What Is PE & VC

THE FUNDAMENTALS OF
PRIVATE EQUITY AND

VENTURE CAPITAL
Author and lead edited by Garry Sharp with
Kelly DePonte and David Huckfield
A PRIVATE EQUITY INTERNATIONAL PUBLICATION
Module 1.Fundamentals
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Module 1:
What is private equity

and venture capital?
COPYING WITHOUT PERMISSION IS UNLAWFUL
THE
FUNDAMENTALS
OF
PRIVATE
EQUITY
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Contents
About the author
iv
Getting the most out of this module
The evolution of venture capital and private equity
5
5
5
6
7
8
8
8
Introduction
Evolution of the US market
Europe
Asia
The 1990s
The dot com bubble
Private equity today
Types of private equity
The private equity cycle connecting institutional

investors and entrepreneurs
The limited partnership
Fund manager remuneration
Alternatives to pooled funds and limited partnerships
Single investor funds
Fund of funds
Gatekeepers
Secondary funds
10
11
12
12
12
13
13
13
Why invest in private equity?
13
The modern private equity firm the shape of a GP
13
13
14
14
Type
Investment focus
Investment style
Case study 1: Get big or die; two very different venture capital tales
15
Case Study 2: The management buyout
17
Case study 3: Investor forces an exit
18
Summary
19
THE FUNDAMENTALS OF PRIVATE EQUITY
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About the author

Garry Sharp independent practitioner, consultant, writer and trainer
Garry Sharp has 22 years experience as a practitioner, consultant, writer and trainer in the private
equity and venture capital markets. He joined independent venture capital company Baronsmead in
1985, becoming a director and shareholder following Baronsmeads own management buyout in
1989. During the early 1990s the company grew to become one of the UKs largest independent private equity firms and was acquired by fund manager Ivory & Sime in 1996. Shortly thereafter Garry
left to co-found Independent Direction, a specialist consultancy to the private equity industry. He sold
Independent Direction in 2005 to concentrate on training and writing, and continues to work in an
advisory capacity in private equity.
Garry has trained newcomers to private equity since 1990, and delivers courses in Western and
Eastern Europe, the Middle East and a wide range of African countries. His first book, The Insiders
Guide to Venture Capital, was published in 1990, followed by five more on private equity, M&A and
corporate finance.
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GETTING THE MOST OUT OF THIS MODULE

Welcome to Module 1 in the Fundamentals of private equity series. This module
introduces the core principles of private equity and venture capital, examines
how they evolved and provides a broad introduction to todays markets. It is
designed to work both as a stand alone section and as part of the whole series.
For the benefit of the stand alone reader, a comprehensive glossary has been
incorporated, which explains the background and use of private equity terminology. All terms which may require explanation or expansion are printed in bold,
to indicate that there is a glossary entry for them.
Private equity the provision of risk and reward sharing (equity) capital to a company whose shares are not freely traded on a recognised stock exchange (private).
The evolution of venture capital

and private equity
Introduction
In 1957, American Research and Development (ARD) the worlds first ever investment
fund to specialise in backing start-up companies
invested $70,000 for a 77 percent equity stake in a
new company created by four students with no
business experience. The company was called
Digital Equipment Corporation, and 14 years later
the investments value had grown to $355 million.
Spectacular successes like this similar stories
include Apple, Intel, Sun Microsystems, Federal
Express and even (in a smaller way) Trivial Pursuit
brought attention to the returns available from a
new way of investing. This, for obvious reasons,
acquired the tag venture capital.
The concept of providing financial backing to
entrepreneurs, sharing risks and rewards in a
privately negotiated transaction, has been
around since time immemorial (Queen Isobels
backing of Christopher Columbus in the late
15th Century is regularly cited as one of the first
examples). More recently, the 1920s and 1930s
saw companies such as Xerox and Eastern
Airlines founded with private backing from
wealthy family trusts. But it was the pioneer
investors in the US during the 1950s, 1960s and
1970s who gave birth to todays private equity
industry, albeit an industry that after three
decades of accelerated evolution bears little
resemblance to its forebears.
However the spectacular growth of private equity, from obscure specialism to economic prominence, has been far from smooth or painless. On
the basis that those who fail to learn from history

are condemned to repeat it and there are parts
of this story it would be better not to repeat a
brief summary of the high and low lights will
bring perspective to all that follows.
Evolution of the US market

The early US venture capitalists were not investment managers in the conventional sense; rather
they were for the most part successful entrepreneurs and corporate managers with extensive
experience in building businesses. The funds
they invested were to a large extent their own
money. (ARD for example had, with great difficulty, raised only $1.8 million, out of a total of $5
million in its first fund, from institutional
investors in 1946; the balance came from the
funds managers, individual investors and family
trusts.) Their approach to investing was very
proactive, becoming closely involved in the day
to day running of the companies they backed, so
that their expertise added at least as much value
as their money.
During the 1970s this began, slowly at first, to
change as pension fund and insurance company
fund managers noted the returns some of the
venture capitalists were achieving. These institutional investors experimented cautiously with
the new asset class; typically only $50 million or
less was raised from these sources each year during the decade (less than 30 percent of the total,
most of which came from individuals and family
trusts). But suddenly and dramatically a tipping
point was reached in 1980, when commitments
to venture capital, during that year alone, shot up
to around $1 billion, reaching nearly $2 billion in
1982 and over $4 billion in 1983.1
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after deciding to become part of a start-up, and was introduced through mutual friends. But it
soon became apparent that the company would need a heavyweight, experienced CEO with credibility on Wall Street.
The first attempts to recruit a CEO highlighted a serious issue eBay had no VC backing. The fact
that with monthly profits of some $200,000 by early 1997 it did not need external funds was irrelevant; in Silicon Valley (eBay was based in San Jose, California) it was regarded as an essential
seal of approval for a company to have raised venture capital, to have been vetted and appraised
and to have passed the test. Without this, eBay couldnt even get an executive search firm to work
for them.
The rule of thumb for a venture capital firm appraising an early stage investment was that there
had to be a clear route to making 10 times the original investment within three years. Benchmark
Partners, a venture capital manager itself only two years old, saw this potential in eBay and in July
1997 invested $6.7 million for a 25 percent equity stake on terms which valued the company at
$20 million before its investment (the pre-money valuation see Module 4). eBay never spent
these funds the money was left untouched in the bank but capitalised on the contacts, credibility and experience of Benchmarks partners. It was Benchmark who recommended a search
firm to find a CEO, who instructed that firm to pursue a candidate who had declined their first
approach, and ultimately played a key role in persuading that candidate Meg Whitman that
she should leave her high profile, secure role at a major corporation, move her family to California
and join a tiny internet start-up.
In September 1998 eBay went public, achieving a listing at a market valuation of $2 billion; this
had grown to $21 billion by the spring of 1999, producing a return for Benchmark on its $6.7 million investment of 100,000 percent in less than two years (albeit based on highly distorted valuations, but nevertheless a spectacular return).
Whilst eBay was preparing for its stock market float in 1998, the boo.com team was trying, with
increasing desperation, to find some backers amongst the US venture capital community. A frustrating round of visits to Wall Street, Boston and California produced a series of rejections and a
decision to increase their first round fundraising target from $2 million to $15 million, and to
appoint an investment bank. Here was a crucial difference with eBay, who had quickly built a close
relationship with Benchmark, their single investor; from the beginning boo.com was going to raise
funds from a syndicate of investors, and an investment bank would play a large role both in the
fundraising and the subsequent investor relations. This was to have enormous consequences.
The boo.com teams approach to JP Morgan coincided with a decision by the London office of that
venerable, old money institution to explore the internet world, and after furious internal debate
they agreed to lead the fundraising. A strength of JP Morgan was the ability to introduce, in addition to mainstream venture capital firms, corporate investors who may be able to add strategic
value. The first round, which closed at $8.8 million in January 1999, included an investment from
Bernard Arnault, the chairman of Louis Vuitton Moet Hennessy (LVMH), who assumed the role of
lead investor.
1999 was characterised by an endless series of fundraising a total of $135 million was ultimately invested and equally endless delays and slippages in the launch date for boo.coms websites.
The team had, in addition to setting itself the phenomenally ambitious task of a simultaneous,
multi-country launch, made serious errors in the design and development of its technology. An
effective single, dominant venture capital investor would have insisted on a simpler strategy,
imposed discipline on the high spending management team (whose excesses in salaries, expenses and over elaborate infrastructure quickly became notorious in London, where they were based)
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Module 2:
Private equity as an
asset class
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Contents
About the author
iv
5
5
5
Introduction
Terminology
Returns and risk
Analysing risk in quoted markets
Risk in private equity
7
7
Assymetric risk and return
Using statistics in measuring private equity performance

Managing risk
Private equity performance
7
8
10
10
11
14
Measuring returns
Comparing private and quoted equity returns
Reasons for allocating funds to private equity
Issues with private equity
16
16
16
16
16
16
Resource requirements
Illiquidity and timescale
Unpredictability
Lack of control
Difficulty of access
Routes to private equity
17
17
17
17
17
17
17
Direct/co-investment
Private equity funds
Fund of funds
Secondaries
Securitised/collateralised products
Publicly-traded private equity
Private equity market drivers
18
18
18
19
19
Availability of investment opportunities

