Structuring Direct Lending Funds: Open-End vs. Closed-End ...media.straffordpub.com › products › structuring-direct...Sep 25, 2019 · operations, reorganizations to achieve tax

Structuring Direct Lending Funds:

Open-End vs. Closed-End StructuresRecurring Regulatory, Valuation, and ERISA Considerations;

Structures to Confront Pervasive Tax Issues

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

The audio portion of the conference may be accessed via the telephone or by using your computer's

speakers. Please refer to the instructions emailed to registrants for additional information. If you

have any questions, please contact Customer Service at 1-800-926-7926 ext. 1.

WEDNESDAY, SEPTEMBER 25, 2019

Presenting a live 90-minute webinar with interactive Q&A

A.J. A (Alex) Gelinas, Senior Counsel, Sadis & Goldberg, New York

Steven Huttler, Partner, Sadis & Goldberg, New York

Daniel G. Viola, Partner, Sadis & Goldberg, New York

Tips for Optimal Quality

Sound Quality

If you are listening via your computer speakers, please note that the quality

of your sound will vary depending on the speed and quality of your internet

connection.

If the sound quality is not satisfactory, you may listen via the phone: dial

1-877-447-0294 and enter your Conference ID and PIN when prompted.

Otherwise, please send us a chat or e-mail [email protected] immediately

so we can address the problem.

If you dialed in and have any difficulties during the call, press *0 for assistance.

Viewing Quality

To maximize your screen, press the ‘Full Screen’ symbol located on the bottom

right of the slides. To exit full screen, press the Esc button.

FOR LIVE EVENT ONLY

Continuing Education Credits

In order for us to process your continuing education credit, you must confirm your

participation in this webinar by completing and submitting the Attendance

Affirmation/Evaluation after the webinar.

A link to the Attendance Affirmation/Evaluation will be in the thank you email

that you will receive immediately following the program.

For additional information about continuing education, call us at 1-800-926-7926

ext. 2.

FOR LIVE EVENT ONLY

Program Materials

If you have not printed the conference materials for this program, please

complete the following steps:

• Click on the link to the PDF of the slides for today’s program, which is located

to the right of the slides, just above the Q&A box.

• The PDF will open a separate tab/window. Print the slides by clicking on the

printer icon.

FOR LIVE EVENT ONLY

Structuring Direct Lending Funds

Open-Ended vs. Closed-End Structures; Structures to Confront Pervasive Tax Issues; and Recurring Regulatory,

Valuation, and ERISA Considerations

September 25, 2019

Steven Huttler, Partner

Sadis & Goldberg LLPSteven Huttler is a partner in the firm’s Financial Services and Corporate Groups. Mr. Huttler has extensive experience in corporate, finance, investment fund and securities matters, including the representation of U.S. and foreign investment funds, underwriters, and private clients in various registered public and private offerings of debt and equity securities totaling in excess of $10 billion.

As part of his investment fund practice, Mr. Huttler has served as corporate counsel to many private investment funds and partnerships based in or domiciled in the United States and in international and offshore jurisdictions such as the Cayman Islands, Bermuda, the British Virgin Islands, Ireland, Luxembourg, Isle of Man, Jersey, Guernsey, Cyprus, Mauritius, United Kingdom, Austria, Russia, India and Gibraltar. Mr. Huttler's legal practice has exposed him to diverse fund clients with an exceptionally wide range of investment programs and structures, including large mutual funds and hedge fund complexes, private equity firms, real estate partnerships and funds, venture capital funds and funds focused on specialty finance assets. He has also counseled small start-up hedge funds and financial industry entrepreneurs. His practice has included structuring and establishing start-up funds and managed accounts, and structuring investment funds to benefit from U.S. double taxation treaties. He has advised management companies and fund managers on compensation structures, restructured and reorganized funds, structured, negotiated and documented fund trades, negotiated seed, joint venture and start up agreements, and advised on a range of sophisticated transactions. He has also represented financial services providers, such as brokerage firms (including proprietary trading broker-dealers), fund administration firms and third party marketing firms in structuring their operations, reorganizations to achieve tax benefits, advising on disputes with clients, and in the development of forms for their pension, investment, trading, administration and other services to investment funds, equity, debt and option traders and other clients.

6

Alex Gelinas, Senior Counsel

Sadis & Goldberg LLP

Alex Gelinas is a Senior Counsel in the firm’s Tax Group. Mr. Gelinas focuses his practice on providing tax advice to investment managers of hedge funds, private equity funds and other investment funds on all aspects of their businesses, including management entity and fund formation, partnership taxation issues, compensation arrangements and ongoing investment activities and transactions. Mr. Gelinas also provides tax advice to U.S. pension funds, sovereign wealth funds and other U.S. and foreign institutional investors in connection with their investments in private equity funds, hedge funds and U.S. joint ventures. He also has extensive experience in providing tax planning advice to high-net-worth individuals and families.In addition, Mr. Gelinas has extensive experience with respect to the “plan assets” and other ERISA regulatory issues applicable to sponsors of, and institutional investors in, onshore and offshore hedge funds, private equity funds and other pooled investment vehicles, including funds-of-funds. He has published many articles and lectured on various tax and ERISA regulatory subjects applicable to the investment management industry. Mr. Gelinas has practiced tax law with major law firms in New York City for several decades.

7

Daniel G. Viola, Partner


Daniel G. Viola is a Partner of Sadis & Goldberg LLP and is the Head of the Regulatory and Compliance Group. He structures and organizes broker-dealers, investment advisers, funds and regularly counsels investment professionals in connection with regulatory and corporate matters. Mr. Viola has been active in the Blockchain and Virtual Currency verticals since 2014. He is also the founder of the Crypto Asset Webinars and serves as an advisory board member to several ICOs. Mr. Viola served as a Senior Compliance Examiner for the Northeast Regional Office of the SEC, where he worked from 1992 through 1996. During his tenure at the SEC, Mr. Viola worked on several compliance inspection projects and enforcement actions involving examinations of registered investment advisers, ensuring compliance with federal and state securities laws. Mr. Viola’s examination experience includes financial statement, performance advertising, and disclosure document reviews, as well as, analysis of investment adviser and hedge fund issues arising under ERISA and blue-sky laws.

