Lexology GTDT Market Intelligence provides a unique perspective on evolving legal and regulatory landscapes. This interview is taken from the Private Equity volume featuring discussion and analysis of emerging trends and hot topics within key jurisdictions worldwide.
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?
M&A activity levels in the US over the first half of 2019 increased 8.4 per cent year over year to US$1.1 trillion of deals, according to Bloomberg. Private equity activity in the US decreased compared to 2018 levels. According to data supplied by PitchBook, through the first half of the year, 2,142 private equity deals totalling US$297.1 billion have occurred in the US, representing an approximate 19.3 per cent decrease in volume and 9.9 per cent decrease in value over the same period last year. With the continued elevation in fund sizes in 2019, the number of ‘mega-deals’ in the United States has increased to 19 deals over US$10 billion in the first half of 2019 compared to 19 in all of 2018, according to Mergermarket.
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?
In part because valuations remain at relatively elevated levels, private equity sponsors continue to look for creative ways to deploy their capital. For example, we have seen sponsors engage in partnerships with strategic sellers, minority preferred investments, add-on acquisitions and joint ventures. Additionally, many private equity sponsors based in the United States are increasingly looking to expand overseas to take advantage of more complex and sizable deals. Add-on acquisitions and minority investments remain a popular avenue to deploy capital in the United States, with add-on acquisitions and deals below US$25 million accounting for about 70 per cent and 37 per cent of all US private equity buyout activity during the period, respectively (Pitchbook).
3 What were the recent keynote deals? And what made them stand out?
Notable private equity transactions in the Americas in the first half of 2019 include: the US$14.1 billion take-private of Zayo Group Holdings, Inc by a consortium including EQT Partners and Digital Colony Partners, the largest private equity-backed buyout announced during the second quarter of 2019; the US$13.4 billion acquisition of GLP’s US logistics assets by Blackstone Group; the US$11.0 billion take-private of Ultimate Software Group by a consortium that included Hellman & Friedman and Blackstone, the largest of the three buyouts of technology companies that exceeded US$1.0 billion in the second quarter of 2019; and the US$10.2 billion acquisition of Buckeye Partners by IFM Investors.
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 growing interest in cross-border deals, particularly among larger funds with the capacity to manage such transactions. Many large-cap sponsors have stand-alone region-focused funds, such as Asia-focused funds, that have fund 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.
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. CFIUS has authority to negotiate and implement agreements to mitigate any national security risks raised by such transactions. Absent a mitigation agreement, 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 sales of portfolio companies that are in sensitive industries or that handle sensitive data and, in each case, that implicate national security concerns, sponsors will be prudent to consider proposing reverse termination fees or pre-emptive divestitures, to discuss possible mitigation measures and to build political support. Since 2012, acquisitions involving Chinese acquirers have been the most reviewed transactions pursuant to the CFIUS review process. Given the Trump administration’s avowed trade policies and anti-China rhetoric, as well as heightened tensions around North Korea and Russia, and with the recent enactment of significant CFIUS reform legislation (the Foreign Investment Risk Review Modernization Act of 2018 (FIRRMA)) that 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. In addition, in late 2018, CFIUS recently implemented a pilot programme pursuant to FIRRMA that imposes mandatory filing requirements for certain transactions involving target companies that deal in certain critical technologies such as semiconductor manufacturing and operate in a defined set of particularly sensitive industries. A failure to satisfy these new 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. 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 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?
In the past year, there has been a relaxation of guidelines promulgated by the Federal Reserve and the Office of the Comptroller of the Currency for financial institutions by the new administration, but there still remains a high degree of uncertainty in the current regulatory environment. Nonetheless, dealmakers have been able to find relatively attractive pricing and availability of credit for transactions involving high quality assets. Overall, the debt financing markets in the US have remained open, with sponsors finding ready access to debt financing in the first half of 2019. In the second quarter of 2019, average debt-to-EBITDA multiples for broadly syndicated leveraged buyout transactions increased to 6.64x overall, and 6.5x for institutional middle market leveraged buyouts over the same period (Refinitiv). For the first half of 2019, average purchase price multiples were at 12.7x for broadly syndicated leveraged buyout transactions overall and 13.3x for institutional middle-market deals (Refinitiv). The average equity contribution for broadly syndicated leveraged buyouts increased to 41.6 per cent overall and is at 49.2 per cent for institutional middle market leveraged buyouts (Refinitiv).
