There is currently a very active market in Puerto Rico, with buyers and lenders eager to put their capital to work in various sectors and industries. Volumes have kept steadily growing and accelerating for many reasons, including substantial demand among mid-sized, developed businesses looking to expand into new markets; the limited supply of local banks; resilient business and asset valuations; and industry acceptance of the use of private equity funds in various transaction types, phasing out the more traditional financing structures.

Recently, there has been an increase in private equity firms and venture capital funds carrying out fast-tracked acquisitions and exits, either accelerating long-term strategies to gain market and growth or in response to the fast-paced market. In a fairly short period of time, the evolution of the private equity model in Puerto Rico has created a new engine for M&A transactional work. This local private equity framework has proved the deal-making capacity that private equity firms bring to the table.

The commercial and residential real estate, lending and credit, entertainment, auto, marine, alternative assets (ie, collectibles), food and food technology, technology, hospitality and lodging sectors have shown significant activity and continued acceleration during 2022 and 2023.

Private equity fundraising has also received a lot of attention from industry leaders, with both seasoned and new investors showing interest in these types of investment vehicles and open to testing the market. This fundraising momentum is likely to continue into the next year, as well-established players are planning additional capital raises and new private equity firms are opening.

The sustained increase in activity has also drawn the attention of local regulatory agencies, with the enactment of new regulations and requests for information aimed specifically at private equity firms and ensuring the proper operation of these new investment vehicles. 

The 933 Exclusion

Generally, US citizens are subject to federal taxation on their worldwide income. The applicable rates vary depending on the nature of the income. US citizens can be subject to rates of up to (i) 20% in the case of long-term capital gains, and (ii) 37% in the case of ordinary income. However, US citizens that are also bona fide residents of Puerto Rico are allowed to exclude from federal taxation (the “933 Exclusion”) all their income, be it ordinary income, interest, dividends or capital gains that is derived from sources within Puerto Rico. The 933 Exclusion did not historically represent a significant tax savings opportunity for individuals that became PR residents, since PR residents were subject to worldwide taxation in Puerto Rico at rates of (i) 10–24% in the case of long-term capital gains, and (ii) 33% in the case of ordinary income. However, the Puerto Rico government has enacted various incentivising laws to attract individuals to Puerto Rico, by providing preferential tax rates on specific activities, business and types of income. With regard to private equity funds, the government of Puerto Rico enacted Act 185 of 2014, known as the Puerto Rico Private Equity Funds Act (Act 185).

Incentives Code

On 1 July 2019, the Governor of Puerto Rico signed Act No 60 into law, known as the Puerto Rico Incentives Code, as amended (the “Incentives Code”), repealing Act 185 of 2014, known as the Puerto Rico Private Equity Funds Act (“Act 185”). Although the Incentives Code generally incorporated the provisions of Act 185, certain benefits changed while other provisions were clarified. As a result, the Incentives Code now establishes the framework for the following:

• requesting treatment as either a Puerto Rico private equity fund (PR-PEF) or private equity funds;
• eligibility requirements; and
• the taxation of funds, among other aspects.

Attractive characteristics of the Incentives Code include, allowing investors to take a deduction of up to a maximum of 30% of their initial investment within a maximum period of ten years, provided that the maximum deduction does not exceed 15% of the investor’s net income prior to such deduction. Investors that invest in a PR-PEF are eligible to deduct up to a maximum of 60% of their initial investment within a maximum period of 15 years, provided that the maximum deduction does not exceed 30% of their net income prior to such deduction. These deductions can be used against Puerto Rico sourced income, providing a significant tax efficiency to both PR residents and those investors that are not residents but have Puerto Rico sourced income.

The general rule is that an investor’s share of income derived by a qualifying fund from interest and dividends is subject to fixed income tax of 10%. However, the distributive share of investors that are registered (or exempt) investment advisers, private equity firms or general partners in interest and dividends derived by a qualifying fund will be subject to income tax at a fixed rate of 5%.

