Cayman Islands private equity funds
Nicholas Butcher and Iain McMurdo From Maples and Calder
The Cayman Islands (Cayman) are home to a well-established and ever-growing domicile for private equity funds. This can be seen in the statistics issued by the Cayman Islands Registrar of Partnerships. While a Cayman private equity fund can be established as a company, or indeed a trust, the overwhelming majority of Cayman private equity funds are set up as partnerships to mirror the preferred domestic vehicle of choice, in particular, by US managers and sponsors. Specifically, for reasons that are set out later, private equity funds are typically established as exempted limited partnerships (ELPs) in Cayman.2 At the end of 2013, there was a total of 14,355 ELPs registered in Cayman. This is more than double the 2006 number of 6,468. The years since the 2008 financial crisis have seen a consistent increase in the number of annual partnership registrations. In 2013 the figure stood at 2,368 compared with 2,037 in 2012, 1,897 in 2011 and 1,543 in 2010.
The reason Cayman has such a well-developed market for private equity funds is a result of its ability to complement onshore fund structures, specifically Delaware partnerships. While founded on Cayman common law principles, which in turn are derived from English law, the Cayman Islands Exempted Limited Partnership Law (first enacted in 1991) was drafted to provide symmetry with the corresponding Delaware statute. It has subsequently been amended, but always with a view to dovetailing with the US market. This policy was, and is, simple in design: it was intended, within the confines of Cayman law, to enable a manager’s offshore fund to operate and be governed consistently with its domestic offering. Add to this the fact that while English law is technically not binding on a Cayman court, it is persuasive to it; the Cayman legal environment is at once both familiar and robust.
The statute is not, of course, the only reason for Cayman’s success. The country provides a tax-neutral environment for fundraising, as under current Cayman law, provided its business is undertaken outside Cayman, no taxes or duties, either directly or by way of withholding, will be levied in Cayman on the trading activities or results of a Cayman-domiciled private equity fund. The combination of practical laws and low fiscal costs has secured the country’s status as a popular and flexible domicile.
This has led to an interesting characteristic of the Cayman funds market: the vast majority of Cayman private equity funds are established by managers who are not themselves resident in the jurisdiction. The Cayman market facilitates the trading activities of the onshore funds industry, and in this sense the trends we see in Cayman are very much a coefficient of the trends experienced or developed in the US, Europe, Asia and other major markets. The flexibility of Cayman law allows the manager or sponsor to replicate or accommodate deal terms driven by onshore factors and requirements.
If Cayman does not make the market trends, it certainly mirrors them. The lead-in time for deals appears to be currently increasing and, in some cases, lasts for many months. Similarly, the fundraising environment is difficult. Increased investor expectation for transparency is reflected in a higher prevalence of side letters along with requests for valid and binding legal opinions – five years ago it was unusual to issue an enforceability opinion with respect to a side letter; now 20 or 30 opinions might be issued on a single closing.
While total funds committed are not at the height of the middle of the past decade, successful managers are still able to raise significant funds using Cayman structures. Even allowing for the fact that not every Cayman ELP is formed to serve as the investment vehicle for a private equity fund, transactions in the jurisdiction in 2013 remained robust, with funds raised ranging between a few million to several billion US dollars, spanning a wide range of investment strategies and geographic focus.
II LeGAL FrAMewOrK FOr FUNDrAISING
Unlike open-ended mutual funds, closed-ended Cayman private equity funds are typically not required to register with the Cayman financial regulator, the Cayman Islands Monetary Authority (CIMA). (By closed-ended, we mean that investors are not entitled to voluntarily purchase or redeem their equity interests prior to the termination of the fund.) This distinction is created by the Mutual Funds Law (2013 Revision), which only requires registration where investors can withdraw at their own option. As it is a common characteristic of a private equity fund to lock up capital for the life of the fund, such funds are closed-ended for the purposes of the law. As such, the legal environment for the fundraising and ongoing investment activities of a Cayman ELP private equity fund is dictated by the contractual relationship established by, and the disclosures set out in, the offering memorandum, subscription agreement and any other ancillary agreement (most notably side letters), and the ELP Law.
