The first half of 2019 has seen increased clarity on a number of substantial
issues that have affected both general and limited private equity partners.
While the outcome of Brexit remains unclear, the preparations of European
firms and regulators have intensified. There is also now the prospect of
welcome consistency in Europe on the regulation of fund pre-marketing.
Meanwhile, in the United States, a number of key provisions in the Tax
Cuts and Jobs Act have been finalized, and rulemaking is underway for
the Foreign Investment Risk Review Modernization Act. In addition,
important proposals and guidance came out of the Securities and Exchange
Commission, and there were notable legal rulings regarding M&A valuation.
Our Midyear Review and Outlook summarizes these developments, as
well as important trends in financing, as funds look to raise capital and
close deals in what continues to be a highly competitive market.
The strong global fundraising market continues—although more capital flows into
fewer hands. Approximately $100 billion was raised in the first quarter of the year alone,
making it one of the most successful first quarters of the past decade, and fundraising
activity levels remain strong as we enter the second half of the year.At the same time,
the period saw less than two thirds the number of fund closings than in the first quarter
of the previous year, largely due to continuing capital concentration. Prior to 2012, there
were only a handful of funds each year with target sizes of $10 billion or more. With these
so-called “mega funds” being raised on a more regular basis, more capital is being raised by
fewer sponsors. We expect this trend to continue for the remainder of the year.
Complex structures and products are becoming more common. Limited partners are
looking for increasingly creative, tailored and cost-effective means by which to make their
investments, fueling demand for sophisticated liquidity solutions, and GPs are responding
accordingly. As the market expands to include more single-asset, fundless sponsor and
stapled transactions, it becomes ever more critical for participants in this space to have
a deep understanding of the commercial and legal issues faced by existing investors,
secondaries, purchasers and GPs and to think creatively to address those concerns
outside of a traditional commingled fund context.
The GP stakes market keeps growing. Staking funds has become an attractive alternative
for LPs looking to diversify their investments. Staking transactions are also appealing
to GPs who wish to secure long-term capital without taking their firm public. Investing
in staking funds has become an attractive alternative for LPs looking to diversify their
In fund finance, sponsors are exploring different ways of raising finance at the fund level:
- It is well established that private equity sponsors raise investment-specific additional
debt in SPV holding companies above a particular investment (such as holdco PIK debt).
An alternative to this type of financing is developing in the fund finance market. There
is a growing availability of finance at the fund level to raise debt against “concentrated
NAV” (i.e., a small pool of private equity investments). This new strategy could
achieve the same result for a sponsor looking to raise holdco PIK in more than one
- We are also seeing sponsors raise funds at the fund level through preferred equity
structures. Increasingly, lenders are helping preferred equity investors provide that
equity funding through leverage to the investor with security over the preferred
As fund finance products and structures continue to diversify, new lenders—including
credit funds—are entering the market.
US M&A and Leveraged Finance
In the first quarter of 2019, we saw a brief slowdown in the number of private equity
M&A deals getting done; sellers still expected the full EBITDA multiples to which the
market had been accustomed, while buyers took a more cautious approach following the
sharp stock market declines of late 2018. Although debt financing was hard to come by
toward the end of 2018, financing markets started to stabilize in the first quarter of this
year. Issuers found secured high-yield bonds an attractive alternative as investor demand
led to upsized bond tranches, attractive pricing and other issuer-favorable terms.
The second quarter saw a return to “business as usual,” with sponsors competing
vigorously for deals, and deal volume picking back up. While bouts of market volatility
persisted, debt markets continued the recovery that began in the first quarter, with
financing available at higher leverage multiples and on sponsor-favorable terms.
Renewed focus on debt activists led sponsors to propose provisions to limit voting by “netshort”
derivative holders; these provisions are becoming more prevalent in the market.
Looking ahead, we expect sponsors to face similar challenges to those in recent years in
terms of getting deals done, given competition for assets and high multiples. In light of
this, we expect continued focus from sponsors on alternatives to traditional control
buyouts, including PIPEs, growth investments and minority stakes.
