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Tax Strategies for Limited Partner
Investors in Private Investment Funds Avoiding Tax Traps Through Side Letters and Other "Hidden" Agreements
Today’s faculty features:
1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific
WEDNESDAY, APRIL 13, 2016
Presenting a live 90-minute webinar with interactive Q&A
Kathleen (Kat) Saunders Gregor, Partner, Ropes & Gray, Boston
Elizabeth M. Norman, Partner, Nutter McClennen & Fish, Boston
Cara Howe Santoro, Nutter McClennen & Fish, Boston
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35.
FOR LIVE EVENT ONLY
Tax Strategies for Limited Partner Investors in Private Investment Funds Kat Gregor, Elizabeth Norman & Cara Howe Santoro April 13, 2016
Agenda
Hot Topics
Initial Questions to Ask
Key Tax Issues
Investor-specific Tax Issues
Overview of Common Fund Structures
Key Aspects of Different Fund Types
Economics and Tips for Negotiating Documents
5
Hot Topics: Partnership Audit Reform
6
Partnership Audit Reform: Bipartisan Budget Act of 2015
New law to take effect in 2018 will create potential exposure to non-profits for tax otherwise born by its for profit partners
Entirely new method of auditing and collecting tax from partnerships
Risk of economic distortion: will current partners be left paying tax for former partners?
Limited ability to elect out of new rules: Not applicable if any partner is itself a partnership for tax purposes, but some joint ventures may be eligible
Currently awaiting proposed regulations on actual implementation of new audit and collection procedures
Hot Topics: Other Issues
Fee Waivers
Proposed Regulations
IRS Audits
Carried Interest Legislation
Recent State Initiative
New York
Massachusetts and other states
Update on Federal Proposals
7
Agenda
Hot Topics
Initial Questions to Ask
Key Tax Issues
Investor-specific Tax Issues
Overview of Common Fund Structures
Key Aspects of Different Fund Types
Economics and Tips for Negotiating Documents
8
What is the Investment?
What kind of fund is it?
Hedge Fund
Fund of Funds
Private Equity or Leveraged Buyout Fund
Real Estate Fund
Venture Fund
Mezzanine Debt Fund
How is the fund structured?
What are the tax consequences to the structure?
9
Other Fund Characteristics
Other important fund characteristics to consider:
U.S.-based or not?
Focus on U.S. investments (or otherwise)?
Is the fund an investor or conducting a trade or business?
Investor: possible disallowance of fund manager fees for US investors (Section 212)
Trade or business: fees may be deductible under Section 162, but UBTI, ECI and CAI concerns
10
What type of investor are you?
U.S. Taxable Individual or Corporation
U.S. State or Local Government
Pension Funds
U.S. Tax-Exempt Investors
Corporate Pension Plans
University and College Endowment Funds
Private Foundations
Charity Endowment Funds
IRAs
11
What type of investor are you? (cont’d)
Non-U.S. Investors Individuals
Non-US entities treated as corporations for US income tax purposes
Pension funds (not taxed in home country)
Non-US Government Investors (Section 892) Sovereign Wealth Funds
Pension Funds
12
Agenda
Hot Topics
Initial Questions to Ask
Key Tax Issues
Investor-specific Tax Issues
Overview of Common Fund Structures
Key Aspects of Different Fund Types
Economics and Tips for Negotiating Documents
13
Key Tax Issue: To Block or Not to Block? 14
What is a blocker corporation?
A “blocker corporation” is a corporation that is placed between the tax-exempt or foreign investors and the source of UBTI and ECI
The blocker corporation incurs and pays tax (if applicable) on the operating income that is allocated to it from the pass-through entity, and thus “blocks” such income from reaching the tax-exempt and foreign investors
Any net after-tax proceeds distributed by the blocker corporation to the tax-exempt and foreign investors should be non-UBTI, non-ECI distributions
U.S. Tax Consequences of a Blocker 15
The U.S. tax consequences of holding a pass-through investment through a blocker corporation depends on the chosen structure
Specifically: Whether the blocker is domestic or foreign Whether the blocker holds all or only a subset of the fund
investments Whether the blocker resides above, below, or parallel to the
Fund The types of investments (such as real estate) held by the
blocker Whether the blocker makes any special elections, such as REIT
status
16
Structures Using Blocker Corporations
There are various types of blocker structures, for example:
Feeder, in which the blocker is positioned “above the Fund” as a direct investor in the Fund
Subsidiary Blocker, in which the blocker is positioned “below the Fund” as a wholly-owned subsidiary of the Fund to invest in one or more portfolio entities
Parallel Blocker or Fund, in which the blocker is a parallel Fund that is formed to invest side-by-side with the main Fund
Alternative Investment Vehicle, in which the blocker invests alongside the fund, and certain investors (such as exempts or non-U.S. investors), invest through the AIV, rather than through the Fund
16
Key Tax Issues: Tax Payment and Filing
Foreign withholding, tax payment and filing obligations Will the GP provide any comfort that the LP will not be
subjected to tax payment or filing obligations in a non-U.S. jurisdiction?
