How do depositary arrangements apply to PE & VC firms?
Before the enactment of the directive, PE and VC funds typically did not have an external custodian or trustee holding the assets of the partnership.
That has now changed with the directive now requiring PE and VC funds to appoint a depositary to safeguard the assets of the fund. The arrangement between the fund manager and the depositary is a formal one - and a written contract of appointment is a mandatory requirement.
The AIFM cannot act as the depositary - instead, for EU AIFs the depositary must be an independent entity based in the same country as the EU fund and must be authorised by the local regulator as a credit institution or an investment firm. In Ireland’s case, the depositary must be authorised by the Central Bank of Ireland.
The directive does, however, give EU member states flexibility to allow professional service firms such as law firms and investment firms to act as depositaries for AIFs in certain circumstances; where funds have lock-up periods of at least five years or where funds do not invest in assets that must be held in custody. Many PE and VC firms will be able to avail of this flexibility.
What are the main responsibilities of the depositary?
The main responsibilities of the depositary are:
In practice, ownership verification may prove to be the most challenging duty of the depositary for PE and VC funds as PE and VC structures can involve numerous legal entities domiciled in several jurisdictions.
Must an AIFM appoint an external valuer?
Under the terms of the directive, a fund valuation must be conducted. It can be conducted internally by the fund manager or by an external third party. It is likely that many PE and VC funds will opt to have the fund manager conduct the valuation internally, in line with current practice.
But one key change that the directive brings is that the fund manager must ensure that any internal valuation is conducted independently of the portfolio management function. This means, in effect, that a portfolio manager is not permitted to value the assets in his own portfolio. The fund manager also has to mitigate any potential conflicts of interest and prevent any undue influence being placed on the individuals carrying out the internal valuation of the fund’s assets.
Obviously some smaller AIFMs with complex asset bases might find it difficult to ensure that the internal valuation is conducted independently of portfolio management. ESMA has indicated, however, that national regulators should apply the principle of proportionality to this requirement by taking into account the operational structure of the AIFM and its corporate governance arrangements.
The directive requires assets to be valued and net asset value per unit to be calculated at least annually. Some real estate and private equity fund managers with longer term investment horizons may have problems with this annual reporting requirement, which may represent a significant change to their existing practice.
How should investments be valued?
The directive provides for assets to be valued in different ways, such as by reference to prices on an active market or by an estimate using valuation models.
Where a model is used for valuing assets:
For funds, where prices in an active market are being used for valuation, fair value measurement as defined by IFRS 13 is appropriate and indicates the price at which the fund can exit its investment or transfer its liability. While an exit price is easy to define where there have been actual transactions, PE and VC funds will generally have to apply a valuation technique. While the IFRS 13 financial standard does not specify a particular technique to determine fair value, two of the most common techniques used for valuing private equity investments are referencing to comparable companies and discounted cash flow. Other less frequently used techniques include comparable transactions (which in the world of private equity, often means a refinancing round) or co-investor dealing.
Various valuation guidelines have also been issued by the private equity industries in Europe and the United States, the EVCA in Europe and the PEIGG in the United States. The broad principles are:
A variety of methodologies should be used to cross-check valuations but don’t be tempted to automatically take the median value of valuations produced by different models. The use of personal judgement is important.
Step 1: Identify all AIFs for which AIFM is appointed / identify internally-managed AIFs
Step 2: Calculate initial own funds (A)
Ref. Article 9 (1,2); L1
Step 3: Calculate additional own funds (B)
Unrelated to Professional Liability Risk ("PLR")
Ref Article 9(3); L1
(B) = (SUM of AIFs PTF - €250 million) * 0.02%
The required total of the initial amount (A) and the additional amount (B) shall not, however, exceed €10 million and shall never be less than a quarter of the previous year's fixed overheads.
Step 4: Calculate additional funds (C) related to PLR
(C) = Value of AIFs managed(*) * 0.01%
(*) Value of the portfolios of AIFs managed: the sum of the absolute value of all assets of all AIFs managed by the AIFM, including assets acquired through use of leverage, whereas derivative instruments shall be value at their market value.
The Directive requires AIFM to have either additional own funds or hold professional indemnity insurance ("PII") to cover potential risks arising from professional negligence.
Ref. Art 9(6), L1 and Art.14,15, L2
When an AIFM decides to choose to cover professional liability risks through professional indemnity insurance, PII needs to cover 0.9% of the value of the portfolios of AIFs managed for claims in aggregate per year, and 0.7% of the value of the portfolios of AIFs managed per individual claim.
The regulation requires AIFMs to establish policies and procedures for operational risk management, to be reviewed at least on an annual basis
Ref. Article 14 (2,4,5); L2
Step 5: Calculate total capital requirements (D)
(D) = (A) + (B) + (C)
Ref. Article 9 (5,8); L1 regarding investment in liquid assets
Does carried interest fall within the directive’s remuneration rules?
The directive’s rules on remuneration apply to all forms of payment paid by the AIFM, including carried interest and any transfer of shares of the fund.
The directive defines carried interest as a share in the profits of the AIF paid to the fund manager as payment for his management of the fund. It excludes any share in the profits of the fund which accrue to the fund manager as a return on his own investment into the fund.
Many carried interest arrangements already comply with some of the directive’s key rules on remuneration - particularly where carried interest is deferred and is in line with the concept that payment of carried interest is an incentive not to take unnecessary risks.
Some important clarifications on remuneration, carried interest and clawback have been produced by both the ESMA and the FCA.
ESMA has indicated that where a payment represents a pro rata return on investment by the AIFM’s employees then this should not be subject to the directive’s remuneration provisions. However, in order for these payments to be considered exempt, any loans made to employees by the fund manager will need to be repaid in full before the return on the fund’s investments is paid to those employees. This clarification by the ESMA is very helpful for co-investment arrangements. However, in a typical PE carried interest arrangement, employees usually pay a nominal amount to acquire their carried interest and are treated as acquiring the carried interest for fair market value for tax purposes.
The FCA has also provided its own clarification on the directive’s provisions on remuneration for the fund manager, particularly as to whether payment to a partner represents remuneration or a return on equity. The FCA has warned that fund managers should not allocate all payments to a partner as a profit share unless there is sound justification for doing so.
The Central Bank, however, has yet to produce guidelines on the directive’s remuneration provisions and it may not do so for some time.
In relation to clawback, ESMA has indicated that clawback provisions should apply to carried interest arrangements where a hurdle linked to return on capital must be overcome before carried interest payments are made to employees. ESMA believes that clawback provisions are necessary to ensure that the interests of employees of the fund manager are aligned with the interests of the fund’s investors. This is significant because currently most carried interest arrangements do not include a clawback provision.
The directive has specific requirements relating to the disclosure of remuneration in AIF annual reports. The total remuneration paid by the fund manager to staff and carried interest paid by the fund itself must be disclosed - with the total remuneration split between fixed and variable remuneration. Fixed remuneration is defined as payments that are not performance-linked while variable remuneration is defined as additional payments linked to performance or, in certain bases, other criteria.
Often carried interest is not paid to the fund manager but is instead paid to a special limited partner. This makes no difference, however, when it comes to disclosure as the directive’s rules on remuneration have been drafted widely enough to ensure that carried interest payments to a special limited partner must also be disclosed in the annual report.