negotiating private equity fund terms: key provisions for...

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Negotiating Private Equity Fund Terms:

Key Provisions for Sponsors and Investors Termination Rights, Standard of Care, Carried Interest and

Management Fees, Conflicts, and Co-Investment Terms

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

WEDNESDAY, FEBRUARY 7, 2018

Alex Gelinas, Partner, Sadis & Goldberg, New York

Steven Huttler, Partner, Sadis & Goldberg, New York

Daniel G. Viola, Partner, Sadis & Goldberg, New York

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Negotiating Private Equity Fund Terms:

Key Provisions for Sponsors and

Investors

February 7, 2018

Steven Huttler, Partner Sadis & Goldberg LLP

Steven Huttler is a partner in the firm’s Financial Services and Corporate Groups. Mr. Huttler has extensive experience in corporate, finance, investment fund and securities matters, including the representation of U.S. and foreign investment funds, underwriters, and private clients in various registered public and private offerings of debt and equity securities totaling in excess of $10 billion.

As part of his investment fund practice, Mr. Huttler has served as corporate counsel to many private investment funds and partnerships based in or domiciled in the United States and in international and offshore jurisdictions such as the Cayman Islands, Bermuda, the British Virgin Islands, Ireland, Luxembourg, Isle of Man, Jersey, Guernsey, Cyprus, Mauritius, United Kingdom, Austria, Russia, India and Gibraltar. Mr. Huttler's legal practice has exposed him to diverse fund clients with an exceptionally wide range of investment programs and structures, including large mutual funds and hedge fund complexes, private equity firms, real estate partnerships and funds, venture capital funds and funds focused on specialty finance assets. He has also counseled small start-up hedge funds and financial industry entrepreneurs. His practice has included structuring and establishing start-up funds and managed accounts, and structuring investment funds to benefit from U.S. double taxation treaties. He has advised management companies and fund managers on compensation structures, restructured and reorganized funds, structured, negotiated and documented fund trades, negotiated seed, joint venture and start up agreements, and advised on a range of sophisticated transactions. He has also represented financial services providers, such as brokerage firms (including proprietary trading broker-dealers), fund administration firms and third party marketing firms in structuring their operations, reorganizations to achieve tax benefits, advising on disputes with clients, and in the development of forms for their pension, investment, trading, administration and other services to investment funds, equity, debt and option traders and other clients.

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Alex Gelinas, Partner Sadis & Goldberg LLP

Alex Gelinas is a partner in the firm’s Tax Group. Mr. Gelinas focuses his practice on providing tax advice to investment managers of hedge funds, private equity funds and other investment funds on all aspects of their businesses, including management entity and fund formation, partnership taxation issues, compensation arrangements and ongoing investment activities and transactions. Mr. Gelinas also provides tax advice to U.S. pension funds, sovereign wealth funds and other U.S. and foreign institutional investors in connection with their investments in private equity funds, hedge funds and U.S. joint ventures. He also has extensive experience in providing tax planning advice to high-net-worth individuals and families.

7

Daniel G. Viola, Partner Sadis & Goldberg LLP

Daniel G. Viola, Head of the Regulatory and Compliance

Group of Sadis & Goldberg LLP, has a diverse practice,

representing investment advisers, funds and broker-dealers. Mr.

Viola structures and organizes broker-dealers, investment

advisers, funds and regularly counsels investment professionals in

connection with regulatory and corporate matters. Mr. Viola

served as a Senior Compliance Examiner for the Northeast

Regional Office of the SEC, where he worked from 1992 through

1996. During his tenure at the SEC, Mr. Viola worked on several

compliance inspection projects and enforcement actions involving

examinations of registered investment advisers, ensuring

compliance with federal and state securities laws. Mr. Viola’s

examination experience includes financial statement, performance

advertising, and disclosure document reviews, as well as, analysis

of investment adviser and hedge fund issues arising under ERISA

and blue-sky laws.

