Following the flurry of consultation papers the fog is starting to clear on exactly what needs to be done to act as depositary for real estate and private equity funds and what impact it will have on fund managers. There is still time for interested parties to comment with Treasury paper responses due before February 27th. The FSA and Treasury are still able to exert some national discretion in respect of implementation of certain AIFMD matters and the area of acting as a depositary is one such area, particularly in the context of acting as a depositary to real estate and private equity funds.
The effort to respond to consultation papers has borne fruit however, with the FSA acknowledging the need to introduce competition to the banks in order to drive depositary costs to levels more in line with the risks associated with acting for these type of funds. There are literally hundreds of UK limited partnerships which have never needed a depositary before and traditional bank custodians are not familiar with these asset classes or the markets. One way that they have helped is to introduce the concept of the “PE AIF Depositary” with a lower level of regulatory capital of €125,000, enabling firms such as Langham Hall to act.
Who needs one?
In our newsletter of May 2012, we reported that real estate faced greater challenges than private equity, especially the smaller fund managers. The main reason for this is the increased use of leverage at the level of the fund. The rules provide that if total assets under management are below the threshold of €500m and there is no “fund level” leverage, there will be no requirement for a fund to have a depositary. However the existence of leverage brings the threshold down to total assets under management across all funds of €100m (excluding funds whose investment periods have closed and where there are no follow on investments to be made). The main problem for which we have been unable to find a solution concerns real estate funds and what constitutes fund level leverage.
Definition of leverage
Just before Christmas, Langham Hall and the Property and Finance Forum hosted a breakfast in which the BPF and EPRA and a collection of senior finance professionals from real estate gathered to debate this point and others. The conclusion we drew was that as long as the debt was at SPV level and not cross collateralised then it should not constitute fund level debt. This approach would be consistent with private equity funds which excludes debt within portfolio companies. However on subsequently speaking to the Treasury (who incidentally have a very good grasp of the issues), the definition may not be as clear cut and seems to be more about whether the fund set out to be highly geared versus specific and sensible gearing obtained in order to acquire a specific asset.
The uncertainty here is not ideal since a significant proportion of real estate industry fund managers has between €100m and €500m of assets under management. This needs to be clarified as a matter of urgency in order for managers to ascertain whether they are in or out of scope. The main conundrum is whether to risk pushing the point and achieving an adverse judgement, or to leave the ambiguity and use one’s own “common sense” judgement that using the “SPV Rule” would protect the fund from debt exposure. The main practical challenge will be for managers’ legal counsel to confirm this point in writing – quite rightly they are nervous that it could go either way.
Role of depositary
There are three main areas of activity for the depositary. In summary they are as follows –
The good news attached to the last requirement is that real estate and unlisted shares are not deemed to be capable of being held in custody. Therefore the “PE AIF Depositary” will have as its main responsibility to verify and record the ownership by the fund of the various entities in the Bid Co or acquisition structure of portfolio companies, down the chain to the operating company or real estate ultimately acquired. For real estate there is the additional work involved with verifying the ownership of the property or indeed “site”, which could take various forms depending on the transaction.
In practice, it will be difficult to avoid the depositary being involved with the acquisition process given that once an acquisition completes, it will be too late to verify ownership. Clearly there will be some work up front to look at the systems and procedures a manager is intending to use to verify ownership itself and collect the necessary information to provide to the depositary. It may therefore be possible to take a more compliance based approach with private equity funds or with simple real estate funds with, for example, central London residential assets. However, more complex private equity real estate funds will have different acquisition scenarios and will involve work up front to agree what needs to be done – a little like a KYC exercise prior to a fund launch.
How much will it cost?
The additional piece of good news in terms of pricing this service is that unlike assets which can be held in custody where there is strict liability for loss by the depositary of assets, where assets cannot be held in custody, the depositary’s liability for failure to properly fulfil its obligations is negligence based. In terms of cost, it is difficult to be exact at this stage since we have only recently had a more complete scope of requirements to discuss with underwriters. However the ability to tailor the approach to each scenario, work to identify and resolve issues plus knowledge of the asset class and in particular what to expect from a property or private equity transaction will all be important factors in reducing risk and being able to price below the traditional banking model.
Various ranges are beginning to be discussed but given the costs are new they are unlikely to be welcomed unless the manager feels as though they are getting extra services and genuine risk reduction.
If you would like to speak to someone in connection with AIF Depository Services at Langham Hall, please contact Rob Short on 020 7597 7900.