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Analysis & Insights

Addressing Fund Structuring Issues in Japan: Cayman Islands Unit Trusts and ELPs

14 Sep 2022

The Japanese asset management industry has continued to grow since the Bank of Japan embarked on monetary policies designed to vanquish deflation.  Pension funds, banks and other institutional investors in the region have allocated increased amounts to asset management companies in the search for yield.

Indeed, some of the largest Japanese institutional investors have already put in place multi-year alternative investment programmes which include alternative asset classes. With a renewed focus on private equity and other alternative assets in the world's third largest  economy,  considerations in structuring the more popular Japanese investment fund vehicles raise a number of important questions.

Significantly, with Japanese institutional investors looking to deploy capital successfully in strategies that will perform well in the global markets, the ability to maximise structural efficiencies in funds is paramount. There is also great demand among investors for customised fund solutions to suit their own particular circumstances, as well as to employ effective corporate governance.

Levels of dry powder stand at record levels globally and the situation in Japan is no different, with major investor programmes at work including Japan's Government Pension Investment Fund ("GPIF"), the world's largest pension fund, holding assets of ¥196.6 trillion (US$1.46 trillion), as of March 2022.  In addition to other powerful domestic investors such as Japan Post Bank, international players like Blackstone, Carlyle and Bain Capital have also been highly active in the market.

Regarding corporate governance, the desire for higher standards reflects the more robust attitudes and policies in concert with the institutionalisation of the investment fund sector.  Since the US$2 billion AIJ Investment Advisors scandal in 2012, the Japanese fund industry has seen a greater reliance on western due diligence firms, while trust banks have built up internal due diligence teams to support their function as gatekeepers.

As Japanese investors increasingly target global assets in their search for yield, the flexibility and infinite structuring possibilities afforded by Cayman Islands fund vehicles mean they are often the preferred fund structure.  Most notably, the Cayman Islands unit trust, of which there is a high degree of familiarity among investors, or the Cayman Islands exempted limited partnership.  Nonetheless, we have begun to see increased use of fund vehicles in some other jurisdictions, if they are able to better accommodate a particular strategy, as outlined below.

Although there is not necessarily a 'one size fits all' approach to fund structuring that can be taken, we hope to offer some views and perspectives in this article.

Flexibility in Structuring

The Cayman Islands unit trust and exempted limited partnership both offer significant flexibility in the approach to drafting and structuring to implement complex investment strategies or bespoke distribution policies which might be required by investors or asset managers.  Unit trusts and exempted limited partnerships can both be established as either closed or open-ended vehicles. However, the unit trust's ability to be established as an umbrella trust, allowing a number of sub-trusts to be established to pursue different investment strategies, is a key advantage. These sub trusts can also accommodate a range of investors and bespoke offering terms, while structured to keep the assets and liabilities of each sub-trust separate and distinct from those of another sub-trust. This added flexibility and the manner in which umbrella trusts and their sub-trusts are created can ultimately increase speed to market and lower the costs of the next fund launch. The Cayman unit trust's popularity with Japanese investors is perhaps best demonstrated by its use to invest in asset classes that, outside of Japan, would be the sole preserve of a limited partnership structure. This includes private equity, venture capital and other alternative assets.  Further details of the private equity type unit trust structure can be found here.

Investor Preference

Whilst the Cayman Islands unit trust has historically been the vehicle of choice for Japanese investors, a number of other jurisdictions and entity types have become increasingly popular over the years as investments cross multiple jurisdictions and asset classes.  One of the key drivers behind this trend is an increase in the number of pension funds, mega banks, regional banks and other Japanese institutional investors who have expanded their investment horizon to include global alternative investments.  This has included the use of Irish unit trusts for Japanese institutional investors who are seeking exposure to infra debt.  For other Japanese investors who remain bound by investment charters that contain a narrow list of permitted investments  and/or investment structures, which criteria are satisfied, Cayman unit trusts continue to provide an effective solution with the due diligence and approval process required to proceed with the investment typically being much quicker than having to seek approval to expand the list of eligible investment structures.

Tax and Operational Considerations

The unit trust can create significant tax and operational efficiencies due to its non-transparent status, it being treated as off-balance sheet and, in most cases, being eligible to obtain securities investment trust tax status in Japan. Depending on the classification of the unit trust, investors need only pay tax as and when distributions are made or redemptions are paid.  Not only does this allow investors to control the timing of their tax liabilities, it also has the potential to reduce the operational burden as the unit trust serves as a blocking entity for tax efficiency purposes.  There is particular benefit if the operational infrastructure of the fund, asset manager and investor is not as robust as it could be, as well as for investors with competing cash­ flow obligations and tax liabilities across broader structures.

This of course, is not always the best outcome and at times, the exempted limited partnership can provide a preferential solution, particularly where the strategy combined with the jurisdiction of the assets and investor allows the parties to avail themselves of certain tax treaty benefits. Notably, the transparent nature of the exempted limited partnership can permit an investor to benefit from the US-Japan tax treaty that is currently in place. 

Governance and Oversight

In addition to the reasons above, Japanese investors have supported the use of the unit trust within investment fund structures as they gain great comfort from the fact that there is a third party trustee responsible for the governance and oversight of the unit trust.  The trustee has a duty of care and overarching fiduciary obligations to act in the best interests of the unitholders as a whole. The existence of this third party governance structure has historically contrasted with the exempted limited partnership model where the general partner of an exempted limited partnership was owned and controlled by the sponsor of the investment fund with no third party oversight. Having said that, we are now seeing some Cayman exempted limited partnerships being established with third party owned and controlled general partners.  This gives additional protection and comfort to investors, knowing that a third party has ultimate control and oversight of the investment fund and the investment manager or investment advisor is merely a service provider.

Legal and Regulatory Issues

The legal and regulatory landscape at the best of times can be difficult to manoeuvre and where cross­ jurisdictional activity is being conducted, care needs to be taken to create a structure that factors in the multiple legal and regulatory environments at play.  With this in mind, it is essential to obtain professional advice to establish a suitable fund infrastructure and engage experienced service providers to minimise the risks in this regard.
From our long standing experience in the Japanese market, working with many of the most prominent domestic investors and international management teams, we have significant experience in these areas and are able to provide added-value to our clients. As the search for yield intensifies and Japanese investors continue to explore global opportunities, the ability to enhance efficiencies and lock-in operational benefits to structures can present significant advantages to managers, while providing a robust approach to corporate governance.

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