Private equity fund economics in Canada: An overview of the essentials

December 12, 2014

Download this publication

Private equity fund economics play an important role in attracting investors to a given fund. Indeed, investors want to know how expenses will be shared, what fees are applicable and how profits will be allocated. The summary below provides a brief overview of the most common fund arrangements with respect to such considerations. That being said, no two funds are the same and a fund’s organizational documents can be tailored to take into account a wide array of particularities unique to a given fund.

CONTRIBUTIONS, DISTRIBUTIONS AND ALLOCATIONS
THE GENERAL PARTNER CONTRIBUTION

Investors expect that either the private equity fund sponsor¹ (the “General Partner”) or one of its affiliates will have a vested interest in the success of the fund. In most cases, investors expect that the General Partner, its affiliates or key executives will make an investment representing anywhere between 1% to 5% of the total capital contributions made by investors. This contribution is significant to investors as it ensures that the interests of the fund’s management team are aligned with their own and also reduces the incentive for the General Partner to incur excessive risk in an attempt to generate greater returns for itself. This is one reason why the Institutional Limited Partners Association recommends that the General Partner itself be required to make a financial contribution to the capital of the private equity fund².

DISTRIBUTION WATERFALLS AND PROFIT-TAKING

A fund’s basic economic structure will most often be set out in the “distribution waterfall” — a mechanism which dictates how profits are to be allocated and in what priority such payouts will be made. All distributions made are net of any fund expenses, liabilities and cash reserves and are done on a pro rata share basis among the investors according to their respective capital contributions to a given investment. Each tier must be satisfied in full before proceeding to the next priority tier.

The following is an example of a basic distribution waterfall that a fund may have in place:

First Tier:
Return of Capital Contribution to Investors
The first distribution provides that investors are entitled to recuperate any capital contributed with respect to a given investment before any other distributions may be made.
Second Tier:
Preferred Return to Investors
The next distribution also flows to investors until they have received an amount equal to the preferred return on their capital contributions. The preferred return, often referred to as the “hurdle rate” with respect to the investment in the fund, provides investors with a determined rate of return (often between 5% and 9% on any capital contributed by an investor to a given investment) before the General Partner is entitled to receive any of the proceeds of the fund’s investments.
Third Tier:
Catch-up Tier
Once investors have seen their capital contributions repaid and their preferred return paid out, the General Partner will benefit from a “catch-up” tier. At this stage, the General Partner will be entitled to share in the profits generated by the fund until it has received an amount equal to the carried interest split (discussed below) it would have otherwise been entitled to as part of the first and second tiers.
Fourth Tier:
Carried Interest Split
The fourth tier entitles both investors and the General Partner to receive fund profits. At this stage, the investors and the General Partner split the pool of any remaining distribution funds payable according to the carried interest split stipulated in the fund’s operating agreement (an 80/20 carried interest split whereby investors receive 80% of the distribution payable and the General Partner receives 20% is commonplace, although this range may vary significantly depending on market conditions and industry standards).

CLAWBACK

A fund’s operating agreement may also include a “clawback” provision relating to the General Partner’s carried interest. Such a provision, which may include a built-in escrow procedure, serves as an adjustment mechanism which requires the General Partner to hold back a certain percentage of its carried interest profit participation to guard against overpayment in the event that any given investment does not prove to be profitable. For example, a clawback may be triggered when, upon calculating the fund’s aggregate returns from any such given investment, the investors have been distributed an amount of the profits that is less than the hurdle rate. In such instances, the General Partner will have to return any excess profits to the fund for re-distribution to investors.

FUND FEES AND EXPENSES
MANAGEMENT FEES

In connection with the establishment of a private equity fund, the General Partner will often either create an affiliated entity or appoint a third-party investment adviser or management company to provide investment advice with respect to the management of the fund. Such arrangements can be crystallized in the form of an advertisement advisory agreement or management services agreement, which will describe exactly which duties and responsibilities are delegated to the appointed entity.

