The SEC has issued guidance to registered private equity advisers regarding escrow arrangements resulting from the sale of a portfolio company. The guidance revolves around a circumstance involving the sale of a portfolio company owned by one or more pooled investment vehicles (typically private equity funds) advised by a registered investment adviser (i.e. a private equity sponsor) and other persons that are not clients of the adviser. As part of the sale or merger, the sellers (including the adviser’s pooled investment vehicle client(s) and other non-client 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 following the closing of the sale or merger. The purpose of an escrow is to hold a percentage of sale proceeds to be used in the event of indemnification or an adjustment to the sale price of a portfolio company included in the terms of the purchase or merger agreement between the sellers and buyer. An escrow typically exists for a limited period of time and the funds remaining after such time are distributed on a predetermined formula to the sellers, including the adviser’s pooled investment vehicle clients.
The custody rule adopted under the Investment Advisers Act (Rule 206(4)-2) requires a registered investment adviser to maintain funds and securities over which it has custody with a qualified custodian (meaning certain banks, broker dealers and the like) in a separate account for each client in the client’s name, or in accounts that contain only the adviser’s clients’ funds and securities that are maintained in the adviser’s name as agent or trustee for the clients. The funds in an escrow often belong to both the adviser’s pooled investment vehicle clients and other sellers that are not advisory clients and are typically maintained in the name of the sellers’ representative. Under these circumstances, advisers believe that the primary protections of these joint escrows for their clients (and pooled investment vehicle investors) are similar in material respects to separate escrows or escrows with only clients’ funds and that creating multiple escrows to fully comply with the custody rule would not significantly change the protections and risks.
The SEC Division of Investment Management stated it would not object if an adviser maintains client funds in an escrow under the above circumstances with other client and non-client assets, provided that:
- the client is a pooled investment vehicle that relies on the “audit provision” and includes the portion of the escrow attributable to the pooled investment vehicle in its financial statements. The “audit provision” requires, among other things, the pooled investment vehicle to be subject to audit at least annually by an independent public accountant registered with, and subject to regular inspection by, the Public Company Accounting Oversight Board, and for the audited financial statements to be distributed to all beneficial owners of the pool within 120 days of the pool’s fiscal year-end.
- the escrow is in connection with the sale or merger of a portfolio company owned by the private equity fund (i.e., for indemnification or to adjust the purchase price);
- the escrow contains an amount of money that 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 at 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 on a predetermined formula to the sellers, including the pooled investment vehicle clients.