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Riskier business

TWO RECENT LARGE DEALS SAW PRIVATE EQUITY FIRMS ESCHEWING TRADITIONAL ‘FUNDING CONDITION'SAFETY NETS

The desire for private equity firms to win auctions is now such thatmany are agreeing to terms that lay the risk of an aborted deal with the equity sponsors themselves.

According to a recent client memo from law firm Weil, Gotshal & Manges, two recent private equity deals ? the $11. 3 billion (€8. 8 billion) SunGard acquisition and the $5. 1 billion (€4 billion) Neiman Marcus deal ? saw the respective private equity consortia accepting the possibility of penalties should the deals fail to close.

Traditionally, LBO deals have come with funding conditions, meaning the proposed buyers are off the hook if debt financing fails to come through. Instead, notes the Weil Gotshalmemo, sellers have taken comfort in the knowledge that private equity firms may suffer reputational harm if they fail to close a transaction.

The SunGard and Neiman Marcus deals will cost their equity sponsors more than just reputation damage if they fail to close. According to information in the public domain, the syndicate that has agreed to buy SunGard ? which includes Silver Lake Partners, Bain Capital, Blackstone, Goldman Sachs, Kohlberg Kravis Roberts, Providence Equity Partners and Texas Pacific Group ? will pay a $300 million ?reverse termination fee? if debt financing is not secured, barring certain material adverse conditions.

The MAC clauses in this case, notes Weil Gotshal, are defined very narrowly to mean a suspension of trading in the debtmarkets for three consecutive days, or a legal or bankruptcy quagmire suffered by the lender. In other words, the equity syndicate is not off the hook if the loan arrangers simply fail to place all the debt necessary to close the deal.

Likewise, on the Neiman Marcus deal, led by Texas Pacific Group and Warburg Pincus, the equity sponsors accepted ?severe? limitations on the traditional funding condition. What's more, the buyers in this case are exposed to liabilities in excess of the reverse termination fee of $140. 3 billion under certain conditions. The buyers could be liable for additional damages of up to $500 million if the deal fails to close for reasons beyond the inability to secure financing. Weil Gotshal describes this as, for example, the buyer deciding to ?cut its losses? and walk away from the deal.

As competition heats up, private equity firms appear willing to accept increased transaction risk in order to clinch deals. With deals the size of SunGard, however, the added risk may be of most concern because it is as yet unknown just how much LBO debt the market can absorb. Limited partners would not be thrilled to learn that nine percent of their equity on a key deal has been paid out as a dead-deal fee.

Tax policy victory for stock options
The US Internal Revenue Service has formally withdrawn proposed rules that would have forced employees with stock option plans to pay certain withholding taxes. According to the National Venture Capital Association, the withdrawn proposed rule in question relates to FICA (for Social Security and Medicare) and FUTA (unemployment) taxes. Under the proposed rules, these withholding taxes would have affected employees with incentive stock options and employee stock purchase plans. The reversal was a result of a Congressional mandate that was included in the American Jobs Creation Act of 2004, according to the NVCA. The rule was first proposed in 2001, and legislation that would have reversed it was nearly failed to pass in 2002 and again in 2003. According to an NVCA statement, the association ?began a lobbying effort to get language included in ?must-pass? legislation that codified that the prior IRS position stating the purchase of stock by an employee under a qualified statutory stock option plan is not subject to withholding taxes.?

VCs press for reform in Mexico
Members of the Latin American Venture Capital Association (LAVCA) and the Mexican Private Equity Association (AMEXCAP) met recently with Mexican policy makers to push for favourable investment laws in the country. The meeting revolved around new capital markets laws currently under review by the Mexican House of Representatives. In attendance were members of the Mexican development finance agency Nacional Financiera and the Multilateral Investment Fund of the Inter-American Development Bank. Private equity investors in Mexico complain that the country's private investment laws are not in line with international best practices, and that investments in small- and medium?sized business in Mexico are fraught with high transaction costs. ?The event was an opportunity for the Mexican government to hear directly from the private sector what reforms are required to promote the [private equity] industry and increase the amount of investment in Mexican companies,? said Antonio Ruiz Galindo, president of the AMEXCAP, in a statement.