8

Overview of Presentation

I. General Partner Removal: “No Fault” vs. “For Cause”

II. Indemnities/General Partner Standard of Care

III. Carried Interest and Management Fees

IV. Conflict and Transaction Fees; Other Regulatory Concerns

V. Co-investments/Capacity Rights

VI. Tax and ERISA

9

General Partner Removal: Various Termination Rights

a. “For cause” vs “no-fault” divorce provisions

b. General issue: percentage of Limited Partners (“LP”) required to remove the General Partner (“GP”)

i. Majority vs supermajority

ii. “For cause” vs. “no-fault”

c. Standard formulation for removal: fraud, gross negligence, willful misconduct, material breach of LPA, criminal misconduct, moral turpitude

i. Historical trend: require a final ruling non-applicable by a court of competent jurisdiction

ii. Takes too long

iii. LP push for no final ruling

iv. Pressure to lower the LP vote required to implement the provision

10

General Partner Removal: Various Termination Rights (cont.)

d. Different Formulations of termination “without cause”

i. No-fault dissolution right, ability to terminate the investment period

ii. Appointment of third-party liquidator

e. Overall Trend:

i. Successful institutional pressure

ii. Lower thresholds, lower votes, less final rulings

f. Reverse Trend:

i. Limited deal flow

ii. Management can demand stronger terms

11

Indemnities/General Partner Standard of Care

a. Classic/historic formulation: indemnification of GP and its partners, members,

officers, affiliates, agents (including legal counsel and other service providers) for all actions or inactions relating to the fund’s activities unless indemnified party has engaged in fraud, gross negligence, willful misconduct, material breach of the agreement, material violation of securities laws

i. Final ruling?

ii. Trend – reject that formulation

iii. LPs try to limit use of “materiality”

b. Trend: carefully limit categories of acceptable scenario. Institutional LPs requesting exceptions for legal costs relating to: (i) regulatory investigations of GP/IM; (ii) disputes between principals; for exclusions from indemnification and (iii) defending allegations of breach of side letters

c. Express provisions setting forth GP’s standard of care

i. No fiduciary obligation = red flag to LPs

12

Carried Interest and Management Fees: Importance and Definitions

• Trend: still draws the most attention

• “Counter-trend”: Except that access to deal flow sometimes dramatically changes the balance of negotiating power

• Overall trend: continue to face pressure from investors for customized structure as well as transparency

• Important Definitions/Alternatives: (timing of performance payments)

• American Carry

• GP/Manager recovers carry on an investment by investment basis (cumulative lookback)

• Distribution is made regardless of fear that losses could be incurred on subsequent investments

• Typically involves a ”clawback” (i.e., “tie-up”)

• European Carry

• GP does not receive carry until LPs receive a return of all capital contributions (on both realized and unrealized investments) plus the total preferred return on aggregate capital contributions

13

Carried Interest and Management Fees: Pressure Points

Trends:

i. Pressure to convert deal-by-deal waterfalls to “European style” waterfalls

ii. Alternatives to European Style waterfall: interim clawbacks, escrowing all or some portion of carried interest otherwise distributable to the GP during the investment period, agreeing to not receive carried interest unless the fund has over performed by some specified percentage

iii. LPs have been asking for limitations/reductions in management fees following the expiration of the fund’s term

iv. According to the 2015 Preqin Private Equity Fund Terms Advisor, a survey found that 48% of managers charge a 20% carry rate for separate accounts compared to 85% of managers running comingled funds

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Carried Interest and Management Fees: Pressure Points (cont.)

v. According to the 2015 Preqin survey, 48% of managers charge no carried interest on co-investments

• Core Investments are so important that other negotiation terms turn on availability

vi. According to the same Preqin survey, separate accounts: average management fee of 1%; mean of 1.15%, but 42% of managers will reduce or remove fees after initial investment phase

vii. According to the same Preqin survey, of commingled vehicles: 73% charge 2% or more during investment period

viii. Pressure from LPs to reduce management fees or offer a choice of economics

(e.g., higher management fee and lower carry vs. lower management fee and

higher carry)

