Seed Investing Series:

Transcription

1 Seed Investing Series: Seeding investment structures and their US tax considerations By Dave Racich, Natalie Deak Jaros, Seda Livian, Amber Williams, Jesse Shapiro and Chintan Muchhala, Ernst & Young LLP

2 Memories of continuous capital inflow and megafund launches may still linger in the minds of many hedge fund managers, but the events of and the ensuing financial crisis brought an end to those days. The recession that followed spurred increased regulation of the financial services sector that would radically change the landscape. Talented investment professionals looking to launch their own alternative investment management firms in the post-crisis era soon learned that traditional sources of capital such as pension funds, endowments and fund of funds had become cautious in deploying capital. All of these factors together created a niche for seed investors as likely suitors for upstart hedge fund managers. The seed business, whereby start-up capital is provided to fund managers (the manager) in exchange for certain privileges and economic benefits, began to see a sort of renaissance. Seed investors typically include, but are not limited to, hedge funds, private equity funds, international private and government pensions and endowments, family offices, investment banks (investing in manager entities only) and private investors. A significant number of start-up funds in the post-crisis era had some form of seed capital arrangement. Given the current regulatory environment as well as the need for stable capital, seed capital often serves as the startup manager s lifeline. It can help with cash flow needs, make a fund more appealing to institutional investors, help establish proper infrastructure and provide managers with institutional knowledge and experience. This article will focus on the tax considerations of managers being seeded, and is the first in a series of articles that will cover various aspects of seeding arrangements. The seed business is evolving and depending on the needs of the investor (the seeder or seed investor) and the entity receiving the capital (the seeder seeded fund), these arrangements can take many forms. The prevailing theme across all seed arrangements is that each contains a form of sweetener for the seeder in exchange for the risk they take on when injecting start-up capital into a particular manager. The sweetener can range from (i) decreased management and incentive fees charged to the seeder s equity account at the fund level, (ii) a form of revenue share in the management and incentive fees earned by the manager (either at the fund or management company and/or general partner level) or (iii) an equity stake in the management company and general partner entities. The third variation provides for participation in the seed s net profit, giving the seeder potential upside from a future liquidity event such as a sale, management buyout or initial public offering (IPO). These arrangements may also provide the seed with initial infrastructure and operational support, including, but not limited to, developing legal agreements, structuring support, administrative support, office space, etc. Many of the equity-stake models may have built-in exit mechanisms, such as a buyout option. Although the ultimate economic arrangements in most seed deals are similar, the ultimate US tax consequences will vary based upon the terms of the agreements. Although US tax may not always be at the forefront of the business deal, careful consideration should be given to US tax consequences when working through these arrangements. 2 Seed Investing Series: Seeding investment structures and their US tax considerations Seed Investing Series: Seeding investment structures and their US tax considerations 1

