Special Paper

EVCA Investor Relations Committee

Special Paper

Why and How to Investin Private Equity

An EVCA Investor Relations Committee Paper

Written by Alex Bance

Max Burger-Calderon

Wanching Ang

Janet Brooks

Patrick Cook

Graham Dewhirst

Remy Kawkabani

Javier Loizaga

Jan Moulijn

Charles Soulignac

Javier Echarri

Apax Partners (D)

Allianz Private Equity Partners (D)

ECI Ventures Limited (GB)

3i Goup Plc (GB)

Bridgepoint Capital (GB)

Credit Suisse First Boston (GB)

Mercapital Servicios Financieros (E)

NIB Capital Private Equity NV (NL)

Fondinvest Capital (F)

EVCA

The European Private Equity and Venture Capital Association (EVCA) exists torepresent the European private equity sector. With over 950 membersthroughout Europe, EVCA's many roles include providing information servicesfor members, creating networking opportunities, representing the industry inpublic affairs and working to promote the asset class both within Europe andthroughout the world. EVCA's activities cover the whole range of privateequity, from seed and start-up to development capital, buyouts and buyins,and the flotation of private equity-backed companies.

About EVCA...

An EVCA Investor Relations Committee Paper

Written by Alex Bance Data prepared by Michael Henningsen

contentsPart One Introduction and Background to the Asset Class Page 2

Part Two Why Invest in Private Equity? Page 5

Part Three Approaches to Portfolio Construction Page 8

Part Four The Practical Aspects of Investment Page 10

Part Five Due Diligence Page 13

Part Six Monitoring the Portfolio and Measuring Performance Page 16

Appendix Glossary of Terms Page 18

Contents

IntroductionPart One Introduction and Background to the Asset Class

1. Introduction

Private equity has arrived as a major componentof the alternative investment universe and is nowbroadly accepted as an established asset classwithin many institutional portfolios. In Europe,sums committed to private equity funds haveincreased dramatically over the last ten years.Consequently, many investors still with little or noexisting allocation to private equity are nowconsidering establishing or significantly expandingtheir private equity programmes.

This document is designed to help such investorsconsider the characteristics of private equityinvestment and how best to approach theconstruction and implementation of a privateequity portfolio. Information on private equity, by

its nature, is harder to come by than informationon the public markets. This can make itchallenging to understand the dynamics of theasset class and to determine how best to constructan investment strategy.

It is useful to begin with an overview of theindustry. Private equity is often categorised underthe umbrella of "alternative investments",comprising a variety of investment techniques,strategies and asset classes that are complimentaryto the stock and bond portfolios traditionally usedby investors. The chart below shows the maincomponents of the alternative investment space ata broad level.

Alternative Investments

Private Equity

• Venture Capital

• Buyout

• Mezzanine Capital

• Special Situations

Hedge Funds

• Long/short

• Global Macro

• Event Driven

• Market Neutral

• Arbitrage

• Emerging Markets

Real Estate

• Office

• Retail

• Residential

• REITs

Physical Commodities

2. Definition of private equity

Private equity investing may broadly be defined as"investing in securities through a negotiatedprocess".

The majority of private equity investments are inunquoted companies. Private equity investment istypically a transformational, value-added, activeinvestment strategy. It calls for a specialised skillset which is considered in more detail in Part 5and which is a key due diligence area forinvestors' assessment of a manager. The processesof buyout and venture investing call for differentapplication of these skills as they focus ondifferent stages of the life cycle of a company.

Private equity investing is often divided into thebroad categories described below. Each has itsown subcategories and dynamics and whilst this issimplistic, it provides a useful basis for portfolioconstruction, which is discussed in Part 3. In thispaper, private equity is the universe of all ventureand buyout investing, whether such investmentsare made through funds, funds of funds orsecondary investments.

Currencies

Interest Rates

Natural Resources

Seed Start-up ExpansionReplacement

CapitalBuyout

Maturity of Company

2

IntroductionVenture Capital

Described as the "business of building businesses", venture capital is investing in companies that haveundeveloped or developing products or revenue. Venture capital has a particular emphasis on entrepreneurialundertakings and less mature businesses.

Seed stage Financing provided to research, assess and develop an initial concept before abusiness has reached the start-up phase.

Start-up stage Financing for product development and initial marketing. Companies may be inthe process of being set up or may have been in business for a short time, buthave not sold their products commercially and will not yet be generating aprofit.

Expansion stage Financing for growth and expansion of a company which is breaking even ortrading profitably. Capital may be used to finance increased productioncapacity, market or product development, and/or to provide additional workingcapital. This stage includes bridge financing and rescue or turnaroundinvestments.

Replacement Capital Purchase of shares from another investor or to reduce gearing via therefinancing of debt.

Buyout

A buyout fund typically targets the acquisition of a significant portion or majority control of businesses whichnormally entails a change of ownership. Buyout funds ordinarily invest in more mature companies withestablished business plans to finance expansions, consolidations, turnarounds and sales, or spinouts ofdivisions or subsidiaries. Financing expansion through multiple acquisitions is often referred to as a "buy andbuild" strategy.

Investment styles can vary widely, ranging from growth to value and early to late stage. Furthermore, buyoutfunds may take either an active or a passive management role.

Special Situation

Special situation investing ranges more broadly, including distressed debt, equity-linked debt, project finance,one-time opportunities resulting from changing industry trends or government regulations, and leasing. Thiscategory includes investment in subordinated debt, sometimes referred to as mezzanine debt financing,where the debt-holder seeks equity appreciation via such conversion features as rights, warrants or options.

3. Historical development of the industry

The phrase "private equity" only becamewidespread in the late 1980s following publicinterest in leveraged buyout ("LBO") fund activity,particularly in the US. In reality, the private equitymarket dates back to the formation of groups inEurope such as Charterhouse DevelopmentCapital in 1934 and 3i in 1945 and, in the US,American Research and Development Corporation("ARD") in 1946.

3i (originally named the Industrial andCommercial Finance Corporation) was founded byUK clearing banks and the Bank of England tomeet the needs of smaller companies and address

the shortage of long-term capital available to themfor development. In contrast, ARD set out tocommercialise some of the new technologies thathad been developed in the war by raisinginstitutional capital using a publicly traded,closed-end investment company. Both newinvestors brought industrial expertise to theirassessment of companies, a shift from thetraditional focus on security.

