5563374 v2

Private Equity Fund Issues in the Current Market: Defaulting LPs, Carried Interest Renegotiation and Taxation of Carried Interest

OUTLINE

1. Changes in the Law affecting Private Equity Funds

(a) Carried Interest Taxation – changes to the law and how they may affect funds

(b) Regulation of Agents/Advisors – new regulations in the United States, Canada and Europe

2. Issues affecting Existing Private Equity Funds

(a) LP Liquidity Issues – what are the issues and why are they arising

(b) LP Defaults – fiduciary duties, restructuring, remedies

(c) Accessing Additional Capital – extensions of time period for follow-on investments or commitment period, recall of capital, recycling of capital, borrowing, management fee waivers, reopening funds, cross-fund investing, annex funds

(d) GP Incentives – changes to funds to incentivize GPs

(e) Secondary Market Transactions – issues involved with transfers

3. Issues affecting New Funds

(a) Fund Raising Environment

(b) Getting to a First Closing

4. Effect of Market Changes on Fund Terms – Looking Forward

(a) What are LPs/GPs going to think about changing in their fund terms going forward?

(i) Default provisions and capital call limitations

(ii) Show me the money – distributions, management fees, offsets, partnership expenses

(iii) Transfer provisions

(b) Increasing GP capital commitments

Taxation of Carried Interests - Current Law and Proposed Legislation

I. Background

a. Private equity ("PE") funds are typically structured as limited partnerships, with investors becoming limited partners ("LPs") and the PE fund manager (typically also a partnership) becoming the general partner ("GP"). GP provides management service to the PE fund in exchange for an interest in future profits of the fund, which is generally referred to as a "carried interest" or "profits interest."

b. Under current law, income resulting from carried interests is often taxed at

capital gains rates (current individual federal rate of 15%). However, there are legislative proposals that generally would tax the carried interest income at ordinary income tax rates (current top federal rate of 35%). This outline provides an overview of the current law as it relates to the taxation of carried interests, as well as the legislative proposals to recharacterize the related income as ordinary income.

II. Current Law

a. Receipt of Carried Interest

i. A service partner (“SP”) is not taxed on the receipt of a profits interest (i.e., a carried interest) in a partnership (“P”).1

1. A "profits interest" in a partnership is the right to receive

future profits in the partnership but does not generally include any right to receive money or other property upon the immediate liquidation of the partnership.

2. Tax-free receipt of a profits interest generally does not

apply if the profits interest relates to a substantially certain and predictable stream of income from partnership assets, such as income from high-quality debt securities or a high quality net lease, or in certain other limited circumstances.2

ii. By contrast, a partnership "capital interest" received for services is

generally includable in the partner's income upon receipt.3 A partnership capital interest is generally an interest that would

1 Rev. Proc. 93-27, 1993-2 C.B. 343; and Rev. Proc. 2001-43, 2001-2 C.B. 191. See also Prop. Reg. Sec. 1.83-3. 2 Rev. Proc. 93-27, 1993-2 C.B. 343; and Rev. Proc. 2001-43, 2001-2 C.B. 191. 3 Section 61 and 83; Treas. Reg. Sec. 1.721-1(b)(1).

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entitle the receiving partner to a share of the proceeds if the partnership's assets were sold at fair value and the proceeds were distributed in liquidation.4

b. Character of Income

i. The character of partnership items (i.e., capital gains or ordinary income) passes through to the partners as if the income items were realized directly by the partners.5 Therefore, to the extent a SP is allocated income, the character of the income passes through.

ii. In a typical PE structure, the PE fund will recognize capital gain

income on the disposition of its investment and, therefore, the SP generally receives capital gain treatment on its allocable share of that income resulting from the carried interest.

c. Self-Employment Tax

i. Employment taxes are generally imposed on the wages of an individual under the Federal Insurance Contributions Act ("FICA"). A similar tax is imposed on the net earnings from self-employment under the Self Employment Contributions Act ("SECA").6

ii. The SECA tax is broken up into two components: (1) the OASDA

component, the rate of which is 12.40% of earnings up to a threshold amount ($102,000 for 2008); and (2) the HI component, the rate of which is 2.90% and is not capped.7

iii. Individuals who are general partners in a partnership are generally

subject to self-employment tax on their distributive share of partnership income. However, certain types of income are excluded, such as gains from the sale or exchange of capital assets.

iv. Under current law, a SP is generally not subject to self-

employment tax on the income that passes through from P as a result of the carried interest.

III. Legislative Proposals

a. To address the perceived inequities of the characterization issues described above, the House of Representative in 2007 passed legislation to

4 Rev. Proc. 93-27, 1993-2 C.B. 343. 5 Section 702 of the Internal Revenue Code of 1986, as amended ("Code"). All section references herein are to the Code, unless otherwise noted. 6 Chapter 21 of the Code and Section 1401. 7 Sections 3101 and 3111.

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tax carried interests as ordinary income (the "Rangel Bill").8 The provision was removed in conference and did not become law.

b. On April 2, 2009, House Ways and Means Committee member Sander M.

Levin introduced a similar provision (the "Levin Bill"), which would tax allocations on a service-related partnership interest as ordinary income.9 This outline primarily focuses on the recently proposed Levin Bill.

c. A carried interest proposal was also reintroduced as a revenue raiser in

President Obama’s fiscal year 2010 budget proposal. Description of the proposal is very general.

IV. The Levin Bill

a. Recharacterization of Income and Loss

i. Under the Levin Bill, any net income allocation with respect to an investment services partnership interest ("ISPI") would be treated as ordinary income.10

1. The term ISPI means any interest in a partnership which is

held by any person if such person provides (directly or indirectly) a substantial quantity of such services as: (a) advising as to the merits of investing in, purchasing, or selling any specified asset, (b) managing, acquiring, or disposing of any specified asset, (c) arranging financing with respect to acquiring specified assets, or (d) any activity in support of any service described in (a) through (c).11 The Levin Bill looks to reasonably anticipated services to be provided (directly or indirectly) by the service partner (or any other person related to such partner) on the date of the acquisition of the ISPI.