3 Most managers are cash basis taxpayers and, therefore, any advance payments of management fees would be taxable in the year they were received. R edu c ed f ee o r no f ee eq u ity c l a ss in th e seeded f u nd: On par with a start-up fund s founder s interest/share class, the seeder will contribute equity directly into the seeded fund and could be charged a reduced management fee or no management fee at all. If charged a reduced management fee, the reduction is typically based on a notional amount of assets under management (AUM) or a percentage of the fees received from other investors, often referred to as a rebate, not to exceed the management fees for which the seeder would otherwise be liable. For tax purposes, this arrangement might create a mismatch with the timing of cash flows to the manager. In certain iterations of this arrangement, the manager may receive prepaid management fees from the seeder. The subsequent rebate serves to return the upfront payment to the seeder, as management fees are earned from other investors. This may create a tax timing difference related to the income inclusion associated with those payments and the timing of associated expenses, depending on the manager s method of accounting. Most managers are cash basis taxpayers and, therefore, any advance payments of management fees would be taxable in the year they were received. However, the seeder will typically earn the rebate quarterly over the course of the year, causing a difference in timing of income recognition to the manager. The example below illustrates the timing mismatch for a cash basis taxpayer that receives management fees upfront from a seed investor. E x a m p l e F und L aunch 1 0 / 1 / Seeder cap ital $ 5 0, 0 0 0, O ther third- p arty $ 2 0 0, 0 0 0, cap ital T otal A UM $ 2 5 0, 0 0 0, Seeder gross $ 1, 0 0 0, ( 2 % of seeder A UM ) T otal management $ 4, 0 0 0, f ees earned f rom other L P s ( 2 % of non- seeder A UM ) T otal management $ 5, 0 0 0, f ees p rior to reb ate Seeder $ 1, 0 0 0, reb ate ( 2 0 % of 2 % of f und A UM ) Seeder net $ - to manager When looked at on a net basis, the seeder will not pay a management fee to the manager. However, the seeder agrees to pay $1,000,000 (one year management fee) up front and receive quarterly rebate amounts over the course of the year as the management fees from the remaining LPs accrue. In this example, even though the fund has launched in October, and the manager has only incurred one quarter of expenses, it will have gross taxable income of $1,800,000 ($1,000,000 of management fees from seeder + $800,000 ($200,000,000 * 2% * ¼ less 20% paid to seeder)). This timing mismatch could create some upfront tax leakage to the manager. The manager could choose to be an accrual basis taxpayer to alleviate some of this burden, but there are other relevant benefi s to being a cash basis taxpayer. C a rried interest a l l o c a tio n: In this instance, the seeder receives a share of the manager s carried interest/incentive allocation. This is often in addition to a reduced or fully eliminated management fee. If the manager generates incentive for the year, the seeder will receive a portion of this income, typically based on a percentage (i.e., 15% or 20%) of the incentive earned by the manager. For tax purposes, this is merely an allocation of the incentive directly to the seeder rather than to the General Partner (GP) and structured a few different ways. The seeder can take its share of the allocation as a Special Limited Partner within the fund or the seeder can take its share of the incentive allocation as a profits interest in the respective GP carry vehicle. In both scenarios the allocation will be a distributive share of income and expense items. The character of the income may include both ordinary and capital gain items. The receipt of capital gain items as opposed to all ordinary income is generally preferable, as it results in a lower overall effective tax rate. Alternatively, if the fund generates effectively connected income (ECI) or state-sourced income, the seeder will also receive an increased share of these items, which may be less desirable to the seeder based on their respective tax sensitivity. 2 Seed Investing Series: Seeding investment structures and their US tax considerations 3

