1 Legal framework
1.1 Which general legislative provisions have relevance in the private equity context in your jurisdiction?
The statute that specifically governs private equity funds is the Private Funds Law, introduced in February 2020. The Cayman Islands initiative to introduce the Private Funds Law arose from an ongoing dialogue that the European Union has been conducting with many jurisdictions to ensure they meet EU requirements in respect of good governance. As noted in the Briefing Note from the Ministry of Financial Services and Home Affairs when the law was introduced, by implementing a simple fund registration regime, this law provides "additional surety and transparency for investors and managers of Cayman Islands investment funds, while better aligning with best market practices, enhanced anti-money laundering and other key regulatory standards".
In essence, the Private Funds Law requires that all private funds, as defined:
- undertake a simple registration process (as opposed to a more substantive authorisation procedure);
- appoint a local auditor to prepare and file annual financial statements with the Cayman Islands Monetary Authority (CIMA); and
- comply with straightforward, commercially sensible requirements around valuation, safe-keeping of assets, cash monitoring, and securities identification (which broadly reflect market standards and best practices of existing managers).
The other key set of regulations relevant to private equity in the Cayman Islands is its suite of anti-money laundering (AML) rules, comprising:
- the Proceeds of Crime Law;
- the Anti-Money Laundering Regulations; and
- the Guidance Notes on the Prevention and Detection of Money Laundering and Terrorist Financing in the Cayman Islands.
Private equity funds and managers in the Cayman Islands must comply with the AML regime.
The AML regime is recognised as reflecting international standards and, through its regular enhancements, is intended to precisely reflect the Financial Action Task Force (FATF) Recommendations, while still providing a sensible and practical risk-based approach.
Outside of this, each entity type has its own governing statute:
- Exempted limited partnerships (ELPs) are governed by the ELP Law; Companies are governed by the Companies Law; and
- Limited liability companies are governed by the Limited Liability Companies Law.
In 2014 the ELP Law underwent a substantive rewrite to better reflect the commercial and legal needs of parties to private equity transactions and fundraises. Some of the private equity-driven amendments that were made under that process, and which make the ELP a more flexible vehicle than many of its peers, included:
- clarifying the rules on fiduciary duties between partners;
- allowing general partners to reduce their fiduciary duties (where expressly agreed with the limited partners); and
- clarifying that agreed-upon default remedies will not be unenforceable as penalties (an issue that plagues various common law jurisdictions).
1.2 What specific factors in your jurisdiction have particular relevance for and appeal to the private equity market?
Based on figures from the Securities and Exchange Commission, in the first quarter of 2019 around 68% of private equity funds globally (outside of the United States) were formed using Cayman Islands vehicles.
The reasons for the Cayman Islands' perennial position as the world's most popular private equity jurisdiction include the following:
- a strong legal framework, based on English common law;
- a robust judicial system which enshrines the rule of law and in which the English Privy Council is the final court of appeal;
- a sensible statutory regime that is cognisant and facilitative of private equity transactions. As noted above, the ELP Law was rewritten in 2014 specifically to ensure that such vehicles could predictably implement private equity fund transactions adopting the commercial terms that have become global norms;
- a strong, FATF-compliant AML regime; and
- an abundance of professional and experienced service providers. The Cayman Islands – as one of the first offshore financial centres, and certainly the most popular among institutional investors – has nurtured generations of experienced professionals to service the investment funds community. From auditors to administrators and lawyers, highly skilled professionals with experience in efficiently executing Cayman Islands private equity transactions can now be found specialising in private equity transactions not only in the Cayman Islands, but across the globe. This makes execution accessible and efficient.
However, the most important factor in the appeal of the Cayman Islands is investor familiarity and confidence. The Cayman Islands has been a popular investment funds jurisdiction for generations. Through political and legal stability, a strong judiciary, the rule of law, global best practice statutes and regulation (which can be applied predictably, with confidence), and the ability to access abundant professional talent to support transactions, the Cayman Islands has made itself the ‘go-to' trusted jurisdiction for investors – particularly in the Americas and Asia, and increasingly (through the adoption of EU complaint economic substance rules and the Private Funds Law) in Europe. While other jurisdictions may try to copy the Cayman Islands statute book, such investor confidence cannot be replaced.
