Private Equity and Venture Capital in The European Economy An Industry Response To The European Parliament and The European Commission

Private Equity and Venture Capital in the European Economy An Industry Response to the European Parliament and the
European Commission
Brussels, 25 February 2009
List of Contributors
EVCA would like to express its gratitude to the following individuals and companies that contributed to this submission: Brussels Task Force - Jonathan Russell - Douwe Cosijn - Pierre de Fouquet - Uli W. Fricke - Drte Hppner - Vincenzo Morelli - Anne Holm Rannaleet - Simon Walker - Nickolas Reinhardt - Javier Echarri Representative Group - Jonathan Russell - Ole Steen Andersen - Kathryn Baker - Kurt Bjorklund - Gianpio Bracchi - Craig Butcher - Rolf Christof Dienst - Andr-Xavier Cooreman - Pierre de Fouquet - Jean-Louis Delvaux - Uli W. Fricke - Christian Frigast - Jeremy Hand - Jaime Hernandez-Soto - Bjorn Hoi Jensen - Johannes Huth - Frederick Johansson - Vincenzo Morelli - Vincent Neate - Thomas U.W. Ptter - Anne Holm Rannaleet - Norbert Reis - Helmut Schhsler - Patrick Sheehan - Marc St John - Aris Wateler - Heikki Westerlund 3i, EVCA Chairman Danfoss A/S, DVCA Reiten & Co Strategic Investments AS, NVCA Permira AIFI Mid Europe Partners Wellington Partners, BVK Sofinim, BVA Iris Capital, AFIC Natixis Private Equity Triangle Venture Capital Group Management GmbH Axcel Lyceum Capital Ltd, BVCA MCH Private Equity, ASCRI EQT Partners A/S Kohlberg Kravis Roberts & Co. SEB Merchant Banking, SVCA TPG Capital LLP KPMG LLP Allianz Capital Partners GmbH IK Investment Partners Limited The Carlyle Group TVM Capital GmbH Environmental Technologies Fund CVC Capital Partners Limited Parcom Capital BV, NVP CapMan Invest A/S (CapMan Group), FVCA 3i, EVCA Chairman, Chairman Task Force 3i Iris Capital Triangle Venture Capital Group Management GmbH BVK TPG Capital LLP IK Investment Partners Limited BVCA Fleishman-Hillard EVCA
PE/VC in the European Economy An Industry Response to the European Parliament and the European Commission - February 2009
List of Contributors
Technical Group PSC and Risk - Uli W. Fricke Triangle Venture Capital Group Management GmbH, Chairwoman - Anne Holm Rannaleet IK Investment Partners Limited - Margaret Chamberlain Travers Smith LLP - Helen Croke Travers Smith LLP - Christopher Crozier Permira - Aleid Doodeheefver Loyens & Loeff N.V. - Roger Fink Pinsent Masons - Les Gabb Advent Venture Partners - Manuel Garca-Riestra SJ Berwin - Patrizia Gioiosa Di Tanno e Associati - Cesar Gonzalez SJ Berwin - Didier Guennoc EVCA - Mary Kuusisto Proskauer - Barry Lawson Bridgepoint International - Thomas Meyer EIB - Florence Moulin Proskauer Rose LLP - Vincent Neate KPMG LLP - Georges Nol EVCA - Jan-Peter Onstwedder 3i - Simon Powell Advent International - Isabel Rodriguez SJ Berwin - Michael Russell Altius Associates - Monique Saulnier Sofinnova - Bernd Seibel TVM Capital GmbH - Mark Soundy Weil Gotschal - Rainer Traugott Linklaters - L.M.H. (Linda) van de Geer Loyens & Loeff N.V. - Christoph von Einem White & Case LLP - Elizabeth Ward Linklaters - Claire Wilkinson Omegafunds - Simon Witney SJ Berwin - Sue Woodman Alchemy Partners LLP EVCA Tax and Legal Committee - Fabio Brunelli Di Tanno e Associati, Chairman - Ana Sofia Batista Abreu Avogados - Marco de Lignie Loyens & Loeff N.V. - Javier Echarri EVCA - Maria Gracia Rubio Baker McKenzie - Dariusz Greszta CMS Cameron McKenna European Investment Fund - Maria Leander - Matthias Lupp Clifford Chance - Robin Painter Proskauer Rose LLP - Jill Palmer 3i
Bernard Peeters Georges Pinkham Daniel Schmidt Jutta Schneider Ulf Sderholm Oliver Stahler Jyrki Tahtinen Jacob Vinther David Widger Simon Witney Andreas Zahradnik
Tiberghien Advocaten SJ Berwin LLP Proskauer Rose Clifford Chance Andulf Advokat Lenz & Staehelin Borenius & Kemppinen Ltd Accura A&L Goodbody SJ Berwin LLP Dorda Brugger Jordis
Other Contributors - Irina Anghel
SEEPEA, South Eastern Europe - Ludo Bammens Kohlberg Kravis Roberts & Co. - Liane Bednarz Latham & Watkins LLP - Erika Blanckaert EVCA - Regina Breheny IVCA, Ireland - Paulo Caetano APCRI, Portugal - Louise Frikov-Petersen Rnne & Lundgren Advokatfirma - Guy Geldhof BVA, Belgium - Natlia Gmbs HVCA, Hungary - Iveta Griacova SLOVCA, Slovakia - Alenka Hren SLEVCA, Slovenia - Henrik Juul Hansen Rnne & Lundgren Advokatfirma - Jrg Kirchner Latham & Watkins LLP - Georges Kourtis HVCA, Greece - Petra Kursova CVCA, Czech Republic - Jrgen Marchart AVCO, Austria - Mirna Marcovic CVCA, Croatia - Silvia Mecchia Di Tanno e Associati - Tjarda Molenaar NVP, the Netherlands - Barbara Nowakowska PPEA, Poland - Justin Perrettson EVCA - Gorm Boe Petersen DVCA, Denmark - Krista Rantasaari FVCA, Finland - Marie Reinius SVCA, Sweden - Jesper Schultz Larsen Rnne & Lundgren Advokatfirma - Knut Traaseth NVCA, Norway - Advokatfirmaet Haavind AS - Advokatfirman Vinge KB - Roschier Attorneys Ltd - Plesner Svane Grnborg Law Firm - Advokatfirman Schjdt DA
Table of Contents
Foreword Executive Summary
1. 2. 3. 4. 5. 6. Background Private Equity: Part of the Economic Solution Private Equity: Poses No Systemic Risk Private Equity: Different to Other Funds, Particularly Hedge Funds Proportionality of the Regulatory Framework Actions Proposed by Private Equity
4 5
5 5 6 6 7 7
Introduction Section I: Overview of the European Private Equity Industry

1. 2. 3. Private Equity Defined Private Equity Investment Model Private Equity Distinct from Other Alternative Assets
9 12
12 14 19
Section II: Risk Analysis of the Private Equity Industry

1. 2. 3. 4. Introduction Specific Risks Systemic Risk Systemic Risk Conclusions
22
22 23 32 34
Section III: Coverage of Law and Regulation, Contractual Agreements and Industry Professional Standards with respect to EU Concerns regarding Private Equity
1. 2. 3. Introduction Coverage of Law, Contractual Agreements and Industry Professional Standards Recommendations relating to Section III
37
37 38 47
Conclusion and Recommendations Annexes

1. 2. Annex I: Detailed Risk Analysis of the Private Equity Industry Annex II: Detailed Analysis Coverage of Law and Regulation, Contractual Agreements and Industry Professional Standards with respect to EU Concerns regarding Private Equity
49 53
53 99
Foreword
In October 2008, the European private equity and venture capital industry met to discuss the position of the industry in light of the increased political scrutiny that was emerging at both EU and Member State levels. Although the catalyst for this meeting was the European Parliament Resolutions on private equity, it was clear that the severe turmoil in global financial markets was leading to calls for a fundamental review of the financial services industry as a whole. A key outcome of the meeting was the creation of an industry Representative Group, comprising some 30 representatives from private equity and venture capital funds, European and national venture capital associations, advisory firms and investors in the industry. The Representative Group formed a Brussels Task Force to formally respond to the European Parliaments Resolutions and support the European Commission in formulating possible EU policy outcomes. This submission is the industrys formal response to the European Parliament and European Commission and is the culmination of an enormous amount of technical analysis that has been carried out by the industry and its advisers. As chairman of the European Private Equity and Venture Capital Association I am immensely grateful to everyone that has contributed to this submission. Although there are too many individuals to thank personally, I would like to express my gratitude to the Representative Group, members of the Brussels Task Force, and the members of the EVCA and national technical committees who provided the backbone of the analysis. I firmly believe that the private equity and venture capital industry has an important role to play in the development of the European economy and is very much part of the solution to helping the EU through this period of unprecedented uncertainty. I hope that this submission will help people to enhance their understanding of the industry and appreciate the vital role that private equity and venture capital will play in providing finance to ambitious growth companies; supporting and developing these companies is critical because it is they that will lead to the sustainable recovery of the European economy and the prosperity we all seek for future generations.
Jonathan Russell 25 February 2009
Executive Summary
In a world faced with a severe financial turmoil, the European private equity and venture capital industry has to play its role in creating a transparent, sustainable, sound and efficient financial system for the future. In the months ahead, the private equity and venture capital industry intends to cooperate very closely with the European Commission and the other EU Institutions in developing an appropriate and proportionate regulatory framework. We believe that this framework should consist of enhanced unified professional standards and an effective enforcement regime with oversight thereof by the appropriate national or European bodies.
1.
Background
In October 2008, the European private equity and venture capital industry met to discuss the position of the industry in light of the increased political scrutiny that was emerging at both national and EU levels. Although the catalyst for this meeting was the European Parliament Resolutions on hedge funds and private equity, it was clear that the severe turmoil in global financial markets was leading to calls for a fundamental review of the financial services industry as a whole. A key outcome of the meeting was the creation of an industry Representative Group, comprising some 30 representatives from private equity and venture capital funds, European and national venture capital associations, advisory firms and investors in the industry. The Representative Group formed a Brussels Task Force to formally respond to the European Parliaments Resolutions and support the European Commission in formulating possible EU policy outcomes. This report provides the industrys response.
2.
Private Equity: Part of the Economic Solution
We believe that the European private equity and venture capital industry can be part of the solution to help overcome the current funding crisis and thereby play an active role contributing to the recovery of European economies. The industry is an important source of long-term capital throughout all stages of a companys growth strategy: from seed capital to larger scale corporate restructurings. The private equity industry employs a hands-on approach to working with management teams to develop more successful businesses. In this way, private equity and venture capital also importantly contributes to European employment, competitiveness and innovation. Clear governance structures ensure an alignment of interests. We recognise that the private equity and venture capital industry has not been successful in effectively communicating its business model nor the economic and social benefits which this model brings with it. The industry is committed to engage more effectively with policy makers and other relevant stakeholders moving forward and contribute to the creation of a regulatory environment that supports dynamic and competitive markets in Europe.
Executive Summary
3. Private Equity: Poses No Systemic Risk
The detailed description and analysis of existing laws, regulations and professional standards demonstrates that the private equity and venture capital industry is already highly-regulated at national and EU level and does not pose systemic risks either through its funding model or the companies in which it invests. Moreover, our assessment shows that the current practices in terms of contractual agreements between sophisticated investors and private equity firms are characterised by a high level of understanding across parties on how contractual clauses should be structured in relation to the underlying investment strategies, their risk and the compensation of managers. Retail investors play an insignificant role in the market and, in the few cases they are engaged, are protected by the laws covering public offerings in every European jurisdiction. As a customer of financial services, the private equity industry is no different from other investors. It has therefore not remained immune from the financial turmoil. The private equity industry supports appropriate changes in capital market regulation which could help to revitalise capital markets, subject that it maintains the level playing field between the private equity industry and other users of financial services. The important recommendations of this report in the areas of industry standards and supervision for private equity are intended to contribute to this objective.
4.
Private Equity: Different to Other Funds, Particularly Hedge Funds
Private equity invests, largely, in unlisted (and therefore illiquid) companies equity where it will usually (alone or together with like-minded investors) acquire a majority stake. On the contrary, hedge funds typically take minority positions in heavily traded, highly liquid securities in public companies, currencies and commodities. Private equity does not implement short selling strategies. In contrast to hedge funds, commitments to private equity and venture capital funds are of a long-term duration (typically 10 years) and are not subject to monthly, quarterly or annual redemption rights, which may in themselves be a source of market volatility. Hedge funds can traditionally carry very high leverage. While private equity firms do not leverage investors equity in the fund, leverage in the portfolio companies is typically no more than two to three times equity value in the buyout sector. Private equity firms performance fees are earned only from the cash returned to investors (beyond a threshold of annual return) via a combination of investment sales and/or cash dividends. Hedge funds typically recognize profits (and associated performance fees) yearly (or more often) based on the spot market value of the assets held.
5.
Proportionality of the Regulatory Framework
We believe that a European regulatory framework needs to reflect the following general principles: Although private equity is characterised as a form of Alternative Investment its business model is distinct from other alternative investments, such as hedge funds. The private equity industry comprises a broad spectrum of investment funds with regards to their size, legal structure and their investment strategies. Private equity incorporates venture capital, growth capital, leveraged buyouts, distressed debt, and turnaround situations. Although private equity is a form of financial investment, it does not generate systemic risk for the economy at large and employs effective risk management techniques appropriate for its business model. Private equity is subject to a range of legislative and supervisory measures already in place at national and European level, as well as regular review. The private equity industry is subject to a wide range of behavioural/ethical codes of conduct and common industry rules. Private equity owned companies are managed in full respect with national social and fiscal laws applicable to the company. Any new rules that are introduced should be fair. Public policy needs to ensure a level playing field and full competition between the private equity industry and other companies and/or institutional investors when undertaking the same economic activity. They should also not discriminate against privately funded companies that are part of private equity investment portfolios, as opposed to all other privately owned companies. Private equity is a global industry both in terms of its fund raising and investment practices. Public policy should recognise this international dimension.
6.
Actions Proposed by Private Equity
The Private Equity and Venture Capital Industry commits to the following: We see this report as an opportunity to work in co-ordination with the European Commission and other EU and national relevant bodies, to enhance the existing behavioural framework to provide all market participants with sufficient confidence in the private equity industry to support its continued growth in Europe. Additionally, the private equity and venture capital industry is fully engaged in the broader review of the European (and global) financial services regulatory framework and is committed to working with policy makers and other constituencies impacted by the industrys investment activities both now and in the future. Specifically, the European private equity and venture capital industry proposes the following: 1. The private equity and venture capital industry is prepared to commit to unify industry professional standards coverage across Europe. That there should be a unified Europe-wide set of standards; That these should be principles-based to allow subsidiarity and national implementation of approved variations to fit with local practices and legislation; and That a process of mutual recognition across trade bodies in Europe should be established.
Executive Summary
The unified Europe-wide set of professional standards will be based on: (i) Code of Conduct; (ii) Corporate governance guidelines in the management of private equity-held companies; (iii) Reporting to investors; (iv) Valuation Guidelines; (v) Transparency and disclosure guidelines; (vi) Governing principles for the establishment and management of private equity funds. 2. The private equity and venture capital industry is prepared to commit to introduce an enforcement regime for the industry professional standards across Europe and make it subject to oversight by the appropriate EU and national supervisory bodies. The enforcement regime that is established will meet the following test: (i) Accountability to European Union and national supervisory bodies; (ii) Protection of the process from conflicts of interest; (iii) Proportionality according to the risk posed by various industry participants; and (iv) Subsidiarity to the legal frameworks of different jurisdictions. 3. The unification of industry professional standards and the establishment of the enforcement regime across Europe could be completed within 12 months. In order to address promptly the concerns of the European Union institutions, the private equity industry commits to deliver within 12 months or a timetable agreed with the relevant EU institutions.
Introduction
The European private equity and venture capital industry has experienced significant growth during the past 10 years and has become an increasingly important source of finance and expertise for companies seeking to achieve their growth aspirations. Particularly in a period of economic uncertainty where there is a scarcity of capital, private equity and venture capital can be part of the solution to the current economic challenges facing companies across the European Union (EU). Private equity provides one of the sources of capital that can help to overcome the current funding crisis and thereby play its own active role in contributing to the economic recovery and continued innovation in the EU (as also set out by the European Commissions Recovery Programme). Although private equity investments represent less than one percent of Europes GDP, they have a substantial impact on European growth prospects and have the potential to play an important role in helping European companies cope with the severe economic downturn. The industry is well funded with long-term committed capital which can provide a vital, alternative form of finance to traditional banking and public equity markets. Also, private equity is about more than providing equity capital. Private equity is distinguished by its hands-on approach to working with management teams to set clear strategic priorities and develop more successful businesses. Active management, the alignment of interests between management and investor, robust corporate governance processes and a focus on value creation are all key aspects of the industrys approach to investment. This role will become particularly important as companies face up to internal reorganisation and competition in a more difficult global economic environment. For this to be achieved, the EU will need a regulatory environment that supports a competitive and dynamic private equity and venture capital market and enhances the EUs capacity to attract and invest further funds. The private equity and venture capital industry therefore welcomes the opportunity to demonstrate that it is both of benefit to the European economy and that it is a responsible actor in financial markets. Over the past two years, concerns have been voiced about the role of private equity in the broader European economy, particularly as certain high profile investments have raised significant media interest. As such, the industry recognises that it must engage with policy makers and other constituencies that are potentially affected by the industrys investment activities and to more effectively communicate its role in supporting the growth of the companies in which it invests. Going forward, the industry will take an active role in the continued political debate on how to respond effectively to the regulatory and prudential challenges posed by the global financial crisis and the economic slowdown. In framing this debate, it needs to be recognised that the private equity and venture capital industry comprises a broad spectrum of investment funds with regards to their size, legal structure and their investment strategies. Private equity incorporates venture capital, growth capital, leveraged buyouts, distressed debt, and turnaround specialists. Any discussions about possible policy intervention or the role of private equity and venture capital in the economy should address these distinctions and the diverse nature of the industry. In October 2008, the European private equity industry held an EU policy meeting to consider its priorities against a rapidly changing global economic and political environment. The European Parliament reports prepared by Members of the European Parliament Rasmussen and Lehne highlighted certain real political concerns to which the industry needed to respond.
10
Introduction
An Industry Representative Group was established following the October 2008 policy meeting which delegated responsibility for preparing a formal response by the industry to the Brussels Task Force. An initial response was made to the European Commission in November 2008 (1) in which the industry committed to conducting a detailed analysis of the concerns raised in the European Parliament reports. Subsequently, the Brussels Task Force has also undertaken to respond to additional concerns from the European Commission arising from the fundamental review of the EU (and global) financial services regulatory framework. As a consequence this submission is backed by the entirety of the private equity and venture capital industry in Europe and its current portfolio of over 20,000 companies ranging from the very small start-ups to large companies, and including every sector of our economy. The principal areas of concern that were raised by the European Parliament can be summarised as follows: What is the potential impact of buyout activity on the social economy; How does the industry manage its relationships with key stakeholders; Is there excessive use of leverage in private equity investments; Clarify corporate governance and shareholder behaviour(s); Is there adequate transparency; and Clarify reporting to investors in private equity and venture capital funds.
Additionally, the Commission requested a detailed risk analysis that may arise from private equity investment and structure. The following paper is a summary of the technical analysis that was conducted in response to these particular issues. The paper has as its objectives to: Describe the private equity industry: the various types of private equity activity and how these differ from other alternative assets, particularly hedge funds; describe the private equity model of equity investment and how this adds value compared to other sources of finance, such as public equities markets; and describe the current situation and outlook for the industry Examine the risks associated with private equity, including the possibility of harm to the global financial system and the specific risks incurred by private equity stakeholders Describe current EU and national regulatory environments, contractual agreements between private equity firms (fund managers) and their investors and industry professional standards (i.e. codes and guidelines) Propose measures to address concerns with private equity
Understandably, the section of the paper that will be probably of greatest interest will be the conclusions and recommendations. However, it would be unfortunate if adequate attention were not given to the very detailed technical analysis provided by this report both in the main text and its technical annexes on the potential degree of systemic risk posed by the industry and the description of the existing laws, regulations and industry professional standards with which the private equity and venture capital industry is already complying. In short, the analysis demonstrates that the private equity industry does not pose systemic risk either through its funding model or through the direct investment in the companies in which it invests. Also, the industry is already highly regulated at a national and EU level and has sought to implement national as well as pan-European industry standards and codes of practice specific to the private equity and venture capital industry.
(1)
Downloadable at: http://www.evca.eu/publicandregulatoryaffairs/evcapositionstatementsandpapers.aspx?id=182
11
Similarly to any other participant in capital markets the private equity and venture capital industry is subject to all rules affecting availability of capital, credit and financing. In this regard, the industry is a user of financial services just like any other investor and will be subject to and supporter of any appropriate changes in the regulatory regime resulting from the current EU and G20 discussions. Private equity and venture capital are not unique in this regard. This said, as private equity and venture capital industry we believe that there is room for improvement on the important area of supervision and co-ordination of industry standards. The industry is prepared to commit to the following: 1. unify the industrys professional standards across Europe; 2. establish an enforcement regime subject to oversight by the appropriate EU and national supervisory bodies; and 3. implement these recommendations in the next 12 months. We see this as an opportunity to work in co-ordination with the European Commission and other EU and national relevant authorities, to enhance the existing behavioural framework to provide all market participants with sufficient confidence in the private equity industry to support its continued growth in Europe. The private equity and venture capital industry is fully engaged in the broader review of the European (and global) financial services regulatory framework and is committed to working with policy makers and other constituencies impacted by the industrys investment activities both now and in the future.
12
Section I: Overview of the European Private Equity Industry
1.
Private Equity Defined
Private equity is simply equity raised by a corporation privately i.e., not raised on a public market. However, rather than funds raised privately from, say, personal contacts or family, it has come to mean equity investments arranged by private equity firms. These are professional services firms that themselves raise funds from investors for a defined period (typically 10 years), with a mandate to: invest the money in equity stakes in companies; participate in the governance of these companies by exercising the voting rights of the fund (and, typically, by joining the board); improve their operational and strategic performance; realize resulting increases in value through private sale or public flotation; and return funds with accumulated gains or losses to investors usually at the end of the 10-year commitment period. Private equity is part of the wider alternative asset class (i.e., as opposed to traditional direct investment in publicly listed equities and debt) which also includes hedge funds, debt funds, commodities, real estate etc. From the perspective of the company, private equity is a source of equity finance that offers an alternative to the traditional choice between bank lending and listing on the stock market, and which comes with committed and engaged professional shareholders focused on growth and value creation. From the perspective of an investor interested in participating in the growth of company value, investing in a private equity fund offers stronger representation in the governance of the portfolio companies, and in some cases, access to otherwise unavailable private investment opportunities in such companies. Private equity investments are long-term by nature, providing equity capital to companies across all stages of their development. In 58% of cases, private equity investments are made for more than five years. In only 12% of cases does private equity exit from its investments within two years (2). This contrasts with investors in the FTSE 100 shares where holding periods are substantially less than 1 year. (3) Private equity activities can be divided into three major categories depending on the life stage or maturity of the company being supported: venture capital, growth capital and buyouts. Distressed debt and turnaround situations are to be considered separate categories which fall within growth capital and buyouts. Venture capital covers the earliest stages of a company and is often further subdivided into seed, early stage and late stage i.e., from the first concept to the point where the company has developed its first product to the point where the company needs capital to expand commercial operations. Venture capital firms typically focus on identifying emerging industries and invest heavily in many companies in these chosen industries. In most cases these companies will be seeking to commercialize a specific innovation, generally technology-driven. Working closely with talented entrepreneurs, venture capitalists typically use their network of managers to help build the companys management team, and their industry contacts and credibility to promote the companys products, services and interests more broadly. Venture capital backed companies are normally only equity financed as they do not generate sufficient positive cash flows in the early stages to support interest payments on debt. When firms do generate free cash flows, they are typically re-invested into the expansion of the business rather than used to finance leverage.
(2) (3)
Stromberg, P., The New Demography of Private Equity, World Economic Forum, 2008. Walker Guidelines, Disclosure and Transparency in Private Equity, July 2007. http://www.walker-gmg.co.uk
13
For those companies which prove successful, venture capital firms use their experience and expertise to help the company raise further early stage capital, execute an initial public offering (IPO) or complete a trade sale to a larger company, to enable the venture capital fund to exit and return cash to investors, and to give the company an ongoing source of finance. The venture capital sector in Europe invested EUR 15.4bn of equity capital in 2003-07. Growth or expansion capital refers to investments (often minority stakes) in small and medium-sized companies (mostly private but sometimes publicly listed companies), in all industry sectors, to help with specific growth challenges such as entering a new market, developing a new product or making strategic acquisitions. An equally important function is to provide support during the transition from private to public ownership, or from the founder of a business to the next generation. The growth sector in Europe invested EUR 45.1bn of equity capital in 2003-07. Buyouts typically involve mature businesses with strong cash generating potential. These include divestments by conglomerates of peripheral businesses; existing private companies whose owners wish to sell (for succession reasons or otherwise); publicly listed companies; and government privatizations of state sector companies. In contrast to venture capital and growth capital, a change of control generally takes place. The private equity firm and the management team buys out all (or the vast majority of) the shares in the company, and refinances its debt. As the companies are more mature and stable it is common for such transactions to be financed by a relatively high level of debt (typically, around 60% of the transaction value for private equity portfolio companies (4) compared with 21% for the largest European publicly quoted companies (5), and therefore they are known as leveraged buyouts (LBOs). The buyout sector in Europe deployed EUR 184.8bn of equity capital in 2003-07.
Table 1: Ranking buyouts by size of equity capital invested (03-07) in EU
Equity value (Euro Millions)
Equity capital deployed (Euro Billions)
Number of investments
Very large Large Medium Small

Source: EVCA/PEREP_Analytics
> 300 150 - 300 15 - 150 <15
48.5 38.7 76.4 21.2
115 193 1,664 8,283
(4) (5)
S&P Leveraged Buyout Review, Q3 2008. Net debt for the MSCI European 500 as reported by Bloomberg, January 2009.
14
2.
Private Equity Investment Model
The private equity investment model is simple in concept, with the following main elements: Investors. Private equity firms raise money from sophisticated and, predominantly, long-term professional investors. Value creation through active ownership. Private equity firms select portfolio companies in the various stages of development described earlier in which to invest this money and thereby acquire shareholder rights. The financing of the company is restructured to align better the incentives of management and investors and increase the potential for growth and value creation. Representatives from the private equity firm, often highly experienced in the industry of the portfolio company, take a very active governance role in directing the companys strategy and supervising management (though leaving day to day operational control to managers). When the value creation plans have been executed and the companies are ready to move into the next development stage (typically after four years or more), the private equity firm and other shareholders will carefully evaluate the optimum point at which to realise the value built-up in the portfolio company at which point they divest and the company is sold, privately or publicly. Alignment of interest and compensation. Private equity firms charge management fees based on the size of the fund they have raised, and receive proceeds based on how much extra cash they return to investors through portfolio company dividends and eventual sale. In addition, investors require the senior investment professionals of private equity firms to make investments in the fund equivalent to 1-5% of the total fund assets.
2.1.
Long-term investors
Investments in private equity funds are usually large (EUR 50m is common for large funds), and committed (10 years is normal). This means that the investors must have predictable long-term financial liabilities and do not need the short-term liquidity offered by public markets. The majority of investors in private equity are pension funds, insurance companies, endowments, family offices or sovereign wealth funds. Investing in a private equity fund effectively means joining a partnership with other investors and the private equity company. As partners, they may participate in the funds advisory board, and are always fully informed of all its activities and those of its portfolio companies. Prior to investing in a fund, investors conduct extensive due diligence of the private equity firm managing the fund. After completing the raising of the fund, the private equity firm invests the equity on behalf of the funds investors, typically over a three to five year period. Most private equity firms raise new funds every two to four years, typically from the same investor community. The frequent need to raise new funds to be a going concern provides one means of ensuring the private equity funds are serving the needs of their investors. Over the last 30 years an ever larger share of the worlds investments has come under the management of these longterm investors who are in a position to invest in private equity (6). This has been one of two important factors in the growth of private equity funds; the other is that those funds are also allocating a larger percentage of their portfolios to private equity. This is a result of increasingly healthy and long-lived populations, which have put pressure on pension funds to seek higher returns. Median performance from private equity investment is similar to stock market indices, but the stronger private equity firms have consistently offered superior returns (7)(8).
(6) (7) (8)
Gompers, Paul and Andrew Metrick, Institutional Investors and Equity Prices, Quarterly Journal of Economics, 116, 229-260, 2001. Kaplan (Univ. Chicago) and Schoar (M.I.T.), Private Equity: Returns, Persistence and Capital Flows, November 2003. Groh (Darmstad) and Gottschlag (HEC, France), The Risk Adjusted Performance of US Buyouts, June 2008.
15
For a pension fund that is 60% invested in debt and 40% in equities, allocating 10% points of the 40% to private rather than public equities would typically lead to a fund that is 10-15% larger after 10 years (9). As a result, equity capital committed to the industry has increased by 20% per annum over the last three decades. However, European private equity capital under management of around EUR 300bn (including invested and committed capital) is still only around 3% of the market value of all equity capital on European public stock exchanges (10). The availability and willingness of long-term investors to fund private equity activities naturally affects penetration levels, which vary significantly across Europe and tend to be highest as a percentage of GDP in those countries (Scandinavia, The United Kingdom, The Netherlands) where there are long-term pools of capital (notably pension funds). Only more recently, with the arrival of international players, has private equity started to take off in Germany (11).
Figure 1: 1.4% 1.2% 1.0% 0.8% 0.6% 0.4% 0.2% 0.0% The United Kingdom France Greece Poland Hungary Germany Denmark Romania The Netherlands Switzerland Czech Republic Portugal Norway Austria Europe Sweden Finland Ireland Spain Belgium Italy PE investments as % of GDP in 2007 (by country of portfolio company)
Source: EVCA/PEREP_Analytics
2.2.
Value creation through active ownership of investments
Private equity firms conduct extensive due diligence on each prospective investment for the fund, and secure any other financing that might complement their equity investment (e.g., debt or mezzanine). They then act as very engaged non-executive directors to the company, with strong participation in determining the composition of the board, deployment of management incentive systems, selection, support and revision of management teams, development of strategy, monitoring of performance and, increasingly, introduction of best management practices (12).
(9) (10) (11) (12)
10-year impact of 60% debt (at 5% IRR), 40% equity (at 8% IRR) vs 60% debt, 30% equity and 10% private equity (at 15-20% IRR). EVCA Yearbook, 2008. Ibid. Acharya (LBS/Stern), Hahn, Kehoe Jan 2009, Corporate Governance and Value Creation Evidence from Private Equity.
16
This well resourced active ownership differentiates private equity ownership from that of public companies. In the case of mature companies (LBOs): Private equity partners spend three times as much time on their role as the typical public company nonexecutive director and draw on their firms considerable resources for support. They have a much stronger shareholder mandate a private equity firm votes a substantial block of shares as the assigned representative for all investors in the fund. They can execute longer-term strategies free of the pressures of public market reaction, and typically hold their investments for several years (13). The freedom from short-term public market pressure as well as the potential investment gains attract highly qualified managers. Research suggests that active ownership by private equity does indeed lead to better management practices and higher productivity growth. A recently published study of 4,000 manufacturing firms in Europe, the US and Asia showed that private equity owned firms had better management practices than firms under any other type of ownership (14). A second recently published study of US manufacturing firms demonstrates that private equity owned firms increase productivity two percentage points above non private equity owned firms within two years and more than 70% of this outperformance is the result of better management of existing facilities (15). Value creation in private equity is also the result of leverage LBOs are usually financed with higher levels of debt than the typical publicly traded firm. Companies acquired through an LBO also tend to have more stable cash flows than the typical publicly traded company. The relatively high debt levels perform three functions for the private equity firm: they amplify equity returns (and incur greater financial risk, which require thorough due diligence and planning); they can create value due to the tax shield that debt provides; and they focus managers on generating cash from mature companies, ensuring that they focus on economically sustainable growth and avoid unrelated acquisitions or unprofitable product lines (16). A number of studies have looked at the impact of ownership structures on R&D investments, capital investments and disposals, and employment and wages. Research and development. Critics have suggested that high debt levels may prevent some firms from investing in productive investments such as research and development. It is conceivable that this could sometimes be the case, particularly in times of financial distress. However, research shows that private equity owned companies, in general, are more effective investors in R&D than their quoted company peers. A study of 495 firms found that companies that undergo a buyout pursue more economically important innovations, as measured by patent citations, in the years after private equity investment. Additionally, the patent portfolios of firms become more focused in the years after private equity investments (17).
(13) (14) (15) (16) (17)
The Global Economic Impact of Private Equity Report 2008 Large Sample Studies, World Economic Forum, mean holding period of 49 months for all exited LBO transactions from 1970-2007. Bloom, Nicholas, et al, Do Private Equity-owned Firms have Better Management Practices?, The Global Economic Impact of Private Equity Report 2009. Anuradha Gurung and Josh Lerner, Private Equity, Jobs and Productivity, The Global Economic Impact of Private Equity Report 2009. Jensen, M. C., Eclipse of the public Corporation, Harvard Business Review, 1989 (Revised 1997). Lerner, Josh et al, Private equity and long-run investment: the case of innovation, The Global Economic Impact of Private Equity Report 2008.
17
Asset Stripping. There are concerns that private equity firms engage in asset stripping selling off important parts of their portfolio companies without due regard for the longer term viability of the remaining entity. A company that sells off a non-essential part of its operations at a fair price to a better owner of the activity is acting economically rationally and in almost all cases in the best interests of all parties. Evidence from the US suggests that private equity-owned companies do indeed divest more relative to non-private equity owned firms (18). But it also shows that they acquire more. Similarly, a study of 66 of the 350 UK deals whose value exceeded EUR 100m (1996-2004) showed that, while there were significant divestments in 13 of the deals, 16 involved significant acquisitions by the portfolio company, the balance of 37 deals had neither significant acquisitions nor divestments(19). So the evidence is that private equity both divests and acquires more i.e. reconfigures the companies they own with a view of enhancing their value. Recent evidence from US manufacturing firms supports this hypothesis the combination of acquisition and divestiture in private equity owned firms contributed to over one-third of the productivity outperformance of these firms.
Employment and wages. Private equity creates returns by developing more focussed, better managed, operationally stronger companies with better prospects for long-term development and growth. In early stage investments growth in number of jobs comes gradually as the portfolio company moves from the initial idea stage into production (own or sub-contracted) marketing and sales. In buyouts an acquisition of a portfolio company may initially lead to reductions of jobs. Either because an acquired mismanaged or underinvested company (which is often the case for so called corporate orphans acquired from larger conglomerates) needs to undertake a necessary restructuring by for example closing unprofitable business or product lines to preserve cash and defend its market position in order to guarantee long term survival, or as a consequence of the portfolio company divesting non-core activities to buyers who see these as core businesses. Over time however, as the portfolio company's business grows stronger organically or through acquisition, an increase in the number of jobs will usually follow. The most recent study undertaken in Europe shows that the number of employees of German buyout companies increases by 4% between the time before the buyout and the time of divestment by the private equity firm (20). US data also suggests an early dip in employment growth relative to non private equity owned firms, followed by a return to average industry growth in net employment. However, this net effect is the result of more gross job destruction combined with more gross job creation. US data also suggests that private equity firms share productivity gains with workers in the form of higher wages, and that the correlation of wage increases to productivity increases is slightly higher in private equity owned firms (21). Overall, it is probably the case that private equity leads to more re-configuration of jobs (more hiring and firing), fewer supervisory layers, and greater productivity. This reconfiguration of jobs has so far been compensated for by stronger growth in private equity-owned firms relative to peers. The positive effects of private equity ownership appear to be durable recent US research shows for exits via IPO, firms that were formerly private equity owned outperform their contemporaneous IPOs for the three to five years following the exit(22). UK research finds that similar effect in the first year (23) suggesting that the private equityinduced dynamic stays with the portfolio company for some time.
(18) (19) (20) (21) (22) (23)
Davis, Steven et al, Private equity and employment, The Global Economic Impact of Private Equity Report 2008. Acharya (LBS/Stern), Hahn, Kehoe, Corporate Governance and Value Creation Evidence from Private Equity, 2009. Source: BVK 2009. More information available at http://www.bvkap.de. Anuradha Gurung and Josh Lerner, Private Equity, Jobs and Productivity, The Global Economic Impact of Private Equity Report 2009. Cao (Boston) and Lerner (Harvard), The Performance of Reverse Leveraged Buyouts, October 2006. Levis, M, The London markets and Private Equity backed IPOs, Cass Business School / BVCA, 2008.
18
Within venture capital investing, value is created in portfolio companies mainly through nurturing innovation-driven growth. Research has shown that venture capital backed companies grow employment, sales, and assets faster than comparable firms without venture backing (24). Faster growth is often driven by innovation. This is reflected by high spend on research and development, which for a venture-backed company is on average nearly six times higher per employee than with mature firms (25). Venture capital firms are able to support portfolio companies in their innovation-led growth by bringing experience and expertise in supporting growing firms and commercialising new technologies and business models.
2.3.
Alignment of interest and compensation
The inherent strength of the private equity investment model is that it is based on the very clear alignment of interests between private equity firms (General Partner GP), their investors or Limited Partners (LP) and the management teams they support. Success or otherwise of the private equity investment is determined at the sale of all or a large part of the portfolio companys equity (the exit) via IPO or private sale. It is a basic principle of private equity investing that returns are achieved through realised gains that are made once an investment is sold not by market valuations. Specific arrangements can vary but a common model is for the private equity firm employees to keep 20% of the difference between the amount initially invested and the amount realised in the fund at the end of the 10-year lifetime of the fund and distributed to investors (known as carried interest or more commonly carry) but only once a threshold of the long term equity market return (usually 8%) is surpassed for the whole fund. As mentioned above, the private equity firm itself typically subscribes 1-5% of the funds capital. Investors believe these arrangements help to align their interests and those of the private equity firm, specifically because rewards accrue based on success in delivering returns, not success in agreeing new investments. Likewise the rewards of private equity portfolio company managers are seen by investors as better aligned to their interests than in other forms of equity investment. Most private equity firms insist on extensive ownership by senior managers and employees. Individual portfolio company executives must co-invest considerable equity stakes in the portfolio company from their own resources and are typically rewarded through option or other incentive arrangements. Private equity firms believe that offering the potential of substantial investment rewards is essential to attract the entrepreneurial calibre of manager needed to execute the strategies of value creation on which their business model is based. However, while the investment rewards for success may be attractive, it is rare for managers of portfolio companies to be offered significant contractually guaranteed compensation irrespective of the performance of the company. In contrast, the rewards of the CEOs of major companies are (typically) not correlated with shareholder returns but, rather, with company size. It is also not uncommon for compensation arrangements to include generous severance terms which tend to be seen by many outsiders as rewards for failure when they are triggered. And the non-executive directors of public companies are usually awarded a flat fee consistent with their major de facto role of overseeing compliance with the rules of the financial marketplace, not driving performance (26). In addition, the typical recurrent cash inflow for the private equity firm is an annual fee of 1.02.5% (depending on fund size) of the funds committed designed to pay running costs and base salaries.
(24) (25) (26)
Alemany and Marti, Unbiased estimation of economic impact of venture capital backed firms, March 2005. Achleitner and Klockner, Employment contribution of Private Equity and Venture Capital in Europe, EVCA, November 2005. Michael Jensen and Kevin Murphy, CEO Incentives Its not how much you Pay, but how.
19
3.
Private Equity Distinct from Other Alternative Assets
Hedge funds, real estate funds, infrastructure funds, debt funds and commodity funds also raise private money or private equity. However, private equity is very different from such funds. Most obviously, they all invest in different things. Private equity invests, largely, in unlisted (and therefore illiquid) companies equity where it usually (alone or together with like-minded investors) will acquire a majority stake. Real estate funds invest in various classes of property and sometimes property-related securities, debt funds in private and listed debt participations and hedge funds typically take minority positions in heavily traded, highly liquid securities in public companies, currencies and commodities. There are also a number of highly important structural differences between private equity and these other types of funds, particularly hedge funds: Private equity typically has funds committed for some 10 years from its investors without redemption capacity whereas hedge fund investors can normally redeem their money at the end of each quarter. Private equity firm performance fees are predominantly earned only from the cash returned to investors (beyond a threshold annual return) via a combination of proceeds from investment sales and/or cash dividends. Hedge funds typically recognize profits (and associated performance fees) yearly (or more often) based on the spot market value of the assets held. Furthermore, the focus and behaviour of private equity and hedge funds are different: Hedge funds use their marketable assets to raise debt for the fund in order to buy even more assets, thereby amplifying returns (if their investments increase in value). Hedge funds can carry leverage from 10 to 50 times their investors equity. While private equity firms do not leverage investors equity in the fund, leverage in the portfolio companies is typically two to three times equity value in the buyout sector. Hedge funds are structured to have a shorter term perspective; to allow them to trade shares freely, they typically do not join the boards of their portfolio companies. Hedge fund assets are re-priced very frequently several times a day sometimes so hedge fund managers focus more on short term price movements than on long term value creation. Private equity firms on the other hand have limited sensitivity to short term stock market prices and expect to stay invested for several years in a company. They typically join the portfolio company board and are actively involved in directing the company. More broadly, hedge funds typically seek to profit from pricing anomalies (often of a technical and transient nature) in public securities and commodity markets. In so doing they make securities markets more efficient and liquid. Private equity firms seek to make superior returns by enhancing the fundamental value of the private companies in which they invest through improved strategy, operational performance and capital structure.
3.1.
Recent dynamics and outlook
3.1.1. Venture capital and growth capital Through the late 90s venture capital investments were dominated by internet technologies and services until the 2001 collapse. Investments have increased gradually since 2003, returning to pre-bubble levels. Hi-tech (31%), life sciences (16%) and energy (11%) are the top three sectors for early stage investments.
20
Since the dotcom bubble burst there have been far fewer opportunities to realize the value of successful venture capital investments by floating the company via an IPO. With this route closed, trade sales have become the predominant way for venture capital companies to exit their investments profitably. Increasingly too, as their portfolio companies have grown, venture capital companies have found themselves owning and financing larger companies and effectively moving into the growth area of the private equity space. The venture capital industry does not expect the IPO market to re-open for portfolio companies until 2010 or beyond, suggesting a very difficult year for exiting investments in 2009. However, growth capital is likely to be an important source of funds in the coming years for companies with concrete expansion opportunities due to the decline in available bank financing brought about by the financial crisis. This in turn will create promising investment opportunities for venture and growth firms with available capital. 3.1.2. Buyouts Not surprisingly, private equity fundraising follows the equity market cycle. During boom times, funds committed expand and new private equity firms enter the market. As equity markets fall, so too do the available funds for investors to allocate to private equity. The credit boom has allowed private equity firms to finance bigger and bigger acquisitions: so-called megadeal leveraged buyouts, increasingly involving companies listed on public markets (27), accounted for 25% of LBO capital deployed in the EU in 2007(28). Some very large companies (with an enterprise value greater than EUR 5bn) have been financed and are now being governed by private equity firms. The freezing of the debt markets however has sharply reduced the scope for leveraged buyouts in mature cash generating companies. Rather than working on new investments private equity firms are now focusing more on supporting the management of their portfolio companies through the current economic difficulties. It is still too early to tell how deep these difficulties are; however, it would not be surprising if private equity firms have had just as much difficulty as other companies in judging how to play the recent credit boom. Some portfolio companies might, in view of the steep downturn, find themselves carrying too much debt as demand for their products contracts or customers are unable to meet their obligations and will be having difficulties in servicing their debt as profits decline. Clearly it is not in the interests of private equity firms, nor of lenders to their portfolio companies, to allow viable businesses to go under, and the former have certain advantages in the current situation: they have the time, expertise and shareholder voting mandate to support highly leveraged companies; they can shield their portfolio companies from volatile stock markets, short selling, speculation etc during the downturn and help them focus on operational and strategic optimization; and they have capital the industry as a whole is estimated to have $472 bn (29) worldwide in capital committed but not yet invested at the end of 2007, and some firms are currently injecting further equity where there is real prospect of recovery, sometimes in exchange for lenders reducing the face value of their credits and converting them partially into equity.
(27) (28) (29)
The Global Economic Impact of Private Equity Report 2008 Large Sample Studies World Economic Forum. EVCA/PEREP_Analytics. Deals over EUR 300 million equity value. Private Equity Intelligence.
21
Private equity portfolio companies are unlikely to be financed with as much debt as they have been recently. The key to the industrys future will be to find new ways to invest committed money at their disposal which deploy private equitys key competitive advantage better governance on behalf of long term investors. Like in other downturns, the coming years will likely be a good time for private equity firms to make investments or pick up strategic add-ons for their portfolio companies as valuations come down. In addition, several buyout firms possess significant experience and successful track records at investing in distressed companies during economic down-cycles, purchasing already leveraged balance sheets that require equity injections, sometimes accompanied by operational restructuring. In performing these investments, buyout firms perform a valuable counter-cyclical investment role when equity capital is very scarce.
22
1.
Introduction
The paper analyses the risks which could be specifically caused by the Private Equity investment model both to the participants and stakeholders in Private Equity and to the Global Financial System. The first sections of the paper analyse the nature and extent of specific risks arising as a result of the Private Equity model. The final section examines whether there is a clear and demonstrable cause-effect relationship between the Private Equity model and Systemic Risk (both Extrapolated Participant Risk and Natural Systemic Risk) and in particular seeks to answer the following questions: Does the Private Equity Firm play a material causal role in the liquidity crisis either as provider or consumer of finance? Does the Private Equity Firm play a material, previously uncontrolled and misunderstood, causal role in the transmission of stress between other participants in the Global Financial System? Private Equitys fundamental strategy is to deliver cash returns to Investors by increasing the value of the Portfolio Companies it acquires. A Private Equity Fund makes investments to hold and develop for 3-7 years. Private Equity investments are illiquid they cannot be easily sold or traded. A Private Equity Fund does not trade in and out of complex positions such as quoted securities or derivatives. Private Equity Investors commit for the lifetime of the Fund (typically 10 years). Unlike a Hedge Fund, Private Equity Investors are not entitled to redeem their investment or cancel outstanding Commitments before the end of the Funds life. A Private Equity Fund carries out extensive financial, legal and commercial due diligence on a business and the sustainability of its projections before investing. In contrast, funds investing in short-term complex or quoted securities will have little information on the underlying business or access to management to inform its investment decision. Private Equity Funds will only draw-down cash from Investors when needed to invest or pay fees and do not hold Investors cash for any significant period of time. In contrast, funds making short-term investments usually receive all of an Investors commitment up front. A fundamental principle of Private Equity is the alignment of the participants interests and risks through the value chain the Manager (and its executives) with the Investors and the Fund and the Fund (and therefore the Investors, the Manager and its executives) with the Portfolio Group, its employees and (if applicable) its Lenders. A Private Equity Manager and its executives invest their own money in the Fund (typically 1-5% of total Investor Commitments) alongside the Investors. They only receive Carried Interest once enough of the Funds investments have been sold for a sufficient gain for the Investors to actually receive back the amount they invested plus an additional return of typically 8%. To align the interests of the Portfolio Company and the Fund, key employees of the business take equity in the Portfolio Company (typically 30-60% of the equity in venture Capital or Growth transactions and 5-20% in Buyout transactions). These employees have a substantial interest in the sustainability and success of the Portfolio Company. While a significant amount of this equity will be held by the business senior management, the Manager will generally encourage this equity to be shared with more junior employees who are key to the performance of the business.
23
The Managers fee is not calculated on unrealised asset values but on fixed commitments or cost of remaining portfolio companies held by the fund. Carried Interest is not paid on unrealised gains in the books of the Fund but out of cash proceeds. In contrast, a Hedge Fund typically pays regular returns to the manager of the fund not just on the disposal of its assets. The returns are generally calculated on the net asset value of both realised and unrealised assets. Investments which have not yet been sold are deemed to have been sold for a profit that then counts towards the calculation of the amount to be returned. A Private Equity Fund does not borrow from banks to leverage itself (other than short-term bridge financing by some Funds) and does not use prime brokers to provide leverage against the security of the Funds assets.
2.
Specific Risks
The exposure of the following participants and stakeholders to Market Risk, Credit Risk, Counterparty Risk, Operation Risk, Financing and Liquidity Risk, Group Risk, Fiduciary Risk and Legal and Regulatory Risk as a result of the Private Equity model is analysed below: The Fund The Investors The Manager The Lenders Portfolio Group Civil Society
Where the potential for risk is identified, the risk management strategies available are highlighted.
2.1.
The Fund
Like any investor in a private company, the Fund is exposed to Market Risk if it incurs a loss on the investments it makes. This risk is faced by any investor in a private company and is not unique to Private Equity. The Manager carries out and obtains extensive financial, commercial and legal due diligence on a business before investing in it. The Manager also develops detailed projections and plans for the business with management and stress-tests them. The alignment of the interests of the Fund and the senior employees of the business gives the Fund comfort about the validity of the projections and plans. Unlike investments in public companies, Private Equity investments are bespoke transactions in which the commercial terms and legal protections for the Fund are heavily negotiated. The Funds liability in relation to its investment is usually limited to the amount it invests. The Fund further mitigates its risk through diversification of its investments. A Buyout Fund typically makes between 8 and 12 investments and a Venture Capital Fund between 20 and 40, in each case over a five-year period and at different stages of the economic cycle. During a market down-turn, a Private Equity Fund can hold onto its investments until the market recovers and the Fund can sell at a profit reducing its exposure to forced sales.
24
The Fund is exposed to Credit Risk that (i) the Portfolio Group will not repay the monies lent to it by the Fund; (ii) the Investors will breach their contractual obligations to pay their Commitments when requested; or (iii) like any business, the bank which holds its funds will become insolvent. When the investment is made, the Manager aims to protects the Funds position with the Portfolio Group through extensive due diligence and assessment of its ability to satisfy its debts to the Fund. Through the life of the investment, the Manager monitors the ongoing financial needs of the Portfolio Group through board representation and reviewing the detailed financial information it receives regularly. In relation to Investors, the Manager carries out due diligence (including Anti-Money Laundering checks) and credit assessments on prospective Investors when they join the Fund and continues to monitor their financial status during the Funds lifetime. There are usually serious consequences for an Investor under the Limited Partnership Agreement if it fails to satisfy its commitments (i.e. loss of all amounts previously invested in the Fund). Standard Private Equity investments do not carry the same Counterparty Risk as market transactions that there is a counterparty failure after the trade is made but before settlement. A standard Private Equity transaction is literally over the counter with delivery of securities taking place when monies are paid. If there is a period of time between entering into the contractual commitment and consummating the transaction, the Fund should ensure that under the legal documents it is only required to pay cash when all other sources of acquisition funding have been paid over. The acquisition vehicle being used will be obliged to pay money to the sellers of the business not the Fund or the Manager. In recent years, sellers on larger transactions have tried to mitigate their Counterparty Risk by obtaining legally binding covenants from the Fund to put the acquisition vehicle in funds. In such circumstances, the Manager and the Fund will potentially have Counterparty Risk and Financing and Liquidity Risk from default by the Investors and (if bank finance is being used) the Lenders. The Manager can mitigate this by (i) organising the draw-down from Investors in advance or arranging bridging financing; and (ii) ensuring the Lenders are contractually obliged to provide financing if the acquisition vehicle is obliged to complete. The Fund will not usually have a separate independent existence. Its activities are performed by the Manager. Therefore, the Fund could only suffer a loss if an Operational Risk arose at the Manager level which affected the value of the Funds investments see below. Before committing to a Fund, Investors will carry out due diligence on the Manager, its track record and how it has operated previous Funds it has managed. During the life of the Fund the Investors generally have the contractual power to replace the Manager for cause. It would be unusual for a Buyout Fund to be contractually obliged to provide further funding to a Portfolio Group. Some Venture Capital Funds may be obliged to invest more money if developmental milestones are met by a business but this money will only be drawn-down from Investors when the milestones are achieved. The Investors interests in the Fund are not redeemable and so the Fund does not have obligations to fund redemption requests. There is no commercial requirement for a Fund to hold any liquid assets and therefore such Liquidity Risks are not generally relevant to Funds.
25
The Fund could be exposed to Financing and Liquidity Risks such that (i) if the Portfolio Group cannot meet its liquidity or financing needs there will be losses to the Funds investment; or (ii) if bridge financing is used to pay for investments (given the uncertain timing of private company investments it can be administratively easier to use bridge financing rather than predict when Investors money will be needed), either the lender fails to provide the financing or the Investors fail to pay their Commitments. It is in the Funds and its Managers control to manage this risk by organising Investors payments and assessing the Investors credit position. Funds typically also impose sanctions on investors for not meeting capital calls. The Fund is dependent on the services provided by the Manager and therefore is indirectly affected by any Group Risks to which the Manager is exposed. The Fund is exposed to Fiduciary Risk because its assets are managed by the Manager, its investments are usually held by a custodian (often also the Manager) and any cash is held in a bank account pending distribution. The Investors should ensure that the Fund is using an investment manager and custodian which are subject to and comply with effective oversight and proper professional standards. As in any business, fraud can never be completely safeguarded against. Legal and Regulatory Risk can prevent Funds based in certain jurisdictions or with certain structures from purchasing target businesses. It is open to the Fund not to invest in that sector or jurisdiction.
2.2.
The Investors
An Investors investment in a Private Equity Fund is illiquid and long term. Investors realise value in their investment by sharing in the proceeds when the Fund sells its investments. An Investor in a Private Equity Fund is not able to redeem its investment in the Fund and the consent of the Manager is usually needed if an Investor wants to sell its interest. There is no registered market through which interests in Private Equity Funds are sold. The only way an Investor could realise its interest before the end of the Fund is to sell it in a bespoke off-market transaction. Therefore the major Market Risks for Investors are generally those faced by the Fund in which they invest see above. The amount an Investor has to contribute to a Fund is fixed when it joins and therefore the Market Risk to the Investor should also be fixed. At no time can any change in the market affect the quantum of an Investors risk. The Investors could face a Credit or Counterparty Risk against the Fund in respect of the payment of dividends or profits on the sale of investments to Investors. However this should probably be seen as a Fiduciary Risk that an intervening fraud or similar prevents the Investors from receiving monies which the Fund has received. Like anyone, Investors are exposed to the Credit Risk that the bank in which the Fund holds cash could fail. Investors are not usually exposed to the Credit Risk of the Manager because it does not normally hold the Funds assets or money. Investors Operational Risks do not relate to the fact that they are an Investor in a Private Equity Fund.
26
Institutional Investors often have internal limits on the amount of assets they may allocate to a particular investment i.e. class-quoted securities; bonds; private equity; real estate etc. Unlike other asset classes, an Investor commits to provide capital to a Private Equity Fund over a long period of time and the timing of the returns it will receive back are unpredictable. These potential Liquidity Risks are typically addressed through internal management and expertise within the Investor. Institutional Investors usually allocate a relatively small amount to Private Equity because of its higher risk profile. Nonetheless, investment in Private Equity is necessary to provide diversification for Investors and drive their returns. Also, Private Equity allows many Investors considerable opportunity to negotiate the terms of their investment with the Manager. Group Risk would only apply if the Managers business was disrupted due to the Group Risks it faces see below. Given that Portfolio Companies tend to be private companies, Investors do not generally receive price sensitive information in relation to the Funds or the Managers activities and so should not be exposed to Market Abuse Risk. Investors face a Fiduciary Risk that the Manager or its executives might have a conflict between their own interests and those of the Fund. Potential Investors undertake extensive due diligence on Managers and their key executives and Managers and Funds are regularly subject to external audits. Most Investors are themselves regulated and will have to meet a standard of due diligence in selecting Managers. Investors usually receive regular and detailed financial information on the Funds performance and investments which allows them to monitor activity. Most Funds have Advisory Committees made of Investors representatives which address any conflicts of interest. Investors can use their considerable negotiating power to ensure that the Fund (particularly the Carried Interest and any co-investment) is structured properly to prevent cherry-picking of good investments by the Manager. Legal and Regulatory Risk can prevent Investors located in jurisdictions which impose disproportionate requirements on Managers or place restrictions on amounts that can be invested in certain asset classes, from investing in a Fund.
2.3.
The Manager
Managers do not trade as principals and the concept of trading books and the Market Risks associated with them do not apply to Managers. A Managers main income is the Management Fee from the Funds it operates. This fee is funded through draw-downs from Investors or out of realised profits in the Fund. During the first half of the Funds life, the fee is calculated on the total amount of Investors Commitments not the value of the Funds assets. In the latter half, it is calculated at the cost of the Funds residual investments. Therefore, the Managers income has little exposure to Market Risk through the fluctuations in values of assets or liabilities. The Fund is contractually obliged to pay the fee to the Manager and the Investors are contractually obliged to provide the Fund with capital to do so. If a Managers assets and liabilities (e.g. staff or property costs) are denominated in a currency different to the currency in which its fees are paid, it may be exposed to exchange rate risk. Private Equity Houses tend to be funded wholly by their owners rather than borrowings so the Manager is only likely to have a small interest rate risk. Like any business, the Manager can use standard hedging techniques in order to manage these risks.
27
In order to align their interests and the risks Investors will require the Manager and its executives to invest in the Fund usually between 1-5% of the Funds Commitments. The Manager therefore is exposed to risk in the valuation of the Funds Portfolio Companies in the same way as the Investors see above. A Managers ability to raise a new fund from Investors will usually depend on the performance of its previous Funds and the strength of the fund raising market. Both may be impacted by market fluctuations. The Managers principal Credit Risk is its direct exposure to the Fund and indirect exposure to Investors in respect of payment of the Managers fee. The failure of one Investor to meet its Commitment to the Fund is unlikely to have a significant impact on the Managers aggregate income. As operator and manager of the Fund, the Manager can mitigate this risk because it controls payments by the Fund. The risk that Investors will not have the financial resources to meet their Commitments is generally managed through credit assessment and due diligence on Investors when the Fund is established and continuing monitoring. The Limited Partnership Agreement usually provides for significant consequences if an Investor fails to meet its obligations to provide funding. A Manager would not usually have Counterparty Risk because it enters into transactions for the Fund as its agent and therefore the Fund rather than the Manager has the liability. Although the Manager is not directly exposed to the Portfolio Companies, their failure will ultimately impact on the return the Manager and its executives receive on their investment in the Fund through the Carried Interest. If a Portfolio Company fails this will impact the amount of the Managers fee in the latter part of the Fund when it is calculated on the Funds residual asset cost. A Manager faces a range of Operational Risks such as (i) business continuity risk; (ii) IT security and processing risk; (iii) departure of key executives; (iv) failing to follow the Funds investment strategies; (v) execution and delivery and processing of investments; (vi) outsourcing risk; (vii) compliance risk for regulated managers; and (viii) reputational risk. Like any business, a Manager can mitigate these risks through operational procedures and controls such as (i) business continuity planning; (ii) regular audits of IT security; (iii) contractual arrangements with executives that tie their gains to the end performance of the Fund and the actual return received by Investors; (iv) extensive due diligence on potential investments and heavily negotiated investment and acquisition documentation in order to safeguard the Funds interests; (vi) robust internal procedures which have to be complied with before making an investment (including stress-testing the commercial rationale for the investment); and (vii) internal compliance procedures and personnel to ensure all applicable regulatory requirements are identified and satisfied. A Manager has a straightforward Financing and Liquidity Risk profile. Its principal income is the Management Fee which is predictable and reasonably secure. Its principal expenses are employment and property expenses, which are also predictable and largely in the Managers control. Rather than a bonus culture, its executives share in the Carried Interest which is not an expense for the Manager. The predictability of the Managers fee contrasts with other managers of investments in quoted securities whose fees vary depending on the level of investor redemptions. The principal Financing and Liquidity Risk is that the Manager will not be able to raise its next Fund because it failed to make enough profit for Investors or the fund raising market is difficult. A Manager will know in advance if it can not raise a new Fund and can plan and manage its expenses accordingly.
28
If the Manager is part of a wider group of companies it may depend on other group members for common services and, depending on the nature of the group, may be exposed to Group Risk if the rest of the group has financial difficulties. Historically Private Equity Firms have been sold by such larger groups to their own management. Like any business, the Manager is at risk of internal and external Financial Crime Risks and the risk that third parties from which it receives funds or which it invests in are money launderers. Such risks can be dealt with through internal controls and audits and complying with the relevant anti-money laundering legislation. The Manager is exposed to the Market Abuse Risk that it, or its staff, will (deliberately or inadvertently) reveal or disseminate inside information and deal in securities in respect of which it has inside information or in a manner which is considered abusive. These risks can be managed by (i) proper training of employees; (ii) putting in place the relevant policies and procedures; (iii) monitoring transactions the Manager is involved in; and (iv) the Manager, its advisors and providers of finance entering into non-disclosure agreements in relation to a potential transaction. The Managers main Legal and Regulatory Risk is that it can not carry on its business in a particular jurisdiction or that the costs of doing so are disproportionately high. Such risks are not unique to Managers of Private Equity Funds.
2.4.
The Lenders
The Venture Capital and Growth Capital sub-sets of Private Equity typically do not use leverage when investing and therefore this section is not relevant to their transactions. Venture Capital and Growth Capital make up the largest proportion of Private Equity in number of firms and volume of transactions. All providers of finance have risks arising in the normal operation of their business which do not arise particularly because of Private Equity funding or management. Lenders to Private Equity backed transactions lend only to the Portfolio Group not the Fund. Lenders rarely take an equity stake in the Portfolio Group to which they lend so they rarely have a Market Risk. If a Lender takes a warrant to subscribe in the future for equity, the exercise of the warrant is entirely within the Lenders control. If the debt in a Portfolio Group is bought and sold, the holder of the debt will have a Market Risk if the debt is trading below par. This risk arises in all lending not just lending to Private Equity backed business. Lenders typically mitigate this risk by spreading their lending over many companies. If the debt is heavily traded there can be issues for market participants in identifying the owner of the economic risk. If the interest rate being paid on the Lenders debt does not reflect the Lenders actual cost of lending, the Lenders will have an interest rate risk. This is relevant to all bank lending not just to Private Equity backed businesses. The Lender has a Credit Risk of default by (i) the Portfolio Group; (ii) the Fund and the Investors if providing bridge funding to the Fund and Investors fail to satisfy draw down demands; or (iii) other Lenders to the Portfolio Group. If a Lender is part of a syndicate or club of lenders to a business, a default by another Lender could give the business cash flow problems and increase the Lenders Credit Risk. If the Facility Agent in the group of Lenders becomes insolvent additional Credit Risk could result. These risks arise from Lenders structures for spreading risk and are not unique to lending to Private Equity backed businesses.
29
Some transactions in recent years (particularly in the UK and US) have used relatively light banking covenants. This can be very advantageous for the Portfolio Group allowing them to trade through difficult times without risk of foreclosure by a Lender. They may have an adverse impact on the ability of a Lender to take pre-emptive action to prevent losses increasing. The Lenders risk to Private Equity businesses is the same as to any business and the Lenders protection is driven by their own credit risk procedures. Lenders manage their risk to the Portfolio Group through detailed credit assessments and due diligence, taking security and entering into heavily negotiated legal documents to give them adequate protection. They can also purchase credit default swap protection against the risk of default. Loans to Portfolio Companies are medium to long-term and illiquid and therefore the Lenders are exposed to Financing and Liquidity Risk. Lenders can spread the risk by putting together syndicates to hold the debt or selling part of the loan commitment. The current financial environment has significantly reduced the market for and value of syndicated loans. The aggregate amount lent to Private Equity backed companies represents only a small percentage of the European banks assets (30). A significant number of Private Equity backed companies would need to become insolvent in order to have a significant effect on Lenders. Lenders to Portfolio Companies typically take security and in the event of default are in control of whether the business should be declared insolvent or continue trading. The UK FSA has noted that the increasing levels of leverage in some Private Equity transactions could affect the viability of the borrower. However the FSA agreed that increasing leverage was not necessarily correlated with declining credit and risk management standards. The increased leverage was available to all businesses and was not driven by Private Equity Firms. Regulated Lenders must hold regulated capital against their loans. If regulations change or Lenders are prohibited from mitigating their risk (through sub-participations, credit default swaps etc.) Lenders may be unable to mitigate the risk of their loans or realise liquidity in them.
2.5.
Portfolio Group
All companies have risks arising in the normal operation of their business which do not arise particularly because of Private Equity funding or management. In most Buyout investments, the Portfolio Group does not have to pay any dividends or interest on the Funds loans or equity until the Lenders debt has been repaid. Obligations to pay dividends or interest are not usually based on floating interest rates, so there is little exposure to Market Risk. Like any business, any exchange or interest rate risk the Portfolio Group has in relation to bank debt can be managed through hedging techniques. If there is disruption within the Portfolio Groups club or syndicate of Lenders because one has become insolvent or is unable to meet its obligations the Portfolio Group could be exposed to Credit Risk see above.
(30)
The ECB estimates this share to be less than 1%. Source: European Central Bank, Monthly Bulletin, Leveraged Buyouts and Financial Stability, August 2007, p. 89-98.
30
Like any business, the Portfolio Group will require debt financing for day-to-day business activities and to make acquisitions. If the debt is not available, or there is a significant rise in interest rates the Portfolio Group could face Financing and Liquidity Risk. With Venture Capital investments, the Portfolio Group may need the Fund to provide on-going funds to continue developing the business. Therefore the Portfolio Group has a potential Credit Risk in relation to the on-going ability of the Fund to provide financial support (and an indirect exposure to the Investors). Increases in the amount of available finance observed over the last years and relatively low interest rates and the current general downturn in the world economy could mean that some businesses may be considered over-leveraged compared to the current value of their assets or EBITDA (earnings before interest, tax, depreciation and amortisation). These factors apply to all individuals and businesses and are not unique to Private Equity backed companies. Acquisition financing is not typically used in Venture or Growth Capital transactions. Due to current reduced trading and the closure of traditional credit markets, Portfolio Companies may have insufficient cash flow to meet their needs. Private Equity Funds can provide additional funding to the business quickly. The Fund will usually be the largest unsecured creditor after the Lenders and therefore its interests will often be aligned with the Portfolio Group, its employees and other unsecured creditors in keeping the business going and from becoming insolvent. If a Portfolio Company is part of a group, the Lenders will usually require that all substantial entities within the group guarantee the borrowing companys liabilities to the Lenders, exposing them to Group Risk. This is a usual requirement of secured bank facilities and is not specific to Private Equity. A Portfolio Company and its employees may have price-sensitive information if involved in a transaction involving a relevant security exposing it to Market Abuse Risk. Training, restriction on information flows and internal procedures should help manage such risk. Where a representative of the Fund/Manager is a director on the Portfolio Companys board, there could be a conflict of interest between the interests of the Fund as a shareholder and the individuals personal responsibility to the Portfolio Company as a director, exposing the company to Fiduciary Risk. The potential for such conflicts occurs in any company where the shareholder is represented on the board and the relevant jurisdictions law will govern all such conflicts. Portfolio Companies are generally private companies. If they become subject to additional legal or regulatory requirements because they are owned by Private Equity Funds, this will impose an additional cost on the company. If these costs and requirements do not apply to all private companies, Portfolio Companies and their businesses will be unfairly prejudiced. If this occurred, a seller may choose not to sell its business to a Private Equity Fund or a Manager may choose not to invest in a particular jurisdiction.
2.6.
Civil Society
Civil Society for these purposes is the collection of individuals and classes of individuals as determined by their sense of belonging (together with their official and unofficial representative groupings) which taken as a whole compete and collaborate to form the system of interaction between people that is the world in which we live.
31
Five particular sections of Civil Society and the Systemic and Specific Risk profile of Private Equity in relation to them are identified here: (i) fiscal authorities; (ii) health and safety authorities; (iii) environmental protection authorities; (iv) workers/ employees; and (v) suppliers. Each section is considered in isolation for the sake of simplicity however there are considerable systemic inter-relationships between the different sections and inevitable tensions between their potentially competing objectives. In each instance the sections significant interaction with the Private Equity industry will be with the Portfolio Group and it is therefore this relationship which is examined. The Private Equity Funds objective to realise a return on its investment in each Portfolio Company for its Investors will potentially compete with the objectives of certain sections of Civil Society. The fiscal authorities objective to secure and maximise the revenue stream for the government of the nation state could create tension between the Portfolio Groups objective of legally minimising its contribution to the tax take. The risk for the fiscal authorities is that through deliberate action or error the Portfolio Group pays less tax than is legitimate. This risk is the same for a Private Equity backed company as it is for any other company within the fiscal authoritys jurisdiction and the fiscal authorities mitigation procedures for this risk are therefore the same. The health and safety authorities objective is to ensure that businesses are operated in a manner that protects the general public and employees and that environmental cost (pollution) is borne by the polluter. All businesses have an environmental footprint. All businesses have to balance the cost of such processes and controls against the profitability and sustainability of the business for its employees and shareholders. The Managers due diligence exercise before making a Private Equity investment will often scrutinise the businesses compliance with health and safety and environmental regulations. In addition, Private Equity has (i) invested in a whole new asset class of so-called clean technology which specifically attempts to reduce the environmental impact of Civil Society; and (ii) because of the increasing environmental protection burden imposed on businesses, developed strategies to create value by acquiring unclean businesses and improving them in terms of their environmental impact. When a Private Equity Fund acquires a company it must abide by all laws in the relevant jurisdiction, like any other company. It is not able to terminate workers employment or change the terms of their work contracts. If the Private Equity Fund acquires assets (rather than a company) the Transfer of Undertakings (TUPE) legislation in the relevant jurisdiction will apply in the same way as to any buyer. A Private Equity Funds aim is to increase the stability and value of the business it acquires and grow it. This strategy should be beneficial for both employees and wider Civil Society as the companys stability increases and more jobs are created. While there is conflict in all businesses between maximising the rewards to workers/employees and maximising profitability and return to investors, employees are a key part of increasing the value of the Funds investment and there is no incentive for the Fund to behave inappropriately towards workers/employees and is indeed prevented from doing so by law. Many of the Investors in Private Equity Funds are pension funds with very high ethical standards. They expect their investment managers to have the same standards. Breach of legal obligations in a Portfolio Group or publicity around inappropriate behaviour towards workers/employees will be very damaging to the Managers ability to raise future funds.
32
As discussed above, alignment of interests between the Private Equity Fund and the Portfolio Groups employees is key to the Private Equity model. A Fund makes equity available to key employees of the business it invests in and wants employees throughout the business to be incentivised to develop and grow the business and its value. This is beneficial for the Fund, its Investors, the employees and the Portfolio Companies. Suppliers to Private Equity backed businesses aim to maximise their returns at the expense of the business just as the business aims to minimise the amount it must pay to suppliers for goods and services received. This is the same for all transacting organisations and is not unique to Private Equity. In fact both parties want a relationship in which the price of exchange between them is broadly equitable and sustainable.
3.
Systemic Risk
Systemic Risk is the possibility that: any of the Specific Risks identified materialise to such an extent that it impacts on the wider Global Financial System (Extrapolated Participant Risk); or harm or damage can be done to the Global Financial System because of characteristics of or flaws in that system (Natural Systemic Risk). In relation to the current financial crisis: the Extrapolated Participant Risk is that real and perceived Credit and Counterparty Risk of participants in the financial markets has arisen to such an extent that liquidity has disappeared; and the Natural Systemic Risk is that the ways in which participants in the system transfer stress to each other are not sufficiently understood or controlled. The questions addressed below are: Does Private Equity play a material causal role in the current liquidity crisis as either a provider or consumer of finance? Does Private Equity play a material causal role (which has previously been uncontrolled or misunderstood) in transmitting stress to other participants? If there is no clear and demonstrable cause and effect between the structures and activity of Private Equity and Systemic Risk, further controlling mechanisms specifically aimed at Private Equity are not necessary. Where such cause and effect is demonstrated, any controlling mechanisms need to be proportionate to the level and effect of the risk.
3.1.
Does Private Equity play a material causal role in the current liquidity crisis as either a provider or consumer of finance?
Private Equity Funds are both receivers and providers of finance within the Global Financial System.
33
3.1.1. Recipient of finance All Private Equity Funds (Venture Capital, Growth Capital or Buyout) receive finance in a similar way from a small number of sophisticated Investors (many of which are regulated entities) and the Manager and its executives through the Carried Interest vehicle. These are the only sources of funding for the Fund. Unlike Hedge Funds, Private Equity Funds do not borrow from banks (other than some limited bridge financing) or prime brokers. The Investors make a commitment to provide a capped amount of financing to the Fund over its lifetime (typically 10 years) and they can not cancel this commitment without consequences. A Private Equity Fund does not hold Investors money pending investment it only draws down money when needed to invest or pay fees. Private Equity Funds may face potential liquidity issues if: its Investors have difficulties, unforeseen at the time of their original investment, in meeting their outstanding Commitment to the Fund. The current financial crisis has meant that the Funds risk that its Investors will not be able to satisfy their Commitments because of other losses they have incurred has increased. However, Investors have a contractual obligation to meet these commitments and have an incentive to do so if they wish to maintain a suitable asset allocation to high return investments; or a bank with which the Fund has placed money fails.
As a recipient of finance, a Private Equity Fund does not cause a risk to liquidity it is potentially affected by it. 3.1.2. Provider of finance Private Equity Funds are also providers of finance. The Venture Capital and Growth Capital sub-sets of Private Equity (which are the largest proportion of Private Equity in terms of number of firms and volume of transactions) do not usually use leverage when investing. Therefore the issues below are largely only relevant to Buyout investments. Financial institutions will usually provide debt financing to the Portfolio Group. If the amount lent is unsustainable the Fund can be exposed to a Credit Risk in relation to its equity investment in the Portfolio Company. Therefore, like any business if the Fund and the Portfolio Companys management team miscalculate the sustainable amount of leverage the business may be at cause of Credit Risk. The aligned interests and risks of the Fund, the Portfolio Groups management and the Lenders helps to protect the Portfolio Group against an unsustainable amount of leverage being taken on and ensures the participants continued commitment to the investment. If the leverage in a very significant number of Private Equity backed businesses became unsustainable at the same time, this potential Credit Risk could lead to a Systemic Risk. Given the diversity of Private Equity investments across industries and the different lifecycles of Portfolio Companies this is unlikely. Private Equity backed businesses are affected by unsustainable amounts of leverage in the same way as other businesses. The risk lies not with the businesses but with the failure of operational control over Credit Risk by lending institutions. Leverage has always been a feature of Buyout transactions. For a period prior to the summer of 2007 there was an unusual abundance of cheap credit available to businesses and individuals which increased the willingness of many (including, but not limited to, many Private Equity Firms) to increase the amount of leverage used in funding investments. The availability of this credit was not driven by Private Equity Firms they have no control over the credit available in the system.
34
3.2.
Does Private Equity play a material causal role (which has previously been uncontrolled or misunderstood) in transmitting stress to other participants?
Private Equity Funds do not trade in any financial market they are not involved in intense and regular buying and selling of securities and other complex financial instruments. Private Equity Funds do not engage in short selling and do not use prime brokers to provide liquidity. Private Equity Funds invest in bespoke, long-term acquisitions which are subject to a substantial amount of due diligence and negotiation. The volume of transactions enacted in the financial markets by Private Equity Funds and their effect on the markets, price formation and trading is de minimis (31). Private Equity Funds structures protect the Fund and its Investors from the forced selling of assets. Private Equity Funds are closed Investors cannot redeem their interests. This protects the Fund from the downward spiral of de-leveraging and declining asset prices caused by forced selling of assets to meet redemption requests in a volatile market. Rather than being forced to sell assets in a declining market, a Private Equity Fund can hold its investments until market stability returns. If the Fund comes to the end of its life, Investors can choose to either extend the Fund or the Manager can distribute the Funds assets directly to them. It is clear that Private Equity Firms do not undertake the type of transactions which are most likely to cause systemic transmission of risk from participant to participant in the market.
4.
Systemic Risk Conclusions
The term failure in the context of a Private Equity Fund is more appropriate to describe a situation where the investment performance is so poor that Investors receive little or no return. In such cases, the Investors suffer and the Manager is unlikely to be able to raise another fund but the wider financial system is not threatened. The de minimis amount of public trading by a Private Equity Fund is unlikely to have any material effect on a counterparty in the extremely unlikely event that the Fund could not meet its obligations or the liability was not covered by the Investors Commitments. The way in which a Private Equity Fund is structured and invests means that its failure should not be thought of in the same way as, for example, a Hedge Fund which might fail leaving a chain of unsettled transactions and liabilities to other market participants on transactions and for repayment of borrowings (e.g. Long Term Capital Management). Investors cannot require the Private Equity Fund to redeem their interests and the Fund is not itself leveraged and so has no obligation to provide and increase margin. Almost all Private Equity transactions take place outside regulated exchanges in the equity securities of private companies and so do not involve a delay between trading and settlement in contrast to other markets where there may be long term outstanding obligations (e.g. under derivative contracts). Even if one or more Investor does not satisfy its funding Commitment, this does not cause the Private Equity Fund to fail. Therefore, the factors which give rise to fund failure in the sense used when discussing Systemic Risk are simply not present in the Private Equity model.
(31)
As a matter of example, public to private transactions in 2007 represented 0.07% of the total stock market capitalisation in Europe. Source: CMBOR/Barclays Private Equity/Deloitte & Federation of European Securities Exchanges (http://www.fese.be).
35
Whilst Lenders have credit exposures to potentially large numbers of different Private Equity backed companies, there is no contagion risk between different borrower Portfolio Companies. The spread of Portfolio Companies into which a Lender will have lent money means that there is no greater risk for the Lender arising from lending into Private Equity backed companies, than there is from lending into any other private company. Venture and Growth Capital funds typically do not use leverage in their transactions. Except in relation to some bridging of Investors Commitments, Lenders do not have direct lending exposure to Private Equity Funds, because such Funds do not borrow in order to leverage their investments. Other capital providers (such as wealthy families, corporates and governments) invest through a private equity type model providing equity, using leverage and having representation on the board of their portfolio companies. Leverage is not unique or new to Private Equity investment. While in recent times some large Private Equity transactions have had access to and used greater leverage than in the past, this was a function of the credit market. Such leverage is also seen in non-Private Equity transactions, such as the purchase of BAA (a critical UK infrastructure provider) by the Ferrovial group of companies and the purchase of high street chains by Baugur. In all these cases the lender, not the equity provider, is responsible for the credit approval process and it is the lender which suffers loss if the Portfolio Company fails. Lenders do not give Private Equity backed companies terms which are not available to other companies. Thus, any losses suffered by lenders if a Portfolio Company fails is not driven or exacerbated by the Private Equity model. Payments to the Manager and the Investors are not driven by the valuation of assets but by their actual realisation. Investors are not entitled to redeem their interests in the Fund before the end of its term. These factors mean that the concerns relating to fund liquidity risk, the use of unrealised valuations to base compensation payments and counterparty risk are not relevant to the Private Equity model. Whilst the amount of funds available for Private Equity investment has increased in recent years, it is still a very modest amount when compared with the amounts traded in the public markets (32) and lent by credit providers. The size and spread of the risks identified means that it is highly unlikely that they can materialise in a way which would damage the Global Financial System. There is no reason why leverage limitations should only attach to Private Equity investment (however defined) and not to other lending situations. The ability of Private Equity Firms to have an adverse impact on market integrity is relatively limited. The Firms are of course subject to the provisions of the Market Abuse Directive. In terms of context, a Private Equity Firms ability to disrupt market integrity in a manner which has systemic implications is minimal compared with regular public market participants. This does not detract from the need, as for all relevant firms to have training, systems and controls to control the risk of leaks and market abuse involving public transactions. In companies where Private Equity Funds have majority control, their relationship with other stakeholders (including minority shareholders and workers/employees) is no different to that of any other majority investor in a privately held company. As far as minority shareholders are concerned, their position will be governed by the applicable local law, unless specific contractual agreements have also been entered into which provide for further specific matters. The employees have exactly the same rights and the Portfolio Companies have exactly the same obligations as arise in any employer/employee relationship.
(32)
The funds raised by buyout firms between 2003 and 2007 represented 2.0% of the total stock market capitalisation in Europe at the end of 2007. Source: PEREP_Analytics for 2007 data, Thomson Reuters/PricewaterhouseCoopers for 2003-2006 data & Federation of European Securities Exchanges (http://www.fese.be).
36
The principal risks might be considered to arise for the Investors in Private Equity Funds. As already noted, these Investors are generally sophisticated institutional investors. Some jurisdictions legislation provide specific structures (for example the venture capital trust in the United Kingdom) under which retail investment may be made in Private Equity. As noted above, the general fund structures are bespoke, negotiated with sophisticated investors and involve levels of disclosure to potential investors that far exceed those required under regulatory requirements generally applicable (e.g. applicable under MiFID to investment managers). Imposing a capital requirement on a Private Equity Fund itself would provide no benefit. The provider of such capital would likely be the Investors in the Fund the same participants who are primarily intended to be protected by such a requirement. The interaction of the Fund with the general marketplace does not give rise to the type of risk for counterparties or credit risk for lenders and other third parties, that would justify the imposition of any requirement on the Fund itself. The principal reasons underlying the imposition of capital requirements (in particular depositor and counterparty protection) are not really applicable to Managers. Managers whose business also falls within MiFID are already subject to the requirements of the Capital Requirements Directive. There may also be other local regulatory requirements. The UK Financial Services Authority regulates Private Equity managers and has for many years operated a fixed and low level capital requirement. This was based on an analysis of the risks that capital is intended to protect against, with the conclusion that it was not really relevant to Private Equity. This approach has never (not even in recent times) been shown to have any weaknesses. The remuneration structures of Private Equity align the interests of the Firm and its executives with the interests of the Fund and its Investors. Since the Manager and its executives invest a significant amount of their own money in the Fund and none of them receive a return unless investments are both realised and realised so as to generate a total return above an agreed rate across the Funds whole portfolio, the structure encourages focus on the transaction and its long term success. Therefore, Private Equity compensation structures do not have the flaws and the associated risks that have been identified in arrangements in other parts of the financial sector, where bonuses often fail to take account of the long term impact of actions and equity vests with immediate effect.
37
1.
Introduction
The European Parliament has highlighted the following concerns as regards the private equity industry: What is the potential impact of buyout activity on the social economy; How does the industry manage its relationships with key stakeholders; Is there excessive use of leverage in private equity investments; Clarify corporate governance and shareholder behaviour(s); Is there adequate transparency; and Clarify reporting to investors in private equity and venture capital funds.
Such concerns have resulted in specific calls from the European Parliament for more regulation for the following areas: 1. Disclosure, transparency and monitoring 2. Information and consultation of workers 3. Limits on asset stripping and capital depletion 4. Limits on leverage 5. Compensation structure 6. Capital requirements This document focuses on the coverage of law, contractual agreement between investors and private equity firms and industry professional standards across these specific areas. It then sets out the mechanisms and processes in place to enforce the industry professional standards. The findings presented below are based on an analysis conducted between October 2008 and January 2009 across ten countries belonging to the European Economic Area. These countries represent around 95% of the total activity of the private equity industry in Europe. The objectives of the analysis were: To assess to what extent the business conduct of private equity firms in relation to the concerns mentioned above is subject to regulation, contractual obligations and industry professional standards. To recommend potential actions regarding complementary regulations, contractual practices and/or industry professional standards. The final chapter describes specific recommendations to be implemented over the course of 2009 to unify industry professional standards coverage across Europe and for improving their enforcement. The findings of this analysis should be considered in light of the following points: The current national landscape of regulation of the private equity industry and industry professional standards is not homogenous across Europe. There are therefore differences in the extent of regulation and selfregulation that addresses the specific concerns raised in the European Parliament with regard to private equity; These differences arise due to the different levels of development in national private equity industries (for example industry maturity, market size, number of participants) as well as differing approaches by national legislatures, governments and regulators;
38
Across the European Union, policymakers should ensure that a level playing field is maintained between private equity firms and other investors. The level playing field should also be kept between private equity portfolio companies and other companies with whom they might compete;
Any final outcomes or conclusions drawn by industry participants or policymakers, regulators or supervisors on the basis of this document should take due consideration of the differences observed across national industries and sub-sector participants to ensure proportionate regulatory frameworks or professional standards suitable to encourage sustainable investment in high growth, job creating businesses;
Any regulation must be purposive and proportionate to its objectives, notably when crafted to maintain a low probability systemic risk within the global financial market. In that respect, the analysis conducted has demonstrated that the private equity industry is not in itself a source of systemic risk (see section on risk analysis).
2.
Coverage of Law, Contractual Agreements and Industry Professional Standards
This section is divided into three, dealing first with applicable law and then with contractual agreements to conclude with professional standards. It is clear from the analysis that where the legal framework does not cover specific points (e.g. statutory accounts that need to be completed and enhanced as regards reporting to sophisticated investors) the industry has voluntarily introduced standards to fill most of these points.
2.1.
The Legal Framework
This analysis does not comment on the extent to which current European legislation is appropriately implemented and focuses on laws relevant to the European Parliaments concerns about the industry rather than being a full analysis of all legislation relevant to the operation and management of private equity firms or portfolio companies. 2.1.1. Disclosure, transparency and monitoring Requirements concerning disclosure, transparency and monitoring may cover many different aspects of business, including, for example, disclosure and transparency with investors, disclosure between a private equity firm and a portfolio company or transparency with wider civil society and the media. All legal frameworks concentrate appropriately on disclosure, transparency and monitoring of the activities between private equity firms and investors, private equity firms and portfolio companies and parties specifically rather than generally interested in particular situations and arrangements. Disclosure and explanation of investment strategies and risk to investors In virtually all jurisdictions a distinction is drawn between retail investors and sophisticated investors. The definitions of these groups may not be consistent across jurisdictions but each jurisdiction applies a higher standard of regulatory oversight to funds targeted at retail investors. Funds targeted at institutional and other sophisticated investors are generally less regulated on the basis that these investors are better placed to make their own assessment of the potential risks inherent in a particular product and these investors do not therefore need the regulatory safety net.
39
Offerings to retail investors (either through listing of a quoted vehicle or otherwise) are strictly regulated in all jurisdictions, notably regarding the disclosure of investment objectives and policies and prominent disclosure of risk factors (33). This regulation may take the form of the Prospectus Directive and relevant local listing rules in the case of listed closed-end funds or UCITS regulations for open-end retail mutual funds. In several Member States, disclosure and explanation of investment strategies and associated risks to sophisticated investors are not subject to specific detailed regulation (34). Even in the absence of specific regulation, the general law and market practice dictate that investors are adequately informed of risks and investment strategies. In countries where the private equity industry has been included in the remit of MIFID and/or is subject to domestic authorization and regulation, disclosure and explanation of investment strategies and associated risks to sophisticated investors are regulated, notably through requirements to inform clients of relevant risks(35). Disclosure and explanation of investment strategies and risk to regulators Private equity firms comply with requirements applying to all entities with the same legal status under the national companies act or limited partnership act (36). Where private equity firms act as sponsors to public offerings, they will comply with the applicable regulatory approvals of the relevant financial supervision authorities (37) and any disclosure document will be required to comply with the Prospectus Directive which, for investment companies, requires disclosure of investment strategies and risks. In certain jurisdictions private equity firms are subject to regulatory licensing and supervision and the regulators can require disclosure of their investment strategies and risks to regulators (38) whilst in others optional application of the supervisory regime to private equity firms makes such disclosure mandatory but where supervision is not opted for standard requirements mentioned in the first paragraph above apply (39). Contract terms providing for unambiguous disclosure and management of risk In no jurisdiction do specific regulations apply to contract terms relating to private equity. In jurisdictions in which MiFID has been applied to private equity, MiFID-derived client disclosures and consents are provided and obtained (40). However in all jurisdictions contract law built on statute or precedent is relevant in the private equity context. In some member states regulations impose certain concentration limits on the funds portfolio composition (41).
(33) (34) (35) (36) (37) (38) (39) (40) (41)
Such regulatory framework can be observed for: Denmark, France, Finland, Germany, Italy, The Netherlands, Norway, Sweden, Spain, The United Kingdom. Denmark, Finland, Germany, The Netherlands, Norway, Sweden. France, Italy, Spain, The United Kingdom. Denmark, Finland, Germany, The Netherlands, Norway, Sweden, The United Kingdom. Denmark, France, Finland, Germany, Italy, The Netherlands, Norway, Spain, Sweden, The United Kingdom. France, Italy, The United Kingdom. Germany. E.g.: The United Kingdom. France, Italy.
40
Register and identify shareholders beyond a certain proportion Companies Acts and other applicable regulations require that shareholders are identified in a register. Depending on the jurisdiction, this information is available either to the appropriate authorities and/or to the public (42). Such requirements also apply to national limited partnerships (43).
Principle-based valuation measures for illiquid assets In the European Union, listed entities abide by compulsory accounting standards (IFRS as adopted for the EU). Unquoted vehicles follow accounting standards according to the legal framework in the relevant jurisdiction. In most of the cases there is consistent audited compliance with the International Private Equity and Venture Capital Valuation Guidelines, which are in all material respects IFRS and US GAAP consistent.
Disclosure and management of conflicts of interest Private equity firms potentially have conflicts between their own interests and those of their investors, between two or more clients, or, as individuals between their roles on the boards of portfolio companies and as investment manager. They are subject to the relevant national company law specifying requirements for directors of companies to act with due care and to promote the interest of the company (44) and not to put themselves in a position where their interests conflict with the interests of the company. In certain jurisdictions further regulation in respect to conflicts of interest applies, requiring variously the development of a detailed conflict management policy, the appointment of a compliance officer or full engagement by senior management in this regard (45). Most private equity firms establish an investor advisory committee to consider conflicts between the interests of investors in the fund and the interests of the management company of the fund. Finally, it should be noted that the International Organization of Securities Commissions (IOSCO) launched an initiative in early 2008 with the objective of releasing guidelines regarding the disclosure and management of conflicts of interest for private equity in 2009.
Money laundering All jurisdictions have legislation to prevent and detect money laundering enacted under the auspices of the Money Laundering Directive (46). These apply to all private equity firms.
2.1.2. Information and consultation of workers Disclosure and explanation of investment strategies and risk to investee companies There are a number of statutory and other binding mechanisms through which employees are kept informed of company strategy and which require consultation of workers in specific circumstances.
(42) (43) (44) (45) (46)
Denmark, France, Finland, Germany, Italy, The Netherlands, Norway, Sweden, The United Kingdom. Denmark, France, Finland, Germany, Italy, The Netherlands, Norway, Spain, Sweden, The United Kingdom. Denmark, Finland, Germany, The Netherlands, Norway, Sweden, The United Kingdom. France, Italy, Spain, The United Kingdom. Denmark, France, Finland, Germany, Italy, The Netherlands, Norway, Spain, Sweden, The United Kingdom.
41
These generally apply across all companies meeting established criteria (for example companies of a certain size, based on a request from a minimum proportion of the workforce). They all apply to private equity portfolio companies as to other private companies. Specifically there are: Employment laws stating that the employer must consult with employees regarding redundancies or matters relating to working or employment conditions and significant changes in the companys activities such as a business reorganization (47). In some jurisdictions, employee board representation in which employee representatives are kept informed and treated as other board members (48). Information and consultation of employees whenever the control of the undertaking or business is transferred Member States have incorporated the Transfer of Undertakings Directive into national legislation. This ensures that, where ownership of business operations is transferred between corporate entities the terms and conditions of employees transferred with the business are protected. In a standard buyout (share sale) there is usually no change in the identity of the employing company and therefore no effect on the employment relationships or employees terms and conditions. Frequently, depending on the characteristics of individual transactions, informing and consulting with employees can and does occur. 2.1.3. Limits on asset stripping and capital depletion Asset stripping, another term to describe the aggressive depletion of the capital of a business is generally a high risk and low return investment activity. Normal legal protections are considered necessary for investors to protect them from unscrupulous directors. In all jurisdictions, Companies Acts, Bankruptcy and Insolvency Acts provide mechanisms to prevent this, for example via directors responsibilities, restrictions on distributions of capital, restoration of capital below a certain threshold and financial assistance regulation (49). 2.1.4. Limits on leverage Companies Acts, Bankruptcy and Insolvency Acts set out requirements on directors to ensure that they do not trade the business into insolvency. In all jurisdictions national legislators have adopted European Directives determining prudential rules on credit providers. The main responsibility for determining the level and cost of leverage in a business sits with the credit provider because that credit provider is accountable to its own investors/shareholders for generating returns and maintenance of capital. Excess leverage is de facto limited, including in private equity portfolio companies, by the capital requirements imposed on lenders.
(47) (48) (49)
Denmark, France, Finland, Germany, Italy, The Netherlands, Norway, Spain, Sweden, The United Kingdom. Denmark, Finland, Germany, Norway, Sweden. Denmark, France, Finland, Germany, Italy, The Netherlands, Norway, Spain, Sweden, The United Kingdom.
42
In certain jurisdictions where excess leverage has been viewed as having no business or commercial purpose, tax policies, for example thin capitalization rules, non deductibility of interest expenses for tax purposes or antiavoidance measures have also effectively limited leverage (50). However, certain of these measures such as non deductibility of interest for tax purposes have severe negative macroeconomic impacts most notably in the downturn in the economic cycle. This pro-cyclicality effect stems from the taxation of their earnings before interest expenses that reduces the cash flows of companies independently from their ability to serve their debt. As a consequence, such tax policies impact negatively companies liquidity. Another negative impact of the non deductibility of interest expenses for tax purposes is that it pushes downwards the values of corporate loans held by pension funds and other institutional investors (51). 2.1.5. Compensation structure Transparency of compensation structure (to investors and authorities) Generally, in jurisdictions where funds are set up as public limited companies, existing regulation applies on disclosure of compensation schemes to shareholders. Authorities can readily access this information according to the reporting provisions presented in Companies Acts (see below) (52). In countries where private equity firms are authorized, relevant authorities can receive information on the compensation structure (53). Transparency of managers remuneration systems, including stock options The remuneration of company board members is generally established as a matter for resolution by the shareholders in the annual general meeting or through disclosure of information to shareholders in the Companies Acts (54). In most Companies Acts or where not, in Corporate Governance Codes, issuance of shares including stock options is also governed by the shareholders (55). Additionally these Companies Acts stipulate that, subject to company size criteria, compensation payable to board members, managing directors and comparable senior officers must be reported in publicly available annual financial statements (56). 2.1.6. Capital requirements For clarity it is necessary to distinguish between general capital requirements imposed by corporate law that protect company creditors and ensure that all business interactions can be managed in an orderly fashion and regulatory capital requirements that are lower limits for capital adequacy imposed on businesses e.g. operating in the financial sector.
(50) (51) (52) (53) (54) (55) (56)
Denmark, France, Finland, Germany, Italy, The Netherlands, Norway, Spain, Sweden. For further details, please see Restricting Interest Deductions on Corporate Tax Systems: Its Impact on Investment Decisions and Capital Markets by Christoph Kaserer, Technische Universitt Mnchen, March 2008. Downloadable at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1130718 Denmark, Finland, Germany, The Netherlands, Norway, Sweden, The United Kingdom. France, Italy, Spain, The United Kingdom. Denmark, France, Finland, Germany, Italy, The Netherlands, Norway, Spain, Sweden, The United Kingdom. Denmark, France, Finland, Germany, Italy, The Netherlands, Norway, Sweden, The United Kingdom. Finland, Germany, The Netherlands, Norway, Sweden, The United Kingdom.
43
Regulatory capital requirements are imposed in the financial sector for two fundamental reasons: Investor protection, where a certain level of capital is expected to be reserved to ensure that depositors are not exposed by lending activity to loss. Such protection is common for the banking and insurance industries; Orderly winding-up protection, where a certain level of capital is expected to be reserved so that in the event that the management entity fails financing will remain available to cover overheads to allow an orderly withdrawal from the marketplace. Such protection is extended beyond the banking and insurance industries to investment management firms including in some jurisdictions private equity firms. At the level of the management companies Private equity firms like other limited liability companies are subject to general requirements across various jurisdictions where a minimum level of capital is required to set up a company and provisions are in place for either capital restoration or liquidation in the event that shareholders equity falls a relevant amount below the registered share capital (57). In certain jurisdictions, private equity firms are expected to maintain regulatory capital to ensure they can, if necessary, be wound up in an orderly manner. The amounts vary (including, for some firms, amounts required by MiFID and the Capital Adequacy Directive) but are at least proportionate to the private equity funds, whereby handover to a replacement manager is not complicated and is implemented in practice with minimum disruption to investors (58). In those jurisdictions where regulatory oversight is optional regulatory capital requirements stem from either MIFID or a specific legal framework (59). In no jurisdictions are private equity firms subjected to capital requirements designed for deposit protection because they do not take deposits. At the level of the funds investment vehicles It is relevant again to stress that private equity funds are not themselves leveraged vehicles and therefore there is no need for capital requirements to protect creditors of the fund. There are no creditors of the fund other than the manager and other advisors and since any capital would have come from investors, this would produce a rather strange result. Where an investment vehicle is structured as a limited liability company in a jurisdiction with general capital requirements applying to all such limited companies (private and public) these requirements will also apply to the fund when used as a fund vehicle (60). In most jurisdictions with legal frameworks to establish limited partnerships, there are no capital requirements for such partnerships (61). In others, a minimum amount of capital is required to set up a private equity limited partnership (62).
(57) (58) (59) (60) (61) (62)
Denmark, Finland, Germany, Norway, Sweden, Spain. France, Italy, Spain, The United Kingdom. Germany, The Netherlands. Denmark, Finland, Germany, The Netherlands, Norway, Sweden. Denmark, Finland, Germany, Norway, Sweden, The United Kingdom. Spain, France.
44
2.2.
Coverage of the Contractual Agreement between Investors and Fund Managers
The vast majority of private equity funds are closed-end funds with a lifetime of 10 years or more, marketed to and raised from a limited number of sophisticated investors. One of the cornerstones of the relationship between the private equity firm and the investors in the fund is the limited partnership agreement (LPA), a thoroughly and exhaustive negotiated contractual agreement between those two parties. Over the years, these negotiations have resulted in a high level of understanding across parties of how contractual clauses should be structured in relation to the underlying investment strategies. As a consequence, some of the usual clauses within the LPA cover several of the European Unions concerns with regard to private equity. 2.2.1. Disclosure and monitoring LPAs typically stipulate quarterly or semi annual reports to investors, including details on the development and performance of each underlying investment as well as of each fund as a whole. The vast majority of LPAs further include explicit references to reporting and valuation guidelines issued by trade associations. LPAs allow for the termination of the management contract in the event of an investor vote, or in case of fraud or gross negligence. They also typically include rights for investors to suspend the funds ability to make further investments in case of substantial changes within the private equity firm.
2.2.2. Compensation structure The entitlement of a private equity firm to receive compensation in the form of management fees and how realised capital gains on investments made are to be split between the investors and the managers provided certain minimum returns have been achieved are clearly set out in the LPA. These clauses are negotiated and documented in great detail.
2.3.
Coverage of Existing Industry Professional Standards across the European Unions Areas of Concern
Besides the issues noted in the Introduction, concerns have been expressed by both the European Parliament and the European Commission about potential for fragmented application of industry professional standards across member states. Concerns were also expressed regarding the appropriateness of the existing enforcement mechanisms. The first section below presents an overview of the existing professional standards and their adoption across countries. The second section sets current enforcement mechanisms. 2.3.1. Overview of the existing industry professional standards and their adoption across countries Existing professional standards cover most of the areas of concern raised by the European Parliament about the Private Equity industry, in many instances complementing the existing law with good practice. We highlight here six classes of industry professional standards and how they have been implemented across a representative selection of national trade associations and in related European countries (63).
45
Code of conduct: There are three categories: Trade associations that have adopted the EVCA Code of Conduct (1983 edition). EVCA itself has with effect from 1 January 2009 adopted the revised (2008) Code Conduct which is based on the IOSCO Model Code of Ethics (64); Trade associations that have developed their own code of conduct (65); and Trade associations that have no code of conduct (66).
Reporting guidelines (67): There are two categories: Trade associations that have adopted the EVCA reporting guidelines (68); and Trade associations that have no reporting guidelines (69).
Valuation guidelines: There are two categories: Trade association that have endorsed the IPEV Guidelines (70); and Trade associations that have no valuation guidelines (71).
Transparency and disclosure guidelines: There are two different categories: Trade associations that have initiated or issued their own guidelines (72); and Trade associations that have no guidelines (73) (including EVCA).
Governing principles guidelines There are two categories: Trade associations that have adopted the EVCA Guidelines (74); and Trade associations that have no guidelines (75).
(63) (64) (65) (66) (67) (68) (69) (70) (71) (72) (73) (74) (75)
These results are based on the analysis of the 10 biggest markets and on Annex II: Professional Standards and their Application on European Private Equity Funds. Denmark, Finland, Germany, Norway, Sweden. France, Italy, The Netherlands, Spain, The United Kingdom. This situation is not observed for the main markets but for Austria and Greece. The reporting guidelines require timely, consistent and relevant information to be provided by private equity firms to investors in order for the latter to monitor their investments. Transparency and disclosure guidelines deal with communication to a wider audience. Denmark, Finland, France, Germany, Italy, Norway, The Netherlands, Sweden, The United Kingdom. Spain. Denmark, Finland, France, Germany, Italy, Norway, The Netherlands, Spain, Sweden, The United Kingdom. This situation is not observed for the main markets but for Greece and the Southeastern Association. Denmark, Finland, Germany, Norway, The Netherlands, Sweden, The United Kingdom. France, Italy, Spain. Germany, The Netherlands. Denmark, Finland, France, Italy, Norway, Spain, Sweden, The United Kingdom.
46
Corporate governance guidelines There are three different categories: Trade associations that have adopted EVCA guidelines (76); One trade association that has developed its own code (77); and Trade associations that have no guidelines (78).
2.3.2. Enforcement of industry professional standards A second and perhaps more important issue raised by the analysis in the preceding section and highlighted by Internal Market Commissioner Charlie McCreevy is enforcement and monitoring mechanisms for compliance with private equity industry professional standards. Enforcement of the legal framework is provided by governments and regulators. It is normal for professional standards to be enforced by other mechanisms. 2.3.2.1. Enforcement by government and regulators In one jurisdiction, France, the regulator (AMF) imposes compulsory membership of trade associations on firms either to AFIC or AFG. The trade associations then require their members to adhere to specific professional standards with both associations having a common compulsory code of conduct (Code de Dontologie). In others, notably the United Kingdom, in a regulatory environment based on high-level principles, industry professional standards are seen by the regulator as supporting the achievement of regulatory outcomes by helping firms to meet their regulatory obligations while maintaining a sufficient degree of innovation and competition (79). 2.3.2.2. Enforcement by other mechanisms Currently, appropriate behaviour of private equity firms is enforced by three mechanisms: By investors; By trade associations; and Enforcement by independent bodies. Investors The great majority of private equity funds are privately negotiated investment vehicles invested in by a relatively small number of very sophisticated long term investors. Many of these investors (e.g public pension funds and others) are very sensitive to the impact that the action of the managers they employ has on civil society. For example many regular investors in private equity are signatories of the UN PRI. The investors hold the ultimate sanction for inappropriate or loss making behaviour by private equity firms which is the withdrawal of their support. This happens both through non-commitment to future funds and through replacement of underperforming managers.
(76) (77) (78) (79)
Finland, Germany, The Netherlands. France. Denmark, Italy, Norway, Spain, Sweden, The United Kingdom. Financial Services Authority Discussion Paper 06/5: FSA confirmation of industry guidance.
47
In particular investors are supportive of and have high expectations on compliance with valuation and reporting guidelines. Trade Associations The EVCA Code of Conduct (edition 2008) is compulsory for all members. Monitoring is exercised by market participants and members of the public who address complaints to the trade association. Complaints are investigated by the EVCA Professional Standards Committee and the sanction of expulsion from membership is within the power of the EVCA Board. In all the national associations a similar power of expulsion exists. Independent Bodies (i) Independent monitoring group An independent group is set up with representatives of stakeholders to provide oversight on specific professional standards, including updates and implementation by market participants, for example the UK Guidelines for Disclosure and Transparency in Private Equity (the Walker Guidelines). Sanctions include expulsion from the trade association membership but much more effective is the knowledge of the public disapprobation that goes with being found to be out of compliance by the independent monitoring group. (ii) Auditors In many jurisdictions, auditors report on the financial statements produced by funds. As part of this process International Standards on Auditing (ISAs) require checks on compliance with law and regulations. The implementation of the International Private Equity and Venture Capital Valuation guidelines to value the underlying investments is also reviewed as they are IFRS and US GAAP consistent. Receiving a qualified opinion on the financial statements to be submitted to investors is a significant controlling mechanism on the behaviour of private equity firms.
3.
Recommendations relating to Section III
The following recommendations aim to address first the concerns regarding the potential fragmented application of industry professional standards across countries and secondly the concerns on enforcement and monitoring mechanisms for compliance with industry professional standards. 3.1. Recommendations for unifying industry professional standards coverage across Europe
The first concern is that the co-existence of guidelines covering the same topics raises the possibility that practitioners will arbitrage to adopt the guidelines they perceive as least damaging to their interests. While differences tend to be small, this nevertheless creates the perception that self-regulation is haphazard. Allied to this is the heterogeneity of guidelines on the same topics, which makes it hard for third parties to understand which participants are subject to which guidelines.
48
Therefore, the following recommendations are being made: 1. That there should be a unified European wide set of minimum standards; 2. That these should be principles based to allow subsidiarity and national implementation of approved variations to fit with local practices and legislation; and 3. That a process of mutual recognition should be established. It is also recommended that those standards should be consolidated into one consistent document and cover: 1. Code of Conduct 2. Reporting Guidelines 3. Valuation Guidelines 4. Transparency and Disclosure Guidelines 5. Governing Principles 6. Corporate Governance Guidelines The United Nations Principles for Responsible Investment will be influential in shaping our thought-process as we approach the implementation of a European wide set of minimum standards for the private equity industry. The exact way in which the matters covered in the existing guidelines will be brought together remains to be agreed; however the overall content will at least cover those matters as are required by the European Commission.
3.2.
Recommendations for improving enforcement
In addition to embarking upon a process of mutual recognition of standards across Europe this paper concludes that enhancements to the enforcement mechanisms are necessary and should be introduced. The regime that is established will meet the following tests: 1. Accountability to EU and national supervisory bodies; 2. Protection of the process from conflicts of interest; 3. Proportionality according to the risk posed by various industry participants; and 4. Subsidiarity to the legal and regulatory frameworks of different jurisdictions. Developing the appropriate enforcement mechanisms will be introduced relatively quickly by embracing the best of existing self regulation and utilising existing processes of monitoring such as audit wherever possible. Clear complaint procedures will be introduced with independent mechanisms to deal with matters arising and with reliable sanctions. The operation of the oversight mechanisms and sanctions will be open to public scrutiny and regularly reported on.
Conclusions and Recommendations
49
Before turning specifically to the Recommendations, it is worth reiterating the points raised in the private equity and venture capital industrys initial submission of November 2008 (80) as they provide additional context and address particular aspects raised by the European Parliament Resolutions on private equity of September 2008. A number of general principles need to be taken into consideration in any discussion about private equity: Although private equity is characterised as a form of Alternative Investment its business model is distinct from other alternative investments, such as hedge funds. The private equity industry comprises a broad spectrum of investment funds with regards to their size, legal structure and their investment strategies. Private equity incorporates venture capital, growth capital, leveraged buyouts, distressed debt, and turnaround situations. Although private equity is a form of financial investment, it does not generate systemic risk for the economy at large and employs effective risk management techniques appropriate for its business model. Private equity funds themselves are not leveraged. The use of leverage (debt) by private equity buyout funds occurs only at the level of their individual portfolio companies and not at the level of the fund itself. Each individual investment/portfolio company is financed based on its own merits, its cashflow generation potential, and subject to an individual credit assessment by banks/financing institutions. Venture Capital backed companies are further normally only equity financed as they do not generate positive cash-flows in the early stages. To avoid confusion, unlike certain hedge funds private equity does not implement short selling strategies. It is also worth noting that, in contrast to hedge funds, commitments to private equity and venture capital funds are of a long-term duration (typically 10 years) and are not subject to monthly, quarterly or annual redemption rights, which may in themselves be a source of market volatility. Private equity is subject to a range of legislative and supervisory measures already in place at national and European level, as well as regular review. National regulation applied to private equity is described in detail in this submission. Any final outcomes or conclusions drawn by industry participants or policymakers, regulators or supervisors on the basis of this document should take due consideration of the differences observed across national industries and sub-sector participants to ensure proportionate regulatory frameworks or professional standards suitable to encourage sustainable investment in high growth, job creating businesses. The private equity industry is subject to a wide range of behavioural/ethical codes of conduct and common industry rules. In its Resolutions of September 2008, the European Parliament recognises that existing wellfunctioning codes and practices should be taken into account. Again, this submission provides a detailed overview of the existing codes and common industry rules. A number of considerations raised by the European Parliament in its Resolutions of September 2008 (for example in the area of company law), although very relevant to private equity, apply to all privately owned, non-listed companies. They therefore have a much wider European Single Market application. Any new rules that are introduced should be fair. Public policy needs to ensure a level playing field and full competition between the private equity industry and other companies and/or institutional investors, family private equity, or sovereign fund private equity. They should also not discriminate against privately funded companies that are part of private equity investment portfolios, as opposed to all other privately owned companies. Private equity is a global industry both in terms of its fund raising and investment practices. Any public policy recommendations should recognise this international dimension. Public policy should follow the better regulation principles and undergo a thorough impact assessment.
(80)
Downloadable at: http://www.evca.eu/publicandregulatoryaffairs/evcapositionstatementsandpapers.aspx?id=182
50
Conclusions and Recommendations
The European private equity and venture capital industry has taken the European Parliaments Resolutions and requests for information by the European Commission very seriously and has already taken several important steps to address them. In particular, this submission includes a detailed analysis of the aspects raised, as well as the additional elements arising from the review of the European Commissions and G20 review of the European and global financial services regulatory framework. This submission includes a thorough review of existing laws across the European Economic Area (81), contractual practices between private equity firms and their investors and industry professional standards. It demonstrates that the business conduct of private equity and venture capital firms in relation to their investors, their portfolio companies and their stakeholders is conditioned by an extensive regulatory environment across Europe. Moreover, the review also shows that the current practices in terms of contractual agreements between sophisticated investors and private equity firms are characterised by a high level of understanding across parties on how contractual clauses should be structured in relation to the underlying investment strategies, their risk and the compensation of managers. Meanwhile retail investors play an insignificant role in the market and, in the few cases they are engaged, are protected by the laws covering public offerings in every European jurisdiction. However, we have indentified that there is room for improvement on the important area of supervision and co-ordination of industry standards. We want to work in co-ordination with the European Commission and appropriate EU and national authorities, to enhance the existing behavioural framework that can provide all market participants with sufficient confidence in the future in the private equity and venture capital industry to support economic recovery in Europe. The private equity and venture capital industry will also be fully engaged in the broader review of the European (and global) financial services regulatory framework and is committed to working with policy makers and other constituencies impacted by the industrys investment activities both now and in the future. We believe that industry recommendations set out in this report should be measured against the following four benchmarks: Clarity of rules: The Leaders of the G20, in their declaration of the Summit on Financial Markets and the World Economy (82), called for private sector bodies to review their existing industry standards. The private equity and venture capital industry recognizes that in order to regain confidence for the financial system, the industry needs to agree on unified principles across Europe. This means that existing industry standards, codes and guidelines need to be consolidated and updated to meet modern regulatory demands. Transparency of rules: The Europe-wide industry principles should then be made easily accessible for supervisors, investors and the general public across Europe. Scope: The Europe-wide principles should apply to the largest cross-section of the private equity and venture capital industry, and especially to those institutions operating across borders. To reflect the diversity of the industry, consideration should nonetheless be given to the size and nature of the respective private equity and venture capital firms and their funds.
(81) (82)
Countries covered represent approximately 95% of the activity of the European private equity industry. These countries are: Denmark, Finland, France, Germany, Italy, The Netherlands, Norway, Spain, Sweden, The United Kingdom. Downloadable at: http://www.america.gov/st/texttrans-english/2008/November/20081117173241xjsnommis0.4479639.html
51
Regulatory Framework: The industry recognises that its regulatory framework must be consistent with existing and future national and European regulatory reforms. Such a framework will have to reflect national traditions and legal regimes while ensuring an appropriate degree of European oversight. The private equity and venture capital industry is prepared to commit to work together with the European Commission and national authorities to develop the details of an appropriate framework within an accelerated timeframe. The industry suggests 12 months.
Specifically, the European private equity and venture capital industry proposes the following: 1. The private equity and venture capital industry is prepared to commit to unify industry professional standards coverage across Europe. That there should be a unified Europe-wide set of standards; That these should be principles based to allow subsidiarity and national implementation of approved variations to fit with local practices and legislation; and That a process of mutual recognition across trade bodies in Europe should be established.
The unified Europe-wide set of professional standards will be based on: (i) Code of Conduct; (ii) Corporate governance guidelines in the management of private equity held companies; (iii) Reporting to investors; (iv) Valuation Guidelines; (v) Transparency and disclosure guidelines; (vi) Governing principles for the establishment and management of private equity funds. 2. The private equity and venture capital industry is prepared to commit to introduce an enforcement regime for the industry professional standards across Europe and make it subject to oversight by the appropriate EU and national supervisory bodies. The enforcement regime that is established will meet the following test: (i) Accountability to European Union and national supervisory bodies; (ii) Protection of the process from conflicts of interest; (iii) Proportionality according to the risk posed by various industry participants; and (iv) Subsidiarity to the legal frameworks of different jurisdictions. 3. The unification of industry professional standards and the establishment of the enforcement regime across Europe could be completed within 12 months. In order to address promptly the concerns of the European Union institutions, the private equity industry commits to deliver within 12 months or a timetable agreed with the relevant EU institutions.
52
Private Equity and Venture Capital in the European Economy An Industry Response to the European Parliament and the European Commission
Annex I: Detailed Risk Analysis of the Private Equity Industry
Table of Contents
Introduction Section I: Discussion of Risk & Definitions Section II: Private Equity Structure & Operations Section III: Risk Analysis of Private Equity Participants and Stakeholders
1. 2. 3. 4. 5. 6. The Fund The Investors The Manager The Lenders The Portfolio Group Civil Society
55
57 59 61 65
65 71 74 80 83 87
Section IV: Systemic Risk

