At a glance:
- Smaller firms will almost always stay local for reasons of cost and efficiency
- There is little to choose between Jersey and Guernsey as an offshore site
- If locating offshore, deal teams will be limited to sourcing, negotiating and advising on investments – they will not make actual investment decisions
- Proponents of the offshore route argue that it offers a more objective decision-making process
- Achieving tax neutrality is crucial to any fund structuring
- The “tipping point” differs substantially for each promoter and jurisdiction, as well as over time
When raising that next fund, the question of where to locate the structure is normally one of the first to be considered and the answer, like most things in life, is never straightforward. This article looks at the possible locations for a fund and attempts to take an objective look at the key factors to consider in choosing a domicile to suit your circumstances.
Smaller private equity promoters in Europe – in this context those under the €50m fund size – will almost always establish local structures because the cost and efficiency advantages for funds in this bracket clearly point in this direction, especially where the promoter is establishing a new business. It is only where there is a compelling need, normally related to a cornerstone or dominant investor requirement, that funds of this size should consider the additional expense of taking the fund outside the local jurisdiction. The UK, for example, which has the largest number of funds in Europe, has arguably some of the best vehicles for private equity, thus an offshore platform should only be considered where it can be demonstrated to provide a real advantage for investors.
In a European context, offshore generally means the Channel Islands. Cayman, Hong Kong, Singapore, Delaware and Mauritius remain very much the exception due in the main to practical considerations such as travel links, direct relationships, time zones and ease of access. As to the relative merits of Jersey vs Guernsey, despite the not unexpected local bias on both islands, in reality there is almost no discernible difference between the two in terms of private equity fund establishment and administration. The choice of island often comes down to where the fund formation lawyer has contacts, where the last fund went, or indeed simply which golf courses or restaurants are preferred.
Within the EU, Malta and Cyprus have tried to duplicate this offshore offering, but to date both have struggled to make much headway. The reasons for this are not immediately obvious, perhaps in part because these islands have still to demonstrate the legal, administrative and accounting expertise required to set up and manage increasingly sophisticated structures. Another reason may simply be the lack of new funds over the last three to four years, meaning opportunities to establish a credible track record have been limited.
Luxembourg has also been busy promoting itself in this space and, while it is a market-leading jurisdiction for real estate and other income-generating funds, it lacks an efficient product in the private equity sphere, where the same tax advantages do not exist. As a consequence, it is more commonly used by the industry for structured products such as special-purpose vehicles and wrapper entities.
Additional costs, structure and loss of control
Locating the GP, and possibly the fund limited partnerships themselves, offshore will mean a fundamental change in the way a promoter deal team thinks, acts and, crucially, is seen to act. To maintain offshore status the fund will be required to demonstrate mind and management offshore, which requires a fundamental shift in the way it does business. The role of the deal team will change and be limited to sourcing, negotiating and advising on investment decisions, with the actual investment decisions themselves having to be made by a GP board located offshore. Consequently, this does add a cost element to the structure and a time element to the decision-making process.
A GP board must be convened and given sufficient time to review documentation in order to make an informed decision. Typically the board requires a minimum of two local directors and administration support which will cost anything from uffe140,000 per annum to run. The time issue can be managed around time-critical closings, typically by preliminary investment approval mandates, but it does require a degree of understanding and respect for the process by all members of the deal team for the structure to work successfully.
A natural result of placing the fund offshore will also, to a certain extent, be a loss of control in investor relations. All correspondence from the GP – typically call notices, distribution notices and quarterly reports – will need to be sent by your administrators offshore, and so it is crucial that thought is given to this and the level of support and oversight you put in place in this area. To some promoters, this option is seen as advantageous as it can be argued that an offshore board brings with it a more objective decision-making process, while the use of a specialist administrator brings expertise and efficiency to the management of a fund. This takes away the back-office headache and allows the onshore team to focus on their investment portfolio. To other promoters, the loss of control and the need to share information with a third party are still seen as steps too far.
Tax neutrality, AIFM and product certainty
Crucial to any fund structuring is achieving tax neutrality, or as close to it, as possible. Achieving tax neutrality is a much more difficult proposition than is portrayed, and it should definitely not be confused with tax evasion. Tax neutrality in a fund context is determined by reference to:
(i) the tax treatment of the GP and carry vehicles
(ii) any VAT payable on services supplied to the fund
(iii) the application of withholding taxes to any returns generated by the fund’s investments
Over a number of years the Channel Islands have developed a fiscal and regulatory environment that provides a simple product and tax neutrality for investors and promoters, both in terms of direct and indirect taxation. For investors this means all distributions, regardless of whether they are income or capital, are returned to them in full without any taxes being withheld. This eliminates the requirement for some investors to claim back or offset taxes paid or withheld in the country of fund origin.
For promoters, the advantage is that it can have a substantial indirect tax advantage in terms of VAT or EU equivalent when compared to an EU context, particularly with regard to supplying an exempt service, such as advisory services. In pure monetary terms, the tipping point of where the Channel Islands may become a more efficient solution is for a fund size of €100m to €200m and above, although these headline numbers will vary from structure to structure and country to country.
In terms of non-monetary considerations, while the detail of the AIFM directive may be less significant in a private equity context than it is sometimes presented and its real impact remains to be seen (particularly given the likelihood of a separate “venture capital” regime), the directive does represent a political shift within the EU. Private equity investment is now in the spotlight and the directive establishes a framework for ongoing political interference which may undermine the product certainty that is so critical for long-term, high-value and otherwise politically sensitive investment activity.
The simple questions that promoters and their advisers should ask are: “what is my tipping point and where do the efficiencies and savings of the offshore product outweigh the associated costs?” As a rule of thumb we know it is somewhere between the €100m to €200m fund size. However, as hopefully this article demonstrates, this is not a simple calculation; it differs substantially from promoter to promoter, jurisdiction to jurisdiction and, crucially, over time.
What is clear is that the more the EU jurisdictions look to the finance industry to shore up their ever increasing debt levels, and the more politically they seek to interfere with the operations of the industry, the more appealing the offshore route and the lower that tipping point become.
Alan Ross is the managing director of the UK onshore office of Aztec Group. To discuss any aspect of the above he can be reached at firstname.lastname@example.org