2. "Specified asset" generally means securities, real estate,

commodities or options/derivative contracts thereto.

ii. Net loss with respect to the ISPI is also treated as ordinary loss, but only to the extent of the prior net income from such interest. Disallowed net loss may be carried forward to future taxable years without limitation.12

8 H.R. 6049, 110th Cong., passed by the House in 2008 and H.R. 3996, 110th Cong., passed by the House in 2007 (collectively, the "Rangel Bill", after House Ways and Means Committer chair Charles B. Rangel). 9 H.R. 1935, 111th Cong. (2009). 10 Levin Bill Section 710(a)(1). Net income means the excess of (i) income/gain over (ii) deduction/loss with respect to the ISPI. Levin Bill § 710(a)(3). Net loss means the excess of (ii) over (i). See id. 11 Levin Bill Section 710(c). 12 Levin Bill Section 710(a)(2).

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iii. Income from an ISPI that is recharacterized as ordinary income is

also subject to self-employment tax.

b. Timing of Taxation

i. Even though the Levin Bill recharacterizes gain from carried interests as ordinary income, there is no special provision to change the timing of the income to GP. Therefore, taxation on a carried interest is still deferred to the point when the PE fund realizes gain from its investment.

c. Invested Capital

i. The recharacterization rules above do not apply to allocations of income, gain, loss or deductions to any portion of an ISPI which is a "qualified capital interest".13

1. Qualified capital interest generally means so much of a

partner's interest in the capital of the partnership as is attributable to (a) the fair market value of any money or other property contributed to the partnership in exchange for the interest, (b) any amounts previously included in gross income with respect to the transfer of the interest, and (c) any items of income/gain taken into account with respect to the interest over any items of deduction/loss taken into account.

2. The invested capital exception only applies to a holder of

an ISPI if (a) allocations of items are made by the partnership to such qualified capital interest in the same manner as allocations are made to other qualified capital interests held by unrelated partners who do not perform services and (b) the allocations made to the other interests are significant compared to the allocations made to the qualified capital interest.

3. Upon a disposition of an ISPI, gain that is attributable to

the qualified capital interest portion of GP's ISPI will not be subject to recharacterization.

ii. An interest is not treated as acquired with invested capital if it is

attributable to a loan made or guaranteed by any other partner or partnership.

13 Levin Bill Section 710(c)(2).

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iii. Any loan or advance to the partnership made or guaranteed, directly or indirectly, by a partner not providing services to the partnership (or any person related to such partner) is taken into account as invested capital of the partner.

d. Disposition of Carried Interest

i. Any gain on the disposition of an ISPI is treated as ordinary

income.14

ii. Gain is recognized notwithstanding other provisions of the Code (e.g., certain non-recognition provisions of the Code, such as I.R.C. § 351 or § 721).

e. Disqualified Interests

i. The Levin Bill includes a provision designed to prevent the avoidance of recharacterization through the use of an entity other than a partnership.15

ii. Any income or gain with respect to an interest in an entity will be

treated as ordinary income if (a) the person performs (directly or indirectly) investment management services for any entity, (b) the person holds a "disqualified interest" in the entity, and (c) the value of the interest is substantially related to the amount of income or gain (whether or not realized) from the assets with respect to which the investment management services are performed.

iii. Disqualified interest generally includes (a) any interest in an entity

other than debt, (b) convertible or contingent debt, (c) any option or other right to acquire property described in (a) or (b), and (d) any derivative instrument entered into (directly or indirectly) with such entity or any investor in such entity.

1. Disqualified interest does not include an interest in a

partnership or a corporation that is taxable in the U.S. (i.e., a domestic corporation or a foreign corporation substantially all of the income of which is effectively connected with a U.S. trade or business).

2. S corporations are also generally excepted from

disqualified interest definition.

14 Levin Bill Section 710(b). 15 Levin Bill Section 710(d).

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f. Other Items

i. Compensation Deduction: Generally, when there is a compensation

payment, a payor usually gets a deduction. However, the Levin Bill does not provide a deduction to the PE fund matching GP's ordinary income recognition, so the effect is likely a reduction of the LPs' capital gain allocation, as under current law.

ii. Impact on Non-Service Partner: Generally, there is no impact to

the non-service partners as a result of the recharacterization of the income related to the carried interest.

iii. Section 83: Section 83 generally provides that the fair market value

of property received in connection with the performance of services is included in the gross income of the person who performed such services in the first taxable year in which the rights in such property are not subject to a substantial risk of forfeiture. However, Section 83(b) generally provides that a recipient can make an election to include "unvested" property in income prior to such vesting. The Levin Bill would add two new rules to Section 83 as follows16:

1. the fair market value of a partnership interest issued for

services would be treated as equal to the liquidation value of the interest, unless the Internal Revenue Services ("IRS") provides otherwise; and

2. the rule for a Section 83(b) election would be reversed,

with the election deemed made unless the partner elects out of the inclusion rule.

iv. Penalties: The proposed legislation would amend section 6662(b)

to include understatements attributable to section 710(d). For this purpose, the penalty rate under section 6662 would be 40%, with no exception for understatements otherwise eligible for relief under the "reasonable cause" exception of section 6664.

16 Levin Bill Section 1.

STIKEMAN ELLIOTT LLP

Impact on Private Equityand Venture Capital Funds

RegistrationReform IN CANADA

Section J of Stikeman Elliott’s Report on Canada’s New Registration RegimeJULY 2009

The Finish Line is Here

© STIKEMAN ELLIOTT LLP JULY 2009

This publication provides general commentary only and is not intended as legal advice.

