Reporting guidelines – IPEV or ILPA Which direction … · By David Larsen, Duff & Phelps and...

Inside this issue

Reporting guidelines – IPEV or ILPA Which direction now?ILPA’s Kathy-Jeramaz Larson and IPEV Board Member David Larsen state their cases Shifting terms & conditions in PE funds: Debevoise IMG survey

Fund-lite and other alternative structures for PE fundraising

The new IPEV Valuation Guidelines

Published in January 2013 by PEAI Publishing Limited9 Honeysuckle GardensCroydon CR0 8XUUnited Kingdom e: [email protected]: +44 (0) 20 8226 4653

ISSN 2052-1677

Executive DirectorMariya Stefanova

Design and ProductionJulie Fostere: [email protected]

© 2013 Private Equity Accounting Insights.

This publication is not included in the CLALicence so you must not copy any portion of itwithout the permission of the publisher.

All rights reserved. No parts of this publicationmay be reproduced, stored in a retrieval systemor transmitted in any form or by any meansincluding electronic, mechanical, photocopy,recording or otherwise, without writtenpermission of the publisher.

Disclaimer: This publication contains generalinformation only and the contributors are not,by means of this publication, renderingaccounting, business, financial, investment,legal, tax, or other professional advice orservices. This publication is not a substitute forsuch professional advice or services, norshould it be used as a basis for any decisionor action that may affect your business.Before making any decision or taking anyaction that may affect your business, youshould consult a qualified professionaladviser. Neither the contributors, their firms, itsaffiliates, nor related entities shall beresponsible for any loss sustained by anyperson who relies on this publication.

The views and opinions expressed in thispublication are solely those of the authorsand need not reflect those of theiremploying institutions.

Although every reasonable effort has beenmade to ensure the accuracy of thispublication, the publisher accepts noresponsibility for any errors or omissionswithin this publication or for any expense or other loss alleged to have arisen in anyway in connection with a reader’s use of this publication.

Q4 | 2012 1

ISSUE 1 | Q4 2012

2 Publisher’s letter

VALUATIONS

3 The new IPEV Valuation Guidelines explainedBy David Larsen, Duff & Phelps and IPEV Board Member

INVESTOR REPORTING

7 COVER STORY: Reporting guidelines – IPEV or ILPA Which direction now?7 Introduction by Mariya Stefanova, Private Equity Accounting Insights9 Q&A with Kathy Jeramaz-Larson, ILPA12 Q&A with David Larsen, Duff & Phelps and IPEV Board

ACCOUNTING

14 Investment entities: Has the wait been worth it?By Jonathan Martin, KPMG LLP

18 The importance of allocations and allocation rules in private equity accountingBy Mariya Stefanova, Private Equity Accounting Insights

PE PORTFOLIO & PERFORMANCE MEASUREMENT

23 The PERACS Risk CurveTM – A novel approach to capturing the risk profile of aprivate equity portfolioBy Prof. Oliver Gottschalg of HEC Paris and PERACS PE Fund Analytics and Track Record Certification

LEGAL

27 How the game is changing: Shifting terms and conditions in private equity fundsBy Geoffrey Kittredge and John W. Rife III, Debevoise & Plimpton LLP

37 Fund-lite and other alternative structures for private equity fundraisingBy Matthew Hudson and Ross Manton, MJ Hudson

INVESTOR RELATIONS

41 Fundraising from pre-marketing to dataroom: Thoughts on building a credibleinvestment case for institutional investorsBy Sarah Clarke, Foundation Fundraising Services

TAX

45 Contemplating a move offshore?By Abigayil Chandra and Paul Megson, Deloitte

48 The UK tax landscape: The importance of private equity being adaptable to changeBy Sara Clark and Timothy Sowter, PwC

51 HMRC challenges to VAT recovery on share acquisition costsBy Ali Hai, Deloitte

53 A review of tax-related developments in private equityBy Abigayil Chandra and Paul Megson, Deloitte

Welcome to the first issue ofthe PEAI Private EquityTechnical Journal. The

private equity asset class hastraditionally been opaque when itcomes to the relatively scarce sourcesof information on specialist tax, legaland accounting topics. Suchinformation tends to be very expensiveas it is pretty much only availablethrough communication channels withthe Big4 and specialist legal firms.Now I am proud to present you withthis unique technical publicationcontaining valuable specialistinformation on all aspects of privateequity. Private Equity Technical Journalcovers investment portfolios andstrategies, valuations, tax, legal,compliance & regulation, investorreporting, accounting, performancemeasurement and investor relations.

I would like to extend great thanks to allour expert contributors who havehelped us make this project true and toour sponsors and advertisers whosefinancial support has allowed us todeliver this exciting launch issue to youfree of charge.

The industry landscape is changing. Thebalance of power is shifting from GPs toLPs and ILPA’s power is growing, there ispressure from LPs for greater alignment ofinterests and many LPs seek moretransparency and scrutiny. These themesand trends are resulting in changing fundterms, new types of fund structures andnew investor reporting options, coupledwith new regulatory and taxrequirements and increased scrutiny fromboth regulators and tax authorities. Also,on top of that comes increased pressurefrom governments, regulators andsociety, resulting in increased demand

for responsible investing and theadditional layer of reporting in the formof environmental, social and governance(ESG) reporting. We will endeavour tobring you timely and informative analysisand insight to help keep you abreast ofthe technical developments and trends inprivate equity.

In this issue where we focus on whathappened in Q4 2012, our main topic isthe new IPEV Investor ReportingGuidelines compared to the ILPAReporting Standards & Templates. Wefeature two exclusive interviews – onewith David Larsen, IPEV Board Memberand MD at Duff & Phelps and anotherwith Kathy Jeramaz-Larson, ExecutiveDirector of ILPA. Another interesting topicis the new edition of the IPEV ValuationGuidelines, which were announced inDecember – David Larsen explains thedifferences from the previous set ofguidelines. We couldn’t have missedone of the most important accountingdevelopments in recent years which

finally became a fact in November: theinvestment entities exception toconsolidation with an insightfulcommentary by Jonathan Martin, KPMGLLP. We also have an extremelyinteresting article by Debevoise &Plimpton on the shifting fund terms andconditions based on proprietaryDebevoise IMG survey, which samples50+ US and European buyout funds.We also have the first lesson of our PEAccounting Series, as well as manyother interesting articles on tax (in thisissue we focus on UK developments),fund formation, private equity portfoliosand investor relations.

In the next issue, with the fast-approaching July implementationdeadline of the European directive oneveryone’s radar, the main topic ofcourse will be the Alternative InvestmentFund Managers Directive (AIFMD). Wewill be examining all its aspects andimplications. We will also be lookinginto some US tax developments such asthe Foreign Account Tax ComplianceAct (FATCA), as well as otherregulatory developments. We willcontinue with the Accounting Series,and will also be launching theValuation Series provided by thevaluation experts Duff & Phelps.

I hope you’ll find reading this first issueenjoyable, relevant and informative. Wewelcome your feedback andsuggestions for new topics so that wecan offer you more exciting articles inthe issues to come.

Enjoy reading!

Mariya StefanovaExecutive DirectorPEAI Publishing

Private Equity Technical Journal2

Publisher’s letter

The IPEV Board released updatedValuation Guidelines to take intoaccount the issuance of Fair Value

rules by the International AccountingStandards Board (IASB) and evolvingbest practice.

In 2011, the IASB issued InternationalFinancial Reporting Standard (IFRS) 13Fair Value Measurements. At the sametime the Financial Accounting StandardsBoard (FASB) issued AccountingStandards Update 2011-4 amendingFASBs Accounting StandardsCodification (ASC) 820 Fair ValueMeasurements. IFRS 13 is effectivebeginning January 1, 2013. With theissuance of IFRS 13 and ASU 2011-4,fair value accounting rules for both USGAAP and IFRS are virtually identical.They use the same definition for fairvalue: “The price that would be

received to sell an asset or paid totransfer a liability in an orderlytransaction between market participantsat the measurement date.” The IPEVValuation Guidelines were updated togive effect for the minor substantivechanges included in the accountingstandards such as calibration, toprovide clarification of the concept of“unit of account” for the private equityindustry, and to incorporate FAQresponses into the guidelinesthemselves. Further, the format of theguidelines was changed to provide theguidelines themselves on a standalonebasis (Section I), commentary on theguidelines (Section II) and specialconsiderations (Section III).

Calibration is a concept that is nowrequired by both the IASB and FASB intheir respective fair value rules. “When

the price of the initial investment in aninvestee company or instrument isdeemed fair value (which is generallythe case if the entry transaction isconsidered orderly), then the valuationtechniques that are expected to beused to estimate fair value in the futureshould be evaluated using market inputs as of the date the investment was made. This process is known as calibration. Calibration validates that the valuation techniques usingcontemporaneous market inputs willgenerate fair value at inception andtherefore that the valuation techniquesusing market inputs as of eachsubsequent measurement date will generate Fair Value at each such date.”1

For example, if a fund purchases 100percent of a private company withEBITDA of 20 at the fair-value price of200, the purchase price multiple ofEBITDA is 10. If comparable companymultiples are 11, the concept of

The new IPEV Valuation GuidelinesexplainedBy David Larsen, Duff & Phelps and IPEV Board Member

Q4 | 2012 3

VALUATIONS

Introduction by Mariya StefanovaOn December 17 2012, after a short consultation period, the IPEV Boardreleased an updated version of its Private Equity and Venture Capital ValuationGuidelines, superseding the previous 2009/2010 version. The December 2012Edition is applicable for reporting periods post-January 1, 2013. A few days afterthe release, the Valuation Guidelines were discussed at one of our annual events,the PEAI 2012 Year-End Accounting, Reporting & Valuations Update for PrivateEquity Funds. Some general partners (GP) have revealed that they havecompared the two editions and struggled to identify the differences. DavidLarsen, IPEV Board Member, and managing director at financial advisory andinvestment banking firm Duff & Phelps, comments on the release of the updatedIPEV Valuation Guidelines.

1 Updated IPEV Valuation Guidelines 2.6.

Calibration is aconcept that is nowrequired by both theIASB and FASB intheir respective fair

value rules.

calibration means that the approximate10 percent difference between thecomparable company EBITDA multipleand the fair value multiple of 10, istracked and re-evaluated at eachmeasurement date. Calibration is a verystrong tool to deal with issues such asvalue associated with control and valueimpacted by liquidity. The updated IPEVValuation Guidelines incorporate anddescribe how calibration is used.

‘Unit of account’ is a much moredifficult concept: it is an accountingterm which identifies the level at whichan asset is aggregated ordisaggregated for fair-value recognitionpurposes. Unit of account is dictated byindividual accounting standards whichare subject to interpretation. Given thatfair value accounting standards seek toreflect the economic behaviour and theperspective of market participants theIPEV Valuation Guidelines general usea market participant view in assessingthe level of aggregation ordisaggregation. For example, whereaccounting guidance is open tointerpretation, if a market participantwould purchase an interest in a privatecompany, not focusing on individualshares; the unit of account would be theoverall interest purchased. However, ifaccounting standards clearly define unit of account, such guidance shouldbe followed.

IFRS 13 and the amendments to FASBASC 820 do not dictate unit of accountand do not require the use of fair value.Other accounting standards, such asFASB ASC Topic 946 under US GAAPor IFRS 9 Financial Instruments requirethe use of fair value however do notprovide specific unit of accountguidance. Some have interpretedinternational accounting standards torequire the unit of account to bedeemed a single share of an investeecompany, where US GAAP often usesthe entire holding as the unit ofaccount. For investments in privatecompanies, the assessment of unit of

account as a single share or as theentire holding could result insignificantly different fair-valueestimates. The update IPEV ValuationGuidelines highlight different unit ofaccount interpretations, but focus onmarket participant assumptions as aguiding factor in estimating fair value.Determining unit of account at a leveldifferent than that used by privateequity investors may result in non-meaningful information.

The updated IPEV Valuation Guidelinesalso provide an expanded descriptionof what value to use for debt whendetermining the fair value of equity in aprivate company. Generally, debt mustbe repaid upon a change of controland therefore is subtracted at par fromenterprise value to determine the FairValue of equity. Further the updatedIPEV Valuation Guidelines provideexpanded special considerationguidance with the addition of SectionIII 5.9 Contractual Rights, and Section

III 5.10 Mathematical Models. Thesection on contractual rights highlightsthe need to determine the fair value offuture consideration to be receivedupon the sale of an underlyinginvestment or portfolio company. Forexample, some GPs sell an investmentwith additional consideration payableupon the achievement of certainmilestones after the sale. Limitedpartners (LP) need to know the fairvalue of such future additionalconsideration. Finally, the MathematicalModels section highlights the fact thatsome auditors have started focusing onmathematical option pricing models asa way to estimate fair value for earlystage investments. The IPEV Boardplans to provide further guidance onmathematical option pricing modelsthrough the FAQ portion of the IPEVwebsite in the near future.

In general the changes made to the2012 updated IPEV ValuationGuidelines do not change the keypractices in determining fair value. The changes improve the readability of the guidelines, provide additionalguidance on specific areas, andhighlight interpretation differencesexisting with the application ofaccounting standards.

THE NEW IPEV VALUATION GUIDELINES EXPLAINEDVALUATIONS


Generally, debt mustbe repaid upon achange of controland therefore is

subtracted at parfrom enterprise valueto determine the fair

value of equity.

David LarsenManaging Director, Duff & Phelps& IPEV Board Member

e: [email protected]

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Knowing which direction to takeon the journey to adopting thebest in investor reporting can

be difficult. ILPA’s Executive DirectorKathy Jeramaz-Larson and IPEV Boardmember David Larsen present thefacts everyone in private equity needsto know.

In April 2012 the IPEV Board releasedfor consultation a set of InvestorReporting Guidelines (IPEV IRG) with aconsultation period that ended in August.The guidelines came as a little bit of asurprise to everybody and given that theIPEV Board has released its final versionof the IPEV IRGs in late October, formany general partners (GP), traditionallyequipped with minimal guidance on howto report to investors, they are now facedwith almost too much guidance tochoose from. For many GPs, they will befacing a very serious decision in theirfuture rounds of fundraising – whether tochoose to report under the IPEV IRGs orapply the ILPA Quarterly ReportingStandards Best Practices andStandardised Templates.

IPEV’s guidelines were prepared at theEuropean Private Equity and VentureCapital Association’s (EVCA) requestand are regarded as supersedingprevious guidelines issued by EVCA andother endorsing organisations’ guidancesuch as the BVCA Reporting Guidelines.

The information that both sets of guidelines(ILPA and IPEV) recommend as bestpractice is not very different in essenceand many GPs already provide thisinformation to their LPs in their quarterlyreports. The difference is rather in theapproaches of the two organisationswhich is understandable as they have twovery different constituencies and thereforegoals. The two organisations are atdifferent positions in the industry spectrum.The IPEV Board, historically, through themembership of many regional industrybodies such as EVCA, BVCA (BritishPrivate Equity and Venture CapitalAssociation), BVK (German Private Equityand Venture Capital Association e.V),AFIC (Association Française desInvestisseurs pour la Croissance), CVCA(Canada’s Venture Capital and PrivateEquity Association), CAPE (ChinaAssociation of Private Equity) and otherlocal industry bodies have seemed to be

GP-focused, although presently it claims torepresent a broader balancedGP/LP/service provider constituency fromacross the world. The ILPA constituencyconsists of institutional limited partners

Q4 | 2012 7

INVESTOR REPORTING

Reporting guidelines – IPEV or ILPA Which direction now?By Mariya Stefanova, Private Equity Accounting Insights

COVER STORY

For many GPs, they willbe facing a very seriousdecision in their future

rounds of fundraising –whether to choose toreport under the IPEV

IRGs or apply the ILPAQuarterly Reporting

Standards Best Practicesand Standardised

Templates.

REPORTING GUIDELINES – IPEV OR ILPA WHICH DIRECTION NOW?

predominantly representing NorthAmerica (65 percent of the members areUS LPs and 11 percent are CanadianLPs),1 or in other words this is anorganisation representing the interest ofthe investors, although they have alsoconsidered input from other constituencies(GPs, auditors and service providers).

The IPEV IRGs do not mandate anyspecific accounting framework. In fact theirintention is to provide information beyondthe applicable GAAP, but most importantlythey do not provide specific templates.

Similarly, ILPA’s Quarterly ReportingStandards Best Practices feature a samplequarterly package, which, despite thegeneral perception that it is a template, isactually just an example. However, ILPAprovides templates for drawdowns anddistribution notices and some largeinstitutional investors such as CalPERSrequested, effective from March 2012,that investee funds they invest in providedrawdown and distribution noticesfollowing exactly the ILPA templates. As aresult, even funds of funds that hadCalPERS as investor had to pass on therequest down to their investee funds. Thereason for the standardised templates is togenerate cost efficiencies throughstandardisation across the whole industry,which is understandable and wouldprobably, in the long term, save costs not

only for LPs, but also for GPs and fundadministrators. Imagine if we are all ableto input information into the samedistribution, drawdown and even quarterlyreport templates, how much time andrelated costs would that save? I haveprepared and reviewed accounts forfunds of funds, and trust me, it is quite ahassle to go through a number ofdrawdowns, distributions and quarterlyreports for investee funds all coming indifferent shapes and forms, so I cancompletely understand ILPA’s endeavoursfor standardisation. The trouble is, which isrecognised by both the IPEV Board, aswell as ILPA, that not all funds can bemade to fit one single quarterly report template.

Now, with all the different sets ofguidelines available to GPs to reportunder (the old EVCA, BVCA and otherlocal guidelines, the superseding IPEVIRG and ILPA Reporting Standards (ILPARS)), there are two important questionsthat they are asking:1. How should the transition from the

EVCA RGs to IPEV IRGs work?2. And what is more important, which

set of reporting guidelines shouldthey adopt particularly in their futurerounds of fundraising?

The answer to the first question would bea matter of the exact wording in alimited partnership agreement (LPA) andwherever it refers to the latest version ofthe EVCA RGs, the transition should berelatively automatic, as the IPEV IRGs aresuperseding the EVCA RGs. However, inother cases where a LPA refers to aspecific edition of the guidelines (withoutexpressly stating ‘or a subsequent editionof the Guidelines’), the transition wouldrather be a result of a negotiationprocess between the GP and its LPs onhow and when (if at all) that transitionshould happen. Whatever the case may

be though, the fact somehow needs tobe communicated to LPs.

