The growth and greater maturity of the venture capital and private equity markets in Europe over the last few years have given rise to funds which increasingly invest across Europe and which have also raised funds from investors across Europe. In contrast, fiscal harmonisation within the EU is still a long way from being achieved, and recently reality has imposed itself on EU thinking so that it has been dropped as an immediate goal.
We have seen a number of pan-European fund structures. These funds have, with varying degrees of success, sought to maximise tax efficiency so as to maximise, in turn, returns to investors. In other words, not surprisingly, private equity houses have not been waiting around for EU-wide tax harmonisation, but have been doing their own financial engineering and finding their own solutions to fiscal disparities across the EU.
An additional layer of complexity exists in the case of funds of funds. This is because they seek to achieve tax efficiency for their investors, while investing in a number of different investee funds, which will often have been structured to meet the needs of a different investor group to that of the fund of funds.
This article seeks to set out some of the main issues that arise when structuring a pan-European fund, based on the experience gained from projects that the Baker & McKenzie European venture capital group has worked on over the last couple of years. The article refers to private equity funds, but is in general equally applicable to venture capital funds.
When structuring a private equity fund, the fund sponsor and its legal counsel seek to achieve certain objectives so as to ensure a successful closing. There are a number of variables that are relevant to structuring any given private equity fund product, and which make fund structuring a complex discipline. The sponsor and its legal counsel would typically aim to satisfy, to the extent possible, each of the following requirements:
Marketing From a marketing viewpoint, the sponsor aims to have a product which is easy to market, and therefore one which is familiar to, and accepted in, the market. Simplicity is not in itself an overriding concern, since there are good reasons for complex structures and the market is used to them. However, it should nevertheless be a clear aim not to complicate the fund/general partner structure unnecessarily.
Few private equity fund structures do not contain some degree of risk, be it to the fund itself, groups of investors, the fund sponsor (including the owners of the management fee and carried interest) or placing agents. A well-structured fund should aim to identify such risks at an early stage and to structure the fund so as to minimise them, while disclosing any residual risks to investors. This should ensure that the fund is marketable to the sophisticated investor universe which invests in private equity funds, and also protects the sponsor against potential securities laws claims.
Fund level tax structuring: From a tax viewpoint, the principal driver behind a fund structure is tax efficiency. This will often involve the use of one or more vehicles that are fiscally transparent, from the viewpoint of investee and investor jurisdictions, as well as the jurisdiction of establishment of the fund.
There may, however, be reasons for using a non-transparent structure. One of these would be the fact that, in a transparent structure, reliance would need to be made on the applicable double taxation treaties between the investee jurisdiction and the jurisdictions where each of the investors is located, as opposed to the jurisdiction of the fund.
The overall aim is to minimise tax leakage from investee companies through to investors and to ensure that the fund and limited partners are not subject to adverse taxation in the jurisdiction of establishment of the fund, or in any investee or investor jurisdiction.
Tax structuring of carried interest: Just as, if not more, importantly, the sponsor’s legal counsel needs to discuss carefully with the principals of the management team how to maximise, through appropriate tax structuring, the management fee and carried interest returns flowing from the fund. Since the sponsor is the party driving the whole process, it is essential to analyse, at an early stage, the tax profile of each of the individuals that will ultimately participate in the carried interest. This will ensure that the part of the overall structure through which the principals receive their carried interest works for each of them.
This is often a challenging exercise, since the principals may be tax residents of different jurisdictions, which may treat their receipts of carried interest differently for tax purposes.
A challenge in this area is to seek to characterise the carried interest as a capital gain flowing from the underlying investment in the fund by the principals (who will generally, in line with industry practice, have committed their own money to the fund). This is as opposed to a performance fee, which is often taxed less favourably in the hands of the principals, wherever they may be tax resident. It is also crucial to avoid VAT on the management fee resulting in an incremental tax cost in the fund structure.
