Clawback provisions – which allow LPs to recoup excessive carried interest distributions from GPs – are increasingly becoming a central focus in GP‑LP negotiations. The importance is highlighted by Upwelling Capital Group’s study which found that approximately one in 14 U.S.‑based PE firms is at risk of a clawback. As a result, LPs are taking a more proactive approach to negotiating GP clawbacks and ancillary protections. Although some sponsors are not giving ground, others have been forced to acquiesce by granting LP-favorable terms (e.g., interim clawbacks) due to the current difficult fundraising environment.

This two-part article series provides context for the increased focus on clawback provisions in GP‑LP negotiations, as well as additional risk mitigation techniques pursued by both parties. This first article provides an overview of the current industry focus on clawback provisions, along with descriptions of additional protections LPs pursue to ensure they receive their share of fund profits. The second article will highlight contractual mechanisms that GPs employ to limit the scope and likelihood of clawbacks, as well as to improve their ability to hold current and former employees accountable for their respective pro rata shares of clawback obligations.

See “How Key PE Fund Terms Are Being Shaped by Current Fundraising Challenges, Liquidity Needs and Distinct Shifts in the Market” (Feb. 9, 2023).

What Are Clawbacks?

Although the concept of a “clawback” is painted with a broad brush, it is useful to distinguish between LP clawbacks and GP clawbacks – the latter of which is the subject of this article series.

LP Clawbacks

Common Scenarios

When LPs are subject to a clawback, they will have to return some or all of the distributions they received at an earlier point in the life of the fund. LPs might be subject to clawbacks if a fund has made distributions to its LPs and no longer has sufficient assets left to cover financial obligation specified in the fund’s limited partnership agreement (LPA), said Tannenbaum Helpern partner Michele Gibbs Itri.

One common LPA requirement is for LPs to indemnify the GP, investment adviser, LP advisory committee or a service provider when a specified scenario occurs, Itri noted. Another clawback scenario is if a purchase price adjustment or indemnification obligation is triggered in connection with the sale of a fund’s portfolio company after the initial distribution of proceeds to LPs. “If, for example, a year after the sale the fund has to cover an indemnity under a sale agreement, then the manager may need to claw back some or all of the cash that was distributed to the LPs,” she explained.

Timing

At present, LP clawback obligations are typically subject to a two-year limit – i.e., two years from the time the distributions took place – and are also often capped at 25% of an investor’s capital commitment, Itri said. “LPs don’t want to be on the hook forever. They want to know, at a certain point in time, they’re not going to have to pay back distributions they receive from a fund.”

Negotiations have become more common, however, around the terms of LP clawbacks, Itri observed. Some GPs are pushing for three-year post-distribution time limits, or for limits set at two years from when a fund liquidates, regardless of when the distributions may have taken place. “The distribution could have been six years ago, but a GP would still have until two years after the fund liquidates to issue an LP clawback,” she explained.

LPs are pushing back at GP efforts to expand time limits of LP clawback obligations. “Institutional investors are trying to negotiate the time period down, or seed investors – the initial investors – are negotiating a change in fund terms, because that really needs to apply across the board to all investors,” Itri continued. As funds vigorously compete to offer favorable terms and lure investors, it is increasingly common for investors to negotiate more favorable LP clawback terms, she added.

GP Clawbacks

If investors do not receive their preferred return – or if the GP receives more than the contractually allotted carried interest allocation – then a GP clawback may be triggered to require the GP to return carried interest it has already received. GP clawbacks are designed to give investors a measure of confidence and security that they are not parking their money in a fund that will fail to perform, and that a manager who does not deliver will not profit from failure.

The likelihood of a GP clawback being triggered depends to a large extent on whether a fund has a European-style waterfall or an American-style waterfall, observed Coran Ober partner David Pentlow. Under a European-style waterfall, a GP will typically not earn carried interest until its LPs receive their initial capital contribution and preferred return. At that point, the typical 80/20 catch-up will come into play, he explained. That waterfall structure largely forestalls a situation where a GP profits disproportionately without having delivered for investors, which reduces the need for a GP clawback.

See “Current Trends and Pressure Points in Negotiations Around Distribution Waterfalls” (Jan. 23, 2025); and “Up Next in SEC Examinations? Waterfall Calculations and Investment Decisions” (May 16, 2024).

Conversely, an American-style waterfall causes profits to be distributed on a deal-by-deal basis, which means that a GP may earn carried interest early in a fund’s life from selling a portfolio company before LPs have received their entire initial capital contribution and preferred return. If the fund suddenly stumbles, however, and its remaining investments end up not being profitable, then a GP may be unjustly enriched before its investors have been made whole, Pentlow stated.

Further, PE strategies generally rely heavily on buying and selling portfolio companies, in pursuit of handsome capital gains over a period of approximately five years, Pentlow noted. “Typically, a PE fund has two to three portfolio companies. Maybe it buys the first one at a nice price and sells it for decent profits, but then the other two are just sitting around,” he posited. “The long-term performance of a fund can be infinitely more variable when a fund pursues investments in a variety of assets with different profiles, solvency and value.”

As a result, GP clawback provisions can be important tools of remediation for investors in funds with American-style waterfalls, particularly if the fund’s performance falters and a conflict crops up between LPs and GPs, Pentlow reasoned.

Increased Attention on GP Clawbacks

Limited LP liquidity caused by a lack of distributions has created a challenging fundraising environment for GPs to navigate. The result has been a “buyers market” that favors LPs in negotiations around fund terms and provisions. Although most might expect that to manifest in reductions in management fees and carried interest, that has not been the case, noted Davis Polk partner Michael S. Hong.

Instead, most negotiating efforts are expended at the margins of economic terms, such as how clawbacks are calculated and structured, Hong continued. “I would say that clawbacks are being wrapped up into the tapestry of more fundamental material economic issues that are up for grabs in the current buyer’s market,” he added. The following are several reasons why clawback provisions are receiving increased attention in current GP‑LP negotiations.

See “Trends in Private Fund Terms and GP‑LP Fundraising Perspectives in the Current Market Environment” (Jul. 27, 2023).

LP Focus on LPA Provisions

How, and whether, clawback provisions are incorporated into fund documents can often depend on a number of different variables, asserted Sadis & Goldberg partner Ron S. Geffner, including:

• the strength of the markets;
• the demand for, and capacity constraint of, the specific product or investment strategy;
• the fund manager’s reputation;
• the sophistication of the manager; and
• the sophistication of the prospective investors.

“The more sophisticated the investor and the larger the investment, the likelier a negotiated clawback,” he added.

To that end, Sidley Austin partner Jennifer A. Spiegel asserted that there is nothing new about investors asking for clawback provisions, or their incorporation into fund documents. A notable uptick has been observable lately, however, among some types of private funds (e.g., closed-end private credit funds) where investors have historically not been quite as assertive about their rights – particularly when an American-style waterfall is in place.

Crucially, investors are also more aware of the types of situations in which they may find GPs to have compromised the investors’ interests and taken undue rewards. As a consequence, they are paying more attention to clawback provisions in fund documents and how they are worded, Spiegel stated. “They want to ensure the clawback is drafted correctly, and by that I mean that the clawback obligation does not just kick in when the GP has received more than 20% of the overall profits, but if the GP got any profits and the LPs didn’t get a full return of capital and a preferred return,” she explained. “To be correctly drafted, the clawback has to address both scenarios.”

See our two-part series: “Latest Trends in GP Removal Provisions, Investment Provisions and Other PE Fund Terms” (Jul. 26, 2022); and “Recent Status of Negotiations of Co‑Investment Access, Management Fees and Other PE Fund Terms” (Aug. 2, 2022).

Broader Applicability of Clawbacks

Historically, investors primarily had to focus on ensuring that standard PE funds with American-style waterfalls had clawback provisions. That is changing, however, as investors become more sophisticated and funds become more complicated.

European‑Style Waterfalls

An interesting recent development is that investors have increasingly insisted on including GP clawback provisions in LPAs of funds that have European-style waterfalls, Spiegel stated. Investors have come to the realization that just because a European-style waterfall is in place, theoretical danger persists where a GP has greater flexibility to reinvest “return of capital” proceeds throughout a fund’s life – which is a particularly common practice with private credit funds, among others.

Clawback risk for a fund with a European-style waterfall is rooted in the sequence in which capital is injected into the fund relative to when the GP may have been in the carry stages of the fund’s waterfall, Hong summarized. “Funds with high recycling capabilities are more prone to sequencing risk because recycling means you have more dry powder that you can call over the life of the fund as compared to funds that have more limited recycling capabilities.”

To illustrate the point, Hong posited a scenario where a GP divested multiple investments in a portfolio, returning capital to investors and, as a result of reaching the profit-sharing stages of the fund’s waterfall, took carried interest. Thereafter, the GP could call capital near the end of the fund’s life to perform one or more follow-on investments, which subsequently underperform and are written off by the GP, he continued. “That creates a scenario where the GP needs to go back to the early stages of the waterfall on a cumulative basis to repay LPs’ initial capital despite the GP having already taken a share of the profits. If the fund is in liquidation, that might result in carry clawback.”

As for the reasons behind the increased focus on clawback provisions in funds with European-style waterfalls, Hong offered two potential explanations. First, he pointed to the rising popularity of private credit funds in the marketplace in recent years. “As credit funds tend to have greater recycling flexibility than their PE fund counterparts, notwithstanding their European-waterfall features, clawback risks have found their way into the current zeitgeist of negotiations,” he explained.

See “ACC and EY Report Examines Growth Trajectory and Recent Trends in Private Credit” (Mar. 6, 2025).

The other potential reason relates to constricted M&A activity over the last 24 months caused by, among other things, high interest rates, political uncertainty around the U.S. elections and ongoing geopolitical tensions. Fund managers have not been divesting their existing portfolio companies or deploying dry powder into new opportunities, Hong observed. Instead, managers have been more likely to deploy capital to bolster their existing portfolio companies via follow-on investments. “As follow-on investments require capital draws late in a fund’s life, there may be some correlation between that phenomenon and people’s awareness around clawback risks,” he reasoned.

See “Dechert and Mergermarket 2025 PE Outlook: Ongoing Fundraising and Liquidity Challenges” (Feb. 6, 2025).

Hybrid and Evergreen Funds

In addition, clawbacks are increasingly coming into play in hybrid funds that invest in illiquid assets, but where LPs either have limited withdrawal rights or remain subject to long lockups and slow payouts, Spiegel observed. Often, GPs of hybrid funds will still receive a significant annual incentive fee despite the slow payout model. “I’ve definitely seen an increase in clawbacks in that context in the last few years, which is unusual because it used to be that clawbacks do not happen after you’re in hedge fund land,” she stated.