8

Overview of Presentation I. Relevance of Direct Fund Lending

II. Structuring Overall in Fund Lending Businesses

III. U.S. Tax Considerations: Sample Structures

IV. Open End vs. Closed End Issues

V. Regulatory Issues Relevant to Direct Lending Funds

VI. ERISA Considerations

VII.Tax Appendix (only if time allows - primarily provided for reference purposes)

9

I. Relevance of Direct Fund Lending

10

Current Investment and Lending Climate – Demand for

Nontraditional Lenders

• Since 2008, the Perfect Storm:

a. Cyclical markets

b. Banks constrained by regulatory/capital requirements

c. Investors needing real income

i. Low interest rate environment

ii. Individual retirees in particular need of income

• Popular Versions:

▫ Real estate finance (sub-themes like commercial, MFH, vacation income properties, etc.)

▫ Corporate lending

▫ Entertainment finance

▫ Health care finance

• Explosion of product

• Clients launching funds “deeper” into investment sectors

• Middle market and consumer lending

• Clients saying too much competition

• Nevertheless, regional players thriving

11

II. Overall Structuring in Fund Lending

Businesses

12

• Clients coming to establish new funds are very often already in the lending business

▫ Lending on their own balance sheet

▫ Originators for other lenders

▫ “Refugees” from I-Banks and other lenders

• Accordingly, structure advice often begins with where asset management business fits into the overall business

• What area “other” businesses?

▫ Origination of Loans

In the future “co-investment”

▫ Servicing of loans

▫ Lending from principal balance sheet

• Conflicts between these business lines

▫ Will be discussed further below

Sample Management Structure for

Lending Businesses

13

Principals

Asset Management Principal Lending Origination

Servicing

III. U.S. Tax Considerations:

Sample Structures

14

U.S. Tax Planning Considerations Drive the Choice of Structures Used

for Direct Lending Funds That Originate Loans Within

the United States

15

The Key U.S. Tax Issue - Funds or other entities that are engaged in loan origination on a regular basis in the United States are treated as engaged in a US trade or business, not investment activity.

In contrast, funds or entities that purchase loans that were originally made by others (i.e., most credit funds prior to 2008) are typically treated as engaged in investment activities, rather than a U.S. trade or business.

U.S. or foreign investors that acquire a partnership interest in a US business partnership are treated as being engaged in the U.S. business of such partnership, even if the investor is a passive limited partner who is not physically present in the United States.

For this tax reason, sponsors of direct lending funds operating in the United States will most likely need different structuring alternatives to accommodate U.S. taxable investors, U.S. tax-exempt investors and non-U.S. investors.

U.S. Corporation Leveraged Blocker Structure

16

U.S. Fund

U.S. Corporation

(Blocker)Offshore

Fund

Cayman-based Fund

(elects partnership status for U.S. Tax

purposes)

U.S. Limited Partnership or LLC

Originates Loan

Loans Invests InOwns Stock

Owns Debt Of Blocker

Corp.

Non-U.S. Investors

U.S. Tax-exempt Investors

U.S. Corporation Leveraged Blocker Structure (cont.)

In this first suggested structure, the non-U.S. and U.S. tax-exempt entities would invest in an offshore fund (typically organized in Cayman or another suitable offshore location). The offshore fund would form a U.S. corporation (“U.S. Blocker”) which would engage in the direct lending activity in the U.S., or would acquire a limited partnership in the onshore partnership which would engage in the direct lending activity. The offshore fund owns the stock of the U.S. Blocker but most of its investment is made to purchase debt of the U.S. Blocker.

The U.S. Blocker would be subject to U.S. corporate income tax on its net income. However, the strategy would be to reduce the U.S. Blocker’s net taxable income by paying deductible interest to the offshore fund on its debt. The strategy contemplates that, for the foreign investors, such U.S.-source interest would be exempt from U.S. withholding tax either as portfolio interest or pursuant to applicable U.S. tax treaties with countries in which the investors in the offshore fund reside.

17


In order for the portfolio interest exemption to be available, the offshore fund would be required to elect to be treated as a pass through entity (i.e., a partnership) for U.S. tax purposes. The portfolio interest exemption is only available if the recipient of the interest is deemed to own less than 10 percent of the voting stock of the U.S. Blocker. Similarly, the treaty-based exemptions from the U.S. withholding tax would only be available if the offshore fund is a pass-through entity for U.S. tax purposes.

▫ Structure requires further work if any investor might hold 10% or more of the offshore fund’s equity

Structure might have multiple classes of equity

The U.S. tax-exempt investors would realize interest income and dividends which are exempt from the tax on unrelated trade or business income (UBTI).

18


Tax Issues and Risks – Debt vs Equity Issues

If the debt to equity ratio of the blocker corporation is “too high”, or the terms of the debt held by the shareholders do not appear to resemble the terms that an unrelated lender would require, the IRS may disallow all or a portion of the blocker corporation’s interest deductions, thereby increasing the blocker corporation’s net taxable income.

Further, the IRS could contend that the disallowed “interest” paid to the blocker corporation’s shareholders is actually a “U.S.-source dividend” which is not eligible for the portfolio interest exemption, and is instead subject to the 30 percent U.S. withholding tax (or lower rate under an applicable tax treaty).

In general, the debt issued to the shareholders must have a stated maturity date, have a reasonable rate of interest (reflecting arm’s-length terms) and should not be subordinated to other indebtedness of the corporation.

19


Tax Issues and Risks – Debt vs Equity Issues

There are “anti-earnings stripping rules” in Section 163(j) of the Code which can cap the amount of interest the blocker corporation can deduct for payments made to its shareholders and other related parties, if such interest payments are exempt from U.S. income tax (“disqualified interest”). This disallowance rule does not apply if the debt-to-equity ratio of the corporation does not exceed 1.5 to one, and the disallowance rule may be inapplicable for other reasons.

Key Point: Section 163(j) only applies to the corporation’s “excess interest expense”, which is defined to include the corporation’s interest expense that is in excess of its interest income.

The blocker corporation’s allowable interest expense deduction could be insufficient to offset all of the blocker corporation’s net income which is subject to U.S. corporate income tax. This would be likely if a portion of the corporation’s income is not interest (e.g., fee income or gain on sale of loans or other property).

