1 What trends are you seeing in overall activity levels for private equity buyouts and investments in your jurisdiction during the past year or so?
After record-setting M&A activity levels in 2021, M&A activity in the United States slowed considerably in the first half of 2022. M&A deal activity reached approximately US$1.27 trillion across 9,681 deals in the first six months of 2022, a year-over-year decrease of 31 per cent in value and 13 per cent in volume, according to Refinitiv. M&A activity in the United States accounted for approximately 42 per cent of worldwide M&A activity during the period, a decrease from the same period in 2021, which was over 45 per cent for only the second time in 15 years. In the first half of the year, 5,384 private equity deals were consummated in the United States, a year-over-year decrease of 12.3 per cent compared to the same period in 2021, for a total deal value of approximately US$686 billion, a decrease of approximately 28 per cent as compared to the same period during 2021 (Refinitiv). Despite decreases in M&A and private equity activity levels globally, private equity sponsors remained some of the most active dealmakers this year, as private equity buyout deals totalled US$996 billion in value globally across more than 11,064 deals, a year-over-year decrease in value of 21 per cent. Private equity based in the United States accounted for nearly 70 per cent of all private equity activity by value in the first half of 2022 (Refinitiv). ‘Mega-deals’ – defined as transactions of US$1 billion or more – also slowed, but remained elevated relative to historical standards. Mega-deals accounted for US$137 billion in deal value in the first six months of 2022, while deals in the range of US$100 million to US$500 million represented the largest share of deal value, accounting for US$200 billion over the same period (PitchBook).
2 Looking at types of investments and transactions, are private equity firms primarily pursuing straight buyouts, or are other opportunities, such as minority-stake investments, partnerships or add-on acquisitions, also being explored?
Following the direct and indirect business impacts of the covid-19 pandemic and the rebound in private equity deal activity during the second half of 2020, private equity sponsors have been increasingly looking for creative ways to deploy their investors’ capital. One solution that has remained popular in 2022 is the use of take-private deals. So far, 18 take-private deals captured over US$58 billion in value, and remained in line with the 46 take-private deals worth a collective US$116 billion for the entire 2021 year, which was the busiest year for take-privates since 2016. In addition, sponsor-to-sponsor deals, in which portfolio companies are sold between private equity firms, became a favoured exit option in the first half of 2022. Private equity investors were forced to rethink their exit models while capital markets suffered and increased regulations on special purpose acquisition company (SPAC) transactions was proposed. In Q1 of 2022, sponsor-to-sponsor deals accounted for 64 per cent of all US exit value (PitchBook).
3 What were the recent keynote deals? And what made them stand out?
Notable private equity transactions in the United States in the first half of 2022 include:
- the US$36 billion acquisition of Equity Office Properties Trust by Blackstone;
- the US$33 billion acquisition of HCA Inc by a private investor group, including affiliates of Bain Capital, KKR and Merrill Lynch;
- the US$12.8 billion acquisition of American Campus Communities, Inc, the largest developer, owner and manager of student housing communities in the United States, by Blackstone;
- the US$10.2 billion acquisition of Zendesk by an investor group led by Hellman & Friedman and Permira; and
- the US$4.5 billion acquisition of Cornerstone Building Brands Inc by CD&R.
4 Does private equity M&A tend to be cross-border? What are some of the typical challenges legal advisers in your jurisdiction face in a multi-jurisdictional deal? How are those challenges evolving?
Significant cross-border private equity activity is atypical, although there has been steady interest in cross-border deals, particularly among larger funds with the capacity to manage such transactions. Several large-cap private equity sponsors have stand-alone region-focused funds, such as Asia-focused funds, that have mandates to make investments in particular geographic regions. It is more common for non-US private equity sponsors, such as European funds or Asian funds, to look to the United States for potential investment opportunities. More broadly, during the first half of 2022, cross-border M&A activity decreased 24 per cent compared to 2021 levels, while the share of cross-border deals among closely affiliated countries increased 51 per cent. The nature of cross-border deals in 2022 reflected the geopolitical tensions on the world stage. Investment from China into the US fell to just US$1.9 billion, while North American investment into Europe increased to US$149 billion in the first six months of the year (E&Y).
The primary challenges to cross-border investments revolve around financing, tax considerations, regulatory compliance and securities laws limitations. In addition, US sponsors seeking to sell portfolio companies to non-US buyers, or considering other transactions involving sales to foreign acquirers, should be aware of the possibility of review by the Committee on Foreign Investment in the United States (CFIUS). CFIUS is a multi-agency committee authorised to review transactions that could result in foreign control over US businesses for potential impacts on US national security. Under the Foreign Investment Risk Review Modernization Act (FIRRMA), enacted in 2018, CFIUS is authorised to review certain ‘other investments’ by a foreign person in a US business, including those that do not convey potential control, if the US business (1) owns, operates, manufactures, supplies or services critical infrastructure; (2) produces, designs, tests, manufactures, fabricates or develops one or more critical technologies; or (3) maintains or collects sensitive personal data of US citizens that may be exploited in a manner that threatens national security (collectively defined in the regulations as TID US Businesses), as well as acquisitions of real estate and leaseholds near sensitive US military or other government facilities. CFIUS has authority to negotiate and implement agreements to mitigate any national security risks raised by such transactions. If CFIUS determines that such risks cannot be mitigated, CFIUS can recommend that the US President suspend, prohibit or unwind a transaction.