Capital gains

In addition, an investor’s distributive share of capital gains realised by the qualifying fund is exempt from Puerto Rico income tax. Generally, income from the sale of personal property, such as the units or shares of a qualifying fund’s portfolio companies are “sourced” to the residence of the seller. If the seller is a US tax resident the source of the income is deemed to be the USA. On the other hand, if the seller is a non-US resident (ie, a PR resident), the income is generally foreign-sourced. Therefore, PR residents that invest in a qualifying fund may enjoy a complete exemption on the capital gains realised by the qualifying fund.

The general rule is that capital gains realised by an investor upon the sale of shares in a qualifying fund are subject to Puerto Rico income tax at a rate of 5%. However, if the investor is a registered (or exempt) investment adviser of the qualifying fund, a general partner of the qualifying fund or a private equity firm, then the gain will be subject to income tax at a rate of 2.5%. As an exception, capital gains realised by investors upon the sale of shares in a qualifying fund will not be subject to the 5% or 2.5% tax (as the case may be) if the gross proceeds from the sale are reinvested in a PR-PEF within 90 days of the sale, in which case the capital gains will not be subject to income tax. In the case of investors that are not PR residents, and US citizens, they would be subject to taxation at the applicable federal level.

Puerto Rico-based funds that export their services

In addition to the benefits offered by the Incentives Code to funds and investors, under a separate section, certain investment advisers who are organised in Puerto Rico or establish operations in Puerto Rico that provide advice to funds located outside of Puerto Rico or to other investment advisers located outside of Puerto Rico (ie, export their services) may elect to be taxed as corporations to benefit from the 933 Exclusion, and the Incentives Code, which provides a preferential tax rate of 4% for services rendered from Puerto Rico to persons located outside of Puerto Rico, such as funds, other investment advisers or investors.

Dividends

In addition, the Incentives Code provides a 0% rate on dividends distributed by the entity to its owners that are PR residents from income derived from export activities.

The terms of the exemption provided to the entity under the Incentives Code are gathered in a “Tax Grant”, which is considered a contract between the government of Puerto Rico and the entity that requested the benefits. The initial term of a Tax Grant under the Incentives Code is 15 years, which can be extended for an additional 15 years.

Relocation to Puerto Rico

Furthermore, under a separate section of the Incentives Code, an exemption from Puerto Rico-sourced passive income (including interest and dividends that flow through the fund) can be obtained by individuals who relocate to Puerto Rico and become PR residents. This includes capital gains, interest, and dividends. The provisions of the Incentives Code that provide these benefits tie into the 933 Exemption, the sourcing rules of the US Internal Revenue Code (IRC) and benefits offered under the Incentives Code. Therefore, for example, an individual who receives interest income from an investment in a fund located in Puerto Rico would be exempt from Puerto Rico and federal taxes. By the same token, given that capital gains are sourced to the residence of the seller and, in the case of partnership, are determined at the level of the partners, investors can greatly benefit from the interplay of the above rules.

Services provided by investment advisers with a Tax Grant to funds outside Puerto Rico

Lastly, an individual who owns an investment adviser that has a Tax Grant (as discussed above) and provides services to an alternative investment fund or to another investment adviser located outside of Puerto Rico can receive dividend distributions subject to a 0% tax rate.

Private equity funds, venture capital funds, investment managers and their investment advisers organised under the laws of Puerto Rico and/or doing business in Puerto Rico are subject to the laws of the USA, all applicable rules and regulations promulgated by the SEC, the local regulator in Puerto Rico, the Office of the Commissioner of Financial Institutions of Puerto Rico (OCIF) and in some instances to the North American Securities Administrators Association’s (NASAA) Model Rules as imposed by the OCIF.

Usually, private equity-backed buyers need to comply with the provisions set forth in Act No 77 of 1964, as amended, known as the Puerto Rico Anti-Monopolistic Act (“Act 77-1964”). Act 77-1964 regulates unlawful mergers and business practices, generally to promote fair competition for the benefit of consumers in an open market economy. Specifically, Act 77-1964 states that it is unlawful to sell, contract to sell, offer to sell, or participate in any step for the sale with the purpose of destroying competition or eliminating a competitor located in Puerto Rico.

