Private Equity in the United States: Frequently Asked Questions - Part I

Amy Johnson-Spina and Joseph Romagnoli, Torys LLP

General Overview

1. What are the general types of investments that fall within the private equity industry?

Investments in the private equity industry generally fall into two categories: (i) investments in private equity funds and (ii) direct investments in companies.

A sophisticated investor may wish to invest in private equity funds, pooling its money with other sophisticated investors. The funds will in turn search out investments in specific types of companies or assets and subsequently manage these to make a profit for both the investor and the principals of the fund. These funds generally fall into the categories of buyout, venture capital, distressed debt, mezzanine, real estate, fund of funds or a hybrid of any of these.[1]

Funds with a buyout strategy generally acquire an undervalued company either in its entirety or a substantial part thereof, for the purpose of retooling it to cause the company's value to appreciate. On the other hand, venture capital funds generally invest in early-stage companies (often in the technology or life sciences industry), receiving shares or other equity interest in return; the purpose of such investment is to support the investee company's initiatives. Funds focused on distressed debt will likely target non-performing loans or distressed companies for the purpose of acquiring and disposing of the debt or underlying assets. Real estate funds focus on the acquisition of real property, either on a property-by-property basis or through the acquisition of existing real estate "portfolios". Fund of funds invest in any of the funds discussed above.

An investor may choose to invest directly in a company or in real estate, as distinguished from investing in private equity funds. These direct investments are often made side by side or as a "co-investment" with an investment or acquisition being led by a private equity fund. An investor in a private equity fund may obtain co-investment opportunities as a result of being an investor in one or more funds. A benefit of direct investments is that the investor receives direct equity holder rights and becomes a direct owner of the entity or property. A co-investor will also typically pay no fees or substantially reduced fees to the fund with which it has made a co-investment. Since direct investments or co-investments have significantly different characteristics from fund investments, these FAQs focus on investments in private equity funds (termed "funds" here).

2. Please give an overview of the history of investments in private equity funds in the United States

Funds have a relatively short history. Traditionally, investment in private companies with the goal of re-selling them was the purview of a few wealthy families. The first big private equity firm came into existence in the late 1960s, and it was not until the 1980s that private equity investors attracted much attention, often as the groups behind that era's hostile takeovers.

In the late 1990s, funds raced to invest in startup companies with unproven business models, resulting in funds extending venture capital monies without the usual safeguards behind such deals - for example, a certain amount of control if the company fell on hard times; limited syndication of investments with other funds; and funds' joining investors in deals without performing adequate due diligence on the companies to be funded.

The increase in the popularity of private equity investment can be seen clearly in the growth of funds in the last three decades. The largest fund in 1980 stood at a value of $135 million. Twenty-five years later, many funds exceeded $1 billion in value (with several funds exceeding $10 billion).

Low interest rates in recent years have also made it easier for private equity buyers to borrow large amounts of cash to finance purchases. At the same time, funds are increasingly joining with other funds in "club deals" to make larger investments - a phenomenon that has resulted, in one case, in potential legal issues. On November 15, 2006, thirteen buyout funds were named as co-defendants in a class action lawsuit in which they were accused of violating federal antitrust laws. Primarily, the complaint alleges that collusion exists among the named funds, arguing that these funds no longer compete against each other for deals, but instead enter into club agreements among themselves or make agreements not to bid against each other in certain transactions. Many private equity professionals argue that there is lots of competition among the funds, particularly given the significant increase in the number of funds and the commitment size of funds raised.

3. What are the main advantages and disadvantages of investing in private equity funds?


(a) High returns: Although there is a high risk in investing in funds, investors have the potential to receive high returns on their investments. For example, in Google's agreement to buy venture-backed YouTube for $1.65 billion, the successful venture capital fund, Sequoia Capital, will reportedly receive approximately $495 million in consideration for its 30% ownership stake in YouTube. Sequoia Capital invested a total of $11.5 million in two separate rounds and was the only venture capital fund invested in YouTube. Obviously, such returns are not the standard by which all funds and deals should be measured, but they illustrate the gains that are possible.