20

Business Issues with Blocker Structures

• Ameliorates tax issues, does not eliminate them

▫ Returns will be lower to non-U.S. and non-taxable U.S. investors

• “Care and Feeding” of Structure

▫ Need for constant attention and possible adjustment to terms of loans, etc.

Especially for open-ended funds

• Lack of certainty of return

▫ Because constantly adjusted, hard to forecast returns

21

Closed-end Registered Investment Company Structure

22

U.S. Corporation(RIC)

Loans

Elects RIC Status

Pays Interest-Related Dividends(No U.S. withholding tax)

Shareholders are:- U.S. Persons- Non-U.S. Persons- U.S. Tax-exempt Entities

Closed-end Registered Investment Company Structure (cont.)

Another possible alternative would be to organize the fund as a closed-end registered investment company (“RIC”) which is taxed under Subchapter M of the Code (i.e., as a mutual fund).

The RIC is a U.S. corporation, but it is allowed to deduct its dividends paid to reduce its taxable net income to zero. The RIC structure acts as a blocker, and does not generate ECI for non-U.S. shareholders of the RIC or UBTI for U.S. tax-exempt shareholders of the RIC. The structure also generates interest-related dividends (sourced from the debt holdings of the RIC) which would be exempt from U.S. withholding tax (as portfolio interest).

The Code imposes investment diversification requirements and other requirements in order to retain RIC tax status.

23

Business Issues with RIC Structure

• RIC structures require registration with the Securities and Exchange Commission and compliance with the regulatory requirements of the Investment Company Act of 1940.

• Very expensive and time consuming to run. Some say $200 AUM before it is worthwhile.

24

The Preferred Structure for US Taxable Investors in Usually

a Pass through Entity (LP or LLC)

25

For U.S. individuals and other non-corporate investors (trusts and estates), the 2017 tax reform law has eliminated the non-corporate itemized deductions for Code section 212 investment expenses (for tax years 2018 through 2025).

However, the trade or business expenses of a direct lending fund remain deductible in full by such U.S. taxpayers.

Other Advantages: Avoidance of entity level income taxation

Drawbacks: Lending businesses generate ordinary income, and few capital gains. Loans may generate non-cash taxable income such as original issue discount (OID) accrual.

U.S. Tax-Exempt Entities Seeking to Invest in a Direct

Lending Fund Organized as a Pass Through Entity Will Prefer

Investing Through a Corporate Feeder or Side-by-Side

Corporate Fund

26

Most U.S. Tax-exempt entities are subject to U.S. income tax on their “unrelated business taxable income” (UBTI). UBTI includes business income derived from an investment in a business partnership, even as a limited partner or other passive investor. UBTI also includes income which is debt-financed.

Certain types of passive income are excluded from UBTI, even if these items are derived from an investment in an active business. Such exempt income items include interest income. However, if the interest income of an operating business is debt-financed, the interest income could be taxed as UBTI for that reason.

If the direct lending fund is organized as a partnership and will use borrowed funds to make loans (in whole or in part), the U.S. tax-exempt investor will prefer to invest through a corporate blocker entity to avoid the UBTI. If the direct lending fund does not use any borrowed funds to carry on its business, it may be feasible for the U.S. tax-exempt entity to be a direct investor in the direct lending fund partnership.

U.S. Tax-Exempt UBTI Blocker Structure

27

U.S. Fund.

U.S. Corporation

(UBTI Blocker)

Taxable Investors

U.S. Limited

Partnership or LLC originates

loans

Tax-Exempt

Investors

Domestic Fund

Own stock and debts of the U.S. Blocker

Non-US Individual Investors and Foreign Corporations Seeking

to Invest in a Direct Lending Fund Organized as a Pass

Through Entity will Prefer Investing Through a Corporate

Feeder or Side-by-Side Corporate Fund

28

Non-US investors seek to avoid realizing any income which is effectively connected US trade or business income (known as “ECI”). Such ECI is subject to US income taxation at the regular rates and the foreign investor would be required to file federal and applicable state income tax returns to report such ECI and pay any tax due.

Branch Profits Tax on Foreign Corporations. Foreign corporate investors would also be subject to a federal branch profits tax in addition to the income tax. This tax is imposed at a 30% rate on the after-tax US business income that is deemed withdrawn from the business e.g., by reason of being distributed to the foreign corporation’s shareholder. Thus, the combined US federal tax rate on ECI withdrawn from the business activity is approximately 44.7% (i.e., 21% federal income tax plus 30% of the remaining 79% after income tax amount.)

When Dealing with U.S. Trade or Business income, Instead of

Investment Income, a Foreign Investor Is Better Off Investing

Through a Leveraged U.S. Blocker Corporation Instead of a

Foreign Corporate Blocker

29

Foreign blocker corporations in zero-tax jurisdictions are widely used by foreign investors to hold U.S. investments. For non-U.S. individuals, the foreign blocker corporation shields the foreign individual from possible U.S. estate taxes.

The US estate tax applies to a foreign person’s property that is deemed situated in the United States (“U.S. situs property”). U.S. securities, including stock and debt obligations of US companies are treated as U.S. situs property. Stock in a foreign corporation, such as a Cayman blocker, is not treated as U.S. situs property, even if all the assets of such foreign corporation are U.S. assets.

Foreign individuals have only the equivalent of a $60,000 exemption from U.S. estate tax, although some countries have negotiated an estate tax treaty with the United States which provides their residents with a U.S. estate tax exemption.

When Dealing with U.S. Trade or Business income, Instead of

Investment Income, a Foreign Investor Is Better Off Investing

Through a Leveraged U.S. Blocker Corporation Instead of a

Foreign Corporate Blocker (cont.)

30

If the foreign blocker only owns investment property, the potential US income taxation is limited to a 30% US withholding tax on certain types of US-source income, such as dividends. US-source “portfolio interest” is exempt from such withholding tax as are most long-term and short-term capital gains (other than gains with respect to sales of US real property interests).

In the case of a foreign blocker that realizes US trade or business income from a direct lending partnership, the foreign blocker could incur federal taxation at a combined 44.7% rate on all of its ECI (assuming the branch profits tax applies).

When Dealing with U.S. Trade or Business income, Instead

of Investment Income, a Foreign Investor Is Better Off

Investing Through a Leveraged U.S. Blocker Corporation

Instead of a Foreign Corporate Blocker (cont.)

