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Private Equity

  1. 1. Spring/Summer 2009 Editor: Roger Mulvihill In this issue Private Equity p1 Description of the TALF Program and Description of the TALF of business located in the U.S.; and (iii) neither the fund nor the investment manager is controlled by Who is an Eligible Borrower Program and Who is an a non-U.S. government. Managers contemplating p2 Avoiding an Audit Eligible Borrower launching TALF funds should be aware that both any investment vehicle that acts as a borrower under Nightmare by Kevin P Scanlan . the TALF program and any 25% owner of any such p5 Selling French and Adam I. Gehrie borrower (which will include investors who own more Distressed Assets: than 25% of the total equity or any class of voting An Increasing Tendency to Trigger The Term Asset- securities of a TALF fund) are subject to the Employ the Deep Pocket’s Backed Securities American Workers Act (“EAWA”) provisions which Liability Loan Facility (“TALF”) make hiring new employees who are in H-1B non- p7 U.S. Private Equity created by the Fed- immigrant status much more difficult. Managers Investments in eral Reserve Bank of New York (the “FRBNY”) is in- who expect a single investor to comprise more than Canadian Income tended to enhance participation in the securitization 25% of the aggregate subscriptions to a TALF fund Trusts markets by providing financing to investors (such as should make such investors aware of the require- p9 Germany: Changes private funds) that will be non-recourse under most ment that they may need to comply with EAWA in Tax Environment circumstances to support their purchases of highly following their investment. for Venture Capital and Private Equity rated asset-backed securities issued on or after Jan- Funds and their uary 1, 2009 and certain high-quality commercial Private Equity Fund Structures are the Portfolio Companies mortgage-backed securities issued prior to January Most Practical Structures for TALF Funds p11 SBICs Revisited 1, 2009 (collectively referred to herein as “ABS”). Securities eligible to be purchased with TALF loans Liquidity of TALF Assets Favors Private Equity p14 Shanghai to Permit Structure Foreign Private include ABS backed by auto loans, student loans, Equity and Growth credit card receivables, Small Business Administra- Although it is possible to repay TALF loans in ad- Capital Firms to tion loans, business equipment leases and loans, vance and otherwise sell the securities collateraliz- Open Shop mortgage servicing advances, vehicle fleet leases, ing a TALF loan, doing so is a cumbersome process p15 News from the and non-automobile floor plan loans. Starting in and cannot easily be accomplished piecemeal to Group June, commercial mortgage-backed securities and provide for the funding of periodic redemptions. securities backed by insurance premium finance Investors in a TALF fund should expect to remain loans will be eligible for TALF loans as well. Although invested in the fund until either the TALF loans to the amount of financing provided by the FRBNY which they have investment exposure mature or, to to TALF loan borrowers varies depending upon the the extent that the fund intends to seek to replace type of ABS that will serve as collateral for the loan TALF financing after the maturity of the associated (and is adjusted from time to time by the FRBNY), TALF loans, the final maturity of the ABS collateral- the TALF loans generally provide borrowers leverage izing the TALF loans to which they have investment of up to 20 times their raised capital (called the exposure. Virtually all of the TALF funds seen are “haircut amount”) on the high end to six times their structured on a long hold private equity platform haircut amount at the low end. rather than on a hedge fund platform with regular liquidity. Generally, private funds will qualify as TALF borrow- ers pursuant to the rules of the TALF program to Mini-Master Structure the extent that they are investment funds that are (i) organized in the United States; (ii) are managed by Any investment fund seeking to be a TALF borrower an investment manager that has its principal place must be an investment fund organized in the U.S. d
  2. 2. D However, non-U.S. and U.S. tax-exempt investors will gen- noted that if the manager chooses to calculate incentive erally prefer to invest through an offshore fund, especially compensation on a loan-by-loan basis (i.e., option (i) in where leverage is employed in the investment strategy. In the preceding sentence), investors may demand a true up order to accommodate that preference, an offshore fund mechanism (i.e., clawback) to ensure that the manager is for such investors is typically established that feeds into a not overpaid in the aggregate. U.S. partnership or limited liability company (into which Kevin P Scanlan . the U.S. taxable investors will invest directly), which U.S. +1 212 649 8716 entity is the ultimate TALF borrower. Managers should note that this structure will require non-U.S. investors, who would typically not be required to qualify as “qualified Adam I. Gehrie purchasers” under the Investment Company Act of 1940 +1 212 698 3657 or as “accredited investors” under the Securities Act of 1933, to meet these qualifications in connection with their investment in the offshore fund. Certain Terms to Consider Avoiding an Audit Nightmare Immediate Drawdown of Capital or Capital Commitment Subject to Drawdowns During the TALF Loan Period. Managers of TALF funds should consider whether they desire to receive the entire amount of an investor’s capital commitment upon the admission of such investor (either to apply immediately to a single TALF loan or to invest in temporary investments pending deployment of capital in future TALF loans) or whether to operate on a more traditional capital commitment/capital call basis. The by Jeffrey M. Katz, Corinna Mitchell, and mechanism chosen in this context will also need to be Scott M. Zimmerman coordinated with the manner in which additional investors are permitted to acquire an interest in investments of the What’s lurking in an auditor’s report? Perhaps more fund purchased prior to the date of their admission. than some borrowers under their credit agreements bargained for. Management Fee Calculation. Generally, TALF funds have been structured so that the manager takes a management Credit agreements typically include a covenant requiring fee on the entire leveraged value of the ABS portfolio for the borrower periodically to deliver to the lenders certain the duration of the fund. In lieu of this approach, some financial information, usually including annual audited managers have avoided the need to value the portfolio by financial statements. Some simply require delivery to taking the management fee on the cost of the ABS pur- the lender of these audited financial statements, without chased with the TALF loan at the time of purchase for the more. Often, however, credit agreements are more de- entire duration of the loan. To the extent managers choose manding, requiring that the audited financial statements to take the management fee on the entire leveraged value also be: of the ABS portfolio, they will need to establish a reliable n “without any qualifications” valuation procedure. n “unqualified in scope or substance” Incentive Compensation Calculation. Because the success of a TALF-loan financed investment is generally measured in n “unqualified as to going concern or scope of audit” return of capital and interest over time instead of ap- preciation of assets, attempting to calculate performance n “without a ‘going concern’ or like qualification, excep- compensation on an annual basis based on unrealized tion or assumption” gains is generally not practicable. Instead, managers n subject to requirements in addition to or combining generally calculate incentive compensation (paid either the foregoing. as a fee or as an allocation) based upon distributions made in excess of total return of capital (and sometimes A particular issue arises when a credit agreement requires a preferred return) with respect to either (i) each TALF that the auditor’s report contain no exception relating loan or (ii) all the investments of the fund. It should be to the borrower’s ability to continue as a going concern. 2 Spring/Summer 2009