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Conflicts, Transaction Fees; Other Regulatory Issues

a. SEC and Institutional focus on these conflicts

b. Emphasis on giving the limited partnership advisory committee (“LPAC”) approval rights over affiliate transactions and requiring GPs to disclose all transaction fees and services provided by affiliates

c. Pressure from LPs to eliminate GP share of transaction/monitoring fees

d. SEC concerns include transparency (full, fair and timely disclosure to investors)

e. Arms length

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Frequently Overlooked Regulatory Considerations

• Broker-Dealer Regulation

• Investment Adviser Regulation

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Broker Dealer Regulatory Considerations

• Basic Rule: Transaction based compensation in securities deal requires broker-dealer registration

• Compensation could be obvious, as in commissions, or “disguised” (e.g., management and incentive fees where no IA services provided)

• Compliance professionals insist on greater compliance with registration

• SEC itself now very focused on these violations and prosecutes them

• Issue: Club Deals may be sponsored by third parties, who are neither existing registered broker dealers (or broker dealer reps) or investment advisers

• Such parties expect to be compensated

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Investment Adviser Considerations • Many sponsors, when made aware of the broker dealer regulatory considerations,

and the difficulty of meeting requirements, often turn quickly to alternatives

• Most frequent alternative: sponsor acting as investment adviser and collecting management and/or incentive fees

• However, the SEC would regard a sponsor who does not provide any investment advice as a disguised broker dealer, and the fees as disguised commissions

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Investment Company Act

• Need for exemption under ICA

• Often overlooked because vehicle is not a “blind pool”(conventionally thought of as a fund)

• Classic Exemptions of 3(c)(1), 3(c)(5), 3(c)(7) would be most relevant

• Increased possibility of availability of 3(c)(5)

• Such increased availability may even serve as a rationale for using the whole SPA/structure

20

SEC’s Recent Pronouncements on Conflicts

• Fees charged by fund managers directly to portfolio companies

• Allocations of investment opportunities

• Allocations of expenses among funds and co-investment vehicles

• Concerns raised about rates on legal fees charged to PE funds and their portfolio companies vs. those of the principals

21

SEC’s Enforcement Cases

• In re Blackstreet Capital Mgmt. et ano., (June 1, 2016): Charged (i) broker fees for purchasing portfolio cos., without SEC registration; (ii) $450k in oversight fees to 2 portfolio cos., (iii) for political/charitable contributions & entertainment expenses & (iv) acquired shares in portfolio cos. & LP interests in PE Fund from others, when should have been repurchased by cos. or reverted to Fund & investors. $3.1MM sanctions.

• In re Cranshire Capital Advisors, LLC (Nov. 23, 2015): Improperly charged fund Manager’s own expenses for attorney for compliance consulting (i.e., registration and compliance program), and for office supplies, computers and utilities.

• In re Cherokee Investment P’rs, LLC, (Nov. 5, 2015): Manager charged Fund for compliance consultant expenses relating to registration and compliance consulting and legal expenses arising from SEC Exam and Investigation

• In re Clean Energy Capital et ano. (Oct. 17, 2014): Improperly charged Manager’s overhead (i.e., salaries, bonuses, benefits & rent) to Funds and caused Funds to borrow from Manager at a high interest rate of 17% while pledging Fund assets as collateral. Changed calculation of dividend distributions adversely to some investors. $2.2MM sanctions

22

SEC’s Enforcement Cases (cont.)

• In re Blackstone Mgmt. P’rs, (Oct. 7, 2015): $39MM in sanctions for PE manager accelerating monitoring fees to portfolio cos. at time of IPO/private sale & getting legal discounts based on Fund using law firm.

– Blackstone Management charged portfolio companies owned by Funds annual

monitoring fees, and accelerated the annual monitoring fees upon the IPO or Private Sale of company.

▫ – Only Disclosed “ability to collect monitoring fees prior to… commitment of capital

but did not disclose its practice of accelerating monitoring fees until after it took the fees.”

– Conflict of Interest in decision to accelerate: benefits Manager at expense of

investor profit.

