Private Equity Report - Debevoise & Plimpton/media/files/insights/publications/2004… · The...

What’s Inside

Business Development Companies and theNew Public Market in Mezzanine Funds

Several high-profile private equity fundsponsors have entered the public fundarena this spring by sponsoring publiclyoffered funds focused on making mezza-nine investments. (These investmentsgenerally consist of subordinated debtsecurities that are often issued withrelated warrants, options or other equitysecurities and are acquired in privatelynegotiated transactions.) Apollo Manage-ment raised $930 million in a mezzaninefund IPO that priced on April 5. Close onApollo’s heels, a number of other privatefund sponsors filed registration state-ments for similar investment vehicles thatwould raise an additional $5 billion.Although the business press has followedthis development in the private equitylandscape, we hope to compare andcontrast these investment vehicles notonly with their cousin, the closed-endmutual fund, but also with the privatefunds that have become the norm in theprivate equity arena.

Each of these new investments vehiclesis structured as a closed-end investmentcompany that has elected to be regulatedas a business development company, or a“BDC,” under the Investment CompanyAct of 1940. A BDC is subject to certain,but not all, provisions of the InvestmentCompany Act as well as certain otherrequirements specific to BDCs.

What makes the BDC an attractivevehicle for mezzanine fund sponsors?First, a BDC has access to a wider pool ofinvestors than the typical private fund.

Private mezzanine funds offer interests inprivate placements to a limited pool ofsophisticated institutions and high-networth individuals. They do this in part toavoid regulation under the InvestmentCompany Act and other federal securitieslaws. By contrast, a BDC offering is gener-ally registered under the Securities Act of1933 and can market its interests to thegeneral public.

Second, unlike the typical registeredinvestment company, a BDC is permittedto charge its investors an incentive fee thatis somewhat similar (although not iden-tical) to the carried interest charged byprivate equity funds. The InvestmentAdvisers Act permits a BDC to charge anincentive fee of up to 20% of realizedgains over a specified period, net of real-ized capital losses and unrealizeddepreciation.

Thus, the sponsor of the BDC maycharge a performance fee (like a privatefund but unlike a registered investmentcompany) and may offer its interests tothe general public (unlike a private fundbut like a registered investment company).

Finally, when a BDCdisposes of an investment, ittypically does not return thecapital invested to investors.In addition, many BDCs offerdividend reinvestmentprograms (DRIPs) that permitshareholders to automaticallyreinvest dividends and otherdistributions in shares of BDC

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Volume 4 Number 3 Spr ing 2004

P r i v a t e E q u i t y Re p o r t

“We’re doing a road show for a family of business developmentcompanies to invest in debt securities—we’re calling it ‘Les Mezz.’”

3 Alert: Pending Legislation

Could Increase Administrative

Costs for Private Funds

4 Trendwatch: European Funds

Revisited

6 The “Inspire Art” Judgment of

the ECJ: New Ways to

Structure Acquisitions in the

European Union

8 VCOC Traps for the Unwary:

Will Your Deal Be VCOC

Compliant?

10 Alert: Proposed HSR Rules

May Mean Filings for

Partnerships and Other

Non-Corporate Entities

11 Lost in Translation – Dispute

Resolution Considerations in

Cross-Border Deals

12 Guest Column: Bonds – No

Longer a Safe Haven?

14 Tyranny of the Minority?

15 Alert: Update on European

Merger Control

16 To Standardize or Not to

Standardize: Recent

Developments in the Private

Equity Valuation Debate

28 Alert: Update on Exiting

by IDS

continued on page 23

letter from the editor2004 has proved to be a year of innovation in the

private equity industry. In the last issue, we alerted

you to the new use of income deposit securities as

an exit strategy. This time on our cover, we discuss

the emergence of a public market for mezzanine

funds offered by private equity sponsors structured

as business development companies.

Following a brief hiatus, during which we added

another 160 funds to our database, we are delighted

to have the Trendwatch column return in this issue.

Geoff Kittredge uses this data to update our earlier

findings on trends in European funds and considers

how certain terms of European funds have evolved

and where they may be headed.

For those of you active in cross-border transac-

tions, we have several articles of interest. First,

Thomas Schürrle and Elisabeth Huber-Sorge

discuss how two recent decisions by the European

Court of Justice should make it easier for investors

to select friendly jurisdictions for the incorporation

of investment vehicles. Elsewhere, we remind

investors of the importance of thinking through

dispute resolutions buried in the back of those

acquisitions agreements in cross-border deals in

order to avoid the unpleasant surprise of having to

litigate a claim later in an unfriendly jurisdiction.

Finally, we alert you to several improvements in the

European merger control process.

In our Guest Column, Stephen V. Kenney, Chief

Investment Officer and a Managing Director at SCS

Financial, a wealth-management firm providing

investment management services in both tradi-

tional and alternative categories, counsels private

equity professionals and other sophisticated

investors on how to construct an investment port-

folio with real growth potential in light of possible

rising interest rates and inflation.

Elsewhere in this issue, Michael Harrell and

Jennifer Spiegel review the recent debate over

industry-wide standardization of valuation stan-

dards for private equity funds, including the pros

and cons of adopting a more rigorous fair-value

standard. We also offer guidance on avoiding traps

for the unwary in structuring transactions to be

VCOC compliant. In addition, we alert you to recent

developments in the IDS marketplace and to

proposed changes that would close various HSR filing

loopholes.

As always, we remind you that the Private

Equity Report is available on line at our Web site

and by e-mail by contacting Dan Madden at

[email protected]. We welcome any sug-

gestions you may have on how we can make the pub-

lication more useful to the private equity community.

Franci J. Blassberg

Editor-in-Chief

Private Equity Partner/ Counsel Practice Group Members

Franci J. Blassberg Editor-in-Chief

Ann Heilman Murphy Managing Editor

William D. Regner Cartoon Editor

Please address inquiries regardingtopics covered in this publication to the authors or the members of the Practice Group.

All contents ©2004 Debevoise&Plimpton LLP. All rights reserved.

The articles appearing in thispublication provide summaryinformation only and are notintended as legal advice.Readers should seek specificlegal advice before taking anyaction with respect to thematters discussed herein.

The Private Equity Practice GroupAll lawyers based in New York, except where noted.

Private Equity FundsMarwan Al-Turki – LondonAnn G. Baker – Paris

Kenneth J. Berman–Washington, D.C.Jennifer J. BurleighWoodrow W. Campbell, Jr.Sherri G. CaplanMichael P. HarrellGeoffrey Kittredge – LondonMarcia L. MacHarg – FrankfurtAndrew M. Ostrognai – Hong KongDavid J. SchwartzRebecca F. Silberstein

Mergers & AcquisitionsAndrew L. BabHans Bertram-Nothnagel – FrankfurtE. Raman Bet-Mansour – ParisPaul S. Bird

Franci J. BlassbergColin W. Bogie – LondonRichard D. BohmGeoffrey P. Burgess – LondonMargaret A. DavenportMichael J. GillespieGregory V. GoodingStephen R. HertzDavid F. Hickok – FrankfurtJames A. Kiernan, III – LondonAntoine F. Kirry – ParisMarc A. KushnerLi Li – ShanghaiHolly Nielsen – MoscowRobert F. QuaintanceJeffrey J. Rosen

The Debevoise & Plimpton Private Equity Report is a publication ofDebevoise & Plimpton LLP919 Third AvenueNew York, New York 10022(212) 909-6000

www.debevoise.com

Washington, D.C.LondonParisFrankfurtMoscowHong KongShanghai

The Debevoise & Plimpton Private Equity Report l Spring 2004 l page 2

Legislation is pending in both theSenate and the House of Representa-tives that, if enacted, would requireprivate equity funds (and other partner-ships) to adjust the tax basis of theirassets upon certain transfers of aninterest in the fund and upon certaindistributions to partners. The ruleswould require a private equity fund torevalue its assets upon these eventsand increase tax compliance costs. As aresult, the rules may cause some fundsto further limit transfers by LPs.

BackgroundA partner’s tax basis in its partnershipinterest is referred to as the “outsidebasis” and a partnership’s basis in thepartnership’s assets is referred to asthe “inside basis.” In general, the trans-feree of a partnership interest succeedsto the transferor partner’s share of thepartnership’s inside basis. Undercurrent law, a partnership is permitted(but is not required) to elect to adjustthe inside basis of its assets (a “754election”) so that the inside basis asso-ciated with the transferred partnershipinterest is equal to amount the trans-feree paid for the partnership interest(i.e., so that the inside basis and theoutside basis are the same).

What Congress is Worried AboutSuppose that a taxpayer (S) contributes$100 to a partnership and the partner-ship buys a security that declines invalue to $40. Upon a sale of the part-nership interest, S would recognize a$60 loss in its partnership interest. Ifthe partnership does not have a 754election in effect, then the partnershipwill continue to have a $100 tax basis inthe security and upon a sale of thesecurity for $40, the buyer of the part-nership interest (B) would be allocateda $60 tax loss from the partnershipeven though B has not experienced aneconomic loss. B’s tax loss would bereversed upon the liquidation of thepartnership. Although the “doubling”of the loss is temporary, it is perceivedas abusive.

As described below, the fix is torequire partnerships to adjust the taxbasis of their assets (the inside basis)upon certain transfers and distribu-tions. If a section 754 election were ineffect in the example above, the part-nership would have been required as aresult of the transfer to reduce its taxbasis in the security from $100 to $40(but only for purposes of computingB’s income and loss). As a result, upon

a sale of the security bythe partnership B wouldnot have been allocated a$60 tax loss.

The LegislationThe proposed legislationwould require a partner-ship to adjust the insidebasis of its assets regard-less of whether or not a754 election was made

upon certain events. As a result, a part-nership would be required to value itsassets each time an interest in the part-nership was transferred. Historically,many private equity funds have beenaverse to valuing their investments.

Although the value of the partner-ship’s assets is one of the drivers inadjusting the partnership’s basis, theanalysis is actually far more compli-cated and needs to be trackedseparately for each transferee partner.Also, since analysis takes into accounta transferee’s tax basis in the acquiredpartnership interest, the transfereepartner will be required to disclose thepurchase price of the partnershipinterest to the partnership.

The administrative burden increasesconsiderably as it relates to a partner ina partnership that is itself treated as apartnership for U.S. income tax pur-poses (an “upper-tier partnership”),e.g., a fund of funds. Upon the transferof an interest in an upper-tier partner-ship, both the upper-tier partnershipand the lower-tier partnership wouldneed to adjust the inside basis of theirrespective assets with respect to thetransferred interest in the upper-tierpartnership.

StatusIt is far from clear whether and when aform of this legislation will be enacted.There is currently a lobbying effortunderway to exclude private equity fundsfrom the ambit of the legislation.— David H. [email protected]

Pending Legislation Could Increase AdministrativeCosts for Private Funds


alert

Kevin M. SchmidtThomas Schürrle – FrankfurtAndrew L. Sommer – LondonJames C. Swank – ParisJohn M. Vasily Philipp von Holst – Frankfurt

Leveraged FinanceWilliam B. BeekmanCraig A. Bowman –LondonDavid A. BrittenhamPaul D. Brusiloff Peter Hockless – LondonA. David Reynolds

TaxAndrew N. Berg

Robert J. CubittoGary M. FriedmanPeter A. FurciFriedrich Hey – FrankfurtAdele M. KarigDavid H. SchnabelPeter F. G. Schuur–LondonRichard Ward – London

Employee Compensation & BenefitsLawrence K. CagneyDavid P. MasonElizabeth Pagel Serebransky

Trust & Estate PlanningJonathan J. Rikoon


The Inspire Art Judgment of the ECJ: New Ways to StructureAcquisitions in the European Union

Private equity firms now have more flex-ibility in structuring and financingtransactions in the EU by utilizing flex-ible entities formed in “friendly” juris-dictions. In two recent decisions,Uberseering of November 2002 andInspire Art of September of last year,the European Court of Justice ruled thata company formed under the laws ofone member state of the EU mayreestablish its entire operations in anyother member state and that state maynot impose any restrictions on thecompany or deny its legal capacity, evenif it has no operations in the memberstate in which it was formed. The Courtexpressly stated in Inspire Art that thisprinciple applies even if the purpose offounding a company in one memberstate was to avoid application of morerestrictive company laws in the memberstate in which the company would actu-ally operate. The Court acknowledgedthat an EU member state may restrictthe ability of a company founded in thatstate to conduct operations in anothermember state, as decided in the Court’sDaily Mail decision some years ago. Butmany member states, such as the UK,do not impose such restrictions.

