Insurance SPVs: Broadening the investor base, easing the tax burden

Using a structure well established in the hedge fund world but little-known insurance contract in the private placement market, private fund managers can expand their investor base.

A niche structure widely used by insurance company investors is increasingly being used by fund managers to offer private investments to those who want to avoid burdensome taxes or whose investment criteria exclude them from investing in many private funds directly.

Private placement life insurance contracts or private placement variable annuity contracts can be a boon for fund managers desiring to cater to a broader and more diversified pool of investors, as well as to their chief financial officers wanting to lighten their administrative load.

The structure works as follows: PE managers need to create special purpose vehicles (either insurance dedicated funds or separately managed accounts), which act as feeders into private asset funds. The SPVs are structured as private placement life insurance contracts or private placement annuity contracts, which can include all kinds of investments including private equity, hedge funds and private real estate investments. The structure allows certain types of investors, including US tax-exempt investors, foreign corporations and sovereign wealth funds, to access private investments while avoiding the tax burden that can be associated with it, since they are insurance policy holders, not limited partners.

Tax benefit

From a tax perspective, they have the same purpose as leverage corporate blockers or total return swaps (without the counterparty risk of the latter), allowing investors in a fund to avoid unrelated business income tax, or UBTI, the tax that impacts tax-exempt investors such as university endowments and US state pension plans — and effectively connected income, or ECI, its equivalent for foreign investors.

“Most private equity investments create a ton of ECI,” says one an expert on PPLI who declined to be named citing compliance issues regarding private placement products. “So these products are always great for that,” he added, though the structures aren’t “as helpful” for fixed, determinable, annual and periodical, or FDAP, income.

The products “allow people to access those investments in a way that can minimize any drag that would be associated with any type of private equity investment, but still keep the efficiency,” the expert said. They can be used in various ways: for single asset deals, as separately managed accounts, or for whole funds, for example.

Expanding the investor pool, reducing admin

Such PPLI and PPVA contracts can broaden the investment horizons for private funds managers, the expert argues. These managers can tap new sources of investors who might not otherwise find it attractive to invest in private equity for tax reasons, or whose investment parameters effectively exclude them from some private funds.

“Private equity managers end up managing money for a whole different pool of capital in a very efficient way that they otherwise might not get access to” by using these insurance vehicles, the expert said.

These structures can also lower the administrative load for CFOs; eliminating the need to issue Schedule K-1 tax reports to limited partners who invest via these structures. And providers do the admin for the vehicles, in some cases even organizing and running capital calls, which the expert says attracts even clients who don’t end up seeing a significant tax benefit.

Most private investments are good fits for this structure, but managers focused on private credit, infrastructure and real estate are especially taking advantage of it recently, the expert said.

The rules

“A private placement insurance contract generally gives you much flexibility,” the expert added. “If you have a private placement annuity, you can include almost anything in it as long as you meet certain rules.”

There are two basic rules these structures must follow. One is investor control: investors (the PPLI or PPVA contract holders) can’t tell the manager what to buy and what not to buy. The SPV’s portfolio also has to meet investment diversification requirements, including that no investment can make up more than 55% of the portfolio, and the portfolio must have at least five investments.

Splitting a single asset into five limited liability companies, then, allows them to meet the diversification criteria. And funds that are in wind-down mode are exempted from the five-asset requirement, the expert said.

Most of the insurance companies started offering these structures for their own funds about 50 years ago, but many have dipped in and out of the field in tandem with economic cycles.

Firms that offer private placement insurance products include Cohn Financial Group, Crown International Group, Lombard International Group, Prudential Financial, Swiss Life, SALI Fund Services, Vie International, and Zurich Insurance Group, among others.

Low interest rates – causing investors to be highly sensitive to the tax impact on overall returns – and increasing interest in private markets in the face of prolonged public market volatility are combining to make these insurance structures more attractive, the expert said.

“I really see some of the institutions being more comfortable with the liquidity premium,” the expert said. “They’re getting really interested with alternative investments.”