The new legal terrain

A variety of proposals are wending their way through all levels of US government that could impact private equity funds, including treating carry as ordinary income and requiring registration with the SEC and possibly state authorities.

That which the US private equity industry has been warily anticipating for months has now become reality: a carried interest tax hike is part of President Barack Obama's proposed 2009 budget. If it is passed as is, the capital gains tax on carried interest profits would be increased from the current 15 percent to the ordinary income rate of up to 39.6 percent.

Since carried interest represents the lion's share of general partners' compensation, such an increase would be a substantial hit to their wallets. With less of a buffer to weather dry periods in between successful high-tech investments like Google, venture capitalists could also be less inclined to invest in the kind of innovative but risky start-ups that could create jobs at an important time.

Lawmakers will spend the next few months debating the proposals, and a more detailed version of the budget will be released in April. David Winter, a partner at Hogan & Hartson, says the decision by the administration to defer the tax increase until 2011 is smart policy for Obama both economically, as no one yet knows how long the recession will last, as well as politically, as he seeks to win support for his initiatives as the budget works its ways through Congress.

Revenue raiser
The budget proposal says the tax hike will raise $2.742 billion in 2011. Between 2010 and 2019 the tax hike is expected to raise a total of $23.894 billion, according to the White House Office of Management and Budget.

Interestingly, revenue expectations taper off after 2014: $3.494 billion in 2014, $2.803 billion in 2015, $1.725 in 2016, and so on down to $1.060 billion in 2019.

This taper effect is not based on the expectation that US GPs will earn less in carry, but rather because the Treasury anticipates that private equity firms will gradually find a way around the tax increase, one Treasury official told The Wall Street Journal.

The most common strategy being quietly circulated as to how GPs might soften the blow of carried interest being treated as ordinary income is for GPs to borrow their portion of the equity in a deal from limited partners. Under this approach, any returns on the deal would be considered capital gains. That said, the President suggests increasing the capital gains rate for individuals earning more than $200,000 per year to 20 percent.

But the Treasury official told the Journal that Washington will counter any new tax avoidance strategies with new policies.

Tax and spend
In addition to carried interest, Winter says there are other proposals in the Obama budget that, while not geared specifically to private equity, will still affect the partners and principals of private equity firms who are high-wage earning citizens. Among these is the reinstatement of the 36 percent and 39.6 percent ordinary income rates for those earning over $200,000 for single taxpayers and $250,000 for married taxpayers, and the move to increase the capital gains rate to 20 percent for those taxpayers.

Also, the rate at which itemised deductions would reduce tax liability would be cut to 28 percent. While $10,000 in itemised deductions reduces tax liability by $3,500 for taxpayers in the 35 percent tax bracket, such deductions would reduce liability by at most $2,800 under the Obama proposal, even for taxpayers in the 39.6 percent tax bracket. Finally, the phase-out of personal exemptions and limitations on itemised deductions for taxpayers earning over $200,000 for single taxpayers and $250,000 for married taxpayers would be resurrected.

“Each tax change will have an impact on high wage earners,” Winter says. “Their income will be taxed at a higher rate, their deductible expenses will not be as valuable, and to the extent they invest some of their own money in their funds and are eligible for capital gains treatment on the gains those investments create, the tax on those gains is going to be 5 percent higher than it is under current law.”

Thou shalt register
Both the House of Representatives and the Senate are mulling bills that would force private equity funds to register with the Securities and Exchange Commission

This February Senators Chuck Grassley and Carl Levin introduced the Hedge Fund Transparency Act, a bill that would require private funds with $50 million or more in assets – including hedge funds, private equity funds and venture capital funds – to register with the Securities and Exchange Commission.

The bill would affect funds that rely on Sections 3(c)1 or 3(c)7 of the Investment Company Act. In order to remain exempt from registering as an investment company, such funds would have to register with the SEC, maintain such books and records as the SEC may require, and cooperate with any request for information or examination by the SEC.

Under the proposed law, funds would also have to file an information form including the name and address of each owner of the fund, the primary accountant and primary broker used by the fund, an explanation of the structure of ownership in the fund, information on any affiliation that the fund has with another financial institution, a statement of any minimum investment commitment required of a limited partner, the total number of any limited partners, and the current value of the assets of the fund and any assets under management by the fund. The SEC would make this publicly available in an electronic, searchable format.

