The vehicles of Europe

As a means of structuring a private equity fund in Europe, the limited partnership hasn't had things all its own way – but it's come pretty close. If a new vehicle is about to be raised – particularly if it's a large fund boasting a decent slab of commitments from US and/or UK-based investors – any alternative structure may well not even be considered.

It would be an exaggeration to say that in May 2004 that all changed. But it did mark the date of birth of the Société d'investissement en capital à risqué (SICAR): a Luxembourg-based entity that, particularly for funds with a large proportion of continental European investors, appeared to offer a real alternative to the limited partnership. Thus far, caution has greeted the introduction of the SICAR and take-up has been slow, perhaps because of reluctance among GP groups to be part of the first generation of firms exposed to something untested. Nonetheless – in the words of one lawyer, the SICAR has unquestionably ?added another piece of kit to the toolbox.?

Other new structures – or adaptations to existing structures – have also been added to the mix. The likes of the FCPR in France and the UBG in Germany are frequently used as ways of accommodating the requirements of investors based in a particular country. Hence, such vehicles are often employed by country-specific funds, or at least funds with a high percentage of investors from one particular jurisdiction.

In this article, we review a selection of these structures and consider some of the key developments and nuances in Europe's ever-changing – and increasingly eclectic – fund structuring environment.

Limited partnership: The Anglo-Saxon choice
The limited partnership fund structure has been a faithful and respected companion to many participants in the private equity industry. Over the last 30 years, the so-called ?Anglo-Saxon LP? has been constantly honed and refined. By the 1980s it was the most popular way of structuring funds, and could be said to have become ?market standard? by the 1990s.

Any private equity fund structure is essentially aiming for one thing above all others: tax transparency. This means that investors are treated as if they are investing directly in portfolio companies rather than through a fund. In effect, there should be no tax charge at the fund level and no charges at the investor level just because investors are shareholders in the fund rather than direct shareholders in the investee company.

It's important to note that the Anglo-Saxon limited partnership is not by any means the only structure that offers investors in Europe a way of achieving this basic goal. But being the first has allowed it to achieve a dominant position. ?The limited partnership is no doubt the most frequently used [private equity fund structure] in Europe,? says Jonathan Blake, head of private equity at SJ Berwin, the London-based international law firm.

Having grown out of the legal systems of the US and UK, it is unsurprisingly of most appeal to private equity firms and their investors from those two countries. Says Jonathan de Lance-Holmes, a partner in the London office of international law firm Linklaters: ?For those who have been investing in private equity for the last 20 years, the limited partnership ticks all the right boxes. They will know typical terms and conditions inside out.?

However, many continental European investors have never felt entirely comfortable with the limited partnership. It is, to recap, based on US and UK legal systems rather than the very different legal jurisdictions found on the Continent. To them, it has always been something of an alien creature (see SICAR section below).

Offshore vs. onshore: Logistical conundrum
To take a brief step away from fund structures, it is important to note an important consideration when raising any European fund: whether to administer it onshore or offshore.

Given their ability to provide various tax and regulatory advantages, the Channel Islands of Jersey and Guernsey swiftly became the natural destination for the administration of European private equity funds (though other locations such as Bermuda and the Cayman Islands now have competing claims).

When the private equity industry was in its infancy, the siren call of the Channel Islands was compelling: registering funds there was, in those days, the only sure way of avoiding double taxation, for example. But in the late 1980s, the UK government decided to try and repatriate fund management business by introducing various tax and regulatory measures designed to level the playing field.

This means decisions on whether to base UK funds onshore or offshore often now boil down to softer considerations than tax or regulation. On the one hand, says Mark Huntley, managing director of fund administrator Heritage International Fund Managers, the Channel Islands' long history of fund administration has generated trust in their ability to do a good job – not only in terms of administration but also related services such as accounting and legal advice.

On the other hand, there are practical problems. To register its fund offshore, the fund manager must have ?manager? status in the offshore location and only ?adviser? status in the jurisdiction(s) in which the fund is invested. In effect, this means that all significant management decisions must be taken offshore. UK GPs registering their limited partnerships in London rather than the Channel Islands are these days likely to do so on the rather prosaic grounds that it means they can avoid the hassle of flying to and from Jersey airport several times a year.

For GPs based in continental Europe, the siren call has been less easy to turn a deaf ear to. Generally speaking, the regulatory environments for fund administration in continental jurisdictions are much less user-friendly than in the UK: therefore, the Channel Islands have a more decisive advantage. Ironically, of course, the logistic demands of holding regular board meetings in the Channel Islands are significantly more problematic for many continental GPs than their UK counterparts given the greater distance involved and an absence of direct flights.

