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Terms and conditions of European private equity funds

Investments in European private equity partnerships are subject to certain terms and conditions. Here SJ Berwin outlines the main ones that investors need to pay careful attention to.

Private equity funds that are aimed principally at institutional investors are usually structured as limited partnerships. This article identifies and explains some of the principal terms and conditions found in a typical private equity limited partnership fund agreement in Europe.

Fund size
The size of a private equity fund depends largely on its targeted investments; buy-out funds generally require considerably larger sums than early-stage funds, for example. The background and track record of the management team are also factors. An established private equity house managing several existing funds will have a ready source of prospective investors and, with an existing track record, will probably find more investors willing to commit significant sums than a newly founded management team raising its debut fund.

The fund size is usually stated as a key term in the private placement or offering memorandum (PPM) used to market the fund. The PPM will specify the anticipated fund size, together with a maximum and possibly also a minimum on amounts to be raised. If commitments do not reach the minimum level specified or are unlikely to approach the targeted fund, then the manager usually will have no alternative but to cancel the fundraising. Investors in debut funds sometimes make their commitment conditional on a minimum amount of commitments being raised by the fund.

Use of Capital
Generally, the fund agreement will say that capital can be applied to finance new investments, expenses of the partnership and advances of profit share to the general partner, subject to restrictions. Investments are made in accordance with the fund's investment strategy as set out in the PPM or partnership agreement, usually with some ability for the fund to make bridging and/or hedging investments. Expenses are generally clearly defined. Capital is normally drawn down from investors on an ‘as needed' basis.

Term
Private equity funds are normally established for a definite term, usually ten years - although recent technology and e-commerce private equity funds in particular have featured shorter terms.

A typical ten-year term will allow time for new investments to be located and acquired and for the management team to add their particular value to those investments. The aim is to achieve a profitable exit within a couple of years. Normally, the fund will only be permitted to make new investments in the first half of its term (the commitment period), although follow-on investments in existing portfolio companies are usually permitted beyond the commitment period. This allows time for the manager to manage and realise the portfolio and liquidate the fund in an orderly manner within the term. Fund agreements may provide for the distribution of unrealised portfolio companies to investors at the end of the term. In addition, the fund agreement usually allows for one or two-year extensions of the term to enable the portfolio to be realised in an orderly manner.

Reinvestment of capital
It is normal for the fund agreement to provide that, once capital has been returned to investors (usually on realisation), it is not subject to further draw-down by the fund. However, the fund agreement may provide that certain categories of capital proceeds can be redrawn from investors. For example, the proceeds of bridging investments, or portfolio investments realised within a reasonably short period after their acquisition date, may be available for reinvestment up to the amount of the original acquisition cost of the investment. In addition, the fund agreement may allow capital proceeds falling into such categories to be retained by the fund for reinvestment, avoiding the need to distribute and redraw.

Duration of fund-raising
Fund raising usually takes place in several stages. These are called closings. The first closing is arguably the most important and only occurs when the manager has received commitments representing a sizeable proportion of the targeted fund. After first closing, the fund agreement will provide for a further period of fund-raising, typically six, nine or 12 months, during which one or more subsequent closings will be held.

The duration of fund-raising needs to be limited so the management team can devote itself to investing and managing the fund after final closing with a definite amount of capital to invest.

It is quite common for the fund to make investments before its final closing. In order to participate in investments made prior to their admission, subsequent investors will usually be required to pay interest on the initial draw-down of their commitment for the period from the first closing date up to the date of the closing at which they are admitted.

Co-investment rights
As an added incentive, some private equity funds offer their investors the opportunity to invest directly alongside the fund in portfolio companies. Also, the fund manager may want to syndicate to co-investors any surplus investment opportunities that the fund is unable to take advantage of because of restrictions on the size of single portfolio investments.

There are various forms of co-investment arrangement. Investors might be invited to co-invest directly on an ad hoc basis or to participate in a special parallel vehicle established to acquire a certain proportion of each portfolio company investment. In the former case, investors will be bound by the same investment documentation as the fund and their exit will effectively be dictated by the fund's exit strategy. In the latter case, the fund manager will also manage the co-investment entity and will effectively be an intermediary between the portfolio company and the co-investors.

Preferred return
The preferred return (or hurdle rate) is a mechanism that, in some types of private equity funds, provides investors withan accelerated return on their commitments, subject to the fund generating profits. Typically, profits in a private equity fund are divided 80/20 between investors and the management team. The preferred return simply affects the timing of profit distributions as between investors and management team, rather than the profit-sharing ratio itself. In certain circumstances it can lead to investors receiving more than their 80 per cent at the end of the fund.

The preferred return is structured as a notional rate of interest on capital advanced by investors pending repayment. The rate of return varies, but is often around eight per cent. The fund agreement will provide that investors must have received their preferred return (in addition to repayment of their capital drawn down) before the management team can participate in the profits. This is commonly referred to as the ‘hurdle'. Assuming the hurdle is reached, the management team will then receive sufficient profits to achieve the 80/20 split (they will ‘catch up' with the investors), and thereafter all profits are distributed in those proportions (subject to further draw-down of capital). If the hurdle has not been reached by the end of the fund, investors will keep the 100 per cent of the fund's net profits (if any) that they have received during the life of the fund in accordance with the preferred return, and the management team will get nothing.

Priority profit share
The ‘general partner's share' (the GPS, a priority share of partnership profits) is normally calculated as a percentage of the total commitments of the fund and/or a percentage of capital drawn down and not repaid for the time being. The GPS may reduce over time to anticipate the general partner devoting less time and resources to the fund in its later stages. For example, the fund agreement might provide that, during the commitment period, the GPS will be calculated as a percentage of the total commitments. After the commitment period and until termination of the fund, it might be as a percentage of the aggregate acquisition cost of unrealised portfolio investments.

In the initial stages of the fund, and later on if the fund does badly, the GPS will usually be funded by drawn down capital. This is only returnable to investors in the event that the fund makes enough profit to cover the relevant amounts. If the management of the fund is delegated to a separate manager, the partnership will not usually bear any additional management charges. A separate agreement between general partner and manager will provide that most, if not all, of the GPS is paid over to the manager as management fee.

The above is intended for information only and does not constitute legal advice. You should consult a suitably qualified professional before taking any action on any particular matter.

© SJ Berwin March 2001