PErspective Newsletter - Winter 2015

December 2015

PErspective Newsletter

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Table of Contents

The Up-C Partnership IPO Structure
PE Fee Scrutiny No Longer the Purview of Just the SEC
The Meaning of Financial Support
BDO Knows International Private Equity: Spotlight on Greater China
Webinar Recap: Is There a Crest in Sight for Manufacturing & Distribution M&A Activity?
Did you know...

The Up-C Partnership IPO Structure

By Jeffrey N. Bilsky, CPA and Avi D. Goodman, CFA, CPA

A company that is considering going public has a long road ahead. When the business is structured as a partnership, it has historically been assumed that the partnership needs to become a corporate entity before the initial public offering (IPO). However, businesses operating as partnerships can take an alternate route that may yield significantly more value: the Up-C partnership structure.

The Up-C partnership structure is often overlooked, but may be highly advantageous in the right situation. The existing partners can increase their total consideration received on future disposition of partnership units by creating certain tax attributes, and subsequently monetizing the associated benefits in the form of cash received as the tax attributes are used.

In the Up-C structure, the business forms a C corporation and raises capital on the public market via an IPO. The C corporation, in turn, contributes the capital generated from the IPO to the capital of the existing partnership (operating partnership) in exchange for interests in the operating partnership. Effectively, the C corporation (public company) is a holding company and serves as the publicly traded vehicle that is invested in the operating partnership alongside the pre‑IPO legacy partners.

Tax Advantages of Up-C Partnership Structures

A conventional conversion of a partnership to a C corporation followed by an IPO results in double taxation with respect to the built-in gain inherent in the partnership assets at the time of conversion. Not only are the partners taxed on the ultimate disposition of stock received for their partnership interests, but the corporation is also taxed on a future disposition of acquired partnership assets.

An IPO undertaken using an Up-C partnership structure, on the other hand, features only a single level of taxation on the built-in gain inherent in the partnership assets at the time of conversion. The legacy partners recognize gain on the ultimate disposition of their ownership interests and obtain potential additional benefits, including an increase in the amount ultimately received for their interests if a tax receivable agreement (TRA) is entered into as part of the structure. The public company, in turn, can receive a step-up in the tax basis of its share of partnership assets that, in many cases, can result in additional tax deductions.

Following the IPO, the legacy partners will continue to benefit from the flow-through nature of a partnership, maintaining a single layer of taxation. Further, a TRA as part of an Up-C partnership structure can add value for the legacy partners, typically entitling them to 85 percent of the tax savings derived from the basis step-up achieved by using the structure.

Additional Considerations

To ensure that the most advantageous post-IPO structure is in place, pre-IPO restructuring transactions are likely necessary. It may not be possible to effectuate certain restructuring steps in a tax-free manner, and some upfront tax costs may result. Any company that is considering an Up-C structure should seek the advice of qualified tax advisors, as determining the optimum pre-IPO structure is not always intuitive. In many cases, several alternative paths lead to the optimum structure, and determining which path is most advantageous to the parties may require complicated tax modeling exercises.

Additionally, the legacy partners will need to evaluate the applicability of the net investment income tax, which imposes a 3.8 percent surtax on investment income in excess of a threshold amount. Net investment income includes net gain attributable to the disposition of property other than assets used in a “non-passive” trade or business. To the extent a legacy partner satisfies the relevant standards and the activity is considered non-passive, an added benefit of the Up-C structure is that the net investment income tax may not apply with respect to that partner.

While many dynamics are at play when it comes to the public market valuation of any security, investment bankers and other market professionals generally do not view a step-up coupled with a TRA obligation as a factor contributing to a reduced market capitalization. One reason for this may be that Wall Street research analysts, and public shareholders in general, typically do not assign full value to the tax attributes of a company, as they can be very difficult to value given the inherent uncertainty regarding their future use. Further, time-value-of-money considerations are also a factor, since many tax attributes can extend 10, 15 or even 20 years into the future, and can have limitations imposed on their ultimate use and may even expire unused. Finally, a common public company valuation metric is a multiple of EBITDA which, by definition, does not take taxes into account.

In addition to working through the complexities of the Up-C structure with tax advisors and counsel, any partnership that is considering such a structure should also work with its investment bankers or other valuation advisors to understand the market dynamics as well as the impact on public market perception and overall valuation.

