EDITORIAL - A classic case of tax planning to reduce tax exposure. If the business is sold, the funds will generate Capital Gains Tax, and the dividend in the hands of the investor will also result in taxation. By borrowing money, the interest in the USA is tax deductible, and only the dividend is subject to tax in the hands of the investor. In commonwealth tax jurisdictions the interest would not be tax deductible in line with basic common law tax principles.
By far the most significant way of realizing on a successful investment by a fund was to dispose of it (sell it or bring it public) once the company had grown to sufficient size and become sufficiently valuable. In the early years of this decade, the tax laws were changed so that dividends were taxed at the same rate as were capital gains. Once this occurred, sophisticated fund sponsors and investment bankers determined that the fund could borrow money against the increasing value of the company, take the proceeds of that loan, and distribute it as a dividend to fund investors, resulting in no greater tax to such investors than if the company had been sold. If fund documents did not deal with dividends, the general partner would often receive a larger share of proceeds than had been intended by the drafters of the partnership agreement.