Private Equity: Issues Under the Radar - June 2006

Joseph W. Bartlett, Founder of VC

"Final" word to managers andowners of non-corporate entities (LLCs and LPs) with offices, or managed by entities with offices, in New York.

The worst is apparently over. Chapter 767 of the New York laws respecting penalties on LLCs and LPs "doing business" for failing formally to qualify and publish with the State Secretary has been amended. The result is set forth in a paper by Howard Lefkowitz of Proskauer, who has diligently followed the legislative trail. Mr. Lefkowitz's take is as follows:

Updated to March 2006 PUBOGRAM

Recent Publication Law Adversely Affecting Limited Liability Entities in New York Amended Before Effective Date; Penalties Softened, But Uncertainty Remains

By: Howard Lefkowitz, Proskauer Rose LLP

On May 24, 2006, the New York Legislature passed Senate Bill S06831-B as a chapter amendment to Chapter 767 of the Laws of 2005 (signed February 3, 2006), which had substantially increased the publication requirements applicable to foreign and domestic limited penalties. The chapter amendment substantially reduces the adverse publication requirements enacted by Chapter 767 and reduces the penalties. On May 31, 2006, the Governor signed S06831-B into law as Chapter 44 of the Laws of 2006 and it became effective together with Chapter 767 today, June 1, 2006.

Chapter 767 of the Laws of 2005 required disclosure of the "ten persons" actively engaged in the business and affairs of the entity and imposed a "suspension of authority" as the penalty for failure to comply with the publication requirements. This legislation had been strongly opposed by major bar associations and others in New York State for the invasion of privacy with respect to the "ten persons" disclosure requirement and the uncertainty with respect to the consequences of the "suspension of authority."

The principal consequences of a "suspension of authority" identified by commentators were (i) possible invalidity of contracts entered into during the "suspension" and (ii) possible personal liability for members or partners for action taken during the suspension. In response to these objections, the Senate S06831 bill was introduced, which eliminated the "ten persons" requirement, and eliminated the "uncertainty" regarding possible liability by expressly imposing joint and several liability on members or partners for the debts of the entity failing to publish. This unlimited personal liability resulted in even greater opposition and outrage by major bar associations, business groups and civic organizations.

S06831 was amended by S06831-B to eliminate the unlimited personal liability provisions, and make other important changes to Chapter 767, namely:

  • The "ten persons" disclosure requirement has been deleted.

  • The penalty for failure to publish remains suspension of authority of the entity to carry on, conduct or transact any business. However, invalidity of contracts and personal liability of the members, managers, partners or agents of the entity are now expressly excluded as consequences of failure to publish or of suspension.

  • The suspension penalty will also apply to pre-existing entities (i.e. formed before the effective date of June 1, 2006) that had not published under the law as it previously existed. The cure period for the compliance is now 12 months (as compared with 18 months) from the effective date, or June 1, 2007. For new entities, the prescribed period of filing the affidavit of publications is 120 days from the date of formation.

  • The requirement that the notice of the formation be published once a week for a period of four weeks in a daily and weekly newspaper has been restored to once a week for six weeks.

  • The text of the notice has been restored to the notice requirements that existed prior to Chapter 767 with no significant changes.

Suspension of the authority will be automatic and without notice and will be automatically annulled upon compliance with the publication requirements.

Notwithstanding the specific exclusion of "invalidity of contract: and "personal liability" as consequences resulting from a suspension of authority, it remains unclear where there may be other consequences.

So, what are the consequences? Here are some questions and thoughts that have occurred to me. I welcome comment and reactions.

Under prior law, before Chapter 767, the only statutory penalty for failure to publish was prohibiting the entity, domestic or foreign, from maintaining an action until publication was cured. That express prohibition has been deleted, and the new "suspension of authority" language of S06831-B inserted in the same place in the text as the deleted language. This suspension of authority could be interpreted to mean the same as the prohibition from maintaining an action. I believe it unlikely that the vague undefined language, "suspension of authority" would be interpreted to mean the same as the clear language that had been used for years but deleted. Could it instead be argued that the deletion of the clear prohibition against maintaining an action suggests that maintaining and action is no longer prohibited?

How will this "suspension" affect daily practice? Inasmuch as government agencies are not required to verify compliance with publication, the ability to obtain from the Department of State a certificate of existence of a domestic entity or a certificate that a foreign (e.g. Delaware) entity has filed an application for authority to do business in New York may not, it would appear, be affected. Similarly, the ability to file UCC financing statements with the Department of State or to record a deed in the office of the register or county recorder may not, it would appear, be affected. If a "long form" certificate is requested from the Department of State, the absence of the filing of certificate and two affidavits of publication would become apparent.

In the past, debt documents and title companied would require proof of publication, as would may lawyers asked to give a "good standing" opinion. It does not appear to me that the practice is this regard is adversely affected by the new "penalty" of suspension of authority.

The uncertainty and vagueness of the suspension may also affect its enforceability in court.