Given the relative rigidity of thecompany laws of many EU memberstates, investors may find resorting to acompany founded under the laws ofanother member state – for example,an English limited liability company –an attractive option in certain circum-stances.

Immediate ConsequencesWith the Uberseering and Inspire Artdecisions, the Court has effectivelyoverruled the legal principle applicablein some of the EU member states thatcompanies with an administrative andeconomic seat (as opposed to the

formal, statutory seat for registrationpurposes) that is primarily located in amember state different from the stateof their incorporation must be re-incor-porated and registered in the memberstate of their economic seat as well,thus making them subject to suchmember’s states laws and regulationsapplicable to the form of companychosen.

Germany, for instance, did notpermit a Dutch BV to operate entirelywithin Germany unless it was re-incor-porated as a German limited liabilitycompany or corporation. As a result ofsuch reincorporation, certain featuresof German company law, such as therules on preservation of capital and onworkers’ codetermination rights at theboard level (Mitbestimmung) wouldbecome applicable to the reincorpo-rated entity. If the reincorporation didnot occur, the company was deemed acivil law partnership, with sometimesdisastrous consequences for the share-holders (for example, unlimited liabilityfor the debts of the company).

As an immediate consequence of theCourt’s judgments, an English limitedliability company or a Dutch BV oper-ating exclusively in Germany must nowbe recognized as such, and only thelaws of the state of incorporation, thatis, English or Dutch law, will govern itscorporate existence and administration.In addition, after Inspire Art it is fairlyclear that an English limited liabilitycompany or a Dutch BV operatingexclusively in Germany should betreated as a German corporation forGerman income and trade tax pur-poses, including the availability of taxconsolidation.

The two Court rulings also pave theway to avoid certain issues that may

arise out of mandatory provisions ofEuropean continental company lawsthat may not be desirable in a givencase or problems in structuring finan-cial instruments or joint-venturearrangements due to the relative inflexi-bility of continental company law. InGermany, for example, foreign investorshave been unpleasantly surprised byseveral German company law provi-sions: the relatively rigid procedures forissuing share capital (particularly in-kind contributions) and the strict ruleson capital maintenance that oftencreate structuring and financinghurdles. The law regarding workers’representation (so-called codetermina-tion) at the supervisory board level forcompanies with more than 500employees – and particularly therequirement that 50% of the membersof the supervisory board of a companywith 2,000 or more employees beselected by employee’s representatives– can create problems, especially in lessthan wholly owned companies. Anotherproblem area of German company lawis, in the context of joint ventures andconvertible debt or preferred stockinstruments, the 75% supermajorityvote required for capital increases,mergers and certain other fundamentalcorporate actions (other continentaljurisdictions provide similar minorityblocking rights).

German capital maintenance rulesfor a GmbH or GmbH & Co KG, two ofthe most common company forms,strictly prohibit repayment of the statedshare capital (that is, the aggregatenominal value of issued shares),including indirectly by means of loansto shareholders or guarantees of share-holder or sister-company debt, therebyconsiderably impeding the flexibility of

financing structures in leveraged acqui-sitions and private equity and ventureinvestments. Moreover, shareholderloans or leases of assets to a Germancompany can become non-terminable,with all payments of interest or rentalsthereon prohibited, if the shareholder’sequity of the German company fallsbelow its stated capital or if thecompany experiences a financial crisisand the shareholder unduly delaysterminating the loan or lease. Englishcompany law is far less restrictive inthis respect, and the availability of so-called “whitewash” procedures forupstream guarantees and loans byEnglish private limited liability compa-nies can provide company manage-ment, shareholders and lenders withgreater certainty as to the validity of agiven financial structure.

German company law also makes itclose to impossible to issue redeem-able or convertible preferred stock onterms comparable to U.S. or UK stan-dards. Often, complicated shareholders’agreements are required, and theredemption or conversion may requirean additional shareholder vote. In somecases, redemption simply is notpossible. If, on the other hand, anEnglish limited liability company isused as the vehicle for a German invest-ment, a far greater variety of convertibleor redeemable equity or debt instru-ments become possible.

As far as worker’s codetermination,an historical cornerstone of Germanlabor policy, is concerned, manyGerman commentators had expectedthat the German federal governmentwould propose new legislation tocounter the Court’s judgments inUberseering and Inspire Art. Eventhough workers’ codetermination existsin varying degrees throughout the EU(except in the UK), the German codeter-mination rules have been perceived byforeign entrepreneurs as particularly

cumbersome when it comes to internalreorganizations and corporate restruc-turings. Because the current Germancodetermination law is applicable onlyto specified forms of German compa-nies, but not to foreign forms ofcompanies, it was widely expected thatGermany would quickly amend itsapplication to foreign company forms.However, that now seems unlikely,since a representative of the FederalMinistry of Justice announced onJanuary 15, 2004 that Germany willaccept the consequences of the Court’sjudgments and is thus not consideringextending the German codeterminationlaws to foreign corporations with theireconomic seat in Germany.

Structural ImplementationAgainst this background, certain invest-ments in, or restructurings involving,German businesses could be moreclosely tailored to investors’ objectivesby using non-German companies.Indeed, Inspire Art could conceivablyopen the door to competition amongmember states to provide the most flex-ible corporate form, much as Delawarebecame the preferred state for the incor-poration of U.S. companies.

In the case of a new start-up companyor the acquisition of an existing busi-ness by a new acquisition vehicle,investors are of course free to choosethe optimal corporate form. It may alsobe possible through various means,such as a spin-off of assets, to transferthe local assets of an existing companyto a foreign company. Such a transfermay have potential advantages. Forinstance, if a German company withlimited liability, a GmbH, with almost500 employees, which is 100% ownedby a (foreign) holding company that isnot subject to the German codetermi-nation rules, intends to acquire by wayof an asset purchase a German busi-ness with another 1,600 employees, the

acquisition of this second business mayresult in the obligation to establish acodetermined supervisory board at thelevel of the GmbH. In light of InspireArt, it might be possible to avoid such aconsequence by transforming theGmbH into an English limited liabilitycompany, which is relocated intoGermany.

Other principles of German laborlaw, in particular the establishment of aworkers’ council with certain informa-tion and consultation rights under theGerman Works Constitution Act at thelevel of each business unit, could not beavoided by establishing and/or convert-ing a German corporate entity into aforeign corporate entity, because theseare provisions of labor, rather thancompany law.

Issues to be ConsideredDespite the many potential advantagesof using a non-continental corporateform, many legal uncertainties, whichwill surely be subject to further courtdecisions at the national and Europeanlevels, remain.

In Inspire Art, the Court stated thatall questions relating to the company’sstatus (such as liability of managingdirectors and capital requirements)must be governed by the law of incor-poration of the company. Althoughcompany law standards have beenmade uniform in certain limitedrespects by a variety of EU directives,there remain significant differences inthe scope of company laws in variousmember states. Consequently, ques-tions of shareholders’ and/or manage-ment duties and liabilities, which in onemember state are governed by compa-ny law, may in another member state begoverned by civil, labor or insolvencylaw. This may lead to unexpectedresults. In some cases, the companycould be subject to two conflicting laws:



Most private equity funds that include U.S. pension plans (or other entities that hold pension plan assets) as investors are intendedto qualify for the venture capital operating company (VCOC) exemption under ERISA. The fund’s qualification as a VCOC enablesthe general partner of the fund to negotiate its management-incentive fee arrangements without regard to the technical require-ments under ERISA governing compensation arrangements for pension plan fiduciaries. Moreover, the fund’s status as a VCOC willgenerally exempt the fund from the complex prohibited transaction rules under ERISA.


Conversely, the failure of a fund toachieve and maintain VCOC statuscould result in the fund’s assets beingtreated as “plan assets” subject toERISA (in the absence of any otherERISA exemption), thereby subjectingthe fund and its general partner to thefiduciary requirements and prohibitedtransaction rules under ERISA. If afund that is deemed to hold planassets fails to comply with the fiduciaryrequirements and prohibited transac-tion rules under ERISA, the generalpartner of the fund and the fiduciariesof the pension plan investors whoauthorized the pension plans’ invest-ment in the fund may be subject to sub-stantial penalties and excise taxes underERISA and the Internal Revenue Code.

Because of the potentially onerousconsequences that could result from afund’s failure to qualify as a VCOC,pension plan investors will typicallyseek protections within the fund agree-ment regarding continued VCOCcompliance. These protections mayinclude a covenant from the generalpartner to operate the fund as a VCOC,a requirement to deliver an opinion ofcounsel as to the fund’s qualificationas a VCOC in connection with thefund’s first portfolio investment,annual certifications from the generalpartner as to continued VCOC compli-ance and the right of the pension planinvestor to withdraw from the fund ifthe fund fails to qualify as a VCOC.

The Department of Labor (DOL)regulations governing VCOCs aresomewhat technical and notcompletely logical. Since the DOL hasissued very limited guidance regarding

the VCOC regulations, and the regula-tions have never been judicially tested,most ERISA lawyers advise their fundclients to follow closely the “letter ofthe law” as it applies to VCOCs. Whilethe VCOC regulations, on their face,appear relatively straightforward, it iseasy to overlook some of the moretechnical details.

The BasicsIn general terms, to qualify as a VCOC,a fund must invest at least 50% of itsassets, valued at cost, in “operatingcompanies” with respect to which thefund obtains (and annually exercises)contractual “management rights.”

The “50% test” must be satisfied onthe date of the fund’s first long-terminvestment and on at least one dayduring the fund’s 90-day “annual valu-ation period.” The annual valuationperiod can be any 90-day periodselected by the fund at the time of itsfirst long-term investment, providedthat the first such period must beginno later than the first anniversary of thedate on which the fund makes its firstinvestment.

An “operating company” is definedin the VCOC regulations as an entityprimarily engaged (directly or througha majority-owned subsidiary or subsidi-aries) in the production or sale of aproduct or service other than theinvestment of capital.

While the VCOC regulations do notclearly define the term “managementrights,” the contractual right to desig-nate a director to serve on the portfoliocompany’s board is generally consid-ered to be a “safe harbor” form of good

management rights. In the absence ofa director right, the contractual right toappoint a board observer and/or theright to advise and consult with man-agement of the portfolio companyusually will suffice. Management rightsmust be exercised at least once annu-ally (ideally on a regular basis) withrespect to at least one of the fund’sinvestments.

Because the “50% test” must bemet on the date of a fund’s first long-term investment, it is imperative thatthis first investment be “VCOC-compliant” (i.e., it must be aninvestment in an operating companywith respect to which the fund obtainscontractual management rights). If thefund’s first long-term investment is notVCOC-compliant, the fund will foreverbe precluded from qualifying as aVCOC. After the fund makes its firstVCOC-qualifying investment, it mustthereafter satisfy the “50% test” on atleast one day during each of the fund’ssubsequent annual valuation periods.

