Part 2: Operational and Tax Considerations
For years, secondary funds were the poor, forgotten cousin of alternative investment funds. The secondaries market had limited activity, mainly from limited partners (LP) trying to exit their investments in old closed-end funds. Transactions in the secondary market were typically at deep discounts. Now, these investments have become much more attractive, and transactions have grown dramatically in the last five years.
In Part 1 of this series, Weaver described some pros and cons of secondary investments that potential investors should consider. This Part 2 presents some operational and tax issues to research before investing.
When buying LP interests in a secondary transaction, these are some points to ponder:
- Focus on quality of investments remaining in the portfolio.
- Consider using consultants to determine the value of the LP interest or the value of the underlying portfolio.
- Reach out to your network to get feedback on the GP as well as the underlying assets of the fund you are targeting.
- Ensure that the target investee fund provides audited financials on a fair value GAAP basis prepared by a reputable audit firm. Ideally, those financials should be available by April 30.
- Understand the rationale for any GP-led restructurings that gave rise to the secondary transaction opportunity. Is the restructuring intended to provide liquidity to existing LPs in the fund, or are there other hidden agendas?
Types of Income
If you are investing through a fund structure, review the private placement memorandum to understand and assess the type of income it may generate. If the investment involves unrelated business taxable income (UBTI) or uses leverage as part of its investment strategy (which can give rise to unrelated debt finance income, which is taxed as UBTI), consider the impact to your tax-exempt investors. Is the prospective investment fund’s strategy to invest in U.S. operating businesses, which can give rise to effectively connected income (ECI)? Is that a sensitivity for your non–U.S. investors? Understanding the nature of the underlying investments and the expected type of income expected to be allocated to your fund is important for evaluating its impact on your fund’s LPs, possible structures, or alternative investment vehicles that may need to be set up as investment considerations.
It’s also important to gather an understanding of the expected character of income that is to be allocated from the prospective investment for your U.S. taxable investors. Will the investment generate interest income taxed at ordinary rates, or, will there be ordinary trade or business income in which there may also be an associated 20% 199A deduction from the 2017 Tax Cut and Jobs Act? Will the income consist of qualified dividends and capital gains taxed at preferential rates, or will it be rental and royalty income with its own set of reporting requirements and limitations?
Foreign Reporting Requirements
As part of the tax due-diligence process, request information on any foreign reporting requirements. Sometimes this may be discussed in the offering materials, or disclosed in a prior-year Schedule K-1. Is the prospective investment a foreign partnership? Does it have holdings in foreign corporations that could be considered passive foreign investment companies, which require separate tax elections and disclosures? There may also be reporting requirements for direct or indirect contributions or ownership in foreign corporations your LPs may need to report on their own returns. These should all be considered, as there are stiff penalties imposed when certain foreign reporting requirements are not met. They can also considerably increase compliance costs for you and your LPs.
Electing Investment Partnerships
When acquiring a partnership interest in the secondary market, ask the exiting LP whether the prospective investment is an “electing investment partnership,” or EIP, under IRC 743(e). If so, a transferor notice should be requested from the exiting LP (transferor). This notice must contain certain information, including the amount of loss recognized, if any, by the transferor on the transfer of interest. If the prospective investment has elected to be an EIP, and a transferor notice is not received from the transferor, gross capital losses allocated from the investment may be disallowed. Rules related to IRC 743(e) and EIPs are complex, but you and your investors should be aware that the tax impact could be meaningful if gross capital losses are disallowed.
Other Tax Considerations
- When will the Schedule K-1 from the prospective investment be received? How will that timing affect your own fund’s timeline for delivering Schedule K-1s to investors?
- Are there state tax considerations to address? If the prospective investment has multiple state operations and generates state-sourced income, you should ask about composite filings, state withholdings and whether state withholding exemption certificates will be provided.
- Can you obtain a copy of the prior year Schedule K-1? This schedule will provide key insights into many of the potential tax issues, such as UBTI/ECI disclosures, character of income generated, and insights into possible foreign reporting requirements.
While investing in secondaries is an attractive option for many investors, it’s important to make sure you address these operational and tax considerations first to avoid investor relations issues. If you have questions on investing in secondary funds, contact Weaver to request a consultation.
Authored by Sindhu Rajesh, CPA, CFE, and Blayne Lowary, CPA.
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