There are a number of issues remaining open, e.g.,

  • Cost of publication for six weeks? About $3,000 to $5,000, all in.
  • Penalty for failure to qualify? Certainly inability to bring an action in a New York court.
  • Curable? Maybe, but the issue arises if immediate injunctive relief is sought and six weeks of publication is required.
  • If the GP/management company files, does the fund itself also have to file? The practice among the Wall Street firms appear to be "yes."
  • Does a filing compromise the tax opinion to off shore investors that the fund is not engaged in a U.S. trade or business? No.
  • If the fund is domiciled in, say, the Caymans but managed de facto from a New York office, does the statute apply? Probably.
  • What is the principal problem for non-compliant firms? The answer is: the opinion practices of the main stream law firms. Obviously, no 'good standing' opinion will issue pending qualification. The question is, given a transaction requiring an opinion, what other exceptions must the opinion giver take because the meaning of "suspension of authority to carry on business" is uncertain. The good news is that the penalty clearly does not:

"affect the validity of any contract or act of the entity, any right or remedy of any other party with respect to such contract or act, or the right of the entity to defend an action or special proceeding in the state, and will also not result in any owner or other agent of the entity being held personally liable for its contractual obligations or other liabilities."[1]

Public/Private Equity Investing: Another Convergence Indicator

The KKR flotation of its affiliate, Private Equity Investors LP,[2] in Amsterdam is high on the radar of, among others, major private equity funds. According to reliable sources, 17 (including Apollo) are lined up in Amsterdam and scheduled to follow KKR. The major metrics:[3] The target raise was $1.5 billion (Merrill and Credit Suisse), increased to $5 billion. The entity, primarily, will co-invest in and with KKR funds, 20 percent of its capital to be invested "opportunistically." Between 70 to 80 percent of the investors are based in the U.S. but the entity remains a "foreign private issuer" (i.e., not subject to SOX) because the U.S. shares are non-voting. (The definition of "foreign private issuer" is that 50 percent of the voting shareholders are non-U.S.). Private Equity Investors is not a traditional fund but a company with an indefinite life.[4]

Transfers of the U.S. shares are restricted to ensure that the holders are qualified purchasers and/or qualified institutional buyers so that the U.S. issuance is not a "public offering" in the U.S. (i.e., it is exempt under rule 144A) and the entity is not a RIC, meaning an investment company required to register under the `40 Act. This, in turn, means that the trading in the U.S. is by appointment, since the buyers must be certificated . hedge funds and family offices, for example. However, the pricing is benchmarked by the Euronext trading data, in turn based on management estimates of NAV backed up by Duff & Phelps opinions that the estimates are "not unreasonable."

One can debate the pluses and minuses of the vehicle at length. On the minus side, high frictional costs; somewhat limited liquidity; the tendency of closed end funds to trade below NAV; limited transparency and shareholder democracy, etc.[5] The big plus is the ability of shareholders, e.g., hedge funds, to access returns from private equity, selected by top decile managers, by investing in securities with at least a modicum of liquidity. The advantage to a hedge fund, relative to an illiquid private equity 'side pocket' inside the fund, are obvious . the fund has its cake and eats it too. The wave, therefore, of the future? Stay tuned.

An Alternative to SPACs and Shells as Exits for Private Equity Fund Portfolio Companies

Given the cold hard fact that the IPO window in the U.S. is more or less closed for flotations by issuers with market capitalizations lower than, say, $600 million, a number of private equity funds are looking urgently for liquidity events in addition to trade sale. In a number of cases, Fund III managers, say, are undertaking to market Fund IV and a liquidity event or two in the existing portfolio would prove to be an enormous boost to what has become a "long hard slog" in front of funds . even some of the best of breed . seeking to raise capital in today's market. There is a lot of money around but very nervous investors, none of whom want to be the next "Bozo." As a consequence, some pretty fancy funds are looking at exit events for their portfolios, by reverse merging the same into a public shell or a SPAC (special purpose acquisition company) which has gone public for the express purpose of merging with a private company within 18 months. (In a paper published some years ago,[6] a student of mine and I did a survey on reverse mergers, which we are updating as Book 20 in The Encyclopedia of Private Equity and Venture Capital, with after-the-merger data on both SPACs and Shells. For a copy of our existing materials, see Sections 8.15 and 8.15.1 of The Encyclopedia.)

There is a variation on the SPAC/Shell theme, however, which may well hold considerable promise. As reported to me, a venture fund specializing in early stage opportunities ran up against the typical problem . a sticky portfolio company or two as the fund reached the end of its term. The portfolio companies were, for the most part, solid . but too small to try and lift the IPO window open; and, for one reason or another, the trade sale route did not seem to reflect the true value, in the opinion of the venture managers, of the companies concerned. What the managers did was, I think, highly creative: They took a look at the seven thousand or so public companies in the "orphanage" . not shells but genuine operating companies. The "orphanage" is home to those companies which are too small to attract much in the way of analytical following, firms handicapped by the fact that the stock is selling off, trading by appointment at prices which do not reflect the valuations which management believes the stock should command. Given the jihad in the U.S. against sell side analysts these days, small companies with limited trading volume are not going to attract many if any, interested analysts; there is no currency sufficient to intrigue the analytical community. One man's problem is, however, another's opportunity.

