Private Equity Spring/Summer 2009 In this issue p1 Description of the TALF Program and Who is an Eligible Borrower p2 Avoiding an Audit Nightmare p5 Selling French Distressed Assets: An Increasing Tendency to Trigger the Deep Pocket’s Liability p7 U.S. Private Equity Investments in Canadian Income Trusts p9 Germany: Changes in Tax Environment for Venture Capital and Private Equity Funds and their Portfolio Companies p11 SBICs Revisited p14 Shanghai to Permit Foreign Private Equity and Growth Capital Firms to Open Shop p15 News from the Group d Editor: Roger Mulvihill Description of the TALF Program and Who is an Eligible Borrower by Kevin P. Scanlan and Adam I. Gehrie The Term Asset- Backed Securities Loan Facility (“TALF”) created by the Fed- eral Reserve Bank of New York (the “FRBNY”) is in- tended to enhance participation in the securitization markets by providing financing to investors (such as private funds) that will be non-recourse under most circumstances to support their purchases of highly rated asset-backed securities issued on or after Jan- uary 1, 2009 and certain high-quality commercial mortgage-backed securities issued prior to January 1, 2009 (collectively referred to herein as “ABS”). Securities eligible to be purchased with TALF loans include ABS backed by auto loans, student loans, credit card receivables, Small Business Administra- tion loans, business equipment leases and loans, mortgage servicing advances, vehicle fleet leases, and non-automobile floor plan loans. Starting in June, commercial mortgage-backed securities and securities backed by insurance premium finance loans will be eligible for TALF loans as well. Although the amount of financing provided by the FRBNY to TALF loan borrowers varies depending upon the type of ABS that will serve as collateral for the loan (and is adjusted from time to time by the FRBNY), the TALF loans generally provide borrowers leverage of up to 20 times their raised capital (called the “haircut amount”) on the high end to six times their haircut amount at the low end. Generally, private funds will qualify as TALF borrow- ers pursuant to the rules of the TALF program to the extent that they are investment funds that are (i) organized in the United States; (ii) are managed by an investment manager that has its principal place of business located in the U.S.; and (iii) neither the fund nor the investment manager is controlled by a non-U.S. government. Managers contemplating launching TALF funds should be aware that both any investment vehicle that acts as a borrower under the TALF program and any 25% owner of any such borrower (which will include investors who own more than 25% of the total equity or any class of voting securities of a TALF fund) are subject to the Employ American Workers Act (“EAWA”) provisions which make hiring new employees who are in H-1B non- immigrant status much more difficult. Managers who expect a single investor to comprise more than 25% of the aggregate subscriptions to a TALF fund should make such investors aware of the require- ment that they may need to comply with EAWA following their investment. Private Equity Fund Structures are the Most Practical Structures for TALF Funds Liquidity of TALF Assets Favors Private Equity Structure Although it is possible to repay TALF loans in ad- vance and otherwise sell the securities collateraliz- ing a TALF loan, doing so is a cumbersome process and cannot easily be accomplished piecemeal to provide for the funding of periodic redemptions. Investors in a TALF fund should expect to remain invested in the fund until either the TALF loans to which they have investment exposure mature or, to the extent that the fund intends to seek to replace TALF financing after the maturity of the associated TALF loans, the final maturity of the ABS collateral- izing the TALF loans to which they have investment exposure. Virtually all of the TALF funds seen are structured on a long hold private equity platform rather than on a hedge fund platform with regular liquidity. Mini-Master Structure Any investment fund seeking to be a TALF borrower must be an investment fund organized in the U.S.
Transcript
Private EquitySpring/Summer 2009
In this issue
p1 Description of the TALF Program and Who is an Eligible Borrower
p2 Avoiding an Audit Nightmare
p5 Selling French Distressed Assets: An Increasing Tendency to Trigger the Deep Pocket’s Liability
p7 U.S. Private Equity Investments in Canadian Income Trusts
p9 Germany: Changes in Tax Environment for Venture Capital and Private Equity Funds and their Portfolio Companies
p11 SBICs Revisited
p14 Shanghai to Permit Foreign Private Equity and Growth Capital Firms to Open Shop
p15 News from the Group
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Editor: Roger Mulvihill
Description of the TALF Program and Who is an Eligible Borrower
by Kevin P. Scanlan
and Adam I. Gehrie
The Term Asset-Backed Securities Loan Facility (“TALF”) created by the Fed-
eral Reserve Bank of New York (the “FRBNY”) is in-tended to enhance participation in the securitization markets by providing financing to investors (such as private funds) that will be non-recourse under most circumstances to support their purchases of highly rated asset-backed securities issued on or after Jan-uary 1, 2009 and certain high-quality commercial mortgage-backed securities issued prior to January 1, 2009 (collectively referred to herein as “ABS”). Securities eligible to be purchased with TALF loans include ABS backed by auto loans, student loans, credit card receivables, Small Business Administra-tion loans, business equipment leases and loans, mortgage servicing advances, vehicle fleet leases, and non-automobile floor plan loans. Starting in June, commercial mortgage-backed securities and securities backed by insurance premium finance loans will be eligible for TALF loans as well. Although the amount of financing provided by the FRBNY to TALF loan borrowers varies depending upon the type of ABS that will serve as collateral for the loan (and is adjusted from time to time by the FRBNY), the TALF loans generally provide borrowers leverage of up to 20 times their raised capital (called the “haircut amount”) on the high end to six times their haircut amount at the low end.
Generally, private funds will qualify as TALF borrow-ers pursuant to the rules of the TALF program to the extent that they are investment funds that are (i) organized in the United States; (ii) are managed by an investment manager that has its principal place
of business located in the U.S.; and (iii) neither the fund nor the investment manager is controlled by a non-U.S. government. Managers contemplating launching TALF funds should be aware that both any investment vehicle that acts as a borrower under the TALF program and any 25% owner of any such borrower (which will include investors who own more than 25% of the total equity or any class of voting securities of a TALF fund) are subject to the Employ American Workers Act (“EAWA”) provisions which make hiring new employees who are in H-1B non-immigrant status much more difficult. Managers who expect a single investor to comprise more than 25% of the aggregate subscriptions to a TALF fund should make such investors aware of the require-ment that they may need to comply with EAWA following their investment.
