Private Equity in United States: Market and Regulatory Overview | Practical Law

Private Equity in United States: Market and Regulatory Overview | Practical Law

A Q&A guide to private equity law in the United States.

Private Equity in United States: Market and Regulatory Overview

Practical Law Country Q&A 1-500-5474 (Approx. 21 pages)

Private Equity in United States: Market and Regulatory Overview

by Larry Jordan Rowe and Justin T Kliger*, Ropes & Gray LLP
Law stated as at 01 Jun 2023USA (National/Federal)
A Q&A guide to private equity law in the United States.
The Q&A gives a high-level overview of the key practical issues including the level of activity and recent trends in the market; investment incentives for institutional and private investors; the mechanics involved in establishing a private equity fund; equity and debt finance issues in a private equity transaction; issues surrounding buyouts and the relationship between the portfolio company's managers and the private equity funds; management incentives; and exit routes from investments. Details on national private equity and venture capital associations are also included.

Market Overview

1. What are the current major trends and what is the recent level of activity in the private equity market?

Market Trends

Private equity (PE) fundraising across the private capital markets spectrum slowed in 2022 amid economic volatility following record-breaking amounts of capital being raised and deployed in 2021, and many general partners (GPs) (the PE firm that manages a private equity fund) sought to encourage their existing limited partners (LPs) to support their newest funds in 2022 rather than focusing on new investors.
Deal count is likewise expected to remain relatively slow despite earlier in the year surpassing 2021's record pace. Further slowing the pace of deals is the fact that sellers are resisting reducing the sale price of assets that were valued much higher before the interest rate hikes of three percentage points since March 2022. (Pitchbook Q3 2022 US PE Breakdown).
The market is generally seeing fewer numbers of funds. However the aggregate fundraising target during that time has not dropped linearly with the number of funds: while the collective target was USD884 billion at the start of 2020, it was only down by USD127 billion to USD757 billion by the third quarter of 2021. That reflects record levels of concentration for the past decade, with the 50 largest funds raising 60% of all capital raised in the first nine months of 2021 (2022 Preqin Global Private Equity & Venture Capital Report).
Among the pandemic's many effects may have been a desire for LPs to invest close to home. LP commitments to existing sponsors and new sponsors in their home markets remained strong. In North America in 2022, the number of managers increased 6% to 1,655 despite the fact that the proportion of new managers globally (5%) was down from the 9% long-term average. (2022 Preqin Global Private Equity & Venture Capital Report).


Fundraising had only a minor slowdown from 2021's record numbers. Although high interest rates, the denominator effect resulting from public markets turmoil and LP exhaustion of allocations will likely lead to a slowdown at the end of this year, such market stresses and opportunities may lead to further focus on sponsor-led restructurings to create liquidity opportunities and special opportunity vehicles to take advantage of new opportunities beyond historical investment objectives. (Pitchbook Q3 2022 US PE Breakdown).


The aggregate number of deals closed was expected to decrease by the end of 2022, compared with 2021 numbers, with an estimated 6,530 transactions in 2022 compared with 9,085 in 2021. Although 2022's strong start was tempered later in the year by high interest rates, there was still much dry powder to be deployed. The estimated 2022 deal count still exceeded that of any year, other than 2021, in the last decade. 2022 deal value was, at an estimated USD819.2 billion, highly likely to trail 2021's estimated USD1.234 trillion, but again is, outside of 2021, expected to be the highest of the decade. (Pitchbook Q3 2022 US PE Breakdown).


The median PE buyout valuation-to-EBITDA multiples increased from 12.8x documented in 2020 to 13.7x documented in 2021 (Pitchbook 2021 Annual Private Equity Breakdown.)


Exit activity soared in 2021, with PE firms exiting 1,731 US companies worth USD854.3 billion. Exit activity involving USD1 billion+ transactions more than doubled year over year. The IPO market was the strongest it had been for two decades, and general partner (GP)-led secondaries were similarly robust. That has changed dramatically in 2022 with the drop in public equities cooling off the IPO market, though GP-led secondaries remain a fixture of the market (Pitchbook 2021 Annual Private Equity Breakdown).
2. What are the key differences between private equity and venture capital?
PE funds generally seek to acquire full ownership or at least controlling interests in more mature companies that will be privately held after acquisition.
VC funds, by contrast, generally seek to acquire minority, non-controlling interests in early-stage companies that will be privately held after acquisition. As such, VC funds may more often invest in companies that will need significant additional follow-on capital and have a higher probability of a boom-or-bust outcome. Due in part to regulatory requirements impacting potential exemptions for VC fund advisers described in Question 9, VC funds generally employ minimal or no leverage in connection with investments, in contrast to many PE funds.
Due to the nature and size of the investments, many VC funds expect to invest in entities treated as corporations and as such often offer fewer alternative tax structuring options for their investors.

Funding Sources

3. How do private equity funds typically obtain their funding?
The primary sources of funding for PE funds in the US are:
  • Public pension funds.
  • Endowments/foundations.
  • Funds-of-funds.
  • Sovereign wealth funds.
  • Corporate pension funds.
  • Banks and other financial institutions.
  • Government agencies.
  • Insurance companies.
  • Wealth managers.
  • Family offices.
  • High net worth individuals.
  • Funds-of-funds.
Although pension funds remain a prime source of fundraising for GPs, many US pension funds have struggled to invest in PE in 2022 as public equity prices have fallen, creating more focus by GPs on attracting sovereign wealth funds and other investors.

Tax Incentive Schemes

4. What tax incentive or other schemes exist to encourage investment in unlisted companies? At whom are the incentives or schemes directed? What conditions must be met?
There is generally no available tax incentive or other scheme to encourage investment in unlisted companies.

