Institutional investors continue to be active investors in private equity (PE). Typically, institutional investors invest in PE as:
- Limited partnership (LP) investors in PE funds,
- Co-investors alongside PE funds, or
- Direct PE investors.
Each arrangement has its own benefits, burdens, and risks and requires that the investor have a requisite level of sophistication and in-house infrastructure.
Investment in PE by institutional investors continues to evolve with LPs moving to direct investment either through co-investment with PE funds with which they have existing relationships or going it alone. Along this journey, many have developed sophisticated in-house infrastructure to support the sourcing, analysis, and execution of deals. Well-advised investors applying efficient tax strategies can benefit from stronger after-tax returns for their stakeholders, helping to position them for greater success.
KPMG’s list of 10 items for institutional investors to consider when seeking to invest in PE
1. Potential changes in US tax law and the economic impact on fund investments.
In evaluating the after-tax yield of a PE investment, institutional investors need to consider the impact of potential US tax law changes, including, but not limited to, an increase in the corporate tax rate, restrictions on deductible interest and changes to GILTI and BEAT. Increased effective tax rates will have a direct impact on after-tax yield.
2. Global tax reform.
Tax reform and transparency has been taken up by local taxing authorities across the globe and by policymakers, including the EU and OECD. It is critical that PE managers and institutional investors proactively engage with these authorities and policymakers to ensure that practical and reasonable reforms are instituted that do not impact legitimate investment structures and tax planning. Engagement with the OECD on the BEPS project Pillar Two proposals by stakeholders could result in positive change for the industry.
3. ESG (Environmental, Social and Governance) investing is not viewed uniformly by investors and consistent measurement is evolving.
Partners in co-investment deals need to understand the ESG frameworks of their institutional investor co-partners and ensure that policies are in place that meet the needs and objectives of all parties. ESG needs to be incorporated into the portfolio company investment due diligence process. It is important that ESG sensitive institutional investors have a mutual understanding over what is expected as part of a sound ESG policy, including the compliance that will be required to meet standards and regulations that may be in place in certain jurisdictions. Transparency and accountability for tax structures put in place for investments across jurisdictions are important for many institutional investors and need to be incorporated into ESG frameworks. A clear and well-documented tax governance framework will be required by many institutional investors to satisfy the rules of the jurisdictions in which they reside.
4. Responsible tax policy.
We expect assessments of the portfolio to determine whether an investee company has engaged in aggressive tax practices will be common. Also, investment mandates will likely increase the obligations of managers to perform reviews on a prospective basis. There is a natural tension between managing the risk of adverse publicity from aggressive tax structuring and maintaining tax efficiency. Finding the balance will be critical.
5. Effective tax structuring and planning to enhance the after-tax cash yield on investments.
Cross-border investing brings the opportunity to benefit from favorable tax treaties and local country taxation. With the ever-changing tax landscape, institutional investors and others investing in PE need to have effective processes in place to monitor and adjust for tax law developments and changes in their home, holding company and investment jurisdictions. Efficient tax structuring should be carefully weighed against any potential reputational risks.
6. Tax as a differentiator in bids.
Private equity buyers compete in a crowded and competitive market; valuations are sky-high. Tax structuring offers an opportunity to differentiate a competitive bid and derive extra value from an investment – proper planning to help minimize unrecoverable taxes and maximize deductible expenses can make a difference. In addition, proper due diligence and understanding tax risks is critical; the willingness to provide indemnities and warranties covering tax risks may be limited and can make an offer less competitive.
7. Global operating models can bring increased complexity that needs to be managed.
As institutional investors move toward direct PE investing, many are choosing to open satellite offices in strategic locations to effectively source deals, develop local relationships and better manage their investments. While establishing local offices can certainly be beneficial from a business perspective, proper policies and procedures need to be implemented to manage associated tax risks, such as permanent establishment and transfer pricing.
8. Digital transformation as a business imperative for tax.
The use of digital tools is an effective and necessary approach for streamlining and boosting the efficiency of tax, compliance and regulatory reporting processes and procedures. As US and global tax and regulatory reporting become inherently more complex, the ability to cost-effectively synthesize data from a wide range of data sources requires investors with mature digital capabilities. In addition to improved compliance and reporting processes, advanced data and analytics capabilities can change the speed at which a target’s tax position can be assessed and factored into bids.
9. Progressive investment methodologies can require additional operational support.
Direct PE investments come with increased legal, tax, accounting, reporting and regulatory issues. Back-office functions, including tax, need to be ready to meet these increased demands. Even if functions like tax compliance are outsourced, internal expertise is still required in order to manage third-party service providers and make sure expectations are met.
10. Private credit opportunities/trend.
Investing on both sides of the capital structure has gained favor over the past few years and private credit strategies continue to grow AUM. We expect this trend will continue. Institutional investors investing in debt will need to be aware of certain tax complexities that may arise from these investments. Sovereign wealth fund investors also need to be mindful of commercial activity concerns to maintain exemption from US tax. While there are tax structuring opportunities to address many of the tax risks from these types of investments, institutional investors will want to understand these structuring and planning opportunities, as well as any associated commercial limitations.
KPMG firms have dedicated private equity practices with professionals who have expertise in fund structuring, reporting and M&A due diligence working with top institutional investors and private equity fund managers from around the world. KPMG professionals can help provide insights and advice on market leading practices to accommodate all parties to a transaction.
Jeffrey Hecht, Partner, Private Equity Tax, KPMG in the US
Melissa Asaf, Partner, Asset Management Tax, KPMG in the US