Private Equity Report What’s Inside

Volume 3 Number 4 Summer 2003 3 Special Tax Issues for Tax- Exempt and Foreign Investors Are the Terms of U.S. and European in Private Equity Funds

Private Equity Funds Converging? 4 The New 15% Tax Rate and the Opportunities It Creates

In the Spring 2002 issue of this publication, we examined the differences between U.S. and 5 Grace Under Pressure: European private equity funds, and found that a number of the previously existing differences Revisiting Fraudulent Conveyance Risk had narrowed in the period from 1997 through 2001. In this issue, we look again at trends in structuring European private equity funds and ask the question: “Are the terms of U.S. and 6 Guest Column: European private equity funds converging?” In trying to answer this question, we reviewed the Be Wary of Consolidation in information added to our proprietary funds database since 2001. To refine our analysis further, Private Equity Transactions we took a more detailed look at 40 major European private equity funds raised in the last two 7 Update on Big-Boy Letters years. Finally, we canvassed the lawyers in our London, Paris and Frankfurt offices who work 8 A Structural Victory for the regularly in this area. We found that the trends identified in our Spring 2002 issue have con- European High-Yield Market tinued and that, in several respects, the terms of private equity funds sponsored by European 9 Hedging Bets on firms continue to move even closer to those of U.S. funds. We predict that this trend will continue. Hedge Fund Regulation

10 Recaps Redux The areas of “convergence” that we identi- to see areas where U.S. and European fied and predict will become more apparent funds differ, and are expected to continue 24 Alert: FCC Insulation include: a possible movement in Europe to differ, although this “non-convergence” Provisions Still Needed for toward the “all-deals-realized-to-date” is often a matter of form over substance. Investment in Media model for carried interest distributions Timing of Carried Interest Distributions 24 Funds With Individual Limited described below; an increased focus in Partners Need to Send Annual Historically, most European private equity Europe on general partner (GP) clawbacks Privacy Notices – And Mean It! funds provided for the return to the LPs of and increased use of carried interest all capital contributed by them to the fund escrows and, to a lesser extent, personal before carried interest was distributed to guarantees of the GP clawback obligation the GP or other carried interest recipient.1 by principals of private equity firms; a move- In this article, we refer to this as the “return- ment in the UK away from the multiple all-contributions-first” model. partnership structures previously required In the U.S., by comparison, since the by the now defunct limit on the number of 1980s most private equity funds have used partners in a UK investment partnership; a different model. The U.S. and an increased use in Europe of so-called model, like the return-all-contri- “limited partner (LP) clawbacks” and “no butions-first model, nets gains fault divorce” provisions. We also continue and losses across the portfolio

1 Two comments are worth noting: first, in the case of funds but, unlike the return-all-contri- sponsored by UK private equity firms, carried interest is typically butions-first model, allows the paid not to the GP, but to a special purpose LP owned by the private equity firm and/or its principals. However, for the sake GP to receive carried interest on of simplicity, in this article we will use the term “GP” to refer to what we shall call an all-deals- the entity receiving the carried interest from the fund, whether or not it is in fact the general partner of the fund. Second, we realized- to-date basis. In this note that as recently as the late 1990s boom era, a number of distribution model, each time a European funds, like many U.S. funds organized before 1985, did not net gains and losses across the portfolio. However, this portfolio company is disposed alternative model is not discussed in the article because the continued on page 12 number of these funds in Europe today is very small. © 2003 Marc Tyler Nobleman / www.mtncartoons.com © 2003 Marc Tyler “This is my carried interest.” letter from the editor The increase in private equity activity in Europe has private equity. Gary Friedman and David Schnabel prompted many observers to ask: are the U.S. and briefly outline the new 15% tax rate and how the European private equity marketplaces converging? alignment of tax treatment of dividends and capital In this issue, we look at the question from two gains is likely to impact deal strategies. Adele Karig significant perspectives: fund terms and financing and David Schnabel focus on the particular tax structures. In our cover story, Michael Harrell and problems faced by tax-exempt and foreign investors Marwan Al-Turki compare fund terms in U.S. and investing in private equity funds who make portfolio European private equity funds, highlighting the areas investments structured as limited liability companies. in which European funds are becoming more like Our Guest Columnists, Edward Kingsley, a their U.S. cousins. Their analysis is based on infor- Partner, and Randall Sogoloff, a Senior Manager, mation from our proprietary database as well as the in the Deloitte & Touche Merger and Acquisition unique perspective on the European private equity Services Group, discuss the potentially broad industry and U.S. practice gathered from the contin- impact of the new FASB rule on consolidation of uous exchange of information and experience by variable interest entities on private equity investing. our team of fund lawyers based in London, Frankfurt, We also have a number of updates for you on Paris and New York. On the financing front, David potential hedge fund regulation, developments Brittenham and Alan Davies discuss how recent in media ownership guidelines and privacy notices developments in structuring European high-yield for individual partners of private equity funds. debt have narrowed (but hardly extinguished) the Remember that you can elect to receive The historical differences between the U.S. and Euro- Debevoise & Plimpton Private Equity Report by e-mail pean markets for intermediate capital. and/or regular mail. If you would like to change In this issue, we also explore the current phenom- your method of distribution or add yourself or enon of “partial-exit” recapitalization, which has others in your organization to our mailing list, provided a method of returning capital to limited please contact Dan Madden at (212) 909-1978, partners in a difficult exit marketplace. or [email protected]. Elsewhere in this issue, we discuss several devel- Franci J. Blassberg opments in the U.S. tax laws and their impact on Editor-in-Chief

Private Equity Partner/ Counsel Practice Group Members

The Debevoise & Plimpton Franci J. Blassberg The articles appearing in this Kenneth J. Berman–Washington, D.C. Franci J. Blassberg Private Equity Report is a Editor-in-Chief publication provide summary Jennifer J. Burleigh Colin W. Bogie – London publication of information only and are not Woodrow W. Campbell, Jr. Richard D. Bohm Ann Heilman Murphy Debevoise & Plimpton intended as legal advice. Sherri G. Caplan Geoffrey P. Burgess – London Managing Editor 919 Third Avenue Readers should seek specific Michael P. Harrell Margaret A. Davenport New York, New York 10022 William D. Regner legal advice before taking any Geoffrey Kittredge – London Michael J. Gillespie (212) 909-6000 Cartoon Editor action with respect to the Marcia L. MacHarg – Frankfurt Gregory V. Gooding www.debevoise.com matters discussed herein. Andrew M. Ostrognai – Hong Kong Stephen R. Hertz Please address inquiries regarding David J. Schwartz David F. Hickok – Frankfurt The Private Equity Washington, D.C. topics covered in this publication Rebecca F. Silberstein James A. Kiernan, III – London Practice Group London to the authors or the members Antoine F. Kirry – Paris All lawyers based in New Mergers and Acquisitions/ Paris of the Practice Group. Marc A. Kushner York, except where noted. Venture Capital Frankfurt Robert F. Quaintance All contents © 2003 Debevoise Andrew L. Bab Moscow Private Equity Funds Kevin M. Schmidt & Plimpton. All rights reserved. Hans Bertram-Nothnagel – Frankfurt Hong Kong Marwan Al-Turki – London Thomas Schürrle – Frankfurt E. Raman Bet-Mansour Shanghai Ann G. Baker – Paris Andrew L. Sommer – London Paul S. Bird James C. Swank – Paris The Debevoise & Plimpton Private Equity Report l Summer 2003 l page 2 Special Tax Issues for Tax-Exempt and Foreign Investors in Private Equity Funds

More and more, private equity funds that is engaged in a trade or business, tax-exempt investors in the private are finding attractive investments in a tax-exempt partner’s share of the equity fund market are already filing portfolio companies structured as entity’s current income is generally returns (or have become reconciled to limited liability companies or partner- UBTI. In the case of gain from the sale the risk of filing), and focus instead on ships that are taxed as flow-through of an interest in an LLC, the gain is the effect of the UBTI on their invest- entities for U.S. tax purposes (LLCs). generally capital gain excluded from ment return. Tax-exempt and foreign investors face UBTI except to the extent of any debt Certain types of U.S. tax-exempt special and complex tax issues when financing at the LLC level (which could investors are subject to special rules: considering becoming limited partners be significant). In contrast, in the case • The prevailing view is that govern- in funds that invest in LLCs, and funds of a portfolio company that is a cor- mental pension plans are not subject face challenges in addressing these poration, a tax-exempt organization is to tax on UBTI. concerns. The issues revolve around generally not taxable either on the • UBTI is viewed as truly toxic to charit- some of our favorite acronyms: UBTI receipt of current income (dividends) able remainder trusts because their and ECI, and the solutions generally from the company, or on gain from exempt status will be lost if they have involve what we affectionately refer to the sale of stock of the company. Note, any UBTI in the taxable year, in which as “blocker structures.” however, that a purchaser desiring a case they become subject to tax on all of step-up in basis of assets would likely The Issue for their income for the year, not just UBTI. Tax-Exempt Investors: UBTI pay more for a company that is an LLC The Issue for Foreign Investors: ECI Most types of tax-exempt organizations, than it would pay for the same If a foreign person is considered engaged such as corporate pension plans, private company if it were a corporation. in a trade or business within the U.S., foundations and colleges and universi- Tax-exempt corporations are subject it is subject to U.S. federal income tax ties, are (despite being termed “tax- to tax on UBTI at regular corporate on its income “effectively connected” exempt”) subject to U.S. tax on income income tax rates (up to 35%). Pension with the U.S. trade or business (ECI). that constitutes “unrelated business plans are subject to tax on UBTI at In addition, the foreign person is required taxable income” (UBTI).1 rates applicable to trusts, which are to file a U.S. federal income tax return, If an LLC is regularly carrying on the same as individual tax rates (until and becomes subject to the audit juris- a trade or business, the tax-exempt 2009, up to 35%, with capital gains diction of the IRS (which, rightly or partner’s share of the income from subject to tax at 15%). Tax-exempt enti- wrongly, many foreign investors dread). the trade or business will generally be ties with $1,000 or more of gross UBTI A foreign person that is a partner in treated as UBTI. Accordingly, when a are required to file annual U.S. income a partnership is considered engaged in private equity fund invests in an LLC tax returns. In the past, some tax- exempt investors that were not already a trade or business within the U.S. if filing such returns, particularly pension the partnership is so engaged. Accord- plans, viewed merely having to file the ingly, if a private equity fund invests in John M. Vasily Friedrich Hey an LLC that is engaged in a U.S. trade Philipp von Holst – Frankfurt return as an unacceptable administra- – Frankfurt Adele M. Karig tive burden, even if the actual tax liability or business, a foreign partner’s share David H. Schnabel Acquisition/High were immaterial. Today, however, most of the LLC’s income is ECI, regardless Yield Financing Peter F. G. Schuur William B. Beekman – London of whether the foreign partner receives Craig A. Bowman Employee 1 UBTI is generally defined as the gross income derived by any distributions. In addition, gain from – London Compensation the organization from any trade or business that is unrelated David A. Brittenham & Benefits to its exempt function – which essentially covers almost any the sale of the fund’s interest in the LLC business a private equity fund portfolio company would Paul D. Brusiloff Lawrence K. Cagney engage in – subject to exceptions for certain types of income would be ECI. In contrast, if the port- A. David Reynolds David P. Mason such as interest, dividends and capital gain. In addition, a Elizabeth Pagel folio company were structured as a U.S. Tax few categories of income that are not business income are, Serebransky Andrew N. Berg by statute, treated as UBTI – the most important being continued on page 16 Robert J. Cubitto Estate & Trust income from debt-financed property. Gary M. Friedman Planning Peter A. Furci Jonathan J. Rikoon

