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Private Equity Fund Formation in 2013 Navigating JOBS Act, State Adviser Registration, SEC "Bad Actor" and "Red Flag" Rules, and the EU's AIFM Directive
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TUESDAY, NOVEMBER 5, 2013
Presenting a live 90-minute webinar with interactive Q&A
Scott W. Naidech, Partner, Chadbourne & Parke, New York
Adam D. Gale, Partner, Mintz Levin Cohn Ferris Glovsky and Popeo, New York
Jonathan R. Talansky, Partner, Mintz Levin Cohn Ferris Glovsky and Popeo, New York
Edouard S. Markson, Partner, Chadbourne & Parke, New York
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FOR LIVE EVENT ONLY
MINTZ LEVIN Mintz Levin Cohn Ferris Glovsky and Popeo PC
Strafford Webinar:
Private Equity Fund Formation
in 2013
Presentation (November 5, 2013) by
Scott Naidech, Chadbourne & Parke LLP
Adam Gale, Mintz Levin
Jonathan Talansky, Mintz Levin
Edouard Markson, Chadbourne & Parke LLP
MINTZ LEVIN Mintz Levin Cohn Ferris Glovsky and Popeo PC
Goals of Presentation • Describe significant changes impacting private equity fundraising in 2013
• Describe recent market trends, including structural changes taking place in
the market
• Highlight changes in “market” terms, including ILPA changes and other
market impacts
• Summarize certain new regulations impacting PE funds (including Dodd-
Frank, state adviser registration, broker-dealer issues, JOBS Act, Bad Actor
Rules, AIFMD, Red Flags, Volcker Rule)
• Sun Capital decision – Ramifications for PE Funds
• FATCA update
1. What do we mean by “Private Funds”?
• Any (i) “blind pool” vehicle (ii) invested by a sponsor (iii) who
often receives a management fee and profit participation (known
as a carried interest or performance fee) (iv) offered to qualified
high net worth investors only
• For purposes of this presentation, “Private Funds” means
“Private Equity Funds”. For example, Venture Capital Funds,
Growth Equity Funds, Buyout Funds, Real Estate Funds,
Distressed Debt Funds, Mezzanine Funds, etc., investing in
illiquid securities
7
2. Key incentives for raising a Private Fund?
• Key Economic Incentives for Sponsor Raising a Fund: Access to
private capital from alternative sources; Carried Interest and
Management Fee
• Key Economic Incentives for a Limited Partner Investing in a
Fund: Access to a diversified pool of investments in a targeted
geographic region and/or industry being managed by a specified
team of experts
8
3. Recent changes in key incentives…
• Ten years ago, most fund negotiations focused on economics;
five years ago…governance; in 2013…back to economics
• Impacts on incentives altering the standard “2 and 20” model –
economy and fund size.
• Volume: currently over 1,900 Private Equity and Real Estate
Funds looking to raise capital, seeking almost $800 billion
• Total amount of probable commitments from this pool: only $250
to $300 billion/year.
• Conclusion: less than one-half of fundraises will successfully
raise their target amounts.
9
173
79 78 78 79 82
212
94 66 94 92137
128
5980
61 8450
171
8667
92110
$105
$219
$361
$547
$665$684
$318$290
$325$364
$269
0
100
200
300
400
500
600
700
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Q1 Q2 Q3 Q4 Full year
Following unprecedented highs, fundraising fell materially through the global economic downturn
($ in billions)
Capital committed to private investment funds by year of final close
Gradual stabilization since 2010 … the “new normal”
- 54%
Data and graphics compiled by Credit Suisse Private Fund Group. Source: Preqin, as of Jul-2013. Includes all Buyout, Distressed, Fund of Funds,
Infrastructure, Mezzanine, Real Estate, Secondaries, Venture and Other (excludes Hedge Funds). Total fund size is accounted for in the year of a fund’s final
closing. Interim closings for funds that have not held their final closing are accounted for in the year of each closing, and amounts are rolled forward to the
quarter in which the final closing occurs. Capital committed in 2003-2007 is provided annually in the year of final closing. Data are continuously updated and
therefore subject to change.
