Structuring an ESG investment fund in Japan

Article 15 December 2021 Experience

At the time of its launch, Japan’s first ESG-focused venture capital fund MPower Partners Fund, established by former Goldman Sachs vice-chair Kathy Matsui and sized at US$150 million, garnered substantial attention within the funds industry.

The MPower Partners Fund is a rarity in Japan given its female leadership, as noted by Bloomberg and other media. In addition, while the venture investment market has expanded rapidly in Japan in recent years, it remains small in comparison to its counterparts in the US and China. The launch of the fund marks a significant milestone in the Japan’s investment fund industry.

Despite the relative newness of ESG funds in Japan, structuring an investment fund powered by an ESG strategy is similar to structuring any other type of investment fund. This article highlights practical insights and advice that fund managers can reference to when seeking to establish an ESG investment fund in Japan.

Thinking it through

In Japan’s investment fund industry, certain fund structures have become widely accepted within specific investor communities. Despite such familiarity, fund managers are still advised to assess how the considerations discussed below may apply to their proposed fund.

There is no guarantee that a fund structure that has worked in the past will work again in the future. Furthermore, given the constant changes in the laws regulating investment funds, it would be precarious to launch a fund without careful assessment of its risks and potential for reward.

The structure of an investment fund is one of, if not its most important feature. While it is easy to fall back on ‘tried and tested’ fund structures, we recommend that fund managers carefully consider the structure of the fund prior to its launch.

Considerations in structuring

When structuring any venture capital fund, taxation is one of most important considerations. The performance of a fund’s strategy is ultimately irrelevant unless both the investment of the fund assets and its distribution to investors are conducted in a tax-efficient manner. Multiple factors can potentially affect tax efficiency, including the nature and domicile of the target assets, the form of the investment fund itself, the administration of double tax treaties, and the jurisdiction of the fund investors.

In addition, it is equally important for fund managers to thoroughly understand any regulatory considerations which may be applicable to the operation of the fund, as each jurisdiction has its unique laws and regulations governing various aspects of its operations. The laws and regulations of each jurisdiction in which the fund will have nexus (e.g., where the investments are made, where the fund is being managed, where the fund interests are being offered, etc.) should be properly examined to ensure that the fund can operate in full compliance with applicable laws. Given the inherently cross-border nature of investment funds, various licenses, registrations, or notifications may be further required by the regulators.

Lastly, it is important to note that the attractiveness of a fund is not necessarily linked to taxation concerns and regulations. Even if an investment fund is created in a manner that is both tax efficient and in full compliance with applicable regulations, there is no guarantee that the fund will raise capital successfully. Investors in certain jurisdictions may have strong preferences for specific types of investment funds based on their structure and domicile. Therefore, some investors will only invest in structures that they have invested in the past.

The ESG component

While the process of structuring an ESG fund does not differ greatly from that of other venture capital funds, the portfolio company selection strategy plays a role of greater significance for ESG funds. ESG fund managers must strictly adhere to various self-imposed investment guidelines that restrict the industries they may invest in and the ways in which investments are to be made.
Due to the recent popularity of ESG strategies among allocators, some fund managers may seek to “greenwash” their fund by adding an isolated ESG component to their strategies. This practice has been made increasingly prevalent by the discrepancies in the interpretations of “ESG”.

However, “greenwashing” does not come without risks. Firstly, various regulators are taking steps to prevent this practice. For example, the US Securities and Exchange Commission released a “Risk Alert” in April following recent examinations of ESG investing and the discovery of problematic ESG investment practices.

Moreover, investors themselves are becoming more sophisticated in their understanding and monitoring of their investments into any ESG fund. We have observed that more and more key investors are documenting additional ESG investment restrictions and monitoring obligations in side letters with fund managers.

In light of recent trends, we anticipate that the popularity of “trueESG-themed investment funds will only continue to grow in the future. As the regulations covering ESG funds continue to evolve and investors gain more experience in such investments, we believe that ESG fund managers who are truly dedicated to championing societal and environmental causes will be able to enjoy further opportunities and success in this space.