Mariya Stefanova
PE Accounting Insights

Published in October 2011 by

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© 2011 PEI

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eISBN 978-1-908-783-53-0

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PEI editor: Anthony O’Connor

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Printed in the UK by: Hobbs the Printers (www.hobbs.uk.com)

To my wonderful children, Alex and Lilly, who inspired me to write this book, my partner Dimitar who has supported me at all times, and my mom who has always been there to provide a helpful hand.

For all the fund accountants across the world who work so hard with very little to guide them. A special thanks to Anthony O’Connor, my editor, who made it all happen. And my sincere gratitude to the expert contributors who have added great value to the book.

Thank you all.

Mariya Stefanova

Contents

Figures and tables

Figures

Tables

About the author

Mariya Stefanova is a founder partner of PE Accounting Insights, a private equity accounting training and consultancy firm, providing specialist training and technical advice for private equity houses, fund administrators and individual fund accountants. She has more than seven years of experience in private equity accounting and more than three years of experience in training fund accountants during which period she has trained over 130 fund accountants.

Previously Mariya was working in the technical department of Augentius Fund Administration LLP, a premium provider of fund administration services specialised in private equity and real estate funds. She was in charge of the technical training of the client services accountants and keeping them up-to-date with the industry and accounting developments. Mariya also provide advice to clients and client-services accountants in resolving complex technical issues, as well as performing technical reviews of accounts, quarterly investors’ reports and complex calculations.

Before joining Augentius in 2008, Mariya worked for fund administrator Mourant International Finance Administration (now State Street) looking after a portfolio of private equity clients. Before joining Mourant in 2006, Mariya worked for Calyon, a French investment bank and before Calyon she was working for Patron Capital Partners, a leading European opportunistic real estate manager.

Mariya started her career with a large chemical company in Bulgaria where she was chief accountant and was subsequently a financial controller for an industrial catering company. Mariya holds a Masters in Finance and Accounting from the University of National and World Economy (UNWE).

E-mail: info@peaccountinginsights.com

Web: http://peaccountinginsights.com

01

Introduction to private equity
for accountants

By Mariya Stefanova

History of private equity

From a number of historical sources and varied interpretations of economic history developments, different authors can draw different plots about the history of private equity. To describe the history of this asset class in any significant detail is outside the scope of this publication, so I have included a brief outline of some of the ways in which the private equity industry has developed over the ages without claiming any originality or historical authenticity of my sources. As a private equity accounting practitioner, you may even want to skip this part and dive into the specific areas of interest.

However, it is vital for any accountant dealing with private equity to understand the commercial nature, the mechanics and the transactions of the fund that will be translated into accounting processes and entries later in this book. Therefore, I would recommend that a private equity industry novice read this section in order to gain a deeper understanding of the evolution of private equity.

Whereas some people think that private equity started in the US after the Great Depression in the 1930s, others think that it is as old as human civilisation itself. Pierre-Yves Mathonet and Thomas Meyer, in the introduction to their book, J-Curve Exposure: Managing a Portfolio of Venture Capital and Private Equity Funds, view Queen Isabella of Castile as a private equity sponsor and the purchase of an interest in Christopher Columbus’ voyage of discovery as a private equity investment whereby she provided not only financial back-up, but also management and recruitment assistance.

This can clearly be said to mimic, to a certain extent, the activities of a contemporary private equity sponsor or manager. Mathonet and Meyer continue with their interesting analogy by describing the refusal of King John II of Portugal to provide financial support to Columbus as an exercise in due diligence, as it followed his request for an independent opinion from his experts on Columbus’ proposal.

Ancient forms

Ancient Rome and Italy

Exploring the history of the limited partnership – the most common legal form for private equity or venture capital funds – it seems that the ‘societates publicanorum’, which started to be used in Rome in the third century BC, may have arguably been the earliest form of limited partnership. Later on in mediaeval Italy, another form resembling the private equity structure called ‘commenda’ appeared, where tenth century Italian merchant families financed trade voyages using an early form of limited partnership. This partnership had ‘sleeping partners’, who were not liable for any debt and stayed at home (similar to limited partners (LP) in a modern limited partnership), while the ‘travelling partners’ controlled the venture and set sail to search for profitable businesses (similar to the general partner (GP) in a modern limited partnership).¹

