This article is sponsored by TMF Group
Private equity’s expansion means different things for different players. For managers in the US mid-market, it is driving asset prices skywards and keeping GPs on the fundraising trail to make the most of the good times. According to Bain’s Global Private Equity Report 2019, mega-funds are frequently launching their own mid-market vehicles as diversification plays.
This leaves many US mid-market firms looking for investors and deal opportunities beyond their borders – and that requires utilising more, or different, fund structures. But private equity’s success has also prompted stricter regulation, and that means even friendly jurisdictions are demanding boots on the ground for locally domiciled vehicles. These jurisdictions still compete for funds, but have tightened regulations.
According to Anastasia Williams, head of private equity, Americas at TMF Group, this requires more discipline and consideration from mid-market firms as to where they domicile funds. These GPs do not have the resources to staff up in three or four countries from scratch. And, given the trend towards more substance requirements and tighter rules in places like the Netherlands and the Cayman Islands, they cannot merely hop to another jurisdiction, because tighter regulations will eventually appear there too. Yet that does not mean there are no opportunities, as new jurisdictions, such as Ontario, are becoming competitive.
If we take a broader view of the state of offshore fund destinations, what does the landscape look like to you at the moment?
This trend towards more substance requirements and stiffer regulations hasn’t just appeared in the last year. For the last decade, regulators around the world have come to understand that private equity is an important asset class and one worth their attention. That doesn’t mean all the reforms are there to scold the industry. Many have been designed for greater clarity and consistency, even if that means less room for interpretation.
In some cases, things are better than expected. Brexit concerns haven’t eroded the appeal of domiciling funds in the Channel Islands, despite concerns about what the UK’s EU exit would mean for these neighbouring jurisdictions. So far, it’s been business as usual.
Yet there’s little doubt we’re witnessing greater substance requirements for private equity firms that choose to structure funds abroad.
In the wake of the OECD’s efforts to crack down on base erosion and profit shifting, jurisdictions around the world are working to balance the need to stay friendly to foreign managers with the need to meet new global standards of transparency and oversight. This project has led to some of the greatest changes in how managers are taxed in a generation.
We see the Netherlands as a bellwether territory. In 2018, it passed several new requirements for foreign investors, including employing a greater proportion of local staff, defined wages for those staff, and local office facilities that vastly exceed a simple mailbox.
The era of simply having an empty shell in some other country may be over. Now managers need people on the payroll. We expect it’s only a matter of time before other jurisdictions, like Luxembourg, follow suit.
What’s the state of play in Luxembourg? Are there any proposals in the works?
Luxembourg is the biggest fund centre in Europe and the second biggest in the world, largely because of its high compliance standards, which are so appealing to LPs. This popularity isn’t just among EU investors. A lot of US LPs like these regulated funds. But this also creates a burden for GPs.
Luxembourg offers a less regulated option called a reserved alternative investment fund. These grew from just 75 in 2016 to 325 in 2017, and reached a total of 575 in 2018. RAIFs are flexible, and provide private equity investors – whether they are GPs or LPs – with an excellent fund-structuring vehicle.
There is also a short time to market the RAIF, which is not subject to any authorisation or ongoing supervision by Luxembourg’s financial regulator, the CSSF. However, the RAIF still needs to be managed by an EU AIFM.
GPs need to double-check that the RAIF makes sense. For example, if firms are looking for commitments from German institutional investors, the RAIF won’t qualify because these LPs need to invest in a corporate structure. And precisely because they are less regulated than other fund structures, greater due diligence by LPs is required.
“Middle-market firms will need to pick and choose a few jurisdictions that make the most sense for their likely LP base”
There have been some recent reforms in the Cayman Islands, a popular destination for fund structures. What do they mean for mid-market GPs?
In June, the Cayman Islands passed the Securities Investment Business (Amendment) Law, which introduces a regulatory regime for ‘excluded persons’.
These excluded persons used to be exempt from registering with the Cayman Islands Monetary Authority. This exemption was in place for those financial services firms catering to high-net-worth or sophisticated investors, who were expected to perform adequate due diligence.
This reform will now require most excluded persons to register and comply with greater reporting requirements. In essence, the amendment creates two new classes of excluded persons: those who will need to register with the CIMA, known as registered persons, and non-registerable people, who do not need to register or obtain licences but who will still need to submit to oversight by the authority for anti-money laundering purposes.
In addition, the amendment puts in place governance requirements for excluded persons. These include the appointment of at least two natural persons to the board of directors, and the need for those natural persons to register as a corporate vehicle before conducting security investment business.
For middle-market firms, this means more time and cost in setting up structures, but it remains to be seen if these reforms will prompt GPs to look elsewhere. The Cayman Islands still offers a relatively friendly regime for US firms.
Are there any alternative jurisdictions that are becoming more attractive because of the global trend towards stricter regimes?
We hear from fund attorneys and other market participants that Ontario is increasingly popular. There’s a shared language and culture, and an understanding of how US private equity works, which might be a real asset for a middle-market firm reaching past its borders for the first time.
In light of stricter regulations, other factors, like culture, may matter more than they ever did.
In the coming years we expect a greater convergence of standards. With less and less difference among jurisdictions, managers may be less inclined to shop around for some ideal place, or to craft increasingly complex structures in pursuit of a particular tax benefit. That tax benefit might not be enough to warrant the complexity and the cost that inevitably comes with it.
Mega-funds will be able to deploy the resources, both in staff and outside expertise, to juggle structures in multiple jurisdictions. But middle-market firms will need to pick and choose a few jurisdictions that make the most sense for their likely LP base.
There was one firm that found a great deal of support in the UAE and ended up establishing a fund structure there for those key LPs.
Just as middle-market firms are focusing on a particular sector to generate proprietary dealflow and expertise, they may need to focus on a few key jurisdictions that make the most sense for them, and their future. There may be little use in hopping to Poland for a few tax advantages that evaporate in a few years as that regime catches up with where the Netherlands is today.
It might be far better to commit to some jurisdictions that may be slightly stricter, but more reliable in the long term. Middle-market firms just don’t have the luxury of globetrotting indefinitely.