This alert is part of a new series of quarterly updates from the Goodwin Private Equity team on important issues for European private equity. As 2019 comes to a close, here are three issues for fund managers to consider.
Brexit and the UK general election
It is sometimes hard to believe that it is nearly three and a half years since the referendum on the UK’s membership of the European Union. At times it seems we are no closer to knowing what “Brexit” will actually mean than we were in June 2016. However, the imminent UK general election may provide more certainty on the path to be taken in 2020, but then again it may not. Of the three feasible outcomes – a Conservative government, a Labour government or a hung parliament, it seems a Conservative government could provide a degree of certainty on Brexit, but only in the very short term.
It is likely to mean that the Withdrawal Treaty negotiated by Boris Johnson (and in large part by Theresa May) will be ratified at some point in early 2020, and the UK will therefore exit the European Union – however that is where any certainty ends. While for private fund managers nothing would change for much of 2020 due to transitional arrangements, what happens after the end of the transition period is still an unknown.
While Boris Johnson says he believes an all-encompassing free trade agreement can be negotiated in such a short time frame, others are not so optimistic. However, a bespoke arrangement for the financial services sector, including access to the Single Market, has never seemed to be on the table even if a free trade agreement is concluded – so UK-based managers will most probably be “third country” managers under EU law going into 2021. But the funds industry in the UK has been preparing for this: some have set up a presence in Luxembourg or other EU member states, with a UK entity acting as an adviser, others have taken advantage of a “third party” AIFM, and some are happy to rely on the national private placement rules (NPPRs) that many Channel Islands and US-based managers have been using to market their funds in the EU since 2013. The main issue with NPPRs is that not all countries have these rules – and they may potentially change in the coming years.
One solution to allow UK managers access to the benefits of the AIFMD passport post Brexit is the concept of the “third country passport,” which was provided for in the AIFMD. This would allow non-EU managers managing non-EU funds to opt in to complying with the AIFMD and in exchange be allowed to market freely in EU member states. However, there is significant uncertainty around how this would operate – each non-EU manager would have to nominate a “member state of reference” and presumably be subject to oversight by that member state’s regulator. Even more significant is the fact that the “third country passport” should already be in place and there are currently no signs of the EU implementing it.
A Labour government would bring the possibility of Brexit being cancelled, as Jeremy Corbyn has promised a referendum on the new deal he intends to negotiate, with remaining in the EU being an option. While remaining in the EU would obviously provide certainty and would largely be welcomed by the financial services industry, the prospect of a Corbyn-led Labour government brings with it other challenges for fund managers. The proposed nationalisation of rail companies, energy supply networks and water companies could have a significant impact on infrastructure funds, which have invested heavily in these industries in recent years. In addition, the Labour manifesto talks about alignment of income and capital gains tax rates (and in fact none of the major parties have committed to freezing capital gains tax rates), meaning under Labour proposals carried interest (and indeed co-investment returns) could be taxed at 50% instead of the current 28%. Just as the increase in tax rates in France led to a noticeable exodus to the UK, it would be a fair guess that any major increases to tax rates from an incoming government may lead to an increase in relocation of investment staff to other jurisdictions.
ILPA Model LPA
At the end of October, the Institutional Limited Partner Association (ILPA) published a model Limited Partnership Agreement with the aim of simplifying the fund formation process for private equity funds. The model LPA incorporates the third version of the ILPA principles and, given the level of detail required in drafting an LPA, provides their views on other matters not specifically covered in those principles.
ILPA has often stressed that they realise a “one size fits all” solution may not be appropriate when it comes to fund terms. On issues such as reporting, consistency across portfolios is something they look to achieve and the publication of reporting templates and guidance has helped with this, but on terms they have until now framed their views in the form of principles rather than model documents.
It may well be a useful document for first-time managers (in particular if it is requested by a cornerstone investor), but it is unlikely that a more established fund manager will adopt this template, given that the terms agreed upon are so often a result of the relative position of investors and the fund manager. It is, as expected, an investor-friendly document and to a large extent follows the ILPA principles. However, there are some areas that managers may consider to be unusual and/or too near the LP-friendly end of the spectrum:
- The LPA includes a “fund as a whole” waterfall in a model for a US fund where a “realised deal by deal” model is still common practice (ILPA has indicated that another model with deal by deal carried interest may be published soon).