The Debevoise & Plimpton Private Equity Report l Summer 2003 l page 3 The New 15% Tax Rate and the Opportunities It Creates

The tax bill enacted last month reduces Foreign Investors makes a taxable spin-off more attrac- the tax rate for U.S. individuals on The new legislation maintains the tive than under prior law. This will be long-term capital gain and most divi- current 30% withholding tax on divi- particularly true for those corporations dend income to 15%. As described dends paid by U.S. corporations to that have losses that can be used to below, this alignment of the tax treat- foreign investors. As a result, the new shield corporate-level gain triggered by ment of dividends and capital gain is legislation will sometimes cause the a taxable spinoff. likely to alter significantly the strategies tax strategies of foreign investors to Sales of Divisions employed in a variety of transactions. diverge from those of U.S. individual In the current economic climate, many investors. Leveraged Recaps Prior to Exit corporations are selling substantial Many private funds are currently Dividends vs. Sales assets so that they can reduce their debt holding portfolio companies that have For funds willing to reduce their interest loads. The favorable dividend rates pre- appreciated in value but are not in a corporation, there are still tax bene- scribed by the new tax law may encour- in a position to be sold in light of the fits to selling stock in a transaction that age companies that are in a relatively general state of the public markets results in capital gain treatment rather strong financial position to make sub- and the absence of strategic buyers. than dividend treatment. For example, stantial dividend payments or share Under the new tax legislation, there is in the case of a sale of shares, the repurchases when they exit a line of an opportunity to extract value from a taxpayer reports the gain arising from business. Public companies may, how- portfolio company at favorable tax rates the sale (i.e., the proceeds received less ever, prefer using the proceeds in a prior to sale by having the company the taxpayer’s basis in the shares). By manner that will not reduce earnings borrow and declare a substantial divi- contrast, a shareholder who receives per share. dend to the fund. In such a case, the a dividend is generally taxed on all of Dividends from Foreign Corporations effect of the tax bill is to reduce the U.S. the proceeds with no reduction for any Dividends received by U.S. individuals individual tax rate from 35% to 15%. In basis in the shares, unless the proceeds from a foreign corporation are eligible the context of a family-owned corpora- exceed the corporation’s earnings for the 15% rate only if they fall into one tion, shareholders desiring liquidity, but and profits. Also, as discussed above, of three categories. not wanting to sell the family business the tax bill has no effect on the 30% or create a public stub, can similarly withholding tax imposed on non-U.S. Corporation Organized in a Treaty Country effect a leveraged recapitalization and investors receiving dividends from Dividends can qualify for the reduced be taxed at the favorable rate. domestic corporations. Since these rate if they are received from a corpor- investors are generally not subject to ation that is eligible for benefits of a any U.S. tax on gains, they will gener- comprehensive income tax treaty with ally prefer transactions structured to the U.S. that includes an exchange The new legislation maintains generate capital gain treatment rather of information program, but only if the the current 30% withholding than dividend treatment. Secretary of the Treasury determines that the treaty is satisfactory for pur- Taxable Spin-offs poses of applying the reduced tax rate. tax on dividends paid by Notwithstanding the dividend relief While there is no guidance on what under the tax bill, tax-free spin-offs will U.S. corporations to foreign treaties will ultimately be deemed remain the most advantageous way of “satisfactory,” it is reasonable to expect distributing the stock of a subsidiary to investors. As a result, the new that corporations organized in the shareholders. In those cases where the jurisdictions of our major trading part- legislation will sometimes stringent requirements to effect a tax- ners will qualify (e.g., UK corporations, free spin-off (e.g., a valid corporate-level cause the tax strategies of French SAs, German AGs, Canadian business purpose, two five-year active corporations, etc.). businesses) cannot be met, however, foreign investors to diverge continued on page 21 the reduction of the dividend tax rate from those of U.S. individual investors. The Debevoise & Plimpton Private Equity Report l Summer 2003 l page 4 Grace Under Pressure: Revisiting Fraudulent Conveyance Risk

Most private equity players haven’t been overly troubled by fraudulent conveyance risks since their transactions were called leveraged buyouts. A recent case, however, has some commentators and practitioners concerned that fraudulent conveyance could be resurfacing as a real transactional risk, at least under certain circumstances. Although a closer look at the case reveals that its relevance and applicability may be limited, still, private equity firms would be prudent to take it into account when due diligencing, structuring and pricing a deal.

The Old Days sonably small capital to conduct its Grace did not receive reasonably equiv- Back in the 1980s and early 1990s, a business). Dealmakers got a stark alent value, and the first prong of a number of courts around the nation reminder recently from the decision constructive fraudulent conveyance were finding leveraged buyout trans- in In re: W.R. Grace & Co. v. Sealed Air analysis was met. actions to constitute fraudulent Corporation that solvency for fraudulent The case itself, however, addressed conveyances. A typical transaction conveyance purposes may be deter- only Grace’s solvency at the time of the might have an acquisition vehicle, mined in hindsight, and that the risk transfer. When Grace went bankrupt, capitalized with minimal equity and of calculating wrong at the time of certain creditors argued that Grace was substantial debt, acquire the target’s a transaction may fall on the debtor insolvent at the time of the transaction stock through a merger in which the and transferee, not the creditors. with Sealed Air, because the tens of target would assume, by operation The Sealed Air Decision thousands of asbestos claims that were of law, all the debt of the acquisition filed after the transaction should be Sealed Air arose out of Grace’s sale vehicle. Courts sometimes collapsed considered liabilities of Grace as of the in 1998 to Sealed Air of its packaging these transactions and viewed the date of the transaction. What about division. This particularly complex deal target as leveraging itself to pay out the fact that neither Grace nor Sealed was structured as a “reverse Morris cash to its stockholders. If things Air could predict the number of claims Trust” transaction in order to obtain went bad quickly, the cash paid to the that would be filed or the dollar amount tax-free treatment for both Grace’s stockholders (especially in a private of those claims? Doesn’t matter – it and Sealed Air’s stockholders. At the company) could constitute a fraudulent was irrelevant whether the future-filed time of the transaction, Grace was conveyance, voidable by a trustee in claims were reasonably foreseeable. comprised of two businesses: its bankruptcy. The only issue in the Sealed Air court’s specialty chemicals business and its The trustee would have to demon- mind was whether, given hindsight, packaging business. The specialty strate two things. First, the debtor there existed liabilities at the time of the chemicals business had sold products would have had to receive less than transaction that rendered Grace insolvent. containing asbestos for many years, reasonably equivalent value for the assets The application of hindsight and the and was at the time of the deal subject it transferred. Courts had little trouble rejection of “reasonable foreseeability” to thousands of pending tort claims, concluding that the target did not are not terribly new concepts to fraudu- with the promise of thousands more. receive reasonably equivalent value lent conveyance lore. However, in the Despite its labyrinthine form, the when it effectively paid out cash to mass tort context, given the unpredict- transaction was effectively an acquisi- its stockholders in the transaction. ability and potentially massive number tion by Sealed Air of Grace’s packaging Second, there must have been actual of claims, burdening the debtor and division (Packco). The value of the or constructive fraud. Actual fraud the transferor with the entire risk of not transaction was put at about $4.9 requires that the debtor actually guessing right or simply not knowing billion – $1.2 billion in cash, which was intended to hinder or defraud a cred- at the time of the transfer seems unfair effectively paid to Grace, and about itor, or intended to incur, or believed – and indeed some other courts have $3.7 billion in new equity issued directly or reasonably should have believed flatly rejected the application of hind- to Grace’s stockholders. Because about that it would incur, debts beyond its sight in the mass tort context. The three-quarters of the consideration ability to pay as they became due. Sealed Air court, though, felt that the went directly to Grace’s stockholders Constructive fraud only requires that victims of asbestos exposure “have and not to Grace itself, it seems clear at the time of the transfer, the debtor their debtor forced upon them,” and that while Sealed Air may have paid was insolvent or became insolvent as that “the commercial expectations reasonably equivalent value for Packco, a result of the transfer (or had unrea- continued on page 21

The Debevoise & Plimpton Private Equity Report l Summer 2003 l page 5 guest column Be Wary of Consolidation in Private Equity Transactions

In January 2003, the Financial Accounting Standards Board (FASB) released Interpretation No. 46 “Consolidation of Variable Interest Entities,” an Interpretation of Accounting Research Bulletin (ARB) No. 51 (the Interpretation). The FASB had originally planned to limit its scope to special-purpose entities where perceived abuses had occurred. However, the FASB found it impossible to define such an entity, and, therefore, created the Variable Interest Entity (VIE) concept, which makes the scope of the Interpretation much broader than originally anticipated. As a result, the Interpretation will likely impact the accounting for many types of entities, including those used in many private equity deals. Private equity investors should understand the new rules and pay careful attention to how the new rules may impact the accounting for their past and future transactions.

