Private Equity Fund Law Blog

Gergen:  The Case for Taxing Private Equity as Ordinary Income

Mark Gergen (UC-Berkeley) has published A Pragmatic Case for Taxing an Equity Fund Manager’s Profit Share as Compensation, 87 Taxes 139 (March 2009):

This article responds to a challenge David Weisbach has put to proponents of taxing a private equity fund manager’s profit share as compensation. [David A. Weisbach, The Taxation of Carried Interests in Private Equity, 94 Va. L. Rev. 715 (2008).] In a spirited defense of the status quo, Weisbach objects to arguments for change that rely on the analogy of a fund manager’s profit share to a compensatory stock option and contingent compensation. His objection to reasoning by analogy in the tax area is more general. The general objection grounds on the premise that principles and concepts of tax law are of secondary relevance in resolving issues of tax policy. To put it baldly, the premise is that when deciding how to tax transaction x a policymaker should care about existing tax law rules that apply to transaction y only insofar as the y rules might alter the response of taxpayers within the intended field of the x rules in undesirable ways. This perspective disregards arguments of fairness or horizontal equity. In this essay I respond to the specifics of Weisbach’s defense of the status quo while accepting his normative premises, taking up the challenge to make a case for proposed Code Sec. 710 that does not depend on argument by analogy or about the unfairness of taxing fund managers at lower rates than working people. I hope to persuade you that proposed Code Sec. 710 stands up pretty well from this perspective.

The immediate question is how to tax a private equity fund manager’s profits share when the profits apparently are a return for time, effort, expertise, and knowledge the manager provides to a fund. Under current law a manager’s profit share is taxed as capital gain if this is the character of the income to a fund, which typically it is. Proposed Code Sec. 710 taxes a manager’s profit share as compensation subject to ordinary rates and to self-employment taxes except insofar as the profits represent a reasonable return on capital invested by a manager in a fund. This is similar to an approach to taxing a service partner in a capital intensive partnership that I advocated over 15 years ago. [Mark P. Gergen, Reforming Subchapter K: Compensating Service Partners, 48 Tax L. Rev. 1 (1992).]

The gist of the pragmatic argument against trying to tax a fund manager’s profit share as compensation is that the effort will complicate tax law while raising little or no revenue because people can easily design around the new rule. I believe this argument rests on unrealistic assumptions about the salience of tax considerations to contract design in the private equity market and about the fl exibility of contract design. But this is no more than a hunch based on past behavior in the area and in related areas. What I do in this article is to use a simple model to identify the least intrusive ways people might restructure a fund to minimize the impact of Code Sec. 710 while preserving a fund’s basic economic structure. The analysis shows that it is difficult for people to dodge most of the brunt of Code Sec. 710 without fundamentally changing a fund’s economic structure. The analysis also suggests a few ways in which Code Sec. 710 can be strengthened. And it clarifi es the key tradeoffs and unknowns facing policymakers in this area. I will address the questions of how to treat equity investors, how to defi ne a reasonable return on a fund manager’s invested capital, how to handle revaluations of a manager’s invested capital, how to handle investor debt-financing of a manager’s invested capital and how to deal with a hybrid financial structure in which the limited partnership interest is a mix of debt and equity. I do not address questions about the scope of Code Sec. 710, nor do I address strategies to avoid Code Sec. 710 that involve restructuring a fund as a corporation.

The video below provides details on hedge fund manager Blackstone refusing a request by the SEC to provide information on the returns of its hedge fund and private equity fund returns. Blackstone will not disclose this performance in its filings to investors (although Fortress complied with the SEC request). For more information on this story, please also see this article.

The video also discusses Google’s plan to commit $100 million to its own private equity fund which will be called Google Ventures. The goal of Google Ventures will be to manage returns.

Other news: Aquila announces the launch of a $400 million hedge fund which will invest in farm properties. The fund will target returns of 20%. There was also news of a hedge fund loan restructure on which Och-Ziff gets absolutely pummelled.

Aquiline Capital Partners LLC Invests in HedgeServ Holdings

HedgeServ Addresses the Increased Industry Demand for External Administration With Real-time Transparency and Reporting

NEW YORK–(BUSINESS WIRE)–Aquiline Capital Partners LLC (“Aquiline”), a New York based private equity firm investing in financial services, today announced it has made an investment in HedgeServ Holding LP (individually and collectively with its affiliates “HedgeServ”), a hedge fund and fund of hedge fund administrator with offices in New York City and Dublin, Ireland. Aquiline will provide growth capital to fund HedgeServ’s development and expansion.

HedgeServ is well positioned to take advantage of a number of broad hedge fund industry trends, including a shift towards efficient, outsourced solutions for administrative processes and increased transparency demands from investors and regulators. The Company leverages a powerful new technology platform to provide its clients with access to the critical, real-time information required to run their businesses, from trading and managing risk through providing information to investors and regulators. The Company’s offering is differentiated by both its innovative technology and its team of experienced professionals. HedgeServ’s senior management has previously built leading companies in the hedge fund administration industry. The Company is led by James Kelly and Gene Mannella, founders of International Fund Services, and Robert Aaron, founder of DPM.

