Escrow has emerged as a potential risk management tool for super funds doing direct investment deals in infrastructure and private equity in an environment where counterparty risk is front of mind. Escrow can be used by buyers and sellers of assets where price uncertainty or counterparty risk exists, and is typically used to help settle large investments or merger and acquisition deals. Victor Penna, head of product, treasury services at JP Morgan, said escrow could be used by super funds investing in infrastructure projects such as public private partnerships (PPPs) or toll roads, where the value of the asset is contingent on future performance.

“The idea is that in that type of transaction, rather than trying to agree an uncertain price on the asset when you’re buying or selling it, you might agree a range,” he said. “You can pay $800 million now, hold back $200 million in escrow, and then pending a measurement of actual performance… if it does perform according to expectations, you’d ultimately release the $200 million over the following two years, otherwise the $200 million might be returned to the acquirer.” Penna said escrow is widely used in major financial markets such as the US and the UK, but has not been used in Australia to date.

“In Australia it hasn’t been used because until now there’s been a fair degree of trust and not a lot of focus on counterparty risk, but what we’re seeing particularly amongst the key funds is trustees are now concerned about counterparty risk,” he said. He said the use of Continuous Link Settlement (CLS) by funds in FX transactions as a risk management tool was an example of the heightened awareness around counterparty risk. JP Morgan delivers escrow services through 12 major hubs across the world, but only launched a centre in Sydney in March.

Penna said super funds could use escrow to manage the increased risks associated with the distressed assets that are becoming available as a result of the global financial crisis. “Escrow primarily is a tool you can use to manage either counterparty risk, because you’re concerned that the other counterparty isn’t going to meet their financial obligations, or price risk, where there’s uncertainty as to the valuation of what you’re buying,” Penna said. “The two are linked because in many cases if you’re looking to buy infrastructure assets, there’s valuation risk at the moment but there’s also counterparty risk because a lot of the assets that will come onto the market over the next six to 12 months will be distressed.”