A CFIUS review can add delays and meaningful uncertainty to transactions, depending on the nature of the target business and the identity of the foreign acquirer. In transactions involving the sale of a portfolio company that is in a sensitive industry or that handles sensitive data, especially to buyers that CFIUS considers are from countries of concern, sponsors will be prudent to consider whether a CFIUS filing is advisable or a mandatory declaration is necessary under the Mandatory Regime (described below), to propose reverse termination fees or pre-emptive divestitures, to discuss possible mitigation efforts the buyer is willing to make and to build political support for the transaction. Since 2012, acquisitions involving Chinese acquirers have been the most reviewed transactions pursuant to the CFIUS review process. Given the US government’s trade policies, rising anti-China rhetoric, heightened tensions around North Korea and Russia, particularly in connection with the conflict in Ukraine, and with the enactment of FIRRMA, which expanded CFIUS’s jurisdiction and created a longer time frame for CFIUS review, among other reforms, many practitioners anticipate a tougher CFIUS hurdle and expect increased scrutiny of inbound investments from Chinese buyers to continue.
CFIUS has also introduced regulations imposing mandatory filing requirements for certain transactions involving target companies active in critical technologies or critical infrastructure, or that have access to the sensitive personal data of US citizens. A failure to satisfy these filing obligations could result in significant fines and penalties for the parties, up to the value of the transaction itself, and introduce additional deal uncertainty and regulatory risks. Parties are required to notify CFIUS of transactions that would result in foreign ownership of a ‘substantial interest’ in a US business where (1) the US business involves critical infrastructure, critical technology or sensitive personal data of US citizens; and (2) a foreign government has a ‘substantial interest’ in a foreign party to the transaction. CFIUS implemented a mandatory filing requirement (the Mandatory Regime) authorised by FIRRMA, that expanded CFIUS’s jurisdiction by granting it the authority to review controlling and non-controlling ‘other investments’ made by a foreign person, whether or not controlled by a foreign government, in a company involved in critical technologies for which a US regulatory authorisation would be required to transfer that critical technology to a foreign investor or a foreign person in the investor’s ownership chain and that affords the foreign person (1) access to any material non-public technical information in the possession of the US business; (2) membership or observer rights on, or the right to nominate, an individual to a position on the board of directors or equivalent governing body of the US business; or (3) any involvement, other than through voting of shares, in substantive decision-making of the US business regarding the use, development, acquisition or release of critical technology. Transactions subject to the Mandatory Regime are subject to mandatory declaration requirements. Although FIRRMA and the Mandatory Regime include certain exceptions for US national-managed investment funds, FIRRMA may increase the number of transactions involving US sponsors and co-investors that would be subject to CFIUS review and investigation, and the timing and substantive risks.
In addition to CFIUS, many jurisdictions around the world restrict foreign direct investment and heads of state and regulatory bodies have the authority to block or impose conditions with respect to certain transactions, such as investments, acquisitions and divestitures, if such transaction threatens to impair national security. In addition, many jurisdictions restrict foreign investment in assets important to national security by taking steps including, but not limited to, placing limitations on foreign equity investment, implementing investment screening or approval mechanisms, and restricting the employment of foreigners as key personnel. All cross-border transactions should be evaluated to determine whether consents or approvals are required under these and other foreign direct investment regulations around the world.
While the regulatory and other challenges in cross-border sponsor exits and other transactions, including CFIUS review, are often manageable in many contexts, they increase the level of resources required and may otherwise complicate the process for executing such transactions.
5 What are some of the current issues and trends in financing for private equity transactions? Have there been any notable developments in the availability or the terms of debt financing for buyers over the past year or so?
The debt financing markets tightened considerably in the first half of 2022 relative to 2021. Volatility and uncertainty have crept into the market as the Federal Reserve has increased interest rates, inflation continued to run rampant at historic levels, supply chain issues persisted and geopolitical problems arose due to Russia’s invasion of Ukraine. As the current inflationary movements persist, the Federal Reserve has indicated potential further rate increases before the end of 2022–2023. As indicators point towards a recession, investors have reached for less credit and looked for safer investments.
Unlike in 2021, in which dealmakers had been able to find relatively attractive pricing and availability of credit for transactions, global loan volumes and credit availability have suffered in 2022. During this period, high-yield corporate bond activity declined significantly. Issuance fell 78 per cent to US$61 billion in the first half, and is down 49 per cent from the US$119 billion issued in the first half of 2019. 2022 volume as a whole is on pace to be the lowest since 2008 (Debtwire). Also during the first half of 2022, global syndicated loan revenue and volume decreased year-over-year 25.4 per cent to US$2.3 trillion and 17.9 per cent to 6,225 deals, respectively. Although syndicated loan value during the second quarter of 2022 witnessed an 18 per cent increase over loan value during the first quarter of the year and volume increased 4 per cent during the same period, this recovery was still far below numbers seen near the end of 2021. Globally, Q1 of 2022 saw a decrease of 36 per cent in value and a 31 per cent drop in volume as compared to Q4 of 2021. Syndicated lending in the United States represented 58 per cent of the global syndicated loan market, but decreased 19.1 per cent year-over-year in value to US$1.36 trillion and 22.5 per cent in volume with 2,541 deals as compared to the first half of 2021 (above data from Bloomberg). Loan volumes secured in the first half of 2022 reached only US$2.2 trillion, which represented the second-lowest value in six years, only narrowly outpacing 2020 levels hindered by the covid-19 pandemic. Globally during this period, investment-grade loans have proven desirable as investors look towards higher-rated, safer companies’ debt for security. In the first half of 2022, US$1.25 trillion was raised in investment-grade space. Additionally, bond sales have plummeted globally. On a year-to-date basis, issuance volume in 2022 fell to US$2.56 trillion across 9,294 deals, down 27.7 per cent from US$4.92 trillion across 12,045 deals at this time last year, and reflected the lowest levels since 2015. The biggest cause for this downturn globally was the drop in corporate bond volumes in high-yield issuances, which printed just US$39.5 billion to date in 2022, down over 80 per cent from this time last year, and the lowest quarterly-to-date since 2011 (all of the above data provided by Debtwire).