Private Equity Fund Structures are the Most Practical Structures for TALF Funds
Liquidity of TALF Assets Favors Private Equity Structure
Although it is possible to repay TALF loans in ad-vance and otherwise sell the securities collateraliz-ing a TALF loan, doing so is a cumbersome process and cannot easily be accomplished piecemeal to provide for the funding of periodic redemptions. Investors in a TALF fund should expect to remain invested in the fund until either the TALF loans to which they have investment exposure mature or, to the extent that the fund intends to seek to replace TALF financing after the maturity of the associated TALF loans, the final maturity of the ABS collateral-izing the TALF loans to which they have investment exposure. Virtually all of the TALF funds seen are structured on a long hold private equity platform rather than on a hedge fund platform with regular liquidity.
Mini-Master Structure
Any investment fund seeking to be a TALF borrower must be an investment fund organized in the U.S.
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However, non-U.S. and U.S. tax-exempt investors will gen-erally prefer to invest through an offshore fund, especially where leverage is employed in the investment strategy. In order to accommodate that preference, an offshore fund for such investors is typically established that feeds into a U.S. partnership or limited liability company (into which the U.S. taxable investors will invest directly), which U.S. entity is the ultimate TALF borrower. Managers should note that this structure will require non-U.S. investors, who would typically not be required to qualify as “qualified purchasers” under the Investment Company Act of 1940 or as “accredited investors” under the Securities Act of 1933, to meet these qualifications in connection with their investment in the offshore fund.
Certain Terms to Consider
Immediate Drawdown of Capital or Capital Commitment Subject to Drawdowns During the TALF Loan Period. Managers of TALF funds should consider whether they desire to receive the entire amount of an investor’s capital commitment upon the admission of such investor (either to apply immediately to a single TALF loan or to invest in temporary investments pending deployment of capital in future TALF loans) or whether to operate on a more traditional capital commitment/capital call basis. The mechanism chosen in this context will also need to be coordinated with the manner in which additional investors are permitted to acquire an interest in investments of the fund purchased prior to the date of their admission.
Management Fee Calculation. Generally, TALF funds have been structured so that the manager takes a management fee on the entire leveraged value of the ABS portfolio for the duration of the fund. In lieu of this approach, some managers have avoided the need to value the portfolio by taking the management fee on the cost of the ABS pur-chased with the TALF loan at the time of purchase for the entire duration of the loan. To the extent managers choose to take the management fee on the entire leveraged value of the ABS portfolio, they will need to establish a reliable valuation procedure.
Incentive Compensation Calculation. Because the success of a TALF-loan financed investment is generally measured in return of capital and interest over time instead of ap-preciation of assets, attempting to calculate performance compensation on an annual basis based on unrealized gains is generally not practicable. Instead, managers generally calculate incentive compensation (paid either as a fee or as an allocation) based upon distributions made in excess of total return of capital (and sometimes a preferred return) with respect to either (i) each TALF loan or (ii) all the investments of the fund. It should be
noted that if the manager chooses to calculate incentive compensation on a loan-by-loan basis (i.e., option (i) in the preceding sentence), investors may demand a true up mechanism (i.e., clawback) to ensure that the manager is not overpaid in the aggregate.
What’s lurking in an auditor’s report? Perhaps more than some borrowers under their credit agreements bargained for.
Credit agreements typically include a covenant requiring the borrower periodically to deliver to the lenders certain financial information, usually including annual audited financial statements. Some simply require delivery to the lender of these audited financial statements, without more. Often, however, credit agreements are more de-manding, requiring that the audited financial statements also be:
n “without any qualifications”
n “unqualified in scope or substance”
n “unqualified as to going concern or scope of audit”
n “without a ‘going concern’ or like qualification, excep-tion or assumption”
n subject to requirements in addition to or combining the foregoing.
A particular issue arises when a credit agreement requires that the auditor’s report contain no exception relating to the borrower’s ability to continue as a going concern.
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To understand the issue, a bit of relevant background is needed on the report accompanying audited financial statements.
The auditor’s report contains the auditor’s opinion on the related financial statements. Under the Auditing Stan-dards Board’s Statement on Auditing Standards no. 58, as amended, auditors may provide unqualified opinion reports or qualified opinion reports (in addition to adverse opinion reports and disclaimer of opinion reports, which are not discussed here).
Qualified opinion reports may include qualifications as to limits on the scope of the audit conducted, lack of evi-dence regarding certain aspects of the audit, or departure from generally accepted accounting principles that have a material effect on the financial statements. In addition, certain circumstances, while not requiring the auditor to take a qualification, may require the auditor to add explanatory language to its report under Statement on Au-diting Standards no. 59, as amended. Such circumstances may include a material change in accounting principles or in the method of their application from a prior period, a substantial doubt as to the entity’s ability to continue as a going concern for a reasonable amount of time (not to exceed one year beyond the date of the financial state-ments being audited), or to emphasize a specific matter or unusual circumstance.
Now, when a credit agreement requires that the auditor’s report contain no exception relating to the borrower’s ability to continue as a going concern, the borrower’s future inability to satisfy financial covenants in the credit agree-ment could lead to an auditor’s inclusion of just such an exception.
This is because the auditor may conclude that there is a likelihood that the borrower will default on a financial covenant, say, within six months after the audit. Upon such default, the lender presumably will be entitled to accelerate the loan. If the effect on the borrower of a future accelera-tion would include its inability to pay its debts as they came due, then an immediate going-concern qualification may be deemed appropriate by the auditor. Statement on Auditing Standards no. 59, noted above, states that the going-concern qualification “[r]elates to the entity’s inability to continue to meet its obligations as they become due without substantial disposition of assets outside the ordinary course of business, restructuring of debt, externally forced revisions of its operations, or similar ac-tions.” The auditor may believe that such an action would need to be taken by the borrower in that circumstance for it to continue meeting its obligations at that future time, so long as it is within 12 months of the date of the financial statements audited.