(b) Safer long-term growth: Funds typically are heavily involved in, and provide needed expertise to, the companies they buy or invest in. Generally, these investing funds will take control of, or at least maintain a presence on, an investee company's board of directors. At the same time, fund managers can deal with hiccups along the way without the distraction of public scrutiny or even intense scrutiny from investors. In addition, fund managers have extensive experience in accreting value in otherwise undervalued companies. Ultimately, this combination often offers a more attractive alternative than investors might otherwise have in the public markets.

(c) Less regulatory scrutiny: Funds do not normally face the same level of scrutiny as other investment vehicles (including hedge funds). Since February 2006, the U.S. Securities and Exchange Commission (SEC) has required certain private fund managers to register, so that the SEC can monitor them more closely. However, most managers do not fall within the SEC's definition of "private funds", which applies only to funds that allow investors to redeem their interests within two years of their investment (e.g., hedge funds). The term of investment in most funds extends well beyond the two-year mark.

(d) Fewer internal resources and access to bigger deals: If an investor were to attempt to build the capability to invest in buyout deals or make investments in venture capital companies and subsequently manage such companies or investments, an enormous amount of in-house resources would be required. For example, at a minimum, the investor would need someone to source the best deals out of the multitude available, someone to negotiate favorable terms regarding such investment, someone to manage the company or investment in an accretive manner (often by becoming involved in the day-to-day management) and someone to determine and expedite the most lucrative exit strategy. It is likely that several people would be required if the investor chose to follow more than one strategy (e.g., buyout deals and venture capital investments). Generally, investors do not want to use these significant internal resources when they can simply outsource such tasks to their choice of fund investment teams. In addition, given that investors are usually engaged in other types of business (and invest in funds as a way of enhancing their returns - e.g., investors may be pension plans or family trusts), they may not have access to the same amount of capital as funds. Accordingly, funds often have access to bigger deals that investors would not be able to participate in on their own.


(a) Less maneuverability: Funds generally tie up investments over a term of approximately 10 years, not counting any term extensions. If an investment in a particular fund is going poorly, there are few practical or realistic opportunities for investors to exit the fund.

(b) Control: Investors in funds commit to invest specified amounts into a fund that is controlled by an investment team. The investor's money is then "called" on an as-needed basis by that team. Once the money is called, the investor has a period of days within which to provide the money and has no opportunity to review or comment on the proposed investment. The investor's primary protection is the inclusion of investment restrictions in the fund agreement (e.g., the limited partnership agreement or limited liability company agreement).

(c) More competition: While certainly an advantage, higher returns can be a double-edged sword. Funds increasingly find themselves competing with many other funds, as well as strategic investors, for fewer deals. In recent years, hedge funds and hybrid hedge/funds have become increasingly more active in private equity investments.

4. What have been the recent key trends in private equity fund formation?

Five of the most significant trends that we have seen over the last five years in fund formation are (i) restricted disclosure of information from the fund to its investors; (ii) inclusion in the fund agreement of a management fee waiver; (iii) inclusion of an investor giveback; (iv) increased availability of recycling of an investor's capital commitments; and (v) increase in overall size of funds.[2]

In response to various actions by newspapers and public advocacy groups, certain pension plans in the United States have been required to disclose information about the funds in which they invest, which previously would have been characterized as confidential. Funds are concerned about the scope of disclosure because (i) they do not want the terms under which they operate to become publicly known (and allow their competitors to undercut them), and (ii) they do not want investors reporting on aspects that are inherently subjective (e.g., valuations) and that therefore could have a detrimental effect on the investment in the marketplace. Investments made by the funds are generally held at cost unless the fund is permitted or required under the fund agreement to write down or write up such investments to reflect a change in the value, which is often in the fund's discretion. Additionally, an investor may calculate its expected rate of return differently than the fund would (e.g., the possibility exists that the investor would have a lower rate of return than the rate calculated by the fund). As a result, funds often limit the information that they will disclose to investors who are more likely to be required to publicly disclose such information. In addition, funds often protect their ability to withhold information from all investors if there is a concern of public disclosure (particularly with respect to confidential information concerning the fund's portfolio company investments).

As this is a currently developing area driven by actions brought by third parties, such as newspapers and advocacy groups, each fund agreement attempts to provide protection against future disclosures that may result.

