Private Equity Fund Structures, Terms, Valuation, and Due Diligence

Private Equity Fund Structures

Limited Partnerships

This is the most common form of ownership structure for private equity funds. In this scenario, the limited partners (LPs) offer funding but do not actively manage the investments. The partners’ liability is typically limited to their investments. The general partner (GP) has unlimited liability in a limited partnership, i.e., he’s liable for all the firm’s debts hence manages the fund.

Limited by Shares

Private equity limited by shares offers better legal security to the partners (GP and LPs), depending on the jurisdiction. Most fund structures are closed-end, i.e., investors can only convert the investment at specified periods and limit new investors from joining the fund only at predefined periods, at the discretion of the GP.

Terms of a Private Equity Fund

The fund draft agreement contains terms that result from arbitration amongst the General Partner and the Limited Partners. In case of oversubscription of funds (i.e., more potential investors than needed), the GP has greater negotiating power. The terms of the fund should be concentrated on supporting the GP and LPs’ interests and stipulating the GP’s rewards.

Economic Terms of a Private Equity Fund

Management Fees

Refers to fees paid to the GP annually as a percent of paid-in capital invested during the fund’s lifetime.

These fees range between 1.5% to 2.5% and, at times, are calculated based on net asset value or invested capital.

Transaction Fees

Refers to GP payments to provide advisory services, i.e., investment banking services for IPOs, acquisitions, and mergers. These fees are usually split evenly (50/50) between GP and the LPs and when paid, they are normally deducted from management fees.

Carried Interest Performance Fees

Refers to the GP’s share of the fund profits and is usually 20% of profits (after management fees).

Ratchet

Specifies the allocation of equity between investors and management of the private equity portfolio company. It permits management to increase their allocation, depending on firm performance.

Hurdle Rate

This is the IRR target that the fund must meet to allow the GP to receive the carried interest. It commonly varies, between 7% and 10%, and encourages the GP to outperform set targets.

Target Fund Size

It is the specified absolute figure and the stated total maximum size of the private equity fund. It depicts the GP’s capacity to manage and raise capital for a fund. Besides, it indicates if actual funds ultimately raised are significantly lower than the targeted amount.

Vintage Year

Refers to the year the fund was initiated. In addition, it facilitates performance comparisons with other funds that have the same investment goals.

Term of the fund

Refers to the life of the firm, usually ten years.

Note:

• Committed capital: Total funds promised by investors to private equity funds.
• Paid-in-capital: Also referred to as “invested capital,” is the total funds received from investors.

Example 1: Calculating Carried Interest With a Hurdle Rate

Consider a fund with committed capital of $150 million, 15% carried interest, and a hurdle rate of 8%. The fund called 80% of its commitments at the start of Year 1. Of this, $80 million was invested in Firm A and $40 million in Firm B. At the end of Year 2, the fund realized a profit of $6 million on the exit from Firm A, while the investment in Firm B remained unaffected. The carried interest is determined on a deal-by-deal basis (i.e., the IRR for determining carried interest is calculated for each deal upon withdrawal).

The resulting theoretical carried interest and the actual carried interest is closest to:

Solution

\(\text{Theoretical carried interest}=(20\text{%}\times $ 6 \text{ million})=$1.2 \text{ million}\)

Using the financial calculator:

PV = -$80; FV = $87; N = 2; PMT = 0; CPT I/Y = 4.28%

Since the IRR of 4.28% is less than the hurdle rate of 8%, no payment is made for carried interest.

Other Terms of a Private Equity Fund and Corporate Governance

Keyman Clause

When a key manager exits the fund or does not spend enough time in the management of the fund, the GP can be banned from creating extra investments until another top manager is appointed.

Disclosure and Confidentiality

Refers to the specifics regarding the fund performance information that can be disclosed. However, information relating to the performance of underlying portfolio firms is never disclosed.

Clawback Provision

Requires that if a fund successively underachieves, the GP is obligated to refund a percentage of the initial profits to the LPs. The clawback provision is typically settled at the fund’s termination but can also be settled annually (also known as true-up).

When a fund reports profits in its initial life, the GP collects payment from the GP’s contractually defined share of profits.

Distribution Waterfall

It indicates the flow of profits to the LPs in consideration that the GP obtains carried interest. The deal-by-deal method specifies that the carried interest can be disseminated after each deal. The fact that one deal could earn, say $20 million, and another could lose $20 million, creates a disadvantage from the LP’s point of view. Still, the GP will receive carried interest on the first deal, even though the LPs have not earned an overall positive return.

In the case of the total return method, carried interest is calculated on the entire portfolio.

The method relies on two variations being:

1. Carried interest can be paid after the entire committed capital is returned to LPs; or
2. Carried interest can be paid when the portfolio’s value surpasses invested capital by a minimum amount (typically 20%).

Note that the former uses committed capital, whereas the latter utilizes capital invested.

Tag Along, Drag Along Rights

When an investor obtains control of a firm, they are forced to extend the acquisition offer to all shareholders, including the firm management.

No-fault Divorce

Occurs when a GP may be fired without cause, only when a supermajority (75% or more) of LPs okay the removal.

Removal for “Cause”

Allows for the dismissal of the GP or early termination of the fund for reasons such as gross negligence of the GP, a “key person” event, the bankruptcy of the GP, etc.

Investment Restrictions

Investment restrictions impose a minimum level of diversification of the fund’s investments, a geographic and sector focus, or borrowing limits.

