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Negotiating Private Equity Fund Terms: Structuring Agreement Provisions for Sponsors and Investors

Structuring 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, NOVEMBER 4, 2015

Steven Huttler, Partner, Moderator , Sadis & Goldberg, New York Alex Gelinas, Partner, Sadis & Goldberg, New York Yehuda M. Braunstein, Partner, Sadis & Goldberg, New York David H. Benz, Principal, Deloitte Tax, Los Angeles

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Negotiating Private Equity Fund Terms

The Shifting Balance of Power

November 4, 2015

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

• fferings 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

• f 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

• perations, 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

• f

their businesses, including management entity and fund formation, partnership taxation issues, compensation arrangements and

• ngoing 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.

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Yehuda Braunstein, Partner Sadis & Goldberg LLP

Yehuda M. Braunstein practices in the firm’s Financial Services and Corporate Groups. Mr. Braunstein’s practice focuses on investment funds, securities, regulatory compliance and investment

• advisers. He regularly structures and organizes

hedge funds, private equity funds (including real estate, distressed and lending funds), funds of funds, separately managed accounts and hybrid

• funds. Additionally, he advises private fund

managers on structure, compensation, employment and investor issues, and other matters relating to management companies. He also structures and negotiates seed investments and provides ongoing advice to investment advisers on securities law issues and regulatory matters.

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David Benz, Principal Deloitte Tax LLP

David Benz is a national Principal serving Deloitte’s Investment Management practice. David specializes in partnership taxation, with a concentration on the alternative investment sector. He has nearly two decades experience in taxation of partnerships, limited liability companies, Subchapter S corporations and related offerings. David also has extensive experience relating to mergers and acquisitions. David has spent much of his career advising hedge funds, private equity funds and real estate

• enterprises. He has represented venture capital, large leverage buy-out, distressed securities,

and event driven funds as well as several publicly traded REITs. Prior to joining Deloitte, David was a principal with Rothstein Kass, serving as the head of the firm’s national partnership tax practice. Before that, David was managing director in the National Tax Office of one of the largest independent tax consulting firms, serving as the technical lead for partnerships. He has also served as a partner and chair of the tax department for a law firm concentrating in the representation of private equity funds and as a senior associate attorney with a Los Angeles-based law firm. David began his career as a tax consultant with Arthur Andersen, participating as a member of its pass-through entities and real estate teams. David was an adjunct professor at Loyola Marymount University’s School of Law as well as California State University – Northridge, where he taught federal taxation of partnerships. He is a frequent speaker at industry events.

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Overview of Presentation

I. No fault kick-out and termination rights

• II. Indemnities/General Partner standard of care

III.Conflicts and transaction fees

• IV. Co-investments
• V. Carried interest and management fees
• VI. Tax and ERISA

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No Fault Kick-out and Termination Rights

a. No-fault removal rights; “no-fault” divorce provisions b. Percentage of Limited Partners (“LP”) voting to remove the General Partner (“GP”) i. Majority vs supermajority c. Rationale: for-cause removal (fraud, gross, negligence, willful misconduct, material breach of LPA, criminal misconduct) requires a finding by a court of competent jurisdiction and takes too long i. LP push for no final ruling d. Pressure to lower the LP vote required to implement the provision e. Versions of termination without cause i. No-fault dissolution right, ability to terminate the investment period ii. Appointment of a third-party liquidator

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Indemnities/General Partner Standard of Care

a. Classic 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 b. Breach of fiduciary duty is less frequent i. No fiduciary obligation = red flag to LPs c. Transparency over what expenses are indemnifiable expenses: LPs have been requesting that legal costs relating to: (i) regulatory investigations of GP/IM; (ii) disputes between principals; and (iii) defending allegations of breach of side letters, be excluded from indemnification d. Express provisions setting forth GP’s standard of care i. Confirmation that GP’s fiduciary duty is not eliminated where GP is authorized to act in its sole discretion e. LPs try to limit use of “materiality”

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Conflicts and Transaction Fees

• a. SEC and Institutional focus on these conflicts
• b. Emphasis on giving the limited partnership advisory committee 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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Co-investments

• Continued 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
• Prequin 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 are usually ½ to ¼ the regular fee (for example, 1/10 or 0/.50)

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Co-investments (cont.)

Fiduciary Considerations in Co-investments

• 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 investors need to be given the opportunity?

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Co-investments (cont.)

