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.
Posts Tagged ‘Private Equity’
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.
These Davis Polk flowcharts are designed to assist banking entities in identifying permissible and impermissible covered fund activities, investments and relationships under the final regulations implementing the Volcker Rule, issued by the Federal Reserve, FDIC, OCC, SEC and CFTC on December 10, 2013.
The flowcharts graphically map the key elements of the covered fund provisions in the final regulations. An introduction to the new covered funds compliance requirements will also be available soon as a standalone module and in a single combined document.
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.
On December 10, 2013, five U.S. financial regulators (the Agencies) adopted a final rule implementing the Volcker Rule.  The text of the final rule and its accompanying preamble are available here.  The Volcker Rule was created by Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) and prohibits banking entities from engaging in “proprietary trading” and making investments and conducting certain other activities with “private equity funds and hedge funds.”
In October 2011, the Agencies released a proposed rule to implement the Volcker Rule. Our analysis of the proposed rule is available here.  The proposal generated extensive and diverse feedback from industry participants, policymakers and the public. After more than two years of deliberation, the final rule reflects the efforts of the Agencies to incorporate this feedback to the extent consistent with statutory requirements and policy objectives.
In the paper, No Free Shop: Why Target Companies in MBOs and Private Equity Transactions Sometimes Choose Not to Buy ‘Go-Shop’ Options, which was recently made publicly available on SSRN, my co-authors (Adonis Antoniades and Donna Hitscherich) and I study the decisions by targets in private equity and MBO transactions whether to actively “shop” executed merger agreements prior to shareholder approval.
We construct a theoretical framework for explaining the choice of go-shop clauses by acquisition targets, which takes account of value-maximizing motivations, as well as agency problems related to conflicts of interest of management, investment bankers, and lawyers. On the basis of that framework, we empirically investigate the determinants of the go-shop decision, and the effects of the go-shop choice on acquisition premia and on target firm value, using a regression methodology that explicitly allows for the endogeneity of the go-shop decision. Our sample includes data on 306 cash acquisition deals for the period 2004-2011.
We allow many aspects of target firms to enter into their go-shop decision, including the nature of their legal counsel, their ownership structure, their size, and various other firm, and deal characteristics. We find that legal advisor characteristics, ownership structure, and the extent to which the transaction was widely marketed prior to the first accepted offer all matter for the go-shop decision.
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 the last edition of the Digest, we discussed the issues and alternatives faced by private equity sponsors when taking a portfolio company public. An IPO exit can be an attractive option for the appropriate portfolio company, but a private company sale at the right valuation is often more compelling because it provides certainty to a sponsor about the price that it will realize and maximizes the sponsor’s internal rate of return.
Although a private company sale may be an attractive exit, the traditional means of securing a selling sponsor’s post-closing indemnification obligations may decrease a sponsor’s IRR. This issue of the Digest discusses a number of strategies employed, and issues faced, by sponsors when they agree to indemnify buyers of their portfolio companies. These strategies include (i) preparing for a private company sale and sharing liability among other equityholders, (ii) utilizing alternative mechanisms to the traditional escrow account, such as representation and warranty insurance, fund guarantees and letters of credit and (iii) mitigating the risk of liabilities beyond those negotiated and assumed by the sponsor seller in the sale contract.
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.