6 How has the legal, regulatory and policy landscape changed during the past few years in your jurisdiction?
As a result of the passage of the Dodd-Frank Act in 2010, most private equity firms continue to be required to register with the Securities and Exchange Commission (SEC) as investment advisers. Although the Trump administration in the United States has signed legislation to roll back certain aspects of the Dodd-Frank Act, the effects of such legislation have not yet been determined. Dodd-Frank imposes extensive compliance obligations for the industry. In addition, in recent years, the SEC has focused 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:
- allocation of expenses (including for the compensation of operating partners, senior advisors, consultants and employees of private equity fund advisers or their affiliates (including seconded employees) for providing services (other than advisory services) to funds or portfolio companies as well as for payment of a private equity fund adviser’s regulatory compliance expenses) to funds or portfolio companies, or both, as well as 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;
- 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);
- allocation of investment opportunities by private equity sponsors among investment vehicles and funds that they manage;
- allocation of co-investment opportunities;
- disclosure of conflicts of interest to investors, including those arising out of the outside business activities of a private equity firm’s employees and directors; and
- receipt of service provider discounts by private equity firms that are not given to the funds or portfolio companies.
Although we believe the ‘broken windows’ enforcement approach under the Obama administration has abated, we continue to see private equity remain a priority for SEC enforcement in the Trump administration. 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.
The JOBS Act and the SEC significantly amended certain aspects of the regulation governing the private offering and sale of securities (including limited partner interests in private equity funds) that are designed to permit greater flexibility for issuers. Despite these recent improvements and the adoption of Rule 506(c) permitting the use of general solicitation and general advertising in private placements, the conditions imposed by the SEC and the heightened compliance obligations (eg, enhanced verification) and costs associated with relying on Rule 506(c) imposed on private equity funds create a burdensome process and private equity funds have not yet utilised such rules in any meaningful way in their current form. In addition, the SEC adopted bad actor disqualification provisions in Rule 506(d) under which issuers are prohibited from relying on the Rule 506 safe harbour (whether or not the proposed offering involves a general solicitation) if the issuer or any other ‘covered person’ was subject to a ‘disqualifying event’ that occurred on or after 23 September 2013, which have in some cases significantly affected the ability of private equity firms to conduct private placements.
On 22 December 2017, President Trump signed major tax reform legislation passed by the House and Senate under the Tax Cuts and Jobs Act (the Tax Reform Bill), which was generally effective as of 1 January 2018. Among the numerous changes included in the Tax Reform Bill were:
- a permanent reduction to the corporate income tax rate;
- a partial limitation on the deductibility of interest paid or accrued on indebtedness properly allocable to a trade or business (subject to certain exceptions);
- a new deduction for individuals receiving certain business income from ‘pass-through’ entities; and
- a partial shift of the US taxation of multinational corporations from a tax on worldwide income to a territorial system (along with a transitional rule that taxes certain historic accumulated earnings and rules that prevent tax planning strategies, which shift profits to low-tax jurisdictions).
The impact of the new and sweeping tax law changes on private equity transactions remains uncertain, although the Internal Revenue Service and Treasury have begun to publish regulatory guidance on some issues.
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 seem 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 as part of the ‘mix’ of factors in connection with effecting such transactions.
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 otherwise largely remains unchanged as of the first half of 2019. However, with a number of prominent private equity names serving in cabinet positions and other roles in the new administration, some people in the industry are expecting that regulators will take a more relaxed approach to oversight of financial sponsors.
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 (PE-backed) exit activity slowed down during the first half of 2019, continuing the trend in exit activity seen in 2018. According to data supplied by Pitchbook, sponsors executed 371 exits in the United States accounting for approximately US$110.1 billion in the first half of 2019, representing a 38.5 per cent decrease in exit volume as compared to the first half of 2018 and a 45.4 per cent decrease in total exit value. Secondary buyouts accounted for the largest proportion of PE-backed exit activity, accounting for 26.0 per cent of all PE-backed exits during the first half of 2019 (PichBook). The business-to-business sector was again the largest sector in the private equity exit landscape, with 20.1 per cent of all total exit value achieved during the period (Pitchbook). The IT sector, however, reached its highest recorded proportion of private equity exit activity, accounting for 18.6 per cent of private equity exits.