  3. 3. D To understand the issue, a bit of relevant background is needed on the report accompanying audited financial statements. The auditor’s report contains the auditor’s opinion on the related financial statements. Under the Auditing Stan- dards Board’s Statement on Auditing Standards no. 58, as amended, auditors may provide unqualified opinion reports or qualified opinion reports (in addition to adverse opinion reports and disclaimer of opinion reports, which are not discussed here). Qualified opinion reports may include qualifications as to limits on the scope of the audit conducted, lack of evi- dence regarding certain aspects of the audit, or departure If a credit agreement requires an auditor’s report without from generally accepted accounting principles that have such going-concern language, then failure to deliver the a material effect on the financial statements. In addition, same would constitute a breach of the credit agreement certain circumstances, while not requiring the auditor and likely also an event of default, and could lead to to take a qualification, may require the auditor to add acceleration and/or other remedies exercise as well. explanatory language to its report under Statement on Au- diting Standards no. 59, as amended. Such circumstances For borrowers facing such a situation under a revolving may include a material change in accounting principles or credit facility, there is usually a more immediate concern, in the method of their application from a prior period, a however. substantial doubt as to the entity’s ability to continue as Once an auditor notifies a borrower that it intends to a going concern for a reasonable amount of time (not to include such going-concern language in its report, the exceed one year beyond the date of the financial state- borrower will be hard-pressed to certify to its lender that ments being audited), or to emphasize a specific matter or no event has occurred that, with the passage of time, will unusual circumstance. become an event of default. Such a certification by the Now, when a credit agreement requires that the auditor’s borrower is a standard condition precedent to the exten- report contain no exception relating to the borrower’s sion of new revolving loans. A borrower in such a situation ability to continue as a going concern, the borrower’s future may potentially be confronted with a liquidity crisis, on inability to satisfy financial covenants in the credit agree- account of its inability to draw on its revolver. To make ment could lead to an auditor’s inclusion of just such an matters worse—and somewhat ironically—the borrower’s exception. inability to draw under its revolver could itself exacerbate the auditor’s liquidity worries that led to the going-concern This is because the auditor may conclude that there is language in the first place. a likelihood that the borrower will default on a financial covenant, say, within six months after the audit. Upon such In cases where the borrower has only term loans and no default, the lender presumably will be entitled to accelerate revolver, then even if the lender chooses not to acceler- the loan. If the effect on the borrower of a future accelera- ate the loan upon the borrower’s technical default of not tion would include its inability to pay its debts as they delivering a clean auditor’s report, such an event still may came due, then an immediate going-concern qualification enable the lender to extract waiver or amendment fees, may be deemed appropriate by the auditor. Statement increased loan pricing, and/or more restrictive operating on Auditing Standards no. 59, noted above, states that requirements or terms from the borrower in exchange for the going-concern qualification “[r]elates to the entity’s curing or waiving such default. In the current environment, inability to continue to meet its obligations as they become such fees could be onerous. due without substantial disposition of assets outside All this could result simply from the borrower’s inability to the ordinary course of business, restructuring of debt, demonstrate that it can prospectively meet a financial test externally forced revisions of its operations, or similar ac- that the parties intended only be performed on the precise tions.” The auditor may believe that such an action would measurement dates specified in the credit agreement (e.g., need to be taken by the borrower in that circumstance for fiscal-quarter ends). It would mean that, even though the it to continue meeting its obligations at that future time, so parties specifically negotiated financial covenants and the long as it is within 12 months of the date of the financial relevant testing dates therefore, language in the auditor’s statements audited. Spring/Summer 2009 3
  4. 4. D report—stemming from the anticipation of future covenant statements, or will have to make a qualified or adverse defaults—would effectively negate such negotiated dates. opinion in the auditor’s report. This is an eventuality likely unanticipated by any borrow- The time frame on which a going concern should be based er—and potentially quite costly. in the UK should be within the “foreseeable future,” but Careful drafting of the credit agreement can avoid this should cover a period of at least 12 months. problem. Of course it is best, where possible, for a bor- rower to attempt to negotiate a covenant that does not UK Case Study impose any requirements on the auditor’s report. Where a lender insists that the report shall not contain going- A borrower with a facility agreement that included rolling concern language, however, a borrower can often succeed financial covenants as well as a loan to value covenant in including language that handles the issue. The language (which could in a similar context be a total net worth cov- would provide that any exception to the auditor’s report enant) was told by its auditors that the auditors may not resulting exclusively from the borrower’s inability to dem- be able to sign off the accounts on a going-concern basis. onstrate prospective compliance with financial covenants The auditors were concerned that the borrower might will not violate the audit requirement. Other solutions are breach its loan to value covenant at some point in the possible as well, depending on the facts of each case. future, based upon their own assessment of what might If hidden bombs such as these are detected and handled have happened to the value of the borrower’s assets. with proper