i GENERAL OVERVIEW
In Australia, private equity (PE) and venture capital (VC) fundraising continues to be strong based on available data. PE and VC funds targeting wholesale investors are lightly regulated (as discussed in more detail below), and as such there are no public records to verify PE and VC fundraising activity.
However, the Australian Venture Capital and Private Equity Association Limited (AVCAL), an industry association representing both private equity and venture capital, publishes a yearbook for each fiscal year ending 30 June. All data in this section is taken from the AVCAL Yearbook for FY2017 (FY2017 Yearbook). The information for the FY2017 Yearbook was obtained via direct submissions to AVCAL and other sources such as firm websites, press releases and industry news sources, and is based on the activities of 86 venture capital and private equity firms.
AVCAL’s data focuses on Australian fund managers – a fund managed by an overseas fund manager is not included unless the fund manager allocates a specific amount to Australian investments. It also disaggregates PE from VC based on a fund’s target investments, as follows:
- a venture capital funds make equity investments for the launch, early development or expansion of a business, typically in an innovative or high-tech product or service and include seed, early stage, later stage and balanced VC funds (but do not include anything included in the definition of ‘private equity’); and
- b private equity refers to growth or expansion, generalist, buyout or later stage, turnaround, secondary and mezzanine funds.
Based on this data, A$2.03 billion in new capital was raised by PE fund managers in FY2017 (slightly less than in FY2016); and 12 PE fund managers successfully raised capital in FY2017 (up from 10 in FY2016).
The VC fund industry is extremely active. AVCAL reports that 19 VC funds were raised in FY2017, and that they raised A$1.32 billion in FY2017, one of the most active years on record.
A number of trends are evident.
The first is that Australian superannuation funds are back, not just in VC (which was a trend evident in the past couple of years) but also in PE. In fact, the amount of Australian investment in PE was approximately double what it was in FY2016, largely fuelled by Australian superannuation funds. Overall, investment in PE and VC broke out by region as follows:
- Australia – 75 per cent;
- North America – 15 per cent;
- Asia – 4 per cent;
- Europe – 2 per cent; and
- other and unknown – 4 per cent.
The public sector’s support of VC was particularly strong in FY2017, with the government contributing A$250 million of matching capital to fund managers raising funds in the biomedical commercialisation space; a A$100 million fund raised by CSIRO; a A$50 million innovation fund raised by the South Australian government; and a A$150 million fund raised by the New South Wales government together with an Australian superfund to invest in job-creating businesses in New South Wales.
There were some signs of reversal of a negative trend from the prior year. As noted last year, the expected flood of persons applying for significant investor visas (visas granted to persons who invest A$5 million in Australia, including A$500,000 into venture capital funds) never materialised. However, more funds have now been able to achieve first closings off the back of investment from visa applicants. This should continue in FY2018.
Overall, the outlook remains positive for FY2018 and FY2019, with some of the most successful fund managers already raising or preparing to raise in the near future.
The formal process of documenting a fund – from information memorandum to first closing – generally takes four to six months. However, the actual time it takes to raise a fund varies significantly depending on the fund manager and the extent to which it can rely on existing LPs to ‘re-up’ for a new fund.
For funds that are established as VCLPs or ESVCLPs (defined below), there is a registration component that presently takes about six to eight weeks (described below).
ii LEGAL FRAMEWORK FOR FUNDRAISING
Most PE funds established by Australian fund managers consist of one or more Australian-domiciled vehicles (described below). The Australian tax treatment for both domestic and non-resident investors in Australian-domiciled vehicles is described in Section III below.
Occasionally the fund structure may include one or more overseas vehicles (such as Delaware, Cayman Islands or Jersey partnerships). This is usually to facilitate investment by non-resident investors in investments outside of Australia.
Australian PE funds are usually formed as a combination of Australian-domiciled unitised trusts (often structured to fit the managed investment trust (MIT) regime and the attribution managed investment trust (AMIT) regime, described below) and a particular form of Australian limited partnership called a ‘venture capital limited partnership’ (VCLP), with the determining factors between the two vehicles often coming down to the nature of the portfolio investment or investments and the profile of the investors. Australian domiciled venture capital funds are typically established either as a VCLP or as an ‘early stage venture capital limited partnership’ (ESVCLP).