CalPERS devises conflicts policy
The California Public Employees' Retirement System (CalPERS) has adopted a new policy designed to prevent conflicts of interest between its various investment consultants. CalPERS, which consults with 28 advisers for its investments in private equity, real estate and other asset classes, announced that it now requires its advisers to disclose any circumstances that might create ?actual, potential or perceived? conflicts. In a statement, the pension said: ?Under the new policy, a conflict exists when a consultant knows or has reason to know that he or she, his or her spouse, or a close relative, domestic partner or other significant personal or business relationship, has a financial or other interest that is likely to bias the consultant's advice to CalPERS.? The policy requires CalPERS' consultants to disclose any conflicts of interest when bidding for contracts. Last month, a report by the SEC found that more than half of pension consultants examined, or their associates, served both pension funds and money managers.

Korea seeks tax change
The government of South Korea is seeking ways to capture capital gains taxes made by foreign private equity investors in the country. These efforts are focused on the handful of offshore tax havens, such as Lubuan in Malaysia, that have tax treaties with South Korea. According to a report in the Korea Times, the government has been prompted by the recent, highly profitable exits of private equity firms to ?revise tax treaties with other countries and domestic tax rules to prevent foreign capital from dodging taxes by using tax havens.? The report cited the recent exits of Newbridge Capital from Korea First Bank; The Carlyle Group from KorAm Bank; and Lone Star from Star Tower as being of particular concern. None of those firms paid capital gains tax in Korea, the report stated. The report quoted an official of the National Tax Service, Chae Kyong-soo, as saying that a revision to the tax rules would be difficult as the counterparties of tax treaties would have to agree to any changes. Of the $8. 9 billion in foreign investment directed to Korea last year, about $6. 6 billion came through Lubuan, Malaysia, according to data submitted by the National Tax Service. Newbridge Capital's investment in Korea First Bank was made through a holding company in Lubuan.

Japan stalls on new private equity tax
Tokyo lawmakers have postponed a vote on legislation that could significantly increase tax rates for overseas private equity firms in Japan as well as forcing them to reincorporate in order to continue doing business in the country. During a debate on the tax bill in the Japanese Diet's House of Councillors, a member of the House asked Ministry of Justice officials whether they had considered the consequences of the legislation on foreign financial firms. The planned vote was then postponed, leading to speculation that the legislators may do a u-turn. The most controversial aspect of the new tax code is Article 821, which would take effect on April 1 2006 and would require foreign-owned businesses operating through branches in Japan to re-incorporate as subsidiaries of foreign-owned companies. Once re-incorporated, firms will be subject to a 42 percent tax rate on their profits.

Survey: VCs thinking globally
A recent survey shows many US venture capital firms plan to expand around the globe, particularly into China and India. The findings are in Deloitte & Touche and the National Venture Capital Association's ?2005 Global Venture Capital Survey.? The poll showed 20 percent of the respondents from US-based venture capital firms plan to increase their global investment activity over the next five years. This number is up from the 11 percent currently investing abroad. The survey was conducted between February and April 2005, and involved 545 venture capitalists in the United States and abroad. The countries that hold the greatest investment interest for venture capital firms over the next five years, according to the survey, are: China (20 percent), India (18 percent), Canada & Mexico (13 percent), Continental Europe (13 percent), Israel (12 percent) and the United Kingdom (11 percent). Some respondents said they are planning to partner with other firms who invest outside of the US. Forty-two percent plan to invest overseas strictly with US-based VCs that already have offices abroad, while 39 percent plan to develop alliances with firms based only in the country of interest. About 30 percent of the respondents plan to open satellite offices in select regions across the world.