The Devil is in the DetailsIt is easy to fall into the trap of takingVCOC qualification for granted. Afterall, a fund sponsor may reason, “Whyshould we need to think about VCOCcompliance when we fully expect thefund to invest in operating businesseswhere we will have at least onemember on the board of directors ifnot control of the board?” Unfortu-nately, it is all too common to comeacross fund investments that, at firstglance, appear to qualify as “good”investments for VCOC purposes, but infact raise difficult compliance issues

VCOC Traps for the Unwary: Will Your Deal be VCOC Compliant?


because of the highly technical natureof the VCOC regulations. An invest-ment that a layman considers to be inan operating business may not consti-tute an investment in an “operatingcompany” within the meaning of theVCOC regulations. Similarly, the mereexistence of management rights in thelayman’s sense, such as the de factoright to a board seat, with respect to aparticular investment may not satisfythe “management rights” require-ments set forth under the VCOCregulations.

Frequently, the “structural details”of VCOC compliance may be over-looked when a fund is negotiating theterms of a portfolio investment. Evenseasoned ERISA lawyers negotiatingthe terms of an M&A deal for a fundclient may fail to spot a VCOC problemfor the fund since their primary focuswill be on ERISA issues pertaining tothe target portfolio company. Thedanger of missing a potential VCOCissue may be particularly acute whenthe fund’s M&A deal counsel is not thefund’s regular counsel.

Here are a few common scenarios towatch out for when doing a VCOC com-pliance check with respect to aproposed portfolio investment by a fundthat is intended to qualify as a VCOC:

Indirect minority investments. In certaincircumstances a fund will invest in aholding company (which could be anLLC, a partnership or a corporation)with one or more co-investors,including an affiliated co-investor suchas an employee fund or other parallelfund. In these circumstances, prob-lems arise if the holding companytakes a minority position in the port-folio company. For example, a fundcould contribute 80% of the funds to aholding company, with a co-investor(who may or may not be an affiliate ofthe fund) providing the remaining20%. The holding company will thenacquire a minority stake in a portfolio

company (and will not hold any otherinvestments).

Based on available guidance fromthe DOL, this investment will notqualify as a good VCOC investment.The problem is that the fund has notinvested in an operating company. Theholding company cannot be consid-ered an “operating company,” becauseit is not engaged (primarily or througha majority-owned subsidiary or subsidi-aries) in the production or sale of aproduct or service other than theinvestment of capital. If the fundowned 100% of the holding company,the holding company could be disre-garded for VCOC purposes and thefund would be treated as if it investeddirectly in the operating company. Butin our example, the fund only owns80% of the holding company (even ifthe fund and the co-investor are affili-ates, they will be treated for VCOCpurposes as separate investors).Accordingly, the holding companycannot be disregarded, and the VCOCfund will be viewed as having investedin the holding company, rather than inthe operating company below.Therefore, regardless of any manage-ment rights that the fund may obtainwith respect to the holding company orthe underlying portfolio company, thestructure of the investment willpreclude its qualification as a goodVCOC investment.

Lesson: Where the fund proposes to acquire

a minority interest in an operating com-

pany, it must make the investment directly

into the operating company or through a

holding company that is 100% owned by

the fund.

Umbrella holding companies with substan-

tial non-majority interest holdings. Avariation of the “indirect minorityinvestment” issue described abovemay arise if the fund invests in anumbrella holding company that owns

multiple chains of operatingsubsidiaries, some of which aremajority owned and others of whichare either minority owned or exactly50% owned. The issue here is whetherthe umbrella holding company willmeet the definition of an “operatingcompany” as defined in the VCOCregulations (i.e., an entity that is prima-rily engaged, directly or through amajority-owned subsidiary or subsidiar-ies, in the production or sale of aproduct or service other than theinvestment of capital). There is no clearguidance under the regulationsregarding how to assess whether anentity is primarily engaged directly orthough majority-owned subsidiaries inoperating activities. One reasonableapproach to this issue would be tomeasure the relative value of theumbrella company’s majority-ownedsubsidiaries as compared to its non-majority owned subsidiaries. If most ofthe company’s value is attributable toits majority-owned operating subsidiar-ies, a strong argument can be madethat the umbrella company is in fact“primarily” engaged through itsmajority-owned subsidiaries in oper-ating activities. If most of the umbrellacompany’s value is attributable to itsminority and 50% owned holdings,there may be other rationales tosupport the umbrella company’s statusas an operating company (e.g., if theumbrella company is actively involvedin the “business” of managing its non-majority owned subsidiaries).

Lesson: Don’t assume that a conglomerate

entity is an “operating company” if it

includes substantial non-majority interest

holdings.

Management rights assigned to investor

group. Occasionally, a fund may investdirectly in a portfolio company with arelated fund (e.g., a parallel fund). Or, a fund may invest through a holding


Proposed HSR Rules May Mean Filings for Partnerships andOther Non-Corporate Entities

alert


The Federal Trade Commission hasproposed sweeping changes to therules for pre-merger notification filingsunder the Hart-Scott-Rodino (HSR) Actthat would eliminate the so-called part-nership loophole and impose filingrequirements for partnerships andother non-corporate entities that aresimilar to the requirements that alreadyexist for joint-venture corporations.

The existing HSR regime has sepa-rate rules for joint-venture corporations,partnerships and limited liabilitycompanies (LLCs) – and no specificrules for other types of non-corporateentities. Generally, there must be afiling for the formation of a joint-venturecorporation if the size-of-person andsize-of-transaction tests are met. Accord-ingly, a filing is required if an investor ina newly formed corporation will acquirein excess of $200 million worth ofvoting securities. Alternatively, the sizetests are met if an investor acquires inexcess of $50 million of voting securi-ties and (1) that investor and anotherare $10 million persons and the jointventure will have assets of at least $100million, or (2) the investor making the$50 million investment is a $100 millionperson and another investor and thejoint venture are $10 million persons.

By contrast, as matters now stand,the formation of a partnership is neverreportable: that’s the partnership loop-hole. Similarly, the acquisition of apartnership interest is treated as theformation of a new partnership, whichis to say that such acquisitions are alsoexempt from reporting requirements.The only exception to this rule is whenthe acquiring person will hold all of thepartnership interests. In that case, the

acquisition is viewed as an acquisitionof the assets of the partnership and afiling is required if (1) the size of thetransaction exceeds $200 million, or(2) the size of the transaction exceeds$50 million, the acquiring person or thepartnership is a $100 million personand the other is a $10 million person.

For the formation of an LLC, the FTCtakes a third approach. Such a forma-tion is exempt from reportingrequirements unless it will result in thecombination of two or more pre-existingbusinesses under common control. Asis the case with partnerships, an acqui-sition of an interest in an LLC is exemptunless the acquiring persons will holdall LLC interests, in which case a filingis required if the size-of-person andsize-of-transaction tests are met.

How could three forms of jointventures come to have three differentsets of filing requirements under theHSR Act? The FTC’s hands-offapproach to partnerships was based, atleast initially, on two notions: (1) thatthe federal authorities should be waryof regulating partnerships too closelybecause their forms vary among thedifferent states and (2) that theantitrust implications of transactionsinvolving partnerships likely are lesssignificant than the implications fortransactions involving corporations.Those same notions applied to somedegree to LLCs, although the FTCrecognized that some LLC transactions,namely those combining existing busi-nesses, had potential antitrustimplications and, therefore, should besubject to reporting.

The current proposal appears to bespurred by the FTC’s recognition that

the use of unincorporated entities,particularly in connection with transac-tions to acquire interests in otherbusinesses, is increasing. In the mate-rials accompanying its proposal, theFTC noted an increase in partnershiptax filings, as well as an increase inpartnerships and LLCs formed inDelaware. The FTC also observed thatcorporations are being replaced byLLCs which, in turn, may be supplantedby limited liability partnerships.Because of these developments, theFTC is seeking a uniform approach toreporting requirements for non-corpo-rate entities that does not departmarkedly from the existing rules forjoint-venture corporations.

Under the proposed rules, theformation of an unincorporated entitywill be potentially reportable if anacquiring person will gain control of thenew entity: that is, the right to 50% ormore of the profits of the entity or, inthe event of dissolution, the right to50% or most of the entity’s assets. Thesize-of-persons test is similar to that forcorporate joint ventures but not thesame, because the size of otherinvestors is not relevant. Thus, the size-of-persons test is met, and a filing isrequired, if the controlling investor willhold in excess of $200 million in votingsecurities or in excess of $50 million, solong as either the acquiring person or thejoint venture is a $100 million personand the other a $10 million person.

Control will also be the triggeringevent for acquisitions of non-corporateinterests. An acquisition of a control-ling interest will be reportable if the sizeof the acquisition (as measured by thecontinued on page 27


Lost in Translation: Dispute Resolution Considerations inCross-Border Deals

The last thing on the minds of privateequity investors in cross-border dealsare dispute resolution provisions thatonly prove relevant if the deals goesbad. But if the deal does go sour later,an unwary U.S. investor may find itselfbeing sued abroad, “lost” in an unfa-miliar foreign court or legal system,translating thousands of pages of docu-ments into the local language andgenerally getting bogged down innumerous procedural disputes abouteverything from proving the investor’sidentity to registering the investor’sfund in the country.

So what can a U.S. private equityfund do? There are several steps youcan take when negotiating the originaldeal to speed up the process andreduce the pain if, in fact, a claim doesneed to be brought or defended, recog-nizing, as always, that the ability toprevail on these issues will depend onbargaining leverage, cultural sensitivi-ties and a host of other transaction-specific factors.

Choose a Familiar and EstablishedGoverning LawA U.S. private equity fund should gener-ally insist upon a law, such as Englishor New York law, that is well-developedand hence predictable, and that willgive effect to the document as written ifa dispute arises. Foreign parties ofteninsist instead on their home countrylaw, for a variety of reasons, includingfamiliarity, nationalism and the burdenof hiring an English or New York lawyer.It is critical that, before agreeing to theapplication of any given law, the U.S.investor identify all differences that mayhave an impact on the interpretation ofthe contract. For example, civil law

systems frequently incorporate by lawcertain code provisions into contractsand, generally speaking, civil lawsystems permit less strict constructionof contract language. As anotherexample, seemingly familiar terms ofart, such as “arm’s length” or “bestefforts,” may not exist in certain juris-dictions, or have less precise meanings.Approach with caution any proposal touse, a “neutral” governing law, such as Swiss law in a given transaction, because the substantive provisionsmay in fact not be “neutral” from thestandpoint of the parties’ expectations.In any event, a choice of a governinglaw other than New York or English law should be made only after discus-sion with counsel in the relevantjurisdiction.

Repress the Urge to Short-cutDocumentationRegardless of the choice of governinglaw, a U.S. investor should seek to usecomprehensive documentation leavingless room for interpretation. While suchan approach may run counter to com-mercial practice in the foreign party’scountry, particularly in jurisdictions inwhich contracts incorporate statutoryprovisions, a comprehensive contract islikely to make it easier for a U.S.investor to compromise on choice ofgoverning law issues, particularly ifstatutory provisions can be waived.Most important, of course, comprehen-sive documentation better ensures ameeting of the minds on the deal.However, there are perils of blindlyusing U.S.-style documentation in dealsgoverned by foreign law, see “ThePitfalls of Using an English Language,U.S.-Style Acquisition Agreement in

Transactions Governed by French Law”in the Winter 2004 issue of this publi-cation.

Arbitrate if You CanThe longstanding debate over litigationversus arbitration is trumped in cross-border deals by the greater prospect ofenforcing a foreign arbitral award thana foreign judgment against the localparty. Most countries are party to atleast one of the international arbitrationconventions that generally requireforeign arbitral awards to be enforcedlocally; there is no counterpart ofcomparable scope for foreign courtjudgments. While enforcement stilldepends on the willingness of thecourts where assets are located to takethese arbitration conventions seriously,the widespread adherence to them andthe actual practice in many jurisdictionsmakes the odds of enforcing an arbitralaward considerably greater.

