Legal lowdown: Michael Halford, Goodwin

The Drawdown (TDD): What challenges have your clients experienced in recent months?

Michael Halford (MH): There’s been a focus on where to domicile PE funds versus where the firm’s headcount is based. We’re seeing a trend where GPs domicile structures in their main business centres, rather than in alternative jurisdictions where they have less presence.

For example, Goodwin’s annual client update showed there’s been a move from domiciling PE funds in Jersey to the UK, so we’ve been doing more UK funds than before. Between 2021-2022, the proportion of Jersey domiciled funds our UK funds team acted on dropped from 33% to 22.5%, while UK domiciled funds climbed from 12.5% to 15%.

Related to that is the ongoing issues we’re still dealing with post-Brexit now that’s very much underway.

TDD: The FCA set out new rules to improve oversight of appointed representatives, placing more responsibility on principal firms. Do you think this is the right move?

MH: The FCA is simply putting more responsibility on authorised firms to monitor what’s going on. The changes look pretty sensible, and I can’t see any of our clients, for example, having a particular issue with this.

I don’t think it will have much impact on PE. It might make authorised firms think twice before going down that route though, as more onus is on them.

TDD: Recently, Lord Sikka pointed to PE fund and deal structures in Switzerland, Jersey and the Caribbean as created for the purpose of “asset stripping, profit shifting and tax avoidance”. What are your thoughts?

MH: This touches on the fact there are lots of global regulatory and tax changes across the globe. The latter is aimed at businesses such as internet or digital services companies basing themselves in one jurisdiction but actually delivering significant revenues from other jurisdictions. This issue impacts PE fund and deal structures, given they inevitably raise cross-border issues.

A PE fund structure is only trying to put LPs in the same position they’d be in - tax wise - if they bought portfolio assets directly. It’s not to avoid tax - it’s simply to minimise any additional tax layers. While some regulations may have been introduced for something completely unrelated to PE, they ultimately impact on every other type of sector depending on where and how they operate. In this case, the rule changes have driven GPs towards rationalising their operations, so they better reflect where the headcount is, and where operations are actually located. I think PE is ahead of the game in terms of that comment because there’s been a trend in PE for a while regarding streamlining operations and where they are based.

I don’t particularly feel there’s any asset stripping or profit shifting by PE funds either. Profit shifting was the focus of the OECD’s BEPS project, which led to the ATAD legislation in Europe. Non-PE related issues have undoubtedly caused further regulation to come into play and we take it on board when structuring funds.

TDD: On 4 August, the Bank of England raised interest rates by 0.5% to 1.75% - marking the highest rate since the GFC. The increase is expected to put pressure on valuations and IRR targets. What can PE learn from the 2008/9 crisis to come out of this situation?

MH: In 2008-9, PE was resilient. There weren’t as many defaults as you’d have expected. We actually saw more defaults in the 2003 Dot Com crash.

However, after the GFC we saw an increase in secondaries, and we’re starting to see more of that again now as LPs reorder their portfolios. In terms of learnings, managers need to be prepared because secondary deals create work for the GP. They’ll be asked lots of information about the fund to pass onto the new buyer, and so on.

Then there’s valuations. They’re quite good at the moment, but wider issues such as the cost of living crisis will inevitably create some impact, which may hit companies. This would in turn impact valuations further down the line.

What’s key to remember is, a lot of capital has been raised for PE funds throughout the pandemic. Only some of that will have been drawn down and invested so far. Similar to 2008-9, some funds would have invested in portfolio businesses with higher valuations just before the GFC in 2007. Then some investments were made after the GFC, enabling funds to take advantage of lower valuations. Therefore funds investing right now won’t automatically have bad returns due to timing. They might have good returns because GPs were able to take advantage of better pricing.

TDD: Moving towards Q4 2022, what key advice would you give to GPs?

MH: It’s incredibly important to get legal advice at a very early stage if you are raising a fund. There are so many new regulations flooding the industry, such as all the ESG regulations and the European pre-marketing regulation, which came into play in August 2021.

With regards to the latter, to go down a reverse marketing route, you need to make decisions on individual countries very early on as to what your strategy is going to be. Therefore it’s better to get everything confirmed before you’ve started investor conversations. Unfortunately, this particular regulation raises the barrier for entry for smaller managers and prices them out due to rising costs, so it’s worth considering all angles.

TDD: What are your focuses for the next six to 12 months?

MH: We’re fortunate to have had a good fundraising period despite the pandemic and there’s no sign of that slowing down, so it’s business as usual for us.

We’re also working with managers on GP-led secondaries. It’s almost a mix of a transaction with a fund because on one hand, the GP is transferring an asset/group of assets into a new fund, but on the other hand you have to create the new continuation fund. The terms of the new fund are often bespoke and involve negotiating between sellers and buyers, which can be challenging within tight timeframes.

Recently during the slight downturn, we’ve seen more queries around valuations. Alongside that, we’re working on a number of preferred equity deals, whereby waterfalls are adjusted to provide funding to a company in a way that provides some protection for new LPs coming into the fund. We’re expecting to see more of those going forward.