counsel, a borrower should be able to rest a Under the facility agreement, the assets were only to be bit more easily at night and avoid one audit nightmare. revalued if required by the lenders. The lenders had not required a revaluation, and had orally advised the borrow- Related Issue Under UK Auditing Standards er that they did not intend to do so at the present time. Despite this, the auditors were still concerned, and stated A number of leveraged facility documents in the European that they would only be able to sign off the borrower’s market will have, as a separate event of default, any quali- accounts on a going-concern basis if greater support was fication of accounts by the borrower’s auditors. provided by the borrower’s shareholders in the form of a The Loan Market Association (“LMA”) publishes a sug- binding letter of support or some other financial support. gested form of leveraged facility agreement. It contains This placed the borrower in the position that its lenders an event of default triggered if the auditors of the group were less concerned about the covenant than the auditors, qualify the audited annual consolidated financial state- and the auditors were requiring financial support for the ments of the parent. However, a number of borrowers will borrower not required by the lenders. Once again, certain have negotiated this away. specific language in the facility agreement, if it had been negotiated at the outset in light of this issue, could have The position governing audits in the United Kingdom is mitigated or solved it. very similar to that in the U.S. The International Standards of Auditing (UK and Ireland) paper no. 570 provides Jeffrey M. Katz guidance for auditors in assessing management’s going +1 212 698 3665 concern assumption. With respect to what the ISA term as “Borrowing Facilities,” the auditor can decide that it is necessary to obtain confirmation about the terms of the Corinna Mitchell bank facilities, and make an assessment of the intentions +44 20 7184 7890 of the bankers relating thereto. As part of the process, auditors will be expected to Scott M. Zimmerman make an independent assessment of whether the entity +1 212 698 3613 has breached the terms of the borrowing covenants, or whether there are indications of potential breaches (ISA (UK and Ireland) 570 at paragraph 21-2). As in the U.S., this clearly covers prospective defaults of financial covenants. If the auditor is not able to get comfortable on these points, it will have to make a disclosure in the financial 4 Spring/Summer 2009
  5. 5. D Selling French Distressed Assets: PE firms should therefore be very cautious when selling a shareholding in a portfolio company experiencing financial An Increasing Tendency to Trigger difficulties and make sure that they gather appropriate the Deep Pocket’s Liability evidence to show they have taken all steps in order to ensure the continuity of the activity after the disposal. by Olivia Guéguen and Isabelle Marguet What are the New Grounds for the Liability of a Selling Shareholder? The disposal of a sub- sidiary is not necessarily Tendency to Extend the Grounds for Shareholder the end of the story for Liability: Case of the Shareholder as Co-Employer the former shareholder. Under French law, a parent company can be held liable It is indeed a well-established principle under French law vis-à-vis laid-off employees of its subsidiary, on the that, in case of a subsequent bankruptcy situation of the grounds that it is considered as their co-employer, when sold subsidiary, the seller’s liability can be triggered if it the business activities, the management, and the interests is evidenced that the selling shareholder is responsible of both companies are considered as one and the same. for mismanagement acts (whether as de jure or de facto manager) having generated a deficiency in assets. Recent French case law, however, seems to extend the cas- es where a shareholder can be considered a co-employer. The current depressed economic situation seems to In particular, the management company of a private encourage French courts to trigger the seller’s liability equity investment fund recently has been held liable to beyond the above principle on new grounds. This is pay damages to the employees of a portfolio company in particularly the case with a view to open new recourses to liquidation based on the fact that it acted as co-employer dismissed employees of a sold subsidiary finally bank- of the portfolio’s employees. The circumstances at issue rupt, especially where the former shareholder can play the were, however, typical of the involvement of a PE firm in deep pocket. its portfolio companies (e.g., regular reporting of manage- A new principle emerges from this recent case law: when ment to the PE firm, chairmanship of the company by a selling a subsidiary, a shareholder has an obligation to representative of the PE firm, or involvement of the PE ensure that the purchaser is in a position to secure the firm in the definition of the business plan and strategy). continuity of the target’s activity after the sale. Spring/Summer 2009 5
  6. 6. D Even if the above case may not be confirmed at the PE firm willing to dispose of a portfolio company should appeal stage, it shows a tendency from French courts therefore take all reasonable steps to make sure that the to broaden the cases in which a shareholder may be purchaser will be in a position to do so (and should gather considered a co-employer and more generally to extend all relevant evidence in this respect). the grounds on which the liability of a deep-pocket share- The following elements are notably scrutinized by the holder can be triggered. judges: Failure to Ensure the Future of the Target Company n the identity of the purchaser: financial resources, French courts have, in various recent cases, determined knowledge of the business sector, and track record in that a parent company having sold its subsidiary could terms of acquisitions; be held liable vis-à-vis dismissed employees in cases n the purchaser’s business plan: it is important that the where the sold entity ended up in liquidation and it was purchaser draws up its own business plan, but the established that the former shareholder failed to take all seller shall ensure that such business plan is serious reasonable steps to secure the future of such sold entity. and consistent with its knowledge of the situation of Based on such case law, employees of the sold entity the target; may now have grounds, dependent upon the circum- n the purchaser’s internal financial resources as well stances of the sale, to claim damages from the former as the financing available from financial institutions shareholder in connection with the prejudice suffered due (the fact that banks support the project will also help to their dismissal in the context of the liquidation of the demonstrate the seriousness of the project); sold entity. It was notably ruled that their prejudice may result from the loss of the opportunity to benefit from the n the ability of the target company to operate on a generous collective dismissal plan that would have been stand-alone basis after the sale: the target must be implemented if the employer had remained in bonis and a independent from the seller after closing—if a com- part of the selling shareholder’s group. mercial relationship is maintained, it should not be essential to the