Why is it important? idates. Therefore, a transaction struc- a one-line investment at fair value, The Interpretation will likely impact tured without considering the new will likely minimize the utility of the private equity investors in a number of rules may result in consolidation of fund financial statements to investors. different ways. Many structures used the investment or joint venture by • A structure in which the holders’ to either acquire or sell an investment an unsuspecting investor, or, in some voting rights are not proportionate to by investment partnerships and corpo- instances, may require the seller to their investments may cause an entity rations will likely be subject to the new continue to consolidate an entity it to be considered a VIE. For example, rules. The use of many traditional planned to be able to deconsolidate. a limited partnership structure whose features such as put and call options, The following is intended to provide activities are controlled by a general guarantees, seller related financing and some insight as to the potential impact partner may be problematic since the management agreements may have a of the Interpretation on private equity general partner typically has a control- significant impact on the determina- investors. However, it is important to ling voting right but only a minority tion as to which party consolidates the note that many implementation issues investment. target or venture. Additionally, the type with respect to the Interpretation’s con- • The determination as to whether an of equity instrument held by investors solidation model remain unanswered. entity is a VIE is based in part on the (e.g., common stock, preferred stock) These unknowns will likely create amount of equity at risk and whether and the type of debt used by the entity additional difficulties in structuring that equity is “sufficient.” (e.g., investment grade, high-yield) may transactions that involve entities that Investments that do not participate also have a significant impact on the may meet the definition of a VIE. significantly in profits and losses of determination as to which party consol- • Private equity funds, including those equity investments provided by certain currently reporting investments at fair related parties would not be consid- value, must apply the provisions of ered equity under the Interpretation. [I]t is important to note the Interpretation since private equity For example, investments in no-divi- investment partnerships are not dend perpetual preferred stock or that many implementation uniformly scoped out of the Interpre- investments in certain redeemable issues with respect to the tation. However, there is great securities may not meet the definition uncertainty as to how to apply the of equity. Investments that do not Interpretation’s consolidation Interpretation’s rules with respect meet the definition of equity cannot to a fund’s investments and the poten- be used in evaluating whether model remain unanswered. tial impact on the fund’s reporting “sufficient” equity exists. The exclu- if consolidation of an investment is These unknowns will likely sion of these investments from total required. Situations where certain equity may make it more difficult for create additional difficulties investments in portfolio companies an investor to conclude that the entity are required to be consolidated by has “sufficient” equity. in structuring transactions the fund, while others are carried as continued on page 20 that involve entities that may meet the definition of a VIE. The Debevoise & Plimpton Private Equity Report l Summer 2003 l page 6 Update on Big-Boy Letters

The last issue of The Debevoise & allegedly made by Dow outside of a claims as a matter of law, the clauses Plimpton Private Equity Report featured definitive purchase agreement for are highly relevant in determining the an article on so-called Big-Boy letters. AES’ purchase of a Dow subsidiary. The reasonableness of any reliance on the In our article, we noted that Big-Boy definitive agreement contained no alleged fraud as a factual matter. The letters arguably violate Section 29(a) of representations regarding the business court noted: the Securities and Exchange Act, which of the subsidiary. Moreover, under Clearly, a buyer in a non-reliance provides that waivers of compliance the confidentiality agreement between clause case will have to show more with any provision of the securities the parties as well as the definitive to justify its reliance than would a laws are void. We also noted that there agreement, AES expressly disclaimed buyer in the absence of such a con- is no case law specifically addressing reliance on any representation and tractual provision. For this reason, the enforceability of these letters. Still, warranty not expressly set forth in the cases involving a non-reliance clause we concluded that Big-Boy letters were definitive agreement. in a negotiated contract between likely to be enforced in most cases due Dow did not dispute that there sophisticated parties will often be in large measure to a very strong judi- were a number of statements made appropriate candidates for resolu- cial bias in favor of enforcing express outside of the definitive agreement, tion at the summary judgment contractual arrangements as written, but it promptly moved for summary stage. We are unwilling, however, particularly when they are the product judgment on the basis that the dis- to hold that the extraction of a of arm’s-length negotiations between claimer provisions would make it non-reliance clause, even from a sophisticated, well-represented parties. impossible for [AES] to show reason- sophisticated buyer, will always We cited a series of cases decided in able reliance on any such statements provided immunity from Rule 10b-5 the Second, Seventh and Ninth circuits as a matter of law. fraud liability. in support of this conclusion. The U.S. District Court for the District The lesson of AES seems to be that, But a case decided by the Court of of Delaware granted Dow’s motion. But at least in the Third Circuit, waiver and Appeals for the Third Circuit since the the Third Circuit reversed, concluding non-reliance clauses of the type com- publication of our article suggests that that to enforce the non-reliance clause monly found in Big-Boy letters may not it is unlikely that the Third Circuit would to bar AES’ 10b-5 claims as a matter of always enable the defendant to dispose enforce the waiver and disclaimer law would be inconsistent with Section of a subsequent claim quickly, as a provisions in a Big-Boy letter to neces- 29(a)’s prohibition on anticipatory matter of law. Even so, they are useful sarily preclude any subsequent 10b-5 waivers of the duties imposed by Rule tools in managing down, if not elimi- claim by the non-insider as a matter of 10b-5. The court said, “As we have noted, nating, the risk of subsequent 10b-5 and law. On the other hand, the case very reliance is an essential element of a fraud claims by undermining a plaintiff’s much supports the proposition that Rule 10b-5 claim. It necessarily follows ability to make out one of the elements the inclusion of these provisions in a that, if a party commits itself never to of a successful 10b-5 case. Big-Boy letter will nonetheless make it claim that it relied on representations Of course that may feel like a Pyrrhic very difficult for a plaintiff to demon- of the other party to the contract, it victory to a defendant in the Third Circuit strate as a factual matter the “reasonable purports anticipatorily [sic] to waive any who has to deal with the cost and hassle reliance” that is an essential element of future claim based on the fraudulent of a full trial to prevail on a 10b-5 claim, any successful 10b-5 or fraud claim. misrepresentations of that party.” as opposed to a defendant in a different In AES Corp v. Dow Chemical Co., 3d While this holding would seem to Circuit who may well be able to get the Cir., No 01-3373, 4/14/03, AES asserted augur poorly for the utility of Big-Boy claim dismissed quickly on summary 10b-5 and fraud claims against Dow letters in the Third Circuit, the court judgment. based on a variety of affirmative went on to emphasize that even though — Stephen R. Hertz misrepresentations and omissions non-reliance clauses cannot bar 10b-5 [email protected]

The Debevoise & Plimpton Private Equity Report l Summer 2003 l page 7 A Structural Victory for the European High-Yield Market

Recent developments in structuring group of institutions, principally large with the automatic stay and other European high-yield debt have investment banks, commercial banks features of the U.S. bankruptcy laws, narrowed the historical differences and specialized mezzanine debt pro- help give high-yield investors leverage between the U.S. and European viders. It generally has standardized in dealing with troubled U.S. compa- markets for intermediate capital in rights and remedies, typically benefiting nies and other creditors. leveraged financings. Increasing pres- on a subordinated basis from the same High-yield bond financing began sure from institutional investors for security and guarantee package as the to develop in Europe in the mid-1990s, change culminated late last year in senior bank debt, with standard subor- and became a popular means of raising a letter from a group of investors to dination blockage periods on payment capital in the telecom sector, among several prominent European under- as well as on the exercise of enforcement others. The relative rights and structural writing houses demanding a number remedies. Senior banks are usually position of high-yield bondholders, of structural improvements. These willing to rely on contractual subordi- however, have been substantially less tensions eased earlier this year with the nation protections with respect to favorable in European financings than successful April closing of a euro and mezzanine lenders, and do not insist on in U.S. transactions. Generally, Euro- sterling senior note offering by Brake structurally subordinating the mezza- pean senior bank lenders have insisted Bros, a UK foodservice distributor, in nine debt at a separate corporate level. that high-yield debt be structurally which a set of novel structural changes Mezzanine debt in European markets is subordinated to the senior bank debt, was hammered out by the under- well-established, with a generally agreed placing high-yield bondholders in a writers, the senior bank lenders and the set of rights and remedies, and its worse position than their mezzanine issuer. In this article, we examine the commercial and legal implications are lender counterparts. That insistence debate on structural and subordination understood and accepted by the banks has been driven in significant part by issues between European senior banks providing senior debt. the belief that bondholders, particularly and high-yield investors, and the recent In the U.S. financing markets, buyers of distressed debt, are less innovative compromise reached in the high-yield bond financing has largely interested than traditional mezzanine Brake Bros financing. supplanted private mezzanine debt in lenders in working with senior banks The origins of that debate lie in the larger financing transactions, driven to achieve a consensual restructuring distinct evolution of the European in significant part by lower cost and in the event of borrower default, pre- leveraged-finance market. Intermediate greater covenant flexibility for issuers, ferring instead to exit swiftly even if it capital – the portion of the capital as well as greater liquidity for investors. means a lower realization on their structure between the senior bank debt U.S. high-yield bonds may be either investment. Largely as a result of senior and the equity – has traditionally come senior or senior subordinated debt. lender resistance, structural subordina- from the private mezzanine market, Senior notes are generally of equal tion has been the norm in European which is well-known in Europe, and priority with senior bank debt, with the high-yield offerings rather than contrac- remains a significant financing source same or a similar guarantee package, tual subordination alone. Thus, in today. European private mezzanine and are sometimes secured. Senior many European transactions, “senior debt is provided by a relatively small subordinated notes are contractually notes” have been issued by a holding subordinated to senior bank and other company, without any restriction on debt, but are not subordinated to trade the exercise of enforcement remedies creditors and typically have a claim on against the issuer, but with no contrac- Largely as a result of senior some or all of the same operating enti- tual rights at all at the operating company ties as the senior banks, either directly level – making these notes effectively lender resistance, structural or by way of guarantee. In addition, equity. In other European transactions, subordination has been the U.S. high-yield debt does not generally holding company notes have had the limit the exercise of enforcement reme- benefit of a pledge of a subordinated norm in European high-yield dies. These characteristics, together downstream loan of the high-yield pro- offerings rather than contrac- tual subordination alone. The Debevoise & Plimpton Private Equity Report l Summer 2003 l page 8 ceeds to the borrower on the senior years, the structural position of Euro- by an investor group led by Clayton, bank debt, but not of guarantees from pean high-yield debt, combined with Dubilier & Rice, Inc. The transaction the operating subsidiaries of that significantly different and less favorable was initially financed with senior bank borrower that guarantee the senior European insolvency regimes, led to facilities, together with a structurally bank debt. painful losses and poor recovery rates subordinated interim loan facility pro- Throughout the late 1990s, it was for high-yield investors. Not surpris- vided to a holding company parent of commonly predicted that high-yield ingly, high-yield investors became less the bank borrower, with the expectation debt would supplant mezzanine debt and less enthusiastic about investing that the interim facility would later be as the preferred method of raising in European leveraged transactions. refinanced with similarly structurally intermediate capital in Europe, as it The structural versus contractual subordinated high-yield notes. However, had in the U.S. But, as default rates subordination debate came to a head high-yield investors balked at investing soared and companies failed in in the Brake Bros high-yield financing. in Brake Bros high-yield notes on increasing numbers in the last several In mid 2002, Brake Bros was acquired continued on page 22

