Private fund managers: Horizon scanning fund level issues for 2021

Building new relationships with investors in a virtual world

Faced with lockdowns and travel restrictions, many GPs reacted creatively during 2020 to build and maintain their contacts with investors. Sending out Netflix-quality videos from portfolio companies, posting hard-copy PPMs to investors’ homes and even running monthly podcasts for existing and prospective investors are just some of the innovations we have seen. But for GPs about to set out on their first virtual fundraising, a few points are worth bearing in mind.

• Some investors cannot invest solely off the back of a virtual due diligence process. Their policies require in-person meetings before their investment committee will sign off on a primary investment. GPs should check this point with prospective investors or ask their placement agent (if using one) to identify those investors that have no problems with proceeding virtually.
• Existing investors can be a real help: their due diligence processes may be easier (given the pre-existing relationship), they may be prepared to increase their commitments (especially if prioritising relationships with existing GPs over virtual relationships with new GPs) and they can also be a source of introductions to new investors.
• References are more important than ever. Given the lack of face-to-face contact, investors are requesting more references than before. GPs should make sure they have their references in place and check that referees are happy to do (potentially numerous) video calls with prospective investors.

Getting to a closing

A number of GPs have pushed back their closing dates, in part because the investor due diligence process has been taking longer, but also because the slowdown in deal activity has translated into slower deployment of prior funds.

GPs who have already held a first closing and are thinking about extending their fundraising period need to weigh up a number of considerations carefully. For example, if the fund is already at a viable size, is an extension in the best interests of the existing investors? If there has been a significant change in the value of the portfolio, what should the approach to subsequent investor equalisation be (again, bearing in mind the interests of the existing investors, not prospective investors who have not yet been admitted to the fund)? Some GPs may think about deferring the equalisation question until hopefully less volatile times, by using capital call facilities to fund acquisitions in the interim.

To maintain closing momentum, we also see GPs holding more frequent but smaller closings, as and when subscriptions are received (with the message being that investor capital is being continually committed), as well as offering fee discounts for early movers.

Funding the team commitment

For some GPs, slower deal activity has meant a delay in receipt of carried interest and/or investment returns from prior funds. This can reduce a GP’s ability to fund a team commitment, of the size expected by investors, to new funds. GPs in this situation look at a number of potential solutions, ranging from a bank facility or preferred equity investment at GP level (secured against management fee and potentially carried interest flows from prior and future funds) to funding the team commitment via a management fee offset, or even to undertaking a GP restructuring, with a third party strategic investor taking a stake in the GP in exchange for funding to bridge the team commitment gap. Another option is some kind of delayed commitment ratchet, where the team commitment increases over the life of the fund as distributions of carried interest and co-investment returns from prior funds eventually flow through – although there are some tricky equalisation issues to consider with this mechanism.

Alternatives to the traditional flagship fund

An increasing number of GPs are also looking to raise capital into top-up funds or are pursuing deal-by-deal models with investment from strategic investors, potentially with a view to flipping those deals into future flagship funds. Stapled secondaries and GP restructurings are also taking place, although not necessarily as publicly as the other alternatives.

Carried interest and the capital gains tax review

Capital gains tax (CGT) is in the spotlight at the moment. This is a result of the Chancellor’s request that the Office of Tax Simplification (OTS) identify areas where the current CGT rules can distort taxpayer behaviour. There was some concern that the OTS might take this opportunity to look again at the CGT treatment of carried interest. However, the OTS report issued in November did not focus on carried interest.

What, then – if anything – should GPs be doing now to address any potential future changes to carried interest taxation? Although it is possible – and even probable – that CGT rates may rise in the future, nothing in the OTS report suggests at this stage that the current CGT treatment of carried interest will change. However, GPs should think about future proofing their fund and carried interest documents as much as possible, by including sufficient flexibility to restructure their carried interest arrangements in the future, should the need arise – for example, the ability to take carried interest out from a different level in the fund structure, or to re-engineer it to something more akin to growth shares.

VAT on investment management fees

The European Commission is reviewing the current VAT exemption for investment management fees. Where that review will come out (and the resulting impact on fund structures) is not yet clear. As with the approach to carried interest, perhaps the best approach for GPs is therefore to preserve as much flexibility in their fund documents as possible, to allow future restructuring of management fees if needed. Various possible structuring options could be available, from taking the management fee out from a different level in the fund structure, to creating a different legal arrangement that generates an equivalent economic benefit, to interposing group entities or creating VAT groups.

Impact of Covid travel restrictions on tax residence of investment structures

The travel restrictions imposed by governments worldwide have in many instances prevented GPs and their personnel from travelling overseas to participate in board meetings, including those of holding companies. This in turn has resulted in questions as to whether the tax residence of those companies has been prejudiced, with board members participating from outside the relevant jurisdiction or meeting simply not being held at all.

Generally speaking, residence is not tested on a day-by-day basis. Instead, it is looked at in the round. So, given the difficulties many GPs may have had this year, it will be important in the coming years to be extra diligent in making sure that meetings are held in the relevant jurisdictions and properly documented - to demonstrate that, in the round, the company in question was resident where it was meant to be.

Looking beyond the immediate horizon, the events of the last year and the associated travel difficulties have caused some GPs to start questioning the need for overseas holding companies and to start thinking about relocating their holding companies to the UK. There are good reasons why UK holding companies are not as attractive as those in other jurisdictions, but the Treasury and HMRC are looking at making changes in this area, to make the UK a more natural jurisdiction for holding companies. GPs typically have full flexibility over where to set up their holding companies, so would have the power to relocate them in the future should that become more attractive. Any restructuring would however need to factor in potential dry tax charges arising within the fund.

Transitioning from the AIFMD passport to the article 42 NPPRs

UK AIFMs will lose their marketing passport on 31 December 2020. Those AIFMs out fundraising in the EU over the end of the transition period will find themselves having to switch from the passport to the NPPR of the relevant member states in which they are marketing. Unfortunately, this will involve complying with different rules in each member state. It is unlikely that UK AIFMs will be able to close EU investors in 2021 without complying with the NPPR formalities, even if they have previously marketed to and negotiated with those investors in 2020 under the passport. Some EU jurisdictions are allowing UK AIFMs to submit their NPPR applications now, in advance of 31 December.

What will marketing under article 42 as a third country manager be like for UK AIFMs?

The NPPR rules vary from member state to member state, with some being relatively light touch and others effectively rendering marketing impossible. For UK AIFMs used to the convenience and speed of the passport, perhaps some of the biggest changes will be the need to deal with the regulators in each target member state (including providing those regulators with regular reporting) and to build in potentially significantly longer lead times into fundraising schedules to allow for the processing of NPPR applications.

Cross-border distribution of funds rules

New EU rules coming into force in August 2021 are likely to make it harder for UK AIFMs to undertake pre-marketing activities in the EU. The rules standardise the definition of pre-marketing and effectively create a pre-marketing passport, which will be available only to EU AIFMs. It is currently unclear whether EU member states will allow third country AIFMs to pre-market AIFs in their territory.

Another obstacle for UK firms is that only authorised EU firms or tied agents of EU MiFID firms will be able to pre-market on behalf of EU AIFMs. So, for example, this would prevent the UK delegated portfolio manager of a Luxembourg fund from pre-marketing that fund on behalf of the Luxembourg AIFM. GPs looking to go out fundraising in 2021 will need to factor these new rules into their proposed marketing strategy.