Mediaeval Islamic world

Forms of limited partnership not only appeared in Europe; in the mediaeval Islamic world the Qirad and Mudarabah institutions were legitimised by Islamic law and jurisprudence. Both institutions are used to signify the same idea, and resemble the Italian commenda quite closely: “To give somebody out of your capital a part to trade in, provided that the profit is shared between both of you, or that an apportioned share of profit is allocated to him... accordingly, the active partner is called Darib, because he is the one who travels and trades. It is also possible that both capitalist and active partner are called Mudarib or Muqarib as both share the profits with each other. The Makkans were depending on commerce for their livelihood; and those who could not exercise commerce by themselves, travelling long distances and leaving their homes for long periods, used to give capital to those able and willing to trade against a certain percentage of net profit.”²

More recent history

In more recent history, the roots of private equity can be traced, as a more organised form of investment, back to private financing employed by the railroad and textile mills in the 19th century. However, three largely negative events in the first half of the 20th century provided the most significant boost to the industry – the two World Wars and the Great Depression of the 1930s.³

The First World War and the War Finance Corporation

The First World War set the scene for private equity when, on April 5, 1918, the US Congress created the War Finance Corporation (WFC) to provide financial support to industries essential for the war and to banking institutions that aided such industries. Since government borrowing to pay for the war had attracted a significant amount of private capital, little capital was available for corporations to borrow. The WFC was designed to make such capital available, but it also assisted in the transition to peacetime by financing railroads under government control, and making loans to US exporters and agricultural cooperative marketing associations before it was abolished on July 1, 1939.

The Great Depression and the Reconstruction Finance Corporation

The next event to set the scene further was the Great Depression, which started in 1929 in the US and quickly spread around the world, lasting until the early 1940s in some regions. In response, US president Herbert Hoover created the Reconstruction Finance Corporation (RFC) to alleviate the financial crisis by lending money to all businesses damaged by the Depression.

The Second World War and the Smaller War Plants Corporation

The Second World War brought the creation of the US Smaller War Plants Corporation (SWPC) in 1942, particularly targeting small businesses which were unable to compete with the more resistant large corporations. Lending money to such small private enterprises and encouraging large financial institutions to make credit available to them became the focus of the SWPC.⁴

American Research and Development Corporation and the father of Venture Capital

A few other events leading to government initiatives contributed to the development of private equity, but the most prominent one was arguably the creation of American Research and Development Corporation (ARD), which is widely considered to be the first organised venture capital firm when it was founded in 1946 by general Georges Doriot who, by many accounts, is described as the father of venture capitalism. A former French army general, Doriot immigrated to the US in the 1920s to earn an MBA and subsequently became a professor and then dean of the Harvard Business School. ARD was originally founded to encourage private sector investments in businesses run by soldiers who were returning from the Second World War. ARD’s major success was its investment in 1957 of $70,000 of equity into a company called Digital Equipment Corporation (DEC), founded by two engineers from the Massachusetts Institute of Technology (MIT), Ken Olsen and Harlan Anderson, who were working on a minicomputer. In the 1970s, when ARD floated the company, the initial public offering (IPO) raised over $38 million.⁵

Other industry boosters

There were also a number of other high-profile organisations and wealthy individuals and families investing in private companies during the first half of the 20th century, such as J.H. Whitney & Company, the Vanderbilts, the Rockefellers and the Warburgs. Increasingly, further legislative change and advancements in financing trends boosted the industry largely in the US:

•The Investment Company Act and the Small Business Investment Company (SBIC) Program – In 1958, the Investment Company Act in the US created the SBIC Program, which supplied equity capital, long-term loans and management assistance to qualifying small businesses, and also played a significant part in the genesis of the modern private equity industry.⁶

•The growing IPO market in the 1960s – In the 1960s, the bull IPO market further assisted the growing popularity of venture capital.