As already noted, the usual legal form a Cayman private equity fund is an ELP formed under the Exempted Limited Partnership Law (2013 Revision) (the ELP Law).
While a private equity fund can be, and sometimes is, structured as a company or trust, the ELP model has two advantages: it allows US managers in particular to use the same vehicle as they do for their domestic offering while preserving freedom of contract through the limited partnership agreement (LPA), and at the same time avoiding the constraints of the maintenance of capital doctrine that applies to a Cayman company.
Maintenance of capital is the price of limited liability for a company. In general terms, it means that the issued capital of a company cannot be reduced or simply returned to investors. The original intention under English law was to enable a concerned investor to carry out a due diligence exercise, based on the enquiry of the company or inspection of public records, to ascertain the capitalisation of a company. That investor could then form its own view as to whether or not to invest based on the strength of the covenant implied by the size of the company’s share capital. The argument followed that this was an important creditor protection as, given limited liability and separate legal personality, a creditor could in the usual course of events only claim against the company, not its shareholders or directors. It therefore followed that the capital needed to be preserved or maintained so that it would be available to satisfy claims. Accordingly, rules, both statutory and common law, grew up to maintain capital, and these are still reflected in modern Cayman company law. For example, a Cayman company cannot reduce its share capital without a court order, special rules apply to the purchase or redemption of its own shares, and pure capital (i.e., capital representing the par, or nominal, value of a company’s shares) cannot ordinarily be distributed to shareholders.3
None of these requirements apply to an ELP, as there is no equivalent of the corporate maintenance of capital doctrine under Cayman partnership law. This is because the general partner (GP) of an ELP has unlimited liability for all the debts and obligations of the partnership to the extent that its assets are inadequate.4 Conversely, the limited partners (LPs), as the name implies, are not so liable (subject to two important exceptions noted below).5 This gives investors – the LPs in a Cayman private equity fund formed as an ELP – the best of both worlds: limited liability, but with almost unfettered ability to receive a return of capital in any situation subject only to the terms of the LPA underpinning the ELP.
An ELP is in fact a collection of contractual rights and obligations expressed through the terms of the LPA, which operates under agency principles through the GP and which has a limited liability wrapper for its LPs courtesy of the ELP Law. As the GP both acts for the ELP and has unlimited liability, there are qualifying criteria: at least one GP must be a Cayman company, another Cayman ELP or a natural person resident in Cayman. It can also be an overseas company, including for these purposes a Delaware LLC, which registers in Cayman as a foreign company.6 This is short of a migration of the foreign company to Cayman and there is no reincorporation in Cayman, but a registered office is required along with submission of an annual return and, as discussed later, it can then fall subject to certain Cayman laws. There appears to be no overall preference for choice of qualification, although, in the majority of cases, either a Cayman company or a foreign-registered company will be used.7
There are no qualifying criteria for the LPs; however, an LP is subject to certain statutory restrictions, again as the price for limited liability. Specifically, an LP is passive. In fact, it is prohibited under the ELP Law from taking part in the conduct of the business of the ELP, and the law requires that all contracts, agreements and the like are entered into by the GP on behalf of the ELP.8
This leads on to the first of the exceptions to limited liability noted above: in summary, an LP who takes part in the conduct of the business of the ELP can lose limited liability with respect to a third party who deals with that ELP and who reasonably believes such LP to be a GP.9 However, all is not lost for an LP who wants to exert internal control on the activities of the partnership, as the ELP Law sets out a series of ‘safe harbours’, which are deemed not to amount to taking part in the conduct of the business. Probably the most helpful of these is as follows:
[…] consulting with and advising a general partner or consenting or withholding consent to any action proposed, in the manner contemplated by the partnership agreement, with respect to the business of the exempted limited partnership.
