Category: 未分類

Why did partnership funds became so widely used? The pass-through nature is of course an important element, but if that is the sole benefit, then it is indifferent from just simply not establishing a fund. Below are some of the factors I can think of:

1. Gathering multiple investors: A fund can gather many investors into one pool. It will make investment process much more cost efficient.
2. Give strong power to the manager: Managers of investment funds tend to have more discretion and decision power compared to directors of ordinary corporations. This creates incentives for the managers to establish an investment fund.
3. Anonymity: In some cases, the investors do not want to make their names known to the investee (or to the public, if the investment requires public disclosure). A partnership can intervene in between in such case and hide the names of the actual investors behind. But this does not work in some cases.
4. Reputation: At least in Japan, investment funds have earned decent reputation as of now, and establishing an investment fund has become “cool” thing.

Financial Instruments and Exchange Act of Japan defines certain investors as eligible investors, who would qualify to invest in a partnership fund (which uses Article 63 exemption). The current Japanese regulation has given a high hurdle to individual investors to qualify as an eligible investor, since it generally requires an individual to have at least more than JPY 100 million in financial assets (which do not include cash and bank deposits). Certain types of entrepreneurs are also eligible, but it is only for funds adopting venture capital exemption which is actually not so frequently used (this is different from the venture capital exemption available in the US securities regulations which is used quite often).

But I feel that there are more individuals who should be allowed to invest into partnership funds and this eligibility hurdle could be mitigated.

My understanding is that this type of asset requirement is similar to (and probably derived from) the definition of “accredited investor” in the US securities regulations (Reg D). Originally, the “high net worth” requirement of accredited investors were a method to categorize the investors who can “fend for themselves” quantitatively with certain thresholds. While the amount of assets held by an individual would be a measure to evaluate his/her investment capacity, it does not necessary reflect whether such person is a sophisticated investor who has sufficient knowledge in financial products.

If that is the case, what are the alternative categories we can add? Here are some thoughts:
– Individuals who passed investment-related well recognized qualifications. Examples: CPA, Financial Planner, CFA, CMA, Security Sales Representative;
– Individuals who have worked for financial services company (that is licensed or registered in Japan – banks, securities firms, insurance companies, asset management companies, etc.) for more than [5] years.

On the other hand, we may need to add stricter requirements to protect investors who are not suitable for this type of investments even though they are high net worth individuals. Putting aside the issues that will arise in the implementation phase, here are some ideas:
– Add more scrutinized process for the elderly;
– Limit the total amount of investments into investment collective schemes to a certain percentage of the total assets owned by the individual.

From the perspective of “law and economics,” corporations are seen as “nexus of contracts.” This is a view that a corporation is made up of many long term contracts. And this nexus of contracts theory applies not only to corporation but to other firms as well. If that is the case, how would limited partnerships be interpreted under the nexus of contracts theory?

There are many things in partnerships that can be argued in the same manner as corporations. When seeing from the principal agency model (which is in a core of nexus of contracts theory), shareholders are principals and directors are agents for a corporation. Whereas, in a limited partnership, limited partners are principals and the general partner is the agent. The general partner, as an agent, will act to maximize the benefit of the principals (the limited partners). In that case, what will be the difference between partnerships and corporations, seeing from this principal agency model? I would like to raise two points.

The first point is that incentives are more aligned between the principals and agents in case of a partnership. The general partner receives certain percentage of the limited partnership’s profit (distribution) as carried interest, so it is very clear that the general partner will make more money if it can bring more profit to the limited partners. On the other hand, directors’ remuneration is often a fixed amount. Even though a stock option can be issued to directors to directly link their incentive to the wealth of shareholders, gains earned by stock options are relatively smaller and it is not so easy to realize the gains earned by stock options. Also, a share price is influenced by many factors and it is difficult for directors to control by their sole efforts (as compared to a profit). And we are all aware that there is an increasing pressure against directors to consider the benefits of stakeholders other than the shareholders. Thus, principal agency model in limited partnerships has much simpler and straightforward incentive alignment.

The second point is that the general partner of a partnership fund has much more discretion in terms of business operation as compared to a director of a corporation. The limited partners do not have the same level of voting rights as shareholders have at shareholders’ meeting. Limited partners’ power to dismiss the general partner is very limited in most cases. Thus, the general partner can concentrate on maximizing long term benefit of its principals, as compared to directors who faces the risk of being dismissed by shareholders’ resolution.

