The past decade brought remarkable change to a number of industries that for generations had operated under time-tested paradigms. Banking has gone beyond cash with digital payments; insurance has become personalised; and the sharing economy has disrupted transportation and hospitality – the list of examples is long. Yet, until recently, the operating model of some private equity firms had been surprisingly inert to change.
In the 1980s, only a handful of private equity firms existed, hardly any of which were household names at that time. Furthermore, the way private equity firms operated was little understood by the general public. The ubiquitous fund structures, typically domiciled in locations such as Delaware or the Cayman Islands, offered attractive features – liability protection for limited partners (LPs) and tax-efficient carry for general partners (GPs). The general economic framework resembled a dogma not subject to challenge – a 2% management fee, 20% carried interest, 8% preferred return and 10-year term.
It is fair to say that these times are over – the coming years will likely bring change to the private equity sector itself and the actors in that sector may be recast in roles more typical of corporations. Keep in mind – since the 1980s, the industry has grown exponentially.
In four decades, this once small corner of finance has become a $5 trillion global sector and major source of value transformation (source). To continue its growth, the private equity sector will need to adapt to change – change driven by regulation, technology and customer demands.
The private equity sector has been and will remain a catalyst for change and value creation through mergers and acquisitions (M&A) – private equity firms address strategic turnarounds and bring about operational transformation at their portfolio businesses. As such, private equity sits at the intersection of many of today’s forces. As a major investor across industries, and one with the ability to look over a longer investment horizon, private equity has an opportunity to use its resources and influence to be an agent of change.
On top of this, most tax authorities increased the scrutiny devoted to private equity firms both at the fund and investment level. They focus on investment holding company substance, i.e. the vehicles that grant tax treaty benefits. Moreover, the OECD BEPS project has resulted in challenges to the level of debt financing (requiring support via debt capacity analysis) and the specific types of financing instruments used and interest rates applied.
Change driven by regulation
On the one side, private equity funds need to brace for tighter regulation from financial regulators around the world. Only recently, the new leadership of the SEC announced exam priorities that will continue to focus on advisers to private funds, and will assess compliance risks, including a focus
on liquidity and disclosures of investment risks and conflicts of interest. On the other side, investors also demand more transparency, accountability and better governance to ensure that their interests are being safeguarded more effectively.
In response, more and more private equity firms are setting up new funds in European-onshore domiciles such as Luxembourg or Ireland using regulated alternative investment funds (AIFs). Let’s be clear – this is a significant change. The first objective of the Alternative Investment Fund Managers Directive (AIFMD) is to protect investors by introducing stricter compliance around how and what information is disclosed. This includes conflicts of interest, liquidity profiles, and an independent valuation of assets. The second objective is to remove some of the systemic risks private equity funds could pose to the larger economy. Here, the AIFMD framework mandates that remuneration policies be structured in a way that does not encourage excessive risk-taking.
As a result, the historical demarcation between traditional funds and alternative funds is diminishing. We expect that alternative funds that are set up under the AIFMD regulatory framework will soon become the preferred investment structure for investors looking for a combination of both a regulated vehicle and alternative investment strategies.
This change will also have a fundamental impact on the existing operating and transfer pricing (TP) models in the private equity industry.
Any AIFMD-regulated fund will need to be managed by an alternative investment fund manager (AIFM) in the EU. The AIFM protects investor interests and is liable both to the investors and regulators. This also implies that any management (as well as performance) fees now arise at the new AIFM (instead of the GP). Subsequently, the fees will need to be split (either on basis of a fee or profit split) between the AIFM, the GP and the related (or unrelated) parties to which the AIFM delegates activities to. These delegated activities include portfolio management and sub-advisory, capital raising and LP services as well as fund administration.
For all delegated activities, tax authorities and regulators alike expect to see arm’s-length (or as the regulators refer to it “economically justified”) remuneration. Also, the GP must be remunerated on an arm’s-length basis, although its role is reduced given that the AIFM now performs the day-to-day management function of the AIF and formally houses the investment committee. This will be challenging – in practice, suitable comparables will need to be identified to remunerate the new AIFM (via a share of the management fee or basis points (bps) of the assets under management (AuM)). This analysis will also need to take into consideration the committed v. called (and invested) capital, as well as regulatory capital and liquidity requirements.
Change driven by customer demand
One of the other major changes that private equity funds need to adjust to is the rise of customisation and bespoke solutions which results from the need of private equity funds to broaden their LP-investor base. While large private equity firms will likely continue to diversify (e.g. across different investment strategies and into real estate, debt funds, or direct lending to their portfolio companies), small firms may be more likely to specialise. Consequently, private equity firms will likely need to revisit their TP model with respect to how the role of the development of new investment ideas/funds is remunerated.
The broadening of the LP-investor base also implies that private equity funds will likely need to transition from indirect marketing (via reverse solicitation) and private placements to direct marketing. Typically, direct marketing activities would rely on EU-passporting and would allow distribution to qualified investors, both inside and outside the EU. This is similar to the Undertakings for the Collective Investment in Transferable Securities (UCITS) regime for broadly-held investment funds, which has also become the dominant regime for investment funds sold to investors in South America or the Asia-Pacific region.