557 846 1,071 1,297 1,466 1,412 930 918 989 945 461Number of
final closings
10
1,6241,561
1,619
1,845
1,958
$888
$699$607
$758 $770
0
200
400
600
800
1,000
1,200
1,400
1,600
1,800
2,000
Q4 2009 Q4 2010 Q4 2011 Q4 2012 YTD 2013
Number of funds raising Aggregate capital sought
Congested fundraising market has caused fundraising duration to increase significantly
Number of funds on the road and aggregate target(1) Time spent on the road for funds closed in Q2 2013(2)
Data and graphics compiled by Credit Suisse Private Fund Group.
(1) Preqin, The Private Equity Fundraising, Q2 2013.
(2) Preqin, The Preqin Private Equity Quarterly, Q2 2013. Represents months from fundraising launch to final close.
(3) Preqin, average of Q1 – Q2 2013.
(4) Preqin, Jul-2013.
16%18% 19%
22%
16%
9%
0
5
10
15
20
25
1-6
Months
7-12
Months
13-18
Months
19-24
Months
25-30
Months
31-36
Months
% o
f Fun
ds
Clo
sed
Average time taken to close: approximately 19 months(3)
($ in billions)
Status of funds on the road(4)
56% of the over 1,900 funds on the road have yet to hold a closing, and the average fundraise is taking 19 months to
complete
No close
56%1st close
31%
2nd close +
13%
Funds yet to hold a first close seeking more than $380 bn
11
Liquidity challenges for LPs are ever-present, but improving
Unfunded commitments remain high(1)
($ in billions) ($ in billions)
Duration of buyout dry powder(2)
$406
$559
$799
$1,002 $1,068 $1,062
$988 $1,007
$944 $1,025
0
200
400
600
800
1,000
1,200
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Buyout Venture Mezzanine Distressed Real Estate Growth Other
Drawdowns from and distributions to LPs (U.S.)(3) Net cash flow to LPs (U.S.)(3)
Data and graphics compiled by Credit Suisse Private Fund Group.
(1) Preqin, Jul-2013. 2013 numbers are as of Jul-2013.
(2) Preqin, Jul-2013. S&P Leveraged Buyout Review, Q1 2013. Bain, 2013. CS PFG Analysis.
(3) VentureXpert, Jul-2013. Cash flow to LPs defined as cash distributions less drawdowns.
Quarterly totals may not sum to annual totals due to rounding.
$49 $59
$78
$131 $113
$54
$85 $83
$64 $66 $66 $67 $79
$35 $23
$73
$89 $101
0
20
40
60
80
100
120
140
2004 2005 2006 2007 2008 2009 2010 2011 2012
Drawdowns Distributions
($ in billions) ($ in billions)
$86 $95
$230 $220
$80 $37
$83 $76 $73
$177
$258
$380 $442 $485 $484
$426 $391
$355
2.1
years
2.7
years
1.7
years
2.0
years
6.1
years13.0
years 5.1
years5.1
years 4.9
years
0
10 0
20 0
30 0
40 0
50 0
60 0
20 04 20 05 20 06 20 07 20 08 20 09 20 10 20 11 20 12
E qu ity va lue o f buyou t inves tm en ts
D ry p ow der f o r buyou ts / yea rs o f sup p ly a t c u rren t dea l p ac e
$10$8
-$5 -$7
$4
$9 $8
$17
$12
-15
-10
-5
0
5
10
15
20
Q 1
' 11
Q 2
' 11
Q 3
' 11
Q 4
' 11
Q 1
' 12
Q 2
' 12
Q 3
' 12
Q 4
' 12
Q 1
' 13
12
Changes of key incentives…
• Larger managers compete for the same capital (from government
plan, pension plans, foreign institutions, sovereign wealth funds)
• Face same pressures, which increases LP leverage in
negotiations
• Pace of investment slowed creating “dry powder”