Choose a Neutral Arbitral SiteAn international arbitration can be heldanywhere in the world, including theforeign party’s home country. Becausethe courts in the place of arbitration willhave jurisdiction to supervise (andhence interfere with) the proceeding,and also have jurisdiction to entertainan application to vacate the award(including on local law grounds), arbi-trating in the foreign party’s homecourt can be dangerous. The conven-tional seats, including New York,London, Paris and Geneva, are usuallypreferable, although there are somecircumstances in which arbitration inthe foreign party’s home jurisdictionmay be desirable.



Bonds – No Longer a Safe Haven?

Since the early 1980s, the twin forcesof declining inflation and interest rateshave fueled a nearly uninterruptedcycle of strong returns for privateequity investments. This economicbackdrop also has resulted in bondindices generating annual returns ofalmost 10% since 1995, versus the5.5% long-term average.

Many strategists see a far differentoutlook for bonds in the years ahead.PIMCO, the major west coast bond-management firm, is revising itsportfolio strategy for 2004, statingthat, “The bond market in 2004 will bechallenging, with upward pressure onrates and full valuations in Treasur-ies.” Mike Even, Chief InvestmentOfficer of the Citigroup Private Bankrecently wrote, “So, while bonds havetraditionally been a ‘safe haven’ forinvestors seeking both income andlow volatility, we think those days areover. Not only are current yields low,

but future returns are uncertain, givingbonds a poor risk-return ratio.”

The question is not whetherinterest rates will rise, but when?Despite repeated assurances to themarkets that interest rates will remainlow indefinitely, Federal ReserveChairman Alan Greenspan recentlymade the statement that “such apolicy stance [of maintaining 1%borrowing rates] will not be compat-ible indefinitely with price stability andsustainable growth; the real federalfunds rate will eventually need to risetoward a more neutral level.”

Rising interest rates and inflationpose dual challenges for private equityprofessionals: the possibility of slowereconomic growth and possiblyreduced IRRs on private equity funds,plus pressure on the returns of bondsand other financial assets.

No matter what lies ahead in themarkets, the most sophisticated way

to protect and grow wealth is to diver-sify broadly across asset classes thathave returns that have a low correla-tion to each other. That meansconsidering strategies that havereturns that are not tied to the sameinfluences in the market, whetherinterest rates, inflation or currencyfluctuations.

The best solution is one that takesinto account the total wealth manage-ment picture: cash flow, tax, estateplanning, philanthropy and otherconsiderations. A cash-flow andcapital-needs analysis can determinewhat level of low-risk, highly liquidinvestments are necessary to fundhousehold and capital expenses. Inmost cases, an allocation to high-grade municipal bonds is appropriateto fund these expenses and to“anchor” the portfolio in a low-riskasset class. An over-allocation to low-yielding bonds, however, could leavethe portfolio producing an unaccept-ably low rate of return. In fact, returnsfor many short-term bonds today arebelow the rate of inflation, producing anegative real return.

Next, an analysis of the risk-and-return tradeoffs for a broad menu ofasset classes will help determine whatstrategies will best meet the long-termgrowth objectives for the portfolio.Some examples of strategies that couldhelp diversify a portfolio of privateequity investments and bonds include:

Private equity professionals are different from other investors. They invest heavily in their own business, the success of which is highlycorrelated with the strength of the public capital markets. Personal investment strategies often balance high-risk, long-term and illiquidprivate equity interests with significant holdings in asset categories at the other end of the risk-and-return spectrum: low-yielding bondsor money market cash instruments. This “barbell” approach to investing has been a sound investment strategy for the past twodecades. But it may not last. Private equity professionals and other sophisticated investors should be asking, “How do I construct aninvestment portfolio that will grow in real terms in the face of a possible environment of rising interest rates and inflation?”

guest column

10-Year U.S. Treasury Yields

16.00%

14.00%

12.00%

10.00%

8.00%

6.00%

4.00%

2.00%

0.00%

Yiel

d

1962

1965

1968

1971

1974

1977

1980

1983

1986

1989

1992

1995

1998

2001

·· Low volatility hedge fund strategies.

Managers who excel at taking advan-tage of mispricings of securities cancontribute meaningful return to port-folios. Importantly, these strategiestend to have a very low correlation tobond and equity market returns.Examples include a “relative value”style of equity investing, fixed incomeand capital market arbitrage strate-gies, and investing in the equity andbonds of distressed companies.These are complex strategies andshould be executed only by experi-enced professionals.

·· Investments in hard assets. Commodi-ties, real estate, energy and othertypes of natural resource or “hard-asset” investments traditionally haveserved as effective “hedges” againstrising inflation. Depending uponportfolio objectives, diversificationamong public and private equityinvestments ranging from managedcommodity futures, precious metalsand energy contracts to timber andreal estate may be appropriate.

·· Floating-rate instruments. Lendersprotect themselves against risinginterest rates through variable orfloating-rate instruments. For theinvestor, floating-rate investmentopportunities are an excellent meansof participating in a rising rate envi-ronment.

Further, all asset allocation decisionsshould be made in the context of thefamily estate plan. The estate plan willdrive decision-making around the styleof investments appropriate for familyportfolios. Children’s trusts, forinstance, may be invested with an eyetoward long-term capital appreciationwithout regard to current cash yield.Liquid assets with high growth potentialare good candidates for a wealthtransfer technique known as a GrantorRetained Annuity Trust. These trustscan pass the appreciation of an invest-ment portfolio to the youngergeneration with advantageous gift taxconsequences. Charitable trusts cangenerate current income for the familywhile providing a future gift to a chosencharitable organization. Private equity

and interests in closely held businesseswork well in family partnerships andLLCs. (For a discussion of estate plan-ning for private equity fund interests seeJonathan Rikoon’s article, “EstatePlanning for Carried Interests” in theFall 2000 issue of this publication.)

The most recent interest-rate cyclehas had a dramatic influence on finan-cial asset returns. From 1962 to 1982,interest rates rose markedly and had adampening effect on investment port-folios. From 1982 to 2004, ratessteadily declined giving a tremendouslift to the economy as well as bond andstock prices. The core question is,“Looking forward, what is the mostlikely capital market scenario and howdo I adjust my asset allocation toprotect and grow wealth?” A soundwealth management plan for busyprivate equity professionals not onlymakes good sense, but can bringpeace of mind, allowing for completefocus on the business at hand. —Stephen V. KenneyChief Investment Officer and Managing Director, SCS Financial


Upcoming Speaking Engagements

May 26-27 Andrew OstrognaiStrategies to Exit Investments: Private Equity & Venture Investment in North AsiaAsia Pacific Venture Capital AssociationNew York, NY

June 2 Sherri G. CaplanInvesting in a Real Estate Private EquityPlatformFifth Annual Real Estate Opportunity & Private Fund Investing ForumNew York, NY

June 17-18 Franci J. Blassberg, ModeratorLeveraged Buyout/Management Buy-out TransactionsInternational Bar AssociationThird International Mergers and Acquisitions ConferenceLondon, England

June 24-25 Jeffrey J. RosenCase Studies

Peter FurciStructure and Tax Analysis

Advanced Forum on Income Deposit Securities (IDSs), Enhanced Income Securities (EISs) and Similar ProductsNew York, NY


Tyranny of the Minority?

A number of recent Delaware caseshave questioned the unfettered abilityof majority shareholders of publiccompanies to sell their controllinginterests, either directly or throughcausing a sale of the entire company.In the latest such case, Hollinger Int’l,Inc. v. Black, the court enjoinedConrad Black from selling a holdingcompany through which he controllednewspaper publisher HollingerInternational – largely because thecourt found Black had “persistentlyand seriously” breached his fiduciaryand contractual duties to HollingerInternational.

Does this signal a fundamentalchange in the balance of powerbetween majority and minority share-holders? We think not. The case turnson its special facts, in particularBlack’s agreement with the companylimiting his freedom to sell the holdingcompany. But the case is a usefulreminder that Delaware courts will usetheir equitable powers to enforcecommitments majority shareholdersmake to their controlled subsidiaries,as well as to police the fiduciary dutiesthat directors of a controlled companyhave to all shareholders – not just tothe controlling shareholder that mayhave nominated them. These areimportant lessons for private equityfirms that take control positions inpublicly traded companies, and fortheir representatives on the boards ofthose companies.

Conrad Black, faced with a specialboard committee conclusion that hehad received millions in unauthorizedpayments from Hollinger Internation-al, entered into a written agreement in

which he promised to repay HollingerInternational, to resign as CEO(though he remained a director) and tosupport a process to consider strategicalternatives for Hollinger International.He also agreed to sell control only aspart of a transaction that equally andratably benefited the other stock-holders, and not to support anytransaction involving shares of theholding company unless necessary toenable the holding company to avoid amaterial default or insolvency – andthen only with as much advance noticeto Hollinger International as reason-ably possible.

Black failed to make the requiredpayments, and immediately began toundermine the strategic process bysecretly negotiating a sale of theholding company through which hecontrolled Hollinger International tothe Barclay brothers, investors whohad expressed a strong interest inacquiring The Daily Telegraph fromHollinger International. Black, who didnot inform the board of the Barclays’interest in the Telegraph, convincedthe Barclays that by buying the holdingcompany, they could gain control ofthe Telegraph without having to partic-ipate in a strategic process with otherbidders. Worried that Hollinger Inter-national might sell the Telegraph outfrom under him, Black caused theholding company to sign a shareholderconsent amending Hollinger Interna-tional’s by-laws to eliminate the specialcommittee and to require unanimousboard approval for a merger or mate-rial asset sale – effectively giving Black a personal veto over any suchtransaction.

When the special committee adopt-ed a poison pill to block the deal withthe Barclays, litigation ensued.

Vice Chancellor Strine, noting thathe found Black “evasive and unreli-able” and that “[h]is explanations ofkey events and of his own motivationsdo not have the ring of truth,” deter-mined that Black had repeatedlybreached his duty of loyalty toHollinger International by failing to tellHollinger International’s board aboutthe Barclays’ interest in buying theTelegraph, misleading the board abouthis dealings with the Barclays, usingconfidential information aboutHollinger International (including thefinancial adviser’s valuation analysis)to further the Barclays transaction andurging the Barclays to try to subvertthe loyalty of the financial adviser tothe special committee. Strine also heldthat Black had violated his agreementwith Hollinger International, findingthat the Barclays transaction, by deter-ring other buyers of HollingerInternational or its assets, negativelyaffected the strategic process and wasnot necessary to avoid a materialdefault or insolvency at the holdingcompany. In light of Black’s conduct,Strine enjoined the Barclays transac-tion, invalidated the by-lawamendments and upheld the poisonpill.

Although the court, based on thefacts before it, enjoined Black fromselling his control position, Strine’sopinion includes language thatsupports the notion that, in mostcircumstances, controlling share-holders are free:



alertUpdate on European Merger Control

Private equity investors and otheracquirers of significant European busi-nesses will be pleased by variousimprovements in the EC mergercontrol process. As of May 1, 2004,the new European Community MergerRegulation (ECMR) came into effect,and 10 additional countries joined theEuropean Community (EC).

The most important benefit of thenew regulations is the extension of“one-stop” EC merger control (forthose transactions having a sufficientCommunity dimension) to the 10 newMember States. Other benefitsinclude: (1) a provision intended todecrease the number of transactionssubject to national-level merger reviewin three or more Member States, (2)the possibility of filing a Form CObefore a binding agreement is signed,(3) some increased flexibility as towhen undertakings (e.g., divestiturecommitments) can be submitted, and(4) the recognition of merger-gener-ated efficiencies as a valid basis forcounteracting a transaction’s negativeeffects on competition. Viewed morebroadly, the new ECMR also makeslimited changes to the filing require-ments and review proceduresapplicable for most transactions.

