i GENERAL OVERVIEW
Private equity funds closed in 2019 raised US$537.2 billion.2 This represents the highest amount raised since the financial crisis and an approximate 16 per cent increase on the aggregate figure raised in 2018 (US$462 billion).3 Dealmaking dipped slightly, but was still strong: 2019 saw US$393 billion in buyout deals and US$224 billion in venture capital deals, compared with US$493 billion and US$271 billion, respectively, in 2018.4 The total number of funds closed increased marginally, but remained lower than the total number in 2017, while the trend towards larger average fund sizes continued. In 2019, the average private equity fund size globally was a record US$662 million.5
As has been the case for several years, these overall fundraising figures are, to a quite significant degree, driven by the continued success, and ever-increasing sizes, of buyout funds, which accounted for more than 62 per cent of the aggregate capital raised,6 and in particular, the mega buyout funds (defined by Preqin as raising at least US$4.5 billion), which continue to return to market earlier and with ever-increasing fund sizes. In total, 2019 saw more than a quarter of private equity capital – US$138 billion – raised by the 10 largest funds. These included Blackstone Capital Partners VIII, which, subject to final allocations, raised over US$26 billion, representing the largest private equity fund ever raised; the US$17.5 billion Advent International GPE IX; the US$16 billion Vista Equity Partners VII; and the €11 billion Permira VII. Growth equity, venture and secondaries funds comprised 14 per cent, 9 per cent and 6 per cent of total fundraising, respectively.7
The European private equity fundraising landscape has largely mirrored these trends, although there was a drop in aggregate fundraising to US$62.6 billion.8 This was largely down to 2019 being a slower year for mega funds capital raising in Europe. 2020 is expected to exceed the very successful 2018 and 2017 for European mega funds, with Ardian, EQT, Apax, BC Partners, Coller Capital, AlpInvest and Nordic (among others) all having announced mega fundraisings for 2020.
As was the case in 2017 and 2018, when record levels of distributions by private equity managers helped underpin investors' desire and ability to reinvest in private equity funds, the same is true of 2019, with exit activity and the strong flow of distributions continuing, leading to investors having significant levels of capital to deploy. The larger, top-performing managers have continued to benefit from this increased investor liquidity, in particular from the larger private equity investors, sovereign wealth funds, public pension funds and larger family offices, who, in tandem with their increased desire to gain greater control over capital deployment and more favourable economics from top-performing managers, have continued to write conspicuously larger cheques, concentrating their exposure in large-cap brand-name sponsors.
From an investor's perspective, there is little indication that the flow of capital into private equity funds will slow down in 2020, not least as a result of the speed and scale by which private equity managers are returning to market with new funds.9 In 2019, funds hit an average 107 per cent of their target capital at the first closing.10 As further evidence of the market disparity between the haves and have-nots, which we have consistently reported on since 2015, a survey by Cobalt found the percentage of investors planning to pursue relationships with new managers in 2020 increased slightly from 2018, but was still lower than in 2017, and the same theme was also evident in a Private Equity International survey in November 2019 that found limited partners' (LPs) top two selection criteria for manager relationships were track record (93 per cent of respondents) and team size and investment capacity (88 per cent). Dry powder continues to scale across all asset classes, with private equity managers holding approximately US$1.5 trillion in dry powder globally.11
As the evidence above suggests, and in much the same vein as for 2018, investors are, on the whole, committing larger amounts of capital to fewer managers and generally seeking to consolidate their general partner (GP) relationships. This market polarisation continues to represent a significant issue for first-time or less experienced managers and for those that lack a truly differentiated strategy. The bifurcated market continues to restrict certain funds from reaching a successful closing, while the larger funds take an ever-increasing portion of investors' total private equity allocation.
Europe and, more specifically, the United Kingdom, western Europe and the Nordic regions, have nevertheless seen a host of highly successful fundraisings in 2019. Permira, Cinven and Altor all held closings for their latest funds in 2019, with larger fund sizes than previously.
ii LEGAL FRAMEWORK FOR FUNDRAISING
i Jurisdiction and legal form
The key drivers in any fund structure are generally those of limited liability, tax transparency and efficiency, ease of use, and flexibility. Notwithstanding the wide range of possible structures that could be utilised, a limited partnership structure is the vehicle of choice for most UK fundraisings.12 As expanded upon further below, the general trend is for the fundraising market to adopt two main strategies in structuring: being located within the UK (thus being subject to the full range of UK tax and regulation, including – in whole or part – the Alternative Investment Fund Managers Directive (AIFMD)), or being located offshore (thereby being outside the UK (and EU) VAT and regulatory net).
The former strategy would generally utilise an onshore limited partnership, usually an English limited partnership (although Scottish or other jurisdictions may be used). The latter strategy would generally involve the use of an offshore-domiciled limited partnership – generally Guernsey or Jersey – although the former seems to be the favoured jurisdiction for offshore private equity funds, albeit with increasing competition from Jersey. Other possibilities include Delaware, the Cayman Islands and Bermuda, but these are very much the exception in a UK fundraising, primarily because of time zone, strength of local service providers and investor familiarity.
Some investors have preferences as to the location of the fund (usually because of the applicable regulatory or tax regime), and this may have an impact on the jurisdiction of the fund or its structure, or both; feeder vehicles or tax 'blockers' may have to be incorporated into the structure to cater for the specific needs of a single investor or a group of investors.
Other fundraisings can take the form of a wide range of onshore and offshore vehicles, such as the Luxembourg limited partnership (SCSp), SICARs, SIFs, RAIFs and French FCPIs or offshore companies, although these structures are not the focus of this chapter.
