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Structuring Private Equity Co-Investments and Club Deals: Risks and Opportunities for Sponsors and InvestorsChoosing the Right Investment Structure, Key Deal Terms, Tax and Regulatory Ramifications

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WEDNESDAY FEBRUARY 27, 2019

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

Alex Gelinas, Partner, Sadis & Goldberg, New York

Steven Huttler, Partner, Sadis & Goldberg, New York

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

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Structuring Private Equity

Co-Investments and Club Deals:

Risks and Opportunities for

Sponsors and Investors

Choosing the Right Investment Structure, Negotiating Key Deal Terms, and Navigating Tax and

Regulatory Ramifications

February 27, 2019

Steven Huttler, Partner

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

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

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Alex Gelinas, Partner

Sadis & Goldberg LLP

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

In addition, Mr. Gelinas has extensive experience with respect to the “plan assets” and other ERISA regulatory issues applicable to sponsors of, and institutional investors in, onshore and offshore hedge funds, private equity funds and other pooled investment vehicles, including funds-of-funds. He has published many articles and lectured on various tax and ERISA regulatory subjects applicable to the investment management industry. Mr. Gelinas has practiced tax law with major law firms in New York City for several decades.

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Daniel G. Viola, Partner


Daniel G. Viola is a Partner of Sadis & Goldberg LLP and is the

Head of the Regulatory and Compliance Group. He structures and

organizes broker-dealers, investment advisers, funds and regularly

counsels investment professionals in connection with regulatory and

corporate matters. Mr. Viola has been active in the Blockchain and

Virtual Currency verticals since 2014. He is also the founder of the Crypto

Asset Webinars and serves as an advisory board member to several ICOs.

Mr. Viola served as a Senior Compliance Examiner for the Northeast

Regional Office of the SEC, where he worked from 1992 through 1996.

During his tenure at the SEC, Mr. Viola worked on several compliance

inspection projects and enforcement actions involving examinations of

registered investment advisers, ensuring compliance with federal and

state securities laws. Mr. Viola’s examination experience includes

financial statement, performance advertising, and disclosure document

reviews, as well as, analysis of investment adviser and hedge fund issues

arising under ERISA and blue-sky laws.

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Overview of Presentation

I. Co-investment structures

II. Economic & Legal Rights of Co-Investor vis-à-vis Investment and Sponsor

III. Economic & Legal Rights of Fund and Limited Partners Relating to Co-Investment

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

V. Tax and ERISA regulatory considerations for sponsors and investors

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Co-Investments & Club Deals: Global

Marketplace Trends• Countervailing

• But in Place for a Good Number of Years

• Dealflow: Paucity of Good, Well Priced Deals

▫ Too Many $ Chasing Too Few Deals

▫ Deep into PE Cycle – many, many players

• Fund Skepticism

▫ Stated Preference for Direct Investments

▫ Skepticism to Investment Funds with Fees

❖ Perception of lack of alignment

• Realty vs. Rhetoric

▫ Rhetoric: “Funds are Over”

▫ Reality: Most Large Investors Don’t Have Infrastructure to Supervise Direct Investment

▫ Nevertheless: Many institutional Investors and Family Offices have Geared Up Infrastructure for Direct Investors

❖ Even More Institutional Investors and Family Offices Seem to Believe that they Have This Infrastructure

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Co-Investments & Club Deals:

Definitions

• Co-Investment

Investment in portfolio company (or other asset) along side investment fund or similar vehicle

• Club Deals

“Stand-alone” investment by multiple investment funds and/or other buyers in portfolio company (or other asset)

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Issues Overview

• Structure

• Economic & Legal Rights of Co-Investor vis-à-vis Investment and Sponsor

• Economic & Legal Rights of Fund and Limited Partners Relating to Co-Investment

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Structures• Co-Investment Investment Vehicle or Other Structure vs. Direct Investment

• Co-Investment Investment Vehicle

▫ SPV

▫ Fund of One

▫ Managed Account

• Co-Investment Direct Investment

▫ In theory, direct relationship between Portfolio Issuer and Investor

▫ Investors can be “Controlled” to act Together

▫ Voting Agreements

▫ Other Structural Tactics to Join Parties

❖ E.g., notes and other instruments requiring majority to act

• Club Deals

▫ More likely to be direct relationship between Portfolio Issuer and Investor

▫ But Since such deals are Often Entered into Public Company Setting, not unusual to Impose terms Requiring Investors to act Together

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Private Equity Fund Structure

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Co-Investment Structure: SPV

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Co-Investment Structure: Fund of One

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Co-Investment Structure:

Managed Account

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Co-Investment Structure:

Direct Investment

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Club Deal Structure

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Target Co.