• In re Apollo Mgmt. V, L.P., et al., (Aug. 23, 2016): $52.7MM in sanctions for misleading disclosures about accelerating portfolio monitoring fees and loan from Fund to Apollo Mgmt. affiliate – As in Blackstone, Apollo accelerated annual monitoring fees upon IPO/Private

Sale of Portfolio Co.

– Apollo only disclosed ability to charge monitoring fees in offering documents, but only disclosed acceleration of monitoring fees after investors committed capital and Apollo accelerated.

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SEC’s Enforcement Cases (cont.)

• In re JH Partners, LLC, (Nov. 23, 2015): PE Manager caused multiple Funds to invest in

same portfolio cos. at different seniority (loans), priority (liquidation) & valuations,

potentially favoring one client over other.

• Manager also loaned over $60 million to portfolio companies without disclosing to investors or LP Advisory Committee; created conflict in seniority with investors and due to using portfolio company assets as collateral.

• Manager waived $24MM in management fees & carried interest; agreed to subordinate $60MM loan to Fund’s investment interest in portfolio cos.; and $225k in civil penalties. LPAC disclosure after fact not enough.

• In re Kohlberg Kravis & Roberts & Co. (June 29, 2015): First broken deal expenses

action.

• $30MM in sanctions for not clearly disclosing charging $338MM in broken-deal & due

diligence expenses to investors only – but not to PE co-investors who also benefitted

from expenses.

• Key Factor in Sanctions: Co-Investors included many KKR executives and officers,

making conflict greater.

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Investment Adviser Registration Who is Required to Register?

• Investment advisers that manage between $100 million and $150 million in assets that manage one (1) or more managed accounts must register with the SEC.

• Investment advisers that manage less than $100 million in assets generally must defer to the relevant investment adviser statutes in the state(s) where they conduct business.

• Investment advisers that can rely on the Private Fund Adviser Exemption may still need to become an Exempt Reporting Adviser with the SEC.

• Investment advisers must include all gross assets (including leveraged amounts) in calculating assets under management.

• Investment advisers to private equity funds must include uncalled capital commitments (not just drawn down capital) in calculating assets under management.

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CFTC Rules Impact on Private Investment Funds - Will You Need to Register as a

Commodity Pool Operator? Background

▫ Any fund trading even a penny of “commodity interests” is considered a “commodity pool,” and its operator must register as a CPO with the CFTC, unless an exemption is available.

▫ “commodity interests” include futures contracts (including security futures), commodity options and retail off-exchange forex transactions.

▫ Most commonly used exemption for operators of private funds has been the 4.13(a)(3) exemption.

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CFTC Rules Impact on Private Investment Funds (cont.)

4.13(a)(3) Exemption

▫ typically used by operators of 3(c)(1) funds

▫ permits a de minimis amount of trading of commodity interests

▫ either (i) the aggregate initial margin and premiums required to establish commodity interest positions, determined at the time the most recent position was established, will not exceed 5 percent of the liquidation value of the fund’s portfolio (taking into account unrealized profits and losses) (the “Margin Test”) or (ii) the aggregate net notional value of the fund’s commodity interest positions does not exceed 100 percent of the portfolio’s liquidation value (the “Net Notional Test”)

▫ the fund may generally not be marketed to the public as a vehicle for trading in commodity interests

Note: The JOBS Act allows general solicitations in connection with Rule 506(c) offerings sold only to accredited investors.

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4.13(a)(3) Exemption Modified

▫ Claiming this exemption had required a “one-time” filing, but now the filing must be made annually within 60 days after every calendar year end.

▫ “Swaps” will be included as “commodity interests” 60 days after the final rules defining “swap” have become effective.

▫ “Swaps” are expected to exclude swaps on single securities or a narrow index of securities, but are expected to include swaps on a broad-based security index.

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CPO Registration—Process

▫ The CPO Itself

Must File Form 7-R through the NFA’s Online Registration System (ORS), and concurrently will become a member of the NFA.

Application fee of $200; NFA annual membership dues of $750.

▫ “Associated Persons” of the CPO

Generally, any person that solicits investors (and supervisors thereof).

Must register with the CTFC on Form 8-R, and become an “associate member” of the NFA

$85 application fee; must submit a fingerprint card for an FBI background check.