2 Regulatory framework
2.1 Which regulatory authorities have relevance in the private equity context in your jurisdiction? What powers do they have?
The key regulator relevant to private equity in the Cayman Islands is the Cayman Islands Monetary Authority (CIMA). Relevantly, CIMA is the regulator responsible for implementation and enforcement of the Private Fund Law and the jurisdiction's anti-money laundering (AML) regime (see question 1.1).
The Private Funds Law includes a range of powers for CIMA, modelled on CIMA's existing powers applicable to regulated mutual funds. These include:
- the ability to require funds to provide such information or documents as CIMA may reasonably require in connection with its functions; and
- the power to apply to court in respect of such orders as it sees fit in respect of non-compliant funds.
Where CIMA considers that a private fund has breached or is at risk of breaching any of its obligations under the Private Funds Law, it has certain powers to enforce special measures against the fund, including a requirement to perform a special audit or provide other reporting as CIMA may request. Additionally, CIMA has certain powers where it is satisfied that a private fund:
- is, or is likely to become, unable to meet its obligations as they fall due; or
- is carrying on business fraudulently or otherwise in a manner detrimental to the public interest or to the interests of its investors or its creditors (among other things).
These powers include the ability to:
- cancel registrations;
- impose conditions or ultimately require the substitution of operators (eg, directors, general partners, trustees); and
- assume control of the affairs of a private fund.
The Taxation Information Authority is also relevant, insofar as it is the regulatory body responsible for ensuring implementation of the Cayman Islands Foreign Account Tax Compliance Act and Organisation for Economic Co-operation and Development Common Reporting Standard reporting rules.
2.2 What regulatory conditions typically apply to private equity transactions in your jurisdiction?
The Cayman Islands provides a relatively light regime for regulation of transactions, noting that private equity tends to be the territory of sophisticated investors. This approach is demonstrated in the Private Funds Law which (as noted in the Briefing Note) is meant to "balance the need for efficiency with investors' desire for transparency and surety".
Accordingly, although the jurisdiction has a robust AML regime that implements the recommendations of the Financial Action Task Force and represents global best practice, regulation of private equity funds is limited to registration under the Private Funds Law, discussed in question 1.1.
3 Structuring considerations
3.1 How are private equity transactions typically structured in your jurisdiction?
The gold standard for private equity funds globally is the Cayman Islands exempted limited partnership (ELP). And although this is easily the most popular collective investment vehicle for private equity funds, the Cayman Islands has a number of alternative structuring tools available, including companies, limited liability companies (LLCs) and unit trusts (which have become popular for certain kinds of private equity funds launched with Japanese sponsors over the last couple of years).
The general partner entity of an ELP fund vehicle is most typically a Cayman Islands exempted company, with Cayman Islands LLCs, foreign companies and foreign partnerships (typically Delaware LLCs and limited partnerships) being used on occasion.
The use of LLCs as a fund vehicle has gained some traction in Asia, although they are used more as a general partner or joint venture vehicle, with the structure not being commonly adopted as a fund vehicle outside of the venture capital space at this stage. The key reason for this is that investors and managers are familiar with, and feel confident in deploying capital through, Cayman Islands ELPs. Although LLCs are fit for purpose and share the same legal and court system, investors and managers wish to use the tried and tested model which ticks all necessary legal boxes and facilitates implementation of their commercial terms.
Where the fund itself is not the acquisition vehicle, a simple Cayman Islands exempted company will often be the entity through which the underlying target is acquired. These companies:
- are simple and quick to incorporate (and can be formed within a day, on an express basis);
- are familiar to investors, managers and service providers (including banks); and
- can be listed on stock exchanges in various jurisdictions, making them versatile in terms of exits.
3.2 What are the potential advantages and disadvantages of the available transaction structures?
The advantages stem from the tried, tested and predictable manner in which the Cayman Islands legal system operates (see question 1.2). Founded on the basis of English common law and adopting the fundamentals of many of England and Commonwealth statutes, investors, managers, and counterparties can confidently use Cayman Islands vehicles knowing that they are founded on a predictable legal system, bound to follow longstanding common law precedent.
3.3 What funding structures are typically used for private equity transactions in your jurisdiction? What restrictions and requirements apply in this regard?
