Volume 4

The Regulatory Challenge Of Distributed Generation

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David B. Raskin*   

I.   Introduction

Recent published reports point toward a growing conviction that the demand for utility service from the U.S. electric grid may soon decline, perhaps substantially, due to the expanding use of distributed generation.[1] One report prepared by a division of Citigroup describes the improving economics of distributed solar power, which the authors expect will continue.[2] A second Citigroup report projects reductions in the demand for utility service in developed markets of up to fifty percent by 2050.[3] Favorable projections for distributed generation, however, depend on assumptions about technological change that may turn out to be overstated, and even if distributed generation grows substantially, millions of homes and businesses will continue to rely on the electric grid for many decades.[4]

Germany has gone further to promote distributed generation[5] than any other industrialized nation, and its experience provides a cautionary tale. More than a decade after Germany initiated its Energiewende,[6] the average residential price for electricity is almost 36 cents per kWh,[7] and rates are projected to rise another thirty to fifty percent in the next ten years.[8] Without a change in policy, German residential electric rates may therefore approach 50 cents per kWh by the end of this decade. In contrast, the average residential rate in the U.S. is approximately 12.5 cents per kWh.[9] Because the average U.S. residence uses approximately 1,000 kWh of electricity per month,[10] the current German rate would be equivalent to an average household tax of $3,000 per year. Rates anywhere near the levels being experienced in Germany would be unacceptable in the U.S.[11]

Even with extraordinarily high and increasing electric rates, aggregate carbon dioxide emissions by the German electric sector are rising.[12] In contrast, U.S. emissions are falling even though renewables constitute a much smaller percentage of the electric energy mix in the U.S.[13] The stability of the German grid is also being put at risk: it has relied more heavily on variable, renewable generation at the same time that grid resources capable of rapidly balancing supply and demand have been shutting down due to anomalous market price signals.[14] Energiewende has also taken a toll on the utility companies that may have to make the grid investments to fix these operating problems. Equity values for Germany’s biggest utilities have fallen by fifty percent or more over the past three years.[15]

While Germany struggles with Energiewende, the growth of distributed generation in the U.S. is being fueled by a controversial regulatory practice known as net metering. If distributed generation comes to play a significant role, the loss of demand for service from the grid may eventually make it difficult for the owners of grid assets to recover their costs, creating what the utility industry calls “stranded costs.” This Article explores the debate over net metering and then turns to the longer-term prospect of having to address potential stranded costs produced by the expanded use of distributed generation.

II.   Net Metering: The Current Battlefield

Most renewable generation in the U.S. is subsidized through investment or production tax credits.[16] This Article focuses on an additional subsidy to distributed renewable generation alone that exists as a result of “net metering” as applied in about forty states. Under net metering, retail customers (including commercial and industrial customers) can offset their electricity purchases from the grid with energy generated behind the retail meter, such as from rooftop solar panels. In most of the states that allow net metering, the credit equals the bundled retail rate. The credit applies not only to foregone consumption but also—with limited exceptions—to the energy generated from behind the meter in excess of the customer’s own use and delivered to the utility.[17]

Net metering therefore values the energy produced by distributed generators at the bundled retail rate for electricity. The bundled retail rate includes, in addition to the cost of producing electric energy, the costs associated with investment in and operation of transmission and distribution facilities and other costs incurred to ensure reliability and fund public policy initiatives endorsed by utility regulators. As noted above, the average residential price of electricity (the average bundled rate) is currently around 12.5 cents per kWh.[18] According to published data as of November 2013, the market price of energy from grid-connected[19] generators is averaging, in most locations, between 2 and 3 cents per kWh during off-peak periods and between 4 and 5 cents per kWh during on-peak periods.[20] Recent sales of grid-connected renewable energy have been priced near or below 3 cents per kWh.[21] Therefore, net metering allows the owners of distributed generation to effectively sell their energy at prices between two and six times the market price for energy.

Grid-connected renewable generators are paid the much lower market price for their energy, so the issue is not, as advocates of distributed generation allege, merely about promoting “clean” energy. A grid-connected solar generator at the same location as a distributed solar generator receives a fraction of the compensation for providing energy using similar—and equally clean—technology.[22] Grid-scale solar generation is actually more efficient, so net metering provides a huge subsidy to a less efficient form of renewable energy.

Utilities point out that the differential is paid by other retail customers. Because virtually all retail service is billed based on energy usage, net metering causes a re-allocation of transmission, distribution, and reliability costs to those customers who do not own distributed generation. Yet, the owners of distributed generation continue to rely on utility service from the grid for back-up and supplemental energy (for example, at night and when it is cloudy). Presently, the use of distributed generation in the U.S. is sufficiently limited that the cost-shifting effects are minor. However, subsidies this large can induce rapid changes. A report recently issued by the California Public Utilities Commission forecasts that net metering will cost the State $1.1 billion per year in 2020.[23] It also finds that the average net metering customer in California has an income almost twice the state’s average, [24] confirming claims that net metering entails a wealth transfer from low- to high-income consumers.

Net metering raises a number of legal issues that are just beginning to be explored. The definition of “net metering service” in the Energy Policy Act of 2005 indicates that Congress did not endorse the subsidy described above.[25] Section 111(d)(11) of the Public Utility Regulatory Policies Act (PURPA)[26] was added in 2005 to a list of retail ratemaking practices that state utility commissions are required to evaluate for use in their jurisdictions. This provision defines “net metering service” as follows:

Net Metering – Each electric utility shall make available upon request net metering service to any electric consumer that the electric utility serves. For purposes of this paragraph, the term “net metering service” means service to an electric consumer under which electric energy generated by that electric consumer from an eligible on-site generating facility and delivered to the local distribution facilities may be used to offset energy provided by the electric utility to the electric consumer during the applicable billing period.[27]

Under this definition, “electric energy” generated by a retail customer’s on-site facility may be used to offset “energy” provided by the utility. The language strongly implies that Congress meant only to ensure that consumers would receive an appropriate credit for the energy supplied from on-site generation and not a credit based on the bundled retail rate that includes costs associated with transmission, distribution, and reliability. If this is correct, net metering as applied in most states is inconsistent with this part of PURPA.[28]

In 2002, the Supreme Court of Ohio addressed this very issue in connection with interpreting Ohio legislation that required public utilities to offer net metering.[29] In that case, FirstEnergy proposed a net metering regime under which net metered customers would receive a credit for energy supplied from on-site generation based on the unbundled generation component of the retail rate.[30] This proposal was rejected by the Ohio Public Utilities Commission, which directed that FirstEnergy offer a credit based on the full bundled retail rate.[31] The Ohio Supreme Court held that FirstEnergy had correctly applied statutory language requiring utilities to provide a credit for the “electricity” produced by on-site generators by offering to credit only the generation component of the retail rate.[32] The Court found that FirstEnergy was correct in contending that a net meter customer “does not provide transmission, distribution or ancillary services,” and therefore the term “electricity” in the statute did not require a credit for the costs associated with these other unbundled services.[33]

Net metering also appears to be inconsistent with provisions of PURPA that were designed to protect electric consumers from cross-subsidization. Under PURPA, utilities are required to purchase energy from qualifying “small power production” facilities that meet eligibility standards established in the law.[34] Under FERC regulations, retail customers that own on-site generators with a maximum net generating capacity of less than 1 MW are permitted to self-implement PURPA’s mandatory purchase requirement without any notification to or approval from FERC.[35] Most retail customers using net metering rely on the mandatory purchase requirement to require their host utilities to purchase their energy.[36] Absent the PURPA requirement, utilities would generally have no obligation to buy energy from distributed generators because the Federal Power Act[37] (the law that applies in the absence of PURPA) does not obligate utilities to purchase energy at wholesale.[38]

PURPA, however, while requiring utilities to buy, also caps the price paid to qualifying facilities at the purchasing utility’s “avoided cost,” which is defined as the cost of energy that would have been supplied from the utility’s own system if the energy had not been supplied by the qualifying facility.[39] Because net metering compensates owners for the energy supplied from distributed generation at the utility’s bundled retail rate, this practice would appear to violate the avoided cost rate cap that is based on the cost of energy alone.

The FERC, however, permits net meter customers to avoid this price cap. The FERC holds that unless a retail customer with on-site generation is a net supplier of energy to the grid over the state retail billing period (almost always one month), no sale takes place under PURPA or the Federal Power Act, even if there are substantial deliveries of energy to the grid during the month.[40] In the absence of a “sale” to the utility, FERC deems that no mandatory purchase of energy is taking place under PURPA and the avoided cost price cap does not apply.[41]

The FERC’s theory, that the existence of a “sale” can be determined by netting metered inflows and outflows over the course of a month, was recently rejected in two appellate cases involving FERC’s use of this same theory to determine whether a retail sale has occurred when generators acquire energy for station service purposes, the mirror image of the net metering situation.[42] In these two cases, the D.C. Court of Appeals held that netting could not be used to determine whether a sale has taken place and that there is a sale whenever energy is delivered from the generator to the utility and vice versa.[43] The FERC’s disclaimers of jurisdiction in MidAmerican and SunEdison may therefore be subject to a renewed challenge, which, if successful, would require net metering rules to be changed at the state level.

This same “netting” theory allows FERC to avoid facing the fact that the prices inherent in net metering are discriminatory. The Federal Power Act prohibits charges for wholesale energy that are “unduly discriminatory,”[44] but this prohibition only applies if there is a FERC-jurisdictional wholesale transaction. MidAmerican Energy and SunEdison therefore provide a rationale for FERC to avoid addressing the huge differential between the prices paid to distributed and grid-connected generators for the energy they supply.

From both economic and environmental perspectives, energy from distributed generation is no more beneficial than other forms of renewable generation. Energy available to meet electric load, whether generated behind the retail meter or from grid-connected generation, provides equivalent value to the electric system. Therefore, the price discrimination inherent in net metering cannot be justified based on differences in the value of the services offered. If anything, distributed solar is less valuable than most energy from grid-connected generators because the energy output of solar facilities varies uncontrollably. Consequently, utilities must have sufficient grid-connected capacity on hand to supply the entire load when solar generation is non-productive. For the same reason, retail customers with distributed generation require access to grid-supplied energy up to their full load at unpredictable times.[45] Indeed, solar generation has a pernicious effect on energy markets because energy from solar generators tends to suppress energy market prices during peak-load periods, providing less revenue for grid-connected generation and falsely signaling to the market that grid-connected generation that is needed for reliability is no longer economic.[46]

In conclusion, net metering as currently practiced in most states provides a huge subsidy to distributed generators over and above the tax subsidy provided to all renewable generation, discriminates against all forms of grid-connected generation (including renewables), forces an inappropriate re-allocation of the costs of the grid to remaining (and disproportionately lower income) customers, and sends a faulty price signal that can cause under-investment in (or early shut down of) grid-connected generation that is needed for real-time balancing purposes and to meet peak demands. These same problems—in larger scale—are among the primary causes of Germany’s growing dysfunction.