If a credit agreement requires an auditor’s report without such going-concern language, then failure to deliver the same would constitute a breach of the credit agreement and likely also an event of default, and could lead to acceleration and/or other remedies exercise as well.
For borrowers facing such a situation under a revolving credit facility, there is usually a more immediate concern, however.
Once an auditor notifies a borrower that it intends to include such going-concern language in its report, the borrower will be hard-pressed to certify to its lender that no event has occurred that, with the passage of time, will become an event of default. Such a certification by the borrower is a standard condition precedent to the exten-sion of new revolving loans. A borrower in such a situation may potentially be confronted with a liquidity crisis, on account of its inability to draw on its revolver. To make matters worse—and somewhat ironically—the borrower’s inability to draw under its revolver could itself exacerbate the auditor’s liquidity worries that led to the going-concern language in the first place.
In cases where the borrower has only term loans and no revolver, then even if the lender chooses not to acceler-ate the loan upon the borrower’s technical default of not delivering a clean auditor’s report, such an event still may enable the lender to extract waiver or amendment fees, increased loan pricing, and/or more restrictive operating requirements or terms from the borrower in exchange for curing or waiving such default. In the current environment, such fees could be onerous.
All this could result simply from the borrower’s inability to demonstrate that it can prospectively meet a financial test that the parties intended only be performed on the precise measurement dates specified in the credit agreement (e.g., fiscal-quarter ends). It would mean that, even though the parties specifically negotiated financial covenants and the relevant testing dates therefore, language in the auditor’s
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report—stemming from the anticipation of future covenant defaults—would effectively negate such negotiated dates. This is an eventuality likely unanticipated by any borrow-er—and potentially quite costly.
Careful drafting of the credit agreement can avoid this problem. Of course it is best, where possible, for a bor-rower to attempt to negotiate a covenant that does not impose any requirements on the auditor’s report. Where a lender insists that the report shall not contain going-concern language, however, a borrower can often succeed in including language that handles the issue. The language would provide that any exception to the auditor’s report resulting exclusively from the borrower’s inability to dem-onstrate prospective compliance with financial covenants will not violate the audit requirement. Other solutions are possible as well, depending on the facts of each case.
If hidden bombs such as these are detected and handled with proper counsel, a borrower should be able to rest a bit more easily at night and avoid one audit nightmare.
Related Issue Under UK Auditing Standards
A number of leveraged facility documents in the European market will have, as a separate event of default, any quali-fication of accounts by the borrower’s auditors.
The Loan Market Association (“LMA”) publishes a sug-gested form of leveraged facility agreement. It contains an event of default triggered if the auditors of the group qualify the audited annual consolidated financial state-ments of the parent. However, a number of borrowers will have negotiated this away.
The position governing audits in the United Kingdom is very similar to that in the U.S. The International Standards of Auditing (UK and Ireland) paper no. 570 provides guidance for auditors in assessing management’s going concern assumption. With respect to what the ISA term as “Borrowing Facilities,” the auditor can decide that it is necessary to obtain confirmation about the terms of the bank facilities, and make an assessment of the intentions of the bankers relating thereto.
As part of the process, auditors will be expected to make an independent assessment of whether the entity has breached the terms of the borrowing covenants, or whether there are indications of potential breaches (ISA (UK and Ireland) 570 at paragraph 21-2). As in the U.S., this clearly covers prospective defaults of financial covenants.
If the auditor is not able to get comfortable on these points, it will have to make a disclosure in the financial
statements, or will have to make a qualified or adverse opinion in the auditor’s report.
The time frame on which a going concern should be based in the UK should be within the “foreseeable future,” but should cover a period of at least 12 months.
UK Case Study
A borrower with a facility agreement that included rolling financial covenants as well as a loan to value covenant (which could in a similar context be a total net worth cov-enant) was told by its auditors that the auditors may not be able to sign off the accounts on a going-concern basis.
The auditors were concerned that the borrower might breach its loan to value covenant at some point in the future, based upon their own assessment of what might have happened to the value of the borrower’s assets.
Under the facility agreement, the assets were only to be revalued if required by the lenders. The lenders had not required a revaluation, and had orally advised the borrow-er that they did not intend to do so at the present time. Despite this, the auditors were still concerned, and stated that they would only be able to sign off the borrower’s accounts on a going-concern basis if greater support was provided by the borrower’s shareholders in the form of a binding letter of support or some other financial support. This placed the borrower in the position that its lenders were less concerned about the covenant than the auditors, and the auditors were requiring financial support for the borrower not required by the lenders. Once again, certain specific language in the facility agreement, if it had been negotiated at the outset in light of this issue, could have mitigated or solved it.
Selling French Distressed Assets: An Increasing Tendency to Trigger the Deep Pocket’s Liability
by Olivia Guéguen and
Isabelle Marguet
The disposal of a sub-sidiary is not necessarily the end of the story for the former shareholder.
It is indeed a well-established principle under French law that, in case of a subsequent bankruptcy situation of the sold subsidiary, the seller’s liability can be triggered if it is evidenced that the selling shareholder is responsible for mismanagement acts (whether as de jure or de facto manager) having generated a deficiency in assets.
The current depressed economic situation seems to encourage French courts to trigger the seller’s liability beyond the above principle on new grounds. This is particularly the case with a view to open new recourses to dismissed employees of a sold subsidiary finally bank-rupt, especially where the former shareholder can play the deep pocket.
A new principle emerges from this recent case law: when selling a subsidiary, a shareholder has an obligation to ensure that the purchaser is in a position to secure the continuity of the target’s activity after the sale.
PE firms should therefore be very cautious when selling a shareholding in a portfolio company experiencing financial difficulties and make sure that they gather appropriate evidence to show they have taken all steps in order to ensure the continuity of the activity after the disposal.
What are the New Grounds for the Liability of a Selling Shareholder?
Tendency to Extend the Grounds for Shareholder Liability: Case of the Shareholder as Co-Employer
Under French law, a parent company can be held liable vis-à-vis laid-off employees of its subsidiary, on the grounds that it is considered as their co-employer, when the business activities, the management, and the interests of both companies are considered as one and the same.