With regards to the second question, sincethe two sets of guidelines (IPEV IRGs andILPA RSs) are essentially not very differentin terms of the information required, theanswer to it would greatly depend on theanswer of two other questions, thequestions being: exactly how powerful isILPA and what is the likelihood of LPs enmasse imposing the ILPA guidelines andtemplates? This is still to be seen in 2013when ILPA will start tracking the results ofthe implementation of its guidelines; ILPA’soriginal expectation was to roll out thestandard formats in 2012 and startmeasuring the results in 2013.

In the wake of the global economicdownturn that unfolded in 2008, ILPA hasbeen representing its 250-plus members2

as the balance of power has steadilyshifted away from GPs in favour of LPs,which has resulted in ILPA havingstrengthened its relative position. The ILPAPrivate Equity Principles, which areembodied in the terms and conditions ofmany private equity funds, are alsoincreasingly being implemented in theLPAs of new fund offerings, spurred on bymany LPs’ new-found bargaining power inthe current tough fundraising conditions.According to Preqin data,3 57 percent ofLPs have previously decided not to investin an otherwise appealing fund due to theproposed terms and conditions, which is aclear evidence of how adherence to theILPA principles can affect GPs. In additionto that, it’s worth mentioning the fact thatnow ILPA has a tool on its website,available to members, that allows LPs toquantify a limited partnership agreement’sadherence to ILPA Private Equity principleswith each principle weighed based on itsimportance. The tool provides a score(the ILPA score) which can be compared

INVESTOR REPORTING


1 According to ‘The ILPA Annual Report 2012: 10 Year Anniversary Special Edition’ a breakdown of ILPA membership by region shows that 65 percent of itsmembers are from the US, 17 percent from Europe, 11 percent from Canada, 3 percent from Asia, 2 percent from the Middle East, 1 percent from Oceaniaand 1 percent from South America.

2 ILPA’s 250-plus members comprise public pensions, corporate pensions, endowments, foundations, family offices and insurance companies representing overUS$1 trillion of private assets globally.

3 The 2012 Preqin Limited Partners Universe.

Q&A with Kathy Jeramaz-Larson, ILPA

PETJ: As a well-respected industry bodyfor private equity investors, how muchof ILPA’s work is about raisingawareness of issues and instigatingcommunication between limitedpartners and general partners ratherthan presenting stakeholders withreporting blueprints and finely detailedguidance templates? Tell us a little bitmore about ILPA’s other less knownactivities and its role in the industry.

Kathy Jeramaz-Larson: Ever since Istarted with the ILPA six years ago, theobjective of the organisation has been toadvance the interests of limited partnersin the global private equity industry;providing a forum for facilitating value-added communications; enhancingeducation in the asset class; andpromoting research and standards in theprivate equity industry. We havereceived a lot of media attention aroundour suite of tools and best practices

which gave us global recognition, butour work extends far beyond this work toinclude executive-level education, hostingof industry round-tables and leadingdiscussions with governments andregulators in support of private equityglobally. It keeps us very busy.

PETJ: What has changed between thefirst and the second version of the ILPAPrivate Equity Principles? Which of theprinciples from the first version still holdtrue and which of them haven’t withstoodthe test of time and why, for example the100 percent offset of transaction feesagainst management fees hasn’t beenfollowed through in the second version,what was the reason for that and arethere any other similar examples?

KJL: As you can imagine, we received alot of ‘feedback’ on our first Principlespublication and we took that feedbackvery seriously... ergo they were rewritten

i) to reorganise the document to make iteasier to follow; ii) to clarify specificelements contained within the documentat the request of general partners; andiii) to better reflect that the documentwas intended as a best practice. Therewere two exceptions. Disclosure relatingto the GP is considered part of the duediligence process and therefore it wasremoved from the Principles. The secondpoint related to style drift. Since thereshould not be any style drift of the

to other GPs’ scores. According to PEManager, the tool is gaining more andmore recognition, for instance the SanDiego City Employees’ Retirement System(SDCERS) has already instructed itsinvestment team to begin using the toolwhen reviewing LPAs with probably otherLPs to follow suit in 2013.4

So, in light of the developments and trendsdiscussed above, for a first-time GP raisingits debut fund, there may be a need toconcede to the ILPA-advocated fund termsand conditions and the ILPA reportingguidelines and templates. However, anestablished and successful top-decile GPwith an oversubscribed subsequent fundmay feel more inclined to downplay the

importance of the ILPA Private EquityPrinciples (and the ILPA score, respectively),as well as their reporting guidelines andtemplates, and not in such a great need tocomply with all of them. But even the mostsuccessful GPs which count among theirfund investors some of the most prominent(and powerful) LPs, as mentioned in theabove example with CalPERS’s requestsfor the standardised drawdown anddistribution templates and SDCERS’sexplicit instructions to their investment teamto use the ILPA score, it is likely that GPswould have accommodated, if not all, atleast some of the LPs’ requirements/ requests or at least be prepared todiscuss with them why ILPA principlesand/or reporting non-compliance

shouldn’t be a deciding factor in assetallocation decisions. And if for now it hasbeen only the drawdown and distributionnotices templates that have been firmlydemanded by some LPs, despite the meritsof the IPEV IRGs, the next step taken byLPs may be also to demand the ILPAQuarterly Reporting Standards with moreand more institutional LPs to follow suit.

In search of answers to the key themesand developments in investor reporting,the following exclusive interviews with IPEVBoard member David Larsen and ILPA’sExecutive Director Kathy Jeramaz-Larsonprovide important context and guidanceon which of the two routes private equitypractitioners may take in the future.

REPORTING GUIDELINES – IPEV OR ILPA WHICH DIRECTION NOW? INVESTOR REPORTING

Q4 | 2012 9

4 PE Manager Weekly: ‘What’s your ILPA score? 6 Jan 2013.


investment thesis, the item was removedas being redundant.

PETJ: Tell us about the process ofdeveloping the Quarterly ReportingStandards and the Drawdown andDistribution Notices Templates. Werethere any professional bodies or auditorsinvolved in advising you in the process?

KJL: The development of the Standardsbegan as a request of general partnersduring our annual GP-LP roundtable. Wewere asked to specifically articulate thereporting requirements that institutionalinvestors deemed to be essential formanaging their private equityprogrammes. To accomplish this goal,ILPA not only queried its members on bestpractices, it consulted with GPs and theirCFOs, auditors, lawyers, technologyproviders, custodians and serviceproviders, incorporating the feedbackand suggestions into the draft prior to therelease for public comment. The commentperiod generated several hundredcomments which were then integratedinto the document where appropriate.

PETJ: When you look at the ILPAQuarterly Reporting Template, one isunder the impression that it mandatesUS GAAP. Why has ILPA chosen thataccounting framework over any other,particularly in the light of the ongoingprocess of convergence between USGAAP and IFRS and have any of your

European members raised that as an issue?

KJL: Actually, the Standards expressly donot mandate US GAAP and were writtenin such a way as to target properdisclosure, not the accounting orregulatory framework in which it isdisclosed. That is something that is oftenoverlooked so thank you for asking.

PETJ: With considerable ongoing focuson best practices in the field ofinvestor reporting, what are the keyaspects the ILPA Quarterly ReportingStandards which set them apart fromother approaches?

KJL: The ILPA Standards stand as the firstdetailed example of best practices asneeded by asset owners in managingtheir private equity portfolios. Anyorganisation that promotes best practicesin investor reporting is only following theILPA Principle of transparency andproper governance.

PETJ: Now with the final version of theIPEV Investor Reporting Guidelinesofficially released on October 29, whichrepresent an alternative to the ILPAReporting Guidelines, what do you expectto be the prevailing form of reportingand what would the considerations beto choose one or the other?

KJL: The reporting requirement betweenany specific LP and GP remains aconfidential discussion between the twogroups. Having said that, by referencingthe ILPA best practice guidelines, not

only have members experiencedaccelerated and focused discussionsaround reporting requirements, GPs havereported increased efficiencies bycreating one set of documents for all of their LPs.

PETJ: Back in 2010, ILPA was part of theIPEV Investor Reporting Guidelines (IVEPIRG) project. Why did ILPA subsequentlydecide to pull out of the IPEV IRGproject and pursue its own route?

KJL: ILPA commenced working on itsstandardised reporting templates at therequest of GPs during the GP-LP roundtable in February 2010; the ensuingworking group included the chair of theIPEV’s Reporting Committee. Since mostof the ILPA standards were penned priorto the resignation of the committee chairfrom the IPEV Board, the ILPA guidelinesthat were published 14 months agoincluded the views of IPEV at that time.

PETJ: There have been the expectedcomparisons drawn between the ILPAQuarterly Reporting Standards and theIPEV Investor Reporting Guidelines,notably in areas such as ‘EssentialDisclosures’ versus ‘AdditionalDisclosures’, deadlines and templates forcapital calls and distribution notices. Willthese comparisons lead to harmonisationbetween the two sets of standards or arethe differences likely to prevail?

KJL: The information contained within acapital call and a distribution notice isvery basic stuff that allows LPs toaccount for transactions properly and

INVESTOR REPORTING


We were asked tospecifically articulate

the reportingrequirements that

institutional investorsdeemed to be

essential for managingtheir private equity

programmes.

efficiently. Requesting that theinformation be reported in a timelyfashion seems pretty obvious for mostpeople so that LPs can properly trackinvestments. Given the focus andattention by the media and governmentson the transparency of the asset class,GPs and LPs appreciate the need forincreased rigour around reporting.

PETJ: Do you think the private equityasset class will benefit from multiplereporting standards or do you thinkthere will be a flight to the mostpractically popular standards in timewhich should be applicable and relevantglobally? Will further work on standardsby ILPA influence market choices?

KJL: As a fiduciary, limited partners arefaced with the need for increasedtransparency and reporting in order toinform and guide their boards, trustees,portfolio managers and risk departments.To serve these various constituencies,investors repeatedly make enquiries ofthe general partners needing furtherdetail into their investments. Bystandardising information flow in theprivate equity industry it should generategreater industry efficiencies, improveuniformity and transparency, and reduceexpenses in administering andmonitoring private equity investments.

PETJ: To what extent do you believe thekey aspects of the ILPA QuarterlyReporting Standards have beenachieved, that is, efficiencies inreporting practices, standards thatimprove transparency and informationsharing for quality managementreporting? Since the ILPA QuarterlyReporting Standards were launched inOctober 2011, where do you thinkmost of the gains and improvementshave been achieved? Are there somethat still need considerable work orsome form of reconsideration?

KJL: The expectation was to roll out thestandard formats in 2012 so tracking ofresults will be a focus for 2013.

PETJ: We have heard from GPs thatlarge institutional LPs such as CalPERSand even funds of funds in whichCalPERS is an investors requiredrawdown and distributions notices thatthey receive from GPs to be in theprescribed ILPA format. Have you heardabout other institutional LPs having thesame requirement and do you think thatthis would be a trend in the future?

KJL: We have received a lot offeedback that the formats have beenadopted elsewhere.

PETJ: Since the capital accounts usuallycome in all forms and shapes and thatdefinitely represents a challenge to theintended standardisation, is there anyindication from LPs that they are trying topress harder towards standardising it,similar to the requests for standardiseddrawdown and distribution notices madeby CalPERS earlier in the year?

KJL: The feedback I get is that this is aniterative process and we should movetowards standardisation before beingforced to do so by third parties that donot understand the data that is beingrequested nor the time and effort tocollect such data.

PETJ: Has it been important for ILPA topublish the Quarterly ReportingStandards during the market cycleswhen investor views are consideredmore by many general partners/fundmanagers? Are you concerned in anyway that these positive moves in investorreporting will be less acknowledgedwhen the balance of influence falls intothe general partners’ court?

KJL: Reporting and transparency willcontinue to be important to both GPs andLPs as both recognise that efficiencies canbe created through adoption of standardsand best practices.

PETJ: Considering the positive levels ofindustry engagement and responses tothe consultation process which led to the

creation of the ILPA Quarterly ReportingStandards, what feedback have you hadsince they were published? Consideringany market reaction or feedback to theILPA Quarterly Reporting Standards, areyou hearing distinct messages fromlimited partners, general partner andprofessional advisers (legal, accounting,tax)? Will this feedback or reaction feedinto future standards work at ILPA?

KJL: We received a lot of very positivefeedback and equally, goodconstructive feedback. We get a lot ofsuggestions on other options forstandardisation and in our style, we willdevelop templates and test them withthe GPs and LPs for applicability andusefulness and roll out accordingly.

PETJ: There is a perception among theGPs that ILPA is trying to impose boththe Private Equity Principles, as well asthe template, using the toughfundraising environment, how wouldyou respond to that?

KJL: Perhaps the GPs that you spoke tofeel that way, but the leading GPs thatwork with us contribute their time andresources to help evolve the bestpractices, build our database, assist andparticipate in educational offerings, andparticipate in our round-tables. I receive alot of encouragement and support fromGPs to keep up the effort and so thoseare the GPs that I listen to. What is thatold saying? You are either part of theproblem or part of the solution. Byworking together I think LPs and GPs havebeen finding it easier to get things done.


Q4 | 2012 11

We will developtemplates and test

them with the GPs andLPs for applicability

and usefulness and rollout accordingly.

Q&A with David Larsen, Duff & Phelps and IPEV Board

PETJ: To set the stage, tell us about IPEVand its role in the industry.

David Larsen: In October 2005, theInternational Private Equity and VentureCapital Valuations Board (IPEV) wascreated as an independent body andcharged with maintaining, promoting,monitoring, and updating the IPEVValuation Guidelines, as well as providingguidance on the application of theValuation Guidelines to all worldwidestakeholders in the Private Equity and

Venture Capital Industry. The EVCA,BVCA , and AFIC created IPEV as anindependent board with geographicallyvaried representation from the industry asa whole including GPs, LPs, auditors andother industry service providers. The IPEVBoard is the most balanced, may I sayneutral, body in the industry as noindividual constituency, LP, GP, auditor,valuation expert, etc. has adisproportionate voice. IPEV is globallybalanced effort focused on industry bestpractice as a whole, taking into accountall perspectives. Most other industryorganisations espouse the perspective oftheir membership. More information canbe found on the IPEV website atwww.privateequityvaluation.com.

PETJ: What or who has instigated thedrafting of the IPEV Investor ReportingGuidelines (IPEV IRG) in the currentenvironment and in the presence of theexisting alternatives such as the EVCAand BVCA Reporting Guidelines and theILPA Quarterly Reporting Standards?

DL: The IPEV Board was tasked in 2010by EVCA with updating the existingEVCA Reporting Guidelines. With theglobal success through adoption of theIPEV Valuation Guidelines and theexpertise and broad perspective of IPEVBoard members, IPEV was a naturalplace for obtaining sensible guidance oninformation necessary for enhanced GP-LP communication.

PETJ: With the final version of the IRG nowpublished (available on the IPEV websiteat www.privateequityvaluation.com),what are the major changes to theoriginal draft released for consultation inApril 2012? What important commentshave you received from constituents thatyou have reflected in the final draft?

DL: The IPEV Board received a numberof comments as a result of theconsultation process. Generally thesecomments can be characterised as LPsexpressing their desire for specificinformation and GPs focusing on the


PETJ: Please tell us about your websitetool that allows LPs to quantify a limitedpartnership agreement’s adherence tothe ILPA PE principles (ILPA score) –how does it work, how the differentprinciples are weighed, could a GP’sscore be compared to others’ and whatproportion of your members arealready using the tool? We have heardthat the San Diego City Employees’Retirement System, for example, hasalready instructed its investment team tobegin using the tool when reviewingfund agreements.

KJL: The ILPA Private Equity Principleswere developed in 2009 to encouragediscussion between LPs and GPs

regarding fund partnerships; outlining LPexpectations of a fund in one document.Once published, ILPA was asked onnumerous occasions to provide a wayfor GPs (to demonstrate) and LPs (toassess) how a fund aligned with theprinciples. We created an online appthat asks a series of over 60 questionsrelated to the key components within theprinciples that are also contained withina LPA. At the end of the process, anumeric value acts as a reference forcomparison and analysis for the LPswhen looking at a fund.

As with any analytical process, the LPArating tool should not be the solecontributing factor in a LP’s fund

selection process, rather, one point ofreference in the decision-making/discussion process. The datawithin the LPA remains confidential tothe user and therefore there is nocentral database with a particular fundrating assigned to its name. But ILPAdoes collect demographics of fundsrated as well as the ratings, allowingmembers to compare individual funds toaggregated values.

INVESTOR REPORTING


Kathy Jeramaz-LarsonExecutive Director, Institutional Limited PartnersAssociation


IPEV is globallybalanced effort

focused on industrybest practice as awhole, taking into

account allperspectives.


cost benefit of providing information.The final version of the IPEV InvestorReporting Guidelines incorporates theBoard’s consideration of all commentsreceived. There were no major changes,but a number of edits to increase overall clarity.

PETJ: Are the new IPEV IRGs designed toreplace the EVCA Reporting Guidelines(EVCA RG)? Just so that there is noconfusion, how would that work – wouldthe EVCA RGs cease to exist or will bothsets of reporting standards continue toco-exist, because many GPs refer to theEVCA RGs in their Limited PartnershipAgreements (LPA)?

DL: The IPEV Investor ReportingGuidelines supersede the prior version ofthe EVCA Reporting Guidelines.

PETJ: If the IPEV IRGs are to replace theEVCA RGs how is the transition fromEVCA RGs to IPEV IRGs supposed towork? What should existing funds thathave adopted EVCA ReportingGuidelines which has been stipulated intheir LPAs do? Should they automaticallyswitch from EVCA RGs to IPEV IRGs andif so, how would you recommend thatthey tell their investors about the change?

DL: To the extent the EVCA RGs arereferred to in LPAs, GPs and LPs wouldmake a determination if, how and whento move to the IPEV IRGs. The changewill occur over time as decided on afund-by-fund basis.

PETJ: In the light of the previousquestion, what are the major differencesbetween the IPEV IRGs and the EVCARGs? Which differences, if any, aremost likely to cause problems for GPs inthe transition period?

DL: The IPEV IRGs provide additionalguidance on specific data elements thatshould be reported by GPs to LPs and thereasons why LPs need the information.Because of the differences among funds,the IPEV IRGs do not prescribe specific

templates or formats. The IPEV IRGsenhance overall best practice and shouldnot provide any problems or conflictsduring the transition period.

PETJ: If the IPEV IRGs are to replace theEVCA RGs, what would happen withthe BVCA Reporting Guidelines (BVCARG) which are essentially identical tothe EVCA RGs? Have there been anytalks between the IPEV Board and theBVCA in that respect?

DL: As a founding association of IPEV,the BVCA provided significant input onthe IPEV IRGs. It would be expected thatthe IPEV IRGs will become the definitivesource of reporting best practice for theBVCA. Individual endorsing associationscould have local requirements in additionto what is included in the IPEV IRGs.