• Management fees have provided greatest share of GP economics
• Fund sizes are being capped at lower amounts
• Greater competition for capital = lower fees and carry, greater LP
controls, increased fundraising periods, higher customization
• Still, sponsors increase their negotiating leverage through certain
key differentiators, including higher performance, strategy
diversification, oversubscription, better terms
13
4. Who are the Sponsors of Private Funds?
• Sponsors range in size from the largest asset managers in the
world to smaller first-time funds
• Private Equity International released the “PEI 300” in May 2012:
1. TPG (Fort Worth, TX): raised $35.7 billion in capital for their Private Funds over
the last five years
2. The Carlyle Group (Wash DC): $32.8 billion
3. The Blackstone Group (New York): $29.6 billion
4. Kohlberg Kravis Roberts (New York): $28.4 billion
5. Warburg Pincus (New York): $26.0 billion
6. Goldman Sachs Principal Investment Area (New York): $24.6 billion
7. Advent International (Boston): $23.1 billion
8. Apollo Global Management (New York): $22.1 billion
9. Bain Capital (Boston): $19.4 billion
10.CVC Capital Partners (London): $18.0 billion
14
Fee envy…
15
US Buyout
Fund I
US Buyout
Fund II
Asia
Fund
US Mezz
Fund
US Real
Estate Fund
GP GP GP GP GP
Investment Adviser
Sponsor
Each Fund pays a Management Fee to the Investment Adviser…can result in large aggregate fees that alter
incentives (from carried interest based to fee based); thus downward fee pressure
Each Fund pays a Carried Interest to the GP
(or an affiliated entity)
Carry
Management Fees
Zombies!
• Pressure on smaller and mid-sized managers to reduce fees and
fundraise
• Given the reduction in commitments and increased pressure, it is
possible that a significant portion of existing fund managers will
cease to continue meaningful operations, becoming so-called
“zombie funds”
• Governance provisions in some fund agreements may be
inadequate to handle orderly liquidations/terminations/Key
Person events/removal events (fund agreements often infer that
the team will remain in place to raise a subsequent fund)
• While the process may be clear, the cost of implementing may
discourage a single LP from pursuing.
• There may be little or no economic incentive for the GP to initiate the
process.
16
Fee anxiety…
17
Fund I ? ? ? ?
GP ? ? ? ?
Investment Adviser
Sponsor
For advisers with fewer funds under management, downward pressure on fees by the “market” means
smaller budget, leaner staff, harder to pay consultants and advisors…less overall fees to manage the team.
Carry
Management Fees
Results…
• Overall result:
• increased LP leverage and lower capital commitments alter dynamics
of negotiation
• longer fundraising periods
• greater investment strategy definition
• lower fees and carry
• greater LP participation in investment process
• co-investment rights
• deal-by-deal opt-outs and investment vetoes
• (some of these are covered later in presentation from a legal perspective)
• “Classes of LPs”: concern that larger LPs have leverage and can
therefore negotiate better terms in side letters, or in separate
parallel or co-investment funds
18
LP portfolio managers (like sponsors) face pressures too…
• Because of the economic turmoil of the past four years, investors
are unable to achieve adequate returns from more traditional
portfolio allocations, e.g., publicly-traded strategies
• Lack of new contributions to trusts
• Uncertain performance of North American and European stocks
• Levels of distrust in Asian and Indian issuers and political
environments
• Challenge: where to find new markets/or strategies for investment
that can provide one or more:
• Current cash flow
• Stability in interim valuations
• Shorter investment horizons
19
5. Recent Structures and Changes in Legal Terms
• Institutional Limited Partners Association (ILPA)
• Download ILPA Principals from www.ilpa.org
• Private Equity Principles 1.0 published in Sept 09
• Private Equity Principles 2.0 published in Jan 2011
• Goals: to establish “best practices” regarding fund partnerships
between GPs and LPs
• Three guiding principles:
• Alignment of Interests
• Governance
• Transparency
20
ILPA: a pretty good outline of issues and considerations…
• ILPA: Outlines Key Principles and Concepts, along with reporting
templates
• Economics:
• carried interest calculation and waterfall structures (deal-by-deal vs.
aggregate-return waterfall structures and considerations)
• Management fee considerations, along with GP Expenses and Fee
Income offsets
• Clawbacks: Principles 2.0 contains detailed Appendix on Carry Clawback
Best Practices (e.g., considerations such as a guarantee or escrow;
clarification that the GP clawback is net of taxes paid; other
considerations based on the waterfall structure)
• Governance:
• Key Man events considerations
• Investment Strategy considerations
• Conflicts of interest, fiduciary duties and LP Advisory Committee
(Appendix A)
21
…but not a checklist!
