The tax status of so-called “carried interests,” held by private equity fund sponsors (and benefitting, in particular, the individual managers of those sponsors) is the subject of this post. A decision by the U.S. Court of Appeals for the First Circuit holding that a private equity fund was engaged in a trade or business for purposes of the withdrawal liability provisions of ERISA (Employee Retirement Income Security Act) has caused considerable comment on the issue of whether a private equity fund might also be held to be in a trade or business (and not just a passive investor) for purposes of capital gains tax treatment on the sale of its portfolio companies. Proposed federal income tax legislation, beginning in 2007 and continuing into 2013, also has raised concern as to the status of capital gains tax treatment for holders of carried interests. The following post addresses both of these developments.
Archive for the ‘Private Equity’ Category
In our recent NBER working paper, Valuing Private Equity, to value PE investments, we develop a model of the asset allocation for an institutional investor (LP). The model captures the main institutional features of PE, including: (1) Inability to trade or rebalance the PE investment, and the resulting long-term illiquidity and unspanned risks; (2) GPs creating value and generating alpha by effectively managing the fund’s portfolio companies; (3) GP compensation, including management fees and performance-based carried interest; and (4) leverage and the pricing of the resulting risky debt. The model delivers tractable expressions for the LP’s asset allocation and provides an analytical characterization of the certainty-equivalent valuation of the PE investment.
In the past two decades, private equity buyout transactions have grown from a niche phenomenon to a ubiquitous form of corporate ownership (e.g., Strömberg, 2008). Traditionally buyouts have involved private equity funds buying companies or divisions from families or conglomerates: such transactions are known as primary buyouts (PBOs). A major trend accompanying the growth of private equity has been the rise of secondary buyouts (SBOs): transactions in which a private equity fund buys a company from another private equity fund. In our paper, The Performance of Secondary Buyouts, which was recently made publicly available on SSRN, we compare buyer returns in SBOs and PBOs.
Private equity deal activity ebbed and flowed, often unexpectedly, in 2013. Despite some slow periods, strong debt and equity markets helped support first nine-months numbers that are well ahead of 2012, although Q4 2013 is unlikely to match Q4 2012, where activity was stimulated by anticipated changes in the tax laws. Successful sponsors again demonstrated their ability to perceive and exploit changing market conditions. Moreover, the private equity industry posted its best fundraising numbers in years. It was a year that showed that Semper Paratus may indeed be the industry’s new motto.
Private equity funds are increasingly using representations and warranties (R&W) insurance and related products (such as tax, specific litigation and other contingent liability insurance) in connection with acquisitions as they become more familiar with the product and its advantages.  Acquirors considering R&W insurance frequently raise concerns about the claims process and claims experience. A recent claim against a policy issued by Concord Specialty Risk (Concord) both provides an example of an insured’s positive claims experience and highlights the possibility for a buyer to recover multiple-based damages under R&W insurance.
R&W Insurance Advantages
Under an acquisition-oriented R&W policy, the insurance company agrees to insure the buyer against loss arising out of breaches of the seller’s representations and warranties. The insurer’s assumption of representation and warranty risk can result in better contract terms for both buyer and seller. For example, the seller may agree to make broader representations and warranties if buyer’s primary recourse for breach is against the insurance policy, and the buyer may agree to a lower cap on seller’s post-closing indemnification exposure as it will have recourse against the insurance policy. In addition, R&W insurance often simplifies negotiations between buyer and seller, resulting in a more amicable, cost-effective and efficient process.
In a recent decision of note concerning the 2012 sale of Morton’s Restaurant Group to Landry’s, Inc., Chancellor Strine of the Delaware Court of Chancery found that a private equity firm with a 28 percent stake in Morton’s was not a controlling stockholder, applied the business judgment rule, and dismissed the stockholder plaintiffs’ challenge to the sale at the motion to dismiss stage of litigation. The Morton’s decision will provide comfort to PE sponsors who hold minority positions in public companies, as it acknowledges the economic reality that even with a finite investment horizon, PE sponsors are incentivized to maximize an exit price and, as a result, bestow a control premium on all stockholders.
In his ruling, Chancellor Strine emphasized the fact that Castle Harlan, the 28 percent stockholder and Morton’s former PE sponsor, had not exercised undue influence over the fulsome nine-month sale process, and that all of Morton’s stockholders received equal consideration in the transaction. The Chancellor explained that this equal treatment among Morton’s stockholders acted as a “safe harbor”; unless there were strong indications to the contrary, he would presume that Castle Harlan’s interest in obtaining the best price in the transaction was aligned with the interests of the other stockholders.