target. Several types of defaults from the selling shareholder have been put forward by French courts to support the liability The financial conditions of the sale should also be care- of such shareholder: fully reviewed. Indeed, subsidiaries experiencing tempo- rary financial difficulties are frequently sold for symbolic n certain acts preceding the sale having weakened the consideration. Seller may also agree to pay for certain post-closing financial situation of the target (e.g., dis- post-closing investments or costs. Favorable financial tribution of dividends, payment of management fees); conditions may, however, be considered with suspicion as n certain decisions concerning the structure of the sale they may reveal that the seller paid to facilitate the sale of (e.g., case in which the target company is placed under its subsidiary and avoid its related obligations as share- a dependency relationship post-closing as its only holder. It should therefore be evidenced that the purpose client is its former shareholder—typical of outsourcing of such favorable financial conditions was to address transactions); specific temporary needs and not to favor an artificial survival of the target. The seller shall also make sure that n certain decisions relating to the financial conditions of all amounts made available to the target in such context the sale (e.g., case where seller injects cash in the tar- be used for the agreed purposes (e.g., through the use of get with a view of artificially maintaining the activity); an escrow agent). n more generally, the failure of the seller to make sure Olivia Guéguen that the purchaser had a serious business plan and +33 1 57 57 80 41 sufficient financial resources to implement such plan. How to Best Secure the Sale of a Portfolio Isabelle Marguet Company? +33 1 57 57 81 07 Based on the above recent case law, the seller has, in practice, the obligation to ensure that the retained pur- chaser is in a position to secure the future of the target. A 6 Spring/Summer 2009
  7. 7. D U.S. Private Equity Investments In the early to mid 2000s, the Canadian income trust market was rapidly growing. By 2002, income trusts in Canadian Income Trusts 1 accounted for 79% of all money raised through IPOs in Canada4 and by 2005, the income trust sector was worth approximately CDN$170 billion, which was then equiva- lent to 10% of the Toronto Stock Exchange (“TSX”).5 The public announcement by a corporate entity of its intention to convert to an income trust could immediately add 10-20% to its share price at that time.6 In the fall of 2006, telecom giants BCE and Telus, both of whom were corporations, were considering a conversion to an income by Daniel M. Dunn, Mark E. Thierfelder, and trust structure. On October 31, 2006 after the markets Amarpreet (Ricco) S. Bhasin2 closed, the Federal Conservative government in Canada announced legislative changes to the taxation of income 2008 ended as a year that many investors would like trusts, effectively ending the tax benefits of the income to forget. Private equity activity was down, on a global trust structure immediately for any newly created trusts, level, by over 70% at the end of 2008 from 2007, with fourth quarter deal volume at the lowest level it has been since the fourth quarter of 2001.3 Notwithstanding some positive movements in U.S. and international stock indices in the spring of 2009, private equity investors remain cau- tious. Many are managing their portfolio investments or are infusing them with additional funds, while keeping an eye out for opportunities, increased levels of liquidity, and easier access to the bank and capital markets. As private equity investors pace themselves through these challenging economic times, the Canadian income trust, a form of publicly traded investment that was viewed as a potential exit vehicle for private equity portfolio com- panies just a few years ago, has again come into focus. Because of a confluence of events, including recent Cana- dian legislative changes, private equity investors are now looking at existing Canadian income trusts as potential portfolio investments. The Canadian Income Trust A Canadian income trust (also known as a Canadian income fund) is a publicly traded investment vehicle that indirectly holds businesses or other income-producing assets that produce a stable stream of income for its unitholders. While all trusts are not identical, there are some common features. Generally, an income trust is a publicly traded entity, but unlike a corporation, it is not taxed at the entity level. The income of an income trust, unless retained in the entity, flows through the trust entity and ends up in the hands of its unitholders in the form of cash distributions on a regular basis, usually monthly. The unitholders are the beneficiaries of the trust and are taxed on the distributions they receive. The principal advantage of the income trust, from a tax point of view, is the effective elimination of any corporate level tax. Spring/Summer 2009 7
  8. 8. D and put in place a sunset provision for most existing Connors Bros.: A Recent Going-Private trusts. The tax advantages are scheduled to expire in their Transaction entirety on December 31, 2010 for most existing trusts. Most income trusts will effectively be taxed as corporate One recent example of a completed going-private trans- entities from January 1, 2011. action of a Canadian income trust sponsored by a U.S. private equity firm using debt financing is the acquisi- Canadian media commentators termed this change to tion by affiliates of Centre Partners Management LLC the tax structure of most income trusts as the “Hal- (“Centre”) of the leading branded seafood company, loween Massacre.” The announcement sent shock waves Connors Bros. Income Fund, whose subsidiaries market through the income trust market. The S&P/TSX Income consumer food products under brands such as Bumble Trust Index closed on October 31, 2006 at 164.86, and Bee®, Clover Leaf®, Brunswick®, and Sweet Sue® (total after two weeks the index was at 135.51.7 In the two enterprise value of approximately $600 million). Dechert months following the Halloween Massacre announce- was lead counsel to Centre on the transaction. The ment, energy income trusts, as a group, lost 25% of transaction, including the various credit arrangements, their value and certain individual income trusts lost was successfully negotiated and signed during the last values in excess of 30%.8 week of September 2008 (in the midst of volatile market conditions) amended in mid-October 2008 and closed on As a consequence of these changes in law and the November 18, 2008. An interdisciplinary team of lawyers depressed capital markets generally, many trusts may be from Dechert’s private equity/M&A, tax, leveraged finance, in a situation in which their values have been discounted. intellectual property, environmental, real property, anti- Jamie Scarlett, a senior M&A lawyer at Torys LLP in trust, and employment groups advised on the transaction. Toronto, notes: The acquisition involved some unique structuring issues, Income trusts have faced difficult challenges since the Hal- including a range of complex credit arrangements and loween Massacre. Depressed credit and stock markets and equity configurations for the division of equity interests the impending change in tax status in 2011 have the sec- among investors and participating