Fund Structuring

5. What legal structure(s) are most commonly used as a vehicle for private equity funds?
The most commonly used vehicle for PE funds is the Delaware Limited Partnership (DLP), which gives limited liability to the investors who are limited partners in the DLP. The fund's sponsor, or an affiliate, typically acts as the general partner and has unlimited liability for the DLP's obligations.
A Delaware limited liability company (LLC) can be used instead of a DLP. However, the LLC is far less popular. There are disadvantages to using an LLC, particularly for funds that invest outside of the US or which have non-US investors. The two primary drawbacks are:
  • LLCs are not recognised as tax transparent in some jurisdictions.
  • In some jurisdictions, investors and LLCs may have difficulty accessing the benefits of tax treaties.
Both DLPs and LLCs are generally treated as tax transparent for US tax purposes. While every US state can be used as a jurisdiction in which to form a DLP or an LLC, Delaware is generally considered the best choice because of its well-thought out and well-developed statutory regime and, partly because so many fund sponsors choose Delaware, its well-developed body of case law.
Some PE funds, due to the nature of their investors or the focus of the fund's investments, are organised offshore. The Cayman Islands is the most typical offshore jurisdiction for a PE fund with a broad investment mandate. Funds organised in the Cayman Islands generally provide a similar level of limited liability to investors to that provided by a Delaware vehicle. Funds with a narrower geographic focus are often organised in other jurisdictions.
6. Are these structures subject to entity-level taxation, tax exempt or tax transparent (flow-through structures) for domestic and foreign investors?
PE funds in the US (or offshore with a US fund sponsor) are typically treated as partnerships for US tax purposes, regardless of whether they are organised as DLPs or LLCs. The fund itself is then generally not taxed in the US, with the exception in certain instances of taxes resulting from partnership audits. Instead, the fund's income flows through to each investor and is taxable at the investor level. The character of the income also flows through to the investors so that capital gains realised by the fund maintain that character in the investors' hands. The flow-through tax treatment applies to both US and non-US investors. However, other jurisdictions may impose taxes on investors' income and even on the fund itself.
7. What foreign private equity structures are tax-inefficient in your jurisdiction? What alternative structures are typically used in these circumstances?
Almost all non-US entities can elect to be treated as a partnership and to be tax transparent for US tax purposes. In some circumstances, fund sponsors may wish to use a non-tax transparent investment vehicle to allow investors to avoid US filing requirements and tax obligations. If so, the entity itself must make the required US filings and tax payments.

Fund Duration and Investment Objectives

8. What is the average duration of a private equity fund? What are the most common investment objectives of private equity funds?


PE funds generally seek to achieve significant long-term capital gains by acquiring a controlling interest in a number of private investments and then improving the management and operations of those companies. The typical term of a PE fund is ten years (often with a right granted to the sponsor to extend for up to two years).
Capital is drawn down from investors during an investment period of generally three to six years, with an investment period of five or six years being the most common. The manager uses the remainder of the term to increase the value of the portfolio investments and seek exit opportunities. Additional capital can be called down after the investment period to meet any additional capital needs of existing portfolio companies and to pay expenses of the PE fund. Difficult exit environments often result in many fund extensions or restructurings.
Recently, there has been an uptick in sponsors exploring "evergreen" funds or other funds with longer lifespans that would minimise the frequency and/or duration of future capital fundraisers. Although these funds remain a relatively small percentage of the overall market, they may be an attractive option for sponsors, as they can reduce the need for, or otherwise simplify, fundraising for sponsors willing to deal with the added administrative complexity.

Investment Objectives

Funds continue to have broad enabling language to make investments of any type, but coupled with certain investment limitations relating to topics such as concentration, geography and investments in public equities and certain other asset classes that may be overridden by approval of investors and/or advisory committees. Outside of the very large funds raised by established sponsors, PE funds are increasingly targeting a specific industry or set of industries as the primary investment strategy.

Fund Regulation and Licensing

9. Do a private equity fund's promoter, principals and manager require authorisation or other licences?
As a result of the Private Fund Investment Advisers Registration Act of 2010, which was signed into law as part of the Dodd-Frank Act, an investment adviser to a private fund is likely to have to register with the US Securities and Exchange Commission (SEC) (or, where assets under management are less than USD100 million, one or more state regulatory authorities). Certain exemptions exist for venture capital (VC) fund sponsors and sponsors of PE funds who have less than USD150 million in assets under management. Some non-US sponsors with limited presence in the US may be able to use this exemption even if they have more than USD150 million in assets under management in total. Sponsors relying on these exemptions are known as exempt reporting advisers and still have certain reduced filing obligations with the SEC.
Also, if a PE fund trades even one commodity interest contract or holds itself out as being able to do so, the sponsor of the fund will be deemed a commodity pool operator (CPO), and the adviser to the fund will be deemed a commodity trading adviser (CTA). Without an exemption, any CPO or CTA must register with the US Commodity Futures Trading Commission (CFTC) and become a member of the National Futures Association. Many PE and VC funds can rely on the CFTC Rule 4.13(a)(3) "de minimis" exemption by filing an annual notice of exemption with the National Futures Association.
10. Are private equity funds regulated as investment companies or otherwise and, if so, what are the consequences? Are there any exemptions?


Investment Company Status

Any issuer that is engaged in investing or trading in securities is considered an investment company and, as a result, must register as an investment company under the US Investment Company Act of 1940 (Investment Company Act) unless an exception is available.