III.   The Return of Stranded Costs

Broadly speaking, the current dispute over net metering is about managing the growth of distributed generation during the period when growth is being fueled by subsidies. If projections such as those made by Citigroup are correct, the cost of energy from distributed generation will decline, eventually making it competitive with energy from the grid without subsidies, and the pace of growth will accelerate. At some point, distributed generation could be married to behind-the-meter storage capability, permitting customers to disconnect from the grid or significantly limit their use of utility service. Investments in distributed generation combined with storage should expand rapidly when and if the combined cost of distributed energy and storage reaches parity with the cost of bundled service from the grid.

In this scenario, as the demand for service from the grid declines and utilities need to recover the cost of the grid from a smaller customer base, utilities will have to respond by filing to raise rates. While this is occurring, a large body of customers will remain dependent on electricity from the grid for a considerable period of time since many customers may not have the resources to install distributed generators and others may choose to take their electric service from the grid.

Even as this possible transition approaches, billions of dollars of grid investments are being made, mostly in response to regulatory mandates.[47] As the use of distributed generation grows, investors in grid assets will demand that regulators provide assurance that their investments will be recoverable over time with a reasonable return. Otherwise, the cost of capital will rise, exacerbating the problem of rising rates during the transition, and in a worst case making it impossible for utilities to raise the capital needed to serve remaining customers and compensate investors for their prior investments in the grid.

Around the turn of the century, the utility industry faced the prospect that investments in generation might be unrecoverable. In those jurisdictions that permitted “retail choice” of electricity suppliers, utility generation was unbundled and re-priced to market. This competitive transformation produced debates over whether utilities were entitled to recover the costs associated with prior generation investments from departing customers when sunk costs exceeded the revenues recoverable at market prices. The differential was known as “stranded costs.”

Utilities argued that they were entitled by law to recover their stranded costs pursuant to an implicit bargain with the government under which utilities had assumed an obligation to serve the public in return for assurance that they would be compensated for their prudent investments made to meet that obligation. Along with many scholars, utilities argued that the law recognized this “regulatory compact” and that failure to permit the recovery of stranded costs represented an unconstitutional taking of utility property.[48] Others argued that no such legal right exists and that allowing utilities to recover their stranded costs would be inconsistent with the transition to competition.[49]

In the states that endorsed retail choice, legislative or regulatory compromises were reached in which utilities recovered most of their stranded costs. The underlying legal question was never resolved decisively in the courts. The stranded cost issue will be different in the context of utility loss of demand to distributed generation. In this context, stranded cost issues will not appear at one point in time (such as a legislative determination to permit retail customer choice) but will emerge gradually as utilities and regulators respond to reductions in aggregate demand for utility service. The stranded cost issue may also include stranded investment in transmission and distribution assets as well as generation. Further, stranded cost recovery will have to be addressed in the context of a declining utility customer base that may ultimately become too small to support recovery. In the last round of stranded costs, customers changing power suppliers remained as transmission and distribution customers of the utility and stranded costs could be recovered in the rates for these unbundled services.

A.  Cost Recovery for Regulated Assets

Assuming distributed generation becomes economical without subsidies, retail customers will be making independent decisions about whether to reduce or jettison utility service, and these decisions will occur over time as the relative economics of grid-produced and distributed electricity change. The stranded cost issue is therefore likely to arise in individual rate proceedings as utilities file to increase their rates to offset the effects of declining demand and regulators respond by requiring offsetting cost reductions to cabin these rate increases to remaining captive customers. As this process unfolds, history teaches that there will be disputes over the prudence of past utility expenditures and over whether particular assets remain “used and useful” and thus eligible for cost recovery.

The Supreme Court’s decision in Duquesne Light Co. v. Barasch holds that a utility’s Constitutional right to recover its costs to serve the public is not infringed by regulatory decisions disallowing individual items of cost.[50] An unlawful “taking” occurs only when the overall level of rates produces insufficient revenue to satisfy the “end-result” test established in FPC v. Hope Natural Gas Co.[51] Hope held that overall rate levels “which enable a company to operate successfully, to maintain its financial integrity, to attract capital, and to compensate its investors for the risk assumed . . . ” are sufficient to pass Constitutional muster.[52] The Hope test is fairly subjective and may not produce rates that are attractive to investors. Duquesne suggests that stranded cost issues will have to be addressed through rate litigation, which means the availability of relief to distressed utilities may be delayed.[53] Without legislation, moreover, the remaining customer base will eventually become too small, forcing utilities to try and convince regulators to permit them to charge exit fees to departing customers. For these reasons, substantial pressure will arise to resolve stranded cost recovery issues through legislation. Legislative fixes will be a hard sell politically, but legislators may be convinced to act in order to prevent important energy policy issues from being decided in the courts.[54]

In determining which facilities remain used and useful, regulators will have to balance reliability and environmental effects as well as economics. They will also have to address complex competing interests. For example, utilities supply power using a combination of owned generation and purchases in the form of FERC-jurisdictional power purchase agreements (PPAs), most of which are the product of regulatory mandates. Federal law protects FERC-jurisdictional PPAs by requiring state regulators to pass through the costs incurred by utility buyers in their retail rates.[55] But this “trapped cost” protection will be a two-edged sword for utilities that face premature retirement of their own generation while continuing to pay third parties for purchased power. FERC may therefore face a host of contract termination disputes. The transition will be made more difficult by the fact that most utility-owned generation is subject to state regulation, PPAs are regulated by FERC, and substantial generation is publicly owned and not subject to traditional rate regulation.

Generation cost recovery is likely to be under pressure before transmission and distribution. For the most part, the electric delivery system operates as an integrated network, and it will be difficult to identify specific assets that are no longer required as demand declines. Nonetheless, a substantial portion of the cost of electricity consists of investments in transmission and distribution, and a regulator under pressure to reduce rates would eventually have to pay attention to the cost of these facilities. Stranded transmission and distribution cost issues will play out simultaneously at FERC (which regulates most unbundled transmission) and in state proceedings (for bundled transmission and local distribution) unless Congress changes jurisdictional responsibilities.[56]

Disputes will likely arise over which assets should be targeted for early retirement. The interstate transmission grid, for example, is an integrated network of facilities owned by a large number of entities.[57] One can imagine a form of competition among transmission asset owners to protect their assets and avoid stranded costs. Most publicly-owned transmission is not subject to FERC or state jurisdiction, which will further complicate the process.

As this process unfolds, utility investors will be watching. As cost recovery uncertainty rises, debt and equity investors will demand higher returns, making it more expensive to maintain a reliable grid and putting further upward pressure on utility rates. At some point, the risks could be large enough that investors will not provide capital on acceptable commercial and regulatory terms, and investment in the grid will become problematic, even as many consumers continue to rely on it.

B.  Unregulated Generation

In regions where utilities have already divested their generation to merchant power producers, capacity and energy is transacted in wholesale markets under the control of RTOs, subject to overarching FERC regulation. Market forces will therefore play a significant role in determining which generators survive as demand declines. The owners of unregulated generation have assumed the market risk and are much less likely to have valid stranded cost claims.

But electricity markets will only provide a partial solution. With recent reductions in natural gas costs and flat demand, grid-connected generation is already under considerable economic pressure, and regulators are being asked to approve additional revenue streams to support reliability and new investment. In response to disputes over market rules, regulators are making critical decisions on the economic margin. Therefore, even where generation is subject to market forces, the future portends complex regulatory disputes over how wholesale markets should be organized to respond to reductions in the demand for energy from the grid. At the core of these disputes, an enduring tension will exist between economics, reliability, and fairness.

IV.   Conclusion

Once a sizable number of customers have invested in distributed generation in response to the subsidies afforded under net metering, changing the economic rules will be difficult, both because some customers will have relied on subsidies to make their investments and others will want the same opportunities as their neighbors. Policymakers therefore should not long defer addressing the consequences of providing these subsidies in order to promote distributed generation over other alternatives. What may appear politically attractive in its early stages can quickly become a regulatory and political quagmire, as the Germans are learning. The U.S. will not countenance electric rates anywhere close to German levels, nor an electric system that is not reliable. Over the long term, any required unwinding of the utility-owned grid due to distributed generation will be extraordinarily complex and will raise many novel and intractable legal and policy issues.



Preferred citation: David B. Raskin, The Regulatory Challenge of Distributed Generation, 4 Harv. Bus. L. Rev. Online 38 (2013), https://journals.law.harvard.edu/hblr//?p=3673.

* David Raskin is a partner in the Washington, DC office of Steptoe & Johnson LLP. He has represented stakeholders in the electric power industry for more than thirty years. During this time, he has been involved in most of the significant federal regulatory initiatives designed to increase competition in the electric industry and has assisted clients in managing the unprecedented changes that have occurred in recent decades.

[1] E.g., Diane Cardwell, On Rooftops, a Rival for Utilities, N.Y. Times, July 26, 2013, http://www.nytimes.com/2013/07/27/business/energy-environment/utilities-confront-fresh-threat-do-it-yourself-power.html; Peter Kind, Disruptive Challenges: Financial Implications and Strategic Responses to a Changing Retail Electric Business, Edison Electric Institute (Jan. 2013), www.eei.org/ourissues/finance/Documents/disruptivechallenges.pdf‎.

[2] Citi Research, Rising Sun: Implications for US Utilities (Aug. 8, 2013), http://www.wecc.biz/committees/BOD/TEPPC/SPSG/Lists/Events/Attachments/706/CITI-Rising%20Sun%20Implications%20for%20US%20Utilities.pdf.

[3] Jason Channell et al., Energy Darwinism: The Evolution of the Energy Industry, Citi Global Perspectives & Solutions 73-75 (Oct. 2013), https://ir.citi.com/Jb89SJMmf%2BsAVK2AKa3QE5EJwb4fvI5UUplD0ICiGOOk0NV2CqNI%2FPDLJqxidz2VAXXAXFB6fOY%3D.

[4] Even if Citi’s aggressive prediction of fifty percent demand reduction by 2015 turns out to be accurate, that prediction leaves fifty percent of electric load dependent on grid service.

[5] In this Article, references to “distributed generation” refer to energy sources located behind the retail meter or connected to a micro grid, where the intent is to remove some load or demand from the system of integrated electric generation, transmission, and distributed facilities that comprise what is referred to in this Article as the “grid.”

[6] Energiewende, or energy transformation, is the product of the German Renewable Energy Act of 2000 (Erneuerbare-Energien-Gesetz) that put in place substantial subsidies for distributed generation and grid-connected renewables. See General Information: Transformation of Our Energy System, Ger. Fed. Ministry for the Env’t, Nature Conservation and Nuclear Safety, www.bmu.de/P118-1/ (last visited Nov. 24, 2013).

[7] Jesse Morris, How Germany’s Solar Evolution Impacts America, Earth Techling (Oct. 12, 2013), http://www.earthtechling.com/2013/10/how-germanys-solar-evolution-impacts-america. Ironically, this article laments the fact that the German feed-in tariff rate for distributed solar is only 20 cents per kWh, well below the full retail rate.

[8] Institute for Energy Research, Germany’s Energy Policy: Man-Made Crisis Now Costing Billions (Oct. 30, 2012), http://www.instituteforenergyenergy research.org/10/20/2012. Many Germans claim they can no longer afford to buy electricity. Germany’s Energy Poverty: How Electricity Became a Luxury Good, Spiegel Online Int’l (Sept. 4, 2013), http://www.spiegel.de/international/germany/high-costs-and-errors-of-german-transition-to-renewable-energy-a-920288.html.

