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Issue 25 / April 2021
Insight we look harder, so you can see further.
The North America edition
Welcome to our 25th issue of Connect, Sanne’s regular, technical bulletin for fund managers, intermediaries and investors.
Fred SteinbergManaging Director, North America - Sanne
Raising capital in times of financial stress always is a delicate balancing act. The near instantaneous halt in cash flows and scramble for new capital injections caused by the Covid-19 pandemic has significantly changed traditional fund raising approaches and the due diligence processes of asset managers and investors.
In times of change, I’ve learned that remaining agile, flexible and nimble is key to maintaining operations and running a successful business where staff feel supported and motivated to continue with business as usual.
In this North America edition of Sanne Connect we feature four strategic partners who touch on some interesting topics, all focusing on some aspect of the evolving landscape or new opportunity for alternative assets.
Our first guest article talks about the continued discussion in Congress to seek the elimination of carried interest tax benefits. Stefan Gottschalk, Don Susswein and Ben Wasmuth from RSM cover some key topics to consider.
Our second article features Ross Goffi, Managing Consultant at Bovill Chicago who takes a look at the SEC’s new Marketing Rule and the impact it may have on what constitutes an advertisement.
Traditionally, most EU closed-end alternative asset and hybrid funds opted to be set up as Luxembourg-based partnerships. Alan Keating and Orlaith Finan at Matheson talk about the much awaited ILP which boosted Ireland to become a jurisdiction of choice for private equity, debt, real asset and closed-ended funds.
SPACs continue to grow in use and popularity. Our final article is from Jacob Wimberly and Kevin Neubauer from Seward & Kissel LLP and tells you what the different stakeholders in a SPAC need to know.
Enjoy the read.
sannegroup.com/our-thinking
In this edition
5 Proposed House bill would have significant impact on carried interest
7 SEC Marketing Rule: What is an advertisement?
9 The Irish Investment Limited Partnership: Partnering for Growth in Private Equity and Real Asset Investment Strategies
11 SPAC Overview for Private Fund Advisers
Sanne Connect North America edition 3
25 Foreword
The receipt of a profits interest would not be taxable but any income or gain later realized would be ordinary income and subject to self-employment tax. The bill would effectively remove the existing favorable rules for real estate funds, and for assets held for more than three years. This bill would generally not be retroactive, but other proposals may emerge as Congress considers this longstanding and controversial issue. Unfortunately, it is not possible to predict at this point what actions, if any, Congress will take in this area.
A new House bill would repeal most of the remaining tax benefits for carried
interests held by managers of private equity funds, hedge funds and certain
other investment partnerships.
Carried interest and other profits interests
Under current law, fund managers holding a carried interest (a type of partnership profits interest, sometimes called ‘carry’) receive shares of the fund’s gain. That gain receives long term capital gain treatment if certain requirements, principally holding period requirements, are met. Section 1061, enacted in 2017, generally requires a three year holding period for gain with respect to carried interest to attain long term capital gain characterization. Long term capital gain is subjected to lower federal income tax rates than ordinary income.
Partners in a partnership generally are not taxed on their initial receipt of profits interests (such as carried interests), provided that they are received when liquidation of the partnership would result in no distribution with respect to the profits interests. The IRS endorsed this treatment in two Revenue Procedures, Rev. Proc. 2001-43 and Rev. Proc. 93-27. The partners are, of course, subject to tax if and when they actually receive a distributive share of partnership profits.
Outline of proposal
The latest legislative proposal to tax gain with respect to carried interests as ordinary income is quite thorough. The proposal would codify the generally favorable treatment of receipt of a profits interest as nontaxable.
A carried interest’s share of partnership gain, however, would be targeted for ordinary income treatment. If enacted as proposed, the ordinary income recharacterization would in many cases apply to carried interest gain recognized after the enactment date.
In addition to making long-term capital gain treatment unavailable, the proposal aims to: (a) make the section 1202 capital gain exclusion on sale of qualified small business stock unavailable, (b) subject gain with respect to carried interests to self-employment tax, and (c) heighten tax penalties for certain tax understatements attributable to carried interests.
Proposed carried interest provisions
The proposal’s primary effect would be to recharacterize net capital gain (a defined term generally representing net long-term capital gain over net short-term capital loss) from an “investment services partnership interest” as ordinary income.
Net capital losses would similarly be recharacterized as ordinary losses, but only to the extent that net capital gain was previously recharacterized as ordinary income—with the effect that a carried interest holder would not be able to obtain an overall benefit over the life of their carried interest from any loss recharacterization.
