Marcus

Peter

Partner, Bonn & schmitt

LioneL noguera

Partner, Bonn & schmitt

Luxembourg and Private Equity – an attractive symbiosisBesides regulated mutual investment funds, Luxembourg has been experiencing a remarkable development in the sector of private equity investments since the 1990s. This accounts for regulated and non-regulated private equity structures.

Regulated private equity

structures are mainly offering

three product types: the

specialised investment

fund (SIF) subject to the

respective Luxembourg

law dated 7 February 2007;

the so-called part II fund in

relation to the Luxembourg

law on undertakings for

collective investment dated

17 December 2010; and

the risk capital company

(SICAR) governed by the

Luxembourg law on venture

capital companies dated

15 June 2004, as amended.

The most common vehicle

for non-regulated private

equity investments is and

remains the Soparfi. Another

interesting type of vehicle

is the securitisation fund

/ company subject to the

respective Luxembourg law

dated 22 March 2004. It may

be regulated or non-regulated

depending on certain factors.

Thus, Luxembourg legislation

offers a wide array of

possible vehicles to choose

from, ranging from an

unregulated full-fledged stock

company being both a legal

person and a tax subject,

to a regulated investment

fund having neither legal

nor tax personality.

Soparfi, SIF, SICAR and part

II funds are currently in the

process of being adapted

to the new AIFM Directive

(EC/2011/61 of 8 June 2011).

The AIFMD is intending to

require alternative investment

fund managers to apply for

authorisation in order to

manage alternative investment

funds (this includes private

equity funds). Unless a private

equity fund is not in the scope

of certain exemption rules of

the AIFMD it will be subject

to more regulation starting in

2014. Nevertheless, the upside

of this advanced regulation

will be the introduction of

the passport allowing AIFM

to offer their management

services and distribute their

alternative investment funds

throughout the European

Union. Luxembourg is

currently preparing a draft

law to transpose the AIFMD

into national law coping

with its content in the most

favourable manner for the

well functioning of the

relationships among investors,

private equity firms and

alternative investment funds

managers. The existence of

SICAR, SIF and part II funds

gives Luxembourg certain

advantages in implementing

the AIFMD as such vehicles

already comply to a great

extent with its requirements.

Securitisation vehicles

are out of its scope.

In virtually all private equity

structures it will thus be

possible to find the vehicle and

investment instrument types

that guarantee an optimal

allocation of management

oversight and financial

rights both in the eyes of

the promoter and investors,

as well as an efficient tax

treatment at all levels of

the structure (distributions

by the investee, receipt of

income by the Luxembourg

vehicle, distributions to

investors and taxation by

their country of residence in

their hands), depending on

the countries of residence

of the majority of the

investors and of the targets.

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40 MarcH-aPriL 2012

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The investor promoter balance of power

Historically the private equity

industry has built momentum

in Luxembourg in the 1990s

using existing corporate

forms. For a wide array of

reasons, including lighter

capital gains taxation of U.S.

investors, in the Anglo-Saxon

world the most widely used

structures were (and still are)

limited partnerships due to

their transparency for tax

purposes. Many promoters

came to Luxembourg

asking for similar vehicles.

Sometimes a société en

commandite simple (SCS,

a pure partnership, with at

least one unlimited liability

partner and limited liability

partners) was used to

replicate very closed forms

of partnerships used by

the industry in the U.S.

However, as in many cases

a stock corporation was also

needed to benefit from the

exemption of dividends and

capital gains on important

participations under the EU

Parent-Subsidiary Directive,

the société en commandite

par actions (SCA) quickly

became a classic preference:

a corporate partnership

limited by shares, which

allows the promoter to

secure control over the

management by assuming

the role of unlimited liability

partner, while treating the

investors as true corporate

shareholders. In a SCA the

unlimited partner also serves

as manager and may only

be removed in exceptional

circumstances, but limited

shareholders will have their

say on any amendment of

the articles of association,

which can thus be used as

a fundamental pact setting

the base rules all participants

in the SCA agree on.

