Why tax reform is proving hard to digest

At a secondaries-themed breakfast we found that, unlike the pastries, changes to US tax rules are not going down well.

Secondaries Investor was pleased to be invited by law firm Proskauer to its Spotlight on Secondaries seminar in London to hear about the latest developments on fund terms, tax reform, GP-led processes and more. Here are a few key takeaways.

– GPs could be on the hook for tax failings of others

The concept of effectively connected income – or ECI – has been a preoccupation of late, brought into the spotlight by President Trump’s tax reform agenda. Applied to secondaries, it means that non-US sellers of stakes in limited partnerships that have even the slightest exposure to a US trade or business can be subject to a 10 percent tax on realisation.

This isn’t easy to enforce – if sellers are non-US entities, there is no mechanism by which to tax them. To get around this, the US government introduced a withholding regime. If you buy an interest in a limited partnership from a non-US person and it contains ECI you have to withhold 10 percent of the purchase price to cover future taxes.

There is another proposed regulation that could further complicate this. If a buyer was supposed to withhold and did not, the GP whose stake is being transferred is liable to pay the tax for them. The bill has been suspended due to a lack of rules around its application, but GPs should be wary.

– Status quo likely to be high on ILPA’s agenda

In September, the Institutional Limited Partners Association confirmed it was to issue an update to its private equity principles that will include guidance on GP-led restructurings.

The guidelines, which could come out as soon as 2018, are expected to focus on disclosure and transparency, particularly on whether conflicts of interest are fully disclosed and mitigated. In the view of Nigel Van Zyl from Proskauer, the treatment of limited partners who don’t respond to requests for action will feature strongly and could prove problematic.

“Status quo is, ‘you can elect to roll into the new deal with exactly the same terms’,” he said. “Often that doesn’t create the critical mass [needed to close the deal] or the objectives that the GP wants to achieve.”

– Deferrals and leverage at the large end, for now

Analysing 50 secondaries transactions between August 2017 and August 2018, Proskauer found that 66 percent of secondaries deal involved no leverage. The deals that do tend to be the largest, with 64 percent of deals larger than €250 million in size involving either third-party funding or deferred payment mechanisms. This could change, however, in line with the changing behaviour of the largest secondaries buyers.

“While two-third of the transactions reviewed did not include any element of deferred consideration or leverage, a growing number of buyers have used such mechanisms,” the firm noted in a presentation. “The larger buyers, accustomed to using leverage for their large transactions, have used it more and more for smaller transactions.”

Write to the author: rod.j@peimedia.com