•ERISA legislation – Following the plummeting stock market in the 1970s, a new piece of legislation was introduced in the US in 1974, namely the Employee Retirement Income Security Act (ERISA), which established minimum standards for pension plans in private industry, ERISA unintentionally caused pension funds to stop investing in high-risk investments, including private equity and venture capital. When the Prudent Man Rule in the same legislation was clarified later in 1978 to allow pension funds to invest in private equity and venture capital, the initial unintended negative effect was not only rectified but further boosted the industry with some big institutional investors gradually starting to increase their allocations to private equity and venture capital.⁷

•Other tax developments in the 1980s – The Steiger Amendment introduced changes to the tax legislation in the US, with the top rate of capital gains tax (CGT) being reduced from 49 percent to 28 percent, and even further reductions following the Tax Act of 1981 additionally boosted the industry.

Private equity in the 21st century

With extensive growth and proliferation into Europe and particularly the UK from the 1980s, venture capital and private equity blossomed from what was at the start of the 20th century a cottage industry into a well-organised alternative asset class, demonstrated by the boom years between 2003 and 2007. As with any maturing asset class the global private equity industry has developed many derivative investment strategies that cater for a number of specialist investment stages and strategies, such as mid-market buyout funds, large leveraged buyout funds, multi-billion dollar private equity funds, infrastructure funds of all sizes, private equity real estate funds, mezzanine funds, distressed and special-situations vehicles, secondaries funds and funds of funds. As the whole universe of private equity recovers from the deeply penetrating global financial crisis, which unfolded in 2008 with the collapse and near-collapse of many financial institutions, the new paradigm for private equity is still evolving. Closer regulatory scrutiny in the US and Europe, a shift in the balance of power between general partners and limited partners, greater questioning of private equity’s returns by informed commentators and academics and the shift in economic power from the West to the East are just some of the major developments shaping the future of the whole private equity class.

What is clear in 2011 is that the private equity industry has undisputedly come a long way since the birth of post-war entrepreneurial optimism of the 1940s.

How to define private equity

Having taught private equity fundamentals to accountants for years, the easiest way to explain private equity to newcomers to the industry is by simply defining the meaning of the two words: ‘private’ and ‘equity’. In simple terms, ‘private’ indicates that the investments are made into private or non-listed companies; ‘equity’ describes investing in equity stakes in those private companies. Although this might be true in the majority of cases, this definition is over-simplistic and, if applied universally, may overlook transactions that are still considered to be part of the asset class, including, for example, public-to-private transactions or private equity investments in public equity (PIPE) deals, or when the deal is structured as convertible debt. A good example of a high-profile PIPE deal is the Alliance Boots transaction in 2007 when a consortium comprising KKR and Alliance Boots’ own deputy chairman, Stefano Pessina, won the bidding war against a rival consortium led by another big private equity house, Terra Firma, to become the first FTSE 100 company to be taken private by a private equity fund.⁸

Bearing this in mind, when explaining private equity to future accountants I always add the proviso that, in the modern world of private equity, it is not always private, nor equity only. Sometimes in investment schedules there is a mixture of listed and non-listed companies and almost always a mixture of debt and equity or even hybrid instruments, for example, preference shares or convertibles.

To elaborate on the definition, private equity can be described as a collective investment scheme whereby investors’ money is pooled together using commitments that are drawn down over the life of the fund and invested in private companies through a mixture of equity and debt instruments.

How does a private equity fund work?

As described in the aforementioned definition, investors commit to the fund on day one; commitment is a legal obligation, assumed by the investors, to deliver funds over the life of the fund (not on day one) as and when funds are needed for investments, management fees or other fund expenses.

A private equity fund manager uses its talent and know-how to find new investments: once an investment is found, the relevant amount is drawn down from investors out of their total commitment and invested in the portfolio company. The private equity manager then works closely with the management of that portfolio company over the holding period (an average of three to five years), aiming to improve the company and raise its value, so that it can potentially be sold to another investor or be floated on the stock market at a profit. Part of this profit would then be returned to the investors and a percentage kept by the manager in the form of an agreed performance fee, which is known as carried interest or carry.

The money invested in the portfolio company could be used for a variety of purposes, including:

•starting up a business (start-ups in the case of venture capital);

•developing new product lines;

•funding new technologies;

•making new acquisitions or strengthening its organic growth;

•expanding working capital or simply strengthening its balance sheet;

•restructuring the company; or

•resolving ownership problems, for example, management buyouts or management buy-ins.