There are two exceptions to registration as an investment company which PE funds often use:
  • The fund has outstanding securities that are beneficially owned by fewer than 100 persons (section 3(c)(1), Investment Company Act). Various look-through rules apply in calculating whether a fund has 100 investors.
  • The fund has outstanding securities which are owned exclusively by persons who are qualified purchasers at the time of acquisition (section 3(c)(7), Investment Company Act).
Qualified purchasers are:
  • Natural persons, family-owned companies and trusts with at least USD5 million in investments.
  • Companies that own and invest at least USD25 million.
If using the 3(c)(7) registration exemption for funds where all the investors are qualified purchasers, there is no limit on the number of investors that a fund can have, although the Securities Exchange Act of 1934 requires registration for any class of securities held by 2,000 persons in total or 500 persons who are not accredited investors.
In addition, an issuer engaged in a public offering must register the offering.

Registration of Securities Issuance

If the securities are offered by an issuer in a transaction that does not involve any public offering, there is no need to register. In general, to qualify as a non-public offering under the safe harbour of Regulation D:
  • The offering must be private and must not involve a general solicitation.
  • The issuer must have a substantive relationship with each prospective investor before the offering and must have knowledge of an investor's suitability to purchase interests in the private offering.
  • There cannot be any advertisement, article or notice, or any communication in any newspaper, magazine or similar media or any radio and television broadcast, that has the purpose or effect of offering or selling the fund.
  • The purchasers of securities generally must be accredited investors, with no more than 35 non-accredited investors purchasing securities in the offering.
Issuers must also take precautions regarding their websites. Issuers should restrict internet pages that provide access to private offerings of securities to prospective investors.
The concerns regarding general solicitation do not apply to offerings relying on Rule 506(c) of Regulation D. Under Rule 506(c), a transaction may qualify as a non-public offering even if the issuer engages in "general solicitation" and "general advertising".
An offering can maintain the exemption under Rule 506(c) so long as all the following conditions are satisfied:
  • The issuer takes reasonable steps to verify that the purchasers of the securities are accredited investors.
  • All purchasers of securities are accredited investors, either because they come within one of the enumerated categories of persons that qualify as accredited investors or because the issuer reasonably believes that they do at the time of the sale of securities.
  • The integration and resale restriction terms of Rules 501, 502(a) and 502(d) are satisfied.
However, such general solicitation may affect other exemptions applicable to the fund or its sponsor.
Because of the 2013 "bad actor" amendments to Rule 506, an offering involving "felons" or "bad actors" cannot rely on Rule 506 for exemption from registration.
11. Are there any restrictions on non-US investors in private equity funds?
There are special rules limiting non-US investors' involvement in obtaining oil and natural gas leases from the US Government, which may impact non-US investors wishing to invest in funds with such a focus.
Additionally, increased scrutiny from the Committee on Foreign Investment in the US may lead some funds to restrict certain governance rights of certain non-US investors in those funds. However, generally funds are not completely restricting investments by non-US investors in such funds.
12. Are there any statutory or other maximum or minimum investment periods, amounts or transfers of investments in private equity funds?
There are no statutorily prescribed maximum or minimum investment periods. Depending on the nature of the PE fund, investment periods generally range from three to six years, with five or six years being by far the most common. Depending on macro-economic situations, funds may have a difficult time deploying capital and, as a result, may seek extensions of investment periods from their investors. This can generally be accomplished with an investor vote.
Alternatively, funds may deploy capital very quickly and may end the investment period early to begin fundraising for a successor fund.
There are no statutory limits on investment transfer amounts. However, if fund interests are transferred to investors who do not meet statutorily prescribed conditions for a registration exemption, that exemption may be lost. In addition, in certain cases the flow-through tax treatment of the fund vehicle may be lost if, as a result of transfers, the fund is considered a publicly traded partnership. Fund sponsors must be careful to ensure that fund interests are not transferred so as to cause these types of problems. As a result, fund documents usually prohibit transfers without the consent of the fund sponsor and generally require a number of conditions to be met to permit a transfer.
To avoid regulation under the Employee Retirement Income Security Act of 1974, fund sponsors may also need to limit the number of pension plan and similar types of investors in the fund and therefore typically control transfers to these types of investors.
Concerns about creditworthiness and money laundering also generally cause fund sponsors to perform due diligence on each new investor in a fund, similar to the type of diligence performed on the initial investors in the fund.
13. How is the relationship between the investor and the fund governed? What protections do investors in the fund typically seek?
In the typical PE fund, the fund sponsor or its affiliate serves as general partner or managing member and, in that capacity, controls almost all activities of the fund. Investors are generally not involved in the operations of the fund. Some of the more common protections investors seek are:
  • Inclusion of an advisory committee made up of representatives of investors, whose approval is required for certain conflicts of interest, valuations and other matters.
  • Investment parameters which cannot be exceeded without investor (or sometimes advisory committee) approval.
  • The ability to remove the general partner (or managing member) for cause or sometimes even without cause.
  • The ability to terminate the fund for cause or without cause.
  • The ability to terminate the investment period early, if the key persons running the fund are no longer devoting sufficient time to the fund or for other causes.
The investor vote required to remove the general partner or terminate the fund or the investment period without cause may be as high as 85% to 90%, but is more commonly 75% to 80%.
Investors also often seek more detailed reporting and notices to obtain comfort through receipt of disclosure and relying on such disclosure to moderate sponsor decision-making where governance protections are limited.

Interests in Portfolio Companies

14. What forms of equity and debt interest are commonly taken by a private equity fund in a portfolio company? Are there any restrictions on the issue or transfer of shares by law? Do any withholding taxes or capital gains taxes apply?

