Private equity fund managers have a large range of domiciles to choose from around the world – at least in theory. In practice, they are impelled towards certain jurisdictions by the circumstances of their funds. With a host of factors to consider, including tax, cost and culture – and, above all, the investor base – selecting the right domicile for a particular fund can be a complex process. The politics of Brexit have made it even more so for funds that want to market to the European Union.
PEI talked to expert lawyers and other service providers to work out what might be the right fit for your fund.
1. THE INVESTOR BASE
By common agreement this is the most important point. “The domicile you choose is driven by who the end investor is going to be,” says Marc Russell-Jones, head of business development for EMEA at MUFG Investor Services in London. “If you have a UK investor base, a UK limited partner structure works very well. If you’re looking to market a fund purely for German investors, a German structure is very acceptable.”
“The key question is, ‘What is the domicile that works for my investors?’,” says David Bailey, group head of marketing, communications and product development at Augentius, the private equity and real estate fund administrator. “Over the years that has increasingly meant multiple jurisdictions. You might have your main domicile in one place, a feeder domicile in another place and Special Purpose Vehicles in other domiciles.”
2. THE TAX TREATMENT
“It is important to have at least one eye on the tax position of investors,” says Caspar Fox, head of European tax at Reed Smith, the law firm, in London. “Brazil, Spain, Italy and other countries have a blacklist of places where investors will suffer a worse tax treatment if they invest in them.” He cites, for example, Jersey’s position on Spain’s blacklist. Fund managers must bear in mind that tax treatment is a dynamic area liable to change: for example, the Channel Islands used to create tax complications for French investors, but no longer does so.
The primary location of the investments, as well as of the investors, must be borne in mind. Some jurisdictions, including Mexico and Brazil, have an adverse view of tax havens. As a result, they tend not to sign tax treaties with them. Because of this, income from investments in these countries may be subject to worse tax treatment if the fund’s jurisdiction is offshore.
Arnold May, tax partner at Proskauer, the law firm, in Boston, says that US managers may prefer to site their funds outside the country to reduce the risk that the underlying investment will be treated as a Controlled Foreign Corporation for partners taxable in the US. US investors potentially bear adverse tax consequences from ownership of stock in a CFC.
3. IS THE PRICE RIGHT?
Some jurisdictions are regarded as inherently more expensive than others. In Luxembourg, “costs are very high”, says Bailey. He gives the example of a fund managed in the UK but domiciled in the Grand Duchy. “If a UK manager employs London lawyers to get everything put together and Luxembourg lawyers to make sure everything is written in accordance with Luxembourg law, the Luxembourg lawyers’ bill will be higher than the London lawyers’ bill.”
On top of this lie the additional costs of having the domicile in a different place from the fund manager. “The cost of setting up a fund domiciled in Germany, managed by Germans and aimed at German investors, will be less than setting up a domicile elsewhere in the EU,” says Russell-Jones. The fund manager can say, as Russell-Jones puts it: “I have my target investors, a domicile my investors are comfortable with, and established distribution channels. I have substance and infrastructure and I don’t have to relocate my people to another jurisdiction, with the additional cost which that involves.”
This cost consideration only applies to funds that want to market within the EU. In such cases, regulators expect the fund to have a real presence in the domicile location, mainly because of the Alternative Investment Fund Managers Directive.
“US-based managers who have set up fund structures in Luxembourg sometimes find the director and annual meeting requirements cumbersome,” says Malcolm Nicholls III, partner in Proskauer’s corporate department. By contrast, “you can form a Delaware or Cayman Islands structure easily. You do not have to have a presence in these jurisdictions, other than a local agent, and there are no local director requirements”.
Fox of Reed Smith notes that UK fund managers with a domicile in the Channel Islands do not have to pay value-added tax to the local service providers.
4. ONSHORE VS OFFSHORE
“It may be slightly cheaper to go offshore, to an unregulated environment, after considering the costs of regulatory approvals and filings,” says Liam Collins, partner in the asset management group at Matheson, the Dublin law firm. “But what you’re sacrificing is the fact that you no longer have a regulated vehicle.”
Institutional investors like the idea that a fund is being monitored by a regulator, say service providers. Because of this protection, “there is a general tendency for managers to look more towards onshore products and away from offshore jurisdictions”.
Fund managers should also consider the possibility that certain European investors do not like offshore domiciles on principle. “A small number of European public entities may like to avoid tax haven jurisdictions such as the Cayman Islands simply for the optics,” says Nicholls of Proskauer. However, he says this should not be over-emphasised: “Most investors in private equity are comfortable with any of the tax havens.”
5. DOES THE CULTURE FIT?
Lawyers and other service providers based outside mainland Europe complain about the culture inside it.
In terms of domiciles, “Luxembourg is very commonly seen if the investments are in mainland Europe”, says Fox of Reed Smith. “But if we don’t have to go there we try not to. Our experience with Luxembourg service providers is that they are quite expensive and not as reactive as Channel Islands service providers, who get it and are more on the same wavelength as US and UK fund managers.”
Some lawyers in the US and UK complain of a nine-to-five culture in Luxembourg, while acknowledging the high degree of expertise there. Fox acknowledges, on the other hand, the centrality of private equity in the country’s business culture creates a sense of security. “The private equity industry is very important to them, so they are not flippantly going to change something that would have a knock-on effect on Luxembourg’s appeal in this sector unless they have really thought it through.”
6. THE BREXIT IMPLICATIONS
Brexit must be considered in the light of the AIFMD, which allows fund managers to market funds that are AIFMD-compliant across the EU. In theory, funds that are not AIFMD-compliant can rely on national private placement rules, but many experts expect this to be phased out. When the UK is no longer in the EU, funds domiciled in the UK will no longer be AIFMD-compliant unless the UK is given an exemption by the EU on the grounds of “regulatory equivalence” – the notion that UK funds are as well-regulated as funds domiciled within the bloc.
Experts think the UK may never be given regulatory equivalence for political reasons. The same shadow hangs over the Channel Islands. The European Securities and Markets Authority has recommended equivalence for them, but the Commission has not yet agreed to this. It may be less minded to do so because the UK, which is responsible for their international relations, was the EU member state pushing for this.
7. A SENSE OF FAMILIARITY
The sages say familiarity breeds contempt, but as far as private equity fund domiciles are concerned it breeds a sense of safety.
“Fund managers should think about what jurisdictions their likely audience is familiar with,” says Fox of Reed Smith. “For example, the British Virgin Islands has done very well at selling itself to the Chinese as a domicile for funds, but if a fund manager suddenly said to a Chinese investor, ‘Here is a Jersey fund’, they would say, ‘Where is that?’”
Experts say that investors in Singapore and the Middle East, however, are most familiar with, and therefore comfortable with, the Caymans.
Following the same principle, “for UK investments our starting point for a domicile would be the UK, or, if you want to be a little bit different, the Channel Islands”, says Fox. “You are following the herd and there’s safety in that.”
Fund managers should bear in mind that this sense of old acquaintance entrenches the appeal of one domicile over another to investors, even if an upstart tries to make itself more attractive. “If you are a UK private equity manager looking at expanding into the continental European market, Luxembourg law is very favourable and accommodating to private equity structures,” says Russell-Jones of MUFG.
Although Ireland has taken steps to make itself more attractive as a domicile for private equity – building on its leading position as a jurisdiction for hedge funds – “it’s a newer piece of legislation so it’s not as familiar to private equity investors”.