Changing landscape Down Under

The evolution of private equity fund structures in Australia has involved two steps forward and one step back.

Over the last four years we have witnessed an evolution in the development of private equity fund structures in Australia. This evolution has involved a three-phase process:

  • ? Pre-July 1, 2002: reliance upon an Australian unit trust structure (AUT) with a direct investment model for offshore investors;
  • ? July 1, 2002 – April 2006: the introduction of the Venture Capital Limited Partnership (VCLP) structure; and
  • ? Post-April 2006: modification to the VCLP and AUT structures and the introduction of a new Early Stage Venture Capital Limited Partnership (ESVCLP) structure.
  • While these changes have made the country a better environment for private equity investors, there is still room for improvement. This article traces the impact of these milestones on the development of the Australian private equity industry.

    Phase 1: the old reliable AUT
    The AUT structure has certain of the features which are common to the limited partnership structure adopted in many international private equity markets, most notably the US. Essentially it allows for a flow through of income to investors with the income retaining its identity in the hands of the investor. This latter feature is important as it allows for a capital gain realized by the AUT to retain its identity when distributed to an investor and therefore be potentially eligible for the discounted tax rules that apply to capital gains realized on investments held for more than 12 months.

    The AUT structure, unlike a limited partnership structure, does not allow for the flow through of losses. In addition, any capital gains derived by the AUT and distributed to non-residents typically attracted Australian tax that had to be effectively collected, in most cases, by the Australian trustee of the AUT (this position is, however, proposed for amendment: see Phase 3 below). Given this fact, the AUT, while appealing to domestic investors, was not appealing to foreign investors, most notably foreign investors that were not subject to tax in their home country (such as foundations, endowments and funds of funds).

    This taxation treatment of realized profits by AUTs resulted in a preference for foreign investors to invest directly in the private equity investee company by way of co-investment arrangements. While Australia's capital gains tax (CGT) regime still applied to such direct investments, generally it was considered to be overridden by the application of a relevant double tax treaty such that no tax was payable (albeit that the Australian revenue authorities did not necessarily share the view).

    The combination of Australia seeking to tax offshore investors in the sector (particularly investors that were tax exempt in their home country) and the fact that unit trust structures were not commonly used in the major international private equity markets was viewed as creating a significant barrier to attracting foreign capital. It was the need to remove these barriers that led the industry to make various submissions to government (which had shown a keen interest in reforming the sector) to create a more level playing field for Australian private equity managers. It was these submissions and the government's willingness to embrace these submissions by the Australian private equity sector that gave rise to Phase 2 of the evolutionary path.

    Phase 2: the VCLP is born
    Essentially, there was a consensus between government and industry that, from a policy perspective, the barriers which were discouraging foreign investors from investing in Australian private equity should be removed.

    Hence, the broad concept was to adopt a flow through limited partnership structure (limited partnerships were, and still are, taxed as companies in Australia – with the exception of VCLPs) and also no longer seek to tax foreign investors on profits derived from the realization of private equity investments.

    In order to achieve these policy objectives, there was a need to ?carve out? from general limited partnerships a limited partnership that was to be used for private equity investment. The ?carve out? limited partnership structure together with its related statutory regime became known as a ?Venture Capital Limited Partnership?.

    While the introduction of the VCLP was met with some initial excitement, it has failed to deliver on the policy objectives that the industry sought to achieve through these reforms. Most notably, this is because of the limitations that are placed upon the activities of a VCLP and the narrow nature of the tax exemption that was introduced, which was limited to investors from only 13 prescribed countries and excluded fund of funds located in low tax countries such as the Cayman Islands.

    In this regard, the investment restrictions which have proved most problematic are:

  • ? the inability to invest in a company that has gross assets (by book value) in excess of A$250 million ($187.7 million; €147.7 million), which largely rules out any significant buyouts in the Australian market place;
  • ? the requirement that the investee company be an Australian resident company with 50 percent of its employees and assets located in Australia – which essentially prohibits any offshore private equity investments by a VCLP;
  • ? the inability to invest in companies that carry on certain finance related activities.
  • The result of these restrictions has been to effectively force private equity managers into operating through hybrid structures which allow managers to make investments which may not meet these VCLP investment requirements. These structures have typically involved the formation of an AUT structure for ineligible VCLP investments and a VCLP structure for eligible VCLP investments. Depending upon the eligibility of a particular investment, the capital is called by the manager into either the AUT or VCLP.

    Accordingly, while the policy motivation for the introduction of the VCLP structure is to be commended, the regulatory framework associated with its actual implementation has proved far too restrictive and has significantly undermined its ability to achieve its original policy intention of providing international investors with a readily recognizable private equity structure akin to the US limited partnership model.

    These problems led industry to make further submissions to government which resulted in the government appointing an independent panel to review the sector. While the report of the independent panel has never been released publicly, it is expected that many of its recommendations have found their way into the government's proposed new initiatives which were announced in the May 2006 annual budget. These announced changes move us into Phase 3, the most current phase of the development of private equity fund structuring in Australia.