This is because this is usually sufficient to enable an LP to participate in an advisory committee of the partnership without concern that it could lose limited liability. This is a potential area for tension for an LP who wants to exert control over a GP, and therefore by extension the ELP itself. We advise that the golden rule for an ‘active passive’ LP is first, only to participate internally within the partnership dealing only with other partners and never with third parties; and second, to have those internal controls expressly documented in the LPA so as far as possible to come within the letter of the safe harbour set out above.
The second exemption to limited liability is clawback on insolvency: if an LP receives a capital – not a profit – distribution and within six months of receipt the ELP becomes insolvent on a cash-flow test, then that LP can become liable to return the distribution together with interest.10
In short, to complete the description of the legal form of an ELP, the partnership does not have separate legal personality: it contracts through the GP, and property vested into the partnership or expressed to be held in its own name is in fact held by the GP. Legal actions would be initiated by the GP on behalf of the partnership. Finally, subject to the terms of the LPA, an ELP can have perpetual succession.
In terms of the fundraising itself, the Cayman Islands is a disclosure-based legal system; there are no prescribed rules for the content of an offering memorandum for a closed-ended private equity fund. However, whatever is or is not said may potentially be actionable. In addition to a contractual claim under the contracts constituted by the offering memorandum, the subscription agreement and any ancillary agreement (such as a side letter), liability could also arise under principles of negligent or fraudulent misrepresentation, while the Contracts Law (1996 Revision) could apply with respect to pre-contractual misrepresentation. To complete the line-up of civil claims, an action for deceit could also arise under tort laws. Finally, in the case of criminal deception, the Penal Code (2010 Revision) could apply.11
All of this means that the role of adequate disclosure to mitigate the liability of the ELP (along with possibly its GP and promoters), as well as to explain the investment terms, strategy and risk factors, is crucial. If an investor (i.e., an LP in the context of an ELP) can show reliance on a disclosure in the offering memorandum and breach of that disclosure that has resulted in damage, then a claim could ensue. This applies equally to the adequacy of risk factors, for example, as it does to more readily apparent contractual terms such as a statement as to the quantum of fees to be charged by the GP or sponsor.
Specific Cayman disclosures that might be expected, in addition to the investment narrative, terms and risk factors, include the legal form (and especially that the fund, if an ELP, does not have separate legal personality) and the exceptions to limited liability described above. Also typically included would be a statement with respect to tax treatment, transmission of investor information under regulatory laws (see Section III, infra) and a statement that the ELP is only authorised to carry on business outside the Cayman Islands. This latter point is significant to the parameters for the solicitation of investors in Cayman.
While a Cayman company is not allowed, under the Companies Law, to offer its securities for sale to the public unless those securities are listed on the Cayman Islands Stock Exchange,12 there is no equivalent for an ELP; however, as shall be seen, an ELP is expressly prohibited from transacting business with the public in the Cayman Islands. In fact, this is what ‘exempted’ in the legal description of an ELP signifies, as only an exempted limited partnership is entitled to apply for the tax exemption certificate described in Section III, infra.13
Although there are no equivalents to securities registration statements or investment promotions in Cayman, the legal requirement that the business of an exempted company or partnership must be undertaken outside Cayman means that it cannot generally deal with the public in Cayman (unless in the case of a company its securities are first listed on the local exchange). In practice, this means that the investors in a Cayman private equity fund will either be resident overseas or will be other Cayman- exempted entities. One Cayman-exempted vehicle can deal with another, as ultimately their respective businesses are carried out outside rather than within Cayman. As the vast majority of Cayman funds are established with exempted status, the restriction does not usually create an issue in practice; however, occasionally a fund will want to take in a Cayman-resident, non-exempt investor. Whether it can lawfully do so will depend on whether the fund has made an offer to the public in Cayman such that it is carrying out business with the public in Cayman.14
While specific advice must be sought prior to making an offer in the Cayman Islands, we can extract the following general principles: a marketing materials can be sent to a limited number of pre-selected investors; b marketing visits should be made on a one-off basis and should be specific to a
limited number of pre-selected investors (unless made on a reverse-enquiry basis); c local immigration and licensing requirements may apply; d the fund can be marketed via a website or other electronic means by the sponsor
to the extent that the website is not provided through an internet or electronic
service provider (e.g., from a server) in the Cayman Islands; e unsolicited calls from investors can be responded to, but the making of calls by
the sponsor could trigger the public business test; f there are no express requirements for the content of marketing materials and,
subject to the public offer prohibition, no prescribed minimum or maximum
number of offerees; and g it is advisable that the following jurisdiction-specific statement is included in
any offering memorandum or equivalent – ‘No offer or invitation to subscribe for [partnership interests] can be made or is made hereby to the public in the Cayman Islands.’
