Private equity fund raising has reached its highest levels since its inception. In 2006, private equity funds raised a record US$215.4 billion, of which US$103 billion was raised by leverage buyout and mezzanine funds. Moreover, the mean amount raised per fund was approximately US$746 in 2006, more than twice the amount raised per fund in 2004. In 2007, Texas Utilities agreed to a record buyout by a consortium of private equity buyers of US$45 billion.
The proliferation of private equity activity has sparked a new trend— private equity funds and fund managers going public. For a private equity fund and fund manager, the benefits of going public may include low-cost, perpetual capital sources; immediate liquidity; tax reduction; and innovative incentives for management.
The investing public may also benefit through the newfound opportunity of private equity investing, which was limited historically to institutional and high net worth investors. There have been numerous recent public offerings by funds and fund managers with global investor bases and cross-border investment portfolios. Completed and proposed initial offerings range in size from approximately US$200 million to approximately US$4 billion. Certain funds also have successfully completed follow-on offerings.
Private Equity Fund v Manager Going Public
It is possible for both a fund and its manager to go public, but there are significant differences between a private equity fund going public and a manager doing so.
When a private equity fund goes public, a new fund (i.e., an acquisition vehicle) is formed to issue shares to the public and to acquire, with the offering proceeds, target portfolio companies from existing funds. The initial offering and the acquisitions happen simultaneously. When the dust settles, the public fund owns the target portfolio companies, typically through controlling interests. The public is entitled to a return of invested capital—approximately 80 per cent of future gains—and possibly an annual return in the range of 6 to 8 per cent (a characteristic of earlier deals but not a requirement).
The external manager will generally be entitled to the traditional “two and twenty”—a 2 per cent management fee and a 20 per cent carried interest. However, the right to receive carry may be based on increased market value, presenting a powerful financial incentive for managers.
A manager going public acquires very different assets. A new public fund manager will issue shares to the public and use the offering proceeds to acquire equity stakes in existing managers that own management fee and carried interest rights in private funds. The public manager is unlikely to directly hold any portfolio companies.
The public will not, therefore, own the underlying portfolio companies of the private equity funds. The public’s ownership is limited to an economic right to speculative, future carry and contractual management fee income.
Public “Private” Equity Fund Structure
An entirely new fund and manager structure is necessary to achieve the desired economic objectives and to satisfy US securities laws. The ultimate structure is similar to that of a traditional private equity fund.
Public fund: Although other US and non-US entities could be employed, the public fund is typically organised as a Delaware limited liability company, which we will call Public LLC. Public LLC must be structured to qualify as a partnership (a flow-through entity for tax purposes) to avoid entity-level taxation. In 2007, the US Internal Revenue Service issued a technical pronouncement obviating the use of a Delaware statutory trust in conjunction with the Public LLC to effectuate the offering—the structure of earlier fund offerings. A single Public LLC is generally more efficient than a trust because a stand alone Public LLC can replicate the benefits of a trust without the associated complexity. For the Public LLC, raising public equity may serve to create a perpetual acquisition vehicle with a low cost of capital.
Furthermore, external borrowing costs can be reduced through the structure. External manager: Public LLC will be managed by an external manager (Manager). The Manager is likely to be organised as a Delaware limited liability company intended to qualify as a partnership or flow-through entity for tax purposes. The Manager will enter into a management agreement with Public LLC entitling the Manager to an approximate 2 per cent fee based on managed capital. The Manager also subscribes for a special class of Public LLC shares that provide the 20 per cent carried interest. The Manager can achieve accelerated liquidity if entitled to receive carry based upon Public LLC market appreciation. Sale of portfolio companies by target private equity fund: The target private equity fund will sell select portfolio companies to the Public LLC for cash, typically in a fully taxable transaction akin to a standard buyout. In certain cases, Public LLC can obtain the tax benefit of a stepped-up, tax basis in depreciable assets, which reduces future taxable income.
Target fund investors/private placement: Simultaneous with the public offering, Public LLC may raise additional capital through a private placement.
Although not a requirement, the private placement permits investors in the target fund to use the sales proceeds (from the sale of the target portfolio companies to Public LLC) to invest in Public LLC. Target fund investors can cash-out on their investment in target portfolio companies while preserving some future upside potential by investing in Public LLC.
A certain amount of navigation through various tax and securities laws is necessary to accomplish this.
Tax Benefits and Pitfalls
A public fund or manager should be structured so that it is no worse off than if it continued as a private enterprise. Certain potential tax pitfalls include: entity level tax (at 35 per cent corporate rates) for Public LLC and Manager; immediate taxation of the Manager (or its members) upon receipt of the carried interest; and the loss of future capital gains treatment on the carried interest.
Significant tax benefits can be also be obtained. For example, tax consolidation (group relief in certain countries) of portfolio company groups can be achieved. It may be desirable if the present value of offsetting tax attributes among portfolio companies exceeds the potential future additional exit costs that can result from consolidation. Moreover, by capitalising portfolio companies with an appropriate balance of equity and internal debt, portfolio company corporate level tax can be reduced with deductible interest expense.
This approach is applicable to US and non-US companies, although consequences to US tax-exempt investors must be considered. Internal debt service also provides a mechanism to deliver annual returns to the public and Manager.
Various countries, including the United Kingdom, Denmark, Germany and the United States, are examining the way private equity funds are taxed. In May 2007, the US Senate Finance Committee held closed door congressional staff briefings to discuss
i) whether publicly traded partnerships (i.e., Public LLC) are circumventing US corporate level tax and
ii) whether changes should be made to current law permitting Managers to receive carried interests without current tax and receive favourable capital gains tax rates (currently 15 per cent) upon receipt of future carry.
Future changes to current law could negatively impact both private and public funds and Managers. Current law may therefore present a brief window of opportunity for funds seeking to go public.
Private equity going public may have a long-lasting impact on the private equity sector. The commercial reasons and potential benefits for public funds and managers are compelling. However, the process is complex, and funds must exercise great care developing appropriate commercial and legal strategies to complete a successful offering. Precision and experience with executing fund and manager public offerings are therefore critical.