Fundamentals of Private Equity and Venture Capital - PEI Media

THE FUNDAMENTALS OF 

PRIVATE EQUITY AND 

VENTURE CAPITAL 

Author and lead edited by Garry Sharp with 

Kelly DePonte and David Huckfield 

A PRIVATE EQUITY INTERNATIONAL PUBLICATION

Module 1: 

What is private equity 

and venture capital? 

COPYING WITHOUT PERMISSION IS UNLAWFUL 

THE FUNDAMENTALS OF PRIVATE EQUITY

Contents 

About the author 

iv 

Getting the most out of this module 5 

The evolution of venture capital and private equity 5 

Introduction 5 

Evolution of the US market 5 

Europe 6 

Asia 7 

The 1990s 8 

The dot com bubble 8 

Private equity today 8 

Types of private equity 9 

The private equity cycle – connecting institutional 

investors and entrepreneurs 10 

The limited partnership 11 

Fund manager remuneration 12 

Alternatives to pooled funds and limited partnerships 12 

Single investor funds 12 

Fund of funds 13 

Gatekeepers 13 

Secondary funds 13 

Why invest in private equity? 13 

The modern private equity firm – the shape of a GP 13 

Type 13 

Investment focus 14 

Investment style 14 

Case study 1: Get big or die; two very different venture capital tales 15 

Case Study 2: The management buyout 17 

Case study 3: Investor forces an exit 18 

Summary 19 


THE FUNDAMENTALS OF PRIVATE EQUITY iii


Garry Sharp – independent practitioner, consultant, writer and trainer 

Garry Sharp has 22 years’ experience as a practitioner, consultant, writer and trainer in the private 

equity and venture capital markets. He joined independent venture capital company Baronsmead in 

1985, becoming a director and shareholder following Baronsmead’s own management buyout in 

1989. During the early 1990s the company grew to become one of the UK’s largest independent private 

equity firms and was acquired by fund manager Ivory & Sime in 1996. Shortly thereafter Garry 

left to co-found Independent Direction, a specialist consultancy to the private equity industry. He sold 

Independent Direction in 2005 to concentrate on training and writing, and continues to work in an 

advisory capacity in private equity. 

Garry has trained newcomers to private equity since 1990, and delivers courses in Western and 

Eastern Europe, the Middle East and a wide range of African countries. His first book, The Insider’s 

Guide to Venture Capital, was published in 1990, followed by five more on private equity, M&A and 

corporate finance. 

iv 

THE FUNDAMENTALS OF PRIVATE EQUITY 

COPYING WITHOUT PERMISSION IS UNLAWFUL

GETTING THE MOST OUT OF THIS MODULE 

Welcome to Module 1 in the Fundamentals of private equity series. This module 

introduces the core principles of private equity and venture capital, examines 

how they evolved and provides a broad introduction to today’s markets. It is 

designed to work both as a stand alone section and as part of the whole series. 

For the benefit of the stand alone reader, a comprehensive glossary has been 

incorporated, which explains the background and use of private equity terminology. 

All terms which may require explanation or expansion are printed in bold, 

to indicate that there is a glossary entry for them. 

Private equity – the provision of risk and reward sharing (equity) capital to a company 

whose shares are not freely traded on a recognised stock exchange (private). 

The evolution of venture capital 

and private equity 

Introduction 

In 1957, American Research and Development 

(ARD) – the world’s first ever investment 

fund to specialise in backing start-up companies – 

invested $70,000 for a 77 percent equity stake in a 

new company created by four students with no 

business experience. The company was called 

Digital Equipment Corporation, and 14 years later 

the investment’s value had grown to $355 million. 

Spectacular successes like this – similar stories 

include Apple, Intel, Sun Microsystems, Federal 

Express and even (in a smaller way) Trivial Pursuit 

– brought attention to the returns available from a 

new way of investing. This, for obvious reasons, 

acquired the tag “venture capital”. 

The concept of providing financial backing to 

entrepreneurs, sharing risks and rewards in a 

privately negotiated transaction, has been 

around since time immemorial (Queen Isobel’s 

backing of Christopher Columbus in the late 

15th Century is regularly cited as one of the first 

examples). More recently, the 1920s and 1930s 

saw companies such as Xerox and Eastern 

Airlines founded with private backing from 

wealthy family trusts. But it was the pioneer 

investors in the US during the 1950s, 1960s and 

1970s who gave birth to today’s private equity 

industry, albeit an industry that after three 

decades of accelerated evolution bears little 

resemblance to its forebears. 

However the spectacular growth of private equity, 

from obscure specialism to economic prominence, 

has been far from smooth or painless. On 

the basis that those who fail to learn from history 

are condemned to repeat it – and there are parts 

of this story it would be better not to repeat – a 

brief summary of the high and low lights will 

bring perspective to all that follows. 

Evolution of the US market 

The early US venture capitalists were not investment 

managers in the conventional sense; rather 

they were for the most part successful entrepreneurs 

and corporate managers with extensive 

experience in building businesses. The funds 

they invested were to a large extent their own 

money. (ARD for example had, with great difficulty, 

raised only $1.8 million, out of a total of $5 

million in its first fund, from institutional 

investors in 1946; the balance came from the 

fund’s managers, individual investors and family 

trusts.) Their approach to investing was very 

proactive, becoming closely involved in the day 

to day running of the companies they backed, so 

that their expertise added at least as much value 

as their money. 

During the 1970s this began, slowly at first, to 

change as pension fund and insurance company 

fund managers noted the returns some of the 

venture capitalists were achieving. These institutional 

investors experimented cautiously with 

the new asset class; typically only $50 million or 

less was raised from these sources each year during 

the decade (less than 30 percent of the total, 

most of which came from individuals and family 

trusts). But suddenly and dramatically a tipping 

point was reached in 1980, when commitments 

to venture capital, during that year alone, shot up 

to around $1 billion, reaching nearly $2 billion in 

1982 and over $4 billion in 1983. 1 


THE FUNDAMENTALS OF PRIVATE EQUITY 5

after deciding to become part of a start-up, and was introduced through mutual friends. But it 

soon became apparent that the company would need a heavyweight, experienced CEO with credibility 

on Wall Street. 

The first attempts to recruit a CEO highlighted a serious issue – eBay had no VC backing. The fact 

that with monthly profits of some $200,000 by early 1997 it did not need external funds was irrelevant; 

in Silicon Valley (eBay was based in San Jose, California) it was regarded as an essential 

seal of approval for a company to have raised venture capital, to have been vetted and appraised 

and to have passed the test. Without this, eBay couldn’t even get an executive search firm to work 

for them. 

The rule of thumb for a venture capital firm appraising an early stage investment was that there 

had to be a clear route to making 10 times the original investment within three years. Benchmark 

Partners, a venture capital manager itself only two years old, saw this potential in eBay and in July 

1997 invested $6.7 million for a 25 percent equity stake on terms which valued the company at 

$20 million before its investment (the pre-money valuation – see Module 4). eBay never spent 

these funds – the money was left untouched in the bank – but capitalised on the contacts, credibility 

and experience of Benchmark’s partners. It was Benchmark who recommended a search 

firm to find a CEO, who instructed that firm to pursue a candidate who had declined their first 

approach, and ultimately played a key role in persuading that candidate – Meg Whitman – that 

she should leave her high profile, secure role at a major corporation, move her family to California 

and join a tiny internet start-up. 

In September 1998 eBay went public, achieving a listing at a market valuation of $2 billion; this 

had grown to $21 billion by the spring of 1999, producing a return for Benchmark on its $6.7 million 

investment of 100,000 percent in less than two years (albeit based on highly distorted valuations, 

but nevertheless a spectacular return). 

Whilst eBay was preparing for its stock market float in 1998, the boo.com team was trying, with 

increasing desperation, to find some backers amongst the US venture capital community. A frustrating 

round of visits to Wall Street, Boston and California produced a series of rejections and a 

decision to increase their first round fundraising target from $2 million to $15 million, and to 

appoint an investment bank. Here was a crucial difference with eBay, who had quickly built a close 

relationship with Benchmark, their single investor; from the beginning boo.com was going to raise 

funds from a syndicate of investors, and an investment bank would play a large role both in the 

fundraising and the subsequent investor relations. This was to have enormous consequences. 

The boo.com team’s approach to JP Morgan coincided with a decision by the London office of that 

venerable, “old money” institution to explore the internet world, and after furious internal debate 

they agreed to lead the fundraising. A strength of JP Morgan was the ability to introduce, in addition 

to mainstream venture capital firms, corporate investors who may be able to add strategic 

value. The first round, which closed at $8.8 million in January 1999, included an investment from 

Bernard Arnault, the chairman of Louis Vuitton Moet Hennessy (LVMH), who assumed the role of 

lead investor. 

1999 was characterised by an endless series of fundraising – a total of $135 million was ultimately 

invested – and equally endless delays and slippages in the launch date for boo.com’s websites. 

The team had, in addition to setting itself the phenomenally ambitious task of a simultaneous, 

multi-country launch, made serious errors in the design and development of its technology. An 

effective single, dominant venture capital investor would have insisted on a simpler strategy, 

imposed discipline on the high spending management team (whose excesses in salaries, expenses 

and over elaborate infrastructure quickly became notorious in London, where they were based) 

16 THE FUNDAMENTALS OF PRIVATE EQUITY 


Module 2: 

Private equity as an 

asset class 



Contents 


iv 



Terminology 5 

Returns – and risk 5 

Analysing risk in quoted markets 6 

Risk in private equity 7 

Assymetric risk and return 7 

Using statistics in measuring private equity performance 7 

Managing risk 8 

Private equity performance 10 

Measuring returns 10 

Comparing private and quoted equity returns 11 

Reasons for allocating funds to private equity 14 

Issues with private equity 16 

Resource requirements 16 

Illiquidity and timescale 16 

Unpredictability 16 

Lack of control 16 

Difficulty of access 16 

Routes to private equity 17 

Direct/co-investment 17 

Private equity funds 17 

Fund of funds 17 

Secondaries 17 

Securitised/collateralised products 17 

Publicly-traded private equity 17 

Private equity market drivers 18 

Availability of investment opportunities 18 

Demand for private equity 18 

Economic infrastructure for private equity 19 

Exit opportunities 19 

Summary 19 

Appendix 1: Enter the Pantheon 20 

Appendix 2: PEI 50 – Private Equity International’s ranking of the 

world’s largest private equity firms 29 

















iv 





focuses on private equity as an asset class. It is designed to work both as a stand 

alone section and as part of the whole series. It necessarily draws upon topics 

reviewed in Module 1, and seeks to avoid repetition of their content. However, for 

the benefit of the stand alone reader, a comprehensive glossary has been incorporated, 

which explains the background and use of private equity terminology. 