The General Partner, or any manager or investment adviser appointed to act on behalf of the fund, will generally receive a management fee based on the aggregate capital committed to the fund (typically about 2%). Occasionally, the management fee will contain two components: one that is based on the capital committed but not yet invested, and the other that is based on the capital that has been invested by the fund. However, it is not uncommon to see a “flat” fee applied to all aggregate committed capital. The management fee is used by the General Partner (or any appointed entity) to employ investment professionals, cover costs associated with the daily functioning of the fund and evaluate potential investment opportunities. Such fees and expenses are borne by the fund (and therefore its investors) and are most often payable on a quarterly or semi-annual basis.

In addition to the fund economics, sales tax considerations and applicable dealer registration requirements in any given jurisdiction are considerations that must be taken into account when implementing any particular fee structure³.

ORGANIZATIONAL OR ESTABLISHMENT COSTS

Those fees associated with creating and setting up the fund are most often paid for by the fund, but are also usually capped at an amount indicated in the fund’s operating agreement. Occasionally, an operating agreement may instead provide that the General Partner will cover establishment costs up to an agreed upon amount. Such expenses include professional fees such as legal and accounting services, as well as administrative and marketing costs incurred at fund formation. Establishment costs will vary greatly depending on the complexity of the fund being created, and on whether any associated feeder funds, alternative investment vehicles or associated entities are being created simultaneously.

OPERATING EXPENSES

The fund will also be responsible for those fees and expenses related to the proper functioning and operation of the fund. Such fees may include ongoing professional or consultancy fees, administrative costs, any applicable taxes or regulatory fees, as well as the management fees payable to the General Partner, investment adviser or management company and any expenses incurred by such persons in carrying on their activities on behalf of the fund.

¹ As a general rule, the promoter of private equity and venture capital funds is the general partner. Private equity and venture capital funds are most frequently created in the form of a limited partnership with a predetermined term.
² See «Private Equity Principles», (version 2.0), Institutional Limited Partners Association (available at: http://ilpa.org/index.php?file=/wp-content/uploads/2011/01/ILPA-Private-Equity-Principles-version-2.pdf&ref=http://ilpa.org/principles-version-2-0/&t=1426810053).
³ For more information on this subject, please see our article entitled “Registration Requirements of Venture Capital and Private Equity Fund Managers in Canada : A Favourable Regulatory Framework” published in the May 2014 Lavery Capital newsletter.

Back to the publications list

Stay tuned for the latest legal news. Subscribe to our newsletter.

Subscribe to publications

Publications that might interest you

September 19, 2024

Financing Quebec’s Energy Transition: Unlocking the Potential of Flow-Through Shares

