How to invest in private equity - BVCA admin

How to invest in private equity
You should refer to your investment consultant for detailed, specific advice on
private equity investment.
What do I need for a successful private equity investment strategy?
A long-term investment horizon.
A suitable investment benchmark return when considering private equity investment.
• To select the right method of private equity investment to suit your requirements (see "Methods of investing in private
equity"). This usually entails engaging a specialist private equity manager.
A spread of private equity investments to diversify the types and stages of the investee companies.
How much should I commit?
An investor is rarely required to invest its maximum commitment to a private equity fund, with
funds typically drawing down from 80%-95% of commitments. Commonly, only a maximum of 60% of
an investor's total commitment is outstanding at any one time.
How is the cash I have committed actually drawn?
Cash is usually drawn down on an investment by investment basis (generally in years one to five).
Cash is returned to the investor as and when investments are realised (often from year three
onwards). This can mean that within a four- to six-year period, you could receive back as much as
you have committed to a fund.
A fund investing in private equity is likely to take longer to repay commitment than one focused on
buy-outs.
How is my investment realised?
Even though funds generally have a 10-12 year life, typically they begin to return cash to investors
after three to five years. A mature portfolio of several private equity funds is usually highly cash
generative.
If one of the investments made by the private equity manager is realised through flotation, the
investors in the fund are occasionally offered the shares in the newly quoted company. More
usually, the shares are held within the fund until finally sold by the private equity manager.
There is a small but growing secondary market in private equity funds. This offers investors a way
of exiting from their entire private equity portfolio before it is wound up. However, secondary
trades in private equity funds are often undertaken at a discount and investors should not rely on
the secondary market. Details of secondary purchasers can be found in the BVCA's Directory of
Members, under 'associate financial members' and on the BVCA's website.
How do private equity managers raise funds?
Private equity firms usually manage funds structured as limited partnerships and tend to raise a
new fund every three to five years. A fund-raising can be spread over several months.
When raising a fund, a private equity firm will produce a private placing memorandum. This
document gives detailed information on:
• the private equity firm;
• the funds and the investments it previously and currently manages and their performances;
• valuation of unrealised investment and valuation policy;

• the firm's executives and their relevant experience;
• the fees chargeable and management incentives;
• the fund's investment strategy;
• reporting methods and details of how often reports will be published.
This memorandum may be sent to institutions directly by the private equity firm or via
intermediaries such as placing agents and investment consultants.
How do I find out who is fund raising?
See the BVCA's list of funds currently being raised on the BVCA's website under 'institutional
investors'.
Also on this website is the BVCA's searchable directory of private equity firms for contact details.
Introduce yourself to private equity firms and get on their mailing lists. Details of firms that
manage limited partnership funds can also be found on the BVCA's website under 'institutional
investors'.
Read the press. Some funds publicise their fund-raising activities through letting journalists know,
but they are not permitted by law to advertise that they are raising a fund. A fortnightly
publication called "...unquote" lists the details of most funds being raised (published by Initiative
Europe on 01737-784 200).
Speak to your investment advisers who are frequently contacted by private equity firms and
placement agents.

Methods of investing in private equity
How can I invest in private equity?
Through private equity funds alongside other investors. These are typically structured as limited
partnerships (fund route).
Through a fund managed exclusively for your scheme by a private equity fund manager (segregated
route).
Through quoted venture and development capital investment trusts (investment trust route).
Through a "fund of private equity funds" managed by a gatekeeper (fund of funds route).
By making direct investments into unquoted companies (direct route).
Fund route
Pros
Over 200 private equity funds enabling a
wide selection of investment
opportunities
Wide range and number of private
equity managers seeking to raise new
funds in which to invest over the next
few years
High level of control
Private equity funds are directly
accountable to you
Many private equity fund managers take
a position on the board of the company
in which they invest to keep in close
contact with the company's
development
Established private equity funds have a
high level of expertise and quality deal
flow.
Segregated route
Pros
High level of control
Good accountability and direct contact
Flexible - no fixed time period and can
be tailored to your requirements, eg.
commitment period.
Investment trust route
Pros
Share price reported on a daily basis
Liquidity
Many investment trust managers take a
position on the board of the company in
which they invest to keep in close
contact with the company's
Cons
Need for staff or advisers to achieve and
maintain a good knowledge of private
equity fund managers, fund raisings,
portfolio content, performance, etc
Minimum level of investment may apply.
Cons
Requires very substantial funds to be
commercially viable and to spread risk.
Cons
Shares may trade at a discount to net
asset value
Increases correlation of returns with
quoted markets.