[9] Energy Info. Admin., Table 5.6.A. Average Retail Price of Electricity to Ultimate Customers by End-Use Sector, (Nov. 20, 2013), http://www.eia.gov/electricity/monthly/epm_table_grapher.cfm?t=epmt_5_6_a.

[10] Energy Info. Admin., How Much Electricity Does an American Home Use?, http://www.eia.gov/tools/faqs/faq.cfm?id=97&t=3 (last updated Mar. 19, 2013).

[11] Germany’s Environment Minister, Peter Altmaier, has acknowledged that Germany has overdone the subsidies and needs to cut them back. Diarmaid Williams, Altmaier says German energy transition could cost $1.34trn, Power Energy International (Feb. 21, 2013), http://www.powerengineeringint.com/articles/2013/02/Altmaier-says-German-energy-transition-could-cost-134trn.html; Minister Altmaier: EEG Cuts Needed—or Energiewende Costs Will Reach Trillion Euro Mark by 2040, German Energy Blog (Feb. 20, 2013), http://www.germanenergyblog.de/?p=12278.

[12] Spiegel Online Int’l, supra note 8; Max Luke, Jessica Lovering & Alex Trembath, Trash, Trees and Taxes: The Cost of Germany’s Energiewende, Energy Collective (Sept. 16, 2013), http://theenergycollective.com/maxluke/274041/trash-trees-and-taxes.

[13] An environmental critique of Energiewende can be found in Will Boisvert, Green Energy Bust in Germany, Dissent (2013), http://www.dissentmagazine.org/article/green-energy-bust-in-germany.

[14] Tilting at Windmills, Economist, June 15, 2013, available at http://www.economist.com/news/special-report/21579149-germanys-energiewende-bodes-ill-countrys-european-leadership-tilting-windmills.

[15] How to Lose Half a Trillion Euros, Economist, October 12, 2013, available at http://www.economist.com/news/briefing/21587782-europes-electricity-providers-face-existential-threat-how-lose-half-trillion-euro.

[16] German subsidies primarily take the form of “feed in tariffs” that guarantee minimum per kWh payments to those employing favored technologies, which are paid out of a pool funded by consumers. See Stefan Nicola, German Industry Wants End of Feed-in Tariff on Rising Power Cost, Bloomberg (Sep 19, 2013, 5:53 AM), http://www.bloomberg.com/news/2013-09-19/german-industry-wants-end-of-feed-in-tariff-on-rising-power-cost.html.

[17] As discussed below, the Federal Energy Regulatory Commission (FERC) has disclaimed jurisdiction over energy supplied from behind-the-meter distributed generation so long as the customer does not supply more excess energy than it acquires from the grid over the course of a monthly retail billing period.

[18] Energy Info. Admin., Table 5.6.A, supra note 9.

[19] This Article refers to generators that are connected on the utility side of the customer meter as “grid-connected generation” for ease of reference. This is a misnomer, however, because all generation, including generation located on a retail customer’s property on the customer side of the meter, is connected to and part of the electric grid. Electricity does not recognize the difference in location; at all times sufficient energy must be supplied to meet the aggregate demand of all users, and the system must be kept in precise balance (supply equaling demand) in order to prevent outages and serious damage to facilities.

[20] See Platts, Megawatt Daily, at 2-10 (November 27, 2013).

[21] American Wind Energy Association, The Cost of Wind Energy in the U.S., http://www.awea.org/Resources/Content.aspx?ItemNumber=5547 (last visited Nov. 24, 2013).

[22] The analysts at Citi put it succinctly: “While residential solar has the advantage of competing against higher residential electricity prices, merchant utility scale solar must compete against wholesale power prices.” Citi Research, supra note 2 at 21.

[23] See Cal. Pub. Utils. Comm’n, California Net Energy Metering (NEM) Draft Cost-Effectiveness Evaluation (2013), available at http://www.cpuc.ca.gov/NR/rdonlyres/BD9EAD36-7648-430B-A692-8760FA186861/0/CPUCNEMDraftReport92613.pdf.

[24] Id. at 110.

[25] Energy Policy Act of 2005, Pub. L. No.109-58, sec. 1251, § 111(d), 119 Stat. 962 (codified as amended at 16 U.S.C. 2621(d)(11)).

[26] See id.; Pub. Util. Reg. Policies Act of 1978, Pub. L. No. 95-617, § 111(d), 92 Stat. 3117, 3142-43 (codified as amended at 16 U.S.C. § 2621(d)(10)(E)(11) (2006)).

[27] Energy Policy Act § 111(d); 16 U.S.C. § 2621(d)(10)(E)(11).

[28] Congress also did not define what it meant by “delivered to the local distribution facilities” in this provision. It may have intended the energy credit to apply only to energy in excess of the customer’s on-site use, or it may have intended that all energy produced on-site be treated as energy provided to the grid because all such energy substitutes energy that would otherwise be supplied from the grid. Either way, the definition provides only for an energy credit, which is not what occurs in most jurisdictions.

[29] FirstEnergy Corp. v. Pub. Utils. Comm’n of Ohio, 768 N.E.2d 648 (Ohio 2002).

[30] Id. at 650.

[31] Id.

[32] Id. at 652.

[33] Id.

[34] Pub. Util. Reg. Policies Act § 210 (codified at 16 U.S.C. § 824a-3(a) (2006)). FERC regulations refer to these as “qualifying facilities.” 18 C.F.R. § 292.101(b)(1).

[35] 18 C.F.R. § 292.203(d) (2010).

[36] See Stephanie Watson, How Net Metering Works, How Stuff Works, http://science.howstuffworks.com/environmental/green-science/net-metering2.htm (last visited Nov. 24, 2013).

[37] 16 U.S.C §§ 791a-825r.

[38] From the earliest days of Federal Power Act jurisprudence, courts have emphasized that wholesale power transactions under the Federal Power Act are voluntary. Fed. Power Comm’n v. Sierra Pac. Power Co., 350 U.S. 348 (1956). In organized Regional Transmission Organization (RTO) markets, any generator that signs a service agreement with RTO is permitted to bid its energy into the market and, if dispatched, gets paid the locational marginal cost of energy, even if the generator does not have a contract with a specific buyer.

[39] Am. Paper Inst. v. Am. Elec. Power Serv. Corp., 461 U.S. 402, 404 (1983).

[40] See MidAmerican Energy Co., 94 F.E.R.C. P 61,340 (2001); Sun Edison LLC, 129 F.E.R.C. P 6,1146 (2009).

[41] Id.

[42] See S. Cal. Edison Co. v. FERC, 603 F.3d 996 (D.C. Cir. 2010); Calpine Corp. v. FERC, 702 F.3d 41 (D.C. Cir. 2012).

[43] See S. Cal Edison Co. 603 F.3d at 1000-01; Calpine Corp. 702 F.3d at 45.

[44] 16 U.S.C. § 824e(a).

[45] California is attempting to overcome this issue by requiring utilities to purchase storage capacity using new technologies to help balance supply and demand. Order Instituting Rulemaking Pursuant to Assembly Bill 2514 to Consider the Adoption of Procurement Targets for Viable and Cost-Effective Energy (published October 17, 2013), Cal. Pub. Utils. Comm’n, 2013 Cal. PUC LEXIS 569, available at http://docs.cpuc.ca.gov/PublishedDocs/Published/G000/M078/K912/78912194.PDF. Whether these alternative technologies will become available in sufficient quantities and at a reasonable cost to replace balancing generation from the grid, and how long this may take, is unknown.

[46] The Economist notes: “Renewables can depress wholesale prices, e.g. when the sun creates a midday jolt. This discourages investors in the flexible, gas-powered generation needed to provide backup for windless, cloudy days.” Energiewinde, Economist, July 28, 2012, at 3. Citi Research, noting that solar production causes lower utilization rates for conventional generation plants, concludes: “This would in a perfect economic world lead to the closure of some higher heat rate gas plants, but the problem of course is that much of this generation capacity needs to remain to cover lost generation on less sunny days and at night, and through the winter . . . .” Citi Research, supra note 2, at 17.

[47] For example, the electric industry is investing significant sums in response to state laws imposing renewable portfolio standards. Large additional investments are being made to modernize the transmission and distribution systems and incorporate so-called “smart grid” technologies. One utility executive recently noted that half the existing transmission grid is more than fifty years old, so sizable investments to sustain it are inevitable. Lisa Barton, IHS The Energy Daily, September 26, 2013, at 14. Several northeastern states are requiring utilities to invest in “hardening” their systems in response to recent storm-related outages. See Diana Cardwell et al., Hurricane Sandy Alters Utilities’ Calculus on Upgrades, N.Y. Times, Dec. 28, 2012, at B1. Since 2005, the utility industry has also been subject to mandatory reliability standards approved by the FERC that require significant ongoing investments in the grid. 16 U.S.C. § 824o (2005).

[48] See, e.g., J. Gregory Sidak & Daniel F. Spulber, Deregulatory Takings and Breach of the Regulatory Contract, 71 N.Y.U. L. Rev. 851 (1996).

[49] See, e.g., Susan Rose-Ackerman & Jim Rossi, Disentangling Deregulatory Takings, 86 Va. L. Rev. 1436 (2000).

[50] 488 U.S. 299, 314-15 (1989) [hereinafter Duquesne].

[51] 320 U.S. 591, 602-03 (1944) [hereinafter Hope].

[52] Id. at 605.

[53] The takings issue will recur if demand declines further over time. If demand declines after rates have been set, utilities will once again under-recover their costs, forcing them to file for another round of rate increases to offset the effect of the loss of load since the prior rate case. Utilities will be playing

“catch-up” to get the revenues needed to recover their costs and attract investment.

[54] Assuming much of the utility industry will have moved into other business lines, including distributed generation, legislators could be less inclined to provide full stranded cost relief in these circumstances.

[55] See Nantahala Power & Light Co. v. Thornburg, 476 U.S. 953, 970 (1986); Entergy La., Inc. v. La. Pub. Serv. Comm’n, 539 U.S. 39, 48 (2003).

[56] In Texas, the Public Utility Commission of Texas (PUCT) regulates all of these functions. In other states where retail rates remain bundled, states will have most of the control over this process for both transmission and distribution assets, unless the FERC chooses (or is forced) to assume jurisdiction over interstate transmission costs that are bundled into retail rates pursuant to the Supreme Court’s opinion in New York v. FERC, 535 U.S. 1 (2002).

[57] FERC has recently decided that more entities should be eligible to build and own transmission facilities. Transmission Planning and Cost Allocation by Transmission Owning and Operating Public Utilities, Order No. 1000, FERC Stats. & Regs. ¶ 31,323 (2011), order on reh’g, Order No. 1000-A, 139 FERC ¶ 61,132, order on reh’g, Order No. 1000-B, 141 FERC ¶ 61,044 (2012), appeal docketed, S.C. Pub. Serv. Auth. v. FERC, No. 12-1232 (D.C. Cir. 2012).


Investing in U.S. Pipeline Infrastructure: Could the Proposed Master Limited Partnerships Parity Act Spur New Investment?

