LEARNING DESIGNED FOR YOU

Introduction to
Private Equity Funds
Part 1
 Agenda

Part 1: Presentation
Characteristics
Key terms & Organisation
Organization of a Private Investments Firm
Formation of a Fund

Part 2: Understand the flows

How do AIF make money?

Alternative Investments Training

2
Introduction

PwC
Characteristics

Alternative Investment is risk capital provided outside of the public markets

By the term "alternative funds" is meant all investment funds that are not already covered by the European Directive on
Undertakings for collective investment in transferable securities (UCITS).

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Characteristics
Key characteristics of an AIF

Characteristics

Inherently riskier than traditional Lack of publicly available information

1 investment funds 5 about investees

Interests in PEF are rarely publicly

2 6 Investments are illiquid
marketed to investors

Performance measured by the internal

3 Typically closed-end funds 7 rate of return (IRR)

Fewer & larger positions - J-curve

4 8 Waterfalls & carried interest
characteristic of return

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 Characteristics
What is Private Equity (“PE”)?

PE is medium to long-term Nevertheless, listing

finance provided in return for and de-listing of
an equity stake in potentially companies is not
high-growth unquoted entirely strange in
companies and aims at PE industry.
realising a capital gain at
The end of the holding
period (not always).*

Main sources
of PE finance

While many PE
Houses do not
specialise in specific
industries, some PE houses
have an industry focus
(e.g. telecoms, healthcare, A PE house is an
beverages/confectionery, etc.) investment company
and/or regional focus. that manages PE funds.

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Characteristics

The nature of the PE Fund results in unique performance characteristics:

• Negative returns for first few years.
• Potential for large positive returns in later years.

Returns of a Successful PEF

Divestment Phase
100

Investment Phase
50

0
The “J-Curve”
Year 2 Year 4 Year 6 Year 8 Year 10

-50

-100

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Characteristics
15.00%

10.00%

5.00%

0.00% Vintage 2005

0 1 2 3 4 5 6 7 8 Vintage 2007

-5.00% Vintage 2009

-10.00%

-15.00%

-20.00%

-25.00%
Source: Prequin, PwC research

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Characteristics
IRR

• Difference with performance of stock indices;

• Time value of money;
• Cash flow-based;
• Net vs. gross IRR.

(refers to the performance to the fund)

(refers to the performance to the investors)

Introduction to Private Equity

PwC Slide 9
Characteristics
How to measure IRR?
Fund Returns Calculations

NAV

20

15
Cash / stock
returns to 10

investors =
"Distribution" 5

time
0

-5

Invested capital =
-10
"Paid-In"
-15

-20

Introduction to Private Equity

PwC Slide 10
Characteristics
How to measure IRR?

PEF Returns Calculations

• Principal metric is IRR since inception calculated net to limited
partner. Beginning point is fixed, endpoint is variable;
• The IRR is calculated as an annualized effective compounded rate of
return using daily cash-flows and annual/quarterly valuations. The
IRR is the return (discount rate) that will equalize the present value
of all invested capital with the present value of all returns, or where
the net present value of all cash flows (positive or negative) is zero:
n
-i
0 =  CFi (1+r)
i=0
Where CFi is the cash flow for period i (negative for takedowns, positive for distributions)

Introduction to Private Equity

PwC Slide 11
Characteristics
How to measure IRR?
Typical Fund Cash Flow - Example of IRR calculation

THE RAW DATA CALCULATION IN EXCEL

Year Takedowns Distributions NAV Column A

1992 (5,201.8) 5,201.8 Row 1 (5,201.8)
1993 (12,749.5) 17,300.2 Row 2 (12,749.5)
1994 (15,299.4) 32,246.0 Row 3 (15,299.4)
1995 (5,099.8) 7,988.0 49,128.1 Row 4 52,016.3
1996 (5,099.8) 73,777.1
1997 (7,649.7) 30,770.5 66,416.4 IRR 1995 = IRR(A1:A4,0)
1998 16,470.9 38,853.7 = 28.9%
1999 11,484.7 25,046.8

