Forms of vehicle
What legal form of vehicle is typically used for private equity funds formed in your jurisdiction? Does such a vehicle have a separate legal personality or existence under the law of your jurisdiction? In either case, what are the legal consequences for investors and the manager?
In the United States, private equity funds are typically formed as limited partnerships in the State of Delaware, pursuant to the Delaware Revised Uniform Limited Partnership Act (DRULPA). A limited partnership formed under the DRULPA will have a separate legal personality, the existence of which will continue until cancellation of the limited partnership’s certificate of limited partnership. A Delaware limited partnership offers investors the benefits of limited liability as well as flow-through tax treatment in the US. The personal liability of a limited partner is generally limited to the amount of the capital contributed or that has been agreed to be contributed (or returned) by such investor. The ‘manager’ is the general partner of the fund with control over and, subject to certain limitations, general liability for the obligations of the partnership.
Forming a private equity fund vehicle
What is the process for forming a private equity fund vehicle in your jurisdiction?
A limited partnership requires at least one general partner and one limited partner, neither of which needs to be a Delaware entity. To form a limited partnership, the general partner must execute and file a brief certificate of limited partnership setting forth certain basic information about the partnership. In Delaware, this filing is made with the secretary of state’s office. Each Delaware limited partnership must have and maintain (and identify in its certificate of limited partnership) a registered office and a registered agent for service of process on the limited partnership in Delaware. The certificate of limited partnership must also identify the name of the partnership and the name and address of the general partners, although the names of the limited partners need not be disclosed. In addition, depending on the US jurisdictions in which the private equity fund conducts its business, it may be required to obtain qualifications or authorisations (as well as comply with certain publication requirements) to do business in such jurisdictions. There is generally no time delay associated with filing the certificate of limited partnership; it can normally be prepared and filed on a same-day basis. The initial written limited partnership agreement to be entered into in connection with the formation of a limited partnership can be a simple form agreement, which can be amended and restated with more detailed terms at a later date. For a limited partnership formed in Delaware, the partnership agreement need not be (and generally is not) publicly filed. The fee for filing a certificate of limited partnership in Delaware is US$200 (although an additional nominal fee may be charged for certified copies of the filing or for expedited processing).
There is an annual franchise tax of US$300. The fees for obtaining authorisation to do business in a particular jurisdiction are usually nominal, but may be more costly in certain states. There are no minimum capital requirements for a Delaware limited partnership.
A private equity fund will typically engage counsel to draft the certificate of limited partnership and the related partnership agreement. Filings in Delaware, as well as in other jurisdictions where an authorisation to do business is required, are typically handled by a professional service provider for a nominal fee (which also provides the registered agent and registered office services referred to above).
Is a private equity fund vehicle formed in your jurisdiction required to maintain locally a custodian or administrator, a registered office, books and records, or a corporate secretary, and how is that requirement typically satisfied?
A Delaware limited partnership must have and maintain a registered office and a registered agent for service of process in the state of Delaware. This requirement is typically satisfied by the limited partnership engaging for a nominal fee a professional service provider to act in these capacities (see question 2). Although under the DRULPA a limited partnership must maintain certain basic information and records concerning its business and its partners (and in certain circumstances provide access thereto to its partners), there is no requirement that such documents be kept within the State of Delaware. There is no requirement under Delaware law to maintain a custodian or administrator, although registered investment advisers under the US Investment Advisers Act of 1940, as amended (the Advisers Act) must maintain an independent custodian of client assets, in order to comply with the requirements of Rule 206(4)-2 (the custody rule) thereunder.
Access to information
What access to information about a private equity fund formed in your jurisdiction is the public granted by law? How is it accessed? If applicable, what are the consequences of failing to make such information available?
Although the DRULPA provides that limited partners are entitled (if they have a proper purpose and subject to such reasonable standards as may be set forth in the partnership agreement or otherwise established by the general partner) to receive a list of the names, addresses and capital commitments of the other partners, a copy of the partnership agreement and any amendments thereto and certain other information, the limited partnership’s partnership agreement may limit or expand this. Further, the partnership agreement may, and typically does, provide that any such information provided to limited partners is confidential and is not to be disclosed by a limited partner to third parties. Therefore, the public is not generally entitled to information (other than the identity of general partners, which is set forth in the certificate of limited partnership) about Delaware limited partnerships. Nevertheless, as a result of the US Freedom of Information Act (FOIA), certain similar state public records access laws and other similar laws, certain limited partners who are subject to such laws may be required to disclose certain information in their possession relating to the partnership. Generally, the information that has been released to date pursuant to FOIA and similar laws has typically been ‘fund level’ information (eg, overall internal rates of return, other aggregate performance information, amounts of contributions and distributions, etc) but not ‘portfolio company level’ information (eg, information relating to individual investments by the fund). Also, limited partnership agreements and the list of limited partners have generally been protected from disclosure to the public. A general partner’s failure to comply with the reporting requirements of applicable law or the partnership agreement (or both) could result in a limited partner seeking injunctive or other equitable relief, monetary damages, or both.
Limited liability for third-party investors
In what circumstances would the limited liability of third-party investors in a private equity fund formed in your jurisdiction not be respected as a matter of local law?
Under Delaware partnership law, a limited partner is not liable for the obligations of a limited partnership unless such limited partner is also a general partner or, in addition to the exercise of the rights and powers of a limited partner, such limited partner participates in the ‘control of the business’ of the partnership within the meaning of the DRULPA. It is generally possible to permit limited partners to participate in all aspects of the internal governance and decision-making of the partnership without jeopardising the limited liability status of a limited partner, as long as it is done in a prescribed manner. Even if the limited partner does participate in the control of the business within the meaning of the DRULPA, such limited partner is liable only to persons who transact business with the limited partnership reasonably believing, based upon the limited partner’s conduct, that the limited partner is a general partner.
In addition, under the DRULPA, a limited partner who receives a distribution made by a partnership and who knew at the time of such distribution that the liabilities of the partnership exceeded the fair value of the partnership’s assets is liable to the partnership for the amount of such distribution for a period of three years from the date of such distribution, and partnership agreements of private equity funds commonly impose additional obligations to return distributions. There may be additional potential liabilities pursuant to applicable fraudulent conveyance laws. In any case, limited partners are liable for their capital contributions and any other payment obligations set forth in the limited partnership agreement or related agreement (such as a subscription agreement) to which they are a party.
Fund manager’s fiduciary duties
What are the fiduciary duties owed to a private equity fund formed in your jurisdiction and its third-party investors by that fund’s manager (or other similar control party or fiduciary) under the laws of your jurisdiction, and to what extent can those fiduciary duties be modified by agreement of the parties?
A general partner of a limited partnership generally will owe fiduciary duties to the partnership and its partners under Delaware law, which include the duties of candour, care and loyalty. However, under Delaware law, to the extent that, at law or equity, a partner or other person has duties (including fiduciary duties) to a limited partnership or to another partner or to another person that is a party to or is otherwise bound by a partnership agreement, the partner’s or other person’s duties may be expanded or restricted or eliminated by the provisions in the partnership agreement, provided that the partnership agreement may not eliminate the implied contractual covenant of good faith and fair dealing. Under Delaware law, a partnership agreement may provide for the limitation or elimination of any and all liabilities for breach of contract and breach of duties (including fiduciary duties) of a partner or other person to a limited partnership or to another partner or to another person that is a party to or is otherwise bound by a partnership agreement, provided that a partnership agreement may not limit or eliminate liability for any act or omission that constitutes a bad faith violation of the implied contractual covenant of good faith and fair dealing. In addition, practitioners should note that contractual standards of duty or conduct set forth in the partnership agreement will replace common law fiduciary duties with respect to Delaware limited partnerships (whether such standards are higher or lower); therefore, precise crafting of the language in a partnership agreement with respect to fiduciary duties relating to a Delaware limited partnership is important.
In addition, investment advisers (whether or not registered) owe fiduciary duties to their clients. Such fiduciary duties are not specifically set forth in the Advisers Act or established by rules promulgated by the Securities and Exchange Commission (SEC), but are imposed on investment advisers by operation of law because of the nature of the relationship between the investment advisers and their clients. Such fiduciary duties are embodied in the anti-fraud provisions of section 206 of the Advisers Act.
Does your jurisdiction recognise a ‘gross negligence’ (as opposed to ‘ordinary negligence’) standard of liability applicable to the management of a private equity fund?
Delaware does recognise a ‘gross negligence’ standard of liability to the extent such standard is provided for in the applicable partnership agreement. As a matter of market practice, the exculpation and indemnification provisions in a private equity fund’s limited partnership agreement typically carve out acts or omissions that constitute gross negligence, but under Delaware law, a partnership agreement could expressly exculpate or indemnify for such acts or omissions.
