Cross-Border Investment Considerations for Limited Partners

The key to unlocking the value of cross-border investments lies in a comprehensive approach that harmonizes legal diligence with commercial strategy, ensuring that investments are not only legally sound but also commercially viable.

The Legal Landscape of Cross-Border Investments

Before engaging in any cross-border investments, take note of the following: (may save you a pretty penny):

?? Tax Laws: Cross-border investments can trigger complex tax implications, including withholding taxes, double taxation, and the application of tax treaties. LPs must structure their investments to optimize tax efficiency while complying with the tax laws of both the home and host countries. GPs and LPs should leverage Double Taxation Agreements (DTAs) to their advantage, a legal tool that mitigates the tax burden and ensures more favorable tax treatment. Crafting a tax-efficient structure often involves setting up holding companies in jurisdictions that have beneficial DTAs with the investment destination country.

Things to Note: Engage in treaty shopping with caution, balancing tax efficiency with the substance requirements to avoid falling foul of Controlled Foreign Company (CFC) rules and Base Erosion and Profit Shifting (BEPS) actions.

?? Regulatory Compliance: Each jurisdiction has its own set of regulations governing foreign investments. These can include restrictions on foreign ownership, capital repatriation limits, and specific sector regulations. Navigating these rules requires thorough legal due diligence to ensure compliance and avoid potential penalties. The legal requirement to comply with both home and host country investment regulations presents a labyrinthine challenge. For instance, the Foreign Account Tax Compliance Act (FATCA) in the U.S. and the Common Reporting Standard (CRS) globally have far-reaching implications for disclosing financial accounts and investment entities.

Things to Note: Establish a robust compliance framework that includes thorough due diligence processes to screen investments for compliance with anti-money laundering (AML) standards, sanctions lists, and foreign investment rules.

?? International Investment Treaties: Investment treaties play a crucial role in providing a legal framework for cross-border investments. They can offer protections against expropriation, ensure fair and equitable treatment, and provide mechanisms for dispute resolution. Understanding these treaties can help investors navigate legal challenges and secure their investments against political and legal risks in foreign markets. Investors should actively seek out countries with bilateral investment treaties (BITs) with their home country.

Things to Note: Prioritize investments in jurisdictions covered by BITs, and incorporate treaty provisions into investment strategies to safeguard assets.

Market and Operational Risk: To mitigate market volatility and operational risks, investors should conduct thorough due diligence on the market conditions, legal environment, and operational capabilities of potential investment targets. This includes assessing political stability, regulatory changes, and the track record of local partners.

Things to Note: Utilize local market experts for due diligence, establish flexible exit strategies in investment agreements, and consider insurance products designed for political and operational risks in foreign markets.

Structuring Cross-Border Investments

Effectively structuring cross-border investments is pivotal to maximizing their potential while minimizing risks. Key structuring considerations include:

?? Holding Companies and Special Purpose Vehicles (SPVs): Utilizing holding companies or SPVs in jurisdictions with favorable tax regimes or investment protection treaties can provide tax efficiencies and enhance legal protections. Utilizing SPVs for cross-border investments allows for risk segregation, operational flexibility, and tax planning. However, the legal structure chosen (corporation, partnership, trust) impacts liability, taxation, and governance.

Things to Note: When establishing SPVs, ensure legal compliance with the economic substance regulations in the chosen jurisdiction to avoid legal challenges or reputational damage.

?? Legal Entity Selection: Choosing the right legal entity for cross-border investments is pivotal. Each entity type, from corporations to partnerships, has distinct legal implications for taxation, liability, and regulatory compliance. The choice affects how investments are structured, how profits are repatriated, and the level of control investors have over their investments.

Things to Note: Evaluate the legal and tax environment of potential jurisdictions for holding companies, focusing on those with strong investor protection laws and beneficial tax agreements with other key investment countries.

?? Contractual Protections: In cross-border investments, the devil is in the detail. Key clauses such as dispute resolution clauses, choice of law, choice of forum (whether exclusive or not), and exit strategies must be included. Additionally, implementing Most Favored Nation (MFN) clauses in agreements can ensure LPs receive the best possible terms in future negotiations.

Things to Note: Draft arbitration clauses with specificity, choosing the arbitral institution and seat of arbitration carefully to ensure proceedings are governed by favorable and neutral legal frameworks.

Risk Management in Cross-Border Investments

Risk management is a critical component of cross-border investment strategies, encompassing:

?? Political and Legal Risk: Strategies to mitigate these risks include comprehensive due diligence, political risk insurance, and leveraging international treaties for protection and dispute resolution. Political risk insurance can be a lifesaver in jurisdictions with unstable political environments. These policies cover expropriation, currency inconvertibility, and political violence.

Things to Note: Negotiate for broad coverage and ensure that the insurance provider has a strong track record of claims settlement in the host country.

?? Currency and Economic Risk: Hedging strategies, such as forward contracts and options, can protect against currency volatility, while thorough market analysis can inform decisions about economic stability. Currency risks can erode investment values quickly. Legal contracts can incorporate hedging agreements directly or ensure that investments are structured to naturally hedge currency exposure.

Things to Note: Use forward contracts or options to manage currency risk, and consider structuring investments in a currency that is stable or appreciates against the investor’s home currency.

?? Market and Operational Risk: Understanding local market dynamics and operational practices through in-depth research and local partnerships can reduce the likelihood of unforeseen challenges. Market volatility and operational challenges in foreign jurisdictions can significantly impact cross-border investments. Legal strategies to mitigate these risks include comprehensive market research, thorough due diligence on partners (track record of such partners) and investment targets, and structuring agreements to include clauses for dispute resolution, exit strategies, and compliance with local laws.

Things to Note: Utilize local market research, establish robust due diligence processes for assessing partners and investment targets, and include exit clauses in contracts to navigate unforeseen challenges effectively.

Use Cases

Emerging Market Renewable Energy Investment:

An LP’s significant infrastructure investment in an emerging market faced regulatory overhaul post-election. Through strategic use of BITs and direct negotiations, the LP secured grandfathering provisions that protected the investment from adverse regulatory changes.

Technology Startup Investment in a Volatile Currency Market:

In investing in a high-tech startup, an LP faced challenges due to stringent foreign ownership laws. The solution involved creating a multi-layered SPV structure that complied with local laws while protecting the LP’s interests, demonstrating the power of creative legal structuring in overcoming regulatory barriers.

Recognizing what needs to be done

Cross-border investments represent a significant opportunity for LPs to diversify and grow their portfolios. However, the success of these investments hinges on the effective integration of legal strategies with commercial objectives.

By navigating the legal complexities of international markets, structuring investments strategically, and employing robust risk management practices, GPs and LPs can overcome the challenges of cross-border investing.

For GPs and LPs, partnering with experts who possess deep domain knowledge and an understanding of the commercial implications of any decision is not just beneficial—it’s imperative for success in the global investment landscape.

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Saravanan Rathakrishnan is a lawyer who specializes in investments funds, family offices, and mergers & acquisitions. He is the author of several journal articles focusing on the law, geopolitics, and finance/economics.