SICAR: The continental choice?
May 2004 saw the introduction of a private equity fund structuring vehicle that appeared tailor made for continental European GPs. Says Jonathan Blake: ?The SICAR can be arranged to do roughly the same job as an LP. Anglo Saxon investors wouldn't think of it first because there's no value added. But it provides a structure that some continental investors may like if all else is equal.?

By way of background, the SICAR is not strictly speaking an entity in its own right. The ?structure? is in fact either a Luxembourg limited partnership (SCA) or a Luxembourg limited liability company (SARL), which is then granted a Société d'investissement en capital à risque (SICAR) licence provided the fund in question is focused on private equity alone.

So why does SICAR possess allure for continental European private equity firms? To return to a point made earlier, the limited partnership has never sat easily with continental investors. Says Jonathan de Lance-Holmes: ?There can be a perception issue for the Anglo-Saxon LP in continental Europe. The way it's put together, the roles and the responsibilities, all look very foreign. There's nothing that resembles it in the legal jurisdictions of continental Europe.?

By contrast, the SICAR draws on European company law – which, as well as being more familiar to continental investors, also results in shorter and simpler fund documentation (because – to put it simply – where there are gaps in the documents, company law fills those gaps). With the Anglo-Saxon limited partnership, says de Lance-Holmes, ?if you don't write it in the documentation, it doesn't apply.? He adds that this is in one sense positive, because it limits the likelihood of subsequent disputes (i.e., ?what you see is what you get?). It can also be important for large funds and/or funds with unusual strategies to have the wording finely honed. Nonetheless, it can also be a time-consuming and expensive process in comparison with the construction of a SICAR vehicle.

But perhaps the most compelling aspect of a SICAR from continental European investors' perspective is its onshore status. As mentioned earlier, the main reason why an offshore vehicle is attractive to them is the contrast between the light regulation in Jersey or Guernsey and the fierce regulation common in their domestic jurisdictions. Luxembourg not only offers a light regulatory touch, but – situated more or less in the heart of Europe – is also much more accessible to most European GP groups.

Despite SICAR's attractions though, private equity firms to date have rarely used it. One firm that did so was European Capital, the European affiliate of Nasdaq-listed investment group American Capital Strategies, when it raised a €750 million debut fund (including €229 million of third-party commitments) in October 2005.

In some quarters, the SICAR was billed upon launch as an alternative to the limited partnership – as if the two were limbering up for headto-head battle. In fact, the relatively low takeup of the SICAR so far reflects that its primary appeal is to a limited constituency: in the main, continental European GPs, with a mainly continental European investor base and operating at the small to medium sized end of the market.

According to Jonathan de Lance-Holmes, though, the perception that the SICAR has failed to gather momentum is on the verge of being challenged. He says: ?There's not much experience of the SICAR so far, so people are understandably cautious. But there are funds currently going to market that will make its use a lot more visible.?

Germany: Mixed fortunes of the UBG
While the limited partnership and the SICAR have obvious attractions for international investors in private equity funds, there are also country-specific vehicles available for use in many European countries. One of the more common reasons for their existence is to offer tax incentives for investing in a given country or a particular sector or type of business within that country.

In the case of Germany, the UBG was introduced in 1987 to stimulate investment in German small and medium sized companies by offering a structure that would reward investors in such businesses with tax breaks. By 2003, when Frankfurt-based Deutsche Beteiligungs(DBAG) used a UBG structure for its fourth fund – which closed on €228 million, with three quarters of total commitments from investors based in Germany – the tax case was compelling. The UBG offered relief on capital gains tax and commercial tax as well as reduced local taxes. ?At the time, we thought it was the perfect vehicle,? recalls Gustav Egger, CFO of DBAG.

But by the time DBAG came to launch its €375 million fifth vehicle in November 2005, things had changed somewhat: notably, the tax-free status of capital gains under the UBG has been thrown into doubt. Holger Fromann, managing director of BVK (the German venture capital association), says political sentiment in the previous government had shifted toward an abolition of CGT-free status. Since the coalition government was formed, abolition has seemed less immediate, but is likely to be back on the agenda when discussions begin about a new tax reform program in 2007/08.

The uncertainty was too much for DBAG, which has used a vermoegensverwaltend structure (which is effectively a German version of a limited partnership) for its latest fund.

TVM Techno Venture Management, the Munich-based venture capital firm, took an interesting approach when it raised its most recent vehicle, the €240 million TVM Life Science Ventures VI fund, in October 2005. Eschewing the UBG, it ran two limited partnership structures side by side: a German LP and a Cayman Islands LP. The terms of the two structures were exactly the same, according to TVM CFO Bernd Siebel.