While each GP will claim to have a set of unique terms relating to its fundraising, there are a number of themes that are common to all, albeit with different formulations and treatments between various funds. While not comprehensive, the main negotiated terms of a private equity fund are as follows.
The target size of the offering is of relevance to investors as they may wish to impose limits on the size of the fund to ensure that it is not too large for the team to manage, thereby ensuring that they focus on transactions of an appropriate size and in appropriate volume for their investment strategy. Thus, investors may seek to cap the size of a fund and, conversely, seek to subject their commitments to a size precondition (i.e., they would only be bound to invest if the fund reaches a 'viable' size), thereby ensuring that they would not be over allocated to that fund, or that the fund would have to make smaller investments in size or number.
The size of the personal commitment made by the executives and its form (i.e., whether financed personally, by waiver – less common in the UK and European market and increasingly less common globally as investors seek to ensure that sponsors and their executives commitments are in 'cash' – or by some other method) is also very pertinent to prospective investors who want to ensure they have 'skin in the game'. Because of investor pressure, the expected number has been steadily increasing and is now likely to start at 2 per cent of fund commitments, although there is wide variation.13
This is the period during which more investors can be admitted to the fund. The 'market' position tends to be 12 months from the first closing of the fund; however, managers have argued for an increase as a response to the increase in time required to fundraise and deal with investor due diligence, etc. Investors have generally accepted this extended period, notwithstanding their concerns that the management team would be distracted from deal sourcing and investment activity by their fundraising efforts. While the very best GPs will raise new funds with relative ease when compared to other market participants, on the whole, GPs are being made to work harder than ever before to win commitments, with more firms and funds than ever before working across a broad spectrum of strategies.14
This period during the fund's life is reserved for investing. The manager will have full discretion to draw down all the funds available during this period (subject to relevant limitations such as investment policy and borrowing restrictions). Here, the old status quo of a five-year investment period is also being modified. Managers, in an attempt to avoid failing to invest their funds fully in the allotted period have argued for the ability to extend their investment periods. This has been met with a variety of responses from investors, some of whom were sympathetic provided that the approval mechanisms were satisfactory, and others who were unmoved and wanted to ensure that their commitments were time-limited to five years.
It is usual for the management fee to be calculated as a flat percentage of committed capital during the investment period, stepping down to a (in many cases reduced) percentage of drawn-down or invested capital after the end of the investment period or on the raising of a successor fund. Investors are very sensitive regarding the scale of management fees and their impact on returns, and thus there has been some downward pressure and heightened scrutiny by investors, albeit with relatively limited success to date.
Investment strategy and limitations
The offering will specify the appropriate investment strategy to be followed by the fund and relevant limitations providing, for example, limits in relation to maximum exposure to any one investment sector, jurisdiction or industry limitations, as applicable. The investment strategy and limitations are an essential part of any fundraising, and investors are focused on ensuring that they understand any risks and to ensure that there is no 'strategy drift'. The growth in importance of certain sovereign wealth funds, state-aided funds or political agencies has resulted in a number of pools of capital (e.g., EU regional aid) that are solely focused on a single jurisdiction or that are prohibited from investing in certain regions, and thus a number of exclusions to the investment policy may be negotiated, or 'sidecar' vehicles with a restricted investment mandate for investing alongside the main fund created, to cater for these specific investors.
In most cases, all transaction fees, break-up fees, directors' fees or monitoring fees would be set off against the management fee so that the investors would receive some or all the benefit thereof, and investors have been pushing strongly, and often successfully, for a full set-off in their favour.15 These types of fees, and critically the full and accurate disclosure of such fees to investors, are also under increasing regulatory scrutiny, notably by the US Securities and Exchange Commission (SEC), which is affecting some major sponsors' readiness to charge such fees, and hence affecting the market position more generally.
There is a general lack of movement with the preferred return, notwithstanding the current low-interest-rate economic environment, and it remains relatively constant in buyout funds, at 8 per cent per annum. Although some funds, most notably some of the largest private managers, have created more bespoke arrangements, they are still very much in the minority, and generally investors prefer less creativity in the structuring of the preferred return mechanism.
Carried interest or distribution mechanism
The standard carried interest payable to the manager, its executives, or both, in private equity funds is 20 per cent of the fund profits. There are two main methodologies for calculating the carried interest – the 'fund-as-a-whole' mechanism and the 'deal-by-deal' mechanism. The former method is most common in Europe, while the latter is most common (although its popularity is dwindling) in the United States. The fund-as-a-whole model is the main European model and is deemed to be investor-friendly in comparison with the deal-by-deal method; and although some high-demand European sponsors are moving towards the US model, most investor negotiations are based around mitigating the risk of any overpayment of carried interest (see below). Premium carry (where a manager is rewarded with an increased carry percentage above certain performance thresholds) or a movement (in whole or in part) to a deal-by-deal as opposed to a fund-as-a-whole waterfall is a signature of some of the best performing funds; however, neither mechanism is commonplace across the industry as yet.
Escrow or carried interest clawback
These provisions can be rather bespoke, as a number of facts and circumstances are relevant – for example, the distribution mechanism of the fund (see above), the creditworthiness of the carry recipients and the likelihood, in light of the investment strategy, of losses post receipt of carry. The fund-as-a-whole distribution model provides that the carried interest is payable only after investors receive an amount equal to the aggregate drawn capital and the preferred return thereon, thereby reducing the risk of any carry overpayment. As such, in Europe, despite the efforts of certain larger LPs, European managers are increasingly relying on clawback mechanisms rather than escrow accounts, which are more commonplace for funds with deal-by-deal waterfalls, as carry can be paid ahead of investors' total aggregate drawn capital being returned to investors. Whether one or the other is used is often in response to the nature of the investors' likely return or drawdown profile and the executives' attitude to risk (i.e., whether they prefer an escrow or subjecting themselves to a later clawback risk).