A société anonyme (SA)

may also be used to group

a number of more active

investors, who would

typically have a greater

say on a key acquisition or

disposal, be it as a matter of

reserved competence within

the articles of association or

because the management

wishes to avoid any

possible liability exposure.

Finally, the Luxembourg

société à responsabilité

limitée (SARL), with its

simple structure and closed

character, is ideally suited

as an interim acquisition

vehicle for assets that may

need to be singled out, such

as real estate properties.

A versatile, reliable legal and regulatory framework

What really matters in the

Luxembourg corporate law

is its versatility. Contrary

to certain neighbouring

countries, the founders

of a company still enjoy

a wide discretion in

drafting clauses of the

articles of incorporation to

accommodate any particular

terms of the promoter-

investor relationship. Each

corporate form is bound by a

set of fundamental principles

(for example, in a SCA, the

equality amongst limited

shareholders) which must be

adhered to, but within those

principles wide freedom is

granted to the drafter. The

notary – a skilled professional,

who in most cases took on

a notarial office only after

many years of practice as

an attorney – will validate

the lawfulness of the articles

and grant legal personality to

the newly formed company

instantly upon executing

the deed of incorporation.

This is a significantly more

flexible approach than

that prevailing for example

in France or Germany

where the attributes of the

different corporate forms are

regulated in much heavier

detail, and where legal

personality is granted upon

registration of the company

with the trade register

after a somewhat lengthier

administrative process.

The contractual approach of

the Luxembourg corporate

law translates in the wide

variety of investment

instruments that may be

issued by a Luxembourg

vehicle, particularly when

such instruments are issued

to limited circles of investors

(i.e. without being impacted

by securities laws and

regulations that attach to

listed securities), as is the case

in a private equity context. It

also facilitates the definition

of attractive remuneration

policies for managers

through direct participation

in the investment vehicle,

sometimes through a

dedicated management

participation vehicle; for

example through special

incentive dividends

based on capital gains or

other performance from

underlying investments.

As mentioned in the

introduction, starting in

2004 with the securitisation

company, followed by

the SICAR and the SIF, the

lawmaker has in effect

MarcH-aPriL 2012 41

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broadened the choice

of vehicles to grant the

promoters and investors

more freedom, not less.

These regulated structures

can either replicate the

traditional corporate

forms, or be organised

around funds without legal

personality, and/or enjoy

extra structuring possibilities

such as the creation of

different investment or

investor compartments

within one and the same

vehicle. The main purpose

of regulation in Luxembourg

is not to arbitrate between

vested interests; rather it

is to offer the extra safety

of regulation (including

depositary bank rules, criteria

for and supervisory oversight

over selection of resident

management, etc.) to those

promoters and investors to

whom such added security

appeals. Hence the need

to implement carefully any

proposed new regulatory

framework, such as the one

arising out of the AIFMD.

Luxembourg should consider

the AIFM Directive less as a

threat and over-regulation

but rather an opportunity

to enhance its status

pertaining to private equity

investments and alternative

investment managers

by relying on the same

advantageous factors as the

ones upon which the UCITS

industry built its success.

Tax adequacy

In many cases, taxation

is also part of the reasons

why promoters choose

Luxembourg. But tax need

not necessarily be wizardry.

For instance, a very simple

reason why so many

investors in the EU choose to

establish an interim holding

company in Luxembourg is

the important participation

exemption. This is basically

the implementation in

Luxembourg tax law of a

European directive of 1990,

which aimed at ensuring

that intercompany dividend

flows would not incur

multiple levels of taxation

where a sizeable participation

is held for some time. As

in all directives, Member

States are free to exceed

the minimum requirements

set by the directive as long

as they further the purpose

of the directive. In 1990,

Luxembourg decided to

grant the dividend exemption

from a 10 percent equity

stake onwards (in lieu of

the minimum 25 percent

that were foreseen by the

directive), as long as such

minimum stake is kept for 12

months at least, and to extend

it to capital gains (which is

optional under the directive).

