On this episode of Fully Invested, Ropes & Gray asset management partners Chelsea Childs and Mike Doherty, along with associate Andrew Lawson, discuss regulatory considerations for "private equity operating companies" and other key features of these alternative investment vehicles.
Transcript:
Chelsea Childs: Hello, and welcome to this Ropes & Gray podcast. I'm Chelsea Childs and I'm here with Mike Doherty and Andrew Lawson. Mike and I are partners in Ropes & Gray's asset management group, and Andrew is an associate in our group. Today, we're going to discuss what we'll call "private equity operating companies," sometimes referred to as "conglomerate vehicles"—and I'm using air quotes here because there is no set industry term for these vehicles; they're not "funds" in the traditional sense, but they are investment vehicles with similar characteristics.
Mike, do you want to kick us off with a quick summary of what these are and then we can get into the details?
Mike Doherty: Sure, Chelsea. The products we're discussing today, although not entirely new, are innovative investment structures that offer access to the type of private equity investments historically available only through private equity funds and similar products. As we'll discuss, by falling outside the Investment Company Act, these vehicles allow a broader swath of the retail market to access the types of investments typically reserved for investors that satisfy the "qualified purchaser" standard required by most private equity funds, while allowing sponsors the flexibility and compensation structures they are used to having with their traditional, institutional-focused, private funds.
Chelsea Childs: Thanks, Mike. Let's take a step back for a second and provide an overview of the trends we're seeing across the industry. As you know, we've seen lots of growth in private markets relative to public markets, as well as increased investor demand for access to private markets. Retail investors have long been constrained in their ability to access these investments. This is because private equity funds often require an investor to be a "qualified purchaser," which is essentially defined as an individual that has at least $5 million in investments or a company with at least $25 million in investments. The investment vehicles available to retail investors who don't satisfy the qualified purchaser standard are typically subject to the regulatory framework of the Investment Company Act. However, the Investment Company Act is, in many ways, incompatible with how many private equity fund sponsors operate, invest, and get compensated.
Mike Doherty: That's right Chelsea; that's why most private equity funds rely on the exemption from regulation available under Section 3(c)(7) of the Act, which limits investors to qualified purchasers. This is a high standard that bars many retail investors. In recent years, there's been a high level of interest in alternative retail products that provide exposure to private market investments within the existing regulatory regime. These products often take the form of business development companies and closed-end interval and tender offer funds, and so are still subject to the Investment Company Act.
The advantage of private equity operating companies is that they aren't subject to the Investment Company Act, nor are they required to limit their investor base to only qualified purchasers. Rather, they're just not considered "investment companies" under the Investment Company Act in the first place because they don't meet the definition of an "investment company" in Section 3 of the Act. Instead, they're deemed to be operating companies for regulatory purposes. As our listeners know, the Investment Company Act is intended to impose shareholder-protective restrictions on retail investment products, but isn't intended to regulate operating companies, like Ford, for example, or holding companies that engage in operating businesses through subsidiaries, such as conglomerates like GE.
Andrew, would you briefly summarize how these private equity operating companies avoid being subject to the Investment Company Act? Then, we can get into the typical characteristics of these vehicles.
Andrew Lawson: Of course, Mike. As noted earlier, conglomerate vehicles are designed so that they don't meet the definition of an investment company. As background, Section 3(a)(1)(A) of the Investment Company Act defines the term "investment company" to include any issuer which "is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting, or trading in securities." We think of these types of investment companies —which we refer to as prima facie investment companies—as your typical registered fund that is clearly recognizable and self-identifies as an investment company.
Section 3(a)(1)(C) is where we see a lot of analysis for clients that may have vehicles with a meaningful amount of assets invested in securities, but that aren't prima facie investment companies. The definition generally provides that an issuer is an investment company if it's in the business of investing in securities and owns investment securities having a value exceeding 40% of the issuer's total assets (exclusive of cash and government securities) on an unconsolidated basis.
This 40% test measures investment securities, which is a narrower subset of securities that excludes, among other things, securities issued by majority-owned subsidiaries which themselves are not investment companies and are not relying on the exception from the definition in Sections 3(c)(1) or 3(c)(7). It also excludes investments that are not "securities" at all, which is an important distinction for the newest forms of private equity operating companies.
Chelsea Childs: Thanks, Andrew. So, by its terms, 3(a)(1)(C) excludes many operating companies, but it may pick up issuers that operate through non-majority-owned subsidiaries—these are subsidiaries in which the issuer owns less than 50% of the outstanding voting securities—because, unlike majority-owned subsidiaries, interests in these entities count as "investment securities."
Mike Doherty: That's right. Time constraints prevent us from discussing other exemptions, but I'll mention two important ones here. The first is Section 3(b)(1) of the Investment Company Act. Section 3(b)(1) is a definitional exclusion that applies to entities engaged primarily in non-investment company businesses, notwithstanding potential investment company status under Section 3(a)(1)(C). The potential difficulty with relying solely on 3(b)(1) is that there's a multifactor analysis used to determine whether an entity is "engaged primarily" in an investment company business. We won't get into the details of that analysis here other than to note that, in our experience, clients often take more comfort in the rigid numerical test provided in 3(a)(1)(C) as opposed to the more subjective analysis required by Section 3(b)(1).
Another potentially relevant exemption is Rule 3a-1 under the Investment Company Act, which provides a more flexible assets test but adds an income test and some additional requirements. Without getting into the details, several of the concepts we will discuss might also help entities relying on 3a-1.
Andrew Lawson: Thanks, Mike. Now that we've set the stage with the regulatory backdrop, let's discuss the private equity operating companies and how they satisfy the tests we summarized earlier to avoid meeting the definition of investment company.