However, the broader private equity marketremained fragmented for some time, consistinglargely of venture investment into early stagecompanies by private individuals (known as"business angels") and, to a lesser extent,

3

4

Introductionfoundations and university and governmentinvestment programmes. Some of the better-known, early venture-backed companies includeDigital Equipment (which went public in 1968valued at US$37 million after Digital's originalfunding of US$70,000 in 1959), Federal Expressand Apple Computer.

The main catalysts in the development of theprivate equity industry in both Europe and the USoccurred in the 1970s. In the UK, the movetowards the Competition and Credit Control policyin 1971 gave banks greater investment flexibility.In the US, clarification of the "prudent man" ruleissued by the US Labor Department in 1978relaxed many of the limitations placed oninstitutional pension funds allowing them to investin private equity and other alternative strategies.

Subsequent structural and legal changesthroughout Europe, for example to pension fundand insurance company regulation, have allowedfor the liberalisation of investment choicesavailable to institutions. In addition, tax reformsaround Europe, which made investments thatreturn capital gains more attractive, have alsobeen a catalyst.

The movement of assets from fixed incomeinvestments into equities and other products wasaccelerated in the late 1990s by a low inflationenvironment. This environment has created aparticular need for growth stocks and highlighteda core skill of successful private equity managers,namely creating conditions for growth in portfoliocompanies.

In the early 1990s the industry began a period ofrapid international growth, culminating in over�200 billion being raised globally in 2000 byprivate equity funds.

4. What are the main sources of private equityfinance?

The spectrum of investors in private equity hasexpanded rapidly to include numerous differenttypes of investors with significant long-termcommitments to the asset class. In general, themajority of commitments to private equity fundsbased in respective geographical regions havecome from institutions within the same region.This is evolving as investors seek a higher level ofgeographical diversification in their private equityportfolios.

The number and calibre of institutions that haveinvested in European private equity funds andallocated significant pools of capital to buildingtheir portfolios demonstrates, in conjunctionwith the rapid growth of the market, thematurity and stature of private equity as an assetclass in Europe.

The charts below illustrate the evolving sourcesof investment in European private equity funds,analysed by investor type. Geographically, over70% of this funding still originates fromEuropean investors.

Sources of European Private Equity

Source: EVCA

Total Funds Raised (1998 - 2002) �161.3bn

6% 8%

6%

6%

24%22%

12%

9%

1%1%

5%

Corporate Investors

Private Individuals

Government Agencies

Banks

Pension Funds

Insurance Companies

Funds of Funds

Academic Institutions

Capital Markets

Realised Capital Gains

Others/Not Available

The fundamental rationale for investing in privateequity is to improve the risk and rewardcharacteristics of an investment portfolio.

Investing in private equity offers the investor theopportunity to generate higher absolute returns whilstimproving portfolio diversification.

1. Long-term historical out-performance

The long-term returns of private equity represent apremium to the performance of public equities.This has been the case in the US for over 20 yearsand also in Europe, following an increase in thenumber of private equity funds, for over 10 years.

5 Year Return Figures: Private Equity Vs MSCI World

Source: Venture Economics / Datastream

For many institutions, such a premium over moreconventional asset classes justifies the different riskprofile of the asset class. Growth in the Europeanprivate equity fund market has been assisted bygrowing awareness amongst investors of the excessreturns from private equity investment that havebeen generated in the US over the longer term andmore recently in Europe too.

2. True stock picking in a low inflation, low growthenvironment

A low inflation environment creates a focus ongrowth stocks as a means of out-performance.One of the core skills of successful private equitymanagers is to pick companies with growthpotential and actively to create the conditions forgrowth in those companies. Since private equityfunds own large, often controlling, stakes incompanies, few, if any, other private equitymanagers will have access to the same companies.Private equity managers are therefore true "stockpickers". This contrasts markedly to mutual funds,which will often hold largely the same underlyinginvestments as their peer group, with variations inweightings being fine-tuned to a few basis points.

3. Absolute returns

Excessive volatility and poor investmentperformance experienced by quoted equityportfolios, many of which have index-trackingstrategies or are benchmarked to an index ("closettrackers"), have led to a swing in favour ofstrategies that seek absolute returns.

Demographic trends have compounded thedesirability of such a change. The pressing need toprovide for an ageing population has obligedmany institutions to adopt a more absolute returnoriented investment approach in order to meetfuture liabilities.

Private equity managers do seek absolute returnsand their traditional incentivisation structure, the"carried interest", is highly geared towardsachieving net cash returns to investors.

4. Portfolio diversification improves risk andvolatility characteristics

Within a balanced portfolio, the introduction ofprivate equity can further improve diversification.Although correlation of returns between privateequity and public market classes is widely debatedand needs further investigation, the numberspresented on the following page, based partly onunrealised gains, do indicate a lower correlation.

5

Why Invest Part Two Why Invest in Private Equity?

35.0%

30.0%

25.0%

20.0%

15.0%

10.0%

5.0%

0%

-5.0%

1980 1990 2000

European Private Equity

US Private Equity

MSCI World

6

Why Invest

1 Long term horizon 30 years, short term horizon 19 years. Correlation ranges for large and small cap stocks; Treasury bills andbonds and corporate bonds.

2 Long term horizon 24 years, short term horizon 16 years. Correlation ranges for large and small cap stocks; Treasury bills andbonds and corporate bonds. Sources: Venture Economics, Investment Benchmarks Report: Venture Capital (2002 Edition)

Long Term

Equity Markets (%) Bonds (%)

Short Term

Quarterly2 0.58 to 0.59 0.58 to 0.61 0.00 to -0.11 -0.22 to 0.03

Annual1 0.57 to 0.59 0.49 to 0.58 -0.18 to 0.12 -0.37 to -0.07

Long Term Short Term

As a result, adding private equity to a balancedportfolio can reduce volatility and contribute toan overall improvement in risk profile. Thiswould allow higher targeted returns for the samelevel of calculated risk, or a reduction to thelevel of risk in the portfolio whilst preserving thetarget rate of return.

5. Whilst the majority of European GDP is generatedby private companies, the private equity market hasmuch fewer funds under management than thepublic markets

There is still plenty of scope for growth in the assetclass and a much greater universe of assets fromwhich to select. This is particularly true in Europewhere private equity fund investment remains amuch smaller proportion of GDP than in the US.

