Golden rules

US private equity firms ignore ‘golden parachute’ rules at their peril.

In private equity, finding and keeping the right management is paramount, and central to this task is proper incentives, meaning money. While in theory making large payments to key executives upon a change of ownership in the portfolio company is a great way to keep these executives focused on a successful exit, in practice, poorly structured ?golden parachute? payments can lead to tax penalties, bemused buyers and embarrassment.

Golden parachute rules in the US have been around since 1984, but the Internal Revenue Service did not formalize regulations until 2004. The heat increased last year when the IRS released a guide for audit examiners specifically to deal with golden parachute situations.

In a recent paper, Lowenstein Sandler lawyers Edward Zimmerman and Brian Silikovitz, together with Mobius Venture Capital managing director Jason Mendelson, argue that many private equity firms may be unaware of the consequences of golden parachute rules.

When a company grants an executive a large ?parachute? payment upon a change of control in the company, the acquirer may be unable to deduct this payment as a compensation expense. What ‘s more, the rewarded executive in question may also have a 20 percent penalty withholding tax imposed on him or her. These rules can be triggered not only upon the sale or initial public offering of a company, but when just 20 percent of the company is acquired and an executive’s pay is increased.

The authors of the paper suggest that golden parachute rules be considered early in the life of an investment, and give specific advice on how best to avoid these expensive penalties:

  • ? If the golden parachute payments are paid by a non-public corporation, the rules are not triggered if, immediately prior to the change in control, 75 percent of the shareholders approve the payments. This becomes tricky because the vote is not sufficient unless the shareholders receive adequate disclosure, which may not be possible if the approval is made long before the change in control. There is a risk that if the vote is delayed until just prior to the change in control, the shareholders will not approve it.
  • ? Any golden parachute payments agreed to within a year before a change in control are presumed to trigger the rules. Therefore these arrangements should be set as far in advance as possible.
  • ? Be careful of accelerated vesting plans, which can trigger the golden parachute rules at or prior to a change of control in the company.
  • ? Beware of ?gross-up? arrangements, whereby a portfolio company essentially pays enough to cover the personal golden parachute penalty tax. This arrangement still does not allow the acquiring corporation to take a compensation expense deduction, and could be quite expensive.

Black Diamond opens in London
Lake Forest, Illinois- and Greenwich, Connecticut-based alternative investment firm Black Diamond Capital Management will establish a new office in London, according to the firm. Heading up Black Diamond’s efforts in London will be Peter Cannon, who most recently was a senior portfolio manager for RMF Investment Management, a division of Man Group. The London operation will focus primarily on leveraged loans across Europe. ?We expect to be adding staff to build out our effort in London in the near term future,? said Bill Bokos, a senior managing director of Black Diamond, in a statement. Black Diamond manages roughly $8 billion in private equity, hedge funds and structured vehicles.

CVC hires leveraged finance specialist
Furthering a trend for private equity firms to bring professional services in-house, London-based CVCCapital Partners has appointed David Wood as a leveraged finance specialist. Wood will work alongside partner Marc Boughton in the London office. In February, the firm appointed Alexander Fotakidis, a former leveraged financier at investment bank CIBC World Markets. Wood was cohead of European leveraged finance at Deutsche Bank for the past six years. Prior to that, he worked as a senior banker in acquisition finance at JP Morgan. CVC said Wood has worked within the leveraged financing and banking market for over 30 years in total, and has been involved in a number of its transactions during that period, including the €1.5 billion ($1.8 billion) acquisition of Ruhrgas, the metering unit of German utility Eon, last June. Other CVC deals Wood has worked on include BASF Inks, Inalta, Kappa Packaging and Lecta.

Study: VCs, CEOs have differing outlooks
A new study conducted by the National Venture Capital Association and Dow Jones VentureOne found that many CEOs would like more time with their backers. The study, which surveyed 700 VCs and CEOs of privately-held, venture-backed companies, found that venture capitalists believe the ideal number of board seats for one VC to be sitting on is an average of 4.6 for early stage companies and 5.5 for later stage companies. CEOs, on the other hand, would prefer their venture capitalists limit their early stage board seats to an average of 4.0 and their later stage board seats to 4.6. Given that 81 percent of VC respondents said getting a board seat is a prerequisite for an investment, there may be little CEOs can do to keep their backers from overextending themselves. However the study also found that in reality VCs are sitting on fewer boards than their ideal, with an average of four board seats per partner in 2005. The study found that 65 percent of VCs say Sarbanes Oxley is the biggest concern facing their audit committees. Only 39 percent of chief executives said it was their top audit committee concern, and only 21 percent said it is a concern when hiring directors.

Apollo prices secondary offering
Apollo Investment, the publicly traded business development company of private equity giant Apollo Management, has raised $268 million in a public offering of securities. The company provides debt to middle market companies, frequently in situations with a private equity sponsor. Apollo Investment originally raised $930 million through an initial public offering in 2004. It was the first of a wave of attempts by private equity firms to create business development companies, although most similar efforts, including registered BDCs from Blackstone and KKR, were cancelled. Apollo Investment was led until recently by Michael Gross, a co-founder of Apollo Management who has announced he will leave Apollo Investment to form a new firm.