Neal Lomax, James Wauchope, Julian Fletcher, Robert Duggan, Alex Last and Simon Thomas
This briefing explains the attractions for international managers, sponsors and investors of the Cayman Islands as the jurisdiction in which to domicile a private equity fund.
The terms ‘private equity’ and ‘closed-ended’ are often used interchangeably, principally to differentiate funds of this type from ‘hedge’ or ‘alternative’ funds which invest in liquid assets and give investors the option to redeem their investments on regular liquidity dates.
The term ‘private equity fund’ commonly denotes a non-retail fund investing in illiquid assets and, while used most frequently in the context of a typical buyout fund, covers a range of funds including real estate funds, venture capital funds, infrastructure funds, credit opportunity and other debt funds, secondary funds and funds of funds.
Private equity/closed-ended funds established in the Cayman Islands normally take the form of limited partnerships (which will be the focus of this briefing) although sometimes are formed as companies.
Mourant Ozannes’ Cayman funds advisory team advises managers, sponsors and investors globally on all aspects of law and regulation pertaining to the structuring and operation of investment funds in the Cayman Islands.
Regulation of investment funds in the Cayman Islands is governed by the Mutual Funds Law of the Cayman Islands although this only applies to open-ended funds. Consequently, closed-ended funds such as private equity funds are not subject to regulatory oversight by the Cayman Islands Monetary Authority. In addition, the fund’s general partner does not require any form of approval or licensing in the Cayman Islands.
Exempted limited partnerships
An exempted limited partnership (ELP), the typical vehicle of choice for a private equity fund domiciled in the Cayman Islands, is formed under, and subject to, the Exempted Limited Partnership Law of the Cayman Islands (the ELP Law). The ELP Law adopts principles similar to those enshrined in the Delaware Revised Uniform Limited Partnership Act, and this similarity with the Delaware model makes the ELP particularly attractive to managers and investors in the US. The key provisions of the ELP Law are summarised below.
There are no capital gains, income, withholding, estate or inheritance taxes in the Cayman Islands. The ELP will apply for (and can expect to obtain) an undertaking from the Cayman Islands government that no form of taxation that may be introduced in the Cayman Islands will apply to the ELP for a period of 50 years from the undertaking being given (hence the ELP's ‘exempted’ status).
An ELP does not have a legal personality of its own (notwithstanding its registration in the Cayman Islands) and is, to this extent, a combination of contractual rights and equitable interests in the assets of the ELP which are held on trust for the partnership by the general partner (and, if there is more than one, by the general partners jointly) and in accordance with the terms of the limited partnership agreement (the LPA).
The general partner (the GP) is the operative legal entity, responsible for managing the business of the ELP and ultimately liable for all debts and obligations of the ELP to the extent that the ELP has insufficient assets. The GP will sign all contracts on behalf and in the name of the ELP. The GP must be either a Cayman resident individual, a Cayman registered company, a foreign company registered in Cayman or another ELP. No additional licences or approvals will be required for the GP, and the GP may have any number of directors who will not be required to be resident in Cayman or to meet in Cayman.
Not having its own legal personality, the ELP is generally regarded from an onshore tax perspective as being tax transparent (or as having ‘see-through’, ‘look-through’ or ‘flow-though’ status, which signify the same thing) with the effect that the ELP itself will not be liable to any onshore taxes, and value distributed by it will ‘flow-through’ to the investors (and may be subject to local taxes in their hands).
There are no restrictions on the number of investors that may be admitted to an ELP. Registration of an ELP and GP can take place on a same-day basis, with the certificates of registration following within three to five working days (a fast track process delivering the certificate in around 48 hours is also available).
The ELP Law
The ELP is essentially a creature of contract, and is formed by the signing of an LPA by the GP and by at least one limited partner. At this point, the LPA will often be a short-form document and will be accompanied by a ‘Section 9 Statement’ made by the GP confirming certain basic details about the ELP and lodged with the Registrar of Limited Partnerships in the Cayman Islands. A short-form LPA can be restated into the full-blown agreement, in accordance with the terms of which investors will be admitted into the partnership.