6. Exposure to the smaller companies market

The private equity industry has brought corporategovernance to smaller companies and provides anattractive manner of gaining exposure to a growthsector that went out of favour with quoted marketinvestors in the mid 1990s for reasons of liquidity.

7. Access to legitimate inside information

A much greater depth of information on proposedcompany investments is available to private equitymanagers. This helps managers more accuratelyassess the viability of a company's proposed

business plan and to project the post-investmentstrategy to be pursued and expected futureperformance. This greater level of disclosurecontributes significantly to reducing risk in privateequity investment. Equivalent information in thepublic markets would be considered "insideinformation". By definition, investors in publicmarkets will know less about the companies inwhich they invest.

Improving the Risk-Return Trade-off

Risk (%)

Retu

rn (%

)

Optimal Mix of 3 Assets

100%Bonds

100% Equity

100% Equity

Portfolio Including Private Equity

Conventional Portfolio

Correlation of Private Equity with Other Asset Classes

7

Why Invest 8. Ability to back entrepreneurs

The wider emergence in Europe of entrepreneurs asan important cog in the economy has beenfacilitated by a period of larger companyrationalisation. This has reflected similardevelopments in the US that, for example, fosteredrapid growth in technological innovation andsubstantial knock-on benefits for the wholeeconomy through the 1990s. Entrepreneurs havealso been at the heart of developments in Europe,creating value in both traditional and hi-techindustries. The private equity asset class offers theability to gain investment exposure to the mostentrepreneurial sectors of the economy.

9. Influence over management and flexibility ofimplementation

Private equity managers generally seek activeparticipation in a company's strategic direction,from the development of a business plan toselection of senior executives, introduction ofpotential customers, M&A strategy and identificationof eventual acquirers of the business. Furthermore,implementation of the desired strategy can normallybe effected much more efficiently in the absence ofpublic market scrutiny and regulation. This flexibilityrepresents another feature whereby risk can bereduced in private equity investment.

10. Leveraging off balance sheet

Buyout managers in particular are able to makeefficient use of leverage. They aim to organise eachportfolio company's funding in the most efficientway, making full use of different borrowing optionsfrom senior secured debt to mezzanine capital andhigh yield debt. By organising the company'sfunding requirements efficiently, the equity returnsare potentially enhanced. In addition, because theleverage is organised at the company level and notthe fund level, there is a ring-fencing benefit: if oneportfolio company fails to repay its borrowing, therest of the portfolio is not contaminated as a result.Thus the investor has the effective benefit of aleveraged portfolio with less downside risk.

However, there are features that investors might not findattractive and which must be understood.

I) Long-term investment

In general, holding periods between investment andrealisation can be expected to average three or moreyears (although this may be shorter when IPOmarkets are especially healthy). Because the

underlying portfolio assets are less liquid, thestructure of private equity funds is normally aclosed-end structure, meaning that the investor hasvery limited or no ability to withdraw its investmentduring the fund's life. Although the investor mayreceive cash distributions during the fund's life, thetiming of these is normally uncertain. "Liquidity risk"is one of the principal risk characteristics of the assetclass. Private equity should therefore be viewed as alonger-term investment strategy.

II) Increased resource requirement

As a result of the active investment style typical ofthe industry and the confidentiality of much of theinvestment information involved, the task ofassessing the relative merits of different privateequity fund managers is correspondingly morecomplex than that of benchmarking quoted fundmanagers. This makes investment in private equityfunds a much more resource-intensive activity thanquoted market investment. Likewise, post-investment monitoring of funds' performance is alsomore resource-intensive. Resource is a key issue inthe development of a private equity programme thatis suitable for the investor.

III) "Blind pool" investing

When committing to a private equity fund, thecommitment is typically to provide cash to the fundon notice from the general partner. Whilst launchdocumentation will outline the investment strategyand restrictions, investors give a very wide degree ofdiscretion to the manager to select the companiesthat the investors will have a share in. Unlike somereal estate partnerships, there is usually no ability atthe launch of a private equity fund to previewportfolio assets before committing, because theyhave not yet been identified. Likewise, there isgenerally no ability to be excused from a particularportfolio investment after the fund is established.

Portfolio Construction

8

Part Three Approaches to Portfolio Construction

Portfolio construction will reflect the principal objectivesof investing in private equity discussed in Part 1,including targeting higher long-term returns and portfoliodiversification through reduced correlation to publicequity markets. Issues of correlation will apply not onlyin connection with other assets, but also amongst theassets in the private equity portfolio itself.

Decision 1 - The size of the private equity allocation

Investors in private equity should be able to accept theilliquid character of their investment, hence the extentto which liquidity may be required is often a factor inthe size of allocation. For this reason, it is often thecase in the US that the investors who make the largestproportional allocations to private equity from theiroverall portfolios are those who are able to invest forthe long term with no specific liabilities anticipated.These would include endowments, charities andfoundations. Pension funds also are often largeinvestors in the asset class. A reputable 2003 surveyfound that the average allocation to private equityamongst US institutions invested in the asset class was7.5%. The comparable figure for European institutionswas 4.0%.

Based on the requirement to increase targeted returnsand/or reduce volatility, the investor will determine theproportion of its overall portfolio that it believes isappropriate to allocate to private equity.

Decision 2 - Number of private equity funds to commit to

It is a challenge for investors to avoid concentration ofrisk within their private equity portfolio and to controlportfolio volatility. It is appropriate to aim for somediversification. The chart below indicates that a level ofdiversification can be achieved by holding at least 6different funds.

Source: Venture Economics / UBS

Decision 3 - Ways of achieving diversification

i) StageThere is limited correlation between returns fromdifferent stages of private equity. Diversification cantherefore reduce risk within a private equity portfolioand this should be an important consideration.

Source: Venture Economics Investment Benchmarks

Report: Venture Capital (2002 Edition)

1Annual correlation based on period of 19 years; quarterlycorrelation based on period of 16 years.

Europe - 5 Year IRR Evolution (in Percentage Points)

US - 5 Year IRR Evolution (in Percentage Points)

Source: Venture Economics / EVCA

As mentioned in Part 1, venture capital can befurther sub-divided into categories ranging fromseed stage to late stage investment. In respect ofbuyout funds, a distinction can be made betweenlarger, mid-market and growth buyouts.