THE FORMULA

-5201.8 + -12749.5 + -15299.4 + (-5,099.8 + 7,988.0 + 49,128.1) = 0

1+IRR19 9 5 (1+IRR19 9 5 )2 (1+IRR19 9 5 )3

Introduction to Private Equity

PwC Slide 12
 Key terms & Organisation
AIF vehicles available in Luxembourg

Alternative investments vehicles in Luxembourg

Regulated vehicles Unregulated vehicles

Supervised by
CSSF
Securitisation Limited
RAIF Soparfi Partnership
vehicles (SCSp/SCS)

Funds SICAR

Part I Part II
SIFs
Funds Funds

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Key terms & Organisation
Investments types and strategies

Type of Funds

The main professional investment-structuring solutions in Luxembourg are:

• The SIF, which provides an operationally flexible and fiscally efficient multi-purpose vehicle
that can be used for all asset classes;
• The SICAR, which is specifically designed for private equity investment and venture
capital;
• The UCI Part II, a flexible but more regulated pooled vehicle;
• The RAIF, a non-regulated fund with quick time to market due to no regulatory approval
necessary;
• Limited Partnership (SCS/SCSp).

The SIF, SICAR and the UCI Part II are lightly regulated investment vehicles subject to
approval and on-going supervision by the CSSF. The RAIF offers many of the same features
as the SIF and the SICAR, but removes the double layer of regulation: only the manager is
regulated - the fund itself is not.
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Key terms & Organisation
Investments types and strategies

Alternative Investments Funds strategies include:

• Private Equity Funds

• Leverage Buyout (LBO) Funds
• Venture Capital (VC) Funds
• Growth Equity Funds
• Debt Funds
• Real Estate Funds
• Infrastructure Funds
• Funds of Private Equity funds

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 Key terms & Organisation
Investments types and strategies
Strategies used depending on the maturity of the target company

Earnings
Growth Special Situations

Mezzanine

LBO
Distressed

Seed & Early-Stage VC

Growth Capital

Period

Expansion VC

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Key terms & Organisation
Main PE Strategies

Why is it used?

A leveraged buyout is the acquisition of Special Situations

a controlling interest in a target company
by using a significant amount of debt.
The most common way for the debt to be
raised is for the target company's assets Mezzanine
to be provided as collateral for the debt.
Target size varies, but the strategy is
LBO aimed at mid and large enterprises,
often public.
The purpose of leveraged buyouts is to
allow companies to make large
acquisitions without having to commit a
lot of capital.
Examples of LBO firms include: KKR,
Carlyle, TPG, Blackstone, and Apollo.

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Key terms & Organisation
Main PE Strategies

Venture capital (VC) is investing in a Why is it used?

company prior to it being public, and
usually in the early stages of its life cycle. Equity Product market fit

VC Venture capital can be classified

according to the stage of development of
the target company to, from seed or
early-stage capital used for start-ups to
later-stage, used to fund the
development of an already established
business.
Examples of VC Funds include Kleiner
Perkins, Sequoia, Accel, August Capital,
and Andreessen Horowitz.
Why is it used?
Same reason, but for larger companies
2017
Expansion
Expertise,… 2022
-100 200
Return multiple = 2X
IRR = 15%
Growth capital is provided to more
mature companies, with products or
services already generating significant
revenue, to fund growth and expansion and
to support the next step of their
development, usually a transformative Growth
event of their life cycle.
They invest more broadly than VC funds in
Capital
terms of industries.
Growth equity funds can be considered as
“bridge” funds between VC and PE.
Examples of Growth Equity funds include:
Summit Partners, JMI, and TA Associates.

