Debevoise & Plimpton Private Equity Report What’s Inside Volume 5 Number 4 Summer 2005 3 Proposed Carried Interest Tax Institutional Fund Sponsors’ Rules: Square Peg, Round Hole Consolidation Woes 5 Navigating Conflicts on Boards of Portfolio Companies Financial institutions that control general New GAAP Rules for Fund General 7 A Tune-Up for Going Privates partners of investment funds are bemoaning Partners — Goodbye to Frivolous recently-approved accounting rules that will Due to the nature of a limited partnership Lawsuits? generally require them to consolidate their (where only the general partners have the 9 Selected Issues to Consider financial results with the results of the funds power to manage the affairs of the partner- When Taking a Portfolio they manage — unless they share control ship), only the general partners of a limited Company Public of the fund with an independent co- partnership are treated as having voting general partner or provide kick-out or equity interests. Thus, the general partners 11 Guest Column: participating rights to the limited partners. are presumed to control the limited The Challenge of Valuation Guidelines Despite criticism from members of the partnership. Under certain circumstances, investment fund community, the Emerging however, the limited partners may have 13 Are Private Equity and Issues Task Force of the Financial rights that are sufficient to overcome the Strategic Deal Terms Accounting Standards Board reached a presumption of control by the general Converging? consensus position that will require that partners. Until the recent EITF action, which virtually every investment fund limited limited partner rights are sufficient and how 15 Trendwatch: Spinouts of Private Equity Funds partnership agreement be amended if the substantial those rights must be for Fund general partner (or any entity that controls general partners to avoid control for 17 For U.S. Companies, Exiting the general partner) prepares GAAP financial accounting purposes has been with Canadian IDSs Falls financial statements and wishes to avoid unclear. Short of Promise including all of the fund’s assets, liabilities, In June, the EITF reached a final revenues and expenses in its own consensus position on Issue No. 04-5, 19 Alert: Most Private Equity Funds Now Exempt from consolidated financial statements. “Determining Whether a General Partner, German Penalizing Tax Fund sponsors that prepare GAAP or the General Partners as a Group, Regime and Reporting and financials have generally avoided Controls a Limited Partnership or Similar Publication Requirements consolidation of the general partner (and Entity When the Limited Partners Have thus themselves, where they control the Certain Rights.” The FASB approved the 20 Second Lien Financing: general partner) with their investment EITF’s action on June 29. A Ten-Point Primer for the funds by including in each fund’s limited Institutional sponsors of investment Borrower (and its Sponsor) partnership agreement a provision allowing funds (“Funds”) will be the most on Intercreditor Dynamics the limited partners to remove the general affected, since those sponsors generally partner “without cause” upon a super- prepare GAAP financial majority limited partnership vote.1 Fund statements, and the general sponsors have claimed — and their partner is usually a controlled auditors have generally supported their subsidiary of the sponsor and position — that such a supermajority thus included in the sponsor’s removal provision is sufficient to overcome consolidated financial the presumption of general partner control statements. For Funds of the fund that would otherwise require sponsored by private equity the general partner to consolidate with the firms that do not prepare fund for financial accounting purposes.2 GAAP financials for the © 2005 Marc Tyler Nobleman / www.mtncartoons.com © 2005 Marc Tyler Under the new EITF rules, however, general partners of their Funds supermajority kick-out rights are not continued on page 23 sufficient to block GP control. “She's affiliated, but we're not consolidating with her.” letter from the editor As all private equity professionals know, tax and Private Equity and Entrepreneurship at Tuck, predict that accounting issues can make or break fund structures as while GPs seem to be adopting valuation guidelines well as deal structures. In this issue, we discuss several tax suggested by PEIGG more broadly in the U.S. than and accounting developments of particular import to the previously thought, recent research indicates that wide- private equity world. Our cover article reports troubling spread adoption of consistent valuation guidelines is news contained in a recent FASB ruling that will require unlikely. most institutional general partners who issue GAAP Elsewhere in this issue, we remind private equity financials to consolidate their financials with those of their sponsors of the dangers of blurring the lines between investment funds and gives some critical steps for GPs to stockholder and director and not being sensitive to the take to avoid consolidation. The