Quebec has set ambitious energy transition and industrial decarbonization targets. The shift to greener practices has to be taken in a context where our energy consumption could rapidly grow under the combined effect of a number of factors, such as the reindustrialization of our economy, population growth, transport electrification and the potential for artificial intelligence to consume vast amounts of energy. Investing in the development of energy infrastructure is therefore critically important, as an abundance of energy is key to economic prosperity. The problem is that public finances are already stretched to the limit with the need to renovate our aging infrastructure, among other things. Encouraging private equity investment is thus vital, and tax incentives can be very effective in this respect. The American example In 2022, the United States passed its Inflation Reduction Act (IRA), with the goal of stimulating investment in the renewable energy sector, in particular. More specifically, the IRA altered or created a number of tax credits to encourage private investment.1 Over the past two years, US businesses have announced a total of almost US$276 billion in new investments in clean energy generation and the capturing or elimination of carbon dioxide and other forms of industrial decarbonization, an increase of 34% on the two years previous.2 The IRA is effective in that it takes the respective situations of various energy sector stakeholders into account in a creative, flexible and pragmatic way, especially where taxation is involved. Energy project promoters often have to wait many years for their projects to generate income and profits, even though the banks and other investment funds they solicit financing from can be presumed to be operating profitable businesses. The tax losses that occur in the years during which such projects are designed and built are therefore of little interest to developers, but of immediate interest to investors. And so, a tax equity market has emerged, in which businesses subject to taxes can invest in the shares of entities set up to develop such projects so as to benefit from tax credits and faster depreciation. Typically, the entity that cashes in the investment and develops the project distributes 99% of income, losses and tax credits to investors until a predetermined return is achieved. Once that return is achieved, the investor’s share of the benefits decreases, and the developer has the option of buying out the investor’s residual share. The IRA has transformed how federal clean energy tax credits are monetized, and it is now possible to buy and sell such credits without having to make a long-term investment. For businesses, this new way of doing things is an additional and attractive way to participate in the growing tax credit market.3 In 2023, the volume of the tax equity market for American projects was around US$20 to 21 billion, up about US$18 billion from the previous year.4 It appears that the trend will continue. It is estimated that the value of the current market, which is particularly attractive to banks, is set to double to US$50 billion a year by 2025.5 The equivalent of flow-through shares The Quebec and Canadian tax deductions mechanism that most closely resembles the US tax equity market is probably flow-through shares. Through these, businesses in the mining and renewable energy sectors can transfer their mining exploration expenses and other expenses—specifically designated as eligible—to investors, who can then deduct them from their own taxable incomes.6 These businesses can thus issue shares at a higher price than they would receive for common shares to finance their exploration and development operations. Investors are willing to pay a higher price in return for the tax deductions afforded by the eligible expenses incurred by the issuing businesses, which can amount to a maximum of 120% of the equity invested in the shares.7 Investors can also claim a 15% or 30% federal tax credit. However, because tax incentives cannot be transferred, our mechanism is more rigid than the American one, and it can only be applied to mineral exploration and development expenses and certain specific expenditures related to renewable energy and energy conservation projects, such as electricity generation using renewable sources like wind, solar energy and geothermal energy.8 With ambition and innovation comes the need to take action Quebec could draw inspiration from the IRA to increase the attractiveness of flow-through shares and broaden their scope of application, thereby creating a new tool to finance the energy transition. The renewable energy sector is similar to the mining sector in many respects, not least in terms of the considerable amount of capital required to build the infrastructure needed to operate a mine or energy generation facility. The flow-through share mechanism, which is well-established and popular with investors,9 could be just as successful in our energy transition context. Making such incentives easier to transfer would also drive the emergence of a market similar to the US tax equity market. A number of Québec flagship companies, such as Hydro-Québec,10 Innergex11 and Boralex,12 are also very ambitious when it comes to developing large-scale energy projects. They face major financing challenges, as do those in the industrial decarbonization and infrastructure renewal sectors. Innovation is necessary to meet these challenges and make the transition to a more sustainable, but just as prosperous, world, and to do so in good time.13 Link Rhodium Group and MIT’s Center for Energy and Environmental Policy Research (CEEPR), Clean Investment Monitor, link Brandon Hill, How to take advantage of tax credit transferability though the Inflation Reduction Act, Thomson Reuters Institute, April 16, 2024, link Allison Good, Renewables project finance to keep pace in 2024, but tax equity rule looms, S&P Global, January 12, 2024, link Lesley Hunter and Mason Vliet, The Risk Profile of Renewable Energy Tax Equity Investments, American Council on Renewable Energy, December 2023, link Link, page in French only Link Link Prospectors & Developers Association of Canada, Flow-through shares & the mineral exploration tax credit explained, link Link Link Link The authors would like to acknowledge the participation and the work done by Sophie Poirier in this publication