As previously noted, in the vast majority of cases the sponsor or manager of a Cayman private equity fund will be based onshore, and the fiduciary or other obligations of that sponsor or manager may in part be governed by laws of its own jurisdiction and also the laws of the jurisdiction in which the offer is made; however, the liability, if any, of the sponsor or manager will also be governed by the nature of the contractual arrangements it has with the fund, the scope of its services and obligations, and the extent of any limitation of liability and indemnification. Common carve-outs for exculpation provisions in the context of a Cayman investment fund are fraud, wilful default and gross negligence. It is worth noting that Cayman does not have a settled definition of gross negligence, and it is therefore usual to see either an express definition or an import of a standard by reference to other laws, usually, in the context of the US market, those of Delaware or New York.
No discussion of fiduciary duties and liability would be complete without referencing the standard for the GP itself. The ELP Law contains a statutory standard that cannot be contracted out of: the GP is required to act at all times in good faith in the interests of the partnership.15 There is no statutory standard of fair dealing. While the good faith duty is fixed by statute, the actions of the GP can be subject to contractual limitation of liability and indemnification provisions, although care must be taken to ensure these do not infringe either public policy or common-law principles with respect to fiduciary exculpation.
III REGULATORY DEVELOPMENTS
As noted above, closed-ended Cayman private equity funds are generally not required to register with CIMA. Care needs to be taken when drafting withdrawal provisions for an investor for regulatory reasons in an otherwise closed-ended fund, for example, where an LP wishes to exit for ERISA16 purposes. This is because the Mutual Funds Law does not exempt voluntary withdrawal in any circumstance. In practice, this is dealt with by turning the withdrawal ‘entitlement’ from one of right in the hands of the investor into one of compulsion in the hands of the GP.
An investment manager or sponsor domiciled or registered in Cayman as a foreign company, and carrying on investment management or advice, will be subject to Cayman’s Securities Investment Business Law (2011 Revision) (SIBL). This requires that a manager or adviser either be licensed by CIMA or register with CIMA as an excluded person. Registration as an excluded person does not imply regulation by CIMA, and such registration is possible where the person to whom the services are provided (i.e., the private equity fund itself) is either a sophisticated person within the definitions set out in the SIBL, or is a high-net-worth person (HNW). As most private equity funds are institutional, the latter test is usually relied upon as this sets the threshold for HNWs at US$5 million in total (as opposed to net) assets.17 The typical Cayman Islands private equity fund will easily reach this benchmark. Registration as an excluded person is achieved by filing a form on an annual basis that gives certain prescribed details with respect to the manager and payment of a fee of approximately US$6,000.
Registration under the SIBL will also bring the manager within the scope of Cayman’s robust and detailed anti-money laundering regime, and the manager will need to meet the client identification and reporting requirements prescribed by the Money Laundering Regulations (2013 Revision).
Of course, it is often the case that the GP will provide investment management or advice services to the ELP fund; however, the GP will typically be exempted from registration, provided it is not separately remunerated for its services other than in its capacity as GP under the LPA and does not otherwise hold itself out as providing such services generally.18 If it does, then it may be required to register as an excluded person.
