Historically, the most common structure used for private equity funds structured in the Cayman Islands was an exempted limited partnership. However, we have seen a shift recently towards structuring private equity funds as exempted companies. This note considers the advantages and disadvantages of both these investment vehicles.
Principal advantages of an exempted company/disadvantages of an exempted limited partnership
Liability of the operator. According to the Exempted Limited Partnership Law (Revised) (the “ELP Law”), an exempted limited partnership shall consist of at least one party called the general partner who shall, in the event that the assets of the exempted limited partnership are inadequate, be liable for all of the debts and obligations of the exempted limited partnership (and at least one party called the limited partner who shall not generally be liable for the debts or obligations of the exempted limited partnership in excess of the capital contributed by it to the exempted limited partnership). In contrast, the directors of an exempted company will enjoy the benefit of indemnities and exclusions or limitations on liability if they are provided for in the exempted company’s articles of association.
Liability of the investors. The nature of the ELP Law is that the liability of a limited partner is limited as long as he does not take part in the conduct of the business of an exempted limited partnership. If the limited partner takes part in the conduct of the business of an exempted limited partnership in its dealings with persons who are not partners, that limited partner is liable in the event of the insolvency of the exempted limited partnership for all the debts and obligations of the exempted limited partnership incurred during the period that he participated in the conduct of the business as though he were a general partner for that period, provided always that the limited partner shall be liable only to a person who transacts business with the exempted limited partnership during such period with actual knowledge of such participation and who then reasonably believed the limited partner to be a general partner. The Companies Law (Revised) (the “Companies Law”) does not provide for such unlimited liability in relation to shareholders of an exempted company. Generally, no contribution is required from any shareholder exceeding the amount, if any, unpaid on the shares in respect of which he is liable.
Registration and maintenance. It is a requirement of the ELP Law that at least one general partner of an exempted limited partnership must, if an individual, be resident in the Cayman Islands, or, if a company, be incorporated under the Companies Law or registered in the Cayman Islands, pursuant to such law, as a foreign company, or, if a partnership, be registered as an exempted limited partnership in accordance with the ELP Law. Accordingly, unless at least one general partner is an individual resident in the Cayman Islands, a private equity fund structured as an exempted limited partnership will require at least two vehicles to be registered and maintained in the Cayman Islands: the exempted limited partnership and the general partner (and if the general partner is an exempted limited partnership, its general partner and so on). As a result, registration and ongoing maintenance costs for a private equity fund structured as an exempted limited partnership will be greater than registration and ongoing maintenance costs for a private equity fund structured as an exempted company.
Legal personality. An exempted limited partnership does not have a separate legal personality and it is a requirement of the ELP Law that the general partner shall enter into all letters, contracts, deeds, instruments or documents of whatever nature on behalf of the exempted limited partnership. Consequently, the property and assets of the exempted limited partnership will be held in the name of the general partner for the benefit of the partnership and all actions, claims, demands or proceedings raised in respect of or against the assets of the exempted limited partnership will be raised by, and in the name of, the general partner on behalf of the exempted limited partnership. There may be circumstances where it is unclear whether a general partner is acting on its own behalf or on behalf of the exempted limited partnership and, in these circumstances, there needs to be appropriate documentation and a clear indication as to the capacity in which a general partner is acting in order to ensure that a general partner does not incur a debt for which it, rather than the exempted limited partnership, is liable or vice versa. An additional consideration is that, in the context of a winding-up, a court in the jurisdiction of incorporation of the general partner (if the general partner is not a Cayman entity) would have a strong position in a convenient forum argument with a Cayman court, since the assets of the exempted limited partnership are owned by the general partner. In contrast, an exempted company has a separate legal personality and is able to enter into its own letters, contracts, deeds, instruments or documents of whatever nature, hold property and assets and raise actions, claims, demands or proceedings in respect of or against its assets in its own name.
Duties between investors. The shareholders of an exempted company do not generally owe duties to each other. In an exempted limited partnership, each partner, at common law, owes a duty of good faith to each other partner. Any breach of this duty could be actionable as between the partners.