Will the GP undertake to minimize foreign withholding taxes and/or assist the LP in obtaining refunds of amounts erroneously withheld (or amounts that can be reclaimed by law)?
Blockers can also be used to block direct payment or filing obligations
FATCA Increased need for information from investors Risk of withholding and indemnification issues
17
Other Key Tax Issues
Tax Information Reporting Will the GP agree to provide K-1s or other informational reporting by a
specific time that is acceptable to the LP? Will the GP provide enough information to the LP?
U.S. Tax Withholding Depending on the LP, you may want to request that the GP notify the LP prior
to withholding any U.S. tax with respect to that LP’s interest. You should confirm that the Fund will comply with FATCA requirements,
including ensuring that non-U.S. Funds (and any non-U.S. AIVs and SPVs) will take steps to avoid additional withholding as a result of its status as a “Foreign Financial Institution.”
How is Withholding treated? As a distribution? If more than the LP’s distribution for a set period, does it
convert to a loan?
Do the tax matters partner/partnership representative provisions appear to give the GP too much power or require too much of the LP in the event of an audit?
18
Agenda
Hot Topics
Initial Questions to Ask
Key Tax Issues
Investor-specific Tax Issues
Overview of Common Fund Structures
Key Aspects of Different Fund Types
Economics and Tips for Negotiating Documents
19
U.S.
Taxable
C Corp.
35% c.g. and o.i.
Fund L.P.
Portfolio
Corp.
Portfolio
LLC
- Gain on interest sale
- Gain on asset sale
- Interest
- Gain on debt sale
U.S. Taxable
Individual
- 20% c.g.
- 39.6% o.i.
- 3.8% nii
- Gain on stock sale
- Dividends
- Interest
- Gain on debt sale
No Fund Blocker desired
Unblocked investor can also claim tax credits
and treaty benefits
U. S. Taxable Individuals and Corporations 20
U. S. State and
Local Government
0% U.S. tax rate
Fund L.P.
Portfolio
Corp.
Portfolio
LLC
Gain/income
No Fund Blocker desired
Unblocked can also claim treaty benefits
Gain/income
U. S. State and Local Government
21
U.S. Tax-Exempt
0% U.S. tax rate
Fund L.P.
Portfolio
Corp.
Portfolio
LLC
- Gain on interest sale (c.g.)
- Interest
- Gain on debt sale (c.g.)
- Gain on stock sale
- Dividends
- Interest
- Gain on debt sale
No Fund Blocker desired
Unblocked investor can also claim treaty benefits
- Gain on sale of
noninventory property
U. S. Tax-Exempt Investors 22
U.S. Tax-Exempt
35% U.S. tax rate
Fund L.P.
Portfolio
LLC
Fees earned by L.P.
Fund Blocker often desired
Unrelated business taxable income (UBTI)
- Operating income
- Gain on sale of inventory
U. S. Tax-Exempt Investors (cont’d) 23
U.S. Tax-Exempt
35% U.S. tax rate
Fund L.P.
Portfolio
Corp.
Portfolio
LLC
Debt-Financed:
- Gain on interest sale
- Interest
- Gain on debt sale
Debt-Financed:
- Gain on stock sale
- Dividends
- Interest
- Gain on debt sale
Debt-financed income is UBTI
Fund Blocker often desired
Debt-Financed:
- Gain on sale
of any property
- Operating Income
U. S. Tax-Exempt Investors (cont’d) 24
U.S. Tax-Exempt
Non-U.S. or U.S.
Feeder Fund
Non-U.S.
Investments
(No UBTI)
U.S.
Investments
(No UBTI)
U.S.