31

The U.S. Blocker Alternative- The alternative strategy would be for the direct lending fund to allow the foreign investors to invest through a U.S. corporation. The foreign investors would own debt issued by the U.S. corporation. The U.S. corporation would be subject to the 21% flat federal income tax rate on its net taxable income. The corporation’s net income would be reduced by deductions claimed for interest paid or accrued on the debt held by the foreign investors. Such U.S.-source interest income paid to foreign shareholders could qualify for exemption from the U.S. 30% withholding tax as either portfolio interest or interest exempt from U.S. withholding tax under an applicable U.S. tax treaty.

“Season and Sell” Strategy

32

OnshoreFund

Offshore Fund

Non-U.S. Investors

U.S. Tax-Exempt Investors

Cayman Entity Elects to be Treated as a

Foreign Corporation

U.S. Taxable Investors

Sells Loans

Limited Partnershipor LLC

Makes Loans

“Season and Sell” Strategy (cont.)

Many funds have used what is known as the “season and sell” strategy in order to avoid a foreign fund being classified as engaged in a U.S. trade or business.

A simple example of such a strategy is as follows: Two parallel funds are formed. One is a U.S. stand-alone partnership and the second is an offshore fund created in the Cayman Islands (or another no- tax jurisdiction) which is treated as a foreign corporation for U.S. tax purposes. The onshore fund originates the loan, holds the loan for a period of time (known as the “seasoning period”) and then may offer to sell a portion of the loan to the offshore fund in a secondary market transaction for a price equal to the estimated fair market value of the portion sold.

33

Tax Issues with “Season and Sell”

Strategy

• Seasoning: how long?

• Agency: is onshore fund an agent?

• Lack of IRS Guidance or tax court rulings

34

Business Issues with “Season and Sell”

StrategyThe onshore fund must have sufficient capital available to originate the loans in order for this structure to be feasible.

Different returns. Note that the investors in the two funds will not have identical returns on their investment, since the price paid by the offshore fund may be different that the value of the loan at the time the onshore fund originated the loan.

▫ If offshore funds have much more capital, the domestic fund would not be able to “Prime the Pump”

Conflicts of Interest. If the same manager entity is acting on behalf of both the seller and the buyer fund, there would be conflict of interest issues, particularly if the manager’s compensation structure is different for each fund.

Independent Appraiser Needed. The fair market value issue is an important point. Funds are advised to engage an independent valuation agent to value some or all of the loans at the time of the sales of such loans to the offshore fund.

35

“Overall Loan” Strategy

36

OnshoreFund

Offshore Fund

Non-U.S. Investors

U.S. Tax-Exempt Investors

Cayman Entity Elects to be Treated as a

Foreign Corporation

U.S. Taxable Investors

Debt Securities

Limited Partnershipor LLC

Makes Loans

(no equity)

“Overall Loan” Strategy (cont.)

The expected U.S. tax treatment of this structure is that the Offshore Fund's lending of money solely to one U.S. Fund will be treated as investment activity rather than engaging in a U.S. lending business. The Offshore Fund will not be advancing funds to any other unrelated parties and would not be holding itself out to anyone as being actively engaged in a lending business.

There is also very old case law which holds that a foreign person who makes only one or two loans in a calendar year will not be treated as regularly engaged in a lending business in the United States. Thus, such a foreign lender has no ECI from such limited activity in the U.S.

The U.S.-source interest should be able to be received by the Offshore Fund free of U.S. withholding tax under the statutory Portfolio Interest exemption.

Note that under this structure, the investment return to the foreign investors will likely be lower than the return realized by the equity investors in the U.S. Fund.

37

U.S. Insurance Product Blocker Structure

38

U.S. Fund

U.S. Corporation

(Blocker)

OffshoreFund

Cayman-based Fund

(elects partnership status for U.S. Tax

purposes)

U.S. Limited Partnership or LLC

Originates Loans

Loans Invests In Pays Premiums

Non-U.S. Investors

U.S. Tax-exempt Investors

U.S. or Foreign

Insurance Company

Fund purchases insurance policy or

annuity contract

U.S. Insurance Product Blocker Strategy

If properly structured:

1. The non U.S. investors avoid ECI.

2. The U.S. tax-exempt investors avoid UBTI.

3. The insurance company is treated as the tax owner of the equity interest in the U.S. fund.

In order for this insurance blocker structure to succeed:

1. The U.S. fund must function as an “Insurance-Dedicated Fund” (“IDF”), i.e., the only direct investors permitted are U.S. or foreign insurance companies.

2. The investors in the insurance contracts cannot have any control over the actions taken by the IDF.

Tax Issues

1. Foreign investors may be subject to U.S. withholding taxes if the insurance company is a U.S. corporation. Treaty relief may apply.

2. The insurance company holds the IDF investment in a segregated asset account.

3. The investors in the insurance contracts get a return tied to the performance of the segregated asset account, minus whatever charges are imposed by the insurance company.

39

IV. Open End vs. Closed End Issues

40

Alternative Structures:

Open Ended vs. Close Ended

1. Open end fund characteristics:

• It looks like a mutual fund

• Designed to last for an indeterminate time into the future

• No specific term for it to close

• Investors accepted and withdraw at specific, periodic times (monthly, quarterly, annually, etc.)

• This requires a mechanism to value the portfolio whenever investors come join

• Mechanism is also required to value the portfolio whenever investors withdraw

41


Open Ended vs. Close Ended (cont.)