6 How has the legal, regulatory and policy landscape changed during the past few years in your jurisdiction?
Most private equity firms continue to be required to register with the Securities and Exchange Commission (SEC) as investment advisers, and the SEC has continued to focus on examining private equity firms with the goal of, among other things, promoting compliance with certain provisions of the Investment Advisers Act that the SEC deems of particular importance. In recent years, certain private equity industry practices have received significant attention from the SEC, which has led, in certain cases, to enforcement actions against private equity fund advisers.
Areas that the SEC continues to highlight as areas of particular concern include, among others, the following:
- the allocation of expenses (including for the compensation of operating partners, senior advisers or consultants and employees of private equity fund advisers or their affiliates (including seconded employees) for providing services (other than advisory services) to funds and portfolio companies, as well as for payments of a private equity fund adviser’s regulatory compliance expenses to funds or portfolio companies, or both;
- also, full allocation of broken deal expenses to funds instead of allocating a portion of such expenses to separate accounts, co-investors or co-investment vehicles, in each case without pre-commitment disclosure and consent from investors;
- the receipt by private equity firms of transaction-based compensation or other fees or compensation from funds or portfolio companies, or both, outside of the typical management fee or carried interest structure (eg, an acceleration of monitoring fees and compensation for the provision of brokerage services in connection with the acquisition and disposition of portfolio companies without being registered as a broker-dealer) without a corresponding management fee offset;
- the allocation of investment opportunities by private equity sponsors among the investment vehicles and funds that they manage;
- the allocation of co-investment opportunities;
- the disclosure of conflicts of interest to investors, including those arising out of:
- the outside business activities and financial interests of a private equity firm’s employees and directors;
- investments made by affiliated different funds managed by a private equity firm in different levels of a company’s capital structure;
- financial relationships between private equity firms and select investors in their funds (eg, seed investor relationships);
- portfolio companies’ use of affiliated service providers affiliated with the private equity firm or its principals;
- fund restructurings; and
- ‘cross transactions’ between funds managed by the private equity firm.
- the receipt of service provider discounts by private equity firms that are not given to the funds or portfolio companies;
- marketing presentations and the presentation of performance information generally; and
- policies and procedures relating to the receipt of material, non-public information (MNPI).
We continue to believe that larger, established private equity firms that continue to provide robust pre-commitment disclosure of and obtain consent for conflicts of interest, in addition to maintaining and enforcing sound compliance policies and procedures to mitigate such conflicts of interest, continue to be better positioned to absorb the incremental costs and compliance burdens associated with such scrutiny.
7 What are the current attitudes towards private equity among policymakers and the public? Does shareholder activism play a significant role in your jurisdiction?
While negative attitudes concerning private equity buyouts seems to have waned over the past few years, shareholder activism associated with M&A activity has become increasingly prominent – irrespective of whether there is any private equity involvement. As a result, private equity sponsors seeking to effect-going private transactions or investing alongside a strategic partner are becoming increasingly mindful of the investor relations aspects of such transactions and are evaluating the risks of potential shareholder activism.
Despite the passage of the Economic Growth, Regulatory Relief and Consumer Protection Act, which rolled back certain regulations and requirements imposed by the Dodd-Frank Act, including stress tests, on small and medium-sized banks, the regulatory landscape largely remains unchanged as of the first half of 2022. However, the Biden administration has signalled an interest in increasing regulatory scrutiny, particularly with regard to antitrust enforcement and greater taxation, which could detrimentally affect M&A activity broadly and private equity activity in particular. Proposed regulations issued by the SEC have reduced private equity favourability towards SPACs as an exit route. The SEC proposals would expand underwriter liability, reduce the scope of a safe harbour for financial projections by tailoring new requirements in line with those of a registration statement for an initial public offering (IPO), and require additional disclosures about SPAC sponsors, conflicts of interest, and sources of dilution.
8 What levels of exit activity have you been seeing? Which exit route is the most common? Which exits have caught your eye recently, and why?