Also, in an override of general partnership tax principles, the proposal would require a carryholder that receives an in-kind distribution from a partnership with respect to that carried interest to immediately recognize any unrealized gain in the distributed property. This gain would be treated as ordinary income, regardless of the character of gain the property would otherwise generate if sold.
Since the proposal would largely require all capital gains with respect to carried interests to instead be treated as ordinary income, the existing three-year holding period rule of section 1061 would be largely mooted. The proposal would therefore repeal section 1061.
Note that, although this proposal and section 1061 both address similar economic interests, the definition of a carried interest under section 1061 is not exactly the same as under the proposal.
Proposed effective date
The proposal’s income recharacterization rules generally would apply to taxable years ending on or after the date it is enacted. Therefore, these proposed rules could apply to taxable events which would have already occurred at the time of passage. However, the effect general net capital gain recharacterization rule (not the property distribution rule) would be limited to the lesser of the net capital gain for the entire year of enactment, or the net capital gain taking into account only gains and losses from the portion of the year after enactment. This could result in favorable treatment for pre-enactment gains, while retaining the ability of pre-enactment losses to offset post-enactment gains (reducing the amount recharacterized as ordinary income).
Miscellaneous provisions
In addition to providing for gain recharacterization, and sometimes acceleration, with respect to carried interests, the proposal would also subject all income with respect to covered carried interests to self-employment taxation, regardless of any other exception from the self-employment tax rules that might apply.
Special penalty provisions would also apply to certain attempts to avoid the rules provided for in the proposal. In particular, the typical 20% accuracy-related penalty would be raised to 40% of any underpayment related to such attempts. In addition, the generally applicable ‘reasonable cause’ exception from penalty application would be limited in a manner to that currently applied to corporate ‘tax shelter’ transactions.
Conclusion
The latest legislative proposal to tax gain with respect to carried interests seeks to apply ordinary income treatment to carried interest regardless of the holding period for the interest or the partnership’s gain property. While passage of this proposal is neither certain nor imminent, it may be worthwhile for fund managers together with their tax advisors to consider alternatives and options that may be preferable should the proposal pass.Ben Wasmuth
Senior Manager, RSM
Stefan GottschalkSenior Director, RSM
Don SussweinPrincipal, RSM
Sanne Connect North America edition 5
01. Proposed House bill would have significant impact on carried interest
A U T H O R S
For more details on RSM, please visit www.rsm.global
The final Marketing Rule expanded the definition of “advertisement”. However, the SEC (mercifully) scaled back the definition of advertisement from the original proposal. Following comments from the industry, communications addressed to one person are no longer included.
The SEC’s definition of an advertisement under the new rule is as follows:
(i) Any direct or indirect communication an investment adviser makes to more than one person, or to one or more persons if the communication includes hypothetical performance, that offers the investment adviser’s investment advisory services with regard to securities to prospective clients or investors in a private fund advised by the investment adviser or offers new investment advisory services with regard to securities to current clients or investors in a private fund advised by the investment adviser, but does not include:
(A) Extemporaneous, live, oral communications;
(B) Information contained in a statutory or regulatory notice, filing, or other
required communication, provided that such information is reasonably designed to satisfy the requirements of such notice, filing, or other required communication; or
(C) A communication that includes hypothetical performance that is provided:
(1) In response to an unsolicited request for such information from a prospective or current client or investor in a private fund advised by the investment adviser; or
(2) To a prospective or current investor in a private fund advised by the investment adviser in a one-on-one communication; and
(ii) Any endorsement or testimonial for which an investment adviser provides compensation, directly or indirectly, but does not include any information contained in a statutory or regulatory notice, filing, or other required communication, provided that such information is reasonably designed to satisfy the requirements of such notice, filing, or other required communication.
The focus of this review is on the first prong of the definition. We don’t address the second prong, which addresses solicitation activity, in this article.
What is not an advertisement is also important to the understanding of an advertisement. The following are not advertisements.
• One-on-one communications (see right for a more in-depth discussion of one-on-one communications)
• Responses to requests for proposal (RFPs)
• Communications with existing investors, that do not offer new or additional services
• Statements about a firm’s culture, philanthropy, or community activity
• Brand content, general educational material and market commentary.
