PErspective Newsletter - Spring 2017

June 2017


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Table of Contents


Silent Cyber Risks Are Heightened Within the Private Equity Industry

By Judy Selby, Jim Evans and Michael Dombrowski

Last month’s high profile WannaCry ransomware attack should serve as a reminder that cyber risks are among the fastest growing risk categories facing the private equity industry and its portfolio investments in the 21st century. What’s notable about WannaCry—other than the fact that it came only days after President Trump signed a much-anticipated executive order on cybersecurity—is the scale of the attack. This was the largest attack of its kind, impacting more than 75,000 organizations in more than 150 countries. Furthermore, until all of these organizations take corrective measures, the threat persists.

Taking constant and deliberate action to protect against these types of attacks has become the new reality for any organization, commercial, nonprofit, governmental and otherwise. For private equity firms, the challenge is threefold:

  • How do you protect fund technology systems from attack?
  • How do you protect portfolio company technology systems from attack?
  • If a weakness is exploited in one system, how do you prevent it from spreading to others?
Locking down fund-level systems to prevent an attack is oftentimes the easiest of the three challenges, primarily because the fund oversaw the building and expansion of those systems. Therefore, it is inherently familiar with both the strengths and weaknesses of the fund technology platform. It becomes more challenging to identify cyber weaknesses and risks among portfolio companies, as the fund is inherently less familiar with legacy technology systems at the portfolio company level. And just as it is challenging to know what cyber risks a potential acquisition target is exposed to, it is equally challenging—if not more so—to identify the risks those system weaknesses could pose to the broader portfolio company and fund-level systems.

To help identify and address these risks, BDO recently launched a risk assessment tool designed to expedite pre-acquisition technology due diligence by identifying potential weaknesses across multiple business functions and risk categories. The web-based solution uses a proprietary risk scoring algorithm to produce a report highlighting areas of strength and weakness in the company’s IT risk and cybersecurity risk processes. The assessment tool can also illuminate areas where cyber insurance can be utilized to mitigate the financial impact associated with residual cyber risk.

Once an initial risk assessment has been performed, private equity firms can then sort results into risk subsections and examine critical business functions, processes, operations and people. From there, users can customize assessments based on specific business goals and compliance needs and work with the BDO team to enhance safeguards and implement risk mitigation strategies.

Running this type of due diligence on target company technology systems will become increasingly important for private equity firms as cyber risks grow. It is important to note that any gap in IT security should be viewed and treated as a gap in internal controls. However, as cyber risks can quickly grow exponentially should an attack occur, firms should take additional care to ensure financial risk is minimized, which includes ensuring sufficient and appropriate cyber insurance coverage is in place.

Here are a few additional recommendations your firm should consider in light of last month’s attack:
  • Don’t forget the human element. As with most cyberattacks, the WannaCry attack was entirely preventable. It succeeded because of human neglect and lack of awareness. Firms should combat this organizational vulnerability by introducing a training program based on employees’ organizational roles, cyber hygiene best practices and regularly testing the program’s effectiveness.
  • Implement a risk-based, threat-driven patch management program. The WannaCry attack could have easily been prevented by installing an available patch to fix a known system weakness. Patch management should be a dynamic, ongoing process for your firm rather than a check-the-box compliance approach. Organizations need to be able to identify system vulnerabilities, understand the degree of risk the vulnerability presents, and work with teams to deploy the update-relevant patches to eliminate those risks.
  • Monitor, monitor, monitor. To be cyber-resilient, organizations need to have threat monitoring and analytics tools to detect an attack, as well as the investigative and digital forensics capabilities to understand what went wrong and measure the scope of the damage. The sooner a cyberattack is detected, the sooner incident response and mitigation strategies can be put into place. When it comes to ransomware, early detection can make all the difference in salvaging critical data and information systems.

For more information on BDO’s risk assessment tool contact:

Jim Evans, leader of BDO Consulting’s Insurance Advisory Services practice. He can be reached at [email protected].

