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Presenting a live 90-minute webinar with interactive Q&A

Structuring Private Equity Co-Investments

And Club Deals: Risks and Opportunities

For Sponsors and Investors Choosing the Right Investment Structure, Negotiating Key Deal

Terms, and Navigating Tax and Regulatory Ramifications

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

THURSDAY, OCTOBER 13, 2016

Alex Gelinas, Partne, Sadis & Goldberg, New York

Steven Huttler, Partner, Sadis & Goldberg, New York

Daniel G. Viola, Partner, Sadis & Goldberg, New York

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Structuring Private Equity

Co-Investments and Club Deals:

Risks and Opportunities for

Sponsors and Investors

Choosing the Right Investment Structure, Negotiating Key

Deal Terms, and Navigating Tax and Regulatory Ramifications

October 13, 2016

Steven Huttler, Partner

Sadis & Goldberg LLP

Steven Huttler is a partner in the firm’s Financial Services and Corporate Groups. Mr. Huttler has extensive experience in corporate, finance, investment fund and securities matters, including the representation of U.S. and foreign investment funds, underwriters, and private clients in various registered public and private offerings of debt and equity securities totaling in excess of $10 billion.

As part of his investment fund practice, Mr. Huttler has served as corporate counsel to many private investment funds and partnerships based in or domiciled in the United States and in international and offshore jurisdictions such as the Cayman Islands, Bermuda, the British Virgin Islands, Ireland, Luxembourg, Isle of Man, Jersey, Guernsey, Cyprus, Mauritius, United Kingdom, Austria, Russia, India and Gibraltar. Mr. Huttler's legal practice has exposed him to diverse fund clients with an exceptionally wide range of investment programs and structures, including large mutual funds and hedge fund complexes, private equity firms, real estate partnerships and funds, venture capital funds and funds focused on specialty finance assets. He has also counseled small start-up hedge funds and financial industry entrepreneurs. His practice has included structuring and establishing start-up funds and managed accounts, and structuring investment funds to benefit from U.S. double taxation treaties. He has advised management companies and fund managers on compensation structures, restructured and reorganized funds, structured, negotiated and documented fund trades, negotiated seed, joint venture and start up agreements, and advised on a range of sophisticated transactions. He has also represented financial services providers, such as brokerage firms (including proprietary trading broker-dealers), fund administration firms and third party marketing firms in structuring their operations, reorganizations to achieve tax benefits, advising on disputes with clients, and in the development of forms for their pension, investment, trading, administration and other services to investment funds, equity, debt and option traders and other clients.

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Alex Gelinas, Partner

Sadis & Goldberg LLP Alex Gelinas is a partner in the firm’s Tax Group. Mr. Gelinas focuses his practice on providing tax advice to investment managers of hedge funds, private equity funds and other investment funds on all aspects of their businesses, including management entity and fund formation, partnership taxation issues, compensation arrangements and ongoing investment activities and transactions. Mr. Gelinas also provides tax advice to U.S. pension funds, sovereign wealth funds and other U.S. and foreign institutional investors in connection with their investments in private equity funds, hedge funds and U.S. joint ventures. He also has extensive experience in providing tax planning advice to high-net-worth individuals and families.

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Daniel G. Viola, Partner


Daniel Viola is the Head of the Regulatory and Compliance Group. He structures and organizes broker-dealers, investment advisers, funds and regularly counsels investment professionals in connection with regulatory and corporate matters. Mr. Viola served as a Senior Compliance Examiner for the Northeast Regional Office of the SEC, where he worked from 1992 through 1996. During his tenure at the SEC, Mr. Viola worked on several compliance inspection projects and enforcement actions involving examinations of registered investment advisers, ensuring compliance with federal and state securities laws. Mr. Viola’s examination experience includes financial statement, performance advertising, and disclosure document reviews, as well as analysis of investment adviser and hedge fund issues arising under ERISA and blue-sky laws.

