The new financial landscape’s broad shape is becoming clear – but a lot of important detail remains unclear. When it emerges, this detail might have significant impacts on private equity managers, as might the still-evolving tax positions of different governments. Against this background, choosing a domicile for a private equity GP or LP takes foresight and insight.
When judging the merits of one jurisdiction over another, private equity firms place their investors’ needs first. In the tough fund-raising climate, investors call the shots and this is unlikely to change. For investors, the best IFCs offer tax neutrality and an appropriate regulatory framework, which will allow them to market into the EU without suffering a disadvantage when seeking investors from further afield.
Each private equity firm will look into a different set of circumstances when making its decision. But the new world has made two factors supremely important:
In essence, four factors underpin a jurisdiction’s quality and stability. These are: Regulation, tax, governance, and infrastructure and geography.
Changing regulation, and especially Europe’s AIFMD, is one of the main catalysts making private equity firms re-evaluate their business architectures. The AIFMD presents a significant challenge to private equity firms – potentially preventing them from marketing to European investors unless the jurisdictions they’re based in comply with the Directive’s key conditions.
Once the Directive has been implemented in July 2013, private equity firms will have to choose whether to market within the EU using the partial ‘private placement’ or full ‘passport’ method. The latter gives unfettered access to Europe’s investors – but on the condition that private equity firms make changes that reach to the core of how they run their businesses. The former involves far fewer changes, greater investment freedom and lower costs, but firms will likely have to register in each of the countries where they wish to market.
Private equity firms want to make this choice on a fund-by-fund basis, which gives them the flexibility to market into the EU and to investors in countries outside Europe. What’s more, some institutional investors might make AIFMD equivalence a pre-condition for investment, wanting to invest in a regulated product.
Some non-EU IFCs are taking a ‘dual approach’ that gives private equity firms flexibility. This means private equity firms will have the choice of marketing in Europe through private placements, or through a full passport when these are available to non-EU countries from.* When marketing in the rest of the world, where a significant proportion of potential private equity investors are based, they can remain as they are, outside the scope of AIFMD.
Considerable uncertainty still surrounds the issue of regulation and especially the AIFMD. Promoters and investors are most likely to favour IFCs with governments that work closely with the EU’s regulatory bodies to make sure that they’re prepared for the Directive’s implementation.
*Passports are likely to be in place from 2015 for third countries (i.e. those outside the E.U.). The European Commission will review the private placement regime in 2017 to see whether it should remain in place, or whether all jurisdictions should move to the full passport from 2018.
Tax collection has become a politically charged issue, causing some private equity firms to re-examine their tax structures. They’re asking whether the advantage they gain from a tax-neutral structure adequately mitigates the potential damage to their reputations caused by some European governments’ concerns about transparency.
Almost all private equity firms have chosen to respect investors’ wishes and base their funds in IFCs that make LP structures available, which are tax neutral. This neutrality has the effect of making sure investors just pay tax once.
Progressive jurisdictions’ governments and private equity firms are working hard to make other countries more comfortable with the concept of tax neutrality. The Organisation for Economic Co-operation and Development has rewarded a number of jurisdictions, including Guernsey and Jersey, by placing them on its ‘white list’ and many jurisdictions also have growing numbers of Tax Information Exchange Agreements.
For their part, private equity firms are increasing the scope of management activities performed in the specialist jurisdictions, mainly for governance purposes and to comply with regulations. This trend is increasing the ‘substance’ of their local operations, which is likely to mollify the tax collection agencies of overseas governments.
What’s more, the new US FATCA legislation, due to be implemented from July 2013, is posing an administrative challenge for private equity managers. Those based in jurisdictions with strong anti-money-laundering regulations and monitoring, particularly where following the FATF recommendations, will find themselves in a strong position when it comes to being ‘FATCA ready’.
Governance is becoming an increasingly important topic. Both investors and regulators want to be sure that Anglo-Saxon jurisdictions with common law, which is less prescriptive than civil law, have adequate protections in place for investors. For this reason, they increasingly expect GPs’ non-executive directors (to whom the governance role falls through common law structure) to take a strong role in making sure that fund is managed in line with their mandates. It’s therefore becoming important that IFCs have a pool of adequately experienced non-executive directors.
In essence, this means that any GP based in a specialist jurisdiction must have a sufficient pool of experienced directors with the appropriate credentials and time to supervise the investment adviser, administrator and other service providers.
Infrastructure and geography
Private equity firms have always relied on the support infrastructure of specialist IFCs and their proximity to key global finance centres – but now this is becoming even more essential. Just as regulators want GPs to have more substance in the financial centres, so investors’ demands for strong governance and more transparency mean that more functions are likely to be carried out locally.
So jurisdictions must offer high-quality service infrastructures with competitive cost bases. They should have extensive networks of specialist service providers – such as administrators, auditors, lawyers, non-executive directors and banks.
Finally, regulators and investors increasingly expect all board directors, including investment managers, to attend board meetings. So specialist financial centres must be close to the large regional financial centres – such as London, New York or Shanghai – with good travel links.