Suitability to target investor groups: The product must be suited to the tax and regulatory profiles of the target investor groups. This means identifying investor groups early and structuring for them. Baker & McKenzie has come across examples of fund sponsors who, after a successful closing in their home jurisdiction, ask for assistance in raising money in subsequent closings from investors in other jurisdictions and with tax or regulatory profiles which differ from those of existing investors. At this point, they may find that the existing structure does not work for such new investors. They would have saved themselves a lot of pain and money if they had made sure from the start that the structure was suited to all potential target investor groups (to the extent feasible and economic). This would obviate the need to set up costly parallel or feeder structures later.
Important investor groups that will have a significant effect on the fund’s structure include tax exempt investors, including ERISA investors, and German investors. Although the latter’s needs, at least as far as German corporate investors are concerned, are less determinative of the overall fund structure since the changes to German tax law was introduced at the beginning of 2001.
Limited liability of investors: It is obviously essential to have a vehicle where the liability of investors in respect of the fund’s obligations is limited to the amount of their investment. This means that if a limited partnership is used the fund’s legal counsel must ensure that the fund’s documentation is drafted in accordance with the parameters required for limited liability of investors (and issue an opinion to that effect). And the manager must ensure that those parameters are respected in relation to the operation of the fund over its life. An example of this in common law jurisdictions is ensuring that limited partners act as passive partners and do not take part in the management of the fund.
Securities laws issues: From a securities laws viewpoint, the sponsor must ensure that the offering of the fund in each of the target jurisdictions does not trigger a public offering. Authorisation issues which arise out of the offering activities of the fund sponsor into the target jurisdictions must also be addressed; in the US this also extends to the activities of the fund itself under the Investment Company Act of 1940, as amended.
ERISA: Finally, if ERISA investors are likely to be a target investor group, whether at the first or at subsequent closings, the fund sponsor must ensure that the fund avoids regulation under ERISA. This will require certain practical steps to be taken and reflected in the fund’s documentation.
Commonly used structures
Two commonly used structures, which are tax efficient for certain major investor groups and which are discussed below, are (i) Netherlands CVs and BVs investing in parallel; and (ii) Delaware limited partnerships.
It should be noted that the discussion below is not designed to be an exhaustive one; pan-European private equity funds are highly structured products. However, the discussion below seeks to identify some of the main issues and so give an overview of the challenges fund sponsors face in structuring a pan-European private equity fund.
Netherlands Parallel CV and BV: There have been many funds, promoted by Benelux sponsors as well other EU sponsors for whom the Netherlands is a convenient jurisdiction, which have been structured as Netherlands CVs and BVs investing in parallel.
CV: A CV (commanditaire vennootschap) is akin to a common law limited partnership and, provided certain conditions are met, will be considered tax transparent in the Netherlands, as well as in certain other key jurisdictions where important investor groups are located. Where a CV is deemed tax transparent in the Netherlands, this effectively means that it does not have a taxable presence in the Netherlands. CVs will also be generally structured such that they will not result in a Netherlands taxable presence for investors.
BV: A BV is a limited company, so that it is generally non-transparent (subject to the ability of US investors to “check the box” so as to achieve effective transparency for it from a US tax perspective). Investors may generally only receive returns from the fund’s investment programme through repayment of share premium or through dividends distributed by the company.
CV & BV comparisons
There are various pros and cons in choosing whether to go into a CV or a BV in this structure. From a fund sponsor’s perspective, a CV provides more flexibility in that, as a contractual arrangement, it gives room to negotiate with the limited partners the provisions of the Limited Partnership Agreement. At the same time it is free from the constraints of corporate law that are imposed by a corporate structure, which has to comply with company law requirements.
Also, a CV is preferable for those investors for whom fiscal transparency results in a more favourable tax treatment of their returns. An example is Swiss individual investors who are an important investor group in the Swiss fund of funds industry. Their returns arising from capital gains on direct investments in the investee companies of the fund would generally be tax free (provided that the gains qualify as private, as opposed to professional, capital gains) whereas returns received as dividends from a corporate fund entity would be subject to income tax.