The ability for a fund to redraw prior distributions is of great importance to the manager to ensure that the fund manager has access to the full amount of investor commitments for the purpose of making investments, including amounts that may have originally been drawn down for management fees or other expenses, bridging investments, etc. The limited partnership agreement will typically set out the type of distributions that can be redrawn and for how long. Certain investors, such as funds of funds, may be unable to redraw from their own investors and thus push back strongly in this regard.
This regulates what other funds the manager can raise, and when. This provision comes under discussion as management houses contemplate setting up bespoke side funds or managed accounts, or when the manager attempts to diversify into a multi-product asset management platform.
These set out the suite of remedies in relation to investors who default on drawdowns. In light of experiences since the most recent global financial crisis, and threatened and actual defaults, these provisions have become more extensive in scope. The increased protection for sponsors, and subsequent investor scrutiny of the knock-on effects to the fund in the event of an investor default, include provisions around management fee coverage and assignment of defaulting investors' interests in the fund.
Key-man or suspension-of-investment-period provisions
These provisions have received a lot of investor attention over the past few years. They protect the investors from a 'key-man event' (i.e., if one or more of the key management personnel ceases to be involved in the management of the relevant fund). As expected, the trigger event is heavily negotiated and specific to each fund and sponsor, and thus much time and attention is given to this particular provision in fund documentation. This term is often linked with the exclusivity provisions, as the ability for a team to perform different functions for different funds is often curtailed.
Removal of the GP on a fault or no-fault basis
These provisions, alongside the key-man provisions, are governance provisions, which have been developing in fund documentation. The relevant voting thresholds and the implications for management fees and carried interest in the event of the removal of the GP are often fiercely negotiated as investors seek to ensure that they are sufficiently protected from a manager that has lost its way.
The most-favoured nation provision entitles other investors to benefit from rights given by side letter or otherwise to other investors. Managers seek to limit applicability by size of commitment, legal status, timing of admission, etc., to both prevent against an ever-increasing administrative burden, but also to ring-fence the terms offered to larger, cornerstone or 'first-mover' investors.
Other negotiable terms
The high level of competition for investors' capital and the enhanced due diligence referred to above has resulted in increased investor attention and negotiation on a number of key terms (most mentioned above). The main themes behind investors' negotiations have been increased alignment of interest, governance and transparency – indeed, these are the three guiding principles enunciated in the Institutional Limited Partners Association (ILPA) Private Equity Principles Version 2.0 published in January 201116 – and while they, in their own words, 'should not be applied as a checklist, as each partnership should be considered separately and holistically', they are revealing as to the concerns of the investor community and serve as a useful basis for discussions on terms. ILPA is increasingly influential as its members also press sponsors to report in accordance with its standard format. Another theme in this market that is having an impact on terms is that of incentives for first closers or large investors. This is often given in the form of a reduced management fee or other economic incentive, although other incentives can be utilised, such as preferred access to co-investments alongside the fund or other enhanced rights. This is increasingly becoming a permanent feature for fundraisings in this market, and a number of funds currently in the market are reported to be offering such incentives.17
ii Key items for disclosure
The legislative backdrop set out in the UK Financial Services Act 2012 (FSA) makes it a criminal offence for any person knowingly or recklessly to make a statement, promise or forecast that he or she knows to be misleading, false or deceptive; or dishonestly to conceal any material facts, if he or she does so for the purpose of inducing, or is reckless as to whether it may induce, another person to engage in investment activity.18
Furthermore, a misrepresentation can occur under English law when an untrue statement of fact or law is made that induces the other party to enter into a contract and suffer a loss. An action for misrepresentation can be brought in respect of a misrepresentation of fact or law. There are three types of misrepresentation: fraudulent misrepresentation, negligent misrepresentation and innocent misrepresentation. If a party is found to have made a misrepresentation that induced another party into entering in a contract, there are various remedies that may be awarded by the courts depending on which type of misrepresentation has been found to have occurred. Generally, the remedies for misrepresentation are rescission or damages according to the form of misrepresentation.
In addition, it is usual for a UK-domiciled manager to be authorised by the UK financial services regulator, the Financial Conduct Authority (FCA). It would also have to comply with the FCA's rules, including the wide-ranging Principles for Business, which include obligations to pay due regard to the information needs of clients and to communicate information to them in a clear, fair and non-misleading manner, and with legislation and rules implementing the AIFMD that prescribe certain information disclosure requirements.
US securities laws and other legislation relating to disclosure and fiduciary duties, while outside the ambit of this chapter, would also be pertinent, as most UK offerings would be extended to US investors, and thus misstatements, omissions or other misleading content may lead to SEC enforcement, federal or state action or civil action. European jurisdictions typically also impose similar 'anti-fraud' requirements.
As such, it is important that the manager performs a verification exercise to ensure that the investor has subscribed on the basis of the best available facts; the manager thereby minimises the risk of damages claims, recession claims or regulatory sanctions should the fund fail to perform as anticipated. As part of this, the manager will review the offering documents and other related promotions to ensure that all facts and circumstances that will be relevant to a potential investor have been adequately disclosed without material omissions, that all statements of fact are accurate, that statements of opinion are reasonable and are honestly held by those to whom they are attributed, and that all inferences that can be drawn from any of those statements are themselves accurate.
As a matter of best practice, this verification process should be performed by the sponsor before issuance of any promotional documents.