The GP and the limited partners may agree between themselves the terms governing the partnership, subject to a relatively light overlay of statutory provisions contained in the ELP Law. Some of the provisions of the ELP Law are mandatory, and some can be varied or waived in the LPA.
The following provisions of the ELP Law are mandatory:
The ELP's name must include the letters ‘LP’ or the words ‘Limited Partnership’.
The ELP must have a registered office in the Cayman Islands, for service of process and forwarding of notices and communications.
The ELP cannot undertake business with the public in the Cayman Islands (other than as may be necessary for the carrying on of its business outside the Islands); this is the basis on which the ELP obtains its ‘exempted’ status.
The GP must act at all times in good faith in the interests of the ELP.
The GP is liable for any debts and obligations of the ELP if the ELP's assets are insufficient to discharge them. Any debt or obligation incurred by the GP in the conduct of the ELP's business shall be treated as a debt or obligation of the ELP. Any property of the ELP conveyed to the ELP or to its GP will be deemed to be held by the GP on trust for the ELP as an asset of the ELP.
A limited partner may not participate in the conduct of the ELP's business, and all contractual documents and papers must be executed by the GP as the contractual party acting on behalf of the ELP. Any limited partner participating in this way, as though it were a general partner, will be liable for the debts and obligations of the ELP, if it goes insolvent, to any person transacting business with the ELP through the limited partner and who had actual knowledge of such limited partner's participation and who reasonably believed that limited partner to be a general partner.
The ELP Law set outs certain non-exhaustive ‘safe harbours’ of activities in which a limited partner may engage without risk of losing its limited liability status. The LPA may nonetheless provide for any amount of limited partner participation in the conduct of the ELP's business (commensurate with the potential liability just noted). A limited partner's participation on an advisory board or investment committee will typically be within the safe harbours.
A limited partner that receives any return of its contributed capital in a period of six months prior to the ELP becoming insolvent will be liable to return the amount received (to the extent that it is needed in whole or in part to discharge a debt or obligation of the ELP incurred during the period that the capital amount in question was an asset of the ELP), together with simple interest at an annual rate of 10% (or other rate specified in the LPA).
A limited partner may transfer all or any part of its partnership interest in the manner provided by the LPA, but such transfer shall not absolve the transferor of any liability previously incurred in respect of (i) its taking part in the conduct of the ELP's business, or (ii) amounts of capital received and required to be returned (both as described above).
An ELP shall continue until wound up and dissolved by resolution of the general partners and a two-thirds majority of limited partners, unless the LPA provides otherwise; and the provisions of the Companies Law and the Companies Winding Up Rules shall apply to govern the winding up and dissolution of an ELP (except to the extent that such provisions are inconsistent with the ELP Law).
If, following the ELP's registration, any change is made to its name, the general nature of its business, its registered office address, its duration or the name and address of its GP (or one of them), the GP must file with the Registrar of Limited Partnerships a statement of the change within 60 days of its occurrence.
The GP must maintain or cause to be maintained at the ELP's registered office in the Cayman Islands a register of partnership interests in the ELP (which must be updated within 21 days of any change) and a register of mortgages and charges on partnership interests. The register of partnership interests is not open to inspection by a non-partner unless the general partner consents, whereas the mortgages register is. Both registers may be maintained in written or electronic form.
The GP of an ELP may enter into side letters with individual investors to provide for contractual arrangements additional to those contained in the LPA. It is common for investors entering into side letters to demand most favoured nation (MFN) clauses guaranteeing them the same rights extended to other recipients of side letters. These arrangements are unobjectionable under Cayman Islands law, but the normal steps must be taken to ensure that the terms of a side letter (and any MFN arrangements) are not in contravention of, or inconsistent with, the terms of the LPA. Nothing in the side arrangements can be allowed to prevent the GP from discharging its obligation under Cayman Islands law to act at all times in the good faith and in the best interests of the fund as a whole.
