Entering with one eye on the exit

selling your business

There has been considerable consolidation in the financial services industry resulting in a number of mergers and acquisitions.

Such consolidation is now predicted within the hedge fund arena because there is a large number of relatively small operators in a thriving business sector. Some are not reaching their potential in the same way that they might if part of a larger operation; others are stellar performers that are attractive to purchasers and therefore in great demand.

Often, one of the furthest things from anyone's mind when setting up a new business is consideration of an exit. The pressures inherent in any start-up also mean it's difficult to plan so far in advance, and when one is not in a strong bargaining position in a start-up, it is not easy to achieve the best contractual arrangements.

But in the event of an opportunity to sell, say to a co-partner or third party interested in entering the hedge fund sector, it's useful to think about what the purchaser of a business will be looking at when considering that business for acquisition.

A potential purchaser will review a number of areas and, if these are in order, this will give comfort and ease the process considerably. However, it's also possible to build in elements that will make the business more attractive and to avoid issues that may discourage an acquisition.

Regulation

It's important to consider where the fund manager, fund or any other related companies are regulated and for the majority this will be offshore. The Cayman Islands have traditionally been a favourite jurisdiction for the incorporation of a fund, while Guernsey and Jersey are increasing in popularity due to recent changes there that have enabled the easier structuring of hedge funds.

However, it's advisable to look for jurisdictions that are accepted by the wider community as offering regulation that is appropriate to the protection of investors but tempered with a regime that is flexible and as open as possible.

In particular, a good balance can be achieved by setting up operations in a jurisdiction that concerns itself more with the regulation of operations of service providers, such as fund administrators, prime brokers and custodians, but leaves the fund largely unfettered to set its own policy. Any concerns as to protection of investors are dealt with by ensuring that there is full disclosure in documentation.

Such a system is attractive to acquirers as it will allow them the flexibility to run a business in the future, yet have confidence in the existing standards and operations adopted by those who provide services to the fund. Furthermore, choosing a jurisdiction that permits funds to migrate or amalgamate with other funds or change their legal form enables acquirers to easily integrate the new business with any existing funds that they may have.

A recent example might be where a fund manager already has an established protected-cell company in Guernsey or segregated-portfolio company in the Cayman Islands and is seeking to acquire a specialist operation that provides a strategy the existing promoter does not have, such as distressed securities or event-driven investment. It will be looking to integrate to achieve economies of scale.

If a specialist fund is in Jersey, then it could migrate and be amalgamated into a cell of a Guernsey or Cayman Islands fund. However, if the fund is in a jurisdiction which does not permit this, it will be less attractive for the acquirer because considerable reorganisation will be required for proper integration in another jurisdiction.

By establishing that specialist fund in a well-known jurisdiction, the regulatory issues of moving will also be easier to deal with.

Tax

The purchaser will look for a straightforward tax system, both for fund manager and for the fund. In most offshore jurisdictions, the fund will be exempt from any tax and this should continue after the acquisition. However, consideration must be given to the manager. In some offshore jurisdictions, it is possible to agree with the authorities on special rates of tax, generally between zero and 30%.

Any change in ownership may affect such agreements, but proper planning should ensure that this will not be a problem for any acquirer. Provision of full information as to the agreements reached in previous years should be documented and retained to ensure that a prospective purchaser is fully informed and comfortable with these arrangements.

There are a number of relevant tax changes on the way. For example, many offshore jurisdictions are now moving to zero corporate tax for fund managers and funds and the EU Directive on Savings may also have minor effects for funds and managers.

Proper planning now in anticipation of the changes to come will ensure that a business is attractive to a purchaser. For example, in relation to the EU Savings Tax Directive, interest payable to an individual will be subject either to a withholding tax in some jurisdictions or disclosure of information to an EU, or other, tax authority.

There are a number of ways to ensure that this unnecessary burden is avoided. One method will be to ensure that there are no payments that are in the nature of interest; another will be the use of a paying agent outside of the EU and treaty countries net.