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Overview of Presentation

I. Co-investment structures

II. Deal documents and key deal terms

III. Current trends in private equity co-investments

IV. Regulatory hurdles: broker, dealer and investment advisor regulation

V. Tax and ERISA regulatory considerations for sponsors and investors

VI. SEC’s Recent Pronouncements on Conflicts

VII. Recent SEC Enforcement Cases

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Co-Investments & Club Deals

• Co-Investment

An equity co-investment (or co-investment) is a minority investment, made directly into an operating company (or SPV for such purpose), alongside a financial sponsor or other private equity investor, in a leveraged buyout, recapitalization, growth capital or other transaction

• Club Deal

A private equity buyout or the assumption of a controlling interest in a company that involves several different private equity firms or institutional investors

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Co-Investment Recapitalization

Structure

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Club Deal Structure

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Capital Structure Pyramid

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Who’s Investing to Bridge the Gap?

• Pension Funds

▫ ERISA

▫ Non-ERISA

• Sovereign Wealth Funds

• Insurance Companies

• Private Equity Funds

• US Tax-Exempts

• US Taxable Investors and High Net Worth Platforms

• Family Offices

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Private Equity Fund Structure

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Drivers

• Concentration

▫ Single Investment

• Really Big Deals

▫ How much is too much?

• Investment Focus

▫ Types of investments

• Deal Access

▫ Deal flow

▫ Premium in today’s market

• Investor Allocations

• Flexibility

▫ Maintain investment control

▫ Unwilling to commit to PE funds on a long-term basis

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Economics

• How do Fund Sponsors make money?

▫ Management fees

▫ Transaction fees

▫ Carried interest

▫ Other fees

• Certain compensation structures provide favorable tax treatment in the U.S.

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Economics

• Management Fees: 1.5 – 2% of Committed Capital initially and, after “Investment Period,” 1.5 – 2% of Invested Capital for each Fund

• Transaction Fees: Until recently, advisory, consulting or transaction fees, break-up fees, etc. (but see recent SEC actions)

• Offset Rights: Until recently, 50 – 100% of Transaction Fees (but see recent SEC actions)

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Deal Documents

• Organizational Documents for Investment Vehicle

▫ Articles/bylaws

▫ Partnership agreement/LLC agreement

• Purchase Agreement

▫ Related to the purchase of the relevant interest

• Others

▫ Notes

▫ Guarantees

▫ Warrants

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Deal Documents • Organizational Documents

▫ Serve as the road map for the portfolio company/joint venture

▫ Economics

▫ Governance

▫ Capital call mechanics

▫ Exits

• Purchase Agreement

▫ Investor representations and warranties

▫ Assists in addressing regulatory concerns

▫ Disclosure regarding tax status

▫ Indemnity from investor

• Others

▫ Notes

Convertible/exchangeable

▫ Guarantees

Credit parties

▫ Warrant coverage

Foot faults can result in failure to exercise

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Trends • Pipeline access is valuable

▫ Investors are negotiating for co-investment rights in connection with their fund investments

▫ Supply/Demand imbalance for capital versus transactions

▫ Sponsor favorable terms in co-investments

Fees

Carry

• Position in the capital stack

▫ Risk involved in the transaction

▫ Demand for the deal

▫ Preferred Equity

Returning a stated amount to the investor

Often coupled with warrant coverage

• Industries

▫ No bright lines for large transactions involving healthy companies

▫ Oil & Gas

Increasing activity for preferred equity/mezzanine debt transactions

Largely a function of temporary depression in market prices

▫ Real Estate

What is a real estate asset?

Large allocations driving new transactions

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Regulatory hurdles: broker, dealer

and investment advisor regulation

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Frequently Overlooked Regulatory

Considerations

• Broker-Dealer Regulation

• Investment Adviser Regulation

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Broker Dealer Regulatory Considerations

• Basic Rule: Transaction based compensation in securities deal requires broker-dealer registration

• Compensation could be obvious, as in commissions, or “disguised” (e.g., management and incentive fees where no IA services provided)

• Compliance professionals insist on greater compliance with registration

• SEC itself now very focused on these violations and prosecutes them

• Issue: Club Deals may be sponsored by third parties, who are neither existing registered broker dealers (or broker dealer reps) or investment advisers

• Such parties expect to be compensated

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Investment Adviser Considerations