The following list highlights theprincipal changes likely to be ofinterest to private equity investors oradvisors active in European M&A. Anumber of more technical items havenot been listed.

Principal Improvements:

·· The 10 accession states (Cyprus,Czech Republic, Estonia, Hungary,Latvia, Lithuania, Malta, Poland,Slovakia and Slovenia) will comewithin the scope of “one-stop” ECmerger control for all transactionsthat qualify for a Form CO filing inBrussels.

·· Parties to a proposed transactionthat does not otherwise qualify for aForm CO notification, but whichdoes qualify for merger controlreview in three or more EC MemberStates, may elect to file a Form CO“one-stop” notification if none of theinvolved Member States objects.

·· The Form CO may be filed before abinding agreement has been signed,if the parties demonstrate to theCommission the existence of a good-faith intention to conclude anagreement (for example, where thereis a signed letter of intent) or if thereis an announcement of an intent tomake a public bid.

·· Efficiencies expected to be generatedby the concentration may be used tohelp justify clearance provided theefficiencies will benefit customersand are merger-specific and verifi-able.

·· Where a proposed concentration hasa Community dimension, but maysignificantly affect competition in adistinct market within a Member

State, the notifying party may requestreferral of all or the relevant part ofsuch concentration to the MemberState for review. (The new ECMR alsocarries forward the right of a MemberState to request a referral to suchMember State in certain circum-stances.) Assuming the MemberState does not object, theCommission has discretion toproceed with the referral.

·· The new ECMR expressly recognizesthe duty of the Commission, if thenotifying party so requests, to reviewand assess ancillary restraints if theyinvolve novel or unresolved ques-tions.

— Gary W. [email protected]

— Molly S. [email protected]

— Thomas Schü[email protected]

— James C. [email protected]

The most important benefit

of the new regulations is the

extension of “one-stop” EC

merger control (for those

transactions having a

sufficient Community

dimension) to the 10 new

Member States.


To Standardize or Not to Standardize: Recent Developments inthe Private Equity Valuation Debate

While uniform (but different) valuationstandards are generally followed in theUK and Europe, there is no accepteduniform set of valuation standards forprivate equity funds in the U.S. Eventhough almost all U.S. private equityfunds prepare their financial state-ments in accordance with U.S.generally accepted accounting princi-ples (U.S. GAAP) – which require thatprivate funds report the “fair value” oftheir investments – U.S. GAAP cur-rently provides little guidance indetermining fair value. U.S. privateequity firms use a number of differentapproaches to valuing their holdings.Thus, two or more private equity firmswith investments in the same portfoliocompany may assign dramaticallydifferent values to those investments.

In the first part of this article, wereview some of the views expressed byproponents and opponents of the useof industry-wide valuation standards.In the second part of this article, wereview some of the different views onthe use of a “fair-value” standard forvaluing private equity investments.Finally, in the third part of this article –and in the accompanying chart – wereview and compare existing valuationstandards and recent proposals fornew, uniform valuation standards.

The Standardization DebateValuation of private equity holdings hasalways been an important issue forinvestors. Valuations are relevant notonly in the reporting context, but also(1) when calculating the amount ofcarried interest distributions when

funds make “in-kind” distributions ofsecurities and (2) for funds that payout carried interest on a “deals realizedto date” basis, when determiningwhether a fund has unrealized lossesthat should reduce carried interestpayments (as is common in buyoutfunds) or has satisfied a fair valuecushion condition to carried-interestpayouts (as is seen in many venturefunds).

Still, pressure to adopt uniformvaluation standards was not significantduring the boom years of the late1990s, what with valuations and IRRsgenerally rising. However, after thetechnology bubble burst, valuations ofpublic tech companies fell while privateequity tech investments were notalways marked down promptly or at all.This led many private equity investors(and fund sponsors) to focus on valua-tion standards. In addition, the trendtoward greater transparency in theprivate equity industry, includingincreasing disclosure of fund perform-ance in response to Freedom ofInformation Act requests, generally hasled some industry participants andobservers to focus on valuation issues.

Despite a growing concern overvaluations, neither investors nor fundsponsors in the U.S. agree on whethera single valuation standard should bedeveloped for use by U.S. private equityfirms. Summarized below are some ofthe various arguments that have beenarticulated both in support of andagainst the creation of a uniform U.S.private equity valuation standard:

Proponents of Valuation Standards

Proponents of a more uniformapproach to private equity valuationcite a number of reasons for standardi-zation:

Harmony with international standards. Asingle U.S. standard for valuation,consistent with international guidelinessuch as those of the British VentureCapital Association (BVCA) and theEuropean Private Equity and VentureCapital Association (EVCA), wouldfacilitate greater cross-border investingand cross-border performance compar-isons.

Limited partner (LP) confidence in valua-

tions. Consistent valuations acrossfunds, which can only be achievedthrough application of a single stan-dard, foster greater confidence amongLPs in their funds’ general partners(GPs), particularly important at a timewhen GP-LP relationships are understress.

Preempt regulatory interference with valua-

tion. Valuation standards may preemptpotential demands for greater trans-parency and uniformity fromregulators. With various corporate andhedge fund scandals and ensuingchanges in the regulatory climate,some are concerned that regulatorssuch as the SEC may eventually extendtheir focus beyond hedge fund valua-tions to private equity fund valuations.

Greater comparability of performance

among funds. Standardization of privateequity valuations enables institutionalinvestors to compare more readily the

Although the idea of a uniform, industry-wide standard for private equity valuations has been discussed for years, the topic hasreceived a great deal of attention in the past six months, with some groups issuing, reviewing or updating proposed and existingvaluation guidelines.


performance across the private equityfunds in their portfolios, and of privateequity funds to the performance of thepublic markets.

Fueling the secondary market. A uniformstandard could help create a moredynamic secondary market by enablingsecondary purchasers to comparemore readily the purchase price of onesecondary fund interest with another.

Critics of Valuation Standards

Some fund investors and sponsors(and other market participants whoselivelihoods depend in part on marketinefficiencies) have also expressedopposition to, or at least skepticismconcerning, the development ofuniform valuation standards:

Valuation is an art, not a science. Privateequity is an illiquid asset class and, assuch, it is impossible to eliminate thesubjective element inherent in valua-tion. Even the development of a singleglobal standard would still require thatGPs make subjective judgment calls inimplementing any such standard.Thus, disparities would still exist; yetinvestors might be misled intobelieving that consistency had beenachieved.

Valuation standardization could incite legal

action. At present, investors understandthat private equity valuations aresubjective. Too much emphasis onstandardization of valuations and theexistence of a single “correct” value ofan investment could lead to lawsuitsagainst those firms that do not reportthe “correct” value of an investment.

Valuing GPs’ subjectivity. Many investorschoose a particular fund managerbecause of their confidence in suchmanager’s unique judgment in respectof market investment opportunities aswell as valuation, i.e., a manager’ssubjective view of the value of a port-folio company is an element of theexpertise for which such manager hasbeen selected. Following a uniformstandard might fetter such manager’sability to exercise its discretionary judg-ment.

Others have approached the valua-tion debate from a differentperspective, by questioning whetherthe more standardized approach tovaluation used in public markets reallyproduces more accurate or reliablevaluations. Jesse Reyes, vice presidentof Venture Economics, questioned:

At one point, Amazon shareswere priced at $175 dollars. Wasthat a good valuation? Probablynot. But it was a real price. Theidea of a good valuation is a slip-pery notion whatever you’retalking about. People say thatprivate equity valuations must bebogus because they aren’t basedon reality. But there have beenplenty of things based on realitythat turned out to be prettybogus.1

Instead, he suggests, investors needto accept that valuing private equitynecessarily involves guesswork.2

The Fair-Value DebateThe debate over standardization hasbeen accompanied by an equallyintense debate over the use of “fairvalue” in valuation standards. U.S.GAAP and many existing and proposedvaluation standards require that privateequity funds “fair value” their holdings.Harmonization of valuation standardsis not likely to be achieved before aconsensus is reached on the meaning

of, and the appropriate techniques todetermine, fair value.

Fair value is generally defined as theamount at which an investment can besold in a current transaction betweenwilling parties, other than in a forcedliquidation or sale, although the exactdefinition may vary depending on thesource. Some private equity funds havehistorically taken the view that privateequity holdings should be carried atcost for as long as possible, arguingthat, in light of the illiquid nature ofprivate equity investments and princi-ples of conservatism, cost is the bestmeasure of “fair value” absent almostany event short of a complete or partialsale. (In this article we refer to this as a“conservative” valuation standard).Others have taken the view that a lessconservative fair-value standard shouldbe applied. They argue that a variety oftechniques (e.g., valuing by looking atearnings multiples, discounted cashflows) should be applied to arrive atwhat they believe will be a more “accu-rate” fair value. (In this article we referto this as a “more rigorous” fair-valuestandard.)

Proponents of a “More Rigorous” Fair-

value Standard

Proponents of a move away fromcarrying investments at cost to morerigorous fair valuing cite a number ofreasons for standardization:

LPs want to measure performance. Invest-ors want to understand how theirportfolios are performing, and cost-based conservative valuations do notreflect current performance adequately.

Fund sponsors market their funds based on

interim performance. A private equityfirm marketing a new fund may use a“more rigorous” standard to valuepredecessor fund holdings at their“true” values, and not at cost, even if

1 “Benchmarks: Private Equity’s Benchmark Blues,” GlobalInvestor, May 1, 2002.

2 Ironically, at least one new fund has been developed thattakes the reverse approach to valuation by applying tradi-tional private equity valuation techniques to investments inthe public markets (“Schroders Bridges a Private/PublicDivide,” Financial Times, July 31, 2003).



To Standardize or Not to Standardize: Recent Developments (cont. from page 17)

Measure ofValue

NVCA

Valuation presumption: investmentcost.

Fair Value is not defined.

BVCA

Fair Value: “[T]he amount for which an assetcould be exchanged between knowledgeable,willing parties in an arm’s-length transaction.”At-cost valuation permitted only where FairValue cannot be reliably measured.

AIMR

Fair Value: “The amount at which an assetcould be acquired or sold in a current transac-tion between willing parties in which theparties each acted knowledgeably, prudentlyand without compulsion.”

Comparison of Valuation Methodologies

ValuationMethodology

Valuation should be adjusted toequate to a subsequent significantequity financing that includes asophisticated, unrelated newinvestor.

� Methodology Hierarchy for “Unquoted Instru-ments”

– Earnings Multiple: Primary

– Price of Recent Investment: Primary

– Net Assets: Primary

– Discounted cash flows or earnings (ofunderlying business): Secondary

– Discounted cash flows (from investment):Secondary

– Industry valuation benchmarks: Secondary

� “Quoted Instruments” are valued at marketprice.

� Methodology Hierarchy

– Market transaction: most recent inde-pendent third-party transaction involving amaterial investment.

– Market-based model: in the absence ofsuch market transaction, may calculateusing market-based model (e.g., free cashflow) and market-based assumptions; themethod that involves the least number ofestimates is preferred.

– Discounted expected future cash flows:the present value of expected cash flows(incorporating risk uncertainty), discountedat the risk-free rate adjusted for credit-worthiness.

ImpairedInvestments

Value should be reduced if acompany’s performance andpotential have significantly deterio-rated.

Fair Value: If at-cost value is used, it should bereduced to reflect estimated extent of impairment.

Examples: failure to meet significant milestonesor service financial instruments; breach ofcovenant; deterioration in forecast performance;significant adverse changes in company’s tech-nological, market, economic, legal or regulatoryenvironment; market conditions deteriorategenerally.

