The Changing Landscape of Private Equity Fund Formation (2013)
The pillars of the conventional fund model in emerging markets remain largely unchanged, however the wave of regulation globally and continuing evolution in LP-GP dynamics are yielding some important shifts in fund terms and structures with implications for governance and operations at the fund level. On 25 June 2013, EMPEA co-hosted a Professional Development Webcast with Debevoise & Plimpton on The Changing Landscape of Private Equity Fund Formation. The summary below highlights some of the trends in fund terms, structures and regulatory developments discussed by Debevoise Partners Marwan Al-Turki, Jennifer Burleigh and Peter Furci.
Trends in Fund Structures
On the whole, fund structures for the emerging markets continue to be primarily limited partnerships domiciled through offshore tax-efficient jurisdictions, such as the Cayman Islands, Mauritius and Cyprus. According to Debevoise Partner Peter Furci, limited partnerships remain the preferred model because “they lend themselves to the basic economics and governance arrangements that are typical to private equity funds,” including limiting the liability of the investors in the fund for any losses over and above their capital commitments, as well as affording flexibility in the economic terms of a given deal, unlike the fixed capital structure of a corporation.
Managers investing and operating funds across multiple countries typically do so via sub-advisers in individual countries, or via a holding company located in a bilateral treaty jurisdiction. In determining the optimally tax-efficient structure for a fund, managers take into account investors’ tax liabilities within their home jurisdictions including those required to operate through feeder funds. In the case of funds of funds, negotiations present particular challenges as a single LP may require a manager to accommodate a wide array of tax structuring needs. Fund structures must also account for the liabilities for individuals sharing in the economics of the fund, i.e., the treatment of carried interest income for investment professionals based on where they’re located.
One of the most important tax considerations for both local teams and funds pooling domestic and international capital is permanent establishment treatment. For single country funds where the teams are physically based in the same places where they invest, the onshore team’s discretionary authority is often limited with final investment decisions relegated to an Investment Committee based offshore, e.g., an India-based team will have an Investment Committee that meets in Mauritius to approve or reject proposed investments. In such cases, it is advised that the deal team is a subset of a larger group offshore, for instance in the US or London. For single country funds where the team is entirely local, it’s generally harder to solve for the avoidance of permanent establishment tax treatment through use of an offshore affiliated entity serving in an Investment Committee capacity.
For single country funds that are investing capital on behalf of both international and domestic limited partners, and where local investors are subject to limitations on “roundtripping” via a third country jurisdiction, two parallel vehicles—onshore and offshore—are typically used. However, Furci cautions that if the two respective investment committees are agreeing to and investing in the same deals, it could call into question the robustness of the offshore investment committee for the purposes of avoiding treatment as a permanent establishment onshore.
Perhaps the single greatest change underway to the conventional fund structure is the rising use of co-investment and parallel funds. One key difference between the two structures is that a co-investment vehicle can invest at reduced fees and carry terms in any particular deal, and may have more flexibility in terms of exit timing, while a parallel fund invests and exits at the same time and in every deal, rather than cherrypicking, and shares in all investment and indemnification expenses.
Key Regulatory Developments
Fund Marketing Rules
In most cases, regardless of where the investors are based or the jurisdiction in use, the same considerations apply —managers marketing funds to investors across multiple jurisdictions to accommodate for the tax profiles of various investors should be aware of what actions will constitute a public offering in some countries or trigger registration requirements in others.
Effective July 22nd, Europe became a different story. Whereas until now private placement regimes allowed relatively unregulated access to institutional investors there, the Alternative Investment Fund Managers Directive will introduce an entirely new layer of regulation for managers marketing funds in Europe. Existing EU-based fund managers must apply for authorization under the Directive by mid-2014, but the regime for non-EU managers and funds is not yet clearly defined, and some countries may opt to extend existing private placement regimes, phasing them out by 2019.
Stepped up enforcement of the U.S. Foreign Corrupt Practices Act (FCPA) and stricter provisions introduced to the UK Bribery Act have far-reaching implications for private equity investors. U.S. rules prohibit the making or promise of payments to any foreign official, broadly defined, in order to influence an official decision to act or not act, or otherwise secure some kind of improper advantage. Notably, U.S. rules include an expansive definition of “U.S. conduct,” going so far as to include any email or phone call coming into the U.S. In addition, monies flowing through U.S. banks can also fall subject to this act.
The U.K. Bribery Act is slightly more expansive than the FCPA, with one key difference being that it extends beyond merely public officials; it also includes bribery by any “associated persons” affiliated with any company “carrying on business” in the U.K., regardless of where the bribe is paid. Additionally, the Act includes a strict liability corporate offence, meaning that a corporation will be held liable for the acts of its officers and employees. The only permissible defense for a corporation so charged is the demonstration that sufficient anti-bribery protocols are in place and that those policies have been adequately communicated and enforced. Notes Debevoise Partner Jennifer Burleigh, “It’s crucial to have both the training and the documentation— in addition to having a program in place, you must have a paper trail that demonstrates the program is being complied with.”
To ensure they don’t run afoul of these rules, private equity firms are advised during the fundraising process to screen prospective investors carefully for affiliations with government entities. In cases where imperfect visibility into a market requires consultants to aid with deal sourcing, private equity firms should evaluate carefully how the consultant is being compensated and the uses for those funds. Use of third parties can be problematic generally, particularly under the U.K. law, as a sponsor can be tagged with the misdeeds of any agent used.
The standard for liability under the FCPA is knowledge, though “knowledge” is broadly interpreted to include conscious avoidance or deliberate ignorance of the actions being taken. Burleigh notes that the key is to “know local practices within each jurisdiction, including permitting, and to also be familiar with any and all government touches for the industries in which you invest.” She additionally recommends that private equity firms conduct risk-based due diligence on all counterparties, with particular attention to any governmental ownership, and that the representations and warranties language in any counterparty negotiation include the ability to review policies and compliance records to ensure no corruption violations are taking place.
Due to the interplay between the two regimes and the broad jurisdictional reach, chances are quite good that any corrupt act will be picked up by at least one of the two sets of rules.
Terms and Conditions
Based on a sampling of 123 funds from the Debevoise IMG Database, spanning emerging and developed PE markets, many aspects of the conventional fund model are largely unchanged. A 10-plus-two year term and a five-year investment period remain the norm, although there has been some movement towards the outer limits. Management fees, by and large, remain close to 2% for the majority of funds, although it is more common, and more palatable to investors, to see a higher management fee for an emerging market fund, due to smaller fund sizes and the increased level of due diligence required.
Other key terms, such as key person clauses and no fault termination have become nearly universal if rarely exercised. Distribution continues to take two forms: the European or “all capital back” waterfall wherein all capital is paid back before any carried interest is paid, and the US deal-by-deal model, with emerging market funds more often falling in the “all capital back” waterfall camp. Whereas there’s been little movement in basic terms, in line with the diversification in structures there are an increasing number of alternative arrangements being offered, such as lower fees or blended fee rates, and occasionally lower carried interest rates for participation in first closing (sometimes called “early bird discounts”) or for making larger commitments.
A replay of EMPEA’s Professional Development Webcast co-hosted with Debevoise & Plimpton on The Changing Landscape of Private Equity Fund Formation, featuring insights from Partners Marwan Al-Turki, Jennifer Burleigh and Peter Furci, can be accessed through the EMPEA website here.
Marwan Al-Turki is a Partner in Debevoise & Plimpton’s London office.
Jennifer Burleigh is a Partner in Debevoise & Plimpton’s New York office.
Peter Furci is a Partner in Debevoise & Plimpton’s New York office.