similar in a private equity deal. Admittedly the end purpose is to acquire a target company and yes, this will result in a large amount of cash being transferred. However, the variety of ways to invest is endless. It includes equity injections (directly or indirectly),l ending, co-investment through different forms of instruments from standard shares to preferred shares, from senior loans to mezzanine structures.

For a depositary, the main challenge in a private equity deal is to secure the relevant information and thereafter to ensure that the fund flow is correctly analysed, duly understood and properly documented for its follow-up. This analysis is far from the standard processes that are in place to provide custody in the mainstream industry. 

It requires closer proximity to the GP and a significant amount of human participation. Consequently, the role of the depositary is being enforced by the European Commission. Is it welcomed, however, by the industry? Perhaps not quite as much as the industry would have expected considering its self-regulation and fund governance being sufficiently robust. Is it anticipated by the industry’s investors? Not convincingly, as most of them in recent years have increased their level of supervision on GPs, obtain more regular and transparent reporting, and make better use of investor advisory boards. However, the depositary function is nonetheless coming soon and it’s certainly here to stay. Is there any way then to turn this into something positive? Or as business scholars are fond of quoting: Turning a threat into an opportunity.

SILVER LINING 

Certainly, some benefits could derive from such a regulation. On the governance side for instance, the depositary will certainly play the role of the catalyst in ensuring that all documents are centrally available in their latest executed version. This is particularly true when transaction closings happen in a rush and consequently all the documents are being frequently circulated around. On the transaction side, having an independent central point confirming the ownership may ease the legal due diligence of potential acquirers. 

However, this can only be done if the depositary function is correctly executed. It seems likely that its requirements will necessarily lead to the depositary being involved to some extent in both fund closings and transaction closings, which might have both cost and timetable implications. From a synergy perspective, bundling both the fund administrator and the depositary together allows obvious time saving and knowledge sharing on complex deals. As mentioned earlier, only detailed analysis of the fund flow would allow a clear understanding of a transaction and this analysis would be complex to achieve if carried out on a standalone basis. The same would prevail for cash monitoring as a quick understanding is necessary to avoid any delay in the transaction settlement.

All this obviously needs to be achieved at a fair price with the appropriate level of protection. This equation is still unsolved as the AIFM directive’s more detailed Level II measures are still in the last round of negotiation and should conclude on the liability regime of the depositary.

As already mentioned, the directive introduces a new player into the loop. This new layer can create complexity and uncertainty in transaction closings but at the same time it can also improve the governance and the good administration of the fund. Its implementation success will mainly rely on the ability of the current and future depositaries to walk away from the UCITS model and to find its own alternative model. 

Alexandre Prost-Gargoz is global head of private equity at Alter Domus. He can be reached at +352 48 18 28 1 or via email at Alexandre.prost-gargoz@alterdomus.com.