When establishing private equity funds targeting investments in Africa, South African fund managers are increasingly starting to look offshore.
The primary reason for this is to attract an international investor base. The choice of jurisdiction of incorporation is, however, also determined by a number of other factors including the location and practical requirements of the fund manager, the location and tax status of the potential investors, the infrastructure available in the chosen jurisdiction and the fund's target investment region. Tax consequences arising for investors, the fund, investee targets and the fund manager also need to be analysed. Offshore jurisdictions such as Mauritius, the Cayman Islands and the British Virgin Islands are generally considered attractive for tax reasons, relatively light touch regulatory regimes and the absence of exchange control restrictions. Mauritius also has a network of double taxation treaties which can be very attractive to funds investing in Africa. These jurisdictions are well known to the international investor community which makes the task of fundraising easier.
Some investors, including some international development finance institutions (DFIs), are restricted from investing in offshore funds as a result of internal policy restrictions and, in the case of South African investors, as a result of exchange control restrictions. South African parastatals, for example, are restricted under the Exchange Control Rulings from using a "tax haven" country as a conduit for outward foreign direct investments elsewhere in the world. This means that a South African DFI may be precluded from investing in an offshore fund, even though that fund may have an African developmental mandate which falls squarely within the developmental mandate of the DFI. The promoter of a private equity fund wishing to court such restricted investors must explore practical ways of accommodating them.
A credible investment prospect
South Africa offers a number advantages as a jurisdiction of incorporation: it has a convenient geographic location for pan-African investment (with many potential investors represented in South Africa), a sophisticated and well regulated financial services industry and a number of double taxation treaties with other African countries. There are various suitable fund vehicles available in South Africa. The most common is probably the en commandite partnership, which is similar to the internationally better known limited partnership. It comprises a general or disclosed partner (usually a company, whose liability is unlimited) and one or more investors which are undisclosed limited partners (whose liability is limited). The primary advantage of an en commandite partnership is that it is transparent for tax purposes, which means that it does not pay tax in its own right. Any income or gains of the partnership are taxed in the hands of its partners. However, a South African en commandite partnership may prove unsuitable for certain investors. There is no single fund vehicle which suits all investors and any structure will ultimately need to be driven by the demands of the fund promoter's investor audience.
There are a number of factors which need to be considered by a local private equity fund making investments in Africa through a South African incorporated vehicle.
Despite recent relaxations of foreign investment allowances, it is likely that the fund will require exchange control approval on a case by case basis for investments outside of the common monetary area of South Africa, Namibia, Lesotho and Swaziland. The administrative process for obtaining exchange control approval adds costs, time and uncertainty to the investment process. One particular African infrastructure fund was able to procure a partial general exemption from the exchange controls, probably granted as a result of the fund’s overt developmental objective and its politically motivated genesis. Normally, though it is difficult for a fund to receive a blanket approval.
An extensive regulatory framework applies to investment funds in South Africa. The regulations promulgated under the Collective Investment Schemes Control Act (CISCA) are restrictive as to the investment activities which can be undertaken by collective investment schemes, including restrictions on the use of borrowings, making it difficult for private equity funds to operate under CISCA’s regulated environment. On the other hand, this regulation can give investors a degree of additional comfort and protection. In any event, South African private equity managers which are members of the Southern African Venture Capital and Private Equity Association (SAVCA) are entitled to an exemption from the provisions of CISCA, provided that they only market their products to selected financial institutions.
If the fund is parallel to an offshore fund it can, depending on the mandates of its investors, have a narrower investment policy than that of the offshore fund. For example, the South African fund may be restricted from investing outside the SADC. This limitation can be regulated contractually between the funds.
If the South African fund is structured as an en commandite partnership and the general partner is a South African entity which frequently concludes contracts on behalf of the partnership inside South Africa, there is a risk that an international investor in the fund may be deemed to have a permanent establishment in South Africa. In these circumstances, the international investor would be taxable in South Africa on its proportionate share of the fund's income and gains. This may be governed by a double tax treaty between South Africa and the country in which the investor is tax resident, and the risk can often be mitigated by limiting the functions which are performed by the general partner in South Africa.
A South African fund which is run in parallel with an offshore fund does involve more documentation (the onshore fund requires its own fund documents), higher costs (legal fees, local administration fees, banking fees, etc) and is administratively more burdensome. The fund manager also needs to apportion each investment between the two funds.
The trend for South African private equity managers to establish funds offshore is likely to continue, particularly as exchange control restrictions are relaxed. However, even if these restrictions are abolished completely, we are still likely to see a number of parallel structures being established onshore.
Lance Roderick, Director at Africa Legal (a division of Deneys Reitz Inc)
