Reproduced with permission from PE Manager

FOR PRIVATE FUND CFOs, COOs, AND COMPLIANCE OFFICERS

Posted 1 Jun 2005

Carry on, my sonEstate planning for private equity professionals often involves passing carried interest on to children – a complicated affair in more ways than one. By David Snow, Editor

Some things in life are guaranteed, like death and taxes. Other things come with no guarantee at all, like carried interest from a private equity fund. Where these topics overlap, complications both legal and emotional abound.

Luckily, there are professionals happy to help general partners with the legal technicalities of transferring carry to children (or grandchildren, or spouses, or other parties) in a tax-efficient manner. As for emotional complexities, you’ll have to look deep within yourself and ask whether you want your children to receive what could potentially be an enormous windfall.

Jonathan Rikoon, a partner in the New York office of law firm Debevoise & Plimpton LLP, advises private equity clients on the former complexity. Rikoon says the principals at many of his firm’s private equity fund clients ask for some form of estate planning advisory work. Within each private equity firm, he says, roughly half of the individual general partners involve transfers of carried interest in their estate planning – usually the most senior partners. Partners who transfer carry typically give away between 10 percent and 60 percent of their own share to family trusts for children and others.

There certainly is no requirement that a GP, while alive, transfer carry to his or her children. The easy alternative is to simply do a one-time transfer of wealth at time of death, an option which leaves the GP “much richer, but which also leaves his family with a large estate tax bill,” notes Rikoon.

This wait-until-death option may turn out to be the best play in the US – if President Bush and the Republican Congress get their way, the estate tax will eventually be repealed for good. Current law calls for the reduction of the estate tax every year until 2010, when it is to be repealed entirely. But the Democrats are pushing for a diminished but ongoing form of estate tax, and the repeal can still be reversed the next time the Congress or White House changes hands. In the meantime, the transfer of wealth while the GP is still alive remains the most tax-efficient option.Current estate tax rates can amount to well over 50 percent of a person’s networth when state and federal rates are combined. By contrast, lifetime “gift” taxes are lower, and sophisticated techniques allow some large lifetime transfers to escape gift and estate tax altogether.

The treatment of carry as a gift is unique because, as all GPs know, a general partner interest at inception of a fund is an asset that could, years later, equal any amount between zero and hundreds of millions of dollars.

DETERMINING THE DISCOUNT

Rikoon says a good estate planning lawyer will help a general partner client “take advantage of the mismatch between current verifiable value and expected future value” in structuring lifetime transfers of carry to offspring.

Legal experts recommend that a transfer structure for carry be put in place upon formation of the fund so that the additional complication of underlying portfolio investments doesn’t need to be initially addressed.

The value of a slice of carry at a fund’s inception is, in fact, greater than zero. As with any business transaction, its value needs to be appraised for tax purposes. This is done through a process familiar to any M&A market participant – by applying a discount to an expected future cash flow. The task of valuing carry on day one falls to a professional appraiser, who might hail from a specialty valuation firm, a local accounting boutique or one of the major accounting firms.

Quite often, the appraiser will run a “Monte Carlo projection,” a technique that uses probability statistics of possible financial results and other variables to predict a likely range of outcomes.

Reproduced with permission from PE Manager

FOR PRIVATE FUND CFOs, COOs, AND COMPLIANCE OFFICERS

At the core of the assessor’s task is answering the question, how will this fund perform? Quite often, the appraiser will run a “Monte Carlo projection,” a technique that uses probability statistics of possible financial results and other variables to predict a likely range of outcomes. The fund performance number at the top of the resulting bell curve becomes the number from which a discounted value is determined for the purposes of tax planning.

Indeed, the difficult process of placing a current value on a fund interest is such that not many appraisers specialize in it. Says Rikoon: “The appraiser needs to spend a lot of time with the principals and testing assumptions against the market. It’s a huge educational investment getting these guys up to speed.”

Because the range of potential outcomes and risks at the inception of a ten-year private equity program is enormous, the discount applied to the value of a portion of carry is significant. Rikoon says that the time-value-of-money discount based on the assumed rate of return necessary to justify the level of business risk, combined with a discount applied to family trust interests (described below), frequently amounts to between 90 percent and 95 percent.

Even with these discounts, when a transfer of interest in a private equity fund is made between GP and GP offspring, real value changes hands, and unless a smart structure is used, the transferor will be hit with an immediate gift tax.