All terms which may require explanation or expansion are printed in bold, to 

indicate that there is a glossary entry for them. 

Introduction 

This module focuses on the private equity industry from the viewpoint of the 

institutional investors – pension funds, endowment funds, insurance companies 

and banks – who provide its raw material – capital. 

The emphasis here, unlike other modules in this series, is on performance issues 

not at the individual investment level but across funds, portfolios of funds and 

the private equity industry as a whole. We are concerned with: 

• How does private equity behave as an asset class – what are its characteristics 

and how do they differ from quoted equities? 

• Why do institutional investors allocate capital to private equity? 

• What are the factors that drive the development of private equity markets? 

Terminology 

It is difficult to avoid confusion in the use of generic terms such as management, 

investor and investment when discussing private equity at the fund level. The private 

equity fund is the core part of the process. It raises money from investors 

(who in turn are themselves managers of investment funds), and is managed by 

a private equity firm, often referred to as a general partner, but also as a manager 

or a management team. It then makes investments (hence becoming an 

investor) in private companies which in turn have their own management teams. 

We therefore need to be careful in our choice of terms for the various participants. 

By institutional investors, investors or limited partners, we mean the 

pension funds, insurance companies and the like who allocate capital to private 

equity funds. By private equity firm, fund manager or general partner, we 

mean the specialist teams who raise private equity funds and are responsible for 

making and managing investments in individual companies. 

Returns – and risk 

The private equity industry consistently claims to 

produce returns to its investors which exceed 

those available from investing in conventional, 

quoted equities. Before examining these (much 

debated) claims in some detail, however, we 

must appreciate that simply comparing annual 

rates of return from the two different asset classes 

is of limited value. This is because institutional 

fund managers do not primarily focus on 

absolute levels of return; they take into account 

the risks associated with making a particular 

investment. Risk, in this context, means the probability 

of failing to achieve a targeted or desired 



Exhibit 3: Distribution when one fund is chosen at random 100,000 times 

30 

25 

Probability (%) 

20 

15 

10 

5 

0 

0 0.5 1.0 1.5 2.0 2.5 3.0 

Fund of funds multiple 

Source: Capital Dynamics simulation of 1,755 US funds as at 31 December 2004. 

3.5 

4.0 

4.5 

5.0 

Exhibit 4: Distribution when one, three, 10 and 30 funds are chosen at random 100,000 times 

Probability (%) 

70 

60 

50 

40 

30 

20 

30 funds 

10 funds 

3 funds 

One fund 

10 

0 

0 0.5 1.0 1.5 2.0 2.5 3.0 

Fund of funds multiple 

Source: Capital Dynamics simulation of 1,755 US funds as at 31 December 2004. 

3.5 

4.0 

4.5 

5.0 

revert to the classic definition of risk as the probability 

of achieving a less than targeted return. 

Stochastic techniques, of which the Monte Carlo 

simulation is the best known, use repeated, random 

selection of variables to produce probability 

distributions. Exhibit 3 shows the distribution 

when one fund is chosen at random 100,000 

times, and as you would expect this is very close to 

the distribution in Exhibit 2, with an unacceptable 

probability of selecting a fund that loses money. 

Exhibit 4 demonstrates what happens when three 

funds, 10 funds and finally 30 funds are selected 

at random. Not only do the mean, median and 

average multiple returns increase, but the probability 

of losing money across the portfolio decreases 

markedly. This may seem counter-intuitive – 

the more funds you choose at random, the greater 

the possibility of choosing losers. However it 

works because of the asymmetric risk we identified 

earlier – successful funds earn multiples 

many times higher than the single multiple which 

is the maximum a fund can lose. A larger portfolio 

will capture more of these successes, which more 

than compensate for the losers and help bring the 

median return closer to the average. 

Hence diversification not only reduces risk, it 

enhances overall returns. 

Avoiding the worst 

Returns can be further enhanced, not by the 

daunting task of selecting the very best fund 

managers, but by meeting the far simpler challenge 

of avoiding the worst. Exhibit 5 shows the 

effects of removing increasing percentages of 



mean that they are highly restricted in terms of the 

information they can share with their investors. 

The problem with governance in this environment 

is that it is required to protect a huge array 

of interests – from shareholders, through 

employees to much more broadly defined interests 

such as the environment and the broader 

community – and to do so with a universally 

applied set of rules and procedures. 

By contrast a private equity backed management 

team has a tightly defined shareholder group and 

a governance structure tailored to a specific and 

explicitly agreed set of objectives (explored further 

in Module 8). The team can share detailed 

information with its investors, discuss and obtain 

specific consent for its strategies and plans, and 

essentially operates in an unregulated environment 

where shareholders are assumed to be 

sophisticated, able to look after their own interests 

and in need of no further protection than that 

afforded by the tenets of corporate law. 

Beyond the regulatory and governance issues, 

there are broader commercial attractions to the 

private equity environment. Foremost among 

these is that the pressure to post earnings growth 

every quarter is alleviated – replaced, of course 

by performance pressures of a different kind (see 

Modules 4 and 5) Beyond this, the intense, often 

misinformed public scrutiny which often follows 

every action, announcement and report from a 

major quoted company is removed (although as 

private equity backed companies become ever 

larger and more economically and politically significant, 

the press and public are showing much 

greater interest in their activities). The freedom 

to make decisions in private, in direct consultation 

with shareholders and lenders, with a focus 

on medium- to long-term value creation without 

worrying about day to day share price performance 

has many attractions. 

The lure of private equity for corporate managers 

is further accentuated by the status issue, which 

although a very personal and human driver is 

highly relevant. Growing public cynicism about 

corporate behaviour – which comes not just from 

a series of accounting scandals but from increased 

questioning about ethics and social responsibility 

– means that being a director of a major quoted 

company no longer has the cachet, the status, that 

it awarded in earlier decades. 

Finally, of course, private equity not only offers 

managers the prospect of significant financial 

gain, but actively incorporates the generation of 

wealth in its fundamental principles. This 

approach centres on shared motivation between 

shareholder and manager and represents a clear 

solution to the perennial corporate management 

challenge – the agency issue. 

The agency issue 

Managers act as agents for their shareholders, 

and are required to make decisions in the best 

interests of those shareholders. But in the quoted 

company environment management may often 

have vastly differing motivations from those 

shareholders and, more importantly, different 

means of achieving rewards. 

Options to purchase shares, short-term performance 

related bonuses, golden parachutes, handcuffs 

and hellos, large salaries, plus access to 

corporate jets, properties, entertainment and 

various other perks are all designed to attract 

and motivate the highest performers to run 

major companies. However no matter how carefully 

these are designed and how extensively 

they are debated, there is the constant risk of a 

structural disconnect between these types of 

remuneration and shareholders’ long-term interests, 

especially now that the tenures of CEOs are 

becoming shorter and shorter. 

A well structured private equity transaction, by 

contrast, ensures that management will gain in 

tandem with its investors. Furthermore, because 

cash is ultimately the only measure used to gauge 

success, it becomes the focus and short-term 

methods to manage profit performance or to 

influence a share price, so common in quoted 

markets, become irrelevant. 

Access to emerging markets 

The development of stock exchanges, the evolution 

of governance and reporting standards, and 

the ability to invest in quoted companies tends to 

lag behind economic growth in developing 

economies. This makes it difficult for investors to 

gain exposure to these economies and private 

equity, with the ability to bypass public 

exchanges offers an alternative route. 

Informed decision making and access to 

insider information 

By definition, investors in quoted stocks are 



Module 3: 

Structuring and raising 

a fund 



Published in September 2007 by: 

PEI Media 

Second Floor 

Sycamore House 

Sycamore Street 

London EC1Y 0SG 

United Kingdom 

Telephone: +44 20 7566 5444 

© 2007 PEI Media Ltd. 

ISBN 1-904696-45-7 978-1-904696-45-2 

This publication is not included in the CLA Licence so you must not copy any portion of it without the 

permission of the publisher. 

All rights reserved. No parts of this publication may be reproduced, stored in a retrieval system or 

transmitted, in any form or by any means, electronic, mechanical, photocopy, recording or otherwise, 

without the prior written permission of the publisher. 

The views and opinions expressed in the book are solely those of the authors and need not reflect 

those of their employing institutions. 

Although every reasonable effort has been made to ensure the accuracy of this publication, the publisher 

accepts no responsibility for any errors or omissions within this publication or for any expense 

or other loss alleged to have arisen in any way in connection with a reader's use of this publication. 

This module is part of a series of 10 modules entitled The fundamentals of private equity. 

The modules in this series are: 

Module 1 

Module 2 

Module 3 

Module 4 

Module 5 

Module 6 

Module 7 

Module 8 

Module 9 

Module 10 

Glossary 

What is private equity and venture capital? 

Private equity as an asset class 

Structuring and raising a fund 

Venture and development capital 

Management and leveraged buyouts 

Private equity real estate and infrastructure 

Due diligence 

Aftercare and exits 

Secondaries and their alternatives 

Running a private equity firm 

A comprehensive list of private equity terms 

and definitions 

To order any of the modules in this series, please contact Private Equity International on: 

+44 20 7566 5444. 

ii 



Contents 


iv 


Terminology 5 

Fundraising – making the case 5 

The GP 6 

Investment strategy and fund categories 6 

Refining the proposal 7 

Size and type of investment 7 

Geography 7 

Sector focus 7 

The management team 7 

Investment track record 8 

Dealflow generation strategy 8 

Use of debt/financial structuring 8 

Syndication 8 

Due diligence processes 9 

Added value/aftercare 9 

Achieving exits 9 

The “perfect” fund proposition 9 

The fundraising process 9 

Identifying potential investors 9 

Pre-marketing 10 

Consistency 10 

The offering memorandum (or private placement memorandum) 10 

Preparation of the investment pitch 11 

Preparation of supporting information 11 

Placement agents 11 

Due diligence 12 

Track record 12 


Terms and conditions 14 

Key commercial issues 14 

Private equity fund structuring 17 

by Nick Benson, Private Funds Group, Clifford Chance, February 2007 


Basic structuring considerations 17 

Specific investor requirements 18 

Multiple vehicle structures 19 

Types of fund vehicle 19 

Limited partnerships 20 

Conclusion 21 

















iv 





focuses on structuring and raising a fund. It is designed to work both as a stand 

alone section and as part of the whole series. It necessarily draws upon topics 

reviewed in earlier modules, and seeks to avoid repetition of their content. 