Open-ended versus closed-end funds

Open-ended funds are collective investment schemes whose capital does vary over time, and for that reason they are also called variable-capital funds; the capital in those funds expands as shares or units are issued, and contracts when shares or units are redeemed. Examples of open-ended funds are unit trusts, open-ended investment companies (OEIC) and investment companies with variable capital (ICVC) in the UK, mutual funds in the US, société d’investissement à capital variable (SICAV) in Luxembourg, hedge funds and exchange-traded funds (ETF).

At the other end of the spectrum are the closed-end funds; their capital does not vary over time and their size, respectively, is constant, which is why they are also referred to as ‘invariable-capital funds’. New shares (units or other instruments) are rarely issued once the fund has launched and shares are normally not redeemable until the fund is liquidated. Examples of closed-end funds are investment trusts in the UK and closed-end companies in the US.

Private equity funds usually take the form of a closed-end fund with their fixed capital being the total commitment which does not change over the life of the fund.

Limited-life versus evergreen funds

In addition to the closed-end structure that the private equity funds adopt, with single or multiple closings (a ‘close’ or ‘closing’ is any intake of new investors in the fund), private equity funds are also usually limited-life funds with a typical life of ten years. There is the further possibility for limited-life funds to be extended by two years if the general partner deems such an extension to be appropriate. In contrast, there are evergreen funds, with no time restrictions limiting the life of the fund. For all fund structures, the first half of the fund life (approximately, but not necessarily, the first five years of the term) is called the ‘investment period’ and the second half is called the ‘divestment period’, although there is typically an overlap between investment and divestment period.

An additional distinction to be made is that while evergreen funds keep recycling the proceeds from disposal of investments, a private equity fund will have returned all the contributions back to its investors by the end of its life, resisting a redraw or clawback of any distributions previously returned to the investors. There are limited exceptions to this rule, usually being the amounts drawn to pay fund expenses by rationalising that such amounts “have not yet been productively invested or put to work” by the fund, or the amounts used to fund temporary and bridge investments (usually less than 12 months) sold as a “quick flip”.⁹

Limited partnership (and fund for joint account)

Limited partnership (or funds for joint account used in certain jurisdiction) is the preferred legal form when structuring private equity funds because the limited partnership is a tax-transparent entity¹⁰ – “an entity which is not taxed either in representative capacity or in its own capacity as a tax-paying entity, but the tax is levied on the participants in the entity based on their share of income in the entity”.¹¹ It is called a tax-transparent or see-through entity because it is treated, for tax purposes, almost as if it does not exist, as if you can see through it all the way to its individual limited partners. In the context of a fund structured as a limited partnership that would mean that the partnership (the fund) itself will not be taxed at the legal-entity level (at the fund level), but the limited partners will bear the tax burden instead or from the limited partner’s perspective, they will be taxed as if that limited partner has a direct investment in the underlying portfolio. The partnership though may still have some obligations to the relevant tax authorities, for example, in the UK and the US, the partnership still needs to file partnership tax returns, but generally the fund will not be subject to taxation.

Regulation and private equity

Private equity funds are usually restricted to sophisticated investors with the very best of them – the so-called top-decile funds – being even invitation-only. This is the reason why, in most jurisdictions, private equity vehicles are usually subject to less regulation (compared to other investment vehicles such as wholesale funds) typically falling within the spectrum from non-regulated to low-regulated vehicles. As only professional investors are allowed to invest in private equity funds, the low level of regulation is justified by the fact that sophisticated investors are professional investors who know what they are doing and should be responsible for their risk-taking. Therefore, professional investors do not need the government or regulator to protect them to the same extent as the general public (unsophisticated investors) would. For that reason, private equity funds are usually non-regulated/unregulated; however, it is important to make a distinction between the fund and the other entities within the structure, or in some cases outside of the structure, as in some jurisdictions, such as the UK, although the fund itself is considered an unregulated collective investment scheme (CIS), the person who sets up or operates the scheme from the UK must be authorised by the Financial Services Authority (FSA) and that person is called an ‘operator’ of the scheme.¹² Usually the regulated entity (the operator) is the manager or the GP.

