The emergence of the offshore fund as a vehicle through which to invest in traditionally high risk markets comes at a time when experienced investors are concerned about the continuing levels of returns from the world equity. This has focussed their attention towards alternative investments, such as; hedge funds and new opportunities such as; real estate funds. The appetite for risk has grown as a consequence of this, and promoters of such opportunities have sought to capitalise by delivering a packaged investment product, which more often than not comes in the form of an offshore investment fund. This article aims to demonstrate a practitioner’s experience of advising on private equity fund transactions. Having been involved in advising clients on a top down approach (more on this later) and encountering practical issues such as dealing with the regulator, I hope my experiences will be a valuable aid to those seeking to enter this new and exciting practice area.
So why the sudden increase in popularity of the offshore fund, and what is it exactly? Like many things in our industry, the offshore fund is shrouded in mystery for no apparent reason. An offshore fund is, after all, simply a collective investment vehicle incorporated and regulated under the laws of an offshore financial services centre (OFSC) – nothing more, nothing less. What makes an offshore fund such an exciting investment proposition is the tax status that it enjoys. Coupled with the freedom to invest in higher risk markets without the stranglehold of regulation (again, more about this later!), this is a potent combination. The popularity of offshore funds as investment vehicles is linked, I believe, to the willingness of investors across the board to invest a proportion of their portfolio into high risk areas. One only has to look at the number of offshore funds that have listed on the AIM market in recent times to appreciate this – funds based in Jersey, Guernsey, Isle of Man and The Cayman Islands investing in sectors from real estate to pharma are testimony to this.
As an advisor, I try to take a “top down” approach and, by this, I mean I am taking into consideration the investors’ tax position and also that of the fund and the underlying investments. They will invest if they believe they will receive a good (above market rate) return on their capital. But an investor who participates in an offshore fund which provides Gap Finance to the film industry, for example, will be less likely to invest if there is a 30% withholding tax at source on the interest return. Likewise, the investor who invests in an offshore fund investing in Bulgarian real estate where no planning has been undertaken with respect to that specific asset class. Using this top-down approach, I have outlined the following key issues to take into account when considering advising an offshore fund.
Tax Status of Investors
A key issue is to identify the type of investor targeted by the fund. The requirements of non-domiciled residents of the UK are very different from those of US citizens for example. The antiavoidance rules (and indeed the regulatory issues) facing a promoter in respect of US investors can be very acute and extremely costly if not considered carefully. Likewise, institutional investors and pension schemes, which may be tax neutral themselves, will want to ensure there is minimum tax leakage all the way through the structure, as they are unlikely to be able to claim any credits for tax suffered. By considering these issues and identifying the model investor it is then possible to determine the most suitable entity for the fund vehicle, and whether it should be closed or open ended.
Choice of Fund Vehicle
The choice of entity for an offshore fund ordinarily is limited to the following:
a) Limited Partnership (LP)
LPs are widely used in offshore fund structures because they are fiscally transparent, which is often a key consideration for institutional investors. The limited partners will be the investors while the general partner will be the entity which manages the partnership.
b) Unit Trust
A unit trust is just like any other trust, the assets of which are vested in a trustee who holds them for the benefit of the unit holders. A manager is appointed to undertake the management and general administration of the fund and allocation and distribution of units to investors. The trust deed governs the way in which the trust operates and will determine issues such as distribution policies, redemption of units and so on. These may be less attractive to investors resident in jurisdictions that do not recognise the trust concept.
c) Limited Company
A limited company is, in many instances, the vehicle of choice since a great degree of flexibility can be achieved through the creation of different classes of shares. It is also relatively easy to list on a stock exchange if this is deemed necessary, or part of the overall strategy of the promoter.
d) Protected Cell Company (PCC)
A relative newcomer to the fund world is the PCC, which is now found in many of the OFSCs. While originally used in the insurance sector for captive arrangements, regulations have been relaxed and the use of PCCs as fund vehicles is becoming more and more common. The PCC is a limited company which can segregate assets within cells, allowing a much diversified fund to be created in terms of investors, currency and asset classes without hugely complex corporate structures. Once the type of entity has been chosen, it is necessary to consider whether it should be open or closed, and then how the management structure should operate. The overriding feature of offshore funds is that distinctive roles for different parties can be created so that a degree of influence can be assigned to the onshore investment advisor without jeopardising the tax status of the fund itself.
Open Ended or Closed?
A closed ended fund is one which essentially locks investors in for a set period, eg, five years, during which time they cannot redeem their shares or units in the fund. They may of course sell their investment (if there is a market) but cannot force the fund to buy back. This is an important factor for the promoter with an illiquid investment structure: under any circumstances, would he want the fund to sell assets and investments to assist in the buy back of shares? Of course at the end of the set period, the fund will be wound up and a distribution made to the investors. An open ended fund, on the other hand, means investors can redeem shares freely and are not “locked in” for a set period of time. The choice between an open ended and closed ended fund will be dictated primarily by the types of investment that the fund will make, but also whether a specific tax treatment for the investors is being built into the model. For example, it may be very beneficial if the core investors are UK residents, for the fund to obtain distributor status but, more often than not, this is not essential.