However, for the benefit of the stand alone reader, a comprehensive glossary has 

been incorporated, which explains the background and use of private equity terminology. 

All terms which may require explanation or expansion are printed in 

bold, to indicate that there is a glossary entry for them. 

Terminology 

It is difficult to avoid confusion in the use of generic terms such as management, 

investor and investment when discussing private equity at the fundraising level. 

The private equity fund is the core part of the process. It raises money from 

investors (who in turn are themselves managers of investment funds), and is managed 

by a private equity firm, often referred to as a general partner, but also as a 

manager or a management team. It then makes investments (hence becoming an 

investor) in private companies which in turn have their own management teams. 

We therefore need to be careful in our choice of terms for the various participants. 

By institutional investors, investors or limited partners, we mean the 

pension funds, insurance companies and the like who allocate capital to private 

equity funds. By private equity firm, fund manager or general partner, we 

mean the specialist teams who raise private equity funds and are responsible for 

making and managing investments in individual companies. 

Raising a new fund is an event of singular strategic 

importance for a private equity firm. The 

firm’s future is, in effect, placed into the hands of 

the institutional investors; the pension funds, 

insurance companies and endowment trusts 

whose capital allocation decisions, as we saw in 

Module 2, are a key influence in shaping the private 

equity industry. These investors will, by 

choosing whether or not to participate in the 

fund, either provide a mandate for continued 

growth or cast a collective vote of no confidence 

from which very few managers will recover. 

The complexity of the fundraising process matches 

its strategic significance, as every aspect of the 

firm’s investment focus, track record, competence, 

people and processes is laid open to 

intense scrutiny and questioning. In many 

respects this represents a mirror image of the 

approach the private equity firm will itself use in 

appraising investment opportunities, although 

they differ considerably in detail. 

The combination of these two factors – the strategic 

importance and the extensive demands of the 

process – requires that the fundraising exercise is 

planned, launched and executed on the basis of 

extensive research, a compelling business case 

and close attention to detail. This module 

reviews the process by starting with the strategic, 

commercial and marketing aspects before moving 

on to consider the various ways in which 

funds are structured and the terms under which 

they are managed. 

Fundraising – making the case 

Every year, more than 400 new funds are 

launched, 1 of which typically less than half reach 

a first close (i.e. raise the minimum amount 

required). Superficially this would indicate that 

the sheer volume of funds seeking capital will 

make it difficult for any single one to draw attention, 

and that there is a medium risk of failure. 

However, all funds – and geographies – are far 



not facilitate a tranched drawdown of committed 

capital. The Luxembourg SICAF is a similar 

vehicle to the SICAV but with fixed rather 

than variable capital; SICAFs may issue partly 

paid-in shares (provided a minimum of 25 

percent of their par value is paid-up at the 

date of issue) but a capital increase or 

decrease requires a change of the articles of 

incorporation by decision of an extraordinary 

general meeting of shareholders. 

The limited partnership is commonly viewed as 

the vehicle of choice for private equity fund managers 

and is the vehicle most often used for private 

equity funds with an international investor 

base. The other vehicles described above tend to 

be used where a more limited range of investors 

is targeted and/or where the manager's activity is 

concentrated in particular jurisdictions, where a 

non-partnership vehicle may be more appropriate. 

The features of limited partnerships are considered 

in more detail below. 

Limited partnerships 

A limited partnership comprises a general partner, 

who is responsible for the operation and management 

of the partnership and has unlimited liability 

for the partnership's liabilities that cannot be 

satisfied out of its assets, and one or more limited 

partners, who cannot be involved in operation or 

management and whose liability is limited to the 

amount of capital contributed by them to the partnership. 

In the private equity fund context, the 

fund manager acts as general partner (though 

often the general partner is a subsidiary of the 

manager rather than the manager itself) and the 

investors are the limited partners. The general 

partner and/or manager of a limited partnership 

will usually need to be regulated in the place 

where it is based, which may be different from the 

jurisdiction of the fund. For example, the UK manager 

of an English limited partnership will need to 

be regulated by the UK Financial Services 

Authority (FSA), whereas an off-shore manager 

operating an English limited partnership fully outside 

the UK would not need to be regulated by the 

FSA in relation to that activity but would need to 

be regulated in the relevant off-shore jurisdiction. 

The main advantages of a limited partnership 

structure include: 

• limited liability for investors (assuming they 

do not participate in “management”); 

• tax transparency; 

• contractual flexibility; 

• manager's autonomy (the limited liability of 

each limited partner generally depends on it 

not becoming involved in management); 

• no/minimal regulatory requirements in 

respect of the vehicle itself; 

• potential for tax efficient management and 

performance fee structuring; and 

• no requirement for public disclosure of the 

partnership agreement or the partnership's 

accounts. 

Meanwhile, the potential drawbacks of limited 

partnerships may include the following: 

• certain countries do not regard limited partnership 

vehicles as tax transparent, which 

may necessitate establishing a separate parallel 

vehicle for investors in such jurisdictions; 

• it will not be possible for a limited partnership 

to take advantage of the EU Parent/Subsidiary 

directive (exempting dividends paid by subsidiaries 

to their parents from tax), although 

subsidiary companies owned by the limited 

partnership and individual investors in the 

limited partnership may be able to do so; and 

• it will only be possible to rely on double tax 

treaty protection to the extent that the underlying 

investor is able to do so (although subfund 

structuring using, for example, Dutch or 

Luxembourg corporate holding entities is usually 

employed to minimise withholding and 

achieve other tax objectives). 

Although it is possible to generalise about the 

features of limited partnerships as a type of fund 

vehicle, there are significant differences 

between the different types of partnership established 

in different jurisdictions, and it is important 

to understand these differences when 

designing a structure. The most common jurisdictions 

for private equity limited partnerships 

are Cayman, Delaware, England, Jersey and 

Scotland. Most of the core characteristics are 

common to all of these jurisdictions; however 

one important distinction is whether the partnership 

is deemed to have separate legal personality 

(Scottish LP) or is a body corporate 

(Delaware LP; Jersey LP by election). Partnerships 

with the latter characteristics may not be 

recognised as tax transparent by the local tax 

authorities in certain jurisdictions where they 

invest, which would remove one of the key rea- 



Module 4: 

Venture and 

development capital 





Second Floor 





Telephone: +44 20 7566 5444 


ISBN 1-904696-46-5 978-1-904696-46-9 













Module 1 

Module 2 

Module 3 

Module 4 

Module 5 

Module 6 

Module 7 

Module 8 

Module 9 

Module 10 

Glossary 







Due diligence 







+44 20 7566 5444. 

ii 



Contents 


iv 



Identifying the opportunities – venture fund strategy 7 

A dose of reality 9 

Making investments 9 

Generating dealflow 9 

Early appraisal 9 

Structuring investments 11 

The principles of investment structuring 12 

Assumptions and targets 12 

Preference 13 

Preferred shares in practice 13 

Xytrak proposed terms 15 

The term sheet 15 

Preconditions to investment 16 

Representations and warranties 16 

Board structure and membership 16 

Provision of information 16 

Consent matters 17 

Share rights 17 

Service agreements 17 

Confidentiality 17 

Payment of costs 18 

Exclusivity agreement 18 

Summary 18 

















iv 





focuses on venture and early stage investing. It is designed to work both as a 

stand alone section and as part of the whole series. It necessarily draws upon topics 






Introduction 

We define early stage investing as the provision 

of equity capital to companies that have not 

yet achieved stable, profitable trading. Exhibit 1 

quickly recaps (from Module 1) the definitions of 

specific types of investment within this 

broad category. 

The factor which unites all investments of this 

type is the significantly higher level of risk 

attached to unproven companies, markets, products, 

technologies and management teams. 

Uncertainty about future outcomes is endemic in 

all forms of investment, but applies to nascent or 

very young companies not only in every possible 

Exhibit 1: Classifications of investment types 

Investment 

type 

Purpose of 

funding 

Investee company 

Characteristics 

Key 

objectives 

Typical exit 

horizon 

Seed corn 

To develop, refine and 

market test intellectual 

property, prototypes 

or concepts 

Non trading, usually no firm 

business plan or commitment 

to a specific route to 

commercial exploitation at 

this stage 

To test and verify the 

practical and commercial 

viability of the product 

or concept 

To establish routes to 

market and a viable 

business model 

To build a commercial 

management team 

5 years 

or more 

Spin-out 

To establish a business 

based on the transfer of 

intellectual property 

from a corporate or 

academic research 

environment 

Similar to seed corn, 

although conceptual or 

intellectual property 

development may be 

more advanced 

As with seed corn. 

Replacing academic or 

scientific priorities with 

commercially driven 

management objectives is 

often the major objective 

with spin-outs 

5 years 

or more 

start-up 

To establish a viable 

trading concern with 

customers, revenues 

and a clear route 

to profit 

A commercially focused, 

backable and (mostly) 

complete management team 

will be in place 

To establish a sustainable 

market presence 

To make clear progress 

towards profitability 

To prove the 

management team 

Up to 

5 years 

Early stage 

To accelerate the 

progress of a 

young company 

Typically will not yet be 

profitable, but will be able 

to demonstrate the viability 

of its product or service 

and markets 

Management team will 

have, to some extent, 

demonstrated their 

competence and 

effectiveness 

To achieve profitable 

trading and a solid 

platform for growth 

3–5 years 



exercise, without the danger of the company 

agreeing a deal with a different investor. 

In addition to the financial aspects we have 

already discussed, the major commercial points 

addressed in a term sheet are: 

• preconditions to investment; 

• representations and warranties; 

• board structure and membership; 

• provision of information; 

• consent matters; 

• share rights; 

• service agreements; 

• confidentiality; 

• payment of costs; 

• arrangement and monitoring fees; and 

• exclusivity. 

Preconditions to investment 

Completion of the investment will always be 

subject to the satisfactory completion of due 

diligence, agreement of legal documents and 

final approval from the investor’s investment 

committee. In addition to these generic conditions, 

the term sheet will also spell out specific 

conditions, including: 

• a detailed outline of the due diligence requirements 

(see Module 8); 

• where appropriate, contemporaneous completion 

of investments from co-investors; 

• restructuring, or creation, of a share option 

pool for employees; 

• regulatory and tax clearances; and 

• key man insurance on senior members of the 

management team. 

There may also be specific milestones to be 

achieved; for example the securing of a patent, 

the appointment of a new member of the management 

team or signing of a commercially significant 

contract. 

