Following the global financial crisis, many critics of the financial services market expected private equity ventures to be the first alternative investment vehicle to disappear. Over the short term, this was true, with investment in private equity vehicles temporarily suspended by many foreign investors as they grappled with issues of liquidity and by Australian institutional investors because of the lack of transparency in private equity funds. However more recently there has been a resurgence of investment into the international private equity market.
Trustees of Australian superannuation schemes and pension funds, in particular, have recently been bullish about private equity in their search for greater alpha. Institutional superannuation trustees hold in excess of two trillion Australian dollars (approximately USD 1.523 trillion) of assets on behalf of Australian superannuants and are beginning to return to direct investment in a more stable post-GFC market.
Historically, there have been two factors which limit the flow of funds from the Australian superannuation industry to international private equity firms. The first, the lack of knowledge or familiarity of Australian trustees with the legal vehicles or structures used to organise private equity investments. The second, the lack of understanding by private equity firms of the Australian regulatory regime which imposes investment restrictions on trustees that can be incompatible with private equity investments.
Here are five common issues which arise where trustees of Australian superannuation schemes consider investing in private equity ventures.
Issues arising from limited partnership structure
The legal vehicle most commonly used to organise private equity investment is the limited partnership, domiciled in a jurisdiction which offers two critical features: limited liability status for investors and tax neutrality. The most common domiciles being Delaware, the Cayman Islands, the British Virgin Islands, Guernsey and Bermuda. However, the partnership structure can provide regulatory concerns for trustees of Australian superannuation schemes .
The first key issue to consider is tax neutrality. Australian superannuation schemes, like most foreign pension and superannuation schemes, benefit from generous tax concessions under Australian taxation law, including the ability in some cases to retain credits on taxation already paid in other jurisdictions. In most cases, private equity funds are able to achieve tax neutrality so that the partnership achieves complete ‘flow-through’ treatment and only the investors, and not the partnership, are taxed in their local jurisdiction. It has become increasingly common for private equity firms to attach appropriate disclosure of the relevant taxation peculiarities, as they apply to Australian superannuation schemes, in their private placement memorandum or offering document.
The second critical issue to consider is whether the conduct of the general partner is deemed to be the conduct of the limited partners, based on the law of the jurisdiction where the limited partnership is domiciled. Trustees of Australian superannuation schemes are subject to specific investment restrictions such as being prohibited from borrowing (except in limited circumstances) or giving a charge over the fund’s assets. In jurisdictions where the general partner’s conduct is deemed to be the conduct of the partnership and/or each limited partner, this may cause issues for Australian superannuation schemes where the general partner engages in borrowing or charging the partnership’s assets, as the trustee of the Australian superannuation scheme could breach superannuation law.
There are a number of ways in which an adverse outcome can be avoided. The first, and most obvious, is by establishing the private equity venture in a foreign jurisdiction where the partnership is recognised as a legal entity in its own right (eg, a limited partnership formed under the Delaware Revised Uniform Limited Partnership Act), so the actions of the general partner are considered the actions of the partnership, rather than those of the individual partners themselves. The second method is to interpose a company between the trustee of the Australian superannuation scheme and the private equity fund. For example, a Cayman Island corporation or limited liability corporation could be used as a ‘blocker’ entity to avoid the conduct of the general partner being imputed to the Trustee. This is the most common way in which foreign pension plans avoid similarly adverse taxation outcomes such as Unrelated Business Taxable Income or Effectively Connected Income.
The final issue involves the drafting of the partnership and subscription agreement, particularly in relation to provisions which could infringe the borrowing or charging prohibition, such as the reinvestment or recall of distributions paid during the investment period. Often, these constitutional documents include clauses which require investors to recall, reinvest or in some cases repay, distributions which have been paid over the investment period. These provisions can be interpreted as creating a form of charge or security interest over the funds already paid, to provide further protection to the general partner in reclaiming these payments, where necessary. However, these provisions may create a charge or give a security interest over an asset of the Trustee of the Australian superannuation scheme in contravention of the prudential regime. Accordingly, unless amendments to the constituent documents can be negotiated, the investment by the Trustee of the Australian superannuation scheme should be held by a ‘blocker entity’ to remove this concern, or the general partner should provide comfort in the form of a side letter that the relevant provisions in the constitutional documents will not be enforced by the general partner vis-à-vis the trustee. Increasingly, general partners are asking their legal counsel to provide opinions that the relevant provisions do not create a charge or security over those assets in the relevant jurisdiction.