The main key items for disclosure to investors are usually set out in the final form offering memorandum, which would typically set out:
- the investment highlights, providing a detailed discussion of the investment strategy for the fund and the process by which investments will be made;
- the track record of the manager or of the relevant executives comprising the management team;
- the curriculum vitae and relevant experience of the key executives;
- a market overview, to provide investors with a macro view of the investment therein;
- the summary of key terms (see above);
- legal and tax matters, describing various regulatory and tax considerations in making an investment in the fund;
- risk factors, to make the investors aware of the risks inherent in an investment in the fund; and
- a summary of selected investments from the track record of the manager, thereby providing the investors with further data and other experience at a granular level.
The most common method of solicitation is by way of an offering memorandum, although this document evolves through a number of stages. It is first conceived as a 'teaser' pitchbook, which is distributed to potential investors to solicit their initial interest or as a follow up to preliminary meetings or due diligence. This is then developed into a draft offering memorandum, which is usually circulated to potential investors and is the main promotional document used for the 'soft-circling' or 'hard-circling' process before concluding discussions and circulating a final form offering memorandum to investors before the fund's first closing. This process would also take into account the relevant AIFMD marketing strategy of the firm (see Section III).
In parallel to this process, it is common for the manager to establish a data site (usually electronic) containing further information on the manager, track record, executives, legal documentation and structure of the offering. Certain investors also tend to issue their own document and information requests in the form of a due diligence questionnaire (DDQ), which the manager must complete and return. Indeed, so common has the DDQ approach become that some managers now pre-complete a 'standard' DDQ for inclusion in the data site so as to expedite the due diligence process. The same considerations as to the accuracy of information provided in the offering memorandum apply to the information provided in the data site or DDQ responses.
Any changes to the terms or other relevant parts of the offering (e.g., track record or revised valuations) that arise as the fundraising progresses are typically communicated to investors by way of an addendum to the offering memorandum.
The manager may also appoint a placement agent who would assist in the preparation of the suite of offering documents and in identifying and soliciting potential investors.
Throughout this process the manager and the placement agent, if applicable, must ensure that they comply with the AIFMD and the relevant marketing regulations of the pertinent jurisdiction of the investor (including the UK), make any required filings and disclosures, and obtain any required authorisation. While not the subject of this chapter, it should be noted that this body of law has been developing and is becoming more extensive (including with various lobbyist and 'pay-to-play' restrictions in the United States), and sophisticated placement agents or managers will now generally seek access (through their legal or marketing advisers) to regularly updated global surveys of the marketing or pre-filing and registration rules of each jurisdiction to ensure that the offering complies with local laws and regulations.
iii REGULATORY DEVELOPMENTS
i Regulatory developments
Overview of the AIFMD
The AIFMD is the principal legislation constituting the regulatory framework applicable to the marketing and management of private equity funds in the UK and the European Union. The AIFMD broadly applies to managers under the following two circumstances: non-EU managers that intend to market a fund to investors in the EU; and EU onshore managers that intend to either market a fund to investors in the EU or manage a fund in the EU.
At present, non-EU managers may continue to rely on existing private placement regimes in individual EU Member States19 to market fund interests to institutional investors, subject to complying with certain minimum requirements under the AIFMD.20 These provisions are a subset of the compliance obligations applicable to fully authorised EU managers, and include:
- prescriptive requirements detailing the information to be disclosed to investors prior to investment and on an ongoing basis;
- a requirement to produce an annual fund report with certain prescribed content;
- regulatory reporting requirements; and
- certain portfolio company transparency, disclosure and 'anti-asset stripping' provisions aimed at preventing private equity firms from making distributions from portfolio companies acquired by the fund other than out of profits.
For those EU jurisdictions that permit non-EU managers to actively raise capital under existing national private placement regimes, there is typically a requirement to register the fund in the respective jurisdiction ahead of any marketing. The level of detail involved in completing marketing registrations varies by jurisdiction, from straightforward notifications (after which a non-EU manager can commence marketing) to rigorous applications for marketing approval requiring extensive supporting documentation. Processing times are similarly varied, with some regulators permitting non-EU managers to market a fund immediately on the submission of a marketing notification, and others taking potentially three months to vet and approve applications for marketing approval.
The UK has chosen to adopt a relatively straightforward registration procedure under its national private placement regime. Non-EU managers may commence marketing a fund once a short marketing notification is completed and filed with the UK regulator, the FCA. In carrying on any marketing activities in the UK, firms are required to continue complying with the UK's pre-AIFMD national marketing rules, the financial promotions regime. Therefore, firms continue to target only those investors (such as regulated firms and high-net-worth entities) that fall within one or more exemptions to the financial promotion restrictions under UK law.
The AIFMD gives EU Member States the discretion to impose stricter requirements on non-EU managers in addition to the minimum requirements set out above. These stricter 'gold-plated' requirements may flow from other provisions of the AIFMD (otherwise not applicable to non-EU managers). For instance, non-EU managers intending to market a fund in Denmark or Germany are required to appoint a depositary for that fund, an obligation that otherwise applies only to fully authorised onshore managers (see below). The UK has chosen not to apply any gold-plated requirements to non-EU managers.
