DealMakers - Q2 2020
How fund managers can benefit from utilising escrow
by Jacolene Otto and Brendan Harmse
In this article, we explore what escrow is, when escrow accounts should be used in private equity, and what options are available to a fund manager.
Escrow agency is defined as a service where a firm opens an escrow account and holds, as agent, funds for clients in escrow, to facilitate certain corporate transactions. The funds held in escrow are released upon the fulfilment by one or both parties of certain conditions, usually stipulated in the signed underlying contract between the parties. Essentially, ‘escrow’ is the name of the process undertaken, often during high-value corporate and financial transactions, which sees related funds being deposited into a temporary holding escrow account after such contract has been signed. The administrator of the escrow account is referred to as an ‘escrow agent’.
The use of escrow accounts is common in private equity and real estate (PERE) acquisition transactions. The buyer will typically place money in escrow which allows it to perform due diligence on the potential transaction while providing comfort to the seller that, if all conditions are met, that buyer will be able to make the payment for the transaction.
However, many people are not aware of the many more benefits of escrow accounts, and how they can be considered in more than just the above-mentioned acquisition transactions.
1. Fund raising
Although the majority of PERE funds are structured as partnerships, where investors commit to the fund and fund managers draw down funds from investors as and when the funds are required, some funds are structured in such a way that they will have open subscription periods in which investors can subscribe to the fund. In these instances, investors will subscribe to the fund and will be required to transfer their full subscription amounts into the fund upon completion of the required KYC/AML on the investor, or at the end of the subscription period.
These subscription periods are often open for up to six months and will have a target minimum fund raise.
If escrow is incorporated into the private placement memorandum in this instance, where investors in the offering invest their funds with the escrow agent, this can ensure that if the fund manager does not raise sufficient funds in the offering/ subscription period, all funds are returned to the investors. If, however, the fund manager does raise sufficient funds in the offering subscription period, the funds can immediately be transferred by the escrow agent to the bank account of the fund to start operations.
2. Escrow in deal making (M&A)
The escrow account provides protection to both the buyer and the seller in deal-making instances. When doing a PERE acquisition transaction, the buyer will place the funds in escrow which will then allow them to continue to perform due diligence on the potential acquisition, and “reserves” the deal for the buyer. It also provides the seller with the assurance that if all the requirements are fulfilled, and the conditions precedent are met, the buyer will be capable of making the required payments.
Additionally, utilising escrow in the acquisition transaction gives the investors comfort that the funds will not be disbursed to a seller where all the conditions have not been met.
3. Payment for certain expenses / follow-on payments
Common in most real estate transactions is real estate tax, or capital gains tax, payable by the buyer in certain jurisdictions. As an example, real estate tax on the acquisition of a property is payable to the tax authorities in four quarterly payments, six months after the completion of the transaction. Funds can be drawn down from investors as part of the initial capital drawdown for the deal, and the funds relating to the real estate tax will be left in the escrow account until the payments to the tax authority become due.
4. Escrow in carried interest clawbacks
Carried interest is an incentive compensation to PERE managers to align their interests with those of fund investors. A percentage of the profits of the fund (over and above the management fee) is kept by the fund manager. The amount is disbursed throughout the life of the fund, and a final computation of the carried interest amount is done upon final liquidation of the fund – taking the returns and profits throughout the fund’s life into consideration.
Therefore, many investors demand that escrow and clawback arrangements are incorporated in the disbursement of amounts to fund managers to ensure that earlier over-payments can be returned if the fund as a whole underperforms. Clawbacks are difficult to enforce if, for example, the recipient has left the fund management company.
The PPM or Limited Partnership Agreement of the fund will therefore include the traditional distribution waterfall, setting out the model, applicable rates and the clawback clause, and an additional clause requiring that a portion of the carried interest disbursed to the fund manager will be kept in an escrow account until final liquidation of the fund, when the final distribution waterfall calculation has been done. The funds in escrow will therefore cover any shortfall to investors first and thereafter be paid out to the fund manager.
What are the options for escrow?
There are a number of options for escrow service providers in the market and it is important for PERE managers to find the right fit.
• Banking institutions
Although certain banks provide escrow services, this is often not profitable for them unless there is a significant amount involved, or a high volume of recurring transactions. Due to the nature of PERE transactions, each one is different and has bespoke requirements. Transactions, therefore, do not always fit into the cookie cutter mould of a bank’s requirements.
Lawyers often provide the escrow service for transactions which are done via their statutory regulated trust accounts. However, this is not regarded as core business and is preferably avoided due to the increasingly higher regulatory AML/KYC requirements. Often, important particulars of the escrow agreement are given too little attention too late in the negotiation process.
• Third party/independent provider
‘best practice’ is for PERE managers to use reputationally strong and sound independent third party escrow agents to whom they can delegate the time-consuming governance and administrative aspects of settling transactions. It is key to check whether their escrow services are provided within a robust compliance framework with strong internal controls.
Potential escrow providers should be interrogated about their corporate cash management and banking platforms, and which currencies they are able to accommodate. Are their escrow vehicles bankruptcy-remote, and their transactions sufficiently legally ring-fenced for risk mitigation, balance sheet, accounting and taxation purposes?
In conclusion, escrow is a useful and often necessary tool for PERE fund managers, and they would do well to clearly understand their options by doing the necessary homework before entering into escrow arrangements.
Otto is Head of Private Equity & Real Estate and Harmse is Head of Corporate Services (SA), Maitland.