The private equity industry has so far remained distant from the Panama Papers scandal that has rattled many corporations and individuals from heads of states to financiers and even artists.
Among the 11.5 million client documents leaked from within Panamanian law firm Mossack Fonseca, there is still a sea of information waiting to be released, so the private equity world could yet find itself under the spotlight.
And while there is yet to be any direct connection between the documents released at the beginning of April and the alternative investment industry, there are at least three ways its effect could be felt, if only indirectly.
One is the location of the jurisdiction used by private equity firms to set up legal entities for funds or portfolio companies. Another is a likely push toward greater transparency over who are the beneficiaries behind investments in private equity funds. And the third is the reminder it gives the industry of the fast-growing importance of cybersecurity.
NOT ALL JURISDICTIONS ARE EQUAL
Panama is an offshore jurisdiction and private equity firms make frequent use of such locations to domicile portfolio companies and investment vehicles.
However, the offshore centres vary in their level of transparency. Some, like the Cayman Islands or Luxembourg, have established tax transnational treaties and are making sure they offer relatively transparent regimes. Others, like Panama, are more opaque.
Panama is actually rarely used in the private equity world. Instead GPs prefer to choose jurisdictions that offer preferential tax treatments, such as the Cayman Islands, Delaware, Guernsey, Jersey and Luxembourg. Hong Kong is also targeting fund managers and passed a bill in July to provide tax exemptions on certain transactions conducted by offshore private equity funds.
Some of the offshore jurisdictions used by private equity firms were quick to distance themselves from the Panama Papers scandal. Cayman Finance, for instance, said that the Cayman Islands is not a secrecy jurisdiction and has a proven track record of transparency and cross-border cooperation, as well as anti-corruption measures. Guernsey reminded the public that it has an effective anti-money laundering and anti-terror financing regime in place.
WHY GO OFFSHORE?
‘Main street’ critics are quick to conclude that regardless of talks of transparency, setting up an entity in an offshore centre equals tax evasion, but this is not the case. Most often, private equity firms, which conduct cross-border financial transactions on a regular basis, want to avoid being taxed twice. While a fund established in an offshore centre may not be taxed in that offshore jurisdiction, profits on investments it makes in New York, for example, will still be taxed under the US tax regime.
It’s also common for a private equity fund to have entities in several tax jurisdictions to fit the needs of different limited partners. One private equity lawyer says that his firm recently set up a Cayman fund for a client because a major LP is used to investing in Cayman structures. The choice of a specific offshore jurisdiction may also be dictated by regulatory efficiency. Offshore jurisdictions can offer more relaxed rules regarding the use of leverage and permitted investment strategies.
The priority is to ensure that the public outcry over less credible jurisdictions such as Panama does not turn into a wider witch hunt that engulfs all offshore regimes. The key is to educate the public on the role that offshore jurisdictions play, and the value they add, not just to their financial clients, but to society and business as a whole.
KNOW YOUR INVESTORS
Perhaps one of the most immediate impacts of the Panama Papers on the private equity universe may be to accelerate the adoption of anti-money laundering regulations for registered investment advisors as proposed last year by the US Treasury Department’s Financial Crimes Enforcement Network (FinCen).
FinCen is in the final stages of drawing up rules that will impose enhanced due diligence requirements on private fund managers, which would force them to identify and verify the principal beneficiaries of legal entities that invest in private equity funds.
Similar efforts are underway in the European Union. Meanwhile, jurisdictions such as the Cayman Islands have expressed interest in participating in a recently launched initiative to develop a new global standard for the exchange of beneficiary information.
There is a dense web of offshore financial legal entities that lie behind the investors in private equity funds. There can be several layers to remove before the name of an actual human beneficiary is disclosed. And it’s not uncommon for unwanted investments from persons looking to fund illegal activities – or to avoid taxes – to find their way into private equity funds, often unbeknown to the managers.
The key point is that there’s currently not much transparency and that the Panama Papers has highlighted an issue that was already on the global business agenda. Most of the large private equity firms are anticipating legal changes and have hired a slew of lawyers and consultants to dig into entities that invest in their funds. They could eventually return money to those investors if they deem it necessary. While the outcome of increased regulation will also likely be greater transparency, it will also push up compliance costs for investment advisors registered with the US Securities and Exchange Commission.
THE IMPORTANCE OF CYBERSECURITY
The Mossack Fonseca leak represents one of the largest and most significant data breaches in history. It should serve as a warning to financial institutions that their data is increasingly vulnerable to cyber-attacks and that these can have devastating consequences for their businesses.
“While much of the fallout from the Panama Papers has focused on the high-profile individuals implicated and concerns about the opaque nature of shell corporations, there are important lessons to be learned about data security, particularly for professional services firms,” wrote law firm Duff & Phelps in a May note.
The SEC has recently been outspoken about the need to strengthen cybersecurity, not only at private equity firms, but also at portfolio companies and third-party vendors. The idea of securing such a volume of sensitive data – from litigation information to fund formation and acquisition documents – can be daunting for private equity firms, who may simply shy away from the task.
Strengthening cybersecurity programmes is not only an internal matter for general partners. Some firms have also expressed concern regarding third party entities, including law firms and administrators. The consequences, both financial and reputational, could be devastating for firms.
For now, the private equity industry, alongside the rest of the financial world, will continue to pay close attention to future revelations emerging from the Panama Papers. ?