Recent French case law, however, seems to extend the cas-es where a shareholder can be considered a co-employer. In particular, the management company of a private equity investment fund recently has been held liable to pay damages to the employees of a portfolio company in liquidation based on the fact that it acted as co-employer of the portfolio’s employees. The circumstances at issue were, however, typical of the involvement of a PE firm in its portfolio companies (e.g., regular reporting of manage-ment to the PE firm, chairmanship of the company by a representative of the PE firm, or involvement of the PE firm in the definition of the business plan and strategy).
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Even if the above case may not be confirmed at the appeal stage, it shows a tendency from French courts to broaden the cases in which a shareholder may be considered a co-employer and more generally to extend the grounds on which the liability of a deep-pocket share-holder can be triggered.
Failure to Ensure the Future of the Target Company
French courts have, in various recent cases, determined that a parent company having sold its subsidiary could be held liable vis-à-vis dismissed employees in cases where the sold entity ended up in liquidation and it was established that the former shareholder failed to take all reasonable steps to secure the future of such sold entity.
Based on such case law, employees of the sold entity may now have grounds, dependent upon the circum-stances of the sale, to claim damages from the former shareholder in connection with the prejudice suffered due to their dismissal in the context of the liquidation of the sold entity. It was notably ruled that their prejudice may result from the loss of the opportunity to benefit from the generous collective dismissal plan that would have been implemented if the employer had remained in bonis and a part of the selling shareholder’s group.
Several types of defaults from the selling shareholder have been put forward by French courts to support the liability of such shareholder:
n certain acts preceding the sale having weakened the post-closing financial situation of the target (e.g., dis-tribution of dividends, payment of management fees);
n certain decisions concerning the structure of the sale (e.g., case in which the target company is placed under a dependency relationship post-closing as its only client is its former shareholder—typical of outsourcing transactions);
n certain decisions relating to the financial conditions of the sale (e.g., case where seller injects cash in the tar-get with a view of artificially maintaining the activity);
n more generally, the failure of the seller to make sure that the purchaser had a serious business plan and sufficient financial resources to implement such plan.
How to Best Secure the Sale of a Portfolio Company?
Based on the above recent case law, the seller has, in practice, the obligation to ensure that the retained pur-chaser is in a position to secure the future of the target. A
PE firm willing to dispose of a portfolio company should therefore take all reasonable steps to make sure that the purchaser will be in a position to do so (and should gather all relevant evidence in this respect).
The following elements are notably scrutinized by the judges:
n the identity of the purchaser: financial resources, knowledge of the business sector, and track record in terms of acquisitions;
n the purchaser’s business plan: it is important that the purchaser draws up its own business plan, but the seller shall ensure that such business plan is serious and consistent with its knowledge of the situation of the target;
n the purchaser’s internal financial resources as well as the financing available from financial institutions (the fact that banks support the project will also help demonstrate the seriousness of the project);
n the ability of the target company to operate on a stand-alone basis after the sale: the target must be independent from the seller after closing—if a com-mercial relationship is maintained, it should not be essential to the target.
The financial conditions of the sale should also be care-fully reviewed. Indeed, subsidiaries experiencing tempo-rary financial difficulties are frequently sold for symbolic consideration. Seller may also agree to pay for certain post-closing investments or costs. Favorable financial conditions may, however, be considered with suspicion as they may reveal that the seller paid to facilitate the sale of its subsidiary and avoid its related obligations as share-holder. It should therefore be evidenced that the purpose of such favorable financial conditions was to address specific temporary needs and not to favor an artificial survival of the target. The seller shall also make sure that all amounts made available to the target in such context be used for the agreed purposes (e.g., through the use of an escrow agent).
U.S. Private Equity Investments in Canadian Income Trusts1
by Daniel M. Dunn, Mark E. Thierfelder, and Amarpreet (Ricco) S. Bhasin2
2008 ended as a year that many investors would like to forget. Private equity activity was down, on a global level, by over 70% at the end of 2008 from 2007, with fourth quarter deal volume at the lowest level it has been since the fourth quarter of 2001.3 Notwithstanding some positive movements in U.S. and international stock indices in the spring of 2009, private equity investors remain cau-tious. Many are managing their portfolio investments or are infusing them with additional funds, while keeping an eye out for opportunities, increased levels of liquidity, and easier access to the bank and capital markets.
As private equity investors pace themselves through these challenging economic times, the Canadian income trust, a form of publicly traded investment that was viewed as a potential exit vehicle for private equity portfolio com-panies just a few years ago, has again come into focus. Because of a confluence of events, including recent Cana-dian legislative changes, private equity investors are now looking at existing Canadian income trusts as potential portfolio investments.
The Canadian Income Trust
A Canadian income trust (also known as a Canadian income fund) is a publicly traded investment vehicle that indirectly holds businesses or other income-producing assets that produce a stable stream of income for its unitholders. While all trusts are not identical, there are some common features. Generally, an income trust is a publicly traded entity, but unlike a corporation, it is not taxed at the entity level. The income of an income trust, unless retained in the entity, flows through the trust entity and ends up in the hands of its unitholders in the form of cash distributions on a regular basis, usually monthly. The unitholders are the beneficiaries of the trust and are taxed on the distributions they receive. The principal advantage of the income trust, from a tax point of view, is the effective elimination of any corporate level tax.
In the early to mid 2000s, the Canadian income trust market was rapidly growing. By 2002, income trusts accounted for 79% of all money raised through IPOs in Canada4 and by 2005, the income trust sector was worth approximately CDN$170 billion, which was then equiva-lent to 10% of the Toronto Stock Exchange (“TSX”).5 The public announcement by a corporate entity of its intention to convert to an income trust could immediately add 10-20% to its share price at that time.6 In the fall of 2006, telecom giants BCE and Telus, both of whom were corporations, were considering a conversion to an income trust structure. On October 31, 2006 after the markets closed, the Federal Conservative government in Canada announced legislative changes to the taxation of income trusts, effectively ending the tax benefits of the income trust structure immediately for any newly created trusts,
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and put in place a sunset provision for most existing trusts. The tax advantages are scheduled to expire in their entirety on December 31, 2010 for most existing trusts. Most income trusts will effectively be taxed as corporate entities from January 1, 2011.