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Key terms & Organisation
Main PE Strategies
Mezza-
nine
Alternative Investments Training
Mezzanine debt is a hybrid of debt and
equity and falls between senior secured
debt and equity in a company’s capital
structure. It is used to bridge financing
gaps, in time, capital structure or in an
LBO deal, as a firm grows and evolves.
The typical form of mezzanine debt is an
intermediate term bond with an equity
kicker, which may be an option, a
warrant or some other conversion
feature.
Senior debt is money owed by a company
that has first claims on a company’s cash
flows. It is more secure than any other debt
such as subordinated debt (also known as
junior debt) because senior debt is usually
collateralized by assets. This means the Senior
lender is granted a first lien claim on the Debt
company’s property, plant or equipment in
the event that the company fails to fulfill its
repayment obligations. The most common
types of senior debt are Senior Term Debt
and Revolving Credit Facility. These form of
lending activities are targetted towards
securing a more risk averse clientele with a
steady cash flow.
Distressed debt looks at companies
experiencing financial hardship that are or
appear to be about to default. Distressed
debt funds buy the debt of these financially
troubled firms and then seek rapid Di-
improvement of the firm. The objective is to stressed
profit as the company becomes more
stable and the value of its debt rises or to
cheaply gain an equity stake in the
company becomes bankrupt.
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Key terms & Organisation
Schematic view and terminology
Carried
Management interest
partner
LP1 LP2 LP.. LPn
GP Supervision

AIFM
Investment CSSF
Advisor - Portfolio
Fund
Management
- Risk Management
- Compliance Depositary
- Valuation Master Lux-Co

Auditor

Transfer
SPV SPV SPV agent

Central
Portfolio company 1 Portfolio company 2 Portfolio company 3 Admin.

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Key terms & Organisation

Key Actors - Definition

Limited Partner (LP) =Investors. Also known as a silent partner, a limited partner is a
business partner whose liability is limited to the amount of their investment in the AIF.

General Partner (GP) = A general partner has the authority to act on behalf of the business
without the permission of the other partners. Unlike a limited partner, the general partner may
have unlimited liability for the debts of the business.
The GP usually choses and hire the other services providers to the funds. It is generally
controlled by the promotor of the Fund. The GP is responsible for the supervision and
governance of the Fund (i.e: preparation of the FS).

Sub-advisor = Third party hired by those charged with governance to advice on the
investments portfolio. Generally sought out by management investment companies because
of their expertise in managing a specific strategy.

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Key terms & Organisation

Key Actors - Definition

Depositary = An agent, bank, trust company, or other organization responsible for supervision
and safeguards the AIF assets.

Transfer Agent = A trust company, bank or similar financial institution assigned by a

corporation to maintain records of investors and account balances and transactions, to cancel
and issue certificates, to process investor mailings and to deal with any associated problems.

Central administrator = is the leading or presiding body or group of people, and the highest
administrative department who oversee all lower departments of an organization.

Domiciliary agent = registers the fund in other countries, publishes NAV, circulars, notice to
shareholders in newspapers and handles outside reporting, translations and other matters.

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Key terms & Organisation
Alternative Investment Fund Manager = legal persons whose regular business is managing
one or more AIFs. It can be part of the group promoting the fund or a third party services
provider. Based on the total assets they manage (+/- 500m €) AIFMS can be either authorized
or simply registered.
Exemplary set-up 1 General Partner:
• Appoints AIFM (incl. decision on scope, i.e. PM/RM/valuation),
• Oversees AIFM / right of removal of mandate,
BoD • Board of the GP signs-off on investment/dis-investment
decisions.
2 AIFM AIF
Investment AIFM:
2
Committee
Portfolio Management performed by Investment Committee (IC),
Mandate mandated by BoD of AIFM to take investment decisions in a given
3 framework (defined by statutes/policy of IC, adopted by BoD).
BoD 1 Members of the IC can have signing power (to implement IC
Investment
General decisions): minimum 2 signatories per document and maximum 1
Advisor
Partner signatory, which is also employed by investment advisor.