PETJ: When the draft IPEV IRGs werereleased in April there were inevitablecomparisons drawn with the ILPAstandards, in areas such as ‘EssentialDisclosures’ versus ‘AdditionalDisclosures’ and templates for capitalcalls and distribution notices. In theintervening months have there beenmoves towards harmony between IPEVand ILPA approaches or do you thinkthe differences will prevail?

DL: Representatives of the IPEV Boardand ILPA Board have met and haveongoing discussions. The IPEV IRGs aresubstantially in harmony in the type ofinformation that is included in ILPA’sReporting Standards and Templates. Inbroadening the EVCA guidelines to aglobal standard, IPEV was able toreference previous work completed byother industry groups (such as AVCAL,ILPA, and PEIGG); the IPEV Boardintends that the principles espoused bythe IPEV IRG work alongside theseefforts to improve investor reporting forour industry.

PETJ: Do you think the private equityasset class will benefit from multiplediffering reporting standards or do you

think there will be a flight to the mostpractically popular standards in timewhich should be applicable and relevantglobally? Could the IPEV IRGs draftingprocess go some way to smoothing outany differences at this stage?

DL: The IPEV IRGs are balanced in theirapproach and were produced aftertaking into account the opinions of bothLPs and GPs. The intention of theguidelines is to provide, from a principle-based perspective, the essential andadditional information that should bereported by GPs to LPs. Given differencesamong fund types and strategies, the IPEVIRGs do not mandate format. The IPEVIRGs work very well alongside otherefforts to enhance best practice.

PETJ: You have also announced thatthere would be some sample reports(not templates) on the IPEV website?

DL: Examples for various funds types,such as venture capital, buyout and fundof funds will be added to the IPEVwebsite in due course.

PETJ: Finally, the same question hasbeen posed to Kathy Jeramaz-Larson,the Executive Director of ILPA – whatare the most compelling reasons forGPs to choose to apply the IPEV IRGsover the alternative, that is, the ILPAQuarterly Reporting Standards?

DL: The IPEV IRGs are principle-based,allow flexibility in how information isshared, yet from an LP perspective focuson the essential data that should bereported by GPs to LPs. The IPEV IRGswork alongside other best-practiceefforts to enhance the overall qualityand timeliness of information providedto LPs.

Q4 | 2012 13

David LarsenManaging Director, Duff & Phelps& IPEV Board Member


In 2011, the IASB released three newstandards dealing with consolidationand related topics. In October 2012,

it amended the standards to remove therequirement for defined investmententities to consolidate investments thatthey control. The burning question iswhether its amendments will address theprivate equity community’s issues andlead to the wider adoption of IFRS.

The short answer to this pressing questionposed in the article title is a decisive ‘itshould do’, which is a vast improvementon the ‘maybe’ that was anticipated aslate as mid-2012. Although the IASB hasmade considerable progress and ‘plainvanilla’ structures are more likely toqualify for the exemption and sotherefore be able to adopt IFRS, thechanges raise further questions about justhow many vanilla structures exist inprivate equity and similar asset classes.They also raise questions about whetherthe amendments are appropriate only forvanilla-type structures and ignore theactivities of a swathe of more complexfunds and fund structures managed byinvestment managers.

Though often misunderstood and notalways loved, in its decade as thecommon accounting framework inEurope, IFRS has brought about

consistency in the accountingrequirements for listed companies in theEuropean Union (EU) and is helping tolead the development of a truly globalset of accounting standards.

That said, the use of IFRS in the privateequity asset class is still fairly uncommon.Many funds and management groupscontinue to use their local GAAP or, as ismore common for funds in the UK, amodified version of local GAAP. Themodified version, often referred to as ‘LPAGAAP’ since it is based on the fund’slimited partnership agreement, can giverise to widely differing accountingpolicies depending on the requirementsof the fund manager and the investors.

Consolidation is the primary reason thatIFRS has not taken hold in private equity.To prepare fund accounts under currentIFRS means that investments (portfoliocompanies) need to be accounted for

as subsidiaries, where there is control.This requires consolidation, which can betime-consuming and costly.

Naturally this has led to very few privateequity houses adopting IFRS.1

Introduction

ACCOUNTING


Investment entities: Has the wait been worth it?By Jonathan Martin, KPMG LLP

Although the IASB hasmade considerableprogress and ‘plainvanilla’ structures aremore likely to qualify

for the exemption andso therefore be able to

adopt IFRS, thechanges raise furtherquestions about justhow many vanillastructures exist inprivate equity.

1 Currently the few exceptions are almost all listed vehicles that are required to apply IFRS (or EU IFRS).

Consolidation is a time-consumingprocess made more frustrating whenthere isn’t a convincing case forpreparing consolidated accounts.Therefore, the ability to apply theinvestment entity amendment to IFRS 10,and not consolidate is clearly welcome.This is especially true as the amendmentmandates fair value through profit or lossaccounting for investments made byinvestment entities, which is the approachthat most private funds presently apply(in line with the IPEV guidelines).

The private equity sector worked longand hard to make the case for aninvestment-entity exemption thatprovides an appropriate answer forfunds wishing to adopt IFRS. For someconsiderable time in the IASB’sdeliberations it appeared likely that theeventual exemption would be unlovedand unused.

So what has changed to lead to thismore positive outlook by the industry? Toqualify for the exemption, funds need tomeet the definition of an investmententity. The definition can be, helpfully,split into two parts: the ‘essentialelements’ and the ‘typical characteristics’.The essential elements are required tomeet the definition of an investment entityand stipulate that, to qualify, a fund must:

• obtain funds from investors toprovide those investors withinvestment management services;

• commit to investors that its businesspurpose is solely to earn returns fromcapital appreciation and/orinvestment income; and

• measure and evaluate performanceof substantially all its investments ona fair-value basis.

Basing the definition on these threecriteria was an approach that

developed over the latter stages of theIASB process and is an improvement onthe approach proposed in the exposuredraft. The proposals in the exposuredraft were very restrictive and mighthave resulted in entities that receivedincome for investment-related servicesbeing precluded from being aninvestment entity.

The first requirement may seeminnocuous and very easy for a fund tocomply with. However, the appendix tothe amendment explicitly excludes aninvestment entity from performing otheractivities such as product co-development and production. Thiscould be an issue for the venturecapital sector where closer links withinvestees are often found. Venturecapital managers will therefore need tobe extra vigilant to ensure that they cancomply with this requirement.

There are, however, other potentialpitfalls. The requirement that substantiallyall investments are measured at fair valueincludes investment property, jointventures and associates, all of whichcould otherwise be treated differentlyunder IFRS. It is likely that this will proveto be minor hurdle for most funds toovercome. Moreover, paragraphs IE9-11of the standard highlight that manyinvestors in investment properties will alsomanage and develop those properties.The development activity forms aseparate substantial part of a real estate

entity’s business activities which mayprohibit it from qualifying as aninvestment entity.

There is no exemption from theexemption. If a fund meets the criteriathen it is required to adopt theinvestment-entity accounting. While thiswill be acceptable to most, there maybe some houses that seek otherwise.Fortunately for them, they will only meetthe definition of an investment entity if allof the criteria are met. Thus, for example,a house seeking not to adopt theexemption could do so simply bycontinuing to measure investmentproperty at historic cost. However, careshould be taken with such a stance asthere is no pick-and-mix approach; afund not meeting the requirements willhave to consolidate, for example,majority-owned investments.

What about debt investments? Typicallythese are managed at amortised costand not at fair value. Even where fairvalue is disclosed in the fund accounts,this is often to comply with disclosurerequirements while the core assets are stillmanaged on an amortised-cost basis.

For those that invest only in debt, thisapproach may not be a problem. Theywill not have subsidiaries that they couldbe required to consolidate and willcontinue to account for their debtinvestments at amortised cost. For thosethat have both debt and equity positions,the position is less clear. Substantially allinvestment must be measured andevaluated on a fair-value basis.Therefore, a fund with a significantinterest in both may be required toconsolidate its controlled holdings unlessit measures and evaluates its debtinvestments on a fair-value basis.

So in conclusion, plain vanilla funds arelikely to meet the essential-characteristicstest, but more exotic funds might not. Forthe larger private equity houses therequirement for ‘substantially all’investments to be measured and

The game changer: To consolidate or not to consolidate

INVESTMENT ENTITIES: HAS THE WAIT BEEN WORTH IT? ACCOUNTING

Q4 | 2012 15

The private equitysector worked long

and hard to make thecase for an investment-entity exemption that

provides anappropriate answerfor funds wishing to

adopt IFRS.

evaluated on a fair-value basis maymean that they cannot meet thedefinition of an investment entity becauseof their debt investments and/or realestate. Furthermore, their otheroperations might result in their notqualifying for the exemption.

The second stage of assessing whethera fund is an investment entity is to look atthe four typical characteristics. Ticksagainst all four are not necessary –another improvement on the earlier draftsof the standard – but those charged withgovernance, the finance team and theirauditors will need to apply carefuljudgement to ensure that non-compliancewith any of the four is not critical. Thefour criteria are:

• the entity holds more than one investment;

• there is more than one investor in the entity;

• the investors are not related partiesof the entity (as defined in IAS 24);and

• the entity has ownership interests inthe form of equity or similar interests.

Making these characteristics typicalrather than mandatory solves some ofthe problems that existed in the originaldraft. For example, a fund will be able toqualify for the exemption at the start andend of its life when there may be onlyone investment. Not necessarily requiringthere to be more than one investmentmay also benefit the growing number ofprivate equity houses that are seeking toraise single-deal funds, often with asmaller number of investors. This occurswhen the investment is unobtainable toindividual investors (for example, whenthe required minimum investment is toohigh for an individual investor). Theconcept of such funds is no different froma typical private equity fund andtherefore it is helpful for the accountingtreatment to be the same.

Entities that do not have all of the typicalcharacteristics but conclude that they areinvestment entities must disclose thereasons for reaching that conclusion.

The IASB’s exposure draft includedwording that suggested that a moreactive owner may have been precludedfrom being an investment entity. Clearlythe benefit of the private equity model isthat ownership is aligned with theexpertise of the private equity house that,in turn, is used to grow, improve and insome cases turn around businesses.

Fortunately, the wording included in theexposure draft that implied that day-to-day involvement in the management ofan investment would disqualify a fund

from being an investment entity has beendropped. In practice, however, inclusionof the wording that was originallyproposed could have been asdamaging as the depositaryrequirements in the draft EU venturecapital standard and could have resultedin almost no private equity houses beingable to apply the amendments.

The simple answer: when it is a parent ofan investment entity. That is to say, that aparent entity of an investment entity doesnot obtain the accounting exemptionafforded to its investment entitysubsidiaries unless the parent, itself, is aninvestment entity. The IASB, thoughnotably not the FASB in its impending USstandard in this area, has precludedparents of investment entities frommaintaining the fair-value accountingadopted in the subsidiary if the parent is,itself, not an investment entity. It remainsto be seen how critical this will be in theuptake of the amendment by the privateequity industry.

The motivation here is to ensure thatconglomerates that are investing insubsidiaries for the long term do notmanipulate the standard to obtain a

Being a hands-on owner

When is an investment entitynot an investment entity?

The ‘typical characteristics’

INVESTMENT ENTITIES: HAS THE WAIT BEEN WORTH IT?ACCOUNTING


The IASB’s exposuredraft included wordingthat suggested that amore active owner

may have beenprecluded from beingan investment entity.

favourable accounting treatment.However, many would argue that thepresence of a private equity house thatmanages a fund in a private equitystructure should not be seen in the sameway. Furthermore, many private equityfunds will not have a parent entity that hasa majority investment in the fund, thoughexamples do exist. The real issue for thetypical parent entity will be how theyadopt the wider requirements of IFRS 10which is outside the scope of this article.

Regrettably this argument has not beenaccepted by the IASB. In fact, all 12 ofthe IASB board voted in favour ofexcluding parent companies from usingthe investment-entity exemption unlessthey also qualify as investment entities.Therefore, larger or more diverse privateequity houses may still not be able tobenefit from the fair-value approachincluded in the standard. In other words,the cost savings at one level will be lostat the next level. This will be of particularconcern for captives and possibly largerbuyout houses where the private equityfunction is essentially a division that sitsalongside hedge, debt and otherfinancial service-type functions.

What problems remain?In following the investment-entityexemption, private equity funds will berequired to measure fair value inaccordance with the guidance in IFRS

13 – Fair Value Measurement. This newstandard, applicable in the EU fromJanuary 1, 2013, does not specify the‘unit of account’; that is, it does notspecify whether the fair value of aninvestment is measured on the basis ofthe total investment or on the basis ofone individual share multiplied by thenumber of shares held.

The former would take account of thecontrol premium and the latter would not.More importantly, a value based on theentire investment would be likely to resultin that value being net of the par valueof its debt, since there are typicallychange of control clauses which wouldrequire the debt to be repaid if theinvestment were sold. These clauseswould not come into effect if anindividual share was sold, and therefore,if the value was based on that of anindividual share, the value would be netof the debt at fair value.

This last significant issue could determinethe success or failure of IFRS in theprivate equity sector. If the unit ofaccount is the individual share then it islikely that IFRS would still not beadopted. Results prepared on this basis,could result in day-one losses (or gains)and would not be helpful to investors forwhom an investment would only ever besold in totality and certainly not oneshare at a time.

The IASB is aware of this issue and itsInterpretations Committee is expected toconsider it further in early 2013. Funds

may wish to carefully monitor how it progresses.

Despite the discussion about fair value,the answer to this question should still bea cautionary ‘yes’. The IASB hasaccepted that the practical andoperational requirements of the privateequity sector are not the same as othersectors and have developed anaccounting standard that allows for this.However, the IASB has developedseveral key criteria which might beeasier to meet for smaller, standardprivate equity houses and their fundsthan for the larger, more diversified ones.By restricting the exemption from beingapplied more widely, the IASB mayhave limited the use of IFRS amonglarger and more diversified houses.

However, questions about themeasurement of fair value still present apossible hurdle which could prevent theprivate equity sector from adopting IFRSand nullify the good progress that theIASB has made in developing anexemption that provides more consistentand comparable information for investorsinto private equity.

So, has the wait been worth it?

Investment entity criteria:Notable exclusions

INVESTMENT ENTITIES: HAS THE WAIT BEEN WORTH IT? ACCOUNTING

Q4 | 2012 17

Jonathan MartinDirector, KPMG


The IASB has acceptedthat the practical and

operationalrequirements of theprivate equity sectorare not the same as

other sectors.

In this first lesson in the PEAI PEAcademy Accounting Series, I amstarting with allocations and

allocation rules because these are whatdistinguish private equity accountingfrom accounting for entities in otherindustries and other asset classes.

During the PEAI 2012 Private EquityAcademy Road Show it became clear

that there is surprisingly still a lack ofsufficient appreciation and understandingof the importance of accurate allocationsto investors, the variety of allocationsrules stipulated in different limitedpartnership agreements (LPA) (and thereason for them being there in the firstplace), and the importance of usingproper systems to arrive at the accuratenet asset value (NAV) allocation toindividual investors when applying morecomplex allocation rules.

This lesson is primarily targeted atgeneral partners (GP) as the topic ishighly relevant to their accounting, but itis also relevant to limited partners (LP) inraising their awareness and providesthem with an insight into the GPs’accounting processes.

Let’s start with a reminder that the mostcommon legal form for private equityfunds is the limited partnership with theinvestors set up as LPs. Each of these LPsowns an interest in the partnership – acertain percentage of it, which is usuallycalculated as a percentage of the total

commitment. This ownership is expressed(in accounting terms) and reported to theLPs as owning a certain proportion ofthe fund’s NAV; to arrive at the relevantproportion of the NAV, a proportion ofall assets, liabilities, income, expensesand gains/losses need to be allocatedto each LP.

• By commitment (and closing date) – thisis the simplest and most commonallocation rule, calculated as a simple

What is an allocation rule andwhy is it so important in privateequity accounting?

Types of allocation rules

ACCOUNTING


The importance of allocations andallocation rules in private equityaccountingBy Mariya Stefanova, Private Equity Accounting Insights

PEAI PRIVATE EQUITY ACADEMY ACCOUNTING SERIES: LESSON 1

Meet the trainer

Mariya StefanovaFounder, Private Equity Accounting Insights


During the PEAI 2012Private Equity

Academy Road Showit became clear that

there is surprisingly stilla lack of sufficientappreciation and

understanding of theimportance of

accurate allocationsto investors.

ratio of each investor’s commitment tothe total fund commitment.

• By remaining commitment – thisallocation rule, which is less commonthan the one based on commitment,has its own particular benefits.Instead of being based on the legalcommitment and constant over the lifeof the fund, it is calculated, as itsname indicates, as a ratio of eachinvestor’s remaining/outstandingcommitments to the totalremaining/outstanding commitment,and therefore it might be potentiallydifferent after each drawdown. It isoften used when there is anexpectation of having excusedinvestors and basically acceleratesthe rate at which commitments aredrawn down from excused investorsafter they have opted out of aparticular investment. It also allowsthem to catch up with the non-excused investors, which will beexplained a little bit later.

• By drawn commitment – this isanother less common allocationrule. This allocation rule is oftenused, similarly to the by-remaining-commitment rule, where there arevariations or exceptions, forexample where there is aGP/founder partner (FP)commitment and the GP/FP is notbearing a share of the priority profitshare (PPS)/GP’s share (GPS) orwhere there are excused investors.

• Specific allocations (e.g. by sharingpercentages) – that allocation rule isanother one used where there areexcused investors commonly used todistribute proceeds from investmentsfrom which certain investors haveopted out, making the percentagesspecific to each investments.

• Combination of allocation rules – veryoften the above allocation rules areused in a combination. In complexLPAs, different allocation rules areused for drawdowns (even fordifferent elements of drawdowns),distributions, net income and capitalgains/losses.

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5*(E

xcus

ed In

vesto

r)10

020

.00%

0.00

%0

100

3070

2050

3040

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l50

010

0.00

%10

0.00

%20

030

015

015

010

050

150

0

ACCOUNTING SERIES: LESSON 1 | THE IMPORTANCE OF ALLOCATIONS AND ALLOCATION RULES IN PRIVATE EQUITY ACCOUNTING ACCOUNTING

Q4 | 2012 19

Making an investment in a specialistprivate equity system is a complexdecision involving many considerationssuch as size of the manager and thenumber of funds, costs and many other factors. Whereas it may beacceptable to use Excel-basedaccounting and run Excel-basedallocations if the by-commitment-onlyallocation rule is used throughout your LPA and there are no excusedinvestors, the moment you get oneexcused investor all becomes muchmore complicated and a by-commitment-only allocation rule would no longer meet the needs of the fund. Generally, with excused investors, the by-commitmentpercentages will become distorted and there should be mechanisms tocompensate for that distortion. Some of those mechanisms is the use of some of the other allocation rulesexplained above, but let’s elaborate on the reasons first.