Michael Dombrowski, managing director in BDO Consulting’s Technology Advisory Services practice. He can be reached at [email protected]

BDO Knows International Private Equity

Spotlight on Argentina

Well into the second year of Mauricio Macri’s presidency, how has Argentina’s shift toward an open economy impacted private equity opportunities in the region? BDO USA’s André Robledo, Jerry Seade and Albert Lopez sat down with BDO Argentina’s Fernando Garabato, Miguel Farah and Paula Kritz to discuss the effects of the historic economic changes and expectations for PE investment in Argentina. Here are some highlights from their conversation:

How have Argentina’s recent political changes impacted the investment landscape?
The 2015 election marked a major shift in our country toward a more open economic policy, which has ushered in a period of growth and a renewed sense of confidence in the economy. Under President Macri, the new administration has lifted some long-standing restrictions on foreign investment. Key among those economic reforms is the Foreign Investment Act, which allows foreign investors to enter into mergers, acquisitions, joint ventures and investments without prior governmental approval. Other measures to improve conditions for foreign investors include reduced tariffs on imports and exports, and easing restrictions on dividends and royalties.

On a macro level, Argentina’s economy has already taken strides toward recovery and is expected to further strengthen in the coming months. Currently, Argentina’s unemployment rate hovers around 8 percent, but that is forecast to decrease to 6.6 percent in 2019. The country’s GDP is experiencing similar trends: In 2017, GDP growth is projected to hit 4 percent, a significant improvement from the slight decline in GDP in 2016. As the local economy accelerates, opportunities have started to emerge for foreign investors.

While foreign direct investment (FDI) into Argentina in 2016 didn’t quite meet expectations, FDI volume is forecast to continue growing in 2017, and the foundation has been laid for a steadier cadence of investments in the coming year.

Which industries do you think will be most attractive for investors during the year ahead?
There are several thriving, vibrant industries that present opportunities for investment. Agriculture is reaping one of the biggest benefits from the government’s current export and import tax policies, making it an attractive choice for many investors. Similarly, the reduced barriers to trade have been a boon for meat production as well. While not a profitable sector under the previous government, meat production has grown rapidly in the past year and begun to deliver nice returns.

Infrastructure is another emerging growth area. The government recently announced a $33 billion USD investment plan—comprising both public and private investments—into infrastructure and transportation between 2016 and 2019.

The plan includes the construction of 2,800 kilometers of roads and highways by 2019 and a $5.4 billion USD investment into railroads. Rosario port will also receive nearly $700 million USD of investments for improvements to roads, railroads and waterways. These investments are critical to strengthen infrastructure used to transport and export agricultural products, among others.

To further promote infrastructure development, the Argentinian government approved a law that enables public-private partnerships and allocates $40 billion USD for infrastructure projects. The law also levels the competitive playing field between public and private investors. In keeping with the current requirements for private investors, the state will no longer be able to unilaterally modify or rescind contracts.

Beyond infrastructure, the renewable energy, financial services, and oil and gas sectors have also seen increased interest from foreign investors, and present attractive opportunities for sustained investments.

How has the current administration relaxed rules on foreign currency control and cross-border trade, and what does it mean for foreign investors?  
In the past, currency controls created a roadblock for foreign investors looking to repatriate capital earned from their investments, but those restrictions have all been lifted. Just this year, the government removed a required holding period for foreign capital. Before this reform investors were subject to a 120-day waiting period before they were able to repatriate funds. Without those restrictions, investors can readily cash out of investments and collect dividends when they’d like and repatriate the capital without costly taxes or exchange rates. The current environment lends itself to the free flow of foreign capital into Argentina, which is a key factor driving foreign investors’ return to the region.

How have valuations in Argentina changed in recent years? Has Argentina’s debt market improved as well?
We’ve seen significant improvement in a wide variety of economic indicators in Argentina, including valuations, availability of debt and interest rates. In the real estate industry, for example, prices increased by about 5 percent in the past year. As new properties are introduced to the market, the volume of transactions is increasing as well. The recent introduction of a 30-year mortgage loan for families—which Argentina did not previously offer—is a further sign of the strengthening economic conditions.

Argentina’s debt market has also taken strides toward recovery, aided in part by the return of FDI. With more capital flowing into the country, debt markets are loosening. From a private equity perspective, an improved debt market makes the country more attractive for investment since many funds generate their return by utilizing leverage.

While prices and valuations are recovering, they’re still on the low side with a lot of room for improvement. Looking at a broader economic indicator, Argentina’s inflation rate was around 33 percent in 2016, but it’s forecast to go down to 10 percent over the next three years. As the inflation rate goes down and the economy continues to grow, interest rates, availability of debt and valuations should begin to reflect those improved market conditions.

What are the primary sources of foreign investment into Argentina?
Nearly two-thirds of investment announcements are driven by foreign investors, while the remaining third comes from inbound investors, according to analysts. The United States and Europe are the two most active regions contributing to foreign investment in Argentina, but we’ve seen interest from a variety of global private equity players and countries that have commercial agreements with Argentina, including Brazil, Chile and Mexico. Consistent with China’s increased investment in Latin America overall, Argentina has seen Chinese investment into the agriculture, infrastructure and energy sectors.