- The preferred return is drafted to accrue on amounts drawn from a subscription facility, not the date such amounts are drawn from investors.
- Guarantees for clawback of carried interest are drafted on a joint and several basis.
- The LPA provides for full forfeiture of all carried interest entitlements on fault removal, including amounts already in escrow.
- There is a narrow definition of follow-on investments and a proposed time limit on follow-ons (e.g. 18 months after the end of the investment period).
- There are narrow recall/reinvestment provisions, including a condition that recalled capital cannot be used for fees or expenses.
- There is no management fee post investment period for investments written down below a certain percentage of cost.
- The MFN provision is automatic with limited carve-outs and no tiering based on size.
EU rules on cross-border distribution of funds
Earlier this year, the new EU regulation and directive on “cross-border distribution of funds” was published, which will come into force in the middle of 2021. The new rules deal with a number of issues, perhaps the most important being that there is now more clarity on what constitutes “pre-marketing,” meaning actions that do not constitute “marketing” for AIFMD purposes. Until now, what constitutes pre-marketing has been determined by the regulators in each member state, leading to considerable variations in approaches. While the new EU rules will only apply directly to EU-based AIFMs, UCITS managers and managers of EuVECA and EuSEF funds, there is the potential that the new rules could impact the various National Private Placement Rules that non-EU managers use to market their funds, so it is worth them taking note also.
The definition of pre-marketing covers the communication of “investment strategies or investment ideas” to professional EU investors “in order to test their interest in an AIF or a compartment which is not yet established, or which is established, but not yet notified for marketing” and “does not amount to an offer … to the potential investor to invest …. in that AIF or compartment.”
Perhaps more helpful are the conditions that set out what managers are not allowed to do (and which logically would constitute marketing under AIFMD), which is providing information that (a) is sufficient to allow investors to commit to investing in an AIF, (b) amounts to subscription documents whether in draft or final form, or (c) amounts to constitutional or offering documents of a not-yet-established AIF in final form. It is clear then that subscription documents, even in draft form, are not permitted, but it appears documents such as marketing presentations and potentially early drafts of limited partnership agreements and PPMs may be permitted as part of pre-marketing as long as they are not in final form and they clearly state that they do not constitute an offer and that the information presented should not be relied upon because it is incomplete and subject to change.
There will be an obligation on managers to notify their “home” regulator within two weeks of beginning pre-marketing activities, and any investment by an EU professional investor within 18 months of the commencement of pre-marketing will be considered as a result of marketing – meaning a full passport application should be made. This poses a question for those managers relying on “reverse solicitation,” meaning investors have approached the manager on their own initiative and therefore the manager has not engaged in marketing.
There is also a denotification procedure for managers who have secured a marketing passport but no longer wish to market their funds. As marketing under the passport requires the payment of fees in certain jurisdictions, it may be a helpful in some cases. However, there is a 36-month “blackout” period following the denotification whereby managers would not be able to pre-market the same AIF or “similar investment strategies or investment ideas.” Therefore, if a manager has not been successful with a fundraising and wants to come back to market within three years following a denotification, they would have to obtain a fresh marketing passport before approaching investors, as pre-marketing would not be permitted. Perhaps an even more interesting question is for managers that successfully market their funds and denotify once the fund is closed – would they be permitted to pre-market a successor fund within 36 months or would that constitute “similar investment strategies or investment ideas”? It seems unlikely that this is the intent of the new rules but on a strict reading of the text it could present an issue.
The new rules will be in place in the summer of 2021 – but it is something that managers should be getting up to speed with now as these rules may come into force in the middle of a fundraising effort that begins next year. In addition, guidance on what constitutes pre-marketing has long been sought by fund managers, so a prudent course would be to take note now of what these new rules say even though they may not yet be in force.