development
Established investment trusts have a
high level of expertise and quality deal
flow
Relatively low fees and transaction cost.
Fund of funds route
Pros
Access to a diversified private equity
portfolio eliminating the risk of underdiversification
Expertise in investing in private equity
funds, knowledge of private equity
managers' performance, methods,
portfolios, fund raising timings, etc
Offers an insight into private equity
fund investment for those who do not
yet wish to be involved in in-house or
direct fund investment
Minimises administration - e.g. only one
set of calls and distributions to deal
with.
Direct route
Pros
Full control
Direct access to unquoted companies.
Cons
Additional layer of fees (from the
gatekeeper and the private equity fund
manager)
Potential barrier between investor and
underlying private equity managers,
reducing contact with, and
understanding of, the private equity
market
Slightly longer-term commitment (up to
15 years).
Cons
Full responsibility
Requires very substantial funds to
achieve an adequate spread of
investments
Cost and commitment: need for
substantial permanent specialist staff
Staff need expertise in negotiating and
structuring the initial investment,
monitoring the companies and exits
Requires access to potential investment
opportunities, as success depends on
quality and quantity of deal flow.

What key points should I consider when selecting a private equity
manager?
Managers of private equity limited partnership funds
Performance record
Ability to add value to portfolio companies (past, present and future)
Deal sourcing ability (past, present and future)
Process established
Exit ability/experience
Experience/commitment/motivation of key executives
Investment strategy fits with your requirements
Evidence of ability to move with changing market conditions to ensure future returns
Flexibility - is the minimum/maximum investment permitted in line with your needs?
Distribution policies - are distributions managed so that investors can obtain cash, thus eliminating
the need for them to take on the task of managing distributions?
Fees and terms
Reporting methods
Gatekeeper/fund of funds manager
Performance record
Proven ability to access the best private equity managers. The better private equity funds are often
oversubscribed and access can be by invitation only
Appropriate diversity across stage, style and geography
Flexibility - is the minimum/maximum investment permitted in line with your needs?
Distribution policies - are distributions managed so that investors can obtain cash, thus eliminating
the need for them to take on the task of managing distributions?
Fees and terms
Reporting methods
What fees are generally charged by a private equity manager?
The annual management fee is usually based initially on the amount of capital committed to the
fund.
Management incentive fees, or carried interest, is usually payable as a proportion of investor
profits after hurdle rates have been achieved.
Fees levied by private equity managers are generally higher than for other asset classes. This is
because the sourcing, purchasing, monitoring and realisation of private companies is more labour
intensive per £1 invested. These higher fees are balanced by higher expected returns. The fees
chargeable will be listed in the private placing memorandum.
Private equity fund returns are generally quoted net of all types of fees, which is how returns are
shown in the BVCA's annual Performance Measurement Survey.

