Lexology GTDT Market Intelligence provides a unique perspective on evolving legal and regulatory landscapes. This interview is taken from the Private Equity volume featuring discussion and analysis of emerging trends and hot topics within key jurisdictions worldwide.
1 What trends are you seeing in overall activity levels for private equity buyouts and investments in your jurisdiction during the past year or so?
The appetite of investors for allocating capital to closed-end funds across a wide spectrum of managers, asset classes and geographic regions has continued unabated in 2019. The strength of new raises has been matched with high volumes and values of deals over the course of the year, with private equity (PE) and venture capital (VC) leading the way in Greater China. Market volatility and growing tensions in the region related to the US–China trade war have had minimal impact on fundraising thus far, with another record year in 2018. In terms of fund strategies, data shows that debt-focused and buyout funds continue to dominate the market, followed by real estate and technology focused funds.
Structure choices, region wide, remain consistent. The Cayman Islands exempted limited partnership (ELP) remains the dominant vehicle for PE and VC funds. It is uncommon for Hong Kong registered limited partnerships or companies to be used to structure private equity funds. General partner entities are most typically Cayman Islands exempted companies, with a fairly even split of ELPs, Cayman Islands limited liability companies (LLCs), foreign companies and foreign partnerships (typically Delaware LLCs and limited partnerships) thereafter. Use of LLCs as a fund vehicle has continued to gain traction in the region, but they are used more as a general partner or joint venture vehicle, with the structure not being commonly adopted as a fund vehicle, outside of the VC space, at this stage. This may slowly turn around as cost-sensitive VC managers and early adopters have started to realise the advantages of the structure after initial discussions with seed allocators.
2 Looking at types of investments and transactions, are private equity firms primarily pursuing straight buyouts, or are other opportunities, such as minority-stake investments, partnerships or add-on acquisitions, also being explored?
Minority stakes and co-investment transactions remain popular. As was the case in 2018, 2019 has seen a number of funds launching large co-investment vehicles. The sovereign wealth funds, pension funds and large family office allocators, that were the catalyst behind this phenomenon in past few years, continue to use their market muscle to drive the trend this year and we anticipate this will continue into 2020. As mentioned above, debt-focused and buyout funds continue to dominate the market.
3 What were the recent keynote deals? And what made them stand out?
On the fundraising side, Walkers were fortunate enough to be involved in the following landmark transactions in the last year.
- The formation of CITIC Capital China Partners IV, LP, which raised US$2.8 billion. This China-focused buyout fund is CITIC Capital’s largest dollar-denominated fund and the fourth-largest pool of capital ever raised for a China-focused fund by a domestic firm.
- The formation of GLP Japan Development Partners III, which raised US$5.6 billion (¥625 billion). This is the largest ever Japan-focused logistics private real estate fund to date.
- The formation of Affinity Asia Pacific Fund V, which raised US$6 billion. This buyout fund was substantially oversubscribed, with nearly US$9 billion in demand.
On the downstream side, Walkers had another very busy year across the firm and acted on many deals of note including advising on the following.
- SoftBank on their acquisition of the Fortress Investment Group LLC, the first large private equity firm in the United States to be traded publicly with approximately US$36 billion assets under management (as at September 2017), in a take-private transaction for US$3.3 billion in cash. Fortress will operate within SoftBank as an independent business headquartered in New York.
- The Carlyle Group, in connection with its US$6.7 billion acquisition of a majority interest in Sedgwick, Inc, a Memphis, Tennessee-based provider of insurance claims management services.
4 Does private equity M&A tend to be cross-border? What are some of the typical challenges legal advisers in your jurisdiction face in a multi-jurisdictional deal? How are those challenges evolving?
Yes. The deals we see out of our Hong Kong office are almost exclusively cross-border, involving the use of Cayman Islands structures for the pooling of capital, with onward investment subsequently being made into the Greater China region. Notwithstanding the China–US trade war, we have seen continued investment into Greater China from Europe, and the US, as well as an uptick in investment from China overseas, particularly into the US.
Typical challenges include regulatory risk and consents, Committee on Foreign Investment in the United States issues, governing law issues and due diligence complications. Cross-border work is more demanding than ever before in this increasingly complex regulatory and compliance environment.
5 What are some of the current trends in financing for private equity transactions? Have there been any notable developments in the availability or the terms of debt financing for buyers over the past year or so?
Secured bank or capital commitment financing continues to be popular in the region, although the market in Asia is still in its infancy compared to the US. The increased popularity of alternative forms of financing stems from the relatively cheap cost of debt capital resulting from prevailing low interest rate levels over the past few years, coupled with improved internal rate of return figures as a result of delayed drawdown of investor commitments.