Companies, investors and regulators are still becoming comfortable with the
requirements and implications of the Committee on Foreign Investment in the
United States (“CFIUS”) Pilot Program in practice. The Pilot Program, launched
last November, requires submitting for CFIUS review any transaction by which a non-US person (i) acquires control over, (ii) obtains access to material non-public technical
information from, or (iii) has substantive decision-making or board seat rights in, a US
business that produces, designs, tests, manufactures, fabricates or develops “critical
technologies” designed for use or used in certain specified Pilot Program industries. As
previously reported, a declaration for a transaction covered by the Pilot Program must be
filed with CFIUS by no later than 45 days before the closing.
To err on the side of caution, parties to a transaction that is or may be covered by the
Pilot Program are, in general, making these filings, even if it is unclear whether the
transaction is covered by the Pilot Program. This risk aversion is understandable, given
that the penalty for not making the filing can potentially be as high as the transaction’s
value. And it appears that in many cases, CFIUS is neither approving nor rejecting the
transactions; instead, it invites parties to file a notice to obtain CFIUS clearance, though
they are not required to do so. As CFIUS gains more experience with the Pilot Program,
it may become more comfortable providing parties with definitive guidance at the end of
the review period.
The US Department of Commerce (“DOC”) is now reviewing the public comments
on defining “emerging technologies.” In November 2018, the DOC published an Advance
Notice of Proposed Rulemaking (“ANPRM”) to assist it in developing criteria for identifying
“emerging technologies” within 14 broad categories—including artificial intelligence,
machine learning, nanotechnology, additive manufacturing, and biotechnology—that
are essential to US national security. Once identified, these will be subject to US export
controls and also will be considered “critical technologies” for the purpose of CFIUS review,
including under the Pilot Program.
In response to the ANPRM, nearly 250 foreign and domestic corporations, industry
associations, advocacy groups, and educational institutions submitted comments.
Many of those comments urged the DOC to avoid a broad-brush approach to defining
“emerging technologies” because doing so could negatively affect US technological
innovation and global competitiveness. Moreover, they noted, most of the ANPRM’s
technology categories have been in widespread commercial use for years, so they are
hardly “emerging” and should not be subject to export controls. Accordingly, commenters
urged that “emerging” technologies should be (i) limited to early-stage, developmental
technologies, and not those that are widely available or are in broad production use,
(ii) subject to export controls only if the technologies are both “essential” to national
security and not already covered by existing export control regimes, and (iii) adopted
through multilateral regimes and be based on end uses and end users.
The DOC is expected to identify “emerging technologies” for further comment later this
year; it will propose new Export Control Classification Numbers governing the export,
re-export or transfer of these technologies. Because non-US acquisitions or equity
investments in US companies that develop or are otherwise involved with “emerging
technologies” may come within CFIUS’ jurisdiction, private equity firms that invest in
such US companies will want to pay attention to these developments. Similarly, non-US
private equity firms doing deals in the US will have to negotiate the rules carefully.
Regulations are needed to further implement FIRRMA’s expansion of CFIUS’s
jurisdiction. Regulations are needed to cover a non-US person’s non-controlling
investments in critical technology, critical infrastructure, and personal data companies,
if that person is accorded access to material non-public technical information, board
seat rights, or substantive decision-making. Regulations also are required to implement
the expansion of CIFUS to certain real estate transactions and to accord flexibility to
investors from to-be-specified allied nations. The Treasury Department is currently
developing these regulations, with the involvement of certain interested parties and
groups. The regulations are expected to significantly shape the breadth and impact of
FIRRMA’s CFIUS reforms. They will be issued by no later than February 2020.
US Capital Markets
Proposed amendments to the SEC’s financial disclosure requirements regarding
significant acquisitions and dispositions could prove a boon to M&A and IPOs. The
SEC’s most recent effort to streamline disclosure requirements would alleviate the burden on
registrants of preparing these financial statements and accelerate the process of presenting
acquisition-related information to investors. Proposed changes include, among other items,
revisions to the test for calculating the significance of an acquisition in order to eliminate
anomalous results, an expansion of the ability to provide abbreviated carve-out financial
statements in connection with acquisitions of business components, and new requirements
related to the presentation of pro forma financial information. While the proposed amendments
will prove beneficial for reporting compliance and capital raising, it remains unclear how the
proposed rules might affect the private placement and leveraged finance markets.