Most Common Form

PE funds commonly take an interest in a portfolio company that provides for a threshold financial return that the portfolio company must achieve for the holders of residual interests to obtain any benefit from their interests in the portfolio company. This often takes the form of convertible preferred stock, in which the preferred stock has a set dividend and liquidation preference that must be returned to the holders of the preferred shares before the holders of common shares receive anything. The convertible preferred shares convert into common shares at specified ratios, allowing the holders of the preferred shares to obtain ownership interest in the common shares if they wish to do so.

Other Forms

Variants of this include combinations of two (or more) types of interests, for example:
  • Notes and warrants to obtain common stock.
  • Non-convertible preferred stock and common stock issued together.
  • Non-convertible preferred stock issued with warrants.


There are generally legal restrictions on the transfer of any of these securities, as well as in certain instances extensive contractual restrictions on the ability to transfer interests in a portfolio company. Typically, these securities cannot be marketed or sold publicly without the portfolio company first registering the securities with the US Securities and Exchange Commission (SEC). However, PE funds may often sell the securities they hold in a portfolio company to other sophisticated buyers under applicable transaction exemptions.


Depending on the facts and circumstances of a particular portfolio company investment, US or non-US withholding taxes and/or capital gains taxes may apply. The applicability of such taxes depends on a number of factors, including:
  • The jurisdiction in which the investment is made.
  • The manner of exit from the investment.
  • Whether gains are derived from current income or on sale of the asset.
  • The use of holding companies.
  • The availability of tax treaties.
  • The tax characteristics of the ultimate beneficial owners.
  • Whether an applicable taxing authority taxes indirect transfers, which is more regularly a concern in the People's Republic of China and in India.
For many investments in portfolio companies, structuring alternatives may be available to partially mitigate the applicability or amount of capital gains tax and/or withholding tax.


15. Is it common for buyouts of private companies to take place by auction? Which legislation and rules apply?
Buyouts of private companies commonly take place by auction. A financial adviser is often engaged by the seller to manage the auction process. The financial adviser seeks to narrow the number of potential bidders to a limited number of likely buyers. This group of potential buyers is then asked to submit final bids. The seller may enter negotiations with one or more of them. There is no legislation that generally governs sales of private companies other than anti-fraud and anti-trust rules. Certain industries or sectors may have specific rules relating to ownership of assets or companies, including private companies, in the applicable industry or sector.
16. Are buyouts of listed companies (public-to-private transactions) common? Which legislation and rules apply?
Buyouts of listed companies (public to private transactions) are common.
A public-to-private transaction requires compliance with a number of Securities Act rules including those governing proxy contests or tender offers (depending on the method used for the acquisition) and disclosure rules. If the target company is established in Delaware (which is common), or in states which follow Delaware common law, and the target's directors determine it is in the best interests of the company to be sold, the directors may have a fiduciary duty in certain instances to obtain the best price for the target company. As a result, targets seek and generally obtain the ability to terminate acquisition agreements if they receive a superior offer (at the cost of paying a break fee).
Care must also be taken to follow process-related requirements, created by both statute and case law (for example, providing the required notice to shareholders and complying with charter and bye-law provisions).
Target companies must also adhere to the rules of the exchanges they are listed on, although these generally do not pose much of a problem if other legal and regulatory requirements are being met.
There are two principal forms an acquisition of a US public company can take:
  • A one-step transaction, involving a proxy solicitation and a vote of the target's shareholders to approve the merger, which then takes place after the solicitation and vote.
  • A two-step transaction, involving a tender offer by the buyer, followed by a merger after the buyer acquires voting control of the target's stock directly from its shareholders in the tender offer.
One-step transactions can take a great deal longer than two-step transactions. Historically, one-step transactions have been PE sponsors' preferred route, despite the additional amount of time they involve. More recently there has been an increased use of two-step transactions involving a tender offer.

Principal Documentation

17. What are the principal documents produced in a buyout?
Regardless of whether a public to private acquisition is one-step or two-step, the principal agreement is a merger agreement between the target company and the acquisition entities formed by the PE sponsor. The merger agreement is necessary because it is almost impossible to locate every single shareholder in a public company, and the merger agreement eliminates the need to do so.
In a private acquisition, the principal agreement is one of the following:
  • A merger agreement.
  • An equity purchase agreement.
  • An asset purchase agreement.
The type of agreement depends on the transaction structure, which depends on numerous factors. In a private acquisition, there may be additional agreements between the seller(s) and the PE sponsor dealing with ancillary matters such as real estate leases, escrow arrangements, transition of services and so on.
The acquisition entity, the PE sponsor's fund and/or the management team may, in connection with the agreements for acquisition and funding of the acquisition entity, enter into other agreements, including:
  • Equity commitment letters.
  • Debt commitment agreements.
  • Guarantees.
  • Subscription agreements.
  • Equity contribution agreements.
  • Shareholders' agreements.
  • Registration rights agreements.
  • Employment agreements.
  • Non-competition agreements.
PE sponsors generally provide the seller with an equity commitment letter from the relevant fund. The equity commitment letter is the fund's binding commitment to provide the equity capital to the acquisition entity. Alternatively, a seller may insist on a direct guarantee from the PE fund. If the sponsor has agreed to a no-financing condition transaction (see Question 18), the guarantee also ensures that the seller can collect the reverse break fee in the event of a triggering termination event.

