- Structuring Considerations in Private Equity
- Main Building Blocks and Vehicles of a PE Structure
- Using a Combination of Vehicles
- Alternative Private Equity Structures
Using a Combination of Vehicles
Why would you want to use a complicated structure instead of having just one fund vehicle?
The reason for using a combination of vehicles is to cater to particular investor groups with specific tax and/or regulatory requirements that cannot be accommodated through the main fund.
For instance, assume that for the majority of your investors a common low partnership (e.g., English Limited Partnership) would work perfectly—it is tax efficient, and the investors are familiar and comfortable with this vehicle. However, there are, for example, two groups of investors, each one facing similar (within the group, but different to the other group) challenges, for which the main fund—the English Limited Partnership—is not an efficient (for tax, regulatory, or other reasons) vehicle. What do we do?
In this case, in order to attract these investors, the sponsor will have to come up with a more desirable vehicle—in fact, two additional vehicles to deal with each group of investor needs, basically creating a combination of vehicles.
To summarize, using a combination of vehicles offers the following advantage:
- Allows the sponsor to cater for different investor requirements
However, it also represents the following challenges:
- Increased complexity, which would require additional resources and skills to understand and administer the structure
- Need to rebalance among the fund entities upon subsequent closings (valid for parallel funds)
- Need to divide costs between the fund entities (also valid for parallel funds)
- Additional cost—each legal entity would involve additional cost to set up and maintain the structure
There are basically two main ways to go about the more complex structure:
- Using a master-feeder structure; or
- Using a parallel structure
A master-feeder structure is a subordinated structure in which investors invest through a feeder fund(s), which then invests in the master fund. (Often direct investors invest directly in the master fund as well, as in Figure 1.3). The master fund performs all the investment-related activities; the original drawdown and distribution activities take place at the feeder level and then are passed on to the master fund, except for any direct investors who invest directly in the master fund (see Figure 1.3).
Figure 1.3 Master-feeder structure
Management fees typically are charged at the master fund level. At the feeder fund level, usually only a symbolic fixed absolute amount (e.g., US$1,000) is charged. The main expense for the management fee charged to the master fund is passed on to the feeder fund through the net asset value (NAV) allocated to the relevant feeder by the master fund.
For many investors, investing directly in a fund that is a common law partnership (such as an English Limited Partnership) might be tax-efficient (and regulatory-efficient). Let’s call these investors “direct investors.” However, for another group of investors, that might not be the most efficient way. To address the tax/regulatory issues specific to that group of investors (for example, Dutch investors), the sponsor might need to set up a feeder vehicle/fund (such as a Dutch CV). Doing so would make investing in the master fund through a feeder more attractive to that particular group of investors—in this case, Dutch investors who need to avoid classification as a “corporation” for Dutch tax purposes, which would lead to adverse tax consequences.
Some sponsors and lawyers organize funds with multiple partnerships for reasons other than tax. For instance, they might want to keep all U.S. investors or all Employee Retirement Income Security Act (ERISA) investors in a separate partnership, to insulate non-U.S. investors from perceived adverse U.S. taxation, ERISA, or litigation risks.
Bottom line: Reasons differ, and lawyers can come up with different solutions depending on your specific circumstances.
Another alternative (see Figure 1.3) is to organize a fund with a main fund vehicle being a common law partnership, for flexibility and familiarity to investors (and sponsors), and to form feeders (as many as you need) or parallel vehicles to cater to major investor groups with specific tax or regulatory (or any other) requirements that investment in the common law partnership cannot accommodate.
You also might have one onshore feeder (such as a Delaware Limited Partnership or an English Limited Partnership) and another offshore feeder (such as a Cayman Exempt Limited Partnership or a Guernsey/Jersey Limited Partnership, respectively).
A master-feeder structure, as described by the International Accounting Standards Board (IASB), is often a common way for both foreign and domestic investors to invest in one central portfolio of underlying investments with different tax benefits, depending on whether an investor is invested in an onshore or offshore feeder fund. As IASB continues, from an accounting perspective, the master fund and the feeder funds together could be viewed economically as one investment company.