• The first reason is that if a by-commitment allocation rule is usedfor subsequent drawdowns, for theexcused investors that have optedout of some of the investments, theircommitment will never becompletely drawn down and someproportion of their commitment,depending on the number and sizeof the investments subject to optouts, will not be utilised, asdemonstrated in Table 1. One wayof overcoming this is by using a ‘by-remaining-commitment’ allocationrule. This automatically takes careof the unutilised commitment byaccelerating the rate at whichcommitments are drawn down fromthe excused investors, compared tonon-excused investors, and allowsthem to catch up with them asshown in Table 2.

Why are there differentallocation rules? Is Excel-based accounting adequate?

Tabl

e 2:

Dra

wdo

wns

with

an

opt-o

ut u

sing

by-re

mai

ning

-com

mitm

ent a

lloca

tion

rule

* In

vesto

r #5

is an

Exc

used

Inve

stor o

ptin

g ou

t fro

m In

vestm

ent A

.

By u

sing

a by

-rem

aini

ng-

com

mitm

ent a

lloca

tion

rule

, all

inve

stors’

com

mitm

ents

have

bee

nco

mpl

etel

y ut

ilise

dan

dth

ere

are

no o

verd

raw

nco

mm

itmen

tsat

the

end

of th

e life

of t

he fu

nd.

Com

mitm

ent

Perc

enta

ges

byco

mm

itmen

t

Adj

uste

d (fo

rth

e Ex

cuse

dIn

vesto

r #5)

by-c

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tpe

rcen

tage

s

Dra

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(DD

) #1

for I

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tmen

t A

Rem

aini

ngco

mm

itmen

taf

ter D

D #

1

Perc

enta

ges

by R

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ning

com

mitm

ent

afte

r DD

#1

DD

#2

for I

nves

tmen

t B(b

y-re

mai

ning

-co

mm

itmen

t)

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aini

ngco

mm

itmen

taf

ter D

D #

2

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ges

by R

emai

ning

com

mitm

ent

afte

r DD

#2

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#3

for I

nves

tmen

t C(b

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mai

ning

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mm

itmen

t)

Rem

aini

ngco

mm

itmen

taf

ter D

D #

3

Inve

stor #

110

020

.00%

25.0

0%50

5016

.67%

2525

16.6

7%25

0

Inve

stor #

210

020

.00%

25.0

0%50

5016

.67%

2525

16.6

7%25

0

Inve

stor #

310

020

.00%

25.0

0%50

5016

.67%

2525

16.6

7%25

0

Inve

stor #

410

020

.00%

25.0

0%50

5016

.67%

2525

16.6

7%25

0

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stor #

5*(E

xcus

ed In

vesto

r)10

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.00%

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100

33.3

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.33%

500

Tota

l50

010

0.00

%10

0.00

%20

030

010

0.00

%15

015

010

0.00

%15

00

ACCOUNTING SERIES: LESSON 1 | THE IMPORTANCE OF ALLOCATIONS AND ALLOCATION RULES IN PRIVATE EQUITY ACCOUNTINGACCOUNTING


• The second, and probably mostimportant, reason is that if there areexcused investors opting out of aparticular investment, whendistributing the proceeds of thatinvestment, it wouldn’t be fair togive a share of the distribution tothe investors that have opted out ofthat investment. Therefore a by-commitment allocation rule for thatdistribution wouldn’t be anappropriate allocation rule. A muchmore appropriate allocation rule inthis case would be a specificallocation rule, often called ‘by-sharing-percentages’, whichbasically means using thepercentages that have been usedfor the original drawdown for thatspecific investment. An example ofhow the specific by-sharing-percentages work is shown in Table 3.

Bottom line, where there is a relevantjustification of the costs involved, thebest way of allocating a share of thefund NAV to each investor is on atransaction-by-transaction basis using aproper private equity specialistplatform/accounting system.

Imagine a fund with a complex structureof allocation rules, using:

1) the by-remaining-commitment rule forinvestment drawdowns;

2) the by-commitment rule for expenses drawdowns;

3) the by-commitment-except-for-GP/FPrule for management fee/ PPSdrawdowns; and

4) the by-sharing-percentages fordistributions and income and gains and by-commitment rule for expenses.

How would you do that if you areusing an Excel-based accounting – by

What is the best way of doingallocations?

ACCOUNTING SERIES: LESSON 1 | THE IMPORTANCE OF ALLOCATIONS AND ALLOCATION RULES IN PRIVATE EQUITY ACCOUNTING ACCOUNTING

Q4 | 2012 21

Tabl

e 3:

Dra

wdo

wns

with

an

opt-o

ut u

sing

by-re

mai

ning

-com

mitm

ent a

lloca

tion

rule

and

dist

ribut

ions

by

spec

ific/

shar

ing

perc

enta

ges

* In

vesto

r #5

is an

Exc

used

Inve

stor o

ptin

g ou

t fro

m In

vestm

ent A

.

Spec

ific

shar

ing

perc

enta

ges

for I

nves

tmen

t AD

istrib

utio

n of

pro

ceed

sfro

m In

vestm

ent A

Spec

ific

shar

ing

perc

enta

ges

for I

nves

tmen

t BD

istrib

utio

n of

pro

ceed

sfro

m In

vestm

ent B

Spec

ific

shar

ing

perc

enta

ges

for I

nves

tmen

t CD

istrib

utio

n of

pro

ceed

sfro

m In

vestm

ent C

Inve

stor #

125

.00%

100

16.6

7%50

16.6

7%33

Inve

stor #

225

.00%

100

16.6

7%50

16.6

7%33

Inve

stor #

325

.00%

100

16.6

7%50

16.6

7%33

Inve

stor #

425

.00%

100

16.6

7%50

16.6

7%33

Inve

stor #

5*(E

xcus

ed In

vesto

r)0.

00%

033

.33%

100

33.3

3%67

Tota

l10

0.00

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010

0.00

%30

010

0.00

%20

0

Com

mitm

ent

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enta

ges

byco

mm

itmen

t

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uste

d (fo

rth

e Ex

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dIn

vesto

r #5)

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omm

itmen

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rcen

tage

s

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wn

(DD

) #1

for

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stmen

t A

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aini

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ter D

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1

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ges

by R

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ning

com

mitm

ent

afte

r DD

#1

DD

#2

for

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stmen

t B(b

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ning

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mm

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t)

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aini

ngco

mm

itmen

taf

ter D

D #

2

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enta

ges

by R

emai

ning

com

mitm

ent

afte

r DD

#2

DD

#3

for

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stmen

t C(b

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ning

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mm

itmen

t)

Rem

aini

ngco

mm

itmen

taf

ter D

D #

3

Inve

stor #

110

020

.00%

25.0

0%50

5016

.67%

2525

16.6

7%25

0

Inve

stor #

210

020

.00%

25.0

0%50

5016

.67%

2525

16.6

7%25

0

Inve

stor #

310

020

.00%

25.0

0%50

5016

.67%

2525

16.6

7%25

0

Inve

stor #

410

020

.00%

25.0

0%50

5016

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16.6

7%25

0

Inve

stor #

5*(E

xcus

ed In

vesto

r)10

020

.00%

0.00

%0

100

33.3

3%50

5033

.33%

500

Tota

l50

010

0.00

%10

0.00

%20

030

010

0.00

%15

015

010

0.00

%15

00

simply allocating the general ledger(GL) account balances? Do you thinkthat this will give you the desired resultand each of your investors will receivean accurate allocation of each item ofassets, liabilities, net income andcapital gains/losses? Some investorswould probably not undertake suchdetailed checking, but it is a potentialrisk which you probably wouldn’t like totake in the current fundraisingenvironment. This is precisely why moreand more investors make sure that aGP’s systems and processes, includingtheir accounting systems andmethodologies, are reliable. Beprepared for some investors askingchallenging questions about yourprocedures, including ones aboutallocating fund NAV. If in doubt, now isthe best time to look into yourprocesses and consider using moresophisticated methods and systems.Doing that would probably also be agood move in the broader context ofthe Alternative Investment FundManagers Directive’s (AIFMD)requirements in Europe, effective fromJuly 2013 and the increased scrutiny bythe Securities and ExchangeCommission (SEC) in the US and theirupcoming examinations of registeredadvisers by their National ExamProgram (NEP) division.

Since the allocations are not subject toaudit and auditors would not typicallylook into them as part of the annualaudit, although it’s my personal opinionthat they should be made part of it, aquick tip for reviewers of fund accountsis to ask the preparer of the accountsto run a report, provided that they areusing a proper specialist private equityaccounting platform, provinginformation on what allocation ruleshave been used for each transaction.The simplest thing to do is to run a GLfor the period under review and simply add an extra column showingthe allocation rule used for eachtransaction on the GP. If the reviewer is aware of the allocation rules

provided in the LPA, it should takehim/her just a few minutes to skimthrough the GL to make sure that the right allocation rules have beenused by the preparer of the accounts.In the case of Excel-based accounting,for a complex allocation model, I believe that it would be difficult to provide a reliable proof even if you have good enough Excelmodelling skills to be able to relativelyaccurately do the allocations. Again,this comes back to the benefits ofhaving a proper specialist privateequity accounting platform.

ACCOUNTING SERIES: LESSON 1 | THE IMPORTANCE OF ALLOCATIONS AND ALLOCATION RULES IN PRIVATE EQUITY ACCOUNTINGACCOUNTING


Where there is ajustification of the costs

involved, the best way ofallocating accurately a

share of the NAV toeach investor is on a

transaction-by-transactionbasis using a proper PE specialist platform.

Referring to well-establishedmethods used by macro-economists, this article discusses a

novel approach to capturing the riskprofile of a private equity portfolio.

The PERACS Risk CurveTM constitutes anovel approach to capturing the riskprofile of private equity portfolio bymeasuring the distribution of relativeperformance across all investments madeby a fund manager. The approach israther simple: it compares the cumulativeprofits generated by a certain sub-set ofthe portfolio to the size of this sub-set. Inother words, it measures to what extentthe worst, say, 20 percent of all dealsare responsible for contributing less than20 percent of all profits. Based on thisintuition, a performance-distribution curveis drawn to calculate a coefficient thatnumerically captures the shape of thiscurve. This makes it possible tographically and quantitatively comparethe risk profile of different private equityportfolios in a novel and insightful fashion.

Many of the commonly used approachesto capture the risk profiles of a private

equity portfolio are: relatively simplistic(consideration of simple loss ratios);unsuitable for private equity due to aviolation of the underlying modelassumptions by the characteristics ofprivate equity (all analyses based on thecapital asset pricing models (CAPM) or a‘beta-logic’); or tend to becomputationally complex and difficult tointerpret intuitively.1 Drawing on a well-established method used bymacroeconomists, we propose a novelapproach to capturing the risk profile of aprivate equity portfolio based on arelatively simple calculation. First, calculatethe profit contribution (either in terms ofsimple dollars or any other currency or interms of net present value (NPV)) of eachinvestment in a private portfolio:

Profit contribution = cash received by investors minusthe capital paid by investors

or

NPV of profit contribution =present value of the cash flowsreceived by investors minus thepresent value of the capital paidby investors

Based on this, we can plot theequivalent of the Lorenz curve used ineconomics as a graphicalrepresentation of the cumulativedistribution function of the empiricaldistribution of profits. The correspondingPERACS Risk CurveTM shows the

Introduction

The PERACS Risk CurveTM – A novelapproach to capturing the risk profileof a private equity portfolioBy Prof. Oliver Gottschalg of HEC Paris and PERACS PE Fund Analytics and Track Record Certification

Q4 | 2012 23

PE PORTFOLIOS & PM

1 For example of the latter point, refer to the paper co-authored by Joost Driessen, Tse-Chun Lin and Ludovic Phalippou entitled A New Method to Estimate Riskand Return of Non-traded Assets from Cash Flows: The Case of Private Equity Funds (February 14, 2011). Journal of Financial and Quantitative Analysis(JFQA), Forthcoming; Available at SSRN: http://ssrn.com/abstract=965917).

THE PERACS RISK CURVETM – A NOVEL APPROACH TO CAPTURING THE RISK PROFILE OF A PRIVATE EQUITY PORTFOLIO

proportion of total profits assumed bythe bottom y percent of the investments.In economics, this approach is primarilyused to represent income or wealthdistribution, where it shows for thebottom x percent of households in aneconomy, what percentage y percentof the total income or wealth they have. The percentage of investments isplotted on the x-axis, the percentage ofprofits on the y-axis. This approachgoes back to the seminal work by MaxO. Lorenz in 1905 on the inequality ofthe wealth distribution.

Every point on the PERACS Risk CurveTM

corresponds to a statement such as ‘thebottom 40 percent of all investments inthe portfolio represent 30 percent of the

portfolio profits’. A perfectly equal profitdistribution would be one in which everyinvestment generated the same profit (inabsolute terms). In this case, the bottom‘N’ percent of investments wouldcumulatively always have ‘N’ percent ofthe profits which would generate aPERACS Risk CurveTM with straight line‘y’ = ‘x’, often called the ‘line of perfectequality’. By contrast, a perfectlyunequal profit distribution would be onein which one investment generated allthe income and all others generatednone. In that case, the PERACS RiskCurveTM would be ‘y’ = 0 for all ‘x’ <100 percent, and ‘y’ = 100 percentwhen ‘x’ = 100 percent, also called the‘line of perfect inequality’.

For a population of size n, with asequence of values yi, i = 1 to n, that areindexed in non-decreasing order (yi ≤yi+1), the PERACS Risk CurveTM is thecontinuous piecewise linear functionconnecting the points (Fi, Li), i = 0 to n,where F0 = 0, L0 = 0, and for i = 1 to n:

Fi = i/n

Si = ∑ij=1 yj

Li = Si/Sn

A PERACS Risk CurveTM curve alwaysstarts at (0,0) and ends at (1,1). It isdesigned to be independent of theabsolute amount of profits generatedby the portfolio, so that it makes it

possible to compare risk profiles ofdifferent private equity fundsindependent of their returns.

If there are investments in the portfoliothat generate a negative profit, that is,cash received is less than cash invested,then the curve will initially be downwardsloping (at a decreasing slope), until itreaches the vertex with the firstinvestments with profits >= zero and thenstarts to increase at an increasing slope.Figure 1 shows the PERACS Risk CurveTM

of a Typical PE Fund PERACS RiskCurveTM for a sample private equityportfolio of 79 investments.

By comparing the PERACS Risk CurveTM

for different private equity portfolios,investors can easily and intuitively assessand compare their risk attributes. Alonger curve represents a larger part ofthe deals that are required to(cumulatively) reach a breakeven pointat which the curve crosses the horizontalaxis. A deeper curve below thehorizontal axis represents largercumulative losses (relative to thecumulative profits of all investments) andoverall a more exponential shapeindicates that profits are concentrated ina low number of investments.

It is important to point out that privateequity investors may differ in theirpreference for different shapes of thePERACS Risk CurveTM. While somelimited partners may favour fund

PE PORTFOLIOS & PM


Figure 1: PERACS Risk CurveTM of a Typical PE Fund PERACS Risk CurveTM for a sample private equity portfolio

Source: PERACS LP.

Perc

ent

-20

60

20

100

0

80

40

Number of transactions

Capital impaired

Profit contributors

Vertex

By comparing thePERACS Risk CurveTM

for different privateequity portfolios,

investors can easilyand intuitively assessand compare their

risk attributes.

THE PERACS RISK CURVETM – A NOVEL APPROACH TO CAPTURING THE RISK PROFILE OF A PRIVATE EQUITY PORTFOLIO PE PORTFOLIOS & PM

managers that systematically generatemoderate levels of return with little loss-making deals, others may invest inprivate equity to find deals that canmove the needle in their overallportfolios and prefer fund managers thatfind big hits and may tolerate somelosses at the same time.

The shape of the PERACS Risk CurveTM

can be quantified in the PERACS RiskCoefficientTM which is a refinement of theso-called Gini coefficient developed bythe Italian statistician and sociologistCorrado Gini and published in his 1912paper entitled Variability and Mutability.The Gini coefficient is used byeconomists to express the area betweenthe line of perfect equality and anygiven Lorenz curve as a percentage ofthe area between the line of perfectequality and the line of perfectinequality. The higher the coefficient, themore unequal the distribution is.

The PERACS Risk CoefficientTM iscalculated in analogy of the method tocalculate the Gini coefficient foreconomies with individuals of negativenet wealth developed in The GiniCoefficient and Negative Income byChau-Nan Chen, Tien-Wang Tsaur and

Tong-Shieng Rhai.2 Figure 2, adjustedfrom the Chen et al (1982) paper,illustrates the case of a portfolio withloss-making deals.

The PERACS Risk CoefficientTM can beintuitively understood and the followingrationale of different areas in this chart:

PERACS Risk CoefficientTM = (A + B)/(A + B + C)

As Chen et al (1982) point out, the area(A + B) is also referred to as the “area ofconcentration” whereas area C is an“area of equalization”. In a portfoliowithout loss-making deals, (B + C) equala size of (1/2) and the PERACS RiskCoefficientTM = (B/2), which is identicalwith the simple Gini coefficient. Table 1show results for PERACS Risk CoefficientTM

for different (non-negative) profitdistribution functions as reference points.

In summary, we have proposed analternative to existing approaches tocapturing the risk profiles of a privateequity portfolio, which can be easilycalculated and intuitively interpreted

and is suitable for the particularcharacteristics of the private equityasset class. Drawing on two well-established methods used bymacroeconomists – the Lorenz Curveand the Gini coefficient – we plot theprofit distribution of private equityportfolios as PERACS Risk CurveTM andquantify the shape of this curve asPERACS Risk CoefficientTM to allowinvestors to easily express and comparekey risk attributes across differentprivate equity portfolios.

Based on this measure, private equityfund managers will be better able toshowcase performance dispersion inthe portfolios, and hence a key elementof risk, in an accurate, standardised,insightful and intuitive fashion. Oncedata is available on PERACS RiskCoefficientTM for a larger set of privateequity funds, there is a chance toestablish a risk-return paradigm forprivate equity that may fulfill a rolecomparable to that of the CAPM forother asset classes.