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Linda E. Carlisle, Daniel A. Hagan and Jane E. Rueger*

The so-called “shale revolution” has upset traditional notions of supply and demand centers for natural gas and crude oil. Demand centers in the Northeast traditionally needed to import natural gas or oil from distant supply centers, such as Texas or Louisiana. However, major plays located near these demand centers, such as the Marcellus shale, are causing directional flows on existing pipelines to change. In addition, these plays have spurred the need for additional pipeline infrastructure development to transport crude oil and natural gas liquids from major shale plays in the Northeast and the Midwest to processing and manufacturing facilities that currently exist or are under development in Texas and Louisiana.

This Article explores combining the traditional oil and gas pipeline structure with solar electric generation to: (1) increase the return on pipeline investments by making the income from a solar electric generation business available to pipeline operators; and (2) lower the cost of operating the pipeline. After a brief overview of the current state of U.S. pipeline infrastructure, this Article describes the structure generally used for current pipeline investment and pending legislation, which would make the structure available to solar electric generation businesses. The Article then explores the potential benefits of combining solar generation and pipeline transportation businesses if the pending legislation passes.

Overview of the Current State of U.S. Pipeline Infrastructure

The past decade has brought sweeping change to the oil and gas industry in the United States. Technological developments in drilling and hydraulic fracturing have allowed extraction of large volumes of shale gas and tight oil that were previously economically infeasible to produce. With respect to natural gas, tight oil and shale gas accounted for forty percent of the total U.S. natural gas produced in 2012.[1] The U.S. Energy Information Administration (EIA) projects natural gas production in the United States will increase from 23.0 trillion cubic feet in 2011 to 33.1 trillion cubic feet by 2040, a forty-four percent increase almost entirely due to projected growth in shale gas production.[2] As of June 2013, EIA ranks the United States fourth in the world with respect to volume of technically recoverable shale gas resources[3] and projects that the United States may become a net exporter of natural gas in years to come.[4] Crude oil production has similarly increased; EIA ranks the United States second in the world with respect to volume of technically recoverable shale oil,[5] and crude oil production from tight plays accounted for nearly all 847,000 barrels per day increase in production in 2012 compared with 2011.[6] This is by far the largest growth in crude oil production in any country.[7]

Development of the infrastructure necessary to fully utilize the wealth of shale oil and gas reserves in the United States has been slow to materialize. Pipelines, particularly large diameter, long-distance interstate pipelines, are very expensive to build. By some recent estimates, onshore pipeline construction costs in the United States can be an average cost-per-mile of $3.1 million.[8] A recently proposed interstate natural gas pipeline is expected to cost approximately $3 billion to build.[9] Moreover, pipelines have a long construction lead-time: it often takes years to work through planning, siting, and obtaining regulatory approvals, prior to beginning construction. Developers have often found it difficult to attract the kind of long-term firm commitments that are necessary to support investment in pipeline infrastructure. Pipelines also face competition from railroads for the crude oil and natural gas liquids transportation business because building new rail is cheaper, and existing rail beds give more delivery point options than pipelines.

Moreover, not all investments in the pipeline transportation business have been successful. For example, the Rockies Express Pipeline (REX), completed in 2009 at a cost of about $6.2 billion, was built to deliver natural gas from Colorado and Wyoming to demand centers as far east as Ohio.[10] The subsequent development of economically recoverable shale gas reserves in the Marcellus and Utica regions has upended REX’s value proposition such that it has operated at a load factor of only sixty-six percent in 2013.[11] This resulted in bond ratings agencies questioning REX’s ability to maintain earnings after its anchor shippers’ contracts expire in 2019, absent timely action to enter into new contracts.[12] Current anchor shippers vigorously oppose entering into new contracts for shale gas shipments from east to west, making REX’s future prospects uncertain.[13]

Master Limited Partnerships[14] Today and the Master Limited Partnerships Parity Act[15]

Master limited partnerships (MLPs) are publicly traded businesses that are taxed as partnerships.[16] A U.S. business entity that is taxed as a partnership, unlike a corporation, is a “pass-through entity” for federal income tax purposes.[17] This means that the partnership does not pay tax as an entity, but rather each partner is allocated his share of partnership income, gain, deductions, losses, and credits annually and pays tax on his distributable share of partnership income regardless of whether the partnership makes any cash distributions to its partners. As a result, there is only a single level of federal income tax (at the partner level) on the income of a partnership. This is in stark contrast to the two levels of tax imposed on the income of a corporation (for a corporation, the income is taxed when earned by the corporation[18] and then again when it is distributed in the form of a dividend to its shareholders).[19]

In 1987, Congress limited the types of businesses that would be taxed as partnerships if they were “publicly traded” out of concern that the widespread use of publicly traded partnerships would erode the corporate tax base.[20] Partnership status, however, was retained for businesses that had traditionally been conducted in partnership form, such as businesses involved in oil and gas exploration and production.[21]

To qualify for MLP status, a business entity that otherwise would be treated as a partnership for federal income tax purposes and whose interests are “publicly traded” must satisfy a “qualifying income” test, which requires ninety percent or more of the gross income of the partnership to be “qualifying income.”[22] Qualifying income includes: (i) passive income such as interest, dividends, and gains from the disposition of property that generates such passive income; (ii) rents and gains from real property; (iii) income and gains from the exploration, development, mining, production, processing, refining, transportation, or marketing of minerals and natural resources; and (iv) income and gains from transactions in commodities in the case of partnerships that buy and sell such commodities as a principal business activity.[23]

MLPs combine the benefits of public corporations whose interests are readily bought and sold on established securities markets and the tax benefits of partnerships, which are not subject to the federal corporate income tax. Such favorable tax treatment allows MLPs to access capital at a lower cost than business entities taxed as corporations. This makes the MLP structure particularly attractive to the capital-intensive pipeline infrastructure transportation business.

In 2008, Congress expanded the definition of qualifying income to include transportation and storage of certain renewable and alternative fuels, such as ethanol and biodiesel, as well as industrial-source carbon dioxide.[24] Income from alternative or renewable energy generation businesses, however, continues to be excluded from qualifying income status.

Legislation has been introduced in the House of Representatives[25] and in the Senate[26] that would expand the definition of qualifying income to allow alternative or renewable energy projects access to the MLP structure. Under the “Master Limited Partnerships Parity Act,” the definition of qualifying income would be expanded to include income from clean energy resources and infrastructure businesses. Qualifying income would include income from renewable energy projects such as wind power, closed and open loop biomass, geothermal, solar, municipal solid waste, hydropower, marine and hydrokinetic, and fuel cells. The legislation would also expand the definition of qualifying income to include income from certain clean energy technologies, including the production, storage, and transportation of renewable fuels, electricity storage, carbon capture and storage, waste heat power production, and energy-efficient building technology.

Opportunities for Solar Generation: Pipeline Infrastructure Synergies

Passage of the Master Limited Partnerships Parity Act could lead to some interesting opportunities and synergies for solar generation and pipeline infrastructure businesses that could begin to address the economic hurdles to pipeline infrastructure development. The Master Limited Partnerships Parity Act would allow a single MLP to be in the pipeline transportation business and the renewable electric generation business because both businesses would generate “qualifying income” that would allow the entity to benefit from favorable tax treatment as a partnership. The solar generation business would give the pipeline operator an additional revenue source from the sale of power, either through bilateral sales, wholesale sales into power markets, or sales under the Public Utility Regulatory Policies Act (PURPA).[27] In addition, the operational costs of the pipeline business would be reduced. For example, while pipeline compressor stations can vary widely by design, they typically incur fuel costs and often emit greenhouse gases and NOx,which imposes additional construction and maintenance costs due to the equipment necessary to meet local or federal emissions limits.[28] As compressor stations are usually spaced approximately every fifty to one hundred miles along a pipeline route,[29] these costs can be significant on long interstate pipelines. Using electricity from solar assets to power compressor operations offers the opportunity to reduce the overall cost of operating the pipeline. Although solar generation only produces power during the day, electric storage devices would allow such power to be used to serve nighttime compressor operations.

Moreover, pipeline companies have right-of-way and permitting institutional knowledge that is readily transferrable to the siting and permitting of solar generation. In the process of constructing a pipeline, pipeline companies must acquire rights-of-way from local landowners along the entire route of the pipeline, including appurtenant parcels for placement of compressor stations that can reach seventy acres each (including the compressor site and additional acreage for sound buffering).[30] Pipeline companies are also familiar with state and local processes for environmental and similar permits. These areas of institutional knowledge are equally relevant to the solar generating facility siting and permitting process.

Infrastructure development related to the shale boom is a complex problem without a single, simple solution. But within every problem lies opportunity, and the beneficial combination of pipeline and solar infrastructure is one potential opportunity that could start to address the need to incentivize investment in pipeline infrastructure in the current economic climate.


Preferred citation: Linda E. Carlisle, Daniel A. Hagan & Jane E. Rueger, Investing in U.S. Pipeline Infrastructure: Could the Proposed Master Limited Partnership Parity Act Spur New Investment?, 4 Harv. Bus. L. Rev. Online 32 (2013), https://journals.law.harvard.edu/hblr//?p=3645.

* Linda E. Carlisle is a Partner in the Tax Group of White & Case LLP. Daniel A. Hagan is a Partner, and Jane E. Rueger is a Counsel, in the Energy Markets and Regulatory Group of White & Case LLP. All are based in White & Case LLP’s Washington, D.C. office. The opinions expressed are those of the authors and do not necessarily reflect the views of the authors’ law firm or its clients.

[1] Energy Info. Admin., Technically Recoverable Shale Oil and Shale Gas Resources: An Assessment of 137 Shale Formations in 41 Countries Outside the United States [hereinafter EIA 2013 Assessment], (June 13, 2013), at 11, http://www.eia.gov/analysis/studies/worldshalegas.

[2] See Energy Info. Admin., Energy in Brief: What Is Shale Gas and Why Is It Important?, (Dec. 5, 2012), http://www.eia.gov/energy_in_brief/article/about_shale_gas.cfm?src=home-f2.

[3] EIA 2013 Assessment, supra note 1, at 10.

[4] Energy Info. Admin., Annual Energy Outlook 2013, (Apr. 2013), at 2, http://www.eia.gov/forecasts/aeo/chapter_executive_summary.cfm.

[5] EIA 2013 Assessment, supra note 1, at 10.

[6] Id. at 12.

[7] Id.

[8] Christopher E. Smith, Worldwide Pipeline Construction: Crude, Products Plans Push 2013 Construction Sharply Higher, Oil & Gas J, (Feb. 4, 2013), http://www.ogj.com/articles/print/volume-111/issue-02/special-report–worldwide-pipeline-construction/worldwide-pipeline-construction-crude-products.html.

[9] Bill Faries & Mike Lee, Spectra Wins $3 Billion Interstate Florida Gas Pipeline, Bloomberg News, (July 26, 2013), http://www.bloomberg.com/news/2013-07-26/spectra-wins-3-billion-interstate-florida-gas-pipeline.html.

[10] Kinder Morgan Energy Partners, Current Report (Form 8-K, Ex. 99.1) at 128 (June 12, 2009).