As a consequence of these registration requirements, a non-EU manager must consider, for each fund that it proposes to raise in the EU, the point in time at which it will have to register the fund for marketing with a local regulator. This in turn will depend on how local regulators interpret the term 'marketing' under the AIFMD.21 In the UK, for instance, the FCA has taken the view that certain 'soft marketing' activities, such as the circulation of a promotional presentation on the fund or a draft private placement memorandum to UK investors, do not constitute marketing for AIFMD purposes. Consequently, firms may carry on such activities in the UK ahead of registering the fund with the FCA (on complying with the UK financial promotion regime). Regulators in EU Member States may adopt a different interpretation of marketing (and some do), potentially leaving a non-EU manager with a narrower range of permissible soft-marketing activities that can be undertaken in those jurisdictions before registration. To the extent permitted by a local regulator, soft marketing enables a non-EU manager to gauge whether there is sufficient investor interest in a particular jurisdiction to justify the initial registration and ongoing AIFMD compliance costs for marketing a fund in that jurisdiction.
The preamble text to the AIFMD clarifies that the requirements under the AIFMD are not intended to apply to situations where an EU investor invests in a fund of its own initiative. This 'reverse solicitation' carve-out is (depending on facts and circumstances) being relied on by non-EU managers who receive indications of interest and requests for additional information from investors in an EU jurisdiction who have not otherwise been solicited by the manager.
The concepts of 'soft marketing' and 'reverse solicitation' under the AIFMD will be revised as a part of the implementation of the forthcoming Omnibus Legislation, as further discussed below.
EU onshore managers whose assets under management exceed certain thresholds (see below) are subject to the AIFMD's full requirements. These requirements include applying for and obtaining permission to manage alternative investment funds from local regulators, and thereafter complying with a wide range of ongoing requirements on matters such as regulatory capital, internal governance, systems and controls, remuneration and, significantly, the appointment of a depositary to perform cash monitoring, safe custody, asset verification and oversight functions in relation to managed funds. In addition, the minimum disclosure and transparency obligations discussed above that apply to non-EU managers also apply to onshore managers. Onshore managers receive an important trade-off for complying with these onerous obligations, in that they benefit from an EU-wide 'passport' under the AIFMD that they can use to market EU funds to EU investors or manage funds across the EU, or both, without registering with local regulators. Despite the passport's intention of giving onshore managers the freedom to market or manage EU funds without complying with local requirements, some national regulators have placed additional requirements on onshore firms using a marketing passport, which currently include appointing a local agent or paying a passporting fee, or both.
Onshore managers that are authorised under the AIFMD are currently not entitled to use a passport to market a non-EU fund in the EU. Rather, onshore managers of such funds are placed on the same footing as non-EU managers in being required to register a non-EU fund for marketing in a particular jurisdiction under national private placement rules.
Onshore managers whose aggregate assets under management fall below the AIFMD's authorisation threshold22 are not required to be authorised under the AIFMD and are only subject to a limited number of requirements under the AIFMD. They are not entitled to benefit from the marketing or management passport under the AIFMD.
Packaged retail and insurance-based investment products
The requirements under EU Regulation No. 1286/2014 on key information documents for packaged retail and insurance-based investment products (the PRIIPS Regulation) became applicable on 1 January 2018. The PRIIPS Regulation requires firms to produce a key information document (KID) if they 'make available' a packaged retail and insurance-based investment product (PRIIP) to retail investors in the EU. The KID is meant to set out the risks, costs and expected returns of the underlying product in a standardised format, and is intended to help retail investors compare products. The rules have extraterritorial application, so they apply to both EU and non-EU managers that make PRIIPs available to retail investors in the EU.
The definition of a PRIIP is extremely wide and covers investment funds and related investment pooling vehicles. The rules do not contain specific carve-outs for carried interest and co-investment vehicles, which managers might choose to make available to retail investors such as 'friends and family'-type investors and EU-based executives within their own organisations. Managers continue to review the application of the rules to these structures on a case-by-case basis.
These requirements will not be applicable to firms who market funds exclusively to large institutional investors in the EU, since such investors are likely to be treated as professional rather than retail investors. The rules state that retail investors may elect to be treated as professional investors in relation to a particular investment fund or type of investment fund, and they permit mangers to treat such investors as elective professional investors (therefore not requiring managers to produce a KID in respect of such investors) subject to following a mandatory assessment and 'opt-up' procedure. In particular, this procedure requires managers to undertake adequate assessments of: (1) the expertise, experience and knowledge of the retail investor, to ensure that the investor is capable of making its own investment decisions and understanding the risks involved; and (2) the retail investor's recent investment activity, financial instrument portfolio and professional background, to ensure that these meet certain minimum prescribed criteria. In addition, the manager is required to make written disclosures regarding the protections that the retail investor might lose as a result of being treated as an elective professional investor.
Finally, following the implementation of the revised Markets in Financial Instruments Directive (MiFID) in the EU on 3 January 2018, local authorities in the EU (including UK local government pension schemes and their administrators) are treated as retail investors by default, and managers seeking to market investment funds to such investors without producing a KID would have to follow a different opt-up procedure to treat them as elective professional clients. The opt-up procedures for local authority investors may differ by EU jurisdiction, and managers should check the requirements on a case-by-case basis.
Extension of the AIFMD passport
According to the AIFMD, the European Securities and Markets Authority (ESMA) may recommend that the benefit of the AIFMD marketing passport be extended to non-EU managers who choose to register with an appropriate EU regulator (their 'Member State of reference') and comply with the AIFMD in full. Pursuant to the AIFMD, the EU lawmakers take the necessary legislative steps to extend the passport on a voluntary basis to non-EU managers within three months of receiving a 'positive' opinion from ESMA. After this time, non-EU managers choosing not to become fully authorised and compliant with the AIFMD may continue to market funds to EU investors on complying with local national private placement registration requirements, as well as the minimum requirements under the AIFMD applicable to them.
Under the AIFMD, this voluntary regime was initially expected to come to an end in late 2018 or early 2019, when it was anticipated that all national private placement regimes in the EU would be terminated and all non-EU managers would be required to become fully authorised under and compliant with the AIFMD.
