Private Funds 2019: Discussion

Who’s Who Legal brings together Gilles Dusemon at Arendt & Medernach and Iain McMurdo at Maples and Calder to discuss issues facing private funds lawyers and their clients in the industry today.

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What is the most significant trend from your jurisdiction over the past 12 months?

Gilles Dusemon: Brexit-related work is clearly shaping the agenda – there has been a very significant increase for fund formation across multiple asset classes (private equity, venture capital, real estate, debt/credit and infrastructure in particular) linked to the requirement to find appropriate alternative investment management solutions for the same products. At the same time, distribution-related structuring topics have moved to the forefront since the new products also need to be marketed. The impact of Brexit is clearly going beyond London-based managers since US sponsors are also converging towards Luxembourg-based investment fund and management solutions.

The acceleration towards Luxembourg-based investment management and fund solutions is such that the funds of funds sector is increasingly interacting with both investors and target funds being located in the same jurisdiction, hence lowering distribution hurdles.

Iain McMurdo: The nature, scope and volume of matters being undertaken in the Cayman Islands across the entire funds market spectrum makes it difficult to point to one specific significant trend.

There are many but they are all linked together by a singular overarching theme; the nature of offshore practice has become more complex, involved and multi-jurisdictional due to onshore and global developments, including US tax reform; more complicated and, at times conflicting, regulatory frameworks; nascent technologies; and a mature funds industry.

We have responded by building our practice groups, specialist expertise and thought leadership initiatives to help steer clients through the legal and operational consequences of these developments, whether it’s embracing new technologies or asset classes, such as crypto-assets, addressing compliance, regulatory and reporting obligations or the challenges which arise throughout a fund’s life-cycle, such as managing conflicts when liquidity is sought at the end of a fund’s term.

What types of investment vehicles are most popular at present and why?

Gilles Dusemon: While Luxembourg special limited partnerships (SCSp or SLP) stand out, the Luxembourg structuring toolbox allows many more legal and regulatory combinations for international investors and investments alike. In the context of an evolving and changing tax environment in many key jurisdictions, eg, France and Germany, the types of investment vehicles thus also evolve towards other regimes, such as the regulated specialised investment funds (SIF/FIS) of the common funds (FCP).

Iain McMurdo: The most popular Cayman-domiciled vehicles by which to structure investment vehicles are: exempted limited partnerships; exempted companies; and limited liability companies.

The Cayman Islands limited liability company, similar to the Delaware variant, was introduced in mid-2016. There have been almost 2,000 Cayman Islands LLCs registered since then.

The popularity of exempted companies and exempted limited partnerships has been unaffected by the introduction of LLCs. Over 2018, formation levels for both exempted companies and exempted limited partnerships are up approximately 40 per cent year-on-year. Based on activity to date, we anticipate over 5,000 exempted limited partnerships will be registered in 2018.

Unless a tax blocker is required, primary fund and parallel vehicles, AIVs and holding vehicles are typically formed as exempted limited partnerships. For funds industry purposes, the ability to provide symmetry with equivalent onshore vehicles – notably Delaware, the Cayman Islands and Luxembourg partnership-type vehicles – in onshore-offshore fund structures can lead to greater ease and cost efficiency of fund administration, pass-through tax treatment and has helped to better align the rights of investors between the different vehicles in the structure.

Offshore feeder funds, in a hedge fund master/feeder structure, remain structured as an exempted company for the benefit of US tax-exempt or non-US investors. The features of an exempted company, being a corporate vehicle with separate legal personality, also lead to these vehicles being commonly used to act as general partner, manager or blocker or holding vehicles.

Cayman Islands LLCs are being increasingly employed in private equity and other closed-ended structures.

The LLC has been an appealing alternative for general partner, upper tier, manager and co-investment vehicles. The absence of share capital (and the absence of the need to maintain a share register), combined with the ability to intuitively track and record the capitalisation of an LLC and its distributions, has also led to LLCs being attractive for blocker, aggregator and holding vehicle applications. As a member is not required to make a contribution but may benefit from profit allocations, the LLC has been adopted for certain employee award and grant schemes.

What effect is the increasing regulatory focus on transparency having on the funds market at the moment?