Hedging Bets on Hedge Fund Regulation

Over the past year, the SEC has been targeted at financially unsophisticated Addressing Fraud through Regulation trying to cast some light on the tradi- investors, including through the Internet. The SEC’s focus on hedge funds is tionally secretive world of hedge funds. Proposals to limit sales of hedge funds attributable at least in part to what With the tremendous growth in the to “accredited investors” may do little it perceives to be a “mini boom” in number of hedge funds and the amount to assuage the SEC’s marketing con- hedge fund enforcement cases over of assets they manage (from $50 billion cerns, because the income and net worth the last year or so. With little to no in assets in 1990 to almost $600 billion standards ($200,000/$1,000,000) of regulatory contact with most hedge today), many commentators believe that Regulation D adopted in 1982 may now funds (which, along with their managers, hedge funds may now be ripe for some be outdated. The SEC may consider are usually unregistered), the SEC has form of regulatory oversight. In May raising these standards in an effort limited means to police or prevent 2002, the SEC launched a formal inves- to curb “retailization.” Of course, any fraud. The SEC may consider requiring tigation of hedge funds. In spring 2003, such revisions to the accredited investor hedge fund managers to register under the SEC hosted a public roundtable standards could affect all private funds, the Investment Advisers Act, an initia- discussion on hedge funds, and Chair- not just hedge funds. tive which could affect private equity man Donaldson testified about his Hedge Fund Disclosure fund managers as well. concerns before both Senate and House After the SEC has digested the infor- The SEC is also questioning whether subcommittees in hearings devoted to mation gleaned from the roundtable and hedge fund disclosure is adequate in hedge funds. The issues under discus- any public comments submitted, we terms of both content and frequency. sion included the following. expect that the SEC staff will issue, by While the SEC grapples with exactly year-end, a report summarizing the Marketing Issues what type of information hedge funds results of its investigation, including One of the SEC’s primary concerns should disclose, Chairman Donaldson proposals for more hedge fund regula- is the “retailization” of hedge funds seems poised to consider disclosure tion. Whether such proposals will impact through the emergence of registered proposals that enhance position trans- the private fund world more generally fund of hedge fund products with parency as well as measures to remains to be seen, but we will report any minimum investments as low as increase investor protection. further developments as they happen. $25,000. The SEC and NASD are both — Jennifer A. Spiegel concerned about marketing efforts [email protected]

The Debevoise & Plimpton Private Equity Report l Summer 2003 l page 9 Recaps Redux

“Partial exit” recaps have gotten a lot of buzz from the business press and have been roundly welcomed by limited partners, fund sponsors and investment bankers alike. They provide an interim solution in a difficult marketplace where limited partners are grateful for returns of capital to offset market losses and “rightsize” their private equity allocations, fund sponsors are concerned about fund performance and IRRs but are unwilling to sell at today’s multiples, and investment bankers are excited about an intermittently vibrant high-yield market in an environment where IPOs are rare. Transactions structured as recapitalizations are nothing new to the private equity landscape and have been utilized in a variety of contexts for many years. For example, transactions accounted for as recaps traditionally provided (and still can provide, especially where there are significant appreciated identifiable intangibles and fixed assets) accounting advantages to private equity acquirors that strategic buyers could not benefit from in cash transactions. (See, “Without Pooling, Are Recaps Doomed?” in the Spring 2001 issue of The Debevoise & Plimpton Private Equity Report.) In addi- tion, recapitalizations to “adjust” the capital structure of troubled companies in connection with workout situations have involved private equity firms, whether as the providers of new capital or the “squeezed-out” equity, through many business cycles. The emer- gence of the partial exit recap, however – in which basically healthy portfolio companies, which have substantially paid down existing debt and generate enough strong cash flow to handle additional leverage, refinance their existing debt to provide a return of capital to equity holders – is a function of an alignment of the stars – including historically low interest rates, a dormant IPO market and low purchase multiples.

These transactions permit a well- on how to avoid foot faulting in struc- unwilling to take that risk. The senior performing portfolio company to use turing a partial exit recap: loan proceeds can be used to refinance its proven and projected earnings Finding the Right Source of Financing the existing senior loan, pay transac- capacity to unlock appreciated value tion expenses and for other general Most partial exit recaps of any magni- and to refinance (and increase) its corporate purposes. tude are dependent on the high-yield debt load as a way of generating cash market. While financing for leveraged Meeting the Dividend Test and returns for investors. Recaps may recapitalizations can come from a Avoiding a Fraudulent Conveyance sound too good to be true. Following variety of sources, the high-yield The risk of personal liability is under- the refinancing, the portfolio company market has been especially robust in standably of huge concern to corporate makes a distribution to shareholders recent months, although the market directors who can be found personally via a dividend or by repurchasing is episodic and the windows seem to liable for the declaration of a willful or a portion of its outstanding equity. open and close without many clues as negligent dividend or another imper- Unless a new equity participant has to the rationale other than the amount missible distribution to shareholders. invested, existing equityholders still of money flowing into the market. In That’s why great care needs to be taken own the business, but have gotten most recapitalization transactions, to structure recapitalized transactions their capital returned and sometimes senior debt will need to be refinanced in ways that effectively manage the two or three times that. Private equity because the distribution of excess cash risk of that liability. firms and their portfolio companies to equityholders is generally prohibited Generally, corporations can pay divi- need to be careful before proceeding by senior debt covenants. Additional dends only out of surplus (total assets with a partial exit recap in order to senior debt can often reduce the minus total liabilities). In most juris- make sure that the transaction does overall borrowing costs of a recapital- dictions, surplus may be determined not raise issues of illegal dividends, ized portfolio company, but secured by any method reasonable under the fraudulent conveyances and disparate lenders will generally not permit circumstances and is generally not treatment of equityholders and create proceeds from their loans to be used based on a balance sheet test. In some unanticipated future impediments to to fund shareholder distributions. states, an additional requirement pro- sale. In addition, notwithstanding the That’s because security interests held vides that distributions out of surplus recent change in the tax law, careful by senior lenders would be invalidated are permitted only if a corporation structuring can make a recapitalization in the (hopefully, remote) event that would be able to pay its debts as they more tax efficient if capital gains treat- the distribution were found to be an come due after the distribution. ment can be achieved. Here’s a primer illegal dividend, and senior lenders are

The Debevoise & Plimpton Private Equity Report l Summer 2003 l page 10 In addition, state fraudulent strate that a corporate action such not dissimilar from the tests for a conveyance statutes prohibit corporate as declaration of a dividend was within Delaware or other U.S. corporation. distributions to shareholders that (with the appropriate legal parameters. Although it is generally the case that some variations): leave the corpora- Directors seeking to approve a the director of a foreign company tion with unreasonably small capital distribution to equity holders should should be as vigilant as a U.S. director (e.g., the corporation becomes insol- be especially vigilant about the process in approving a dividend, no leveraged vent within a reasonable period of they undertake to evaluate the merits recapitalization should be undertaken time after the dividend or the corpora- of a leveraged recapitalization. A record in any jurisdiction (be it Luxembourg tion cannot generate sufficient revenue reflecting careful deliberation and or Colorado) without advice from to sustain its operations); or were thoughtful analysis will go a long way competent local counsel. made with an intent to hinder, delay towards protecting the directors from One of the ways that a Board can or defraud any creditor; or were made liability in the event that 20/20 hind- enhance a record of due deliberation is when the corporation believed it would sight shows that the portfolio company to engage a valuation expert to vet the incur debts beyond its ability to pay. could not support additional debt proposed transaction in order to get Unlike state illegal dividend statutes, added in the recap. comfort that it has satisfied applicable fraudulent conveyance statutes impose Directors should also understand legal standards in approving the transac- liability for wrongful distributions on the provisions of the Directors and tion. Typically, an expert will value the the recipients of such dividends – a Officers Liability Policies (D&O portfolio company on a going-concern company’s equity holders and, poten- Policies) applicable to their actions. basis by applying standard valuation tially, the limited partners who receive Typically, such policies cover directors techniques, including discounted cash the distribution from the private equity for wrongful acts such as negligence, flow analysis and market valuation fund. The statute of limitations in many breach of duty and error, but not for continued on page 18 states for recovery of a corporation’s willful violations or deliberate acts of fraudulently conveyed assets can extend fraud. While there is no case law that up to six years. In light of LP clawback addresses whether improper dividends Directors seeking to approve provisions in many fund documents, constituted insured, wrongful acts under limited partners are naturally concerned D&O Policies, negligent acts should a distribution to equity that they not receive proceeds from be covered, but willful or intentional acts holders should be especially leveraged recaps that are distributed giving rise to an improper dividend in violation of fraudulent conveyance will probably not be covered. Therefore, vigilant about the process statutes. directors will want to make sure that Fortunately, state law generally the decision to pay a dividend was con- they undertake to evaluate protects director decision-making by sidered in a manner that would make the merits of a leveraged applying the business judgment rule. it hard for their actions to be found to In the U.S., courts are loathe to sub- be a willful violation of the dividend recapitalization. A record stitute their judgment for that of a statute. Directors should have a sound company’s directors, as long as the basis to conclude that they are reflecting careful deliberation directors’ judgment at the time was following the applicable law. reasonably defensible as a business Recapitalizations of portfolio com- and thoughtful analysis matter, even if wrong in hindsight. panies organized in foreign jurisdictions will go a long way towards As noted above, in the case of a divi- may be particularly quirky. Directors of dend, state law generally permits a companies organized in those jurisdic- protecting the directors from corporation’s board to use any method tions may not have the advantage of reasonable under to circumstances protective doctrines like the business liability in the event that to value its assets and liabilities for judgment rule. Many jurisdictions 20/20 hindsight shows that purposes of calculating available sur- that are popular for holding companies plus. Most states also protect directors (e.g., the Netherlands, Luxembourg, the portfolio company could who rely on professional evaluations etc.), however, have statutory tests for or other expert opinions which demon- distributions to shareholders that are not support additional debt added in the recap. The Debevoise & Plimpton Private Equity Report l Summer 2003 l page 11 Are the Terms of U.S. and European Private Equity Funds Converging? (cont. from page 1)

