An Essential Player In The Private Equity Arena

Friday, February 1, 2008 - 01:00

Editor: Would you please give our readers some information about your background?

Loiacono: I have been practicing for over 20 years and with Eisner for 18 years, 10 as a partner and co-head of our tax department for five years. I have been focusing on the private equity fund arena since 1992. Although Eisner is a middle market firm, we have the opportunity to see all aspects of the fund business, including the management companies, the general partnerships as well as the individual sponsors of the private equity funds. I also serve a number of portfolio companies.

Editor: Do you serve both the large as well as the smaller private equity funds?

Loiacono: We serve all sizes of funds - from early stage venture capital funds to middle market buyout funds up to the mega buyout funds - from first-time managers to mature branded organizations.

Editor: As a professional who assists private equity funds with tax planning, do you spend your time primarily in planning for the funds themselves in terms of tax strategies or do you primarily assist the funds in setting up tax strategies for their target companies?

Loiacono: My time is spent predominantly on the fund's tax matters. However, the firm and I assist the funds in structuring purchases and sales of their portfolio companies as well as due diligence.

Editor: What are some of the components of your tax strategies for these large funds?

Loiacono: Since the investors of the larger funds are frequently tax exempt and/or foreign, we structure the funds and the portfolio companies to prevent the income from being considered unrelated business taxable income (UBTI) for the tax exempts and effectively connected income (ECI) for the foreign investors. We also factor in the tax compliance implications. For example, by organizing the fund in an offshore jurisdiction, U.S. taxable investors might avoid the imputation of cashless taxable income (known as Subpart F Income) from a foreign portfolio company. This structure may also reduce some of the ongoing U.S. tax compliance for U.S. owners of foreign entities. Recently, private equity funds have been willing to retain the LLC structure for certain portfolio companies. Flow-through structures like the LLC for U.S. businesses will generate UBTI and ECI. So, we also utilize blocker corporate entities for the tax exempt and foreign investors, while still protecting the tax benefits for the taxable U.S. investors.

Editor: Is all income that flows to equity sponsors treated as a capital gain or are their overrides treated as ordinary income?

Loiacono: Most of the overrides are treated as capital gains. The overrides are "in kind," meaning that the character of the income depends on the type of taxable income that is being generated at the fund level. There are times, of course, where the override can be dividend income. If the underlying portfolio company has a recapitalization event, there could be a dividend that is allocated to the fund sponsors, which in the case of a domestic portfolio company is generally structured as a qualified dividend to avail the recipients of the lower tax rates. Occasionally, if a foreign entity is involved, the distribution may not qualify for the special dividend treatment.

Editor: At what point in the process should the sponsors invoke your services when they are negotiating to buy a company?

Loiacono: I generally like to be involved before the issuance of the letter of intent, especially when there are discussions about the structure of the transaction as a stock versus asset purchase, however, it depends on the structure of the target company - whether it is domestic or foreign. These subjects can be quite complex. It is always best to have the input of a tax advisor early in the process.

Editor: When you do a stock transaction, what stock is being exchanged for the stock in the target company?

Loiacono: It depends. On the purchase side, stock transactions are generally taxable stock transactions so it could be cash or stock of Newco, a newly formed subsidiary, exchanged with the stock of the acquired company. These stock transactions would not be considered tax-free. On the sale side, the stock of the acquirer could be publicly traded stock or non-marketable securities - depending on the acquirer.

Editor: What part of the due diligence do you play in examining the books of a target company?

Loiacono : My focus is predominantly on tax. We obviously look at the structuring that is in place prior to the buyout to determine if that structure is sound. We certainly review the tax compliance of the company - meaning that we review whether the target has been making its filings properly, have elections been made on a timely basis? We also examine the state and local filings as well as international filings. We pay particular attention to compensation plans - both equity-based and deferred compensation - to determine whether those areas have been treated properly. In addition, we review NOL limitations as well as the opportunity to step-up the basis of the assets.

Editor: What are some of the other red flags you look for when pouring over the books of a target company?