“With its record of success in building hedge fund administration companies and creating solutions for the evolving hedge fund industry, HedgeServ’s entrepreneurial management team positions the company well to address current market dynamics,” said Jeff Greenberg, chief executive of Aquiline. “It is an opportune time to back an industry participant with HedgeServ’s unique capabilities and service model.”

“Recent industry events have made real-time access to data on positions, pricing and risk critical issues for industry participants. HedgeServ provides hedge fund managers with an efficient means to address these key issues,” said Mr. Kelly. “Aquiline’s depth of experience in the asset management industry makes them an ideal partner for HedgeServ as it builds its business.”

About Aquiline Capital Partners LLC

Aquiline is a private equity firm based in New York investing in financial services enterprises in industries such as property and casualty insurance, banking, specialty finance, securities, asset management, life insurance, and transaction processing. Aquiline seeks to add value to its portfolio companies through strategic, operational, and financial guidance.

About HedgeServ Holdings LP

HedgeServ provides a powerful new technology platform and an advanced service model to enable hedge funds to meet the demands of a dynamically evolving industry. HedgeServ companies are located in New York City and Dublin, Ireland. HedgeServ Ltd. is a registered fund administrator with the Irish Financial Services Regulatory Authority (IFSRA). HedgeServ employs over 150 of the most experienced and capable industry professionals.

Contacts

For Aquiline Capital Partners:
Finsbury Group
Andy Merrill / Tripp Kyle
+1-212-303-7600
andy.merrill@finsbury.com
tripp.kyle@finsbury.com
or
For HedgeServ:
Ermis Financial
Caroline Chartier, +1-212-810-9218
cac@ermisfinancial.com

Private equity funds, much like hedge funds, are undergoing a sea change.  As hedge fund and private equity fund investors demand more performance reporting and increase their due diligence requests, managers are going to need to respond with more information than ever before.

****

Houlihan Smith to Co-Host Panel on the Changing Landscape of Fund Reporting

NEW YORK, Feb. 11 /PRNewswire/ — Houlihan Smith & Company, Inc. will be co-hosting an upcoming Private Equity breakfast seminar on “The Changing Landscape of Fund Reporting: What it means for the Limited Partners and Fund Sponsors.” The event will be held at the Penn Club in New York City on March 4th. The event will feature Dan Katsikis, COO and CFO, of J.C. Flowers & Co. as its moderator.

Karl D’Cunha, Senior Managing Director at Houlihan Smith, will serve as a panelist for the breakfast discussion. Joining D’Cunha will be John Wiencek, Managing Director of Mourant Fund Services, and Thomas Bell, Partner at Simpson Thacher & Bartlett LLP. In an environment where Private Equity firms are facing complex valuation and reporting questions, these industry leaders will discuss critical issues and emerging trends facing limited partners and fund sponsors.

D’Cunha heads the Financial Advisory Group at Houlihan Smith, which provides fairness opinions, solvency opinions, complex valuations, and structured finance advisory. He is also co-head of the firm’s Hedge Fund Advisory Services Group and team leader of its Technical Standards Committee. He has worked with the world’s largest private equity firms and hedge funds on valuation, accounting, and compliance issues.

HOULIHAN SMITH & COMPANY INC. (houlihansmith.com, hedgefundvaluation.com and hedgefundrestructuring.com) is a specialized investment banking firm that provides financial advisory and financing services to public and private businesses. Founded in 1996, Houlihan is recognized as a leading provider of financial opinions, financing, merger and acquisitions advisory, and other corporate advisory services. The Houlihan name is synonymous with deal-making expertise and leadership in valuation and fairness issues. Houlihan has experienced professionals located in Chicago, New York and Los Angeles. Houlihan has represented dozens of Committees on a broad range of financial matters and is a member in good standing of the Financial Industry Regulatory Authority (FINRA) and registered as a licensed broker-dealer.

Karl D’Cunha, CA

Senior Managing Director

Houlihan Smith & Company, Inc.
105 W. Madison, Suite 1500
Chicago, IL 60602
tel: 312-499-5900
fax: 312-499-5901

http://www.houlihansmith.com

http://www.fairnessopinion.com

http://www.solvencyopinion.com

Registration Likely under Hedge Fund Transparency Act

The bill recently submitted to the Senate by Senator Charles Grassley may require private equity fund managers to register with the SEC and subject private equity funds to certain disclosure requirements.  The Hedge Fund Transparency Act would replace the current exemptions found in the Investment Company Act with more onerous registration provisions.  It is unclear right now whether the bill will make it through Congress without changes; it is also unclear whether Grassley intended for private equity and venture capital funds be included in the act.  In addition to requiring hedge fund registration, the Act would require funds to disclose the names and addresses of their investors.  The Act also requires funds to implement certain AML requirements.

If you are a fund manager and have questions about private equity fund registration, please feel free to contact us.

Private equity law firms generally provide start up and ongoing legal services to private equity firms.  Many of these law firms are the major national and international law firms.  While these law firms do create a great deal of value for their clients, smaller “boutique” private equity and investment management law firms can often provide a great deal of value to client while minimizing legal costs.