of at a gain, the GP is allowed to take thus happy to defer receipt of income However, thus far we have not seen its carried interest on that deal, so long and tax thereon) than is the case with this approach seriously negotiated in as investors have received a return private equity boutiques owned by the U.S. of all capital invested in that portfolio individual principals. In addition, an We think that it is likely that, for company and in all portfolio compa- institutional fund sponsor may also be better or worse, the movement in nies previously disposed of, related more averse to exposing the institution Europe toward the U.S. all-deals-real- fees and expenses, and amounts by to clawback risk. For both reputational ized-to-date model for distributions will which companies that remain in the reasons and because it is a “deep continue. European LPs may succeed portfolio have been written down or pocket,” an institutional fund sponsor in slowing this down in the short term, written off.2 The all-deals-realized-to- may realize that it will be required to but in the long term we think the trend date model has the advantage of make the fund whole if a clawback is will accelerate for a number of reasons. potentially allowing the GP to receive triggered, even if some of the carried First, European GPs, in particular the carried interest much earlier than would interest was paid to individuals who middle market buyout funds that are be the case with the return-all-contri- worked for the institution but then left currently in vogue, are asking for it more butions-first model, but significantly and defaulted on their fair share of the frequently. Second, despite clawback increases the risk of the GP receiving an clawback obligation. concerns, this model has achieved “overdistribution” of its carried interest The information in our database broad acceptance in the U.S. and has entitlement, requiring a “clawback” shows an increase in the number of obvious appeal to European private from the GP of the over-distribution. European funds following the U.S. all- equity firms not affiliated with large (For more detail on these two models deals-realized-to-date model in the last institutions (the number of which, as and GP clawbacks, see “Clawbacks: 12 months. However, the U.S. model is noted above, is rapidly increasing in Protecting the Fundamental Business by no means “market” in Europe, and Europe in proportion to the number of Deal in Private Equity Funds” in the the best-known and most successful institutional houses). Third, U.S. LPs, Fall 2000 issue of this publication.) UK funds continue to follow the Euro- who are increasingly active investors Whatever one’s preferred model, it pean model of returning all contributions in European funds, are familiar and is the case that, until recently, most pri- first. A number of European LPs have generally comfortable with this vate equity funds organized by European told us that they are resisting any trend approach. sponsors have followed the return-all- in Europe toward adoption of the U.S. As for the U.S., we do not expect contributions-first model. This may be distribution model. We are aware, for to see the return-all-contributions-first due in part to the historically greater instance, of a recent high profile Euro- model take hold there in any mean- proportion of institutionally sponsored pean fund that went to market with ingful way, despite concerns expressed funds in Europe (which is rapidly a U.S.-style all-deals-realized-to-date by some U.S. LPs about the greater changing as such institutions spin off distribution scheme, but was forced clawback risk posed by the all-deals- their private equity businesses), as during the course of negotiations with realized-to-date model. compared to the U.S. with its large LPs to change to the return-all-contri- Security for GP Clawbacks number of boutique private equity butions-first model. Clawbacks from the GP of overdistri- firms. It seems likely that institutional Interestingly, in recent months, butions of carried interest are almost fund sponsors with multiple lines of some U.S. LPs have been discussing universal in the U.S. and in Europe. business are less focused on early the desirability of returning to the However, one area where we do see a receipt of carried interest (they may be return-all-contributions-first model for difference is in the security for these less dependent on the cash flow and U.S. funds (or for annual “true-ups” clawbacks. Since most GPs are special of the clawback, which has a similar 2 We note that many U.S. venture capital funds use a some- purpose vehicles that immediately economic effect). This is perhaps not what different formulation, which appears to be the “return- distribute carried interest out to the all-contributions-first” model, but is not. The partnership surprising, given the number of U.S. agreements of these venture funds state that all contribu- private equity firm and/or its princi- GPs that are currently facing large tions must be returned first, but then permit early payouts pals, the GP’s clawback obligation to of carried interest if certain fair-value tests are met. In effect, clawback obligations in funds using these funds operate much like buyout funds, on an all-deals- the fund has little substance: the GP realized-to-date basis. the all-deals-realized-to-date model.

The Debevoise & Plimpton Private Equity Report l Summer 2003 l page 12 In general, as the European generally has no assets. Thus, in the to cover “end-of-the-fund” liabilities, U.S. LPs have required that most claw- including fund indemnification obliga- market matures, and with back obligations be guaranteed by the tions.) This compared to 19% of U.S. regulatory changes and individuals or institutions that own buyout funds in our database that had the GP. Indeed, these guarantees are LP clawbacks during this period. Since increasing transparency, we almost universal and clearly “market” 1997, the percentages increased to 15% in the U.S., although there are often for European funds and 37% for U.S. believe that European funds intense discussions between GPs and funds. In the past year, we have seen will move more toward the LPs as to whether the guarantees this trend accelerate in Europe. Of the should be joint and several, or merely 40 European funds reviewed for this U.S. models and adopt the several, obligations of the guarantors. article, 18% had LP clawbacks. LP claw- Holdbacks or escrows of carried backs now appear frequently in at least U.S.-style terms. interest to secure the clawback obliga- the first drafts of partnership agreements tion are relatively unusual in the U.S., of European funds that we review, by comparison. Only 18% of the buyout whereas even two years ago we rarely funds reviewed for this article, 68% funds and 5% of the venture capital saw such provisions in European funds. (27) had a no-fault divorce provision in funds in our database that were organ- We expect that LP clawbacks will one form or another. We expect this ized after 1990 have such provisions become more common in both U.S. trend to continue, with these provi- (not surprisingly, escrows and hold- and European funds, and that they sions possibly becoming as common backs are more frequent in first-time will rapidly become as prevalent in in European funds as in U.S. funds. funds, and less so for funds sponsored European as in U.S. funds. It should be noted, however, that by more established firms). No Fault Divorce Provisions there is one twist that differentiates In Europe, the situation seems to be European no-fault divorce provisions As with LP clawbacks, we are seeing reversed. We see holdbacks/escrows from their U.S. counterparts. European more European funds include so-called securing the clawback obligation with no fault removal (but not no fault “no-fault divorce” provisions, i.e., increasing frequency in Europe; indeed, suspension) provisions usually have provisions that allow a supermajority they are much more common in Europe “tails;” that is, they generally provide of LPs to vote either to suspend the than in the U.S. Until recently, however, that the fund manager will be entitled investment period or to remove the we rarely saw personal guarantees by to receive management fees for anywhere GP, in either case without cause. In principals. This may be changing. In from six months to two years after the our Spring 2002 look at this issue, we the past six months or so we have seen no-fault removal provision is exercised. saw that in the period from 1990 to a small increase in the numbers of U.S. provisions do not contain this tail; 1996 (when the Mercer Report, which personal guarantees in European funds. in the U.S. such a tail is seen as overly strongly advocated such provisions, It is possible that personal guarantees aggressive by most LPs and, in any was issued), no-fault divorce provisions will become more prevalent in Europe, event, most likely would be deemed a were included in 32% of U.S. buyout particularly as U.S. institutions increase penalty that is not permissible under funds and 25% of European funds. In their participation in the market; however, the Investment Advisers Act of 1940. the period from 1997 to 2001, the per- there remains a deeply ingrained resist- centages had increased to 51% for U.S. Single Partnership ance to personal guarantees by European funds and 26% for European funds. In the Winter 2002 and Winter 2003 principals, who may well prefer contin- Since 2001, we have seen a issues of this publication, we reported uing to offer large carried interest significant increase in the frequency on the elimination in the UK of the holdbacks rather than guarantees. of these provisions in European funds, requirement that UK investment part- LP Clawbacks due perhaps to increased penetration nerships have no more than 20 As discussed in our Spring 2002 issue, of the European private equity market partners. The old requirement had from 1990 through 1996, none of the by U.S. institutional investors. Whatever resulted in many UK funds being European funds in our database had LP the reasons, we believe that these organized as a series of parallel part- clawback provisions. (Such provisions provisions have now become “market” nerships, each with no more than 20 require partners to return distributions in Europe. Of the 40 recent European continued on page 14

The Debevoise & Plimpton Private Equity Report l Summer 2003 l page 13 Are the Terms of U.S. and European Private Equity Funds Converging? (cont. from page 13)

partners. The resulting proliferation of nership, with special provisions “built rate investors, resulting in the creation vehicles, especially as UK funds grew in” to address concerns of particular of a B.V. for them and a C.V. or a part- much larger in the late 1990s, has had classes of investors, such as ERISA nership vehicle for other categories of a number of negative consequences: investors and banks. That being said, investors. Nevertheless, with the elim- it increased organizational costs; it we do often help U.S. fund clients ination of the artificial UK 20-partner complicated closings (because, for organize parallel and feeder vehicles to limit, and as funds and their counsel example, if the fund made an invest- deal with tax and regulatory concerns adjust to the new regime, we believe ment in a portfolio company before its of particular classes of investors that the simpler and less burdensome final closing, and then the relative sizes (including certain European investors), U.S. model, of only one partnership of the parallel partnerships shifted as but investors often decide, upon closer or perhaps two or three parallel and additional investors were admitted, it examination, that these additional vehi- feeder vehicles, will become the norm became necessary to transfer cash and cles are not needed. As a result, most in the UK. securities among partnerships to keep U.S. private equity funds consist of one Other Areas of Convergence their respective holdings proportionate partnership or, at most, two or three We see additional areas where the to their relative sizes); it increased parallel and feeder vehicles that address terms of U.S. and European private administrative burdens, and costs, on the needs of all classes of investors, equity funds are becoming more alike. fund managers over the entire 10 year eliminating unnecessary cost and admin- First, while levels of investor due dili- (or longer) term of the fund; it required istrative burdens. gence and insistence on transparency, that separate audits be done for each Some fund groups and lawyers in the as well as the sophistication of investors partnership; and it complicated voting UK have continued to organize funds in negotiating fund terms, is uneven on, for instance, amendments. Some with multiple partnerships for reasons on both sides of the Atlantic, European LPs have expressed concern that these other than tax concerns. They may wish, investors are perhaps still behind their multiple partnerships also decrease for instance, to keep all U.S. investors, American counterparts in these areas. transparency: one LP may never see or all ERISA investors, in a separate part- We expect, though, that the amount of the partnership in which another sim- nership to insulate non-U.S. investors due diligence by European investors, ilarly situated LP invests. from perceived adverse U.S. taxation, and their aggressiveness and sophisti- The use of parallel partnerships ERISA or litigation risk. While we under- cation in negotiating terms and insisting encouraged UK sponsors to place stand these concerns, we believe that on greater disclosure by GPs, will different categories of investors into some of them are overstated and can increase as their exposure to private different partnerships. The most typical be addressed with, for instance, excuse equity as an asset class increases. example of this is U.S. investors, whom and mandatory transfer provisions (as In addition, we expect investors in UK fund sponsors have often placed is common in the U.S.). funds organized in both the U.S. and into a parallel partnership, which was It should be noted that, because Europe to negotiate more intensely over sometimes a Delaware (as opposed to the tax regimes across Europe are not the sharing of transaction fees charged an English) partnership. U.S. pension harmonized, we do expect to continue by fund sponsors. This has been an plans and other investors subject to to see and work on more parallel and issue of concern to LPs for many years ERISA sometimes also have had their feeder vehicles in Europe than is the now, and has not gone away. Our sense own partnership. case in the U.S., in order to optimize is that, in the past, this issue was less In the U.S., by comparison, there returns for different classes of European heavily negotiated in Europe than in the has been no such restriction on the investors. An example is the Netherlands U.S. We believe, though, that recently number of partners in an investment parallel C.V./B.V. structure, often used European investors have become as partnership, and for over two decades because corporate fund structures, heavily focused on this issue as their U.S. our firm has helped organize funds for which are rarely used in the U.S., are counterparts. We predict that this issue U.S. fund sponsors using a single part- tax efficient for certain European corpo-