2. Closed end fund characteristics:

• It is often referred to in the jargon of professionals and industry managers as "PE fund"

• Designed to last only for pre-determine time into the future

• Investors often make commitments rather than make immediate investments

• Specific periods identified in advance of the fund:

• Closing period: period until which the fund may accept new commitments

• Capital commitment call period: period until which the fund may call capital from investors who commit capital

• Investment period: period until which the fund may make new investments

• Investment "harvest" period: period until which the fund can hold the assets before they must be sold

42



2. Closed end fund characteristics (cont.):

• Investors generally may not withdraw at any time

• This means that NAVs will generally not be required for purposes of new and withdrawing investors

• NAVs will generally required for GAAP and other reporting purposes, but not economic terms of the fund

• Sometimes NAVs will required for certain other economic terms of the fund:

Limited adjustments to new investor investments (based on NAVs)

Limited withdrawals

Capital write-offs (for waterfalls)

Calculations of management fees

43



3. Comparison of Such Structures:▪ From most legal and operational perspectives, the closed end structure is preferable▪ Key advantages of closed end: fund economic terms not determined by NAVs

• SEC doesn't like these funds• Regulator and investor concerns about such structures: unreliability of NAVs• Fraud and other malfeasance have dogged these assets in these structure

• Performance and management fees set to AUM in open ended fund • Conflicts have proved irresistible many times, historically (e.g., when fund is having

problems) • Some auditing firms will not audit an open end fund with illiquid assets

• Others set expansive requirements for valuation agents and methodologies• It will likely be expensive to deal with valuation

▪ Operational advantages:• NAVs are just hard to strike

• Under GAAP is not always crystal clear• Legal risks make auditors and others fearful and more demanding of the process

• Selling assets for withdrawals:• Illiquid assets are hard to sell

44



3. Comparison of Such Structures (cont.)

• Key advantage open end fund advantage is typically only one:

Liquidity at times is an absolutely essential term to interest the investor pool in the fund

Particularly for retail and family office investors, the need for some liquidity can be absolutely critical to signing up an investors

Beware of illusion of liquidity

Particularly important for those of you reviewing a fund for an investor (e.g., quarterly liquidity except for the fine print)

45



4. Adaptions to Open End Structure: Hybrid Structure:

▫ When: if marketing advantages of open ended structures are irresistible

▫ Adaptation: Timing of Liquidity

Long initial lockups

2-3 years (co-terminus with maturity of many products)

Exaggerated examples: life settlement fund we are working on now with 10 year initial lockup

Problem with long initial lockups:

Simply puts off the day of reckoning

How does one satisfy a wave of withdrawals a few years from now?

Other classic tactics:

Frequency of withdrawal (irrespective of lockups)

Notice Periods

Gates

Side pockets

However: marketing challenge

Side pockets in particular are very unpopular

Infrequent withdrawal periods also unpopular

46



4. Adaptions to Open End Structure: Hybrid Structure (cont.):

More complicated barriers to withdrawal:

Instead of only initial lockup, also impose "rolling lockup“ e.g., only withdraw every 2-3 years

Different flavors: sometimes anniversary of particular investment by investors

Sometimes a single withdrawal opportunity for everyone every 2-3 years

Adaptation: Funding of Liquidity

Payment of withdrawal subject entirely to availability of capital to pay it off

Payment of withdrawal subject entirely to subsequent sale of portfolio investments and having relevant proceeds available from it

5. Newer strategies

• Length of Payout periods

• Novel Payout calculations (e.g., disassociate from NAV?)

47

V. Regulatory Issues Relevant to Direct

Lending Funds

48

Conflicts, Transaction Fees; Other

Regulatory Issues

a. SEC and Institutional focus on these conflicts

b. Emphasis on giving the limited partnership advisory committee (“LPAC”) approval rights over affiliate transactions and requiring GPs to disclose all transaction fees and services provided by affiliates

c. Pressure from LPs to eliminate GP share of transaction/monitoring fees

d. SEC concerns include transparency (full, fair and timely disclosure to investors)

e. Arms length

49

Frequently Overlooked Regulatory

Considerations

• Broker-Dealer Regulation

• Investment Adviser Regulation

50

Broker Dealer Regulatory Considerations

• Basic Rule: Transaction based compensation in securities deal requires broker-dealer registration

• Compensation could be obvious, as in commissions, or “disguised” (e.g., management and incentive fees where no IA services provided)

• Compliance professionals insist on greater compliance with registration

• SEC itself now very focused on these violations and prosecutes them

• Issue: Club Deals may be sponsored by third parties, who are neither existing registered broker dealers (or broker dealer reps) or investment advisers

• Such parties expect to be compensated

51

Investment Adviser Considerations

• Many sponsors, when made aware of the broker dealer regulatory considerations, and the difficulty of meeting requirements, often turn quickly to alternatives

• Most frequent alternative: sponsor acting as investment adviser and collecting management and/or incentive fees

• However, the SEC would regard a sponsor who does not provide any investment advice as a disguised broker dealer, and the fees as disguised commissions

52

Investment Company Act

• Need for exemption under ICA

• Often overlooked because vehicle is not a “blind pool”(conventionally thought of as a fund)

• Classic Exemptions of 3(c)(1), 3(c)(5), 3(c)(7) would be most relevant

• Increased possibility of availability of 3(c)(5)

• Such increased availability may even serve as a rationale for using the whole SPA/structure

53

SEC’s Pronouncements on Conflicts

• Fees charged by fund managers directly to portfolio companies

• Allocations of investment opportunities

• Allocations of expenses among funds and co-investment vehicles

• Concerns raised about rates on legal fees charged to PE funds and their portfolio companies vs. those of the principals

54

SEC’s Enforcement Cases

• In re Blackstreet Capital Mgmt. et ano., (June 1, 2016): Charged (i) broker fees for purchasing portfolio cos., without SEC registration; (ii) $450k in oversight fees to 2 portfolio cos., (iii) for political/charitable contributions & entertainment expenses & (iv) acquired shares in portfolio cos. & LP interests in PE Fund from others, when should have been repurchased by cos. or reverted to Fund & investors. $3.1MM sanctions.

• In re Cranshire Capital Advisors, LLC (Nov. 23, 2015): Improperly charged fund Manager’s own expenses for attorney for compliance consulting (i.e., registration and compliance program), and for office supplies, computers and utilities.

• In re Cherokee Investment P’rs, LLC, (Nov. 5, 2015): Manager charged Fund for compliance consultant expenses relating to registration and compliance consulting and legal expenses arising from SEC Exam and Investigation

• In re Clean Energy Capital et ano. (Oct. 17, 2014): Improperly charged Manager’s overhead (i.e., salaries, bonuses, benefits & rent) to Funds and caused Funds to borrow from Manager at a high interest rate of 17% while pledging Fund assets as collateral. Changed calculation of dividend distributions adversely to some investors. $2.2MM sanctions

55

SEC’s Enforcement Cases (cont.)