management from tor in a funk. Trading prices are low and access to capital is multiple jurisdictions. difficult, so income trusts can’t grow through acquisition. Daniel M. Dunn Many of these income trusts have a good business and +1 212 698 3857 will be looking for a way to restructure or go private before 2011. Private equity investors may be able to play a role in this next wave of income trust activity. Mark E. Thierfelder +1 212 698 3804 Following the Halloween Massacre, there had been ap- proximately $65 billion worth of foreign and leveraged buyouts of income trusts in Canada as of August 2008.9 Amarpreet (Ricco) S. Bhasin While the legal changes and market dislocation have been +1 212 698 3891 key drivers in this development, it is important to note that many income trusts are based on businesses that ______________________________________________________ historically have provided stable cash flows, a charac- teristic that makes such businesses attractive portfolio 1 Dechert LLP is not authorized to practice Canadian Law and this discussion should not be viewed as legal advice on Canadian investments, and facilitate the debt service required in a legal issues. leveraged buyout. Moreover, the tax features of an income 2 Admitted to Practice in Ontario, Canada. trust structure often afford significant flexibility in structur- ing an acquisition. An acquisition transaction can take the 3 Online source: Davies, Megan, “Private equity deals at five- form of the acquisition of trust units, purchases out of year low,” Thomson Reuters (December 23, 2008). bankruptcy, an acquisition of a trust’s business via a stock 4 Online source: Brethour, Patrick and Chase, Steven, “The or asset deal at its operating subsidiary level, or some little trusts structure that grew,” (October 13, 2005). combination of the above. In these various acquisition forms, it may be possible to achieve an efficient tax basis 5 Online source: “The Government Takes a Stand On Income “step-up” in both Canadian and U.S. business assets, Trusts,” (subsidiary is TAL Global Asset Manage- ment Inc.) (September 21, 2005). which can enhance the after-tax cash flow of the business going forward. Synthetic or hybrid financing techniques 6 Sexton, Chris, “Finance’s Trust Tax Denies Tax Benefits to New Income Funds,” KPMG Wireless Telecom, Issue Three may also be employed to reduce further the taxable in- at 45 (2006). come (and, consequently, the tax liability) of the business. 8 Spring/Summer 2009
  9. 9. D 7 Online source: “What’s new from Liberals on income trusts? n The fund’s equity capital must amount to EUR 1million Not much,” Financial (September 22, 2008). or more, of which 25% must be paid in immediately 8 Arya, P.L., Taxation of Income Trusts in Canada: Effects on and the remaining amount within one year after its Structure, Conduct and Performance, Canadian Economics approval by the BaFin; and Association. n The minimum capital commitment of each investor 9 Online Source: National, August 24, 2008. in the fund must be EUR 25,000. The new regime is not available for venture funds wholly owned by banks or other companies, as the law requires Germany: Changes in Tax that an eligible fund may not be affiliated with an investor on the fifth anniversary of its BaFin approval and that an Environment for Venture Capital investor may not hold 40% or more of the voting shares and Private Equity Funds and their in the fund at that time. Portfolio Companies To benefit from the new regime, at least 70% of the fund’s assets must be composed of equity participations in by Thomas Gierath portfolio companies with the following criteria: n The portfolio company must be established as a corpo- Germany has improved its tax environ- ration having its statutory seat and place of manage- ment for venture capital investments by ment in a member state of the European Economic implementing a new regulatory and tax Area; regime for eligible German seed and early-stage funds. However, private equity n It must not be established more than 10 years before funds do not benefit from this legislation. Rather, addition- the fund’s initial investment and must not run or al recent changes in German tax law are disadvantageous acquire businesses which are older than the company for private equity investors and portfolio companies. itself; New Regime for Venture Capital Funds n Its equity must not exceed EUR 20 million at the initial investment of the fund and its shares must not be In 2008, after a long political controversy, Germany listed on a stock exchange; enacted a new regulatory and tax regime for domestic venture capital funds. It provides tax benefits for the fund’s n It must not be a parent company of another corpora- investors and its portfolio companies, and legal certainty tion both being members of a German fiscal unity regarding the tax treatment of eligible funds. However, the (Organschaft). new laws will apply only to seed and early-stage funds. For reasons of risk diversification, the fund may not hold Prior to the changes, the tax treatment of German venture more than 90% of a portfolio company’s equity and an capital and private equity funds was based only on admin- investment in one portfolio company may not represent istrative directives and, as a consequence, fund sponsors more than 40% of the fund’s assets. A portfolio company had to apply for binding rulings before setting up a fund to ceases to be eligible for the fund (available for the 70% as- safeguard the tax position of both the fund set test) on either (i) the third anniversary of an IPO of the and its investors. company or (ii) the 15th anniversary of the fund’s initial investment in it, whichever is earlier. The new regime only applies to German-domiciled venture capital funds (so-called risk capital funds—Wagniskapital- The new laws provide tax benefits for the fund’s investors beteiligungsgesellschaften) that are approved and regulated and its portfolio companies. The fund will be deemed tax by the German Regulator (BaFin) and that comply with the transparent for German income tax purposes if (i) the following requirements: fund is established as a limited partnership; (ii) the fund does not hold portfolio companies on a short term basis; n The fund’s purpose must be the acquisition, holding, (iii) the fund does not reinvest proceeds from portfolio and disposal of equity participations in eligible companies, but distributes them to its investors; and (iv) portfolio companies (as set out below); in case the fund assumes or provides debt to its portfolio companies or advises portfolio companies, such activities n The fund must be managed by at least two qualified are not provided by the fund itself but through a wholly and experienced managers; owned corporate subsidiary of the fund. Spring/Summer 2009 9
