Private Equity

By Professor Stefano Caselli

Università Bocconi and SDA Bocconi

MODULE 1

PRIVATE EQUITY

AND VENTURE

1.  What Is Private Equity and Venture Capital?

2. Why Companies Need Private Equity And Venture Capital

3. Private Equity Clusters: Through the

Fund's Life Cycle

4. Seed, Startup, and Early Stage Financing

5. Expansion Financing

6. Replacement Financing

7. Vulture Financing

8. Private Equity and Venture Capital: Today and Tomorrow – Interview

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Content

Preliminary Definitions

The definition of Private Equity (PE) is based on two aspects, each related to the two man characteristics of the PE relation:

à  PE is a source of financing: It is an alternative to other sources of

liquidity, (such as a loan or an initial public offering (IPO)) for the company receiving the financing.

à  PE is an investment made by a financial institution: Private Equity

Investor (PEI) in the equity of a non-listed company (i.e. not a public company).

Throughout the course, the definition of PE will be used in its broad meaning, which also includes Venture Capital.

Venture Capital is a very specific case of PE. It is the investment in the very early stages of a company’s life.

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The Need of Financing

How does the relationship between the PEI and the venture-backed company (i.e. the company financed by the PEI) work?

Private Equity Investor Assets Debt Equity Venture-Backed Company shares

The investor gets shares of the equity of the company in return for the inflow of cash.

The Consequences the Financing

As a consequence, the relationship between the venture-backed company and the PEI is based on some relevant issues:

•  A company needing money for a certain and clearly identified reason;

•  The company collects money with the issuance of equity on the private market,

the company does not pay any interest expenses to the PEI; •  The newly issued shares will be bought by the PEI;

•  The professional investor will not only become a shareholder but will contribute

to the management of the company. The smaller the company is, the larger the contribution of the PEI in the business management will be;

•  The professional investor will create profit only through the generation of capital

gain, i.e. exiting from the investment by selling shares to someone else on the market.

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The most critical aspect in PE is the strict relationship between the investor and the entrepreneur.

The Difference between: PE and Investing in

a Public Company

Public

Private

1

PRICING

LIQUIDITY

MONITORING

The price is driven by the market, either upwards or downwards.

Liquidity is very high.

Whenever an investor wants to sell the shares of the public company there is always a buyer.

When trading on the stock

exchange, there is always a very high level of protection for the shareholders, regardless their stake in the company.

The price is the result of the

negotiation process which be both easy or hard.

Selling the shares is not so easy. Since there is no stock exchange, finding a new shareholder can very hard and time consuming.

The shareholders (the PEI) have to protect themselves and the values generated by the

company. All of the rules will be stated in a formal agreement.

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2.  Why Companies Need Private Equity And

Venture Capital

3. Private Equity Clusters: Through the Fund's Life Cycle 4. Seed, Startup, and Early Stage Financing

5. Expansion Financing 6. Replacement Financing 7. Vulture Financing

8. Private Equity and Venture Capital: Today and Tomorrow – Interview with

Fabio Sattin

Why Would a Company Need PE?

§  PE is a source of financing;

§  And PE is an investment.

… but why would a company need PE? Why should a company let an external investor sit on its board of directors and make managerial decisions? (Note: The bank would have been an outsider.)

The venture-backed company wants to enjoy some direct and indirect benefits that a company can exploit when financed by a PEI. 1. Certification Benefit 2. Network Benefit 3. Knowledge Benefit 4. Financial Benefit

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1. The Certification Benefit

Due to the long screening phase before deciding to invest in a company, if the PEI finally does choose to invest in the venture-backed company, in a way, that confirms the very high quality of the company’s accounts.

This can give a sign of great health of the company and this high quality can be used as a kind of promotion for the venture-backed company’s brand.

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2. The Network Benefit

The PEI can give the company a very strong network, in terms of suppliers, customers and banks therefore multiplying its possible contacts.

3. The Knowledge Benefit

§  Soft Knowledge: the capability to manage the business

§  Hard Knowledge: the specific-field knowledge of a business, this applies

particularly to high-tech or pharmaceutical industries

With this knowledge, an investor can even carry the company through very hard and difficult steps, such as a merger and acquisition (M&A) process.

The PEI plays the role of an advisor and mentor.

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4. The Financial Benefit

The financial benefit is generated through the injection of cash in return for shares of the venture-backed company.

The increase generates the following effect on the cost of capital:

Positive effect on the cost

of capital

EQUITY

RATING

If a company needs at least one of the four benefits, then PE is the only choice; if not, there are other sources of financing, each suitable for the life stage

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Financing and Life Cycle of a Company

2

Founder

& Family Partners Other Angels Private Equity Banking System Credit Trade Financial Markets

Development These sources are not right for the company _{does not yet exist at this stage}

Startup

The risk is too high for banks

(capital requirements) Early Growth Mature Age To do something complex

Expansion Maybe for an _IPO

Crisis or

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Content

1. What Is Private Equity and Venture Capital?

2. Why Companies Need Private Equity And Venture Capital

3.

Private Equity Clusters: Through the Fund's Life Cycle

4. Seed, Startup, and Early Stage Financing 5. Expansion Financing

6. Replacement Financing 7. Vulture Financing

The Taxonomy of PE Clusters

1. To understand if a company can use PE to accomplish its needs;

2. And to identify the different kinds of PE investment (and the right one).

As said in the first clip, the definition of PE is an umbrella definition: It identifies as many clusters as the numbers of the company’s life cycle stages as long as it (the company) is not listed.