Demand for private equity
Economic infrastructure for private equity
Exit opportunities
Summary
19
Appendix 1: Enter the Pantheon
20
Appendix 2: PEI 50 Private Equity Internationals ranking of the

worlds largest private equity firms
29
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About the author

corporate finance.
iv
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focuses on private equity as an asset class. It is designed to work both as a stand
alone section and as part of the whole series. It necessarily draws upon topics
reviewed in Module 1, and seeks to avoid repetition of their content. However, for
the benefit of the stand alone reader, a comprehensive glossary has been incorporated, which explains the background and use of private equity terminology.
All terms which may require explanation or expansion are printed in bold, to
indicate that there is a glossary entry for them.
Introduction
This module focuses on the private equity industry from the viewpoint of the
institutional investors pension funds, endowment funds, insurance companies
and banks who provide its raw material capital.
The emphasis here, unlike other modules in this series, is on performance issues
not at the individual investment level but across funds, portfolios of funds and
the private equity industry as a whole. We are concerned with:
How does private equity behave as an asset class what are its characteristics
and how do they differ from quoted equities?
Why do institutional investors allocate capital to private equity?
What are the factors that drive the development of private equity markets?
Terminology
It is difficult to avoid confusion in the use of generic terms such as management,
investor and investment when discussing private equity at the fund level. The private equity fund is the core part of the process. It raises money from investors
(who in turn are themselves managers of investment funds), and is managed by
a private equity firm, often referred to as a general partner, but also as a manager or a management team. It then makes investments (hence becoming an
investor) in private companies which in turn have their own management teams.
We therefore need to be careful in our choice of terms for the various participants. By institutional investors, investors or limited partners, we mean the
pension funds, insurance companies and the like who allocate capital to private
equity funds. By private equity firm, fund manager or general partner, we
mean the specialist teams who raise private equity funds and are responsible for
making and managing investments in individual companies.
Returns and risk

The private equity industry consistently claims to
produce returns to its investors which exceed
those available from investing in conventional,
quoted equities. Before examining these (much
debated) claims in some detail, however, we
must appreciate that simply comparing annual
rates of return from the two different asset classes is of limited value. This is because institutional fund managers do not primarily focus on
absolute levels of return; they take into account
the risks associated with making a particular
investment. Risk, in this context, means the probability of failing to achieve a targeted or desired
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Exhibit 3: Distribution when one fund is chosen at random 100,000 times

30
Probability (%)
25
20
15
10
5
0
0
0.5
1.0
1.5
2.0
2.5
3.0
Fund of funds multiple
3.5
4.0
4.5
5.0
Source: Capital Dynamics simulation of 1,755 US funds as at 31 December 2004.
Exhibit 4: Distribution when one, three, 10 and 30 funds are chosen at random 100,000 times
70
30 funds
10 funds
3 funds
One fund
Probability (%)
60
50
40
30
20
10
0
0
0.5
1.0
1.5
2.0
2.5
3.0
Fund of funds multiple
3.5
4.0
4.5
5.0
Source: Capital Dynamics simulation of 1,755 US funds as at 31 December 2004.
revert to the classic definition of risk as the probability of achieving a less than targeted return.
Stochastic techniques, of which the Monte Carlo
simulation is the best known, use repeated, random selection of variables to produce probability
distributions. Exhibit 3 shows the distribution
when one fund is chosen at random 100,000
times, and as you would expect this is very close to
the distribution in Exhibit 2, with an unacceptable
probability of selecting a fund that loses money.
Exhibit 4 demonstrates what happens when three
funds, 10 funds and finally 30 funds are selected
at random. Not only do the mean, median and
average multiple returns increase, but the probability of losing money across the portfolio decreases markedly. This may seem counter-intuitive
the more funds you choose at random, the greater
the possibility of choosing losers. However it

works because of the asymmetric risk we identified earlier successful funds earn multiples
many times higher than the single multiple which
is the maximum a fund can lose. A larger portfolio
will capture more of these successes, which more
than compensate for the losers and help bring the
median return closer to the average.
Hence diversification not only reduces risk, it
enhances overall returns.
Avoiding the worst
Returns can be further enhanced, not by the
daunting task of selecting the very best fund
managers, but by meeting the far simpler challenge of avoiding the worst. Exhibit 5 shows the
effects of removing increasing percentages of
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mean that they are highly restricted in terms of the

information they can share with their investors.
The problem with governance in this environment is that it is required to protect a huge array
of interests from shareholders, through
employees to much more broadly defined interests such as the environment and the broader
community and to do so with a universally
applied set of rules and procedures.
By contrast a private equity backed management
team has a tightly defined shareholder group and
a governance structure tailored to a specific and
explicitly agreed set of objectives (explored further in Module 8). The team can share detailed
information with its investors, discuss and obtain
specific consent for its strategies and plans, and
essentially operates in an unregulated environment where shareholders are assumed to be
sophisticated, able to look after their own interests and in need of no further protection than that
afforded by the tenets of corporate law.
Beyond the regulatory and governance issues,
there are broader commercial attractions to the
private equity environment. Foremost among
these is that the pressure to post earnings growth
every quarter is alleviated replaced, of course
by performance pressures of a different kind (see
Modules 4 and 5) Beyond this, the intense, often
misinformed public scrutiny which often follows
every action, announcement and report from a
major quoted company is removed (although as
private equity backed companies become ever
larger and more economically and politically significant, the press and public are showing much
greater interest in their activities). The freedom
to make decisions in private, in direct consultation with shareholders and lenders, with a focus
on medium- to long-term value creation without
worrying about day to day share price performance has many attractions.
The lure of private equity for corporate managers
is further accentuated by the status issue, which
although a very personal and human driver is
highly relevant. Growing public cynicism about
corporate behaviour which comes not just from
a series of accounting scandals but from increased
questioning about ethics and social responsibility
means that being a director of a major quoted
company no longer has the cachet, the status, that
it awarded in earlier decades.
Finally, of course, private equity not only offers

managers the prospect of significant financial
gain, but actively incorporates the generation of
wealth in its fundamental principles. This
approach centres on shared motivation between
shareholder and manager and represents a clear
solution to the perennial corporate management
challenge the agency issue.
The agency issue
Managers act as agents for their shareholders,
and are required to make decisions in the best
interests of those shareholders. But in the quoted
company environment management may often
have vastly differing motivations from those
shareholders and, more importantly, different
means of achieving rewards.
Options to purchase shares, short-term performance related bonuses, golden parachutes, handcuffs and hellos, large salaries, plus access to
corporate jets, properties, entertainment and
various other perks are all designed to attract
and motivate the highest performers to run
major companies. However no matter how carefully these are designed and how extensively
they are debated, there is the constant risk of a
structural disconnect between these types of
remuneration and shareholders long-term interests, especially now that the tenures of CEOs are
becoming shorter and shorter.
A well structured private equity transaction, by
contrast, ensures that management will gain in
tandem with its investors. Furthermore, because
cash is ultimately the only measure used to gauge
success, it becomes the focus and short-term
methods to manage profit performance or to
influence a share price, so common in quoted
markets, become irrelevant.
Access to emerging markets
The development of stock exchanges, the evolution of governance and reporting standards, and
the ability to invest in quoted companies tends to
lag behind economic growth in developing
economies. This makes it difficult for investors to
gain exposure to these economies and private
equity, with the ability to bypass public
exchanges offers an alternative route.
Informed decision making and access to
insider information
By definition, investors in quoted stocks are
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Module 3:
Structuring and raising

a fund
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Published in September 2007 by:

PEI Media
Second Floor
Sycamore House
Sycamore Street
London EC1Y 0SG
United Kingdom
Telephone: +44 20 7566 5444
2007 PEI Media Ltd.
ISBN 1-904696-45-7 978-1-904696-45-2
This publication is not included in the CLA Licence so you must not copy any portion of it without the
permission of the publisher.
All rights reserved. No parts of this publication may be reproduced, stored in a retrieval system or
transmitted, in any form or by any means, electronic, mechanical, photocopy, recording or otherwise,
without the prior written permission of the publisher.
The views and opinions expressed in the book are solely those of the authors and need not reflect
those of their employing institutions.
Although every reasonable effort has been made to ensure the accuracy of this publication, the publisher accepts no responsibility for any errors or omissions within this publication or for any expense
or other loss alleged to have arisen in any way in connection with a reader's use of this publication.
This module is part of a series of 10 modules entitled The fundamentals of private equity.
The modules in this series are:
Module 1
Module 2
Module 3
Module 4
Module 5
Module 6
Module 7
Module 8
Module 9
Module 10
Glossary
What is private equity and venture capital?

Private equity as an asset class
Structuring and raising a fund
Venture and development capital
Management and leveraged buyouts
Private equity real estate and infrastructure
Due diligence
Aftercare and exits
Secondaries and their alternatives
Running a private equity firm
A comprehensive list of private equity terms
and definitions
To order any of the modules in this series, please contact Private Equity International on:
+44 20 7566 5444.
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Contents
About the author
iv
5
5
Terminology
Fundraising making the case
The GP
Investment strategy and fund categories
6
7
7
7
7
7
8
8
8
8
9
9
9
9
Refining the proposal

Size and type of investment
Geography
Sector focus
The management team
Investment track record
Dealflow generation strategy
Use of debt/financial structuring
Syndication
Due diligence processes
Added value/aftercare
Achieving exits
The perfect fund proposition
The fundraising process

Identifying potential investors
Pre-marketing
Consistency
The offering memorandum (or private placement memorandum)
Preparation of the investment pitch
Preparation of supporting information
Placement agents
Due diligence
9
9
10
10
10
11
11
11
12
12
13
Track record
The management team
Terms and conditions
14
14
Key commercial issues
Private equity fund structuring
17
by Nick Benson, Private Funds Group, Clifford Chance, February 2007

Introduction
Basic structuring considerations
Specific investor requirements
Multiple vehicle structures
Types of fund vehicle
Limited partnerships
Conclusion
17
17
18
19
19
20
21
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About the author

corporate finance.
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Page 5

focuses on structuring and raising a fund. It is designed to work both as a stand
alone section and as part of the whole series. It necessarily draws upon topics
reviewed in earlier modules, and seeks to avoid repetition of their content.
However, for the benefit of the stand alone reader, a comprehensive glossary has
been incorporated, which explains the background and use of private equity terminology. All terms which may require explanation or expansion are printed in
bold, to indicate that there is a glossary entry for them.
Terminology
It is difficult to avoid confusion in the use of generic terms such as management,
investor and investment when discussing private equity at the fundraising level.
The private equity fund is the core part of the process. It raises money from
investors (who in turn are themselves managers of investment funds), and is managed by a private equity firm, often referred to as a general partner, but also as a
manager or a management team. It then makes investments (hence becoming an
investor) in private companies which in turn have their own management teams.
We therefore need to be careful in our choice of terms for the various participants. By institutional investors, investors or limited partners, we mean the
pension funds, insurance companies and the like who allocate capital to private
equity funds. By private equity firm, fund manager or general partner, we
mean the specialist teams who raise private equity funds and are responsible for
making and managing investments in individual companies.
Raising a new fund is an event of singular strategic importance for a private equity firm. The
firms future is, in effect, placed into the hands of
the institutional investors; the pension funds,
insurance companies and endowment trusts
whose capital allocation decisions, as we saw in
Module 2, are a key influence in shaping the private equity industry. These investors will, by
choosing whether or not to participate in the
fund, either provide a mandate for continued
growth or cast a collective vote of no confidence
from which very few managers will recover.
The complexity of the fundraising process matches its strategic significance, as every aspect of the
firms investment focus, track record, competence, people and processes is laid open to
intense scrutiny and questioning. In many
respects this represents a mirror image of the
approach the private equity firm will itself use in
appraising investment opportunities, although
they differ considerably in detail.
The combination of these two factors the strategic importance and the extensive demands of the
process requires that the fundraising exercise is
planned, launched and executed on the basis of
extensive research, a compelling business case
and close attention to detail. This module
reviews the process by starting with the strategic,
commercial and marketing aspects before moving on to consider the various ways in which
funds are structured and the terms under which
they are managed.
Fundraising making the case