Direct and indirect communications
The definition of advertisement specifically includes direct and indirect communications. Direct communications are pretty straight-forward, that is, communications made directly from the adviser to prospective investors. The SEC takes care to distinguish indirect communications saying “we understand that investment advisers often provide intermediaries, such as consultants, other advisers, and promoters with advertisements for dissemination. Those advertisements are indirect because they are statements provided by the adviser for dissemination by a third party.”
The SEC goes on to say where an adviser has participated in the creation or dissemination of an advertisement, or where an adviser has authorized a communication, the communication would be a communication of the adviser. However, where an adviser provides materials to an intermediary, the adviser is not responsible for modifications made by the intermediary.
The SEC also notes third party information may be attributable to an adviser. Whether third-party information is attributable to the adviser is a facts and circumstances analysis. However, the SEC will look to determine (1) whether the adviser has explicitly or implicitly endorsed or approved the information after its publication (what the SEC terms “adoption”) or (2) the extent to which the adviser has involved itself in the preparation of the information (“entanglement”). These concepts have direct application in the context of advisers’ social media usage which we will address in a separate specific article.
One or more persons
As noted, the SEC modified its originally proposed definition of advertisement such that the final definition generally does not include communications to one person. Communications including hypothetical information are the exception although in certain circumstances even these communications may not be advertisements.
The one-on-one exclusion applies regardless of whether the adviser makes the communication to a natural person with an account or multiple people representing a single entity or account. This is generally in line with accepted practice. Nonetheless, the SEC makes it clear if an adviser’s prospective investor is an entity, an adviser is permitted to provide communications to multiple people employed by or owning the entity without those communications being subject to the rule.
The SEC addresses bulk emails and algorithm-based messages designed to “nominally directed at or ‘addressed to’” only one person saying “[the communications] are in fact widely disseminated to numerous investors”. Additionally, customizing a template presentation or mass mailing by filling in the name of an investor and/or including other basic information about the investor would not result in a one-on-one communication.
How Bovill can help
With 18 months to the implementation date Bovill can help you understand the specific tenets of the Marketing Rule that apply to you, amend and provide guidance policies and procedures and review current marketing materials for compliance with the general and performance advertising requirements.
02. SEC Marketing Rule What is an advertisement?
The definition of advertisement specifically includes direct and indirect communications. Direct communications are pretty straight-forward, that is, communications made directly from the adviser to prospective investors.” Ross Goffi
Ross GoffiManaging Consultant, Bovill Chicago
What is an “advertisement” under the Marketing Rule?
Sanne Connect North America edition 7
The U.S. Securities and Exchange Commission’s (SEC) new Marketing Rule has expanded its definition of what constitutes an advertisement. Whereas
understanding what is or isn’t an advertisement is important, the details are complex and require some scrutiny.
In late December, the SEC adopted a modernized Marketing Rule for investment advisers. The Final Rule Release runs to over 400 pages with a lot of content to digest.
A U T H O R
For more details on Bovill, please visit www.bovill.com
03. The Irish Investment Limited Partnership
We are excited about the fact that Ireland now offers the full suite of preferred legal structures for such investment strategies going forward.”
Orlaith Finan
Recognising the demand among global fund sponsors to utilise a suitable investment limited partnership vehicle for all types of private fund or real asset investment strategies such as private equity, real estate, venture capital, infrastructure, credit and loan origination, a number of important enhancements have recently been made to Ireland’s investment limited partnership (“ILP”) regime. Accompanying these enhancements, the Central Bank of Ireland (the “Central Bank”) has also helpfully updated its rulebook for closed-ended qualifying investor alternative investment funds (“QIAIFs”), which means that Ireland now has a ‘best-in-class’ limited partnership regime building on Ireland’s reputation as the domicile of choice for fund sponsors wishing to establish European regulated investment funds.
The Irish funds industry has continued to grow from strength to strength and asset levels in funds domiciled in Ireland have now passed the EUR 3 trillion milestone, with over 7,800 Irish domiciled funds in existence, over 550 fund promoters having established funds in Ireland from over 50 countries and Irish funds being distributed in over 90 jurisdictions. This growth has been achieved as a result of Ireland’s strong regulatory environment, service provider expertise and product range in a dynamic and ever evolving international funds industry, together with the fact that Ireland is now the only English speaking common law jurisdiction within the European Union (the “EU”). The updates to the ILP are a testament to Ireland’s commitment to catering for the international funds industry.