ESMA has taken certain preliminary steps in publishing advice and opinions on the extension of the AIFMD passport to firms and funds in various non-EU jurisdictions on two separate occasions. On 30 July 2015, it concluded that Jersey, Guernsey and Switzerland presented no significant obstacles to the extension of the AIFMD passport. On 19 July 2016, ESMA issued positive advice with respect to the extension of the passport to Canada, Guernsey, Hong Kong, Japan, Jersey, Singapore and Switzerland and caveated opinions with respect to Australia and the United States.
The Commission, Parliament and the Council have been considering ESMA's advice and are yet to issue any formal communication on when they will take the necessary legislative steps to implement it. At the time of writing, the general view among industry participants is that these steps are not likely to be taken in the near future.
Proposals to amend the AIFMD
On 1 August 2019, the cross-border directive on distribution of collective investment undertakings and a related regulation came into force across the EU. Both pieces of legislation (together the Omnibus Legislation) will start to apply following a period of two years (i.e., from 2 August 2021), and will amend (among other matters) certain provisions under the AIFMD relating to the cross-border distribution of investment funds. The key changes under the Omnibus Legislation include:
- permitting authorised EU managers to undertake certain defined 'pre-marketing' activities, with a view to testing investors' interest in an investment fund, prior to obtaining a marketing passport for that fund. An AIFMD marketing passport will not be required where no subscription documents (including in draft form) are distributed, and no final form constitutional or offering documents are distributed to investors;
- EU managers will be required to notify their home state regulator within two weeks of commencing pre-marketing in any EU Member State;
- a formal limitation on managers' ability to rely on reverse solicitation, where a subscription within 18 months of the commencement of any pre-marketing activity will be deemed to have resulted from active marketing, triggering the passporting requirement under the AIFMD;
- allowing for the discontinuation of marketing and the removal of funds from EU regulators' registers (subject to certain conditions being met, including conditions relating to investor participation levels); and
- requiring EU managers seeking to appoint a third party to carry out pre-marketing on their behalf to ensure that such third party is a MIFID investment firm (or a tied agent of a MIFID investment firm, a Capital Requirements Directive IV credit institution, an undertaking for collective investment in transferable securities management company or another EU alternative investment fund manager).
As drafted, the requirements under the Omnibus Legislation do not appear to apply to non-EU managers marketing under the national private placement regimes of EU Member States. However, the legislation expressly prohibits EU Member States from adopting laws and regulations that are more advantageous for non-EU managers, and as such, there is a concern that EU Member States may seek to impose similar requirements on non-EU managers.
Article 69 of the AIFMD requires the European Commission to review the functioning of the AIFMD; in particular, its impact on investors within the EU and in third countries, and the degree to which its objectives have been met. In 2019, KPMG conducted a general survey addressed to the stakeholders that are most affected by the AIFMD and produced a report with its findings. The report is lengthy and provides an indication of the topics that are likely to be considered by the European Commission in its review. These include a lack of harmonisation in implementing the rules across EU Member States, non-effective reporting requirements, inconsistent leverage calculation methodologies, onerous requirements in respect of investments in non-listed companies and divergent approaches across Member States in implementing the AIFMD marketing passport. The European Commission will continue its review of the AIFMD, taking into consideration the report's information and conclusions alongside other sources of data and further analysis. More information will be available in 2020 when the European Commission issues its reports to the European Council and the European Parliament.
On 23 June 2016, the UK electorate voted for the United Kingdom to leave the European Union and, consequently, on 29 March 2017, the UK government invoked Article 50 of the Treaty of the European Union, commencing the two-year period for negotiating the terms of the UK's withdrawal from the EU (Brexit). The European Union and UK government mutually agreed to extend the date of the UK's withdrawal twice. After a number of iterations, the European Commission and the UK's negotiators reached a provisional agreement on the terms of the United Kingdom's withdrawal from the EU in October 2019. The UK formally left the EU on 31 January 2020 at 11pm, after which the UK entered the transition period specified in the withdrawal agreement, which is scheduled to end on 31 December 2020.
On the expiry of the transitional period, UK-based financial services firms will cease to benefit from passporting rights under EU legislation, including the marketing and management passporting rights currently available to UK managers authorised under the AIFMD. Should UK fund managers lose passporting rights under the AIFMD, they would be treated post-Brexit (in the absence of any bespoke arrangements) as a third country and be subject to the same fundraising regime currently applicable to non-EU managers. In these circumstances, to fundraise in the EU, UK managers would have to comply with the initial registration and ongoing AIFMD obligations required under the national private placement regimes of individual EU Member States (as set out above).
In the UK, the FCA has made provision for a 'temporary permissions regime' so that EU firms and investment funds have a backstop to enable them to continue their business in the UK with minimal disruption on the UK's departure from the EU and the expiry of the transitional period. The regime will permit EU-based managers who have been relying on a passport to market funds in the UK to continue temporarily marketing in the UK for a period of three years, subject to having complied with certain notification requirements. The notification window for this temporary permissions regime was extended following the delay to the UK's withdrawal process and closed at the end of 30 January 2020.
For non-EU managers, it is unlikely that Brexit will prompt fundamental changes to the manner in which funds are currently marketed in the UK or elsewhere in the EU, and such managers are expected to continue to comply with the registration requirements under the UK's national private placement regime. However, once the EU lawmakers take the necessary steps to extend the AIFMD passport to non-EU managers, the UK will no longer be available as a Member State of reference for non-EU managers who opt to take advantage of the passport's extension.
ii Tax developments
One of the main fund structuring objectives is to ensure that the investors in the fund suffer no additional taxes as a result of investing through the fund rather than investing directly in the underlying assets. For this reason, private equity funds in the UK are typically established as limited partnerships so that they are viewed as transparent for most UK tax purposes and do not fall into tax and generate tax leakage at the fund entity level.
