For some time now, Japanese institutional investors have been allocating increasing amounts to alternative asset classes, including private equity, venture capital, infrastructure and private debt (collectively “Private Equity”) in search of yield1. However, with domestic investment returns, particularly bonds, continuing to be affected by chronically low interest rates, this is an accelerating trend. For example, in fiscal 2020, Japanese life insurers increased their holdings of “other” securities, i.e. securities other than conventional stocks and bonds, by 27%, including in funds.2.
PE Mutual Funds
This increased interest in Private Equity by Japanese life insurers, banks and other institutional investors has seen the rapid increase in the use of the “private equity type unit trust” (the “PE Type Unit Trust”). The PE Type Unit Trust is a Cayman Islands mutual fund (the preferred investment vehicle of many Japanese investors) that incorporates some features of a private equity fund, including a capital call function and provisions relating to defaulting investors. Mutual funds of the PE type generally invest in private equity through one or more Cayman Islands companies incorporated with limited liability (each an “Investment Subsidiary”).
Some benefits for investors of using the PE Type Unit Trust structure to gain exposure to Private Equity include, but are not limited to:
- Investor knowledge – the Cayman Islands Unitary Trust is already one of the most popular investment vehicles used by Japanese investors to seek exposure to more complex strategies.
- Tax benefits – it is generally possible to obtain securities investment trust tax status in Japan (see below).
- Off-balance sheet – the PE Type Unit Trust is treated for accounting purposes as an off-balance sheet vehicle, which means that no consolidation of accounts is required.
- JPY hedging – many Japanese investors wish to hedge any non-JPY currency exposure resulting from making non-JPY denominated Private Equity investments. JPY hedging is more difficult when using a Limited Partnership (“LP”) structure, as gains/losses from Private Equity investments are not recognized until the relevant investment is n has not been realized, which may take several years after the investment has been made. In contrast, in a PE type mutual fund structure, realized and unrealized gains are distributable and there is a current net asset value that can be used for the purpose of calculating the non-JPY exposure that must be covered.
- J-Curve – the J-Curve effect (the historical tendency for private equity funds to generate negative returns in the early years and investment gains in the peripheral years as corporate portfolios mature) often results in early realized losses for investors in an LP structure, especially when a private equity program is in its infancy. In a PE Type Unit Trust structure, although realized losses may result in lower net asset values and possibly fewer distributions, investors do not need to recognize realized losses to the same extent as with an LP structure. . The J-Curve effect would only show up in the form of a lower net asset value per unit, with losses only being realized if and until redemptions are made. If no redemptions are made, investors will not need to recognize realized losses, a radically different experience from using an LP structure.
Use of investment subsidiaries
As noted above, mutual funds of the PE type generally invest through one or more investment subsidiaries. One of the advantages of investing through an investment affiliate, from the perspective of the fiduciary, is that the fiduciary is protected against any potential unintended personal liability that might otherwise arise from making commitments to underlying private equity funds. Since a Cayman Islands unit trust does not have a separate legal personality, when the Cayman Islands unit trust commits capital to an underlying private equity fund, it is effectively the trustee (owner legal assets) who makes the commitment. The fiduciary is then required to pay the entirety of this obligation, even if the Japanese end investors default on their obligation to the fiduciary. From the trustee’s point of view, this would be problematic. The Investment Subsidiary provides a solution to this problem since it is the Investment Subsidiary (and not the trustee) who commits to the underlying private equity fund.
Another advantage of investing through an investment subsidiary is that the shares of the investment subsidiary are considered “securities” within the meaning of the Japanese Financial Instruments and Exchanges Law (Law No. 25 of 1948), which means that the PE Type Unit Trust can obtain securities trust status.
Irish PE type trusts
Recently, some Japanese promoters have started replicating the PE Type Unit Trust structure using Irish vehicles. While Japanese investors found that an Irish mutual fund structured as an Alternative Investment Fund for Qualified Investors (QIAIF) could accommodate the range of European alternative investments to which they sought to allocate capital, note that this structure has been adopted for Japanese investors seeking exposure to European infrastructure, in particular infrastructure debt in the form of loans, bonds, swaps and notes.
Conclusion
The PE Type Unit Trust not only offers a solution to Japanese investors; it also provides opportunities for Asian, American and European investment managers who are increasingly exploiting new opportunities to manage the private equity allocations of some of Japan’s largest investors.
Footnotes
1. https://maples.com/en-ca/knowledge-centre/2018/11/japans-increasing-attraction-to-alternative-investments
2. https://www.nri.com/en/knowledge/publication/fis/jamb
The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.
