Structuring an Investment: Legal, Business and Tax Issues from a Private Equity Fund Investor’s Perspective
The Malaysian Venture Capital and Private Equity Development Council is seeking to accelerate the prominence of the private equity (“PE“) industry, given the positive overall outlook for the Malaysian capital market1. PE activities (attracting investable funds) contribute to economic growth and the wider business climate by propelling increased productivity and greater product innovation. The PE sector in Malaysia is still in the burgeoning stages, with steady growth potential in the country’s private investments market. According to the Securities Commission, the registered PE corporations in Malaysia recorded a 261% increase in committed funds – from RM205 million in 2015 to RM714 million at the end of 2016.
PE investment raises and pools capital from high-net-worth parties, which is then invested into primarily private companies (or taking companies private from public stock exchanges, if initially publicly listed). Once equity ownership is acquired in the company, fund managers streamline the company’s operations with the view of long-term capital appreciation and selling the portfolio companies for profit. PE represents mostly buyouts; investments in larger and more mature companies that use significant amount of debt financing. PE firms quest for highly synergistic strategies in the funds that they manage for the greatest returns to its investors. Investors strive for higher returns and a worthwhile, attractive investment in consideration for the higher risk in terms of long lock-up periods, lack of liquidity of PE investments and their inability to exit when desired. PE fund investors should consider the business, legal and tax issues when structuring an investment.
1. FUND STRUCTURE
In contrast to hedge funds that focus on short-term quick profit on marketable securities like derivatives and commodities, PE funds invest in companies that may focus on a particular industry sector and are close-ended. Typically, the holding period of a portfolio company is 10-12 years, which may be extended for a further 1-2 years particularly if a fund is going through a difficult period. There may be 5–8 investments during this investment tenure. Investors are unable to withdraw their investments so this structure is suitable for patient investors who can afford to lock up their capital for that charter life and look at the longer-term perspective/potential of portfolio companies.
Legal Structure
Virtually all PE funds are structured as limited partnerships, with PE firms serving as general partner (“GP”) that raises capital from limited partners (“LP”) into the fund. GPs perform the day-to-day operational/administrative duties and could be, but not necessarily, the fund manager. LPs are passive investors including institutional investors like pension funds, or family offices. PE funds are primarily open to sophisticated investors rather than retail investors. Although previously there were substantial entry requirements in PE funds in Malaysia with high initial commitment, i.e. RM 3 – 5 million, the minimum investment has since been reduced to a more affordable rate of RM 50,000. LPs are only liable for the investments they put into the fund, whereas the GP has unlimited liability for the actions of the fund.
Funds are established under a Limited Partnership Agreement (“LPA”) signed at the funds’ inception, governing its investment mandate. The GP has significant discretion to make investments.
The Commitment Period
The PE fund raises capital for a certain period of time (“capital raising period”), usually 12 – 18 months, after which the fund is closed to new investors after the initial closing. The first 5 years of the fund’s life is known as the “investment period”. During this time, the GP conducts due diligence and evaluates potential investments. This is followed by the “harvest period”, which is the remainder of the fund’s existence and once initial investments have been made. Typically, no new investments can be made once the investment period has expired, though additional investments in the existing portfolio companies are possible. The harvest period is when the fund fuels the expansion of the portfolio. The GP will help restructure the investee company and develop strategies to enhance its profitability.
This is also the period where the fund return proceeds from investments, though some PE funds have the ability to ‘recycle’ the distribution proceeds whereby they reinvest the proceeds realized on the investments into new portfolio companies. Investors can negotiate the timing or percentage limitations on recycling of capital commitment. From a liquidity perspective, this may be undesirable for investors because recycling will further extend an investor’s investment period. In contrast, hedge funds do not have such recycling provisions (as there are no capital calls).
Committed Capital, Drawdown and Capital Call Defaults
The GP issues calls for capital from the LPs and the LP is required to make a series of capital contribution over the fund’s life when and as needed. However, unpredictable events could occur during this period where investors may be unable to satisfy that commitment. The capital to be paid is drawn down incrementally upon notice period. Sometimes, the GP co-invest (typically 2-5%) to exemplify an alignment of interest with the LPs. In contrast, hedge funds, which invests in public equities, draws down 100% of an investor’s capital at the time of subscription – an up-front contribution. Investors must be cognizant and evaluate default provisions as LPAs often contain onerous penalty clauses against defaulting investors such as such as rescinding the defaulted capital call, charging default interest or requiring the other investors to cover for the defaulting investor’s shortfalls through additional capital. It is therefore imperative for investors to evaluate the fund’s default provisions and defaulting risks to avoid potentially risking losing all the capital they have invested into the fund.
For example, a clause in a partnership agreement may stipulate that an LP who is in default for failing to contribute the called up capital may have a certain period from the date of delivery of the capital call notice in which to cure that default. This may be by contributing his share of the called up capital and must also pay the non-defaulting LPs, in proportion to their percentage interests in profits and losses. This could be an amount equal to perhaps six percent (6%) per annum of the defaulting LPs called up capital for the duration in which he has failed to honour such called up capital – as liquidated damages.