Employment

The restructuring of an acquired company is always a consideration. However, it must be borne in mind that there are restrictive employment laws that have been adopted in all jurisdictions and which concern themselves with unfair dismissal, notice periods and redundancy. In relation to senior employees, contractual arrangements may often go further than any rights that exist under employment legislation.

However, in looking ahead to an exit and building a business at an early stage, it is appropriate to keep in mind the costs that an acquirer may suffer in restructuring the company at a later date. In an ideal world, contractual arrangements should, therefore, be drafted to provide the greatest possible flexibility.

Outsourcing provides one solution in this respect. Instead of managing everything in-house, such as corporate administration, valuations, shareholder registration, investment dealing, accounting, custody, settlements, compliance and so on, the appointment of external administrators will ensure that there are fewer employment issues to deal with.

The relationship will be entirely a contractual one and, with proper notice provisions, a purchaser will be able to remove an administrator more easily than reorganising an entire department in-house.

Another advantage of outsourcing is that it gives acquirers greater comfort. They know that a third party is involved in running a fund, providing another level of checking and compliance.

Valuation

The valuation of any business is always a difficult issue but avoiding obvious expense for an acquirer is something that can be achieved at an early stage. Some of the ways of achieving this are mentioned above, such as outsourcing and flexible employee contracts. Creating flexible structures is also an important factor.

An advantage of offshore funds is that the board of directors will be non-executive and should be easily changeable without compensation for loss of office. The board of an offshore fund will often comprise a representative of the administrator, a representative of the fund manager and another professional from the offshore jurisdiction, such as a lawyer.

Where it is essential to the business to keep certain individuals, it will be important to offer them incentives and a number of ways of doing this have been used over the years. Increasingly, we are seeing equity in the fund management group being provided to senior executives through options and employee benefit trusts. In setting up such schemes, it is important to ensure that the scheme retains flexibility so that changes can be made appropriately in the future.

Often such schemes will have provision for 'good leavers' and 'bad leavers' and need careful consideration to ensure that those who remain in the business reap the most reward. It is also advisable to set up such schemes in jurisdictions where the law is flexible and allows easy administration.

Such jurisdictions are often offshore, which has the added benefit that where executives are resident in more than one country, tax advantages exist through being neutral for all members of the scheme.

Using offshore jurisdictions is also popular with executives as the lack of any requirement to file accounts typically ensures that one's private wealth and affairs are not open to scrutiny. Omissions from The Sunday Times' 'Rich List' may prove this point.

Shareholders' agreement

Finally, for small businesses, a shareholders agreement may be in place. It is surprising how many start-up businesses fail to complete such agreements, despite time and money being spent negotiating most of the terms and the encouragement given by lawyers, accountants and other professional advisors to finalise matters.

They are crucial when it comes to considering an exit and such issues as 'tag-along', 'drag-along' and key personnel rights and restrictions after the sale should be agreed in advance to ensure an easy and cost-effective sale of the business.

author: roger le tissier

Roger Le Tissier is a partner of the Ogier Group and the founding partner of the Guernsey law firm Ogier & Le Masurier, which specialises in commercial matters. The new firm has undergone significant growth since opening and now acts for many leading financial institutions. Le Tissier has wide-ranging experience in international finance, banking, insurance, trusts, securitisations and also holds a number of directorships, including those of funds. He was seconded to the Guernsey Financial Services Commission for 18 months as part of an initiative by the Commission. His duty involved the authorisation of funds and the licensing of applicants under the relevant laws and was involved in the policy-making of the Commission, where his opinion was sought on the interpretation of laws and rules relating to various matters. He was also compliance officer at Guernsey International Fund Managers Limited, the largest fund administrator in Guernsey.

key points

Keep in mind what a purchaser will examine in a potential target and the costs they may incur in restructuring it if necessary.

Document all agreements with authorities on tax and other regulatory matters so potential acquirers have a paper trail of what is in place.

Ensure contractual arrangements have flexibility, for example, by outsourcing some functions.