Although the proposed rule changes would affect all SEC-reporting companies, private
equity firms stand to benefit in particular from certain of the proposed changes.
Proposed revisions to the “income test” for determining significance, for example, would
allow applicants to use the more favorable of income or revenue. As a result, many
highly leveraged registrants, who might otherwise fail the significance test due to the
impact on net income of ongoing debt payments, will now be able to avoid triggering the
disclosure requirements that would accompany a finding of significance. The proposed
expansion of the ability to provide carve-out financial statements will create greater
certainty for acquirers and remove the need to negotiate for the sellers’ cooperation to
provide a complete set of audited financial statements under difficult conditions. Finally,
the proposed changes to the presentation of pro forma financial information should
allow acquirers to more realistically present the impact of the transaction to investors,
including through adjustments reflecting expected synergies. (However, the preparation
and inclusion of synergy adjustments will require increased attention from management
and their auditors to ensure accuracy and compliance with the rule requirements.)
The House Committee on Financial Services passed a bill that would codify the
prohibition on insider trading. No provision of the Securities Act or the Exchange
Act explicitly prohibits insider trading, leaving prosecutions to rest solely on judicial
interpretation of rules that prohibit fraud in securities transactions. The proposed
“Insider Trading Prohibition Act” would address this gap by expressly setting forth the
requirements to prove insider trading and broadly expanding insider trading liability.
Under current interpretation, insider trading liability largely depends on the government
proving that a defendant breached a fiduciary duty, or other duty of trust and confidence,
to keep material nonpublic information confidential. The proposed bill would prohibit
trading on information “wrongfully” obtained or communicated, where “wrongful”
is defined as not only a breach of a duty, but also “theft, bribery, misrepresentation or
espionage,” “a violation of any federal law protecting computer data or the intellectual
property or privacy of computer users,” or “conversion, misappropriation or other
unauthorized and deceptive taking of such information.” These and other changes
eliminate the current requirement for the government to prove that a “tipper” received
a personal benefit from sharing the confidential information. Under the bill, the
government would merely need to prove that the “tippee” was aware, or recklessly
disregarded, that such information was wrongfully obtained or communicated.
Asset managers should note the proposed bill’s standard for “control person” liability,
which provides that a control person shall not be liable if that person or their employer
did not “participate in, profit from, or directly or indirectly induce the acts constituting the
violation.” Time will tell how narrowly this provision will be interpreted, but the proposed
bill may put institutions at a greater risk of incurring liability due to the insider trading
of their employees than under current law. The Insider Trading Prohibition Act must be
passed by both the House and Senate and then signed by President Trump before going
into effect, but if passed it would likely have a substantial impact on the prosecution of
insider trading and bring welcome clarity to this area of law.
Slack's direct listing proves Spotify was not a one-off—but are PE-backed companies
likely to follow suit? Slack’s decision to go public through a direct listing in June 2019—following Spotify’s decision last year to do the same—spawned numerous headlines
suggesting a fundamental shift in the IPO market. Direct listings let investors trade in a
company’s existing stock without the company selling any shares, meaning it does not
actually raise money for itself or pre-IPO investors. Instead, the purpose is to trigger a
liquidity event for the existing shareholders or facilitate future capital raises. The success of
this strategy thus depends upon the company having no immediate need for new funding
and a large, diverse shareholder base that can provide sufficient liquidity on the first day of
trading. (These requirements may be why only two big, VC-backed companies have utilized
it so far.) Although we expect an uptick in interest in direct listings, we do not see this as a
desirable option for PE portfolio companies which (i) frequently use an IPO event to de-lever
their balance sheet to levels acceptable to public equity investors and (ii) are unlikely to
have a diverse enough investor base of non-affiliates to enable a liquid market in the stock.
This June saw the Securities and Exchange Commission ("SEC") complete a
major rulemaking initiative that requires broker-dealers to act in the best interest
of their retail customers. As part of this initiative, the SEC issued the final version of
its interpretative guidance regarding the standard of conduct for investment advisers
and the fiduciary duty that an investment adviser owes to all—not just retail—clients.