The Puerto Rico Department of Justice Office of Monopolistic Affairs (OMA) is authorised to investigate and initiate legal action to protect free competition practices in accordance with the Puerto Rico Antitrust Act, which was enacted to regulate any unlawful restraints of trade or commerce and exempts the legal regulation of public utilities, insurance companies and any other enterprises or entities subject to special regulation by the governments of Puerto Rico or the USA. As per the Puerto Rico Antitrust Act, similar to the federal antitrust laws, a contract, combination in the form of trust or otherwise, or conspiracy that “unreasonably restrains trade or commerce in Puerto Rico” is illegal. With regard to M&A, the Puerto Rico Antitrust Act states that it shall be unlawful if the effect of such acquisition may be to “substantially lessen competition, or to tend to create a monopoly”. These antitrust regulations will generally apply to business combinations and private equity-backed buyers.

In addition, if the private equity firm or venture capital fund enjoys a preferential tax treatment under the Incentives Code or Act 185, it will be subject to the oversight of the Office of Incentives for Businesses in Puerto Rico (OI) and the Puerto Rico Treasury Department. Furthermore, depending on whether or not it relies on an exception from registration under SEC Rule 203-1(l) or 203-1(m), there are different types of limitations on the type of portfolio company acquisitions that the entity can undertake and/or the amount of leverage it can assume.

The OCIF has shown an increasing interest in investment vehicles in Puerto Rico. In recent months, it has specifically been focused on private equity fund or venture capital fund registration status, corporate organisation, their investment managers and investment advisers, the offering and the Tax Grant (if any).

The level of legal due diligence varies, but there is certain information that is generally requested, mostly consisting of confirmatory verifications and validations. This means that, when the investment is to be made by the investors and the fund, they should be very much assured of their decision to move forward in the absence of any new material findings.

The key purpose for legal due diligence in private equity transactions is to corroborate assumptions made by the buyer in arriving at a certain valuation, and to substantiate that the target investment is not exposed to large unidentified liabilities or contingencies, and to thoroughly evaluate the target investment’s structure and compliance with applicable laws and regulatory frameworks. A due diligence exercise typically covers the following:

• general corporate information;
• governmental and regulatory documents;
• financial documents;
• litigation documents;
• material contracts;
• real estate and assets;
• environmental matters;
• employee compensation and benefit documents;
• intellectual property;
• tax matters; and
• insurance.

Vendor due diligence is not a common feature of private equity transactions in Puerto Rico.

Most acquisitions by private equity funds are typically carried out by private stock or membership interest purchase agreements. Other acquisitions by private equity funds are performed by acquiring the debt of the target company, by issuing new debt to the target company and/or by entering into debt that converts to ownership of the target company (eg, convertible promissory notes). Furthermore, acquisitions by private equity funds are commonly structured by using a special purpose vehicle (SPV), which will be the entity directly responsible for the purchase of the investment or the issuance of the debt.

As a general rule, funds that will target both their investments and investor base in Puerto Rico are organised as limited liability companies (LLCs). LLCs organised in Puerto Rico are taxed as corporations by default. However, the Puerto Rico Internal Revenue Code of 2011, as amended (PR IRC), allows LLCs to elect to be treated as partnerships or disregarded entities for income tax purposes, even if the LLC has only one member. As with tax elections made pursuant to the IRC, the election to be taxed as a partnership under the PR IRC allows funds to be transparent for Puerto Rico tax purposes, making the members the parties responsible for the tax liability instead of the fund. Furthermore, the PR IRC provides that every LLC that is treated as a partnership by reason of its election or provision of law or regulation under the IRC, or the similar provision of a foreign country, or whose income and expenses are attributed to its members for federal income tax purposes or those of the foreign country, shall be treated as a partnership for purposes of the PR IRC, and shall not be eligible to be taxed as a corporation.

As mentioned in 5.1 Structure of the Acquisition, most private equity funds tend to use SPVs in the transaction, thus separating the fund from the target investment. The private equity fund backing the SPV buyer is typically structured as a “qualifying private fund” exempt from registration under SEC Rule 203(m)-1. The term “qualifying private fund” refers to any private fund that is not registered under Section 8 of Federal Investment Company Act of 1940, as amended (ICA), and has not elected to be treated as a business development company pursuant to Section 54 of the ICA.