London Business School's key recommendations to pension fund
investors
In January 2000, an independent report was undertaken by London Business School, commissioned
by the BVCA and supported by the National Association of Pension Funds, which examines private
equity as an asset class for pension fund investors. Some of the key recommendations made by the
report follow.
• Take a long-term perspective
The decision to invest should be taken with a long-term perspective in mind since it normally
takes three to five years before investors experience positive returns and net cash flows.
• Be prepared to make higher nominal fund allocations
Usually a maximum of 80% - 95% of an investor's committed capital is drawn down. Investors
should be prepared to make higher nominal fund allocations to this asset class in order to
achieve their target exposure. Commonly, only around 60% of an investor's total commitment
is outstanding at any one time.
• Appoint a dedicated private equity fund manager
Managers of private equity portfolios should be subjected to different organisational
procedures from the managers of marketable security portfolios.
The assessment of track records and selection of private equity firms - skills that have a
large impact on the returns of a private equity portfolio - require an expertise which is quite
different from analysing public equity markets. London Business School suggests that pension
funds appoint exclusive private equity managers and subject them to different incentive and
monitoring procedures.
• A well-structured portfolio
A well-structured private equity portfolio has attractive cash flow implications. Initially it
will require net contributions over several years. After this period, such a portfolio should
generate positive net cash flows for a longer period.
• Growth in the secondary market
The growing secondary market has led to a substantial improvement in the liquidity of the
private equity industry.
• Diversify between funds and managers
Diversification between funds and managers smooths cash flows and can reduce the spread of
returns. (Details of private equity firms can be found on the BVCA's website at
www.bvca.co.uk and in the BVCA Directory of Members.)

Frequently asked questions and answers
What size is the industry?
Over £60 billion has been invested by UK private equity firms in over 25,000 companies between
1984 and 2003.
Over £67 billion has been raised by independent private equity funds from 1988 to 2003.
Market capitalisation of venture and development capital investment trusts totalled £6 billion in
September 2003.
"Captive" private equity funds - those owned and only obtaining funds from their parent
organisations (such as banks or insurance companies), accounted for 6% of 2003's total UK
investment.
How liquid is private equity investment in practice?
Technically, investment trusts are unable to distribute realised gains, but in practice liquidity is
gained through their quotation. As with all quoted shares, this is subject to general constraints on
marketability, such as the size of the holding.
Individual limited partnerships are unquoted, but are self liquidating and distribute realised gains
and dividends to investors during the life of the fund. It may be noted that because these funds
draw down capital in several tranches and make periodic distributions, commonly only a maximum
of 60% of an investor's total commitment is outstanding at any one time.
Typical private equity fund cash flow
(Commitment = 100)
Source: Westport Private Equity Limited
Are private equity investment returns under downwards pressure?
The size and number of some funds raised, particularly recently, have made press headlines. It is
worth noting, however, that most of these are larger buy-out funds with a pan-European rather
than purely UK focus. The continental European market is less mature than that in the UK.
A well-structured fund, run by a good manager with strong pricing disciplines that prevents
overpayment, should be able to maintain the higher levels of returns.
Your adviser should know the investment policies of the private equity funds and their potential
returns.

What sort of private equity funds are available for investment?
See the section on "Methods of investing in private equity" which will give you some pointers.
Different pension funds will have different requirements and resources.
Should investment be in more than one fund?
A portfolio of private equity fund investments may be advisable in order to give a spread, as with
investment in any other asset class. This can be achieved either by investing in more than one fund
or by investing in a fund of funds.
Why invest in private equity?
With suitable diversification, you can achieve long-term superior returns.

Appendix 1 - Private equity terms and definitions
The term "private equity" is the term generally used in Europe to cover the industry as a whole,
both buy-outs and venture capital. "Venture capital" is a subcategory covering the seed to
expansion stages of investment. Private equity describes equity investments in unquoted companies
often accompanied by the provision of loans and other capital bearing an equity type risk. Below
are descriptions of the different stages of private equity investment.
Types of private equity
Buy-in management buy-out (BIMBO)
Provision of equity capital to enable a company's management to acquire the business they manage
with the assistance of some incoming management.
Institutional buy-out (IBO)
Provision of equity capital to enable a private equity firm to acquire a company, following which
the incumbent and/or incoming management will subscribe for or otherwise acquire a stake in the
business.
Management buy-in (MBI)
Funds provided to enable an external manager or group of managers to buy into a company.
Management buy-out (MBO)
Funds provided to enable current operating management and investors to acquire an existing
product line or business.
Public to private (PTP)
The purchase of all of a listed company's quoted shares using a special purpose vehicle funded with
a mixture of debt and unquoted equity.
Refinancing bank debt
To replace or reduce a company's level of gearing.
Replacement capital
Equity capital which allows existing equity investors to buy back, replace or redeem their
shareholding.
Rescue/turnaround
To provide equity to finance a company in difficulties or to rescue it from receivership.
Secondary purchase
Purchase of existing shares in a company from another private equity firm. This is often done when
a private equity manager wishes to sell his stake in a company to allow him to wind down a mature
fund at the end of its life, or from another shareholder or shareholders.
Venture capital
• Seed
Provision of equity capital to allow a business concept to be developed, perhaps involving the
production of a business plan, prototypes and additional research, prior to bringing a product
to market and commencing large-scale manufacturing.
• Start-up
Financing provided to companies for use in product development and to fund their initial
marketing. Companies may be in the process of being set up or may have been trading for a
short time, but may not have sold their product commercially.
• Other early stage
Provision of equity capital to initiate commercial manufacturing and sales in companies
which have completed the product development stage, but may not yet be generating
profits.

