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Ireland Netherlands Canada Belgium Germany United States France Bermuda Switzerland Luxembourg Hong Kong AA-
Ireland Netherlands Canada Belgium Germany United States France Bermuda Switzerland Luxembourg Hong Kong
INVESTMENTS DIVESTMENTS & DEALS & DISTRIBUTIONS
INVESTMENTS DIVESTMENTS CUSTOMISED REPORTING FUNDRAISINGLIQUIDATION& DEALS & DISTRIBUTIONS VALUE-ADDED SERVICES CUSTOMISED FUNDRAISINGLIQUIDATION RISK MANAGEMENT & COMPLIANCE SERVICES VALUE-ADDE
INVESTMENTS DIVESTMENTS & DEALS & DISTRIBUTIONS
INVESTMENTS DIVESTMENTS CUSTOMISED REPORTING FUNDRAISINGLIQUIDATION& DEALS & DISTRIBUTIONS VALUE-ADDED SERVICES CUSTOMISED FUNDRAISINGLIQUIDATION RISK MANAGEMENT & COMPLIANCE SERVICES VALUE-ADDE
1.1 1.2 1.3
FOREWORD
Despite the recent slowdown experienced by the industry, private equity continues to play a key role in the economy. It notably represents a fundamental source of support to non-listed 2.1 companies during their whole lifecycle. It also contributes directly towards the creation of companies, the promotion of innovation and new technologies, growth, employment and re- newal of the economic landscape. However, as an asset class, private equity is probably one of the less well understood seg-
ments of the current financial markets. It is also certainly one of the most specialised. Com- 2.2 pared to other investment funds, private equity funds differ in strategy, operating model, structure and objective.
As a clear understanding of the mechanisms of private equity is required, we thought it appropriate to develop this comprehensive brochure which covers the different aspects of 3.1 the industry. This guide will provide the reader with an insight into the main concepts and features of private equity, a market overview and a presentation of the main industry players, legal frameworks and vehicles. It also addresses fiscal aspects and operational issues, as well as the perspectives for the industry. 3.2
As an experienced player in Europe and in North America, with a full range of services to pri- vate equity firms, CACEIS has a deep understanding of this vast and ever-evolving industry. It is this experience, expertise and know-how, gained through supporting many clients over the years that we share in this brochure. 4.1
We trust you will find this publication both relevant and informative. 4.2 4.3 4.4
1.1 1.2 EXECUTIVE SUMMARY
The term private equity is a broad description of an industry which encompasses a wide range of activities that can differ in a number of fundamental ways, where funds can have different investment strategies and operating models. Private equity funds are generally formed as limited partnerships 1.3 or a legally similar structure, which varies from country to country.
This concept of limited partnership among others, as well as the roles and responsibilities of the dif- ferent players involved (General and Limited Partners, placement agents, depositary banks, adminis- 2.1 trative agents, registrar and transfer agents, auditors, legal and tax advisers), must be well under- stood in order to gain a clear comprehension of this complex asset class. One should keep in mind that private equity funds deeply differ from other types of investment funds in terms of governance, risk, structure, assets and liquidity, valuation, reporting and rewards to fund managers. 2.2 Fiscal aspects and adequate structuring are crucial in the private equity business. Together with tax and legal advisers, the General Partner shall determine the ideal investment structure after a thor- ough analysis of all important elements of the project. Furthermore, as the operational model of pri- vate equity funds has little in common with traditional funds, there are a number of operational issues to address at the different stages of the fund lifecycle, namely with regard to assets valuation, report- 3.1 ing and complex waterfall distributions. In this framework, the right skills, experience and resources are vital to succeed and expert service providers play a key role.
In the wake of the global economic downturn, what are the perspectives for the private equity indus- try? A few points can be highlighted: 3.2 • The acceleration of the industry’s globalisation (although North America is historically and by far the largest private equity market worldwide, recent years have already seen a rise in the importance of the Asia-Pacific region and emerging markets as investment destinations); • A time of challenges, as shown by the very tough fund raising conditions experienced by private 4.1 equity firms at the moment, but also of opportunities, the best returns being usually made in troubled times; • The evolution of the partners relationship in favour of investors, which finds expression in enhanced selection, financial negotiations and in the request for more transparency and information;
• Last but not least, the increased level of government regulation could have major impacts on 4.2 the industry, in particular the AIFM draft directive currently under discussion at the European Union level. 4.3 4.4
1. INDUSTRY OVERVIEW...... 9 1.1 Introduction to private equity ...... 9 1.1.1 Definition...... 9
1.1.2 A brief history of private equity...... 10 1.1 1.1.3 Main concepts of private equity...... 12 1.1.4 Comparison between private equity funds and traditional funds...... 20 1.2 Private equity strategies and sectors ...... 22 1.2.1 Venture capital ...... 22 1.2.2 Buyouts...... 23
1.2.3 Mezzanine financing...... 19 1.2 1.2.4 Distressed debt ...... 23 1.2.5 Private equity real estate ...... 24 1.2.6 Clean technologies...... 25 1.2.7 Infrastructure ...... 26 1.3 Market overview...... 27 1.3 1.3.1 The North American private equity market...... 28 1.3.2 The Western European private equity market...... 30 1.3.3 The Asian and rest of the world private equity market...... 33
2. MAIN ACTORS AND STRUCTURES...... 35
2.1 Roles and responsibilities of main actors ...... 35 2.1 2.1.1 General Partner...... 35 2.1.2 Limited partner...... 36 2.1.3 Placement agent...... 37 2.1.4 Depositary ...... 37 2.1.5 Administrative agent (fund administrator)...... 38
2.1.6 Registrar and transfer agent...... 38 2.2 2.1.7 Auditor...... 38 2.1.8 Legal adviser ...... 39 2.1.9 Tax adviser ...... 39 2.2 Overview of main legal frameworks and vehicles...... 41 2.2.1 Luxembourg...... 42 3.1 2.2.2 France...... 46 2.2.3 Ireland...... 48 2.2.4 The United States...... 50 2.2.5 Switzerland...... 51 2.2.6 The United Kingdom...... 52
2.2.7 The Channel Islands...... 52 3.2
3. FISCAL AND OPERATIONAL ISSUES...... 55 3.1 Fiscal aspects...... 55 3.1.1 Preamble...... 55 3.1.2 Investment scheme structure...... 55
3.1.3 Examples of common setups...... 56 4.1 3.1.4 Financing the investments...... 57 3.1.5 VAT effects...... 58 3.2 Operational issues...... 59 3.2.1 Preamble...... 59 3.2.2 Subscriptions...... 60 4.2 3.2.3 Capital calls and capital distributions...... 60 3.2.4 Investments...... 61 3.2.5 NAV calculation/IRR...... 63 3.2.6 Reporting...... 65 3.2.7 Waterfall distribution...... 68 4.3 4.4 A thorough understanding of PE | page 5 4. PERSPECTIVES FOR THE INDUSTRY ...... 71 4.1 Private equity, a global industry...... 71 4.2 A time of opportunities and challenges...... 73 4.3 The evolution of the GP/LP relationship ...... 75 4.3.1 Increasingly selective LPs...... 75 4.3.2 Financial negotiations...... 75 4.3.3 More information required by investors...... 76 4.4 New regulatory issues...... 77 4.4.1 In the United States...... 77 4.4.2 In Europe: the AIFM draft directive...... 77
CONCLUSION: NEED FOR EXPERTS...... 83
APPENDICE: REGULATION REFERENCES...... 85
BIBLIOGRAPHY...... 89
GLOSSARY OF PRIVATE EQUITY TERMS AND ACRONYMS...... 91
page 6 | A thorough understanding of PE 1.1 INDEX OF FIGURES
FIGURE TITLE PAGE
1 Private equity and companies’ lifecycles 10 2 Major events in the history of private equity (1950-2009) 10 1.2 3 Investors’ cash flows and returns generated by private equity investments 15 4 Performance calculation and waterfall 16 5 Illustration of direct investment 18
6 Illustration of the interposition of an SPV for tax purposes 18 1.3 7 Global private equity secondary market (2003-H1 2009) 20 8 Comparison of private equity funds versus traditional funds 21 9 Evolution of distressed private equity fund raising (1992-2008) 24 10 Private equity real estate funds on the road over time worldwide (2005-2009) 25 2.1 11 Main sectors targeted by private equity infrastructure 26 12 Number and value of funds in the market by strategy as at Q3 2009 27 13 Number and value of funds in the market by region as at Q3 2009 28 14 Capital commitments to US private equity funds and number of funds (1980-2008) 28
15 Venture capital investments in 2008 by industry sector in the United States 29 2.2 16 Private equity investments as a percentage of GDP per country in Europe, 2008 31 17 Breakdown of funds raised by type of investors in Europe, 2008 32 18 Private equity fund raising and investments in Europe 32 19 Emerging markets private equity global fund raising and investment (2001-H1 2009) 33 3.1 20 Emerging markets fund raising and investment, breakdown by country (2007-H1 2009) 34 21 Main players of a typical private equity fund 35 22 Profile of investors depending on the business stage of development 36 23 Main private equity fund structures across the European Union 41
24 Examples of securitisation structures 43 3.2 25 Comparison of the Luxembourg private equity structures 44 26 Comparison of the French private equity structures 46 27 Evolution of the assets and the number of FCPR (including FCPI and FIP) in France (1990-2008) 47 28 Evolution of QIFs Net Asset Value and number of funds (2002-H1 2009) 48 4.1 29 Main characteristics of Irish private equity vehicles 49 30 Main features of the US Limited Partnership 50
31 Evolution of capital under management and number of US venture capital funds (1980-2008) 50
32 NAV of private equity funds in Guernsey in £ million (2002-2008) 53 4.2 33 Illustration of investment scheme structure 55
34 Illustration of an arrangement optimising the investment structure with the investors’ domiciliation 56
35 Illustration of an arrangement with a feeder fund 56 36 Illustration of an arrangement based on the limited partnership model 57 4.3 37 Typical lifecycle of a private equity fund 59
38 Investment process into private equity assets 61
39 Illustration of fund summary and current portfolio summary reporting 66 4.4 A thorough understanding of PE | page 7
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1. INDUSTRY OVERVIEW 1.1 1.1
1.1 Introduction to private equity
1.1.1 Definition
Private equity is private capital raised by a corporation, i.e. not raised on a public market, in a wide variety of situations, ranging from finance provided to business start-ups to the purchase of large, mature, quoted companies. It encompasses a broad range of strategies, instruments and investment sectors, devel- oped further in section 1.2. This includes venture capital, buyouts, fund of funds, mezzanine financing, distressed debt, private equity real estate, clean technologies, infrastructure, etc. In this publication, the term private equity will be used in a broad sense to include all these aspects. From the perspective of the company, private equity is a source of equity finance that of- fers an alternative to the traditional choice between bank lending and listing on the stock market, focused on growth and value creation1.
We can distinguish different stages during which private equity plays a key role in the com- pany’s lifecycle, as displayed in figure 1:
• During the process of companies’ set up, for financing innovation and new technologies, through venture capital. Venture Capital is focused on young, entrepreneurial companies and is an essential part of value creation in the whole private equity financing cycle. It provides financing for start-ups at their inception or shortly after their first technical or commercial developments. Much of this segment is technology-related e.g. in new infor- mation and communication technologies, life sciences and healthcare, electronics and new materials industries.
• In the later stage, on the occasion of an expansion project for companies having strong growth potential, through expansion capital (also known as growth capital). Expansion capital financing is provided to purchase holdings in existing, generally profitable compa- nies by subscribing new capital. Portfolio companies have growth profiles that necessitate the consolidation of their financial structures e.g. to develop new products or services, set up a foreign subsidiary, make an acquisition or increase their capacity.
• In the context of acquisitions, transfer or buy-out, through buy-out capital. Buy-outs focus on mature businesses with stable cash flows. Usually the private equity funds obtain con- trol of the target company. Leveraged buyout funds use leverage (debt) to help finance the purchase of the target company.
• In the case of difficulties, through turnaround capital. Turnaround capital (also known as rescue capital) consists in acquiring underperforming businesses or businesses in out-of- favour industries, to restructure them financially or operationally.
1Source EVCA, “Private equity and venture capital in the European economy”, 25 February 2009 A thorough understanding of PE | page 9 RETOUR SOMMAIRE
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Figure 1: Private equity and companies’ lifecycles
Stock- exchange Consolidation listing
Company value Company Transmission Industrial transfer Transfer of Expansion capital to Growth another investment Buy-out of fund distressed Transfer of Innovation companies capital to Creation management
Venture Capital Expansion Capital Buy-out Capital Turnaround Exits Time
Source: AFIC (French private equity association), 2009
1.1.2 A brief history of private equity
This section aims at relating the history and development of private equity across time, which actually occurred through a series of boom and bust cycles since the middle of the twentieth century, as illustrated hereafter.
Figure 2: Major events in the history of private equity (1950-2009)
The 2nd VC & private equity boom and The 3rd private equity the internet The first boom and The credit bubble The burst of the golden private equity age of private crunch and Early private boom the internet equity the ensuing equity and bubble economic downturn the growth of Silicon Valley
1960 1980 1990 2000 2003 2007 2009
Pre-history and origins of modern private equity
Copyright CACEIS, 2009
Pre-history and origins of modern private equity Investors have been acquiring businesses and making minority investments in privately held companies since the dawn of the industrial revolution. However, it was not until after World War II that what is considered today to be true private equity investments began to emerge. In the United States, one of the first steps towards a professionally-managed ven- ture capital industry was the Small Business Investment Act of 1958.
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Early private equity and the growth of Silicon Valley (1960s and 1970s) 1.1 1.1 During the 1960s and 1970s, venture capital firms focused their investment activity prima- rily on starting and expanding companies. These companies were often exploiting break- throughs in electronic, medical or data-processing technology. As a result, venture capital came to be almost synonymous with technology finance. It was also in the 1960s that the common form of private equity funds still in use today emerged and in 1964, KKR had the revolutionary idea to use the first official leveraged buyout (LBO)2 .
The first private equity boom (1980s) The decade of the 1980s is associated with the LBO boom, culminating in 1989 with the largest operation in history only surpassed 16 years later, a $31.1 billion takeover of RJR Na- bisco, closed by KKR. With the increased LBO activity and investor interest, the mid-1980s witnessed a major proliferation of private equity firms, such as the Blackstone or Carlyle groups. The collapse of the junk bonds market in 1989 and 1990 announced the end of the LBO boom. The 1980s also saw a proliferation of venture capital investment firms; From just a few dozen firms at the start of the decade, there were over 650 venture capital firms by the end of the 1980s.
The second venture capital & private equity boom and the internet bubble (1990s) Beginning roughly in 1992 after a 3-year decline and continuing through the end of the dec- ade, the private equity industry once again experienced a tremendous boom, both in ven- ture capital and LBOs with the emergence of big name players managing multi-billion dollar sized funds. Although in the 1980s, many of the acquisitions made were unsolicited and unwelcome, private equity firms in the 1990s focused on making buyouts attractive proposi- tions for management and shareholders. At that time, “Big companies that would once have turned up their noses at an approach from a private-equity firm were now pleased to do business with them.”3 The late 1990s were a boom time for venture capital as firms in Sand Hill Road in Menlo Park and Silicon Valley benefited from a huge surge of interest and mas- sive capital investment in the nascent internet and other computer technologies, resulting in a situation of overstated valuations.
The burst of the internet bubble (2000 to 2003) The internet bubble burst in March 2000, as a consequence of the irrational exuberance and over-optimism that pushed the private and public company market valuations to an unsustainable level. By mid-2003, the venture capital industry had shrivelled to about half its 2001 capacity. Meanwhile, as the venture sector collapsed, the activity in the LBO market also declined significantly.
The third private equity boom and the golden age of private equity (2003-2007) From 2003, the combination of decreasing interest rates, loosening lending standards and regulatory changes for publicly traded companies set the stage for the largest boom private equity had seen. By 2004 and 2005, major buyouts were once again becoming common. In 2006, USA Today reported retrospectively on the revival of private equity, with the following words: “LBOs are back, only they’ve rebranded themselves private equity and vow a hap- pier ending. The firms say this time it’s completely different. Instead of buying companies
2This concept is explained in section 1.2.2 3Source: The Economist, “The new kings of capitalism, survey on the private equity industry”, November, 25, 2004 A thorough understanding of PE | page 11 RETOUR SOMMAIRE
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and dismantling them, as was their rap in the 1980s, private equity firms… squeeze more profit out of underperforming companies. But whether today’s private equity firms are simply a regurgitation of their counterparts in the 1980s… or a kinder, gentler version, one thing remains clear: private equity is now enjoying a Golden Age. And with returns that triple the S&P 500, it’s no wonder they are challenging the public markets for supremacy.” 4 This buyout boom was not limited to the United States, as industrialised countries in Europe and the Asia-Pacific region also experienced new records set. Post bubble, private equity firms were looking for investment opportunities where the business has proven potential for realistic growth in an expanding market, backed up by a well researched and documented business plan and experienced management. Furthermore, with depressed markets and company valu- ations, private equity funds were able to cut better deals at lower prices.
The credit crunch and the ensuing economic downturn (2007-2009) In July 2007, the turmoil that had been affecting the mortgage markets spilled over into the leveraged finance and high-yield debt markets. By the end of September, the full extent of the credit situation became obvious as major lenders including Citigroup and UBS AG an- nounced major write-downs due to credit losses. Once again, private equity was entering a bust cycle. Fund raising collapsed following the credit crunch and in the first half of 2009, was occurring at half the rate of 2007 and 2008 levels. At the same time, private equity firms were forced to use less leverage in the acquisition of companies.
1.1.3 Main concepts of private equity
In the following section, the main concepts of private equity will be explained to provide readers a clearer picture of the mechanisms of this complex asset class: limited partnerships, investee companies, fund raising, capital calls and investment periods, management fees, distributions, fund structures, primary and secondary funds will be covered.
Limited partnership The private equity investment model is based on the alignment of interests5 between a pri- vate equity firm/manager the( General Partner – GP), its investors (Limited Partners – LPs) and the management teams they support6. These parties are generally linked together by a legal structure called a limited partnership, used by many private equity funds. A limited partnership usually has a fixed duration: the GP manages and monitors the invest- ments in order to obtain the highest value at the time of exit. If some of the investments run beyond the fund’s maturity date, the limited partnership can be extended until all invest- ments are realised (i.e. trade sale, Initial Public Offering (IPO), or recapitalisation). When all investments are fully divested, the limited partnership is wound up. A private equity fund is typically governed by its limited partnership agreement, which states the economic and contractual rights between the GP and the LPs. Among the im- portant terms and conditions generally found in a limited partnership agreement are target investments and investment restrictions which set forth what the fund is expected and per- mitted to invest in, the terms on which the LPs may replace the GP and the fund’s govern- ance structure, as well as the contributions terms and the timing and manner in which a
4 Source: USA Today, “Private equity firms spin off cash” by Matt Kranz, March 16, 2006 5 Nota: In November 2009, the International Organisation of Securities Commissions (IOSCO) released a consultation report on private equity conflicts of interest, setting out a number of principles for effective mitigation of conflicts of interest in private equity. page 12 | A thorough understanding of PE 6The roles and responsibilities of these players are described in chapter 2.1. RETOUR SOMMAIRE
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private equity fund will make distributions to its LPs. 1.1 In addition to the limited partnership agreement, separate side letters may set out specific, individual, preferential agreements between a GP and a LP, e.g. with respect to manage- ment fees, advisory board seats, or co-investment rights.
Investee companies Investee companies (also called portfolio companies) are enterprises (often small or me- dium-sized companies) or infrastructures in which private equity fund managers invest the fund’s capital. They are generally selected because of their drive, their potential for growth or because they are promising infrastructure projects.
The private equity firm provides more than finance to investee companies, notably it: • Enables a growth strategy; • Professionalises a company; • Offers on-going support to the management on strategic and policy matters; • Represents a broader perspective on corporate development; • Provides management expertise and a sounding board for management ideas; • Opens networking opportunities/connections.
Private equity managers have typically a greater degree of involvement in their investee companies compared to other investment professionals, such as mutual fund or hedge fund managers. This is due to the larger size of their holdings in individual investee compa- nies (which can be up to 100%), their longer investment horizons, and the relatively lower number of companies in individual fund portfolios. And as a result of their closer involve- ment, private equity managers are naturally expected to play a greater role in influencing the corporate governance practices of their investee companies.
Fund raising Fund raising refers to the process through which a private equity firm solicits financialcom - mitments from private, corporate or institutional investors (the LPs) to pool them into a pri- vate equity investment fund. Commitments represent the LP’s obligation to provide a certain amount of capital to a pri- vate equity fund when the GP asks for capital in order to proceed to an asset purchase: Contrary to traditional funds where subscription monies can be invested right after sub- scription, private equity funds investment process is more lengthy and thus subscription proceeds are generally needed at a later stage, hence a commitment to contribute rather than an immediate payment of the subscription. Private equity fund raising is most often carried out through private placement, which means that the fund units/shares are placed with a selected number of private investors instead of through a public offering. Firms typically set a target when they begin raising capital and ultimately announce that the fund has closed at that amount. Fund raising is measured in terms of aggregate capital raised on fund level.
• Initial and subsequent closings The initial offering period is the first period during which investors will be offered to subscribe to the fund’s units/shares, as determined by the GP. The last day of this period is called the initial closing date.
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After the initial closing, there might be additional periods during which investors will be offered to subscribe to the fund’s units/shares, as determined by the GP. They are called subsequent closings. When a GP announces a final closing, then the fund is no longer open to new investors. In order to align the interests of the LPs with those of the GP, the GP is often requested to make a commitment amounting for at least 1% of the aggregate commitments (or one share/unit, depending on the legislation in force in a specific domicile) received by the fund at initial closing and any subsequent closings. This percentage is negotiated between the GP and LPs.
• Private Placement Memorandum The GP offers shares to investors on the basis of the information contained in the Private Placement Memorandum (PPM). This document aims at informing potential investors about: > The structure of the private equity company; > The investment objectives, strategy and restrictions; > The management, governance and administration; > The depositary and administration agent; > The shares of the company and capital funding; > Restrictions on the ownership of shares; > The determination of the Net Asset Value (short “NAV”) and potential temporary sus- pension of the NAV calculation (if applicable); > Distributions; > Costs, fees and expenses; > Financial year, general meetings of shareholders and documents available for inspection; > Taxation; > Duration and liquidation of the company; > Data protection; > Exculpation and indemnification; > General risk considerations.
Capital calls and investment period A capital call is whenever a private equity fund manager (usually a GP in a partnership) re- quests that an investor in the fund (an LP) provides additional capital through a contribution that has been agreed to through the above described commitment process. Capital calls occur when cash is required by the fund in order to pay fees (incorporation or ongoing) or to purchase an asset. Capital call amounts can be netted with distribution proceeds if an exit takes place coincidently.
During the investment period, i.e. the period during which the fund will make investments into new portfolio companies, the GP issues a capital call notice on behalf of the fund to each investor, requesting the payment of the amount specified therein to be contributed to the fund.
Capital contributions to make portfolio investments are typically drawn down over an initial three to five year period known as the commitment period or the investment period. The amount of the request to pay a certain percentage of the initially committed capital (usually
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called drawdown or capital call) depends on the investment opportunities a private equity 1.1 vehicle has identified and deems suitable. Once the commitment period is over, the fund’s manager will monitor and manage invest- ments to maximise value and realise returns over the life of the fund. Follow-up investments may require further draw downs of capital during this phase, but investments in new portfo- lio companies are usually prohibited.