Buyer Protection

18. What forms of contractual buyer protection do private equity funds commonly request from sellers and/or management? Are these contractual protections different for buyouts of listed companies (public-to-private transactions)?
Buyer protections in a private acquisition generally include:
  • Representations and warranties. Buyers typically obtain representations and warranties from the seller covering both the entity or assets being sold and the ability to sell them.
  • Interim operating covenants. Buyers typically require covenants from the seller requiring the seller to, between signing and closing:
    • operate the business as usual; and
    • not enter into certain transactions without the buyer's consent.
  • Closing conditions. Buyers also typically obtain closing conditions, including:
    • receipt of required governmental and third-party consents by the seller;
    • no material adverse change in the target entity;
    • receipt of buyer's debt financing;
    • compliance with covenants by the seller; or
    • a bring-down of seller's representations and warranties.
  • Post-closing indemnification provisions. The seller must usually indemnify the buyer for breaches of the seller's representations, warranties and covenants. This may also include specific indemnities for pre-closing taxes, known environmental issues and other matters. Sellers typically require buyers to agree to a basket cap, so that small amounts are not indemnified, and a cap on potential indemnity claims. There is also typically a reasonable survival period, during which the buyer can bring an indemnification claim post-closing. Indemnification baskets, caps and the corresponding survival periods are usually highly negotiated.
Typically, a PE sponsor does not seek any special protections from the target's management team. If the target's management team is selling equity in the transaction, members of the team normally share pro rata in any post-closing indemnification obligation and escrow hold-back.
PE funds' obligations to close are sometimes not subject to their receipt of debt financing. In exchange, funds negotiate for a cap on the total damages payable to the seller if they fail to close due to a failure to receive their debt financing or for any other reason. The cap typically takes the form of a reverse break fee payable by the fund. These reverse break fees are typically a small percentage (2% to 3.5%) of the total transaction value, or may be slightly more if the sponsor fails to close for any reason other than a failure to obtain debt financing. In these deals it is common to have provisions barring sellers from being able to seek specific performance to force the closing, even if all conditions to the buyer's obligations to close the deal have been satisfied.
In a public to private transaction, there is typically no post-closing indemnification or other post-closing protections, so buyers rely on interim operating covenants and the no-material-adverse-change closing condition as their key protections.
19. What non-contractual duties do the portfolio company managers owe and to whom?
The principal non-contractual duty that portfolio company managers owe the target company is the common law duty of good faith and loyalty. This duty of loyalty prohibits management from disadvantaging the company for their own benefit or pursuing company opportunities for themselves. The duty of loyalty generally requires disclosure to the board of directors once an opportunity involving the target company presents itself. Management representatives on the board of directors usually withdraw from board deliberations concerning these opportunities to avoid conflict of interest.
20. What terms of employment are typically imposed on management by the private equity investor in an MBO?
Beyond typical employment terms such as title, term, compensation (including incentive compensation), benefits, termination and severance, the most important employment terms typically imposed on management by a PE sponsor are non-competition, non-solicitation and confidentiality terms.
State law governs employment contracts and so the enforceability of non-competition clauses can vary widely from state to state. Most states will enforce a non-competition clause that is reasonable in scope (considering restrictions on types of employment, geography and duration), although some states (such as California) will not enforce non-competition clauses due to them being against public policy.
Non-solicitation clauses typically cover employees, customers and suppliers. The scope of these clauses often does not extend to general solicitations through mass-media that are not targeted at any particular person or group.
Confidentiality obligations are typically broadly drafted, although they may be constrained by certain regulatory requirements such as in relation to laws and rules protecting whistleblowers.
21. What measures are commonly used to give a private equity fund a level of management control over the activities of the portfolio company? Are such protections more likely to be given in the shareholders' agreement or company governance documents?
In a single sponsor transaction, the PE sponsor typically controls all the fully diluted equity of the company other than that owned by management (usually 10% to 20%). As a result, the sponsor has both voting and economic control over the business.
The PE sponsor and the other equity holders generally enter into a shareholders agreement that gives the sponsor the right to nominate a majority of the company's directors, and includes a voting provision under which all parties to the agreement agree to vote in favour of the sponsor's board nominees. Shareholders' agreements also usually contain provisions, such as drag-along rights, that give the sponsor control over exit transactions.
In consortium transactions, or in a transaction where there are one or more significant minority investors, the shareholders' agreement may include provisions requiring a super-majority vote that gives the minority a veto over certain fundamental transactions, such as financings, significant add-on acquisitions, sales of significant assets and exit transactions. In consortium transactions there is often also a desire to place such voting provisions and the provisions relating to the nomination and election of directors in the company charter, which is often more difficult to amend than a shareholders' agreement.

Debt Financing

22. What percentage of finance is typically provided by debt and what form does that debt financing usually take?
The percentage of financing typically provided by debt depends on the size of the transaction and how much debt can be obtained under prevailing market conditions.
The fundamental different types of debt financing used in buyout transactions are:
  • Senior secured first and/or second lien financings.
  • Subordinated mezzanine financings.
  • Senior secured bonds.
  • Unsecured senior or subordinated bonds.
  • Convertible and other hybrid debt financings.
A senior secured financing is senior to the borrower's other debt and a significant portion of the borrower's assets serve as collateral. Such financings consist of one or more term loan facilities that are used to finance the acquisition and a revolving credit facility that is used for working capital. The extent to which these types of debt are used depends on:
  • Availability.
  • The size of the overall financing.
  • The costs of each type of financing.
  • The fund sponsor's preferences among the types of debt financing available.

Lender Protection

23. What forms of protection do debt providers typically use to protect their investments?


Debt providers typically protect their investments by obtaining security interests in the borrower's assets and by obtaining guarantees from the borrower's subsidiaries, secured by the relevant subsidiaries' assets.
There are a number of contractual and structural mechanisms that are also used by debt providers. Debt providers can contract with each other to subordinate one class of creditors to another class. The two groups can agree that one group will not have any rights in an insolvency proceeding until the other class of creditors has been repaid in full.
Debt providers can also obtain structural seniority by extending debt to an operating company subsidiary of a holding company, rather than to the holding company itself. Lenders at the operating level are repaid before creditors with a claim at the holding company level, because the operating company subsidiary must satisfy all of its debt claims in an insolvency proceeding before the holding company receives whatever value is left as a result of its holding equity in the subsidiary.