• Transparency
• Fee disclosures
• ILPA standardized templates
• Capital call and distribution notices
• Annual and quarterly reports
• Appendix C covers additional considerations on reporting
• Not a laundry list of must-haves
• ILPA: our terms are not to be applied as a “checklist”; each partnership
should be considered separately and holistically
• Goal is to provide terms and principles to be considered and that will result in
better investment returns and a more sustainable private equity industry
• Generally, considered more “pro-LP” and not the “market standard”; the ILPA
terms continue to be discussed, debated and augmented
22
6. Hot areas for investments…
• Hot Sectors
• Healthcare
• Technology
• B-to-B
• Software
• Energy & infrastructure and other Real Assets
• Global demand for energy especially in emerging markets
• Renewables (driven by environmental regulations and macro events, e.g.,
Fukushima, reduction in coal capacity)
• Hot Geographies
• BRICs less “hot”, but…
• Peru; Chile; Colombia
• Turkey and MENA
• Africa
23
Other key terms being negotiated…
• Key Man
• New funds
• Established funds
• Removal Events
• For Cause/other than for Cause
• Mechanics and Voting
• Clawbacks
• Reporting
• ILPA forcing standardization
• Co-Investments
• Pipeline
• Disclosure
• Securities concerns
24
7. Public investments in alternative asset managers
• Larger asset managers have over the last few years gone public
• The Blackstone Group (NYSE: BX)
• Kohlberg Kravis Roberts & Co. (NYSE: KKR)
• Apollo Global Management (NYSE: APO)
• Oaktree Capital Group (NYSE: OAK)
• The Carlyle Group (NASDAQ: CG)
• An investment in these shares may (or may not) relate to an
investment in their managed funds, carried interest, management
fees, portfolio fee income, or other revenue streams
• Public filings provide a wealth of information on the detail and
scope of their operations and aspirations
25
1. Dodd-Frank – Investment Adviser Registration
2. State Investment Adviser Exemptions
3. Broker-Dealer Registration Issues for PE Funds
4. JOBS Act
5. Bad Actor Rules
6. AIFMD
7. Red Flags Rule
8. Volcker Rule
Regulatory Issues
26
• Exemption for advisers who solely advise private funds with assets
under management in the US of less than $150mm
• In calculating assets under management, include both uncalled capital
commitments and outstanding investments; must calculate on a gross
basis (i.e., amounts borrowed are included)
• Venture capital exemption: Exemption for advisers who solely advise
“venture capital” funds
• For exemptions, still need to file Part 1 of Form ADV
• Real Estate Funds: No specific exemption for real estate ("RE") fund
managers, but depending on what the RE fund invests in, and how the
investments are structured, the rules may not apply
1. Dodd-Frank: Investment Adviser Registration
27
Non-US Fund Managers:
– Foreign private advisers: Exemption for non-US advisers to
private funds with small US client and investor bases (less than
$25mm under management and less than 15 clients and
investors in the US), and no place of business in the US
– No filing at all required if meet that exemption.
– Otherwise, should fit within the $150mm exemption, as long as
not managing $150mm from an office in the US.