• Expansion
Provision of equity capital to grow and expand an established company. For example, to
finance increased production capacity, product development, marketing and to provide
additional working capital. Also known as "development" or "growth" capital.
Terms of private equity
Carried interest or carry
Equivalent to a performance fee, this represents the share of a private equity fund's profit that will
accrue to the general partners (also see "Hurdle rate").
Committed funds or raised funds
Capital committed by investors. Cash to the maximum of these commitments may be requested or
drawndown by the private equity managers usually on a deal-by-deal basis. This amount is different
from invested funds for three reasons. Firstly, most partnerships will initially invest only between
80% and 95% of committed funds. Second, it may be necessary in early years to deduct the annual
management fee which is used to cover the cost of operation of a fund. Third, payback to investors
usually begins before the final draw down of commitments has taken place.
Distributions
These are payments to investors after the realisations of investments made by partnership.
Exits, divestments or realisations
Private equity investors generally receive their principal returns via a capital gain on the sale or
flotation of investments. Exit methods include a trade sale (most common), flotation on a stock
exchange (common), a share repurchase by the company or its management or a refinancing of the
business (least common). Secondary purchases of the company by another private equity firm are
becoming an increasingly common phenomenon.
Draw downs
These are payments to the partnership by investors in order to finance investments. Funds are
usually drawn down from investors on a deal-by-deal basis.
Funds of funds
These are funds whose principal activity consists of investing in private equity funds. Investors in
funds of funds can thereby increase their levels of diversification.
Gatekeepers
These are specialist advisers who assist institutional investors in their allocation decisions to private
equity.
General partners
These are the private equity firms, who select investments, structure deals, monitor investments
and design the appropriate exit strategies on behalf of the limited partners.
Hurdle rate
This is the minimum return to investors to be achieved before a carry is permitted. A hurdle rate of
10% means that the private equity fund needs to achieve a return of at least 10% per annum before
the profits are shared according to the carried interest arrangement.
Interim return
The final rate of return of a private equity investment can, by definition, only be calculated when
all investments are sold and the fund is wound up. Most return calculations therefore produce
interim IRRs which are close to the final rate of return after approximately three to six years. This
convergence period is usually shorter for buy-out funds than for early stage and development funds.
Internal rate of return (IRR)
The IRR method is the most appropriate method for calculating the returns of a private equity fund.
In essence, the IRR represents the rate at which positive and negative cash flows are discounted so
that the net present value of the fund amounts to zero. It is not consistent with the time weighted