Other special issues or requirements
Are there any other special issues or requirements particular to private equity fund vehicles formed in your jurisdiction? Is conversion or redomiciling to vehicles in your jurisdiction permitted? If so, in converting or redomiciling limited partnerships formed in other jurisdictions into limited partnerships in your jurisdiction, what are the most material terms that typically must be modified?
Restrictions on transfers and withdrawals, restrictions on operations generally, provisions regarding fiscal transparency and special investor governance rights on matters such as removal of the general partner or early dissolution of the private equity fund are all matters typically addressed in the provisions of the partnership agreement and will vary from fund to fund. Typically, the partnership agreement will require the consent of the general partner to effect a transfer of a partnership interest in a limited partnership. This requirement enables the general partner to maintain the fund’s compliance with applicable legal, tax and regulatory requirements and exemptions, as well as evaluate the appropriateness as a commercial matter of the proposed transferee. Although there is generally no right for a limited partner to withdraw from a Delaware limited partnership under the DRULPA, the limited partnership agreement for a private equity fund may provide for certain withdrawal rights for limited partners, typically only in limited circumstances for legal and regulatory reasons. Limited partners have the right to petition the Delaware Court of Chancery for withdrawal or similar equitable relief in egregious circumstances (eg, fraud); however, obtaining such relief can be difficult.
In converting or redomiciling a limited partnership formed in a non-US jurisdiction into a limited partnership in a US jurisdiction (eg, Delaware), particular attention should be given to requirements of the certificate of limited partnership domestication and certificate of limited partnership that may be required to be filed, as well as any other requirements of the applicable state’s laws relating to maintaining a limited partnership in such jurisdiction (see question 2). In addition, depending on where the redomiciled fund conducts its business, it may be required to obtain qualifications or authorisations to do business in certain jurisdictions. Any provisions of the partnership law of the state into which such domestication is effected that are otherwise inconsistent with the pre-existing governing agreement of such partnership should be reviewed and modified as necessary to ensure conformity with the applicable law. Consideration should also be given to the tax consequences of converting or redomiciling a limited partnership.
Certain aspects of US securities laws apply differently with respect to US and non-US private equity funds. For example, in determining whether a private equity fund formed in the US will qualify for exemption from registration under the Investment Company Act of 1940, as amended (the Investment Company Act), all investors, both US and non-US, are analysed for determining the fund’s compliance with the criteria for exemption. By contrast, in the case of a private equity fund formed in a jurisdiction outside the US, the staff at the SEC has taken the position that only US investors must be analysed for the purposes of making that same determination (assuming certain other requirements are met).
Section 12(g) of the Securities Exchange Act of 1934, as amended (the Exchange Act) generally requires that any issuer having 2,000 or more holders of record (or 500 or more holders who are not ‘accredited investors’ as defined by the SEC) of any class of equity security and assets in excess of US$10 million register the security under the Exchange Act and comply with the periodic reporting and other requirements of the Exchange Act. This section has the practical effect of imposing a limit of 1,999 investors in any single US-domiciled private equity fund. In addition, Rule 12g3-2(a) under the Exchange Act provides an exemption from the registration requirement described above for a non-US domiciled private equity fund that qualifies as a ‘foreign private issuer’ and has fewer than 300 holders of equity securities resident in the US. Rule 3b-4(c) under the Exchange Act provides that a private equity fund that is organised outside of the US generally qualifies as a foreign private issuer unless more than 50 per cent of its outstanding voting securities are held by US residents and any of the following applies: a majority of its executive officers and directors are US citizens or residents; more than 50 per cent of its assets are located in the US; or its business is administered principally in the US.
For purposes of generally accepted US accounting principles, to avoid consolidation of the financial statements of a private equity fund with its general partner, which is an issue of particular concern for some publicly listed private equity fund sponsors, the fund must provide its unaffiliated limited partners with the substantive ability to dissolve (liquidate) the fund (and appoint a third party as liquidator) or otherwise remove the general partner without cause on a simple majority basis (often referred to as kick-out rights).
Fund sponsor bankruptcy or change of control
With respect to institutional sponsors of private equity funds organised in your jurisdiction, what are some of the primary legal and regulatory consequences and other key issues for the private equity fund and its general partner and investment adviser arising out of a bankruptcy, insolvency, change of control, restructuring or similar transaction of the private equity fund’s sponsor?
Depending on the structure of a private equity fund and its general partner and the specific provisions of their operating agreements, the bankruptcy or insolvency of the ultimate sponsor of a private equity fund could result in the bankruptcy or dissolution of the private equity fund’s general partner or investment adviser or of the fund itself. Moreover, such a bankruptcy or insolvency event could result in the inability of the sponsor to meet its funding obligations with respect to its capital commitment to the private equity fund. Depending on the terms of the private equity fund’s partnership agreement, such a default could constitute a ‘cause’ event and thereby trigger rights of the limited partners to remove the private equity fund’s general partner, dissolve the private equity fund itself or cause the forfeiture of all or a portion of the general partner’s unrealised carried interest, or all of these. In addition to such ‘cause’ protections, a sponsor bankruptcy may result in a private equity fund’s limited partners seeking to exercise the ‘no-fault’ remedies included in many partnership agreements, which often permit termination of the investment period, removal of the private equity fund’s general partner or dissolution of the private equity fund. With respect to US bankruptcy law, a sponsor that has filed for reorganisation under Chapter 11 of the US Bankruptcy Code should still be permitted to operate non-bankrupt subsidiaries (including, for example, related private equity funds and their general partners) as ongoing businesses, although this raises a variety of operational issues including, for example, whether ordinary course investment and private equity fund management decisions must be approved by the bankruptcy court.
A change of control or similar transaction with respect to an institutional sponsor may also give rise to statutory and contractual rights and obligations, including one or both of the following:
- a requirement under the Advisers Act for registered investment advisers and those required to be registered to obtain effective ‘client’ consent (namely, consent of the private equity fund’s limited partners or a committee thereof) to transactions involving an ‘assignment’ of the sponsor’s investment advisory contract (which a change of control generally triggers); and
- the ability of the private equity fund’s limited partners to cancel the commitment period, dissolve the fund, remove the general partner or sue the general partner for a breach of a negative covenant against transfers of interests in the general partner under the terms of the private equity fund’s partnership agreement.
Regulation, licensing and registration
Principal regulatory bodies
What are the principal regulatory bodies that would have authority over a private equity fund and its manager in your jurisdiction, and what are the regulators’ audit and inspection rights and managers’ regulatory reporting requirements to investors or regulators?
Advisers Act registration requirements and exemptions
The SEC has the authority to regulate investment advisers pursuant to the Advisers Act. Investment advisers may also be subject to regulatory requirements at the state level. Under the Advisers Act, all investment advisers to private equity funds are generally required to be registered with the SEC under the Advisers Act unless they meet one of the following limited exemptions from such registration:
- the venture capital fund adviser exemption - investment advisers solely to venture capital funds (private funds that represent themselves to their investors and prospective investors as pursuing a venture capital strategy and that comply with other significant requirements, including limitations of the amount of leverage they may incur and type of assets in which they may invest);
- the foreign private adviser exemption - investment advisers who are not holding themselves out to the public in the US as an investment adviser or advising registered funds, have no US place of business, have fewer than 15 US clients and US investors in total in private funds, and have assets under management (AUM) (as discussed below) from such US clients and US investors of less than US$25 million; and
- the private fund adviser exemption - investment advisers solely to private funds with AUM of less than US$150 million (discussed further below). However, for non-US investment advisers, the private fund adviser exemption provides that a non-US investment adviser would not be required to register as long as the following is true:
- it has no client that is a US person except for qualifying private funds; and
- any assets managed by such adviser at a place of business in the US are solely attributable to private fund assets the total value of which is less than US$150 million.
AUM includes 100 per cent of any securities portfolios or private funds for which an investment adviser provides continuous and regular supervisory or management services, regardless of the nature of the assets held by the portfolio or the private fund. In addition, AUM includes 100 per cent of any proprietary assets, assets managed without receiving compensation and any uncalled capital commitments to private funds.
