Offshore legal and fund structure considerations
By Ian Gobin (pictured) & Philip Graham – 2020 is a presidential election year in the US. Economists generally forecast a period leading up to it which avoids any major US financial market upsets. However, this time it’s building up to be anything other than a normal election year.
Against the backdrop of President Trump’s impeachment, we are not only left considering how this will play out domestically in the US, but also on the wider international stage. The macro picture is exceptionally complicated right now. While the UK seems to be finally stepping towards a conclusion on the Brexit debacle, political instability is rife and the US is certainly no exception. But however it plays out from here, it is interesting to see that the overwhelming majority of financial commentators are not expecting an imminent recession or US financial market meltdown. Irrespective as to your feelings towards President Trump, the US economy has flourished during his reign and for us in the Cayman Islands and British Virgin Islands, the investment funds industry has also thrived, despite all of the legislative changes which have circled the industry.
These major offshore centres have proved to be incredibly robust and over the years have both introduced new legislation, often ground breaking in the offshore world and often to a higher standard than adopted onshore, to overcome, for example, so called “blacklists” imposed by certain countries or supranational/international organisations, such as the CFATF, EU and the OECD. As and when there is a challenge, the Cayman Islands and the BVI react nimbly with a measured and professional approach. We’re absolutely sure we’ll see more of this in 2020.
One of the most common scenarios we encounter offshore, is a US-based manager who initially, and logically, establishes a domestic fund to attract US taxable investors. With the performance and track record going in a healthy direction, the manager begins to turn their attention to US tax-exempt investors, such as charities, pension funds, and university endowments, as well as investors based outside of the US, who like the strategy as set out in the pitch book and want to invest.
To avoid potential US tax exposure that could result from direct investment in a US pass-through entity such as a US limited partnership or US limited liability company, US tax-exempt and non–US investors will want to come into an offshore “blocker” vehicle. This is where we enjoy speaking to managers and discussing the options available to them. The three most widely-used options are “side-by-side”, “master-feeder” and “mini-master”. Taking each in turn:
With a side-by-side structure, the US fund and the offshore fund both make investments directly, with trade tickets allocated between them. Given the extra administration involved and the potential for a conflict of interest, we rarely have managers opt for side-by-side funds, unless there is a specific reason to keep the relevant investor bases entirely separate.
Probably the most popular and traditional route is to set-up a master-feeder structure. Here, we would create two new offshore vehicles, an offshore feeder and an offshore master. The existing US fund will contribute its assets into the offshore master upon the launch of the new structure. In turn, the offshore feeder will take in the US non-taxable investors and the non-US investors and “feed” into the offshore master. The offshore master will make all of the investments on behalf of both feeder funds (the US fund and the offshore feeder) from this point forward, creating a collective investment offering in the most tax efficient manner.
In a mini-master structure, a single offshore fund is established which is taxed as a corporation to benefit US tax-exempt investors and block UBTI and non-US investors.
The very fact of only needing to create one new offshore vehicle saves cost, both on formation and also in terms of upkeep and therefore has proven popular with startup and emerging managers. The offshore fund invests directly into the existing US fund, which will then act as the master fund for the US non-taxable and foreign investors. It will also remain the fund into which the US taxable investors will continue to invest. This provides two additional benefits; firstly, the existing US-taxable investors will not need to be moved and secondly, the existing assets of the domestic fund can also remain where they are. Both factors vastly reduce the administration around the restructuring and subsequently reduce the cost as well. While there are some tax consequences to be discussed around the use of this structure, it has proved to be appealing to those looking to dip their toe in the waters of offshore vehicles.
In all models, it’s also important for the US manager to consider how they will be paid in the most tax efficient manner. It is crucial that US managers discuss how this may be structured with their US counsel. At the moment, the current preference is for US managers to take their performance fee as an allocation from the relevant master fund, be it the offshore or in the case of the mini-master, the onshore (master) fund.
While there are many other options available to a US manager in this situation, both of these cover a large segment of the market and should give anyone reading this article a solid platform to begin their discussions with their US and offshore legal service provider. One aspect that should be noted, as a final point, is that if managers are considered marketing into the EU, they will need to seek advice on the marketing restrictions within this region. While both the Cayman Islands and BVI vehicles continue to operate under the long-standing EU national private placement regimes, managers need to be very clear regarding their EU marketing strategy, especially with the position of the UK being somewhat a grey area right now. With that in mind, Harneys can also assist with the structuring of investments funds in Luxembourg, which is undoubtedly the pre-eminent European funds jurisdiction and has a wide range of structuring solutions for a manager looking to attract EU investors, as well as the possibility of more cost-effective solutions in Cyprus. Whilst the lack of stability and certainty can be daunting, we see it as an exciting challenge and look forward to helping guide you through yet another year of change.
Ian Gobin is joint global head of Harneys Investment Funds and Regulatory groups. Ian advises on the legal and regulatory treatment of investment funds, private equity funds and management companies established in the Cayman Islands and the British Virgin Islands. He also advises on structured finance, fund finance, IPOs, digital assets/blockchain technology and digital security offerings.
Philip Graham is joint global head of Harneys global Investment Funds and Regulatory groups. Phil is a leading advisor on all aspects of British Virgin Islands and the Cayman Islands investment funds, including pre-formation strategy, regulatory compliance and restructuring. Phil has over fifteen years of experience advising in connection with all types of fund vehicles, including private equity and hedge funds, limited partnerships, and startups operating in the FinTech space.