The US Securities and Exchange Commission (SEC) used to take a slightly different regulatory approach. The Investment Advisers Act of 1940 (Advisers Act) required registration of fund advisers that provided investment advisory services to more than 15 clients, but private equity firms used a registration exemption available to advisers with less than 15 clients that avoided “holding themselves out to the public” in the US as investment advisers (Private Advisers Exemption) thus avoiding Advisers Act registration.

The registration under this regime was less onerous than its UK counterpart, but with the new regime, effective from July 21, 2011 (although the deadline for registration was postponed until March 30, 2012), the rules have tightened. Following the global financial crisis, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act)was introduced as an attempt to reform the US financial system.¹³ The new Private Fund Investment Advisers Registration Act of 2010 (Registration Act), as part of the Dodd-Frank Act, removed the Private Adviser Exemption previously set forth in Section 203(b) (3) of the Advisers Act, 14 and introduced three new exemptions instead (the Private Fund Adviser Exemption, the Foreign Private Adviser Exemption and the Venture Capital Fund Adviser Exemption), which in practice mean that unless they qualify for some of the exemptions, all private fund advisers, including non-US advisers, with $150 million or more of assets under management (AUM) attributable to US investors, are required to register with the SEC as investment advisers under the Advisers Act by March 30, 2012.

However, the financial crisis did not precipitate change only in the US, as Europe has constructed an even more draconian piece of legislation in the shape of the Alternative Investment Fund Managers Directive (AIFMD). After long debates and lobbying, on November 11, 2010, the European Parliament plenary approved the final text of the AIFMD and the European Union (EU) member states will have two years from the date of publication in the official journal in early July 2011 to transpose the directive into their local legislation. In practical terms this means that from July 2013, this directive will impact all the alternative investment fund managers that not only have registered offices in the EU, manage alternative investment funds authorised or registered in the EU, or have registered offices or a head office in the EU, but also those funds that market any alternative investment funds in the EU.

Therefore, even if the fund or its fund manager has no connections with the EU, but markets the fund to investors in the EU, it would have to comply with the directive.

The AIFMD will impose a number of strict requirements with regards to authorisation, including marketing (passport regime), capital requirements, risk management, internal and external reporting, valuation, depositary requirement, remuneration policies and operating models, which may impose a huge administrative burden and significantly increased costs. This may potentially bring an end to some smaller funds that will be unable to bear the costs of implementing the requirements of the AIFMD.

Private equity as part of alternative investment asset classes

Private equity is considered to be part of the so-called alternative investment asset classes, that is, alternative to traditional portfolios, which typically comprise stocks or listed equities, bonds and cash deposits. Historically, alternative asset classes have included real estate, commodities, rare coins and stamps, gemstones, artwork and even trading cards, but these days they are usually associated with hedge funds, private equity, venture capital, real estate funds, infrastructure funds and commodity funds.

Alternative investment asset classes are appealing to investors because their lack of correlation with other types of investments may help to increase or stabilise portfolio returns. Part of the approach to robust portfolio management is diversifying investments, so that if one type of investment is performing poorly, another can make up the shortfall.¹⁵

Another attraction might be, as mentioned above, the more relaxed inherent regulatory requirements. However, what alternatives bring to the table, as part of bigger portfolios, is the different risk-reward profile usually taking the form of consistently higher returns than the traditional instruments, as a trade-off for the perceived increase in risk. It is debatable, however, whether ‘gambling’ on the stock of one company is less risky than investing in a fund of funds where your risk is spread over a wide basis of underlying portfolio companies. Good examples would be investing in BP’s shares, which following the oil spill off the Gulf of Mexico in 2010 became associated with the worst environmental disaster in US history, or the departure of a key person, such as Apple’s CEO Steve Jobs taking an undisclosed leave of absence due to health concerns. These events caused the share price of both companies to plummet and could have potentially proved fatal for an investor with an ill-diversified portfolio.

