Olivier Sciales Investments Law Blog on Lawyers.com

The Luxembourg law of 15 June 2004 relating to the investment company in risk capital, as amended from time to time (and for the last time on 29 October 2008) (the “SICAR Law”) has created a Luxembourg vehicle (“SICAR”) whose principal object is investing in risk bearing capital issued by domestic and foreign companies. The main features and advantages of the SICAR Law are its legal flexibility and interesting tax treatment. This legal framework for Luxembourg private equity and venture capital funds has had a significant impact in European private equity deal structures. We also discuss hereunder the main changes introduced by the Law of 29 October 2008 and the guidelines issued by the Luxembourg regulator (CSSF) on the concept of “risk capital”.

I.          KEY FEATURES OF THE SICAR

(a)        Definition of “investment in risk capital”

The SICAR Law limits the object of a SICAR to investment in venture capital and private equity. Risk investments are defined in the SICAR Law in a broad manner as to include any direct or indirect contribution of assets to entities in view of their launch, their development or their listing on a stock exchange. Risk capital includes any investment that creates for the investor a high risk with the expectation to realize a gain whose importance is proportional to the risk borne. We discuss in section (V) in more detail the circular issued by the CSSF on the concept of “risk capital”.

(b)        Legal form

A SICAR can adopt most of the legal forms used in Luxembourg, such as the company limited by shares (S.A.), the limited liability company (S.àr.l.), the partnership limited by shares (S.C.A.), etc.

(c)        Eligible investors

The shares in a SICAR can only be subscribed by qualified investors who are:

• Either an institutional investor ; or
• A professional investor ; or
• Any investor who (i) has confirmed in writing that he adheres to the status of well-informed investor and (ii) invests a minimum of 125,000 Euro in the company or (iii) has obtained a certificate from a credit institution certifying his experience and his knowledge in adequately appraising an investment in risk capital.

(d)        Authorisation by the CSSF

A SICAR must be authorized by the CSSF. The authorization procedure entails:

• The approval of the constitutional documents (prospectus, articles of incorporation, ancillary agreements with service providers, etc…);
• Examination whether the directors are reputable and have sufficient experience (however, there is no requirement as to the financial background or capital adequacy of the directors and shareholders of the SICAR);
• The approval of the institutions that will act as custodian, administrative agent and auditor.

(e)        Light supervision during the life of the SICAR

Any changes to the constitutional documents must be approved by the CSSF. Only annual accounts need to be issued (no semi-annual accounts). There are furthermore no risk diversification rules and no restrictions as to the investment policy of the SICAR (other than those mentioned in the circular issued by the CSSF containing guidelines and clarifications on the criteria applied by the CSSF when assessing whether a project is eligible under the SICAR Law or not. We have discussed these guidelines under section (5).

(f)        Capital requirements

The subscribed share capital of a SICAR may not be less than 1,000,000 Euro, of which only 5% needs to be paid up. This minimum must not be subscribed upon incorporation but must be reached within a period of 12 months following the authorization of the company.

II.        ADVANTAGES OF THE SICAR

(a)        From a corporate law perspective

• No obligation to create a legal reserve. This allows investors to distribute the entirety of their profit;
• No restrictions on redemption of shares or payment of dividends or interim dividends except those mentioned in the articles of incorporation. This allows investor to receive the profits on investments shortly after they have been made;
• Subscribed capital needs only to be paid up to an amount of 5%;
• Not subject to any debt-to-equity ratio;
• Flexibility as to the issue of new securities. There are no formalities attached;
• Possibility to provide for a variable share capital.

(b)        From a tax perspective

(i)         At the level of the target company (with regard to the income distributed    by     the target company to the SICAR)

• Withholding tax, if any, on income distributed by the target company to the SICAR should be reduced in accordance with the double tax treaty between Luxembourg and the country of residence of the target company;
• Normally, based on the parent-subsidiary directive, no withholding tax should be levied on dividends distributed by EU target companies to the SICAR, in cases where the conditions of the participation exemption provided by the domestic legislation of the target country are met.

