Matthew Stocker, Olivaire Watler and Charlie Pywell examine the crucial role IFCs play in facilitating investment in emerging markets.
Investing in emerging markets is, in many respects, a fundamentally different prospect to investing in the more traditional and mature markets.
The nature of these markets and the challenges and risks associated with them often serve to make investments into them less predictable than in developed markets, but with that unpredictability comes opportunity. As such, emerging markets remain attractive to investors. Alongside this, international financial centres (IFCs) such as the Cayman Islands are regularly used to facilitate such investments and remain well placed to continue to do so.
It can be difficult to talk generally about the emerging markets, investments into them and the structures used to facilitate such investments, as the term ‘emerging markets’ now spans such a varied and disparate group of countries.
The traditional emerging markets of the BRIC nations (Brazil, Russia, India and China) – which became BRICS in 2010 with the addition of South Africa – are only really part of the story. The term ‘emerging markets’ is now generally understood to mean a group of about 25 countries, ranging from Central and South America, Africa, Asia and parts of Europe. Accordingly, while it is possible to make some observations about the types of investments and structures used to invest into them, any such analysis is, by definition, general in nature.
With that said, there are certain considerations that frequently arise for investors looking for opportunities in emerging markets.
Primarily, there is a higher degree of legal risk and complexity associated with such investments. The risks often include regulatory issues (including the need to obtain certain consents), political issues (which can lead to reputational risk) and, in many cases, complexities arising out of local law requirements (for example, a requirement for local national involvement).
Although these risks to the wider transaction are often not of direct relevance to the lawyers in an IFC who may be assisting with the implementation of the investment structure (often in conjunction with their ‘onshore’ counterparts), all parties and advisors to the transaction will have them in mind. In order to ensure that the risks are identified and mitigated and an appropriate structure is used, it is imperative that the investor has advisory teams in place in all relevant jurisdictions with appropriate knowledge and experience from early in the process.
Of course, some local law issues can be structured around – for example, structuring an emerging market investment through an IFC can be an effective method of avoiding the need for local consents that may be required on a transfer of shares – but those that cannot be dealt with in such a way will need to be tackled early.
Why use IFCs for investments in the emerging markets?
As the macro-economies of the emerging markets grow, businesses within such markets continue to seek international capital. Foreign investments into the emerging markets and, indeed, external investment activity from within such markets demand efficient vehicles to facilitate orderly flows of capital. For that purpose, international investors routinely establish vehicles in IFCs such as the Cayman Islands (and also Bermuda and the British Virgin Islands) to facilitate the inflow and outflow of capital to and from such markets.
Many of the reasons for establishing such vehicles in such IFCs - which typically sit as holding companies and ‘cash-pooling’ entities at the top of the structure for investments into an emerging market - do not differ significantly to the reasons for using such vehicles in any other type of transaction. These reasons are well versed and documented, and in essence are as follows:
They each offer robust and straightforward legal and regulatory schemes together with a strong history of English common law. The legal and regulatory schemes are modern and commercial and, importantly for transactions in emerging markets, are often flexible. In addition, the legal systems in these IFCs are generally regarded as creditor friendly (with the absence of debtor friendly insolvency regimes such as Chapter XI in the US), which is clearly attractive to lenders and helps to increase liquidity in such structures.
The Cayman Islands, the British Virgin Islands and Bermuda are each a self-governing British territory enjoying a tradition of parliamentary government, a judicial system focused on providing a dedicated financial services judiciary and whose appellate courts include the Judicial Committee of the Privy Council in London. In the context of an emerging market transaction where the investment itself may have a high jurisdictional risk, many investors are attracted to the low jurisdictional risk associated with established IFCs.
The ease and speed in which entities and structures can be established in these jurisdictions, together with a relatively low cost of maintenance is clearly attractive to investors.
