Institutional investors may enjoy increased after-tax returns through the proper use of private placement variable insurance (PPI) – or as we call it, structural alpha. Much has been written about the benefits to both non-US investors (reduced friction associated with ECI and FIRPTA taxes) and US tax exempts (reduced friction associated with UBTI tax), and many institutional investors have seen the power of years of compounding on improved after-tax returns.
But investors cannot establish a private placement insurance structure unilaterally. It requires an asset manager willing and able to manage a portfolio in accordance with the governing rules and regulations, and an insurance company to issue the insurance contract and make the investment on behalf of the contract.
Sophisticated professionals at asset management firms, and their advisers, have the deep experience with complex structures required to attract capital from a variety of global institutional investors, and are familiar with the associated legal and operational requirements. But when insurance concepts are woven into traditional asset management structures, even intrepid managers and lawyers may pause. Despite the historical relationship and dependencies between investment and insurance, and the billions of dollars invested through insurance structures, insurance can, at first glance, seem foreign.
We find managers’ trepidation stems from two areas. Firstly, given that PPI structures are relatively niche, there are a number of myths and misconceptions surrounding them. Secondly, managers are commonly under the impression that they alone will have to figure out the nuances of said structures. This article seeks to demystify the structures, debunk myths, and encourage exploration at the intersection of investments and insurance.
Myth one: My fund type is prohibited from PPI
The most pervasive myth is that highly illiquid funds or funds organized as ‘draw down’ funds are prohibited inside a PPI structure. Managers question if there are limitations on illiquidity inherent with the structure (there are not), and how the IRS 817 Diversification Rule (which very generally says a portfolio must meet certain diversification tests throughout its life) works during ramp-up and harvesting periods.
The fact is that billions of dollars of illiquid assets are already in private placement insurance structures for US and non-US institutional investors, and managers can call and distribute capital inside an insurance portfolio the same way they do today. Importantly, managers can create an insurance structure that is substantially similar to their existing fund structure in order to accommodate capital calls and distribute proceeds when investments are realized.
Fact: illiquidity and capital calls are acceptable in these insurance policies
Myth two: IDF requirement
The second myth is that insurance wrappers can only invest in commingled insurance dedicated funds (IDFs), which is at odds with the increasing popularity of managed accounts. It is not true that IDFs are required.
In fact, US and non-US investors’ PPI policies frequently invest via managed accounts. This gives alternative investment managers and investors the freedom to engage on the basis which suits them best, be it a fund or managed account.
Fact: commingled funds and managed accounts are acceptable structures inside these insurance policies
Myth three: Investor communication restrictions
The third myth is that working through private placement insurance structures disintermediates managers from investors, meaning that they will not be able to speak or have a direct relationship with their end investor. This myth comes from a distortion of the so-called investor control doctrine, which is IRS guidance that governs communications in a PPI structure. A relationship between the end investor and asset manager can absolutely exist, however it needs to be managed carefully.
Understanding various real-world applications of the doctrine often requires the help of experienced specialist practitioners. These specialists can help managers parse specific issues such as voting rights, LPAC participation, investor conferences, co-investments and marketing to prospects. Lastly, it is crucial to ensure communications are done in compliance with all relevant rules and regulations in order to maintain the tax benefits enjoyed by end investors.
Fact: investor and prospect communications can be robust when done carefully.
Getting the most out of PPI
Armed with a deeper understanding of insurance structures, managers and their advisors can explore them with confidence. In fact, many of the world’s top investment managers currently utilize them and find them more attractive than more traditional structures such as leveraged blockers and REITs. As such, there are a multitude of tried and tested templates that can be followed and customized to specific needs.
In conclusion, many investors may be able to boost their after-tax return by investing through a private placement insurance structure. Managers stand to gain from implementing insurance structures, given the many benefits, among them the ability to attract new assets from a wider range of global institutional investors.
But it is important to work with a specialist with both insurance and institutional alternative investment expertise to help create the most effective structure for the manager and investor. Managers should know that there are resources to help them set up and run these structures confidently, and not be dissuaded from taking advantage of the potential benefits they can provide to their investors.
Virginia Klein is executive vice president and head of investments at Lombard International (USA)