Limited Partnerships in Sweden & Abroad
For the past few days, I’ve been ruminating on forming something similar to the classical private equity entity structure, using (preferably) Swedish corporate structures, however, still being open to the idea of using offshore entities if required. All of this comes from a simple problem: I handle the investments of my family members (in stocks, bonds, other notes), currently divided up by a login for each family member — which I found a bit tedious, and thus, I started crawling down the 72hour rabbit hole I’ll now spend some time unearthing.
A typical simple private equity structure looks like the following:
Limited Partners: Commit capital (the investors) and have limited liability — meaning they cannot lose more than their invested capital, i.e., debtors won’t chase them in the event of bankruptcy or related catastrophic events. In my case, these would be my family members.
General Partner: Manages the funds in the limited partnership. Moreover, has unlimited liability for the partnership’s obligations — meaning creditors will hunt you to the ends of the earth to get the money owed (this would be my role). Anyways, wealthy fund managers control their risk appetite, and usually, another Limited Liability entity (LLC, C-corp, another LP) is used as the general partner, so as to act as a shield of the liability from the natural person’s perspective.
Limited Partnership: Legal entity that holds investments made at the discretion of the general partner.
Firstly, if I had simply been born in the U.S./UK where English law is in effect, this article would not exist, since I would’ve simply formed a partnership á la Buffett Partnership, Ltd. However, being born & having my family members being Swedish it’s not that simple.
It turns out we do have a Limited Partnership structure in Sweden, called ”Kommanditbolag.” However, was I to use this structure, and my family members invest as Limited Partners as natural persons, i.e., not through a personal holding company, all income from the partnership would be taxed as active income on their individual tax returns. In essence, this means they would pay social security + earned income tax, which is outrageous seeing as they are simply putting up capital and being completely passive in all regards. Therefore, this structure was out of the question (thanks to the Swedish IRS).
Offshore Limited Partnerships
Following this setback, I started investigating using partnership entities registered in other countries. As it turns out, were I to form the Limited Partnership in countries such as Jersey and Guernsey (places I have been brought up / socially conditioned to view as tax havens), the income would be subject to capital gains tax instead of active income tax (if Swedish, see this IRS page). This stipulation also named and therefore included partnerships formed in Great Britain, a nation within which I felt more comfortable with the idea of forming entities. I did also find some public filings on EQT Fund VII (NO.1) on a UK government website, showing its feasibility, seeing as EQT is one of the most well-known Swedish private equity firms.
Registering in another country is always tedious, exposing me to IRS scrutiny with regards to where the business is actually conducted, requires “boots on the ground” for mail correspondence with the government, and more. Therefore, I continued down the rabbit hole to see how other Swedish PE firms organized their funds and decided to investigate Altor specifically, a firm I have visited physically twice within the past few years.
Ownership debentures (Swe. “Kapitalandelslån”)
Investigating the balance sheet of the entities formed by Altor for their funds (the entities were simply limited liability companies, Swedish C-corporation equivalents since we sadly do not have LLCs), I found something interesting: most of their balance sheet comprised of ownership debentures. Realizing this was the instrument used to get and pay out the profits of the fund, I investigated what the note actually entailed. Apparently, they were banned until 2006 (after which they were re-introduced) and actually maintain a history back to the Kreuger crisis (his debt was mostly in the form of ownership debentures). Anyways, as far as I understand it, these debentures — in contrast to normal bonds — have their payouts tied to the performance of the underlying entity (the fund).
And thus, we enter into some legal gray zone — they are incredibly similar to actually owning shares in the company but without the rights of a shareholder, i.e., voting rights, etc. Seeing as there are laws in Sweden governing the structure of share classes, specifically where no class is allowed to have voting power greater than 10 times any other class, this eliminates the possibility of “vote-less” shares, something I believe Altor tries to accomplish with these debentures instead. Furthermore, without investigating it further, there seem to be tax benefits for foreign owners to hold debentures instead of shares, avoiding Swedish withholding tax — which could be another reason for Altor’s decision to use said instrument, seeing as they typically take in capital from foreign investors.
However, I came across some excellent writing where ownership debentures were mentioned, with preferred shares also being viewed as a vehicle through which the investors’ capital can be contributed to the fund. Furthermore, I came across another website (which I cannot find right now), stating that the preferred way of taking capital from domestic investors was through preferred shares, with debentures only being used for foreign ones. Giving the preferred shares 1/10th the voting power of ordinary shares, with special rules with regard to the payout structure, seems to be the best fit for my “mini-partnership.” This will also be beneficial when I decide to start personal holding companies for my family members, as their dividends from the fund would then be tax-exempt following the rules of owning non-publicly traded companies (swe. “Näringsbetingade andelar”).
With this voting structure, for me as a fund manager to maintain 50% of the voting power, for every $1.00 contributed by a “limited partner”, I would need to contribute 10 cents. Seeing as I will contribute around 40–50% of the AUM, that will not be a problem.
Buffett’s 0/6/25 w/ high watermark
During Buffett’s early years, after consolidating the partnerships, he decided on a compensation structure usually referred to as the 0/6/25, referring to the 0% management fee (no guaranteed payout), 6% hurdle rate (meaning the first 6% of gains go to the limited partners only) and 25% performance fee (on gains above 6%). This was also paired with a “high watermark clause”, essentially stopping Buffett from double counting gains and further disincentivizing poor performance. Seeing as this is the structure I would like to use if I ever decide to take in outside capital in the form of partnerships, I find it adequate to learn the legal jargon required to implement it in practice.
Honestly, seeing as I would trust my family with all my capital, the easiest structure would just be forming a C-corp with one class of shares, not bothering with any fee structure, and simply investing that way. However, traversing this path of knowledge has taught me way more about private equity and corporate structuring than I thought it would, and establishing the “fund” using an official legal structure will serve as a track-record establisher and some sort of proof that I “know what I’m doing” — even though I obviously do not — if ever any other investors would entrust me with their hard-earned funds.
I am off to reread the Buffett Partnership letters (again), and possibly even start tackling his Berkshire Hathaway letters too.
March 23rd, 2023