The Debevoise & Plimpton Private Equity Report l Summer 2003 l page 14 will continue to be a major focus for pays some or all of that amount on ences in the interpretation or enforce- investors on both sides of the Atlantic. to the fund manager). As for carried ability of such provisions in different In general, as the European market interest, UK funds generally follow the jurisdictions. For example, although matures, and with regulatory changes BVCA/UK Inland Revenue model and many fund agreements purport to and increasing transparency, we believe pay carried interest to a special purpose indemnify the GP against acts other that European funds will move more LP rather than to the GP. These last than “gross” negligence, the laws of toward the U.S. models and adopt the two issues are outlined in the article Delaware, France, Germany, Jersey, U.S.-style terms discussed above. Our comparing the structures of U.S. and England and The Netherlands may view comes from the perspective European funds appearing in the Winter give this term different meanings – or that we have of the European industry 2003 issue of this publication. no meaning at all. Similarly, although through our team of fund lawyers in Second, some techniques that are many fund agreements provide for London, Paris and Frankfurt, who work commonly used in the U.S. to achieve forfeiture by an LP of some or all of its closely with our U.S. fund lawyers and tax savings for GPs – as payment of interest in the fund if the LP defaults on continuously exchange market intelli- organizational expenses and place- a capital call, such provisions may not gence across the Atlantic divide. ment fees by the fund, coupled with be enforceable in some of these juris- Areas Where Differences Remain offsets to the management fee for dictions, such as England, in contrast to organizational expenses in excess of Delaware, where forfeiture provisions Despite the areas of convergence the cap and offsets for all placement are explicitly authorized by the Delaware discussed above, in a number of fees – have not been used in Europe, limited partnership law. Thus, differences respects, U.S. and European private generally because the same tax con- will continue to exist among jurisdic- equity funds will continue to differ, cerns do not exist in Europe. tions, absent changes in the law, even although these differences are often Third, other innovative techniques where the fund terms do not appear more a matter of form than substance. that we have developed for private to be different. First, European funds will continue to equity sponsors – such as funding of be structured somewhat differently Conclusion the GP’s capital commitment through from U.S. funds, largely for tax reasons. The European and the U.S. markets for a management fee deferral mecha- At the investor level, this is driven by private equity funds continue to evolve. nism, and integrated estate planning the fact that European tax and regula- While we cannot predict the future, for the principals of private equity firms tory regimes vary greatly, so that one we are seeing the adoption in Europe – are only now beginning to be seen in fund structure will not necessarily work of a number of U.S.-style terms and Europe. We are discussing these tech- for all of the main European investors provisions with which we are inti- niques and approaches, which we have in this asset class. At the GP level, mately familiar, and we expect these used in the U.S. for well over a decade carried interest optimization poses trends to continue. now with our European clients, but thus challenges where principals are tax — Michael P. Harrell far they have not been widely adopted residents of more than one country, for [email protected] in Europe. much the same reasons. This leads to — Marwan Al-Turki Finally, we note that an under- a variety of solutions to this problem, [email protected] standing of the laws of the jurisdictions which are generally different from those where private funds are organized or used in the U.S. At the manager level, operate is important. Some terms of VAT concerns (where VAT is charged U.S. private equity funds and European on management fees, resulting in an private equity funds appear to be the irrecoverable cost to the fund) are also same or are expressed in the same way relevant; for instance, in order to get (such as the standard of care and the over this problem, UK funds structure mechanics of default provisions). the management fee as a guaranteed However, such provisions in fact may profit share of the GP (which in turn operate differently because of differ-

The Debevoise & Plimpton Private Equity Report l Summer 2003 l page 15 Special Tax Issues for Tax-Exempt and Foreign Investors in Private Equity Funds (cont. from page 3)

corporation, current income (such as dividends) would foreign investor could opt out of an investment that was be subject to U.S. withholding tax at 30% (subject to treaty expected to produce UBTI or ECI (but this had limited appeal reduction), but gain on the sale of stock of the portfolio to sponsors of funds with significant tax-exempt and foreign company would not be taxed (unless the portfolio company investors); a “group trust” was occasionally used by some were a so-called “FIRPTA” company – but that’s a subject for pension plans that didn’t want to file returns, but it could not another article). Note again, however, a purchaser might pay be utilized by any other investors, and only served to shift more for an LLC than it would for a corporation. the filing burden without mitigating the tax (and imposed A foreign person is subject to U.S. federal income tax on administrative costs and burdens). Ultimately, the most its income effectively connected with a U.S. trade or business popular approach became the blocker structure. at the regular graduated rates applicable to U.S. individuals There are as many variations of blocker structures as or corporations, as applicable (currently, the maximum is there are law firms creating blocker structures (perhaps more!), 35% for corporations and 38.6% for individuals). In addition, but the essence is that the investment in an LLC is held however, a foreign corporation is subject to the “branch through an entity taxed as a corporation for U.S. tax purposes profits” tax at the rate of 30%. This is a tax on the “dividend (a blocker corporation) for those tax-exempt and foreign equivalent amount” of a foreign corporation, which approxi- investors who elect to invest through the blocker structure. mates the 30% withholding tax that would be applicable if For all other investors (including the general partner of the foreign corporation conducted the business through a the fund), the LLC interest is not held through the blocker U.S. corporate subsidiary and then the subsidiary dividended corporation. In the simplest blocker structures, the electing out the profits to the foreign corporation. As a result of the tax-exempt or foreign investors simply invest in the fund branch profits tax, a foreign corporation could have an effec- through an offshore “feeder” – an entity that becomes a tive U.S. federal income tax rate as high as 54.5%. (The limited partner in the fund. (This is the structure commonly branch profits tax may be reduced by treaty.) used for hedge funds.) Certain types of foreign investors are subject to special rules:

Electing Tax-Exempt • Foreign governments (including governmental pension and Foreign LPs trusts) are subject to special rules – they are generally

Offshore Blocker exempt from tax on all their income from stocks and bonds Other LPs GP and domestic securities. • Some foreign charitable entities receive exempt status under the Code, in which case they are only subject to tax on their ECI or U.S. income which is UBTI. Fund What Can Be Done? Prior to the mid-1990s when LLC investments became more

common, the typical private equity fund desiring to attract U.S. Operating Other Portfolio U.S. tax-exempt and foreign investors simply agreed to use Partnership Companies “best efforts” or “reasonable best efforts” (or some lesser standard) to minimize or avoid UBTI and/or ECI. Once all of the 50 states adopted LLC statutes, and funds began to This structure serves the purpose of eliminating the U.S. see more and more prospective targets structured as LLCs, tax return filing requirement for the electing investors, but they (naturally) became more and more reluctant to con- does not eliminate the tax – and in some cases may increase strain their ability to make these investments. However, the tax (because, for example, foreign investors will lose the funds clearly wanted to offer some protection to their tax- benefits of any tax treaties with the U.S. they may be entitled exempt and foreign investors, which are a large constituency. to, and tax-exempt investors subject their income to the Funds took a number of different approaches: some utilized branch profits tax). an excuse (or opt-out) mechanism, whereby a tax-exempt or

The Debevoise & Plimpton Private Equity Report l Summer 2003 l page 16 A second blocker structure is the subsidiary structure, where the tax-exempt and foreign investors become direct Electing Tax-Exempt Other LPs and Foreign LPs limited partners in the fund and the fund establishes the blocker corporation as a subsidiary of the fund. In this All LPs GP U.S. Blocker structure, when the fund invests in an LLC, it routes only the capital of the electing tax-exempt and foreign investors through the blocker corporation, and specially allocates income from the LLC to non-electing partners and income Main Fund AIV from the blocker corporation to electing partners.

Other Portfolio U.S. Operating GP All LPs Companies Partnership

Fund This structure has the advantage of not requiring electing

Route capital of foreign investors to file U.S. tax returns, as with the first electing LPs Route other structure, and offers flexibility on exit as with second struc- LPs’ capital diagram U.S. Blocker ture, but at the price of some complexity.

Fund Subsidiary- Some things to note about blocker structures: Dividing Partnership • Generally, the more complicated you are willing to go, the more you are able to optimize the tax results to different categories of investors. Other Portfolio U.S. Operating Partnership Companies • Some blocker structures must be established upon forma- tion of the fund, which is a benefit if the fund is reasonably certain it will invest in LLCs, because the structure is set This structure has some weaknesses – foreign investors and ready to go when an LLC investment is found. Others may be required to file U.S. tax returns, for instance – but it can be postponed (and the costs, expenses and complica- provides for possibilities to eliminate tax on exit of the invest- tions postponed) until an LLC investment is found, which ment. For example, if the LLC goes public, the fund can is a benefit for funds that are unsure they will ever make an utilize the blocker corporation as the IPO entity (or merge LLC investment. the blocker corporation into the portfolio company once it • A blocker corporation could have the added benefit of has converted to a corporation) and then sell the stock with- “blocking” trade or business income for state tax purposes, out triggering any tax to the electing tax-exempt or foreign shielding the tax-exempt or foreign investor from the investors. If the LLC fails to convert to a corporation, the requirement of having to file state tax returns in states fund may be able to sell stock of the blocker when it exits where the private fund’s LLCs are doing business. Some the investment, again eliminating any tax for the electing funds have used blocker corporations primarily for this investors (but probably with some reduction in the purchase purpose. price, because a buyer of the stock will not receive a tax basis — Adele Karig step-up on the share of the assets held through the blocker). [email protected] As a third alternative, a private fund could establish a — David H. Schnabel parallel partnership (sometimes referred to as an “alternative [email protected] investment vehicle”) that will make all operating partner- ship investments to be made by the fund. In one variation, all of the fund’s investors would become partners in the alternative investment vehicle, and electing tax-exempt and foreign investors would invest in the alternative investment vehicle through a blocker corporation.