As a tax-neutral jurisdiction which imposes no restrictions on the flow of capital and with no rules prohibiting or limiting financial assistance, Cayman is an extremely attractive and flexible jurisdiction for fundraising and for financing (using both equity and debt issuances). For example, Cayman Islands private equity funds frequently use subscription line financing at the fund level. Senior and mezzanine debt financing is also available. However, there are no specific limits as to the scope of funding solutions available to deploy in respect of Cayman Islands private equity vehicles. Equity funding is also common and preferred equity financing solutions, including offerings where target entities engage in multiple series financing rounds, are widely adopted.
3.4 What are the potential advantages and disadvantages of the available funding structures?
Tax neutrality and the lack of restrictions in relation to financing structures, together with a robust anti-money laundering regime, are the key advantages of the Cayman Islands.
3.5 What specific issues should be borne in mind when structuring cross-border private equity transactions?
Most of the issues that need to be considered as onshore issues.
3.6 What specific issues should be borne in mind when a private equity transaction involves multiple investors?
Most of the issues that need to be considered as onshore issues. However, in a corporate context, director fiduciary duties will need to be considered, as it is a common law requirement that directors of corporate vehicles (including financing special purpose vehicles (SPVs)) act in the best interests of the company as a whole. This issue can be more flexibly managed, however, if the financing vehicle is an ELP or LLC whose governing statutes allow the constituent documents to modify and reduce the fiduciary duties of the SPV's operator in line with Cayman Islands requirements.
4 Investment process
4.1 How does the investment process typically unfold? What are the key milestones?
As Cayman Islands legal counsel are generally co-counsel, supporting onshore lawyers in relation to these transactions, milestones are generally set by the relevant onshore firms and their clients. This can vary depending on the jurisdictions of those parties.
4.2 What level of due diligence does the private equity firm typically conduct into the target?
This is generally determined by the onshore advisers and their clients. This can vary depending on the jurisdictions of those parties.
4.3 What disclosure requirements and restrictions may apply throughout the investment process, for both the private equity firm and the target?
This is generally determined by the onshore advisers, their clients, and potentially, based on compliance with onshore regulatory regimes. This can vary depending on the jurisdictions of those parties.
4.4 What advisers and other stakeholders are involved in the investment process?
This will be determined based on the jurisdiction of the target, the acquirer and other onshore regulatory issues.
5 Investment terms
5.1 What closing mechanisms are typically used for private equity transactions in your jurisdiction (eg, locked box; closing accounts) and what factors influence the choice of mechanism?
As Cayman Islands legal counsel are generally co-counsel, supporting onshore lawyers in relation to these transactions, the closing mechanisms are generally determined by the relevant onshore firms and their clients. This can vary depending on the jurisdictions of those parties.
5.2 Are break fees permitted in your jurisdiction? If so, under what conditions will they generally be payable? What restrictions or other considerations should be addressed in formulating break fees?
Break fees are not prohibited under Cayman Islands law, provided that the terms of such fees are not inconsistent with common law and equitable principles, such as rules in relation to the enforceability of penalties. The general principle in relation to unenforceable penalties comes from English common law which, to summarise, has the effect that a provision (which might include a break fee, depending on how it is framed) may be unenforceable as a penalty if it is a secondary obligation which imposes a detriment on the contract breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation.
5.3 How is risk typically allocated between the parties?
As Cayman Islands legal counsel are generally co-counsel, supporting onshore lawyers in relation to these transactions, risk allocation is generally negotiated between the relevant onshore firms and their clients. This can vary depending on the jurisdictions of those parties and their bargaining position.
5.4 What representations and warranties will typically be made and what are the consequences of breach? Is warranty and indemnity insurance commonly used?
As Cayman Islands legal counsel are generally co-counsel, supporting onshore lawyers in relation to these transactions, representations and warranties are negotiated and stipulated by onshore firms and their clients.
6 Management considerations
6.1 How are management incentive schemes typically structured in your jurisdiction? What are the potential advantages and disadvantages of these different structures?
Management incentive schemes are common in Cayman Islands private equity funds. They can take a variety of forms, including ‘special limited partner' arrangements, bonus pools and specialised employee share option plans and vehicles.