Initial public offering (IPO) exit value during the second quarter of 2019 reached US$21.8 billion and accounted for 35.1 per cent of total PE-backed exit activity, its highest proportion since the second quarter of 2013 (PitchBook). Despite a slowdown in IPO activity during the first quarter of 2019, overall IPO activity rebounded during the second quarter, with 75 IPOs raising nearly US$30 billion during the quarter, the highest amount since the third quarter of 2014, according to FactSet. The quarter’s five mega-IPOs accounted for more than half of all proceeds, together raising US$15.3 billion (FactSet). After a lack of PE-backed listings during the first quarter of 2019, 12 IPOs during the second quarter were backed by private equity sponsors, including two of the quarter’s mega-IPOs (FactSet). More than half of US IPO listings during the second quarter of 2019 were backed by financial sponsors and financial sponsor-backed IPOs raised US$23.6 billion of the nearly US$30 billion raised during the second quarter (FactSet). The largest PE-backed IPO of the second quarter of 2019 was the offering by Avantor, Inc, which raised approximately US$3.8 billion.
Other notable private equity exits during the first half of the year included KKR’s sale of First Data Corporation to Fiserv, Inc for US$38.5 billion and Apax Funds, CPPIB and PSP Investments’ sale of Acelity to 3M Company for US$6.7 billion.
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?
Although global private equity fundraising has slowed somewhat in recent years as compared to historic levels in 2016 and 2017, fundraising activity during the first half of 2019 was strong overall with 81 per cent of funds closed in the first half of 2019 achieving or exceeding their target size, according to Preqin. Fundraising by established, top-performing sponsors at the upper end of the private equity market continued to account a significant portion of the capital raised. Although total capital raised in the first half of 2019 was on par with that raised in the first half of 2018 (US$221 billion as compared to US$201 billion (Preqin)), the number of funds closing decreased to 527 from 764 during the same period (Preqin). This reflects continued consolidation within the private equity fundraising market in favour of such established sponsors with proven track records.
Further, competition among private equity funds has continued to increase as the number of private equity funds in the market has continued to increase in recent quarters, reaching 3,951 funds in market at the beginning of the third quarter of 2019, as compared to 3,037 in the third quarter of 2018 while the amount of capital targeted by private equity funds has remained relatively steady, increasing only 3.5 per cent from US$948 billion at the beginning of the third quarter of 2018 to US$981 billion at the beginning of the third quarter of 2019 (Preqin).
Global macroeconomic uncertainty and difficult economic and political conditions in certain regions have shifted fundraising dynamics in favour of North America during the first half of 2019. In the second quarter of 2019 alone, 139 North America-focused funds closed on US$68 billion of aggregate capital, while 43 Europe-focused and 45 Asia-focused funds closed on US$21 billion and US$15 billion of aggregate capital, respectively (Preqin). As of the beginning of the third quarter of 2019, there were more than 1,500 funds in market targeting North America and Asia, while only 500 funds in market as of the beginning of the third quarter of 2019 were targeting Europe (Preqin). Further, as of the end of the second quarter of 2019, 53 per cent of institutional investors are seeking to make new commitments in North America-focused private equity funds in the next 12 months; however, by contrast, possibly in light of the uncertainty regarding Brexit, the number of institutional investors seeking to make new commitments in Europe-focused private equity funds in the next 12 months has decreased to 49 per cent from 61 per cent in the prior year (Preqin).
Institutional limited partners are continuing to place increased emphasis on consistent track records and stability, tending to make larger commitments to fewer private equity funds, and established top quartile sponsors have continued to be able to raise larger funds in shorter periods of time and capture a greater share of the overall private equity fundraising market.
High pricing levels of assets and low interest rates have contributed to the substantial exits and distributions to limited partners over the past few years and have enhanced private equity fundraising for many sponsors as investors seek to redeploy those distributions into new private equity funds. Many institutional investors have also increased their overall portfolio allocation to the private equity asset class. The amount of capital distributed by private equity funds to investors in recent years has been significantly more than the amount of capital called from investors. As of the end of the second quarter of 2018 (Preqin), dry powder held by private equity funds was estimated to have reached a record US$1.54 trillion.
There has also been a continued focus on strategic relationships and alternative fundraising strategies, including customised separate account arrangements, co-investment arrangements and multi-strategy (umbrella) arrangements and new product development (eg, a number of established sponsors have raised longer life, lower risk and return funds in asset classes like private equity and real estate).
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?
While 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 the sponsor, below is a simplified framework and timeline for a typical private equity fundraising.
In most cases, the 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 of the United States (eg, the Cayman Islands). Legal counsel will also 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. 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 to such documents 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 fundraising process has been accelerated to six to 12 months in recent years). 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. 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?