The growing creativity of fund structures and compensation plans, and the increasingly hybrid characters of many vehicles, have also made clawbacks more common, Spiegel asserted. As evergreen private credit funds are allowing investors to take part in successive investment periods instead of moving into a harvest period, fund economics tend to play out over a longer time, she reasoned. “I definitely see clawbacks being implemented in these types of evergreen credit vehicles, both on a tranche-by-tranche or vintage-by-vintage basis, and also across tranches.”

See “Emerging Industry Trends Include Rise of Evergreen Structures, Tax Complications and Private Credit Funds” (Jan. 9, 2025).

Additional LP Risk Mitigation Tactics

An end-of-life GP clawback provision merely represents a baseline measure that LPs insist on putting in place to prevent the overpayment of carried interest to GPs. The following are additional mechanisms that LPs request in negotiations meant to both enhance and supplement those clawback provisions to ensure maximum protection.

Interim Clawbacks

Some investors are seizing on the current market dynamics to negotiate for interim clawbacks, with nearly two-thirds (64%) of funds providing them in 2024 per a recent survey conducted by Paul Weiss. Negotiating interim clawbacks into fund documents for funds with American-style waterfalls can spare investors from having to wait until a fund’s final distribution to get back any excess carried interest paid to the GP via an end-of-life clawback, explained Simpson Thacher partner Michael W. Wolitzer.

See “Recent Survey Shows Market Adversity Is Tempering LPs’ Ability to Negotiate Key PE Fund Terms” (Sep. 5, 2024).

Interim clawbacks can be thought of as a concession or a compromise that some sponsors are making to investor demands, Wolitzer stated. Although LPs are not certain to receive that concession, many are highly likely to seek it as a means of curbing the risk that GPs will draw too much carried interest too early in the life of the fund. “Over the last several years, more and more LPs are asking for an interim clawback in the American-style waterfall, just to have a couple of opportunities to evaluate whether a clawback is needed before the end of the fund life,” he reasoned.

Interestingly, there is no market standard for determining the interim point for those clawbacks. “Different types of interim clawbacks exist, coming into play at different points within an investment period, and they are typically the subject of extensive negotiations,” noted Simpson Thacher partner Deborah Gruen. The timing could lie directly in the middle of a fund’s performance period; closer to the beginning or the end; or even at multiple points depending on what LPs and GPs negotiate.

It is worth noting, however, that interim clawback provisions are uncommon for funds with European-style waterfalls, Hong clarified. “GPs of funds with European-style waterfalls do not tend to be in the carry stages until late in their fund lives. Given that, the interim clawback becomes relatively moot, although end-of-term GP clawbacks still persist.”

See “Chasing Waterfalls: Analysis and Market Response to ILPA’s Deal‑by‑Deal Waterfall Model LPA (Part One of Two)” (Sep. 15, 2020).

Escrow Requirements

Another way that LPs will seek to protect themselves from overpayment of carry to a fund manager is to negotiate for an escrow provision to be included in fund documents. Escrow provisions require GPs to put a portion of each carry distribution – typically between 15% and 20%, although that can vary – into an escrow account, Hong summarized.

The agreed portion of carry distributions stays in the escrow account for an indefinite period until any interim or end-of-life clawback provisions, as applicable, are exercised in the fund documents, Hong continued. “Any repayment of proceeds pursuant to a clawback provision is paid first from the escrow account. If the escrow is sufficient, then any balance in the account goes to the GP. If, however, the escrow account is insufficient, then the GP is usually liable to cover the difference of any amount owed,” he explained.

GPs prefer to avoid escrow provisions because they both defer the GP’s receipt of carry distributions and, just as frustratingly, require the cash to sit in the account, earning little compared to the fund’s portfolio, Hong noted. “Often the parties will pre-negotiate for the escrow account to be invested in a prescribed set of low-risk type of instruments,” he explained. “There was a time when some GPs had discretionary authority to invest escrow proceeds into deals, but that is pretty rare now.”

Notably, escrow provisions are far less common than GP clawback provisions for managers going to market with new funds. “Unless a firm has had an escrow concept baked into its documents since early in their life, it is pretty rare for GPs to offer an escrow option as opposed to a clawback,” Hong observed. “That said, GPs will sometimes agree to escrow provisions if they are struggling to fundraise – particularly in the current environment – or if LPs were burned by the GP performing poorly in past funds, resulting in a clawback,” he added.

Individual Guarantees

Clawback provisions in fund documents are direct contractual agreements between a GP and its LPs. Those agreements entail the risk, however, that a GP can become insolvent and unable to repay improperly distributed carried interest under those clawback provisions. As an additional layer of protection, most LPs insist that investment professionals at firms who are receiving carried interest distributions must sign guarantees with LPs on a several, not joint, basis to backstop the agreed-upon clawback obligations, Hong stated. “At the end of the day, those individual guarantees reassure investors that someone will pay them back if and when appropriate,” Wolitzer added.

As a practical matter, individual investment professionals do not sign separate signature pages for guarantee agreements with each LP, Hong explained. “Instead, the guarantee is expressed as a contract for which the LPs are express third-party beneficiaries such that, for all intents and purposes, there is a direct contractual obligation between the employee receiving the carry and the LPs,” he described. Further, it is not structured as a joint and several obligation of each individual guarantor – i.e., each individual is only liable up to their share of the clawback amount, but not sums exceeding what the individual received, he clarified.

It is important to be clear, however, that not all types of fund managers are expected to grant those types of individual guarantees, Hong noted. “Bulge bracket fund managers that are obviously creditworthy are not expected to grant those rights to investors; instead, it’s typically middle-market firms with around 25 investment professionals who receive a slice of carry distributions,” he explained.

Also, it is highly unlikely that LPs will ever practically need to act upon those individual guarantees, Hong noted. “That would be a ‘hell and damnation’ scenario, as no LP would probably ever invest with that firm again if a clawback devolved to investors suing individual guarantors in court for clawback obligations,” he reasoned. “More often than not, if the GP wants to have any going concern value, then they will negotiate with the LPs to buy themselves some time to eventually repay the money themselves.”

The Standards Board for Alternative Investments (SBAI) has published two documents that outline ongoing concerns about valuation methodologies and offer ideas and proposals for improving industry practices.

The first document is the “Valuation Standards – Review of existing Standards and proposal for addition of new Standards specific to Private Market Assets” (Consultation Paper), which proposes updates to the SBAI’s Alternative Investments Standards (Standards), which offer a framework for assessing the quality of fund managers’ valuation processes as to illiquid assets.

Concurrent with releasing the Consultation Paper, the SBAI issued its “Private Market Valuations: Governance, Transparency, & Disclosure Guidelines” (Guidance). The Guidance suggests alternative methodologies to value illiquid assets; tips when using independent valuation agents; and considerations when using valuations in liquidity management tools (e.g., GP‑led secondaries).

This article briefly summarizes the Standards, the revisions proposed in the Consultation Paper and key points raised in the Guidance, along with insights and commentary from PE industry experts.

For other SBAI guidance, see our two-part series on avoiding parallel fund conflicts: “New SBAI Standards and Case Study Provide Guidance for Mitigating Conflicts” (May 5, 2020); and “Specific PE, Real Estate and Private Credit Issues and Mitigation Tips” (May 12, 2020).

Context of Consultation Paper

Impetus for Valuation Standards

In the SBAI’s view, investors have come to rely heavily on fund managers and service providers to accurately and reliably value illiquid assets and to manage, sell and trade those assets in a manner that is fair and consistent with their fiduciary duties. The SBAI contends, however, that investors frequently raise concerns that fund managers fall short of fulfilling those duties, including as to:

• conflicts of interest, sometimes arising from managers’ direct involvement in valuing assets;
• inaccurate valuations, which can be manipulated or otherwise adversely affected by such factors as:
  • smoothed volatility;
  • lagging marks;
  • inflated marks during fundraising periods; and
  • broad disconnects from public market valuations;
• inconsistent valuations, often resulting from a lack of standardization among fund managers and the use of subjective valuation methodologies; and
• investors’ inability to perform their own due diligence, rooted in a lack of transparency from managers not sharing information around valuations.

According to the SBAI, those issues have “far-reaching” consequences for investors, including:

• inequitable treatment of investors in the same fund, particularly if it is an open-ended vehicle or one providing liquidity at specific times;
• overpayment of fees when calculations are based on a fund’s net asset value (NAV) and assets are overvalued;
• inaccurate portfolio hedging and rebalancing based on incorrect private fund valuations; and
• flawed assessments of investment teams’ performance.

Regulatory authorities have seized on those issues to heighten their focus on private fund valuation practices. Specifically, the Consultation Paper enumerates active efforts by the International Organization of Securities Commissions, the U.K.’s Financial Conduct Authority and the Australian Prudential Regulation Authority to target transparency concerns and conflicts of interest in valuations.

See “FCA Review Assesses Fund Managers’ Implementation of ESG Goals” (Apr. 18, 2024).

Existing SBAI Standards

The valuation section of the Standards applies generally accepted accounting principles (GAAP) standards in setting forth a number of rules and guidelines, with specific policy prescriptions relating to three general areas: governance arrangements, investor disclosure requirements and methods for treating hard-to-value assets.

When it comes to governance, the Standards require:

• having arrangements in place to mitigate conflicts of interest;
• segregating the valuation function when a fund manager performs in-house valuations;
• codifying the valuation process – which addresses controls and monitoring – through a valuation policy document; and
• escalating any material valuation issues promptly to the firm’s governing body.

As for disclosure, the Standards call for:

• disclosing the firm’s valuation policy to investors;
• disclosing portfolio managers’ involvement in valuations;
• being transparent about the percentage of the portfolio in liquidity buckets;
• notifying investors of material increases in hard-to-value assets;
• periodic reporting of side pockets’ value; and
• disclosing any other material issues to investors.

Finally, as to hard-to-value assets, the Standards mandate:

• applying a consistent approach in the valuation of hard-to-value assets; and
• using side pockets, including as to fees, timing and eligible assets.

Proposed Changes

Although the SBAI acknowledges that the Standards are well meaning and incorporate “many well-defined techniques and methods,” it still faults the Standards for allowing managers a high degree of subjectivity and for being subject to assumptions on the part of valuation service providers. In its Consultation Paper, the SBAI proposes the following amendments to the Standards.

Manager‑Led Secondaries

Valuations are of critical importance in manager-led secondary transactions, which occur when a fund manager elects to sell an asset between one vintage fund and another to raise cash to distribute to the prior fund’s investors. As the fund manager is acting as both buyer and seller, manager-led transactions pose inherent conflicts of interest.

Hence, the SBAI proposed adding language to Standard 6 of the Standards to require manager‑led secondaries to be completed “in accordance with managers’ fiduciary obligations, disclosures to regulators and investors, and compliance policies and procedures governing the transactions.” In addition, managers would be required to commission an independent valuation or fairness opinion in connection with the transaction.