Conclusion
The introduction of these reforms to the ILP is a welcome and significant development for the Irish funds industry and reflects an industry which is constantly seeking to develop and grow, building on the positive experiences of the many fund sponsors who have already established funds in Ireland. The enhanced and modernised ILP will further strengthen Ireland’s fund product range, providing an attractive vehicle for sponsors seeking to establish private fund and real asset investment funds in Europe.
Partnering for Growth in Private Equity and Real Asset Investment Strategies
Alan KeatingPartner and Head of New York Office, Matheson
Orlaith FinanSenior Associate, Matheson
A U T H O R S
Sanne Connect North America edition 9
The ILP is an alternative investment fund (“AIF”) which is authorised and regulated by the Central Bank, typically, as a QIAIF under the Alternative Investment Fund Managers Directive (“AIFMD”). An ILP is constituted by an Irish law governed limited partnership agreement (“LPA”) between at least one general partner (“GP”) and one limited partner (“LP”). The ILP has no separate legal personality and the GP is responsible for the management and operation of the ILP, and has personal liability for the debts and obligations of the ILP and contracts (directly or indirectly through its delegates) for the ILP. The ILP’s assets, liabilities and profits belong jointly to the LPs in the proportions agreed in the LPA. An LP has limited liability up to contributed capital (or up to the capital which it has undertaken to commit).
A QIAIF ILP that is managed by an authorised alternative investment fund manager (“AIFM”) in the European Economic Area (“EEA”) can be marketed throughout the EEA using the AIFMD passport. For fund sponsors without an EU AIFM, there is a vibrant market of third party providers available in Ireland. The QIAIF offers a trusted, flexible (as there are no material investment restrictions, eligible asset criteria or restrictions on borrowing) and efficient route for fund sponsors to comply with the requirements of, and to avail of the marketing benefits of, AIFMD. Another benefit with the QIAIF is its speed to market, a QIAIF ILP is capable of being authorised within 24 hours of a single filing of documentation with the Central Bank.
A QIAIF ILP requires both an Irish depositary (or real asset depositary) and administrator to be appointed. The depositary’s primary role is the safe-keeping of assets, whose responsibilities will include oversight and valuation of assets, or in the context of a real asset depositary (which is likely to be relevant in many instances), will include the safe-keeping of documents of title in the context of assets which are not capable of being registered or held in an account directly or indirectly in the name of the depositary.
As limited partnership vehicles are the most recognisable and widely used investment fund vehicles globally for private funds or real asset strategies, we are excited about the fact that Ireland now offers the full suite of preferred legal structures for such investment strategies going forward.
What changes have been made as a result of the reforms to the ILP?
• Providing for the establishment of ILPs as umbrella funds with multiple sub-funds and segregated liability between those sub-funds. The ability to establish an umbrella structure allows managers to establish multiple sub-funds within the same ILP, allowing for separate investors, separate pools of assets and differing investment strategies without the need for multiple ILPs;
• Streamlining the manner in which changes may be made to the LPA;
• Codifying a ‘white list’ of activities in which a LP can engage in certain activities without being deemed to be taking part in the conduct of the business of the ILP and risk losing the benefit of limited liability;
• Simplifying the procedures in respect of the return of capital to the LPs;
• Permitting an ILP to differentiate between share classes and / or investor participations / interests;
• Allowing broad LP default provisions;
• Permitting the redomiciliation of partnerships from other jurisdictions and setting out a streamlined process for such redomiciliation;
• Confirming that a GP no longer requires Central Bank authorisation and a minimum capitalisation;
• Clarifying that an ILP can issue interests other than at NAV in
recognition of capital accounting;
• Clarifying that LPs may be excused or excluded from participating in an investment;
• Confirming that, unless varied in the LPA, the register of LPs and capital accounts does not need to be made publicly available;
• Permitting stage investing; and
• Providing for carried interest, distribution waterfalls and catch-up payments.
Irish Tax Considerations
As a matter of Irish law, an ILP is treated as tax transparent. As a result, any income, gains or losses at the level of an ILP shall be treated for Irish tax purposes as arising, or, as the case may be, accruing, to each LP (in proportion to how income, gains and losses are shared under the terms of the LPA) as if such income, gains or losses had arisen, or, as the case may be, accrued, to the LPs without passing through the hands of the ILP.
Distributions can be made by an ILP to the LPs free of any Irish tax implications as all of the underlying profits of the ILP shall already have been allocated to the LPs for Irish tax purposes.
