Where to set up a private equity fund
An overview of a number of factors to consider when evaluating and determining the legal domicile of a private equity fund, as well as regulatory, structuring and tax matters related to private equity funds across various International Financial Centers
Private equity funds are collective investment vehicles investing in securities such as equity (e.g. ordinary shares, preferred shares), debt instruments (e.g. notes, bonds) and hybrid instruments (e.g. hybrid bonds and other subordinated debt) from privately-held companies that are not publicly traded (or that will cease to be publicly traded after acquisition).
Such collective investment schemes can generally be divided into two broad categories: venture capital funds, and (leveraged) buyout funds.
Venture capital funds tend to invest in equity of early-stage start-ups with high growth potential and thus potentially large returns (but also losses), but which have limited access to sources of capital. Conversely, buyout funds tend to invest in more mature and established private companies.
Generally, venture capital funds’ return strategy is appreciation of capital invested, aiming at a potential liquidity event such as an IPO where investees are listed in public markets, or in a potential buyout by a private equity firm.
Although buyout funds’ investment strategies also focus on capital appreciation and potential capital gains upon potential partial or full exit or disposal in a buyout or listing in public markets, their investment strategies may also be oriented towards the generation of investment income in the form of dividends or interest over time.
Both venture funds and buyout funds are generally involved in the management of the investees by holding positions on the boards of such companies.
Due to their long-term investment strategies, private equity funds are generally structured as closed-ended funds where redemptions of fund interests by investors are not available.
Typically, due to the risk associated with the illiquidity of their investments – private equity funds are not aimed at retail investors, but rather at professional and institutional investors such as other collective investment schemes, as well as family offices, corporate investors and financial institutions.
Fund managers and operators generally domicile their private equity funds in large financial centers, which provide the appropriate legal and tax environment as well as financial services infrastructure for these vehicles to operate. Such large financial centers generally include the USA, Luxembourg, Cayman Islands, the Channel Islands, and to a lesser extent Hong Kong, Bermuda, BVI, Ireland or the Netherlands, among many others.
In this article, we have reviewed certain key aspects that may be taken into account when evaluating the suitability of a structure or jurisdiction for a specific private equity fund, as well as a summary of the main regulatory and structuring aspects related to establishing and operating private equity funds in the USA, Luxembourg, Cayman Islands and Jersey. Structures and regulatory matters related to establishing fund managers are out of the scope of the article.
The article does not intend to be comprehensive and does not intend to cover in-depth all the multiple factors that may be weighed in when establishing a private equity fund. The article is just a high-level summary of certain aspects that may be taken into consideration. It is not legal advice or tax advice of any kind, and it is just for informational purposes. Therefore, its contents should not be relied upon.
What to consider when setting up a private equity fund
The following are some relevant aspects that a fund manager or fund operator may consider when evaluating jurisdictions for domiciling a private equity fund. Each fund manager or operator may prioritize one or others depending on the specific circumstances of the private equity fund.
Tax Neutrality and Structuring
A collective investment scheme is a financial intermediary whereby investors invest money in exchange of interest in such vehicle, and expect to receive a return derived from the investments made by the fund that are managed by the fund manager. Furthermore, fund managers and operators have the mandate to maximize profits arising from investors’ monies.
Therefore, tax neutrality is one of the most relevant factors that must be taken into consideration when structuring a private equity fund.
Investors will not generally accept or desire an additional layer of taxation (additional tax due to investing via a fund structure instead of directly investing in the “portfolio” company) and therefore fund managers and operators will need to ensure that investing through their private equity fund will not lead to double taxation – in the source country of income where the investee is tax resident (e.g. income tax on company profits and withholding tax on dividends distributed), and in the jurisdiction of tax residency of the fund (e.g. income tax on investment income or capital gains tax on the disposal of interests).
Given that a private equity fund may invest in companies located in various countries, double taxation is likely to occur if the same is not properly addressed.
Aware of the potential issues arising from double taxation, jurisdictions with financial centers aiming at the formation of capital tend to enable either tax transparent structures with or without legal personality, and/or specific tax regimes or participation exemptions for collective investment schemes. This can provide exemptions from taxes and/or preferential tax rates to investment income and capital gains, as well as exemptions from withholding taxes to further distributions to nonresident investors.
Another tax consideration relates to withholding taxes that most countries generally levy on dividend, interest and royalty payments made to nonresidents (e.g. a foreign private equity fund). Such withholding tax is generally applied to gross payments and can be up to 35% in certain countries.
In order to boost foreign investment flows between countries, tax treaties for the avoidance of double taxation may substantially reduce or even exempt the above-mentioned payments from withholding taxes. Therefore, the availability of double tax treaties – considering the main targeted jurisdictions for the investments of the fund, as well as the requirements to qualify for such treaty preferential rates or benefits – may also be another factor to be weighed in when evaluating jurisdictions for domiciling the fund.
That being said, funds incorporated as tax opaque vehicles (e.g. companies limited by shares) in certain ‘offshore’ jurisdictions such as the Cayman Islands, as well as tax transparent vehicles, do not generally have access to such double tax treaties.
Due to their absence of corporate taxes as well as certain political reasons, offshore jurisdictions do not generally conclude double tax treaties (no risk of double taxation). And due to their disregarded status for tax purposes and, in some cases, lack of legal personality (meaning that they do not have a tax resident status in their jurisdiction of domicile) – tax transparent vehicles such as limited partnerships do not generally have access to double tax treaties (with certain exceptions).
The above may lead to two main issues. On the one hand, tax opaque vehicles without access to preferential treaty rates may face substantial withholding taxes in the countries where their investees are tax resident. And on the other hand, management of withholding taxes for tax transparent vehicles may be of substantial complexity (different investors located in different jurisdictions whose withholding tax rates may differ).
Furthermore, certain fund vehicles, such as limited liability companies (LLCs) whose company law is based in US law, may have different tax status in the different jurisdictions where the portfolio company, the fund and the investor may be located (tax opaque vs tax transparent). This “tax status mismatch” may lead to a high degree of complexity in tax reporting, disadvantageous tax situations, as well as an inability to access double tax treaty benefits.
In order to address the above, fund managers and operators may make use of ‘intermediate’ holding companies to act as investors of their portfolio companies, which could provide certain benefits.
When the fund vehicle is a tax transparent structure or a structure whose tax treatment differs depending on the country (such certain limited partnerships or LLCs) – an intermediate holding company may act as a tax opaque blocker, and thus standardize the level of taxation related to, for instance, withholding taxes. Such intermediate holding companies would generally be established in a jurisdiction that does not levy withholding taxes on dividends (to avoid unnecessary additional taxation).
When the fund is either a tax opaque or tax transparent vehicle, such holding company may provide for access to double-tax treaties and lower withholding taxes in the country where the portfolio companies are located. One also needs to consider that accessing such treaty benefits is not as straightforward – a number of tax treaties provide for limitation of benefits clauses, or specific local requirements to be considered a tax resident person (or eligible to benefits) for the purposes of the double tax treaty. This is in addition to anti-abuse and anti-tax avoidance legislation which may limit treaty benefits in order to avoid so-called “treaty shopping”.
Generally, and especially for holding vehicles, an economic rationale (other than purely tax reasons) as well as certain economic substance may be expected in order to access lower withholding tax rates.
The location of the investors may also be relevant from a tax structuring perspective. For instance, local legislation may penalize investors from a tax perspective when investing into foreign tax opaque structures (e.g. PFIC in the USA). Parallel Fund structures and Master-Feeder structures segregating investors into different capital formation vehicles according to their tax residency may also be used. This was covered in a previous article, which can be found here.