The use of milestones can be refined by breaking 

an agreed investment amount into tranches, 

individual slices which can only be drawn 

when the company achieves specific pre-agreed 

objectives. 

Representations and warranties 

The simple objective of warranties provided by the 

company and its management is to ensure that the 

information they have provided to investors is 

accurate, complete and not misleading. The principal 

areas covered by warranties are: 

• historic accounts; 

• current trading and management accounts; 

• financial projections and forecasts; 

• the business plan; 

• due diligence reports; 

• ownership of assets including IP; and 

• no litigation or contractual breaches 

outstanding. 

Board structure and membership 

One of the major changes that accompanies raising 

venture capital for the first time is the introduction 

of a formalised reporting and decision 

making process, which will be centred around 

the board of directors. The board acts as both the 

primary decision making body and the main 

interface between management and investor. It is 

essential that board meetings are a forum for 

open debate and discussion, and that the management 

team does not attempt this to circumvent 

this by making decisions in private and 

presenting the board with fait accompli. 

The investor will invariably require, at the very 

minimum, the right to appoint an investor director. 

An important consideration here is that company 

law requires directors to act in the best 

interest of all shareholders, and not a particular 

group. To avoid conflicts of interest, the investor 

may appoint an observer to the board, or use a 

different executive from the investor director 

when decisions are needed. 

Appointment of a chairman or additional nonexecutive 

directors will be made in agreement 

with the management team, although the 

investor may reserve the ultimate right to decide 

should agreement not be reached. 

Other areas relating to the board are: 

• frequency and timing of board meetings; and 

• the composition of audit and remuneration 

committees or their equivalent. 

Module 8 looks at the composition and management 

of boards, as part of the aftercare process, 

in greater detail. 

Provision of information 

The reporting cycle will be closely linked to the 



Module 5: 

Management and 

leveraged buyouts 





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Module 2 

Module 3 

Module 4 

Module 5 

Module 6 

Module 7 

Module 8 

Module 9 

Module 10 

Glossary 







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+44 20 7566 5444. 

ii 



Contents 


iv 


The buyout principle – three different routes to value creation 5 

Creating value in buyouts 5 

The consequences of leverage 7 

The future for value creation 7 

Evolution of the buyout markets 8 

Management buyouts 9 

Failures 9 

Investment criteria – characteristics of a buyout company 11 

Strategy and market positioning 11 

The company 11 


The buyout process 12 

Auctions 12 

The management role in a buyout and conflicts of interest 12 

The application of leverage – types of debt and their uses 14 

Senior debt 14 

Working capital facility 14 

Subordinated or junior debt 14 

Second lien debt 14 

Mezzanine debt 14 

High yield bonds 15 

Securitisation 15 

Institutional debt 15 

Documentation 15 

The MBO model 21 

Summary 23 

















iv 





focuses on management and leveraged buyouts. It is designed to work both as a 

stand alone section and as part of the whole series. It necessarily draws upon topics 






The explosive growth in buyouts over the last 

three decades is a direct result of the natural, 

inherent strengths of the buyout model. The 

essential elements of this model are: 

• a close partnership between the management 

team of a buyout company and the investors 

and lenders who finance its acquisition; 

• precise and careful tailoring of the buyout’s 

financial structure to the cash and profit generation 

characteristics of the company; 

• clear objectives, shared between management 

and investors, which enable a high degree of 

focus in setting the company’s strategic and 

operational priorities; and 

• ownership structures which reinforce the 

management team’s motivation to achieve 

these objectives by sharing the rewards. 

The buyout principle – three 

different routes to value creation 

The underlying principle behind a buyout is the 

use of a target company’s assets and – more 

importantly – future cashflow as the basis on 

which to fund its acquisition. 

Creating value in buyouts 

There are three routes to creating equity value in 

a buyout company, and whilst most investments 

demonstrate a blend of all three, modern market 

conditions have profoundly altered the mix; we 

shall return to this topic after reviewing the basic 

principles. 

These principles can be demonstrated through a 

simple example. DemCo is the subject of a buyout 

at a total cost (acquisition price plus professional 

and arrangement fees) of €100 million, which is a 

multiple of 10 on its annual earnings before interest 

and tax (EBIT) of €10 million. Adding back non 

cash expenses – depreciation and amortisation – of 

€4 million per year gives us an EBITDA, which is a 

rough proxy for the company’s surplus operating 

cashflow, of €14 million. This clearly provides the 

capacity to service debt, and for this example we 

assume that equity investors provide €30 million 

of the acquisition cost, with the balance, €70 million, 

coming as a combination of loans with an 

overall interest cost of seven percent. 

By running the company with a tight focus on 

cash generation, not only is the interest cost covered 

but debt principal repayments can be made 

– for this simple example we have assumed a €5 

million repayment at the end of year 1, increasing 

by €1 million per year thereafter as the reducing 

interest burden helps free up more cash for 

debt repayment. 

As Exhibit 1 overleaf demonstrates, each debt 

repayment enhances the equity value even if the 

company itself does not grow in value. After four 

years, if the company, still generating €10 million 

EBIT a year is sold for the same €100 million 

price at which it was bought, so that the EBIT 

multiple is unchanged, equity investors have 

nearly doubled the value of their investment, 

which produces an internal rate of return (IRR) 

of 22 percent per annum (before allowing for the 

fact that some of this upside will have been 

shared with the management team). 

This approach to generating equity returns by 

using the cash generation capacity to repay debt 

is referred to as the financial engineering 

approach to value creation. 

However, any management team unable to produce 

some degree of profit growth is unlikely to 



Exhibit 4: Trends of buyouts/buy-ins, 1981–2006 

Number 

800 

700 

600 

500 

400 

300 

200 

100 

Number 

Value 

12,000 

10,000 

8,000 

6,000 

4,000 

2,000 

Value (€ millions) 

0 0 

1981 

1982 

1983 

1984 

1985 

1986 

1987 

1988 

1989 

1990 

1991 

1992 

1993 

1994 

1995 

1996 

1997 

1998 

1999 

2000 

2001 

2002 

2003 

2004 

2005 

2006 

Sources: CMBOR, Barclays Private Equity, Deloitte. 

Exhibit 5: Growing sponsor involvement in global M&A volume, 1999–2006 

25 

20 

Volume ($ billions) 

% of global M&A 

519 

% of global volume 

15 

10 

5 

157 162 

104 

146 

173 

285 

356 

0 

1999 2000 2001 2002 2003 2004 2005 

Year 

Sources: SDC Platinum and Citigroup. 

Q1–Q2 

2006 

Exhibit 6: Surging average deal size for private equity-related transactions, 1999–2006 

Average deal size ($ millions) 

800 

600 

400 

200 

US 

Europe 

0 

1999 2000 2001 2002 2003 2004 2005 

Year 

Sources: SDC Platinum and Citigroup. 

Q1–Q2 

2006 



Module 6: 

Private equity real estate 

and infrastructure 





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Module 2 

Module 3 

Module 4 

Module 5 

Module 6 

Module 7 

Module 8 

Module 9 

Module 10 

Glossary 







Due diligence 







+44 20 7566 5444. 

ii 



Contents 


iv 


Growth of the private equity real estate market 5 

Real estate investment categories 6 

Value added activities 7 

Opportunistic 7 

Real estate asset types 7 

Infrastructure investments 8 

Privatisations and buyouts 9 

Public private partnerships, concessions and new projects 10 

Types of PPP 11 

Private equity and infrastructure 14 

Appendix 1: 20 landmark transactions in private equity real estate history 15 

Appendix 2: The structure of things 27 

















iv 



preceded the private equity hotel craze by a 

good seven years. 

In a transaction valued at more than $980 million, 

the private equity groups acquired the 

hotel portfolio from a 100-year-old publicly 

held company that was controlled by a family 

trust. Once the dust settled, Blackstone and 

Colony had a clutch of luxury UK lodging 

assets: The Savoy, Claridge’s, The Berkeley and 

The Connaught. In addition to owning four of 

the seven “superluxury” hotels in London, the 

investor group walked away with The Lygon 

Arms, a country-house hotel in the Cotswolds 

region, and the quintessentially English restaurant 

Simpson’s-in-the-Strand. 

In the buyer’s minds, the benefits of the transaction 

were threefold. The firms held a majority 

of London’s 1,250 luxury hotel rooms. In 

addition, the hotels had recently seen a number 

of capital improvements that, according to 

Blackstone, had affected annual numbers 

without being seen in operating performance. 

Finally, the investors saw a number of opportunities 

to create value in the assets: During 

their ownership, Colony and Blackstone added 

additional rooms, contemporary lounges and 

high-class restaurants; divested themselves of 

non-core assets like staff lodging and the 

Savoy Group laundry business; and sold off 

the Lygon Arms property in June 2003 to pay 

down debt. 

The investor group rode out the storm that hit 

the hotel market at the beginning of the 

decade: the foot-and-mouth crisis in the UK; a 

business downturn in the US; the terrorist 

attacks of September 11, 2001; SARS; and 

armed conflict in the Middle East. While it no 

doubt affected the bottom line, the investors 

held onto the properties long enough to experience 

some upside from the revitalisation of the 

market. In May 2004, the Savoy Group was 

sold to an investor group led by Dublin-based 

Quinlan Private for £750 million, approximately 

a 1.8x return on investment. 

Colony and Blackstone have continued to make 

hotels an important part of their investment 

strategies – and made European property takeprivates 

an important part of everyone else’s. 

A gamble on Harvey’s 

1999 

When Colony Capital spent $1.2 billion to buy 

an additional four gambling parlours from 

Harrah’s and Caesar’s last April, the firm 

became the proud owner of the largest privately 

held casino company. Although those investments 

have had a shaky first year, there is no 

denying Colony’s strength in the gaming sector. 

All of this was set in motion by one purchase: 

the firm’s 1999 acquisition of Harvey’s Casino 

Resorts in Lake Tahoe for $405 million. The 

firm later sold the company, which also owns 

hotels and casinos in Iowa, to Harrah’s for $625 

million two years later. 

“When Colony bought Harvey’s, we saw an 

industry with only big, strategic players and no 

one to sell to except each other,” Colony chief 

executive officer Tom Barrack told sister publication 

Private Equity International last year. 

“We thought we could act as a liaison to all 

these larger companies. Now, the consolidation 

in the industry has been great fuel for our 

acquisition program.” 

