PRIVATE EQUITY FUND STRUCTURES AND VALUATION
3.1 Understanding Private Equity Fund Structures
The limited partnership has emerged as the dominant form for private equity structures in most jurisdictions. Funds that are structured as limited partnerships are governed by a limited partnership agreement between the fund manager, called the general part- ner (GP), and the fund’s investors, called limited partners (LPs). Whereas the GP has management control over the fund and is jointly liable for all debts, LPs have limited liability, i.e., they do not risk more than the amount of their investment in the fund.
The other main alternative to the limited partnership is a corporate structure, called company limited by shares, which mirrors in its functioning the limited partnership but offers a better legal protection to the GP and to some extent the LPs, depending on the jurisdictions. Some fund structures, especially the Luxembourg- based private equity fund vehicle SICAR (société d’investissement en capital à risque), are subject to a light regulatory oversight offering enhanced protection to LPs. The vast majority of these private equity fund structures are “closed end,” which restricts existing investors from redeeming their shares over the lifetime of the fund and limiting new investors to entering the fund only at predefined time periods, at the discretion of the GP.
Private equity firms operate effectively in two businesses: the business of manag- ing private equity investments and the business of raising funds. Therefore, private equity firms tend to plan their marketing efforts well in advance of the launch of their funds to ensure that the announced target fund size will be met successfully once the fund is effectively started. The premarketing phase of a private equity fund, depending on whether it is a first fund or a following fund, may take between one to two years. Once investors effectively commit their investments in the fund, private equity managers draw on investors’ commitments as the fund is being deployed and invested in portfolio companies. Private equity funds tend to have a duration of 10–12 years, generally extendable to an additional 2–3 years. Exhibit 6 illustrates the funding stages for a private equity fund.
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Exhibit 6 Funding Stages for a Private Equity Fund
marketing
marketing follow-on fund
1 year 10 years 2 years
Cash flows back to investors Indications of fund performance Most private equity is invested via partnerships of a limited duration How are private equity funds structured?
Commitments by investors Multiple ‘closings’
draw down/investment Realization or returns and exit extension
Fund terms are contractually defined in a fund prospectus or limited partnership agreement available to qualified prospective investors. The definition of qualified investors depends on the jurisdiction. Typically, wealth criteria (exceeding US$1 mil- lion, for example) and/or a minimum subscription threshold (minimum €125,000, for example) apply. The nature of the terms are frequently the result of the balance of negotiation power between GPs and LPs. Although the balance of negotiation power used to be in favor of LPs, it has now turned in favor of GPs, at least among the over- subscribed funds. Any significant downturn in private equity may change the balance of power in favor of LPs. Negotiation of terms has the objective to ensure alignment of interests between the GP and LPs and defining the GP’s incentives (transaction fees, profit shares, etc.) The most significant terms may be categorized into economic and corporate governance terms.
Economic Terms
■ Management fees represent a percentage of committed capital paid annually to the GP during the lifetime of the fund. Fees in the region of 1.5 percent to 2.5 percent are fairly common. Although less frequent, management fees may also be calculated on the basis of the net asset value or on invested capital.
■ Transaction fees are fees paid to GPs in their advisory capacity when they pro- vide investment banking services for a transaction (mergers and acquisitions, IPOs) benefiting the fund. These fees may be subject to sharing agreements with LPs, typically according to a 50/50 split between the GP and LPs. When such fee- sharing agreements apply, they generally come as a deduction to the management fees.
■ Carried interest represents the general partner’s share of profits generated by a private equity fund. Carried interest is frequently in the region of 20 percent of the fund’s profits (after management fees).
■ Ratchet is a mechanism that determines the allocation of equity between share- holders and the management team of the private equity controlled company. A ratchet enables the management team to increase its equity allocation depend- ing on the company’s actual performance and the return achieved by the private equity firm.
■ Hurdle rate is the internal rate of return that a private equity fund must achieve before the GP receives any carried interest. The hurdle rate is typically in the range of 7 percent to 10 percent. The objective is to align the interests of the GP with those of LPs by giving additional incentives to the GP to outperform traditional investment benchmarks.
EXAMPLE 2
Calculation of Carried Interest
Suppose that a LBO fund has committed capital of US$100 million, carried interest of 20 percent, and a hurdle rate of 8 percent. The fund called 75 per- cent of its commitments from investors at the beginning of year 1, which was invested at the beginning of year 1 in target company A for $40 million and target company B for $35 million. Suppose that at the end of year 2, a profit of
$5 million has been realized by the GP upon exit of the investment in company A, and the value of the investment in company B has remained unchanged.
Suppose also that the GP is entitled to carried interest on a deal- by- deal basis, i.e., the IRR used to calculate carried interest is calculated for each investment upon exit. A theoretical carried interest of $1 million (20 percent of $5 million) could be granted to the GP, but the IRR upon exit of investment in company A is only 6.1 percent. Until the IRR exceeds the hurdle rate, no carried interest may be paid to the GP.
