While offshore vehicles have been components of US private equity funds for decades, these vehicles continue to grow in popularity among private investment fund managers. Concerns over tax treatment for US taxexempt investors and overseas investors have long been the primary drivers for the use of offshore vehicles to structure private equity funds, but the internationalization of investor bases and the mounting demands of LPs are sending more dollars through the Cayman Islands.
To entice a diverse group of investors to commit to their funds, even first-time fund managers are coming to realize the necessity of adopting more complex fund structures that typically involve offshore vehicles. In the past, these types of structures were typically used by established firms raising follow-on funds, say fund formation experts. The plain vanilla Delaware partnership structure on its own may no longer be a sufficient draw for investors, particularly those with special tax considerations, and fund formation experts are quick to point out that the same tax issues can easily apply for both a Fund V and a first-time fund.
?As funds start to invest in larger and more international deals, it becomes very important to structure the fund in a way that can accommodate the varied and sophisticated types of deals that are being done,? says Bob Friedman, a New York-based partner at law firm Dechert. ?The structure of a fund has to be flexible enough to engage in these deals while satisfying the particular concerns, sometimes conflicting, of a number of investor constituents.?
One driver for utilizing offshore structures is that these vehicles can be used to optimize investor participation in a fund – particularly in the form of tax efficiency for those falling into the tax-exempt and overseas categories. According to Michael Collins, a Boston-based partner at DLA Piper Rudnick Gray Cary law firm, by using offshore structures, GPs come closer to finding an ?organization and configuration of funds such that every investor can fully participate in every investment? rather than be compelled to choose to be excluded from certain types of investments or acquisitions.
At the same time, GPs benefit from having the freedom to make as many good investments as possible, without being ?hamstrung? by tax concerns, says Collins. More sophisticated fund structures can allow GPs the flexibility to invest in a wider range of investment opportunities – which as a group are also becoming increasingly complex in terms of international presence and company structure.
With the confluence of these factors, GPs have become less hesitant than in the past to adopt offshore structures straight off the starting blocks when forming a fund to cater to ?inbound? investments from LPs, rather than, or in addition to, using tax blockers at the investment level for ?outbound? investments once the fund has been formed. According to fund formation experts, the advantage of having a ?blocker? entity above the fund instead of underneath the fund is that the former allows the GP to take out its carry and calculate it at the fund level before taxes are assessed, whereas carry is taken net of tax when the blocker is placed between the fund and the investment.
How offshore funds are structured can have significant impact on the after-tax returns for investors. The needs of each group of investors differ significantly, and there are different ways to address these concerns when structuring the vehicle. The chief purposes of establishing offshore vehicles for private equity funds are to shield tax-exempt investors from unrelated business taxable income (UBTI) gains and non-US investors from taxes on effectively connected income (ECI). How the funds are ultimately structured depends on where the sliding scale of leverage rests among LPs and between the LP and GP.
But before trying to decide which type of offshore structure is most appropriate when forming a fund, a firm should ask itself if the benefits to having a tax blocker are enough to justify setting one up in the first place, says David Moldenhauer, a New York-based partner at law firm Clifford Chance. For a private equity firm, such structures are typically useful only if the fund is expected to invest directly in assets that would generate UBTI gains, such as real estate or LLC partnerships that have business activities in the US.
If a firm has determined that its investment strategy warrants setting up an offshore tax blocker vehicle, the next decision to make is whether to set up the fund in the form of parallel vehicles or a feeder fund. Parallel funds, or what some in the industry refer to as cabinet funds, involve setting up separate funds for each investor type, for instance, by having distinct funds for non-US investors, tax-exempt ERISA plan investors, run of the mill US taxable investors, and European investors subject to tax treaty benefits. Meanwhile, feeder funds are typically structured to allow investors to invest in trusts that consolidate the capital and direct it into a single, central tax-blocking vehicle.
On whether parallel or feeder funds are most appropriate, the recommendations of fund formation advisers vary. While some fund formation experts point out that most of the larger buyout funds raised in 2005 were structured with feeder funds rather than parallel funds, most experts tend to lean toward using parallel funds.
DLA Piper Rudnick's Collins comments that parallel funds have been used for years and still tend to make a lot of sense, although ?having separate funds like this can become a bit unwieldy,? he says.
According to Moldenhauer, although both parallel and feeder funds are both often used, parallel funds tend to be a more efficient choice. A feeder fund provides a single blocker rather than blockers on a deal-by-deal basis, as is the case with parallel funds. The advantage of having deal-by-deal blockers is that these blockers can then be liquidated on an investment by investment basis, and the liquidation of these blockers allows a fund to avoid branch profits tax.
?The feeder stays as long as the fund exists, so it is going to have its share of gain on the sale of each underlying LLC investment. That gain will be subject to corporate tax, but it will also be subject to branch profits tax because the feeder vehicle is not practically able to qualify for the exception available when you liquidate a corporation,? says Moldenhauer. ?If you bring your foreign investors into a parallel fund that sets up single purpose, single investment blockers, then the single investment blockers – when selling the investment – will pay corporate level tax of roughly 35 to 40 percent when liquidated, and no further branch profits tax.?
In determining whether and how to set up offshore vehicles for private equity funds, there are administrative and cost considerations for GPs to take into account as well.
?The set-up costs are less important than operational costs,? says Moldenhauer of structuring offshore vehicles. ?Usually, setting up funds is just a matter of duplicating documentation, especially for parallel funds. Setting up a feeder likewise does not in and of itself involve a large cost – there is very standard documentation for feeder vehicles that pass through the investors in the feeders the rights and obligations that they would have as direct investors.?
However, on the operating side, the effort and resources required are more extensive. GPs managing funds that involve offshore vehicles must be prepared to manage the administrative burden of tracking multiple entities, multiple accounts, multiple tax returns, operating expense allocations, transfers between entities and obtaining multiple signatures for documentation, among other considerations, says Moldenhauer.
Given these considerations, whether it is economical to set up an offshore structure is ?largely a matter of investor demand and fund size,? says Moldenhauer. ?We've seen situations where parallel vehicles have been set up for specific categories of investors, and fund managers find that additional accounting costs are so high so as to constitute a serious burden to the fund management and to the financial results of the fund for the parallel vehicle. The reason was that the parallel vehicle was set up to accommodate a single/small number of investors that in aggregate did not invest enough to justify the costs.?
Moldenhauer points to an approximate benchmark of $50 million as being a minimum fund size in order for the administration costs of offshore vehicles to become economical, although in practice, much smaller funds have been structured with offshore vehicles. ?Below $50 million can be problematic. In the past, the threshold may have been a little lower, but the cost of maintaining a fund entity is increasing,? says Moldenhauer, although he does not believe fund size has been a major factor in deciding whether to set up offshore fund structures.
Offshore vehicles ?should be considered and adopted more frequently now because, one, there are now more opportunities to invest in companies that are in the form of LLCs, and, two, LPs have become more sophisticated about wanting to optimize tax treatment, not just as a safety net but to optimize net after-tax yield,? says Michael Collins.
Consequently, Collins recommends that, beyond hiring a counsel who understands how a fund will be invested and therefore can help the GP adopt the best structure, GPs should also spend much more time on tax planning – for both their funds' inbound and outbound investments – up front.