Co-investment

It allows the LPs to invest in other funds of the GP at low or no management fees. It provides the GP with additional funds and prevents the GP from using diverse funds to invest in the same portfolio firm. A conflict of interest may arise if the GP takes capital from one fund to invest in a troubled firm that had received capital from another fund earlier.

Example: Applying the Distribution Waterfalls Method

Consider a fund that has committed capital of $200 million and carried interest of 20%. An investment of $80 million is made and, later in the year, the fund exits the investments and earns a profit of $44 million.

Determine if the GP will receive carried interest under the three distribution waterfall methods.

Solution

Step 1: Calculate the carried interest using the deal-by-deal method as follows:

$$\text{Carried Interest}=(20\% \times \$ 44 \text{ million})=\$ 8.8 \text{ million}$$

Under this method, the carrying interest can be distributed after each deal; hence $8.8 million is paid to the GP.

Step 2: Compare the portfolio value with the committed capital using the total return method as follows:

$$ \begin{align*} \text{Total proceeds from the investment} & =\$ 80 \text{ million}+\$44 \text{ million} \\ & =\$124\text{ million} \end{align*} $$

In this case, the committed capital is $200 million, while the total proceeds from the exit are only $124 million; hence no carried interest payment is made.

Step 3: Compare the portfolio value with the invested capital using the total return method as follows:

$$ \begin{align*} \text{Invested capital} & =\$80 \text{ million} \times 100\% \text{ Invested capital} \\ & + 20\% \text{ typical minimum threshold}) \end{align*} $$

$$\text{Invested capital}=$80 \text{ million} \times 120\text{%}= $ 1.6 \text{ million}$$

Note that the carried interest is paid under this method when the portfolio value exceeds the invested capital. In this case, the portfolio value is $124 million compared to the invested value of $96 million. Therefore, the carried interest of $8.8 million will be paid to the GP.

Example: Applying a Clawback Provision Method

Using the above example, assume that in Year 2, another investment of $35 million is exited and results in a loss of $8 million. Further, assume that the deal-by-deal method and a clawback with annual true-up are applicable.

Determine if the GP is to return any prior profits to the LPs.

Solution

In the deal-by-deal method, the GP was paid a carried interest of $8.8 million.

Considering the loss of $8 million, the GP owes the LPs 20% of the loss as follows:

$$20\text{%}\times $ 8 \text{ million}=$ 1.6 \text{ million}$$

Private Equity Fund Valuation

Private equity fund valuation employs the net asset value (NAV), which refers to the value of the fund assets minus liabilities corresponding to the accrued fund expenses.

Calculating NAV

The General Partner (GP) values the funds assets in the following ways:

1. At cost adjusted for subsequent financing and devaluation.
2. At the market value or lower cost.
3. By revaluing a portfolio firm anytime there is new financing.
4. At cost, with no adjustment until exit.
5. Discount factor being applicable for restricted securities.
6. The less frequent application of illiquidity discounts to values based on those of comparable publicly traded companies.

Issues in Calculating NAV

If the NAV is only adjusted when financing subsequent rounds, then the NAV will be staler when financing is infrequent.

There is no conclusive method for calculating NAV for a private equity fund because it is usually not possible to determine the market value of portfolio companies until exit.

Undrawn LP capital obligations are not included in the NAV calculation but are liabilities for the LP. The value of the obligations depends on the cash flows created from them. These, nevertheless, are pretty uncertain. When a GP has distress-raising funds, the value of these obligations will be low.

A stockholder needs to be aware that funds with various policies and maturities can utilize diverse valuation practices. At the start, a venture capital investment can be valued at cost. Afterward, the valuation can be done using comparables.

Private Equity Investments Due Diligence

When undertaking any investment, external investors are required to conduct thorough due diligence of a private equity fund due to the following characteristics:

• Private equity funds exhibit returns that tend to persist. This explains why a fund’s historical performance is valuable data. i.e., high performers tend to keep high performance, and low performers tend to keep low performance.
• The return inconsistency between high performers and low performers is enormous and can be 20%.
• Private equity investments are primarily illiquid and long-term investments. However, a private equity investment is usually shorter than expected because when a portfolio firm is exited, the funds are immediately refunded to the fund investors.

Question

Consider a GP in private equity which has invested in portfolio Firm A funded by private equity Fund A. Portfolio Firm A is experiencing financial difficulty hence, the GP has considered using funds from a recently established private equity fund, Fund B.

The GP has most likely violated which of the following terms in the private equity prospectus?

1. The tag-along, drag-along clause.
2. The co-investment clause.
3. The no-fault divorce clause.

Solution

The correct answer is B.

The co-investment clause stops the GP from utilizing capital from different funds to invest in the same portfolio. Portfolio Firm A may be a poor use of the funds from Fund B investors hence creating a potential conflict of interest.

A is incorrect. Whereas a ‘tag along’ clause protects minor investors, a ‘drag along’ clause protects the interests of the majority shareholders. A ‘drag along’ clause allows a significant shareholder (or group of shareholders) to ‘drag’ the minor stockholders into a joint sale of the entire undertaking.

C is incorrect. A “no-fault divorce” clause permits investors to remove the general partner after the final closing date and either terminate the Partnership or appoint a new general partner.

Reading 38: Private Equity Investments

LOS 38 (g) Explain private equity fund structures, terms, due diligence, and valuation in the context of an analysis of private equity fund returns.