[11] Peter Behr, Rockies Express shippers fight a proposed change in gas flows, EnergyWire, (July 26, 2013), http://www.eenews.net/stories/1059985120. Load factor refers to customers’ actual utilization of a pipeline’s capacity compared to its maximum capacity.

[12] Id.

[13] See id.

[14] For federal tax purposes, master limited partnerships include both limited partnerships and limited liability companies.

[15] S. 795, 113th Cong. (2013); H.R. 1696, 113th Cong. (2013).

[16] See I.R.C. § 7704(c)(1) (2012).

[17] See id. § 701.

[18] See id. § 11.

[19] See id. § 61(a)(7).

[20] H.R. Rep. No. 100-391, pt. 2, at 1064 (1987), reprinted in 1987 U.S.C.C.A.N. 2313-378, 2313-680.

[21] Id. at 2313-683.

[22] I.R.C. § 7704(c)(2) (2012).

[23] See id. § 7704(d).

[24] See id. § 7704(d)(1)(e).

[25] H.R. 1696, 113th Cong. (2013).

[26] S. 795, 113th Cong. (2013).

[27] PURPA was enacted in 1978 with the intent to spur development of more efficient and renewable generating facilities developed and owned by entities independent from incumbent franchised utilities. See Fed. Energy Regulatory Comm’n, What is a Qualifying Facility? http://www.ferc.gov/industries/electric/gen-info/qual-fac/what-is.asp (last visited Nov. 23, 2013). To that end, PURPA established a new class of generating facilities called qualifying facilities that receive special rate and regulatory treatment. See id. One type of qualifying facility, the small power production facility (SPP QF), is a generating facility of eighty-megawatts or less that uses, as a primary energy source, renewable (hydro, wind, or solar), biomass, waste, or geothermal resources. See id. Facilities that meet the size and fuel requirements to be SPP QFs and file a simple self-certification form with the Federal Energy Regulation Commission enjoy numerous rate and regulatory benefits. See Fed. Energy Regulatory Comm’n, What Are the Benefits of QF Status?

http://www ferc.gov/industries/electric/gen-info/qual-fac/benefits.asp (last visited Nov. 23, 2013).

[28] Ranier Kurz et al., Gas Compressor Station Economic Optimization, Int’l J. of Rotating Machinery, Vol. 2012, available at http://www.hindawi.com/journals/ijrm/2012/715017/.

[29] Energy Info. Admin., Natural Gas Compressor Stations on the Interstate Pipeline Network: Developments Since 1996 (Nov. 2007),


[30] See, e.g., 240 No. 7 Pipeline & Gas J., Millennium Touts Completion of Minisink Compressor Station, (July 2013), http://www.pipelineandgasjournal.com/millennium-touts-completion-minisink-compressor-station.

Brazilian Private Equity Funds (FIPs): A DNA Change in Brazilian M&A Deals

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José Carlos Junqueira Sampaio Meirelles*

Caio Carlos Cruz Ferreira Silva


Brazil has become a preferred destination for private equity[1] investments from all over the globe.[2] The country’s recently achieved investment-grade[3] status was perhaps the missing push needed to put Brazil on the radar of private equity investors and in the mainstream of international business transactions.[4]

The longstanding efforts undertaken in Brazil to reconcile sustainable growth with sound economic policies and reliable legal and regulatory frameworks have helped steer the country out of one of the worst global economic downturns, drawing yet more attention to its promising and underexplored market as an attractive alternative for investors. Mindful of these developments and related opportunities, private equity investors have been deploying substantial funds in Brazil, fueling an unprecedented flow of countrywide M&A activity.[5] The number of private equity deals that have taken place in M&A arena has increased by roughly 168% since 2007,[6] and private equity investors have rapidly developed into one of the driving forces behind business ventures across a variety of industries.[7]

The above data helps put in perspective the rising magnitude of private equity investments in the Brazilian M&A context, a trend that is expected to be further amplified going forward.[8] The data also suggests that private equity investments exert a high degree of influence in the transformation of several sectors in the Brazilian economy, primarily by fostering the reallocation of assets and capital among entities and the reorganization of domestic businesses in pursuit of efficiency and profitability.

From a legal standpoint, the intensification of private equity activity has prompted investors and governmental authorities to come up with creative transactional structures and regulatory approaches to facilitate private equity ventures, while coping with the demands and challenges of an increasingly competitive market. The result of this interaction has been instrumental in reshaping the Brazilian M&A landscape.

M&A deal structures[9] and market players in Brazil have evolved over the past ten years,[10] and private equity sponsors catalyzed several of these changes.[11] This Article, however, focuses on one specific change: most M&A deals in Brazil involving private equity players have been undergoing an important DNA change stemming from the increasing use of the Brazilian Private Equity Fund (Fundo de Investimento em Participações (FIP)) on the buy-side and the sell-side of these transactions.

Unlike U.S. corporate law, Brazilian law does not provide for limited liability partnerships (LLPs) or limited partnerships (LPs), and until recently private equity investments in Brazil were predominantly structured through holding companies. These classic private equity transactions—formally implemented either through direct acquisitions/investments or via local holdings incorporated as a limited liability company (sociedade limitada[12]) or a corporation (sociedade por ações (S.A.)[13])—are now gradually making way for structures involving domestic investment funds[14] as the vehicle to acquire or invest in, hold, and manage portfolio companies until divestment is completed.

The most popular private equity vehicle in the Brazilian M&A practice is by far the FIP, whose structure bears some similarity to the partnership fund model generally adopted in the U.S. and in Europe. The Brazilian Securities and Exchange Commission (Comissão de Valores Mobiliários (CVM)[15]) introduced FIPs to Brazil through Rule No. 391 (CVM Rule 391/03), issued on July 16, 2003.[16]

By laying down the legal and regulatory grounds for the establishment of an investment conduit that local and foreign investors formerly lacked when sponsoring private equity ventures in Brazil, CVM Rule 391/03 largely contributed to a rapid expansion of FIPs in M&A deals.[17] More importantly, investments and exit strategies successfully implemented by FIPs since 2004 created an encouraging track record that helped Brazilian private equity-backed M&A transactions achieve high priority on the agendas of institutional investors.

The regulatory flexibility and generally favorable tax regime accorded to FIPs make FIPs a unique and powerful tool for structuring M&A transactions involving targets in Brazil. Additionally, investors can utilize FIPs for fundraising, deal financing, and implementing exit strategies, as applicable CVM regulations allow the placement of their units in the market. This Article illustrates the many ways in which private equity-backed M&A deals have undergone a DNA change in Brazil, derived—to a large extent—from the rise of FIPs as a common vehicle in such transactions.


CVM Rule 391/03 is the core regulation applicable to FIPs.[18]The self-contained and investor-friendly legal regime applicable to FIPs makes FIPs the preferred and most flexible private equity vehicle in Brazil. The adaptability of the FIP allows investors to contractually stipulate the most suitable set of governance and operational rules that will govern the FIP itself and their legal interaction as owners of the vehicle. These rules are customarily amalgamated in the FIP’s charter, investment commitment agreements, quotaholders agreements,[19] and a variety of service contracts,[20] which regulate matters bearing on investment policy, decision-making procedures, capital commitments and calls, issuance and placement of units (quotas), distribution of proceeds, investment and divestment periods, minimum net equity requirements, management and performance fees, and liquidation, among others.

2.1. Form and Ownership Structure

The FIP is, in essence, a collective investment vehicle formed as a condominium,[21] allowing co-ownership of assets to be exercised among investors. FIPs can only operate in Brazil upon registration with the CVM, and FIPs, along with their securities (quotas) and investors (quotaholders), are subject to the CVM’s oversight. The FIP must be organized as a closed-end[22] condominium consisting of an un-personified pool of assets managed and represented by an administrator[23] registered with the CVM.

The FIP form can be especially attractive to private equity investors seeking lower individual exposure to risks through the gathering of funds by an investor pool and asset diversification.[24] The FIP can also provide its owners with a platform for centralized professional management of target companies with the requisite market and financial skills that otherwise would not be available to investors acting individually or through subsidiaries.[25] Additionally, Brazilian law requires the FIP to obtain a federal taxpayer number and to book the transactions it engages in on its own name and on its own behalf.[26]

2.2. Ownership Rights and Quotas

Equity units known as “quotas” represent the ownership interest rights of the FIP’s investors, or quotaholders.[27] Each quota in an FIP corresponds to a ratable share of the portfolio assets held under joint ownership by the quotaholders.[28] Thus, the value of each quota is calculated as the division of the net equity of the FIP by the number of outstanding quotas. Each quota carries one vote in the quotaholders’ general meeting,[29] unless the organizational documents of the FIP admit classes of quotas with different voting rights.[30]

2.3. Permitted Investments

The FIP’s investment objectives primarily comprise the acquisition of stock, debentures, subscription warranties, or other securities convertible into or exchangeable for stock issued by publicly held (listed) or closely held corporations in Brazil, whose management must be actively monitored by the FIP. The remaining portion of the FIP’s portfolio can consist of liquid fixed-income instruments and other financial assets, mainly for cash management purposes.

The FIP’s charter must establish the eligibility criteria[31] that apply to publicly held companies that the FIP invests in. These companies are also subject to the minimum set of corporate governance standards imposed by CVM Rule 391/03. Closely held companies that the FIP invests in have to comply with certain minimum governance guidelines such as (a) the establishment of a unified one-year term of office for the entire board of directors (no staggered boards); (b) annual audit of their financial statements; (c) disclosure of related-party agreements, shareholders’ agreements, stock option plans, and share buyback plans; and (d) the obligation to adhere to certain differentiated levels of corporate governance practices in case the company goes public.[32]

Investments by the FIP in either closely or publicly held companies are not subject to minimum revenue or net worth requirements. There are no mandatory concentration or diversification requirements that apply to the allocation of the FIP’s portfolio in equity investments, except if otherwise defined in the FIP’s charter. The FIP can concentrate its entire net equity in a single target or distribute its investments in as many targets as decided on by the FIP’s quotaholders or investment committee. Further, there are no restrictions on the number of FIPs that can invest in a single company.

2.4. Investment Restrictions

The FIP cannot invest in derivatives, except for hedging purposes. Furthermore, only the invested companies that make up the FIP’s portfolio may hold direct ownership in real estate assets, not the FIP itself. Consequently, when FIPs are used to structure real estate investments, the invested companies held by the FIP are generally the ones either directly holding the real estate assets or investing in Special Purpose Companies (SPCs), which will then hold the real estate assets.[33] FIPs are not permitted to invest overseas.[34] Further investment restrictions include the prohibition from soliciting or contracting loans (except under very specific limited circumstances) and providing guarantees (except when approved by a qualified majority of 2/3 or more of the quotaholders in a general meeting and as expressly permitted by the fund’s bylaws).[35] These restrictions constrain the FIP’s ability to raise debt in the market to fund acquisitions or investments.[36] Nonetheless, holding companies or SPCs that the FIP invests in can be used as vehicles in leveraged acquisitions of, or investments in, target companies.

