Private Investment Funds
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Private equity funds ___ (basic definition)
commit capital in the securities of privately held high risk, potentially high return businesses, in divisions and subsidiaries of large conglomerates, and in securities of listed companies typically to make them private. These include venture capital and hedge funds.
structure of limited partnership (graph)
fund taxation- motivations
-avoiding double taxation: Fund isn't taxed, passed through to investors. Investors report their gains, losses etc, but these aren't typically recognized.
- Gains for the partnership preserve their character. If a partnership's income is generated by the sale or exchange of capital assets, then the gain recognized in the transaction will be capital gain, and the partners will report their share of this income accordingly.
tax hypo 1: A partnership of two and invest in two bonds-- one a TE bond and another a taxable bond under the code. TE bond gets income of $1,000. Taxable bond gets income of $1,000. Okay to create an allocation in partnership agreement that splits the income for tax purposes?
No. With everything split 50/50, no economic difference to the partners if the income comes from regular bond and other from TE bond. Unless actual economic effect, IRS will ignore the special allocation in the partnership agreement.
- -created for tax purposes with substantial the same terms as the main fund
- -often for offshore investors who want to avoid tax liabilities
alternate investment vehicle structure (AIV)
for investors of the main or parallel fund to have a specific investment (not the entire fund) held in an alternative structure within the fund because it's preferential-- for tax, regulatory, or other purposes-- to not be held in main investment structure.
-Feeders are used for tax purposes so that investors may invest into a fund indirectly so that they don't face the tax consequences of the fund's jurisdiction of incorporation.
- one type of feeder is a blocker: blocker treats fund as if it's a corporate taxpayer.
-Investors in the feeder fund don't receive direct allocation or distributions of fund income ⇨ non US investors not required to file US federal tax returns and pay US income tax in connection with these allocations and distributions.
- US tax-exempt investors also prefer feeder funds organized as blockers to reduce likelihood that their investment generates "unrelated business taxable income" (e.g. New York investors since New York State assesses UBTI tax for partners).
- location of blockers before carry??
- -investment entities formed alongside the fund. Unlike parallel funds or AIVs, do not necessarily have the same terms as the main fund.
- -Mostly negotiated on a deal-by-deal basis to accommodate investments made by particular investors outside the fund. allows LPs to invest larger amount of money without the associated fees.
types of distributions
carry- percentage of profits distributed to GP to reward for performance when underlying investments are profitable
returns- return of capital contributions to the LPs and preferred return on investment
tax distribution- since a partner is responsible for tax liability even if cash not distributed, agreement may have a provision to give partner a distribution to pay that income tax.
catch-up- distributed to GP so that the ratio of distributions of profits to the GP and LPs equal the carried interest split. Without catch-up distribution, the GP will never receive its full carried interest percentage of profits.
-the GPs right to receive a share of the profits attributable to the capital invested by limited partners in the fund
- usu 20% of the profits
types of carry
- deal by deal without loss carryforward
- not used as much today since it pays carry without regard to losses from other deals within the fund
- deal by deal with loss carryforward
- carry that takes into account previously realized losses on deals that have been disposed of and write-down attributable to investments not yet sold.
- back-ended carryrequires that investors receive distributions of their full invested capital plus their full preferred return before the GP receives any carried interest distribution. Can significantly delay distributions to GP since life time of fund can be several years. Can also create taxable income without corresponding fund distributions to GP to pay tax. So GP may negotiate for tax distributions alongside back-ended carry arrangements.
carried interest- hypo 1. If GP invests 3% of the capital of a private equity fund and waterfall provision gives GP 20% carry, the GP will receive:
- -all of the profits of the 3% investment
- -20% of the profits derived from the remaining 97% of capital invested by the LPs
carried interest hypo 2. Assume a fund's profits are $100 following a return of capital contributions. The GP's negotiated carried interest is 20% and the preferred return rate is 8%. If there is no catch up provision, 1) what will investors receive as their preferred return 2) How much will the GP receive?
- 1) $8
- 2) 20% of $92= 18.40
carried interest hypo 3. Assume a fund's profits are $100 following a return of capital contributions. The GP's negotiated carried interest is 20% and the preferred return rate is 8%. If there is a catch up provision with GP attaining 100% of profits after distributing preferred return, 1) What will investors receive as their preferred return? 2) How much will the GP receive?