(ii)     At the SICAR level (with regard to the income received by the SICAR)

Fully taxable at a rate of 28,59%, but:

• Dividend distributions by a SICAR are not subject to withholding tax;
• Income derived from transferable securities (for instance dividends received and capital gains on the sale of shares) is exempt from Luxembourg corporate income tax. Income that is not related to investment in risk capital is subject to corporate income tax of 28,59% (for example interest earned on bank deposits, management fees, etc…);
• No wealth tax is due;
• No withholding tax on liquidation payments;
• No VAT on the management of the SICAR;
• No subscription tax (taxe d’abonnement).

(iii)     At investor level

Foreign investors are not subject to Luxembourg tax on any capital gain realized upon the sale of the shares of the SICAR.

III.       PRACTICAL RELEVANCE (EXAMPLES) OF THE SICAR

• Used as holding company for repatriation of profits as there is an exemption of capital gains realized by non-resident investors on the shares of the SICAR;
• Used as holding company for subsidiaries to which the participation exemption does not apply. Based on the Law, there will always be an exemption of income from transferable securities (even if the conditions of the participation exemption have not been fulfilled);
• Used as draw-down structure (intermediary financing equity company) in order to downstream cash for investments in risk capital, as there is no wealth tax of 0,5% on the net asset value.
• Used for private equity structures (as alternative to other vehicles such as the Soparfi or the SIF (specialized investment fund).

IV.       GUIDELINES ON THE CONCEPT OF “RISK CAPITAL”

On 5 April 2006, the CSSF issued a circular letter (06/41) (the “Circular”) containing guidelines and clarifications on the criteria applied by the CSSF when assessing whether a project is eligible under the SICAR law or not.

(a)        Concept of risk capital

The purpose of the SICAR law is to favour the collection, in a vehicle specialized in risk capital, of funds contributed by well-informed investors accepting with full awareness and in expectation of a better return the increased risks most often associated with risk capital, i.e. lower liquidity, higher price volatility and lower credit quality.

Risk capital is defined in the SICAR law in a broad manner as to include any direct or indirect contribution of assets to entities in view of their launch, their development or their listing on a stock exchange. The Circular reminds that SICAR application files submitted for CSSF approval require the simultaneous combination of two elements i.e. (i) a high risk associated with the investment in the target company and (ii) the intention to develop the target company, which is broadly construed as the “creation of value” at the level of the target companies.

(b)        In general

The creation of value may take different forms:

?        The type of financing

Financing may be through bond issuance, bridge financing, share capital, mezzanine loans, convertible loans, etc.

?        Different investment types

It may take the form of buy-offs, LBO’s, MBO’s, and management buy-ins, etc.

?        No restrictions as to the exit of investors 

The exit of the investors in the target company can be structured in the most efficient way from a legal and tax perspective (i.e. via a trade sale of assets or via an initial public offering).

?        Risk repartition

The SICAR law does not impose any risk repartition with respect to the selected investments and it is thus possible that certain SICARs limit their investments to one or several companies active for example in a niche market or in extremely specialized sectors.

?        Holding period

The CSSF stressed that the contemplated holding period of an investment is an important criterion in determining whether it is eligible to be considered risk capital. Therefore, the declared intention of the SICAR must be in general to acquire financial assets with a view of a resale at a profit.

(c)        Special case for real estate investments

Whereas the SICAR law does not allow SICARs to directly hold real estate properties, the indirect investments via entities which hold real estate properties is permitted. The Circular gives criteria of eligibility of investments in private equity real estate under the SICAR Law.

The CSSF has confirmed that private equity real estate investments must be made for the purpose of creating value, which can be understood as a change to the existing conditions such as the enhancing of the valuation of the real estate by renegotiation of contracts, renewal of tenants and refurbishment of the properties. Furthermore it is necessary to demonstrate that the relevant real estate represents a specific risk, beyond the normal real estate risk attached to such real estate in a given market.  Such specific risk can lay for example in the fact that it is difficult to find tenants or that the real estate is located in an unfavourable zone.

The CSSF has set out a series of criteria which will be taken into account when assessing whether a private equity real estate investment is eligible to fall within the scope of the SICAR law.

?     The potential for significant profit due to the specific risks attached to the property;

?     High risk/ expected return ratio;

?     Identity of the management, the nature of their remuneration and procedure for selecting real estate property;

?     Financial participation of the managers;

?     Active development of property, limited holding period ;

?     Nature of financing: significant leverage, mezzanine type of financing.