These vehicles are described in more detail below.
i Unit trusts
A unit trust creates a contractual relationship between unitholders (investors and beneficiaries) and a trustee (legal holder of the property and manager) under a trust deed or constitution. As a unit trust does not have a separate legal personality, the trustee contracts on behalf of the trust subject to a general provision limiting the trustee’s liability to the assets of the trust.
A unit trust is managed by a trustee, manager or both. The trustee usually has the right to deal with the trust assets on a discretionary basis on behalf of the investors. A management entity is often appointed by the trustee within the structure to advise them, though this is mainly for fee-streaming purposes.
An MIT is essentially a unit trust with certain characteristics. Numerous tests must be met in order to qualify as an MIT, such as:
- the trustee must be an Australian resident for tax purposes;
- the trust cannot be a trading trust;
- a substantial portion of the investment management activities must be carried out in Australia in regard to certain assets;
- the trust must be a ‘managed investment scheme’ at the time the payment is made for Corporations Act purposes;
- the unitholding must satisfy concentration of ownership requirements; and
- in some cases, the trust must be managed by a licensee who has an Australian financial services licence (AFSL) that permits it to provide financial services to wholesale clients.
In exchange, the MIT provides greater certainty in terms of tax treatment. Please see Section III, infra for further details.
Further, eligible MITs can elect to be treated as ‘attribution MITs’ (AMITs). AMITs benefit from:
- an attribution method (rather than the existing trust tax rules) to attribute specific classes of income, offsets and credits to unitholders, based on their entitlements;
- the ability to attribute any under or over distributions to unitholders during the income year the discrepancy is discovered; and
- tax treatment as a fixed trust, assisting the flow through of franking credits and carried forward tax losses.
In order to be eligible as an AMIT, a trust must be a MIT, the trust deed must clearly define the entitlements of all unitholders to the trust’s income and capital and the trustee must elect for the trust to be treated as an AMIT.
These eligibility requirements must be met for each income year. Should the requirements not be satisfied, the trusts will continue to be taxed under the normal trust taxing provisions.
The VCLP regime was introduced in 2002 to increase foreign investment in the Australian venture capital sector by offering a familiar fund structure (the limited partnership) with tax benefits (see Section III below for further details) in exchange for making investments in Australian businesses that meet certain eligibility criteria. Because of these restrictions, VCLPs have largely been restricted to venture capital and mid-market private equity funds.
A VCLP must have a minimum capital raising of A$10 million by investors to be formed. VCLPs generally have a life of five to 15 years.
The requirements for a VCLP include:
- investments must be at risk and can only be made in shares or options in a company or units in a trust;
- the target needs to have an Australian nexus (subject to certain exceptions);
- the target cannot have more than A$250 million in total assets (including goodwill);
- the target must not engage in certain ineligible activities like property development;
- the target must have a registered company auditor (subject to a de minimis exception for small companies);
- the target must be unlisted at the time the investment is made (unless it delists within a certain period of time);
- the target may only invest funds invested in it by the VCLP in other entities in certain circumstances; and
- the total amount invested in the target by the VCLP must not exceed 30 per cent of the VCLP’s commitments.
The ESVCLP is essentially an extension of the VCLP regime. It was introduced to encourage early stage venture capital investment by offering further taxation advantages for investors (see Section III below for comments regarding the tax treatment of ESVCLPs) provided the fund only invests in early-stage investments (the term ‘early-stage investments’ is not defined, but relevant regulatory authorities currently view this as an additional requirement on top of the criteria specified in detail in the legislation) and meets certain other tests. The requirements for investments are similar to those for VCLPs, except that the target must not have more than A$50 million in total assets; the rules relating to investments in listed entities are different; and there are restrictions on buying ‘pre-owned’ (as opposed to newly issued) shares. An ESVCLP also has some different registration requirements compared to VCLPs, including a fund cap of A$200 million and investor spread requirements (no one investor may hold more than 30 per cent of the fund). Despite these restrictions, the ESVCLP structure has gained popularity with high net worth investors who value the tax advantages offered by the ESVCLP and want exposure to early-stage venture capital.
