A THOROUGH UNDERSTANDING OF PRIVATE EQUITY

RETOUR SOMMAIRE

A CACEIS PRODUCT DEVELOPMENT PUBLICATION - 2010

FISCAL AND OPERATIONAL ISSUES

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. 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 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. Once the relevant formula has been chosen, further decisions need to be taken. The first one deals with the component of the matrix.

3.2

A thorough understanding of PE | page 69