It is unclear to what extent the bill would require performance disclosure. Public US institutions, such as public pensions, are already typically required to disclose the fund-level performance of their GP relationships.

The bill would also require that funds establish an anti-money laundering programme and report suspicious transactions. Funds would also have to comply with the same requirements as other financial institutions for producing records requested by a federal regulator under the USA Patriot Act.

The new bill would require registration of the fund rather than the management company, and so is separate from the process of registering the management company as an Investment Advisor. As law firm Paul, Weiss, Rifkind, Wharton & Garrison noted in a recent client alert, some firms may need to register both the management company and the funds the management company forms.

The hedge fund and private equity industries are likely to lobby against certain provisions of the bill which would be “difficult to live with” says Marco Masotti, co-head of Paul Weiss's private equity practice. LPs often prefer to keep their names out of the public domain, for instance.

There are technical issues to be worked out as well, including how the bill would interact with other regulations governing private placements of interests in private funds.

“There are parts of it that don't gel well with other securities laws, like the laws relating to how to privately offer securities, privacy laws because it requires disclosure of who the investors are,” Masotti said. “A lot of those issues are going to have to be worked out.”

Separately, a bill introduced in the US House of Representatives would eliminate the registration exemption to the Investment Advisors Act of 1940 for investment advisors with fewer than 15 clients.

The amendment to the ‘40 Act, HR 711, was introduced by Representatives Michael Capuano and Michael Castle. It would eliminate Section 203(b)(3) of the Act, which exempts advisors with fewer than 15 clients – which in the case of private equity firms is typically interpreted to mean 15 pooled investment vehicles – from registering with the Securities and Exchange Commission.

If the bill passes, all US advisors to private equity funds would be required to register, as well as non-US advisors of US domiciled funds. It imposes restrictions on advisory contracts, requires that advisors use “qualified custodians” for client assets, requires advisors to file Form ADV, subjects advisors to SEC inspections, requires extensive recordkeeping, and requires the development of a systematic compliance programme.

“Both of these proposals were clearly written by people who don't have a great deal of understanding about how private equity and hedge funds are run,” says Timothy Clark, a partner in Proskauer Rose's private equity practice. “None of the nuances that you'd like to see were there. They were clearly thrown together with a great deal of haste. Hopefully our legislators can be educated as to why some of this would be extraordinarily damaging to our industries.”

State of play
New proposals to increase oversight of private equity in Connecticut likely won't have a big impact on most funds domiciled there

While general partners and hedge fund managers in every state in the US will be affected by President Obama's carried interest tax hikes, should they be passed, lawmakers in Connecticut are proposing further measures to increase oversight and regulation of the industry there. The state is currently home to roughly 200 hedge funds, including top US manager Bridgestone, which have around a third of global hedge fund assets under management.

As part of the three new bills up for vote in the state, institutions with under $5 million in assets and individuals with less than $2.5 million in assets would be barred from investing in private funds. Funds would also be required to disclose side letters, information about their portfolios to Connecticut pension plan investors and changes in management strategy, as well as undertake an annual audit and buy a $500 license each year in order to conduct business in the state.

The moves come in the wake of the Bernie Madoff scandal, in which the Connecticut town of Fairfield's pension scheme lost up to $30 million through the disgraced investor's Ponzi scheme. The state's treasurer also announced in December that for the first time the state's three pension funds would allocate 8 percent of their assets to hedge funds.

But while the proposals have raised fears that new regulations could drive funds out of the state to places like New York or Boston, Jim Nix, a partner in Dechert's alternative investments practice, said he is not convinced the new legislative proposals will represent much of a burden on fund managers, because most funds already impose a higher standard for investors than the proposed $5 million and $2.5 million for institutions and individuals, respectively. Such funds want to avoid taking money from people who may be investing their whole nest egg and subsequently drawing fire if such less-wealthy individuals suffer substantial losses.

“It's a good practice to hold your investors to a higher standard,” Nix said. “I don't see the Connecticut change as being that significant for most fund managers, as they are already imposing higher suitability standards.”