For further information, please contact your Stikeman Elliott representative or any member of our Securities Group at www.stikeman.com

J

Impact on Private Equity and Venture Capital Funds There are no provisions of the final proposal for National Instrument 31-103 Registration Requirements and Exemptions (31-103) and the related amendments to the provinces and territories’ Securities Acts and other instruments and policies that are specific to private equity funds or venture capital funds, so the application of the registration requirements under 31-103 and the related amendments will need to be considered under the basic principles of the regime. These basic principles are generally that a person in the “business of trading” in securities is required to be registered as a dealer; a person in the business of advising others as to the investing in or the buying or selling of securities is required to be registered as an adviser and a person who acts as an investment fund manager (that is, who directs the business, operations or affairs of an investment fund) is required to be registered as an investment fund manager.

Meaning of “Investment Fund” Key for the investment fund manager registration requirement is the meaning of “investment fund”, since it is only managers of investment funds that must register. The term “investment fund” is defined in the securities legislation of the various provinces and territories (jurisdictions) and refers to: ■ a mutual fund, being an issuer whose primary purpose is to invest

money provided by its security holders and whose securities are redeemable on demand, or within a specified period after demand, at an amount computed by reference to the value of the fund’s net assets, or

■ a non-redeemable investment fund, being an issuer that is not a mutual fund and whose primary purpose is to invest money provided by its security holders and that does not invest for the purpose of seeking to exercise control of an issuer or of being actively involved in the management of any issuer in which it invests.

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In each case, the facts will be key in assessing the impact of the new registration regime in 31-103 for any fund, including one that characterizes itself as a private equity or venture capital fund. Some guidance has been provided by the Canadian Securities Administrators (CSA) in Companion Policy 31-103CP Registration Requirements and Exemptions (31-103CP) on how this test for investment fund status would be applied in particular factual situations. The CSA have indicated that they anticipate providing supplemental guidance at a later date.

In 31-103CP, the CSA note that:

■ venture capital and private equity investing are distinguished from other forms of investing by the role played by venture capital and private equity management companies (collectively, VCs). This type of investing includes a range of activities that may require registration;

■ VCs typically raise money under one of the prospectus exemptions in NI 45-106, including for trades to “accredited investors”. The investors typically agree that their money will remain invested for a period of time. The VC uses this money to invest in securities of companies that are not publicly traded. The VC usually becomes actively involved in the management of the company, often over several years;

■ examples of active management in the company include the VC having:

• representation on the board of directors;

• direct involvement in the appointment of managers; or

• a say in material management decisions;

■ the VC looks to realize on the investment either through a public offering of the company’s securities, or a sale of the business. At this point, the investors’ money can be returned to them, along with any profit.

■ investors rely on the VC’s expertise in selecting and managing the companies it invests in. In return, the VC receives a management fee or “carried interest” in the profits generated from these investments. They do not receive compensation for raising capital or trading in securities;

■ applying the business trigger factors to the VC activities as described above, there would be no requirement for the VC to register as:

• a portfolio manager, if the advice provided in connection with the purchase and sale of companies is incidental to the VC’s active management of these companies; or

• a dealer, if both the raising of money from investors and the investing of that money in companies are occasional and uncompensated activities;

■ if the VC is actively involved in the management of the companies it invests in, the investment portfolio would generally not be considered an investment fund. As a result, the VC would not need to register as an investment fund manager; and

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■ the business trigger factors and investment fund manager analysis may apply differently if the VC engages in activities other than those described above.

For a discussion of the registration requirements for dealers, advisers and investment fund managers in the context of investment funds, see the discussion under the topics Impact on Investment Fund Managers and Impact on Investment Funds.

Registration Reform in Canada:The Finish Line is HereCanada’s new registration rule was published by the Canadian securities administrators in finalform on July 17, 2009.

The new regime is expected to be in force September 28, 2009 with transition periods forimplementation of aspects varying. The new regime, which has been several years in the making,is intended to harmonize, streamline and modernize registration requirements and exemptionsacross all Canadian jurisdictions. It regulates dealers and advisers, effectively eliminating thedealer registration exemption for trading in the exempt market in Canada, and imposes a newregistration requirement for investment fund managers.

The new regime has significant implications for Canadian and non-Canadian market participants,particularly those now doing business on an unregistered or exempt basis.

This document is one part in a series that details the regime and its impact on particular types ofmarket participants and their business activities. The complete document includes the followingsections:

A Overview of Canada’s New Registration Regime

B Impact on Limited Market Dealers and Unregistered Dealers Trading in the Exempt Market

C Impact on Investment Fund Managers

D Impact on Portfolio Managers and Investment Counsel

E Impact on International Dealers and Non-Canadian Dealers Trading in the Exempt Market

F Impact on International Advisers

G Impact on Investment Dealers and Mutual Fund Dealers

H Impact on Issuers Generally

I Impact on Investment Funds

J Impact on Private Equity and Venture Capital Funds

K Impact on Non-Canadian Investment Funds Privately Placing Securities in Canada

L New Compliance Requirements for Registrants

M Registering in Multiple Jurisdictions

N Quebec’s Derivatives Act

O Trading or Advising in Commodity Futures

P Useful Links

If you would like a copy of any of the other sections, in electronic or print format,please contact your Stikeman Elliott representative, email us at info@stikeman.comor visit our website at www.stikeman.com

Canadian Business Law –WorldwideStikeman Elliott is recognized nationally and internationally for the sophistication of itsbusiness law practice. The firm is a Canadian leader in each of its core practice areas –corporate finance, M&A, securities, banking, corporate-commercial, real estate, tax,insolvency, structured finance, competition, intellectual property, employment andbusiness litigation – and has developed in-depth knowledge of a wide range of industries.