“FLIPS” AND “FLICKS”

Internal Revenue Service rules stipulate that the gift of one part of one class of interest in a fund (such as a carried interest stake in the general partner) can only be transferred along with the same fraction of the other classes (such as the GP’s capital investment). Thus a GP must transfer a “vertical slice” of his or her interests to avoid tax headaches.

In addition, Rikoon says his GP clients typically do not transfer the vertical slice of interests directly to an offspring but rather to an investment vehicle, structured either as a family limited partnership (FLP) or a family limited liability company (FLLC), which has the benefit of allowing the GP to retain control over the reinvestment of proceeds during his or her lifetime and may provide creditor protection and other benefits. The GP also sets up a family trust to deal with long-term asset management and cash distributions to family members after the GP’s death. For this to avoid the estate tax the terms must be locked in at inception.

The actual transfer or gift by the GP is of a non-controlling interest in the FLP or FLLC, which may actually include most or all of the economic benefits of the entity.In fact, transferring only an interest in a FLP or FLLC generates an even larger value discount because the vehicles are highly illiquid and not controlled by the recipient trust or child.

For maximum tax efficiency, the planning doesn’t stop there. A plain vanilla gift still creates significant gift tax exposure. Smarter transfer methods include contributions of FLLC interests to a “grantor retained annuity trust” (GRAT), which pays the GP an annuity that wipes out the gift value – but preserves the expected growth in value for the family trust.

Assume a scenario where a GP’s interest in a fund is estimated to someday be worth $100 million, and at today’s discounted value that interest would be worth $5 million if placed in an FLLC. The GP has decided to transfer 60 percent of that value to a grantor trust for his son, in the form of a noncontrolling majority interest in the FLLC, appraised at $3 million. He funds

Jonathan Rikoon

In the first round of planning, it’s ‘Let’s give everything to the kids as soon as possible.’ Then if they start to get very successful, they begin to rethink whether they want their kids getting that much money and just sitting around the club, sipping gin and tonics.

Reproduced with permission from PE Manager

FOR PRIVATE FUND CFOs, COOs, AND COMPLIANCE OFFICERS

the trust with a gift of $600,000 of seed money. The trust then buys the FLLC interest for a down payment of $300,000 plus 15-year notes worth the remaining $2.7 million. Over time, the cash on hand plus cash flow from the private equity fund allows the trust to pay off the note.

The seed money gift has to be reported to the IRS, which could decide that the appraisal was too low and assess gift tax that would eat into or perhaps exceed the lifetime $1 million gift tax exemption ($2 million for a married donor). But there would be no income tax on the sale or on the note interest, no gift or estate tax on distributions of carry or other profits on fund realizations going forward (remember, that’s expected to amount to $60 million), and any gift tax risk is lower than what a simple gift would have triggered – and far lower than the $30 million or more of estate tax that this 60 percent share of the carry will trigger if there is no transfer at all.

Rikoon says the administrative complexity of setting up these transfer structures is substantial, but once established “the finance staff [of the private equity firm] doesn’t spend all that much time on these things.”

Limited partners will naturally get queasy at the thought of general partners using firm resources (ie, the management fee) to aid in personal estate planning. Here again the proper structure makes all the difference.

Rikoon says many firms will deem it appropriate for the management company to pay for some aspects of fund structure designed to permit partner tax and estate planning, because this is related to overall compensation and retention of talented partners. But administrative and legal work specific to each partner – the appraisal, for example – should probably be paid for by the individual partners, says Rikoon.

Rikoon says that it is important for GPs to create flexible structures for their carry-centered estate planning because as circumstances change, parents may change their minds about what is best for their children. This is where the values of the individual partner come into play. Rikoon says he has seen a number of situations where carried interest has swollen to a size beyond the expectations of the GP, and this has led the GP to wonder whether the amount of profit previously earmarked for his or her children is too much. “In the first round of planning, it’s ‘Let’s give everything to the kids as soon as possible,’” says Rikoon. “Then if they start to get very successful, they begin to rethink whether they want their kids getting that much money and just sitting around the club, sipping gin and tonics.”

Rikoon adds there’s nothing wrong with people sitting around the club sipping gin and tonics, but like many aspects of estate planning, it’s a potential lifestyle outcome a client should carefully consider before setting up a large transfer of wealth. n

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