Every year, more than 400 new funds are
launched,1 of which typically less than half reach
a first close (i.e. raise the minimum amount
required). Superficially this would indicate that
the sheer volume of funds seeking capital will
make it difficult for any single one to draw attention, and that there is a medium risk of failure.
However, all funds and geographies are far
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not facilitate a tranched drawdown of committed capital. The Luxembourg SICAF is a similar vehicle to the SICAV but with fixed rather
than variable capital; SICAFs may issue partly
paid-in shares (provided a minimum of 25
percent of their par value is paid-up at the
date of issue) but a capital increase or
decrease requires a change of the articles of
incorporation by decision of an extraordinary
general meeting of shareholders.
The limited partnership is commonly viewed as
the vehicle of choice for private equity fund managers and is the vehicle most often used for private equity funds with an international investor
base. The other vehicles described above tend to
be used where a more limited range of investors
is targeted and/or where the manager's activity is
concentrated in particular jurisdictions, where a
non-partnership vehicle may be more appropriate. The features of limited partnerships are considered in more detail below.
Limited partnerships
A limited partnership comprises a general partner,
who is responsible for the operation and management of the partnership and has unlimited liability for the partnership's liabilities that cannot be
satisfied out of its assets, and one or more limited
partners, who cannot be involved in operation or
management and whose liability is limited to the
amount of capital contributed by them to the partnership. In the private equity fund context, the
fund manager acts as general partner (though
often the general partner is a subsidiary of the
manager rather than the manager itself) and the
investors are the limited partners. The general
partner and/or manager of a limited partnership
will usually need to be regulated in the place
where it is based, which may be different from the
jurisdiction of the fund. For example, the UK manager of an English limited partnership will need to
be regulated by the UK Financial Services
Authority (FSA), whereas an off-shore manager
operating an English limited partnership fully outside the UK would not need to be regulated by the
FSA in relation to that activity but would need to
be regulated in the relevant off-shore jurisdiction.
The main advantages of a limited partnership
structure include:
limited liability for investors (assuming they
do not participate in management);
20
tax transparency;
contractual flexibility;
manager's autonomy (the limited liability of
each limited partner generally depends on it
not becoming involved in management);
no/minimal regulatory requirements in
respect of the vehicle itself;
potential for tax efficient management and
performance fee structuring; and
no requirement for public disclosure of the
partnership agreement or the partnership's
accounts.
Meanwhile, the potential drawbacks of limited
partnerships may include the following:
certain countries do not regard limited partnership vehicles as tax transparent, which
may necessitate establishing a separate parallel vehicle for investors in such jurisdictions;
it will not be possible for a limited partnership
to take advantage of the EU Parent/Subsidiary
directive (exempting dividends paid by subsidiaries to their parents from tax), although
subsidiary companies owned by the limited
partnership and individual investors in the
limited partnership may be able to do so; and
it will only be possible to rely on double tax
treaty protection to the extent that the underlying investor is able to do so (although subfund structuring using, for example, Dutch or
Luxembourg corporate holding entities is usually employed to minimise withholding and
achieve other tax objectives).
Although it is possible to generalise about the
features of limited partnerships as a type of fund
vehicle, there are significant differences
between the different types of partnership established in different jurisdictions, and it is important to understand these differences when
designing a structure. The most common jurisdictions for private equity limited partnerships
are Cayman, Delaware, England, Jersey and
Scotland. Most of the core characteristics are
common to all of these jurisdictions; however
one important distinction is whether the partnership is deemed to have separate legal personality (Scottish LP) or is a body corporate
(Delaware LP; Jersey LP by election). Partnerships with the latter characteristics may not be
recognised as tax transparent by the local tax
authorities in certain jurisdictions where they
invest, which would remove one of the key rea-
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Module 4:
Venture and
development capital
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PEI Media
Second Floor
Sycamore House
Sycamore Street
London EC1Y 0SG
United Kingdom
Telephone: +44 20 7566 5444
2007 PEI Media Ltd.
ISBN 1-904696-46-5 978-1-904696-46-9
Module 1
Module 2
Module 3
Module 4
Module 5
Module 6
Module 7
Module 8
Module 9
Module 10
Glossary

Due diligence
Aftercare and exits
and definitions
+44 20 7566 5444.
ii
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Contents
About the author
iv
Introduction
Identifying the opportunities venture fund strategy
7
9
A dose of reality
Making investments
Generating dealflow
Early appraisal
Structuring investments
The principles of investment structuring
Assumptions and targets
Preference
Preferred shares in practice
Xytrak proposed terms
The term sheet

Preconditions to investment
Representations and warranties
Board structure and membership
Provision of information
Consent matters
Share rights
Service agreements
Confidentiality
Payment of costs
Exclusivity agreement
Summary
9
9
9
11
12
12
13
13
15
15
16
16
16
16
17
17
17
17
18
18
18
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About the author

corporate finance.
iv
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Page 5

focuses on venture and early stage investing. It is designed to work both as a
stand alone section and as part of the whole series. It necessarily draws upon topics reviewed in earlier modules, and seeks to avoid repetition of their content.
Introduction
We define early stage investing as the provision
of equity capital to companies that have not
yet achieved stable, profitable trading. Exhibit 1
quickly recaps (from Module 1) the definitions of
specific types of investment within this
broad category.
The factor which unites all investments of this

type is the significantly higher level of risk
attached to unproven companies, markets, products, technologies and management teams.
Uncertainty about future outcomes is endemic in
all forms of investment, but applies to nascent or
very young companies not only in every possible
Exhibit 1: Classifications of investment types

Investment
type
Purpose of
funding
Investee company
Characteristics
Key
objectives
Typical exit
horizon
Seed corn
To develop, refine and

market test intellectual
property, prototypes
or concepts
Non trading, usually no firm

business plan or commitment
to a specific route to
commercial exploitation at
this stage
To test and verify the

practical and commercial
viability of the product
or concept
To establish routes to
market and a viable
business model
To build a commercial
management team
5 years
or more
Spin-out
To establish a business
based on the transfer of
intellectual property
from a corporate or
academic research
environment
Similar to seed corn,

although conceptual or
intellectual property
development may be
more advanced
As with seed corn.

Replacing academic or
scientific priorities with
commercially driven
management objectives is
often the major objective
with spin-outs
5 years
or more
start-up
To establish a viable
trading concern with
customers, revenues
and a clear route
to profit
A commercially focused,
backable and (mostly)
complete management team
will be in place
To establish a sustainable
market presence
To make clear progress
towards profitability
To prove the
management team
Up to
5 years
Early stage
To accelerate the
progress of a
young company
Typically will not yet be

profitable, but will be able
to demonstrate the viability
of its product or service
and markets
Management team will
have, to some extent,
demonstrated their
competence and
effectiveness
To achieve profitable
trading and a solid
platform for growth
35 years
24/8/07
6:12 pm
Page 16
exercise, without the danger of the company

agreeing a deal with a different investor.
In addition to the financial aspects we have
already discussed, the major commercial points
addressed in a term sheet are:
preconditions to investment;
representations and warranties;
board structure and membership;
provision of information;
consent matters;
share rights;
service agreements;
confidentiality;
payment of costs;
arrangement and monitoring fees; and
exclusivity.
Preconditions to investment
Completion of the investment will always be
subject to the satisfactory completion of due
diligence, agreement of legal documents and
final approval from the investors investment
committee. In addition to these generic conditions, the term sheet will also spell out specific
conditions, including:
a detailed outline of the due diligence requirements (see Module 8);
where appropriate, contemporaneous completion of investments from co-investors;
restructuring, or creation, of a share option
pool for employees;
regulatory and tax clearances; and
key man insurance on senior members of the
management team.
There may also be specific milestones to be
achieved; for example the securing of a patent,
the appointment of a new member of the management team or signing of a commercially significant contract.
The use of milestones can be refined by breaking an agreed investment amount into tranches, individual slices which can only be drawn
when the company achieves specific pre-agreed
objectives.
Representations and warranties

The simple objective of warranties provided by the
company and its management is to ensure that the
information they have provided to investors is
16
accurate, complete and not misleading. The principal areas covered by warranties are:
historic accounts;
current trading and management accounts;
financial projections and forecasts;
the business plan;
due diligence reports;
ownership of assets including IP; and
no litigation or contractual breaches
outstanding.
Board structure and membership

One of the major changes that accompanies raising venture capital for the first time is the introduction of a formalised reporting and decision
making process, which will be centred around
the board of directors. The board acts as both the
primary decision making body and the main
interface between management and investor. It is
essential that board meetings are a forum for
open debate and discussion, and that the management team does not attempt this to circumvent this by making decisions in private and
presenting the board with fait accompli.
The investor will invariably require, at the very
minimum, the right to appoint an investor director. An important consideration here is that company law requires directors to act in the best
interest of all shareholders, and not a particular
group. To avoid conflicts of interest, the investor
may appoint an observer to the board, or use a
different executive from the investor director
when decisions are needed.
Appointment of a chairman or additional nonexecutive directors will be made in agreement
with the management team, although the
investor may reserve the ultimate right to decide
should agreement not be reached.
Other areas relating to the board are:
frequency and timing of board meetings; and
the composition of audit and remuneration
committees or their equivalent.
Module 8 looks at the composition and management of boards, as part of the aftercare process,
in greater detail.
Provision of information
The reporting cycle will be closely linked to the
24/8/07
6:31 pm
Page i
Module 5:
Management and
leveraged buyouts
24/8/07
6:31 pm
Page ii

