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We advise private equity clients on a range of matters from fund formation to business transactions. Fund formation, in particular, is a complex and important issue on which private equity funds must focus. Private equity funds and hedge funds are generally structured in the form of limited partnerships, which consist of a general partner, or sponsor, operated by the fund's management team, and limited partners, who are the investors and do not participate in the management of the fund. General partners often then contract with an affiliated but distinct management company, which assumes management responsibilities.
There are a variety of considerations when forming a fund, and many of the issues are set forth in the terms of the limited partnership agreement (LPA), which specifies various economic terms, including the carried interest (typically close to 20% of profits) the hurdle rate, high-water mark, preferred return for limited partners, term for the fund, and the structure of the fund's waterfall.
In addition to needing an LPA that both the general partner, or sponsor, executes, along with all of the limited partners, the general partner will also generally enter into a management agreement with an affiliate that is assigned day-to-day management responsibilities. The management firm will typically be paid 1-2% of the fund’s committed assets under management, and this amount sometimes scales down later in a fund’s life when capital has been more fully deployed. At the fund’s outset, limited partners in a private equity fund generally commit to funding a certain amount, and the fund’s general partner can “call” that capital as needed as investment opportunities are sourced and pursued.
Carried Interest You Say?
Carried interest is a controversial subject that has received a fair amount of attention by commentators and politicians. It refers to the portion of a general partner’s interest in a fund that is a “profits interest” and subject to capital gains taxes, which, in the case of long-term capital gains, means a lower tax rate. There are some complicated tax rules that dictate whether an interest qualifies as a profits interest. Fundamentally, however, the analysis looks at whether in a hypothetical liquidation of the fund’s assets, would the recipient of the interest receive anything at the time of grant. If the answer is yes, then the recipient of the interest is receiving something of value today, creating a taxable event. As opposed to a profits interest, an interest that would entitle the holder to value in a hypothetical liquidation is known as a capital interest. On the other hand, if the recipient is not entitled to anything in a hypothetical liquidation upon receipt, then the interest could be a profits interest, meaning there is no tax upon receipt and the interest qualifies for capital gains. In an effort to increase returns, some funds have deployed what is known as a management fee waiver, which allows the fund to waive receipt of management fees in exchange for a commensurate amount of additional carry that has a potentially lower tax rate. This practice has come under considerable IRS scrutiny, and whether a management fee waiver passed regulatory scrutiny depends on various factors, including whether the receipt of additional carry is subject to true “entrepreneurial risk” and hence provides an uncertain benefit or whether the waiver and exchange provides a clear benefit at the time of the waiver.
A Regulatory Minefield
When setting up a fund, it is important to ensure that the fund falls within certain regulatory exemptions that make the fund model viable. For instance, private funds typically want to be exempt from the Investment Company Act of 1940, which provides registration exemptions for funds with less than 100 beneficial owners (the 3(c)(1) exemption). If an investment company owns more than 10% of the voting securities of a fund, then all the owners of that entity will be considered beneficial owners for the purposes of 3(c)(1). The other exemption, 3(c)(7), exempts funds whose investors are exclusively qualified purchasers, which are ultra-high-net-worth individuals or entities.
Funds also generally want to steer clear of falling under the Employment Retirement Income and Security Act (ERISA) plan fiduciary requirements, which apply to funds whose assets under management are at least 25% ERISA assets. If a fund’s assets exceed the 25% threshold, they are subject to various additional rules and legal burdens, including becoming fiduciaries with limitations on certain investment activities and increased liability. The threshold also applies to each separate class of capital in the fund.
Private equity funds also sometimes fall within the venture capital operating company (VCOC) exemption to ERISA, which provides an exemption for funds whose assets, starting on the date of its first long-term investment and at least one day during an annual 90-day period, are at least 50% invested in operating companies with sufficient management rights in those operating companies. Management rights would include things like the ability to appoint officers or directors and to examine books and records, and the
Private equity funds and hedge funds also must carefully account for various tax issues, including certain tax issues that are unique to tax-exempt limited partners, such as foundations and endowments. In the case of tax-exempt investors, funds often must be careful not to generate unrelated business taxable income (UBTI), which arises from the operation of a business unrelated to the tax-exempt entities' underlying purpose, the income of which flows through the partnership to the investor and is subject to income tax.
In summary, there are a whole host of issues that private equity and hedge funds must consider and we are equipped to provide that guidance and to assist with legal issues with arise with funds portfolio companies.