Must obtain Series 3 license, subject to exemptions.

29


CPO Registration—Process – (cont.)

▫ “Principals” of the CPO

Generally, any general partner, managing member, director, executive officer and 10% owner.

Must file a Form 8-R through ORS.

$85 application fee.

Must submit a fingerprint card for an FBI background check (except for “outside directors”).

Not considered to be registered with the CFTC or members of the NFA; rather, they are “listed” as Principals of the registered CPO.

30


CPO Registration—Ongoing Obligations

▫ Disclosure

A “Disclosure Document” for pool participants must be prepared in accordance with Rules 4.24 and 4.25 and must accompany subscription documents.

The Disclosure Document must be accepted by the NFA prior to use.

▫ Reporting

Distribute to investors unaudited monthly “Account Statements” within 30 days of each month end.

Distribute to investors and file with the NFA audited “Annual Reports” within 90 days after each year end (subject to extension requests).

Annual CFTC registration update.

Annual NFA questionnaire.

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CPO Registration—Ongoing Obligations – (cont.)

▫ Reporting (cont.)

File Form CPO-PQR

CPOs divided into “small” (less than $150 million), “medium” (between $150 million and $1.5 billion) and “large” (greater than $1.5 billion).

Small CPOs: file NFA Form PQR on quarterly basis within 60 days of the quarters ending March, June & September. Also required to file a year-end report (Schedule A & schedule of investments) within 90 days of the calendar year end.

Medium CPOs: file NFA Form PQR on a quarterly basis within 60 days of the quarters ending in March, June & September. Also required to file CFTC Form CPO-PQR’s Schedules A & B annually, within 90 days of the calendar year end.

Large CPOs: file CFTC Form PQR schedules on a quarterly basis within 60 days of the quarter end. CPOs that file Form PF with the SEC in lieu of CFTC Form CPO-PQR required to file NFA Form PQR with NFA on a quarterly basis within 60 days of the quarter end, except for December 31st quarter, which will be due within 90 days of quarter end.

▫ Recordkeeping

Must make and keep prescribed records in an accurate, current and orderly manner at main business office.

Keep for 5 years; must be readily accessible for 2 years.

Open to inspection by DOJ and CFTC.

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CPO Registration “Lite”

▫ A Section 4.7 exemption provides relief from many of the requirements of a registered CPO, effectively substituting significantly less onerous requirements.

▫ Requires that every investor in the fund be a “qualified eligible person” (“QEP”).

▫ A QEP includes an entity with total assets in excess of $5 million or an individual that is an accredited investor, provided, in each case, that the person owns securities of issuers not affiliated with such person and other investments with an aggregate market value of at least $2 million.

33

Co-Investment/Capacity Rights: Surprising Driver of Marketing and Negotiations

a. Historically, fees and expenses would be the most important and heavily negotiated economic issue

b. Perhaps this is still true on its face; but only based on participants’ and attorneys’ time and effort in negotiations of such matters

c. But we believe that deal flow is now perhaps the true driving force:

i. Determines who gets funded

ii. Determines negotiating position

34

Co-investment/Capacity Rights: “Hot-button” Issues and Positions

• Request for co-investment rights, including “early bird” or “big bird” incentives (preferential terms for early commitments or large commitments (e.g., priority co-investment rights))

• According to one survey, 38% of GPs have offered co-investment opportunities

• According to one survey, 53% would consider offering such opportunities

• Preqin survey of 80 fund manager found 76% offer co-investment rights to build stronger relationships with LPs, and 51% of GP’s view co-investments as a valuable method for gaining access to additional capital for deals, allowing for investment into a larger transactions

• More likely to be utilized by mid to large size managers

• Fees on such investments are usually ½ to ¼ the regular fee (for example, 1/10 or 0/.50)

35

Co-investments/Capacity Rights: Fiduciary Considerations in Co-Investments

Regulatory Backdrop: SEC’s focus on PE Industry, fairness among management vs. investors, and among investors

• Will LPs be treated pari passu and offered deals at the same time as the fund?