Consideration should be given to making specific provision in the LPA for the GP to enter into side arrangements with individual investors within specified parameters. In all cases, Cayman Islands legal advice should be sought.
A legal opinion will typically be required from the fund's onshore and offshore legal advisors. The offshore opinion will be addressed to the investors and will speak to the valid formation and good standing in the Cayman Islands of the ELP and its GP the ability of the ELP (acting by the GP) to enter into the LPA and other documentation, the enforceability of the LPA and other documentation and the enforceability of the obligations thereunder of the GP.
Exempted limited companies
The contractual flexibility of the LPA and the relatively light statutory overlay of the ELP Law combine to ensure that the ELP is the vehicle of choice for managers choosing Cayman as the domicile for their private equity fund. It is possible, however, to use a Cayman Islands exempted limited company as the fund vehicle and to largely (if not entirely) replicate the mechanics of an LPA in the company’s articles of association, often in tandem with an LPA-style shareholders’ agreement.
The articles will require careful drafting to replicate limited partnership mechanisms, and the following is illustrative of the issues requiring consideration:
Capital calls can be effected in one of two ways: (i) partly paid shares are issued in respect of the first closing, with provision for additional sums to be paid on those shares on each subsequent closing or capital call; or (ii) fully paid shares equal to amount of capital called at first closing are issued, with additional fully paid shares being issued for each subsequent closing or capital call. The difficulty with approach (i) is that partly-paid shares cannot be repurchased by the company as a matter of Cayman Islands law, which causes difficulties (for example) when enforcing forfeiture provisions against a defaulting limited partner. Additionally, partly-paid shares must be allocated a distinguishing number in the company’s books, which places an administrative burden on the company’s directors or administrator.
Capital accounting can be replicated by including in the articles a mechanism for tracking additions and subtractions from each investor’s capital account, but this is generally more difficult than using the contractual flexibility of an LPA. The directors of a corporate fund will be under an obligation to treat all shares in a class identically, and this complicates the scenario in which an investor has to be treated differently (for example when it becomes a defaulting partner, or when its participation in distributions differs contractually from that of other investors). While it is conceptually possible to make provision in the articles for the variation of economic entitlements attaching to a share of any class without prior sanction by class consent or other corporate action, the mechanics will be more cumbersome than those customarily found in an LPA.
Interest payments made by additional partners being admitted in subsequent closings can be implemented by the establishment in the company’s books of a separate class account for each investor, in order to enable interest payments by incoming investors to be allocated amongst existing investors.
Claw-back provisions are possible, but more difficult, to draft in articles of association.
The tax transparency of a Cayman Islands company can be achieved for US managers and US non-taxable investors by means of the ‘check the box’ procedure, the broad effect of which will be that the company (whether a standalone fund, master fund or feeder fund) will be treated as a partnership for US tax purposes. That said, the same managers and investors may well be more familiar with an ELP and it may be more acceptable (not to mention cost effective) to use an ELP as the pooling vehicle, with corporate ‘blocker’ vehicles being established to cater for investors with specific regulatory and tax considerations.
The tax exempt, tax transparent, non-regulated and highly flexible nature of the ELP and the absence of regulatory or licensing requirements touching the general partner, together with the flexibility of the Cayman Islands exempted limited company, combine to make the Cayman Islands the pre-eminent jurisdiction for offshore private equity funds. From its offices in the Cayman Islands, Mourant Ozannes' Cayman funds advisory team is well placed to assist managers, sponsors and investors with all aspects of Cayman law and regulation pertaining to investment funds.
This briefing is only intended to give a summary and general overview of the subject matter. It is not intended to be comprehensive and does not constitute, and should not be taken to be, legal advice.