S&K Private Equity Year In Review & 2021 Outlook

February 10, 2021


With 2020 in the rear-view mirror, the end of the COVID-19 pandemic in sight and Democrats controlling both the Legislative and Executive branches of government as a backdrop, S&K’s private equity group is focused on the future.

2021 PE Outlook
Within this memorandum, we describe our outlook for 2021 and make some predictions about private equity fundraising, deal flow and tax and regulatory changes, including:

• First-Time Fund Managers Will Make a Comeback
• The Impact of the New Administration on ERISA Issues Will Become Clear.
• Fund Finance Will Continue to be Active.
• The President Biden Tax Plan Would Have a Huge Impact on PE—if it Became Law.
• SPACs Will Continue to Rise.
• Opportunistic M&A will Continue, with Terms Focused on Protecting against Overpayment.
• The Industry Will Begin to Grapple with the New SEC Marketing Rule.

First-Time Fund Managers Will Make a Comeback.
There is no doubt that the COVID-19 pandemic was a particular challenge for first-time PE fund managers. The lack of in-person communication impacted PE investors’ ability conduct traditional due diligence on PE managers. Established relationships with institutional investors were even more important than in prior years given established trust and familiarity investors had with managers with whom they had invested previously. As a result of this inherent fundraising disadvantage, a number of emerging managers planned to wait on the sidelines until in person interactions were again possible. However, as the pandemic continued and remote work became the norm, we began to see investors pivot and entertain the idea of allocations to first time managers. Now, with the production of the COVID-19 vaccines ramping up, we expect to see a surge in first time fund managers deciding that the time is finally right to raise a fund, and equally, interest from LPs for such managers.

The Impact of the New Administration on ERISA Issues Will Become Clear.
From an ERISA perspective, we are keeping our eyes on the following:
• The continuation of the low interest rate environment will have ERISA plans looking to alternative investments for their Fixed Income allocations in 2021.
• The just effective Financial Factors in Selecting Plan Investments regulation will stifle ERISA plan investments in impact funds; however, President Biden’s nominee for Secretary of Labor is Marty Walsh whose background is with organized labor, which historically has pushed for ERISA investments to be able to promote collateral benefits.
• The big ERISA question for 2021 is where ERISA issues fall among the priorities of the Biden administration and the Democratic-controlled Congress.

Fund Finance Will Continue to be Active.
The fund finance industry performed extremely well in 2020 and will continue to grow and expand in 2021.
• In addition to growth in subscription lines, NAV and hybrid facilities will continue to increase in 2021. We would also anticipate that there will be an increase in management company lines, GP-led solutions and ESG linked facilities.
• As the market stabilized more quickly than most expected after the initial COVID related reactions, we believe that some of the documentation tightening and pricing adjustments that we saw in 2020 will relax in 2021.
• We would also expect to see a continued surge in bespoke solutions and financings, as well as increased interest from non-bank lenders, such as insurance companies.

The President Biden Tax Plan Would Have a Huge Impact on PE—if it Became Law.
While it is uncertain what will be legislatively achievable, the President Biden tax plan would have a significant impact on private equity firms, their principals and their portfolio companies. Specifically, the plan includes the following:
• Taxes long-term capital gains and qualified dividends at the ordinary income tax rate of 39.6% on incomes above $1 million and eliminates step-up in basis for capital gains taxation.
• Reverts the top individual income tax rate for taxable incomes above $400,000 from 37% under current law to 39.6% under previous law.
• Increases the corporate income tax rate from 21% to 28%.
• Caps the tax benefit of itemized deductions to 28% of value for those earning more than $400,000, which means that taxpayers earning above that income threshold with tax rates higher than 28% would face limited itemized deductions.
• Imposes a 12.4% Social Security payroll tax on income earned above $400,000, evenly split between employers and employees.
• Restores the Pease limitation on itemized deductions for taxable incomes above $400,000.
• Eliminates certain real estate industry tax provisions.
• Creates a minimum tax on corporations with book profits of $100 million or higher.
• Doubles the tax rate on Global Intangible Low Tax Income (GILTI) earned by foreign subsidiaries of US firms from 10.5% to 21%.
• Phases out the qualified business income deduction (Section 199A) for filers with taxable income above $400,000.
• Imposes a new 10% surtax on corporations that “offshore manufacturing and service jobs to foreign nations in order to sell goods or provide services back to the American market.”
• Establishes an advanceable 10% “Made in America” tax credit for activities that restore production, revitalize existing closed or closing facilities, retool facilities to advance manufacturing employment, or expand manufacturing payroll.

SPACs Will Continue to Rise.
Special purpose acquisition companies (SPACs), also known as “blank check companies,” are currently experiencing a significant resurgence, and many of them have been sponsored by PE managers. SPAC IPO activity in 2020 far exceeded 2019 levels, which itself was a record breaking year for total capital raised. Following the IPO of a SPAC, the SPAC management team has a defined period of time (typically 18 to 24 months) to complete a successful “De-SPAC Transaction.” Given the number of IPOs in 2020, there will inevitably be an increase in the number of De-SPAC Transactions in 2021. Moreover, we would not be surprised if PE managers who have been considering sponsoring a SPAC get off the sidelines and participate in the resurgence in 2021.

SPACs Are Back, Back Again: What You Should Know
To listen to S&K’s podcast titled “The Resurgence of SPACs”, click here.

Opportunistic M&A will Continue, with Terms Focused on Protecting against Overpayment.
The pressure on results of operations – particularly in respect of many consumer goods, industrial, and other non-technology focused businesses – will impact M&A pricing negotiations, with sellers looking for multiples based upon normalized / historical results, and buyers seeking pricing that both takes into account recent COVID impacted results and the related risks in assuming operations and revenue will snap back to historical observations. A traditional way to manage the divergent perceptions and goals informing the resulting bid-ask spread are earnouts, deferrals, and other structured purchase prices that match additional payments with validation of the seller thesis. It is expected that heavily structured purchase prices will continue to be observed in many areas, particularly in those industries whose operations and results were most affected by COVID.

The Industry Will Begin to Grapple with the New SEC Marketing Rule.
The Securities and Exchange Commission (“SEC”) recently adopted amendments to current Rule 206(4)-1 (the “Advertising Rule”) and rescinded Rule 206(4)-3 (the “Cash Solicitation Rule”) under the Investment Advisers Act of 1940, as amended (the “Advisers Act”). The amendments merge the requirements of the Advertising Rule and the Cash Solicitation Rule into new Rule 206(4)-1, which covers investment adviser marketing (the “Marketing Rule”). The Marketing Rule, which applies to SEC-registered investment advisers including PE managers, is designed to modernize the requirements governing adviser advertising and payments to third-party solicitors. The Marketing Rule will not likely take effect until 2022, but it will require such significant changes to a PE manager’s marketing materials and their policies and procedures regarding the same; we expect that many will begin evaluating what steps are needed to comply in 2021.

For more information on the New Investment Adviser Marketing Rule, click here.

If you have any questions regarding the matters covered in this e-mail, please contact  your primary Seward & Kissel attorney.