In determining whether an investment adviser can rely on the private fund adviser exemption, the SEC considers an investment adviser’s principal office and place of business as the location where the investment adviser controls the management of private fund assets, although day-to-day management of certain assets may take place at another location. An investment adviser with its principal office and place of business in the US must count all private fund assets, including those from non-US clients toward the US$150 million limit in calculating AUM. An investment adviser with its principal office and place of business outside of the US need only count private fund assets it manages at a place of business in the US toward the US$150 million limit. An investment adviser provides ‘continuous and regular supervisory or management services’ with respect to a private equity fund from a place of business in the US if its US place of business has ‘ongoing responsibility to select or make recommendations’ as to specific securities or other investments the fund may purchase or sell and, if such recommendations are accepted by the fund, the investment adviser’s US place of business is responsible for arranging or effecting the purchase or sale. However, the SEC does not view merely providing research or conducting due diligence to be continuous and regular supervisory or management services at a US place of business if a person outside of the US makes independent investment decisions and implements those decisions. Therefore, a private fund adviser with its principal office and place of business outside of the US that cannot meet the terms of the foreign private adviser exemption because it has raised more than US$25 million from US investors can often rely on the private fund adviser exemption because the type or number of non-US clients or the amount of assets managed outside of the US are not taken into account when calculating the AUM of an investment adviser with its principal office and place of business outside the US.
Investment advisers relying on the venture capital fund exemption or the private fund adviser exemption are considered to be exempt reporting advisers (ERAs) and are required to report with the SEC by filing certain portions of Form ADV, Part 1 within 60 days of relying on the exemption. These portions require disclosure of certain basic information with respect to the investment adviser, its activities and the private funds that it advises. An adviser’s Form ADV filing must be amended at least annually, within 90 days of the end of the investment adviser’s fiscal year, and more frequently for certain specific changes. The SEC is authorised to require an ERA to maintain records and provide reports, and to examine such ERA’s records, which means an ERA’s books and records are subject to SEC inspection. The SEC has in the past indicated that it intends to examine ERAs as a part of the SEC’s routine examination programme. ERAs are not required to file Form PF described below. Investment advisers relying on the foreign private adviser exemption are not required to file reports with the SEC.
In addition to the exemptions described above, certain investment advisers are excluded from the definition of ‘investment adviser’ and thus are not required to register under the Advisers Act. For example, a ‘family office’, which is generally a company owned and controlled by family members that provides investment advice only to family clients and does not hold itself out to the public as an investment adviser, is so excluded from the definition.
On the other hand, subject to certain exceptions, investment advisers with less than US$100 million in AUM are generally prohibited from registering with the SEC under the Advisers Act and must instead register as an investment adviser in the state in which they maintain a principal office and place of business and be subject to examination as an investment adviser by the applicable securities commissioner, agency or office.
A registered investment adviser with at least US$150 million of ‘private fund’ (ie, a fund relying on 3(c)(1) or 3(c)(7)) AUM is required to file Form PF with the SEC, which requires disclosure of certain information regarding each private fund an investment adviser advises, including gross and net asset value, gross and net performance, use of leverage, aggregate value of derivatives, a breakdown of the fund’s investors by category (eg, individuals, pension funds, governmental entities, sovereign wealth funds), a breakdown of the fund’s equity held by the five largest investors and a summary of fund assets and liabilities. Registered investment advisers to hedge funds are also required to report additional information about the hedge funds they advise, including fund strategy, counterparty credit risk and use of trading and clearing mechanisms. Large private fund advisers are required to report more extensive information, with the nature of the information dependent upon their strategy. Additional disclosure requirements apply to registered investment advisers to private equity funds with at least US$2 billion in AUM (ie, large private equity advisers). Such disclosure requirements focus on fund guarantees of controlled portfolio company obligations, leverage of controlled portfolio companies and use of bridge financing for controlled portfolio companies. In addition, registered investment advisers to hedge funds with at least US$1.5 billion in AUM (ie, large hedge fund advisers) must report on an aggregated basis information regarding exposures by asset class, geographical concentration and turnover, and for hedge funds with a net asset value of at least US$500 million, they must also report certain information relating to such fund’s investments, leverage, risk profile and liquidity. For registered investment advisers that manage only private equity funds, real estate funds and venture capital funds (as well as registered investment advisers to hedge funds that have a smaller AUM), the form has to be filed annually within 120 days of the fiscal year-end. Large hedge fund advisers must file Form PF on a quarterly basis within 60 days of the end of each fiscal quarter. Unlike Form ADV filings, which are available on the SEC’s website, Form PF filings are confidential and such information is exempt from requests for information under FOIA. However, the SEC is required to share information included in Form PF filings with the Financial Stability Oversight Council and in certain circumstances US Congress and other federal departments, agencies and self-regulatory organisations (in each case, subject to confidentiality restrictions). We note that, for purposes of Form PF, a private fund that is required to pay a performance fee based on unrealised gains to its investment adviser or has the ability to borrow in excess of certain thresholds or sell assets short is deemed to be a per se hedge fund.
Regulation applicable to unregistered advisers
Even unregistered investment advisers (whether ERAs or not) are subject to the general anti-fraud provisions of the Exchange Act, the Advisers Act (see question 6), state laws and, if required to register as a broker-dealer with the Financial Industry Regulatory Authority (FINRA) (see question 11), similar rules promulgated by FINRA, and the SEC and many of the analogous state regulatory agencies retain statutory power to bring actions against a private equity fund sponsor under these provisions.
US Commodity Futures Trading Commission (CFTC) regulation
The CFTC has the authority to regulate commodity pool operators (CPOs) and commodity trading advisers (CTAs) under the US Commodity Exchange Act. CFTC regulations broadly include most derivatives as ‘commodity interests’ that cause a private equity fund holding such instruments to be deemed a ‘commodity pool’ and its operator (typically the general partner, in the case of a limited partnership) to be subject to CFTC jurisdiction as a CPO and/or its adviser (typically the investment adviser) to be subject to CFTC jurisdiction as a CTA, and, unless an exemption is available, to become a member of the National Futures Association (NFA), the self-regulatory organisation for the commodities and derivatives market. The CFTC regulations will generally apply on the basis of holding any commodity interest, directly or indirectly and, as such, CPO and CTA status should be considered with respect to all investment activities and products, including, for example, private funds, real estate investment trusts, business development companies, separate managed account arrangements and any subsidiary entities, alternative investment vehicles and other related entities and accounts. CPOs managing private equity funds may claim certain exemptions from registration with the CFTC, which may include no-action relief (including for CPOs of ‘funds of funds’, real estate investment trusts and business development companies), the ‘de minimis’ exemption under CFTC Rule 4.13(a)(3) (providing relief for CPOs that engage in limited trading of commodity interests on behalf of a commodity pool) and ‘registration lite’ under CFTC Rule 4.7 (providing relief from certain reporting and record-keeping requirements otherwise applicable to a registered CPO if the interests in such pool are offered only to ‘qualified eligible persons’ (which includes a ‘qualified purchaser’ described in question 24 and ‘non-United States persons’) in a private offering of securities (including an offering that complies with Rule 506(c) under the Securities Act, as described in question 24)), and corresponding exemptions are available to CTAs of private equity funds. The confluence of regulatory measures taken in the post-financial crisis period, including the expansion of the meaning of commodity interests to include most swaps and the repeal of the broad exemption under CFTC Rule 4.13(a)(4), which was commonly relied upon by CPOs of private equity funds that rely on the 3(c)(7) exemption from registration under the Investment Company Act (ie, the qualified purchaser exemption described in question 24) placed additional regulatory pressure on private equity fund sponsors to monitor whether their activities will deem their private equity funds to be commodity pools (eg, because the funds hedge their currency or interest rate exposure by acquiring swaps), and to appropriately assess the registration requirements for CPOs and determine whether they meet the de minimis exemption from such registration, which requires consideration of a number of factors early in the process of structuring a fund and throughout its term. If an exemption or other relief is not available, a sponsor of a fund that invests in commodity interests (including derivatives) may be required to register with the CFTC and NFA, in which case it will become subject to reporting, record-keeping, advertising, ethics training, supervisory and other ongoing compliance obligations and certain of its personnel will become subject to certain proficiency requirements (eg, the Series 3 exam) and standards of conduct.
What are the governmental approval, licensing or registration requirements applicable to a private equity fund in your jurisdiction? Does it make a difference whether there are significant investment activities in your jurisdiction?
The offering and sale of interests in a private equity fund are typically conducted as ‘private placements’ exempt from the securities registration requirements imposed by the Securities Act, the regulations thereunder and applicable state law. In addition, most private equity funds require their investors to meet certain eligibility requirements so as to enable the funds to qualify for exemption from regulation as investment companies under the Investment Company Act. Accordingly, there are no approval, licensing or registration requirements applicable to a private equity fund that offers its interests in a valid private placement and qualifies for an exemption from registration under the Investment Company Act.
