Private equity managers have made little secret of their dismay at being forced to appoint a depositary to look after assets which are intrinsically hard to custody, and even harder to misappropriate. The independent private equity administration specialist Augentius endeavours to provide a service which is an inexpensive and unobtrusive as possible.

“The need to have a depositary is one that is going to be with us for the future,” says David Bailey, group head of marketing, communications and product development at Augentius, the specialist private equity and real estate fund administrator. “It is not a one-off.” If there is a temptation to regard 22 July 2014 as a terminus, it is not one at which David Bailey expects to alight. At this point, an assets under management (AuM) figure below the €500 million threshold for private equity funds is the only way to escape registration as an alternative investment fund manager under the Alternative Investment Fund Managers Directive (AIFMD), and registering as an alternative investment fund manager (AIFM) entails the appointment of a depositary bank. Which is why Augentius set up a depositary company for its clients in March 2013. It took on its first client - the €6½ billion SL Capital Partners - four months later. “We have [ten] clients live now, and a steady flow of take-ons in the pipeline,” says Bailey. Though he does not see the immediate opportunity as massive – he estimates just 100 private equity firms in Europe are unable to escape compliance because they are above the €500 million in total assets under management threshold. Sub-€500 million managers that are not actively fund-raising are exempt. Private equity funds also remain a largely offshore phenomenon.

“If you are a hedge fund manager, and you have leverage at the fund level, the threshold is €100 million, which pretty much catches everybody,” says Bailey. “If you are a private equity manager, where the leverage is in the deal, not in the fund, then the entry point is €500 million in invested capital. You could be running three funds of €150 million each, and not be caught by the AIFMD. Since the threshold is measured by invested funds, and not by capital commitments, you could have two €500 million funds, and if one was not yet invested and the other was only 60 per cent done, you could have €1 billion of commitments but still be under €500 million. That is why only 100 private equity managers, or less, are actually in the marketplace for depositary services today.”

That said, David Bailey does predict the depositary business will continue to grow steadily over the next few years. “Over time, certain institutional investors will invest only in private equity funds that are AIFMD-compliant,” he says. “They will be driven to that conclusion by their political lords and masters. So there will be pressure from limited partners. There will also be managers that want to raise a fund, and see it as advantageous to be seen to be AIFMD-compliant. In addition to that, there are a lot of managers from outside the European Union (EU) that want to raise money in Europe, which will require passporting, which in turn requires a depositary.

”Of course, until the private placement regimes expire in 2015 or 2018, private equity managers are assuming they can continue to raise funds from sophisticated institutional investors in Europe (Germany apart, where the regulator is insisting even private placements be protected by a depositary). Bailey agrees that it is too risky for managers to rely on reverse solicitation. “People are actively trying, very hard, to avoid the use of depositary services and the additional costs that come with them, but within five years all of that will have disappeared,” predicts Bailey. “The private placement regime will have gone, and AIFMD will have become the new norm.”

It is already the norm In France, Germany and Luxembourg, where funds have long had to appoint a depositary bank, irrespective of the size of the fund, although the compliance obligations were not as onerous as those laid down by the AIFMD. Bailey knows this, having spent five years in Luxembourg in the 1990s, servicing fund management clients of the Bank of Bermuda. As it happens, because the AIFMD does not insist that the depositary role be fulfilled by a bank, the Directive has created a new business opportunity for Augentius. “The Directive has opened up that market to administrators,” he says.

It may close other markets, if European investors become expensive to access, but ultimately David Bailey thinks the only funds that will be prevented from fund-raising in Europe by the AIFMD will be emerging market funds. This is because no depositary will be willing to assume the risk in certain jurisdictions. That said, unlike the depositary banks to hedge fund managers, private equity depositaries such as Augentius are not lumbered with strict liability for assets that go missing. This concession reflects the nature of the assets owned by private equity funds. “It is very difficult to fraudulently sell an unquoted asset,” explains Bailey. “It is also very difficult for us to have custody of the assets, and we are not required to do so.”

Indeed, a private equity and real estate administrator like Augentius is not authorised to hold even financial instruments unless it is prepared to put up at least £4 million in capital. Augentius has posted only £125,000, and elected to outsource the safekeeping of financial instruments held by its clients – generally stocks acquired when an asset goes public – to Société Générale Securities Services as sub-custodian. The French bank alone assumes strict liability for their safety. However, even a limited function private equity depositary cannot escape liability for negligence in the performance of its duties, and liability of any sort does change the character of a commercial relationship. The question is: how testing can a relationship get?

David Bailey says Augentius has already resigned accounts when the firm became uncomfortable with the behaviour of the client. “If the depositary decides a manager is in breach of AIFMD, the depositary will in the first instance refer the issue back to the manager,” he explains. “If the depositary does not get an adequate response from the manager – and bear in mind the manager has a legal responsibility under the Directive to provide the depositary with all the information it requires – it will raise its concerns with the regulator. After all, the depositary is liable. If it has concerns, and does nothing about them, then the depositary becomes liable. In a way, the depositary is the eyes and ears of the regulator.”

And what Augentius is expected to watch and listen for is, crudely speaking, unverified ownership of assets, dodgy valuations, excessive executive remuneration and cash flows being siphoned off. Put less plainly, Augentius Depositary Company Limited plies private equity managers with oversight and compliance (monitoring the operational procedures followed by the manager to ensure they comply with the Directive), asset verification (checking the assets are properly registered in the name of the fund) and daily cash monitoring and reconciliation (checking bank statements to ensure cash payments and receipts are legitimate and match invoices) services.