Canadian media commentators termed this change to the tax structure of most income trusts as the “Hal-loween Massacre.” The announcement sent shock waves through the income trust market. The S&P/TSX Income Trust Index closed on October 31, 2006 at 164.86, and after two weeks the index was at 135.51.7 In the two months following the Halloween Massacre announce-ment, energy income trusts, as a group, lost 25% of their value and certain individual income trusts lost values in excess of 30%.8
As a consequence of these changes in law and the depressed capital markets generally, many trusts may be in a situation in which their values have been discounted. Jamie Scarlett, a senior M&A lawyer at Torys LLP in Toronto, notes:
Income trusts have faced difficult challenges since the Hal-loween Massacre. Depressed credit and stock markets and the impending change in tax status in 2011 have the sec-tor in a funk. Trading prices are low and access to capital is difficult, so income trusts can’t grow through acquisition. Many of these income trusts have a good business and will be looking for a way to restructure or go private before 2011. Private equity investors may be able to play a role in this next wave of income trust activity.
Following the Halloween Massacre, there had been ap-proximately $65 billion worth of foreign and leveraged buyouts of income trusts in Canada as of August 2008.9 While the legal changes and market dislocation have been key drivers in this development, it is important to note that many income trusts are based on businesses that historically have provided stable cash flows, a charac-teristic that makes such businesses attractive portfolio investments, and facilitate the debt service required in a leveraged buyout. Moreover, the tax features of an income trust structure often afford significant flexibility in structur-ing an acquisition. An acquisition transaction can take the form of the acquisition of trust units, purchases out of bankruptcy, an acquisition of a trust’s business via a stock or asset deal at its operating subsidiary level, or some combination of the above. In these various acquisition forms, it may be possible to achieve an efficient tax basis “step-up” in both Canadian and U.S. business assets, which can enhance the after-tax cash flow of the business going forward. Synthetic or hybrid financing techniques may also be employed to reduce further the taxable in-come (and, consequently, the tax liability) of the business.
Connors Bros.: A Recent Going-Private Transaction
One recent example of a completed going-private trans-action of a Canadian income trust sponsored by a U.S. private equity firm using debt financing is the acquisi-tion by affiliates of Centre Partners Management LLC (“Centre”) of the leading branded seafood company, Connors Bros. Income Fund, whose subsidiaries market consumer food products under brands such as Bumble Bee®, Clover Leaf®, Brunswick®, and Sweet Sue® (total enterprise value of approximately $600 million). Dechert was lead counsel to Centre on the transaction. The transaction, including the various credit arrangements, was successfully negotiated and signed during the last week of September 2008 (in the midst of volatile market conditions) amended in mid-October 2008 and closed on November 18, 2008. An interdisciplinary team of lawyers from Dechert’s private equity/M&A, tax, leveraged finance, intellectual property, environmental, real property, anti-trust, and employment groups advised on the transaction. The acquisition involved some unique structuring issues, including a range of complex credit arrangements and equity configurations for the division of equity interests among investors and participating management from multiple jurisdictions.
______________________________________________________1 Dechert LLP is not authorized to practice Canadian Law and this
discussion should not be viewed as legal advice on Canadian legal issues.
2 Admitted to Practice in Ontario, Canada. 3 Online source: Davies, Megan, “Private equity deals at five-
year low,” Thomson Reuters (December 23, 2008).4 Online source: Brethour, Patrick and Chase, Steven, “The
little trusts structure that grew,” Globeinvestor.com (October 13, 2005).
5 Online source: “The Government Takes a Stand On Income Trusts,” CIBC.com (subsidiary is TAL Global Asset Manage-ment Inc.) (September 21, 2005).
6 Sexton, Chris, “Finance’s Trust Tax Denies Tax Benefits to New Income Funds,” KPMG Wireless Telecom, Issue Three at 45 (2006).
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7 Online source: “What’s new from Liberals on income trusts? Not much,” Financial Post.com (September 22, 2008).
8 Arya, P.L., Taxation of Income Trusts in Canada: Effects on Structure, Conduct and Performance, Canadian Economics Association.
9 Online Source: National Post.com, August 24, 2008.
Germany: Changes in Tax Environment for Venture Capital and Private Equity Funds and their Portfolio Companies
by Thomas Gierath
Germany has improved its tax environ-ment for venture capital investments by implementing a new regulatory and tax regime for eligible German seed and early-stage funds. However, private equity
funds do not benefit from this legislation. Rather, addition-al recent changes in German tax law are disadvantageous for private equity investors and portfolio companies.
New Regime for Venture Capital Funds
In 2008, after a long political controversy, Germany enacted a new regulatory and tax regime for domestic venture capital funds. It provides tax benefits for the fund’s investors and its portfolio companies, and legal certainty regarding the tax treatment of eligible funds. However, the new laws will apply only to seed and early-stage funds.
Prior to the changes, the tax treatment of German venture capital and private equity funds was based only on admin-istrative directives and, as a consequence, fund sponsors had to apply for binding rulings before setting up a fund to safeguard the tax position of both the fund and its investors.
The new regime only applies to German-domiciled venture capital funds (so-called risk capital funds—Wagniskapital-beteiligungsgesellschaften) that are approved and regulated by the German Regulator (BaFin) and that comply with the following requirements:
n The fund’s purpose must be the acquisition, holding, and disposal of equity participations in eligible portfolio companies (as set out below);
n The fund must be managed by at least two qualified and experienced managers;
n The fund’s equity capital must amount to EUR 1million or more, of which 25% must be paid in immediately and the remaining amount within one year after its approval by the BaFin; and
n The minimum capital commitment of each investor in the fund must be EUR 25,000.
The new regime is not available for venture funds wholly owned by banks or other companies, as the law requires that an eligible fund may not be affiliated with an investor on the fifth anniversary of its BaFin approval and that an investor may not hold 40% or more of the voting shares in the fund at that time.