Figure 3 illustrates the investors’ cash flows during the investment period and the harvest period (the period when investors receive distributions), the returns, as well as the J-curve effect.
Figure 3: Investor’s cash flows and returns generated by private equity investments
Capital commitments Capital is drawn down as Distributions to investors occur as investment exits are are made at the needed during the investment realised (years 3-10) and usually commence before the fund's closing period (years 1-6) entire commitment has been drawn
Harvest period Investment period Investors'cash flows Performance Capital calls Distributions Investment returns
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10
Copyright CACEIS, 2009
Private equity funds tend to deliver low or negative returns in early years and investment gains in the outlying years as the portfolios of companies mature and increase in value. The effect of this timing on the fund’s interim returns is known as the J-curve effect since a graph of returns versus time would then resemble the letter J, as illustrated above.
In the initial years, investment returns are negative due to management fees, which are drawn from committed capital, and under-performing investments that are identified early and written down. It can take several years for the portfolio valuations to reflect the efforts of the GPs. Over time, progress is made by investee companies and justifies a value for the business that is higher than its original cost, resulting in unrealised gains.
In the final years of the fund, the higher valuations of the businesses are confirmed by the partial or complete sale of investee companies, resulting in cash flows to the partners (GP and LPs). However, not all funds will be profitable given the inherent risk of investing in private equity.
Management fee Throughout the life of the fund the manager of the private equity fund typically receives an annual fee called the management fee, as compensation for the investment management
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The calculation method of this management fee is detailed in the PPM. Generally, the man- agement fee paid during the commitment period (also termed the investment period), when the manager is sourcing new investments, is based on aggregate committed capital to the fund, and thereafter the fee is based on the amount of capital that is actually invested by the fund in portfolio investments. For example, 1.75% management fee based on commitment size for an investment period of five years, reducing to 1.5% of the cost of remaining investments after the investment period.
Capital contributions to pay management fees and other operating expenses are usually advanced by (or drawn down from) LPs periodically over the course of the fund’s life. The management fee is part of the expenses of the fund, and is typically recouped by the LPs before the manager is paid the carry (see section below).
Distributions The timing and manner in which a private equity fund makes distributions to its partners (GP and LPs) are provided in the partnership agreement. These provisions regarding the order of priority in which a private equity fund makes distributions are commonly referred to as the waterfall, as illustrated in figure 4: First repayment of capital, then preferred return, then catch-up, then carry/return to LP and claw back. These concepts are explained hereafter.
Figure 4: Performance calculation and Waterfall
Contributed Capital 100% to LP 100% of total contributed capital of LP
Capital Gains 80% to LP, 20% to GP Hurdle 10% preferred return to LP (Hurdle)
Catch-up 40% to GP and 60% to LP until 20/80 balance
“Standard” Profit Sharing Clawback: 80/20? 80% to LP - 20% to GP
Source: Ernst & Young, 2009
• Repayment of capital and preferred return (hurdle) When portfolio investments are sold (or realised), a private equity fund will usually dis- tribute investment proceeds to the fund’s LPs. Generally, all capital realised is distrib- uted to the LPs until the value of the LPs’ capital contributions has been returned to them, in addition to an amount representing a return on the LPs’ investment, referred to as the preferred return or the hurdle.
The hurdle rate is the Internal Rate of Return (IRR) – for example, 8% - that the fund must achieve before the manager may receive an interest in the proceeds of the fund. From an investor perspective, the hurdle rate lessens the impact of poor performance on the return on investment in case of low return and gives the manager the incentive to page 16 | Cross-border distribution of UCITS achieve returns higher than the hurdle. RETOUR SOMMAIRE
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• Catch-up and carry/return to LPs 1.1 Once the LPs receive their capital contributions and the preferred return, the next distri- butions made by the private equity fund are typically allocated between the GP and the LPs. The catch-up provision allows the GP, once the preferred return is reached, to receive all distributions until profits are split according a defined percentage (generally 80/20) between the LPs and the GP. This amount distributed to the GP is referred to as the carry. This performance fee mechanism aims at creating real economic incentive for fund managers to achieve significant capital gains.
The European waterfall is to be distinguished from the US waterfall business model: > With a European waterfall, the LP receives all its capital and its preferred return before the GP receives carry. This is already largely in place with European GPs and signifi- cantly reduces the LP’s risk. > With a US waterfall, the GP’s carry is calculated and paid out on a deal by deal basis as each transaction is realised, with the performance of all prior realised and written-off deals included in each successive calculation of carry.
• Claw back As the manager’s share of gains may be paid out during the life of the fund, investors are generally granted a claw back provision, which ensures that any excess distributions representing more than the specified percentage of the cumulative profits is returned back to the LPs by the GP.
The typical fee structure at partnership level usually reads 2-20-8, meaning 2% manage- ment fee, 20% carry and 8% catch-up with claw back, but many other creative variations are possible.
Another concept that has emerged to deal with the issue of credit risk on excess distribu- tions is the mechanism of escrow account, which foresees that as long as LPs have part of their committed capital at risk, the GP agrees to pay part or all of the carry distributions into an escrow account to guarantee the repayment of potential excess distributions.
Fund structures: direct funds versus fund of funds The investment fund structure is typically determined by the nature of investments and their means of ownership, as well as tax considerations. Fiscal aspects are detailed further in chapter 3.1. Direct funds must be distinguished from fund of funds:
• Direct funds In this case, investments are: > Either directly held by the fund. For example, as illustrated in figure 5, a private equity real estate fund can purchase various buildings and directly hold them in its portfolio.
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Figure 5: Illustration of direct investment
Private equity real estate fund
Copyright CACEIS, 2009
> Or held through intermediary vehicles, the so-called Special Purpose Vehicles (SPVs), which suit different purposes:
- An SPV can be inserted between the fund and the investment in order to benefit from more favourable tax treaties between the fund’s domicile and the location of the as- set, as illustrated in figure 6.
Figure 6: Illustration of the interposition of an SPV for tax purposes
Private equity fund
Domicile 1
SPV
Dividends/interest paid under the framework of a double taxation treaty between domicile 1 and 2
Domicile 2
Copyright CACEIS, 2009
- An SPV can be inherited from the previous owner from whom the asset is purchased: legacy ownership structures may involve offshore holding companies and may be the rule in some countries.
- An SPV is in some cases necessary to concentrate some portion of the asset financing in its domicile or to concentrate some related operations, e.g. property management of a private equity real estate asset.
The combination of these scenarios for different setups can lead to complex structures combining the different options and ownership cascades.
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• Fund of funds A private equity fund of funds invests in a selection of other private equity funds, instead 1.1 of directly acquiring companies. Fund of funds have historically served an important function in the private equity industry:
> For investors, they provide instant access to a diversified portfolio of investments with- out the need for a complex and costly private equity investment program, since the fund of funds invests in private equity funds which are focused on various geographic and industry sectors, as well as in private equity funds at various stages of their life cycle. Fund of funds are often an entry point into private equity; New investors in pri- vate equity often gain access to the industry through fund of funds, before moving on to invest a larger proportion of their allocation into direct investments, as they become more knowledgeable and experienced in this asset class.
> For fund managers, they act as a vital source of capital, especially for those without a long track record and those focusing on niche industries and regions.
Primary funds versus secondary funds
• Primary funds Primary fund investing refers to investments made by an investor in a private equity fund during initial and subsequent closings, i.e. when capital commitments are being solicited. By making a primary fund investment, an investor participates in the fund from its inception and can realise the full benefit of distributions and gains as portfolio invest- ments are made and realised. In addition, investors who make primary fund investments may have an opportunity to negotiate terms and conditions with the promoter of the fund, as the fund is being established.
• Secondary funds S econdary fund investing refers to the purchase of an existing portfolio of private equity fund investments, after some or all of the capital commitments of the LPs have already been called and invested. T he secondary market provide an additional way for investors to get into private equity by buying exposure to private equity funds either directly or through secondary fund of funds. I t also enables existing LPs, who can no longer honour commitments, to transfer their shares and exit a private equity fund before the end of the fund’s lifecycle, via a privately negotiated “secondary” transaction with the GP’s consent.
O ne of the main advantages of the secondary market for buyers is that they can avoid the J-curve effect and have the opportunity to achieve a higher Internal Rate of Return (IRR). Indeed, in a secondary transaction, the limited partnerships are already a few years old and buyers can expect mostly distributions and very few drawdown calls. Thus, the money invested is not tied up for a decade but just for a few years. Buyers also face little complex- ity in planning their liquidity needs for capital calls, and mostly only face the uncertainty of unknown distributions7. In addition, by investing in the secondary market, an LP can access funds of older vintages8, providing increased diversification.
7 Source: Euromoney Books, “Exposed to the J-Curve: Understanding and managing private equity fund investments” by Ulrich Grabenwarter and Tom Weidig, 2005 8 The vintage year represents the year in which the fund made its first investment. A thorough understanding of PE | page 19 RETOUR SOMMAIRE
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The secondary market dates back to the global economic crisis of the early 1990s, which resulted in a lack of liquidity at many financial and corporate institutions, especially those with illiquid assets such as private equity. Since its emergence, the secondary market has been alternating between downward cycle and upward cycle9, gaining more maturity during each new period of economic turmoil. However, despite a great deal of interest and a large number of investors looking at the possibility of selling private equity portfolios, transaction volumes did not meet expectations and remained relatively low throughout 200910, with a transaction volume reaching only $5 billion in the first half of 2009. Figure 7 shows the evolution of the global private equity secondary market since 2003, in terms of transactions and fund raising.
Figure 7: Global private equity secondary market (2003 - H1 2009)
21
18 18.0 16.2 15.6 15.0 15
12
In $bn 10.0 10.7 9.0 9 7.4 7.0 6.7 6.3 6 5.0 5.0 3.1 3
0 2003 2004 2005 2006 2007 2008 H1 2009 Transactions Fund raising
Source: Cogent Partners, 2008 & Dow Jones private equity analyst, 2009
1.1.4 Comparison between private equity funds and traditional funds
Private equity funds differ from other types of investment funds. Indeed, private equity fund managers generally seek to control the businesses they invest in and choose an optimum capital structure for their investee companies. Thus, private equity funds operate with much better information, stronger controls and influence over management than traditional funds. Besides, investors in private equity funds are generally well-informed investors, i.e. profes- sionals capable of making independent investment decisions and understanding the risks related to those decisions. They typically commit to a 10-year investment in each fund. Com- pared to many other investment fund types, this is a long-term commitment and private eq- uity is basically an illiquid market.
These usual differences are summed up in the table 8 hereafter.
9 Source: Dow Jones Guide to the Secondary Market Buyers, “A good time to invest in secondary funds”, June 2008 page 20 | A thorough understanding of PE 10 Source: Preqin Ltd, “The private equity secondaries boom – When will it occur?”, December 2009 RETOUR SOMMAIRE
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Figure 8 – Comparison of private equity funds versus traditional funds 1.1 Private equity fund Traditional fund Investors > Restriction to few well- > Numerous public investors informed investors in most (retail market) cases (depends on the vehicle used) Control and influence > Substantial or controlling stake > Small minority stakes, no in the business control and no special rights Financial structure of > Use of debt possible > No debt as part of investments investments > Personal investment of > No personal investment of business managers in the business managers company they manage (share of the risks and rewards of the > Ongoing subscriptions and business) redemptions > Multiple closings within first 12 months requiring rebalances (equalisations) Information available prior to > Substantial financial, > Access to publicly available investment commercial and legal due information only diligence undertaken by PE funds prior to making an investment Reporting to fund managers > Regular detailed reporting > No detailed information to fund and investors to PE fund managers and managers and investors (only investors in PE funds (individual fund NAV) LP reporting, with special arrangements for some LPs) Valuation > Quarterly financial reporting > Daily/weekly/monthly valuations > Assets valued by managers > Assets valued by market > Complex accounting issues independent administrator requiring considerable (depending on countries) expertise > Complex valuation issues
Assets > Minimal cash balances and no > Substantial cash balances with stock to lend large portfolios to lend > Numerous OTC instruments > Few OTC instruments Liquidity in underlying > Private equity is illiquid by > Liquidity of investments investments nature Rewards to fund managers > Management fees + carried > Fee income interest (share of capital profits) Fund structure and exit > Partnership, potential highly > Corporate structure, generally complex structures straightforward > Generally limited life of 10 > No limited duration, years permanent capital > Closed-ended fund > Open-ended fund > Long-term capital > Investors can sell their fund commitments to the fund; shares/units at any point in investors not authorised to time request the redemption of their shares. Investor shares may only be transferred, pledged or assigned with the written consent from the GP Source: ICAEW, 2008 and CACEIS, 2009
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1.2 Private equity strategies and sectors
There are a variety of sectors within the private equity industry. Some private equity funds focus on a specific type of strategy or instrument, such as venture capital, buyout, fund of funds, mezzanine or distressed debt, while other private equity funds focus on specific industries such as real estate, clean technologies or infrastructure. All these sectors are further detailed in the section hereafter.
1.2.1 Venture capital
Venture capital is a strategy which consists of investing in start-up and early stage compa- nies with a business model based on new technologies or other innovations. Venture capital firms typically focus on identifying emerging industries and invest heavily in companies in these industries. In most cases these companies will be seeking to market a specific inno- vation, generally technology-driven. High-tech (31%), life sciences (16%) and energy (11%) are currently the top three sectors for early stage investments in Europe11.
In other words, this strategy focuses on “building businesses” by investing in companies in the conceptual stage or companies where products have not yet been fully developed and where revenues and/or profits may be several years away. Thus, venture capital carries an increased level of risk since the investee companies are less established firms whose business models rely on unproven technologies or developing markets. In compensation, venture capital offers the prospects for high returns on investment if the investee compa- nies become successful and can finally be sold to strategic investors.
Venture capital funds are the most popular private equity fund type in number worldwide. This can be explained by the numerous start-up companies launched every year, driven by government programs that seek to encourage enterprise creation, as well as by active business angels (i.e. private investors who invest in unquoted young entrepreneurial com- panies) in the United States. For these start-up companies, traditional debt financing is not always available since they generally lack the collateral, track record or earnings required to get a loan. As a consequence, they have recourse to venture capital. However, it should be noted that after the peak experienced towards the end of 2007, fund raising for venture funds declined worldwide in the past 2 years, in the context of the eco- nomic crisis.
The venture capital industry is dominated by three big markets: The United States, Israel and the United Kingdom, which have developed in different directions. Whereas the US ven- ture capital industry is the oldest, the Israeli venture capital industry is relatively new and predominantly focused on high-tech. The UK venture capital industry is one of the oldest in Europe but it is less high-tech and early stage oriented than the US and Israeli industries12.
11Source: EVCA, “Private equity and Venture capital in the European Economy – An industry response to the European Parliament and the European Commission”, 25 February 2009 page 22 | Cross-border distribution of UCITS 12Source: BVCA, “Benchmarking UK venture capital to the US and Israel: What lessons can be learned?”, May 2009 RETOUR SOMMAIRE
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1.2.2 Buyouts
Buyout is a private equity strategy which consists in the purchase of controlling interest in one corporation by another corporation in order to take over assets and/or operations, often with the idea of improving and selling them later. Buyout focuses on mature businesses with
stable cash flows. 1.2 A leveraged buyout (LBO) refers to a buyout when the acquisition is leveraged through debt financing, whereas a management buyout (MBO) refers to a buyout when the acquisition is made by the company’s managers or employees.
Most private equity capital is invested in the buyout sector worldwide. The GPs of the larg- est buyout funds are currently located in the United States and the United Kingdom. They are famous names such as Blackstone Group, Hellman & Friedman, KKR or Candover Partners.
Until 2007, the private equity industry growth was largely driven by the buyout sector, with mega funds of increasingly large size closing consistently in excess of their original targets as a result of institutional investors’ confidence in the ability of these managers to create value. However, the large buyout market was strongly hit by the economic crisis and its plight received considerable attention. Indeed, the credit crisis has left many banks short of liquidity and unwilling to issue new leveraged loans, triggering a sharp slowdown in LBO activity.
1.2.3 Mezzanine financing
Mezzanine financing can be debt (usually unsecured or subordinated debt) or equity (usu- ally preferred equity) or a mixture of debt and equity and targets more mature companies, which need capital to grow, expand or restructure operations, enter new markets or finance a major acquisition without a change of control of the business. This instrument allows investors to make indirect participation in a private company, by using warrants, subordinated debt, options or convertible bonds. It gives the lender the right to convert a loan into ownership in the company, if the loan is not paid back on time and in full. Since the private equity investor grants a loan to the borrowing company very quickly with little due diligence or required collateral, the lender can charge a high rate of interest, which is often in the 20-30% range. Mezzanine financing is advantageous, because it is treated like equity on a company’s balance sheet, which may make it easier to obtain standard bank financing.
The withdrawal of banks and an increase in private and public companies looking for more flexible sources of credit is opening up opportunities for mezzanine finance funds.
1.2.4 Distressed debt
Distressed debt refers to the bonds of a company that is either in or approaching bankrupt- cy. Some private equity funds specialise in purchasing such debt at significant discounts with the expectation of exerting influence on the restructuring of the company and then selling the debt once the company has meaningfully recovered.
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We can distinguish credit opportunity funds that purchase debt or loan obligations based on their assessment of underlying credit quality, from distressed debt control funds which aim at assuming control and thereafter restructure the companies’ capital structures and operating models13.
Figure 9: Evolution of distressed private equity fund raising (1992-2008)
$47bn $45.2bn Liquidity Crisis
$17.3bn $12bn Tech Crisis $8.5bn
Asian Crisis $7.8bn $4.4bn Aggregate capital raised in $bn
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Source: Preqin Ltd, 2009
A weak economy generally creates increased investment opportunities in distressed debt, as displayed by figure 9, contrary to other private equity strategies and instruments such as buyout, venture capital or mezzanine investment, the returns of which are generally posi- tively correlated to economic trends. Hence, the current economic crisis has led to an in- crease in opportunities for distressed private equity firms, as it had already been the case during the Asian crash and the dotcom crash. The distressed private equity share in the overall industry increased from less than 3% in 2005 to more than 9% in 2008.
1.2.5 Private equity real estate
Private equity real estate typically involves a private equity firm collecting money from in- vestors to create a private equity fund, which then looks for potentially profitable real estate to purchase. The private equity fund creates a portfolio of real estate investments that the fund manager believes will be relatively low-risk while still lucrative.
The private equity real estate industry dates back to the 1980s but recent years have seen private equity real estate funds grow, in terms of number of funds on the road and in terms of aggregate target, from being a niche sector in the real estate asset class to being an important and essential component of any institution’s investment portfolio, as displayed in figure 10.
13Source: Investment & Pensions Europe (IPE), Special Report Private Equity, “A time of difficulty and opportunity” by Nick page 24 | Cross-border distribution of UCITS Chronias, April 2009 A CACEIS PRODUCT DEVELOPMENT PUBLICATION - 2010 - PUBLICATION DEVELOPMENT PRODUCT CACEIS A 1.2.6 and ahighproportionofinvestors inprivateequitynowseekingtogain exposure. and venture capital fund managers seeing suitable opportunities opening up for investment, improving the potential profitability of the market, with increasing numbers of private equity in assisted have sector.factors tech These clean the within technologies in improvements and energy for demand global ever-increasing the and governments national by provided incentives and regulations of levels growing issues, environmental and change climate awareness of investor and consumer increasing the with in ties sector this of growth The 15 14 sarily correlatewiththoseoftheprivateequitymarketasawhole neces not do market tech clean the in fluctuations and growth, of level high a for potential the has market the that feel many as investments, tech clean by about brought benefits diversification the and gains financial potential the in interested are investors addition, In opportunity to address sustainability issues whilst simultaneously creating long-term value. the offers sector tech clean the investments, responsible making at aiming investors For includes naturalresources,energyandotherenvironmentalfocusedproducts. which industry, technologies clean the in capital invests then which fund, equity private a Private equity clean tech involves a private equity firm raising funds from investors to create Clean technologies established realestatemarketsofNorthAmericaandWestern Europe being higher risk. Many investors also feel that the best opportunities are to be found in the as perceived are which economies, emerging in invest than rather with, familiar more are they which markets, established more towards look will investors many outlook, cautious their given that, natural perhaps is It commitments. few making is majority vast the and ful In the current economic context, investors in private equity real estate are being very care Source: PreqinLtd,2009 Figure 10: Private equity real estate funds on the road overtime worldwide (2005-2009) Source: Preqin Ltd, “The 2009 Preqin Private Equity Cleantech Review”, May 2009 Source: Preqin Ltd, “Real estate Spotlight”, June 2009 Number of funds 100 150 200 250 300 350 400 450 50 0 A-5JN0 A-7JN0 JAN-09 JAN-08 JAN-07 JAN-06 JAN-05 18 4 29 16 76 33 ubro ud AggregateTarget Number of funds 273 127 384 228 15 . 14 . 0 50 100 150 200 250 300 350 400 450
- - Aggregate target in $bn A thorough understanding of PE of understanding thorough A INDUSTRY OVERVIEW INDUSTRY RETOUR SOMMAIRE RETOUR
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Since 2004, the number of funds that include clean tech investments as part or all of their industry scope has grown rapidly at the worldwide level, nearly quadrupling. Despite the slowdown in the global economy, this sector seems set to continue its growth. A recent survey on global trends in venture capital16 shows that in Europe 71% of venture capitalists surveyed said they intended to increase their investments in clean technologies.
1.2.7 Infrastructure
The private equity infrastructure sector involves investments in a broad range of infrastruc- ture projects in various fields, such as transport, energy, telecoms and healthcare as illus- trated in the table below.
Figure 11 – Main sectors targeted by private equity infrastructure
Energy and services to Social and leisure Transport Communication the community infrastructures > Roads and motorways > Natural gas > Cable networks > Hospitals > Bridges > Electricity > Information and > Schools, universities communication > Ports > Energy performance technologies > Urban restoration > Airports > Renewable energies > Satellites > Prisons > Railways > Water > Broadband internet > Stadium and other sportive > Waste management infrastructures Copyright CACEIS, 2009
The infrastructure fund industry has grown in both developed and emerging markets from what most considered a small subset of the private equity industry, into what is now often considered to be an asset class on its own.
This sector displays little correlation with other markets; Whatever the state of the economy or consumer confidence, consumer demand for the services provided by infrastructure as- sets is generally quite inelastic, as the assets are often essential utilities such as water and electricity provision. Social infrastructure assets, such as schools and hospitals, are considered to be particularly defensive investments, as their revenue streams are espe- cially resilient in the face of an economic downturn. As a consequence, infrastructure funds expect a continuing ability to attract institutional investors, although many investors have been forced to delay making new investments in the current economic context17. Furthermore, the long-term nature of infrastructure investing, as well as the diversification and increased returns it can offer, makes it an attractive opportunity for many sovereign wealth funds. The illiquid nature of infrastructure investment is not an issue for these funds as they have vast amounts of capital at their disposal and have little difficulty in meeting capital calls18.
