Overview

Legal Lingo seeks to break down legal buzzwords, concepts and jargon into bite-size explanations to make the industry more accessible for aspiring trainees. Read the full directory below.

Foreign Direct Investment (FDI) is defined by the Organization for Economic Co-operation and Development (OECD) as:

‘a category of cross-border investment in which an investor resident in one economy establishes a lasting interest in and a significant degree of influence over an enterprise resident in another economy.’

Over the last few years (and following the global COVID-19 pandemic), governments around the world have implemented FDI regimes to protect what they consider to be strategically important businesses from foreign acquisition or influence.  An FDI regime offers a national government the ability to investigate and potentially block or impose conditions with respect to a proposed investment from (typically) foreign investors in companies operating in key sectors of the economy.

Historically, these sectors focused on key areas of national security, such as military and defence-related companies. However, driven in part by increased geopolitical threats elsewhere and developments in powerful technologies, the concept of national security now includes critical infrastructure (including energy networks and ports), communications assets, and advanced technology and data (e.g., artificial intelligence, quantum computing, and advanced encryption technologies and materials).  The COVID-19 pandemic has also highlighted the relevance of a much wider range of businesses being directly related to matters of national security and public health (e.g., companies working on vaccines and personal protective equipment). 

Against a backdrop of increasing global protectionism, FDI regulation has become a critical piece of the regulatory jigsaw in recent years, such that careful consideration must be given to the application of FDI rules to cross-border M&A from the outset, alongside merger control and other regulatory clearances.  This can be the case even for acquisitions of minority interests as little as 1%.  While most investors are unlikely to be viewed as ‘problematic’, these regimes have significant implications for investors, particularly in terms of transaction timetables.  Investors need to consider both their own position but also that of any investment partners, and factor in these approval requirements into their acquisition strategies.

Want to find out more about FDI? If so, here are links to three excellent articles on the subject: 

  • Forbes: Twitter, Your Time Is Up
  • Reuters: Germany blocks Chinese takeover of satellite firm on security concerns
  • The Economist: The pandemic cut annual FDI flows by one-third

An introduction to carried interest, a.k.a. “incentive fee”, “performance fee” or “carry”.

Carried interest is a method of compensation received by individual fund managers (ie. executives) in private FUND or hedge fund structures.

These executives receive a share of the profits generated by the realization of the fund’s investments in portfolio companies. It is typically paid to the carried interest recipients at a rate of 20% of the fund’s profits (with 80% paid to the fund’s investors). However, carried interest is generally only paid after the fund returns the initial capital investors put into the fund plus a certain minimum return (known as the preferred return or hurdle rate) to investors.

Therefore, the level of Carried Interest paid to executives is derived from the performance of the underlying investments and the amount (if any) is not guaranteed. It aligns the interests of the executives with the performance of the fund and creates an additional incentive to maximize the fund’s returns for investors.  

Typically, the amounts of Carried Interest paid to executives is also subject to other restrictions. For example, if the fund fails to meet a certain level of return or an unforeseen liability arises, any overpayment of Carried Interest previously paid to the executives could be required to be repaid back to the fund and paid to investors via a process known as “Clawback” to ensure that no more than 20% of the profits have been paid as carry.

Most fund managers also charge a management fee (typically of around 1.5 - 2% per annum of an investor’s commitment), however unlike carried interest the management fee is not dependent on fund performance.

Institutional strip" and “sweet equity” are two cornerstone terms used in private equity transactions.  

Institutional strip refers to securities invested into by (institutional) private equity sponsors to fund the purchase of a target business. 

Institutional strip will typically consist of a combination of ordinary shares and preference shares or loan notes.  Alongside the private equity sponsors, senior / key members of a target’s management team will be expected to either rollover existing equity interests in the target or otherwise invest their own cash to subscribe for institutional strip.  The intention is for the management team to put “skin in the game” (i.e. bear the financial risk of the acquisition alongside the private equity sponsor), thereby creating alignment between the sponsor and the management team.  

Alongside the concept of institutional strip, sweet equity operates to incentivise the management team with the growth / performance of the target business.  In UK private equity transactions, sweet equity typically takes the form of ordinary shares held by the management team, which will appreciate in value as the target business grows.  This serves to incentivise management to promote the success of the business and maximise its value.

Most people are comfortable with the term 'private equity'. Firms like Bain Capital, TPG and Advent in the US and 3i, Bridgepoint and Cinven in the UK have been investing money in businesses, developing them and selling them on for decades. But private equity and venture capital are just part of a wider private capital universe. It is an area of finance that has been around forever but has become increasingly commented on in the last couple of years. 

