The ability to hire top quality managers to run portfolio companies is, most people would assume, an essential element of a thriving private equity industry. The UK tax authorities – after three years of giving the opposite impression – are now among those apparently sharing such a conclusion.
At the end of August, HM Revenue & Customs (HMRC) issued a press release announcing preferable tax treatment for performance ratchets, a common form of equity incentive used in private equity-backed companies. The announcement represented a welcome about-turn from the Revenue's prior stance.
The ratchets are arrangements whereby the proportion of a company's shares held by managers is increased if preset performance targets are achieved. For example, explains John Baldry, a partner in the London office of international law firm Kirkland & Ellis, the share of any profits from a deal might initially be distributed 90 percent to the GP and 10 percent to the management team. When a certain level of return beyond this is accomplished, the ratchet kicks in and the distribution of profits might become, for example, 80 percent to 20 percent respectively.
Previously, based on their interpretation of various provisions in the UK's Finance Act 2003, HMRC had indicated that at least part of the gain achieved under performance ratchets could be made subject to income tax and national insurance, resulting in a tax liability of up to 41 percent for the employee and 12.8 percent for the employer. Until then, it had been assumed that managers would only receive a levy based on capital gains tax at a rate potentially as low as ten percent for the employee and zero for the employer.
The HMRC's latest announcement makes clear that, as long as ratchets are structured appropriately, they will be subject only to capital gains tax. Even more encouragingly, managers will be able to reclaim any tax that has been overpaid in relation to past gains.
However, some uncertainties still remain. For example, the favorable tax treatment only applies where a ?reasonable market value? has been paid for the ratchet – a concept that is open to different interpretations. In addition, the HMRC guidance deals only with situations where managers invest at the same time as the fund. Some confusion still remains in relation to the tax treatment of managers that invest subsequently.
Also, there are worries that the latest guidance will not be the final word. In a client note on the subject, London-based law firm Norton Rose speculates that: ?Companies may well seek to exploit HMRC's climb-down by introducing new equity incentive arrangements. However, the possibility of future anti-avoidance legislation cannot be ruled out.?
In a recent Financial Times article, meanwhile, Paul Megson, head of tax in the private equity group at KPMG, hinted that another U-turn could be in the pipeline: ?It is good news but it is not entirely clear that the Revenue wouldn't want to legislate to get back to the position it had before.?
For the time being, however, the UK private equity industry is in a mood for celebration – particularly the British Venture Capital Association, the industry body that has been in talks with the UK Government's Treasury department ever since the 2003 Finance Act first raised the prospect of punitive tax for private equity managers.
John Baldry insists the new tax guidance has come at an important time, given the focus of many investors on extracting operational improvements. ?There is increasing reliance on management at a time of increased risk and deals being highly leveraged. They need to be 110 percent committed and that means offering sufficient incentive. Sixty percent of the money is still a lot of money, but 90 percent is a lot better.?
Washington pro will advise buyout lobby
The largest US private equity firms have hired Harry Clark, a Washington DC insider, to help establish a private equity lobbying group, according to a source close to one of the sponsor private equity firms. The firms sponsoring the formation of the lobbying group include The Carlyle Group, The Blackstone Group, Texas Pacific Group and Kohlberg Kravis Roberts. According to a source, confirming earlier reports, the firms have tapped Clark, who now lives in Greenwich, Connecticut, to help set up the group. Clark was a founding partner of Clark & Weinstock, a powerful lobbying firm that was acquired by Omnicom Group in 1996. Clark left Omnicom in 2001 to form Stanwich Group, which advises corporations on public policy. Clark's most notable recent client was the creditors' committee of bankrupt WorldCom and MCI. He has also recently represented Google before regulators. He was recently named of counsel to global communications firm Brunswick Group.
German tax change poses ?threat?
A change made over the summer to a draft of German tax legislation may ?pose a new threat to existing deal structures,? according to a client memo from law firm SJ Berwin. The changes make it more burdensome for a company to establish ?substance? in Luxembourg for the purposes of creating a Luxembourg holding company. Already, German law requires that a Luxembourg entity must show a non-tax business activity in order to be recognized as legitimate. Many companies set up in Luxembourg in order to enjoy tax benefits when dividends are paid from one EU resident to another. The SJ Berwin memo warns that if the change goes through, existing structures may ?need to be unraveled or reshaped.? European courts may still strike down the law if it is changed, and the German legislature may withdraw the change.
Pre-merger benefits may be enforced
The participants in a medical plan offered by a company that is acquired may enforce the buyer's requirement to continue providing the benefits at premerger levels, a recent ruling in the US Fifth Circuit Court of Appeals found. The case in question is Halliburton Co. Benefits Comm. V. Graves et al. according to a recent client memo from law firm Debevoise & Plimpton. The memo recommends that a buyer ?provide that nothing in the merger agreement is to be construed to limit any rights that any parties may have under any applicable plan to amend, modify or terminate that plan.? Many GPs assume that they are protected by the ?no third party beneficiaries? clause with regard to the benefits provided to employees of target companies. But based on the new ruling, private equity buyers in the US can be held to any benefits plan to which the merger agreement commits them.
Liquid Realty promotes Jensen to CFO
Liquid Realty Partners, the San Francisco real estate secondary investment specialist, has promoted Andrew Jensen to chief financial officer from director of finance, the firm announced last month. Prior to joining Liquid Realty, Jensen was senior controller of San Francisco buyout firm Gryphon Investors. Before that he was an audit manager with Arthur Andersen. ?Andrew's promotion is significant for the firm, as well as for him, because it is a milestone of the growth Liquid Realty has experienced in the last year,? said Jeffrey Giller, a managing principal and chief investment officer of the firm. Liquid Realty was founded in 2002 to pursue secondary transactions in the private equity real estate market. The firm has roughly $900 million in capital under management.