London-based World Finance magazine named Stikeman Elliott as the2008 Best Corporate & Commercial Team in Canada. Additionally, theInternational Financial Law Review honoured Stikeman Elliott as 2007National Law Firm of the Year (Canada), while Chambers Global identifies itas one of Canada's two top-tier Corporate/M&A practices. The firm is

frequently ranked among Canada’s leaders in domestic and cross-border M&Aand corporate finance league tables. The National Litigation Group, whose

specializations include class actions, securities litigation and restructurings, has beenranked among the top three business litigation practices in Canada by Lexpert. AmongStikeman Elliott’s other highly regarded practices are competition/antitrust (named as aleader by the Global Competition Review), taxation (highly ranked by Lexpert) andstructured finance (widely considered to be Canada’s foremost practice in that field).

The firm’s clients can expect a consistently high level of service from each of its eightoffices who work together on major transactions and litigation files, and regularlycollaborate with prominent U.S. and international law firms on cross-bordertransactions of global significance. The firm has invested heavily in leading-edgeknowledge management systems in order to assure our clients of advice of the highestquality, grounded in the accumulated expertise of Stikeman Elliott’s national andinternational practice.

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www.stikeman.com

On June 17, 2009, the U.S. Department of the Treasury released President Barack Obama's plan to overhaul the U.S. financial regulatory system entitled "Financial Regulatory Reform -A New Foundation: Rebuilding Financial Supervision and Regulation" (the "~lan").' Among other things, the Plan proposes the registration of certain private fund advisers, required disclosures by private funds advised by an SEC-registered adviser and strict regulation of private funds that may pose a threat to financial stability. The announcement of the Plan comes just one day afier Senator Jack Reed introduced the Private Fund Transparency Act of 2009, which also calls for the registration of private fund advisers.

Registration of All Private Fund Advisers - Citing both the need to gather information on private funds to assess the potential systemic implications of the activities of private funds and investor protection concerns, the Plan proposes that all advisers to private funds "whose assets under management exceed some modest threshold" be required to register with the US. Securities and Exchange Commission (the "SEC") under the US. Investment Advisers Act of 1940, as amended (the "Advisers Act"). Although the proposal does not define "private fund" for these purposes (nor does it state whether the requirement would be limited to advisers to investment companies relying on the exceptions provided in Sections 3(c)(7) and 3(c)(l) of the US. lnvestment Company Act of 1940, as amended), it is clear that the registration requirement would apply equally to all types of private fund advisers (including advisers to hedge funds, buyout funds and venture capital funds).

Private Fund Requirements

Regulatory Requirements. Under the Plan, private funds advised by an SEC-registered adviser will be subject to recordkeeping requirements; disclosure requirements with respect to investors, creditors and counterparties; and certain undefined "regulatory reporting requirements." In addition, the SEC will be authorized to conduct regular, periodic examinations of such funds to monitor compliance with these requirements. Although some of these fund-

' "Financial Regulatory Reform-A New Foundation: Rebuilding Financial Supervision and Regulation" (June 17, 2009) available at http:llwww.ustreas.~ov/news/indexl.html.

level required disclosures may be duplicative of the disclosure a registered adviser is required to make with respect to the funds it manages, some items clearly go beyond what a registered adviser would be required to disclose in its Form ADV. Only once additional details emerge will we know how much more extensive these disclosure requirements may be.

Confidential Reporting. In addition, each private fund advised by an SEC-registered adviser will be required to report to the SEC on a confidential basis such fund's amount of assets under management, borrowings, off-balance sheet exposures and "other information necessary to assess whether the fund or fund family is so large, highly leveraged or interconnected that it poses a threat to financial stability." Implementation of this proposal will hopefully clarify what such "other information" might entail so that private funds are not subject to unlimited or ill- defined information requests and can prepare their recordkeeping procedures and organize their back office policies accordingly.

Potential Regulation of Private Funds as Financial Holding Companies

The Plan proposes that the SEC share private funds' confidential reports with the Federal Reserve, in its new role as systemic risk regulator. The Federal Reserve would then determine whether any of these funds meet the criteria for Tier 1 Financial Holding Companies (broadly defined by the Plan as any financial firm whose combination of size, leverage and interconnectedness could pose a threat to financial stability). If a fund satisfies such criteria, the fund would then be subject to regulation as a Tier 1 Financial Holding Company (a "Tier 1 FHC"), which would mean being subject to the jurisdiction of the Federal Reserve and its consolidated supervision of Tier 1 FHCs. Among other regulations to which it would be subject, a private fund deemed a Tier 1 FHC would be subject to the "prudential standards" for Tier I FHCs, which include capital, liquidity and risk management standards that are stricter than those applicable to other financial firms.

Broker-Dealer Reform

To increase fairness for investors, the Plan proposes that broker-dealers offering investment advice be subject to fiduciary duties to investors and that the regulation of investment advisers and broker-dealers be harmonized. Stating that an investment adviser and a broker-dealer providing "incidental advice" appear in all respects identical from the vantage point of the retail customer, the Plan calls for new legislation to bolster investor protections and bring consistency to the regulation of these two types of financial professionals by:

requiring that broker-dealers who provide investment advice about securities to investors be subject to the same fiduciary obligations as registered investment advisers;

requiring such broker-dealers to provide simple and clear disclosure to investors regarding the scope of the terms of their relationships with investment professionals; and

prohibiting certain conflict of interests and sales practices that are contrary to the interests of investors.

Permanent Role for the SEC's lnvestor Advisory Committee

SEC Chairman May Schapiro recently announced the formation of an lnvestor Advisory Committee to give investors a greater voice in the SEC's work. The Plan calls for the lnvestor Advisory Committee to be made permanent by federal statute. The lnvestor Advisory Committee's charter contemplates a broad role for the Committee, including: (i) advising the

SEC on matters of concern to investors in the securities markets; (ii) providing the SEC with investors' perspectives on current, non-enforcement, regulatory issues; and (iii) serving as a source of information and recommendations to the SEC regarding the SEC's regulatory programs from the point of view of investors.