As a general matter, if 25 per cent or more of the total value of any class of equity interests in a private equity fund is held by ‘benefit plan investors’ (disregarding the value of interests held by the sponsor and its affiliates, and anyone providing investment advice to the private equity fund and its affiliates, unless they themselves are ‘benefit plan investors’), the private equity fund must be operated to qualify as an ‘operating company’ such as a ‘venture capital operating company’ (VCOC) or a ‘real estate operating company’ (REOC). In general, for purposes of applying the 25 per cent test, the term ‘benefit plan investors’ includes only those plans and arrangements that are subject to fiduciary responsibility standard of care under Title I of the Employee Retirement Income Security Act of 1974 (ERISA) and prohibited transaction rules under Title I of ERISA and section 4975 of the Internal Revenue Code of 1986 (the Code), such as US corporate pension plans and individual retirement accounts as well as entities whose assets include plan assets (such as a fund of funds). Plans that are not subject to the fiduciary responsibility standard of care under ERISA or prohibited transaction rules under ERISA and section 4975 of the Code, such as US governmental pension plans and pension plans maintained by non-US corporations, are not counted for purposes of the 25 per cent test. Qualification as a VCOC generally entails the private equity fund having on its initial investment date and annually thereafter at least 50 per cent of the private equity fund’s assets, valued at cost, invested in operating companies as to which the private equity fund obtains direct contractual management rights. The private equity fund must exercise such management rights with respect to one or more of such operating companies during the course of each year in the ordinary course of business.
The sponsor of a private equity fund engaging in certain types of corporate finance or financial advisory services may be required to register as a broker-dealer with FINRA and be subject to similar audit and regulation.
Registration of investment adviser
Is a private equity fund’s manager, or any of its officers, directors or control persons, required to register as an investment adviser in your jurisdiction?
In the absence of an applicable exemption, exception or prohibition, a private equity fund’s manager will be subject to registration as an investment adviser under the Advisers Act. (See question 10.)
Those investment advisers registered under the Advisers Act (whether voluntarily or because an exemption, exception or prohibition is not available) are subject to a number of substantive reporting and record-keeping requirements and rules of conduct that shape the management and operation of their business, as well as periodic compliance inspections conducted by the SEC.
As part of the shift towards more systematic regulation and increased scrutiny of the private equity industry, the SEC continues to focus on the examination of private equity firms. Certain private equity industry practices have received significant attention from the SEC and have led to a number of enforcement actions against private equity fund advisers in recent years. Areas that the SEC has highlighted to be of particular concern include, among others, the following:
- allocation of expenses to funds or portfolio companies, or both, without pre-commitment disclosure and agreement from investors (including for the compensation of operating partners, senior advisers, consultants and seconded and other in-house employees of private equity fund advisers or their affiliates for providing services (other than advisory services) to funds or portfolio companies or both);
- full allocation of broken deal expenses to funds instead of separate accounts, co-investors or co-investment vehicles without pre-commitment disclosure and agreement from investors;
- marketing presentations, and the presentation of performance information generally;
- receipt by private equity firms of compensation from funds or portfolio companies, or both, which is outside the typical management fee or carried interest structure without a corresponding management fee offset, without pre-commitment disclosure and agreement from investors as well as an acceleration of monitoring fees;
- receipt by private equity firms of transaction-based or other compensation for the provision of brokerage services in connection with the acquisition and disposition of portfolio companies without being registered as a broker-dealer;
- allocation of investment opportunities among investment vehicles they manage and between such funds and the private equity fund advisers, affiliates or employees;
- allocation of co-investment opportunities;
- disclosure of other conflicts of interests to investors, including those arising out of the outside business activities of a private equity sponsor’s employees and directors;
- valuation methods;
- receipt of service provider discounts by private equity firms that are not given to the funds or portfolio companies without pre-commitment disclosure and agreement from investors;
- plans to mitigate or respond to cybersecurity events;
- failure to fully allocate fees from portfolio companies to management fee paying funds to offset such management fees without pre-commitment disclosure and agreement from investors;
- allocation of interest from a loan to the private equity fund adviser only to the adviser or its affiliates without pre-commitment disclosure and agreement from investors;
- pay to play violations; and
- late filing of required filings (eg, Form PF).
Fund manager requirements
Are there any specific qualifications or other requirements imposed on a private equity fund’s manager, or any of its officers, directors or control persons, in your jurisdiction?
There are no particular educational or experience requirements imposed by law on investment advisers, although the education and experience of certain of an investment adviser’s personnel are disclosable items in the Form ADV. As a matter of market practice, the required experience level of an investment adviser’s management team will be dictated by the demands of investors. If required to register as a broker-dealer with FINRA, a private equity fund sponsor would need to satisfy certain standards in connection with obtaining a registration (eg, no prior criminal acts, minimum capital, testing, etc). Also, a private equity fund’s sponsor is typically expected to make a capital investment either directly in or on a side-by-side basis with the private equity fund (but see question 16 with respect to limitations on sponsor commitments in bank-sponsored private equity funds). Investors will expect that a significant portion of this investment be funded in cash, as opposed to deferred-fee or other arrangements.
Describe any rules - or policies of public pension plans or other governmental entities - in your jurisdiction that restrict, or require disclosure of, political contributions by a private equity fund’s manager or investment adviser or their employees.
The SEC has adopted Rule 206(4)-5, a broad set of rules aimed at curtailing ‘pay-to-play’ scandals in the investment management industry. The rules, subject to certain de minimis exceptions, prohibit a registered investment adviser, as well as an ERA and a foreign private adviser (covered advisers), from providing advice for compensation to any US government entity within two years after the covered adviser or certain of its executives or employees (covered associates) has made a political contribution to an elected official or candidate who is in a position to influence an investment by the government entity in a fund advised by such investment adviser. The rules also make it illegal for the covered adviser itself, or through a covered associate, to solicit or coordinate contributions for any government official (or political party) where the investment adviser is providing or seeking to provide investment advisory services for compensation to a government entity in the applicable state or locality. Investment advisers are also required to monitor and maintain records relating to political contributions made by their employees.
In addition to the SEC rule, certain US states (including California, New Mexico, New Jersey and New York) have enacted legislation and certain US public pension plans (including the California Public Employees’ Retirement System (CalPERS), the California State Teachers’ Retirement System (CalSTRS), the New Mexico State Investment Council and the New York State Common Retirement Fund) have established policies that impose similar restrictions on political contributions to state officials by investment advisers and covered associates.
Use of intermediaries and lobbyist registration
Describe any rules - or policies of public pension plans or other governmental entities - in your jurisdiction that restrict, or require disclosure by a private equity fund’s manager or investment adviser of, the engagement of placement agents, lobbyists or other intermediaries in the marketing of the fund to public pension plans and other governmental entities. Describe any rules that require a fund’s investment adviser or its employees and agents to register as lobbyists in the marketing of the fund to public pension plans and governmental entities.
With effect from 20 August 2017, the SEC’s pay-to-play rules discussed above broadly prohibit a covered adviser from making any payment to a third party, including a placement agent, finder or other intermediary, for securing a capital commitment from a US government entity to a fund advised by the investment adviser unless such placement agent is registered under section 15B of the Exchange Act and subject to pay-to-play rules adopted by the Municipal Securities Rulemaking Board or FINRA. The ban does not apply to payments by the investment adviser to its employees or owners.
Certain US states have enacted legislation regulating or prohibiting the engagement or payment of placement agents by an investment adviser with respect to investment by some or all of such state’s pension systems in a fund advised by such investment adviser. Such regulations and prohibitions vary from state to state. For example, California has enacted legislation that requires placement agents, which can include third-party placement agents as well as the investment manager’s employees, officers, directors and other equity holders (unless such persons spend at least a third of their time managing the securities or assets invested by the investment adviser), to register as lobbyists before soliciting investments from its state-level public pension plans (CalPERS, CalSTRS and the University of California to the extent it is investing retirement (as opposed to endowment) assets). The California law also prohibits placement agents from receiving fees that are contingent on securing investments from the plans and requires disclosure of any fixed placement fees or other compensation paid to solicit investments from such state pension plans.
The California law requiring placement agents to register as lobbyists may also require such registration of certain of an investment adviser’s own employees and partners who are involved with the solicitation of investments from the California state pension plans, such as marketing or investor relations personnel. The compensation paid to such employees and partners of the investment adviser who directly solicit the plan is also required to be disclosed. In addition, investment advisers who retain third-party placement agents to solicit the California state pension plans or whose employees and partners are covered by the lobbyist-registration law are considered ‘lobbyist employers’ under California law and are required to make certain public filings in addition to such placement agents and employees. Kentucky has also recently adopted registration requirements with respect to placement agents soliciting investments from Kentucky state pension plans that are similar to those applicable to California state public pension plans. Various other states may also have lobbying laws that effectively require investment advisers and their employees who solicit state and local pension plans to register as lobbyists. Counties, cities or other municipal jurisdictions may require lobbyist registration or disclosure or both. For example, in New York City, local rules effectively require investment advisers and their employees who solicit local pension plans to register as lobbyists.