Private equity-backed exit activity decreased sharply in the first half of 2022, which was consistent with the overall slowdown of activity that the M&A environment witnessed following the second half of 2021. According to data supplied by PitchBook, as at the end of the second quarter of 2022, US private equity sponsors executed 536 exits that aggregated to approximately US$326.6 billion, a decrease of approximately 57 per cent in exit value and exit count as compared to the fourth quarter of 2021. With falling valuations in both public and private markets, private equity sponsors are choosing to hold portfolio companies rather than sell for less favourable prices. Despite the slowdown in exit activity, one of the trends that has maintained momentum in 2022 has been general partner (GP)-led secondary sales of portfolio companies to newer funds established by the same GP or to continuation funds established by the GP. Such a structure provides earlier investors in a private equity fund a path to liquidity while still allowing the GP and other investors to remain invested in highly prized portfolio company assets for a longer hold period.
IPO exit value during the first half of 2022 highlighted the most dramatic slowdown. While the first half of 2021 achieved the strongest recorded opening six months for IPOs, the first half of 2022 saw only US$3.4 billion of completed value, and accounted for less than 2 per cent of the private equity-backed public listing exit value recorded for the full year of 2021 (PitchBook). Only two IPO exits have been registered year-to-date for 2022 (Mergermarket) and in Q1 2022, public listings accounted for just 0.6 per cent of total exit value in the United States. Notably, the market for SPAC IPOs dried up after fuelling much of the success seen in 2020 and early 2021. As SEC regulations targeting SPAC transactions have been promulgated, there are hundreds of SPACs looking for a partner and many saw sponsors back out of transactions. The first half of 2022 has seen a total of 30 break-ups of SPAC transactions, while only one such case occurred in the first half of 2021. On the whole, only 17 breakups occurred in all of 2021. The De-SPAC Index, a basket of companies that have completed their tie-ups, has crashed 67 per cent and more than 700 SPACs are on the clock to close or find deals ahead of approaching deadlines (Bloomberg).
9 Looking at funds and fundraising, does the market currently favour investors or sponsors? What are fundraising levels like now relative to the past few years?
There continues to be robust investor demand for opportunities to invest in private equity funds, though the market is also facing headwinds due to macroeconomic uncertainty. In particular, in light of recent volatility in the public markets, certain investors may delay further allocations to private equity to rebalance their portfolios. However, many funds are also performing well enough to raise and are returning back to market in force. During the first half of 2022, the number of funds on the fundraising trail as well as the aggregate amount of capital being targeted have hit record levels. In this competitive and otherwise challenging private equity fundraising landscape, the current market appears to favour those sponsors who are experienced, with strong track records and pre-existing limited partner relationships.
Global private equity fundraising in the first half of 2022, while robust with respect to many sponsors and sectors, underwent a slowdown in the aggregate relative to the same period in 2021. Aggregate fundraising volume dropped 27 per cent year-on-year, to US$337 billion. The total number of funds holding final closings during the first half of 2022 decreased nearly 40 per cent to 622, compared to 1,033 during the first half of 2021. However, the average size of funds closed during the first half of 2022 reached US$542 million, its highest level since 2017. This increase was driven largely by mega-funds, the top four of which raised at least US$15 billion each, as further discussed below. Consistent with recent prior periods, capital was concentrated at mega-funds (ie, funds raising approximately US$5 billion or more) of the recognised top-performing sponsors. This concentration demonstrates the continued consolidation in the private equity industry in favour of larger, established sponsors with proven track records as a result of institutional limited partners seeking to make larger commitments to fewer funds, consolidate manager relationships and invest with sponsors with whom they had prior relationships (particularly in light of the inability to meet new sponsors in person in light of pandemic-driven travel restrictions). Specifically, in the first half of 2022, the 10 largest funds together raised US$133 billion, which represents about 40 per cent of the total capital raised during this period. This indicates an increase in consolidation from 2021, where the 10 largest funds that reached a final close during the first half of 2021 raised approximately one-third of the total capital raised during the period.
Regarding the distribution of capital across different types of private equity funds, buyout funds accounted for 52 per cent of capital raised during the first half of 2022, while venture and growth funds constituted 22 and 17 per cent of capital raised, respectively. Buyout funds, however, made up only about 20 per cent of funds closed, while venture funds accounted for nearly 50 per cent.
Geographically, fundraising was concentrated in North America during the first half of 2022, in line with 2021. North America-focused funds accounted for 44 per cent of all capital raised in the first six months of this year, a similar proportion as in prior years. Comparatively, the percentage of total capital raised by Asia-Pacific-focused funds was 38 per cent, and by Europe-focused funds, 6 per cent, representing a slight decrease from 2021. Compared with the first half of 2021, in the first half of 2022 Europe-focused funds raised US$8 billion less capital than the prior period, while Asia-Pacific-focused funds raised around the same amount. Additionally, funds targeting multiple geographic regions attracted US$129 billion, or 38 per cent, of aggregate capital raised during the first half of 2022.