2.5. Special Purpose Companies (SPCs)

While companies in which the FIP invests must be publicly or closely held corporations, prevailing regulations impose no restrictions as to the type of business organization of the SPCs that can be held by target companies (S.A.s) directly owned by the FIP. As Figure 1 depicts, the FIP can use these SPCs—through target companies—to channel private equity investments in equity participations and assets that would otherwise not be permitted at the FIP level,[37] which creates liability-shields for the FIP’s quotaholders.[38]

 Image 1, Section 2.5

Peculiarities pertaining to target or asset acquisitions, costs, time, tax efficiencies, and regulatory implications may be some of the motivations that lead corporate planners to adopt multiple corporate layers under an FIP, like the ones exemplified in Figure 1.

2.6. Eligible Investors

The risks associated with private equity investments generally make such investments unsuitable for the general public. As for FIPs specifically, typical risks involve: (a) illiquidity of the securities and assets making up the FIP’s portfolio (as opposed to other investments in more liquid asset classes); (b) concentration in securities issued by only a few target companies or by target companies pertaining to given industries or sectors; (c) failure to comply with the investment policy due to the lack of eligible targets; (d) other risks particularly related to the target companies, including a spectrum of business, financial, and legal risks and contingencies; (e) risks related to the management and operation of the FIP; and (f) market and credit risks.[39] CVM Rule 391/03 acknowledges these risks concern and limits investment eligibility in FIPs to investors whose financial capabilities and sophistication enable them to make informed investment decisions.[40] CVM Rule 391/03 also sets at R$100,000 (approximately US$43,000 as of November 2013) the minimum capital commitment in the FIP per quotaholder.[41] Hence, only “qualified investors” as defined by the CVM, can acquire the quotas of an FIP.[42] This target investor restriction gives private equity investors great latitude to structure FIPs and regulate their operation according to the rules suited for each particular deal or set of deals.

Among local qualified investors, pension funds have been one of the most active players in the domestic private equity scenario.[43] Non-resident investors must make the required investment in accordance with the rules of Resolution No. 2,689, issued by the National Monetary Council (CMN) on January 26, 2000 (CMN Resolution 2,689/00),[44] which apply in addition to the prerequisites of CVM Rule 391/03. CMN Resolution 2,689/00 basically allows non-resident private equity investors to remit funds into Brazil to subscribe for and pay in FIPs’ quotas and repatriate their capital abroad.[45]

2.7. Active Participation in the Management of Target

CVM Rule 391/03 requires the FIP to actively participate in the invested companies’ strategic policies and management, notably by appointing members to their boards of directors.[46] The requirement to actively participate in the decision-making process of the target companies and influence their strategy and management is one of the core features that make FIPs especially attractive to private equity investors. Whatever form the FIP investment in a target company takes,[47] under CVM Rule 391/01, the FIP must retain some degree of effective influence in the invested companies’ strategic decisions.

In order to satisfy the investment eligibility test, the FIP may: (a) hold stocks that are part of the controlling block of the invested company; (b) enter into shareholders’ agreements granting it decision powers over the invested company; or (c) enter into other agreements or arrangements that ensure the FIP’s actual influence on the strategic policy and management of the invested company (agreements or arrangements of this sort can entail, for example, veto rights and supermajority quorums).

2.8. Management and Governance

In contrast to the partnership structure of many U.S. private equity funds, the administration, portfolio management, and distribution of equity interests of an FIP are not performed by a general partner but rather by an independent legal entity accredited with the CVM to engage in securities portfolio administration activities: the so-called FIP administrator (administrador).[48] The administrator is responsible for the legal representation of the FIP as well as for managing the FIP’s routine activities, which include paying fees, receiving dividends and interest, preparing financial statements and reports, signing shareholders’ agreements of companies in which the FIP is a shareholder, providing reports and information to investors, in addition to other activities established in the FIP’s charter or determined by the quotaholders’ general meeting.

The quotaholders who attend the general meeting are the key decision-makers in an FIP and have exclusive authority over key matters such as the amendment of the charter, the removal of the administrator, the merger or liquidation of the FIP, the issuance and distribution of new quotas, the extension of the duration of the FIP, and the operation of the committees and administrative bodies of the FIP. Resolutions of the general meeting generally require a majority vote of the attendees, unless a supermajority vote is mandated by CVM Rule 391/03 or by the FIP’s charter.

Certain FIPs also have internal committees and boards to enrich their decision-making processes and to ensure informed decisions regarding the FIP’s investments and divestitures.[49] More complex FIPs might also have advisory boards and technical committees to advise on matters pertaining to the industry or sector of each target company.[50]

2.9. Distributions and Dividends, and Investment and Divestment Periods

While investors of mutual funds organized as open-end mutual condominia can have their quotas redeemed at any time, quotaholders of closed-end mutual funds like FIPs are only entitled to redeem their quotas at the end of the FIP’s term, and thus remain locked-in for the entire term of the FIP. Nevertheless, the FIP is allowed to make recurring distributions (amortizações) to its quotaholders during the term of the FIP. An FIP may divest itself of one or more of its portfolio companies and distribute the sales proceeds to its quotaholders without having to wait until the termination of the FIP. It may also reinvest such proceeds in other targets, subject to the applicable provisions of the FIP’s charter.[51] Additionally, if the FIP’s charter allows its quotaholders to receive dividends from companies in which the FIP has invested, such dividends may be distributed directly by the target company to the FIP’s quotaholders, ratably according to their respective ownership interests in the FIP.

Quotaholders also have the right to terminate the FIP at any time by qualified majority voting at a meeting, even during the investment period. This right is usually exercised by quotaholders when the FIP has disposed of all of the securities and assets in its portfolio before the end of the FIP’s term of duration or in situations where the FIP has not been able to find eligible target investments.

2.10. FIP Registration and Reporting Requirements

FIPs must be registered with the CVM in order to operate and are subject to continued scrutiny by the CVM.[52] The CVM imposes flexible and relatively simple conditions for registration of FIPs. When an investment channels through an FIP, the CVM requires that the FIP regularly report information about its financial standing and performance, including general information about its portfolio. Other than these CVM reporting requirements, there are no disclosure obligations affecting private equity investments, except for the Central Bank of Brazil’s reporting requirements, which are applicable to foreign investments entering Brazil, and the disclosure requirements that may be imposed by local antitrust authorities. However, if the company is or becomes listed, it must then comply with several disclosure and publicity requirements under Brazilian law.[53]

2.11. Offering of Quotas

The distribution of FIPs’ quotas is considered a public offering of securities under Brazilian securities laws and regulations[54] and, as such, is subject to prior registration with the CVM. If an FIP’s quotas are to be distributed to the public, the requirements set forth in CVM Rule No. 400, of December 29, 2003 are triggered.[55] Nonetheless, under Rule No. 476, issued by the CVM on January 16, 2009 (CVM Rule 476/09),[56] a fast-track procedure applies to certain restricted placements.[57]

2.12. Taxation of FIP and its Quotaholders

FIPs are generally exempt from income tax on the gains derived from their financial investments because of the FIP’s characterization as a condominium under Brazilian law. In contrast, Brazilian tax law does not treat the Brazilian target companies in which the FIP invests as tax-transparent and instead taxes them as independent entities. The fact that the FIP itself is per se exempt from taxation on acquisitions and divestitures makes it a very attractive vehicle for private equity investment. Further, the tax treatment accorded to non-resident quotaholders of FIPs give them an extra incentive to employ such vehicles.

Dividends received by the FIP and repaid to its quotaholders are currently not subject to the Brazilian withholding income tax (WHT). Interest on net equity[58] received by the FIP and repaid to quotaholders as well as other payments made to FIP’s quotaholders domiciled in Brazil are subject to WHT at the rate of fifteen percent.[59] However, WHT assessed on the income earned by non-resident investors arising from an interest in an FIP as well as upon repatriation of the capital originally invested in the FIP are currently subject to a zero percent rate,[60] provided that certain conditions are met.[61] This exemption partly explains why foreign private equity feeder funds and other non-resident investors usually treat FIPs as the preferred vehicles for private equity investments in Brazil.

Savings from a zero reduction on the WHT levied on income distributions made by the FIP may be crucial to determining the economic advisability of an M&A transaction and allow private equity investors to maximize the value-capturing potential of certain opportunities.[62] As the FIP itself is a tax neutral entity (pass-through vehicle), even resident investors take this factor into consideration when structuring M&A deals, with the intent to defer taxes at least for the term of the FIP.

2.13. FIP Structure

 Image 2, Section 2.13

Figure 2 shows a standard FIP structure and the payment flows typically carried out among transaction participants, as enumerated below:

1.  FIP issues quotas to Qualified Investors;

2.  Qualified Investors subscribe and pay quotas to the FIP;

3.  During the investment period, the FIP invests the amounts raised through the offering of its quotas in securities of one or more target companies;

4.  The remaining net equity of the FIP is invested in other assets and securities authorized under the FIP’s charter;

5.  Proceeds arising from payments of dividends and interest on equity by target companies, sales of other assets and securities comprising the FIP’s portfolio, and other distributions are disbursed to the FIP normally following the expiration of the FIP’s investment period; and

6.  The FIP makes distributions to quotaholders.


Brazil has become a preferential stop for private equity sponsors seeking high returns from investments in local target companies. The surge of private equity investments carried out in Brazil over the past decade had two major ramifications. First, it powered an unmatched flow of M&A activity across nearly all business sectors of the Brazilian economy. Second, it fostered a revamp of the legal and regulatory framework of private equity-backed ventures in Brazil.

From a legal perspective, the measures that Brazilian authorities adopted primarily focused on making available to local dealmakers cutting-edge tools, features, strategies, and structures that private equity sponsors and conduits generally employ in the international M&A arena. In this context, FIPs came to light in 2003, in a clear attempt to facilitate private equity investments and to adapt to an increasingly competitive market for transnational business combinations. CVM Rule 391/03 tailored FIPs so as to meet such demands, not surprisingly making them the most successful private equity vehicle in Brazil.

As FIPs gain prominence, the classic private equity investment model[63] that prevailed until the late 1990s is rapidly losing ground in Brazil, as are the tools, features, strategies, and structures associated with this deal wave. The benefits of FIPs outweigh corporate-based structures by encompassing more flexibility, less bureaucracy, lower transaction costs, and more tax efficiencies. Moreover, FIPs can also provide synergies as domestic hubs of private equity investments in a diversified portfolio of target companies and can finance such undertakings through the placement of quotas.

The foregoing scenario converges in what this Article claims to be a DNA change in Brazilian M&A deals. Part II addressed the role that FIPs are playing in this process and highlighted the regulatory stability and structuring possibilities introduced by CVM Rule 391/03 that are largely contributing to a swift expansion of such conduits in the Brazilian M&A practice.[64] Some of the distinguishing features of FIPs discussed in Part II also support the conclusion that their widespread use is reshaping the Brazilian M&A landscape. As the roster of reasons supporting this proposition is extensive, it suffices to recapitulate here that the adaptability of FIPs to a wide range of transactional circumstances and requirements, coupled with the favored tax regime accorded both to the fund itself and to its quotaholders, increasingly make FIPs the most suitable structuring option for private equity-sponsored M&A deals in Brazil.

