4 Myths about ESVCLP Funds

Myth 1: An angel investor has no control over the investments of an ESVCLP

This myth has evolved from a misunderstanding of the prohibition contained in the Partnership Act 1892 (NSW) forbidding limited partners of an incorporated limited partnership (including an ESVCLP) from taking part in the management of the business of the partnership.

In fact, the relevant provisions go on to state that a limited partner is not to be regarded as taking part in the management of the business of the partnership merely because the limited partner or a person acing on behalf of the limited partner is an officer of a general partner that is a body corporate.  The effect of this carve out is that an angel investor may be a director of the general partner of the ESVCLP, and thereby have direct involvement in investment decisions.

In addition, an angel investor who has co-invested with other investors through an ESVCLP may be engaged to give professional advice to the fund, give a guarantee or indemnity in respect of any liability of the partnership, take any action for the purpose of enforcing the rights or safeguarding its interests, act as a lender to, or fiduciary for, an associate of the partnership and participate on a committee (or appoint a representative to do so) which considers and approves or disapproves key issues relating to the operation of the partnership including proposals to change the nature of the business of the partnership (including a change in, or departure from, any investment guidelines, policies or conditions relating to the business of the partnership), proposals for the adoption or variation of a valuation methodology for the partnership and proposals relating to any conflict of interest or related party transaction.

Myth 2: An ESVCLP will need to be registered as a managed investment scheme (MIS)

The Corporations Act 2001 (Cth) defines a MIS as a scheme where people contribute money (or money’s worth) as consideration to acquire rights (interests) to benefits produced by the scheme, any of the contributions are to be pooled to produce financial benefits for the members who hold interests in the scheme and the members do not have day to day control over the operations of the scheme.

Whilst a co-investment vehicle structured as an ESVCLP is likely to fall within this definition, the key issue is whether or not the MIS is required to be registered. It is the registration requirement that creates the additional compliance obligations and the associated costs.

One exception to the requirement for a MIS to be registered is where the co-investment vehicle has less than 20 members and is not being promoted by a person who is in the business of promoting managed in vestment schemes. The promoter of an ESVCLP is generally the General Partner. The question as to whether or not the General Partner is a person in the business of promoting managed investment schemes will be a question of fact. Under the common law test the courts generally look for elements of system, repetition and continuity in a person’s actions in assessing whether a business is being carried on. Not all of these elements are required, but the presence of all three will indicate the carrying on of a business. However, the legal commentary on this issue draws a distinction between “the methods of promotion [that] are characteristic of a business” and, for example, “informal approaches to friends and acquaintances”[1]. It is arguable in circumstances where a group of angel investors come together to co-invest through an ESVCLP the parties cannot be said to be in the business of scheme promotion and therefore the ESVCLP will not need to be registered as a MIS.

A further exception to the requirement for registration is that a MIS is not required to be registered if the issue of interests in the scheme would not have required a Product Disclosure Statement (PDS) to be issued. A PDS is only required to be issued to ‘retail clients’. The definition of ‘retail client’ excludes a person who pays $500,000 or more for its interest in the scheme or a person who has net assets of at least $2,500,000 or a gross income for each of the last 2 financial years of at least $250,000. In the majority of cases, a typical angel investor will not be a ‘retail client’.

Myth 3: Funds are about the fund manager making money, not the investors

In a typical fund, passive investors are prepared to reward the fund manager for the expertise it brings to the investment selection and management process. The structure of this reward will be set out in the fund deed and is ordinarily comprised of a management fee (which allows the fund manager to cover the costs of operating the fund and provides a small level of guaranteed profit for services) and the carried interest (which is the fund manager’s performance bonus and is ordinarily not payable until the investors have received distributions equivalent to both the capital they invested and an agreed level of return).

The key to remember is that each of these reward structures (as well as everything else in the fund deed) are matters for negotiation. The most successful funds seek to achieve a win-win scenario between fund manager and investor whereby the structure of the reward is considered by both sides to be fair consideration for the value brought to the fund by the fund manager.

In circumstances where a group of angel investors come together to co-invest through an ESVCLP and each appoint a representative to sit on the board of the General Partner, it may be agreed, for example, that the management fee is to be limited to the bare costs necessary to operate the fund and that the carried interest is to be done away with altogether. After all, the aim of the game is to ensure the maximum possible return to the limited partners. This is also a better tax outcome since the returns to limited partners from an ESVCLP is tax-free whilst the carried interest is taxable in the hands of the General Partner (albeit, on capital account rather than revenue account).

Myth 4: Committed capital will be trapped for the entire investment period

Once an investor has agreed to commit a specified level of capital to the fund, it will need to ensure that level of funds is available to answer calls on capital that are made by the General Partner from time to time.

However, ordinarily the fund deed will empower the General Partner to reduce the level of committed capital or to return capital to the limited partners.

Conclusion

As angel investors begin to re-assess their appetite for risk in the current climate, co-investment between angels will become more popular and co-investment structures will need to become more tax-effective than the humble unit trust. Where a group of angel investors share a similar investment style and philosophy and wish to co-invest with each other, the ESVCLP provides the most tax-effective structure through which to do so.

For further information in relation to this article please contact Steven Maarbani of PricewaterhouseCoopers on 02 8266 6834 or steven.maarbani@au.pwc.com.