CRC Energy Efficiency Scheme: BVCA's guidance for private equity firms

Practical Law UK Legal Update 2-502-3279 (Approx. 6 pages)

CRC Energy Efficiency Scheme: BVCA's guidance for private equity firms

by PLC Environment

Terms used in this note

Terms which appear in capital letters in this note are defined in Practice note, CRC Energy Efficiency Scheme: PLC glossary and abbreviations.

References in this note to the "CRC Order" are to the CRC Energy Efficiency Scheme Order 2010 (SI 2010/768).

Are private equity funds required to register for the CRC?

The CRC Energy Efficiency Scheme (CRC) requires Undertakings that are part of a Group and which meet the Qualification Criteria to register for, and participate in, the CRC as a Group. Groups are defined in the CRC Order by reference to the definitions of Parent Undertaking and Subsidiary Undertaking in the Companies Act 2006 (the 2006 Act). For more information, see Practice note, CRC Energy Efficiency Scheme: impact on corporate structures: Groups of Undertakings.

The use by the CRC of the 2006 Act definitions for establishing the existence of a Group for CRC purposes has presented particular difficulties for the private equity industry. Practitioners and industry participants have expressed concern over the extent to which the rules might require a private equity fund (a Fund), the managing entities of such a Fund and a Fund’s portfolio companies to be classified as a single Group under the CRC Order, which would then have to register for the CRC.

In its June 2009 submission to the Department of Energy and Climate Change (DECC) on the original draft of the CRC Order, the British Private Equity and Venture Capital Association (BVCA) argued that the CRC would unfairly treat those companies backed by a Fund as forming a single Group, despite there being no commercial link between them other than having a common shareholder (that is, the Fund). In spite of the Environment Agency's (EA's) concession permitting disaggregation of Significant Group Undertakings (SGUs) (for more information, see Disaggregation of investee companies that are SGUs, below), the industry’s concerns were not reflected in the final CRC Order, with the EA indicating that it expects firms to take an inclusive approach to CRC grouping. As a result, the private equity industry is now obliged to consider the extent to which it must register its Funds as Participants in the CRC.

The position seems relatively clear in respect of limited partnership Funds which take controlling interests in portfolio companies. A limited partnership Fund which holds (including through a nominee) a majority of voting rights in a portfolio company will usually be treated as the Parent Undertaking of that company. Where a Fund holds a majority of voting rights in a number of unconnected portfolio companies, all those companies, together with the Fund, are to be treated as one Group under the CRC and required to register as such. For a more detailed analysis, see PLC Corporate, Practice note, CRC Energy Efficiency Scheme: the impact on private equity fund structures.

However, the position has not been so clear in relation to other entities within a Fund structure. In particular:

Will a general partner (GP) of a Fund (and other entities within the management structure of the Fund) be treated as the Parent Undertaking of that Fund?
How are Funds to be treated where they comprise parallel partnerships, under common management, where no single partnership is the Parent Undertaking of any portfolio company?

The BVCA guidance

In May 2010, the BVCA issued a bulletin entitled "Registering for the CRC Energy Efficiency Scheme: General Guidance for Private Equity Firms" (the Guidance) to its members on the practical implications of the CRC for Funds. Amongst other things, the Guidance sets out the key steps that private equity firms should take ahead of the forthcoming deadline for registration to participate in the Introductory Phase of the CRC (which began on 1 April 2010). Also included is a discussion of the two key issues outlined above, following the advice of David Chivers QC. This legal update, approved by the BVCA, summarises the content of that Guidance.

Summary of the BVCA guidance

In the Guidance (which has not been endorsed by the EA), the BVCA notes that it aims to provide guidance to firms on the general legal principles that apply when assessing whether entities within a Fund structure are grouped for CRC registration purposes. The Guidance also states that as the analysis is both legally complex and highly fact-specific, the position of individual private equity firms will vary, so the Guidance should not be viewed as a substitute for obtaining specific legal advice. No responsibility is taken by BVCA for decisions made by individual firms as to whether and/or how they are required to participate in and/or comply with the CRC. Further, the Guidance notes that private equity firms may find it appropriate to consult with their auditors and the auditors of each fund.

The Guidance notes that the EA has indicated its preferred approach is for private equity firms to treat all entities in a private equity fund structure as forming a single Group (subject to the rules on disaggregation). As a result, the Guidance says that private equity firms that reach the conclusion that their organisation comprises a number of separate Groups, rather than a single Group, for CRC purposes, need to ensure that their analysis is documented and retained (as part of the Evidence Pack) as it is likely to be needed in the case of an audit by the Administrator.

Is the general partner a Parent Undertaking of the limited partnership Fund?

The Guidance notes that two key issues to consider when trying to answer this question are:

Whether the GP is entrenched (that is, it cannot be removed by the limited partners using the "no fault divorce" clauses that often exist in limited partnership agreements).
Whether the GP actually exercises a dominant influence over the limited partnership.

The Guidance says that where a GP is entrenched, the deeming provisions of Schedule 7 of the 2006 Act apply so that the GP should be considered to be the Parent Undertaking of the limited partnership. Where the GP cannot be removed, these provisions will not apply.

