Travers Smith's Alternative Insights: Carried interest and continuation funds

A regular briefing for the alternative asset management industry.

Continuation funds offer investors a choice: take liquidity if you need it, or retain exposure to assets with further potential upside. As we have written before, these deals are a healthy innovation, and don’t bear the hallmarks of a "pyramid scheme" – but the inevitable conflicts of interest must be carefully managed. Regulation, investor oversight and media scrutiny all help to ensure that they are.

Investors are heavily focused on alignment of economic interest as a way to alleviate conflicts. When putting together a continuation fund, therefore, a sponsor will think hard about how to ensure that the interests of continuing investors are properly aligned with the future economic interests of the GP. That usually means leaving significant money on the table, and any carried interest that might crystalise on the secondary transaction will form an important part of the discussion. In practice, the fund managers will re-invest, or "roll", a large proportion, perhaps all, of their carried interest into the new structure. That reassures continuing investors, and should also drive up the price for the benefit of the exiting LPs.

Carried interest – which delivers a share of future realised profits – aligns economic outcomes: the performance-related incentive is only triggered if the investors have actually made gains. In the context of a continuation fund, continuing investors want to know that this alignment remains, and that the secondary sale is not an opportunity for managers to benefit when the continuing investors are not taking cash out.

That said, the proportion of reinvested carried interest will depend on the deal. Single-asset deals typically involve all of the carry being reinvested; for multi-asset deals, it may be around 75% - 80%. If some executives are retiring, investors may be less insistent on them reinvesting, on the basis that they will not be contributing to future upside. Moreover, the terms of the carried interest in the new vehicle may be different to ensure that it is not price dilutive for the continuation fund investors. There may be a lower carried interest rate which ratchets up with out-performance or carried interest that is subject to a higher hurdle than was previously set.

But, although carried interest holders may not take cash out, the tax authorities look at the transaction differently: continuation fund transactions usually result in crystallisation of carried interest, which is a taxable event. That creates a structuring challenge – and one which is more acute now that UK carried interest taxation is extremely complex following a series of legislative changes since 2015.

Because a tax charge will be triggered when the carried interest is allocated to an individual, the documents will typically include a mechanism to allow for the tax that arises to be released to the individuals affected in order to ensure that they can meet their tax liabilities.

…although carried interest holders may not take the cash out… continuation fund transactions usually result in crystallisation of carried interest, which is a taxable event.

Legislative changes have meant that 28% is the minimum UK tax rate on carried interest. Carry that is attributable to gains realised on the sale will be taxed at 28% and carry attributable to income (for example, accrued interest or dividends) will (in effect) be taxed at 45% (for interest) or 38.1% (for dividends) under ordinary tax principles.

However, it is also important to structure the deal carefully to ensure that any pre-sale reorganisation does not result in additional, unexpected tax leakage, and to ensure that the carried interest rolled over continues to be subject to the expected carried interest tax regime – as opposed, for example, to being characterised as a fee under the disguised investment management fee tax rules.

It is also challenging if team members are being awarded carry in the new structure. In that case, team members who do not pay full value for new carried interest can be subject to tax charges on award of the carried interest and the house will need to consider what the value of the new carried interest is – in particular, whether it is compliant with the BVCA/HMRC Memorandum on value, or whether a valuation is needed.

Rules known as the "income-based carried interest" regime (which apply to carried interest holders who are self-employed partners in an LLP) also need to be carefully considered on any continuation fund deal. If, at the point the carried interest arises to the relevant individual, the average holding period of all of the original fund's investments (tested as of that date) is less than 40 months, some or all of the carried interest will be income-based carried interest, taxable as UK trading income at 47% (including a 2% national insurance surcharge).

Investors will not get directly involved in these structural arrangements, but they will expect the appropriate team members to be properly incentivised with carried interest and will understand, or possibly expect, that re-allocations are needed to ensure that the right people are in line for performance-related pay-outs if things go well.

The tax issues are all manageable, but they do need active consideration. Carried interest terms are an important way for the GP to demonstrate commitment to the continuation fund, and ensure alignment of interest with LPs – but tweaking terms and allocations, and requiring reinvestment from team members, will make it vital to think carefully about tax at the structuring stage, and not as an afterthought.

On 19 October 2022, at 5.00pm (GMT), our Sustainability, ESG and Impact team are hosting a webinar for Travers Smith clients on latest developments in European ESG regulation. Please register your interest in attending and we will send full details.

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