According to one observer, Asian private equity is currently the ?flavor of the month? among German limited partners, with China a particularly attractive draw. Nothing uniquely German about this phenomenon, you might think – both China and the Asia Pacific region generally are currently corralling money at an unprecedented rate from investors all over the world. But, given certain idiosyncratic tax complexities, German investors find it a tougher task than their counterparts in many developed countries to gain the access they desire.
The most fundamental issue for German investors is to avoid what one local lawyer describes as ?penalizing taxation? under German tax rules, which can apply when an LP is committing to a foreign fund. The issue is, unsurprisingly, a potential deal breaker. Until mid-2004, say lawyers, it was a very difficult problem to negotiate. But then the German tax authorities issued a ruling saying that penalizing tax could be circumvented if the foreign vehicle qualified as a partnership from a German tax perspective.
Achieving that qualification is easier said than done, says Friedrich Hey, a tax partner in the Frankfurt office of international law firm Debevoise & Plimpton. He says: ?In certain emerging markets, where vehicles often have different features from those in developed countries, it's often borderline whether the vehicle will be viewed as having the characteristics of a German partnership.?
Even if this obstacle is negotiated, other potential landmines stand in the way. One is the danger that tax-exempt investors will find themselves exposed to taxable income – similar to the UBTI issue faced by certain US investors in private equity funds. One way in which German investors have sought to avoid taxable income liability is by attaining socalled ?designated limited partner? status, which involves having co-management authority over the fund. This is a tricky issue, according to Hey, because ?there is tension between having control over the cash and not being seen as involved in the management of portfolio companies.? Investors are not allowed to play a management role, as this would leave them exposed to unlimited liability.
A third issue is the regulatory environment in which insurance companies and pensions operate in Germany. Such organizations are generally free to invest anywhere within the EU, but restrictions may be imposed on investments made elsewhere in the world, including Asia. Hey says this can be overcome through the use of a European feeder vehicle, which pools cash from European investors and then feeds into a subsequent structure before finally being invested in the Asian vehicle. ?From a regulatory perspective, this looks a little like avoidance, but it's accepted by the [German tax] authorities subject to certain provisos,? says Hey.
Hey adds that German investors don't have it all bad from a tax point of view. He says that investors in other continental European countries such as neighboring France have their own unique issues that can make life equally difficult. In addition, he points out that German investors do not have to cope with anything as onerous as the ERISA rules in the US.
Nonetheless, German investors find themselves making more demands than those from many other parts of the world at a time when the popularity of Asian funds means many have the power to decide the type of investors they want and the terms on which those investors are allowed to come to the party. ?We do see a lot of interest on the part of German investors in Asian funds, but that translates into sponsors having the upper hand on terms,? says Hey.
When such investors may only be committing a few million dollars apiece, accommodating their demands might be perceived as too burdensome. Hence, while Asian private equity might be flavor of the month, German LPs hungering for a bite might find themselves on starvation rations.