16Source: Deloitte, “Global trends in venture capital 2009 global report“, June 2009 17Source: L’Agefi Hebdo, “Les fonds infrastructures veulent se faire une place”, 16-22 April 2009 page 26 | A thorough understanding of PE 18Source: Preqin Ltd, “Infrastructure spotlight – Sovereign Wealth Funds investing in infrastructure”, April 2009 RETOUR SOMMAIRE
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1.3 Market overview
The international private equity markets have developed, matured and extended their reach to newer markets over the past twenty years. Outside the United States, highly developed private equity markets are found in Canada, Australia, and in many European countries, led by the United Kingdom. Private equity has also begun to take root in less developed markets, especially in the BRIC countries (Brazil, Russia, India, China).
At the end of Q3 2009, the worldwide private equity market consisted of 1,571 funds, with an aggregate target of $735 billion. The private equity industry took a considerable hit during
the recent economic crisis and significantly, the aggregate target of funds in the market 1.3 was down 21% from its peak of $934.2 billion, recorded one year earlier in Q3 200819.
Figure 12 gives details of funds in market by strategy at the end of Q3 2009: • In terms of number of funds worldwide, venture capital funds and private equity real estate funds were far ahead with more than 400 funds each, followed by buyout funds. • In terms of aggregate target value, private equity real estate, buyout and infrastructure funds made up the largest segment, accounting for nearly 64% of the market.
Figure 12: Number and value of funds in the market by strategy as at Q3 2009
500 500 450 441 450 403 400 400 350 350 300 300 250 235 250 191 200 168 165 200 Number of funds of Number 150 150 119111 100 83 100 $bn in value target Aggregate 53 56 51 50 41 50 28 25 18 19 15 50 10 9 5 8 1 0 0
Other Buyout Venture Balanced Real Estate Distressed Mezzanine Secondaries Infrastructure Fund of funds Co-investment Natural Resources Source: Preqin Ltd, 2009 Number of funds Aggregate Target Value
We can distinguish 3 big markets worldwide, detailed in the following sections: • North America-focused funds traditionally constitute the most numerous funds in market with a 48.1% market share and also the largest aggregate target value with a 54.4% market share. The US market is by far the most mature and developed, with a private equity invest- ment as percentage of GDP rate over 1% in 2008. • Asia- and Rest of the world-focused funds account for 27.8% of the total private equity market in terms of number of funds and 22.8% of the global aggregate target value. The Asia and Rest of the world market is seen as a high-potential market, especially emerging markets which, despite rapid growth, remain under-penetrated. • Western Europe has a 24.1% market share in terms of number of funds and a 22.8% market share in terms of aggregate target value. This market, taken globally, is by far less mature
19Source: Preqin Ltd, “Private equity spotlight”, October 2009 A thorough understanding of PE | page 27 RETOUR SOMMAIRE
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than the US market, with an average private equity investment as percentage of GDP rate of 0.42% in 200820. In terms of average size, Europe-focused funds tend to be larger than their Asia- and Rest of the world-focused counterparts.
Figure 13 displays the number of funds and the aggregate value in $ billion as at Q3 2009 for each region:
Figure 13: Number and value of funds in market by region as at Q3 2009
800 800 756 700 700
600 600
500 500 436 399.7 400 379 400
Number of funds of Number 300 300 Aggregate target in $bn in target Aggregate 200 167.7 167.6 200
100 100
0 0 North America Asia & Rest of the World Europe
Source: Preqin Ltd, 2009 Number of funds Aggregate Target
1.3.1 The North American private equity market
North American private equity firms account for 53% of the total number of private equity fund managers worldwide and the overwhelming majority of these are based in the United States, which remains the most developed country for private equity.
Capital commitments to US private equity funds increased by 9,200% between 1980 and 2008, as displayed in figure 14.
Figure 14: Capital commitments to US private equity funds and number of funds (1980-2008)
Venture Buyouts and Mezzanine Private Equity
Year Capital $ m No. Funds Capital $ m No. Funds Capital $ m No. Funds 1980 2,025.6 52 183.5 4 2,209.1 56 1981 1,486.5 75 126.8 4 1,613.3 79 1982 1,705.4 87 611.3 13 2,316.7 100 1983 3,942.2 143 1,351.3 15 5,300.5 158 1984 2,964.3 116 3,482.5 22 6,446.8 138 1985 3,988.5 121 3,024.5 22 7,013.0 143 1986 3,788.4 103 5,001.9 31 8,790.3 134 1987 4,376.7 116 15,565.7 41 19,942.4 157 1988 4,435.0 104 11,326.4 50 15,761.4 154 1989 4,902.6 105 11,966.2 78 16,868.8 183 1990 3,229.0 87 7,861.1 62 11,090.1 149
page 28 | A thorough understanding of PE 20Source: EVCA, 2009 RETOUR SOMMAIRE
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Venture Buyouts and Mezzanine Private Equity
Year Capital in $m No. Funds Capital in $m No. Funds Capital in $m No. Funds 1991 2,002.8 42 5,866.6 27 7,889.4 69 1992 5,215.3 80 11,031.3 58 16,246.6 138 1993 3,943.6 88 16,128.9 79 20,072.5 167 1994 8,928.0 140 20,415.3 98 29,343.3 238 1995 9,859.6 172 26,293.3 102 36,152.9 274 1996 11,845.2 162 29,655.2 99 41,500.4 261 1997 19,772.5 244 41,055.4 129 60,827.9 373 1998 29,692.0 288 61,568.7 160 91,260.7 448 1999 55,808.9 451 53,556.5 153 109,365.4 604 2000 105,004.6 653 75,254.7 154 180,259.3 807 1.3 2001 39,056.4 321 49,904.1 120 88,960.5 441 2002 9,329.8 206 24,118.2 88 33,448.0 294 2003 11,607.8 163 31,040.1 101 42,647.9 264 2004 19,845,2 219 50,908.7 137 70,753.9 356 2005 28,727.5 235 97,403.2 179 126,130.7 414 2006 31,827.6 241 147,989.7 179 179,817.3 420 2007 35,398.0 247 205,260.1 208 240,658.1 455 2008 27,947.8 210 177,890.1 179 205,927.9 389 Source: NVCA (National Venture Capital Association - United States), 2009
However, in 2008 the US industry was clearly affected by the credit crunch and general economic turmoil as the volume of completed LBOs dropped 40% from 2,097 in 2007 to 1,241 in 2008. The total amount invested through LBOs dropped even more dramatically, from $489.5 billion to $116.5 billion for the same period, due largely to a 75% decline in the amount invested in deals over $2.5 billion21. The credit crunch, coupled with the global recession, brought the private equity industry down from its dramatic 2007 heights.
TheSource: top NVCA fund (National raising Venture states Capital for Association venture capital - United States), investments 2009 in 2008 in the United States remained California, Massachusetts and New York. Much of the fund rais- ing was done by established, often larger, firms. Capital was also successful- ly raised by new funds in promising sectors, such as clean technology, and those with proprietary deal flow prospects22. The following pie chart displays the break- down of venture capital investments in the United States by industry sector in 2008.
Figure 15: Venture capital investments in 2008 by industry sector in the United States
Telecommunications 6% Software 17% Biotechnology 16%
Semiconductors 6% Business Products and Services 2% Retailing/Distribution 1% Computers and Peripherals 1% Networking and Equipment 2% Consumer Products and Services 2% Electronics/Instrumentation 2% Medical Devices Financial Services 2% and Equipment 12% Healthcare Services 1%
Industrial/Energy 16% Media and Entertainment 7% IT Services 7% Source: NVCA, 2009
21 Source: PitchBook Data, Inc., “Economic Turmoil Leads to Record Drop in Private Equity Investment Activity in 2008”, January 2009 22 Source: NVCA, “National Venture Capital association Yearbook 2009”, March 2009 A thorough understanding of PE | page 29 RETOUR SOMMAIRE
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The growth in the overall Canadian private equity market occured more recently than that of the United States. To date in 2009, in terms of investments, firms in the United States continue to receive three times the level of venture capital support than their Canadian counterparts23.
1.3.2 The Western European private equity market
The Western European private equity market is concentrated in a small number of coun- tries and dominated by the United Kingdom – the largest and most developed private equity industry in Europe and second only in size to the United States -, followed by France and Germany:
• The United Kingdom’s predominance in the European private equity market can be ex- plained by several factors: the availability of funds to invest, opportunities to make invest- ments, people with the necessary skills to source, negotiate, structure and manage invest- ments, as well as the availability of exit opportunities such as the large equity market. The private equity industry has been an important contributor to domestic investments for dec- ades; Between 1984 and 2008, the amount invested by the British private equity industry into local businesses totaled over £70 billion in around 25,000 companies24. Firms located in the United Kingdom have also attracted the largest proportion of European private equity investments in recent years, although investments in UK–based companies suffered the steepest decline in 2008 compared to the other European regions.
• France is traditionally the third-largest private equity business worldwide, behind the United States and the United Kingdom. Amounts invested in private equity in the country doubled over the past 5 years, from c5.2 billion in 2004 to c10.0 billion in 2008. Nearly 1,600 companies in the venture, expansion, buyout or turnaround stages, 80% of which were small- and medium-sized businesses with fewer than 250 employees and sales under c50 million, received private equity investments in 2008. Thanks to the FCPI in- novation funds, which have been providing fiscal advantages to investors since 1997, France is one of the few European countries having benefited from regular investments in innovation, even after the internet bubble burst in 200125. Today these investments fo- cus mainly on information technologies, telecommunication, medical and biotechnology. In addition, the French TEPA Act of 2007, under which individual investors in small- and medium-sized businesses benefit from a wealth tax (ISF) reduction, seems to have been a catalyst in the increase of private investment in the FIP regional investment funds and the FCPI innovation fund’s 2008 vintage26.
• Germany, the third largest private equity market in Europe, has still further growth poten- tial as a target for private equity investments, compared to other European countries, with a 0.28% rate of private equity investment based on GDP (see figure 16). In 2008, 1,140 Ger- man companies ranging from start-ups to large caps were funded with private equity. In total, private equity firms investedc 8.4 billion in these companies, mainly in the chemicals and materials industry, business and industrial products, as well as construction sectors.
23 Source: CVCA, “Venture capital investment level is the lowest in 14 years”, 10 November 2009 24 Source: BVCA, “The economic impact of private equity in the United Kingdom”, February 2008 25 Source: L’Agefi Hebdo, “Le capital-risque réserve sa cagnotte aux seconds tours” by Edwige Murguet, 2-8 April 2009 page 30 | A thorough understanding of PE 26 Source: Unquote France, Issue 100, “FCPI and FIP funds receive increased backing”, April 2009 RETOUR SOMMAIRE
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Other active private equity markets in Europe, although far behind the top 3, are Italy, Spain, the Netherlands, Sweden, Norway and Switzerland. The latter acts as a European entry point for foreign investors, attracting heavy flows of foreign capital, notably through its strong fund of funds industry which enable investors to diversify their investments while enjoying an indirect exposure. Moreover, banking tradition fuels the pool of talented private equity managers in the country. Although the general tax exemption for capital gains is not specific to the private equity industry, it is an important factor for investors in Switzer- land. In 2008, fund raising in the country doubled compared to the previous year, reaching E3.1 billion27.
The level of maturity of the private equity market is still heterogeneous across Europe, as 1.3 shown by the rate of private equity investments as percentage of GDP per country in Eu- rope. In 2008, this rate ranged from 1.24% for the United Kingdom to 0.03% for Hungary, as displayed by figure 16.
Figure 16: Private equity investments as a percentage of GDP per country in Europe, 2008
1.4% 1.241% 1.2% 1.0% 1.022% 0.8% 0.6% 0.450% 0.418%0.394% 0.4% 0.301%0.284% as a percentage of GDP 0.258% 0.239% 0.238% 0.207% 0.194%0.193%0.189% 0.2% 0.168%0.142% 0.082%0.073% 0.043%0.032%0.030% 0%
Italy Spain FranceEurope Finland Poland GreeceAustria Ireland Sweden Germany NorwayPortugalDenmarkBelgium Romania Hungary SwitzerlandNetherlands United Kingdom Czech Republic
Source: EVCA & PEREP analytics, 2009
At the same time, the structure of the different national markets has become increasingly similar and the buyout segment now predominates in all countries despite difficulties in obtaining leverage in 2008.
With regard to the sources of capital for private equity in Europe in 2008, as displayed in figure 17, pension funds continued to be overall the main source, accounting for 25.1% of all funds raised in 2008, compared with 17.5% in 2007. Fund of funds were overall the second most important source of capital, committing up to 14.4% of the total capital raised, while bank commitments continued overall to decrease their contribution, dropping from 11.5% in 2007 to 6.7% in 2008. However, it should be noted that this breakdown can vary significantly from one country to another, with pension funds playing a major role in the United Kingdom for example, while banks remains the main subscribers in Italy and Spain. Meanwhile, private individuals and family offices now dominate the French private equity market in terms of funds raised by source, due to high tax incentives for investors.
27 Source: EVCA yearbook 2009 A thorough understanding of PE | page 31 RETOUR SOMMAIRE
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Figure 17: Breakdown of funds raised by type of investors in Europe, 2008
Academic Institutions 0.2% Banks 6.7% Capital Markets 1.6% Unknown 17.5% Corporate Investors 2.9% Endowments and Foundations 4.5%
Family Offices 4.2% Private Individuals 4.9%
Fund of Funds 14.4%
Pension Funds 25.1% Government Agencies 4.9%
Insurance Companies 6.6% Other Asset Managers 6.4% Source: EVCA & PEREP analytics, 2009
The following graphs show private equity fund raising and investments in Europe across the main centres of activity:
Figure 18: Private equity fund raising and investments in Europe
Fund raising (in € billion) 2008 fund raising -21% 45 36.9 38 +27% France 26% 30 29.1 -47% United Kingdom 23 -57% -25% 58% Germany 5% ( in € billion) 15 10.0 12.7 5.7 5.3 8 2.4 3.0 2.3 2.8 Italy 5% 0 Spain 6% 2007 2008 2007 2008 2007 2008 2007 2008 2007 2008 France Germany Italy Spain UK
Investments (in € billion) -37% 2008 investments 39,8 40 France 20% -20% 30 -5% +30% 25,2 United Kingdom 20 -32% 12,6 49% Germany 14%
( in € billion) 10,0 10 7,5 7,1 4,2 5,5 4,44,4 3,0 0 Italy 11% 2007 2008 2007 2008 2007 2008 2007 2008 2007 2008 France Germany Italy Spain UK Spain 6%
Source: Grant Thornton, 2009
The United Kingdom remains the largest European country for private equity activity with E29.1 billion funds raised and E25.2 billion invested in 2008.
In 2008, France experienced an exceptional fund raising of E12.7 billion with a 27% increase compared to the previous year, thanks to a few significant deals. At the same time, the other European markets were hit by a strong decline in fund raising, especially Germany with a 57% decrease compared to the previous year. France was finally hit later by the economic downturn, recording an 88% decrease in fund raising in the first half of 200928 compared to the same period in 2008.
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Most markets saw a decline in amounts invested in 2008, the Italian private equity market being a notable exception explained by an increase of buyout operations29.
In terms of geographical origin of funds raised in Europe in 2008, most commitments came from European investors (54.5%), with a very significant contribution of domestic sources in France, Germany, Italy and Spain, the United Kingdom being an exception. At the same time, North American LPs contributed 36.5% and Asian & Rest of the world LPs contributed 9% to the funds raised.
1.3.3 The Asian and rest of the world private equity market 1.3
Developed Asia Developed Asia is composed of Japan, South Korea, Australia and New Zealand. It is a small market accounting for around 2% of the global private equity investment activity. This is in this region that private equity first emerged in Asia in the 1970s, with the first venture capital deals being completed in Japan. Japan continues to be one of Asia’s most active markets for raising private equity capital. However, this market remains relatively hard to penetrate for foreign investors. The Australian and New Zealand markets are robust and private equity has developed rap- idly in both countries. They offer a legal and tax environment which is similar to Europe’s, while in South Korea, private equity investment is still perceived as risky due to its political instability and recent tightening of regulations that apply to foreign investors30.
The emerging markets The emerging markets include emerging Asia, Latin America, Eastern Europe, Russia, the Middle East, and Africa. As displayed in the table hereafter, private equity fund raising for emerging markets reached a record-breaking $66.5 billion in 2008, bucking international trends and represent- ing a 12% increase compared to 2007, before collapsing to $16.2 billion in the first half of 2009. At the same time, private equity investments reached their highest level in 2007 with $53.1 billion, before collapsing to $12.8 billion in the first half of 200931. However, this decline came nowhere near the drop seen in developed private equity markets (the United States, Western Europe and developed Asia).
Figure 19 – Emerging markets private equity global fund raising and investment (2001-H1 2009)
H1 In $bn 2001 2002 2003 2004 2005 2006 2007 2008 2009 Global fund raising- 6.5 3.2 4.6 6.6 26.5 33.2 59.2 66.5 16.2 emerging markets Out of which emerging Asia 5.2 1.1 2.2 2.8 15.4 19.4 28.7 39.7 11.1 Global investment- 3.7 2.0 7.0 7.2 11.8 34.7 53.1 47.8 12.8 emerging markets Out of which emerging Asia 2.0 0.3 4.5 4.3 7.7 22.5 30.4 28.3 10.5 Source: EMPEA (Emerging Markets Private Equity Association), October 2009
29 Source: Grant Thornton, “Private equity for 2008 in the main centres of activity in Europe”, 9 June 2009 30 Source: CAAM CI, “Private equity in the Asia-Pacific region, a high-potential market”, 2007 31 Source: EMPEA, “Emerging markets private equity statistics”, 29 October 2009 A thorough understanding of PE | page 33 RETOUR SOMMAIRE
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Emerging Asia continues to dominate the emerging markets landscape, representing around 60% of the total funds raised and of the investments in the region in 2008. Other emerging sub- regions lag far behind. In 2008, five countries accounted for almost 50% of all investments: China, India, Brazil, Russia and South Africa, as shown in figure 20. In particular, companies in China and India received the majority of this new capital with $9.0 billion and $7.6 billion invested respectively. Both coun- tries witnessed enormous growth between 2007 and 2008 in terms of fund raising and no other single region accounted for more than 10% of total capital raised at that time.
Figure 20 – Emerging markets fund raising and investment, breakdown by country (2007-H1 2009)
In $bn 2007 2008 H12009 FUND RAISING Brazil 2.5 3.6 0.2 China 3.9 14.5 3.9 Russia 1.8 0.9 0.9 India 4.6 7.7 2.5 South Africa 0.5 0.2 N/A Other countries 45.9 39.7 8.7 INVESTMENT Brazil 5.3 3.0 0.4 China 9.5 9.0 6.5 Russia 0.8 2.6 0.1 India 9.9 7.6 1.9 South Africa 3.4 1.2 0.5 Other countries 24.3 24.4 3.4
Source: EMPEA (Emerging Markets Private Equity Association), October 2009
With a private equity investment/GDP rate of only 0.21%32, today China remains Asia’s most attractive destination in investors’ eyes, although caution dictates that deals are taking longer Source: EMPEA (Emerging Markets Private Equity Association), October 2009 to close. The market was still doing relatively well in the first half of 2009 and no major collapse was seen. This was not the case in India, which saw investments dropping significantly in the first half of 2009. Market conditions have recently deteriorated in the country. Foreign investors, including big international names such as Blackstone and Fidelity, have now turned very cautious about making investments in India after being hit with hefty losses in 2008. In India’s private equity arena, experienced investors argue that there are too many players and not enough invest- ments, with an estimated 540 active funds in the country33. A survey carried out in April 200934 showed that LPs ranked Brazil as the second most attractive destination for GP investment over the following 12 months behind China, while confidence in Russia as an investment destination declined markedly. The survey also revealed that LPs with exposure to emerging markets had no intention of retreating and believed that recent-vintage emerging markets private equity funds would outperform equivalent developed market funds because of a lower reliance on debt to finance transactions and continuing – albeit slow eco- nomic growth. The real challenge will be to convince Western investors to maintain exposure to what are considered riskier markets. Indeed, the majority of LPs believe the risks of emerging markets private equity have increased over the last year, especially in Russia, Eastern Europe, and Africa.
32 Source: EMPEA, “Emerging markets private equity statistics”, 29 October 2009 33 Source: Asia Money, “Core private equity players prepare to place their bets”, May 2009 page 34 | A thorough understanding of PE 34 Source: EMPEA, “Emerging Markets Private Equity Survey 2009”, April 2009 RETOUR SOMMAIRE
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2. MAIN ACTORS AND STRUCTURES
2.1 Roles and responsibilities of main actors
The private equity business model involves different players. Figure 21 displays the main parties generally involved in a private equity fund: The GP (private equity firm/manager), the LPs (investors), the placement agent (if different from the GP), legal and tax advisers, and the various service providers (depositary, administrative agent, registrar, transfer agent and auditors). Their respective roles and responsibilities are described hereafter.
Figure 21: Main players of a typical private equity fund
Other advisers FundFund management management
Legal adviser External adviser InvestmentInvestment committee committee
Tax adviser Private equity house Regulatory (General Partner/Investment manager) Placement 2.1 agent • Selection Regulator • Supervision • Monitoring Limited Partners • Custody (Investors) • Development Depositary • Fund admin. bank Insurance • Mgt + Perf. fee • Audit companies Administrative Pension funds Private equity fund agent
Banks • Fund raising/ Commitments Registrar and • Capital calls • Capital calls transfer agent Business angels • Distribution • Investments High net worth • Divestment Auditor individuals • Distribution Corporates
FundsFund of of funds funds Private equity fund Private equity fund
Family offices DI DI DI DI DI DI Sovereign wealth funds Portfolio DI: Direct investment
Source: Adapted from Ernst & Young, 2009
2.1.1 General Partner
The term GP refers to the private equity firm as an entity that: • Establishes investment funds that collect capital from investors and reinvest this capital in investee companies; • Is legally responsible for managing the fund’s investments and, in theory, has unlimited personal liability for the debts and obligations when the fund is set up as a limited partnership. It should be noted that in practice, GPs use specific structuring to avoid assuming this unlimited personal liability.
The GP is also responsible for selecting the depositary, the administration agent, the regis- trar and transfer agent and other such agents as deemed appropriate. Furthermore, the GP shall provide quarterly reports on its activities and investments to all shareholders.
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As already mentioned in section 1.1.3, the GP has to commit an amount of capital to its own fund, so as to align the interests of the LPs with those of the GP.
In order to keep the fund running, the GPs receive a management fee (the service fee paid in consideration for the management services performed to the benefit of the fund), as well as a percentage of the profits, a carried interest used as an equity incentive. The value of this equity interest in the future profits of the fund depends on the fund performance (e.g. 20% realised gains).
As previously seen, all these items agreed on between the GP and the LPs are set out in a limited partnership agreement.
2.1.2 Limited Partner
The term LP refers to parties which invest capital in private equity, generally through specialised funds or investment companies rather than by investing directly in the capital of a company. LPs may be institutions (pension funds, banks, insurance companies, etc.), corporates, high net worth individuals or fund of funds.
Considering the level of risk, long-term return expectations and usually lightly regulated charac- teristic of private equity, the investment in private equity funds is for the large part reserved to well-informed investors. Investors in private equity are generally attracted by the opportunity to generate potentially higher long-term returns, whilst improving the diversification of their portfo- lios. Their liability is limited to the capital contribution. In exchange for the cash they provide, the LPs receive income, capital gains, dividends and leverage on the possible tax advantages the fund itself benefits from.