Correlation between Sectors of Private Equity

Venture Capital1

Buyouts

Quarterly 0.47

Annual 0.36

Venture

1986

-10

-5

0

10

15

20

Buyouts

5

1988

1990

1992

1994

1996

1998

2000

2002

Number of FundsMean S.d

2019181716151413121110987654321

024681012141618

%

Example of volatility of returns versus number of funds held

Venture

1986

-10

-5

20

-15

0

10

15

20

30

25Buyouts

5

1988

1990

1992

1994

1996

1998

2000

2002

9

ii) Geography

Geographical diversification can be secured inEurope through the use of country-specific, regionaland pan-European funds. Non-European exposure isalso widely available, in particular through USfunds, but also for example through Global, Israeli,Latin American and Asian funds.

A simple diversification model (whose weightings toeach segment are not necessarily equal) might lookas follows:

iii) Manager

Selecting a variety of managers will reduce manager-specific risk.

iv) Vintage year

Timing has an impact on the performance of funds,as opportunities for investment and exit will beimpacted by external economic circumstances. Forthis reason it has become normal practice tocompare the performance of funds against others ofthe same vintage. There may be marked differencesin performance from one vintage year to another. Inorder to ensure participation in the better years, it isgenerally perceived to be wiser to invest consistentlythrough vintage years, as opposed to "timing themarket" by trying to predict which vintage years willproduce better performance.

v) Industry

In venture investing, most of the focus tends to be ontechnology based industries. These can be sub-divided, for example into healthcare / life sciences,information technology and communications.Buyout funds tend to focus on technology to a lesserextent, providing exposure to such sectors asfinancial institutions, retail and consumer, transport,engineering and chemicals. Some have a specificsector focus.

Decision 4 - How to implement the strategy

Given the typical minimum investment size of privateequity funds, establishing a diversified portfolio willrequire certain minimum levels of capital commitment. It

will also take time to put into effect, bearing in mindvintage year diversification and the over-riding objectiveto identify the best managers in a given area. Part 4 coversthese and other practical aspects of investment.

Decision 5 - How to plan for the volatility of cash flows -the J-curve

An investor is typically required to fund only a smallpercentage of its total capital commitment at the outset.This initial funding may be followed by subsequentdrawdowns (the timing and size of which are generallymade known to the investor two or three weeks inadvance) as needed to make new investments. Just-in-timedrawdowns are used to minimise the amount of time thata fund holds uninvested cash, which is a drag on fundperformance when measured as an internal rate of return("IRR"). Investors need to maintain sufficient liquid assetsto meet drawdown obligations whenever called. Penaltycharges can be incurred for late payment or, in extremecases, forfeiture of an investor's interest in the fund. Inmost funds' early years, investors can expect low ornegative returns, partly due to the small amount of capitalactually invested at the outset combined with thecustomary establishment costs, management fees andrunning expenses.

As portfolio companies mature and exits occur, the fundwill begin to distribute proceeds. This will generally take afew years from the date of first investment and, as withdrawdowns, the timing and amounts will be volatile.When drawdowns and distributions are combined toshow the net cash flows to investors, this normally resultsin a "J-curve", illustrated in the chart below. Asdistributions normally commence before the wholecommitment has been drawn, it is unusual for an investorever to have the full amount of its commitment actuallymanaged by the manager. In the illustration below, netdrawn commitments peak at around 80%.

Typical fund annual cash flows to investors

Portfolio Construction

Drawdowns

(40)

(20)

0

40

60

80Distributions

20

(80)

(60)

Larger BuyoutsMid-Market/

Special Situation Venture Capital

US

Europe

ROW

100

1 2 3 4 5 6 7 8 9 10

Cumulative Cash Flow

(100) Year

%

Aspects of Investment

10

Part Four The Practical Aspects of Investment

1. The principal means of private equity investment

The principal means of private equity investment are:

a) Investing in private equity funds

b) Outsourcing selection of private equity funds, for example through a fund of funds

c) Direct investment in private companies.

While it is sometimes the ultimate objective ofinvestors to be able to make direct investmentsinto companies, compared with investing throughfunds it requires more capital (to achieve similardiversification and exposure), a different skill set,more resource and different evaluation techniques.Whilst this can be mitigated by co-investing with afund and the rewards can be high, there is higherrisk and the potential for complete loss of investedcapital. This strategy is recommended only toexperienced private equity investors. For mostinvestors the use of private equity funds would bepreferred, selected in-house or through outsourcedselection.

In-house private equity fund investment programme

Investors in a fund generally expect to gainbroader exposure through a portfolio built duringthe commitment period by investmentprofessionals who specialise in discovering,analysing, investing, managing and exiting fromprivate company investments. Being diversifiedamongst a number of different investments helpsensure that the risk of total loss of capital in thefund is relatively low compared to investingdirectly in unquoted companies. Compared toquoted equity funds, private equity funds ofteninvest in relatively concentrated portfolios, forexample there might be 10–15 companies in atypical buyout portfolio or 20–40 companies in aventure capital portfolio. Some factors thatinvestors should consider when selecting funds arediscussed in Part 5.

Outsourcing

(i) Fund of Funds

A fund of funds is a pooled fund vehicle whosemanager evaluates, selects and allocates capitalamongst a number of private equity funds.Because many funds of funds have existingrelationships with leading fund managers, andbecause commitments are made on behalf of apool of underlying investors, this can be aneffective way for some investors to gain access tofunds with a higher minimum commitment or toheavily subscribed funds. Many funds of funds are"blind" pools, meaning that exposure to particularunderlying funds is not guaranteed. Rather theinvestor is relying on the record of the manager toidentify and secure access to suitable funds. Somefunds of funds by contrast do disclose a pre-selected list of investments. Investors in funds offunds need to balance the extra layer ofmanagement fees and expenses involved againstthe cost of the extra resource that the investorwould need itself to select and manage a portfolio.Fund of funds investors should be able to achieveefficiently the diversified exposure referred to inPart 3 through a smaller deployment of capitalwith managers selected on rigorous criteria. It alsodecreases the burden of ongoing monitoring,reporting and administration.