Liquidity

Private equity funds, considering their closed-end and limited-life nature and the typical ‘10-and-2’ lock-up period, are generally considered to be illiquid and perceived to be long-term investments. However, despite the low liquidity widely assumed by investors, it is important to bear in mind that there is still the mechanism of partner transfers provided for in the limited partnership agreement (LPA), as well as secondary fund investing. Partner transfers will be discussed Chapter 8. As for secondary transactions, while the illiquid nature of private equity funds is “strictly true as a matter of law”, in practice, there is a very active secondary market, with specialist secondary funds that would readily quote a price for your interest in a private equity fund.¹⁶

Value creation

Some people describe private equity firms as ‘locusts’, a pejorative term which found fame after the then chairman of Germany’s Social Democrat (SPD) party Franz Müntefering coined the phrase in a speech in April 2005 to describe private investors, private equity funds and investment banks. Private equity has been criticised across Europe, particularly in countries with a tradition of strong socialist politics, such as Denmark, France and Germany, and their lexicon of opposition has adopted words such as ‘locust’ and phrases including ‘asset strippers’ when referring to the private equity managers.

In 2007, as a result of a debate sparked by the trade unions, the UK Treasury Select Committee summoned a group of bosses from some of the largest UK-based private equity firms to question them about private equity practices. One commonly cited phrase to make it the journal of classic private equity quotes is that private equity partners “pay less tax than a cleaning lady”, according to a comment made by Nicholas Ferguson, chairman of SVG Capital.¹⁷

Notwithstanding the great scrutiny, public relations stumbles and intensifying regulation, private equity as an investment model has the potential to outperform other asset classes. When it comes to creating value, a fully operational and professionally motivated private equity fund works intimately with a portfolio company’s management over the investment holding period to improve the company’s value, so that maximum return can be achieved at exit.

The J-Curve

This introductory chapter would not be complete without mentioning the J-Curve – also referred to as the hockey stick – as returns are negative in the first years followed by a positive upswing in return in successive years. In my career I have worked with and trained many private equity fund accountants, many in senior positions who have never heard of the J-Curve, so it is important to mention this very private equity phenomenon here.

The J-Curve is the perfect depiction of the fund lifecycle in terms of its returns, represented by the cash flows between the investors and the fund, and calculated as an internal rate of return (IRR) on these cash flows (see Figure 1.1). This is used to illustrate the historical tendency of private equity funds to deliver negative returns in early years (during most of the investment period) – the so called ‘valley of tears’ – before beginning to show positive returns later on in the lifecycle as the portfolios of companies mature.¹⁸

Due to the specifics of the private equity fund lifecycle and the mechanics of a private equity fund, depicted best by the J-Curve, unlike other traditional asset classes, where periodic, usually annualised returns are used to measure performance, in private equity annual returns are not a valid measure and cannot be used as a guide to private equity performance.¹⁹ Instead, cumulative returns on a since-inception basis, represented by the IRRs and coupled with some multiples are considered to better reflect the private equity fund and manager’s performance. How performance is measured in private equity is explained in more detail in Chapter 18.

Conclusion

In this chapter I have outlined the brief history of private equity and discussed the fundamentals of the asset class, starting with the definition, through to the mechanics and the differentiators of a private equity fund – comprising its open-endedness, limited life, limited liquidity, light regulation, its place among alternative investment asset classes with its potential to outperform other asset classes, the most popular legal form for PE funds. I’ve also addressed the limited partnership (and fund for joint account); the J-Curve as the best depiction of a private equity fund’s returns over its lifecycle; and the public perception and the value creation of the asset class.

¹ The Origins of Western Economic Success, Meir Kohn.

² Money, interest and quirad, Mahmud Abu Saud.

³ Private Equity – History, Governance, and Operations, Harry Cendrowski, James P. Martin, Louis W. Petro and Adam A. Wadecki.

⁴ Ibid.

⁵ Cendrowski et al.

⁶ For further information, see www.sba.gov

⁷ Cendrowski et al.

⁸ KKR Wins Race for Alliance Boots, by James Quinn and Richard Fletcher, The Telegraph, April 24, 2007

⁹ The Debevoise & Plimpton European Private Equity Handbook 2004, Debevoise & Plimpton.

¹⁰ Other common terms for this include see-through, look-through, pass-through and flow-through but, whatever the term the meaning is essentially the same.

¹¹ Securitisation glossary, Vinod Kothari.

¹² According to the FSA Handbook glossary: “Operator (in relation to any other collective investment scheme (which includes unregulated schemes within which category falls PE and VC funds)) any person who, under the constitution or founding arrangements of the scheme, is responsible for the management of the property held for or within the scheme.”

