Top five challenges — and solutions — when setting up a cross-border private equity fund

Setting up a fund in a new jurisdiction can provide these and other benefits, but there are difficulties and potential pitfalls. Many of these pitfalls may be unfamiliar to fund managers and other stakeholders who have little to no cross-border fund management experience. Even those with experience are often surprised when expanding into a new country. Each jurisdiction has its own regulations, for example, and even in blocs like the EU, authorities in one state may enforce regulations differently than those in another.

To better understand the most common challenges managers face when establishing a cross-border fund, we spoke with three professionals with decades of experience in fund administration.

Rosemary McCollin is funds director, Vistra UK. She has spent the majority of her career in fund services and has worked in both London and New York. Jonathan Ferrara, managing director, Channel Islands at Vistra, has 30 years’ experience in private banking, wealth management and corporate services. London-based Jillu Malik is Vistra’s director, private equity and real estate, and has been in the fund administration space for two decades.

1. Choosing a structure 

What are some of the important questions a fund manager should ask before setting up a fund structure in a new country? Are there elements of the process that are commonly overlooked and may cause unexpected costs or delays?

Jonathan: The fund manager must understand why they are picking a particular location and the benefits and drawbacks that a jurisdiction brings. Benefits are often clearly understood. For example, there’s an opportunity to market to a wider investment community, or a strong and stable operating environment with good legal, accounting administrative support, or tax neutrality for investors and investments, and so on.

The disadvantages of a jurisdiction, however, are often overlooked or underestimated. Disadvantages can include a more complex regulatory environment and related increased costs, along with operational challenges such as a shortage of quality local workers or the need to navigate multiple jurisdictions, currencies, time zones and cultures.

Rosie: Fundamentally, a manager’s focus is on securing investors and making investments. When setting up a fund in a particular country, the marketing rules and appeal of that domicile to investors is key. Is the market open to Europe, for example, and to what extent can premarketing occur? Usually, a manager has a long list of investors that has prompted them to create the fund, but is the manager aware of the finer regulatory details of premarketing to those investors? An AIFM [alternative investment fund manager] in Luxembourg, for example, can cover these rules and make sure no unexpected issues occur. 

Jillu: You also need to understand the tax implications of setting up in that country for both the investment cash flows and the investor cash flows. You should ask: Is the capital funding structure — either through loan notes or shares — the most tax efficient way to return cash to investors given the new country’s tax regulations? What are the local corporate governance requirements and the substance needed to transact in the country?

Anti-money laundering regulations are also key, in particular for investors who may need to disclose information as a UBO [ultimate beneficial owner]. Finally, does the country have the infrastructure and resources to allow you to operate efficiently and ensure that transactions can be made securely, accurately and without delay?

In certain scenarios, a fund manager may find they need to choose a different structure than the one they originally established or planned for. What are some of the ramifications of this?

Rosie: When a fund launch has a slight shift in structure type, it’s usually for a very good reason. For example, you may want to take advantage of new tax benefits or support a change to the number of investors. The typical impulse is to write off any legal work incurred to that point, but a good, experienced lawyer in the domicile can use what has already been drafted and amend that language to fit the new structure.

Having a clear understanding of the regulatory reporting requirements of the new structure should come from your advisors, and it’s important for the manager to have a thorough understanding of all the implications of the change. Perhaps the new structure is better for costs overall, but you may need to fill specific AML [anti-money laundering] or MLRO [money laundering reporting officer] roles, which carries its own costs. Knowing the reasons for these kinds of changes, and how they fit into the overall budget, enables all parties to get comfortable with the changes.

Jillu: Structural changes can lead to delays and high fund costs. You may need to revise documents, such as the prospectus, limited partnership agreements or the private placement memorandum. This may lead to lower returns or unfavourable income taxation, reducing the investors’ appetite for the investment.

Jonathan: When you need to change an existing structure — for example, due to a regulatory change or because you want to market in new areas — the key is seeking good third-party advice. You’ll need to discuss what you want to achieve to understand the various options and, ultimately, choose the best one.

It’s important to conduct this due diligence early and involve all affected stakeholders. You may assume that big changes are necessary, but in some cases small amendments or additions to the structure could achieve the desired outcome. This is similar to getting good legal and tax advice when establishing the fund, which can help ensure you save significant time, effort and money later.

The ramifications when making changes to an existing structure are mainly the time and cost, along with disruptions to the fund manager, administrator and investors. Minimising all of these while achieving the new objective should be the main aim.

2. Complying with economic substance requirements

Certain fund domiciles require a firm to have economic substance. What are some elements of economic substance that fund managers may overlook?

Jonathan: Economic substance rules are developing all the time, and they vary by jurisdiction. A fund manager is normally closely monitored in their own jurisdiction, but it’s also important to keep in mind that activities in the jurisdiction where outsourced fund administration activities are performed can also create compliance obligations.

So, it’s important to understand the specific regulations in the location where you need to demonstrate substance as well as the regulations where any outsourced activities are taking place. In both locations you need to ensure that you or your provider monitors any changes in the rules to ensure compliance and protect the integrity of the activities throughout the structure’s lifecycle.

Also, don’t underestimate the total amount of work that needs to be performed in a jurisdiction to meet substance requirements. As organisations increasingly outsource work, and even employ local workers from outside their home jurisdictions, robust control and monitoring are required to manage any economic substance risk. Also, some functions (such as those related to decision-making, transaction approval and certain control activities) can affect substance status, even in cases where a single activity is done. There have not been many challenges to economic substance rulings so far, but we can expect this to change as authorities in many jurisdictions increase enforcement. 