To benefit from the new regime, at least 70% of the fund’s assets must be composed of equity participations in portfolio companies with the following criteria:
n The portfolio company must be established as a corpo-ration having its statutory seat and place of manage-ment in a member state of the European Economic Area;
n It must not be established more than 10 years before the fund’s initial investment and must not run or acquire businesses which are older than the company itself;
n Its equity must not exceed EUR 20 million at the initial investment of the fund and its shares must not be listed on a stock exchange;
n It must not be a parent company of another corpora-tion both being members of a German fiscal unity (Organschaft).
For reasons of risk diversification, the fund may not hold more than 90% of a portfolio company’s equity and an investment in one portfolio company may not represent more than 40% of the fund’s assets. A portfolio company ceases to be eligible for the fund (available for the 70% as-set test) on either (i) the third anniversary of an IPO of the company or (ii) the 15th anniversary of the fund’s initial investment in it, whichever is earlier.
The new laws provide tax benefits for the fund’s investors and its portfolio companies. The fund will be deemed tax transparent for German income tax purposes if (i) the fund is established as a limited partnership; (ii) the fund does not hold portfolio companies on a short term basis; (iii) the fund does not reinvest proceeds from portfolio companies, but distributes them to its investors; and (iv) in case the fund assumes or provides debt to its portfolio companies or advises portfolio companies, such activities are not provided by the fund itself but through a wholly owned corporate subsidiary of the fund.
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German portfolio companies of above privileged risk capital funds benefit from the new laws, as they are partly exempted from the forfeiture of tax loss carry forwards in case of a transfer of a substantial holding in the company or in case of substantial capital injections in it (as set out below). Under certain circumstances, the portfolio company instead may deduct losses accumulated in its German business unit from its future earnings over a five-year period.
Other Changes for German Private Equity and Venture Capital Funds
Aside from the new regime for risk capital funds, the tax environment for German private equity funds, particularly buyout funds, has not improved over the last few years. Unlike in other EU countries, there is no special regulatory and tax regime available for these funds. Tax transparency can only be achieved if certain requirements set out by administrative directives are fulfilled. A tax treatment of such funds is far from legal certainty.
Moreover, the German legislature and administrators have implemented new laws affecting investors and managers of all German venture capital and private equity funds (including risk capital funds governed by the above new regime).
First, investments by German private investors in private equity and venture capital funds are now fully taxable irre-spective of any holding in the underlying equity or holding periods. Prior to the changes, these investors were able to benefit from a tax exemption on gains arising on the sale of portfolio companies where their investment represented
less than 1% of the underlying equity, and provided that the fund held the shares in the relevant portfolio company for a period of at least one year. The flat rate income tax (Abgeltungsteuer) enacted in 2009 eliminates this tax exemption. In cases where the investment represents less than 1% of the underlying equity, capital gains from the disposal of portfolio companies are now taxed at a rate of 25%. In contrast, if the investment represents 1% or more of the underlying equity, 60% of the capital gains are taxed at the individual tax rate of the investor.
Further, management fees paid by funds that have been set up in 2008 or later are again subject to German VAT (currently 19%). The former tax exemption of such pay-ments, which many other EU countries provide, has been abolished pursuant to an administrative directive from 2007. It is currently unclear if and when the German tax authorities will correct this negative treatment of German funds.
Finally, the taxation of carried interest paid to the fund sponsors has been slightly increased. Whereas formerly 50% of such payments were taxed at the individual tax rate of the sponsor, this basis has been increased to 60%, leading to a tax rate of approximately 29% for carried interest payments. Pursuant to a grandfathering rule, funds that have been set up before 2009 still benefit from the former law.
Changes for German Portfolio Companies
German tax legislation in the last several years has af-fected private equity investments, particularly at the level of portfolio companies. German and international buy-out
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funds suffer from new limitations on the deductibility of interest for acquisition finance provided by banks. Restrictions on the use of existing tax loss carry forwards of German portfolio companies following an investment by a fund affects both venture capital funds and private equity funds.
Whereas interest paid for acquisition finance of Ger-man private equity transactions was, in principle, tax-deductible in the past, such interest payments from 2008 onwards are only deductible for tax purposes up to 30% of an entity’s EBITDA. Non-deductible interest in one year can be carried forward to the following fiscal year, where it will be again subject to the interest-limitation test. There are three exceptions currently available, the most impor-tant one being an allowance for interest expense paid by the German entity of less than EUR 1million per fiscal year. (Please see additional details in the Autumn 2007 issue of Dechert’s Private Equity Newsletter).
Additionally, private equity and venture capital invest-ments are materially affected by restrictions regarding the use of existing tax loss carry forwards of German corpo-rate portfolio companies following a fund’s investment. Since 2008, such losses partly disappear if more than 25% of the shares in the company are transferred, even on the parent company level, and the entire tax losses disappear in case of a transfer of more than 50% of the shares. The same applies in case of equity contributions in financing rounds if the participation quota in the equity of the company will be changed accordingly. Transactions set out before will also lead to a forfeiture of interest carry forwards resulting from the above limited deductibility of interest payments.
Having realized that the before-mentioned restrictions have effected the industry, the German legislature has exempted—at least partly—eligible portfolio compa-nies from above-mentioned risk capital funds from the forfeiture of tax loss carry forwards (please see above). Furthermore, as the above restrictions in particular are detrimental in down-turning markets, the German upper house (Bundesrat) has started an initiative to soften the relevant provisions. Papers issued by it request a higher annual tax allowance for an unlimited deduction of interest payments (up to EUR 3 million) and an unlimited use of tax loss carry forwards in turnaround situations. However, it is currently unclear if and to what extent the above initiative will be enacted by the legislature.
The current fund-raising challenge for many mid-sized private equity funds has caused some fund sponsors to con-sider, or in some cases reconsider, the formation of small business investment
companies, better known as SBICs.