(d)        Indirect investments

The Circular clarifies the types of companies that can be used in a structure of indirect investment in risk capital. The indirect investment via an UCI (undertaking for collective investment) or another private equity vehicle is acceptable provided the investment policy of the UCI restricts them to investing in assets that are eligible under the SICAR Law. However, the investments into hedge funds are not eligible as hedge funds do not pursue the creation of value for its own investments.

(e)        Political risk

The geographical localization of investments in countries where there is a political risk can be taken into account when assessing whether a given investment constitutes a given risk. However, it is possible that it may be necessary to demonstrate the existence of additional risk factors so that creation value at the level of the target company can be proven.

(f)        Mezzanine loan

Mezzanine financing is an eligible form of financing insofar as the financing is made to a non-listed company or to a listed company if the financing is given in view of a specific development project.

(g)        Investment in listed securities

A SICAR may invest in listed securities when associated to a specific development project or if aimed at a delisting.

It should be noted that the CSSF has not set out hard rules on what does or does not qualify as a SICAR but rather guidelines and clarifications. Each SICAR project will be reviewed by the CSSF on a case-by-case basis.

V.        AMENDMENTS TO THE SICAR LAW

On 29 October 2008, a law was passed amending the existing SICAR Law of 15 June 2004 with the aim to make the SICAR regime more attractive to private equity and venture capital investors.

The main amendments that have been voted are briefly set out hereunder:

• Umbrella structure

The new SICAR Law has introduced the possibility to create multiple compartments. The principle of compartment segregation already well known for SIFs, securitization vehicles and UCITS funds is now also applicable to the SICAR. Compartment segregration means that the liabilities of the SICAR can be split into different compartments each of which are treated as separate entities making distinct transactions. The rights of investors and creditors are limited to the risks of a given compartments's assets. Each of the compartments can be liquidated separately without triggering the liquidation of other compartments of the SICAR. The main advantage of the umbrella SICAR is that it can issue several tranches of securities corresponding to different collateral and providing different values, yields and redemption terms. It is important that the constitutional documents of the SICAR expressly provide for the possibility to have multiple compartments and expressly outline the rules that are applicable to them. The issue document must outline the investment policy of each compartment. The shares of the umbrella SICAR may be of different value.

• Minimum capital

The share premium (if any) will be taken into account for the computation of the minimum capital. The share capital increased by the share premium must be at least 1,000,000 Euro to be reached within a period of 12 months from its authorization by the CSSF.

• No requirement to publish the NAV

Under the initial SICAR Law it was required to provide the net asset value to the investors every 6 months. This provision has been abolished.

• Valuation of assets

The valuation of the assets of the SICAR must be based on the fair market value (rather than the foreseeable sales price estimated in good faith).

• Reduction of the duties of the custodian

The SICAR Law has reduced substantially the duties of the custodian. More in particular, the following duties do not need to be fulfilled by the custodian under the new SICAR Law:

- control that the subscription price for the securities of the SICAR has been received within the time limits set forth in the constitutive documents;

- control that in transactions involving the assets of the SICAR, a consideration is paid or delivered to it within the customary time limits;

- control that the income of the SICAR is applied in accordance with its constitutive documents.

The abolition of the above control duties previously imposed on the SICAR will certainly reduce the annual costs charged by the custodian of a SICAR.

• Annual report

The annual report must be provided to investors within a period of 6 months after the end of the financial year rather than be "published" as was required under the initial SICAR Law.

• Limited partnership (soci¿ en commandite simple)

The SICAR can now be set up as a soci¿ en commandite simple (limited partnership) with a variable share capital.

VI.       CONCLUSION

The SICAR offers in a market place renowned the world over an attractive new vehicle which also ensures that, from a Luxembourg tax point of view the vehicle is totally neutral for the investors and which reduces the regulatory burden while ensuring a minimum of protection from investors. The SICAR may become the vehicle of choice for private equity and venture capital investors. It is important in each project to carefully examine which vehicle would suit the best (Soparfi, SICAR, SIF or a securitization vehicle).