These duties include the duty of care, which requires that an investment adviser provide
advice that is in the best interests of the client, and the duty of loyalty, which obligates an
investment adviser to eliminate or make full and fair disclosure of all conflicts of interest
such that a client “can provide informed consent to the conflict.”
The interpretation includes several notable clarifications made in response to comments
received when the interpretation was proposed last year. For example, the interpretation
seeks to address concerns that some conflicts of interest are too complex to be addressed
with full and fair disclosure. The interpretation recognizes that disclosures should be
“clear and detailed enough for the client to make an informed decision to consent” and
notes that whether a client has provided informed consent will depend on the facts and
circumstances, including the sophistication of the client. Importantly, the interpretation
emphasizes the differences between retail and institutional clients, recognizing that
institutional clients “generally have greater capacity and more resources than retail
clients to analyze and understand complex conflicts and their ramifications,” and that
their objectives are commonly “shaped by [their] specific investment mandates.”
We expect that the SEC’s Division of Investment Management will now turn its efforts
to developing amendments to the Investment Advisers Act’s “advertising” rule to
address provisions imposing unnecessary burdens on private equity fund sponsors. The
Division is also continuing its review of the Investment Advisers Act’s “custody” rule.
Hurry up and wait for Brexit. UK firms’ Brexit planning reached fever pitch in the first
quarter of 2019. For some firms, this activity culminated in new office openings and
team moves made in advance of the original March 29 deadline. For others, their work
amounted to a dress rehearsal, with full implementation postponed when Brexit was
deferred. Given the continuing political uncertainty, firms continue to plan for both a
“Hard Brexit”—one with no Withdrawal Agreement or transitional arrangements—and
a measured withdrawal, guaranteeing continuity until at least December 31, 2020. With
October 31, 2019 the next possible Hard Brexit date, there is little respite.
Similarly, steps taken by the UK government and the financial services regulators to
accommodate the regulatory impact of a Hard Brexit—including the onshoring of
EU legislation and the establishment of a temporary permissions regime for EU firms
currently passporting their activities into the EU—were largely concluded by March 29. Only
toward the end of the process was there willingness by EU governments to establish
reciprocal arrangements that would provide continuity for UK firms exercising passport
rights into the EU. But while many states ended up providing some similar transitional
relief, it was without the benefit of co-ordination at the EU level. The application of
those regimes has now been deferred until 31 October 31 at the earliest.
Brexit continues to inform EU legislation. New legislation from the European
Commission governing investment firms’ capital requirements includes changes
to the right of access for third-country firms that was contemplated by the EU’s
Markets in Financial Instruments Regulation (MiFIR). The conditions for access—originally designed to provide consistent standards for access by third-country firms to
wholesale clients in the EU—will be significantly tightened. In particular, where third-country
firms provide services into the EU at a scale that is of systemic importance
for the EU (such as commercial lending), the “equivalence” assessment is recast into a
detailed assessment of the UK’s rules, while also taking into account future convergence
or divergence of the UK’s rules to their EU equivalents. Access by UK firms under MiFIR
and other Directives continues to rely heavily on this concept of equivalence, an uneasy
combination of technical assessment and political decision making.
The legislation governing investment firms’ capital requirements mentioned above
amounts to a fundamental change in scope for those firms in terms of capital,
remuneration and associated disclosures and reporting. European private equity firms
structured as investment advisers (as opposed to fund managers) and subject to the
Markets in Financial Instruments Directive (MiFID) will need to hold substantially
more capital—equivalent to a quarter of annual fixed overheads—than at present,
and larger firms will need to step up to remuneration and governance rules similar
to those for banks and broker-dealers under the Capital Requirements Directive. UK
private equity firms that are authorized under MiFID are concerned that the regulatory
and financial burden of these new rules will place them at a significant competitive
disadvantage to their EU-based counterparts.
ESG becomes part of the regulatory equation. The European Commission continued
its push to ensure that environmental, social and governance (ESG) factors are taken
into account in how asset managers structure products and make investment decisions.
