Sovereign wealth and public pensions (SWP) funds are reaching new levels of success: increasing deal activity, larger ticket sizes, and portfolio diversification. Larger, more diverse portfolios present new challenges and require new capabilities, especially where tax is concerned.
This article will detail the current trends among SWP funds, the tax issues they face today, and how to prepare for the issues they will likely face in the coming years.
The pandemic opened strategic opportunities
Deal activity briefly paused for many investors as the pandemic began to roil markets in March 2020. However, within a few months, deal activity quickly rebounded. Investors had significant capital to deploy, and depressed fair market values across many private markets prompted a move by some to engage in opportunistic buying.
A rapid recovery in the public equities markets provided an uplift in assets under management (AUMs), leading to additional opportunities to rebalance portfolios toward alternative investments. Many investors enjoyed great success in 2020 and did even better throughout 2021.
As investor capital recognised the value of the largest asset managers’ track records amid uncertainty, many large asset managers became even larger in this period. This movement may also be credited to existing relationships these asset managers had with institutional investors.
Smaller asset managers appeared to have more difficulty raising capital during the pandemic, perhaps because diligence and relationship building was challenging without in-person meetings. The increased allocations to the largest managers created more opportunities for institutional investors to strategically co-invest in opportunities with these managers.
KPMG observed some increased tax efficiencies as many clients were deploying capital to managers with whom they already had relationships. This reduced some of the tax negotiation typically required of new manager relationships – for example, with respect to structural tax matters specific to certain investors. In turn, ‘sponsor/investor’ tensions that conflict with commercial or legal drivers were also reduced. We expect this trend to continue.
Accelerated shift to alternative investments
In recent decades, SWP funds have steadily increased their investments beyond public equities and bonds to alternative investments including those allocations to real estate, infrastructure, private equity, private credit and venture capital. In addition, 2020 and 2021 saw large investments in digital infrastructure, healthcare, education, renewables and investments related to environmental, social, and governance (ESG) concerns. These trends were likely driven in part by the pandemic, but also due to a shift in consumer sentiments, a continued drive toward innovation, and stakeholder demands.
Venture capital (VC) also witnessed tremendous interest from SWP fund investors. While remaining small as a percentage of total AUM, allocations have consistently grown as investors seek VC returns. We are observing a steady increase in the number of direct deals, as investors develop their in-house capabilities to source and execute on their own deals outside of traditional GP-LP structures.
The US remains the biggest recipient of venture capital investment, but institutional investors are also ramping up their investments in Asia; specifically in Indian- and Chinese-based companies. This appears to be driven by opportunities for diversification from the US market as well as increasing transparency and sophistication in the non-US VC markets, and the tremendous business prospects for venture companies directly serving the vast opportunities presented by these emerging markets.
With the continued pivot to alternatives, we are seeing an increased demand for assistance with tax due diligence, structuring and tax compliance. In addition, the establishment of continuation funds, increased demand for direct lending funds, direct investments into VC companies, and shareholder assignments to portfolio investments will all contribute to growing tax complexities for SWP fund investors.
Changing portfolios drive changing operating models
As SWP funds diversify their portfolios, they are also building their in-house investment departments to handle more than the traditional selection and evaluation of third-party asset managers. Teams are increasingly focused on co-invest opportunities and, in some circumstances, they are sourcing direct deals, playing lead roles and identifying co-investors. Commercially, these opportunities offer better returns through reduced fees and carried interest.
From a tax perspective, institutional investors are playing a greater role in designing and potentially benefitting from bespoke cross-border tax structures. However, these structures present certain additional complexities normally handled by the sponsor, such as increased demands for due diligence and operational tax matters.
The increasing attention on tax from multiple angles is motivating many SWP funds to proactively manage tax issues, and driving the development of sophisticated in-house tax departments, including middle office and investment support. Through the strategic hiring of tax professionals with broad tax backgrounds, these departments are being equipped with tools to more effectively manage institutional tax risks, and communicate the tax issues to stakeholders, governments, and the public.
We think that tax expertise, whether in-house or external, will be critical to effectively manage these portfolios.
