ALI-ABA Course of Study Sophisticated Estate Planning Techniques

Transcription

1 397 ALI-ABA Course of Study Sophisticated Estate Planning Techniques Cosponsored by Massachusetts Continuing Legal Education, Inc. September 4-5, 2008 Planning for Private Equity Professionals By Marc J. Bloostein Ropes & Gray L

2 398 2

3 399 PLANNING FOR PRIVATE EQUITY PROFESSIONALS Marc J. Bloostein Ropes & Gray L I. INTRODUCTION Private equity funds are investment vehicles that raise capital for the purpose of making private investments in business enterprises. These include, for example, venture capital funds and leveraged buy-out funds. In general, investors subscribe at the outset to contribute a fixed amount of capital throughout the life of the fund. The capital is drawn down as individual investments are made, and no capital is returned to investors until an individual investment is disposed of. Typically, the individuals who manage these funds are compensated in part with a carried interest in the fund, which is a special kind of partnership interest that entitles them to a share of the profits of the entire fund (not just on the capital they invested). This carried interest is a unique currency that may be used for gifts to family members it has a relatively small value at the outset of the fund because the cash flow that it will produce is largely unpredictable, but if the fund is successful, the actual cash flow can be worth many times the original gift tax value of the carried interest. Transferring carried interests can be complicated. Private equity funds are typically organized as a series of tiered partnerships (or entities taxed as partnerships), and it s often a big task just to understand how the fund is structured in the first place. Once the structure is clear, there are a number of technical issues to consider in determining whether it s even possible to make a completed gift of the particular carried interest. There are also valuation issues, including the potential application of the special valuation rules of I.R.C These materials will explain the typical private equity fund structure (Section II); analyze the transfer tax and other issues that often arise in connection with transferring carried interests (Section III); and outline strategies for transferring carried interests in the context of the fund manager s overall estate plan (Section IV). II. UNDERSTANDING THE FUND STRUCTURE It is crucial to understand what property interests a private equity fund manager (referred to as a Fund Principal or Principal ) has in order to determine whether carried interests may be transferred and how a transfer would be effectuated. Therefore, the planner needs to understand the structure of the Fund (all the entities making up a particular private equity fund will be referred to collectively as the Fund ) what are the different entities, how are they related to one another, and what interest does the Principal have in each entity? In addition, it is important to understand the economics of the Fund how are management fees and profits allocated? The carried interest is generally reflected in the allocation provisions of the lowest tier Fund entity, the limited 2008 by Marc J. Bloostein. All rights reserved _5.DOC

4 400 partnership that holds the invested capital. Often there is an organizational chart available that depicts the various entities that make up the Fund, and such a chart can be very helpful in understanding the structure. A. Typical Fund Structure 1. The Fund Limited Partnership The entity in which investors ( Fund s ) actually invest is typically a limited partnership (the Fund Limited Partnership ), and the Fund Limited Partnership holds title to the assets the Fund acquires. Sometimes there are two or more separate Fund Limited Partnerships organized to accommodate differently situated investors. For example, there might be a U.S.-based entity for taxable U.S. investors and an offshore entity for tax exempt and foreign investors, and there might be an entity suitable for investors who meet certain investor qualification requirements and one for those who do not. 2. The Fund A separate entity (the Fund ) serves as general partner of the Fund Limited Partnership (or of each of the Fund Limited Partnerships if there is more than one). The Fund is typically a limited partnership or a limited liability company, and the Fund Principals are typically limited partners or members of the Fund. Often another entity, a limited partnership or limited liability company, will serve as or manager of the Fund. 3. The Management Company A separate Management Company usually provides management and administrative services to the Fund. Typically it has no ownership interest in the Fund but provides services on a contractual basis in exchange for a management fee. The Management Company is often organized as a limited liability company. Fund Principals will typically be employees of the Management Company, and some or all may have an ownership interest in the Management Company. 4. Other Fund Entities There may be other entities on the organizational chart in addition to those listed above. There may be a separate entity through which principals coinvest in the portfolio companies. There may be tiers of entities above the Fund, and there may be a limited partner entity receiving some allocation of carried interest that in turn allocates distributions among Fund principals or employees. See Illustration 1: Typical Fund Structure _5.DOC -2-

5 401 Mgt. Co. [LLC] Management Agreement Managing Members Fund Principals Key Fund Principals Managing Members [Limited Partnership] of [LLC] Fund Limited Partnership Fund s [Investors] Portfolio Companies [Corporations] Illustration 1: Typical Fund Structure B. Economics 1. Capital Contributions Fund s sign subscription agreements in which they agree to contribute a specified amount of capital when the Fund calls it. The Fund has a capital commitment to the Fund as well, often in the range of 0.2% to 1% of the Fund. In addition, the Fund Principals may agree to invest additional dollars alongside the Fund directly in the Fund s portfolio companies. The Fund typically issues a capital call notice just prior to when it needs funds for an investment. It is impossible to predict with any kind of certainty how long it will take for a Fund to be fully invested and how long a Fund will hold investments before disposing of them, although one can get a rough idea by looking at the history of predecessor Funds. 2. Management Fees A Fund typically pays management fees to the Management Company on a quarterly or other regular basis. A typical management fee is 2% of committed capital per annum. 3. Allocation of Investment Returns _5.DOC -3-