It is common for the general partners to manage the acquisition (or sale) documentation. As the general partners oversee the day-to-day operations of the firm and manage the portfolio companies, they will lead the acquisition (or sale). Depending on the complexity of the transaction, on some occasions the general partners engage the investment adviser of the fund or a third-party subject matter expert adviser for additional support during the due diligence process. From a documentation standpoint, very few general partners or investment advisers have sufficient expertise to draft and review the transactional documents and, therefore, a law firm should be hired to assist in the complex document drafting.

Generally, private equity deals are financed through capital contributions in the fund, either directly by the limited partners in their personal capacity or by a parent company wholly owned by the limited partners. Typically, the fund provides investors with an approximate target for the fund size and the minimum amount of investment that must be committed by the investors prior to becoming partners in the fund (ie, the capital commitment). Once the fund determines the investment it wishes to pursue, the general partner or investment adviser will notify the partners of the amount of capital that they must provide the fund (ie, capital call) and the timeframe in which they must provide it. The capital call should, in no case, exceed the capital commitment made by the partners, unless the partners and the fund reach an agreement to do so. Once the fund has sufficient funds, it deploys them in pursuit of the investment. Most private equity deals are geared towards the fund obtaining a majority ownership interest in the investment, debt issuance or a hybrid of both through what is known as a mezzanine financing.

Deals involving a consortium of private equity sponsors are not common in Puerto Rico, but co-investment by other investors, including corporate investors, alongside the private equity fund is very common. Of late, the majority of private equity fund sponsors are requesting the ability to offer co-investments as an attractive element of their structures, during the organisation stage of the fund. For example, co-investments tend to provide private equity firms with more flexibility on the terms and conditions of a particular transaction. Private equity firms can have more capital available to invest in other projects rather than in a single transaction. Co-investments may also improve relationships with investors and the distribution of the investment risk.

For co-investors, the co-investment transaction may allow exposure to additional information and access to due diligence or materials that would not otherwise have been available solely to the private equity fund. Co-investments can also help the co-investor make better decisions and adjust their broader portfolio to best fit their investment needs.

Another advantage is that an institutional investor may receive better fee arrangements in the co-investment special purpose vehicle compared to investing in the main private equity fund. For example, a private equity firm that may wish to attract institutional investors could reduce fees.

Lastly, co-investors are typically limited partners or their affiliates alongside the general partner by way of passive stakes by the co-investors and where the fund and its limited partners are already investors. In some limited circumstances, external co-investors operate alongside the general partner of the fund by way of passive stakes.

The predominant form of consideration used in private equity transactions in Puerto Rico is cash. Earn-outs and deferred consideration are not common features of private equity transactions in Puerto Rico. However, some private equity funds opt to implement a milestone approach investment where a second larger investment is made in a company once it has achieved certain performance metrics.

The involvement of a private equity fund may affect the type of consideration mechanism used, depending on whether the fund has elected to operate with a Tax Grant under the Incentives Code and whether the partners in the fund hold individual Tax Grants also issued under the Incentives Code. If the fund and the partners do hold Tax Grants, the fund will mainly target income streams covered under the corresponding Tax Grants.

Historically, a private equity buyer would not usually require enhanced or additional protections when making an investment but recently this has begun to change, as private equity buyers are starting to request the same enhanced protections typically used by institutional buyers. Corporate buyers will typically request collateral and other types of security instrument to protect their investment.

The vast majority of private equity transactions are based on locked-box considerations, but no interest is charged on leakage.

Generally, dispute resolution mechanisms are in place for all types of private equity transactions.

The typical conditions to closing are as follows:

• regulatory approvals, as may be required;
• the approval of certain contractual counterparties;
• the conversion of convertible instruments; and
• corporate resolutions approving the transaction.

Material adverse effects provisions are very common in private equity transactions, particularly when the transaction is not designed as a simultaneous sign and close.

Third-party consents are generally requested for closing a private equity deal, when material contracts are involved that require consent for assignment or when a change of control occurs. This is more common in certain industries, such as distribution, services, etc.