Investments in private equity vehicles are typically performed by the signature of an irrevocable subscription agreement, by which the investor commits himself to invest into a private equity vehicle a substantial amount of money, called on in partial payments during the first few years of the fund’s life cycle.
The profile of private equity investors generally depends on the business stage of development, as shown in the following figure:
Figure 22: Profile of investors depending on the business stage of development
Early-Stage financing Expansion-Stage financing Stage of - Seed - Initial expansion Acquisitions and Buyouts development - Start-up - Intermediate expansion - Bridge
- Founder capital - Founder capital - Private investors - Angel investors - Private investors - Venture capital funds - Private investors - Venture capital funds Profile of - Venture capital funds - Institutional investors - Institutional investors investors - Institutional investors - Government-backed corporations - Government-backed corporations - Government-backed corporations - Corporate strategic investors - Corporate strategic investors - Corporate strategic investors
Type of investment - Higher risk/higher return Equity subordinated debt Lower risk/lower return - Equity
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2.1.3 Placement agent
Generally fund raising is directly carried out by the GP. However, the GP, which is often a boutique operation in the private equity world, may prefer to focus on management issues rather than on raising capital. In that case, the GP may hire a placement agent, who will be remunerated with a percentage of the funds raised (generally between 1 and 2%).
The placement agent is a company specialised in finding institutional investors, high net- worth individuals or other private investors willing and able to invest in a private equity fund or company issuing securities.
Today, placement agents do not simply introduce private equity funds to potential LPs. They are highly valued advisers who both understand and know their LPs and the market’s ap- petite for different strategies. They will advise and assist fund managers at every stage of the fund raising process with: 2.1 • Detailed pre-marketing strategies for going to market (e.g. the United States versus Eu- rope, pension funds versus family offices etc.); • Marketing materials; • Due diligence preparation; • Positioning and terms negotiations; • Scaling back fund sizes (if too large).
2.1.4 Depositary
In the case of regulated funds and depending on the fund jurisdiction, the GP shall appoint a depositary for the fund.
The depositary is responsible for the general supervision of the assets of the fund and the custody of the assets entrusted to it. It provides the following services to private equity funds: • Holds and safekeeps assets, oversees them when non-securitised assets; • Arranges settlement of any purchases and sales of securities – Collects information on and income from such assets (dividends in the case of equities and interest in the case of bonds); • Manages cash transactions, performs foreign exchange transactions where required; • Provides regular reporting on all custodian activities to their clients; • Offers other services upon request such as cash management, escrow or pledge account facilities, debt or bridge facilities.
For the custody of the assets entrusted to it, the depositary may appoint correspondents, selected amongst professional service providers duly authorised to carry out their functions in the relevant jurisdictions (called sub-custodians).
Depositary banks have also a growing expertise in the administration of private equity funds, in order to offer a full service package.
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2.1.5 Administrative agent (fund administrator)
The administrative agent is responsible for the domiciliation of the fund, the maintenance of records and other general administrative functions as well as the processing of the cal- culation of the fund’s Net Asset Value (NAV). He is also responsible for providing the fund’s financial reports. As such, he provides the following services to private equity funds: • NAV calculation; • Portfolio accounting; • Bookkeeping and consolidation with local or international GAAP; • Portfolio performance computation; • Domiciliary services; • Other services depending on their competencies and offering, such as asset valuation, risk ratios monitoring, legal services, investor services, etc.
In countries such as France and the United States, this function can currently be carried out by the private equity asset management company itself, which could be called into question in Europe by the AIFM directive if a mandatory independent valuator was enforced (see section 4.4.2.).
Furthermore, in North America, the recent events during the financial crisis have led to a re- 2.2 evaluation of the fund administrator role by major investment companies and/or investors, causing them to reconsider their practice of self-administration.
2.1.6 Registrar and transfer agent
The registrar and transfer agents are responsible for the processing of the issue and re- demption of the fund units/shares and settlement arrangements thereof. They shall further- more assist the GP and/or the fund to determine whether the prospective investors willing to subscribe for units/shares meet the possible eligibility requirements set out. This function is often carried out by the same entity as the depositary or the administrative agent, depending on the country.
2.1.7 Auditor
Auditors are appointed by the GP. They are responsible amongst other things for issuing an audit opinion on the financial statements of the investment vehicle prepared bythe GP (sometimes delegated to a professional fund administrator). This opinion will declare whether the financial statements have been prepared in accordance with applicable ac- counting standards and be based on audit work executed in accordance with applicable auditing standards (International Standards on Auditing for example).
As the audit opinion will cover the financial statements, it will implicitly cover: • The income and expenses of the investment vehicle; • The carried interest and other performance fee calculations; • The fair value of the investment; • The compliance with applicable laws, regulations and investment limits; • The accuracy of the tax provision.
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2.1.8 Legal adviser
Regulatory pressure has increased the need for frequent legal advice. A private equity project often requires external legal support for the entire structure and in many cases each party involved (fund, manager and banks acting as a syndicate) will ap- point their own lawyer in order to ensure that the investment is effectively protected from a legal point of view.
Usually legal advisers are asked to draft the following agreements or documents: • Structuring and financing: Assistance regarding the structure of the private equity fund, the domicile, ensuring the relation with the local regulatory authorities, advice on finan- cial, regulatory and fiscal compliance requirements, write out the constitutional docu- ments necessary for the establishment and offering of the private equity structure; • Shareholders’ or subscription agreement (details the terms of the investment, including the obligations of the GP, the indemnities given to the existing shareholders, penalty claus- 2.1 es and shareholders’ rights); • Loan stock or debenture agreement: The contract establishes the terms under which dif- ferent forms of financing are provided; • Service agreements: Formalise the conditions of employment of key members of GP or external service providers (administrator, depositary, etc.); • Investments: Includes legal opinions on investment process, acquisition and divestment process, related financing.
Many law firms specialised in private equity provide a complete set of services to private equity firms through any phase of the private equity investment lifecycle: • Investment period strategy: Investment advice concerning the legal, financial, tax struc- turing, valuation of investee companies and market due diligences issues; • Exit Strategy: Advice regarding the regulatory, tax and accounting issues related to the repatriation of funds to investors, valuation of investee companies, vendor due diligence or advice on mergers and acquisitions.
2.1.9 Tax adviser
Private equity firms have also a constant need in tax advisory. As private equity has be- come an industry and local business angels have been largely replaced by international investment companies, tax advisers help GPs to set up suitable investment schemes in a worldwide framework.
These tax experts structure companies in different jurisdictions, select and fine tune financ- ing contracts adapted to these countries, negotiate tax rules with the authorities and review the structures agreements with third parties.
As more deeply described in chapter 3.1 (Fiscal aspects), tax advisers mainly work in 3 areas: • Improvement of structure for LPs; • Improvement of structure for GPs; • Cash repatriation.
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These improvements can be done on different aspects of the tax: • VAT costs can be reduced (up to 10%) if the management companies and or the funds are located in a EU Member State with a low VAT rate. Luxembourg has the lowest standard VAT rate (15%), which is allowed by the VAT Directive 2006/112/EC. • Tax on income can be reduced by using various legal jurisdictions, hybrid financing con- tracts, tax treaties between jurisdictions, negotiations with tax authorities, or some spe- cific type of companies (i.e. for transparency). 2.2
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2.2 Overview of main legal frameworks and vehicles
Most private equity investments are channelled through an investment vehicle in the form of an independent, private, fixed-life, closed-end fund. These funds typically have a life of ten years that can be extended upon agreement with their investors. They can be set-up as a regulated or unregulated structure. It should be noted that regulated funds are subject to certain restrictions, including invest- ment and borrowing limits (although in the case of funds targeted at professional investors, institutions and high net-worth individuals, derogations might be available from many of the restrictions). Additionally, they are subject to certain requirements as to the suitability of the promoters and managers of those funds and in certain countries such as Luxembourg must appoint independent custodians and administrators. In Europe, virtually every country has created its own investment vehicle – as illustrated by the map below – with special tax treatment, but often only applicable to domestic investors or with substantial constraints with respect to the fund’s operating activities.
Figure 23: Main private equity fund structures across the European Union 2.2 References to the main Ky legal texts regulating AS, KS private equity in France, Ireland, Luxembourg Aktiebolag, Kommanditbolag and the United States are summed up English LP Scottish LP in appendix. K/S Limited Partnership CV, BV CEIF GmbH PRICAF & Co KG
SICAR,SIF
FCPR MiFiG
LP for Coll.Inv.Schemes
FCR
SCR AKES FCR Fondo Chiuso
Copyright CACEIS, 2009
Moreover, some countries have attempted to offer structures incorporating flexibility to ac- commodate individual investors’ needs such as the United Kingdom LP or the Luxembourg SICAR, trying to replicate the possibilities Delaware structures offer for US-based investors. In this section, we have chosen to focus our analysis on four major jurisdictions where CACEIS is established: Luxembourg, France, Ireland and the United States. We will also have a few words about the promising Swiss market, as well as about the United Kingdom and the Channel Islands, as they are currently unavoidable locations for the private equity industry in Europe.
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2.2.1 Luxembourg
Benefiting from a flexible tax and legal environment, but also from a well-educated, mul- tilingual and multinational workforce, as well as a concentration of highly skilled service providers and niche experts, the Grand Duchy of Luxembourg has in a few decades become one of the major locations for investment funds, being today the world’s second largest fund centre, surpassed only by the United States. In addition to being the leading domicile and servicing centre for cross-border distribution of UCITS worldwide, the country has been taking active steps over the past few years to at- tract a significant share of the alternative investment industry and has been quietly building up a solid reputation as a home for structuring regulated private equity funds and private equity deals. The expertise gained in fund administration has been successfully transferred to the private equity arena and Luxembourg has built up a robust private equity model and servicing platform.
Luxembourg offers a choice of both non-regulated and regulated structures that meet the different requirements of investors and sponsors:
• The SOPARFI (“Société de Participation Financière”) is a financial participation company and was first introduced in 1990. As a fully taxable company, this structure was designed to benefit from the large double tax treaties network concluded by Luxembourg, as well as from the European Union’s parent-subsidiary directive. The SOPARFI was the most suit- able structure for private equity until the implementation of the SICAR in 200435. Today the SOPARFI is still extremely popular as an intermediary vehicle.
• The UCI Part II (Undertakings in Collective Investment) is Luxembourg’s traditional mutual fund vehicle, which is retail-oriented and subject to the standard supervision by the CSSF Luxembourg financial services sector regulator.
• The SICAR (“Société d’Investissement à Capital A Risque”) is an investment company in risk capital launched in June 2004, that has since become the Grand Duchy’s flagship vehicle for private equity. In October 2008, the new SICAR Law of 24 October introduced a set of further enhancements to the SICAR law such as the possibility to create sub-funds and the upgrading of the Luxembourg Limited Partnership SICAR structure. The number of SICARs, in particular, has dramatically increased every year since their creation in 2004, reaching 239 registered vehicles as at 31/12/2009, as per the CSSF records. This vehicle has been used by some of the top 20 private equity houses, as well as by small- and mid-sized private equity players, to invest in venture capital, private equity, mezzanine and other risk capital investments such as opportunistic real estate, microfi- nance or, more recently, clean energy technologies. All types of fund structuring are avail- able (direct funds, private equity fund of funds, master-feeder structures)36.
• The SIF (Specialised Investment Fund) was created in February 2007 specifically to en- courage the development of the alternative investment industry in Luxembourg. Contrary
35 Source: Privateequitywire, “Luxembourg private equity services 2008”, August 2008 page 42 | A thorough understanding of PE 36 Source: Ernst & Young, “Private Equity Ernst & Young Luxembourg”, February 2009 RETOUR SOMMAIRE
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to the SICAR, which is reserved for private equity and venture capital, as well as oppor- tunistic real estate and other areas such as microfinance, the SIF can also be used for property investments and hedge funds.
• The SV (Securitisation Vehicle) was introduced by the Luxembourg Law on securitisa- tion of 22nd March 2004 to create a favourable legal framework for securitisation in and through Luxembourg. The Law defines securitisation as the operation by which a SV pur- chases or assumes, directly or through the intervention of intermediary entities, the risks relating to assets or engagements by issuing securities (shares, bonds…), the value or yield of which depend on such risks37. The main highlights of SV are flexibility for arrangers (namely in terms of choice of legal structure, of issueable securities and of regulated or unregulated structures), legal cer- tainty and tax neutrality. SVs proved to be attractive investment vehicles thanks to the wide range of securitisation transactions covered and a regime of tax neutrality.
Main benefits of securitisation can be summed up as follows38: > Transforming illiquid assets into a source of financing through conversion into tradeable securities; > Achieving a better rating for the securities than the long term rating of the originator;
> Accelerating payment on receivables (sophisticated factoring); 2.2 > Removal of assets and risks from originator’s balance sheet.
On the market, SVs can be used in a variety of more or less complex structures, such as the ones illustrated below:
Figure 24: Examples of securitisation structure
Issuance of securities to the capital market Intra-group transactions
Parent Investor Trustee Preference Shares or Bonds
Issue of Cash securities
SV Issuer Lux Soparfi Equity (Ordinary Shares)
Transfer of Cash Securitisation Assets/Risk SV Originator (Industrial group, Bank, Investment fund) Funding + Transfer of Assets and Risks
Source: KPMG, 2004
The main features of these 5 vehicles are summed up in figure 25.
37 Source: KPMG, “Luxembourg securitisation vehicle, a new facility for tax efficient capital market investments and intra-group transactions”, 2004 38 Source: ALFI, “The Luxembourg law on securitisation of 22nd March 2004” by Elvinger Hoss & Prussen, 2004 A thorough understanding of PE | page 43 RETOUR SOMMAIRE
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Figure 25 – Comparison of the Luxembourg private equity structures
UCI Part II SICAR SIF SOPARFI SV Applicable legislation Investment funds Act SICAR Act (2004), SIF Act (2007) Companies Act (1915) Law of 22 March 2004 Part II (2002) amended by New SICAR Law of October 2008
Legal structures Forms available: Forms available: Forms available: Forms available: Forms available: > SICAV > SICAR > SICAF > Any corporate type of > Securitisation company > SICAF > Mutual Fund (FCP) entity or securitisation fund > Mutual Fund (FCP) > SICAV
Legal forms available: Legal forms available: Legal forms available: Legal forms available: Legal forms available: > SA (for SICAV and > SA > SA > Any corporate type of > Securitisation SICAF) > SARL > SARL entity company: > SCA (for SICAF only) > SCA > SCA - SA > SARL (for SICAF only) > SCS > SCoSA - SARL > SCoSA - SCA - Cooperative society in the form of a PLC > Securitisation funds: - Co-ownership (mutual) fund - Fiduciary (trust) fund Eligible investors Unrestricted Well-informed investors Well-informed investors Unrestricted Unrestricted (i.e. institutional or (i.e. institutional or professional investors professional investors or other investors with or other investors with min investment of min investment of E125,000) E125,000) Eligible assets Unrestricted (subject to Risk capital Unrestricted Unrestricted No limitation as to type CSSF prior approval) of assets or risks that can be securitised; No active management of the assets Risk diversification Yes (in principle, No (e.g. may serve Yes No No requirement investment in any target as a feeder for a A SIF cannot invest company may not Luxembourg or foreign more than 30% of its exceed 20% of the NAV) vehicle) assets or commitments to subscribe into instruments of the same nature issued by the same issuer (Circular 07/309)
Borrowing restrictions 25% of NAV No limitation No limitation No limitation No limitation (if SV is substantially financed by the issuance of securities) Minimum capital E1.25m to be reached E1m to be reached E1,25m to be reached E12,500 for SARL or Not required for requirements within 6 months within 12 months within 12 months E31,000 for SA/SCA contractual form following approval following approval following approval Regulated structure Yes Yes Yes No Both cases possible Yes / No Supervision Authority CSSF CSSF (light supervision) CSSF (light supervision) No supervision CSSF in case of regulated securitisation vehicles (the SV may exist as a non-regulated entity or as a regulated entity)
Number of structures 651 as at 30/11/2009 239 as at 31/12/2009 964 as at 30/11/2009 Not applicable Irrelevant as the SV recorded by the (includes all funds, not (includes all funds, not (includes all funds, not may also exist as a non Supervisory Authority only private equity) only private equity) only private equity) regulated entity
Tax regime Part II funds are Fiscally opaque SICARs SIFs are subject to an SOPARFIs are fully Securitisation funds subject to an annual (i.e. all SICARs except annual subscription tax taxable companies, are neither subject subscription tax ("taxe those established under ("taxe d’abonnement") of subject to an aggregate to corporation taxes d’abonnement") of the form of an SCS) are 0.01% p.a.of their NAV. corporation tax burden nor to the annual 0.05% p.a. of their NAV. fully taxable. which currently subscription tax ("taxe Classes of shares Unlike FCPs, SICAV/Fs amounts to 28.59%. d’abonnement"). which are reserved for can benefit from certain However, SOPARFIs can Institutional Investors double tax treaties. benefit from exemptions Securitisation are subject to a Investments may be to corporation tax for companies are subject subscription tax at a made through fully dividends received from to corporate income reduced rate of 0.01%. taxable subsidiaries share-holdings, capital tax and municipal tax, benefiting from double gains made on the however all recorded tax treaties and the sale of share-holdings liabilities towards EU parent-subsidiary and gains made on investors and all directive. liquidation of companies other creditors are a in which shares are deductible expense. held.
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UCI Part II SICAR SIF SOPARFI SV Tax regime Unlike FCP, SICAV/F However, they can Exemption is granted on No withholding tax benefits from certain generally avoid any the following conditions: except if SV falls double tax treaties. substantial tax in > Dividend and under the EU Savings Investments may be Luxembourg as they are liquidation gains directive. made through fully authorised to exempt exemption on share- taxable subsidiaries from their tax base all holdings of at least benefiting from double income and capital 10% or an acquisition tax treaties and the gains deriving from: cost of at least E1.2 EU parent-subsidiary > Investments in million provided such directive. transferable securities qualifying holding (tax authorities have participation is held for accepted in certain at least 12 months; cases that loans > Capital gains may be assimilated exemption of share- to securities for the holdings of at least purpose of the tax 10% or an acquisition exemption, as long as cost of at least the loan agreement E6 million provided includes a clause such qualifying providing for the holding participation possibility to transfer is held for at least 12 the loan to a third months. party); A 15% withholding > Temporary cash tax will be applied on investments pending the gross amounts of investments in risk dividends paid by the capital for a maximum SOPARFI (subject to tax period of 12 months. treaties and EU parent- subsidiary directive). No SICARs established withholding tax is levied as an SCS are fiscally on liquidation payments. transparent and the There is no formal legal profit share of foreign rule concerning thin investors investing in capitalisation. these SICARs is not The Luxembourg tax subject to any tax in authorities usually
Luxembourg. consider that an 2.2 acceptable debt/equity Fiscally opaque SICARs ratio is 85:15. If this may in principle claim ratio is not complied treaty protection and with and the SOPARFI is benefit from the parent- over-indebted, interest subsidiary directive. paid on the excess debt However, the eligibility on a loan received from of SICARs must be its shareholder or to a reviewed on a case-by- bank, when the loan of case basis depending the bank is guaranteed on the jurisdiction of the by the shareholder, target company. can be considered as a hidden profit distribution subject to dividend withholding tax at a rate of 15% and such interest is then not deductible.
Administrator/ > Depositary required > Depositary required > Depositary required > Auditor required if two In case of regulated SV: Depositary/Auditor (credit institution); (credit institution); (credit institution); of the following criteria > Depositary required requirement > Administrative agent > Administrative agent > Administrative agent are met during two (credit institution); (Luxembourg PFS) (Luxembourg PFS or (Luxembourg PFS) successive years: > Administrative agent required unless the unregulated company) required; - Total balance sheet (Luxembourg PFS) administration duties required unless the > Auditor. exceeds E3.125 required unless the are performed by the administration duties million; administration duties management company are performed by - Net turnover exceeds are performed by the itself in Luxembourg; the SICAR or the E6.25 million; securitisation company > Auditor. management company - Average number of itself in Luxembourg; itself in Luxembourg; employees exceeds > Auditor. > Auditor. 50.
Source: LFF-ALFI, 2009
Over the past five years, an increasing number of private equity vehicles have been set up in Luxembourg following the implementation of the SICAR and SIF as new lightly regulated onshore structures that proved to be major successes. Indeed, these complementary vehicles offer key advantages: Tax neutrality for investors and high tax efficiency for GPs, flexibility in structuring through various corporate forms, variable capital and compartments/sub-funds, as well as operational efficiency (achieved for instance by an explicit consolidation exemption). Both vehicles have put Luxembourg on the map as a leading jurisdiction for private equity structuring. Even during the recent financial situation, private equity in Luxembourg has shown surprising levels of growth, still picking up new funds and with private equity houses and man-
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2.2.2 France
France provides several types of suitable domestic fund structures for venture capital, as well as fiscal incentives to encourage investments in the asset class: • The FCPR (“Fonds Commun de Placement à Risques”) is the most commonly used struc- ture for private equity funds in France (in 2008, 85% of the private equity capital raised in France was collected through these funds). This vehicle is tax transparent for domestic and non-domestic LPs, and offers (by law) non-domestic LPs the ability to avoid having a permanent establishment in the country. FCPRs can be authorised funds (“FCPR agréés”), funds registered via the fast-track procedure (“FCPR allégés”) or contractual funds (“FCPR contractuels”). Contractual FCPRs, inspired by the Anglo-Saxon limited partnerships, have been recently introduced. These vehicles have fewer regulatory constraints than usual FCPRs and are for qualified investors and accredited investors only39. • The FCPI (“Fonds Commun de Placement dans l’Innovation”) is a kind of authorised FCPR fund dedicated to investments in innovation. • The FIP (“Fonds d’Investissement de Proximité”) is a kind of authorised FCPR fund dedi- cated to local or regional investments. The main features of these vehicles are summed up in the table hereafter:
Figure 26 – Comparison of the French private equity structures
FCPR FCPI FIP Applicable legislation Financial and Monetary Financial and Monetary Code, Financial and Monetary Code, Code, Articles L214-36 to 38 Article L214-41 Article L214-41-1 Legal structure Mutual fund (almost always Mutual fund (almost always UCITS) Mutual fund (almost always UCITS) UCITS) Eligible investors > Authorised FCPR: Public Public Public > Contractual FCPR & FCPR “allégé“: Well-informed Eligible assets and Risk capital: Min 50% of the Risk capital: Min 60% of the assets Risk capital: Min 60% of the assets risk diversification assets (except contractual Investment only in innovating firms Investment only in firms located in a requirement funds) selected geographical zone Borrowing restrictions Max 10% of the net assets Max 10% of the net assets Max 10% of the net assets (except contractual funds) Minimum capital E400,000 E400,000 E400,000 requirement Regulated structure > Authorised FCPR: Yes Yes Yes Yes/No > Contractual FCPR & FCPR “allégé“: Declaration procedure to AMF only Supervisory Authority AMF AMF AMF Number of structures 487 264 153 recorded by the as at 31/12/2009 as at 31/12/2009 as at 31/12/2009 Supervisory Authority Tax regime Conditions to qualify for Conditions to qualify for favourable Conditions to qualify for favourable favourable tax treatment tax treatment (individual investors): tax treatment (individual investors): (individual investors): At least 60% of the assets of the At least 60% of the assets of the At least 50% of the assets of FCPI must be invested in innovative FIP must be invested in EEA non- an FCPR must be invested companies established in the listed companies, which must be in non-listed resident European Economic Area (EEA) and located in at the most three different companies (French or subject to local corporate income geographical regions (in France or foreign) that carry out tax. These qualifying assets can in the EEA). This qualifying portfolio operational activities and are include listed companies with a must invest at least 10% of its subject to local corporate market capitalisation of less than assets in newly created companies. income tax. These qualifying E150 million but only up to 20% of These qualifying assets can include assets can include listed the total assets. listed companies with a market companies with a market capitalisation of less than E150 million capitalisation of less than but only up to 20% of the total assets. E150 million but only up to 20% of the total assets.