“All valuations must, at a minimum, recognizewhen assets have suffered a diminution invalue.”

Examples: breach of covenant, failure toservice debt, filing for bankruptcy, majorlawsuit or loss/change of management.

LiquidityDiscount forPublicly TradedStock

Yes. 10% discount recommended ifa high number of shares is held;30% discount recommended forpublic securities that are restricted.

Yes. Recommended range of 10-30% in incre-ments of 5%. Discount required if there is a riskholding might not be sold immediately or thereis a formal restriction on trading.

No.

AdditionalNotes

� GAAP-compliant with exceptions; advisesagainst overly conservative valuation.

� Methodologies should be applied consistentlyfrom period to period, except where a changewould result in better estimates of Fair Value.

� Basis of valuation must be logically consis-tent and applied rigorously.

� Any change in valuation principle ormethodology from one period to the nextmust be explained.



EVCA

Two types of valuation:

1. Conservative Value: Value at-cost unless (a) a new financing round or partial sale(“arm’s-length”) has taken place in which case value should be based on transac-tion price or (b) there has been a material and permanent diminution in value (see“Impaired Investments” column).

2. Fair-Market Value: “[T]he estimated amount for which an asset should exchangeon the date of valuation between a willing buyer and a willing seller in an arm’s-length transaction after proper marketing wherein the parties had each actedknowledgeably, prudently and without compulsion.”

PEIGG

Fair Value: “The amount at which an investment could be exchanged in a currenttransaction between willing parties, other than in a forced or liquidation sale.”

� Methodology for “Unquoted Investments” (two valuations are recommended)

– Conservative Value: See “Measure of Value” column

– Fair-Market Value: Market-based model or Earnings Multiple approach mayalso be applied where no transaction has occurred and where the investment hasrevenues and either profits or positive cash-flow

� “Quoted Investments:” Market price.

� Methodology should be used consistently until a new methodology will provide abetter approximation of value.

� At-cost/latest round of financing may be appropriate. However, if manager’s reviewindicates circumstances such that a “material change in value” has occurred, fairvalue should be approximated. Examples of changes in circumstances:

– The current performance of the company is significantly above or below expec-tations at the time of the original investment;

– Market, economic or company-specific conditions have significantly improvedor deteriorated since the time of the original investment; or

– Substantial decreases in the value of public debt, defaults on any obligations ofthe company, a bankruptcy filing, significant ownership dilution caused by recapi-talization or long term liquidity concerns.

� Fair value should be approximated using the following methodology hierarchy:

– Comparable Company Transactions: examination of third-party investments/transactions in comparable equity securities

– Performance Multiple: application of most appropriate and reasonable multiplederived from market-based conditions or recent private transactions

– Other Valuation Methodologies: Discounted Cash Flow, Net Asset Value andIndustry Specific Benchmark methodologies may also be appropriate in certaincircumstances.

Written down only in increments of 25% once there has been a “material andpermanent” diminution in value below cost. Such material and permanent diminu-tion in value may result from: a breach of covenant, failure to service debt, a filingfor creditor protection or bankruptcy, a major lawsuit (particularly concerning intel-lectual property rights), loss or change of management, fraud within the company,substantial changes in market conditions, significant lowering of profitabilitymargin, performance substantially below expectations.

Fair value/GAAP compliant methodology.

Yes. Value adjusted for lack of marketability when quoted investments are restricted. Yes. A marketability discount of 0-30% may be taken only whena restriction (within meaning of GAAP) on sale exists.

� Guidelines emphasize transparency and disclosure.

� Any changes in valuation method from period to period, andthe effect of such change, should be clearly stated.

� All valuations should be calculated to account for the dilutionresulting from the exercise of ratchets, options or otherincentive schemes.

Valuation adjustments should be based on actual positive andnegative events, not upon expectations.


they use cost for financial reportingand purposes other than marketing.Some feel this phenomenon showsthat these private equity firms believethat cost in fact does not reflect the fairvalue of those holdings. Proponents ofa “more rigorous” fair value argue thatfirms should be able to use these more“accurate” valuations without creatinginconsistencies with reporting conven-tions typically followed.

Harmony with UK and European stan-

dards. A more rigorous fair valueapproach enables investors to comparethe performance of a U.S.-based fundmore readily with European and U.K.funds.

Secondary market reliance on valuations.

Both buyers and sellers in the growingsecondary market, many of which arenot distressed, need a more accurateand current valuation than a conserva-tive cost-based valuation.

Critics of a “More Rigorous” Fair-value

Standard

Proponents of a more conservative,cost-based approach to fair value cite anumber of concerns over proposals toadopt more rigorous fair-value stan-dards:

Volatility. More rigorous quarterly fairvalues for investments may lead tomore volatility in carrying values andmay prove misleading when a write-updoes not prove substantiated upondisposition of an investment.

Impracticality for early-stage investments.

A more rigorous fair-value approachmay not be practical for some venturecapital firms because identifying publiccompany comparables for an earlystage company with little operatinghistory may be too difficult, if notimpossible.

Impracticality for minority investments.

More rigorous fair valuation method-ologies may not be practical for aventure capital fund or a private equityfund with a large number of minorityinvestments for which the fund has fewor no board seats and, as a result, onlyvery limited information on which tobase its valuations.

Incentive to overvalue. A more rigorousfair value approach is dangerousbecause firms are encouraged to writeup, even in the absence of a third-partyvaluation event to validate the write-up.Such write-ups can affect carriedinterest payouts, which can be prob-lematic, as many LPs have faceddifficulties in recent years enforcing GPclawback provisions.

Conservative is better. A conservative,cost-based approach to valuation canlead to fewer negative surprises toinvestors and reduce the likelihood ofneeding to rely on GP clawback provi-sions – if one assumes that aconservative approach to valuationdiscourages write-ups but does notdiscourage write-downs (which maynot be the case). This is not a problemfaced in the U.K. and Europeanmarkets where fund terms historicallyhave required repayment of all investedcapital before any carried interestpayments can be made.

Cost and effort. More rigorous fair valuedeterminations, especially if done on aquarterly basis, can be costly and time-consuming and still not lead to moreaccurate determinations of fair value.Not every firm can afford to undertakesuch an exercise, and even those whocan may be diverting resources awayfrom other more important investmentactivities.

The Current and Evolving ValuationLandscapeCertain provisions of the existing andproposed valuation guidelinesdiscussed below are summarized inthe chart on page 18.

United Kingdom

The BVCA, founded in 1983, is therepresentative body for the privateequity industry in the UK. The vastmajority of private equity forms organ-ized in the UK are BVCA members. TheBVCA published its first valuationguidelines in 1991. The second versionof these guidelines was updated andendorsed in June 2003.

The BVCA guidelines rely on “fairvalue” as their core valuation principle,requiring the basis of a valuation to befair value “except in rare occasionswhen Fair Value cannot reliably bedetermined.” The BVCA divides themethodologies to be used to deter-mine fair value into “primary” and“secondary” methods. Among theprimary methods are earnings multi-ples, the price of recent investment andnet assets. Among the secondarymethods are discounted cash flows orearnings of underlying businesses,discounted cash flows from the invest-ments and industry valuationbenchmarks. The BVCA guidelines areintended to be consistent withInternational Accounting Standards(IAS), with a notable exception for theBVCA recommendation of discountsfor publicly traded instruments, whichis prohibited by IAS 39.

Europe

The EVCA, also formed in 1983, repre-sents the interests of the private equityindustry in Europe by promotingprivate equity investing to, and educat-ing, investors, policy makers and



entrepreneurs. The EVCA currently hasover 950 members. The EVCA pub-lished its first valuation guidelines in1993, which were later updated by theEVCA’s Task Force on Valuation in2000 and adopted in 2001.

The EVCA’s valuation principles arebased on surveys indicating thatinvestors wish to see two separatevaluations: (1) a conservative valuation(based on cost or the last round offinancing), to be used for capitalaccount purposes and (2) a morerigorous fair value determination, to beused to determine the future value andprospects of an investment. In deter-mining fair value, the EVCArecommends (in the absence of anythird-party transaction) using (1)comparable companies with estab-lished valuations and (2) earningsmultiples with an illiquidity discount ofat least 25%. The EVCA also recom-mends discounts for publicly tradedinstruments, regardless of whether theinstruments are subject to restrictions.The EVCA guidelines have served asthe base for other regional guidelineswithin Europe, such as those of theAssociation Française des Investis-seurs en Capital (AFIC) in France.

United States

The majority of U.S. private equityfunds tend to use conservative cost-based valuation principles. Some arguethat cost-based valuations are notalways consistent with a fund’s obliga-tion under GAAP to report the fairvalue of an investment because, at acertain point, cost may be a stalemeasure of a portfolio company’sworth. Still, many U.S. firms take theview that in light of the illiquidity ofprivate equity holdings and principlesof conservatism, private equity invest-ments should be carried at cost until adisposition or third party investment.They take this view in an environmentwhere the accounting profession and

GAAP have not yet provided sufficientguidance for U.S. firms on how todetermine fair value in the privateequity context. However, the FinancialAccounting Standards Board (FASB) isnow in the midst of a fair-value projectfrom which more detailed guidance onfair-value methodologies is expected toemerge.

Attempts at standardization. Efforts tostandardize private equity firms’approaches to valuation in the U.S.began in the late 1980s when an AdHoc Committee of the NationalVenture Capital Association (NVCA)proposed the first private equity valua-tion standards in the U.S. In 1989, theNVCA presented these standards in anall-member forum but after a heateddebate chose not to take a position onthe standards or to adopt themformally. Ironically, the guidelinesconsidered by the NVCA – which itrefers to only as the “Proposed VentureCapital Portfolio Valuation Guidelines”(NVCA Guidelines) – have been themost widely followed valuation guide-lines among U.S. private equity firmsover the last 15 years.

Not long after the NVCA Guidelineswere drawn up, Venture Economicsintroduced the first systematic per-formance measurement report withlong-term statistics on private equity,leading to greater transparency amongprivate equity firms. In 1994, theSubcommittee on Private EquityPresentation Standards of the Asso-ciation of Investment ManagementResearch (AIMR), a global industryassociation comprising both invest-ment professionals and financialanalysts, recommended that standardguidelines be used for private equityvaluation and, in 1999, adopted its firstversion of the Global InvestmentPerformance Standards (AIMR GIPS).In January 2004, the Subcommitteepublished amended AIMR GIPS guide-

lines to become effective in January2005. Meanwhile, in late 2003, thePrivate Equity Industry GuidelinesGroup (PEIGG), a voluntary group ofindustry representatives formed in2002, issued guidelines with a markedemphasis on “more rigorous” fairvalue. (These amended AIMR GIPSguidelines and PEIGG Guidelines arediscussed below.)

AIMR’s new GIPS principles. The AIMRGIPS Principles introduce a hierarchyof fair-value methodologies to enablefirms to derive fair values. At the top ofthe hierarchy is the use of relevantpublic data, such as comparable publiccompany transactions, followed bymarket-based multiples (e.g., price toearnings, enterprise value to EBIT andenterprise value to EBITDA) in themiddle tier and then discountedexpected future cash flows at thebottom of the hierarchy. AIMR recom-mends that valuations be reviewed byan independent party, such as an inde-pendent advisory board.

The new AIMR GIPS Principles offera bit more detail than PEIGG’s guide-continued on page 22

Although the traditional

assumption in the U.S. has

been that conservative valu-

ation is good, PEIGG now

aims to replace the concept

of conservatism with that of

prudence . . . The valuation

guidelines are intended to

comply with U.S. GAAP,

which requires that private

equity investments be

carried at fair value.


lines, although they fall short of thelevel of detail offered by their UK andEuropean counterparts. While AIMR isconsidered by most to be the leadingU.S. industry association for buy sideand sell side equity analysts and mutualfund managers, AIMR is generallyconsidered a less influential voice in theprivate equity world.