1. 2. 3. 4. 5. 6. Introduction Private equity and its relationship with systemic liquidity risk Receipt of finance Provider of finance Private equity and the systemic transmission of stress between market participants Systemic risks Conclusions
91
91 92 92 93 95 96
56
Introduction
57
This paper analyses the risks which potentially could be specifically caused by the Private Equity model both to the participants and stakeholders in Private Equity and to the Global Financial System. Private Equity in this paper includes all sub-sets Venture Capital (seed capital, early stage and late stage), Growth Capital and Buy-outs (small, mid-market and large). However, where a particular type of risk is not applicable to a specific sub-set of Private Equity, this has been highlighted. Section I of this paper provides: a brief explanation of what risk means in this context; and descriptions of the specific types of risk and participants in the Private Equity model.
Section II provides a brief description of how Private Equity Funds are typically structured and operate. The inter-relationships of Private Equity participants and the way in which Private Equity Funds operate are key to understanding the risk analysis that follows. Section III analyses the specific risks potentially faced by each of (i) the Manager; (ii) Investors; (iii) the Fund; (iv) Lenders; (v) the Portfolio Group; and (vi) Civil Society because of the Private Equity model. Where the potential for risk has been identified, the risk management strategies available to the participants have been highlighted. The specific risks that have been considered are: Market Risk Credit Risk Counterparty Risk Operational Risk Financing and Liquidity Risk Group Risk Fiduciary Risk Market Abuse Risk Financial Crime Risk Legal and Regulatory Risk
Credit Risk, Counterparty Risk, Financing and Liquidity Risk, Group Risk, Market Risk and Operational Risk are often referred to as Prudential Risks, as they comprise a section of risks that can reduce a firms financial resources where the result of the risk crystallising may adversely affect confidence in the financial system or prejudice consumers. All commercial activity carries risks, both for the principal actors and those affected by their activities and the first three Sections of this paper therefore analyse the nature and extent of risks arising in the sector. However the question of key interest in the current debate is whether such risks have the potential for impact on the wider financial system. Section IV examines whether there is a clear and demonstrable cause-effect relationship between the Private Equity model and Systemic Risk (both Extrapolated Participant Risk and Natural Systemic Risk) and provides some conclusions on this issue.
58
Introduction
In particular: Does the Private Equity Firm play a material causal role in the liquidity crisis either as provider or consumer of finance? Does the Private Equity Firm play a material, previously uncontrolled and misunderstood, causal role in the transmission of stress between other participants in the Global Financial System? The UK Financial Services Authority carried out a detailed review of risk and Private Equity, its papers are attached, and we refer to some of their conclusions below. (In this paper we describe the methods of operation of Venture Capital and Private Equity Firms. We consider that the descriptions given reflect the practices of the vast majority of such Firms, although there will of course always be a few Firms whose business models or practices differ in some respect from those described.)
Section I: Discussion of Risk & Definitions

Risk
Risk is defined as the possibility of meeting danger or suffering harm or loss; exposure to this The Oxford Paperback Dictionary. All businesses operate within an ever-changing system which encompasses governments and their authorised representatives, providers of finance, other businesses as suppliers, competitors and customers, individuals as customers, employees and participants in civil society. Within this dynamic system businesses establish their strategic and operational objectives (within the applicable legal/regulatory framework) usually motivated by the desire for gain or profit over varying timescales. In this context, a risk is the possibility of any cause that would make it less likely that the business will achieve its objectives or exposure to such a possibility. This also applies to all other participants within the system, each of whom has their own desires or objectives which may or may not be achievable dependent on the risks inherent in their objectives and the participants ability to control those risks. The objectives of the business (or of any other system participant) may be considered to be the (potential) reward commonly referred to in the concept of risk-reward trade off. It is normally assumed that there is a connection between the certainty of achievement of an objective and the value of the reward inherent in that objective. Where the certainty is less the reward will be higher and vice versa. The dynamic nature of the system means that businesses must frequently assess their objectives and the risks. The degree of certainty of achievement of an objective is measured by the probability, severity and multiplicity of risks to be overcome in achieving it. It is also important to note that this is only true up to a point. There will always be catastrophic but remote possibilities, the impact of which is disproportionate such that a low risk, low reward activity nevertheless fails to achieve its objectives.
59
Definitions
When capitalised in this paper the following words and expressions shall carry the meanings explained below: Carried Interest: The proportion of the realised profits on the Funds investments which is paid to the Manager and its executives. For a fuller explanation please see paragraph 14 of Section II. Commitments: The fixed amount an Investor contractually commits to invest in a Fund over the Funds lifetime. Counterparty Risk: Risk that the other party to a transaction is unable to meet its obligations therefore giving rise to the risk that a transaction will not complete, or that an expected benefit will not arise. Counterparty risk is a type of Credit Risk. Credit Risk: Risk arising when a person is exposed to loss if another party fails to discharge its credit obligation to that person, including by failing to perform in a timely manner. Excessive credit losses can erode an investors or lenders capital and threaten its viability and its ability to meet its own obligations. Other credit risks include (i) issuer risk where an issuers insolvency can result in the value of its securities or debt falling to nil; and (ii) performance risk where a person risks incurring losses by another party failing to perform non-financial obligations.
60
Section I: Discussion of Risk & Definitions
Fiduciary/Agency Risk and Conflicts of Interest: Risks arising when a persons assets are subject to the management or control of a third party, where a third party acts as agent or where a third party exercises a discretion which can affect the interests of the relevant person.
Financial Crime Risk: Risk that a business will be involved in or suffer loss as a result of any kind of criminal conduct relating to money, financial services or markets (including offences relating to fraud or dishonesty or handling the proceeds of crime and money laundering).
Financing and Liquidity Risk: Risk that a person, although balance sheet solvent, either does not have available sufficient financial resources to enable it to meet its obligations as they fall due, or can secure such resources only at an excessive cost.
Fund: The entity in which Investors collectively pool their money in order to make investments. The Fund is typically structured as a limited partnership or similar vehicle. For a fuller explanation please see Section II. Listed Private Equity Funds are generally structured as corporate vehicles.
Group Risk: Risk arising where a company is part of a group and may therefore (i) have exposures to its fellow group companies; (ii) have dependencies on other group companies; and/or (iii) be affected by risks arising in other parts of its group as well as from its own activities.
Investors: The sophisticated investors in Private Equity Funds typically institutional investors, pension funds, investment funds, endowments, fund of funds and other sophisticated investors, such as family offices. Legal and Regulatory Risk: Risk arising where (i) a persons activities do not comply with the law, exposing it to the risk of civil or criminal sanction, including the risk that its contracts are unenforceable; or (ii) changes in law or regulation adversely affect the legality of an entitys activities, operations or contracts.
Lenders: Banks and other providers of finance (other than the Fund) to Portfolio Companies. Manager: The entity which manages the Fund and takes investment decisions on behalf of the Fund. Either the General Partner or a separate entity within the Private Equity Firms group may carry on this role. Market Abuse Risk: Risk that the person will be involved in transactions which involve market abuse either through the misuse of information or as a result of the way in which transactions are effected. Market Risk: Risk arising from fluctuations in values of, or income from, assets or in interest or exchange rates including interest rate and currency risks. Operational Risk: Risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events. Portfolio Company: The entity in which a Fund indirectly invests to acquire an interest in a business. The Portfolio Company, its subsidiaries (and the holding vehicles through which the Fund invests) are referred to as the Portfolio Group and the Portfolio Companies. Portfolio Companies are usually private limited companies (e.g. Limited, GmbH or s..r.l.) as opposed to public companies (e.g. PLC, AG or SA). In a minority of cases, as a result of a Buy-out, a public company may be taken private.
Private Equity: Includes all industry sectors Venture Capital (which may be sub-divided into seed capital, early stage and late stage), Growth Capital and Buy-outs (which may be sub-divided into small, mid-market and large Buy-outs).
Private Equity Firm: This is a loose term generally used to describe the group which owns the General Partner/Manager.
The above explanations of risk types are based on the concepts as generally understood by financial regulators and reflected in legislation such as MiFID, the CRD and the Market Abuse and Money Laundering Directives.
Section II: Private Equity Structure & Operations
61
Set out below is a general summary of the relationships between the participants in a typical Private Equity structure. There are a number of different legal structures available depending on the jurisdiction, but substantively they produce broadly the effect described.
Private equity structure

1. Sophisticated Investors (which are typically pension funds, investment funds, financial institutions and other sophisticated investors such as family offices) pool their funds together in a collective vehicle (the Fund) in order to make investments. The Fund is typically constituted as a limited partnership which is effectively a transparent vehicle. The Investors, through the Fund, jointly own the Funds assets subject to the provisions of the Limited Partnership Agreement. 2. Each Investor in a Fund is a Limited Partner and will contractually commit to contribute a fixed amount of money to the Fund (the Investors Commitment) over its lifetime (typically 10 years, although there is usually flexibility to extend this period if necessary, for example to give more time to realise investments). An Investor will only pay a small amount of its Commitment when it joins the Fund. The rest of its Commitment will be drawn-down from the Investor as and when needed by the Fund. A Private Equity Fund is a closed fund the Investors are not entitled to withdraw the amounts they have invested or cancel their unpaid Commitments before the Fund is wound up. 3. The total amount an Investor pays to the Fund is capped at the amount of its Commitment. As a Limited Partner in the Fund, an Investors maximum liability for the Funds liabilities should be limited to its Commitment like a shareholder in a limited company. In order to maintain their limited liability, an Investor cannot be involved in the operation and management of the Fund or the investments it makes. 4. Unlike the Investors, the General Partner has unlimited liability for the Funds liabilities. The General Partner is typically constituted as a limited liability company and is owned by the Private Equity Firm. A Private Equity Firm aims to manage several Funds (which are at different stages in their life cycles) at the same time. It generally uses one vehicle within its group to act as the Manager of all of the Funds it operates (particularly if the national jurisdiction requires the Manager to be regulated). 5. The General Partner receives a share of the Funds profits for acting as General Partner. This payment is funded either by drawing down some of the Investors Commitments or out of the Funds realised profits. If the General Partner is not acting as the manager of the Fund it pays a fee to the Manager because it is actually the entity providing most of the services to the Fund (the Management Fee). The Management Fee provides the financial resources to scope out potential investments, select the correct investments for the Fund, get actively involved in Portfolio Companies, provide information to Investors and organise all the necessary Investor administration.
62
6. When the Manager decides to make an investment in a Portfolio Company, it will draw down the monies needed from the Investors. The Fund will then use this money to subscribe for shares in the Portfolio Group. Some Funds also provide debt to the Portfolio Group. These are typically long-term unsecured loans which are subordinated to any secured bank debt and are not repaid until the Fund is realising the equity in its investments. Until there is a realisation, the interest on the debt typically accrues but is not paid to the Fund. If bank debt is provided (which would not usually be the case in Venture Capital investments) the Portfolio Companys subsidiaries will borrow the money and the bank debt will be secured against their assets. Where bank debt is used, the Fund will not usually be allowed to take any money out of the Portfolio Company without the Lenders consent. 7. When the Fund sells its indirect investment in a Portfolio Company (typically after 3-7 years) profits from the sale will be distributed to Investors. The Fund does not usually hold on to Investors cash. 8. It should be noted that typically Venture Capital and Growth Capital (which are the largest proportion of Private Equity in number of firms and volume of transactions) do not use leverage when investing.
Operation of a fund
9. The Investors and the General Partner will enter into a Limited Partnership Agreement (the LPA). The LPA is a complex and detailed legal document and is the binding constitution of the Fund dictating how profits and liabilities are apportioned and the commercial terms of the Fund. As part of its due diligence process, a potential Investor to a Private Equity Fund will instruct legal advisers to review the terms of the LPA and related legal documents. The Manager will generally have substantial negotiations with potential Investors on the terms of the LPA. 10. Some of the key issues for Investors are (i) the fees paid to the General Partner/Manager; (ii) the investment period; (iii) the apportionment of realised profits and losses between the partners through the Carried Interest arrangements; (iv) the basis on which the Investors can remove the General Partner/Manager or terminate investments; and (v) the consequences if key executives leave the Private Equity Firm. 11. In addition to the LPA, Investors sometimes enter into separate agreements with the General Partner/Manager which cover points that are particular requirements for that Investor such as specific ethical or political restrictions on the type of investments that can be made by the Fund (i.e. prohibiting investments in tobacco products). The LPA will usually oblige the Manager to disclose all such agreements to all Investors. 12. Therefore, an investment in a Private Equity Fund and the relationship between the Manager and Investors is significantly different from an investment in other types of vehicles which are pre-packaged products available only on the stated terms and non-negotiable with potential investors. Before investing in a Private Equity Fund an investor has the opportunity to carry out due diligence on the Manager and its previous track record and negotiate the commercial terms of its investment. Research has show that a significant percentage of Investors have rejected investing in Private Equity Funds where they do not reach agreement on the commercial terms.
63
Alignment
13. A fundamental principle of Private Equity is the alignment of the interests of the participants through the value chain the Manager (and its executives) with the Investors and the Fund and the Fund (and therefore the Investors, the Manager and its executives) with the Portfolio Company, its employees and Lenders. The structure outlined above has been developed over many years to ensure that the participants interests are aligned in a common objective. 14. The Manager is aligned with the Investors in the Fund because it (and its Executives) invest their own money in the Fund (typically between 1 and 5% of total Investor Commitments) alongside the Investors usually through a separate Carried Interest Vehicle. The Carried Interest Vehicle does not share in the profits on the Funds investments in the same way as the Investors its return is primarily through what is known as the Carried Interest. Carried Interest can be structured in a variety of ways but the basic principle is that proceeds from the Funds investments are distributed first to the Investors until they have been paid the amount they invested plus an additional return on their money (typically 8%). Only after Investors have received this return will the Carried Interest Vehicle receive any monies in respect of its investment in the Fund. The Carried Interest Vehicle is typically entitled to 20% of the profits once the Investors have earned their agreed return. The Manager and its executives and some Investors sometimes also invest their own funds alongside the Fund directly in Portfolio Companies. 15. In order to align the interests of the Fund and the employees to create value in the business, key employees are given the opportunity to invest in the Portfolio Company alongside the Fund. In a Venture Capital or Growth investment employees will on average hold around 60% of the equity share capital. In a Buy-out investment, employees will typically hold up to 20% of the equity share capital. This gives them a substantial interest in the sustainability and success of the Portfolio Company. While a significant amount of this equity will be held by the business senior management, the Manager will generally encourage this equity to be shared with more junior employees who are key to the performance of the business. As well as incentivising employees to create value in the business, the Fund can also take comfort from the fact that the employees are buying into the future development of the business and its new structure and strategy. Before making an investment in a Portfolio Company the Manager will spend time with the business key employees. Their assessment of the business is important to the Manager. Once a Fund has invested in a business it relies on the Portfolio Companys employees to manage the business and drive forward the agreed strategy. 16. The Funds investment is often entirely in equity and unsecured debt with the consequence that it is subordinated. If bank debt is provided to the Portfolio Group (which would not usually be the case in Venture Capital or Growth investments), the Lenders debt will be repaid first. In addition to the due diligence they carry out, Lenders can also take comfort that the Fund and the senior management are backing the business and believe its new structure and strategy is sustainable.
64

Investment strategy
17. The fundamental strategy of a Private Equity Fund is to deliver cash returns to its Investors by increasing the value of the Portfolio Companies it acquires. Portfolio Companies are usually private limited companies rather than public companies. A Private Equity Fund makes investments each of which it intends to hold and develop over a period of 3-7 years. A Private Equity Funds investments in its Portfolio Companies are illiquid they cannot be easily sold or traded. Unlike a Hedge Fund, a Private Equity Fund does not trade in and out of complex positions such as quoted securities or assets or derivatives of them. For that reason, Investors in a Private Equity Fund commit for the lifetime of the Fund (typically 10 years). Again, unlike a Hedge Fund, Private Equity Investors are not entitled to redeem their investment or cancel outstanding Commitments before the end of the Fund. 18. A Private Equity Fund carries out extensive financial, legal and commercial due diligence on a business before it invests in it. Due diligence is also carried out on the business management and the sustainability of their projections for the future performance of the business. The Manager of a Private Equity Fund will challenge and test these projections and during its investment will be involved in overseeing the management of the business and advising on its strategy and operations. The Fund or the Manager will also usually appoint one or more people to act as directors of the top company in the Portfolio Group. In contrast, the type of fund that invests on a shortterm basis in complex or quoted securities will have relatively little information on the underlying business and little access to management to inform its investment decision. 19. A fund making short-term investments will usually receive the full amount of an Investors Commitment when they join the fund. By contrast, a Private Equity Fund will only draw-down cash from Investors when it needs to make an investment or pay fees. The Private Equity Fund does not hold Investors cash for any significant period of time. When in cash, money is typically held in a bank account in the name of the Fund. 20. A Private Equity Managers fee is not based on asset values and it usually only receives its Carried Interest once the Funds investments have been sold for a profit and Investors have received a return. Carried Interest is not paid on an unrealised gain in the books of the Private Equity Fund. A Hedge Fund typically pays regular returns to the manager of the fund not just on the disposal of its investments. The returns it pays are generally calculated on the current net asset value of both its realised and unrealised assets. Investments which have not yet been sold are deemed to have been sold for a profit that then counts towards the calculation of the amount to be returned. 21. A Private Equity Fund does not borrow from banks to leverage itself (other than short-term bridge financing by some Funds see section 1.12 of Section III). Therefore the Fund itself and its assets are not leveraged. Private Equity Funds do not use prime brokers to provide leverage against the security of the Funds assets.
Section III: Risk Analysis of Private Equity Participants and Stakeholders