Accompanying Guidance

As guidance for fund managers to satisfy the revised requirements in Standard 6, the SBAI suggests that managers should:

• disclose to investors the possibility of cross-trades, explaining how they will be undertaken and how proper pricing will take place;
• offer “a reasonable and plausible logic” for the manager‑led transaction;
• be clear as to who will pay for any external valuation or opinion;
• carefully weigh any external competitive auctions or bids;
• notify investors of the manager‑led transaction as early as possible, giving them sufficient time to consider the plans;
• seek LP and/or LP advisory committee (LPAC) consent for the transaction, as necessary;
• give investors access to the independent valuation report;
• disclose any conflicts of interest;
• perform any cross-trades for listed securities at fair market prices;
• carefully consider how the cross-trade might affect market prices, particularly in cases of low liquidity or low trading volumes; and
• monitor cross-trades on an ongoing basis, and keep records to illustrate the trade played out in the interest of both funds.

Alignment of Interests

The issues the SBAI raised around accurate valuation of assets in manager‑led secondaries are a good reflection of the conversations that private funds lawyers often have with their clients, according to Alston & Bird partner Heather N. Wyckoff.

Although the purpose of the Standard and guidance is to foster trust between managers and investors in the performance of manager‑led transactions, that is not the only issue for managers to weigh. “The relationship with investors, and that level of trust, is very important,” Wyckoff conceded. “But, also, you’d want to be protected against any sort of claims with the benefit of hindsight – and even when the transaction is occurring at a premium – that you could have disposed of those assets at an even higher valuation than what was realized.”

At the same time, Wyckoff believes that managers and investors may share a broader alignment of interests on this topic than some realize. “The manager’s relationship with investors is not limited to a snapshot of a particular fund or transaction – institutional investors often have a relationship with the manager that extends beyond that fund,” she noted. “To maintain that goodwill, managers want investors getting liquidity to be comfortable with the price at which the asset is being sold, and for the investors participating to be comfortable with the price at which it’s being acquired.”

Valuation Methodology

Managers enjoy a significant degree of flexibility when it comes to the use of valuation techniques and approaches, subject in some cases to the investment type and the availability of market data, the SBAI observed. Among various inputs used to determine valuations, growth and discount rates are examples of types that are subject to managers’ subjective judgment and decisions. According to the SBAI, the upshot is that all that subjectivity can have a material impact on valuations.

Proposed Changes

The following are the proposed revisions to Standard 6 of the Standards as to valuation methodologies – and accompanying guidance – that the SBAI issued in the Consultation Paper.

Selection and Changes

Managers should disclose, in their valuation policy, the valuation methodologies they expect to use during the fund’s life. It is crucial for managers to include highly detailed disclosures and to avoid such vague, open-ended phrases as “any reasonable or justifiable methodology that the Manager chooses or sees fit,” the SBAI emphasized. Further, if the manager deviates from its prescribed valuation methodologies during the life of the fund, then investors should be notified.

As guidance for implementing that change, the SBAI suggested that managers should, upon acquiring an asset, determine what valuation methodology may be suitable for that asset, and should make disclosures in advance of any potential changes to that methodology. The SBAI gives the example of venture capital investments where an asset has not yet begun to generate any revenue, and an option pricing model may come into play. If and when the business in question begins to generate revenue, then the manager may want to shift to an income-based valuation method – but should disclose that potential shift in advance.

It is vital for managers to provide a rationale for any change in an existing valuation methodology or the adoption of a new one, according to the SBAI. Managers should spell out what situations and/or market conditions might trigger such a change.

Aggregation

If managers put a valuation to use that involves the weighting of methodologies or valuation components, they must be ready to explain the process – especially as it applies to how weightings are calculated and put to use. In the SBAI’s view, aggregation of methodologies is fair and appropriate as long as managers are transparent about the weightings given to each methodology and the reasons behind them.

Inputs, Adjustments and Assumptions

Managers must be ready to provide details on any inputs, adjustments and assumptions used in the valuation process if they could have a material impact on such outcomes as:

• growth rate;
• discount factor;
• EBITDA adjustments;
• unrealized cash flows; and
• future cash flows.

Again, in the SBAI’s view the key is transparency and disclosure around all inputs. Not only should managers be prepared to engage with investors and discuss those topics, but the SBAI argues that managers should “be prepared to defend their assumptions and inputs and be able to provide evidence to back up their assertions.”

Further, managers should be prepared to be forthcoming with any details of sensitivity analysis they undertake as to inputs, adjustments and assumptions used in valuation modeling. Again, managers should be ready to discuss the sensitivity analysis with investors.

See “SEC Enforcement Action Scrutinizes Substantive Details of Level‑3 Valuation Policies and Procedures” (Jun. 29, 2023).

Experts’ Analysis

Protecting Managers’ Discretion

The SBAI’s efforts to encourage disclosures, and the use of third-party valuation experts, is not especially controversial or problematic, Wyckoff said. A push for more disclosures can have unforeseen consequences, however, by blurring lines in fund governance. “Requiring more disclosure can get sticky when an investor wants the ability to challenge valuations, or to have any kind of say in the decision-making process around what is or isn’t in a valuation policy,” she noted.

Ultimately, a firm’s valuation policy is up to the manager, and extends across different products that the manager operates, Wyckoff continued. Allowing an investor to push too hard for a role in valuations can have “ripple effects” that might disadvantage other investors in the same products or suite of funds, and “is something the other investors aren’t really signing up for,” she explained. “It’s really important for the manager to maintain discretion as to what is in the best interests of the fund generally.”

Ensuring Equitable Disclosures

The SBAI’s argument about making sure investors feel they are treated fairly compared to other investors is not hard to understand, Wyckoff acknowledged. Some investors tend to be more assertive than others, particularly when it comes to institutional investors.

“Institutional investors have resources and will hire law firms to advocate for how they think a fund should operate and if they want a right, for example, to be notified of changes to the valuation policy,” Wyckoff said. “If that’s a common point that institutional investors push on, a fund manager should consider giving all investors the right to request a copy of the then-current valuation policy. If you’re going to give that type of notification to certain people at the table, however, I understand the SBAI’s point about making it available to everyone.”

Valuation Service Providers

Some of the most detailed proposals in the Consultation Paper address the engagement of valuation service providers (e.g., independent valuation providers). The SBAI calls for revising Standard 5 to require expanded due diligence around vendor selection, along with evidence of those diligence efforts. As guidance to comply with that new standard, the SBAI asserted that any manager thinking of engaging such a service provider must:

• review and consider a range of potential parties;
• assess whether a candidate can provide both accurate and timely valuations of the type of assets in question;
• take a close look at the provider’s staffing resources and the experience levels of its staff;
• review industry references and feedback about the provider’s staff;
• ask whether the provider is a member of the International Valuation Standards Council or another standard-setting body; and
• make sure that vendor selection takes place independently of the investment team.

Once managers have made a selection, the SBAI’s revisions would require managers to disclose to investors all details of the services the valuation expert will provide, including any limitations to that service. To guide those efforts, the SBAI calls for managers to disclose:

• whether the valuation provider will value all portfolio positions, a sample of them or materially large portfolio positions;
• whether the provider will offer detailed valuations, a range of possible values or verification that the managers’ calculated mark presents no material issues; and
• whether the provider will submit any verification of manager valuation models.

If managers take on a legal or contractual obligation to adopt or implement third-party independent valuations, the SBAI’s revised standards would mandate disclosing that to investors. Managers would also be required to disclose any instances of altering or ignoring valuations derived independently and externally.

To avoid conflicts of interest, fund managers should share with investors the payment structure they agree to with third-party valuation agents, and provide guarantees that no parties determining valuations will be unduly influenced by those who benefit from higher or lower valuations. Also, the SBAI requires managers to disclose to investors if private market investors wholly or partly own the valuation service provider. To that end, managers should disclose what policies and procedures they have in place to avoid any conflicts of interest.

Accounting Standards

The Consultation Paper calls for amending Standard 6 of the Standards to require managers to provide full disclosures to investors, when launching a fund or vehicle, of the accounting standards they will follow, along with explanations of any deviations therefrom with appropriate evidence. The SBAI also proposes that managers be transparent about the circumstances or market conditions that might cause any deviation from their specified accounting standards.

Further, the SBAI proposed a new rule requiring managers that oversee an asset or fund in a jurisdiction that does not follow a globally recognized standard (e.g., GAAP) to adopt alternative standards such as the International Valuation Standards. Deviations from GAAP typically relate to relatively minor issues such as amortization of organizational experiences or reserves for contingent liability, Wyckoff noted. “It is usually disclosed to investors that those two items may deviate from GAAP, and, to the extent there’s a deviation, managers often maintain two different sets of books, but that deviation is not usually material enough to risk qualification of an audit.”

“This comes up more regularly in a hedge fund, because the valuation is used to calculate fees,” Wyckoff continued. “A manager would say, ‘I’m going to calculate fees based on NAV that includes non‑GAAP adjustments for things like amortization, but I’m also going to keep issuing GAAP financial statements. So there may be a deviation between the value I use to calculate fees and what the audit shows.’”

Use of Auditors

When it comes to the selection, appointment of and engagement with auditors, the SBAI’s proposed changes to Standard 5 of the Standards are very much in line with those for independent valuation service providers. Specifically, auditors should be selected who are competent, capable and sufficiently experienced in auditing financial statements for funds investing in illiquid or non-listed assets.

As part of its due diligence efforts to satisfy that requirement, the SBAI advises managers to:

• consider a range of candidates;
• assess providers’ abilities to perform appropriate accounting scrutiny;
• review the resources at the auditor’s disposal;
• parse industry feedback, references and reputation; and
• ascertain whether the auditor is a member of a standard-setting industry organization, such as the Association of International Professional Accounts.

In conjunction with those efforts, the SBAI would require managers to carefully explain to investors the basis for their decision of which auditor to engage, the scope of the task the auditor will perform and the auditor’s precise role in the valuation process. Managers should also fully disclose to investors, in a timely manner, any comments or concerns that auditors raise about valuations.

Stress Testing

In the further interest of transparency, the SBAI proposes adding a requirement to Standard 8 of the Standards for managers to conduct periodic stress testing and analysis to understand how various market conditions might cause changes to asset values. Such testing is, in essence, a risk management exercise, and might not necessarily lead to any reevaluation of a fund asset, the SBAI explained.

As part of its guidance on the proposed requirement, the SBAI noted that specific scenario analyses may come into play for different asset classes. For example, the Consultation Paper posits that liquidity stress testing may not be useful for making assessments in a closed-ended investment structure, yet might be helpful for hybrid structures offering investors some degree of liquidity. The SBAI urges managers to consider a full range of approaches that might be relevant to their strategy.

See “Improving Compliance Programs With Gap Analysis and Risk Assessments” (Dec. 14, 2023).

