Financial Services Insights - November 2012 - Navigating the Morass of OID Rules for Private Equity Funds

In the last few years it has become more common for private equity funds to stray from their traditional investments in convertible preferred stocks of investee companies and to structure more secure types of investments. The need for security in case of a distressed sale or bankruptcy naturally leads to an instrument with greater characteristics of debt. Bridge Loans – with and without warrants – convertible debt, asset-based lending and other debt-type instruments are limited only by the imagination of the investor and the investee’s need for capital.

However, herein lies a trap for the unwary: 
Many a private equity fund has become ensnared in the OID – original issue discount – trap. 

BACKGROUND

OID is an old form of debt that the IRS doesn’t like very much because originally it led to income deferral. The Internal Revenue Code added Sections 1271-1275 to create taxable income from OID even where no cash interest is paid. This is commonly called “phantom income” because of the taxability of this income despite the lack of cash.

The plain vanilla type of debt investment is a note that carries a stated interest rate for its life. The interest is paid periodically according to the terms of the note. If the investor is an accrual method taxpayer, then regardless of whether the interest is actually paid or not, the taxpayer accrues the interest income when earned and reports it as taxable income. A cash basis taxpayer generally waits until actual receipt of the cash before reporting the interest as taxable income.

In illiquid companies, such as start-ups, fast-growing companies and others whose need for cash supersedes the desirability of paying timely interest, debt may be issued for a discount from face value, thus allowing for unpaid interest. For example, a company needs to borrow $1,000,000 and the market rate of interest for its credit profile would be 7%, but it merely accepts $900,000 and promises to repay $1,000,000 in 3 years. Ordinarily, a cash basis taxpayer will avoid picking up any income for the 3-year period as no cash is actually paid, but the OID rules require the pickup of interest on a current basis even without the receipt of cash. Hence, the term “phantom income” – there is taxable income but no cash to pay the tax. 

THE TRAP

What is the relevance of these rules to a private equity fund?  Ordinarily it will avoid buying OID instruments from investee companies. But a new bridge loan with warrants can create an instrument subject to the OID rules.

Here’s how it works:

A private equity fund lends $1,000,000 to a company – often one in which it already holds an alphabet soup of convertible shares and which it is now seeking to keep alive – and receives back a note with a stated face value of $1,000,000.  So far, so good.

But other lenders are asking for, and getting, warrants to buy the common stock of the borrower for, say, a penny a share. The private equity fund asks for, and receives, warrants to buy 100,000 shares of common for a penny a share. 

This can create OID. 

The reason is that the warrants ordinarily have a fair value that can be quite significant and the private equity fund has to allocate the $1,000,000 it paid for the package of debt and warrants to each component piece. Depending on the length of the warrant exercise period, the exercise price, the volatility of the investment and/or like comparables in the public markets, a value must be assigned to the warrant piece. This reduces the amount paid for the debt, yet the face of the debt remains the same.

For example, if $1,000,000 was paid for a five-year face note carrying a 7% interest rate and 100,000 warrants exercisable for five years at a penny apiece exercise price, and fair valuation says the warrants are worth $100,000, then only $900,000 was paid for the note, leaving $100,000 of OID. This $100,000 of OID has to be amortized into income of the private equity fund at $20,000 for each year for five years, thus creating “phantom income.”

A TEMPTING BUT INCOMPLETE SOLUTION

Internal Revenue Code Section 1272 seems to exclude from the OID rules many bridge loans made by private equity funds, since they are generally of a short duration of one year or less. However, there are two problems here:

• First, many one-year bridge loans are extended beyond a year due to the inability of the debtor to pay. While not certain, it is likely that the IRS could prevail in excluding many bridge loans from the short-term exception.
• Secondly, and less well known, many private equity funds, which are generally structured as partnerships to permit pass-through taxation only at the investors’ level, simply do not qualify for this exclusion.  Why?  The short-term exception generally does not apply to any accrual based taxpayer. Moreover, in the case of partnerships and other pass-through entities, one looks through the partnership itself to its partners and, if accrual-basis taxpayers hold 20% or more of the partnership interests for at least 90 days in a taxable year, then the short-term exception does not apply.

Most private equity funds do not have 80% of their interests owned by partners on a cash basis for tax purposes because they raise funds from pension funds, fund of funds (which require a further look-through), corporations, S corporations, blocker corporations and other non-cash basis taxpayers. Thus, even a bridge loan for less than one year with warrants will likely create “phantom income” for the fund and its taxable investors.

AVOIDING PHANTOM INCOME

Here are a few suggestions:

1. Instead of getting separate warrants attached to the bridge loan, increase the conversion feature. Most bridge loans are convertible into shares of the underlying company. The conversion ratio is set at the time of the investment and is calculated using the fair value of the shares at the time of the loan. Instead of warrants as a kicker, increase the conversion ratio to take into account the extra shares the warrants would provide. Interestingly, there is no OID created by this extra conversion kicker.
   The economics of the transaction are not the same if the fund intends to be paid back in full and not convert. However, in our experience, most bridge loans are in fact converted into additional shares, so this often is a viable alternative.
2. Assign a de minimis value to the warrants. The Internal Revenue Code provides an exception to the OID rules where the warrants have a value less than ¼ of 1% of the note face multiplied by the number of years of the note term. For example, if the note has a face of $1,000,000 and a term of 2 years, then a value of less than $5,000 assigned to the warrants will not create OID. While a Black-Scholes or similar model of valuation might create a value greater than this, especially in the case of penny warrants and longer note terms, if the fund and the issuer both agree in writing to a value that is de minimis – and better yet if an independent valuation firm will support this – the fund may be able to support a tax return position for this value. This is partly because the issuer is agreeing to forego a tax deduction from the additional interest created by OID, so there is tax symmetry between them. 
3. Make the investment as convertible preferred equity rather than as a bridge loan and make it superior to all other equity issued. The likelihood is that a bridge loan would be subordinate to other lenders and creditors such as banks, employee payroll, asset-based lenders, etc. and the greater security of a debt instrument is only to put it ahead of other equity holders.  Making the investment as a preferred convertible equity preserves that security right and avoids the issue of OID. While this may create a so-called “redemption premium,” the only tax penalty that results is some ordinary income instead of capital gain on redemption – and only if the issuer has earnings and profits, which is not often likely in the typical investments made by private equity funds.
4. Make the argument that the bridge loan is really equity under Internal Revenue Code Section 385(c).   This generally requires the issuer to agree that for tax purposes the funds are really another infusion of equity providing no interest deduction – but the fund may have the economic power to force the issuer into this position depending on how badly the issuer needs the capital. While under legal principles a bridge loan may qualify as debt, at the point where a bridge loan is made, many issuers cannot receive loans from traditional sources such as banks due to high debt-to-equity ratios, lack of earnings history, weak forecasted cash flow and the like – so the bridge loan may really be equity for tax purposes under so-called “thin capitalization” or other rules.

THE BEST APPROACH 

Solutions such as those above may sometimes be implemented after a bridge loan is completed but before tax returns are filed – but this approach is often risky.  The best approach is for the private equity fund to consult professional advisors familiar with this issue at the time of loan origination, permitting negotiations and documentation at the time of investment. 

Financial Services Insights - November 2012 

• Additional Disclosure Requirements Related to Balance Sheet “Netting” Take Effect in 2013 
• Navigating the Morass of OID Rules for Private Equity Funds 
• Updated AICPA Auditing Standards Board Guidance in Reporting Pursuant to the Global Investment Performance Standards (GIPS)