The International Funds team is a very substantial team within the legacy SJ Berwin European firm and we have now successfully established a Global Funds team covering China, Hong Kong, Australia and now the proposed offices in United States (for fund formations) and Singapore as well as Europe and the Middle East. At the core of what we do is structuring, advising on taxation, regulation and other legal issues, helping to set the terms and conditions, drafting the documents, negotiating with investors and establishing private equity funds. We also do similar funds in relation to energy and infrastructure, natural resources, real estate, venture capital, debt products, funds of funds and secondaries as well as the downstream transactional work when the fund acquires or sells portfolio companies. We are the establishing these funds not only all the countries where we have offices but also other countries internationally.
My own background with these funds goes back to the early 1980's when I was a senior associate or young partner with the firm. A client of Stanley Berwin (the late founder and senior partner of SJ Berwin) asked me to set up a venture capital fund for one of his clients which had to fulfil a number of requirements like those below. At that stage I knew nothing about fund structuring and had no idea where to start, particularly as the client wanted the structure to be onshore in England for tax purposes rather than the Jersey or Cayman structures that had been used before. We ended up suggesting a limited partnership, which was something that had never been used in this situation before and, despite a number of people thinking that it could not work, we ended up getting the agreement of the UK Inland Revenue and the Department of Trade and Industry to using limited partnerships in this way in 1987. Since then, they have become the standard structure used for private equity and similar funds.
I. Basic Characters
The basic fund model is a closed ended, limited life, self-liquidating fund. This means a fund which raises capital either as cash or as commitments from investors at the outset and then closes (although there can be more than one closing). It then makes a single series of investments, typically over a 3-5 year period, which normally involves acquiring a substantial stake in companies and in many cases control (when it called a "buyout"). The fund then continues to hold and monitor and, hopefully, add value to those portfolio companies for a further period of, say, 5 years and then sells or realises its investment in each portfolio company. As share proceeds or income are received, the money is distributed to the investors. The fund, therefore, has a limited life of about 10 years (with provision for limited extensions) and as each investment is sold, the proceeds are distributed rather than re-invested so that when the last investment has been sold and distributed, the fund will automatically have liquidated.The terms and conditions of the fund reflect this. A particular feature is that most investors will expect to negotiate and discuss the terms of the limited partnership agreement or other constitutional documents and some also ask for side letters. Since there can be several hundred investors in some larger funds coordinating all these comments particularly if some lead to amendments (which is usual) and the side letters (which usually need then to be given equally to all investors under "Most Favoured Nation" provisions) is a huge challenge.
This is the most typical model for a private equity style fund but there are alternative models. The first is where the fund is evergreen or perpetual so that the proceeds of realisation of each investment are re-invested. The question is then how investors in the fund can realise their investment and these funds are often quoted on a stock exchange to provide a means of realisation. Another common model is the open-ended model, common in the hedge fund world but sometimes also used for other asset classes. This allows investors to acquire an interest in the fund at any time either by expanding the fund itself or by purchasing from existing investors and also gives investors a right to have their interest redeemed again either by the fund itself or by selling their interest in a controlled manner (and there are normally limitations on the right of redemption). This model is clearly most suited for liquid, easily tradable investments such as quoted securities where one can sell part of a holding and also acquire more, rather than illiquid investments like private equity or infrastructure investments but it is sometimes used in a restricted form for these asset classes too.
Although this article covers all these models to some extent, it is mainly focused on the private equity style model, the closed ended limited life self-liquidating model which is often structured internationally as a limited partnership.