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

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Carried Interest and Management Fees

• Continue to face pressure from investors for customized structure as well as transparency
• American Carry
• GP/Manager recovers carry on an investment by investment basis
• Distribution is made regardless of losses incurred on subsequent investments
• Benefits the GP/Manager as investors bear the risk of loss on future investments
• Typically involves a clawback
• European Carry
• GP does not receive carry until all capital contributions (on both realized and unrealized

investments) plus the total preferred return on aggregate capital contributions are made to the investors

• Hybrid Carry
• GP receives carry when current gains exceed the aggregate excess of losses over gains on

previously sold investments

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Carried Interest and Management Fees

(cont.) a. Pressure to convert deal-by-deal waterfalls to “European style” waterfalls b. 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 overperformed by some specified percentage c. LPs have been asking for limitations/reductions in management fees following the expiration of the fund’s term d. According to the 2015 Prequin 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

(cont.) e. According to the Prequin survey, 48% of managers charge no carried interest on co- investments f. According to the Prequin 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 g. According to the Prequin survey, commingled vehicles: 73% charge 2% or more during investment period h. 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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• Similar to previous versions taxing gains as ordinary income

▫ Familiar terminology from prior bills (e.g., investment service partnership interest)

• Carried Interest would be subject to self-employment income tax
• Clarifies that partnership interest is subject to Section 83 and makes Section

83(b) election automatic for some partners

• Adds exception for 1202 gain exclusion

Carried Interest Fairness Act of 2015

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▫ In lieu of capital gain treatment, emphasis will be on deferral of recognition but using an American style carry  Founders’ shares  Fund Alignment Rights (FARs) and Stock Appreciation Rights (SARs) ▫ Renewed focus on management fees  Removes economic uncertainty of carry  Allows for better NII planning  Caveat: Section 212

Carry Planning in the Future

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Simplified Fund Structure

Fund Appreciation Right

1% Fund 99% Options to acquire a 20% interest in exchange for services U.S. Persons Investors Feeder Other Partners 51% 51% 49% Other Partners GP Mana. Company 49%

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▫ Current tax treatment depends on classification as a capital interests or a profits interest.  Capital Interest: an interest that would give the holder a share of the proceeds if the partnership's assets were sold at fair market value and then the proceeds were distributed in a complete liquidation of the partnership  Profits Interest: an interest in a partnership that is not a capital interest ▫ Current tax treatment of profits interests governed by revenue procedures,

• Rev. Proc. 93-27 and Rev. Proc. 2001-43:

 If these apply, no income on grant of profits interest, and all income allocated retains pass-through character  STAY TUNED!!!

Compensatory Profits Interests

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▫ Specific terms of profits interests are a matter of design:  Allocations can be limited to certain types of income  Interest can be entitled to priority/“catch-up” allocations ▫ Interest can be subject to service and performance-based vesting ▫ Section 83(b) elections are not required where the Revenue Procedures apply, but may be advisable in some (if not all) situations ▫ Section 409A doesn’t apply ▫ The Internal Revenue Service (“IRS”) has taken the position that an individual cannot be both an employee and a partner with respect to the same entity

Compensatory Profits Interests

(cont.) 24

▫ How it works  Typically, GP’s management fee is waived in lieu of GP making its capital commitment (or some portion thereof)  GP gets credit (and corresponding profits interest) in exchange for the fixed fee  Intended outcome is that GP receives capital gains treatment on allocation made to profits interest as opposed to ordinary income for fixed fee (also benefits investors who face Section 212 concerns)  Substantial variation in terms of waivers ▫ Long-awaited new guidance issued July 22, 2015  Proposed Regulations  Examples  Clarification and amendment of Rev. Procs.

Management Fee Waivers

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▫ Six factors considered in a facts and circumstances test focused on entrepreneurial risk ▫ Factor 1 is most important as it goes to the heart of entrepreneurial risk

• Where the manager receives a capped allocation of income if the cap is

reasonably expected to apply in most years;

• Where the manager receives an allocation for one or more years in which the

manager’s share is reasonably certain;

• Where the manager receives an allocation of gross income;
• Where the manager receives an allocation (formulaic or otherwise) that is

predominantly fixed in amount, is reasonably determinable, or is designed to assure that sufficient net profits are highly likely to be available for the manager’s allocation (by way of example, if the LPA makes an allocation of net profits from a specific transaction or accounting period to the manager without regard to the

• verall performance of the fund over its entire life); and
• Where the manager receives an allocation under an arrangement in which a fee

for future services is waived in a manner that is non-binding or fails to timely notify the fund and the LPs of the waiver and its terms.

