A THOROUGH UNDERSTANDING OF PRIVATE EQUITY

RETOUR SOMMAIRE

A CACEIS PRODUCT DEVELOPMENT PUBLICATION - 2008

INDUSTRY OVERVIEW

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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