It is a set of duties that bear comparison with the “depositary lite” services offered by fund administrators and custodians to hedge fund managers. Understandably, given that the vast majority of assets held by private equity funds are not susceptible to conventional safekeeping, Augentius does not have to distinguish between clients that want to buy a full depositary service and those that are happy with something lighter. However, David Bailey is at pains to emphasise the services do put a considerable burden of responsibility on the depositary. “The regulators wrote the Directive with substantial compliance and oversight requirements for the regulators themselves to carry out,” he says. “They then put their heads in their hands and said, `Oh my goodness, who is going to carry out oversight to make sure the managers do all of this work?’ They decided to give the job to the depositary, and make the depositary liable for it.”

Of the three duties, compliance and oversight checks are potentially the most onerous. The trick, says Bailey, is to document procedures and then agree with the manager what evidence needs to be produced to prove they are being followed. Valuations are a case in point. These are a notorious challenge in private equity, thanks to the nature of the assets, and are really provided only for institutional investors needing to control their annual asset allocations. “Everybody is locked into the fund for ten years, and any valuation has to be run on the basis of comparables, so it is no more than an indicative finger in the air,” says David Bailey. “No one is trading, and there are no subscriptions. It is to help investors. If they find they are over-allocated, they will reduce their allocation to private equity the following year.” For the fund, the depositary has to identify a documented valuation procedure, assess its reasonableness, and ensure it is pursued consistently. Other oversight duties are similar. The depositary has to check a remuneration policy is in place as well, and that it is being followed continuously. By comparison, asset verification is less relentless, once the initial work is done. Nevertheless, to verify the ownership of assets Augentius had to recruit a team of lawyers to plough through deal documentation and public registers to create a record of all the assets of a fund. Once that is done, says Bailey, it is relatively simple to keep it up to date on an annual basis. Likewise, cash movements can be monitored merely through read-only access to client bank accounts.

They are in any event infrequent. After all, it is an axiom of private equity fund management to minimise cash holdings by remaining fully invested at all times. As David Bailey points out, private equity funds cannot remain open-ended, even in the same way as a hedge fund wary of crowded trades, because the markets in which they operate are not as large or liquid as the publicly traded securities markets. In fact, this is why most private equity funds remain relatively small by comparison with the largest hedge funds. “A private equity manager needs to restrict the amount of capital he or she manages, because if the fund is doing $25-50 million deals, it will not need more than$500 million in terms of commitments,” explains Bailey. “The deal flow is not limitless in the same way that it is in the public markets.”

He says the relatively small size of private equity funds means that managers have a natural bias towards independent providers that can better understand their scale, especially when they are not being offered the assurance of full and strict liability, for which a bank with ostensibly deep pockets is appealing. As David Bailey points out, the pricing of depositary services by large banks is contingent on the bundling of multiple services, which increases conflicts of interest and concentrates risks. “We do not insist on doing the administration as part of the price of providing a depositary service,” he explains. “We are happy to do it on a stand-alone basis. Private equity managers are uncomfortable going to the big banks anyway, precisely because they know the big banks want more than the administration. The big banks have also become very big, and want only the big mandates.” Bailey contrasts that size and scale with the independence and specialisation of his own firm. “There are very few independents who do not do hedge funds as well as private equity and real estate funds, and even fewer independent hedge fund administrators that do private equity,” he says. “We are true specialists. It is all we do.” Bailey reckons banks in particular lack the patience and skills to execute private equity business well. “Banks have people who sit by conveyor belts, and pick things up when they fall off the conveyor belt, and then try and work out why it has fallen off the conveyor belt, and put it back on,” he says. “Private equity does not work like that. Deals are complex, multi-jurisdictional, have complex structures, and close at three o’clock in the morning. They are also highly personalised, to each private equity house, and each transaction. That just does not work for an electronic conveyor belt.”

What is proving hard even for Augentius to avoid commoditising is the price of the depositary services the firm offers. Bailey admits that Augentius provides the service as much to keep existing clients sweet as win new ones, and he is certainly not advancing it as a commercial proposition in its own right. Private equity managers are in any event driving a hard bargain. “Neither limited partners nor general partners perceive economic value in the depositary service,” explains Bailey. “There is no Madoff risk in private equity, so the main reason for appointing a depositary does not apply in this industry. Frankly, private equity managers see a depositary as more of an encumbrance than a service.”

Opportunities to provide additional services on top of the basic product are scarce. Even regulatory reporting, often touted as a value-added service, is really part of what must be provided. But even if they are reluctant buyers of depositary services, regulators do insist each fund affected must go through a proper selection process before making their choice. Augentius, which has acted for some time as a custodian to American managers under the Dodd Frank Act and for even longer as a regulated custodian to private equity funds domiciled in Guernsey, reckons it is well-placed to win any RFP process launched to choose an AIFMD-compliant custodian. “We have worked hard with the European Securities and Markets Authority (ESMA) and the Financial Conduct Authority (FCA) and others to develop a sensible, pragmatic and cost-effective depositray service,” says David Bailey. “It is important that depositaries ensure the proper protection of assets for investors but at the same time do not impose additional work on managers. This is exactly how our depositary service will work.”