• Investment should be on same terms (some exceptions exist)

• Will the opportunity come at the expense of a fund? Need to consider whether the fund has capacity at the time of the co-investments

• Best to work from allocation guidelines among the fund, LPs and third parties

• Disclosure to LPs in advance (whatever the policy is)

▫ At the same time, note that giving out more info to co-investors could be problematic

• Do all LPs need to be given the same opportunities?

36

Co-investments/Capacity Rights: Other Potential Conflicts to Watch Out For

• Offering to new investors for relationship/marketing at expense of existing investors

• Investments made at different levels of capital structure

• Different fee structures

37

Tax Considerations for Investors in Private Equity Funds The Typical Investor Participants in Private Equity Funds Include:

1. US TAX-EXEMPT INVESTORS THAT ARE SUBJECT TO TAX ON UNRELATED TRADE OR BUSINESS INCOME (“UBTI”)

A. US “Fortune 500” Pension Funds

B. US University and College Endowment Funds

C. Other US Tax-Exempt Entities (Foundations, Charitable Organizations)

D. Self-Directed Retirement Plans and Individual Retirement Accounts of High Net Worth Individuals

Such tax-exempt investors would realize UBTI if they make any debt-financed investments (i.e., investments using borrowed funds made directly or by a partnership in which they are partners (including limited partners)). In addition, such tax-exempt investors would realize UBTI if they own equity interests in partnerships that are engaged in a trade or business in the US or anywhere in the world.

PREFERRED FORM OF INVESTMENT: If there is a risk of UBTI, such Tax-exempt entities typically invest through “blocker corporations “organized in “zero tax” jurisdictions like the Cayman Islands or British Virgin Islands.

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Tax Considerations for Investors in Private Equity Funds (cont.)

2. US TAX-EXEMPT INVESTORS THAT ARE NOT SUBJECT TO THE UBTI RULES

A. Retirement Plans for State and Local Government Employees (e.g., CALPRS, CALSTRS, New York State and Local Retirement System, Florida State Employees Retirement Plan, Etc.)

PREFERRED FORM OF INVESTMENT: Such governmental employee plans are typically exempt under section 115 of the Internal Revenue Code (as governmental entities) rather than Code section 501, and are thus exempt from UBTI. Therefore, they would typically invest through pass-through entities.

2. US TAXABLE INSTITUTIONAL INVESTORS

A. Publicly Traded “C” Corporations

B. Insurance Companies

C. Private “C” Corporations

39

Tax Considerations for Investors in Private Equity Fund (cont.)

PREFERRED FORM OF INVESTMENT: As a general rule, these taxable US corporate investors favor investments in portfolio companies organized as pass-through entities, which allow them to benefit currently from the flow through of operating losses.

3. US HIGH NET WORTH INDIVIDUALS (INCLUDING FAMILY OFFICES)

A. Family Offices (typically partnerships of individuals)

B. High Net Worth Individuals

PREFERRED FORM OF INVESTMENT: Such taxable individuals would prefer to derive tax-favored income such as long-term capital gains and qualified dividends. In addition, they would prefer to be in pass through entities in order to derive any tax benefits from operating losses or capital losses. Such US individuals want to avoid investing through foreign “blocker” corporations that could be classified as “passive foreign investment companies” (PFICs) or “controlled foreign corporations (CFCs).

40


4. FOREIGN TAXABLE INVESTORS

A. Foreign Corporations

B. Foreign High Net Worth Individuals and Family Offices

Non-US Persons (including foreign corporations) are generally not subject US income tax on capital gains derived from investments in US securities but would be subject to US income tax on any income that is “effectively connected” with a US trade or business (“ECI”), including their share of ECI derived by a partnership in which they are a partner (including a limited partner).

BLOCKER CORPS NEEDED. Thus, if the US portfolio company is organized as a partnership and is engaged in a US business, such foreign investor typically avoids direct exposure to ECI by investing through either (a) a foreign blocker corporations organized in “zero-tax” jurisdictions or (b) a US blocker corporation which may also issue its debt instruments to such non-US investors.