The most commonly cited advantage of using Cayman for an incentive scheme is the tax neutrality of the jurisdiction. As noted in question 9.1, the Cayman Islands imposes no taxes on profits, income, capital gains or otherwise.
Another advantage is the variety of vehicle types available to deploy for these structures. As noted in question 3.1, the Cayman Islands has a number of structure available and each can be used for management incentive vehicles. Traditional trust and corporate employee stock ownership plan-style arrangements can be deployed using Cayman trusts or companies.
However, in a private equity context, partnerships are now commonplace because of their flexibility, the tried-and tested nature of exempted limited partnerships and, often, tax flow-through treatment onshore.
More recently, limited liability companies (LLCs) have become popular because of the flexibility of their governance and the ability of the manager or managing member to make distributions on a discretionary basis without needing to act in accordance with traditional corporate fiduciary duties. This allows parties to adopt rules for incentive distributions that can then be deployed by the manager in accordance with the discretions that the parties have agreed should be given to it. LLCs are also cost efficient to form and run, and can be established on a same-day basis with straightforward documentation available.
6.2 What are the tax implications of these different structures? What strategies are available to mitigate tax exposure?
Please see question 9.
6.3 What rights are typically granted and what restrictions typically apply to manager shareholders?
The rights granted under these schemes are usually economic participation rights only, most typically tied to investment or fund performance. In many cases these economic rights will vest over time (typically a period of between three and five years).
6.4 What leaver provisions typically apply to manager shareholders and how are ‘good' and ‘bad' leavers typically defined?
The drivers behind this will typically be driven by what is commercially common in the jurisdiction of the underlying manager.
7 Governance and oversight
7.1 What are the typical governance arrangements of private equity portfolio companies?
These arrangements will generally be established based on advice from relevant onshore firms and their clients. This can vary depending on the jurisdictions of those parties and what is customary in the industry of the target.
7.2 What considerations should a private equity firm take into account when putting forward nominees to the board of the portfolio company?
See question 7.1.
7.3 Can the private equity firm and/or its nominated directors typically veto significant corporate decisions of the portfolio company?
See question 7.1.
7.4 What other tools and strategies are available to the private equity firm to monitor and influence the performance of the portfolio company?
See question 7.1.
8.1 What exit strategies are typically negotiated by private equity firms in your jurisdiction?
As Cayman entities are used as vehicles for private equity transactions globally (as opposed to private equity transactions taking place in the Cayman Islands), this question is better answered by reference to the rules and practices of the jurisdiction in which the transaction parties and underlying businesses are located.
8.2 What specific legal and regulatory considerations (if any) must be borne in mind when pursuing each of these different strategies in your jurisdiction?
9 Tax considerations
9.1 What are the key tax considerations for private equity transactions in your jurisdiction?
The Cayman Islands imposes no taxes on profits, income, capital gains or otherwise. No legislation has been proposed to change this and none is anticipated. Rather, it is a tax-neutral jurisdiction that is attractive for cross-border private equity transactions and fundraising.
This characteristic is enhanced by its early adoption and implementation of the US Foreign Accounts Tax Compliance Act and the Organisation for Economic Co-operation and Development's Common Reporting Standard rules, which oblige Cayman Islands entities to report and share information in accordance with international best practice. This, combined with its robust anti-money laundering regime, makes Cayman an appealing jurisdiction choice and a leading financial centre.
The economic substance rules introduced in 2019 that affect certain specific relevant activities in the Cayman Islands (but not investment funds) do not present domestic tax issues. The Cayman Islands economic substance rules do not apply to investment funds or to general partners of private equity funds. So although this is an important change driven by the Cayman Islands government's commitment to combating international harmful tax practices, it is not a Cayman Islands tax change that affects private equity funds (domiciled in the Cayman Islands) themselves.
9.2 What indirect tax risks and opportunities can arise from private equity transactions in your jurisdiction?
No indirect taxes are imposed in the Cayman Islands. Accordingly, no goods and sales tax, value added tax, sale tax or similar taxes are imposed on private equity transactions conducted using Cayman Islands vehicles.