4 W A seeder may also choose to provide a loan directly to the manager. Management fee profit share: In this scenario, the seeder receives a portion of the manager s management fee revenue, which can be structured multiple ways. The manager could arrange to pay the seeder based on gross income, without regard to expenses. For tax purposes, such payments may be characterized as guaranteed payments. This arrangement could also exist in situations where the seeder receives a reduced management fee, or a management fee rebate that exceeds the management fee they are paying. Alternatively, the payments to the seeder could be related to net profits, taking into account both revenue and expenses of the manager. The sharing of management fee revenue may be earned directly from the manager, or structured through an interest in the fund and indexed to the fees earned by the manager. The two structures will have very different tax effects. Depending on the form of the arrangement, the management fee revenue earned through an interest in the manager could be viewed as income from a trade or business or potentially as a guaranteed payment for the use of capital. If the manager is operating in the US, the income may be deemed as either effectively connected income to ECI to a US trade or business or Fixed Determinable Annual Periodic (FDAP) Income. If the management company is located outside the US, the income will be foreign sourced and could create a local tax issue for the seeder in that respective non-us jurisdiction. All factors should be examined in considering this approach including whether the seeder entity receiving this income stream is a US or non-us taxpayer. Whether the seeder is sensitive to ECI or state and local taxes will depend on the type of entity receiving the profit share on behalf of the seeder. If the seeder is investing through their respective fund structure, they should be mindful of potential withholding implications to the extent they have any foreign partners. Managers should be cautious of any withholding obligations they may have with respect to distributions paid to foreign partners. Corporate blockers can be used to mitigate ECI leakage to the seeder; however, there will be inherent tax inefficiency as a result of using a blocker. Seeders earning their income via a net profits interest in the management company would receive an allocation of all income and expense items. However, this arrangement only tends to occur when there is a broader, longer-term business relationship with the manager, as some of the aforementioned tax issues could make this form of economic investment more complicated for the seeder. o rk ing c a p ita l l o a n A seeder may also choose to provide a loan directly to the manager to assist with launch and building of infrastructure. The main issue from a tax perspective is to determine if the agreement qualifies as debt for tax purposes or if the agreement could be viewed by as disguised equity. Some factors to consider include whether the seeder has creditor rights; whether there is a stated maturity for the loan; the timing of full payout of principal in the future; and whether the loan constitutes the majority of the fund s capital. Assuming the loan is respected as such for federal tax purposes and the manager is based in the US, the interest will likely not qualify for the portfolio interest exemption and could be considered US source income subject to FDAP withholding. The aforementioned structures are some of the more common ones, and seeders can utilize any combination thereof. The terms and structures of these deals will play a significant role in the overall tax efficiency of the arrangement, as will the ultimate exit strategy of the seeder. As part of any seed arrangement, the tax implications should be an integral aspect of the analysis by both the seeder and the manager. Significant upfront planning is essential as unanticipated tax consequences may arise during formation or upon exit from the arrangement. 4 Seed Investing Series: Seeding investment structures and their US tax considerations Seed Investing Series: Seeding investment structures and their US tax considerations 5

5 A b o u t th e a u th o rs: D a ve R a c ic h dave.racich@ey.com Dave is partner in the Wealth & Asset Management Tax N a ta l ie D ea k J a ro s natalie.deak@ey.com Natalie is a partner in the Wealth & Asset Management Audit Seda L ivia n seda.livian@ey.com Seda is a partner in the Wealth & Asset Management Tax A m b er W il l ia m s amber.williams@.ey.com Amber is a senior manager in the Wealth & Asset Management Tax J esse Sh a p iro jesse.shapiro@ey.com Jesse is a partner in the Wealth & Asset Management Audit E Y Assurance Tax Transactions Advisory A b out E Y EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confiden e in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization, and may refer to one or more, of the member firms f Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com. EY is a leader in serving the global financial services marketplace Nearly 43,000 EY financial ervices professionals around the world provide integrated assurance, tax, transaction and advisory services to our asset management, banking, capital markets and insurance clients. In the Americas, EY is the only public accounting organization with a separate business unit dedicated to the financial ervices marketplace. Created in 2000, the Americas Financial Services Offi e today includes more than 6,900 professionals at member firm in more than 50 locations throughout the US, the Caribbean and Latin America. EY professionals in our financial ervices practices worldwide align with key global industry groups, including EY s Global Wealth & Asset Management Center, Global Banking & Capital Markets Center, Global Insurance Center and Global Private Equity Center, which act as hubs for sharing industry-focused knowledge on current and emerging trends and regulations in order to help our clients address key issues. Our practitioners span many disciplines and provide a well-rounded understanding of business issues and challenges, as well as integrated services to our clients. With a global presence and industry-focused advice, EY s financia services professionals provide high-quality assurance, tax, transaction and advisory services, including operations, process improvement, risk and technology, to financial ervices companies worldwide EYGM Limited. All Rights Reserved. SCORE No. CK1027 ED None This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax, or other professional advice. Please refer to your advisors for specific advi e. ey. com The views expressed herein are those of the authors and do not necessarily reflect the views of Ernst & Young LLP. C h inta n M u c h h a l a chintan.muchhala@ey.com Chintan is a senior manager in the Wealth & Asset Management Audit