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FCPR FCPI FIP Tax regime Tax incentives for individual investors: > Exemption from French tax on income distributed and on capital gains realised on the sale of shares in the fund when they are sold or redeemed after a five-year restricted period and the individual investor does not hold more than 25% of the shares of a company included in the fund’s portfolio of investments. > An income tax reduction equal to 25% of the amount invested in the funds, up to E12,000 per person. > A wealth tax reduction equal to 50% of the amount invested, up to E20,000 per person. However, French residents remain liable to social security contributions at 12.1%. Favourable tax regime for investors: Certain investments in French or EU-resident small or medium companies (SMEs), as defined under EU law, benefit from income tax and wealth tax advantages, where the investments are: > Made directly or through a holding in non-listed SMEs subject to local corporate income tax. > Held for a minimum five-year period. If so, individual investors can benefit from: > An income tax reduction equal to 25% of the amount invested, up to E20,000 per person. > A wealth tax exemption and/or reduction. Favourable tax regime for SMEs: Tax incentives, such as tax research credits, are available to support and encourage the development of innovative companies. In addition, an attractive tax and social security regime applies to innovative newly-created companies («Jeunes Entreprises Innovantes») (JEIs), which are SMEs dedicating more than 15% of their total expenses to research and development. JEIs can benefit from: > A total exemption for the first three profitable years, and a partial exemption (50%) for the following two profitable years, from social security contributions and corporate income tax. > An exemption from business tax for the first seven years (under certain conditions)
Administrator/ These funds must have a custodian for their assets, which must be a financial institution. Custodian requirements Copyright CACEIS, 2009 2.2 The majority of private equity and venture capital investors in France use FCPR, FCPI or FIP because these legal structures are tax neutral. In addition, as they are regulated funds (UCITS), and therefore supervised by the AMF financial regulator, investors have a degree of protection and transparency that other types of vehicles do not provide. The constraints, in terms of prudential ratios (ratios of capital to assets) and investment policy, applicable to FCPR are less strict than for more specialised funds (such as FCPI or FIP).
In the last decade, the assets of FCPR (including FCPI and FIP) in France multiplied by 15, while their number increased from 154 in 1998 to 996 at the end of 2008, as displayed in graph 27. As already mentioned, these venture capital funds benefit from highly attractive tax incentives for investors, which can explain this exponential growth.
Figure 27: Evolution of the assets and the number of FCPR (including FCPI and FIP) in France (1990-2008)
55 1,100 996 50 1,000
45 846 900
40 741 800 35 700 32 602 30 30 600 514 25.5 25 445 500 Number of FCPR FCPR of Number
FCPR assets in in assets €bn FCPR 20 368 400 18 276 15 300 226 12.53 190 10.7 10.8 10 154 200 137 143 138 133 134 119 123 124 7 7.5 5.2 5 100 Copyright CACEIS, 20091.2 1.4 1.6 1.8 1.5 1.5 1.7 2 2.1 0 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Source: AFG, 2009
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2.2.3 Ireland
Ireland is a jurisdiction that has become synonymous with alternative investments, includ- ing hedge funds and private equity funds. As a domicile for private equity funds, Ireland offers a variety of potential fund structures both regulated and unregulated:
• Regulated vehicles include unit trusts, variable capital investment companies and com- mon contractual funds, each of which can be open-ended, limited liquidity or more fre- quently closed-ended schemes, with the level of investment and borrowing restrictions and permitted investment mechanics being set by the targeted investor profile – retail, professional or qualifying investor – with strict rules as to custody, asset management and fund administration. These private equity vehicles are referred to as non-UCITS structures.
The Qualifying Investor Fund (QIF) is the non-UCITS vehicle most frequently used for pri- vate equity funds in Ireland, because of its flexibility; Indeed, the Financial Regulator’s usual conditions for borrowing, leverage and diversification of investments do not apply to the QIF, thereby enabling sophisticated investors to use this structure for a wide range of investment purposes. Furthermore, since February 2007, a QIF fund can be authorised by the Irish Financial Regulator within 24 hours of the submission of relevant documentation to the Financial Regulator40. The following graph displays the rapid growth of QIFs since 2002.
Figure 28 – Evolution of QIFs’ Net Asset Value and number of funds (2002-H1 2009)
1200 109,051 1000 92,669 93,999 89,933 800 67,337 600
Number of funds 43,548 400 27,864 200 18,124
0
2002 2003 2004 2005 2006 2007 2008 JUN-2009 Net Asset Value (EMillion) Number of funds (including Sub-funds)
Source: IFIA (Irish Funds Industry Association), 2009
• Unregulated structures are generally housed within limited partnership structure estab- lished under the Limited Partnership Act, 1907. They are referred to as LPs. This structure provides maximum flexibility to promoters and investors with regard to the marketing of the fund, making of investments, ongoing governance, dissolution and return of capital on liquidation of the fund, as no licenses are required unless the fund is providing certain investment services.
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The main features of both structures, QIF and LP, are summed up in the table below.
Figure 29 – Main characteristics of Irish private equity vehicles
QIF LP Applicable legislation > Non-UCITS regulatory regime: > The Limited Partnership Act, 1907 - Non-UCITS investment companies: Part XIII of the Companies Act, 1990 - Non-UCITS unit trusts: Unit Trusts Act, 1990 - Investment Limited Partnerships (non-UCITS): Investment Limited Partnership Act, 1994 - Non-UCITS common contractual funds: Investment funds, companies and miscellaneous provisions act, 2005 > The rules governing QIFs are set out in the Financial Regulator’s Non-UCITS Notice N0. 24 Legal structure > Investment company > LP > Unit trust > Investment Limited Partnership (ILP) > Common contractual fund Eligible investors > Qualifying investors individuals with > Private placement only a minimum net worth of E1.25 million (excluding principal private residence/ contents) or institutions who own or invest on a discretionary basis at least E25 million (or are themselves owned by qualifying investors) Eligible assets and > Unrestricted > Unrestricted risk diversification requirement Borrowing restrictions > Unrestricted > Unrestricted
Minimum capital > Minimum initial subscription > Unrestricted 2.2 requirement requirement per investor of E250,000 or equivalent in other currencies (no limits made on subscriptions there after)
Regulated structure > Yes > No Yes / No Supervisory Authority > The Irish Financial Regulator > N/A Number of structures > 1,153 funds including sub-funds as at > N/A recorded by the 30/11/2009 Supervisory Authority Tax regime > Irish investment funds exempt from > Partnership: Tax transparent. Irish tax on their income and gains, > LPs subject to taxation on their share irrespective of where their investors of underlying income and gains of the are resident. Partnership itself. > No withholding taxes apply on income distributions on redemption payments made by a QIF to non-Irish resident investors. > Depending on the tax status of a QIF investor in their home jurisdiction, a QIF can also be structured as a tax transparent vehicle resulting in the retention of the tax benefits (e.g. reduced withholding taxes) enjoyed by investors through direct ownership. > A QIF may also hold investments through Special Purpose Vehicles to improve tax efficiencies.
> Tax incentive schemes to encourage investment in venture capital companies: - Business expansion scheme; - Seed capital scheme; - Qualifying patent exemption; - Relief for investment in renewable energy generation.
Administrator/ > Irish registered fund administrator > No requirement Custodian requirements required > Irish based trustee/custodian required
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It is worth noting that Ireland is not only a fund domicile, but also a fund administration centre of excellence across all asset classes, including private equity funds. Today Ireland boasts being the largest administration centre in the world for alternative investments. The country’s fund administration success has been based on innovation, good legal and regula- tory framework, excellent business environment and the ability to provide experienced staff that can facilitate the processing of sophisticated products.
2.2.4 The United States
Nearly all US venture capital funds are structured as limited partnerships. The most popular US jurisdiction for formation is Delaware, since the Delaware LP offers full tax transparency to US investors and has established itself as a suitable platform for dealing efficiently with the regula- tory constraints of US-based institutional investors. The principle characteristics of the US limited partnership entity are detailed in the table below.
Figure 30 – Main features of the US limited partnership
US LP
Application legislation Formation > Laws of state of formation (e.g. Delaware)
Offering/Marketing > US Securities Act of 1933, as amended (“USSA”) Also to be considered: > US Employee Retirement Income Security Act of 1974 as amended (ERISA); > State securities regulation; > FDIC Bank Holding Company Act (BHCA).
Registration > USSA Regulation D > US Investment Company Act of 1940, as amended (exemptions under section 3I(1) or 3I(7))
Disclosure > US Securities Exchange Act of 1934, as amended > USA Patriot Act
Non-US offerings > USSA Regulation S
Fund Managers > US Investment Advisers Act of 1940, as amended > State investment Adviser regulations
Promoter (third party) > US National Association of Securities Dealers > State broker dealer/placement agent registration
Legal structure > Limited Partnership (usually one GP and multiple LPs)
Eligible investors > “Accredited investor” or “qualified purchaser”
Eligible assets and risk > Unrestricted diversification requirements
Borrowing restrictions > None – dictated in the Limited Partnership Agreement (“LPA”)
Minimum capital requirement > None – dictated in the LPA (typically $1 - $5 million for individuals, $5 million and higher for entities
Regulated structure Yes/No > No
Supervisory Authority > None currently – proposals in both houses of congress such as the Hedge Fund Transparency Act and the Hedge Fund Advisor Registration Act of 2009 would provide the SEC with oversight
Number of structures > Not applicable recorded by the Supervisory Authority
Tax regime > Limited partnerships are not taxed. Investors in the fund are taxed directly on their portion of income, expenses, gains and losses in the fund
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The last decade witnessed a significant growth in terms of US venture funds capital under management, while the number of venture capital funds in existence nearly doubled (see figure 31).
Figure 31: Evolution of capital under management and number of US venture capi- tal funds (1980-2008)
300
250 Number of US venture capital funds in existence: 1988: 715 funds 1998: 1,085 funds 200 2008: 1,366 funds
150 Capital under mangement in $bn in mangement under Capital 100
50 2.2
0 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Source: NVCA, 2009
As it is the case in Europe (refer to adequate part of brochure), an increasing pressure on regulation of private funds and/or their advisers emerged in the wake of the economic cri- sis. The United States did not escape this trend with Treasury Secretary Tim Geithner speak- ing in favor of measures according to which all advisers to private funds with assets under management over a certain threshold would be required to register with the SEC (Securities and Exchange Commission) and therefore be subject to some regulatory supervision. Two legislative proposals have been introduced in the US Congress early 2009 in that respect: the Hedge Fund Transparency Act (Grassley/Levin Bill) that would require all - and not only hedge funds - privately offered funds with at least $50 million in assets to register with the SEC (among other), and the Hedge Fund Advisor Registration Act that would remove the exemption from SEC registration for investment advisers with fewer than 15 clients on any 12 months period and would also apply to private equity funds.
2.2.5 Switzerland
Although most of the venture capital funds active in the Swiss market are offshore LPs, governed under the laws of Guernsey, Jersey, Cayman Islands, Scotland and other Anglo- Saxon jurisdictions41, it should be noted that since 2007, it is possible under Swiss law to incorporate Limited Partnerships for Collective Investment Schemes investing in private equity, with the new SCPC (“Société en Commandite de Placements Collectifs”) vehicle.
41 Source: Practical Law Company, “Private equity 2009 Volume 2: Venture Capital”, 2009 A thorough understanding of PE | page 51 RETOUR SOMMAIRE
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The Swiss LP requires that the GP be a Swiss company limited by shares, while the LPs must be qualified investors, such as institutional investors, high net worth individuals, or individuals who have entered into an asset management agreement with a supervised financial intermediary.
However, in practice, market participants are still reluctant to use Swiss LPs, and tend to rely on non-Swiss structures while appointing a Swiss investment manager. This can be explained by the fact that Swiss LPs were introduced only two years ago, that they do not receive tax ben- efits (although this disadvantage can be mitigated if it is properly structured and a ruling from the competent tax authority is obtained), and that they are regulated by the Swiss Financial Market Supervisory Authority (FINMA) (which can also be an advantage as domestic pension plans for instance are required to invest in regulated investment schemes).
As these issues are addressed, administration costs decline and transparency increases, it is expected that the Swiss LP will become a more attractive alternative to offshore LPs.40
2.2.6 The United Kingdom
The United Kingdom offers to LPs and fund management companies one of the most fa- vourable environment for private equity and venture capital. Pension funds and insurance companies do not face any constraints when investing in the asset class, apart from those defined in the European Union directives. Moreover, the country provides an appropriate domestic fund structure, which functions as a model for several other national regimes, as well as tax incentives to stimulate investments in private equity and venture capital.
Both the English limited partnership and the Scottish limited partnership are suitable fund structures for private equity and venture capital investments. The English limited partnership is tax transparent for the purpose of UK taxation on income and chargeable gains for domestic as well as non-domestic LPs. In the absence of a trad- ing activity, non-domestic LPs can avoid having a permanent establishment in the country. Furthermore, although management fees for managing a private equity and venture capital fund would in theory be subject to VAT, the fund management arrangements typically be structured so as to ensure that UK VAT does not have to be charged on the management fees. Finally, fund this structure is free from undue restrictions.
2.2.7 The Channel Islands
Guernsey and Jersey have both positioned themselves as key centres for establishing off- shore funds, particularly in the real estate and private equity sectors over the last decade. Indeed, European Union directives on fiscal harmonisation, financial services and company law do not have direct effect in Channel Islands.
Since a few years, Guernsey has been growing its reputation as a leading offshore private equity domicile in Europe. As displayed by figure 32, the net asset value of private equity funds in the island increased dramatically over the past 5 years by 14% during 2008 alone despite the adverse global market conditions that have seen amounts raised by private eq- uity funds across Europe fall by some 10% in 2008.
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Figure 32: NAV of private equity funds in Guernsey in £ million (2002-2008)
45,000 40,000 35,000 30,000 25,000 20,000 15,000 10,000 5,000 0
2002 2003 2004 2005 2006 2007 2008
Source: Guernsey Finance, 2009
The agency for development of the financial sector in Guernsey namely “Guernsey Finance” underlines the fact that the island boasts a pool of dedicated specialists in private equity funds: Experienced administrators as well as fund managers and custodians, accounting services, legal experts. Guernsey also boasts a reliable infrastructure: A pragmatic regulatory environment for pri- vate equity funds, fast track capability with the Qualifying Investor Funds (QIFs) – a self- certification regime targeting experienced investors-, a competitive tax environment and effective IT capabilities for both complex and simple private equity fund structures43. 2.2 So far, Jersey has lagged behind its neighbour as a European offshore centre for private equity but it is catching up fast. The island offers a wide range of regulation including the very light touch expert funds and the new unregulated funds introduced in February 2008.44
43 Source: GuernseyFinance, “Private equity funds in Guernsey”, 2009 44 Source: Privateequitywire, “Jersey attracts global fund administrators”, December 2008 A thorough understanding of PE | page 53
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A CACEIS PRODUCT DEVELOPMENT PUBLICATION - 2010 FISCAL AND OPERATIONAL ISSUES
3. FISCAL AND OPERATIONAL ISSUES
3.1 Fiscal aspects
3.1.1 Preamble
When it comes to fiscal aspects, the main issue is the global tax structuring of private equity projects, encompassing both cash repatriation aspects and investment structures.
The investment scheme structure set up aims at getting efficient cash flows. Indeed, all private equity houses focus on maximising cash repatriation from underlying investments and therefore IRR for investors. As investments are often spread internationally, taxation of such flows is closely monitored.
Following the fund raising process, when there are already soft commitments (i.e. intentions to invest into the fund) from LPs and the investment deal pipeline steams up, the GP reviews the choice of domicile of the investment structure and the most suitable corporate forms in light of, among others, the following criteria:
The potential investors: • From which region do they come? Europe, MENA, North America, etc. • From which country? Germany, Italy, etc. • What kind of investors are they? Institutional investors, family offices, private persons, etc.
The deal pipeline: 3.1 • Which investment strategies? Mezzanine, distressed, venture capital, real estate oppor- tunistic, real estate projects, infrastructure projects, etc. • Where are the target investments located? In the United States, Europe, MENA, Asia, Africa, etc.? • What kind of financing instruments? Debt, equity, guarantees, a mix of instruments?
The corporate governance: • Who should make the decisions? The board of directors, the investment adviser, a sub- adviser, etc. • Where are most of the managers located? In the same country? In different countries?
3.1.2 Investment scheme structure
Holding Companies (Hold Co), Financing Companies (Fin Co) and Joint Ventures (JV) are the most popular ways for structuring the investment scheme, as illustrated in figure 33.
Figure 33: Illustration of an investment scheme structure
Investment Fund Third party investors
INTERM 1 FIN Co SPV 1 HOLD JOINT SPV SPV Co VENTURE 2 3
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Tax advisers will propose an investment scheme per investment type or a general model for the whole structure.
3.1.3 Examples of common setups
Two different investment funds Private equity houses may run two different investment funds in parallel in order to accom- modate for different classes or families of investors. Figure 34 shows an example of set up with one Luxembourg domiciled fund to meet the requirements of European institutional investors and one Moroccan domiciled fund for the MENA investors, both funds investing in the same assets.
Figure 34: Illustration of an arrangement with two different investment funds in parallel European Investors MENA Investors
Units/shares Dividends Capital gains
Luxembourg Moroccan investment investment fund (regulated) vehicle
Shareholder loan: 95% Equity: 5% Fixed interest/ Dividends floating interest Capital gains
Target Target Target Target 1 2 3 4
Copyright CACEIS, 2009
Investing through a feeder It is also common to see private equity houses creating feeder funds for some specific countries before investing in the investment vehicle (in the same country or in offshore vehicles), as illustrated in figure 35.
Figure 35: Illustration of an arrangement with a feeder fund
Investors country 1 Investors country 2
Common shares Dividends Capital gains
Feeder Fund (regulated)
Dividends Institutional shares Capital gains Offshore investment fund
Equity: 1% Capital gains Profit participation Net income loan: 99% at target 1 level
Target 1 Target 2
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Using a limited partnership with a waterfall distribution model When choosing an investment structure, the limited partnership with a waterfall distribution model is still the favourite structure. The GP makes all decisions with a minimum investment into the vehicle, and LPs are not supposed to make decisions. However, LPs might be in- volved in the vehicle’s life thanks to committees organised like investment committees, audit committees, valuation committees and so on.
Figure 36: Illustration of an arrangement based on the limited partnership model
Partners Limited Partners Equity
General Partners IRR until hurdle (limited liabilities) Ordinary shares % of performance above hurdle (80%) GP shares + Carried Carried shares interest
Limited Investment partnership adviser Equity Convertible Net (1 to 5%) preferred income equity at target 1 certificate level
Target 1 Target 2
Copyright CACEIS, 2009
3.1.4 Financing the investments 3.1
Private equity collective investment vehicles investing in target companies need to determine and locate the financial instruments between the various entities: • Between investors and collective investment vehicles; • Between investment vehicles and intermediaries/SPVs; • Between the intermediaries/SPVs; • Between intermediaries/SPVs and the target companies following the need to locate debt and other financing instruments in the most appropriate structure;
For tax efficiency, private equity houses generally use a mix of equity/debt instruments.
Equity stakes should grant security to the investment fund, thanks to the decision powers at the intermediaries/SPVs level, but the final goal is the exit of the target company or the SPV holding. The GPs sell their shares, report realised profit or loss on stocks and are taxed accordingly.
Some hybrid instruments can give more flexibility to the GPs that may choose to convert the debt into shares of the financed company in order to take an additional equity stake, such as convertible bonds or convertible participating equity certificates. Moreover, for taxation pur- poses, these hybrid instruments can be seen as equity or as debt, depending on countries.
Tax advisers can negotiate specific tax rulings for investment structures, thanks to this mix between equity and debt in the different domiciles of the intermediaries and SPVs. There is no general tax structure or tax rule. The instruments created are tailored in function of the type of final investment, the exit strategies, the countries, the type of company, the type of fund or
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Many instruments are available: • Shares; • Bonds and convertible bonds; • Preferred rights; • Profit participation loans and interest free loans; • Options; • Convertible preferred equity certificates; • Swaps; • Preferred equity certificates; • Etc.
3.1.5 VAT aspect
A significant fiscal aspect is the Value-Added Tax (VAT). The choice of jurisdiction for the investment vehicle, the investment advisory company or the GP can have an impact on VAT, as illustrated hereafter: • FSA regulated investment advisers can be VAT exempted in the United Kingdom; • The management companies established in Luxembourg benefit from a 15% VAT rate charged on the services rendered to them, if no exception or exemption applies which, compared to the 21% VAT rate in Belgium, accounts for a 600 basis point gain on invoices’ gross amount. • Management services rendered to funds located in Luxembourg are VAT exempt under certain conditions. In general financial services are exempt from VAT.
Private equity houses are concerned about the investments and the profits they can realise on target investments but should also pay a particular attention on each point of the fiscal structuration stated in this chapter if they want to improve the efficiency of their invest- ments proceeds.
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3.2 Operational issues
3.2.1 Preamble
As already mentioned in section 1.1.4., the operational model of private equity funds has little in common with regular funds. Listed investments are few in number if there are any at all, NAV calculation is infrequent, there are usually no subscriptions or redemptions and reporting is very specialised. If not outsourced to a trusted provider, all the above must be delivered by the private equity firm. In order to reduce operational issues, it is therefore a best practice to establish an operating memorandum for each private equity fund, which gathers roles and responsibilities of the nu- merous intervening parties and precisely describes the processes, including timing and report- ing considerations.
As regards outsourced back-office functions, depositary and fund administration services must often be provided by a specialised team, since reporting is hard to automate and services must be customisable and tailored to the fund’s needs to ensure high quality of service.
Robust risk management is also essential due to the higher levels of risk inherent in this type of investment and the fact that the promoter does not always have a solid financial base.
Furthermore, although stellar performance will undoubtedly remain the most significant inves- tor selection criteria, qualitative factors are increasingly seen as a way to differentiate a private equity fund from its competitors. Qualitative factors include:
• The quality, quantity and transparency of reporting to investors, often the only source of infor- mation on the non-quoted companies;
• Effective methods of investment valuation, taking into account unrealised profit, which often forms a significant part of the actual yield. It is worth noting that there is a trend towards com- 3.2 pliance with European trade association recommendations on portfolio valuation;
• And, finally, the GP is scrutinised by increasingly thorough due diligence procedures, so the need to comply with regulations relating to prevention of money-laundering and accounting principals is paramount.