Corp. Blocker
Investments
(UBTI)
U. S. Tax-Exempt Investors (cont’d) Parallel Fund Structure
25
U.S. Tax-Exempt Investor Parallel Fund Structure
Why use non-U.S. Feeder?
Not have to report non-U.S. investments
Can avoid "controlled foreign corporation" (CFC) treatment where substantial investors are non-U.S. investors and fund owns 50% or more of the non-U.S. portfolio company
Minimize risk that Fund interest will be treated as part of non-U.S. individual investor’s estate for U.S. estate tax purposes
26
U.S. Tax-Exempt Investor (cont’d) Parallel Fund Structure
Why use U.S. Feeder?
Easier to claim U.S. treaty benefits—only need to issue W-8BEN to U.S. Feeder
Will treaty benefits "flow-through" a non-U.S. Feeder to a non-U.S. investor? Generally, non-U.S. entity must be fiscally transparent for non-U.S. as well as U.S. purposes
See also Section 894(c).
27
Non-U.S. Investors
U.S. tax goals
Avoid having to file a U.S. income tax return
Limit U.S. tax on “Effectively Connected Income” (ECI).
If ECI:
Must file U.S. federal, state, and local returns
Must pay income tax at regular, federal, state and local rates
Non-U.S. corp must also pay U.S. 30% “branch profits” tax
Limit U.S. tax on FDAP income
30% U.S. withholding tax rate unless U.S. tax treaty applies
Claim U.S. treaty benefits where possible
28
Non-U.S. Investors (cont’d)
Effectively Connected Income (ECI) is income recognized by a non-U.S. person that is effectively connected with a business carried on in the U.S.
Does fund have a loan origination business?
“Securities trading safe harbor” protects offshore funds
ECI includes share of operating income from a pass-through entity conducting business in the U.S.
Non-U.S. partners are deemed engaged in a U.S. business
Sale of partnership interest in partnership that generates ECI: IRS takes the position that gain is ECI
FIRPTA income treated like ECI
29
Non-U.S. Investor
0% U.S. tax rate
Fund L.P.
Portfolio
Corp.
Portfolio
LLC
U.S. Source:
- Portfolio interest
- Gain on debt sale
No Fund Blocker desired
Portfolio
Corp.
Non-U.S.
Source:
- Gain/income
U.S. Source:
- Gain on stock sale
Non-U. S. Investors (cont’d) 30
Non-U.S. Investor
30% U.S. tax rate (unless treaty applies)
Fund L.P.
Treaty benefits can be
claimed
Non-U.S. pension fund from
a treaty country – 0% U.S.
tax rate
No Fund Blocker desired Portfolio
Corp.
U.S. Source:
- Dividends
- Non-portfolio interest
Non-U. S. Investors (cont’d) 31
Non-U.S. Investor
35%/39.6% U.S. tax rate
Fund L.P. Fund Blocker usually
desired
Gain on interest sale (ECI)
Portfolio
LLC
U.S. Source:
- Gain on sale of operating assests (ECI)
- Operating income (ECI)
Non-U. S. Investors (cont’d) 32
Non-U.S. Investor
Non-U.S. or U.S.
Feeder Fund
Non-U.S.
Investments
(No ECI)
U.S.
Investments
(No ECI)
U.S.
Corp. Blocker
U. S.
Investments
(ECI)
Non-U. S. Investors (cont’d) Parallel Fund Structure
33
UBTI and ECI—Not Exactly the Same
Some investments may generate UBTI, but not ECI
Debt-financed income (including stock sales, dividends, and interest)
Some investments may generate ECI, but not UBTI
Sale of partnership interests where partnership conducts a U.S. trade or business
Investments in U.S. real property holding corporations (holding 50% or more of gross assets in U.S. real property)
Loan commitment fees not UBTI, but may be ECI
Accordingly, a blocker that avoids all ECI may be too broad for a U.S. tax-exempt investor; and a blocker that avoids all UBTI may be too broad for a non-U.S. Investor
34
Non-U.S. Governmental Investors
Non-U.S. Governments (including their controlled entities) are generally exempt from U.S. tax under IRC Section 892 on income from investments from securities, except income from the conduct of a "commercial activity" (CAI)
If a controlled entity has CAI (either U.S. or non-U.S.), it could lose its Section 892 exemption (but recent relief in proposed regulations—“inadvertent” and “de minimis” standards; interest in non-controlled LP)
Investments in operating partnerships generate CAI
Non-US Government owning U.S. real property or 50% or more of the stock of a United States Real Property Holding Corporation (USRPHC) can generate CAI
35
Non-U.S. Government
0% U.S. tax rate
Fund L.P.