Contractual and Structural Mechanisms

Contractual covenants also provide lenders with some protection. Such covenants can include obligations to maintain the financial health of the borrower as well as other negative and affirmative covenants. Lenders can also be protected by keep-well arrangements under which fund sponsors agree to provide the borrower with capital in certain situations.

Financial Assistance

24. Are there rules preventing a company from giving financial assistance for the purpose of assisting a purchase of shares in the company? If so, how does this affect the ability of a target company in a buyout to give security to lenders? Are there any exemptions?
There is no prohibition on a company giving financial assistance in connection with the purchase of its own shares. Courts can void guarantees and security given by a target company if a fraudulent transfer has occurred (such as a transfer of assets when the transferor is insolvent). Creditors in leveraged buyout transactions often rely on the guarantee provided by the acquiring fund that the borrower and its subsidiaries will be solvent after the buyout transaction, including any debt resulting from the transaction and the provision of any guarantees and security.

Insolvent Liquidation

25. What is the order of priority on insolvent liquidation?
Most portfolio companies in need of bankruptcy relief use the provisions of Chapter 11 of the Bankruptcy Code, regardless of whether the goal of the proceedings is the liquidation of the business or the reorganisation of the business as a going concern.
The statutory priorities for repayment are:
  • Secured claims, to the extent of the value of the underlying collateral.
  • Administrative claims (generally, claims that arise after a bankruptcy is commenced and before the effective date of the plan of reorganisation).
  • Priority claims (for example, certain claims for unpaid wages and taxes).
  • General unsecured claims.
  • Equity.
A senior secured creditor with liens on a material portion of a debtor's assets may agree to be effectively subordinated to the payment of a predetermined portion of administrative and priority claims, as the price of liquidating through Chapter 11. This is because a Chapter 11 liquidation can be more advantageous for the senior secured creditor than simply foreclosing on its collateral.
In a bankruptcy proceeding, the rights of any single holder, including rights relating to priorities of distribution, can be waived by an affirmative vote of a majority of holders (that is, two-thirds in amount and one-half in number) within the same class. Inter-creditor and subordination agreements are enforceable in a Chapter 11 proceeding to the same extent as outside of bankruptcy.
A court can also subordinate one creditor's claim to another creditor's claim (or the claims of all other creditors) if it is shown that the creditor has engaged in inequitable conduct (for example, fraud or breach of fiduciary duties) that resulted in an injury or disadvantage to the other creditor(s). If so, the subordinated claim is treated as lower in priority than the claim to which it is subordinated, but the subordination does not affect its treatment in relation to any other claim or to equity.
Additionally, a court will look past the form of debt to determine its substance and may recharacterise debt as equity (and treat it as lower in priority than all claims) if this is determined to be the economic substance of the transaction.

Equity Appreciation

26. Can a debt holder achieve equity appreciation through conversion features such as rights, warrants or options?
It is possible for a debt holder to participate in the appreciation of equity value through convertible securities such as rights, warrants or options, but it is not very common in US buyout transactions. Debt holders generally do not participate in the equity in large transactions. In small and middle-market transactions, it is common for mezzanine lenders and hedge funds to invest alongside the equity participants in the equity rather than receiving warrants or other convertible securities, although in some transactions, share purchase warrants are a part of the overall financing provided by the debt holders.

Portfolio Company Management

27. What management incentives are most commonly used to encourage portfolio company management to produce healthy income returns and facilitate a successful exit from a private equity transaction?
The most common management incentives used to encourage portfolio company management are:
  • Share options.
  • Restricted shares.
  • Other share-based awards.
  • A combination of these.
In small and middle-market transactions, incentive plans commonly account for 10% to 15% of the fully diluted equity. Incentive plans are relatively smaller in larger transactions and commonly account for between 5% and 10% of the fully diluted equity. Incentive awards are usually subject to both time-based vesting (for at least some portion of the awards) and performance-based vesting. Performance-based vesting is usually based on the sponsor's return on its investment.
Restricted stock is sometimes used to allow the recipient to gain favourable tax treatment by electing to be taxed on the fair market value of the common share grant at the time of grant and to pay income taxes at ordinary income rates, with appreciation generally taxed at capital gain rates on realisation.
Senior managers may also be required to invest in the transaction, either through a direct cash investment or through the rollover of their current equity holdings in the target company. The structure, nature and amount of such required investment depends on individual circumstances. Sponsors generally work with managers to try to design equity rollovers in a tax-efficient manner.
28. Are any tax reliefs or incentives available to portfolio company managers investing in their company?
Corporations can offer incentive share options (ISOs). ISOs are taxed at capital gains rates when the shares are sold if certain requirements are met. No tax is due when they are exercised and therefore the issuer is not entitled to a tax deduction. To achieve capital gains treatment, the shares must be held for both:
  • Two years following the ISO's grant date.
  • One year after the ISO is exercised by the manager.
Companies are limited in the amount of ISOs they can grant and as a result ISOs are not widely used.
Portfolio companies that are operated in a pass-through form can grant managers profits interests in exchange for performing services for the company. These profits interests generally represent the right to a share of the venture's future profits and are treated as capital gains at the level of the manager, to the extent that the underlying income is a capital gain. This differs from ordinary income from the exercise of non-qualified share options or the vesting of restricted shares without a section 83(b) election. When the portfolio company is sold, the gain is typically treated as capital gains at the level of the manager.
Bills have been introduced in Congress several times over the last few years that propose to tax the carried interest earned by managers of PE and hedge funds at ordinary income rates (they currently receive capital gains treatment). The Tax Cuts and Jobs Act of 2017 imposed a three-year holding period requirement to tax carried interest at more favourable long-term capital gain rates.
29. Are there any restrictions on dividends, interest payments and other payments by a portfolio company to its investors?
As long as the dividend payments are in accordance with the portfolio company's charter and contractual obligations, the payment of dividends by a solvent company is generally unrestricted. State laws generally prohibit the payment of dividends by a company that is a going concern if after giving effect to the distribution, the company would not be able to pay its existing and reasonably foreseeable debts, obligations and liabilities.
30. What anti-corruption/anti-bribery protections are typically included in investment documents? What local law penalties apply to fund executives who are directors if the portfolio company or its agents are found guilty under applicable anti-corruption or anti-bribery laws?