(ii) Consultants

Consultants will offer similar expertise to fund offund managers, but may offer a choice ofdiscretionary or advisory services. The latter willfacilitate construction of a tailor-made portfolio, asopposed to committing to a blind pool alongsideother investors. Consultants may also offersegregated rather than pooled accounts.Consultancy services are also offered by somefund of funds managers.

PE Fund

CompanyInvesting in PE Funds

PE Fund

Company

PE Fund

Company

CompanyDirect Investments

Funds of FundsInvestors

11

Aspects of Investment2. Private equity fund structures

Example of a simplified fund structure

a) Legal and taxation aspects

The many legal jurisdictions in Europe make itdifficult to create a fund structure that can bemarketed effectively to investors in differentregulatory and taxation environments. Often it isnecessary to create two or more vehicles, withdifferent structures or domiciles, to permitinvestors in different countries to co-invest in acommon portfolio. Two of the principalconsiderations in any fund structure are:

- the structure should not prejudice the investor's tax position; and

- investors should have the benefit of limited liability.

In relation to tax, it is important that there shouldbe no additional layer of tax at the level of thefund, nor should investors be rendered liable totax in another country as a result of the fund'sactivities. As a result, fund structures are oftenbased on the principle of "transparency". In otherwords, investors are treated as investing directly inthe underlying portfolio companies.

A common structure used internationally is the USor English limited partnership. However, althoughbased on the principal of transparency, they maynot always be recognised as transparent in otherjurisdictions. Some of the more common fundstructures that satisfy the criteria of transparencyand limited liability in different jurisdictions are:

Finland Limited partnership

France FCPR and FCPI

Germany GmbH & Co KG

Netherlands CV (partnership)

Sweden Limited partnership

UK Limited partnership

There are, in addition, numerous incorporated andother structures available that may better suitdifferent investors on a country by country basis.

b) Liquidity

Private equity investing is a long-term investmentactivity and for this reason private equitymanagers generally impose rigid restrictions onthe transferability of interests in their funds. Issuesof liquidity can therefore put some investors off.There are however ways these can becircumvented.

i) Quoted private equity funds

There are a number of high-quality private equityfunds in Europe that are quoted on majorEuropean stock exchanges. Whilst many of thesewere established to take advantage of tax benefits(for example freedom from tax on capital gains forquoted investment trusts in the UK), they remainless common than privately held vehicles.

Some of the reasons for this include:

- the tendency of quoted investment companies to trade at a discount to asset value, which may fluctuate, eroding the return on investment or making it more volatile.

- the limited ability to return cash to investors - this means that when portfolio investments arerealised, the cash received remains inside the fund and dilutes its performance until such time as it can be re-invested.

Nevertheless, some investors can for regulatoryreasons only invest in quoted securities and forthese investors quoted private equity funds remaina good option.

ii) Development of the secondary market

There is a rapidly developing market in interests inexisting private equity funds, referred to as"secondaries". A secondary offering may comprisea single manager's entire fund of directinvestments or, more commonly, a portfolio ofinterests in a number of different funds.

There is a growing number of well-financedinvestors that specialise in purchasing interests inexisting funds from their original investors.Generally, however, investors should not assumethat secondary purchasers will offer a liquid orattractive exit path.

$8 millionCompany C

$3 millionCompany D

$5 millionCompany B Etc.

$100 millionCommited Capital

Investors$99 million

Manager$1 million

$10 millionCompany A

Aspects of Investment

12

For the larger secondary portfolios, it is commonfor a buyer to be secured through an auctionprocess. For the smaller transactions, these areoften effected in a confidential manner, sometimeswith buyer and seller matched by the fund'smanager or by an intermediary.

One of the keys to a secondary transaction issecuring the goodwill of the underlying manager.The manager often has the ability to refuse orrestrict transfer of the interest. In addition,valuation of the underlying assets is facilitated bythe co-operation of the manager.

As institutional private equity programmesincrease and start to reach maturity, the ability forinvestors to realise some existing commitments inorder to raise cash for future commitments willbecome more attractive. This will be one of thefactors that accelerates the development of thesecondaries market going forward.

c) Breaking new ground

i) Structured products

Specialist techniques of structuring funds havemore recently allowed private equity fundproducts to be offered with features that areattractive to particular types of investor. Throughsecuritisation, incorporated fund vehicles havebeen able to offer interests to investors in the form

of notes or bonds with credit ratings, includingconvertible securities. Such interests may alsobenefit from partial or complete guarantees of theprincipal sum invested. To date, such productshave usually been funds of funds structured as"evergreen" funds, meaning that realisedinvestment returns are not distributed to investorsbut reinvested within the fund. Likewise,commitments have generally been drawn down atthe outset rather than on a just-in-time basis forinvestment. These funds are normally quoted.

ii) High Net Worth Investors

High net worth investors are becoming asignificant and active section of the market. Sinceit is not practical for many to secure diversifiedexposure to a variety of funds, bearing in mind theusual minimum commitment size, there are avariety of pooled vehicle types that may beoffered. For example, dedicated feeder structuresmay provide specific single-fund exposure toprivate investors on a pooled basis. A variation ofthis model is a pooled vehicle that providesexposure to several (for example between four andsix) pre-selected funds. Alternatively, investors canoutsource their investment decision-making (asdiscussed above) by investing in one of the fund offund products available to high net worthinvestors, for example through private banks.

d) Typical private equity fund terms

Minimum Commitment Often between �5 million and �10 million

Manager’s Commitment Fund managers typically invest their personal capital alongside their investors'capital, which often creates a higher level of confidence in the fund. Investorslook for a "meaningful" manager investment of at least 1% of the fund.

Partnership Term The investment term for most private equity funds is 7 to 10 years, with thepossibility of extensions. The investment remains usually illiquid during thisperiod of time but distributions may be made as investments are sold.

Investment / On average, private equity funds invest committed capital over a three to sixCommitment Period year period.

Management Fees Fund fees traditionally include an annual management fee of around 1.5% to2.5% of committed capital, which should approximate the actual costs ofoperating.

Incentive / A share, typically 20%, of total gains that is payable to the manager. This is Performance Fees known as "carried interest".

Preferred Return The carried interest may be subject to the fund exceeding a certain level ofreturns on the drawn down money. This preferred return is a margin on the riskfree return per annum over the life of the fund.