Specific consideration must be given by private equity funds when investing in entities that hold preferential Tax Grants. Subject to the amount of ownership being purchased by the private equity fund, prior consent from government agencies may be required to avoid the risk of having the Tax Grant be revoked.

Hell or high water provisions are not usually accepted by a private equity-backed buyer, with such burden usually being placed on the seller’s side.

Break fees are not common in Puerto Rico but may be agreed to in certain scenarios involving publicly traded buyers.

A private equity seller or buyer can usually terminate an acquisition agreement in the following circumstances:

• when the deal has not closed by a certain “drop dead” date;
• when third-party or required government consents are not granted or obtained; or
• for reasons stemming from the due diligence.

Transactions where the seller is a private equity fund and the buyer is another private equity fund are not common in Puerto Rico at this time but the market is likely to develop and require those types of transactions.

A private equity seller normally provides typical title, no liens and authority warranties to a buyer upon an exit. The management team provides business representations to a buyer on exit. It is customary for a cap to be placed on liability for business warranties, but fundamental warranties are either uncapped or capped at the purchase price. Full disclosure of the data room is typically not allowed against the warranties. Typical limitations on liability for warranties in Puerto Rico include basket, caps and sunsets.

Indemnities are generally the only protection provided to private equity buyers and sellers. Insurances are not common, and escrows are only considered when a corporate buyer is involved.

Litigation is not common in connection with private equity transactions in Puerto Rico.

Public-to-private private equity transactions are not common in Puerto Rico.

Under the PR IRC, partnerships (including funds) must file an Informative Income Tax Return for Pass-Through Entity, and their income flows through and is taxed to the partners. The partnership must also make estimated tax payments equal to 30% of any taxable income that is subject to tax at regular rates (if any). The fund must also make the needed tax payments that correspond to the income that is subject to the preferential tax rate applicable to any taxable income that is subject to a preferential tax rate under the PR IRC. The estimated tax payments may be claimed by the partners as a credit on their annual Puerto Rico Income Tax Return. Accordingly, the estimated tax payments are not an additional tax, but merely a prepayment of the partner’s income taxes.

The fund must also provide each of its partners with an informative return detailing all the information required by the partner for the purposes of completing their income tax return.

The fund income tax return must include audited financial statements, including certain supplementary information established by law, prepared by a Certified Public Accountant who is licensed to practise in Puerto Rico. This requirement only applies to funds with a gross income exceeding specific thresholds provided in the PR IRC.

Furthermore, funds that operate with a Tax Grant must provide audited annual reports to their partners, including audited financial statements prepared under the Generally Accepted Accounting Principles (GAAP), as well as an unaudited report on the performance of individual portfolio companies, and a compliance certificate which confirms the private equity fund’s compliance with the terms and conditions of the Tax Grant. Quarterly unaudited financial statements must also be provided to partners.

Puerto Rico does not have a mandatory offer threshold.

Cash is the most common form of consideration used in Puerto Rico. However, securities have recently also started to be used as compensation.

Takeovers are not common in Puerto Rico.

Squeeze-out mechanisms are not common in Puerto Rico.

It is not common to obtain irrevocable commitments to tender or vote from the principal shareholders of a target company.

Equity incentivisation of the key management team is a common feature of private equity transactions in Puerto Rico. The key management team is usually provided equity depending on their expertise and their role in the company and industry sector.

Management participation is typically structured as sweat equity subject to vesting. Managers will usually subscribe for ordinary equity or a tracking phantom equity that will follow the performance of a particular metric. Also, a cliff and/or vesting schedule will be included in the management equity (see 8.3 Vesting/Leaver Provisions).

Leaver provisions for key management shareholders are typically included in Puerto Rico to attract and retain top talent in many private equity funds, especially in the tech sector. The typical leaver provisions for management shareholders are:

• death;
• permanent disability or permanent incapacity through ill health;
• permanent disability or permanent incapacity through ill health of the executive’s spouse or child;
• retirement (at normal retirement age);
• redundancy;
• unjustifiable dismissal by the company; and
• on some occasions, dismissal by the company where the executive has failed to meet certain performance expectations.