PEI Media
Second Floor
Sycamore House
Sycamore Street
London EC1Y 0SG
United Kingdom
Telephone: +44 20 7566 5444
2007 PEI Media Ltd.
ISBN 1-904696-47-3 978-1-904696-47-6
Module 1
Module 2
Module 3
Module 4
Module 5
Module 6
Module 7
Module 8
Module 9
Module 10
Glossary

Due diligence
Aftercare and exits
and definitions
+44 20 7566 5444.
ii
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6:31 pm
Page iii
Contents
About the author
iv
The buyout principle three different routes to value creation
5
5
7
7
8
9
9
Creating value in buyouts

The consequences of leverage
The future for value creation
Evolution of the buyout markets
Management buyouts
Failures
Investment criteria characteristics of a buyout company

Strategy and market positioning
The company
The management team
The buyout process

Auctions
The management role in a buyout and conflicts of interest
The application of leverage types of debt and their uses

Senior debt
Working capital facility
Subordinated or junior debt
Second lien debt
Mezzanine debt
High yield bonds
Securitisation
Institutional debt
11
11
11
11
12
12
12
14
14
14
14
14
14
15
15
15
Documentation
15
The MBO model
21
Summary
23
iii
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Page iv
About the author

corporate finance.
iv
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Page 5

focuses on management and leveraged buyouts. It is designed to work both as a
stand alone section and as part of the whole series. It necessarily draws upon topics reviewed in earlier modules, and seeks to avoid repetition of their content.
The explosive growth in buyouts over the last

three decades is a direct result of the natural,
inherent strengths of the buyout model. The
essential elements of this model are:
a close partnership between the management
team of a buyout company and the investors
and lenders who finance its acquisition;
precise and careful tailoring of the buyouts
financial structure to the cash and profit generation characteristics of the company;
clear objectives, shared between management
and investors, which enable a high degree of
focus in setting the companys strategic and
operational priorities; and
ownership structures which reinforce the
management teams motivation to achieve
these objectives by sharing the rewards.
The buyout principle three

different routes to value creation
The underlying principle behind a buyout is the
use of a target companys assets and more
importantly future cashflow as the basis on
which to fund its acquisition.
Creating value in buyouts

There are three routes to creating equity value in
a buyout company, and whilst most investments
demonstrate a blend of all three, modern market
conditions have profoundly altered the mix; we
shall return to this topic after reviewing the basic
principles.
These principles can be demonstrated through a
simple example. DemCo is the subject of a buyout
at a total cost (acquisition price plus professional
and arrangement fees) of 100 million, which is a
multiple of 10 on its annual earnings before inter-
est and tax (EBIT) of 10 million. Adding back non

cash expenses depreciation and amortisation of
4 million per year gives us an EBITDA, which is a
rough proxy for the companys surplus operating
cashflow, of 14 million. This clearly provides the
capacity to service debt, and for this example we
assume that equity investors provide 30 million
of the acquisition cost, with the balance, 70 million, coming as a combination of loans with an
overall interest cost of seven percent.
By running the company with a tight focus on
cash generation, not only is the interest cost covered but debt principal repayments can be made
for this simple example we have assumed a 5
million repayment at the end of year 1, increasing by 1 million per year thereafter as the reducing interest burden helps free up more cash for
debt repayment.
As Exhibit 1 overleaf demonstrates, each debt
repayment enhances the equity value even if the
company itself does not grow in value. After four
years, if the company, still generating 10 million
EBIT a year is sold for the same 100 million
price at which it was bought, so that the EBIT
multiple is unchanged, equity investors have
nearly doubled the value of their investment,
which produces an internal rate of return (IRR)
of 22 percent per annum (before allowing for the
fact that some of this upside will have been
shared with the management team).
This approach to generating equity returns by
using the cash generation capacity to repay debt
is referred to as the financial engineering
approach to value creation.
However, any management team unable to produce some degree of profit growth is unlikely to
24/8/07
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Page 10
Exhibit 4: Trends of buyouts/buy-ins, 19812006

800
12,000
Number
Value
700
10,000
Number
8,000
500
400
6,000
300
4,000
200
2,000
100
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
Value ( millions)
600
Sources: CMBOR, Barclays Private Equity, Deloitte.
Exhibit 5: Growing sponsor involvement in global M&A volume, 19992006

25
Volume ($ billions)
% of global M&A
% of global volume
20
519
356
15
285
10
162
157
5
0
173
146
104
1999
2000
2001
2002
2003
2004
2005
Year
Q1Q2
2006
Sources: SDC Platinum and Citigroup.
Exhibit 6: Surging average deal size for private equity-related transactions, 19992006
Average deal size ($ millions)
800
US
Europe
600
400
200
1999
2000
2001
2002
2003
Year
2004
2005
Q1Q2
2006
Sources: SDC Platinum and Citigroup.
10
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6:39 pm
Page i
Module 6:
Private equity real estate

and infrastructure
24/8/07
6:39 pm
Page ii

PEI Media
Second Floor
Sycamore House
Sycamore Street
London EC1Y 0SG
United Kingdom
Telephone: +44 20 7566 5444
2007 PEI Media Ltd.
ISBN 1-904696-48-1 978-1-904696-48-3
Module 1
Module 2
Module 3
Module 4
Module 5
Module 6
Module 7
Module 8
Module 9
Module 10
Glossary

Due diligence
Aftercare and exits
and definitions
+44 20 7566 5444.
ii
24/8/07
6:39 pm
Page iii
Contents
About the author
iv
Growth of the private equity real estate market
Real estate investment categories
6
7
7
7
Value added activities

Opportunistic
Real estate asset types
Infrastructure investments
Privatisations and buyouts
Public private partnerships, concessions and new projects
Types of PPP
Private equity and infrastructure
8
9
10
11
14
Appendix 1: 20 landmark transactions in private equity real estate history
15
Appendix 2: The structure of things
27
iii
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Page iv
About the author

corporate finance.
iv
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6:39 pm
Page 22
preceded the private equity hotel craze by a

good seven years.
A gamble on Harveys
1999
In a transaction valued at more than $980 million, the private equity groups acquired the
hotel portfolio from a 100-year-old publicly
held company that was controlled by a family
trust. Once the dust settled, Blackstone and
Colony had a clutch of luxury UK lodging
assets: The Savoy, Claridges, The Berkeley and
The Connaught. In addition to owning four of
the seven superluxury hotels in London, the
investor group walked away with The Lygon
Arms, a country-house hotel in the Cotswolds
region, and the quintessentially English restaurant Simpsons-in-the-Strand.
In the buyers minds, the benefits of the transaction were threefold. The firms held a majority of Londons 1,250 luxury hotel rooms. In
addition, the hotels had recently seen a number of capital improvements that, according to
Blackstone, had affected annual numbers
without being seen in operating performance.
Finally, the investors saw a number of opportunities to create value in the assets: During
their ownership, Colony and Blackstone added
additional rooms, contemporary lounges and
high-class restaurants; divested themselves of
non-core assets like staff lodging and the
Savoy Group laundry business; and sold off
the Lygon Arms property in June 2003 to pay
down debt.
The investor group rode out the storm that hit
the hotel market at the beginning of the
decade: the foot-and-mouth crisis in the UK; a
business downturn in the US; the terrorist
attacks of September 11, 2001; SARS; and
armed conflict in the Middle East. While it no
doubt affected the bottom line, the investors
held onto the properties long enough to experience some upside from the revitalisation of the
market. In May 2004, the Savoy Group was
sold to an investor group led by Dublin-based
Quinlan Private for 750 million, approximately a 1.8x return on investment.
Colony and Blackstone have continued to make
hotels an important part of their investment
strategies and made European property takeprivates an important part of everyone elses.
22
Colonys first casino acquisition launches

an empire
When Colony Capital spent $1.2 billion to buy

an additional four gambling parlours from
Harrahs and Caesars last April, the firm
became the proud owner of the largest privately held casino company. Although those investments have had a shaky first year, there is no
denying Colonys strength in the gaming sector.
All of this was set in motion by one purchase:
the firms 1999 acquisition of Harveys Casino
Resorts in Lake Tahoe for $405 million. The
firm later sold the company, which also owns
hotels and casinos in Iowa, to Harrahs for $625
million two years later.
When Colony bought Harveys, we saw an
industry with only big, strategic players and no
one to sell to except each other, Colony chief
executive officer Tom Barrack told sister publication Private Equity International last year.
We thought we could act as a liaison to all
these larger companies. Now, the consolidation
in the industry has been great fuel for our
acquisition program.
Today Colony is one of the few private equity
firms licensed in US gaming Barrack has
referred to the licensing process as a Bataan
death march and its acquisitions have included
the Las Vegas Hilton and the Resorts company.
Earlier this year, the firm joined a consortium of
investors including Goldman Sachs and
Providence Equity Partners in acquiring Kerzner
International, the owner of the Mohegan Sun
Casino in Connecticut and the Atlantis Resort in
the Bahamas, for $3.6 billion. With deregulation
occurring across the country and more and
more US states legalizing some form of gambling, the gaming sector is big business these
days and Colony is one of its biggest players. The
firm is even looking overseas: In conjunction
with the Las Vegas Sands, Colony portfolio company Fairmont Hotels is planning to develop a
new resort in Far East gaming mecca Macau.
The monolithic Time Warner Center

2000
Apollo and The Related Companies fix up a

blighted Columbus Circle
When construction started on the Time Warner
24/8/07
6:39 pm
Page 29
Exhibit A2.3: Private equity restructures breakdown of global infrastructure deal volumes
by acquirer, 19982006 YTD
150
Private equity
Non-private equity
$ (billions)
125
100
75
50
25
0
1998
1999
2000
2001
2002
Year
2003
2004
2005
2006
YTD
Source: Thomson Financial.
Or, as Chuck Leitner, the global head of

