Eric Sloan Deloitte Tax LLP
David Schnabel Debevoise & Plimpton LLP
Private Equity: Passthrough Investments
Practising Law Institute:
Tax Planning for Domestic & Foreign Partnerships,
LLCs, Joint Ventures & Other Strategic Alliances
Spring 2015
Lewis R. Steinberg
2
Agenda
• What is a Private Equity Fund?
• Investments in Passthroughs
− What are Passthrough Investments?
− How do Passthrough Investments Arise?
− How are Passthrough Investments Structured?
− Considerations in Evaluating Passthrough Investments
− Up-C Structure
− Exiting Passthrough Investments: Sales
− Exiting Passthrough Investments: IPOs
• Investments in Non-U.S. Companies
3
What is a Private Equity Fund?
4
Basics of Private Equity
• What is a Private Equity Fund
• Difference from Hedge Funds
• Very active in M&A
5
Simplified Overview Structure
Sponsor
PE Fund
(Delaware)
Sponsor Commitment
20% Carried Interest
Investor Commitment
GP LP
Investors
6
Simplified Topside Structure
LP LP
PE Fund
(Delaware)
Sponsor
(Delaware)
GP LP LP
U.S. Taxable Investors U.S. Taxable
Investors Principals
U.S. Taxable Investors U.S. Taxable
Investors Non-U.S. Investors
U.S. Taxable Investors U.S. Taxable
Investors Tax-Exempt U.S. Investors
U.S. Taxable Investors U.S. Taxable
Investors Taxable and Super
Tax-Exempt U.S. Investors
U.S. Taxable Investors U.S. Taxable
Investors Sovereign Investors
7
What are Passthrough Investments
and
How Do They Arise?
8
What are Passthrough Investments?
• Portfolio company is a partnership or LLC
• Taxable income is taken into account at the fund investor level
• No portfolio company level federal income tax
9
How do Passthrough Investments Arise?
• Asset purchases (carve out or otherwise)
• LLC or partnership target
• S corporation target
• § 336(e)
• Joint ventures with strategics
10
How are Passthrough Investments Structured?
11
Typical PE Investment in a Passthrough Investment
Blocker
(Delaware)
AIV 2
AIV 1
GP
Portfolio
Company
Sponsor
LP LP
U.S. Taxable Investors
U.S. Taxable Investors Principals
U.S. Taxable Investors
U.S. Taxable Investors
Non-Electing Investors
U.S. Taxable Investors U.S. Taxable
Investors Electing Investors
AIV 3
Sub-Partnership
12
AIVs in Relation to Main Fund
Blocker
(Delaware)
AIV 2
AIV 1
GP
Portfolio
Company
Sponsor
LP LP
U.S. Taxable Investors
U.S. Taxable Investors Principals
U.S. Taxable Investors
U.S. Taxable Investors
Non-Electing Investors
U.S. Taxable Investors U.S. Taxable
Investors Electing Investors
AIV 3
Sub-Partnership
Main Fund
Portfolio Companies
13
Considerations in Evaluating Passthrough Investments
14
Considerations: Pros and Cons
Pros
• Potential to be paid for step-up upon exit
(e.g., TRA)
• One layer of tax (no tax for state pension
plans)
• Impact of tax distribution on preferred
return
• Treatment of management
Cons
• Complexity
• Requires additional decisions and
negotiation by sponsor
• Recapture income to the GP
• Potential loss of corporate NOL and ability
to monetize at exit
• Treatment of COD income
• State tax returns
• Add-on acquisitions where target is a
corporation
• Confusion and grumpiness by some LPs
15
• Complexity
• Requires additional decisions and negotiation by sponsor
• Recapture income to the GP
• Potential loss of corporate NOL and ability to monetize at exit
• Treatment of COD income
• State tax returns
• Add-on acquisitions where target is a corporation
• Confusion and grumpiness by some LPs
Considerations: Cons
16
• Difficult when buying from another PE firm that already has a blocker
• Treatment of the members of the GP
• Use of AIVs
• Treatment of foreign subsidiaries and FTCs
• Treatment of step up in computing tax distributions
• Use of multiple blockers where going to exit over time
• Type of business–large cap, middle market, real estate and energy
Other Considerations
17
Up-C Structure
18
Managing
Member
TRA
UP-C Structure – Simplified Ending Structure
AIV 1
PubCo
Portfolio
Company
Non-Managing
Member
AIV 2
TRA
Electing Investors
Non-Electing Investors
Public
19
Exiting Passthrough Investments: Sales
20
Blocker
AIV 1
Portfolio
Company
AIV 2
Sponsor
GP GP LP LP
Partnership 1
Sale of Typical PE Investment in an Operating Partnership
Non-Electing Investors
Electing Investors
21
Sale of Typical PE Investment in an Operating Partnership (cont'd)
• Partnership 1 liquidates and distributes its interest in Portfolio Company to Blocker and Sponsor.
Blocker
AIV 1
Portfolio
Company
AIV 2
Sponsor
GP GP LP LP
Partnership 1
Electing Investors
Non-Electing Investors
22
Sale of Typical PE Investment in an Operating Partnership (cont'd)
Blocker
AIV 1
Portfolio
Company
AIV 2
Sponsor
GP GP LP LP
• Sponsor and AIV sell their interests in Portfolio Company; AIV2 sells its shares of Blocker (perhaps at a discounted purchase price).
• What if the buyer is another fund?
Electing Investors
Non-Electing Investors
23
Exiting Passthrough Investments: IPOs
24
• What is a tax receivable agreement?
─ What attributes are covered?
• What is needed?
─ § 754 election
─ § 743(b) adjustment to step up basis
─ Other tax attributes (e.g., NOLs, credits. etc.)
• Financial statement treatment
─ Liability for gross payments
─ Valuation allowance needed?
Tax Receivable Agreements
25
• Depends on nature of transaction that gave rise to ITR
─ Taxable purchase
─ Reorganization
─ Current distribution
• Installment sale
─ Principal and imputed interest
─ Basis recovery
─ Election out
• "With and Without" calculation
• When does the actual payment occur?
Characteristics of an ITR
26
• Common issues to consider
─ Ordering of multiple exchanges
─ Not enough taxable income
─ Permanent loss of ITR benefit
─ Law changes
─ What is the character of interest on the payment?
Characteristics of an ITR (cont’d)
27
Investment in a Non-U.S. Corporation
28
Sponsor
(Cayman)
LP LP LP GP LP
U.S. Taxable Investors
U.S. Taxable Investors Principals
U.S. Taxable Investors
U.S. Taxable Investors
Taxable and Super Tax-Exempt
U.S. Investors
U.S. Taxable Investors
U.S. Taxable Investors
Tax-Exempt U.S. Investors
U.S. Taxable Investors
U.S. Taxable Investors
Non-U.S. Investors
U.S. Taxable Investors
U.S. Taxable Investors
Sovereign Investors
AIV
(Cayman)
Portfolio
Company
(Non-U.S.)
Investment in a Non-U.S. Corporation
