Most private equity funds have a life span of ten years or more, so structuring funds for any possible regulatory change is simply impossible. Instead, fund formation lawyers attempt to build the maximum flexibility into the structure to address the latest regulatory stance. Given the number of geographies that firms invest and raise capital in these days, that flexibility to respond to various regimes becomes vital.
For example, one deal attorney explains that a fund domiciled in the Cayman Islands was exploring an acquisition in Brazil this year only to find that the country just rescinded Cayman's exemption from capital gains tax that other territories enjoy. In response, the fund merely created another entity, domiciled in Canada, to complete the acquisition and maintain the exemption.
What allowed the fund managers to quickly create the entity was an alternative investment clause (AIV) within the partnership agreement. AIV clauses grant GPs the power of attorney to create new entities for a given acquisition without consulting LPs. They come in two types: subsidiary and parallel AIV clauses, each with their own advantages and resulting risks. However, some investors may bristle at allowing any such entities to be created without their counsel, though most simply need to be reminded of their purpose.
The subsidiary AIV is owned directly by the fund, (either in whole or in part with other investors) and that AIV in turn owns the portfolio investment. This new vehicle can take advantage of tax treaties that the fund can't, and allow the fund to invest in operating LLCs without putting non-US and tax exempt LPs in an adverse tax situation. Investments in an operating LLC can cause both types of investor to earn ECI and UBTI, in conflict with many agreements' provision to minimize both. Unfortunately, while subsidiary AIVs address that issue, they cause the entire fund to bear a corporate-level tax, not just those concerned with avoiding ECI or UBTI. According to a recent client memo from the law firm Proskauer Rose, there are variations of these AIVs to minimize this, but there will still be some corporate tax slippage for LPs with this entity.
The parallel AIV is one way to avoid slippage associated with the subsidiary AIV, as the entity is not owned by the fund, but by a subset of the fund's partners, including the GP. The parallel AIV invests in the portfolio company alongside the main fund, which also holds a direct investment in the company. The parallel AIV is not a parallel fund, as the latter is created to make multiple investments and the former is meant for a single portfolio investment. This type of AIV avoids incurring any corporate level tax burden, though it may cause tax exempt and non-US LPs to indirectly bear a greater tax burden through the US “branch profits” tax. The parallel AIV may also require non-US investors to file in the US in certain circumstances.
While neither AIV structure is perfect, they are both adept at minimizing or outright blocking UBTI and ECI for tax exempt or non-US LPs. That said, these clauses require the LPs to relinquish the power of attorney to approve these entities, which is crucial as few GPs have time during an acquisition process to secure investor approval for an AIV. That rationale doesn't always win over LPs when a fund is first formed.
LPs are often reluctant to be placed in an AIV vehicle in a different jurisdiction if they haven't been given an opportunity to review those documents prior to their admission, says William Sturman a New York based partner with the law firm Akin Gump Strauss Hauer & Feld. “It's natural during the fundraising process that LPs would hesitate to give this kind of flexibility, but as they're becoming more sophisticated about the asset class they understand the value to the GP and the fund to be able to consummate deals quickly.”
It should be noted that while AIV clauses grant power of attorney to create these entities, they also aim to replicate the economics and regulatory protections of the primary fund agreement. “We always stress that these AIVs are materially similar to the original fund agreement, save for any revisions or restructuring that may need to be made to address the issues raised by the particular deal, and, in any event, such restructuring is done with the intent of maximizing fund returns,” says Sturman.
Even if both the GP and LP agree, maintaining these vehicles can be costly for the GP. “There are set-up costs, filing obligations, and maintenance, and firms need to be mindful that the entity remains separate enough from the main fund to satisfy local regulatory regimes,” says Dan Finkelman of Proskauer Rose. Regardless, the flexibility AIVs grant may be worth the trouble, especially as no GP can predict when a tax treaty may expire.