Similarly, the directive

allows Member States to

consider that 5 percent

of the dividend or gain so

derived can be allocated to

expenses that were previously

deducted in connection

with such income, so that

the exemption is in practice

95 percent in virtually all

neighbouring countries.

Luxembourg on the contrary

has chosen to exempt 100

percent and to reintegrate

only the actual expenses

effectively deducted for

tax purposes, which –

specifically on multi-million

investments – will rarely

make up 5 percent.

Of course, the range

of investment vehicles

susceptible of being used

for a private equity fund

means that it is possible

to accommodate the

requirements of many

investor/investee countries

(tax personality, availability

of benefits under double tax

treaties, or on the contrary

tax transparency). The

instruments and securities

issued to investors may

also be tailored differently

depending on how such

investors would for instance

be taxed on dividend income

vs. interest income, as long

as the instrument chosen

matches the economics

of the structure.

As so many vehicles and

instruments can be custom-

tailored to a significant

extent, when a taxable entity

is chosen as private equity

investment vehicle it often

becomes very useful to

seek an advance clearance

with the tax authorities to

ensure the tax treatment

of such a “one-of-its-kind”

private equity investment

company remains secured

and predictable. In turn, this

allows the authorities to

understand the economics of

the contemplated structure

ex ante, and to verify that

the legal agreements of

the parties are on arm’s

length terms in line with

such economics.

Such clearances remain

confined to direct taxes,

though. The VAT treatment

of the vehicle and its

management structure will

in each case need to be

thoroughly analysed. VAT

taxability and the eventual

availability of exemptions

will depend on the exact

nature of any management

services provided and on

the remuneration profile for

such services. Depending on

whether the Luxembourg

vehicle and/or its management

company is considered a VAT

taxable person or not, the VAT

treatment of any inputs in the

management process, such as

advisory services rendered by

third parties, will be different.

The dynamic potential of

Luxembourg as a European

hub for private equity and

alternative investment funds

is thus considerable. But

Luxembourg’s weakness is

that it remains difficult to

attract and retain a sufficient

number of talented people

to fuel the growth in the

number of these structures.

On the tax front for instance,

compared to the number of

options available to build the

ideal investment structure,

relatively little has been

done to facilitate the entry

of new talent, such as e.g.

asset managers. Many private

equity firms are typically lean

organisations with greater

investor accountability, where

small but gifted players can

end up managing billions in

investments with a team of

less than ten managers and

staff in total. As such, they will

place higher emphasis than

large organisations on the

value of each individual, just

as we lawyers do, and given

their role in the economy

it seems efficient that they

be allowed to remain so.

By Lionel Noguera and Marcus Peter

42 MarcH-aPriL 2012

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About

Bonn & Schmitt has a strong track

record pertaining to setting-up

and assisting private equity and

alternative investment structures

on an ongoing basis since the early

1990s. The fi rm has been involved in

the very fi rst private equity deals ever

done in Luxembourg. In 1995 Bonn &

Schmitt created the now well-known

SCA structure for Deutsche Morgan

Grenfell then one of the fi rst market

entrants in this area. Subsequently

to this deal, the SCA has become

industry standard before the SICAR

law entered into force. As one of the

few legal fi rms with actual experience

in the private equity sector for so

many years, Bonn & Schmitt took a

leading role in shaping the 2004 law

on SICARs. Finally, Bonn & Schmitt

was the fi rst Luxembourg law fi rm to

create a joint venture private equity

vehicle between Europe and the Far

East, called Mandarin, still being the

fl agship model for Chinese/European

joint ventures. International Financial

Law Review has just granted the

fi rm its “High Yield Deal of the Year”

European Award for its assistance to

sellers EQT in the sale of KabelBW to

Liberty Global, Inc.

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