Institutional Investor Newsletter

Welcome

Welcome to the inaugural issue of DLA Piper’s Institutional Investor Newsletter. The aim of this occasional (and long overdue) publication is to keep you informed about developments in the investment funds space, share our perspective on a hot topic or two, and stay connected through updates about our team of lawyers.

Our team strives to provide you with all the benefits of a global law firm, and we’re committed to working for the success of all of the institutional investors we are privileged to call our clients: public and private pension funds, endowments, insurance companies, funds of funds, sovereign wealth funds, development finance organizations, and other institutions.

Investing in funds in today’s global marketplace often requires advisors with international reach, on-the-ground knowledge, and industry experience. We try to bring each of these attributes to bear in all of our work for you. In 2022, we assisted our clients in over 2,000 transactions in jurisdictions and sectors spanning the investment funds space.

For more information about the scope and scale of our practice, please visit our DLA Piper home page.

We view ourselves as an extension of you, our clients, and we want to partner with you for the long term. We think of you often, hoping that you are keeping safe and well. Please do not hesitate to reach out if you have any questions or if we may be helpful in any manner. We are looking forward to another successful year ahead, and we hope you enjoy this update from our team.

Legal term corner

Understanding writeoffs

Question: When is a writeoff not really a writeoff?

Answer: When it requires a determination in accordance with the Internal Revenue Code.

The Securities and Exchange Commission remains focused on private fund valuations and specifically on the calculation of management fees based on such valuations. Private equity funds commonly charge management fees based on invested capital during the step-down period following the end of a fund’s investment period, and the management fee base is often reduced in respect of investments that have been permanently written off.

Sponsors have generally retained discretion to determine whether an investment is permanently written off for purposes of calculating management fees unless the partnership agreement contains a specific formula or an objective test; however, the SEC has made clear through recent investigations and enforcement actions that it no longer defers to the sponsor in situations where such discretion is potentially abused to the sponsor’s benefit.

Where a sponsor has included a more objective formula in the partnership agreement, no matter how onerous, the SEC has not taken issue with the nature of that test so long as it has been put through the process of disclosure to, and negotiations with, private fund investors.

You may have seen sponsors include in their partnership agreements a statement that a portfolio investment will be deemed permanently written off, and thus excluded from the management fee base, where it has been deemed worthless for purposes of US federal income taxes. Sometimes you’ll also see a reference to Internal Revenue Code 165(g), which is the operative federal income tax provision permitting an investment to be treated as a loss from sale or exchange where such investment has become “worthless” during the taxable year.

While this language has been around for years, we’ve seen an uptick in sponsors seeking to include similar wording when introducing permanent writeoff concepts for the first time. In other cases, we’ve also seen such language proposed as a revision where the writeoff language in prior funds was deemed too broad or ambiguous, with fund counsel citing increased SEC scrutiny as their reason for the change.

What may be less apparent, however, is that these writeoff terms are often illusory, given the difficulty in actually deeming a security “worthless” for federal income tax purposes. As such  – notwithstanding that a sponsor may have written off an investment for its own internal purposes, may be required to treat the investment as realized under the distribution waterfall, or may otherwise have fully abandoned the investment as worthless – unless the IRS would permit the sponsor to treat it as worthless under the very stringent terms of 165(g), LPs will continue to pay full management fees on the invested capital associated with that portfolio investment.

We recently negotiated this point for a client, and, to place the issue in context, we asked for a pro forma determination of management fees for the sponsor’s most recent funds calculated by factoring investments that were fully written-off, but not satisfying the stringent IRS standard.  Fund counsel disclosed that management fees would have been multiple millions of dollars lower had such funds used our requested formula.  When asked why the sponsor saw fit to charge full fees on investments that it had otherwise written off entirely, counsel said the sponsor had “hoped” that the companies would ultimately rebound.  In our view, investors should not be made to pay management fees on hope.

Find out more about writeoff terms by contacting any member of our team.