Conclusion and implications

Q4 | 2012 25

Table 1: PERACS Risk CoefficientsTM for different (non-negative) profit distributionfunctions

Profit function PERACS Risk Coefficient

y = 1 for all x 0.000

y = log(x) 0.130

y = x 0.138

y = x½ 0.194

y = x + b (b = 10% of max Profit) 0.273

y = x + b (b = 5% of max Profit) 0.297

y = x 0.327

y = x2 0.493

y = x3 0.592

y = 2x 0.960

Figure 2: A portfolio containing loss-making deals

Source: Adjusted from Chen et al (1982).

Cum

ulat

ive

prof

its

y2

y1

y3

y4

y5

y6

y7

y8

Investments

1/8 2/8 3/8 4/8 5/8 6/8 7/8 8/8

A

BC

2 Oxford Economic Papers, New Series, Vol. 34, No. 3 (Nov., 1982), pp. 473-478.

Professor Oliver GottschalgHEC Paris & Co-Founder & Headof Research, PERACS PE Analyticsand Track Record Certification


We consider n deals and write Yj for the profit of the jth dealwhich is to be ordered from lowest to highest:

(1)

Some of Yj can be negative, but the total profit is positive:

(2)

and so is the mean:

(3)

Then the Gini coefficient may be defined as:

(4)

where is the mean difference.

Write as the profit share of the jth deal. (4) can thenbe expressed as:

(5)

It goes without saying that y1 ≤ y2 …≤ yn and that .

Expanding (5), we have:

(6)

where k is defined in such a way so that .

We are now ready to examine the range of the coefficient.The minimum value is obviously zero, which is attained whenevery deal contributes its proportional share of the total profitso that yj = 1/n for all j. If one deal represents all the profitand the other deals together represent nothing at all, so that:

(6) reduces to:

(7)

If profits are non-negative, so that yj = 0 for j < n, and if thenumber of deals, n, becomes greater and greater, Gapproaches one. However, if negative profits are present, sothat yj 0, then G may exceed unity, for, with yj 0, it isapparent that:

In general, G 1 depends on:

(8)

Y1 # Y2 # f #Yn

Yj > 0n

1∑

µ = Yj/n > 0n

1∑

G = M/2µ

M = (2/n2) (Yj - Yi)n

j =1

∑i < j ∑

yj = Yj/nµ

G = (yj - yi)n1` j

n

j=1

∑i< j∑

yj =1n

1

∑

G = ((y2 - y1) + (y3 - y1) + (y4 - y1) + ... + (yn - y1) + (y3 - y2) + (y4 - y2) + ... + (yn - y2) + (y4 - y3) + ffff h + (yn - yn - 1))

n1` j

= yj(2j - (n +1))n1` j

n

1

∑

= yj(n -1- 2(n - j))n1` j

n

1

∑

= 1- yj(1 + 2(n - j))n1` j

n

1

∑

= 1+ jyj - yj (1 + 2(n - j))n2` j

k

1

∑ n1` j

n

k+1

∑

yj = 0k

1

∑

k = n -1, yn = 1, yj = 0n-1

1

∑

G = 1- + jyj n1 n-1

1

∑n2` j

jyj > 0n-1

1

∑n2` j

jyj yj (1 + 2(n - j))n2` j

k

1

∑ n1` j

n

k+1

∑><

THE PERACS RISK CURVETM – A NOVEL APPROACH TO CAPTURING THE RISK PROFILE OF A PRIVATE EQUITY PORTFOLIOPE PORTFOLIOS & PM


Appendix: Extract from The Gini Coefficient and Negative Income by Chau-Nan Chen, Tien-Wang Tsaur andTong-Shieng Rhai

Source: Chau-Nan Chen, Tien-Wang Tsaur and Ton-Shieng Rhai, Oxford Economic Papers, New Series, Vol. 34, No. 3 (November 1982), pp. 473–478.

Comparing the key business and legal terms of a sample of post-2009 US and European

buyout funds and how they comparewith recommendations in the ILPA Guidelines.

In the wake of the global financial crisis,limited partners (LP) have enjoyed asignificant increase in their negotiatingleverage as capital available for newfunds has dwindled at a faster pacethan the number of general partners(GP) pursuing that capital. One of thekey embodiments of this greater LPnegotiating clout can be found in theInstitutional Limited Partners Association’sPrivate Equity Principles (ILPA Guidelines)published in September 2009 andupdated in January 2011, which seek toprovide a set of globally recognisedindustry guidelines.

While it is clear that LPs are betterplaced today to demand more investor-friendly terms than they were five yearsago, the impact that this has had onmarket practice with respect to variousindividual fund terms is not immediatelyapparent. Funds are not being raised

that apply the ILPA Guidelines wholesale(and indeed the ILPA Guidelines areclear that such an approach is notintended), but funds are generallyunable to maintain the same terms thatthey may have secured in 2007. Sowhere is the market today?

Although we do not purport to have adefinitive answer to that question,Debevoise & Plimpton LLP doesmaintain a proprietary database thattracks over 50 key business and legalterms in approximately 2,000 funds(Debevoise IMG Database). Byexamining a sampling of 24 US buyoutfunds and 28 Western Europeanbuyout funds from this database, ineach case raised since 2009, thisarticle seeks to highlight the general

Introduction

How the game is changing: Shifting terms and conditions in private equity fundsBy Geoffrey Kittredge and John W. Rife III, Debevoise & Plimpton LLP1

Q4 | 2012 27

LEGAL

1 Geoffrey Kittredge is a partner, and John W. Rife III is an associate, in the Investment Management Group of Debevoise & Plimpton LLP. Copyright© 2012Debevoise & Plimpton LLP. All Rights Reserved.

While it is clear that LPs are betterplaced today todemand more

investor-friendly termsthan they were five

years ago, the impactthat this has had onmarket practice withrespect to various

individual fund termsis not immediately

apparent.

prevalence of certain terms in the post-global financial crisis era in two distinctmarkets and to compare those generaltrends with the recommendationscontained in the ILPA Guidelines. Thefunds in the US sample range in sizefrom approximately $150 million toover $4 billion in commitments,including two funds under $500 million,

nine funds between $500 million and$1 billion and 13 funds over $1 billion.The funds in the European samplerange in size from approximately $200million to over $8 billion incommitments, including 12 funds under$500 million, nine funds between $500million and $1 billion and seven fundsover $1 billion.

Although the 20 percent carried interestrate remains the standard in privateequity, we have seen increased LPscrutiny of the so-called distribution‘waterfall’, that is, the way in whichcapital is returned to LPs and GPs.European funds have traditionally offereda ‘return-all-contributions-first’ waterfall,while US counterparts have employed a‘realised-deals-to-date’ waterfall, which iscommonly referred to as ‘deal-by-deal’.Despite this scrutiny and the clearendorsement by the ILPA Guidelines of areturn-all-contributions waterfall, the statusquo has largely been retained in thepost-global financial crisis era and westill see a majority of US fundssucceeding in retaining the deal-by-dealwaterfall while European funds generallycontinue to offer a return-all-contributionswaterfall (see Figure 1).

Where a fund employs a deal-by-dealwaterfall, the ILPA Guidelines contain anumber of recommendations to“enhance” that model, includingproviding for an interim carried interestclawback, triggered both at regularintervals and upon specific events (suchas a key-person event). Despite theserecommendations, interim clawbacksremain rare in both the US and Europe(see Figure 2).

LPs are increasingly pressing the GP tocatch-up to its share of carried interestfollowing the satisfaction of the preferredreturn at a rate slower than 100 percent.While the majority of both US andEuropean funds retain a 100 percentcatch-up rate, there is greater variation inthe approach among the Europeanfunds in our sample (see Figure 3).

In the US and Europe, LPs are focusedon the protections they receive to

Distributions

Carried interest clawbackprotections

HOW THE GAME IS CHANGING: SHIFTING TERMS AND CONDITIONS IN PRIVATE EQUITY FUNDSLEGAL


Figure 1: Distribution waterfall provisions in sample US and European funds

Source: Debevoise IMG Database.

% o

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Deal-by-deal Return all contributions

US buyout funds (24)European buyout funds (28)

Figure 2: Frequency of carried interest clawback operation in sample US and European funds


% o

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Interim End of term only


Figure 3: Catch-up rates in sample US and European funds


% o

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50% 100%60% to 66% 80%Catch-up percentage to the carried interest partner


address the potential for an over-distribution of carried interest. In additionto ensuring that the carried interestclawback is drafted in an effectivemanner, LPs are also focused onbackstop protections to ensure that anycarried interest clawback obligation willbe satisfied in the event that the GP itselfhas insufficient assets to do so. Thisbackstop protection generally takes theform of either a guarantee or thepayment of a certain amount of carriedinterest into an escrow account.

The clawback-guarantee approach ismore prevalent in US funds than inEuropean funds. Where a guarantee isoffered, LPs are increasingly requestingthat the clawback obligation beguaranteed on a joint-and-several basisby each of the individual carryrecipients. Despite this pressure, joint-and-several guarantees remain rare in bothUS and European funds (see Figure 4).

European funds are much more likely toprovide for a percentage of carriedinterest distributions to the GP to be paidinto an escrow account for the purposeof satisfying any clawback obligationsthat may arise (only three of the 24 USfunds in the sampling included anescrow account). The ILPA Guidelinessuggest that, where an escrow accountapproach is used, at least 30 percent ofthe carried interest distributions to the GPshould be deposited in that account. Infact, we are seeing the majority ofEuropean funds agreeing to escrowmore than 30 percent, despite theinherent clawback protections that arisefrom the general trend of these funds toemploy return-all-contributions waterfalls(see Figure 5).

In addition to LP attention to the carriedinterest clawback, there is also increasedpressure to limit the all-partner givebackthat applies in the event that distributionsreceived from a fund are required to be

returned to enable the fund to satisfy itsliabilities, such as a claim from a partythat is indemnified pursuant to the funddocuments or a liability to a third partyarising in connection with an exitedportfolio investment. While the inclusionof an all-partner giveback has long beencommon practice in US funds, theseprovisions have been less prevalent inEuropean funds. This continues to be

reflected by the larger proportion of USfunds that still provide for an all-partnergiveback, although a majority ofEuropean funds also include suchgiveback provisions today (see Figure 6).

Though all-partner giveback provisionsare common, the approach tocalculating the maximum amount thatcan be required to be returned to the

All-partner givebacks

HOW THE GAME IS CHANGING: SHIFTING TERMS AND CONDITIONS IN PRIVATE EQUITY FUNDS LEGAL

Q4 | 2012 29

Figure 4: Carried interest clawback guarantees in sample US and European funds


% o

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None Joint and severalSeveral


Figure 5: Escrow arrangements – percentage of distributions held in escrow in sample US and European funds


% o

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< 30% > 30%30%


Figure 6: All partner giveback provisions in sample US and European funds


% o

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No Yes


HOW THE GAME IS CHANGING: SHIFTING TERMS AND CONDITIONS IN PRIVATE EQUITY FUNDS

fund and the period of time duringwhich distributions received can berequired to be returned are heavilynegotiated. As a result, both US andEuropean funds reflect an array ofapproaches to determining the cap on

the all-partner giveback obligations andthe period of time during which thoseobligations endure.

In terms of the maximum amount ofdistributions subject to the all-partner

giveback, US and European funds tendto determine this amount by: i)reference to a specific percentage ofeach partner’s commitment; or ii) aformula that specifies an amountdetermined as the lesser of a specifiedpercentage of each partner’scommitment and a specifiedpercentage of distributions received byeach partner. The exact percentagesare subject to negotiation and vary, buttend not to exceed 25 percent (seeFigures 7 and 8).

With respect to the time period duringwhich the all-partner giveback may beexercised, funds tend to limit this to eithera specified number of years followingthe date of the fund’s termination, aspecified number of years following thedate of the distribution required to bereturned, or the earlier of a specifiednumber of years following the date ofthe fund’s termination and a specified(typically greater) number of yearsfollowing the date of the relevantdistribution. Although liabilities that maybe required to be satisfied from the all-partner giveback are not always linkedto specific distributions, LPs tend to pushfor distribution-linked time limits, whichprovide earlier certainty that all of adistribution may be retained, distributedto their investors or deployed in adifferent investment, and as LPnegotiating power has increased, anumber of funds have acquiesced to thatpressure (see Figure 9).

Despite the shift in negotiating power infavour of LPs and the ILPA Guidelinesrecommendations with respect tomanagement fees, there has not beenwidespread pressure to change theheadline 2 percent of commitments feelevel during a fund’s investment period.As a general matter, LPs are regularlyrequesting lower fee rates and, in someinstances, GPs are agreeing. Consistentwith market practice before the global

Management fees

LEGAL


Figure 7: Cap on all-partner giveback amounts (source basis) in sample US and European funds


% o

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Based oncommitments

Based on lesserof % commitmentsand % distributions

Based on distributions


Figure 8: Cap on all-partner giveback amounts (percentage basis) in sample US and European funds


% o

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< 25% > 25%25%


Figure 9: Time limit on all-partner giveback obligations – reference date – in sample US and European funds


% o

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5

2530354045

15

Date of relevantdistributions

Earlier of periodafter relevant distribution

and termination

Date oftermination


financial crisis, larger funds are underpressure to charge less than 2 percenton the basis that operational expensesare not linearly correlated to fund size. InEuropean funds, we have seen thispressure on funds with aggregatecommitments in excess of $1 billion,while US funds in the sampling havebeen more successful in retaining the 2percent rate until size nears the $2billion mark (see Figure 10).

Pressure has been more intense on thefee rate applicable following the end ofthe investment period, and this isespecially noticeable in US funds wherewe see over half agreeing to a lowerrate during this period (see Figure 11).

While pressure on headline fee rates hasbeen less intense, there has been amarked increase in LP focus on ‘specialdeals’ for LPs committing to a fund early

in its fundraising process and for LPscommitting a substantial percentage of afund’s target size. Where GPs offer anincentive to LPs participating in a fund’sfirst close (a so-called ‘early-birddiscount’), we typically see such anincentive take the form of a 5-to-10percent reduction in the headlinemanagement fee rate. These early-birddiscounts present risks for GPs in that LPscommitting at a later stage will oftenpress to receive the benefit of at least aportion of that discount. Agreeing tosuch a request risks disrupting relationswith the LPs committing at the firstclosing; refusing such a request riskscompromising a fund’s ability to raisecapital at subsequent closings.

Management fee discounts for LPscommitting a substantial percentage of afund’s target size are more varied, withthe trigger percentage (or percentages,

where a number of increasingly deepdiscounts are offered to LPs committingincreasingly large amounts) varyingwidely depending on a number offactors relating to the GP and itsparticular market.


Q4 | 2012 31

Figure 10: Management fee during investment period by fund size – all funds

Source: Debevoise IMG Database.%

of c

apita

l com

mitm

ents

0

2.0

1.0

3.0

0.5

2.5

1.5

0 500 4000+1000 1500 2000Fund size ($ m)

2500 3000 3500

US buyout fundsEuropean buyout funds

Figure 11: Post-investment period percentage rate in sample US and European funds


% o

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Same % as duringinvestment period

Lower % than duringinvestment period


Consistent with marketpractice before the

global financial crisis,larger funds are underpressure to charge lessthan 2 percent on thebasis that operational

expenses are notlinearly correlated to

fund size.


An alternative that we have seen someGPs implement to attempt to addressthe imperfections with the early-birddiscount and size-based discountapproaches is to offer a managementfee rate applicable to all LPs that varies depending on the aggregateamount of commitments to the fund

(with the overall rate decreasing as theamount of aggregate commitmentsincreases). This creates a more naturalalignment of interests among the LPs(and between LPs and GP) with respect to the fundraising process,although may still leave certain LPs thatare committing larger amounts feeling

as if other LPs are piggybacking ontheir commitments.

While focus on the traditional 2 percentmanagement fee rate has beeninconsistent following the global financialcrisis, pressure to offset transaction feesearned by the GP against managementfees has been intense. The ILPAGuidelines identify GP wealth creationfrom transaction fees and other fees asbeing a source of misalignment of interest.Historically, US funds have retained alarger portion of transaction fees thanEuropean funds and this remains the casetoday, but LP pressure has resulted in themajority of US funds in the samplingoffsetting at least 80 percent oftransaction fees and a clear majority ofEuropean funds offsetting 100 percent oftransaction fees (see Figure 12).

Another key issue in LP negotiationsrelates to the amount and source of aGP’s commitment to its fund. The ILPAGuidelines suggest that “a GP’s owncapital at risk serves as the greatestincentive for alignment of interest.” LPfocus on GP commitments involve twokey aspects: i), LPs investing in both USand European funds increasingly pushGPs to invest a greater proportion ofaggregate fund size; and ii) LPsincreasingly push GPs to fund all oftheir commitment in cash (rather thanpartly through a reduction in, or offsetagainst, the management fee). In ourexperience, European GPs tend tocommit 1 percent of a fund’s total size,whereas US GPs are more likely tocommit in excess of 2 percent. In theUS, a majority of GPs partly fund thesegenerally larger commitments by wayof a management fee reduction. InEurope a significant majority of GPsfund their commitment entirely in cash(see Figures 13 and 14).

Sponsor commitments

Transaction fees

LEGAL


Figure 12: Transaction fee sharing in sample US and European funds


% o

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50% 100%60% to 75% 80% to 90%Transaction fee offset rates


Figure 13: Size of GP commitment as percentage of total capital commitments in sample US and European funds


% o

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< 1% > 2%1% 1+% to 2%


Figure 14: Method of funding GP commitment in sample US and European funds


% o

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All cash Cash and managementfee reduction


In the post-global financial crisis era, LPsare also focusing on their protections inthe event that there is a breakdown in therelationship between the GP and its LPs.While it is standard to provide for the GPto be removed in situations where it hasbeen finally determined by a court thatthe GP engaged in ‘for-cause’ behaviour(such as fraud or criminal activities), thereis a broader range of potentialprotections available to LPs to negotiatethat can be exercised at any time.

The first is a right for a fund’s LPs toremove the GP without the need for acourt to determine the GP’s conduct hasamounted to ‘for-cause’ behaviour. Thisno-fault removal right is uncommon in USfunds. European funds are more likely toinclude such a right, typically exercisableby 75 percent or more in interest of theLPs (see Figure 15).

An alternative approach is a right for theLPs to elect to instigate the dissolution ofa fund. The ILPA Guidelines suggest thatwhere such a right is included, it shouldbe exercisable by 75 percent in interestof the LPs. Such a right is relatively rarein European funds, but more common inUS funds. Where such a right is agreed,US funds are more likely to require avote of more than 75 percent in interestto trigger the dissolution than theirEuropean counterparts. No-fault removaland no-fault dissolution rights are

occasionally triggered by a lowerpercentage, although where this is thecase it is often to accommodate a GP’sfinancial account deconsolidationconsiderations (see Figure 16).