• In re Blackstone Mgmt. P’rs, (Oct. 7, 2015): $39MM in sanctions for PE manager accelerating monitoring fees to portfolio cos. at time of IPO/private sale & getting legal discounts based on Fund using law firm.

– Blackstone Management charged portfolio companies owned by Funds annual monitoring fees, and accelerated the annual monitoring fees upon the IPO or Private Sale of company.

▫– Only Disclosed “ability to collect monitoring fees prior to… commitment of capital but did

not disclose its practice of accelerating monitoring fees until after it took the fees.”

– Conflict of Interest in decision to accelerate: benefits Manager at expense of investor profit.

• In re Apollo Mgmt. V, L.P., et al., (Aug. 23, 2016): $52.7MM in sanctions for misleading disclosures about accelerating portfolio monitoring fees and loan from Fund to Apollo Mgmt. affiliate

– As in Blackstone, Apollo accelerated annual monitoring fees upon IPO/Private Sale of Portfolio Co.

– Apollo only disclosed ability to charge monitoring fees in offering documents, but only disclosed acceleration of monitoring fees after investors committed capital and Apollo accelerated.

56

SEC’s Enforcement Cases (cont.)

• In re JH Partners, LLC, (Nov. 23, 2015): PE Manager caused multiple Funds to invest in same

portfolio cos. at different seniority (loans), priority (liquidation) & valuations,

potentially favoring one client over other.

• Manager also loaned over $60 million to portfolio companies without disclosing to investors or LP Advisory Committee; created conflict in seniority with investors and due to using portfolio company assets as collateral.

• Manager waived $24MM in management fees & carried interest; agreed to subordinate $60MM loan to Fund’s investment interest in portfolio cos.; and $225k in civil penalties. LPAC disclosure after fact not enough.

• In re Kohlberg Kravis & Roberts & Co. (June 29, 2015): First broken deal expenses action.

• $30MM in sanctions for not clearly disclosing charging $338MM in broken-deal & due diligence

expenses to investors only – but not to PE co-investors who also benefitted from expenses.

• Key Factor in Sanctions: Co-Investors included many KKR executives and officers, making

conflict greater.

57

Investment Adviser Registration

Who is Required to Register? • Investment advisers that manage between $100 million and $150 million in assets

that manage one (1) or more managed accounts must register with the SEC.

• Investment advisers that manage less than $100 million in assets generally must defer to the relevant investment adviser statutes in the state(s) where they conduct business.

• Investment advisers that can rely on the Private Fund Adviser Exemption may still need to become an Exempt Reporting Adviser with the SEC.

• Investment advisers must include all gross assets (including leveraged amounts) in calculating assets under management.

• Investment advisers to private equity funds must include uncalled capital commitments (not just drawn down capital) in calculating assets under management.

58

CFTC Rules Impact on Private Investment Funds - Will You

Need to Register as a Commodity Pool Operator?

Background

▫ Any fund trading even a penny of “commodity interests” is considered a “commodity pool,” and its operator must register as a CPO with the CFTC, unless an exemption is available.

▫ “commodity interests” include futures contracts (including security futures), commodity options and retail off-exchange forex transactions.

▫ Most commonly used exemption for operators of private funds has been the 4.13(a)(3) exemption.

59

CFTC Rules Impact on Private Investment Funds (cont.)

4.13(a)(3) Exemption

▫ typically used by operators of 3(c)(1) funds

▫ permits a de minimis amount of trading of commodity interests

▫ either (i) the aggregate initial margin and premiums required to establish commodity interest positions, determined at the time the most recent position was established, will not exceed 5 percent of the liquidation value of the fund’s portfolio (taking into account unrealized profits and losses) (the “Margin Test”) or (ii) the aggregate net notional value of the fund’s commodity interest positions does not exceed 100 percent of the portfolio’s liquidation value (the “Net Notional Test”)

▫ the fund may generally not be marketed to the public as a vehicle for trading in commodity interests

Note: The JOBS Act allows general solicitations in connection with Rule 506(c) offerings sold only to accredited investors.

60


4.13(a)(3) Exemption Modified

▫ Claiming this exemption had required a “one-time” filing, but now the filing must be made annually within 60 days after every calendar year end.

▫ “Swaps” will be included as “commodity interests” 60 days after the final rules defining “swap” have become effective.

▫ “Swaps” are expected to exclude swaps on single securities or a narrow index of securities, but are expected to include swaps on a broad-based security index.

61


CPO Registration—Process

▫ The CPO Itself

Must File Form 7-R through the NFA’s Online Registration System (ORS), and concurrently will become a member of the NFA.

Application fee of $200; NFA annual membership dues of $750.

▫ “Associated Persons” of the CPO

Generally, any person that solicits investors (and supervisors thereof).

Must register with the CTFC on Form 8-R, and become an “associate member” of the NFA

$85 application fee; must submit a fingerprint card for an FBI background check.

Must obtain Series 3 license, subject to exemptions.

62


CPO Registration—Process – (cont.)

▫ “Principals” of the CPO

Generally, any general partner, managing member, director, executive officer and 10% owner.

Must file a Form 8-R through ORS.

$85 application fee.

Must submit a fingerprint card for an FBI background check (except for “outside directors”).

Not considered to be registered with the CFTC or members of the NFA; rather, they are “listed” as Principals of the registered CPO.

63


CPO Registration—Ongoing Obligations

▫ Disclosure

A “Disclosure Document” for pool participants must be prepared in accordance with Rules 4.24 and 4.25 and must accompany subscription documents.

The Disclosure Document must be accepted by the NFA prior to use.

▫ Reporting

Distribute to investors unaudited monthly “Account Statements” within 30 days of each month end.

Distribute to investors and file with the NFA audited “Annual Reports” within 90 days after each year end (subject to extension requests).

Annual CFTC registration update.

Annual NFA questionnaire.

64


CPO Registration—Ongoing Obligations – (cont.)

▫ Reporting (cont.)

File Form CPO-PQR

CPOs divided into “small” (less than $150 million), “medium” (between $150 million and $1.5 billion) and “large” (greater than $1.5 billion).

Small CPOs: file NFA Form PQR on quarterly basis within 60 days of the quarters ending March, June & September. Also required to file a year-end report (Schedule A & schedule of investments) within 90 days of the calendar year end.

