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Partner, Head of Corporate and M&A Practice, Integrites ILF
Private Equity Financing: the Ukrainian Model
Global Trends in Private Equity Financing
Private equity (hereinafter — PE) investment is a type of financing when portfolio (non-strategic) investors, usually specialized private equity funds and so-called “family offices”, invest in the share capital of company shares which are not traded on stock exchanges. Therefore, a PE investor takes a higher risk in terms of proper information disclosure by the investee company and participation in its corporate governance but, at the same time, expects a higher yield on its investment, as compared with investments in the shares of publicly-traded companies. In some cases, PE financing may combine investments in share capital and providing debt financing.
According to a number of research reports, global PE financing in 2016 sees some decline, but it remained near record high levels both in Europe and the US. Even though each of those two large PE markets has its own specifics (e.g., in the US, micro financing or financing at very early stages of companies’ development, so-called “angel investments” or “seed investments”, are more popular), the outlook for both the amount of total capital invested and number of deals is positive for the next few years to come.
While the first PE investors emerged in Ukraine more than two decades ago, they were limited to a few professional investments companies and international financial institutions managing funds raised from Western-based private or institutional investors. The most popular industries for such PE funds were agriculture and food processing, financial services, retail, commercial real estate, production of household products. The second wave of PE financing on the Ukrainian market was inspired by the rapid growth of information and computer technologies in Ukraine, and the range of PE investors expanded by a number of investment funds which grew out as a separate line of business of large Ukraine-based business and financial groups. Currently, the main focus of PE funds has shifted to IT, e-commerce, cyber security, pharmaceuticals, export oriented agri-production and food processing.
Distinctive Features of PE Financing
A typical PE fund would have its internal investment policy guidelines. Investment policy guidelines determine, inter alia, maximum percentage of the fund which may be invested in one investee, minimum and maximum ticket size (limits on value of separate investments), preferred industries and regions for investment, target rates for return on investment, fund’s expected lifespan (which generally ranges between 7 to 10 years), and potential mechanisms for divestment (as most investors in PE fund do not see a return from their investment until they exit). There are a number of most common exit strategies for PE funds such as an IPO, sale to portfolio investors, merger with or acquisition by a strategic investor (a larger company active in a similar or complementary type of business), or liquidation. Quite often the preferred exit strategy would determine, to some extent, the desirable characteristics for investee companies.
PE funds may differ as to what stake they would be willing to acquire in one investee. Thus, some of the largest institutional PE funds present in Ukraine consider acquisition of minority stakes only, while others do not invest in companies where they cannot acquire a majority stake or obtain full operational control. Also, taking into consideration the great influence of regulatory procedures and requirements on some businesses (e.g., construction of residential or commercial real estate) or specifics of Ukrainian corporate governance, co-investments by a smaller local PE investor and its large international peer are becoming more and more popular in Ukraine.
Since PE funds rely on distribution of proceeds resulting from the exit from their investment rather than on regular dividend payment or interest payments (which is the case for debt financing), PE Funds make investments in companies with high growth potential with the aim of increasing the value of the company (and of their investment, accordingly). One of the ways to increase a company’s value can be to improve its business model, expand the product lines and clients base and enter new markets. Strengthening management capabilities, either through increasing qualification of existing operational management with the use of PE fund manager’s own know-how and human resources, involvement of external experts or combination of both, is another way to make an investee company more attractive in the eyes of potential future buyers. Also, ensuring that internal accounts and annual audited reports are prepared in full compliance with international standards is a must for large institutional investors or for companies being prepared for an IPO.
Conventional Structuring of PE Financing
In Western jurisdictions, PE funds are often structured as limited partnerships where the general partner (the PE fund manager) takes the responsibility for selecting investee companies for the fund and then taking part in the management of such investee companies, and limited partners (the passive investors) provide most of the financing for the PE fund. Largely due to possible unfavorable tax implications, limited partners in PE funds usually do not take an active role in the corporate governance or operation of business of investee companies. In most cases, all the entities and contractual arrangements may be set up in, and regulated by the law of the jurisdiction where an entity that will be managing the PE fund is established.
Ukrainian Model for PE Deals
Unfortunately, Ukraine has not yet developed a legal framework allowing the structuring of PE deals within the contour of the Ukrainian jurisdiction only in a way which would be comfortable for a PE investor willing to invest in Ukraine-based businesses. Therefore, most PE transactions are structured with the intensive use of foreign legal elements. A typical structure for an institutional PE fund investing in Ukraine-based business would look as follows: a Ukrainian operating company (established in the form of a limited liability company) is fully owned by, in most cases, a Cypriot special purpose vehicle (selection of the Cypriot jurisdictions is explained by the favorable terms of the tax treaty entered into between Ukraine and Cyprus), which, in turn, is owned by a limited partnership registered in one of the so-called “tax haven” jurisdictions — British Virgin Islands, Isle of Man, or Jersey. The use of a limited partnership (a tax transparent entity) in such structures means that profit distribution to the investors will not be affected by taxes levied at the level of the limited partnership. An agreement setting forth the investment policies of the PE fund, investors’ commitments to provide funding, terms for admission of additional limited partners, allocation of costs and distribution of profits, corporate governance rules, etc. is concluded between the general partner and initial limited partners at the level of limited partnership.
Structuring a PE fund in the conventional way requires a substantial amount of effort, time, human and financial resources from all parties involved, and may look too cumbersome for those Ukrainian investors and investee companies that just started their journey on the PE financing path. Local investments of smaller (“family-office type”) Ukraine-based PE funds are often structured through the use of nominal individual owners of Ukrainian operating companies, intensive use of low-taxed individual entrepreneurs as subcontractors in a company’s operational activities, dividing ownership over the main assets and IP rights among a group of formally unrelated legal entities or individuals, which makes such structures more vulnerable in terms of long-term sustainable operation and deter many Western institutional PE funds from investing in businesses structured in such a way. At the same time, converting the business operations of such a business into a more conventional model would with a high probability negatively affect the profitability of the business and may eat up all the company’s operating profitability, a critical factor to be taken into account by any PE fund when making an investment.
Regulatory and other Barriers on the Investors’ Pathway to Ukraine
In addition to corporate structuring issues, PE funds willing to invest in Ukrainian business may face a number of other regulatory and legal barriers which they rarely see in most other jurisdictions competing with Ukraine for financial resources. Extreme overregulation of currency exchange operations, harsh restrictions on repatriation of dividends to a non-resident parent company, the vulnerable legal status of shareholders’ and option agreements, absence of the contractual concepts of warranties and indemnities, the weak judicial system and low enforceability of court decisions and arbitral awards — all those factors present in Ukraine are accounted for by investors when planning their investment strategies and selecting countries for providing PE financing.
Actions Required from Ukrainian Legislators
Both local and foreign investors await a clear and unambiguous signal from the Ukrainian authorities that investors will be treated fairly, that corruption will be fought and eventually eliminated in most areas related to business activities,. Futhermore, that the judicial system will be reorganized in a manner that would allow to rely on it without the fear of being treated unfairly. It is an immediate task for the Ukrainian Parliament to eliminate those gaps and problems in the Ukrainian legal system, as well as it is within the main goal, and in the best interests of the entire legal and business community, to help legislators to bring the Ukrainian legal framework into conformity with the best international standards and practices.