Furthermore, the GP often reserves the right to terminate the defaulting investor’s right to contribute to subsequent capital and buy out the investor’s interest. Other common default provisions include requiring an investor to forfeit its interest in the fund – some investors are required to forfeit 100% of its interest while others may be subjected to a forfeiture rate of around 20-50%.
GPs may also call for the defaulting investor’s entire commitment (i.e. an accelerated capital call), reserving the right to withhold all future distributions that would otherwise be payable to the defaulting investor.
Payment Structure, Remuneration of Fund Managers, Carried Interest
Key legal provisions that investors should consider are fees and expenses. The fund’s disclosure documents (prospectus or info memo listing down the parameters and pertinent info on investment targets and strategy) should disclose how expenses are distributed. GPs receive management fees – typically 2% of the total committed capital of the fund paid in advance per Quarterly Period on an annualized basis. The GPs will receive this fee even no accomplishments were made. Additionally, a performance fee/percentage of the excess profits above the Capital Commitment (“carried interest/carry”) is paid to incentivize the GPs. A majority of funds use 20% as their carry level. Critiques of PE pointed out that the way the carry incentivize the GP is skewed and excessive, including Warren Buffet, who said, “it’s a lopsided system whereby 2% of your principal is paid each year to the manager even if he accomplishes nothing- or, for that matter, loses you a bundle – and additionally 20% of your profit is paid to him if he succeeds…” However, this also allows GPs to take risks in order to maximize the transaction.
Investors receive their original investment back plus 80% of the fund’s profits; hence the term ‘80/20 Split’ (“distribution waterfall”). This compensation fee is based on a hurdle rate – the minimum rate of return to the investor (customarily 7-8% per annum). The GPs must meet the hurdle rate before collecting the carried interest, though early collection may be allowed upon a profitable exit.
Claw-Back and Key-Man Provisions
Particularly when early carry is taken, investors should demand ‘LP clawback’ provisions – a mechanism ensuring the disbursed incentive fee received by the GP shall be returned to the investor’s capital amount if, once the funds’ aggregate returns have been calculated, the return to investors is below the hurdle rate.
However, enforcement of a clawback provision is difficult especially when the GP has already invested its carry. When drafting LPAs, investors should require they receive their return before the GP receives its share of profits. Investors may require a percentage of the carry to be held in escrow, to be repaid in the event of an under-performing investment.
Another protective mechanism is incorporating a ‘key-man provision’, which suspends the investment period if a key person in the fund management team ceases involvement in the fund. If there is no qualified replacement and if investors do not vote to reinstate the investment period, the fund will be terminated.
2. RISK MANAGEMENT
Liquidity Risk
The illiquid investment nature of PE is risky. An investor’s capital is locked-up from the initial call of capital to final liquidation, which could be for as long as 12 years. In contrast, hedge funds provide for investors to redeem their interests periodically after initial lockup period. PE investors are not able to access their funds before the manager realizes the investments or withdraw their investment until all investments have been divested. This is problematic because if an investor needs to sell in difficult market periods to reduce further losses, they are unable to circumvent the liquidity risk. It is because of this illiquidity and limited maneuverability that investors expect higher returns. Whilst the secondary market may provide an early exit route by selling partnership interest to another LP to liquidate their stake, the secondary market for PE investments is still relatively small with low trading volumes and largely discounted prices. Ultimately, a transaction has to be conducted on a bilateral basis, requiring the GP’s consent. Another business issue related to illiquidity is that new investors entering the fund at later stages (subsequent to earlier capital calls) are liable for “catch-up contributions”. They have to ‘catch up’ on their share of the amount of capital that has been previously drawn. Furthermore, they are required to pay interest charge on that amount (“cost of carry contribution”) to compensate the initial investors.
Issue with Blind Pools and Excused Rights
PE funds are ‘blind pools’ – it is up to the GP to select investments and investors are usually unable to preview portfolio assets and are not permitted to opt in or out of specific investments.
This could be an issue if an investment contravenes an investor’s religious or ethical beliefs. For example, in April 2017, Japan’s legislature introduced a bill allowing integrated resorts (IR) with restricted casino floor space – a scheme to develop Japan’s tourism. This has since paved way for foreign investors vying to invest in IRs. However, Islamic-compliant investors would not be able to invest in this sector so they should engage Shari’ah advisors/firms with Shari’ah compliant investment policy to advise on investments. Some firms, such as Ekuinas, explicitly set out a negative investment list. This restricts the pool of investee companies in Malaysia.
Similarly, in Islamic finance, hedge funds are controversial fund structure. Whilst hedge funds are efficient given its liquidity, they are viewed as operating purely out of speculations/uncertainty, which is not allowed under Shari’ah. They also do not disclose using short selling strategies (borrowing stock you do not own, selling it in hopes the value of those shares will decline, then buy back those shares at a lower price in hopes to make profit),even though short selling drives down overpriced securities hence improving market efficiency. As such, investors should negotiate to include ‘excused right’ provision in an LPA or appoint an investor committee to act as a forum by monitoring investment activities.