Gilles Dusemon: The increased regulatory focus on transparency is not a new trend for Luxembourg-based investment funds. Since Luxembourg alternative investment funds have a long-standing tradition as CSSF-regulated alternative investment funds, the regulatory focus on transparency is not new. Hence the concept and its application have always been on the agenda and the current focus translates into a more granular approach building upon past practice while making sure that adjustments happen if and when needed.

Iain McMurdo: Sponsors are very focused on fair disclosure in light of various enforcement actions, particularly with respect to fees and conflicts of interest matters.

At the establishment stage, this is reflected in longer and more detailed disclosures in offering and constitutional documents. By way of example, as to what costs will be allocated to the fund as fund expenses as opposed to incurred by the manager.

Given the regulatory framework is evolving quickly and becoming more complex, we are seeing an increasing number of sponsors look to outsource compliance functions, such as AML/KYC verification and tax-transparency reporting obligations, to third-party specialists who can keep pace with the fast-changing nature of global regulation. This allows managers to dedicate more resources to their core investment-focused activities.

During a fund’s life cycle, sponsors are involved in an ongoing dialogue with investors and advisory boards to ensure conflicts are fairly disclosed.

The scope for conflicts can be particularly acute at the end of a fund’s life, for example where liquidity is sought, or value optimised, by way of a GP-led secondary transaction or a term extension.

In those instances, a sponsor may receive new material information in the midst of an LP consent process or prior to a deal being consummated which needs to be disclosed to ensure investors are treated fairly and able to make an informed decision based on updated information.

What role do you see for crypto currencies in the funds space moving forward?

Gilles Dusemon: This remains a very difficult topic due to the lack of regulatory guidance other than risk warnings. While there is regular and continuous interest from managers and investors alike, the servicing hurdles and legal and regulatory uncertainties operate as barriers to entry. It should nevertheless only be a question of time before the (servicing) value chain can be established in full.

Iain McMurdo: We have established a number of alternative investment funds whose investment strategy has either permitted or entirely focused on higher potential crypto-assets, including underlying blockchain technology.

As an asset class, crypto-currencies have a role to play in so far as their volatility and comparatively low correlation to other more traditional asset classes has an appeal for managers looking to structure a diversified portfolio which can improve overall investor returns.

There are, however, a number of challenges within the existing regulatory framework which need to be addressed if crypto-assets, including crypto-currencies, are to break through and play a more substantial role in the funds space.

There is currently a dearth of quality regulated custody solutions. Few broker-dealers, banks or qualified custodians have yet ventured into crypto-asset custody services although the position could change quite quickly. Their role is particularly important given crypto-assets are analogous to digital bearer securities.

Beyond usual KYC/AML protocols, the ownership history of crypto-assets is important to verify to ensure they have not been tainted before being contributed to, or otherwise acquired by, a fund. Auditors can play an important role in this respect.

Beyond an asset class, it is difficult to see crypto-currencies playing a significant role in the funds space unless currency is digitised on a blockchain by governments with effect that it ends up with fiat status.

In your opinion, how competitive is the legal market currently?

Gilles Dusemon: The market is evolving competitively – the close cooperation between local firms and internal fund formation counsel against the background of an influx of new firms into the market and the relatively stable footprint of international firms established locally means that competition for talent has intensified.

Iain McMurdo: The legal market is very competitive across all the jurisdictions in which we practice.

In response to this, we focus on our clients’ challenges, their requirements for legal services and other complementary services that we offer. Many of our clients have developed a deep relationship with the Maples group. They value our ability to partner with them across our global network, our proven and long-standing commitment to our legal, corporate administration, fund administration and fiduciary service lines while sharing a common approach to risk management and data security. We have become trusted advisers to our clients who value our experience and breadth of expertise.

We are constantly developing our business to align with market developments and client demand. By way of recent example, we have just extended our legal service offering to Luxembourg where we have had a fiduciary and corporate administration presence for over 10 years.

This has been primarily driven by North American and European manager clients who have enjoyed working with Maples in other jurisdictions and have requested we expand our jurisdictional reach as Luxembourg is highly complementary to our existing British Virgin Islands, Cayman Islands, Irish and Jersey capabilities.

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