Japanese institutional investors have been allocating increasing amounts to alternative asset classes, including private equity, venture capital, infrastructure and private debt (collectively "Private Equity") for some time now in the search of yield1. However, with returns on domestic investments, particularly bonds, continuing to be hit by chronically low-interest rates, this is a trend that has been gathering pace. For example, in FY2020, Japanese life assurers increased their holdings in 'other' securities, i.e. securities other than conventional equities and bonds, including fund investments, by 27%2.
PE Type Unit Trusts
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 unit trust (the preferred investment vehicle for many Japanese investors) that incorporates some characteristics of a private equity fund, including a capital call feature and defaulting investor provisions. PE Type Unit Trusts typically invest in Private Equity through one or more Cayman Islands companies that are incorporated with limited liability (each an "Investment Subsidiary").
Some investor benefits of using the PE Type Unit Trust structure to obtain exposure to Private Equity include but are not limited to:
- Investor familiarity – the Cayman Islands unit trust is
already one of the most popular investment vehicles used by
Japanese investors for seeking exposure to more complex
strategies.
- Tax advantages – it is usually 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, meaning no
consolidation of accounts is required.
- JPY Hedging - many Japanese investors wish to hedge any non-JPY
currency exposure arising from making non-JPY denominated Private
Equity investments. JPY hedging is more difficult when using a
limited partnership ("LP") structure, given gains /
losses arising from Private Equity investments are not recognised
until the relevant investment has been realised, which may be many
years after the investment has been made. By contrast, in a PE Type
Unit Trust structure, , both realised and unrealised gains are
distributable and there is a current net asset value that can be
used for the purposes of calculating the non-JPY exposure that is
to be hedged.
- J-Curve - the J-Curve effect (the historical tendency of private equity funds to deliver negative returns in early years and investment gains in the outlying years as the portfolios of companies mature) often results in early realised losses for investors in an LP structure, especially when a private equity program is in its infancy. In a PE Type Unit Trust structure, while realised losses may result in lower net asset values and possibly fewer distributions, investors need not recognise realised losses to the same extent as with using an LP structure. The J-Curve effect would show up only as a lower net asset value per unit figure, with losses not being realised unless and until any redemptions are made. If no redemptions are made, investors will not need to recognise realised losses, a drastically different experience to using an LP structure.
Use of Investment Subsidiaries
As noted above, PE Type Unit Trusts typically invest through one or more Investment Subsidiaries. One advantage to investing through an Investment Subsidiary, from the trustee's perspective, is the trustee is protected from unintended potential personal liability that might otherwise arise from making commitments to underlying private equity funds. Given a Cayman Islands unit trust does not have a separate legal personality, when the Cayman Islands unit trust commits a capital amount to an underlying private equity fund, it is actually the trustee (the legal owner of the assets) that makes the commitment. The trustee is then liable to pay all of that commitment, even if the end Japanese investors default on their commitment to the trustee. From the trustee's perspective, this would be problematic. The Investment Subsidiary provides a solution to this issue since it is the Investment Subsidiary (and not the trustee) who makes the commitment to the underlying private equity fund.
Another advantage of investing through an Investment Subsidiary is the shares in the Investment Subsidiary are regarded as "Securities" within the meaning of the Financial Instruments and Exchange Act (Act No. 25 of 1948) of Japan, meaning the PE Type Unit Trust can obtain securities investment trust status.
Irish PE Type Unit Trusts
Recently, some Japanese promoters have begun to replicate the PE Type Unit Trust structure using Irish vehicles. While Japanese investors have found that an Irish unit trust structured as a qualifying investor alternative investment fund (QIAIF) can accommodate the range of European alternative investments they are seeking to allocate capital towards, it is noticeable that this structure has been adopted for Japanese investors who are seeking exposure to European infrastructure, particularly infrastructure debt in the form of loans, bonds, swaps and notes.
Conclusion
The PE Type Unit Trust not only provides a solution for Japanese investors; it is also providing opportunities for Asian, US and European investment managers who are increasingly tapping new opportunities to manage allocations to Private Equity from some of Japan's largest investors.
Footnotes
2. https://www.nri.com/en/knowledge/publication/fis/jamb
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