Other benefits may arise from using intermediate holding companies to hold interests in portfolio companies. For instance, to avoid certain administrative burden, additional reporting requirements or investment requirements that may be placed on vehicles domiciled in certain jurisdictions when investing locally or in specific strategic sectors – as opposed to locally-incorporated vehicles or vehicles incorporated in a common market area (e.g. European Union), as well as other matters such as making the investment more appealing from the investee’s legal perspective or facilitating the participation in general meetings, among others.
When it comes to the potential tax liability in the jurisdiction where the fund manager operates,most financial centers have safe harbour regimes that prevent fund vehicles from being taxed locally in the jurisdiction where the fund manager is located due to ‘place of effective management implications’ from a tax residence perspective, or the constitution of ‘permanent establishments’. The same is covered further below.
Private equity funds are generally structured as limited partnerships, limited liability companies whose ownership is divided into membership interests/participations/quotas or companies limited by shares. The availability of the desired structures, and the provisions of the laws governing such structures will also be relevant when evaluating jurisdictions for domiciling a private equity fund.
Limited Partnerships (LPs) are the most common structures due to their tax transparency and the flexibility that they provide when determining the terms of the relationship between the fund vehicle, the fund operator and the investors.
LPs are vehicles which may or may not have legal personality (depending on the jurisdiction, and in some jurisdictions based on election).
LPs generally consist of a partnership agreement between the general partner and the limited partners to carry on a business (or investments).
The general partner is the fund operator who will have control over the management of the LP and who assumes unlimited liability towards the debts and obligations of the LP, whereas the limited partners are the investors with no management rights and whose liability is limited to the capital contributed to the LP. The general partner is usually a corporation whose board has a fiduciary duty to act in the best interest of the limited partners of the LP, and may be, but does not necessarily need to be, the investment manager.
LPs are generally tax transparent vehicles, meaning that no additional layer of taxation occurs at the vehicle level. The profits or losses of the LP are attributed to the partners for tax purposes (regardless of whether they are distributed or not). Such tax transparency is generally recognized in virtually all jurisdictions.
The partnership agreement is the governing document of the LP, governing the terms of the LP and the rights, obligations of and overall relationship between the general partner, the LP and the limited partners. LP legislation in various financial centers tends to be flexible, providing greater discretion to the partners of the LP, how such LP shall be governed and the terms applicable to investors in the LP – as opposed to more rigid statutes applicable to corporations.
For instance, matters such as capital accounts and variation of economic entitlements between different classes of investors, among others – are generally more simply adapted and/or managed according to the needs of the fund operator / investors than in companies limited by shares. Such flexibility also largely depends on the partnership law of the specific jurisdiction.
Furthermore, subject to the relevant partnership law, partnership agreements may limit and/or eliminate general partner’s fiduciary duties to the limited partners and the LP.
LP agreements also provide for flexibility on determining restrictions on transfers and withdrawals or matters related to early dissolution.
Private equity funds may also be structured as companies limited by shares or corporations. In such a category, we would include both common law based companies limited by shares as well as limited liability companies from civil law-based legal systems.
The fund operator would hold the management shares and have the right to vote in the general meetings and appoint the members of the board of directors of the fund, whereas investors would invest in the vehicle in exchange for participating shares giving a right to profits (but generally no voting rights).
Such companies are generally more rigid structures subject to a number of mandatory provisions on how they shall be governed provided by the relevant corporate law.
The articles of association / bylaws / constitution of a company limited by shares generally need to be closely modeled on the relevant corporate law, and directors of companies limited by shares may assume greater personal liability related to their fiduciary duties than a manager or general partner of an LLC or LP. The flexibility when determining the terms of the constitutional documents and corporate requirements and formalities of companies limited by shares also largely varies depending on the jurisdiction.
Companies limited by shares are tax opaque entities with legal personality, although in certain jurisdictions, they can be treated as partnerships for tax purposes (transparent). This applies mainly in the US, where foreign companies limited by shares may be tax transparent upon “check-the-box” election unless they are “per se corporations” (which include all public companies of common law-based jurisdictions (e.g. PLC in the UK), and corporations of civil law-based jurisdictions (e.g. AG in German-speaking countries).
Then, private equity funds may also be structured as limited liability companies based on US law (LLC). This includes US LLCs, and LLC structures available in offshore jurisdictions such as the Cayman Islands or Bermuda.
LLCs are hybrid entities, sharing features with both companies limited by shares and LPs. Like companies limited by shares, LLCs have legal personality and the liability of its members is limited up to the (unpaid) capital commitment, whereas, like partnerships – LLCs are governed by a contract between the members (the LLC Operating Agreement). LLC legislation also tends to be flexible in terms of how the LLC shall be governed, leaving most of its terms up to the LLC Agreement concluded between the members, much in the same way as with LPs and their LP Agreements.
The fund operator will generally hold the management interests of the LLC (voting rights), whereas investors will hold the participating interests of the LLC (profit rights and no voting rights). LLCs are generally managed by a board of managers appointed by the holders of the management interests.
The tax treatment of LLCs may be problematic in certain instances. LLCs are a construct of US law, and in the US they are treated as disregarded (single member) or as a partnership (multimember) for tax purposes, unless they elect otherwise. Offshore LLCs are generally formed in offshore jurisdictions with the absence of corporate tax law (or broadly exempt from the relevant corporate tax law).
However, given that they have legal personality and are structured as a company, as opposed to a partnership, most jurisdictions will treat LLCs as tax opaque entities. This could create a tax treatment mismatch in LLCs sharing both US and non-US investors, or LLCs aiming at accessing treaty benefits, as advised above.
There are notable exceptions such as Australia where, according to ATO guidance, the tax transparency of foreign LLCs (specifically, US LLCs) is generally recognized. However, in most jurisdictions, due to an absence of jurisprudence or even contradictions between courts and tax office rulings / guidance, or determination of tax status based on interpretations of the terms of the LLC Agreement, there may be substantial tax uncertainty.
Legal and Regulatory Matters; Certainty; Infrastructure and Costs
Fund managers and fund operators will generally consider the regulatory environment, as well as the legal and tax certainty that the relevant jurisdiction may provide.
Given that a private equity fund will generally be aimed at professional and institutional investors who are well-versed and have the capability of understanding and assuming the risks of investing in such vehicles – private equity fund managers and operators will tend to prefer jurisdictions with a light-touch regulatory environment where both regulatory requirements for establishing and operating the fund – and their associated costs – are reasonable.
Legal and tax certainty are also relevant aspects – private equity funds tend to have a long-term investment strategy, in many cases longer than a decade, and any material change to their tax and regulatory framework can have an enormous impact both economically and operationally.
The legal basis of the legal system of the relevant jurisdiction,availability of jurisprudence in certain matters and how such jurisprudence may be legally binding, may also be brought into consideration. For instance, fund managers based in common law-based jurisdictions tend to prefer common law-based jurisdictions for establishing their fund vehicles, due to familiarity and available legal precedent.
Another example – Delaware, which has been a widely-used jurisdiction for large corporations and investment fund vehicles, has the Court of Chancery – an equity court with vast experience and competency on equity-related transactions, including case law, which provides for a higher degree of legal certainty on how courts may rule on certain disputes.
Legal provisions related to a fund’s oversight functions, conflicts of interest, and risk management, among others, applicable under both corporate and investment fund laws of the relevant jurisdiction, may also be taken into consideration to effectively evaluate the legal liability and compliance requirements from operating a fund domiciled in a specific jurisdiction.
Furthermore, fund operators and fund managers would tend to select jurisdictions with robust AML/CTF/anti-fraud/international tax compliance rules to avoid potential reputational blows of the jurisdiction that could affect the fund in the mid/long-term, and the ability to invest in certain countries and/or onboard investors from certain countries, and/or access certain financial services.
The availability of service providers such as banks, fund administrators, accountants and lawyers with a comprehensive understanding of private equity funds as well as the associated costs are also other aspects to take into consideration.