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The Taxonomy of PE Clusters

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The Taxonomy of PE Clusters

The six life stages each related to the suitable private equity investment are as follows: 1. DEVELOPMENT

The life cycle starts with development. It is the moment in which the founders start to create and try to develop the business idea.

The corresponding investment of the PEI is seed financing. 2. STARTUP

This is when the business actually starts. For this phase, the PE investment is called startup financing.

3. EARLY GROWTH

This represents the moment when the company start its growth. In the professional world, this is known as “the financing of the day after.” The PE investment is the early growth financing.

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3

These kinds of investment make up the venture capital subsample.

The Taxonomy of PE Clusters

4. EXPANSION

In this phase, the sales keep on growing at a very high rate. The corresponding investment of the PE is called expansion financing.

5. MATURE AGE

This is the moment when sales growth is stable. The PE investment is called replacement.

6. CRISIS

In the end, when (and if) the company comes across its decline, in this case the PE investment will be very hard and it is called vulture financing.

In each stage there is a different market and a different risk-return profile.

The Taxonomy of PE Clusters

The PEI can either be a minority or a majority shareholder and depending on which it is, approach can be different:

à Hands-On: The investor provides the support a company requires under the forms of the four benefits seen in the second clip and in addition they operate together with the entrepreneur.

à Hands-Off: The investor provides the support the company requires in the forms of the four benefits seen in the second clip but the PEI does not give any

additional support.

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Content

1. What Is Private Equity and Venture Capital?

2. Why Companies Need Private Equity And Venture Capital

3. Private Equity Clusters: Through the

Fund's Life Cycle

4.  Seed, Startup, and Early Stage Financing

5. Expansion Financing

6. Replacement Financing

7. Vulture Financing

Replacement Financing

The Venture Capital Fundamental

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4

Seed Financing

The Seed Financing is the most complex and riskiest activity among the PE investment.

It is the investment of an idea or of an research and development (R&D) project, it is in fact very industry-oriented: it usually deals with the biomedical, IT, and the

pharmaceutical industries / sectors. Under seed financing, the uncertainty of the project is high because the investor has to trust the idea of the entrepreneur. This is why the managerial role of the investor is very limited.

There are two levels of risk:

1.  The capability for the idea to generate on output

2.  If there is an output: does this output have a marketability?

Seed Financing

Because this phase is very risky, there are three golden rules an investor needs to know:

1.  100/10/1 RULE

•  The investor has to screen one hundred projects, finance ten of them and be lucky (and able) enough to find the one successful one.

•  The activity is risky that you must invest on much more that one project. The investor needs to invest a huge amount of money. The “psychological threshold” is one billion €. •  By the time the investors find the winning project they will have lost much of their

beginning investment.

2.  SUDDEN DEATH RISK

•  Because this investment occurs before the company is founded, the investors have to protect themselves in case the person owning the project’s idea suddenly can no longer preform his or her job.

•  The solution to this risk is in the Incubator Strategy, an ad hoc infrastructure in which the inventor can work without worrying about his or her ideas being stolen.

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Seed Financing

• The investors usually invest in the markets they know the best.

• Despite this, in some cases, the idea may be a good one without a market willing to buy it.

• Such is the case in which the investors look for venture philanthropy, set up by non-profit institutions with the investors themselves.

Startup Financing

The Startup Financing is the financing of a new company starting its own initial operations.

The entrepreneurs and the founders’ need of cash derives from the necessity to buy the necessary equipment to start (e.g. equipment, inventory, building, etc.) the business. In this kind of financing the risk is still very high, leading to a high level of protection for the investor.

The level of risk depends on the fact that the PEI is betting on a business plan. Because the investor is neither a non-profit organization nor a High Net Worth Individual (HNWI), there are several ways in which this can occur.

1.  PUT OPTION

• This tool is used to sell back to the entrepreneur the shares the investor bought. This tool is quite dangerous: it assumes that if the business plan does not work, the founder will still have money to pay off the PE. For this reason, the put option may be used together with a second tool…

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Startup Financing

•  This is a pledge for the investor over some valuable assets of the newly founded company and this is usually used together with the put option.

3.  STOCK OPTIONS FOR THE INVENTOR

•  Another way to reduce the risk the business plan is not accurate and reliable is to grant the inventor some stock options. In this way the entrepreneur will also enjoy the

profitability of the company.

4.  BALANCE BETWEEN MONEY AND SHARES

•  The PEI needs to find the right combination between not losing all its investment (such is the case when the PE owns 95% of the equity) and not having any say in the

management of the business (such is the case when the PEI owns 2% of the equity) •  For instance, for the investor the right balance would be owning 48% of the company.

Early Growth Financing

Early growth Financing is the financing of the first phase of growth of a new company that has started generating sales.

The entrepreneurs and the founders’ need of cash derives from the necessity to buy inventory and to sustain the gap existing between cash flow and money needed. In this phase, the cash flow is still negative, but not as much as in the previous stages of life of the company.

The risk is still high for the PEI since it is investing in a very young company and when they make the injection, they do not exactly know how the company will turn out.

In this phase, there is a very hands-on approach. If the PEI thinks that the company is based on a good idea, but the business plan is not adequate, it helps rewrite the business plan (à

knowledge effect, see Clip 2).

For this reason the PEI usually has a high amount of shares in the equity of the company. On average this financing occurs up to the end of the first three year after the startup stage. In this kind of investment, the PEI may also not have any protections, due to the high stake in the equity of the company and to the adoption of a hands on approach.