The IC needs to take all investment decisions during physical

meetings in Luxembourg - also applies to GP and HoldCos
validation.
Investment Committee – AIFM
(exemplary composition) 3 Investment Advisor:
The Investment Advisor should not have the majority of votes/seats
• Management team representatives in the Investment Committee (IC).
• Risk Manager(non-voting)
• Members of BoD of General Partner
• Investment Advisor representatives

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Key terms & Organisation

Key Actors - Definition

Special Purpose Vehicle (SPV)=A legal entity created for a limited purpose. SPVs are used
for a number of purposes including the acquisition and/or financing of a project, or the set up
of a securitisation or a structured investment vehicle.
They are usually used because they are free from any pre-existing obligations and debts, and
are separate to the parties that set them up for accountancy, tax and insolvency purposes.

External Valuer= AIFMs can ensure the valuation function to an external valuer, which must
be a legal or natural person independent from the AIF, the AIFM.
The appointment of the depositary appointed for an AIF as external valuer of that AIF, is
subject to the condition that it has functionally and hierarchically separated the performance of
its depositary functions from its tasks as external valuer and the potential conflicts of interest
are properly identified, managed, monitored and disclosed to the investors of the AIF.

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Quiz
legal persons whose regular business is managing one or more
5 AIFs. Its core functions are Portfolio Management and Risk
Management. Responsible for the Valuation of the investments.

1 Investment Manager An agent, bank, trust company, or other organization responsible

2 for supervision and safeguards the AIF assets.

2 Depositary
Professional in charge of selecting investments to manage the
1 portfolio, either directly or indirectly (Investment Adviser) to
3 Central administration meet specified investment goals for the benefit of the investors.

registers the fund in other countries, publishes NAV, circulars,

notice to shareholders in newspapers and handles outside
4 Transfer agent 6
reporting, translations and other matters.

Individual(s) or legal entity who commit initiate the fund and

provide initial funding, usually in view of attracting other
5 AIFM investors. It relies on third parties or service providers, either
7 affiliates or independent contractors, to manage the fund and
carry out other operational and administrative activities.

6 Domiciliary agent
A trust company, bank or similar financial institution assigned by
a corporation to maintain records of investors and account
7 Fund sponsor 4 balances and transactions, to cancel and issue certificates, to
process investor mailings and to deal with any associated
problems.

is the leading or presiding body or group of people, and the

3 highest administrative department who oversee all lower
departments of an organization.
Organisation of a Private Investment Firm

Typical organisation of a Private Investment Firm

Investors
Committee Advisory Board
(optional)

PI House • Investment committee

• Valuation committee

Investors Investments
Administration
Management Department

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Organisation of a Private Investment Firm

Investors Management
This department is mainly in charge of fund raising and management of relationships with the
investors in the Fund. It includes:

• fund raising: Road shows, marketing presentations to potential investors (use of Placement
Agent?), preparation of information about the Fund (Private Placement Memorandum
[“PPM”]).

• negotiation with investors (Term Sheet, Subscription Agreements). Most widely negotiated
points include: management fees, “key man provision”, “no fault” or “for cause” suspension
clause, confidentiality agreement, extra information
rights, ….

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Organisation of a Private Investment Firm

Investments Department
The managers of this department are mainly in charge of investing the Fund assets in
accordance with the Fund’s investment policy through:

• deal origination.

• due diligence process.

• presentation to the GP Investment Committee/Advisory Board: investment proposal

submitted for approval, which accurately reflects the potential of the investee’s business.

• investment negotiation and completion.

• structuring: To reach a “Share Purchase Agreement”/“Investment agreement” mentioning

the information required from the investee, the degree of the Fund’s involvement in the
investee’s business, exit provision, corporate governance, warranties, ….

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Organisation of a Private Investment Firm

Investments Department

• Follow-on investments: Further investments into an investee’s business to fund future

expansion plans or to re-finance a poorly performing company.