It is expected that overall fundraising levels will remain steady in the near term. There are 4,055 private funds in the market as at 20 July 2022 seeking to raise US$1.23 trillion in total capital, compared to 3,060 funds that were targeting US$703 billion at the same time last year. Many investors are also placing a premium on managers with established track records that have navigated a number of past economic cycles. Larger institutional investors will continue to consolidate their relationships with experienced fund managers and competition for limited partner capital among private equity funds will continue to increase, with alternative fundraising strategies (eg, customised separate accounts, co-investment structures, continuation funds, early-closer incentives, umbrella funds, anchor investments, core funds, growth equity funds, impact funds, GP minority stakes investing, secondaries and complementary funds (ie, funds with strategies aimed at particular geographic regions or specific asset types)) playing a substantial role. As a result, established sponsors with proven track records should continue to enjoy a competitive advantage and first-time funds will need to accommodate investors by either lowering fees, expanding co-investment opportunities, focusing on unique investment opportunities or exploring alternative strategies. It should be noted that of the US$1.23 trillion in total capital targeted as of the end of July 2022, approximately 17 per cent is being sought by the 10 largest funds which are overwhelmingly managed by established sponsors. Moreover, it is anticipated that private equity fundraising will continue to focus on established, dominant markets in North America and Europe. Finally, it is also expected that the SEC will continue to focus on transparency (eg, full and fair pre-commitment disclosure and informed consent from investors) with respect to conflicts of interest (including, among others, conflicts of interest arising from the allocation of costs and expenses to funds and portfolio companies, the allocation of investment opportunities and co-investment opportunities, and the receipt of other fees and compensation from funds, portfolio companies or service providers). Given this, larger private equity firms with the resources in place to absorb incremental compliance-related efforts and costs are likely to continue to enjoy a competitive advantage over their peers.
10 Talk us through a typical fundraising. What are the timelines, structures and the key contractual points? What are the most significant legal issues specific to your jurisdiction?
The characteristics of a typical fundraiser reflect recent upward trends in investor demand for opportunities to invest in private equity funds and the consolidation of investor capital in experienced fund managers. Fundraising in today’s environment has become less episodic and more resource-intensive, with fund structures, terms and marketing timelines customised to most effectively address the business objectives of sponsors, particularly experienced sponsors with proven track records. The following is a simplified framework and timeline for a typical private equity fundraising.
In most cases, typical fundraising will begin with the preparation and distribution of a private placement memorandum to investors, which includes important information about the sponsor and the fund, including a term sheet setting forth the key terms of the fund and the offering of interests, along with additional disclosure information pertaining to the fund. Many private equity funds are structured as Delaware limited partnerships, but the structure and jurisdiction of the fund will depend largely on the sponsor and the asset class, geographic focus, and anticipated investor base of the fund. It is not uncommon for private equity funds to be organised in jurisdictions outside the United States (eg, the Cayman Islands, Ireland or Luxembourg).
Legal counsel will work closely with the sponsor as part of the fundraising to prepare the draft limited partnership agreement, investment management agreement, subscription agreement and related fund documents, which are the definitive agreements governing the operation of a private equity fund. Key contractual points in the fund documents will vary on a case-by-case basis, but often include economic arrangements (eg, management fees and carried interest), tax structuring provisions and minimisation covenants, investment allocation provisions, limited liability protections, standards of care, governance rights, co-investment arrangements and allocations of expenses. It should be noted that increased regulatory scrutiny has resulted in a change in how marketing and offering documents are prepared. Environmental, social and governance (ESG) factors have also emerged as a fundamental underwriting criterion for investors, and although North America and Asia have lagged behind Europe in the adoption of ESG principles, the prevalence of these factors in recent client fundraising due diligence indicates that implementation is accelerating across all regions. As a result, drafting fund documents is now a resource- and time-intensive exercise, as pages and pages of granular disclosure are often added to such documents and more frequent updates are often made throughout fundraising in an effort to increase transparency.
Following delivery of the fund documents to investors, counsel and the sponsor will work closely with investors to resolve any questions or comments and, once a critical mass of investors’ subscriptions has been secured, the fund will hold an initial closing. Fundraising timelines in private equity can vary significantly depending on the sponsor involved and the type and size of fund being raised, running anywhere from a few months to a few years. Once an initial closing has been held, a private equity fund will typically be permitted to hold subsequent closings over a period of 12 to 18 months (although the average time spent in market by funds that held final closings during the first half of 2022 increased compared to funds closing beforehand). As the regulation of private equity funds continues to increase, it remains very important for sponsors to work closely with counsel to ensure that all necessary steps are taken to permit marketing in each jurisdiction in which fund interests are to be marketed.
11 How closely are private equity sponsors supervised in your jurisdiction? Does this supervision impact the day-to-day business?
Private equity firms are subject to substantial regulation and supervision in the United States, and the regulatory environment in which private equity firms operate is becoming increasingly complex. The regulation and supervision of private equity firms affects not only the manner in which interests in private equity funds are marketed and sold to investors, but also the day-to-day business and operations of private equity firms themselves.
The principal laws and regulations applicable to private equity firms affecting their day-to-day business and operations include, among others:
- the Securities Act of 1933 (affecting the manner in which private equity funds market and sell interests to investors);
- the Securities Exchange Act of 1934 (affecting ongoing reporting obligations and placing practical limitations on the number of investors in private equity funds);
- the Advisers Act (imposing substantive regulations and reporting provisions on many private equity fund advisers);
- the Investment Company Act of 1940 (establishing certain eligibility requirements and limitations on investors in private equity funds);
- the Commodity Exchange Act (regulating the ownership of commodities by private equity funds); and
- the Employee Retirement Income Security Act of 1974 (imposing restrictions and onerous fiduciary requirements on private equity funds deemed to hold ‘plan assets’).