All these operational issues are detailed in the following sub-sections. For a better compre- hension before addressing the different operational aspects (subscriptions, capital calls, investments, NAV/IRR, reporting, distribution waterfall), figure 37 displays the typical fund lifecycle from the GP’s and from the depositary/central administrator’s points of view.
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Figure 37: Typical lifecycle of a private equity fund
•Marketing Material (PPM) •Financial Sponsors •Road shows •Valuation •Management Team •Commitment •Adds on investment
•Choice of jurisdiction •Due diligences on •Exit strategies •Appropriate tax and targets Partner •Divestments General legal structure •Investments •Authorisation •Tax structuring •Carried interest
Fund idea Fund set up Fund raising Investments Investment Divestments Distributions Fund management to investors liquidation
•Compliance work on •Due diligence on managers investments •Payment flow •Coordination with regulators/ •Payment flows •Monitoring payments to advisers investors/managers •Fund set up •Monitoring drawdowns •Operating memorandum •Compliance work on assets Depositary/ Depository /
•Monitoring of capital calls Central admin •Income collection Central administrator •KYC investors process NAV calculation / reporting
Source: PricewaterhouseCoopers, 2007
3.2.2 Subscriptions
The first phase of relationship with investors is the fund raising period when contacts are established by the GP directly or through fund raisers. The fund in its initial form of doc- umentation is introduced to potential investors selected based on the fund patterns de- scribed in term sheets or private placement memorandums. At this stage and up until the fund is incorporated, soft commitments can gathered and rep- resent intentions to invest into the fund. As from the fund legal existence or at least the GP existence, so-called hard commitments can be entered into by investors.
They are formalised in commitment or subscription agreements which outline the conditions under which capital will be called from the signatory investors. Commitments are signed for a specific amount, with a defined callable period, present notice periods and outlines all necessary information in terms of Anti Money Laundering (AML)/Know Your Customer (KYC) which will be required from investors in order to invest into the fund.
3.2.3 Capital calls and capital distributions
Capital call/drawdown Private equity funds are generally set up as closed-end limited partnerships. To enter into this kind of fund, the LPs sign a subscription agreement which means that they commit to invest a determined amount. They do not fund their capital contribution all at once. Typically, 5 to 10% of commitments are drawn upon formation of a fund, with the remainder called over time as directed by the GP and as needed for new investments and/or fund expenses. The deal for any GP is of course to draw exactly the amount required in best time to optimise fund performance and then the IRR.
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• Operational aspects Once the GP has clearly defined his cash need, then he determines, often via his fund administrator, the amount to be drawn to each LP and a capital call notice is sent to each LP defining the amount drawn, the payment date and the reason of the call (investments, expenses, etc.). Generally, this notice is sent to LPs ten to twenty days prior the payment date.
• Penalties Once a LP makes a commitment to a fund, he cannot withdraw or otherwise discontinue his participation without incurring heavy penalties. A typical penalty for missing a capital account deadline consists in diluting the tardy partner’s capital account. Subsequent defaults result in additional cuts and may even result in the total elimination of the partner’s capital account. Funds usually have provisions for taking legal action against defaulting partners. While these are rarely invoked, pressure from remaining LPs has forced GPs to initiate such proceedings in some cases.
Capital distributions As a reminder, capital distributions are the returns received by an investor in a private eq- uity fund, that is to say the income and capital realised from investments less expenses and liabilities. Once a LP has had his cost of investment returned, further distributions are actual profit. As already mentioned, the partnership agreement determines the timing of distribu- tions to the LPs and how profits are divided among LPs and the GP.
The challenge for any GP consists in maximising cash-to-cash returns: 1. To increase the IRR (and then his performance fees); 2. To return capital to investors as quickly as possible to maximise reinvestment opportunities.
• Distribution in kind Distribution in kind can mainly happen when an investment has resulted in an IPO. An LP may receive his return in the form of stock or securities instead of cash. This can be controversial, as the stock may not be liquid and LPs can be left with shares that are 3.2 worth a fraction of the amount they would have received in cash. There can also be restrictions in the United States regarding the period when an LP is authorised to sell the stock (Rule 144). In that case, the share value may have decreased by the time the LP is legally allowed to sell it.
■ • Operational aspects Once the GP has realised an underlying asset, he determines, often via his fund administra- tor, the amount to be paid back to each LP. A distribution call notice is sent to each LP defin- ing the amount paid, the payment date, as well as the allocation between return of capital and profit. Generally, this notice is sent to LPs three to five days prior the payment date.
Reporting The GP, often via his fund administrator, holds for each LP a capital account which gathers and summarises all the calls paid and distributions received by this latter. He also holds quarterly the current position of each LP within the partnership, the percentage of holding and the remaining commitment.
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3.2.4 Investments
The typical investment process into private equity assets can be split in three steps, as il- lustrated in figure 38:
Figure 38: Investment process into private equity assets
1. Pipeline 2. Investment 3. Exit phase management phase
Copyright CACEIS, 2009
1. Pipeline management Pipeline management phase includes due diligence, which is a key point in private equity, and consists of maintaining a list of target companies or properties, their business plan review, by analysing the following major factors that can influence the success of the in- vestment: • Company and management background – history and development; • Operating and ownership structure of the company; • Product or services – competitive advantages; • Markets: Size, growth and competition; • Expansion strategy; • Prior equity financings, if any; • Amount of capital required and its proposed use;
The due diligence process covers evaluation of the product/services, the management team and their background, technology, markets, competition, financial plan as well as the exit opportunities. This process is followed by the formal investment approval45, often com- pleted by a term sheet summarising the principal terms of the investment and dispatched among interested parties. If the business fits into the investment philosophy, the GP will initiate meetings with the company’s management in order to determine the strategy and the operating plan in greater detail and will start contemplating the investment itself.
2. Investment phase The investment phase includes the following aspects: • Deals and transactions; • Risk management controlling, including compliance on investments; • Monitoring of the cash flows and drawdown; • Income collection and distribution of proceeds; • Reporting, such as financial statements and/or investor reporting.
Before starting detailed negotiations, the GP appoints investments advisers, such as audi- tors, lawyers and/or consultants in order to conduct the financial, tax, legal and technical due diligence and to understand the target company and its industry if the case may be. All the information collected will be used during the negotiation phase.
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While completing the final decision making process, the legal agreements are drafted around the terms agreed in the term sheet. On confirmation of the investment decision, the documents, such as the investment agreement, the share purchase agreement, the man- agement agreement, the advisory agreement, financing agreements, etc., are signed and funds transferred based on the cash flow requirements of the company.
The ongoing management of investments includes: • Monitoring of the cash flow and potential additional drawdown; • Income collection and distribution of proceeds; • Reporting, such as financial statements and/or investor reporting.
3. Exit phase The exit phase includes the following aspects: • Fine-tune predefined exit strategy (planned right from the beginning); • Prepare divestment deal and transaction planning; • Compliance on divestments; • Monitor payments to managers and investors; • Reporting.
As the company matures (usually after two to four years) the GP prepares the company for an exit – either a trade sale (sale to a larger party, multi-national or conglomerate), an IPO, or recapitalisation. Once the company has exited, investors’ money will be returned with the profit that has been gained for them after paying fees for the consultant and carried interest to the GP.
3.2.5 NAV calculation/IRR
Private equity managers may be required to carry out periodic valuations of investments as part of the reporting process to investors in the funds they manage. 3.2
The NAV of a private equity fund is the amount estimated as being attributable to the investors in that fund on the basis of the value of the underlying investee companies and other assets and liabilities. The NAV gives to third parties, such as leverage providers, financial regulators or tax authorities, a financial overview of the private equity vehicle, in addition to giving to share- holders a value of their investments. Existing or subsequent shareholders willing to invest in a private equity fund also need to know the NAV, but allocated per share. NAV calculation is a key issue and must notably take into account the type of vehicle, the type of assets held and the legal obligations related to investors’ requirements.
Assets valuation issues NAV calculation implies to be able to value correctly the assets held by private equity funds, which demands high expertise, as with little trading it is hard to determine the market value of illiquid assets. Another impediment in valuation is the uncertainty of future cash flows. Even though the product offered is potentially successful, the managers may lack experience in mak- ing a success of it and there is no guarantee of the timeframe needed to achieve that success.
Fair value, i.e. the price at which an orderly transaction would take place between market participants at the reporting date (measurement date), is a key issue. For quoted instruments,
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unquoted investments, the estimation of fair value requires the valuer to assume the underly- ing business is realised at the reporting date, appropriately allocated to the various interests, regardless of whether the underlying business is prepared for sale or whether its shareholders intend to sell in the near future. Thus, in order to determine the fair value of an investment, the valuer will have to exercise judgement and make necessary estimates to adjust the market data to reflect the potential impact of other factors such as geography, credit risk, foreign currency, rights attributable, equity prices and volatility.
Hereafter is an illustration of issues to consider: • When valuing debt instruments, loans or mezzanine loans, cash flow forecasts are impor- tant but the GP should also assess other items such as the borrower’s solvency; • For distressed strategies for example, the valuation is done on three different axes: The future cash flows, the value of collaterals and the potential restructuring opportunities.
Furthermore, there are five main valuation methodologies for unquoted instruments. The most widely used are as follows: • Price of recent investment (i.e. use of the initial cost of the investment itself or the price at which a significant amount of new investment was made); • Multiples (i.e. the application of an earnings multiple to the earnings of the business being valued in order to derive a value for the business); • Net assets (i.e. deriving the value of a business by reference to the value of its net assets); • Discounted Cash Flows (DCFs) or earnings of underlying business (i.e. deriving the value of a business by calculating the present value of expected future cash flows or the present value of expected future earnings); • Industry valuation benchmarks (i.e. use of industry-specific norms such as price per sub- scriber for cable television companies for example).
The valuation methodology should be clearly described in the fund’s PPM and discussed with the administrative agent and the auditor. Some methodologies can be used for cross- checking. Thus, discounted cash flows are mostly used as cross-check methodology.
Valuation guidelines Over the past few years, much attention has been paid to the development of valuation guidelines:
• In Europe, a consortium of three private equity and venture capital associations (AFIC, BVCA, EVCA) have founded the IPEV Board, which has issued international valuation guidelines46, intended to conform to the International Accounting Standards Board (IASB) rules. They reflect the need for greater comparability across the industry and for con- sistency with IFRS (International Financial Reporting Standards) and US GAAP (Generally Accepted Accounting Principles) accounting principles. These valuation guidelines are used by the industry for valuing private equity investments and provide a framework for fund managers and investors to monitor the value of existing investments. In order to be consistent with IFRS and US GAAP, the new guidelines are based on the overall principle of fair value. Indeed, the IPEV Board confirms fair value as the best measure of valuing private equity portfolio companies and investments in private equity funds.
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• A self-appointed group of private equity practitioners, fund managers, fund of funds man- agers and others, the PEIGG (Private Equity Industry Guidelines Group), has also published valuation guidelines47, which are the most commonly referred to guidelines in the United States. In these guidelines, the PEIGG underlines the most important reasons for reporting assets at fair value: > Investors’ desire to measure interim performance; > Investors’ need for fair value data to report investments in their own financial statements; > A manager’s need to report and measure valuations in accordance with fund agreements; > The need to determine the allocation of distributions of fund realisations.
Consolidations & IFRS impacts In the past five years, an increasing number of private equity funds chose to use IFRS in- stead of local GAAPs. Main reasons are the willingness to exit the private equity vehicle through an IPO and the need for investor reporting for consolidation purposes. IFRS has become more and more popular with the various bankruptcies of companies since Enron Corporation and more recently, with the subprime crisis.
3.2.6 Reporting
As the private equity industry has grown and matured, its participants have become in- creasingly interested in improving the consistency and transparency of information ex- changed by participants. There is a strong desire from both GPs and LPs to improve the information sharing process. Managers have a duty to provide reports that allow investors to monitor and evaluate their investments, while investors have a fiduciary responsibility to understand their investments. Additionally, as private equity becomes a more significant portion of portfolios, boards and investment officers request more information on their investments. The extent of informa- tion required by investors varies due to a wide range of factors, such as type of organisa- tion, reporting structure, staff size and level of sophistication48.
The quality of reports may be used by investors to compare private equity houses to com- 3.2 petitors. The private equity industry has traditionally focused its efforts on continually improving its communication with investors. Due to its increasing importance in the global economy, the industry also feels the need for more communication of a wider range of interested parties (e.g. employees and existing shareholders of portfolio companies, trade unions, etc.).
Working groups and associations such as the EVCA, the BVCA, the PEIGG, the ILPA (Insti- tutional Limited Partners Association) among others, have undertaken an effort to publish a set of reporting guidelines for the content, format and delivery of fund information that seeks to increase reporting consistency and transparency. Such reporting guidelines have been widely adopted in Europe and beyond.
Software providers have also completed their range of modules to provide managers with tools allowing them to produce more easily and efficiently such reports and to allow inves- tors to get a direct web access to their reports.
48 Source: PEIGG, “Reporting and performance measurement guidelines”, March 2005 49 Source: EVCA, “EVCA reporting guidelines”, June 2006 (reprint January 2009) A thorough understanding of PE | page 65 RETOUR SOMMAIRE
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Requirements There are key principles to be considered when disclosing information to investors49: • Transparency: The information on all relevant topics regarding the evolution of the fund should be communicated to investors in a transparent manner; • Relevance: The information provided should allow each investor to monitor its own in- vestment; • Consistency: The information provided to investors should be consistent over time.
Level of information The manager should provide investors with certain fund level information on a quarterly ba- sis, including a fund overview, a view of the current portfolio, realised or partially realised investments. In addition, fund performance such as IRR and return multiples should be presented net of any fees. Portfolio company performance, to the extent disclosed, should be presented on a gross basis.
Figure 39 displays examples of fund and portfolio reporting.
Figure 39: Illustration of fund summary and current portfolio summary reporting
FUND SUMMARY 2005 2009 20042008 % Committed % Committed € million € million capital capital Total committed 1,000 100% 1,000 100% Total drawdowns 600 60% 402 40% Total remaining available for drawdown 400 40% 598 60% Potential drawdowns for next reporting period 100 10% 200 20% (recommendation) Cumulative distributions 200 20% 135 14% Recallable distributions - - - - Fair value of portfolio 595 328 Total other assets and liabilities (5) (5) Total net assets value 590 323 Contingent liabilities (including debt, guarantees, - - etc.) Gross IRR 23.9% 19.9% Net IRR 19.9% 16.6% Multiple to investors Distributions to paid-in capital (DPI) 0.33 x 0.34 x Residual value to paid-in capital (RVPI) 0.98 x 0.80 x Total value to paid-in capital (TVPI) 1.32 x 1.14 x Paid-in capital to committed capital 0.60 x 0.40 x Total invested in portfolio companies 580 58% 383 38% Total additional committed to portfolio companies 118 12% 79 8% Total additional planned for follow on investments 100 10% 80 8% Total allocated to portfolio companies 798 80% 542 54% Source: EVCA guidelines, 2006 (reprint 2009)
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CURRENT PORTFOLIO SUMMARY (in €million) Fair value of Interest & Date of initial Stage of initial Cost of Fair value Gross IRR on Geography Industry % Ownership the invest- dividends cost as of unrealised investment investment investment ment as of since 31/12/2008 inception 31/12/2008 investments Quoted companies
Company Y 10/09/2007 UK Service Expansion 35.00% 20.00 85.00 - 4.25 202.58% Company U 22/10/2006 France Automotive Expansion 9.40% 40.00 58.00 - 1.45 18.45% Company S 25/06/2006 Holland Retail Expansion/Later 12.60% 22.00 34.00 2.5 1.55 18.85% Unquoted companies Company T 08/12/2008 Sweden Healthcare Early stage 22.00% 28.00 28.00 - 1.00 N/A Company N 14/10/2008 France Retail Expansion 18.00% 41.00 41.00 - 1.00 N/A Company M 21/06/2008 Belgium Service Expansion 14.00% 33.00 33.00 - 1.00 N/A Company L 09/03/2008 UK Automotive Expansion 12.00% 36.00 36.00 - 1.00 N/A Company K 26/01/2008 France Communications Early stage 39.00% 29.00 22.00 - 0.76 -25.7% Company J 07/01/2008 UK Healthcare Buyout 90.00% 31.00 23.00 1.00 0.74 -26.2% Company I 07/10/2007 France Software Early stage 40.90% 12.00 6.00 - 0.50 -43.0% Company H 11/05/2007 France Industrial products Expansion 16.10% 30.00 52.00 3.00 1.73 39.8% Company F 09/02/2007 Norway Communications Early stage 31.70% 21.00 31.00 - 1.48 22.8% Company E 06/02/2007 Germany Communications Early stage 28.00% 18.00 40.00 - 2.22 52.2% Company D 23/01/2007 UK Healthcare Expansion 12.20% 22.00 11.00 - 0.50 -30.0% Company C 10/12/2006 USA Communications Expansion 45.00% 27.00 44.00 - 1.63 26.7% Company B 02/09/2006 France Service Buyout 95.00% 37.00 40.00 1.50 1.08 3.4% Company A 18/07/2006 UK Retail Expansion 9.60% 23.00 11.00 0.50 0.48 -25.9% TOTAL 470.00 595.00 8.50 1.27 17.5% Source: EVCA guidelines, 2006 (reprint 2009)
Capital accounts Managers should include a detailed capital account in their investor report that includes the change in an investor’s equity and capital contribution from inception date to the current reporting date. 3.2 The capital account statement should at least provide details for the individual LPs, along with details for all LPs, the GP and total capital.
Hereafter is the basic information to display: • Committed capital; • Percentage of ownership; • Opening capital account balance; • Capital contributions; • Management fees paid; • Expenses paid (if out of commitment); • Net investment income or loss (realised and unrealised); • Distributions; • Carried interest paid and/or received; • Ending capital account balance at fair value; • Remaining commitment.
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Portfolio Company Information The following information should be disclosed for portfolio company investments at the time of the initial investment: • Company name; • Brief company description; • Company contact and location details; • Summary investment thesis; • Names of key managers; • Names of co-investors if any; • Date of investments/additional investments/exits; • Industry and sub-sector; • Financial figures (EBITDA, balance sheet, current valuation, etc.); • Potentially, GP comments on coming events.
This information should be updated yearly with material changes. Both managers and investors may desire to disclose/receive information other than finan- cial information concerning the portfolio companies.
Finally, an important element to be taken into account in the reporting of information to in- vestors is the impact of local laws (such as Freedom of Information Acts regarding the right of access to information held by public authorities) requests.
3.2.7 Waterfall distribution
As seen in the Main concepts of private equity chapter (1.1.3.) – Distribution subsection, private equity vehicles proposed to non in-house investors do have performance fees paid to investment managers or GPs that are, in most of the structures, based on an allocation of profits and losses between shares of the LPs and shares held by the GP or a carried vehicle. Whereas hedge funds use performance fees with hurdle rates and high watermark levels, private equity funds have waterfall distributions with hurdle rates based on IRR or annual performance rates, with claw backs and sometimes with escrow accounts.
Detailed provisions for waterfall distributions are described in the fund PPM as already mentioned and are in principle easy to understand. However, in practice, the calculation of special provisions such as preferred return, catch-up and claw back clauses, reserve accounts, etc. is often very complex. GPs, auditors and administrative agents often face a number of issues regarding the calculation/application of wordings created by legal advis- ers wanting to keep the maximum flexibility level in the interpretation of the process.
The main issue faced when calculating the carried deals with the choice of the IRR that should be applied are as follows: • Which formula? • Which components? • IRR of the vehicle or IRR per project? • IRR computation and IFRS/functional currency?
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One of the biggest disadvantages when using IRR for the performance is to compute an inac- curate IRR. Manually computed algorithms provide more accurate figures but have their own limits as there may be multiple solutions when there are several investments cash flows done during the calculation period. However, the result is accurate when there is one initial payment in and only cash flows out after. Moreover, the IRR calculation takes the unrealistic assumption that interim positive cash flows are reinvested at the same rate of return as the one of the project that generated them. In order to keep the calculations simple for accountants, GPs and auditors, the IRR is generally calculated using IRR formulas in spreadsheets (XIRR or MIRR Microsoft Excel functions), even if the results of these formulas are an approximation of the true IRR value.
Once the relevant formula has been chosen, further decisions need to be taken. The first one deals with the component of the matrix.
The IRR can be computed net of fees or gross of fees. This can be the case for fees included in the commitment (such as general and administration expenses) or out of the commitment (such as management fees that might be out of the investors’ commitments). The fees cash flows are usually included in the calculation of IRR as long as the legal documen- tation does not state it differently.
Most of GPs, accountants and auditors agree on the fact that IRR is computed at the investment vehicle level and that components of the matrix should be as follows: Cash flow date, cash flow amount and information in/out. However, some GPs, willing to report the performance of their investments, prefer to have IRR calculated on the projects/investments they have made, which has a different result than IRR computed on the overall vehicle itself. This accrues the risks in the calculation of the NAV per share but is a possibility when the legal documentation is written accordingly.
NAV under IFRS can be calculated in different currencies during the life of the vehicle as per the possible changes in the functional currency. As a result, when an investment vehicle changes 3.2 its functional currency, the IRR computation might be biased by the capital currency change in the accounts. This process should be discussed between auditors, administrators and GPs in order to avoid miscalculations.
IRR computation is not the only issue faced. The claw back process and escrow account prin- ciple might also be problematic for private equity administrators who should protect inves- tors and work closely with GPs. Where performance fees are paid automatically or through invoices, carried interest is an allocation of the profits to a share class that can distribute cash to the partners at any moment. GPs managing their first fund are often required by their LPs to have these in place for limiting risks of GPs’ insolvency at the end of the vehicle’s life. On the other hand, the GP needs cash flows for the team that usually just runs this vehicle. Most of the time, legal documentation does not supply any rule on this topic. On a practical basis, the process is covered in operating memorandums that should be followed by GPs and administrators/depositaries but does not provide security for LPs.
More generally speaking, the operational issues faced in the carried and distribution waterfall processes, as any other operational issues, should be covered in service level agreements, operating memorandums or communications from GPs/administrators to LPs.
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4. PERSPECTIVES FOR THE INDUSTRY
In a fast evolving environment and in the current economic context, the private equity industry is facing major challenges. However, despite the uncertainty, there are opportunities for suc- cess. These challenges and opportunities are examined hereafter.
4.1 Private equity, a global industry
Despite the current economic challenges, the private equity industry globalisation phenom- enon, already underway, is likely to intensify, as target geographies and fund investor bases become increasingly international.
Emerging markets should have a continuing influence and shape the future of the industry. As recently reported by the emerging market private equity association50, in face of the global economic downturn, investors plan increased exposure to the region, including the BRIC countries and the Middle East. This increased investor confidence stems not only from the prospect of stronger growth in emerging economies, but also from the increasing maturity of the sector. These markets will certainly remain the most attractive for GPs as well, taking into consid- eration the ready availability of capital and consequently the fund raising easiness.
As for Sovereign Wealth Funds (SWFs), with ample liquidity and wide latitude for deploy- ing their capital, they should also extend their influence into the private equity’s domain in the future. These foreign government-controlled funds are faced with growing scrutiny and remain somewhat controversial in the Western world, since many funds remain opaque in terms of the level of information they release pertaining to their investment strategies. Are they a real competitor for the private equity industry and to what extent? In this respect, it should be noted that managers of non-pooled investments such as SWFs are excluded from the AIFM directive scope.
