Private Equity Report

Private Equity Report What’s Inside Volume 3 Number 3 Spring 2003 Securitization of Private Equity Fund Interests: Could This Be the Year to Start Expensing Stock Options? page 3 What Every Fund Sponsor Should Know Guest Column: Due Diligence – A Duffer’s Delight page 4 The possibility of securitizing private equity be counted on the fingers of one hand. fund interests has been under discussion Nevertheless, interest in CFOs remains Do Big-Boy Letters Really Work? for several years now, in both the private strong. Now that more of these transac- page 5 equity and asset-backed securities busi- tions are on the drawing board, sponsors Making Sense of the New Tax nesses. To date, the institutions that have of private equity funds ought to be aware Rules Applicable to Confidential created securitized pools of interests in of the issues raised by CFOs. Transactions page 6 private equity funds have done so in order During the past four months, three China’s Revised Venture Capital to move these assets off their balance major financial institutional investors with Rules: The Rule-Making Process sheets, often to obtain regulatory capital significant private equity portfolios have in China page 8 relief. These pools are sometimes referred notified a number of our private equity to as CFOs, which is shorthand for “collat- sponsor clients that the financial institu- Indemnification by Stockholders eralized fund obligations” and a take off on tions intend to securitize their portfolios of of Public Targets page 10 the abbreviations for “collateralized debt interests in private equity funds, including Going, Going, Gone? page 11 obligation” funds (CDOs) and “collater- funds sponsored by our clients. Among alized loan obligation” funds (CLOs). In other things, these financial institutions Convertible Preferred Shares a CFO, as in any securitization, assets – have asked our clients to consent to trans- à la Française page 12 in this case interests in private equity funds fers of limited partnership interests in our Alert: – are transferred to a special purpose clients’ funds to SPVs formed in connec- German Funds Made Easier vehicle (SPV). That vehicle, or another tion with the securitizations. While a transfer page 28 vehicle that owns all or substantially all by a limited partner in a fund to an unaffil- of the equity in the SPV, issues one or, iated third party raises certain business and typically, several series of notes and equity legal issues, generally these issues are interests to institutional investors. The easily handled. A transfer in connection more senior of these notes often are rated. with a securitization, however, raises In a CFO, even more so than in most significant additional legal and business securitizations, however, the assets being issues, including (1) disclosure of con- transferred into the SPV are highly illiquid fidential fund information, and cash flows are unpredictable – distri- including potentially sensitive butions out of private equity funds are portfolio company informa- “lumpy.” These limitations and other busi- tion, to unrelated third parties, ness and regulatory concerns, discussed (2) creditworthiness of the below, raise serious concerns about new limited partner (the SPV), whether private equity funds are an appro- (3) increased risk of litigation, priate asset class to be securitized, and (4) tax and regulatory con- make these transactions difficult to siderations, (5) anti-money complete. Thus, despite all of the talk about laundering compliance issues the securitization of private equity fund and (6) legal fees and expenses portfolios, the number of such transac- incurred by the fund sponsor tions that has been completed to date can in its review of the securitization continued on page 14 © Nobleman / www.mtncartoons.com Tyler 2003 Marc letter from the editor As we put this issue of The Debevoise & Plimpton capital funds, the rulemaking process illustrates Private Equity Report to bed, it appears that Spring the surprising willingness of Chinese rulemaking has finally, at long last, arrived. In celebration of its authorities to work constructively with industry pro- return, and, undoubtedly, of many of you to the fair- fessionals. From Europe, we also describe structuring ways, our Guest Columnist, Joseph F. Coughlin, a techniques that can mimic some of the benefits of Managing Partner at Corporate Risk Solutions LLC, convertible redeemable preferred shares notwith- aptly uses a golf analogy to explain how the incred- standing the absence of a class of preferred stock ible tightening of the insurance market over the last under French company law. year-and-a-half necessitates that private equity firms Steve Hertz provides an interesting analysis of carefully diligence the insurance marketplace as part the enforceability of “Big-Boy” letters given spare case of their pre-bid processes. law and legal prohibitions against waivers of securi- In our cover article, Michael Harrell and Mia ties law protections. His article suggests key provisions Warren discuss the much-touted, but rarely completed, for private equity investors to include in such letters transaction of securitizing private equity fund inter- to maximize the prospect of their being enforced. ests and outline the legal and regulatory constraints Finally, in the context of a chilled deal environment that should make fund sponsors think carefully and with recent corporate scandals making all buyers before consenting to a securitization of its funds’ of businesses, both public and private, skittish, interests by institutional investors. Andrew Bab suggests that seeking a limited indem- Elsewhere in this issue, David Mason reports that nity from stockholders of a public target may be just FASB is once again considering making the fair value the way to move a stalled deal forward. method of valuing stock options mandatory in the These are just some of the topics we present in wake of recent corporate accounting scandals and this issue for your interest and consideration. As discusses the pros and cons of voluntarily adopting always, if there is a issue of concern or a region of the fair value method early. interest to your business that you would like to see From an overseas perspective, Jeffrey Wood, a addressed in these pages, we welcome your partner in our Hong Kong office, reports that while comments and suggestions. the recently adopted 2003 Chinese foreign invest- Franci J. Blassberg ment rules do not fundamentally change the overall Editor-in-Chief attractiveness of investing in China-based venture 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 Bogie – London publication of Ann Heilman Murphy information only and are not Woodrow W. Campbell, Jr. Richard D. Bohm Debevoise & Plimpton Managing Editor intended as legal advice. Sherri G. Caplan Geoffrey P. Burgess – London 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 Please address inquiries regarding www.debevoise.com matters discussed herein. Andrew M. Ostrognai – Hong Kong Stephen R. Hertz topics covered in this publication David J. Schwartz David F. Hickok – Frankfurt The Private Equity Washington, D.C. to the authors or the members Rebecca F. Silberstein James A. Kiernan, III – London Practice Group London of the Practice Group. Antoine Kirry – Paris All lawyers based in New Mergers and Acquisitions/ Paris Marc A. Kushner All other inquiries may be York, except where noted. Venture Capital Frankfurt Robert F. Quaintance directed to Deborah Brightman Andrew L. Bab Moscow Private Equity Funds Kevin M. Schmidt Farone at (212) 909-6859. Hans Bertram-Nothnagel – Frankfurt Hong Kong Marwan Al-Turki – London Thomas Schürrle – Frankfurt E. Raman Bet Mansour Shanghai All contents © 2003 Debevoise Ann G. Baker – Paris Andrew L. Sommer – London Paul S. Bird & Plimpton. All rights reserved. James C. Swank – Paris The Debevoise & Plimpton Private Equity Report l Spring 2003 l page 2 Could This Be the Year to Start Expensing Stock Options? It is usually taken as an article of faith More than 200 public companies, to criticism. Some of it from “purists” that a portfolio company should use including Coca-Cola and American who argued that companies were only the “intrinsic value” method of APB Express, have switched to the fair value telling half the story, in that only future Opinion No. 25 (Accounting for Stock method. FASB has announced that it is grants would be expensed. In addition, Issued to Employees) to account for reexamining the issue, which is usually and perhaps more importantly, many option grants to employees, because viewed as an opening for FASB again companies criticized the rule because under this method a fixed stock option to try to make the fair value method compensation expenses would seem granted with a fair market value exer- mandatory, as it tried in the mid-1990s to artificially ramp up year-to-year. cise price will have no intrinsic value – (when it was forced to back down For example, let’s take a company that no difference between the share value under overwhelming pressure from each

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