Since the SEC gained oversight of the industry under the Dodd-Frank Act, private equity firms remain the subject of regulatory and public scrutiny. The SEC continues to find more regulatory lapses among private equity firms, particularly related to expenses and expense allocation, conflicts of interest and other disclosure matters and, most recently, MNPI policies and procedures. Private equity firms with dedicated compliance, investor relations and administrative resources necessary to manage the increased regulatory and compliance burdens in addition to investor demands in today’s competitive fundraising environment are likely to continue to enjoy an advantage in the future.
12 What effect has the AIFMD had on fundraising in your jurisdiction?
The AIFMD has resulted in two approaches to fundraising in the European Economic Area (EEA) by US fund managers:
- the use of national private placement regimes (NPPRs); and
- the use of hosted solution platforms.
Some US managers avoid active marketing in the EEA but will admit investors to their fund at the initiative of the investor (reverse solicitation). Although reverse solicitation is sometimes referred to as a way of marketing in the EEA, it is an exclusion that allows investors domiciled or established in the EEA (EEA investors) to invest in funds at their own initiative without thereby subjecting the fund manager to compliance with the AIFMD. As it is not a method of active fundraising (or, if used to that effect, it would be a circumvention of the AIFMD) it is not considered further here.
The two approaches to fundraising reflect the options available under the AIFMD depending on whether the fund manager is:
- a non-EEA alternative investment fund manager (non-EEA AIFM); or
- an authorised EEA alternative investment fund manager (EEA AIFM).
For marketing by a non-EEA AIFM, the AIFMD allows national authorities to operate (at their option) an NPPR. In countries that permit marketing under NPPRs, a non-EEA AIFM may market an alternative investment fund solely within the territory of the relevant country, provided that the non-EEA AIFM complies, at a minimum, with a limited subset of AIFMD requirements. By contrast, for an authorised AIFM, the AIFMD provides a streamlined passport system that (subject to certain limitations) permits the marketing of EEA funds to professional investors anywhere in the EEA. The AIFMD makes provision for the possibility of extending this passport system to non-EEA AIFMs, but there is, as yet, no indication as to when or if it will ever become available to US fund managers.
To understand why the AIFMD has resulted in a bifurcation between NPPRs and hosted solutions, it is useful to consider further aspects of each approach.
National private placement regimes
There is no requirement for EEA member states to allow non-EEA fund managers to privately solicit investors in their member state. Where it is permitted, the member state is required to impose at least the following requirements:
- pre-investment disclosure;
- periodic reporting (Annex IV reporting);
- annual report; and
- if applicable:
- notification and disclosure requirements in relation to the acquisition of significant stakes or control of non-listed companies and issuers; and
- restrictions on certain distributions, capital reductions and share redemptions in respect of portfolio companies (the anti-asset-stripping rules).
Member states are free to impose more stringent measures than those listed above. At present, some EEA states do not operate NPPRs at all. Some EEA states apply the minimum requirements described above, others require the minimum plus, for example, the appointment of a depositary, and some require compliance with substantially all of the AIFMD, making it impossible or practically impossible for a non-EEA AIFM to market a fund in that member state.
The process for obtaining marketing approval under an NPPR (where it is allowed) varies, though it usually requires the advice of local counsel and is therefore costly and time-consuming. This has resulted in a number of US private equity funds, particularly smaller firms that do not have the necessary compliance and fundraising infrastructure in place, to be disadvantaged by the complexity and cost, especially where there is no certainty of raising capital. Further, the minimum requirements noted above (and, if applicable, the appointment of a depositary) create an ongoing administrative and compliance burden for the life of the fund (or until registration is terminated).
Notwithstanding these obstacles, for some non-EEA AIFMs, NPPRs have facilitated the repeated raisings of large funds. They has proven to be a reliable and predictable process that is minimally disruptive to the sponsor’s existing business model, as costs are known (many are one-off), ongoing compliance for annual reports and regulatory reporting is incremental, and it does not involve a long-term or open-ended commitment to an establishment in the EEA or to complying with EU laws, as they may evolve or be extended in the future.
The main disadvantages to NPPRs are:
- it is either not permitted or not practical in certain key countries in western Europe;
- there is (currently) no common meaning of ‘pre-marketing’ for gauging interest before formally registering under an NPPR;
- NPPRs have a patchwork of notification and application procedures across the member states where they are permitted (and in some cases approval from the regulator can take months); and
- Annex IV reporting must be submitted in different formats through different electronic portals to each member state where the alternative investment fund is registered for marketing.
The main alternatives to NPPRs are forming an entity to become authorised as an EEA AIFM and engaging a hosted solution.
Forming a legal entity in an EEA member state and obtaining authorisation as an AIFM is a significant business commitment. Although a small number of US managers have established, or acquired, authorised AIFMs, it is not a plausible alternative for most sponsors and is not often considered further.
A hosted solution involves engaging an authorised EEA AIFM that agrees to manage and market a fund sponsored by a non-EEA AIFM. Typically, a new alternative investment fund is established in the EEA, commonly in Luxembourg or Ireland. The EEA AIFM (the host) agrees to manage the alternative investment fund and market the fund in selected member states under its marketing passport. The EEA AIFM will typically either delegate management to the non-EEA AIFM or engage the non-EEA AIFM to provide investment advice. Increasingly, delegation seems to be more popular than an advisory arrangement, even though it may subject the delegate to certain remuneration rules.