• Many sponsors, when made aware of the broker dealer regulatory considerations, and the difficulty of meeting requirements, often turn quickly to alternatives

• Most frequent alternative: sponsor acting as investment adviser and collecting management and/or incentive fees

• However, the SEC would regard a sponsor who does not provide any investment advice as a disguised broker dealer, and the fees as disguised commissions

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Investment Company Act

• Need for exemption under ICA

• Often overlooked because vehicle is not a “blind pool”(conventionally thought of as a fund)

• Classic Exemptions of 3(c)(1), 3(c)(5), 3(c)(7) would be most relevant

• Increased possibility of availability of 3(c)(5)

• Such increased availability may even serve as a rationale for using the whole SPA/structure

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Tax Considerations in Structuring Private Equity Co-

Investment Transactions

The Typical Investor Participants in Private Equity Co-Investments Include:

1. US TAX-EXEMPT INVESTORS THAT ARE SUBJECT TO TAX ON UNRELATED TRADE OR BUSINESS INCOME (“UBTI”)

A. US “Fortune 500” Pension Funds

B. US University and College Endowment Funds

C. Other US Tax-Exempt Entities (Foundations, Charitable Organizations)

D. Self-Directed Retirement Plans and Individual Retirement Accounts of High Net Worth Individuals

Such tax-exempt investors would realize UBTI if they make any debt-financed investments (i.e., investments using borrowed funds made directly or by a partnership in which they are partners (including limited partners)). In addition, such tax-exempt investors would realize UBTI if they own equity interests in partnerships that are engaged in a trade or business in the US or anywhere in the world.

PREFERRED FORM OF INVESTMENT: If there is a risk of UBTI, such Tax-exempt entities typically invest through “blocker corporations “organized in “zero tax” jurisdictions like the Cayman Islands or British Virgin Islands.

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Investment Transactions (cont.)

2. US TAX-EXEMPT INVESTORS THAT ARE NOT SUBJECT TO THE UBTI RULES

A. Retirement Plans for State and Local Government Employees (e.g., CALPRS, CALSTRS, New York State and Local Retirement System, Florida State Employees Retirement Plan, Etc.)

PREFERRED FORM OF INVESTMENT: Such governmental employee plans are typically exempt under section 115 of the Internal Revenue Code (as governmental entities) rather than Code section 501, and are thus exempt from UBTI. Therefore, they would typically invest through pass-through entities.

2. US TAXABLE INSTITUTIONAL INVESTORS

A. Publicly Traded “C” Corporations

B. Insurance Companies

C. Private “C” Corporations

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Investment Company Act

• Need for exemption under ICA

• Often overlooked because vehicle is not a “blind pool”(conventionally thought of as a fund)

• Classic Exemptions of 3(c)(1), 3(c)(5), 3(c)(7) would be most relevant

• Increased possibility of availability of 3(c)(5)

• Such increased availability may even serve as a rationale for using the whole SPA/structure

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PREFERRED FORM OF INVESTMENT: As a general rule, these taxable US corporate investors favor investments in portfolio companies organized as pass-through entities, which allow them to benefit currently from the flow through of operating losses.

3. US HIGH NET WORTH INDIVIDUALS (INCLUDING FAMILY OFFICES)

A. Family Offices (typically partnerships of individuals)

B. High Net Worth Individuals

PREFERRED FORM OF INVESTMENT: Such taxable individuals would prefer to derive tax-favored income such as long-term capital gains and qualified dividends. In addition, they would prefer to be in pass through entities in order to derive any tax benefits from operating losses or capital losses. Such US individuals want to avoid investing through foreign “blocker” corporations that could be classified as “passive foreign investment companies” (PFICs) or “controlled foreign corporations (CFCs).

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4. FOREIGN TAXABLE INVESTORS

A. Foreign Corporations

B. Foreign High Net Worth Individuals and Family Offices

Non-US Persons (including foreign corporations) are generally not subject US income tax on capital gains derived from investments in US securities but would be subject to US income tax on any income that is “effectively connected” with a US trade or business (“ECI”), including their share of ECI derived by a partnership in which they are a partner (including a limited partner). Thus, if the US portfolio company is organized as a partnership and is engaged in a US business, such foreign investors typically avoid ECI by investing through foreign blocker corporations organized in “zero-tax” jurisdictions.