Read more
April 26, 2024

New rules will make it easier to transfer family businesses

The 2023 Federal Budget (the “Budget”), tabled on March 28, 2023, proposes amendments to certain provisions of the Income Tax Act (ITA) that would make “genuine” intergenerational business transfers no longer subject to the anti-avoidance rules of section 84.1 and allow the transferor to benefit from their capital gains exemption. To do so, the Budget establishes new general conditions that the parties must meet, as well as specific conditions that apply to “immediate” transfers, or those made over a period of no more than 36 months, and “gradual” transfers, or those that take five to ten years to complete. The general conditions that the parties must meet when disposing of a company may be summarized as follows: The vendor must be an individual other than a trust. Immediately prior to the transfer, the vendor, alone or with their spouse, must control the currently operating company. At the time of the transfer, the purchasing company must be controlled by one or more of the vendor’s children, who must be at least 18 years of age. The notion of “child” also includes stepchildren, grandchildren and nieces and nephews. The shares of the company being transferred must be qualified small business corporation (QSBC) shares or shares of the capital stock of a family-farm or family-fishing corporation (QFFP). The specific conditions relate to the transfer of control, economic interests and management of the company, and vary from case to case. FOR AN IMMEDIATE TRANSFER (36-MONTH TEST) In the case of immediate transfers, de jure control (being the holding of the majority of shares having voting rights), and de facto control (which includes the economic influence making effective control of the company likely), must be transferred at the time of sale. Voting and participating shares not transferred to the purchasing company at the time of sale must be transferred within the following 36 months, such that after this period, the transferor may hold only preferred shares, that is, non-voting or non-participating shares for an indefinite period (vs 10 years in the case of a gradual transfer). Also, the child, or at least one member of the group of children, must participate in the family business on a regular, significant and continuous basis for a minimum period of at least 36 months after the transfer is made. Lastly, the transferor must take reasonable steps to transfer the business’s administration and know-how and completely cease to manage the business before the 36th month after the transfer was made. FOR A GRADUAL TRANSFER (FIVE–TO–TEN–YEAR TEST) If the transfer is gradual, only de jure control must be transferred at the time of disposition. The balance of the voting and participating shares not transferred at the time of disposition must be transferred within 36 months of the first transfer. However, under the rules respecting gradual transfers, the transferor will only be bound to transfer de facto control of the business within 10 years of the initial transfer. In the case of a transfer of economic interests, the vendor is expected to significantly reduce the value of the equity and advance they have invested in the business within 10 years of the initial sale. The same requirement for a child’s active participation in the company and transfer of the management of the business apply, but this time for a period of 60 months after acquisition. PREVIOUS RULES (Bill C-208) The provisions of the 2023 Federal Budget have the effect of setting aside certain requirements of Bill C-208 applicable to the realization of a capital gain. Under Bill C-208, for the transferor to benefit from their capital gains exemption, the operating company and the purchasing company could not be amalgamated within 60 months of the sale. The bill also required that an independent assessment of the fair market value of the company’s shares be filed with the Canada Revenue Agency, along with an affidavit signed by the vendor. However, as of January 1, 2024, these criteria are no longer applicable. An assessment will no longer be required, although under section 69 of the ITA, the transfer will still have to be made at fair market value. The 2023 budget (reinforced by the 2024 Federal Budget) also introduces new rules for the alternative minimum tax, a temporary tax that the transferor in an intergenerational business transfer often has to pay. To avoid having this temporary tax becoming permanent, it’s important to understand the subtleties of these new rules. Our team of tax professionals will be happy to help you and answer any questions you may have about these new legislative changes.