A typical vesting clause will usually last four years and have a one-year cliff.

One of the most used restrictive covenants agreed to by management shareholders is a non-compete agreement. In Puerto Rico, the courts often disfavour non-compete clauses, as Article II sec. 16 of the Constitution of Puerto Rico recognises the right of every worker to choose his or her occupation and freely resign. To protect this liberty of choice, Puerto Rico courts have carefully interpreted non-compete clauses and imposed rigorous requirements for their validity. When these are not met, the contract will most likely be deemed invalid and unenforceable.

Valid non-compete clauses require the employer to have a legitimate interest in the contract – ie, the business would be substantially affected if the employer does not receive protection under a non-compete agreement. The scale of this interest is measured, considering the position of the manager within the company – the existence of the manager’s interest will be directly related and reliant on the manager’s position in the company, and whether they compete with the company in the future.

The extent of the prohibition must correspond to the interest of the company, regarding restriction terms or affected customers. The purpose of the ban should be limited to activities like those conducted by the employer and does not have to be limited to specific functions. Also, the term of the non-compete agreement should not exceed 12 months, understanding that any additional time is excessive and unnecessary to adequately protect the employer.

In terms of the reach of the prohibition, the contract must specify the geographic boundaries and/or affected customers. The geographical area to which the restriction applies should be limited to the area strictly necessary to prevent real competition between the employer and employee. When the non-competition clause concerns customers, it should refer only to those who personally attended the employee for a reasonable period before leaving or in a period immediately preceding the exit of the manager. These elements are evaluated in light of the nature of the industry involved and the possible related public interest.

Additionally, the company must offer something to the manager in return for signing the non-compete agreement, such as a promotion, additional benefits at work or the enjoyment of any similar substantial changes in employment conditions, including a manager keeping a position after a change in ownership of the company when another consideration also applies.

As with any contract, non-compete agreements must have the essential elements for validity: consent, object and cause. However, it is a strict requirement that the managers freely and voluntarily sign the non-compete agreement: undue pressure or coercion by the company would render the non-compete agreement invalid and unenforceable.

In summary, the elements of a valid non-competition agreement in Puerto Rico are as follows:

• the company must have a legitimate interest in the agreement;
• the scope of the prohibition in the non-compete agreement must fit the company’s interest but not exceed 12 months;
• the company shall offer a consideration in exchange for the employee signing the non-competition covenant, other than mere job tenure;
• non-competition agreements must be valid contracts; and
• non-competition covenants must be in writing.

Management typically does not have rights under minority protection provisions.

The most common control mechanisms awarded to limited partners in the private equity fund on specific portfolio investments are board appointment rights and information rights. However, most of the board appointment rights and information rights are granted at the private equity fund level and not at the portfolio investment level.

It would be extremely difficult for a private equity fund majority shareholder to be held liable for the actions of its portfolio company, as two corporate veils would have to be pierced. However, such corporate veils may be pierced by a court of law in an extreme case where both the private equity fund and the portfolio company are part of a scheme to commit fraud.

In Puerto Rico, the typical holding period for private equity transactions is between three and six years. The most common exit route is a trade sale, which allows all management and institutional investors to be entirely cashed out and focused on new ventures. Dual track exits are uncommon in Puerto Rico. Recently, there has been in interest in rolling on investment into a follow-on fund as opposed to an exit once the term to commence winding down of the fund is close.

Private equity sellers typically reinvest upon exit, depending on the given term of the private equity fund and any reinvestment restrictions. In those instances in which, within 90 days counted from the sale, the investor reinvests the entire gross income generated in a Puerto Rico private capital fund, the capital gains realised by the investors of such funds will not be subject to any income tax.

Drag rights are agreed to in private equity investments. The typical drag threshold for any person(s) selling is that they hold more than 50% ownership.

Tag rights are also typical in private equity investments. The typical tag threshold for any person is that they hold more than 50% ownership.

Because of the limited number of IPOs in the Puerto Rico market, exit by means of an IPO is not a common practice. In any case, the trends affecting lock-ups and relationship agreements would likely follow those in the US mainland.