Managers of private equity funds and other private investment funds that are registered as investment advisers with the Securities and Exchange Commission (SEC) under the Investment Advisers Act of 1940 (Advisers Act) are required to comply with Rule 206(4)-2, known as the custody rule. The SEC’s Division of Investment Management has provided guidance on applying the custody rule to two common scenarios that arise in the structuring of investments and dispositions by private equity funds and other private investment funds:
- The use of special purpose vehicles (SPVs) for making investments
- The use of escrow accounts when selling interests in portfolio companies
The Custody Rule
The custody rule applies to private fund managers who are registered as investment advisers at the federal level, and specifies a number of requirements that apply when an adviser has custody of advisory client funds or securities. For this purpose, pooled investment vehicles, such as private equity funds and other private investment funds managed by a fund manager registered as an investment adviser, are considered to be advisory clients of the fund manager, and the fund manager generally is considered to have custody of the assets of those private funds.
Fund managers are exempt from many of the custody rule requirements if they comply with the audit provision of the custody rule with respect to their managed private funds.
The audit provision requires, among other things, that the private fund be audited at least annually by an independent public accountant registered with, and subject to regular inspection by, the Public Company Accounting Oversight Board. It also requires that the audited financial statements be distributed to all beneficial owners of the private equity fund within 120 days of the fiscal year-end of the fund, or within 180 days of the fiscal year-end for a fund of funds (Rule 206(4)-2(b)(4)).
Generally speaking, most fund managers choose to comply with the audit provision. A fund manager who does not rely on the audit provision must, among other things, obtain an independent verification of the funds and securities of each private fund managed. The fund manager also must have a reasonable basis for believing that the qualified custodian sends quarterly account statements to each beneficial owner of the private equity fund (Rule 206(f)-2(a)(2)-(5)).
The custody rule does not apply to exempt reporting advisers.
Private equity funds and other private investment funds often use SPVs to facilitate making portfolio investments. These SPVs often are wholly owned by one or more funds managed by the same fund manager, though in some situations there also may be outside investors in an SPV that are not funds managed by the fund manager (and thus are not advisory clients of the fund manager within the meaning of the Advisers Act).
The SEC, in adopting the custody rule, stated that a fund manager could treat an SPV as a client separate and apart from the related private funds, or the manager could treat the assets of an SPV as assets of the related private funds.
In situations where a fund manager treats an SPV as a separate advisory client under the custody rule, the fund manager must comply separately with the custody rule’s audited financial statement distribution requirements. In other words, the fund manager must have the SPV audited, and then must distribute the audited financial statements of the SPV to the beneficial owners of the private funds that own the SPV.
In situations where a fund manager treats an SPV’s assets as assets of the private fund that owns the SPV, the SPV’s assets must be considered within the scope of the financial statement audit of the related private funds. This treatment generally involves including the assets and liabilities of the SPV in the financial statements of the private fund that owns the SPV and results in footnote disclosure concerning the SPV. However, a separate audit of the SPV is not necessary.
SPVs Owned Solely by Managed Funds
The SEC’s recent guidance addresses three common scenarios that arise in the use of SPVs by private equity and other private fund managers, and clarifies that the assets of an SPV can be included in the audit of the applicable fund in each scenario:
- One private fund creates an SPV for a single investment.
- One or more private funds invest in an SPV that holds a single investment.
- One or more private funds invest in an SPV that holds multiple investments.
In each case, this guidance applies only if the SPV has no owner other than the private fund manager, the manager’s related person(s), or private funds managed by the fund manager or the fund manager’s related person(s).
SPVs Owned by Managed Funds and Third Parties
Another common scenario in the use of SPVs by private fund managers is to establish an SPV through which one or more private funds managed by the fund manager invest, but in which third-party investors also invest. In this scenario, the SPV has third-party owners other than the fund manager, the fund manager’s related person(s), or the fund manager’s private fund clients.
The SEC guidance states that in this scenario, the SPV must be treated as a separate client for purposes of the custody rule. Therefore, a fund manager seeking to comply with the audit provisions of the custody rule must have the SPV separately audited and comply with the custody rule’s audited financial statement distribution requirements with respect to the SPV.
Escrows frequently are used in connection with the sale of a portfolio company owned by one or more private equity funds or other private funds managed by a registered investment adviser. Where there are multiple sellers, as part of the sale or merger, the sellers (including the private funds and the other owners of the portfolio company) often appoint a “sellers’ representative” to act on their behalf with respect to a portion of the sale proceeds held in an escrow after the closing. The escrow generally holds a percentage of the sale proceeds to be used in the event of indemnification or an adjustment of the sale price of a portfolio company, as required by the transaction agreement. An escrow typically lasts for a limited period of time and the funds remaining after such time are distributed based on a predetermined formula to the sellers, including the applicable private equity funds.
Application of the custody rule to this type of escrow arrangement generally would require that the portion of the escrow applicable to the private fund be held in a separate escrow account for the benefit of only that private fund, rather than in a commingled escrow account for the benefit of all of the sellers.
The guidance provides that a private fund manager can participate in a commingled, post-sale escrow account without violating the custody rule if:
- the private fund relies on the audit provision and includes the portion of the escrow attributable to the fund in its financial statements;
- the escrow is in connection with the sale or merger of a portfolio company owned by the fund (i.e., for indemnification or to adjust the purchase price);
- the escrow amount is agreed upon as part of a bona fide negotiation between the buyer and the sellers;
- the escrow exists for a period of time that is agreed upon as part of a bona fide negotiation between the buyer and the sellers;
- the escrow is maintained by a qualified custodian; and
- the sellers’ representative is contractually obligated to promptly distribute the funds remaining in the escrow at the end of the escrow period based on a predetermined formula to the sellers, including the private equity fund.
Private fund managers may wish to take this guidance into account in structuring escrow arrangements in connection with portfolio company depositions.
Full text of the SEC’s guidance on applying the custody rule to these private equity situations is available online.