1. The Fund
65
Market Risk 1.1. The main Market Risk to which the Fund is exposed is the risk of incurring a loss on the investments which it makes. A range of factors may give rise to a loss, including: 1.2. 1.3. investing at too high a price; or a fall in the general stock market, giving rise to the risk that an initial public offering of a Portfolio Company would realise less than the initial purchase price paid by the Fund; or an absence of demand amongst private buyers for the particular Portfolio Company; or adverse currency movement where investment is made in a currency other than that in which the Fund receives financing from Investors; or in relation to early stage/development investments, failure of a particular product or technology or lack of market demand for it; or in relation to early stage/development investments, failure to raise further funding to continue development.
These risks are faced by any investor in a private company and are not unique to the Private Equity industry. The Funds investments are generally in shares in private companies for which there is no market. Therefore the value of a Funds assets can only definitively be established on a realisation. Realisation of a Private Equity investment is likely only to occur on a single occasion some years after the initial investment is made. In the interim, whilst there are methods and principles for valuing the investments which are held, there is usually no means of verifying that the valuation produced represents what would be obtained on a realisation as at the valuation date. Given that the valuation of the Funds assets before realisation is not relevant to the calculation of payments to Investors or the Manager and the Investors can not realise their interests in the Fund before the end of its term, this does not give rise to a Market Risk. Risk management
1.4.
A hallmark of Private Equity transactions is the extensive financial, legal and commercial due diligence on a target undertaken by the Manager on behalf of the Fund. That due diligence is typically carried out by the Manager with specific aspects outsourced to experienced professional accountants, law firms and (on larger transactions) corporate finance advisors. This level of due diligence is far higher than is typically undertaken by investors who take a stake in a quoted company or by banks making a significant loan. This preliminary work is intended to put the Manager in the best possible position to decide whether the Fund should make an investment and if so at what price and with what financing structure.
1.5.
The Manager will generally also produce detailed projections of the expected financial outcome of the Portfolio Group and the Funds investments in it. Such projections are typically stress-tested to measure the effect unexpected events or a reduction in trading would have on the investment. The Fund often receives warranties from the targets senior management legally confirming that the projections (and assumptions on which they are based) are reasonable and warranting certain facts about the state of the business and its liabilities. Such legal protections are not usually available to an investor in market securities.
66
1.6.
The Private Equity model is deliberately designed to ensure that once the investment is made, the interests of the Manager and its executives are closely aligned to the interests of Investors, ensuring they are focused on increasing the value of Portfolio Groups. For the Manager and its executives, this is achieved through the Carried Interest (see section 14 of Section II). Unlike many Hedge Funds or other funds investing in quoted or other securities, the Manager and its executives will not receive any Carried Interest or return on any co-investment until investments have actually been realised giving an adequate return to Investors. Neither the Managers fee nor Carried Interest is calculated on or paid out on unrealised valuations.
1.7.
An important point to note is that investment in Private Equity is not intended to be low risk. However, the quantum of the risk is fixed for Investors at the outset. The Fund will have a certain amount of diversification in its investments, mitigating risk. For example, a Buy-out Fund typically makes between 8 and 12 investments over a five-year period and at different stages of the economic cycle. A Venture Capital Fund typically makes between 20 and 40 investments over a five-year period. In order to provide adequate portfolio risk diversification, the earlier stage a Venture Capital Funds investments are the greater number of its investments. In either type of Fund, these investments will be in different types of business sectors or in different jurisdictions.
1.8.
During a market down-turn, a Private Equity Fund can hold onto its investments until the market recovers and the Fund can sell at a profit. It is not forced into selling investments to fund investors redemptions or collateral calls like other funds.
Credit Risk 1.9. A key Credit Risk is that a Portfolio Group will fail to repay the amounts lent to it by the Fund. A Fund will typically make loans to a Portfolio Group which are subordinated to those made by the Lenders whose debt is also usually secured these loans are in effect akin to equity. Repayment to the Fund is normally due only on the sale of the Portfolio Company. Accordingly, if the sale of the Portfolio Company fails to generate sufficient monies to repay both the Lenders loans and the Funds loans, the Fund will not be repaid. 1.10. A Fund is also exposed to a Credit Risk that an Investor will breach its contractual obligation to pay its share so the Fund can (i) pay fees to the Manager etc.; or (ii) make an investment. This is also analysed in the Counterparty and Liquidity Risk sections below. 1.11. Like any business, the Fund also faces the Credit Risk that the bank at which it holds its funds becomes insolvent. 1.12. Some Private Equity Funds obtain bridge financing from third-party lenders to fund their investments before cash is drawn-down from Investors. If an Investor breaches its contractual obligation to provide the cash, the Fund could have insufficient funds to repay its bridge funding. Risk management 1.13. A Fund relies on its Manager to make the correct initial investment decision when making a loan to the Portfolio Group, based on extensive due diligence and industry expertise (as to which see further sections 1.4 to 1.6 above).
67
1.14. The Manager also monitors the ongoing financing needs of the Portfolio Group, with a view to protecting the investment of the Fund, through board representation and the detailed financial information it is contractually entitled to regularly receive. 1.15. The risk that an Investor will not have the financial resources to meet its Commitment when called by the Fund is generally managed when the Fund is established through a credit and general assessment of each Investors ability to meet its Commitment. This is of great importance to the Manager and the contractual arrangements between Investors and the Fund usually provide for serious consequences if an Investor fails to fund, in particular an Investor who defaults on a Commitment usually forfeits its rights in respect of existing investments to the other Investors. The Manager will continue to monitor the financial status of the Investors during the life of the Fund.
Counterparty Risk 1.16. The Fund may be said to incur Counterparty Risk to Investors the risk that they might default on their funding Commitment but this is analysed in sections 1.27 to 1.36 below as a form of Financing and Liquidity Risk. 1.17. There is an element of Counterparty Risk in any transaction in securities which are admitted to trading on a market (exchange or MTF or similar market). If these transactions occur through normal market mechanisms, then the Fund is subject to the normal risks associated with such trading, in particular counterparty failure after the trade is made but before settlement. This is a risk for the Fund, not the Manager, as the Manager will be acting as agent for the Fund and will not have guaranteed the performance of the counterparty to the Fund or vice versa. 1.18. Counterparty Risk for the Fund does not arise on a standard Private Equity investment (i.e. one which is not on-market in a publicly traded security which in this context would usually be a public to private transaction), which is an over the counter transaction in which delivery of securities (usually issue of securities by the new holding company) takes place at the same time as the delivery of monies by the Fund. Each investment by the Fund in and/or in direct acquisition of Portfolio Groups is an unique transaction the terms of which are heavily negotiated between the parties. They usually complete at a full face-to-face completion meeting at which securities are issued or exchanged and money is paid by the Fund in return. Therefore, the risks are not the same as those which arise in other markets where there may be long-term outstanding obligations, for example under derivative contracts. 1.19. In some transactions there is a time period between entering into the contractual commitment and consummating the transaction, usually because certain regulatory or commercial consents are needed (a Split Transaction). In a Split Transaction, the detailed legal agreements (which are heavily negotiated by the Manager) should protect the Fund so that it is only required to provide cash when all other sources of acquisition funding are available. The acquisition vehicle being used, rather than the Fund, will be obliged to provide money to the sellers on completion of the transaction although some sellers have in recent years asked the Fund to provide legal confirmation that it will provide funds to the acquisition vehicle. When this occurs, the Manager needs to ensure that monies from Investors will be provided or have some other mechanism (such as a bridge facility) in place so that it is not exposed.
68
1.20. Where a publicly traded company is acquired by a Fund (a public to private transaction), local law or regulation may require the Fund to confirm on announcing its offer that it has sufficient funds to meet its obligations. In these circumstances the Manager and the Fund will have to arrange for Investors to provide their cash commitments (or obtain alternative bridge funding) prior to exchange of contracts or announcement. 1.21. If Lenders providing acquisition financing fail to provide their funds on completion of the transaction, the acquiring vehicle and the Fund, indirectly, could be exposed to a Financing Risk. The legal documentation should be structured so that the Lenders are contractually obliged to fund if the acquisition vehicle is obliged to complete. However, if the Lenders fail to fund in breach of contract, the acquiring vehicle will have to pursue them for damages (which can be a lengthy process) and may not be able to obtain other funds to satisfy its obligations to the sellers. Risk management 1.22. In relation to Split Transactions, the Manager can mitigate Counterparty Risk by (i) organising draw-downs from Investors before becoming contractually committed to complete the transaction; (ii) if monies are not drawndown in advance, arranging bridge financing and ensuring that the bridge lenders contractual commitment to provide finance matches the acquiring companys commitment to pay the sellers; and (iii) ensuring that the Fund is not obliged to provide funding to the acquiring vehicle if other funding sources default. 1.23. In relation to public market securities, a Fund relies on the Manager to trade through creditworthy counterparties in exchange and similar market transactions. Risks for the Fund in these circumstances are the same as for any other market participant. 1.24. In relation to over the counter acquisitions, Counterparty Risk for the Fund can be mitigated by taking adequate legal advice and building in the necessary protections for the Fund in the transactional documents.
Operational Risk 1.25. The Fund will not usually have a separate independent existence in an active sense. Its activities are usually performed by the Manager and other fiduciaries. The Fund could suffer losses if an Operational Risk arising at the Manager, administrator or custodian level affects the value of the Funds interest in its investments see sections 3.18 to 3.23. The Funds risks are therefore derived from the entities which provide it with services. Risk management 1.26. Before committing to invest in a Fund, an Investor will generally carry out due diligence on the Manager and its previous operations and track record. If necessary, during the life of the Fund, the Investors generally have the contractual power to replace the Manager for cause. Investors will be aware of the identity of the administrator and custodian and can put pressure on the Manager to replace these entities if necessary.
69
Financing and Liquidity Risk 1.27. When the Fund makes an acquisition, it will invest in newly established companies, some of which will, if a leveraged Buy-out transaction, also take up bank financing in order to acquire the target. The acquisition vehicle will be contractually obliged to make payments to the sellers of the target which it will fund from the sources referred to above. On Venture Capital and smaller Private Equity transactions there probably will not be any bank funding. The Funds investment is met by drawing-down cash from Investors. 1.28. The most common practice is that the funds are drawn from Investors in anticipation of the expected date for the acquisition and the banks transfer their funds at the time of signing and completing the acquisition. 1.29. On larger Split Transactions, the sellers may require a legal commitment from the Fund that it will put the acquiring vehicle in funds to pay the sellers on completion of the transaction. If the Fund gives such a commitment and an Investor defaults on its obligation to provide the cash, the Fund would have a legal obligation to pay the consideration to the sellers without necessarily having the financial resources to meet such obligation. It is highly unlikely that a significant number of Investors would all default on their Commitments. On a public to private transaction, local law or regulatory requirements may require the Fund to confirm on announcing its offer that it has sufficient funds to meet its obligations. In most circumstances the Manager and the Fund will have to obtain cash from Investors (or obtain alternative bridge funding) prior to entering into the contractual commitment or announcement. 1.30. If Lenders providing acquisition financing fail to provide their funds on completion of the transaction, the acquiring vehicle and the Fund, indirectly, could be exposed to a Financing Risk. The legal documentation should be structured so that the Lenders are contractually obliged to fund if the acquisition vehicle is obliged to complete. However, if the Lenders fail to fund in breach of contract, the acquiring vehicle will have to pursue them for damages (which can be a lengthy process) and may not be able to obtain other funds to satisfy its obligations to the sellers. 1.31. If the Investors default shortly before a transaction, the Fund or the Manager would be liable for the professional fees incurred in getting the acquisition to that stage. It is in the Funds and its Managers control to organise the Investors payments in advance and understand whether an Investor will have difficulty meeting the payment. In these circumstances the Funds would typically have virtually no Financing Risk. 1.32. It would be unusual for a Buy-out transaction to contractually oblige the Fund to provide ongoing finance to a Portfolio Group following purchase of the relevant target company. The Manager usually decides on a caseby-case basis whether to make a new or follow-on investment. Some Venture Capital transactions may oblige the Fund to provide further funding if the business achieves key developmental milestones. The cash for this further funding will only be drawn-down from Investors if and when the milestones are achieved. Accordingly, there is no commercial requirement for Funds to hold any liquid assets; and, therefore, the issue of Liquidity Risk is not generally relevant to Funds. 1.33. It should be noted that interests in a Private Equity Fund are not normally redeemable so the Fund will not therefore have the obligation to meet redemption requests. This reflects the illiquidity of the underlying assets of the Fund.
70
1.34. A Fund is exposed to losses in the event that a Portfolio Group is unable to meet its liquidity or financing needs. 1.35. Some Funds obtain bridge financing from third party lenders to either fund their investment Commitments before Investors draw-down the relevant cash or to leverage the Investors financing. These Funds are exposed to failure by the relevant lender or the credit market to make financing available when the Fund is contractually obliged to provide the funding. The bridge financing is usually secured against undrawn Investor Commitments giving the bank comfort. A bank would not be prepared to provide bridge financing unless it had assessed its Credit Risk to the Investors. 1.36. The only regular payment due from the Fund is the payment to the General Partner/Manager. This is paid out of the Funds realised profits or (in the early years before any profits have been generated) out of the Investors contributions. The Manager will instruct the Investors to make sufficient contributions to the Fund to cover this in accordance with their outstanding Commitments. Accordingly the Funds Financing Risk is that the Investors will default. Risk management 1.37. The risk that Investors will not have the financial resources to meet their Commitments when called by the Fund is generally managed when the Fund is established through a credit and general assessment of Investors ability to meet their Commitments. 1.38. It is in the Funds and its Managers control to organise its Investors payments in advance and understand whether an Investor will have difficulty meeting the payment.
Group Risk 1.39. The Fund is principally dependent on the services provided to it by the Manager and is therefore indirectly affected by any Group Risks to which the Manager is exposed see section 3.30.
Fiduciary Risk 1.40. The Fund is exposed to Fiduciary Risk both because its assets are managed by the Manager and because its investments will be held by a custodian (which may be the Manager) and any cash will be held either in a client account or in a bank account. 1.41. In addition to the risk of fraud, the Fund faces the indirect risk that the Manager will take insufficient measures to guard against Financial Crime Risk (for example of illicit money being committed by an Investor) or Market Abuse or Operational Risk. Risk management 1.42. The Fund should use an investment manager and custodian which are subject to and comply with effective oversight and proper professional standards. The methods used by the fiduciary to manage conflicts of interest, including adequacy of disclosure of conflicts and methods of management of conflict should be monitored. As in any business, fraud can never be completely safeguarded against.
71
Legal and Regulatory Risk 1.43. Legal and regulatory structures can be used to prevent Funds established in certain jurisdictions and/or using certain structures from purchasing target companies. These restrictions may be explicit in legislation. More commonly, regulators use their veto over the purchase of certain types of target companies to block certain types of investors, which may include non-nationals and Funds. In these cases, the restriction is implicit in the way a jurisdictions regulators or government behave. Risk management 1.44. Not to invest in the relevant sector and/or in the relevant jurisdiction.
2.
The Investors
Market Risk 2.1. Investments in Private Equity Funds are by their nature illiquid long-term investments. Investors typically hold partnership (or similar) interests in the Fund rather than a security or other readily transferable interest. Often the consent of the Manager is required if an Investor wants to sell its interest in the Fund. 2.2. Investors do not expect to realise their investment through selling their interest in the Fund, but rather by payments from the Fund representing their share of proceeds when the Fund sells its Portfolio Companies. This means there is no registered market in the interests in a typical Private Equity Fund. Although interests in Funds are sold from time to time as secondary interests, and the number of such transactions has increased over time, these are bespoke off-market transactions. No Investor in a Private Equity Fund would make a commitment in the expectation that he would be able to fully realise it before the Fund is wound up. 2.3. An exception to this might arise where the Fund itself is constituted as a body corporate, with shares which are listed and/or admitted to trading on a market, such as a venture capital trust in the UK or a Luxembourg SICAV. However, shares in venture capital trusts or SICAVs tend to be thinly traded (if at all in some cases) and their market valuation is usually at a discount to the Funds net asset value. Such shares are also no different in their risk-reward profile to the investor from other quoted investment vehicle shares. 2.4. Accordingly, the major Market Risks faced by Investors are generally the same as those faced by the Fund in which they invest please see sections 1.1 to 1.8. In the case of Funds structured without separate legal personality, including most limited partnerships, the Market Risk is the Investors direct risk, in proportion to their Commitment, but for the purposes of this paper may conveniently be analysed by reference to the Fund as a single undertaking. 2.5. It is also very important to note that the Market Risk to the Investor is fixed at the amount of its total Commitment when it joins the Fund. At no time can any change in the market affect the quantum of an Investors risk.
72
Credit Risk/Counterparty Risk 2.6. The Investors principal Credit/Counterparty Risk arises in relation to their entitlement to any dividends or capital returns from the Fund. This risk is likely to be directly against the Fund which will be due to make payments to Investors once its other liabilities have been met. This risk is probably more properly seen as a Fiduciary Risk because, provided that the Fund has generated profits which are due to be distributed, there is no real Credit Risk that the Fund is not able to afford its obligations. Instead there is a Fiduciary Risk, that an intervening fraud or similar act prevents it from making the distribution see section 2.17. 2.7. The Investor is of course exposed to the Credit Risk that the bank at which the Fund holds its account becomes unable to meet its obligations to the Fund. 2.8. The Investors are not usually exposed to the Credit Risk of the Manager because the Manager does not normally hold the Funds assets or money. Even if it does, provided that the structures used create a proper segregation of client assets/money, there is no Credit Risk.
Operational Risk 2.9. Any Operational Risks of Investors do not relate to the fact they are an Investor in a Private Equity Fund.
Financing and Liquidity Risk 2.10. An Investor is contractually obliged to meet cash calls by the Fund in relation to its outstanding Commitment. The Investor has a Financing and Liquidity Risk that it will be unable to finance its Commitment because it has suffered losses elsewhere in its business or investments or it has not received expected distributions of profits from other funds it has invested in because they have not been able to dispose of investments. 2.11. Institutional Investors in Private Equity may face other risks because of the unique profile of the Commitment and structure of the investment. Investors often have limits on the amount of their assets that can be allocated to a particular investment class quoted securities; bonds; private equity; real estate etc. In contrast to other asset allocations, an Investor usually commits capital to a Private Equity Fund for the long term. The Investor has to actually provide the cash over a long period and the timing of the returns it may receive is unpredictable. When an institution first invests in Private Equity Funds, it may need to adapt its normal asset allocation procedures. Risk management 2.12. Allocation and similar risks are typically addressed by institutional Investors obtaining independent expert advice on their Private Equity Commitment from their usual professional advisers or from one of a number of specialist consultancies. Several larger Investors have developed extensive in-house expertise. Typically, institutional Investors allocate a relatively small amount to Private Equity because of its higher risk profile. Nonetheless, investment in Private Equity is necessary to provide diversification for Investors and drive their returns.
73
2.13. In addition, Private Equity affords many Investors considerable opportunity to negotiate with the Manager over the terms of their investment, which may not be the case in relation to other asset classes. Investors legal counsel can assist in negotiating the terms of investment to the Investors advantage and by reference to market norms. 2.14. Beyond prudent asset allocation, risk management in this situation involves seeking to renegotiate the size of the Investors Commitment with the Manager. Until recently this has not been an issue because of competition amongst Investors to raise their Commitment levels. However, in the last few months there have been examples of institutions seeking to reduce their commitments because losses or devaluations of their investments in quoted securities or real estate can mean that their Private Equity investments could exceed their internal allocation limits.
Group Risk 2.15. This risk would only be applicable if the Managers business is disrupted due to the Group Risks that it faces (see sections 3.30 and 3.31). This may affect the Managers ability to perform effectively, at least for a period of time, which may affect the Funds performance, and therefore the Investor.
Market Abuse Risk 2.16. Investors are generally not given unpublished price sensitive information in relation to the Funds or the Managers activities. Where a draw-down needs to be made to purchase a quoted company, this is normally sent to Investors after the matter is public; if not then there is normally no disclosure to the Investors about the identity of the target.
Fiduciary Risk 2.17. Investors are exposed to the risk that an intervening fraud or similar act prevents the Fund or the Manager distributing monies due to Investors. 2.18. Investors also face the risk that Managers or individual executives might put themselves into a situation in which their own interests conflict with those of the Fund. Risk management 2.19. Investors are typically subject to regulations governing the approach they must take to their investments. Investors undertake extensive due diligence on Managers, principals and key executives. Investors are also actively and extensively engaged in negotiating the terms of their investment. Managers and Funds are regularly subject to external audits. In most instances and most jurisdictions in the European Union, the Investors are themselves regulated and will have a standard of due diligence they have to meet in selecting fund managers. The effect of applicable law and/or local regulation may also impose liabilities on Managers for breach of fiduciary and similar duties.
74
2.20. Investors usually negotiate the right to receive regular and detailed financial information on the Funds investments and its performance. 2.21. For this reason, Private Equity Fund structures have developed to align the interests of Investors and Managers, including through the Carried Interest and prohibiting cherry-picking of co-investment opportunities by the Manager or its executives. Usually advised by specialist professionals, Investors often have considerable negotiating power and opportunities to exercise supervision and otherwise mitigate Fiduciary Risk. 2.22. Most Funds have Advisory Committees made up of representatives of the Investors where conflicts of interest are addressed.
Legal and Regulatory Risk 2.23. Potential Investors located in a jurisdiction which imposes disproportionate requirements on Managers when promoting a Funds interests or that have legal restrictions on how much can be invested in a particular asset class, may effectively be prevented from having the opportunity to invest in a Fund. This can occur because of the regulatory status of the Manager and/or the type of fund structure used and its location. Different jurisdictions often have different rules on the types of Investor to whom a Manager may promote a Fund, making it difficult for a Manager to promote a Fund in multiple jurisdictions. Risk management 2.24. Investors may be given the opportunity to invest via feeder structures designed specifically for a certain type of Investor in a certain jurisdiction. However, this is often a costly solution and may not always be available.
3.
The Manager
Market Risk 3.1. A Manager will be exposed to Market Risk if any of its income, assets or liabilities is affected by the valuation of assets or by interest or exchange rates. Managers do not trade as principal and the concepts of trading books and the Market Risks associated with trading books are not applicable to them. 3.2. A Managers main source of income during the initial investment period of the Fund is the management fee paid through the Fund. The management fee is used to meet the Managers business costs, expenses and overheads, e.g. salary and property costs. Management fees are calculated based on the value of Investors Commitments not the value of the Funds assets. The Managers income therefore has little exposure to fluctuations in the market value of the Funds assets or liabilities. 3.3. For many Private Equity Funds, the management fee reduces or is calculated based on the Funds residual asset cost at the end of an initial investment period (typically five years). At that point, the risk profile changes. However, at this point a Manager will usually be raising a new Fund, which will give rise to additional management fee income. This is always on terms agreed with the previous funds investors.
75
3.4.
The Manager may be exposed to exchange rate risk if its own assets and liabilities are denominated in a currency other than the currency in which its fees are paid because, for example, it has raised a Euro fund but is based in Sweden.
3.5.
The Manager is only likely to have a small interest rate risk (on any incidental or interim investments), unless it has borrowings of its own. This is not a common feature with Private Equity Firms which tend to be funded wholly by their owners.
3.6.
The Manager and its executives will typically be required by Investors to invest in their Fund (typically up to 1-5% of total Commitments to the Fund) and receive a share in its profits by way of Carried Interest. The Manager and its executives may also invest in Portfolio Companies alongside their Funds. Properly structured to prevent cherry-picking of investments by the Manager and its executives, the interests of the Manager and its executives are aligned with the interests of the Fund and its Investors and the Manager and its executives are equally exposed to risk in the valuation of the Funds Portfolio Companies.
3.7.
A Managers ability to raise a new Fund will often be dependent on the strength of the fund raising market and the performance of the Managers previous Funds, both of which may be impacted by market fluctuations. Risk management
3.8.
Funds which are body corporates and listed and/or admitted to trading on a market, such as a venture capital trust in the UK, can reduce the discount on the share price to the net asset value by buying in any excess of shares.
3.9.
Like any other business, the Manager can use standard hedging techniques in order to manage exchange and interest rate risks.
Credit Risk 3.10. The Managers principal Credit Risk arises from its exposure to the Fund (via the General Partner) for payment of the management fee (which, once invoiced, is a debt due from the Fund). The Manager is directly exposed to the Fund, and indirectly exposed to Investors, because if the Investors breach their contractual obligations to pay monies to the Fund when called, the Fund will not otherwise be able to pay fees due to the Manager. If a Portfolio Company fails this will impact the valuation of the Funds assets and the amount of the management fee in the latter part of the Fund. 3.11. The failure of any one Investor to meet its Commitment to the Fund is unlikely to have a significant impact on the Managers aggregate income, mitigating this risk. The Fund is a collective vehicle and it would require a significant number of Investors to breach their contractual obligations before the Managers income was significantly reduced. 3.12. Most Funds never draw down all of the Commitments during the initial investment period because they need to preserve some capital for follow-on to support existing investments, if necessary, and for management fees.
76
Risk management 3.13. As operator and manager of the Fund, the Manager directly and indirectly controls the payments due to it from the Fund. The Manager often has authority to take unpaid fees from the Funds bank account. If the Fund receives Investors Commitments as they fall due, there is no real risk that the Manager will not be paid its fee, unless the bank with which the Funds account is maintained is itself unable to meet its obligations to its creditors. 3.14. The risk that Investors will not have the financial resources to meet their Commitments when called by the Fund is generally managed when the Fund is established through a credit and general assessment of Investors ability to meet their Commitments. An Investors ability to meet its Commitment is of great importance to the Manager and the contractual arrangements between Investors and the Fund usually provide for serious consequences if an Investor fails to meet its obligations i.e. loss of all amounts previously invested in the Fund by the Investor. Therefore there is significant downside for an Investor if it chooses to breach its obligations to the Fund, which encourages Investors to continue performing their obligations. The Manager is most at risk of an Investor breach at the beginning of a Funds life cycle where Investors do not have investments to lose; but the Investor may still be pursued for its breach of contract.
Counterparty Risk 3.15. The Manager will generally not have any Counterparty Risk because even where the Manager enters into transactions as agent for the Fund, it is the Fund that is the party (and therefore has the liability) not the Manager. 3.16. Unless a Manager or its executives co-invest alongside a Fund in a Portfolio Company it will not incur Credit/Counterparty Risk on the failure of an Portfolio Company, because it is not directly exposed to the Portfolio Company. However, the failure of a Portfolio Company will ultimately impact on the return available from the performance of the Fund. If the total performance of the Fund (taking into account the performance of all investments) is poor, the Manager and the executives will not receive their Carried Interest and/or have their co-invest returned and it may have a negative effect on the Managers ability to raise new Funds. 3.17. If at completion of a transaction an Investor does not deliver its funds and no bridge financing is arranged, with the result that the transaction cannot be completed, then the sellers have a Counterparty Risk to the Fund. Due to the way in which the transactions are structured (unless the Fund has entered into a specific commitment letter) the Fund and the Manager will not be contractually liable to the sellers although a disgruntled seller could still try to bring an action against them.
Operational Risk 3.18. The Manager has a range of Operational Risks. The principal Operational Risks are likely to arise out of: Business continuity risk IT security and processing risk Departure of key executives Execution, delivery and processing of investments Outsourcing risk Compliance risk for regulated managers Reputational risk (including those which could result from any of the above risks)
77
Risk management 3.19. Like any other business, risk management includes carrying out business continuity planning, putting in place the necessary procedures and carrying out regular audits of IT security. 3.20. The potential for key executives leaving is managed by putting in place contractual arrangements with executives that tie their gains to the end performance of the Fund and the actual return received by Investors. An executive is usually incentivised to stay with the Manager for the life of a Fund through leaver provisions and similar contractual arrangements that can result in executives losing a significant amount of their share of the Carried Interest and/or co-invest if they cease working for the Manager or go to work for the Managers competitors. 3.21. A Fund is not usually dependent on a single executive. The Fund documents often identify a group of key executives whose continuing involvement is important to Investors and set out the consequences if a certain number of them leave. 3.22. A Manager will typically instruct experienced professional advisers to carry out extensive legal, financial and commercial due diligence for the Fund on its potential investments. The Funds investments in Portfolio Groups are bespoke commercial transactions. The Manager heavily negotiates the acquisition and investment documentation in order to safeguard the Funds interests. 3.23. Managers generally have internal operational procedures with which they have to comply before making an investment in a Portfolio Group which stress-test the commercial rationale for the investment and the validity of its projected returns. Investors expect to see that the Manager has robust procedures in place and may review these before committing to an investment in a Fund. 3.24. Regulated Managers put in place internal compliance procedures and personnel to ensure that all applicable regulatory requirements are identified and satisfied.
Financing and Liquidity Risk 3.25. A Manager generally has a fairly straightforward Financing and Liquidity Risk profile. Its principal income comes from the management fee. The management fee is predictable, both in amount and timing of payment (because it is agreed in advance at the time the Fund is established) and reasonably secure (initially being dependent only on the Investors meeting their Commitments to the Fund). A Managers principal expenses are its employment and property costs which again tend to be predictable and largely within the Managers control. There is no significant bonus culture in the Private Equity industry - executives receive a share in the profits made by the Fund through their investment in the Fund via the Carried Interest Vehicle which is not an expense for the Manager. Therefore, whilst the Manager will have processes to determine the adequacy of its financial resources, for most this is a fairly simple calculation. 3.26. The principal Financing and Liquidity Risk for a Manager is that it will fail to make sufficient profit with its current Fund to attract Investors to a new Fund. However, were the Manager not able to raise a new Fund it will know well in advance that it will run out of cash when it closes its current Fund and can plan accordingly.
78
Risk management 3.27. This can be managed by stress-testing a Managers financial resource requirements and identifying means by which these could be increased if required (for example, by obtaining access to secured funding or by reducing expenditure) and evaluating the continuing ability of Investors to satisfy Commitments. 3.28. The general predictability of the management fee contrasts with the position of managers of funds which invest in quoted securities. Whilst the fees charged by these managers are also fixed at the outset, redemptions by investors are generally permitted, so the income stream from the fees is less predictable. By contrast, redemptions are not generally permitted in Private Equity Funds because of the illiquid nature of the underlying assets. This means the Funds size is fixed for a minimum period once the Fund is raised. The predictability of the management fee in the Private Equity model means that there is no commercial incentive for a Manager to obtain debt financing from a lender or a large amount of financing from the Managers owners. 3.29. The use of Carried Interest to incentivise senior executives based on actual cash returns on investments made and exited means that staff expenses for Private Equity Funds are more predictable and less expensive (in terms of annual compensation costs to be met from the Managers income) for the Manager.
Group Risk 3.30. A Manager can be (i) a stand alone entity owned by its executives; or (ii) part of a larger group of companies which are involved in operating and managing Private Equity Funds (this group will usually be ultimately owned by the executives); or (iii) part of a larger group that is involved in a wide range of financial services banking, insurance, asset management etc. 3.31. Private Equity Firms which are part of a larger group may depend on other parts of their group for common services (such as IT or HR services) and may be exposed if the group as a whole encounters financial difficulties. This may lead to a decision, for example, to sell the Manager, the holdings in the Funds and/or direct holdings in an Portfolio Group. By definition, Group Risks depend on the nature of the group of which the Manager is a member and its interaction with and dependency on other group companies. Risk management 3.32. Proper assessment of exposure to Group Risk and monitoring of the services provided by the rest of the group is important. In practice, there is no real risk management technique that an individual group company can use that is relevant to the continuing inclusion of that entity within the group. History shows that a number of Private Equity Firms have been sold when they have been part of a larger group generally to their own management in a management buy-out.
Financial Crime Risk 3.33. Like any other business, the Manager faces both internal and external Financial Crime Risks. It faces the risk of internal fraud (such as the theft of money or other property from it or the theft of data) and external fraud (such as fraudsters gaining access to its accounts or IT systems to operate a fraud).
79
3.34. It also faces the risk that, when raising a Fund, making an investment or selling an investment it may encounter third parties who are money launderers. Risk management 3.35. This can be managed by putting in place internal control systems, carrying out internal audits and employment vetting and separating functions (where possible) between employees to ensure adequate risk management. 3.36. Checking IT security including by vetting external contractors and carrying out due diligence on any third parties used. 3.37. Carrying out appropriate anti-money laundering checks on Investors and, on a risk-based approach, the persons with whom the Manager deals in the course of negotiating a transaction. The Money Laundering Directive applies in all European jurisdictions. 3.38. In addition, the Fund can choose with whom and in what jurisdictions it does transactions. For ethical and political reasons, certain Investors will insist that the Fund does not invest in certain jurisdictions or industries.
Market Abuse Risk 3.39. The Manager faces the risk that it will (deliberately or inadvertently) reveal information which is inside information in breach of the rules concerning disclosure of inside information and/or may (deliberately or not) be involved in the dissemination of rumours concerning a relevant investment. As a result, the Manager may deal (or cause the Fund to deal) in securities in relation to which the Manager has inside information. 3.40. The Manager also faces the risk that its staff may deal in securities in relation to which it has inside information. 3.41. There is a risk that the Manager will deal with securities in a manner which is considered abusive under the Market Abuse Directive. Risk management 3.42. Training all employees on the laws and regulations relating to insider dealing and market abuse. (Managers and their employees are subject to the Market Abuse Directive.) 3.43. Putting in place personal account dealing policies and leak and rumour policies, robust confidentiality policies and internal procedures for restricting the flow of information about affected securities (both internally and to third parties) and prospective investments. Where the Manager is part of a bigger financial services group, chinese walls and other mechanisms will be put in place to prevent information leaking across divisions. 3.44. Monitoring transactions with which the Manager is involved and, if rumours are circulating, to ensure that the Manager, and/or its staff is not involved in the circulation or confirmation of rumours. 3.45. Non-Disclosure Agreements are usually entered into by key participants in Private Equity investments under which the Fund, the Manager, its advisors and the providers of finance contractually agree not to disclose any information about the business it is evaluating.
80
Fiduciary Risk 3.46. Generally the Manager is itself a fiduciary, rather than exposed to Fiduciary Risks. However, where it deals as an agent on behalf of the Fund through a third party then it is subject to the risk that that third party could fail in the performance of its obligations. Risk management 3.47. Assessment of a third party and carrying out due diligence of its ability to perform its obligations to the Manager and Fund.
Legal and Regulatory Risk 3.48. The main Legal and Regulatory Risk faced by a Manager is that it is unable to carry on its business or deal with Investors or Portfolio Groups in a particular jurisdiction, or that the costs of doing so are disproportionately high. Such risks are not unique to managers of Private Equity Funds. Risk management 3.49. Taking legal advice and avoiding problematic jurisdictions, e.g. by not investing or establishing offices in those jurisdictions or moving to other jurisdictions.
4.
The Lenders
This Section 4 is not relevant to the Venture Capital and Growth Capital sub-sets of Private Equity which typically do not use leverage when investing. Venture Capital and Growth Capital make up the largest proportion of Private Equity in number of firms and volume of transactions.
Market Risk 4.1. Lenders to Private Equity backed transactions lend only to the Portfolio Group not the Fund. In relation to loans to the Portfolio Group, Lenders are exposed to Credit Risk rather than Market Risk see sections 4.7 to 4.14 below. 4.2. If the Lenders debt in a Portfolio Group is bought and sold, the Lenders will have Market Risk if the debt is trading below par. 4.3. Lenders will have Market Risk if they are also in the position of being an investor in the Portfolio Group by also taking a direct equity stake. Some banks in recent years have acted as principal lender to Portfolio Groups in which they also hold a significant equity stake. 4.4. Mezzanine debt providers sometimes take a warrant to subscribe for equity in a Portfolio Group to which they have provided debt. The decision to exercise the warrant and acquire the equity is completely within the control of the debt provider who can assess the risk profile in acquiring the equity at the relevant time.
81
4.5.
Lenders have interest rate risk if the interest rate paid by the Portfolio Group borrower is not calculated with reference to a standard which accurately reflects the Lenders cost of lending. For example, Lenders generally lend at a margin related to LIBOR or another similar international benchmark and in the recent market there have been concerns that this does not reflect the true cost at which banks are having to borrow money, leading to discussions as to whether this entitles the Lenders to invoke market disruption clauses to increase the cost of borrowing for the Portfolio Group. This is a consequence of the current market issues and is relevant to all such bank lending not just bank funding for Private Equity backed companies.
4.6.
The FSA has identified that if the debt created in connection with a leveraged buyout is heavily traded there can be issues for those market participants concerned involving unclear ownership of the economic risk.
Credit Risk 4.7. The Credit Risk of a Lender is default by a Portfolio Group and potentially by other institutions who are lending to the Portfolio Group. 4.8. Where the Lender is lending as part of a syndicate of banks, if another Lender in the syndicate or club defaults on its lending commitments there may be a shortfall in the amount of funds available to the Portfolio Group giving it, at least, cash flow problems. Lenders in a syndicate are generally each liable for their own commitment, not for each others commitment, but the failure of one Lender to meet its commitment can increase the Credit Risk that has been taken on by the Portfolio Group. This risk arises from the banks spreading the lending burden (and limiting their total exposure to risk) and is not unique to lending to Private Equity backed companies. 4.9. Where a loan is administered through a bank which also acts as a facility agent (intermediating between the Lenders and the borrower) additional risks can occur if the bank acting as facility agent becomes insolvent. In such circumstances the facility agent may have received payments from other Lenders which it has not passed on to the Portfolio Group, and vice versa, potentially leaving borrowers and Lenders out of funds. An insolvent facility agent may also prevent the syndicate or club acting effectively if under the control of administrators it is not able to take active control and manage the other Lenders to protect their collective interests in the Portfolio Group. Again these risks are consequences of the banks lending structure and are not unique to lending to Private Equity backed companies. 4.10. Recently some transactions (particularly in the UK and US) have used relatively light banking covenants. These can be very advantageous to the Portfolio Group (and therefore the Fund and its Investors) as they may enable a Portfolio Group to trade through difficult times without being at risk of foreclosure by a Lender. However, they may have an adverse impact on the ability of a Lender to take pre-emptive action to prevent losses from increasing. 4.11. If a Lender is providing bridge financing to a Fund (see section 1.12) it will have a potential Credit Risk in relation to the Investors if they fail to satisfy the demand for draw-down from the Fund.
82
Risk management 4.12. In relation to the Portfolio Groups Credit Risk, carrying out a credit assessment of and due diligence on the Portfolio Group, taking security over its assets and entering into adequate legal documentation are the principal mitigants for the Lenders. Lenders typically insist on seeing (and sometimes are able to rely on) the due diligence carried out for the Fund. We note that the FSA Feedback Statement refers to the fact that Lenders had increased the amounts of credit they were willing to extend on Private Equity transactions, and considered that a risk exists that leverage in some individual transactions could increase to levels affecting the viability of the borrower. The FSA agreed that increasing leverage was not necessarily correlated with declining credit and risk management standards, but noted the importance for such Lenders to have robust systems and controls. 4.13. Putting together clubs or syndicates of various lending institutions allows the principal arranging bank to spread the risk across lenders and limit each Lenders exposure to the risks. Lenders may also be able to sell part or all of their interest in loans to other Lenders through novation and sub-participation in over-the-counter transactions after the initial loan transaction. Similarly, a Lender may use this mechanism to purchase an exposure to a loan (rather than provide the initial loan to the borrower). The current financial environment has significantly reduced the market and value of syndicated loans but this is not specific to Private Equity related loans. 4.14. Lenders may purchase credit default swap protection against the risk of default by a borrowing Portfolio Group. Typically this will be purchased from a major financial institution or insurer.
Financing and Liquidity Risk 4.15. Loans to Portfolio Groups are generally medium to long term and are accordingly illiquid. Risk management 4.16. Lenders can sell part of their loans (or exposure to their loans) to syndicatees and other investors, creating some liquidity. The current financial environment has significantly reduced the market and value of syndicated loans but this is not specific to Private Equity related loans. 4.17. The total amount of loans to Private Equity backed companies represent only a small percentage of the European banks assets. There would need to be a significant number of Private Equity backed companies becoming insolvent to have a significant effect on their Lenders. As secured lenders, if Portfolio Companies are breaching the terms of their banking facilities the Lenders are in control and should be able to decide whether to put the Portfolio Company into administration, restructure it or allow it to continue trading.
Financial Crime Risk 4.18. Any fraud or money laundering risk of the Lender to Private Equity backed companies is no different from that faced in relation to the rest of the Lenders business. It is perhaps less risky because the Lender (in addition to the anti-money laundering checks it takes itself) can take comfort in the Manager having conducted extensive due diligence.
83
Market Abuse Risk 4.19. Lenders are in the same position as the Manager and should have similar risks and similar risk management policies See sections 3.39 to 1.45.
Legal and Regulatory Risk 4.20. Regulated Lenders must hold regulatory capital against their loans. If changes to the Capital Requirements Directive or its implementing provisions were to prohibit Lenders from entering into sub-participations, novations, credit default swaps etc. Lenders may be unable to mitigate the risk of their loans and/or realise liquidity. 4.21. Lenders which have invested traditionally through sub-participations or novations (e.g. credit default obligation funds) could effectively be prohibited through doing so if securitisation legislation prohibits EU banks from selling loan interests to this type of Investor. Risk management 4.22. The risk here is effectively that Lenders will be prohibited from using existing risk management techniques or indeed from investing by new regulation or legislation.
5.
The Portfolio Group
All companies have risks which arise in the normal operation of their business. The particular nature of these risks will largely be determined by the nature of their business. This section 5 only identifies those risks that may be said to arise particularly from a Private Equity funding or management model.
Market Risk 5.1. The structure of a Funds investment could expose the Portfolio Group to fluctuations in interest or exchange rates, for example, if its obligations to pay dividends on preference shares or to pay the interest on debt are calculated with reference to floating interest rates (which would not be typical) or if they (or the principal of any debt or redeemable shares) are payable in a currency which is different from the currency in which the Portfolio Group receives its principal income. In mid-market and larger Private Equity transactions the dividend on the Funds preference shares or interest on its loans is typically fixed for the duration of the investment. 5.2. Where bank debt is being used to fund the Portfolio Group, the Fund is usually not allowed to receive any interest on its debt or dividends on its shares until all of the bank debt has been repaid. This means the Portfolio Group does not have to use its cash to service amounts it owes to the Fund.
84
Risk management techniques 5.3. The Portfolio Company may be able to use hedging techniques to manage its exposure to exchange or interest rate fluctuations and these are often considered at the time of investment. It is possible to fix translation/ transaction exposure in the early years to provide certainty.
Credit Risk 5.4. The Credit Risk of the Portfolio Group in this context arises from the issues discussed in sections 4.7 to 4.14 above where there is disruption within its lending banks either because a Lender has become insolvent or is unable to meet its continuing obligations.
Financing and Liquidity Risk 5.5. Debt financing for day-to-day business activities will generally be obtained from third-party lenders. The Portfolio Group is exposed to an inability to obtain adequate debt finance either to fund its general balance sheet requirements or its cashflow requirements. 5.6. Portfolio Groups looking to make significant acquisitions may seek financing from the Fund. This is an indirect exposure to the Fund (and indirectly to the Investors) in the sense that, if the Investors do not advance their outstanding Commitments, further financing may not be available to the Portfolio Group (though it could look to other sources in this circumstance, such as third party lenders). 5.7. With a Venture Capital investment, the Portfolio Group may need the Fund to provide on-going funds to continue developing its business. The Fund is not usually contractually obliged to provide these further tranches of funds to the Portfolio Group but it may do so in order to protect and develop its original investment. Such a Portfolio Group has a potential Credit Risk in relation to the on-going ability of the Fund to provide additional support (and an indirect potential exposure to the Investors). As discussed in section 2 above, a Fund relies on its Investors to satisfy their obligations to the Fund and pay down cash when requested. 5.8. Where the initial transaction to purchase the Portfolio Group itself relied on leverage, the Portfolio Group will have interest payment obligations to the Lenders in relation to the debt just like any other company which borrows money to fund its operations. Along with all other businesses, the Portfolio Groups are exposed to a closure of the debt markets (making it difficult to refinance) or a significant increase in interest rates (making it difficult to obtain commercially sustainable finance). 5.9. These risks are no different from those faced by other private companies relying on debt financing. The key issue for all such companies is the sustainability of that financing.
85
5.10. As a result of recent increases in the amount of available finance, the relatively low interest rates of recent years and the general downturn in the world economy, some Portfolio Groups may be considered to be over-leveraged compared to the current value of their assets or level of EBITDA (earnings before interest, tax, depreciation and amortisation). These factors apply to all businesses and individuals and are not unique to Private Equity backed companies. Acquisition financing is not usually available to Venture Capital backed companies. If a business is over-leveraged it may breach the covenants it has given to the Lenders allowing them to call for immediate repayment of their debt. Recently some transactions (particularly in the UK and US) have used relatively light banking covenants. These can be very advantageous to the Portfolio Group (and therefore the Fund and its Investors) as they may enable an Portfolio Group to trade through difficult times without being at risk of foreclosure by a Lender. However, they may have an adverse impact on the ability of a Lender to take pre-emptive action to prevent losses from increasing. 5.11. The Portfolio Group may also not have sufficient cash flow to meet its interest payments to the Lenders because of reduced trading due to current economic conditions. If a Portfolio Group is in this situation it can look to the Fund to negotiate with the Lenders and possibly provide further equity funding to stabilise the group. The Fund will often be the largest unsecured creditor (subordinate to the banks) and therefore its interests should be aligned with the Portfolio Group, its employees and other unsecured creditors to protect the Portfolio Group from being put into administration by the Lenders and ensuring its continued survival and in turn the Funds investment in it. 5.12. If the debt issued by the Portfolio Group is heavily traded this may result in increased diversity of debt ownership. The FSA noted that this was a positive factor in reducing individual exposure to default and hence Systemic Risk, but could make the management of a corporate restructuring or default workout more complex. Risk management 5.13. Both the Fund and the Portfolio Group can mitigate the risk of unexpected demands for further funding or breaches of covenants occurring by producing detailed financial models and projections showing the expected cash flow and investment requirements of the Portfolio Group and stress-testing it. 5.14. In the event of a closure of the traditional credit markets or a significant increase in bank interest rates, the availability of finance from outside the traditional banking sector is important. Private Equity Funds can provide additional funding to businesses speedily where needed. The legal documents often give greater flexibility than the statutory constraints and procedures other companies have to face. This ability to obtain funding from some shareholders quickly and on a bespoke basis is not easily available to quoted companies (which would have to go through a rights issue process or similar) or other private companies who do not have institutional shareholders with accessible sources of cash outside the traditional banking system.
Group Risk 5.15. It is not considered that any particular issues arise out of the Private Equity funding mechanisms that are relevant in the context of Group Risk assessment. If a Portfolio Company is part of a group, the Lenders will usually require that all substantial entities within the group guarantee the borrowing companys liability. This is a usual requirement of secured bank facilities and is not specific to Private Equity.
86
Financial Crime Risk 5.16. The Portfolio Groups exposure to money laundering risk and internal/external fraud risk are essentially dependent on its business model and not on the fact of any Private Equity investment. It may, however, be subject to a higher degree of scrutiny in its dealings because of the requirements of the Manager, so that instances of criminal activities are more likely to be reported to the authorities than would be the case without private equity involvement.
Market Abuse Risk 5.17. A Portfolio Group and its employees may have price-sensitive information if it is involved in a transaction which involves a relevant security. Risk management 5.18. Training and restriction on information flows, compliance with disclosure and transparency rules, including impositions of personal account dealing restrictions, as relevant.
Fiduciary Risk 5.19. There is a potential exposure to conflicts arising out of the Private Equity model where a representative of the Fund is a member of the Portfolio Companys board. This can present the individual who is such a director with a personal conflict of interest between the interests of the Fund as a shareholder and his personal duties as a director. Risk management 5.20. Generally a director owes a duty to the company. Such conflicts are dealt with in accordance with the applicable corporate law, which may on occasions require the individual director not to participate in decisions or in certain circumstances either to resign from the board or to cease to participate in decisions made by the Manager.
Legal and Regulatory Risk 5.21. Portfolio Companies are generally privately held companies. If they become subject to additional legal or regulatory requirements by virtue of being backed by a Private Equity Fund (which would not otherwise apply to the private company) this would impose additional cost. The impact of those requirements would largely depend on the level of cost imposed. For instance, imposing limitations on the type of financing which Portfolio Groups may obtain could limit the ability of financing to such groups. Risk management 5.22. Ultimately a potential seller of a Portfolio Group could choose not to sell the group to a Private Equity Fund and/or a Manager may decide not to invest in a particular jurisdiction.
87
6.
Civil Society
The interests of Civil Society have been given a separate section in this paper because it is in the effect that a Private Equity investment has on Civil Society that legislators and regulators perceive that intervention in the mechanisms of the industry may be necessary. What has gone before is an explanation of the systemic and specific risk profile of Private Equity as a participant in the Global Financial System. This section 6 concentrates on the systemic and specific risk profile of Private Equity in Civil Society. Section IV explores whether Private Equity causes a systemic risk to the Global Financial System. Civil Society for these purposes is the collection of individuals and classes of individuals, together with their official and unofficial representative groupings which taken as a whole compete and collaborate to form the system of interaction between people that is the world in which we live. The collection of individuals into official and unofficial groupings for the purposes of understanding civil society has no widely accepted set of definitions but is more determined by individuals sense of belonging. Hence grouping could be by age; membership of political parties; membership of trade unions; membership of religions; and so on. This paper is clearly not intended to create a widely accepted definition of such groupings. Alternatively this paper identifies five particular sections of Civil Society, sets out the way in which they may interact with the Private Equity industry and brings to light the risks that any of those particular sections face in their dealings with Private Equity and the mitigants to those risks. In each case it is necessary to presuppose that the section has certain objectives which it is trying to achieve and that as highlighted in Section I, a risk is any possibility that the objective will not be achieved. The five sections considered are: Fiscal authorities; Health and safety authorities; Environmental protection authorities; Workers/employees; and Suppliers.
Each section is considered in isolation for the sake of simplicity. However there are considerable systemic interrelationships between the different sections and inevitable tensions between their potentially competing objectives. For example the fiscal authorities may wish to maximise tax revenues which can be achieved if corporates spend less money on health and safety, environmental protection, salaries and with suppliers therefore becoming more profitable and paying more taxation in absolute terms. In each instance the sections significant interaction with the Private Equity industry will be with the Portfolio Group and it is therefore this relationship which is examined. The Private Equity Funds objective to realise a return on its investment in each Portfolio Group for its Investors will potentially compete with the objectives of certain sections of Civil Society.
88
Fiscal authorities 6.1. The objective of the fiscal authorities is to secure and maximise the revenue stream for its government. This objective creates tension between the Portfolio Groups objective of legally minimising its contribution to the tax take. 6.2. The risk for the fiscal authorities is that through deliberate action or error the investment company makes less than its legitimate payment of taxation. This risk is exactly the same for the investment company owned by a Private Equity Fund as it is for any other corporate entity operating within the jurisdiction of the fiscal authority. The fiscal authorities mitigation procedures for this risk are therefore the same as for any other company.
Health and safety authorities 6.3. The objective of the health and safety authorities is to ensure that businesses are operated in a manner that protects the general public and employees specifically from business practices that carry a high risk to health and safety. In all businesses there is a trade off between the cost of processes and controls to prevent injury through bad business practice and exposure to health and safety risks and the goal of profitability. While this will also be true in Private Equity backed businesses, they are not unique. 6.4. It is in the nature of the acquisition and disposal of Private Equity investment companies that extensive due diligence is undertaken, using professional providers including accountants and lawyers and more specifically health and safety consultants, especially when acquisitions are of businesses in industries with high potential exposures, for example chemicals or construction businesses. 6.5. Company responsibility for health and safety sits with the board of the Portfolio Company. In particular in Private Equity transactions, the business compliance with health and safety regulations is subjected to scrutiny by the Fund and the Lenders.
Environmental protection authorities 6.6. The objective of environmental protection authorities, separated here from health and safety authorities because of the current perceived importance of environmental issues to Civil Society, is to ensure that businesses operate in a manner that ensures that environmental cost (pollution) is borne by the polluter. Many authorities have been created and introduced precisely to ensure that environmental impact costs are borne by those responsible for them. All businesses have an environmental footprint and the Private Equity backed Portfolio Companies are no exception. 6.7. The due diligence processes of Private Equity on acquisition and disposal operate in relation to environmental risk in exactly the same way as they do for health and safety risk as described in paragraphs 6.3 to 6.5.
89
6.8.
Additionally Private Equity interacts with environmental risk in two specific ways. First through the investment by Venture Capital and Growth Capital in particular (though also Buy-out firms) in a whole new asset class of so-called clean technology. This is the investment of Private Equity Fund money in businesses which are specifically attempting to reduce the environmental impact of Civil Society. Second as a result of the increasing environmental burden imposed on businesses by authorities to operate in a way that provides environmental protection is seen by many Private Equity Funds as a commercial opportunity. Strategies to create value by acquiring unclean businesses and improving them in terms of their environmental impact are becoming common.
Workers/Employees 6.9. Like any other company, a Private Equity Fund owned company must abide by all laws in the relevant jurisdiction. It is not able to terminate workers employment or change the terms of their work contracts just because it acquires the company. If the Private Equity Fund acquires assets and a business (rather than a company) the Transfer of Undertakings (TUPE) legislation in the relevant jurisdiction will apply in the same way as to any buyer. 6.10. A Private Equity Funds aim is to increase the value of any business it acquires and grow it. This strategy should be beneficial for both employees and wider Civil Society as the companys stability increases and more jobs are created. 6.11. Workers/employees are aiming at job security and reward commensurate with the contribution they make to the enterprise. Through campaigning and collective bargaining unions of workers/employees seek to secure the most advantageous legal protection for their members in various jurisdictions. There is a conflict in all businesses between maximising the rewards to workers/employees and maximising profitability and, through profitability, the return to investors. This is true in relation to Private Equity backed companies and all other companies. 6.12. Businesses operate within a legal framework that governs their treatment of workers/employees. Depending on jurisdiction the framework will include protection for the individual and for collective bargaining. These legal frameworks apply equally to Private Equity backed Portfolio Companies. 6.13. One feature of the Private Equity investment cycle is that sale of a business is frequently accompanied, as aforementioned, by due diligence by the purchaser. One key aspect of this due diligence will be an assessment of the skills, abilities, motivation, retention and loyalty of the workforce. There is therefore no incentive for the Private Equity Fund to behave inappropriately towards workers/employees. 6.14. Many of the investors in Private Equity Funds are pension funds (indeed it is rare to find a Private Equity Fund that does not have at least one pension fund in its investor base). These investors frequently have very high ethical standards and expect their investment managers to have standards likewise. Breach of legal obligations in a Portfolio Company or publicity around inappropriate behaviour towards workers/employees is very damaging to the Private Equity Managers ability to raise finance. 6.15. The Private Equity Manager must balance financial return with legal and moral obligations to the workers/employees in Portfolio Companies in the same way that any other investor must do so.
90
6.16. As discussed in Section II, alignment of interests between the Private Equity Fund and the employees of its Portfolio Companies is key to the Private Equity model. A Fund will make equity available to employees of the business it invests in. The Fund will want key employees throughout the business to be incentivised to develop and grow the business and its value. This is beneficial for the Fund and its Investors, the employees and the Portfolio Companies.
Suppliers 6.17. Suppliers to Private Equity backed Portfolio Companies aim to maximise their returns at the expense of the Portfolio Company just as the Portfolio Company aims to minimise the amount it must pay to suppliers for goods and services received. This is the same for all transacting organisations and is not unique to Private Equity. In fact both parties want a relationship in which the price of exchange between them is broadly equitable and sustainable. 6.18. The key factor in sustainability is proportionately to the complexity and rarity of the good or service that is supplied. Where the good or service is simple the risk of sustained supply is low and therefore a relatively low price will be charged for that good or service whereas when the good or service is complex then the risk of sustained supply is high and a relatively high price will be charged for that good or service. All pricing between participators in the exchange of goods and services is determined by the relative supply and demand power structures prevailing, which change over time.
Summary 6.19. One key feature of management under Private Equity is that Investors in the Private Equity Fund believe that in each of the negotiating relationships with the other sections of Civil Society, the management teams working in Portfolio Companies and supported by Private Equity executives will demonstrate a high level of skill and success thereby generating superior returns. 6.20. Implicit in this is that the generation of superior returns will be achieved within the appropriate and relevant legal framework and in a way which ensures a continued sustainable position for each section of a Civil Society.

1. Introduction
91
The definition of risk in Section I referred to a system within which businesses operate. More specifically one aspect within this system is the system of financing or financial markets. The transactions between buyers and sellers in government securities, company shares, bonds and other debt instruments, commodities, currencies, insurance and other risk diversification products and derivatives of all such instruments, and the mechanisms for facilitating these transactions, including but not limited to the action of fiscal and regulatory authorities, form a complex Global Financial System. This Global Financial System operates meta to the specific risks relevant to any individual participants such as those set out in Section III. There is therefore a class of meta-risk, which includes those risks which involve the possibility of harm or damage to the Global Financial System. Such meta-risks we call Systemic Risk. In order to examine the Systemic Risk implications of Private Equity activity we consider that there are two sub-categories of Systemic Risk. The first of these categories we may characterise as the possibility that any specific risk as identified and defined in Section III materialises to such an extent that its impact is systemic. Any specific risk may become systemic if it materialises frequently enough. For example, during a period of normal economic stability the risk of unemployment is largely specific to individuals or small groups of individuals. In times of economic crisis the risk of unemployment is systemic. We can name this Extrapolated Participant Risk. The second category of Systemic Risk we characterise as the possibility of harm or damage to the Global Financial System arising directly from characteristics of or flaws in that system. Certain factors make the Global Financial System sustainable in the first place, including: Trust and confidence. Market participants need to believe that the system is operating effectively. If market participants stop believing in the system they stop participating and the system stops operating. Predictability. Market participants create models of how the system and components of the system work. These models will inevitably have flaws and if these flaws are, or become, significant the system becomes unstable. Regulation. The set of government and quasi-government rules which govern the behaviour of participants. If regulation fails to anticipate inappropriate behaviour or regulators do not adequately predict the consequences of permitted behaviour market failure can follow. Our second category of Systemic Risk directly acts on these factors and we can name this Natural Systemic Risk. Underlying the calls for more extensive regulation of the Financial Services Sector, which have gained considerable momentum in the current financial crisis, there are two hypotheses relating to Systemic Risk. One relates to an Extrapolated Participant Risk and the other to a Natural Systemic Risk. The Extrapolated Participant Risk is that liquidity, the availability of credit between financial market participants that makes transacting possible, has disappeared as the real and perceived Credit and Counterparty Risk of Financial Market Participants has spiralled out of control.
92
The Natural Systemic Risk is that the mechanisms by which stress for one firm or class of firms, is transmitted to other firms, or classes of firms, have not been understood. This has meant that the actions of governments, fiscal authorities and regulators to stem the crisis have not yet had the consequences intended. This Section IV deals directly with the two challenges posed to regulators by the foregoing, namely: Does the Private Equity firm, in general or as Venture Capital firm, Growth Capital firm or Buy-out firm play a material causal role in the liquidity crisis either as provider or consumer of finance? Does the Private Equity firm, in general or as Venture Capital firm, Growth Capital firm or Buy-out firm play a material, previously uncontrolled and misunderstood, causal role in the transmission of stress between firms or classes of firms? If in either case there is no clear and demonstrable cause-effect relationship between the structures of or activity by Private Equity and Systemic Risk then there will be no need for legislators and regulators to introduce controlling mechanisms. If there is such a cause-effect relationship such mechanisms need to be proportionate to the risk.
2.
Private equity and its relationship with systemic liquidity risk
As with other asset classes Private Equity may be identified as having issues arising out of the current systemic liquidity issues in the current market as either a recipient or provider of finance. It is in the differences in operating structure between the Private Equity Fund and other asset classes, for example public equity investment funds or Hedge Funds, that the cause and effect relationships can most usefully be examined. As recipient of finance, it is possible to consider all sub-sets of Private Equity together since, with very few exceptions, they receive their financing in the same way, regardless of whether they invest as Venture Capital, Growth Capital or Buy-out. As provider of finance, the difference in the investing models of Venture Capital, Growth Capital and Buy-out firms is such that this paper treats their relationship with Systemic Liquidity Risk separately. As explained in section 4 below, this is because they have differing uses of leverage.
3.
Receipt of finance
Private Equity Funds of all sub-sets are marketed to institutional investors (many of which are regulated entities) and a small number of equivalent sophisticated very high net worth individuals as closed-end, limited life vehicles. Investment in a Private Equity Fund involves a minimum ten-year commitment in an illiquid asset. Private Equity Funds financing is entirely through Investors equity or equity-like participations. Sales of interests in Funds (secondary interests) do happen but this has not been explored in detail here because these are niche transactions for specialist investors. Private Equity Funds are rarely leveraged at the Fund level, contrary to Hedge Funds which usually use leverage at a fund level, e.g. by borrowing on margin from prime brokers.
93
Fees for the management of the Fund (which typically vary between 0.5% and 2% of the assets under management) are fixed at the time the Fund is established and do not vary with market values over the life of the Fund. Where fees do vary, it is through a step-down mechanism according to time criteria or other non-value based or non-judgemental standards. There is no significant bonus culture in the Private Equity industry. Executives are normally required by their Investors to invest in parallel into the Fund, thereby ensuring alignment of interest. This is reinforced as the executives will only receive their share in the profits made by the Fund (through the Carried Interest) once Investors have received the cash they have invested plus a hurdle. The potential liquidity issues a Private Equity Fund may face are: Investors in the Fund may have unforeseen difficulty in meeting their commitments to the Fund; and The Fund needs to manage its own cash inflows and outflows and will therefore operate a bank account and is exposed to the failure of the bank. As a result of the current crisis in the financial markets the risk to Private Equity Funds that Investors will have unforeseen difficulty in meeting their Commitments has increased. However, Investors are contractually obliged to meet these Commitments and have an incentive to do so if they wish to maintain a suitable asset allocation to high return investments. To date, only limited numbers of defaults by Investors have been registered and these have been manageable. As recipient of finance, the Private Equity Fund is only an effect in respect of Liquidity Risk, not a cause.
4.
Provider of finance
This paper concentrates on the Buy-out sub-set of Private Equity as a provider of finance. This is because the Venture Capital and Growth Capital sub-sets of Private Equity (which are incidentally the largest proportion of Private Equity in number of firms and volume of transactions) do not on the whole use leverage when investing. If they do, then the risk assessment is the same as for a Buy-out although the systemic implications are unlikely to be the same, in part because of the relatively small size of the transactions.
Figure 2: The basic structure of a Private Equity Buy-out investment
It is worth noting that in all instances Private Equity Funds are the equity providers not
Private Equity Fund Lenders
the providers of debt finance. The Manager, together with the Portfolio
Provision of Equity Finance
Provision of Debt Finance
Groups management team, negotiate the best possible debt financing arrangement that they can to allow the Portfolio Group to operate as a sustainable and growing business.
Portfolio Group
94
The components of the negotiation will be: Amount, term and amortization schedule; Security; and Cost or interest rate.
Banks lend to Private Equity backed companies as part of normal arms length transactions and pricing on such debt is subject to the same commercial pressure and negotiation as all lending and is based on an assessment by the banks of the borrowers ability to service its debt. The Private Equity Funds equity risk exposure can increase if the Portfolio Groups exposure to Credit Risk increases as a result of an unsustainable loan position for the Lenders. The aligned interests of the Private Equity Fund, the Portfolio Groups management and the Lenders usually protects the Portfolio Group and ensures their participants continued commitment to it. For example, putting aside the risk of criminal behaviour, the lending institutions credit risk vis--vis the Portfolio Group will increase when: The amount lent to the Portfolio Group is more than the Portfolio Group can repay; The security provided by the Portfolio Group is unreliable or unsustainable; or The amount of reward received by a Lender is insufficient for that Lender to meet its own cost of capital.
In all these cases, the Private Equity Fund has an increased chance that its equity investment in the Portfolio Group will lose value. If a Portfolio Group does not perform according to managements plan for the business, the Private Equity Fund may have caused Credit Risk for the Lenders and put its own equity at risk. This Credit Risk may become Extrapolated Participant Risk (i.e. Systemic) if this becomes true of a very significant number of Portfolio Group businesses at the same time. This is very unlikely as Portfolio Companies operate in different sectors of the real economy, have different management teams and are in different business cycles. Leverage has always been a feature of Buy-out transactions. For a period prior to the summer of 2007 there was an unusual abundance of cheap credit available to businesses and individuals which increased the willingness of many entities (including, but by no means limited to, some Private Equity Firms) to increase the amount of leverage in funding investments. The availability of the credit was not driven by Private Equity Firms; indeed they have no control over the credit available in the system. The responsibility for operational control over the Credit Risk of a Portfolio Group sits with the Lenders rather than the Private Equity Fund. Even during the recent downturn, there has been no evidence to suggest that a concentration of under-performing Private Equity credit has caused Systemic Risk among Lenders.
95
5.
Private equity and the systemic transmission of stress between market participants
With the benefit of hindsight, there are now known to be a number of previously unforeseen flaws in the Global Financial System which were inadequately understood and controlled resulting in the systemic transmission of stress between market participants. An attempt to list these exhaustively is not included here, but examples include, inter alia, naked short selling, public market manipulation, off balance sheet financing, CDOs and CLOs, sub-prime lending and rating practices. Private Equity Funds do not trade in the equities market or indeed in any other financial market. By trade we mean activity of the kind undertaken by Hedge Funds and other regular participants in the liquid markets, where there is intense and regular buying and selling of securities and other financial instruments, often with the benefit of leverage and employing various techniques, including short selling. Private Equity investment does not involve the use of prime brokers to provide support services (including custody) and liquidity. Where funds use administrators and custodians this is for efficiency of administration and security over share ownership documents (typically physical, materialised certificates). Short selling is not a technique used by Private Equity Funds and is characteristic of trading rather than investment strategies. The volume of transactions enacted in the financial markets by Private Equity Funds are de minimis and their effect on the efficiency of the markets, price formation and trading conditions is, as a general rule, also de minimis. Within the capital markets, compared, for example, with the amounts of money managed in the Hedge Fund industry, the amounts managed by Private Equity are very small. Unlike Hedge Funds, Private Equity Funds are not themselves leveraged but use leverage at the level of the Portfolio Company as described in section 3 above. The Private Equity Fund is therefore never exposed to transactions under which it could have liabilities which exceed the value of the Fund. It is worth noting that Private Equity investments are usually by their nature illiquid, they are not traded on the general markets and they do not raise the same issues of unwinding as arise in the context of Hedge Fund failure. Most Funds have a ten-year duration and there is a limited secondary market where fund interests can change hands between Investors (with the Private Equity Managers consent). This trading of secondary interests never affects the Funds liquidity and in most Funds the Manager has the right to distribute investments in specie to Investors when liquidating a Fund at the end of its life. This means that forced selling of assets due to market conditions is so rare as to be almost non-existent. Private Equity Funds are not structured such that Investors can redeem their interests. They do not face redemption requests from Investors and consequently have no obligation or need to sell assets into the fragile and volatile markets. They have not contributed therefore to the downward spiral of deleveraging and declining asset prices. Each Private Equity investment is unique, and the issue of crowding of positions in similar assets is not relevant.
96
There are a number of market activities that can be said to have caused the systemic transmission of risk from participant to participant in the market place. The exact proportion in which they have done this remains unclear. However, what is clear is that Private Equity Funds do not undertake the transactions which are most likely to be at cause in this respect.
6.
6.1.
Systemic risks Conclusions

The Private Equity investment model is not unique to so-called Private Equity Firms, (being the term used to refer to firms which invest pools of third party funds). Other capital providers, such as wealthy families, corporates and governments invest through structures which provide equity investment within a leveraged structure and have investor representatives on the boards of their portfolio companies. Whilst this paper identifies a range of risks faced by participants and stakeholders in Private Equity, the size and spread of these risks means that is it inherently unlikely that they can materialise in a way which would damage the Global Financial System.
6.2.
The term failure in the context of a Private Equity Fund is more appropriately used to describe a situation where the investment performance is so poor that Investors receive little or no return. In such cases, the Investors suffer and the Manager is unlikely to be able to raise another Fund but these issues do not give rise to threat to the wider financial system. The de minimis amount of public trading by a Private Equity Fund is unlikely to have any material effect on a counterparty in the extremely unlikely event that the Fund could not meet its obligations. Such public trades are by definition in a specific security in the context of a particular potential transaction, not part of a widespread trading pattern with multiple counterparties involving vast sums of money and exposure. It would be extremely unlikely that the Fund would incur a liability which would not be covered by cash commitments from Investors.
6.3.
The way in which a Private Equity Fund is constituted and invests means that it is not appropriate to think in terms of failure of such a Fund in the same way as, for example, a Hedge Fund which might fail leaving a chain of unsettled transactions and liabilities to other market participants on transactions and for repayment of borrowings (e.g. Long Term Capital Management). Investors cannot require the Private Equity Fund to redeem their interests, the Fund is not itself leveraged and so has no obligation to provide and increase margin, and almost all of its transactions take place outside regulated exchanges in the equity securities of private companies and so do not involve a delay between trading and settlement. Therefore, the factors which give rise to fund failure in the sense used when discussing Systemic Risk are simply not present in the Private Equity model. Even if one or more Investor does not satisfy its funding Commitment, this does not cause the Private Equity Fund to fail. Although the ability of the Fund to make future investments might be affected (and therefore the return enjoyed by other Investors reduced), this has no systemic consequences.
6.4.
Whilst Lenders have credit exposures to potentially large numbers of different Private Equity backed companies, there is no contagion risk between different borrower Portfolio Companies. The spread of Portfolio Companies into which a Lender will have lent money means that there is no greater risk for the Lender arising from lending into Private Equity Portfolio Companies, than there is from lending into any other private company. Venture Capital and Growth Capital funds typically do not use leverage in their transactions. As noted above (except in relation to bridging the draw-down of Investors Commitments) Lenders do not have direct lending exposure to Private Equity Funds, because Funds do not borrow in order to leverage their investments.
97
6.5.
Leverage is not unique to Private Equity investment, and whilst in recent times some large Private Equity transactions have had access to and used greater leverage than in the past, this was a function of the credit market. Such leverage is also seen on non-Private Equity transactions, such as the purchase of BAA (a critical UK infrastructure provider) by the Ferrovial group of companies and the purchase of high street chains by Baugur. In all these cases the lender, not the Private Equity Fund or other type of investor, is responsible for the credit approval process and it is the lender which suffers loss if the Portfolio Company fails. Lenders do not give Private Equity backed companies terms which are not available to similar companies which are not backed by Private Equity. Thus, any losses suffered by lenders if a Portfolio Company fails is not driven or exacerbated by the Private Equity model.
6.6.
Valuations of the Funds assets are carried out in accordance with international industry standards. Payments to the Manager and the Investors are not driven by the valuation of assets but by their actual realisation. Investors are not entitled to redeem their interests in the Fund before the end of its term. These factors mean that the concerns in relation to the fund liquidity risk, the use of unrealised valuations to base compensation payments and counterparty risk are not relevant to the Private Equity model.
6.7.
Whilst the amount of funds available for Private Equity investment has increased in recent years, it is still a very modest amount when compared with the amounts traded in the public markets and lent by credit providers.
6.8.
There is therefore no reason to consider that if any of the risks identified materialise there would be damage to the Global Financial System caused by the Private Equity model. As far as leverage limitations are concerned there is no reason why such limits should only attach to Private Equity investment (however defined) and not to other lending situations.
6.9.
The ability of Private Equity Firms to have an adverse impact on market integrity is relatively limited. The Firms are of course subject to the provisions of the Market Abuse Directive. The UK Financial Services Authority (the FSA) hypothesised that there could be a particular risk arising in transactions where a public company is taken private because a greater number of persons is usually involved than might be the case in standard public company takeovers, increasing the risk of leaks. However the number of such public market transactions is very small in the context of the Private Equity industry as a whole and is already subject to European law and the related enforcement mechanisms. In terms of context, a Private Equity Firms ability to disrupt market integrity in a manner which has systemic implications is minimal compared with regular public market participants. This does not detract from the need, as the FSA continues to emphasise, for all relevant firms to have training, systems and controls to control the risk of leaks and market abuse involving public transactions.
6.10. Private Equity Funds do not generally take minority stakes in public listed companies in order to agitate for governance or other changes. The usual reason for the holding of an interest in a public company by a Private Equity Fund is because either: the Fund is making a bid for the entity in order to take it out of the public market or; the entity is a successful investment which has now obtained a public quotation, and the Fund is left with a part of its holding, which in due course it will dispose of.
98
6.11. In companies where Private Equity Funds have majority control, their relationship with other stakeholders (including minority shareholders and workers/employees) is no different to that of any other majority investor in a privately held company. As far as minority shareholders are concerned, their position will be governed by the applicable local law, unless specific contractual agreements have also been entered into which provide for further specific matters. The employees have exactly the same rights and the Portfolio Companies have exactly the same obligations as arise in any employer/employee relationship. 6.12. The principal risks might be considered to arise for the Investors in Private Equity Funds. As already noted, these Investors are generally sophisticated institutional investors. Some jurisdictions legislation provide specific structures (for example the venture capital trust in the UK) under which retail investment may be made in Private Equity. As noted above, the general fund structures are bespoke, negotiated with sophisticated investors and involve levels of disclosure to potential investors that far exceed those required under regulatory requirements applicable generally, for example those applicable under MiFID to investment managers. 6.13. The notion of imposing a capital requirement on a Private Equity Fund itself would make no sense. The provider of such capital would likely be the Investors in the Fund the same participants who are primarily intended to be protected by such a requirement. The interaction of the Fund with the general marketplace, as noted above, does not give rise to the type of risk for counterparties or credit risk for lenders and other third parties, that would justify the imposition of any requirement on the Fund itself. As far as the Manager is concerned, as demonstrated above, the principal reasons underlying the imposition of capital requirements (in particular depositor and counterparty protection) are not really applicable. It should also be noted that those Managers whose business also falls within MiFID are subject to the requirements of the Capital Requirements Directive. There may also be other local regulatory requirements. The UK Financial Services Authority regulates Private Equity managers and has for many years operated a fixed and low level capital requirement. This was based on an analysis of the risks that capital is intended to protect against, with the conclusion that it was not really relevant to Private Equity. This approach has never (not even in recent times) been shown to have any weaknesses. 6.14. The remuneration structures of Private Equity align the interests of the Firm and its executives with the interests of Investors. Since Managers and its executives invest a significant amount of their own money in the Fund and none of them receive a return unless investments are both realised and realised so as to generate a total return above an agreed rate across the Funds whole portfolio, the structure encourages focus on the transaction and its long term success the employees as well as the Investors have to live with the consequences of what has been done. Therefore, Private Equity compensation structures do not have the flaws and the associated risks that have been identified in arrangements in other parts of the financial sector, where bonuses often fail to take account of the long term impact of actions and equity vests with immediate effect.
The UK Financial Services Authority carried out a review into the Private Equity industry and the appropriate level and form of regulatory engagement with the Private Equity sector. It published both a Discussion Paper and a Feedback Statement which contained an extensive risk analysis, those papers are downloadable at http://www.fsa.gov.uk/pages/library/policy/dp/2006/06_06.shtml. The risks which were identified by the FSA as being particularly of high significance were risks relating to market abuse and to conflicts of interest. We have referred to the market abuse issue above. The potential for conflicts of interest arises both as between the Fund Manager and Investors, and as between Investors. The FSA paper notes that the principal mechanism for dealing with these conflicts is the agreed contractual arrangements with Investors. The paper also highlights potential conflicts which may arise where a Private Equity Firm is part of a larger group, where other entities may provide services either to Portfolio Companies or to the Fund in connection with transactions. However none of the issues identified were considered to be likely to raise global systemic issues.
Private Equity and Venture Capital in the European Economy An Industry Response to the European Parliament and the European Commission
Annex II: Detailed Analysis Coverage of Law and Regulation, Contractual Agreements and Industry Professional Standards with respect to EU Concerns regarding Private Equity
Table of Contents
Introduction Part I: Detailed Analysis by Country of Law and Regulation, Contractual Agreements and Industry Professional Standards with respect to Private Equity
1. Denmark 2. 3. 4. 5. 6. 7. 8. 9. 10. Law and regulation Contractual agreements between parties and related entities Industry professional standards Law and regulation Contractual agreements between parties and related entities Industry professional standards Law and regulation Contractual agreements between parties and related entities Industry professional standards Law and regulation Contractual agreements between parties and related entities Industry professional standards Law and regulation Contractual agreements between parties and related entities Industry professional standards Law and regulation Contractual agreements between parties and related entities Industry professional standards Law and regulation Contractual agreements between parties and related entities Industry professional standards Law and regulation Contractual agreements between parties and related entities Industry professional standards Law and regulation Contractual agreements between parties and related entities Industry professional standards Law and regulation Contractual agreements between parties and related entities Industry professional standards
101
103
105
105 105 111 113 117 117 120 122 125 126 133 135 139 140 148 150 153 153 161 163 167 168 178 180 185 185 190 192 195 196 205 208 209 209 213 215 217 217 225 227
Finland
France
Germany
Italy
The Netherlands
Norway
Spain
Sweden
The United Kingdom
102
Table of Contents
Part II: Private Equity Funds and Contractual Relationships with their Investors Governance, Reporting and Transparency
1. The Limited Partnership / Investment Management Agreement an overview
231
231
Part III: Articulation of EVCA Industry Professional Standards with the EU Concerns in respect of Private Equity
1. 2. Scope, Coverage and Enforcement of EVCA Industry Professional Standards in respect of private equity
237
237 239
Detailed analysis of the coverage of the EVCA Industry Professional Standards as regards the EU Concerns
Conclusion and Recommendations Annexes