Fund GPs:
- Can rely on the Investment Manager’s filing, if certain requirements
are met
Dodd-Frank: Investment Adviser Registration (Con't)
28
• Fund managers who are exempt from SEC registration still need to
check the investment adviser registration requirements of the state of
their principal office and place of business
• For most states (but not NY), solely under state rules if AUM under
$100 million
• Some states have recently added additional requirements to meet the
state exemption
• For example, California and Massachusetts:
o For 3(c)(1) funds, can only charge carried interest to investors that are
Qualified Clients under Adviser Act definition
o Must file Form ADV as Exempt Reporting Adviser
2. State Investment Adviser Registration Exemptions
29
• April 2013 – SEC Div. of Trading & Markets speech – new approach
• Investment Banking/Acquisition/Disposition Fees
o Fund manager (or affiliate) charges success fee to portfolio co. or to fund
for identifying sellers or purchasers , or structuring transactions
o Unless 100% of that success fee is offset against fund management fees,
then SEC suggesting that fund manager must register as a B-D
• Personnel in Marketing Department
o Dedicated sales force, regardless of how compensated, "may strongly
indicate" B-D registration required
• Paying Commissions to "Finders"
o Beware of potential consequences – Ranieri matter; rescission
3. Broker-Dealer ("B-D") Registration
30
• Under prior rules, PE funds could not engage in any general
solicitation or general advertising when raising a fund
• JOBS Act eliminated this prohibition, provided that:
o Everyone who ends up investing in the fund is an “accredited investor”
(though "reasonable belief" standard still applies)
o Fund takes “reasonable steps” to verify accredited investor status
o Fund relies on Rule 506 – called Rule 506(c)
• Reasonable Steps:
o Fund determines what steps are reasonable
o But just relying on investor reps or checking boxes is insufficient
o Safe harbor (non-exclusive list) included in rules
4. JOBS Act – General Advertising
31
• Safe Harbor – Applies Only to Natural Person Investors:
o (A) Income – IRS Forms and rep as to future income
o (B) Net Worth – Bank/brokerage statements; credit report; rep as to liabs.
o (C) Written Confirmation from: B-D, RIA, Licensed Attorney or CPA that
they have taken reasonable steps to verify within prior 3 months
o (D) Prior investors who invest in subsequent close – certification
• Otherwise – Facts and Circumstances Test as to Reasonable Steps:
o Type of Investor (e.g., plan, entity, natural person)
o Amount of information about investor
o Nature of offering – how investor solicited; terms of investment
JOBS Act – General Advertising (Con't)
32
• SEC's Release – Tips on Reasonable Steps
o High investment amount may be sufficient, with confirmation of no loan
o Can rely on publicly available info (e.g., Form 990 for a tax-exempt)
o Third party verification okay – if reasonable basis to rely on it
• Potential Pitfalls
o CFTC Registration Exemptions unchanged (e.g. CPO) – no public offering
o State exemptions – may still have a restriction on general advertising
o Non-US laws – especially on website
o RIAs – must keep records of advertisements
o Use of track record in general advertisements
JOBS Act – General Advertising (Con't)
33
• What Can Funds Do Under 506(c) Offering
o Freely advertise and market
o No restriction of website access – for US persons
o Fund manager personnel can speak more freely to press and conferences
o Freely use social media (but note RIA record-keeping)
o No need to number PPMs (but still good idea)
• Form D Amended – must indicate if relying on 506(c)
• Reg S Offering – can conduct concurrent with 506(c) offering
JOBS Act – General Advertising (Con't)
34
• Cannot rely on Reg D of Rule 506 if fund manager and affiliates,
solicitors, fund investors with 20% voting power, or affiliated issuers
have been subject of certain criminal, regulatory or civil proceedings
o Persons covered go well beyond those under fund manager's control
o Bad actor events go beyond list in Form ADV Item 11
o Form D amended – must certify that have no disqualifications
• Exception if did not know and "exercised reasonable care" by making
"factual inquiry into whether any disqualifications exist"
• Waivers: can apply to SEC for "good cause"; regulator issuing order
determines disqualification not necessary
• Events Prior to Sept. 2013 – Do not disqualify, but must disclose
5. Bad Actor Rules
35
• What Constitutes Exercise of Reasonable Care:
o Scope of inquiry depends on facts and circumstances
o SEC suggested reps and covenants sufficient for third parties, if have no