The above is a condensed version of a 2-part series by the authors as published in the November and December 2015 issues of The Tax Adviser, a publication of the AICPA®. Part 1 can be found at

Jeffrey N. Bilsky, CPA, is a senior director in BDO’s National Tax Office, and can be reached at

Avi D. Goodman, CFA, CPA, is a managing director in BDO’s Transaction Advisory Services practice. He can be reached at


PE Fee Scrutiny No Longer the Purview of Just the SEC

By Lee Duran

The SEC Enforcement Division’s Asset Management Unit has been scrutinizing the private equity (PE) industry for years to ensure that fund managers aren’t misallocating or unfairly charging fees and expenses to investors. However, it is no longer just the SEC that is examining fee structures and disclosures — recent developments suggest that policymakers and institutional investors are taking a closer look, as well.

The Treasurer of California, John Chiang, recently called for legislation requiring full transparency in the reporting of the fees PE firms charge. Through this request, Mr. Chiang is hoping to “solve the problem of investors who pay excessive fees to PE firms and do not have sufficient visibility into the nature and amount of those fees.” Some PE firms have stated that disclosing their agreements with investors would reveal trade secrets. Additionally, private equity fund managers have claimed that classification of operating costs — and the extent to which they should be explained — can be a matter of interpretation. However, this rationale has not satisfied regulators or institutional investors.

The standard fee structure calls for the “2 and 20,” wherein a 2 percent annual management fee covers overhead, while the private equity firm earns 20 percent if it achieves a certain return threshold. Generally, investment sponsors to funds will utilize these management fees to cover their costs for normal operations, broken deals, advisory work, etc. However, the SEC has observed an apparent trend in advisors shifting expenses from themselves to their clients during the fund’s life without proper disclosure to limited partners. 

Among the charges the SEC finds the most problematic are advisory fees, transaction fees and monitoring fees. A common example is the use of third-party advisors or “operating partners.” Portfolio companies or funds may directly pay many of these operating partners without sufficient disclosure to investors. Further, these advisors are not usually treated as employees or affiliates of the fund sponsor and, therefore, their fees rarely offset management fees. The SEC states that “Operating Partners are members of the management team and think these costs should be absorbed by the PE fund sponsor out of the management fee. Instead it is charged as an operating cost, which comes out of the pockets of investors.”

Another common area criticized by the SEC and institutional investors is the payment of breakup fees in the event that a transaction is not completed. The breakup fee is designed to offset the time and money the PE fund sponsor has spent negotiating a deal that never came to fruition. However, the PE fund sponsor might not inform investors that breakup fees are included in operating expenses.

So, what is a PE fund sponsor to do?
  • Fund sponsors should analyze all the direct and indirect fees they are collecting, as well as all expenses being charged to the fund. The sponsor should then determine if these expenses are clearly and accurately disclosed to investors.
  • Funds should ensure they have formalized policies and procedures in place to define how fees and expenses are calculated, as well as to review and monitor the accuracy of fee calculations and charges.
  • Compare the fees charged to the fund or portfolio companies to ensure that these are reasonable in accordance with the operating agreement. However, determining whether or not a particular fee or expense is covered under existing disclosure requirements could come down to a judgment call. As a result, fund sponsors should carefully consider these costs with their legal counsel. This may also be an indication that the Limited Partnership Agreement needs to be modified to handle the fee arrangement more clearly.
  • Ensure disclosure of the types of expenses accompanied by a detailed description of allocations. Some fund sponsors have recommended the issuance of an interim investor memorandum in discussing any changes to fees and expenses being charged to the fund.
In this current environment, PE fund sponsors would do well to consult with their advisors on disclosures and, when in doubt, err on the side of caution and timely disclosure.

Lee Duran is partner and leader of the Private Equity practice at BDO. He can be reached at

The Meaning of Financial Support

As we approach the 2015 reporting season, we thought it pertinent to remind PE fund sponsors of new disclosure requirements regarding financial support provided to a portfolio company. 

Pursuant to Accounting Standards Codification (ASC) 946-2050, a fund sponsor is required to disclose quantitative and qualitative information about any financial support that it provides, whether required to provide or otherwise. Accounting standards indicate that financial support includes “loan, capital commitment or guarantee.” However, for purposes of applying the disclosure requirements in the standards, financial support would generally include amounts without which the investee would be unable to maintain its existing operations.

Financial support provided to an investee is required to be disclosed and disaggregated by financial support a fund sponsor was contractually required to provide and financial support it was not contractually required to provide. Such disclosure must include the type and amount of financial support (including when the fund sponsor assists an investee in obtaining financial support) and the primary reason for providing the financial support. A fund sponsor is also required to disclose financial support it is contractually required to provide its investees, but has not yet done so.