Medium CPOs: file NFA Form PQR on a quarterly basis within 60 days of the quarters ending in March, June & September. Also required to file CFTC Form CPO-PQR’s Schedules A & B annually, within 90 days of the calendar year end.

Large CPOs: file CFTC Form PQR schedules on a quarterly basis within 60 days of the quarter end. CPOs that file Form PF with the SEC in lieu of CFTC Form CPO-PQR required to file NFA Form PQR with NFA on a quarterly basis within 60 days of the quarter end, except for December 31st quarter, which will be due within 90 days of quarter end.

▫ Recordkeeping

Must make and keep prescribed records in an accurate, current and orderly manner at main business office.

Keep for 5 years; must be readily accessible for 2 years.

Open to inspection by DOJ and CFTC.

65


CPO Registration “Lite”

▫ A Section 4.7 exemption provides relief from many of the requirements of a registered CPO, effectively substituting significantly less onerous requirements.

▫ Requires that every investor in the fund be a “qualified eligible person” (“QEP”).

▫ A QEP includes an entity with total assets in excess of $5 million or an individual that is an accredited investor, provided, in each case, that the person owns securities of issuers not affiliated with such person and other investments with an aggregate market value of at least $2 million.

66

VI. ERISA Considerations

67

ERISA Considerations Relating to Private Investment Funds

1. Plan Assets Issues; Fiduciary Status and Prohibited Transaction Issues

If the assets of an entity (e.g., a corporation, partnership or trust) are treated as plan assets of a benefit plan investor that owns an equity interest in such entity, the parties having management authority over the assets of such entity would be treated as fiduciaries under ERISA with respect to such plan investors. In addition, transactions entered into by such plan asset entities would be subject to ERISA scrutiny including complex prohibited transaction rules.

A. General Rules on Plan Assets Status

Under the ERISA plan assets regulations, the assets of an entity in which a plan has an equity interest will not be treated as plan assets if the equity interests are(1) publicly traded securities or (2) a security issued by an investment company registered under the Investment Company Act of 1940.

68

ERISA Considerations Relating to Private Investment Funds (cont.)

In all other cases the assets of the entity will be treated as plan assets for ERISA purposes unless:

(1) the entity qualifies as an “operating company” which term also includes a “venture capital operating company” or a “real estate operating company”; or

(2) the aggregate investment in the equity interests of the entity that are owned by “benefit plan investors” is less than 25 percent of the outstanding equity interests in such entity (the Insignificant Plan Investment Exception”).

CAUTION: An equity interest is defined as any interest in an entity other than an interest that is treated as indebtedness under local law and has “no substantial equity features”.

69


B. Operating Company Definition

An operating company is defined as an entity that is “primarily engaged, directly or through a majority owned subsidiary or subsidiaries, in the production or sale of a product or service other than the investment of capital.”

(1) Start-up Ventures and Companies Engaged Solely in Research and Development May not Qualify under this Definition.

(2) The Venture Capital Operating Company (“VCOC”) and Real Estate Operating Company (“REOC”) Exemptions Were Added Later.

CAUTION: The direct lending fund may not be considered an operating company until it is “up and running.”

70


VCOC Definition

To qualify as a VCOC, the entity must satisfy two requirements: First, at least 50 percent of the entity’s assets (at cost) must be invested in “venture capital investments” or “derivative investments” as defined. Second, the entity must obtain and exercise “management rights” with respect to at least one of its operating company investments. The term “venture capital investment” is defined as an investment in an “operating company” in which the investing entity has obtained management rights.

REOC Definition

The REOC definition is similar to the VCOC definition. In order to be a REOC, the entity must: (1) have at least 50 percent of its assets (valued at cost) “invested in real estate that is managed or developed and with respect to which such entity has obtained the right to substantially participate directly in the management or development activities”; and (2) be directly engaged in real estate management or development activities.

71

VII. Tax Appendix

72

Tax Considerations for U.S. Taxable Investors

U.S. citizens and residents and other U.S. taxable investors have historically preferred to invest in funds that are treated as partnerships for U.S. tax purposes (typically formed as limited partnerships or limited liability companies).

A key benefit is that partnerships avoid entity level income taxes. Instead, all income, deductions and losses are passed through each taxable year to the partners. In addition, the character of the partnership’s income, gain, loss, deduction and credits passes through to the partners.

Direct lending partnerships have some unfavorable tax characteristics:

Ordinary Income: Direct lending activities typically generate interest income that is ordinary in nature. In addition, any gains realized on sales of the loans by a lending business would generally be treated as gains from non-capital assets, which would result in ordinary income rather than long-term capital gain.

Phantom Income: Loans that are issued with original issue discount (OID) generate “phantom income” (i.e., non-cash accrued income) notwithstanding that the interest is not actually received, even for cash method investors.

73

Tax Considerations for U.S. Taxable Investors (cont.)

State and Local Tax Issues. State and local tax laws typically exempt out-of-state limited partners from taxation on investment fund activity in the state or locality that constitutes investing in stocks and securities. Funds that are engaged in loan origination are often ineligible for this exemption.

For example, New York City has an unincorporated business tax applicable to partnerships that are engaged in a trade or business in New York City. Funds are exempt from the NYC tax if they are just investing and trading in stocks or securities (including debt instruments), but would be subject to this tax if the fund is engaged in a loan origination business.

Publicly Traded Partnership Issues. Funds that have frequent admissions of investors and that allow frequent redemptions run a risk of being classified as publicly traded partnership (PTP). Unless an exemption applies, PTPs are subject to entity level income taxation as a corporation. There is a safe harbor rule that exempts a PTP from taxation as a corporation if at least 90 percent of its gross income is “qualifying income”. Income from a loan origination business would not be treated as qualifying income under this PTP safe harbor.

74

Tax Considerations for U.S. Taxable Investors (cont.)

Passive Activity Loss Issues. Under the passive activity loss rules, which apply to non-corporate taxpayers, personal service corporations and certain closely held corporations, a limited partner’s share of losses incurred in a loan origination business would be able to offset only income from another passive activity (and not salary, other active business income or the partner’s portfolio income). Income from an “equity-financed lending activity” may be classified as non-passive income, which would mean that it could not be offset by passive activity losses of the partner.