The new PEIGG valuation guidelines.

Although the traditional assumption inthe U.S. has been that conservativevaluation is good, PEIGG now aims toreplace the concept of conservatismwith that of prudence. Thus, the newPEIGG valuation guidelines released inlate 2003 recommend that investmentsbe fairly valued on a “prudent andconsistent” basis. The valuation guide-lines are intended to comply with U.S.GAAP, which requires that privateequity investments be carried at fairvalue.

PEIGG recommends updating valua-tions when a “material change in value”has occurred in a portfolio company.Examples of changes might be acompany’s success or failure to achievecertain milestones or technology break-throughs or materially exceeding orfailing to meet budget limits. In addi-tion to company-specific events, thePEIGG Guidelines also suggest thatprivate equity firms take into considera-tion the improvement or deteriorationof general market, economic orindustry conditions as compared withthe date of the original investment. TheGuidelines also recommend that valua-tions be updated quarterly.

Among the valuation methodologiesrecommended are comparable public

company transactions or earningsmultiple methodologies. Different firmsco-investing in a single portfoliocompany are encouraged to consulteach other to establish a single valua-tion for that company. (Some suggestthese conversations occur infrequentlybecause of misplaced fears of conse-quences under anti-trust laws.)3 Inaddition, the PEIGG Guidelines suggestthat private equity firms organize semi-independent valuation committees toestablish valuation standards to befollowed by a fund’s GP. However, theGP of a fund retains the discretion asthe ultimate judge of a portfoliocompany’s valuation.

Fund managers are entitled to retaintheir existing valuation methods for“some period of time” before switchingto the fair value method. Establishingan exact period of time for transitionwas a contentious issue among PEIGGmembers, as a venture fund mightconsider six months to be a long periodwhereas a buy-out fund might considertwo years as a long period.

The PEIGG Guidelines eliminate theliquidity discount taken on the stockprice of a portfolio company takenpublic. Typically, private equity firmsdiscount the price of publicly held stockduring any mandatory hold or lock-upperiod or when the firm holds a largeblock of such stock. Note that the FASBcurrently prohibits a liquidity discountfor publicly traded stock unless thestock is restricted by a governmental orcontractual limitation exceeding oneyear in duration.

Reception of the new PEIGGGuidelines has been mixed, with threemember firms of PEIGG indicating theywould not be adopting the guidelines.In his initial reaction to the PEIGGGuidelines, NVCA chairman Jim Breyerechoed this concern: “The troubling

issue is the suggestion that, on a quar-terly basis or an annual basis, thereshould be write-ups of portfolio-company valuations without third-partyvalidation. That’s a slippery slopebecause it just leads to more arbitraryvaluations when it comes to write-ups”(emphasis added).

The NVCA has maintained itsneutral position in the private equityvaluation debate by declining toendorse the new PEIGG Guidelines.Instead, the NVCA recommended thatits members “create, follow andcommunicate clearly the specific proce-dures and methodologies used forvaluing their portfolios.” This recom-mendation is consistent with findingsof the Center for Private Equity andEntrepreneurship of the Tuck School atDartmouth, which suggest that formost investors clearer and moredetailed explanations of the valuationmethodology used is more importantthan consistency of valuations.4

ConclusionAlthough reception of the new PEIGG andAIMR guidelines has been mixed, theyhave focused and enlivened the debateover standardized valuation and the tech-niques to be used to determine fair value.We hope to apprise you of future develop-ments in the continuing debate overprivate equity valuation, includingreporting on the results of the FASB’s fair-value project later this year. — Michael P. [email protected]

— Jennifer A. [email protected]

3 Private Equity Valuation and Reporting ConferenceProceedings, pp. 34-35, June 2003, Center for Private Equityand Entrepreneurship, Tuck School of Business atDartmouth.

4 Proceedings.



stock. Thus, a BDC can recycle itscapital and reinvested earnings indefi-nitely rather than being faced with theprospect of liquidation once it has real-ized on its initial investments.

BDCs have had an interestinghistory. In 1980, in order to promotecapital formation for small businessesand “democratize” venture capitalinvesting, Congress amended theInvestment Company Act to establish aspecial regulatory framework forventure capital pools. These provisionsare primarily designed to ensure that aBDC’s investments are generallylimited to venture-stage or financiallytroubled companies and that the BDCoffers to play an active role in themanagement and policies of the port-folio companies in which it invests.

Historically, the BDC structure hasnot always proven to be an especiallyattractive alternative to traditionalprivate buyout and venture capitalfunds. (In 2000, one journalist foundthat of the 58 BDCs organized since1980, 40 were no longer around oractively traded and 10 were “micro-scopic.”) Perhaps because the portfolioinvestments held by such funds areoften held at cost for five or more yearsuntil they are finally realized, andbecause investors do not receive anyprofits until such time, an active tradingmarket for a BDC may not develop.Consequently, interests in buyout andventure capital funds structured asBDCs have tended to trade at a dis-count to net asset value. Mezzaninefunds, however, produce a regular yield,which may facilitate development of amore active trading market.

Several noteworthy provisions of theInvestment Company Act applicable toBDCs are discussed below. A private fundsponsor studying whether to launch aBDC will need to consider these require

ments and whether it is prepared to takeon the additional regulatory requirements.

Independent Board And CorporateGovernanceAt least 50% of the board of directors ofa BDC must be independent and will besubject to many of the corporate gover-nance provisions mandated by theSarbanes-Oxley Act of 2002. The inde-pendent directors will typically havetheir own counsel.

Investment Advisers Act RegistrationMany private fund sponsors prefer notbe registered under the InvestmentAdvisers Act. If the sponsor wants tomanage a BDC, it will have to register.

SEC ExaminationsBDCs (and their advisers) are subjectto periodic examinations by the SEC.The SEC will examine books andrecords, including e-mails, and inter-view portfolio managers and otherpersonnel to determine if applicableregulatory requirements are beingcomplied with.

Recently, the SEC adopted a rule thatrequires BDCs (like other registeredinvestment companies) to adopt andimplement written policies and proce-dures reasonably designed to preventviolation of the federal securities laws bythe BDC. Under the rule, the BDC musthave a Chief Compliance Officer (CCO)responsible for the administration ofthese policies. The CCO’s designationand compensation must be approved bythe BDC’s board of directors, including amajority of the independent directors.Moreover, only the BDC board will beable to remove the CCO from his or herposition. It is likely that the SEC willfocus on the implementation of this rulein its future examinations, since it isviewed as a key initiative to addressingmany of the compliance issues facinginvestment companies.

Public ReportingBDCs are subject to the periodicreporting requirements required of allpublic companies under the SecuritiesExchange Act of 1934. These reports,which are publicly available, will containrelatively detailed disclosuresconcerning the BDC’s operations.Preparation of the financial statementswill also require judgments to be madeconcerning the value of investments,and disclosure of those valuations.Investments for which there is nomarket quotation (in other words, mostof the BDC’s investments) must bevalued at “fair value.”

Investment Advisory AgreementThe BDC sponsor will enter into aninvestment advisory agreement withthe BDC that will specify, among otherthings, the investment advisory fee. TheInvestment Company Act requires thatthe investment advisory agreementmust provide, in substance, that it maybe terminated at any time, without thepayment of any penalty, by the BDC’sboard of directors or by vote of amajority of the BDC’s outstandingcommon stock on not more than 60days’ written notice to the investmentadviser. While termination of the invest-ment advisory agreement is relativelyuncommon, it is still probably on adifferent order of magnitude than thatfaced by the general partner of a privateequity fund, who may have provisionsthat provide it may only be replaced forcause or by super-majority vote.

Qualifying AssetsMost of a BDC’s portfolio investmentsmust be in certain qualifying assets setforth under the Investment CompanyAct, which include securities of privateor thinly traded public U.S. companies,


BDCs and the New Public Market in Mezzanine Funds (cont. from page 1)


BDCs and the New Public Market in Mezzanine Funds (cont. from page 23)

cash, cash equivalents, U.S. govern-ment securities and high quality debtinvestments that mature in one year orless. A BDC may not acquire any secu-rity unless, after such acquisition, atleast 70% of the BDC’s assets areinvested in such qualifying assets. Upto 30% of a BDC’s assets may be innon-qualifying assets such as securi-ties of publicly traded companies andnon-U.S. issuers.

Managerial AssistanceA BDC is required to offer, and to provideupon request, “significant managerialassistance” to any portfolio companywhose securities are counted in the 70%qualifying asset basket described above.The standard for what constitutes mana-gerial assistance for purposes of theInvestment Company Act is similar tothe standard of “management rights”required in connection with main-taining a private equity fund’s statusas a venture capital operating company.(For a discussion of these rules see“VCOC Traps for the Unwary: Will YourDeal Be VCOC Compliant?” appearingon page eight of this issue.) Under theInvestment Company Act, managerialassistance may involve, among otherthings, any arrangement whereby theBDC, through its directors, officers,employees or general partners, offers toprovide, and, if accepted, does provide,significant guidance and counsel con-cerning the management, operations, orbusiness objectives and policies of aportfolio company. It may also involve theexercise by the BDC of a controlling influ-ence over the management or policies ofthe portfolio company by the BDC actingby itself or as part of a control group.

LeverageA BDC is subject to limits on leverage.Generally, a BDC’s asset coverage mustequal at least 200% after any borrowing.

Limits on Transaction With AffiliatesLike registered investment companies,BDCs are subject to limits on theirability to engage in transactions withaffiliates. While the affiliated transac-tion provisions applicable to BDCs aresomewhat less onerous than thoseapplicable to registered investmentcompanies, they can still present chal-lenges. For example, if the sponsorexpects the BDC to coinvest with itsprivate funds that have similar invest-ment objectives, it will be required toseek an SEC order permitting co-investment. Such an order, if it isforthcoming, may be subject to signifi-cant conditions (such as prohibitionson coinvestments in companies inwhich the private fund has an existinginvestment).

Other Ongoing RequirementsA BDC is subject to various otherrequirements under the InvestmentCompany Act, including the retentionof a custodian to hold all the BDC’ssecurities, and to purchase a fidelitybond. In addition, BDCs are subject tothe periodic filing requirementsrequired of all public companies underthe Securities Exchange Act of 1934.

RIC for Tax PurposesRecently organized BDCs have electedto be treated as regulated investmentcompanies, or “RICs,” for federalincome tax purposes, so that the BDCswill not be subject to U.S. federalincome tax on realized capital gainsdistributed to the company’s share-holders. Furthermore, the character ofa RIC’s earnings as long-term capitalgains or qualifying dividend incomemay be passed on to the RIC’s share-holders so that they may be subject toa reduced tax rate. To qualify as a RIC,a BDC must meet certain require-ments, including the following:

Distribution requirements. A RIC mustdistribute 90% of its ordinary incomeand net short-term capital gains eachyear. Income test. A RIC must derive at least90% of its annual gross income fromdividends, interest, payments withrespect to certain securities loans,gains from the sale or other disposi-tion of stock or securities, or foreigncurrencies, or certain other income(including gains from options, futuresand forward contracts) derived from thebusiness of investing in such stock,securities or currencies.Diversification test. As of the close ofeach fiscal quarter, (1) at least 50% ofthe value of a RIC’s assets must berepresented by cash, cash items(including receivables), U.S. govern-ment securities, securities of otherRICs, and, subject to certain limita-tions, a diversified portfolio of othersecurities (including, for example,mezzanine investments) and (2) notmore than 25% of the value of theRIC’s assets may be invested in thesecurities of any one issuer (other thanU.S. government securities or securi-ties of other RICs) or two or moreissuers controlled by the RIC andengaged in the same, similar or relatedtrades or businesses.