Management Fee Waiver Guidance

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▫ Five “minor” factors - not weighed as heavily in determining entrepreneurial risk, but their presence might indicate a faulty fee waiver

• Where the manager has a transitory (temporary) partnership interest;
• Where the manager receives an allocation and distribution in a comparable time

frame to that in which a non-partner service provider would typically receive a payment;

• Where the manager becomes a partner in the fund primarily to obtain tax

benefits (i.e., treatment as an allocation as opposed to fee) that would not have been available if its services had been provided in a third-party capacity;

• Where the value of the manager’s partnership interest in general and with respect

to continuing fund profits is small in relation to the allocation and distribution; and

• The arrangement provides for different allocations or distributions with respect

to different services rendered, the services are provided either by one person or by persons that are related under section 707(b) or 267(b), and the terms of the differing allocations or distributions are subject to levels of entrepreneurial risk that vary significantly with respect to different services received

Management Fee Waiver Guidance (cont.)

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▫ Examples  Clawback  Fixed election period ▫ The Profits Interest Revenue Procedures  In applying the existing revenue procedures, the IRS intends to treat any related party fee waiver as violating the terms of the revenue procedures (specifically, the 2 year holding requirement)  The IRS also intends to amend the existing revenue procedures to carve out from their application any interest received in connection with a partner forgoing an amount that is substantially fixed for the performance of services  So even if one complies with the proposed regulations (assuming they are finalized in substantially similar form), one could still get ensnared by the revenue procedure.  Consequence of falling outside the safe harbor of the revenue procedures?  Recognition and valuation

Management Fee Waiver Guidance (cont.)

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ERISA Considerations Relating to Private Equity Funds and Co-Investment Transactions

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

If the assets of an entity (e.g., a corporation, partnership or trust) 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.

• ERISA imposes strict fiduciary responsibility requirements on parties that are deemed to be

fiduciaries of employee benefit plans that are subject to ERISA. The performance compensation arrangements for the managers of a typical private equity fund and the related party transactions that the private equity funds generally engage in would not comply with such ERISA requirements.

• Therefore, ERISA compliance for private equity funds generally consists of entirely avoiding the

application of ERISA to the fund’s assets and to the activities of its investment manager by relying

• n one of the plan assets exemptions in the ERISA regulation which defines “plan assets” for

ERISA regulatory purposes (the “Plan Assets Regulation”).

• A. General Rules on Plan Assets Status

Under the ERISA Plan Assets Regulation, 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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ERISA Considerations Relating to Private Equity Funds and Co-Investment Transactions (cont.)

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

• perating 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”). As a result of 2006 legislation, the term “Benefit plan investors” no longer includes governmental plans, church plans an non-U.S. plans.

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ERISA Considerations Relating to Private Equity Funds and Co-Investment Transactions (cont.)

• B. Operating Company Definition

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.” (1) Start-up Ventures and Companies Engaged Solely in Research and Development May not Qualify under this Definition. (2) The Venture Capital Operating Company (“VCOC”) and Real Estate Operating Company (“REOC”) Exemptions Were Added Later.

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ERISA Considerations Relating to Private Equity Funds and Co-Investment Transactions (cont.)

VCOC Definition To qualify as a VCOC, the entity must satisfy two requirements: First, at least 50% of the entity’s assets (at cost) must be invested in “venture capital investments” or “derivative investments” as defined. Second, the entity must

• btain 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. 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.

• Many private equity funds rely on the Insignificant Plan Investment Exception (also known as the

“Under 25 Percent Plans Limitation”). This limitation must be satisfied throughout the life of the Fund. Thus it is necessary to police any secondary market transactions in Fund shares to ensure that the benefit plan investor limitation is not exceeded.

• The alternative VCOC Exemption is used by some funds. This exemption is exceptionally technical.
• Funds relying on the VCOC exemption typically engage legal counsel to provide an ERISA opinion

to plan investors that the fund qualifies as a VCOC upon the fund’s first acquisition of a qualifying long- term investment.

• Annually thereafter, the investment manager of the fund provides a certification to the fund’s plan investors that

the VCOC conditions have been satisfied during the fund’s “annual valuation period”.

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If you have questions, please contact: Steven Huttler 212.573.8424 shuttler@sglawyers.com Yehuda Braunstein 212.573.8029 ybraunstein@sglawyers.com Alex Gelinas 212.573.8159 agelinas@sglawyers.com

Sadis & Goldberg LLP 551 Fifth Avenue, 21st Floor New York, NY 10176

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If you have questions, please contact: David Benz Principal Deloitte Tax LLP +1.646.265.2583 dbenz@deloitte.com

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