13

Due DiligencePart Five Due Diligence

1. The importance of manager selection

The principal criteria for private equity fundselection usually relate to the credentials ofmanagement teams. The variation in performancebetween upper and lower quartile managers in theprivate equity market is substantially more diversethan in listed equity and bond markets. The chartbelow illustrates the importance in private equity ofselecting upper quartile management teams.

Source: Venture Economics

2. What to look for in a potential fund investment

Investors should evaluate each manager'scredentials by investigating closely its track recordand reputation. Previous research has shown that amanager's track record can be an indicator (thoughnot a guarantee) of future success as the percentageof new funds that become top quartile performershas historically been highest amongst managers ofprevious top quartile funds. The following are somekey considerations:

a) Investment strategy and market opportunity

A proposed fund's investment strategy should beclear and very similar to that on which themanager's track record is founded. The track recordshould demonstrate a disciplined approach and theability to adhere to the articulated strategy. Theamount of money being raised should be clearlyjustified by the magnitude of the perceivedinvestment opportunity and the extent of themanager's resources. The investment strategy shouldbe attractive in the context of the wider economiclandscape, which will impact the marketopportunity.

b) Track record

Publicly available statistics showing upper quartilerates of investment performance are becoming more

accurate as a benchmark for funds by sector andvintage year. Prospective investors need to examineinternal rates of return on investments inconjunction with multiples of original cost realised.Consistent upper quartile returns over an extendedperiod of time and a good number of realisedinvestments are preferred. Returns are often quotedon a "gross" and "net" basis. The gross returnrepresents the fund's return on its investments anddoes not take into account the fees and expenses ofthe fund or the dilutive effect of holding uninvestedcash. The net return represents the investor's returnand is also referred to as the "cash on cash" return.Returns on realised investments are often alsodistinguished from returns on unrealisedinvestments. Investors should look for a largeproportion of realised investments in the portfolio. Inrespect of unrealised investments, investors willwant to examine valuation policy. An analysis of thedispersion of returns on an investment by investmentbasis illustrates the volatility of returns and riskassociated with the investment strategy. Investorsshould look for a level of volatility that is consistentwith the strategy. For example, buyout returns oughtto be less volatile than venture capital returns.Another way to analyse a track record is by methodof value creation. For instance, portfolio returns canbe attributed to different elements of the strategy,including growth in sales, reduction in costs,improvement in price / earnings multiple and cashgeneration / deleveraging. A record thatdemonstrates a large proportion of returns beinggenerated through earnings growth is often popular.

c) Investment team

An assessment of the ability of a manger toreproduce previous upper quartile performance willfocus on the individuals comprising themanagement team, their incentivisation and the pastand future continuity within the team. The mostimportant aspect of each individual's backgroundshould be solid experience as a private equitymanager. Additional attributes, such as relevantoperational, sector or scientific experience, arehelpful. It is important that the core members of themanagement team have already been working as ateam for a significant period and departures fromthis core team over time have been minimal. Thiswill provide clearer attribution of the investmenttrack record to these individuals and give somecomfort as to the future continuity of the team. It isnormally very helpful to speak to businesscounterparts (for example portfolio company

Top quartile return boundary

All Private Equity

-10% -5% 0% 5% 10% 15% 20%

3rd quartile return boundary

Buyout &Mezzanine

Venture Capital-5.9% 0.4% 10.7%

0.0% 8.9% 18.7%

-6.2% 1.1% 12.1%

Median return

Dispersion of European Active Management Returns by Quartile

Due Diligence

14

executives or peer group fund managers) inrespect of the individuals, as they may providesome insight into the dynamics of the team.Further comfort with respect to the future can bederived from the incentivisation structure. Broadly,all the key executives should receive a fairproportion of the carried interest and ideally itwould be spread widely throughout the team. Thiswill give comfort as to the strength and depth ofthe team. It will also evidence planning for thefuture succession of senior managementresponsibility within the management team.Personal commitments to the fund by themanagement team that are meaningful in thecontext of their net worth are also a goodindicator of commitment.

d) Summary of key skills

Successful private equity managers will be able todemonstrate a number of key skills. Some of theseare described below.

Focus on Business Plans Business plans will be carefully built and analysed prior to any investment.Scrutinising a business plan and helping to create the conditions for its effectiveexecution is one of the major areas where private equity managers can addvalue to their portfolio companies.

Selectivity Good private equity managers will see a large number of potential transactions and Specialisation each year, which permits them to be extremely selective, pursuing only those

where they have the knowledge and capability to "add value." A full technological and operating knowledge of these opportunities has become increasingly important as the industry matures.

Ability to Negotiate Unlike the purchase of a public security, a private equity manager does nothave to buy exclusively on the basis of price. The manager can negotiate avariety of protections including exclusion of liabilities, indemnities andretroactive price adjustments.

Inside Unlike the purchase of a public security, the private equity manager can Information legally employ inside information such as management projections in its

investment process.

Strong Management Strong management, both within the private equity manager and the companyitself, is crucial to the success of an investment. The private equity manager willdepend heavily on the company’s management in the day to day operations ofthe business.

Value Added Focus Ownership and management become aligned, which almost always occurs to a greater degree than is usual in public equity. In addition the private equity manager will become involved in the strategic direction of the company and the risk management of the business. The imposition of debt, common in a buyout investment, forces aggressive business plans.

Governance / Control Unlike the governance structure of a public company, the private equity manager often has a degree of control or influence, allowing strategic and even operational intervention when necessary.

The Skill Set OfA Private Equity

Manager

Governance /Control

Focus onBusiness Plans

Selectivity &Specialisation

Value AddedFocus

Ability toNegotiate

InsideInformation

StrongManagement

15

Due Diligencee) Deal origination and investment process,monitoring and exit

Investors will generally look for a co-ordinatedorigination strategy and a disciplined procedurefor evaluating investments. This should includeevaluation of the business plan, the likely exitroute and expected investment returns. Thereneeds to be proven discipline amongst theprincipals of the fund as to application ofdecision-making criteria. This will include pricingdiscipline and it is an advantage for managers todemonstrate transactions declined on pricinggrounds. In venture capital, investors may look forevidence of preparedness to cut losses in under-performing investments rather than following on insubsequent rounds. In buyout funds, the ability totap the debt markets efficiently is an advantage.With regard to monitoring, how the manager usesvaluation metrics or milestones in the businessplan will be of interest. Having alternative exitstrategies is a strength in all private equity and theway a manager plans for an exit is a key factor.

f) Number and variety of underlying investments

The greater the number of underlying investments,the greater the diversification of risk. If theinvestments are very concentrated in number, orfocused in one particular geography or field ofoperation, then the risk becomes moreconcentrated. However, private equity managerstend to be heavily committed to investments andtherefore the number of deals that a team cansource, evaluate, operate and realise is strictlylimited. So there is also risk if a team spreads itselftoo thinly or operates in fields or geographieswhere it has limited prior experience.

g) Portfolio fit

Given the importance of building a diversifiedportfolio an investor should ensure that the type offund and its strategy fits into their broader privateequity portfolio strategy without unnecessaryduplication.

h) Quality of client servicing, reporting andadministration

Transparency and regularity of reporting are a keyarea to enable investors to monitor the progress oftheir fund portfolios. Manager attention to thisresponsibility does vary.