Generally, the investment team is required to commit to the fund a certain amount of money (which varies from fund to fund) to demonstrate to the investors that the team has some "skin in the game". As a part of the terms of most investments in funds, investors are usually required to pay a management fee to the investment team. It has become increasingly common in U.S. buyout funds for the investment team to waive a portion of the management fee, instead directing the investors to contribute an equal amount to the fund on the team's behalf as a part of its capital commitment. Accordingly, the investment team is entitled to receive any profits generated from that contribution in accordance with the distribution "waterfall". This reduction in the management fee effectively permits the investment team to convert management fees (taxed at ordinary income rates) to capital contributions (taxed at more favorable capital gains rates).

Throughout the life of the fund, investors receive distributions upon the disposition of an investment by the fund. Accordingly, if a subsequent liability arises that the fund does not have sufficient assets to pay without a giveback obligation on the part of the investor, the investment team would be left to pay a disproportionate share of the liability. It has therefore become increasingly common, although arguably still controversial, to require investors to "refund" prior distributions if a subsequent liability arises. The terms of such refund will vary from fund to fund but generally include (i) a restriction based upon the time during which such refund can be required (e.g., two or three years after the date of the distribution or two or three years after the dissolution of the fund); (ii) a cap on the amount of such refund (e.g., all distributions made or a percentage thereof); and/or (iii) a restriction on the purpose for which such refund can be required (e.g., indemnification liabilities or all liabilities). Regardless, investors often insist that the fund look to its assets (including any unfunded capital commitments of investors) before seeking a refund from its investors.

The investment strategies of investors differ. When certain investors determine the amount of their investment, they want to ensure that this amount is their maximum exposure (other than for any refunds required, as discussed in the previous paragraph). Other investors would prefer that the amount of their investment represent the amount that is fully invested by the fund and that, therefore, fees and expenses be above that amount. The rationale for this latter approach is that the amount committed should be the full amount on which the investor earns a return and that fees and expenses should be separate. To comply with these differing viewpoints, funds will often be permitted to "recycle" certain distribution proceeds up to a specified cap. For example, if a fund makes an investment that is disposed of for a profit within 12 to 18 months of the date of the investment, the fund may then be able to reinvest the investors' capital contributions for such investment (or, alternatively, the fund may be able to reinvest the proceeds realized on the investment that exceed the investors' capital contributions). The rationale for this type of recycling is that since the money was not at work for a long period and the investor earned a profit, the fund should be entitled to put the money back to work. Another example of recycling would permit the fund to reinvest an amount equal to the capital contributions of the investors made for the purpose of fees and expenses. Alternatively, rather than specifying the type of distribution proceeds that can be recycled, there may be a cap on the total amount of distribution proceeds from capital commitments that can be reinvested (e.g., 110%-120%).

Practical and Legal Aspects of Private Equity Investment

5. What legal entities may typically be used as vehicles for investments in private equity funds? What are the advantages and disadvantages of each?

Limited partnerships:

Most commonly, a limited partnership (typically formed in Delaware for U.S. funds) is the vehicle used in the formation of a fund. Its advantages include the protection of investors (as limited partners) from the liabilities of the fund so long as such investors do not participate in the management of the fund. Accordingly, the partnership agreements of most funds clearly specify which actions the limited partners may take regarding the oversight of the fund. In addition, a limited partnership is a flow-through entity for tax purposes. Fund investors' chief realization of value is through a distribution. As such, a fund that is organized as a partnership will see distributions taxed only once, and often such distributions will be subject to the more favorable long-term capital gains tax on the individual limited partners - a far more attractive option than the tax treatment funds would receive if organized as corporations. A disadvantage of this vehicle is that the limited partners must effectively hand over control of their investment to retain their limited liability.

Limited liability companies:

An alternative vehicle used for the formation of a fund is a limited liability company (typically formed in Delaware for U.S. funds). It has similar advantages to the limited partnership vehicle because investors (as members) are protected from the liabilities of the fund. The members are not restricted from participating in the management of the fund. Like the limited partnership vehicle, it is a flow-through entity for tax purposes. A disadvantage of this vehicle is that it does not have the extensive case law as a fund formation vehicle that the limited partnership vehicle has. Given the relative newness of the LLC form and the lack of corporate formalities, courts may be more likely to pierce the corporate veil and therefore subject the investors to liability in a situation where members directly manage an LLC, a management structure that is not forbidden by the legislation. Use of an LLC may pose U.S. federal income tax issues for non-U.S. investors, depending on their jurisdiction of residence.