• Disposal of the investment: Establishing the appropriate point to dispose of an investment in

accordance with existing divestment strategy while maximising the return to the investors.

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Organisation of a Private Investment Firm

Administration
This department is responsible for all the support functions of the PI House:
• Finance:
− Monitoring financial resources to allow the manager to trade and to implement the investment policies of
funds under management.
− Implementation of internal financial reporting procedures.

• Human Resources: Hiring a staff of adequate size to fulfil all obligations to all funds under management.
• Risk management & Procedures: Segregation of Fund assets from the manager’s own assets, prevention
from money laundering, compliance with law, procedures to resolve conflicts of interest, internal review
and controls.
• External assistance: Legal, tax, accountancy advice and specialist consultants.
• Reporting to investors: Information given to investors about the Fund’s performance and life (possibly
according to certain profession guidelines such as the Invest Europe Reporting Guidelines).
• Portfolio monitoring: Periodical valuation of investments, appraisal of the performance of the investment
against agreed targets and milestones; recommendation of any remedial action if necessary.

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Organisation of a Private Investment Firm

Advisory Board

• More a consultative role.

• Used as a “pool” of industry experts to advise the GP.
• Review of fund performance and strategy.

Generally includes external advisors who have specific industry knowledge and extensive
network of contacts.

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Organisation of a Private Investment Firm

Investors Committee (optional)

• Forum for the LP’s to discuss certain issues with GP.

• Review of conflict of interest situations.
• Modification of LP agreement.

Includes most important LP’s.

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 The typical lifecycle of a Private Equity structure
The Manager and the Depositary view
• Reporting to investors
• Marketing material (PPM)

• Financial Sponsors • Road shows

• F/u of targets
• Commitment/

General
Partner
• Fund management
team subscription agreements • Valuation

• Adds on investment
• Choice of jurisdiction
• Exit strategies
• Due diligences on
• Appropriate tax and targets • Divestments
legal structuration
(SPA’s)
• Investments
• Authorisation (SPA’s) • Carried interest
• Tax structuring

Fund Management Disposal Distribution Liquidation

Fund Idea Fund raising Investing
structuring of investments of investments to investors of the fund

and central
Depositary
• Compliance work on
• KYC - due diligence • Compliance work on • Compliance work on
on managers investments
assets

admin
divestments
• F/u payment flow
• Coordination with • F/u income • F/u payment flow
regulators/advisors • Monitoring of draw collection -
downs • Monitoring payments
• Fund set up distribution
to investors/
• Operating memo managers

• NAV calculation
• Accounting of the fund
Introduction to Private Equity
PwC • Compliance of prospectus 33
• Reporting
Understand the Flows

PwC
Understand the Flows
Money flows
GP AIFM fee
AIFM

Management fees + Carried GP Share

initial set up costs interest contrbution

LP capital
contributions
Banks
Investors AIF Loans

(“LP’s”) Distribution to LPs

Capital
Mezzanine
Dividends &
Interests
contribution &
loans
Funds
Co-investments
contributions
SPV
Sale proceeds
Purchase
price
Capital Dividends &
contribution & Interests
Seller loans Purchaser

Operational
Company
Introduction to Private Equity
PwC 35
 Understand the Flows
To get started

Agreements and Documentation

• Private Placement/Offering Memorandum/Prospectus.
• Subscription Agreements.
• Articles of Incorporation/Articles of Association.
• Investment management agreement/Advisory agreement.
• Structure chart.

Introduction to Private Equity

PwC 36
Part 2: Understand the Flows

• How do AIF make money?

• The Investment cycle
• The Capital cycle
• Income cycle

Introduction to Private Equity

PwC 37
Understand the Flows
How do Private Investments (PI) houses make money?

• Usually 2 main components:

- Annual charge (management fee) ~ 2% pa;
- Performance related fee ~ 20% of “super-profit”;
• Annual charge usually based on total money committed to the fund
(allocated to priority profit share);
• Performance fee usually % of capital gains (carried interest);
• Performance fee usually subject to a “hurdle”.