eturn (TWR) used for other components of a scheme's investment portfolio and care should be
taken in making comparisons.
Investment stage
In this publication, the term investment stage refers to the fund's investment preferences. In
accordance with the cut-offs used for the BVCA's annual Performance Measurement Survey, funds
were divided into:
• Early stage funds - investing in companies in the seed (concept), start-up (within three years
of a company's establishment) and early stage of development;
• Development funds - investing in expansion stage companies, for example, established
companies which raise private equity to make acquisitions, fund working capital, buy new
plant, etc. Also small management buy-outs (MBOs) and buy-ins (MBIs) with less than £10m of
equity invested;
• Mid MBO funds - investing in MBOs and MBIs with £10m-£100m of equity invested;
• Large MBO funds - investment in MBOs and MBIs with more than £100m of equity invested;
• Generalist funds - investing in companies at a variety of stages of development.
Limited partnerships
In limited partnerships, institutional investors generally constitute the limited partners and private
equity firms act as general partners.
The minimum investment considered by many private equity firms usually amounts to 1% of the
total funds being raised. The maximum investment usually accepted from a single investor
corresponds to about 10% of the total fund size. The majority of private equity funds include
between 10 and 30 limited partners.
A limited partnership usually has a life fixed initially at 10 years during which the general partners
select investments, structure deals, monitor investments and design the appropriate exit strategies
on behalf of the limited partners. The partnership's funds will usually be invested by the general
partners within three to five years. Despite being set up with an initial life of 10 years, many funds
continue to exist beyond that period because some investments will not be fully realised within the
intended life of the fund. When all investments are fully divested, a limited partnership can be
terminated or "wound up".
Private equity funds
Managed by private equity firms who raise funds from external sources, such as pension funds,
insurance companies and others. There are over 200 such funds managed by BVCA members. For
the pros and cons of investment - see the section on "Methods of investing in private equity".
Secondary market
The secondary market enables investors to buy and sell stakes in private equity funds whilst it is
ongoing.
Trade sale
This is the sale of the equity share of an investee company to another company.
Venture and development capital investment trusts
Quoted private equity funds that invest "a significant portion of [their] ...portfolio in the securities
of unquoted companies" (definition: Association of Investment Trusts). There are around 20
managed by BVCA members. For the pros and cons of investment - see the section on "Methods of
investing in private equity".

Appendix 2 - The economic role of the UK private equity industry
Funds invested by BVCA members
£ millions
Source: BVCA
The UK private equity industry is the largest and most developed in Europe - accounting for 47% of
total annual European private equity investment in 2003 - and is second only to the USA in world
importance. The industry's impact on Europe is shown through the investments undertaken by BVCA
members' UK offices into overseas companies. Not included, however, are those investments made
by BVCA members' offices based overseas. These are growing rapidly as local contacts and networks
are increasingly seen as important in developing an active international private equity business.
For companies in which private equity investments are made, it marks the beginning of a
relationship that generally will span three to seven years or more.
Private equity firms not only commit funds, but also contribute their extensive experience,
contacts and advice to companies in which they invest. This input was rated highly by private
equity backed companies in recent research.
The private equity industry has a crucial role to play in financing and helping create successful
enterprises in the UK. In a major independent survey of the economic impact of private equity in
the UK, it was demonstrated that over a four year period:
• Private equity backed companies create more jobs
Over the five years to 2003/4, private equity backed companies increased their staff levels
at a rate of just over five times that of FTSE 100 companies and three times that of the
companies in the FTSE 250.
The number of people employed in private equity backed companies increased by 20% p.a.,
against a national growth rate of 0.6% p.a. It is estimated that companies that have received
private equity account for the employment of around 2.7 million people, equivalent to 18%
of the current private sector workforce.
• Private equity backed companies boost the UK economy
On average, over the five years to 2003/4, private equity backed companies increased their:
- sales by 23% p.a., or twice as fast as FTSE 100 companies;
- exports by 20% p.a., compared with a national growth rate of 3.3%;
- investment by 5% p.a. compared with a national increase of 1.9%.
• 81% of the companies could not have existed or would have grown less rapidly without
private equity
• Over three-quarters of the companies felt that the private equity firms had made a major
contribution in addition to the provision of money.
Other major contributions cited by private equity backed companies included private equity
firms being used as a sounding board for ideas, challenging the status quo, for their financial
advice, guidance on strategic matters and their contacts and market information.

The UK private equity industry is continuing to prove its resilience by anticipating and shaping
economic developments. Whatever the industry's achievements, we are not complacent. The
industry continues to evolve with new areas and methods of investment to ensure that returns to
investors and management teams continue to be maximised. There is much evidence that the
industry is continuing to expand its influence.