- 1) $8
- 2) $20 ($2 from getting 100% of profits after returning preferred rate to LPs+ $18 after getting 20% of remaining $90 profit)
taxation of LPs- what is a distribution waterfall and what is its relationship with partnership taxation?
distribution waterfall: an arrangement that creates a tiered priority for how proceeds of investments are paid.
Partners receive proceeds of investment in proportion to their relative capital contributions to that investment
taxation of LPs: relationship between partnership allocations and distribution waterfall
- Because tax obligation is passed through to LPs, the agreement has to:
- 1) allocate income, loss, and other tax attributes to LP based on the LP's interest in the Fund
- 2) set rules for the cash being shared with and distributed by the Fund. The rules for how this cash is shared between the fund sponsor and fund investors is the distribution waterfall.
-The allocation provisions should reflect the economics of the distribution waterfall
- - allocation has to have either "substantial economic effect" OR is done according to the "partner's interest in the partnership."
- ---both tests look to who receives the economic benefit and who bears the economic burden of items of income and loss
taxation of the LPs: for the allocation of profits and losses to have substantial economic effect, the partnership must:
- 1) maintain capital accounts under detailed Treasury rules
- 2) make liquidating distributions according to positive capital accounts
-customary to have profit and loss allocation reflect the distribution waterfall through "forced allocations"
if no substantial economic effect, IRS ignores allocation and partner would have to pay the taxes
taxation of the LPs: example of a capital account
taxation of the LPs: role of capital accounts
Partnership keeps track of allocations of profits and losses through book entry capital accounts cerated for all partners
- Capital accounts reflect for each partner:
- - capital contributions made by the partner
- -profits and losses allocated to the partner under allocation provisions
- - distributions to the partner from contributed capital and earnings according to the waterfall provisions or otherwise
taxation of the LPs: UBTI
distribution waterfall provisions- carry
33 Securities Act §4(a)(2)
private offering exemption-
exempts from the registration and prospectus delivery requirements of Section 5 of any transactions by an issuer not involving any public offering", but most funds opt to meet the 33 Act Reg D requirements because enhanced certainty that there's a "safe harbor" for exemption
4(2) does NOT extend to anti-fraud provisions, so ensure that disclosures made to investors are not false or misleading in any material aspect.
not about purchaser, but the actions of the offeror!
self-executing- no notice or other filings or regulatory approvals required for exemption to be effective
Regulation D- overview and accredited investors
- 1. First test individual net worth
- 2. Test if general solicitation
Reg D contains the current set of SEC rules governing exemptions for private offerings and defines accredited investors (see Rule 506)
- Banks are accredited investors
- If partnership: must have over 5 mil in assets and not formed for the purpose
- If individual, must have:
- -at least $1 mil net worth alone or with spouse OR
- -individual income in excess of $200,000 in each of the two most recent years or joint income above $300,000 for two years AND reasonable expectation of reaching the same income level in the current year.
Reg D- Rule 502 (c)
general solicitation and advertising
- 502(c):when a private offering is made in reliance on Reg D, neither the issuer nor any person acting on its behalf may offer or sell the securities by means of any form of "general solicitation or general advertising," including:advertisements, articles, notices or other communications published in
- magazines or
- similiar publications or
- broadcast over radio or television and
- (maybe) unrestricted notice on the internet
- good practice to avoid any comment when asked for information in media (i.e. interview requests in investment newsletters)
Reg D- 502 (b)
no specific info required to be furnished when LP interests in PE fund are sold only to accredited investors --> disclosure requirements triggered if the offering extended to persons that are not accredited investors
Reminder: doesn't extend to anti-fraud provisions!, only registration and prospectus delivery requirements; so disclosures may not be false or misleading in any material respect
502(d)-issuer of securities to exercise reasonable care to ensure that the purchasers are not underwriters
Reg D- Rule 506 (b)
Safe harbor exemption
506(b)(2)(i)- no more than 35 purchasers, excluding "accredited investors"--> in effect, permits sales to an indefinite # of accredited investors; but in practice too many would be cause for concern
- focuses on number of purchasers not number of those offered securities
Rule 506 (c)
an issuer may use general solicitation to offer and sell securities, provided that:
- -the issuer takes reasonable steps to verify that the purchasers of the securities are accredited investors:
- - all purchasers of securities are sold; and
- - the sales otherwise satisfy the definitional, integration and resale provisions of the Regulation D safe harbor
- if U.S. and with int'l subscription and foreign countries have laws against solicitation, fund would be restricted from those foreign investors
- Either a 506(b) or 506(c) offering. If 506(b) up to 35 non accredited investors but no solicitation. If 506(c) general solicitation but all accredited investors
Reg D- Rule 506(d)
no one at GP level and/or with 20% in fund can be bad actor
avoid violating 1940 Act Section 7(d) which requires registration of offshore funds and registration under 4(a)(2):
offers by a foreign issuer (including an offshore fund) where there is no US market interest need to satisfy the following conditions:
- 1) the offer and sale is made in an offshore transaction; and
- 2) there are no "directed selling efforts" in the United States
Regulation S/ Regulation D relationship
-US fund with foreign investors: a nexus with U.S. laws, so need exemption from 33 Act registration requirement. But rely on Reg S not Reg D
- -U.S. fund, one U.S. investor, 9 non U.S. investors
- can offer with Reg S for foreign and Reg D for U.S.; non integrated, not *required* to offer via Reg S for foreign investor
- Does Reg D apply if foreign fund and a U.S. citizen abroad?