Frequency of Valuations

The SBAI proposes adding a new item to Standard 8 requiring managers to undertake regular valuations of fund assets, in keeping with the fund’s redemption rights. Redemption rights are critical in determining the frequency of such valuations. For example, assets within evergreen funds offering limited redemption rights should undergo more frequent valuations than those of closed-ended funds, as annual valuations are appropriate for the latter. “It is common for managers to produce valuation ‘estimates’ in the interim period between official valuations,” the Consultation Paper states. “This should be considered a good practice to follow.”

In the further interest of full transparency and disclosure, the SBAI proposes adding a requirement that managers be ready to offer a comparison showing how past valuation estimates have measured up to actual outcomes (i.e., as reflected in sale prices). That would help provide investors with a sense of how accurate valuation methodologies have been over time, the SBAI argues.

Liquidity

Finally, the Consultation Paper proposes adding a new item to Standard 8 that would help investors grasp how a lack of liquidity – defined as the presence of active buyers and sellers in a market at a given time – may affect valuations. The SBAI would require managers to be ready to speak with investors about the impact of liquidity or its absence on valuations.

SBAI Guidance: Governance, Transparency and Disclosure

The Guidance addresses many of the same topics as the Consultation Paper. Many of the specific policy prescriptions in the two documents are identical, including those relating to:

• improving valuations and transparency around valuations;
• promoting fair and equitable investing;
• selecting outside service providers; and
• protecting the interests of investors.

Liquidity Management Tools

A meaningful difference in the Guidance is that it more closely examines certain types of liquidity management tools where valuations can be particularly sensitive and prone to manipulation, such as private market secondaries, GP‑led secondaries and NAV lending. The Guidance offers a few concrete proposals addressing valuation issues in each of those contexts.

Private Market Secondaries

Private market secondary transactions, involving the buying and selling of investor commitments in private funds in the secondary market, offer a number of benefits to investors, the SBAI conceded. Investors can buy or sell shares of PE funds before the maturation of the underlying investments. In terms of liquidity, those types of transactions provide several advantages for investors, such as portfolio diversification, the ability to reduce risk exposure and the opportunity to exit investments sooner than anticipated if the investor deems it in their best interest.

At the same time, however, the SBAI warns of the acute danger that pricing uncertainty, or differences between the expectations of buyers and sellers, may arise. Returns may also suffer if a buyer in a private market secondary transaction takes on underperforming assets or funds with undisclosed liabilities. For those types of transactions, the SBAI asserts that accurate valuations and transparency around valuation methodology are especially critical, as is the need for due diligence.

GP‑Led Secondaries

Guidance

Accurate and fair valuations of assets are also important in GP-led secondary transactions in which the GP of a private fund initiates the sale or restructuring of fund portfolio assets. Negotiations with LPs around liquidity options or the sale of specific assets are common, but concerns around accurate valuations and conflicts of interest – with the GP operating as both the buyer and seller – persist.

To illustrate what it views as the severity of the issue, the Guidance references the SEC’s private fund adviser rules (PFAR), which the U.S. Court of Appeals for the Fifth Circuit ultimately struck down in June 2024. Under the pretense of protecting investors, the PFAR would have subjected all GP‑led transactions to independent valuations and fairness opinions before the transactions could proceed – similar to the standard proposed by the SBAI in the Consultation Paper.

See “Fallout From the Fifth Circuit’s Bombshell Ruling Vacating the Private Fund Adviser Rules” (Jun. 27, 2024).

Expert Analysis

The fact that the PFAR faced its demise in a Fifth Circuit court ruling in June 2024 is not without significance for the SBAI’s proposals, asserted Cleary Gottlieb partner Kenneth S. Blazejewski.

At the time PFAR was proposed, Blazejewski and his colleagues believed it mandated what nearly all sponsors doing secondaries transactions had already adopted as a common practice absent other clear market support for transaction pricing. Sponsors already understood that getting fairness opinions helped demonstrate that they had satisfied their fiduciary obligations. “The SEC was mandating, in rules, something we thought the market had already figured out,” he summarized.

The market has ways of solving valuation issues on its own, without heavy-handed rules and statutes, and what is true in the case of the PFAR also applies to some degree to the Guidance around secondary transactions, Blazejewski reasoned. “Private fund investors are sophisticated investors, and with the appropriate disclosure, they can make decisions about their investments,” he added. “So, I can’t say, overall, that everything in the Consultation Paper sounds merited, given that the managers we work with are largely already making a lot of valuation-related disclosures.”

Room for Improved Disclosures

In some deals, there is always room for more diligence and disclosure, especially when it comes to highly diversified secondary transactions, Blazejewski acknowledged. “In a very large deal, for example, an investor could be acquiring indirect exposure to multiple funds that each have a dozen or more portfolio companies,” he stated.

In that scenario, even a very sophisticated secondary investor will not conduct due diligence and valuation work on 100 percent of the assets in the portfolio, Blazejewski continued. “For the remainder of the portfolio – typically constituting less material positions – there needs to be a way to ascribe value to what the secondary investor’s going to pay.”

If that is the reality for the most sophisticated investors, it can be still truer for less sophisticated ones in the rapidly growing secondaries market, Blazejewski conceded. They may be particularly vulnerable to accepting sponsors’ NAV numbers without performing proper diligence. “Therefore, any inconsistencies in the way sponsors come up with those NAV numbers can be a potential source of inefficiency,” he reasoned. “If that’s part of what the SBAI is trying to solve, then that seems to be in the interest of a more efficient market.”

Nonetheless, the case for letting the market sort things out on its own is strong, concurred Cleary Gottlieb partner Adam Fleisher. “I’m a strong proponent of private ordering, and in this market, in particular, the investors generally are good at expressing themselves,” he asserted. “Our clients also generally want to make their investors happy and provide the disclosures they need, so there’s strong transparency.”

NAV Lending

An increasingly popular financing strategy is NAV lending, where PE funds take out loans secured against the collateral of their underlying portfolio asset values. NAV lending is likely to take place during the “value creation phase” of a fund, or late in an investment period after most of the LPs’ capital has been called. NAV loans typically:

• are collateralized against diverse portfolio investments;
• have floating-rate coupons and long-dated maturities;
• are supported by payments to the lender funded with cash flows from underlying investments;
• have loan-to-value ratios in the 5‑30‑percent range; and
• are structured such that the underlying assets will be monetized before the loan matures.

The Guidance describes high levels of discomfort among LPs with NAV financing, citing a Coller Research Institute study finding that only seven percent of LPs are comfortable with GPs freely employing NAV facilities. The SBAI attributes LPs’ lack of trust toward NAV lending to their risk of overleveraging assets that are already highly levered.

Once again, valuations are critical. The overvaluation of assets when sizing a NAV facility may result in loan defaults, while undervaluing assets might lead to a credit crunch. The underlying assets may be subject to sudden and dramatic market shifts, affecting not only their value but the terms of the NAV loan. Cognizant of those risks, lenders may impose stricter loan terms than they otherwise would.

Alternative Valuation Sources

Emphasizing the danger of inaccurate valuations in various contexts, the Guidance specifically took a deeper dive on several alternative valuation sources that managers can use as to illiquid or hard-to-value assets.

Public Market Equivalents

Public market equivalents (PMEs) compare the returns of a PE fund to a corresponding public market index, thereby helping investors see how their private investments measure up to opportunities available in the public markets. Different PE funds necessitate comparison with different PMEs, but the British Private Equity & Venture Capital Association has put forward a few standard models – including the Long-Nickels PME, the Kaplan-Scholar PME and the Capital Dynamics PME – which use different methodologies and set different benchmarks for assessing the comparative performance of PE investments.

PE Benchmark Indices

Through the use of PE benchmark indices, it is possible to track how PE investments and/or portfolios perform over a given period of time. A number of factors will go into the composition of a specific index, such as the type of investments held, their geographic scope and the investment vintage. However, bespoke PE benchmark indexes are only as good as the quality of available data, and highly advanced methodologies come into play when factoring in valuations, cash flows and performance metrics.

Publicly Listed PE Managers

Another resource for those concerned with the fairness and accuracy of valuations is performance information provided by publicly listed PE managers. Investors can turn to those managers as benchmarks to assess their own funds’ performance. The SBAI cautions, however, that differences between the accounting and reporting practices of private and publicly listed entities can make direct comparisons difficult. “Despite these challenges, publicly listed [PE] managers offer a useful proxy for assessing market trends, investor sentiment, and broad industry performance within the [PE] space,” the Guidance states.

The whirlwind of the second Trump administration has not left the IRS unscathed. Trump broke with precedent by promising to fire the tax-collecting agency’s commissioner, leading him to resign. Plans to add a further 10,000 employees are on hold following Trump’s executive order freezing federal hiring, which follows his statement about intending to fire or reassign 90,000 recently hired IRS staffers.

The IRS has not yet, however, felt the force of those proposed changes. In fact, there are indications the upheaval at the IRS may be more limited than elsewhere. One reason is that Trump is hunting for revenue to pay to extend and expand the Tax Cuts and Jobs Act of 2017 (TCJA). Although the president hopes tariffs will cover those costs, he has also indicated a desire to close the “carried interest” loophole. Those efforts could be a sign that certain recent IRS audit and enforcement activities targeting fund managers and their personnel could survive the current deregulatory environment.

Those trends were discussed by a panel at the Private Investment Fund Tax & Accounting Forum featuring Kostelanetz LLP partners Caroline D. Ciraolo and Melissa Wiley, as well as Eisner Advisory Group partner Miri Forster. This article summarizes the panel’s insights on which entities are receiving increased audit attention; the types of claims facing more IRS scrutiny; and how to effectively navigate the audit and enforcement process.

See our two part series “Hot Topics in Tax and Negotiating Tips for Private Fund LPs”: Part One (Aug. 10, 2023); and Part Two (Aug. 24, 2023).

Building a Better IRS

IRS Funding: Its Function and Its Future

Despite spending their careers advocating for high-income taxpayers against the IRS, none of the panelists seemed eager to see the extra funding for the agency disappear. “I want to underscore just how significant that amount of money still is, and how transformational that can actually be for the IRS,” Wiley said. “Those who deal with the IRS should be silently cheering and saying, ‘Yes, please give them more money for customer service.’”

Further, the IRS’ technology for individual tax account administration dates to the Kennedy administration, Wiley added. “The IRS needs the appropriate technology in-house so it can perform necessary work, especially on complex audits.”

New Initiatives and Efficiency Measures

According to Wiley and her fellow panelists, the IRS has put its extra funding to good use, including:

• restructuring its audit and enforcement teams;
• focusing on more efficient ways to resolve disputes; and
• targeting audits with the highest potential return: high-income individuals, large corporations and complex partnerships.

“They have reorganized their field attorneys,” Forster explained. There had previously been separate teams focused on large, international businesses, and small business and self-employed individuals. “They’ve pulled them all together to pool their resources,” allowing “more people to be more sophisticated on complex structures.”