Well, the second point raises a question that whether limited partners can monitor and control its agent (the general partner) effectively as expected by principal agency theory. However, the general partner has sufficient incentive to achieve good performance for the limited partners, because if the performance of the fund is poor, the general partner will not be able to raise its subsequent funds and will be required to exit from the investment fund industry in a few years.

To summarize, partnership funds are more loyal to original concept of the principal agency theory. Thus, investors may have become aware that investments in partnerships funds have lower agency cost and thus better return as compared to other vehicles such as corporations. I believe that the above is one of the factors that have contributed to the increasing use of partnerships over the years.

(Of course I do not deny that tax structuring is very important factor in choosing partnerships as investment vehicles, but it is sometimes meaningful to see things from a different angle.)

The Japanese government (Financial Services Agency) recently announced (on April 1st) a guidance about the treatment of carried interest under the Japanese tax rules. The purpose of the guidance was to clarify and (softly) authorize the practice that spread among the Japanese fund community in the past several years where the distribution to the general partner is treated as capital gain which may have tax advantage as compared to being treated as total business income.

In this guidance, the FSA referred to the concept of a “special limited partner”, who receives carried interest while being a limited partner. This is justified by the fact that members of the special limited partner are actually the managers of the fund. My understanding is that special limited partner is rarely used in current Japanese funds, and it is interesting that the FSA referred to such concept in a publicly announced document. While the context appears to imply that the special limited partner belonged to a non-Japanese fund, I predict that special limited partners will be more recognized in Japan fund community and be more broadly used by Japanese funds in a few years.

At present, there is a movement in Tokyo (and Japan) to attract global investment funds to Japan, as indicated by the fact that the Tokyo Metropolitan Government launched and is pursing the concept of being a “financial city”. However, there are some aspects of Japan’s current investment fund regulations that make foreign investment funds difficult to enter into Japanese market. I would like to point out three things that could possibly be modified to foster investment fund activities in Japan.

The first point is changing the fund regulation regarding subscription and investment management to a group basis. Under the current Financial Instruments and Exchange Act (FIEA), only the GP entity of a fund is allowed to conduct offering and management business under the special exemption of the FIEA. However, under the U.S. fund regulations, a group company of the GP entity is treated in the same way as the GP entity, subject to the condition that certain requirements are met.  In many cases, the actual day-to-day operations of global investment funds are carried out by another operating company within the group that is not the GP entity. Therefore, global investment funds established based on the standard US fund structure must take into account the differences between the US and Japanese regulations when entering into the Japanese market. This should be changed if Japan wants to attract global investment firms.

The second point is giving more flexibility to formation of internal funds. Global investment funds often create small internal funds (partnership vehicles), in which only related parties of the investment firm participate. However, under the FIEA, the creation of such small funds must meet the same regulations as those for large funds that solicit outside institutional investors. As a result, it sometimes becomes difficult to provide the same incentive package to Japanese PE fund managers as to those of the overseas managers within the group.

The last point is eliminating the overseas investment restriction for investment limited partnerships. An “investment limited partnership” is the most common vehicle currently used to set up an investment fund in Japan. However, under the relevant law, investment in overseas companies by an investment limited partnership is limited to less than 50%, and in practice, it is perceived that much lower percentage (than 50%) can be invested in overseas companies, since this 50% threshold is calculated on contribution amount basis and must be met throughout the life of the fund. For this reason, it is difficult for funds that invest globally to use investment limited partnerships, and in some cases they are forced to set up their funds outside Japan, even if all of the fund managers are Japanese and all investors are Japanese companies.

Of course, it is natural that regulations differ from country to country. However, in order to attract global funds from overseas to Japan and to increase investment funds established in Japan, Japan should consider a way to ensure that overseas funds can maintain their existing framework in Japan without spending too much cost for local customization.

I have been hanging around investment funds industry, especially related to venture capital funds and private equity funds, for almost 20 years. In 2002, I started working for a Japanese venture capital fund.  Since then, I switched my job and became a lawyer more than 10 years ago, but have been involved in supporting many venture capital funds and private equity funds.

When I entered the Japanese venture capital industry, it was few years after the time when Limited Partnership Act for Investment had been enacted in Japan, and the investment fund market was still immature in many aspects.  Investment funds were definitely not the mainstream of Japanese businesses. In the 20 years since then, Japanese peoples’ view towards the investment funds have changed dramatically.  Both private equity funds and venture capital funds became one of the most highly regarded workplace in Japan.

In this blog, I intend to write various topics related to the investment funds and enhance people’s interest in this industry.