1. 2. 3. European legal regime relating to asset stripping and further potential risks relating to private equity transactions Restrictions in Scandinavian legislation on asset stripping from limited liability companies Professional Standards and their Application on European Private Equity Funds
249 251
251 281 291
Introduction
103
Private equity firms active in Europe, like other types of asset management organisations, are regulated and supervised under legal and administrative frameworks established in their home jurisdictions and by other relevant jurisdictions in which they operate. In addition, private equity firms are subject to a number of contractual requirements placed on them by their investors. Furthermore, their operations are also governed by accepted best practices which have been codified into a series of self-regulatory industry professional standards. As a consequence, private equity firms active in Europe are governed by a framework comprised of three main elements: 1. Law and regulation of the home and other relevant jurisdictions (which can include relevant pan-European and/or international law and regulations); 2. Contractual provisions built into the Limited Partnership Agreements with investors, as well as other contracts; 3. Industry Professional Standards, consisting of professional standards of the home and other relevant jurisdictions, as well as consistent standards established by the EVCA as the primary professional body for the industry in Europe. At any one time, one, or more, or all of the above elements may be applicable to the underlying activities of private equity firms in Europe:
Figure 3
Law and Regulation
Private Equity: Mutually Reinforcing Framework
Contractual Agreements
Professional Standards (Self Regulation)
104
Introduction
Against this background, recent concerns at EU level with respect to private equity, notably the European Parliament Resolutions on Private Equity and Hedge Funds and the Transparency of Institutional Investors should be assessed. The European Parliament has highlighted the following concerns as regards the private equity industry: What is the potential impact of buyout activity on the social economy How does the industry manage its relationships with key stakeholders Is there excessive use of leverage in private equity investments Clarify corporate governance and shareholder behaviour(s) Is there adequate transparency, and Clarify reporting to investors in private equity and venture capital funds
Such concerns have resulted in specific calls from the European Parliament for more regulation for the following areas: 1. Disclosure, transparency and monitoring 2. Information and consultation of workers 3. Limits on asset stripping and capital depletion 4. Limits on leverage 5. Compensation structure 6. Capital requirements One additional issue also noted by both the Parliament and the Commission was potential fragmentation or gaps in the application of the laws, contractual agreements and industry standards. To fully analyse the issues raised by both the Parliament and Commission, a review of the main European private equity markets, representing around 95% of the total activity of the private equity industry in the European Economic Area Denmark, Finland, France, Germany, Italy, the Netherlands, Norway, Spain, Sweden and the United Kingdom was undertaken (Part I). For each country, the review looked at the national law and regulation, contractual agreements and industry professional standards in force. Given the role that contractual relationships between private equity investors and industry funds play within the overall governance framework, additional detailed remarks from the perspective of industry practitioners are included in Part II. Further, in Part III a review of the EVCA professional standards, including their enforcement, was conducted. The objectives of the review presented in Parts I to III were: To assess to what extent the business conduct of private equity firms in relation to the concerns mentioned above is subject to regulation, contractual obligations and industry professional standards. To recommend potential actions regarding complementary regulations, contractual practices and/or industry professional standards.
Part I
Detailed Analysis by Country of Law and Regulation, Contractual Agreements and Industry Professional Standards with respect to Private Equity
1.
1.1.
105
Denmark
Introduction
Private equity firms in Denmark for the purposes of this memorandum are defined as closed-end private equity funds and firms managing or advising said closed-end funds. Generally these funds are not specifically regulated under Danish securities markets legislation but are subject to the same legal framework as such business vehicles in general, including relevant pan-European and/or international law, regulations and professional standards. The national industry body is the Danish Venture Capital and Private Equity Association (DVCA), the members of which are entities active in the Danish private equity and venture capital markets. The DVCA currently has 173 members of which 20 are venture capital entities, 27 are private equity entities, 76 are business angels and 48 are associated members (the latter include advisers and other parties with an interest in the private equity business). The DVCA furthermore accepts as its associate members communities or private individuals who play a part in the development of the industry in Denmark. 23 members of the DVCA are members of EVCA.
1.2.
Governed by law / regulation
The most common legal structures used by private equity firms domiciled or operating in Denmark are foreign and Danish limited partnerships and Danish limited liability companies. As to private equity funds the most common legal structure is a limited partnership, whereas for management companies limited liability companies are commonly used. There is no specific legislation that applies only to private equity firms in Denmark. Depending on the form in which a private equity firm is set up (see further below) and the type of investors the private equity firm has, it will be subject to the same legislative and regulatory requirements as are applicable to any other entity with similar structure, investing in similar assets and seeking capital from the same type of investors. Furthermore, limited partnerships are governed by limited partnership agreements or the like determining the specific applicable corporate governance rules, including investment policy, fees, liabilities, conflicts of interest etc. In the rare cases where a Danish private equity firm is to be listed on a stock exchange, it needs to be set up as a public limited liability company and must comply with the rules applicable to listed companies and the regulation of the relevant stock exchange, in addition to the corporate legislation for public limited liability companies. 1.2.1. Capital requirements 1.2.1.1. At the level of management companies (operational risk) Management and advisory companies of Danish private equity funds are generally limited companies and as such subject to the general capital requirements applicable to all limited companies.
106
Part I
Danish limited liability companies which are private (the form most commonly used for private equity management companies) require a minimum capital of DKK 125,000 (approximately EUR 16,600). The minimum capital requirement for a Danish public limited liability company is DKK 500,000 (approximately EUR 66,600). 1.2.1.2. At the level of the funds - investment vehicle (exposure risk) Danish private equity funds are most often established as limited partnerships. A limited partnership consists of one (or more) general partner(s) subject to personal, unlimited, joint and several liability, and a number of limited partners subject to a limited liability. Often limited partnerships consist of one general partner which is a limited liability company in order to limit the general partner liability. Limited partnerships must be registered with the Danish Commerce and Companies Agency (DCCA), if the general partner is a limited liability company (e.g. a private or public limited liability company). There are no minimum capital requirements for Danish limited partnerships. A fund may, however, also be set up as a public limited liability company or a private limited liability company. Please refer to 1.2.1.1 above for capital requirements. Furthermore, in Denmark a fund may also be set up as a limited partnership company (in Danish: Partnerselskab) which can be characterized as a hybrid between a public limited liability company and a limited partnership (83). The statutory minimum capital requirement for a limited partnership company is DKK 500,000 (approximately EUR 66,600). However, the limited partnership company structure is not widely used in Denmark. 1.2.2. Regulatory disclosure and related monitoring 1.2.2.1. Overview Danish limited liability companies (and limited partnership companies) are required to be registered with the DCCA. Limited partnerships have to be registered, too, if the general partner is a limited liability company. This implies that the articles of association and information as to the board of directors, management board, founders, equity capital, objective, provisions regulating the power to bind the entity and for partnerships, also the identity of the general partner, is public. Furthermore, Danish limited liability companies (and limited partnership companies) along with limited partnerships registered with the DCCA, cf. above, are generally subject to an obligation to file audited annual reports with the DCCA (however, a few exceptions exist). Annual reports of these entities are, thus, publicly available. Companies listed on a regulated market are subject to additional disclosure obligations. Moreover, the DVCA has issued guidelines on transparency and disclosure that apply to members of the DVCA under certain circumstances. Reference is made to 1.4.2 below.
(83)
A limited partnership company is a partnership limited by shares and it is, thus, generally subject to the Danish Public Limited Companies Act as Danish public limited liability companies (with the necessary adjustments). However, a limited partnership company is not a separate tax entity as public limited liability companies, as it is generally tax transparent. Furthermore, there is flexibility as to the management structure of the limited partnership company. A limited partnership company consists of one (or more) general partner(s) subject to personal, unlimited, joint and several liability and one (or more) limited partner(s) either in the form of a public limited liability company participating with its entire capital as a limited partner or of more limited partners of the company contributing with a specific amount of capital to the company which is divided into shares.
107
1.2.2.2.
(Mandatory) disclosure and explanation of investment strategies and risk to investors (sophisticated and retail) For investments in private equity firms admitted to listing on a regulated market or offered to a broad range of investors (provided certain exceptions are not applicable), the private equity firm needs to draft a prospectus and in this should be included information as to investment objective and policies along with the prominent disclosure of risk factors relevant to the fund or its industry. A prospectus would need to be approved by the Danish Financial Supervision Authority (the DFSA). Furthermore, the DVCA guidelines on transparency and disclosure include provisions concerning investment strategies. Reference is made to 1.4.2 below.
1.2.2.3.
Disclosure and explanation of investment strategies and risks to regulators Reference is made to 1.2.2.1 and 1.2.2.2 above.
1.2.2.4.
Register and identify shareholders According to the Danish legislation, limited liability companies must have a register of shareholders, in which the owner of every share is identified. However, this is not registered with the DCCA and is thus not public information. However, an entity may be subject to disclosure obligations regarding larger shareholders in the annual report. Furthermore, shareholders of a listed company are subject to a publication obligation, insofar as they generally possess 5% or more of the voting rights or share capital of the company. The general partner of Danish limited partnerships and limited partnerships, cf. 1.2.2.1 above, is registered with the DCCA and the identity hereof is thus public. Furthermore, the DVCA guidelines on transparency and disclosure include provisions concerning publication of investors of the fund. Reference is made to 1.4.2 below.
1.2.2.5.
Management and disclosure of conflicts of interest Danish private equity firms are generally not subject to any disclosure obligations regarding conflicts of interest. However, companies listed on an exchange in a regulated market may be obliged to disclose such issues. Danish corporate legislation comprises provisions with the purpose of avoiding conflicts of interest.
1.2.2.6.
Prevention of money laundering The Third Money Laundering Directive has been implemented in the Danish legislation.
1.2.3. Information and consultation of employees Under Danish law there are two different sets of rules regarding information and consultation of employees which may be applicable in connection with an acquisition: The Danish Act on consultation and information of employees/collective bargaining agreements and The Danish Transfer of Undertakings Act. Please refer to 1.2.3.1 below.
108
Part I
1.2.3.1.
Informing and consulting employees during the transfer of control of undertakings or businesses The Danish Act on consultation and information of employees/collective bargaining agreements (i) Outside the collective bargaining agreements, employers who employ more than 35 employees are subject to an obligation to inform and consult the employees representatives about circumstances which could have a material impact on the companys employees. (ii) Employers, who employ more than 35 employees comprised by collective bargaining agreements will pursuant to the Co-operation Agreement (Samarbejdsaftalen) between the Danish employers Association (Dansk Arbejdsgiverforening) and the Danish Labour Organisation (LO) have a similar obligation. (iii) Consequently, a contemplated sale of the company employing more than 35 employees will trigger this obligation, regardless of whether the acquisition is an asset-deal or an acquisition of the majority of the shares. (iv) The information and consultation are to take place as early as to allow any views, ideas and proposals from the employees to be included in the basis for the companys decision, i.e. in principle before signing. (v) It will be possible to impose a confidentiality obligation on the employees representatives. (vi) As regards transfers of a listed company, it will be generally accepted to inform and consult the employees representatives at the same time as the information about the contemplated acquisition is given to the Danish stock exchange. (vii) The obligation will comprise both the seller and the purchaser, if the contemplated acquisition could have a material impact on the employees. (viii)If the employer-company does not comply with these obligations, the company may be liable to pay a penalty. The Danish Transfer of Undertakings Act (i) The Danish Transfer of Undertakings Act implements the EC Directive 2001/23 and comprises all transfers of undertakings or part of an undertaking, thus the information and consultation obligation in this Act is only relevant in assets transfer as opposed to share deals. (ii) According to this Act the seller must in due time inform and consult his employees about the contemplated transfer, including: The date of the proposed transfer, The reason for the transfer, The legal, economic and social consequences of the transfer for the employees and Any measures being initiated towards the employees (measures can be downscaling, changes in working procedures, changes in terms and conditions for the employees etc.). (iii) Due time is not defined in the Act, however it is recommended that the information is given to the employees as early as possible and before closing. (iv) If the purchaser-company has employees, they are to be informed likewise. (v) If the employer-company does not comply with these obligations, the company may be liable to pay a penalty. No power of veto Please note that although the employees are required to be informed and in some cases consulted, they have no power to veto the employer-companys decision.
109
The connection of the two schemes In acquisitions (assets transfers) where both schemes are applicable; it is in principle possible to comply with the obligation in one procedure, if the timing complies with the above mentioned deadlines.
Unions The information and consultation obligations for an employer do not include the employees trade unions.
Board representation Companies with more than 35 employees are obliged by mandatory rules to accept a claim from the employees regarding employee-elected board members. Such employee elected board members must be elected by means of an election and they will be elected for a four-year period. Employee elected board members must represent the interests of the company as opposed to specific interests of the employees. Furthermore, the DVCA has implemented a set of transparency and disclosure guidelines which include provisions concerning communication to employees in the portfolio company. Reference is made to 1.4.3 below.
1.2.3.2.
Disclosure and explanation of investment strategies and risk to portfolio companies There is no separate legal obligation to discuss investment strategies with the employees of portfolio companies except for situations in which the strategy itself would imply collective redundancies. As set out above, however, employees in companies with more than 35 employees are entitled to board representation.
1.2.3.3.
Transfer of undertakings directive in relation to leverage buyouts The Danish Transfer of Undertakings Act only applies to asset transfers. Normally an LBO is structured as a share deal. Reference is made to 1.2.3.1 above for a description of the various regulation.
1.2.4. Asset stripping and capital depletion 1.2.4.1. Prevention of asset stripping through common rules on capital maintenance There is no Danish legislation which specifically prohibits asset stripping. However, in limited liability companies the board of directors has a statutory obligation to ensure that the companys financial situation is sound at all times in the context of the companys operations and objectives. Failure to comply with this obligation may imply personal liability for the members of the board of directors. Furthermore, the Danish legislation regarding limited liability companies comprises a provision regarding capital loss. If the equity of a private equity firm set up in the form of a limited liability company is reduced below 50% of the registered share capital, the board of directors of the company has an obligation to convene a general meeting within a maximum period of six months therefrom. At this general meeting the board of directors shall make a statement concerning the financial position of the company and, if required, propose any measures to be taken, including the dissolution of the company. Failure to comply with this provision may imply personal liability for the board of directors. If the general meeting of the company does not adopt any of the proposed measures by the board of directors, the members of the board of directors may probably be forced to resign as director in order to avoid the risk of personal liability.
110
Part I
Moreover, the Danish legislation regarding limited liability companies comprises provisions regarding capital depletion in favour of shareholders. Thus, transfer of the funds and assets of the company to the shareholders may only be in the form of either (i) dividend based on the latest approved annual accounts, (ii) extraordinary dividend, (iii) in connection with a reduction of the share capital, or (iv) in connection with the dissolution of the company. For dividend distribution may only be used retained earnings as well as reserves less loss carried forward. If dividend is distributed as extraordinary dividend (and thus not at the annual general meeting of the company), an auditorreviewed interim balance sheet and a statement from the board of directors declaring that the extraordinary dividend does not exceed what is considered reasonable with regard to the financial position of the company or the parent company as the case may be, need to be drafted. Furthermore, Danish legislation sets out that a buyer must announce any dividend to be distributed by a Danish listed company in the first year after the takeover of such company before the takeover. If not, such distribution of dividend is not allowed. Statements of the board of directors as well as the auditor prior to every capital decrease are furthermore mandatory. It is further stipulated in the Danish legislation regarding limited liability companies that a Danish limited liability company may not grant loans to finance the acquisition of shares in the company or shares in its parent company. Nor is a limited liability company entitled to make assets available or provide assets as security in connection with such acquisition. Eventually, regulation exists regarding right to employee representation in the board of directors of larger public limited liability companies, publication of annual reports, various tax rules with the purpose of maintaining the companies tax base, and Danish bankruptcy legislation which inter alia contains mechanisms to recover funds that have been used in transactions favouring certain debtors and/or causing insolvency of the company. This regulation may also contribute to prevention of asset stripping. 1.2.5. Limits on leverage (that are sustainable for the private equity fund/firm and the target company) Danish limited liability companies are subject to a prohibition against unlawful financial assistance, i.e. making company assets available or providing assets as security in connection with an acquisition of the same company. Reference is also made to 1.2.4 above. Furthermore, the Danish anti-avoidance legislation applies to all companies as well as a number of fiscally transparent entities, e.g. in general also Danish limited partnerships. The key elements of the Danish anti-avoidance legislation may be summarised as follows: The rules on thin capitalization imply that interest on controlled debt is not deductible if controlled debt for a group exceeds DKK 10,000,000 and debt to equity ratio exceeds 4:1 at the end of the tax year. If net financial expenses on a group basis exceed DKK 21,300,000 (2009 figures), restrictions on tax deductibility may apply. Under the interest ceiling limitation, the financial expenses are maximised to an amount determined as a standard rate of the Groups taxable value of all assets save for financial assets. Under the EBIT restrictions, net financial expenses in excess of 80% of taxable income before financial expenses are not tax deductible in the year but are eligible for carry forward to future years. A 30% withholding tax applies to interest payments made between controlled entities if the receiving entity is resident in a so-called tax haven (i.e. a jurisdiction outside EU/EEA and with whom Denmark has not entered into a tax treaty). Interest payments subject to withholding tax are deductible irrespective of the thin capitalization position of the debtor entity.
111
Pursuant to the Danish rules on transfer pricing all transactions between controlled entities must be concluded on general market terms as if the parties to the transactions had been independent entities (the arms length principle). Furthermore, documentation showing that the arms length principle has been complied with must be prepared.
1.2.6. Compensation structure 1.2.6.1. Transparency of the compensation structure (to investors and authorities) Compensation payable by a private equity fund to its management company (in the form of management fees and carried interest) will normally be fully disclosed to investors in the marketing materials for the fund and is the subject of extensive negotiations. Information in this regard will also appear from the annual report if the relevant entities are subject to an obligation to include such. Moreover, the DVCA guidelines on transparency and disclosure include provisions concerning an obligation to disclose a general description of the carried interest programme if it differs significantly from the market standard. Reference is made to 1.4.2. below. 1.2.6.2. Transparency of managers remuneration systems With regard to remuneration of the board of directors, the Danish legislation regarding limited liability companies stipulates that the shareholders shall in the annual general meeting resolve upon the remuneration to be paid to board members. Information in this regard will also appear from the annual report. According to the Danish legislation regarding limited liability companies, adoptions on the issuance of stock options or other incentive programmes for the board of directors and/or the management board may be made. However, this is subject to certain procedural requirements. Listed private equity firms are subject to specific requirements as regards the scope and disclosure of the details of incentive programmes.
1.3.
Governed by contractual agreements
1.3.1. Capital requirements 1.3.1.1. At the level of management companies (operational risk) Usually, there are no additional requirements, as investors are typically relying on the rules presented under 1.2.1 above. 1.3.1.2. At the level of the funds - investment vehicle (exposure risk) Fund size is usually subject to negotiations and documentation may provide for a minimum and a maximum size. When structured as a limited partnership, cf. 1.2.1 above, the investors capital commitment to the private equity fund is usually not paid in full in advance but rather drawn when needed. Furthermore, this is also a part of the discussion with banks in relation to obtaining loans for acquisition of a portfolio company.
112
Part I
1.3.2. Contractual disclosure and monitoring 1.3.2.1. Contractual disclosure and explanation of investment strategies and risks to investors (sophisticated and retail) Private equity funds are generally not marketed towards retail investors unless they are listed. For listed funds, the disclosure of investment strategies and risks is as set out in 1.2.2.2 above. Unlisted private equity funds are typically marketed pursuant to a document known as a private placement memorandum which will contain detailed disclosure of the funds investment strategy and related risks. Fund agreements typically provide for annual and semi-annual or quarterly reports to investors. Portfolio companies of private equity funds furthermore generally have contractual obligations vis--vis lenders to provide information on economic performance etc. 1.3.2.2. Contractual clauses covering lock-up periods, cancellation and termination Private equity funds are typically closed-ended which means that investors have no ability to require repayment of their investment during the life of the fund. Consequently, lock-up periods and conditions governing cancellation and termination are not relevant to most private equity funds. The fact that investors have no ability to redeem and will only receive a return on their investment in the fund as and when the funds underlying investments are realized is usually very evident in fund agreements and the placement memorandum. Many private equity funds allow for termination of the management contract in the event of an investor vote, or in the case of fraud or gross negligence. These provisions are extensively negotiated with investors and vary from fund to fund. They also typically include rights for the investors to suspend the funds ability to make investments if the management team is subject to extensive changes or if there is a change of control. Investors typically have downside protections which are heavily negotiated. 1.3.2.3. Register and identify shareholders See 1.2.2.4 above. Typically contractual documents do not extend these disclosure obligations. 1.3.3. Information and consultation of employees 1.3.3.1. Informing and consulting workers during the transfer of control of undertakings or businesses Reference is made to 1.2.3 above. 1.3.3.2. Disclosure and explanation of investment strategies and risks to investee companies There are typically no additional contractual provisions. Reference is made to 1.2.3.2 above. 1.3.3.3. Transfer of undertakings directive in relation to leverage buyouts In Denmark, the provisions of the transfer of undertakings directive are typically not expanded by contractual provisions to apply to situations which are not covered by the directive, as the Danish Act on Consultation and Information of Employees or collective bargaining agreements typically will apply. Reference is made to 1.2.3.1 and 1.2.3.3 above.
113
1.3.4. Asset stripping and capital depletion 1.3.4.1. Prevention of asset stripping through common rules on capital maintenance On an LBO, the banking agreements typically include covenants restricting dissemination in addition to the legal rules restricting this set out in 1.2.4.1 above. 1.3.5. Limits on leverage 1.3.5.1. The level of leverage is sustainable for the target company Under most fund agreements, the ability of the fund to borrow (as opposed to the ability of portfolio companies or acquisition vehicles e.g. in the form of a holding company to borrow on a nonrecourse to the fund basis) is severely constrained and is usually restricted to bridging, pending the receipt of capital called from investors, to cover a default on a capital call from an investor, and to certain other limited circumstances. 1.3.6. Compensation structure 1.3.6.1. Transparency of the compensation structure (to investors and authorities) The entitlement of a private equity firm to receive compensation in the form of management fees, carried interest (performance fees) or other types of remuneration, will be set out in the fund agreements (to which each of the fund investors is a party). These are heavily negotiated and documented in great detail. The arrangements are, however, confidential to the parties and do not form part of any notification to any regulatory authority. 1.3.6.2. Transparency of managers remuneration systems There are typically no additional contractual provisions. Reference is made to 1.2.6.2 above.
1.4.
Governed by self regulation / professional standards
The DVCA has a code of conduct and each member of the DVCA is obliged to comply with it. In 2008, the DVCA furthermore implemented recommendations as regards disclosure and transparency: Active ownership and transparency in private equity funds Guidelines for responsible ownership and good corporate governance. The guidelines are based on the Walker Working Group, but go further in respect of financial reporting of private equity portfolio companies. The guidelines comprise a principle of comply or explain and failure to both comply and explain can result in exclusion from the DVCA and supervision by a governing body with an external majority. Reference is made to 1.4.2.3. below. 1.4.1. Capital requirements The DVCAs code of conduct and guidelines on disclosure and transparency comprise no additional rules besides the legal rules set out in 1.2.1 above. 1.4.2. Disclosure and monitoring 1.4.2.1. Portfolio companies The DVCA guidelines state that the portfolio companies of private equity funds which are DVCA members shall disclose their annual report on their website as soon as they are published.
114
Part I
The DVCA guidelines comprise additional requirements to the content of the annual reports of portfolio companies. In general, portfolio companies are to provide additional detailed information on the following in their annual reports as a supplement to applicable legislation: 1.4.2.2. Operational and financial developments Corporate governance Financial and other risks Employee matters.
Private equity funds The disclosure obligations comprise inter alia disclosure of the following information on the funds website: A description of the funds history and origin A description of the funds management and organisation, including general partners and individual board members, showing significant directorships and other posts held by each member A possibility to download the management companys accounts A general description of the carried interest programme if it departs significantly from the market standard General strategy for the management Policy for corporate social responsibility Investment criteria Investors by type and country Statement of assets under management A general description of the funds companies stating: i ii iii Geographical location Industrial sector Contact names and references to portfolio companies websites including key figures for the companies iv Examples on how the management company has created value in portfolio companies General information on developments in portfolio companies An overview of divestments by sector, fund and exit year with a description of the buyer of each company Possibility to download annual reports from the portfolio companies.
1.4.2.3.
Enforcement & monitoring In the event that a private equity und or a portfolio company declines to either comply with or to render a statement of non-compliance with the guidelines, this is reported by an independent audit firm (currently Deloitte) to the DVCA Committee for Corporate Governance. The Committee has an external majority with the powers ultimately to impose the sanction of exclusion from the DVCA. Exclusion may have a negative impact on the funds future fundraising abilities.
1.4.2.4.
Coverage of relevant entities The DVCA disclosure and transparency guidelines apply to private equity funds as well as private equity portfolio companies, provided however that certain conditions listed in the guidelines are met:
115
A private equity fund is covered by these guidelines if it is: a private equity member of the DVCA; has committed capital of at least DKK 500 million, calculated as total committed capital for all funds that are managed by a given management company and invest directly in companies; has a company structure which includes one or more investors (limited partners); and undertakes the bulk of its activities in Denmark.
Members of the DVCA whose ultimate parent company is registered in a country other than Denmark therefore cannot be required to comply fully with the DVCA guidelines, as they may be subject to the guidelines that apply where the fund is registered. A private equity portfolio company covered by these guidelines is a Danish company (group) which: is controlled by one or more Danish or foreign private equity funds (regardless of whether these funds are covered by the guidelines); and is, as a minimum, of a size resulting in classification as a class C (large) company under the Danish Financial Statements Act. 1.4.3. Information and consultation of employees 1.4.3.1. Informing and consulting workers during the transfer of control of undertakings or businesses The DVCA guidelines include provisions concerning communication to employees in the portfolio company. The guidelines inter alia comprise obligations to: Reveal the plans for the company and the opportunities and consequences that this has for employees Disclose communication material, messages etc. to ensure relevance and backing within the organisation Set a communication plan vis--vis employees containing Q&As on issues that workers reasonably can be expected to want answers to. 1.4.3.2. Disclosure and explanation of investment strategies and risks to investee companies There are no specific self-regulation rules. 1.4.3.3. Transfer of undertakings directive in relation to leverage buyouts There are no specific self-regulation rules. 1.4.4. Asset stripping and capital depletion There are no specific self-regulation rules in this respect. 1.4.5. Limits on leverage There are no specific self-regulation rules in this respect. 1.4.6. Compensation structure The DVCA guidelines on transparency and disclosure include provisions concerning an obligation to disclose a general description of the carried interest programme if it differs significantly from the market standard.
116
Part I
1.4.7. Other professional standards The DVCAs code of conduct sets out that investment reports to investors should be in accordance with industry standards (generally interpreted to include the International Private Equity and Venture Capital Valuation Guidelines). Applicable Accounting Standards (FAS/IFRS depending on company (private/public)) Furthermore, EVCA Reporting Guidelines and International Private Equity and Venture Capital Board (IPEV) or Private Equity Industry Guidelines Group (PEIGG), valuation guidelines (in respect of valuation of portfolio companies) apply to members of the DVCA.
1.5.
Upcoming Danish bill on new corporate legislation
On 26 November 2008, the Committee for Modernising Danish Company Law has submitted a report proposing a number of alterations of the Danish corporate legislation. The final bill is expected to be tabled in the Danish Parliament in the spring of 2009. If the bill is drafted and adopted based on the report, this will inter alia imply the following key alterations of the corporate legislation for Danish limited liability companies: (i) (ii) The minimum capital requirement of DKK 125,000 for private limited liability companies is removed. Requirement for the payment of a minimum of 25% of the share capital plus any premium for companies with a share capital in cash of DKK 500,000 or more (applies to both private and public limited liability companies). The subscribed capital remains a claim on the subscriber and is payable on demand. (iii) (iv) (v) (vi) Full voting rights on all shares even if the entire subscription amount has not been paid in. Shareholders register publicly available in relation to ownership and voting rights exceeding 5%. Capital owners may unanimously decide that resolutions relating to the company shall be passed otherwise than on a general meeting. However, the rule does not apply to listed companies. Norwegian, Swedish or English may be used as the language on general meetings if resolved by a simple majority of votes. Other languages may be used if resolved by a 9/10 majority. Shareholders rejecting such language may demand their shares redeemed by the company. (vii) Corporate documents shall not necessarily be drafted in Danish, but may be filed with the Commerce and Companies Agency in Swedish, Norwegian or English without translation. (viii) No longer a requirement that the interim balance has been reviewed by the auditor in the event of extraordinary dividends. (ix) The Danish financial assistance regime will be amended in a more flexible manner, and shareholder loans and granting of loans to finance the acquisition of shares in the company or shares in its parent company as well as making assets available or providing assets as security in connection with such acquisition, utilizing the distributable reserves is allowed on market terms and conditions, generally subject to approval by the general meeting. (x) (xi) Loans to parent companies may be granted to companies within the EU/EEA as well as companies in countries considered low-risk countries by the OECD. Access to issue shares with no voting rights and voting rights attached to certain shares cannot exceed 10 times the voting rights attached to other shares with identical denomination. (xii) Private limited liability companies will be able to acquire treasury shares, and the 10% limit on holding of treasury shares will be removed. It will be possible to acquire treasury shares within the distributable reserves, however acquisition of treasury shares may only include fully paid shares. (xiii) Possibility of a more flexible management structure in public limited liability companies by choice between three different models.
117
2.
2.1.
Finland
Introduction
Private equity firms in Finland, managing closed-end funds, are not specifically regulated under Finnish securities markets legislation as opposed to e.g. mutual funds. Private equity firms are thus subject to the same legal framework as limited companies in general. The national industry body is the FVCA (Finnish Venture Capital Association), the actual members of which are entities active in the Finnish private equity and venture capital markets. The FVCA accepts as its associate members communities or private individuals who play a part in the development of the industry in Finland. The number of members at the moment is 37 full and 75 associate members. 25 members of the FVCA are members of EVCA.
2.2. Governed by law/regulation Although there is no private equity specific legislation that would be applicable to private equity firms managing closed-end funds, the offering of a typical closed-end private equity fund should be evaluated under the Finnish Securities Markets Act (1989/4954, as amended, SMA) and related regulation. The SMA applies to the issuance of securities to the public, the transfer and clearing of securities issued to the public as well as to public trade in securities. Additionally a listed private equity firm is naturally required to comply with applicable stock market rules. 2.2.1. Capital requirements 2.2.1.1. At the level of management companies (operational risk) Management companies of Finnish private equity funds (i.e. closed-end funds) are generally limited companies and as such subject to the general capital requirements applicable to all limited companies. Finnish limited liability companies require a minimum capital of EUR 2,500. The minimum share capital of a management company of a mutual investment fund (UCITS) is EUR 125,000. The minimum share capital for a regulated investment firm varies between EUR 25,000 and EUR 730,000. 2.2.1.2. At the level of the funds - investment vehicle (exposure risk) There are no minimum capital requirements for Finnish limited partnerships, although the capital commitments of partners are required to be registered with the Finnish Trade Register. 2.2.2. Regulatory disclosure and related monitoring 2.2.2.1. Overview Private equity firms managing closed-end funds are not subject to any specific disclosure or monitoring obligations in addition to those applicable to other Finnish companies. Financial statements of limited liability companies need to be filed with the Finnish Trade Register as well as financial statements of limited partnerships in which the general partner is a limited liability company.
118
Part I
The most common structure for private equity funds established by Finnish firms is the limited partnership. Finnish limited partnerships need to be registered with the Finnish Trade Register. Depending inter alia on the investors to which a private equity fund is offered, the SMA requires material information to be disclosed in connection with the fundraising. 2.2.2.2. (Mandatory) disclosure and explanation of investment strategies and risk to investors (sophisticated and retail) There is no private equity specific legislation that would be applicable to private equity firms managing closed-end funds but the SMA may be applicable. Under the SMA, securities shall not be marketed or acquired in business by giving false or misleading information or by using procedure that is contrary to good practice or otherwise unfair. If a fund would be marketed to the public (which usually is not the case) it may be relevant to consider whether a prospectus needs to be drafted and, unless an exemption applies, approved by the Finnish Financial Supervision Authority (the FFSA). 2.2.2.3. Disclosure and explanation of investment strategies and risks to regulators See 2.2.2.2. 2.2.2.4. Register and identify shareholders According to the Finnish Companies Act (21.7.2006/624 as amended), limited liability companies need to have a share register and a shareholder register, in which the owner of every share is identified. The share register and the shareholder register shall be kept accessible to everyone at the head office of the company. Everyone has the right to receive copies of the share register, the shareholder register or parts thereof against a nominal compensation i.e. the expenses of the company. The partners of limited partnerships (most funds are limited partnerships in Finland) are noted in the Finnish Trade Register which information is publicly available (also through online databases). 2.2.2.5. Management and disclosure of conflicts of interest Directors Under the Finnish Companies Act, the management of the company shall act with due care and promote the interests of the company. Private Equity firms The same rules apply. 2.2.2.6. Prevention of money laundering The Act on Preventing and Clearing Money Laundering and Funding of Terrorism (2008/503) transposes the Third Money Laundering Directive into Finnish law. 2.2.3. Information and consultation of employees 2.2.3.1. Informing and consulting workers during the transfer of control of undertakings or businesses Finland (like the other Nordic countries) has implemented the EU Transfer of Undertakings Directive.
119
In addition, there are a number of statutory and other binding mechanisms through which employee information and consultation may be required in Finland, for example: Collective agreements are binding upon all employers that are members of an employers association, which is a party to the respective agreement. Furthermore, there are certain collective agreements that are binding upon all employers even if these are not members of an employers association. The Act on Co-operation within Undertakings (334/2007 as amended) requires certain co-operation proceedings with the employees in certain situations. The Employment Contracts Act (55/2001 as amended) also contains provisions protecting employees and imposes information and consultations obligations on the employers. 2.2.3.2. Disclosure and explanation of investment strategies and risks to investee companies There is no separate legal obligation to discuss investment strategies with the employees of investee companies except for situations in which the strategy itself would imply collective redundancies. 2.2.3.3. Transfer of undertakings directive in relation to leverage buyouts In an LBO there is usually no change in the identity of the employing company, and therefore such an LBO does not have any effect on the employment relationship, or employees terms and conditions. 2.2.4. Asset stripping and capital depletion 2.2.4.1. Prevention of asset stripping through common rules on capital maintenance The Companies Act and the Act on Recovery to Bankruptcy Estates (758/1991) provide some mechanisms to prevent asset stripping and capital depletion, for example: The Companies Act provides that the Board of Directors is obliged to act in the interest of the Company and that the Board of Directors, a shareholders meeting or the Managing Director may not make decisions favouring one shareholder (or a third party) at the expense of the Company or other shareholders. The Companies Acts defines and restricts the ways capital is distributed to shareholders. Other transactions that reduce the assets of the company or increase its liabilities without a sound business reason shall constitute unlawful distribution of assets. Under the Companies Act, a Member of the Board of Directors, a Member of the Supervisory Board and the Managing Director is liable in damages for the loss that he or she, in violation of the duty of care referred to in the Companies Act (please refer to Section 2.2.2.5 above) has in office deliberately or negligently caused to the company. Such persons are also liable for the loss that they in violation of other provisions of the Companies Act or the Articles of Association deliberately or negligently cause to the company, a shareholder or a third party. Under the Companies Act, the Board of Directors is required to notify the Trade Register in the event that the equity of the company is negative. The Companies Act also provides for financial assistance rules preventing an acquiring company from using the assets of the target company to pay the purchase price or using such assets as collateral for acquisition finance. The Act on Recovery to Bankruptcy Estates contains a mechanism to recover funds that have been used in transactions favouring certain debtors and/or causing insolvency of the company.
120
Part I
2.2.5. Limits on leverage (that are sustainable for the private equity fund/firm and the target company) There are no statutory restrictions on leverage for Finnish limited companies or limited partnerships. However the providers of credit are regulated entities. Levels of leverage will further be affected by the ability of the borrower to obtain tax deductibility of interest payments. This issue is mostly covered by case law and there are no statutory provisions in this respect. 2.2.6. Compensation structure 2.2.6.1. Transparency of the compensation structure (to investors and authorities) Fees and carried interest are subject to negotiations and will be set forth in fund documentation. As regards disclosure in connection with marketing a fund, see 2.2.2.2. 2.2.6.2. Transparency of managers remuneration systems Shareholders may generally not directly affect the remuneration of the companys personnel in other ways than by exercising their power in appointing the board members. According to the Companies Act, the annual report of a limited liability company shall contain separate information on loans, liabilities and commitments to related parties and on the main terms thereof, if the sum total of the loans, liabilities and commitments exceeds EUR 20,000 or 5% of the equity of the company, as it appears on the balance sheet. The company and another person shall be considered related parties if one controls the other or if one otherwise has significant influence in the financial and business decision-making of the other. As regards decisions on stock options (or issuance of shares), such decisions are to be made by the shareholders meeting, provided that the shareholders meeting may authorise the Board of Directors to decide on issuances within specified limits.
2.3.
2.3.1. Capital requirements 2.3.1.1. At the level of management companies (operational risk) There are usually no additional requirements. 2.3.1.2. At the level of the funds - investment vehicle (exposure risk) Fund size is usually subject to negotiations (and documentation may provide for a minimum and a maximum size). 2.3.2. Contractual disclosure and monitoring 2.3.2.1. Contractual disclosure and explanation of investment strategies and risks to investors (sophisticated and retail) Please refer to the answers in 2.2.2 above. Fund documentation always sets forth an investment strategy and limitations which are usually also described in a placement memorandum (which would typically also describe related risks). Fund agreements typically provide for annual and semi-annual or quarterly reports to investors.
121
2.3.2.2.
Contractual clauses covering lock-up periods, cancellation and termination Private equity funds are typically closed-ended which means that investors have no ability to require repayment of their investment during the life of the fund. Consequently, lock-up periods and conditions governing cancellation and termination are not relevant to most private equity funds. The fact that investors have no ability to redeem and will only receive a return on their investment in the fund as and when the funds underlying investments are realised is usually very evident in fund agreements and the placement memorandum. Many funds allow for termination of the management contract in the event of an investor vote, or in the case of fraud or gross negligence. These provisions are extensively negotiated with investors and vary from fund to fund. They also typically include rights for the investors to suspend the funds ability to make investments if the management team is subject to extensive changes or if there is a change of control. Investors typically have downside protections which are heavily negotiated.
2.3.2.3.
Register and identify shareholders See paragraph 2.2.2.4 above. Typically a funds contractual documents do not extend these disclosure obligations.
2.3.3. Information and consultation of employees 2.3.3.1. Informing and consulting employees during the transfer of control of undertakings or businesses Depending on the company, there may be relevant provisions in employment-related documents or agreements, but typically the employee relies upon the extensive legal rules referred to in paragraph 2.2.3 above. 2.3.3.2. Disclosure and explanation of investment strategies and risks to investee companies There are typically no additional contractual provisions. 2.3.3.3. Transfer of undertakings directive in relation to leverage buyouts There are typically no additional contractual provisions. Please see paragraph 2.2.3 above. 2.3.4. Asset stripping and capital depletion 2.3.4.1. Prevention of asset stripping through common rules on capital maintenance On an LBO, the banking agreements typically include covenants restricting dissemination in addition to the legal rules restricting this set out in paragraph 2.2.4.1 above. 2.3.5. Limits on leverage (that are sustainable for the private equity fund/firm and the target company) Under most fund agreements, the ability of the fund to borrow (as opposed to the ability of portfolio companies or acquisition vehicles to borrow on a non-recourse to the fund basis) is severely constrained and is usually restricted to bridging, pending the receipt of capital called from investors, to cover a default on a capital call from an investor, and to certain other limited circumstances.
122
Part I
2.3.6. Compensation structure 2.3.6.1. Transparency of the compensation structure (to investors and authorities) The entitlement of a private equity firm to receive compensation in the form of management fees, carried interest (performance fees) or other types of remuneration, will be set out in the fund agreements (to which each of the fund investors is a party). These are heavily negotiated and documented in great detail. The arrangements are, however, confidential to the parties and do not form part of any notification to any regulatory authority. 2.3.6.2. Transparency of managers remuneration systems See 2.2.6.2.
2.4.
Governed by self regulation / professional standards (industry professional standards and investor relations)
The FVCA has a code of conduct and each member is required to agree to comply with it. In the event a member breaches the code of conduct, the member may be expelled from the FVCA. The FVCA is currently preparing rules concerning disclosure and transparency which should be approved in the beginning of 2009. The rules will follow the comply or explain principle. 2.4.1. Capital requirements There are no additional rules beyond the extensive legal rules set out in paragraph 2.2.1 above. 2.4.2. Industry imposed disclosure and related monitoring 2.4.2.1. Portfolio companies New rules expected to recommend that the private equity firm discloses with respect to each portfolio company i.a. the name, time of investment, line of business, exits and contact details. 2.4.2.2. Private equity firms New rules expected to recommend that the private equity firm discloses i.a. information on its management, ownership, history, investors (classification and geographical investor base), names, sizes and investment strategies of funds under management as well as principles applied in relation to valuation and investor reporting. New rules expected to recommend that the private equity firm discloses with respect to each portfolio company i.a. the name, time of investment, line of business, exits and contact details. 2.4.2.3. Enforcement and monitoring In the event a member breaches the code of conduct or the disclosure and transparency rules, the member may be expelled from the FVCA. 2.4.2.4. Coverage of relevant entities The recommendations on transparency apply to all members of the FVCA making majority or minority investments in portfolio companies.
123
2.4.3. Information and consultation of employees 2.4.3.1. Informing and consulting employees during the transfer of control of undertakings or businesses There are no specific self-regulation rules. 2.4.3.2. Disclosure and explanation of investment strategies and risks to investee companies There are no specific self-regulation rules. 2.4.3.3. Transfer of undertakings directive in relation to leverage buyouts There are no specific self-regulation rules in this respect. Please see paragraph 2.2.3 above. 2.4.4. Asset stripping and capital depletion There are no additional self-regulation rules. 2.4.5. Limits on leverage (that are sustainable for the private equity fund/firm and for the target company) There are no additional self-regulation rules. 2.4.6. Compensation structure 2.4.6.1. Transparency of compensation structure There are no additional self-regulation rules. 2.4.7. Other professional standards The FVCA has issued valuation guidelines (implements International Private Equity and Venture Capital Valuation Guidelines). Applicable Accounting Standards (FAS/IFRS depending on company (private/public)).
124
Part I
125
3.
3.1.
France
Introduction
The national industry body is the French Private Equity and Venture Capital Association, Association Franaise des Investisseurs en Capital (AFIC), which has more than 490 members. 280 are private equity firms. About 70 are members of EVCA. The most commonly used structures for private equity funds in France are: The Fonds Commun de Placement Risques (FCPR), The Fonds Commun de Placement dans lInnovation (FCPI) and the Fonds dInvestissement de Proximit (FIP), which are specific FCPRs, reserved to individual shareholders who will be entitled to a tax reduction, The Socit de Capital-Risque (SCR)
The FCPR is a joint ownership of financial instruments and deposits (coproprit dinstruments et de depots). An FCPR is not a legal entity (i.e. it does not have a personnalit morale). Thus, it does not have the legal capacity to enter into contracts. All contracts concerning the FCPR must be signed by the management company (socit de gestion de portefeuille) of the FCPR which is its sole legal representative. An FCPR is formed by a management company and a custodian (dpositaire). The custodian of an FCPR is chosen by the management company from a list established by the French finance ministry. The custodian must have its registered office in France. The role of the management company is to make all investment and divestment decisions on behalf of the FCPR. The management company always acts in the best interest of the unit holders. The SCR must take the form of a socit par actions (e.g. a French socit anonyme or a French socit en commandite par actions). The SCR is therefore subject to all the rules applicable to such companies. However, provided the SCR opts for special tax treatment, and provided further that the SCR meets several requirements, it is entitled to certain tax exemptions and its shareholders may be entitled to certain tax benefits. FCPRs are regulated by the Autorit des Marchs Financiers (the AMF). However, a SCR will only be regulated by the AMF if it is public offering. As a consequence, private equity firms active in France are governed under the following framework:
126
Part I
3.2.
Governed by law/regulation FCPRs and their management companies are governed by: (i) the French Financial and Monetary Code (Professional Practice Requirements, Obligations of Investment Service Providers, Prevention of Money Laundering, products that is to say FCPR, FCPI and FIP); (ii) AMF General Regulation (rules relating to management companies and products) and specific regulation (called instructions relating to the approval of French management companies and to the formation of FCPRs) and in particular: AMF General Regulation, Books III (services providers) and IV (collective investment products) Instruction of June 6, 2000 that deals with FCPRs Instruction of February 8, 2008 on management companies Instruction of July 15, 2008 on rules of conduct applicable to the marketing of UCITS
Asset management activities, including the activities conducted by private equity firms which manage an FCPR, FCPI or FIP, are regulated and can only be carried out in France by a person authorised by the AMF. Firms which do not carry out asset management activities in France may still need to be authorised in respect of investment advice. Non-compliance with the AMF Rules may lead to regulatory sanction, such as a fine. As far are FCPRs are concerned, it is necessary to distinguish those opened to the public (FCPR agr) that must be approved by the AMF from those reserved for qualified investors (FCPR allg). The FCPR allg is open to the following investors: (i) investors mentioned in Article L. 214-35-1 of the French Financial and Monetary Code (CMF), i.e. investors with the competence and means necessary to understand the risks inherent in transactions in financial instruments, i.e., qualified investors as defined in the second paragraph of Article L. 411-2 of the CMF including OPCVMs (organismes de placements collectifs en valeurs mobilires, that is to say UCITS) and qualified investors and foreign investors in an equivalent class pursuant to the law of the country in which their headquarters are located; as well as the Management Company, its directors and officers, its employees and any individuals acting on its behalf; (ii) States, or in the case of a federal State, one or several members that make up the federation; (iii) the European Central Bank, any national central bank, the World Bank, the International Monetary Fund, and the European Investment Bank; (iv) investors initially subscribing for or acquiring units for an amount not less than EUR 30,000, who have held a position professionally in the finance industry for at least one year, that has enabled the investor to gain knowledge about the strategy implemented by the FCPR in which the investor plans to subscribe;
127
(v) investors which are individuals or legal entities initially subscribing for or acquiring units for an amount not less than EUR 30,000 provided such persons fulfil one of the following three conditions: 1. they contribute technical or financial assistance to unlisted companies that fits the objectives of the Fund with a view to their creation or future development; 2. they assist the management company of the FCPR in finding potential investors or otherwise contribute to the management companys objectives in the identification, management and disposition of investments; or 3. they have knowledge of private equity by having previously invested directly in non-listed companies or FCPRs allgs or as a subscriber either in an FCPR not advertised or marketed to the public or in an FCPR allg or in an unlisted socit de capital-risque. (vi) investors initially subscribing for or acquiring units for an amount not less than EUR 30,000, and possessing cash deposits, life insurance products, or a portfolio of financial instruments with a total value not less than EUR 1,000,000; (vii) companies fulfilling two of the three following criteria, at the end of the most recent fiscal year: total balance sheet greater than EUR 20,000,000, total revenue greater than EUR 40,000,000, equity capital greater than EUR 2,000,000;
(viii) investors subscribing for or acquiring units for an amount not less than EUR 500,000. AMF Compliance A portfolio management company is required to appoint a compliance officer called RCCI and produce a compliance manual and monitoring programme to demonstrate that the firm has the systems and controls in place which are necessary to carry out its regulated activity. This compliance manual will set the compliance and professional standards for deal executives in private equity firms and is issued to all employees. RCCIs and directors of companies are required to fully engage in the compliance of the firm, to ensure that its policies and procedures are up-to-date and to ensure compliance with the AMF Rules. SCRs are governed by: the French commercial Code as any commercial company, the law of July 11, 1985.
A very small number of private equity SCRs are listed on the Eurolist. In this case, they are also regulated by the AMF. 3.2.1. Capital requirements 3.2.1.1. At the level of management companies (operational risk) According to article 312-3 of the AMF General Regulation, the share capital of a portfolio management company must be at least EUR 125,000 and must be fully paid in cash at least to this minimum amount. Moreover, its capital must be at least equal to the higher of the following two amounts: EUR 125,000 plus an amount equal to 0.02% of assets under management by the portfolio management company in excess of EUR 250 million; One-quarter (1/4) of general operating expenses for the preceding financial year.
128
Part I
3.2.1.2.
At the level of the funds - investment vehicle (exposure risk) The minimum capital required in order to form an FCPR is EUR 400,000. There are rules that limit the exposure risk of an FCPR. It is necessary to distinguish between FCPRs agrs (approved FCPR) and FCPRs allgs (non-approved FCPR): (i) Approved FCPRs must comply with the following diversification rules at any time as from the 2nd anniversary of the AMF approval: no more than 10% of the net assets of the FCPR may be invested in shares issued by 1 single company no more than 35% of the net assets of the FCPR may be invested in shares issued by 1 single OPCVM (UCIT) no more than 10% of the net assets of the FCPR may be invested in shares issued by 1 single OPCVM (UCIT) subject to the simplified procedure no more than 10% of the net assets of the FCPR may be invested in units of 1 single partnership or other investment entity. (ii) FCPR allgs, that are only opened to qualified investors, may not invest more than 50% of their net assets in a single OPCVM or in a single eligible entity. Furthermore, an approved FCPR cannot hold more than 35% of the shares or the voting rights of any one company, nor hold more than 10% of the shares or interests of any one investment entity. FCPRs allgs may not hold more than 10% of the shares or interests of any one UCIT which does not qualify as en eligible entity. However, it should be noted that even if the legal restrictions applicable to FCPRs allgs are not important, it is very common to provide further restrictions in by-laws.
3.2.2. Regulatory disclosure and related monitoring 3.2.2.1. Disclosure and explanation of investment strategies and risks to investors (sophisticated and retail) Since the entry into force of the MiFID Directive, management companies must give appropriate information to their clients (either sophisticated or retail) relating to the proposed financial instruments and investment strategies, which must include appropriate guidelines and warnings about the inherent risks of investing in such instruments or of certain investment strategies. According to article 314-33 of the AMF General Regulation, Investment services providers shall provide clients with a general description of the nature and risks of financial instruments, taking into account, in particular, the clients categorisation as either a retail client or a professional client. That description must explain the nature of the specific type of instrument concerned, as well as the risks particular to that specific type of instrument in sufficient detail to enable the client to take investment decisions on an informed basis.
129
Moreover, management companies must provide holders with all necessary information about the management of the collective investment schemes. This information is given in several documents including the FCPR annual report. However, more and more management companies bind themselves to provide reports to their investors relating to the evolution of the portfolio and to the new equity participations on a quarterly basis. 3.2.2.2. Disclosure and explanation of investment strategies and risks to regulators In order to be approved by the AMF, French management companies must disclose their investment strategies and risks to the regulator. Moreover, this information will figure in the by-laws of the fund which may be subject to prior approval of the AMF (FCPR agre) or to the control of the AMF (FCPR allg). The Companies Act requires French companies to file audited financial statements at the Greffe du Tribunal de commerce so any private equity firm or any portfolio company owned by a private equity fund will be bound by these provisions. It should be noted that specific provisions are applicable to listed companies. 3.2.2.3. Contractual clauses covering lock-up periods, cancellation and termination FCPRs are closed-end funds. According to article L.214-36 of the CMF, the lock-up period cannot exceed 10 years. However, according to article L.214-38-1, contractual FCPRs (FCPR contractuel) are authorised to provide lock-up periods that exceed the common length of 10 years. The law also provides that the FCPR is dissolved at the end of its term or in advance upon decision of the Management Company after having notified the Custodian. At least, the General Regulation of the AMF requires the automatic dissolution of Funds in the following cases: (i) if the total value of the funds net assets remains, for a period of thirty days, less than three hundred thousand (300,000) euros if the fund is held by more than twenty unit holders or than 160,000 euros if the Fund is held by less than twenty unit holders , unless the Management Company contributes all or part of any of the Funds assets into one or more funds that the Management Company manages; (ii) under certain circumstances, if either the Custodian or the Management Company ceases to exercise its functions because of a cessation of activity or a friendly or legal liquidation or a legal or regulatory impediment to continue these functions; and (iii) if a request is made for the redemption of all the units. 3.2.2.4. Register and identify shareholders Article 311-3 of the AMF General Regulation provides that the portfolio management company shall inform the AMF of any changes in key items in the original request for authorisation, notably concerning direct or indirect share ownership. The AMF shall inform the company in writing of any consequences that such changes may have on the authorisation. Article 312-2 of the AMF General Regulation provides that the portfolio management company shall disclose the identities of its direct or indirect shareholders as well as the amounts of their holdings. The AMF shall assess the quality of the companys shareholders having regard to the need for sound and prudent management and proper performance of its own supervisory responsibilities. It shall make the same assessment of partners and members in an economic interest grouping.
130
Part I
Moreover, in order to be approved by the AMF, shareholders of management companies that hold or will held a stake of at least 10% of the management company must file a declaration. In this declaration, the shareholder must indicate if it has been subject to criminal procedures, what kind of relations it will have with the management companies, if it holds stakes in other companies etc. 3.2.2.5. Management and disclosure of conflicts of interest According to the General Regulation of the AMF, management portfolio companies shall take all reasonable measures to detect conflicts of interest that arise in the course of providing investment and ancillary services or management of collective investment schemes: (i) Either between itself, relevant persons, or any person directly or indirectly linked to the investment services provider by control, on the one hand, and its clients, on the other hand; (ii) Or between two clients. In order to do so the company must establish an effective conflicts of interest policy and disclose the conflicts of interest to their clients to enable them to take an informed decision. Moreover, a compliance officer (called RCCI see above) must be appointed in any management company to assess the adequacy and effectiveness of policies and to advise the relevant persons responsible for investment services so that they comply with the professional obligations of investment services providers. 3.2.2.6. Prevention of money laundering Management companies are required by the law to declare to the Public Prosecutor any transactions they have knowledge of which involve sums which they know to be the proceeds of an offence. Moreover, under certain circumstances, they are required to declare to the authority called TRACFIN any sums which might derive from drug trafficking, fraud against the financial interests of the European Communities, corruption or organised crime, or which might contribute to the financing of terrorism. TRACFIN is the French anti-laundering authority. It depends on the Ministers of Economy, Finance and Employment. They also have to declare: any transactions involving sums which might derive from drug trafficking, from fraud against the financial interests of the European Communities, from corruption or from organised crime, or which might contribute to the financing of terrorism; any transaction in which the identity of the principal or the recipient remains dubious despite the checks carried out; and any transaction executed by financial entities for their own account, or on behalf of third parties, with natural persons or legal entities, including their subsidiaries or establishments, acting as, or on behalf of, fiduciary funds or some other asset management instrument, when the identity of the grantors or the recipients is not known. Furthermore, management companies must act with a high degree of vigilance when they enter into a contract with a new client or with a client who is not physically present for identification purposes and when they are faced to transaction of a certain amount, subject to unusually complex conditions and does not appear to have any economic justification or lawful purpose.
131
The AMF requires that the management company appoints a person (generally a manager) in order to be the contact of the TRACFIN. 3.2.3. Information and consultation of employees 3.2.3.1. Informing and consulting employees during the transfer of control of undertakings or businesses Under French law, the employer must inform the comit dentreprise (which must be set up in companies of at least 50 employees). Moreover, in companies of at least 300 employees, the employer must inform the comit dentreprise, at least once a year, of the investment strategies. 3.2.3.2. Disclosure and explanation of investment strategies and risks to investee companies No specific regulation. 3.2.3.3. Transfer of undertakings directive in relation to leverage buyouts No specific regulation. 3.2.4. Limits on asset stripping and capital depletion 3.2.4.1. Prevention of asset stripping through common rules on capital maintenance The portfolio management company must be able to prove at any time that its capital is at least equal to the higher of the following two amounts: EUR 125,000 plus an amount equal to 0.02% of assets under management by the portfolio management company in excess of EUR 250 million One-quarter of general operating expenses for the preceding financial year.
Moreover, a fund will be automatically dissolved in any of the following cases: if the total value of the funds net assets remains less than EUR 300,000 for a period of thirty days, unless the management company contributes all or part of any of the funds assets into one or more funds that the management company manages; if either the custodian or the management company ceases to exercise its functions and another custodian or management company has not been appointed; if a request is made for the redemption of all the units.
3.2.5. Limits on leverage (that are sustainable for the private equity fund/firm and the target company) FCPRs are required to not exceed the debt ratio of 10% of their assets. However, it should be noted that the new French vehicle, called the FCPR contractuel, created by the Act on the Modernization of the Economy that came into force in August 2008, may freely set its investment and commitment rules and is not subject to investment quotas, risk ratios or portfolio concentration restrictions, other than self-imposed ones. In addition, their debt may exceed 10% of their assets (84).
(84)
Article L.214-4 of the Financial and Monetary Code.
132
Part I
3.2.6. Compensation structure 3.2.6.1. Transparency of the compensation structure (to investors and authorities) The AMF requires to know how the remuneration is organised. Investors must have access to this information in the by-laws. Moreover, according to articles 314-77 and -78 of the general regulation of the AMF Portfolio management companies shall be remunerated for their management of portfolios by a management fee and, if applicable, a proportionate share of subscription and redemption fees or by incidental fees and The management fee may include a variable portion tied to the outperformance of portfolio relative to the investment objective, provided that: (i) It is expressly provided for in the simplified prospectus of the collective investment scheme. (ii) It is consistent with the investment management objective as set forth in the prospectus. (iii) The share of outperformance allocated to the management company must not induce that company to take excessive risk with regard to the investment strategy, investment objective and risk profile set forth in the prospectus of the collective investment scheme. 3.2.6.2. Transparency of managers remuneration systems Stock options The extraordinary general meeting may authorise the board of directors or the executive board to grant stock options to some or all of the companys staff. The extraordinary general meeting determines the period during which the said authorisation may be used by the board of directors or the executive board, which shall not exceed thirty-eight months. However, authorisations granted before the publication date of Act No. 2001-420 of 15 May 2001 relating to the new financial regulations shall remain valid until they expire. The board of directors or the executive board determines the conditions under which the options shall be granted. The said conditions may include a prohibition on the immediate reselling of some or all of the shares, but the period imposed for retaining the shares shall not exceed three years from the date on which the option is exercised. Options may be granted or exercised even before the share capital has been fully paid up. The subscription price is determined by the board of directors or the executive board, on the day on which the option is granted, in the manner stipulated by the extraordinary general meeting based on the auditors report. If the companys shares are not admitted to trading on a regulated market, the subscription price is determined in accordance with the objective methods applicable to the valuation of shares which takes account of the companys net assets position, profitability and business prospects, applying a weighting specific to each case. The said criteria are assessed, if appropriate, on a consolidated basis or, failing that, by taking the financial elements of their significant subsidiaries into account. Failing this, the subscription price is determined by dividing the amount of the re-valued net assets by the number of securities in existence calculated on the basis of the most recent balance sheet. A decree determines the method for calculating the subscription price.
133
If the companys shares are admitted to trading on a regulated market, the subscription price cannot be lower than 80% of the average of the prices quoted at the twenty stock-exchange trading days preceding that day, and no option shall be granted less than twenty stock-exchange trading days after detachment from the shares of a coupon giving entitlement to a dividend or a capital increase. Moreover, a special report informs the ordinary general meeting each year of the number, expiry dates and price of the options to subscribe or purchase shares which, during the year and relative to the duties and functions performed in the company, have been granted to each of those executives by the company and the companies affiliated to it.
3.3.
Governed by contractual agreements Articles of association of the management company (and its code of ethics). The by-laws (rglement) of the fund (FCPR) are a binding legal agreement between the management company and the custodian. It governs the operation of the FCPR which sets forth the following terms and conditions: its investment policy, the subscription for FCPR units, the rights conferred by the units, the allocation and distribution of FCPR proceeds, information communicated to unit holders, management fees. By-laws relating to an FCPR open to the public are subject to prior approval of the AMF. In case of an FCPR reserved to sophisticated investors (FCPR allg or FCPR contractuel), the management company has to file the by-laws with the AMF within one month.
3.3.1. Capital requirements 3.3.1.2. At the level of management companies (operational risk) There are usually no additional requirements. 3.3.1.3. At the level of the funds investment vehicle (exposure risk) As stated above, legal restrictions applicable to FCPRs allgs are not very restrictive. Therefore it is common that by-laws of FCPR allgs provide additional rules. 3.3.2. Contractual disclosure and monitoring 3.3.2.1. Contractual disclosure and explanation of investment strategies and risks to investors (sophisticated and retail) FCPRs and moreover FCPRs reserved to qualified investors issue a document called a Rglement (LPA) and a private placement memorandum which contain detailed disclosure of the funds investment strategy and related risks. 3.3.2.2. Contractual clauses covering lock-up periods, cancellation and termination FCPRs are typically closed-end funds. Their rglement indicates the lock-up period which cannot be more than 10 years (except for contractual FCPRs). Many funds allow for termination of the management contract in the event of an investor vote, or in the case of fraud or gross negligence. These provisions are extensively negotiated with investors and vary from fund to fund. They also typically include rights for the investors to suspend the funds ability to make investments if the management team is subject to extensive changes or if there is a change of control. Investors typically have extensive downside protections which are heavily negotiated.
134
Part I
3.3.2.3.
Register and identify shareholders There is usually additional information in the private placement memorandum.
3.3.2.4.
Management and disclosure of conflicts of interest There are typically additional contractual provisions. In FCPRs allgs, there is usually a specific committee (with the main investors) that deals with these kinds of issues. Moreover, specific rules are generally granted in Rglements.
3.3.2.5.
Prevention of money laundering There are typically no additional contractual provisions.
3.3.3. Information and consultation of employees 3.3.3.1. Informing and consulting employees during the transfer of control of undertakings or businesses There are typically no additional contractual provisions. 3.3.3.2. Disclosure and explanation of investment strategies and risks to investee companies There may be additional contractual provisions. 3.3.3.3. Transfer of undertakings directive in relation to leverage buyouts There are typically no additional contractual provisions. 3.3.4. Asset stripping and capital depletion Under most rglements, the ability of the fund to borrow (as opposed to the ability of portfolio companies or acquisition vehicles to borrow on a non-recourse to the fund basis) is severely constrained and is usually restricted to bridging, pending the receipt of capital called from investors, to cover a default on a capital call from an investor, and to certain other limited circumstances. 3.3.5. Limits on leverage (that are sustainable for the private equity fund/firm and the target company) There are typically additional contractual provisions. In particular, in contractual FCPRs that are authorised to borrow more than 10% of its asset, the LPA must provide a limit. 3.3.6. Compensation structure 3.3.6.1. Transparency of the compensation structure (to investors and authorities) As well as being disclosed in the funds marketing materials, the entitlement of the private equity firm to receive compensation in the form of management fees, carried interest (performance fees) or other types of remuneration (such as portfolio company monitoring fees, directors fees, financing fees etc.), will be set out in the Rglement which is the main contractual document relating to the fund and which is an agreement to which each of the fund investors are party. These are heavily negotiated and documented in great detail. 3.3.6.2. Transparency of managers remuneration systems There may be a remuneration committee.
135
3.4.
Industry professional standards and investor relations (governed by self regulation / professional standards)
AFICs code of ethics applies to all AFIC members. It should be pointed out that in France, in order to be approved by the AMF, a management company must be a member of one of the two French associations that act in the field of Private Equity. These two associations are the AFIC and the AFG (Association Franaise de Gestion Financire) but the AFIC is the sole to be specialised in this area. AFIC members must comply with regulations, act competently, diligently and fairly, not disclose confidential information, carry out their business autonomously and with independence, avoid conflicts of interest etc. In order to ensure that AFIC members apply these provisions, a Compliance committee (which comprises (i) members elected by the shareholders meeting of the AFIC and (ii) previous chairmen of the association) may decide to issue penalties (from warning to disqualification). Code of ethics of management companies authorised to invest private equity of their officers and employees. This code is common to the two French associations, the AFIC and the AFG. Moreover, it has been approved by the AMF. Since then, any private equity management company must fulfil its provisions and in particular rules applicable to conflicts of interest (investment allocation, co-investments, additional investments, methods for selling equity interests and services provided by the management company or related companies). These rules figure in the code of ethics of the management company.
Table 2: Objective of the standards Clarity - Enforcement and monitoring Coverage
AFICs code of ethics
Code of ethics of management companies authorised to invest private equity of their officers and employees
Objective of the standards
Transparency Equal treatment Fairness Harmonisation of practices
Conflicts of interest Exercise of shareholder rights Relations with investors Clear and precise provisions
Clarity Enforcement and monitoring
Made of guiding principles
AFICs compliance committee By the AMF By investors since these rules figure (elected members + previous chairmen of the AFIC) in the by-laws of the fund Penalties such as warning disqualification All members of the AFIC (companies and their employees) Management companies authorised by the AMF to invest private equity (officers and employees)
Coverage
136
Part I
3.4.1. Capital requirements There are no additional rules. 3.4.2. Industry imposed disclosure and related monitoring By signing the Charter of Private Equity Investors, the private equity firms agree to promote transparency in the exercise of their activity and particularly in the measurement of its economic and social impact in their interactions with each of their portfolio companies. Moreover, under AFICs code of ethics, members bind themselves to treat the companies in which they invest fairly, in a manner consistent with the rules of the profession. They shall establish the level of their active contributions. Each member must be able to fulfil its duties as a shareholder completely. By-laws (rglement) of the fund (FCPR) provide that the net asset value of shares are calculated at least twice a year and that this net asset value is communicated to shareholders. Moreover, the management company undertakes in the by-laws to fulfill the obligations stated in the EVCA Reporting Guidelines. Therefore, companies will have to disclose some specific information regarding the fund and the portfolio companies. There may be additional commitments in the by-laws. 3.4.3. Information and consultation of employees Generally there is no specific commitment. However, under specific circumstances (due to the firm size, to the presence of unions etc.), the fund and its management company may undertake to inform employees, to explain investment strategies etc. Furthermore, by signing the Charter of Private Equity Investors, the private equity firm binds itself to promote good labour relations. In their capacity as mandated company directors and shareholders, the signatories agree to promote the development of good labor relations, the key to success in efficient and balanced company growth. In particular, they undertake to propose, within the scope of the companys governing bodies, open dialogue with employee representatives at the time of entry into the capital of the company and of their investment exit. 3.4.4. Limits on asset stripping and capital depletion There are no additional rules. 3.4.5. Limits on leverage (that are sustainable for the private equity fund/firm and for the target company) There are no additional rules. 3.4.6. Compensation structure 3.4.6.1. Transparency of compensation structure By signing the Charter of Private Equity Investors, the private equity firms agree to fulfil rules in term of transparency etc. and to promote the equitable sharing of value creation. They agree to propose the implementation or expansion of profit-sharing or equity ownership schemes, to the largest possible number of employees, at terms adapted to the situation of each company. In this context, they agree, specifically, to promote and extend the implementation of profit-sharing agreements as provided for by law.
137
3.4.7. Other professional standards Principes directeurs devant rgir les Plans dInvestissement des managers et salaris des oprations de Capital Transmission en France (2007) This contains recommendations regarding the way to associate managers with the value issued by LBO transactions. AFICs Charter of Private Equity Investors (2008) As professional shareholders, private equity investors are committed to promoting principles of good governance for each company of their portfolio they are involved with. By signing this Charter, private equity investors publicly express the values they wish to promote, the responsibilities they assume and the commitments to which they subscribe. Best Practices Guide of the AFIC, dealing with the internal control processes of management companies, transparency and security of the management processes. International Private Equity and Venture Capital Valuation Guidelines By-laws provide that funds apply the International Private Equity and Venture Capital Valuation Guidelines developed by the Association Franaise des Investisseurs en Capital (AFIC), the British Venture Capital Association (BVCA) and the European Private Equity and Venture Capital Association (EVCA). International Private Equity and Venture Capital Reporting Guidelines.
138
Part I
139
4.
4.1
Germany
Introduction
Before going into specific details, paragraph 1 of this overview summarises the framework of statutory rules and regulations relevant to the private equity (PE) industry in Germany. Paragraph 2 indicates certain subject matters that from practical experience are market standard practices and as such are typically included in the (contractual) agreements governing a German private equity or venture capital fund. German professional standards (self regulation) are addressed in paragraph 3. There is no legal definition of a private equity fund (PEF) under German law. Only two categories of PEFs are regulated by specific German laws: Equity Investment Companies (Unternehmensbeteiligungsgesellschaften) under the Act concerning Equity Investment Companies (Unternehmensbeteiligungsgesetz, UBGG) and Venture Capital Companies (Wagniskapitalbeteiligungsgesellschaften) under the 2008 implemented Act for the Promotion of Venture Capital Participations (Gesetz zur Frderung von Wagniskapitalbeteiligungen, WKBG). PEFs active in Germany qualifying in exceptional circumstances as an investment institution would in addition generally be subject to the licensing requirement of the German Investment Law Act. Most PEFs active in Germany however operate without a license either as they do not qualify as an investment institution within the meaning of the Investmentgesetz (InvG) because of their active involvement in their portfolio companies, or do not elect to be treated (i) as an Equity Investment Company to be licensed pursuant to the UBGG or (ii) as a Seed Venture Capital Fund to be licensed pursuant to the WKBG. A PEF is indirectly impacted by regulation applicable to either the investors investing in it and/or the portfolio companies in which it invests. This is particularly relevant to institutional investors and listed portfolio companies. Also, the German private equity industry is increasingly faced with harmonised rules set out at European Union (EU) level. European Directives cover many areas of the industry activities, such as licensing and conduct of business rules (MiFID), disclosure (Prospectus Directive, Transparency Directive) and money laundering (Third Money Laundering Directive). Furthermore, there are terms and conditions relating to PEFs and private equity investments that are not so much dictated by rules and regulation of German law, but have rather developed in practice. These relate in particular to disclosure and monitoring of investments in PEFs (see paragraphs 2 and 3). The landscape of German (national level) professional standards for the private equity industry is very much similar to the one at European level. The only exemption thereto is the newly implemented German Disclosure Guideline. The representative association for private equity firms in Germany is the German Private Equity and Venture Capital Association Bundesverband deutscher Kapitalbeteiligungsgesellschaften eV BVK. The BVK has 320 members. 207 of the private equity firms active in Germany are members of the European Private Equity and Venture Capital Association (EVCA).
140
Part I
4.2.
PEFs are not governed by a general German private equity-specific law. To implement a broad PE-Law such as the ones in Luxembourg or Switzerland or specific legislation as the ones in France or Italy was suggested by experts to the German Federal Government in 2007, but the Ministry of Finance favoured to implement only the WKBG for very small Venture Capital Companies which, however, has yet to be used by a single Venture Capital Fund. Only two categories of PEFs are regulated by specific German laws: Equity Investment Companies (Unternehmensbeteiligungsgesellschaften) under the Act concerning Equity Investment Companies (Unternehmensbeteiligungsgesetz, UBGG) and Venture Capital Companies (Wagniskapitalbeteiligungsgesellschaften) under the 2008 implemented Act for the Promotion of Venture Capital Participations (Gesetz zur Frderung von Wagniskapitalbeteiligungen, WKBG). While the UBGG, which has been used by approximately 80 mostly small and local or regional PEFs, provides the 16 German States and therein their State Ministries for Economics to exercise the monitoring activities, the WKBG delegates this to the Federal Financial Supervisory Authority (BaFin). Most PEFs placing interests in Germany are not subject to a specific regulatory regime for private equity funds or other alternative investment vehicles, but rather have to comply with various requirements in different German laws and regulations which may or may not specifically regulate the alternative investment segment of the German capital markets, but are of general application. Such requirements include in particular, but without limitation, the provisions of the German Banking Act (Kreditwesengesetz), special provisions of the German Sales Prospectus Act (Verkaufsprospektgesetz) or the requirements of the German administrative pronouncements on the taxation of venture capital and private equity funds as of December 16, 2003 (the PE Pronouncement) in order to provide full transparency of PEFs for German tax purposes. Generally, German PEFs structured as limited partnerships seek to comply with the criteria for non-commercial treatment as set out in the PE Pronouncement in order to avoid the respective PEF to be engaged in a trade or business for German tax purposes. The consequence otherwise would be that all non-German limited partners were subject to German taxation. Since most limited partners are US or UK pension funds which are exempt from tax they will not invest in a non-transparent fund at all. Most PEFs offering rights of participation in Germany operate without a license. Such PEFs generally do not qualify as an investment institution within the meaning of the InvG because of the active involvement in their portfolio companies. However, an offer in Germany of rights of participation in a PEF requires a prospectus being made available that is compliant either (i) with the Sales Prospectus Law (Verkaufsprospektgesetz VerkProspG) if the participations do not qualify as securities, but are marketed in a public offering and the minimum capital commitment is less than EUR 200,000, or (ii) with the Securities Prospectus Law (Wertpapierprospektgesetz WpPG) if the participations qualify as securities and are marketed in a public offering. Because unregulated German PEFs are generally structured as closed-end limited partnerships participations in an unregulated German PEF do generally not qualify as securities; as a consequence, an offer in Germany of rights of participation in an unregulated German PEF requires a prospectus only if the requirements are pursuant to the VerkProspG. Participations in non-German PEFs may, however, qualify as securities. PEFs are typically closed-end funds and must therefore generally comply with the Prospectus Directive (Directive 2003/71/EC) as implemented in the WpPG if the participations therein qualify as securities. There are several exceptions and exemptions in relation to the prospectus requirement pursuant to the WpPG. The exceptions and exemptions to the WpPG licensing requirement as listed above, will equally avail a PEF to be exempt from the WpPG prospectus requirement. Open-end PEFs must in addition to the prospectus prepare a WpPG compliant simplified prospectus.
141
PEFs must generally comply with the Act on the Prevention of Money Laundering (Geldwschegesetz GeldWG) implementing the Third Anti Money Laundering Directive (see paragraph 4.2.2.6. for more details). The principal corporate legislation of PEFs that take the form of a German corporate legal entity is the German Law on Limited Liability Companies (GmbH Gesetz GmbHG) or the German Stock Corporation Law Act (Aktiengesetz AktG). For PEFs that take the form of a (limited) partnership legislation is provided in the German Code of Commerce (Handelsgesetzbuch or HGB). Solvency issues are governed by the German Insolvency Act (Insolvenzordnung). 4.2.1. Capital requirements 4.2.1.1. At the level of management companies (operational risk) German Law requires a management company in the form an AG (Aktiengesellschaft) or a GmbH (Limited Liability Company) to maintain a minimum amount of capital of EUR 50,000 and EUR 25,000, respectively. The amount of capital paid in of an AG or a GmbH is publicly recorded in the trade register of the Local Court at the registered seat of such company. There are no minimum capital requirements for management companies that take the form of a (limited) partnership. The contributed capital paid in of a German partnership as far as it refers to the partnership capital at risk (Hafteinlage) is publicly recorded in the trade register of the Local Court at the registered seat of such partnership (see also paragraph 4.2.4.1). To the extent a PEF is regulated by the UBGG, the UBGG requires such an Equity Investment Company to have a minimum capital of at least EUR 1,000,000. Likewise, if the PEF chooses to be regulated as a Venture Capital Company the WKGB requires such a Venture Capital Company to have a minimum capital of at least EUR 1,000,000, too. 4.2.1.2. At the level of the PEF investment vehicle (exposure risk) For PEFs in the form of an AG, GmbH or partnership, see corporate capital requirements (if any) above. 4.2.2. Regulatory disclosure and related monitoring 4.2.2.1. Overview financial accounting Annual accounting PEFs that take the form of an AG or GmbH or otherwise have legal personality fall within the scope of German financial accounting rules contained in the German Commercial Code (Secs. 264 pp. HBG) that implements in particular the fourth (78/660/EC) and seventh (83/349/EC) Company Directive and the Transparency Directive. These rules generally contain an obligation to prepare on an annual basis in accordance with German generally accepted accounting principles (GAAP): Annual report The annual accounts containing singular accounts, i.e. a balance sheet, profit and loss account and explanatory notes thereto, and (if any) the consolidated accounts. The annual accounts generally require to be audited. Exemptions from the auditing requirement exist depending on the size of the corporation and therefore the PEF. PEFs in the form of a (limited) partnership are under the obligation to keep accounts pursuant to Sec. 264a HGB. However, this accounting requirement is in certain aspects less extensive than the requirements for corporations.
142
Part I
The annual accounts must be prepared and signed by all members of the PEFs statutory board of managing directors and must generally be made available if the PEF is a GmbH for inspection and adoption by the general meeting of its shareholders within six (6) months following the PEFs financial year. The annual accounts must generally be deposited for public inspection at the trade register with the Local Courts. 4.2.2.2. Mandatory disclosure and explanation of investment strategies and risks to investors (sophisticated and retail) Although no general specific regulation for PEFs exists, however, there is regulation for certain Venture Capital Companies which will be regulated under the new Act on the Promotion of Venture Capital Participations. The same applies to Equity Investment Companies under the Act concerning Equity Investment Companies (UBGG). Venture Capital Companies shall be subject to the supervision of the BaFin, which has the competence inter alia to request information and submission of documents to carry out investigations. Venture Capital Companies are obliged to immediately notify BaFin on: each change of their articles of association; the intention to appoint a new manager (including information on his/her reliability and qualification for the position); the resignation of a manager; and the termination of the funds activities.
Furthermore, Venture Capital Companies are obliged to prepare annual accounts and financial reports, which need to be audited and disclosed. Equity Investment Companies are subject to the supervision of the relevant Supreme State Authority (Oberste Landesbehrde), which has the competence inter alia to request information and submission of documentation as well as to carry out investigations. Equity Investment Companies are obliged to immediately (i) notify the relevant Supreme State Authority on each change of their articles of association and (ii) disclose their audited annual accounts to the relevant Supreme State Authority. For listed fund vehicles and open-end investment funds the general reporting and disclosure obligations under the German Stock Corporation Act and/or the InvG would apply. It should be noted that there are very specific requirements for open-end investment funds. As PEFs are almost never set up as regulated investment funds in Germany, there are no such formal requirements. The German PE industry follows the EVCA reporting guidelines that are widely implemented through contractual requirements between the fund manager and their investors.
143
4.2.2.3.
Disclosure and explanation of investment strategies and risks to regulators The current German laws do not provide for any PE-specific disclosure and monitoring or information and consultation of workers of portfolio companies obligations of PEFs other than those which apply in general to all shareholders in German corporations.
4.2.2.4.
Register and identify shareholders PEFs in the form of an AG or GmbH with registered (book entry) shares are due to maintain a share register in which the name, contact details and other data (e.g. number of shares owned) of the shareholders are recorded. For PEFs in the form of a (limited) partnership no such requirement exists although in practice a record of such information will generally be kept. Furthermore in a limited partnership every limited partner is by name and the amount of the interest held by him registered in the trade register of the Local Court at the registered seat of the partnership.
4.2.2.5.
Management and disclosure of conflicts of interest German Law contains a general conflict of interest provision that is relevant for PEFs in the form of an AG as well. This provision entails that in case of any transaction between an AG and its managing directors the company must generally be represented by such companys supervisory board. Overall, the German Civil Code prohibits any kind of self dealing and it is left in accordance with German corporate laws to the shareholders assemblies to decide whether they authorise individual members of the management board to act not only on behalf of the company but at the same time and within the same transaction on their own behalf and/or on behalf of a third party including related companies. There are no specific conflict of interest rules applying to PEFs. However, the general corporate rules covering the legal entities used for the PEF, e.g. a limitation of voting rights etc. would apply to PEFs set up as such entity as well.
4.2.2.6.
Prevention of money laundering The revised Act on the Prevention of Money Laundering (GeldwG) entered into force on 1 August 2008 to implement Directive 2005/60/EEC (Third Money Laundering Directive). The GeldwG applies, amongst others, to PEFs. The GeldwG envisions providing a framework that is more risk based than principle based. This means that a PEF is required to attain the object of the law, namely, combating of money laundering and the preventing of financing of terrorism, but they are allowed a certain amount of discretion as to the manner in which they structure their policy in order to achieve the envisioned result. PEFs may adjust the degree of investigation according to the type of client, relationship or transaction. The GeldwG provides PEFs with greater opportunities to harmonise their identification policy on the concrete risks of getting involved in money laundering within the PEFs.
144
Part I
4.2.3. Information and consultation of employees The current German laws do not provide for any PE-specific disclosure and monitoring or information and consultation of workers of portfolio companies obligations of PEFs other than those which apply in general to all shareholders in German corporations. 4.2.3.1. Information and consultation of employees whenever the control of the undertaking or business is transferred The provisions under the German takeover legislation for listed companies oblige such companies to inform their employees in the event of a company takeover. No such duty to inform existed for non-listed companies so far. Within the scope of amendments to secs. 106 para. 2 sentence 2 and 109a of the Employees Representation Act (Betriebsverfassungsgesetz, BetrVG), in the event of a change of control, an unlisted companys economic committee (Wirtschaftsausschuss) or, if one does not exist, its works council (Betriebsrat), is to be informed in the same manner as required for listed companies. Control over a company is acquired if at least 30% of the voting rights in the company are held. In this case, the management must inform the employees, in particular about the potential purchaser and its intentions as to the future business activity of the company and the consequences thereof for the employees. In the event of a bidding process prior to the takeover of the company, the economic committee or the works council shall be informed about the potential purchasers and their intentions regarding the future of the company and the consequences thereof for the employees. The duty to inform applies, however, only to the extent that the companys business and trade secrets are not endangered. 4.2.3.2. Disclosure and explanation of investment strategies and risks to investee companies As a principle trade unions and the works council determine what information they need to be able to fulfil their consultative role or to render a proper advice. There is no separate legal obligation to discuss investment strategies with the employees of investee companies. In practice it is often a matter of negotiations what information is shared. 4.2.4. Asset stripping and capital depletion 4.2.4.1. Prevention of asset stripping through common rules on capital maintenance The managing directors of a German GmbH or the members of the executive board of a German AG or SE (socit europenne) are under fiduciary duties towards the company they manage. A violation of these duties resulting into damages for the company may trigger damage claims against the managing directors and might in certain cases lead in addition to criminal proceedings. It should be noted that the degree of the fiduciary duties depends on the relevant legal set up. Whereas a managing director of a GmbH needs to comply with the instructions of its shareholders (unless such instructions violate the laws or threaten the existence of the company) a director of an AG acts independently of the AGs shareholders basing his decisions solely on the best interest of the company.
145
The transfer of assets from a corporate entity to a shareholder or related party below its fair market value would be viewed as a hidden profit distribution, which would have adverse effects both on the company and the respective shareholders. In practise, this should prevent asset stripping below market value to a wide extent. It is best practise in Germany to cover hidden profit distributions within the articles of association, so that the standard articles of association prevent asset stripping and declare it a violation of the corporate rules if nevertheless conducted by the management upon request by one of its shareholders. Although no specific regulatory provisions concerning asset stripping or capital depletion solely for private equity exist in Germany, the capital maintenance rules set up under the GmbHG and the AktG make it very difficult to deplete capital in Germany. AGs, GmbHs and/or regulated PEFs are bound by the minimum amounts of capital according to the respective German corporate laws. In addition, German Law requires resolutions of management of an AG being approved by the general meeting when these relate to an important change in the identity or character of a company or the undertaking (e.g. a portfolio company), including in any case: (i) a transfer of the undertaking or virtually the entire undertaking to a third party; (ii) the entry into or termination of a long-term cooperation of the company or a subsidiary with another legal person or partnership or as a fully liable partner in a limited partnership or general partnership, if such cooperation or termination is of a far-reaching significance for the company or leads to the profit sharing and/or the management of the company by such third party. Members of a management board of an AG or GmbH may face personal liability for asset stripping to the extent it qualifies as improper performance of their duties and serious culpability of such members. In particular management supervision of an AG or GmbH (board of supervisory directors) must consider the interests of all stakeholders (such to include employees). Under the German Insolvency Law Act, when a company enters into a transaction at an undervalue i.e., makes a gift or otherwise enters into a transaction on terms that the company receives no consideration or enters into a transaction for a consideration the value of which, in money or moneys worth, is significantly less than the value, in money or moneys worth, of the consideration provided by the company, the court may make such order as it believes might fit for restoring the position to what it would have been in if the company had not entered into that transaction (if the company enters into insolvency within a certain period). Also, pursuant to said Act, a company gives a preference to a person if that person is one of the companys creditors or a surety or guarantor for any of the companys debts or other liabilities or the company does anything (or suffers anything to be done) which has the effect of putting that person into a position which, in the event of the company going into insolvent liquidation, will be better than the position he would have been in if that thing had not been done. The court can set aside such a preference (if the company enters into insolvency within a certain period).
146
Part I
4.2.5. Limits on leverage (that are sustainable both for the private equity fund/firm and the target company) Other than economic restrictions indirectly resulting from the new tax regime implemented with the Tax Reform Act 2008 (such as e.g. restricted deductibility of interest payments Zinsschranke), there are no limits to the investments of PEF assets. There are in particular no direct risk diversification requirements at the level of the PEF. Please note that there are regulated asset pools like Real Estate Investment Trusts (REITs) available under German law which would be subject to the principles of risk diversification. However, PEFs are generally not eligible to be set up using such structures. However, as a general principle of law, management (and management supervision) of German portfolio companies when obtaining funds from PEFs should at all times consider the interests of all stakeholders (such to include employees) when obtaining funds from PEFs and to act as prudent businessmen. According to the German case law, directors have to take the standard of improper performance of duties into account while leveraging their companies (see paragraph 4.2.4). A companys director is responsible for losses a third party suffers due to obligations being left unpaid, if such director, on taking up the obligation (in view of the facts and circumstances) knew or ought to have known that the company was unable to perform its financial obligations. 4.2.5.1. Transparency of the compensation structure (to investors and authorities) In respect of PEFs (or PEF portfolio companies) in the form of an AG or GmbH, the remuneration of managers or of the management company (to the extent constituting the statutory board of management (Geschftsfhrung) is set by the general meeting of shareholders, or the supervisory board (if instituted). No such rule exists for a German partnership. However, in practice no investor will adhere as a partner to a partnership without prior approving the management remuneration principles. According to the German Corporate Governance Code, large publicly listed companies must include in the notes to their annual accounts: Remunerations and other payments to (former) members of the management and of the supervisory board. Statement of options for managers, supervisory board members and employees. For certain AGs, loans, advance payments, and guarantees to their managers must also be included in the notes to their annual accounts. Small and medium-sized companies are not required to disclose such information. Detailed remuneration transparency provisions apply for listed companies pursuant to the German Corporate Governance Code. Under the Code, the supervisory board has to ensure that the right balance is struck between (a) the fixed and variable components of the remuneration and (b) short and longer term remuneration. Ultimately, remuneration policy must serve the interests of the company and its affiliated enterprise; in other words, be aimed at creating long-term value.
147
The Corporate Governance Code comprises of the following principles with respect to remuneration: The level and structure of the remuneration which the management board members receive from the company for their work shall be such that qualified and expert managers can be recruited and retained. When the overall remuneration is fixed, its impact on pay differentials within the enterprise shall be taken into account. If the remuneration consists of a fixed component and a variable component, the variable component shall be linked to predetermined, assessable and influenceable targets, and shall include on-time and annually payable components linked to the business performance as well as long-term incentives containing risk elements. Both components of the remuneration must be appropriate, both individually and in total. The remuneration structure, including severance pay, shall be simple and transparent. It shall promote the interests of the company in the medium and long term, may not encourage management board members to act in their own interests or take risks that are not in line with the adopted strategy, and may not reward failing board members upon termination of their employment. The supervisory board is responsible for this. The level and structure of remuneration shall be determined by reference to, among other things, the results, the share price performance as well as the personal performance, the performance of the management board, the economic situation, the performance and outlook of the company taking into account its peer companies. The shares held by a management board member in the company on whose board he sits are long-term investments. The amount of compensation which a management board member may receive on termination of his employment may not exceed two annual salaries, plus may not exceed the remuneration for the remaining term of the employment contract. The supervisory board shall determine the remuneration of the individual members of the management board, on a proposal by the remuneration committee. The report of the supervisory board shall include the principal points of the remuneration report concerning the remuneration policy of the company. This shall describe transparently and in clear and understandable terms the remuneration policy that has been pursued and give an overview of the remuneration policy to be pursued. The full remuneration of the individual management board members, broken down into its various components, shall be presented in the remuneration report in clear and understandable terms. 4.2.5.2. Transparency of managers remuneration systems Although no specific laws exist or apply for PEFs, see paragraph 4.2.5.1 above. Furthermore, the annual shareholders meeting (SM) of a German stock corporation (AG) does not resolve about the remuneration of the Executive board members (Vorstand). The SM however resolves about the remuneration for the non-executive members/supervisory board members (Aufsichtsrat). In the SM shareholders may under certain circumstances inquire about the remuneration of the managers. The issue of stock options for members of the Executive board (Vorstand) requires a vote of the SM. In a limited liability company (GmbH) the SM by law has the right to decide about remuneration issues unless the shareholders have delegated such issues to a voluntary established Advisory or Supervisory Board (Beirat).
148
Part I
4.3.
The contractual agreements of PEFs which set the rights and obligation of the fund and its manager are the Limited Partnership Agreement (LPA) of the fund and the by-laws of the manager of the fund. The LPA sets all rules valid between the investors on the one side and the PE fund and the PE fund managers on the other side. The by-laws of the manager of the PEF include all rules which the PE fund manager sets for itself. 4.3.1. Capital requirements 4.3.1.1. At the level of management companies (operational risk) On the level of the PE fund manager there is typically not any additional capital requirement. 4.3.1.2. At the level of the funds - investment vehicle (exposure risk) Typically PEFs are fully funded by either partnership capital or equity capital. The LPA defines the total amount to be paid into the PEF from investors. A certain minimum amount to be paid in is usually not defined in German LPAs. As German limited partnerships are the typical legal form of private equity funds, the LPA differs between the so-called liability contribution which is to be registered with the German trade register (Hafteinlage) and the additional contribution (sonstige Einlage) which the investors are obliged to pay in based on capital calls from the fund manager. The liability contribution is typically a small amount as more of a token amount (such as EUR 100 per investor). As PEFs are typically not leveraged on a fund level, the equity/debt ratio of private equity funds in Germany is typically 100/0. Only in certain rare situations is the fund manager allowed to draw down on a loan, such specific situations may be to bridge the time between capital call from investors and due date of such capital call. 4.3.2. Contractual disclosure and monitoring 4.3.2.1. Contractual disclosure and explanation of investment strategies and risks to investors Here the Limited Partnership Agreement (LPA; see also sections of the submission on contractual agreements and industry professional standards) typically provides an extensive framework with a lot of detailed content on what the PE funds disclosure towards investors is. Disclosure from the PEF towards investors is typically based on the EVCA reporting standards which are often mentioned as a basis and obligation for the PE fund manager within the LPA. This includes full disclosure of the PE funds investment strategy, both to retail as well as to sophisticated investors. As the LPA is not a document towards any regulating body, it is silent about the disclosure of the investment strategy to any regulatory body. In addition to the LPA, the prospectus of the PE fund, written when the fund is marketed to investors, also contains a detailed disclosure and explanation of investment strategy and risks to investors. In terms of risk management, the LPA typically foresees certain criteria to be met for risk diversification: e.g. maximum investment percentage for investments into a single company, into certain regional areas, or depending on the fund strategy into certain industry segments.
149
4.3.2.2.
Contractual clauses covering lock-up periods, cancellation and termination Generally PE funds are closed funds with a defined lifetime and investors have no ability to require repayment of their investment during the life of the PE fund. Consequently, lock-up periods and conditions governing cancellation and termination are not relevant to most PE funds. The fact that investors have no ability to redeem and will only receive a return on their investment in the PE fund as and when the funds underlying investments are realised is disclosed to the investors in the offering materials as well as the LPA. Typically, the LPA of PE funds foresees termination of the management contract in the event of an investor vote (no fault divorce) and in case of fraud or gross negligence. These provisions are extensively negotiated between investors and PE fund manager and vary from fund to fund. They also typically include rights for the investors to suspend the funds ability to make investments if the management team is subject to significant changes or if there is a change of control.
4.3.2.3.
Register and identify shareholders Ownership structure of the PE fund is typically disclosed towards investors but this varies from fund to fund. Especially with institutional investors the name of each investor is disclosed towards all other investors. In terms of general register and disclosure to the public, the legal name of the investors is typically registered with the German trade register in case of typical limited partnership structures (see Sec 1 above).
4.3.3. Information and consultation of employees The LPA typically is silent about any information and consultation both towards the employees of the PE fund as well as towards employees/workers within the portfolio companies. 4.3.4. Asset stripping and capital depletion The LPA is also typically silent on rules to avoid certain measures taken by the fund manager with respect to its portfolio companies such as asset stripping and/or capital depletion. 4.3.5. Limits on leverage (that are sustainable for the private equity fund/firm and the target company) Typically PE funds do not use any leverage at the level of the fund itself. For investment in their portfolio companies, the LPA typically does not define a limit on a certain leverage maximum that the PE fund shall not exceed. For Venture Capital funds investments in portfolio companies are typically not leveraged at all. 4.3.6. Compensation structure The compensation structure from the PE fund towards its managers is in nearly all cases governed by the LPA. Compensation structures typically include an annual management fee and a profit share, so-called Carried Interest, which is depending on the final success of the PE fund. Management fee is paid on an annual basis to cover the ongoing cost of the fund managers. Carried interest is the share of the PE fund manager in the final profit of the PE Fund and is in most cases set at 20% of profits following the investors having received back their invested and committed capital as well as a certain defined minimum interest on their invested capital (somewhere between 4%-8% p.a., so-called hurdle rate).
150
Part I
4.4.
The German Private Equity Association (BVK) has followed in the past very closely the concept of self regulation as set by the EVCA and implemented the EVCA Reporting Guidelines, the International Private Equity and Venture Capital Valuation Guidelines, the EVCA Governing Principles and the EVCA Corporate Governance Guidelines as binding or recommended for all BVK members. In addition, a Code of Conduct has also been approved which is basically the German version of the EVCA Code of Conduct with minimal changes. Finally, Germany as one of the first countries in Europe developed its own Transparency and Disclosure Guidelines for large Buyout transactions and Funds in October 2008. 4.4.1. Capital requirements There are no additional rules mentioned in any professional standard. 4.4.2. Industry imposed disclosure and related monitoring The German Code of Conduct requires the disclosure of the development of the investment portfolio and its fair value towards the investors (principle 4). In addition, the EVCA Reporting Guidelines as well as the International Private Equity and Valuation Guidelines define the minimum standards of such disclosure and require a whole package of detailed information to be disclosed towards investors. This is in general also required according to the EVCA Governing Principles, principle 7 Transparency. These principles and requirements relate all to the relationship between PE fund manager and investors. The Transparency and Disclosure Guidelines for large Buyout transactions and Funds recommend disclosure not only to investors but also to the general public. It recommends the disclosure of a controlling PE firms name as part of the annual financial reporting of a portfolio company including which board members are affiliated with such PE firm. It also recommends PE firms to disclose on their website details about the portfolio companies where the PE firm has invested, more general information about the PE firm, its history, investment principles and strategy, and basis information about the investors of the PE funds managed by the PE firm. 4.4.2.1. Portfolio companies The German Code of Conduct requires the disclosure of the development of the portfolio companies and its fair value towards the investors (principle 4). In addition, the EVCA Reporting Guidelines as well as the International Private Equity and Venture Capital Valuation Guidelines require a broad set of information to be disclosed towards investors regarding information about the individual portfolio companies. This is in general also required according to the EVCA Governing Principles, principle 7 Transparency. These principles and disclosure requirements relate all to the relationship between PEF manager and investors, i.e. not towards the general public. The Transparency and Disclosure Guidelines for large Buyout transactions and Funds recommend disclosure not only to investors but also to the general public. It recommends the disclosure of a controlling PE firms name as part of the annual financial reporting of a portfolio company including which board members are affiliated with such PE firm. It also recommends to PE firms to disclose on their website details about the portfolio companies where the PE firm has invested.
151
4.4.2.2.
Private equity firms Again, a detailed set of disclosure requirements is implemented in the various named standards, all applicable between the PEF and its investors. The Transparency and Disclosure Guidelines for large Buyout transactions and Funds recommend in addition to disclose to the general public more general information about the PEF, its history, investment principles and strategy, and basic information about the investors of the PEFs managed by the PE firm.
4.4.2.3.
Enforcement & monitoring In the event a member does not follow the rules and breaches any of the above mentioned standards, this member will first be asked by the BVK to comply with the guidelines. In the case of a breach of the German Code of Conduct, such member may be finally expelled from the BVK. All other guidelines are on a recommendation basis only.
4.4.2.4.
Coverage of relevant entities The recommendations on transparency apply to all members of the BVK, independent from Venture Capital or Private Equity investments and also independent from majority or minority investments in portfolio companies. The Transparency and Disclosure Guidelines for large Buyout transactions only applies to PEF which are members of BVKs Large Buyout group.
4.4.3. Information and consultation of employees The EVCA Corporate Governance Guidelines as adopted by the BVK require the respect for the interest of all stakeholders including the employees of companies where PE firms invest (principle 3.5). In addition, it recommends to act openly, honestly and with integrity, balancing the interests of the company, the needs of effective decision making and the needs of other stakeholders including employees (principle 4.5). In addition, the Transparency and Disclosure Guidelines for large Buyout transactions and Funds recommend a timely and effective communication with employees, ensuring that the employees are being informed in particular about material strategic decisions or about material transactions to the extent that this is possible for reasons of confidentiality. 4.4.4. Asset stripping and capital depletion There are no additional rules specifically for the prevention of asset stripping and capital depletion other than the overall general principles included in the EVCA Governing Principles, EVCA Corporate Governance Guidelines and as part of the German Code of Conduct. 4.4.5. Limits on leverage (that are sustainable for the private equity fund/firm and for the target company) There are no additional rules specifically on any limits on leverage other than the overall general principles included in the EVCA Governing Principles, EVCA Corporate Governance Guidelines and as part of the German Code of Conduct.
152
Part I
4.4.6. Compensation structure 4.4.6.1. Transparency of compensation structure The EVCA Corporate Governance Principles require that the board is responsible for setting the remuneration of key executives and senior management of portfolio companies (principle 5.4). The EVCA reporting guidelines require the full disclosure and transparency of the compensation between a PE fund and its fund manager (Section F) towards its investors.
153
5.
5.1.
Italy
Introduction
The typical domestic structure for investing in private equity in Italy is the management company/closed-end investment fund reserved to qualified investors or hedge fund (SGR/fondo chiuso riservato/fondo speculativo), although in principle other vehicles may be used, which are regulated by the Bank of Italy (and for some aspects by the National Commission for Companies and the Stock Exchange Market, or Consob Commissione Nazionale per le Societ et la Borsa). The national industry body is AIFI (Associazione Italiana del Private Equity e Venture Capital) that at the moment has 129 full members, of which 37 are also members of EVCA.
5.2.
Governed by law/regulation
Legislation introducing Italian closed-end funds was enacted with Law No. 344 of August 14, 1993. All the provisions of Law No. 344/1993 as well as those regulating civil law aspects of investment funds have been repealed and replaced by Legislative Decree No. 58 of February 24, 1998 (the Consolidated Act on Financial Brokerage Activities; Testo Unico delle disposizioni in materia di intermediazione finanziaria). In particular, the current main implementing provisions are the following: Decree of the Ministry of Treasury No. 228 of May 24, 1999 (regulations on the general criteria that investment funds must comply with); Decree of the Ministry of Treasury No. 468 of November 11, 1998, (regulations on the experience and integrity requirements for directors, members of the board of auditors and general managers of Italian SGRs, asset management companies and Societ di Intermediazione a Capitale Variabile, SICAVs); Decree of the Ministry of Treasury No. 469 of November 11, 1998, (regulations on the integrity requirements for shareholders of Italian SGRs, asset management companies and SICAVs); Regulations of the Bank of Italy of April 14, 2005 (concerning the collective portfolio management, which has replaced, inter alia, the Regulations of the Bank of Italy dated 1 July 1998, 20 September 1999 and 24 December 1999); Regulation adopted jointly by the Bank of Italy and Consob on October 29, 2007 (concerning the organisation of the intermediaries); Regulations of the National Commission for Companies and the Stock Exchange Market (Consob) No. 16190 of October 29, 2007 as amended from time to time (concerning the intermediaries, which has replaced the Regulation of Consob No. 11522/1998); Regulations of Consob No. 11971 of May 14, 1999, as amended from time to time (concerning the issuer of securities). Under Italian law, an investment fund represents an independent pool of assets which is divided into units held by a plurality of investors and managed by a regulated manager. In particular, a closed-end fund is a mutual fund in which the right to redeem the units may be exercised by the investors only at predetermined dates.
154
Part I
Italian funds are managed by Italian management companies (SGR) that must be authorised by the Bank of Italy (that releases the authorisation after a consultation with Consob) and registered in a special register (kept by the Bank of Italy) and the funds are regulated by fund rules (Regolamento) that have to be approved by the Bank of Italy too. Consequently, the instrument that is used for private equity and venture capital in Italy is under the control of the Bank of Italy. Therefore, the Italian funds are mainly regulated by law and by regulation issued by the Bank of Italy and by Consob. The Regolamento regulates, inter alia, the following aspects: The name of the fund; The duration of the fund; The purposes of the fund; The features of the fund (e.g. the business purposes, the investment policy); The bodies responsible for the selection of investments and the criteria for the apportionment of investments; The manner of participating in the fund, the time limits and procedures for the issuance and cancellation of certificates and for the subscription and redemption of units, as well as the procedures for the liquidation of the fund. As the fund must derive from one or more issuances of units of equal value, (that must be subscribed within 18 months from the date of the publication of the prospectus or, if the units are not offered to the public, from the date the Regolamento has been approved by the Bank of Italy), the Regolamento also provides rules governing the modalities for the issuance of units at different moments. The new units can be issued only once the commitments undertaken in relation to the previous issuances have been fully drawn down; The minimum subscription size; Indications concerning the certificates. Units will be represented either by registered or bearer certificates depending on the investors preference. The certificates will comply with Italian law and will have the signature of a director of the SGR and of an officer of the custodian bank. The SGR may issue cumulative certificates that represent multiple units. An investor may, at any time, request the issuance of single certificates; A description of the different classes of units (if any) and of the relating rights; Details of the expenses to be borne by the fund or by the SGR; The amount of (or the method for determining) the fees due to the SGR and the charges to be borne by the investors; The method for determining the funds operating income and profits and, where appropriate, the manner in which the latter are allocated and distributed. The typical components of closed-end funds are the following: (a) the SGR; (b) the assets of the fund; (c) the investors; (d) the custodian bank (banca depositaria)(85).
(85)
According to article 38 of the Legislative Decree of February 24, 1998 No. 58, the depositary bank in performing its functions, shall: (a) verify the legitimacy of the operations of issuing and redeeming units and the application of fund income; (b) verify the correctness of the calculation of the value of the funds units or, if appointed to do so by the SGR, make the calculation itself; (c) verify that in transactions involving a funds assets any consideration is remitted to it within the customary time limits; (d) carry out the instructions of the SGR unless they conflict with the law, the Regolamento or the prescriptions of the supervisory authorities. The depositary bank shall be liable to the SGR and investors for any loss suffered by them as a result of its failure to perform its obligations. The directors and members of the board of auditors of the depositary bank shall promptly inform the Bank of Italy and Consob, within the scope of their respective authority, of irregularities they discover in the management of the SGR and in the management of investment funds.
155
5.2.1. Capital requirements 5.2.1.1. At the level of management company The capital requirements of an Italian management company are provided by article 34 of the Legislative Decree of February 24, 1998, No. 58 as enacted by the Regulation of the Bank of Italy issued on 14 April 2005. According to the mentioned rules, the paid-up capital is at least EUR 1,000,000. SGRs with a lower share capital may be allowed under certain circumstances (86). Furthermore, particular rules are provided by the Regulation of the Bank of Italy of April 14, 2005 with regard to minimum assets of the SGR (Patrimonio di vigilanza) and the duties of the SGR to observe such minimum requirements. 5.2.1.2. At the level of the funds investment vehicle Investment funds shall be set up in conformity with the limits and criteria provided by the Bank of Italy in the Regulations of April 14, 2005. Under the principal rules applicable to closed-end funds: the fund cannot invest more than 20% of its net asset value in unlisted financial instruments issued by the same entity; the management company cannot hold, through the funds it manages, more than 10% of the voting rights of a listed company; the fund can borrow money within the limit of 10% of its net asset value; the fund can give its assets as guarantees to cover financings only where the guarantees are instrumental to or connected with the performance of the fund; the fund can give financings that are instrumental to or connected with the acquisition of participations in target companies. The amount of money lent is compounded in the calculation of the above mentioned limit of 20%. 5.2.2. Regulatory disclosure and related monitoring 5.2.2.1. Overview Italian Law imposes reporting requirements for the SGR, the fund and the portfolio company as shown below. The legal form that the Italian management companies must adopt is that of a societ per azioni (i.e. a company limited by shares or S.p.A.). According to article 2435 of the Italian Civil Code, within 30 days from the approval, a copy of the annual accounts, accompanied with the reports referred to in article 2428 and 2429 and by the minutes of approval of the members meeting or the supervisory board, shall be filed under the responsibility of the directors with the office of the register of enterprises or sent by mail by registered letter return receipt prepaid. The accounts must be communicated to the Bank of Italy.
(86)
SGRs with a lower minimum capital are allowed if (i) the SGR carries out exclusively the promotion and/or the management of closed-end funds, (ii) the majority of its capital has to be held by universities, research centres, university and bank foundations, public territorial authorities, university consortium participated by universities and chambers of commerce and (iii) the maximum initial commitment of the fund is not higher than EUR 25 million. Moreover, the funds have to be closed-ended, reserved to qualified investors (with a minimum subscription amount of EUR 250,000) and must invest in start up companies or companies specialized in R&D or high tech focused.
156
Part I
With regard to the portfolio company, if the portfolio company is an S.p.A. (i.e. a company limited by shares) see above the provisions of article 2435 of the Italian Civil Code. Specifically S.p.A. with shares listed on a financial market must send a copy of the abovementioned documents to Consob. If the portfolio company is an Srl (i.e. a limited liability company), article 2478-bis of the Italian Civil Code provides that within 30 days of the decision of the members of approval of the accounts, a copy of the accounts approved and the list of the members and of the other holders of rights of corporate holdings must be deposited with the register of enterprises in accordance with Article 2435 (87). With regard to closed-end funds, according to article 2 of the Ministerial Decree No. 228/1999, in addition to the financial reports prescribed for commercial firms by the Civil Code, and using the same procedures, an Italian management company must: (a) keep a daybook of the fund in which the transactions concerning the management of the fund and the transactions in relation to the issue and redemption of fund units must be recorded; (b) prepare a statement of operations of the fund within 60 days of the end of each financial year or of the shorter period in relation to which earnings are distributed; (c) prepare a half-yearly report on the management of the fund within 30 days of the end of the half year. Such documents are filed with the Bank of Italy and are communicated to the investors and to the custodian bank. According to article 3 of the mentioned Ministerial Decree No. 228/1999, the documents referred to in letters b) and c) must be kept available for consultation by the public at the head office of the management company. Furthermore, such documents shall be made available to the public within 30 days of their preparation. The last statement of operations of the fund and the last half-yearly report must also be made available to the public at the head office of the custodian bank and in the branches of the latter specified in the fund rules. Investors also have the right to receive copies of these documents at home free of charge. The report on operations must specify the benchmark chosen by the fund for the purpose of comparing results. Funds reserved to qualified investors and Speculative Funds may adopt different forms of disclosure from those specified in the preceding paragraphs provided they are specified in the fund rules. The document under letters (b) and (c) must be sent to the Bank of Italy within the term indicated in the Regulation of 14 April 2005 (88). With regard to the criteria of evaluation of the assets of the fund the Italian fund must comply with the criteria set out by the Bank of Italy in the Regulation of April 14, 2005. 5.2.2.2. (Mandatory) Disclosure and explanation of investment strategies and risks to investors (sophisticated and retail) According to the definition of article 1, paragraph 1 of the Legislative Decree No. 58/1998, closedend fund means mutual fund in which the right to redeem units may be exercised by participants only at predetermined maturities.
(87) (88)
Italian Civil Code and Legislative Decree No. 58/1998. Article 37 of the Legislative Decree No. 58/1998 as enacted by the Ministerial Decree No. 228 of 24 May 1999.
157
According to article 37, paragraph 2-bis of the Legislative Decree No. 58/1998, the regulation referred to in paragraph 1(89) shall also identify the matters for which meetings of participants in closed-end funds shall be called to adopt resolutions that are binding on the SGR. Such meetings shall in any case be called to vote on the replacement of the SGR, admission to listing where this is not provided for and changes to the investment policy. Meetings shall be called by the board of directors of the SGR, inter alia at the request of participants representing at least 10% of the value of the units in circulation, and resolutions shall be adopted with the favourable vote of at least 50% plus one of the units represented in the meeting. In no case may the quorum be less than 30% of the value of all the units in circulation. The resolutions adopted by meetings shall be submitted to the Bank of Italy for its approval. They shall be deemed to be approved where four months elapse from their submission without the adoption of a measure rejecting them. According to the provision of the regulation No. 16190 issued by Consob on October 29, 2007 (that was issued in fulfilment of the provisions of the Legislative Decree No. 164/2007 that has enacted MiFID in Italy), the intermediaries shall provide investors or potential investors with a general description of the nature of risks involved with the financial instruments concerned, in particular taking into account the investors category as a retail or professional customer. The description shall illustrate the characteristics of the specific type of instrument involved, together with the risks related to such instruments, in sufficient detail to allow the customer to adopt informed investment decisions. Such information is usually given in specific documents as precontractual information. With regard to the public offer of units of funds, article 1, letter t) and article 94 of Legislative Decree No. 58/1998, provide, for those who want to make an investment incentive, the previous communication to Consob, with attached a specific document (prospetto informativo) filling the details of the products which are going to be offered. Nevertheless, as an exemption from the duty of the prospetto informativo, article 100 (as executed by article 33 of Consob regulation dated 14 May 1999 No. 11971, as amended time by time) of the already mentioned Legislative Decree No. 58/1998, expressly provides that the aforesaid formalities do not apply, inter alia, if the offers are addressed to no more than one hundred investors or to qualified investors only. 5.2.2.3. Disclosure and explanation of investment strategies and risks to regulators Considering that the duties briefly described under point 5.2.2.2 are provided by acts issued by the regulators (Bank of Italy and Consob), their violation implies an intervention of such Authorities. In this respect, specific limits to the investments of the funds are provided on a general basis in the prudential rules for limiting and spreading risk issued by the Bank of Italy on April 14, 2005. According to the provisions of the laws in force such limits may be derogated by the funds reserved to qualified investors or by fondi speculativi on the condition that the new different limits are provided in the Regolamento that as said must be submitted to the approval of the Bank of Italy.
(89)
The provision refers to a regulation of the Minister for the Economy and Finance.
158
Part I
Furthermore, the persons appointed for the control of the activity of the SGR (as the responsible for the internal audit, the responsible of the compliance, the risk manager) shall also oversee that the SGR does not exceed the limits provided by the Regolamento or by the regulations issued by the Bank of Italy. 5.2.2.4. Register and identify shareholders All the investors of the Fondo Chiuso are registered in the register of the Fondo Chiuso. 5.2.2.5. Management and disclosure of conflicts of interest In respect of the Italian funds that invest in financial instruments certain kinds of deals that give rise to formal conflicts of interests are forbidden by law. According to article 12, paragraph 3 of the Ministerial Decree No. 228 of May 24, 1999, funds may not invest in assets sold or contributed directly by a shareholder, director, general manager or member of the board of auditors of the management company or of a company belonging to the same group, nor may such assets be sold directly or indirectly to such persons. Neither may funds invest in financial instruments deriving from securitizations of receivables assigned by shareholders of the management company or other persons belonging to their group for an amount exceeding 3% of the value of the fund. Some other kind of conflict may be managed by the SGR on the condition that they are well described and disclosed to the investors, according to the provisions of the regulation of Consob No. 16190/2007. Rules concerning the conflict of interest are provided also by Regulation adopted jointly by the Bank of Italy and Consob on October 29, 2007. According to such provisions the SGR, inter alia, has to identify the relevant cases of conflict of interest and the way to manage them. It is consolidated that, as far as funds of private equity are concerned, the deals which may give rise to conflict of interest are submitted to the previous opinion of an advisory committee composed by representatives of the investors. Such committee and its rules of functioning are usually provided by the Regolamento. 5.2.2.6. Prevention of money laundering The SGRs have a specific duty of identification of the investors in order to comply with the provisions of Italian antimony laundering law (Legislative Decree No. 231/2007). The Fondo Chiuso (through the SGR) is registered in the shareholders book of the target company. 5.2.3. Information and consultation of workers 5.2.3.1. Informing and consulting workers during the transfer of control or undertakings or businesses The legislative Decree No. 25/2007, provides for companies with at least 50 employees a duty of consultation of the employees with regard to decisions of the company that imply, inter alia, relevant change in the organisation of the work and with regard to the performance of the company. The information and the consultation shall be carried out according to the provisions of the collective labour agreement. 5.2.3.2. Disclosure and explanation of investment strategies and risks to investee companies See above under point 5.2.3.1.
159
5.2.3.3.
Transfer of undertakings directive in relation to leverage buyouts Directive No. 2001/23/EC was enacted in Italy by the Legislative Decree 276/2003, that has amended article 2112 of the Italian Civil Code. The Italian Civil Code provides that in case of transfer of business, the labour relationship continues with the transferee and the employees retains all rights deriving from it (article 2112 of the Italian Civil Code). Specifically, the mentioned Article 2112 of the Italian Civil Code provides that In the case of transfer of business, the labour relationship continues with the transferee and the employee retains all rights deriving from it. For the purpose and the effect of this Article 2112 of the Civil Code, the transfer of business is intended to include any transaction which as a consequence of an assignment or merger, causes the change of title to an organized economic activity, with or without profit, for the purpose of the production or exchange of goods or services, pre-existing to the transfer and which maintains in the transfer its identity, irrespective of the agreement or the resolution pursuant to which the transfer of the business is perfected, including the usufruct or the lease of business. The provision of this Article are also applicable to the transfer of part of the business, intended as an autonomous part of an organized economic activity identified as such by the assignor and the assignee at the time of its transfer.
5.2.4. Asset stripping and capital depletion 5.2.4.1. Prevention of asset stripping through common rules on capital maintenance There are a number of provisions protecting against asset stripping and excess leveraging. According to article 2392 of the Italian Civil Code, the directors shall fulfil the duties imposed upon them by law and by the by-laws with the diligence required by the nature of the appointment and by their specific competences. They are liable in solido to the company for the damages deriving from the non-observance of such duties. Article 2501 bis provides specific requirements to carry out leveraged mergers of acquired target companies. Article 2358 restricts the practice of financial assistance (90). Sanctions are provided by articles form 2621 to 2641 of the Italian Civil Code. Inter alia the following situations are punished: fictitious formation of the capital; undue repayment of capital contributions; illegitimate division of corporate assets by the liquidators; unfaithfulness disposal of assets; agiotage; false corporate communications; etc.
Furthermore, according to article 2433, paragraph 3, if a loss in the companys capital occurs, no distribution of profits can be made until the capital is reinstated or reduced in a corresponding amount. According to article 2446 (Reduction of capital pursuant to losses), when it appears that the companys capital has diminished by more than one-third as a result of losses, the directors or the management committee, or in the event of their failure, the board of auditors or the supervisory board, shall call the meeting without delay to take appropriate action.
(90)
Italian Civil Code, Bankruptcy Law.
160
Part I
If the losses do not prove to have been reduced to less than one-third within the following fiscal year, the meeting or the supervisory board that approves the annual accounts of such period shall reduce the capital in proportion to the losses that have been ascertained. Failing this, the directors and auditors or supervisory board shall petition the tribunal to provide for a reduction of capital to the extent of the losses shown in the annual accounts. According to article 2447 of the Italian Civil Code (reduction of capital below legal minimum), if by reason of the loss over one-third of the capital falls below the minimum established by law the director or the management board and in case of their failure the super advisory board shall without delay call the meeting to decide on the reduction of the capital and the concurrent increase thereof to an amount not less than said minimum or on the reorganisation of the company. Further fulfilments are provided for companies with shares listed in regulated markets (91). 5.2.5. Limits on leverage (sustainable both for the private equity fund/firm and the target company) As far as Italian closed-end funds are concerned, the regulation of the Bank of Italy of April 14, 2005, provides that a closed-end fund can borrow money within the limit of 10% of its net asset value. As far as target companies are concerned, see under paragraph 5.2.4. 5.2.6. Compensation structure 5.2.6.1. Transparency of the compensation structure (to investors and authorities) The Regolamento (according to the provision of the regulation of the Bank of Italy of April 14, 2005) shall provide for the costs system of the fund. In this perspective it must provide which costs are borne by the funds (as the management fee), which are borne by the investors and which are borne by the SGR. The above mentioned regulation provides that all costs not specified as borne by the fund or the investors shall be borne by the SGR. Furthermore, the regulation of Consob No. 16190/2007 provides that intermediaries (including the SGR) shall provide retail customers and potential retail customers with information on the costs and charges involved in the provision of services (92).
(91) (92)
Articles 2433 paragraph 3, 2446 and 2447 of the Italian Civil Code and article 47 and following of the regulation No. 11971 issued by Consob on May 14, 1999 (regulation implementing the Legislative Decree No. 58/1998 concerning the issuers). Specifically according to article 32 of the Consob regulation No. 16190/2008, the intermediaries shall give the following information: provision of services, including the following elements where relevant: (a) the total amount payable by the customer for the financial instrument, investment service or accessory service, including all related fees, commissions, charges and expense, and all taxes to be paid through the intermediary or, if an exact total cannot be indicated, the basis on which said total shall be calculated in order that the customer may perform verification; (b) where any part of the total amount indicated under paragraph a) above must be paid or is expressed in foreign currency, an indication of said currency, with related taxes and exchange commission due; (c) an indication of the possibility that other charges to the customer may emerge, including tax, in relation to the financial instrument transactions or investment service, that shall not be payable through or imposed by the intermediary; (d) the payment methods.
161
Moreover, incentives may be received by the SGR at the conditions provided by law only (93). 5.2.6.2. Transparency of managers remuneration systems According to the Italian Civil Code (article 2389), the fees for the members of the board of directors are established (at the time of their appointment) by the shareholders meeting. The fees may be represented in whole or in part by participation in the profits or by the attribution of the right to subscribe at a predetermined price shares of future issue (i.e. by the attribution of stock option). The remuneration of directors vested with special appointments in compliance with the by-laws is decided by the board of directors, after having heard the board of auditors. If provided by the by-laws, the shareholders meeting may determine an aggregate compensation for the remuneration of all directors including those vested with special appointments. The above mentioned rules apply both to managers appointed as members of the boards of directors of target companies and to those appointed as members of the boards of directors of the SGR (that is an S.p.A. i.e. a limited liability company).