Portfolio
Corp.
Portfolio
LLC
U.S. Source:
- Interest
- Gain on debt sale
No Fund Blocker desired
Portfolio
Corp.
Non-U.S.
Source:
- Gain/income
U.S. Source:
- Gain on stock sale
- Interest
- Dividends
Non-U. S. Governmental Investors (cont’d) 36
Non-U.S. Government
35% U.S. tax rate
Fund L.P.
Fund Blocker desired
Gain on interest sale (CAI)
Portfolio
LLC
U.S. Source:
- Operating income (CAI)
- Gain on sale of operating assets (CAI)
Non-U. S. Governmental Investors (cont’d) 37
Non-U.S. Government
Non-U.S. or U.S.
Feeder Fund
Non-U.S.
Investments
(No CAI)
U.S.
Investments
(No CAI)
U.S.
Corp. Blocker
U. S.
Investments
(CAI)
Non-U. S. Governmental Investors (cont’d) 38
ECI, FDAP and CAI—Not Exactly the Same
Some investments may generate ECI but not CAI
Investments in U.S. real property holding corporations (USRPHC) (holding 50% or more of gross assets in U.S. real property)
Only CAI if Non-U.S. Government holds 50% of more of USRPHC
Some investments may generate CAI but not ECI
Sale at gain of non-U.S. corporate entity controlled by Non-U.S. Government, which would be a USRPHC if formed in the U.S., is taxable CAI, but would not be ECI
Some investments may generate FDAP withholding for non-U.S. Investors, but not for Non-U.S. Governmental Investors
39
Agenda
Hot Topics
Initial Questions to Ask
Key Tax Issues
Investor-specific Tax Issues
Overview of Common Fund Structures
Key Aspects of Different Fund Types
Economics and Tips for Negotiating Documents
40
Parallel Fund Structure
Most tax efficient fund structure generally is to use separate parallel funds for each type of investor
Administrative costs
Should each investment have a newly-formed separate blocker?
This can avoid U.S. dividend withholding tax on exit
But if a single blocker is used for multiple investments, income and gain from one investment can be offset by losses from another
Risk of aggregation of different fund entities used in parallel/AIV structure due to applying carried interest across all funds Sun Capital decision
41
Main Fund
Other Investors
Parallel Fund
Portfolio
LLC
Intermediate
Partnership
GP
Electing U.S. Tax-Exempt, Non-U.S. and Non-U.S.
Governmental Investors
Blocker Corp.
Portfolio Corp.
Carry Carry
Simplified Parallel Fund 42
AIV “A”
Other Investors
AIV “B”
Portfolio
LLC
Intermediate
Partnership
GP
Main Fund
All Investors
Blocker Corp.
Portfolio Corp.
Carry
Carry
Electing U.S. Tax-Exempt, Non-U.S. and Non-U.S.
Governmental Investors
Alternative Investment Vehicle 43
Other Investors
Portfolio
LLC
GP
Electing U.S. Tax-Exempt, Non-U.S. and Non-U.S. Governmental Investors
Main Fund L.P.
Feeder Fund
(Offshore)
Portfolio Corp.
Feeder Fund – No Flexibility 44
Non-U.S./U.S. Tax-Exempt
Investors
Fund
U.S.
Corp. Blocker
Taxable Investors
Portfolio
LLC
Taxable investor capital
Sensitive investor capital
Subsidiary Blocker Structures 45
Agenda
Hot Topics
Initial Questions to Ask
Key Tax Issues
Investor-specific Tax Issues
Overview of Common Fund Structures
Key Aspects of Different Fund Types
Economics and Tips for Negotiating Documents
46
Investing in Hedge Funds
• Hedge Funds
– Lightly regulated
– Sold in private offerings
– Sophisticated investors (e.g., “qualified purchaser”)
– Variety of investment approaches/risk profiles, often highly risky, and often employ leverage
– Often hold many small positions in public securities, with some exposure to private, illiquid investments
– Investors typically can invest/exit on a periodic basis (e.g., monthly, quarterly, annually) based on NAV, although, limitations may apply (e.g., “gate” provisions, lock-up periods, withdrawal fees)
47
Investing in Hedge Funds, cont’d
Onshore/offshore structure
Typically Cayman “master fund” – taxed as a partnership
Onshore feeder – Delaware LP or LLC
Taxable investors invest here
Simplifies reporting for U.S. taxable investors
Offshore feeder – Cayman company (or LP that box checks to be treated as a corp)
Tax-Exempts and Non-U.S. investors invest here
Offshore feeder may make sense for taxable investors given Section 212 limitations on deductibility of management and other fees and NII Medicare tax
48
Types of U.S. Funds – Hedge Funds (cont’d)
• Issues for taxable investors
– Is the fund a “trader” for tax purposes?