There was political agreement on a Regulation that will require firms to disclose how
sustainability risks are taken into account in decision-making, and related proposals from
the European regulator, ESMA, for amendments to the operational requirements in the
Alternative Investment Fund Managers Directive (AIFMD). There has been considerable
debate as to what it means to take sustainability risks into account in investment decisionmaking,
and whether firms should be required to incorporate factors that do not have
a material, foreseeable impact on portfolio value. The final Regulation represents a
compromise, requiring firms to explain how they take into account ESG factors that affect
value and to say whether and how they take account of ESG factors that do not affect
value. All firms that do not take non-value issues into account must explain why not and,
after a transition period, larger firms will lose this right and must explain how they take
all material ESG issues into account. Clearly, the sustainability agenda will continue to
permeate regulatory policy-making and firms’ investment decision-making, governance
requirements and their disclosure and reporting obligations.
Consistency arrives for pre-marketing. The Commission also adopted the Directive
and Regulation on cross-border distribution of funds. These rules introduce consistency in
Member States’ approaches to “pre-marketing” funds in Europe under the marketing passport
and a consistent “de-notification” procedure. Although designed to improve the operation of
the fund marketing passport, Member States are expected to also apply these rules to non-EU
managers marketing under private placement regimes, although, as with other initiatives
governing EU managers, there is some uncertainty as to the practical application to non-EU
managers. The legislation also tightens the “reverse solicitation” exemption (with a new filing
required of managers that pre-market), giving regulators the means to more closely supervise
this exemption and possibly signalling less tolerance of its use.
More attention to stakeholders in the UK. In the UK, new corporate governance rules
will have an impact on larger portfolio companies. Concerned that insufficient attention
was being given to “stakeholders” in corporate decision-making, the UK government has
mandated that UK companies will need to explain how employee and other stakeholder
interests have been taken into account by board directors. Any company that is not
“small” or “medium-sized,” and any company with at least 250 UK employees in its
group, will have to publish additional information on stakeholder engagement. These
rules are likely to change boardroom behavior in many companies. At the same time,
very large private companies—with either 2,000 or more employees or turnover above
£200 million and a balance sheet in excess of £2 billion—will have to disclose which
corporate governance code they comply with, or explain their corporate governance
arrangements in some detail. The new Wates Principles have been developed in tandem
with this new reporting requirement and are designed to be used by large private
companies. It is expected that they will be widely adopted.
A number of the changes made by the Tax Cuts and Jobs Act (TCJA) were clarified
and finalized by the IRS and Treasury this year. Of particular interest for private equity
firms was the release of proposed regulations regarding Section 1446(f) withholding.
The TCJA introduced a tax on a foreign partner’s gain from the sale of a partnership
interest to the extent of that partner’s share of the partnership’s built-in gain that would
be “effectively connected income” (or “ECI”). Section 1446(f) requires the purchaser of
a partnership interest to withhold 10 percent of the amount realized by a foreign seller
unless an exception applies. In addition, if the purchaser fails to withhold, the partnership
is required to withhold distributions from the purchaser.
The IRS initially issued a Notice suspending the partnership withholding provisions.
However, recently released proposed regulations reinstate the obligation of a partnership
to withhold on future distributions to a transferee if the transferee fails to withhold on the
transferor or to provide an appropriate certification. The proposed regulations will go into
effect beginning with transfers that occur 60 days after the final regulations are published.
Taxpayers are generally permitted to rely on either the Notice or the proposed regulations
until the proposed regulations are finalized.
For secondary transfers, because there is currently no secondary liability on a fund for
failures to withhold, a fund technically does not need to do anything until final regulations
are issued. For subsequent closings, if a fund has no ECI investments or only has dry closings,
there is no need to take action. If a fund has an ECI investment and prior draw-downs, the
fund could provide a “25 percent certificate”—stating that if the fund sold all of its assets,
less than 25 percent of the gain would be ECI—to the new partners as part of the admission
process (assuming, of course, that this is factually accurate). If a 25 percent certificate cannot
be provided, the Fund should consider alternative structures to address withholding.
Other notable changes for private equity funds arising from the TCJA involve the
taxation of carried interest. In order for carried interest to be subject to the favorable
long-term capital gain rate, a fund must generally hold a capital investment for three years.