Bang for the Audit Buck

Audits of high-income individuals, partnerships and companies really pay off for the IRS. Audits of returns of the top 1% of filers return $3.18 for each dollar spent, and those of the top 0.1% return $6.29. In addition, approximately 77% of the tax gap is attributable to underreported income, especially by the three target groups. “Even if a taxpayer is trying to report every last dollar on their tax return, these are difficult returns. Very wealthy individuals have very complex businesses and really complex structures,” Wiley reasoned.

Previously, the IRS did not have the means to focus on audits of complex partnerships, Wiley said. Under the previous leadership, the agency planned to increase the number of audits of:

• partnerships with assets over $10 million tenfold, from 0.1% to 1%;
• large corporations, from 8.8% to 22.6%; and
• wealthy taxpayers, from 11% to 16.5%.

The agency had also targeted performing audits of another 125,000 high-income non-filers, and had initiated audits of a number of large partnerships and complex pass-through arrangements (e.g., private funds), she added. The future of those IRS audit plans, along with the future of many of the newly-hired examiners, remain uncertain under the new administration.

New Pass-Through Unit

The former IRS leadership also made significant structural changes to how the agency approaches complex businesses such as private fund advisers. To handle a large increase in partnership and pass-through returns over the last decade, a new Pass-Through Unit was established to focus on large partnerships and global high-wealth individuals and entities.

“The IRS has spent a lot of resources in hiring and training this new group,” Wiley said. “We have seen a lot of global high-wealth exams opened, as well as audits of high-net worth individuals that then spread out, on an enterprise level, to the partnerships, corporates and LLCs with which that person is affiliated,” he explained. In addition, the IRS created a new associate chief counsel office focused on pass-through trusts and estates. The Pass-Through Unit could be at risk, however, from the budget cuts proposed by the Trump administration.

Alternative Dispute Resolution

The IRS used alternative dispute resolution (ADR) in just 0.5% of cases reviewed by the IRS Independent Office of Appeals (Appeals), and its use actually fell precipitously from a low initial level from 2013 to 2022. Two years later, Appeals established a new ADR Program Management Office. “That was a big announcement, and it was welcomed because cases can be so expensive,” Ciraolo noted.

The new office quickly announced three pilot programs to test changes to the IRS’ Fast Track Settlement (FTS) program – which allows mediation while a case is still within the exam process – and to Post-Appeals Mediation (PAM). A key pilot change to the former is allowing FTS on an issue-by-issue basis; previously, if a single issue in a case was ineligible for FTS, then the entire case was ineligible. “It’s an effective way to get past a sticking point in an audit and move on to completion,” Wiley enthused. “We’re going to see an uptick in focusing on discrete issues in massive audits,” Ciraolo agreed.

Other objectives of the pilot programs include:

• ensure more consistent and deliberate consideration of FTS and PAM requests;
• provide explanations when FTS and PAM requests are denied;
• direct Appeals to contact taxpayers directly to inform them that FTS may be applied in their case; and
• remove the limitation precluding PAM eligibility for those who participate in FTS.

In addition, deadlines – 60 days for small businesses and self-employed individuals, and 120 days for large businesses and international cases – “are being observed, and they are driving resolutions,” Ciraolo stated.

Still, hurdles remain to participating in FTS, Ciraolo noted. Requests must come before a statutory notice of deficiency is issued. Matters ineligible for FTS include:

• partnership cases under the Tax Equity and Fiscal Responsibility Act of 1982;
• issues docketed in any court;
• cases in which a competent authority request have been made; and
• situations when the IRS finds that a taxpayer has not acted in good faith during an audit.

Incentivizing Self‑Correction

Beyond notifying taxpayers of their eligibility for FTS, both the Large Corporate Compliance program and the new Pass-Through Unit have employed “friendly letters” reminding subsidiaries of large foreign corporations of their U.S. tax obligations, Wiley said. Similar friendly letters are also being sent to partnerships about whose returns the IRS has questions or concerns, with an invitation to remediate before formal action is taken. Some 150 large foreign corporations have received such letters, and about 500 partnerships. It is all part of an IRS effort to “incentivize self-correction.”

One area where taxpayers should take a considered approach to self-correction are cases involving non-filers, such as the 1,600 already targeted and the 125,000 that might be, Ciraolo suggested. “It’s a very scary situation when you’re receiving a CP59 notice [stating that the IRS has no record that a prior personal tax return has been filed],” she said. “A paralysis sets in, particularly with high-income individuals thinking, ‘How do I get back into compliance without destroying my life?’”

“There are tools to do that, many of which will avoid any kind of public notice of non-compliance, Ciraolo continued. “It is important not to stick your head in the sand because it can get so much worse, whereas it can also be dealt with early in a way that is favorable to the non-filer – in fact, sometimes better than rushing to file tax returns and taking advantage of the voluntary disclosure practice.”

Technology

As discussed, much of the IRS’ technological infrastructure dates to the 1960s, which brings problems beyond mere inefficiency. “The IRS has struggled to hire computer programmers to service their systems because so many are programmed in COBOL – a language no longer taught in computer science programs,” Wiley observed.

The IRS had hoped to replace the outdated systems in 2025, but the hiring freeze and potential budget cuts could frustrate those plans at a time when the agency hopes to increase its use of artificial intelligence (AI) to efficiently select large corporations for audit, Wiley noted. “It would use AI to find returns that are more likely to have issues, and not audit ones that are probably okay.”

Recent Trends in IRS Examinations and Audits

Employee Retention Credits

The Coronavirus Aid, Relief, and Economic Security Act, signed in 2020 by President Trump during his first term, established the employee retention credit (ERC) – a lucrative tax credit to employers who kept employees on the payroll, which was worth up to $26,000 per employee. IRS officers even dangled the ERCs as a way to offset outstanding tax liabilities. All told, ERC claims totaled approximately $250 billion before the IRS implemented a moratorium on them in 2023.

Following the pandemic, “the IRS is in a full-blown enforcement rage,” Ciraolo said, training some 300 revenue agents and investigators to identify improper ERC claims and pursue monetary recoveries. There are over 400 criminal investigations under way, and 17 people have been convicted – with sentences averaging almost two years in prison.

The IRS had hoped to process the remaining 400,000 claims worth $10 billion by the end of 2024, taking an aggressive approach during audits and disallowing thousands of claims. Although certain voluntary disclosure programs and windows have closed, the voluntary withdrawal program for unpaid claims remains open – along with new processes for payroll companies and third-party payers to resolve incorrect claims.

Qualified Small Business Stock Exclusion

The IRS has a close eye on uses of the qualified small business stock (QSBS) exclusion under Section 1202 of the Internal Revenue Code. To be eligible to exclude up to 100% of gains recognized on the sale or exchange of QSBS:

• the stock in question must be C‑corporation stock;
• the company must have had gross assets of $50 million or less before and immediately after the equity was issued; and
• at least 80% of a company’s assets must be actively used in a qualified business.

It is essentially a checklist that examiners can use to disallow what could be a very large deduction, Forster said.

“The IRS is checking that all the requirements are met,” Forster emphasized. “You must prove that you have a qualified trade or business that meets the requirements. It is not enough that the K‑1 says it may be a qualified small business. Someone needs that data to really prove it.”

See our two-part series: “Techniques for Preserving Qualified Small Business Stock Benefits for Early‑Stage Investments” (Jan. 19, 2021); and “Tips for Realizing Qualified Small Business Stock Benefits for Fund Investments and Certain Convertible Instruments” (Jan. 26, 2021).

Charitable Contributions

Another examination area that, according to Wiley, “does not require a high level of sophistication in terms of getting through the regulations” are charitable contributions. “You would be surprised at how many times a few things on the compliance checklist are missed,” she added. “I have seen clients lose donations of hundreds of thousands of dollars because they did not follow the rules. There is a ton of non-compliance or foot faults on Form 8283.”

The most common issues that lead to disallowance of a charitable contribution are lacking appropriate documentation of gifts to entities with which the taxpayer is affiliated, lack of a qualified appraisal or failure to get the recipient to sign Form 8283, Wiley recounted. “Those types of cases are great for ADR,” Ciraolo added.

Shareholder Loans

IRS examiners are increasingly interested in shareholder loans – both those made by a shareholder to a corporation, and those made by a corporation to a shareholder, Ciraolo noted. Specifically, the agency is concerned about the use of the former to claim deductions for interest paid on loans that are more properly treated as equity investments, and the latter as a form of disguised compensation. “The IRS is concerned that loans are not being captured as taxable income on the shareholder’s returns – e.g., the shareholder will deem the loan uncollectible and the entity will also declare it worthless, so nobody pays taxes on it,” she explained.

Facts and circumstances – under factors established in 1972 in Estate of Mixon v. United States – are used to determine a loan’s status, and proper documentation is key, Ciraolo stated. “Those factors help lawyers make the case that a transfer is a loan, and might help avoid arousing the IRS’ ire. “The IRS is referring matters for criminal investigation, including several prosecutions pending right now where the IRS is taking the position that they represent willful mischaracterization and either a false statement on tax returns or outright tax evasion by shareholders.”

See “Ways That Tax Concerns Drive Structuring Strategies for PE, Real Estate and Private Credit Funds” (Jul. 12, 2022).

Aircraft Campaign

The Large Business & International (LB&I) Division of the IRS has a current campaign focused on corporate aircraft use. The IRS is taking a closer look to confirm business and personal use allocations and the deductions that stem from them, as well as the treatment of personal use as a taxable fringe benefit.

“This is an area that the IRS has not been secretive or shy about saying they are interested in,” Wiley said. The LB&I has also not been shy about using external sources to support their claims, such as Federal Aviation Administration tag data and subpoenaed flight manifests. “If a plane repeatedly went to, say, Hawaii or the Bahamas and the individuals did not have business interests there, that’s going to be a red flag,” she stated. Examiners are also paying close attention to claims that aircrafts were employed for business purposes more than half of the time during the coronavirus pandemic.

Open Questions

Pass‑Through Entity Taxes

The TCJA put a $10,000 limit on state and local tax (SALT) deductions – hitting residents of high-tax states, where many private fund managers live and work, particularly hard. In response, states began adopting pass-through entity tax (PTET) laws, allowing qualified pass-through entities and S‑corporations to pay taxes at the entity level – making them fully deductible for federal income tax purposes. To date, 36 states and one locality have passed PTET laws; indeed, the only states with personal income taxes that have not even considered them are Delaware and North Dakota.

See “How the Tax Cuts and Jobs Act Will Affect Private Fund Managers and Investors” (Feb. 22, 2018).

In response, the IRS issued Notice 2020‑75, accepting that PTET should not be taken into account when applying the $10,000 limit on SALT deductions, and promising formal, permanent guidance to that effect. Four years later, the agency has still not issued that guidance, and, according to Wiley, IRS exam teams – particularly those conducting mail audits – are increasingly ignoring, or are ignorant of, the notice. She notes that she keeps a copy of Notice 2020‑75 handy, “and frequently show it in the course of exams to hopefully make the issue go away quickly.”

