Who’s Who Legal brings together Patricia Volhard at Debevoise & Plimpton, Maya Issacharov at Amit, Pollak, Matalon & Co and Phil Bartram at Travers Smith to discuss issues facing private funds lawyers and their clients in the industry today, including the regulation of funds, fund formation and the choice between “onshore” and “offshore” jurisdictions.
Patricia Volhard: It is not so much a question of more or less regulation. It is more a question of poor versus good regulation. Regulation should be positive both for the regulated industry as well as the investors if it is clear and well tailored for the sector. Conversely, if regulation is conceived of too broadly and without enough thought given to its application in specific sectors, it can have a negative effect. For example, the private equity industry has been regulated in the UK for a long time, in contrast to some other EU member states, but that regulation hasn’t made it any less attractive as a sector. Indeed, private equity in the UK could be seen to have flourished precisely because of that well-thought-out and well-implemented regulatory environment. MIFID II seems a regulation that triggers many questions as to how it should be applied for private equity managers – for example, regarding disclosure of fees and charges and taping, and without guidance by ESMA it will be the source of incredible legal uncertainty for both investors and fund sponsors. Another source of legal uncertainty in Europe is the inconsistent application and interpretation of EU law. Hence, a consistent application monitored through a strong EU regulator which has sufficient know-how and expertise to give guidance and help the industry to apply the new rules, could be a positive development.
Maya Issacharov: Financial regulation generally serves to maintain financial stability and market confidence, to protect investors and reduce financial crime. A regulatory regime that takes these important objectives into account, but also provides well-crafted exemptions from full compliance is likely to strike the best balance. Israel, for example, maintains a regulatory regime that provides a full exemption for funds targeting only qualified investors and/or a small number of investors. This approach allows funds to lower organisational and compliance costs and to quickly and easily access the market, thus increasing healthy competition in the market and encouraging emerging managers. While, in my opinion, additional regulatory burden is generally not necessary, it is important for regulators to update and adjust existing rules and regulations to properly address and permit new financial products and technologies, such as the blockchain initial coin offerings (ICOs). Start-up companies of late have been raising extraordinary amounts of money through ICOs, all while the legal and regulatory framework of the ICOs and the issued “tokens” is still unclear. The uncertainty is damaging to this emerging technology.
Phil Bartram: Properly targeted regulation is great. I applaud the SEC’s work on clear disclosure of fees and costs, for example. The jury is still out, but the various transparency requirements of MiFID II have the potential to make markets more efficient and to improve investors’ returns. If that happens, investors may have more confidence to invest and they may do so through funds, which is in the industry’s long term interests. The FCA’s proposals to extend the Senior Managers and Certification Regime to all UK firms is another example of regulation done right.
The trouble is that regulation is so often poorly targeted and lacks rigorous cost-benefit analysis. This is particularly the case in Europe (including the UK), where blockbuster, or portmanteau, legislation such as AIFMD or MiFID II tries to deal with multiple markets, multiple market actors and various public policy fears, all in one go. Barely has one law been implemented than the next is on its way. I respect the fact that radical changes needed to be made following the crisis but now I think politicians ought to let regulators have some breathing space, to get down to the nitty-gritty, using the powers they already have.
Patricia Volhard: I fully agree with Phil that success is generally conceived differently depending on the side you stand on. But the overarching consensus should always be that a successful fund is a fund in which both sides feel that they’ve had success. We see that terms negotiations continue to be a “tale of two cities”, with established fund sponsors coming to market with strong prior fund performance able to achieve considerably better results in relatively quick fund-raises, compared with first-time fund sponsors with little track record and established fund sponsors with weaker prior fund performance. Nonetheless, as European fundraising markets have recovered following the global financial crisis, fund terms negotiations have become increasingly balanced between LPs and GPs, with fund sponsors clawing back negotiating leverage from the very LP-favourable market that prevailed in the immediate aftermath of the global financial crisis. Being able to structure balanced fund terms, which both sides feel are beneficial to them, requires a blend of commercial expertise and deep knowledge of the ever-changing legal, regulatory and tax regimes to which private equity firms are subject and is in my view one of the key aspects that will in the end define whether or not LPs and GPs view the fund as a success. Fund formation has therefore become a long-term success factor, besides other important factors such as investment strategy, economic trends, etc.
