When private funds lawyers get together, regulation is the first topic on everyone’s lips. The Alternative Investment Fund Managers Directive – initially seen as a burden – is actually an advantage, argues Marco Pierettori, general counsel of InvestIndustrial, a mid-market buyout firm which closed its sixth fund on its €2 billion hard-cap in February, making it the first fund of its size to focus primarily on Southern Europe. “AIFMD is not as bad as people initially thought it would be. It helps to have clear rules about marketing, depositories and internal controls.”
Pierettori is part of a group of in-house legal experts gathered for pfm’s general counsel roundtable at the London offices of law firm MJ Hudson at the end of August. Kicking off the agenda is the EU’s regulatory framework and – more specifically – its impact on fund marketing.
In the post-AIFMD world, many private fund managers trying to raise money within the EU without a marketing passport or national placement regimes have to rely on reverse solicitation. In other words, marketing their funds only to investors who have approached them first. But it is clear from the discussion around the table that the European Securities and Markets Authority may focus its scrutiny on reverse solicitation in the future.
“I have seen examples of provisions being put into fund documents whereby the investor initiates the discussion in respect of the next fund,” says Ted Craig, head of the secondaries team at alternative assets-focused law firm MJ Hudson. “This type of provision includes, for example, the investor acknowledging that they are interested in receiving information relating to a subsequent fund.
“The argument being that, from a marketing perspective, when the manager is raising the subsequent fund, they have been made aware by that investor of its interest in the fund in advance.”
Another potentially contentious area under AIFMD relates to the disclosure of fund terms between investors. Under the rules managers are supposed to disclose any preferential treatment received by a limited partner, such as in a side letter. Managers are, however, sometimes reluctant to do this.
According to Craig, it is not uncommon for a Most Favored Nation provision (where side terms agreed with a specific investor are offered to all other investors) to be tiered by investor size, not only for which LPs are offered those terms, but even whether those terms are disclosed. Only an investor of the same size or bigger will be told what side terms have been agreed with a specific LP. This appears to contradict the requirement under AIFMD for fund terms to be disclosed to all of them.
“As part of our practice working with LPs, we have challenged this and have had to ask managers if they are comfortable that they are AIFMD compliant. They have argued that the AIFMD disclosure requirement is satisfied by the disclosure of the fact that side terms – which themselves may not be disclosed – may be agreed with other investors,” Craig added.
The lawyers around the table represent a global law firm; a US-headquartered manager with international reach; a firm with offices in Switzerland, Luxembourg and the UK; a London-based mid-market firm; and a Switzerland-headquartered fund investor (as a side note, four of the five worked at some point at SJ Berwin – now King & Wood Mallesons). Among this group of geographically diverse businesses the impact of Brexit has so far been minimal.
US-based alternatives giant Blackstone, which has increased its legal and compliance headcount in recent years, is not affected by EU regulations as much as other managers, says Geoffrey Bailhache, managing director of the firm’s legal and compliance group. “Blackstone’s EU operations are essentially sub-advising investment managers who are based in the US. Therefore, we are not scoped into many the regulations that impact EU investment managers on a day to day basis.”
However, as a result of Brexit, many international funds are considering where they want to establish their managers, adds Bailhache.
Pierettori was recently one of three operations professionals to move from InvestIndustrial’s offices in Lugano to London, to bring the firm’s investor relations, legal and ESG teams together under one roof. Like Bailhache, he does not think that Brexit will cause too many issues. “InvestIndustrial companies have been based and licensed in the UK, Luxembourg and Switzerland for over 20 years, therefore if adjustments will be needed in view of Brexit, we believe we have the necessary flexibility to achieve it.”
According to John Atherton, general counsel at Adveq, which started life as a fund of funds and now invests in multiple private equity strategies, some of Adveq’s LPs, especially those which need to be part of an EU vehicle for Solvency II purposes, are already indicating a preference for non-UK fund structures.
“Although there is not a specific legal reason to structure funds using another jurisdiction at this time, some of our investors are preferring not to use English or Scottish limited partnership fund structures post-Brexit,” he says.
The domicile of choice for Adveq has been Luxembourg. “We have structured funds over the summer using Luxembourg partnerships, whereas otherwise we may have used a Scottish limited partnership,” Atherton adds.
Luxembourg is proving to be a popular jurisdiction for managers to establish funds following the Brexit referendum. Alongside its new Reserved Alternative Investment Fund structure, which allows the establishment of funds without approval from Luxembourg’s financial regulator, the nation also offers a limited partnership structure similar to the UK’s, making it easy for managers to reconsider their location.
The UK’s decision to leave the EU also means – almost certainly – that it will no longer be able to shape EU law. Without the UK’s input, “I think that the EU will be less informed because the UK brings a lot of experience to the table,” says Andrew Panayides, general counsel at London-headquartered private equity firm Duke Street, which focuses on mid-market leveraged buyout and growth capital investments in Western Europe.
However, it could be worse, adds Pierettori. “If Brexit happened 10 years ago the outlook could have been different. For example, if AIFMD was passed without the UK’s input, it could have been less flexible.”
While Brexit seems to be a ‘storm in a teacup’ to those around the table, a much bigger storm is brewing: the OECD’s global initiative to prevent Base Erosion and Profit Shifting.
