Fund Appreciation Rights

Transcription

1 Fund Appreciation Rights What They Are and How They Can Work for Institutional Investors and Hedge Fund Managers Panelists: Joel D. Almquist, K&L Gates Partner James E. Earle, K&L Gates Partner Rick Ehrhart, Optcapital Nicholas S. Hodge, K&L Gates Partner Thom Young, Optcapital FAR is a registered trademark of Optcapital

2 FARs : What and Why?

3 The Alignment Challenge Alignment of interests is more important than alpha generation these days according to investors in the industry s top hedge funds Absolute Return: Hedge Fund Report Card Performance fees should create alignment of incentives through timing mechanisms (e.g. deferments, holdbacks, and/or claw backs), appropriate hurdle rates, and egalitarian terms for all investors. URS Summary of Preferred Hedge Fund Terms The present model provides the possibility of a hedge fund manager realizing a 20 percent performance fee at the end of a bonanza year. If the fund suffers a significant decline the next year, the manager could still have a large net gain at the end of the two years, but the investor may break even or even lose money. CalPERS Press Release March 27,

4 Keys to Better Long Term Alignment Multi Year Performance (incentive) compensation measured over life of investment (not year by year) Co Investment Manager s capital invested pre tax, tax deferred side by side with Investor s Mutual Commitment Investor and Manager commit capital for coterminous periods Transparency Manager has ability to withdraw and thereby signal Investors Sustainability & Stability Funding business Attracting and retaining human capital 4

5 How Did We Get Here? Traditionally, incentive comp measured and banked annually Annual fees (whether paid or deferred) Annual profit allocations ( carried interest ) Extent of alignment: Fees co invested pre tax, tax deferred (but annual measurement) A few large investors negotiated longer (multi year) performance periods or claw backs against previous year s comp 2008 New IRC Section 457A No more deferral of fees from offshore Funds and all existing deferred comp taxable no later than 2017 All comp from offshore funds must be taxed each year Result: multi year comp periods banned and claw backs unworkable thereby largely eliminating traditional techniques designed to achieve long term alignment 5

6 Funding Partners & Employees NQDC Fund Plan Level ABC Offshore Fund, Ltd ABC Offshore Fund 409A Plan Manager Plan Level ABC Manager LLC ABC Manager Partner Plan ABC Manager Employee 409A Deferred Compensation Plan Partner A (60%) Partner B (40%) Portfolio Manager Trader Analyst 6

7 Current State Current Alignment is Short Term Only Annual Incentives Investors pay for unrealized returns Moral Hazard single year comp periods and less co investment may lead to excessive risk taking Conflict of Interest carried interest incents long term gains over short term, while Investors want highest return without regard to tax effects Institutional Investors Seek Better Alignment Annual crystallization causes Investors to pay more than agreed rate Investors seek multi year comp periods and co investment 7

8 A Long Term Alignment Solution FARs Stock Appreciation Rights (SAR) settled in Fund Shares or net settled call Option to buy Fund Shares (these are identical in operation) are exempt from 457A (and 409A) if properly structured Fund issues FAR to Manager on percentage of Investor s investment Manager s benefit is Spread excess of NAV over Strike Price Strike Price is equal to or greater than NAV on grant date Spread grows pre tax, tax deferred, at gross performance until FAR exercised Manager can exercise at any time during the Exercisability Term Spread received is taxable as ordinary income 8

9 FARs vs Annual Incentive Comp Year 1 Return: 50% Annual Comp: 20% of Annual Profits on 100% of Investment $100m $10m $40m FARs : 100% of Cumulative Profits on 20% of Investment $40m $10m $80m $20m 0 1 Year 0 1 Year 9

10 Fundamental Difference Annual Comp Year 1 Return: 50% Year 2 Return: 30% $100m $10m $40m $42m $98m With Annual Comp, Investor pays $7m on $2m cumulative loss $3m $7m FARs $40m $10m $80m $20m With FAR, Investor claws back $6m of incentive comp earned in year 1 and pays exactly 20% of cumulative profit of $5m $36m $9m $1m $84m $20m 0 1 Year 0 1 Year 1 2 Year 1 2 Year 10