Australian PE and VC fund documentation has become reasonably standardised for similarly structured funds, though the terms can significantly vary. Although the documents may look very different to partnership agreements seen overseas, the overall coverage is the same, including:
- procedures for admitting investors and dealing with fund interests;
- procedures for capital calls, capital call relief events and dealing with investor defaults;
- management fees, offsets for outside fees and recoverable expenses;
- distributions, including the distribution waterfall;
- procedures for removal of the general partner, trustee or manager (for cause and for convenience), termination fees and post-removal carried interest;
- governance, including:
• powers and duties of the general partner, trustee or manager including the right of indemnity out of fund assets for actions taken on behalf of the fund;
• limitation of liability of investors;
• advisory committee structure; and• matters requiring advisory committee or investor approval; and
- restrictions on raising new funds.
In general, Australian fund terms are starting to be more aligned with international funds, as the influence of non-resident investors on PE fund documentation is felt. Although there has been a general shift in negotiating power towards LPs, top fund managers are still able to raise funds on favourable terms.
In Australia, wholesale investors (persons investing more than A$500,000 and institutional and professional investors) are the investors typically targeted by PE and VC funds. Australian law does not require disclosure to these parties for issues of interests in PE and VC funds (such as through a prospectus or product disclosure statement), but does require that the fund manager not engage in misleading or deceptive conduct.
As long as offers are made only to wholesale investors (described above), the most common method of solicitation of investors for fundraising is to distribute a private placement memorandum to interested parties that outlines the details of the fund and the investment plan.
In these cases, there are no real limitations on such solicitation, although:
- the fund manager must hold or be an authorised representative under an Australian financial services licence (AFSL) (discussed below) with appropriate authorisations covering the financial services being provided; and
- for VCLPs, ESVCLPs, MITs and AMITs, the number, mix and identity of investors will be relevant for ongoing registration and eligibility requirements, so this will affect solicitations.
Trustees of PE and VC funds formed as unit trusts have duties in equity to act in the best interests of members. These duties will be reinforced through a trust deed that establishes the trust. General partners and fund managers typically have similar duties imposed upon them by contract.
Managers of funds are required to hold an AFSL in order to provide financial services. The AFSL imposes duties to act efficiently, honestly and fairly, effectively imposing fiduciary obligations upon the licensed entity to investors.
As noted above, the majority of Australian PE and VC funds are formed as MITs, VCLPs or ESVCLPs.
All of these are generally flow-through vehicles with respect to the income and profits of the fund being taxed in the hands of the investor (however, see comments below regarding MIT withholding tax (MITWHT) and withholding tax on dividends and interest paid to non-residents).
The Australian income tax consequences for investors will depend on the character of the gains derived by the fund. The view of the Australian Taxation Office (ATO) is that, generally, gains made by private equity funds are treated as being of an income character (as opposed to being of a capital nature).
The requirements for a unit trust to be a MIT or AMIT and for a limited partnership to be a VCLP or ESVCLP are prescriptive and extensive. However, where they are met, they offer certainty of Australian income tax treatment for overseas (and in some cases domestic) investors.
iii REGULATORY DEVELOPMENTS
For wholesale PE and VC funds, there are two main sources of regulation.
First, ASIC has regulatory oversight of the operation of PE and VC funds in Australia through its financial services licensing function (described in more detail below).
Second, a fund manager is regulated under Australia’s anti-money laundering and counter-terrorism financing laws (described in more detail below).
The Australian Private Equity & Venture Capital Association Limited released a code of PE governance in 2011. The association was established to promote and represent the interests of the PE and VC industries in Australia. The code outlines principles to assist PE and VC firms to be better governed. Compliance with these principles is not, however, compulsory. Regardless, investors expect managers, general partners and trustees to follow the principles and to report to investors when they do not comply with them.
Where the fund targets and accepts investment from wholesale investors only (described above), the fund does not need to be registered with ASIC.
If issues of interests in a PE fund are to retail persons, the fund will need to be registered and additional licensing, financial and disclosure requirements will apply to the fund manager.