In December 2012, we published an Alert after a Federal District Court concluded that: (1) a private equity fund was not a “trade or business” for purposes of determining whether the fund could be liable under the Employee Retirement Income Security Act of 1974 (“ERISA”) for the pension obligations of one of its portfolio companies and (2) consequently, the private equity fund could not be liable for its portfolio company’s pension obligations under Title IV of ERISA, even if the fund and the portfolio company were part of the same “controlled group.” Our December Alert, which contains background on the issue and a summary of the state of the law through December 2012, may be found here. This post is to advise that the First Circuit Court of Appeals has reversed the 2012 Federal District Court opinion.
In Sun Capital Partners III LP v. New England Teamsters & Trucking Indus. Pension Fund (No. 12-2312, July 24, 2013), the First Circuit Court of Appeals has concluded that: (a) a private equity fund can be a “trade or business” for purposes of determining “controlled group” joint and several liability under ERISA and (b) as a result, the private equity fund could be held liable for the pension obligations of its portfolio company under Title IV of ERISA, if certain other tests are satisfied. Under ERISA, a “trade or business” within a “controlled group” can be liable for the ERISA Title IV pension obligations (including withdrawal liability for union multiemployer plans) of any other member of the controlled group. This “controlled group” liability represents one of the few situations in which one entity’s liability can be imposed upon another simply because the entities are united by common ownership, but in order for such joint and several liability to be imposed, two tests must be satisfied: (1) the entity on which such liability is to be imposed must be a “trade or business” and (2) a “controlled group” relationship must exist among such entity and the pension plan sponsor or the contributing employer.
On April 19, 2012, the Board of Governors of the Federal Reserve System (“Board”) issued a statement of policy (the “Conformance Statement”) clarifying that a banking entity covered by Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the so-called “Volcker Rule”) has until July 21, 2014 (unless extended by the Board) to fully conform its activities and investments to the requirements of that section (the “Conformance Period”).
The Volcker Rule presents the potential for drastic change to covered banking entities through largely banning their participation in proprietary trading or hedge fund and private equity investments. The Volcker Rule itself became effective on July 21, 2012, notwithstanding the lack of a final rule adoption from the five federal agencies charged with its implementation.
In the Conformance Statement, the Board clarified for covered banking entities that they would have a two-year period—until July 21, 2014—in which to “conform all of their activities and investments.” However, the Conformance Statement also places conformance obligations on covered banking entities during the Conformance Period. Below, we review what covered banking entities must do during this period in order to conform their activities to the requirements of the Volcker Rule during the Conformance Period.
It is virtually impossible to obtain accurate historical data on the entire universe of hedge funds. In our paper, Exploring Uncharted Territories of the Hedge Fund Industry: Empirical Characteristics of Mega Hedge Fund Firms, forthcoming in the Journal of Financial Economics, we identify previously unexplored data sources whereby collecting data on fewer than four hundred large hedge fund management firms that do not participate in major commercial databases adds to the observable industry in assets under management (AUM) terms by as much as 34% in 2001 rising to 65% by the end of 2010. Towards the end of our sample period, these nonreporting firms collectively manage US $862 billion of AUM that is missing from the reported US $1,322 billion of AUM managed by firms in the three major commercial databases combined. We manually collect the names and AUMs of large hedge fund firms that do not participate in commercial databases from surveys published by Institutional Investor and Absolute Return+Alpha magazines, which are good sources of information with almost a decade of continuous history. These previously untapped sources of data provide valuable insight into the capital formation process of the industry over the past decade. While commercial databases have successfully depicted data on the growing trend of hedge fund industry’s AUM, from US $278 billion in 2001 to US $1,322 billion in 2010, there is a more important trend in the capital formation process of the industry that has not been considered in the research literature. We show that over this past decade, the AUM of nonreporting mega hedge fund firms has grown from US $118 billion (2001) to US $863 billion (2010). Results point to a rapid growth of mega hedge fund companies opting for privacy dropping out of the voluntary system of reporting to commercial databases. The empirical evidence confirms that a small group of mega hedge fund firms manages the bulk of the assets in the industry. Taken together, this implies that the assets of the hedge fund industry are concentrated in the hands of a small number of mega management firms with rising opacity as their AUM increases.
In Koehler v. NetSpend Holdings Inc., the Delaware Court of Chancery found that the directors of NetSpend likely breached their Revlon duty to obtain the highest price reasonably available for stockholders by pursuing a single-bidder strategy for selling the company. The board’s lack of knowledge as to the company’s value and related failure to contact potentially interested parties set it apart from other single bidder cases such as Plains Exploration, a recent case where the court found a single-bidder sale process to be reasonable. Nevertheless, the Court declined to enjoin the merger because an injunction could risk the stockholders’ opportunity to receive a substantial premium over the market price for their shares.