  10. 10. D German portfolio companies of above privileged risk less than 1% of the underlying equity, and provided that capital funds benefit from the new laws, as they are partly the fund held the shares in the relevant portfolio company exempted from the forfeiture of tax loss carry forwards in for a period of at least one year. The flat rate income tax case of a transfer of a substantial holding in the company (Abgeltungsteuer) enacted in 2009 eliminates this tax or in case of substantial capital injections in it (as set exemption. In cases where the investment represents less out below). Under certain circumstances, the portfolio than 1% of the underlying equity, capital gains from the company instead may deduct losses accumulated in its disposal of portfolio companies are now taxed at a rate of German business unit from its future earnings over a five- 25%. In contrast, if the investment represents 1% or more year period. of the underlying equity, 60% of the capital gains are taxed at the individual tax rate of the investor. Other Changes for German Private Equity and Venture Capital Funds Further, management fees paid by funds that have been set up in 2008 or later are again subject to German VAT Aside from the new regime for risk capital funds, the tax (currently 19%). The former tax exemption of such pay- environment for German private equity funds, particularly ments, which many other EU countries provide, has been buyout funds, has not improved over the last few years. abolished pursuant to an administrative directive from Unlike in other EU countries, there is no special regulatory 2007. It is currently unclear if and when the German tax and tax regime available for these funds. Tax transparency authorities will correct this negative treatment of German can only be achieved if certain requirements set out by funds. administrative directives are fulfilled. A tax treatment of such funds is far from legal certainty. Finally, the taxation of carried interest paid to the fund sponsors has been slightly increased. Whereas formerly Moreover, the German legislature and administrators 50% of such payments were taxed at the individual tax have implemented new laws affecting investors and rate of the sponsor, this basis has been increased to 60%, managers of all German venture capital and private leading to a tax rate of approximately 29% for carried equity funds (including risk capital funds governed by interest payments. Pursuant to a grandfathering rule, the above new regime). funds that have been set up before 2009 still benefit from First, investments by German private investors in private the former law. equity and venture capital funds are now fully taxable irre- spective of any holding in the underlying equity or holding Changes for German Portfolio Companies periods. Prior to the changes, these investors were able to German tax legislation in the last several years has af- benefit from a tax exemption on gains arising on the sale fected private equity investments, particularly at the level of portfolio companies where their investment represented of portfolio companies. German and international buy-out 10 Spring/Summer 2009
  11. 11. D funds suffer from new limitations on the deductibility of interest for acquisition finance provided by banks. SBICs Revisited Restrictions on the use of existing tax loss carry forwards by Roger Mulvihill of German portfolio companies following an investment by a fund affects both venture capital funds and private The current fund-raising challenge for equity funds. many mid-sized private equity funds has caused some fund sponsors to con- Whereas interest paid for acquisition finance of Ger- sider, or in some cases reconsider, the man private equity transactions was, in principle, tax- formation of small business investment deductible in the past, such interest payments from 2008 companies, better known as SBICs. onwards are only deductible for tax purposes up to 30% of an entity’s EBITDA. Non-deductible interest in one year SBICs are federally licensed investment funds, usually can be carried forward to the following fiscal year, where it structured like traditional private equity limited partner- will be again subject to the interest-limitation test. There ships, which are eligible to borrow on a non-recourse are three exceptions currently available, the most impor- basis through the Small Business Administration (the tant one being an allowance for interest expense paid by “SBA”) at the rate of two dollars of borrowing for each the German entity of less than EUR 1million per fiscal dollar of private capital raised by the fund sponsor. Under year. (Please see additional details in the Autumn 2007 SBA regulations, the sponsor must raise a minimum issue of Dechert’s Private Equity Newsletter). of at least $5 million from private sources, although a minimum of $10 million or more is more common Additionally, private equity and venture capital invest- since smaller funds are often too small to operate ef- ments are materially affected by restrictions regarding the ficiently. After a successful operating history, the SBIC use of existing tax loss carry forwards of German corpo- may increase its leverage ratio from 2 to 1 to 3 to 1 with rate portfolio companies following a fund’s investment. SBA approval. The borrowing is in the form of ten-year Since 2008, such losses partly disappear if more than debentures repayable by the SBIC at maturity with 25% of the shares in the company are transferred, even semi-annual interest payments at the 10-year Treasury on the parent company level, and the entire tax losses note rate at the time of issuance of the debentures plus disappear in case of a transfer of more than 50% of the roughly 200 basis points. The maximum borrowing from shares. The same applies in case of equity contributions the SBA may not exceed $127 million at September 2008 in financing rounds if the participation quota in the equity (which amount is adjusted based on the rate of inflation). of the company will be changed accordingly. Transactions Debenture borrowings are taken down as needed for set out before will also lead to a forfeiture of interest carry investments and expenses along with the fund’s private forwards resulting from the above limited deductibility of capital commitments in somewhat the same manner as interest payments. customary private equity fund drawdowns once the fund has drawn down $2.5 million of private capital. A fund Having realized that the before-mentioned restrictions structured for maximum government leverage (about have effected the industry, the German legislature has $127 million) at 2 to 1 then would require private capital exempted—at least partly—eligible portfolio compa- commitments of $63.5 million. On licensing, an SBIC nies from above-mentioned risk capital funds from the may obtain a borrowing commitment from the SBA for up forfeiture of tax loss carry forwards (please see above). to two times private capital for five years so that the SBIC Furthermore, as the above restrictions in particular are is not subject to unforeseen changes in the government detrimental in down-turning markets, the German upper funding process. The good news is that the SBA has had house (Bundesrat) has started an initiative to soften the ample funds to dole out under the debenture program relevant provisions. Papers issued by it request a higher and is not likely to experience any budgetary cut backs in annual tax allowance for an unlimited deduction of light of the Administration’s stimulus plans. interest payments (up to EUR 3 million) and an unlimited use of tax loss carry forwards in turnaround situations. The SBIC program has experienced a somewhat uneven However, it is currently unclear if and to what extent the history. Established in 1958 as a straight debenture above initiative will be enacted by the legislature. program to help finance small businesses, many of the earliest funds financed principally real estate ventures Thomas Gierath with often unfavorable results. The Reagan Administra- +49 89 21 21 63 17 tion considered terminating the program in the 1980s principally for ideological reasons, but the program gained new life and bipartisan political support in the first Spring/Summer 2009 11