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Conclusion on Venture Capital

After an overview on the venture capital different clusters, we can define some common features for this subsample:

1.  The investment is often characterized by a high level of risk. 2.  The PEI needs to have a hands on approach.

3.  The PEI must have a very deep knowledge of the field where the company operates in.

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Content

1. What Is Private Equity and Venture Capital?

2. Why Companies Need Private Equity And Venture Capital?

3. Private Equity Clusters: Through the

Fund's Life Cycle

4. Seed, Startup, and Early Stage Financing

5.  Expansion Financing

6. Replacement Financing

7. Vulture Financing

8. Private Equity and Venture Capital: Today and Tomorrow – Interview

with Fabio Sattin

Startup

In clip 4 the venture capital has been presented. In the following Clips (5, 6, and 7), we will see the other clusters belonging to the PE family which are made for the phases of expansion, mature age, and crisis.

The PE Clusters

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Expansion Financing

The expansion financing takes place in the fastest phase of growth of a firm to consolidate its position in the market.

The investment is only used to sustain the (reducing) gap existing between the cash flow and money needed.

In this phase, the level of risk is moderate (and it mostly depends on the business) because the trend of development of the business is well known.

In this cluster the stake held by the PE is not usually very high. The expansion financing deals are about the growth of a company.

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5

In an adult company, growth can be: 1.  Internal (or organic)

2.  External

According to the growth a company finds itself in, the role of the PEI changes.

Expansion Financing

Internal Growth

We say that a company grows via internal growth when it plans to grow “by itself.” This means that investments in fixed assets and in working capital will be made.

The role of the PEI: the investor needs to provide money to the venture backed company in order to buy and/or sustain the procurement of working capital and to purchase new assets.

Because this kind of deal is not difficult for a PEI, the offer is very wide and there is a very high number of investors providing this financing.

This kind of financing can be an alternative to a loan.

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Why should a company choose PE over a bank?

Because the need for extra money comes with other needs which can be accomplished with one of the four benefits seen in Clip 2.

Expansion Financing

External Growth

We say that a company grows via external growth when it plans to grow by acquiring another company (i.e. carry on an M&A) in order to enhance the level of sales and exploit the synergies coming from this operation. This path is much more complicated than the internal growth and it may be undertaken by an adult company in order to enter a new market.

The role of the PEI: the investor has to sustain the M&A and in this case, they not only have to provide the venture-backed company with the money necessary, but they also have to:

a. Screen and scout the market

b. Support the negotiation with the potential target c. Provide the Venture-backed Company with money d. Support the M&A process

(also from a legal and a fiscal point of view) e. Legal and taxation support

f. The integration process after the operation

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The injection of money can be done in two ways:

1. The PEI invests in the venture-backed company, from which it gets shares and the company has to get enough money to carry on the M&A. If the process is successful the venture-backed company and the target will merge.

Expansion Financing

External Growth

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Expansion Financing

External Growth

The PROs

The venture-backed company will merge with the target and the company will benefit from the synergies.

The CONs

The venture-backed company is going to give the investor a portion of the synergies created.

In order to address this drawback, there is another way to do and M&A using PE.

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Expansion Financing

External Growth

2. The second way in which this M&A can be done is as follows:

• The PEI builds a Special Purpose Vehicle (SPV). The SPV is an “empty box” built only for the purpose of a specific extraordinary operation. This company does not have any assets nor liabilities and equity before the operation takes place.

• The PEI and the venture-backed company collect money from the banking system and put the cash collected in the SPV.

In this way, they will have enough capital to buy another company.

This option can be used in two cases:

a. When the venture-backed company has got a huge financial need and it does not want to further increase the amount of debt.

b. The company wants to keep the SPV as a separate entity, this happens when the

Expansion Financing

External Growth

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SPV

BANKING SYSTEM

Expansion Financing

External Growth

In this way, the PE will not benefit from the synergies created. On the other hand:

• This second option is more expensive than the first one;

• The PEI has a minor incentive in creating synergies (this may entail that lower synergies will be created)

• The company has to obtain financing from banks to invest in the SPV:

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Content

1. What Is Private Equity and Venture Capital?

2. Why Companies Need Private Equity And Venture Capital?

3. Private Equity Clusters: Through the

Fund's Life Cycle

4. Seed, Startup, and Early Stage Financing

5. Expansion Financing

6.  Replacement Financing

7. Vulture Financing

8. Private Equity and Venture Capital: Today and Tomorrow – Interview

with Fabio Sattin

PE Clusters

6

Replacement Financing occurs when a company is beyond the phase of fast growth and is in the mature age stage.

Replacement Financing

Replacement financing takes place in the mature age of a company and the role of the PEI is that of replacing an existing shareholder.

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6

These deals do not derive from the arise of need of money of a company.

A company needs replacement financing when it wants to face strategic decisions linked either to governance, status, or corporate finance decisions.

The level of risk is moderate and linked to the quality of the strategic process that has to be put in place.

There are three kinds of operations belonging to this cluster: 1. Leverage Buyout (LBO)

2. Private Investment in Public Equity (PIPE) 3. Corporate Governance (CG) Deals

Leverage Buyout

LBO is very commonly used, especially in the Anglo-Saxon world, where they account for 45%.

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The role of an investor is not only to finance the company but to identify the target company that the venture-backed company has to buy at 100%.

This operation takes place in the following steps:

1. When the PEI identifies the potential target, the PEI itself creates an SPV (for the

SPV definition, see clip 5) of which it becomes the full owner (i.e. 100%

shareholder).