Intermediate Holding Companies
One of the most significant aspects of advising on a fund deal is to take into account the anticipated tax leakage on the specific investments that will be made. Tax at source, whether it be on rental income, interest on loans or royalties on IP investments, is a fundamental issue which needs to be addressed. This will often involve very detailed planning to ensure that investments are considered on a case-by-case basis to ensure the tax structure used delivers optimal returns. An intermediate holding company, established in a high-tax jurisdiction, is often set up by the fund to reduce rates of withholding tax and to allow a tax efficient repatriation of profits to investors. Similarly, a group finance company could be an important addition to the fund structure, much the same as any other corporate group. Jurisdictions such as Austria, Cyprus, Luxembourg, Malta, the Netherlands and Switzerland are frequently considered for both functions.
Management and Control
If the fund is incorporated or established offshore, it is imperative for tax purposes that it is managed and controlled offshore. This does not mean that certain functions, particularly the investment advisory role, cannot be devolved to an onshore entity. However, the relationship between the parties must be governed by an appropriately drafted contract to ensure management of the fund is not carried on in the onshore jurisdiction, such as the UK. The role of
the offshore parties is fundamentally important to the success of the structure and the need to ensure that clear reporting lines, audit trails and decision making processes are implemented from the date the fund is established is of paramount importance.
Partnership Traps
For UK tax purposes, a capital gains tax (CGT) liability may arise where a limited partnership is used as the fund vehicle if careful planning is not undertaken. Gains realised by a limited partnership are outside the scope of the CGT anti-avoidance rules because the investors are taxed on an arising basis in any event. In many instances a corporate structure is established beneath the LP to capture income and gains, allowing reinvestment without an immediate charge on the investors. It is here that problems may be encountered. For the purposes of UK tax law, partners are “associated” which means the UK resident and domiciled partners of a limited partnership would be counted as one for the purposes of the CGT rules. If, together, they have an interest in the fund greater than 10%, the anti-avoidance rules will apply to any gains realised by the underlying holding company. To avoid this, the holding company must be incorporated in a jurisdiction that has a double tax treaty with the UK, which is based on the OECD Model Convention and contains a capital gains tax article.
Controlled Foreign Company (CFC) Rules
It is also necessary to ensure that the fund, if established as a corporate entity, does not become a CFC. In order to achieve this, it is often advisable to include a provision in the statutes of the fund and/or a section in the prospectus, stating that no shareholder (or related party) is entitled to 25% or more of the fund’s profits. The prospectus should, however, be explicit that each investor is responsible for taking independent advice before investing!
Regulatory Issues
The popularity of funds, and the desire of promoters to establish these, is driven on the one hand by the appetite of investors for alternative investment strategies and, on the other, by the ease of which such funds can now be established. At least this is the theory; in practice it can be quite different. Many of the leading OFSCs have introduced a fast-track procedure for the establishment of funds which are to be targeted at so-called expert or qualified investors. Provided the investor meets certain criteria, the fund should qualify for the fast-track procedure. This is in effect self-certification, whereby the offshore administrator is taking the responsibility of vetting the fund, the fund promoter and investment advisor/manager, removing this burden from the local regulator. In principle, provided the offshore administrator is satisfied that all the boxes are ticked, the fund ought to be approved by the regulator in a matter of days. This is the theory, in practice my experience varies. In Guernsey, for example, the regulator is very pragmatic, giving the licensed administrator the responsibility of vetting the whole proposed structure. The Jersey regulator on the other hand is far more “hands-on” in its approach, being very keen to satisfy itself that the investment advisor has relevant experience in the market sector, that an adequate “span of control” exists as regards the investment advisor and so on.
Listing
In many instances, the prospect of listing on a junior stock market is very appealing, not least because it allows the promoter to reach a larger market and create liquidity in the stock. London’s AIM market has seen a number of offshore fund listings, especially for central and eastern European property funds. Not to be overlooked is the Channel Islands Stock Exchange (CISX) which is a very quick, efficient and cost effective alternative. Moreover, the use of funds (private unit trusts and PCCs in particular), may produce fascinating tax advantages if a listing is sought, and can be very attractive to family office clients and the super high-net worth.
Ten Key Points of Note
So, in summary, when considering establishing an offshore fund, the promoter must:
1. Have a clear and detailed business plan prepared at the outset. This will form the heart of the prospectus of CIM (Confidential Information Memorandum) which has to contain sufficient information to allow prospective investors to make an informed decision.
2. Be clear on the investment strategy that the fund will adopt and the criteria for making investments.
3. Establish a pipeline of deals in which the fund can invest.
4. Make sure the relationship between the fund and the various other parties is clearly defined within legal contracts.
5. Ensure the offshore administrator has experience in this type of structure – can they deliver NAV calculations and a streamlined service to investors?
6. Ensure that management and control of the fund (the decision-making process and so on) take place offshore.
7. Only submit the relevant application forms when the proposed fund structure and parties have in principle been agreed.
8. Make sure the investment advisor has relevant experience in the sectors in which the fund will invest. If necessary, bolster the board of the fund with suitably qualified non executives with specific skill-sets and experience.
9. Ensure that all onshore regulatory requirements are satisfied, eg, does the fund need to be FSA “badged”?
10. How is the investment advisor’s remuneration structured? Can the tax position be maximised through the use of trusts, global employment companies and other such arrangements? The above is intended to provide an overview of the key considerations of advising on private equity fund structures. Specific advice is always necessary.