A THOROUGH UNDERSTANDING OF PRIVATE EQUITY

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Germany Netherlands

Ireland Belgium France Switzerland

Canada United States

Luxembourg

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INV ES TMENTS & DEALS

DIV ES TMENTS & DIS TRIBUTIONS

CUS TOMIS ED REPORTING

INV ES TMENT S & DEALS FUNDRAIS ING

DIV ES TMENT S & DIS TRIBUT IONS

LIQUIDATION

V ALUE-ADDED S ERV ICES

CUS TOMIS ED

RIS K MANAGEMENT & COMPLIANCE S ERV ICES

FUNDRA IS ING

LIQUIDAT ION

V ALUE-ADDE

1.1 1.2 1.3 2.1 2.2 3.1 3.2 4.2 4.1 4.4 4.3

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 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- 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 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. 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.

We trust you will find this publication both relevant and informative.

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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 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- 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. 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- 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: • 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 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 the industry, in particular the AIFM draft directive currently under discussion at the European Union level.

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 1.1.3 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 1.2.4 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 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 MAIN ACTORS AND STRUCTURES........................................................................................................... 35 2.1 Roles and responsibilities of main actors ...................................................................................... 35 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 2.1.7 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 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 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 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 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

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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

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INDEX OF FIGURES

FIGURE

TITLE

PAGE

1 2 3

Private equity and companies’ lifecycles

10 10 15

Major events in the history of private equity (1950-2009)

Investors’ cash flows and returns generated by private equity investments

4

Performance calculation and waterfall

16

5 6 7 8 9

Illustration of direct investment

18 18 20 21 24 25 26 27 28 28 29 31 32 32 33 34 35 36 41 43 44 46

Illustration of the interposition of an SPV for tax purposes Global private equity secondary market (2003-H1 2009) Comparison of private equity funds versus traditional funds Evolution of distressed private equity fund raising (1992-2008)

10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29

Private equity real estate funds on the road over time worldwide (2005-2009)

Main sectors targeted by private equity infrastructure

Number and value of funds in the market by strategy as at Q3 2009 Number and value of funds in the market by region as at Q3 2009

Capital commitments to US private equity funds and number of funds (1980-2008) Venture capital investments in 2008 by industry sector in the United States Private equity investments as a percentage of GDP per country in Europe, 2008

Breakdown of funds raised by type of investors in Europe, 2008 Private equity fund raising and investments in Europe

Emerging markets private equity global fund raising and investment (2001-H1 2009) Emerging markets fund raising and investment, breakdown by country (2007-H1 2009)

Main players of a typical private equity fund

Profile of investors depending on the business stage of development Main private equity fund structures across the European Union

Examples of securitisation structures

Comparison of the Luxembourg private equity structures Comparison of the French private equity structures

Evolution of the assets and the number of FCPR (including FCPI and FIP) in France (1990-2008) 47

Evolution of QIFs Net Asset Value and number of funds (2002-H1 2009)

48 49

Main characteristics of Irish private equity vehicles

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

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

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

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INDUSTRY OVERVIEW

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INDUSTRY OVERVIEW

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 creation 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. We can distinguish different stages during which private equity plays a key role in the com- pany’s lifecycle, as displayed in figure 1:

1 Source EVCA, “Private equity and venture capital in the European economy”, 25 February 2009

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Consolidation Transmission Company value Figure 1: Private equity and companies’ lifecycles

Stock- exchange listing Industrial transfer Transfer of capital to another investment fund Transfer of capital to management

Expansion Growth

Buy-out of distressed companies

Innovation Creation

Time

Venture Capital Expansion Capital Buy-out Capital

Turnaround

Exits

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 internet bubble

The 3rd private equity boom and the golden age of private equity

The credit crunch and the ensuing economic downturn

The first private equity boom

The burst of the internet bubble

Early private equity and the growth of Silicon Valley

1960

1990

2000

2003

2007

1980

2009

Pre-history and origins of modern private equity

Copyright CACEIS, 2009

P re - 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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E arly private equity and the growth of S ilicon V alley (1960 s and 1970 s ) 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 . T he first private equity boom (1980 s ) 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. T he second venture capital & private equity boom and the internet bubble (1990 s ) 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. T he 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. T he 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

1.1

2 This concept is explained in section 1.2.2 3 Source: The Economist, “The new kings of capitalism, survey on the private equity industry”, November, 25, 2004

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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. T he 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. In the following section, themain 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. L imited partnership The private equity investment model is based on the alignment of interests 5 between a pri- vate equity firm/manager ( the General Partner – GP ), its investors ( Limited Partners – LPs ) and the management teams they support 6 . 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. 6 The roles and responsibilities of these players are described in chapter 2.1. Main concepts of private equity

1.1.3

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private equity fund will make distributions to its LPs. 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. I nvestee 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. F und raising Fund raising refers to the process through which a private equity firm solicits financial com- 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. C apital 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 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.

1.1

Figure 3: Investor’s cash flows and returns generated by private equity investments

Capital commitments are made at the fund's closing

Capital is drawn down as needed during the investment period (years 1-6)

Distributions to investors occur as investment exits are realised (years 3-10) and usually commence before the entire commitment has been drawn

Harvest period

Investment period

Investors'cash flows

Performance

Investment returns Distributions Capital calls

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. M anagement 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 services rendered and irrespective of the distribution to be made to the shareholders.

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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). D istributions 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)

40% to GP and 60% to LP until 20/80 balance

Catch-up

“Standard” Profit Sharing 80% to LP - 20% to GP

Clawback: 80/20?

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 achieve returns higher than the hurdle.

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• Catch-up and carry/return to LPs 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. F und 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.

1.1

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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 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. • 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 Secondary 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. The 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. It 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. One 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 distributions 7 . In addition, by investing in the secondary market, an LP can access funds of older vintages 8 , providing increased diversification. > 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. P rimary funds versus secondary funds

1.1

7 Source: Euromoney Books, “Exposed to the J-Curve: Understanding and managing private equity fund investments” by Ulrich Grabenwarter and TomWeidig, 2005 8 The vintage year represents the year in which the fund made its first investment.

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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 cycle 9 , 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 2009 10 , 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

18.0

18

16.2

15.6

15.0

15

12

10.0 10.7

9.0

In $bn

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 10 Source: Preqin Ltd, “The private equity secondaries boom –When will it occur?”, December 2009

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