Introduction to Private Equity

PwC 38
Understand the Flows
How do PI Houses make Money?

Management Fees
• Generally between 150 to 200 bps (lower for PE funds-of-funds);
• Often based on committed capital for initial years (investment period) and then on draw-
down minus distributions until maturity of the fund;
• May be calculated on assets/net assets/unreturned invested capital;
• Might switch between methodologies after achieving certain benchmarks (e.g. 85% draw
down of committed capital);
• Might charge different fees depending on size of the investor’s commitment
e.g. under $5m = 125 bps and $5m and over = 100 bps.
Guidance
• Verify the terms of the management fee calculation in the prospectus and the management
agreement signed by the parties;
• Map the calculation spreadsheet to the prospectus/agreement by making clear references
to the relevant sections.

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Understand the Flows
How do PI Houses make Money?

Preferred return:

• Return promised to investors before any performance allocation (i.e. carried interest) is
provided to Management or GP shares;
• Hurdle rate typically ranging from 5% to 15% (annual rate of return);
• Takes into consideration the time-value of the investment.

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Understand the Flows
How do PI Houses make Money?

Carried interest:
• Defined as the fee or special allocation of profits given to the Founder/General Partner (also
called the Carried Interest Partner) when certain performance measurement is achieved.
• Large return on small commitment.
• As a general rule, no fee or profit will be due to the GP before such time when investors
have been repaid their original investments plus a preferred return (the hurdle rate).

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Carried interest

A carried interest in a private equity fund represents a profit for the general partner
(GP) independent of the GP’s investment contribution.

A typical carried interest will be 20% (usual range between 10% and 25%) of the PI fund’s
distributions after:

1. All investment and management expenses have been paid;

2. Invested capital (investment cost) has been returned to all partners; and
3. Accrued preferred returns have been paid to the limited partners.

➢ The carried interest holder is only entitled to a carried interest allocation when the PI fund
generates an annualised return in excess of the preferred return.

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How do PI houses make money?

How the performance element works - an example

Original Investment 10mln

Sale Price 16mln

Profit 6mln

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How do PI houses make money?

How the performance element works - an example

6mln capital profit

Hurdle Rate of 10%

based on the 10mln First 1mln to the Investors
investment

Next 5mln is split …

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How do PI houses make money?

How the performance element works - an example

6mln capital profit

Hurdle Rate of 10%

based on the 10mln First 1mln to the Investors
investment

80% 20%

4mln to investors 1mln to the GP

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Carried interest

Consideration

• Is carried interest an expense of the fund or a mere capital reallocation between the limited
partners and the general partner?
• At what point in time should a Fund either provide for carried interest or make allocations to
the carry party?
• Verify the terms of the performance fee calculation in the prospectus and the signed
management agreement.
• Calculation spreadsheet prepared by a Fund Admin employee familiar and experienced
with performance fees.
• Methodology reviewed upfront by the carry party (usually the investment manager) and the
auditor.
• Map the calculation spreadsheet to the prospectus/agreement by making clear references
to the relevant sections.
• Accounting & disclosure requirements

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Other considerations
Most common source of errors

• Prospectus subject to interpretation: basis of allocation, basis of calculations, key dates.

• Manual inputs/absence of formulas/use of excel shortcuts.
• No testing of all possible scenarios up front.
• Accounting of performance fees: difference between amount calculated and amount
booked.

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Claw back provisions

→ What if, at the fund’s maturity, there is an overall loss?

• “Claw back” arrangements usually apply to take account of loss-making investments and
expenses;
• Payment to escrow accounts;
• Reallocation of historical incentives;
• Refunding of money to the fund from the sponsor;
• Alternative means (offsetting future management fees).

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http://www.pwc.com/lu
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In this document, “PwC” or “PwC Luxembourg” refers to PricewaterhouseCoopers, Société coopérative which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal
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