Co-Investment: Why Investment

Vehicles• Strongest Control Exerted Over Assets

▫ All assets often held and sold together: pre-emptive, co-sale rights (drag/tag)

▫ Ensure consistent behavior by investors

▫ Prevent veto or chaotic behavior by single investor (esp. large groups)

▫ Counterparty (Portfolio Company) prefers “a single address”

▫ Counterparty generally deals with Sponsor that brought deal together

• Charge Fees and Expenses

▫ Performance Allocations

Fund like at 20% or the like

But existing LPs often negotiate to pay less

▫ Management Fees

If they exist, they are typically lower than fund (e.g., 1% vs. 2% etc.)

But again existing LPs often insist on no such fees

▫ Other Fees

▫ Expenses

Ease of administration for charging expenses equally

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Co-Investment: Which Investment

Vehicles• SPV

▫ Multiple Investors

▫ Sponsors like Structure to Control Expectations for:

❖ Fees – more likely in such structures compared to below (but still generally lower than those of fund)

❖ Control – investors often need to negotiate for ability to exercise different rights to invest and/or sale separately – structure not set up for it as much

▫ Large Institutional Investors, Family Offices Might Prefer Alternatives if Making a Large investment

❖ Ensure consistent behavior by investors

• Fund of One

▫ One Investor

▫ Can Co-exist with SPV with Multiple investors, or be an alternative

▫ Tailored Terms

▫ Still Sets Fund-like expectations for:

❖ Fees

❖ Expenses

❖ Control

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Co-Investment: Which Investment

Vehicles (cont.)

• Managed Account

▫ One Investor

▫ Can co-exist with SPV and Funds of One, or be an alternative

▫ Tailored Terms

▫ Can be Different (not “Fund-like”) expectations for:

❖ Fees

❖ Expenses

❖ Control

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Economic & Legal Rights of Co-Investor

vis-à-vis Investment and Sponsor

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Economics of Sponsors of PE Funds and

Co-Investment Vehicles (etc.)

• How do Fund Sponsors make money?

▫ Management fees

▫ Transaction fees

▫ Carried interest

▫ Other fees

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Contrast: Private Equity Economics vs.

Co-Investment Entities (etc.)

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

• Transaction Fees: Until recently, advisory, consulting or transaction fees, break-up fees, etc. (but see SEC actions in last couple of years)

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

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Affiliate Transactions/Advisory Fees

• Confirm existence of affiliate transaction provision

▫ Formulation: unless (i) approved by independent LPs of the like, and/or (ii) bona fide transaction on arm’s length terms.

▫ If only includes (ii) above, must negotiate advisory fees paid to the lead sponsor or affiliates.

▫ Most sponsors will agree to limits to a defined amount or to methodology (e.g., ties EBITDA thresholds, ultimate caps) that is disclosed up front before you invest.

• Diligence: a copy of the advisory agreement

▫ Confirm that it terminates automatically on an exit

▫ Confirm that the lead sponsor is not “over-protected” (e.g., indemnified for gross negligence or misconduct)

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Preemptive Rights

• Preemptive rights extremely common to co-investors, especially in direct investment settings

• Co-investor should insist on them in almost every circumstance

• Two key aspects of preemptive rights often not addressed appropriately:

▫ Subsidiary Issuances – not just TopCo/SPV

Avoid financial and structural subordination

▫ Issuances in Connection with Future Acquisition

Background: common exception to preemptive rights is issuances of equity related to a future acquisition of another business.

Often drafted as “an issuance made in connection with an acquisition”

❖ Drafting is ambiguous, allows two interpretations of the scope of equity issuances exempted from preemptive rights: (1) equity issued to the target or its owners as consideration for the acquisition itself and (2) equity issued to raise capital to fund the purchase price for the acquisition. An exception to your preemptive rights in the case of (1) is common and acceptable dilutions, but you should not be excluded from participating in (2) because it is a capital raise.