The broader implication for TP is that dependent agent permanent establishments (DAPEs) are more likely to become an issue for private equity funds depending on how/where new clients are developed and capital raising is de-facto being performed. We are already observing the first US-based private equity funds with EU-domiciled funds applying for Markets in Financial Instruments Directive II (MiFID II) top-up licenses that allow them to distribute their funds to a broader range of investors under the MiFID II distribution framework.
Change driven by COVID-19
Enduring more than one full year of the COVID-19 pandemic also had clear impacts on the private equity sector globally. Essentially, the COVID-19 lockdowns forced private equity firms to adopt virtual working models overnight. The long-term impact of the COVID-19 pandemic on both private equity firms and portfolio companies remains to be seen.
The COVID-19 pandemic also further posed a challenge for private equity funds to resort to restructurings and secondary transactions in order to create liquidity for investors as fund lives expired.
In this context, the major difficulty faced by private equity funds was the inability to get on-site and visit businesses that had investment potential. While a target might look great on paper, deal teams still need to visit potential targets and see how they operate on a day-to-day basis to form their investment decision.
As a result, some deals were initially delayed (in the hopes that an on-site visit would be possible at some point) or even fell through, though the M&A market began to make a comeback towards the end of the third quarter in 2020. This may become less of a problem as travel restrictions are lifted and as private equity firms adapt to a post-COVID environment. Nonetheless, it will not change that investors expect private equity funds to have boots on the ground when assessing the viability of a specific company as an investment target.
In addition to the due-diligence dimension, raising capital in a virtual environment can be challenging. On top, the need for investment committees and board meetings for the portfolio companies to meet virtually and decision-making to be performed virtually/out of home-office jurisdictions adds another level of complexity for TP purposes.
The private equity sector is facing tectonic changes that other industries already experienced in the last decade – changes are driven by regulation, technology and customer demands. Investors and regulators are pushing for more transparency, accountability and governance, which in turn is resulting in new fund structures and operating models with far-reaching TP implications. As investors demand more customised alternative investment solutions, the need to broaden the LP-investor base will likely accelerate the move to direct marketing strategies to raise new capital. The COVID-19 pandemic has had a clear impact on the work environment in the private equity sector, as it poses new challenges for cross-border due diligence and raising capital in a virtual environment.
The private equity sector will remain an important catalyst for change and value creation but the historical demarcation between traditional funds and alternative funds is diminishing, with carry-over effects on traditional TP models in the industry.
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Ralf Heussner is a partner with Deloitte Germany and has an extensive international track record of more than 19 years’ experience advising clients on addressing the tax, operational and regulatory dimensions of their international operations covering the design of target operating models, restructurings and TP.
Ralf’s experience covers a broad range of complex engagements for financial services companies on business model design/optimisations and restructurings to align the tax, operational and regulatory dimension of their operations. Recent examples include the alignment of financial/banking regulations (e.g. Basel and MiFID) and tax rules (e.g. on funds TP, cross-border distribution models or design of tax governance models), supporting financial institutions across the banking, insurance, investment management and fintech space on Brexit related restructurings as well as the recent trend of alternative asset manager moving into regulated fund structures.
Ralf has been voted into Euromoney’s Guide to the World’s Leading TP Advisors.
T: +81 80 3432 9319
Samuel Gordon is a TP/financial services tax partner with Deloitte Tokyo Japan. He is the global TP leader for the financial service industry. He also serves a regional or global lead TP advisor for clients across three major financial services hubs – Tokyo, Hong Kong and Singapore.
Samuel is a bilingual (English–Japanese) TP professional with more than 22 years of advisory and in-house experience. He advises clients on TP and permanent establishment strategy, planning, documentation, risk assessments, APAs; in-house TP governance, systems, controls and reporting. Hel focuses on TP for financial services and fintech industry clients and intercompany treasury issues of all types of clients. He brings to bear his prior in-house experience to help clients enhance their transfer pricing and overall tax management.
Samuel regularly speaks at TP and tax conferences in Tokyo, Hong Kong, Singapore, New York and London. He is active with several financial services industry associations and he has contributed articles to trade and academic publications.
T: +49 69 7569 57232
Anodri Suchdeve is a senior manager at Deloitte in Frankfurt, Germany.
Anodri started her career at Morgan Stanley and worked in the corporate tax department in New York, and financial control group in Frankfurt, primarily focused on controlling, TP, financial and regulatory reporting and thereafter the operational TP team in New York. After serving many years at Morgan Stanley, she joined Mitsubishi UFJ Financial Group in New York, and led the operational TP group as the Vice President while continuously streamlining operations, systems and especially alleviating and harmonising challenges between business units and related parties.
Anodri advises a number of financial services clients on various TP matters, including operational TP topics.
T: +1 212 436 2366
Jon Gemus is a principal in Deloitte’s New York TP practice and is the Americas TP investment management industry leader. Jon has assisted investment management clients at all levels of the value chain, including at the management company level, deal team level and portfolio company level. At the deal team and portfolio company level, Jon assists clients in structuring leveraged acquisitions via debt capacity and pricing analyses. Experience at the management company level includes support for investment research, advisory and management services, as well as deal sourcing and execution services.
Jon’s work in the financial transaction and valuation space includes intercompany debt pricing and debt capacity analyses related to acquisitions, refinancings and recapitalisations for clients in industries including technology, chemicals, consumer products, manufacturing and financial services, among others. He has also performed numerous IP and equity valuations for technology and financial services clients related to IP transfers, cost sharing and intercompany legal entity and workforce transfers.
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