information to the contrary
o For fund and affiliates own officers – additional steps may be necessary
o For placement agents – may need to consult FINRA BrokerCheck
• Action Items
o Sub Docs – Incorporate Bad Actor reps for investors with 20% ownership
o Employees – Complete Bad Actor questionnaire, and background checks
o Placement Agent Agreements
o Offerings lasting over one year
Bad Actor Rules (Con't)
36
• Who Is Covered
o Any managing member, GP, director, executive officer, or other officer
participating in the offering, of:
- Fund's investment manager
- The Fund
- Anyone paid remuneration for solicitation
o Any affiliated issuer and any predecessor to the issuer
o 20% Beneficial Owners of Total Outstanding Voting Equity Securities
- If some investors are non-voting, may affect 20%
- Total outstanding – not by class
Bad Actor Rules (Con't)
37
• Now in effect and applies if meet any of the following:
o Market to European investors
o Fund vehicle is organized in Europe
o Fund manager based in Europe (including a branch office)
• Non-EU Fund Manager Marketing to European Investors
o Need to comply with National Private Placement Regimes (NPPRs) in
each country where market – unless meet exemption
o Or rely on "reverse solicitation"
- Marketing not at direct or indirect initiative of fund manager
o In 2015 – can become AIFMD authorized and rely on passport regime
6. AIFMD (Alternative Investment Fund Managers Directive)
38
• Exemption for Smaller Fund Managers
o AIFMD not apply if manager has AUM below €100 million (~US$135M)
o If fund not employ leverage, then AUM below €500 million (~US$690M)
• NPPR Requirements
o Must register with relevant country's regulator
o Comply with rules on reporting to regulators and disclosure to investors
o If began marketing prior to July 2013, have until July 2014 to comply, but
need to check each country's rules
• AIFMD Authorized – may not be practical, as includes restrictions on
remuneration to fund managers
AIFMD (Con't)
39
• Not apply to fund managers at all if not an RIA
• Not apply to fund manager if no authority to redirect investor's
proceeds to third parties or others upon instructions from the investor
o Need to check power of attorney if narrowly drafted
• Not apply to fund manager if no investors are individuals
• Does apply to fund manager if regularly lend money to permit investors
to make an investment in the fund, pending receipt or clearance of
investor's capital
o Not apply solely because fund itself borrows money pending receipt of
investor contributions
7. Red Flags Rule
40
If Rule applies:
• Must develop a written program designed to detect, prevent and
mitigate identity theft in connection with the opening of "covered
accounts" (accounts for individuals)
• Need policies and procedures to:
o Identify relevant Red Flags indicating possible identity theft
o Detect Red Flags that the program incorporates
o Respond appropriately to any Red Flags detected
o Ensure program is updated periodically
• Continued administration, including obtaining approval from
CCO, training, oversight of service provider arrangements
Red Flags Rule (Con't)
41
• Volcker Rule generally prohibits banking entities, including affiliates of
banks, from engaging in, sponsoring or investing in private equity funds
(and hedge funds), but the Rule is subject to a number of exceptions.
• Volcker Rule also prohibits a bank from engaging in "proprietary
trading," but those are less relevant to funds.
• Rule does not go into effect until July 21, 2014, and we are still waiting
for final rules to be promulgated.
• Grandfather Provision: Regulators may, upon application by any
banking entity, extend the period
o (i) for up to 5 years (until 2019)
o (ii) to the "extent necessary to fulfill a contractual obligation that was in
effect on May 1, 2010” if fund is an “illiquid fund”
8. Volcker Rule
42
The 3% Exception to the General Prohibition:
• A banking entity may acquire or retain an ownership interest in a
covered fund if, among other things, it:
(i) owns not more than 3% of the total ownership interests in any single fund; and
(ii) invests an aggregate amount not exceeding 3% of the banking entity's Tier 1
capital (i.e., the bank's regulatory capital) in covered funds as a whole.
• Seed Investment Exception: There is an exception to the 3% rule to
allow the banking entity to make a seed investment in a fund (in
which case it can own 100% of the fund) - provided that within one
year of the covered fund's establishment, the banking entity must
reduce its ownership to no more than 3% of the total ownership
interests in the covered fund.
