This article was first published by The Business Times Wealth Issue on 13 July 2021
A NEW US$150 million venture capital fund in Japan, launched by former Goldman Sachs vice-chair Kathy Matsui, made the headlines recently as one of Japan's first environmental, social and governance (ESG)-focused venture capital funds.
The MPower Partners Fund is a rarity in Japan for its female leadership, as media such as Bloomberg noted. It also made news because while the venture investment market has expanded rapidly in Japan in recent years, it remains small in comparison with the US and China.
Despite the relative newness of ESG funds in Japan, structuring an investment fund that has an ESG strategy is actually quite similar to structuring any other type of investment fund.
Thinking it through
In the investment funds industry, certain fund structures have become generally accepted within the investor community for specific types of strategies or investors. However, despite any such widespread acceptance of a specific fund structure, fund managers should still make the effort to properly assess each consideration discussed here and to accurately assess how each factor may specifically apply to their own contemplated fund proposition.
Based on our experience, assuming that a fund structure adopted by one fund manager would be appropriate for others is risky as it is very rare for two fund managers to be exactly alike.
Furthermore, laws and regulations surrounding investment funds are constantly evolving. There is no guarantee that a fund structure that may have worked in the past will work again in the future.
While it is very easy to fall back on ''tried and tested'' fund structures seen in the market, we can only recommend that fund managers properly think through the structure of the fund. Fund structure is one of the most important - if not the most important - features of an investment fund.
Considerations in structuring
Here are some customary factors to think about when structuring any venture capital fund.
One of the most important considerations is tax. The performance of a fund's strategy is ultimately irrelevant unless both the investment of the fund assets and any distribution to investors can be made in a tax-efficient manner. There are many factors that should be considered to optimise tax efficiency. These include the type of target assets, domicile of target assets, form of the investment fund itself, application of any double tax treaties, and jurisdiction of the fund investors.
It is equally important to properly understand any regulatory considerations which may be applicable to the operation of the fund. Each jurisdiction has its own unique laws and regulations governing various aspects of funds' operations.
Therefore, the laws and regulations of each jurisdiction that the fund will have nexus (eg: where the investments are being made, where the fund is being managed, where the fund interests are being offered, etc) should be properly examined to ensure that the fund can operate in full compliance with applicable law.
What licenses or registrations are necessary for the fund manager? What notifications, if any, are required by the regulator to offer the relevant fund interests in the jurisdiction? Given the inherently cross-border nature of investment funds, professionals in numerous countries will likely need to be consulted to ensure full compliance.
Lastly, the fund has to be attractive to investors and unfortunately, this is not always about taxes and regulations. Even if an investment fund is created in a manner that is both tax efficient and in full compliance with applicable regulations, there is no guarantee that the fund will raise capital successfully.
The fact of the matter is that investors in certain jurisdictions may have preferences for specific types of investment funds both in terms of structure and domicile. Some investors will only invest in structures that they have invested in the past, so familiarity and convention could determine a fund's success.
The ESG component
While the structuring of an ESG fund is not necessarily different from any other venture capital fund, what makes an ESG fund different is the manner in which it invests in the portfolio companies. ESG fund managers must strictly adhere to various self-imposed investment guidelines and restrictions relating to the industries that they may invest in and how they will make such investments.
This investment strategy, which is typically disclosed in the fund documents, differentiates the fund from non-ESG strategy funds.
As a final note, due to the recent popularity of ESG strategies among allocators, some fund managers may seek to ''greenwash'' their fund by adding an ESG component to their strategies. Due to the varying interpretations of the precise definition of ''ESG'', the practice of ''greenwashing'' has become more widespread.
However, it is our experience that greenwashing is risky at best.
First, it is important to note that various regulators are taking steps to prevent this practice. For example, in the US, the US Securities and Exchange Commission released a ''Risk Alert'' in April following recent examinations of ESG investing and flagged problematic ESG investment practices.
Moreover, we believe that investors themselves are becoming more sophisticated in their understanding and monitoring of their investments into any ESG fund. It is not uncommon to see key investors document various additional ESG investment restrictions as well as monitor obligations in side letters with fund managers.
At the end of the day, we anticipate that the popularity of ESG-themed investment funds will only grow in the future. With the evolving regulatory landscape around ESG funds and as investors gain more experience in such investments, many ''true'' ESG fund managers will find further opportunities and success in this space.
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.