• deductibility of management fees and expenses
– GP’s performance compensation structured as a partnership allocation of profits
• If paid as fee and fund is not trader – Section 212 deductibility limitations
– Management fees and other expenses should be paid at the master fund level
• Risk that under logic of Rev. Rul. 2008-39, if paid at the feeder level may not be deductible.
– Investment in offshore feeder may offer tax advantages
• Deferral of 3.8% Medicare tax on NII until distribution
• Effective deduction of management fees in non-trader fund
49
Types of U.S. Funds – Hedge Funds (cont’d)
• Issues for Non-U.S./U.S. Tax-Exempt investors
– Trading in stocks and securities safe harbor for feeder
– Offshore feeder is effective “blocker” for UBTI and ECI
• But corporate income tax and branch profits tax on any ECI
– Non-U.S. government investors cannot access 892 benefits through offshore feeder
– Allocation of FATCA risk
50
Investing in Private Equity Funds
Private Equity Funds Very lightly regulated Sold in private offerings Sophisticated investors
Investments consist of a relatively small number of controlling equity positions in private corporations
Investors invest at inception and receive cash only as underlying investments are sold and proceeds distributed
Limited term (e.g., 10-12 years)
Typically no leverage - Bridge financing not uncommon
Illiquid
51
Investing In Real Estate Funds
Real Estate Funds Very lightly regulated Sold in private offerings Sophisticated investors
Structure may vary significantly fund to fund, from private-equity type funds that make a small number of large investments, to funds that make a large number of investments in smaller deals
Funds may also be structured as REITs, or incorporate REITs into a partnership structure
May or may not have limited term; varying degrees of liquidity; many funds will utilize leverage at the fund level
52
Real Estate: ECI and UBTI-driven Structures
514(c)(9) and Real Estate Investments Exception to debt-financed UBTI rule for certain acquisition
indebtedness of Educational Organizations, Qualified Retirement Plans, and Certain Related Organizations, used to purchase real estate.
Note that it does not apply to other exempts, including charitable foundations and non-Educational charitable organizations
To fall within this exception, the debt must meet certain requirements, including (but not limited to) the following:
Purchase Price fixed as of date of acquisition or improvement of property
Payment of principal and interest (and timing of payment) not dependent on the revenue, profits or income derived from the property (Continued…)
53
– UBTI: When an investment is held through a partnership: satisfy both the “Qualified Allocations” and “Fractions Rule” with respect to allocations from the partnership
• The Qualified Allocations Rule generally requires that allocations meet the “substantial economic effect provisions of section 704(c) of the Code, and fall within the definition of qualified allocation under section 168(h)(6) of the Code.
• The Fractions Rule is satisfied if the organization receives the same distributive share of each item of partnership income, gain, loss, deduction, credit, or basis. The purpose is generally to prevent shifting of items among partners.
• Note that if you represent a Fund-of-Funds, the investors in the Fund-of-Funds will only benefit if the Fund-of-Funds itself meets these requirements.
Real Estate: ECI and UBTI-driven Structures
54
Real Estate: ECI and UBTI-driven Structures, Cont’d
- ECI: Risks for non-U.S. investors in US real estate, even through corporations.
In general, non-US persons generally do not pay U.S. tax on disposals of stock or securities of U.S. issuers
FIRPTA (Foreign Investment in Real Property Tax Act) is an exception to this general treatment
FIRPTA imposes a tax on gains realized from the disposition of a U.S. real property interest, which includes direct real estate holdings and:
Partnership/flow-throughs that hold U.S. real estate
Interests in a “U.S. real property holding corporation” (USRPHCs)
Direct or indirect rights to share in proceeds, appreciation or profit of U.S. real estate
55
Real Estate: Risks of ECI
FIRPTA gains (and other “trade or business” gain) are treated as ECI, which most non-U.S. investors want to avoid. Why?