Location of Investors, Fund Managers and Investees
The location of investors should also be taken into account when assessing jurisdictions for establishing the fund. Sophisticated investors would generally invest in structures in which they are familiar to minimize their legal due diligence and associated risks.
Furthermore, from a regulatory perspective, the targeted jurisdictions should also be taken into account. For instance, an authorized alternative investment fund manager (AIFM) in the EU targeting EU investors would generally establish the fund vehicle in the EU (e.g. Luxembourg, Netherlands, Ireland) in order to access passporting rights across the EU to solicit EU investors, and ease of access to EU financial services.
Funds targeting non-EU and non-US investors might prefer light-touch regulatory environments and flexible offshore structures such as those available in the Cayman Islands, the Channel Islands, BVI,Bermuda or even in the UK, whereas funds targeting US investors will generally do so via (feeder) vehicles registered in Delaware.
The geographic location of the activities of the fund manager may also be relevant. Recent regulatory developments arising from OECD’s Forum on Harmful Tax Practices (FHTP),the OECD’s Base Erosion and Profit Shifting (BEPS) Inclusive Framework guidelines and the European Union Code of Conduct Group (EUCoCG) on Business Taxation standards on ‘harmful tax practices, as well as accepted regulatory practices arising from appropriate supervision of regulated entities – has led to increased economic substance requirements placed on fund managers.
Regulated private equity fund managers located in international financial centers are subject to substantial activity requirements from both a tax and regulatory compliance perspective. Such substantial activity requirements generally involve private equity fund managers being controlled and managed in the jurisdiction where they are domiciled and regulated, conducting their core-income generating activities from such jurisdiction, as well as having adequate people, premises and expenditure in such jurisdiction.
Although investment fund vehicles are generally out of the scope of such economic substance requirements, fund managers are increasingly considering fund structures within the geographical scope of fund manager operations in order to ease their regulatory and tax compliance requirements.
Most international financial centers with a substantial number of regulated fund managers provide ‘safe-harbour’ regimes to avoid an offshore fund vehicle from being taxed in the jurisdiction where the fund manager / operator is tax resident and/or operates.
Generally, in most jurisdictions, a foreign company would be subject to taxes locally by way of having its place of effective management found locally (corporate tax residency), or having a place of business and/or dependent agent regularly exercising the authority to conclude contracts, or otherwise business presence in the form of management or employees (permanent establishment or locally-sourced income). Safe harbour regimes allow offshore fund vehicles to be exempt from taxes locally even if the presence of the fund manager / operator could lead to the offshore fund vehicle being tax resident or constituting a permanent establishment in the jurisdiction where the fund manager operates.
For instance, in the USA, non-US companies are subject to tax in the USA on US-sourced income. US-sourced income may be effectively connected income to a US trade or business, or income arising from fixed, determinable, annual, or periodic payments from US sources (FDAP). FDAP generally includes dividends, interest and royalties that must be withheld at the source by the payer.
Effectively connected income to a US trade or business (ECI USToB) includes income generated by a company via its US-based activities. On a high-level, fund managers managing offshore funds from within the USA avoid US taxes on such ECI USToB via two statutory safe harbors, and treasury regulations available under the US Internal Revenue Code that mainly provide that income/gains generated via trading in stocks, securities, or commodities by a US nonresident (e.g. offshore fund vehicle) may not be deemed ECI USToB even if it is carried out by an employee or agent with discretionary authority located in the US.
A similar safe harbour regime applies in the UK – the Investment Manager Exemption. On a high-level, the following are the tests that must be met:
- the UK fund manager is in the business of providing investment management services.
- the transactions are carried out in the ordinary course of that business
- the investment manager acts in an independent capacity
- the requirements of the 20% test are met (not meeting the 20% test does not disqualify a fund vehicle from accessing the exemption but provides for certain restrictions)
- the investment manager receives remuneration for provision of the services at not less than the rate that is customary for such business
The location of the investments (i.e. the jurisdictions where the issuers of the equity / debt instruments are located) could also be brought into consideration from a legal, regulatory and tax perspective.
As previously covered, certain jurisdictions may place a higher administrative burden or reporting burden for foreign investment from certain countries or regions. Certain structures located in certain jurisdictions may also lead to higher regulatory scrutiny. For instance, if the fund’s investments mainly consist of EU-based companies, it may be more appropriate to use a EU-based structure to leverage administrative, reporting and legal synergies.
Tax benefits may also be considered, especially when the fund vehicle is a tax opaque structure. A tax-opaque fund investing primarily in countries where double-tax treaties are available -and where compliance for eligibility to treaty benefits applies (i.e. avoiding treaty benefits to be denied under provisions of domestic legislation, or limitation of benefits clauses of the same treaties) – may benefit from lower dividend or interest withholding taxes.
Where to set up a private equity fund
The Cayman Islands is one of the largest fund domiciles with around 12,000 registered mutual funds (typically, hedge funds) and another 13,000 registered private funds (typically, private equity funds/venture capital funds).
Typically, investment managers of Cayman funds are based in the USA, Cayman, as well as Asian financial centers such as Singapore and Hong Kong.
Private equity funds (closed-ended funds) have traditionally been unregulated in the Cayman Islands, but that changed in early 2020 when the Private Funds Act entered into force.
Cayman funds can be registered under the Mutual Funds Act or the Private Funds Act, and are regulated and supervised by the Cayman Islands Monetary Authority (CIMA).
The Mutual Funds Act (Revised) defines a “mutual fund” as a company, unit trust or partnership that issues equity interests, the purpose or effect of which is the pooling of investor funds with the aim of spreading investment risks and enabling investors in the mutual fund to receive profits or gains from the acquisition, holding, management or disposal of investments but does not include a person licensed under the Banks and Trust Companies Act (2021 Revision) or the Insurance Act, 2010 [Law 32 of 2010], or a person registered under the Building Societies Act (2020 Revision) or the Friendly Societies Act (1998 Revision).
“equity interests” are defined as a share, trust unit, partnership interest or any other representation of an interest that —
(a) carries an entitlement to participate in the profits or gains of the company, unit trust or partnership; and
(b) is redeemable or repurchasable at the option of the investor and, in respect of a company incorporated in accordance with the Companies Act (2021 Revision) (including an existing company as defined in that Act), in accordance with but subject to section 37 of the Companies Act (2021 Revision) before the commencement of winding-up or the dissolution of the company, unit trust or partnership, but does not include debt, or alternative financial instruments as prescribed under the Banks and Trust Companies Act (2021 Revision).
Therefore, a mutual fund would be an open-ended fund (shares redeemable at the option of the investor). Given the long-term investment strategy of a private equity fund and the lack of liquidity, they are generally structured as closed-ended funds (redemption of shares at the option of the investor not enabled).
Closed-ended funds are regulated under the Private Funds Act (Revised), which defines a “private fund” as a company, unit trust or partnership that offers or issues or has issued investment interests, the purpose or effect of which is the pooling of investor funds with the aim of enabling investors to receive profits or gains from such entity’s acquisition, holding, management or disposal of investments, where :
(a) the holders of investment interests do not have day-to-day control over the acquisition, holding, management or disposal of the investments; and
(b) the investments are managed as a whole by or on behalf of the operator of the private fund, directly or indirectly.
Private equity funds would therefore be generally registered with CIMA under the Private Funds Act (Revised) as private funds. The registration application must be submitted within 21 days after acceptance of capital commitments from investors.
The registration procedure is straightforward and mainly consists of complying with formalities. A term-sheet or offering document together with the constitutional documents of the structure, as well as administrator (where applicable) and auditor consent letters, and resumes of the compliance officers must be submitted. The registration is generally processed in a matter of days.
Regulatory requirements are mostly divided into five areas: Valuation, Accounting & Audits, Custody, Cash Monitoring and AML/CTF Compliance.