II. Limited Partnership Structure
The main issue that the structure is addressing is avoiding an additional layer of tax which would arise in many countries if the structure were a simple company. In that case, the fund company would be liable to tax on selling investments at a profit or on income received from investments and the investors as shareholders in the fund company would be liable to tax again on receiving distributions from the company or on the liquidation of the company with the result that the investors would be liable for more tax than they would have been if they had made the investment directly themselves. The limited partnership structure is tax transparent in most countries so that where the limited partnership makes a taxable profit the investors as limited partners are liable to tax as if they had made that profit themselves. The alternative is using a corporate structure in a tax haven such as Cayman. So one ends up using a limited partnership structure or an onshore corporate structure if one is sure that will not create an additional layer of tax, for example, for a domestic RMB fund. In an international situation it is more common to use a limited partnership based in a tax haven such as Cayman.
Apart from avoiding the double-charge or additional charge to tax, investors want to ensure that their liability is limited to their investment and the private equity house will want to ensure that it is suitable for different types of investor and that it is flexible and that is tax efficient for the house and the management team in respect of carried interest or management incentive. It also needs to be simple to administer.
All of these requirements are usually met by a limited partnership structure. In an international context there may be investors coming from several different countries, the fund may have management teams in several different countries and there may also be investments being made in several different countries and so no one structure will necessarily work in every situation, but the limited partnership is well tried and tested and works or can be adapted to most situations. The basic structure is set out in the Figure 1 which shows the fund as a Cayman limited partnership with investors as limited partners and with a general partner in the Cayman Islands advised by an advisory company in the PRC. It is important that it is only advice being given and not management decisions that are being taken in the PRC to avoid establishing a taxable permanent establishment in the PRC which will render the fund and its investors liable to tax in the PRC. There is also a special limited partner which is a carried interest limited partnership in which the PRC advisor or more commonly the individual members of its management team are limited partners and thereby receive their carried interest. There are a number of variations on how the carried interest can be structured to seek to ensure that it is not taxable as remuneration but as capital gain or dividend income. The fund then invests in portfolio companies in the PRC or elsewhere often through an intermediate holding company for example in Hong Kong to reduce withholding taxes. Although not shown on the slide, some of the investors are also invited to participate on an investor advisory committee which exists for consultation purposes and to decide on conflicts of interest but does not make decisions nor does it decide whether or not to make specific investments. A similar onshore based structure is used for domestic RMB funds.
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The basic terms of a private equity fund are that the fund pays an annual management fee through the general partner to the managers or advisors of a percentage that is usually between 1.5 per cent and 2.5 per cent of the total commitments to the fund. That management fee is paid during the commitment period of, say, 5 years and then reduces to the same and sometimes a lower percentage of the costs of the investments remaining in the fund so that as investments are sold and the proceeds distributed the management fee reduces. There is also a carried interest paid to the manager or more commonly directly to the executives within the management company of 20 per cent of the profits made by the fund. This is normally subject to a preferred return so that the .way the cash flows work (which is often called the cash "waterfall") is as follows. The investors are first paid their invested commitment in the fund. Investors will then receive a preferred return on that commitment equal to an interest rate of 8 per cent. Distributions in excess of that amount go to the management team until they have “caught up” on the preferred return paid to the investors so that once they have caught up they have received 20 per cent of the profits. Then any remaining distributions are divided 80/20 between the investors and the management team. The result is that the managers receive 20 per cent of the total profit provided that the preferred return of, typically, 8 per cent has been reached. The managers are also normally asked to make a commitment themselves to the fund which is commonly 1 per cent or more of the total commitments to the fund to help align their interests further.
There are also a number of non-financial terms, for example giving investors the right to remove the general partner or to stop the fund from making further investments for example if the key individual investment professionals in the management team leave; these are called key man provisions. Typically, all these terms and conditions are set out in considerable detail in a limited partnership agreement and these terms are negotiated by most investors before they invest in the fund.
The typical investors in these funds are institutional investors commonly pension funds, insurance companies, sovereign wealth funds, family offices, government agencies and banks as well as some corporates and they come from all over the world.