In terms of using financing for downstream M&A investment, sponsors have been able to obtain covenant-lite packages. However, we anticipate that macro issues and global uncertainty (fears of a global economic recession, political uncertainty and trade tensions) will affect the price of debt packages in the coming months and years.
6 How has the legal, regulatory and policy landscape changed during the past few years in your jurisdiction?
The regulatory changes over the past year affecting PE funds and their sponsors have been mainly driven by changes in law and regulations in the Cayman Islands.
Reflecting the commitment of the Cayman Islands to the Organisation for Economic Co-operation and Development’s Base Erosion and Profit Shifting project, the Cayman Islands has implemented the International Tax Co-Operation (Economic Substance) Law, 2018 (Cayman ES Law) and associated regulations. The Cayman ES Law requires certain entity types carrying on a prescribed list of activities to satisfy the economic substance test. Investment funds (including PE and VC funds), including entities through which an investment fund directly or indirectly operates or invests, are out of scope of the Cayman ES Law. The impact of the Cayman ES Law on Cayman domiciled fund managers should be considered in the circumstances to consider if this role remains practical.
The Proceeds of Crime Law and the Anti-Money Laundering Regulations (AML Regulations) of the Cayman Islands have been updated over the past 24 months to ensure the framework of the jurisdiction is robust and capable of safeguarding the integrity of the jurisdiction’s financial sector. Changes have been made to clarify that the scope of the AML Regulations apply to all investment funds, regulated or unregulated. The AML Officer requirements have also been enhanced to include an additional role of deputy money laundering reporting officer (as well as compliance officer and money laundering reporting officer).
The Cayman Islands requires financial institutions, including investment entities, to undertake due diligence and reporting on account holders in accordance with Foreign Account Tax Compliance Act and the Common Reporting Standards. Investment funds must ensure relevant disclosures are made and information is collected from investors to enable annual reports to the Cayman Islands Tax Information Authority.
PE firms and their investors continue to look at the Cayman Islands political and legal framework with certainty and confidence.
7 What are the current attitudes towards private equity among policymakers and the public? Does shareholder activism play a significant role in your jurisdiction?
The Hong Kong government and regulators are supportive of the asset management industry in general, particularly in trying to grow the domestic funds industry. In terms of PE specifically, the Hong Kong government is in the process of developing a variety of initiatives, which we understand are intended to enhance Hong Kong’s competitive position as a PE hub. This may include clarification as to how carried interest is to be taxed, however no definitive timetable or details of the proposed initiatives have been announced by the Hong Kong government. Globally (including for the majority of Hong Kong and China-based sponsors) the Cayman Islands remains the domicile of choice for PE vehicles and we expect will continue to do so for the foreseeable future.
There are not a large number of activist investors in the Hong Kong and China markets, although as capital markets become more sophisticated we expect this to change. In terms of the Hong Kong Stock Exchange in particular, the fact that the public float requirement is relatively low and a large number of companies are family or founder-controlled, the scope for activist investor activity is more limited.
8 What levels of exit activity have you been seeing? Which exit route is the most common? Which exits have caught your eye recently, and why?
PE firms appear to be starting to use some of their significant stores of dry powder to make new and larger investments than in the past few years. In terms of exits, initial public offerings, secondary transactions and trade sales all continue to be utilised. However, listing on the A-Share market in China continues to be challenging and this has forced a number of sponsors to consider alternative routes to exit. It may not be a coincidence that we are seeing an increase in secondary transactions in Asia and PE sponsors that focus on secondary transactions have been expanding in the region.
However, macro and political issues continue to cause deal and debt pricing to remain uncertain.
9 Looking at funds and fundraising, does the market currently favour investors or sponsors? What are fundraising levels like now relative to the past few years?
The appetite of investors for allocating capital to closed-ended funds across a wide spectrum of managers, asset classes and geographies has continued unabated in 2019. The heightened activity of 2018 has persisted, with the headline-grabbing, billion dollar-plus fund launches complemented by a steady flow of smaller funds, often offering more esoteric or niche strategies. Globally the amount of capital allocated to PE and VC sponsors has surpassed US$2 trillion.
PE and VC fundraising has been very strong across the region, with China and Singapore standing out. While it is estimated that global PE and VC funding grew by around 11.5 per cent in 2018, the Singapore Venture Capital and Private Equity Association estimates investments into Asia in the same period grew by 37.6 per cent, surpassing allocations made into Europe.
Sponsors with solid investment track records and great brand recognition have continued to raise jumbo funds with relative ease. It has not been uncommon to see regional managers with good track records hit their target raise at first closing. Such sponsors, now on their third, fourth or higher vintage fund, are often fully subscribed with re-up investors even before a roadshow and have more negotiating power on terms. However, a number of large pension funds and other allocators have started to set up or bolster their physical presence in Asia. These investors, together with increasingly sophisticated and influential regional sovereign wealth funds and multifamily offices are readily able to dictate terms in certain segments of the market.