In addition, public pension plans may have their own additional requirements. In states where state law does not ban placement agent fees or require disclosure, the public pension plans themselves may have such bans or requirements.
Describe any legal or regulatory developments emerging from the recent global financial crisis that specifically affect banks with respect to investing in or sponsoring private equity funds.
In 2013, the five US regulatory agencies responsible for implementing the ‘Volcker Rule’ provisions of Dodd-Frank approved final rules (the ‘Final Rules’) that generally prohibit ‘banking entities’ from acquiring or retaining any ownership in, or sponsoring, a private equity fund (and engaging in proprietary trading). On 24 May 2018, the Economic Growth, Regulatory Relief and Consumer Protection Act (the Reform Act) was enacted and, among other financial regulatory changes, modified the Volcker Rule’s ‘banking entity’ definition. For purposes of the Volcker Rule, as implemented by the Final Rules and as amended by the Reform Act, the term ‘banking entity’ means any insured depository institution (other than certain limited-purpose trust institutions and insured depository institutions that do not have, and are not controlled by a company that has, more than US$10 billion in total consolidated assets and total trading assets and trading liabilities that are more than 5 per cent of total consolidated assets), any company that controls such an insured depository institution, any company that is treated as a bank holding company for purposes of the International Banking Act (such as a foreign bank that has a US branch, agency or commercial lending subsidiary) and any affiliate or subsidiary of such entities.
There are a number of exceptions to the basic prohibition on banking entities investing in or sponsoring private equity funds. In particular, banking entities are permitted to invest in covered private funds that they sponsor, provided that the investment does not exceed 3 per cent of the fund’s total ownership interest on a per-fund basis, or 3 per cent of the banking entity’s ‘Tier 1 capital’ on an aggregate basis, and provided that certain other conditions are met. For these purposes, covered funds generally include funds that would be investment companies but for the exemptions provided by section 3(c)(1) or section 3(c)(7) of the Investment Company Act.
In June 2018, the five US regulatory agencies responsible for implementing the Volcker Rule proposed certain limited modifications to the Final Rules, but whether such administrative modifications will be adopted (or in what ultimate form) is uncertain.
Would a private equity fund vehicle formed in your jurisdiction be subject to taxation there with respect to its income or gains? Would the fund be required to withhold taxes with respect to distributions to investors? Please describe what conditions, if any, apply to a private equity fund to qualify for applicable tax exemptions.
Generally, a private equity fund vehicle, such as a limited partnership or limited liability company, that is treated as a partnership for US federal income tax purposes, would not itself be subject to taxation with respect to its income or gains. Instead, each partner would take into account its distributive share of the partnership’s income, gain, loss and deduction.
However, liability for adjustments to a fund’s tax returns may be imposed on the fund itself in certain circumstances in the absence of an election to the contrary.
If the fund generates income that is effectively connected with the conduct of a US trade or business (ECI), including as a result of an investment in US real estate or certain real estate companies, the fund will be required to withhold US federal income tax with respect to such income that is attributable to the fund’s non-US investors, regardless of whether it is distributed. In general, subject to an exception for investments in certain real estate companies, trading in stock or securities (the principal activity of most private equity funds) is not treated as generating ECI. Gain or loss from the sale or exchange of an interest in a fund by a foreign partner will be considered ECI and therefore subject to US tax to the extent that such partner would have been allocated ECI if the fund sold all of its assets at fair market value as of the date of the sale or exchange. Recently enacted tax reform legislation (the Tax Reform Bill) would also require the transferee of an interest in a partnership engaged in a US trade or business to withhold 10 per cent of the amount realised by the transferor on the sale or exchange, and the fund would be required to withhold from future distributions to the transferee if the transferee fails to properly withhold. Funds that hold investments that generate ECI often allow non-US investors to participate through one or more entities treated as corporations for US tax purposes with respect to such investments, in which case such corporations would file US tax returns and pay tax associated with such ECI investments. Non-US investors may still be subject to US withholding tax on dividends and/or interest paid by such corporations.
The fund will also be required to withhold with respect to its non-US investors’ distributive share of certain US-source income of the fund that is not ECI (eg, US-source dividends and interest) unless, in the case of interest, such interest qualifies as portfolio interest. Portfolio interest generally includes (with certain exceptions) interest paid on registered obligations with respect to which the beneficial owner provides a statement that it is not a US person. A non-US investor who is a resident for tax purposes in a country with respect to which the US has an income tax treaty may be eligible for a reduction or refund of withholding tax imposed on such investor’s distributive share of interest and dividends and certain foreign government investors may also be eligible for an exemption from withholding tax on income of the fund that is not from the conduct of commercial activities.
The Foreign Account Tax Compliance Act requires all entities in a broadly defined class of foreign financial institutions (FFIs) to comply with a complicated and expansive reporting regime or be subject to a 30 per cent withholding tax on certain payments. This legislation also requires non-US entities that are not FFIs either to certify they have no substantial US beneficial ownership or to report certain information with respect to their substantial US beneficial ownership or be subject to a 30 per cent withholding tax on certain payments. This legislation could apply to non-US investors in the fund, and the private equity fund could be required to withhold on payments to such investors if such investors do not comply with the applicable requirements of this legislation.
The taxation of a private equity fund vehicle as a partnership for US federal income tax purposes is subject to certain rules regarding ‘publicly traded partnerships’ that could result in the partnership being classified as an association taxable as a corporation. To avoid these rules, funds are not commonly traded on a securities exchange or other established over-the-counter market and impose limitations on the transferability of interests in the private equity fund vehicle.
Local taxation of non-resident investors
Would non-resident investors in a private equity fund be subject to taxation or return-filing requirements in your jurisdiction?
Non-resident investors that invest directly in a private equity fund organised as a flow-through vehicle in the US would be subject to US federal income taxation and return filing obligations if the private equity fund (or an entity organised as a flow-through vehicle into which the private equity fund invests) generates ECI (including gain from the sale of real property or stock in certain ‘US real estate property holding corporations’) (see question 17). In addition, all or a portion of the gain on the disposition (including by redemption) by a non-US investor of its interest in the fund may be taxed as ECI. Similar US state and local income tax requirements may also apply.
Local tax authority ruling
Is it necessary or desirable to obtain a ruling from local tax authorities with respect to the tax treatment of a private equity fund vehicle formed in your jurisdiction? Are there any special tax rules relating to investors that are residents of your jurisdiction?
Generally, no tax ruling would be obtained with respect to the tax treatment of a private equity fund vehicle formed in the US. While there are many special taxation rules applicable to US investors, of particular relevance are those rules that apply to US tax-exempt investors in respect of unrelated business taxable income (UBTI).
Must any significant organisational taxes be paid with respect to private equity funds organised in your jurisdiction?
There are no significant taxes associated with the organisation of a private equity fund in the US.
Special tax considerations
Please describe briefly what special tax considerations, if any, apply with respect to a private equity fund’s sponsor.
Special consideration is given to structure the carried interest such that it is treated as a partnership allocation eligible for taxation on a flow-through basis. It is sometimes desirable to separate the general partner (namely, the recipient of the carried interest) and the investment manager (namely, the recipient of the management fee) into separate entities (see question 32).
Under the Tax Reform Bill, the fund must have a three-year holding period (rather than the standard one-year holding period) for an investment or asset in order for carried interest distributions to be eligible for favourable long-term capital gain treatment. In addition, an individual carried interest participant will only be eligible for long-term capital gain treatment upon disposition of any interests in a carry vehicle (other than capital interests) if such participant has a three-year holding period for the interests. Further, Congress has previously proposed legislation that, if enacted, would result in carried interest distributions that are currently subject to favourable capital gains tax treatment being subject to higher rates of US federal income tax than are currently in effect. Whether such legislation would be enacted in addition to changes in the Tax Reform Bill is uncertain.
In addition, some sponsors implement arrangements in which a sponsor waives its right to all or a portion of management fees in order for it or an affiliate to receive an additional distributive share of the private equity fund’s returns. Proposed regulations, if finalised, could treat participants in such management fee waiver arrangements as receiving compensatory payments for services rather than allocations of the fund’s underlying income. The preamble to the proposed regulations also indicates that existing safe harbours that treat the grant of a ‘profits interest’ as a non-taxable event may not apply to management fee waiver arrangements.
Please list any relevant tax treaties to which your jurisdiction is a party and how such treaties apply to the fund vehicle.
The US has an extensive network of income tax treaties. How a treaty would apply to the fund vehicle depends on the terms of the specific treaty and the relevant facts of the structure.
Other significant tax issues
Are there any other significant tax issues relating to private equity funds organised in your jurisdiction?