Volcker Rule (Con't)
43
Sun Capital & Private Equity Funds
45
• A PE Fund's portfolio company (SBI) was in bankruptcy and stopped its contributions to a multiemployer pension plan (TPF)
• TPF demanded payment of SBI's withdrawal liability under ERISA
• TPF also asserted that the PE Fund was jointly and severally liable for the withdrawal liability under ERISA, on the basis that it was a "trade or business" that is "under common control" with the primary ERISA obligor (29 U.S.C. § 1301)
Sun Capital – Basic Facts
46
• No offices or employees
• Report only investment income
• Make investments with the aim of turning them around and selling them at a profit
• The Fund agreements vest the General Partner with authority to manage the Fund, which includes managing and supervising investments.
• GP receives a 2% management fee from the Fund, plus a share of profits
• Subsidiary management companies provide management services to the Fund's portfolio companies for a fee.
• This fee results in an offset to the management fee owed by the Fund
• The employees of the management companies are actively involved in the operations and management of the portfolio companies' businesses.
Key Features of Sun Funds
47
• The Funds were in a "trade or business" under ERISA (and remanded for other issues) – but the business of SBI itself.
• Holding was based on the fact that the Funds were not merely passive investors (as mere investment is not a "trade or business"), but were, through agents, "actively," "extensively" and "intimately" involved in the management, operation and supervision of SBI.
• The court focused heavily on the management fee offset, characterizing it as the "economic benefit" that most clearly distinguished the Fund from an ordinary, passive investor.
– "It is one thing to manage one's investments in businesses. It is another to manage the businesses in which one invests"
– "Under Delaware law, it is clear that the GP of [the Fund], in providing management services to SBI, was acting as an agent of the Fund."
• The standard used by the court was not taken from tax precedent, but was held to be not inconsistent with such precedent, including the Supreme Court's decisions in Groetzinger (1987), Higgins (1941) and Whipple (1963).
The Sun Capital Holding
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• The Sun Capital decision emphasized the fee offset arrangement as a key factor in its holding
• Practitioners have historically expressed concern that the offset arrangement gives rise to the characterization of the offending fees as having been received by the fund itself in respect of services performed "on behalf of" the fund
• For this reason, management fee offsets are commonly carved out of many LP covenants.
• But isn't this just an economic arrangement? How does it change the nature of the Fund's activities?
Management Fee Offset
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• A Private Equity Fund that invests in securities of portfolio companies treated as corporations for U.S. tax purposes is not engaged in a trade or business, notwithstanding the substantial managerial activities that the GP/Manager may conduct.
• This is based on the fact that a PE Fund acquires portfolio companies as investments with a view to long-term appreciation, doesn’t execute enough trades to be a "trader," and doesn’t have the customers that are necessary for "dealer" status.
Traditional View
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• Sponsor – Ordinary income on gains?
– §1221(a)(1)
– Investor vs. Trader vs. Dealer. "Promoter"?
• Tax-Exempt Investors – UBTI
– Statutory exemption (§512(b)(5))
• Significance of "customers" in both of these categories. Further guidance would likely be necessary
• Non-U.S. Investors – ECI
– Eligibility for trading safe harbor of §864?
• Management fee deductions?
– Possible pro-taxpayer overall result
What are the potential ramifications if a PE Fund is treated as engaged in a business for tax purposes?
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• ECI/UBTI covenants and "opt-outs," availability of blocker/AIV structures – Typically, the covenants and the definition of "ECI"
carve out the activities of the Fund itself, as well as the management fee offset, which is typically contained in the Investment Advisory Agreement
• LP waiver of unapplied balance of fee offset – Usually elected upfront
– Does it really help?
Common "Trade or Business" Provisions in Fund Documents
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• Case decided under ERISA, not IRC
• Fund Sponsors should focus on covenants that go to this issue
• Courts can read PPMs and other marketing materials
• The court did not really address the "promoter"/"corporate developer" argument
– "Promoter" characterization would have a more significant impact on PE funds
– Possible change to taxation of carry without legislative action?