A private fund’s net asset valuation must be carried on by an independent third party at least once per year. A private fund may appoint an independent NAV-calculation agent or a fund administrator for such purpose. In certain cases, smaller funds may opt for the NAV calculation to be performed by a director or fund manager of the fund, as long as such valuation function is isolated from the management function, and potential conflicts of interest are disclosed to investors.
Private funds must also appoint an independent auditor based in the Cayman Islands prior to registration with CIMA, and submit annual auditor reports.
Private funds must also appoint a custodian to hold custodial fund assets, and undertake title verification of such assets – unless it is impractical due to the nature, size and/or investments of the fund. In the latter case, the verification may be carried on by the fund administrator (if any) or by the directors or managers of the fund – as long as such verification function is carried out independently from the management of assets and potential conflicts of interest are disclosed to investors.
Much in the same way, cash flow monitoring may be undertaken by an independent third party such as an administrator or custodian, or by the directors or fund managers of the fund, as long as cash monitoring functions are carried out independently and potential conflicts of interest are disclosed.
Cayman funds are considered ‘relevant financial businesses’ pursuant to the Proceeds of Crime Act (Revised), and therefore, Cayman funds must comply with relevant AML legislation including the same Proceeds of Crime Act (Revised), the Anti-Money Laundering Regulations, among others such as Terrorism Act or the Anti-Corruption Act.
Such AML legislation provides for certain regulatory requirements including but not limited to maintaining procedures for establishing and verifying the identity of investors and other counterparties; adopting a risk-based approach to monitor financial activities; maintaining adequate systems to identify risks related to persons, countries and activities; maintaining training and screening procedures for employees, record-keeping and internal reporting procedures; as well as adopting internal controls and monitoring procedures and designating an anti-money laundering compliance officer, money laundering reporting officer and deputy money laundering reporting officer.
Compliance officers do not need to be based in the Cayman Islands, but they must be approved by CIMA. CIMA will expect such compliance officers to have the qualifications and experience to fulfill their duties.
From an economic substance perspective – the International Tax Co-Operation (Economic Substance) Act (Revised) explicitly excludes investment funds, although Cayman-registered fund managers must comply with substantial activity requirements.
Cayman Islands funds are generally structured as exempted companies incorporated under the Companies Act (Part VII), (Revised), as a limited liability company (LLC) registered under the Limited Liability Companies Act (Revised), or as an exempted limited partnership registered under the Exempted Limited Partnerships Act (Revised).
Most private equity funds are structured as exempted limited partnerships (ELP). An ELP does not have legal personality and is governed by a partnership agreement between a Cayman Islands exempted company or an LLC acting as general partner and the limited partners (investors). The general partner assumes unlimited liability towards the ELP and has management rights on the LP business/investments. Limited Partners have limited liability towards the ELP up to their capital contributed, and have the rights to receive profits from the ELP. The rights, obligations and affairs of the ELP are governed by the partnership agreement.
ELPs are tax transparent vehicles whose tax transparency is generally recognized in most jurisdictions.
Otherwise, private equity funds may be structured as exempted companies. Exempted companies are companies limited by shares with legal personality. Members (shareholders) subscribe shares of the company in exchange for a capital contribution. Shares may provide for different profit and voting rights. Generally, the fund operator/sponsor will hold voting shares (management shares), whereas investors will hold non-voting shares giving a right to profits.
Exempted companies are governed by their memorandum of association and articles of association, and are managed by a board of directors.
Exempted companies can also be formed as segregated portfolio companies (SPC). Although they are not as commonly used for private equity funds – SPCs provide the possibility to establish segregated portfolios or cells in which assets and liabilities of each cell are separated from the master SPC and from the other cells/portfolios – therefore avoiding cross-contamination risks and ring-fencing liabilities.
It is akin to having several companies within a company – each cell can issue shares separated from other cells or the master company with its own balance sheet. This structure is more suitable for investment companies that use leverage for purchasing assets (therefore protecting other assets from liabilities arising from the leverage), and for investment companies to issue different classes of shares for different portfolios in order to have a broader offering according to the risk-appetite of different groups of clients and investors.
Alternatively, private equity funds may be formed as LLCs. LLCs can be considered a hybrid between an exempted company and an ELP, as previously explained in this article.
There are no taxes in the Cayman Islands applicable to companies. Investment funds are required to pay annual registration fees to the General Registry and to CIMA.
The Cayman Islands does not have any relevant double tax treaty concluded with any other country (other than the UK), and therefore, Cayman Islands funds and companies do not have access to any treaty benefits related to withholding taxes on payments that may apply at the source where the payers are located.
The US has the largest fund market worldwide with double-digit trillions of assets under management.
Corporate law in the US varies across each State, with Delaware the preferred US jurisdiction for both private equity funds, as well as corporations with an international / multi-state business approach.
Delaware is generally preferred for a number of reasons. Its court of equity – the Court of Chancery – is well known for its experience and competency ruling in corporate disputes. There is also an extensive body of legal precedent with comprehensive and reasoned written opinions, which provides for legal certainty. Furthermore, corporate disputes in Delaware are exclusively resolved by judges, instead of juries. Delaware’s Court of Chancery has judges specialized in corporate law and only handles cases related to commercial and equity matters.
Its company statutes are also known for their reasonable flexibility on the management of companies and balance between investors’ and management’s protections. A substantial number of jurisdictions have based their corporate laws on Delaware law.
In the US, unless exempted – investment funds are regulated under the Investment Company Act and supervised by the Securities and Exchange Commission (SEC).
Section 3 of the Investment Company Act defines an ‘‘investment company’’ as any issuer which—
(A) is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting, or trading in securities;
(B) is engaged or proposes to engage in the business of issuing face-amount certificates of the installment type, or has been engaged in such business and has any such certificate outstanding; or
(C) is engaged or proposes to engage in the business of investing, reinvesting, owning, holding, or trading in securities, and owns or proposes to acquire investment securities having a value exceeding 40 percent of the value of such issuer’s total assets (exclusive of Government securities and cash items) on an unconsolidated basis.
Section 3 also provides for a number of exceptions which are generally leveraged by private equity funds to avoid being subject to registration with the SEC under the Investment Companies Act. Such exceptions apply to “private investment companies”.
A private equity fund may rely on Section 3(c)(7) which provides that the fund’s securities are owned by ‘qualified purchasers’ – individuals who own not less than USD 5 million in investments or entities that own and invest on a discretionary basis not less than USD 25 million.
Alternatively, Section 3(c)(1) requires the fund to have no more than 100 investors to benefit from an exemption of registration under the Investment Companies Act.
Both Section 3(c)(7) or Section 3(c)(1) prohibit general solicitation and advertisement but private equity funds generally raise capital on a private placement basis thus complying with such sections.
When it comes to registration requirements pursuant to the Securities Act, private equity funds generally rely on Rule 506(b) of Regulation D of the Securities Act. This is a private placement offering exempted from registration with the SEC without general solicitation or general advertisement, where securities must be purchased directly from the issuer and not from an underwriter.
The Securities Exchange Act also requires that any fund (issuer) having 2,000 or more investors (or 500 non-accredited investors) and assets over USD 10 million, register the security under the Exchange Act and comply with reporting and other requirements imposed by the Exchange Act. Therefore, private equity funds generally tend to have a maximum of 1,999 to avoid registration.
Private equity fund managers may also be subject to registration with the SEC under the Advisers Act. However, there are a number of exceptions:
- venture capital fund adviser exemption which applies to fund managers managing only venture capital funds, which are limited to the amount of leverage they may incur and type of assets invested, among other conditions.
- foreign private adviser exemption which applies to fund managers without a place of business in the US, have less than 15 US clients and investors investing in their funds with a total amount of assets under management of less than USD 25 million, do not present themselves to the US public as an Investment Advisor and do not manage public funds registered under the Investment Company Act.
- private fund adviser exemption which applies to advisers managing private funds with assets under management of less than USD 150 million.
