Cause and effect: the future of the infrastructure fund has been saved
Cause and effect: the future of the infrastructure fund
Author: João Almeida
3 minutes read
- Alternative Investment Fund Managers Directive (AIFMD)
- Evolving tax landscape
- Carried interest
- The importance of fund structuring
Over the last decade, we have witnessed a stream of record-breaking events in terms of both fund raising and deal size within the infrastructure funds sector.
Throughout 2018 we saw an increased concentration of capital distributed among fewer funds, raising a combined US$85billion (compared to US$75billion in 2017)1. At the same time, while we have seen a decrease of 22% in the number of completed deals compared to 2017, the average deal size increased, emphasizing the universal consensus that valuations are high.
Fund managers are facing increased pressure to successfully deploy the record-breaking amounts of capital raised in recent years, while also maintaining the strong risk-adjusted returns that have previously attracted investors to this asset class.
External factors which should be at the forefront of any GP or LP’s mind, both when launching a new fund or when revisiting existing funds before asset disposals:
One of the most important features of the AIFMD is the possibility for AIFs to be marketed to professional investors under an EU passport. This depends on whether they are managed by fund managers authorized under the AIFMD and located within any EU Member State, without the need to negotiate each local regime.
There is also the key question of where to establish their operational footprint in a post-Brexit world with several jurisdictions introducing internal reforms to attract these nomadic fund managers.
Traditionally the decision on where to establish an AIFM was primarily driven by regulatory considerations (in order to benefit from the AIFMD Passport), with portfolio and risk management being performed or supervised in the jurisdiction of the investor pooling vehicle. However, having the AIF and the master holding platform (pooling all the investments) in the same jurisdiction provides an opportunity to align regulatory and tax substance demonstrating genuine business purpose for setting up an active investment platform. Going forward we would expect to see an increase in the number of single jurisdiction funds structures.
The evolving tax landscape also supports a move towards single jurisdiction fund structures established in a place where genuine operational activities exist.
Following numerous discussions and revisions, the final version of the Anti-Tax Avoidance Directive (ATAD) has now been published in the Official Journal of the European Union. The general deadline for EU Member States to transpose the text into national law was 31 December 2018, with provisions applying as of 1 January 2019 (with some exceptions).
For some of the measures introduced by the ATAD, EU Member States have options on how to transpose them into their national law. Ergo, there are some differences from EU Member State to EU Member State.
The provisions of the ATAD will apply to all taxpayers that are subject to corporate tax in one or more EU Member States and will affect new investments, as well as existing structures which have been previously set-up.
The purpose of the controlled foreign company rule (CFC) is to reallocate undistributed income (which would not have been taxed or exempt in parent jurisdiction) of a 50% owned direct/indirect subsidiary or permanent establishment, to the jurisdiction of the controlling entity under certain conditions.
The purpose here is to introduce limitation to the tax deductibility of any “exceeding borrowing costs” to a percentage of the taxpayer’s tax-based EBITDA. Carve-outs are available, namely for AIF vehicles and long-term infrastructure projects which provide, upgrade, operate and/or maintain a large-scale asset (that is considered to be in the general public interest by a Member State) where the operator, borrowing costs, assets and income are all within the European Union. However, these limitations are expected to be difficult to apply on a practical basis.
On 1 January 2020, ATAD II is expected to become effective, which extends the anti-hybrid rules to entities and to non-EU transactions/structures. This is possibly one of the most impactful changes in recent years from a fund structuring perspective.
One of the main purposes of the MLI is to allow the minimum standard for the prevention of treaty abuse (the principal purpose test or “PPT”). This was to be introduced in existing double tax treaties without the need for each jurisdiction to renegotiate each treaty individually.
To understand whether the MLI will impact any specific existing or future investment the asset managers will now need to consider whether the implemented structure relies on domestic legislation or on double tax treaties and in case of the latter, which options were followed by each jurisdiction. This analysis is of particular relevance on the payment of interest and dividends throughout the investment holding period and on non-resident capital gains upon an exit.
The calculation of carried interest is set out in the fund formation documents (prospectus or Limited Partnership Agreement) and is typically set as a fixed percentage of the fund’s net gains after the investors have been repaid of their drawn down commitments and preferred return (hurdle rate).
Depending on how the carry is designed and structured, it may be impacted by the changing tax landscape. This namely refers to the cases where the carry has a tax treatment at the level of the carry holders, which differs from the tax treatment at the level of the carry vehicle.
What we have outlined here may mean that the entire infrastructure fund industry will see their investments impacted. Therefore, they may need to change their pre-established holding platforms and pooling vehicles when considering new fund raising, regardless if they have EU investors, US investors, pension funds, sovereign funds, insurance companies or high net worth individuals.
GPs need to map their investor base with a higher level of detail, analyze whether the vehicles used by each investor hamper the tax status of the investment platform as a whole, and work together with the investors and their advisors in order to determine the most suitable legal form for each pooling vehicle.
Some of the questions that should be asked when setting-up the fund pooling vehicles:
- What is the cornerstone investors’ tax profile in their domestic jurisdiction (EU vs. US vs. other countries, pension fund vs. insurance company vs. sovereign fund, taxable vs. tax exempt, etc.)?
- How do the cornerstone investors regard the investor pooling vehicle from a tax perspective (opaque vs. transparent) and the financing instruments issued by the pooling vehicle (equity vs. debt)?
- Does the fund pooling vehicle and holding platform have an adequate level of substance?
- Is the carry structure sustainable or is it treated differently at the level of the fund pooling vehicle, the carry holders and of the carry vehicles?
A more detailed version of this article is available in the Reflexions magazine.
1 Preqin Alternatives 2019 Report