The Tax Reform Bill has resulted in fundamental changes to the tax code. Among the numerous changes included in the Tax Reform Bill are:
- a permanent reduction to the corporate income tax rate;
- a partial limitation on the deductibility of business interest expense;
- an income deduction for individuals receiving certain business income from pass-through entities;
- changes in the treatment of carried interest, which generally requires the fund to have a three-year holding period for an investment or asset in order for carried interest distributions to be eligible for favourable long-term capital gain treatment (as further described in question 21);
- a partial shift of the US taxation of multinational corporations from a tax on worldwide income to a territorial system (along with a transitional rule that taxes certain historical accumulated earnings and rules that prevent tax planning strategies that shift profits to low-tax jurisdictions); and
- a suspension of certain miscellaneous itemised deductions, including deductions for investment fees and expenses, until 2026.
The partial limit on the deductibility of business interest expense disallows deductions for business interest expense (even if paid to third parties) in excess of the sum of business interest income and 30 per cent of the adjusted taxable income of the business. Business interest includes any interest on indebtedness related to a trade or business, but excludes investment interest, to which separate limitations apply. The impact of the Tax Reform Bill on funds and their portfolio companies is uncertain.
US tax rules are very complex and tax matters play an extremely important role in both fund formation and the structure of underlying fund investments. Consultation with tax advisers with respect to the specific transactions or issues is highly recommended.
Selling restrictions and investors generally
Legal and regulatory restrictions
Describe the principal legal and regulatory restrictions on offers and sales of interests in private equity funds formed in your jurisdiction, including the type of investors to whom such funds (or private equity funds formed in other jurisdictions) may be offered without registration under applicable securities laws in your jurisdiction.
Exemptions from requirement to register fund interests
To ensure that a private equity fund offering securities in the US will satisfy the requirements necessary to avoid registration of the interests in the fund with the SEC, a private equity fund sponsor will customarily conduct the offering and sale of interests in the private equity fund to meet a private placement exemption under the Securities Act. The most reliable way to do this is to comply with the safe harbour criteria established by Rule 506 under Regulation D under the Securities Act. Offers and sales of securities that comply with Regulation D will not be deemed to be a transaction that involves a public offering. The applicability of the exemptions will depend on the manner of the offering. Under the Rule 506(b) exemption, the private equity fund sponsor must not make any offers or sales by means of general solicitation or general advertising. In addition, the private equity fund cannot have more than 35 non-accredited investors. Each such non-accredited investor, either individually or with a representative, must also be sophisticated (ie, must have sufficient knowledge and experience in financial or business matters to make them capable of evaluating the merits and risks of the potential investment).
Under the Rule 506(c) exemption, the private equity sponsor may broadly solicit and generally advertise the offering, so long as, among other requirements, ‘reasonable steps’ are implemented to ensure that each investor in the private equity fund is an accredited investor at the time of the sale of securities to that investor.
An ‘accredited investor’, as defined in Rule 501 under Regulation D, generally includes a natural person with a net worth (either individually or jointly with a spouse) of more than US$1 million or income above US$200,000 in the past two years (or US$300,000 in joint income with a spouse for those two years and a reasonable expectation of reaching the same income level in the current year), and certain entities with more than US$5 million in total assets. For purposes of the US$1 million net-worth test described above, the value of the investor’s primary residence is excluded from the calculation of the investor’s total assets and the amount of any mortgage or other indebtedness secured by an investor’s primary residence is similarly excluded from the calculation of the investor’s total liabilities, except to the extent the estimated fair market value of the residence is less than the amount of such mortgage or other indebtedness. There is also a timing provision in the net-worth test designed to prevent investors from artificially inflating their net worth by incurring incremental indebtedness secured by their primary residence to acquire assets that would be included in the net worth calculation. Under the timing provision, if a borrowing occurs in the 60 days preceding the purchase of securities in an exempt offering and is not in connection with the purchase of the primary residence, the amount of such incremental indebtedness must be treated as a liability for the net worth calculation. The SEC is authorised to adjust the ‘accredited investor’ definition for individuals every four years as may be appropriate to protect investors, further the public interest or otherwise reflect changes in the prevailing economy.
Rule 506(c) provides some non-exclusive, non-mandatory methods of verifying that a natural person is accredited (eg, reviewing tax returns or bank account statements) and, to the extent these methods are not used, or a sponsor is verifying the accredited investor status of an entity, in determining whether the steps taken by an issuer to verify eligibility are objectively reasonable, sponsors should consider the particular facts and circumstances of each offering and each purchaser, including the following:
- the nature of the purchaser and the type of accredited investor that the purchaser claims to be;
- the amount and type of information that the issuer has about the purchaser; and
- the nature, terms and manner of the offering.
Given that these increased verification measures with respect to sales under Rule 506(c) generally result in increased compliance burdens and costs for issuers, and in some cases investors are reluctant to provide or are sensitive about providing the additional information required as part of the enhanced verification procedures, private equity firms are not yet widely relying on the Rule 506(c) exemption, and this exemption is not expected to play a significant role in private equity fundraising in the future.
Another factor impeding utilisation of the Rule 506(c) exemption by private equity firms is that the use of general solicitation in reliance on Rule 506(c) may affect other aspects of a private equity sponsor’s regulatory compliance regime. For example, it is possible that the use of general solicitation or general advertising by a private equity fund under Rule 506(c) could have an adverse impact on its private placement under the securities laws of other jurisdictions in which it conducts its offering as the securities laws thereof may not permit general solicitation in their current form.
The potential impact of pending SEC proposed amendments to Rule 506 would also create additional burdens for reliance on Rule 506(c). A private equity fund relying on a private placement exemption contained in Regulation D under the Securities Act must file electronically with the SEC a notice on Form D within 15 calendar days after the date of first sale of securities. Form D sets forth certain basic information about the offering, including the amount of securities offered and sold as well as whether any sales commissions were paid to any broker-dealers and, if so, the states in which purchases were solicited by such broker-dealer. For purposes of the Form D filing deadline, the SEC considers the first date of sale to occur on the date on which the first investor is irrevocably contractually committed to invest. Therefore, depending on the terms and conditions of the contract, such date could be deemed to be the date on which a private equity fund receives its first investor subscription agreement and not necessarily the typically later closing date. The SEC has proposed amendments to Regulation D, which would impose additional procedural requirements on issuers seeking to rely on Rule 506(c) to engage in a general solicitation by requiring that an initial Form D (with heightened disclosure requirements) be filed at least 15 days before commencing any such general solicitation and that a final amendment to Form D be filed within 30 days of the termination of any such offering. Under other proposed amendments, failure to comply with the Form D filing requirements (whether or not involving a general solicitation) would result in an automatic one-year disqualification from relying on a Rule 506 exemption.
In addition to federal securities law compliance, most states have similar notice-filing requirements. While state registration of securities is pre-empted under the Securities Act, private equity sponsors should be cognisant of the state law notice-filing requirements in the various jurisdictions in which they will or have offered or sold limited partnership interests to investors. Many states require a notice filing, consisting of a copy of a Form D and a filing fee, to be made within 15 calendar days after the date of first sale in the state. Anti-fraud provisions under applicable state laws apply despite the pre-emption described above.
Under Rule 506(d), issuers are prohibited from relying on the Rule 506 exemptions (whether or not the proposed offering involves a general solicitation), if the issuer or any other ‘covered person’ was subject to a ‘disqualifying event’. Covered persons include the issuer and its predecessors, affiliated issuers (ie, issuers that issue securities in the same offering, such as parallel funds and related feeder funds), directors and certain officers, general partners and managing members of the issuer, beneficial owners of 20 per cent or more of an issuer’s outstanding voting equity securities calculated on the basis of voting power (which could include limited partners in related private equity funds if the issuer and such related fund vote together), any investment manager to a pooled investment fund issuer, any ‘promoter’ connected with the issuer in any capacity at the time of the sale and any persons compensated (directly or indirectly) for soliciting investors (eg, placement agents), as well as the general partners, directors, officers and managing members of any such investment manager or compensated solicitor. For purposes of these ‘bad actor’ rules, disqualifying events include certain criminal convictions, court injunctions and restraining orders, final orders of state and federal regulators, SEC disciplinary orders, stop orders and cease-and-desist orders, suspension or expulsion from a securities self-regulatory organisation and US Postal Service false representation orders. A number of these disqualifying events are required to occur in connection with the purchase or sale of securities and include a look-back period of five to 10 years depending on the particular facts surrounding the disqualifying event. Disqualification is not triggered by actions taken in jurisdictions other than the US. While only disqualifying events that occur after the rule’s effective date (23 September 2013) will disqualify an issuer from relying on a Rule 506 exemption, Rule 506(e) provides that disqualifying events that occurred prior to such date but within the applicable look-back period would nonetheless be required to be disclosed to investors in connection with any sales of securities under Rule 506 within a reasonable time prior to such sale. Under Rule 506(e), a failure to provide this disclosure will not prevent an issuer from relying on a Rule 506 exemption if an issuer can show that it did not know and, in the exercise of reasonable care could not have known, that the issuer or any other covered person was subject to a disqualifying event, although this reasonable care exception requires factual inquiry into whether any disqualifications exist. This factual inquiry will depend on the facts and circumstances concerning, among other things, the issuer and the other offering participants. Additionally, the SEC may grant waivers from disqualification under certain circumstances, including if the issuer has undergone a change of control subsequent to the disqualifying event.
