At a glance
Here is the typical (and simplified) business model of the private equity/venture capital industry: The PE/VC firm sets up a fund and seeks "capital commitments" from institutional and high-net-worth investors. For the first 5 to 6 years of the fund’s life, the firm would source attractive targets to acquire and draw "capital contributions" from the investors to fund those deals, while collecting management fees based on the total commitments. For the remaining term of the fund, the firm would seek to exit the investments by selling the acquired assets for a profit and generate returns for investors. Management fees are still collected during this exit period but may be calculated based on a small base (typically on the then "invested capital"). Profits generated for investors above a certain hurdle ("preferred return") are shared with the firm ("carried interest"). These arrangements are typically held together through a structure known as a "limited partnership."
Although PE/VC investments in Thailand have sprung up and grabbed the headlines for quite some time, the acquirers usually fund the investments with their own money through their own PE/VC arms. However, Thailand has recently seen a growing interest in the traditional PE/VC business model of raising funds from third-party investors and making money through management fees and carried interest. Attention has been paid to a relatively new type of investment vehicle called private equity trust (PE trust). In this article, we will explore several aspects of PE trust, which we found to have gained traction and generated interest in the Thai capital market recently.
What is PE trust?
PE trust is a type of investment vehicle under the Trust for Transactions in the Capital Market Act B.E. 2550 (the "Trust Act") and is regulated by the Securities and Exchange Commission (the "SEC").1 Key legal characteristics set by the SEC are that (1) PE trust needs to raise funds from more than one eligible investor2 with no intention to be a "private trust" and (2) the legal form of investment is equity (or provision of financial support in exchange for an option to subsequently acquire equity) with an arrangement that allows for participation in the management (or to otherwise have an active role with respect to the operation) of the investee companies.
The SEC intends PE trust to be a new type of investment vehicle for "private equity"3 fundraising and investment activities in Thailand, much like what other countries have achieved with their limited partnership vehicles.4 But despite its name, PE trust can be used for a variety of investment strategies: private equity, venture capital, debt and other types of investments. Throughout this article, we will explore in greater detail how PE trust can mimic the typical private equity fund that takes the form of limited partnership found in places like Singapore, the Cayman Islands, Luxembourg and the United States.
Concepts borrowed from foreign limited partnership
The contents of a trust deed are regulated under the Trust Act and relevant SEC notification.5 But to the extent the trust deed meets the minimum contents6 set out by law, there is ample room for the parties to flexibly bake in their commercial arrangements as part of the trust deed. This is by design. As mentioned earlier, the Office of the SEC intends this type of investment vehicle to resemble offshore private equity funds that take the form of limited partnership. In fact, this drafting flexibility allows trust sponsors to employ many typical mechanics of foreign limited partnership agreements which is an appealing feature of PE trust. We will discuss two examples of such mechanics here: capital commitment/contribution and distribution waterfall.
1. Capital commitment and capital contribution
One feature that distinguishes offshore private equity funds from typical Thai investment vehicles such as mutual funds and limited companies is when capital is contributed to the vehicles. Thai investment vehicles usually require the capital to be contributed entirely upfront with no additional commitments made by the investors. An exception might be how stock in private companies can be partially paid upfront (which must be at least 25% paid up). By contrast, offshore private equity funds usually do not require any capital to be contributed when the fund is set up but investors make commitments to contribute capital when called upon at a later stage, usually in installments. Underlying this practice is the fact that most private equity funds do not deploy capital immediately following their formation, coupled with the fact that fund performance is typically measured as an internal rate of return (IRR). As an aside, undrawn commitments available to the fund manager are called, in the industry’s parlance, "dry powder," representing the acquisition ammunition at the fund’s disposal. As of June 30, 2021, according to Bain, the industry’s dry powder stood at a whopping USD 3.3 trillion.