RREEF, the real estate and infrastructure arm
of Deutsche Bank, puts it: Just about everybody that talks about infrastructure has
Australian accents.
Contrasted with the mature infrastructure
market in Australia, the developing countries
of Asia, particularly China and India, are also
witnessing a boom in infrastructure as their
surging economies necessitate vast new networks of roads, tunnels, ports et cetera.
According to a report last year in the Wall
Street Journal, China is planning to spend up to
$400 billion on infrastructure through 2010,
while consulting firm McKinsey has estimated
that India needs over $250 billion in infrastructure investment.
The single most important bottleneck is infrastructure, Aashish Kalra, managing director of
Trikona Capital, which is partnering with
IL&FS for a $100 million infrastructure joint
venture, told PEIs sister publication Private
Equity Real Estate in 2006.
US: A new market

Despite the size of the infrastructure market in
the US the Bureau of Economic Analysis has
estimated it at $5.6 trillion the sector is relatively immature in terms of private investment. This is primarily due to the municipal
bond markets, which have provided govern-
ments with robust financing for public infrastructure projects. In recent years, however, as
the countrys infrastructure has aged and the
ability to raise capital via taxes has diminished, more and more public entities are looking to the private sector.
Estimates suggest that the US needs
$1.6 trillion over the next five years just to
repair and build highways, bridges, dams, airports, railroads and other infrastructure,
Dale Anne Reiss, the head of Ernst & Youngs
global real estate practice, said in an
early 2007 statement. The annual tab to
maintain the nations 50-year old highway
system is $176 billion alone. With real estate
capital flows at their highest levels ever,
I would not be surprised to see more pension
funds and other long term investors move
into private funding of key infrastructure
developments.
In recent years, the most prominent examples
of US infrastructure investments have been
toll roads. From the greenfield development of
the San Joaquin Toll Road in California in the
1990s to the recent privatisation of the
Chicago Skyway, widely regarded as a landmark transaction in the sector, local governments across the country have followed suit.
And given the current state of the nations
infrastructure, as highlighted by Reiss, many
experts predict that privatisation of existing
toll roads will accelerate.
29
24/8/07
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Page i
Module 7:
Due diligence
24/8/07
6:42 pm
Page ii

PEI Media
Second Floor
Sycamore House
Sycamore Street
London EC1Y 0SG
United Kingdom
Telephone: +44 20 7566 5444
2007 PEI Media Ltd.
ISBN 1-904696-49-X 978-1-904696-49-0
Module 1
Module 2
Module 3
Module 4
Module 5
Module 6
Module 7
Module 8
Module 9
Module 10
Glossary

Due diligence
Aftercare and exits
and definitions
+44 20 7566 5444.
ii
24/8/07
6:42 pm
Page iii
Contents
About the author
iv
What is due diligence?
Types of due diligence
5
5
5
6
6
6
6
6
6
7
7
Commercial due diligence

Financial due diligence
Management due diligence
Legal and regulatory due diligence
IT due diligence
Technology or product due diligence
Environmental due diligence
Forensic due diligence
Other specialist due diligence
Vendor due diligence
The due diligence process

Professionalism
Clear focus
Careful planning
Allocation of resources
Transparent decision making
Careful selection of advisers
The sale process and early due diligence

The sales process
Detailed due diligence
The data room

The brief
Historic financial performance
Working capital movements and cashflows
Historic performance against budget
The financial projections
Financial reporting and control systems
The post-transaction funding structure

Objectives
Selection of advisers
The management viewpoint
Gathering information for CDD

Looking to the future
Methodology
Due diligence issues and problems

Obtaining information
Integration of disciplines
Presentation and correlation of results
Summary
7
7
7
7
8
8
8
8
8
8
8
10
10
10
10
11
11
11
12
12
13
13
14
14
17
17
18
18
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19
19
19
iii
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Page iv
About the author

corporate finance.
iv
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Page 5

focuses on the due diligence process. It is designed to work both as a stand alone
section and as part of the whole series. The module necessarily draws upon topics reviewed in earlier modules, and seeks to avoid repetition of their content.
What is due diligence?

In its simplest terms, we can define due diligence
as the process of assuring that all the assumptions
on which an investment or acquisition decision
are based do, in fact, hold true; an exercise in validation or verification. In modern practice, however, it goes further than this, as the results of a
thorough, detailed and focused series of reviews
into a companys markets, processes, finances,
management, technologies, assets, intellectual
property and customers will in many cases identify areas where improvements can be made, risks
reduced and additional gains realised.
The levels of competition in modern private equity markets demand that investors must consistently add value in order to outperform. As we saw in
Modules 4, 5 and 6 this added value is increasingly
generated by identifying, instigating and driving
performance enhancements, in tandem with the
investee companys management teams. To do this
requires ever deeper understanding of markets,
companies and strategic opportunities. The due
diligence exercise can contribute to this understanding by providing essential raw material to
inform the entire investment, growth and realisation process, rather than being seen as a tedious
and non-productive hurdle between commercial
decision making and completion.
As with every aspect of private equity, the most
valuable due diligence exercises are those where
investors, their advisers and the management
team are fully engaged, with shared objectives
and complete openness.
Types of due diligence

Due diligence has evolved in depth, complexity
and sophistication, and in modern practice is

broken down into a series of different disciplines.

Commercial due diligence (CDD), also referred to
as market, or strategic due diligence, is focused on:
establishing the credibility of the revenue projections in the investee companys business plan;
providing an objective, impartial assessment
of the companys markets and its position in
them; and
testing and evaluating the key strategic drivers in the companys business plan.
With the growing importance of earnings, or performance, enhancement as the route to value
creation in the buyout market, a subset of CDD
operational due diligence is becoming an
increasingly prominent part of the process.
As the Clinovia case study in Module 5 demonstrates, market due diligence need not be limited
to specific investment proposals but can also be
used as a tool for identifying attractive sectors or
investment opportunities.

Whilst the focus of CDD is primarily external,
financial due diligence (FDD) looks in detail at
the company itself, providing a review of:
the companys historic financial performance;
working capital movements and cashflows;
comparison of actual performance with forecasts and budgets;
the financial projections;
financial reporting and control systems;
tax compliance; and
24/8/07
6:42 pm
Page 17
Manufacturing due diligence expertise is supported by our dedicated manufacturing team whose
expertise has developed working on high profile strategy and operational engagements for major
international blue-chip manufacturers.
We also back our own market insights via the PA Ventures programme, as evidenced by the successful spin-off of Ubinetics, the innovative 3G equipment supplier.
Recent examples of where PA has applied this specialised knowledge in strategic due diligence
assignments include:
A major European private equity deal where PA Consulting Group worked with an equity sponsor
on the due diligence of a specialist manufacturer of chemicals. By mapping the underlying manufacturing technology to the changes in demands for various polymer and substitute products, PA
were able to greatly enhance the financial sponsors view of the key capital investment priorities.
For a 2006 deal, involving a major European PE house, PA Consulting Group were able to apply a
strategic due diligence team of manufacturing specialists to evaluate the real competitive advantage of the core technologies, identifying potential market applications, and uncovering specific
high risk areas such as product warranty, all issues that materially impacted on the deal value.
A best practice approach to strategic due diligence

These cases illustrate how strategic due diligence, based on an ability to add value well beyond a
cursory market examination, has yielded significant deal value to our clients.
As the private equity mid-market becomes more competitive expect to see more financial sponsors
investing in true strategic due diligence.
Looking to the future
Appraisal of the management team is a core

part of the private equity firms responsibilities
and, naturally, starts from the very first meeting. It also continues through the life of the
investment, as considered in Module 8, as the
investor constantly updates and refreshes her
view of the team.
Although there is, by necessity, a heavy degree of

reliance on past performance in appraising the
management team, it is also essential to project
this appraisal into an assessment of suitability for
the demands of running an independent, private
equity backed company. This requires a clear
understanding of roles, responsibilities and success criteria post-investment.
Despite this, management due diligence will also

be undertaken as a separate, formal exercise
designed to reinforce or question the
investors views. The process will examine three
principal areas:
the track record, performance, competence
and integrity of each senior executive on an
individual basis;
the structure, efficiency, compatibility and
effectiveness of the senior management team
as a unit; and
the extent to which each individuals motivation and personal objectives are aligned with
the focus on value growth and realisation
inherent in any private equity financing.
Two examples of failures in this area will help

reinforce the message. The first concerned the
buy-in/buyout of a company making injection
moulded plastic components for a highly specialist sub sector. The company was purchased from
its founder who had also been the CEO and
retired from business after the sale. A new incoming chief executive, who offered particularly
strong sales and marketing credentials, combined
with the incumbent production director to form
the nucleus of the new management team.
Unfortunately the due diligence process failed to
identify that the highly complex, custom developed application of injection moulding machinery, which gave the company its competitive edge,
17
24/8/07
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Module 8:
Aftercare and exits
24/8/07
6:46 pm
Page ii

PEI Media
Second Floor
Sycamore House
Sycamore Street
London EC1Y 0SG
United Kingdom
Telephone: +44 20 7566 5444
2007 PEI Media Ltd.
ISBN 1-904696-50-3 978-1-904696-50-6
Module 1
Module 2
Module 3
Module 4
Module 5
Module 6
Module 7
Module 8
Module 9
Module 10
Glossary