The Debevoise & Plimpton Private Equity Report l Summer 2003 l page 17 Recaps Redux (cont. from page 11)

analysis based on a portfolio com- governance, however (not to mention are able to keep, after paying taxes. pany’s industry peer group comparables. fraudulent conveyance analysis), at a Before May 2003, when the tax rate for Other techniques that value a com- minimum directors should review their U.S. individuals on most dividend pany’s assets on a stand-alone basis company’s projections and discuss income was reduced to 15% from 38.6%, are generally less useful where the with management the company’s it was often critical to structure a company is expected to continue as ability to satisfy comfortably its obliga- recapitalization so that distributions a going-concern. Even though the tions following the recapitalization. to equity holders received capital gain surplus test might seem to imply a pre- The report prepared by the valuation treatment. However, now that the U.S. ference for an asset-based valuation consultant should be addressed to the individual tax rate for capital gain and method to determine the amount by Board and delivered prior to the dividend income is generally the same which a company’s assets exceeds meeting evaluating and approving the (15%), obtaining capital gain treatment its liabilities, case law (in Delaware) recapitalization transaction. As with is less important. (See, “The New 15% and dividend statutes (in other states) many major transactions, two meetings Tax Rate and the Opportunities It generally make it clear that the directors are often better than one – an initial Creates,” elsewhere in this issue.) may use any reasonable method to cal- meeting to discuss the recap proposal Nevertheless, there are still benefits culate the value of a company’s assets and a second one to approve it. While to structuring a recapitalization in a and liabilities to determine available hiring an outside valuation consultant manner that results in capital gain surplus for a dividend. may seem like an unnecessary trans- treatment. For example, when capital In addition, the valuation expert action expense to a private equity firm gain treatment applies, an equity can analyze the portfolio company’s that values, buys and sells businesses holder is taxed on the gain received in projections and provide an indepen- professionally, the consultant’s fees the recapitalization (i.e., the proceeds, dent basis for concluding that the are “short money” for the procedural less the basis in the equity repur- company should be able to pay its protection they buy for the directors chased). In contrast, an equity holder debts as they come due, after giving and shareholders. In addition, an inde- who receives a dividend is generally effect to the recapitalization. Such pendent valuation review can serve as taxed on all of the proceeds received analysis is similar to the work a an important “reality check” for the with no reduction for any basis in the consultant would do if rendering a business and its projections. equity (unless the distribution exceeds solvency opinion to the portfolio Transaction Tip: The valuation the corporation’s earnings and profits). company’s board, a service not all report should address the appropriate In addition, the recent changes in valuation firms provide. A Board applicable law. Careful review of a U.S. law do not affect the 30% with- should also consider receiving a draft of the report well in advance of holding tax imposed on non-U.S. solvency or similar opinion, especially a Board meeting is advisable so that investors receiving dividends from if the requirements for approving it can be revised to address all of the U.S. companies. Such investors are shareholder distributions in the juris- important issues unique to your trans- generally not subject to U.S. tax on diction in which the portfolio company action. While these points may seem gains and will generally prefer a trans- is organized conditions a permissible obvious, the valuation report is of little action structured to result in capital dividend, in part, on a finding that the value if it consists mostly of boiler- gain treatment. corporation is expected to be able to plate, rather than a clear analysis that Thus, structuring a leveraged pay its debts as they come due and addresses the legal standards and recapitalization will in many cases permits directors to reasonably rely other matters necessary to demonstrate continue to be an exercise of turning on expert advice. Although Delaware the appropriateness of the specific dividend income into capital gain corporations sometimes get solvency transaction. income. In some cases this is easy. opinions prior to effecting leveraged Structuring a Recap to Minimize Taxes For example, if the portfolio company recaps, Delaware does not condition was funded in part with convertible Your tax advisor is sure to point out to payment of a legal dividend on such debt, a repurchase of the debt gener- you that the size of the dividend is less a finding. As a matter of corporate ates capital gain, including any gain important than the amount of it you

The Debevoise & Plimpton Private Equity Report l Summer 2003 l page 18 Directors approving recapi- attributable to the conversion feature. they need not be treated the same. For Even better, if the portfolio company example, a large portion of manage- talization transactions should is an LLC (treated as a partnership for ment’s equity is generally held in make sure that all equity tax purposes) it may be possible to the form of options. Option holders structure the debt-financed distribu- generally would not participate in a holders are treated fairly, tion on a tax deferred basis. distribution to shareholders. In addi- In the more typical case, however, tion, the shareholder distribution will although they need not be achieving capital gain treatment is more reduce the company’s equity value and treated the same. complicated. Specifically, capital gain thereby reduce the value of outstanding treatment requires that the distribution options. Therefore, the Board needs be effected as a redemption in which the to consider how the recap impacts protection, which prohibits a debt from portfolio company buys back stock from management options and may decide being redeemed for a fixed period, often its equity holders, such as the fund to pay a special bonus and/or provide four or five years. Most strategic buyers (rather than declaring a dividend) and for an adjustment to the strike price of would to be forced to tender for the the fund reduce its percentage interest outstanding options, regardless of high yield debt, which would increase (based on vote and value) in the port- whether the option plan automatically their acquisition cost by a significant folio company by a significant amount. provides for such an adjustment. amount. After the “no-call” period, the Although there is no minimum reduc- The possibility of disparate treat- debt is often redeemable, but only at a tion required, the fund can qualify for ment of equityholders has important premium that could also be expensive a capital gain safe harbor if its percen- implications and requires focusing on to an acquiror. Change of control puts tage interest in the vote and value of the company’s aggregate equity value are often included in high yield debt the company after the redemption (and early in the transaction process. The to protect bondholders, although, any related transactions) is 80% of its board members must be careful that depending on the interest rate environ- percentage interest in the company they are fulfilling their duties to all ment, bondholders may prefer not to prior to the redemption (and the related shareholders. If some portfolio com- exercise the put (often at 101% of par transactions) and the fund ends up pany directors are also shareholders or sometimes higher) if they could bene- with less than 50% of the total voting who will increase their holdings or fit from a strategic acquiror owning and power of the company. will otherwise benefit from the recap deleveraging the business. If a company redeems stock from in a manner different from other Given the relative state of the high- all of its shareholders pro rata, each stockholders, such directors may be yield and IPO markets and the under- shareholder’s percentage interest in deemed interested directors not enti- standable appetite of limited partners the company will remain unchanged tled to the protection of the business for returns of capital, carefully struc- and the redemption will be treated as judgment rule. In those instances, it tured recapitalizations are an attractive a dividend for tax purposes. However, may be appropriate to form a special partial exit alternative for strong cash if the redemption is coupled with a committee of disinterested directors flow generating businesses held by new equity infusion, the redeeming to review a proposed leveraged recap- private equity sponsors. shareholders’ percentage interest in italization transaction in order to — Franci J. Blassberg the company will go down and the preserve the protection of the busi- [email protected] transaction can result in capital gain ness judgment rule. treatment. Sometimes other private — Marc A. Kushner Impact on Final Exit [email protected] equity participants provide the new Although a partial exit may be very equity infusion and become minority — Newton Davis attractive to private equity sponsors [email protected] shareholders in the newly recapital- and their limited partners, the new ized company. debt incurred to effect a leveraged Disparate Treatment of Equity Holders recap may adversely impact the cost Directors approving recapitalization or timing of the final exit. transactions should make sure that all High yield debt and other mezza- equity holders are treated fairly, although nine debt generally has “no-call”

The Debevoise & Plimpton Private Equity Report l Summer 2003 l page 19 Be Wary of Consolidation in Private Equity Transactions (cont. from page 6)

• Even if the investments meet the defi- certain circumstances, result in the ties. Amendments to past transactions nition of equity, other aspects may be conclusion that the entity is a VIE. may be necessary to continue to achieve problematic with respect to whether If the entity is considered a VIE, the off-balance sheet treatment. the equity is “sufficient” under the determination as to which party should Given the complexities involved in Interpretation. For example, the use consolidate is based on which party implementing the Interpretation’s rules of high-yield debt to fund a transaction will absorb the majority of the risks and the potential impact on private equity or the existence of a debt guarantee (expected losses) and/or the majority deals, private equity investors should may result in the conclusion that the of the rewards (expected residual carefully consider the new rules when equity is not “sufficient,” because the returns) of the VIE. structuring transactions. This will entity cannot operate without additional There are other projects at both the help avoid any last-minute structuring subordinated financial support from FASB and the Accounting Standards surprises or unintended accounting other parties. This may result in the con- Executive Committee that will provide consequences for all parties involved clusion that the entity is indeed a VIE. guidance related to the appropriateness in the transaction. • The characteristics of the equity at risk of fair-value accounting by certain invest- — Edward Kingsley is also critical in determining whether ment partnerships and consolidation of Partner, Deloitte & Touche an entity is a VIE. Many structures a general partner’s interest by a parent — Randall Sogoloff include provisions that may not impart organization. Once finalized, this guid- Senior Manager, Deloitte & Touche the equity with the right characteristics. ance will need to be considered along Examples of typical provisions that with the Interpretation by investment may be problematic include a put partnerships and corporate parents. option that allows the holders to put What is the Effective Date? their investment to a third party, a The Interpretation is effective immedi- guarantee provided by a third party ately for new transactions entered into that requires additional funding if on or after February 1, 2003. For public needed, a minority veto or partici- company transactions that closed prior pating right attached to mandatorily to February 1, 2003, the new rules are redeemable preferred stock or the effective on July 1, 2003. For private- existence of a management service company transactions that closed prior agreement between the entity and to February 1, 2003, the new rules are a third party service provider. The not effective until the end of the next inclusion of such provisions may, in annual reporting period (December 31, 2003 for calendar year-end companies). The requirements of the Interpretation If the entity is considered a apply to all transactions (past and future) involving variable-interest enti- VIE, the determination as to which party should consoli- date is based on which party will absorb the majority of the risks (expected losses) and/or the majority of the rewards (expected residual returns) of the VIE. The Debevoise & Plimpton Private Equity Report l Summer 2003 l page 20 The New 15% Tax Rate and the Opportunities It Creates (cont. from page 4)

Readily Tradable on a U.S. Exchange Shares of a Corporation Incorporated individual holders to the beneficial rate Dividends from a foreign corporation in a U.S. Possession of tax on dividends), but as debt for can also qualify for the reduced rate Finally, dividends are eligible for the 15% foreign purposes (thereby entitling the if “the stock with respect to which such rate if they are received from a corpora- issuer to a local deduction for interest). dividend is paid is readily tradable on tion incorporated in a possession of the Hybrids of this variety have long been an established securities market in the United States. used in intra-European transactions. U.S.” Thus, a publicly traded Bermuda Hybrid Instruments — Gary M. Friedman company can pay dividends that qualify [email protected] The new law creates an incentive for for the 15% tax rate. foreign issuers to sell securities into the — David H. Schnabel U.S. market that qualify as equity for U.S. [email protected] tax purposes (thereby entitling U.S.