A third, less permanent, option is for LPs toinsist on a right to elect to suspend thecommitment or investment period, a rightwhich is also less common in European

funds. In the US funds that we see withsuch a right, the threshold vote required totrigger such a suspension tends to behigher than the 66.6 percent in interest LPvote that the ILPA Guidelines recommend,typically requiring a vote of 75 percent ormore in interest of the LPs (see Figure 17).

Considering these no-fault protectionsmore broadly, the majority of European

Investor protections


Q4 | 2012 33

Figure 15: No-fault GP removal rights in sample US and European funds


% o

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None 75% or higher vote66.66% vote


Figure 16: No-fault dissolution rights in sample US and European funds


% o

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None > 75% vote< 75% vote 75% vote


Figure 17: No-fault suspension of commitment period rights in sample US and European funds


% o

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None 80%+ vote66.66% vote 75% vote



funds are likely to agree to the inclusionof one such protection for LPs, whereasUS funds in contrast reflect a morediverse approach to no-fault protections(see Figure 18).

In addition to these no-fault protections, LPsare also very focused on the protectionsincluded in a fund’s partnershipagreement in the event that there is asignificant change to the senior investmentteam, commonly referred to as the ‘key-person’ provision. While the precise eventthat is required to trigger a fund’s key-person provision is unique to the GP andits team, if the key-person provision istriggered, a fund’s investment periodgenerally is either automaticallysuspended or the GP is required to put asuspension of the investment period to avote of the LPs. US funds have traditionallyleaned towards the latter formulation whileEuropean funds have tended towards theformer. Following the global financial

crisis, European funds continue to providefor automatic investment-period suspensionand there is a trend towards the sameformulation in US funds (see Figure 19).

Although it is tempting to make broadgeneralisations about market practice inthe post-global financial crisis period, it isdifficult to do so accurately. While ourdata indicates certain trends in both theEuropean and US markets, this data isbased on a finite sampling. Theappropriate terms for any individual fundare primarily a function of a range offactors unique to that fund and its GP,such as whether it is a first-time fund, thespecific LPs that it is targeting, its trackrecord and the level of competition that itfaces, and to a much lesser extent afunction of ‘common’ practice in thegeography in which it will operate.

Conclusion

LEGAL


Figure 18: Number of no-fault removal, suspension and termination provisions adopted per fund in sample US and European funds


% o

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None 31 2


Figure 19: Key-person provisions in sample US and European funds


% o

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Automatic Triggered by a vote


Geoffrey KittredgePartner, Debevoise & Plimpton


John W. Rife IIIAssociate, Debevoise & Plimpton


Although it is temptingto make broad

generalisations aboutmarket practice in thepost-global financial

crisis period, it is difficultto do so accurately.

Debevoise is one of the world’s leading providers of legal services to private

equity firms and their investment funds, portfolio companies and individual

partners. The firm’s private equity funds practice is one of the largest in the

world, whether measured by the number of funds, total committed capital or

resources devoted to private equity fund formation. Debevoise is also a leader in

private equity M&A, renowned for crafting innovative solutions for some of the

largest and most complex transactions in the industry.

In working with private equity clients, our lawyers take full advantage of

the firm’s international experience, including unrivalled knowledge of fund

structures across the globe, as well as significant experience with private equity

portfolio investments and other minority investments characteristic of funds.

This combination of in-depth knowledge and broad-based experience in the

many different regions in which we operate enables Debevoise to provide “one-

stop shopping” for fund structuring and formation, mergers and acquisitions,

buy-side investments, financing, exits (either strategic sale or IPO) and all other

investment considerations for our private equity clients.

With the experience of over 200 dedicated lawyers worldwide, our private

equity practice has successfully developed a global market leading position.

connectedNew York

Michael P. [email protected]+1 212 909 6349

919 Third AvenueNew York, NY 10022

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about us

The fund-lite structure and otherinnovative fundraising solutionsare becoming appealing

alternative approaches for someinvestors still unsure of taking the blind-pool traditional route.

Since the 2008 financial crisis manyinvestment fund managers, andparticularly new fund managerslaunching their first fund, have found theprivate equity fundraising market to bevery challenging. Without any real clarityon the fundraising outlook and withinvestors remaining reluctant to makenew investments, fund managers areexploring a range of structuring optionsto raise capital to finance newinvestments. This article presents aspecial focus on the popular fund-litedeal-by-deal structure and discussessome of the alternative structures that aregaining market popularity.

Investors now often require visibility ofthe underlying target company beforeinvesting and are reluctant to commit toa blind-pool of capital. Fund-litestructures are not only being used byfirst-time managers to provide a basefrom which to build a track record anda bridge to larger pools of committedcapital, but also by larger more

established managers generally looking to create a bridge until theirnext fundraise.

A fund-lite, which is in many ways similarin structure to a standard private equitylimited partnership, features a generalpartner (GP)/manager managing thefund entity through a managementagreement and a separate carry limitedpartnership to reward the manager(through which the carried interest wouldbe paid, de facto deal-by-deal as thereis only one investment in a typical fund-lite deal-by-deal structure).

The key differences between a fund-liteand a more traditional blind-pool fundare to be found in the detail of theLimited Partnership Agreement. Thereare some surprisingly beneficial termsfor GPs in these structures, but at thesame time they can also containenticing terms for the fund investors. Theterms can also address some of thecurrent concerns of investors investing

into private equity funds. The keydifferences are discussed below.

1. Shorter life of the fundFund-lites typically have durations of fiveto seven years compared to 10 years fora typical blind-pool fund, as theinvestment period is effectively immediate,with the exception of buy-and-build orventure capital strategies. Investors benefitfrom having their funds tied up for ashorter period of time, creating greatervisibility for future allocations.

Challenging market

The fund-lite structure

Fund-lite and other alternativestructures for private equity fundraisingBy Matthew Hudson and Ross Manton, MJ Hudson

Q4 | 2012 37

LEGAL

Investors benefit fromhaving their funds tied

up for a shorterperiod of time,

creating greatervisibility for future

allocations.

2. Reduced scope of the investmentobjectiveA fund-lite is formed to invest in a singlecompany, and the scope of the fund’sinvestment objective will be limited to thespecified target company. This is a keydifference as the fund investor will knowfrom the outset the identity of the targetcompany that the fund will be investing in.Having a clear view of the targetcompany, therefore, serves to reduce partof the risk of investors being unhappy withthe fund’s investment, as may happen in ablind-pool fund. As a result, detailedinvestment objectives of larger blind-poolfunds, which would include the sector,exposure limits and geographic locationsof investments, will not be required.

3. FeesIn a fund-lite arrangement managementfees are only charged on drawn capital.

Investors often oppose fees payable oncommitted (undrawn) capital, which is acommon grievance for investors in thecurrent challenging environment.

4. No key-man clauseAs investors know the identity of thetarget company from the outset, byagreeing to invest in a fund-lite theyexpressly approve the underlyinginvestment in the target company. As aresult, key-man clauses are eitherreduced in scope or removed entirely.

5. No escrow or clawback for carryAs the carried interest is effectively paidon a deal-by-deal basis under the fund-lite model and is only in relation to thetarget company, neither an escrowaccount for any carry retention or aclawback provision is required. As deal-by-deal carry on blind-pool funds has

become increasingly difficult to obtainfrom investors, the fund-lite structure isbeneficial for managers as it rewardsthem for each successful deal.

6. No reinvestment of realised fundsGiven the deal-by-deal nature of thefund-lite, any realisations are distributedto the investors and further reinvestment isgenerally not permitted, save for buy-and-build strategies or certain venturecapital investments.

7. No restrictions on future fundsA manager will also generally be free toraise successive funds following theinvestment. This has the benefit for themanager of being able to seek furtherinvestment opportunities following aninvestment in a target company andallow the manager to raise a series offund-lite structures to build out its

FUND-LITE AND OTHER ALTERNATIVE STRUCTURES FOR PRIVATE EQUITY FUNDRAISINGLEGAL


Figure 1: Example fund-lite structure

Team Investors

On-shore adviser

Off-shoreGP/manager

SPV

Target company

Carrypartnership

Target companylimited partnership

‘deal fund’

Advisory agreementManagement agreement

Limited partners

Limited partner Limited partners

Management agreement

Notes:On-shore adviser • Often formed as a limited liability partnership to house the investment team. • Provide advice to the GP/manager under an advisory agreement.

Off-shore GP/manager• Often formed as a limited company and located in the jurisdiction of the deal fund for regulatory reasons.• Manage the deal fund under a management agreement.

Carry partnership• Generally structured as an off-shore limited partnership vehicle that selected team members will be limited partners of, and through which they will receive

any future carry.• The carry partnership will be a limited partner in the deal fund.

Deal fund• Generally structured as an off-shore limited partnership, through which the investors will provide their commitments, and is managed by the GP/manager. • The investors and the carry partnership will be limited partners.• The deal fund will invest in the target company, either directly or through an SPV following appropriate tax advice.

investment programme or to provide abridge until the next fund.

As discussed above, the fund-litestructure offers managers and fundinvestors a number of advantages, andmore specifically can align many of theinterests of both parties. While thefundraising process for managers on adeal-by-deal basis can be time-consuming when simultaneouslybalancing the related negotiations for atarget company, there are significantadvantages. These advantages include:the opportunity to create a track record;to invest in the best vintages; to cementinvestor relationships; and to enjoybenefits of the deal-by-deal carry.

A limited partnership structure, ratherthan a corporate special purposevehicle (SPV), is preferable for a GP, asinvestors in a corporate SPV can seekto manage or restrict the GP, whereasthey are largely prevented from doingso in a limited partnership structure due to the risk of losing their limitedliability status.

For new and emerging managers thatare seeking to launch first-time funds,fund-lite structures allow managers tolaunch an investment programme in achallenging economic climate such astoday’s. In addition, the managemententities formed as part of the structurewill also form the basis of theirmanagement group for future funds. Atypical fund-lite structure, together withrelated management entities, would bein a similar form as set out in Figure 1:Example fund-lite structure.

In addition to the fund-lite structure, thereare a number of other alternativestructures that can be utilised by privateequity fund managers.

In a pledge fund investors pledgecapital to a manager but do not haveany obligation to provide this capital,subject to certain restrictions. The typicalduration would be shorter than a blind-pool fund (as little as three years) andthe fee structure would includemanagement fees on drawn capital andcertain allowable abort fees. Carry canbe structured on a deal-by-deal basisand investors may also be removed fromthe fund if they opt out of a number ofdeals in a row.

A ‘combo’ fund is similar to a pledgefund, but with a small amount ofcommitted capital, which is then increasedby pledged amounts for each identifieddeal. Fees are on the committed capitalportion and amounts drawn down on thepledge. Carry can be on a fund-as-a-whole basis on the committed capital anddeal-by-deal on the pledge. This structureblends the qualities of a blind-pool fundand a pledge fund.

An aggressive co-invest model is acontract entered into with a managerunder which the investor agrees toinvest in a percentage of a dealselected by a manager, provided themanager can source the outstandingbalance of funding required tocomplete a specified deal.

Annual pools give investors the right toopt out of commitments to a fund eachyear, providing them with greaterflexibility when determining their assetallocations. Typically in such structures,the carry is annualised and managementfees are on annual commitments.

Managed accounts are commonlyassociated with larger institutionalinvestors and hedge funds, however theyare now becoming increasingly commonin the private equity space. In acontractually binding arrangement aninvestor will enter into an agreement witha manager to manage a specifiedamount of capital and to source andmanage investments. A key factor is that

an investor’s funds will always remainsegregated from other investors and theinvestments will be made in the name ofthe investor. The added advantage foran investor is that it may terminate thisrelationship at any time and will havedirect access to any assets.

Top-up funds are suitable where a fundmanager seeks to avoid a largescalesubsequent fundraising process. Aseparate vehicle would be formed toprovide follow-on investments for acurrent fund. These structures willtherefore allow a fund manager tocontinue its existing investment strategy inthe short-to-near term.

Investment clubs are where a group willpay a fee and appoint a team to carryout investments on their behalf. They arecommon in angel investing and are alsomoving up the size curve in the currenttricky markets.

As investors seek access to newgeographies and enhanced returnswithout necessarily the related overexposure of a blind-pool fund, the use of fund-lite structures and otheralternative structures is set to continueduring these uncertain economic times.It is also wise to be thoughtful of limited partners’ needs at all times todevelop and maintain strong investorrelationships for any current or future fundraisings.

Other alternative structures

Fund-lites: Some conclusions

What is on the horizon?

FUND-LITE AND OTHER ALTERNATIVE STRUCTURES FOR PRIVATE EQUITY FUNDRAISING LEGAL

Q4 | 2012 39

Matthew HudsonSenior Partner, MJ Hudson


Ross MantonAssociate, MJ Hudson


With fundraising processesnow taking as long as 18to 24 months to complete,

effective preparation of adifferentiated, well-presented investmentcase has never been so valuable.

Over the last decade, many limitedpartners (LP) have created andmaintained their own comprehensive in-house ‘fund universe’ database. Althougha fund considered an unviable investmentprospect may still be invited for a datacollection meeting, it is clear that generalpartners (GP) without a credibleinvestment case are likely to spend a lotof time and resources on LPs that do notintend to invest. Over 18-24 months, thecosts for some GPs can be substantial.

In today’s challenging fundraisingmarket, securing a meeting is just thebeginning – the real challenge is topresent a credible investment case thatsecures an opportunity to reach thedecision-makers and convince them tocommit the necessary resources to anintensive due diligence process.

Throughout the fundraising process, thepressure is on to present a consistentlycompelling case for investment that doesnot allow LPs to say ‘no’. This article

introduces a number of key areas of bestpractice that GPs could deploy toimprove their fundraising efforts.

As part of large, often under-resourcedorganisations, many institutional LPs aresubject to a variety of requirements,guidelines, policies and responsibilitiesthat are rarely appreciated by GPs. Mostare not solely motivated by a search foroutperformance and are therefore lessexcited by high-return strategies and moreinterested in meeting basic investmentcriteria than GPs might think.

Above all, it is important to make lifeeasy for LPs. Potential investors have

huge demands on their time and limitedpatience with GPs who fail to deliverthe required information when and howit is wanted. Of primary interest to LPsare whether the GP’s team has mademoney in the past and whether it canbe successful again. These answers

Appreciate the audience

Fundraising from pre-marketing todataroom: Thoughts on building acredible investment case forinstitutional investorsBy Sarah Clarke, Foundation Fundraising Services

Q4 | 2012 41

INVESTOR RELATIONS

Potential investorshave huge demands

on their time andlimited patience with

GPs who fail todeliver the required

information.

should be at the centre of anyfundraising campaign.

Further steps to making life easy – andearning valuable goodwill – caninclude, for example, ensuring that thefund’s environmental, social andgovernance (ESG) position is preparedand evidenced in advance; reducing theburden of referencing by engaging athird party to produce independentreference checks for LP eyes only; andeven ensuring that all soft-copydocuments are fully editable.

With so many private equity funds in themarket, there is a lot of emphasis onensuring that offerings are differentiated.To many GPs this simply means ‘beingdifferent’. This is an unhelpfulinterpretation that distracts some GPsfrom focusing on what LPs need toknow. Instead, their time is wasted onefforts to identify minute – and generallyperipheral – points of difference from competitors.

Knowing the market and understandingcompetitors is valuable (although GPsshould remember that they arecompeting for commitments against abroadly defined allocation pool, not justfunds that they are likely to see on theirown deals). But no matter how preciselythe differences are defined – by dealsize, regional presence or nuancedsector focus – the argument cannot beconvincing without clear appreciation ofthe context and rationale for anydifferences.

True differentiation is not aboutsuperficial differences. Even in the mostcrowded markets, every fund and firm isdifferent because it is managed byteams of different people, with differentskill sets and the ability to see differentopportunities in the same market. Onlywhen a GP has a full appreciation ofhow its team, strategy and market

opportunity work together to create acomplete offering is it able to describethe investment case with the necessaryprecision to differentiate its fund fromthose of its competitors.

Having appreciated the audience andfigured out a differentiated investmentcase, the next challenge is to keep aconsistent focus on the LPs’ needs andthe GP’s story.

New ideas and stand-out marketingcampaigns can work, but all a busy LPreally wants to know is whether the teamhas made money in the past andwhether it can do so again. Everyelement of the fundraising campaign –and every point in the fundraisingdocumentation – should address thosequestions. A fund that provides LPs withthe right answers is well positioned toengage and hold investor interest overthe long term.

Each document should be carefullystructured to engage and hold an LP’sattention by starting with simple,straightforward strengths and moving onto more complex, ambiguous or weakerpoints. The early sections of anydocument are a great opportunity tofocus on marketing points, with technicaland legal detail firmly consigned to thelater pages in order to leave the keymessages complete and unalloyed.

GPs are experts, LPs are generalists. It isa fine line to tread between assumingtoo much audience knowledge andinformation overload. With anyinvestment case, but especially wherethe offering is complex or unusual, it isnecessary to build the argument step bystep and to have the discipline towithhold all but the most essentialinformation until LPs understand, and fully

appreciate, the basics of how theoffering works.

Too often, key marketing points are lostamong a welter of peripheral detail,much of which is either irrelevant,repetitive or an echo of statementsmade by every other private equity firm. All marketing communicationsshould be focused on key messages:communicators must be confident about the messages and how theyshould be expressed.

Assuming too much knowledge can beworse. Without a clear explanation ofthe key points of more complex markets,for example, LPs are unable toappreciate the opportunity or how theGP team’s particular combination of skillsis so well suited to its environment.

To ensure that the offering is fullyappreciated, it is often necessary toinclude explanations, but every elementof these should be relevant to the fund.An LP should be told only the facts that itneeds to know in order to appreciatethe opportunity – anything else isindulgent and unnecessary. Thisphilosophy should be applied to allmarketing communications. For example,some pitchbooks can be very weightyand this can depress an audience as itrealises that it has to sit through everyone of those slides that just thumpedonto the table. Where there is a lot ofsupporting information, it is moreaudience-friendly to hand out a slimpitchbook of 15-20 slides and reserve amore substantial set of appendices foruse during the pitch.

All communication, particularly theprivate placement memorandum (PPM)and pitchbook, should be clearlysignposted so that LPs are reassured thatthe GP will cover all the areas ofinterest. During the first pitch, forexample, if the development of the

Focus

Not too much, not too little

Differentiation

Signposting

FUNDRAISING FROM PRE-MARKETING TO DATAROOM: THOUGHTS ON BUILDING A CREDIBLE INVESTMENT CASE FOR INSTITUTIONAL INVESTORSINVESTOR RELATIONS


argument is clearly signposted, LPs aremore likely to relax and wait for thesections of particular interest rather thanbringing up unrelated questions that canslow the pace of the pitch.