SBICs are federally licensed investment funds, usually structured like traditional private equity limited partner-ships, which are eligible to borrow on a non-recourse basis through the Small Business Administration (the “SBA”) at the rate of two dollars of borrowing for each dollar of private capital raised by the fund sponsor. Under SBA regulations, the sponsor must raise a minimum of at least $5 million from private sources, although a minimum of $10 million or more is more common since smaller funds are often too small to operate ef-ficiently. After a successful operating history, the SBIC may increase its leverage ratio from 2 to 1 to 3 to 1 with SBA approval. The borrowing is in the form of ten-year debentures repayable by the SBIC at maturity with semi-annual interest payments at the 10-year Treasury note rate at the time of issuance of the debentures plus roughly 200 basis points. The maximum borrowing from the SBA may not exceed $127 million at September 2008 (which amount is adjusted based on the rate of inflation). Debenture borrowings are taken down as needed for investments and expenses along with the fund’s private capital commitments in somewhat the same manner as customary private equity fund drawdowns once the fund has drawn down $2.5 million of private capital. A fund structured for maximum government leverage (about $127 million) at 2 to 1 then would require private capital commitments of $63.5 million. On licensing, an SBIC may obtain a borrowing commitment from the SBA for up to two times private capital for five years so that the SBIC is not subject to unforeseen changes in the government funding process. The good news is that the SBA has had ample funds to dole out under the debenture program and is not likely to experience any budgetary cut backs in light of the Administration’s stimulus plans.
The SBIC program has experienced a somewhat uneven history. Established in 1958 as a straight debenture program to help finance small businesses, many of the earliest funds financed principally real estate ventures with often unfavorable results. The Reagan Administra-tion considered terminating the program in the 1980s principally for ideological reasons, but the program gained new life and bipartisan political support in the first
Bush Administration. In the late 1990s, Congress and the SBA restructured the entire SBIC program by adding a government-financed equity alternative to the debenture program. These equity SBA financings (so-called “partici-pating securities”) were structured much like preferred stock with the SBA receiving an annual coupon (a “pri-oritized payment”) and a profit participation. For better or worse, the equity program coincided with the Internet boom and licensed SBICs mushroomed. Predictably, after several years of outsized gains, many of these partici-pating security SBICs faltered with the collapse of the Internet boom, and after some outsized losses the second Bush Administration halted the equity program in 2005, but not the debenture program. Notwithstanding its may ups and downs, the SBIC program has funded numerous American success stories, including Apple Computer, Federal Express, and others.
The SBIC program has traditionally attracted first-time fund sponsors who are not well known enough or oth-erwise cannot raise funds from institutional investment sources. Often these SBIC applicants are “spinning out” of established fund groups with some claim to a favor-able track record or, more likely, a shared performance record. Lately, in light of the generally difficult fund-raising environment, the debenture program has attracted inter-est from established fund sponsors, including institutional managers.
The SBA believes that some of the earlier difficulties in SBIC performance were due to inexperienced managers, so the SBA in the licensing process now places consider-able stress on the practical investment experience of the management team (at least two of whom must be substantially full-time), and their collective ability to carry out the SBIC’s business plan and strategy. The SBA has rejected applicants whose investment experience was limited or too remote from venture capital investing, although the SBA seems more open recently to consider-ing investment experience that, as one industry official noted, does not fit “squarely within the box.” In addition, the SBA requires that the SBIC receive at least 30% of its private capital from three or more investors who are unrelated to the management or from a single investor satisfying certain institutional qualifications to ensure that an independent investor or investors are also keeping an eye on management.
The managers may charge the SBIC a management fee of 2.5% on three times the amount of private capital for the lesser of five years or until 80% of private capital and leverage have been drawn down and thereafter 2.5% of the cost basis of loans and investments in active portfolio companies. Management fees are reduced dollar for dollar
by any board, consulting and other fees received from portfolio companies and the permissible management fee declines to 2% when the base exceeds $120 million. The profit split among the private capital investors will typi-cally provide for a carried interest to the manager on the entire investment portfolio similar to a traditional private equity fund.
Consistent with the original concept of the SBIC program as a financing source for small business, the SBA regula-tions require that SBICs only invest in “small businesses,” which are defined as enterprises with a net worth (exclud-ing goodwill) of less that $18 million and average after tax income for the prior two years of less than $6 million or, failing that, enterprises that meet certain size tests (typi-cally less than 500 employees). At least 20% of invested funds must be invested in “smaller businesses” defined as enterprises with a net worth (excluding goodwill) of less than $6 million and average after-tax income for the prior two years of less than $2 million. The SBIC may retain investments in portfolio companies that subsequently exceed these size standards.
While many SBIC managements are able to function successfully within the size standards, the SBA diversifica-tion requirements are frequently a greater burden. The SBA regulations restrict an SBIC from investing more than 20% of its private capital in any single portfolio company without SBA prior approval. An SBIC with private capital of, say, $30 million then could not invest more than $6 million in any portfolio company without prior approval that could limit “build out” or “follow on” investment strategies. However, the SBA has approved “overline” investments.
SBIC investments in portfolio companies may take the form of debt, debt with equity features (such as warrants or conversion rights), or equity securities. Debt securities must be issued for a term of at least one year, except for certain bridge loans. The interest rate on debt securities is the higher of 19% or 11% over the higher of the SBIC’s weighted debenture cost or the current debenture rate. For debt securities with equity features, the permitted rate is the higher of 14% or 6% over the higher of the SBIC’s weighted cost of debentures or the current debenture rate. Since the SBIC must cover its annual interest costs on SBA debentures and other operating expenses, it will need to ensure an adequate stream of payments from its portfolio companies after taking into consideration its annual management fee. The SBIC may require the portfolio company to redeem the SBIC’s equity investment after one year based on a predetermined earnings or book value formula or a third party appraisal.
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Like all government programs, the SBA largesse comes with strings in the form of relatively comprehensive regulations. Generally, the SBA regulations cover the usual ground: self-dealing; certain prohibited kinds of invest-ments like real estate and passive business activities; SBA reporting and audit requirements; capital impairment standards; permissible distributions; and the like.