2. The PEI collects money up and highly leverages the SPV up to a ratio of 90% debt and 10% equity.

Leverage Buyout

4.  The SPV buys the target company either through a negotiation process or through a hostile process and trough an IPO on the stock exchange. The aggressiveness of the operation depends on the level of debt used by the PE to buy the target company.

5.  The PE fully owns the target company.

After the acquisition, the PE will sell the target to anther company.

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Leverage Buyout

•  Low D/E ratio

•  Assets that can be easily be sold on the market

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Private Investment in Public Equity

Even though the investment is made in a public entity it still belongs to the PE world: the profit mechanism is still not related to the stock exchange.

This deal is not done with trading purposes. The purpose is to buy a minority stake and then to sell it to another potential shareholder at a price not based on the stock exchange (which usually is three - four times bigger). This stake has to be big enough to become the biggest shareholder.

To make this deal work the PEI has to understand the small amount of shares which is necessary to be the owner of the company. For this reason, these deals can

become very aggressive.

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Corporate Governance Deals

CG deals, just like PIPE, do not derive from financial needs of the company.

The PEI invests in a company to manage the redesign of the corporate governance. These operations occur particularly when there are problems in the management succession.

In the case of corporate governance deals there is a reputational risk, rather than a financial one.

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Content

1. What Is Private Equity and Venture Capital?

2. Why Companies Need Private Equity And Venture Capital

3. Private Equity Clusters: Through the

Fund's Life Cycle

4. Seed, Startup, and Early Stage Financing

5. Expansion Financing

6. Replacement Financing

7.  Vulture Financing

8. Private Equity and Venture Capital: Today and Tomorrow – Interview

with Fabio Sattin

PE Clusters

7

This is the final clip related to PE clusters.

The final stage of the life cycle of the company will be presented: Vulture (or distressed) financing.

Vulture Financing

Vulture financing takes place in the final stage of a company’s life cycle, when it enters its decline phase or, worse, a crisis.

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7

Money is used to sustain the financial gap generated from the decline of growth. The financial aid coming from the PEI is used to launch a survival plan.

Due to the life stage, this activity is very risky, even though the level of risk also depends on the sector of the venture-backed company. For this reason, the PEI fully understand the field in which the company operates.

Vulture Financing

There are two deals included in this definition:

1. Restructuring financing (or turnaround) 2. Distressed financing

The separation of the vulture financing in two different kinds of deals derive from two different ways to differently regulate the deals.

Restructuring Financing

In restructuring financing, the company is facing a crisis, but is still alive.

The need of financing derives from the settlements of debts with banks and with suppliers. At the same time, money can be used to re-launch the business, therefore in some cases money can be used to buy further assets or invested to redesign the business plan.

These strategic needs make the PEI not only a financer for the troubled company but also an advisor.

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7

The company needs the strategic support from the PEI Restructuring financing Distressed financing

Restructuring Financing

Because the risk is very high due to the strategic nature of the role of PE, the investor is a majority shareholder: there is a very strong hands-on approach and this needs a majority stake in the equity of the company.

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For the high difficulty of the deal and due to the elevated riskiness of these projects, it is very difficult to find a PEI investing in such deal, it is more of an investment banking activity.

Distressed Financing

This may look a bit contradictory to the other clusters of PE in which the main goal of a PE deal is to finance a company finding itself in the need of money.

The aim of PE is not in fact to merely finance the company, rather to buy the relevant (and valuable) assets of the company.

In this case, an investor is going to buy: •  Patents •  Brands •  Contracts •  Equipment •  … 53

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Contrarily to replacement financing, distressed financing is a very common deal for PEI and it occurs when the company is dead.

Distressed Financing

Why would a PEI want to buy the assets of a defaulted company?

1. In some cases, the PE may be a trader of assets. This means that the investment is made only to sell such assets to a third buyer.

2. In other cases, the PEI buys the assets because it inserts them in other venture-backed companies in its portfolio.

The assets are bought before a court, and the negotiation process can be tough between the court and the investor. As a matter of fact, it is a desire of the court to maximize the liquidity of a company when it goes bankrupt, so that it can pay off its debts.

Sometimes the court implements the “poison pill.” This means that the PEI is going to buy a valuable asset mandatorily together with another less valuable assets or together with a debt of the company.

These deals work differently according to the different countries. In the US, these deals work very well: there is a chapter in the United States Bankruptcy Code dedicated to the distressed financing (Chapter 11) (find out more about Chapter 11 at this link).

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Content

1. What Is Private Equity and Venture Capital?

2. Why Companies Need Private Equity And Venture Capital

3. Private Equity Clusters: Through the

Fund's Life Cycle

4. Seed, Startup, and Early Stage Financing

5. Expansion Financing

6. Replacement Financing

7. Vulture Financing

8.  Private Equity and Venture Capital: Today and

Tomorrow – Interview with Fabio Sattin

Founder of a Private Equity Firm: Private Equity Partners

Chairman of the EVCA in the past.

Professor of “Private Equity and Venture Capital” at Bocconi University

Who

Is Fabio Sattin?

Today, what is state of the art in private equity and venture capital all around the world?

“Today PE is an engine for the economic growth, especially for Europe and Italy.

As for Europe, one of the main hurdles is made up of the big role the banking system plays (huge difference with respect to the US).

In Europe, There is the need to create a new financial intermediary, not

“banking-related,” which should possess specific knowledge on companies and their development and this is why PE can be (and is) so important in Europe.

Nowadays we can see an increasing interest in private debt, again standing as a signal that PE in Europe plays a fundamental role.”