The entire issue may go away, however, as Trump has expressed support for increasing the SALT cap he imposed eight years ago, and a group of five Republican congressmen from three high-tax states – New York, New Jersey and California – have pledged to sink any budget deal that does not at least more than double the size of the SALT deduction, Wiley recounted. “Until that time, I expect this to continue to be something of an issue.”

See “Employment‑Related Tax Issues and Significant U.K. Tax Developments for PE Sponsors to Monitor (Part Two of Two)” (Feb. 1, 2022).

Self‑Employed Contributions Act Taxes

In November 2023, the U.S. Tax Court ruled in Soroban Capital Partners LP v. Commissioner that the exemption from Social Security tax on distributive shares of income or losses received by LPs under Section 1402(a)(13) of the Self-Employed Contributions Act (SECA) applies only to passive investors. Further, the court said that state-law classifications are not determinative; a functional analysis is required to determine “the role of the LP and whether they are truly an LP,” Forster explained.

See “Tax Court Ruling Is a Setback for Fund Managers Structured As Limited Partnerships” (Feb. 8, 2024).

The issue remains unsettled, however. Both parties have filed briefs laying out proposed analyses. According to Forster, Soroban’s proposed nine-factor test “is not looking at the partners’ function,” while the agency points to the U.S. Tax Court’s 2011 decision in Renkemeyer v. Commissioner, which barred law firm partners from exempting their distributive share of self-employment tax. Cases involving Denham Capital Management and Point72 Asset Management are also pending, as is a new petition filed by PE firm Riverstone Equity Partners. In addition, Sirius Solutions has appealed its SECA defeat to the U.S. Court of Appeals for the Fifth Circuit, challenging the Tax Court’s application of its decision in Soroban.

Navigating an IRS Audit

The following are suggestions offered by Wiley for if a fund manager becomes subject to an IRS examination on the above issues or others, which will be increasingly likely if the IRS’ present plan to focus more attention on large corporations and complex partnerships survives the current upheaval in Washington.

See our two-part series: “Synopsis of the IRS Partnership Audit Process and How It Can Be Addressed in Fund Documents” (Apr. 12, 2022); and “Modifications, Amended Returns and Push‑Out Elections As Cures for Imputed Underpayments From IRS Partnership Audits” (Apr. 19, 2022).

Manage Expectations

Provide senior executives in the fund manager with a realistic timeframe for an audit. “The IRS is not going to go away quickly, even if you achieve the golden ring of no change or even a refund,” she explained. “There will be a lot of bodies in the room, from the revenue agents to subject matter experts to group managers, and sometimes even territory managers.”

On the topic of timing, it is important to clearly communicate any delays or issues as they arise. “The old days of deadlines being aspirational goals are over,” Wiley noted. Be proactive about seeking extensions where necessary.

Prepare for the Opening Conference

Proper preparation for the examination’s kick-off is key. Consider carefully whether to include the client or request a recording. It is very valuable to prepare a presentation to introduce the fund manager and its business to the IRS, and to help direct the exam, Wiley recommended. “It is a real opportunity to try and get ahead of a client interview,” she explained. “Get a lot of data and do a presentation at the end of the opening conference with the IRS team. You may eliminate or at least reduce their desire to interview the investigation targets right away, which I try to push off as much as humanly possible, if not entirely.”

Going over the nature of the business and industry, as well as any significant transactions, with the exam team “can really focus and narrow the audit in a way that is helpful because they are not going to spend three years talking about things that aren’t relevant, answering the same questions over and over,” Wiley reasoned. To that end, managers should “try to understand the lens through which the auditor is seeing things,” she suggested. “If you do the best you can to make things easy for IRS examiners, then that is going to come back and benefit you.”

Know the Chain of Command

Do not guess or assume in the face of a question one does not understand - ask for clarification, Wiley suggested. To that end, she recommended – “when you’re not in an adversarial position” – to understand the chain of command on the IRS side and know how to reach out to each member “so that if a problem arises, you’re not trying to chase down who you should be speaking to.”

Review the Bipartisan Budget Act Roadmap

Fund managers should refer to the IRS’ Bipartisan Budget Act of 2015 (BBA) roadmap for taxpayers, showing the three parts of the audit process and the potential steps and recourses available within it, Forster suggested. To ensure a smooth BBA process, understand the power of attorney requirements and restrictions on when partnership representatives can be changed.

In addition, it is important to note that Administrative Adjustment Requests must be filed before a Notice of Administrative Proceedings letter is issued, and that imputed underpayment modification requests must be submitted to the BBA’s online portal – early registration and submission recommended, Forster continued. Advisers should consider whether to make a deposit to stop interest from accruing, and whether that should be paid by individual partners or the partnership, she added.

See “How the New Partnership Audit Regulations Affect Private Funds: Understanding the BBA and Appointing a Partnership Representative (Part One of Two)” (Oct. 19, 2017).

Fund financing continues to grow despite various headwinds in recent years. To help industry participants understand the current landscape and recent trends, Haynes Boone recently published its “Fund Finance Annual Report: 2024” (Report). The Report details trends in different terms, structures and considerations in the fund financing industry, as well as the rapid rise of non-bank lenders as a source of financing for subscription facilities and, more prominently, net asset value (NAV) facilities.

The Report draws on internal data from hundreds of fund finance facilities the firm has worked on (HB Data); survey results from the attendees of NAVember in November 2024 (NAVember Survey); and the results of an industry-wide survey administered by Haynes Boone in January 2025 (HB Survey), which received more than 170 responses from over 100 different sponsors, lenders and service providers. This article summarizes key takeaways from the Report, as well as additional market insights from the co-authors of the Report, Haynes Boone partners Aleksandra Kopec and Brent Shultz.

For additional insights from Haynes Boone, see “Structuring Margin Loans for PE Funds and Addressing Key Facility Terms With Lenders” (Nov. 1, 2022); and “Alternative Financing Facilities: Streamlined Borrowings and Longer Loan Durations With Hybrid Facilities” (Mar. 3, 2020).

Subscription Line Facilities

Pricing

Margins/Spreads

According to HB Data, subscription line pricing (margin/spread) climbed steadily between Q3 2022 and Q4 2023. Although pricing has been trending downward since Q4 2023, the average margin/spread has not dipped dramatically and remains slightly higher than the average reported in Q2 2023. The majority (62%) of HB Survey respondents expect pricing to decrease 5‑15% in H1 2025, and 4% anticipate a more significant drop. Nearly one-third of HB Survey respondents anticipate no material change in the same period.

The Report notes that subscription line pricing continues to compress across the market, with 54% of HB Survey respondents reporting pricing below 220 basis points (bps), compared to only 7% in the previous year. Although overall market pricing has compressed, smaller facilities (below $50 million) have a wider range of pricing, whereas larger syndicated transactions offer a narrower band. The pricing for longer-term facilities (i.e., two years or more) is often 10‑15 bps higher than shorter-term facilities.

Upfront Fees

Most (88%) HB Survey respondents reported upfront fees of 30 bps (per annum) or less in Q4 2024, compared to only 52% in the previous year. The Report notes that North America is the largest global fund finance market and has the highest, most dynamic upfront fee environment.

Unused Fees

The Report observes that 82% of HB Survey respondents saw unused fees of 30 bps or less in Q4 2024, while only 43% reported the same in Q4 2023. The Report explains that bifurcation of unused fees has become a common tool for lenders to incentivize facility usage and notes that the range of bifurcated unused fees has also increased – the difference between the bifurcated unused fees may now be up to 25‑50 bps compared to 5‑10 bps in the past.

Initial Tenor

HB Data showed that the average initial tenor for subscription lines was approximately 17.52 months in H2 2024, which was close to the averages seen earlier in 2024 (16.61 months in H1) and 2023 (18.25 months in H1 and 19.75 months in H2). The average tenor was higher in 2022 (25 months in H1 and 22.05 months in H2).

The Report notes that lenders are hesitating to commit to longer terms due to capital requirements and evolving market conditions.

Financial Covenants and Lender Protections

When asked about the financial covenants and lender protections seen in H2 2024, HB Survey respondents most commonly cited a minimum NAV covenant (55%), followed by a minimum funded capital commitments requirement (43%), fair market value of investments test (34%), minimum number of investments requirements (28%) and fundraising target requirements (23%).

The Report observes that credit agreements continue to see a variety of financial covenants and there is no “one size fits all” approach.

Borrowing Base Approaches

According to HB Data, approaches to the borrowing base varied by initial facility size in 2024. Facilities of at least $1 billion typically consisted of designated investors (66% of those in the category), and the remainder used a flat advance rate or included investors (17% used each approach). The distribution of borrowing base approaches was similar for facilities between $200 million to $999 million, with 45% including and designating investors, 28% using a flat advance rate, 21% including investors and 6% using a coverage rate.

The results for facilities below $200 million were quite different, however. The most popular approach was a coverage ratio (46%), followed by a flat advance rate (20%). The remainder either included and designated investors (17%) or included investors (also 17%).

Volume of Borrowing

When asked how the volume of borrowings in H2 2024 compared to H1 2024, 40% of HB Survey respondents said there was no material change. About one-third of respondents saw a slight increase (i.e., 5‑15%) and 6% reported a more significant increase in volume of borrowings (i.e., more than 15%). One-fifth of respondents saw a decrease in borrowing volumes that was either slight (17%) or significant (3%).

The majority (53%) of lenders expect a slight increase in the volume of borrowings in H1 2025, and 33% anticipate no material change. Sponsors have a similar view, with 46% anticipating no material change and 39% expecting a slight increase. However, 15% of sponsors anticipate a significant increase in the volume of borrowings compared to just 8% of lenders. No sponsors anticipate any decrease, while 6% of lenders expect a slight decrease.

The Report notes that the increase of sponsors’ usage of borrowings under subscription lines supports the sentiments that 2025 will see increased investment opportunities.

Committed Facilities and New Originations

According to HB Data, the vast majority of facilities were committed (89%) rather than uncommitted (11%), which is consistent with the previous two years’ results. The Report explains that the strong preference for committed facilities reflects the stability of the subscription financing market and confidence that commercial terms will remain consistent.

HB Data also shows an increase in new originations of subscription facilities in 2024 (81%), which is up from 71% in 2023. The Report notes that the increase in new subscription facilities correlates to more sponsors reaching successful fund closings.

Private and Public Ratings

When sponsors were asked about their openness to private ratings of facilities, 44% said they were moderately open, 14% were considerably open and 7% were very open. Approximately one-fifth were only slightly/somewhat open, and 14% were not at all open to the idea.