The Private Fund Transparency Act of 2009

On June 16th, Senator Jack Reed (0-RI) introduced the Private Fund Transparency Act of 2009 (the "Private Fund Act") in the Senate. The Private Fund Act would eliminate the "private adviser exemption" under Section 203(b)(3) of the Advisers Act and would require all private fund advisers managing in excess of $30 million to register with the SEC under the Advisers Act. Similar to the Plan, the Private Fund Act would authorize the SEC to gather information on private funds that are advised by an SEC-registered adviser in order to assess what risks such funds may pose to financial stability and share such information on a confidential basis with other federal agencies.

Although neither the Plan nor the Private Fund Act provide a specific time frame by which advisers would be expected to register with the SEC, fund advisers that are not yet registered should begin to familiarize themselves with the substantive requirements of the Advisers Act in anticipation of registration.

This memorandum is not intended to provide legal advice, and no legal or business decision should be based on its content. Questions concerning issues discussed in this memorandum may be addressed to any of the following:

Marco V. Masotti (21 2) 373-3034 Robert M. Hirsh (212) 373-3108

Yvonne Y.F. Chan (212) 373-3255 Mitchell L. Berg (21 2) 373-3048

Stephanie R. McCavitt (21 2) 373-3558 Jennifer A. Spiegel (21 2) 373-3748

How has the current economic environment affected private equity funds?The market has obviously affected private equity funds, both on the deal side, where there is a lack of good deals and a tight credit market for financing, and on the fundraising side, where the ability to raise funds has been severely constrained. In addition, there seems to be a heightened tendency towards regulation of hedge funds, and some of the changes are likely to affect private equity funds as well.

There have also been issues with defaulting investment funds that are refusing or failing to meet their capital call requirements. As the number of funds in the market drops, we’ll see more secondary market transactions – where either the fund’s investment portfolio is sold or the fund is merged with another fund. These secondary transactions may also arise where an investor cannot make its capital commitments and instead attempts to sell its interest in the fund.

What’s behind institutional investors not meeting their capital calls?In addition to the general economic conditions, many of the funds (and pension funds in particular) have specific policies for percentages of their funds to be invested in different asset classes. As public markets (and other investments like real estate) fall in

value, the percentage value invested in private equity increases in proportion to their other investments. This is particularly true for funds that have committed capital that has not yet been entirely invested or where the private equity firm has not written down its investments since no market event has occurred. If the capital is committed but not yet invested, it shows as a commitment to that asset class, which is now in excess of the market value of the investments being held in other asset classes. As a result, some of these investors need to reduce their exposure to the private equity asset class. In addition, some investors may have liquidity issues due to the issues with both public markets and markets in other assets classes that have made it more difficult to sell their investments.

And what can private equity firms do about this?That depends on what the limited partnership agreements say with respect to defaulting investors. Many agreements have what were seen to be quite draconian provisions for defaulting investors – things like an automatic reduction in their capital account, the ability of other investors to buy their interest (at a discount) or to set off the purchase price for the interest against the capital call, or losing the ability to receive distributions going forward. Unfortunately, where the fund did not have a significant number of investments or the investments were not performing well, these measures may not have proven to be as effective as was hoped. Also, private equity firms may be reluctant to enforce these remedies due to the relationship they hope to maintain with their investment partners for future fundraising activities, as well as reputational issues.

Dangers of

private equity defaults

Samantha Horn is a partner at Stikeman Elliott LLP and head

of their Toronto office Private Equity & Venture Capital group.

She is also the current chair of the Private Equity and Venture

Capital Committee of the American Bar Association’s Business

Law Section. In an interview, Horn discusses the dangers of

private equity defaults.

Interview

Another significant difficulty is that the non-defaulting investors were usually called upon to fill the gap on the defaulting investors’ capital call (not to exceed their capital commitment), so this may mean the non-defaulting investors end up with a higher proportionate interest in the fund than they originally bargained for. There has been one case in the US where a firm sued two of its defaulting investors, CapGen Capital Advisors LLC v. Chalice Fund LP and another, filed in Delaware.

A lawsuit like that seems unusual. Can you describe the circumstances of the case?A lawsuit like this is unusual, particularly given the fact that most private equity firms want to maintain good relations with their investors. I think it speaks to the level of concern among firms in relation to defaults in capital calls.

Cap Gen issued a capital call with respect to its $500 million fund. Two of its smaller investors defaulted on their commitments. It is seeking payment of the outstanding capital contributions with interest (plus expenses of the lawsuit) and a court order compelling the investors to make all future capital contributions. Cap Gen has chosen not to exercise the rights it has under the fund documents (including reduction of all or a portion of the defaulting investor’s interest in the fund), but instead to sue. The case has not yet been heard at the trial level, but has sent shock waves through the private equity community.

Are there other options for firms in the event of a default?Some other ideas include having the firm agree to defer making capital calls in exchange for lengthening the commitment period of the fund. This may be a good solution where the firm is not planning to make investments in the near future, given the market and, in particular, the state of the credit markets. Some very large funds have also permitted a limited reduction in capital commitments. Some funds have helped investors access credit lines to fund capital calls or transfer their interests to a third party buyer capable of funding the commitments.

So if you were to predict, what effect do you think these issues will have when people turn to renegotiating the terms of private equity funds?On the private equity side, I suspect firms will take a hard look at the default provisions, particularly for the “anchor” investors of a fund.

On the institutional side, the key person clauses are going to be particularly important, as are the clauses allowing a certain percentage of the investors to remove the private equity fund without cause. Also, given the fact that secondary transactions are now morelikely,investorsmaytrytobuildinsomeflexibilityto enable a sale of the portfolio or a merger with another fund in certain cases (for example, where a key person event occurs). Investors may also want to closely examine the fund terms with respect to the default provisions and the frequency and accuracy of valuations of the underlying portfolio investments.

2009 Annual ABA Meeting

1

Efficiently Completing Transactions of all Sizes and Structures

Buyer and Seller Expectations and Issues

Underlying GP Considerations

The Sales Process

2

Process Overview – Four Stages

1. Preliminary Matters

GP Communications/Consent to Disclose

Due Diligence

Identify Prospective Buyers

Legal Document Preparation

2. Marketing / Initial Bids

3. Execution / Final Bids & Pricing

Obtain Transfer Agreements from GP

Purchase & Sale Agreements Provided to Final Bidders

Structure the Transaction

Negotiation of Legal Documents

4. Closing

Coordinate Execution of Legal Documents

3

Preparation of Portfolio

— Gather and review all Fund documents and records

Partnership Agreement

Subscription Agreement

PPM

Financial Statements

Side Letters

Capital Call & Distribution Notices

AIV Agreements and Elections

Annual Meeting Materials

Any other material correspondence

— Set up and maintain data room of documents— Similar process for sale of Direct Interests

4

Sample Sell-Side Process ChartWeek 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16

General Partner Communications

Data Collection

Prepare On-line Data Room

Due Diligence

Prepare Marketing Materials

Identify Prospective Buyers

Legal Document Preparation (NDA & PSA)

Introductions

Negotiate and Collect Non-Disclosure Agreements and Distribute Bid Materials

Provide Access to On-Line Data Room

Assist Buyer Due Diligence

Obtain Initial Indications of Interests and Finalize Bidder List

Obtain Transfer Agreements from General Partners

Provide Draft Purchase and Sale Agreements to Final Bidders

Detailed Buyer Diligence

Final Bids

Transaction Structuring

Sign Letter of Intent

Purchase and Sale Agreement Negotiation and Execution

Initiate Right of First Refusal (ROFR) Process (if required)

Negotiate and Review Transfer Agreements

Coordinate Payment of Transfer Expenses

Coordinate Completion of Purchase and Sale Agreement Schedules

Closings

5

Sale Process

What Buyers are looking for

What makes a portfolio saleable

Differences for secondary directs

6

Sale Process (cont’d)

— Roadblocks to getting a deal done— Difficult GPs— ROFRs & Preemptive rights— Need to educate Sellers— Lack of information about the portfolio / bad recordkeeping— Too large a process— Publicly traded partnership restrictions

7

Sale Process (cont’d)

— Role of the Agent

Sale strategy

Portfolio packaging

Guidance on process

Knowledge of buyers/market

Confidentiality for Seller

Interface with the GPs

8

Sale Process (cont’d)

GP Concerns

Want to ensure that confidential information will be protected

Want to know who the potential Buyers are

Worried about reputation (if their Fund is included in the process)

Worried about sale price / valuation impact

What Sellers can do to get GPs comfortable

Communication

Understand Expectations

Confidentiality

Maintain a Controlled process

9

III. Deal Structures & Issues

Deal structures and issues

Young secondaries

Structured and synthetic secondaries

Other considerations

10

What is a Secondary Transaction?

Traditional definition: the purchase and sale of pre-existing investor commitments to private equity and other alternative investment funds

However, transaction types and structures are evolving

Basic types:— Sale of limited partner interests

Included in sale is contributed capital and unfunded commitments

— Sale of direct interests in operating companies (“Secondary Directs”)

— Numerous hybrid structures

11

Typical Secondary Transaction

Seller (Existing LP)

Buyer (Prospective LP)

Purchase & Sale Agreement

Purchase Price Paid to Seller

LP Interest(s) Transferred to Buyer(also includes funded

investments and unfunded commitment)

Fund(s)

GP Consents to Transfer of LP Interest from Seller

to Buyer

General Partner(Manager of the Fund)

Assignment & Assumption Agreement

12

Evolving Deal Structures

Single Interest & Portfolio (more fully-funded interests)

Strips & Carveouts

Stapled Transactions

Young secondaries /Secondary-Lite /Busted Primary

Seller financed/delayed payment

Manager spinouts

Secondary directs

Tertiary liquidity (interests in FOF or other secondary funds)

Annex Funds

GP liquidity (purchase of GP or “house” commitments)

Synthetic secondary (economic transfer/total return swap)

Hedge funds as sellers (side pockets/illiquid assets)

Hedge fund investors as sellers (“gated” interests)

Stressed/Distressed Sellers

Structured secondary (JV or structured cashflow)

Traditional

New & Resurgent

13

Secondary “Lite” Transaction

Early stage secondary deal in which the majority of the Seller’s and Fund’s capital has not yet been funded

Often used as an alternative to a primary investment to reduce “J-curve”

14

“Structured” Secondary Transaction

Includes a wide variety of negotiated transactions between the buyer and seller that typically is customized to the specific needs of the buyer and seller; typically, the buyer and seller agree on an economic arrangement that is more complex than a simple transfer of 100% ownership of the limited partner interests

Typically involves contribution of assets to special purpose vehicle, with a pre-determined cashflow and profit sharing arrangement among the parties

Sometimes utilized by Seller to maintain relationships with GPs and exposure to private equity portfolio

15

“Synthetic” Secondary Transaction

A derivative transaction where the seller retains legal title to the interest but sells an economic interest in the underlying portfolio interest to a counterparty.

Also referred to as an “economic transfer”

16

Advantages/Disadvantages to Alternative Structures

Economics highly variable and negotiated

Corporate governance and control are important

Counterparty risks

Impact on transfer process

Tax and accounting/regulatory considerations

17

IV.Other Business, Legal and Tax Considerations

Deal Terms

— LP Clawbacks— ROFR’s & Preemptive Rights— Defaulting LPs (distressed Sellers)— Blockers & AIVs— EIP/Basis Adjustments

18

IV.Other Business, Legal and Tax Considerations (cont’d)

Other Themes & Issues

— MACs— Structured & Synthetic Secondaries— Economic Transfers— Indemnities— Break-up Fees— Deal Leverage— Publicly Traded Partnership (PTP) restrictions (2%)— Qualified Matching Service

19

Deal Execution: Other Considerations

— Some funds only process transfers during certain times of the year (e.g., end of quarter)

— Review of transfer requirements under governing documents — Unique requirements, such as needing unanimous consent of

the LPs for certain transfers or structures — Is Buyer an existing LP of fund/manager (precedent

documents)— Tax, 40 Act, HSR or other considerations— Assignment of seller’s side letter rights— Ability to negotiate new side letter rights with GP to cover buyer

specific issues on MFN, tax, confidentiality and other matters— Stamp duties

14865047

Private Equity Fund Issues in the Current Market: Defaulting LPs, Carried Interest Renegotiation and Taxation of Carried Interest

OUTLINE

1. Changes in the Law affecting Private Equity Funds

(a) Carried Interest Taxation – changes to the law and how they may affect funds

(b) Regulation of Agents/Advisors – new regulations in the United States, Canada and Europe

2. Issues affecting Existing Private Equity Funds

(a) LP Liquidity Issues – what are the issues and why are they arising

(b) LP Defaults – fiduciary duties, restructuring, remedies

(c) Accessing Additional Capital – extensions of time period for follow-on investments or commitment period, recall of capital, recycling of capital, borrowing, management fee waivers, reopening funds, cross-fund investing, annex funds

(d) GP Incentives – changes to funds to incentivize GPs

(e) Secondary Market Transactions – issues involved with transfers

3. Issues affecting New Funds

(a) Fund Raising Environment

(b) Getting to a First Closing

4. Effect of Market Changes on Fund Terms – Looking Forward

(a) What are LPs/GPs going to think about changing in their fund terms going forward?

(i) Default provisions and capital call limitations

(ii) Show me the money – distributions, management fees, offsets, partnership expenses

(iii) Transfer provisions

(b) Increasing GP capital commitments

5563374 v2

BOCA RATONBOSTON CHICAGO HONG KONG LONDON LOS ANGELES NEW ORLEANS NEW YORK NEWARK PARIS SÃO PAULO WASHINGTON

Timothy M. Clark

Timothy M. Clark is a partner in Proskauer's

Corporate Department. His practice focuses on

alternative investment funds, representing hedge

funds, private equity and venture capital funds in

fund formation, as well as structuring transactions

such as mergers and acquisitions, private

placements and equity offerings. Tim also has

extensive experience representing real estate

private equity funds. He advises clients in the

United States, Europe and Latin America.

Recently, Tim has been involved in the formation

of global buy-out, real estate, distressed debt and

mezzanine funds. He also advises clients with

respect to Investment Advisers Act and

Investment Company Act compliance issues.

A frequent lecturer on alternative investing, Tim is

also a CCO University Faculty Professor for the

Regulatory Compliance Association ("RCA"), and

has published numerous articles on private funds

and compliance-related issues.

Publications and Lectures include:

– Publication: Structuring Issues for Hedge

Funds

– Publication: Implications of the Pension

Protection Act of 2006 for Unregistered

Funds and Asset Managers

– Lecture: Hedge Funds in the Capital Markets

– Lecture: Hedge Funds: Good or Bad for the

Market

– Lecture: Integrated multi-purpose brokerage

hedge fund servicing solutions

– Lecture: Panel discussion: Implementing and

maintaining compliance infrastructure to

effectively and efficiently manage and

mitigate compliance risk

Tim graduated from New York University Law

School in 1991, where he was Articles Editor of

the Annual Survey of American Law, and received

his bachelor's degree from Oberlin College in

1988, with honors.

© 2009 Proskauer Rose LLP

Bruce I. Ettelson, P.C., is a partner at Kirkland & Ellis LLP, where he leads the firm’s Private Funds Group. His practice focuses on structuring and forming premier private equity funds and their management companies, including billion dollar plus funds for AEA, American Capital Strategies, Bear Stearns, Energy Capital Partners, Golden Gate Capital, Madison Dearborn Partners, Nautic Partners, Paul Capital Partners, Summit Partners and Vestar Capital Partners. Mr. Ettelson has represented over 75 private equity firms in the formation of more than 200 private equity funds. He is also involved in the structuring and formation of private equity funds associated with commercial and investment banks, represents investors in making and monitoring investments in private equity funds, and represents private equity clients in general corporate counseling.

Mr. Ettelson was selected as one of “40 Illinois Attorneys Under 40 to Watch” by The Law Bulletin Publishing Company and named as one of “The International Who’s Who of Private Funds Lawyers” by Law Business Research Ltd. every year it has been published. The Legal 500 U.S., in its 2009 edition, recognized Mr. Ettelson as one of eight leading lawyers in the Private Equity Funds category and noted that “clients describe him as ‘incredibly bright with lots of energy,’ but at the same time, ‘extremely careful and very thoughtful,’ with an ‘almost encyclopedic knowledge of private equity.’” Additionally, Chambers & Partners, the international legal publisher, ranked Mr. Ettelson first in Private Equity: Fund Formation in its 2009 Chambers USA guide, calling him an “absolutely top-notch, dynamite attorney” who “always has his finger on the pulse of the market.”

Mr. Ettelson is a frequent lecturer, speaker, and panel moderator and has also published numerous articles on private equity and fund formation matters. He received a J.D., cum laude, from the University of Chicago Law School, where he was a John M. Olin Fellow in Law and Economics, and a B.S. degree, magna cum laude, from the Wharton School of the University of Pennsylvania.

