New funds need exit strategy
Interview with Lachlan Roos – What are the key issues a manager needs to be aware of when setting up a fund?
There are two key issues that a new fund manager should look at when they’re setting up a new fund. The first is simplicity of the structure. It needs to be easily understood both to them and to potential investors. The second is speed to market. How quickly can they start to invest and make money. Those are the areas of focus when people talk to us about envisaging their new business.
Typically, what we discuss with a manager is whether he wants to go down the unregulated fund path with a standard Caymans-based master/feeder structure or whether he wants something regulated onshore in Luxembourg or Ireland. Cayman funds give you speed to market but regulated markets take longer to set up in because of the regulatory hurdles involved.
Are there variations in terms of setting up funds in different jurisdictions? Is it simply the case that Cayman vehicles are more straightforward to establish?
Yes, it’s faster and simpler. The lawyers know what they’re doing and there’s no regulation that you have to satisfy. What we generally see from the virgin start-up market is that, nine times out of ten, managers go with a Caymans master/feeder structure. The regulated onshore market is usually where we see mature managers establishing funds. They may already have a Caymans operation in place and decide that in order to attract different investors they want an onshore vehicle to add to their funds group.
What are the key points a new manager must be clear about and that you advise on from a tax perspective?
When you’re setting up your fund structure you need to consider what your investors might expect, what are the asset classes you’re going to invest in, assess what income those assets are going to generate and how that’s going to affect you from a tax perspective. Depending on whether you’re receiving dividends, capital gains or interest on the assets you’re holding in the fund, you then need to apply certain structuring to make sure you don’t suffer withholding tax on the returns otherwise it’ll impact on the rate of return of the fund.
The Caymans doesn’t have any tax treaties with anyone to reduce withholding tax in the territories you’re investing in, so you need to look at sub-structures below the Caymans to make sure that it works tax efficiently. For example, if you’re a credit fund and you’re receiving interest you need to set up a structure that will enable interest to get paid back gross rather than net of withholding tax. That’s where we start to use sub-fund structures such as Luxembourg vehicles etc.
If you’re a UK-based manager you also have to think about permanent establishment risks. Your fund could have a taxable presence in the UK because you’re based in the UK making all the investment decisions on behalf of that fund.
In the UK, we have a trading safe harbour, which is called the Investment Manager Exemption. Similar trading safe harbours exist in the US, Hong Kong and Singapore.
The UK safe harbour means that while you might, in theory, have a permanent establishment or a taxable presence in the UK, the authorities will allow you to be exempt from UK tax so long as you satisfy the various tests of the manager exemption. This ensures you don’t bring your offshore fund into the UK tax net.
Do new managers tend to be aware of this or is it something they discover subsequent to speaking with PwC?
They tend to become aware of it once they meet with us or their prime broker. Typically, a new fund manager will start by speaking to one of the prime brokerage houses, outlining his plans for the new fund. The broker will give them the run down on how the industry works and tell them about trading safe harbours. So they will have heard the term but they won’t know the details or what they have to do to abide by it.
Given the vast array of hedge fund strategies out there, are some capable of being more tax efficient than others?
There are some that lend themselves to greater planning than others. Take quant funds, for example. We talk with them a lot and do a lot of IP planning for them with regards to the location of the ‘black box’ and the algorithms they use. This creates a lot of IP and subsequent value. Planning with our clients to try and move that IP value outside of a taxable jurisdiction obviously creates greater tax efficiencies than a standard structure.
From a standard structure viewpoint, if you’re not covering yourself off with withholding taxes properly and suffering tax in jurisdictions that you can’t claim back, then you’re going to be less tax efficient than someone who is. Generally, most fund managers become quite savvy on this as they talk to us.
What should fund managers do in relation to tax if they’re investing in multiple markets and making significant capital gains?
It’s a matter of considering where your investments are held and adjusting your structure or investment strategy to satisfy the fact that you won’t suffer tax in those locations.
FIN 48 is new accounting regulation under US GAAP. As an example, if you’ve sold an asset in Spain, Germany or Brazil to name a few, the rule FIN 48 creates is that you may need to create a provision in your accounts for the tax you potentially should have paid. The confusion for many is that even though the tax rule exists in these locations, historically, for many, they’ve never actually collected it.
To combat the issue, rather than dealing in physical securities in those locations managers are using swaps with their prime brokers. That’s a discussion you need to have with a manager when they’re starting up. It helps us to tailor how they make those investments so as to ensure they don’t suffer tax. We either put them through a tax treaty vehicle or we might get them to trade the derivative through a swap contract.
Could you explain the step-by-step process involved when a manager first speaks to PwC up to the point when the fund goes live?
Initially, the manager works with us on the tax side to get their structuring right, both for the fund and the management house. As part of the structuring, we need to tie-in all personal tax issues of the founders. That’s important given that it’s an owner-run business. This is the initial hurdle, along with the FSA application.
Next is the implementation phase, which involves lawyers drafting the contracts and bringing together all the documentation such as LLP agreements and advisory agreements between the funds and the managers. Once implemented and FSA approval has been given, the manager is ready to trade. From then on, you’re into day-to-day operational issues of running a fund/manager.
When you’re structuring a Caymans fund, for example, what’s the timeframe involved?
It takes about a week to explain the structuring process for a Caymans fund and knuckle down any specific details. Things like the offering memorandum take time. From the start of structuring through to full implementation, you’re usually looking at a two to three-month timeframe.
With the fund up-and-running, how frequently do you engage with managers?
Personally, I have monthly calls with almost all my clients. I also speak to them on an ad hoc basis, typically once a week, in relation to the deals they’re doing.
How does that work from a cost perspective?
It depends on how the client wants to fashion the relationship. I work on a time- spent basis, a retainer basis and a fixed-fee basis with clients. Simple tax returns are a fixed cost but a client might say they want to do a bespoke deal in a new territory, meaning I either work on a time-spent basis or bring a cap of some sort.
In your experience, what tend to be the typical problems that managers face in year one?
I’d say the main thing is people not taking time to seek proper advice on the structure they’re using, discovering six months down the line that there’s leakage from a tax perspective or they can’t get the investors they wanted because of the type of vehicle they’re using. There are also operational issues with respect to running the structures that managers sometimes fail to pay enough attention to.
If you had one piece of critical advice to a new fund manager what would it be?
I’d say it boils down to structure. Make sure the structure will work for your business in terms of the assets you’re going to invest in, from an operational/infrastructure perspective, and that you think about an exit strategy. Are you going to hold the business and keep it in the family, or are you going to sell it at some point in the future? Because that will impact on what your structure should look like from day one.
Lachlan Roos is UK tax hedge fund leader at PricewaterhouseCoopers
Please click here to download a copy of the Hedgeweek Special Report: Setting Up Alternative Investment Funds 2011
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