Sponsors were less open to public ratings of facilities, however, with 46% completely opposed and none being very open. With that said, the majority of sponsors still expressed some degree of openness to the concept – 31% were considerably open, 15% were slightly/somewhat open and 8% were moderately open.

A minority (25%) of sponsor respondents said they were not at all open to private credit providers as lenders of record, but the same proportion were considerably open to the idea, 16% were moderately open and 34% were slightly/somewhat open.

The Report observes that 2024 saw a greater variety in types of lenders, with new institutional lender entrants joining an increased number of private credit and insurance providers. More lenders are considering ratings implications when structuring facilities and asking their counsel to consider that in the documentation.

For more on subscription lines, see “Marketing Rule FAQ Clarifies SEC Expectations for Calculating Net and Gross IRR When Using Subscription Credit Facilities” (Apr. 4, 2024); and “Negotiation Tips to Limit Subscription Credit Facility Lenders’ Ability to Directly Contact Fund Investors” (Oct. 12, 2021).

NAV Financings

Pricing

The majority (56%) of survey respondents said the average margin/spread pricing for NAV facilities in H2 2024 was 300‑400 bps, 20% reported pricing below 300 bps and 13% were in the 401‑500 bps range.

According to the NAVember Survey results, the average upfront fees in 2024 were most commonly 26‑40 bps per annum (35% of respondents), followed by 15‑25 bps (30%). One-fifth of respondents said upfront fees in 2024 were more than 50 bps per annum. The NAVember Survey also showed that the majority of respondents saw early termination fees on NAV facilities either most of the time (26%) or some of the time (31%).

The Report notes that there continues to be a significant spread variance from deal to deal. Pricing is now more competitive than in the past two years, especially when high-quality underlying assets are involved. Sponsors may find willing lenders for lower-quality assets, but pricing and advance rates are likely to reflect that.

Tenor and LTV

According to NAVember data, the average tenor for NAV facilities in 2024 was 3‑4 years (66% of respondents). Nearly one-fifth of respondents reported NAV facility tenors of 1‑2 years, and 15% reported tenors of at least 5 years.

The majority (57%) of NAVember respondents said the initial loan-to-value (LTV) ratio was 10‑25%, and about a quarter said it was 26‑40%. NAVember data also showed that the LTV cure period was most often 31‑90 days (44% of respondents), followed by 16‑30 days (35%) and 15 days or less (16%). Only 5% of respondents reported LTV cure periods of more than 90 days.

Use of Proceeds and Leverage

The vast majority (81%) of NAVember Survey respondents said NAV facility proceeds were used for new or follow-on investments. Other uses included managing portfolio company indebtedness (12%) and making distributions to investors (5%) (i.e., synthetic distributions).

Just over two-thirds of NAVember Survey respondents said they had not seen LPs express concern about leverage in NAV facilities, but 31% had seen such concerns raised. Although there have been some negative public relations around the use of NAV proceeds, Kopec reasoned that has ultimately had a positive impact because it opened up conversations about the purpose of NAV facilities and how they should be disclosed. “Increased transparency has benefited the product,” she observed.

See our two-part series: “LP Concerns and Common Misconceptions About the Rise of ‘Synthetic’ Distributions” (Jul. 11, 2024); and “Communication Tactics, LPA Provisions and Fund Structures to Allay LPs’ Anxiety About ‘Synthetic’ Distributions” (Jul. 25, 2024).

The HB Survey results show that most NAV facility proceeds are used for new or follow-on investments, Shultz noted. The ability to add leverage is accretive to a fund’s overall portfolio when LPs are unable, or do not want, to provide more capital. Proceeds are rarely used for synthetic distributions, but discussions during NAVember indicated that when that happened it was often requested by LPs. The guidelines issued by the Institutional Limited Partners Association encourage more clarity and transparency, but do not suggest NAV facilities should not be used, he added.

See “ILPA Guidance on NAV Facilities Aims to Improve Transparency and Engagement With LPs” (Oct. 3, 2024).

Security Package

HB Survey respondents use a range of security measures, but most include a pledge of account for distributions (80%), a pledge of equity in the holding vehicle (74%) and/or a negative pledge (also 74%). Other security measures include a direct pledge of portfolio assets (47% of respondents), fund guarantee (36%), an equity commitment letter (26%) and a minimum balance in the distribution account (6%).

Minimum Uncalled Capital Requirement

The majority (52%) of HB Survey respondents do not have any minimum uncalled capital requirement. The remaining respondents said there was a minimum uncalled capital requirement in NAV financings some of the time (40% of respondents) or most of the time (8%).

Looking Ahead: 2025

Most HB Survey respondents believe market activity in 2025 will increase slightly (62% of respondents) or significantly (18%). Similarly, the institutional level of activity in 2025 is expected to increase slightly (51%) or significantly (32%). Lender hold sizes in 2025 are also expected to increase slightly (46%) or significantly (12%), although 39% of survey respondents do not anticipate any material change.

The Report notes that, while lenders previously held considerable leverage, the influx of private capital and non-bank financial institutions has tipped the scales toward borrowers. In the previous year’s survey, 80% of respondents said lenders had more bargaining power, but only 18% shared that view in the current survey.

Facility Types

According to the HB Survey respondents, the most common types of facilities offered by lenders in 2024 were:

• syndicated subscription lines (84%);
• bilateral subscription lines (75%);
• separately managed account subscription lines (63%);
• umbrella facility subscription lines (54%);
• hybrid facilities (43%);
• bilateral NAV facilities (42%); and
• syndicated NAV facilities (40%).

In theory, hybrid facilities – combining the benefits of both subscription facilities and NAV facilities – offer a very efficient model, but they are quite rare because a fund needs to be in a particular place in its life for the flexibility of the facility to make a real difference, Kopec said. Although 43% of lenders claim to offer hybrid facilities, they may not actually enter into any such transactions, Shultz added.

See “Alternative Financing Facilities: Streamlined Borrowings and Longer Loan Durations With Hybrid Facilities” (Mar. 3, 2020).

Targeted Fund Strategies

When asked about lender-targeted fund strategies, survey respondents most commonly pointed to PE (61%), followed by private debt (47%), infrastructure (38%), secondaries (32%), real estate (29%) and venture capital (8%). Approximately one-third of lenders do not limit themselves to any specific fund strategy, which the Report notes is consistent with the flexibility and increased creativity in the fund finance industry.

The targeted strategies reflect what lenders will look at and do not necessarily reflect deals that are actually executed, Shultz noted. Although lenders are more open to considering different strategies, deals are still primarily in the PE space. Middle market buyout and similar funds are the bedrock of PE, but private debt and secondaries are increasingly popular strategies, he added.

Respondent Concerns and Optimism

The top three concerns for sponsors in 2025 are a lack of good deal opportunities (58% of respondents), difficulty fundraising (33%), and banking turmoil and disruption/inability to fill out their fund finance facilities (25%).

On the other hand, lenders are most concerned about the competitive landscape/new lender entrants (67%), a weakened deal pipeline (quality and/or quantity) (35%), and the difficult exit environment and potential for funds to fail (30%). The Report notes that regulatory changes were the top concern for lenders in the previous year (cited by 43% of respondents), but that dropped to fourth place in the current survey (26%).

Despite sponsor and lender concerns, most respondents believe that 2025 will be a much better exit environment (70%) and a better fundraising environment (54%). Optimism around fundraising is felt in financing because funds do not need financing facilities unless they are doing well on fundraising, Kopec explained. “There seems to be a tailwind now and some deals that were being discussed are actually coming to market, which reflects the fact that a better fundraising environment means quicker execution.”

An improved fundraising environment may result in borrowers exiting older facilities, which will free up capital for new facilities, Shultz noted. “Although the regulatory landscape seems more certain in 2025 and there is a general feeling of cautious optimism, there may still be speed bumps around trade instability and other potential challenges,” he cautioned.

Additional Insights

Expanding Market Participants

Bank failures in 2023 sent shockwaves through the market, Shultz said. Many lenders exited the space and financing demand tightened, driving a spike in pricing. The market has now adjusted in a healthy and dynamic way, however, with more entrants coming in. Although the subscription facility space is still dominated by traditional banks, more players are taking a larger role than in the past, he added. Conversely, there has been a rise in the number of non-bank lenders offering NAV facilities – especially among insurance providers and private credit sponsors, he observed.

Private credit sponsors are interested in the fund financing industry because they are able to thrive by providing more creative structures to achieve a higher return, while still benefiting from the fact that financing facilities are generally considered very safe credit products, Shultz noted. Typically, all the returns of a private fund are pledged in support of a NAV facility, so default risk is lower for lenders as fund managers are strongly incentivized to resolve any issues with the lenders. “Workout scenarios are rare, but they tend to be a collaborative process between the lender and fund that allow time for a sale that benefits everyone,” he observed.

“Despite the growth of the fund finance industry amidst the influx of many new entrants and several institutions creating divisions or departments, there is still a high level of connectedness and a sense that participants are working together, which benefits the product,” Kopec assured.

Traditional Banks vs. Non‑Bank Lenders

Traditional bank lenders are doing NAV deals that are a little more conservative in structure and terms but offer better pricing than non-bank lenders, Shultz stated. For example, a traditional bank may offer the secured overnight financing rate (SOFR) with fewer covenants and collateral, while a non-bank lender may offer SOFR plus 500 or 600 with more flexibility. “Private credit funds are typically able to offer more flexible terms than traditional lenders, and the net result is more innovation, more players in the market, lower overall pricing and a very dynamic market,” he asserted.

One interesting development in the industry of late is that private credit lenders are creatively offering financing solutions across managers’ fund structures, Kopec said. Banks will often stretch to a NAV facility when offering a subscription line, which is their version of creativity. Private credit lenders may take that a step further, however, by offering a subscription line and NAV facility, plus another NAV facility for a separate fund in the enterprise. “That may be something that funds start to think about more. It comes at a price, but the creativity doesn’t have be within one structure – it can be across structures and linked together, because funds operate as an enterprise,” she explained.

Although it is notable that non-bank lenders are able to offer more flexible and creative fund financing solutions, borrowers still tend to prioritize pricing when deciding between competing offers, Kopec said. The lender’s ability to hold the whole facility sometimes comes close to pricing as a decisive factor, as does the ability to execute a closing in a timely and smooth manner, Shultz noted. For example, if term sheets for a NAV deal are received from an established lender with higher pricing and a new entrant with lower rates, the borrower may choose the deal with higher pricing because it is concerned about the new entrant’s ability to deliver on its promises, he clarified.

See our two-part series: “Nuances and Trends in Negotiating Loan‑to‑Value Ratios in NAV Facilities” (Apr. 26, 2022); and “Covenants, Diligence and Collateral Considerations of NAV Facilities for Private Funds” (May 10, 2022).