11 A Real Difference in 2008 Actual $53m If FARs As of end of 2008, Investor would have had 20% more profit * Source: CSFB Tremont Long/Short Index. Returns grossed up for estimated annual performance fees. 11

12 Superior Attraction & Retention FARs are ideal vehicle for financing Manager s NQDC Plan for PMs, analysts and traders ( Participants ) Manager NQDC Plan can provide for Participant vesting and Participant accounts that mimic Spread of FARs Because FARs are tax deferred until exercise, Manager (i.e., Partners) incurs no cost from providing NQDC to Participants 12

13 Funding Partners & Employees NQDC Fund Plan Level ABC Offshore Fund, Ltd ABC Offshore Fund FAR Plan Manager Plan Level ABC Manager LLC Partner A (60%) ABC Manager Partnership Agreement Allocating FARs Partner B (40%) Partners are allocated FARs Portfolio Manager ABC Manager Employee 409A Deferred Compensation Plan Trader Analyst Employees accounts mimic FAR Spread 13

14 The FAR Advantages Investor Benefits Compensation for performance for agreed upon period Claw back ensures compensation doesn t exceed agreed rate Side by side co investment Transparency of manager compensation Manager Benefits An alignment solution that will attract capital from like minded, long term investors Effective tool to attract and retain top talent Pre tax, tax deferred accumulation of capital available for business continuity 14

15 FAR Tax Structure and Considerations

16 Traditional Incentive Allocation (Carried Interest) and Incentive Fee Incentive Allocation made annually by domestic fund 20% of appreciation in each partner s capital account. This ensures that only partners who have experienced gains since their admission are charged Allocation allows general partner/managing member to benefit from lower tax rate on long term capital gains generated by the fund. High water mark If the value of a capital account drops, the manager will not earn another incentive allocation until the value again rises above its last high point (the high water mark ). Loss Recovery Account keeps track of this. Incentive Fee charged annually to offshore fund 20% of appreciation with respect to each class of shares This ensures that only shares that experience gains are charged Ordinary income Managers sometimes deferred receipt of fees and thereby deferred taxes 16

17 Legislative Developments Carried interest Proposed legislation (see H.R. 1935) would treat all allocations with respect to investment services partnership interest which would include the GP s interest in a fund as compensation income Deferred incentive fees Ability to defer fees payable by an offshore fund has been eliminated by the 2008 enactment of Code Section 457A 17

18 New Section 457A Eliminates any deferral under a nonqualified deferred compensation plan of a nonqualified entity when there is no substantial risk of forfeiture of the rights to compensation Penalizes compensation deferral that results from a performance measurement period of longer than one year Nonqualified deferred compensation plan has the meaning given that term under section 409A, except that such term shall include any plan that provides a right to compensation based on the appreciation in value of a specified number of units of the service recipient 18

19 Nonqualified Entity Nonqualified entity means Any foreign corporation unless substantially all of its income is Effectively connected with the conduct of a trade or business in the U.S., or Subject to a comprehensive foreign tax Any partnership unless substantially all of its income is allocated to persons other than Foreign persons with respect to whom such income is not subject to a comprehensive foreign tax, or Tax exempt organizations Substantially all = 80% (per Notice ) 19

20 Notice excludes from the definition of nonqualified deferred compensation plan : for both corporate and partnership nonqualified entities: options on service recipient equity with FMV exercise price with no deferral beyond exercise of option or vesting of equity for corporate nonqualified entities only: service recipient stock settled (by its terms and in fact) SARs with FMV exercise price 20

21 409A Compliance The exceptions under section 457A for options and SARs are based upon the regulations under section 409A. 409A regulations provide a comprehensive regulatory regime expressly intended to address the risk of using options/sars as a form of "disguised" deferred compensation. Key requirements: the option/sar must be (i) granted with respect to service recipient stock, (ii) by an eligible issuer of service recipient stock, (iii) with a strike price not less than FMV on date of grant and (iv) includes no other deferral features (other than recognition of spread upon exercise). Regulations include a specific provision regarding an investment vehicle service recipient and permits grant of an option/sar by the investment vehicle to its direct service providers. 21