It's worth noting first that these conglomerate vehicles appear best suited for certain investment strategies, such as infrastructure and private equity, as opposed to venture capital investments, minority investments or private credit. This is because private equity operating companies need to hold at least 50% of the outstanding voting securities of portfolio companies so that their interests in those companies can be considered "majority-owned subsidiaries" for purposes of Section 3(a)(1)(C)'s 40% cap on investment securities. That being said, it certainly makes sense to think about how these structures and the concepts behind them might be adapted for other asset classes.
Chelsea Childs: That's right, Andrew. It's also important to note that a conglomerate vehicle has meaningful leeway to hold investment securities, just not above the 40% threshold. This leaves the sub-40% bucket open for minority positions that would be considered investment securities. And in fact, many of the older private equity operating companies have done just this—they've invested a large percentage of their assets in just a few (and sometimes even just one) majority-owned subsidiaries.
The limitation on the traditional version of the private equity operating company works best for "stand-alone" entities that hold the majority positions in a single vehicle. This can exclude many larger private equity investments, especially for newer or relatively smaller vehicles. It also raises challenges for sponsors who want the retail product to co-invest alongside their flagship 3(c)(7) funds where the private equity operating company might only take a minority economic position in a portfolio company.
Mike Doherty: That's correct, Chelsea; but newer versions of the private equity operating company seek to address this issue and satisfy the 40% test by holding a minority economic interest in a portfolio company alongside a sponsor's larger private equity funds. In this setup, the private equity operating company effectively holds governance power that is larger than its economic interest. Because the Investment Company Act's definition of a majority-owned subsidiary is tied to voting power rather than economic interest, the private equity operating company can potentially take the position that these investments are in fact majority-owned subsidiaries.
The private equity operating company can also accomplish this by holding portfolio companies alongside the sponsor's private funds through partnerships that are structured as joint ventures between the private equity operating company and the flagship funds. Without diving too deeply into the details, there is a line of SEC staff positions and court cases that support the position that a JV interest is not a "security," and if the JV interest is not a "security," it is not an "investment security" for purposes of the 40% limitation on investments in investment securities.
Chelsea Childs: Of course, in order to be comfortable with this approach, the structure of the JVs needs to be carefully considered in light of the relevant case law and applicable SEC no-action letters—it isn't sufficient to say something is a JV if it doesn't have the features of a joint venture as articulated in prior regulatory guidance. For example, the JV participant should have a level of influence over the management of the JV that is consistent with a JV interest rather than a merely passive interest.
Andrew Lawson: A final point worth noting on this JV structure is that it works because the JVs are managed in a way that reflects the commonality of interests between the various JV participants: the conglomerate vehicle and the private funds. Because the conglomerate's voting and ownership powers are disproportionate to its economic interest, it's important that the managers have clearly disclosed this structure to their private fund investors.
Chelsea, do you want to touch on some of the commercial terms of these vehicles?
Chelsea Childs: Sure. I'll start with the liquidity features available to investors. Some conglomerate vehicles are listed on the New York Stock Exchange or another national securities exchange. Like a traditional public operating company, these listed vehicles provide investors with daily liquidity at market prices. Benefits to this format include a familiar IPO process and the ability to raise additional capital in secondary or at-the-market offerings. One of the drawbacks to exchange-listed vehicles, however, is that they have to comply with the relevant rules of the exchange, such as holding annual shareholder meetings. In addition, because listed vehicles trade frequently at a discount to their net asset value, an investor seeking to exit a vehicle may receive less than the value of the underlying assets the vehicle holds.
On the other hand, conglomerate vehicles that aren't exchange-listed are structured much like closed-end tender offer funds from a liquidity standpoint. They typically conduct quarterly repurchase offers for shares, generally for around 5% of their outstanding shares or net asset value. Unlisted vehicles can sell shares at net asset value, can offer multiple share classes with different fee structures, and they don't have to comply with listing requirements or be as concerned with activist investors.
Mike, before we go, do you want to touch briefly on manager compensation structures and tax considerations for these vehicles?
Mike Doherty: Thanks, Chelsea—that sounds good to me. We see a range of compensation structures for these vehicles, but they generally include a management fee of 1.25-2% and performance-based compensation between 15-25%, subject to hurdles between 5-8.75%, with high-water marks and catch-ups being common. Being able to charge this performance-based compensation, which is similar in many ways to a private equity fund, is one of the primary benefits of these vehicles being out of scope of the Investment Company Act.
As for the tax structure, at a high-level, the structure is broadly similar to that of many private equity funds. For example, because the conglomerate vehicles are taxed as partnerships, investors are taxed on the income that they generate whether or not they distribute those profits (sometimes referred to as "phantom income"). In addition, also similar to a private equity fund, because the conglomerate vehicles are pass-throughs for tax purposes, the character of the income from them will generally pass through to their investors. Investors in conglomerate vehicles receive a Schedule K-1 each year that they must report in connection with the filing of their tax returns and pay any tax that is owed. The structure is different from a typical mutual fund, where investors are generally only taxed on the distributions they receive or are deemed to have received, as mutual funds are generally corporations for U.S. federal tax purposes (although, they do have their own special tax rules). Mutual fund investors generally receive a Form 1099 rather than a K-1. Although every situation is unique, the tax reporting that investors receive in connection with investing in mutual funds tends to be simpler than the tax reporting investors receive from a partnership.
Chelsea Childs: That's all we'll cover for today. If any of our listeners, or readers, have questions about these conglomerate vehicles, please reach out to Mike or me or another contact at Ropes & Gray. Additionally, be on the lookout this spring for a webinar where we'll get into further detail and discuss other topics of relevance to asset managers who are interested in forming a conglomerate vehicle. You can subscribe and listen to the series of podcasts wherever you regularly listen to podcasts, including on Apple and Spotify. Thank you again for listening.
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