41


US Withholding Taxes: The United States imposes a 30 percent withholding tax on US-source dividend and certain types of interest income (other than “portfolio interest”). US tax treaties with foreign jurisdictions in which the foreign investor may be residents typically reduce the US withholding tax on dividends to 15 percent and interest income to zero. However, the blocker corporations organized in “zero tax” jurisdictions are not eligible for the benefits of any US tax treaties.

PREFERRED FORM OF INVESTMENT: Foreign taxable individuals typically invest through a blocker corporation. In addition to avoiding the ECI exposure, such individuals would also be protected from US estate tax exposure by owning the US investment through a foreign corporation.

42


5. SOVERIGN WEALTH FUNDS

Although sovereign wealth funds are not treated as US tax-exempt entities, The Internal Revenue Code contains a special provision (Section 892) which exempts sovereign wealth funds and their home country subsidiaries from federal income tax on certain types of US-source income, including dividends and capital gains on sales of corporate stocks and interest income and gains from sales of debt securities. US trade or business income derived as an equity investor in a US partnership is not covered by this special statutory exemption. Unlike the US tax-exempt entities that are subject to UBTI, sovereign wealth funds do not incur any US tax liability if they, or partnerships in which they invest, use borrowed funds to acquire income-producing property.

PREFERRED FORM OF INVESTMENT: If the portfolio company is a partnership, the sovereign wealth funds typically use blocker corporation structures to avoid US trade or business income. If the target portfolio company is a US corporation, the sovereign wealth fund will prefer to invest directly in the stock of such corporation.

43

How Can a Private Equity Fund Accommodate the US Tax Needs of the Different Types of Investors Previously Described

Private equity funds are generally organized as pass-through entities (e.g., limited partnerships) for US tax purposes. Most of the potential tax issues for US tax-exempt investors and non-US investors can be avoided if the private equity fund were to invest only in portfolio companies that are corporations for US tax purposes. Long-term and short-term capital gains of non-US investors are exempt from US income taxation (unless the gains are from the sale of a “US real property interest”). Similarly, capital gains on sale of corporate stock are exempt from UBTI as long as the tax-exempt investor or the private equity fund did not incur acquisition indebtedness with respect to such stock.

However, many funds acquire equity interests in private companies that are themselves partnerships and that are engaged in business in the US. Under the US tax rules applicable to partnerships, including tiers of partnership entities, the fund’s US trade or business income from its ownership of equity interests in a portfolio company that is a business partnership would pass through to a non-US limited partner as income effectively connected with a US trade or business “(ECI”). The non-US limited investor would be required to file a US federal income tax return with respect to such ECI and the fund would have to withhold with respect to such ECI. Similarly, a US tax-exempt investor could realize UBTI with respect to its share of the net business income and or debt-financed income passing through the fund to such limited partner.

Private equity funds typically use special holding vehicles, including US or foreign blocker corporations to “block” such problematic income for such investors.

44

ERISA Considerations Relating to Private Equity Funds

1. Plan Assets Issues; Fiduciary Status and Prohibited Transaction Issues

If the assets of an entity (e.g., a private equity fund organized as a limited partnership) are treated as plan assets of a benefit plan investor that owns an equity interest in such entity, the parties having management authority over the assets of such entity would be treated as fiduciaries under ERISA with respect to such plan investors. In addition, transactions entered into by such plan asset entities would be subject to ERISA scrutiny including complex prohibited transaction rules.

Sponsors of private equity funds typically do not want to be treated as fiduciaries under ERISA with respect to investors in their funds that are ERISA-covered plans and want to ensure that the transactions entered into by their funds are not subject to ERISA regulation. Generally, private equity funds cannot be managed in accordance with the US Department of Labor (DOL)’s approved methods for charging performance fees and would have difficulty complying with the ERISA strict constraints on fiduciary self-dealing, conflict of interest and related party transactions.

45

ERISA Considerations Relating to Private Equity Funds (cont.)

