Feb. 11, 2020

Four Common Fund Structures to Mitigate ECI Risks When a PE Sponsor Launches a Private Credit Strategy (Part Two of Two)

Although PE sponsors are accustomed to highly complex structures to optimize the tax treatment of each portfolio company their funds acquire, the typical PE fund tends to have a fairly straightforward structure. This is not the case, however, for a PE sponsor that adds an additional private credit strategy. Unlike equity investments in the PE context, direct or indirect lending by private credit funds can introduce unfamiliar tax issues for sponsors to navigate. Among them, non‑U.S. or tax-sensitive investors (together, Tax-Sensitive Investors) in private credit funds may be subject to U.S. income tax on any income effectively connected (ECI) to a “trade or business” (e.g., loan origination) in the U.S. This second article in a two-part series details the ECI risks faced by Tax-Sensitive Investors, while weighing the pros and cons of four of the most common private credit fund structures that can be used to mitigate that tax impact. The first article discussed several factors for PE sponsors to consider before launching an additional private credit strategy, including personnel needs and potential issues with a sponsor’s existing PE funds. See our two-part series “Ropes & Gray Survey and Forum Consider Credit Fund Structures, Leverage, Conflicts of Interest and Challenging Environment”: Part One (Jul. 19, 2018); and Part Two (Jul. 26, 2018).

Alternative Financing Facilities: How GP and Co‑Investment Facilities Increase Sponsors’ “Skin in the Game”

PE sponsors have been incredibly aggressive in recent years about pursuing fund-level leverage through subscription facilities and net asset value facilities. Because those types of financing facilities have been ubiquitous among PE funds, they have also attracted attention from limited partners and certain regulatory agencies for the way they are used and disclosed. Although other types of financing facilities have not garnered as much attention in recent years, they can be powerful tools for PE sponsors. General partner (GP) facilities enable sponsors to directly have more “skin in the game” by using leverage to finance their contributions to the PE funds they manage. Similarly, co‑investment facilities indirectly serve a similar purpose by allowing a sponsor’s employees and principals to finance their personal investments in those same PE funds. To better understand GP and co‑investment facilities, the Private Equity Law Report recently interviewed Proskauer partner Ron D. Franklin. This article summarizes the features and uses of those facilities; explains the driving forces behind them; and highlights issues PE sponsors should consider before putting those facilities in place. For more on financing facilities, see “Characteristics and Benefits of NAV Facilities for Secondary Funds” (Sep. 10, 2019); and “Operational Challenges for Private Fund Managers Considering Subscription Credit and Other Financing Facilities (Part Three of Three)” (Jun. 16, 2016).

RWI in the Secondary Market: Financial Impact on Transactions and the Process of Obtaining Insurance (Part One of Two)

It has become common for representation and warranty insurance (RWI) to be used in merger and acquisition (M&A) transactions, and the practice appears to now be gaining momentum in the secondary market. While RWI can provide benefits to sellers and buyers in secondary transactions, it may also introduce additional complexity and increased upfront costs. The evolution, use and potential future of RWI in secondary market transactions was recently discussed at the Kirkland Liquidity Solutions Academy. Moderated by Kirkland & Ellis partners Michael D. Belsley and Jessica H. Sicsu, the panel featured Matthew Heinz, senior managing director of Aon Transaction Solutions; Dale Addeo, managing director of Evercore; and Anna Rozin, vice president of M&A insurance at AIG. This first article in a two-part series discusses the history of RWI in transactions; the economic benefits it can offer to both buyers and sellers; and an overview of the timing and process for putting RWI in place. The second article will detail some of the key terms for RWI policies, as well as unique considerations when it is used in secondary restructurings led by general partners. For additional commentary from Kirkland & Ellis on the secondary market, see “Current Trends in the PE Secondary Market and Key Differences Between Europe and the U.S.” (Oct. 22, 2019).

Practical Tax Considerations Arising From Trends in European Fund Structuring

A developing theme in recent years has been the extent to which current fund structures will continue to achieve the aim of minimizing tax leakage. This has largely emanated from coordinated action of the Organisation for Economic Co‑Operation and Development and E.U. member states to tackle and prevent perceived tax avoidance and treaty abuse. As a result, it is now important to carefully consider not only whether the economic substance of a fund structure can withstand scrutiny from a tax perspective, but also whether it will continue to minimize tax leakage in the future. In a guest article, Will Smith and Caleb McConnell, partner and associate, respectively, at Sidley Austin, address a number of the important changes to the international tax framework that have affected the tax planning involved in fund structuring. In addition, the article provides practical points to consider for a European fund structure in light of these international tax changes. For analysis of other tax issues, see “Sidley Panel Discusses Operational and Tax Challenges of Hybrid Funds” (Nov. 5, 2019); and “PE Real Estate Funds: Unique Fund Terms and Notable Tax Items (Part Three of Three)” (Sep. 3, 2019).

Using Cyber Insurance to Mitigate Risk: Finding an Insurer and Navigating the Application Process (Part One of Three)

Historically, PE sponsors have focused their compliance and risk management efforts on issues typical to the private funds industry (e.g., conflicts of interest and improper expense allocations). Amid a recent spate of high-profile cyber attacks, however, PE sponsors are focusing their efforts on cybersecurity and taking out cyber liability insurance to protect their businesses and portfolios. Although insurance does not mitigate all of an organization’s cyber risk, it is an important element of a multi-pronged approach to managing that perpetual risk. The Private Equity Law Report interviewed legal and insurance industry experts about the current state of the cyber insurance market and what companies need to know about this risk-management tool. This first article in a three-part series describes the trend toward increased adoption of cyber insurance, explains how to find the right insurer and provides actionable advice on navigating the application process. The second article will address how much coverage is necessary and how companies can be savvier about having the right terms in place. The third article will discuss techniques for managing the cyber liability policy after it has been issued, as well as how to work with the broker and insurer in the event of a cyber breach. See “Surveys Show Cyber Risk Remains High for Investment Advisers and Other Financial Services Firms Despite Preventative Measures” (Jul. 20, 2017); and “Cyber Insurance Coverage, Pre-Breach Mitigation Efforts and Post-Breach Response Plans Can Reduce Harm to Fund Managers From Cyber Attacks” (Jan. 19, 2017).

Regulatory Lawyer Michelle Kirschner Joins Gibson Dunn in London

Gibson Dunn announced that Michelle Kirschner has joined the firm’s London office as a partner. Focused on noncontentious financial services regulation, Kirschner represents a wide range of financial institutions, including hedge fund managers, PE sponsors, integrated investment banks and corporate finance boutiques. She has extensive experience advising clients on areas such as systems and controls; market abuse; conduct risk; and regulatory change management and compliance, including the recast E.U. Markets in Financial Instruments Directive; the Market Abuse Regulation; and the Senior Managers and Certification Regime. See “ACA Panel Reviews Effects of Impending MiFID II on U.S. Advisers” (Dec. 7, 2017); and “ESMA Strives to Prepare Markets As MiFID II, MiFIR and Brexit Approach” (Oct. 12, 2017).