Exemptions from requirement to register funds
To ensure that a private equity fund will satisfy the requirements necessary to avoid regulation as an ‘investment company’ under the Investment Company Act, the fund must be excluded from the definition of investment company. Under section 3(c)(7) of the Investment Company Act, each investor in the fund will typically be required to represent that it is a qualified purchaser. In the event that not all of a private equity fund’s investors are qualified purchasers, the fund may still be excluded from the definition of an ‘investment company’ under section 3(c)(1) of the Investment Company Act by limiting the number of investors to not more than 100 (all of which must still be accredited investors for Regulation D purposes and with respect to which certain ‘look through’ attribution rules apply). A qualified purchaser as defined in section 2(a)(51)(A) of the Investment Company Act generally includes a natural person (or a company owned directly or indirectly by two or more natural, related persons) who owns not less than US$5 million in investments, a company acting for its own account or the accounts of other qualified purchasers that in the aggregate owns and invests on a discretionary basis not less than US$25 million in investments and certain trusts. In order to rely on section 3(c)(1) or 3(c)(7), a private equity fund sponsor must not be making or presently proposing to make a public offering. One way that a sponsor can meet this requirement is by complying with Regulation D, as described above.
Certain rules under the Investment Company Act provide additional clarification for the above requirements. Rule 3c-5 under the Investment Company Act provides that ‘knowledgeable employees’ (namely, executive officers and directors of the sponsor and most investment professionals who, as part of their regular functions or duties, have been participating in the private equity fund’s investment activities, or substantially similar functions or duties for another fund, for at least 12 months) are ignored for the purposes of the 100-person limit for purposes of section 3(c)(1) and the qualified purchaser requirement for purposes of section 3(c)(7). Similarly, for funds organised outside the US, the SEC staff has taken the position that non-US investors are generally ignored for purposes of the 100-person limit of section 3(c)(1) and the qualified purchaser requirement of section 3(c)(7).
For real estate funds, section 3(c)(5)(C) of the Investment Company Act provides another exclusion from the definition of ‘investment company’ for any issuer who is primarily engaged in purchasing and acquiring mortgages or other liens in real estate.
If the sponsor of a private equity fund is a registered investment adviser under the Advisers Act, then in certain circumstances each investor may need to represent that it is a ‘qualified client’ as defined in Rule 205-3 under the Advisers Act. A qualified client generally includes a natural person or company with a net worth exceeding US$2.1 million or that has US$1 million under management with the investment adviser, although the SEC is required every five years to adjust these dollar amounts for inflation, excluding the value attributable to such person’s primary residence (as further described above). A qualified client also includes both qualified purchasers as defined in the Investment Company Act and nearly all persons that fall under the ‘knowledgeable employee’ definition above (with the exception of an advisory board member, who is not included in the definition of ‘qualified client’).
Types of investor
Describe any restrictions on the types of investors that may participate in private equity funds formed in your jurisdiction (other than those imposed by applicable securities laws described above).
Other than compliance with certain aspects of the anti-money laundering provisions of the USA PATRIOT Act (the Patriot Act) discussed in question 28, as a general matter there are no such restrictions other than those imposed by applicable securities laws described above or which may arise under the laws of other jurisdictions. Sponsors of private equity funds may choose to limit participation by certain types of investors in light of applicable legal, tax and regulatory considerations and the investment strategy of the fund. Restrictions may be imposed on the participation of non-US investors in a private equity fund in investments by the private equity fund in certain regulated industries (eg, airlines, shipping, telecommunications and defence). (See question 16 with respect to recently enacted restrictions on bank holding companies investing in private equity funds.)
Identity of investors
Does your jurisdiction require any ongoing filings with, or notifications to, regulators regarding the identity of investors in private equity funds (including by virtue of transfers of fund interests) or regarding the change in the composition of ownership, management or control of the fund or the manager?
There is generally no requirement to notify the state of Delaware or the SEC as a result of a change in the identity of investors in a private equity fund formed in Delaware (including by virtue of transfers of fund interests) or regarding the change in the composition of ownership of the fund. However, in the case of a manager who is an investment adviser registered under the Advisers Act or an ERA, changes in identity of certain individuals employed by or associated with the investment adviser must be reflected in an amendment to Part 1 of the investment adviser’s Form ADV promptly filed with the SEC, and in certain circumstances a change of management or control of the fund or of the manager or investment adviser may require the consent of the investors in the private equity fund. In the event of a change of the general partner of a Delaware limited partnership, an amendment to the fund’s certificate of limited partnership would be required to be filed in Delaware and such change would need to be accomplished in accordance with such limited partnership’s partnership agreement. Additionally, a private equity fund that makes an investment in a regulated industry, such as banking, insurance, airlines, telecommunications, shipping, defence, energy and gaming, may be required to disclose the identity and ownership percentage of fund investors to the applicable regulatory authorities in connection with an investment in any such company.
Licences and registrations
Does your jurisdiction require that the person offering interests in a private equity fund have any licences or registrations?
Generally, the sponsor of a private equity fund in the US would not be required to register as a broker or dealer under the Exchange Act as they are not normally considered to be ‘engaged in the business’ of brokering or dealing in securities. The rules promulgated under the Exchange Act provide a safe harbour from requiring employees and issuers to register as a broker or dealer subject to certain conditions, including such employees not being compensated by payment of commissions or other remunerations based either directly or indirectly on the offering of securities. If compensation is directly or indirectly paid to employees of the sponsor in connection with the offering of securities, the sponsor may be required to register as a broker-dealer (see questions 10 and 11). If a private equity fund retains a third party to market its securities, that third party generally would be required to be registered as a broker-dealer.
Describe any money laundering rules or other regulations applicable in your jurisdiction requiring due diligence, record keeping or disclosure of the identities of (or other related information about) the investors in a private equity fund or the individual members of the sponsor.
Although private equity funds generally have historically not been subject to the anti-money laundering regulations of the Patriot Act, on 25 August 2015, the Financial Crimes Enforcement Network (FinCEN), a bureau of the US Department of the Treasury, proposed regulations that would impose anti-money laundering obligations on investment advisers registered with the SEC under the Advisers Act (Covered Advisers). Covered Advisers would be included in the definition of ‘financial institution’ in regulations implementing the Patriot Act and, consequently, would be required, among other things, to establish and implement risk-based anti-money laundering programmes and file suspicious activity reports with FinCEN. The proposed rules do not, however, include a customer identification programme requirement, as required for other financial institutions. FinCEN proposes delegating authority to the SEC to examine compliance with the proposed rules.
Although these proposed rules are not currently effective, as a best practice many private equity funds have already put into place anti-money laundering programmes that meet the requirements set forth in the Patriot Act’s regulations. These requirements include the following:
- developing internal policies, procedures and controls;
- designating an anti-money laundering compliance officer;
- implementing an employee training programme; and
- having an independent audit function to test the programme.
Currently, there are no regulations in effect that would require the disclosure of the identities of (or other related information about) the investors in a private equity fund or the individual members of the sponsor. If an investment adviser to a private equity fund is registered under the Advisers Act, the investment adviser must disclose on Form ADV the educational, business and disciplinary background of certain individuals employed by or associated with the investment adviser. Similar disclosure may be required for investment advisers that are or have affiliates that are broker-dealers registered with FINRA.
Are private equity funds able to list on a securities exchange in your jurisdiction and, if so, is this customary? What are the principal initial and ongoing requirements for listing? What are the advantages and disadvantages of a listing?
Because of certain adverse tax consequences arising from status as a publicly traded partnership and the difficulty that such a listing would impose on being able to establish an exemption from registration under the Investment Company Act, private equity funds do not typically list on a securities exchange in the US (see also question 17). The applicable listing requirements would be established by the relevant securities exchange.
Restriction on transfers of interest
To what extent can a listed fund restrict transfers of its interests?
As discussed above, private equity funds do not typically list on any US exchange. However, if listed, the ability of such a fund to restrict transfers of its interest would be dictated by the listing requirements of the relevant securities exchange as well as the other governing agreements of such fund.