Investment documents may include protections regarding the Foreign Corrupt Practices Act (FCPA). The FCPA generally prohibits fund executives from offering or giving bribes to a "foreign official", "foreign political party or party official", or any candidate for foreign political office, to obtain or retain business opportunities. The FCPA generally applies to:
  • US persons, including US companies, controlled subsidiaries and affiliates of US companies, and citizens, nationals and residents of the US, wherever located.
  • In certain circumstances, non-US persons, including non-US companies and non-US citizens outside the US.


The US Department of Justice (DOJ) and the US Securities and Exchange Commission (SEC) both enforce the FCPA. Violators of the FCPA may be subject to both criminal and civil penalties.
In criminal cases, firms are subject to a fine of up to USD2 million per violation of the anti-bribery provisions. Individuals are subject to a fine of up to USD100,000 and/or imprisonment for up to five years, per violation. However, under the Alternative Fines Act, the fines imposed on firms and individuals can be much higher: the actual fine can be up to twice the benefit that the defendant sought to obtain by making the corrupt payment.
In civil actions, a fine of USD10,000 can be assessed for each act committed in furtherance of the offence, potentially making the total fine greater than USD10,000. Fines imposed on individuals must not be paid by their employer or principal. In addition, persons or firms found in violation of the FCPA can be barred from doing business with the US Government and can be ruled ineligible for export licences.
Investment documents may also include protections from the UK Bribery Act (Bribery Act). The Bribery Act is similar to the FCPA, which criminalises the payment of bribes to foreign officials. However, the Bribery Act is more expansive in three ways:
  • It imposes a strict liability criminal offence that applies to any company with ties to the UK that fails to prevent an associated person (that is, anyone performing services on the company's behalf) from paying a bribe. The only defence to liability is if the company can prove that it had adequate procedures in place to prevent the bribery from occurring.
  • It does not contain any exceptions for facilitation payments or relatively insubstantial payments made to facilitate or expedite routine governmental action.
  • It criminalises purely commercial bribery that is unconnected to any public or governmental official, unlike the FCPA.
Additionally, investment documents may include protections regarding the OECD Convention on Combating Bribery of Foreign Public Officials in International Business Transactions (Convention). The Convention applies to the bribing of foreign public officials. The Convention applies irrespective of, among other things:
  • The value of the advantage and its results.
  • Perception of local custom.
  • Local authorities' tolerance of these payments.
  • The alleged necessity of the payment in order to obtain or retain business or other improper advantage.
The convention applies as soon as an offer or promise is made, whether directly or through intermediaries, and applies even in cases of a third party beneficiary. Penalties are specified by each country but are comparable to FCPA penalties. Many countries specify unlimited fines and ten years' imprisonment.

Exit Strategies

31. What forms of exit are typically used to realise a private equity fund's investment in a successful company? What are the relative advantages and disadvantages of each?

Forms of Exit

The three most common forms of exit used to realise a PE fund's investment in a successful company are the:
  • Sale to a financial buyer such as another PE fund.
  • Sale to a strategic buyer.
  • Initial public offering (IPO).
Sales to financial buyers or strategic buyers can take the form of either a sale of the company or of assets. It is also possible to have a carve-out sale in which a portion of a successful company is sold or even, on rare occasions, brought public.
Private sales, whether to financial or strategic buyers, are significantly more common than IPOs. The viability of an IPO depends to a great extent on market conditions.

Advantages and Disadvantages

The advantage of an IPO is that it is possible to realise significantly greater value in the long term. However, in most IPOs the fund sponsor does not sell most (or any) of its shares. Instead, newly issued shares are sold to the public. As a result, even with a successful IPO, the fund sponsor still has market risk in relation to its shares in the company, as well as the continued business risk of operating the portfolio company.
Although greater value may be realised over the long term from an IPO, the private sale is by far the more common exit strategy. The advantage of a private sale is that the PE fund sponsor realises all the value of the sale immediately and no longer has to deal with either business or market risk in relation to its investment.
Sales to other PE fund sponsors remain a particularly common form of exit. From a fund investor perspective, a sale to another PE fund may mean there is no exit at all if the investor is also invested in the acquiring fund.
32. What forms of exit are typically used to end the private equity fund's investment in an unsuccessful/distressed company? What are the relative advantages and disadvantages of each?

Forms of Exit

The two primary forms of exit used to end a PE or VC fund's investment in an unsuccessful company are to sell the company (an asset or a stock sale) where the equity holders do not receive anything, or to enter into voluntary bankruptcy.