Lack of understanding of fee structure
A typical private equity venture will charge a 2% management fee throughout the lifetime of the investment and deduct a performance fee upon the realisation of the partnership’s assets. The return of profit at the end of the partnership’s term to investors and the general partner follows a ‘waterfall’ structure, typically, in the following order:
- capital is returned to the investors equal to their paid-up committed capital
- a ‘preferred return’ (typically around 8%) is provided to the investors
- the payment of carry to the general partner (ordinarily 2%) and
- the remainder, allocated as 20% to the general partner and 80% shared between the limited partners.
‘Carried interest’ is the term used to ‘connote’ the incentive compensation scheme for the general partner. The hidden issue, however, is that private equity investments are typically presented in a manner which suggests that the general partner receives no portion of the limited partners’ initial ‘preferred return’, but rather only receives compensation after the ‘preferred return is paid’. This representation can be misleading, as while the ‘preferred return’ is, in fact, paid prior to any general partner compensation, the general partner nonetheless takes their 20% not only from the excess funds but from the ‘preferred return’ as well.
This is somewhat usual in the Australian landscape because incentive compensation received by an Australian manager is treated as ordinary income and in particular, is unable to be taxed as a capital gain (compared, the United States of America and other similar jurisdictions, where carried interest is used to attract capital gain tax treatment of what is generally considered ordinary income). For this reason, private equity firms should aim to simplify their fee disclosure in their private placement memorandum or offering document.
Lack of understanding of negotiating power
Due to the significant capital held by Trustees of Australian superannuation schemes, they have the capacity to be an important cornerstone investor in private equity ventures. Consequently, general partners are often willing to negotiate favourable terms to attract investment to new ventures. However, there seems to be a lack of knowledge in Australia of what rights or benefits can be achieved in negotiations where a particular investment is significant.
Generally speaking, a private equity manager would only consider an investor as being ‘significant’ if they invest greater than twenty percent of the total capital commitments, or if they are the first investor to agree to participate in the partnership (ie, a ‘seed’ investor). A significant investor of this kind is able to negotiate a number of favourable terms. The most common clauses which Australian investors look to are:
- a most favoured nation clause in a side letter
- a position on the partnership’s advisory committee and
- extra reporting and information rights.
However there are many other benefits which significant investors can seek to negotiate including: a share in the general partner’s returns, priority in the parri passu repayment of limited partners, a loan or waiver of the management fees, priority in any redemption or liquidation offers and/or rights or opportunities to co-invest alongside the partnership, whether generally or in particular circumstances.
Reporting and valuation requirements for Australian superannuation funds
In most private equity vehicles formal valuations are conducted in accordance with the private equity firm’s valuation policy, usually on an annual basis. Reporting of these valuations and ‘up-to-date’ investment figures are also provided an annual basis, however, most firms also offer quarterly investor reports.
There are number issues with these valuation and reporting methods for trustees of Australian superannuation schemes. In particular:
- the reporting frequency generally does not align with Australia’s income tax year which begins on 1 July and ends 30 June each year
- the private equity firm’s valuation methods and policies generally differ to the Trustee’s, which will be based on Australian accounting concepts and
- the ad-hoc reporting may not provide sufficient information to satisfy the auditor or regulator of the Trustee of the Australian superannuation scheme.
Accordingly, private equity firms are well advised to offer these investors additional access to reporting and information, including where it is required to satisfy the investor’s domestic taxation obligations or otherwise required by a federal regulator.
History of Australian superannuation schemes
Australian superannuation schemes generally have a particular demographic or industrial slant to their membership base. For this reason, many Trustees have other non-economic considerations which they must be cognisant of when deploying funds which they hold for the benefit of their members. For example, some superannuation schemes represent employees of the nursing and hospital industrial sector and may be prohibited or discouraged from deploying their member’s funds in the tobacco industry.
At the time of formation, investors in private equity funds, and often the general partners themselves, are uncertain of the type of investments in which the committed capital will be deployed. Accordingly, this creates the risk that the investment that the general partner ultimately selects will be in conflict with the preferences of an Australian superannuation scheme investor.
In order to avoid the penalties which may be associated with exiting a private equity venture and to ease the concerns of Trustees of Australian superannuation schemes, private equity funds should consider embedding exit rights for these investors, should a proposed investment conflict with their investment restrictions. Alternatively, private equity firms could create a mechanism in the constitutional documents to allow the general partner to offer these investments to the other investors in a co-investment vehicle (such as a parallel or feeder vehicle) in situations where the Australian superannuation scheme investor is unable to invest, which can be used to effectively remove the superannuation scheme from the syndicate of investors, in relation to that particular investment.