General partnership vehicles:

Funds may choose to have a corporation serve as general partner of a limited partnership to avoid the potentially unlimited personal liability otherwise associated with the role of general partner in a limited partnership. Organizing the general partner as an S Corporation avoids the extra level of taxation generally associated with corporations. Limitations are imposed on an S Corporation, however - in particular, a restriction on the nationality of its shareholders and the requirement that it maintain only one class of stock; these limitations make it less favorable than other forms. More recently, funds have begun forming as limited partnerships in which the general partner is a Delaware limited liability company. The limited liability company general partner receives partnership-like tax treatment while removing the personal liability of the members and managers. The limited liability company also allows greater flexibility in its formation and particularly in its management, which need not follow traditional corporate formalities.

6. What techniques are available to minimize tax liability? How do the positions of U.S. and non-U.S. investors differ in this regard?

A fund is generally classified as a partnership for U.S. federal income tax purposes. The income, gain, loss, deduction and credits of the fund pass through to, and generally retain their character in the hands of, the partners. Most of the income is long-term capital gain from the disposition of stock, which is taxed at a maximum rate of 15% for non-corporate investors (compared with rates of up to 35% for ordinary income).

The general partner is granted a "carried interest" entitling it to 20% (and sometimes more) of the cumulative profits of the fund. The carried interest is a "profits interest" for tax purposes. The general partner is taxed only when profits are allocated to it, not upon receipt of the profits interest at the inception of the fund. The general partner entity itself is usually classified as a partnership for U.S. federal income tax purposes, so allocations of long-term capital gain pass through to the individual members of the general partner and are taxed at the favorable 15% rate described above.

Non-U.S. limited partners generally are not subject to U.S. tax on gain derived upon the disposition of stock or debt securities of a U.S. corporation (other than stock of U.S. real property holding corporations). However, non-U.S. investors are taxed on income that is "effectively connected" to a trade or business conducted within the United States and are required to file a U.S. federal income tax return in any year in which they are deemed engaged in such a trade or business. In a fund, investments in operating partnerships or limited liability companies generate effectively connected income. To avoid direct imposition of tax and U.S. filing obligations on non-U.S. partners, most funds agree to structure investments of non-U.S. partners into an operating partnership or limited liability company through one or more "blocker corporations".

U.S. tax-exempt investors are subject to tax on "unrelated business taxable income" or "UBTI". In a fund, typical sources of UBTI are investments in operating partnerships and limited liability companies, as well as income from debt-financed property. Most funds agree to structure investments in a manner intended to minimize the likelihood of a tax-exempt investor's directly realizing UBTI, using blocker corporations or other holding vehicles.

7. (a) What are some applicable U.S. securities laws and other regulatory requirements relating to the promotion or management of a private equity fund?

In connection with the offering of interests of a fund to investors, funds generally rely on the exemption from registration under Rule 506 of Regulation D of the U.S. Securities Act of 1933, as amended. Under Rule 506, such offering transaction will be deemed private (and not public) so long as there are no more than 35 purchasers of the interests of the fund that are not "accredited investors". Each purchaser that is not an "accredited investor" must either alone or with a representative have the knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment; or the fund must reasonably believe, immediately prior to making the sale, that such purchaser comes within this description.

An "accredited investor" is defined to include (i) any corporation or partnership not formed for the specific purpose of acquiring the securities offered, with total assets in excess of $5 million; (ii) any director, executive officer or general partner of the issuer of the securities being offered or sold, or any director, executive officer or general partner of a general partner of that issuer; (iii) any natural person whose individual net worth, or joint net worth with that person's spouse, at the time of the purchase exceeds $1 million; (iv) any natural person who had an individual income exceeding $200,000 in each of the two most recent years or joint income with that person's spouse exceeding $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year; and (v) any entity in which all the equity owners are accredited investors.