BDO Knows International Private Equity: Spotlight on Greater China

The private investment environment in Greater China – the Chinese mainland, Taiwan and Hong Kong – has seen a great deal of change in recent years as the Chinese government has sought to combat economic stagnation and instability in the stock markets.

Our own Lee Duran sat down with Kenneth Yeo, director and head of Specialist Advisory Services with BDO in Hong Kong, to discuss his firsthand observations and predictions for private equity investment in the region. 

Read More 

Webinar Recap: Is There a Crest in Sight for Manufacturing & Distribution M&A Activity?

Last month, BDO hosted its first Manufacturing & Distribution (M&D) Merger & Acquisition (M&A) Outlook webinar, “Is There a Crest in Sight for Manufacturing & Distribution M&A Activity?

Dan Shea, Managing Director and Head of Private Equity Coverage for BDO Capital Advisors, LLC and Jerry Dentinger, Partner and Leader of the firm’s Central Region Transaction Advisory Services Practice, co-presented alongside Rick Schreiber, Partner and National Leader of BDO’s M&D practice. During the webinar, the thought leaders took attendees on a journey along the path of M&D deal flow in 2015 and shared thoughtful insights on current and future activity in the space. Key takeaways included:

Industry Conditions Favor Investment
Before the Great Recession, investors weren’t batting an eye at deals in the manufacturing space. Today, however, the industry is attracting their attention. In fact, manufacturing stocks are tracking alongside the S&P 500’s overall performance. Why are investors favoring the industry? For many reasons, including its sustainable energy cost advantage, shrinking labor cost disparity, an influx in niche manufacturers and a competitive edge in innovation. Of equal importance is the space’s cyclicality which has typically allowed for reasonable purchase valuations which has ultimately led to attractive investment returns.

Private Equity is Well Positioned to Benefit
This year, the market has been incredibly active with no shortage of deal closing. More private equity investors are taking spots at the table, providing stiff competition against strategic buyers. In many deal negotiations, private equity investors are willing to offer prices comparable to or greater than those offered by strategic buyers. This is partly because private equity investors possess a large pool of un-invested capital totaling approximately $500 billion. The available equity as well as debt capital, coupled with a limited universe of sellers has bolstered intense competition. Both premium as well as average assets have been trading hands as private equity firms aggressively put money into deals where they believe they can build value.

Changes on the Horizon in 2016?
The headline as we look toward 2016 is that while economic indicators could slow the pace of activity, investors are still interested in the sector, though they may be more selective and exhibit more restraint. While the market may remain active, the rate of deals could change, with lenders pulling back should the economy slow. If this is the case, valuations could decline and deal volume could level off. However, the U.S. holds a number of advantages today, including relatively low energy costs, a narrowing labor gap and high levels of innovation, and its economic high ground will continue to attract onshore investment in manufacturing, even despite the strong U.S. dollar. Finally, buyers will most likely display more discipline, which is particularly healthy in light of the advanced age of the current economic upcycle.

Between the arrival of a new—and election—year and the persistence of economic changes, it will be interesting to see how deal flow dynamics in the M&D industry shift in 2016.

Did you know...

The National Center for the Middle Market’s 3Q 2015 Middle Market Indicator indicates that in Q3 2015, nearly two-thirds of middle market companies report improved company performance versus one year ago.

Private-equity backed add-on deals hit a record $310 billion through November 4, 2015, exceeding the $274 billion spent on similar deals during all of last year, according to data provider Dealogic.

According to the 2015 BDO 600 CEO and CFO Pay Study, total direct compensation for CFOs in the non-banking financial services sector increased 22 percent between 2014 and 2015, while their CEO counterparts experienced a 5 percent decline in compensation.

The  average price multiples buyout firms paid for assets has grown to an all-time high of 11.18 times EBITDA as of the third quarter of 2015, says Standard & Poor’s Capital IQ’s LCD unit.

Worldwide mergers and acquisitions, excluding buyouts, have totaled $3.68 trillion this year, beating the previous 2007 record, reports Dealogic. In contrast, the $172 billion total in leveraged buyouts in 2015 is less than a third of the record $639 billion of deals completed in 2006.

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

Lee Duran
San Diego


Joe Gordian

Scott Hendon
  Ryan Guthrie 
Costa Mesa

Karen Baum 
  Tuan Hoang
Los Angeles


Joe Burke 
McLean, VA


Kevin Kaden 
New York


Fred Campos


Todd Kinney 
New York


Lenny Dacanay


Matt Segal 

Jerry Dentinger
  Dan Shea
Los Angeles