The private equity fund itself will also be subject to certain reporting requirements: if any person resident in Cayman knows or suspects, or has reasonable grounds for knowing or suspecting, that another person is engaged in criminal conduct or is involved with terrorism or terrorist property, and the information for that knowledge or suspicion came to their attention in the course of business in the regulated sector, or other trade, profession, business or employment, the person will be required to report such knowledge or suspicion to the Financial Reporting Authority of the Cayman Islands, pursuant to the Proceeds of Crime Law, 2008 of the Cayman Islands, if the disclosure relates to criminal conduct or money laundering, or a police officer of the rank of constable or higher; or the Financial Reporting Authority, pursuant to the Terrorism Law (2011 Revision) of the Cayman Islands, if the disclosure relates to involvement with terrorism or terrorist financing and property. Such a report shall not be treated as a breach of confidence or of any restriction upon the disclosure of information imposed by any enactment or otherwise.
As previously noted, invariably a private equity fund will be structured as an exempted vehicle in Cayman, meaning that it cannot do business with the public in Cayman. In the context of an ELP, this means that in return for a fee of approximately US$1,800 it can apply to the Cayman government for, and expect to receive, a tax exemption certificate (TEC). The TEC will confirm that no law subsequently enacted in Cayman imposing any tax to be levied on profits or income or gains or appreciations shall apply to that ELP, or to any of its partners, in respect of the operations or assets of that ELP or the partnership interests of its partners. The TEC will also usually confirm that any such taxes and any tax in the nature of estate duty or inheritance tax shall not be payable in respect of the obligations of the ELP or the interests of its partners.19
Currently, the TEC has insurance value only, as under current Cayman law there are no taxes levied in Cayman, which would be applicable to an exempted private equity fund. Naturally, investors in the fund will be taxed at applicable local rates when proceeds are repatriated to their own jurisdiction, but there is no first-instance charge to tax in Cayman; however, virtually all funds apply for a TEC.
As will be apparent from the foregoing, there have been no relevant changes in Cayman tax law over the past year, and none are currently expected. Similarly, the Cayman regulatory regime has been very stable over the past year with no material changes in the context of a closed-ended private equity fund. There has been a consultation with respect to possible changes to the ELP Law (see Section IV, infra). Finally, it is worth noting that Cayman legislated away the unhelpful decision in the English case of Mercury20 through changes to the Companies Law. In summary, the judgment in Mercury appeared to require physical rather than electronic closings, which would create obvious impracticalities in the context of modern multi-jurisdictional transactions. The changes to the law effectively allow the contractual parties to determine how agreements will be deemed executed.
Revisions to the ELP Law were introduced in early 2013 to authorise the holding of the register of limited partnership interests otherwise than at the registered office, provided that on request details must be made available to the Tax Information Authority of the Cayman Islands.21
The European Alternative Investment Fund Managers Directive (the Directive) came into force in the European Union (EU) and adhering member states of the European Economic Area (EEA) on 22 July 2013. Although at the time of writing not all EU Member States have implemented the Directive into their national laws and finalised their guidance, the Directive is in force and may apply to Managers of Cayman Islands private equity funds who market to investors in the EEA or perform risk management or portfolio management functions from within the EEA. One requirement of the Directive with respect to marketing Cayman alternative investment funds into the EEA is for relevant cooperation agreements to be entered into between CIMA and the EU Member State in which the fund will be marketed. CIMA has now signed cooperation agreements with the majority of EU Member States. In addition to cooperation agreements, Managers will also have to comply with reporting, disclosure and asset stripping and EU private equity rules. Whilst a detailed analysis of the Directive is beyond the scope of this chapter, marketing activities may be exempted temporarily under transitional rules or permanently if reverse solicitation rules apply, the fund has a single investor only or if the Manager manages closed-ended unleveraged assets of less than €500 million. Managers will need to consider carefully the application of the Directive to such funds before any marketing or management activities are undertaken in the EEA.
Cayman private equity funds will ordinarily be ‘financial institutions’ for the purposes of the Foreign Account Tax Compliance Act of the United States (FATCA) and will accordingly need to comply with the requirements of FATCA concerning reporting information on foreign assets held by US persons. In November 2013, Cayman signed a Model 1 Inter-Governmental Agreement with the United States which will simplify compliance by private equity funds with FATCA; for example there will be no need for a Cayman private equity fund to enter into a reporting agreement directly with the IRS (reporting will be undertaken, where relevant, via the Cayman Islands Tax Information Authority) although a global intermediary identification number will still need to be obtained.