Due diligence
Aftercare and exits
and definitions
+44 20 7566 5444.
ii
24/8/07
6:46 pm
Page iii
Contents
About the author
iv
Introduction
Aftercare
5
5
6
6
6
7
7
7
7
7
8
8
8
8
9
9
Protecting value
Reporting structure
Modern trends in reporting
Informal reporting
Board structure and composition
Executive directors
Non-executive directors
Representing the investor
Monitoring progress and performance
Contributing to growth and development
Characteristics of the effective non-executive
Board committees
The chairman and board meetings
Operating partners
Aftercare who does it
Underperformance
10
10
10
10
10
11
11
Causes of underperformance
Addressing underperformance
Anticipation
Analysis
Action
Follow-on investments
Fund reporting
11
11
Annual report
Valuation
The valuation process
Calculating the enterprise value
The multiple
The earnings figure
EBITDA multiples
Early stage companies
Calculating the value of the funds investment
Structuring issues
12
12
12
13
13
13
13
13
14
Types of exit
Stock market flotation (IPO)
The secondary buyout
Re-leveraging
14
15
16
17
17
Exits
Summary
18
iii
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Page iv
About the author

corporate finance.
iv
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6:46 pm
Page 5

focuses on the aftercare and exit aspects of the private equity cycle. It is
designed to work both as a stand alone section and as part of the whole series.
The module necessarily draws upon topics reviewed in earlier modules, and
seeks to avoid repetition of their content. However, for the benefit of the stand
alone reader, a comprehensive glossary has been incorporated, which explains
the background and use of private equity terminology. All terms which may
require explanation or expansion are printed in bold, to indicate that there is a
glossary entry for them.
Introduction
Aftercare
The culmination of the investment process

dealflow generation, appraisal, negotiation, due
diligence, legal documentation and, finally,
completion of the investment marks the beginning, and not the end, of the investment cycle.
Whilst selection and structuring are critical to
private equity success, it is once the investment
has been made that the creation and realisation
of value begins. The investors contribution to
value creation lies in the approach to, and implementation of, aftercare, and he will play a key
role in the realisation of this value through driving the exit process.
The aftercare function is driven by two key

objectives:
protecting the value of the investment; and
adding and realising value.
Exhibit 1 summarises the key aspects of the
investors role during the life of the investment.
Protecting value
Validating
The period immediately following completion of
an investment can represent, for the investor, the
Exhibit 1: Aftercare priorities and the investors role

Reporting
regime
Board
structure
Protecting
Progress
reporting
Management
appraisal
Financial
reporting
Validating
Testing
Monitoring
EXIT
VALUE
Adding
Creating
Strategy
development
Operational
enhancements
Realising
Acquisitions
Management
development
Exit routes
Exit strategy
Financing
growth
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Page 9
Operating partners
Earlier modules Module 5 in particular identified the growing requirements for private
equity firms to add operational value to their
investee companies. This has led in many cases
to a significant change in the make up of many
firms executive teams, which have broadened
to include individuals with significant, senior
level operational experience and a deep understanding of a particular sector or market.
Although investors have always used external
consultants and expertise to help them appraise
and develop companies, the incorporation of
operating partners into the team brings this
expertise into the equity ownership and carried
interest return pool, making them an integral
part of the team with a reward structure better
aligned to the creation of value. Specific models of operating partner involvement vary
between firms.
At one extreme, major industry names are hired;
for example Louis Gerstner (former IBM chairman, currently chairman of Carlyle), Jack Welch
(former CEO of General Electric, at Clayton,
Dubilier and Rice) and Paul ONeill (former US
Treasury Secretary, special adviser to the
Blackstone Group).
Expertise is also, in many firms, tightly integrated into the process by building deal teams
around industry sectors, which helps not only in
sourcing and appraising investments but identifying opportunities to add value quickly post
investment. An alternative to sector specialisation is a focus on more generic business capabilities that can be applied across a range of
investee companies. This can incorporate areas
such as supply chain management, sales force
management, management development or
even highly specialist areas such as the provision of health and medical benefits (a significant and growing expense for many companies).
Related to this latter approach is the provision
by some private equity firms of shared purchasing of goods and services, designed both to
reduce cost and increase the efficiency of the
procurement process.
Whilst this greater involvement in operational
issues is becoming widespread across the private
equity industry, the approach is not universal.
Some firms identify fundamental difficulties
with its adoption, primarily centred on the
potential for disruption and discord it can bring.

The risks it can entail include:
friction caused by imposing a senior industry
figure on top of an existing management team;
a lack of understanding of the private equity
approach by operating partners who come
from a major corporate background; and
the added degree of risk entailed in backing a
company with an incomplete team, and relying on an operating partners input.
Aftercare who does it

The question of where, and to whom, a private
equity firm should allocate responsibility for
aftercare is a source of perennial debate within
the industry. Broadly speaking, there are three
approaches:
the original deal team retains responsibility
for the investment;
responsibility is immediately passed to a dedicated, specialist aftercare team; and
there is a phased transition, with the original
deal team retaining the relationship for a period of time one or two years before the
aftercare team takes over.
The arguments in favour of the deal team retaining responsibility are:
they will have the deepest understanding
of the company at the time the investment
completes;
they will have built a relationship with the
management team, and a first hand understanding of their strengths, personalities,
areas of potential weakness and development
requirements; and
they will have clear ownership of the value
creation and realisation strategy, having been
primarily responsible for developing it with
the companys management.
The potential drawbacks to this approach, however, and arguments for a dedicated team include:
the personalities required of investment executives, to find and drive investments through
to completion, do not always suit the different
demands associated with aftercare;
the investment team may not have the specialist sector or operational skills required to add
value; and
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Page i
Module 9:
Secondaries and
their alternatives
24/8/07
7:00 pm
Page ii

PEI Media
Second Floor
Sycamore House
Sycamore Street
London EC1Y 0SG
United Kingdom
Telephone: +44 20 7566 5444
2007 PEI Media Ltd.
ISBN 1-904696-51-1 978-1-904696-51-3
Module 1
Module 2
Module 3
Module 4
Module 5
Module 6
Module 7
Module 8
Module 9
Module 10
Glossary

Due diligence
Aftercare and exits
and definitions
+44 20 7566 5444.
ii
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Page iii
Contents
About the author
iv
What drives the need for liquidity?
History overview of the primary private equity market
The structural issue and transparency
The rise of specialised secondary funds
Secondary sales and purchases: practical issues

Difficulties in execution
Motivations of institutional investors: portfolio management
Recent variations: primary secondaries
More recent variations: direct secondaries
The fund managers perspective: investor relationships and stapled secondaries
The role of intermediaries
Alternatives to secondary sales
10
10
10
11
11
12
12
13
13
14
16
Trading exchanges/bulletin boards

Securitised vehicles
Total return swaps
The future: The evolution continues
18
Summary
21
Appendix 1: A brief private equity liquidity timeline
22
Appendix 2: Specialised secondary funds
23
Appendix 3: Secondaries the pricing dynamic
25
iii
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Page iv
About the author

Kelly DePonte Probitas Partners
Kelly DePonte is a partner and head of research and due diligence for Probitas Partners alternative
fund placement activities. Prior to joining Probitas Partners, Kelly was Managing Director at Pacific
Corporate Group, a leading provider of alternative investment advisory, managing and consulting
services to institutional clients, where he oversaw the partnership investment program. Before joining PCG, Kelly held various positions at First Interstate Bancorp in private equity, asset liability management and derivatives. He earned an MBA from the Anderson Graduate School of Management at
UCLA, and a BA in communications from Stanford University.
iv
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Page 5

focuses on private equity secondaries and their alternatives. It is designed to
work both as a stand alone section and as part of the whole series. The module
necessarily draws upon topics reviewed in earlier modules, and seeks to avoid
repetition of their content. However, for the benefit of the stand alone reader,
a comprehensive glossary has been incorporated, which explains the background and use of private equity terminology. All terms which may require
explanation or expansion are printed in bold, to indicate that there is a glossary entry for them.
In any market, secondary activity is driven by

three major factors: volume in the primary market, investment structure, and transparency.
Issues with all of these factors mitigated against
the development of a strong secondary market
in private equity until the last decade, when the
growth of straight secondary sales and the creation of liquidity alternatives exploded. Even
though institutional private equity vehicles
have existed since the 1940s, the volume of
activity in the primary market did not warrant
an institutional approach to secondary activity
until the mid-1980s, and only in the late 1990s
did the primary market really begin to dramatically expand.
What drives the need for liquidity?

Before delving more deeply into history, however, it is useful to address participant motivations. Exhibit 1 summarises briefly buyer and
seller motivations. While some circles may still

stigmatise fund managers whose fund has been
sold, most transactions are driven by the strategic needs of the seller. In fact, in dollar terms,
most transactions have been driven by large
financial institutions such as banks and insurance companies who have decided that private equity is not a core business and who use
the secondary market to exit private equity
entirely, with the goal of redeploying capital
into core business lines. Recently, more activity
has been driven by institutional investors seeking to rebalance their portfolios.
It is also important to note the buyers motivation. Increasingly, investors with a long-term
commitment to private equity seek to purchase
positions in specific funds in order either to
develop a relationship with a fund manager
to gain access to future funds being raised,
or to strengthen a relationship with a the man-
Exhibit 1: Summary of buyer and seller motivations

Why do institutions sell existing
private equity positions?
Why do institutions buy secondary

private equity positions?
Most often, sales of private equity funds are driven by

the internal motivations of the seller and not
performance issues. Reasons for selling include:
Institutions purchase secondary positions for a variety

of reasons given their strategic goals:
Inability to fund future commitments

Need for current cash
Shift in institutional strategy away from private
equity or long-term assets in general
Need to rebalance portfolio allocations between
private equity sub-sectors
House cleaning of stub positions or problem
funds that will not be supported in the future in
order to decrease administrative burdens
To generate returns based upon the cash flow

potential of the portfolio
To gain access to future funds to be raised by the
general partner of the fund being purchased
To minimise the J-curve impacts on an
overall portfolio
To rebalance portfolio allocations between private
equity sub-sectors
To add vintage year or sector diversification to
a portfolio
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Page 10
difficult to track, as the exact sub-allocations to

secondaries within fund-of-funds, or allocations
within institutional investors alternative programs are not widely advertised and can also be
flexibly adjusted. In total, however, the amount
of money focused on secondary market investing
is in the range of two to three times the amount
raised for specialised secondary funds.
Secondary sales and purchases:

practical issues
Difficulties in execution
Though secondary sales have been around for a
long time, there are a number of issues that make
the execution of secondary transactions difficult.
Problems with the traditional sales process
include the following:
The potential for deep discounts. Secondary
purchases are usually executed at a discount
to the fund managers carrying value though
the level of discount fluctuates with market
forces. (A more detailed primer on secondary
pricing dynamics is included in Appendix 3 on
pages 2526.) Throughout the 1990s, the
increasing number of funds focused on secondary investing resulted in pressure on these
discounts, resulting in transactions being executed at prices in the range of 75 percent to 85
percent of reported NAV. With the bursting of
the internet bubble these discounts increased,
resulting in transaction values of zero percent
to 50 percent of reported NAV for venture capital funds, and to 40 percent to 70 percent of
NAV for buyout funds. Over the last three
years the market has rebounded significantly,
to the point that high quality buyout funds
often trade at a premium to NAV.
Long time required to execute. The process of
selling a partnership position takes a long
time. The due diligence process by a potential
buyer to establish a final price especially
when a portfolio of a number of partnerships
is involved can take weeks to accomplish.
Once the due diligence process is completed,
the final sale, or legal transfer of rights and
obligations from one party to another, must be
approved by the fund manager in a process
that can also take weeks or months as the fund
manager often has little motivation to help the
process and respond quickly.
Right of first refusal. A significant number of
funds contain right of first refusal clauses
10
which mandate that, before a position can be

transferred to another investor, current LPs in
the fund have the right to match the price.
This clause can add to the complexity of the
sales process and affect details of the bidding
process.
Due diligence can be intensive and disruptive.
The due diligence process that a buyer necessarily performs in order to develop a firm bid,
especially in situations where the buyer is not
intimately familiar with the partnerships
being sold, is usually intensive and can be disruptive for both parties. This can result in
damaged relationships with the fund manager
an important consideration for a buyer
whose interest in purchasing a position may
be driven by a desire to gain access to future
funds to be raised by that same GP.
May impact the relationship with a fund manager and access to future funds. Selling a partnership, especially if it is part of a targeted
portfolio rebalancing effort as opposed to a
wholesale portfolio sale, may communicate
the message to a fund manager that its efforts
and the relationship are not valued. Just as the
purchaser of a partnership interest seeks to
establish a relationship, selling a position
communicates the opposite. A seller seeking
to maintain a relationship and future access to
a fund being sold needs to proceed carefully.
Motivations of institutional investors:

portfolio management
Over the last few years, more institutional
investors (as opposed to specialised secondary
fund managers or fund-of-funds managers) have
begun to consider both purchasing and selling
positions in the secondary market for portfolio
management purposes. The motivations for
these investors include the following:
To provide flexibility in rebalancing a portfolio.
A portfolio manager may decide to rebalance a
portfolio in order to reduce overall exposure
and maintain it within allocations, or to
decrease or increase exposure to specific market or industry sectors. The sale of positions in
the portfolio or the purchase of positions on
the open market can be effective tools to reach
those goals.
To change portfolio cash flow dynamic. In situations where a portfolio manager needs to generate cash, the sale of private equity positions
can both generate immediate cash and at the
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Page 14
Exhibit 7: Secondary private equity ABS structure

Portfolio being securitised
Financing structure
Undrawn
commitments
Liquidity facility
Bank or insurance
company
AA tranche
A tranche
BBB tranche
Investments
outstanding
Structured
bond buyers
BB tranche
B tranche
Equity tranche
Purchasers of
residual risk
Note: The difference in size between the facilities is driven by the discount and the need to over collateralise the
top rated tranches.
Securitised vehicles
To date, most of the effort in producing structured vehicles has been in the primary market as
structured fund-of-funds, but the technology
developed in this area is now being applied in the
secondary market. The primary goal of these
structures as applied to private equity portfolios
is to decrease the discount to NAV on secondary
positions and to make the portfolio more marketable through the use of financial structuring.
There is no common nomenclature yet for these
structures, though collateralised fund obligations
and private fund obligations have been used frequently. They are based on standard asset backed
security (ABS) financial technologies that have
been used for years to create securities backed by
mortgages, credit card receivables, auto loans,
commercial bank loans and corporate bonds.
The goal of most ABS structures is to create a more
efficient financing vehicle for assets by taking a
large portfolio and stripping the cash flow generated by the underlying securities into different
obligations. Each strip or tranche has different
cash flow characteristics and has a credit rating
that declines with each descending strip depending upon the collateral or cash flow priority held in
support of that particular security. The last strip in
the structure is the unrated equity strip, which
retains all of the residual return and risk. Each
strip is then sold to different types of investors on
the basis of their respective risk/return appetite. A
sample structure is shown in Exhibit 7.
The structure outlined in Exhibit 7 differs from a
typical ABS structure by the inclusion of a liquid-
14
ity facility. Private equity portfolios are different

from most ABS situations in that, even with a seasoned portfolio, new funding is required as commitments are drawn down. Though the early
return of capital on certain investments provides
a means of funding future draw-downs, it is prudent to arrange a liquidity facility or line of credit with a bank to ensure that future commitments
will be met in a timely manner regardless of the
realisation experience of the portfolio.
Another way of looking at the structure is as a
leveraged investment in private equity for those
willing to invest in the equity tranche. The various
tranches senior to the equity tranche effectively
provide debt financing to purchase the portfolio,
while the residual risks and residual benefits
accrue to the holder of the equity tranche.
To date, relatively few private equity transactions
either in the primary fund-of-funds market or in
the secondary market have been rated by the
credit rating agencies. However, Standard and
Poors, Moodys, and Fitchs have all established
rating policies for securities collateralised by portfolios of private equity partnerships. At a summary level, the policies of all three require similar
elements in order to achieve specified rating levels. These elements include, for example, professional portfolio oversight, specified levels of
portfolio diversification, differing levels of overcollateralisation or cash flow preference, and equity protection provided by the unrated tranche.
Issues with the ABS structure
Fundamental issues with the ABS structure
have kept it from being widely used as a means
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Page i
Module 10:
Running a private
equity firm
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Page ii

PEI Media
Second Floor
Sycamore House
Sycamore Street
London EC1Y 0SG
United Kingdom
Telephone: +44 20 7566 5444
2007 PEI Media Ltd.
ISBN 1-904696-52-X 978-1-904696-52-0
Module 1
Module 2
Module 3
Module 4
Module 5
Module 6
Module 7
Module 8
Module 9
Module 10
Glossary

Due diligence
Aftercare and exits
and definitions
+44 20 7566 5444.
ii
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Page iii
Contents
About the author
iv
The institutionalisation of private equity and its meaning for a general partner
Building the right structure: roles and responsibilities
Human capital: attracting and retaining talent
7
7
8
8
Human capital
Attracting talent
Retaining talent
Carried interest: meaning, uses and calculation

Meaning
Uses
Calculation
Effect of GPs retirement on carried interest
Reporting: managing the GP/LP dialogue
9
9
9
10
11
11
11
11
12
Objectives
Reporting obligations
Delivery methods
A GPs technology requirements

What does a private equity-specific software package have to do?
Operational infrastructure
12
12
13
13
14
15
15
Overview of the process

Different steps necessary
Timeframe
Costs
Fund administration requirements
16
16
16
17
Bookkeeping and accounts

Investment portfolio activity and custody
Secretarial and compliance
Outsourcing fund administration pros and cons

Pros
Cons
17
18
18
Summary
19
iii
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Page iv
About the author

David Huckfield Baring Private Equity International
David Huckfield has 20 years experience in the international private equity industry as a partner of
Baring Private Equity. In 2004 he played a leading role in coordinating and structuring the 8-way management buyout of the Group from ING Bank. Previously he was Group Chief Operations Officer,
based in London, responsible for operations and compliance worldwide. During his tenure funds
under management grew from $100 million to $2 billion as the Group expanded from a pan-European
partnership with four offices to an inter-continental institution with a network of 18 offices in 13
countries managing more than 20 funds. He held more than 60 directorships across the Group and is
now a non-executive director of Baring Private Equity International with a focus on corporate governance standards. In this capacity he continues to chair the General Partner Boards of most of the
Groups $3.4 billion of private equity funds operating in Russia, Asia, India, Europe and Latin America.
iv
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Page 5

focuses on running a private equity firm. It is designed to work both as a stand
alone section and as part of the whole series. The module necessarily draws upon
topics reviewed in earlier modules, and seeks to avoid repetition of their content.
The institutionalisation of private

equity and its meaning for a
general partner
Private equity has long since ceased to be the nascent industry it was when the first venture capital pioneers made it a recognisable business
more than quarter of a century ago.
Institutionalisation has been defined as to make
part of a structured and usually well-established
system and throughout this module there is an
undercurrent of what are, in reality, institutional
imperatives that are fashioning the way general
partners (GPs) go about their business. Limited
partners (LPs) and GPs alike are becoming more
sophisticated in their approach to the structuring
of the product and the business process required
to maximise returns on capital.
Investors, especially the largest who are institutions in their own right, have turned the formation of a fund into a highly complex operation
requiring greater assistance (and consequently
expense) of specialist legal and tax professionals
to develop a structure and a set of fund documents to help manage the high risks attached to
private equity investments. This is typified by the
range and number of vehicles that now comprise
a fund and the complexity of clausing in the fund
partnership agreement; dealing with such matters as tapering management fees, carried interest hurdles and clawbacks, environmental
policies, corporate governance and conflict of
interest resolution, among others.
Fuelling this trend is the drive by financial services regulators around the world, especially
those in certain jurisdictions formerly known as
tax havens anxious to improve their reputa-
tions, to impose more and more regulation on

the private equity industry. Many of these regulators now require practising professionals to
pass specialist tests and exams leading to GPs to
incur the expense of more formal training programmes before being licensed to operate.
Training programmes have also had to be
extended to include anti-money laundering procedures which can look like maddening bureaucracy to a GP dealing with world-renowned
institutional investors.
Freedom of Information legislation is in a similar way feeding a media frenzy for disclosure of
fund performance data, previously subject to
restricted access by GPs, especially from
investors in the public sectors as their investment of pensioners funds come under closer
scrutiny. Major investors, private equity associations and other trendsetters are at the same
time seeking greater transparency in fund
reporting. All this is presenting GPs with a
greater challenge to their obligations under
confidentiality undertakings to portfolio companies and competing legislation such as insider-trading laws which is taking up more
management time in designing systems that
provide a happy medium.
These disclosure demands have also led to the
creation of industry guidelines such as the International Private Equity and Venture Capital Guidelines and the Corporate Governance and
Professional Standards and Reporting Guidelines
endorsed by the European Venture Capital
Association, among others. Market and peer
pressure on GPs to adopt such guidelines means
greater investment in systems and procedures
and an increase in the demand for private equity
specific software to facilitate reporting.
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Page 12
of members including representatives of certain