From an accounting perspective, the feeders are just another LP investing in the main/master fund. Therefore, the accounting for the feeder should be similar to an FoF—that is, taking an allocation of the NAV of the main/master fund.
From the master fund’s perspective, the feeder is just another LP. Therefore, they should be treated like the other direct investors/LP by providing them with a quarterly report and capital account that includes their relevant allocation of the master fund’s NAV. However, depending on the accounting framework/GAAP (Generally Accepted Accounting Principles), some specific requirements might apply.
For instance, under U.S. GAAP, a feeder fund is required to separately present its allocated share of the master fund’s net investment income and realized and unrealized gains and losses in its financial statements. In addition, for investment companies regulated by the 1940 Act, each feeder fund is required to present a complete set of the master’s financial statements along with its financial statements. This requirement is optional for unregulated investment companies.
Under International Financial Reporting Standards (IRFS), IASB has taken a slightly different view on that.
Structures Involving Blockers
Another type of structure that can also be viewed as an FoF structure for accounting purposes. In this case, an investment company invests in a blocker entity.
Some sponsors insert a “blocker” or “stopper” fund to change the character of the underlying income or asset (or both), primarily to address entity qualification criteria under tax, regulatory, or legal guidelines. Inserting a blocker fund converts “bad” assets and income into “good” assets and income (a dividend instead of a distribution from a limited partnership), allowing the investment company to maintain its status or to achieve a more beneficial tax outcome.
A number of different situations might give rise to the need to use parallel structures. One of the most common situations, for example, is where taxpaying and tax-exempt U.S. investors require the partnership through which they invest to make different elections for U.S. tax purposes. U.S. tax-exempt investors who do not want to have unrelated business taxable income (UBTI)—as they might be liable for tax on its UBTI and required to file certain tax returns—would typically require that their partnership elects to be treated as a corporation or hold investments through a corporation, and U.S. taxpaying investors would typically want their partnership to be treated as a tax transparent entity/partnership.
Although parallel structures are used most often for tax reasons, sometimes sponsors also use them to place different categories of investors into different vehicles for other than tax reasons. For instance, large investors paying reduced management fee/priority profit share (PPS) might be placed in one partnership while all the other investors who pay headline management fee rates are placed in a separate one.
Many examples (and as many reasons) prompt a sponsor to use a different parallel structure, and the aforementioned ones are just a few of them.
For reporting purposes, all parallel partnerships can be viewed as one partnership/entity because, if these reasons did not apply, the sponsor would have simply set up just one fund or vehicle. The reporting for parallel funds often reflects that by presenting a set of aggregated accounts in addition to the individual sets of accounts for each parallel vehicle. Under U.S. GAAP that is acceptable, but bear in mind that some auditors may challenge this concept under IFRS.
Figure 1.4 Parallel structure
Master-Feeder or Parallel Structure?
Although sometimes the same goals may be achieved by using either master-feeder or parallel structure—for example, to resolve the issue with the different tax elections mentioned earlier—sometimes there may be advantages to a master-feeder structure compared with a parallel structure.
For instance, a master-feeder structure can be used if an investor in the master fund cannot, due to internal rules or otherwise, make up more than a certain percentage (e.g., 5%) of the vehicle he is participating in due to the fact that all the investors participate (directly or indirectly) in the master fund. If you are to use a parallel fund instead, the percentage of that investor who participates through a feeder fund may go over the restricted percentage.
Another example is when you have U.S. ERISA investors and the sponsor is relying on the so-called “25% limit exemption” from the master fund constituting “plan assets,” which requires that the aggregate amount of investment in the master fund subject to ERISA is less than 25%. Under a master-feeder structure, all the investors in the feeders count as investors in the master fund, which would not be the case with a parallel structure. In addition, if the business of the feeder fund is limited to investing in the master fund, you can claim that there is no investment discretion exercised by the manager/GP with respect to the feeder fund.