Today Colony is one of the few private equity 

firms licensed in US gaming – Barrack has 

referred to the licensing process as a Bataan 

death march – and its acquisitions have included 

the Las Vegas Hilton and the Resorts company. 

Earlier this year, the firm joined a consortium of 

investors including Goldman Sachs and 

Providence Equity Partners in acquiring Kerzner 

International, the owner of the Mohegan Sun 

Casino in Connecticut and the Atlantis Resort in 

the Bahamas, for $3.6 billion. With deregulation 

occurring across the country and more and 

more US states legalizing some form of gambling, 

the gaming sector is big business these 

days and Colony is one of its biggest players. The 

firm is even looking overseas: In conjunction 

with the Las Vegas Sands, Colony portfolio company 

Fairmont Hotels is planning to develop a 

new resort in Far East gaming mecca Macau. 

The monolithic Time Warner Center 

2000 

Colony’s first casino acquisition launches 

an empire 

Apollo and The Related Companies fix up a 

blighted Columbus Circle 

When construction started on the Time Warner 



Exhibit A2.3: Private equity restructures – breakdown of global infrastructure deal volumes 

by acquirer, 1998–2006 YTD 

150 

125 

Private equity 

Non-private equity 

$ (billions) 

100 

75 

50 

25 

0 

1998 1999 2000 2001 2002 2003 2004 2005 

Year 

Source: Thomson Financial. 

2006 

YTD 

Or, as Chuck Leitner, the global head of 

RREEF, the real estate and infrastructure arm 

of Deutsche Bank, puts it: “Just about everybody 

that talks about infrastructure has 

Australian accents.” 

Contrasted with the mature infrastructure 

market in Australia, the developing countries 

of Asia, particularly China and India, are also 

witnessing a boom in infrastructure as their 

surging economies necessitate vast new networks 

of roads, tunnels, ports et cetera. 

According to a report last year in the Wall 

Street Journal, China is planning to spend up to 

$400 billion on infrastructure through 2010, 

while consulting firm McKinsey has estimated 

that India needs over $250 billion in infrastructure 

investment. 

“The single most important bottleneck is infrastructure,” 

Aashish Kalra, managing director of 

Trikona Capital, which is partnering with 

IL&FS for a $100 million infrastructure joint 

venture, told PEI’s sister publication Private 

Equity Real Estate in 2006. 

US: A new market 

Despite the size of the infrastructure market in 

the US – the Bureau of Economic Analysis has 

estimated it at $5.6 trillion – the sector is relatively 

immature in terms of private investment. 

This is primarily due to the municipal 

bond markets, which have provided governments 

with robust financing for public infrastructure 

projects. In recent years, however, as 

the country’s infrastructure has aged and the 

ability to raise capital via taxes has diminished, 

more and more public entities are looking 

to the private sector. 

“Estimates suggest that the US needs 

$1.6 trillion over the next five years just to 

repair and build highways, bridges, dams, airports, 

railroads and other infrastructure,” 

Dale Anne Reiss, the head of Ernst & Young’s 

global real estate practice, said in an 

early 2007 statement. “The annual tab to 

maintain the nation’s 50-year old highway 

system is $176 billion alone. With real estate 

capital flows at their highest levels ever, 

I would not be surprised to see more pension 

funds and other long term investors move 

into private funding of key infrastructure 

developments.” 

In recent years, the most prominent examples 

of US infrastructure investments have been 

toll roads. From the greenfield development of 

the San Joaquin Toll Road in California in the 

1990s to the recent privatisation of the 

Chicago Skyway, widely regarded as a landmark 

transaction in the sector, local governments 

across the country have followed suit. 

And given the current state of the nation’s 

infrastructure, as highlighted by Reiss, many 

experts predict that privatisation of existing 

toll roads will accelerate. 



Module 7: 

Due diligence 





Second Floor 





Telephone: +44 20 7566 5444 


ISBN 1-904696-49-X 978-1-904696-49-0 













Module 1 

Module 2 

Module 3 

Module 4 

Module 5 

Module 6 

Module 7 

Module 8 

Module 9 

Module 10 

Glossary 







Due diligence 







+44 20 7566 5444. 

ii 



Contents 


iv 


What is due diligence? 5 

Types of due diligence 5 

Commercial due diligence 5 

Financial due diligence 5 

Management due diligence 6 

Legal and regulatory due diligence 6 

IT due diligence 6 

Technology or product due diligence 6 

Environmental due diligence 6 

Forensic due diligence 6 

Other specialist due diligence 7 

Vendor due diligence 7 

The due diligence process 7 

Professionalism 7 

Clear focus 7 

Careful planning 7 

Allocation of resources 8 

Transparent decision making 8 

Careful selection of advisers 8 

The sale process and early due diligence 8 

The sales process 8 

Detailed due diligence 8 

The data room 8 

Financial due diligence 10 

The brief 10 

Historic financial performance 10 

Working capital movements and cashflows 10 

Historic performance against budget 11 

The financial projections 11 

Financial reporting and control systems 11 

The post-transaction funding structure 12 

Commercial due diligence 12 

Objectives 13 

Selection of advisers 13 

The management viewpoint 14 

Gathering information for CDD 14 

Management due diligence 17 

Looking to the future 17 

Methodology 18 

Due diligence issues and problems 18 

Obtaining information 18 

Integration of disciplines 19 

Presentation and correlation of results 19 

Summary 19 

















iv 





focuses on the due diligence process. It is designed to work both as a stand alone 

section and as part of the whole series. The module necessarily draws upon topics 






What is due diligence? 

In its simplest terms, we can define due diligence 

as the process of assuring that all the assumptions 

on which an investment or acquisition decision 

are based do, in fact, hold true; an exercise in validation 

or verification. In modern practice, however, 

it goes further than this, as the results of a 

thorough, detailed and focused series of reviews 

into a company’s markets, processes, finances, 

management, technologies, assets, intellectual 

property and customers will in many cases identify 

areas where improvements can be made, risks 

reduced and additional gains realised. 

The levels of competition in modern private equity 

markets demand that investors must consistently 

add value in order to outperform. As we saw in 

Modules 4, 5 and 6 this added value is increasingly 

generated by identifying, instigating and driving 

performance enhancements, in tandem with the 

investee company’s management teams. To do this 

requires ever deeper understanding of markets, 

companies and strategic opportunities. The due 

diligence exercise can contribute to this understanding 

by providing essential raw material to 

inform the entire investment, growth and realisation 

process, rather than being seen as a tedious 

and non-productive hurdle between commercial 

decision making and completion. 

As with every aspect of private equity, the most 

valuable due diligence exercises are those where 

investors, their advisers and the management 

team are fully engaged, with shared objectives 

and complete openness. 

Types of due diligence 

Due diligence has evolved in depth, complexity 

and sophistication, and in modern practice is 

broken down into a series of different disciplines. 

Commercial due diligence 

Commercial due diligence (CDD), also referred to 

as market, or strategic due diligence, is focused on: 

• establishing the credibility of the revenue projections 

in the investee company’s business plan; 

• providing an objective, impartial assessment 

of the company’s markets and its position in 

them; and 

• testing and evaluating the key strategic drivers 

in the company’s business plan. 

With the growing importance of earnings, or performance, 

enhancement as the route to value 

creation in the buyout market, a subset of CDD – 

operational due diligence – is becoming an 

increasingly prominent part of the process. 

As the Clinovia case study in Module 5 demonstrates, 

market due diligence need not be limited 

to specific investment proposals but can also be 

used as a tool for identifying attractive sectors or 

investment opportunities. 

Financial due diligence 

Whilst the focus of CDD is primarily external, 

financial due diligence (FDD) looks in detail at 

the company itself, providing a review of: 

• the company’s historic financial performance; 

• working capital movements and cashflows; 

• comparison of actual performance with forecasts 

and budgets; 

• the financial projections; 

• financial reporting and control systems; 

• tax compliance; and 



Manufacturing due diligence expertise is supported by our dedicated manufacturing team whose 

expertise has developed working on high profile strategy and operational engagements for major 

international blue-chip manufacturers. 

We also back our own market insights via the PA Ventures programme, as evidenced by the successful 

spin-off of Ubinetics, the innovative 3G equipment supplier. 

Recent examples of where PA has applied this specialised knowledge in strategic due diligence 

assignments include: 

A major European private equity deal where PA Consulting Group worked with an equity sponsor 

on the due diligence of a specialist manufacturer of chemicals. By mapping the underlying manufacturing 

technology to the changes in demands for various polymer and substitute products, PA 

were able to greatly enhance the financial sponsors’ view of the key capital investment priorities. 

For a 2006 deal, involving a major European PE house, PA Consulting Group were able to apply a 

strategic due diligence team of manufacturing specialists to evaluate the real competitive advantage 

of the core technologies, identifying potential market applications, and uncovering specific 

high risk areas such as product warranty, all issues that materially impacted on the deal value. 

A best practice approach to strategic due diligence 

These cases illustrate how strategic due diligence, based on an ability to add value well beyond a 

cursory market examination, has yielded significant deal value to our clients. 

As the private equity mid-market becomes more competitive expect to see more financial sponsors 

investing in true strategic due diligence. 

Management due diligence 

Appraisal of the management team is a core 

part of the private equity firm’s responsibilities 

and, naturally, starts from the very first meeting. 

It also continues through the life of the 

investment, as considered in Module 8, as the 

investor constantly updates and refreshes her 

view of the team. 

Despite this, management due diligence will also 

be undertaken as a separate, formal exercise 

designed to reinforce – or question – the 

investor’s views. The process will examine three 

principal areas: 

• the track record, performance, competence 

and integrity of each senior executive on an 

individual basis; 

• the structure, efficiency, compatibility and 

effectiveness of the senior management team 

as a unit; and 

• the extent to which each individual’s motivation 

and personal objectives are aligned with 

the focus on value growth and realisation 

inherent in any private equity financing. 

Looking to the future 

Although there is, by necessity, a heavy degree of 

reliance on past performance in appraising the 

management team, it is also essential to project 

this appraisal into an assessment of suitability for 

the demands of running an independent, private 

equity backed company. This requires a clear 

understanding of roles, responsibilities and success 

criteria post-investment. 

Two examples of failures in this area will help 

reinforce the message. The first concerned the 

buy-in/buyout of a company making injection 

moulded plastic components for a highly specialist 

sub sector. The company was purchased from 

its founder who had also been the CEO and 

retired from business after the sale. A new incoming 

chief executive, who offered particularly 

strong sales and marketing credentials, combined 

with the incumbent production director to form 

the nucleus of the new management team. 