The venture capital fund adviser exemption and the private fund adviser exemption are required to report with the SEC within 60 days of relying on the exemption, and annually. Generally, if the adviser has less than USD 100 million in assets under management, it may be required to register with the securities regulator of the state where it operates rather than with the SEC.
Investment advisers relying on the above exemptions are not generally required to appoint an independent custodian of their funds’ assets.
Currently, investment advisers are not required to maintain AML/CTF compliance programs required under the Bank Secrecy Act or to file suspicious activity reports. However, this may change in the near future as per proposals of the finCEN.
Most Delaware-registered private equity funds are structured as LPs under the Delaware Revised Uniform Limited Partnership Act. Unlike Cayman exempted limited partnerships, Delaware LPs do have legal personality and constitute a separate legal entity.
The LP pools capital from limited partners (investors), and the fund manager invests such capital on behalf of the LP into securities issued by private companies. The general partner, which is usually structured as an LLC, receives carried interest (e.g. performance fees) and delegates management to a separate management company, which will charge management fees for the services under a management services agreement.
For US-based fund operators, establishing a separate company to provide management services may provide certain tax and legal benefits, such as:
- isolate the investment manager and the received management fees from the LP structure
- in some cases, the general partner may also invest some capital in the fund (thus separating the investment manager from the general partner who is an investor)
- carried interest (performance) may have access to a beneficial tax treatment (long-term capital gains), whereas management fees are active ordinary income (if the investment manager was to receive performance fees, these would be generally taxed at a higher rate than carried interest received by the general partner)
- due to different classes of “income” (carried interest vs management fees), the promoters of the fund may (or may not) prefer to have different tax treatment for the investment manager (as opposed to being taxed as a partnership, the investment manager may elect to be treated as a corporation)
The Delaware Revised Uniform Limited Partnership Act provides certain flexibility on the terms of the partnership. For instance, under Delaware law, a general partner will generally owe fiduciary duties to the partnership and its partners, including the duties of candour, care and loyalty. However, such duties may be expanded or restricted or eliminated under the partnership agreement, and replace common law fiduciary duties, as long as the implied contractual covenant of good faith and fair dealing is maintained.
The partnership agreement may also provide for limitations or elimination of liabilities arising from breach of contract or breach of duties, as long as it does not limit liability for any act or omission that constitutes a bad faith violation of the implied contractual covenant of good faith and fair dealing.
Private equity funds in Delaware may also be structured as limited liability companies under the Limited Liability Company Act. The fund sponsor or operator will generally subscribe the management interests (voting), whereas investors would subscribe the participating interests (non-voting). The managing member will generally receive carried interest and will delegate management of the investments to a separate investment manager, in a similar fashion to LP structures. The LLC will be governed by the LLC agreement which shares similar attributes with partnership agreements.
LLCs may also be formed as a Series LLC in Delaware, allowing for segregation of assets and liabilities within the same legal entity. Each series has its own assets and liabilities isolated from those of other series.
LPs in the US are tax transparent vehicles, meaning that profits (and losses) are passed through, and attributed to the partners for tax purposes, regardless of whether profits are actually distributed or not.
The tax transparency of a limited partnership is widely recognized in almost all jurisdictions. This means that non-US investors would pay taxes according to their country of residence and the source of the income. Generally, US managers may establish feeder structures for non-US investors to avoid tax complexity arising – for instance, from different withholding tax rates on investment returns paid by investee companies – depending on whether a given investor is located in a treaty or non-treaty jurisdiction.
Private equity funds structured as LLCs are also treated as a partnership for tax purposes in the USA (unless they elect otherwise, which is not common). However, when it comes to mixing US and non-US investors within the same LLC structure, further complexities arise, as the vast majority of non-US countries do not recognize the fiscally transparent status of the LLC and treat such LLC as a corporate body for tax purposes. This means that while a US investor may be subject to taxes on non-distributed profits, a non-US investor would not be subject to taxes until such profits are distributed. Furthermore, US withholding tax complexities may also arise leading to double taxation for the non-US investor – as well as non-US withholding tax, given that due to its tax transparent status, an LLC itself may not have access to double-tax treaty benefits from certain tax treaties.
Furthermore, non-US investors investing in US tax-transparent structures may also incur a tax reporting liability in the US if the structure generated effectively connected income to a US trade or business (for private equity funds, that would commonly be investments in companies which receive income from US real estate).
Therefore, US managers seeking to raise capital from non-US investors (and US tax-exempt investors) generally do so via master-feeder structures separating US and non-US (and US tax-exempt investors) into different feeder structures for tax optimization and tax reporting and compliance ease purposes.
Jersey is a notable offshore financial center when it comes to collective investment schemes. Assets under management in Jersey are around USD 400 billion, with around a third from private equity funds.
Jersey has a comprehensive legal framework for collective investment schemes with different types of funds subject to different regulatory requirements, depending on the number of investors of the fund, the type of investors, and the jurisdictions in which the funds may be marketed.
Jersey collective investment schemes are authorized, regulated and supervised (where applicable) by the Jersey Financial Services Commission (JFSC).
Generally, private equity funds are established in Jersey either as regulated funds such as a Private Fund (when the number of offers or investors does not exceed 50), or otherwise, as an Expert Fund or Eligible Investors Fund under the the Collective Investment Funds (Jersey) Law, or alternatively, as an an Unregulated Eligible Investors Fund.
Regulated Funds may be marketed to EEA investors through NPPR regimes, whereas Unregulated Funds cannot.
Jersey Private Funds
Jersey Private Funds are defined in Jersey as a “private investment fund involving the pooling of capital raised for the fund and which operates on the principle of risk spreading”. Private Funds may or may not provide for redemptions at the option of the investor.
Jersey Private Fund consists of a collective scheme in which the number of offers (understanding an offer as an offer that is capable of acceptance, excluding pre-marketing materials) of investment fund units for subscription, sale or exchange does not exceed 50 and the number of investors does not exceed 50 either.
Jersey Private Funds must only accept investors who are professional investors with a minimum initial subscription of at least GBP 250,000.
Professional investors are investors whose net worth (either alone or jointly with his or her spouse or civil partner) is over USD 1 million, excluding their home and any rights under a contract of insurance; or a legal entity or legal arrangement (e.g. trust) with assets available for investment over USD 1 million.
Persons who conduct securities and investment business, fund business, trust company business or their employees, directors, partners or consultants, as well as family trusts and entities whose members are professional investors (i.e. individuals whose net worth is higher than USD 1 million or legal persons with more than USD 1 million of assets available for investment) may also be considered professional investors and thus eligible for investing in a Jersey Private Fund.
Persons who conduct securities and investment business, fund business, trust company business, or their employees, directors, partners or consultants, as well as family trusts and entities whose members are professional investors (i.e. individuals whose net worth is higher than USD 1 million or legal persons with more than USD 1 million of assets available for investment) may also be considered professional investors and thus eligible for investing in a Jersey Private Fund.
Professional clients as defined under the EU’s Markets in Financial Instruments Directive (MiFID), i.e. institutional investors such as governments, banks and other investment funds, and entities meeting two of the following: a balance sheet over EUR 20 million, net turnover of EUR 40 million, and/or equity of EUR 2 million, are also considered Professional Investors for the purposes of Jersey Private Funds.
Although preparing (and filing) an offering document is not strictly required, Jersey Private Funds must file for and obtain consent from the JFSC under the Control of Borrowing (Jersey) Order 1958 in order to operate. Such consent is obtained in a matter of days.
Main requirements include the production of an investment warning and disclosure statement which must be made available and acknowledged and signed by investors. The investment warning shall mainly provide that the fund is only suitable for professional investors, a declaration of suitability if the subscriber is subscribing fund units on behalf of retail investors, and an acknowledgment of the risks of losing all the investment.