■ Target fund size is expressed as an absolute amount in the fund prospectus or information memorandum. This information is critical as it provides a signal both about the GP’s capacity to manage a portfolio of a predefined size and also in terms of fund raising. A fund that closed with a significantly lower size rela- tive to the target size would raise questions about the GP’s ability to raise funds on the market and would be perceived as a negative signal.
■ Vintage year is the year the private equity fund was launched. Reference to vintage year allows performance comparison of funds of the same stage and industry focus.
■ Term of the fund is typically 10 years, extendable for additional shorter periods (by agreement with the investors). Although infrequently observed, funds can also be of unlimited duration, and in this case are often quoted on stock mar- kets (such as investment trusts).
Corporate Governance Terms
■ Key man clause. Under the key man clause, a certain number of key named executives are expected to play an active role in the management of the fund.
In case of the departure of such a key executive or insufficient time spent in the management of the fund, the “key man” clause provides that the GP may be prohibited from making any new investments until a new key executive is appointed.
■ Disclosure and confidentiality. Private equity firms have no obligations to dis- close publicly their financial performance. A court ruling8 requiring California Public Employees Retirement System (CalPERS) to report publicly its returns on private equity investments, the Freedom of Information Act (FOIA) in the United States, and similar legislation in other European countries have led pub- lic pension funds to report information about their private equity investments.
Disclosable information relates to financial performance of the underlying funds but does not extend to information on the companies in which the funds invest.
This latter information is not typically disclosed. The reporting by CalPERS is a prominent example of the application of this clause.9 Some private equity fund terms may be more restrictive on confidentiality and information disclosure and effectively limit information available to investors subject to FOIA.
■ Clawback provision. A clawback provision requires the GP to return capital to LPs in excess of the agreed profit split between the GP and LPs. This provision ensures that, when a private equity firm exits from a highly profitable invest- ment early in the fund’s life but subsequent exits are less profitable, the GP pays back capital contributions, fees, and expenses to LPs to ensure that the profit split is in line with the fund’s prospectus. The clawback is normally due on termination of the fund but may be subject to an annual reconciliation (or
“true- up”).
■ Distribution waterfall. A distribution waterfall is a mechanism providing an order of distributions to LPs first before the GP receives carried interest. Two distinct distribution mechanisms are predominant: deal- by- deal waterfalls allowing earlier distribution of carried interest to the GP after each individual deal (mostly employed in the United States) and total return waterfalls resulting in earlier distributions to LPs because carried interest is calculated on the prof- its of the entire portfolio (mostly employed in Europe and for funds- of- funds).
Under the total return method, two alternatives are possible to calculate carried interest. In the first alternative, the GP receives carried interest only after the fund has returned the entire committed capital to LPs. In the second alterna- tive, the GP receives carried interest on any distribution as long as the value of the investment portfolio exceeds a certain threshold (usually 20 percent) above invested capital.
EXAMPLE 3
Distribution Waterfalls
Suppose a private equity fund has a committed capital totaling £300 million and a carried interest of 20 percent. After a first investment of £30 million, the fund exits the investment 9 months later with a £15 million profit. Under the deal- by- deal method, the GP would be entitled to 20 percent of the deal profit, i.e., £3 million. In the first alternative of the total return method, the entire proceeds of the sale, i.e., £45 million, are entitled to the LPs and nothing (yet) to the GP. In the second alternative, the exit value of £45 million exceeds by more than 20 percent the invested value of £30 million. The GP would thus be entitled to £3 million.
8 S. Chaplinsky and S. Perry, “CalPERS vs. Mercury News: Disclosure comes to private equity,” Darden Business Publishing.
9 Information about CalPERS’ private equity holdings is available from the company’s website, www.
calpers.ca.gov.
Continuing the above example with a clawback provision with an annual true- up, suppose that the deal- by- deal method applies and that a second invest- ment of £25 million is concluded with a loss of £5 million 1 year later. Therefore, at the annual true- up, the GP would have to pay back £1 million to LPs. In practice, an escrow account is used to regulate these fluctuations until termi- nation of the fund.
■ Tag- along, drag along rights are contractual provisions in share purchase agree- ments that ensure any potential future acquirer of the company may not acquire control without extending an acquisition offer to all shareholders, including the management of the company.
■ No- fault divorce. A GP may be removed without cause, provided that a super majority (generally above 75 percent) of LPs approve that removal.
■ Removal for “cause” is a clause that allows either a removal of the GP or an ear- lier termination of the fund for “cause.” Such “cause” may include gross negli- gence of the GP, a “key person” event, a felony conviction of a key management person, bankruptcy of the GP, or a material breach of the fund prospectus.
■ Investment restrictions generally impose a minimum level of diversification of the fund’s investments, a geographic and/or sector focus, or limits on borrowing.
■ Co- investment. LPs generally have a first right of co- investing along with the GP. This can be advantageous for the LPs as fees and profit share are likely to be lower (or zero) on co- invested capital. The GP and affiliated parties are also typically restricted in their co- investments to prevent conflicts of interest with their LPs. Crossover co- investments are a classic example of a conflict of interest. A crossover co- investment occurs when a subsequent fund launched by the same GP invests in a portfolio company that has received funding from a previous fund.