5.3.
Governed by contractual agreements between parties and related entities
5.3.1. Capital requirements 5.3.1.1. At the level of management companies There are no additional requirements, further to the legal rules referred to in part 1 above. 5.3.1.2. At the level of funds investment vehicle In case of funds reserved to qualified investors as well as in case of speculative funds (Fondi speculativi), the Regolamento may provide investment limits different from those established on a general basis in the prudential rules for limiting and spreading risk issued by the Bank of Italy (see the examples under paragraph 5.2.1.2). For example, with reference to this kind of funds, the Regolamento may provide that (i) the fund may acquire the majority of the share capital of the target company or (ii) the base of calculation of the aforesaid limits may be the total amount of the fund and not the value of its activities, (iii) the fund, under determined conditions, may invest in listed companies more than the above mentioned limit of 10% etc.
(93)
According to article 73 of the Consob regulation No. 16190/2007, in relation to the provision of collective asset management services, asset management companies and SICAVs may not pay or claim fees or commissions, or provide or receive non-monetary services, except: (a) fees, commissions or non-monetary services paid or provided to or from an investor or person acting on behalf of the investor; (b) fees, commissions or non-monetary services paid or provided to or from a third party or person acting on behalf of said third party, where the following conditions apply: (b 1) the existence, nature and amount of any fees, commissions or services or, where such amount cannot be ascertained, the calculation method for said amount are communicated clearly to the investor, in a full, accurate and understandable manner, prior to provision of the service; (b 2) payment of the fees or commissions or the provision of non-monetary services is required to increase the quality of the collective asset management service and must not impede any company obligation to serve the best interests of the UCITS; (c) adequate fees that make provision of the management service possible or are necessary for such purpose, e.g. depository costs, regulatory and exchange commissions, compulsory withdrawals or legal expense, and which, by nature, cannot enter into conflict with the companys duty to act in an honest, fair and professional manner in the best interests of the UCITS. 2. Pursuant to subsection 1b), asset management companies and SICAVs may communicate the essential terms of agreements concluded with regard to fees, commissions or non-monetary services in summary format, providing further details on request from the investor.
162
Part I
5.3.2. Contractual disclosure and related monitoring With regard to the criteria of evaluation of the assets of the fund, the Regolamento may provide that in addition to the criteria issued by the Bank of Italy (that are the official ones) the SGR may adopt (for the benefits of the investors) the criteria issued by EVCA. Such provision is usually included in the Regolamento of closed-end funds with foreign qualified investors. Furthermore, in addition to the report provided by law, if requested by the investors, the Regolamento may provide for non-audited (usually quarterly) progress reports, including a description of each portfolio company acquired by the fund, such other information concerning the financial instruments acquired, a statement of capital invested in relation to each investor, indication of realised capital gains and capital losses with regard to investments disposed (in the previous quarter), the distribution made by the fund to the investors in proportion to their units and any other information the SGR shall furnish. 5.3.2.1. Contractual disclosure and explanation of investment strategies and risks to investors (sophisticated and retail) As known private equity funds are typically closed-ended which means that investors have no ability to require repayment of their investment during the life of the fund. The fact that investors have no ability to redeem and will only receive a return on their investment in the fund as and when the funds underlying investments are realised will be clearly disclosed to investors in the Regolamento and in the precontractual information provided by Consob. The investment strategy and the risk of investment is described in the Regolamento (also in fulfilment to the regulations of the Bank of Italy of April 14, 2005). According to the provision of paragraph 5.2.2.2, the Regolamento of many funds allows for termination of the management contract in the event of an investor vote, or in case of fraud or gross negligence. These provisions are usually negotiated with investors and vary form fund to fund. They also typically include rights for the investors to suspend the funds ability to make investments if the management team is subject to extensive changes (so called suspension mode) or if there is a change of control. Investors typically have extensive downside protections which are heavily negotiated. 5.3.2.2. Contractual clauses covering lock-up periods, cancellation and termination The policy of investments must be described in the Regolamento according to the provisions of the Bank of Italy and however outlines of specific risks must be disclosed to the investors according to the regulation issued by Consob. 5.3.2.3. Register and identify shareholders Further to earlier remarks above, typically contractual documents do not extend these disclosure obligations. 5.3.3. Information and consultation of workers See section 5.2.3 above.
163
5.3.4. Limits on asset stripping and capital depletion On an LBO, the banking agreements may include covenants restricting dissemination in addition to the legal rules restricting this set out in section 5.2.4 (above). 5.3.5. Limits on leverage (that are sustainable both for the private equity fund/firm and the target company) As noted above for what concerns Italian closed-end funds, the regulation of the Bank of Italy of April 14, 2005, provides that the closed-end funds can borrow money within the limit of 10% of their net asset value. Nevertheless, in case of funds reserved to qualified investors or of fondi speculativi, the Regolamento may provide investment limits different from those established on a general basis in the prudential rules for limiting and spreading risk issued by the Bank of Italy (for example, with reference to this kind of funds, the Regolamento may provide that the base of calculation of the aforesaid limits may be the total amount of the fund and not the value of its activities or a different percentage that is submitted to the approval of the Bank of Italy). With regard to target companies, see section 5.2.4 (above). 5.3.6. Compensation structure 5.3.6.1. Transparency of the compensation structure (to investors and authorities) As well as being disclosed in the Regolamento, the entitlement to the SGR or the mangers to receive the management fee as well as the entitlement to the SGR and/or the manager to receive compensation in the form of carried interest (performance fees) or other types of remuneration (such as portfolio monitoring fees, directors fees, transaction fees etc.) will be set out in the Regolamento. These are negotiated and documented. Such information is provided to the Investors, also, in a specific document according to the provisions of the Regulation Consob No. 16190/2007. 5.3.6.2. Transparency of managers remuneration systems See paragraph above.
5.4.
Industry professional standards and investor relations (governed by self regulation / professional standards) Manual of Procedures According to article 15 of the regulation issued jointly by the Bank of Italy and Consob, on October 29, 2007, the intermediaries (among which the SGRs are included) must describe the procedure for the execution of their services in order to guarantee the duty of correctness, transparency and confidentiality.
164
Part I
The SGRs are used to satisfy the fulfilments provided by the mentioned article 15 adopting a code of self-regulation (Manuale delle Procedure) that according to the mentioned article 15 is compulsory and provides for information regarding inter alia: the organization and the corporate governance of the SGR; the duties of the SGR relative to the procedures for the subscription of the units of the fund, for the drawdown of the commitments subscribed, for the reimbursements of the funds. In such context the Manual of Procedures will provide for the description: (i) of the documents that the SGR shall provide and the procedures that such company shall follow with regard, inter alia, to the identification and the classification of the investors as far as concerns the purpose of MiFID (as enacted in Italy) and of the anti-money laundering law; (ii) of the procedures that the SGR will apply with regard to the draw down of the commitment and the remedies in case of defaulting investors; (iii) of the procedure and the controls that the SGR shall execute in case of disposal of the units of the funds; (iv) etc. ; the procedure of investment, monitoring and divestment executed by the SGR on behalf of the funds managed. In such section the cases of conflict of interests are described and the rules to solve such conflicts are provided; the procedures for the administration of the SGR and of the Funds. The Manual of Procedures provides for the description of the accounting books of the SGR and of the Fund and for the accounting duties of the SGR and of the Fund as well as for the identification of the responsible for such duties; the procedures to guarantee the confidentiality with regard to the flow of information known in the exercise of the activity. the system of control of the SGR (i.e. internal audit, compliance, risk management).
The procedures adopted must be monitored by the SGR over the time and if needed amended or implemented by the SGR. The adoption of the mentioned procedures is under the control of the Bank of Italy and of Consob. In case of non adoption or non compliance with the Manual of Procedures, Article 190 of the Legislative Decree No. 58/1998 provides for pecuniary administrative sanctions applicable to the persons performing administrative or management functions and to employees of the intermediaries. According to Article 195 of the Legislative Decree No. 58/1998, the administrative sanctions referred to, inter alia, Article 190 above mentioned shall be imposed by the Bank of Italy or Consob, to the extent of their duties, with a decree stating the grounds for the decision, after notifying the charges to the interested parties. Code of Conduct The industry body AIFI issued a Code of Conduct that, according to the information provided, is adopted by its members. The Code of AIFI actually in force is focused mainly on duties of confidentiality and on matters of conflict of interest.
165
Penalties for the intermediaries in case of non compliance with the code of conduct do not seem provided. AIFI informally confirmed that such Code will be replaced, within this year, by a new one that should provide the principles to be included in the Manual of Procedures (see paragraph above) according to the news provided by MiFID. As informally anticipated by AIFI, they are working on a Code of Business Ethics with the purpose to regulate the relationship between the partners. With regard to other matters of the template no additional rules beyond the extensive legal and contractual rules set out respectively in paragraph I and in paragraph II result. 5.4.1. Capital requirements 5.4.1.1. At the level of management companies (operational risk) There are no additional rules beyond the extensive legal/regulatory rules set out in paragraph 5.2.1 above. 5.4.1.2. At the level of the funds investment vehicle (exposure risk) As far as concerns funds reserved to qualified investors or Fondi Speculativi the information about the adoption of limits of investments different from those established on a general basis in the prudential rules for limiting and spreading risk issued by the Bank of Italy may be given in the Manual of Procedures. 5.4.2. Industry imposed disclosure and related monitoring Some information concerning the risk of investments may be provided by the Manual of Procedures. Furthermore the Manual of Procedures describes the procedures followed by the SGR with regard to the activity of investment, monitoring and divestment of the interests in investee companies acquired by the funds managed by the above mentioned SGR. In this context the Manual of Procedures gives evidence of specific rules provided by the Regolamento or by the agreements executed to acquire the participation that may affect the procedure of investment/monitoring/divestment. In this context the Manual of Procedures provides for the description of the cases of conflict of interests and for the procedure to solve such conflicts. The Manual of procedures provides also for the typical risks that the SGR may be met with in the execution of its activity and for the procedure that the responsible for the management risk shall follow to manage them. A specific section listing the anti-money laundering duties (as provided by the Legislative Decree No. 231/2007) applicable to the SGR is usually provided in the Manual of Procedures. Provisions concerning the conflicts of interests are envisaged by the Code of Conduct issued by AIFI. 5.4.2.1. Portfolio companies No additional rules result beyond the provisions under paragraphs 5.2.2, 5.3.2 and 5.4.2.
166
Part I
5.4.2.2.
Private equity firms The information about the adoption of criteria of evaluation in addition to the criteria issued by the Bank of Italy may be given in the Manual of Procedures.
5.4.2.3.
Enforcement & monitoring No additional rules result beyond the provisions under paragraphs 5.2.2, 5.3.2 and 5.4.2.
5.4.2.4.
Coverage of relevant entities No additional rules result beyond the provisions under paragraphs 5.2.2, 5.3.2 and 5.4.2.
5.4.3. Information and consultation of employees No specific information seems to be given in the Manual of Procedures and in the Code of Conduct. 5.4.3.1. Informing and consulting employees during the transfer of control of undertakings or businesses No additional rules result beyond the provisions under paragraph 5.2.3.1. 5.4.3.2. Disclosure and explanation of investment strategies and risks to investee companies No additional rules result beyond the provisions under paragraph 5.2.3.2. 5.4.3.3. Transfer of undertakings directive in relation to leverage buyouts No additional rules result beyond the provisions under paragraph 5.2.3.3. 5.4.4. Asset stripping and capital depletion Generic rules concerning the duty of the SGR to ensure the sound and prudent execution of its activity of management company may be provided by the Manual of Procedure and by the Code of Conduct. See paragraphs 5.2.4 and 5.3.4. 5.4.5. Limits of leverage (that are sustainable for the private equity fund/firm and for the target company) No additional rules result beyond the provisions under paragraphs 5.2.5, 5.3.5. 5.4.6. Compensation structure Information concerning the costs borne by the SGR and by the funds managed by the SRG as well as the existence of inducements are indicated by the Manual of procedures. Such information may affect the procedure for the administration of the Fund and of the SGR. 5.4.7. Other professional standards No additional rules result beyond the provisions under this paragraph 5.4.
167
6.
6.1.
The Netherlands
Introduction
Paragraph 1 of this overview summarises the framework of statutory rules and regulations relevant to the private equity industry in the Netherlands. Paragraph 2 indicates certain subject matters that from practical experience are standard market practices and as such are included in the (contractual) agreements governing a Dutch private equity fund. Dutch professional standards (self regulation) are addressed in paragraph 3 of this overview. There is no legal definition of a private equity fund (PEF) under Dutch law. PEFs active in the Netherlands qualifying as an investment institution are generally subject to the licensing requirement of the Dutch Act on financial markets supervision (Wet op het financieel toezicht or AFS, see paragraph 1). (94) Most PEFs active in the Netherlands operate without a license either as they do not qualify as an investment institution within the meaning of the AFS because of the active involvement in their portfolio companies, so called participatiemaatschappijen, or rely on an exception or exemption to the AFS licensing requirement. A PEF is indirectly impacted by regulation applicable to either the investors investing in it and/or the portfolio companies in which it invests. This is particularly relevant to institutional investors and listed portfolio companies. Also, the Dutch private equity industry is increasingly faced with harmonised rules set out at European Union (EU) level. European Directives cover many areas of the industry activities, such as licensing and conduct of business rules (MiFID), disclosure (Prospectus Directive, Transparency Directive) and money laundering (Third Money Laundering Directive). Furthermore, there are terms and conditions relating to PEFs and private equity investments that are not so much dictated by rules and regulation of Dutch law, but have rather developed in practice. These relate in particular to disclosure and monitoring of investments in PEFs (see paragraphs 2 and 3). The landscape of Dutch (national level) professional standards for the private equity industry is rather patchy. Many industry participants have designed their own set of rules (e.g. pension funds and insurers as private equity investors as well as private equity real estate firms and hedge fund managers etc.). The representative association for private equity firms in the Netherlands is the Dutch industry association of private equity firms (Nederlandse Vereniging van Participatiemaatschappijen or NVP). The NVP has 55 members. 42 of private equity firms active in the Netherlands are members of the European Private Equity & Venture Capital Association (EVCA).
(94)
Please note that the licensing requirement of the AFS applies to the manager (beheerder) of the investment institution except in the case of a self managed investment company.
168
Part I
6.2.
Dutch law regulatory aspects of PEFs are primarily governed by the AFS and the rules and regulations issued pursuant to it. A PEF may qualify as an investment institution. An investment institution is defined in the AFS as: an investment company or investment fund that solicits or obtains monies or other assets for collective investment in order to allow the participants to share in the proceeds of such investment. To the extent a PEF qualifies as an investment institution, a PEF offering rights of participation (deelnemingsrechten) in the Netherlands is generally required to be licensed by the AFS and is regulated by the Dutch Authority for the Financial Markets (Stichting Autoriteit Financile Markten or AFM) and the Dutch Central Bank (De Nederlandsche Bank or DNB). Supervision as regards conduct of business is exercised by the AFM; prudential supervision is exercised by the DNB. Licensing requirements that are relevant to capital requirements, disclosure and monitoring, asset stripping and capital depletion, leverage and compensation structures are addressed in the relevant paragraphs below. Most PEFs offering rights of participation in the Netherlands operate without a license. Such PEFs either do not qualify as an investment institution within the meaning of the AFS because of the active involvement in their portfolio companies, so called participatiemaatschappijen, or rely on an exception or exemption to the AFS licensing requirement. The exceptions and exemptions, respectively, include: an offer of rights of participation exclusively to qualified investors (gekwalificeerde beleggers); an offer to a group of less than 100 persons; or an offer of rights of participation with a minimum nominal value of EUR 50,000 (or the equivalent thereof in another currency) each, or an offer of rights of participation for a minimum aggregate consideration payable of at least EUR 50,000 (or the equivalent thereof in another currency). However, an offer in the Netherlands of rights of participation in a PEF will as a general rule require a prospectus being made available that is compliant with the AFS. PEFs are typically closed-end funds and must therefore generally comply with the Prospectus directive (Directive 2003/71/EC) as implemented in the AFS. There are several exceptions and exemptions in relation to the prospectus requirement. The exceptions and exemptions to the AFS licensing requirement as listed above, will equally avail a PEF to be exempt from the AFS prospectus requirement. Open-end PEFs must in addition to the prospectus prepare an AFS compliant simplified prospectus (financiele bijsluiter). Certain AFS conduct of business rules may apply irrespective of the licensing or prospectus requirement (see under paragraph 6.2.2.5). Where PEFs are admitted to listing on NYSE Euronext Amsterdam, they must comply with the Euronext regulations contained in its Rule Books and the disclosure and transparency rules of the AFS. PEFs must generally comply with the Act on the Prevention of Money Laundering and Terrorist Financing (Wet ter voorkoming van witwassen en financieren van terrorisme or Wwft) implementing the Third Anti Money laundering directive (see paragraph 6.2.2.6 for more details). The principal corporate legislation of PEFs that take the form of a legal entity (rechtspersoon) is the Dutch Civil Code (Burgerlijk Wetboek or DCC); for PEFs that take the form of a partnership legislation is provided in the Dutch Code of Commerce (Wetboek van Koophandel). Solvency issues are governed by the Dutch Bankruptcy Act (Faillissementswet).
169
Where a Dutch company is acquired by a PEF in a public to private transaction, the SER Resolution concerning the Merger Code 2000 (SER-Besluit Fusiegedragsregels 2000) applies in respect of workers consultation, in addition to rules on public offers pursuant to the AFS, see paragraph 6.2.3.1. 6.2.1. Capital requirements 6.2.1.1. At the level of management companies (operational risk) The Dutch Civil Code requires a management company in the form a public company (naamloze vennootschap or NV) or a private company (besloten vennootschap or BV) to maintain a minimum amount of capital of EUR 45,000 and EUR 18,000, respectively. The amount of capital paid in of an NV or a BV is publicly recorded in the trade register of the Dutch Chamber of Commerce (Kamer van Koophandel). There are no minimum capital requirements for management companies that take the form of a partnership. The contributed capital paid in of a Dutch partnership is publicly recorded in the trade register of the Dutch Chamber of Commerce (see also paragraph 6.2.4.1). To the extent a management company is regulated by the AFS, the AFS requires such a management company to have a minimum capital of at least EUR 125,000 (in case of a managed portfolio of less than EUR 250 million) and EUR 225,000 (in case of a managed portfolio of more than EUR 250 million). 6.2.1.2. At the level of the PEF investment vehicle (exposure risk) For PEFs in the form of an NV, BV or partnership, see corporate capital requirements (if any) above. AFS regulated PEFs (95): paragraph 6.2.1.1 above applies mutatis mutandis to the PEF. To the extent a PEF (or rather its management company) is AFS regulated, the AFS generally requires a PEF to appoint a depositary (bewaarder) for the safekeeping of the assets under management only in case of such PEF lacking legal personality (rechtspersoonlijkheid). The AFS contains a number of requirements (minimum capital, integrity tests etc.) for depositaries. Regulated PEFs with legal personality and non-regulated PEFs may on a voluntary basis opt to appoint a depositary. In the unlikely event of open-end PEF that is AFS regulated, such a PEF must maintain a liquidity reserve of 10% of its managed assets. 6.2.2. Regulatory disclosure and related monitoring 6.2.2.1. Overview Financial accounting Annual accounting PEFs that take the form of an NV or BV or otherwise have legal personality (96) fall within the scope of Dutch financial accounting rules contained in the Dutch Civil Code (title 9 of Book 2 of DCC) that implements in particular the fourth (78/660/EC) and seventh (83/349/EC) Company directive and the Transparency directive.
(95) (96)
See footnote 94. This regime equally applies for partnerships of which all liable partners are foreign joint stock companies.
170
Part I
These rules generally contain an obligation to prepare on an annual basis in accordance with Dutch generally accepted accounting principles (GAAP): an annual report the annual accounts (containing singular accounts, i.e., a balance sheet, profit and loss account and explanatory notes thereto, and (if any) the consolidated accounts) The annual accounts generally require to be audited. Exemptions from the auditing requirement exist depending on the size of the PEF. PEFs in the form of a partnership are under the obligation to keep accounts pursuant to DCC however this accounting requirement is less extensive than the requirements for legal entities. PEFs listed on NYSE Euronext Amsterdam or a multilateral trading facility (such as Alternext Amsterdam) or their so listed management companies must prepare consolidated accounts (if any) in accordance with IAS/IFRS. The annual accounts must be prepared and signed by all members of the PEFs statutory board of managing directors (and all members of its supervisory directors (if any) and must generally be produced for inspection and adoption by its general meeting of shareholders within five (5) months following the PEFs financial year. The annual accounts must generally be deposited for public inspection at the trade register of the Chamber of Commerce. Semi-annual accounting AFS regulated PEFs or their management companies must prepare unaudited semi-annual accounts in accordance with Dutch GAAP. PEFs listed on NYSE Euronext Amsterdam or a multilateral trading facility (such as Alternext Amsterdam) or their so listed management companies must prepare semi-annual consolidated accounts (if any) in accordance with IAS/IFRS. AFS regulated PEFs must file their annual and semi-annual accounts with the AFM (with respect to the annual accounts within four (4) months, and with respect to the semi-annual accounts within nine (9) weeks). Adopt principles based valuation measures for illiquid assets PEFs that are subject to Dutch Civil Code financial accounting rules (see above) have to valuate their illiquid assets either against acquisition price or current cost. 6.2.2.2. Disclosure and explanation of investment strategies and risk to investors (sophisticated and retail) PEFs must communicate information to their investors in a way that is clear, fair and not misleading. For regulated PEFs this general principle is set out in further detail in the AFS and includes the following: Prospectus (see under paragraph 6.2). In addition, PEFs need to include in their prospectus details of their investment objective and policies and prominent disclosure of risk factors specific to it and its industry. The risk factors must be ranged in order of importance. Registration document in relation to the PEFs investment manager (and depositary, if applicable). Simplified prospectus (financile bijsluiter) in case of open-end PEFs. Monthly update or fact sheet containing at least the following information: (a) the total value of the investments of the PEF, (b) an overview of the composition of the investments, (c) the number of outstanding shares/units; and (d) insofar as the shares/units in the PEF are repurchased or repaid either directly or indirectly out of the assets at the investors request: the most recent net asset value of the units, stating the moment when this net asset value was determined.
171
On the website of its investment manager: the investment managers registration document and prospectus of the PEF managed by it, the investment managers license (and dispensation from the AFM in relation to such license and its agreement with a depositary).
Additional corporate and regulatory disclosure requirements exist for listed PEF (including amongst others in relation to price sensitive information, requirements resulting from the Transparency Directive (2000/52/EEC), notification of major shareholdings, et cetera) (see under paragraph 6.2). See also paragraph 6.2.2.4.
6.2.2.3.
(Mandatory) Disclosure and explanation of investment strategies and risks to regulators Other (regulatory) key disclosures to regulators / market are: Any change in the details provided earlier to AFM as regards the properness of the persons determining or co-determining the policy of the investment manager and the persons forming a part of a body responsible for supervising the policy and the general affairs of the investment manager. The intention to amend the investment managers registration document insofar as this concerns details regarding inter alia the activities of the manager and the types of PEF it manages, the persons (co-)determining the (day-to-day) policy of the manager, the persons belonging to a body responsible for supervising the policy and the general affairs of the manager, or the general information concerning the manager. A change in certain details referring to the offering of rights of participation in a PEF under the investment managers management at least two weeks prior to the change. Additional corporate and regulatory disclosure requirements exist for listed PEFs (including amongst others in relation to price sensitive information, requirements resulting from the Transparency Directive (2000/52/EEC), shareholdings etc.) (see under paragraph 6.2).
6.2.2.4.
Register and identify shareholders PEFs in the form of an NV or BV with registered (book entry) shares are due to maintain a share register in which the name, contact details and other data (e.g. number of shares owned, pledge or usufruct arrangements) of the shareholders are recorded. For PEFs in the form of a partnership no such requirement exists although in practice a record of such information will generally be kept. The number of limited partners of a Dutch partnership is publicly recorded on a no names basis to the trade register of the Chamber of Commerce (see paragraph 6.2.1.1). Currently the identification of shareholders for PEFs that have bearer shares on issue is rather difficult. The same applies for listed PEFs with registered shares (central securities depositaries). However, draft legislation has been made available for consultation containing a proposal amongst others to allow listed companies to trace the identity of their shareholders and to require qualifying shareholders (voting threshold) to disclose their intentions in respect of their shareholdings. In respect of institutional investors (e.g. banks, insurers, pension funds, regulated PEFs) are due to disclose their voting policy in respect of listed companies on their website.
172
Part I
6.2.2.5.
Management and disclosure of conflicts of interest The Dutch Civil Code contains a general conflict of interest provision that is relevant for PEFs in the form of an NV or BV. This provision entails that in case of a conflict of interest between a company and a member of its management board, such company must generally be represented by such companys supervisory board. In accordance with Dutch Civil Code, the shareholders meeting shall at all times be authorised to appoint a person that is especially assigned the authority to represent the company in matters of conflicting interest (tegenstrijdig belang persoon). Under the AFS, PEFs have to disclose agreements with affiliated parties in their prospectus. Such disclosure comprises (amongst others) an overview of the agreement, kind of transaction and if the transaction occurred at arms length. Irrespective of a PEF being regulated or non-regulated, certain rules of conduct following from the AFS apply. These rules are to the effect that (i) internal provisions are being determined concerning the handling of price sensitive information (voorwetenschap) and private transactions in financial instruments by directors and employees; (ii) conflicts of interest with respect to transactions in financial instruments are being controlled, and (iii) adequate measures are present in order to comply with these rules. The Dutch Civil Code requires investees companies qualifying as a large company (structuurvennootschap) to establish a supervisory board. The supervisory board is intended to represent all stakeholders and accordingly serves as an oversight board. In addition, conflicting interest issues are addressed in rather great detail in the Dutch Corporate Governance Code (the Code) that applies to Dutch companies with a listing at NYSE Euronext Amsterdam or elsewhere.
6.2.2.6.
Prevention of money laundering The Act on the Prevention of Money Laundering and Terrorist Financing (Wwft) entered into force on 1 August last to implement Directive 2005/60/EEC (Third Money Laundering Directive). The Wwft applies, amongst others, to investment institutions. The Wwft envisions providing a framework that is more risk based than principle based. This means that a PEF is required to attain the object of the law, namely, combating of money laundering and the preventing of financing of terrorism, but they are allowed a certain amount of discretion as to the manner in which they structure their policy in order to achieve the envisioned result. PEFs may adjust the degree of investigation according to the type of client, relationship or transaction. The Wwft provides PEFs with greater opportunities to harmonise their identification policy on the concrete risks of getting involved in money laundering and the financing of terrorism within the PEFs.
173
6.2.3. Information and consultation of employees 6.2.3.1. Informing and consulting employees during the transfer of control of undertakings or businesses There are a number of mechanisms and bodies through which employee information and consultation may be required in the Netherlands, for example: Trade unions in many industries it is common that a collective bargaining agreement between trade unions on the one side and employers associations on the other side is entered into. The Ministry of Social Affairs can declare certain provisions of a collective bargaining agreement binding on all employees or employment contracts in a particular industry. This means that all employers and employees in the relevant industry are bound by those provisions, irrespective of whether they are a member of an employers association that is party to the collective bargaining agreement. A collective bargaining agreement may provide information and consultation rights to trade unions. (Act on collective labour agreements, Wet op de collective arbeidsovereenkomst) The Rules of conduct in relation to mergers set out in the resolution of the Social and Economic Council of 2000 (the Merger Code) apply to the acquisition of direct or indirect control over all or part of the activities of another enterprise. The Merger Code is limited to mergers or takeovers whereby an enterprise (as a buyer, seller or object of the envisaged transaction) is involved that is established in the Netherlands and regularly employs 50 employees or more. The Merger Code requires the parties involved in a merger to provide timely information to, and subsequently consult with, trade unions that are actively involved in the enterprise of the parties involved in such a manner that the views of the trade unions can be of meaningful influence on the transaction and its modalities. The notification to the trade unions must include: (i) an explanation of the reasons for the merger; (ii) the intentions regarding the company policies to be pursued; and (iii) the anticipated social, economic and legal consequences and the proposed measures to be taken in connection therewith. In a meeting with the trade unions, which must take place, the trade unions must be given the opportunity to discuss: (i) the basic principles underlying the policies of the enterprise to be adopted in connection with the merger (inclusive social, economic and legal aspects); (ii) the basic principles of measures to prevent, eliminate or reduce adverse consequences for the employees, including financial compensation; (iii) timing and manner of notification to all employees; and (iv) a report on the discussions that are held. An important exception is applicable when the merger falls outside Dutch jurisdiction. If a foreign enterprise acquires a Dutch target, the applicability of the Merger Code is dependent on the consequences that such transaction may reasonably be expected to have for the Dutch employees of the acquiring party. Where a merger involves two foreign enterprises, the Merger Code is only applicable if the objective of the merger is (primarily) the Dutch enterprise. Commonly, the relative number of personnel employed in the Netherlands as compared to the number of personnel employed abroad will provide a fair indication as to whether the Merger Code applies. Together with the trade unions, the Committee for Merger Affairs of the Social and Economic Council must be notified (this notification must also be made if there are no active trade unions involved but where the other criteria of the Merger Code are met). (Rules of conduct in relation to mergers set out in the resolution of the Social and Economic Council of 2000, SER Fusiegedragsregels)
174
Part I
Works council A Dutch enterprise that generally employs 50 employees or more is obliged to establish a works council. A works council has the right to render its advice on a contemplated decision to transfer control over a company or a part thereof. The advice of the works council must be obtained at such time that the works council may exercise meaningful influence on the transaction and its modalities. This means that management must consult the works council before the decision to enter into the transaction is taken and before the modalities of the transaction are decided and agreed upon. In the request for advice, the works council must be given full details on: (i) the proposed decision(s); (ii) the reasons behind the proposed decision(s); (iii) the consequences of the decision(s) for the employees; and (iv) the measures that are to be taken in connection with such consequences. The works council may not render its advice until there has been at least one consultative meeting on the subject. There is no fixed period within which the works council must render its advice. The works council is given a reasonable period of time. As a rule of thumb a period of 3 to 4 weeks should be sufficient. The advice may be positive, neutral, made subject to conditions or negative. Once the advice has been received, the entrepreneur will have to resolve whether or not the advice is adhered to. If management decides to adopt a decision that contravenes the advice given by the works council or if facts and circumstances become known which, had they been known to the works council at the time of presenting its advice, might have led to a different result, the works council may appeal to the Enterprise Chamber of the Amsterdam Court of Appeal within one month of the enterprises notification of its decision to proceed with the transaction. During this one month period the enterprise must suspend the implementation of its decision. The first available ground of appeal is that procedural requirements have not been complied with. The second available ground of appeal is that the enterprise could not reasonably have reached the decision had it weighed the interests involved, whereby a certain degree of discretion by management is permitted. Because of this limited scope of review, appeals are not easily granted on the substantive issue. If the Enterprise Chamber finds that the enterprise could not reasonably have come to the decision had it weighed the interests involved, the Enterprise Chamber may, inter alia, issue an order requiring the enterprise to: withdraw the decision in whole or in part, and to reverse specified consequences of that decision. Third party rights are however respected and will not be affected by an adverse decision of the Enterprise Chamber. (Works Council Act, Wet op de ondernemingsraden)
Other personnel representation A Dutch enterprise that generally employs between 10 and 50 employees or more is obliged to establish a personnel representation body (personeelsvertegenwoordiging) if the majority of the employees requests management to do so. A personnel representation body must also be requested to render its advice on a contemplated transaction. If management decides to adopt a decision that contravenes the advice given by the personnel representation body, management is however not obliged to suspend the implementation of its decision during one month. Also, the personnel representation body does not have the possibility to initiate proceedings with the Enterprise Chamber.
175
If the legislation regarding a transfer of undertaking within the meaning of article 7:662 and further of the Dutch Civil Code (hereinafter: TUPE legislation) is applicable and no works council or personnel representation is installed, TUPE legislation provides that all employees should be informed on (i) the contemplated decision to enter into a transaction, (ii) the contemplated transaction date, (iii) the reasoning behind the transaction, and (iv) the legal, economic and social consequences of such transfer (if any) and the contemplated measures to alleviate such consequences. (Dutch Civil Code) European works council (EWC): If central management of a community scale undertaking or group of undertakings (at least 1,000 employees within the EU and at least 150 in each of two member states) is in the Netherlands, and a written request is made by 100 or more employees in at least two member states, then central management must set up a negotiating body to negotiate an EWC, or a procedure for information and consultation. (European Works Council Act, Wet op de Europese ondernemingsraden) Collective redundancies Where an employer proposes to dismiss as redundant 20 or more employees within the region of one Centre for Work and Income (CWI) within a period of 3 months, the employer must inform the CWI and must inform and consult the trade unions that are actively involved in the enterprise. A works council and a personnel representation body have the right to render their advice on a contemplated collective redundancy. (Collective Redundancy Notification Act, Wet melding collectief ontslag and Works Council Act, Wet op de ondernemingsraden) 6.2.3.2. Disclosure and explanation of investment strategies and risks to investee companies As a principle trade unions, the works council and the personnel representation body determine what information they need to be able to fulfil their consultative role or to render a proper advice. There is no separate legal obligation to discuss investment strategies with the employees of investee companies. In practice it is often a matter of negotiations what information is shared. 6.2.3.3. Transfer of undertakings directive in relation to leverage buyouts It is very unlikely that there would be a specific extension of TUPE legislation to cover an LBO (i.e. share sale transaction). Such an extension is unnecessary because there is no change in the identity of the employing company, and therefore no effect on the employment relationship, or employees terms and conditions. Although TUPE legislation with regard to information and consultation obligations does not apply to a share sale, the obligations under 6.2.3.1 and relevant subsections are applicable. 6.2.4. Asset stripping and capital depletion 6.2.4.1. Prevention of asset stripping through common rules on capital maintenance No such specific regulatory provisions solely for private equity exist in the Netherlands: from a Dutch corporate law perspective, management (and management supervision) of both PEFs and Dutch target companies in the form of NVs or BVs are subject to certain corporate law capital protection rules and regulations (such as: financial assistance rules, limits on distributions to shareholders, limits on purchase by a PEF of shares in its capital and a prohibition for a PEF to subscribe for its own shares for no value). NVs, BVs and/or regulated PEFs are bound by the minimum amounts of capital according to the Dutch Civil Code and AFS, respectively (see paragraph 6.2.1.1).
176
Part I
In addition, the Dutch Civil Code requires resolutions of management of an NV being approved by the general meeting when these relate to an important change in the identity or character of a company or the undertaking (e.g. a portfolio company), including in any case: (i) a transfer of the undertaking or virtually the entire undertaking to a third party; (ii) the entry into or termination of a long-term cooperation of the company or a subsidiary with another legal person or partnership or as a fully liable partner in a limited partnership or general partnership, if such cooperation or termination is of a far-reaching significance for the company; (iii) the acquisition or divestment by it or a subsidiary of a participating interest in the capital of a company having a value of at least one-third of the amount of its assets according to its balance sheet and explanatory notes or, if the company prepares a consolidated balance sheet, according to its consolidated balance sheet and explanatory notes in the last adopted annual accounts of the company. Members of a management board of an NV or BV may face personal liability for asset stripping to the extent it qualifies as improper performance of duties (onbehoorlijk bestuur) and serious culpability (ernstig verwijt) of such members. In particular management supervision of an NV or BV (board of supervisory directors) must in accordance with DCC consider the interests of all stakeholders (such to include employees). Under the Dutch Bankruptcy Act, when a company enters into a transaction at an undervalue i.e., makes a gift or otherwise enters into a transaction on terms that the company receives no consideration or enters into a transaction for a consideration the value of which, in money or moneys worth, is significantly less than the value, in money or moneys worth, of the consideration provided by the company, the court may make such order as it thinks fit for restoring the position to what it would have been if the company had not entered into that transaction (if the company enters into insolvency within a certain period). Also, pursuant to said act, a company gives a preference to a person if that person is one of the companys creditors or a surety or guarantor for any of the companys debts or other liabilities or the company does anything (or suffers anything to be done) which has the effect of putting that person into a position which, in the event of the company going into insolvent liquidation, will be better than the position he would have been in if that thing had not been done (faillissementspauliana). The court can set aside such a preference (if the company enters into insolvency within a certain period). 6.2.5. Limits on leverage (that are sustainable both for the private equity fund/firm and the target company) Except for PEFs in the form of a Dutch REIT (fiscale beleggingsinstelling) and UCITS, there are no statutory leverage restrictions that apply to PEFs. However, as a general principle of law, management (and management supervision) of Dutch portfolio companies when obtaining funds from PEFs should at all times consider the interests of all stakeholders (such to include employees) when obtaining funds from PEFs. In respect of Dutch target companies that have instituted a works council, it is noted that debt financing qualifying as significant credit (belangrijk krediet) by PEFs is subject to advice from the targets works council. According to the Dutch case law, directors have to take the standard of improper performance of duties into account while leveraging their companies (see paragraph 6.2.4.1). A companys director is responsible for the loss a third party suffers due to obligations being left unpaid, if such director, on taking up the obligation (in view of the facts and circumstances) knew or ought to have known that the company was unable to perform.
177
6.2.6. Compensation structure 6.2.6.1. Transparency of the compensation structure (to investors and authorities) In respect of PEFs (or PEF portfolio companies) in the form of an NV or BV, the remuneration of managers or the management company (to the extent constituting the statutory board of management (directie)) is set by the general meeting of shareholders, or the supervisory board (if instituted). No such rule exists for a Dutch partnership. However, in practice no investor will adhere as a partner to a partnership without approving the management remuneration. According to the Dutch Civil Code, companies must include in the notes to their annual accounts: Remunerations and other payments to (former) members of the management and supervisory board (aggregate amount as well as allocated amounts). Statement of options for managers, supervisors and employees. For certain NVs, loans, advance payments, and guarantees to their managers must also be included in the notes to their annual accounts. Small and medium-sized companies (97) are not required to disclose such information. AFS-regulated PEFs have to disclose all costs of management, including their method of calculation, in their prospectus. Therefore, management fees, carried interest and any other form of compensation payable by a regulated PEF to its manager will be fully disclosed to investors and regulators. In practice, the same will also apply to unregulated PEFs (see paragraph 6.2.2.2). Detailed remuneration transparency provisions apply for listed companies pursuant to the AFS and the Corporate Governance Code. Under the Code, the supervisory board has to ensure that the right balance is struck between (a) the fixed and variable components of the remuneration and (b) short and longer term remuneration. Ultimately, remuneration policy must serve the interests of the company and its affiliated enterprise; in other words, be aimed at creating long-term value. The Corporate Governance Code comprises of the following principles with respect to remuneration: The level and structure of the remuneration which the management board members receive from the company for their work shall be such that qualified and expert managers can be recruited and retained. When the overall remuneration is fixed, its impact on pay differentials within the enterprise shall be taken into account. If the remuneration consists of a fixed component and a variable component, the variable component shall be linked to predetermined, assessable and influenceable targets, which are predominantly of a long-term nature. The variable component of the remuneration must be appropriate in relation to the fixed component.
(97)
A small sized company is a legal person which satisfies two or three of the following requirements: (i) the value of the assets amounts to no more than EUR 4,400,000; (ii) the net turnover for the financial year amounts to no more than EUR 8,800,000; (iii) the average number of employees during the financial year is less than 50. A medium sized company is a legal person which satisfies two or three of the following requirements: (i) the value of the assets amounts to no more than EUR 17,500,000; (ii) the net turnover for the financial year amounts to no more than EUR 35,000,000; (iii) the average number of employees during the financial year is less than 250.
178
Part I
The remuneration structure, including severance pay, shall be simple and transparent. It shall promote the interests of the company in the medium and long term, may not encourage management board members to act in their own interests or take risks that are not in keeping with the adopted strategy, and may not reward failing board members upon termination of their employment. The supervisory board is responsible for this. The level and structure of remuneration shall be determined by reference to, among other things, the results, the share price performance and non-financial indicators that are relevant to the companys long-term value creation.
The shares held by a management board member in the company on whose board he sits are long-term investments. The amount of compensation which a management board member may receive on termination of his employment may not exceed one years salary, unless this would be manifestly unreasonable in the circumstances.
The supervisory board shall determine the remuneration of the individual members of the management board, on a proposal by the remuneration committee, within the scope of the remuneration policy adopted by the general meeting.
The report of the supervisory board shall include the principal points of the remuneration report concerning the remuneration policy of the company. This shall describe transparently and in clear and understandable terms the remuneration policy that has been pursued and give an overview of the remuneration policy to be pursued. The full remuneration of the individual management board members, broken down into its various components, shall be presented in the remuneration report in clear and understandable terms.
6.2.6.2.
Transparency of managers remuneration systems See paragraph 6.2.6.1 above. It follows from the Dutch Civil Code that the remuneration of managers (to the extent constituting the statutory board of management) is set by the general meeting of shareholders, or the supervisory board (if instituted).
6.3.
Governed by contractual agreements between parties and related entities
6.3.1. Capital requirements 6.3.1.1. At the level of management companies (operational risk) There are usually no additional requirements, because investors rely on the legal rules referred to as set out in the Dutch Civil Code (see paragraph 6.2.1 above). 6.3.1.2. At the level of the funds - investment vehicle (exposure risk) There are usually no additional requirements, because investors rely on the legal rules referred to as set out in the Dutch Civil Code (see paragraph 6.2.1 above). 6.3.2. Contractual disclosure and related monitoring 6.3.2.1. Disclosure and explanation of investment strategies and risk to investors (sophisticated and retail) There are usually no additional disclosures (other than the mandatory AFS disclosures) made by AFS-regulated PEFs.
179
However, unregulated PEFs often disclose more (and more frequent) financial accounting and other financial information than required by statute following EVCA guidelines on reporting and valuation. Generally, unregulated PEFs report on a quarterly basis. Often IAS/IFRS is chosen as the reporting standard on a voluntary basis. Investment strategy and risks are generally set out in rather great detail in the offering materials (private placement memorandum). The offering and fund documentation for PEFs typically also addresses conflicts of interest issues. In view hereof, so-called advisory boards are often established which function as an oversight board. 6.3.2.2. Contractual clauses covering lock-up periods, cancellation and termination Generally PEFs are closed-ended and investors have no ability to require repayment of their investment during the life of the fund. Consequently, lock-up periods and conditions governing cancellation and termination are not relevant to most private equity funds. The fact that investors have no ability to redeem and will only receive a return on their investment in the fund as and when the funds underlying investments are realised will be disclosed to investors in the offering materials. Management is generally remunerated on the basis of a back ended performance fee (carried interest) once the investors shall have received their contributed capital and pre-agreed preferred return. Many funds allow for termination of the management contract in the event of an investor vote (no fault divorce) and/or in the case of fraud or gross negligence. These provisions are dealt with in great detail in the fund documentation. The fund documentation also typically includes rights for the investors to suspend the PEFs investment period if the key executives of the management team leave or the management team is subject to extensive changes. 6.3.2.3. Register and identify shareholders See paragraph 6.2.2.6 above. Typically a funds contractual documents do not extend these disclosure obligations. 6.3.3. Information and consultation of employees 6.3.3.1. Informing and consulting employees during the transfer of control of undertakings or businesses Given the extensive legal rules referred to in paragraph 6.2.3 above, typically no further rules are implemented. 6.3.3.2. Disclosure and explanation of investment strategies and risks to investee companies There are generally no additional contractual provisions. 6.3.3.3. Transfer of undertakings directive in relation to leverage buyouts Please see 6.2.3.3 above. 6.3.4. Asset stripping and capital depletion 6.3.4.1. Prevention of asset stripping through common rules on capital maintenance There are generally no additional contractual provisions.
180
Part I
6.3.5. Limits on leverage (that are sustainable for the private equity fund/firm and for the target company) In practice the ability of PEFs to borrow funds (as opposed to the ability of portfolio companies or acquisition vehicles to borrow on a non-recourse to the fund basis) is severely constrained and is often restricted to bridging, pending the receipt of capital called from investors, to cover a default on a capital call from an investor, and to certain other limited circumstances. 6.3.6. Compensation structure 6.3.6.1. Transparency of the compensation structure (to investors and authorities) As well as being disclosed in the funds marketing materials, for funds structured as limited partnerships, the entitlement of the PEF to receive compensation in the form of management fees, carried interest (performance fees) or other types of remuneration (such as portfolio company monitoring fees, directors fees, financing fees etc.), will be set out in the limited partnership agreement which is the main contractual document relating to the fund and which is an agreement to which each of the fund investors are party. These provisions are negotiated and documented in great detail. The arrangements are, however, confidential to the parties and do not form part of any notification to any regulatory authority. 6.3.6.2. Transparency of managers remuneration systems As remuneration systems are previously negotiated and laid down in the fund documentation, there is a minimum level of alteration. General, a PEFs remuneration structure can only be altered with the approval of all shareholders.
6.4.
Governed by self regulation / professional standards (Industry professional standards and investor relations)
The key professional standard is the conduct and membership code of the NVP of 2007 (NVP Code) in respect of law and regulation, enduring relationship with portfolio companies, transparency and communication to investors and the public and confidentiality. The general principles are further addressed in certain best practices. The NVP Code does describe the topics for which agreements should be reasonably reached and in which way NVP members should, in their actions, take into consideration the interests and responsibilities of other interested parties, in the event of a (planned) investment in a portfolio company registered in the Netherlands (98). 6.4.1 Capital requirements 6.4.1.1. At the level of management companies (operational risk) The NVP Code does not provide for additional best practices or requirements in this respect. 6.4.1.2. At the level of the funds - investment vehicle (exposure risk) The NVP Code does not provide for additional best practices or requirements in this respect.
(98)
The code of conduct is based on Dutch law and legislation. Where investments in portfolio companies outside the Netherlands but in Europe are involved, the EVCA guidelines as mentioned in footnote 100, offer a sound basis.
181
6.4.2. Industry imposed disclosure and related monitoring According to the NVP Code, NVP members shall endorse the following best practices: (i) PEFs shall inform investors, before participating in the fund, of the characteristics of the fund (sector, type of financing, size and duration of the investments, company management, valuation guidelines and reporting structure). The documentation shall be recorded in an information memorandum or, if applicable, a prospectus, in line with the applicable laws and regulations. (ii) PEFs shall inform their investors sufficiently, taking into consideration their specific information needs and in line with the information memorandum or prospectus, while taking into account the interests of the portfolio company or companies. If institutional investors which are subject to supervision invest in a PEF, the latter will make every effort to ensure that same can comply with the applicable policy rule of the Dutch Central Bank (De Nederlandsche Bank or DNB)(99). A PEF preferably follows the applicable international and EVCA guidelines (100) on company management, valuation and reporting. (iii) A PEF has an obligation to make every effort to ensure that no funds from non-specified sources are included in its fund(s), to prevent money laundering and financing of terrorism. (iv) Prior to the investment, a PEF, together with any other intended shareholders and the members of the management (whether participating or not) of the portfolio company, will draw up a plan outlining as much as possible the strategic course, the financial structure, the expected duration of the participation and the tasks and responsibilities of the supervising party (101). (v) The agreements between a PEF and the management of the portfolio company are recorded in a management agreement (in the case of participating management: a shareholders agreement), outlining, among other things, the frequency and content of information distribution, company management of a portfolio company and non-disclosure stipulations, as well as the loan agreement(s), the articles of association and the extent of the decision-making powers (102). Said decision-making powers cover the following: the strategy of the company and the operational and financial objectives and secondary terms and conditions used in the strategy, which are laid down in agreement with the shareholders. The management of the company is subsequently made responsible for the management of the company, which includes its responsibility for the realisation of the objectives of the company. The management reports on this issue to the supervisory body and to the general meeting of shareholders. In fulfilling its task, the management shall focus on the interests of the company and its associated operations and, to this end, will take into consideration the appropriate interests of all parties involved in the company. The supervision of the execution of the operational tasks is the responsibility of the supervisory body. The management will provide the supervisory body with all information it requires to execute its tasks in a timely fashion. The management is responsible for compliance with all relevant laws and regulations, controlling the risks associated with the company activities and for the financing of the company. The management shall report on this and discuss internal risk management and control systems with the supervisory body.
(99) (100) (101) (102)
Policy rule on key principles for assessing the risk management for alternative investments issued by DNB on August 2007 (Beleidsregel beoordeling risicobeheer van alternatieve beleggingen). EVCA Governing Principles, ed. March 2003; EVCA Corporate Governance Guidelines, ed. June 2005; International Private Equity and Venture Capital Valuation Guidelines, ed. June 2005 and EVCA reporting Guidelines, ed. June 2006. If the transaction in question is a so-called public to private, the plan cannot be made before the transaction, but same will be done within at the most six months after the transaction. If the loan agreements and articles of association officially are not part of the management agreement this article should be read as if it were the case.
182
Part I
(vi) A PEF shall close a shareholders agreement with its co-shareholders that includes the basic presumptions of the plan as meant under 6.4.2 (iv). The shareholders agreement may also include articles on subjects including the frequency and content of information distribution, company management of the portfolio company and confidentiality stipulations, as well as loan agreement(s), articles of association and the extent of decision-making powers (103). (vii) A PEF will cooperate with possible co-shareholders on the basis of reciprocal transparency and will provide all information, with regard to which it ought to be reasonably aware, that is of importance to the other party for the cooperation, while taking into consideration the interests of the portfolio company or companies. (viii) The authorities and operating methods of the supervisory body (if instituted) are recorded in a code and/or in the articles of association of the company and in the shareholders agreement. In the event that a Supervisory Board is instituted as supervisory body, the Supervisory Board will be aware of the plan as meant under 6.4.2 (iv) and of the stipulations and agreements recorded in the shareholders agreement. (ix) A private equity company announces which companies it has in its portfolio unless it is subject to any nondisclosure obligation in this matter. (x) The responsibility for transparency about the portfolio company vis--vis the public is primarily that of the portfolio companys management. Said responsibility carries more weight in accordance with the greater the public role of the company, and according to current public opinion is not decided solely by the law and ensuing duty to submit the annual accounts to the Chamber of Commerce. A PEF which is a shareholder in large companies should make an effort to use its influence as a shareholder to insist, whenever relevant, on a certain level of transparency towards the public. Register and identity of shareholders beyond a certain proportion The NVP Code does not provide for additional best practices or requirements in this respect. 6.4.2.1. Enforcement and monitoring The NVP Code is based on certain general principles supported by all members. These principles have been developed into guidelines which the NVP considers to be best practices, but which individual members may deviate from if, in their specific situation, they have found a better way to adhere to the principles or have other sound reasons to deviate from the best practices. The best practices primarily apply to the situation in which the PEF is the majority shareholder. If a PEF is a minority shareholder, they shall make every reasonable effort within their power to adhere to the best practices described in the NVP Code. The purpose of the NVP Code is to record the main obligations of the NVP members. Since 20 May 2008, the NVP Code is compulsory for all members. The NVP will not actively supervise adherence to the NVP Code nor supervise in any other way. However, if the NVP Executive has sufficient indications to assume that a member has systematically failed to adhere to the codes, it reserves the right to expel the member in question.
(103)
See footnote 102.
183
6.4.2.2.
Coverage of relevant entities NVP members. These comprise companies and other legal entities which have as their core business the providing of risk-bearing capital to non-listed companies.
6.4.3. Information and consultation of employees 6.4.3.1. Informing and consulting workers during the transfer of control of undertakings or businesses The main outlines of the plan as meant under paragraph 6.4.2 (iv) will be communicated, insofar as required, to, if applicable, the workers council of the investee company. 6.4.3.2. Disclosure and explanation of investment strategies and risks to investee companies See under paragraph 6.4.3.1. 6.4.3.3. Transfer of undertakings in relations to buyouts Please see 6.2.3.3 above. 6.4.4. Asset stripping and capital depletion There are no additional rules beyond the legal rules set out in paragraph 6.2.4 above. 6.4.5. Limits on leverage (that are sustainable for the private equity fund/firm and for the target company) The level of leverage is sustainable for the target company. The level of leverage is according to NVPs best practices to be included in the strategic plan the PEF is required to make with the portfolio companies. 6.4.6. Compensation structure There are no additional rules beyond the rules set in paragraph 6.2.6 above. 6.4.7. Other professional standards INREV Guidelines published by the European Association for Investors in Non-listed Real Estate Vehicles (INREV) which provide guidance to non-listed real estate fund managers on how they should present information on non-listed real estate funds consistently and transparently. The INREV Guidelines provide an integrated set of principles, best practice requirements and further guidance for the governance and information provision for non-listed real estate vehicles. HFSB Standards published by Hedge Fund Standards Board Ltd. (HFSB) which provide standards for hedge fund managers. They are also intended to apply to broader asset management groups but only in respect of their hedge fund management activities. HFSB Standards concern inter alia: disclosure to investors, valuation, risk management, fund governance and shareholder conduct. Hedge fund managers who have signed up to the HFSB Standards are required to conform on a comply or explain basis.
184
Part I
185
7.
7.1.
Norway
Introduction The national industry body The national industry body is the Norwegian Venture Capital and Private Equity Association (NVCA), the actual members of which are entities active in the Norwegian private equity and venture capital markets. Primary membership of the NVCA is open to independent, professional management companies in which investment in new ventures, company growth or corporate restructuring plays a significant role, which exercise active ownership, which have at least EUR 10 million in capital under management, and which have investment in Norway as a substantial part of their overall business. Associate membership is open to independent, professional management companies which have less than EUR 10 million in capital under management, and which have investment in Norway as a substantial part of their overall business, as well as venture entities in corporate structure and service suppliers to the industry, as consultants and law firms. Membership of the NVCA imposes an obligation on members to observe the associations code of ethics. Members must work to achieve the associations objects, and observe its statutes as well as decisions taken under these. Members can be suspended andor excluded for breaches of the ethical code. The number of members as of 12th of January 2009 was 90 in total, whereas 36 primary members and 54 associate members of which 68 are investing members. Regulation and legal framework Private equity firms in Norway managing closed-end funds, are not specifically regulated under Norwegian securities markets legislation as opposed to e.g. mutual funds. Private equity firms are thus subject to the same legal framework as limited liability companies or limited partnerships in general. As a consequence, private equity firms active in Norway are governed under the below mentioned framework, in addition to relevant pan-European and/or international law, regulations and professional standards:
7.2.
There is no private equity specific legislation that would be applicable to private equity firms managing closed-end funds. Most funds in Norway are limited partnerships, being subject to the Norwegian Partnership Act (Partnership Act). These are not subject to the regulations in the Norwegian Securities Trading Act (STA) or the Norwegian Private Limited Liability Companies Act (Companies Act) with regard to company specific regulation, i.e. issuer specific regulation. It should be noted, however, that many of the market participants interacting with private equity firms and thereby affecting the operations of private equity firms, such as investment banks and providers of credit, are regulated entities and thus subject to authority supervision. Furthermore, any investor specific regulation, including such in the STA, will also be applicable to any private equity fund.
186
Part I
Funds and management companies established as Norwegian private limited liability companies are governed by the Companies Act. These companies, also including foreign limited liability companies, are also subject to certain provisions in the STA. The STA includes the prospectus requirements for issuance and offer of transferable securities (shares) to the public, rules on trade in financial instruments (shares) listed on a regulated market as well as the legal framework for regulated investment firms. Additionally a listed private equity firm is naturally required to comply with applicable stock market rules. Where a Norwegian listed company is acquired by a private equity firm in a public to private transaction, the take over rules of the applicable market place will apply. According to the STA, mandatory bid obligations are triggered for any person who through acquisition becomes the owner of shares representing more than 1/3 of the voting rights in a Norwegian company whose shares are quoted on a Norwegian regulated market. 7.2.1. Capital requirements 7.2.1.1. At the level of management companies (operational risk) Management and advisory companies of Norwegian private equity funds (i.e. closed-end funds) are generally private limited liability companies and as such subject to the general capital requirements applicable to all private limited liability companies. Norwegian private limited liability companies require a minimum share capital of approximately EUR 10,000. The minimum share capital of a management company of a mutual investment fund (UCITS) is EUR 125,000. Regulated investment firms are subject to requirements both to so-called start capital and so-called liable capital. The minimum start capital requirement is usually EUR 730,000, but is EUR 50,000 for firms that do not wield customers funds. In addition, the minimum liable capital shall at all times be 8 per cent of a so-called basis of computation, consisting of the aggregate of the basis for credit risk, market risk and operational risk (all defined). However, for investment firms that operate a certain limited scope of services, the minimum liable capital shall at all times be 25 per cent of last years fixed costs. 7.2.1.2. At the level of the funds investment vehicle (exposure risk) The minimum capital contribution from each limited partner in Norwegian limited partnerships is approximately EUR 2,000. The capital commitments of the partners are required to be registered with the Norwegian Register of Business Enterprises The Brnnysund Registers. The registered information is publicly available. If the fund is a private limited liability company, then the minimum share capital is approximately EUR 10,000. The articles of association, revealing the share capital, are registered with the Brnnysund Registers and are publicly available. 7.2.2. Regulatory disclosure and related monitoring 7.2.2.1. Overview Private equity firms managing closed-end funds are not subject to any specific disclosure or monitoring obligations in addition to those applicable to other Norwegian companies. Financial statements of limited liability companies need to be filed with the Register of Company Accounts (part of the Brnnysund Registers) as well as financial statements of limited partnerships in which the general partner is a limited liability company.
187
As stated above, the most common structure for private equity funds established by Norwegian firms is the limited partnership. Norwegian limited partnerships need to be registered with the Brnnysund Registers. 7.2.2.2. (Mandatory) disclosure and explanation of investment strategies and risks to investors (sophisticated and retail) There is no private equity specific legislation that would be applicable to private equity firms managing closed-end funds, but the STA may be applicable for funds established as limited liability companies. Under the STA, no-one may employ unreasonable business methods when trading in financial instruments (including shares) and conduct of business rules shall be observed in approaches addressed to the general public or at individuals which contain an offer or encouragement to make an offer to purchase, sell or subscribe to financial instruments or which are otherwise intended to promote trade in financial instruments. Further, for funds established as limited liability companies, the STA has extensive prospectus rules applicable to any invitation to invest in transferable securities in the fund, also dependent on the number of investors in the Norwegian market to which the offer is directed, the total amount of the offer and the minimum capital contribution. The prospectus must either be approved by the Oslo Stock Exchange through a specific approval process or simply registered by the Norwegian Register of Business Enterprises. As stated above, funds incorporated as limited partnerships are not directly subject to the STA, and there are no prospectus requirements. Such funds must of course still provide relevant information to the potential investors, but the information necessary to be provided must satisfy general rules under Norwegian background law on information to be provided by the offeror or seller of goods. Private equity funds admitted to listing on a regulated market or offered to a broad range of investors (and certain exceptions are not applicable) need to include in their prospectus details of their investment objective and policies and prominent disclosure of risk factors specific to it or its industry. A prospectus would need to be approved by the Oslo Stock Exchange through a specific approval process. 7.2.2.3. Disclosure and explanation of investment strategies and risks to regulators See 7.2.2.2. 7.2.2.4. Register and identify shareholders According to the Companies Act, private limited liability companies need to have a shareholders register giving overview of the owners of the companys shares, the respective shareholdings, date of purchase, pledges etc. The shareholders register shall be kept accessible to everyone at the head office of the company. Everyone has the right to receive copies of the shareholders register or parts thereof against a nominal compensation i.e. the expenses of the company. The partners of limited partnerships (as stated above, most funds are limited partnerships in Norway) are registered with the Brnnysund Registers, in which the information is publicly available (also through online databases).
188
Part I
7.2.2.5.
Management and disclosure of conflicts of interest Directors Under Norwegian companies law, the management of the company shall act with due care and promote the interests of the company and the shareholders joint interest. Private equity firms The same rules apply.
7.2.2.6.
Prevention of money laundering Regulations on measures to combat the laundering of proceeds of crimes etc. (Money Laundering Regulations), laid down by the Ministry of Finance on 10 December 2003 in pursuance of the Act on measures to combat the laundering of proceeds of crime etc., (No. 41 of 20 June 2003, Money Laundering Act) sections 5, 6, 8, 10, 15, 18 and 19. Cf. EEA Agreement annex IX No. 14 (Directive 2000/12/EC) and No. 23 (Directive 91/308/EEC as amended by Directive 2001/97/EC), incorporates the Third Money Laundering Directive into Norwegian law.
7.2.3. Information and consultation of workers 7.2.3.1. Information and consultation of employees whenever the control of the undertaking or business is transferred The Norwegian Working Environment Act of 17 June 2005 No. 62 contains provisions on information and consultation of the employees. General provisions, which implement the ICE Directive, are given in Chapter 8 for undertakings that regularly employ at least 50 employees. The employer is obliged to provide information concerning issues of importance for the employees working conditions and discuss such issues with the employees elected representatives. The obligation to inform and consult includes the current and expected development of the undertakings activities and economic situation, the current and expected workforce situation, decisions that may result in considerable changes in the organisation. Provisions on information and consultations prior to dismissals and collective redundancies are given in Chapter 15, section 15-1 and 15-2. Prior consultations with the employee representatives and filing a specified notice to the Labour and Welfare Service (NAV) are mandatory in the event of a collective redundancy. The employer is furthermore obligated to inform and consult the employee representatives and the employees in the case of and prior to a transfer of undertaking, cf. Chapter 16, (Section 16-5 and 16-6). The Norwegian Companies Act of 13 June 1997 No. 44 section 6-4 and 6-5 contains provisions on the employees right to elect members to the companys board of directors. For information on collective agreements, see 7.3.3 below.
189
7.2.3.2.
Disclosure and explanation of investment strategies and risks to investee companies There is no separate legal obligation to discuss investment strategies with the employees of investee companies, unless the situation is covered by the general provisions mentioned above in 7.2.3.1.
7.2.3.3.
Transfer of undertakings directive in relation to leverage buyouts In an LBO there is usually no change in the identity of the employing company, and therefore such an LBO does not have any effect on the employment relationship, or employees terms and conditions. The employer is furthermore obligated to inform and consult the employee representatives and the employees in the case of and prior to a transfer of undertaking, cf. Chapter 16, (Section 16-5 and 16-6.) as described above in 7.2.3.1.
7.2.4. Asset stripping and capital depletion 7.2.4.1. Prevention of asset stripping through common rules on capital maintenance Norwegian companies law and the Bankruptcy Act of 1984 provide some mechanisms to prevent asset stripping and capital depletion, for example: Under Norwegian companies law, the Board of Directors is obliged to act in the interest of the Company. Further, according to the Companies Act, the Board of Directors, a shareholders meeting or the Managing Director may not adopt any resolution which may tend to give certain shareholders (or others) an unreasonable benefit at the expense of the Company or other shareholders. The Companies Act defines and restricts the ways capital is distributed to shareholders. The company may only distribute the annual profit according to the adopted income statement for the last financial year and other equity, after deduction of, inter alia, uncovered losses; R&D, goodwill and net deferred tax benefits accounted for, and total nominal value of own shares. In no case may dividends be declared in excess of an amount which is compatible with careful and good business practice, with due regard for any loss which may have occurred after the last balance sheet date, or which may be expected to occur. Under the Companies Act, a Member of the Board of Directors and the Managing Director is liable in damages for the loss that he or she has intentionally or negligently caused the company, a shareholder or others. Under the Companies Act, it is the Board of Directors responsibility to ensure that the company at all times has an equity which is adequate in terms of the risk and scope of the companys business. If the equity is presumed to be less than this requirement, then the Board of Directors shall forthwith deal with the matter. The same action shall be taken if the companys equity is assumed to be less than half the share capital. The Companies Act also provides for financial assistance rules preventing the company from making funds available or grant a loan or issue security for the purpose of any acquisition of shares or the right to shares in the company or the companys parent company. The Bankruptcy Act contains a mechanism to recover funds that have been used in transactions favouring certain creditors and/or causing insolvency of the company.
190
Part I
7.2.5. Limits on leverage (that are sustainable for the private equity fund/firm and the target company) The level of leverage has an impact on the tax deductibility of the investors interest payments (thin capitalisation rules). No company may obtain tax deductibility beyond what would be in line with sound market practice (often, as a thumb figure, said to be approximately 80:20). The issue is mostly governed by the tax authorities practice and there are no statutory provisions in this respect. 7.2.6. Compensation structure 7.2.6.1. Transparency of the compensation structure (to investors and authorities) Fees and carried interest are subject to negotiations and will be set forth in fund documentation. As regards disclosure in connection with marketing a fund, see 7.2.2.2. 7.2.6.2. Transparency of managers remuneration systems The Board of Directors decides the remuneration for the managing director, and the managing director decides the remuneration for the other managers (within any guidelines given by the Board of Directors through the budget or otherwise). Shareholders may generally not directly affect the remuneration of the company personnel in other ways than by exercising their power in appointing the board members. As regards decisions on stock options (or issuance of shares), such decisions are to be made by the general meeting. However, the general meeting may authorise the Board of Directors to decide on issuances within limits specified in advance by the general meeting. Board members remuneration must, under the Companies Act, be approved by the general meeting.
7.3.
7.3.1. Capital requirements 7.3.1.1. At the level of management companies (operational risk) There are usually no additional requirements, because investors are happy to rely on the legal rules referred to in paragraph 7.2.1 above. 7.3.1.2. At the level of the funds - investment vehicle (exposure risk) Fund size if usually subject to negotiations (and documentation may provide for a minimum and a maximum size). However, as regards capital requirements for the fund entity as such there are usually no requirements in addition to the ones referred to in paragraph 7.2.1. above because investors are happy to rely on the legal rules. 7.3.2. Contractual disclosure and monitoring 7.3.2.1. Disclosure and explanation of investment strategies and risk to investors (sophisticated and retail) Funds are typically marketed, both to retail and sophisticated investors, pursuant to a document known as a private placement memorandum which will contain detailed disclosure of the funds investment strategy and related risks. Fund agreements typically provide for annual and semi-annual or quarterly reports to investors.
191
Portfolio companies of private equity funds furthermore generally have contractual obligations vis--vis lenders to provide information on economic performance etc. 7.3.2.2. Contractual clauses covering lock-up periods, cancellation and termination Private equity funds are typically closed-ended which means that investors have no ability to require repayment of their investment during the life of the fund. Consequently, lock-up periods and conditions governing cancellation and termination are not relevant to most private equity funds. The fact that investors have no ability to redeem and will only receive a return on their investment in the fund as and when the funds underlying investments are realised is usually very evident in fund agreements and the placement memorandum. Many funds allow for termination of the management contract in the event of an investor vote, or in the case of fraud or gross negligence. These provisions are extensively negotiated with investors and vary from fund to fund. They also typically include rights for the investors to suspend the funds ability to make investments if the management team is subject to extensive changes or if there is a change of control. Investors typically have downside protections which are heavily negotiated. 7.3.2.3. Register and identify shareholders See paragraph 7.2.2.4 above. Typically a funds contractual documents do not extend these disclosure obligations. 7.3.3. Information and consultation of workers 7.3.3.1. Information and consultation of employees whenever the control of the undertaking or business is transferred Collective agreements between an employers association and an employee organization, will also include provisions on information and consultations with employees representatives an employees. Regulations within a collective agreement will usually impose extensive obligations on the employer, similar to the obligations regulated in the Working Environment Act Chapter 8. Collective agreements are binding upon all employers that are members of an employers association, which is a party to the respective agreement. Furthermore, there are certain collective agreements that are binding upon all employers even if these are not members of an employers association. Depending on the company, there may be relevant provisions in employment-related documents or agreements, but typically the employee relies upon the extensive legal rules referred to in paragraph 7.2.3 above. 7.3.3.2. Disclosure and explanation of investment strategies and risks to investee companies There are typically no additional contractual provisions. 7.3.3.3. Transfer of undertakings directive in relation to leverage buyouts There are typically no additional contractual provisions between investors and private equity firms in this regard. Please see paragraph 7.2.3 above.
192
Part I
7.3.4. Asset stripping and capital depletion 7.3.4.1. Prevention of asset stripping through common rules on capital maintenance On an LBO, the banking agreements typically include covenants restricting dissemination in addition to the legal rules restricting this set out in paragraph 7.2.4.1 above. 7.3.5. Limits on leverage (that are sustainable for the private equity fund/firm and the target company) The level of leverage is sustainable for the target company Under most fund agreements, the ability of the fund to borrow (as opposed to the ability of portfolio companies or acquisition vehicles to borrow on a non-recourse to the fund basis) is severely constrained and is usually restricted to bridging, pending the receipt of capital called from investors, to cover a default on a capital call from an investor, and to certain other limited circumstances. 7.3.6. Compensation structure 7.3.6.1. Transparency of the compensation structure (to investors and authorities) The entitlement of a private equity firm to receive compensation in the form of management fees, carried interest (performance fees) or other types of remuneration, will be set out in the fund agreements (to which each of the fund investors is a party). These are heavily negotiated and documented in great detail. The arrangements are, however, confidential to the parties and do not form part of any notification to any regulatory authority. 7.3.6.2. Transparency of managers remuneration systems See 7.2.6.2.
7.4.
The NVCA has a code of conduct and ethical guidelines and each member is required to agree to comply with it. In the event a member breaches the code of conduct or the ethical guidelines, the member may be expelled from the NVCA. The NVCA is currently preparing rules concerning disclosure and transparency which should be approved in the beginning of 2009. The rules will follow the comply or explain principle. 7.4.1. Capital requirements There are no additional rules beyond the extensive legal rules set out in paragraph 7.2.1 above. 7.4.2. Industry imposed disclosure and related monitoring 7.4.2.1. Portfolio companies New rules expected to recommend that the website of portfolio companies with headquarters in Norway shall disclose inter alia the shareholder structure of the company, the line of business and turnover of the company, the members of the board of directors of the company, certain financial reporting and certain major events.
193
7.4.2.2.
Private equity firms The NVCA code of conduct states that members are obliged to provide relevant reports regarding its investment activities in accordance with industry practice. It furthermore obliges the members to contribute information to industry reports conducted or authorised by the NVCA. The NVCAs new recommendations regarding transparency state that the website of private equity firms shall disclose inter alia information on the overall fund and ownership structure, its management, size and specific focus of its funds, investors (classification and geographical investor base), as well as principles applied in relation to valuation and investor reporting and for the settlement of conflicts of interest. The NVCAs new recommendations regarding transparency furthermore state that the website of private equity firms shall disclose with respect to each portfolio company inter alia the name, time of investment, line of business, exits and a reference to the website of the portfolio company.
7.4.2.3.
Enforcement & monitoring In the event a member breaches the disclosure and transparency rules, the member may be expelled from the NVCA. The recommendations on transparency will not be binding but many members of the NVCA are expected to abide by the recommendations.
7.4.2.4.
Coverage of relevant entities The recommendations on transparency will apply to all members of the NVCA making majority or minority investments in portfolio companies. Where a member is subject to similar recommendations issued by another venture capital association it may make appropriate adjustments.
7.4.3. Information and consultation of employees 7.4.3.1. Informing and consulting employees during the transfer of control of undertakings or businesses There are no specific self-regulation rules. 7.4.3.2. Disclosure and explanation of investment strategies and risks to investee companies There are no specific self-regulation rules. 7.4.3.3. Transfer of undertakings directive in relation to leverage buyouts There are no specific self-regulation rules in this respect. Please see paragraph 7.2.3 above. 7.4.4. Asset stripping and capital depletion There are no additional self-regulation rules. However, the NVCA code of conduct requires the members to operate in a responsible manner and not to take any actions that may put at risk the general publics opinion on the private equity industry. Furthermore, the code states that members should take a long term view on value creation and the financial operation of its investments and not engage in short term speculative investment activities. The code also obliges the members to act with specific care in connection with transactions made with private individuals.
194
Part I
7.4.5. Limits on leverage (that are sustainable for the private equity fund/firm and for the target company) Please see 7.4.4 above. 7.4.6. Compensation structure There are no additional self-regulation rules. 7.4.7. Other professional standards The NVCA has endorsed the International Private Equity and Venture Capital Valuation Guidelines (IPEV guidelines)(104) Applicable Accounting Standards (FAS/IFRS depending on company (private/public))
(104)
The International Private Equity and Venture Capital Valuation Guidelines were developed by the Association Franaise des Investisseurs en Capital (AFIC), the British Venture Capital Association (BVCA) and the European Private Equity and Venture Capital Association (EVCA) and were launched in March 2005 to reflect the need for greater comparability across the industry and for consistency with IFRS and US GAAP accounting principles. Valuation guidelines are used by the private equity and venture capital industry for valuing private equity investments and provide a framework for fund managers and investors to monitor the value of existing investments. The new guidelines are based on the overall principle of fair value in order to be consistent with IFRS and US GAAP.
195
8.
8.1.
Spain
Introduction
Pursuant to Spanish Law, Private Equity Entities are financial entities whose main corporate purpose consists of acquiring temporary stakes in the share capital of non-financial companies, which are neither engaged in real estate nor at the time of acquiring the stake are listed (105) on the primary stock exchange or any other equivalent regulated market of the European Union or the remaining members of the Organisation for Economic Cooperation and Development (OECD). In Spain there are two types of vehicles specially designed for investing in private equity: The Private Equity Fund (Fondo de Capital Riesgo or FCR), which is an independent pool of assets divided into units held by a plurality of investors. FCRs lack legal personality and, thus, they must be managed by a management company; and The Private Equity Company (Sociedad de Capital Riesgo or SCR) is a public limited company which has legal personality and may choose either to be managed by a management company or be self-managed. Private Equity Vehicles (ECRs), this is, FCRs and SCRs, may adopt two forms, Simple Regime ECR (rgimen simplificado) or Common Regime ECR (regimen comn). Simple Regime ECRs operate under a more flexible administrative procedure, both regarding the legal requirements and timing for approval. To qualify as a Simple Regime ECR, the following requirements must be met: (i) minimum commitment of EUR 500,000 per investor, except institutional investors (106); (ii) maximum of 20 investors (not counting institutional investors, directors and employees of the ECR/SGECR); and (iii) strictly private placement of quotas in the FCR. If the ECRs do not comply with these requirements they shall be treated as Common Regime ECRs which are normally used for public placements and retail investors. The management companies of ECRs (Sociedades Gestoras de Entidades de Capital Riesgo or SGECRs) are Spanish public limited companies whose main corporate purpose is the management of private equity entities, whether they are FCRs or SCRs. Pursuant to Spanish Law, Collective Investment Institutions (Instituciones de Inversin Colectiva) may also carry out the management of FCRs and SCRs. Spanish Private Equity Entities, ECRs and SGECRs (PEEs) are regulated and supervised by the Spanish Securities Market Commission (Comisin Nacional del Mercado de Valores or CNMV). The national industry body is ASCRI (Asociacin Espaola de Entidades de Capital Riesgo) with 106 members of which 28 are also members of EVCA.
(105) (106)
In Spain, public to private transactions are permitted. Pursuant to Spanish Law, institutional investors are: (a) any legal entity authorised or regulated to operate in the financial markets (i.e. credit institutions, investment firms, insurance companies etc.); (b) national and regional governments, central banks, international and supranational institutions; and (c) legal entities which are neither small nor medium companies.
196
Part I
8.2.
Governed by law/regulation Spanish Private Equity Law Spanish Private Equity Entities are primarily regulated by Law 25/2005 regarding private equity entities and their management companies (Ley 25/2005, de 24 de noviembre, reguladora de las Entidades de Capital-Riesgo y sus Sociedades Gestoras or the Spanish Private Equity Law). In order to carry out private equity activities in Spain, PEEs must be authorised and approved by the CNMV, and registered in its special register. PEEs are subject to the supervision of the CNMV and non-compliance with the Spanish Private Equity Law may lead to regulatory sanctions by the CNMV or ultimately the loss of the CNMV authorisation. Moreover, the CNMV may pursue criminal charges against individuals where appropriate. Money laundering obligations are regulated and supervised by a special body of the Bank of Spain, the Commission of Anti-money Laundering and Monetary Infractions (Comisin de Prevencin del Blanqueo de Capitales e Infracciones Monetarias or Sepblac). Other key legislation/regulations Besides the Spanish Private Equity Law, other provisions are applicable to PEEs: Circular of the CNMV 11/2008 regarding accounting rules and financial statements of PEEs (Circular 11/2008, de 30 de diciembre, de la Comisin Nacional del Mercado de Valores, sobre normas contables, cuentas anuales y estados de informacin reservada de las entidades de capital-riesgo). Circular of the CNMV 7/2008 regarding accounting rules and financial statements of PEEs (Circular 7/2008, de 26 de noviembre, de la Comisin Nacional del Mercado de Valores, sobre normas contables, cuentas anuales y estados de informacin reservada de las Empresas de Servicios de Inversin, Sociedades Gestoras de Instituciones de Inversin Colectiva y Sociedades Gestoras de Entidades de Capital-Riesgo). Circular of the CNMV 5/2000 regarding accounting rules and financial statements of PEEs (Circular 5/2000, de 19 de septiembre, de la Comisin Nacional del Mercado de Valores, sobre normas contables y modelos de estados financieros reservados y pblicos de las entidades de capital riesgo y de sus sociedades gestora). Collective Investment Institutions Law (Ley 35/2003, de 4 de noviembre, de Institucionesd e Inversin Colectiva) and its implementing regulations. Public Limited Companies Act (Public LCA) applicable to SGECRs and SCRs in relation to aspects not regulated by the Spanish Private Equity Law (Texto refundido de la Ley de Sociedades Annimas, aprobado por Real Decreto Legislativo 1564/1989, de 22 de Diciembre como regimen supletorio par alas SCRs), and also to portfolio companies in the form of public limited companies (Sociedad Annima or S.A.). Private Limited Liability Companies Act (Private LLCA and, together with the Public LCA, Corporate Laws) (Ley 2/1995 de 23 de marzo, que regula las Sociedades de Responsabilidad Limitada), applicable to portfolio companies in the form of private limited companies (Sociedad Limitada or S.L.). Securities Market Law (Ley 24/1988. de 28, del Mercado de Valores).
197
Law 19/1993 on measures against money laundering (Ley 19/1993, de 28 diciembre sobre determinadas medidas de prevencin del blanqueo de capitales, modificada por la Ley 19/2003, de 4 de Julio). Royal Decree 217/2008 regarding financial services companies which implements the MiFID Directive (Real Decreto 217/2008, de 15 de febrero, sobre el rgimen jurdico de las empresas de servicios de inversin y de las dems entidades que prestan servicios de inversin y por el que se modifica parcialmente el Reglamento de la Ley 35/2003, de 4 de noviembre, de Instituciones de Inversin Colectiva, aprobado por el Real Decreto 1309/2005, de 4 de noviembre).
8.2.1. Capital requirements 8.2.1.1. At the level of management company Pursuant to the Spanish Private Equity Law, SGECRs shall have minimum share capital of EUR 300,000 which shall be fully paid up at the time of incorporation. 8.2.1.2. At the level of the funds investment vehicle Different capital requirements are provided for FCRs and SCRs: FCRs must have minimum net equity of EUR 1,650,000 which shall be fully paid in cash at the time of constitution; and SCRs must have a minimum share capital of EUR 1,200,000 and at least half of it shall be paid up at the time of incorporation. The balance shall be paid within three years of its incorporation. In addition, the Spanish Private Equity Law provides diversification obligations in order to reduce exposure risk: ECRs must invest at least 60% of their assets in shares or units of portfolio companies. ECRs may not invest more than 25% of their assets in a single portfolio company, or more than 35% of their assets in portfolio companies of the same group. However, these limits are increased to 40% in the case of Simple Regime ECRs. Notwithstanding the above, these requirements do not apply during the first three years following the ECRs incorporation or during a period of 24 months from the date of a divestment as a consequence of a breach of the above diversification obligations. In the case of Common Regime ECRs, the Minister of Economy and Finance and the CNMV, may establish limitations to the investment in certain types of assets or activities, such as a minimum liquidity ratio to be maintained. 8.2.1.3. At the level of portfolio companies Corporate Laws in Spain also require minimum share capitals for portfolio companies, being EUR 60,101 for S.A. companies and EUR 3,006 for S.L. companies. In specific industries, such as financial or insurance, there are additional requirements and minimum share capital figures are higher.
198
Part I
8.2.1.4.
General capital requirements applicable to SGECRs, SCRs or portfolio companies Under Spanish law, in order for the share capital figure to reflect the reality of the capitalisation of a company, the net equity of a company cannot be reduced, due to accumulated losses, to an amount of less than half its share capital. If a company incurs in such a situation of net equity shortfall, and does not solve it by means of reducing the net equity figure, increasing the share capital figure or compensating losses, its directors will have to mandatorily propose the general meeting of shareholders to dissolve the company. If the directors fail to do so, they will become jointly and severally liable for the debts incurred by the company after the net equity shortfall situation has been identified. It is worth highlighting that, for the purposes of calculating the net equity shortfall, participating loans can be considered as net equity, provided that (i) the loans are of a subordinated nature in the event of insolvency or liquidation, (ii) their interest rates are, at least partially, made dependent on the evolution of the activity of the company and (iii) early repayments are only permitted if an amount equal to that repaid is contributed to the net equity.
8.2.2. Regulatory disclosure and related monitoring 8.2.2.1. Overview Spain imposes reporting and supervision requirements upon regulated entities including the requirement for such entities to prepare and file periodic financial statements and reports with the CNMV or the Bank of Spain. Disclosure obligations may vary depending on whether the entity is a Simple Regime ECR or a Common Regime ECR. With regard to portfolio companies, as they are not regulated by the CNMV, the only disclosure obligations are provided by the Commercial Registry regulations as, every year, Spanish companies must file their annual accounts with the Commercial Registry for them to be publicly available. Such annual accounts must be verified by an independent auditor, except if the relevant company is entitled to file abbreviated balance sheets, in which case it is exempted from auditing requirements. This exception does not apply to PEEs. Abbreviated balance sheets may be prepared by companies that within two consecutive financial years satisfy at least two of the following requirements: (i) total amount of assets does not exceed EUR 2,850,000; (ii) net annual turnover does not exceed EUR 5,700,000; (iii) average number of workers employed during the financial year is not greater than 50. In addition, in the event that shareholders representing at least 5% request that the accounts are audited or the Court requests the accounts to be audited, such companies would need to audit the relevant accounts even if they are entitled to file abbreviated balance sheets.
199
8.2.2.2.
Disclosure and explanation of investment strategies and risks to investors (sophisticated and retail) Spanish Private Equity Law requires Common Regime ECRs to publish for circulation among investors an annual report and a prospectus, which must meet the following specifications: (i) The prospectus must be edited by the entity prior to its filing with the administrative registry. (ii) The annual report must contain the annual accounts, the management report and the auditors report. These documents must be filed with the CNMV and made available to the investors at the registered address of the SGECR. The auditors report and audited annual accounts of Common Regime ECRs are available to the public. Moreover, the Spanish Private Equity Law provides that investors in Common Regime ECRs are entitled to request and obtain complete, accurate, precise and permanent information regarding the entity, the value of the shares or units, as well as the stake of the investor in the entity. With respect to Simple Regime ECRs, the above obligations are not specifically set out in the law. However the CNMV, through its internal circulars, has required Simple Regime ECRs to file their audited annual accounts on an annual basis with it. Such audited annual accounts must be at the disposal of the ECRs investors, but do not need to be made available to the public. In the case of SCRs, because they are public limited companies, they also have to file their annual accounts with the Spanish Commercial Registry (Registro Mercantil).
8.2.2.3.
Disclosure and explanation of investment strategies and risks to regulators In Spain, investment strategies must be included in the Memorandum of an FCR (Memoria), Articles of Association (Estatutos Sociales) of an SCR or the Management Regulations (Reglamento de Gestin) of an FCR, which are documents that must be approved by the CNMV prior to the incorporation of such entities. Any amendment to such document requires prior approval by the CNMV and, thus, the CNMV is always aware of the investment strategies which are subject to its supervision. On the other hand, directors of SGECRs are obliged to elaborate and approve, within the first three months of each financial year, the annual accounts, the proposal for the distribution of results and the management report. Such accounting documents must be filed with the CNMV on an annual basis. Furthermore, PEEs must provide the CNMV with as much information as required by the latter, regarding activities, investments, resources, assets, financial statements, investors, economic-financial situation, as well as notify the occurrence of any relevant fact.
8.2.2.4.
Register and identify shareholders Private Equity Entities All the investors in an SCR are registered in the shareholders register of the company while investors in a fund are recorded in the funds register. The identity of investors must be disclosed to the CNMV but is not available to the public. Likewise, at the level of portfolio companies, the identity of their shareholders is recorded in the shareholder register, except in the event that the portfolio company is an S.A. with bearer shares (as opposed to nominative shares).
200
Part I
If an investor, either by itself or through an intermediary, acquires or transfers a significant interest in an ECR (20% of the share capital or patrimonial assets), it shall notify the CNMV of such transfer within ten business days of the relevant transfer. Portfolio Companies Although all corporate resolutions including capital increases have to be filed with the Spanish Commercial Registry, and therefore made available to the public, the identity of the shareholders does not need to be disclosed except in the following circumstances: (i) In S.L. companies, capital redemptions in which contributions are repaid to shareholders require that the identity of the shareholders is filed with the Commercial Registry. (ii) Sole shareholding companies must file a declaration of their sole shareholding status with the Commercial Registry. Finally, foreign investments or divestments in Spanish companies must be declared to the Foreign Investments Registry of the Spanish Ministry of Industry for statistical purposes, and the identity of the foreign investors and their ultimate shareholders must be disclosed. 8.2.2.5. Management and disclosure of conflicts of interest Under Spanish Law, fiduciary duties of the directors include limitations to protect against conflicts of interest with the company in which they are appointed as directors. Such limitations differ depending on the nature of the company: (i) In S.A. companies, which include SCRs, SGECRs and portfolio companies, directors must disclose to the board of directors any situation of direct or indirect conflict they may have with the interests of the company. In the event of conflict, the affected directors must abstain from participating in the transaction to which the conflict relates. In all events, situations of conflicts of interest of the directors will be disclosed in the annual corporate report made public within the annual accounts. (ii) In S.L. companies (i.e. portfolio companies only), conflict of interest limitations are stronger; directors cannot undertake the same or a similar activity to that of the company or render services to the company, unless approved by the general meeting of shareholders. If the director involved is also a shareholder, he must abstain from voting on the relevant resolution. Notwithstanding the above, the Spanish Private Equity Law explicitly allows investments by ECRs in companies of their own group within certain limitations. ECRs may invest up to 25% of their assets in companies belonging to their group or to the group of their management company provided that the following requirements are met: (i) That the articles of association or management regulations contemplate such investments. (ii) That the entity or, as the case may be, its management company, has a formal procedure, contained in its internal conduct regulations, which allows it to prevent conflicts of interest and makes sure that the operation is carried out in the exclusive interest of the entity. The verification of the satisfaction of these requirements is the responsibility of an independent commission created within its board or of an independent body to which the management company entrusts this function. (iii) That the prospectus and the periodic public information of the entity include detailed information about the investments made in group entities.
201
Pursuant to the Spanish Private Equity Law, SGECRs and self-managed SCRs are required to produce an internal conduct regulation (Reglamento Interno de Conducta) in order ensure that such entities have adopted adequate systems and controls necessary to carry out their regulated activity and prevent potential conflicts of interest. Such internal conduct has to be approved by the CNMV prior to the incorporation of such entities. 8.2.2.6. Prevention of money laundering The SGECRs and self-managed SCRs have a specific duty to properly identify its investors in order to comply with the provisions of Law 19/1993 regarding measures against money laundering. Such entities are obliged to implement procedures to guarantee compliance with anti-money laundering laws and regulations and the KYC (Know Your Customer) principle. They also have to produce a manual for all employees which shall include such procedures. Additionally, management companies have to implement, within their structure, a Control Unit (Organo de Control) which will be in charge of all anti-money laundering issues and procedures. The board of directors will appoint a member of the Control Unit as a representative of the management company before the special body of the Bank of Spain, the Sepblac, and must notify the latter of any suspicious transactions or investors. 8.2.3. Information and consultation of workers 8.2.3.1. Informing and consulting employees during the transfer of control or undertakings or businesses The ICE Directive has been duly implemented in Spain through the enacting of Law 38/2007 dated November 6th, which amends the Workers Statute on issues regarding information and consultation of employees and protection of employees in cases of insolvency of employers (Ley 38/2007 que Modifica el texto refundido de la Ley del Estatuto de los Trabajadores, aprobado por Real Decreto Legislativo 1/1995, de 24-3-1995). This law has incorporated new rights regarding the provision of information to and consultation of employees as basic rights and has set out new definitions in connection with such rights. Under Spanish Employment Law, transfers of undertakings are regulated by section 44 of the Legislative Royal Decree 1/1995 of 24 March that regulates the Spanish Workers Statute (WS). Section 44 of the WS imposes an information and consultation obligation upon the Transferor and the Transferee: Information obligation (107) Both the Transferor and the Transferee must provide the legal representatives of their respective employees involved in the transfer with the following information: expected date of the transfer; grounds for the transfer (i.e. the legal basis for the transfer);
(107)
Please note that, although the majority of Spanish case law considers that the legal effect of a failure to comply with the information obligations is an administrative sanction, a sentence of the Supreme Court of Madrid dated 21 December 2005 held the transfer of the business to be null and void due to the fact that the Transferor breached the information obligation. The consequence of such judgement was that the affected employees which had been transferred to the Transferee, had the option to return to their jobs with their former employer (the Transferor).
202
Part I
legal, financial and social consequences for the employees arising from the transfer; and any expected changes in terms and conditions of the employees. If there are no legal representatives involved, this information must be provided directly to the affected employees themselves.
This information must be provided in good time (not defined by the legislation) before the transfer is carried out. Please note that the law does not specify whether the notification must be served before or after the contracts/agreements documenting the transfer. If the transfer occurs as a result of a merger or a spin-off, the information must be supplied, at the latest, at the time the shareholders meetings are convened to approve the merger or spin-off (in Spain the shareholders meeting should be convened with at least 30 days notice). Employees legal representatives have no right to veto or to impose conditions on the transfer of the business. Consultation obligation In the case that the Transferee or the Transferor foresees the adoption of new terms and conditions (i.e. a collective redundancy, geographical transfers etc.) with respect to their respective employees as a consequence of the transfer, a consultation period with the employees legal representatives must be undertaken in relation to the proposed measures and the consequences for the employees. Such consultation period must take place in good time (not defined by the legislation) before the measures are taken. During the consultation process, the parties are obliged to negotiate in good faith with a view to reaching an agreement. Should the measures foreseen consist of collective transfers or substantial collective modifications of working conditions, the procedure for the period of consultations referred to by the preceding paragraph shall adjust to what is set forth in sections 40.2 and 41.4 of the WS. Failure to comply with the aforementioned information and consultation duties does not render the transfer invalid; however, such failure is considered a serious breach which may be sanctioned by the labour authorities with a fine ranging from EUR 626.00 to EUR 6,250.00. Additionally, there are collective bargaining agreements which provide a similar kind of protection to that provided by section 44 WS for cases where a transfer of undertakings does not properly take place but rather a mere transfer of services contracts or sales of part of the business occurs. Typical collective bargaining agreements that include this type of clause would be: Baggage Handling, Cleaning, Security and sometimes also Catering Services. 8.2.3.2. Disclosure and explanation of investment strategies and risks to investee companies Under Spanish Law there are no statutory obligations regarding disclosure of investment strategies and risk to investee companies.
203
8.2.3.3.
Transfer of undertakings directive in relation to leverage buyouts It is very unlikely that there would be a specific extension of TUPE to cover an LBO (i.e. share sale transaction). Such an extension is unnecessary for the following key reasons: (i) There is no change in the identity of the employing company, and therefore no effect on the employment relationship, or employees terms and conditions. (ii) In any event, the courts have adopted a somewhat purposive approach to TUPE. It may therefore apply where, following a share sale, the business is integrated into that of a holding company. In that sense a transfer of undertakings would take place and the information and consultation obligation would have to be followed as set out in point 8.2.3.1 above.
8.2.4. Asset stripping and capital depletion There are no specific regulations in Spain to avoid asset stripping and capital depletion. Nevertheless, fiduciary duties of the directors include their obligation to properly manage the company with the diligence of a responsible businessman and a loyal representative, which means that they would ultimately be liable for any mismanagement of the business, including asset stripping. This limitation applies also to de facto directors, defined as those individuals or corporate entities who have not been appointed as directors but who exercise decisive influence over the management of a company, and, by so doing, subject themselves to the same fiduciary duties and directors liability. Directors shall be liable to the company, the shareholders and the companys creditors for any damage they may cause by their own acts or omissions which are either in breach of the law, in breach of the companys articles of association or performed without due diligence. Therefore, disposal of core assets of a company for the purposes of distributing the resulting proceeds to the shareholders, being materially detrimental to the company and for the benefit of the shareholders, will result in a breach of the directors duties. A company will have a claim against its directors for the direct loss caused to the company as a consequence of the directors misconduct. This corporate action has the purpose of repairing the loss caused to the company. Additionally, shareholders may request the calling of a general meeting for the company to decide upon whether to bring an action for liability of directors and may jointly file an action for liability of directors in defence of the companys interests in the event that the directors do not convene the general meeting requested for such purpose, or where the company does not file the action within one month of the date of passing of the relevant resolution, or else where the resolution was against claiming liability. The companys creditors may bring a claim against the directors where such claim has not been brought by the company or its shareholders, whenever the companys assets are insufficient to pay their claims. In addition to the corporate action, there is also the possibility of an action in favour of shareholders or other third parties (individual action) which has the purpose of repairing the loss caused to them arising from the directors misconduct.
204
Part I
Moreover, the Spanish Insolvency Law (Ley 22/2003, de 9 de Julio. Ley Concursal) sets out several mechanisms to protect companies and creditors from asset stripping and capital depletion. Pursuant to such law, if a company is declared insolvent by a commercial law judge (concurso), the judge may rescind any contract entered into by the company up to 2 years prior to the judicial declaration of insolvency even if there was no fraudulent intention in the transaction. Furthermore, the Spanish Insolvency Law sets out cases in which the directors of the company will be deemed jointly liable to the companys creditors and may be sued under civil law or prosecuted under criminal law, inter alia, insolvency status caused by fraudulent actions or wilful misconduct, breach of accounting obligations or if up to 3 years prior to the judicial declaration of insolvency the company has failed to file its accounts with the Commercial Registry, fraudulent disposal of assets etc. Nonetheless, such liability may be contested and the judges decision may be appealed. 8.2.5. Limits on leverage (sustainable both for the private equity fund/firm and the target company) Under Spanish Law there are no statutory leverage restrictions that apply to private equity entities. Such types of limitations are mostly regulated by the management regulations (Reglamento de Gestin) or shareholders agreement (Pacto de Accionistas) which are contractual in nature. Notwithstanding the above, in the case of Common Regime ECRs, the Spanish Private Equity Law explicitly enables the Minister of Economy and Finance and the National Securities Market Commission to establish limits to external financing that may be obtained by such type of ECRs. As regards target companies, it is worth highlighting that, under Spanish laws, financial assistance regulations might limit the ability of financed vehicles to merge with target companies (which is a common structure used to assign the debt repayment to the target company). However, the Companies Restructuring Law, which has not yet been enacted and is currently in draft form, contains a new regulation on this issue, imposing additional disclosure obligations in the case of mergers in which one of the merging companies has obtained financing in the three previous years to acquire the other merging company. 8.2.6. Compensation structure 8.2.6.1. Transparency of the compensation structure (to investors and authorities) Compensation payable by an ECR to its manager (management fees and carried interest) is fully disclosed to investors in the marketing materials of the ECR and is subject to intensive negotiations. Furthermore, in order to authorise the incorporation of an SGECR or self-managed SCR, a memorandum (Memoria) must be presented to and approved by the CNMV. The Spanish Private Equity Law requires that such document contains a business plan which includes the compensation structure. The memorandum as well as any amendment made to it must always be approved by the CNMV and therefore the latter and other investors are always aware of the current compensation structure. 8.2.6.2. Transparency of managers remuneration systems Under Spanish Law, there is a presumption that members of the board of directors are not remunerated unless expressly provided for in the companys Articles of Association. Where there is such a provision, the remuneration system (i.e. percentage of profits, stock options, specific amount, remuneration in specie etc.) has to be set out clearly and precisely.
205
Applicable rules vary depending on whether the company is a public limited company (Sociedad Annima or S.A.) or a private limited company (Sociedad Limitada or S.L.). With respect to public limited companies, the remuneration may consist of a percentage of the companys profits, stock options or another system (i.e. specific amount, remuneration in specie etc.): (i) If the remuneration consists of a percentage of the profits, such percentage must be expressly stated in the companys Articles of Association (with a maximum limit of 10%). (ii) Stock option plans are proposed by the board of directors and must be approved by the shareholders general meeting. (iii) The amount of the remuneration to be distributed by any other system shall be determined by the board (unless the Articles specifically provide that it should be determined by the shareholders general meeting) and disclosed in the Annual Memorandum of the company (Memoria Anual). Such Memorandum, whether formulated in full or abbreviated form, shall include the amount of every directors and managers salary, expenses and any other type of remuneration payable during each financial year. The Memorandum, along with the balance sheet, must be approved by the shareholders general meeting and then filed with the Commercial Registry on an annual basis and, thus, they are available to the public. As regards private limited companies, if the remuneration consists of a percentage of the profits (again, with a maximum limit of 10%), such percentage shall be determined in the Articles of Association. On the other hand, amounts distributed under any other remuneration system shall be determined and approved every year by the general shareholders meeting. Managers remuneration systems are also included in the memorandum (Memoria) of the SGECRs or SCRs which have to be approved by the CNMV and, thus, the CNMV is always aware of the remuneration system of managers.
8.3.
8.3.1. Introduction SGECRs are governed by several contractual agreements which generally include the companys Articles of Association and a shareholders agreement. FCRs are governed by Management Regulations (Reglamento de gestin or LPA) which is a binding legal agreement entered into by the SGECR and the investors which must be authorised by the CNMV prior to its constitution. Any amendments agreed thereafter need to be filed with the CNMV and certain amendments may require the authorisation of the CNMV. The LPA provides the terms and conditions of the FCR, the subscription of its quotas and the rights attributed thereto, the allocation and distribution of proceeds and other private equity funds standard provisions (fees, investor protection measures etc.).
206
Part I
SCRs are governed by the companys Articles of Association which include the main terms and conditions of the SCR and which shall be authorised by the CNMV similarly to the FCRs LPA. As the Articles of Association cannot include the standard provisions of an LPA, it is very common for the manager of an SCR and its investors to enter into a shareholders agreement which sets out private equity funds standard provisions (fees, investor protection measures etc.). Conversely to the LPA of an FCR, shareholders agreements are not subject to the supervision of the CNMV. Together with the above-mentioned agreements, other contracts to bear in mind in the Private Equity industry in Spain would be agreements for the acquisition of portfolio companies or agreements with financial entities financing such acquisitions. 8.3.2. Capital requirements 8.3.2.1. At the level of management companies There are no additional requirements, further to the legal rules referred to in part 1 above. 8.3.2.2. At the level of the funds investment vehicle There are usually no additional requirements. 8.3.2.3. At the level of portfolio companies Financial entities providing financing for the acquisition of portfolio companies, which repayment obligations commonly end at the level of such portfolio companies, contractually impose capital requirements in the form of limitations to capital redemptions and requiring capital ratios. 8.3.3. Contractual disclosure and monitoring 8.3.3.1. Contractual disclosure and explanation of investment strategies and risks to investors (sophisticated and retail) Pursuant to the Spanish Private Equity Law, a summary of the funds investment strategy shall be included in the LPA (for FCRs) and the Articles of Association (for SCRs) and generally both documents are distributed to the investors prior to entering into the subscription agreement. If necessary, a more detailed description of the investment strategies together with the investment risks can be disclosed in the Private Placement Memorandum or PPM (if issued by the manager (108)) or other marketing materials. If no PPM is issued or no marketing materials are provided, the investment risks are included in the subscription agreement. SCRs include the funds investment strategy in the Articles of Association and investment risks are disclosed in the PPM (if issued by the manager) or other marketing materials. If no PPM is issued or no marketing materials are provided, the investment risks are included in the subscription agreement. 8.3.3.2. Contractual clauses covering lock-up periods, cancellation and termination FCRs and SCRs are typically closed-end funds. Investors have no ability to require repayment of their investment during the life of the fund. The PPM or other marketing materials issued, and the subscription agreement include specific risk factors and clauses dealing with this.
(108)
Spanish private equity funds do not always issue a PPM and when issued they are often drafted in English and addressed to international institutional investors.
207
Many funds allow for termination of the management contract in the event of an investor vote (no fault divorce), or in the case of fraud or gross negligence. These provisions are extensively negotiated with investors and vary from fund to fund. They also typically include rights for the investors to suspend the funds ability to make investments if certain key executives or the management team have breached their exclusive dedication commitment or if there is a change of control. Investors typically have extensive downside protections which are heavily negotiated. 8.3.3.3. Register and identify shareholders See paragraph 8.2.2.4 above. Funds documents do not normally extend to such disclosure obligations, but rather provide for the confidentiality of investors. 8.3.4. Information and consultation of employees 8.3.4.1. Informing and consulting employees during the transfer of control of undertakings or businesses These are compulsory statutory obligations and cannot be waived by the parties. In that sense, please see section 8.2.3 above. 8.3.4.2. Disclosure and explanation of investment strategies and risks to investee companies There are generally no additional contractual provisions. 8.3.4.3. Transfer of undertakings directive in relation to leverage buyouts In Spain, there are typically no additional contractual provisions other than those provided in the Law. 8.3.5. Asset stripping and capital depletion Management regulations of private equity funds (FCRs) and shareholders agreements of private equity companies (SCRs) may include leverage limitations. Such documents are subject to negotiation with investors. 8.3.6. Limits on leverage (that are sustainable for the private equity fund/firm and for the target company) In practice, the ability of ECRs to borrow funds (as opposed to the ability of portfolio companies or acquisition vehicles to borrow on a non-recourse to the fund basis) is severely constrained by the LPA and the shareholders agreement and is often restricted to bridging, pending the receipt of capital called from investors, to cover a default on a capital call from an investor, and to certain other limited circumstances. At the level of portfolio companies and the financing of their acquisitions, the financial entities always require covenants on debt ratios. 8.3.7. Compensation structure 8.3.7.1. Transparency of the compensation structure (to investors and authorities) As well as being disclosed in the funds marketing materials, the entitlement of the FCR/SCR to receive compensation in the form of management fees, carried interest (performance fees) or other types of remuneration (such as portfolio company monitoring fees, directors fees, financing fees etc.), is negotiated and documented in great detail in the limited partnership agreement/ shareholders agreement. Such documents are the main contractual documents relating to the fund and are entered into by all the investors and the manager.
208
Part I
However, as mentioned previously, only the LPA and the Articles of Association shall be approved by the CNMV and shall be subject to its supervision. Thus, arrangements included in the shareholders agreement of an SCR will not be disclosed to or be subject to the supervision of the CNMV. 8.3.7.2. Transparency of managers remuneration systems In Spain, the remuneration of directors and managers is not usually disclosed in any contractual documents between the management company and private equity entitys investors and/or target companies. 8.3.8. Management and disclosure of conflicts of interest Specific provisions in this regard are included in the LPA/shareholders agreement and any conflicts of interest must be submitted for the approval of an investor committee or a board of directors composed by investors. 8.3.9. Prevention of money laundering The LPA/shareholders agreement and subscription agreements acknowledge that the manager is subject to certain anti-money laundering and KYC obligations and that for these purposes investors may be required to disclose certain information requested by the manager.
8.4.
In Spain, ASCRI has not been very active in setting local industry professional standards, and thus, most private equity entities apply the EVCA guidelines (International Private Equity and Venture Capital Valuation Guidelines and EVCA Reporting Guidelines 2009).
209
9.
9.1.
Sweden
Introduction
Private equity firms in Sweden (which for the purpose of this memorandum are defined as firms managing or advising and/or operating closed end funds), are not specifically regulated under Swedish securities markets legislation as opposed to e.g. mutual funds. Private equity firms are thus subject to the same legal framework as companies in general, including relevant pan-European and/or international law, regulations and professional standards. The national industry body is the SVCA (Swedish Private Equity and Venture Capital Association), the members of which are entities active in the Swedish private equity and venture capital markets. The SVCA currently has 211 members and 90 associated members (the latter include advisers and other parties with an interest in the private equity business). The SVCA furthermore accepts as its associate members communities or private individuals who play a part in the development of the industry in Sweden.
9.2.
The most common legal structures used for private equity firms domiciled or operating in Sweden are foreign and Swedish limited partnerships and Swedish limited liability companies. There is no legislation specific to private equity firms in Sweden. Depending on the form in which a private equity firm is set up (see further below) and the type of investors the private equity firm has, it will be subject to the same legislative and regulatory requirements as are applicable to any other entity with similar structure, investing in similar assets and seeking capital from the same type of investors. Thus, e.g. the Swedish Companies Act will apply to any private equity firm set up in the form of a limited liability company. Typically, managers of private equity firms are not regulated entities under Swedish law as private equity firms are not investing, in or giving advice with respect to investments in, financial instruments and as the investors of private equity firms are generally professional investors. It should be noted, however, that many of the market participants interacting with private equity firms and thereby affecting the operations of private equity firms, such as investment banks and providers of credit, are regulated entities and thus subject to authority supervision. The few Swedish private equity firms that are listed are set up as limited companies and are required to comply with the rules applicable to public limited companies and listing requirements of, and other regulation applicable to, the relevant exchange on which they are traded. Where a Swedish company is acquired by a private equity firm in a public to private transaction, the takeover rules of the applicable market place will also apply.
210
Part I
9.2.1. Capital requirements 9.2.1.1. At the level of management companies (operational risk) Management and advisory companies of Swedish private equity funds are generally limited companies and as such subject to the general capital requirements applicable to all limited companies. Swedish limited liability companies which are private (the form most commonly used for private equity firms) require a minimum capital of SEK 100,000. As further described below, if the equity of a private equity firm set up in the form of a limited liability company is reduced below 50% of the registered share capital, it shall, if the capital is not restored within a certain period, be liquidated. 9.2.1.2. At the level of the funds - investment vehicle (exposure risk) For funds set up as limited liability companies, the minimum capital is as set out above SEK 100,000. If a fund is set up as a public limited company, e.g. because it is listed, the statutory minimum capital requirement is SEK 500,000. There are no minimum capital requirements for Swedish limited partnerships, although the capital commitments of partners are required to be registered with the Swedish Companies Register. 9.2.2. Regulatory disclosure and related monitoring 9.2.2.1. Overview Private equity firms are not subject to any specific disclosure or monitoring obligations in addition to those applicable to other Swedish companies. The Companies Act requires Swedish limited liability companies to file audited financial statements with the Company Register so any private equity firm comprising or including a Swedish limited liability company, or any portfolio company owned by a private equity fund will be bound by these provisions. Swedish limited companies and limited partnerships furthermore need to be registered with the Swedish Companies Register. 9.2.2.2. (Mandatory) Disclosure and explanation of investment strategies and risks to investors (sophisticated and retail) Private equity funds admitted to listing on a regulated market or offered to a broad range of investors (and certain exceptions are not applicable) need to include in their prospectus details of their investment objective and policies and prominent disclosure of risk factors specific to it or its industry. A prospectus would need to be approved by the Swedish Financial Supervision Authority (the SFSA). 9.2.2.3. Disclosure and explanation of investment strategies and risks to regulators See 9.2.2.1 and 9.2.2.2. 9.2.2.4. Register and identify shareholders According to the Swedish Companies Act, limited liability companies need to have a share register and a shareholders register, in which the owner of every share is identified. The share register and the shareholder register shall be kept accessible to everyone at the head office of the company. Everyone has the right to receive copies of the share register, the shareholders register or parts thereof against a nominal compensation i.e. the expenses of the company.
211
The partners of Swedish limited partnerships are noted in the Swedish Companies Register which information is publicly available (also through online databases). 9.2.2.5. Management and disclosure of conflicts of interest Private equity firms are not subject to any specific regulations regarding conflicts of interest in addition to those applicable to other Swedish companies. Under the Swedish Companies Act, the directors of the company shall act with due care and promote the interests of the company. 9.2.2.6. Prevention of money laundering The Third Money Laundering Directive has been transposed into Swedish law. 9.2.3. Information and consultation of employees 9.2.3.1. Informing and consulting employees during the transfer of control of undertakings or businesses There are a number of statutory and other binding mechanisms through which employee information and consultation may be required in Sweden, for example: Consultation obligations Swedish employment law states that an employer is obliged to consult with an employees trade union regarding a transfer of business from one employer to another, a termination due to redundancy, or matters which specifically relates to the employees working or employment conditions, inter alia, re-deployment. If the employer is bound by a collective bargaining agreement, the consultation obligation is broader. The employer is in such case obliged to consult with the trade unions with which the employer is bound by collective bargaining agreement not only regarding matters which relates to individual employees, but also prior to making any decisions regarding significant changes in its activities, for example decisions on reorganising the companys business. The union consultations need to be completed before the employer makes any decision regarding the matter at hand, but the trade unions have no right to veto against the employers decision. Board representation Trade unions with which an employer is bound by collective bargaining agreement have, provided that the number of employees in the company exceeds 25, a right to appoint employee representatives to the board. The employee representatives of the board have the same rights and obligations as all other members of the board. 9.2.3.2. Disclosure and explanation of investment strategies and risks to investee companies There is no separate legal obligation to discuss investment strategies with the employees of investee companies except for situations in which the strategy itself would imply collective redundancies. As set out above, however, employees are in many cases entitled to board representation and the representatives on the board would naturally be privy to this type of information and part in discussions and decisions in relation thereto.
212
Part I
9.2.3.3.
Transfer of undertakings directive in relation to leverage buyouts In an LBO there is usually no change in the identity of the employing company, and therefore such an LBO does not have any effect on the employment relationship, or employees terms and conditions. The TUPE directive has been implemented in Sweden and consequently, if an LBO would be performed as a transfer of assets the employees of the business which is subject to the transfer will have a right to be transferred to the purchaser.
9.2.4. Asset stripping and capital depletion 9.2.4.1. Prevention of asset stripping through common rules on capital maintenance The Companies Act and the Bankruptcy Act provide some mechanisms to prevent asset stripping and capital depletion, for example: The Companies Act provides that the Board of Directors is obliged to act in the interest of the Company and that the Board of Directors, a shareholders meeting or the Managing Director may not make decisions favoring one shareholder (or a third party) at the expense of the Company or other shareholders. The Companies Act defines and restricts the ways capital is distributed to shareholders. Other transactions that reduce the assets of the company or increase its liabilities without a sound business reason shall constitute unlawful distribution of assets. Under the Companies Act, a Member of the Board of Directors, and the Managing Director is liable in damages for the loss that he or she, in violation of the duty of care referred to in Companies Act has in office deliberately or negligently caused to the company. Such persons are also liable for the loss that they in violation of other provisions of the Companies Act or the Articles of Association deliberately or negligently cause to the company, a shareholder or a third party. Under the Companies Act, a voluntary liquidation of a company is required if the equity of the company has been reduced below 50% of the registered share capital and has not been restored in full within a certain period. Board representatives that do not take the required measures where a companys equity is negative may incur a personal liability for debts incurred by the company after such date. The Companies Act provides for financial assistance rules preventing an acquiring company from using the assets of the target company to pay the purchase price or using such assets as collateral for acquisition finance. The Bankruptcy Act contains a mechanism to recover funds that have been used in transactions favoring certain debtors and/or causing insolvency of the company. 9.2.5. Limits on leverage (that are sustainable for the private equity fund/firm and the target company) There is no statutory restriction on leverage for Swedish limited companies or limited partnerships. However, the providers of credit are regulated entities. In addition to capital adequacy requirements, Swedish law requires providers of credit to make a credit assessment prior to granting credit which provides protection against excessive debt ratios. Levels of leverage will furthermore be affected by the ability of the investor to obtain tax deductibility of interest payments, and potentially by anti-avoidance legislation if the borrowing is for an unallowable purpose (i.e. not a business or commercial purpose).
213
9.2.6. Compensation structure 9.2.6.1. Transparency of the compensation structure (to investors and authorities) Compensation payable by a private equity fund to its manager (in the form of management fees and carried interest) will be fully disclosed to investors in the marketing materials for the fund and is the subject of extensive negotiations. 9.2.6.2. Transparency of managers remuneration systems As regards remuneration to the board, the Companies Act stipulates that the shareholders shall in the annual general meeting resolve upon the remuneration to be paid to board members. Furthermore, according the Swedish Annual Reports Act, bonus payments and equivalent compensation payable to members of the board of directors, the managing director, and comparable senior officers must be specified separately in the annual report and consequently are publicly available. According to the Companies Act, decisions on the issuance of stock options (or shares or other equity related securities) are to be made by the shareholders meeting, provided that the shareholders meeting may authorise the Board of Director to decide on issuances within specified limits. Listed private equity funds are subject to specific requirements as regards the scope and disclosure of the details of incentive programmes.
9.3.
9.3.1. Capital requirements 9.3.1.1. At the level of management companies (operational risk) There are usually no additional requirements, because investors are happy to rely on the legal rules referred to in paragraph 9.2.1 above. 9.3.1.2. At the level of the funds - investment vehicle (exposure risk) Fund size if usually subject to negotiations and documentation may provide for a minimum and a maximum size. However, as regards capital requirements for the fund entity as such there are usually no requirements in addition to the ones referred to in paragraph 9.2.1. above because investors are happy to rely on the legal rules. 9.3.2. Contractual disclosure and monitoring 9.3.2.1. Disclosure and explanation of investment strategies and risks to investors (sophisticated and retail) Private equity funds generally cannot be marketed to retail investors unless they are listed. For listed funds, the disclosure of investment strategies and risks is as set out in paragraph 9.2.2.2 above. Unlisted funds are typically marketed pursuant to a document known as a private placement memorandum which will contain detailed disclosure of the funds investment strategy and related risks. Fund agreements typically provide for annual and semi-annual or quarterly reports to investors.
214
Part I
Portfolio companies of private equity funds furthermore generally have contractual obligations vis--vis lenders to provide information on economic performance etc. 9.3.2.2. Contractual clauses covering lock-up periods, cancellation and termination Private equity funds are typically closed-ended which means that investors have no ability to require repayment of their investment during the life of the fund. Consequently, lock-up periods and conditions governing cancellation and termination are not relevant to most private equity funds. The fact that investors have no ability to redeem and will only receive a return on their investment in the fund as and when the funds underlying investments are realised is usually very evident in fund agreements and the placement memorandum. Many funds allow for termination of the management contract in the event of an investor vote, or in the case of fraud or gross negligence. These provisions are extensively negotiated with investors and vary from fund to fund. They also typically include rights for the investors to suspend the funds ability to make investments if the management team is subject to extensive changes or if there is a change of control. Investors typically have downside protections which are heavily negotiated. 9.3.2.3. Register and identify shareholders See paragraph 9.2.2.4 above. Typically a funds contractual documents do not extend these disclosure obligations. 9.3.3. Information and consultation of employees 9.3.3.1. Informing and consulting employees during the transfer of control of undertakings or businesses Depending on the company, there may be relevant provisions in employment-related documents or agreements, but typically the employee relies upon the extensive legal rules referred to in paragraph 9.2.3 above. 9.3.3.2. Disclosure and explanation of investment strategies and risks to investee companies There are typically no additional contractual provisions. 9.3.3.3. Transfer of undertakings directive in relation to leverage buyouts Please see 9.2.3.3 above. In Sweden the provisions of the Transfer of undertakings directive are typically not expanded by contractual provisions to apply to situations which are not covered by the directive as the Swedish Act on consultation and information of employees or collective bargaining agreement typically will apply. 9.3.4. Asset stripping and capital depletion 9.3.4.1. Prevention of asset stripping through common rules on capital maintenance On an LBO, the banking agreements typically include covenants restricting dissemination in addition to the legal rules restricting this set out in paragraph 9.2.4.1 above. 9.3.5. Limits on leverage (that are sustainable for the private equity fund/firm and the target company) Under most fund agreements, the ability of the fund to borrow (as opposed to the ability of portfolio companies or acquisition vehicles to borrow on a non-recourse to the fund basis) is severely constrained and is usually restricted to bridging, pending the receipt of capital called from investors, to cover a default on a capital call from an investor, and to certain other limited circumstances.
215
9.3.6. Compensation structure 9.3.6.1. Transparency of the compensation structure (to investors and authorities) The entitlement of a private equity firm to receive compensation in the form of management fees, carried interest (performance fees) or other types of remuneration, will be set out in the fund agreements (to which each of the fund investors is a party). These are heavily negotiated and documented in great detail. The arrangements are, however, confidential to the parties and do not form part of any notification to any regulatory authority. 9.3.6.2. Transparency of managers remuneration systems See 9.2.6.2.
9.4.
The SVCA has a code of conduct and each member is required to agree to comply with it. In 2008, the SVCA furthermore implemented recommendations as regards disclosure and transparency. 9.4.1. Capital requirements There are no additional rules beyond the extensive legal rules set out in paragraph 9.2.1 above. Please see also section 9.4.4 below. 9.4.2. Industry imposed disclosure and related monitoring 9.4.2.1. Portfolio companies The SVCA recommendations state that the website of portfolio companies with headquarters in Sweden shall disclose inter alia the shareholder structure of the company, the line of business and turnover of the company, the members of the board of directors of the company, certain financial reporting and certain major events. 9.4.2.2. Private equity firms The SVCA code of conduct states that members are obliged to provide relevant reports regarding its investment activities in accordance with industry practice. It furthermore obliges the members to contribute information to industry reports conducted or authorised by the SVCA. The SVCA recommendations regarding transparency state that the website of private equity firms shall disclose inter alia information on the overall fund and ownership structure, its management, size and specific focus of its funs, investors (classification and geographical investor base), as well as principles applied in relation to valuation and investor reporting and for the settlement of conflicts of interests. The SVCA recommendations regarding transparency furthermore state that the website of private equity firms shall disclose with respect to each portfolio company inter alia the name, time of investment, line of business, exits and a reference to the website of the portfolio company.
216
Part I
9.4.2.3.
Enforcement and monitoring In the event a member breaches the code of conduct, the member may be expelled from the SVCA. The recommendations on transparency are not binding but many members of the SVCA have undertaken to abide by the recommendations.
9.4.2.4.
Coverage of relevant entities The recommendations on transparency apply to all members of the SVCA making majority or minority investments in portfolio companies. Where a member is subject to similar recommendations issued by another venture capital association it may make appropriate adjustments.
9.4.3. Information and consultation of employees 9.4.3.1. Informing and consulting workers during the transfer of control of undertakings or businesses There are no specific self-regulation rules. 9.4.3.2. Disclosure and explanation of investment strategies and risks to investee companies There are no specific self-regulation rules. 9.4.3.3. Transfer of undertakings directive in relation to leverage buyouts Please see 9.2.3.3 above. There are no specific self-regulation rules in this respect. 9.4.4. Asset stripping and capital depletion There are no specific self-regulation rules in this respect. However, the SVCA code of conduct requires the members to operate in a responsible manner and not to take any actions that may put at risk the general publics opinion on the private equity industry. Furthermore, the code states that members should take a long term view on value creation and the financial operation of its investments and not engage in short term speculative investment activities. The code also obliges the members to act with specific care in connection with transactions made with private individuals. 9.4.5. Limits of leverage (that are sustainable for the private equity fund/firm and for the target company) Please see 9.4.4 above. 9.4.6. Compensation structure There are no additional self-regulation rules. 9.4.7. Other professional standards The SVCAs code of conduct sets out that investment reports to investors should be performed in accordance with industry standards (generally interpreted to include the International Private Equity and Venture Capital Valuation Guidelines). Applicable Accounting Standards (FAS / IFRS depending on company (private / public)).
217
10. The United Kingdom

