Letter from Amsterdam: Dechert and European Private Equity CFOs and COOs Share Key Regulatory Concerns
Dechert was again pleased to support the SuperReturn CFO/COO Forum, held in Amsterdam in September. Nearly 200 GPs, LPs and key individuals from the private equity and venture capital industry came together for three days of discussion and debate. This article summarises some of the topics discussed during the forum.
Fund Structures and Marketing: Key Operational Issues
Key discussion themes included:
- Implementation of the AIFMD within the industry continues to generate a range of issues. These include, among others, the necessity to appoint a depositary to provide safe-keeping of assets, navigating restrictions on asset stripping, and practical issues surrounding regulatory reporting. The different approaches taken by different EU Member State regulators were discussed, and it is clear that these differences continue to pose operational challenges. While for EU managers of EU funds, full-scope compliance with AIFMD can enable them to obtain a marketing passport providing the right to market to institutional investors without having to rely on national private placement regimes (NPPRs) – where those are available – relatively few GPs are in fact making use of the marketing passport. This is notwithstanding the fact that many NPPRs vary markedly according to jurisdiction. Many private equity managers are avoiding the more difficult jurisdictions altogether.
- Many US and Asia-Pacific (APAC) managers are focusing on their domestic clients (or in any event, clients in countries where marketing is more straightforward), unless they are raising substantial sums of European capital. This “selective” approach to Europe has been helped by a relatively buoyant fundraising market in the United States in particular. At present, the main downside of this approach in Europe has been a lack of choice for some European investors. In a less favourable fundraising climate, non-European managers may have to become more engaged with Europe in order to complete their fundraises.
- The marketing passport has been embraced by some in the PE industry – generally, the larger managers. In addition, problems with the implementation of the passport (including extra fees and annual charges imposed by some regulators) have meant that its operation is not completely seamless. The overall effect is to add to fundraising costs, which takes some of the lustre off the passport.
- With the precise ambit and regulatory treatment of reverse solicitation unclear in many jurisdictions, and most regulators having failed to provide meaningful guidance, managers in general remain wary of relying too heavily on reverse solicitation. It is especially hard for smaller private equity managers without pre-existing brand awareness in Europe. Given the uncertainty regarding reverse solicitation and the potential for inadvertently marketing to EU investors in breach of AIFMD, managers are looking increasingly towards NPPRs or passport solutions.
- The European Securities and Markets Authority (ESMA) has recommended that the passport be extended to Switzerland (subject to further domestic legislative changes), Jersey and Guernsey. However, additional work is needed before this is operative. At best, it would start to give these countries the ability to offer marketing optionality. Other major markets and domiciles – including the United States, Hong Kong and Singapore – will have to wait and see before ESMA reaches a firm decision as to whether they will be able to access the passport directly.
- There was vigorous debate as to the virtues and relative merits and disadvantages of fund structures in "offshore" domiciles (such as the Channel Islands) and "onshore EU" jurisdictions (such as Luxembourg). Cogent arguments can be made for “coming onshore” or “staying offshore” – but ultimately this will be determined by a particular manager’s investor relationships and investors’ preferences, as well as the manager’s fundraising objectives. Some managers are doing both, using parallel vehicles.
- Regulation has ramped up operational costs. The introduction of a requirement to have a depositary (providing asset safe-keeping, monitoring cash-flows and performing an oversight function) creates an additional cost and operational burden. There was much discussion about the various different (and equally valid) approaches to how costs are shared between investors and management companies. Investors present at the conference struggled to find tangible benefits associated with the additional cost base.
- Regulators recognise that managers have found the AIFMD authorisation process to be lengthy, although they argue this is because national competent authorities have struggled with the sheer volume of registrations. The ongoing focus on improving the quality of the data that managers supply to national regulators through the Annex IV reporting regime appears set to continue for some time, as managers and regulators alike settle on a process to provide – and extract useful information from – Annex IV data.
- Views differed as to how far away we are from an AIFMD “brand value” that provides investors with an internationally recognised stamp of approval.
The Impact of the SEC Focus on Fees and Expenses
Private equity firms registered with the U.S. Securities and Exchange Commission (SEC) must provide disclosure to fund investors regarding fee charges, expenses and potential conflicts of interest, if such firms wish to reduce the risk of SEC scrutiny. The SEC has taken a growing interest in fee practices and transparency at private equity managers – particularly following passage of the Dodd-Frank Act, which now brings previously unregulated private equity managers along with hedge fund managers under the remit of the SEC. Some of the discussion points are noted below:
- In May 2014, Andrew Bowden, then-Director of the SEC’s Office of Compliance Inspections and Examinations (OCIE), discussing “inherent risks in private equity”, cautioned about potential conflicts of interest private equity firms may face with respect to fees, expenses and portfolio company valuations. Mr. Bowden indicated that OCIE had “identified what we believe are violations of law or material weaknesses in controls” regarding fee collection and expense allocation in more than 50% of the examinations conducted.