9.3 What preferred tax strategies are typically adopted in private equity transactions in your jurisdiction?
There are no direct or indirect taxes in the Cayman Islands. Accordingly, being tax neutral, many managers and investors will wish to structure transactions through Cayman Islands vehicles.
10 Trends and predictions
10.1 How would you describe the current private equity landscape and prevailing trends in your jurisdiction? What are regarded as the key opportunities and main challenges for the coming 12 months?
Against the context of the global coronavirus pandemic, it is difficult to be definitive as to the current landscape.
Prior to the pandemic, the appetite of investors for allocating capital to Cayman Islands closed-ended funds across a wide spectrum of managers, asset classes and geographies had continued upwards, as in previous years. This is evidenced by the fact that more than 2,400 new exempted limited partnerships (which are primarily used for private equity funds) were formed in 2019, bringing the total in existence to just under 29,000. And even in the face of the pandemic, we have continued to form and launch new funds (albeit with generally longer fundraises).
10.2 Are any developments anticipated in the next 12 months, including any proposed legislative reforms in the legal or tax framework?
We do not expect any new laws directed at the private equity space in the coming 12 months. Rather, we anticipate administrative guidance from, and streamlining of processes with, the Cayman Islands Monetary Authority relating to the recently introduced Private Funds Law.
The introduction of the Private Funds Law in February 2020, and the entry into force of its registration regime on 7 August 2020, were significant steps forward for the jurisdiction.
As the global trend towards further-reaching regulation continues, and with investors demanding that transactions have some form of governmental regulatory authority oversight, the introduction of this sensible registration regime – focusing on ensuring compliance with global best practice in anti-money laundering regulation while enshrining the Cayman Islands' characteristically commercial approach to legislation – has been seen as a step towards ensuring that Cayman retains its position as the most popular jurisdiction in the world for private equity funds.
Additional regulation and guidance to clarify the operation of this new regime is expected in the next 12 months, and this should further cement investor and manager confidence.
11 Tips and traps
11.1 What are your tips to maximise the opportunities that private equity presents in your jurisdiction, for both investors and targets, and what potential issues or limitations would you highlight?
In order to maximise the opportunities that private equity presents in the Cayman Islands, investors, managers and their advisers need only be sensible and pragmatic, and recognise the inherent advantages that come with the use of Cayman Islands vehicles and the Cayman Islands as a jurisdiction. Although other jurisdictions may introduce vehicles intended to compete with the Cayman Islands, these will not have all of the advantages associated with the Cayman Islands including the following:
- Investor familiarity and confidence: This has been developed in the course of thousands of transactions and funds using Cayman exempted limited partnerships (ELPs). This track record cannot be matched by any jurisdiction, makes Cayman the gold standard for PE transaction structuring, and ultimately saves time and cost, while guaranteeing a high level of quality control around structuring and documentation.
- A predictable and stable legal system: This enshrines concepts of English common law and equity, supported by an experienced judiciary and governed by the rule of law. When investors' money is locked in for the life of the fund, legal risk, change-of-law risk, judicial risk and the ability to predict the outcome of a dispute on day one become increasingly important. Cayman's tried-and-tested legal system, with laws drafted to support the private equity industry, helps to manage these risks in a way that other jurisdictions simply cannot.
- Tax neutrality, coupled with global best-practice tax transparency (through adoption and implementation of the US Foreign Account Tax Compliance Act and the Common Reporting Standard). This, combined with the ability to obtain tax exemption certificates from government guaranteeing no imposition of tax in the Cayman Islands for up to 50 years, provides a tax certainty that other jurisdictions cannot provide – especially with exemptions that are subject to conditions or, worse, potential changes to law. It also largely eliminates the need to obtain costly tax advice and prepare tax returns.
- The right level of regulation: Cayman Islands statutes are written for the purposes of engendering commercial and investment fund transactions. However, the recent improvements to the anti-money laundering regime, the 2014 rewrite of the ELP Law and the recent introduction of the Private Funds Law demonstrate that the Cayman Islands continues to nimbly implement a level of regulation that is consistent with the demands of global regulators and the risk appetite of investors, but also facilitates transactions without suffocating the parties with regulation which is overly complex and difficult to understand and implement.
Against this backdrop, provided that market participants are reminded of the above advantages of using the Cayman Islands, there are no real issues to highlight or limitations.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.