While not expressly addressed in the Guidance, PLC considers that a GP may be treated as the Parent Undertaking of a Fund on that basis that it is a "member" of the Fund and has the right to appoint or remove a majority of the Fund’s "board of directors", being one of the tests for establishing a Parent/Subsidiary Undertaking relationship (section 1162(2)(b), 2006 Act). For more detail on the basis for this view, see PLC Corporate, Practice note, CRC Energy Efficiency Scheme: the impact on private equity fund structures: Is the Fund a Subsidiary Undertaking?.

The Guidance notes that "no fault divorce" clauses, which might operate to break the Parent/ Subsidiary Undertaking relationship between a GP and a Fund, can often be exercisable only after an initial "entrenched" period. As such, it will be important to determine whether any "no fault divorce" clause is exercisable on the Qualification Day of the relevant Phase (which is when the fact that a Group exists, or that an Undertaking is part of a Group, is to be determined for each Phase). The Qualification Day for the Introductory Phase is 31 December 2008. For more information about the various milestones in each Phase see, CRC Energy Efficiency Scheme: PLC timeline.

Where a GP actually exercises dominant influence over a Fund, it will be the Parent Undertaking of that Fund. The Guidance notes that this requires a "fact-sensitive analysis that turns primarily on the extent to which the GP determines the operating and financial policies of the limited partnership". The Guidance also explains that if the GP's discretion is constrained by the limited partnership agreement (for example, by prescribing the geographic areas or industry sectors the fund can invest in) and the GP cannot make changes to the investment policy of the fund without the limited partners' agreement, then the GP will not normally be regarded as exercising a dominant influence and will not, therefore, be the Parent Undertaking of the limited partnership fund.

Multiple fund structures

The Guidance says that where a private equity firm sponsors a number of different Funds managed by a common GP, it will need to analyse whether the GP of each Fund is the Parent Undertaking of the relevant Fund and also whether the firm is the overall Parent Undertaking of the entire structure under the CRC.

The Guidance notes that on the Qualification Day of the relevant Phase, the various Funds may have different entrenchment provisions (that is, some newer Funds may still be in an entrenchment period where the "no fault divorce" clause cannot be exercised, whilst other earlier Funds may now have active "no fault divorce" clauses that can be exercised), so that the Funds may be grouped differently for the purposes of the CRC. The Guidance goes on to explain that there may, therefore, be a number of Groups for the purposes of the CRC within the structure of a private equity firm; Funds in the initial entrenched period will probably be grouped with the private equity firm and the GP of those funds. Funds that have active "no fault divorce" clauses may form separate Groups for the purposes of the CRC.

Parallel fund structures

The Guidance also considers how the CRC might apply to a Fund which comprises a number of separate, or parallel, limited partnerships. In such a structure, the parallel partnerships may invest alongside each other. Where no single partnership satisfies the 2006 Act tests for establishing a Parent/Subsidiary Undertaking relationship, might the interests of all the partnerships be aggregated for the purposes of the CRC, as all forming part of the same Fund?

The Guidance notes that this is a complicated area in which the legal position is not clear. The Guidance considers that the answer will turn on whether the parallel partnerships are managed on a unified basis (section 1162(4)(b), 2006 Act). To that end, the Guidance sets out a number of factors to take into account in reaching a decision. However, the BVCA’s view is that the most conservative course would be to aggregate the interests of each parallel partnership within a Fund. If those aggregated interests would satisfy any of the 2006 Act tests under section 1162, that Fund would be a Parent Undertaking.

For a discussion of the potential difficulties presented by he interpretation of section 1162(4)(b) as regards parallel partnerships, as well as a diagram illustrating a typical structure for such a Fund, see PLC Corporate, Practice note, CRC Energy Efficiency Scheme: the impact on private equity fund structures: Parallel partnerships.

Disaggregation of investee companies that are SGUs

Where a Fund determines that it will be required to participate in the CRC, it may be possible to disaggregate certain investee companies (or groups of companies) that themselves meet the Qualification Criteria in order to minimise the impact of the CRC on the Fund.

The investee companies that meet the Qualification Criteria independently of the rest of the Fund's Group are known as Significant Group Undertakings (SGUs). However, Funds should note that they cannot disaggregate all SGUs, such that the remainder of the private equity fund's Group falls below the Qualifying Amount (6,000 MWh).

For more information about disaggregating investee companies, see PLC Corporate, Practice note, CRC Energy Efficiency Scheme: how to apply the Qualification Criteria to private equity funds: Significant Group Undertakings.

Funds that decide to disaggregate any investee companies (or groups of companies) that are SGUs should be aware that the deadline for registration for the Introductory Phase for Groups that wish to disaggregate SGUs is 30 June 2010 rather than 30 September 2010. For more information on disaggregation, see Practice note, CRC Energy Efficiency Scheme: overview: Companies and other types of Undertakings.

Further information

For more information on:

The impact of the CRC on private equity funds, see:
The penalties for failing to register for the CRC, see Practice note, CRC Energy Efficiency Scheme: enforcement and penalties.
An overview of the CRC, see Practice note, CRC Energy Efficiency Scheme: overview.
The CRC in general, see the CRC Survival Kit.

CRC Energy Efficiency Scheme: BVCA's guidance for private equity firms | Practical Law