Q&A

According to you, are Europe and the US are two different worlds concerning private equity?

“There is a European way to play PE which is very different from the American one. I recall that years ago the, then Italian Ambassador, a big PE player in the US, once said that Europe is a completely different market.

Why is that? Europe (excluding the UK) can be taken as one very big country with many family businesses and PE can help them to develop à this changes the approach a PE has when investing in a family business.

We can say that PE has adapted also to invest in each specific country. Basing on my experience in the US, I can tell that in continental Europe, PE players support

generational change: again, a different way to do PE.”

Q&A

What are the key trends in the market for private equity and venture capital?

“After the financial crisis, today PE is definitely changing like many other industries. In the first place there is a problem at the fundraising level, which has become more difficult and PE firms had to come up with new strategies to do fundraising, like club deals, co-investments, SPACs.

The second problem is the fees’ structure. The fact that the fees are calculated on the committed capital is under a review process by many funds.

Again, I see many sovereign funds investing in PE.

On the deal-side, in Europe SMEs are the main target for PE investments (€ 45 bio invested each year).

In the future, I think that the investments may have a different structure.”

Q&A

The industry is changing: new strategies are coming up, in the US we see majority investments, whereas we see minority investments in Europe. How do you see the market in terms of strategic choices of the biggest players in the market, as the company of yours?

“One of the most important aspects is the fact that in Europe most deals are not very large. In addition, minority investments will still make the majority of the deals.

For these reasons, PE firms are boosting their industrial skills in order to enhance their industrial know how à PE is not a replacement for the managers, they are active owners, not active managers.

Having said that, it is necessary for the PE investors to have a solid knowledge of the company and of the sector in order to help companies to develop their strategies. This must be done without overlapping the role of the management team.”

Q&A

By Professor Stefano Caselli

Università Bocconi and SDA Bocconi

MODULE 2

PRIVATE EQUITY

AND VENTURE

Content

1

1.  Private Equity Investors: The Map to Investigate

3.  Closed-End Funds in Europe: Lifetime of a Fund

4.  Management Fees and Carried Interest

5.  Investment Firms and Banks in Europe

6.  Limited Partnerships in the US

7.  The SBIC Experience in the US

8.  Funds and VCT in the UK

Introduction

In the previous module we have seen:

•  When a company needs the intervention of PE

•  The deals a PEI can undertake to provide the financial aid a company needs We need to explore the world of the investors.

In this module we will discover: •  Who can be a PEI

•  How an investor works

•  How the regulation works for PE •  The remuneration of PE

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The Formats

Regardless where the deal occurs, there are two formats, each having its regulation and players:

1. The European Union format: This format is regulated by a Directive of the European Union.

2. The Anglo-Saxon format: This format is regulated by US and UK laws.

The European format has been adapted and is now used in, Brazil, and Russia, and others; whereas the Anglo-Saxon format is also used in India and Australia.

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Using one of the two formats does not

necessarily mean that the deal occurs in the area of the format.

The European Union Format

In the European Union, there are two Directives regulating PE activity and, at the same time, they regulate the entire financial system in the European Union:

•  The Banking Directive

•  The Financial Services Directive

Behind these directives lies the idea that the financial system in Europe has to be managed with stability, for this reason, before a financial institution becomes active, there must be an approval by both the local and central authorities.

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Within this framework, there are three players that can be a PEI:

1.  Banks

–  In Europe they are universal and they –  can provide any kind of financial service

2.  Closed-End Funds

–  They have an ad hoc structure and they are –  The most suitable player that can be a PE investor

3.  Investment Firms

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The European Union Format

Regulated by the banking directive

Regulated by both:

-  the financial services directive

-  the new AIFM (Alternative Investment

The main difference between the two formats is the idea that each has of PE.

In the Anglo-Saxon world, PE is not a financial service (as it is in Europe), rather it is an entrepreneurial activity.

This idea means that when talking about PE in the Anglo-Saxon world, the regulatory framework is made up of:

In the end, in the Anglo-Saxon format, there is no supervisor.

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1

The Anglo-Saxon Format

Common law +

Ad hoc fiscal rules

+

The Formats

The taxonomy of the formats must be clear and must be applied as follows:

Local players (i.e. the perimeter of the investment is within the country of origin of the PEI itself: a US PEI investing in the US only is a local player) must apply the legal framework of the country of origin of the investor.

Global players (i.e. the perimeter of the investment is outside the country of origin of the PEI itself) can opt for one format or the other one according to the needs of their portfolio.

Content

₂

1.  Private Equity Investors: the Map to Investigate

2.  Closed-End Funds in Europe: An Overview

4.  Management Fees and Carried Interest

5.  Investment Firms and Banks in Europe

6.  Limited Partnerships in the US

7.  The SBIC Experience in the US

8.  Funds and VCT in the UK

9.  Taxation Around the World

10.  New Solutions: SPACs, Private Debt Funds, Venture Philanthropy, and Crowd Funding

As anticipated (module 2 clip 1), PE in Europe is a financial activity regulated within the financial system legal framework and there are three vehicles that can be a PEI in Europe:

1.  Banks

–  In Europe they are universal and they –  can provide any kind of financial service

2.  Closed-End Funds

–  They have an ad hoc structure and they are –  The most suitable player that can be a PE investor

3.  Investment Firms

In this clip, the attention is focused on closed-end funds.