Good signposting, resulting from a clear,planned structure, is also reassuring forthe writer or presenter, who can beconfident that there is time and space forto make all the necessary points withoutrushing or attempting to cover too manyideas at once in order to fit them in.Often, GPs seeking to raise funds withcomplex stories make the story seemeven more complex by overloading theaudience with information early on. Aclear, well-signposted structure ensures amore measured pace, avoiding the needfor later repetition.

Fundraising is formally launched whenthe PPM is distributed to LPs, outlining thefull investment case. Based on thisdocument, LPs will decide whether thefund presents a genuine investment targetand therefore whether the GP willreceive a meaningful meeting with seniordecision-makers.

This is arguably the most importantopportunity to make a convincinginvestment case. The PPM provides thetraditional platform for the developmentof a detailed argument that bringstogether the key areas of team, strategy,opportunity and track record. This is acomplex document that can be difficultand time-consuming to draft.

Over the years, GPs have attempted tofind alternatives to the PPM as theprimary marketing document. But despiteits length and the fact that many GPs findit difficult to draft an acceptable PPM, itremains at the centre of the standardfundraising process.

The teaser, for example, providesenough scope only to introduce the main

points of the fund – there is no room fordifferentiation through accuratedescription. The due diligencequestionnaire, by contrast, offers toomuch space and not enough focus. Thepure investment case is easily lost amongthe detail of the offering.

Most often, GPs will attempt to use apitchbook as the primary marketingdocument, preferring the brevity andfocus of Powerpoint over the wide emptyspaces of Word.

However, Word provides much morescope for accurate and thereforecompelling explanation and descriptionthan Powerpoint bullets. Powerpoint doesnot enable full development of key pointsnor does it allow the writer to connectkey points together. Powerpoint isdesigned to enhance an oralpresentation, where the speaker makesthe links, brings in anecdotes and other‘proofs’ and speaks more deeply toimportant points as required. Withoutthat commentary, the exact meaning ofthe pitchbook’s points are often missedor misinterpreted.

In contrast, the PPM’s Word formatencourages full explanation anddevelopment. This is a necessary featureof any effective investment case, whichwill always be driven by an accuratedepiction of how the different elementsof team, strategy and opportunity cometogether to create a unique offering.

It is obviously much easier to create asummary from a full statement than viceversa: once the PPM is in place, it is arelatively simple matter to draw outsummarised material for a pitchbook. It ismuch more difficult to expand generalbullet points into a detailed investmentcase and there is a danger that thedetail of the team’s vision may be lost orcorrupted in the process.

In any case, many LPs still expect to seea PPM in advance of a first pitch. Since2007, this has been an unanswerablepoint in favour of PPM-led marketing.

Oral presentation of the investment case– whether during the first pitch, duediligence meetings or informal phonecatch-ups – can be as important ascredible documentation.

There is an increasing trend towardspresentation training for those taking thelead on first pitches and this can only behelpful in ensuring that the full power ofthe investment case comes through in a40-minute presentation. Training in otherforms of contact remains neglected,despite the importance of every point ofcontact with LPs in building a fullysupported investment case.

Detailed preparation in advance of anycontact with LPs can ensure that the keymessages are so thoroughly ingrainedthat the GP is able to speak confidently,concisely and compellingly at any noticeand in any situation. Each contactprovides the opportunity to repeat a keypoint or to provide proof of the coremessages. Over 18–24 months, evenshort phone calls can mount up into avaluable body of evidence.

Increasingly, LPs expect to meet withmost or all of the team during the due

Optimise first contact

Presentation

Whole-team approach

FUNDRAISING FROM PRE-MARKETING TO DATAROOM: THOUGHTS ON BUILDING A CREDIBLE INVESTMENT CASE FOR INSTITUTIONAL INVESTORS INVESTOR RELATIONS

Q4 | 2012 43

The PPM provides thetraditional platform forthe development of a

detailed argumentthat brings together

the key areas of team,strategy, opportunity

and track record.

diligence process. All team membersneed to know the key points, not only onstrengths, but also on perceivedweaknesses. During the due diligenceprocess, every team member isresponsible for ensuring that the fund isconsistently seen as a credibleinvestment proposition.

These are the meetings that LPs will useto dig beyond the marketing spin. Duediligence meetings are likely to focus onprevious transactions and the team. Allteam members need to know what theymay be asked and – most importantly –the motivations for asking.

The whole team should be trained,whether in-house or externally, inunderstanding and meeting theexpectations of institutional investors, andon the fund’s investment case and therationale behind it.

When team members understand LPneeds and motivations, they are morelikely to construct answers – particularlywhen talking about deals – that coverpoints of real interest to the audience,rather than themselves. For example, theGP is likely to be interested in what eachportfolio company does and how itworks. The LP, however, is moreinterested in how the investment fits thestrategy of the current fund andanticipated returns.

When other team members know whatthe fundraisers are saying to LPs, andwhy, the relevance and value of theircommunications to those LPs increases.They are therefore more able to supportthe fund’s investment case from their ownexperience; focusing on relevantinformation; and incidentallydemonstrating the strength and capacityof the investment team.

By contrast, scripted answers and rotetraining are less valuable – thisapproach is generally counter-productiveas it is easy for an experienced investorto spot and demolish prepared answers.

With the whole team involved insupporting the investment case, the task ofensuring consistent messaging is madesomewhat easier. Particularly during aperiod when LPs are looking for reasonsto say ‘no’, even the strongest investmentcase needs consistency. The duediligence questionnaire and dataroom arethe areas where contradictory informationis most likely to appear.

Whereas some facts, statistics, referencesor even team statements that weaken orcontradict elements of the investmentcase are not unusual or disastrous,wherever possible the fundraising teamshould be aware of those contradictions.The team should also be prepared withcredible explanations because an alertLP will take the opportunity to unpick anyinconsistent detail.

Any lengthy process runs the risk ofturning stale or becoming outdated.Regular reviews of the pitch,documentation and dataroom ensurethat information remains relevant andinteresting. It can also breathe new lifeinto the presentation, particularly whereGPs have the luxury of changingpresenters. It also ensures that the rest ofthe team remains on-message during duediligence meetings, especially wherethere are new joiners.

Written updates and briefings should beissued to LPs throughout the fundraisingprocess. This is a valuable means ofstaying in touch and maintainingmomentum. Where there has been a lotof deal activity, team changes or marketdevelopments during a long process,GPs may provide a formal updatedocument, either as a short briefing orvia an updated interim PPM draft. Bycollecting individual updates into asingle document, the GP not only createsan additional opportunity to remind LPsabout the key messages of the fund, butalso controls which updates are retainedby the LP audience.

Of course, none of these suggestionscomes with a guarantee of success – noteven success in securing meaningfulmeetings – and certainly not success inpersuading notoriously commitment-shyLPs to say ‘yes’ to a first closing. But itdoes make the LP’s life easier and awell-differentiated and well-presentedfund is more likely to remain at the top ofan investor’s in-tray. In this environment,that counts for a lot.

Like most professionals, GPs are underpressure to cut costs, increaseproductivity and focus on the bottom line,but this is not the time to starteconomising on communication with thepeople that have the money.

In the longer term, funds and GPs thatemerge from this period with areputation as credible investmentprospects are likely to find futurefundraisings a much easier ride. LPs thatdon’t commit this time around may still beworth the wooing.

Keep it fresh

Conclusion

Consistency

FUNDRAISING FROM PRE-MARKETING TO DATAROOM: THOUGHTS ON BUILDING A CREDIBLE INVESTMENT CASE FOR INSTITUTIONAL INVESTORSINVESTOR RELATIONS


The due diligencequestionnaire anddataroom are the

areas wherecontradictory

information is mostlikely to appear.

Sarah ClarkeDirector, Foundation FundraisingServices Ltd


As the regulatory environment inEurope becomes increasinglyonerous, European private equity

managers are faced with the choice ofwhether moving additional operationsoffshore (outside Europe) is indeedworthwhile. Though regulatory concernstypically drive these debates, there is ofcourse ensuing value-added tax (VAT)benefits associated with maintaining anoffshore fund manager. Clearly, whetheran offshore manager has true economicand commercial substance andoperations will be the key practicalconsideration for a move offshore and tosecure the perceived benefits.

The Alternative Investment Fund ManagersDirective (AIFMD) is the principal piece ofregulation that will change the wayprivate equity fund managers in theEuropean Union (EU) conduct business.The AIFMD was born out of the 2008global financial crisis and the perceivedneed to better regulate financial institutionsacross the board. For the first time,managers of private equity funds will berequired to seek authorisation under anew and comprehensive EU-wideregulatory framework.

The AIFMD will impact how privateequity managers market their funds, howthey remunerate their staff and ultimatelyhow they operate their business. Thisdirective requires all funds to have adepository (an independent third-partyentity to safeguard assets and monitor

the cash flows of the fund). It alsorequires fund managers to support highercapital-adequacy levels and removesprivate placement as a means offundraising, which are concerns forprivate equity managers, not only from acost-and-resource perspective but alsofrom a practical operational standpoint.

While EU alternative investment fundmanagers (AIFM) that are within scopeof the AIFMD will be required to complywith the full suite of AIFMD provisions,non-EU managers – those wishing tomarket to EU investors – should onlyneed to comply with disclosure-basedrequirements such as providinginformation to investors and submittingperiodic returns to the Financial ServicesAuthority (FSA) in the UK, for example, inorder to continue to market their fundswithin Europe. Indeed, the strictdepositary-liability regime does notapply to the private placement of non-EU funds and the private placement ofnon-EU funds is not expected to bephased out before 2018, so there is aperiod of time for which non-EU fundscan continue to use private placement

for fundraising and will avoid costlydepository costs.

This differing scope of the AIFMD for EUand non-EU AIFMs has thereforeprompted some managers to consider thecosts and benefits of operating from anon-EU jurisdiction. There are in principletwo ways of achieving an offshorestructure from a regulatory perspective:

1) by having an non EU (offshore)manager which appoints an EU(onshore) investment adviser; or

Alternative Investment FundManagers Directive

Contemplating a move offshore?By Abigayil Chandra and Paul Megson, Deloitte

Q4 | 2012 45

TAX

Differing scope of theAIFMD for EU andnon-EU AIFMs hastherefore promptedsome managers toconsider the costs

and benefits ofoperating from a non-

EU jurisdiction.

CONTEMPLATING A MOVE OFFSHORE?

2) with a non-EU (offshore) fund managerwhich appoints an EU (onshore)discretionary investment manager.

Under the first option, technically theoffshore manager should have thestructure and expertise to makemanagement decisions (including theinvestment-management decisions),adopting or rejecting the adviceprovided by the investment adviser.Under the second option, the offshoremanager has a more limited role in themanagement of the fund because itdelegates the management of investmentdecisions to the discretionary investmentmanager, but nevertheless it retains keyoverhead management decisions aboutportfolio management, risk, investorrelations and other key business areas.

Clearly to move offshore can be a majorshift in the modus operandi for manymanagers. However, as well as thepotential for reducing the immediateimpact of the AIFMD, having a non-EU/offshore manager also introduces aVAT benefit. Specifically, where servicesare provided to a manager outside theEU, the services are not subject to VATbut entitle the supplier of the services torecover their own input VAT associatedwith the supply. Therefore any offshoremanager receiving advice from EUsuppliers should not suffer VAT on thosecosts and the EU suppliers should beable to treat the supply as taxable forthe purposes of determining theirrecovery of input VAT.

This VAT treatment is a straightforwardapplication of the VAT rules without anysubstantial associated complexity. Thekey to ensuring that these VAT benefitsactually apply is that the offshoremanager really is managing the fundoffshore and has sufficient substanceand expertise to demonstrate that.

The substance requirements that are key toan offshore structure being effective from aVAT perspective are in many waysmirrored by the AIFMD. The AIFMD isclear that it will look through any AIFMthat is a “letter box entity”, that is, one thatdoes not have sufficient substance andcapabilities of its own (such as those notdelegated or outsourced) to undertake theresponsibilities of a true fund manager,namely the entity actually performing theinvestment management functions whichare defined for this purpose as theportfolio management or risk managementfunctions. Provisions under the AIFMD seta quantitative limit on the tasks that theAIFM can delegate and means that tasksdelegated must not substantially exceedthe tasks remaining within the AIFM. Ofcourse, this can be quite different from thestructures adopted by some private equitymanagers where the general partner (GP)retains control and oversight of themanagement of the fund but delegatesthe day-to-day activities to a manager,adviser or service providers.

It is therefore imperative in successfullyimplementing an offshore structure for aprivate equity manager to be able todemonstrate that the offshoreGP/manager has a physical presenceoffshore from which the business isoperated. It should also show that it hasa suitably qualified and experiencedteam to make the decisions that amanager should ordinarily be making.

The precise substance requirements ofmaintaining an offshore structure willdepend on how that offshore structure is

set up, that is, whether the offshore GPappoints an onshore adviser ordiscretionary manager.

1 Offshore manager, onshoreinvestment adviser Where an offshore manager is takinginvestment advice and recommendationsfrom onshore advisers, the offshoremanager will need to demonstrate that ithas the capabilities and expertise toproperly consider, debate and challengerecommendations that it receives and thatit does not merely rubber-stamp advicereceived from advisers within the EU.

The offshore manager should not justhave the power and autonomycontractually to make decisions, but itshould also exercise these powers inactuality. As well as having clear andwell-documented procedures setting outhow investment decisions are made, thecomposition of the committee makingthese decisions and where the decisionsare in fact made, it will also be importantto evidence that these procedures andpractices are actually operated andfollowed and that the onshore adviser isnot making decisions about investments.

Typically a structure where theinvestment decisions are made offshorewill involve the offshore GP having aninvestment committee which wouldconvene with regular frequency, at theGP’s offices outside the EU and withsufficient information to enable them tomake suitably considered decisions. It isimportant that the onshore adviser doesnot have the power to, and does not inactual fact, make decisions about theacquisition or disposition of investmentsof the funds. Therefore, the investmentcommittee should have the followingcharacteristics:

• Comprise members with sufficientprivate equity experience andexpertise to make suitablyconsidered decisions and should nothave a majority of its memberscoming from the onshore adviser.

Key substance requirements

TAX


As well as thepotential for reducingthe immediate impactof the AIFMD, having

a non-EU/offshoremanager alsointroduces a VAT benefit.

CONTEMPLATING A MOVE OFFSHORE? TAX

• Convene regularly and be providedwith sufficient information so that ithas adequate time and details to beable to judge each recommendationand demonstrate that the de factoposition is that it is justrubberstamping the advice received.

• Convene at the GP’s own premisesoutside the EU and a majority ofmembers should attend in person atthose premises. Where members ofthe committee attend by phone, theyshould do so from a non-EU location.

As the AIFMD defines the managementof a fund to be both portfoliomanagement and also risk management,so in addition to demonstrating that theoffshore GP makes the investmentdecisions, it should also make clear thatit undertakes the risk managementfunction. What is meant by ‘riskmanagement’ is not completely clear butthe offshore GP should ensure that it hasrisk management policies set out whichset risk limits for the fund and how riskwill be monitored on an ongoing basis.

2 Offshore manager, onshorediscretionary investment manager Under a structure where the offshore GPdelegates the investment management toan onshore manager, great care willneed to be taken to ensure that theoffshore GP can still justifiably beregarded as the AIFM. While under thisscenario it would not be necessary foreach investment decision to be madeoutside the EU, it will still be necessaryto establish that the offshore GP hassufficient expertise to oversee, superviseand monitor the investment managementfunctions it has outsourced to theonshore discretionary manager and anyother delegated functions.

As discussed, the AIFMD limits thenumber of functions that can bedelegated by an AIFM which means theoffshore GP will need to retain, andconduct offshore, other functions tocontinue to fall outside the full scope ofthe AIFMD. Therefore, while the

substance of the offshore GP under thisstructure would be less than where theoffshore manager undertakes theinvestment management of the fund aswell, the GP would still need to maintainsufficient substance and resources to beable to undertake the functions that itretains. The GP’s management boardshould be commensurate to itsoperations and its membership shouldnot mirror that of the onshorediscretionary manager. Board meetingsshould be held at the GP’s offshoreoffices with a majority of directorsattending in person and the mattersdiscussed at these meetings should be ofsufficient importance to warrant board-level consideration rather than matters ofa routine or non-strategic nature.

Given that the AIFMD will have significantcost, resource and operational impact forEuropean private equity managers it is notsurprising that considerable thought isbeing given to whether structural changeswould be desirable. A move to anoffshore structure is certainly not adecision to be taken lightly given the workinvolved to ensure that the structure iseffective, both from a tax perspective butperhaps more importantly from aregulatory perspective. There must be truesubstance and capabilities located in theoffshore jurisdiction and real care needsto be taken over what functions areundertaken within and outside the EU.

Ultimately, time will tell whether privateequity managers will deem the costs ofachieving the necessary level of substanceto outweigh the benefits and potential costsavings that a move offshore couldachieve. However, in addition to ananalysis of the monetary costs andbenefits, we do see managers taking apragmatic approach as to whether theyare able to adequately resource a non-EUmanager and how sufficient substancecan be achieved. Questions that privateequity houses are considering include,who from the EU team would be willing torelocate/increase their time in the non-EUjurisdiction, how, and how frequently,can the investment committee conveneoutside the EU, and can the investmentdecisions really be taken outside the EUin the often time-pressurisedcircumstances that surround deal work?Clearly the demand for skilled personnelin the key non-EU countries couldincrease significantly and whether thepool of such personnel can expandsufficiently to meet that demand will beanother important factor for managers(and the offshore jurisdictions themselves)to consider. What ‘price’ a particularmanager places on such factors, whichcan be less tangible, will obviously varybetween managers and should not beunderestimated in the debate of whethera move offshore is judicious. Even wherethe predicted cost savings are material,we have seen in some cases that this isnot sufficient to convince an EU managerto make the significant operationalchanges that would be necessary tomake the structure effective.

Is moving offshore a feasibleresponse?

Q4 | 2012 47

A move to an offshorestructure is certainlynot a decision to be

taken lightly given thework involved toensure that the

structure is effective

Abigayil ChandraAbigayil Chandra, Senior Manager, Deloitte


Paul MegsonPaul Megson, Partner, Deloitte


Private equity practitioners in theUK should be fully aware of theongoing scrutiny by HMRC as it

seeks to fill budgetary shortfalls bydelivering new approaches to raisingtax revenues.

