It is typical in private equity funds for certain tax-sensitive investors, including U.S. tax exempts and non-U.S. investors, such as sovereign wealth funds, to own their indirect interests in certain types of fund investments through an entity taxable as a U.S. corporation (a so-called “Blocker”), which insulates such investors from the direct obligation to pay U.S. taxes and file U.S. tax returns. Blockers are often used when a fund invests in portfolio companies that are not organized as corporations for U.S. tax purposes, but rather as “flow-through entities,” such as LLCs or limited partnerships taxed as partnerships for U.S. tax purposes. In such cases, it is the Blocker (rather than the investor) that pays the U.S. tax and files U.S. tax returns with respect to operating income of the portfolio company.
Private equity fund sponsors often make an effort to structure an exit to include the sale of a fund Blocker by the blocked investors (rather than the Blocker selling its share of the underlying portfolio company) to avoid paying the corporate tax in the Blocker that would be owed on its share of the appreciation in the investment. As such, it has become more commonplace to see private equity buyers being “required” to buy Blockers when acquiring flow-through investments from private equity sellers.
There are many tax considerations involved when a private equity buyer is considering whether and how to acquire a Blocker from a private equity seller, including the fact that the private equity buyer will generally not receive a “step-up” in the tax basis of the share of the assets of the portfolio company owned by the Blocker. The particular focus of this blog post, however, is on three potential fund structures that may be used by a private equity fund buyer when acquiring a portfolio company that is partially blocked by a private equity seller.
The baseline structure would involve the private equity buyer acquiring both the flow-through and blocked portions of the investments under a single aggregating vehicle taxed as a partnership for U.S. tax purposes. Because such aggregating vehicle could realize income for which tax-sensitive investors in the private equity buyer would need to be blocked, many funds are required to utilize a Blocker with respect to the tax sensitive investors’ interest in the entire investment, including the portion of the investment that is already blocked in the acquired Blocker. This “double blocking” has the potential to be tax inefficient for such investors, particularly in the case of a future leveraged recapitalization of the portfolio investment, in which case the new Blocker could have a corporate tax on the portion of such distribution relating to the acquired Blocker.
In another structure, a private equity fund buyer may be able to avoid the issue of double blocking by acquiring the blocked and unblocked portions of the portfolio company, effectively, as two separate investments. The acquired Blocker would be acquired in the typical manner in which the fund acquires corporate investments, while the flow-through portion of the investment would be acquired through a blocked structure for tax-sensitive investors. If this is the preferred route for the private equity buyer, the purchase agreement will typically need to be drafted to reflect such structure. In addition, in this structure, any rollover equity or new management equity is likely to be issued at the existing portfolio company flow-through entity (since there is no new aggregator as there is in the first structure). This may come at a cost to the private equity sponsor because the rollover equity holders and management equity holders would not suffer the corporate tax leakage attributable to the acquired Blocker (including in respect of historic taxes of the acquired Blocker, if any).
In the final structure, the acquired Blocker would be acquired by the private equity fund solely for the benefit of the tax-sensitive investors in its fund. While it may be a benefit for the fund’s unblocked investors to limit their exposure to the corporate taxes of the acquired Blocker, the primary goal of the final structure is to provide tailored blocking for tax sensitive investors (without double blocking) and as a result maximize the total amount of the target company that is unblocked after the acquisition. In such case, assuming that the expectation would be to sell any Blockers on exit, this more limited blocking could increase the step-up that may be delivered to a future buyer on exit, which may result in a higher overall sale price. The above discussion is a very general overview of certain structural considerations that may arise when private equity buyers acquire Blockers from private equity sellers. However, this blog post only discusses some of the nuances involved in such structures generally and with respect to the specific issues discussed above. These structures raise many complex issues for private equity sponsors to consider. We would be happy to discuss how and whether any of these structures would be viable for a private equity fund in any specific acquisition taking into account its fund structure and applicable fund documents.