The marketing passport is only available for the marketing of an EEA alternative investment fund and, then, only if the EEA fund is not a feeder fund to a non-EEA master or not a feeder fund to an EEA master that is not managed by an authorised EEA AIFM. For this reason, the hosted solution is commonly used in a parallel investment structure with a non-EEA AIF, which avoids a master–feeder structure.
The right to market under the passport is that of the EEA AIFM – the AIFM has access to the marketing passport, but that does not allow the non-EEA AIFM to market on its behalf in the EEA. The most straightforward solution to this problem is to engage a placement agent authorised in the EEA to act as an intermediary to the market on behalf of the AIFM.
EEA investors are familiar with the hosted solution model and there is no indication that the involvement of a third-party AIFM adversely affects their investment decision – possibly the opposite is the case for some institutional investors, insofar as they prefer to invest in an EEA alternative investment fund with the full protections of the AIFMD. For a similar reason, regulators may prefer the model to an NPPR, for example, because the alternative investment fund and AIFM are within the regulatory perimeter and EU investors receive the full protection of the AIFMD.
A hosted solution addresses most of the shortcomings of marketing under NPPRs, but most importantly it allows access to all countries in the EEA. However, it does entail:
- negotiating a set of service agreements (with the AIFM, and possibly with the depositary and fund administrator);
- establishing an EEA alternative investment fund;
- working with, or under, an entity that is itself subject to all of the requirements of the AIFMD;
- establishing a parallel investment structure; and
- engaging a marketing intermediary.
These factors do mean that the costs, which continue for the life of the fund, may only be justified if the marketing effort results in the raising of a significant amount of capital from investors from whom capital could not otherwise be raised under NPPR.
In summary, the AIFMD contemplated marketing by non-EEA AIFMs under NPPRs. While NPPRs are workable and preferable for some non-EEA AIFMs, the advantages of the marketing passport combined with the attractiveness to some institutional investors of investing in an EEA alternative investment fund, managed by an authorised EEA AIFM, has spawned an industry of hosted solution platform providers.
13 What are the major tax issues that private equity faces in your jurisdiction? How is carried interest taxed? Do you see the current treatment potentially changing in the near future?
US tax rules are very complex and tax matters play an important role in both fund formation and the structure of underlying fund investments. US private equity funds are generally structured as pass-through entities for US tax purposes. Acquisitions by private equity firms can sometimes be structured such that the target is also a pass-through entity for US tax purposes. This allows the sponsor to avoid or minimise the effect of double taxation that results from US corporate income tax and may also permit a private equity sponsor to monetise a step-up in the tax basis of the assets of the target. However, such flow-through structures could create US tax issues for tax-exempt and non-US limited partners of private equity funds that require special fund structures to address (which may include the use of corporate ‘blocker’ entities). Private equity transactions may also involve investments in target entities that are treated as corporations for US tax purposes. Generally, the substantial amount of debt involved in leveraged buyout transactions affords a target company significant interest expense deductions that could be available to offset taxable income, subject to certain limitations. Given the importance of the availability of interest deductions to modelling leveraged acquisitions, careful attention must be paid to the terms of the acquisition debt and the limitations on the deductibility of interest under the US tax rules. Consultation with dedicated tax advisers with respect to the structuring of specific transactions and related tax issues is highly recommended.
Private equity sponsors must also consider the impact of potential tax reform. President Biden’s administration has indicated that one of its top legislative priorities is significant tax increases and various other changes to US tax rules. Legislation has been proposed that includes, among other changes, a corporate alternative minimum tax and certain changes to the taxation of carried interest, as discussed further below. Whether any of these changes will be enacted and their impact on private equity are uncertain.
In recent years, private equity sponsors and their portfolio companies have also considered the impact of the tax relief provisions of the Coronavirus Aid, Relief and the Economic Security Act, including suspending the 80 per cent net operating loss limitation, the limitation on the utilisation of business interest expense deductions, and the deferral of certain employer payroll tax payments, among other changes. Additionally, in light of the covid-19 pandemic, many portfolio companies have repurchased debt at a discount (or had their debt repurchased by a private equity sponsor or related party at a discount), which can result in the cancellation of indebtedness income to the borrower and raise other tax considerations for both issuers and sponsors.
Special consideration is given to structuring the carried interest such that it is treated as a partnership allocation eligible for taxation on a flow-through basis. It is sometimes desirable to separate the GP (namely, the recipient of the carried interest) and the investment manager (namely, the recipient of the management fee) into separate entities for state tax and other purposes. Section 1061 of the Internal Revenue Code typically requires the GP of a private equity fund to hold an investment for three years in order for the carried interest related to such an investment to be treated as capital gains for tax purposes. Additionally, Congress has recently proposed legislation that would lengthen the required holding period to at least five years and make certain other changes to the taxation of carried interest. The application of these rules to private equity funds is unclear and may result in an even longer holding period in certain situations.
Private equity sponsors must also be aware of tax issues relating to management and employee compensation, which will be relevant to structuring management’s investment and post-closing incentives. An example of one such tax issue is that compensation triggered by a change of control, including certain severance and consideration for equity holdings, may be excess parachute payments, which are subject to a 20 per cent excise tax (in addition to ordinary income taxes) and may not be deducted by the target.