Accordingly, the sponsor of the private equity fund seeks to avoid the fund being considered a “plan asset fund” for ERISA regulatory purposes by either limiting the percentage of the fund which can be owned, in the aggregate, by “benefit plan investors” ( i.e., ERISA-covered plans and IRAs) to less than 25 percent of each class of equity interests in the fund (thus qualifying for the “Insignificant Plan Investment” exception discussed below), or by operating the fund to qualify for an exemption from plan asset status for a “Venture Capital Operating Company (VCOC) (or in some cases, an alternative exemption provided for a “real estate operating company” (REOC).

A. General Rules on Plan Assets Status

Under the ERISA plan assets regulations, the assets of an entity in which a plan has an equity interest will not be treated as plan assets if the equity interests are(1) publicly traded securities or (2) a security issued by an investment company registered under the Investment Company Act of 1940.

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In all other cases the assets of the entity will be treated as plan assets for ERISA purposes unless:

(1) the entity qualifies as an “operating company” which term also includes a “venture capital operating company” or a “real estate operating company”; or

(2) the aggregate investment in the equity interests of the entity that are owned by “benefit plan investors” is less than 25 percent of the outstanding equity interests in such entity (the Insignificant Plan Investment Exception”).

CAUTION: An equity interest is defined as any interest in an entity other than an interest that is treated as indebtedness under local law and has “no substantial equity features”.

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B. Operating Company Definition

General Rule. An operating company is defined as an entity that is “primarily engaged, directly or through a majority owned subsidiary or subsidiaries, in the production or sale of a product or service other than the investment of capital.” A private equity fund would not satisfy this definition.

(1) However, ERISA plan asset regulations have been amended to provide that a fund can also qualify as an operating company if it meets the definition of a the Venture Capital Operating Company (“VCOC”) or a Real Estate Operating Company (“REOC”) in such regulations.

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VCOC Definition

To qualify as a VCOC, the private equity fund must satisfy two requirements: First, at least 50 percent of the fund‘s assets (at cost) must be invested in “venture capital investments” or “derivative investments” as defined. Second, the fund must obtain and exercise “management rights” with respect to at least one of its operating company investments. The term “venture capital investment” is defined as an investment in an “operating company” in which the investing entity has obtained management rights.

The requirements in the ERISA regulations to qualify a fund for VCOC status are quite technical. Therefore, private equity funds that are relying on the VCOC exemption typically engage legal counsel to provide an ERISA opinion letter to the plan investors which concludes that, upon the acquisition of fund’s first-long term investment, the fund should qualify as a VCOC.

The fund must continue to satisfy the “asset test” and “management test” each year during a specified measuring period in order to retain its status as a VCOC. Accordingly, the investment manager of the private equity fund typically provides a certification to the fund’s benefit plan investors each year that the fund satisfied the VCOC requirements during its applicable measuring period.

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A “venture capital investment” is an investment in an operating company, other than a VCOC, with respect to which the investor has or obtains “management rights”. Note that a “start-up” company that does not yet derive any revenues from the sale of a product or service would not qualify as an operating company, even if the fund acquired the requisite management rights.

“Management rights” are contractual rights directly between the fund and an operating company that allow the fund “to substantially influence the conduct of the management of the operating company”. The right to appoint a member of the company’s board of directors would qualify, but the DOL has stated that other contractual rights, including the right to periodically inspect the books and records of the company and meet with management, could also suffice.

The typical offering document for a private equity fund provides that upon the final closing of the offering the investment manager would decide whether to rely on the Insignificant Participation exemption or the VCOC exemption to avoid plan asset status for the fund.

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REOC Definition

The REOC definition is similar to the VCOC definition. In order to be a REOC, the entity must: (1) have at least 50 percent of its assets (valued at cost) “invested in real estate that is managed or developed and with respect to which such entity has obtained the right to substantially participate directly in the management or development activities”; and (2) be directly engaged in real estate management or development activities.

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If you have questions, please contact:

Sadis & Goldberg LLP 551 Fifth Avenue, 21st Floor

New York, NY 10176

Steven Huttler

Alex Gelinas

Daniel Viola

212.573.8424 212.573.8159 212.573.8038 [email protected] [email protected] [email protected]

mailto:[email protected]



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