A BV is a structure which is favoured by many EU and other institutional investors in that, provided that it is structured appropriately, there should be no foreign or Netherlands taxation of the capital gains it realises on its investments, nor should there be any withholding taxes on distributions by it to investors outside the Netherlands.
It should, however, be noted that the Netherlands, in common with other civil law jurisdictions such as Luxembourg and Belgium, which are often used in fund structures, imposes capital duty on the issue of shares. While this has decreased to 0.55 per cent since January 1, 2001, it still results in a tax leakage of that amount in total returns to investors.
Delaware Limited Partnership
Another commonly used vehicle is a Delaware limited partnership. This may be used by European private equity houses, who will often use it as a vehicle for investment by US investors into their funds (in parallel with European vehicles). Also, it may be used by US houses raising funds from European investors.
A Delaware limited partnership has a number of advantages which make it a very suitable structure for a private equity fund, hardly surprising given that it is one of the most commonly used structures for this purpose in the US. In line with other non-corporate vehicles, it enjoys the advantages of being a contractual arrangement, whose terms may be freely altered to suit the deal, without the constraints of company law requirements for example, as to share capital.
It is also very easy and quick to establish it is possible to have a Delaware limited partnership established within two hours and it is not necessary to have to have finalised the Limited Partnership Agreement in order to do so this may be filed later.
The US is perhaps the most highly regulated jurisdiction in the world, both from a legal and a tax viewpoint, or at least it is perceived to be. Consequently, European fund sponsors are sometimes concerned at the potential burden of administering a Delaware limited partnership, and that the fund may be subject to US taxation by virtue of being established there.
European investors may be concerned that, if they adhere to a Delaware limited partnership, they will be required to make lengthy filings to the Internal Revenue Service which, apart from bringing them within the net of the IRS, will be costly to prepare. The administrative burden, at least for the fund and its non-US investors, may perhaps not be seen as excessive. The partnership will have to file an annual partnership return, which would include schedules identifying its immediate owners (the partners) and their distributive shares of partnership income. The maintenance costs are low.
It is generally reasonably straightforward to ensure that the activities conducted by the partnership are not considered to be a trade or business in the US. As a result, the partners should not be required to file a federal income tax return by reason of their interests in the partnership. However, a Delaware limited partnership may not be a suitable investment vehicle for all European investors.
One example is French investors. France will tax returns allocable to French resident limited partners in accordance with French domestic law. First it is determined to which type of French partnership the Delaware limited partnership may be assimilated (this will generally be a societe en commandite simple) and, on that basis, the tax regime applicable to its partners. This may, in turn (depending on a number of factors) make the investment unattractive for French investors (other than French tax exempt investors, for whom it will not make a difference).
Another example is Netherlands investors with more than a five per cent interest in the fund, for whom a Delaware limited partnership, in common with other transparent structures, may prevent them from utilising the participation exemption, which may otherwise be available to exempt from Netherlands taxation returns from the fund.
A Delaware partnership may also have drawbacks for US investors investing in Europe, since investee companies in which the fund owns a majority stake may be deemed to be controlled foreign corporations for US tax purposes, which may have adverse tax consequences for US investors in the fund. On the other hand, a Delaware limited partnership will be a suitable vehicle for most types of English investors and will generally be suitable for tax exempt investors, such as pension funds.
This article touches on some of the main issues encountered when structuring and marketing a pan-European private equity fund. Since this is such a structured product, except for the most plain vanilla project, it will generally be possible to come up with an optimal structure only once the fund sponsor and its counsel have had a detailed discussion of the fund’s intended investment programme and target investor groups. Provided they spend time doing this at the outset, it will smooth the way for the pre-marketing process. And in this area, like in so much else in life, simple may in fact be best.