Foreign private equity funds have also started to return to Argentina throughout this past year. That trend is expected to accelerate in 2017, as the full impact of Macri’s open economic policies begin to take hold.

Andre Robledo is a managing director in Transaction Advisory Services and the Leader of LATAM TAS at BDO USA. He can be reached at [email protected].

Fernando Garabato is a corporate finance partner at BDO Argentina. He can be reached at [email protected].

A Private Equity Fund Adviser’s Guide to Setting Compliance Priorities

By Timothy Mohr, CFE and Peter Garcia

With the Trump Administration’s nomination of Jay Clayton to head the SEC, discussions about a new era of deregulation are beginning to grow, particularly with regard to the repeal, in whole or in part, of the Dodd-Frank Wall Street Reform and Consumer Protection Act. While there remains uncertainty about what degree of deregulation the financial services industry will see, it is fairly safe to assume the level of regulatory scrutiny over private equity firms will remain unchanged.

What we are seeing is the U.S. Securities and Exchange Commission (SEC) allocating more of its resources this year to investment adviser examinations. The SEC also established a specialized team, called the Private Funds Unit, to focus on private equity firms, in particular. It is evident that regulators are turning up the pressure on the industry. Upon review of recent regulatory enforcement actions, most hinged on whether the private equity firm had failed to perform under the expected fiduciary standard, as required under the Investment Advisers Act of 1940.

To avoid the risk of being subject to SEC action, private equity fund advisers may want to take note of the hot areas raised in recent SEC examinations and enforcement proceedings, which are as follows: 1) accurately disclosing conflicts of interest; 2) ensure consistency of disclosures; 3) ensure fees and expense allocation practices are appropriate; and, 4) establish and maintain adequate and appropriate written policies and procedures that specifically cover the foregoing points.

Compliance Best Practices

From a general perspective, private equity fund advisers can address regulatory risks by broadening the scope of compliance programs and conducting frequent third-party compliance reviews, as the SEC tends to view this as a sign of a positive culture of compliance at the top. Additionally, private equity fund advisers should organize front, middle and back offices into separate and independently functioning areas of operations, such as accounting, operations, administration, marketing, investment management and compliance. Organizing these functional areas under one compliance program can help ensure that all procedures address actual and potential regulatory conflicts in a meaningful way and are subject to compliance oversight and continuous review.

As noted earlier, the SEC’s examination proceedings and enforcement actions have focused on conflicts of interest surrounding the allocation of certain types of fees and expenses, such as accelerated monitoring fees, broken-deal expenses, and the unauthorized or inappropriate shift of expenses from the adviser to the funds. For example, the SEC recently found a firm in violation for failing to disclose to its investors the accelerated monitoring fee arrangement it had with its portfolio companies until after the fact. The SEC also cited a firm that used fund assets to cover entertainment and other expenses that should have been borne completely by the adviser. These mishaps could have easily been avoided. Private equity fund advisors should take the following proactive measures to mitigate regulatory risks.

First, private equity fund advisers should submit for compliance review all fees allocated to portfolio companies in which a benefit is realized by the adviser. This step can assist with demonstrating that the documented allocation is fair and equitable and consistent with pre-determined, stated methodologies.

Secondly, private equity firms should manage their methodologies of broken-deal expenses. The SEC has found many instances where private equity firms fail to disclose the allocation of broken-deal expenses where co-investment vehicles are involved. The straightforward solution to address this concern is to ensure that the investment opportunity expense allocation methodology is clearly defined and disclosed, especially for situations involving co-investment vehicles. The methodology for investor participation in co-investment vehicles should also be clearly defined and disclosed.

Thirdly, private equity firms should adopt for all procedures the guiding principle of fully disclosing what you do and doing what you disclose. The SEC has difficulty finding fault with procedures drafted, disclosed and implemented this way. If investors accept these disclosures by signing a subscription document or limited partnership agreement that makes clear they have read and agree with all disclosures, the SEC’s ability to bring an action against the adviser is extremely limited.

To meet the SEC’s expectations, it is important to ensure that potential and actual conflicts of interest relating to these issues—as well as how identified conflicts are mitigated—are accurately and consistently disclosed in all external communications, such as an offering memoranda, marketing materials, due diligence questionnaires, responses to prospective investors, Form ADV Part 2A, email and websites, to name just a few.