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US Withholding Taxes: The United States imposes a 30 percent withholding tax on US-source dividend and certain types of interest income (other than “portfolio interest”). US tax treaties with foreign jurisdictions in which the foreign investor may be residents typically reduce the US withholding tax on dividends to 15 percent and interest income to zero. However, the blocker corporations organized in “zero tax” jurisdictions are not eligible for the benefits of any US tax treaties

PREFERRED FORM OF INVESTMENT: Foreign taxable individuals typically invest through a blocker corporation. In addition to avoiding the ECI exposure, such individuals would also be protected from US estate tax exposure by owning the US investment through a foreign corporation.

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5. SOVERIGN WEALTH FUNDS

Although sovereign wealth funds are not treated as US tax-exempt entities, The Internal Revenue Code contains a special provision (Section 892) which exempts sovereign wealth funds and their home country subsidiaries from federal income tax on certain types of US-source income, including dividends and capital gains on sales of corporate stocks and interest income and gains from sales of debt securities. US trade or business income derived as an equity investor in a US partnership is not covered by this special statutory exemption. Unlike the US tax-exempt entities that are subject to UBTI, sovereign wealth funds do not incur any US tax liability if they, or partnerships in which they invest, use borrowed funds to acquire income-producing property.

PREFERRED FORM OF INVESTMENT: If the portfolio company is a partnership, the sovereign wealth funds typically use blocker corporation structures to avoid US trade or business income. If the target portfolio company is a US corporation, the sovereign wealth fund will prefer to invest directly in the stock of such corporation.

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Diagrams of Co-Investment Structures

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Diagrams of Co-Investment Structures

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ERISA Considerations Relating to Private Equity Co-

Investment Transactions

1. Plan Assets Issues; Fiduciary Status and Prohibited Transaction Issues

If the assets of an entity (e.g., a corporation, partnership or trust) are treated as plan assets of a benefit plan investor that owns an equity interest in such entity, the parties having management authority over the assets of such entity would be treated as fiduciaries under ERISA with respect to such plan investors. In addition, transactions entered into by such plan asset entities would be subject to ERISA scrutiny including complex prohibited transaction rules.

A. General Rules on Plan Assets Status

Under the ERISA plan assets regulations, the assets of an entity in which a plan has an equity interest will not be treated as plan assets if the equity interests are(1) publicly traded securities or (2) a security issued by an investment company registered under the Investment Company Act of 1940.

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In all other cases the assets of the entity will be treated as plan assets for ERISA purposes unless:

(1) the entity qualifies as an “operating company” which term also includes a “venture capital operating company” or a “real estate operating company”; or

(2) the aggregate investment in the equity interests of the entity that are owned by “benefit plan investors” is less than 25 percent of the outstanding equity interests in such entity (the Insignificant Plan Investment Exception”).

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B. Operating Company Definition

An operating company is defined as an entity that is “primarily engaged, directly or through a majority owned subsidiary or subsidiaries, in the production or sale of a product or service other than the investment of capital.”

(1) Start-up Ventures and Companies Engaged Solely in Research and Development May not Qualify under this Definition.

(2) The Venture Capital Operating Company (“VCOC”) and Real Estate Operating Company (“REOC”) Exemptions Were Added Later.

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VCOC Definition

To qualify as a VCOC, the entity must satisfy two requirements: First, at least 50% of the entity’s assets (at cost) must be invested in “venture capital investments” or “derivative investments” as defined. Second, the entity must obtain and exercise “management rights” with respect to at least one of its operating company investments. The term “venture capital investment” is defined as an investment in an “operating company” in which the investing entity has obtained management rights.

REOC Definition

The REOC definition is similar to the VCOC definition. In order to be a REOC, the entity must: (1) have at least 50 percent of its assets (valued at cost) “invested in real estate that is managed or developed and with respect to which such entity has obtained the right to substantially participate directly in the management or development activities”; and (2) be directly engaged in real estate management or development activities.