Monitoring...

16

Part Six Monitoring the Portfolio and Measuring Performance

1. Monitoring

If an investor is to take an active approach tomonitoring the activities of a fund holding, thiscan be a resource consuming exercise. Largerinvestors may be offered a place on the fund'sAdvisory Board, which generally focuses oninvestor and conflict issues.

Some investors will review in detail the investmentcase for each of the fund's investments. In someinstances the opportunity to co-invest may bemade available.

Achieving a close working relationship with thefund manager is a long-term objective, which willpromote a deeper understanding of the strengthsand weaknesses of the manager and its investmentstrategy.

Investors that want to build a close relationshipwith their managers should ensure that they areable to dedicate an appropriate level of resource.For this reason, many investors will limit thenumber of private equity fund managerrelationships that they maintain and to whom theycommit funds.

As mentioned earlier, regular and comprehensiveinvestor reporting by the manager is essential toeffective portfolio monitoring. This should includedetailed financial statements for the fund, astatement of the investor's account and detailedcompany by company reviews including prospectsfor realisation.

Investors should expect that the IRRs reported bytheir portfolio funds will show a J-curve profile, asdiscussed above in Part 3.

2. Measuring performance

a) IRR and multiple

Performance over time is typically measured asinternal rate of return and absolute gains aremeasured as a multiple of original cost. By usingboth measures simultaneously it is possible toillustrate the nature of returns. For example, ahigher multiple combined with a lower IRR wouldindicate that the returns had been achieved over alonger period. Conversely, a higher IRR over ashorter period may be based on a small absolutegain. It is important for investors to be aware thatit is common for anomalous and unsustainableIRRs to be produced by uplifts in valuation that

occur early in a fund’s life. In addition, significantrealisations achieved early in a fund's life willhave a material impact on a fund's final IRRperformance even though its aggregate multiplemay not be equally impressive. Thus it is alwayspreferable to look at both measures in tandem.

The IRR is defined as the discount rate used toequate the cash outflows associated with aninvestment and each of the cash inflows fromrealisations, partial realisations or its mark-to-market (the expected value of an investment at theend of a measurement period). The IRR calculationcovers only the time when the capital is actuallyinvested and is weighted by the amount investedat each moment.

b) Peer group benchmarking

When comparing a fund's performance with thatof other private equity funds, it is important tocompare like with like. First, one should comparefunds in the same sector. For example, to comparea buyout fund with a venture capital fund wouldbe meaningless. Comparing two mid-market pan-European buyout funds against each other wouldbe appropriate.

To compare sub-sector funds established duringthe same vintage year is also appropriate. As fundsgenerally invest committed capital over a three-to-six year period and generally harvest investmentsin years three to ten, no meaning can be derivedfor example from comparing a fund in its first yearto a fund in its sixth year. Also, funds withdifferent vintage years may have experiencedsubstantially different economic and investmentenvironments, which makes such comparisonsinadvisable.

Whilst private equity funds do not usually publishtheir return data, funds of funds and consultantswill have built up their own databases of returninformation and should be in a position to makecomparisons. In addition, statistics of increasingaccuracy are publicly available showing aggregatequartile performance by vintage year, geographyand sector.

c) Benchmarking against different classes of assets

The IRR computation is similar to that used tocompute the yield-to-maturity on a fixed incomeinvestment. It is however different from the time-weighted rate of return calculation that is standard

17

...& Measuringfor mutual funds and hedge funds as the variabilityof the timing and amounts of private equity fundcash inflows and outflows make it unsuitable.

As a result, benchmarking against other assets isnot a straightforward process. One method is topick a benchmark index and to apply to a notionalholding of that index the same cash flows that areexperienced as a holder of an interest in theprivate equity fund. For example, when the funddraws down cash, it is treated as a purchase of thebenchmark index of the same amount. When cashis returned, again it is treated as a realisation ofthe same amount from the notional holding. If thefund out-performs the index, then the notionalholding will have been reduced to nil before thefund finishes distributing. Benchmarking aportfolio in aggregate is also an option.

18

GlossaryAppendix Glossary of Terms

AcquisitionThe obtaining of control, possession or ownership of acompany.

AngelA wealthy individual who invests in entrepreneurial firms.Although angels perform many of the same functions asventure capitalists, they invest their own capital rather thanthat of institutional and other individual investors.

Asset StrippingDismantling an acquired business by selling off operationaland/or financial assets.

Average IRRThe arithmetic mean of the internal rates of return.

BalancedA venture fund investment strategy that includes investmentin portfolio companies at a variety of stages.

Bridge FinancingMezzanine financing for a company expecting to go publicwithin six months to a year or prior to raising a new fundinground.

BufferUnused credit facility or cash reserves.

Burn RateTimeframe for a company to use up a capital injection.

Buyout The purchase of what is normally a majority stake in anestablished mature company.

Capital GainsShort or long-term profits from the sale of assets.

Capital under ManagementThe amount of capital available to a management team forprivate equity investments.

Capital Weighted Average IRRThe average IRR weighted by fund size with fundscontributing to the average in proportion to their size.

Captive FundInvestment fund partly owned by a larger financialinstitution.

Carried InterestAlso known as "carry". The share of profits from investmentsmade by the fund (generally 20-25%) that the managersreceive. Typically, carried interest is only paid after investorsreceive their original investment back plus a preferredreturn.

CommitmentAn investor’s obligation to provide a certain amount ofcapital to a fund.