On the basis that the fund is treated as tax transparent, the characterisation of the receipts of the fund as income (e.g., interest or dividends) or capital (e.g., sale proceeds) should be preserved for UK-resident investors (and some other categories of investors – although this is jurisdiction-specific and on a case-by-case basis). While this means that withholding tax issues can arise without appropriate planning, it historically enabled investors to secure capital treatment for any carried interest. With a current difference in rates of up to 45 per cent (for income) against up to 28 per cent (for capital), securing such capital treatment is an important objective for most UK-resident carried interest holders. For those carried interest holders who are UK-resident but domiciled outside the UK, there is also the possibility to defer or keep the proceeds outside the purview of the UK tax regime with appropriate structuring (known as the 'remittance basis' of taxation), although this planning has been somewhat eroded in recent years (see further below).
However, there are several different regimes in the UK that can treat at least part of a carried interest return as income rather than capital. These relate to: (1) disguised investment management fees (DIMF); (2) income-based carried interest (IBCI); and (3) employment-related securities (ERS).
The DIMF rules took effect from 6 April 2015 and, very broadly, are designed to ensure that individuals involved in the management of certain investment schemes are taxed on the receipt of management fees from investment funds as either trading income or employment income (in both cases, at rates currently of up to 47 per cent). The rules seek to address structures that would otherwise result in a portion of any management fees being taxed as investment returns in the hands of the individuals (often at capital gains tax rates or lower).
The IBCI rules took effect from 6 April 2016 and, if applicable, tax carried interest as DIMF trading income (as above) if it constitutes IBCI (as opposed to capital gains). In summary, the extent to which carried interest is IBCI depends on the average holding period of the underlying investments of the scheme that gives rise to the carried interest. There is currently an exclusion from the IBCI rules for carried interest that constitutes an employment-related security (see below).
The ERS rules (which, unlike the more recent DIMF and IBCI regimes, have existed since 2003) may bring profits on certain 'securities' into charge as employment-related earnings (and taxed at current rates of up to 47 per cent). Securities for these purposes include units in a collective investment scheme, which, under the ERS rules, include partnership interests in a carried interest partnership. Employment includes any former employment as an 'office-holder' (which extends to directors). In addition, 'salaried members' are also treated as employees for these purposes. However, the ERS rules may not be relevant to partners in a partnership (other than salaried members in a UK limited liability partnership – as above – or partners who are also directors of companies within the fund structure or fund portfolio companies).
In addition to the DIMF and IBCI rules described above, further changes were made in 2015 to the way UK capital gains tax rules are applied to carried interest. From 8 July 2015, 'base cost shift' was abolished and a new minimum level of taxation imposed on carried interest. These changes were designed to ensure carried interest holders are taxed on their true economic gain – whereas historically base cost shift would have given certain carried interest holders deductions in excess of the sums actually given by them as consideration for the acquisition of the right to that carried interest. The effect of the rules is that all carried interest arising on or after 8 July 2015 is subject to a minimum level of taxation of 28 per cent. The rules do not, however, displace pre-existing income tax rules, so when carried interest comprises income amounts (e.g., interest, dividends), income tax is due (at rates of up to 45 per cent) as well as capital gains tax. Relief may be claimed to prevent double taxation, but particular care has to be taken with regard to UK-resident carry holders who are also US taxpayers to ensure double taxation between the UK and the United States does not arise. Consequently, it remains critical to ensure that, on first principles, carried interest retains the character of underlying returns in the form of capital gains, and that underlying capital returns are not reclassified as income.
It should also be noted that the UK capital gains tax rate was reduced from 28 per cent to 20 per cent with effect from 6 April 2016, but this reduction does not apply to carried interest, which continues to be taxed at the 28 per cent rate.
From 6 April 2017, individuals who have been resident in the UK for 15 out of the past 20 years are deemed domiciled in the UK for all tax purposes, with the effect that the remittance basis of taxation referred to above is no longer available. Further, if an individual has a domicile of origin in the UK and subsequently leaves the UK, shedding that domicile (acquiring a domicile of choice somewhere else), the UK domicile of origin will resurrect itself on the individual returning to the UK and becoming UK-resident.
On the UK real estate side, new rules came into force in April 2019 bringing non-UK residents into the charge to UK capital gains tax on the disposal (both direct and indirect) of UK commercial real estate, which represents a significant change for funds (and their investors) investing in UK real estate.
More generally, the impact of the Organisation for Economic Co-operation and Development (OECD) base erosion and profit shifting (BEPS) project, and of the EU anti-abuse directives, ATAD I and ATAD II, is starting to be seen across many jurisdictions, particularly in the response to the BEPS treaty-abuse and anti-hybrid measures, in response to which the UK implemented detailed and far-reaching anti-hybrid rules with effect from 1 January 2017. Likewise, the Danish cases on the interpretation of beneficial ownership and abuse of rights have made a significant impact, from a withholding tax perspective, on most international fund structures and the flow of funds from EU subsidiaries ultimately to fund investors.23
Looking forward, there continues to be a number of developments and challenges. Perhaps most notably the latest OECD 'BEPS 2.0'24 initiative should not be underestimated, with the potential to change the global tax landscape significantly by altering how profits are allocated between jurisdictions (Pillar 1) and introducing a new globally coordinated regime for minimum tax and anti-base erosion measures (Pillar 2). The EU mandatory disclosure regime, which entered into effect on 25 June 2018, adds to compliance burdens and, while first reporting does not begin until August 2020, the disclosure obligations capture arrangements from 25 June 2018 (where conditions for disclosure are met). As a result, procedures for information gathering and reporting should be put in place by affected parties now. Brexit, BEPS 2.0 progress and EU Member States' implementation of the ATADs, therefore, are key items to watch carefully as we progress through the year ahead.