  12. 12. D Bush Administration. In the late 1990s, Congress and the by any board, consulting and other fees received from SBA restructured the entire SBIC program by adding a portfolio companies and the permissible management fee government-financed equity alternative to the debenture declines to 2% when the base exceeds $120 million. The program. These equity SBA financings (so-called “partici- profit split among the private capital investors will typi- pating securities”) were structured much like preferred cally provide for a carried interest to the manager on the stock with the SBA receiving an annual coupon (a “pri- entire investment portfolio similar to a traditional private oritized payment”) and a profit participation. For better equity fund. or worse, the equity program coincided with the Internet Consistent with the original concept of the SBIC program boom and licensed SBICs mushroomed. Predictably, after as a financing source for small business, the SBA regula- several years of outsized gains, many of these partici- tions require that SBICs only invest in “small businesses,” pating security SBICs faltered with the collapse of the which are defined as enterprises with a net worth (exclud- Internet boom, and after some outsized losses the second ing goodwill) of less that $18 million and average after tax Bush Administration halted the equity program in 2005, income for the prior two years of less than $6 million or, but not the debenture program. Notwithstanding its may failing that, enterprises that meet certain size tests (typi- ups and downs, the SBIC program has funded numerous cally less than 500 employees). At least 20% of invested American success stories, including Apple Computer, funds must be invested in “smaller businesses” defined as Federal Express, and others. enterprises with a net worth (excluding goodwill) of less The SBIC program has traditionally attracted first-time than $6 million and average after-tax income for the prior fund sponsors who are not well known enough or oth- two years of less than $2 million. The SBIC may retain erwise cannot raise funds from institutional investment investments in portfolio companies that subsequently sources. Often these SBIC applicants are “spinning out” exceed these size standards. of established fund groups with some claim to a favor- While many SBIC managements are able to function able track record or, more likely, a shared performance successfully within the size standards, the SBA diversifica- record. Lately, in light of the generally difficult fund-raising tion requirements are frequently a greater burden. The environment, the debenture program has attracted inter- SBA regulations restrict an SBIC from investing more than est from established fund sponsors, including institutional 20% of its private capital in any single portfolio company managers. without SBA prior approval. An SBIC with private capital The SBA believes that some of the earlier difficulties in of, say, $30 million then could not invest more than $6 SBIC performance were due to inexperienced managers, million in any portfolio company without prior approval so the SBA in the licensing process now places consider- that could limit “build out” or “follow on” investment able stress on the practical investment experience of strategies. However, the SBA has approved “overline” the management team (at least two of whom must be investments. substantially full-time), and their collective ability to carry SBIC investments in portfolio companies may take the out the SBIC’s business plan and strategy. The SBA has form of debt, debt with equity features (such as warrants rejected applicants whose investment experience was or conversion rights), or equity securities. Debt securities limited or too remote from venture capital investing, must be issued for a term of at least one year, except for although the SBA seems more open recently to consider- certain bridge loans. The interest rate on debt securities ing investment experience that, as one industry official is the higher of 19% or 11% over the higher of the SBIC’s noted, does not fit “squarely within the box.” In addition, weighted debenture cost or the current debenture rate. the SBA requires that the SBIC receive at least 30% of For debt securities with equity features, the permitted rate its private capital from three or more investors who are is the higher of 14% or 6% over the higher of the SBIC’s unrelated to the management or from a single investor weighted cost of debentures or the current debenture satisfying certain institutional qualifications to ensure that rate. Since the SBIC must cover its annual interest costs an independent investor or investors are also keeping an on SBA debentures and other operating expenses, it will eye on management. need to ensure an adequate stream of payments from The managers may charge the SBIC a management fee its portfolio companies after taking into consideration of 2.5% on three times the amount of private capital for its annual management fee. The SBIC may require the the lesser of five years or until 80% of private capital and portfolio company to redeem the SBIC’s equity investment leverage have been drawn down and thereafter 2.5% of after one year based on a predetermined earnings or book the cost basis of loans and investments in active portfolio value formula or a third party appraisal. companies. Management fees are reduced dollar for dollar 12 Spring/Summer 2009
  13. 13. D Like all government programs, the SBA largesse comes they are invited to meet with the Committee. If approved, with strings in the form of relatively comprehensive applicants are issued a so-called “go forth” letter (usually regulations. Generally, the SBA regulations cover the usual several months after submission of the MAQ) and are ground: self-dealing; certain prohibited kinds of invest- then invited to file a formal application that incorporates ments like real estate and passive business activities; SBA much of the information in the MAQ along with the fund’s reporting and audit requirements; capital impairment legal documents. The whole process can run anywhere standards; permissible distributions; and the like. from four to six months (or sometimes more) although the SBA is trying to streamline the process. Prospective participants in the SBIC program must first receive a license from the SBA. The SBA has streamlined Roger Mulvihill the licensing process to permit applicants to get a sense +1 212 698 3508 of whether they will qualify for a license before expending too much time and money on the effort. All applicants first fill out a Management Assessment Questionnaire (“MAQ”) that covers the background of the sponsors in some detail, including specific information on the investment history of the applicants, their investment strategy, expected deal flow and the like. Although at first glance rather intimidating (the MAQ runs some 30 pages plus exhibits), the information—such as the applicant’s investment history and returns—is probably readily available. The MAQ is then reviewed by the SBA’s Invest- ment Committee and, if the applicants appear qualified, Spring/Summer 2009 13