Private Equity Fund Formation Services

The central service which private equity law firms provide is the actual formation of the private equity fund which will generally include the following services

• Establishing the entities which will act as the fund (and management company if appropriate)
• Drafting the private placement memorandum (sometimes referred to as the offering memorandum)
• Drafting the limited partnership agreement (these are the governing legal documents)
• Drafting a subscription agreement
• Providing capital call assistance
• Provide ongoing transactional assistance

What to look for in a private equity law firm?

Each private equity firm is different and has different needs.  A firm may have limited legal needs outside of the initial fund formation process.  Some funds need extensive ongoing legal assistance; for example, some firms will need a law firm to help draft and negotiate private placement investments in portfolio companies.  A firm should first determine what these immediate and ongoing needs are.  Once these needs are established the firm can then go lawyer shopping.

There are two central concerns that private equity firms should consider: cost and service.

Cost – generally the initial fund formation is done on a flat fee basis.  The costs can range significantly.  Some boutique law firms can provide the fund formation service for $20,000 to $35,000 depending on the private equity strategy employed.  More established firms will start at $45,000 or $50,000 for basic fund formation services.  The top tier very large international law firms will start at $75,000 or more for basic fund set up.

Ongoing legal work is usually billed to the client on an hourly basis.  Boutique firms bill associates out at around $150-$350 while partners will bill out anywhere from $400-$700 an hour.  Larger law firms will bill associates out at $250-$500 and partners will bill out at anywhere from $600-$1,000, depending on the partner’s level of expertise.  The attorney should be able to provide the private equity firm with an expected cost on any project billed on an hourly basis.

Services – generally the law firm will provide all of the necessary services needed by the private equity group, however the question is whether the services will be provided by uninterested partners and overworked associates.  At very large law firms, the partner’s attention is usually focused on the clients who bring in the most work.  Accordingly most work gets handed down to overworked associates who have a decreased incentive to keep the client happy.  Many private equity groups become frustrated with this structure.

Boutique law firms typically provide greater partner involvement in all aspects of the relationship which groups tend to prefer.  The boutique law firm generally provides work that is as sophisticated as the large law firm while providing the client with more “face to face” time.

Contact a Private Equity Law Firm today

Our group of experienced private equity attorneys are here to help you start your fund or complete a transaction.  Please contact us today to discuss your firm and your goals, you can also contact us at 404-550-3554.  We look forward to helping you.

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SEC Charges Silicon Valley Venture Capitalist William J. “Boots” Del Biaggio III With Defrauding Clients and Banks Out of $65 Million

The Commission filed today a civil injunctive action against Silicon Valley venture capitalist, William J. “Boots” Del Biaggio III, in federal district court in the Northern District of California alleging that he engaged in two distinct securities fraud schemes, defrauding investors, banks and private lenders out of $65 million. Del Biaggio used the funds to maintain a lavish lifestyle, which included buying an interest in a professional hockey team, satisfying substantial gambling debts, and paying expenses on his family’s luxury home. Without admitting or denying the complaint’s allegations, Del Biaggio has agreed to a permanent injunction from further violations of the antifraud provisions of the federal securities laws. In addition, Del Biaggio has consented to the institution of public administrative proceedings against him in which he will be barred permanently from serving as an investment adviser. Finally, Del Biaggio also has agreed that, at a later date, the court in this matter shall determine the amount of ill-gotten gains (disgorgement) and civil monetary penalties that Del Biaggio shall be required to pay.

According to the Commission’s complaint, Del Biaggio engaged in two distinct securities fraud schemes. First, Del Biaggio fraudulently pledged securities owned by innocent customers of a San Francisco-based broker dealer as collateral for more than $45 million in personal loans. Beginning in August 2007, Del Biaggio obtained brokerage account statements of unknowing customers with the help of a friend who was a managing director at a San Francisco brokerage firm, and then falsified the account statements to make it appear that Del Biaggio owned the assets in the accounts. To obtain more than $45 million in loan proceeds, Del Biaggio supplied the forged account statements to multiple banks and private lenders and signed agreements pledging the securities in the innocent customers’ accounts. As alleged in the complaint, Del Biaggio used $25 million of the loan proceeds to purchase an interest in the Nashville Predators professional hockey team, and used the rest for other personal expenses.

In the second scheme, according to the Commission’s complaint, Del Biaggio misappropriated more than $19 million from individual investors he advised. The Commission alleges that between 2003 and 2008, Del Biaggio used his reputation as a prominent venture capitalist and role as the founder and CEO of established venture firm Sand Hill Capital L.P. to entice dozens of his advisory clients to invest in three investment funds he formed. The complaint alleges that Del Biaggio then misappropriated the money or used it to buy stocks which he then pledged as collateral for personal loans. The Commission alleges that Del Biaggio used the proceeds of his fraud to pay for other business and personal expenses. [SEC v. William J. "Boots" Del Biaggio III, Case No. CV- 08-05450 (JCS) (N.D. Cal.](LR-20820)

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