Prospective participants in the SBIC program must first receive a license from the SBA. The SBA has streamlined the licensing process to permit applicants to get a sense of whether they will qualify for a license before expending too much time and money on the effort. All applicants first fill out a Management Assessment Questionnaire (“MAQ”) that covers the background of the sponsors in some detail, including specific information on the investment history of the applicants, their investment strategy, expected deal flow and the like. Although at first glance rather intimidating (the MAQ runs some 30 pages plus exhibits), the information—such as the applicant’s investment history and returns—is probably readily available. The MAQ is then reviewed by the SBA’s Invest-ment Committee and, if the applicants appear qualified,
they are invited to meet with the Committee. If approved, applicants are issued a so-called “go forth” letter (usually several months after submission of the MAQ) and are then invited to file a formal application that incorporates much of the information in the MAQ along with the fund’s legal documents. The whole process can run anywhere from four to six months (or sometimes more) although the SBA is trying to streamline the process.
Shanghai to Permit Foreign Private Equity and Growth Capital Firms to Open Shop
by Michael M. Hickman
and Basil H. Hwang
The Shanghai Financial Services Office recently announced that Shanghai will soon permit foreign private equity and growth
capital firms to establish wholly owned subsidiaries or Sino-foreign joint ventures in the city. The rules and regula-tions are expected to be promulgated in a month or so, at which time this new opportunity will be clearer.
Preliminary indications are that the rules may permit a combination of investment and asset management activi-ties, and that investments may be made with convertible currency or RMB. These new companies will be regulated as financial institutions. As was the case with the first foreign commercial bank licensees in Shanghai, it appears that these private equity and venture capital firms will be steered to locate in the Pudong New Area of Shanghai.
The rules, when issued, are likely to address a number of areas, including minimal capital requirements and inves-tor qualifications. Published reports indicate that a mini-mal funded capital of US$10 million may be required. In addition, consistent with earlier moves to expand foreign participation in financial and banking services and high technology venture capital funds, we would expect that the rules will set out investor qualifications. These types of qualifications typically require the investor to have several
years of operating history and a certain amount of assets. It is also expected that investors will be called upon to confirm that they have not been subject to any adverse regulatory actions in their home jurisdiction in the past several years.
These new rules will likely expand existing rules permitting a foreign investor to form a foreign-invested venture capital enterprise (“FIVCE”) to invest solely in privately held high technology companies in China. Additional information regarding FIVCEs is available in “Renminbi-Denominated Funds: An Emerging Platform for Private Equity Invest-ment in China?” (DechertOnPoint “Private Equity” Newslet-ter, p. 4 (Summer 2008), available at http://www.dechert.com/library/Private_Equity_09-08.pdf). Unlike the FIVCE rules, the new rules are expected to permit investments in a wide variety of industries by private equity and growth capital firms through either wholly owned subsidiaries or joint ventures.
Tax considerations are also expected to feature promi-nently in the new rules. The fundamental tax issue will be the treatment of gains and whether it will be possible for the China-based firms to act as pass-through conduits for tax purposes. These tax features have recently been addressed in the context of the domestic Chinese partner-ship law, which permits a typical general partner and lim-ited partner structure. However, to date, the partnership law has not been extended to permit foreign interests as either general or limited partners. Shanghai’s innovation in the context of foreign private equity and growth capital funds may be a first step in this direction.
However, it is not likely that the gates will be thrown wide open immediately. Developments of this sort in China typically commence with some degree of caution, as was the case with the earlier rules permitting FIVCEs. It is expected that these new private equity and venture capital firms will be closely regulated, although at this point it is not clear which regulatory bodies will be directly involved. If foreign private equity and venture capital can succeed in Shanghai, the domestic industry should also indirectly benefit.
This bold and innovative move by Shanghai is a welcome development and is consistent with Shanghai’s stated goal of becoming a significant international financial center.
June 26 Craig Godshall spoke on “Today’s SPACs: How the Lessons Learned Will Affect Future Structures” at the SPAC Conference 2009 in New York.
June 18 Thomas Friedmann spoke on “Capital-Raising Strategies in a Frozen Market: Evaluating Financing Alternatives: Rights Offerings, RDOs, ATMs and PIPES” at a webcast hosted by Strafford Publications Teleconference.
June 15-17 Susan Camillo spoke on “Tackling Control Group ERISA Issues and Ensuring Plan Asset Compliance” at the Private Equity Tax Practices 2009 conference in Boston.
April 22 Thomas Gierath spoke on “Emerging Markets – A Credit Crunch Solution?” at the Legal Week Private Equity Forum 2009 in London.
April 21 Dechert hosted a seminar entitled “U.S. Rights Offerings: A Creative Way to Raise and Deploy Capital in a Dysfunctional Market” in the firm’s New York office. Topics included why backstopping a rights offering can provide private equity investors with attractive returns and relatively quick liquidity.
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To obtain a copy of the related presentation materials, please contact Michelle Lappen at + 1 212 698 8753 or [email protected].
Our Practice Continues to Expand Worldwide
In May, Dechert opened an office in Moscow and brought aboard three new partners: Laura Brank, Shane DeBeer, and Konstantin Konstantinov.
Laura Brank (U.S.-qualified), focuses on M&A, corporate governance, joint ventures, corporate finance, banking, and project finance.
Shane DeBeer (U.S.- and UK-qualified), concentrates on complex international transactions with a focus on oil and gas, liquefied natural gas (LNG), and other energy-related matters.
Konstantin Konstantinov (U.S.- and Russia-qualified) focuses on project finance, securities regulation, secured finance, debt restructuring, and M&A.
François Hellot joined our Paris office in April as a partner specializing in private equity, M&A, and capital markets for both French and international clients.
The United States Treasury Department issues Circular 230, which governs all practitioners before the Internal Revenue Service. Circular 230 was amended to require a legend to be placed on certain written communications that are not otherwise comprehensive tax opinions. To ensure compliance with Treasury Department Circular 230, we are required to inform you that this letter is not intended or written to be used, and cannot be used, by you for the purpose of avoiding penalties that the Internal Revenue Service might seek to impose on you.
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