Driven by the appeal of the multiple income streams and the ability to bring capital and strategic alliances to asset managers, GP stakes investments—wherein investors acquire a minority interest in asset managers’ firms—continue to attract interest.
As with any significant investment, both asset managers and those funding them must consider the tax implications of their proposed transactions. Each have their own tax priorities, which must be balanced not only against each other, but also against the intended pre-tax economics of the transaction. Common tax objectives include:
- Avoiding an immediate taxable income event to either party
- Generating amortization deductions to benefit one party or the other
- Deferring recognition of income related to the investment for as long as possible
- Obtaining long-term capital gain, or other tax-favored return, from the management firm post- transaction
It is frequently impossible to achieve all of one party’s tax objectives, much less both parties’ goals. Complex pre-tax economics, such as investors’ unequal rights to participate in the firm’s income streams (e.g., net management fees and carried interests), can introduce additional structuring difficulties. Nevertheless, careful planning combined with transparent negotiations can at least leave both parties secure in the knowledge that they have achieved all that was possible.
In particular, one trap for the imprudent we have repeatedly observed occurs when individual managers are seeking to reduce their equity in the firm by distributing a portion of the investment proceeds to themselves. Although most fund management organizations are structured as a series of partnerships for tax purposes—and cash distributions from partnerships can often be taken tax-deferred—this particular type of transaction carries a significant risk of re-characterization as a sale, by the managers to the investors, of a portion of the firm. This ‘disguised sale’ would be taxable immediately, just as if the managers had directly sold a portion of the firm to the investors.
Although there are structuring options that may provide similar liquidity to the managers as a distribution of the invested proceeds without causing a disguised sale, such options would entail changes to the pre-tax economic structure of the transaction.
Moreover, accepting investments into a fund manager’s organization engenders new annual compliance concerns. Fund GPs are undoubtedly accustomed to pressure from fund investors to issue tax information, including Schedule K-1, as soon as possible. Many fund managers have been able to operate at a more relaxed pace with respect to their management entities, however, because all invested parties are internal to the firm. With an outside investor in the management structure, however, fund accounting departments may see the same time pressure they are inured to at the fund level escalate to the management company level.