At the present time there are two ways of marketing funds in the European Economic Area (EEA):
- a passport system for authorised EEA alternative investment fund managers (EEA AIFMs) who wish to market EEA alternative investment funds (EEA AIFs) anywhere in the EEA; and,
- in jurisdictions where it is permitted, the marketing of AIFs by non-EEA AIFMs in accordance with the national private placement regimes (NPPRs).
Such bifurcation has gradually given rise to different approaches to fundraising in the EEA by US fund managers.
For example, some US fund managers will avoid actively marketing to EEA investors altogether, but will passively admit EEA investors if they seek to invest on their own initiative. Others will selectively use NPPRs. Finally, more recently there has been an uptake of the use of hosted solutions, and in a minority of cases, some US firms have established a subsidiary in the EEA that has become an authorised AIFM.
Reverse solicitation is an exception to the marketing rules, which allows EEA investors to invest in funds managed by US fund managers without any active marketing by the US fund manager. Reverse solicitation is generally considered to mean a solicitation by a prospective investor without any prior solicitation by the AIFM or any agent acting on its behalf in relation to the relevant fund. Since reverse solicitation does not provide for active marketing by US fund managers or any agent acting on its behalf, it is generally not considered to be a sound basis on which to plan a marketing initiative across Europe.
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 states; where it is permitted, the member state is free to impose requirements more stringent than the minimum required under the AIFMD. As it stands, some member states do not allow any marketing by non-EU fund managers and of those that do allow it, some ‘gold-plate’ the standards imposed by the AIFMD.
In practice, the patchwork of private placement regimes across EEA member states is costly and time-consuming to navigate and has in practice hindered or had a negative effect on the desire of some US managers to raise capital in Europe. The application process for marketing by non-EEA fund managers (where it is allowed) varies with some member states requiring only an email notification in a prescribed form, while others grant a formal approval on the basis of a detailed application. However, unlike in the past, in member states where approval is required, the process now takes (on average) only a couple of months.
While the registration and approval process has settled into a predictable pattern, there still remains legal uncertainty about certain fundamental concepts: what constitutes ‘pre-marketing’; what constitutes reverse solicitation; is a change in the private placement memorandum or limited partnership agreement a ‘material change’; how long can a borrowing facility be outstanding and still be of a temporary nature; how is leverage to be calculated; how do the asset stripping rules apply to a large international group, among others.
Marketing under NPPR has meaningfully increased the compliance burdens and costs associated with private equity firms marketing alternative investment funds to non-retail investors in the EU, resulting in a number of US private equity funds, particularly smaller firms that do not have the necessary compliance and fundraising infrastructure in place, deciding not to market in Europe to avoid the additional regulatory burdens and costs imposed by the AIFMD. Minimum transparency requirements under the AIFMD (eg, annual reports, periodic AIF and AIFM reports, pre-investment disclosure to investors, notification in respect of control of non-listed companies, etc) create ongoing and time-critical administrative and compliance burdens for non-EEA fund managers and result in significant additional costs and administration.
In recent years, the use of a hosted solution provider has become more popular. This involves engaging a third party, authorised EEA AIFM with an established platform to manage and market a new AIF established in the EEA (most commonly in Luxembourg or Ireland). The EEA AIFM then either delegates portfolio management to the non-EEA AIFM of the fund manager or engages the non-EEA AIFM of the fund manager to provide investment advice. There is a tension between the EEA AIFM being able to demonstrate that it has the expertise, resources and independence to supervise and monitor its delegate (including the ability to analyse any non-binding investment advice it receives) and providing a platform on which a non-EEA AIFM can carry out its intended investment strategy with as little interference as possible. In addition, the fund manager must bear the costs of engaging a third party service provider for the life of the fund. Finally, as a consequence of Britain’s anticipated exit from the European Union, there is a higher level of scrutiny on arrangements that provide access to the European market, including hosted AIFM platforms.
Finally, authorisation of a subsidiary established in the EEA has the advantage of obtaining access to marketing throughout the EEA under a passport and overcomes the disadvantages of working with, or under the direction of, a third-party hosted solution; however, it requires a substantial commitment to maintaining a sophisticated European operation. Only a small number of US fund managers have taken this route. It requires, as a threshold condition, an establishment in a member state with sufficient resources (human, technical, financial) to comply with the regulatory system. For most US fund managers, it is not a realistic or commercially viable alternative to NPPR or, even as an interim step, to engaging a hosted solution.