Australian VCLPs or ESVCLPs must be registered as incorporated limited partnerships in a state and as a VCLP or ESVCLP with Innovation and Science Australia (the federal government body that oversees the VCLP and ESVCLP programme).
Typically, a domestic PE or VC fund manager will be obliged to hold, or be an authorised representative under, an AFSL, which will set out the authorised activities that the manager may perform. Generally, the licensed or authorised entity may be the manager of the fund, the trustee of the trust or general partner of the VCLP or ESVCLP.
Many international PE or VC funds carrying on business in Australia may be able to obtain licensing relief where they have only limited connection to Australia or where Australia and their home jurisdiction have implemented ‘passporting’ arrangements.
The AFSL licensing regime requires entities to prepare and lodge audited accounts publicly and to comply with strict compliance requirements. ASIC has the right to inspect books and records of such entities with regard to compliance with the Corporations Act at any time.
Authorisations covered by an AFSL are publicly available information.
By issuing fund interests, a fund is providing a designated service under Australian Anti-Money Laundering and Counter-Terrorism Financing legislation (AML/CTF) and needs to comply with the AML/CTF as a reporting entity.
As a reporting entity, the fund is subject to the following obligations:
- enrolling with AUSTRAC (the regulator);
- performing investor identification and verification and ongoing investor due diligence, including monitoring transactions;
- reporting to AUSTRAC suspicious matters within 24 hours or three business days, as required;
- reporting to AUSTRAC transactions greater than A$10,000 within 10 business days after their occurrence;
- providing AUSTRAC with compliance reports;
- implementing and adhering to an AML/CTF programme that includes the designation of an AML/CTF compliance officer, systems for identifying, mitigating and managing risks, employee risk awareness training and due diligence programmes, transaction monitoring, independent review of the AML/CTF programme and investor identification and verification procedures; and
- retaining records relating to investors and retaining each AML/CTF programme in force for a period of seven years after the record ceases to be in force.
The reporting obligations include the disclosure of the identity of the fund’s investors and sponsor’s members when reporting to AUSTRAC.
Where a MIT is used as the fund vehicle, the MIT is able to make an election to deem certain gains made by the MIT to be on capital account, effectively providing a statutory safe harbour against the ATO position regarding gains being made on revenue account, described above. This means potential concessional tax rates for certain Australian investors such as individuals, trusts and complying superannuation funds. Furthermore, non-resident investors in a MIT will generally not have any Australian income tax liability unless the relevant capital gain made by the MIT is in relation to taxable Australian property (for example, interests in land and non-portfolio interests in land-rich entities) or the non-resident investor has a permanent establishment in Australia.
Subject to meeting certain additional requirements, distributions to non-residents by a MIT of certain non-tax-exempt amounts may qualify for MITWHT at a 15 per cent rate (depending on the nature of the income distributed (see below for details) and the tax residence of the investor). However, where the investor is a resident of a country other than an ‘information exchange country’ (as defined by income tax regulations), the applicable rate of MITWHT is 30 per cent. A 10 per cent rate may be available for eligible distributions by MITs that hold only certain energy-efficient buildings constructed from 1 July 2012.
This withholding tax will apply to various distributions, including distributions of taxable capital gains (namely, capital gains derived in relation to taxable Australian property) and income that has an Australian source (such as rental income in relation to land situated in Australia). Unfranked dividends and interest paid to a non-resident investor by a MIT are not subject to MITWHT and instead are subject to different withholding rates (generally 30 per cent in the case of an unfranked dividend (subject to the operation of any applicable double tax agreement (DTA)) and generally 10 per cent in the case of interest).
Because Australian resident investors are taxed by assessment, a MIT does not generally need to withhold from amounts paid to Australian resident investors.
Where a VCLP is used as the fund vehicle, subject to certain exceptions, both income and losses are attributed to investors. Australian investors will need to include the relevant partnership profit in their assessable income or claim the corresponding deduction for any loss. Subject to an exception that applies to certain superannuation investor entities and unlike for MITs, there is no statutory safe harbour for gains made by a VCLP. Such gains may be regarded by the ATO as gains made on revenue account (such gains will not be concessionally taxed as capital gains).