how to cure if U.S. fund mistakenly did general solicitation?
Either 6 month cooling off period or set up abroad and solicit to foreign investors any time after general solicitation
why subject to Investment Company Act?
Either a holding company and holds itself out as an investment company or do 100% investments, so need an exemption
- e.g. Berkshire Hathaway not an investment company because doesn't hold itself out as one by claiming to invest others' money
- don't want to be an investment company because:
- - subject to various registration requirements
- -can't have certain charges (i.e. carried interest)
- - intricate related party transactions restricts activities in which private equity co.s likely to engage
Investment Company Act- 3(c)(1)
- not an investment company if:
- 1) the issuer's outstanding securities (other than short term paper) are beneficially owned by fewer than 100 persons and
- 2) issuer is not making and does not presently intend to make a public offering of its securities
- issue is whether company is privately held
- 100 person limit applies to the holders of all securities except for short-term paper--whether securities are debt or equity or voting or non-voting makes no difference for this purpose. questions usu. arise as to the 100 person limit
Investment Company Act- 3(c)(1)(A)
look through provision:
i.e. if 98 LPs form an LP that owns more than 10% of fund, then look through
- i) if a company owns ten percent or more of the outstanding voting securities of a private investment company and
- ii) the ten percent owner is an investment company but for the 3(c)(1) and (7) exceptions then
owners of the outstanding securities of the ten percent owner are deemed to hold outstanding securities of the private investment company.
look through- formed for the purpose
if an entity has at least 40% of its assets in a single fund, SEC issues no action letter saying fund was formed for the purpose of investing in the fund
applies to both 3(c)(1) and 3(c)(7) funds
eg. entity has net assets of 900,000 and 700,000 in the fund, then look through because over 40% and formed for the purpose
1940 Investment Company Act- 3(c)(7)
An entity is exempted from requirements of an investment company under 1940 Act if all of the investors are "qualified purchasers":
-natural person or family owned company exempted if owns at least $5 mil in investments
-trust not formed for specific purpose of acquiring securities and each settlor or other contributor is a QP or
- any other entity who in aggregate owns and invests at least $25 mil
- if entity less than $25 mil, look through and beneficial owners under 3(c)(1)
34 Act 12(g)
if more than 2000 investors, subject to reporting requirements even though a 3(c)(7) fund doesn't limit number of investors.
Investment Advisers Registration Act of 2010
If U.S. based manager
> $150 mil assets under management (AUM) → SEC registration
$100-150 mil AUM → state registration
$100 mil-$150 AUM but $1 or more non fund client(s) → SEC
$25-$100 mil → state registration, unless state stated doesn't register advisers
< $25 mil → state registration
- If non-US manager → Foreign Private Adviser's Exemption:
< $25 mil from U.S. investors, no office in U.S., AND no more than 15 clients (aka investors)then no obligation to register with SEC
but 25 mil easily reached, so Exempt Reporting Adviser:
- applies to both US based and foreign based advisers
- < $150 mil from U.S. persons in FUNDS (if not in funds then subject to full registration)
- - unlimited # of clients in the U.S. as long as in private funds
- → subject to Registration Light
- i.e. if Paris based mgr w/ $125 mil managing from biz in U.S. can be exempt from full registration and subject to "Registration Lite"
prohibits covered funds ie 3(c)(1), 3(c)(7) funds
- - 3% or more of bank's capital can't be in covered funds
- - 3% of fund can't consist of bank commitment
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