The increased regulation imposed by the AIFMD, together with a broader trend towards increasing scrutiny and regulation of private equity firms, has compelled many private fund managers to adopt more systematic and integrated compliance operations as part of their overall fundraising activities. We believe that larger established managers that either have the systems and resources in place or that can readily adapt to these requirements are better placed to absorb the incremental costs and compliance burdens associated with the AIFMD. Larger managers should therefore enjoy a competitive advantage among their peers as smaller firms will likely feel a disproportionate impact on their businesses as a result of the AIFMD. The result of this relative disadvantage may favour hosted solutions, because, in theory, the non-EU manager engaging a hosted solution bears only a small proportion of the cost for dedicated compliance, but gains the efficiency of marketing throughout the EU under the passport and can focus more attention on the investment strategy.
Regulatory compliance is an integral part of any private equity sponsor’s global marketing programme. Fund managers that do not have the resources and counsel necessary to address the additional regulatory and compliance obligations arising out of the AIFMD may find it increasingly difficult to comply with the AIFMD and to market funds in the EEA.
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. Tax issues that have been given particular focus as of late include:
- the implementation of the numerous changes related to the Tax Reform Bill (as described at question 6),
- the implementation of due diligence, information reporting and withholding rules pursuant to the Foreign Account Tax Compliance Act (FATCA);
- the proper tax treatment (including deductibility) of monitoring fees paid by underlying portfolio companies to a private equity fund’s investment adviser; and
- the partnership audit rules, which may impose liability for adjustments to a partnership’s tax returns on the partnership itself.
Consultation with dedicated tax advisers with respect to specific transactions and issues is highly recommended.
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 general partner (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.
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 which 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 facts, 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 tax 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 both private equity deal activity and fundraising?
Overall, US private equity deal flow slowed in the first half 2019 as compared to the same period in 2018. It remains uncertain whether debt financing markets will hold firm in a potentially more volatile macro-environment going forward. We believe that valuations for highly sought-after targets for sale may continue to be propped up by strong competition. US private equity funds continue to hold a record amount of deployable capital, having accumulated more than US$1.54 trillion by the end of the second quarter of 2019, according to Preqin. In addition, we expect to see a continued trend towards add-on acquisitions and smaller deals as sponsors work more closely with industry executives to find transactions with synergies to build portfolio company value.
We also expect that the trends and developments witnessed in the first half of 2019 with respect to fund formation will continue as the consolidation in the private equity industry continues. Competition for investor capital among private equity funds will continue to increase, with alternative fundraising strategies continuing to play a substantial role, Likewise, established sponsors with proven track records and the ability to absorb incremental burdens associated with today’s continued scrutiny and enhanced regulation of the private equity industry should continue to enjoy a competitive advantage.
In conclusion, we would expect that the second half of 2019 will likely mirror the private equity sponsor activity in the first half of the year. High levels of dry powder combined with easy access to debt financing is likely to drive dealmaking. However, overall volume may be tempered by fewer quality targets coming to market and the continued trend of smaller add-on, or strategic, acquisitions by portfolio companies. Political, economic and regulatory uncertainty may also temper deal flow as dealmakers wait to see whether the new administration in the United States will undertake rollback of financial regulations, including parts of the Dodd-Frank Act. Each of these factors creates uncertainty for the direction of private equity deal activity in the second half of 2019.
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, reflecting the depth (in terms of size and liquidity) of its capital market and an ingrained culture of innovation. The United States is home to many of the world’s most successful and well-established private equity firms, which have traditionally raised the largest buyout ‘mega’ funds. Historically, US-focused fundraising has surpassed that of all other regions for private equity investment. As the traditional base of private equity, the United States has attracted the lion’s share of capital over the years, and 2019 has been no different. During the second quarter of 2019, 139 North America-focused funds raised US$68 billion of aggregate capital according to Preqin (as compared to 43 Europe-focused funds raising US$21 billion and 45 Asia-focused funds raising US$15 billion in the second quarter of 2019). Through the years, the private equity industry has matured and the experience of fund managers have 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?
The main consideration in selecting a legal adviser is depth of experience in the private equity sector and a creative and commercial approach to problem-solving. Practical experience combined with industry acumen are critical to advising complex transactions dealing with fund formation, minority investments, M&A, financing solutions and exit transactions.
In addition, counsel should have insight into the needs of every participant in private equity transactions, such as private equity sponsors, senior bank lenders, subordinated and bridge lenders, tax advisers, management and financial investors and underwriters. As such, a client would benefit from counsel that offers cross-practice excellence (eg, finance and banking practice areas that provide advice to private equity clients on financing solutions at all levels of the capital structure).