In an era in which cross-border taxation has become a key consideration for asset managers, Ireland continues to enhance its reputation as a global financial hub through positive enhancements to its regulatory and taxation frameworks. In recent years, incremental adjustments have been made to the tax treatment of dividends received by Irish-resident companies from non-Irish-resident entities. Industry bodies across various sectors have, for many years, articulated a need for Ireland to introduce a form of dividend participation exemption into its tax code to sit alongside the existing capital gains participation exemption. The introduction of such an exemption, as part of the Finance Act 2024, represents a culmination of this ongoing dialogue and consultation between stakeholders and Ireland’s Department of Finance.

This measure aims to enhance Ireland’s holding company regime by exempting qualifying foreign dividends from Irish corporation tax in the hands of the Irish recipient company. The addition of a dividend participation exemption to Ireland’s tax code is an important development, further enhancing Ireland’s position as a leading jurisdiction for private market investment structures. Although the scope of this exemption is presently limited to E.U./European Economic Area (EEA) countries and treaty jurisdictions, it marks a significant advancement in addressing complex double-taxation issues and simplifying compliance for cross-border operations.

This article explains how the dividend participation exemption operates; its practical implications and benefits; the eligibility requirements; the implementation and compliance considerations; and the strategic implications for asset managers.

See the two-part series “Holistic Evaluation of Innovations Intended to Propel the Irish Private Funds Framework”: Part One (Jul. 12, 2022); and Part Two (Jul. 19, 2022).

Background

Prior to the enactment of the Finance Act 2024, Ireland was unique in being the only E.U. Member State not to offer a foreign dividend participation exemption. Such regimes provide important efficiencies for companies managing cross-border operations, however. With its introduction, Ireland aligns itself with peer countries such as the Netherlands and Luxembourg, further enhancing its appeal as a market leading destination for asset holding and investment vehicle structuring.

Moreover, the dividend participation exemption reflects the evolving demands of international taxation. Ireland’s adoption of this measure complements global initiatives such as the Organization for Economic Cooperation and Development’s Pillar Two Framework, which seeks to establish a minimum global corporate tax rate, while also protecting Ireland’s status as a tax-efficient and business-friendly jurisdiction.

How the Dividend Participation Exemption Operates

Under Ireland’s new dividend participation exemption, Irish-resident companies can exclude qualifying foreign dividends and distributions from their taxable income. This removes the need to claim double taxation relief in the form of complex foreign tax credit/deduction calculations for foreign taxes paid on such dividends in the source jurisdiction, thereby simplifying compliance.

To eliminate the risk of double taxation, the exemption primarily applies to dividends and distributions originating from subsidiaries that meet specific criteria tied to:

• the relevant subsidiary;
• the relevant parent company and holding period; and
• the relevant distribution.

By reducing administrative burdens and tax liabilities, this provision offers significant relief to Irish companies operating internationally. It also provides a more predictable and streamlined approach to managing foreign-sourced income.

See “Ireland’s Department of Finance Consults on Framework for Funds Sector” (Nov. 16, 2023).

Practical Implications and Benefits

Simplification of Tax Compliance

One of the key benefits of the dividend participation exemption is its potential to simplify tax compliance for Irish-resident companies. Under the previous regime, companies receiving foreign dividends were required to carry out complex calculations and claim double tax relief to offset taxes paid abroad. With the exemption in place, qualifying dividends are excluded from Irish corporation tax altogether, reducing the administrative workload. This is particularly advantageous for asset managers that receive dividends from diverse international portfolios.

See the two part series “Hot Topics in Tax and Negotiating Tips for Private Fund LPs”: Part One (Aug. 10, 2023); and Part Two (Aug. 24, 2023).

Enhanced Returns and Cash Flow

The dividend participation exemption may improve investment returns and cash flow for qualifying companies by removing the need to pay Irish corporation tax on foreign dividends. This may allow businesses to retain and deploy capital more efficiently, enhancing their ability to seize market opportunities, adjust portfolios and maximize returns for investors. For asset managers, the improved liquidity enhances portfolio flexibility, while companies benefit from greater financial stability and predictability around taxation arrangements.

Stronger Global Competitive Position for Ireland

Tax efficiency plays a pivotal role for global asset managers when choosing jurisdictions for establishing holding companies or investment vehicles. The introduction of this dividend participation exemption in Ireland will bring the country in line with its counterparts, boost its competitiveness and make it more attractive for international businesses.

Eligibility Requirements for the Dividend Participation Exemption

To benefit from the dividend participation exemption, companies must meet the specific eligibility criteria discussed below.

Relevant Subsidiary

Distributions eligible for exemption must originate from a “relevant subsidiary,” which is defined as a subsidiary that is resident in an E.U./EEA country or in a jurisdiction with which Ireland has a double-tax treaty. The subsidiary must not be generally exempt from non-Irish taxes, and the residency requirements must be satisfied both on the date of distribution and for at least five years prior to distribution or since the subsidiary’s incorporation. It is possible that the geographic scope of eligible jurisdictions may expand in the future, subject to alignment with Ireland’s Pillar Two legislation.

Relevant Parent Company and Holding Period

The dividend participation exemption applies to distributions made to a “relevant parent company,” which must be within the scope of Irish corporation tax. The parent company must hold a minimum of five percent of the subsidiary’s ordinary share capital, entitling it to at least five percent of assets available for distribution to equity holders upon a winding-up. This ownership threshold must be maintained for an uninterrupted period of at least 12 months. Notably, holdings through intermediaries in non-relevant territories will not satisfy this requirement.

Relevant Distribution

A “relevant distribution” must be treated as income of the recipient parent company for Irish corporation tax purposes. It should originate from the profits or assets of the relevant subsidiary. Certain distributions are excluded from exemption eligibility, including:

• distributions that are deductible for corporation tax purposes in the foreign jurisdiction;
• payments arising from debt claims; and
• distributions from offshore funds.

Implementation and Compliance Considerations

Effective from January 1, 2025, Irish-resident companies receiving dividends from qualifying EEA/treaty jurisdictions must assess their eligibility for this participation exemption and ensure compliance with the new requirements. Companies must verify that distributions are correctly documented to substantiate the exemption claim. Additionally, at the time of preparing their Irish corporation tax return, companies must decide whether to elect for the dividend participation exemption or retain the tax-credit double taxation relief approach.

When an election for the exemption is made, it will apply to all in-scope distributions received during the relevant accounting period. Importantly, once an election is made, the parent company will forfeit access to double-tax relief for those distributions under existing Irish domestic tax rules.

Strategic Implications for Asset Managers

The new dividend participation exemption is a welcome development for Ireland’s financial services industry, enhancing its competitiveness as a location for holding companies and investment vehicles. By eliminating the complexity of managing foreign tax credits, it enables smoother cross-border transactions and reduces the administrative burden. Ireland has long been a favored destination for holding companies, due to its favorable corporation tax rate and comprehensive double-tax treaty network. The introduction of the dividend participation exemption – sitting alongside the existing capital gains participation exemption regime – further enhances its appeal, particularly for multinational corporations seeking to centralize their global operations in a tax-efficient jurisdiction.

It is anticipated that Ireland’s now enhanced holding company regime will complement the use of investment limited partnerships in private asset regulated fund structures. Lastly, by adopting the dividend participation exemption, Ireland aligns its tax framework with international best practices. This not only bolsters its reputation for responsible tax policy but also positions it as a forward-thinking jurisdiction in the face of significant global tax reform.

As Ireland continues to adapt to the evolving demands of global business, the dividend participation exemption underscores its commitment to fostering a favorable tax environment for international investors. In conclusion, this policy is not merely a technical adjustment but a strategic step forward. It reaffirms Ireland’s status as a premier destination for global businesses and provides companies with new opportunities to optimize their tax strategies while contributing to Ireland’s economic growth.

See “Practical Tax Considerations Arising From Trends in European Fund Structuring” (Feb. 11, 2020); and “Tax, Legal and Operational Advantages of the Irish Collective Asset-Management Vehicle Structure for Private Funds” (Aug. 13, 2015).

 

Shane Geraghty is a partner and member of the asset management and investment funds practice at K&L Gates. He advises domestic and international asset managers in relation to the structuring, authorization and operation of a broad range of Irish fund vehicles. He has particular experience in advising on alternative asset investment and private market fund structures, including for hedge, PE, private credit and real estate fund strategies. Geraghty also has experience in dealing with fund financing arrangements and has advised credit institutions in relation to regulatory requirements impacting such facilities. In addition, he has advised on the structuring of Cayman Islands fund products, having previously worked as an attorney-at-law in the Cayman Islands.

Patrick McClafferty is a founder and partner of Nexus Taxation. A leading Irish tax advisor, he has more than 20 years of experience in the financial services tax field, having previously worked at EY in their financial services tax group. He also acts as an independent fund and special purpose vehicle director and is approved by the Central Bank of Ireland. McClafferty is a chartered tax advisor with the Irish Taxation Institute and a fellow chartered accountant with Chartered Accountants Ireland.

Elaine Butler is a senior manager at Nexus Taxation and also heads up its tax compliance department. She has more than 13 years of financial services taxation experience and specializes in advising on Irish fund and Section 110 structures. In addition to her tax advisory clients, Butler runs a tax compliance book covering corporation tax, value added tax, investment undertaking tax and directors’ payroll. She is also a chartered tax advisor with the Irish Taxation Institute.

Cadwalader has announced that Bronwen Jones, Douglas Murning and Matthew Worth have joined as partners in the firm’s fund finance practice in London. The trio enhances the leveraged finance, private credit, special situations and restructuring capabilities of the firm’s U.K. team.

For insights from Cadwalader, see “The State of NAV Loan Facilities in the PE Industry and Current Obstacles to Widespread Adoption” (Feb. 9, 2023); and “U.K. Long‑Term Asset Fund: Where It Fits Among U.K. Fund Regimes and How Managers Can Launch One (Part One of Two)” (Feb. 15, 2022).

Jones represents banks and other financial institutions, sponsors, GPs and fund managers on a wide range of fund finance matters, including subscription credit facilities, net asset value (NAV) facilities, hybrid facilities, GP facilities and co‑investment facilities.

Murning focuses his practice on working with private credit and PE sponsors on fund financing, leveraged finance, private debt and special situations. He also specializes in NAV and portfolio financings, primarily advising investment banks and private credit sponsors.

Worth’s practice covers all aspects of fund finance and private credit, with a particular focus on NAV financings for PE sponsors and direct lending. He also has significant experience in a broad range of debt finance, including leveraged finance, project finance, infrastructure finance, special situations and restructuring.

See “Key Considerations for Private Credit Funds Seeking Leverage Through Fund Financing Facilities” (Nov. 16, 2023); and “Nuances and Trends in Negotiating Loan‑to‑Value Ratios in NAV Facilities (Part One of Two)” (Apr. 26, 2022).

Jones was previously a partner at Macfarlanes, while Murning and Worth both join from Ashurst where they were partner and counsel, respectively.