Advantages and Disadvantages

The bankruptcy procedure is preferred because the buyer gets clean title to all the assets and the seller is assured of having no remaining liabilities. In a sale of the company outside of bankruptcy, no matter how strong the contractual arrangements may be, the seller is always left with the possibility that liabilities may remain its responsibility.
In a voluntary bankruptcy, the portfolio company can sell all or substantially all of its assets with court approval. It is unusual for such sales to result in any proceeds being paid to the equity holders, and some classes of creditor may also receive proceeds equalling only a small percentage of their claims.


33. What recent reforms or proposals for reform affect private equity?

New SEC Chair and Increased Regulatory Activity

Gary Gensler was confirmed in February 2021 as the SEC's new chair and has ushered in an increase in enforcement activity.
In March 2022, the SEC proposed a broad set of rules governing special purpose acquisition companies (SPACs) which would expand the list of activities that could be considered underwriting activities. The rules also contain significantly increased disclosure requirements, including as to SPAC sponsors' identity, potential conflicts of interests and projections of future performance. In any event, the SPAC market boom of 2020 and 2021 had already significantly cooled in 2022.
The SEC has additionally focused its attention on enhancing environmental, social and governance (ESG) disclosure by advisers, in particular by attempting to make claims about ESG more qualitatively meaningful to investors.
The SEC is focused on making sure investment managers do what they say they are going to do, in particular by testing GPs' activities against the statements they make in their disclosures to protect against "green-washing." The SEC underscored its commitment to its rigorous ESG approach by fining BNY Mellon Investment Adviser Inc USD1.5 million for failing to engage in proprietary ESG reviews the adviser claimed it had implemented, when in fact not all of its funds were subjected to such reviews.

New Marketing Rule

The compliance date for the SEC's new Rule 206(4)-1 (New Marketing Rule) finally arrived on 4 November 2022. The New Marketing Rule codifies a number of prior SEC positions and adds some additional new requirements.
The New Marketing Rule expressly prohibits advertisements that include a "material statement of fact" that the adviser does not have a reasonable basis for believing it will be able to substantiate. The SEC issued a risk alert on 19 September 2022 to emphasise that it will review during its routine exams whether investment advisers have a reasonable basis for believing they will be able to substantiate material statements of fact in advertisements.
Types of advertising statements specifically prohibited by the New Marketing Rule includes, among others, hypothetical performance, unless the adviser:
  • Adopts and implements policies and procedures reasonably designed to ensure that the performance is relevant to the likely financial situation and investment objectives of the intended audience.
  • Provides certain additional information.
Advertising gross performance (the return before expenses or any deductions) is also now expressly prohibited unless accompanied by net performance. Additionally relevant to private funds is that placement agent relationship are now subject to the New Marketing Rule, particularly any statements that would be considered endorsements of a private fund sponsor.

Record-Keeping Rule Updates

In connection with the New Marketing Rule, the SEC amended Advisers Act Rule 204-2 (required books and records) to require investment advisers to create and keep certain records (such as records of all advertisements they disseminate, including certain internal working papers, performance-related information, and documentation for oral advertisements, testimonials and endorsements). The SEC reviews SEC-registered private fund advisers for compliance with these record-keeping requirements.

Proposed Private Fund Rules

On 26 January 2022, the SEC proposed new rules and amendments that could fundamentally change various aspects of private funds in the US. At the time of publication, industry participants are expecting the SEC to adopt a significant percentage of such rules in the relatively near term, and private fund sponsors should be prepared for potential changes.
The rules, if adopted in their proposed form, would for the first time regulate the content of contracts between private fund advisers and private fund investors.
For example:
  • Certain indemnification standards could not be waived.
  • Certain regulatory expenses could not be charged to a fund or its investors.
  • Loans from affiliates could not be made to the fund.
  • Obligations to return excess carried interest could no longer be reduced by taxes.
Certain other common industry practices, such as acceleration of monitoring fees charged to portfolio companies would also be prohibited.
Side letters, which are a common feature of today's private fund landscape, would be impacted by limitations on preferential treatment with respect to certain issues such as liquidity and portfolio information and required disclosure with respect to any other preferential treatment.
Additional reporting requirements would also be put in place, including:
  • an obligation to distribute quarterly statements within 45 days after each calendar quarter end.
  • the format and content of such statements would be regulated to provide greater uniformity.
If adopted in their current form, these rules could apply both to existing funds and newly raised funds. For now, industry participants are generally waiting to see what final rules, if any, will be promulgated.

COVID-19 Impact

Although deal flow dropped in the early months of the COVID-19 outbreak, it came roaring back at the end of 2020 and remained vigorous in 2021 and into early 2022. The pandemic skewed buyout activity towards deals in the technology, life sciences and healthcare sectors, with a focus on assets that provide downside risk protection as well as growth potential. COVID-19 had at least a temporarily uneven impact on different industries, with valuations for companies in travel, hospitality, and leisure falling during the height of the pandemic, and remote learning, telehealth, and similar companies experiencing skyrocketing valuations.
Fundraising saw similar trends of early disruption in March 2020, and slowdown followed shortly thereafter by a record high fundraising environment. Long-term effects remain uncertain.

Contributor Profiles

Larry Jordan Rowe


Ropes & Gray LLP

T +1 617 951 7407 
E [email protected]
Professional qualifications. Massachusetts, US
Areas of practice. Private investment funds; hedge funds; investment management; investment advisers; private equity transactions.

Justin T. Kliger


Ropes and Gray LLP

T +1 617 951 7197 
E [email protected]
Professional qualifications. Massachusetts, US
Areas of practice. Private investment funds; hedge funds; investment management; investment advisers.
*the authors would like to thank Debbie McElwaine for her contribution to this article.