last few years have seen conflicts of interest that inevitably arise when controlling numerous spinouts of private equity groups from big stockholders have Board seats, and we give a ten point institutions into their own boutique firms. One could primer on second lien financings. surmise that the FASB ruling may encourage more Last year, we reported on the prospect of income financial institutions to divest their private equity funds deposit securities as a hot new exit strategy for companies rather than face the risk of consolidation. Our Trendwatch without the growth prospects for a traditional IPO. In this column analyzes the legal and commercial issues facing issue, we update you on how the IDS strategy has been all managers contemplating spinning out a private received to date. equity group. Finally, we review recently proposed rules from the U.S. Private equity professionals face a myriad of unfamiliar governing the transfer of partnership interests which if challenges both when taking public companies private adopted will have significant impact on how private equity and when taking portfolio companies public. In our last firms structure carried interests and other common transfers issue, we discussed the first scenario; in this issue we unless safe harbors are found; and from Germany, we report on recent Delaware case law that suggests more announce that most private equity funds will be exempt protection for controlling shareholders from frivolous from the penalizing tax rules and reporting and lawsuits following the announcement of a going private publication requirements of last year’s Investment Tax Act. transaction. Elsewhere, we consider whether deal terms in This fall will mark the five year anniversary of the Private private equity public to private deals are starting to mirror Equity Report. We hope it has provided useful guidance those of strategic deals in the U.S. On the flip-side, on issues facing private equity professionals in a rapidly another article reminds us of the issues sponsor firms changing deal environment. Keep your eye out for our should bear in mind before taking a portfolio company Best of the Debevoise & Plimpton Private Equity Report, public. which we expect to publish before year-end. In our Guest Column, Colin Blaydon and Fred Wainwright, both Professors at the Tuck School of Franci J. Blassberg Business at Dartmouth and principals at the Center for Editor-in-Chief Private Equity Partner/ Counsel Practice Group Members The Debevoise & Plimpton Frankfurt Franci J. Blassberg The Private Equity Mergers & Acquisitions Private Equity Report is a 49 69 2097 5000 Editor-in-Chief Practice Group Andrew L. Bab publication of All lawyers based in New Hans Bertram-Nothnagel – Frankfurt Moscow Ann Heilman Murphy Debevoise & Plimpton LLP York, except where noted. E. Raman Bet-Mansour – Paris 7 095 956 3858 Managing Editor 919 Third Avenue Paul S. Bird Private Equity Funds New York, New York 10022 Hong Kong William D. Regner Franci J. Blassberg Marwan Al-Turki – London 1 212 909 6000 852 2160 9800 Cartoon Editor Colin W. Bogie – London Ann G. Baker – Paris Richard D. Bohm Shanghai The articles appearing in this Kenneth J. Berman–Washington, D.C. www.debevoise.com Geoffrey P. Burgess – London 86 21 5047 1800 publication provide summary infor- Jennifer J. Burleigh Washington, D.C. Margaret A. Davenport mation only and are not intended Woodrow W. Campbell, Jr. 1 202 383 8000 Michael J. Gillespie Please address inquiries regarding as legal advice. Readers should Sherri G. Caplan Gregory V. Gooding topics covered in this publication seek specific legal advice before Michael P. Harrell London Stephen R. Hertz to the authors or the members taking any action with respect to the Geoffrey Kittredge – London 44 20 7786 9000 David F. Hickok – Frankfurt of the Practice Group. matters discussed herein. Any Marcia L. MacHarg – Frankfurt Paris James A. Kiernan, III – London discussion of U.S. Federal tax law Andrew M. Ostrognai – Hong Kong 33 1 40 73 12 12 All contents ©2005 Debevoise & Antoine F. Kirry – Paris contained in these articles was not David J. Schwartz Plimpton LLP. All rights reserved. Marc A. Kushner intended or written to be used, and Rebecca F. Silberstein it cannot be used by any taxpayer, Li Li – Shanghai for the purpose of avoiding penalties Hedge Funds Christopher Mullen – London that may be imposed on the Byungkwon Lim Holly Nielsen – Moscow taxpayer under U.S. Federal tax law. Gary E. Murphy Robert F. Quaintance, Jr. Jennifer A. Spiegel William D. Regner The Debevoise & Plimpton Private Equity Report l Summer 2005 l page 2 Proposed Carried Interest Tax Rules: Square Peg, Round Hole In May 2005, the IRS issued for the first Election. A variety of detailed z In addition, the proposed rules time a comprehensive set of rules requirements must be met in order include a host of other provisions that governing the transfer of partnership to qualify for this election, such as could affect how the members of the interests in connection with the perfor- including certain language in the GP and the Manager are taxed.