The risk disclosure statement shall contain the fact that the fund has obtained consent from the JFSC but that such consent is not an endorsement or opinion of the fund or the accuracy of any statements made by the fund (and that the JFSC has no liability towards the investors), and a declaration of the fund operator that any statements made by the operator or the fund are accurate.
Jersey Private Funds are specified as a Schedule 2 business for the purposes of the Proceeds of Crime (Jersey) Law 1999 and the Proceeds of Crime (Supervisory Bodies) (Jersey) Law 2008, and are required to comply with said legislation including the Money Laundering (Jersey) Order 2008, which provides AML-related requirements such as conducting due diligence on investors, and appointment of compliance officers, among others, in a similar fashion to Cayman funds.
An annual compliance return must also be submitted annually.
Private Funds must also appoint a Designated Service Provider that is a company regulated by the JFSC under the Financial Services (Jersey) Law 1998 to carry on Fund Services Business (e.g. Administrator, Investment Manager, Trustee). On a high-level, the role of the Designated Service Provider is to conduct due diligence on the fund and its promoters, ensure that the fund meets the eligibility criteria as a Jersey Private Fund, ensure compliance with AML regulations, and act for fund reporting matters with the FSC (e.g. submission of audited accounts, annual compliance return, etc.).
Private Funds managed by Alternative Investment Fund Managers may also be marketed in the EEA through NPPR, subject to certain disclosure, transparency and reporting requirements pursuant to the EU’s AIFMD and having received authorization from the JFSC under the Alternative Investment Funds (Jersey) Regulations. If the Private Fund units are marketed to EEA Investors, the Fund will need to produce an offering document, appoint an auditor and have two resident directors (either at the fund vehicle level, or a general partner, who shall be a Jersey entity, as the case may be).
For below-threshold AIFMs managing on a consolidated basis leveraged funds valued at less than EUR 100 million; or unleveraged closed-ended funds valued at less than EUR 500 million – the above-mentioned requirements do not apply but JSFC consent is still required.
Expert Funds are regulated under the Collective Investment Funds (Jersey) Law but subject to substantially lean regulatory requirements.
Expert Funds are open-ended or closed-ended funds whose interests are exclusively offered to Expert Investors. Investors making a subscription of at least USD 100,000 are considered Expert Investors.
Investors who meet the conditions for being Professional Investors under the Private Funds regime covered above are also generally considered Expert Investors.
Unlike Private Funds, Expert Funds are not restricted to a specific number of investors but an offering document must be prepared and filed with the JFSC together with the application form and a declaration of compliance. Complete applications are generally cleared in 3-4 days.
The offering document generally needs to contain information about the structure of the fund, the service providers, auditors, potential conflicts of interest, investment objective and investment strategies, any changes that could materially affect investors, the basis upon which any subsequent offerings may be made, asset valuation and fund units methodology, fees and charges, custody arrangements, and certain risk disclosure statements and investment warnings, among others.
After registration, a Fund Certificate is granted to the fund (or to the general partner, if the fund is structured as a limited partnership). The Fund must comply with the code of practice “Certified Funds Code”, which provides for certain operational, financial and compliance requirements.
If the Expert Fund is structured as a company, at least two resident directors with appropriate experience must be appointed. If the Expert Fund is structured as a limited partnership, the General Partner must be a Jersey entity with at least two resident directors. Directors must be approved by the JFSC under fit and proper tests.
Expert Funds must have either a fund administrator or an investment manager that is regulated in Jersey or any OECD member state, or a country with which the FSC has entered into a Memorandum of Understanding (including countries such as Gibraltar, Cayman Islands, BVI, Bermuda, Guernsey, UAE, among many others).
The requirement of appointing a Custodian is generally waived for closed-ended funds.
The appointment of an auditor and submission of auditor reports is required.
Like Private Funds, Expert Funds must also appoint a designated service provider, and comply with AML/CTF obligations. Expert Funds may be marketed to EEA investors through NPPR if they comply with the Alternative Investment Funds (Jersey) Regulations in a similar fashion to Private Funds.
Eligible Investors Fund
Jersey Eligible Investors Funds are subject to substantially similar requirements as Expert Funds. They are open-ended or closed-ended funds that are marketed to “Eligible Investors”. Eligible Investors include investors who make an initial minimum subscription of not less than USD 1 million, or a person or entity (or an employee of such entity) whose ordinary business or professional activity includes acquiring, managing or giving advice on investments; or an individual or entity whose property has a total market value of not less than USD 10 million.
These are funds that are subject to notification to the JFSC only of basic terms of the fund and declaring that the fund qualifies as an Unregulated Fund pursuant to the Collective Investment Funds (Unregulated Funds) (Jersey) Order. They can only be offered to Eligible Investors (as described above), and they cannot be marketed to EEA investors.
Such funds are not subject to regulatory requirements such as the preparation of an offering document, appointment of resident directors, or the appointment of designated service providers or auditors, among others, other than those applicable to companies and limited partnerships under the Companies (Jersey) Law and Limited Partnerships (Jersey) Law, respectively, as well as AML/CTF obligations.
Private equity funds in Jersey are generally structured either as companies limited by shares under the Companies (Jersey) Law or LPs under the Limited Partnerships (Jersey) Law.
LPs are formed by a partnership agreement between a general partner assuming unlimited liability (the fund operator) and limited partners whose liability is limited to the capital contributed.
Unlike in the Cayman Islands, the general partner of a Jersey LP does not necessarily need to be a locally incorporated company, unless the LP is an Expert Fund or an Eligible Investor Fund.
An LP in Jersey may elect to have a legal personality separate from its partners as Separate Limited Partnerships and Incorporated Limited Partnerships.
Separate Limited Partnerships (SLP) have separate legal personality but they are not incorporated. The assets of the SLP may be held in the name of the SLP or in the name of the general partner under the partnership agreement. Either the SLP or its general partner is able to initiate legal action and legal action may be initiated by or against the SLP or its general partner. Otherwise, SLPs are substantially similar to regular LPs.
Incorporated Limited Partnerships (ILP) are corporate bodies with the capability to sue and be sued, and enter into contracts in their own name. ILPs share a number of attributes with companies such as perpetual succession or dissolution processes. Certain tax uncertainty may arise on the tax treatment (transparent vs opaque) of ILPs in foreign jurisdictions.
Otherwise, private equity funds can be structured as a common company limited by shares, or alternatively as protected cell companies or incorporated cell companies.
Protected cell companies consist of a core and several ring-fenced protected cells, creating separate portfolios of assets and liabilities that are statutorily segregated. Cells do not have a separate legal personality from the core but they have their own cellular capital, meaning that investors may invest only in a specific cell.
Incorporated cell companies are similar to protected cell companies, but each cell is a separated legal entity with its own legal personality and the capacity to enter into contracts on its own, although they share a common board of directors.
Limited partnerships are tax transparent vehicles under Jersey law, and such tax transparency is generally recognized in most jurisdictions. Profits (and losses) are attributed to the partners who pay tax according to their tax residence.
However, the tax transparency status of an Incorporated Limited Partnership may be disputed in certain jurisdictions, given that ILPs are corporate bodies.
Companies limited by shares are tax opaque vehicles. Jersey’s standard tax rate is 0%, and collective investment funds may elect to be exempt from tax other than income or gains arising from real property located in Jersey (which are subject to 20% tax).
Luxembourg is the second largest domicile for funds after the US, and the first for cross-border funds.
Private equity funds targeting EEA investors are generally formed in Luxembourg, and are the main players of the overall fund sector in the country.
The Commission de Surveillance du Secteur Financier (CSSF) is the financial regulator in charge of authorizing and supervising (where applicable) collective investment schemes and fund managers in Luxembourg.
Alternative Investment Funds (AIF) are subject to the Law of 12 July 2013 on alternative investment fund managers, which defines an AIF as any collective investment undertaking, including investment compartments thereof, which raises capital from a number of investors with a view to investing it in accordance with a defined investment policy for the benefit of those investors, and which does not require authorisation pursuant to the UCITS Directive.