Iv OUTLOOK
It is fair to say that in the first decade of this century we have witnessed a rise in the formation of successor leverage buyout funds with investment periods becoming shorter as sponsors successfully deployed capital in acquisitions. Since the worldwide financial credit crisis, investment periods are moving back to a more traditional cycle of four to five years. In addition, managers have been seeking to use follow-on investment and recycling provisions to their fullest extent with a view to timing the market on the launch of their next fund. Fundraising (both in terms of fund size and speed to market) has moved back towards historical trends equivalent to 2000 to 2003, but nevertheless managers successfully launch funds, and the Cayman Islands continues to be the favoured jurisdiction for fund managers.
The ELP continues to be the favoured vehicle for private equity funds and 2013 witnessed a record year for the jurisdiction with respect to the number of partnerships formed, 2,368 in total. This exceeds the numbers formed in any other year including the banner years of 2007 and 2008 respectively and augurs well for the future resurgence of private equity fund formation in the Cayman Islands. There is strong interest from the US and Europe – traditionally significant markets for Cayman – but also increasing interest from Latin America (especially Brazil), and Asia (notably China, Korea and Japan). We expect a new generation of sponsor to emerge and look to Cayman as a result of Dodd-Frank’s Volcker Rule as the banks spin out their proprietary trading desks.
Notwithstanding the introduction of regulation of private equity managers in the US and the EU, the Cayman Islands regulatory regime is not expected to change materially, meaning that the tried and tested, flexible and cost-efficient environment for private equity structures in Cayman will continue. That said, the Cayman Islands has responded to the increased regulation of the private equity industry across the world. There will be consequential changes resulting from the US FATCA and the equivalent UK FATCA with increased reporting requirements being imposed on the Cayman Islands funds by the end of the year with respect to the US FATCA. Following the signing of the inter-governmental agreement (IGA), the Cayman Islands is now gearing up to deal with the onward reporting requirements under the US FATCA including adopting legislation to implement the IGA. We expect many of the sponsors will outsource to administrators the reporting requirements imposed on them by the increased regulation and rely on the administrators to ensure full due diligence is conducted with respect to the investors of their funds. Likewise, the UK IGA, signed by the Cayman Islands and the UK on 5 November 2013 compels Cayman Islands foreign institutions, among other things, to report information annually to the Cayman Islands Tax Information Authority on financial accounts that are held by UK persons. Steps to establish the legislative and operational framework to implement the UK IGA are underway.
It is a characteristic of the Cayman funds industry, since its first inception, that the country has been able to marry robust laws with a pragmatic commercial approach to business. We expect 2014 will be a busy year for the Cayman Islands legislature. Not only will it introduce enabling legislation for the US FATCA and UK FATCA regimes but we also expect that the Cayman Islands will continue to refine its laws to ensure it maintains its preferred status amongst the private equity sponsors around the world. In 2011, Cayman overhauled its Companies Law, and consultation is now underway with respect to the ELP Law. It is expected that emphasis will no doubt be placed on appropriate symmetry with the equivalent Delaware statute, as well as the introduction of business-friendly concepts such as foreign partnerships qualifying to act as GP. The revisions to the ELP Law are expected in 2014 as is the introduction of the Third Party Beneficiaries Law. This law will allow third parties to rely on contractual rights granted to them in contracts (such as limited partnership agreements) to which they are not a party. This will allow contractual arrangements in the Cayman Islands to mirror arrangements offered under Delaware or other US state laws and under English law.
As the Cayman Islands continues to respond and adapt to regulatory changes around the world and improve the laws relating to the investment vehicles preferred by sponsors and investors alike, we expect the next few years will witness a significant growth in the jurisdiction’s share of the private equity and venture capital fund formation market.
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