The Investment Company Act of 1940, as amended, requires the following to register as investment companies: (i) issuers that engage (or propose to engage) primarily in the business of investing, reinvesting and trading in securities; (ii) issuers that engage (or propose to engage) primarily in the business of issuing face-amount certificates of the installment type; or (iii) issuers that engage in the business of investing, reinvesting, owning, holding or trading in securities and own or propose to acquire investment securities having a value exceeding 40% of the value of the issuer's total assets. The majority of funds rely on an exemption from registration under the Investment Company Act. See Q&A 7(b) for discussion.

The Investment Advisers Act of 1940, as amended, requires the following to register as investment advisers: (i) persons who, for compensation, engage in the business of advising others, either directly or indirectly or through publications or writings, regarding the value of securities or the advisability of investing in, purchasing or selling securities; or (ii) persons who, for compensation and as a part of a regular business, issue or promulgate analyses or reports concerning securities. The majority of funds take the position that their general partners, managers or other investment team members fall under the Investment Advisers Act's exception that such persons are not required to register as investment advisers if during the course of the preceding 12 months they have had fewer than 15 clients and do not hold themselves out generally to the public as investment advisers, nor act as investment advisers to any registered investment company or a company that has elected to be a business development company. For the purpose of determining the number of clients of an investment adviser, no shareholder, partner or beneficial owner of an investment fund will be deemed to be a client of the investment adviser unless the person is a client of such investment adviser separate and apart from his or her status as a shareholder, partner or beneficial owner.

The U.S. Employee Retirement Income Security Act of 1974, as amended (ERISA), governs the investment of the assets of certain employee benefit plans that may be investors in a fund. Under ERISA and regulations issued by the Department of Labor (DOL), when a plan covered by ERISA acquires an equity interest (such as the interests of a fund) in an entity that is neither a "publicly offered security" nor a security issued by an investment company registered under the Investment Company Act, the assets of the ERISA plan generally include not only such equity interest but also an undivided interest in each of the underlying assets of such entity unless it is established that (i) ownership of each class of equity interest in an entity by "benefit plan investors" has a aggregate value of less than 25% of the total value of such class of equity interest outstanding at such time, determined on the date of the most recent acquisition of any equity interest in the entity; or (ii) the entity is a "venture capital operating company" as defined in the DOL regulations.

The USA PATRIOT Act (The Uniting and Strengthening America by Providing Appropriate Tools Required to Interrupt and Obstruct Terrorism Act of 2001) requires that financial institutions establish and maintain compliance programs to guard against money-laundering activities. The PATRIOT Act requires the Secretary of the U.S. Treasury Department to prescribe regulations to govern the anti-money-laundering policies of financial institutions. The Financial Crimes Enforcement Network (FinCEN), a bureau of the Treasury, has proposed regulations that would require certain pooled investment vehicles to follow anti-money-laundering policies or procedures. Although these regulations are not yet final, the final version adopted by FinCEN could possibly apply to funds. Moreover, legislation or regulations could be enacted to require funds or service providers to funds to share information with governmental authorities regarding investors in funds. Such legislation and/or regulations could also require funds to implement additional restrictions on the transfer of fund interests. Accordingly, funds generally require information from investors to verify, for any reason whatsoever, the identity of an investor and the source of the payment of subscription monies, or to comply with any applicable customer identification programs required by FinCEN, the U.S. Securities and Exchange Commission (SEC) or other federal regulatory authority.

In addition, interests in funds may not be offered, sold, transferred or delivered, directly or indirectly, to certain persons, including (i) a person or entity who is a "specially designated national and blocked person" within the definitions set forth in the U.S. Department of the Treasury's Office of Foreign Assets Control (OFAC) Regulations of the Treasury; (ii) a person acting on behalf of, or an entity owned or controlled by, any government against whom the United States maintains economic sanctions or embargoes under the OFAC Regulations; (iii) a person or entity who is within the scope of Executive Order 13224 - Blocking Property and Prohibiting Transactions with Persons who Commit, Threaten to Commit, or Support Terrorism, effective September 24, 2001; or (iv) a person or entity whose contributions to the fund will be derived from or related to, directly or indirectly, any illegal or illegitimate activities or any individual or organization identified as a terrorist or as a terrorist organization by the United Nations or the U.S. federal government.

(b) Are private equity funds generally regarded as investment companies?

The majority of funds rely on exceptions under section 3(c)(1) or 3(c)(7) of the Investment Company Act from being required to register as an investment company under the Investment Company Act.