No Irish stamp duty applies to the transfer, exchange or redemption of interests in ILPs. No capital duty is payable on the issue of interests in ILPs. In addition, no Irish value added tax (“VAT”) applies on the provision of management, administration and global custody services to the ILP.For more details on Matheson, please visit www.matheson.com
In 2020, SPACs accounted for 248 initial public offerings (“IPOs”) and raised approximately $83 billion dollars, which was about half of the overall IPO activity on Wall Street. SPACs are off to an equally impressive start in 2021, and private funds have been getting in on the action.
What is a SPAC?
A SPAC is a company with no initial assets or operating business that completes an IPO, with the IPO proceeds held in trust for an unspecified future acquisition or other business combination (the “De-SPAC Transaction”). Following the IPO, the SPAC management team has a defined period of time (typically 18 to 24 months) to complete a successful De-SPAC Transaction, which must be approved by the SPAC’s investors. If the De-SPAC Transaction is not approved and the SPAC investors do not approve an extension of the initial period, then the trust proceeds, plus accrued interest, will be returned to investors.
04. SPAC overview for Private Fund Advisers
For SPAC Merger Targets:
• Private operating companies can use a SPAC to become a public company without going through the traditional IPO process since the SPAC is already publicly listed and typically meets the requirements for trading on the relevant stock exchange. This process results in a much quicker time frame and can reduce market pricing exposure since the terms are negotiated and agreed with the SPAC.
For Sponsors:
• Management teams deploying a buy-out or acquisition strategy through a SPAC have the potential to earn a substantial return on their nominal investment for sponsoring the SPAC (the “promote”) if the De-SPAC Transaction is successful. Private funds and other qualified investors can gain exposure to these economics through subscriptions for interests in the applicable sponsor. These investments are typically restricted from sale at least until the applicable De-SPAC Transaction, and will be worthless if the SPAC is unsuccessful in a completing a De-SPAC Transaction.
• SPAC sponsors, which may include investment advisers to private funds (i.e., hedge funds, private equity funds, venture capital funds or real estate funds), have access to a larger group of potential investors.
• Unlike in the case of the typical private fund, retail investors can invest in a SPAC IPO and there is no private placement restriction on advertising the SPAC IPO.
• SPAC units are traded on the secondary market and SPACs may require additional financing before the De-SPAC Transaction, offering arbitrage and special situation investment opportunities during a SPAC’s life-cycle.
For SPAC Investors:
• Retail investors can get exposure to strategies and investments opportunities that are liquid and in which they might not otherwise be eligible to invest through a private fund.
• As mentioned above, given that SPACs may require additional financing before a De-SPAC Transaction, investors may have access to arbitrage and special situation investment opportunities during a SPAC’s life-cycle.
• SPAC public equity investors have limited downside exposure as a result of each investor’s opportunity to redeem their common shares for cash at the time of the De-SPAC Transaction, and if the De-SPAC Transaction is not approved by investors, the trust proceeds, plus interest, will be returned to all investors.
Special Considerations for Advisers to Private Funds
An investment adviser to private funds will need to determine whether it has made full disclosure of all material conflicts of interest relating to an investment in SPAC units. For example, a conflict of interest would arise if the investment adviser or its affiliates have interests in a SPAC sponsor and a private fund advised by the investment adviser invests in the SPAC IPO units. The adviser’s interests may be better aligned with its clients if the adviser’s only investment in the SPAC’s securities are made through its private fund clients. There is also the potential for conflicts of interest to the extent that multiple private fund clients participate in different securities of the SPAC.
Jacob WimberlyAssociate, Seward & Kissel LLP
Kevin NeubauerPartner, Seward & Kissel LLP
A U T H O R S
What Benefits Does the SPAC Structure Offer?
If an investment adviser sponsors a SPAC and the investment adviser’s private fund clients use strategies that are similar to the strategy that will be used by the SPAC, the investment adviser will also need to consider whether the SPAC is diverting investment opportunities, or the time of its investment professionals, from the private fund clients. Moreover, existing funds contemplating an investment in a SPAC’s securities will need to determine that the investment is permitted under the relevant fund agreements and that the risks, including any potential conflicts of interest, relating to the investment have been adequately disclosed.
Sanne Connect North America edition 11
Special purpose acquisition companies (“SPACs”), also known as “blank check companies”, are all the rage on Wall Street right now.
An investment adviser to private funds will need to determine whether it has made full disclosure of all material conflicts of interest relating to an investment in SPAC units.” Jacob Wimberly
For more details on Seward & Kissel LLP, please visit www.sewkis.com
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Head of Communications
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