The term 'private capital' refers to investments in unlisted assets, often (but not always) by private pools of money such as buyout firms, sovereign wealth funds, private investment funds and wealthy investors.  Institutions with a long-term view, such as pension funds and university endowment funds are also active in the market (either via direct investments or through investments in funds), as are banks. The distinction between private capital and private equity is that the former is the umbrella term for all types of investments in unlisted assets. This includes private equity (investments in private companies and/or buyouts of public companies) but also encompasses venture capital (investments in early stage companies with high growth potential), real estate (investments in real estate assets), private debt (debt investments that are not publicly traded), infrastructure (investments in infrastructure assets) etc.  

Want to find out more about private capital? If so, here are links to three excellent articles on the subject: 

“Withholding tax” or “WHT” refers broadly to tax which the person making a payment has to deduct from that payment and account for to the tax authorities. The UK makes some payers withhold tax on certain types of payment including, amongst other things, certain salary and interest payments. Instead of requiring the recipient to pay all the applicable tax following receipt of the full amount, a portion of the payment is withheld and paid directly to HMRC by the payer and the recipient gets a “credit” for that in their tax return. Withholding tax can therefore be considered a collection mechanic.

For example, if income tax were charged at 20% on a £100 salary payment, the employer would instead pay the employee £80, and hand £20 directly to HMRC. The employee should then not have to pay the same tax again in their annual tax return.

Withholding tax benefits tax authorities in several ways, for example:

  1. It often means the tax accounting and payment is done by the party better equipped to do so – for example, employer payroll departments rather than individual employees.
  2. It provides a tool against tax evasion/ non-compliance. Where payments are made “gross,” i.e. including the tax amount of a payment, they can become more difficult to tax, particularly where a payee is located overseas. Taxing at the source can mean catching the payment while it is still in the tax authority’s control.
  3. It can offer a cash flow advantage. Rather than waiting for the end of the period when the recipient completes their tax returns, the tax authorities are paid the tax earlier by the recipient.

Definition:

A Sovereign Wealth Fund is a state-owned investment vehicle run and managed by a government agency. A nation typically establishes a sovereign wealth fund when there are budget or trade surpluses on its balance of payments. The surplus capital can then be pooled into a state-owned fund which the government uses to make investments for the benefit of its citizens and their economy. 

Common types of Sovereign Wealth Funds include:

Stabilization funds: used to insulate the economy from inflation and volatile commodity prices, a common risk with the large influxes of revenue from mineral wealth like oil.

Future generation funds: designed to invest surplus revenue into a diverse portfolio of assets to provide for future generations.

Public pension reserve funds: set up to put money aside to finance a nation’s pension system.

The world’s largest sovereign wealth funds:

Norway: Norway’s sovereign wealth fund is currently the largest in the world with $1.27tn worth of assets under management. The Norway Government Pension Fund was established in 1990 to invest the large revenues derived from the nation’s oil wealth. 

China: China’s sovereign wealth fund is the second largest with $941bn worth of assets under management. The China Investment Corporation Fund was established in 2007 due to surplus foreign exchange reserves. 

Abu Dhabi: The Abu Dhabi Investment Authority was established in 1976 to manage the budgetary surplus derived from state-owned oil and has $578bn worth of assets under management.

Emerging Trends:

Countries with budget deficits, such as Turkey, South-Africa and Senegal, are establishing sovereign wealth funds to better manage state owned assets in a government’s portfolio.

Investments made by private equity buyout funds have the following key characteristics:

  1. The fund’s participation in the target is anticipated to be a 4 to 6-year investment horizon in order to realize a profit for investors. This contrasts with corporate M&A where the buyer may well expect to own the target in perpetuity;
  2. Private equity funds seek out competent management teams to manage the company day-to-day under the guiding hand of the fund’s overarching growth strategy;
  3. This management team is incentivized by receiving equity in the target company, pro rata to a personal investment on the same terms that the fund invests on (“strip equity”) and/or via shares purchased at a low initial cost that have the potential for significant upside (“sweet equity”), allowing managers to directly benefit from any increase in the company’s value; and
  4. The target business is acquired via a mixture of the funds received from fund investors and debt finance, known as leveraged finance. On a successful investment, the leveraged finance will enhance returns for investors.

A “private equity fund” is an investment fund, often in the form of a limited partnership, that uses money invested by private investors to acquire shares in private companies, either directly or by delisting public securities (hence “Private Equity” or “PE”). There are also funds that lend debt but these are usually referred to as “credit funds”. Investors in the PE fund, for example sovereign wealth funds or pension funds, become limited partners (or “LPs”) in the PE fund. Via the PE fund, these investors deploy considerable capital in moderate-term investments (often referred to as “portfolio companies”) in expectation of significant returns from the pre-agreed fund investment strategy. 

The investments for the PE fund are sourced, implemented and managed by the general partner, or manager, of the fund. In practice, this is a group of individuals otherwise known as the “private equity deal executives” who are rewarded through a combination of bonuses, co-investment and carried interest for executing investments and, in particular, making successful returns. 

The investments are then sold for a capital gain with the profits divided between the LPs and the fund managers.