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SEC’s Recent Pronouncements on Conflicts

• Fees charged by fund managers directly to portfolio companies

• Allocations of investment opportunities

• Allocations of expenses among funds and co-investment vehicles

• Concerns raised about rates on legal fees charged to PE funds and their portfolio companies vs. those of the principals

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SEC’s Enforcement Cases

• In re Blackstreet Capital Mgmt. et ano., (June 1, 2016): Charged (i) broker fees for purchasing portfolio cos., without SEC registration; (ii) $450k in oversight fees to 2 portfolio cos., (iii) for political/charitable contributions & entertainment expenses & (iv) acquired shares in portfolio cos. & LP interests in PE Fund from others, when should have been repurchased by cos. or reverted to Fund & investors. $3.1MM sanctions.

• In re Cranshire Capital Advisors, LLC (Nov. 23, 2015): Improperly charged fund Manager’s own expenses for attorney for compliance consulting (i.e., registration and compliance program), and for office supplies, computers and utilities.

• In re Cherokee Investment P’rs, LLC, (Nov. 5, 2015): Manager charged Fund for compliance consultant expenses relating to registration and compliance consulting and legal expenses arising from SEC Exam and Investigation

• In re Clean Energy Capital et ano. (Oct. 17, 2014): Improperly charged Manager’s overhead (i.e., salaries, bonuses, benefits & rent) to Funds and caused Funds to borrow from Manager at a high interest rate of 17% while pledging Fund assets as collateral. Changed calculation of dividend distributions adversely to some investors. $2.2MM sanctions

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SEC’s Enforcement Cases (cont.)

• In re Blackstone Mgmt. P’rs, (Oct. 7, 2015): $39MM in sanctions for PE manager accelerating monitoring fees to portfolio cos. at time of IPO/private sale & getting legal discounts based on Fund using law firm.

– Blackstone Management charged portfolio companies owned by Funds annual monitoring

fees, and accelerated the annual monitoring fees upon the IPO or Private Sale of company. ▫ – Only Disclosed “ability to collect monitoring fees prior to… commitment of capital but did

not disclose its practice of accelerating monitoring fees until after it took the fees.”

– Conflict of Interest in decision to accelerate: benefits Manager at expense of investor profit.

• In re Apollo Mgmt. V, L.P., et al., (Aug. 23, 2016): $52.7MM in sanctions for misleading disclosures about accelerating portfolio monitoring fees and loan from Fund to Apollo Mgmt. affiliate – As in Blackstone, Apollo accelerated annual monitoring fees upon IPO/Private Sale of

Portfolio Co.

– Apollo only disclosed ability to charge monitoring fees in offering documents, but only disclosed acceleration of monitoring fees after investors committed capital and Apollo accelerated.

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SEC’s Enforcement Cases (cont.)

• In re JH Partners, LLC, (Nov. 23, 2015): PE Manager caused multiple Funds to invest in same

portfolio cos. at different seniority (loans), priority (liquidation) & valuations,

potentially favoring one client over other.

• Manager also loaned over $60 million to portfolio companies without disclosing to investors or LP Advisory Committee; created conflict in seniority with investors and due to using portfolio company assets as collateral.

• Manager waived $24MM in management fees & carried interest; agreed to subordinate $60MM loan to Fund’s investment interest in portfolio cos.; and $225k in civil penalties. LPAC disclosure after fact not enough.

• In re Kohlberg Kravis & Roberts & Co. (June 29, 2015): First broken deal expenses action.

• $30MM in sanctions for not clearly disclosing charging $338MM in broken-deal & due diligence

expenses to investors only – but not to PE co-investors who also benefitted from expenses.

• Key Factor in Sanctions: Co-Investors included many KKR executives and officers, making

conflict greater.

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If you have questions, please contact:

Steven Huttler

212.573.8424

[email protected]

Alex Gelinas

212.573.8159

[email protected]

Daniel G. Viola

212.573.8038

[email protected]


551 Fifth Avenue, 21st Floor

New York, NY 10176

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mailto:[email protected]