Maya Issacharov: It is very important. Formation includes, among things, the determination of the investment scope in a manner that takes into account market trends and investor preferences, the ability to reach and raise the requisite investment amount from investors, while taking into account investors’ strategic contribution to the fund and its brand. The negotiation of the investment terms must be focused on closing the investments in the short term, while also bearing in mind that the result of negotiations with the investors will last for the duration of the fund and potentially also impact successor funds. The crafting of the individual managers’ roles in the fund and establishing effective economic incentives with a view towards achieving a stable and long-lasting relationship is also a key process in the initial formation of a fund. Finally, the initial formation must balance tax structuring of the fund to make it attractive for potential investors while maximising the managers’ tax results and of course the proper navigation of the regulatory maze to avoid pitfalls that, in some cases, may result in dire consequences for the fund and even the managers on a personal level.
Phil Bartram: How do you define success? Limited partners and general partners might think of different things.
An LP will define success as high-risk-adjusted returns, which depend mainly on the investment policy. The fund structure must not create a drag on those returns. Tax transparency is absolutely vital. Since the financial crisis, tax law has ballooned: BEPS/ATAD, FATCA/CRS, disguised employment, tax on carry, etc. The structure of the fund, including any holding vehicles, needs to put the manager in the best possible position to avoid tax charges in an uncertain and fast-changing fiscal environment. The simplicity and efficiency of a fund is also important. If there are high frictional costs in running a complicated structure that will be material to returns on some strategies, such as CLO CMV products for example.
A GP would regard itself as successful if its next closed-end fund were oversubscribed, or if it managed to grow AUM across strategies. The key factors to successful fund raising remain a good track record and a favourable market (such as we have had recently as investors search desperately for yield). Being lucky is also very important! Legal structuring comes some way down the list. However, investor regulation – capital or solvency charges associated with particular structures – will affect investors willingness to invest, so the GP must get that right. Saving a few dollars by designing a fund which can be marketed efficiently (for example, without paying multiple high-registration fees in numerous countries) will not hurt.
Patricia Volhard: I think traditional private investment funds still generally provide all facilities that investors require, provided they are willing to adapt to the market environment. We are, for example, seeing that investor requests on “softer” issues (ESG, reporting, excuse, etc) are becoming more detailed and nuanced as a consequence of their own more detailed and nuanced internal policies and procedures and greater focus on transparency issues. It is difficult for fund sponsors to resist these requests (and, in many cases, they are considered “easy gives” from the fund sponsor’s perspective because the requests don’t directly impact the economics) but it is also very important that the traditional private equity fund sponsor understands how acceding to these requests may impact the ongoing operation of the fund.
Where “traditional” smaller private investment fund firms with limited personnel capacities may struggle is the ever-growing importance of the location of the fund vehicle and the manager and the extent to which they can comply with regulatory requirements, both from marketing and investment perspectives. It remains to be seen whether smaller private investment fund firms will still be able to meet such ever-growing expectations of investors in the long-run.
Maya Issacharov: Apart from investors’ general concerns regarding performance and market conditions, investors are increasingly concerned with the fee structure. Investors are also looking for access to a wider range of opportunities and for a better alignment of interests with the managers. These fee and access issues have been partially addressed by the creation of separate accounts and mandates, tailored for the specific needs of particular investors and charging lower fees. Another similar solution is the provision of co-investment opportunities by the funds, on a case-by-case basis, or through dedicated “overage funds”. The emergence of new technologies and investment models based on artificial intelligence and the blockchain technology (which still has significant scaling challenges) has the potential of transforming the way funds will raise money and make investments and will likely also affect the fee structure.