UCITS are collective investment schemes that invest in publicly traded securities and other liquid assets, are subject to strict risk diversification policies, and are prohibited from conducting short selling, among other restrictions.
Therefore, private equity funds would be Alternative Investment Funds as opposed to UCITS. AIFs are strictly aimed at professional and institutional investors.
AIFs in Luxembourg may be regulated or non-regulated but, unless exempt, they must appoint an authorized Alternative Investment Fund Manager (AIFM) based in Luxembourg or another EEA member state.
However, Luxembourg-based AIFMs may not need to obtain CSSF authorisation and be subject to a simple registration regime if they directly or indirectly (including through affiliated entities, on a consolidated basis) manage AIFs:
- that are not leveraged and have no redemption rights for a period of 5 years, and whose aggregate assets under management do not exceed EUR 500 million; and
- whose assets under management, including any assets acquired through the use of leverage, do not exceed EUR100 million.
A number of private equity fund managers could meet the above conditions as below-threshold AIFMs, and avoid full AIFM authorization requirements.
Such below-threshold AIFMs should register with the CSSF, report to the CSSF the AIFs to which they provide services including their investment strategies, principal instruments and investment exposures.
AIFs managed by such below-threshold AIFMs do not benefit from marketing passporting rights across the EEA, although they may access alternative marketing passport regimes available under the European venture capital funds regulations (EuVECA) or the European social entrepreneurship funds (EuSEF) regulations.
If the AIF is structured as a corporate body (e.g. company), it may choose to be internally managed (when permitted). In such cases, the AIF may be required to obtain approval as an AIFM with the CSSF, which could require:
- an initial paid-up capital / net assets of EUR 300,000;
- maintaining additional reserves or an adequate professional indemnity insurance;
- applying remuneration policies in line with risk management policies;
- implementing special procedures for determining, monitoring and addressing conflicts of interests;
- implementing a risk management system for managing risks related to the investment strategy;
- implementing an appropriate liquidity management system;
- reporting to CSSF results of stress tests, main traded instruments, markets and other disclosures;
- comply with certain disclosures obligations and anti asset stripping measures.
Funds may be organized as investment companies with variable capital (SICAV) – open-ended funds whose capital increases and decreases due to subscriptions and redemptions; or as investment companies with fixed capital (SICAF) – closed-ended funds whose increase or decrease of capital is subject to corporate decision.
Generally, an AIF investing in private equity would generally be either unregulated or avail of any of the below regimes:
- Reserved Alternative Investment Funds (RAIFs)
- Specialised Investment Funds (SIFs)
- Investment Companies in Risk Capital (SICARs)
AIFMs may establish their private equity funds in Luxembourg as Unregulated Funds. Unregulated funds are not required to receive any approval or authorization from – and are not supervised or regulated by – the CSSF, as long as their assets under management do not exceed EUR 100 million.
Such funds are generally formed as either limited partnerships (Société en commandite simple, SCS) or as special limited partnerships (Société en commandite spéciale, SCSp) to benefit from tax transparency treatment.
A depositary based in Luxembourg and appointment of a Luxembourg-approved auditor is generally required.
Establishing an unregulated fund in Luxembourg would generally take around one month.
Reserved Alternative Investment Funds (RAIF)
Reserved Alternative Investment Funds (RAIF) are subject to the Law of 23 July 2016 on Reserved Alternative Investment Funds, and are indirectly regulated via their fund manager.
The Fund manager must be an AIFM which is authorized by the CSSF or by the regulator of another EEA-member state. The AIFM is generally obliged to report RAIF activities to the CSSF.
RAIFs are aimed at “well-informed investors”. In summary, well-informed investors are:
- institutional investors, i.e. banks, investment funds, etc.;
- per-se professional investors, i.e. regulated companies, large undertakings (meeting two of the following: a total balance sheet of at least EUR 20 million; a net turnover of at least EUR 40 million; equity of at least EUR 2 million), government and public sector entities, and other institutional investors such as securitisation vehicles;
- directors and managers of the RAIF;
- investors who meet two of the following: the investor has carried out transactions, in significant size, on the relevant market at an average frequency of 10 per quarter over the previous four out of ten quarters; the size of the investor’s financial instrument portfolio, defined as including cash deposits and financial instruments, exceeds EUR 500,000 and/or the investor works or has worked in the financial sector for at least one year in a professional position, which requires knowledge of the transactions or services envisaged.
RAIFs can be marketed across the EU to professional and institutional investors. Notification to the domestic regulator still applies.
RAIFs are required to reach EUR 1.25 million in net assets under management within 12 months of their launch, and are subject to risk diversification – for instance, a RAIF may not invest more than 30% of its assets in securities of the same kind from the same issuer.
RAIFs must appoint a Luxembourg-based administrator, and a Luxembourg-based depositary approved by the CSSF. Accounts of the RAIF must be submitted annually in the form of an auditor report prepared by a CSSF-approved independent auditor.
An issuing document must also be prepared which shall include relevant fund information, e.g. investment strategies and objectives, fund manager, the depositary, the auditor and any other service provider; valuation methodology, etc.
Generally, RAIFs take the form of contractual funds, SICAV or SICAF. They can be set up as a stand-alone fund or as an umbrella fund made up of multiple sub-funds.
Given that no authorization for the RAIF itself is required, establishing a RAIF would generally take around 1-2 months.
Specialised Investment Funds (SIF)
SIFs are governed by the Law of 13 February 2007 on Specialised Investment Funds. They are regulated vehicles which require authorization from the CSSF.
The authorization procedure generally takes around three months and involves filing certain documents such as an issuing document (or prospectus when applicable), KYC/AML policies, a business plan, the constitutional documents of the company, structure chart, portfolio composition and risk management policies, as well as a number of other documents which may be requested, such as the management agreement.
SIFs must reach EUR 1.25 million in net assets under management within 12 months of their launch (with 5% paid-up capital required on launch), are only available to well-informed investors, and are subject to risk-spreading obligations in a similar fashion as RAIFs.
An issuing document must also be prepared fulfilling certain disclosure requirements, as well as producing monthly and annual reports submitted to the CSSF. Annual accounts must be audited by an approved independent auditor and submitted to the CSSF. Like RAIFs, SIFs must appoint a Luxembourg administrator, and depositary .
They are also generally structured in the form of contractual funds, SICAV or SICAF. They can also be structured with multiple compartments, segregating assets and liabilities – although different investment strategies and policies may not differ between compartments.
Investment Companies in Risk Capital (SICAR)
SICARs are subject to the Law of 15 June 2004 relating to the investment company in risk capital. They also require authorization from the CSSF, and if they qualify as an AIF, they shall appoint an AIFM to benefit from EEA’s marketing passport rights.
SICAR’s must exclusively invest in assets which involve a high risk inherent in portfolio investments, and an intention of growth of the issuers. Generally, that would mean securities issued by non-listed companies. Unlike RAIFs and SIFs, they are not subject to any risk diversification mandate.
They may be established as a company or as a limited partnership, and compartments’ segregation of assets and liabilities may also be enabled.
They must be marketed to well-informed investors and must reach at least EUR 1 million of paid-up share capital within 12 months of their launch (5% at the time of incorporation). Like SIFs and RAIFs, they must prepare and file an issuing document and submit annual reports, and must appoint a Luxembourg-based administrator, depositary and an approved auditor.
There are a variety of fund structuring options in Luxembourg. Funds can be structured in any of the following corporate forms as provided under the Luxembourg law of 10 August 1915 on commercial companies:
- Société en commandite simple (SCS), i.e. common limited partnership
- Société en commandite spéciale (SCSp), i.e. special limited partnership
- Société en commandite par actions (SCA), i.e. limited partnership with share capital
- Société à responsibilité limitée (SARL), i.e. limited liability company
- Société anonyme (SA), i.e. corporation
The above fund vehicles may be established either as a SICAV or a SICAV, as discussed above.