2

The European Union Format

Regulated by the banking directive

Regulated by both:

-  the financial services directive

-  the new AIFM (Alternative Investment

Closed-End Funds

An investment made through closed-end funds consider a two-level system involving two different institutions:

•  Asset Management Company (AMC) •  Closed-End Fund

The AMC is a financial institution.

It can host many funds at the same time (they can be both closed and open-end) and it can manage financial services as defined by the Financial Services Act (i.e., personal management of savings, dealing, brokerage, advisory).

The closed-end fund is a separate entity that invests money for a pool of investors.

When referring to closed-end funds, there are three players to consider:

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2

AMC

Investors

Closed-End Fund

Closed-End Funds: Players

2

Financial institution approved and supervised by the local authority, whose task it is to manage the fund.

The AMC shares some characteristics with a consulting

company. In fact, it is not a financial institution but a cluster of people advising.

There are AMCs owned by banks, private individuals (boutiques of PE), and the government.

There are no constraints in terms of shareholders, except for the commitment the AMC must own in every fund, which must be equal to 2%.

AMC

Closed-end

Funds

Investors

Closed-End Funds: Players

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2

A fund is a separated amount of money, given by the

investors, managed by the Asset Management Company. This amount of money can be used to invest into financial assets or in other assets such as real estate, gold, etc.

A fund can be open end or closed end, where the distinction is driven by two parameters:

•  The maturity (fixed or not)

•  The amount of money to invest (fixed or not).

These funds can never use debt

AMC

Closed-end

Funds

Investors

Closed end funds have a fixed maturity and a fixed amount of money to invest.

Closed-End Funds: Players

2

Investors put money in the funds and from the moment when they do that, they automatically lose any right to have a

tailor-made investment. Their investment will be managed by the AMC together with the other money belonging to the fund. When they invest, they receive a certificate with the value they invested in the fund.

Typically investors are:

-  High net worth individuals -  Banks -  Insurance companies -  Pension funds -  Corporations -  Governments

AMC

Closed-end

Funds

Investors

The existence of this “double level” is necessary to analyze the (very few) rules both for the asset management company and for the closed-end fund - the same all over Europe.

For the AMC, the set of rules concerns:

Closed-End Funds: Rules for the

AMC

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2

The choice of a short albeit well-organized system responds to the need to better regulate a country-specific financial system.

The rules are verified by the country supervisor, checking over the whole life of the AMC

Management rules Governance rules

Minimum requirements to operate

Closed-End Funds: Rules for the

Fund

For closed-end funds, the set of rules concerns three items:

2

Investment policy

Internal code of activity General rules

Content

₃

1.  Private Equity Investors: the Map to Investigate

2.  Closed-End Funds in Europe: an Overview

3.  Closed-End Funds in Europe: Lifetime of a Fund

5.  Investment Firms and Banks in Europe

6.  Limited Partnerships in the US

7.  The SBIC Experience in the US

8.  Funds and VCT in the UK

9.  Taxation around the World

10.  New Solutions: SPAC, Private Debt Fund, Venture Philanthropy, and Crowd Funding

Closed-End Fund

In the previous clip, closed-end funds were presented, together with the relative

regulatory frameworks and the players they interact with over their life (i.e. the investors and the AMC).

The goal of this clip is to understand how those funds work.

All the rules concerning the functioning of a closed-end fund are stated in the set of rules called internal code of activity (see module2, clip2), approved by the authority.

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Closed-End Funds in Europe

Closed-end funds are the most important vehicle in Europe for PE.

Their length is fixed, meaning that the investors can invest in the beginning and divest in the end of the fund.

The liquidity is no problem for the investors nor the AMC. For this reason closed-end funds are the perfect tool to undertake a PE investment.

Typically, the average size of a fund is €100-300 million and this amount is divided into tickets an investor can buy. Each ticket typically has a value of €1 million. For instance, if the amount of money of the fund is €100 million, and each ticket is worth €1 million, the fund needs (as a maximum) 100 investors.

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3

Closed-End Fund: Lifetime of a Fund

When presenting the lifetime of a closed-end fund, some milestones must be set. In its lifetime the following moments are the most important:

•  Time 0 •  Time 3

•  Time N – 0.5 (where N is the end of the fund)

•  Time N + 3

3

-1.5 0 3 N – 0.5 N N + 3

Fundraising Draw down period Getting to time N Extra time

Closed-End Fund

Fundraising

Before launching any activity, the AMC needs the approval by the authority, where the approval depends on three criteria:

•  The size of the fund

•  The value of every ticket •  The investment target.

Once the approval is granted, the AMC has as a maximum 18 months

to collect the all of its money.

Generally, 4-5 months is the average time taken by an AMC to collect the whole capital that will be invested. As a matter of fact, if the AMC does not collect money before the time allowed, they usually stop beforehand, otherwise they would lose their reputation.

In fact, 50% of the funds all over Europe do not manage to get to time 0.

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3

-1.5 0

Fundraising

Closed-End Fund

Draw Down Period

At time 0, the fundraising phase comes to an end.

In this period the AMC has the possibility ask the investors to deposit a percentage of their commitment (e.g. 10%).

The time is set at 3 years, because collecting all the capital from the investors will take much more time than it does in capital markets. In the time going from time 0 and the third year, the closed-end fund has to cash in all the money previously subscribed by the investors, who can also deposit their investment with installments.

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0 3

Draw Down Period

Closed-End Fund

Getting to Time N

At time 3, the investors have to have entirely injected all the money equivalent to their tickets. So, after the three years, the AMC keeps on investing until the end of the fund. In fact, some investing activity can have already taken place before Time 3 but, not using the entire amount.