Corporate VenturingVenture capital provided by large corporations to furthertheir own strategic interests.

DilutionA reduction in the fraction of a firm's equity owned by thefounders and existing shareholders associated with a newfinancing round.

DistributionCash or the value of stock payments to investors after therealisation of investments in the partnership.

Distributions to Paid-in CapitalThe amount a partnership has distributed to its investorsrelative to the total capital contribution to the fund.

Due DiligenceThe investigation and evaluation of a management team'scharacteristics, investment philosophy, track record andterms and conditions prior to committing capital to the fund.

Early StageA fund investment strategy involving investment incompanies carrying out product development and initialmarketing, manufacturing and sales activities.

Equity KickerOption for private equity investors to purchase shares at adiscount.

Exiting StrategyA fund's intended method for liquidating its holdings whileachieving the maximum return possible.

First Stage/Round The first round of financing following a company's startupphase that involves an institutional venture capital fund.

FundThe investment vehicle, often a limited partnership, to whichthe investors commit capital.

Fund CapitalisationThe total amount of capital committed to a fund byinvestors.

Fund Focus The indicated area of specialisation of a private equity fund.

Fund of FundsA fund which takes minority equity positions in other funds.If the focus is primarily investing in new funds this is aPrimary fund of funds and if focusing on investing in mature,existing funds this is referred to as a Secondary fund offunds.

GatekeepersSpecialist advisers who assist institutional investors in theirprivate equity allocation decisions. Most manage funds offunds.

General PartnerA partner in a limited partnership responsible for the day-to-day operations of the fund.

Holding Period The amount of time an investment remains in a portfolio.

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GlossaryHorizon Return An IRR calculation between points in time where thebeginning point is variable and the end point is fixed. Anexample would be the 3, 5, and 10 year returns ending12/31/99.

Inception The starting point at which IRR calculations for a fund wouldbe calculated; generally, the vintage year or date of firstcapital takedown.

Investment Philosophy The stated investment approach or focus of a managementteam.

IRR (Internal Rate of Return) The discount rate that equates the net present value (NPV) ofan investment's cash inflows with its cash outflows.

IPO (Initial Public Offering) The sale or distribution of a stock of a portfolio company tothe public for the first time.

LBO (Leveraged Buyout)A fund investment strategy involving the acquisition of aproduct or business, from either a public or privatecompany, utilising a significant amount of debt.

Lead Investor Member of a syndicate of private equity investors usuallyholding the largest stake, in charge of arranging thefinancing and most actively involved in the overall project.

Limited Partners The investors in a limited partnership.

Limited Partnerships The legal structure used by most private equity funds.Usually fixed life investment vehicles. The general partner ormanagement firm manages the partnership using policy laiddown in a Partnership Agreement. The Agreement alsocovers terms, fees, structures and other items agreedbetween the limited partners and the general partner.

Liquidation The sale of the assets of a portfolio company to one or moreacquirors where venture capital investors receive some ofthe proceeds of the sale.

Lower Quartile The point at which 75% of all returns in a group are greaterand 25% are lower.

Later Stage A fund investment strategy involving financing for theexpansion of a company which is producing, supplying andincreasing its sales volume.

Management Buyin (MBI) Take over of a company by external management.

Management Buyout (MBO) Take over of a company by existing management.

Management Fee Compensation for the management of a fund's activities,generally paid quarterly from the fund to the general partneror management company.

Mature Funds Funds which have been investing for at least five years.

Median The mid-point of a distribution where half of the sample areless than or equal to the median and half of the samplegreater than or equal to the median.

Mezzanine A fund investment strategy involving subordinated debt (thelevel of financing senior to equity and below senior debt).

Paid-in Capital The amount of committed capital an investor has actuallytransferred to a fund. Also known as the cumulativetakedown amount.

Pooled IRRA method of calculating an aggregate IRR by summing cashflows together to create a portfolio cashflow and calculateIRR on portfolio cashflow.

Portfolio Company The company or entity into which a fund invests directly.

Placement Agent A financial intermediary hired by private equityorganisations to facilitate the raising of new funds.

Preferred Return Either (i) the set rate of return that the investors must receivebefore the general partners can begin sharing in anydistributions, or (ii) the level that the fund's net asset valuemust reach before the general partners can begin sharing inany distributions.

Quartile Segment of a sample representing a sequential quarter (25%)of the group. (First 10 out of 40 funds - first quartile, etc.)

Ratchet Arrangement whereby the eventual value of a targetedbusiness depends on its future performance.

Realisation Ratio The ratio of cumulative distributions to paid-in capital.

Realised Multiple The ratio of total gain/(loss) to cost of realised investments.

Residual Value The remaining equity which an investor has in a fund.

Restricted Securities Public securities which are not freely tradable due tosecurities regulations.

Second Stage/Round Funds provided for the early expansion of a company.

Appendix

Glossary

20

Secondary Buyout/SaleExit mechanism whereby one investment firm sells itsposition in a company on to another investment firm.

Seed Stage An investment strategy involving portfolio companies whichhave not yet fully established commercial operations, andmay also involve continued research and productdevelopment.

Standard Deviation A measure of the dispersion of the frequency distribution.

Takedown Schedule The plan providing for the actual transfer of funds from theinvestors.

Terms and Conditions The financial and management conditions under whichfunds are structured.

Third Stage/RoundFunds provided for the major expansion of a companywhose sales volume is increasing and which is breakingeven or profitable.

Trade Sale Sale of a portfolio company to another company, typicallyoperating in the same industry.

Turnaround Financing provided to a company at a time of operational orfinancial difficulty with the intention of improving thecompany's performance.

Upper QuartileThe point at which 25% of all returns in a group are greaterand 75% are lower.

Valuation Method The policy guidelines a management team uses to value theholdings in the fund's portfolio.

Venture Capital Describes the universe of venture investing (see PrivateEquity). It does not include buyout investing, mezzanineinvesting, fund of fund investing or secondaries.

Vintage The year of fund formation and first takedown of capital.

Warranty Statement made by vendor regarding the terms of aproposed transaction.

Write-down A reduction in the value of an investment.

Write-off The exit from an investment at a valuation of zero.

Write-up An increase in the value of an investment.

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This EVCA Special Paper is published by the European Private Equity & Venture Capital Association (EVCA). ©Copyright EVCA March 2004