Statistics from Japan over the past couple of years regarding private equity (PE) and venture capital (VC) investment have been impressive. In 2017, there was a 15x year-on-year increase in dry powder raised, a 30 percent increase in the number of funds launched and the value of deals executed more than double.
The drivers behind this growth are varied. Increased interest from overseas; and a shift in mindset to greater acceptance of PE among domestic investors, coupled with negative interest rates and lacklustre performance of other investments are named as contributing factors. However, Japanese domestic banks and pension funds allocating billions to the space is the headline that grabs most attention.
Not surprisingly, the interest of such allocators has had the knock-on effect of determining how some funds are structured, resulting in departures from global trends and the emergence of what has been referred to as the “private equity-style unit trust” (PESUT). This should not come as a surprise, as demands of large investors typically impact investment structure. However, there are questions as to whether the PESUT is a one-size-fits-all or if it is hammering a square peg into a round hole.
The gold standard — limited partnerships
Globally, the vast majority of PE funds remain structured as Cayman Islands limited partnerships. In Japan, this trend is no different.
There are numerous reasons for this, including that:
- laws governing partnerships have been enacted intentionally to facilitate the commercial demands of investors and managers in PE. The Cayman Islands Exempted Limited Partnership Law even permits the fiduciary duty of the general partner to be disapplied, and for remedies otherwise unenforceable as penalties to be enforced in an exempted limited partnership;
- partnerships are, fundamentally creatures of contract, governed by negotiated terms in the partnership agreement, rather than prescriptive rules of statute, or rules of equity in the case of trusts. This allows parties the flexibility to participate on a preferred basis that has come to characterise PE including by providing rights of: (i) co-investment; (ii) excuse; (iii) information rights; (iv) committee participation; and (v) distribution in-kind rights;
- it is simple for an investor to enter into a side letter allowing it to invest on terms specific to its own investment criteria without changing the investment terms of other investors; and
- partnerships are, typically, tax transparent “flow throughs” providing the benefits of capital gains treatment to investors and carried interest recipients.
The alternative — private equity-style unit trusts
In contrast, the PESUT, being a trust, is subject to often antiquated rules of equity that impose strict fiduciary duties on the trustee and do not permit the same level of flexibility.
This means that although a “commitment-and-call” mechanism can be readily drafted into a subscription agreement — and default remedies can be included in the documents if investors fail to fund (although there is a real risk that these are unenforceable in a trust) — a trustee cannot readily avoid its fiduciary duty to act in the best interests of the beneficiaries and to treat them equally. This can prevent the practical implementation of the terms lawyers draft into the documentation and preclude side letters (which almost always lead to one investor being preferred over others).
In a multiple investor fund, the result is that either that:
- the commercial terms that investors desire will be unavailable;
- the operator of the fund will not be able to exercise its discretion in the manner to which industry is accustomed;
- the documentation becomes extremely complicated; or
- a mixture of the above.
That said, a PESUT has a couple of characteristics that are irresistibly attractive to certain investors. When it comes to tax reporting, a trust can effectively be treated as a “blocker”, allowing for reporting to take place at the trust level. Trusts are also more familiar to certain investors. Japanese tax and regulatory considerations may also weigh in to favour PESUTs in certain situations.
The trade off
To oversimplify the balancing act of many complex issues, the question is whether your investors want (i) a private equity fund, or (ii) a trust that invests in private equity.
If investors can all invest on substantially identical terms (as in a “fund-of-one”); will not require side letters, excuse rights or otherwise unequal treatment; but are familiar with trusts, a PESUT may be ideal. With thoughtful drafting, certain traditional PE features can even be incorporated.
However, if it is imperative to implement the full functionality that the broader PE industry treats as standard for its collective investment vehicles, a PESUT may be unwieldy, expensive and impractical. A combination of the rigid rules of equity, and the strict fiduciary requirements of professional trustees to treat all beneficiaries can result in the structure and documentation being unnecessarily complex or, worse, economically unviable. Where the flexibility to meet the preferences of varied investors is imperative, a partnership is often still the preferred route.
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