The public offering of mezzaninefunds structured as BDCs is a signifi-cant new trend impacting the privateequity arena. We will continue tomonitor this trend, and its effects onthe private equity industry, as itdevelops.—Kenneth J. [email protected]

—Colette C. [email protected]

—Michael J. [email protected]

the company law of its state of incorpo-ration and the labor law or insolvencylaw of the state of operations, forexample.

In addition, the member state’s taxlaws are not uniform and are not readilyadapted to the situation of relocation ofcompanies. For instance, the criterionfor the determination of a company’sresidency for tax purposes tends to be,in the first instance, the place of incor-poration. The company may, however,

be considered to be resident in anotherjurisdiction from which it is managed inaddition to, or in substitution for, thejurisdiction of incorporation, dependingon the domestic tax rules of each juris-diction and the terms of any double-taxtreaty between them. The tax residencyof the company may also change duringits life as a result of change of law orthe way in which the company ismanaged. These issues require carefulconsideration and monitoring if unde-

sirable tax costs are to be avoided.Lastly, local managers often are not

acquainted with the rules governingforeign companies. The same applies tothe courts, which are not readily in aposition to render judgments oncompany law issues governed by othermember states’ laws.— Thomas Schü[email protected]

— Elisabeth [email protected]


The Inspire Art Judgment of the ECJ: New Ways to Structure Acquisitions (cont. from page 7)


VCOC Traps for the Unwary (cont. from page 9)

company with a related co-investor,and then the pooled investmentvehicle may take a majority position ina portfolio company (so, the “indirectminority investment” problemdiscussed above does not exist). So far,the investment is sound for VCOCpurposes. However, if the manage-ment rights obtained with respect tothe operating company are providedjointly to the related investor group(i.e., they “share” the rights), the“group rights” can be problematic forVCOC purposes. This “group rights”scenario may arise, for example, if thefund and its affiliated co-investor arecollectively defined in a shareholdersagreement as the “Investor” and theagreement then conveys the manage-ment rights to the Investor, rather thanto the fund alone.

Under the VCOC regulations, whenan individual investor has a right toparticipate in collective decisions withrespect to the group’s managementrights, that investor has not obtaineddirect contractual management rightsthat would qualify under the VCOCregulations. To resolve a “group rightsissue” in circumstances wheremembers of a related group ofinvestors are granted group rights,typically the members enter into anagreement that provides that onemember of the group will be the “leadinvestor” with respect to that right. Or,for example, if various rights areobtained (such as more than onedirector), the rights could be “dividedup,” with some going to one fund andsome to the other fund.

Lesson: Where the fund is co-investing with

a consortium of other investors in a port-

folio company, each fund that is intended

to qualify as a VCOC should obtain its own

unilaterally exercisable management rights.

Management Rights Must be Contractual

Rights. Sometimes a fund incorrectlyassumes that, because of its majorityownership, it has sufficient rights(such as the right to elect directors)that derive merely from its sharehold-ings. Unfortunately, rights that derivemerely from share ownership may notqualify as “management rights,” be-cause they are not direct contractualrights under the VCOC regulations.Direct contractual rights are usuallyfound in a shareholders’ agreement, asubscription agreement, a partnershipagreement, an LLC operating agree-ment or a separate management rightsagreement, signed by the fund and theoperating company. Such rights mayinclude rights to appoint directors ofthe portfolio company, rights to adviseand consult with management andrights to receive information from theportfolio company.

Lesson: Management rights must be writ-

ten, contractual rights pursuant to an

agreement signed by both the fund and the

operating company in which it is investing.

Management Rights Must Flow Directly to

the Fund. The VCOC regulations requirethat management rights flow directlyfrom the operating company to thefund. Occasionally, a transaction isstructured so that the fund invests inan operating company through aspecial purpose vehicle (e.g., a holdingcompany). If the governance docu-ments provide that the board seats orother management rights go to thespecial purpose vehicle rather than tothe fund itself, then the requirementfor “direct” management rights will notbe satisfied. In order to avoid thisproblem, there needs to be a specific

contractual acknowledgement that thespecial purpose vehicle will exercise itsrights on behalf of the fund, or thegovernance documents need toinclude the fund as a party and providefor the rights to be given to the fund.

Sometimes, portfolio investmentsare “warehoused” and then transferredto a fund. In these circumstances, itshould be made clear that the manage-ment rights obtained in the ware-housed investment are transferred tothe transferee fund following thetransfer. It is helpful to have the trans-feror entity, the fund and the portfoliocompany enter into an acknowledg-ment that the management rightsformerly held by the transferor havebeen transferred to, and are nowdirectly exercisable by, the transfereefund.

Lesson: Make sure that the management

rights inure directly to the fund even if addi-

tional language needs to be inserted into

the agreement conveying the management

rights (or a separate agreement is required).

Consult with an ERISA LawyerProbably the most important lesson totake from the above illustrations is toconsult with an ERISA lawyer regardingthe VCOC ramifications of a proposedinvestment if there is any question asto whether the investment will beVCOC compliant. Many of the VCOC“structural detail” problems that cancreep up can be easily managed if theyare identified early on in the transac-tion negotiations. — Margaret A. [email protected]

— Jamin R. [email protected]


Lost in Translation: Dispute Resolution Considerations in Cross-Border Deals (cont. from page 11)

Don’t Litigate in Foreign CourtsIf the parties choose litigation, keep inmind that the foreign courts, particu-larly in emerging markets, may nothave much experience in interpretingcomplicated documentation, and theremay also be a home-court advantagefor the local party. Although an investorultimately may have to go into the localcourts to enforce a judgment or fore-close on collateral, the merits of thecase should generally be litigatedoutside of the local courts. Sometimesjust the risk of litigating in the localcourts could force a U.S. investor tocompromise or entirely forego a claimthat it would otherwise pursue.

Choose Exclusive JurisdictionWhere arbitration is chosen, it shouldbe exclusive, with resort to courts onlyfor prejudgment remedies, to enforcethe agreement to arbitrate or to enforcethe arbitration award. Where a judicialforum is instead designated, it wouldstill usually be preferable to achieve thecertainty that comes with exclusivity,rather than try to preserve the flexibilityto sue in the forum that seems best atthe time the dispute arises. As anotherexample, a party more likely to be thedefendant (such as a seller in an M&Atransaction) may wish to maximize

protection against suit in a hostileforum. Although U.S. courts are gener-ally required by statute to enforceforeign-country money judgments ifcertain requirements are met, enforce-ment would generally not be required ifthe foreign judgment was obtained inviolation of a valid forum-selectionclause. Various options, like waivers ofjury trials in U.S. courts or selection ofparticular branches or divisions of thelocal judiciary, should also be consid-ered when selecting courts as thedispute resolution mechanism.

Consider Investment VehicleNationalityThe nationality of the investment vehi-cle will typically and appropriately bedriven by tax, management or otherpriorities. However, the nationality ofthe investment vehicle may have impor-tant jurisdictional consequences if adispute arises. Investors will be barredfrom U.S. Federal courts if they fail tosatisfy the requirements for diversityjurisdiction. And investors of certainnationalities have protections underinternational law against foreign Statemistreatment of their investmentsunder bilateral investment treaties. Tworecent decisions by the European Courtof Justice should allow for broader

choices of where to incorporate invest-ment vehicles and thus allow forgreater protections afforded by certainjurisdiction’s company laws. See, “TheInspire Art Judgment of the ECJ: NewWays to Structure Acquisitions in theEuropean Union,” elsewhere in thisissue.

Avoid Last-Minute CompromisesDispute resolution issues should beaddressed early in the negotiations, sothat they do not become “deal points”at the 11th hour. Given the typical pres-sure to complete the deal, extraneousconstraints may otherwise prevent theU.S. investor from getting the protec-tion it should have (e.g., foregoing NewYork or English law because the foreignparty has not retained New York orEnglish counsel) or cause inadequatelyconsidered compromises (e.g., achoice-of-law/choice-of-forum trade-offthat results in arbitration in an unsuit-able jurisdiction). — John M. [email protected]

— Mark W. [email protected]

— Kevin M. [email protected]

Proposed HSR Rules (cont. from page 10)

acquiring person’s total investment inthe unincorporated entity) and the sizeof the parties to the transaction meetstandards similar to those set forthabove.

The FTC will accept comments onthe proposed rule-making until June 4,2004. Adoption is considered likely.

One reason is the prospect of addedrevenue; the new rules will result inadditional filings – and additional filingfees. The rules are also likely to besupported because they appear to bringgreater logic and consistency to HSRfiling requirements for joint ventures.

We will update you on the status ofthe proposed rules later this year. — Daniel M. Abuhoff [email protected]

In the last issue of The Private EquityReport we gave an overview of the newIDS product and reported stirrings ofactivity among sponsors and invest-ment bankers. Since then, there havebeen important developments. Inshort order, each of the major ac-counting firms found itself con-sidering several transactions in whichthese yield-based units consisting ofcommon stock and subordinatednotes were to be issued, and they be-gan to raise concerns as to whether it

would be necessary to book a reservefor taxes to cover the risk that the IRSmight seek to recharacterize the notesas equity. Ultimately, the accountantspromulgated a nearly uniform seriesof structural requirements that wouldhave to be met for them to consent tofilings with the SEC. Most important,they indicated that it would be neces-sary to place at least 10% of the debtseparately; that is, not in unit form. Inaddition, they required 10% of theequity to be held outside of the units

for a minimum period of two years.More than a dozen deals were swiftlyrestructured and are now on file, twoquite close to market at press time. Inaddition, faced with such substantialdeal volume, the SEC is also taking afresh look. The details of all of this arestill being worked out, but there isevery reason to expect a flurry of dealsin the marketplace by the summersolstice. — Jeffrey J. [email protected]

Update on Exiting by IDSalert

Tyranny of the Minority? (cont. from page 14)

·· to dispose of their shares as they seefit, without interference from thesubsidiary board and

·· to approve by-law amendments thatare not inconsistent with Delawarecorporate law, even though they maysubstantially impinge on theautonomy of the board.

Strine acknowledged that “[i]n thetypical case, the parent owes nocontractual or fiduciary obligation topermit the subsidiary to proceed” withan asset sale. But in this case, Blackhad undertaken those duties, in lightof his agreement to support thestrategic process. Similarly, althoughStrine found that the by-law amend-ments were not inconsistent withDelaware law, he also found they were“clearly adopted for an inequitablepurpose and having an inequitableeffect” (namely, to enable Black to

breach his fiduciary and contractualobligations to the company), and weretherefore invalid – although he notedthat “it is no small thing to strikedown bylaw amendments adopted bya controlling stockholder.”

With regard to the poison pill,Strine recognized that “fiduciary dutyprinciples ought to take into accountthe legitimate expectations of control-ling stockholders in evaluatingdirectors’ use of a rights plan.” Strinealso expressed his belief that, in theordinary case, the argument that “it isperverse that a subsidiary’s inde-pendent board would use a poison pillto keep its parent corporation fromselling itself” would generally be adecisive one. However, Strine held thatthe adoption of the pill was a reason-able response to the imminent threatthe Barclays transaction posed toHollinger International’s strategicprocess, although he also noted that

once the board completes the strate-gic process, the continued use of thepill “would be suspect, absent furthermisconduct justifying its continueduse.”The bottom line: controlling share-holders retain considerable freedom indealing with their shares and in exer-cising their rights as shareholders.However, they may limit that freedomas a result of promises they make tothe subsidiary, and if they engage ininequitable conduct, they shouldexpect that the Delaware courts will bewilling to step in to protect the inter-ests of the minority shareholders. — Meredith M. [email protected]

— Gary W. [email protected]

— William D. [email protected]


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