Since the private equity industry is set to become increasingly cross-border, hubs such as Luxembourg and Ireland should seize the opportunity to play a growing role for structuring and servicing private equity funds in the future, as they have already demonstrated in the 4.1 retail fund arena with UCITS.
Furthermore, new asset classes such as infrastructure, real estate, renewable energy or microfinance will also continue to contribute to the globalisation of private equity. Indeed, they appeal to a broad range of global investors as the challenges they cover represent a concern of the worldwide development (e.g. climate change, limited natural resources, combating poverty, etc.).
50 Source: EMPEA, “Emerging Markets Private Equity Survey 2009”, April 2009 A thorough understanding of PE | page 71
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4.2 A time of difficulties and challenges
The current crisis poses significant challenges to the private equity industry which had enjoyed unprecedented growth over the past decade, partly thanks to unfettered access to cheap credit.
With the shortage of debt financing, mega-buyouts are no longer in scope, and private equity companies are focusing on mid-markets deals. In Europe, the LBO market re- duced by a factor of ten between 2007 and 2009, with only �10.3 billion invested for the first half of 200951. Prospects for buy-outs in the second half of 2009 and beyond remain clouded by uncertainty due to the continuing global recession and the shortage of debt. Exiting from investments has also become difficult with trade sales and secondary buy- outs in short supply and no stock market flotation of buy-outs in the first half of the year52. Until the recovery occurs, most private equity professionals will be more conservative with the value and volume of their deal flow53. In the middle of such turmoil, it is very difficult to make predictions about how the private equity landscape is likely to evolve following this major crisis.
On one hand, GPs are currently experiencing some of the toughest fund raising condi- tions in the history of private equity, as a result of investors being less able and willing to commit new capital. The Financial Times has described the situation in the following terms: “Big investors in private equity, including pension funds, insurers, endowments, family offices and charities, are steering clear of new private equity funds as they lick their wounds over losses from money put into earlier funds.54”
On the other hand, despite the current difficulties, there are many reasons to remain optimistic. Opportunities do exist; Megadeals may have vanished but not medium-sized or all-equity deals. In addition, the ongoing financial crisis has severely depressed the prices for equity assets around the world and the 2009 and 2010 vintage years are likely to represent an opportunity of a lifetime for those LPs with the courage to commit new capital to these markets. The current crisis could also lead to a positive survivorship selection, with only reliable funds remaining on the market. Last but not least, private equity firms are well poised to stand in as a new class of share- holder in the overturned public-equity market, in developing economies and in financial institutions. They possess a large amount of capital, exactly what the economy needs in order to support the financial giants that have been collapsing recently. As such, private
equity could prove to be the new stimulant of the economy. 4.2
51 Source: La Tribune, “Aucun signe de vie sur le marché du LBO”, 9 October 2009 52 Source: CMBOR (Centre for Management Buy-Out Research) website, 2009 53 Source: The Economist, “Mapping the recovery, New strategies for private equity markets – A report from the Economist Intelligence Unit”, 2008 54 Source: Financial Times, “Investors steer clear of private equity funds” by Martin Arnold, 2 April 2009 A thorough understanding of PE | page 73 RETOUR SOMMAIRE
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There is still general agreement among LPs that private equity is an attractive invest- ment strategy that can provide superior returns to public equities. A recent publication55 underlines that the best private equity firms have persistently outperformed both their private equity counterparts and the public-equity markets in good and bad times over the past two decades. Private equity performance figures to the end of June 2009 confirmed that, although negative, private equity returns were still generating better returns than public indices, continuing the industry’s long-standing history of being a top-performing asset class56.
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4.3 The evolution of the GP/LP relationship
The evolution of the GP/LP relationship and the shift of power in favour of LPs have been largely highlighted in the past months. In September 2009, the Institutional Limited Partners Associa- tion (ILPA), which gathers 220 US LPs, reminded GPs of the best practices expected by LPs in terms of alignment of interests, governance and transparency57. These suggested best prac- tices are intended to serve as a basis for continued discussion among and between the GP and LP communities with the goal of improving the private equity industry for the long-term benefit of all its participants.
4.3.1 Increasingly selective LPs
LPs are becoming increasingly selective about who they partner with. In the future, they can be expected to work with a smaller, more exclusive selection of GPs with strong investment strat- egies. LPs expect GPs to have a coherent and robust strategy for each individual investment that can be thoroughly tested in due diligence. Discipline, a track record of success and robust investment methodologies are coming to the fore. Each GP should have a sense of where in- vestments fit into the overall investment plan and a strong understanding of the sector and associated risks. Risk management in general is expected to be tightened up58.
4.3.2 Financial negotiations
The alignment between GPs and LPs became distorted in the boom years and resulted in a disparity between the risk exposure and returns enjoyed by GPs as compared with LPs. Returns for private equity investors suffered their worst decline on record in 2008; GPs made $148 billion in capital calls from LPs, but only distributed $63 billion in return59. An increase in capital calls, decrease in distributions and the scarcity of debt financing for deals have made it difficult for private equity firms to raise financing for new funds. In light of the current crisis, LPs are expected to be more pragmatic in future and to see returns and evidence of real value creation, a basic principle that some GPs had sometimes forgotten during the boom years60. For those investors that have decided to commit to new funds, they have been increasingly able to negotiate more investor-friendly terms in the funds’ limited partnership agreements. Last year’s large discrepancy between the amount of capital calls and distributions seems to have emboldened institutional investors to seek greater contractual rights and better financial terms from GPs. Thus, there is today an increasing pressure from LPs on GPs of the largest funds to reduce the management fee rates for new vehicles looking to raise capital. Investors are seeking to bring management fee levels more in line with the actual costs associated with running funds of different size and type. The average management fee demanded by GPs is now estimated at 1.8% (compared to an average rate of 2%, which had held steady for the past several years) and there is likely to be increased pressure for further reduction. LPs have also been able to win some concessions on restrictive covenants. 4.3
57 Source: ILPA, “Private equity principles”, 8 September 2009 58 Source: Ernst & Young, “Shifting sands, Limited Partners’ perspectives on the future of private equity”, September 2009 59 Source: Preqin Ltd, 2009 60 Source: Unquote France, Issue 100, “Private equity set to be public relations nightmare”, April 2009 A thorough understanding of PE | page 75 RETOUR SOMMAIRE
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4.3.3 More information required by investors
More vigilant, LPs have also proved to be very demanding regarding fund transparency in re- cent months. The increased uncertainty of the recession has resulted in LPs requiring more fre- quent and detailed information to monitor portfolio performance more effectively and to identify and focus on poor performance in a timely manner61. Many LPs now require to be better in- formed about the underlying companies in their private equity portfolios. More specifically, LPs want to get a better idea of how earnings, debt levels, and valuations are changing over time. This information is critical because it allows them to better monitor the underlying companies, make comparisons across sectors and deal types, and measure the effectiveness of the GP. Quality investor reporting and transparency are key tenets to the success of private equity as an institutional investment asset class.
Historically, requests from LPs for additional information were often met with resistance by GPs. However, times are changing and the ILPA’s private equity principles now include recom- mendations for making the selected financial information (valuation, revenue, debt, EBITDA, profit and loss, cash position, burn rate) available to LPs as a part of the quarterly report. This is a major step towards greater transparency for investors.
61 Source: Ernst & Young, “Shifting sands, Limited Partners’ perspectives on the future of private equity”, page 76 | A thorough understanding of PE September 2009 RETOUR SOMMAIRE
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4.4 New regulatory issues
As the financial crisis has exposed a series of vulnerabilities in the financial system in Europe and in North America, this has led to a debate on increased transparency and regulation for all significant actors in financial markets, including private equity.
4.4.1 In the United States
In the United States the first half of 2009 brought forth several statements and initiatives re- garding regulation of the private equity industry and more broadly alternative investments. Treasury Secretary Timothy Geithner has proposed regulatory reform to address systemic risk, consumer and investor protection, elimination of gaps in current regulatory structure, and international coordination62. Thus, the Private Fund Transparency Act of 2009, introduced by Senator Reed in June 2009, would amend the Advisers Act to require investment advisers to private funds who manage assets in excess of $30 million to register with the SEC regarding the maintenance of books and records, custody of fund assets, compliance policies and procedures, advertising, and the examination of financial and other records by the SEC. A number of private equity’s larg- est players, such as the Carlyle Group, the Blackstone Group or KKR, are already registered with the SEC.
With the Treasury Department, President and both houses of Congress actively pursuing increased oversight of the alternative asset industry, it is inevitable private equity fund man- agers will be required to publicly disclose information that in the past was considered privi- leged information, although not a number one priority.
Besides, the current market sentiment, which is driving transparency across a broad spec- trum of structured products including private equity, as well as calls for players to show their hand more fully, have raised the bar on investor reporting, performance fee analysis, independence of audit and administration and improvement in the overall corporate govern- ance culture. LPs are namely looking for more frequent and more detailed reporting, many conducting quarterly reviews on their portfolios.
It is likely, with increasing sophistication and variation in the investment model and a wider investor base, that the need to disclose will drive alternative and private equity players to outsource more of their non-core activity to administrators and depositaries who can manage data, deliver independence and produce clear and concise reporting on a diverse range of geographically spread investments.
4.4.2 In Europe: the AIFM draft directive
Background On April 2nd 2009, the G20 leaders issued a declaration aimed at strengthening the financial system. In particular, they agreed to extend regulation and oversight to all systemically impor- tant financial institutions, instruments and markets63.
62 Source: Fredrikson & Byron, P.A. “Government Attention on Private Equity Could Mean Changes for the Industry” by K. Lis Holter, Timothy R. Nelson & Leigh-Erin Irons, 2 April 2009 4.4 63 Source: G20 London summit, “The Global Plan for Recovery and Reform”, 2 April 2009 A thorough understanding of PE | page 77 RETOUR SOMMAIRE
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The statement singled out hedge funds for additional regulation but made no mention of whether private equity funds would also be subject to greater scrutiny by financial authorities. However, following the G20, on April 30th 2009, the European Commission released a directive proposal on Alternative Investment Fund Managers (AIFM) with the aim of creating a compre- hensive and effective regulatory and supervisory framework for alternative investment fund managers within the European Union.
Under this proposed directive, European managers of non-UCITS investment funds – which include private equity funds, hedge funds, real estate funds, commodity funds and other types of institutional funds – would have to comply with a common set of rules in term of licensing and supervision, in return for a European passport.
Several of the provisions in the Commission’s draft were highly controversial. The European venture capital association as well as the industry as a whole did not welcome the EU Com- mission draft proposal, arguing that it means “increased levels of disclosure that rival buyers do not have to comply with, spiralling costs that will severely affect mid-market firms and rules being needlessly imposed given the lack of systemic risk in the private equity industry”64. Nota- bly, the industry blamed the proposal for lumping together private equity with all other alterna- tive investments, whereas one size does not fit all and it has been clearly acknowledged that private equity does not create systematic risk. Across the Channel, little interest was demon- strated for tightening the regulation of private equity funds. For its part, the British private equity and venture capital association declared that the United Kingdom had already gone some way towards self-regulation of the industry with guidelines on transparency and disclosure put in place some 18 months ago65.
The Swedish Presidency of the Council of the European Union publicly issued a compromise proposal on 12 November 2009, followed by a revised text on 25 November 2009. The latest compromise proposal addresses many of the areas of concern for the industry but others still remain. The text will be influential as a basis for discussion; it should be noted, however, that the text needs to be agreed by the Council, before also reaching an agreement at European Commission and European Parliament levels.
On 23 November 2009, the rapporteur of the European Parliament’s Committee of Economic and Financial Affairs on the AIFM Directive, Jean-Paul Gauzès, issued its draft report proposing amendments to the text proposed by the Commission (known as “Gauzès report”). The pro- posed amendments will be considered and revised by the Committee of Economic and Finan- cial Affairs.
The European Commission being the sole institution empowered to draft legislation, it may come forward with a new draft in the light of the Council’s proposals, the amendments pro- posed by the European Parliament, and other discussions66.
64 Source: Financial News Online, “The EU private equity: The devil is in the detail” by Paul Hodkinson, 11 May 2009 65 Source: Dow Jones Newswires, “Private equity rails against EU regulation proposals” by Marietta Cauchi, 20 April 2009 page 78 | A thorough understanding of PE 66 Source: Ernst & Young, “AIFM-The Alternative Investment Fund Managers Directive”, December 2009 RETOUR SOMMAIRE
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Assessment of impacts It is still early days for the AIFM directive but we can reasonably think that, should the AIFM directive be enforced, the new regulatory landscape for non-UCITS funds set up within the Eu- ropean Union would have a significant impact on the private equity industry in most European jurisdictions.
Indeed, the amended proposed draft plans to impose to alternative investment managers com- pliance with a series of very restrictive requirements in order to obtain the passport, for in- stance in terms of: • Authorisation: Managers of AIF domiciled in an EU member state would be required to obtain authorisation in accordance with the directive; • Own capital and internal organisation; • Ongoing supervision: The AIFM would be required to provide the competent state authority with regular update information on the identity of the AIF it manages, the organisational and risk management arrangements it has in place, the markets and assets in which it would like to invest, its principal exposures, performance data and concentrations of risk; • Transparency requirements: In order to protect investors, specific information would have to be communicated before investment including a description of the valuation procedures and the liquidity risk management; • Restrictions and limitations on leverage: Where AIFM employ systematically high levels of leverage in one of more of their AIFS, the directive outlines the disclosure that must be made to investors and regulators.
Furthermore, until now, most private equity funds have been structured under ordinary, non- specific, legal forms that are governed by the commercial and companies laws of the member states. The draft directive would transform these ordinary legal structures into true funds with authorised fund managers, mandatory depositaries and a whole set of regulations inspired by those applicable to UCITS, although the AIFM directive aims at regulating fund managers and not the funds themselves. It should be noted that France constitutes an exception since, from the outset, French FCPR venture capital funds have been classified as UCITS under internal French law. All authorisa- tions, legislation and regulations are already fully applicable to them. Furthermore, out of the 27 European Union countries, France was the only one to consider that the MiFID directive should apply to funds.
Private equity managers are not used to the level of regulation that could be implemented by the draft directive as vehicles used to promote such type of investments are often very flexible structures. Thus, they will have to fully understand the goals and the positive impacts of the new regulation. Although the draft directive aims at establishing a harmonised EU framework for the authorisation and operation of the AIFM in Europe, it radically alters the current man- ner in which AIFMs operate in Europe. Such a huge change could create panic among private equity managers and, as a consequence thereof, drive them to offshore jurisdictions.
Furthermore, there are still some provisions in the directive that have to be clarified. Fund struc- turing experts will have to follow the updates and developments in relation thereto daily. Their support to clients should be crucial to face up to consequences of the directive. 4.4 A thorough understanding of PE | page 79 RETOUR SOMMAIRE
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CACEIS’s opinion in Luxembourg In the context of the recent financial turmoil, an uncertain economic outlook for 2010 and regu- latory developments at both a European and national level, what can be seen as the major challenges faced by private equity firms going forward? Clearly, it may be too early to draw any definite conclusions in this respect. However, as a leading provider of custodial and fund administration services to the private equity industry in particular and the funds industry in general, CACEIS is well positioned to give an opinion, taking into account the likely effects of the European Commission text published on 30th April 2009.
(1) Changes to the role of the custodian The depositary’s monitoring duties, “knowing at all the times how the assets of the UCI/SIF/ SICAR are invested and where and how they are available” may no longer be understood as a “lighter” supervisory regime on the part of the custodian.
Recent financial turbulence has highlighted some of the control functions of the depositary bank, including confirmation of holdings by the private equity vehicles, reconciliations and monitoring of settlements of the portfolio and overdrafts. Robust controls on any fund’s out- sourced services (not only sub-custodians and prime brokers) and a counterparty to fund’s transactions in order to ensure settlement in a timely manner are of the utmost importance.
Current discussions at the EU Commission on the reform of the current architecture of the fi- nancial system are aimed specifically at reviewing the definition and interpretation of the -de positary’s duties and liabilities. Furthermore, the AIFM’s proposed directive permits exempts the custodian from liability for losses, if it can demonstrate that a loss was unavoidable (rein- forced “obligation de moyen”, with the burden of proof remaining on the depositary). Both the above underline the growing importance of depositaries’ supervisory role.
As a consequence, it is in the interests of private equity firms to entrust the assets of their fund to depositary banks which focus on maintaining or setting up, as the case maybe, high standards of quality-control to ensure compliance with Luxembourg laws and regulations and prevailing EU regulation regarding the supervisory role.
(2) On the valuation process Over the past years, administrators of private equity fund vehicles have been increasingly so- licited to contribute to the valuation process. However, in practice administrators tend not to see themselves as valuation agents and leave the valuation of certain private equity assets to expert pricing agents or the governing bodies of the fund in question. This practice is in line with the recommendations of the IOSCO and AIMA.
It will be certainly challenging for fund managers to comply with the requirements of the draft AIFM directive, which requires AIF funds to appoint a valuation agent which is independent from the fund manager, to ensure the fair valuation of the assets under management as well as the valuation of their shares or units.
In the future, the ability to provide such a service is likely to become a key factor for both admin- istrators and valuation agents. Fund managers will have to see how to optimise their contribu- tion to the process of different service providers without making them endorse uncontrolled responsibilities. Valuation agents and AIFM still need to agree whether the ultimate responsibil- page 80 | A thorough understanding of PE ity for the valuation remains with the fund’s governing body. RETOUR SOMMAIRE
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(3) On the outsourcing of functions, in particular to offshore entities Outsourcing of certain tasks, in particular custodian and central administration duties and glo- bal outsourcing thereof as regards private equity structures, needs, under the current regula- tory framework, to be discussed with the CSSF on a case by case basis.
Such outsourcing may not be facilitated should the draft AIFM directive be implemented in its current form. It currently provides a series of restrictions on delegation and outsourcing that creating significant constraints. For example, delegation of portfolio management activities or of risk management will only be allowed if the outsourced services provider is another AIFM authorised to manage a fund of the same type. Furthermore, no delegation may be given to the depository or the valuation agent, or even, unless certain restrictive conditions are complied with, to an agent domiciled outside the EU.
As a consequence, the text could lead to the ineligibility of certain core and non-core services currently possible to delegate. To circumvent this difficulty, mutualised substance solutions could be created for such clients in the vein of Fastnet Luxembourg’s Risk Management and Management Company offer for UCITS clients, which should be adapted accordingly.
(4) On the capital and substance requirements As of today, portfolio managers and GPs of private equity funds established under the form of SICAVs are not subject to any capital requirement other than those imposed by Luxembourg laws on commercial companies on the basis of legal form which they have adopted. For exam- ple, if they are established under the form of a limited liability company (“société anonyme”) the minimum capital is set up to €31,000. Under the AIFM proposal, fund managers will be obliged to maintain own funds. It is worth not- ing that there are no limits on the capital required, which is less stringent than the rule applied to portfolio managers under MIFiD but more so than that applied to management companies under UCITS III.
In line with proposal under item (3) above, to keep large private equity fund managers from abandoning the EU as they do not wish or are not in the position to comply with such capital requirements, solutions could be found within Luxembourg’s UCITS III substance offer if ap- propriately tailored to such managers.
(5) On cross-border marketing of the private equity funds Currently, the activities of private equity funds established in the European Community are reg- ulated by a combination of national laws and regulations and general provisions of European Community law. Investment managers established in the EU are regulated through the provision of portfolio management services under Article 5 of MIFiD. National and EU rules and general provisions are supplemented in some areas by industry- developed standards. Numerous private equity organisations have established principles and codes of best practice over recent years. As a consequence, private equity funds are sold within the EU under a patch-work of national private placement rules where such rules exist. However, certain countries do not permit investment into non-UCITS funds (such as private eq- uity funds) in their jurisdiction without prior registration with local authorities and compliance 4.4 with a certain number of national laws. A thorough understanding of PE | page 81 RETOUR SOMMAIRE
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The proposed AIFM directive is intended to overcome gaps in national regulations as managers who currently market actively non EU AIF’s in the EU will enjoy the distribution facilities granted under the directive only after a period of three years following the entry into force of the direc- tive, to the extent that they comply with the above described conditions.
Just as for for UCITS, the greater flexibility given in terms of passporting management services will raise a series of legal and operational challenges. Given the added complexity of cross- border schemes, it is likely that the multi-jurisdictional presence of CACEIS will be of added value for clients wishing to combine the advantages of both the proximity of its provider and the benefits of centralising its operations.
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CONCLUSION: NEED FOR EXPERTS
Private equity is an expert market where the right skills, experience and resources are vital to succeed.
As we have seen, private equity funds deeply differ from regular funds and their operational models have little in common. Private equity is a complex and unique activity requiring spe- cific skills from all players involved; An appropriate understanding of the various key private equity processes - such as fund raising and capital calls, distributions, complex illiquid port- folio valuation methods, reporting to investors in accordance with the industry associations’ guidelines, etc.- is crucial.
In addition, the environment is rapidly evolving: There are today increasing sophisticated private equity deals in a cross-border environment, with larger private equity funds holding more complex investments and covering more jurisdictions, as well as an increased inves- tor and public scrutiny focusing on proper governance, valuation and reporting issues.
As a result, private equity firms need specialised services, which go over and above tradi- tional fund structuring, custody, fund administration, accounting, corporate and risk moni- toring services, and cover their needs. Thus, besides the choice of private equity vehicles, the selection of expert service providers, able to deliver tailored and highly professional services (particularly in terms of reporting and performance ratios, investment monitoring and compliance with legislation), is a key element and bring a significant competitive ad- vantage to these vehicles. Moreover, choosing the right service provider enables the client to focus on its front office investment management activities rather than focusing on opera- tional and back office administrative issues, as well as to benefit from a single entry point able to answer all questions.
However, such specialists are hard to find. Bringing together the right competences into one dedicated team is a genuine challenge for private equity service providers. Indeed, fund administrators, depositaries or transfer agents often face difficulties in putting together the right skills and the right people to efficiently service their clients. Given the closed-ended nature of private equity funds, the stability of the service providers’ staff is a must, as the cli- ent relationship should last for a minimum of ten years provided that no major issue arises.
A combination of investment fund and corporate experience is highly recommended for this staff, since even packaged as a fund, private equity structures use a number of special pur- pose vehicles or acquisition vehicles assimilated to commercial companies in their corpo- rate governance and life, accounting and financing aspects. This has a direct impact on the profile of accountants sought, as a pure fund accounting experience is far from sufficient: Corporate and commercial accounting is necessary, local GAAPs, IFRS and consolidation culture a must. Besides, an extremely high level of responsiveness to investment and corporate events is commonly required by GPs as those often small-sized organisations are mostly concentrat- ed on their business and investment pipeline. It becomes then counter-productive to fully segregate tasks and a real “coordinator” is required to dispatch information on transactions and organise the service rendered. Relationship managers or business unit managers fulfill
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this role. A solid background in client servicing, funds, corporate governance, accounting and the ability to understand clients’ businesses are required for this position where a high degree of creativity, proactivity and of course availability is needed.
All these constraints coupled with well-known demographic factors fuel global demand for talented individuals. There is no such thing as a general definition of talent, and part of the dif- ficulty consists in spotting the key people.
