Christopher Rose of Squire, Sanders & Dempsey -
The Russian private equity industry has grown substantially over the past decade and the next 10 years are poised for even greater growth. Here is a bird's eye view of a typical Russian private equity fund structure, identifying the more significant business and legal issues arising when forming such funds.
Typical fund structure
Although Russian law provides for the establishment of investment funds (known as PIFs), most foreign investors won't find a private equity fund formed under Russian law to be acceptable or tax efficient. Therefore, most private equity funds involving foreign investors are formed offshore. These offshore funds are frequently organized as limited partnerships, because such vehicles are tax transparent, provide investors with limited liability, have flexible capital structures and generally can be formed quickly. Moreover, from a governance perspective, a limited partnership has the advantage of vesting the authority to manage the fund in the hands of a general partner controlled by the sponsor of the fund, while the investors participate passively in the fund as limited partners.
The most popular jurisdictions for offshore private equity funds investing in Russia are currently the Cayman Islands, Isle of Man, Guernsey and Jersey. These jurisdictions are typically favoured above others because of their advantageous tax regimes and because they are familiar to most foreign investors.
When a limited partnership structure is used, it is customary for the sponsor to form a new limited liability company to serve as the general partner of the fund since a general partner has unlimited liability under the laws of virtually all jurisdictions. Often, the general partner and possibly a management company are incorporated in the same jurisdiction as the fund. A Russian company or a foreign company with a branch office located in Russia will also normally be included in the fund structure to act as local investment adviser.
The fund is also likely to need an intermediate holding company. As Russian-sourced income received by a foreign entity other than through a permanent establishment in Russia may be subject to withholding tax (absent a tax treaty relieving this burden), fund investments are often made through Cyprus, Luxembourg or Dutch holding companies, which can take advantage of double-taxation treaties in effect with Russia.
In a private equity fund formed as a limited partnership, the general partner (sponsor) will have authority over the day-to-day management of the fund, including identifying, evaluating and negotiating prospective investments, monitoring these investments on behalf of the fund and exiting investments to achieve liquidity. In return for these services, the general partner is paid an annual management fee, which is expected to cover its salaries and operating costs. Management fees in Russia-focused private equity funds generally range from 2% to 2.5% of capital commitments. In addition, the general partner receives a carried interest as remuneration for its efforts. Typically, the carried interest is 20% of the profits of the fund, but this may vary depending on the agreement of the parties.
Most funds (or their general partners) retain a manager and a local investment adviser to provide portfolio management and administrative services to the fund. The manager is usually an affiliate of the fund's sponsor but may be part of an established fund management group. The manager a will enter into a management agreement setting forth its responsibilities, its authority (and limits on authority) and remuneration. A separate agreement will be entered into with the local adviser.
Advisory boards and investment committees are common structures in private equity funds. They serve two very different purposes. Advisory boards are generally created to assist the general partner in sourcing and optimizing investments for the fund. The advisory board may also consult with and provide advice to the general partner on a range of other issues, including conflict of interest or valuation questions. Members of the advisory board are often prominent local businessmen with important contacts and access to deal flow.
In contrast, investment committees are generally created at the insistence of major investors to create a structure that gives them, individually or collectively, approval rights over fund investments. The terms of the limited partnership agreement may require the creation of an investment committee and prohibit investments from being made without the approval of the investment committee.
Limited partners make commitments to contribute capital in specified maximum amounts when they subscribe for interests in the fund. In addition, the limited partnership agreement will sometimes specify that 1-2% of the capital raised by the fund be committed by the general partner. The resulting capital contributions are used to fund investments and pay fund expenses in a manner consistent with the investment strategy or guidelines established for the fund. Limited partners are not generally required to contribute all of their capital commitments at the time of their initial subscription. Instead, the general partner draws down capital commitments as needed to fund investments, commonly on 10 to 20 days' notice. Limited partnership agreements typically stipulate serious consequences in the event a limited partner fails to make a capital contribution when requested, including forfeiture or forced sale of the defaulting limited partner's interest.
Profits generated by a private equity fund are generally divided according to a formula that provides the general partner with a 20% carried interest on realized gains distributed to the limited partners, subject to repayment of the limited partners' capital contributions and a stipulated interest component or "preferred return" (typically around 8%). To balance the general partner's desire to receive distributions of profits as investments are exited with the limited partners' objectives of assuring that not more than the agreed carried interest percentage finds its way into the general partner's pocket, the carried interest is often subject to a "clawback" - an obligation imposed upon the general partner to restore to the fund carried interest distributions in the event that later exits result in a lower total return to the limited partners.
The management company, custodian and register holder of a private equity fund formed under Russian law are required to be licensed. However, if the fund is formed under foreign law it will not subject to Russian licensing requirements. The sponsors will, of course, be required to comply with the requirements applicable to forming limited partnerships and limited liability companies (for the general partner, manager and intermediate holding company) under the laws of the jurisdictions in which they choose to organize such entities.
The sponsors will need to comply with securities laws applicable to offering partnership interests in the jurisdictions in which investors (whether natural persons or legal persons) are located. Most jurisdictions have regimes that permit the sale of securities to wealthy or sophisticated investors, or institutional investors, without the sponsor having to comply with the complex process of registering the issuance of securities. Nevertheless, as a practical matter, the sponsor will need to produce an offering memorandum describing, among other things, the investment opportunity the fund offers, risk factors, the credentials of the sponsor and its team, their remuneration and any related-party transactions, and other relevant details.
Christopher Rose, Partner, Squire, Sanders & Dempsey LLP
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