Unfortunately the due diligence process failed to 

identify that the highly complex, custom developed 

application of injection moulding machinery, 

which gave the company its competitive edge, 



Module 8: 






Second Floor 





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Module 1 

Module 2 

Module 3 

Module 4 

Module 5 

Module 6 

Module 7 

Module 8 

Module 9 

Module 10 

Glossary 







Due diligence 







+44 20 7566 5444. 

ii 



Contents 


iv 



Aftercare 5 

Protecting value 5 

Reporting structure 6 

Modern trends in reporting 6 

Informal reporting 6 

Board structure and composition 7 

Executive directors 7 

Non-executive directors 7 

Representing the investor 7 

Monitoring progress and performance 7 

Contributing to growth and development 8 

Characteristics of the effective non-executive 8 

Board committees 8 

The chairman and board meetings 8 

Operating partners 9 

Aftercare – who does it 9 

Underperformance 10 

Causes of underperformance 10 

Addressing underperformance 10 

Anticipation 10 

Analysis 10 

Action 11 

Follow-on investments 11 

Fund reporting 11 

Annual report 11 

Valuation 12 

The valuation process 12 

Calculating the enterprise value 12 

The multiple 13 

The earnings figure 13 

EBITDA multiples 13 

Early stage companies 13 

Calculating the value of the fund’s investment 13 

Structuring issues 14 

Exits 14 

Types of exit 15 

Stock market flotation (IPO) 16 

The secondary buyout 17 

Re-leveraging 17 

Summary 18 

















iv 





focuses on the aftercare and exit aspects of the private equity cycle. It is 

designed to work both as a stand alone section and as part of the whole series. 

The module necessarily draws upon topics reviewed in earlier modules, and 

seeks to avoid repetition of their content. However, for the benefit of the stand 

alone reader, a comprehensive glossary has been incorporated, which explains 

the background and use of private equity terminology. All terms which may 

require explanation or expansion are printed in bold, to indicate that there is a 

glossary entry for them. 

Introduction 

The culmination of the investment process – 

dealflow generation, appraisal, negotiation, due 

diligence, legal documentation and, finally, 

completion of the investment – marks the beginning, 

and not the end, of the investment cycle. 

Whilst selection and structuring are critical to 

private equity success, it is once the investment 

has been made that the creation and realisation 

of value begins. The investor’s contribution to 

value creation lies in the approach to, and implementation 

of, aftercare, and he will play a key 

role in the realisation of this value through driving 

the exit process. 

Aftercare 

The aftercare function is driven by two key 

objectives: 

• protecting the value of the investment; and 

• adding and realising value. 

Exhibit 1 summarises the key aspects of the 

investor’s role during the life of the investment. 

Protecting value 

Validating 

The period immediately following completion of 

an investment can represent, for the investor, the 

Exhibit 1: Aftercare priorities and the investor’s role 

Reporting 

regime 

Progress 

reporting 

Board 

structure 

Validating 

Financial 

reporting 

Management 

appraisal 

Protecting 

Testing 

Monitoring 

EXIT 

VALUE 

Adding 

Creating 

Realising 

Strategy 

development 

Operational 

enhancements 

Acquisitions 

Management 

development 

Financing 

growth 

Exit routes 

Exit strategy 



Operating partners 

Earlier modules – Module 5 in particular – identified 

the growing requirements for private 

equity firms to add operational value to their 

investee companies. This has led in many cases 

to a significant change in the make up of many 

firm’s executive teams, which have broadened 

to include individuals with significant, senior 

level operational experience and a deep understanding 

of a particular sector or market. 

Although investors have always used external 

consultants and expertise to help them appraise 

and develop companies, the incorporation of 

operating partners into the team brings this 

expertise into the equity ownership and carried 

interest return pool, making them an integral 

part of the team with a reward structure better 

aligned to the creation of value. Specific models 

of operating partner involvement vary 

between firms. 

At one extreme, major industry names are hired; 

for example Louis Gerstner (former IBM chairman, 

currently chairman of Carlyle), Jack Welch 

(former CEO of General Electric, at Clayton, 

Dubilier and Rice) and Paul O’Neill (former US 

Treasury Secretary, special adviser to the 

Blackstone Group). 

Expertise is also, in many firms, tightly integrated 

into the process by building deal teams 

around industry sectors, which helps not only in 

sourcing and appraising investments but identifying 

opportunities to add value quickly post 

investment. An alternative to sector specialisation 

is a focus on more generic business capabilities 

that can be applied across a range of 

investee companies. This can incorporate areas 

such as supply chain management, sales force 

management, management development or 

even highly specialist areas such as the provision 

of health and medical benefits (a significant 

and growing expense for many companies). 

Related to this latter approach is the provision 

by some private equity firms of shared purchasing 

of goods and services, designed both to 

reduce cost and increase the efficiency of the 

procurement process. 

Whilst this greater involvement in operational 

issues is becoming widespread across the private 

equity industry, the approach is not universal. 

Some firms identify fundamental difficulties 

with its adoption, primarily centred on the 

potential for disruption and discord it can bring. 

The risks it can entail include: 

• friction caused by imposing a senior industry 

figure on top of an existing management team; 

• a lack of understanding of the private equity 

approach by operating partners who come 

from a major corporate background; and 

• the added degree of risk entailed in backing a 

company with an incomplete team, and relying 

on an operating partner’s input. 

Aftercare – who does it 

The question of where, and to whom, a private 

equity firm should allocate responsibility for 

aftercare is a source of perennial debate within 

the industry. Broadly speaking, there are three 

approaches: 

• the original deal team retains responsibility 

for the investment; 

• responsibility is immediately passed to a dedicated, 

specialist aftercare team; and 

• there is a phased transition, with the original 

deal team retaining the relationship for a period 

of time – one or two years – before the 

aftercare team takes over. 

The arguments in favour of the deal team retaining 

responsibility are: 

• they will have the deepest understanding 

of the company at the time the investment 

completes; 

• they will have built a relationship with the 

management team, and a first hand understanding 

of their strengths, personalities, 

areas of potential weakness and development 

requirements; and 

• they will have clear ownership of the value 

creation and realisation strategy, having been 

primarily responsible for developing it with 

the company’s management. 

The potential drawbacks to this approach, however, 

and arguments for a dedicated team include: 

• the personalities required of investment executives, 

to find and drive investments through 

to completion, do not always suit the different 

demands associated with aftercare; 

• the investment team may not have the specialist 

sector or operational skills required to add 

value; and 



Module 9: 

Secondaries and 

their alternatives 





Second Floor 





Telephone: +44 20 7566 5444 


ISBN 1-904696-51-1 978-1-904696-51-3 













Module 1 

Module 2 

Module 3 

Module 4 

Module 5 

Module 6 

Module 7 

Module 8 

Module 9 

Module 10 

Glossary 







Due diligence 







+44 20 7566 5444. 

ii 



Contents 


iv 


What drives the need for liquidity? 5 

History – overview of the primary private equity market 6 

The structural issue and transparency 7 

The rise of specialised secondary funds 8 

Secondary sales and purchases: practical issues 10 

Difficulties in execution 10 

Motivations of institutional investors: portfolio management 10 

Recent variations: primary secondaries 11 

More recent variations: direct secondaries 11 

The fund managers’ perspective: investor relationships and stapled secondaries 12 

The role of intermediaries 12 

Alternatives to secondary sales 13 

Trading exchanges/bulletin boards 13 

Securitised vehicles 14 

Total return swaps 16 

The future: The evolution continues 18 

Summary 21 

Appendix 1: A brief private equity liquidity timeline 22 

Appendix 2: Specialised secondary funds 23 

Appendix 3: Secondaries – the pricing dynamic 25 




Kelly DePonte – Probitas Partners 

Kelly DePonte is a partner and head of research and due diligence for Probitas Partners’ alternative 

fund placement activities. Prior to joining Probitas Partners, Kelly was Managing Director at Pacific 

Corporate Group, a leading provider of alternative investment advisory, managing and consulting 

services to institutional clients, where he oversaw the partnership investment program. Before joining 

PCG, Kelly held various positions at First Interstate Bancorp in private equity, asset liability management 

and derivatives. He earned an MBA from the Anderson Graduate School of Management at 

UCLA, and a BA in communications from Stanford University. 

iv 





focuses on private equity secondaries and their alternatives. It is designed to 

work both as a stand alone section and as part of the whole series. The module 

necessarily draws upon topics reviewed in earlier modules, and seeks to avoid 

repetition of their content. However, for the benefit of the stand alone reader, 

a comprehensive glossary has been incorporated, which explains the background 

and use of private equity terminology. All terms which may require 

explanation or expansion are printed in bold, to indicate that there is a glossary 

entry for them. 

In any market, secondary activity is driven by 

three major factors: volume in the primary market, 

investment structure, and transparency. 

Issues with all of these factors mitigated against 

the development of a strong secondary market 

in private equity until the last decade, when the 

growth of straight secondary sales and the creation 

of liquidity alternatives exploded. Even 

though institutional private equity vehicles 

have existed since the 1940s, the volume of 

activity in the primary market did not warrant 

an institutional approach to secondary activity 

until the mid-1980s, and only in the late 1990s 

did the primary market really begin to dramatically 

expand. 

What drives the need for liquidity? 

Before delving more deeply into history, however, 

it is useful to address participant motivations. 

Exhibit 1 summarises briefly buyer and 

seller motivations. While some circles may still 

stigmatise fund managers whose fund has been 

sold, most transactions are driven by the strategic 

needs of the seller. In fact, in dollar terms, 

most transactions have been driven by large 

financial institutions – such as banks and insurance 

companies – who have decided that private 

equity is not a core business and who use 

the secondary market to exit private equity 

entirely, with the goal of redeploying capital 

into core business lines. Recently, more activity 

has been driven by institutional investors seeking 

to rebalance their portfolios. 

It is also important to note the buyer’s motivation. 

Increasingly, investors with a long-term 

commitment to private equity seek to purchase 

positions in specific funds in order either to 

develop a relationship with a fund manager 

to gain access to future funds being raised, 

or to strengthen a relationship with a the man- 

Exhibit 1: Summary of buyer and seller motivations 

Why do institutions sell existing 

private equity positions? 

Most often, sales of private equity funds are driven by 

the internal motivations of the seller and not 

performance issues. Reasons for selling include: 

• Inability to fund future commitments 

• Need for current cash 

• Shift in institutional strategy away from private 

equity or long-term assets in general 

• Need to rebalance portfolio allocations between 

private equity sub-sectors 

• “House cleaning” of stub positions or problem 

funds that will not be supported in the future in 

order to decrease administrative burdens 

Why do institutions buy secondary 

private equity positions? 