Key Takeaways
FOREIGN ACCOUNT TAX
COMPLIANCE ACT (FATCA)
Update
53
All Together Now: FATCA
• Who Are You? (Townsend)
• U.S. person
• FFI
• NFFE
• I Don’t Know if I’m Coming or Going (Wainer/Fien)
• U.S. person making payments
• FFI making payments
• FFI or NFFE receiving payments
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Y’all Ready For This?
• June 30, 2014
• Last day of grandfather period
• Accounts already open are “preexisting accounts”
• July 1, 2014
• Withholding begins on withholdable payments
• New account opening procedures required
• March 31, 2015
• Reports due with respect to calendar year 2014
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Sponsored Investment Entities
• In general – Treas. Reg. 1.1471-5(f)(1)(i)(F)
• “Registered deemed-compliant FFI”
• Sponsoring entity must:
• Register with IRS
• Register sponsored entity with IRS (GIIN)
• Be authorized to manage the FFI and enter into contracts on behalf of the
FFI (such as a fund manager, trustee, corporate director, or managing
partner)
• Agree to perform all participating-FFI requirements on behalf of the
sponsored FFI
• Sponsored, closely held investment vehicles – Treas. Reg.
1.1471-5(f)(2)(iii)
• “Certified deemed-compliant FFI”
• 20 or fewer individuals own all debt and equity in FFI (disregarding
debt owned by certain FFIs), or 100% of equity owned by such FFI
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Scott W. Naidech: Scott is a Partner at Chadbourne & Parke LLP. He
represents domestic and international sponsors (with a particular focus on Latin
America and other emerging markets) in the structuring, establishment and
operation of their private equity funds. He has formed buyout, growth capital,
real estate, energy, infrastructure, mezzanine and venture capital funds, among
others, ranging in size from $50 million to over $16 billion of committed capital.
He also advises clients on leveraged buyouts, acquisitions, recapitalizations and
divestitures, and general corporate matters. In 2013, he was recognized in Best
Lawyers in America and The Legal 500 for his work in private funds law. He can
be reached at [email protected].
Edouard S. Markson: Ted is a tax partner at Chadbourne & Parke LLP with
extensive experience in financing transactions, mergers and acquisitions, and
joint ventures. He has represented a wide variety of private equity funds in tax
structuring related to both fund formation and transactional matters. He is listed
in The Legal 500 (2008, 2009 and 2010) for tax. He can be reached at
57
Adam Gale: Adam is a Partner in the New York office and Co-Chair of
the Investment Funds Group of Mintz Levin Cohn Ferris Glovsky and
Popeo P.C. He forms and structures, and provides regulatory and
compliance advice to, private equity funds, real estate funds, hedge
funds, and registered funds. He also provides regulatory advice to
broker-dealers and banks. Adam represents both well-established and
start-up entities. Adam also represents a number of major institutional
investors in their investments into private funds, as well as family
offices. He can be reached at: [email protected].
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Jonathan Talansky: Jonathan is a Partner at Mintz Levin Cohn Ferris
Glovsky and Popeo P.C. He specializes in federal income taxation, with
an emphasis in financial instruments, mergers and acquisitions, capital
markets and investment funds. Jonathan’s work in M&A transactions
includes leveraged buy-outs, joint ventures, public company mergers,
and leveraged spin-offs. Jonathan has advised private equity and real
estate opportunity funds in connection with fund formation and structure
issues, side-letter negotiation and deal execution. Jonathan has advised
on various financial products such as hybrid debt instruments, call spread
convertibles, equity derivatives and investment units. He also regularly
reviews bank loan credit agreements and offering documents relating to
securities such as common stock and convertible debt. He was recently
recognized as a Rising Star in Tax by New York Super Lawyers.
He can be reached at: [email protected].
MINTZ LEVIN Mintz Levin Cohn Ferris Glovsky and Popeo PC
ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN TO BE USED,
AND CANNOT BE USED, BY ANY PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING
PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING
OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.