The UK is no exception among leadingjurisdictions – all faced with significantbudget deficits and shortfalls in taxrevenues – that are taking steps to closesignificant budget deficits. The revenue-generating powers of taxation haveunsurprisingly been the focus ofgovernment attention in many developedeconomies, and private equity inparticular is having to manage increasedscrutiny in relation to the taxes the assetclass pays as well as coping with moretax complexity in general.

Among the many examples of changesin tax law and their impact on privateequity funds, one area which illustratesjust how radical change can be, and thepotential impact from economic,reporting and public relationsperspectives, is the renewed debateabout whether the rates of taxation ofthe wider tax regime applying to generalpartners and carried interest holdersshould be reviewed.

This is a debate which was reignited inMarch 2012 when Lord Myners, formerCity Minister in HM Treasury in London,queried in the House of Lords (upperchamber of Parliament) where he sits asa life peer whether this specific review oftax rates should take place.

It is useful to note the response of theCommercial Secretary to the Treasury,Lord Sassoon: “Tax legislation does notprovide a favourable rate of tax for theincome of partners in the private equityindustry. Amounts received by suchpartners are subject to the normal ratesof income tax or capital gains tax,depending upon which is appropriate,as determined by tax legislation andcase law.”

Sassoon’s comment is of interestbecause in fact many investments inprivate equity funds were and still are

funded by debt as well as equity. This isbecause interest on UK debt advancedto portfolio companies is tax-deductiblein those companies (all other thingsbeing equal), and the tax position of theinvestee company and returns to, andthe tax profile of, the external investors inthe fund (many are UK and foreigninstitutions) are fundamentalconsiderations in any private equity deal.

The tax spotlight in UK private equity

TAX


The UK tax landscape: The importance of private equity being adaptable to changeBy Sara Clark and Timothy Sowter, PwC

Tax legislation doesnot provide a

favourable rate of taxfor the income of

partners in the privateequity industry.

Lord Sassoon, Commercial Secretary to the Treasury

Indeed, the loss of tax revenue to theTreasury resulting from private equityhouses’ leveraging when they acquireUK companies, which had previouslypaid tax, was probably far moresignificant than any tax loss that mayhave resulted from allocations of capitalgains to executives. The loss of tax onleveraged UK deals is probably whatprompted the Treasury to extend in2005 legislation limiting interestdeductions on highly leveraged UKcompanies to entities owned by privateequity funds, which were previouslyconsidered out of the scope of those rules.

It is worth noting that a consequence ofdisallowing the interest in the portfoliocompany is that it can give rise to a“corresponding adjustment” (i.e. areduction in income on which tax ispayable) for any UK resident partners inthe fund to whom that disallowed interestfalls to be allocated.

Out of this discussion it follows thatprivate equity houses and theirexecutives were and still are receivingallocations of interest income taxable,typically taxable at higher income taxrates, in spite of an apparent‘preference’ for capital gains taxable atlower capital gains tax rates. Morefundamentally, the lower rates of tax,which private equity houses and theirexecutives were and still are subject to,were and continue to be stronglyinfluenced by the changes in UK taxrates and legislation and theirapplication to the tax treatment under theBVCA 1987 agreement (reached at atime when tax rates for income and

capital gains were the same), and not a favourable tax treatment conferredby the agreement of 1987. When thisBVCA agreement was reached, UKcapital gains and income tax rates hadbeen brought into line with each otherby the then Conservative government.Individuals were taxed at a higher rateof 40 percent and corporates at a mainrate of 35 percent on both income and gains.

By the end of the 1990s the governmenthad introduced a 30 percent differentialfor individuals between income andcapital gains tax rates, albeit the tax rateof 10 percent only arose in respect ofcertain capital gains assets. Thatdifferential was narrowed in subsequentbudgets to 12 percent. Nonetheless, bythe end of 2007, just before the debtcrisis, people outside and indeed withinthe private equity industry werequestioning the tax treatment of funds andwhether it was appropriate for executivesin the private equity industry to be payingtax of only 10 percent on their returns,when the basic income tax rate is 22percent and the higher rate is 40 percent.

There are many other areas ofcomplexity, including but not limited tothe impact of changes in profit sharingratios and the taxation of debt on anaccruals basis (i.e., unrealised basis) forUK corporates but a receipts basis forUK individuals so the key question ishow best can private equity houses dealwith the complexity and factor incapacity to deal with tax change.

There are often numerous stakeholders ina private equity fund that are within thecharge to UK tax, including the fund’smanagement or general partners andalso fund investors or limited partners.Consequently the way in which profitsare divided between the partners for UKtax purposes (the partnership UK taxallocations) are an importantconsideration for private equity housesthroughout the fund’s lifecycle.

The agreement between the Departmentof Trade and Industry, the British PrivateEquity & Venture Capital Association(BVCA) and the Inland Revenue(renamed HM Revenue & Customs inApril 2005) which sets out the UK taxtreatment of private equity funds andassociated entities was reached in 1987.There have been significant changes inthe economic and tax environment inwhich private funds operate, but theagreement still applies today andremains largely unchanged since it firstcame into being some 25 years ago.

Under the agreement the generalpartner responsible for managinginvestments on behalf of investors is apartner in the fund and receives and istaxed on a share of capital and incomegains arising from the fund’s underlyinginvestments. The private equityexecutives responsible for setting up the

The complex background of taxation of UK-basedprivate equity

THE UK TAX LANDSCAPE: THE IMPORTANCE OF PRIVATE EQUITY BEING ADAPTABLE TO CHANGE TAX

Q4 | 2012 49

fund who identify and execute dealsare also partners in the fund (usuallyindirectly through a separate vehicle)and they receive a share of incomeand capital gains (otherwise known as carried interest) once a return overand above the original cost ofinvestments is achieved for the fund’sexternal investors.

Furthermore, private equity houses areoften required by their investors to runco-investment schemes, under which theexecutives and employees of the privateequity house invest in the sameinvestments alongside the externalinvestors in the funds, the idea being thatthe private equity houses put their ownmoney at risk alongside their fundinvestors’ capital.

The general partner, carried interestpartners and co-investors are often withinthe charge to UK tax and are taxed onthe basis of their share of income andcapital gains arising from the investmentsmade by the fund.

The 1987 agreement was reached at atime when private equity and venturecapital were very much in their infancy.To illustrate how private has grown,BVCA data shows there was a total of£645 million worth of funds raised in1987, whereas in 2007 and 2008,which was the latest peak in the privateequity, the total raised £33 billion and£27 billion, respectively, according toTowers Watson data. The globalfinancial crisis has taken its toll with only £6.6 billion worth of funds raised in 2010.

Nonetheless these numbers give anindication of just how much has changedsince the end of the 1980s and howmuch the UK PE industry has grown. It isstill exponentially larger than it was in1987 in spite of the economic downturn.

UK income and corporation tax ruleshave both diverged and changed agreat deal in that period as indeed has

tax at an international level. This is ofgreat significance for private equityhouses given their 10-year-plus terms andmanaging the tax position of generalpartners, employees and deal executiveswithin the charge to UK tax, as well asthat of external investors, has becomeincreasingly complex.

Given the typical lifespan of a privateequity fund and the rapid pace of taxchanges, there is a need to build asmuch flexibility into limited partnershipagreements to assist the private equityhouse in managing the inevitablechanges in tax that are likely to takeplace during the life of each fund at thetime it is set up.

If the different investment stakeholders’tax profiles in the structure should beconsidered each time a new fund is setup then who should be involved?

It is highly recommended that anyproposed fund structure, associatedpartnership agreements and legaldocumentation should be reviewed bythe advisers that will be dealing with taxallocations matters year on year workingtogether with the legal advisers draftingthe documents. This should ensure thatthe tax implications for stakeholders areclear to all concerned from the outset

and that the potential for allocations ofdry income (for which no cash has beenreceived), double taxation or allocationsof partnership expenses to entities thatcannot take a deduction for them ismitigated in so far as possible.

During the life of the fund, it is bestpractice to involve specialists in taxallocations matters at the timeinvestments are made and disposed ofso that the impact of transactions on theprivate equity house is taken intoaccount, as well as the impact onexternal investors and the portfoliocompany which are typically consideredon acquisitions and disposals.

It is also helpful to ensure thatappropriate lines of communication are inplace with portfolio companies and theiradvisers during the investment holdingperiod so that any potentialcorresponding adjustments are identifiedand claimed within the relevant time limits.

In general, UK tax allocations have toapply UK tax legislation and statements ofpractice fairly in a manner consistent withthe limited partnership agreement and theBVCA model agreement. Given thevolatility of markets, the current economicenvironment, increasing scrutiny and thepace of tax change, exercising andexhibiting sound judgement wheninterpreting these interlinking elements ismore critical than ever.

How private equity housesshould effectively bemanaging tax risk

Closing comments

THE UK TAX LANDSCAPE: THE IMPORTANCE OF PRIVATE EQUITY BEING ADAPTABLE TO CHANGETAX


There is a need tobuild as much flexibilityinto limited partnershipagreements to assist

the private equityhouse in managing the

inevitable changesin tax.

Sara ClarkDirector, Senior Manager, PwC


Timothy SowterSenior Manager, PwC


Private equity professionals shouldpay close attention to certain VATtest cases which could lead to

greater scrutiny by HMRC.

In recent years, there has beenincreasing focus by the UK tax authorityHM Revenue & Customs (HMRC) onthe recoverability of value-added tax(VAT) on share acquisition costs. Thoughthere is currently no known litigationdirectly involving VAT recovery on privateequity acquisition costs, it does appearthat HMRC is more frequentlychallenging the VAT recovery in thiscontext. A recent private equity surveyundertaken by Deloitte shows that thenumber of enquiries and challenges byHMRC in relation to VAT recovered ontransaction costs has more than doubledin the last three years.

The most common reasons forchallenging VAT recovery in this context include:

• querying the recipient of theservices, that is, HMRC arguing thatthe entity incurring the costs is notthe beneficiary (or sole beneficiary)of the services;

• the timing of invoices and VATgrouping arrangements;

• the ability to demonstrate sufficienteconomic and commercialsubstance within the acquisitionvehicle; and

• successfully evidencing to HMRC’s satisfaction that there is an immediate and direct link to taxable supplies.

The leading case concerningtransaction costs involves BAA Limitedand its parent company AirportDevelopment Investments Limited (ADIL)which incurred VAT on its acquisition ofBAA. Following the acquisition, ADILjoined the BAA VAT group and soughtto recover VAT on acquisition costsincurred by ADIL with reference to theVAT group’s taxable supplies. Theprincipal reason for HMRC refusing VATrecovery was the point that in HMRC’s

view, there was no direct and immediatelink between the costs incurred by ADILand the taxable activities of the VATgroup. At the time the acquisition costswere incurred, ADIL was not a memberof BAA’s VAT group and the court alsofailed to identify a clear intention forADIL to become a member of the BAAVAT group.

Why HMRC challenges arebecoming more common

Reason for challenges by HMRC

Case focus: BAA Limited

HMRC challenges to VAT recoveryon share acquisition costsBy Ali Hai, Deloitte

Q4 | 2012 51

TAX

A recent private equitysurvey undertaken byDeloitte shows that the

number of enquiriesand challenges by

HMRC in relation toVAT recovered on

transaction costs hasmore than doubled inthe last three years.

Although the BAA case involves acorporate acquisition – and is stillsubject to ongoing litigation – it doeshave a bearing on the private equitysector and has highlighted a number ofpoints that may mitigate the risk ofsuccessful challenge by HMRC in thiscontext including the following:

• Demonstrating a direct andimmediate link between the activitiesof the entity incurring the costs andthe costs incurred.

• Ensuring contractual arrangementsmake it clear that the acquisitionvehicle is the recipient andbeneficiary of the services (forexample, the addressee of reportsand engagement letters) and is responsible for paying forservices supplied in relation to the acquisition. Simply paying fees or being named as a party on an engagement letter may not be sufficient.

• Ensuring board minutes or similardocumentation record intendedactivities of the acquisition vehicleand also any intention it may

have to join the VAT group of the target.

• Ensuring the submission of VATgrouping applications, issue ofinvoices and payments madehappen in the right order and at the right time.

• Where possible, considerationshould be given to ensuring, theacquisition vehicle is itself engagedin an ‘economic activity’, to supportits VAT recovery position.

The greatest challenge for many oftenproves to be effective implementation,which was a key factor in the decisionagainst BAA.

A decision from the Court of Appeal onthe BAA case is expected soon. If thedecision goes against BAA, it would bereasonable to expect enquiries fromHMRC to become even more commonand therefore paying close attention toproactive management of these issueswill take on greater significance.

Conclusion

Lessons from the BAA case

HMRC CHALLENGES TO VAT RECOVERY ON SHARE ACQUISITION COSTSTAX


Ali HaiSenior Manager, Deloitte


A decision from theCourt of Appeal on

the BAA case isexpected soon. If the

decision goesagainst BAA, it would

be reasonable toexpect enquiries from

HMRC to becomeeven more common.

Areview of the latestdevelopments and new formsof taxation which will have

some degree of impact on the privateequity asset class.

Following the issue of the draft FATCA regulations by the InternalRevenue Service (IRS) in the US inFebruary 2012, a joint statement was issued by the US, France,Germany, Italy, Spain and the UK to work together on FATCA and share information. To this end, The UK-US Inter GovernmentalAgreement (IGA) was signed inSeptember 2012.

Under the IGA all UK financialinstitutions will have to report theinformation required for FATCA toHMRC which will then share it with theIRS under the terms of the UK-US taxtreaty. This effectively removes anychoice that financial institutionstheoretically had over whether tocomply or not.

Mexico, Denmark and Ireland have all now signed IGAs with the US. The IRS has announced that they are in discussions with over 50countries and hence, further countriesare expected to announce IGAs in due course.

GermanyGerman legislation currently exempts 40percent of carried interest from taxationand subjects the remaining 60 percent tonormal income tax rates. However, newproposals have recently beenannounced to abolish this exemption.The draft legislation sets out that thisexemption will be removed with effectfrom 2013.

SwedenA proposal to tax carried interest from private equity funds of up to SEK5 million at general income taxrates (up to 55 percent), and anyamounts in excess of SEK 5 million atthe capital gains rate (30 percent) wasmade in March 2012. This proposalhas since been withdrawn and no newlegislation is currently expected. Thereare however several pending court

cases in which Skatteverket – theSwedish tax agency – is arguing thatcarried interest related directly orindirectly to individuals resident inSweden constitutes business income forthe Swedish advisory company. Assuch, the taxation of carried interest inSweden remains unclear in light of the litigations.

FATCA and inter-governmentalagreements

Taxation of carried interest inGermany, Sweden and France

A review of tax-related developmentsin private equityBy Abigayil Chandra and Paul Megson, Deloitte

Q4 | 2012 53

TAX

Under the IGA all UK financial

institutions will haveto report the

information requiredfor FATCA to HMRCwhich will then shareit with the IRS underthe terms of the UK-

US tax treaty.

FranceThe draft finance bill for 2013 sets outproposed new rules for carried interestto be taxed as salary at progressiverates (up to 45 percent) instead of atcapital gains tax rates. It is currentlyunclear whether carried interest willremain within the scope of the ordinarysocial security base. Managers aresubject to the social surtax of 15.5percent (of which 5.1 percent wouldbecome deductible) on their qualifiedcarried interest. In the case of non-qualified carried interest, managers aresubject to a 30 percent social surtax,which is not tax-deductible. If enacted,the new rules will come into effectretrospectively from 1 January 2012.

Anti-avoidance consultationHMRC has published a consultationdocument seeking views on proposalsto reform two anti-avoidance provisionson the basis of the EuropeanCommission’s view that these measuresmust not go beyond what is reasonablynecessary in order to prevent abuse ortax avoidance:

(i) Attribution of gains to members ofclosely controlled non-residentcompanies (s13)

The rules in effect look through a non-UKresident closely controlled company, andattributes chargeable gains realised bythe company to UK resident participators(with a greater than 10 percent interest)in proportion to their interests.

A new motive defence has beenproposed where there is either no taxavoidance motive, or where an offshorecompany is established for businesspurposes. HMRC is also consideringchanging the 10 percent de minimisparticipation limit to either a higher limit(possibly 25 percent) or to take

account of ‘influence’ over thecompany. A de minimis limit forreporting gains taxable under thissection is also being considered andthere are plans to review how taxtreaties apply. If enacted the proposedchanges could have retrospective effectfrom 6 April 2012 but taxpayers maybe able to opt out of the changes forthe 2012/2013 year.

(ii) Transfer of assets abroad (s720)

Broadly, the rules impose a charge to income tax on individuals who are ordinarily resident in the UK where there has been a transfer ofassets abroad and, as a result of thetransfer, income becomes payable to a person abroad, but the individualscan still enjoy income, or receive acapital sum or other benefits from the arrangements.

A new exemption focusing on thecharacter of the arrangements enteredinto has been proposed – in particular,whether transactions are on arm’slength terms and the extent of realoverseas economic activity resultingfrom the arrangements. This is intendedto be an objective test looking at theeconomic result of the transfers. Otherproposals include changing thedefinition of overseas person so that a non-UK incorporated company which is a UK resident for corporation

tax purposes is no longer defined as an overseas persons and thegovernment would also like to stoptreaty claims which result in double non-taxation.

These changes will also applyretrospectively from 6 April 2012 butthere will be no opt out election.

Taxation of interestIn March 2012 HRMC consulted onamending the exemption from UKwithholding tax on interest paid withrespect to quoted Eurobonds so that it would not apply where the Eurobondis issued intra-group, and listed on a stock exchange on which there is no substantial or regular trading inthe Eurobond. Following theconsultation, HMRC withdrew theproposal so that quoted Eurobondsremain a viable route for eliminatingwithholding tax on loan notes forprivate equity structures.

The March 2012 consultation alsoincluded a proposal requiring that thewithholding tax due on funding bonds(PIK notes) be paid to HMRC in cash,rather than HMRC being required toaccept funding bonds as payment forthe tax deducted. This proposal wasalso withdrawn in October so that thereis no requirement to pay tax on afunding bond in cash and PIK notescan continue to be issued to HRMC.There is however a new requirement to state the value of the funding bondat issue.

UK HMRC consultations onanti-avoidance reforms andtaxation of interest

A REVIEW OF TAX-RELATED DEVELOPMENTS IN PRIVATE EQUITYTAX


Abigayil ChandraAbigayil Chandra, Senior Manager, Deloitte


Paul MegsonPaul Megson, Partner, Deloitte


HMRC is alsoconsidering changing

the 10 percent deminimis participation

limit to either a higherlimit (possibly 25

percent) or to takeaccount of ‘influence’

over the company.

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