The length of the fund can be defined by the AMC, as long as it is shorter than 30

years. Usually, 90% of the funds have a maturity of 10 years. As a matter of fact, for an AMC, 10 years is a maturity long enough to make two investments:

1.  Year 0 - 3: first investment

2.  Year 3 - 5: exit from the first investment 3.  Year 5 - 7: second investment

4.  Year 7 - 10: exit from the second investment

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3

3 N – 0.5 N

Getting to Time N

Closed-End Fund

Extra Time

After the end of the closed-end fund there is the possibility to use up to three year of extra time.

As was presented in the first week, PE tends to have low liquidity, and as such sometimes an AMC does not have the whole liquidity it would need to pay off the investors right away.

When the fund finally comes to an end, the AMC valuates the fund and spreads this value among all the investors coherently with the amount of tickets bought by each investor in the beginning of the fund.

3

N N + 3

Extra Time

Content

4

1.  Private Equity Investors: the Map to Investigate

2.  Closed-End Funds in Europe: an Overview

3.  Closed-End Funds in Europe: Lifetime of a Fund

4.  Management Fees and Carried Interest

6.  Limited Partnerships in the US

7.  The SBIC Experience in the US

8.  Funds and VCT in the UK

9.  Taxation Around the World

10.  New Solutions: SPAC, Private Debt Fund, Venture Philanthropy, and Crowd Funding

The Economic Mechanism of an AMC

In closed-end funds there is an interaction between the investors and the AMC.

Investors will be paid, and a gain or loss will be generated at the end of the fund (i.e. either at time 10 or at time 13 (see module2 clip3)).

What about the managers of the funds?

The goal of this clip is to understand how the AMC is remunerated over the fund’s lifetime.

4

The Economic Mechanism of an AMC

1.  Management fees

2.  Carried interest

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4

Please note: the rules that will be presented are also valid for fund

managers operating in the US as long as they operate in PE deals.

1. Management Fees

Management fees correspond to the amount of money an AMC receives every year from closed-end funds.

Closed-end funds are the vehicles generating: •  Revenues, in the form of capital gains

•  Dividends coming from the companies in which the investment is made •  Losses, in case the deal is not successful

The management fees is a fixed percentage of money calculated on the value of the closed-end fund in the beginning of the fund itself.

For instance, in the case of a closed-end fund being worth €100 million bearing management fees at 2%, every year the AMC receives €2 million from the fund.

4

1. Management Fees

The management fees must be precisely calculated for they have to cover: •  Operating costs

•  Remuneration of the advisor helping the AMC in the consulting activity •  Remuneration of the technical committee

The percentage of the management fees is in fact computed with the capital

budgeting approach. That means that it is computed replying to the question: “Is the amount enough to properly cover all expenses?”

The reply is in fact not in the percentage per se, rather it stands in the absolute value of these fees.

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4

1. Management Fees

In case an AMC belongs to a bank, all the above-listed costs will be easily covered. On the contrary, if the AMC is an independent entity, covering all the above-listed expenses can be very tough.

For instance, in venture capital, AMCs are owned by professionals and not by financial institutions, because they need a workforce who can fully be devoted to the venture-backed company.

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2. Carried Interest

The second source of remuneration for the AMC is made up of the carried interest.

It is computed only at the end of the closed-end fund’s life cycle.

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4

IRR: it is a discount rate that equals the investments with the present values of the future returns of such investments.

Maximizing the carried interest is the ultimate goal and desire of an AMC.

CARRIED INTEREST = % x (Final IRR – Hurdle IRR)

2. Carried Interest

The carried interest is the spread between the final IRR and a hurdle (a.k.a. threshold) IRR multiplied by a fixed percentage.

Usually, the fixed percentage ranges between 25-30%; the hurdle rate ranges between 7-8%. This means that, at the end of the fund, the AMC will receive a carried interest if and only if the final IRR is larger than 7-8%..

The carried interest formula is also called “the waterfall mechanism.”

This mechanism can be used either with or without catch-up, where the choice to calculate IRR one way or the other is up to the AMC and must be agreed in the Internal Code of

Activity.

•  Without catch-up: The carried interest is computed on the difference between the final IRR and the hurdle rate.

4

CARRIED INTEREST = % x (Final IRR – Hurdle IRR)

Content

5

1.  Private Equity Investors: the Map to Investigate

2.  Closed-End Funds in Europe: An Overview

3.  Closed-End Funds in Europe: Lifetime of a Fund

4.  Management Fees and Carried Interest

5.  Investment Firms and Banks in Europe

7.  The SBIC Experience in the US

8.  Funds and VCT in the UK

9.  Understanding Taxation Around the World

10.  New Solutions: SPAC, Private Debt Fund, Venture Philanthropy, and Crowd Funding

PE Players in Europe

As anticipated in clip 1 of this module, PE in Europe is a financial activity regulated within the financial system’s legal framework and there are players players that can be a PE investor in Europe:

1.  Banks

2.  Closed-end funds

3.  Investment firms

In this clip, the attention is focused on the other two players of the European format.

PE Players in Europe: Banks

In Europe, banks are universal: They can undertake any kind of financial activity except for the following ones:

•  Collective asset management activity •  Insurance activity

•  Non financial activities

However banks can hold equities of AMCs, insurance companies, and non financial firms.

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5

PE Players in Europe: Banks

When a bank wants to directly invest in the private equity of a company (whether it be listed or non), not only does it have to follow very strict constraints and rules but it is necessary for the bank to set aside a lot of regulatory capital, due to the strict regulation constraints imposed on banks by Basel II and III.