2. Distribution waterfall
A quintessential feature of most private equity funds, a distribution waterfall is the method by which distributions are made by a fund to various parties (notably, investors and fund manager). A topic that easily warrants a dedicated article, a distribution waterfall, in simple terms, determines when and how much, if any, the general partner or the fund manager gets to take a share of the investors’ profit — called "carried interest" or "carry" — usually after the investors have received a return of their contributed capital and preferred return8 (sometimes called "hurdle" or "hurdle rate"). A distribution waterfall, however, varies in terms and complexity. For example, some funds might specify several tiers of hurdles and carry.
The flexibility of PE trust documentation allows the mechanics of a distribution waterfall, however complex, to be baked in to allow the return on investment to be allocated among the trust manager and investors in a pre-determined order.
Here is a simple illustration.
In this illustration, the investor (LP) will get all the investment proceeds until it has received all of its contributed capital9 plus an IRR of 8% per annum. Thereafter, the fund manager (GP) will take 20% of each profit dollar that would otherwise belong to the investor until the investor has received a return that represents an IRR of 12% per annum, at which point the fund manager’s profit sharing percentage will increase to 30%.
Key legal concepts
1. Relevant parties
Relevant parties in any PE trust include trustee, trust manager, settlor and investors.
a) Trustee as legal owner and settlor
As PE trust is still considered one form of trust, a licensed trustee is required to be involved as the sole legal owner of the trust’s assets. Only trustees with a PE trust-specific license can act as one for PE trust. As of this writing, there are three trustees with such license published on the SEC website. In addition to holding the assets of the trust, the trustee as a licensed business operator is required to ensure that the trust under its management is managed according to the trust deed and relevant laws and regulations.10
As for formalities, there needs to be a settlor who transfers an initial asset in the form of cash to the trustee in order to set up a PE trust. A settlor must either be the trustee itself or a duly registered trust manager. Typically, especially in cases where the trust manager is not duly registered with the Office of the SEC to act as settlor, the trustee takes both the roles of trustee and settlor.
b) Trust manager as manager of the fund
In what the SEC envisions as a checks-and-balances arrangement, the trustee is required to appoint a third-party "trust manager" to manage the affairs of the trust. To act as the trust manager of a trust does not require any license from the SEC. In the real world, the trust manager is the sponsor of the deal (or the general partner, or GP, in the context of a foreign limited partnership) who engages a licensed trustee to act as both trustee and settlor to set up a PE trust. Day-to-day and investment responsibilities, including benefits such as management fees and carry, will belong to the trust manager while the roles of the trustee will be limited to supervisory ones such as supervising the trust manager to manage the trust according to the trust deed and those directly related to the regulator such as routine filings.
c) Investors as beneficiaries
Lastly, there have to be beneficiaries who will reap the benefits from the returns generated by the trust. Although the law does not require the beneficiaries to be the provider of funding to the trust, in reality it is the trust’s investors who provide the funding and reap the benefits as trust beneficiaries. The terms are therefore often used interchangeably.
2. Setting up a PE trust
Unlike other types of trust such as REITs (real estate investment trust), setting up a PE trust does not require approval from the Office of the SEC. In fact, as soon as the following actions are taken, a PE trust is said to have been formed:11
(a) initial cash is transferred by the settlor to the trustee as an initial asset of the trust;
(b) the trust deed is entered into between the settlor and the trustee;12 and
(c) where the trustee also acts as the settlor, a declaration of trust formation (issued by the trustee) is filed with the Office of the SEC.
We view PE trust as a very flexible and interesting vehicle alternative bound to generate a great deal of interest in the private equity/venture capital space in Thailand. This structure offers to investors an option to invest in promising businesses relying on the management of experienced trust managers and licensed trustees. It could also benefit private equity/venture capital firms as a way to attract funding and securing preferred economic arrangements. In fact, we have seen a growing number of clients in the industry looking to understand this vehicle in depth.
Aspiring fund sponsors looking to set up a PE trust will need to find legal advisors who genuinely understand the ins-and-outs of both PE trust and foreign limited partnerships to help navigate the deals properly.