- It is not just regulators taking note – investors are demanding more information from their private equity managers regarding fees and expenses.
- Private equity firms must review fund disclosures and ensure that investors are fully aware of all fund charges. The SEC has expressed concern that, although direct private equity investors are sophisticated investors, there is a good deal of indirect retail investor exposure to the asset class via pension funds. There is no regulation per se regarding private equity fees, barring restrictions on charging carried interest to investors who do not meet certain high-net-worth thresholds. As such, there is flexibility as to what private equity managers can charge to a fund, providing this is transparent and disclosed to investors.
- In focusing on this issue, the SEC has demonstrated robustness when dealing with firms it believes may have breached their fiduciary duties by, among other things, charging inappropriate expenses to investors, providing insufficient transparency as to fees, or misallocating expenses from broken deals. The presenter discussed recent SEC settlements involving private equity firms – in some instances involving fines of millions of dollars.
- While the SEC recently indicated that it has seen improvements in disclosure, it is critical that private equity firms do not lose sight of their transparency obligations – and, in fact, such firms have been disclosing more in-depth fee information to investors. Fee disclosure is likely to be a focus of regulators going forward.
The OECD BEPS Action Plan: A Sleeping Time Bomb for Private Equity?
Base Erosion and Profit Shifting (BEPS) – an initiative spearheaded by the Organisation of Economic Co-operation and Development (OECD) to clamp down on tax avoidance schemes adopted by multinational corporations – could have a huge impact on the private equity industry and its operations, even though the fund management industry was not the primary target of BEPS. The drive to implement BEPS (a 15-point action plan) has gathered momentum, and the BEPS package will be presented to finance ministers of the G20 in October 2015 in Lima, Peru. It is anticipated the action plan will be finalised in December 2015, with BEPS implementation occurring in either 2016 or 2017. Some of the discussion points are noted below:
- Action 6 of the 15-point action plan is of particular concern. It aims to prevent treaty shopping or treaty abuse, whereby taxpayers seek to take advantage of bilateral tax treaties in order to lower their taxes. Action 6 would curtail treaty shopping through its Limitation on Benefits (LOB) and main purpose provisions – this could have major ramifications for private equity, particularly those firms managing funds that have established treaty-eligible subsidiaries domiciled in tax-efficient jurisdictions. A financial institution (such as a private equity fund) might set up an entity or structure in a low-tax jurisdiction (such as Luxembourg or the Netherlands) without a link to, or little relation with, either: the investors; or the jurisdiction in which investments are made. Under BEPS, structuring an entity in such a manner could be deemed to be inappropriate treaty shopping. As such, private equity firms may need to reconsider how their investment structures operate going forward, so as to comply with BEPS.
- Any fund that has reduced withholding tax on income or dividends through the use of a treaty-eligible company based in a tax-efficient jurisdiction could be impacted under BEPS. Many private equity funds structure their investment vehicles in tax-neutral jurisdictions, as their underlying investors are often global. It is essential that fund managers ensure they have a meaningful presence in jurisdictions where they have structured their treaty-eligible fund entities.
- A further tax initiative – also OECD-led – is the Common Reporting Standard (CRS). CRS, which involves the automatic exchange of tax information among more than 50 jurisdictions, will create a significant challenge for fund administrators and managers as it is a huge data-gathering exercise. CRS will require participating jurisdictions to obtain information regarding accountholders from financial institutions, and to share this data with other signatory jurisdictions. CRS is modelled on the US Foreign Account Tax Compliance Act (FATCA), and its UK equivalent – the so-called “Son of FATCA” – and may prove to be exceptionally bureaucratic for managers, requiring them to liaise with fund administrators and other third parties.
- Meanwhile, the Directive on Administrative Co-operation 2 (DAC2) will come into force at the beginning of 2016. This Directive requires the automatic exchange of information by Member States with respect to all cross-border EU tax rulings. While the Automatic Exchange of Information already requires EU countries to do so, the latter is not rigorously enforced and Member States have been selective about what they disclose. Member States will now be obliged to share, on a quarterly basis and in a standardised format, any cross-border tax rulings.
- Other localised tax measures include the UK’s proposals to effectively increase the rate of tax on carried interest to at least the 28% capital gains tax rate, by abolishing so called “base cost shift”. This proposal would have a major impact on private equity and some hedge fund managers. Recent UK rules have also prevented management fees from being treated as capital gains through profit sharing and other arrangements, and such fees are now taxed as income. One fund manager COO indicated that these changes could make the UK a less attractive place for private equity to operate. However, it was also acknowledged that certain EU jurisdictions tax managers at much higher rates.