In June 2014, the staff of the Securities and Exchange Commission’s (SEC’s) Division of Investment Management provided guidance (the Guidance Update) on how private fund managers using special purpose vehicles (SPVs) and escrow accounts may comply with Advisers Act Rule 206(4)-2 (the Custody Rule)  with respect to such vehicles and accounts.
Under the Custody Rule, registered investment advisers have custody of the assets of each private fund for which they or their affiliates serve as general partner or managing member or where they otherwise act in a “control” capacity. Such registered investment advisers (or private fund managers) generally comply with the Custody Rule by delivering audited financial statements for the fund to each beneficial owner within 120 days of the end of each fund’s fiscal year.
The Guidance Update clarifies how the audit provision of the Custody Rule applies to private fund managers whose funds utilize SPVs and/or escrow accounts. Depending on the circumstances, the private fund manager may be required to obtain a separate audit for SPVs and/or escrow accounts utilized by a private fund.
The Guidance Update provides that a separate audit of a SPV is not required if:
- The SPV’s assets are included in the scope of the audited financial statements of one or more private funds advised by the private fund manager; and
- The SPV is not owned by any parties other than the private fund manager, the private fund manager’s related persons and private funds advised by the private fund manager.
The Guidance Update clarifies that a separate audit is required for any SPV that does not meet the above requirements. This clarification could potentially be problematic for private fund managers who utilize SPVs such as liquidating trusts for the purposes of segregating their funds’ illiquid assets and making in-kind distributions to funds’ investors once any portion of the SPV is so distributed.
The Guidance Update with respect to escrow accounts is limited to a fairly narrow set of circumstances. With regard to escrow accounts, the Guidance Update states that the Division of Investment Management would not object if an adviser maintains assets owned by a private fund in an escrow account so long as:
- The portion of the escrow account owned by the private fund is included in the private fund’s audited financial statements;
- The escrow account is for the sale or merger of a portfolio company owned by the private fund;
- The amount of money held in the escrow account was negotiated by the buyer and seller of the portfolio company;
- The duration of the escrow account was negotiated by the buyer and seller;
- The escrow account is maintained at a qualified custodian; and
- The sellers’ representative is contractually obligated to promptly distribute the funds remaining in the escrow account at the end of the escrow period on a predetermined formula to the sellers, including the private funds.