22 Common Stock Offshore Fund 409A regulations describe options and rights with respect to service recipient stock that, as of the date of grant is common stock for purposes of section 305 and the regulations thereunder of a corporation that is an eligible issuer of service recipient stock. Are shares of an offshore fund common stock for purposes of section 305? 22

23 Common Stock Offshore Fund For purposes of section 305, common stock is any stock that is not preferred stock. The term preferred stock generally refers to stock which, in relation to other classes of stock outstanding, enjoys certain limited rights and privileges (generally associated with specified dividend and liquidation priorities) but does not participate in corporate growth to any significant extent. 409A regulations also provide that service recipient stock does not include a class of stock that has any preference as to distributions other than distributions of service recipient stock and distributions in liquidation of the issuer, nor any stock subject to a mandatory repurchase obligation (other than a right of first refusal) or subject to a put or call right that is not a lapse restriction if the price is other than fair market value. 23

24 Common Stock Offshore Fund Which offshore fund shares are common stock? Offshore funds often have many classes of stock designed to take into account Timing of investment by different investors new issues eligible and ineligible investors Sidepockets Creation of preferred shares to provide SAR base SAR must be with respect to common shares Offshore fund stock is redeemable at net asset value (so it is not subject to a put or call right that is not a lapse restriction if the price is other than fair market value). 24

25 Is an offshore fund an eligible issuer? Generally, an eligible issuer is the corporation for which the service provider provides direct services on the date of grant of the stock right, and any corporation in a chain of corporations or other entities in which each corporation or other entity has a controlling interest in another member of the chain. In a master feeder structure, does the investment manager provide services to the master or to the feeder? Or to both? 25

26 Service Recipient Stock Domestic Fund Notice includes in the definition of service recipient stock an equity interest in a non corporate entity. So a nonqualified option on an equity interest in a partnership is also excluded from the application of section 457A. This treatment does not extend, however, to stock settled SARs. 26

27 Stock Settled Requirement for SARs Notice permits FMV options. Notice permits FMV SARs that by their terms at all times must be settled in service recipient stock and are in fact settled in service recipient stock. How long must the service recipient stock be held by the service provider following exercise of option or SAR? 27

28 Why are Options and SARs OK under 457A? House Report explains Section 457A Under 457A, nonqualified deferred compensation includes any arrangement under which compensation is based on the increase in value of a specified number of equity units of the service recipient. But nonqualified deferred compensation does not include an arrangement taxable under section 83 providing for the grant of an option on employer stock with an exercise price that is not less than FMV on the date of grant if such arrangement does not include a deferral feature other than the feature that the option holder has the right to exercise the option in the future. Notice allows stock settled SARs because they are equivalent to stock options with a cashless exercise. Also, they are taxable under section

29 Service Recipient Stock Offshore Fund Option or SAR is with respect to PFIC stock Option to acquire PFIC stock is treated as PFIC stock for purposes of PFIC anti deferral provisions PFIC related considerations: purging election at time of option or SAR exercise Qualified electing fund (QEF) election following exercise 29

30 Service Recipient Stock Domestic Fund Compensatory options on partnership interests Proposed Regulations not final How is deduction allocated among partners? Valuation issues FMV vs. liquidation value. Procedural requirements for using liquidation value. When does service provider become a partner? Capital accounts and partnership allocations. 30

31 Legislation affecting Domestic Funds H.R proposed Section 710 partners providing investment management services to partnership Ordinary income treatment, including any income or gain with respect to options and other disqualified interests with respect to partnership Should not impact options with respect to domestic fund 31

32 Corporate and Financial Institution Compensation Fairness Act, H.R Passed by the House on July 31, 2009 Section 4 of that Act would require certain covered financial institutions to have compensation structures that (i) properly measure and reward performance, (ii) are structured to account for the time horizon of risks and (iii) are aligned with sound risk management. Options/SARs, properly designed and administered, can accomplish all three stated goals. 32

33 FARs : How?

34 FAR Design Investor Objectives Multi year compensation Side by side Mutual commitment Transparency Sustainability & stability Manager Objectives Attract capital Retain talent Tax efficient wealth accumulation 34

35 Co Investment Commitments INVESTOR CAPITAL COMITTMENT For agreed upon capital commitment period ( lock up ), Investor cannot redeem without penalty MANAGER COMMITMENT No exercises, OR In event of exercise, Investor can redeem without penalty AFTER LOCK UP Investor can redeem without penalty and Manager can exercise SIGNALING In any event, Investor may require Manager to give advance notice of any exercise so Investor can make redemption decision HOLDING PERIOD After exercise, how long must Manager hold shares 35

36 Strike Price Design Strike Price can never be less than NAV of Underlying Security at date of grant Typically, initial Strike Price set to equal NAV at grant Investor moving from NAV that is below high water NAV may want initial Strike Price to be above NAV at grant Strike Price can be indexed to create hurdle rate or to cover financing costs in the event FARs continue beyond redemption of Underlying Security 36

37 New Appreciation Grants Investor invests $100m and FAR percentage is 20% End of Yr 1 50% Return Beginning of Yr 2 End of Yr 2 20% Return $22.4m $40m $10m $20m $32m $10m $20m $8m $32m $6m $10m $20m $8m $1.6m $80m Initial FAR (20% of $100m contribution) $80m New Appreciation FAR (20% of $40m growth) $80m 37

38 One Design Example Strike Price is indexed to management fee Staggered lock ups FARs Available for Exercise Strike Price Growth (hurdle) NAV at Grant Year 0 Year 1 Year 2 Year 3 Year 4 Spread Strike Price Growth Initial Strike Price 38

39 Summary: Complete Solution FAR Fund 1 FAR Fund 2 FAR Fund 3 Fund Plan Level FAR Fund 1 Plan FAR Fund 2 Plan FAR Fund 3 Plan Partnership Agreement Manager Employees 409A Plan Mgr Plan Level Vestin g Class Class Vestin g Class Class Vestin g Class Class Partner A (60%) Partner B (40%) Portfolio Manager Trader Analyst 39

40 Design Considerations Grant percentage on Contributions Grant frequency and percentage on New Appreciation Strike Price Initial Strike Price (can be equal to or greater than NAV) Strike Price Growth Rate initially and after redemption (if any) Co investment commitments Holding period after Exercise Rule governing action upon redemption Exercise or Convert Shareholder notification of Exercises Integration with Manager s 409A account balance Plans 40

41 Implementation Considerations Bolt on or start new? Shareholder notice MFN Trading Use of feeder fund to avoid expense erosion to FAR Ensuring underlying shares are service recipient common stock Avoiding distribution preferences Ensuring FMV issuance capital structure should avoid appearance of issuing FAR s at less than FMV Integration with Manager s 409A Plans 41

42 Operational Considerations Tracking FARs and Share Classes by Investor and in aggregate VUS, Strike Price and Spread Share Class NAVs (Common and Preferred) Contribution Grants, New Appreciation Grants and Replacement Grants Effect of redemptions on FAR s limited to Investor s FAR s FAR exercise methodology Investor neutral FAR exercise notifications PFIC filings Accounting treatment 42

43 Operational Considerations (cont d) Integration with Manager s 409A Plans or Partner Plans Self administration or third party administration FAR Plan Manager s NQDC Plans for Partners and Employees Coordination with Fund Administrator 43

44 Question and Answer Session For those attending via the webinar, please send your questions via the chat box on your screen. Our webinar host will relay the questions to the panel. 44

45 Webinar Recording For those of you who would like to listen to this program again, we will be distributing a link to a recorded version of the program. If you have any follow up questions, please feel free to contact Matt Prinn at or matt.prinn@klgates.com 45