10.1. Introduction Private equity firms active in the United Kingdom, like other types of asset management organisations, are regulated by the Financial Services Authority (FSA). The national industry body is the BVCA (British Private Equity and Venture Capital Association). There are 220 private equity firms who are members of the BVCA/EVCA and seven EVCA-only UK member firms. As a consequence, private equity firms active in the United Kingdom are governed under the following framework, in addition to relevant pan-European and/or international law, regulations and professional standards: 10.2. Governed by law/regulation FSA Rules The principal legislation relating to the regulation of private equity firms in the United Kingdom is the Financial Services and Markets Act 2000 (FSMA) and instruments made under it (the FSA Rules). Asset management activities, including the activities conducted by private equity firms, are regulated and can only be carried out in the United Kingdom by a person authorised by the Financial Services Authority (FSA) under FSMA. Firms which do not carry out asset management activities in the United Kingdom may still need to be authorised in respect of investment advice and the arranging of deals. Non compliance with the FSA Rules may lead to regulatory sanction, for example a fine (the highest amount fined by the FSA to date is 17million and compensation to customers has been ordered at much higher levels) or ultimately the loss of FSA authorisation and thereby the ability to operate and trade within the financial services sector in the United Kingdom. In addition, the FSA has the power (and is willing to exercise this power) to prosecute criminal charges against individuals where appropriate, with possible jail sentences imposed. FSA Compliance A regulated firm is required to appoint a compliance officer and produce a compliance manual and monitoring programme to demonstrate that the firm has the systems and controls in place which are necessary to carry out its regulated activity. This compliance manual will set the compliance and professional standards for deal executives in private equity firms and is issued to all employees. We are aware of some UK regulated firms with offices in other European jurisdictions, who issue this manual to all of their staff, including those outside the United Kingdom and expect such individuals to observe the requirements laid down. This is typically to ensure the various offices within a group are applying a common minimum standard of conduct, policies and procedures. Senior management are required to fully engage in the compliance of the firm, to ensure that its policies and procedures are up-to-date and to ensure compliance with the FSA Rules. Senior Management Systems and Controls will cover a number of key areas such as (i) the allocation of functions and responsibilities amongst the firms senior managers; (ii) risk management and the annual risk report; (iii) the finance officers and the compliance officers respective roles; (iv) audit and IT systems; (v) business continuity management and (viii) requirements with regard to record keeping.
218
Part I
Employees and management of private equity firms will be expected to adhere carefully to the requirements of the compliance manual, not only because of the personal liability they may incur if they breach the FSA Rules (as referred to above), but also because an express term to this effect may be included in their employment contract. In any event, a breach of the FSA Rules may be sufficient to constitute gross misconduct and give grounds for dismissal from employment. Other key legislation/regulations A small number of private equity funds are listed on the London Stock Exchanges main market. Any such fund, but not the private equity firm that manages it (unless it is also listed), will need to comply with the Listing Rules and the Disclosure and Transparency Rules made by the FSA under FSMA. The principal corporate legislation relating to the regulation of private equity owned companies is the Companies Act 2006 (the Companies Act). For companies in financial difficulties, the Insolvency Act 1986 (the Insolvency Act) also includes important provisions. Where a UK, Channel Island or Isle of Man company is acquired by a private equity firm in a public to private transaction, the City Code on Takeovers and Mergers (the Takeover Code) will also apply (see further paragraph 10.2.3.1 below). 10.2.1.Capital requirements 10.2.1.1. At the level of management companies (operational risk) The United Kingdom imposes capital requirement regulations at the level of the management company for private equity and venture capital funds through the FSA Rules. The FSA Rules are framed under the statutory powers given by FSMA. The FSA Rules provide that every firm must at all times maintain adequate financial resources. The FSA interprets this requirement as meaning that the firms capital, provisions against liabilities, cash and other liquid assets must be sufficient in terms of quantity, quality and availability. Firms must notify the FSA promptly in the event that they may in the foreseeable future fail to continue to meet this requirement. The FSA also imposes further quantitative requirements, which differ from firm to firm based on a fund managers classification and activities. A MiFID Exempt Manager and Operator of a Private equity/Venture Capital fund structured as a collective investment scheme must at all times maintain own funds (i.e. capital subscribed by its owners, less deductions for losses and investments in own shares) of at least 5,000. This is designed to ensure that a fund managers owners will always make sufficient capital contributions to cover any trading loss. A private equity fund manager which is subject to MiFID and the Capital Adequacy Directive is typically required to have own funds of of its annual fixed overheads. The private equity firms compliance manual referred to under the heading FSA Compliance above will detail such regulatory capital requirements and the regulatory returns that will need to be made to the FSA.
219
10.2.1.2. At the level of the funds - investment vehicle (exposure risk) Apart from a requirement that the amount of capital contributed to a UK limited partnership must be registered at the Companys Registry and cannot be repaid before the end of the life of the partnership, there are no capital requirement regulations or limitations at the fund level in the United Kingdom because this aspect is addressed at the level of the management company. Since the manager of the fund has to be an FSA authorised entity and has to meet capital requirement regulations, the fund itself is not subject to such regulations. 10.2.2.Regulatory disclosure and related monitoring 10.2.2.1. Overview The FSA Rules impose reporting and supervision requirements including the requirement for such regulated private equity firms to make quarterly financial returns. The nature and extent of the FSAs supervisory relationship with an individual firm depends on how much of a risk it considers that firm could pose to the FSAs statutory objectives. The framework the FSA uses to assess that risk is called ARROW the Advanced Risk Responsive Operating frameWork. (In November 2006, the FSA published a discussion paper 06/6 - Private equity: a discussion of risk and regulatory engagement. The FSA published its feedback on this discussion paper in June 2007 (feedback statement 07/3). The most significant risks the FSA highlighted in relation to private equity were those posed by (i) market abuse, particularly with respect to public-to private transactions; and (ii) conflicts of interest (see further paragraph 1.2.5 in relation to conflicts). The offence of market abuse is set out in FSMA and the FSAs Code of Market Conduct and relates to qualifying investments admitted to trading on a prescribed market and covers, amongst other things, insider dealing, tipping off and misuse of information. As a result of the review, the FSA is maintaining its focus on market abuse in the context of private equity, both through supervisory interaction with relationship managed firms and ongoing work in its Markets Division. The FSA will be keen to see that market abuse is dealt with sufficiently in a firms compliance manual, including the firms dealing rules and procedures in relation to insider trading and that these policies are affectively upheld.) The Companies Act requires UK companies and LLPs to file audited financial statements at Companies House so any private equity firm comprising or including a UK company or LLP, or any portfolio company owned by a private equity fund will be bound by these provisions. Similarly, if a private equity fund is structured as a UK company (as a number of the listed private equity funds are) then they will also need to comply with these filing requirements. The most common structure for private equity funds established by UK-based firms is the limited partnership. In order to be an English limited partnership, a partnership has to be registered with the Registrar of Limited Partnerships under the Limited Partnership Act 1907 (the Limited Partnership Act). Certain limited partnerships are required to prepare audited financial statements and make them available for inspection under the Partnerships (Accounts) Regulations 2008, which implement a European Directive.
220
Part I
10.2.2.2. (Mandatory) Disclosure and explanation of investment strategies and risks to investors (sophisticated and retail) Under the FSA principles applicable to regulated firms, private equity firms must communicate information to their clients in a way that is clear, fair and not misleading. In addition, private equity funds admitted to listing on a regulated market need to include in their prospectus details of their investment objective and policies and prominent disclosure of risk factors specific to it or its industry. Communications are a key area which will be covered in the private equity firms compliance manual. The manual will set out the rules with regard to financial promotions, non-promotional communications with clients and marketing a fund. The manual will also outline the FSA Rules with regard to returns and notifications to the FSA, detailing the obligations on employees and the compliance officer and the requirements with regard to record keeping. 10.2.2.3. Disclosure and explanation of investment strategies and risks to regulators Under FSA Rules, a regulated private equity firm must establish, implement and maintain adequate risk management policies and procedures, including effective procedures for risk assessment, which identify the risks relating to the firms activities, processes and systems, and where appropriate, set the level of risk tolerated by the firm. 10.2.2.4. Register and identify shareholders The Companies Act requires that every company must keep a register of its members and this must be available for inspection (in most cases at its registered office). Many private equity firms are established as limited liability partnerships under the Limited Liability Partnership Act 2000. Under this legislation, each member must be publicly registered as such with the Registrar of Companies. In respect of private equity funds, as stated in paragraph 10.2.2.1 above, the most common form that such funds take is the limited partnership. The Limited Partnership Act requires that the identity of all partners in an English limited partnership be publicly notified to the Registrar of Limited Partnerships. 10.2.2.5. Management and disclosure of conflicts of interest Directors Under the UK Companies Act, a director must avoid situations in which he has or can have a direct or indirect interest that conflicts with, or may conflict with, the companys interests. This applies, in particular, to the exploitation of property, information or opportunity, and whether or not the company could take advantage of the property, information or opportunity. This duty is not infringed if the situation cannot be regarded as likely to give rise to a conflict of interest or if authorisation has been given by shareholders or independent directors and the correct procedures are followed. Private Equity firms Following the recent FSA review of the private equity market mentioned in paragraph 10.2.2.1 above, the FSA is focusing on conflicts of interest in private equity firms (Capital Markets Bulletin, July 2008). The FSA expects to see tailored arrangements, policies and procedures in place to manage conflicts effectively and senior management should be fully engaged in all aspects of conflict identification and management.
221
The FSA will be keen to see that conflicts policies and management are dealt with effectively in the firms compliance manual and that senior management is fully engaged with this to ensure such policies are being upheld. 10.2.2.6. Prevention of money laundering The Money Laundering Regulations 2007 apply the Third Money Laundering Directive to FSA regulated private equity firms. The FSA follows guidance produced by the Joint Money Laundering Steering Group (JMLSG) which includes a section specifically on private equity. The Proceeds of Crime Act 2002 and the Terrorism Act 2000 which also aim to prevent money laundering also apply to private equity firms. A firms compliance manual will normally address money laundering and terrorist financing. This will include how to report suspicions of money laundering and terrorist financing, customer due diligence procedures, record keeping and the role of the Money Laundering Reporting Officer (MLRO). 10.2.3.Information and consultation of employees 10.2.3.1. Informing and consulting employees during the transfer of control of undertakings or businesses There are a number of mechanisms and bodies through which employee information and consultation may be required in the United Kingdom, for example: Trade unions If a UK employer recognises a trade union, then the scope of the employment-related matters which the employer must negotiate with the trade union representatives (collective bargaining) will be set out in the collective agreement. (Trade Union and Labour Relations (Consolidation) Act 1992) Employee consultative body UK employers with more than 50 employees who receive a valid request from at least 10% of the workforce must negotiate with employee representatives for an agreement on information and consultation of employees in relation to economic and employmentrelated matters. (Information and Consultation of Employees Regulations 2004 (ICE Regulations)) Collective redundancies Where an employer proposes to dismiss as redundant 20 or more employees at one establishment within a 90-day period, the employer must inform and consult with affected employees or their representatives. (Trade Union and Labour Relations (Consolidation) Act 1992) European works council (EWC): If central management of a community scale undertaking or group of undertakings (at least 1,000 employees within the EU and at least 150 in each of two member states) is in the United Kingdom, and a written request is made by 100 or more employees in at least two member states, then central management must set up a negotiating body to negotiate an EWC, or a procedure for information and consultation. (Transnational Information and Consultation Regulations 1999)
222
Part I
Where there is a relevant transfer of an undertaking under TUPE 2006, the transferee (or buyer) and transferor (or seller) must inform and consult representatives (either trade union representatives, or elected representatives) of any of their own employees who will be affected by the transfer or measures taken in connection with it. (Transfer of Undertakings (Protection of Employment) Regulations 2006 (TUPE)) Under the Takeover Code, an offeror is required to cover the likely repercussions on employment, the locations of the offeree companys places of business and its intentions with regard to the continued employment of the employees including any material change in the conditions of employment. Further the board of the offeree company must circulate to the companys shareholders an opinion on the offer which must include the effects of implementation of the offer on employment, the offerors strategic plans for the offeree company and their likely repercussions on employment and the locations of the offeree companys places of business. (The Takeover Code is applicable to UK, Channel Island and Isle of Man companies traded on a regulated market in any of the above jurisdictions, which either have registered offices or have their place of central management and control in the abovementioned jurisdictions.) 10.2.3.2. Disclosure and explanation of investment strategies and risks to investee companies See paragraph 10.2.3.1 above. There is no separate legal obligation to discuss investment strategies with the employees of investee companies. However, this could be required pursuant to one of the employee information and consultation mechanisms summarised in paragraph 10.2.3.1 above (for example, under the terms of an agreement with the employee consultative body, or through the collective redundancy consultation process, if a consequence of the strategy would be the dismissal of more than 20 employees). 10.2.3.3. Transfer of undertakings directive in relation to leverage buyouts It is very unlikely that there would be a specific extension of TUPE to cover an LBO (i.e. share sale transaction). Such an extension is unnecessary for the following key reasons: There is no change in the identity of the employing company, and therefore no effect on the employment relationship, or employees terms and conditions. Although the TUPE information and consultation obligations do not apply to a share sale, there are other UK mechanisms which may be relevant to an LBO. These include a collective redundancy situation, or where there is an existing employee consultative body see paragraph 10.2.3.1 above for further details. In any event, the courts have adopted a somewhat purposive approach to TUPE. It may therefore apply where, following a share sale, the business is integrated into that of a holding company. TUPE was last updated in the United Kingdom in 2006, following a lengthy consultation process. The Government chose not to extend TUPE to cover share sales, which reflects the position under the European Acquired Rights Directive. The European Commission confirmed as recently as July 2007 that it does not consider there to be any justification for extending the ARD to change of control situations, as there is no change in employer.
223
10.2.4.Asset stripping and capital depletion 10.2.4.1. Prevention of asset stripping through common rules on capital maintenance The main protections within the UK company law against so-called asset stripping and other misuse of a directors powers are contained in the UK Companies Act and related legislation. Under the Companies Act a wide variety of fiduciary duties are imposed on directors in carrying out their functions such as the following: A director of a company has a fiduciary duty to act in the way he considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole. In carrying out this duty he must have regard (amongst other matters) to: the likely consequences of any decision in the long term; the interests of the companys employees; the need to foster the companys business relationships with suppliers, customers and others; the impact of the companys operations on the community and the environment; the desirability of the company maintaining a reputation for high standards of business conduct; and the need to act fairly as between members of the company.
Under the Company Directors Disqualification Act 1986, a director of a company can be disqualified for general misconduct, persistent breaches of company legislation, fraud in a winding-up, participating in wrongful trading, or unfitness generally. This includes any misfeasance or breach of fiduciary or other duty by a director, any misapplication of the companys property, and the extent of the directors responsibility for the company entering into any transaction liable to be set aside as being a transaction to defraud creditors, and any failure by the company to comply with the administrative and procedural requirements of the Companies Act in general. Under the Insolvency Act, when a company enters into a transaction at an undervalue and then enters into insolvency within a certain period, the court may make such order as it thinks fit for restoring the position to what it would have been if the company had not entered into that transaction. Also under the Insolvency Act, a company gives a preference to a person if that person is one of the companys creditors or a surety or guarantor for any of the companys debts or other liabilities or the company does anything (or suffers anything to be done) which has the effect of putting that person into a position which, in the event of the company going into insolvent liquidation, will be better than the position he would have been in if that thing had not been done. The court can set aside such a preference (if the company enters into insolvency within a certain period). Under the Companies Act, a transaction must not infringe rules on distributions to shareholders or otherwise constitute an illegal reduction of the companys capital. A dividend declared in excess of a companys distributable profits is unlawful and a reduction of share capital should not affect the creditors of a company adversely.
224
Part I
10.2.5.Limits on leverage (that are sustainable for the private equity fund/firm and the target company) Levels of leverage will be affected by the ability of the investor to obtain tax deductibility of interest payments. This may be limited in the United Kingdom by the transfer pricing rules if the borrowed amount or rate is not arms length, and anti-avoidance legislation if the borrowing is for an unallowable purpose (i.e. not a business or commercial purpose). The UK Government has also proposed the introduction of a possible new worldwide debt cap to prevent international groups from putting a greater amount of debt into the UK part of the group than the group as a whole has borrowed. Draft legislation and guidance have been issued for consultation (December 2008). When considering whether the level of leverage is sustainable, a director will also need to consider his directors duties. As mentioned in paragraph 10.2.4 above, the Companies Act provides that a director of a company has a fiduciary duty to act in the way he considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole. Where a company is insolvent, directors will have an overriding duty to act in the best interests of creditors (and, consequently, the duty to shareholders is subordinated). The Insolvency Act requires directors of companies in financial difficulty to have special regard to matters involving wrongful trading and fraudulent trading. As mentioned in paragraph 10.2.4 above, the Department for Business, Enterprise and Regulatory Reform has the power to apply to the Court for disqualification of directors in various circumstances, including where a director has persistently breached his duties or is involved in fraudulent or wrongful trading. 10.2.6.Compensation structure 10.2.6.1. Transparency of the compensation structure (to investors and authorities) Compensation payable by a private equity fund to its manager (in the form of management fees and carried interest) will be fully disclosed to investors in the marketing materials for the fund and is the subject of extensive negotiations. As referred to in paragraph 10.2.2.2 above, any communication from an FSA regulated private equity firm to its clients must be clear, fair and not misleading and this would include in relation to disclosure of compensation. As above, in the context of funds admitted to listing the FSAs Prospectus Rules require disclosure of fees payable to service providers (which would include any investment manager or adviser) and their method of calculation. 10.2.6.2. Transparency of managers remuneration systems The Companies Act and regulations applying to large/medium sized companies and separate regulations applying to small companies set out information to be given in the notes to the accounts concerning directors remuneration. Small companies are not required to disclose as much information as large/medium sized companies. The information large/medium sized companies must disclose include the aggregate amount of remuneration paid to directors and the aggregate amount of gains made by directors on the exercise of share options. There is no requirement for shareholders to approve remuneration. However, the Companies Act provides that certain transactions between the company and the director require shareholder approval, e.g. (i) substantial property transactions; (ii) loans to directors; (iii) payments for loss of office, or (iv) long term contracts (over 2 years). Shareholders also have the right to receive copies of directors service contracts.
225
10.3. Governed by contractual agreements between parties and related entities 10.3.1.Capital requirements 10.3.1.1. At the level of management companies (operational risk) There are usually no additional requirements, because investors are happy to rely on the legal rules referred to in paragraph 10.2.1 above. 10.3.1.2. At the level of the funds - investment vehicle (exposure risk) There are usually no additional requirements, because investors are happy to rely on the legal rules referred to in paragraph 10.2.1 above. 10.3.2.Contractual disclosure and monitoring 10.3.2.1. Contractual disclosure and explanation of investment strategies and risks to investors (sophisticated and retail) Due to the regulatory status of private equity funds in the United Kingdom, they cannot generally be marketed to retail investors unless they are listed. For listed funds, the disclosure of investment strategies and risks is as set out in paragraph 10.2.2.2 above. Unlisted funds may be marketed to certain categories of sophisticated investor in the United Kingdom. These funds are typically marketed pursuant to a document known as a private placement memorandum (PPM) which will contain detailed disclosure of the funds investment strategy and related risks. 10.3.2.2. Contractual clauses covering lock-up periods, cancellation and termination Unlike hedge funds which are typically open-ended and provide for investor redemptions (subject to restrictions due to lock-up periods or the ability of the fund to suspend redemptions in certain circumstances), private equity funds are typically closed-ended which means that investors have no ability to require repayment of their investment during the life of the fund. Consequently, lock-up periods and conditions governing cancellation and termination are not relevant to most private equity funds. The fact that investors have no ability to redeem and will only receive a return on their investment in the fund as and when the funds underlying investments are realised will be clearly disclosed to investors in the PPM. Many funds allow for termination of the management contract in the event of an investor vote, or in the case of fraud or gross negligence. These provisions are extensively negotiated with investors and vary from fund to fund. They also typically include rights for the investors to suspend the funds ability to make investments if the management team is subject to extensive changes or if there is a change of control. Investors typically have extensive downside protections which are heavily negotiated. 10.3.2.3. Register and identify shareholders See paragraph 10.2.2.4 above. Typically a funds contractual documents do not extend these disclosure obligations.
226
Part I
10.3.3.Information and consultation of employees 10.3.3.1. Informing and consulting employees during the transfer of control of undertakings or businesses There may be provisions in employment-related documents (e.g. a staff handbook) which are relevant, but typically the employee relies upon the extensive legal rules referred to in paragraph 10.2.3 above. 10.3.3.2. Disclosure and explanation of investment strategies and risks to investee companies There are typically no additional contractual provisions. 10.3.3.3. Transfer of undertakings directive in relation to leverage buyouts There are typically no additional contractual provisions. 10.3.4.Asset stripping and capital depletion 10.3.4.1. Prevention of asset stripping through common rules on capital maintenance On an LBO, the banking agreements will include covenants restricting dissemination in addition to the legal rules restricting this set out in paragraph 10.2.4 above. 10.3.5.Limits on leverage (that are sustainable for the private equity fund/firm and the target company) Under most fund LPAs, the ability of the fund to borrow (as opposed to the ability of portfolio companies or acquisition vehicles to borrow on a non-recourse to the fund basis) is severely constrained and is usually restricted to bridging, pending the receipt of capital called from investors, to cover a default on a capital call from an investor, and to certain other limited circumstances. 10.3.6.Compensation structure 10.3.6.1. Transparency of the compensation structure (to investors and authorities) As well as being disclosed in the funds marketing materials, for funds structured as limited partnerships, the entitlement of the private equity firm to receive compensation in the form of management fees, carried interest (performance fees) or other types of remuneration (such as portfolio company monitoring fees, directors fees, financing fees etc.), will be set out in the limited partnership agreement which is the main contractual document relating to the fund and which is an agreement to which each of the fund investors are party. These are heavily negotiated and documented in great detail. The arrangements are, however, confidential to the parties and do not form part of any notification to any regulatory authority. 10.3.6.2. Transparency of managers remuneration systems Often the investment agreement/articles of association of the company require a remuneration committee to be established. This typically will include at least one investor director (i.e. the private equity shareholder appointed director) and the terms of reference for the remuneration committee will be agreed by the shareholders in the investment agreement/articles.
227
10.4. Governed by self regulation / professional standards (Industry professional standards and investor relations) The main guidelines applicable in the United Kingdom are the Walker Guidelines for Disclosure and Transparency in Private Equity (the Walker Guidelines). In addition, other key guidelines applied by the UK private equity industry are the International Private Equity and Venture Capital Valuation Guidelines (IPEV Guidelines), the EVCA Valuation Guidelines and the EVCA/BVCA reporting guidelines which set out best practice guidelines for disclosure and transparency towards investors in private equity and venture capital funds, see further paragraph 10.4.2.2 below. There are also a number of UK specific professional standards which are noted in paragraph 10.4.7 below. 10.4.1.Capital requirements There are no additional rules beyond the extensive legal rules set out in paragraph 10.2.1 above. 10.4.2.Industry imposed disclosure and related monitoring 10.4.2.1. Portfolio companies Companies covered by the Walker Guidelines are required to: Publish an annual report and accounts on their website within six months of their year-end to include: (i) the identity of the private equity fund or funds that own the company, the senior managers or advisers who have oversight of the funds and detail of the composition of the board; (ii) the type of annual business review that quoted companies currently have to produce under the Companies Act (the Enhanced Business Review); and (iii) a financial review to cover the risk management objectives and policies in the light of the principal financial risks and uncertainties facing the company, including those relating to leverage, Publish an update on its website no later than three months after mid-year giving a brief account of major developments in the Company; and Provide data to the BVCA, particularly for the purpose of an enlarged economic impact study.
10.4.2.2. Private equity firms Each private equity firm is required to: Publish an annual review to include enhanced disclosures or regularly update its website showing: (i) a description of its own structure and investment approach and of the UK companies in its portfolio, an indication of the leadership of the firm in the UK and confirmation that arrangements are in place to deal with conflicts of interest; (ii) a commitment to conform to the guidelines on a comply or explain basis; and (iii) a categorisation of its limited partners by geography and by type. Use established guidelines, such as those published by the EVCA, for reporting to limited partners and for the valuation of investments; Provide data to the BVCA for an enlarged economic impact study and to allow industry-wide attribution analysis on private equity returns; and Communicate promptly and effectively with employees, particularly in times of strategic change.
228
Part I
10.4.2.3. Enforcement & monitoring The Walker Guidelines operate on a comply or explain basis, with any non-compliance to be explained on the companys website. An independent monitoring group has been established to ensure an adequate level of conformity with the guidelines the Guidelines Monitoring Group (GMG). Following its establishment, the GMG commissioned PricewaterhouseCoopers to assist it in reviewing the extent to which portfolio companies met their disclosure requirements. In particular, the GMG will consider the extent to which the Enhanced Business Review mentioned in paragraph 10.4.2.1 above, has been complied with. In the case of material non-conformity, the GMG will discuss the matter in confidence with the private equity firm and/or portfolio company concerned. The GMG will give the relevant firms an opportunity to correct any exceptions in the following years accounts and to address them in the meantime by including the information on the companys website. The interim update that companies are required to publish under the guidelines may also provide an appropriate media for doing so. If a commitment to take early remedial action is not given and the non-compliance has not been adequately explained, it could lead to public censure. Ultimately, the GMG can terminate a private equity firms membership of the BVCA. 10.4.2.4. Coverage of relevant entities The Walker Report defines a portfolio company as a UK company which has been acquired by one or more private equity firms: in a public to private transaction where the market capitalisation, together with the premium for acquisition of control, was in excess of 300 million, more than 50% of revenue were generated in the United Kingdom and UK employees totalled in excess of 1,000 full-time equivalents; or in a secondary or other non-market transaction where enterprise value at the time of the transaction is in excess of 500 million, more than 50% of revenues were generated in the United Kingdom and UK employees totalled in excess of 1,000 full-time equivalents. A private equity firm, for the purposes of the guidelines, is a firm authorised by the FSA that manages or advises funds that either own one or more portfolio companies (as defined above) (or have a designated capability to engage in such investment activity in the future). Some private equity firms have decided to apply the Walker Guidelines to all of their investee companies (including those outside the United Kingdom), notwithstanding that they are not caught by the definition of a portfolio company. The Walker Guidelines cover the UKs largest buyout companies accounting for over 80% of funds under management by BVCA members. The Guidelines apply to portfolio companies broadly equivalent to FTSE 350 companies in size. The 54 companies currently complying with the requirements for portfolio companies cover a substantial proportion of private equity owned companies by value.
229
10.4.3.Information and consultation of workers 10.4.3.1. Informing and consulting workers during the transfer of control of undertakings or businesses As mentioned in section 10.4.2 above, according to the Walker Guidelines a portfolio company should publish its annual report and accounts on its website within six months of the year-end which must include: the identity of the fund(s) that own the company, senior managers of the fund(s) and detail on the composition of its board; and main trends and factors likely to affect the future development and position of the company and its business and this should include information on the companys employees. In particular at a time of strategic change, a private equity firm is required to ensure timely and effective communication with employees, either directly or through its portfolio company, as soon as confidentiality constraints are no longer applicable. 10.4.3.2. Disclosure and explanation of investment strategies and risks to investee companies According to the Walker Guidelines, a portfolio companys annual report and accounts should include a financial review to cover risk management objectives and policies in the light of the principal financial risks and uncertainties facing the company, including those relating to leverage. 10.4.3.3. Transfer of undertakings directive in relation to leverage buyouts As mentioned in section 10.4.3.1 above, the Walker Guidelines require a private equity firm, in particular at a time of strategic change, to ensure timely and effective communication with employees, either directly or through its portfolio company, as soon as confidentiality constraints are no longer applicable. 10.4.4.Asset stripping and capital depletion The disclosure requirements referred to in section 10.4.2 above are relevant as affected private equity firms and portfolio companies will be subject to considerable transparency with regard to the investment strategy and financial position of the company. 10.4.5.Limits on leverage (that are sustainable for the private equity fund/firm and for the target company) There are no additional rules beyond the extensive legal rules set out in paragraph 10.2.5 above. 10.4.6.Compensation structure 10.4.6.1. Transparency of compensation structure There are no additional rules beyond the extensive legal rules set out in paragraph 10.2.6 above. 10.4.6.2. Transparency of managers remuneration systems There are no additional rules beyond the extensive legal rules set out in paragraph 10.2.6 above.
230
Part I
10.4.7.Other professional standards The Combined Code on Corporate Governance published by the Financial Reporting Council which sets out standards of good practice in relation to issues such as board composition and development, remuneration, accountability and audit and relations with shareholders. This is primarily applicable to listed companies, but certain private equity owned companies consider these standards when, for example establishing remuneration and audit committees. Guidelines on responsible investment disclosure published by the Association of British Insurers which require boards of companies to confirm that they have assessed and are managing environmental, social and governance risks. Applicable Accounting Standards All companies (other than small or medium-sized companies) are required to state whether their accounts have been prepared in accordance with applicable accounting standards and disclose any material departures from them. Most private companies report under UK GAAP, although some may choose to prepare their accounts in accordance with International Accounting Standards (IAS), in which case a statement to that effect must be included in the notes to the accounts.
Part II
Private Equity Funds and Contractual Relationships with their Investors Governance, Reporting and Transparency
231
1.
The Limited Partnership / Investment Management Agreement an overview
Private Equity Funds (PE funds) are closed-end funds marketed to and raised from a limited number of sophisticated institutional investors, predominantly pension funds (public and private), insurance companies, banks, funds of funds, endowments and family offices. The number of investors in each PE fund varies but is usually somewhere between 20 and 60. The English Limited Partnership is a structure frequently used for international PE Funds marketed to international investors. For more locally marketed funds (investing predominantly also in the local market) local limited partnerships structures, limited liability company structures or other local fund structures can be seen. The Limited Partnership structure provides investors with a well understood transparent structure allowing them the same tax treatment as if they had invested directly into the underlying portfolio companies. Each investor in a fund will contractually commit to contribute a fixed amount of money (the investors Commitment) over the lifetime of the Fund subject to cash calls (drawdowns) from the private equity firm. The risk of the investor is capped at its commitment. The Limited Partnership Agreement (LPA) is a heavily negotiated contractual agreement between the general partner (the private equity firm, typically the PE fund manager or an affiliate) and the limited partners (the respective investors) provides the legal framework under which the fund operates and clearly defines the fiduciary responsibilities of the private equity firm. The term of the LPA is usually 10 years with a possibility to prolong by up to 2-3 years in order to allow for orderly realization of the underlying investments minimizing exposure to adverse market conditions. PE funds not structured as limited partnerships are normally governed by an Investment Agreement which in all material respects will adopt the same commercial terms as an LPA. In general there has over the years been a harmonization of terms and conditions within each sub-segment of PE funds e.g. large buy-out, mid-market buy-out, small buy-out and venture (seed, early-stage and late-stage). Summaries of PE fund Terms and Conditions are regularly produced by different sources and can be purchased by investors, private equity firms, advisors and other interested parties. Once funds have been invested and exited private equity firms will need to raise new funds in order to make further investments. New funds are normally raised at 3-5 year intervals implying a continuous evaluation of the private equity firm and its performance as well as terms and conditions. Funds are marketed to investors on the basis of a Private Placement Memorandum which outlines among other things the strategy of the fund, its key employees and their backgrounds, the track record of previous funds and the key terms and conditions. Investors will conduct their own further due diligence which may include both on-site visits at both the PE firm and select portfolio companies and thorough desk-based research and follow-up through for example detailed questionnaires.
232
Part II
This enables them to assess (amongst other) relevance of defined strategy to the market opportunity, consistency of investment decision making process, value creation record, governance, compliance and risk management procedures, staff motivation and alignment of interest, relationships with portfolio companies, banks and advisors etc before making a recommendation to their Investment Committee. The due diligence process generally lasts several months. A private equity firms ability to raise new funds is highly dependent upon its historic track record of creating consistent returns, consistent investment strategy, organizational stability and development, and its credibility and reputation in the investor community. The private equity firm and its senior investment professionals are typically required by the investors to invest up to 5% of the overall fund size to ensure alignment of interest and sharing of risk between the private equity firm and the investors. Similarly a PE fund will usually require management of portfolio companies to invest alongside the fund as it makes its investment into the company. This creates a strong alignment of interest between the Investors, the private equity firm and its executives as well as the portfolio company managers as all are sharing the same risk in relation to the individual portfolio company. Over its investment period (usually 3-7 years) a PE Fund will make a number of investments into different portfolio companies which are then actively managed with a view to building long term value which will be realized upon exit in the form of actual capital gains. The LPA will also state how these gains are to be shared between Investors and the private equity firm as well as the size of the management fee and any other fees payable to the private equity firm. The LPA will also stipulate the frequency of reporting to investors (usually quarterly or semi-annually) as well as the basis of such reporting and inherent valuation methodologies. These are generally dictated by a set of rigorous industry standards such as the International Private Equity and Venture Capital Guidelines. Most PE funds will hold an annual investor meeting and in addition to providing detailed written reports on a quarterly or semi-annual basis they are in frequent contact with their investors. Investors typically also pay regular visits to the private equity firm or are visited by the private equity firm on a recurring basis. All this makes for a close and interactive relationship between private equity firm and investor as well as a high degree of accountability. Furthermore most Funds also have an Advisory Council where the largest investors would be represented and which would have a role in the management of conflicts of interest, key man issues and other matters of key concern to the investors. The following section outlines how the points raised by the Commission are covered by the contractual agreements between the PE funds and their investors.
1.1.
Capital requirements
1.1.1. At the level of management companies (operational risk) There are usually no additional requirements imposed by investors, because investors are happy to rely on the legal requirements relating to the relevant structure used and will have done significant due diligence on the private equity firm itself, will be aware of the legal and regulatory requirements to which it is subject and will ensure they are satisfied as to the segregation of fund assets and money. Accordingly they have no direct financial exposure to the private equity firm if it were to be insolvent and further know that this is unlikely due to the predictability of the management fee. The private equity firm is entitled to an annual management fee which is set at a fixed negotiated percentage of fund commitments and it will balance its operational costs (mainly staff, property and advisor costs) accordingly.
233
1.1.2. At the level of the fund investment vehicle (exposure risk) Fund size is usually subject to negotiations and documentation may provide for a minimum and a maximum size. Also the size of the private equity firm contribution will be negotiated. As PE funds are closed-end funds they do not provide for early redemption. Investors are well aware of the long term and illiquid nature of their equity investment. An investor wanting to reduce or exit its commitment to a fund will need to find a buyer for its stake on the market for secondary fund interests and such buyer is subject to approval by the private equity firm. PE funds are typically not leveraged in accordance with the terms of the LPA. Under most fund agreements, the ability of the fund to borrow (as opposed to the ability of portfolio companies or acquisition vehicles to borrow on a non-recourse to the fund basis) is severely constrained and is usually restricted to bridging, pending the receipt of capital called from investors, to cover a default on a capital call from an investor. As regards capital requirements for the fund entity as such there are no additional requirements due to the absence of risks that would mandate a capital requirement on this level.
1.2.
Disclosure and monitoring
1.2.1. Disclosure and explanation of investment strategies and risk to investors (retail and sophisticated) The majority of private equity funds are not marketed to retail investors. In the cases where they are targeting retail investors marketing would in any case be subject to the laws and regulations pertaining to offerings to retail investors in each respective jurisdiction. For listed funds, the disclosure of investment strategies and risks is normally set out in the listing prospectus in accordance with what is required by the respective listing authority, stock exchange or market place. Unlisted funds are typically marketed pursuant to a document known as a Private Placement Memorandum which will contain detailed disclosure of the funds investment strategy and related risks. Fund agreements typically provide for annual and semi-annual or quarterly reports to investors including detail on development and performance of each underlying investment as well as for each fund as a whole. In many cases the LPA further stipulates reporting and valuation in accordance with the EVCA/IPEV guidelines. Portfolio companies of private equity funds furthermore generally have contractual obligations vis--vis lenders to provide information on economic performance etc. 1.2.2. Contract terms that provide for an unambiguous disclosure and management risk, for measures to be taken in the event of thresholds being exceeded, for a clear description of lock-up periods and for explicit conditions governing cancellation and termination Private equity funds are typically closed-ended which means that investors commit their capital for the life of the fund, forsaking the right to early redemption, to enable the private equity firm to make genuinely long-term investments. Consequently, lock-up periods and conditions governing cancellation and termination are not relevant to most private equity funds. The nature of this long-term commitment is very evident in the fund agreements and the private placement memorandum and widely understood to be one of the fundamental characteristics of the asset class.
234
Part II
Although the security of investor funding is critical to the private equity firms ability to make genuinely longterm investments, the LPAs generally provide a range of protections for the investors. The detail varies from one fund to another but they will typically allow, for example, for termination of the management contract in the event of an investor vote, or in the case of fraud or gross negligence on the part of the private equity firm. They also generally include rights for the investors to suspend the funds ability to make investments if the management team is subject to extensive changes or if there is a change of control. Additional investor protection clauses exist for example key man provisions that are heavily negotiated. 1.2.3. Register and identity of shareholders beyond a certain proportion Typically a funds contractual documents do not extend these disclosure obligations but rather provide for the confidentiality of the agreement and its parties as would be normal in a privately negotiated agreement. However in many cases when funds are structured as limited partnerships the identity of investors will be known through the public register. The same applies for most corporate vehicles in many jurisdictions.
1.3.
Information and consultation of workers
1.3.1. Information and consultation of employees whenever the control of the undertaking or business is transferred Not covered in the Fund documentation. Depending on the target company, there may be relevant provisions in employment-related documents or agreements, but typically the employee relies upon the legal rules of the relevant jurisdiction which will apply irrespective of purchaser as are tied to the employer which typically does not change in a buyout or private equity investment. 1.3.2. Disclosure and explanation of investment strategies and risk to investee companies There are typically no contractual provisions. However as portfolio companies will generally be subject to change programmes and strategic shifts (involving acquisitions, geographical or product line expansion etc) in order to achieve the intended operational improvements, open and clear communication both between the Fund and the portfolio company board/executives as well as throughout the companys different managerial and employment levels is a necessary tool in the value creation process. As executives of the private equity firm typically serve as directors on the portfolio company board they will ensure that the PE Funds strategic objectives are clearly articulated and understood. As managers of portfolio companies are normally required to invest alongside the Fund in order to ensure alignment of interest there will commonly be a jointly developed business plan outlining the road map for the long term value creation. 1.3.3. Potentially adapt the transfer of undertakings directive (i.e. TUPE in the UK) to the specific situation of LBO Please see above.
235
1.4.
Asset stripping and capital depletion
1.4.1. Prevention of asset stripping through common rules on capital maintenance PE funds are in business to deliver realized returns to their investors from making capital gains through the acquisition, holding and exit of portfolio companies over a 3-7 year horizon as stated in the investment agreements. Only when such cash returns, normally on a fund basis, exceed certain negotiated thresholds is the private equity firm entitled to the carried interest (a predetermined share of realized cash profit). PE Funds are long-term providers of capital to portfolio companies and expect to make their gains from exiting strong well managed companies with good market positions and continued potential for growth. Professional buyers of any kind will not pay full value for underinvested, asset stripped, mismanaged companies and as such there is no commercial logic for a PE fund to pursue such strategy. If value is not created positive returns to investors will not be achieved and ultimately the investors will not commit new amounts to such fund managers which will not be able to raise new funds. In a buyout, the banking agreements further typically include covenants restricting dissemination in addition to the legal rules restricting this prevalent in most jurisdictions.
1.5.
Limits on leverage
1.5.1. The level of leverage is sustainable for the target company While the use of leverage plays its part in the private equity investment model each portfolio company is financed on its own merits and further subject to individual due diligence and credit assessment by credit providers, in most cases regulated banks. Banks will further receive regular updates and formal reports from the portfolio company including the monitoring of set covenants.
1.6.
Compensation structure
1.6.1. Transparency of the compensation structure (to investors and authorities) The entitlement of a private equity firm to receive compensation in the form of management fees, carried interest (performance fees) on their investment or other types of remuneration, will be set out in the fund agreements (to which each of the fund investors is a party). These contracts are heavily negotiated and documented in great detail. The fundamental principle is to ensure the alignment of interest between investors and the private equity firm. The arrangements are, however, confidential to the parties and do not form part of any notification to any regulatory authority. 1.6.2. Transparency of managers remuneration systems, including stock options, through formal approval by the general meeting of the companys shareholders Though normally not specifically dealt with in the LPA Investors are generally aware, as part of their due diligence, of the nature of management incentive programmes put in place for portfolio company managers. The size and dilution effects of these are normally also evident in the reporting to investors as values of portfolio companies, in accordance with set industry standards, are reported assuming exercise of any management incentives deemed to be in the money at the reporting date.
236
Part III
Articulation of EVCA Industry Professional Standards with the EU Concerns in respect of Private Equity
237
1.
Scope, Coverage and Enforcement of EVCA Industry Professional Standards
EVCA has over 1,300 members in 53 countries. As a result, its Industry Professional standards carry international influence, notably when dealing with the industrys sophisticated investor base, who are often subject to specific treatment by regulators and supervisors in their home jurisdictions. As such and by way of example, private equity investors often use such standards as benchmarks when drawing up contractual agreements and undertaking monitoring of private equity funds activities. The current nature of the standards is twofold: Firstly, EVCAs Code of Conduct (109) is a primary, overarching code of broad behavioural principles, in line with IOSCO Guidelines, adherence to which is compulsory for all members. The Code requires all EVCA Members to: Act with integrity; Keep promises; Disclose conflicts of interest; Act in fairness; Maintain confidentiality, and Do no harm to the industry. The Code also contains general enforcement provisions that can arise from any inquiries and/or complaints arising from market participants and the public generally. The ultimate EVCA enforcement action is expulsion from the EVCA membership. Secondly, the Code of Conduct is supported by a series of supplementary guidelines which address industry specific issues and activities. These can also stand alone and govern interactions between and relationships with private equity fund managers and their investors, and their underlying portfolio (investee) company. In terms of interactions between the Fund Manager and its investor, EVCAs Governing Principles and Sound Practices for Establishment and Management of Private Equity Funds (2003) (110) covers among others: Respect of Legal Requirements, Contractual Terms & Conditions; Management of Business with Integrity and Fund with Skill, Care and Diligence; Adequacy of Financial & Operational Resources; Due regard to Investors Interests; Ensure Transparency; Fair Management of Conflicts of Interest and Protection of Investors Assets. EVCA Reporting Guidelines (updated in 2006) (111) covers among others: Statutory accounts; Timing; Fund and Portfolio reporting; Capital account, Fees and carried interest; and Performance measurement. Valuation Guidelines (1993, updated 2001 and replaced by International Private Equity and Venture Capital Valuation (IPEV) Guidelines in 2005) (112) further ensure transparency on a global level, through their consistency with US GAAP and IFRS, as well as dealing with questions and comments from stakeholders and evaluate the need for adjustment through the IPEV Board (113).
(109) (110) (111) (112) (113)
http://www.evca.eu/uploadedFiles/Home/Toolbox/Industry_Standards/evca_code_of_conduct_08.pdf http://www.evca.eu/uploadedFiles/Home/Toolbox/Industry_Standards/evca_governing_principles.pdf http://www.evca.eu/uploadedFiles/Home/Toolbox/Industry_Standards/evca_reporting_guidelines_2006.pdf http://www.evca.eu/uploadedFiles/Home/Toolbox/Industry_Standards/evca_international_valuation_guidelines.pdf or http://www.privateequityvaluation.com http://www.privateequityvaluation.com
238
Part III
Turning to relationships with and interactions between private equity fund managers and their portfolio (investee) companies, EVCA Corporate Governance Guidelines (2005)(114) are based on OECD principles and are also supported by a series of guidance notes that outline their use and cover among others: Conducting business in a responsible and ethical way (i.e. fair and honest dealing); Implementing Anti Money Laundering measures, and ensuring a high standard for the governance of investment portfolio. EVCA Industry Professional Standards offer a number of potential advantages and benefits as part of a framework that governs the private equity industry and its activities: They provide a common set of guidelines for all industry practitioners on a pan-European and international basis, and provide flexibility within a consistent framework so that they can be applied to specific circumstances; They complement existing regulation by offering enhanced flexibility for regulators and supervisory authorities when addressing specific issues with respect to private equity. As part of a process of regulatory oversight in some jurisdictions, notably those using principles-based regulation, Industry Professional standards can bridge the gap to achieving high level statutory principles and regulatory objectives. They are appropriate for their main stakeholders (such as institutional investors) and constitute a reference/foundation for contractual agreements and related monitoring (such as the EVCA reporting and related valuation guidelines); They offer the possibility for further review, development and expansion in conjunction with industry stakeholders.
The compliance with the Code of Conduct is mandatory for the members. Members sign on to the code with their membership application and renew the commitment to comply every year as part of the annual membership renewal process. EVCA process of enforcement: complaints about EVCA members not being in compliance with the Code of Conduct are received by the EVCA secretariat. The Professional Standards Committee with the support of the secretariat conducts a thorough research on the issue and provides a recommendation to the Executive Committee and Board of EVCA as to how to resolve the issue. The Board will decide on actions to be taken. The most serious sanction is the eviction of the member from the association. Approximately once every year EVCA receives a complaint and deals with it. There has been one eviction in the last 5 years. For the supplementary guidelines, the main enforcement mechanism is based on the contractual agreements between investors and the private equity firms. In practice, the enforcement mechanism is very strong as fund managers will ensure that they do not violate their contractual obligations vis--vis their investors.
(114)
http://www.evca.eu/uploadedFiles/Home/Toolbox/Industry_Standards/evca_corporate_governance_guidelines.pdf
239
2.
Detailed analysis of the coverage of the EVCA Industry Professional Standards as regards the EU Concerns in respect of private equity
EVCA Code of Conduct (115) October 2008 (reprint January 2009)
EVCA membership creates a responsibility on the part of the member firm and individuals in the firm to act in a manner which is both ethical and beneficial to the image and interests of the Industry and its participants. This has long been recognised by EVCA, which issued its first Code of Conduct in 1983. Compliance with the Code has always been obligatory for EVCA members, who include a wide range of Industry participants, such as venture capital and buyout firms (often referred to as General Partners), investors such as pension funds, insurance companies, Fund-of-Funds and family offices (often referred to as Limited Partners) as well as associates from related professions (such as legal advisors and placement agents). In October 2008, EVCA updated the 1983 Code of Conduct with a set of minimum principles with which compliance is mandatory for all members and their employees. The updated Code was developed having regard to the Model Code of Ethics: A Report of the SRO Committee for the International Organisation of Securities Commissions (IOSCO) published in June 2006. The objectives of the 2008 Code are: To state the principles of ethical behaviour that members of EVCA abide by; To assert on behalf of the membership the collective view that high standards of commercial honour and just and equitable principles of trade and investment shall be observed; and To provide the basis for consideration of and dealing with lapses in professional conduct within EVCA.
The six principles as set out in the Code are: 1. Act with integrity 2. Keep your promises 3. Disclose conflicts of interest 4. Act in fairness 5. Maintain confidentiality 6. Do no harm to the industry The Principles which comprise the Code stand together as a whole rather than independently of each other. A litmus test for application of these Principles is personal conviction that ones actions would stand up to the scrutiny of a third party. An alternative test is to judge ones action by reference to whether one would find it acceptable for other parties to pursue a similar course of action under similar circumstances. Compliance for EVCA members with the Code is dealt with through the Professional Standards Committee on behalf of the Board of Directors of EVCA. In the event of a proven serious case of misconduct by a member the sanction is expulsion of that member from EVCA.
(115)
http://www.evca.eu/uploadedFiles/Home/Toolbox/Industry_Standards/evca_code_of_conduct_2009.pdf
240
Part III
Other EVCA Industry Professional Standards
In addition to the Code, EVCA has published a series of related documents that present principles that should govern the professional relationship between the three key groups of industry participants, namely the General Partner (private equity firm), the Limited Partner (investor), and the investee (portfolio) company. These documents outline the key elements of governance, transparency and accountability that are expected of the main industry participants towards one another: EVCA Governing Principles EVCA Corporate Governance Guidelines International Private Equity and Venture Capital Valuation Guidelines (in collaboration with AFIC, BVCA and several other institutions) EVCA Reporting Guidelines
The observance of the various guidelines by EVCA members facilitates the work EVCA does on their behalf, such as representing the interests of EVCA members with such European and International institutions and organisations, investor associations, national governments and investors in the Industry worldwide. Before continuing, it should be noted that for each and every EVCA Industry Professional Standard and all related remarks, Acting within the Rule of Law and within the Laws and Conduct of Business Rules of a particular jurisdiction in which an EVCA member firm operates is the minimum expected of all members and their employees. It should also be noted that all EVCA guidelines are drafted so as to be applicable to as wide a range of situations and circumstances as possible. No particular operational jurisdiction is envisaged and therefore references to shareholders, the board and management should be taken as functional titles rather than particular legal structures. It is important to recognise that the private equity industry encompasses a broad range of investment situations from early stage venture capital and development capital to large leveraged buyouts. These principles set out in these guidelines are intended to be applied to all such investment situations while recognising that the specific activities that take place will differ in different circumstances. Further to the above, the following sections set out below a series of key recommendations and best practices as outlined in the EVCA industry professional standards in respect of EU-level concerns with respect to private equity. Finally, it should be noted that the examples are non-exhaustive: for ease of reading, a subsequent table (on page 247) provides a further comprehensive overview.
2.1.
Capital requirements
2.1.1. Capital requirements at the level of management company EVCA Governing Principles set out that these should be considered and observed by EVCA Members and those involved in the establishment and management of private equity and venture capital funds (including those advising on and arranging investments) at all stages during their life cycle (which will usually comprise fundraising, investing, management of investments, disposal of investments, distributions to investors and liquidation of the fund). Specifically, point 5 of the principles notes that, in terms of adequacy of resources: A fund operator should ensure an adequate level of financial and operational resources for the management of the fund.
241
This is developed further in section 3.10.3, which states that the fund manager; should maintain adequate financial resources to allow it to continue trading during the life of all funds under management. The manager should implement internal financial reporting procedures to ensure that it monitors effectively its financial position on an ongoing basis. If the manager becomes aware that its financial resources have been seriously eroded, it should liaise with investors in funds under management to agree measures to remedy the situation. 2.1.2. Capital requirements at the level of the funds investment vehicle This issue is not specifically addressed by EVCA professional standards.
2.2.
Industry disclosure and related monitoring
2.2.1. Disclosure and explanation of investment strategies and risks to investors (sophisticated and retail) In addition to setting out a series of related issues to be addressed by private equity funds notably in their early stage planning and preparation (section 3.1.1 onwards), section 3.2.6 of the EVCA Governing Principles recommend that fund documentation should address at least the following issues: the investment scope of the fund (e.g. target economies, target regions etc.); the investment policy, investment criteria and investment period of the fund, including the applicable investment, lending and borrowing guidelines and investment restrictions (NB: These must be set out particularly clearly as, often, these important matters will not be set out in any detail in other key documents, and they are usually incorporated by cross-reference to the information memorandum); the provisions that the manager will make for follow-on investments; a description of the legal structure of the fund; a description of the management structure and the management team, identification of the key executives of such team and the regulation of key man events (such as departure of a key executive); a summary of the powers of the manager; conflict of interest resolution procedures; whether any advisory or investors committee will be established and what its function will be (section 3.7.4); how transaction and directors fees received by the manager will be treated; the carried interest arrangements; co-investment rights and powers; the mechanics for drawdown of commitments; default mechanics in the event of investors defaults on drawdowns (which should normally impose significant sanctions on default to reduce the risk of such default); the cost and fee structure (including expenses borne by the fund); the valuation principles that will apply; the reporting obligations that the manager will have to investors (section 3.7.1); exit strategies; how distributions to investors will be made (section 3.6.1.); term, termination and liquidation procedures for the fund; any restrictions on the circumstances in which the initiators or the manager will be permitted to establish any other fund with a similar investment strategy or objective; the policy on co-investment with other funds managed by the manager or any of its associates;
242
Part III
the circumstances in which investments may be purchased from or sold to other funds managed by the manager or its associates (section 3.5.5); the pricing of interests, units, shares etc.; and a summary of the risk factors that are relevant to investment in the fund, including a general warning to investors of the risks that are inherent in investing in funds, and also any particular risk factors that may adversely affect the funds ability to carry out the investment policy or to meet any projection or forecast made.
The fund documentation (information memorandum or similar and constitutional documentation) should be prepared and made available to investors in sufficient time for them to consider it prior to closing. Appropriate subscription documentation and confirmation of a participation should also be circulated. The initiators should take advice to establish whether the law in any jurisdiction where the documentation will be sent requires any other issues to be addressed. 2.2.2. Disclosure and explanation of investment strategies and risks to regulators EVCAs Corporate Governance Guidelines (section 3.1) states: The conduct of the business should always be in accordance with the applicable laws and regulations of the jurisdictions in which the business takes place including, but not exclusively, fiscal legislation, competition legislation, consumer and data protection legislation and anti-money laundering measures. 2.2.3. Register and identity of shareholders Section 4.1 of the EVCA Corporate Governance Guidelines governs behaviour with other stakeholders, notably that; The negotiation of shareholder rights should be conducted openly and with clarity. 2.2.4. Management and disclosure of conflicts of interest EVCAs Governing Principles state in section 3.7.2 (see also 3.9.1) that the private equity (fund) manager: should seek transparency in its relationship with investors by ensuring that all investors receive all significant information regarding the fund in a clear and timely manner, provided that communicating such information is permitted by law. The manager should not breach confidentiality obligations binding on it but should seek to be relieved of such obligations if they prevent proper reporting to investors. The manager should follow the agreed procedures for disclosure of conflicts of interest to investors. In respect of interactions with investee companies, sections 3 and 4 of the EVCA Corporate Governance Guidelines outline key points of relevance, with the Introduction to the Guidelines establishing the concept of managing potential conflicts of interest openly, honestly and with integrity. Section 3.5 on Respect for Stakeholders states: The conduct of the business will be successful in the long term where the interests of stakeholders, including investment fund providers (i.e. limited partners), the fund manager, the board of directors, company management, employees, customers, suppliers and other stakeholders are respected and in which conflicts of interest are managed appropriately.
243
Section 4.1 states: The negotiation of shareholder rights should be conducted openly and with clarity. Due consideration should be given in advance to potential areas of conflict and where conflict does arise the resolution of that conduct should, to the extent possible, be conducted fairly. Section 4.4, Responsibilities in relation to the board establishes responsibilities when appointing members of the board numerous recommendations including the following: The Private Equity and Venture Capital Investor should ensure its board appointees do not have conflicts of interest with their role as members of the board. 2.2.5. Principles-based valuation measures for illiquid assets Fair estimates of valuations and timely production of reports to investors are very important standards of fair dealing expected to be followed by market participants. Principles-based valuation measures are established and described clearly in the IPEV Guidelines which are an internationally adopted and highly respected global set of principles for valuing illiquid assets. These guidelines, as set out in more than 30 pages of detailed text, were developed by AFIC, BVCA and EVCA with carefullyconsidered input and endorsement of 32 other national and international associations. The main topics are the concept of fair value; principles of valuation; and valuation methodologies, detailed further by IPEV as follows: general topics relating to valuation methodologies; selecting the appropriate methodology; price of recent investment; earnings multiples; net assets; discounted cash flows or earnings (of underlying business); discounted cash flows (from the investment); industry valuation benchmarks; available market prices.
The IPEV Guidelines also contain application guidance on related topics such as internal funding rounds; bridge financing; mezzanine loans; rolled-up interest loan interest; indicative offers; events to consider for their impact on value; and impacts from structuring. The EVCA Corporate Governance Guidelines (CGG) also address this issue under section 4.3, Responsibilities in relation to performance information deals with the requirement to provide information in accordance with legislation, as well as the common practice for Private Equity and Venture Capital Investors to require more frequent and detailed information than required by legislation. 2.2.6. Prevention of money laundering EVCAs Governing Principles section 3.2.3 state that: Initiators and managers should comply with the relevant local rules in any jurisdiction where they market the initiative. In addition, during fundraising, initiators should take steps to ensure that investments are not made to effect money laundering. These steps should include verifying the origin of funds offered for investment and the identity of potential investors. Investment should not be accepted where the source of the investment causes concern (e.g. where the investment originates in a FATF black-listed country) or the investors identity cannot be verified.
244
Part III
Subscription documentation should also include suitable warranties from investors in the fund regarding the origin of money invested, although such warranties should not be considered to be a substitute for making appropriate enquiries. The fund documentation may include provisions that allow the manager to require investors to withdraw from the fund, if the manager reasonably believes that the investment has been made in order to undertake money laundering. Moreover, the EVCA Corporate Governance Guidelines specifically address this issue under section 3.1, Laws and regulations, which states: The conduct of the business should always be in accordance with the applicable laws and regulations of the jurisdictions in which the business takes place including, but not exclusively, fiscal legislation, competition legislation, consumer and data protection legislation and anti-money laundering measures.
2.3.
Information and consultation of workers
Section 3.5 of the Corporate Governance Guidelines on Respect for Stakeholders states: The conduct of the business will be successful in the long term where the interests of stakeholders, including investment fund providers (i.e. limited partners), the fund manager, the board of directors, company management, employees, customers, suppliers and other stakeholders are respected and in which conflicts of interest are managed appropriately. Section 4.5 states further that The Private Equity and Venture Capital Investor should act openly, honestly and with integrity, balancing the interests of the company, the needs of effective decision making and the needs of other stakeholders. 2.3.1. Informing and consulting workers during the transfer of control or undertakings or businesses (See ICE Directive and transfer of undertakings directive) See section 2.3 above. 2.3.2. Disclosure and explanation of investment strategies and risk to investee companies Within the context of related investment decision-making, in advance of any investment, the EVCA Governing Principles (section 3.3.1) make clear reference to due diligence, recommending that a private equity (fund) manager should: seek sufficient information to allow it to properly evaluate the investment proposition being put to it and to establish the value of the investee business. This information should address all appropriate issues (which may include the financial position of the investee business, the experience and ability of its management team, the market in which the investee business operates, the potential to exploit any technology or research being developed by the investee business, possible scientific proof of any important concept, protection of important intellectual property rights, pensions liability, possible environmental liabilities, litigation risks and insurance matters) This process should also include testing the assumptions upon which business plans are based, verifying the identity, resources and experience of managers and co-investors and objectively evaluating the risks that may arise from investing and the potential return on investment. Any other appropriate checks (including checks on vendors) to ensure that the investment does not facilitate money laundering should be carried out.
245
Recommendation 3.3.2 of the governing principles then continues: The results of the due diligence exercise and executives recommendations should be distilled to a written investment proposal which accurately reflects the potential of the investee business. The investment proposal is an important document; not only does it provide a written record of the information considered in making an investment decision, but it can also provide a yardstick by which the success of an investment can be judged. Investment decisions should be made by suitably senior and experienced personnel. Wherever possible, the investment decision should be made by more than one person jointly (ideally by an investment committee). If the person(s) responsible for proposing an investment is involved in making the investment decision, then others should be involved in taking the decision and the proposer(s) should not have a deciding vote. Significant changes to an investment proposal may require further approval. In addition, EVCAs Corporate Governance Guidelines (section 3.6) on Transparency states: Success for a Private Equity and Venture Capital Investor depends upon clear disclosure and timely communication of relevant and material information to facilitate high-quality decision-making. The Private Equity and Venture Capital Investor will seek to establish transparent communication with company management. Section 4.2 of the Corporate Governance Guidelines, Responsibilities in relation to strategy deals with the primary role of the general partner fund manager in working with investee company management to define the corporate strategy to be executed. Sections 5 and 6 of the Corporate Governance Guidelines include numerous references to strategy and risk management, presented as recommendations and examples of current good practice: (5.1): The board share a collective responsibility to ensure that the business strategy is set and kept under continuous review. (5.2): The board shares a collective responsibility for the identification and assessment of risk. (5.3): The board shares a collective responsibility for the management of risk. (6.1): Management are responsible for establishing the control environment. (6.2): Management are responsible for establishing procedures for risk assessment. (6.3): Management are responsible for control activities.
2.3.3. Transfer of undertakings directive in relation to leverage buyouts EVCAs Corporate Governance Guidelines (section 4.5) state that The private equity and venture capital investor should act openly, honestly and with integrity, balancing the interests of the company, the needs of effective decision making and the needs of other stakeholders.
2.4.
Asset stripping and capital depletion
The EVCAs Code of Conducts sixth principle is to do no harm to the industry and this implies operations that would include asset stripping or abuse of employees.
246
Part III
2.5.
Limits on leverage
The EVCAs Code of Conducts sixth principle is to do no harm to the industry and this implies operations that would include asset stripping or abuse of employees. 2.5.1. The level of leverage is sustainable both for the private equity fund/firm and the target company EVCAs Corporate Governance Guidelines (Section 3.4.) state as a general principle and from a long-term perspective, The business model of the private equity and venture capital investor aims to create value by taking a long term view of investment and supporting management of the investee company in the achievement of long term objectives and strategies. 2.5.2. Transparency of the compensation structure (to investors and authorities) Section F of the EVCA Reporting Guidelines (fees and carried interest) addresses these matters from the perspective of private equity funds and their investors. In addition, as a general principle at the level of interaction between private equity funds and portfolio companies, Section 3.6 of the EVCA Corporate Governance Guidelines on Transparency state that: Success for a Private Equity and Venture Capital Investor depends upon clear disclosure and timely communication of relevant and material information to facilitate high-quality decision-making. The Private Equity and Venture Capital Investor will seek to establish transparent communication with company management. Sections 5 and 6 of the EVCA Corporate Governance Guidelines continue by including numerous references to strategy and risk management, presented as recommendations and examples of current good practice, including section 5.4: The board are responsible for setting the remuneration of key executives and senior management. This states that: The board should determine appropriate levels of remuneration of executives and should keep levels of remuneration under review. Conflicts of interest in establishing remuneration levels for board members should be avoided where possible and managed openly and constructively in all cases. 2.5.3. Transparency of managers remuneration systems, including stock options, through formal approval by the general meeting of the companys shareholders Sections 5 of the Corporate Governance Guidelines sets out in section 5.4, The board are responsible for setting the remuneration of key executives and senior management. This section 5.4 states further that: The board should determine appropriate levels of remuneration of executives and should keep levels of remuneration under review. Conflicts of interest in establishing remuneration levels for board members should be avoided where possible and managed openly and constructively in all cases. Section 5.5 continues Where and to the extent appropriate, management agreements should be used to set out the interactions between the Private Equity and Venture Capital Investor, board and management of the investee company.
Table 3: EVCA Industry Professional Standards
EU Level concerns with respect to Private Equity 3 (15)
EVCA Code of EVCA Corporate Conduct Governance Guidelines (cf IOSCO; 2008) (cf OECD; 2005) EVCA Governing Principles (2003) International Valuation Guidelines (2006)
EVCA Reporting Guidelines (Disclosure to investors; 2006)
I. Capital requirements
At the level of management companies (operational risk)
At the level of the funds investment vehicle (exposure risk)
II. Increased disclosure and monitoring 3 (3) 3 (3) 3 (3) 3 (1) 3 (6) 3 (13) 3 (1,2) 3 (1,8) 3 (6,8,9,10, 11,13,14,16) 3 (4) 3(1) 3 (2) 3 (4,16) 3 (3,10,11,14,15) 3 (5) 3 (1,2,3,7,12) 3 (1,2,3,5)
(Mandatory) Disclosure and explanation of investment strategies and risks to investors (sophisticated and retail)
Disclosure and explanation of investment strategies and risks to regulators
Contractual clauses covering lock-up periods, cancellation and termination
Prevention of money laundering
Register and identify shareholders
Adopt principles based valuation measures for illiquid assets
Management and disclosure of conflicts of interest
III. Information and consultation of workers 3 (3) 3 (1) 3 (3) 3 (3) 3 (16) 3 (12) 3 (12) 3 (6) 3 (16) 3 (9) 3 (5,7,10,13)
Disclosure and explanation of investment strategies and risks to investee companies
Transfer of undertakings directive in relation to leverage buyouts
IV. Asset stripping and capital depletion Prevention of asset stripping through common rules on capital maintenance
V. Limits on leverage Limits on leverage (sustainable for private equity fund/firm and target co.)
VI. Compensation structure
Transparency of the compensation structure (to investors and authorities)
Transparency of managers remuneration systems
Footnotes: see next page
247
248
Part III
EVCA Code of Conduct (1) The Code of Conduct (CoC) sets acting within the Rule of Law and within Laws and Conduct of Business Rules in a relevant jurisdiction as the absolute minimum standard. (2) Guiding Principle 3 of the CoC is specifically to disclose conflicts of interest and this is elaborated at section 2.3 to embrace all conflicted parties and establishes the need for diligence in the identification of conflicts. (3) The CoC sixth principle is to do no harm to the industry and this implies operations that would not be counter to any of the principles here (i.e. no asset stripping, no abuse of workers etc.) EVCA Corporate Governance Guidelines Introduction to the Corporate Governance Guidelines (CGG) establishes concept of managing conflicts openly, honestly and with integrity (2) Money laundering is specifically referred to at point 3.1, Law and Regulations, of the CGG (3) 3.2 of the CGG highlights a relationship with the investee company define by negotiated, mutually agreed rights and responsibilities for all parties. (4) 3.5 of the CGG is Respect for Stakeholders (5) 3.6 of the CGG refers to seek to establish transparent communication with investee company management. (6) 4.1 of the CGG governs behaviour with other stakeholders. (7) 4.2 of the CGG governs disclosure of strategy to management teams. (8) 4.4 of the CGG establishes responsibilities when appointing members of the board. (9) 4.5 of the CGG governs responsibilities to other stakeholders, including employees. (10) 5.1 of the CGG establishes collective strategic responsibility. (11) 5.2 of the CGG establishes responsibilities for risk management (12) 5.4 of the CGG establishes responsibilities for remuneration structures, including responsibilities for ensuring they remain appropriate. (13) 5.5 of the CGG establishes the use of Management Agreements. (14) 6.2 of the CGG further defines the risk management responsibilities of management. (15) 6.4 of the CGG establishes managements responsibilities for internal and external communication and sets out principles for accuracy, clarity, unambiguousness, security and timeliness. (16) 3.4 of the CGG: the long term view
(1)
EVCA Governing Principles Governing principle number 7 under header The Governing Principles at start of document (2) Section 1.2 Investors and Marketing (3) Section 2.2 Target Investors (4) Section 2.3 Origin of funds (5) Section 2.6 Structure of the Documentation (6) Section 2.6 Structure of the Documentation (7) Section 2.7 Presentation to Investors (8) Section 3.8 Co-investment and parallel investment by the manager and its executive (9) Section 3.9 Co-investment and parallel investment by fund investors and other parties (10) Section 4.3 Follow-on investments (11) Section 5.5 Sales to another fund managed by the same manager (12) Section 7 Investor relations, 7.1 reporting obligations, 7.2 Transparency, 7.3 Investor relations generally, 7.4 Investors committee (13) Section 7.4 Investors committee (14) Section 9.1 Conflicts of interest (15) Section 10 Managers internal organisation, 10.3 Financial resources (16) Section 10.4 Procedures and organisation
(1)
EVCA Reporting Guidelines Section A - General Consideration (2) Section C - Fund reporting (3) Section D - Portfolio reporting (4) Section D - 8 Specific information concerning each investment (5) Section D - 9 Significant events and issues (6) Section F - Fees and Carried Interest
(1)
(1)
International Valuation Guidelines IPEV are the internationally adopted and highly respected global set of principles for valuing illiquid assets
Conclusion and Recommendations
249
Far from being unregulated, the business of private equity firms is subject to many regulations. As the private equity industry does not represent a systemic risk and is part of the solution of the current economic crisis, there are no obvious societal gains to be achieved from more regulation. Moreover, there is a risk that badly designed regulation could hamper the positive impact of the private equity industry on the European Economic recovery. The Leaders of the Group of Twenty, in their declaration of the Summit on Financial Markets and the World Economy (116), called for private sector bodies that have already developed best practices for private pools of capital to bring forward proposals. Industry professional standards do allow an appropriate level of innovation and at the same time can rapidly be adapted to evolution in markets and products. However, the private equity industry recognizes that in order to regain confidence for the financial system, industry professional standards need to be unified across Europe. The current situation for the private equity industry is characterized by the co-existence of guidelines covering the same topics. While differences tend to be small, this nevertheless creates the perception that self-regulation is haphazard. A second and perhaps more important issue is the need for an enforcement regime for the industry professional standards across Europe. Currently, industry professional standards are mainly enforced through the conditions attached by investors to their commitments in funds and via trade bodies. In light of the economic and financial challenges and the need to regain confidence, not only regulation needs to be redesigned but the enforcement mechanisms of industry professional standards should also be enhanced. As a consequence, the European private equity industry makes the following recommendations aim to address firstly the concerns regarding the potential fragmented application of industry professional standards across countries and secondly the concerns on enforcement and monitoring mechanisms for compliance with industry professional standards.
Recommendations for unifying industry professional standards coverage across Europe

