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Private Equity – Fundamentals Essay Example

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Pages: 6 (1506 words)
Published: June 7, 2018

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What are angel funds?

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Provides financing to companies in earliest stages of development

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Mezzanine funds

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Provides funding to more established firms

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Funds of funds structure

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Fund invests in other private equity funds

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Private equity structure - principal

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partners of the GP of fund & the management company GP makes the investment decisions for the fund entitled to a distributive share but generally doesn't pay fees

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GP - allocation

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Generally receives a preferential profit allocation from the LPs "Carry Allocation" Management company receives a fee but generally not a partner

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Potentail reason for the development or creation of AIV or alternative investment fund

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special purpose partnership - make investments separate from the primary fund - investments in an operating partnership

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What are parallel funds

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Serves to meet special tax objectives of the tax exempt or foreign investors Vehicle for the aforementioned investors make their investment (Cayman islands) Invest in the primary fund or co-invest directly in the portfolio company with the primary fund

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Reasons for the use of blocker corporations

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Often used to minimize the unrelated business income and effectively connected income -Usually required in the partnership agreement -Placed between the foreign tax exempt investor and

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the Fund -Foreign investor doesn't realize ECI or state source income and will avoid federal & state tax filing requirements No UBTI for the tax-exempt investors

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Basic private equity structure

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Principals GP Entity - Management company Fund Limited partners - directly into the fund

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Typical features of the general partner in a basic private equity structure

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Usually a US or flow through entity in which the participants include - Principals - Can be an investment bank or other financial institution (provide services as employees)

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Features of the management company

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a US or flow through entity Participants - Active in the managing the fund (principals) - Investment banks

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LPs

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passive participants - furnish most of the investment capital - US tax-exempts (Portfolio income is generally tax-exempt for dividends, interest, capital gain - special rules for debt financed income or gain) ERISA considerations - Venture capital operating company qualification - taxable us investors - foreign institutional investors

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Venture capital operating company qualification

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two primary requirements (1) >= 50% of the entity's assets (valued at cost) must be invested in venture capital investments (2) Obtain and exercise management rights in connection with one or more of its operating company investments Exception for the initial investment "

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VOCC - exception for the initial investment

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"that the funds received as

initial capital contribution from employee benefit plans by such entity for investment in short-term investments would constitute plan assets during the period preceding the entity's first long-term investment unless the entity qualifies for one of the other exceptions contained in the plan asset regulation" -DOL

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Regulation definition of venture capital investment

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an investment in an operating company but not another venture capital operating company -Has or obtains management rights

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When does a company have management rights?

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Direct contractual rights to "substantially participate in or influence the conduct of the management of the operating company " -No other investor can qualify as having management right thus disqualified as a venture capital investment

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Requirements for real estate operating company

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(1) Entity must have at least 50% of its assets invested in real estate which is managed or developed & with respect to which such entity has the right to substantially participate directly in the management or the development activities (2) Directly engaged in real estate management or development activities *Short term investments pending long term commitment are disregarded -

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Reg 2510.3-101(d)(2)

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Qualifications for real estate operating company 50% rule Short term investments pending long term commitment are disregarded - Initial capital contributions don't need to be invested immediately Annual valuation date ; 90-day grace period

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General rule for significant plan investments - Equity participation by benefit plan investors

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As long as they meet the criteria for significant investments in an entity, the underlying assets of the entity are deemed to be plan assets Definition (Significant): - participation is significant if immediately after the acquisition any equity interest - 25% or more of the value of any class equity interests

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Benefit Plan Investors - Significant investment test Calculation

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disregard any interests held by a person who has discretionary authority or control over the assets of the entity (such as the GP of the partnership) OR Renders investment advice for a fee with respect to such assets ONLY USE THE CONTROLLING PERSONS (disregard GP or principals )

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Definition of benefit plan investor

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an employee benefit plan subject to the fiduciary rules ERISA (Employee Retirement Income Security Act)

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Potential phantom income

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Section 305 taxable stock distributions 702(a) partnership allocations Section 951 subpart F income section 956 investment in US property section 1291 excess distributions section 1293 qualified election fund inclusions

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General rules for non-US investors in the fund

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Gains generally not subject to FIRPTA

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Impact of effectively connected income - Non -US investors

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subject to net basis taxation

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Tests for determining effectively connected income

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(1) Level of engagement in the business or trade (2) Source and character of the income (3) Effectively connected to a

US trade or business ECI - can be either US or foreign base income (source of the income depends on the character of the income)

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Categories of US source income - ECI

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(1) fixed or determinable income or periodical FDAP income, 871(a) ; 881(a) or gain from sale of a capital asset (2) All Us source income not in category (1) 864(c)(2) -Trading in stock, securities, or commodities through an independent agent is not considered an active trade or business within the US as long as the investor doesn't have an office or other fixed place of the business in the United States that directs or effects the transactions (trading safe harbor) - NO CONCERN FOR THE VOLUME OF TRADING

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Exception for 864(b)

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The nonresident alien will not be considered to be engaged in a trade or business if the personal services are performed for a foreign employer by a nonresident alien individual who is not present in the US for more than a total of 90 days Day = calendar day in which any portion of the day for which the nonresident alien is physically present in the United States

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Non-US investors in the private equity fund - periodical income & dividends

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subject to gross basis withholding Exclusion for most interest treaty eligbility

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Section 892

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Sovereign investors -Generally sovereign wealth funds (State owned investment fund investing globally in real and financial assets) -Generally not

taxable on various types of passive income unless: (1) Commercial activity income (2) Controlled commercial entity

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Private Equity Fund - Capital contributions

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Made when called by the GP 3-5 yr commitment period for investments and expenses -Made pro rata by all partners in proportion to their capital commitments

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Private Equity Fund - Distributions

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Typically distributed 80% to all partners based on their respective capital contributions & 20% carried interest to the GP -Preferred return on their capital (8%) - LPs entitled to a preferred yield -GP receives a catch up distributions (20% of the cumulative Fund profits)

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Priority of carry in waterfall distribution

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Carry paid on investment by investment basis Full payout of all capital invested before carry paid Clawback - obligation by the GP to remit excess distributions to fund or its investors -may be net of taxes - preserves economic arrangement

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Carried interest

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A profits interests entitling the GP to a percentage of aggregate net gains from investments -Carry generally on realized investments - Needs to be properly structure to avoid current taxation - 83(b) elections

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Special tax characteristics of carried interest

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Preferential capital gains rates not subject to SE tax GP may be allocated income and this tax due before entitled to any cash

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Tax Distribution Provision Assumptions - Private Equity Fund

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class="flashcard__a_text">Each investor bears the marginal tax rate equal to the highest rate borne by a member of the GP Each investor resides in a jurisdiction of investor or member of GP that bears the highest tax rate (i.e., NY or CA) Each investor earns no external income

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Tax consequences of the management fees

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(MANAGMENT COMPANY) - Ordinary income (FUND) management fee is treated as an investment expense - deduction subject to 2% limitation LPs - will not receive tax benefit from the management fee because of the portfolio deduction subject to 2%

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What is the management fee offset

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A percentage of other fees received by the fund manager from third party - offset future management fees - Prevents UBTI or ECI (structure a reduction) - Can be re-casted by the IRS

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What is management fee waiver?

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GP waives all or a portion of the management fee -Fund makes a new investment and capital call (LPs agree to contribute capital to Fund) GP is allocated income from the investment as if the GP made the deemed contribution (GP priority allocation of gain when that investment is sold) - results in potential deduction to the LPs Management fee turns into profit interest

Private Equity – Fundamentals Essay Example

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