Participation in private equity transactions
Legal and regulatory restrictions
Are funds formed in your jurisdiction subject to any legal or regulatory restrictions that affect their participation in private equity transactions or otherwise affect the structuring of private equity transactions completed inside or outside your jurisdiction?
The primary restrictions concerning the types of investments that a private equity fund may make are typically contained in the private equity fund’s limited partnership agreement. These restrictions often include limits on the amount of capital (typically expressed as a percentage of the fund’s capital commitments) that may be deployed in any one investment, a restriction on participation in ‘hostile’ transactions, certain geographic diversification limits, a restriction on investments that generate certain types of tax consequences for investors (eg, UBTI for US tax-exempt investors or ECI for non-US investors), a restriction on certain types of investments (eg, venture capital investments, ‘blind pool’ investments, direct investments in real estate or oil and gas assets) and so on. Individual investors in a private equity fund may also have the right (either pursuant to the partnership agreement or a side letter relating thereto) to be excused from having their capital invested in certain types of investments (tobacco, military industry, etc) and to participate in certain types of investments in a certain manner (eg, to participate in UBTI or ECI investments through an alternative investment vehicle or an entity treated as a corporation for US federal tax purposes, or both).
There may also be limits on and filing requirements associated with certain types of portfolio investments made by a private equity fund. For example, investments in certain media companies may implicate the ownership limits and reporting obligations established by the US Federal Communications Commission. Other similarly regulated industries include shipping, defence, banking and insurance. Regulatory considerations applicable to mergers and acquisitions transactions generally (eg, antitrust, tender-offer rules, etc) also apply equally to private equity transactions completed by funds. Consideration should also be given to the potential applicability of the Sarbanes-Oxley Act and applicable US state laws relating to fraudulent conveyance issues, as discussed in more detail in the US Transactions chapter.
In addition, in general if benefit plan investors hold 25 per cent or more of the total value of any class of equity interests in the private equity fund (as described above), the private equity fund may, to avoid being subject to the fiduciary responsibility standard of care under ERISA and prohibited transaction rules under ERISA and the Code, need to structure its investments in a manner so as to ensure that the private equity fund will qualify as a VCOC or an REOC within the meaning of the ERISA plan asset regulations. Qualification as a VCOC generally entails having on its initial investment date and annually thereafter at least 50 per cent of the private equity fund’s assets, valued at cost, invested in operating companies as to which the private equity fund obtains direct contractual ‘management rights’ and exercising such management rights with respect to one or more of such operating companies during the course of each year in the ordinary course of business.
Compensation and profit-sharing
Describe any legal or regulatory issues that would affect the structuring of the sponsor’s compensation and profit-sharing arrangements with respect to the fund and, specifically, anything that could affect the sponsor’s ability to take management fees, transaction fees and a carried interest (or other form of profit share) from the fund.
Depending on the state in which a private equity fund is formed and operates, there may be tax advantages to forming separate entities to receive the carried interest and management fee (and other fee) payments in respect of the fund and other unique structuring requirements. For example, funds whose manager has a place of business in New York City typically use this bifurcated structure. Additionally, as noted in question 21, the Tax Reform Bill requires funds to have a three-year holding period (rather than the standard one-year holding period) for an investment or asset in order for carried interest distributions to be eligible for favourable long-term capital gain treatment. In addition, an individual carried interest participant will only be eligible for long-term capital gain treatment upon disposition of any interests in a carry vehicle (other than capital interests) if such participant has a three-year holding period for the interests. Further, Congress has previously proposed legislation that, if enacted, would result in typical carried interest distributions being taxed at a higher rate, and proposed regulations and related guidance may limit the tax benefits of management fee waiver arrangements. Moreover, tax rules limit a sponsor’s ability to use fee deferral arrangements to defer payment of tax on compensation and similar profits allocations.
The sponsor’s ability to take transaction fees is likely to be the subject of negotiation with investors in the fund, who may seek to have a portion of such fees accrue for their account as opposed to that of the sponsor through an offset of such fees against the management fee otherwise to be borne by such investors. In certain circumstances, depending on the structure of a private equity fund, the manner in which a sponsor may charge a carried interest or management fee can be affected by the requirements of ERISA or the Advisers Act.
Update and trends
Updates and trends
Although private equity fundraising decreased by 24 per cent in 2018 in comparison with 2017 (which was a record year for private equity fundraising), private equity fundraising remains healthy. According to Preqin, 1,176 private equity funds reached a final close in 2018, with a total of US$432 billion in commitments.
Private equity fundraising conditions continue to favour established sponsors with strong track records as the industry trend towards consolidation and the ‘flight to quality’ continues. For example, the 10 largest private equity funds that reached a final close in 2018 raised 24 per cent of total capital raised in 2018 and private equity funds of US$1 billion or more raised US$264 billion in 2018, according to Preqin. A key driver of this consolidation has been institutional limited partners often seeking to make larger commitments to fewer funds and consolidating their relationships among a smaller group of fund managers.
The increased acceleration in the pace of fundraising continued in 2018 with private equity firms returning to the market more quickly than in past years.
The continued focus on strategic relationships and alternative fundraising strategies, including customised and/or multi-strategy separate account arrangements, co-investment arrangements, ‘umbrella’ arrangements and other anchor or strategic investments, has played a significant role in private equity fundraising in recent years. For example, a number of established sponsors are raising lower-risk, longer-term funds (‘core’ funds), and a number of sponsors have increased their focus on raising ‘complementary’ funds (eg, funds with strategies aimed at particular geographic regions or specific asset types). In addition, in 2018, GP ‘minority stakes’ investing played an increased role in private equity fundraising, and the secondaries market was highly active as well. Early-closer incentives and other accommodations in terms continued to play an increased role in private equity fundraising in 2018.
The strong performance by private equity funds and record distributions to investors in recent years have provided an ongoing source of liquidity for many institutional investors and have led to an increase in overall allocations to private equity for many institutional investors, broadening both the breadth and depth of the private equity asset class among investors. Moreover, given that private equity as an asset class has outperformed the public markets and has been more stable relative to the volatility in the public markets in recent years, institutional investors may increasingly shift allocations from the public markets to private equity. Given this, funds possess a nearly unprecedented amount of ‘dry powder’, or capital not yet deployed, with US$1.2 trillion on hand as of December 2018, according to Preqin. As a result of such increased levels of dry powder coupled with the availability of financing, the number of private equity deals announced through 2018 reached an all-time high and aggregate deal value reached the second highest amount since the global financial crisis. However, certain private equity sponsors and investors remain concerned about asset pricing.
As investors continue to consolidate their relationships within the private equity industry and key investors seek to strengthen bonds with certain private equity sponsors, dedicated investor relations teams have developed at private equity firms to comply with investors’ demands for customised rights (eg, reporting and transparency) and increased scrutiny of marketing materials.
As a result of the strength of private equity fundraising in recent years, established sponsors are seeking more sponsor-favourable fund terms in an effort to reverse terms put into place around the onset of the global financial crisis and realign interests between themselves and investors.
It is expected that the SEC will continue to focus on transparency (eg, pre-commitment disclosure and consent from investors) with respect to conflicts of interests, among other matters. As a result, fund documentation is likely to remain complex, and more granular reporting will continue to be provided on a variety of topics, including fees and allocation of costs and expenses. Recent SEC enforcement actions and examinations have focused on, among other things, the allocation of costs and expenses to funds or portfolio companies, the allocation of investment opportunities and co-investment opportunities, the receipt by private equity firms of compensation or other fees or compensation from funds or portfolio companies, which are outside of the typical management fee or carried interest, the use of fund level leverage, plans to mitigate or respond to cybersecurity events, the role of technology in private equity and conflicts of interest related thereto, and has caused many private equity firms to carefully reconsider and enhance their disclosure and practices with respect thereto.
Continued regulatory constraints (particularly among banks and other financial institutions) have increased the role played by sovereign wealth funds and high-net-worth investors (eg, bank feeders) in the private equity asset class.
A number of the larger and more established private equity firms continue to face distinct firm issues relating to the interplay between their status as public companies and their sponsorship and management of private funds.
We expect that fundraising for 2019 will remain strong as 3,749 private equity funds are seeking to raise approximately US$972 billion as of the beginning of 2019, despite continuing economic concerns and political volatility, according to Preqin. We also expect that the trends and developments witnessed in 2018 will continue in the near-to-medium term as the consolidation in the private equity industry continues. Competition to secure LP capital among private equity funds will remain high and continue to increase in 2019, with alternative fundraising strategies continuing to play a substantial role. Increasingly, risk-averse allocation decisions by investors, coupled with the volatility in the public markets, will continue to allow established sponsors with proven track records to enjoy a competitive advantage. Finally, regulatory constraints are likely to continue to create opportunities for private equity firms and may result in continued opportunity in secondary and private debt businesses of private equity sponsors.