Investments in assets that are not traded on the stock exchange are becoming increasingly popular with Swiss pension funds. In doing so, it is important to consider not only market risks, but also legal and tax peculiarities.
Careful examination is mandatory
The global demand for so-called private market investments has been unbroken for years and is primarily driven by investments from insurance companies and pension funds. The private equity industry, for example, recorded global inflows of more than 450 billion dollars in 2017. Private debt funds recorded inflows of more than $100 billion globally in the same period. As a means of diversification and not least as a result of the persistently low interest rate environment, private market investments are also becoming increasingly important for Swiss pension funds. For example, the 2017 activity report of the Higher Supervisory Commission for Occupational Pensions (OAK BV) indicates that Swiss investment foundations set up various investment groups in the area of alternative investments (especially private equity) in the reporting year.
Characteristics of private market investments
Traditionally, private market investments can be categorised as follows: Private equity, private debt, private infrastructure and private real estate. What private market investments have in common is that they are typically not listed on a stock exchange, i.e. there is no exchange trading. Pricing takes place through negotiation between the parties involved in a transaction and is largely subject to the negotiating skills and market power of the participants. Publicly accessible transaction information is usually lacking. The limited liquidity leads to low valuation frequency with considerable valuation margins. Due to the capital intensity of private market investments, equity-based investments are often financed with a significant amount of leverage, which increases the expected return on equity but also the investment risk.
Structural forms of private market investments
Private market investments are typically accessed through the following direct and indirect structural forms.
The investor purchases fund units during the fund’s placement phase.
The investor acquires existing fund units from another investor.
- Fund of funds
The investor acquires shares in a fund, which in turn invests in investments of third-party managers.
- Direct investments
As a strategic investor, the investor acquires shares in companies or SPVs (special purpose vehicles) independently of a manager.
The investor invests directly in individual companies or SPVs parallel to a manager.
Legal and commercial aspects
Investments via investment structures
Due to the complexity, illiquidity and lack of standardisation of private market investments, a detailed analysis of all legal and commercial conditions is indispensable in the due diligence process. The sometimes widespread practice of relying on the due diligence of globally investing seed and co-investors may entail the risk that no or insufficient consideration is given to the individual regulatory or commercial circumstances of a Swiss pension fund. Identified deficits can be overcome by side letters. The following six points in particular should be taken into account during due diligence.
- Alignment of interests: In illiquid investments, the appropriate alignment of interests of manager and investor plays a central role. This alignment can be achieved, for example, through an appropriate participation of the manager in the investment during the entire term as well as through the so-called carry (see so-equal).
- Carry: Carry is the manager’s disproportionate share of the profits from the management and sale of investments. The personal commitment of the manager is rewarded as performance-related remuneration, which he provides through his special know-how, his experience and his contacts. The US style carry (deal-by-deal carry) is riskier for the investor than the European style carry (total portfolio carry) and should be specifically justified by the manager. Overpaid carry should be repaid by the manager (claw-back mechanism) and any overpayments should be secured by a guarantee.
- Management fee: The management fee, based on the actual capital invested and not on the capital committed or called by the investor, should be the manager’s „base remuneration“. Any additional services provided by the manager, such as advisory services or compensation from board membership, should be set off against the management fee.
- Governance: Managers who manage the assets of multiple clients must establish an investment process that ensures that investments are fairly and appropriately allocated to all clients. Conflicts of interest should be transparently disclosed to the investor and addressed accordingly. An independent evaluation of the investments should be carried out on a regular basis, if possible. 5.
- Advisory committee: the investment should provide for an investment committee composed of investors, which decides in particular on matters where the manager is subject to a conflict of interest.
- Transparency: The manager must ensure that comprehensive transparency is provided prior to the investment decision with regard to all material investment criteria, as well as ongoing detailed information on the financial situation (in particular fees) and the investment situation, including leverage. The total expense ratio (TER) must be shown separately.
Direct investments differ fundamentally from investments via (collective) investment vehicles. They are not subject to the specifications of the investment vehicle, such as adherence to the investment strategy or the involvement of all investors, for example in the case of maturity extensions or the adjustment of the investment strategy. In addition, unlike fund investments or diversified securitisations, direct investments do not have any diversification in themselves. This can contribute to an increase in management and administration costs as well as to an increase in investment risk.
From the point of view of the tax-exempt Swiss pension fund, care should be taken to make investments via tax-transparent investment structures as a matter of principle. This may enable the reclaiming of locally withheld withholding taxes. The manager should prepare all documents required for a possible tax reclaim and make them available to the pension fund. A corresponding obligation should be fixed in the contractual documentation. Otherwise, investments should be made in investment vehicles optimised for tax-exempt investors, whereby the tax optimisation can be carried out by the manager (for example, via „leveraged blocker“ structures). The avoidance of US tax filings can be achieved through so-called „US tax blockers“. In the case of entrepreneurial direct participations, care must be taken to ensure that the tax exemption of the Swiss pension fund is not negatively affected.
Private market investments are characterised by active management, low standardisation as well as a lack of stock exchange trading and individual pricing. Investments in private market assets require an active investor who, in addition to detailed investment due diligence, also conducts sound legal and tax due diligence prior to the investment decision in order to avoid imponderables during the term or upon settlement of the investment. Individual side agreements between the investor and the promoter can usually lead to a significant improvement in the governance, transparency and TER of the product. However, practice shows that the so-called legal & tax due diligence is sometimes neglected with regard to the particularities of Swiss pension funds.