¹³ Financial Reform Matters: Non-US Private Fund Managers Required to Register with the SEC, Jason E. Brown, Raj Marphatia, William F. McCormack and Mark J. Tannenbaum, Ropes & Gray LLP

¹⁴ Summary of Regulatory Obligations of Registered Non-US Investment Advisers to Private Equity Funds, Ropes & Gray LLP.

¹⁵ Alternative Assets Classes: An Introduction, Gregory H. Skidmore, Belray Asset Management.

¹⁶ Private Equity as an Asset Class, Guy Fraser-Sampson, John Wiley & Sons, 2010.

¹⁷ Extra tax break for buy-out partners, Martin Arnold, FT.com, June 19, 2007.

¹⁸ Exposed to the J-Curve: Understanding and Managing Private Equity Fund Investments, Ulrich Grabenwalter, Tom Weidig; J-Curve Exposure: Managing a Portfolio of Venture Capital and Private Equity Funds, Pierre-Yves Mathonet, Thomas Meyer

¹⁹ Private Equity as an Asset Class (Second Edition), Guy Fraser-Sampson, John Wiley & Sons, 2010.

02

Private equity structures and
types of funds

By Mariya Stefanova

Private equity fund structures

There are two crucial documents a fund accountant needs to understand in order to be able to prepare reliable financial statements (accounts) for a private equity fund:

1.The legal structure of the fund.

2.The terms of the limited partnership agreement (LPA).

In this chapter, I will focus on summarising some specific details of the most popular fund structures that are important in terms of accounting. An accountant does not need to be a lawyer or a tax expert, but there are certain basic concepts that he or she must understand. While this book is not meant to be a comprehensive guide to fund structures, if you are interested in finding out more about this subject you can read a comprehensive reference to all fund structures in Private equity fund structures by the Private Funds Group at Clifford Chance in Appendix I of this book.

The first point to understand is that the fund structures are predominantly tax-driven, aiming to minimise the tax amount for the partners, the fund and related entities, or in other words for the structure as a whole, as well as for its individual participants.

Limited partnerships and tax transparency

In Chapter 1, I explained that a limited partnership (and its equivalents) is the preferred legal form for private equity funds as this is a tax-transparent entity. The partnership is regarded as tax-transparent, mainly for the purposes of capital gains, whereby the assets of the fund, which are usually investments in portfolio companies, are considered to be held by the partners as direct investments, not by the partnership itself. Such transparency, however, does not mean the fund is forgotten by the tax authorities; the partnership may still need to file partnership returns in certain jurisdictions as mentioned in Chapter 1 or withhold tax on interest from debt instruments from certain non-exempt limited partners, for example.

Legal form and choice of jurisdiction

Although the structuring considerations are explained in detail by expert lawyers in Appendix I, it is important to mention a few important considerations that are discussed at seminars and in a few very good publications that I treasure (see footnotes), which have proved to be very useful in my practice as a fund accountant and trainer.

One of the first challenges for a lawyer and tax adviser is to decide on the jurisdiction of the fund and related entities. The fund could be structured as a Delaware limited partnership; a limited partnership in another onshore common law jurisdiction, such as England or Scotland; or an offshore common law jurisdiction, for example, the Cayman Islands or Channel Islands; or a corporate fund vehicle, such as a Netherlands besloten vennooschap (BV); a Luxembourg société d’ivestissement à capital risque (SICAR) or a specialised investment fund (SIF), which seem to be increasingly popular in Europe since they first appeared in 2004 and 2007, respectively; or a local vehicle, such as a fonds communs de placement à risque (FCPR), a French venture capital fund, or an Italian fondo chiuso (FC).¹

A combination of factors, such as the jurisdiction or domicile and the specific tax circumstances of the investors, along with the nature and geography of the investments, will be taken into consideration and their advantages or disadvantages reviewed before a final decision can be made.

Onshore versus offshore funds

Reviewing the advantages or disadvantages of setting up a fund in an offshore or onshore jurisdiction is outside the scope of this book, but it is worth mentioning them in brief in order to help fund accountants gain a better insight into the fund structures they work with.

It is important to remember that offshore structures are usually not required to prevent tax arising at the fund level (particularly direct tax), as that is naturally resolved by the transparency of the limited partnership structure.

²