Loiacono : We certainly scrutinize the tax provision work papers. There have been so many public company restatements in recent times that this area is rife with concern. We review transfer pricing, both on the domestic and the foreign side. We also review state and local tax structuring and exposure for non-filings. We review equity based-compensation issues such as whether stock options were issued at the appropriate prices, what valuations were used? Did those valuations make sense based on equity transactions that occurred, based on the fair value of the stock? Would any equity transactions upset the strike prices of the stock options issues at different points in time? Essentially, we are looking for compliance with Section 409A. Depending on the target, we may focus on the ability to make a Section 338(h)(10) election - which is a stock purchase treated as an asset purchase for tax purposes.

Editor: What about tax indemnification. Do you suggest to the fund how much indemnification for tax deficiencies it should ask for?

Loiacono : Although part of the tax indemnification is standard, the due diligence typically drives this part of the contractual process. We may provide insight into interplay of uncertain tax positions taken in the past and statute of limitations. Of course, this could impact escrow provisions.

Editor: Do you customarily advise your clients to structure asset sales or cash for stock sales?

Loiacono : It depends which side of the transaction we are on. Buyers generally want to buy assets to achieve a step-up in the basis of the assets. Sellers generally want to sell stock of a C corporation to avoid double taxation. Also, when pass-through entities are involved, there may be state and local tax implications as well.

Editor: Do you go outside for an appraisal or is that done internally by colleagues at Eisner?

Loiacono : It depends on the transaction and our relationship with the private equity fund. If we are engaged as auditors, we will have an independence problem at the audit level - so we cannot perform an appraisal.

Editor: In the event of an asset sale, is your expertise called upon in terms of an appraisal of assets? Do you also look at the depreciation on these assets - normal wear and tear, proper write-offs?

Loiacono : Generally, I do not get involved at that level. It is generally the valuation person. In an asset sale, the appraisal is more financial-accounting focused and a job for the appraiser than it is tax focused since on the tax side most of the intangible assets get thrown into the same catchall bucket which is a 15 year amortization schedule. So we are not as focused on the different categories of intangible assets. However, there are exceptions to every rule. Occasionally, there may be a significant tax rate differential due to the allocation of the purchase price.

Editor: Do private equity sponsors utilize offshore subsidiaries to shelter income?

Loiacono : Generally no, that has not been my experience. I answer that question for U.S.-based funds with predominately U.S.-based general partners. However, when you serve complex private equity sponsor organizations - where they are multi-national investors - there can be multiple entities to accommodate the different types of investors as well as the different taxing jurisdictions of the investors. Correspondingly, there can be multiple general partner entities to accommodate the different pools of limited partners. There could be one general partner vehicle for the U.S.-based general partners, and there could be another for the European-based general partners. This topic gets exponentially complex as you have multiple fund vehicles.

Editor: Do you see situations where the installment sale is used in making acquisitions ?

Loiacono : I see installment sales as escrow arrangements and "earn-outs." We certainly see earn-out transactions quite frequently, especially when a closely held business is being acquired and the seller/manager is needed to transition the business post-sale.

Editor: What advice would you give to corporate counsel who might be interested in divesting some of their company's assets or a division to a private equity buyer?

Loiacono : I would say that if a company has the potential to be part of a private equity transaction, that planning has to begin years in advance. That company should start acting as a quasi-public company; to ensure that its corporate house is in order such as constituting a board and periodically reviewing its corporate documents with counsel; that it is SOX compliant; that it has taken on the mind-set of a public entity. By conducting yourself like a public company, a future due diligence process may go much smoother. Occasionally, poor tax structuring or taking aggressive tax positions may cripple a negotiation. For example, we have performed due diligence on growth-stage technology companies that have entered into equity-based compensation transactions which were poorly documented. This gives the legal and accounting professionals much cause for concern in that there can be an unknown equity transactions or issuances at prices that cause tax and accounting problems such as a violation of Section 409A. Of, course, these issues may be compounded if discovered late in the process. Therefore, it also makes sense for the company to have its financial statements audited by a quality audit firm. This way, a potential acquirer can understand the impact of a business combination on its own financial statements.

Please email the interviewee at cloiacono@eisnerllp.com with questions about this interview.