Summary: At our recent Funds First seminar we shared some technical and market updates on issues and developments in carried interest. We were delighted to welcome James Jacobs from Lazard as a guest speaker. This briefing sets out some of the highlights of the issues discussed, which we hope will also be of interest to those who could not attend the seminar itself. We hope to see you again in the autumn for the next in our series of Funds First seminars
An overview of key legal issues on carried interest structuring
In our seminar we delved into some of the legal issues encountered in carried interest structuring. Initially we looked at modifications that can be made to a classic deal-by-deal model to reduce the disadvantages typically perceived with such models, in particular the greater risk of carry overpayments, and lesser incentive for a manager to seek to achieve optimal performance across the whole portfolio. It was observed that investors are requesting specific changes, including for example, that:
- all expenses, as well as significantly written down assets, be included in the waterfall calculation; and
- restrictions be imposed so that carry is not paid until for example the portfolio value test is satisfied (namely the fair value of the remaining portfolio is at least equal to that of the unrealised contributions).
Clawback was then analysed, and a few of the observations are noted below.
- There is no reason why investors should not be asking for their catch-up period share of profits to be caught by the clawback obligation, although this is often overlooked.
- Investors are seeking commitments from GPs that they will seek the repayment of any tax that has been paid on carry which is subsequently subject to clawback. This is in line with the Institutional Limited Partners Association (“ILPA”)’s suggestion that clawback payments be grossed up.
- Provisions for interim clawbacks and a series of interim clawbacks are being introduced to overcome the issues associated with end of life clawbacks.
- It is perhaps a step too far for investors to have a direct right to enforce guarantees provided by individual carry recipients. Provided investors have a confirmation from the GP that individual guarantees are in place, it may be preferable for the right to enforce to be retained by the GP, who can take a commercial decision regarding whether or not to incur the cost, time and associated ill-feeling, or to swallow the financial hit themselves.
Carry considerations following a GP removal were also discussed – we have selected some of the key points on this, as set out below.
- Unless a pure deal-by-deal model is adopted, which is unusual, there is no simple method of calculating the carry following a removal without cause, where it seems ‘fair’ that the exiting GP receives all or at least a sizeable share of the carry from existing investments. Crystallising carry at the time of removal using the fair market value of the existing investments, or allocating a percentage of the carry for the entire fund, are compromises used to try to achieve a fair result, albeit it was acknowledged that there are evident flaws in each.
- When considering removals for cause, it was noted that the definition of ‘cause’ is heavily negotiated. We are increasingly seeing a distinction being drawn between ‘cause’ (e.g. material, unremedied breaches with detrimental effect) and ‘bad acts’ (e.g. final, non-appealable court decision for fraud or dishonesty); where the carry consequences for removal due to a ‘bad act’ are more severe.
Market trends and developments
Investors’ appetite for private European real estate funds remains strong, with US$113 billion raised by 216 funds in 2015. But the fundraising market has slowed in the last two quarters, and 2015 is expected to be the peak year of inflows since 2010. We are also seeing more capital concentrated in fewer hands, as a result of a trend since 2013 of a decrease in the overall number of funds, corresponding with an increase in average fund size. Other current market factors impacting liquidity in private markets were discussed, some examples of those with a negative impact being:
- political issues (in particular, the pending ‘Brexit’ referendum) and geopolitical factors; and
- stock market volatility – more uncertainty makes fundraising slower; as well as the slowdown in China and the oil price collapse;
and with a positive impact:
- institutions becoming more focussed on yield, and therefore shifting their allocations out of fixed income products and towards real estate; and
- continuing low interest rates.
Carried interest fund terms have not changed significantly in recent years, with an example of typical market terms for a closed-ended value added or opportunistic fund being a 1.5% management fee, 20% carry, 9% hurdle and 50:50 catch-up arrangement. With the exception of the largest institutional fund managers who wield the most pricing power, management fees tend to reduce as fund size increases.
The panel discussed some other topics of interest when structuring and reviewing carried interest arrangements, including the impact of co-investment commitments on carried interest arrangements. Some headline points are below.
- There is no ‘market standard’ fee arrangement for co-investment, although heavily- reduced fees are becoming less common, and a ‘half carry, half fee’ is generally considered a fair compromise.
- Co-invest is often more relevant for larger/ more significant investors in a fund who have the capacity to process transactions quickly and efficiently.
- Where co-investment is structured in parallel vehicles to the fund, at the manager’s discretion, a ‘deal-by-deal’ carry structure may be applied.
- Openness and transparency is key, and some managers may be moving towards having a co-investment policy.
The trend of menu pricing was also discussed - where investors are offered different classes of interests with different managements fee/carried interest rates and hurdle. These more flexible fee arrangements are most often seen in the non-real estate asset classes, for instance, private equity funds. In contrast, the panel agreed that what was more prevalent in the real estate funds space was fee breaks to large and first close investors, which often track through to other investors through most favoured nations provisions.
A question was posed as to whether providing investors with a range of choices on bespoke fee structures may create an inherent misalignment between the manager and its investors, and as a consequence make it harder for the manager to act as a true fiduciary for the whole fund.
Key tax developments
Following on from last year’s introduction of the disguised investment management fee rules and the abolition of the “base cost” shift for carry recipients, the government has brought forward two new rules on the taxation of carried interest effective for carry arising on or after 6 April 2016.
The first rule is that gains realised by carry holders will continue to be taxed at the 28% rather than the reduced rate of 20% (which will apply to all other assets apart from residential property).
The second is that profits arising to carry holders in a fund will be taxed in whole or in part as income (under the disguised investment management fee rules) unless, on average, the fund holds its investments for at least 40 months. These are known as the “income-based carried interest rules”. We have outlined some of the key features below.
- Where the fund holds its investments on average for between 36 and 40 months a tapering rule applies, under which a proportion of the profit is taxed to income and a proportion as a capital gain.
- In determining the average length of holding, a weighted approach is taken so that if one investment is twice the size (by value) of another, then the length of time for which the first investment is held will count for twice as much as the other.
- Beyond the apparent simplicity of this rule, the legislation contains detailed rules on how to apply the test in different contexts and (of course) there are both specific and general anti-avoidance rules which will make it difficult for even creative tax planners to find ways around the new provisions. So, for example, an investment will be treated as sold by a fund not only if it is sold under general principles but also if the fund ceases to be exposed to the risks/rewards of the investments.
- One important limitation of the new income-based carried rules is that they do not apply if carried interest arises to an individual in respect of “employment related securities”. This means that the new rules will, in practice, only apply to those who are self-employed for tax purposes. But the government has given itself the power to amend this rule by secondary legislation (statutory instrument) so quite how long that will continue to be the case remains a matter of conjecture.