Similarly, in a GP sale, carry recipients must have held their partnership interest in the GP
entity for three years. The relevant regulations to implement these provisions have not
yet been released and there is some uncertainty around how these rules will actually be
applied. It is worth noting that there have been further legislative proposals in Congress
regarding carried interest, such as Senator Ron Wyden’s (D-OR) bill to impose annually a
current “deemed compensation” amount subject to ordinary rates. Thus, it seems that the
final chapter in the saga of carried interest may not yet be written.
Finally, the TCJA introduced significant changes to the taxation of international
operations under the controlled foreign corporation (CFC) rules. Previously, US
persons were taxed on active foreign earnings only on repatriation, while passive foreign
earnings were generally currently taxed. Under the TCJA, US persons are also taxed on
active foreign earnings that exceed a specified formula, whether repatriated or not. The
new rules were particularly stacked against US individuals (e.g., GP members), creating
traps for unwary PE funds. The IRS just released new sets of complex regulations that may
significantly change the landscape for PE funds and their US individual investors once
again—this time, mostly for the better. In particular, the new rules may level the playing
field between US and offshore venues when funds are choosing jurisdiction. We will be
covering these changes in detail as they develop.
A federal court ruling reminds investment advisers that communications with
compliance professionals may not be privileged. In S.E.C. v. Alderson, an investment
adviser sought a compliance firm’s advice during the course of an SEC examination.
Although most of the compliance firm’s employees who provided the advice to the
investment adviser were attorneys, they did so pursuant to a contractual relationship
that explicitly disclaimed that they were providing legal advice. As a result, the US
District Court for the Southern District of New York concluded that most of the
communications between the adviser and the compliance firm were not protected
by the attorney-client privilege. For private equity firms that engage compliance
professionals, whether in-house or externally, the decision is an important reminder that
communications with such professionals often may not be protected by privilege. Firms
should therefore consider hiring law firms—particularly during SEC exams—to engage
and direct the work of third-party compliance firms to ensure that communications are
protected by the attorney-client privilege.
The SEC’s ability to bring certain negligence-based enforcement actions alleging
“willful” misconduct has been curtailed. In the past, the SEC took the view that
an investment adviser or its employees were engaged in “willful” conduct by simply
engaging in a voluntary act. This allowed the SEC in enforcement proceedings to
seek industry bars, suspensions and censures without establishing that the actor had
behaved intentionally or with extreme recklessness. A recent decision by the US Court
of Appeals for the DC Circuit in The Robare Group v. S.E.C, however, rejected the SEC’s
interpretation in a case concerning an adviser’s failure to disclose conflicts of interest in
its Form ADV. The court held that an adviser only acts “willfully” for purposes of Section
207 of the Investment Advisers Act of 1940, which prohibits filing false or misleading
Forms ADV with the Commission, if the adviser intentionally or with extreme
recklessness made a material misstatement or omission—in other words, merely
completing or filing a Form ADV is not a “willful” act. This decision provides comfort to
private equity advisers: As a practical matter, the SEC will only be able to allege Section
207 violations against the person or persons who directly drafted and reviewed the
Form ADV where it can be shown that the person acted intentionally or with extreme
recklessness. Further, to bring an action against an advisory firm, the Commission
will need to establish that intentional or extremely reckless conduct of a person can be
imputed to the firm. Additional litigation will determine whether the decision curtails
the SEC’s ability to obtain bars, suspension and censures for any negligence-based
violations, since those measures require “willful” conduct as well. In settled proceedings,
however, the Commission appears to be taking the position that it can continue to seek
those remedies for negligence-based violations.
Asset Management Litigation
In April 2019, the Delaware Supreme Court issued an opinion in Verition Partners
Master Fund Ltd. v. Aruba Networks, Inc., reaffirming the path laid out in DFC
Global and Dell for the Chancery Court to place a significant emphasis on deal price
when determining fair value. Although the Supreme Court has not created a brightline
standard or even presumption in favor of deal price, it has emphasized that when
unaffiliated, unconflicted parties negotiate at arm’s length in an efficient market, deal
price should be given significant weight. A more detailed discussion on the topic can be