Rosie: I’d add that local directors can often be a point of contention with managers, as directors are usually an expensive part of substance requirements, especially if local regulators require two directors rather than just one. Managers can feel removed from the business and its strategy. That is, they may not feel as if they’re part of the wider team that’s building the fund, but instead like isolated individuals working for a third party.

In fact, managers play an essential role by building local expertise and conducting independent reviews of all decisions and strategies. This gives investors a strong sense of comfort about the fund’s governance. The local directors can provide colour and context to local rules to both the manager and investors and play the role of fair mediator on disputes that can occur over a 15-year fund life.

3. Establishing a bank account

There has been a long trend of consolidation in many industries, including banking. How has this affected the private equity market, in particular the ability to establish a bank account in a new jurisdiction?

Jillu: The banking world has changed over the years, with stricter due diligence requirements on clients and more stringent KYC requirements. As a result, good banking relationships have become more important to ensuring timely, efficient processes. The Silicon Valley Bank intervention has many VC and PE investors deconsolidating to reduce the risk that comes with placing a high percentage of assets in just one bank.

Rosie: Luckily, the wider market is opening up to new providers. This enables bank accounts to be opened relatively quickly, while still allowing the multiple-provider choice managers want, with underlying institutional-bank backing.

Jonathan: Banking has indeed seen major changes in recent years, with challenger banks entering the arena and traditional banks de-risking and focusing on specific areas. This has created challenges for many sectors, including the private equity space, where risk and reward are being carefully evaluated by banks.

The importance of banking relationships — whether direct with the asset manager or via their service providers — is key to ensuring good service, protecting assets and delivering the required product set. The problem area has quite simply been CDD [customer due diligence], as banks have had increasing regulations placed on them, yet the process has been highly manual and inefficient. The process has started to get easier, as more electronic methods are being used, and it should improve further as adoption becomes more widespread.

One word of caution: some very low-rated banks have entered this space on the basis of no overnight balance sheet risk and minimum capital requirements, and these can have significant intra-day credit risk in respect of payments. So, fund managers should always do full due diligence on any bank they use to properly protect investors.

4. Fulfilling AML/KYC requirements

Anti-money laundering and know-your-customer requirements vary by jurisdiction, sometimes dramatically. What are some of the ramifications of this, and what options do firms have to efficiently manage these discrepancies?

Jonathan: Despite the global focus and international cooperation on anti-money laundering processes, each jurisdiction still has individual legislation and local interpretation of regulations. As a result, clients that have activities in different jurisdictions are often asked for very different information to meet the required standards. GDPR has complicated this, as firms without effective information-security policies find it harder to share information on clients. This can have significant ramifications, including clients having to provide the same information many times over to the different jurisdictions of the same provider.

In addition, the level of information required can be different by location. For example a UBO [ultimate beneficial owner] is defined in jurisdictions differently, as are PEPs [politically exposed persons]. This increases KYC compliance costs and risk, including the risk of fines, sanctions and reputational damage.

Many firms are now addressing this with electronic systems, linked to passport offices and other databases, that provide independent verification and information. These are being enhanced by systems that hold the master information on each person and allow locally required additional data to be added when necessary. Clear client agreements providing access to this data across the organisation (only on a need-to-know basis) ensure GDPR compliance.

Rosie: Managers who have portfolio companies that span regions and continents need fund administration providers with a consistent, consolidated KYC approach. Everyone finds documentation collation frustrating, and when the thresholds don’t match, it’s particularly off-putting. This is why provider options related to onboarding and transitions now include using technology, people power and sophisticated reliance letters. 

5. Understanding and following regulatory quirks or other unexpected requirements

Are there any new or evolving regulations that have been particularly challenging for firms and investors to comply with?

Rosie: In the UK in late 2023, the new Economic Crime and Corporate Transparency Bill will come into force, increasing identity verification measures for new and existing directors and persons of significant control.

The exact requirements won’t be clear until the bill has passed after 4 September 2023, so it’s important to select a provider that understands the likely new rules and will be able to ensure prompt compliance. Typically, this will mean a large, experienced provider that has a record of remaining nimble in the face of changing requirements.

Jonathan: ESG regulations have been developing at pace across all industries. The need for common standards has been a priority for legislators and industry bodies. The problem has been getting standards that can be agreed on by all jurisdictions, and ensuring that information is accurate and comparable.

The issue of “greenwashing,” or making misleading sustainability claims, has also made this area ripe for increased regulation. In the EU, the corporate sustainability reporting directive [CSRD] will evolve alongside similar regulations in other jurisdictions around the world.

What’s the best way to understand all your obligations in a new jurisdiction before setting up a fund there? And what’s the best way to maintain compliance after a fund has been established?

Rosie: Before selecting a domicile, a manager will have done extensive research, and part of that process will be working with legal and tax advisors on doing business in the region. As the manager starts to appoint auditors, fund service providers and others, those third parties will elaborate on compliance obligations in the region and fill in any gaps. Once a fund goes live, those in the fund’s ecosystem will continue to provide updates on any regulatory changes and indicate if the fund’s activities have resulted in additional obligations, such as reporting thresholds or AML-review frequency.

A manager should look for providers that are clearly part of the region’s fund-industry framework, such as providers with representatives on committees that provide regulatory feedback and those lobbying regulators where appropriate. A manager should also assess the credibility of a provider’s senior management.