  14. 14. D Shanghai to Permit Foreign years of operating history and a certain amount of assets. It is also expected that investors will be called upon to Private Equity and Growth Capital confirm that they have not been subject to any adverse Firms to Open Shop regulatory actions in their home jurisdiction in the past several years. by Michael M. Hickman These new rules will likely expand existing rules permitting and Basil H. Hwang a foreign investor to form a foreign-invested venture capital enterprise (“FIVCE”) to invest solely in privately held high The Shanghai Financial technology companies in China. Additional information Services Office recently regarding FIVCEs is available in “Renminbi-Denominated announced that Shanghai Funds: An Emerging Platform for Private Equity Invest- will soon permit foreign ment in China?” (DechertOnPoint “Private Equity” Newslet- private equity and growth ter, p. 4 (Summer 2008), available at http://www.dechert. capital firms to establish wholly owned subsidiaries or com/library/Private_Equity_09-08.pdf). Unlike the FIVCE Sino-foreign joint ventures in the city. The rules and regula- rules, the new rules are expected to permit investments in tions are expected to be promulgated in a month or so, at a wide variety of industries by private equity and growth which time this new opportunity will be clearer. capital firms through either wholly owned subsidiaries or Preliminary indications are that the rules may permit a joint ventures. combination of investment and asset management activi- Tax considerations are also expected to feature promi- ties, and that investments may be made with convertible nently in the new rules. The fundamental tax issue will be currency or RMB. These new companies will be regulated the treatment of gains and whether it will be possible for as financial institutions. As was the case with the first the China-based firms to act as pass-through conduits foreign commercial bank licensees in Shanghai, it appears for tax purposes. These tax features have recently been that these private equity and venture capital firms will be addressed in the context of the domestic Chinese partner- steered to locate in the Pudong New Area of Shanghai. ship law, which permits a typical general partner and lim- The rules, when issued, are likely to address a number of ited partner structure. However, to date, the partnership areas, including minimal capital requirements and inves- law has not been extended to permit foreign interests as tor qualifications. Published reports indicate that a mini- either general or limited partners. Shanghai’s innovation mal funded capital of US$10 million may be required. In in the context of foreign private equity and growth capital addition, consistent with earlier moves to expand foreign funds may be a first step in this direction. participation in financial and banking services and high However, it is not likely that the gates will be thrown wide technology venture capital funds, we would expect that open immediately. Developments of this sort in China the rules will set out investor qualifications. These types of typically commence with some degree of caution, as was qualifications typically require the investor to have several the case with the earlier rules permitting FIVCEs. It is expected that these new private equity and venture capital firms will be closely regulated, although at this point it is not clear which regulatory bodies will be directly involved. If foreign private equity and venture capital can succeed in Shanghai, the domestic industry should also indirectly benefit. This bold and innovative move by Shanghai is a welcome development and is consistent with Shanghai’s stated goal of becoming a significant international financial center. Michael M. Hickman +852 3518 4738 Basil H. Hwang +852 3518 4788 14 Spring/Summer 2009
  15. 15. D News from the Group Upcoming/Recent Seminars Our Practice Continues to and Speaking Engagements Expand Worldwide June 26 Craig Godshall spoke on “Today’s In May, Dechert opened an office in Moscow and SPACs: How the Lessons Learned Will Affect brought aboard three new partners: Laura Brank, Future Structures” at the SPAC Conference 2009 Shane DeBeer, and Konstantin Konstantinov. in New York. Laura Brank (U.S.-qualified), focuses on M&A, June 18 Thomas Friedmann spoke on “Capital-Raising corporate governance, joint ventures, corporate Strategies in a Frozen Market: Evaluating Financing finance, banking, and project finance. Alternatives: Rights Offerings, RDOs, ATMs and PIPES” at a webcast hosted by Strafford Publications Shane DeBeer (U.S.- and UK-qualified), Teleconference. concentrates on complex international transactions with a focus on oil and gas, liquefied natural gas June 15-17 Susan Camillo spoke on “Tackling (LNG), and other energy-related matters. Control Group ERISA Issues and Ensuring Plan Asset Compliance” at the Private Equity Tax Konstantin Konstantinov (U.S.- and Russia-qualified) Practices 2009 conference in Boston. focuses on project finance, securities regulation, secured finance, debt restructuring, and M&A. April 22 Thomas Gierath spoke on “Emerging Markets – A Credit Crunch Solution?” at the Legal François Hellot joined our Paris office in April Week Private Equity Forum 2009 in London. as a partner specializing in private equity, M&A, and capital markets for both French and April 21 Dechert hosted a seminar entitled “U.S. international clients. Rights Offerings: A Creative Way to Raise and Deploy Capital in a Dysfunctional Market” in the firm’s New York office. Topics included why backstopping a rights offering can provide private equity investors with attractive returns and relatively quick liquidity. ______________ To obtain a copy of the related presentation materials, please contact Michelle Lappen at + 1 212 698 8753 or Spring/Summer 2009 15
  16. 16. About Dechert LLP With offices throughout the United States, Europe, and Asia, Dechert LLP is an international law firm focused on corporate and securities, business restructuring and reorganization, complex litigation and international arbitration, real estate finance, financial services and asset management, intellectual property, labor and employment, and tax law. © 2009 Dechert LLP All rights reserved. Materials have been abridged from laws, court decisions, and . D administrative rulings and should not be considered as legal opinions on specific facts or as a substitute for legal counsel. This publication, provided by Dechert LLP as a general informational service, may be considered attorney advertising in some jurisdictions. Prior results do not guarantee a similar outcome. The United States Treasury Department issues Circular 230, which governs all practitioners before the Internal Revenue Service. Circular 230 was amended to require a legend to be placed on certain written communications that are not otherwise comprehensive tax opinions. To ensure compliance with Treasury Department Circular 230, we are required to inform you that this letter is not intended or written to be used, and cannot be used, by you for the purpose of avoiding penalties that the Internal Revenue Service might seek to impose on you. U.S. Austin • Boston • Charlotte • Hartford • Newport Beach • New York • Philadelphia Princeton • San Francisco • Silicon Valley • Washington, D.C. • EUROPE Brussels London • Luxembourg • Moscow • Munich • Paris • ASIA Beijing • Hong Kong