Institutions purchase secondary positions for a variety 

of reasons given their strategic goals: 

• To generate returns based upon the cash flow 

potential of the portfolio 

• To gain access to future funds to be raised by the 

general partner of the fund being purchased 

• To minimise the J-curve impacts on an 

overall portfolio 

• To rebalance portfolio allocations between private 

equity sub-sectors 

• To add vintage year or sector diversification to 

a portfolio 



difficult to track, as the exact sub-allocations to 

secondaries within fund-of-funds, or allocations 

within institutional investors’ alternative programs 

are not widely advertised and can also be 

flexibly adjusted. In total, however, the amount 

of money focused on secondary market investing 

is in the range of two to three times the amount 

raised for specialised secondary funds. 

Secondary sales and purchases: 

practical issues 

Difficulties in execution 

Though secondary sales have been around for a 

long time, there are a number of issues that make 

the execution of secondary transactions difficult. 

Problems with the traditional sales process 

include the following: 

• The potential for deep discounts. Secondary 

purchases are usually executed at a discount 

to the fund manager’s carrying value though 

the level of discount fluctuates with market 

forces. (A more detailed primer on secondary 

pricing dynamics is included in Appendix 3 on 

pages 25–26.) Throughout the 1990s, the 

increasing number of funds focused on secondary 

investing resulted in pressure on these 

discounts, resulting in transactions being executed 

at prices in the range of 75 percent to 85 

percent of reported NAV. With the bursting of 

the internet bubble these discounts increased, 

resulting in transaction values of zero percent 

to 50 percent of reported NAV for venture capital 

funds, and to 40 percent to 70 percent of 

NAV for buyout funds. Over the last three 

years the market has rebounded significantly, 

to the point that high quality buyout funds 

often trade at a premium to NAV. 

• Long time required to execute. The process of 

selling a partnership position takes a long 

time. The due diligence process by a potential 

buyer to establish a final price – especially 

when a portfolio of a number of partnerships 

is involved – can take weeks to accomplish. 

Once the due diligence process is completed, 

the final sale, or legal transfer of rights and 

obligations from one party to another, must be 

approved by the fund manager in a process 

that can also take weeks or months as the fund 

manager often has little motivation to help the 

process and respond quickly. 

• Right of first refusal. A significant number of 

funds contain “right of first refusal” clauses 

which mandate that, before a position can be 

transferred to another investor, current LPs in 

the fund have the right to match the price. 

This clause can add to the complexity of the 

sales process and affect details of the bidding 

process. 

• Due diligence can be intensive and disruptive. 

The due diligence process that a buyer necessarily 

performs in order to develop a firm bid, 

especially in situations where the buyer is not 

intimately familiar with the partnerships 

being sold, is usually intensive and can be disruptive 

for both parties. This can result in 

damaged relationships with the fund manager 

– an important consideration for a buyer 

whose interest in purchasing a position may 

be driven by a desire to gain access to future 

funds to be raised by that same GP. 

• May impact the relationship with a fund manager 

and access to future funds. Selling a partnership, 

especially if it is part of a targeted 

portfolio rebalancing effort as opposed to a 

wholesale portfolio sale, may communicate 

the message to a fund manager that its efforts 

and the relationship are not valued. Just as the 

purchaser of a partnership interest seeks to 

establish a relationship, selling a position 

communicates the opposite. A seller seeking 

to maintain a relationship and future access to 

a fund being sold needs to proceed carefully. 

Motivations of institutional investors: 

portfolio management 

Over the last few years, more institutional 

investors (as opposed to specialised secondary 

fund managers or fund-of-funds managers) have 

begun to consider both purchasing and selling 

positions in the secondary market for portfolio 

management purposes. The motivations for 

these investors include the following: 

• To provide flexibility in rebalancing a portfolio. 

A portfolio manager may decide to rebalance a 

portfolio in order to reduce overall exposure 

and maintain it within allocations, or to 

decrease or increase exposure to specific market 

or industry sectors. The sale of positions in 

the portfolio or the purchase of positions on 

the open market can be effective tools to reach 

those goals. 

• To change portfolio cash flow dynamic. In situations 

where a portfolio manager needs to generate 

cash, the sale of private equity positions 

can both generate immediate cash and at the 



Exhibit 7: Secondary private equity ABS structure 

Portfolio being securitised 

Undrawn 

commitments 

Investments 

outstanding 

Financing structure 

Liquidity facility 

“AA” tranche 

“A” tranche 

“BBB” tranche 

“BB” tranche 

“B” tranche 

Equity tranche 

Bank or insurance 

company 

Structured 

bond buyers 

Purchasers of 

residual risk 

Note: The difference in size between the facilities is driven by the discount and the need to over collateralise the 

top rated tranches. 

Securitised vehicles 

To date, most of the effort in producing structured 

vehicles has been in the primary market as 

structured fund-of-funds, but the technology 

developed in this area is now being applied in the 

secondary market. The primary goal of these 

structures as applied to private equity portfolios 

is to decrease the discount to NAV on secondary 

positions and to make the portfolio more marketable 

through the use of financial structuring. 

There is no common nomenclature yet for these 

structures, though “collateralised fund obligations” 

and “private fund obligations” have been used frequently. 

They are based on standard asset backed 

security (ABS) financial technologies that have 

been used for years to create securities backed by 

mortgages, credit card receivables, auto loans, 

commercial bank loans and corporate bonds. 

The goal of most ABS structures is to create a more 

efficient financing vehicle for assets by taking a 

large portfolio and stripping the cash flow generated 

by the underlying securities into different 

obligations. Each “strip” or tranche has different 

cash flow characteristics and has a credit rating 

that declines with each descending strip depending 

upon the collateral or cash flow priority held in 

support of that particular security. The last strip in 

the structure is the unrated “equity” strip, which 

retains all of the residual return and risk. Each 

strip is then sold to different types of investors on 

the basis of their respective risk/return appetite. A 

sample structure is shown in Exhibit 7. 

The structure outlined in Exhibit 7 differs from a 

typical ABS structure by the inclusion of a liquidity 

facility. Private equity portfolios are different 

from most ABS situations in that, even with a seasoned 

portfolio, new funding is required as commitments 

are drawn down. Though the early 

return of capital on certain investments provides 

a means of funding future draw-downs, it is prudent 

to arrange a liquidity facility or line of credit 

with a bank to ensure that future commitments 

will be met in a timely manner regardless of the 

realisation experience of the portfolio. 

Another way of looking at the structure is as a 

leveraged investment in private equity for those 

willing to invest in the equity tranche. The various 

tranches senior to the equity tranche effectively 

provide debt financing to purchase the portfolio, 

while the residual risks – and residual benefits – 

accrue to the holder of the equity tranche. 

To date, relatively few private equity transactions 

– either in the primary fund-of-funds market or in 

the secondary market – have been rated by the 

credit rating agencies. However, Standard and 

Poor’s, Moody’s, and Fitch’s have all established 

rating policies for securities collateralised by portfolios 

of private equity partnerships. At a summary 

level, the policies of all three require similar 

elements in order to achieve specified rating levels. 

These elements include, for example, professional 

portfolio oversight, specified levels of 

portfolio diversification, differing levels of overcollateralisation 

or cash flow preference, and equity 

protection provided by the unrated tranche. 

Issues with the ABS structure 

Fundamental issues with the ABS structure 

have kept it from being widely used as a means 



Module 10: 

Running a private 

equity firm 





Second Floor 





Telephone: +44 20 7566 5444 


ISBN 1-904696-52-X 978-1-904696-52-0 













Module 1 

Module 2 

Module 3 

Module 4 

Module 5 

Module 6 

Module 7 

Module 8 

Module 9 

Module 10 

Glossary 







Due diligence 







+44 20 7566 5444. 

ii 



Contents 


iv 


The institutionalisation of private equity and its meaning for a general partner 5 

Building the right structure: roles and responsibilities 6 

Human capital: attracting and retaining talent 7 

Human capital 7 

Attracting talent 8 

Retaining talent 8 

Carried interest: meaning, uses and calculation 9 

Meaning 9 

Uses 9 

Calculation 10 

Effect of GP’s retirement on carried interest 11 

Reporting: managing the GP/LP dialogue 11 

Objectives 11 

Reporting obligations 11 

Delivery methods 12 

A GP’s technology requirements 12 

What does a private equity-specific software package have to do? 12 

Operational infrastructure 13 

Overview of the process 13 

Different steps necessary 14 

Timeframe 15 

Costs 15 

Fund administration requirements 16 

Bookkeeping and accounts 16 

Investment portfolio activity and custody 16 

Secretarial and compliance 17 

Outsourcing fund administration – pros and cons 17 

Pros 18 

Cons 18 

Summary 19 




David Huckfield – Baring Private Equity International 

David Huckfield has 20 years’ experience in the international private equity industry as a partner of 

Baring Private Equity. In 2004 he played a leading role in coordinating and structuring the 8-way management 

buyout of the Group from ING Bank. Previously he was Group Chief Operations Officer, 

based in London, responsible for operations and compliance worldwide. During his tenure funds 

under management grew from $100 million to $2 billion as the Group expanded from a pan-European 

partnership with four offices to an inter-continental institution with a network of 18 offices in 13 

countries managing more than 20 funds. He held more than 60 directorships across the Group and is 

now a non-executive director of Baring Private Equity International with a focus on corporate governance 

standards. In this capacity he continues to chair the General Partner Boards of most of the 

Group’s $3.4 billion of private equity funds operating in Russia, Asia, India, Europe and Latin America. 

iv 





focuses on running a private equity firm. It is designed to work both as a stand 

alone section and as part of the whole series. The module necessarily draws upon 

topics reviewed in earlier modules, and seeks to avoid repetition of their content. 





The institutionalisation of private 

equity and its meaning for a 

general partner 

Private equity has long since ceased to be the nascent 

industry it was when the first venture capital 

pioneers made it a recognisable business 

more than quarter of a century ago. 

Institutionalisation has been defined as “to make 

part of a structured and usually well-established 

system” and throughout this module there is an 

undercurrent of what are, in reality, institutional 

imperatives that are fashioning the way general 

partners (GPs) go about their business. Limited 

partners (LPs) and GPs alike are becoming more 

sophisticated in their approach to the structuring 

of the product and the business process required 

to maximise returns on capital. 