Another example involves the tax treatment of different types of stock options. If an option is an incentive stock option, under typical circumstances, no income is realised by the recipient upon grant or exercise of the option and no deduction is available to the company at such times. Employees recognise tax at capital gains rates when the shares acquired upon option exercise are ultimately sold (if the applicable holding period requirements are met) and the company takes no deduction. If the award is a non-qualified stock option, no income is recognised by the recipient at the time of the grant and no deduction is available to the company at such time. Rather, income is recognised and the deduction is available to the company at the time of option exercise. There are a number of limitations on incentive stock options and private equity sponsors generally prefer to maintain the tax deduction. Accordingly, non-qualified stock options are more typical.
A final example involves non-qualified deferred compensation. If a deferred compensation plan is non-qualified, all compensation deferred in a particular year and in prior years may be taxable at ordinary income rates in the first year that it is not subject to substantial risk of forfeiture, unless payment is deferred to a date or event that is permitted under the Internal Revenue Code section 409A’s rules governing non-qualified deferred compensation.
14 Looking ahead, what can we expect? What might be the main themes in the next 12 months for private equity deal activity and fundraising?
After private equity deal activity excelled in 2021 and reached historic highs, the beginning of 2022 saw a considerable drop off consistent with the broader M&A market. Although the significant decrease relative to 2021 is notable, the volume and value in private equity transactions thus far in 2022 remain roughly in line with pre-pandemic activity levels. While global economic factors, including inflationary headwinds and interest rate hikes promulgated by the Federal Reserve and other central banks, greatly affected Q1, the second quarter of 2022 showed promising signs of life. Global M&A was up over 5 per cent in Q2 compared to Q1 of this year. Mega-deals – defined as transactions of US$1 billion or more – contributed significantly to this uptick. While the volume and pace of these mega-deals are still down from 2021, they remained elevated relative to historical levels, accounting for US$137 billion in deal value over the first six months of 2022.
During 2020 and into 2021, the covid-19 pandemic and resulting travel and other restrictions disrupted private equity fundraising, disproportionately impacting first-time funds and funds that had not yet begun fundraising. Nevertheless, large, blue-chip sponsors with strong pre-existing limited partner relationships and fundraising in process at the beginning of 2020 remained successful. We expect that the trends and developments witnessed in recent years, with respect to fund formation, will continue as the consolidation in the private equity industry continues too. We believe that competition for investor capital among private equity funds will persist, with alternative fundraising strategies and strategic relationships continuing to play a substantial role. Likewise, we believe that allocation decisions by risk-averse limited partners will continue to favour larger, established sponsors with strong track records and the ability to absorb the incremental burdens associated with today’s market environment as well as the continued scrutiny and enhanced regulation of the private equity industry. In addition, we believe that private equity funds will encounter valuation issues as uncertainty and volatility within the markets remain (particularly for those firms relying on public company comparisons and discounted cash flow valuations). Finally, a decline in public market values could result in an imbalance in investors’ portfolios, causing such investors to reduce their private fund exposure to maintain certain asset allocations, and it is possible that funding defaults by such investors will increase.
In conclusion, with financial market volatility, credit and exit opportunities drying up, and inflationary issues persisting, we would expect that, during the second half of 2022, private equity activity levels will remain suppressed as in the first half of the year relative to last year. High levels of dry powder, which Pitchbook reports have reached US$2.3 trillion in June 2022 – triple the amount which existed at the beginning of the global financial crisis – are likely to incentivise dealmaking, but uncertainty regarding valuations and future performance of many companies, as well as of the regulatory landscape and potential further interest rate increases, will remain a fundamental challenge. However, it is unlikely that private equity firms will sit on the sidelines, and many will likely seek to take advantage of lower valuations to pursue attractive assets. Overall, the outlook for the remainder of 2022 is uncertain in light of macroeconomic volatility and it appears unlikely that we will see an immediate reversion to the historic activity levels seen in 2021.
The Inside Track
What factors make private equity practice in your jurisdiction unique?
Overall, the United States continues to rank as the top market for private equity. As the traditional base of private equity, the United States has attracted the lion’s share of capital over the years and 2022 has been no different, as US private equity firms raised more than half of last year’s total in Q2 alone, with US$176 billion committed across 191 funds (Pitchbook). Through the years, the private equity industry has matured and the experience of fund managers has broadened such that investors continue to view the United States as an attractive jurisdiction for their investment
What should a client consider when choosing counsel for a complex private equity transaction in your jurisdiction?
Depth of experience in the private equity sector and a creative and commercial approach to problem-solving. Practical experience combined with industry acumen is also critical and counsel should have insight into the needs of every participant. As such, a client would benefit from counsel that offers cross-practice excellence.
What interesting or unusual issues have you come across in recent matters?
As private equity deal activity peaked in the first half of 2021, and then fell in the first half of 2022, private equity firms in the United States have continued to shift much of their focus to the continued use of add-on acquisitions to boost the profiles of their existing portfolio companies. GP-led secondary sales of portfolio companies to newer funds established by the same GP or to continuation funds established by a GP and private investment in public equity have been increasingly used as a means to deploy capital. Additionally, take-private transactions maintained their momentum in the first half of 2022, with 18 take-private deals capturing over US$58 billion in value already completed. The healthcare sector has been notable for its activity in Q2, with four take-privates completed, while the US$44 billion agreement by Elon Musk to acquire Twitter has made headlines in recent months (Pitchbook).