larger (for example: exceeding $X million or Y
percent), Investors in the fund and sometimes
individuals with no affiliation to the fund. The
advisory council will meet at least twice a year to
receive a report from the GP on matters falling
within the jurisdiction of the advisory council
which may include:
consenting to, reviewing or waiving any matter requiring their consent under the partnership agreement such as departures from the
main investment strategy, investments that
exceed specified limits;
approving the budget for partnership expenses;
approving changes in named key men who
have left the employment of the GP;
reviewing and/or approving portfolio valuations; and
reviewing and/or resolving conflicts of interest.
the private equity industry. Alternatively they may

be content to develop home-made solutions
using standard off-the-shelf spreadsheet, database
and presentation software.
The main factors that influence their preferred
choice of solution are the scale of their business,
the financial cost of replacing legacy systems and
the human resources required to achieve the
transition. Least inclined to embark on significant investment in custom applications are the
small firms operating entirely from a single site
without any outsourcing of fund administration.
They are likely to have developed their own inhouse systems using proprietary software tools.
Larger firms with a more complex business
model, for example, operating internationally
and using third-party administrators are most
likely to be attracted by the prospects of
installing an all singing-all dancing custombuilt solution.
Delivery methods
The annual financial statements and associated
reports due under the partnership agreement
will normally by distributed by post but may also
be sent by email where agreed. In addition GPs,
or their fund administrators where outsourcing is
used, may make such information available to
authorised users via secure websites.
The partnership agreement will also usually
require the GP to hold an annual meeting of LPs.
The agenda of such meetings typically include
detailed reporting on the progress of the fund
and its investment portfolio including presentations from portfolio company CEOs.
It is also often the practice of GPs to send LPs
newsletters from time to time reporting material
events such as new investments, realisations
and milestone achievements.
A GPs technology requirements

What does a private equity-specific
software package have to do?
GPs need software packages that fulfil many functions including storing records, calculating statistics, maintaining accounts and generating reports.
They may choose a number of discrete separate
software applications or a one-stop-shop solution from one of the growing number of providers
that have developed custom packages based on a
range of platforms specially to meet the needs of
12
The main tasks that private-equity specific software has to do relate to the source and application of funds under management and include
the following:
Marketing and contact relationship management. This will include an address book module for existing and potential contacts who may
be investors, portfolio companies, intermediaries etc; it must be able to handle the coordinates and of multiple contacts with individual
organisations and link into other modules of
the software. Records should include profile
information that will enable data sorting,
analysis and reporting. In marketing it is used
to identify potential investors for new funds
and coordinate approaches to them.
Capital account transacting. Possibly included
in the fund accounting module but often
tracked in greater detail in a module of its
own. This must be capable of handling various
ratios for the allocation of the purchase and
sale of investments, operating revenue and
expenses, realised and unrealised profits and
losses, capital calls and distributions.
Dealflow tracking. For every investment that is
made, a private equity firm may process many,
many more to a greater or lesser extent. Some
may be rejected as non-starters, some may
proceed to one or more meetings with the
entrepreneurs, others may be the subject of
work-in-progress for many months and be
Glossary.Fundamentals
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Page i
Glossary
24/8/07
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Page ii

PEI Media
Second Floor
Sycamore House
Sycamore Street
London EC1Y 0SG
United Kingdom
Telephone: +44 20 7566 5444
2007 PEI Media Ltd.
ISBN 1-904696-53-8 978-1-904696-53-7
This glossary is associated with a series of 10 modules entitled The fundamentals of private
equity. The modules in this series are:
Module 1
Module 2
Module 3
Module 4
Module 5
Module 6
Module 7
Module 8
Module 9
Module 10
Glossary

Due diligence
Aftercare and exits
and definitions
+44 20 7566 5444.
ii
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Page 15
LP
See Limited partner.
Management buy-in (MBI)
Where an outside manager or team purchases an ownership stake

in a company and replaces the existing management team.
Management buyout (MBO)
The acquisition of a company by its management team, usually in

partnership with external lenders and/or private equity investors.
Management fee
The fee paid by a private equity fund to the funds manager, generally in the range of 1.5 percent to 2.5 percent of the funds committed capital per annum. The fee is intended to cover the managers
overhead and salary costs in finding, making and monitoring
investments. It will scale down in later years as the funds portfolio,
and hence the associated workload, reduces.
Management ratchet
See Ratchet.
Mandatory redemption
The requirement for a company to purchase all of an investors

shares, at a set price on a certain date.
Market flex
Changes made to the terms of a loan (principally the interest rate),

within limits pre-agreed with the borrower, in order to match them
to market conditions when selling parts of the loan onto other
lenders in a syndicate
Marketability discount
A discount applied to the valuation of an unquoted company to

reflect that fact that its shares are not publicly-quoted and cannot
be sold in an open market. Generally varies from 0 to 30% according to the size of the company, and the certainty and likely timing
of an exit.
MBO
See Management buyout.
MBI
See Management buy-in.
Mezzanine financing/loan
A junior loan which carries the right to participate in the equity of

the borrower, usually by carrying options to purchase shares at a
nominal value. Hence mezzanine lies somewhere between pure
equity and pure debt finance. Mezzanine loans will usually carry a
significantly higher interest rate than that which applies to senior
debt, and will carry a long-term (eight or more years) bullet
repayment.
Mezzanine notes
Publicly-traded bonds which have mezzanine terms.
Middle market
Medium-sized companies; definitions vary according to region, but

in Europe companies valued in the 100 million to 500 million
range would be regarded as mid-market.
Multiple
A means of valuing a company by multiplying a key financial indicator, such as EBIT. The higher the multiple, the higher the anticipated growth rate in profit or cash generation. The price earnings
ratio commonly calculated for public companies, by dividing the
share price by earning per share, is a multiple.
15
The Fundamentals of Private Equity and Venture Capital

As the private equity and venture capital industry continues to
expand and evolve globally it is crucial that professionals
entering the industry understand its many facets fully. The
Fundamentals of Private Equity and Venture Capital provides
a comprehensive manual to all those wanting an accessible,
informed and insightful guide to this dynamic asset class. This
unique series pulls together the ten most important topics on
private equity and venture capital and, as a set, delivers an allencompassing guide to the subject. Whether a new entrant to
this market wanting to gain a clear understanding of the industry
or a professional needing to expand their knowledge on a
specific area, The Fundamentals of Private Equity and
Venture Capital is a vital resource to all those working in the
private equity or venture capital industry wherever you are
based in the world.
Brought to you by the team that publishes Private Equity International and PrivateEquityOnline.com, The Fundamentals of
Private Equity and Venture Capital is split into ten modules and
a detailed up-to-date glossary essential for any professional in
need of an understanding of individual elements of the industry
or of the asset class as a whole.
These modules are:
1. What is Private Equity and Venture Capital?
2. Private Equity as an Asset Class
3. Structuring and Raising a Fund
4. Venture and Development Capital
5. Management and Leveraged Buyouts
6. Private Equity Real Estate and Infrastructure
7. Due diligence for Private Equity and Venture Capital Firms
8. Aftercare and Exits
9. Secondaries and their Alternatives
10. Running a Private Equity Firm
11. Glossary
Fundamentals is a must-have companion for any private

equity firm, investment group, investment bank or advisory firm
engaged with the industry. It has been expressly written and
designed to deliver concise guidance and analysis, drawing
on the real-world expertise of its authors and editor.
KEY FEATURES
Fundamentals has been written and edited by three
established authors and professionals in the field of private
equity and venture capital: Garry Sharp, Kelly DePonte and
David Huckfield.
Modules include real world examples and case studies from
leading firms involved with private equity and venture capital.
Key articles from Private Equity International supply
relevant commentary and context.
The layout of every module has been designed to optimise
ease of use and comprehension, including valuable data in
charts and tables, boxed checklists and valuable section
summaries.
The language is accessible and friendly and delivers
important knowledge in a digestible way.
A list of recommended reading is included to enhance your
knowledge further.
A comprehensive and up-to-date glossary of industry terms
is included.

What Is PE & VC

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THE FUNDAMENTALS OF

PRIVATE EQUITY AND

A PRIVATE EQUITY INTERNATIONAL PUBLICATION

What is private equity

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Getting the most out of this module

The evolution of venture capital and private equity

Types of private equity

The private equity cycle connecting institutional

Why invest in private equity?

The modern private equity firm the shape of a GP

Case Study 2: The management buyout

Case study 3: Investor forces an exit

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THE FUNDAMENTALS OF PRIVATE EQUITY

About the author

THE FUNDAMENTALS OF PRIVATE EQUITY

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GETTING THE MOST OUT OF THIS MODULE

The evolution of venture capital

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the basis that those who fail to learn from history

Evolution of the US market

THE FUNDAMENTALS OF PRIVATE EQUITY

THE FUNDAMENTALS OF PRIVATE EQUITY

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THE FUNDAMENTALS OF PRIVATE EQUITY

Getting the most out of this module

Returns and risk

Analysing risk in quoted markets

Risk in private equity

Assymetric risk and return

Using statistics in measuring private equity performance

Private equity performance

Issues with private equity

Routes to private equity

Private equity market drivers

Availability of investment opportunities

Appendix 1: Enter the Pantheon

Appendix 2: PEI 50 Private Equity Internationals ranking of the

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THE FUNDAMENTALS OF PRIVATE EQUITY

About the author

THE FUNDAMENTALS OF PRIVATE EQUITY

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GETTING THE MOST OUT OF THIS MODULE

Returns and risk

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THE FUNDAMENTALS OF PRIVATE EQUITY

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

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

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

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the possibility of choosing losers. However it

THE FUNDAMENTALS OF PRIVATE EQUITY

mean that they are highly restricted in terms of the

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Finally, of course, private equity not only offers

THE FUNDAMENTALS OF PRIVATE EQUITY

Structuring and raising

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THE FUNDAMENTALS OF PRIVATE EQUITY