As well as considering taxation, one has to consider the impact of regulation on marketing the fund internationally and on making investments in whatever countries the investments are made. Examples are the Alternative Investment Funds Manager Directive in Europe and both marketing and special pension fund legislation in the United States. There is also considerable regulation of how these funds operate in China.There is little or no regulation or taxation in the Cayman Islands which is one of the reasons why it is so frequently used for international funds but there is still regulation and taxation according to where the fund is marketed, where the fund is managed and where the fund invests.
We are able to structure private equity or similar funds in this way in all parts of the world with a little local tax and regulatory advice and are currently acting on funds across Europe, China, Asia, Africa, South America, Australia, India and the Middle East, Turkey and Japan.
III. RMB Funds and International Funds in China
With international funds trying to raise money from various countries, China has long been an attraction for international PE houses. However, due to lack of specific rules and regulations for onshore capital's investment into offshore PE funds and other types of private funds, Chinese investors' participation in international private funds has yet to become a common practice up till now.
Chinese investors intending to make overseas investment are generally subject to outbound investment filing, approval and foreign exchange registration at National Development and Reform Commission (NDRC), Ministry of Commerce (MOC), State Administration of Foreign Exchange (SAFE) and their local counterparts respectively. As is shown in the left column of Figure 2, Structure A is the most straightforward structure for domestic investors to invest overseas. However, the filing and approval of NDRC and MOC are usually granted based on their review of certain investment project and the overseas entity to be established. In terms of investment into offshore private funds, the authorities may find it difficult to grant their approval when little information on a specific project is provided. As an alternative, some domestic investors apply for the establishment of an offshore SPV, and the SPV will then invest in the overseas private fund. In practice, such arrangement may be approved in some places, but the SPV's investment amount may not be a large sum.
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In response to the above uncertainties, national and local authorities in China are proactively probing into different options for investment in offshore funds in recent years. Some pilot programs and investment vehicles are being and to be adopted by local governments, for example the Qualified Domestic Limited Partnership (QDLP) pilot program in Shanghai and the Qualified Domestic Investment Enterprise (QDIE) (to be launched) in Qianhai, Shenzhen. The QDLP pilot program adopts the investment structure as exhibited in the right column of Structure B in Figure 3. Under this structure, the domestic investors of the offshore fund will first invest in an onshore feeder fund. The feeder fund will then invest in the offshore funds. So far, the QDLP pilot program in Shanghai has approved a batch of 6 QDLP funds investing into offshore hedge funds. The contemplated QDIE program in Qianhai, Shenzhen is expected to be a program similar to QDLP, and may give green light to investments in offshore private funds after its adoption in the near future.
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With respect to the administration of marketing and fundraising activities of private funds, China Securities Regulatory Commission (CSRC), the regulator of private funds in China, drafted the Draft Provisional Regulations of the Private Investment Fund (Draft) and submitted the Draft to the State Council for discussion in this early April. The Draft is applicable to all fundraising activities of private funds, provided that such activities are conducted within China. Thus offshore private funds may also have to comply with the requirements thereunder when they are raising capital from Chinese investors.
The parallel funds structure we discussed includes an offshore fund for foreign investors (USD Fund) and one onshore fund for local investors (RMB Fund), with the goal to co-invest into certain onshore or offshore portfolio companies. Unlike the traditional offshore parallel funds which may make substantially all investments together on pro-rata basis, co-investment by RMB and USD parallel funds in proportion to their respective commitments may not be possible or appropriate due to that: (i) there are restrictions on foreign investment in certain industries in China; (ii) there are restrictions on domestic investors investing overseas; (iii) there exists obstacle to obtain necessary approval for certain foreign investment or overseas investment in practice; and (iv) portfolio companies may have their preference for the funding from one of the parallel funds. Therefore, conflicts may arise, and the parallel fund manager is supposed to make efforts to mitigate such conflicts and risks, although it is almost a mission impossible to utterly eliminate all the conflicts, such as portfolio deal allocation, timing and size of successor funds, fund manager's carried interest distribution waterfall, and fund manager's input of resources, etc.