The interesting outcome, he notes, is that 75 percent of investors committed to the German LP structure and only 25 percent to the Cayman Islands structure, even though only 60 percent of the investors were international. This was because while all US based LPs committed to the Cayman Islands structure, almost all UK-based LPs opted for the German version: demonstrating that not all Anglo-Saxon investors will necessarily plump for an Anglo-Saxon structure. The matter of where the fund structure was based was ?not an issue? for the UK LPs, notes Siebel.

Hence, the German LP is in the ascendancy: an increasingly trusted vehicle for international investors, it is also the only refuge for domestic investors all the while uncertainty reigns over prospects for the UBG.

France: Singular vehicle
Formed in 1983, the French Fond Commun de Placement a Risques (FCPR) vehicle has gone through countless iterations since that date designed to make it more attractive to investors. Perhaps its most significant evolution came in 2002 as a result of the government's Loi de Finances legislation, which set out to streamline and modernize the rules applicable to FCPRs.

In many ways, the FCPR is one of Europe's more unusual fund vehicles. Normally defined as a ?joint ownership of securities? it is not a legal entity and cannot therefore enter into contracts – instead contracts are concluded by the management company on the FCPR's behalf.

The management company, which must be approved by the French Securities Exchange Commission, has sole responsibility for the management of the FCPR including all decisions to sell or make investments. But, in addition, the FCPR must also have a custodian – normally a large French bank – which has custody of the FCPR's assets and which must verify that the deals the management company is carrying out conform with French legislation and also with the FCPR's own by-laws.

Given these idiosyncrasies (and apparent complexities), one might have anticipated the FCPR being shunned by international investors. According to Michael Diehl, a partner at Paris-based mid-market buyout firm Activa Capital, this is far from the case: ?From our experience, international investors are completely at ease with it and they understand it completely,? he says. Activa used an FCPR vehicle for its most recent fundraising, which closed on €162 million in December 2003.

Rather than being put off by the complicated ownership structure, many investors see within it the security of solid corporate governance. They also take comfort in a guarantee under French law that investors' liability will be limited to the extent of their commitment to the fund. In addition, the FCPR offers tax transparency similar to that offered by any limited partnership structure.

Diehl says French-focused GP groups like his are confident that they do not have to make special allowances for international investors: ?Most French private equity funds investing in France will use the FCPR vehicle irrespective of the make-up of their investor base,? he says. ?However, there are some French-based pan-European funds that would go down the LP route.?

Due to what might be termed unforeseen circumstances, the popularity of the FCPR is set to grow over the next few years. In October 2004, an agreement was struck between the French Finance Ministry and the country's insurance industry by which insurers will raise their commitment to private equity from an average level of 1.4 percent to 2 percent. It was stipulated that the extra capital – estimated to total around €6 billion by the end of 2007 – should be invested either directly or through common French fund vehicles such as the FCPR.

The future: Multi-faceted or unified?
There appear to be two very different possible directions for European private equity fund structuring in the future. On the one hand, we could see more new structures arising – possibly one or two that, like the LP and SICAR vehicles, have an appeal to international investors; others that may be tailored more closely to the demands of domestic institutions.

Currently, there is plenty of evidence of the wind blowing in that direction. In Spain, for example, the passing of a new Venture Capital Act has brought in its wake various innovations designed to help private equity funds: notably making it easier for domestic institutions to invest in the asset class as well as simplifying the process for launching funds of funds and making it more straightforward for funds to invest in public companies.

In the emerging private equity markets of Eastern Europe, change is also afoot. In Poland, the Investment Funds Act 2004 created a vehicle through which Polish pension funds could invest in the asset class for the first time. There have also been recent tax incentives tacked onto domestic structures in a number of countries in the region, including the komanditni spolecnost in the Czech Republic and the kockazati toke alapok in Hungary.

What is more, there are also European countries currently without their own domestic private equity fund vehicle, but where demand for one is strong. One example is Switzerland, where the Swiss Private Equity and Corporate Finance Association (SECA) has been in lobbying mode. ?We have a very strong private equity industry here using offshore structures, which is crazy,? exclaims Massimo Lattmann, chairman of SECA.

But despite this very evident trend toward fund vehicle diversification, it is not something that necessarily works in the best interests of GPs and LPs. Which is the reason why industry body the European Private Equity & Venture Capital Association (EVCA) is currently campaigning for a single European fund structure – which, it claims, would mirror the situation in the US, where ?one vehicle and one structure can be used throughout the country?.

A spokesperson for the EVCA said the organization has been in talks with the European Commission about the issue, which have indicated ?a willingness on the part of the Commission to address some of the issues surrounding the industry's need for a single fund structure?. They added that the Commission had requested the EVCA's participation in an expert group in early 2006 at which specific recommendations can be submitted.