By Matt Mulry, Dillon Eustace – Cayman has seen a healthy increase in private equity funds year on year over the past decade. The popularity of Cayman private equity funds has been fuelled by both the evolution of hedge fund managers’ businesses into the private equity fund space and by the increased use of private equity funds to pursue distressed asset investments.
The Cayman exempted limited partnership (ELP) structure is the most commonly used entity for Cayman private equity funds and is internationally recognised as a flexible, tax-neutral, low-cost fund vehicle. ELPs do not have their own legal personality and their general partner will enter into contracts on their behalf and hold their assets on trust for investors in accordance with the terms of their limited partnership agreement. As a result the ELP is likely to give rise to transparency for the purposes of onshore tax liabilities. The Cayman limited liability company (LLC) was introduced last year as a similarly flexible, tax-neutral, low-cost fund vehicle but which has a corporate personality. The LLC is has been developed for private equity fund managers and investors who need a vehicle that will not be transparent for the purposes of onshore tax.
An ELP or LLC established as a private equity fund may be formed for any lawful purpose provided that it does not undertake business with the public in the Cayman Islands. Both the ELP and the LLC are established as contractual arrangements between their passive investors and one or more active general partners or managers. The general partner of an ELP or manager of an LLC is established as a special purpose vehicle to insulate the promoter from liability, takes on an oversight role of the fund’s service providers and has ultimate responsibility for the fund’s operations. If the assets of the ELP are not sufficient to cover its obligations its general partners will be liable for all of those obligations. A general partner must act at all times in good faith and in accordance with any additional duties provided for in its limited partnership agreement. The managers of the LLC mange the operations of, and will be liable and owe duties to, their LLC to the extent provided in the limited liability company agreement.
The ELP and the LLC are both flexible structures ideally suited for use as closed-ended investment vehicles seeking investment during a capital raising period and drawing down commitments in order to fund investment opportunities and operating costs as they arise. Each of these Cayman vehicles are established under legislation that was drafted with the key terms of private equity vehicles in mind including investor allocations and distributions, carried interest waterfalls, preferred returns, catch up provisions, hurdles, flexible fee and allocation provisions, investor default provisions, claw-backs, key man provisions, and advisory committee terms. The Cayman legislation has been developed so that the ELP and the LLC will integrate with onshore vehicles in master-feeder, parallel and co-investment funds facilitating the creation of structures which are operationally consistent between their onshore and offshore components and across the range of investment products offered by their managers.
At least one general partner of an ELP must be a corporate entity or a partnership or a Cayman resident individual. Where a corporate entity or partnership is used this must be a Cayman domiciled company or partnership or a non-Cayman company or partnership which has been registered in Cayman as a foreign registered company or as a foreign registered partnership. Cayman resident directors are not required to be appointed to the general partner and an LLC is not required to appoint Cayman domiciled managers but in each case this may be beneficial depending on onshore tax advice. An ELP requires at least one limited partner and an LLC requires at least one member but there is no requirement that any limited partner or member be resident or registered in Cayman. An ELP and a LLC are both required to maintain a registered office in Cayman.
The investors in an ELP or an LLC established as a private equity fund will be issued with interests that entitle them to a share in the performance of the fund. The assets and liabilities of each vehicle and the profits derived from those assets will be allocated to investors in the proportions agreed in the limited partnership agreement or the limited liability company agreement. Generally the Cayman legislation is permissive and the contractual arrangements forming the constitution of the ELP and the LLC are largely down to negotiation between its investment manager and its key investors. Interests in each vehicle can be issued in different classes in order to apply different fee, liquidity, reporting or other terms between investors in the fund. Limited partners in an ELP are not, as such, liable for the obligations of their ELP, however if a limited partner participates in the conduct of the business of their ELP they may be liable for its obligations in the event of insolvency. Any such liability is restricted only to persons who transact business with the ELP with actual knowledge of such participation and who reasonably believed the limited partner to be a general partner of the ELP. Cayman legislation provides for a non-exclusive list of activities which a limited partner can undertake and which are not considered to be participation in the conduct of the business of an ELP. These include acting as a director of the general partner, serving on an advisory committee of the ELP and consenting to or withholding consent to actions proposed by the general partner. Members of an LLC will be liable to the LLC to the extent provided for in its limited liability company agreement, generally for the amount of their undrawn capital commitment and for the return of capital in specified circumstances. Cayman legislation governing the ELP and the LLC allows wide flexibility to impose sanctions on investors that default on their commitments to contribute capital and provides a non-exclusive list of common sanctions seen in private equity structures and which are expressly permitted under Cayman law. Generally distributions can be made to investors in accordance with the constitutional documents of each type of Cayman private equity fund subject to the satisfaction of specific solvency requirements.
A Cayman private equity fund is not subject to prescribed investment objectives or restrictions and there are no content requirements for its offering documents. Changes to the structure of each fund vehicle can be made in accordance with the terms of the limited partnership agreement or the limited liability company agreement and these will generally provide for non-material changes to be made by the general partner or manager without the need for investor consent. Cayman has negotiated international co-operation agreements and introduced legislation intended to support the extension of the European marketing passport to Cayman private equity funds. Once the fund passport system is extended to jurisdictions outside Europe a Cayman private equity fund should be able to take advantage of the system by opting-in to a higher level of regulation under Cayman law thereby complying with detailed disclosure and reporting requirements on a par with those currently applicable to European funds using the existing fund passport system.
The tax-neutrality of ELPs and LLCs means that there is no Cayman income or capital gains tax imposed on distributions made to their investors. Each entity may also apply for an undertaking that no law enacted in Cayman imposing any tax on profits or gains will apply to its distributions for the next 50 years which provides additional security to investors. A Cayman private equity fund is likely to be a reporting financial institution for the purposes of Cayman legislation implementing the United States’ Foreign Account Tax Compliance Act and the OECD’s Common Reporting Standard. The registration, due diligence and reporting requirements which arise from this legislation is generally delegated to a private equity fund’s administrator and the procedures are closely aligned with existing anti-money laundering requirements to ensure that the use of Cayman vehicles for private equity structures remains a low cost option.
The development of private equity funds in Cayman evidences the continuation of a strong collaboration between the Cayman government, the Cayman funds industry and their international counterparts. Cayman’s ability to adapt to the continuing demands of international co-operation and compliance pressures whilst striving to re-energise and develop its financial services products ensures that it maintains its leading competitive edge in the offshore funds markets. The increased use of Cayman vehicles to structure private equity funds is leading to acceptance of the jurisdiction by more traditional private equity fund managers and their investors. With this growing flow of private equity fund work into Cayman we expect to see a greater demand for Cayman ELP and LLC structures in venture capital, real estate, infrastructure, technology, health care, energy and art funds in addition to the distressed asset funds which prevail in the current market.
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