The BEPS project aims to significantly decrease base erosion, where the amount of money that can be taxed in a country is reduced, and profit shifting, where the business activity is undertaken in one country but the profits are allocated to a country with a lower tax rate. Nations including the UK, France, Japan and Australia have started implementing legislative changes since the final recommendations of the project were released by the OECD last year.
“BEPS may prove to be one of the most important things that is going to impact our industry in the next decade,” says Bailhache. “How people respond to BEPS, how it impacts business structures and how firms find a way to continue with business in way that is compliant with expectations and reality is going to be very important.”
The OECD has said that it will continue to examine issues related to the treaty entitlement of private equity and venture capital funds to ensure that the new treaty provisions are appropriate.
The project requires tax authorities to place added scrutiny on substance during tax audits, to ensure that the amount of organizational and economic substance in any given location is in line with the taxable profits in the jurisdictions where a multinational firm operates.
In addition, the project aims to limit financing cost deductions in a group. A cap on the amount of tax relief companies can seek on interest payments of its earnings announced in the UK budget this year is in line with this action point, and from April 1 2017, interest deductibility will be limited to 30 percent of UK EBITDA.
Private equity transactions often involve substantial levels of debt finance, and may mix external debt from banks with internal debt from shareholders. As a result, these rules will likely affect the leverage arrangements of some private equity portfolio companies.
“The [BEPS] policy will have an immediate cost around how interest is going to be deductible, so managers will work that into how much they price assets and what their expected return is,” says Bailhache.
The US initially took the position that few or no changes in its domestic law would be necessary because existing rules are generally consistent with the BEPS proposals. But in July, the Treasury Department and IRS finalized a rule which will require US-based multinational corporations to provide detailed, country-by-country income tax information to the tax authorities on an annual basis for each country in which they do business.
The BEPS project is currently at the lobbying stage, with industry bodies working to ensure that these rules work fairly for private equity and venture capital funds. The general counsels around the table are under no illusion that BEPS is going to be a focus point for the private funds industry in the future.
Having dissected some of the broad underlying trends, we ask the group to point to some of the more granular risks on their radar. What are they flagging up to their investment teams?
Panayides mentions how important it is for general counsels to ensure that their team is aware of the laws, rules and regulations applicable to their business, in particular in relation to the Securities and Exchange Commission’s broker-dealer rules.
“A deal may be put to you which the team is not keen on pursuing. They may, however, know a house in the US who may want to pursue that deal. You can’t simply ‘pass on’ the deal to the US house in exchange for a commission, as you would likely need to register with the SEC in advance of doing so,” says Panayides.
The allocation of investments between multiple fund products and clients is another consideration for an in-house legal team. If a manager has overlapping products, how do they apportion opportunities fairly? While firms might only occasionally have blind pool funds that compete with each other for opportunities, if they manage several separate accounts, then the situation will come up more frequently.
“One of the most important considerations for us is to allocate investments fairly among our investment products and making sure that we have a robust allocation policy in place,” says Adveq’s Atherton. “This is an integral part of our decision making process at the Investment Committee level.”
As in-house lawyers become more involved in commercial decisions – from fundraising to regulatory compliance – they become more valuable members of the firm’s team. As these two red flag examples highlight, however, there is much more at stake than box-ticking.
As Pierettori puts it: “General counsels have become more accountable. Whereas in the past, CFOs were mainly held accountable for a firm’s operational decisions, now the general counsel is also expected to put their neck and reputation on the line.”
Around the table
Geoffrey Bailhache is a managing director and head of EMEA legal & compliance at Blackstone. He began his career at SJ Berwin, then worked at Weil Gotshal & Manges for four years focusing on international M&A and private equity before joining Blackstone in 2010. Bailhache is also an active participant of the BVCA Legal & Technical Committee and the Invest Europe Regulatory Committee.
Panayides trained and qualified at SJ Berwin (now King & Wood Mallesons). As an associate at KWM, Andrew specialized in investment funds, finance and corporate acquisitions. Panayides left KWM in October 2015, when he joined Duke Street as its general counsel. He is responsible for all legal and regulatory compliance matters.
Atherton is Adveq’s general counsel, private investment structures. He advises Adveq with respect to the formation, operation, legal structuring and terms of its global private investment funds and investments. Before joining Adveq, Atherton spent nine years at Proskauer Rose and SJ Berwin. During this time he advised on the structuring and raising of international private investment funds, co-investment schemes, private fund secondary transactions and carried interest arrangements.
Pierettori joined InvestIndustrial in 2009 as general counsel. Previously, he worked at Lehman Brothers as head of the legal and compliance division for the Italian operations and, prior to that, he was an associate with US law firm Davis, Polk and Wardwell. Marco speaks English, Italian and French, and in 2015 he received the European Counsel of the Year Award by the International Law Office.
Ted Craig is a partner at MJ Hudson. He has a broad private fund practice, acting for fund managers on the establishment of private equity, venture capital, infrastructure and other closed ended funds, and for investors on their primary investments into private funds. Craig also heads MJ Hudson’s secondaries team and advises clients on all aspects of private equity secondaries transactions.
Photography by Peter Searle