Investors, especially the largest who are institutions 

in their own right, have turned the formation 

of a fund into a highly complex operation 

requiring greater assistance (and consequently 

expense) of specialist legal and tax professionals 

to develop a structure and a set of fund documents 

to help manage the high risks attached to 

private equity investments. This is typified by the 

range and number of vehicles that now comprise 

a fund and the complexity of clausing in the fund 

partnership agreement; dealing with such matters 

as tapering management fees, carried interest 

hurdles and clawbacks, environmental 

policies, corporate governance and conflict of 

interest resolution, among others. 

Fuelling this trend is the drive by financial services 

regulators around the world, especially 

those in certain jurisdictions formerly known as 

“tax havens” anxious to improve their reputations, 

to impose more and more regulation on 

the private equity industry. Many of these regulators 

now require practising professionals to 

pass specialist tests and exams leading to GPs to 

incur the expense of more formal training programmes 

before being licensed to operate. 

Training programmes have also had to be 

extended to include anti-money laundering procedures 

which can look like maddening bureaucracy 

to a GP dealing with world-renowned 

institutional investors. 

Freedom of Information legislation is in a similar 

way feeding a media frenzy for disclosure of 

fund performance data, previously subject to 

restricted access by GPs, especially from 

investors in the public sectors as their investment 

of pensioners funds come under closer 

scrutiny. Major investors, private equity associations 

and other trendsetters are at the same 

time seeking greater transparency in fund 

reporting. All this is presenting GPs with a 

greater challenge to their obligations under 

confidentiality undertakings to portfolio companies 

and competing legislation such as insider-trading 

laws which is taking up more 

management time in designing systems that 

provide a happy medium. 

These disclosure demands have also led to the 

creation of industry guidelines such as the International 

Private Equity and Venture Capital Guidelines 

and the Corporate Governance and 

Professional Standards and Reporting Guidelines 

endorsed by the European Venture Capital 

Association, among others. Market and peer 

pressure on GPs to adopt such guidelines means 

greater investment in systems and procedures 

and an increase in the demand for private equity 

specific software to facilitate reporting. 



of members including representatives of certain 

larger (for example: exceeding $X million or Y 

percent), Investors in the fund and sometimes 

individuals with no affiliation to the fund. The 

advisory council will meet at least twice a year to 

receive a report from the GP on matters falling 

within the jurisdiction of the advisory council 

which may include: 

• consenting to, reviewing or waiving any matter 

requiring their consent under the partnership 

agreement such as departures from the 

main investment strategy, investments that 

exceed specified limits; 

• approving the budget for partnership expenses; 

• approving changes in named key men who 

have left the employment of the GP; 

• reviewing and/or approving portfolio valuations; 

and 

• reviewing and/or resolving conflicts of interest. 

Delivery methods 

The annual financial statements and associated 

reports due under the partnership agreement 

will normally by distributed by post but may also 

be sent by email where agreed. In addition GPs, 

or their fund administrators where outsourcing is 

used, may make such information available to 

authorised users via secure websites. 

The partnership agreement will also usually 

require the GP to hold an annual meeting of LPs. 

The agenda of such meetings typically include 

detailed reporting on the progress of the fund 

and its investment portfolio including presentations 

from portfolio company CEOs. 

It is also often the practice of GPs to send LPs 

newsletters from time to time reporting material 

events such as new investments, realisations 

and milestone achievements. 

A GP’s technology requirements 

What does a private equity-specific 

software package have to do? 

GPs need software packages that fulfil many functions 

including storing records, calculating statistics, 

maintaining accounts and generating reports. 

They may choose a number of discrete separate 

software applications or a “one-stop-shop” solution 

from one of the growing number of providers 

that have developed custom packages based on a 

range of platforms specially to meet the needs of 

the private equity industry. Alternatively they may 

be content to develop “home-made solutions” 

using standard off-the-shelf spreadsheet, database 

and presentation software. 

The main factors that influence their preferred 

choice of solution are the scale of their business, 

the financial cost of replacing legacy systems and 

the human resources required to achieve the 

transition. Least inclined to embark on significant 

investment in custom applications are the 

small firms operating entirely from a single site 

without any outsourcing of fund administration. 

They are likely to have developed their own inhouse 

systems using proprietary software tools. 

Larger firms with a more complex business 

model, for example, operating internationally 

and using third-party administrators are most 

likely to be attracted by the prospects of 

installing an “all singing-all dancing” custombuilt 

solution. 

The main tasks that private-equity specific software 

has to do relate to the source and application 

of funds under management and include 

the following: 

• Marketing and contact relationship management. 

This will include an address book module 

for existing and potential contacts who may 

be investors, portfolio companies, intermediaries 

etc; it must be able to handle the coordinates 

and of multiple contacts with individual 

organisations and link into other modules of 

the software. Records should include profile 

information that will enable data sorting, 

analysis and reporting. In marketing it is used 

to identify potential investors for new funds 

and coordinate approaches to them. 

• Capital account transacting. Possibly included 

in the fund accounting module but often 

tracked in greater detail in a module of its 

own. This must be capable of handling various 

ratios for the allocation of the purchase and 

sale of investments, operating revenue and 

expenses, realised and unrealised profits and 

losses, capital calls and distributions. 

• Dealflow tracking. For every investment that is 

made, a private equity firm may process many, 

many more to a greater or lesser extent. Some 

may be rejected as non-starters, some may 

proceed to one or more meetings with the 

entrepreneurs, others may be the subject of 

work-in-progress for many months and be 



Glossary 





Second Floor 





Telephone: +44 20 7566 5444 


ISBN 1-904696-53-8 978-1-904696-53-7 











This glossary is associated with a series of 10 modules entitled The fundamentals of private 

equity. The modules in this series are: 

Module 1 

Module 2 

Module 3 

Module 4 

Module 5 

Module 6 

Module 7 

Module 8 

Module 9 

Module 10 

Glossary 







Due diligence 







+44 20 7566 5444. 

ii 



LP 

Management buy-in (MBI) 

Management buyout (MBO) 

Management fee 

Management ratchet 

Mandatory redemption 

Market flex 

Marketability discount 

MBO 

MBI 

Mezzanine financing/loan 

Mezzanine notes 

Middle market 

Multiple 

See Limited partner. 

Where an outside manager or team purchases an ownership stake 

in a company and replaces the existing management team. 

The acquisition of a company by its management team, usually in 

partnership with external lenders and/or private equity investors. 

The fee paid by a private equity fund to the fund’s manager, generally 

in the range of 1.5 percent to 2.5 percent of the fund’s committed 

capital per annum. The fee is intended to cover the manager’s 

overhead and salary costs in finding, making and monitoring 

investments. It will scale down in later years as the fund’s portfolio, 

and hence the associated workload, reduces. 

See Ratchet. 

The requirement for a company to purchase all of an investor’s 

shares, at a set price on a certain date. 

Changes made to the terms of a loan (principally the interest rate), 

within limits pre-agreed with the borrower, in order to match them 

to market conditions when selling parts of the loan onto other 

lenders in a syndicate 

A discount applied to the valuation of an unquoted company to 

reflect that fact that its shares are not publicly-quoted and cannot 

be sold in an open market. Generally varies from 0 to 30% according 

to the size of the company, and the certainty and likely timing 

of an exit. 

See Management buyout. 

See Management buy-in. 

A junior loan which carries the right to participate in the equity of 

the borrower, usually by carrying options to purchase shares at a 

nominal value. Hence mezzanine lies somewhere between pure 

equity and pure debt finance. Mezzanine loans will usually carry a 

significantly higher interest rate than that which applies to senior 

debt, and will carry a long-term (eight or more years) bullet 

repayment. 

Publicly-traded bonds which have mezzanine terms. 

Medium-sized companies; definitions vary according to region, but 

in Europe companies valued in the €100 million to €500 million 

range would be regarded as mid-market. 

A means of valuing a company by multiplying a key financial indicator, 

such as EBIT. The higher the multiple, the higher the anticipated 

growth rate in profit or cash generation. The price earnings 

ratio commonly calculated for public companies, by dividing the 

share price by earning per share, is a multiple. 



The Fundamentals of Private Equity and Venture Capital 

As the private equity and venture capital industry continues to 

expand and evolve globally it is crucial that professionals 

entering the industry understand its many facets fully. The 

Fundamentals of Private Equity and Venture Capital provides 

a comprehensive manual to all those wanting an accessible, 

informed and insightful guide to this dynamic asset class. This 

unique series pulls together the ten most important topics on 

private equity and venture capital and, as a set, delivers an allencompassing 

guide to the subject. Whether a new entrant to 

this market wanting to gain a clear understanding of the industry 

or a professional needing to expand their knowledge on a 

specific area, The Fundamentals of Private Equity and 

Venture Capital is a vital resource to all those working in the 

private equity or venture capital industry wherever you are 

based in the world. 

Brought to you by the team that publishes Private Equity International 

and PrivateEquityOnline.com, The Fundamentals of 

Private Equity and Venture Capital is split into ten modules and 

a detailed up-to-date glossary – essential for any professional in 

need of an understanding of individual elements of the industry 

or of the asset class as a whole. 

These modules are: 

1. 

2. 

3. 

4. 

5. 

6. 

7. 

8. 

9. 

10. 

11. 

What is Private Equity and Venture Capital? 

Private Equity as an Asset Class 

Structuring and Raising a Fund 

Venture and Development Capital 

Management and Leveraged Buyouts 

Private Equity Real Estate and Infrastructure 

Due diligence for Private Equity and Venture Capital Firms 

Aftercare and Exits 

Secondaries and their Alternatives 

Running a Private Equity Firm 

Glossary 

Fundamentals is a must-have companion for any private 

equity firm, investment group, investment bank or advisory firm 

engaged with the industry. It has been expressly written and 

designed to deliver concise guidance and analysis, drawing 

on the real-world expertise of its authors and editor. 

KEY FEATURES 

• Fundamentals has been written and edited by three 

established authors and professionals in the field of private 

equity and venture capital: Garry Sharp, Kelly DePonte and 

David Huckfield. 

• Modules include real world examples and case studies from 

leading firms involved with private equity and venture capital. 

• Key articles from Private Equity International supply 

relevant commentary and context. 

• The layout of every module has been designed to optimise 

ease of use and comprehension, including valuable data in 

charts and tables, boxed checklists and valuable section 

summaries. 

• The language is accessible and friendly and delivers 

important knowledge in a digestible way. 

• A list of recommended reading is included to enhance your 

knowledge further. 

• A comprehensive and up-to-date glossary of industry terms 

is included.

Fundamentals of Private Equity and Venture Capital - PEI Media

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