Tax imposed at U.S. tax rates
Collected partially through withholding
Non-US person with ECI (including FIRPTA gain) also incurs a US federal income tax filing obligation
What about branch profits tax? Requires a close look at the fund structure; can push tax rate over 50%
Possible Solutions? US blockers (but note that the U.S. blocker itself may be a USRPH which
would trigger FIRPTA gain if sold, but that’s a pretty unlikely exit). Doesn’t solve tax or filing completely, but pushes it down a level. Can leverage blocker for greater efficiency.
Depending on structure, REITs can help minimize taxation, but need to be “domestically controlled”
56
Sample FIRPTA Structure
Non-U.S. Fund
Non-U.S.
Investments
(No FIRPTA)
U.S.
Non-Real
Estate
Investments
(No FIRPTA)
U.S.
Corp. Blocker
U. S. Real
Estate
Investments
57
FIRPTA Structures (cont’d)
Non-U.S. Fund
Non-U.S.
Investments
(No FIRPTA)
U.S.
Non-Real
Estate
Investments
(No FIRPTA)
U.S.
Corp. Blocker
U. S. Real
Estate
Investments
Offshore Blocker
Loan
Financing the U.S. Blocker: Potential
Complications (Withholding Tax,
Earnings Stripping, AHYDO, Section 267)
Interest
58
Non-U.S. Funds with U.S. Investments
• Same general structural considerations as above
– Non-U.S. Investors will be focused on ECI
– If fund holds real estate assets, FIRPTA may also apply
– Special structuring requirements for non-U.S. investors
– Treaty planning and additional documentation requirements
– Non-U.S. corporation in structure (including offshore blocker entity)? Potential branch profits tax
• U.S. source income = FATCA implications for fund and its investors
59
Venture Funds
Venture Funds Very lightly regulated Sold in private offerings Sophisticated investors
Investments consist of positions in companies that are in the early stages of development
Often will structure its investments as non-controlling, preferred interests
Tend to make more investments than PE funds
60
Venture Funds (cont’d)
Higher return, higher risk
Similar tax concerns to PE funds
Focus on different types of investments Preferred stock and convertible debt
Pass-through targets are more common
Fund may have more leverage over portfolio company Better access to information (e.g., CFCs, PFICs)
Increased control over tax structuring on exit
Portfolio companies more likely to use complicated compensation structures Options, SARs and restricted stock
61
Mezzanine Debt and Other Credit Funds
Can be structured similar to either PE fund or a hedge fund, depending on investment horizon
Complicated structuring alternatives
CLOs and other structured products
Key issue for non-U.S. investors: portfolio interest expense exclusion to FDAP withholding
Increasing risk of ECI from loan origination
YA Global case
Example of IRS following SEC enforcement
62
Fund of Funds
All of the above! Concerns driven by investor base and asset classes
Evergreen structures create particular complexity
Tiered filing obligations Can cause delays in reporting information to investors
Less control over tax attributes of underlying funds PFICs and CFC
Information rights
Protections against foreign tax filing and payments
Higher reliance on principles in side letters
63
Agenda
Hot Topics
Initial Questions to Ask
Key Tax Issues
Investor-specific Tax Issues
Overview of Common Fund Structures
Key Aspects of Different Fund Types
Economics and Tips for Negotiating Documents
64
Carried Interest 65
General partner entitled to a profits participation (“carried interest,” “promote”, “performance allocation”)
Distribution waterfall of fund’s operating agreement sets out amount of carried interest and manner in which it is distributed: usually set percentage of profits (typically 20%, can be higher or
lower)
typically subordinated to the return of capital contributions and the preferred return to the fund’s investors
Timing of payment unpredictable
depends on profitability of fund’s investments
Lower in priority to payments to fund’s investors
Generally taxed as a capital gain to the general partner
Management Fees 66
Conflicting Interests of Managers and Investors
The key economic incentive for investors in a private equity fund is the opportunity to earn a high rate of return on their invested capital.
The key economic incentives for sponsors of the fund, on the other hand, are to earn management fees and a profit participation on the fund’s investments (i.e., the carried interest).