This means that the capital gain obtained through the investment can be counterweighted by the regulatory capital it has to set aside.

5

PE Players in Europe: Banks

For the reasons mentioned above, it is very rare that a bank invests directly and become a PEI.

Banks usually invest in closed-end funds to ultimately participate to some PE activities.

Banks only directly invest if there needs to be an urgent intervention to save a company in a certain industry or area or if the venture-backed company is of particular importance.

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5

PE Players in Europe: Investment Firms

Investment firms in Europe are regulated by the Banking Directive and can undertake the same activity as banks with the exception of collecting money through deposits. According to the regulation they comply to, there are two kinds of investment firms.

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PE Players in Europe: Investment Firms

Type 1 Investment firms

They do not have any specific constraints to manage their activities and the supervision impact is quite soft.

They do not undergo any regulatory capital rules.

Type 2 Investment firms

They face the same constraints set for banks and for them the supervision impact is hard. In this case, all investments undertaken by the firm entail a regulatory capital as if they were banks.

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5

In Europe, the most widespread kind of firm is the second type.

Cash

Debt

Equity

PE Players in Europe: Investment Firms

5

PE Players in Europe: Investment Firms

The role of the two kinds of shareholders is necessary to replicate, in the investment firm, the relation existing between an AMC and the investors within closed-end

funds.

As a matter of fact:

•  A-shareholders: act as an AMC. They are remunerated with the management fees and with a yearly carried interest (it is computed every year because the

investment firm does not come to and end, unlike the closed-end fund).

•  B-shareholders: act purely as investors and cannot influence the management of the investment. They are remunerated with the difference between the profits and the carried interest given to A-shareholders.

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5

PE Players in Europe: Investment Firms

•  A small group of investors may want to create a captive vehicle and they do not want to comply to very strict regulations. Such is the example of the so-called “family offices,” a group of family members who want to invest their own money.

5

Content

6

1.  Private Equity Investors: the Map to Investigate

2.  Closed-End Funds in Europe: An Overview

3.  Closed-End Funds in Europe: Lifetime of a Fund

4.  Management Fees and Carried Interest

5.  Investment Firms and Banks in Europe

6.  Limited Partnerships in the US

8.  Funds and VCT in the UK

9.  Understanding Taxation Around the World

10.  New Solutions: SPAC, Private Debt Fund, Venture Philanthropy, and Crowd Funding

PE Players in the Anglo-Saxon World

Looking at the Anglo-Saxon markets, it’s can be noted that investments in PE are not regulated by a regulation framework, rather they are market-related.

This derives from the Anglo-Saxon idea that the market discipline is more powerful and important than a financial authority regulation.

PE Players in the US

The US financial market is driven by common law and great importance is covered both by the local courts’ work and by the federal court’s work.

Some federal acts have created a general framework for the financial system. This framework is not based on financial institutions but on relevant financial activities. The pillars are represented by:

•  Discipline on stock exchange and securities •  Corporate governance rules

•  Discipline for insurance and pension funds •  General rules for banks

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PE Players in the US

1.  Venture Capital Funds (VCFs or simply, funds) 2.  Small Business Investment Companies (SBICs) 3.  Banks

4.  Corporate Venture 5.  Business Angels

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The two institutional vehicles in the US market

Venture Capital Funds

Venture capital funds are the most popular PE instruments in the US. Regardless of the name, they can operate in every PE deal.

The legal entity supporting a VCF is called the limited partnership (LP).

An LP is one of the typical structures to create a company in the US, whereas

common organizational forms are: sole proprietorship, partnership, limited-liability partnership, limited partnership, S-corporation and C-corporation.

That means PE investment is considered a business activity and not a financial activity as it is in Europe.

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6

Venture Capital Funds

An LP is the legal entity with the mandatory presence of two different groups of shareholders:

LP

The Limited Partners (LPs) must own 99% of the equity of the LP, whereas the

General Partners (GPs) must own 1% of it. This is set by US law.

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Venture Capital Funds

Limited Partners are solely investors. They do not manage the company and are limitedly liable to the extent of their investment.

General Partners are the managers of the company and they are fully liable for the LP liabilities. This means that in the worst-case scenario they lose everything.

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COMPARISON WITH EUROPE

LPs are like the investors in closed-end funds. GPs are like the AMCs in closed-end funds.

Even though the holding stake is different

Venture Capital Funds

What does being “fully liable” mean?

It means that the GPs are responsible for the liabilities.

Full liability is something that is not stated in the rules of the closed-end funds

(Note: remember that closed-end funds can not leverage). The fact that a fund can

leverage makes it a hedge fund, entailing a higher risk-return combination than the one in Europe.

The functioning of a fund is regulated by a Limited Partnership Agreement and it is made by GPs and LPs, where the content is very similar to the one of the internal code of activity, except for the parts referring to debt policy.

The only difference with the fact that in Europe, it is a code, therefore in case of a legal battle they go before a Supervisor. On the contrary in the US it is a contract, then they go before a Court.

6

Venture Capital Funds

What does being “fully liable” mean?

In addition the GPs want to protect themselves due to the full liability. This is why GPs usually is a management company and it operates via a Limited Liability

Partnership (LLP) working just like an AMC in Europe.

GPs want to be protected, but the LPs do not want them to be too safe. This is why the assets of the LLP will be a collateral of the debt of the VCF.

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6

Assets

Debt

Equity

Venture Capital Funds

What does being “fully liable” mean?

6

LP

LLP