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Special Purpose or Co-investment

Vehicles

• “Back-to-back rights” or typical rights in PE deals

▫ Key substantive co-investor rights: tag-along rights, preemptive rights, and even rights to tax distributions

Should be implemented into the governing documents of co-investment vehicle, so that investor can make independent decision about how and when to utilize them

• Veto on syndicator transfer

▫ Managing member/general partner remain the lead sponsor for the life of investment or at least until the lead sponsor exits the investment to a substantial degree

Argument: SPV governing documents for most vehicles already impose tight transfer restrictions on LPs, but non on the managing member or general partner to transfer or delegate its rights and authority to act in that role. Ask for consistency in this regard.

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IPO Scenarios

• LLC/LP issuers:

▫ Docs contemplate restructuring of issuer for IPO

▫ Members/LPs: must facilitate the conversion to corporation

• Sometimes: “Up-C” structure

▫ Allow typical corporate IPO but still allow pre-IPO investors to be LPs/Members

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Unwitting Restrictive Covenants

• Co-investor almost universally means being subject to a drag-along provision rights

• Drag-along provisions typically contain broadly worded covenants requiring the dragged investors to take all actions requested/execute all documents/not block impede exit transaction

▫ Usually coupled with a power of attorney

▫ Might request that these broadly worded covenants exclude any requirement to become bound by a non-compete, non-solicit, or similar restrictive covenant

▫ At a minimum, co-investor should not be subject to more restrictions than lead sponsor

▫ If co-investor has any commercial relationship with the divested company (such as a license, supply agreement, etc., not unusual for a strategic co-investor) – co-investor should also not be required to modify its terms or extend or renew the commercial agreement by operation of these broadly worded covenants

▫ Should be expressly excluded from the drag-along’s requirements

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Board Seats

• Board Committees

• Subsidiary Boards

• Confirm “primary” indemnification (Delaware Chancery Court’s decision in Levy v. HLI Operating Co., 924 A.2d 210 (Del.Ch. 2007)).

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Economic & Legal Rights of Fund and

Limited Partners Relating to

Co-Investment

• Perspective of Fund, Sponsor and Limited Partners (not for deals)

▫ Within Context of Launch of Fund

• Co-Investment disclosures in PPM

▫ Allocation of such Opportunities: Formula

▫ Sponsor willing to Commit?

❖ Other constituencies for deals: management, deal stores

• Expectations of institutional investors/family offices

▫ In historically crowded PE fund field, sponsors must offer these to attract investors

▫ Expectations of lower fees for LPs – or none

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Regulatory hurdles: broker, dealer

and investment adviser regulation

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Frequently Overlooked Regulatory

Considerations

• Broker-Dealer Regulation

• Investment Adviser Regulation

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Broker-Dealer Regulatory Considerations

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

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

• Compliance professionals insist on greater compliance with registration

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

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

• Such parties expect to be compensated

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Investment Adviser Considerations

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

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

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

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Investment Company Act

• Need for exemption under ICA

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

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

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

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

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Tax Considerations in Structuring Private Equity

Co-Investment Transactions

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

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

A. US “Fortune 500” Pension Funds

B. US University and College Endowment Funds

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

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

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

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

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Co-Investment Transactions (cont.)

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

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

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

2. US TAXABLE INSTITUTIONAL INVESTORS

A. Publicly Traded “C” Corporations

B. Insurance Companies

C. Private “C” Corporations

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

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

A. Family Offices (typically partnerships of individuals)

B. High Net Worth Individuals

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

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4. FOREIGN TAXABLE INVESTORS

A. Foreign Corporations

B. Foreign High Net Worth Individuals and Family Offices

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

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

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

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5. SOVERIGN WEALTH FUNDS

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

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

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Diagrams of Co-Investment Structures

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Diagrams of Co-Investment Structures

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ERISA Considerations Relating to Private Equity

Co-Investment Transactions

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

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

A. General Rules on Plan Assets Status

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

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

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

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

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B. Operating Company Definition

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

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

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

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VCOC Definition

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

REOC Definition

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

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If you have questions, please contact:

Steven Huttler

212.573.8424

[email protected]

Alex Gelinas

212.573.8159

[email protected]

Daniel G. Viola

212.573.8038

[email protected]


551 Fifth Avenue, 21st Floor

New York, NY 10176

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