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APPENDICE – REGULATION REFERENCES
1- Main legal texts at domestic level
You will find hereafter the references to the main legal texts relative to private equity, for the following leading jurisdictions where CACEIS is established: France, Ireland, Luxembourg and the United States.
France
• FCPR vehicles Authorised funds (“FCPR agréés”) > Article L214-36 of the Financial and Monetary Code > Articles 414-1 to 414-13 of the General Regulation of the Autorité des Marchés Financiers (AMF), Book IV – Collective Investment products, Title 1 – Collective Investment Schemes, Chapter IV – Venture Capital Funds (Fonds Communs de Placement à Risques), Section I > AMF instruction No.2009-05 of 4 June 2009 relating to the full prospectus of authorised FCPR > AMF instruction No.2009-03 of 2 April 2009 relating to authorisation procedures and share- holder information Funds registered via the fast-track procedure (“FCPR allégés”) > Articles L214-37 and L214-38 of the Financial and Monetary Code > Articles 414-14 to 414-32 of the General Regulation of the Autorité des Marchés Financiers (AMF), Book IV – Collective Investment products, Title 1 – Collective Investment Schemes, Chapter IV – Venture Capital Funds (Fonds Communs de Placement à Risques), Section II > AMF instruction No.2009-06 of 4 June 2009 relating to the full prospectus of FCPR funds registered via the fast-track procedure > AMF instruction No.2009-04 of 2 April 2009 relating to declaration procedures and share- holder information Contractual FCPRs (“FCPR contractuels”) > Article L214-38-1 of the Financial and Monetary Code, dated 4 August 2008 > Articles 414-33 to 414-48 of the General Regulation of the Autorité des Marchés Financiers (AMF), Book IV – Collective Investment products, Title 1 – Collective Investment Schemes, Chapter IV – Venture Capital Funds (Fonds Communs de Placement à Risques), Section III > AMF instruction No.2009-09 of 3 November 2009 relating to the full prospectus of contractual FCPR > AMF instruction No.2009-04 of 2 April 2009 relating to declaration procedures and share- holder information
• FCPI vehicles > Article L214-41 of the Financial and Monetary Code > Articles 414-1 to 414-13 of the General Regulation of the Autorité des Marchés Financiers (AMF), Book IV – Collective Investment products, Title 1 – Collective Investment Schemes, Chapter IV – Venture Capital Funds (Fonds Communs de Placement à Risques), Section I > AMF instruction No.2009-05 of 4 June 2009 relating to the full prospectus of authorised FCPR > AMF instruction No.2009-03 of 2 April 2009 relating to authorisation procedures and share- holder information
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• FIP vehicles > Article L214-41-1 of the Financial and Monetary Code > Articles 414-1 to 414-13 of the General Regulation of the Autorité des Marchés Financiers (AMF), Book IV – Collective Investment products, Title 1 – Collective Investment Schemes, Chapter IV – Venture Capital Funds (Fonds Communs de Placement à Risques), Section I > AMF instruction No.2009-05 of 4 June 2009 relating to the full prospectus of authorised FCPR > AMF instruction No.2009-03 of 2 April 2009 relating to authorisation procedures and share- holder information
Link to detailed legal texts: http://www.amf-france.org
Ireland
• QIF vehicles > Non-UCITS regulatory regime: - Non-UCITS investment companies: Part XIII of the Companies Act, 1990 - Non-UCITS unit trusts: Unit Trusts Act, 1990 - Investment Limited Partnerships (non-UCITS): Investment Limited Partnership Act, 1994 - Non-UCITS common contractual funds: Investment funds, companies and miscellaneous provisions act, 2005 > The rules governing QIFs are set out in the Financial Regulator’s Non-UCITS Notice No.24 Link to detailed legal texts: http://www.financialregulator.ie
• LP > Limited Partnerships Act, 1907
Luxembourg
• UCI Part II vehicles > Part II of the Law of December 20, 2002 on Undertakings for Collective Investment > CSSF Circular 02/77 on the protection of investors in case of NAV calculation error or breach of investment rules > IML Circular 97/136 on financial information to be provided by public funds > IML Circular 91/75 clarifying certain aspects of the UCI legislative framework (Chapter I lays down specific rules applying to Part II funds investing in Private Equity and venture capital)
• SIF vehicles > Law of February 13, 2007 on Specialised Investment Funds (SIF Law) > CSSF Circular 07/283: entry into force of the law of February 13, 2007 relating to SIFs > CSSF Circular 07/310 regarding financial information to be provided by SIFs > CSSF Circular 07/309 concerning risk diversification requirements applicable to SIFs
• SICAR vehicles > Law of June 15, 2004 on SICAR, amended by the Law of October 15, 2008 (SICAR Law mod- ernisation) > CSSF Circular 06/272 on technical specifications regarding the communication to the CSSF, under the law on prospectuses for securities, of documents for approval or for filing and of notices for offers to the public of securities issued by SICARs and admissions of securities issued by SICARs to trade on a regulated market page 86 | A thorough understanding of PE > CSSF Circular 06/241 on the concept of risk capital in SICARs RETOUR SOMMAIRE
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• Securitisation vehicles (SV) > Law of 22 March 2004
Link to detailed legal texts: http://www.cssf.lu
• SOPARFI vehicles > Companies Act, 1915
The United States
• The US Limited Partnership
Formation Laws of state of formation (i.e. Delaware) US Securities Act of 1933, as amended (“USSA”) also to be considered US Employee Retirement Income Security Act of 1974. as amended (ERI- Offering/Marketing SA) State securities regulation FDIC Bank Holding Company Act (BHCA) Applicable USSA Regulation D legislation Registration US Investment Company Act of 1940, as amended [exemptions under section 3(c)(1) or 3(c)(7)] US Securities Exchange Act of 1934, as amended Disclosure USA Patriot Act Non-US offerings USSA Regulation S US Investment Advisers Act of 1940, as amended Funds Managers State investment Adviser regulations US National Association of Securities Dealers Promoter (third party) State broker dealer/placement agent registration
Link to detailed legal texts: http://www.sec.gov
2 - AIFM directive (European Union)
Initial legislative document: • EU Commission draft proposal Proposal for a Directive of the European Parliament and of the Council on Alternative Invest- ment Fund Managers and amending Directives 2004/39/EC and 2009/…/EC, released by the Commission of the European Communities on 30/04/2009 Link to the full text: http://ec.europa.eu/internal_market/investment/docs/alternative_invest- ments/fund_managers_proposal_en.pdf
Proposals of amendments to the legislative text: • Gauzès Report (European Parliament) Draft report on the proposal for a Directive of the European Parliament and of the Council on Alternative Investment Fund Managers and amending Directives 2004/39/EC and 2009/…/ EC, released by the Committee on Economic and Monetary Affairs, European Parliament, on 23/11/2009 Link to the full text: http://www.europarl.europa.eu/oeil/file.jsp?id=5774032
• Swedish Presidency compromise proposal Proposal for a Directive of the European Parliament and of the Council on Alternative Invest- ment Fund Managers and amending Directives 2004/39/EC and 2009/…/EC – Revised Presi- dency compromise proposal, released by the Council of the European Union on 25/11/2009
Link to the full text: http://register.consilium.europa.eu/pdf/en/09/st16/st16622.en09.pdf A thorough understanding of PE | page 87 RETOUR SOMMAIRE RETOUR SOMMAIRE
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ILPA, Private equity principles, 8 September 2009
INVESTMENT & PENSIONS EUROPE (IPE), Special report private equity, a time of difficulty and opportunity, by Nick Chronias, April 2009
IOSCO, Private equity conflicts of interest Consultation report, November 2009 A thorough understanding of PE | page 89 RETOUR SOMMAIRE
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IPEV Board, International private equity and venture capital valuation guidelines, September 2009
KPMG, Luxembourg securitisation vehicle, a new facility for tax efficient capital market investments and intra-group transactions, 2004
L’AGEFI HEBDO . Les fonds infrastructure veulent se faire une place, 16-22 April 2009 . Le capital risque réserve sa cagnotte aux seconds tours, by Edwige Murguet, 2-8 April 2009
LA TRIBUNE, Aucun signe de vie sur le marché du LBO, 9 October 2009
McKINSEY, The future of private equity, Spring 2009
NVCA, National Venture Capital Association Yearbook 2009, March 2009
PEIGG . Updated US private equity valuation guidelines, March 2007 . Reporting and performance measurement guidelines, March 2005
PITCHBOOK DATA INC, Pitchbook release first quarter 2009 private equity statistics,April 2009
PRACTICAL LAW COMPANY, Private equity 2009 volume 2: Venture capital, 2009
PREQIN LTD . The private equity secondaries boom – When will it occur?”, December 2009 . The 2009 Preqin private equity real estate fund of funds review, 2009 . Private equity spotlight, July 2009 & October 2009 . Real estate spotlight, June 2009 . The 2009 Preqin private equity cleantech review, May 2009 . Infrastructure spotlight – Sovereign Wealth Funds investing in infrastructures, April 2009
PRIVATEEQUITYWIRE . Jersey attracts global fund administrators, December 2008 . Luxembourg private equity services 2008, August 2008
THE ECONOMIST . Mapping the recovery, new strategies for private equity markets – a report from the Economist intelligence unit, 2008 . The new kings of capitalism, survey on the private equity industry, 25 November 2004
UNQUOTE FRANCE . Issue 100, FCPI and FIP funds receive increased backing, April 2009 . Issue 100, Private equity set to be public relations nightmare, April 2009
USA TODAY, Private equity firms spin off cash, by Matt Kranz, 16 March 2006
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A CACEIS PRODUCT DEVELOPMENT PUBLICATION - 2010 GLOSSARY
GLOSSARY OF PRIVATE EQUITY TERMS AND ACRONYMS
AFIC “Association Française du Capital Investissement” French private equity association Business A private investor who provides both finance and business expertise to angel an investee company. Buyout A buyout is a transaction financed by a mix of debt and equity, in which a business, a business unit or a company is acquired with the help of a financial investor from the current shareholders (the vendor). Buyout Fund Funds whose strategy is to acquire other businesses; This may also include mezzanine debt funds which provide (generally subordinated) debt to facilitate financing buyouts, frequently alongside a right to some of the equity upside. BVCA British Venture Capital Association Capital call When a private equity fund manager (usually a GP in a partnership) requests that an investor in the fund (a LP) provide additional capital. Usually a LP will agree to a maximum investment amount and the GP will make a series of capital calls over time to the LP as opportunities arise to finance startups and buyouts for example. Capital The returns that an investor in a private equity fund receives. It is distribution the income and capital realised from investments less expenses and liabilities. Once LPs have had their cost of investment returned, further distributions are actual profit. The partnership agreement determines the timing of distributions to LPs, as well as how profits are divided among LPs and the GP. Carried A share of the profit accruing to an investment fund management interest company or individual members of the fund management team, as a (or Carry) compensation for the own capital invested and their risk taken. Carried interest (typically up to 20% of the profits of the fund) becomes payable once the limited partners have achieved repayment of their original investment in the fund plus a defined hurdle rate (i.e. a certain pre- agreed rate of return). Catch-up This is a common term of the private equity partnership agreement. Once the GP provides its LPs with their preferred return, if any, it then typically enters a catch-up period in which it receives the majority or all of the profits until the agreed upon profit-split, as determined by the carried interest, is reached. Claw back The mechanism by which overpaid carry is returned to LPs. Closing A closing is reached when a certain amount of money has been committed to a private equity fund. Several intermediary closings can occur before the final closing of a fund is reached. When a firm announces a final closing, the fund is no longer open to new investors. Commitment A LP’s obligation to provide a certain amount of capital to a private equity fund when the GP asks for capital. Covenants An agreement by a company to perform or to abstain from certain activities during a certain time period. Covenants usually remain in force for the full duration of the time a private equity investor holds a stated amount of securities and may terminate on the occurrence of a certain event such as a public offering. Affirmative covenants define acts which a company must perform and may include payment of taxes, insurance, maintenance of corporate existence, etc. Negative covenants define acts which the company must not perform and can include the prohibition of mergers, sale or purchase of assets, issuing of securities, etc. CVCA Canadian Venture Capital Association Debt financing Raising money for working capital or capital expenditure through some form of loan, by arranging a bank loan or by selling bonds, bills or notes (forms of debt) to individual or institutional investors.
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Disbursement An investment by a fund in a company. Distressed The bonds of a company that is either in or approaching bankruptcy. debt Some private equity funds specialise in purchasing such debt at deep discounts with the expectation of exerting influence in the restructuring of the company and then selling the debt once the company has meaningfully recovered. Drawdown See Capital call Due dilligence This is one of the main processes which takes place before a transaction is completed. The aim is to ensure that there is nothing which contradicts the financier’s understanding of the current state and potential of the business. The individual elements of due diligence may include commercial due diligence (markets, product and customers), a market report (marketing study), an accountants report (trading record, net asset and taxation position) and legal due diligence (implications of litigation, title to assets and intellectual property issues). Early-stage Seed and start-up stages of a business. Early-Stage Venture capital funds focused on investing in companies in the early part Fund of their lives. EBITDA Earnings before interest, taxes, depreciation and amortisation – a financial measurement often used in valuing a company (price paid expressed as a multiple of EBITDA). EMPEA Emerging Markets Private Equity Association Equity stake When a company or organisation owns shares in a company. Escrow An account in which a GP’s carry is held prior to being recalculated and account paid out on a pre-agreed date. EVCA European Venture Capital Association Exit Liquidation of holdings by a private equity fund. Among the various methods of exiting an investment are: Trade sale; Sale by public offering (including IPO); Write-offs; Repayment of preference shares/loans; Sale to another venture capitalist; Sale to a financial institution. Exit strategy A private equity house or venture capitalist’s plan to end an investment, liquidate holdings and achieve maximum return. Expansion Also called development capital. Financing provided for the growth and capital expansion of a company, which may or may not break even or trade profitably. Capital may be used to finance increased production capacity, market or product development, provide additional working capital. Fair value The price at which an orderly transaction would take place between market participants at the reporting date (measurement date). FCPI “Fonds Commun de Placement dans l’Innovation” French private equity fund dedicated to investments in innovation. FCPR “Fonds Commun de Placement à Risques” French private equity fund. FIP “Fonds d’Investissement de Proximité” French private equity fund dedicated to local or regional investments. Fee income Management fees expressed as a percentage of the funds raised, payable to fund managers. The larger the fund, the greater the fee income, although the percentage generally declines from around 2% in smaller funds to 1-1.5% in larger funds. Financial A secondary deal involving a funds’ portfolio of companies that are secondaries relatively mature (five to seven years old), with some exits already realised, but not all capital drawn down. The main interest for the buyer is to negotiate a potential discount on the fund portfolio. Fund of funds A fund that takes equity positions in other funds. A fund of funds that primarily invests in new funds is a primary or primaries fund of funds. One that focuses on investing in existing funds is referred to as a secondary fund of funds.
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Fund raising The process in which venture capitalists themselves raise money to create an investment fund. These funds are raised from private, corporate or institutional investors, who make commitments to the fund which will be invested by the GP. GAAP Generally Accepted Accounting Principles (GAAP) is the term used to refer to the standard framework of guidelines for financial accounting used in any given jurisdiction. GAAP includes the standards, conventions, and rules accountants follow in recording and summarising transactions and in the preparation of financial statements. General A partner in a private equity management company who has unlimited Partner (GP) personal liability for the debts and obligations of the limited partnership and the right to participate in its management. The General Partner earns a management fee and a percentage of gains (carried interest). Hurdle rate A return ceiling that a private equity fund management company needs to return to the fund’s investors in addition to the repayment of their initial commitment, before the GP becomes entitled to carried interest payments from the fund. The term “preferred return” is often used as equivalent. IFRS International Financial Reporting Standards (IFRS) are standards, interpretations and the framework adopted by the International Accounting Standards Board (IASB). ILPA Institutional Limited Partners Association Internal Rate In a private equity fund, the net return earned by investors from the of Return (IRR) fund’s activity from inception to a stated date. The IRR is calculated as an effective compounded rate of return, using monthly cash flows and annual valuations. This is the most appropriate performance benchmark for private equity investments. Initial Public Shares in a company that have been placed on a stock exchange. An IPO Offering (IPO) is always just the first time a company’s shares are listed - if a company has a listing on another market or in another country, then the listing is not an IPO, merely a secondary, or additional listing. IPEV International Private Equity and Venture Capital association J-curve The curve generated by plotting the returns generated by a private equity fund against time (from inception to termination). The common practice of paying the management fee and start-up costs out of the first drawdowns does not produce an equivalent book value. As a result, a private equity fund will initially show a negative return. When the first realisations are made, the fund returns start to rise quite steeply. After about three to five years the interim IRR will give a reasonable indication of the definitive IRR. This period is generally shorter for buyout funds than for early stage and expansion funds. Later stage Expansion, replacement capital and buyout stages of investment. LBO A buyout in which the NewCo’s capital structure incorporates a (leveraged particularly high level of debt, much of which is normally secured against buyout) the company’s assets. Lead investor The venture capital investor that makes the largest investment in a financing round and manages the documentation and closing of that round. The lead investor sets the price per share of the financing round, thereby determining the valuation of the company. Leverage The use of debt to acquire assets, build operations and increase revenues Limited An investor in a limited partnership/private equity fund. The General Partner (LP) Partner is liable for the actions of the partnership while the Limited Partners are generally protected from legal actions and any losses beyond their original investment. The Limited Partner receives income, capital gains and tax benefits.
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Limited The legal structure used by most venture and private equity funds. The partnership partnership is usually a fixed-life investment vehicle, and consists of a GP (the management firm, which has unlimited liability) and LPs (the investors, who have limited liability and are not involved with the day-to- day operations). The GP receives a management fee and a percentage of the profits. The LPs receive income, capital gains, and tax benefits. The GP (management firm) manages the partnership using policy laid down in a partnership agreement. The agreement also covers, terms, fees, structures and other items agreed between the LPs and the GP. Management Fixed percentage paid by the LP to the GP to make an investment into a fee private equity vehicle, for example; 2% per annum based on commitments. MBO This is the purchase of a business by its management, usually in (Management co-operation with outside financiers (e.g. private equity providers). Buy-Out) Buy-outs vary in size, scope and complexity but the key feature is that the managers acquire an equity interest in their business, sometimes a controlling stake, for a relatively modest personal investment. The existing owners sell most or usually all of their investment to the managers and their co-investors. Mezzanine Loan finance that is halfway between equity and secured debt, either finance unsecured or with junior access to security. Typically, some of the return on the instrument is deferred in the form of rolled-up payment-in-kind (PIK) interest and/or an equity kicker (in a mezzanine loan, equity warrants payable on exit). A mezzanine fund is a fund focusing on mezzanine financing. Net Asset The amount estimated as being attributable to the investors in a Value (NAV) private equity fund on the basis of the value of the underlying investee companies and other assets and liabilities. NVCA National Venture Capital Association (United States) Offering A legal document that provides details of an investment to potential memorandum investors. For example, a private equity fund will issue a PPM when it is or Private raising capital from institutional investors. Also, a startup may issue a Placement PPM when it needs growth capital. Memorandum (PPM) PEIGG The Private Equity Industry Guidelines Group Performance See Carried interest fee Placement Specialists in marketing and promoting private equity funds to institutional agent investors. They charge a percentage of any capital they help to raise for the fund. Portfolio One of the companies in which a private equity firm has invested. company Also called Investee company. Preferred See Hurdle rate return Private equity Private equity provides equity capital to enterprises not quoted on a stock market. Private equity can be used to develop new products and technologies (also called venture capital), to expand working capital, to make acquisitions, or to strengthen a company’s balance sheet. It can also resolve ownership and management issues. A succession in family- owned companies, or the buyout and buyin of a business by experienced managers may be achieved by using private equity funding. Private equity A private equity investment fund is a vehicle for enabling pooled fund investment by a number of investors in equity and equity-related securities of companies. These are generally private companies whose shares are not quoted on a stock exchange. The fund can take the form of either a company or an unincorporated arrangement such as a Limited Partnership.
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Realisation Realisation is the sale, redemption or repayment of an investment, in whole or in part, or the insolvency of an investee company, where no significant return to the private equity fund is envisaged Rescue (or Financing made available to an existing business which has experienced turnaround) trading difficulties, with a view to re-establishing prosperity. SCPC “Société en Commandite de Placements Collectifs” Swiss private equity vehicle Secondary An investment where a fund buys either, a portfolio of direct investments investment of an existing private equity fund or limited partner’s positions in these funds. Secondary A market or exchange in which securities are bought and sold following market their initial sale. Investors in the primary market, by contrast, purchase shares directly from the issuer. SICAR “Société d’Investissement à Capital A Risque“ Investment company in risk capital, Luxembourg private equity vehicle SIF Specialised Investment Fund Luxembourg vehicle SOPARFI “Société de Participation Financière“ Financial participation company, Luxembourg vehicle Subscription Agreement further to which one or more investors undertake to subscribe agreement to, and whereby the competent corporate body (or the members thereof) undertakes to decide (or to vote in favour of), an upcoming issue by one or more target companies of shares, bonds, convertible bonds, warrants or other financial instruments to such investors. The agreement will set out the type and amount of instruments to be issued, the representations and warranties, the indemnification in the event of misrepresentation and may also include post-closing covenants (such as further investment obligations or restrictions on the transfer of the instruments that will be acquired). SV Securitisation Vehicle, Luxembourg Syndication A group of venture capitalists jointly investing in an investee company. or syndicated Where an investment is too large, complex or risky, the lead investor may investment seek other financiers to share the investment. This process is known as syndication. Venture Professional equity co-invested with the entrepreneur to fund an early- capital stage (seed and start-up) or expansion venture. Offsetting the high risk the investor takes is the expectation of higher than average return on the investment. Venture capital is a subset of private equity. Vintage year The year of fund formation and first drawdown of capital. Waterfall The distribution waterfall sets out the order and terms by which distributions are paid to various partners in a limited partnership
In the European waterfall model, the GP is not paid carry until LPs receive distributions equal to their total contributed capital and a preferred return.
In the US waterfall model, the GP’s carry is calculated and paid out on a deal by deal basis as each transaction is realised. The split of carry between the GP and LPs is rebalanced either at each subsequent transaction and/or at the end of the fund’s life. Write-off The write-down of a portfolio company’s value to zero. The value of the investment is eliminated and the return to investors is zero or negative. Source: CACEIS, adapted from EVCA and NVCA glossaries, 2009
A thorough understanding of PE | page 95 ABOUT THE AUTHORS
Nathalie COLLOT 36 years old, is Product Manager at CACEIS in Paris since 2008. She started her career working for HSBC Global Asset Management in Paris, before joining JP Morgan Futures & Options Brokerage business in London. She then worked as a management consultant on numerous projects in the asset management, securities services and investment banking fields during a 7-year period. + 33 1 57 78 12 21 [email protected]
Hervé SCHUNKE 40 years old, joined CACEIS Luxembourg Private Equity & Real Estate Servicing as Head of the department in early 2008. He started his career in Luxembourg as an auditor for Coopers & Lybrand for 4 years, before holding during 13 years a number of fund industry positions in custody, fund accounting, transfer agency, relationship management and sales, successively with Brown Brothers Harriman, Credit Lyonnais and CACEIS. + 352 4767 6367 [email protected]
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