Due Diligence
With a significant amount of discretion given to the GP, investors must mitigate losses through operational due diligence and assess the sustainability of the GP’s investment strategy. The GP’s track record is a good indication of its ability to acquire/add value to portfolio companies and to deliver good returns. A rule of thumb for investors is to see that their fund manager is a regulated entity with fund management license. This will reduce manager’s specific risk.
3. TAX ISSUES
Investors should always settle tax due diligence as they will be subject to tax attributes of fund investments. A way to minimize tax burdens is to invest in the PE fund indirectly through a flow through entity e.g. a partnership. Corporations are subject to double taxation (entity level and investor level), whilst partnerships are taxed once at investor level. PE firms with tax specialists conduct tax planning in jurisdictions that impose less tax. Investors do not want to be rendered liable to double taxation on the profits/gains where the fund and investors are based. Foreign investors are attracted to investing in Luxembourg because its taxation system exempts withholding tax, capital gain tax, income tax and wealth tax. Where most countries charge vendors up to 25% on capital gain tax, Malaysia’s tax environment is favorable in that there are no such taxes for selling businesses in Malaysia.
The most tax-efficient way to take profit share on exit is for funds to structure investments through blocker corporates. Feeder funds, for example, are special purpose vehicles (SPVs) structured as ‘blockers’ for tax purposes and are corporate taxpayers for income tax so investors do not receive direct distributions of fund income. The feeder fund invests directly in the fund as an LP, allowing the GP to manage the aggregation of investors’ capital, particularly where investors are from various tax regimes. It may be necessary to set up a SPV where investments are to be leveraged by borrowings, as this will affect the investors’ tax position. An advantage of offshore funds is when the company is being sold; the buyer does not have to pay stamp duty. Some funds have a specific geographic limitation to a region/country instead of a globalized strategy as investors may not want to be subjected to increased tax liability or be obliged to file a tax return in a foreign jurisdiction. Nevertheless, investors should still comply with the tax requirements in their own jurisdictions.
4. HARVESTING AND EXIT STRATEGY
After the fund buys out a majority stake in an investee company, it focuses on growing the company (“harvesting phase”). The GP may bring in a new management team to operate, strategize and manage the company. Restructuring the company will enhance its value by improving cash flow and increasing margins to generate higher returns. Subsequently, the GP will evaluate potential exit strategies once profit objectives have been reached or to limit losses.
The exit process is a liquidity event and is of paramount importance to the overall success of the investment. Investors should articulate the best option to maximize returns. One way is to look at microeconomic conditions. For example, the bank’s ability to finance the buyer might be affected by a period of tight credit, thereby affecting exit opportunities because potential investors are not able to finance the investment given market risks and fluctuations. When the market is bad and there are no buyers, it is not possible to offload the company.
A strategic acquisition is perhaps the most desirable and popular exit route for PE funds for investors as they hinge on selling stake to another party, with the added benefit of a complete exit and divestment as well as immediate realization of return upon closing of the sale. The buyer often pays a premium or higher multiples based on strategic interest. The process of the sale involves the strategic buyer learning of the investee company’s trade secrets, innovative products and synergies. This means that if the potential strategic buyer walks away from the deal, it gains competitive advantage from trade secrets. So, investors should ensure reasonable steps are put into place before revealing any trade secrets and contacts.
Exit by way of an initial public offering (IPO) means investors will not receive returns immediately because they have to wait for completion. IPO allows capital to be raised quickly through floatation on the stock market. Going public entails substantial transaction costs and indirect costs like disruption of operation as the management team diverts its focus on the IPO. Nevertheless, an IPO likely provides investors with the highest return on investment with high valuation potential, depending on the stability of the market conditions.
Dividend recapitalization is another exit strategy where PE funds take up additional debt on their balance sheet and use it to pay certain dividends to its investors. The debt is onto the company, hence why it is viewed negatively. Liquidation is another exit route, though the least desirable option for investors as recovery of investment is by company winding up.
4. CONCLUSION
There are various legal, business and tax issues that PE fund investors may encounter, but there are appropriate mitigations for each. Firstly, investors need to conduct disciplined due diligence and evaluate the potential GP’s investment strategy, its expertise and experience. The GP’s track record is a key indicator in its ability to handle the investments. Secondly, PE fund investors need to settle tax due diligence and assess ways in which they could minimize their tax obligations. Thirdly, the investors should demand that certain provisions to be incorporated in an LPA order to safeguard their interest. Thereafter, investors should continuously check the semi-annual reports provided by the GP to monitor the fund’s performance.
When the time comes to exit the investment, the investors should consider market conditions and liquidity requirements. Investors should be mindful of which strategy suits and should be adopted in order to receive the highest returns for their investment whether the exit route is via a strategic acquisition, an IPO, a management buyout or dividend recapitalization.
PE funds may be of high investment risk; nonetheless its investors have the potential of receiving high returns in their investments upon exiting at higher value.
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- Securities Commission Malaysia: Annual Report 2016 (Part 5 | Statements, Statistics and Activities)
Written by:
Syaizta Kamal (general@azmilaw.com)