    Phase 3: the new reform agenda
    In May 2006, the government announced that it would reform the existing VCLP rules in the following key ways:

  • ? remove the restrictions on the country of residence of investors, which will seemingly result in a broad based exemption being introduced for all foreign investors investing in a VCLP. This will significantly improve the benefits available to foreign investors investing in the structure and replace the current narrow list of potential investors eligible for the existing exemption; and
  • ? relax the requirement which limits investment by a VCLP to only Australian companies that have 50 percent of their assets and employees in Australia. It is envisaged that the relaxation is likely to involve the VCLP being entitled to hold a certain minor proportion of its investments in offshore investee companies.
  • While these proposed reforms are to be commended, there are some notable exceptions from the list. The most important of these is the fact that there has been no change to the A$250 million investee asset cap. Accordingly, even after the introduction of these reforms, a VCLP will not be a viable investment structure for Australian managers wanting the opportunity to operate in the medium to large buyout space. Hence, those managers seeking to access the benefits of the VCLP structure are still likely to have to use the dual AUT/VCLP structure.

    A further twist in this evolutionary path is the fact that, completely unrelated to the private equity focused reforms, the government has separately announced that it intends to remove the existing CGT regime as it applies to non-residents so as to only seek to tax non-residents on assets that are predominantly direct or indirect land interests. These unrelated CGT changes are of great significance. It effectively means that after the date of introduction of these changes, non-residents will not be subject to Australian CGT unless the profit they derive is attributable to the sale of shares in an investee company which has more than 50 percent of its assets in the form of land or land interests. This would not usually be expected to be the case in respect of private equity investments.

    The further big news related to this proposed reform is the fact that this change will extend to capital gains distributed by an AUT. Therefore, a non-resident investor in an AUT will no longer be subject to Australian tax on any capital gains made by the AUT from the realization of its underlying investments unless those investments relate to land interests.

    It is expected that these abovementioned CGT changes will be introduced by the end of the year.

    Given these changes, the perplexing issue for Australian managers seeking to raise money from offshore investors is whether they should persist with the use of a dual AUT/VCLP structure or merely establish a single AUT structure. The potential problem with relying on the single AUT structure is that if the gains derived by the AUT are regarded as revenue gains (i.e. akin to ordinary trading income) rather than capital gains, the abovementioned reforms to the CGT rules will not apply and a foreign investor will still be subject to tax under Australian domestic law. By contrast, if the investment was made via the VCLP structure, then based on the government's proposed announcement, a foreign investor would be completely exempt from Australian tax on its share of any profit realized by the VCLP, irrespective of whether the profit is regarded as a revenue or capital gain.

    Accordingly, there are still advantages to be obtained through the use of the AUT/VCLP dual structure albeit that it comes at the cost of simplicity.

    The other interesting feature of the 2006 budget reforms involves the introduction of the ESVCLP structure. Essentially this structure has the added advantage over the VCLP structure in that any gains derived by domestic investors as well as foreign investors will be exempt from tax. It follows from this that any losses derived by domestic and foreign investors will not be deductible.

    Consistent with the name of this new structure, it is targeted at early stage venture. Accordingly, while it is unclear at this stage what the precise requirements will be to be registered as an ESVCLP, the government has announced that the following requirements will apply;

  • ? the maximum fund size will be A$100 million;
  • ? investee companies cannot have total assets in excess of A$50 million (this compares with the A$250 million assets cap applicable to a VCLP); and
  • ? compulsory divestment must be made by the ESVCLP if the total assets of the investee company exceed A$250 million.
  • Given the limits on the size of an ESVCLP, this structure is unlikely to generate any excitement for offshore investors.

    While there has been significant improvement in the legislative environment surrounding private equity fund structuring in Australia, we are still some way from achieving the goal of having an internationally recognized limited partnership structure comparable with that used in the US market place. Having said that, foreign investors should feel a degree of comfort that while things are not as straightforward as in the US, managers can achieve fund structures which will generally provide foreign investors with their ultimate goal of obtaining access to the Australian private equity market without having their profits from the realization of those investments subject to Australian tax.

    The choice of how best to achieve that outcome will be governed by the relevant manager's target market, and in particular whether it is the manager's expectation that the vast majority of its deals will exceed A$250 million. If that is the case, then the most likely structure to be utilized is an AUT, perhaps with a direct co-investment structure for offshore investors. If, on the other hand, the vast majority of the deals to be done by the manager can be conducted through the VCLP structure, then it is likely that an Australian manager would choose to pursue the dual AUT/VCLP structure.

    Hopefully, Phase 4 of this journey will see the further unshackling of the VCLP structure by the removal of the current investment restrictions, such that Australia will truly have a private equity fund structure comparable with that of the US. Mark Goldsmith is a partner at Sydney-based law firm Gilbert + Tobin.