Certain non-resident investors (such as tax-exempt foreign residents, a foreign venture capital fund of funds and where the foreign investor holds less than 10 per cent of the VCLP’s committed capital) are given a specific exemption from Australian income tax on gains made in relation to investments held by the VCLP. If a non-resident investor does not satisfy the exemption criteria, it may have an Australian income tax liability in relation to gains made by the VCLP.
There is no withholding tax on distributions of gains on investments made by a VCLP to non-residents.
Unfranked dividends or interest derived by the VCLP and paid to a non-resident investor are subject to withholding (generally 30 per cent in the case of an unfranked dividend (subject to the operation of any applicable DTA) or generally 10 per cent in the case of interest).
Because Australian resident investors are taxed by assessment, generally no amount needs to be withheld from amounts paid to them.
Where an ESVCLP is used as the fund vehicle, subject to certain exceptions, both Australian investors and foreign investors may be entitled to tax-free returns in Australia from the ESVCLP.
Key tax features of the ESVCLP regime for investors include:
- limited partner’s share of any gain or profit from the disposal or realisation of an eligible venture capital investment by the ESVCLP is exempt from Australian income tax, if the partnership owned the investment for at least 12 months;
- limited partner’s share of income derived from an eligible venture capital investment (for example, dividends paid by an investee) held by the partnership is exempt from Australian income tax. Unfranked dividends or interest derived by the ESVCLP and paid to a non-resident investor are subject to withholding (generally 30 per cent in the case of an unfranked dividend (subject to the operation of any applicable DTA) or generally 10 per cent in the case of interest); and
- capital gain or capital loss arising from the disposal of an eligible venture capital investment by the ESVCLP is not made by the ESVCLP but is made by the limited partners. Such a capital gain or capital loss from the disposal of an eligible venture capital investment will be disregarded for Australian income tax purposes if the ESVCLP owned the investment for at least 12 months.
Losses made by an ESVCLP are typically not deductible to investors.
Certain investors in new ESCVLPs may be entitled to a non-refundable tax offset of up to 10 per cent of the value of new capital invested.
vi Foreign CGT regime
Generally, a purchaser of an asset will have to withhold and remit 12.5 per cent of the purchase price to the ATO unless the seller is able to establish that the seller is a resident of Australia or the asset being sold is not taxable Australian property (broadly direct or indirect interests of at least 10 per cent in Australian land).
vii Corporate collective investment vehicle (CCIV)
In December 2017, the Australian government released draft legislation on the tax treatment of a CCIV, a new type of corporate investment vehicle. Similar to an AMIT, a CCIV which satisfies various conditions will qualify as an attribution CCIV (ACCIV) and will be taxed on a character flow-through basis. It is proposed that the CCIV rules will apply to income years commencing on or after 1 July 2018.
Aside from the continued tinkering with Australian tax laws as they affect private equity and the SIV regime, another significant development is the increasing regulation of foreign investment in Australia. Sovereign wealth funds and public pension funds are a significant source of capital for PE funds in Australia. However, each of these is considered to be a ‘foreign government investor’ for purposes of Australia’s foreign investment rules. If foreign government investors from one country comprise 20 per cent or more of an Australian domiciled PE fund, or foreign government investors from multiple countries comprise 40 per cent or more of an Australian domiciled PE fund, the fund itself (and ultimately its investees) will be considered to be a foreign government investor – meaning virtually all of its investments in Australia (and the downstream acquisitions by its investees) will be subject to Australia’s foreign investment approval regime. Foreign investment applications now attract fees, which in the case of business acquisitions range from A$25,300 to A$101,500 depending on the value of the acquisition. While this added regulatory burden does not appear to have dampened fundraising, it has increased the cost of doing business in Australia for private equity funds. The government has developed a new business exemption certificate which essentially allows fund managers to receive prospective approval for a number of potential investments under one application. It remains to be seen how effective this will be in relieving the burden on private equity investors.
The government also intends to use the foreign investment review process to review tax structuring more closely, particularly for acquisitions by PE funds.
1 Deborah Johns and Muhunthan Kanagaratnam are partners at Gilbert + Tobin.