The first concern is that the co-existence of guidelines covering the same topics raises the possibility that practitioners will arbitrage to adopt the guidelines they perceive as least damaging to their interests. While differences tend to be small, this nevertheless creates the perception that self-regulation is haphazard. Allied to this is the heterogeneity of guidelines on the same topics, which makes it hard for third parties to understand which participants are subject to which guidelines. Therefore, the following recommendations are being made: That there should be a unified European wide set of minimum standards; That these should be principles based to allow subsidiarity and national implementation of approved variations to fit with local practices and legislation; and A process of mutual recognition should be established.
(116)
Downloadable at: http://www.america.gov/st/texttrans-english/2008/November/20081117173241xjsnommis0.4479639.html
250
Conclusion and Recommendations
It is also recommended that those standards should be consolidated into one consistent document and cover: Code of Conduct Reporting Guidelines Valuation Guidelines Transparency and Disclosure Guidelines Governing Principles Corporate Governance Guidelines
The United Nations Principles for Responsible Investment will be influential in shaping our thought-process as we approach the implementation of a European wide set of minimum standards for the private equity industry. The exact way in which the matters covered in the existing guidelines will be brought together remains to be agreed; however the overall content will at least cover those matters as are required by the European Commission.
Recommendations for improving enforcement

In addition to embarking upon a process of mutual recognition of standards across Europe this paper concludes that enhancements to the enforcement mechanisms are necessary and should be introduced. The regime that is established will meet the following tests: Accountability to EU and national supervisory bodies; Protection of the process from conflicts of interest; Proportionality according to the risk posed by various industry participants; and Subsidiarity to the legal and regulatory frameworks of different jurisdictions.
Developing the appropriate enforcement mechanisms will be introduced relatively quickly by embracing the best of existing self regulation and utilising existing processes of monitoring such as audit wherever possible. Clear complaint procedures will be introduced with independent mechanisms to deal with matters arising and with reliable sanctions. The operation of the oversight mechanisms and sanctions will be open to public scrutiny and regurlarly reported on.
Annexes
1. Annex 1: European legal regime relating to asset stripping and further potential risks relating to private equity transactions
Introduction
251
1.1.
This memorandum summarizes (i) the legal and tax regimes for asset stripping from limited liability companies, (ii) the protection of limited liability companies against undue financial assistance and other forms of upstream loans/security imposed by their shareholders and (iii) the protection of listed limited liability companies against secret stake building, each (i) (iii) in scenarios which are typical for private equity transactions. This memorandum covers certain key jurisdictions of Europe (France, Germany, Italy, Spain and the United Kingdom; together the Key Jurisdictions). Asset Stripping for the purpose of this memorandum shall (i) be the disposal of core assets by a company followed by the subsequent distribution of the resulting proceeds of the disposal to its shareholders or (ii) the unduly high distribution of liquid assets to the shareholders, e.g. to pay off acquisition debt incurred by the shareholders as part of a leveraged finance transaction, even when such disposal and distribution risk to be materially detrimental to the company. The memorandum outlines the legal safeguards against asset stripping under corporate law as well as certain UK capital markets provisions. Furthermore this memorandum addresses the question whether the applicable tax regime in the Key Jurisdictions would discourage shareholders from asset stripping. As for the types of limited liability companies, this memorandum will only cover such national legal forms of limited liability companies which are used for large and medium-sized companies as these are the key targets for private equity investors. Such legal forms are the Socit Anonyme (SA) (France), Gesellschaft mit beschrnkter Haftung (GmbH), Aktiengesellschaft (AG) (Germany), Societ per azioni (SpA), Societ a responsabilit limitata (Srl) (Italy), Sociedad Annima (SA), Sociedad de Responsabilidad Limitada (SL) (Spain) and Private company limited by shares (Ltd.) and Public company limited by shares (Plc) (United Kingdom). Financial assistance for the purpose of this memorandum shall mean the assistance given by a company for the purchase of its own shares or the shares of its parent company by an investor. Such assistance can be given in different ways, for instance by an advance payment, a direct loan or a guarantee or other security for a loan by financing banks in order to support the investors acquisition debt. Upstream loans for the purpose of this memorandum are post-acquisition loans which the target company grants to its parent company and which do not qualify as financial assistance. The term upstream security encompasses security for a loan which a third party has granted to the parent company. Finally this memorandum will briefly cover the protection of listed public limited liability companies against secret stake building, in particular through notification and other transparency requirements.
252
Annexes
1.2.
Executive summary
1.2.1. National legal safeguards against asset stripping All Key Jurisdictions contain strict safeguards under corporate or capital markets laws in order to prevent asset stripping. Creditors and minority shareholders shall thus be protected against adverse effects of asset stripping instead of being merely referred to insolvency laws. Such preventive regulations against asset stripping govern both (i) the initial sale of core assets and the subsequent distribution of the proceeds of the disposal to its shareholders (whether in the form of profit distribution, buybacks of own shares, reduction of share capital) and (ii) the unduly high distribution of liquid assets to the shareholders. Preventive regulations include measures such as: the requirement of shareholders resolutions; the liability of shareholders if they act to the detriment of the company; the risk of personal liability of the legal representatives of a company if they act to the detriment of the company; and strict capital maintenance rules implementing the Second Company Law Directive (77/91/EEC).
1.2.2. Asset stripping and Taxation Most European member states levy ordinary tax rates on capital gains from the disposal of assets and business units as well certain duties on fair market values of transferred assets. Asset stripping strategies therefore are, considering the tax burden triggered, on the basis of current tax laws, unattractive. Only share deals may, often due to the participation exemptions introduced in a number of member states, provide for an exception to these rules. With a view of the lack of attractiveness of asset stripping strategies, European member states have in the past consequently not seen any reason to provide for specific anti avoidance rules for asset stripping rules. 1.2.3. National legal safeguards against undue financial assistance and other forms of upstream loans/security imposed by the shareholders to the target company Financial assistance All Key Jurisdictions implemented the strict restrictions on financial assistance of public limited liability companies required by the wording of Art. 23 of the Second Company Law Directive (Directive 77/91/EEC) prior to its amendment. Most Key Jurisdictions not only implemented Art. 23 but also enacted additional limitations, namely provisions governing by-passing structures and transactions with the same effect as the transactions listed in Art. 23. Moreover, many Key Jurisdictions also enacted restrictions on financial assistance of private limited liability companies thereby going beyond the applicability scope of Art. 23 Directive 77/91/EEC. Art. 23 was recently deregulated by Directive 2008/68/EC as the European legislator intends to ease changes in the ownership while at the same time stipulating safeguards protecting both shareholders and creditors. Even though the member states are now able to permit public limited liability companies to grant financial assistance up to the limit of the companys distributable reserves, provided they make such transactions subject to the very strict substantial and procedural conditions set forth in the new wording of Art. 23, so far only Italy has implemented Art. 23 as amended by Directive 2008/68/EC.
Submission paper on the private equity industry to the European Commission and the European Parliament - February 2009
253
Upstream loans/securitiy All Key Jurisdictions also contain limitations with respect to such upstream loans/security to a parent company or a third party which do not qualify as financial assistance. Preventive regulations encompass a variety of effective measures such as: restrictions on related party agreements; the requirement that the granting of the loan/security must comply with the target companys corporate purpose and interest; the prohibition to affect the non-distributable reserves when granting the loan/security; test whether the claim against the borrower is fully realizable and/or the necessity to point out the reasons for granting the loan/security.
1.2.4. National legal safeguards against secret stake building in listed target companies All Key Jurisdictions contain provisions in order to protect listed companies against secret stake building, in particular through notification requirements. Such provisions also govern secret stake building through certain financial instruments. As a general rule, the aforementioned national provisions are based on the implementation of the Transparency Directive (Directive 2004/109/EC) and its substantiating Directive 2007/14/EC. According to Art. 13 (1) Directive 2004/109/EC, certain financial instruments also have to be considered for the purpose of the voting rights thresholds. In some Key Jurisdictions, this also includes cash settled equity swaps. Furthermore, certain Key Jurisdictions also require shareholders reaching certain voting right thresholds (e.g. 10%) to disclose their intentions and plans for the company.
1.3.
National legal safeguards against asset stripping
1.3.1. Sale of assets of a company Most Key Jurisdictions contain restrictions on the legal bodies of a limited liability company (executive board/advisory board/shareholders) with respect to the sale of the assets of a company. A sale of substantial assets without a prior approval of the general meeting might be void and might have to be rescinded, unless the buyer acts in good faith. Such restrictions contain various approaches, which can be classified as listed below. Moreover most Key Jurisdictions impose a strict liability on the legal representatives if they sell assets without the prior consent of the general meeting. 1.3.1.1. Mandatory resolution of the general meeting prior to the sale of assets The sale of a certain percentage, value or key part of a limited liability companys assets may be subject to a mandatory resolution of the general meeting even in the absence of special provisions in the articles of association or by-laws of the company. Such Key Jurisdictions also stipulate a majority requirement for such resolution.
Submission paper on the private equity industry to the European Commission and the European Parliament - February 2009
254
Annexes
France If the transferred assets constitute the sole activity or the most significant part of the activities of the company, the sale of such assets may deprive the selling company of its corporate purpose. In this case a prior authorization of the shareholders will be requested in accordance with Art. L.225.96 of the French Commercial Code (Code de commerce). Such prior authorization shall be adopted with a 2/3 majority vote of the shareholders present or represented, provided that (i) a minimum quorum of at least one third of the shares carrying voting rights is reached at the meeting held upon first convening notice and (ii) a minimum quorum of at least one quarter of the shares carrying voting rights is reached at the meeting held upon second convening notice. If the assets are sold without such prior authorization, a court may pronounce the nullity of the sale. Such nullity can be asserted by both the company itself and by its shareholders. The legal representative may also be subject to civil liability. Furthermore, the agreements relating to such sale (agreements entered into between the seller/purchaser, its directors/managers and/or shareholders holding more than 10% of the share capital) are subject to a specific control procedure as they are subject to a prior authorization of the board of directors and approval at the shareholders meeting by a simple majority vote of the shareholders on the basis of a special report of the statutory auditors. If the seller is a socit anonyme with a management board (directoire) and a supervisory board (conseil de surveillance), the prior approval of the supervisory board is required in the event of any transfer of real property.
Germany According to the so-called Holzmller/Gelatine-jurisprudence, the divestment of approximately 75% of the assets of a German public limited liability company (Aktiengesellschaft) into a subsidiary of such company is subject to a resolution of the general meeting as the shareholders of the divesting company no longer have any direct, but only an indirect control of such assets. Also, under Sec. 179 a German Stock Corporation Act (Aktiengesetz-AktG) the sale of the entire assets of the company to a third party requires a resolution of the general meeting. Both resolutions shall be adopted with a 2/3 majority vote of the shareholders present or represented. If the managing directors effect a transaction without such prior resolution, such transaction might be invalid. Similar to the French legal regime, prevailing legal doctrine and some higher regional courts (Oberlandesgerichte) require a prior amendment of the articles of association by the general meeting if the sale of the transferred assets deprive the selling company of its corporate purpose as defined in its articles of association (Satzungsunterschreitung). If the assets are sold without such prior authorization, the sale might be invalid and subject to the threat of rescindment.
Italy Under Art. 2479 of the Italian Civil Code (Codice civile) any resolution of the board of directors that has a substantive effect of modifying (even if it does not formally do so) the company object (as it might be the case of the sale of all the companys assets) must be previously approved by a resolution of the quotaholders meeting. This rule is set up to prevent directors from de facto amending the company object without a prior resolution of the quotaholders meeting.
255
If the managing directors implement such transaction without a prior resolution of the quotaholders meeting they might be held liable therefore. According to Italian scholars the transaction may, however, be considered valid and effective, unless it can be proven that the buyer has not acted in good faith and with the aim to damage the company. Moreover, quotaholders who have ot approved the transaction having the above effect may withdraw from the company be redeeming their quota. Spain Under Spanish law, there are a number of cases requiring or recommending a shareholders meeting. Such cases are not specifically governed by any statute but rather by case law or corporate governance provisions and thus, need to be considered on a case by case basis. Similar to the other Key Jurisdictions covered above a disposal of the key operating or essential assets which are necessary to carry out the companys object may require a resolution of the general shareholders meeting in the cases where such actions imply a change of the companys object. In this event rules regarding amendment of the companys by-laws should be followed, especially the corresponding quorum (50% of the voting share capital in first call and 25% in second call) and majority requirements (approval by 2/3 of the attending or represented shareholders with voting rights should be obtained if the quorum is under 50% of the voting share capital). It is not sufficient that the company object is merely slightly amended. It must rather be completely changed or substantially amended. In particular case law and corporate governance regulation applicable to listed companies (Vid. Recommendation 3 of the so-called Conthe Code) require that an effective amendment of the corporate object occurs instead of a mere nominal amendment. Spanish Law confers a separation right in favor of the shareholders who did not vote in favor of the change of the companys object. Therefore, in the event a disposal of key operating or essential assets implying a change of the companys object is effected without a shareholders approval such shareholder may claim that he has a separation right. Additionally, directors may be held liable. Comparable to German law the conversion of a listed company into a holding company through the process of subsidiarisation, i.e. by reallocating the core activity of the company to a subsidiary, is recommended by the Conthe Code to be subject to a shareholders resolution. United Kingdom Under English law, there are rules requiring the company to obtain the shareholders approval for substantial asset transactions between the company and a director. Under s191 of the Companies Act 2006 (the 2006 Act), an asset is substantial in relation to a company if its value either exceeds (i) both 10% of the total value of the companys assets and 5,000, or (ii) 100,000. Public companies which are listed on the London Stock Exchange or the junior AIM market are subject to certain rules (the Listing Rules and AIM Rules respectively). Both sets of rules impose a series of class tests which measure the size of the disposal by reference to a number of financial criteria (e.g. gross profits) relative to the selling company.
256
Annexes
Under the Listing Rules, shareholder approval and a regulatory information service announcement are required if a transaction equals or exceeds 25% of certain thresholds relating to the companys gross assets, profits, gross capital and the consideration value of the transaction, a majority of the shareholders must approve the transaction and an announcement must be made on a regulatory information service. Under the AIM Rules, a disposal which, when aggregated with any other disposal(s) the company has made over the previous twelve months, exceeds 75% of any of the class tests set out in the AIM Rules (which relate to gross assets, profits, turnover, consideration and gross capital), is deemed to result in a fundamental change of business, and is subject to majority shareholder approval. 1.3.1.2. Prohibition for (majority) shareholders to act to the detriment of a subsidiary and corresponding liability Most Key Jurisdictions contain provisions according to which a (majority) shareholder must not act to the detriment of a subsidiary, for example by instructing the company to sell its core assets even if such sale is not in the interest of the company. If a (majority) shareholder or its representatives violate such rules, they are generally liable. France Under French law a shareholder, whether majority or minority shareholder, may be subject to the same liability as a manager if it can be proved that the shareholder actively manages or has actively managed the business of the company on a continuous and regular basis and entered into agreements or took decisions which were binding on the company in lieu of the companys duly appointed corporate representatives (dirigeant de fait). Generally, de facto managers incur the same criminal sanctions as duly elected or appointed directors and executive officers. While the rules pertaining to the civil liability of directors or executive officers of a socit anonyme do not apply to de facto managers, their liability is governed by the standard civil rules set out in Art. 1382 of the French Civil Code (Code civil). Furthermore, majority shareholders exercising their voting rights may be held liable to minority shareholders if it can be proved that they used their voting rights with the intention to abuse the minority shareholders. Such abuse of voting rights is restrictively defined under French case law. An abuse of majority is committed if the majority shareholders of a company take a decision which is (i) contrary to the corporate interest of such company, (ii) for the sole benefit of the majority shareholders of the company and (iii) detrimental to the minority shareholders interests. The sanction for an abuse of majority is the invalidity of the decision concerned and/or the allocation of damages to the minority shareholders. In particular, minority shareholders may challenge an asset stripping mechanism by arguing that the disposal of assets followed by a distribution to the shareholders of the proceeds of the disposal constitutes an abuse of majority, since (i) such operations are not justified by a business rationale and are thus contrary to the corporate interest of the company concerned by such disposal and (ii) the sole purpose of the distribution is to allow the majority shareholders to receive the proceeds of the disposal.
257
Germany Under German group company law (Konzernrecht), there are a number of provisions stipulating that a majority shareholder must not act to the detriment of a subsidiary. For instance, pursuant to Sec. 311 et sec. German Stock Corporation Act (Aktiengesetz-AktG) a majority shareholder of a public limited company (Aktiengesellschaft) must compensate any disadvantage caused to the company within one year. In case of a domination and/or profit transfer agreement, the majority shareholder is required to annually balance all losses of the subsidiary. In case of a private limited liability company (Gesellschaft mit beschrnkter Haftung) the courts have developed detailed rules prohibiting that a majority shareholder intentionally destroys the existence of the company (existenzgefhrdender Eingriff). If the aforementioned provisions and rules are violated, both the majority shareholder and (directly or indirectly) its representatives are liable towards the company.
Italy Art. 2497 of the Italian Civil Code (Codice civile) concerning groups of companies provides for a specific tort liability of the parent company towards the subsidiarys other shareholders and its creditors in the event that the parent company is deemed to have acted to the detriment of them. The legal standard of such liability depends on the damages caused by the parent company (i) to the subsidiary minority shareholders for having prejudiced the controlled companys profitability and the values of participations held by the shareholders in the subsidiary, and (ii) to creditors for damages caused with respect to the integrity of the subsidiarys assets. In order to avoid such liability, the parent company is required to either (i) prove that the action in question was in the best interest of the group of companies the company belongs to and that the benefits for the company deriving from belonging to the group outweigh the detriment caused by the parent companys actions or (ii) that the damages have been entirely eliminated by a transaction directed to such purpose. Should a parent company instruct the subsidiarys directors to sell assets with the exclusive aim of distributing the relevant proceeds to its shareholders, the parent company may be deemed liable towards (i) the subsidiarys minority shareholders for causing a devaluation of their participations in such subsidiary, and towards (ii) its creditors for having caused a damage to the integrity of the subsidiarys assets. In addition, the subsidiary itself is entitled to sue its directors for having carried out the instructions of the parent company and caused damages to the subsidiary. As far as the Srl is concerned, it is worth noting that, under the second paragraph of Art. 2476 of the Italian Civil Code (Codice civile), quotaholders intentionally authorizing or approving the implementation of a transaction that prejudices rights of the company, quotaholders and/or third parties rights shall be held jointly responsible together with the directors. This rule provide for a joint liability of directors and those quotaholders who have approved or authorised the transaction having a prejudicing effect on companys, quotaholders and third parties rights.
258
Annexes
Spain According to Spanish case law, a holding company of a corporate group can be held liable for certain actions of a subsidiary or other controlled entity, if the subsidiary is insufficiently capitalized to fulfill all claims such company is exposed to. In such case, creditors may request the court to pierce the corporate veil and make the shareholders personally liable for the debts, liabilities and obligations of the business itself (which they generally would not be liable for, due to the limited liability protection afforded to limited liability companies). Spanish Law does not contain a specific rule whereby the majority or controlling shareholders owes a duty of care to the minority shareholder or to subsidiary companies although new Spanish corporate governance trends are debating over it. Though, there are a number of protecting rights that minority shareholders holding a qualified stake (in most cases 5% of the share capital) in the company have (i.e. right to call a general shareholders meeting, submit proposals to be discussed at shareholders meetings, appoint in the case of Sociedades Annimas a representative on the board of directors in proportion to the stake held (the so-called proportional representation), among others).
United Kingdom Under English common law, there is a rule that the proper claimant in an action on behalf of the company is the company itself and therefore a shareholder can not bring such an action. There is an exception to the rule, which allows shareholders to bring an action on behalf of the company alleging that the majority shareholders were using their powers for their own benefit the fraud on the minority exception. This derivative action concept has been codified in the 2006 Act and extended, putting the common law rules on a statutory basis. The 2006 Act provides that a shareholder may seek permission of the court to bring an action directly against a director on behalf of the company in respect of a cause of action arising from an actual or proposed act or omission involving negligence, default, breach of duties or breach of trust.
1.3.1.3.
Obligation of the legal representatives to act in the interest of the company Under all Key Jurisdictions, the legal representatives are obliged to act in the companys interests. Otherwise they may be personally liable and may also face criminal charges. Such legal representatives must therefore in principle reject any detrimental instructions from the majority shareholder. The very few exceptions to such rule (such as the German rules on group companies stated above) all stipulate that the (majority) shareholder shall compensate any disadvantage he has imposed on the company. France Under French law all actions accomplished on behalf of the company by its legal representatives must be directly or indirectly related to its corporate purpose and must be entered into in the interest of the company. A sale of assets must thus be justified by a business rationale and must not jeopardize the future development of the company. If the legal representatives fail to act accordingly, they are subject to civil and/or criminal penalties.
259
Civil liability The directors of a French public limited liability are subject to civil liability for a (i) breach of applicable statutes or regulations, (ii) breach of the by-laws provisions or (iii) for acts of mismanagement. In particular, they are liable for their decisions or actions in violation of the corporate interest of the company, even if such violation was unintentional (as a result of an imprudent decision, or in the case of negligence). Directors have a general obligation of diligence, competence and to act in the corporate interest of the company. Therefore, in order to avoid personal liability, directors shall reject detrimental instructions from the majority shareholder which are contrary to the corporate interest of the company. Criminal liability Pursuant to Art. L.242-6 of the French commercial code (Code de commerce), criminal sanctions apply against the directors, the chairman of the board and the managing director of a socit anonyme who, acting in bad faith or in a way which they know is contrary to the corporate interest of the company, misuse the assets or credit of the company or the powers they have in it, for a personal purpose or in order to favor another company or business in which they hold direct or indirect interests. Such officers may incur up to 5 years imprisonment and a fine of up to 375,000. Germany Pursuant to Sec. 317 para. 3 of the German Stock Corporation Code (Aktiengesetz), the legal representatives of the majority shareholder which are responsible for impairing the subsidiary are personally liable. As a general rule stated in Sec. 76 and 93 of the German Stock Corporation Code (Aktiengesetz AktG), the legal representatives of a German public limited liability company (Aktiengesellschaft) must only consider the interests of the company and are not obliged to follow any instructions of the majority shareholder, unless a domination and/or profit transfer agreement has been concluded with such shareholder. If the legal representatives violate the above stated rules, they can be held liable under both civil and criminal law. Italy While directors are in principle entitled to sell assets of the company, they are subject to certain fiduciary duties. Directors must (i) comply with the duties imposed upon them by law and by the articles of association with the required diligence; (ii) act in the companys best interest; and (iii) among others, preserve the value of companys assets in order to protect the rights of the creditors and other stakeholders.
260
Annexes
If such fiduciary duties are violated by the directors, they may be liable towards the company and its creditors (see Artt. 2392 and 2394 of the Italian Civil Code (Codice civile) applicable to the SpA and Art. 2376 of the Italian Civil Code (Codice civile) applicable to the Srl). For instance, directors might be held liable if they sell assets of the company for a price lower (to an extent that exceeds the boundaries of the business judgment rule) than their fair value. Such of liability may be also applicable to directors if the proceeds of the transaction are distributed to the shareholders. In this case creditors can file an action against such directors as far as they prove that their claims against the company may be prejudiced by such sale and the subsequent distribution. According to Art. 2626 of the Italian Civil Code (Codice civile) (applicable to both SpA and Srl) directors who have taken actions that have effects equivalent to those of a reduction of the share capital without recurring to an appropriate capital reduction, face imprisonment of up to one year. Such requirement may be violated by directors who sell to shareholders company assets for a price lower than their fair value. Spain Spanish law provides for a set of 4 fiduciary duties relevant to the directors of a company: (i) general duty of care; (ii) fidelity; (iii) loyalty; and (iv) secrecy. Theses fiduciary duties primarily require the directors of the company to act in the interests of the company. Directors should therefore avoid acting for the benefit of the majority shareholder or for their own benefit. Compliance with these duties is paramount in Spanish regulation. If they fail to do so, they are liable vis--vis the company, the shareholders or the companys creditors. Any action in breach of such duties cannot be authorised or ratified by a general shareholders meeting. As a result the directors cannot avoid liability. There are two types of actions which can be brought against the directors. The first type of action (the so-called Social Claim Accin Social de Responsabilidad) can be brought by the Company, shareholders holding more than 5% of the share capital and in certain cases by the creditors of the company. The other type of action (the so-called Individual Claim Accin Individual de Responsabilidad) can be brought by any shareholder or third party for the damages caused by the directors actions. United Kingdom English law sets out a number of duties with which the directors of a company must comply. Many of these are founded on common law rules but some have recently been codified under the 2006 Act. The duties set out in the 2006 Act are: Duty to act within powers (Sec. 171) Duty to promote the success of the company (Sec. 172) Duty to exercise independent judgment (Sec. 173) Duty to exercise reasonable care, skill and diligence (Sec. 174) Duty to avoid conflicts of interest (Sec. 175) Duty not to accept benefits from third parties (Sec. 176) Duty to declare interest in a proposed transaction or arrangement (Sec. 177)
261
A director may be in breach of these statutory and common law duties if he fails to prevent the impairment of the company by the actions of a majority shareholder. In such case the director will be personally liable to the company for breach of fiduciary duties, negligence or breach of trust. The shareholders may also be able to bring an action on behalf of the company against the director using the derivative action procedure described above. The company can enter into agreements that may bind the directors to exercise their powers in certain ways (for example, shareholders agreements). The 2006 Act does provide that the duty to exercise independent judgment is not infringed by a director acting in accordance with an agreement which was entered into by the company and which restricts the future exercise of discretion by the directors, or by directors acting in a way authorised by the companys constitution. However, directors must at all times act in accordance with their common law and statutory duties, and must act in the best interests of the company. 1.3.2. Distribution of assets In all Key Jurisdictions the distribution of assets (i.e. profit distribution, buybacks of own shares, reduction of the share capital) to the companys shareholders is restricted by capital maintenance rules. In the event that assets of the company have been sold to the detriment of the interests of the remaining shareholders, creditors or employees, the provision on distribution of assets still contain very strict rules for the payment of dividends to distribute proceeds from such sale. 1.3.2.1. Distribution of dividends General rule: Only distributable profits may be distributed In all limited liability companies falling within in the scope of the Second Company Law Directive (Directive 77/91/EEC) a distribution of dividends can only be effected if after such distribution both the registered capital and any mandatory capital reserves are covered by assets whose book value corresponds to such registered capital and mandatory capital reserves. As such provisions protect creditors they are mandatory and cannot be set aside by an unanimous resolution of the shareholders. Such requirements have been fully implemented into all Key Jurisdictions and apply to the following companies: Socit Anonyme (SA) (France), Gesellschaft mit beschrnkter Haftung (GmbH), Aktiengesellschaft (AG) (Germany), Societ per azioni (SpA), Societ a responsabilit limitata (Srl) (Italy), Sociedad Annima (SA), and Sociedad de Responsabilidad Limitada (SL). The English law rules are set out below and apply to both public and private companies. France A distribution of dividends is only allowed as long as the share capital and the mandatory capital reserves are not affected by such distribution. Pursuant to Art. L. 232-11 of the French Commercial Code (Code de commerce), the shareholders of a company may only distribute: (i) the distributable profits of the company which are equal to the net income of the previous financial year, reduced by the amount of the losses of the previous financial years and the amount of the legal reserves, and increased by the retained earnings; and (ii) the reserves, with the exception of the legal reserves, the reserves required by the by-laws and the revaluation differential (carts de rvaluation). It has to be noted that the distributable reserves include the capital premium and the special reserves of long-term capital gain.
262
Annexes
Please note that no distribution is allowed, if, as result of such distribution, the shareholders equity of the company becomes less than half of the amount of its share capital. Germany Under German law a distribution of dividends is only allowed, if neither the registered capital nor any mandatory reserves are affected thereby: (i) Pursuant to Sec. 57 para. 3, 58 para. 4 of the German Stock Corporation Act (Aktiengesetz-AktG) only the net retained profit as determined by the general meeting may be distributed to the shareholders of a public limited company (AktiengesellschaftAG), i.e. the profit retained after the deduction of the amounts necessary to cover the registered capital and mandatory reserves. (ii) According to Sec. 30 of the German Act on limited liability companies (GmbHG), likewise only the net retained profit may be distributed to the shareholders of a private limited company (Gesellschaft mit beschrnkter Haftung GmbH), i.e. the profit retained after the deduction of the amounts necessary to cover the registered capital. There are no mandatory reserves in a GmbH. Italy Italian corporate law contains several rules for the protection of the integrity of capital that limit the distribution of profits: (i) a company may distribute assets to its shareholders as long as such distribution does not affect the minimum legal capital of the company itself and its mandatory reserves; (ii) no dividends may be distributed in case of losses until the capital is reinstated or reduced by a corresponding amount (see Art. 2433 of the Italian Civil Code (Codice civile) for the SpA and Art. 2478 bis of the Italian Civil Code (Codice civile) for the Srl); (iii) shareholders may only distribute the profits resulting from the last approved financial statements and after deduction of any losses, and, in general, the amount of profits which may be distributed is subject to a specific limit. In fact, shareholders may not distribute profits in whole if the amount of the legal reserve included in the approved financial statements is less than 20% of the registered capital of the company (see Art. 2430 of the Italian Civil Code (Codice civile) for the Spa and Art. 2478 bis of the Italian Civil Code (Codice civile) for the Srl); (iv) Art. 2433 bis of the Italian Civil Code (Codice civile) provides for specific limits to payments on account of dividends; (v) Art. 2431 of the Italian Civil Code (Codice civile) (which applies to the SpA) regarding the share premium reserve stipulates that the shares premium, including those deriving from the conversion of corporate bonds, can not be distributed until the legal reserve resulting from the last approved financial statements has reached 20% of the legal capital of the company. Spain According to Spanish law (see Art. 215 of the Ley de Sociedades Annimas), payment of dividends can only be effected if the legal and the statutory reserves (if applicable) have been fully covered and provided that the net worth of the company is higher than the share capital.
263
Payment of interim dividends (see Art. 216 of the Ley de Sociedades Annimas) can only be effected if the following conditions are fulfilled: (i) interim accounts shall be drawn up by the directors showing that the funds available for distribution are sufficient; and (ii) the amount to be distributed may not exceed the total profits made since the end of the last financial year for which the annual accounts have been drawn up, plus any profits brought forward and sums drawn from reserves available for this purpose, less losses brought forward and sums to be placed to reserve pursuant to the requirements of the law or the statutes. United Kingdom Section 829 of the 2006 Act defines distribution very broadly as meaning every description of distribution of a companys assets to its members, whether in cash or otherwise. While the most common form of distribution is a dividend, distributions can be made in any form available i.e. assets, returns of capital and share buy-backs are all available to both public and private limited companies. There are two basic requirements that a company must meet before making a distribution: 1. The company must have sufficient distributable profits. The 2006 Act defines these as its accumulated, realized profits so far as not previously utilized by distribution or capitalization, less its accumulated realized losses, so far as not previously written off in a reduction or reorganization of capital duly made; and 2. The distribution must be made by reference to relevant accounts. These accounts can be the most recent annual accounts or specially prepared interim or initial accounts but must allow assessment of the companys profits, losses, assets, liabilities, share capital and reserves. There are additional regulatory requirements for public companies and investment companies. Section 831 of the 2006 Act imposes additional capital maintenance requirements on public companies. A public company may only make a distribution if the amount of its net assets is not less than the aggregate of its called up share capital and undistributable reserves; and to the extent that, the distribution does not reduce the amount of those assets to less than that aggregate. The 2006 Act also provides that certain intra group transfers may be treated as distributions. Section 845 of the 2006 Act provides that if a company does have distributable profits, assets may be transferred at below book value. This will be regarded as a distribution in kind. The amount of the distribution is the amount by which the book value of the assets exceeds the amount or value of the consideration received by the company. If the company does not have sufficient distributable profits (determined as described above) to cover that distribution in kind, then the transaction is likely to be an unlawful distribution. Consequences of a breach of the rules governing distributions of dividends France Pursuant to Art. L.223-17 of the French Commercial Code (Code de commerce), the company can ask for the restitution of dividends received by the shareholders, when the distribution of dividends did not comply with the legal requirements. In such case, the company shall prove that the shareholders were aware of the unlawful distribution or that given the circumstances, could not have been ignorant of that fact. The restitution of dividends is barred by the applicable statute of limitation after 5 years.
264
Annexes
Pursuant to Art. L.232-12 3 of the French Commercial Code (Code de commerce), any dividend distributed in violation of the Art. L.232-12 1 of the French Commercial Code (i.e. prior approval of the accounts and existence of distributable amounts) is considered as a distribution of unlawful dividends. In such case, criminal sanctions apply against the directors, the chairman of the board and the managing director of a socit anonyme and they may incur up to 5 years imprisonment and a fine of up to 375,000. Such officers may also be subject to civil penalties, as described above. Germany Under German law, dividends unlawfully paid to shareholders can be recovered unless the shareholders received them in good faith Such principle is contained in Sec. 62 German Stock Corporation Act (Aktiengesetz-AktG) and in Sec. 31 of the German Act on limited liability companies (GmbHG). In the latter case, however, the company can reclaim all means necessary to satisfy its creditors from the shareholder, even if such shareholder acted in good faith when receiving the dividends. The legal representatives who unlawfully distributed dividends to any shareholder are liable towards the company. Creditors are entitled to sue the legal representatives on behalf of the company (Sec. 62 para. 2 German Stock Corporation Act (Aktiengesetz-AktG)). Furthermore, the legal representatives might also face criminal charges for embezzlement (Sec. 266 German Criminal Code (Strafgesetzbuch-StGB)). Italy Dividends illegally paid to shareholders can be recovered, unless they have been collected by shareholders in good faith and on the basis of untrue financial statements regularly approved showing the corresponding profits. If the directors violate one of the above mentioned rules, they may incur civil liability. In addition, also criminal provision may apply to directors who violate the above provisions. Art. 2627 of the Italian Civil Code (Codice civile) punishes with imprisonment up to one year directors who distribute profits or account on dividends not effectively made or determined by law as legal reserves, or who divide reserves also not created with profits which cannot, pursuant to law, be distributed. As a result, directors may only distribute profits if the following conditions are met: (i) the financial statements report a profit; (ii) the ordinary shareholders meeting has approved a distribution of the reported profits; (iii) the distribution does not affect any legal reserves. In this regard, it is worth to note that under Italian law, at least 5% of the yearly reported profits must be transferred to a legal reserve account, until the mentioned reserve does not reach an amount of 20% of the companys registered capital. In addition, whereas the company has issued shares for a price higher than their pair value, the amount resulting from the premium paid by shareholders must contribute to form a legal reserve account and cannot be distributed to shareholders. The rationale of the mentioned provisions is to ensure the integrity of the companys registered capital and, ultimately, to protect creditors rights. Therefore, should directors violate one or more of the above rules, they might be incur in a criminal liability as per Art. 2627 of the Italian Civil Code (Codice civile).
265
Spain Art. 217 the Ley de Sociedades Annimas provides that dividends unlawfully paid to shareholders must be paid back by them plus the legal interest accrued since the payment was made. This is the case if the shareholder was actually aware that the payment was unlawful or, given the factual circumstances, they could have known it was unlawful. Directors may also be held liable as well as in accordance with the regulations described hereunder. Spanish regulation does not specifically address the problem of the material infra-capitalization (when the net worth of the company is too low to face the risks and investments undertaken by the company), case law has found the shareholders of the company to be personally liable vis--vis the companys creditors, by means of the pierce of the corporate veil doctrine. In the cases of nominal infra-capitalization (when the shareholders have made contributions to the company in the form of loans when they should have in fact made contributions to the share capital), case law has, in some cases, re-characterized them as share capital to face the companys debts.
United Kingdom Where an unlawful distribution is made (for example, where a distribution is made where the company does not have sufficient distributable profits), the shareholder will be liable to repay the company for the distribution (or the proportion of the distribution that was unlawful), unless he received the distribution in good faith. If the distribution was made otherwise than in cash, under section 847 of the 2006 Act, the shareholder will be liable to repay the company a sum equal to the value of the assets. It is worth noting that in relation to the good faith point above, that a shareholder who receives a distribution without knowledge, or without reasonable grounds for believing that it was unlawful, will not have to repay it. In any case, the directors must have regard to their duties to the company. They will need to be sure that the company will be solvent following the distribution and should take into account any changes to the financial position of the company since the date of the relevant accounts. They should also consider the future cash requirements of the company.
1.3.2.2.
Share buy-backs France Pursuant to Art. L.225-206, II, 1 of the French Commercial Code (Code de commerce), share buy-backs are only possible in certain specific cases, which are the following: reduction of share capital realized through the repurchase by the company of its own shares followed by their cancellation; attribution of shares to the employees or managers of the company; and improvement of the financial management of the working capital of the French listed companies.
Art. L.225-210 of the French Commercial Code (Code de commerce) provides that (i) the company can not hold more than 10% of its share capital, (ii) the acquisition of its own shares by the company shall not reduce the shareholders equity below the amount of the share capital and the mandatory reserves, and (iii) the company shall have a reserve, other than the mandatory reserves, at least equal to the value of the shares owned by the company.
266
Annexes
If the company does not comply with such rules, the shares owned by the company shall be sold within a period of one year from their acquisition date. Failing to do that, the shares owned by the company shall be cancelled. A breach of these rules by the directors, the chairman of the board and the managing director of a socit anonyme constitutes a criminal offence. Germany According to Sec. 71 para. 1 no. 8 Stock Corporation Act (Aktiengesetz-AktG) a stock corporation may purchase its own shares on the basis of an authorization of the shareholders meeting which does not exceed 18 months and which sets forth the lowest and the highest price for the shares and that such purchase may not exceed ten percent of the share capital. According to the prevailing legal doctrine, the determination of such price range need to make sure that the actual price will be very close to the market price. Furthermore, according to Sec. 71 para. 2 Stock Corporation Act, such purchase shall only be permitted if the stock corporation is able to create a reserve for its treasury stock as required by Sec. 272 (4) of the Commercial Code without reducing either its share capital or any reserve required by law or the articles of association. Hence, only distributable reserves may be used for a share buy back while the registered capital and the mandatory reserves remain unaffected. Italy With reference to the possibility for a company to buyback its own shares, it is preliminary necessary to point out that Italian law does not allow Srl to buy back its own quotas. Therefore the following applies only to the SpA. Art. 2357 of the Italian Civil Code (Codice civile) provides that a company can purchase its own shares unless their purchase price exceeds the profits available for distribution and the available reserves as shown in the last duly approved financial statements. In any event, a resolution of the shareholders meeting is required in order for the company to buyback its own shares. In addition with specific reference to companies making recourse to the market of capitals (117), the par value of own shares purchased by such companies may not exceed one tenth of the registered capital of the company, and, for such purpose, the shares owned by controlled companies must also be counted. Shares bought back in violation of the above mentioned rules, must be sold within one year starting from the day of the purchase. Otherwise directors are bound to reduce the numbers of the issued shares accordingly and proceed with the reduction of the legal capital of the company. Italian law imposes also criminal provisions for the violation of rules on repurchases. In particular, directors that buy-back shares in violation of the above mentioned rules causing damages to the integrity of the legal capital are punished with imprisonment up to one year.
(117)
According to Art. 2325 bis of the Italian Civil Code companies making recourse to the market of capitals are considered those having shares listed on regulated markets or highly distributes among the public.
267
Spain Pursuant to Art. 75 et seq. of the Ley de Sociedades annimas a company (Sociedad Annima) may purchase its own shares on the basis of an authorization of the shareholders meeting which does not exceed 18 months and which sets forth the price range for the shares and that such purchase may not exceed ten percent of the share capital or five percent in the case of listed companies. Acquisition of treasure stock shall only be permitted if the company can be set up without reducing either its share capital or any legal or statutory reserves. The shareholders rights attached to the shares acquired by the company shall be suspended. A Sociedad Limitada may purchase its own shares only in a limited number of cases established in Art. 40 of the Ley de Sociedades de Responsabilidad Limitada. The applicable regime in the case of a Sociedad de Responsabilidad Limitada is more restrictive than in the case of Sociedades Annimas, though, the reserve and suspension of rights requirements are also applicable.
United Kingdom English law regulates the purchase of own shares. Market purchases by a listed company must be approved by the companys shareholders. Although the legislation requires only a simple majority, the institutional shareholder community generally expects a listed company to obtain the approval of 75% of the shareholders. The Listing Rules limit the number of shares which can be bought back by a company. The payment for the purchase of its own shares by a company must be made out of distributable profits or out of the proceeds of a fresh issue of shares made for the purpose of the repurchase. The directors will need to make reference to the relevant accounts and ascertain the level of distributable profits. Where the accounts are qualified by the auditors, the auditors will need to state whether that qualification is material in the context of the buy-back. A similar process is required to be undertaken by the directors as if the company was making a distribution by way of dividend. A private limited company may in certain circumstances purchase its own shares out of capital (as opposed to out of distributable profits or the proceeds of a new issue). Such a purchase will in any case need to be approved by a special resolution by a 75% majority of the shareholders.
1.3.2.3.
Capital decreases France The shareholders may decide to distribute a part of the share capital of the company through a reduction of the companys share capital. Apart from a reduction of the share capital if the company has incurred losses, the share capital may be decreased when the size of the company or its activities no longer justify the amount of its share capital. A reduction of the share capital is decided upon a resolution of the extraordinary shareholders meeting, requiring a two-third majority vote of the shareholders. A limited liability company may reduce its share capital by the reduction in number of its outstanding shares (which can be achieved either through a repurchase by the issuer of its own shares followed by their cancellation or by a direct cancellation, although this last process is rarely used) or by the reduction of the par value of its shares (in the latter case, the amount of cash that could be up streamed by means of such a reduction of the share capital would be limited to the amount of the par value of the shares).
268
Annexes
The statutory auditor must submit to the shareholders at least 15 days prior to the general meeting deciding the reduction of the share capital a report on the terms, consequences and conditions of the reduction. French corporate law grants to the creditors of the company a right to challenge a proposed reduction of the share capital if the proposed transaction would result in placing them in a less advantageous situation. Thus, in the event of a reduction of the share capital, the creditors would be allowed to petition the competent commercial court within 20 days following the publication of the decision taken by the shareholders meeting to reduce its share capital for either (i) the repayment of all outstanding debts or (ii) the granting of guarantees or security interests. Until such 20-day period or the court proceeding has been terminated, the reduction of the share capital may not be completed. Germany Under German law there are specific rules governing capital decreases aimed at protecting companys creditors. A capital reduction requires the companys managing directors to publish three times an announcement that the shareholders have passed a resolution to reduce the companys nominal share capital by a majority (Sec. 58 para. 1, 53 para. 2 German Limited Liability Companies Act (GmbHG)) or a majority resolution of the shareholders of a public limited liability company (Aktiengesellschaft) present or represented (Sec. 222 para. 1 German Stock Corporation Act Aktiengesetz (AktG)). The capital reduction may only be filed with the commercial register of the company after one year following the third publication of the announcement. The capital reduction only becomes effective upon its registration with the commercial register. In this way, creditors become aware of the envisaged capital decrease and can require that their claims may be secured. Moreover it has to be stressed that a capital reduction must not affect the minimum registered capital requirements. Italy Italian Law provides for specific rules for the SpA and the Srl concerning the capital decrease aimed at protecting the companys creditors. In particular, Art. 2445 and Art. 2482 of the Italian Civil Code (Codice civile) respectively regulating the SpA and Srl contain the procedure to be followed in order to reduce the registered capital of a company. According to said provisions, the reduction of capital may be legally resolved only if: (i) such reduction does not affect the minimum legal capital requirements; and (ii) the relevant extraordinary shareholders meeting resolution to be registered with the competent companies register has not been opposed by companys creditors. In this respect, should directors implement a capital reduction without observing the above mentioned rules, in addition to the provisions setting out their civil liability, also Art. 2629 of the Italian Civil Code (Codice civile) may apply which punishes directors with the imprisonment up to three years.
269
In addition to the foregoing, Art. 2446 and Art. 2482 bis respectively regulating SpA and Srl provide specific and mandatory procedures to be followed by directors should the capital of the company be diminished by more than one third as a result of losses. Moreover, Art. 2447 of the Italian Civil Code (Codice civile) applicable to the SpA and 2482 ter of the Italian Civil Code (Codice civile) applicable to the Srl, stipulate that, should the capital of the company fall under the minimum capital requirements set forth by law, directors must without delay call the meeting to decide on the reduction of the capital and the concurrent increase thereof to an amount not less than the minimum or on the transformation of the company. In such cases, should directors fail to comply with the mandatory provisions set forth by the above mentioned rules, they are liable according to the rules described under section 2 above and also pursuant to Art. 2631 of the Italian Civil Code (Codice civile) which provides for administrative sanctions. Spain Under Spanish law there are specific rules governing capital decreases aimed at protecting companys creditors and shareholders. A capital decrease requires in the case of a Sociedad Annima that the companys directors publish an announcement in a newspaper and in the Commercial Registry Official Gazette. In this event rules regarding amendment of the companys by-laws should be followed, Art. 164.3 of the Ley de Sociedades Annimas establishes that when the capital decrease implies an amortization of shares and the capital decrease does not affect equally to all shareholders approval is required from the affected shareholders. An offer in accordance with the Spanish takeover regulation (Real Decreto 1066/2007) shall be made if the share capital decrease is effected in a listed company by means of the acquisition of shares to be amortized by the company. Pursuant to Art. 79 of the Ley de Sociedades de Responsabilidad Limitada in case the capital decrease does not affect all shareholders equally an unanimous consent of the shareholders shall be obtained. Finally, it is worth noting that in the case that a capital decrease of a Sociedad de Responsabilidad Limitada implies that contributions by the shareholders are paid back to such shareholders a three months prior notification to creditors shall be made. Ordinary creditors may oppose to the capital decrease unless their credits are not paid back or guaranteed by the company. United Kingdom Under the 2006 Act, there are now two ways in which a UK company may reduce its share capital. Firstly, both public and private companies may implement a court approved reduction. The reduction will need to be approved by 75% of the shareholders. The court will consider the interests of creditors of the company. A listed company will also need to consider the relevant Listing Rule or AIM Rule requirements. The process takes around 6 weeks.
270
Annexes
Secondly, the 2006 Act has recently introduced a director approved solvency statement route that private companies only may use. The expedited solvency statement route requires the directors to make a statement as to the current and future solvency of the company. Under section 643 of the 2006 Act, the directors must make a statement that each of the directors has formed the opinion, as regards the companys situation at the date of the statement, that there are no grounds on which the company could then be found to be unable to pay its debts. In addition, the directors must be of the opinion that the company will be able to pay its debts as they fall due within one year of the statement.
1.4.
Asset stripping and Taxation
Most European member states levy ordinary tax rates on capital gains from the disposal of assets and business units as well certain duties on fair market values of transferred assets. Asset stripping strategies therefore are, considering the tax burden triggered, on the basis of current tax laws, unattractive. Only share deals may, often due to the participation exemptions introduced in a number of member states, provide for an exception to these rules. With a view of the lack of attractiveness of asset stripping strategies, European member states have in the past consequently not seen any reason to provide for specific anti avoidance rules for asset stripping rules. Taxation at ordinary tax rates Tax laws of most European member states provide for a taxation of capital gains from the sale of assets at ordinary tax rates. More specifically, the disposal of single assets or even separate business units leads to a full taxation of any hidden reserves at tax rates between 12.5% (Ireland) and 28% (UK), 30% (Germany) and 34.4% (France). In addition, remarkably high charges and duties levied in addition to the taxes on income (eg real estate transfer taxes between 3 and 5% of the fair market values and registration taxes amounting up to 2%) are levied upon transfer. Anti avoidance rules in case of hive downs/spin offs Even if business units are spun out or hived down into newly formed subsidiaries, tax laws of the European member states provide for taxation at ordinary tax rates upon the reorganization or at least upon disposal of the shares in the subsidiary receiving the business unit. In the latter case, tax laws usually provide for lock up periods between 3 (e.g. France) to 7 years to benefit from a full tax exemption of the capital gains derived from the sale of the shares. No offsetting with loss carry forwards As loss carry forwards at the level of portfolio companies, if any, usually have fallen away in the context of acquisition of target due to the change of control rules implemented by most member states, an offsetting of the tax burden triggered by the transfer of assets and business units is in practice not feasible. No specific anti avoidance rules As asset stripping strategies do lead in most cases to a full taxation of the capital gains realized at ordinary tax rates, the tax laws of the European member states do, different from other aspects associated with merger and acquisitions (e.g. financing aspects) not provide for any specific anti avoidance rules.
271
1.5.
National legal safeguards against undue financial assistance and other forms of upstream loans/security imposed by the shareholders to the target company
1.5.1. Financial assistance All Key Jurisdictions implemented the strict restrictions on the giving of financial assistance of public limited liability companies required by the the wording of Art. 23 of the Second Company Law Directive (Directive 77/91/EEC) prior to its amendment. The wording of Art. 23 contained a strict prohibition on financial assistance with the very narrow exception of transactions (i) concluded by banks and financial institutions within their ordinary course of business and (ii) effected with a view to the acquisition of shares by or for the companys employees or the employees of an associate company. Such permitted transaction had to be financed out of the distributable reserves. Moreover, most Key Jurisdictions enacted additional limitations going beyond such European restrictions. Inter alia, such additional national limitations prohibit by-passing structures such as the acquisition of the shares in the target company by a third party on behalf of or on account of the target company. Some Key Jurisdictions also contain the restrictions on financial assistance to private limited liability companies, thereby going beyond the scope of application of Art. 23 Directive 77/91/EEC. Art. 23 was recently deregulated by Directive 2008/68/EC as the European legislator intended to ease changes in the ownership while at the same time stipulating safeguards protecting both shareholders and creditors. The member states are now able to permit public limited liability companies to grant financial assistance up to the limit of the companys distributable reserves, provided they make such transactions subject to both the strict substantial and procedural conditions set forth in the new wording of Art. 23. Such conditions consist, inter alia, of the requirements to (i) effect the transaction at fair market conditions, in particular with respect to interests in favor of the lending company and the granting of security by the borrower, (ii) duly investigate the borrowers credit standing, (iii) submit the transactions to the general meeting for prior approval subject to a qualified majority of at least two-thirds of the votes attaching to the shares or the subscribed capital represented, (iv) provide an extensive written report covering in particular the liquidity and solvency risks involved, and (v) include, among the liabilities in the balance sheet, a reserve, unavailable for distribution, of the amount of the aggregate financial assistance. So far only Italy has utilized the deregulation potential contained in the new wording of Art. 23. The following remarks state into which national statutes Art. 23 was implemented and highlight a few particular national safeguards which go beyond the requirements of both the old and the new wording of Art. 23 of the Second Company Law Directive (Directive 77/91/EEC). 1.5.1.1. France In France, Art. 23 of Directive 77/91/EEC was fully implemented into Art. L. 225-216 of the French Commercial Code (Code de commerce) with respect to public limited liability companies (socits anonymes). A loan, a guarantee, a security interest or other type of financial assistance granted in breach of this provision could be void, pursuant to article L.235-1 of the French Commercial Code (Code de commerce). In the event of a breach of the financial assistance prohibition, the directors, the chairman of the board and the managing director of a socit anonyme may incur a fine of up to 9,000, pursuant to article L.224-24 3 of the French Commercial Code (Code de commerce).
272
Annexes
Pursuant to Art. L. 225-206-II of the French Commercial Code (Code de commerce), it is strictly prohibited for a third party to purchase the companys shares for the account of the company unless the third party is an investment service provider in the meaning of Art. L.531-1 of the French Monetary and Financial Code (Code montaire et financier) or a member of a regulated market. If the directors, the chairman of the board and the managing director of a socit anonyme purchase the companys shares in breach of such provision, they commit a criminal offense and may incur a fine of up to 9,000. Any third party purchasing the companys shares for the account of the company may incur the same criminal sanction as an accomplice. The shares purchased in breach of article L.225-206-II of the French Commercial Code (Code de commerce) shall be sold within a period of one year from their acquisition date. Failing to do that, such shares shall be cancelled. A breach of these rules by the directors, the chairman of the board and the managing director of a socit anonyme constitutes a criminal offence and they may incur a fine of up to 9,000. 1.5.1.2. Germany Sec. 71a of the German Stock Corporation Act (Aktiengesetz-AktG) fully complies with the strict requirements set forth in the old wording Art. 23 Directive 77/91/EEC. Such provision applies to public limited liability companies. Furthermore there are some provisions against by-passing the rules on financial assistance. According to Sec. 71a para. 2 of the German Stock Corporation Act (Aktiengesetz-AktG) any transaction between the company and another party is void, (i) if the other party is entitled to purchase shares of the company on behalf of the company and (ii) if in this case the purchase of such shares by the company itself would be in breach of the rules governing share buybacks. Under Sec. 71d para. 1 of the German Stock Corporation Act (Aktiengesetz-AktG), a third party acting in its own name but for the account of the company may only acquire or hold the companys shares to the extent that such purchase would be permitted under the rules governing share buybacks. 1.5.1.3. Italy As stated above, Italy implemented the deregulation potential of Art. 23 as amended by Directive 2006/68/EC. The rules concerning financial assistance are contained in Art. 2358 of the Italian Civil Code (Codice civile) and apply to both private and public limited liability companies (Soziet per azioni-Spa). It is worth noting that they also apply to limited liability partnerships (societ in accomandita per azioni) as pursuant to Art. 2454 of the Italian Civil Code (Codice civile) this type of company is subject to the same rules applicable to the SpA. If public limited liability companies whose shares listed on regulated markets or highly disseminated among the public, grant financial assistance, it is worth noting that the provisions set out by Art. 2391 bis of the Italian Civil Code (Codice civile) apply. This rules concern transaction with related parties and stipulate that the company must adopt procedures assuring that all transactions with related parties are transparent and correct from both a procedural and substantive prospective on the basis of the principles set out by CONSOB, the Italian Financial Supervisory Authority. On April 9, 2008 CONSOB has set out a draft of the principles to be adopted that are subject to the final approval before becoming effective.
273
1.5.1.4.
Spain Public limited liability companies The deregulation potential of Art. 23 as recently amended by Directive 2006/68/EC has not yet been implemented in Spain. There is, however, a draft bill (Proyecto de Ley sobre modificaciones estructurales de las sociedades mercantiles) which is currently under discussion in the Spanish Congress. In Spain, the provisions on financial assistance of public limited liability companies (Sociedades annimas) are contained in Art. 81 of the Royal Legislative Decree 1564/1989, of 22 December relating to Sociedades annimas (LSA). Art. 81 LSA not only contains the general prohibition of financial assistance required by Art. 23 Directive 77/91/EEC but also contains a sort of general clause which goes beyond Art. 23 Directive 77/91/EEC, as it governs any other transaction with the same effects as those explicitly referred to in Art. 81 LSA. In the event of an infringement of Art. 81 LSA the parties involved therein may be subject to the general rules on civil and criminal liability. Furthermore, Art. 81.1 LSA sets forth a specific administrative liability for an infringement of the prohibition on financial assistance, whereby, the directors and executives of, and any person with power to represent the company that has infringed the prohibition and of the controlling company, which has encouraged the infringement, can be held responsible. When determining the amount of the fine, the significance of the infringement and the damages caused to the company, its shareholders and third parties, shall be taken into account. The fine can amount up to the face value of the acquired shares. According to section 88 of the LSA any agreement between the company and any other person or entity by virtue of which the latter undertakes or is authorised to carry out in his own name but on behalf of the company any transaction which the company is prohibited from doing under the rules on financial assistance may be considered void. Private limited liability companies The Spanish legislator also enacted regulations on financial assistance of private limited liability companies by the Law 2/1995, of 23 March, relating to Sociedades de Responsabilidad Limitada (SL) (LSRL). Similar to Art. 81 LSA, the Art. 40.5 LSRL does not establish a numerus clausus list of the transactions covered but a general clause having the same scope as Art. 81 LSA by the prohibition. In the event of an infringement of the prohibition on financial assistance under Art. 40.5 LSRL, the persons involved in such infringement may be subject to essentially the same legal consequences as stipulated in the LSA with, however, a few special features of the administrative liability, the main one being the following: only the directors of the company that has infringed the prohibition are held responsible for the infringement. The LSRL does, in contrast, not extend the administrative liability to the executives of, or to other persons with power to represent the company that has infringed the prohibition or of the dominant company, who has encouraged the infringement.
274
Annexes
1.5.1.5.
United Kingdom The financial assistance regime in the United Kingdom has recently been amended by a repeal of certain sections of the Companies Act 1985 (the 1985 Act) which prohibits the giving of financial assistance by public limited liability companies. The regime will be further amended by the enactment of the relevant provisions of the 2006 Act. The requirements of Art. 23 Directive 77/91/EEC are contained in Sec. 154 of the 1985 Act (section 678 of the 2006 Act when enacted). A breach of Sec. 154 of the 1985 Act (or Sec. 680 of the 2006 Act when enacted) is a criminal offence for the company and every company officer in default. As previously stated, should an unlawful return of capital occur, Sec. 841 of the 2006 Act states that if the member knew or had reasonable grounds for believing that such a distribution was an unlawful return of capital then the member is liable to repay it to the company or pay the company a sum equal to the distribution. The directors of the company will also have to be aware of their common law fiduciary duties to the company and also of their statutory obligations pursuant to Sec. 171 to 177 of the 2006 Act). Directors may be personally liable to the company for breach and the shareholders may also be able to bring an action on behalf of the company against the director using the derivative action procedure.
1.5.2. Upstream loans/security All Key Jurisdictions contain a variety of limitations with respect to granting so-called upstream loans and security to a parent company or a third party (including banks) which do not qualify as financial assistance. 1.5.2.1. France Pursuant to Art. L.225-38 and seq. of the French commercial code (Code de commerce), loans granted to a parent company may be considered as related parties agreements (i.e. agreements entered into between the company as borrower and its directors/managers and/or shareholders holding more than 10% of the share capital as lender). As such, these agreements are subject to a specific control procedure: a prior authorization of the board of directors and approval at the shareholders meeting, requiring a simple majority vote of the shareholders, on the basis of a special report of the statutory auditors. These provisions provide for an exception for transactions carried out in the ordinary course of business and entered into at normal conditions. Upstream loans may further be subject to Art. L.511-5 of the French Monetary and Financial Code (Code Montaire et financier) which prohibits any entity which is not an authorised credit institution (i) from carrying out banking transactions on a usual basis, and (ii) from receiving funds that are payable on sight or with a maturity of less than two years from the public (fund receipts with different terms are caught by the first prohibition). Such prohibition is mitigated by the provisions of Art. L. 511-7 of said Code, which provides for an exception to the French banking monopoly to companies which are part of the same group, i.e. financial transactions with entities with which there are direct or indirect capital relationships, giving one of such companies actual controlling power over the others. Consequently, a loan may be freely granted to the parent company, provided that the parent company has an effective supervision over the lending subsidiary, i.e. for instance by holding more than 50% of the subsidiarys share capital.
275
Pursuant to Art. L. 571-3 of the French Monetary and Financial Code (Code Montaire et financier), individuals carrying out activity in violation of the aforementioned prohibitions may incur criminal sanctions of up to EUR 375,000 in fine and up to three-year imprisonment. Pursuant to Art. L. 571-1 of the French Monetary and Financial Code (Code Montaire et financier) and Art. L. 131-38 and L. 131-39 of the French Criminal Code (Code Pnal), legal entities are subject to fines of up to EUR 1,875,000 and other possible sanctions such as winding-up, closing of branches, prohibition or suspension of certain activities. The upstream loan /security needs also to be in consistency with the corporate purpose of the lending company. The lending companys corporate purpose (as stated in its by-laws) shall expressly include the possibility for the company to carry out all transactions, in particular financial ones, likely to be related to its purpose. Moreover, the contemplated transaction needs to be able to be considered as part of the lending companys financial management, i.e. as a profitable use of the financial resources of the company. The managers may be held liable, if they grant a loan of the company in breach of the corporate purpose. Furthermore, an upstream loan/security must also adhere to the corporate interest of the lending company. Generally, all actions accomplished on behalf of a company by its legal representatives must be entered into in the interest of the company. Consequently, a loan must have a financial or economic compensation for the lending company, i.e. the proposed transaction must not constitute a burden for the company, which would compromise the continuation of its activities. Where the corporate benefit is not sufficiently evidenced at the level of the lending company, French courts may consider the existence of a corporate benefit for the group of companies involved in the transaction, provided that certain conditions are met. If the upstream loan/security fails to be in the corporate interest of the company, the managers may be subject to civil and/or criminal penalties. In case the directors, the chairman of the board or the managing director of a socit anonyme who, acting in bad faith or in a way which they know is contrary to the corporate interest of the company, misuse the assets or credit of the company or the powers they have in it, for a personal purpose or with a view to favouring another company or business in which they are directly or indirectly interested, they are subject to the criminal sanctions set forth in Art. L.242-6 of the French commercial code (Code de commerce). Such criminal sanctions consist of up to 5 years imprisonment and a fine of up to 375,000. 1.5.2.2. Germany Upstream loans Under the recently modified German provisions on limited liability companies (Sec. 30 German Limited Liability Company Act (Gesetz betreffend die Gesellschaften mit beschrnkter HaftungGmbHG) and Sec. 57 the German Stock Corporation Act (Aktiengesetz-AktG)), both a private and a public limited liability company may grant a loan to a parent company irrespective if such loan is being paid out of the share capital of a private limited liability company (in such company only the share capital is subject to capital maintenance rules) or by a public limited liability company (in such company, the entire equity is subject to capital maintenance rules) as long as the repayment claim of the company against the shareholder appears to be fully realizable which means that such shareholder will be able to repay the loan.
276
Annexes
Furthermore, the loan must bear reasonable interests. Due to the recent enactment of the modified German provisions and the hitherto lack of sufficient analyses in legal doctrine, it is still unclear if the loan needs to be secured by the parent company in order to be regarded as fully realizable. Furthermore, under general fiduciary duties the board of directors must carefully consider if the granting of a loan to the parent company is in the best interest of the company. Pursuant to 64 sentence 3 German Limited Liability Company Act (Gesetz betreffend die Gesellschaften mit beschrnkter Haftung-GmbHG) any member of the board of directors is obliged to compensate any payment to a shareholder which necessarily had to lead to the illiquidity of the company, unless this was unpredictable subject to a certain standard of care. Upstream security Similar to upstream loans, under the recently modified German laws on limited liability companies (Sec. 30 German Limited Liability Company Act (Gesetz betreffend die Gesellschaften mit beschrnkter Haftung-GmbHG) and Sec. 57 the German Stock Corporation Act (Aktiengesetz-AktG)), both a private and a public limited liability company may provide a security for a loan granted to the parent company by a third party irrespective if such security is paid out of the share capital of a private limited liability company or the equity of a public limited liability company, provided that certain conditions are fulfilled. The exact scope of such conditions is not entirely clear yet as the respective discussion in legal doctrine has just evolved. In any case the board of directors has to carefully asses the risk if the security will actually be enforced at a later time. If such risk is significant, the board of directors has to further examine if a potential recourse claim against the parent company can be reported in full. If this is impossible, the provision of the security will be unlawful. 1.5.2.3. Italy Although Italian corporate law does not provide for specific provisions regulating upstream loans/security, certain rules of the Italian Civil Code (Codice civile) may be applicable to both a SpA and a Srl in such matters. From a general prospective a guarantee or a loan can be granted by the subsidiary to the parent company as long as this is in the subsidiarys interest. Otherwise the subsidiarys directors may be held liable. In addition, Art. 2497 Italian Civil Code (Codice civile) stipulates that a company exercising activities of direction and coordination of companies (attivit di direzione e coordinamento), may be deemed liable for tort if it pursues its own interest (or the interest of a third party) in violation of the principles of good corporate and entrepreneurial management. In order for the parent company to avoid such tort liability, it has to prove that (i) the action taken was in the best interest of the group of companies the subsidiary belongs to and that the benefits for the subsidiary deriving from belonging to the group outweigh the detriment caused by the parent companys actions or (ii) that the damages have been entirely eliminated by a transaction directed to such purpose.
277
In addition, Art. 2497ter Italian Civil Code (Codice civile) stipulates that companies adopting decisions influenced by the company exercising direction and coordination activities must analytically indicate the reasons and the interests underlying such decisions. If the target company thus intends to grant a loan/security to its parent company, it has to specifically point out the reasons and interests justifying such decision. Italian commentators deem that in the absence of the reasons supporting the decisions adopted by the shareholders meeting or by the board of directors, the shareholders, directors and auditors are entitled to challenge the relevant resolutions. 1.5.2.4. Spain In Spain, upstream loans/security are primarily restricted by tax regulations relating to transfer pricing (Article 16 of the Spanish Corporate Income Tax Act (Real Decreto Legislativo 4/2004, de 5 de marzo, por el que se aprueba el texto refundido de la Ley del Impuesto sobre Sociedades). The conditions for operations between a company and its controlling company must hence be established at arms length and by reference to the conditions that would have been agreed for similar transactions between or with independent parties. Such transactions shall be disclosed in the relevant tax documentation. In the event any of the companies involved is a listed company, the disclosure should be made in the annual financial reports (memoria de las cuentas anuales) and in the annual corporate governance report. In the event the controlling company is the sole shareholder of the company any agreement entered into between both companies (including any financing agreements or loans) should be in writing and a record of any such agreement should be kept. Additionally the sole shareholder shall be liable for any profit it may have obtained resulting in any damage to the company for a period of two (2) years. 1.5.2.5. United Kingdom There are no express restrictions on the provision of loans by a limited company to its parent. However, if the loan is not on arms length terms and in accordance with accounting practices, a provision is (immediately) required to be made in the accounts of the lender (due to the risk that the borrower will not be able to repay the loan), such loan will be subject to common law maintenance of capital rules. The aforementioned provision for such loan will reduce the distributable reserves of the company and, in the event such provision exceeds these, will be treated as an unlawful return of capital and will be immediately repayable in accordance with Sec. 841 of the 2006 Act. The directors of the lending company will also have to be aware of their common law fiduciary duties to the lender and also of their obligations pursuant to sections 171 to 177 of the 2006 Act (as detailed above, p. 274). Directors may be personally liable to the company for breach and the shareholders may also be able to bring an action on behalf of the company (lender) against the director using the derivative action procedure. Similar to upstream loans, limited liability companies may provide security for a loan granted to a parent company by a third party, subject to the restrictions set out above regarding maintenance of capital and the duties of the directors.
278
Annexes
1.6.
National legal safeguards against secret stake building in listed target companies
All Key Jurisdictions contain provisions in order to protect listed companies against secret stake building, in particular through notification requirements. Such provisions also govern secret stake building through certain financial instruments. As a general rule, the aforementioned national provisions are based on the implementation of the Transparency Directive (Directive 2004/109/EC) and its substantiating Directive 2007/14/EC. Inter alia, Art. 9 (1) Directive 2004/109/EC requires shareholders, who acquire or dispose of shares of an issuer whose shares are admitted to trading on a regulated market and to which voting rights are attached, to notify and disclose to the issuer if, as a result of the acquisition or disposal, the voting rights held by such shareholder reach, exceed or fall below the thresholds of 5%, 10%, 15%, 20%, 25%, one third (and/or 30%), 50% and two-thirds (and/or 75%) of all voting rights. Directive 2004/109/EC furthermore contains a number of provisions which attribute voting rights held by third parties to the shareholder, provided that certain conditions are fulfilled (e.g. voting rights held by an entity controlled by that shareholders, voting rights held by a third party in its own name but on behalf of the shareholder etc.). According to Art. 13 (1) Directive 2004/109/EC, the notification requirements laid down in Art. 9 also apply to a natural person or legal entity who holds, directly or indirectly, financial instruments that result in an entitlement to acquire, on such holders own initiative alone, under a formal agreement, shares to which voting rights are attached. Some Key Jurisdictions also include cash settled equity swaps when calculating the aforementioned thresholds. The following remarks state into which national statutes Artt. 9 (1), 13 (1) Directive 2004/109/EC were implemented and highlight a few particular national provisions which go beyond such requirements and contain additional safeguards against secret stake building in listed public limited liability companies. 1.6.1 France Article L.233-7-I of French Commercial Code (Code de commerce) contains the notification thresholds required by Art. 9 Directive 2004/109/EC and additional thresholds of 90% and 95%. Any crossing of such thresholds must be notified to the issuer and the Financial Market Authority (Autorit des Marchs Financiers, hereafter AMF) within five trading days following the crossing of the relevant threshold. The by-laws of the company may provide for an additional statutory threshold which may not be less than 0.5%. Pursuant to article L.233-7 VII of the French Commercial Code (Code de commerce), in the event where the threshold of 10% or 20% is crossed, the person concerned shall further specify its intentions for the next twelve months to the company and the AMF within ten trading days following the crossing of the relevant threshold. The person concerned is hence required to provide information on whether (i) it is acting alone or in concert, (ii) it is contemplating to make further acquisitions, (iii) it is seeking to acquire a controlling interest in the company and (iv) it is seeking to be a member of the board of directors, management board (directoire) or supervisory board (conseil de surveillance). Such declarations are binding and any change in the disclosed intent can only be justified by significant modifications in the environment, the situation or the shareholding of the person concerned. The changes in the intents of the person concerned must be disclosed in a new declaration of intent to the company and to the AMF in the same conditions as described above.
279
In case of non-compliance with the threshold and the declaration of intent disclosure requirements, the voting rights attached to the shares exceeding the relevant threshold are suspended for a period of two years following the effective compliance with the disclosure requirements. In addition, at the request of the chairman of the company, a shareholder or the AMF, the commercial court may decide the suspension, in whole or in part, of the voting rights held by a shareholder who did not comply with the disclosure requirements and the declaration of intent. Such suspension may be declared for a period of up to five years. The AMF may further impose financial sanctions on the defaulting shareholder. Moreover, pursuant to Art. L.247-2 of the French Commercial Code (Code de commerce), the directors, the chairman of the board and the managing director of a legal entity or any individual failing to comply with the disclosure requirements provided by Art. L.233-7 of the French Commercial Code (Code de commerce) may incur a fine of 18,000. There is no explicit French provision requiring to also include cash settled equity swaps into such calculation. However, please note that the AMF published a report regarding the disclosure requirements and the declarations of intent in October 2008. Such report recommended to include financial instruments that are exclusively settled in cash, such as CFD or equity swaps, providing for an economic exposition of the shares of a company, in the calculation of the thresholds (recommendation n3). The relevant provisions of the French Commercial Code (Code de commerce) may be amended in 2009. 1.6.2. Germany In Germany, Art. 9 Directive 2004/109/EC was implemented into Sec. 21 and 22 of the Securities Trading Act (Wertpapierhandelsgesetz). The German legislator added an additional threshold of 3% of the voting rights. The holding of certain financial instruments (i) is attributed to the voting rights of a shareholder and (ii) also triggers its own notification requirements. However, cash settled equity swaps do not qualify as financial instruments covered by such notification requirements. Moreover shareholders reaching a threshold of 10% of the voting rights in a company have to comprehensively disclose their plans for the company and the origin of the means used for acquiring the shares. 1.6.3. Italy The disclosure requirements regarding relevant stakes held in Italian SpA are provided for in Italy since 1998 pursuant to the ICF and its implementing regulation issued by CONSOB (Consob Regulation on listed issuers No. 11971/1999; the Rules) The legislative framework has been recently amended following the implementation in Italy of the Transparency Directive (Directive 2004/109/EC). However, the implementation process is not completed yet, since CONSOB still has to amend the Rules. Under Italian law, there is an additional notification threshold of 7.5% of the voting rights, 10% and any subsequent multiple of 5%). The current provisions governing the calculation of financial instruments for the purpose of the voting rights thresholds do not include cash-settled derivatives. However, such exclusion could be amended in the future because CONSOB has stated that certain types of derivatives, such as equity derivative swaps, are very often misused to hide the ownership of shares and voting rights with the purposes to build up a stake in a listed company with the aim at launching a takeover bid. It should be also highlighted that a cash-settled derivative could trigger the disclosure requirements if the agreement, oral or written, between the parties provides for (i) the change of the settlement method providing for the physical settlement or (ii) the right of each of the parties to amend the terms of the derivates transaction (which implies that the parties can also change the nature of the derivatives transaction, i.e. cash vs. physical delivery of the underlying shares).
280
Annexes
1.6.4. Spain Spanish regulation provides for an additional duty to notify the holding of voting rights exceeding, reaching or falling below 3%, 25%, 35%, 40%, 45%, 60%, 70%, 80% and 90%. Additionally, any financial instrument which gives any third party the right to acquire, at its sole discretion, voting shares (i.e. swaps) shall be disclosed as well. 1.6.5. United Kingdom Pursuant to rule 5 of the UK Financial Service Authoritys (FSA) Disclosure Rules and Transparency Rules (DTR), a person reaching a holding of 3% or more of a listed companys total voting rights and capital in issue has to notify the listed company and the FSA once the holding exceeds or falls below every 1% above 3%, regardless of whether a takeover is contemplated. The obligation extends to require the disclosure of voting rights held by a concert party or a person as an indirect holder of shares, for example situations where a person is entitled to acquire, dispose of or exercise the voting rights attaching to shares (DTR 5.2.1R). Under DTR 5.3 (Notification of voting rights arising from the holding of certain financial instruments), disclosure is required in respect to certain financial instruments. Currently, provided the swaps are cash settled and do not confer voting rights, there is no disclosure requirement pursuant to DTR 5. The FSA intends to issue new rules in February 2009, with the effect that from 1st September 2009, existing shares and long positions in contracts for difference (CfDs) and other similar economic interests will be aggregated and become disclosable at an initial disclosure threshold of 3%. Intermediaries entering into CfDs to provide liquidity to the market will be exempt from the disclosure regime.
281
2.
Annex 2: Restrictions in Scandinavian legislation on asset stripping from limited liability companies
Introduction
2.1.
We have been asked to provide an overview of Scandinavian legislation relating to the prevention of asset stripping from limited liability companies. In respect of jurisdictions outside Sweden, input has kindly been provided by the following law firms: (i) (ii) Roschier Attorneys Ltd. in respect of Finland; Plesner Svane Grnborg Law Firm in respect of Denmark; and
(iii) Advokatfirmaet Schjdt DA in respect of Norway. This memorandum has been limited to cover legislation preventing asset stripping from limited liability companies, which is the corporate form generally used by the entities in which private equity invests in Scandinavia. For the purpose of this memorandum we have defined asset stripping as the disposal of assets by a company followed by the subsequent distribution of the resulting proceeds of the disposal to the shareholders even when such disposal and distribution risk to be materially detrimental to the company.
2.2.
Summary
All Scandinavian countries have legislation restricting limited liability companies ability to dispose of assets at prices below market value as well as regarding distributions to shareholders. Unlawful transactions and distributions may lead to liability for damages, repayment obligation and even criminal sanctions. Said rules are furthermore strengthened by requirements for statements from the board and auditors in connection with e.g. distributions and liquidations, taking into account the capital requirements posed by the type and scope of the relevant business and thereto related risks as well as the consolidation and liquidity requirements and other relevant matters. Furthermore, board representation for employees and public access to annual accounts providing a comprehensive view of each companys financial situation ensures transparency and further contributes to reduce the risk for asset stripping activities.
2.3.
Asset stripping
2.3.1. Sweden 2.3.1.1. Divestments of assets A decision to divest assets of a limited company can generally be taken by the managing director of the company provided that the decision is deemed to be made in the ordinary course of the companys operations.
282
Annexes
If a divestment would not be deemed to be within the ordinary course of the companys operation, it needs to be approved by the board of directors of the company. In making their decisions, the managing director and the board are to take into account the interests of the company. A decision to divest assets may under certain circumstances require shareholder approval, e.g. where assets are sold to a shareholder at a price below market value (in which case the restrictions regarding distributions as further described below would apply), or in the event that the transaction would be deemed to change the character of the companys operations (e.g. if all assets or a specific division within a group are sold) as set out in the articles of association of the company. 2.3.1.2. Distribution of assets General In Sweden, a limited liability companys distribution of assets is primarily regulated by the rules regarding value transfers in the Swedish Companies Act (Sw. aktiebolagslagen (2005:551)) (the SCA). The SCA states that a value transfer includes (i) distribution of profits, (ii) acquisitions of a companys own shares (subject to certain exceptions) (ii) reduction of the share capital for repayment to the shareholders and (iii) any other transactions as a consequence of which the companys assets are reduced and for which there is no corporate benefit for the company. Thus, the concept of value transfers comprises, inter alia, the disposal of assets at a price below market value and the acquisition of assets at a price exceeding the market value. According to the SCA, two tests shall always be applied when determining the maximum value available to shareholders or others for value transfers, the so called amount restriction (Sw. beloppssprren) and the prudence rule (Sw. frsiktighetsprincipen). As these rules have been established for the protection of the creditors of limited liability companies, they may not be set aside even with the consent of all shareholders. The Amount Restriction and the Prudence Rule According to the first rule, the amount restriction, a value transfer may not be made unless the companys restricted equity is intact immediately following the value transfer. Accordingly, the book value of the assets that remain in the company after the distribution, must at least amount to the book value of the debt, provisions and restricted equity. The assessment shall be based on the latest adopted balance sheet, taking into account changes in the restricted equity after the balance day. According to the second rule, the prudence rule, value transfers, even if permitted according to the amount restriction, may only be made as long as they are deemed justifiable taking into account: (i) the equity requirements caused by the nature, scope and risks associated with the operations of the company, and (ii) the companys solidity (and other financial key ratios), liquidity and financial position in other respects.
283
This means that a value transfer, irrespective of the result of the application of the amount restriction, may only be made as long as it is deemed justifiable, i.e. the amount which may be distributed could be smaller but never larger than the amount of distribution permitted according the amount restriction. The capital which must be retained in the company according to the prudence rule must be decided in the light of the circumstances in each specific case and on the basis of the specific conditions under which the company acts. In addition, when applying the prudence rule to companies which are parent companies in a group, the test shall be applied to the group taken as a whole. With certain exceptions, shareholders can only decide on a dividend payment if and to the extent the board has proposed that the dividend payment shall be made. The boards recommendation shall include a statement from the board with respect to the above-mentioned tests and generally a statement from the board and an auditor with respect to the companys position. The Consequences of Unlawful Value Transfers An unlawful value transfer is invalid and the recipient thereof is normally obliged to repay any amount or assets unlawfully received. The obligation to repay the relevant amount applies irrespective of whether the recipient is a shareholder or another person. In addition, those who have participated in an unlawful value transfer, such as e.g. board members, may be personally liable for any amount which is not repaid. Furthermore, such persons may be liable to pay damages and even criminal sanctions. Miscellaneous The SCA sets out a minimum requirement as regards the equity level of limited companies as compared to the registered share capital. Simplified, it can be said that if the equity falls below fifty per cent of the registered share capital and is not restored, the company shall be liquidated. The board and shareholders may face a risk of personal liability for the companys debts and liabilities unless accounts are prepared and shareholder meetings are called according to a specific procedure in order to resolve whether to liquidate the company or restore the equity. Asset stripping transactions could furthermore be caught by provisions in the Swedish Bankruptcy Act (Sw. Konkurslag (1987:672)) regarding recovery of transactions in the event of insolvency of the company. These provisions include, inter alia, a provision stating that a value transfer could be recovered if it has occurred during the period up to six months before the day of the petition for bankruptcy. If the value transfer has occurred prior to said date but up to a year before the date of the petition for bankruptcy, it can still be recovered unless it is shown that the debtor after the transaction still retained property which clearly met his debts.
284
Annexes
2.3.2 Finland 2.3.2.1. Divestments of assets Divestment of assets of a company shall generally be resolved upon by the Board of Directors of the company. In cases where the divestment would fall within the ordinary course of the companys activities, the resolution could also be made by the Managing Director of the company. Generally, significant divestments of assets would not, however, fall under the Managing Directors competence. There is no explicit rule in the Finnish Companies Acts (the FCA) requiring a shareholder resolution for particularly significant divestments, e.g. the sale of all assets of the company. There is some old and obscure case law that hints at such requirement existing, but the validity of such cases on typical situations is highly questionable, as the cases relate to unusual companies which had unusual provisions in their Articles of Association. Due to the legal uncertainty, it is not altogether clear what the majority requirement for such situation, if such exists, would be (i.e. likely either simple majority or 2/3 majority of votes cast and shares represented in the meeting). In practice, e.g. sales of whole divisions or significant subsidiaries of major companies have been resolved by the Board of Directors. It is always possible, however, for the Board to voluntarily take any divestment resolution to the shareholders meeting. Correspondingly, unanimous shareholders may take any matter belonging to the Board of Directors to be resolved by the shareholders. Many older companies have a provision in their Articles of Association requiring that e.g. sales of real property shall always be resolved by the shareholders meeting. 2.3.2.2. Distribution of assets The FCA rules on distribution of assets are based on the traditional Nordic/European norm where distributable assets are primarily limited by the balance sheet, i.e. generally companies can distribute only the unrestricted equity evidenced by the latest confirmed (and audited, if the company has an auditor) balance sheet. However, the FCA furthermore includes a solvency test stating that even unrestricted equity cannot be distributed if the company is or will become insolvent as a result of the distribution. The resolution to distribute assets shall be passed by the shareholders meeting. The shareholders cannot resolve to distribute assets in excess of what the Board of Directors has proposed or otherwise consents to, with the exception that the company shall always distribute half of the accounting profit from the latest accounting period (up to 8% of the equity of the company and within the general limitations of distributable assets) if so required my shareholders holding at least 1/10 of all shares in the company. The shareholders meeting may authorize the Board to resolve upon certain kinds of distributions (dividends, repayment of invested unrestricted equity, repurchase of own shares). Certain characteristics of distributions can be governed by the Articles of Association as long as such provisions do not violate mandatory creditor protection provisions (examples of such possible provisions include a clause obliging the company to redeem own shares subject to sufficient equity, clauses giving different share classes different dividend rights and various liquidation preference provisions).
285
The FCA regulates normal ways to distribute assets in a generally similar manner as the SCA, i.e. dividends, repurchase of own shares and decrease of share capital and other restricted equity. In addition, under the FCA, unanimous shareholders may distribute unrestricted equity of the company (subject to the solvency test and possible restrictions e.g. in the Articles of Association) in whatever manner they please. This provision allows e.g. the company to sell its assets at a price less than market value, if such resolution is passed within the terms of the provision, i.e. the deficit does not exceed the distributable assets. The sale is confirmed unanimously in a shareholders meeting. Particularly relevant for asset stripping purposes is the provision of the FCA defining unlawful distribution as any other transaction than lawful means of distribution, which reduce the assets of the company or increase its liabilities without a sound business reason. Effectively, this provision rules out any asset stripping transactions which do not have a sound business reason or do not take place in the form of distribution of assets (as described above) as unlawful distribution. The provision, together with the general purpose of the company to strive to generate profit, set the general corporate benefit requirement which the company must follow in all of its transactions, including e.g. giving guarantees and pledging assets on behalf of related companies or third parties debt. In general, a group benefit is generally not deemed as a valid business reason, i.e. the benefit of parent company does not generally justify deviations from the arms length principle for corporate law purposes. Under the FCA, transferring assets for underprice to a (wholly-owned) subsidiary, is, however, generally easier, as assets transferred to a subsidiary remain in the indirect control of the transferor and therefore generally such transfer does not reduce the assets of the transferor. However, supporting of a subsidiary in a very critical financial standing (nearing bankruptcy) may be deemed as throwing the money to a black hole if there is no reason to expect that the company ever receives the monies back with yield. The Consequences of Unlawful Value Transfers Unlawful distribution may lead to liability for damages, repayment obligation and even criminal sanctions. The liability for damages and criminal sanctions may affect both the members of the Board of Directors (and Managing Director) and the shareholders participating in any such resolution or action. The liability exits both vis--vis the company and third parties (including other shareholders and creditors). Generally, harm caused to the company does not entitle other shareholders to claim damages to themselves but instead they have to raise the claim for damages on behalf of the company. Miscellaneous Transactions between related parties may result in the application of recovery/claw-back rules in the event of insolvency of the Finnish company. The recovery rules are generally more stringent with respect to related-party transactions than otherwise. Supporting a subsidiary nearing bankruptcy is an example of a situation where Finnish recovery rules have been actually applied.
286
Annexes
2.3.3. Norway 2.3.3.1. Divestments of assets A decision to divest assets of a limited company can generally be taken by the managing director of the company provided that the decision is deemed to be made in the ordinary course of the companys operations. If a divestment would not be deemed to be within the ordinary course of the companys operation, it needs to be approved by the board of directors of the company. In making their decisions, the managing director and the board are to take into account the interests of the company. A decision to divest assets may under certain circumstances require shareholder approval, e.g. where assets valued at more than 10% (private limited companies) or 5% (public limited companies) of the nominal share capital are sold to a shareholder, or in the event that the transaction would be deemed to change the character of the companys operations (e.g. if all or substantially all assets are sold or if the business of the company is altered through the transaction so that it no longer coincides with the business description of the articles of association). 2.3.3.2. Distribution of assets The company may only distribute as dividends the annual profit according to the adopted income statement for the last financial year and other equity after deduction of any uncovered losses, accounts entered in the balance sheet for research and development, goodwill and net deferred tax benefits, the total nominal value of own shares which the company has acquired for ownership or as security in previous financial years, and credit and security which under these provisions fall within the limits of distributable equity and the part of the annual profit which pursuant to law or the articles of association is to be set aside to a non distributable fund or cannot be distributed as dividends. However, the company may not distribute dividends if the equity according to the balance sheet is less than 10% of the balance sheet sum, without following the procedure for the reduction of the share capital. Shareholders can only decide on dividend payments if and to the extent the board has proposed that the dividend payment shall be made. A capital reduction (of the share capital and/or the share premium fund) may be decided on by the shareholders but is subject to a 2 months creditor notice period after which the board and auditor need to issue a statement confirming that no creditor has objected to the capital reduction. 2.3.3.3. The Consequences of Unlawful Value Transfers An unlawful value transfer would normally be invalid and the recipient thereof would be obliged to repay any amount or assets unlawfully received. The obligation to repay the relevant amount applies irrespective of whether the recipient is a shareholder or another person. In addition, those who have participated in an unlawful value transfer, such as e.g. board members, may be personally liable for any amount which is not repaid. Furthermore, such persons may be liable to pay damages and even criminal sanctions.
287
2.3.4. Denmark 2.3.4.1. Divestments of assets Generally, the management of a limited company may decide to divest assets belonging to the company. It is, however, required that the divestment is part of the day-to-day business of the company. The day-to-day business shall not include transactions which are unusual or of great significance in consideration of the position of the company. Such transactions which are not part of the day-to-day business may only be carried out by the management pursuant to a specific authorisation given by the board of directors, save, however, where a resolution of the board of directors cannot be awaited without major inconvenience to the business of the company. Accordingly, transactions which are of a material or unusual character require the approval of the board of directors of the company. Further, a decision to divest assets may under certain circumstances require the approval of the shareholders. Such approval will be necessary if the contemplated transaction implies that the character of the companys business is changed and such change is not in accordance with the object of the company. Whether the approval of the shareholders in other situations requires the consent of the shareholders is contentious. It has in Danish literature been argued that a divestment of a company in whole or in part requires the consent of the shareholders. The view has not been confirmed by any case law and there is no explicit regulation hereon. Consequently, if a company divests a material part of the company it is advisable that the matter is submitted to the shareholders for their approval even though it is not explicitly required by the Danish companies legislation. By submitting the matter to the shareholders, the board of directors will avoid subsequent criticism of the transaction also. 2.3.4.2. Distribution of assets Under Danish corporate law, we have identified the following rules which apply to Danish limited companies and which protect a companys capital or (directly or indirectly) may prevent asset stripping: (i) the board of directors is obliged to ensure that the companys financial position is sound; (ii) the board of directors and the management may be held liable if they inflict losses on the company (willfully or negligently); (iii) distributions may be made, inter alia, as ordinary or extraordinary dividends and distribution in connection with capital decrease; dividends may only be paid in respect of distributable reserves and the dividend shall in no event exceed an amount which is reasonable in consideration of the financial position of the company and in parent companies, the financial position of the group; (iv) capital decrease may only be made for limited purposes, and if a capital decrease is paid to the shareholders in other assets than cash, such decrease shall at least correspond to the value of such other assets and this must be verified by an independent valuation expert (i.e. an auditor); (v) providing loans or security to shareholders, members of the board of directors or management is, as a general rule, prohibited; (vi) financial assistance is prohibited;
288
Annexes
(vii) remuneration to the board of directors and the management shall be usual (in respect of the type and extent of the work) and must be reasonable in respect of the companys financial position; (viii) if a takeover bid is made, it is prohibited to enter into new or amend existing incentive agreements with the board of directors and the management; (ix) the offeror is obliged to provide information about a contemplated distribution of the target companys funds in the 12 months following the execution of the takeover; (x) the shareholders are prohibited from passing resolutions which are clearly likely to confer upon certain shareholders or other parties undue advantages over other shareholders or over the company; and (xi) a shareholder shall be liable to compensate any loss which he may have inflicted upon the company, other shareholders or any third parties if it is caused by a willful or grossly negligent violation of the Danish company act or the articles of association of the company. The Consequences of Unlawful Value Transfers The board of directors may (individually), and in special circumstances, be subject to criminal liability according to the Danish Criminal Code, e.g. (i) fraud committed by an agent against its principal; (ii) fraud against creditors; and (iii) which applies to a person who sets aside his/her obligation to handle a financial matter on behalf of someone else, e.g. a manager in respect of a company, which results in a considerable loss. Further, in the event that distributions have been made to the shareholders in contravention of the provisions of the Danish company act, such shareholders shall repay the amounts received (plus interest). With respect to payment of dividend, repayment shall only take place if the shareholder realised or ought to have realised that the payment was illegal. Miscellaneous Under Danish insolvency law, we have identified the following rules which may prevent asset stripping: (i) payments made by unusual means of payments (e.g. real property or goods) may be subject to a hardening period (if it may not be considered as an ordinary payment) when insolvency proceedings have been initiated; and (ii) transactions which improperly favor one creditor for the detriment of other creditors may be subject to a hardening period if the debtor became insolvent in connection with the transaction and said creditor knew hereof or of the circumstances which made the transaction improper. 2.4. Transparency
2.4.1. Sweden The Swedish Annual Reports Act (Sw. rsredovisningslag (1995:1554)) contains provisions concerning the preparation and publication of annual reports, consolidated financial statements, and interim reports. An annual report shall consist of, inter alia, a balance sheet, a profit and loss account, and a directors report, and all Swedish entities are obliged to file its annual report with the Swedish Companies Registration Office within one month of the adoption of the balance sheet and profit and loss account by the general meeting. When the annual report and the directors report for a limited liability company has been submitted to the registration authority, the authority shall give public notice thereof, and the annual report is thereafter publicly available.
289
Where copies of an annual report and auditors report for a limited company have not been submitted within 15 months after the expiry of the financial year, the members of the board of directors and managing directors shall be jointly and severally liable for the obligations incurred by the company. Furthermore, each person who is obliged individually or jointly with another, to submit annual reports or auditors reports to the registration authority, may be ordered by the registration authority to fulfil such obligation on pain of fine. As regards remuneration to the board, the SCA stipulates that the general meeting shall resolve upon the fees and other compensation for board assignments to each and every member of the board of directors. According the Swedish Annual Reports Act, bonus payments and equivalent compensation payable to members of the board of directors, the managing director, and comparable senior officers must be specified separately in the annual report and consequently are publicly available. 2.4.2. Finland All Finnish entities are liable to register their annual accounts with the Finnish Trade Register, generally within 6 months from the end of the accounting period and for limited liability companies, within two months of its confirmation. A company not complying with this may be fined or, ultimately, set in mandatory liquidation in addition to possible liability for damages. According to the Finnish Bookkeeping Act, annual accounts shall comprise of a balance sheet, profit and loss account and notes to accounts. Also specifications to the balance sheet and specifications to notes are to be attached to the annual accounts. On certain conditions a financial statement (report of acquiring of the assets and their use during the accounting period) and an annual report are to be attached. If the company is liable to auditing of the annual accounts, an auditors report is to be included in the annual accounts. Every item of the balance sheet, profit and loss account and financial statement have to be compared to last accounting periods similar item by showing the last accounting periods item. The information in the notes to accounts and annual report does not need to be compared to last accounting periods information. A small company may prepare a short version of profit and loss account and balance sheet, and it does not need to prepare financial statement or annual report and does not need to show all the notes to accounts. However, a public company, despite of its size, shall prepare all the mentioned documents. A company is considered small if only one, at maximum, of the following limits has been exceeded in the closed accounting period and the accounting period before that: (i) the turnover is 7.3 MEUR; (ii) the balance sheet total is 3.65 MEUR; and (iii) the number of people working for the company is approximately 50. According to the Finnish Bookkeeping Decree, the salaries and remuneration of managing director, deputy managing director, board or administrative board members and deputy members as well as other persons belonging to similar organs shall be specified in the notes to the accounts. Besides the salaries and remuneration, also the total amount of loans granted to them as well as the decrease and increase in the amount of loans during the accounting period with indications of interest rates and other principal terms of the loans shall be specified. The total amount and main contents of guarantees and contingent liabilities are to be specified. It should be also stated if no guarantees or contingent liabilities are given. Pension commitments related to the duties of the management are to be specified as well. Small companies (as defined above) do not need to specify the salaries and remuneration of management of the company. Please be informed that a companys registered annual accounts are public information and available in the Finnish Trade Register.
290
Annexes
2.4.3. Norway A limited liability company must report the annual accounts to the Norwegian Register of Business Enterprises. The annual accounts must include profit and loss accounting, balance sheet, cash flow account and notes to the annual account. Furthermore, information concerning, inter alia, remuneration to the managing director and the members of the board, shall be specified in the annual accounts. The annual account shall also include a list of major shareholders. The annual accounts are publicly available. 2.4.4. Denmark Please be informed that the Danish accounting rules are based on EU-directives (and IFRS) and that the financial accounts of limited companies are publicly available. The rules are set out in the Danish Financial Statements Act. Danish companies are divided into four different categories (A, B, C and D) and different reporting rules apply to each category. Category A companies are generally small, one-man companies, whereas Category B and C companies are companies which satisfies more than one of the following conditions during each of the two most recent financial years: (i) the average number of employees has exceeded 50 (250 for Category C); (ii) the audited balance sheet total has exceeded DKK 36 million (DKK 143 million for Category C); and (iii) the reported net turnover has exceeded DKK 72 million (DKK 286 for Category C). Category D companies are state owned companies and companies which have their shares or debt instruments listed on a regulated market and such companies are subject to the most extensive reporting obligations in respect of annual accounts. In general, the annual accounts may include (and must for companies of a considerable size) a statement of the board of directors and management, auditors opinion, directors report, applied accounting policies, profit and loss account, balance sheet and notes to the accounts. Furthermore, category C and D companies shall in their annual accounts specify the total remuneration to existing and former members of the board of directors and management and such companies shall also specify the total obligations to pay out pensions to such members. Further, if category C and D companies have laid down incentive programs for the members of the board of directors and management, they shall specify (i) the categories of directors and managers to which the program applies, (ii) which remunerations the program include, and (iii) the necessary means to assess the value hereof.
2.5.
Tax This memorandum does not cover taxation issues. It may be noted, however, that an asset transfer generally is not tax efficient (as compared to e.g. share transfers) and furthermore that transactions taking place on non-arms length terms between related parties may lead to tax issues, such as a violation of transfer pricing rules. Danish counsel has also highlighted their rules regarding interest deductions as rules which may prevent asset stripping. It is stated that the rules on interest deductions which allow Danish companies to deduct net financing expenses for tax purposes are subject to the three main limitation tests: (i) thin capitalisation test; (ii) the asset test (cap rule); and (iii) the EBIT test, cf. section 11 of the Danish Corporation Tax Act. The Danish tax rules on interest deductions apply to all companies which are covered by section 11 of the Danish Corporation Tax Act (i.e. companies with controlled debt which are thinly capitalised).
291
3.
Annex 3: Professional Standards and their Application on European Private Equity Funds
What is commonly referred to as Private Equity Funds is the management of pools of capital on behalf of collectives of investors to acquire stakes in assets, usually companies that are not traded on public markets. The management of each specific pool of capital is governed by a contractual arrangement between the manager (usually known as the General Partner or GP) and the investors (usually known as the Limited Partners or LPs). The pools contractual vehicle is usually known as the Fund, the extensive contractual arrangement between the manager and the investor typically called the Limited Partnership Agreement or LPA. It is negotiated and signed between sophisticated institutional investors and the managers of the fund and provides the legal framework for the investment into the fund. Each acquisition of a particular asset by the fund is in turn governed by a series of contractual arrangements between the fund, the vendor of the asset, the management of the asset, other investors in the asset and other relevant parties. Therefore every transaction within the Private Equity arena is governed by the laws of contract in the jurisdiction(s) in which that transaction takes place. Professional standards in the Private Equity Industry have been implemented by Supra National and National Associations in order to govern behaviour over and above the requirements of the law. The European Private Equity and Venture Capital Association (EVCA) issues professional standards for its members, the most authoritative of which is the Code of Conduct which is compulsory for members and enforced through EVCAs Executive Committee and Board of Directors. Every National Association in Europe either has its own set of Professional Standards or adopts those of EVCA. Therefore virtually every firm in the industry in Europe is governed through membership of its National Association or EVCA by standards set above and beyond the requirements of the law. The members of EVCA represent approximately 80-85% of the money under management by the European Private Equity industry. In principle it has to be noted that the most significant self-regulatory aspect is rooted in the fact that in order to stay in business, fund managers need to have investors confidence. This is owed to the fact that funds are invested over a three to five year period. In order to continue to have funds to invest and to keep and motivate staff a new fund has to be raised once the previous one is fully invested. This implies that fund managers are constantly put through a rigorous screening and due diligence process by their investors and potential investors, all of whom are sophisticated. What follows is an exposition of the various codes issued by the National Associations and EVCA (or such other Supra National Associations) across Europe.
292
Annexes
3.1.
Code of Conduct
Guiding ethical principles for the Private Equity industry. The compliance with the Code of Conduct is mandatory for the members. Members sign on to the code with their membership application and renew the commitment to comply every year as part of the annual membership renewal process. EVCA process of enforcement: complaints about EVCA members not being in compliance with the Code of Conduct are received by the EVCA secretariat. The Professional Standards Committee with the support of the secretariat conducts a thorough research on the issue and provides a recommendation to the Executive Committee and Board of EVCA as to how to resolve the issue. The Board will decide on actions to be taken. The most serious sanction is the eviction of the member from the association. EVCA status of enforcement: Approximately once every year EVCA receives a complaint and deals with it. There has been one eviction in the last 5 years. Similar processes of application and enforcement of the Code of Conduct are in place at the level of the National Associations, stipulated in the bylaws or comparable procedures of each association.
Table 4
Supra or national association by country/region
EVCA standard
Own national standard
Europe Austria Belgium Croatia Czech Republic Denmark Finland France Germany Greece Hungary Ireland Italy The Netherlands Norway Poland Portugal Russia Slovakia Southeastern Association Spain Sweden Switzerland The United Kingdom Total
* Modeled on EVCAs 1983 Code of Conduct. ** Code of Conduct under development, will be based on EVCAs.
x x** x x* x* x x* x x x x x* x* x x x x x* x x 11
293
3.2.
Reporting Guidelines
Best practice guidelines for disclosure and transparency towards investors in Private Equity and Venture Capital funds. EVCA as well as the National Associations does not mandate the application of the Reporting Guidelines to members. However, for the vast majority of Private Equity and Venture Capital funds, the Limited Partnership Agreement (the agreement between the fund manager and its investors) or similar statutes the mandatory application of the EVCA Reporting Guidelines by the fund. The Limited Partnership Agreement is negotiated and signed between sophisticated institutional investors and the managers of the fund and provides the legal framework for the investment into the fund. Process of enforcement: Investors will ensure that the quarterly reporting they receive from the fund is in compliance with EVCA Reporting Guidelines. Status of enforcement: In practice, the enforcement is very strong as fund managers will ensure that they do not violate their contractual obligations vis--vis their investors.
Table 5
EVCA standard
* Endorsed by the NVCA although not compulsory for members. ** Code of Conduct refers to Industry Standards in terms of reporting to investors.
x x x x x x x x x* x x
x** x*** 1
13
*** BVCA reporting guidelines dated 2005 (in line with outdated EVCA reporting guidelines). Walker guidelines recommend EVCA reporting guidelines.
294
Annexes
3.3.
Valuation Guidelines
Guidelines that stipulate the valuation methodology applied by Private Equity and Venture Capital funds. The International Private Equity and Venture Capital Valuation Guidelines or IPEV Guidelines were launched in March 2005 to reflect the need for greater comparability across the industry and for consistency with IFRS and US GAAP accounting principles. Valuation guidelines are used by the Private Equity and Venture Capital industry for valuing Private Equity investments and provide a framework for fund managers and investors to monitor the value of existing investments. The IPEV Guidelines are based on the overall principle of fair value in order to be consistent with IFRS and US GAAP. While EVCA as well as the National Associations does not mandate the application of its Valuation Guidelines to members, for the vast majority of Private Equity and Venture Capital funds, the respective Limited Partnership Agreement or similar states the mandatory application of the EVCA Valuation Guidelines by the fund. The Limited Partnership Agreement is negotiated between sophisticated institutional investors and the managers of the fund and provides the legal framework for the investment into the fund. Process of enforcement: Investors will ensure that the valuations reported in the quarterly reporting they receive from the fund are in compliance with the Valuation Guidelines. Status of enforcement: In practice, the enforcement is very strong as fund managers will ensure that they do not violate their contractual obligations vis--vis their investors.
Table 6
IPEV/EVCA
x x x x x x x x x x x x x x x x x x x x x 21
295
3.4.
Transparency and Disclosure Guidelines
There is full transparency between Private Equity and Venture Capital funds and their investors with regular and detailed reporting in accordance with established industry standards (Reporting Guidelines and Valuation Guidelines) as stipulated in the Limited Partnership Agreement or similar. This reporting includes detailed reporting on the development of the portfolio companies in which the fund has invested. In recognition of the growing interest around the asset class of Private Equity a number of National Associations have developed or are developing guidelines for increased transparency and disclosure to the general public. Transparency and Disclosure Guidelines targeted towards the general public do include information both on the level of the Private Equity fund which is making the investment as well as on the level of the portfolio company which receives funding. In order to avoid disadvantages for Private Equity funded businesses compared to their domestic peers, transparency and disclosure on the level of the portfolio companies need to be closely tied in with national law and legislation. Since differences in national legal systems require a country specific response the National Associations have taken the lead on Transparency and Disclosure Guidelines.
Table 7
EVCA standard
Europe Austria Belgium Croatia Czech Republic Denmark Finland* France Germany Greece Hungary Ireland Italy The Netherlands** Norway* Poland Portugal Russia Slovakia Southeastern Association Spain Sweden Switzerland The United Kingdom Total
* Working on transparency guidelines. ** Transparency covered in NVP Code of Conduct.
x x 4
296
Annexes
3.5. Governing Principles Best practice guidelines for the interaction between fund managers and investors. The Governing Principles have been developed by EVCA as a guiding tool, its principles are widely followed and adopted by industry practitioners. While EVCA does not mandate the application of its Governing Principles to members, for the vast majority of Private Equity and Venture Capital Funds, the Limited Partnership Agreement or similar describes rules and principles for the interaction of the fund manager with the fund and its investors that are in line with the Governing Principles. The Limited Partnership Agreement is negotiated between sophisticated institutional investors and the managers of the fund and provides the legal framework for the investment into the fund. Process of enforcement: Investors will ensure that the fund managers comply with the Limited Partnership Agreement. Status of enforcement: In practice, the enforcement is very strong since fund managers will ensure that they do not violate their contractual obligations vis--vis their investors.
Table 8
EVCA standard
x x
x x
297
3.6.
Corporate Governance Guidelines
Best practice guidelines for the interaction between fund managers and their portfolio companies, the Corporate Governance Guidelines have been developed by EVCA as a guiding tool and are in practice widely followed and adopted by industry practitioners even if not officially adopted as such. The application of the Corporate Governance Guidelines is voluntary for the members.
Table 9
EVCA standard
x* x x x
* A national code exists for listed companies, expected over time to also be adopted by privately held companies; well developed company law with clear division of responsibilities between owners, boards and management.
298
EVCA February 2009 Bastion Tower, Place du Champ de Mars 5, B-1050 Brussels, Belgium Tel: + 32 2 715 00 20 Fax: + 32 2 725 07 04 e-mail: info@evca.eu web: www.evca.eu