While a lot remains unclear with where the new administration’s regulatory focus will be, we know with a high degree of certainty that the SEC’s private equity fund adviser examination initiative will not be discontinued. Until we know more, heeding the SEC’s signals provided through examination and enforcement activities is an appropriate strategy for establishing compliance priorities within your organization.

Tim Mohr is a principal and national leader of BDO Consulting’s Financial Services Advisory practice. Tim can be reached at [email protected].

Peter Garcia is a senior associate at BDO Consulting and can be reached at [email protected].

What Retail’s New Reality Means for Private Equity

By Scott Hendon and Natalie Kotlyar

The retail model is rapidly changing online and off. Driven by changing consumer expectations about brand experience and convenience, traditional retailers are expanding their online and omnichannel offerings, while some online retailers are laying down their first brick-and-mortar stores. Despite recent headlines touting the end of retail off the back of Q1 earnings, there’s been a sustained spike in deal activity as retailers strive to develop the right balance of consumer channels.

General retail e-commerce M&A activity topped out at $17 billion in 2016, representing about an eightfold increase from 2014’s $2.36 billion in M&A activity, according to BDO & Pitchbook’s Current State of E-Commerce, published in May, which outlines strategic and financial deal activity across the sector. Furthermore, retailers expect deal activity to continue to rise in 2017. Nearly half (46 percent) of retail CFOs surveyed in BDO’s 2017 BDO Retail Compass Survey of CFOs forecast an uptick in retail M&A activity this year. More than two-thirds (38 percent) of these CFOs cite competition and consolidation as the driving factors for deals.

Much of the increased deal activity in recent years has been driven by strategic buyers. In fact, more than half of retail CFOs (56 percent) anticipate M&A activity will continue to be driven by strategic buyers in 2017, with an estimated average EBITDA multiple of 7.0, the highest in the survey’s history.

That means we’re likely to see more deals like Walmart’s acquisition of last year. That acquisition was made to immediately bolster Walmart’s e-commerce presence and to compete with Amazon. Walmart paid a premium ($3.3 billion) compared to’s valuation ($1.35 billion), but it appears to have paid off. Walmart’s global e-commerce sales for 2016 increased 15 percent from the previous year, and its U.S. e-commerce sales gained 36 percent.

At the same time, there have been recent strategic acquisitions that have delivered less clear results. Look to examples like the 2015 flash-sale startup Gilt Groupe’s sale to Hudson’s Bay Co. for $250 million or Bed Bath & Beyond’s $100 million acquisition of One Kings Lane. Both deals enabled the buyers to enter the flash-sale space at a discounted rate, but the market ultimately slowed. Gilt Groupe’s sale now seems like a win; however, the brand was previously valued at $1 billion before losing steam as the flash-sale trend has slowed. A similar story was told for One Kings Lane. The total acquisition amount was never released, but estimates put the deal around $150 million, a far cry from the company’s previous valuation of $900 million.

So how does that impact financial buyers? According to BDO’s PErspective Eighth Annual Private Equity Study, published in February, one in 10 of the more than 200 private equity executives surveyed for the report said the retail & distribution sector presented the greatest opportunity for new investment in 2017. The retail sector ranked fifth in that category behind manufacturing, technology, healthcare and natural resources. Driving interest in the sector was the belief that retail and distribution valuations would come down (67 percent) and that sale to a strategic buyer would be available at exit (69 percent).

Our view is that private equity firms focused on the retail sector are likely to see sustained competition from strategic buyers for deals in the short term, particularly with targets like that can provide an out-of-the-box e-commerce solution. There could also be opportunities for private equity firms to identify traditional retailers with a strong brand following and an underdeveloped omnichannel strategy. For those companies, there could be the potential to drive value by restructuring operations, bringing down cost—particularly real estate costs—and building out an omnichannel offering, similar to the approach Sycamore Partners has taken in the sector. Despite recent Wall Street woes for retailers, we anticipate continued demand from strategic buyers long term that will position private equity buyers to have a clear path to exit.

The rule of thumb for private equity firms operating in the retail sector should be to proceed, but proceed with caution. Retail as we know it is rapidly changing. Just as the industry is different today from what it was 50 years ago, it will be totally transformed by 2067. And our bet is transformation will come relatively quickly, so there is a good opportunity for disruptors and innovators in the sector to shape what the future model of retail will look like.

Scott Hendon is a partner and national leader of BDO’s Private Equity practice. He can be reached at [email protected].

Natalie Kotlyar is a partner and national leader of BDO’s Consumer Business practice. She can be reached at [email protected].