Grace Under Pressure: Revisiting Fraudulent Conveyance Risk (cont. from page 5) involved in corporate tax-avoidance solvency of the parent was analyzed (for tigation of its former transactions must take second place.” Ultimately, instance, Sealed Air obtained a solvency might have uncovered the fraudulent the parties settled, and Sealed Air paid opinion as a condition to the closing transfer risk inherent in the Grace deal. Grace’s estate more than $800 million of the transaction), under the Sealed Evaluating the structure of transac- in cash and stock, effectively increasing Air case, none of that matters – the tions is also critical. Even if there is a the original purchase price by 17%. only question is whether in fact, based question of solvency, there can be no Lessons for Private Equity on hindsight, the seller’s liabilities fraudulent conveyance if the debtor exceeded its assets at the time of the receives reasonably equivalent value So what are the lessons for private transaction. There is very little that a in the transaction. Buyers should try equity firms? Perhaps the most impor- buyer can do to protect itself if there to avoid structures where value paid tant message is that when acquiring are liabilities that are simply unknown for an asset goes to stockholders a business from a parent company, the at the time of the transaction. Due rather than the seller itself. Fraudulent buyer may want to look at whether diligence may, however, uncover risks conveyance concerns may also arise the parent is rendered insolvent by the or the tip of what an alert buyer may where a portfolio company returns transaction. Performing some measure predict to be a much larger iceberg. value to its stockholders in the form of due diligence on the parent may be The buyer could then decide against of a dividend – something that may as critical as performing it on the target going forward, or focus more carefully become more common under the business. What are the parent’s liabil- on the structure of the transaction. recently enacted tax rules. While these ities? What might they be expected to Even where a private equity buyer types of structures have always raised be? In particular, are the parent’s prod- is acquiring an entire company (rather a red flag, the Sealed Air case highlights ucts prone to result in mass tort liability? than a business or subsidiary of a the fact that through the application This might be true, for instance, of larger entity), awareness of the fraud- of hindsight, the risks may be greater chemical or drug manufacturers. ulent conveyance risk can prove to than one might think, particularly where But another important message is be quite important. For instance, if a mass torts are involved. that no matter how good the due dili- buyer wanted to acquire Sealed Air — Andrew L. Bab gence is, no matter how carefully the (before the lawsuit was filed), an inves- [email protected]

The Debevoise & Plimpton Private Equity Report l Summer 2003 l page 21 A Structural Victory for the European High-Yield Market (cont. from page 9)

that basis and demanded structural guarantees of the notes from the bank debt, including a remedy standstill period, enhancements to their rights. The borrower and its material subsidiaries give the senior banks sole control over senior banks, on the other hand, had and a second priority lien over the shares enforcement against the bank borrower restrictions in place prohibiting the of the main operating company, the and its subsidiaries for a period of time bank borrower and its subsidiaries principal asset of the bank borrower. following a default. from issuing or guaranteeing the high- These changes gave the high-yield The issuer also received some benefits yield refinancing of their parent’s investors the following benefits: first, from the structural revisions, including interim facility, and were not initially the bondholders have a direct claim some protection against enforcement prepared to waive any of those restric- on the bank borrower and its material action against it unless some period of tions and rely solely on contractual subsidiaries on a subordinated basis, time had passed and the action received subordination of the high-yield debt. through the intercompany loan pledge majority bondholder approval. The elim- In a complex compromise, the and the upstream guarantees, subject ination of SEC registration obligations senior banks ultimately agreed to allow to payment and remedy blockage provi- avoided a statutory prohibition on the high-yield debt issued by the holding sions. Second, the operating company provisions limiting a single bondholder’s company parent the benefit of several guarantees give the high-yield investors ability to sue for past due payment, structural enhancements which, while equal priority with trade creditors of and relieved the company of increased falling short of granting complete struc- those companies. Third, the second financial reporting obligations that tural parity with the senior bank debt, priority lien over the shares of the main would have arisen from the guarantee together represented a significant operating subsidiary puts the high-yield standstill provisions. improvement over previous European investors ahead of non-bank creditors Taken together, the guarantee and transaction structures. The enhance- of the bank borrower with respect to security interest enhancements brought ments included a first priority lien on those shares, its principal asset. The the transaction structure closer to the the downstream loan of the high-yield second priority lien is particularly typical structure for a senior subordi- proceeds to the borrower of the senior important to providing recovery value nated note offering in the U.S., giving bank debt, subordinated upstream for the high-yield investors, because the high-yield investors meaningfully their subordinated operating company improved rights and remedies, while guarantees are released upon foreclo- preserving for the issuer the cost and Taken together, the guarantee sure on the stock of the main operating flexibility advantages of a high-yield company by the senior banks, and financing. As the subordination debate and security interest that foreclosure action may not be subject continues, these improvements are enhancements brought the to any stay on insolvency; current likely to become a baseline against English law permits senior lenders with which future European high-yield offer- transaction structure closer a security interest in substantially all of ings will be measured. a borrower’s assets effectively to block — David A. Brittenham to the typical structure for such a stay, although pending changes [email protected] a senior subordinated note in English law will reduce their ability — Alan J. Davies to do so in future transactions. At the [email protected] offering in the U.S., giving same time, the contractual subordination provisions applicable to the high-yield the high-yield investors meaningfully improved rights and remedies,while preserving for the issuer the cost and flexibility advantages of a high-yield financing. The Debevoise & Plimpton Private Equity Report l Summer 2003 l page 22 Recent and Upcoming Speaking Engagements

June 12 Michael P. Harrell, Marwan Al-Turki Are the Terms of U.S. and European Private Equity Fund Terms Converging? Practitioners’ Roundtable London, England

June 20 Kevin M. Schmidt Update on Private Equity Trends Advanced Doing Deals New York, NY

June 24 Sherri G. Caplan Negotiating Lower Management Fees, Carries and Other More Favorable Terms for Private Equity Funds 2003 Limited Partners Summit New York, NY

July 9 Marwan Al-Turki Dealing with Departures of Private Equity Executives The 2003 Private Equity COOs and CFOs Forum London, England

August 12 Kenneth J. Berman The Future of Advisers Act Regulation New York, NY

September 11-12 Franci J. Blassberg Special Problems When Acquiring Divisions and Subsidiaries ALI-ABA Conference on Corporate Mergers and Acquisitions New York, NY

September 23 Michael P. Harrell Best Practices in PPMs and Roadshows

Franci J. Blassberg, Moderator Innovations in LBO Deal Structuring

The Private Equity Analyst Conference New York, NY

The Debevoise & Plimpton Private Equity Report l Summer 2003 l page 23 alert FCC Insulation Provisions Still Needed for Investment in Media

The loosening of rules that restricted one the FCC counts whether a fund (or any make investments in communications company’s ownership of multiple media other investor) “owns” – or is deemed companies in order to allow both the outlets by the FCC in early June is some to have an “attributable interest” in – limited partners (and the funds them- of the biggest news in years for private a media company for purposes of deter- selves) greater freedom to make funds interested in media transactions. mining compliance with the various investments in the communications On the upside, the regulations will make ownership rules. Currently, the FCC sector within the restrictions of the it easier for funds targeted at the media rules provide that limited partners will, FCC’s rules without having to worry sector to invest in multiple television generally speaking, have an attribut- about the limiting effect of any present stations – or television and radio stations able interest in any media company or future separate investments by any and newspapers – in the same market. in which the fund itself is deemed to of the limited partners. Of course, one shouldn’t start organ- have an attributable interest. Fortunately, In short, in the wake of the decision, izing multiple closings quite yet, because the FCC allows a fund and its limited these insulation provisions are still with the FCC’s decision will be appealed and partners to avoid this result if the part- us: they remain necessary to ensure that could still get reversed by the courts or nership agreement contains certain limited partners do not, by reason of be repealed by Congress. Furthermore, prescribed provisions that effectively fund investments, have interests in media private funds investing in the media “insulate” the limited partners from companies that are in excess of what the space will still have to pay attention having any control over or connection now-somewhat liberalized multiple and to the FCC’s cross-ownership restric- with the fund’s media portfolio com- cross-ownership rules permit. tions, because the decision left many panies (including with respect to — Jeffrey P. Cunard of those rules completely untouched. the addition or removal of a general [email protected] The decision also leaves unchanged partner). These provisions are included the complicated rules that govern how in documentation for funds that may

Funds With Individual Limited Partners Need to Send Annual Privacy Notices – And Mean It!

In recent years, having individual join the fund and annually thereafter. program must address safeguards limited partners has imposed an addi- Federal privacy regulations require that implemented by any service providers tional regulatory burden on private a domestic fund send a privacy notice with whom the fund shares information equity funds. U.S. federal regulations to all its limited partners who are indi- about individual limited partners. impose restrictions on disclosure by viduals at the start of the partner’s Contracts with service providers must private funds of the personal infor- relationship with the fund and annually contain provisions to ensure that the mation of their limited partners who thereafter. Fund sponsors should deter- service providers institute appropriate are individuals (as opposed to trusts, mine when their annual update notice safeguards. (Certain existing contracts pension plans, corporations, founda- should be sent; in many cases, the date must be amended to include these tions and other institutional investors). would have been July 1 (the anniversary provisions by May 24, 2004.) In light The regulations do not require that a of the date when notices were first of these requirements, we have prepared fund “look through” non-individual required to be mailed). model Policies and Procedures for the investors. These regulations apply to Federal regulations also require that Safeguarding of Limited Partner Infor- domestic U.S. funds (e.g., funds organ- a domestic private fund develop, imple- mation. Please contact us if you would ized in Delaware). ment and maintain a comprehensive like to receive a copy of our model. Basically, if your private equity fund written information security program — Kenneth Berman has individual limited partners, you may providing administrative, technical and [email protected] be required to send each of those part- physical safeguards designed to protect — Shannon Conaty ners so-called privacy notices when they partners’ personal information. Such a [email protected]

The Debevoise & Plimpton Private Equity Report l Summer 2003 l page 24