Under section 3(c)(1), a fund will not be deemed to be an investment company under the Investment Company Act if its outstanding securities are beneficially owned by not more than 100 persons and if it is not making and does not presently propose to make a public offering of its securities. Beneficial ownership by a person is deemed to be beneficial ownership by one person, except that if the person owns 10% or more of the outstanding voting securities of the fund and the person is or, but for the exception found in section 3(c)(1) or 3(c)(7) of the Investment Company Act, would be an investment company, beneficial ownership is deemed to be by the holders of such person's outstanding securities.

Under section 3(c)(7), a fund will not be deemed to be an investment company under the Investment Company Act if its outstanding securities are owned exclusively by persons who, at the time of acquisition, are "qualified purchasers" and if it is not making and does not at that time propose to make a public offering of such securities. A "qualified purchaser" includes (i) a natural person who owns not less than $5million in investments (as defined in the Investment Company Act) and (ii) any person, acting for its own account or the accounts of other qualified purchasers, who owns and invests on a discretionary basis not less than $25 million in investments.

8. (a) What is the impact of globalization upon investments in private equity funds?

Typically, when a fund is formed, the investment team is restricted from investing outside a specific geographical area. This is generally insisted upon by the investors who wish (i) to know where their money is being put to work, and (ii) to ensure that the investment team is capitalizing upon the strengths of its members and not being stretched too thinly. The primary impact of globalization on funds has been an increasing number of funds formed to invest in previously obscure geographical areas. For example, a fund focused on emerging markets may intend to invest primarily in India, Russia and China. Thus, investors are able to select funds that offer higher risk/reward investment profiles as well as gain exposure in previously inaccessible geographical areas.

Interestingly, the recent annual report of the UN Conference on Trade and Development indicated that there are signs of rising hostility from labor unions and politicians around the world toward fund managers, based largely upon the short time horizon of the investments and the fact that funds usually rely on job cuts to generate the increase in profitability and capital gains that they seek.

(b) What legal issues may arise from investments by the fund in foreign jurisdictions?

Each jurisdiction brings its own particular set of issues. A common requirement among those investing in foreign jurisdictions is obtaining assurance that such investment would not lead to increased tax liability, create an obligation to file a tax return in a foreign jurisdiction and compromise an investor's limited liability. Often investors will negotiate for the fund agreement to contain protective language to prevent these negative effects.

(c) What factors may be relevant to the decision of where to establish a private equity fund?

Generally, a fund is domiciled in the country where the investment team is domiciled. Other factors that are also taken into consideration are the primary location of investments, the primary location of investors, the familiarity of investors with the jurisdiction, the tax exposure and treaty benefits of the jurisdiction and the limited liability protection for investors. In the United States, funds are generally formed under to the laws of the State of Delaware, but often include parallel offshore vehicles for certain foreign investors.

Continued in Part II in the next BOTW

Thank you to Peter Keenan, Darren Baccus, Andrew Beck and Mark Tice for their contribution in answering these frequently asked questions. We also acknowledge Mondaq's contribution in providing the questions.

Amy Johnson-Spina is an associate in the firm's New York office, concentrating in corporate law with an emphasis on private equity transactions. Amy advises private equity fund managers and institutional investors on a broad range of issues, including acquisitions and investments (direct and indirect).

Jay Romagnoli is a member of the Torys' Executive Committee and the head of the firm's Private Equity Group in New York. His practice focuses on private equity, mergers and acquisitions, and financing transactions for public and private companies, equity sponsors and financial institutions. He has represented private equity clients in a broad range of corporate transactions, including their consolidation programs and venture capital investments. He has also advised debt and equity financiers in numerous transactions, including leveraged buyout transactions, secured credit facilities and leveraged recapitalizations.

[1] Note that for purposes of these FAQs, we have omitted any discussion of hedge funds, which although arguably a subset of private equity funds, are governed by separate laws and regulations, and therefore are worthy of a separate discussion.

[2] In addition to those trends listed, within the last year funds have begun to include provisions in their fund agreements allowing for the possibility of future public offerings with respect to entities above the fund that are wholly owned by the fund's investment team. We expect that this trend may continue with increased frequency depending upon the success of the Blackstone initial public offering.