Recent Court Decision Has Implications for Members of a Fund Management Company

By Francois Hechinger and Jeff Bilsky

Private equity funds typically utilize a limited liability company (LLC), treated as a partnership for tax purposes, to provide management services to the main fund entity. Members of the management entity oftentimes receive compensation in the form of guaranteed payments along with a distributive share of net operating income generated by the management company.

Under general tax rules, guaranteed payments for services provided and a partner’s distributive share of partnership income are subject to self-employment tax. However, a limited partner’s share of partnership income is not subject to self-employment tax. Consequently, to the extent members of a management company are “limited partners,” their distributive shares of management company income may not be subject to self-employment tax.

In Vincent J. Castigliola et ux., et al. vs. Commissioner, the Tax Court addressed the meaning of the term “limited partner” for purposes of the self-employment tax exemption.

Overview of the case

The taxpayers in Castigliola were members of a professional LLC (PLLC) treated as a partnership for tax purposes. The PLLC was engaged in the practice of law in the state of Mississippi and the members were actively engaged in the management and operations of the practice. The members received guaranteed payments for services performed as well as a distributive share of operating income. The members did not dispute that their guaranteed payments were subject to self-employment tax. However, the members argued that they were limited partners for self-employment tax purposes and their distributive share of partnership income was therefore not subject to self-employment tax.

The Tax Court concluded that in the absence of a statutory definition of the term “limited partner,” it is necessary to consider congressional intent and not necessarily rely on state law designations. Ultimately, the Tax Court concluded that the primary characteristics of a limited partner include (1) limited liability and (2) lack of control of the business. Since the taxpayers in Castigliola participated in material decisions of the business, i.e., had control over the business, the Tax Court concluded that the members could not have qualified as limited partners. Consequently, the members’ guaranteed payments and distributive share of earnings were properly subjected to self-employment tax.

Key takeaways for PE firms

  • The Castigliola decision is consistent with the Tax Court’s earlier decision in Renkemeyer, Campbell, & Weaver LLP v. Commissioner in concluding that the term “limited partner” should be determined based on congressional intent and not, for example, on state law designations.
  • Citing Renkemeyer, the IRS concluded in CCA 201436049 that managing members of a management company operating as an LLC treated as a partnership for tax purposes were not limited partners for purposes of the self-employment tax exception. The IRS’ conclusion is premised on the determination that the members performed extensive services on behalf of the LLC and their distributive shares of income were not of an investment nature.
  • No case law or IRS guidance directly addresses whether limited partners of a state law limited partnership who actively participate in the operations or management of the entity can be treated as limited partners for purposes of the self-employment tax exception.
  • Given the recent developments in this area, a reasonable question is whether use of a state law limited partnership as the management entity will allow for application of the self-employment tax exception on the limited partners distributive share of earnings. Based on the Tax Court’s focus on congressional intent in similar situations, however, care should be taken in relying solely on state tax designations for purposes of applying the self-employment tax exception.
  • Note that limited partners who “actively participate” in the business of the limited partnership are unlikely to be subject to the net investment income tax. Query, then, whether a viable position exists where such limited partners are subject to neither self-employment tax nor the net investment income tax.
For more information on imposition of self-employment tax on LLC members, read the Tax Alert prepared by the BDO Federal Tax practice.

Francois Hechinger is a lead partner for BDO’s Bay Area high net worth individuals tax practice. He can be reached at [email protected].

Jeff Bilsky is a partner and technical practice Leader in the National Tax Office Partnership Taxation group at BDO USA. He can be reached at [email protected].

Did You Know...

According to Preqin, there are currently 1,908 private equity funds whose combined assets amount to $635 billion of investor capital.

General retail e-commerce M&A activity reached $17 billion in 2016, representing about an eightfold increase from 2014’s $2.36 billion in M&A activity, according to BDO & Pitchbook’s Current State of E-Commerce.

The majority (28 percent) of private equity fund managers surveyed in the BDO PErspective Eighth Annual Private Equity Study anticipate closing two new platform deals in 2017, and a quarter of respondents hope to invest between $10 to $29 million again this year.

Despite Brexit, PE firms fundraised $24 billion in Q1 and could be on track to surpass 2016’s total of $93 billion, according to Pitchbook’s Q1 2017 European PE Breakdown.

PE funds raised a combined $237 billion globally to invest in commercial real estate at the onset of 2017, outpacing the 2016 total of $202 billion, according to Preqin

For more information on BDO USA's service offerings to this industry, please contact one of the following practice leaders: