Private equity has long gone offshore to form holding companies in the service of acquisition and more recently, to create fund structures nimble enough for a diverse body of LPs, that range from tax exempt to foreign, from private individuals to public pension funds.
The choices for GPs are many, but several offshore legal specialists admit that by and large, the choice of a given territory is less based on some novel new structure than on habit, and in some cases, something as simple as proximity. The Caribbean wins business from the US on this point and the Channel Islands are often popular among Europeans for the ease of coordinating efforts with an office within their time zone.
Contrary to the popular myth of offshore's exotic fiscal tricks, more often than not, the virtues of operating in a known regime outweigh any potential upside realized in a less familiar domicile. However, with the surge of activity from alternative assets, these havens are competing with real vigor and creativity, arguing for GPs to explore new territory. What may surprise some GPs is just how geographically close the alternatives may be.
The Cayman Islands
Paving hedge funds' way into private equity
The US remains the principal source of the territory's activity as the country's alternative assets boom prompted a subsequent flood of registrations. The Cayman Islands' long history of a light and efficient regulatory regime make it a frequent destination of choice for many private equity practitioners, but the sheer volume of hedge fund registrations has stolen the spotlight.
The Cayman Islands Monetary Authority (CIMA) reports it regulates over 80 percent of the world's hedge funds, with roughly 7000 funds registered there. Law and accounting firms bloomed in response, granting any incoming fund managers substantial local resources to establish themselves. As hedge funds broaden their investment scope, the locale's private equity experience becomes all the more relevant to their new clients.
The next GP to sigh on word of hedge funds playing in their sandbox should note the Cayman Islands' role in facilitating the trend. CIMA offers no restrictions on hedge funds moving into other strategies, and its segregated portfolio company legislation allows fund managers to create separate cells within a given fund. The placing of assets into one cell frees that cell from any liabilities associated with the other cells of a fund, allowing a single fund to pursue radically different approaches. With accounting and legal services already in place for private equity, these new hybrid funds find not only a friendly regulatory environment in Cayman, but sophisticated administrative services as well.
David Moldenhauer, a partner at the law firm Clifford Chance, suggests that while the Cayman Islands remains a popular choice, its dominant position may not remain the case.
?Although there continue to be many Cayman-organized funds, and I agree that their system is stable and reliable, they tend not to be the preferred structure for funds investing into the US or Western Europe. Funds investing in Asia often are organized in the Cayman Islands, as are certain funds-of-funds that seek a diverse investor base.?
The Channel Islands
Nibbling away at Cayman's lead
While often spoken in the same breath as the Cayman Islands, the territories of Jersey and Guernsey are a distant second in terms of activity, though the two have enjoyed some respectable growth, with further tax reforms to take effect in 2008.
The number of Jersey funds rose by 17 percent to 1,055 over the twelve months ending in June 2006 while the total value of Jersey funds in that period increased by 42 percent to £159.7bn. Over a comparable time period, Guernsey funds enjoyed a value increase of 37 percent to £92.6 billion, with the number of funds up 15 percent to 642. This growth is credited to reforms over the past few years that have produced a fast and flexible regulatory regime, with a slew of further changes expected to take effect by 2008.
The majority of this activity is from the UK and Europe with private equity representing a substantial amount of the funds cropping up there, though there's a fair share of property vehicles. The region is striving to serve UK hedge fund managers on the same scale as the Cayman serves the US, though that's not yet the case.
Currently, the States of Guernsey have resolved that by 2008 the rate of income tax on company profits will be zero percent, with a few notable exceptions. Certain specified banking activities will be subject to income tax at 10 percent, and trading activities within the jurisdiction of the Office of Utility Regulation (electricity, telecom and post) will be subject to income tax at 20 percent.
Resident shareholders will be taxed at 20 percent on their distributed profits and on all Guernsey rental and investment income and individual taxpayers will be liable to the standard rate on their investment and non-Guernsey trading income up to a defined income ceiling with a maximum tax payable of £250,000 on any individual's income from such sources. ?Wealth taxes,? such as inheritance and capital gains taxes, will remain off the table.
Only Guernsey has resolved to implement these reforms, though Jersey is expected to mirror these changes shortly. Many general partners traditionally view Jersey as trailing its neighboring island in regulatory affability, though the perception has changed somewhat during the tenure of David Carse, the director-general of the Jersey Financial Services Commission, whose three-year stewardship is now ending.
While not yet on equal footing with the Cayman Islands, the perennial runner-up status might be an asset in competing for funds in a post-Enron environment. Clifford Chance's Moldenhauer says that one of the rationales for choosing the Channel Islands is that for marketing purposes they are seen as slightly more reputable than the Cayman Islands.
?We have seen over the past couple of years a reduction in funds organized in the Cayman Islands, principally because of reputational concerns on the part of some investors in investing in tax haven entities and because of some anti-haven measures in the tax rules of some countries where investments might be made.?
The devilish detail
On the most superficial level, Belgium has an advantage ?it's hard to imagine the country as a shady tax haven. Despite a corporate income tax rate of 33.9 percent, some regulators in South Korea are demanding the country be added to the Organization for Economic Cooperation and Development's (OECD) list of tax havens. As with many issues raising the ire of South Korean regulators, the situation can be traced back to Lone Star's activities in their country.
The private equity firm conducted its sale of the Korea Exchange Bank through its Belgian unit, escaping all Korean taxes on profits from the sale as a result. If the corporate income tax rate is higher in Belgium than in Korea, where rates range from 13 to 25 percent, why did Lone Star structure the deal in such a way?
The rationale lies in the fact that capital gains realized by a Belgium-based company on shares in a domestic or foreign company are exempt from corporate income tax. The American Council for Capital Formation notes similar arrangements in the Netherlands, Hong Kong and Singapore as well.
These tax benefits allow such countries with relatively high corporate income tax rates to attract the headquarters of larger, multinational companies, with the added security of a complex system of double taxation treaties in place, thereby thwarting efforts by tax authorities to close these loopholes.
Despite the clamoring by some local tax authorities, the OECD has stressed that any additions to its tax haven list will be made when it's clear that companies are choosing the area for tax avoidance over other issues.
Discovering the Dutch Coop
The CV, the traditional limited partnership in the Netherlands, may find itself replaced by a vehicle that's not so new to the books. The vehicle, known as the Dutch Cooperative Association (Dutch Coop), commonly referred to as a farmer's cooperative for its traditional application, has been used well beyond its rural roots by local advisors for roughly the past seven years or so, but is just now gaining traction with private equity groups.
Matthew Saronson, a partner in Debevoise & Plimpton's tax department explains, ?The Dutch Cooperative enjoys an exemption from Dutch dividend withholding tax. We've seen the Dutch Cooperative used as a private equity fund and have considered it as a holding company in two other transactions in the last six months.?
The BV is the standard private Dutch company. The Coop is generally the same as a BV without the dividend withholding tax. While popularized within the agricultural sector, the regulatory language surrounding the vehicle doesn't limit it to a single industry. For example, a Dutch bank has operated as a Coop for many years.
?The Dutch Coop can also be used as a holding company for European investments, as a better way to repatriate your profits to the US,? says Saronson. ?The Dutch Coop can benefit from the parent-subsidiary directive, which prevents the imposition of withholding tax on dividends paid by other EU resident companies if the Dutch parent company has a substantial interest in the paying company. In addition, with respect to the receipt of dividends, the Dutch Coop is generally entitled, under the Dutch 'participation exemption' rules, to receive dividends paid by other EU resident companies free of Dutch income tax if it owns a sufficient number of shares of the company and meets certain other requirements.? (For more detail on the Dutch Coop and other developments in the Netherlands please refer to the feature from PricewaterhouseCoopers on p. 27).
SICAR remains a novelty
When the SICAR was first introduced in May 2004, many expected the new structure to attract continental European GPs in droves. While not an entity in its own right, the SICAR is either a Luxembourg limited partnership or Luxembourg limited liability company which is then granted a SICAR license provided the fund in question is focused on private equity alone.
The rationale of this structure was to offer two key benefits over the standard UK limited partnership. One was that it draws on European company law, whereas the Anglo-Saxon option appeared somewhat alien within the legal jurisdictions of continental Europe. This allowed for much shorter and simpler fund documentation, as the company law fills in any gaps left by the documents. The second was its onshore status, complete with Luxembourg's comparatively light regulatory touch, while all the more accessible for European GP groups.
The initial expectations were outsized from the start, as the SICAR was wrongly construed as an alternative to the English limited partnership, when it was in fact, aimed at a much smaller constituency, namely continental European GPs with a primarily continental investor base and operating in the small to medium end of the market. But even among this niche, the vehicle has failed to generate much momentum.
Moldenhauer explains the continued reticence towards the structure: ?I believe there are three principal reasons why private equity groups are slow to adopt the structure: one, the time and cost required to register a SICAR; two, the ongoing cost of a SICAR, particularly the cost of using a Luxembourg custodial bank; and three, the uncertainty regarding the types of investments that may be held by a SICAR, particularly loans to portfolio companies that are not structured as bonds or other securities.?
Emerald access to the EU
Offshore advisors from the Caribbean and the Channel Islands expect major competition from Ireland in the coming years. With a smaller, less diverse economy, Ireland's tax and regulatory authorities enjoy great room to maneuver, and its EU membership allows funds domiciled here to be marketed to retail investors across the European Union. As more alternative assets are made available for retail investment, some funds have already left the Channel Islands to take up residence in Dublin and Luxembourg in response.
One of the telltale signs of Ireland's new status as an offshore center is the arrival of Maples & Calder to Dublin. The Cayman Islands-based offshore advisory firm launched a fund administration business in the city, to serve as the base of its European fund administration business. The business was the result of a merger with Binchys, a local practice dedicated to corporate finance issues. To underscore the priority the firm places on the initiative, they're relocating the Cayman-based commercial partner and firm-wide finance chief Julian Reddy to Dublin to co-head the operation alongside Jennifer Caldwell, a senior partner of Binchys.