STIKEMAN ELLIOTT LLP PROFILE

Samantha Horn

5300 Commerce Court West, 199 Bay Street, Toronto, Canada M5L 1B9 Direct: (416) 869-5636 Fax: (416) 947-0866 sghorn@stikeman.com

Law Practice Samantha Horn is a partner in the Toronto office of Stikeman Elliott and practices corporate and commercial law. Her practice is primarily in the areas of mergers and acquisitions and private equity and venture capital financing, including investments and buyouts, as well as fund formation activities. Ms. Horn is the head of Stikeman Elliott's Private Equity and Venture Capital Group in Toronto and co-chair of the firm's Continuing Legal Education Committee.

Ms. Horn as been recognized by the 2007 Canadian Legal Lexpert Directory, as a leading practitioner in the Corporate Mid-Market and Private Equity sectors. She is also listed in the 2008 edition of The Best Lawyers in Canada.

Professional Activities Ms. Horn is the chair of the Private Equity and Venture Capital Subcommittee of the Business Law Section of the American Bar Association for a 3 year term which commenced in August 2006. Ms. Horn is also a member of the Canadian Bar Association, the Canadian Venture Capital & Private Equity Association, Women in Capital Markets and WAVE - Women's Association of Venture and Equity, a U.S. Organization. In 1996, Ms. Horn was seconded for a short period of time to Working Ventures Canadian Fund Inc., a labour-sponsored venture capital fund, as an investment analyst. She has participated as a speaker in various seminar programs with respect to venture capital financing, including as a speaker at the CVCA Annual Conference in 2004 and 2005, as Chair of a panel on D&O Insurance Issues at the ABA meeting in August 2004, on a panel on later round financing issues at the ABA meeting in March 2007 and on a panel discussing fund formation issues at a conference in June 2007. Ms. Horn also participated in a mock negotiation of a term sheet at the Venture All-Stars conference in Seattle in 2004.

Publications Ms. Horn has written various articles on issues of interest to private equity and venture capital firms which include:

> “Top 10 Issues to Consider in Creating a Private Equity Fund”, June 2007;

> “Employee Optionholders and Shareholders – Foresight is Key to Maintaining Flexibility for the Future”, April 2006;

> “OSC Decision in Momentas Case Raises Registration Concerns for Private Equity and Venture Capital Funds” January 2006;

> “Representation and Warranty Insurance: A Better Way to Get Deals Done?”, August 2005;

STIKEMAN ELLIOTT LLP PROFILE 2

> “Board Observers Beware: A Discussion of Liabilities and Risks Facing Board Observers from a United States, Canadian, and Italian Law Perspective”, January 2005; and

> “Staying Out of Jail: Beware of Section 347”, July 2004.

Education Queen's University (LL.B. 1991, Economics 1986-88).

Bar Admission Ontario, 1993.

Michael J. Kliegman Michael Kliegman is a partner in the New York City PricewaterhouseCoopers Mergers & Acquisitions Tax Group, specializing in due diligence and all aspects of structuring business acquisitions and reorganizations. He has been representing private equity and corporate clients in domestic and international transactions for more than 20 years. Before joining PricewaterhouseCoopers in 1988, he was engaged in private law practice, specializing in leveraged buyout transactions. Previously, he spent several years in the IRS National Office, including the position of Group Chief, where he issued rulings on corporate acquisitions, reorganizations, bankruptcy and spin-offs. Mr. Kliegman has published extensively in the field of business taxation, and has spoken on various topics of taxation related to mergers & acquisitions. He holds a B.A. degree from the University of Pennsylvania, a J.D. degree from Boston University, and a LL.M. in Taxation from Georgetown University.

Private Equity and Venture Capital Committee

“Where the World’s Leading Private Equity and Venture Capital Practitioners Meet”

The Private Equity and Venture Capital Committee focuses on issues facing lawyers who form and represent private equity and venture capital funds and those who advise entrepreneurs and companies seeking financing from those sources. The committee addresses the regulatory, securities, corporate, tax, intellectual property, and other concerns of the private equity and venture capital communities. The committee also provides a forum for exchanging views on transaction terms and documents used in venture capital, LBO and MBO financings. The committee is also focused on annotating transactional document forms in an effort to educate and assist practitioners in venture capital and private equity financings. It also addresses legislative and administrative initiatives affecting venture capital and buyout funds, venture-backed companies, and their investors.

We welcome your interest and invite you to join the committee.

Knowledge and Networking

The committee meets twice a year at the Section Spring Meeting and ABA Annual Meeting. Programs are presented by experienced practitioners who have particular expertise in respect to the subject matter. With committee membership, you'll have access right at your fingertips any time you need it to all the materials and resources used in committee sponsored programs whether you are able to attend the meeting or not. Past program materials can be found in the online Section Program Library found within the Meetings Portal. The committee's electronic newsletter, Preferred Returns, delivered to your desktop via the members-only listserve, will keep you abreast of current developments and hot topics in the private equity and venture capital arena, and you have the opportunity to contribute as well.

Involvement

The committee has 10 subcommittees and task forces. With committee membership, the amount of time you dedicate is entirely up to you. You can belong to any of these specialized groups and then be informed of their ongoing projects and programs. These specialized groups give you the opportunity for direct involvement and networking with practitioners who share your area of interest.

Savings Discounts on Committee and Section Publications and Products

• Visit the ABA Web Store at www.ababooks.org.

Discounted Registration to Committee and Section Meetings • Save the Date! Section Spring Meeting in Denver, CO on April 22-24, 2010.

<<< Join the committee! >>> Committee membership is free for Business Law Section members.

For immediate enrollment in the committee or Section, log in at www.ababusinesslaw.org.