Read more
April 16, 2024

Tax opportunities under the Indian Act

Although it is not often well-understood in business and tax circles, the Indian Act (the “Act”), coupled with federal and provincial tax laws, provides several tax planning opportunities for Indigenous taxpayers. These laws provide various tax exemptions for people who qualify as “Indians” under the Act, as well as for “bands” and other “councils.” These terms are defined in the Act and require case-by-case analysis, but essentially they refer to people of Indigenous origin who have at least one family member who is registered or entitled to be registered as an Indian within the meaning of the Act. The criteria for a tax exemption In particular, those who qualify can benefit from a tax exemption when income is earned on a “reserve.” There are several criteria to be met, and although the Canada Revenue Agency (“CRA”) has issued guidelines on the subject, their application remains a question of fact that varies depending on the particular circumstances applicable to each taxpayer. In general, the CRA requires that income earned by an “Indian” within the meaning of the Act be sufficiently connected to a reserve to be exempt. This is the case when, for example, income-generating services are performed entirely or almost entirely within the territory of a reserve, when the employer and the employee reside on a reserve, or when income is derived from non-commercial activities carried out by a band. Business income can also be tax-exempt, but the criteria for being considered connected to a reserve are stricter, since generally only income-generating activities situated on a reserve will be tax-exempt. However, it is still possible to organize the affairs of a taxpayer and their corporate entities to ensure that these criteria are met, or to highlight certain connecting factors. Such planning, if done properly, is entirely legitimate and can result in significant tax savings. In a recent interpretation (CRA Views 2022-0932231I7), the CRA illustrated this principle by considering employment income related to an off-reserve airport to be exempt, even if none of the guidelines are followed, in cases where such an airport is necessary to supply a reserve that has no other means of transportation and delivery. This interpretation shows that the connection between an income and a reserve is not established solely by the physical presence of the income-generating business, and that several other arguments, sometimes more subtle, can be used to support the connection between an income and a reserve. A few nuances to consider However, care must be taken when a company is incorporated by someone who qualifies as an “Indian.” A company with its head office on a reserve cannot qualify as “Indian” within the meaning of the Act. Its income therefore cannot be tax-exempt, and will be taxed according to the usual rules. Despite this, certain plans can ease the tax burden on these companies and on shareholders who qualify as “Indians” under the Act, such as paying wages and bonuses to an employee shareholder. But it’s essential to carefully analyze the various pitfalls and risks that such planning entails. Furthermore, certain exemptions exist for companies formed by bands, but the eligibility criteria are strict and require a thorough analysis of the proposed structure. In addition to the income tax exemption, “Indians” within the meaning of the Act and certain entities mandated by bands may benefit from a tax exemption when they purchase goods on a reserve or have goods delivered to them on a reserve. Different exceptions and nuances apply. However, companies headquartered on a reserve are not exempt from their tax collection obligations and may be required to register for the GST/QST. To help you understand these rules and ensure optimal tax planning, we invite you to consult our tax team. We look forward to working with you on your business projects.

Read more
April 9, 2024

The Government of Canada extends the Mineral Exploration Tax Credit for an additional year

On March 28, 2024, the Department of Finance Canada announced a one-year extension to the 15% Mineral Exploration Tax Credit (“METC”) available to investors in flow-through shares. The extension means that the METC will be effective until March 31, 2025. This announcement came at a time when uncertainty loomed over the industry and some stakeholders feared that the government would not renew the METC. Over time, this tax credit has become a key component of flow-through share financings. It is intended to enhance the tax deductions already available to flow-through share holders and ultimately help companies raise capital for mineral exploration. The METC was last renewed in 2019 for a five-year period, indicating the government’s long-term commitment to the sector at that time. And while this renewal is welcome news for exploration companies, it should be noted that the shorter one-year horizon of the extension does not provide the same assurance regarding the incentive’s future. It is possible that this one-year renewal reflects the government’s intention to promote the new 30% Critical Mineral Exploration Tax Credit (“CMETC”) instead, on which more information can be found here: Federal Budget 2022: Good News for Mining Exploration Companies! In closing, it is important to note that the one-year extension to the 15% METC will not affect the period during which the 30% CMETC is available for critical mineral exploration, which will end on March 31, 2027, and is subject to renewal. If you were planning on financing non-critical mineral exploration, you may want to complete this transaction in the coming year in order to benefit from the 15% METC. Our team of professionals specializing in securities, mining law and taxation is available to answer any questions you may have concerning this new measure and to guide you in arranging a successful flow-through financing.

Read more