In any event, despite all the existing dry powder collected by sponsors, there has not been any substantial slowdown in fundraising.
10 Talk us through a typical fundraising. What are the timelines, structures and the key contractual points? What are the most significant legal issues specific to your jurisdiction?
Increased regulatory complexity and compliance has definitely impacted fund raising timetables. However, the phenomenon of sponsors doing follow-on funds with familiar investors has had a converse effect on time frames. Similarly, smaller, more nimble players with strong seed investors or family and friends backing are also coming to market within a few months.
Keeping launch timetables short is also supported by the fact that, as noted above, most funds continue to use the tried-and-tested Cayman exempted limited partnership structure. Its versatility and familiarity to both sponsors and investors, together with the fact that it is regarded by service providers in the region as the gold standard, helps contain launch timetables.
On the other hand, side letters continue to increase in complexity, especially for mega follow-on funds of our many large PE sponsor clients.
11 How closely are private equity sponsors supervised in your jurisdiction? Does this supervision impact the day-to-day business?
Whether a PE sponsor is required to license its Hong Kong office will depend upon whether the Hong Kong office carries on a business in a regulated activity under the Hong Kong Securities and Futures Ordinance. Historically, many PE sponsors did not license their Hong Kong offices with the Hong Kong Securities and Futures Commission (relying on a relevant exemption), however this trend appears to be reversing and many sponsors are now choosing to become licensed with the Hong Kong Securities and Futures Commission.
In the Cayman Islands, the updates to the AML Regulations described above (which apply to all investment funds, including PE funds, as well as to Cayman domiciled investment managers) and increased oversight from the Cayman Islands Monetary Authority will ensure that the framework of the jurisdiction is robust and capable of safeguarding the integrity of the jurisdiction’s financial sector.
12 What effect has the AIFMD had on fundraising in your jurisdiction?
The AIFMD private placement regimes allow Cayman Islands funds to be marketed in a vast majority of European Economic Area member states, so many funds wanting to do business in the region have not been swayed by the regulatory changes imposed by the AIFMD. However, the popularity of the passport in Asia is limited given the cost and complexity of obtaining the AIFM licenses.
Although the European Securities and Markets Authority (ESMA) has deferred its assessment on whether it would recommend extending the AIFMD marketing passport to the Cayman Islands, we are confident that the Cayman Islands can satisfy any concerns ESMA may have and be granted the passport in the near future.
13 What are the major tax issues that private equity faces in your jurisdiction? How is carried interest taxed? Do you see the current treatment potentially changing in the near future?
It is important to note that the introduction of the Cayman ES Law is not a domestic tax issue. The Cayman ES Law does not apply to investment funds or to general partners of PE Funds. So although this is an important change driven by a desire to reduce international harmful tax practices, it is not a Cayman Islands tax change that affects PE funds (domiciled in the Cayman Islands) themselves. Further it is important to note that the Cayman Islands do not impose any taxes on profits, income, capital gains or otherwise. No legislation has been proposed to change this and none is anticipated.
In Hong Kong, we expect further developments and guidance from the Inland Revenue Department on the treatment of carried interest.
In terms of taxation of the investors and the fund manager itself, this will be largely be dependant on individual circumstances and tax residency of those persons.
14 Looking ahead, what can we expect? What might be the main themes in the next 12 months for both private equity deal activity and fundraising?
Subject to any significant downturns in the global economy, we expect to see an uptick in M&A activity as PE firms begin to tap their glut of dry powder. This will no doubt result in a very competitive market and potentially cause pricing issues. Additionally, macro issues continue to cause deal and debt pricing to remain uncertain, which disproportionately disadvantages sponsors, particularly in auction scenarios.
The Inside Track
What factors make private equity practice in your jurisdiction unique?
Hong Kong is a globally oriented and liberal economy, with a highly skilled workforce and a trusted and efficient legal system. This, combined with a traditionally low tax environment and relatively low bureaucracy, helps create an excellent environment not only for private equity, but also as a great place to do business. The Cayman Islands, as the private equity fund domicile of choice in the region, is also politically stable and has a well-developed and trusted legal and business environment. Its familiarity to both private equity sponsors and investors, together with the fact that it is regarded by service providers in the region as the gold standard, helps contain launch timetables and makes it the jurisdiction of choice for Asian sponsors and investors.
What should a client consider when choosing counsel for a complex private equity transaction in your jurisdiction?
Deal experience, competence and responsiveness are certainly prerequisites, however personal relationships also matter so teams with positive personalities and a sense of perspective (possibly even a sense of humour!) will make any complex and time-pressured deal easier for all parties.
What interesting or unusual issues have you come across in recent matters?
Given that the majority of private equity deals are cross-border, each will have its own unique issues, whether involving tax, regulation or commercial points particular to that deal.