The Cayman Islands, the British Virgin Islands and Bermuda are each ‘tax neutral’. Additionally, they have each signed up to information exchange agreements with numerous jurisdictions to combat tax evasion, are members of the International Organisation of Securities Commission and are on the OECD White List – meaning that they have implemented the internationally agreed tax standard and are, accordingly, not considered to be a tax haven by the OECD. In addition, the regulatory standards in these jurisdictions are internationally acknowledged, including with respect to compliance with international standards on anti-money laundering and combatting terrorist financing.
The tax neutrality of these IFC-based structures enables a clean flow of capital (both upstream and downstream) without attracting an unnecessary additional layer of taxation. It does not, of course, mean the investors avoid tax in their own jurisdiction – only that they are not subjected to structural leakage.
They each have a sophisticated legal and financial services industry with an educated and motivated workforce (often drawn from the leading players in onshore jurisdictions) who understand, and have experience of, the demands (including aggressive timeframes) of international transactions.
Horses for Courses?
As a leading IFC, the Cayman Islands offers sophisticated financial products, which have been developed and demanded by internationally traded hedge funds, private equity funds and structured finance outfits. These products differ subtly to those in other leading IFCs such as the British Virgin Islands and Bermuda but, ultimately, they all achieve substantially the same objective.
Absent any overriding tax reason, the choice of one IFC over another by investors establishing vehicles for investments into the emerging markets is often driven by fairly narrow or arbitrary distinctions (and sometimes nothing more than name recognition for certain types of investments in certain markets). Nevertheless, it is fair to say that the main Caribbean IFCs of Cayman and BVI, together with Bermuda, while competing and offering similar solutions in certain areas such as investment funds, have each carved out special niches.
As a brief and very general overview: the British Virgin Islands are generally recognised as being a leading provider of special purpose vehicles for joint ventures or structured finance transactions (and are regularly used for investments into Russia); Bermuda offers a welcoming regulatory environment for insurance and for offerings conducted by public companies; and the Cayman Islands have developed as a centre of excellence for specialised investment funds (both hedge and private equity), offshore banking and sophisticated corporate and finance transactions.
The flexible and stable legal and regulatory systems in IFCs such as the Cayman Islands, the British Virgin Islands and Bermuda provide investors into emerging market economies with jurisdictional comfort. Tax neutrality, the absence of withholding tax and the ability to easily transfer funds or pay dividends to non-resident shareholders are also clearly attractive features of IFCs for international investors.
There is a generally acknowledged relationship between the implementation of tax neutral IFC-based structures and a continued and improved development of emerging market economies. It is arguable that, without tax neutral IFC-based structures facilitating investments in emerging markets, many of such investments (which aide and enhance economic growth) may be less viable.
Charlie Pywell is an Associate in the Corporate department of Conyers Dill & Pearman in the Cayman Islands. Charlie joined Conyers in 2014. Charlie has a broad corporate practice with particular expertise and focus on corporate finance (including funds finance and leveraged finance), M&A and capital market transactions. Charlie regularly advises investment banks, private equity funds and large corporates on cross border and multi-jurisdictional aspects of their transactions.
Olivaire Watler is Counsel in the Corporate department of the Cayman Islands office of Conyers Dill & Pearman. Olivaire joined Conyers in 2008 and became counsel in 2012. He has extensive experience in all aspects of corporate and commercial law including hedge funds and private equity funds, partnership, banking, regulatory matters, project financing, structured financing and asset financing with a special focus on aircraft financing and registration advising both lenders and lessors.
Matthew Stocker is Counsel in the Cayman Islands office of Conyers Dill & Pearman. He has over 20 years of transactional experience, including 15 years as an offshore attorney (Cayman primarily but also BVI). Matthew has acted in relation to many financings of various types and structures, including numerous aircraft, vessel and other asset financings, capital markets transactions, securitizations and acquisition finance matters. Similarly, he has worked on a wide range of corporate transactions, M&A, initial public offerings, other listing matters, corporate restructurings and numerous venture capital deals.