Rethinking carried interest

In light of tax reform introduced in the US, some private equity and venture capital firms are revisiting their LPAs to change the way carry is paid out, says EisnerAmper’s David Helprin.

Q The Trump administration’s Tax Cuts and Jobs Act is wide-ranging. What are the most pertinent provisions for private fund managers?

DH: The carried interest rule and the business interest expense limitation provision are probably two of the more significant provisions for the private funds world. Some of the other international tax issues are highly relevant as well.

Q Starting with the limitations imposed on carried interest – specifically that investments need to be held for longer than three years to qualify as long-term capital gains – is this a big deal for the private equity and venture capital community?

DH: When it comes to the private equity industry, the carried interest provision won’t have as significant an impact. Generally most PE or VC funds hold their investments for longer than three years. However, there could be instances where the fund has early exits or made later add-on investments that may be impacted by the new provision.

Q Will the impact of the carried interest provision be more keenly felt by other private fund managers, such as those in private credit? 

DH: Hedge funds are affected as indeed are private credit funds. Hedge fund investments, however, are typically shorter-term in nature, so it is not as impactful for them. In the private credit world it is very common to hold your assets for between one and three years, so they would be significantly impacted by this provision.

Q How are your clients reacting to this change?

DH: One of the things that we are seeing, particularly in the private equity and venture capital world, is that people are considering looking at and amending their limited partnership agreements to determine when the GP will take their carry allocation from the fund. They are considering amending the agreement to allow them to not take carry on gains after less than three years, so they can defer them to gains that would exceed the three-year period.

Q Is that specific to funds paying carry on a deal-by-deal basis?

DH: No, this could be done on American or European style carry. There are nuances to it, but they are considering changes to the LPA to allow them to waive carry relating to deals that close within the three-year holding period and to take carry on deals later on to the extent of the appreciated value from the date of the election to defer. There are certain things that you need to work through to do this, and should work with legal counsel to include amendments in the LPA to achieve this. 

Q Can you explain how this would work from a technical perspective?

DH: If carry is being paid on a realized deal it allows the general partner, assuming the deal is in the carry, to waive carry on a particular deal and catch it up on a later deal. If they are doing this, then there needs to be a risk of forfeiture – a risk of loss; otherwise it would not hold with the US tax rules. They are waiving the carry allocation on a specific deal or realization and then will ultimately catch up that waived carry on future deals or disposals.

Q The limitations on business interest expenses represent another significant area of tax reform for private funds. Is there anything in  particular that you can advise your clients to do in light of it? 

DH: We are having discussions with our clients in relation to what impact this may have. What we are seeing and what we are hearing within the industry is that this issue of expense limitation could have an impact on the leveraged buyout industry and the amount of leverage used in deals and interest expense used at a portfolio company level, which could have an impact on the value of underlying portfolio companies.

Q But presumably there is not very much a private fund manager can do about this, other than perhaps modify their strategy slightly?

DH: I think that people are less inclined to use as much debt and would put more equity capital in to the investments, as well as take a closer look at those portfolio companies to see how much debt they incur and the impact that would have on the valuation of that company.

How would you say the Tax Cuts and Jobs Act is affecting international operations of US private fund firms?

DH: There were a number of international tax reform provisions included in the bill; this was the most significant change in US tax law since the Reagan administration’s Tax Reform Act of 1986. There is a lot in there and most of it is applicable from 2018 forwards.  A number of provisions, however, including the Section 965 repatriation provision, were actually applicable from 2017 and so have had an immediate impact.

People call it a number of different things – the transition tax, the toll tax – effectively what it says is that to the extent that a US person has an interest in a CFC [controlled foreign corporation] and to the extent that there is undistributed earnings that have not been previously taxed since 1986 – when the code was last significantly amended – that amount would be considered repatriated and would need to be included as income.

Q What would be the knock-on effect for private equity firms?

DH: Obviously a number of US private equity funds invest in non-US portfolio companies, so it is important for them to look at and analyze the nature of their portfolio and how their non-US companies are treated from a US tax perspective, be they a controlled foreign corporation or a specified foreign corporation, then they may be impacted and need to include, as part of the K-1s they provide to their investors, their share of the repatriation income inclusion in 2017. That is something that is relevant right now.