Taking advantage of the investor-friendly legal and regulatory regime accorded to FIPs, private equity investors have found in the FIP form great latitude to engage in domestic M&A transactions. Moreover, private equity investors are now able to influence the management of target companies according to the rules that they consider more suitable for each given deal. This DNA change in Brazilian M&A deals has optimized the investment landscape to the benefit of the investor. In sum, the ongoing boom of M&A transactions involving private equity sponsorship through FIPs means that M&A practitioners should familiarize themselves with FIP structures so as to stay ahead of the legal curve in the rapidly evolving Brazilian investment landscape.



Preferred citation: José Carlos Junqueira Sampaio Meirelles & Caio Carlos Cruz Ferreira Silva, Brazilian Private Equity Funds (FIPs): A DNA Change in Brazilian M&A Deals, 4 Harv. Bus. L. Rev. Online 15 (2013), https://journals.law.harvard.edu/hblr//?p=3636.

* José Carlos Junqueira Sampaio Meirelles: Corporate Partner, Pinheiro Neto Advogados; Adjunct Professor of the University of Illinois; Guest Faculty Member of Duke University School of Law; LL.B., University of São Paulo Law School, 1986; LL.M., University of Illinois, 1989.

† Caio Carlos Cruz Ferreira Silva: Corporate Senior Associate, Pinheiro Neto Advogados; LL.B., University of São Paulo Law School, 2003; LL.M. in International Law, University of São Paulo Law School, 2007; LL.M., Harvard Law School, 2011.

[1] In this Article, references to private equity are used in accordance with the broad definition in article 2 of CVM Rule 391/03, a rule issued by the Brazilian Securities and Exchange Commission (Comissão de Valores Mobiliários (CVM)) introducing the Brazilian version of private equity funds. See infra Part II. Under this definition, private equity includes any acquisition of, or investment in, securities of a Brazilian publicly or closely held corporation with the purpose of actively participating in its decision-making process and influencing its capital structure, management, and operations through the adoption of value-enhancing strategic policies.

[2] See, e.g., Guillermo Parra-Bernal, Big private equity eyes Brazil for tasty deals, Reuters (Dec. 16, 2009), available at http://www.reuters.com/article/2009/12/16/us-brazil-privateequity-analysis-idUSTRE5BF2DL20091216; Spencer Ante, Brazil: The next hotbed of venture capital and private equity, Businessweek.com (Jun. 29. 2009), http://www.businessweek.com/the_thread/techbeat/archives/2009/06/brazil_the_next_hotbed_of_venture_capital_and_private_equity.html; Mike Dorning, U.S. Loses No. 1 to Brazil-China-India Market in Investor Poll, Bloomberg (Sep. 21, 2010), http://www.bloomberg.com/news/2010-09-21/u-s-loses-no-1-to-brazil-china-india-market-in-global-poll-on-investing.html.

[3] In general, “investment grade” refers to a classification assigned by rating agencies to entities that are deemed capable of paying off their debt.

[4] Since September 2009, when Moody’s updated Brazilian government debt’s rating to the investment grade category, Brazil’s investment-grade status has been recognized by all the three major rating agencies. Standard & Poor’s and Fitch Ratings elevated Brazil’s rating to investment-grade in April and May 2008, respectively. Brazil is also rated investment-grade by the Canadian rating agency Dominion Bond Rating Service and by the Japanese agencies Rating and Investment Information and Japan Credit Rating Agency. See Public Debt Strategic Planning Department – Investors Relations, Brazil Becomes Investment Grade by Moody’s, Brazilian Treasury (Tesouro Nacional) (2009), available at http://www3.tesouro.fazenda.gov.br/english/hp/downloads/Nota_Investment_Grade.pdf.

[5] In a recent study on mergers and acquisitions in Brazil, PricewaterhouseCoopers reported an average of 384 announced transactions per year from 2002–2005, while the yearly average for 2006–2009 soared to 646 transactions. The yearly average further increased to 773 transactions announced from 2010–2012. See Mergers and Acquisitions in Brazil, PricewaterhouseCoopers (Dec. 2012), http://www.pwc.com.br/pt/publicacoes/servicos/assets/fusoes-aquisicoes/mea-in-brazil-december.pdf. In 2009, Brazil hosted 79 of the 176 private equity transactions that took place in Latin America, channeling US$2 billion of the US$3.27 billion invested by private equity funds in the region. See Orlando Fernández, Private equity in Latin America, Private Law Company (PLC) (Sep. 21, 2010), available at http://crossborder.practicallaw.com/9-503-3821. Following this trend, in 2012, private equity and venture capital firms invested US$7.9 billion in Latin America, according to the Latin American Private Equity and Venture Capital Association. See Vinod Sreeharsha, Private Equity and Venture Capital Investments Rise in Latin America, The New York Times, DealBook (March 5, 2013), http://dealbook.nytimes.com/2013/03/05/private-equity-and-venture-capital-investments-rise-in-latin-america. Accounting for US$5.7 billion of the total channeled to the region, Brazil stands out as the country attracting the most money in Latin America. Id.

[6] See Mergers and Acquisitions in Brazil, PricewaterhouseCoopers, supra note 5.

[7] These industries include food and beverages, real estate, information technology, health, education, energy, infrastructure, logistics, oil and gas, mining, reforestation and consumer products, among others.

[8] Other factors supporting this trend include the steady improvement of local macroeconomic conditions and the overall investment climate, the rising liquidity of the Brazilian capital market, and the investment gap that exists in pivotal areas such as infrastructure, energy, health and education. See Rodrigo B. Feitosa, Fabio Terepins & Hermano Kemps, Brazilian Private Equity: Moving Centre Stage, INSEAD (Faculty & Research Working Paper, 2011), available at http://www.insead.edu/facultyresearch/research/doc.cfm?did=48210.

[9] See infra the remainder of Part I for a description of typical deal structures and corporate entities more commonly employed in the context of private equity transactions carried out over the last decade.

[10] Economies of scope and scale—other than those typically sought in M&A combinations—have become even more far reaching through arrangements permitting the management centralization of many targets and assets under a single investment conduit, putting the capital of its investors and the expertise of its service providers to the service of several companies, industries, and sectors. Exit strategies otherwise impracticable have become feasible through public or private offerings of securities due to a functional regulatory framework and an evolving capital market, which is capable of providing investors with liquidity to sell their stakes either through initial public offers (IPOs) or secondary offers. See Leonardo L. Ribeiro, Antonio Gledson de Carvalho & Claudio V. Furtado, Private Equity and Venture Capital in an Emerging Economy: Evidence from Brazil, 8–9 (Working Paper, 2006), available at http://ssrn.com/abstract=912523. Nine out of the sixteen Brazilian companies that went public on the São Paulo Stock Exchange (BM&FBOVESPA) between 2004 and 2005 were financed by private equity or venture capital investors. Id. at 8.

[11] Among such innovations, it is worth highlighting a set of measures enhancing governance standards and transparency in the Brazilian capital markets, including the protection of minority shareholders by means of a reduction of the proportion of preferred non-voting stock that may be issued in relation to common voting stock, tag-along rights to minority common stockholders at a price equal to eighty percent of the price paid to the controllers in case of a sale of control, the regulation of going private tender offers affecting takeovers and unsolicited bids, as well as the adoption of voluntary listing levels on BM&FBOVESPA (Nível 1, Nível 2 and Novo Mercado), imposing on companies listed in such segments more stringent corporate governance standards than those required by Brazilian Corporation Law.

[12] The sociedade limitada is the type of Brazilian business organization that most closely mirrors the limited liability companies, limited partnerships, and closely held companies under U.S. and U.K. laws. They are currently the most common company form in the country, especially due to the flexibility accorded to the structuring of this type of business entity and the relatively low level of legal requirements and formalities to which it is subject under Brazilian law. For more information on limitadas, see Pinheiro Neto Advogados, Doing Business in Brazil, Vol. 1, Chapter 2, F (2010).

[13] The sociedade por ações (S.A.) is the type of Brazilian business organization that is similar to corporations and joint-stock companies under U.S. and U.K. laws. An S.A. can be publicly or privately held. A publicly held S.A. and its securities must be registered with the CVM, and its securities can be traded on the stock exchange or on regulated over-the-counter markets. The securities of a closely held company are not available to the general public. For more information on S.A.s, see Pinheiro Neto Advogados, Doing Business in Brazil, Vol. 1, Chapter 2, G (2010).

[14] The Brazilian regulatory framework encompasses a profusion of investment fund categories, each tailored to carry out investments in a particular asset class. As far as private equity investment is concerned, the equity funds that can be used are typically FIPs, Venture Capital Investment Funds (Fundos de Investimento em Empresas Emergentes (FIEEs), focused on start-ups and small targets) and Stock Investment Funds (Fundos de Investimento em Ações, rarely adopted in part on account of regulatory constraints on portfolio composition).

[15] Similar to the U.S. Securities and Exchange Commission, the Comissão de Valores Mobiliários (CVM) is a federal agency linked to the Ministry of Finance that is in charge of the regulation, development, control, and supervision of securities markets in Brazil, including FIPs, their investors, and quotas.

[16] Instrução CVM [CVM Rule] No. 391, de 16 de julho de 2003, Diário Oficial da União [D.O.U.] de 18.7.2003 (Braz.), as amended, [hereinafter CVM Rule 391/03].

[17] As of December 31, 2012, there were 517 FIPs registered with the CVM, with a combined net equity of approximately US$53.5 billion. See CVM’s Register of FIP’s Net Equity (Cadastro de Patrimônio Líquido de FIP) (Mar. 2013), available at http://cvmweb.cvm.gov.br/SWB/Sistemas/SCW/CPublica/ListaPLFdoExcvFech/CPublicaListaPlFdoExcvFech.aspx?TPPartic=73. Nine out of the 517 FIPs currently registered with the CVM were under liquidation. Compared to FIPs, the use of Mutual Investment Funds in Innovative Emerging Companies (Fundos Mútuos de Investimento em Empresas Emergentes Inovadoras (FMIEEs)) is infrequent. As of the same date, only thirty-four FMIEEs were registered with the CVM (two of which were currently under liquidation), with an aggregated net equity of US$376.3 million. See CVM Register of FMIEE’s Net Equity (Cadastro de Patrimônio Líquido de FMIEE) (Mar. 2013), available at http://cvmweb.cvm.gov.br/SWB/Sistemas/SCW/CPublica/ListaPLFdoExcvFech/CPublicaListaPlFdoExcvFech.aspx?TPPartic=72.

[18] FIPs are also governed by a specific regulation, Instrução CVM [CVM Rule] No. 409, de 18 de agosto de 2004, D.O.U de 24.8.2004 (Braz.), as amended (CVM Rule 409/04), which provides for the creation, management, operation, and disclosure of most Brazilian investment funds. This rule applies to FIPs on a supplementary basis, when its provisions do not contravene CVM Rule 391/03. FIPs are subject to Brazilian securities statutes but not to the Brazilian Corporation Law (Lei [Law] No. 6,404, de 15 de dezembro de 1976, D.O.U. de 17.12.1976, as amended).