BEPS 2.0 uncertainties complicate structuring and planning
The OECD project to harmonise international tax rules is well underway. Under the project, known as BEPS 2.0, more than 135 countries have agreed on a final set of model rules for preventing base erosion and profit shifting.
The two-pillar solution outlines a new approach to the allocation of taxing rights (pillar one) and establishes a global minimum tax of 15% (pillar two). The rules are complex and require that countries implement domestic legislation. As the focus shifts toward domestic implementation, the tax teams of SWP funds face the challenge of assessing the impact of these developments on their investment portfolios.
In particular, the global minimum tax rules under pillar two could significantly impact institutional investors. The rules, guidance and commentary published by the OECD attempts to underscore that the rules are not intended to apply to sovereign wealth funds, foreign governments, or other government investors meeting the definition of an ‘excluded entity’.
However, questions remain as to whether the rules and definitions will cover all scenarios and investment structures, or if the evolving investment landscape creates traps for the unwary outside of the most basic investment structures, leading to taxation where it otherwise would not have been due.
Amid this uncertainty, many SWP funds are conducting detailed pillar two assessments. Evaluating existing structures and investments in light of the model rules and commentary allows institutional investors to identify areas of potential risk and begin scenario planning, a trend we expect to continue.
Reputational risk becomes more acute
ESG initiatives and intra-governmental moves toward tax transparency continue to gain momentum. Managing adverse tax publicity is becoming one of the more challenging risks facing SWP funds, since they are typically considered governmental investors and collectively invest hundreds of billions of dollars each year. With such active portfolios, the chances are not insubstantial that an investment or structure could attract adverse tax publicity, whether warranted or not.
Further, as these investors often deploy ‘patient’ capital, many have longstanding structures in infrastructure, real estate or private equity that may warrant review as the tax structuring landscape may have changed since implementation.
The investors that KPMG firms work with are mindful of the tax reputational risks at three levels:
1. Investor
Is the investor directly involved in aggressive structuring, insufficient tax compliance, or poor tax governance? What expectations do the shareholders have about tax? The answers to these questions will help determine investor sensitivities to adverse tax publicity and help form the right approach to managing risks.
2. Third-party asset manager
Third-party asset managers’ activities can be attributed to the investor, and the manager should be mindful of the investor’s tax and legal structure, and its sensitivities. Often, the contractual investment management documentation will govern many of the tax aspects, but investors have also been asking managers to provide further assurances through investor tax statements, which typically outline the tax principles that the manager intends to abide by.
3. Portfolio or investee companies
Tax risk can reside within a portfolio or investee company. Where that company is engaged in irresponsible tax practices, high-profile investors can be associated with such acts, even when they did not have direct governance. The risk increases where the investor does have direct governance, through board seats or other controls. Investors can take actions to manage this risk by monitoring their portfolios closely and seeking to influence investee company tax policy with public statements of tax expectations. Investors may seek to exit investments when they perceive undue levels of adverse tax publicity.
Some large SWP funds have been proactive in managing these risks. Danish institutional investors have published a common set of principles embedded in a ‘tax code of conduct’, encouraging responsible tax policy by their managers and engaging in spot checks to audit the managers’ adherence to the code.
Meanwhile, Norway’s wealth fund, Norges Bank Investment Management (NBIM), has divested of investments in hundreds of companies based on ESG screening, including for tax, believing that responsible tax behaviours are important to societies. NBIM also divests from companies with weak tax governance and publishes its tax policy and expectations of its investee companies.
KPMG firms are seeing clients use technology to help manage tax risk at many levels. Data analytics are already a common element of tax due diligence work for many investors. We have tools that analyse public information to help determine whether a target or portfolio of companies are associated with adverse tax publicity and that provide ongoing monitoring of an existing portfolio. We expect the demand for ESG-related risk monitoring to continue to trend upwards as reporting standards become the norm and are increasingly required.
Final thoughts
Tax issues will continue to command greater attention as tax transparency measures create risks and international rules squeeze historical approaches. SWP funds may need a more sophisticated approach to tax as growing assets under management and portfolios continue to become more complex and diversified.
Institutions that recognise and prepare for the increasing pressures on tax departments are best placed to handle the ever-changing tax landscape.
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