The creative fund managers targeted companies listed on a NASDAQ Small Cap Market, the American Stock Exchange and the Over-The-Counter Bulletin Board, the shares of which are selling under, say, $5 per share. 'Going private' is technically a solution of sorts; but the SEC staff's hostility to going private has established transaction costs ranging from $500,000 to $1 million in fees and expenses . even for the smallest companies.[7]

The fund managers' solution was and is to sift through and classify, with the help of some relatively uncomplicated algorithms, the matrix of "orphanage" residents and then identify, vis-…-vis each of the fund's portfolio companies, a set of, say, 10 or 15 candidates which might constitute a match with the portfolio company involved. Thus, assume the process spots a public company in the orphanage, its stock trading at, say, $1.00 a share . too low for an escape from the orphanage. The VC fund's proposition is a merger with a portfolio company in a complementary line of business with the orphan . doubling, say, the revenues and assets of the orphanage resident. Assume a fifty-fifty split between the portfolio company and the orphan, the math is simple. If the stock price goes to $3 from $1, everybody has made money. If the two businesses can operate more efficiently and productively . and generate, say, additional revenues which support trading at $4 or $5 a share, the transaction produces the kind of multiples any venture fund would be proud of. If this method of operation catches on, it could solve a couple of problems. First, a significant boost to the IRRs in funds reaching the end of their term, now dampened by the sticky illiquidity caused by the IPO closed window. Secondly, it can boost companies out of the orphanage, where no one makes much money . the stockholders, the managers, the U.S. economy.

Joseph W. Bartlett,, Founder of VC

[1] Valle & Venter, "Changes to Publication Requirements in New York State," NYLJ, Jun. 2006.

[2] Sender, "KKR's $5 Billion IPO Experiment," WSJ, C2 (May 21, 2006).

[3] The prospectus is hard to get, an obvious measure to prevent purchases by unqualified U.S. shareholders.

[4] According to Dan Primack,

KKR lists six main differences between traditional LPs and PEI shareholders. They are:

  1. Traditional LPs make commitments when a fund begins, but only make actual contributions when the firm issues capital calls. PEI shareholders are making one-time securities purchases, so fund everything up-front.
  2. The PEI agreement contains no key-man provision.
  3. The PEI management fee is based in PEI's overall equity in KKR funds, which will stay constant. This is different than management fees paid by LPs, which are reduced over time as unfunded commitments are eaten away by capital calls. Also, PEI shareholders will not receive management fee reductions based on alternate payment of transaction, monitoring and/or breakup fees.
  4. PEI has no claw-back provision.
  5. PEI shareholders will receive less information than would traditional LPs, due to various confidentiality issues. PEI will issue only annual and quarterly reports that include consolidated financial statements of the overall partnership, a discussion and analysis by management and respective results f operations, liquidity and capital resource. Individual portfolio company valuations only will be provided by companies in which PEI itself holds at least a 3% position.
  6. There will be no PEI distributions, except to help shareholders pay certain U.S. tax obligations. The only way for PEI shareholders to generate ROI is to sell their securities."

Primack, "Last Word on KKR IPO," Private Equity Week, May 11, 2006.

[5] Herewith, courtesy of a discussion by George J. Mazin at Dechert, some, and only some, of the issues raised by side pockets, maintained within the four corners of a hedge fund.

Should the investments in the side pocket be viewed for financial reporting purposes at their fair value but at cost for reporting net asset value? Does the valuation issue, apples to oranges so to speak, impact the auditing firm's ability to render as unqualified opinion? Upon a liquidity event in the side pocket . a sale of a position or an IPO . should the gain or loss on the private equity investment be netted against the performance of the portfolio as a whole in order to determine whether the managers are entitled to a percentage of the gain? If the hedge fund liquidates, what about assets in the side pocket which may, as in the norm in venture capital, hang around forever? Assume that an investor in a hedge fund has redeemed its interest but remains invested in the side pocket because there is no practical way to redeem. Does the investor remain n the fund for purposes of the Section 3(c)(1) exemption from the `40 Act; the 25% ERISA threshold; the `34 Act limitation on 300 or 500 shareholders of record? Assume an investor withdrawing from the fund, should it be subjected to a buy-out, whereby the remaining investors and/or the managers enjoy a call (and perhaps the investor has a put) vis-…-vis the investor's interest in the side pocket portfolio.

[6] Bartlett and Kunz, The Journal of Private Equity, Winter 1998, "Reverse Mergers and Shells: A Preliminary Analysis."

[7] Again, stay tuned for a coming attraction . Book 17 in The Encyclopedia, on "Going Private."