Is the past PE governance model sustainable in the current business environment?

Private Equity has been a strong performing alternative asset class during the last decade with investors in search of yield. The recent fundraisings undertaken in record time attest to this statement.

However, this industry has undergone systemic changes mostly through the supervision of the financial regulators and tax authorities and primarily through the Alternative Investment Fund Managers Directive (“AIFMD”) and OCED’s Base Erosion and Profit Shifting package (“BEPS”) and the EU Anti-Tax Avoidance Directive (“ATAD”), challenging the operational substance requirements.

How have these changes impacted the industry?

A controlled and harmonised framework for the alternative asset management industry is a positive outcome from a regulatory and tax administration point of view. However, this sentiment may not necessarily be shared by the market players, as they are the ones who have to deal with the operational realities.

One of the benefits of complying with AIFMD is that it has allowed players access to the European market through the passport. The last couple of years have demonstrated that it has become increasingly difficult to market funds using the National Private Placement Regimes (“NPPR”). NPPR also significantly slows down the time to market for new funds and this is not attractive for players in a bullish fundraising environment.

For most of the players, complying with AIFMD meant a significant change in the operations. Portfolio Management and/or Risk Management functions are not necessarily new to the industry, but having them performed by the regulated AIFM led to a certain degree of confusion and a change in the business conduct for the managers. Furthermore, it is imperative to have the proper involvement of the AIFM portfolio manager and risk manager in the investment cycle as a strong requirement to duly meet the operational substance expectations set by the ESMA.

A similar analogy can be observed on the tax side under the substance-focused part of the OECD BEPS and EU ATAD rules. The key message is that it is imperative to show involvement of the holding directors and employees through the transaction cycle and lifetime of an investment.

On the transfer pricing side, we also have to consider the new credit risk management assessment on the SPV to assess their capacity to face potential bad evolution of the creditworthiness of the entities financed.

Figure 1: Three new layers of controls with overlaps

Figure 1: Three new layers of controls with overlaps

It is fair to say that the information available in this industry is overwhelming; however, there is a lack of consensus and standardisation on what it means for the different players in the immediate short term or when building a sustainable business model. Adding further to the confusion is a lack of alignment when it comes to the local interpretation and expectations from the different tax administrations across Europe.

As such, even though globally the PE industry is doing well in terms of capacity to raise money and deliver performance, the old operating models are being seriously challenged and there is a need to adapt to these changes in the regulatory and tax environment.  In addition to adapting to new operating models, other challenges have also arisen vis-à-vis finding the skilled persons who are knowledgeable in the PE business and familiar with the ongoing changes in the regulatory and tax world. Based on the feedback we collected during our recent meetings most of the market players are struggling to align on how to modify their internal set-up to meet these new requirements.

Any reasonable exit door? If not, how to take the benefit of that new environment?

Let’s be clear, these changes cannot be avoided. However, it does not mean that the existing models need to be completely changed and that entire teams need to move from one country to another.

Admittedly, however, it is probably time to go back to the drawing board. This is potentially a good opportunity to rethink, reinforce and streamline the existing processes.

First, the responsibilities of the GP, Investment team, the AIFM, SPV and Masterholdco Boards must be clearly defined and properly split. This exercise may sound easy at first but in reality, it can be quite daunting given the internal setup and the existing relationship with the various third parties. The main reason being that usually, the vehicles have been set-up separately and for different purposes. Here they need to work together in a streamlined way with the right levels of review and controls at each level. Proper and adequate documentation is the key arrow in the quiver needed in the event of an audit performed by the financial regulator or the local or foreign tax administrator, which will facilitate demonstration that the work has been performed as defined in the procedures. The good news is that there are several excellent tools and solutions now available to facilitate the design, monitoring and documentation of such processes.

Any risk of not meeting these requirements?

If we talk about not meeting the requirements of AIFMD, the risks are of different types. Some of the risks might be perceived to be of limited impact (e.g. remarks provided by the Regulator with some time to upgrade and meet the standards). Some might be very material ones (e.g. on boarding capacities blocked for a defined period of time, publication of names with potential impact on the reputation to loss of license).

On the tax side, fines and/or rejection of double tax treaty benefits are examples of what could be part of the bill that will diminish the returns to the LPs. Reputation is key in this industry and having the name dragged through litigations over a long period, may harm the ability to raise future funds. As tax litigations may take a considerable amount of time, any tax claims will delay liquidation of Funds and distribution of proceeds to the LPs.

Any positive conclusion?

In summary, understanding how the changing regulatory and tax environment is impacting your business is the first step. Fund managers who ignore the growing wave of changes are at risk of potentially being at the receiving end of unpleasant and costly tax challenges and disputes, thereby impacting their reputation. In order to prepare for the future, it is imperative for PE Managers to embrace this momentous opportunity to redesign operations while continuing to do what they do best – invest in real economy while continuing to deliver returns to the investors.

However, these changes also present a momentous opportunity to design your operations for a sustainable and successful business making Luxembourg the heart of your operations.

Contact us

Benjamin Gauthier

Partner, Financial Services Consulting, PwC Luxembourg

Tel: +352 49 48 48 4137

Prasanta Mandal

Manager, PwC Luxembourg

Tel: +352 49 48 48 5928

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