75

U.S. Tax Considerations for U.S.

Tax-Exempt Investors

To the extent an investment strategy is likely to generate unrelated business taxable income for the U.S. tax-exempt investor, the tax-exempt investor would typically prefer to invest in an offshore fund treated as a foreign corporation to prevent its realizing UBTI.

UBTI is generally the excess of gross income from an unrelated trade or business conducted by the tax-exempt entity, or by a partnership in which it is a partner, over the deductions attributable to such business. In addition, UBTI also includes “unrelated debt-financed income”, including debt-financed income of partnerships in which the tax-exempt entity invests.

Although loan origination could be treated as a business, the Code provides that certain types of income, including interest, are specifically excluded from UBTI, regardless of whether such income items are derived in conducting a business, except to the extent such income items are considered “debt-financed income”. In addition to interest income, certain loan commitment fees and origination fees are also excluded from UBTI (if not debt-financed).

If the loan origination fund is a pass-through entity, the key tax issue for a prospective U.S. tax-exempt investor is whether the fund intends to use borrowed money in making its investments.

76

U.S. Tax Considerations for Non-U.S.

Investors

Non-U.S. investors generally prefer to invest in U.S. partnership funds through a non-U.S. corporation (i.e., a “foreign blocker”). A foreign corporation will not be subject to the U.S. corporate income tax if it is not engaged (directly or as a partner in a partnership) in a trade or business within the United States. However, the non-U.S. investor’s share of any income that is effectively connected with a U.S. trade or business (“ECI”) is subject to the U.S. federal income tax.

U.S. Withholding Tax. Non-U.S. persons are also subject to U.S. withholding tax on certain types of U.S.-source income, including dividends and certain types of interest, that are not effectively connected with a U.S. trade or business of the non-U.S. person. The Code contains an exemption from the U.S. withholding tax for “portfolio interest”, provided certain conditions are satisfied. U.S. tax treaties also provide a U.S. withholding tax exemption for interest income from sources in the United States, provided that such interest is not ECI.

Trading Safe Harbor. Code section 864(b)(2)(A)(ii) provides that, for a taxpayer that is not a dealer in such property, the term U.S. trade or business does not include investing in and trading in stocks and securities (including debt instruments) for the investor’s account (the “Trading Safe Harbor”). As discussed below, loan origination would generally not be eligible for exemption from U.S. taxation under this Trading Safe Harbor.

77

U.S. Tax Considerations for Non-U.S.

Investors (cont.)

U.S. Estate Tax Issues for Non-U.S. individuals. Non-U.S. individuals are subject to U.S. federal estate taxation at death on certain types of property that is considered “situated in the United States” (“U.S.-situs property”). There is only a small standard deduction available to estates of non-U.S. persons. U.S. estate tax treaties provide more generous relief for decedents that are domiciled in certain countries.

Definition of U.S.-Situs Property. U.S.-situs property includes equity interests in U.S. securities (including stock in U.S. corporations and debt instruments of U.S. obligors), equity interests in U.S. partnerships, and interests in U.S. real property, but does not include stock in a foreign corporation (such as a “blocker corporation”), even if such foreign corporation owns U.S.-situs property.For this reason, non-U.S. individuals will often hold U.S. assets in a foreign corporation (typically organized in a “zero-tax” jurisdiction, such as Cayman or the British Virgin Islands) to avoid possible federal and state estate taxation.

78

Under What Circumstances is Lending Treated as a U.S.

Trade or Business?

As noted earlier, investing in and/or trading debt instruments of U.S. obligors can be exempt from U.S. federal income taxation under the Trading Safe Harbor. The courts and the IRS have held that the volume of money invested and the frequency of the trading activity are irrelevant to the applicability of the Safe Harbor. However, the Safe Harbor is not applicable to direct lending activities which are carried out as a business in the United States.

Is the Activity Continuous, Regular and Considerable?

The Code does not contain a clear test for what type of activity is treated as a U.S. trade or business.

The courts that have considered the question have focused on whether the activity in question is “continuous, regular and considerable”. As a result this is a “facts and circumstances test”.

79


Trade or Business? (cont.)

2009 IRS Chief Counsel’s Memorandum

In 2009, the IRS released a Chief Counsel Advice memorandum on loan origination activities of a foreign corporation which concluded, under the facts described in such memorandum, that such corporation was in fact engaging in a U.S. trade or business. This memorandum, which was prepared in connection with an IRS audit of an offshore fund, caused considerable concern among lawyers and accountants who were advising hedge funds and other private investment funds that had crept into the direct lending sphere in the United States after the 2008 financial crisis.

80


Trade or Business? (cont.)

Law Firms and Accountants Opinions on the ECI Issue Currently Vary

Among law and accounting firms, opinions diverge as to the number of lending transactions that an offshore fund may originate in a year before the fund is more likely to be treated as engaged in a U.S. trade or business. Some firms are known to take the view that five or fewer transactions in a year are likely to be treated as safe to avoid ECI, while other firms are known to set the limit at three or two loans.

There is one very old reported case, involving a non-U.S. person who was travelling in the U.S. and made one loan (and conducted limited other U.S. activities). The Tax Court concluded that one isolated financing activity was not sufficient to establish a U.S. trade or business. Pasquel v. Commissioner, 12 TCM (CCH) 1431 (1953).

81

Loan Origination Versus Secondary Market Transactions

As previously discussed, purchasing loans, or participations therein, in the secondary market, after someone else has made the original loan, is treated as investment activity which is covered by the Trading Safe Harbor.

Distinguishing loan origination from secondary market activity is sometimes difficult. If the loan originator is an affiliate of the fund or other party purchasing the loan, the IRS could contend that the loan originator was active as an agent for the buyer of the loan.

82

83

If you have questions, please contact:

Steven Huttler

212.573.8424

[email protected]

Alex Gelinas

212.573.8159

[email protected]

Daniel G. Viola

212.573.8038

[email protected]


551 Fifth Avenue, 21st Floor

New York, NY 10176

84

mailto:[email protected]



Documents

Structuring Direct Lending Funds: Open-End vs. Closed-End ...media.straffordpub.com › products › structuring-direct...Sep 25, 2019 · operations, reorganizations to achieve tax