Top-performing managers remain very well positioned for the foreseeable future. Investors have significant liquidity with more on the immediate horizon as legacy funds continue to make healthy distributions and the almost universally high asset prices seen in the market will, in the short term, further exaggerate this state of affairs. There continue to be a substantial number of challenged fundraisings, and those managers unable to sufficiently differentiate themselves by strategy, track record or unique selling point, or indeed those who display outperformance of the market, may have to adopt alternative strategies such as deal-by-deal financings, single investor mandates (including managed accounts) or bespoke or particularly investor-friendly economic terms, rather than simply benefit from rising asset prices. While a number of first-time fund sponsors have been successful, the bar for entry is set high.
The market for managers selling stakes in themselves to third parties has been on the rise for some time, and is now no longer a minority activity, but a part of the mainstream private equity industry. Investor sentiment remains mixed, however, with 45 per cent of investors believing that managers that sell stakes in themselves to third parties make them a less attractive investment partner, while 12 per cent see such activity as a positive.25 Investors remain vigilant on ensuring alignment of interests between manager and investors, focusing on issues surrounding the control and governance of the broader business (in particular, investment strategy) as well as the use and source of management fee revenue and sponsor commitment.
Secondaries, fund restructurings and recapitalisations are now further entrenched in the industry as an established, adaptable and opportunistic firm or portfolio management tool. The liquidity opportunities available and explored by investor and manager alike continue to offer enhanced flexibility to all involved. Managers are also increasingly seeking to delay exits of some of their top-performing assets, 'the GP-led secondaries market, perhaps the largest beneficiary of extended holding times, has seen explosive growth over the past decade and is the fastest-growing sector in the secondaries space'.26
The outlook for private equity fundraising in 2020 is, in the main, positive. This is driven by the large number of firms either planning to raise a fund or actively market one. The industry is increasingly driven by the larger managers' timing, and target fund sizes. Several large European and many similar-sized North American managers can be expected to raise funds in 2020. Although investor appetite for smaller funds still exists – Private Equity International reports 50 per cent of investors will consider first-time managers opportunistically, but just 8 per cent have a defined pool of capital to allocate to such managers – and track record above all else remains the key motivator for investor commitments, concerns regarding a market correction and the ability of smaller managers to remain competitive in an environment of seemingly ever-increasing asset prices, mean that the bifurcation of the fundraising market between smaller and larger managers remains prominent.
1 Jeremy Leggate, Prem Mohan and Ian Ferreira are partners at Kirkland & Ellis International LLP.
2 Private Equity International's Annual Fundraising Report 2019.
5 Private Equity International's Annual Fundraising Report 2019.
6 'Private equity fundraising reaches post-crisis high', Private Equity International, 13 January 2020.
8 Private Equity International's Annual Fundraising Report 2019.
9 'Private equity fundraising expected to fall in 2020', Financial News, 19 December 2019.
11 'Private equity races to spend record $2.5tn cash pile', Financial Times, 27 June 2019.
12 Structures aimed at the retail market, such as venture capital trusts, are not considered here.
13 Institutional Limited Partners Association Principles Version 2.0, 'General Partner Commitment' states that 'the GP should have a substantial equity interest in the fund and that it should be contributed in cash as opposed to being contributed through various management fees'.
15 ILPA 2.0, 'General Partner Fee Income offsets'.
18 Section 89 of the FSA.
19 Some jurisdictions (notably Austria, France and Italy) have chosen either to terminate existing private placement regimes following the implementation of the AIFMD or to impose highly onerous compliance requirements that result in effectively precluding a non-EU manager from marketing a fund using private placement.
20 The private placement regimes in Member States were initially expected to be closed in late 2018 or early 2019. However (as explained later in this section), the timetable for these events will now depend on when (if at all) the EU lawmakers complete the necessary steps to extend the passport on a voluntary basis to non-EU managers.
21 The AIFMD defines marketing as a direct or indirect offering or placement, at the initiative of the manager or on behalf of the manager, of units or shares of an alternative investment fund it manages, to or with investors domiciled or with a registered office in the European Economic Area.
22 Broadly, aggregate assets under management exceeding €500 million for unleveraged funds that do not have redemption rights exercisable during a period of five years from the initial investment in the fund; or €100 million for leveraged funds.
23 T Denmark and Y Denmark v. the Danish Ministry of Taxation (joined Cases C-116/16 and C-117/16) and N Luxembourg 1, X Denmark A/S, C Danmark I and Z Denmark ApS v. the Danish Ministry of Taxation (joined Cases C-115/16, C-118/16, C-119/16 and C-299/16)).
24 Base Erosion and Profit Shifting Project – 'Programme of Work to Develop a Consensus Solution to the Tax Challenges Arising from the Digitalisation of the Economy' (May 2019) and 'Statement by the OECD/G20 Inclusive Framework on BEPS on the Two-Pillar Approach to Address the Tax Challenges Arising from the Digitalisation of the Economy' (January 2020).
25 'Red lines in the LP-GP relationship', Private Equity International, 29 November 2019.
26 'Private equity fundraising expected to fall in 2020', Financial News, 19 December 2019.