Private Equity and Venture Capital in The European Economy An Industry Response To The European Parliament and The European Commission

Transféré par

Informations du document

Titre original

Copyright

Formats disponibles

Partager ce document

Partager ou intégrer le document

Options de partage

Avez-vous trouvé ce document utile ?

Ce contenu est-il inapproprié ?

Droits d'auteur :

Formats disponibles

Private Equity and Venture Capital in The European Economy An Industry Response To The European Parliament and The European Commission

Transféré par

Droits d'auteur :

Formats disponibles

Private Equity and Venture Capital in the European Economy An Industry Response to the European Parliament and the

Other Contributors - Irina Anghel

Introduction Section I: Overview of the European Private Equity Industry

Section II: Risk Analysis of the Private Equity Industry

Conclusion and Recommendations Annexes

Jonathan Russell 25 February 2009

Private Equity: Part of the Economic Solution

Private Equity: Different to Other Funds, Particularly Hedge Funds

Proportionality of the Regulatory Framework

Actions Proposed by Private Equity

Downloadable at: http://www.evca.eu/publicandregulatoryaffairs/evcapositionstatementsandpapers.aspx?id=182

Section I: Overview of the European Private Equity Industry

Private Equity Defined

Equity value (Euro Millions)

Equity capital deployed (Euro Billions)

Very large Large Medium Small

> 300 150 - 300 15 - 150 <15

48.5 38.7 76.4 21.2

115 193 1,664 8,283

Section I: Overview of the European Private Equity Industry

Private Equity Investment Model

(6) (7) (8)

Value creation through active ownership of investments

(9) (10) (11) (12)

Section I: Overview of the European Private Equity Industry

(13) (14) (15) (16) (17)

(18) (19) (20) (21) (22) (23)

Section I: Overview of the European Private Equity Industry

Alignment of interest and compensation

Private Equity Distinct from Other Alternative Assets

Recent dynamics and outlook

Section I: Overview of the European Private Equity Industry

(27) (28) (29)

Section II: Risk Analysis of the Private Equity Industry

Section II: Risk Analysis of the Private Equity Industry

Section II: Risk Analysis of the Private Equity Industry

Section II: Risk Analysis of the Private Equity Industry

Section II: Risk Analysis of the Private Equity Industry

Section II: Risk Analysis of the Private Equity Industry

Section II: Risk Analysis of the Private Equity Industry

Systemic Risk Conclusions

Section II: Risk Analysis of the Private Equity Industry

Coverage of Law, Contractual Agreements and Industry Professional Standards

The Legal Framework

(33) (34) (35) (36) (37) (38) (39) (40) (41)

(47) (48) (49)

(50) (51) (52) (53) (54) (55) (56)

(57) (58) (59) (60) (61) (62)

Coverage of the Contractual Agreement between Investors and Fund Managers

(76) (77) (78) (79)

Recommendations relating to Section III

Recommendations for improving enforcement

Conclusions and Recommendations

Downloadable at: http://www.evca.eu/publicandregulatoryaffairs/evcapositionstatementsandpapers.aspx?id=182

Conclusions and Recommendations

Annex I: Detailed Risk Analysis of the Private Equity Industry

Section IV: Systemic Risk

Section I: Discussion of Risk & Definitions

Section I: Discussion of Risk & Definitions

Section II: Private Equity Structure & Operations

Private equity structure

Section II: Private Equity Structure & Operations

Section II: Private Equity Structure & Operations