Funds can also be established as contractual funds – Fonds Commun du Placement (FCP). FCPs do not have legal personality – they are established via a public deed entered by the fund manager and the custodian, whereby they have a contractual obligation with investors, which in turn have direct ownership of the fund’s underlying assets on a pro-rata basis.
Generally, a private equity fund would be formed as a SCS or SCSp, and to a lesser extent as a SARL or a SA in the case of RAIFs, SICARs and SIFs.
SCS and SCSp are substantially similar structures. The main difference is that a SCSp has legal personality, whereas a SCS does not.
SCS/SCSp have a general partner who has management powers (e.g. fund operator or fund manager) and assumes unlimited liability for the debts and obligations of the SCS/SCSp, and limited partners (investors) who receive profits arising from such investment management, but do not have any management rights.
SCS/SCSp benefit from the previously discussed contractual freedom available in common law-based limited partnerships. The partnership agreement provides for the terms governing the LP, and the relationship between the general partner and the limited partners – which can be freely set at the discretion/agreement of the general partner(s) and the limited partners.
The general partner is often structured as a SARL, although it is not a requirement.
SARLs are limited liability companies whose interests are represented by shares that are non-transferable unless a majority of the members approve such transfer. SARLs are not authorized to issue non-voting shares.
SARLs must have a maximum of 100 shareholders, and a minimum share capital of EUR 12,000 fully paid-up at the time of incorporation. They are governed by its articles of association, which are subject to fewer statutory provisions than SAs, and are managed by a board of managers.
SAs are public limited companies by shares – the typical corporation. The minimum share capital is EUR 31,000 (at least 25% must be paid up at the time of incorporation). A SA is governed by its articles of association and is managed by its board of directors who must consist of at least three members (unless the SA has only one shareholder). SAs are authorized to issue non-voting shares.
Both SAs and SARLs are not subject to any nationality / residency requirements for managers/directors or shareholders.
SCAs are a combination of a partnership and a corporation. Like a partnership, it has general and limited partners, and like corporations, it has share capital and issue shares. SCAs are subject to substantially more rigid provisions applicable to SAs than SCS/SCSp.
Unregulated Funds (other than RAIFs)
Unregulated funds structured as SCSs or SCSps are not subject to corporate income taxes or withholding taxes. They are tax transparent vehicles whose tax treatment is widely recognized in most jurisdictions.
Despite its tax transparent status, SCS/SCSp could potentially be subject to municipal business tax (in Luxembourg City of 6.75%) if they carry out a business activity.
A “business activity” is defined under Luxembourg tax law as (i) an independent activity with (ii) a lucrative intent that is exercised in (iii) a permanent manner and (iv) constitutes a participation in the general economic life.
An Alternative Investment Fund would not generally be carrying out a business activity given that its object and purpose are investments.
That being said, if the general partner is a Luxembourg company, or a foreign company with a permanent establishment in Luxembourg, and holds at least 5% of units/interests of the SCS/SCSp, the SCS/SCP may be subject to municipal business tax.
SCS and SCSp do not have access to treaty benefits arising from double tax treaties, although their investors may have access to treaties between their country of tax residence and the countries where investees of the fund are domiciled.
An unregulated fund structured as a company (e.g. SARL, SA) would be subject to Luxembourg corporate income taxes and municipal business taxes.
The Corporate income rate is 17% for companies with taxable income in excess of EUR 200,001, leading to an effective tax rate of 24.94% in Luxembourg City (taking into account the solidarity surtax of 7% on the CIT rate, and including the 6.75% municipal business tax rate applicable).
Dividends and capital gains are treated as ordinary income and taxed at the standard rate. However, dividends and capital gains derived from the sale of shares may be tax-exempt, provided that the shareholding constitutes at least 10% of total ownership in the share capital or an acquisition price of at least EUR 6 million (capital gains) / EUR 1.2 million (dividends), and the company has held or intends to hold a qualifying shareholding for at least 12 months.
Dividends paid to nonresidents are generally subject to 15% withholding tax, unless reduced under a double tax treaty or the recipient is a company.
A net wealth tax on the fair market value of the company’s worldwide net assets at a rate of 0.5% for the first EUR 500 million of net assets and 0.05% for the rest may also apply.
Given the above, from a tax standpoint – SARLs and SAs may be suitable for unregulated funds other than RAIFs in very specific scenarios (e.g. ability to access participation exemptions due to its portfolio composition, and where exemptions from withholding taxes are available due to treaties).
RAIFs and Regulated Funds
RAIFs and regulated funds structured as SCSs and SCSps are tax transparent vehicles without access to double tax treaties.
RAIFs and Regulated Funds structured as companies have access to preferential tax regimes, which generally result in nil taxation.
For instance, RAIFs and SIFs are not subject to corporate taxes nor net wealth taxes, and their distributions are exempt from withholding taxes as well.
RAIFs and SIFs are subject to a subscription tax of 0.01% on its net assets. An exemption from subscription tax may apply if the fund invests in other funds that are subject to subscription tax, or invests in money market instruments only, or its main investment objective is to invest in institutions.
SICARs (structured as companies) are subject to regular corporate income taxes. However, they have access to a tax exemption on income and gains arising from risk capital securities. Given that SICARs are aimed at investing in risk assets – this generally means that no corporate tax applies. SICARs must only pay the minimum net wealth tax of EUR 10,070, regardless of its actual net assets.
RAIFs that only invest in risk capital may also elect to be taxed under the SICAR’s tax regime.
The Bottom Line
There are a significant number of factors and complexities to consider when structuring a private equity fund and determining its domicile.
Achieving tax neutrality, and minimizing taxes via intermediate structures in order to not penalize your investors, is perhaps one of the most relevant aspects as it directly affects the return on investment.
However, such intermediate structures must also have a valid economic reason other than taxes, and comply with current substantial activity in order to access tax benefits, especially in double-tax treaty scenarios.
The availability of structures that are adjusted to the needs of fund managers and investors, and the provisions of the laws governing such structures, will also be determinant when evaluating jurisdictions for domiciling a private equity fund.
Private equity funds’ investors are generally sophisticated investors and institutional investors who would avoid any non-common structures that could lead to substantial due diligence and risks.
Fund managers will tend to use well-known and widely-used structures in which investors are familiar – in jurisdictions where there is substantial legal and tax certainty as well as available legal precedent and a strong judiciary system based on the rule of law.
The location of your investors, and targeted portfolio companies and investments, is another relevant factor. For instance, the ability to leverage marketing passporting rights in the EEA is strictly reserved for EEA AIFMs who manage EEA-based AIFs. Otherwise, authorization under national private placement regimes of each EEA would need to be obtained.
Other operational factors may also need to be taken into consideration. The availability of service providers with a comprehensive understanding of private equity funds, as well as the setup and operational costs, are relevant in a decision-making process.
From a jurisdiction standpoint, as we have seen – there are substantial differences on regulatory requirements and compliance burden across jurisdictions. For instance, EEA-based alternative investment funds are subject to substantially more burdensome regulatory obligations than their counterparts in the USA.
Although all jurisdictions offer both companies and limited partnerships, there are relevant differences between such structures across jurisdictions. The requirements and ability to access tax-neutral status for tax opaque vehicles also differ greatly.
This is why a careful, holistic assessment of each and every factor of the intended fund should be undertaken in order to determine the most suitable jurisdiction to establish it in.
At Flag Theory, we can help you navigate across jurisdictions, and assist with determining their suitability for your private equity fund. We will explore and compare jurisdictions side by side, taking into account your unique specifics in order to make informed decisions. Contact us today, it will be a pleasure to help you.