Phil Bartram: While some of the largest investors would love to avoid paying the manager his or her fees and carry, and a small number are already capable direct investors, I think the outlook is pretty bright for managers of traditional funds. There will continue to be a very important place for flagship blind pool funds, particularly in illiquid strategies such as leveraged buyout, or infrastructure. The benefits of being able to write big cheques, while still diversifying exposures, remain obvious.
Fund structures are always evolving to reflect changing circumstances, for example achieving greater transparency on fees and costs.
There will be variations on the closed-end fund theme, such as funds with much longer investment periods, or funds which pursue co-investment strategies. These will all be part of the rich tapestry, alongside funds-of-one and separately managed accounts at the more liquid end. In the liquid world, the rise of the ETF is fascinating, but I don’t think they will displace traditional actively managed funds entirely.
Maya Issacharov: I believe that fund closures will increase for as long as the low-interest-rate policy around the world continues. However, high valuations and fierce competition on deal flow pose major challenges for private equity and venture capital funds. Hedge funds are recovering after a period of low returns and real estate and infrastructure funds are attracting more attention, given their relatively high returns and specific characteristics.
Phil Bartram: With one or two exceptions, the recent closures have been hedge funds. For hedge, a lot will depend on macroeconomic factors, for example whether asset classes finally become less correlated and whether some bubbles start to burst. I understand that equity long-short funds are having a strong year.
Patricia Volhard: It still matters, as many investors care about the fund vehicle being based in an EEA member state for regulatory reasons. For example, from a Solvency II perspective it is more interesting for an investor if a private equity fund is located in the EEA. At the same time, the flexibility of fund vehicles and infrastructure of service providers (depositaries etc) is also important. Also, marketing rules are constantly evolving as various international jurisdictions develop more tailored rules regarding the offering of private fund interests. Depending upon the jurisdiction and the manner of marketing and also the investor types that are being approached, it may be advantageous to go the on-or offshore route. Some jurisdictions permit also marketing to so-called semi-professionals) which includes high-net-worth individuals who do not necessarily qualify as professionals) under the EU passport regime but not under the NPPR. In certain jurisdiction a NPPR is not even available.
Brexit will also play an important role in answering this question as it will inevitably change the trade and regulatory landscape in Europe and the impacts on funds and their sponsors as well as portfolio companies could be significant.
Maya Issacharov: Certain “offshore” jurisdictions are going out of their way to address industry needs, in terms of offering various types of legal entities, updating the legislation to account for changes in the way of doing business, providing quick and efficient registration options, as well as maintaining quick and efficient court systems for dispute resolution. Those jurisdictions are also taking steps to reduce and eliminate tax evasion (for example by enforcing FATCA and CRS). The aforesaid, combined with the tax neutrality offered by those jurisdictions, makes them superior to many “onshore” jurisdictions. However, the desirability of ultimately investing through them depends on the investor’s home jurisdiction, which may sometimes provide tax incentives for “onshore” investment with disincentives for “offshore” investment.
Phil Bartram: Many of the onshore jurisdictions have developed their tax and regulatory rules and improved the flexibility of their corporate and partnership laws such that locating a PE fund offshore is less effective as a means to avoid or reduce regulatory and tax burdens, or increase structuring and operating flexibility. Onshore, some wrinkles do remain though, for example with VAT on the management fee in some countries.
The big factor now is substance, which is required both for regulatory and for tax reasons, particularly in light of the BEPS treaty-shopping rules. When a team comes to us looking to structure a fund, we start with the question: where are your people? It is expensive to create substance – either onshore or offshore – where you don’t have it naturally. Lots of houses will therefore double-down on their historical approach.
We do see some investors sniffy about investing offshore, but they are the minority and to date it remains possible to navigate global securities marketing laws pretty well from the Channel Islands, say.