Principal disadvantages of an exempted company/advantages of an exempted limited partnership
Flexibility. Private equity funds have historically been structured as partnerships because their principal features are more readily built into the flexible framework of a partnership than into the rigid confines of a company. Partnerships allow flexibility in terms of how capital is raised, allocated and returned as waterfall distributions. This flexibility is also helpful when there are seed investors that are entitled to a share in the management fee or carried interest and wish to participate by way of an allocation to their capital account. However, it is possible to build into a company structure the features of a private equity fund. Following is a discussion of how a company structure can be used to mirror provisions normally found in a partnership agreement.
- Contributions. Although a private equity fund structured as an exempted company (the “fund”) could use unpaid/partly paid shares, it is common practice for a fund to issue fully paid shares with an obligation to subscribe for further shares up to its total commitment, in which case an investor would only subscribe initially for the number of shares necessary to cover the required contribution at the initial closing. There would however be included in the subscription agreement (and possibly in the fund’s articles of association) an obligation to subscribe for further shares at a fixed price up to a certain amount which would match the required “capital commitment”.
- Default in payment of contributions. If the fund uses fully paid shares with a contractual obligation for the investor to subscribe for further shares, the subscription agreement (and possibly the fund’s articles of association) could include different sanctions in the event that such shareholder failed to subscribe for further shares when required to do so by the fund. Those sanctions could include interest on any overdue amounts or a forced sale of shares. Depending on the nature of the sanction in any particular case, it may be held to be penal in nature (because it is not a genuine pre-estimate of loss). However in the case of Johnson v. Johnson  1 WLR 1026, similar sanction provisions were found to be enforceable but not beyond the actual loss suffered. In other words, the court will simply refuse to enforce the provision to the extent the penalty is greater than the amount of the loss. The provision is not struck out and it does not affect the validity of the other clauses.
- Allocations. The fund’s articles of association can be drafted to include partnership style accounts. The issue price for shares will be fixed and allocations will be made amongst the accounts based on their respective balances as at the end of each fiscal period. Accordingly, a net asset value concept would be redundant. The fund could have one class of voting shares which would be owned by the investment manager and one class of non-voting shares which would be owned by the investors.
- Distributions. All of the distributions received by the fund can, after payment of any expenses, be paid out by way of redemption (but see discussion under paragraph (f) below) or as dividends to shareholders provided such distributions constitute profits or can be paid out from the share premium account and that following such payment the fund is able to pay its debts as they fall due in the ordinary course of business. Accordingly, the issue price should be at a high premium. Dividends can be paid on unpaid/partly paid shares so long as it is authorised in the fund’s articles of association.
- Transfers. The articles of association of the private equity fund can be prepared to provide that fully paid or unpaid/partly paid shares can only be transferred with the consent of the directors. However if a partly paid share is transferred, the transferor remains liable as a past member if: (i) a winding up commences within one year after he ceased to be a member; and (ii) the present member is unable to contribute what is due on the shares in question. Additionally the transferee must also sign the share transfer form in respect of any unpaid/partly paid share since he is assuming liability for the balance of the issue price. If the private equity fund is structured to use fully-paid shares, then there would be no remaining contingent liability on the transferor.
- Withdrawals. If the fund uses fully paid shares, they could be purchased/redeemed by the fund at an aggregate purchase price equal to the value of the shareholder’s account on the relevant day. Unpaid/partly paid shares cannot be redeemed or purchased by the fund and the only alternative for the holders of such shares would be to require a transfer to a qualified investor.
Overall, an exempted limited partnership offers more flexibility whilst exempted companies afford more legal protection, certainty and lower set-up and maintenance costs. So which vehicle is more desirable? Much will depend on what the target investors are comfortable with which can change depending on the market. Otherwise use an exempted company, save that when you have complex allocation/distribution requirements (e.g. seed investor) it makes sense to use as exempted limited partnership.