Management Fees 67
The fund’s investment manager or advisor will receive a management fee (typically 1.5%-2% of total committed capital) for its investment advice rendered to the fund (and to the fund’s general partner)
Management fees are: In addition to carried interest Used to cover overhead costs of a fund’s operations Paid in regular intervals (usually on quarterly or semi-annual basis) Usually taxed as ordinary income Generally paid from either (i) the investors’ capital contributions to the
fund or (ii) the proceeds from the fund’s investments
If investors make capital contributions to the fund to cover management fees, such contributions may reduce unfunded capital commitment
Deviations from Standard Fee Structures 68
Management fees often deviate from the market rate of 1.5%-2% of the fund’s capital commitments: Larger funds and funds with less oversight and monitoring
requirements typically charge lower management fees.
Mezzanine Funds — historically 1.5% management fees.
Smaller, First-Time Funds — may have management fees of 2.5%.
Real Estate Funds — management fees often charged based on the amounts invested in properties.
Side-by-side Vehicles — investors in the co-investment entities are often charged less than 2%.
Fund managers sometimes forego market rate management fees for increased carried interest
Considerations for Fee Structures
Management Fee Waiver
Management Fee Waiver Design To ensure interest is a “profits” interest rather than a “capital” interest To reduce risk of “disguised payment for services”
New Fee Waiver Regulations Many pre-existing fee waivers won’t work IRS intent on reclassifying allocations of profits into compensation
where there is a compensatory intent If a GP keeps fee waivers, likely to change substantially
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Considerations for Fee Structures (cont’d) 70
Other Fees and Management Fee Offsets Reduction of management fees if the investment manager receives
transactional fees directly from the fund’s portfolio companies or other activities.
Management fees are routinely reduced by 50%–100% of transaction fees, which include:
Break-Up Fees
Directors Fees
Advisory and Similar Fees
Acquisition and Disposition Fees
Affiliate Service Fees
Risk of reclassification by the IRS
Sun Capital decision (ERISA context… but apply more broadly?)
Tax Distribution Provisions
Intended to ensure that the GP (and other partners) are able to pay tax on “phantom” income
Key Questions: Who gets them? Just the GP or all investors?... can be important for
taxable investors
Are there limitations on cash flows (i.e., to avoid borrowing)?
How often will the GP receive tax distributions?
How is the “tax” calculated?
Hypothetical or actual?
What state or locality is assumed?
Cumulative or non-cumulative?
Coordination with distribution waterfall and clawback (i.e., is it treated as an advance?)
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Allocations and Clawbacks
Compare distributions, allocations and liquidation provisions to check whether structure achieves the intended economics Allocations must have substantial economic effect or be in accordance
with the partners interests in the partnership under section 704(b) of the Code in order to be respected…
GP Clawbacks – Key Questions:
Is the GP required to return excess distributions? If so, is the excess calculated before or after the GP’s tax is taken into
consideration? Does the Clawback appear to cover the full amount and is it supported by
guarantees from principals of the GP?
LP Clawbacks – Key Quesitons:
Is the LP required to return any portion of its distributions? Under what circumstances and for how long?
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Negotiating GP Undertakings
Level of Undertaking:
Will (flat), Reasonable Best Efforts, Reasonable Efforts, or Commercially Reasonable Efforts?
Nature of Undertaking:
Minimize UBTI or ECI, avoid UBTI or ECI, avoid investments that generate UBTI or ECI, or maximize after-tax returns of tax-exempt or non-U.S. investors?
Any caveat for GP discretion?
All investors or class of investors? (cf “maximize after-tax returns to the limited partners” with above)
Act in best interests of Fund, investors overall or class of investors?
Carve-out for management fee offset, or any other particular activity of a fund?
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Negotiating GP Undertakings (cont’d)
Example
(note: this is an actual example of a GP-friendly provision proposed by GP’s counsel; provisions vary greatly)
The General Partner shall use commercially reasonable efforts to structure Portfolio Investments in a manner that will not result in the realization by any Tax-Exempt Partner of more than a de minimis amount of UBTI, other than UBTI that may result from reductions in Management Fees pursuant to Section 7.2.
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Side Letters & Other Negotiation Strategies
Key Tax Issues commonly addressed
PFIC/QEF election and CFCs
Foundation issues
ERISA issues
MFN clauses
Prohibited transactions
892 Non-U.S. Governmental Investors
Non-U.S. investor-specific issues
Tax reporting
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Questions?
Kathleen (Kat) Saunders Gregor
Ropes & Gray
Elizabeth M. Norman
Nutter McClennen & Fish
Cara Howe Santoro
Nutter McClennen & Fish