[19] FIPs held by more than one group of related investors or used as a conduit to implement joint ventures or associations between private equity investors and other strategic partners are often subject to quotaholders’ agreements that regulate the participation of investors in the definition of the strategies and management policy of the FIP, including matters like the exercise of voting rights or control power, preemption rights, and purchase and sale of quotas at the FIP level.

[20] These service contracts include administration and portfolio management agreements, depository or custody agreements, and agreements with consultants, advisors, and industry experts hired by the FIP.

[21] Under Brazilian law, a condominium can be defined as a joint property (in rem) right exercised by two or more persons over a certain asset or pool of assets, each holder (a co-owner or condômino) owning a pro rata fraction of such asset. The condominium itself has no legal personality apart from that of its owners, and the Brazilian Civil Code (Lei [Law] No. 10,406, de 10 de janeiro de 2002, D.O.U. de 11.1.2002 (Braz.), as amended) sets forth its central legal tenets. Statutes and regulations have elaborated on the legal concept of condominium to develop various legal structures, such as joint ownership of common areas of residential and commercial buildings and, most importantly for the purposes of this Article, quotas (securities) of mutual funds regulated by the CVM. For a further discussion of FIP’s quotas, see infra section 2.2.

[22] A mutual fund can be formed either as an open-end condominium, in which quotaholders can redeem their units at any time, or as a closed-end condominium, in which units can only be redeemed at the end of the funds’ term, except in the case of liquidation of the fund. However, distributions can generally be made to quotaholders throughout the term of the fund and pursuant to its organizational documents. See infra section 2.9.

[23] See infra section 2.8.

[24] An FIP can be funded either publicly or privately, at the beginning of its operations or during its term of duration, and in a single offering or a series of offerings. The mix of alternatives available for FIP capitalization is further described in section 2.11.

[25] This feature is especially important in FIPs that invest in multiple target companies in the same industry, allowing quotaholders to benefit from economies of scale and scope that a centralized management structure and FIP-related efficiencies can provide.

[26] While the FIP is an un-personified entity under Brazilian civil law, tax regulations require the FIP to be registered with the National Register of Legal Entities (Cadastro Nacional da Pessoa Jurídica (CNPJ)).

[27] Resembling a limited partner (LP) in a U.S. partnership, the quotaholder of an FIP is the equity owner (co-owner) of a unit (quota) representing a fraction of the FIP’s net equity. According to the legal concept of condominium under Brazilian law, quotaholders of the FIP are not entitled to ownership rights over the securities and assets in its portfolio, but rather to the appropriate proportion of the total assets comprising the FIP’s portfolio and available for distribution.

[28] Section 2.9 discusses how FIP’s quotaholders are remunerated for their investment and the types of distributions they are entitled to receive from the FIP. FIPs having a sole quotaholder (exclusive FIPs) are also permitted, provided that such quotaholder is a qualified investor. See infra section 2.6.

[29] See infra section 2.8.

[30] If the FIP issues more than one class of quotas, each class can have distinct voting rights as defined by the FIP’s charter. This possibility allows the FIP to accommodate in its ownership base investors with contrasting profiles and interests, changing their level of involvement in the FIP’s governance and activities as particular deal circumstances may demand. Additionally, the FIP can attach to each class of quotas different economic rights, but exclusively in connection with the administration and performance fees relevant to each class and respective calculation bases. Consequently, the issuance of classes of quotas establishing different remuneration criteria among quotaholders of distinct classes is not permitted, which grants quotaholders an undivided right in the portfolio securities and assets of the FIP.

[31] Frequently, such criteria are specified based either on those required under the voluntary listing levels on the São Paulo Stock Exchange (BM&FBOVESPA, Nível 1, Nível 2 and Novo Mercado) or the minimum corporate governance standards imposed on closely held companies by CVM Rule 391/03.

[32] See CVM Rule 391/03.

[33] See infra section 2.5 and Figure 1 (FIPs, Target Companies and SPCs).

[34] According to article 35, item VI(a) of CVM Rule 391/03, all companies comprising the FIP’s portfolios must be incorporated and headquartered in Brazil. Despite the growing internationalization of M&A transactions and the demand from local institutional investors for such flexibility, the CVM has not changed this rule.

[35] See art. 35, items II e III, of CVM Rule 391/03.

[36] This differs from the leveraged buyout structures that are common in private equity-sponsored M&A deals in the U.S.

[37] See supra section 2.4.

[38] Under Brazilian Corporation Law, the liability of an FIP with respect to an SPC or any other invested target company is generally limited to the unpaid portion of the issuance price of such SPC’s or target company’s shares (that is, the portion subscribed for but not yet paid in by the FIP). Once the FIP pays in the shares of the SPC or the target company, the FIP and its quotaholders are no longer responsible for any liabilities in connection with companies held in its portfolio, except in very limited circumstances. These limited circumstances include, for example, liabilities associated with acts perpetrated with fault or willful misconduct and in violation of the law or the target companies’ organizational documents, and instances where the application of the disregard of legal entity doctrine can be applied under Brazilian law.

[39] Additionally, equity losses incurred by the FIP’s quotaholders are not limited to the subscribed capital, meaning that they may be called to make extraordinary capital contributions to the FIP in cases where the assets available are not sufficient to fulfill liabilities arising from target companies.

[40] See CVM Rule 391/03.

[41] See id.

[42] The definition of “qualified investors” includes the following investors: (a) financial institutions; (b) insurance companies and special savings companies (sociedades de capitalização); (c) open- and closed-end pension funds; (d) individuals or legal entities with financial investments that hold financial investments in excess of R$300,000 (roughly US$130,000) and that attest in writing their status as qualified investors; (e) investment funds exclusively targeted to qualified investors; (f) portfolio managers and securities consultants authorized by the CVM, in relation to their own funds; and (f) social security regimes instated by the Federal Government, States, Federal District or Municipalities. See CVM Rule 409/04, art. 109.

[43] Pension funds became one of the most active players in the domestic private equity scenario mainly after the National Monetary Council (CMN) recognized private equity as a separate asset class and allowed closed pension funds (Entidades Fechadas de Previdência Complementar) to invest up to twenty percent of their portfolios in quotas of FIPs. See Resolução CMN [CMN Resolution] No. 3.792, de 24 de setembro de 2009, D.O.U. de 28.9.2009 (Braz.), as amended.

[44] See Resolução CMN [CMN Resolution] No. 2.689, de 26 de janeiro de 2000, D.O.U. de 27.1.2000 (Braz.), as amended.

[45] For the purpose of foreign capital registration with the Central Bank of Brazil, the FIP must be registered with the CVM, and its quotas must be tradable either on the stock exchange or organized over-the-counter market. See art. 6 of CMN Resolution 2,689/00.

[46] See CVM Rule 391/03.

[47] Forms that the investment may take include a control acquisition, minority participation, or joint venture, inter alia.

[48] The functions of both the FIP’s administrator and portfolio manager (gestor de carteira) may be performed by the same legal entity. Alternatively, the FIP’s administrator may retain an equally qualified third party to manage the portfolio of the FIP. The administrator and the portfolio manager can be held liable for losses borne by the quotaholders if they act with fault or in violation of the law, the CVM rules, or the FIP’s charter.

[49] These internal bodies are more relevant in FIP structures where the investors have a passive or secondary role in defining investment policies. As a result, in many instances investors prefer to entrust the details of portfolio management of an FIP to groups of private equity professionals, business developers, industry experts or technicians who are also empowered to follow up on the performance of the FIP’s investment portfolio and the administrator’s activities vis-à-vis its obligations to the FIP.

[50] Supervisory boards have become more common in the FIP business due to the rules recently introduced by the Governance and Best Practices Code for Private Equity Funds (FIPs) and Emerging Companies Investment Funds (FIEEs), which state that such boards are to oversee investment decisions made by the investment committee whenever conflicts of interest arise between quotaholders and the FIP’s administrator or portfolio manager.

[51] Normally, distributions occur only after the expiration of the investment period defined in the FIP’s charter. The investment period often goes from the inception of the FIP until two or three years after, and during this period FIP is expected to undertake investments and deploy funds in target companies in fulfillment of its investment policy. Distributions may also be made in kind, such as in assets, rights, or securities, as long as the relevant distribution rules have been previously agreed upon and are stipulated in the FIP’s charter.

[52] Registration is generally granted within five business days from the filing of the proper documentation with the CVM.

[53] See Instrução CVM [CVM Rule] No. 400, de 29 de dezembro de 2003, D.O.U. de 9.1.2004 (Braz.), as amended.

[54] See, e.g., art. 26 of CVM Rule 391/03.

[55] In this case, the FIP must submit the CVM filing, along with a detailed prospectus, notices, and marketing materials for underwriters and offering participants to use in the public offering, as well as statements signed by the FIP’s administrator and the offering’s underwriter in connection with the legality of the offering and the truthfulness of the information then provided to the public. See Instrução CVM [CVM Rule] No. 400, de 29 de dezembro de 2003, D.O.U. de 9.1.2004 (Braz.), as amended.

[56] See Instrução CVM [CVM Rule] No. 476, de 16 de janeiro de 2009, D.O.U. de 19.1.2009 (Braz.).

[57] In restricted placements, a maximum of fifty potential investors are initially approached and no more than twenty investors ultimately subscribe quotas of the FIP. See art. 3, item I, of CVM Rule 476/09. Moreover, the FIP’s quotas offered under CVM Rule 476/09 are subject to a ninety-day lock-up, which begins with their subscription or acquisition by the respective investor, see art. 13 of CVM Rule 476/09, and the FIP cannot carry out another public offer of quotas within four months from the date of termination of the last offer, unless such new offer is submitted for registration by the CVM. See art. 9, of CVM Rule 476/09.

[58] Under Brazilian law, interest on equity (juros sobre capital próprio) is essentially a tax-deductible payment, made by corporations to their shareholders, of a notional interest rate calculated by the application of a long-term interest rate over the company’s capital stock.

[59] See art. 25 of Instrução Normativa [Rule] No. 1,022, de 5 de abril de 2010, D.O.U de 7.4.2010 (Braz.), as amended, and art. 2 of Lei [Law] No.11,312, de 27 de junho de 2006, D.O.U de 28.6.2006 (Braz.) (Law 11,312/2006).

[60] See art. 3 of Law 11,312/2006.

[61] In order to enjoy such tax benefits, the following conditions must be met: (a) the FIP’s quotaholder cannot hold—individually or jointly with related persons—quotas representing forty percent or more of all the FIP’s quotas or forty percent or more of the total income of the FIP; (b) the FIP cannot hold in its portfolio debt securities exceeding five percent of the FIP’s net equity; and (c) the foreign investor cannot be resident or domiciled in a country defined by Brazilian law as a tax haven jurisdiction (a country where income is not taxed or subject to taxation at a maximum rate lower than twenty percent). See id.

[62] From a deal perspective, a positive side effect of this mutually beneficial “increase in the pie” is to induce private equity investors—as owners and controllers of the FIP—to take a more risk-seeking approach towards the closing of M&A transactions in Brazil that would otherwise not be feasible.

[63] See supra Part I.

[64] The investments and exit strategies successfully implemented by FIPs since 2004 likewise created an encouraging track record that stimulated the propagation of FIPs among foreign institutional investors seeking opportunities in emerging markets.