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FinancingChangePRIVATEEQUITYDEMYSTIFIEDAnexplanatoryguideSecondeditionJohnGilliganandMikeWrightFinancingChangeAninitiativefromtheICAEWCorporateFinanceFacultyThefirsteditionofPrivateEquityDemystified–AnExplanatoryGuidewaspublishedinAugust2008,asthefirstreporttobeissuedunderFinancingChange,thethoughtleadershipprogrammeoftheICAEWCorporateFinanceFaculty.Thefacultyistheworld’slargestnetworkofprofessionalsinvolvedincorporatefinanceandcountsaccountants,lawyers,bankers,otherpractitionersandpeopleinbusinessamongitsmembers.FinancingChangeaimstoadvancetheeconomicandsocialcontributionofcorporatefinanceactivitybypromotingbetterunderstandingandpractice.SincethepublicationofthefirsteditionofPrivateEquityDemystifiedthemajoreconomieshavemovedfromgrowthtorecession,theglobalbankingcommunityhasexperiencedunprecedentedturmoilanddistressandwehaveallcometobefamiliarwiththeterm‘creditcrunch’.Wehavealsoseenthepublication,inApril2009,oftheEuropeanCommission’sproposedAlternativeInvestmentFundManagersdirectivewhichwouldcoverprivateequityfunds.Thesecondeditionbuildsontheworkofthefirsteditiontoreflectthisrecentturmoilandexaminesthewayinwhichthebankingmarkethaschangeditsapproachtoprivateequityinvestments.Italsoincludesmorediscussionofbothmid-marketbuy-outsandthedynamicsoftherestructuringindustry.Itremainsthecasethatmediacoverageofprivateequityandsomepubliccommentaryhavefrequentlydisplayedapoorunderstandingofhowprivateequityoperates,yetthesesourcesarefrequentlyrelieduponasfact.Thisguideprovidesanobjectiveexplanationofprivateequity,recognisingthatforpublicscrutinytobeeffectiveitmustbeconductedonaninformedbasis.Thispublicationisunlikelytoresultinareductioninthescrutinyofprivateequity.Itsvaluewillbemeasuredinbetter-informeddebate,inprivateequity’seffectiveengagementwithwiderstakeholdersandinwellthoughtoutpublicpolicies.Wewelcomeviewsandothercommentsonthisworkandrelatedthemes.ForfurtherinformationontheFinancingChangeprogrammepleaseemailfinancingchange@icaew.comortelephone+44(0)2079208685.ForinformationontheICAEW’sworkinfundingacademicresearchpleasecontactGillianKnight,ResearchManageron+44(0)2079208478.Thereport,whichincludesasummaryofacademicstudiesandreferencesisalsoavailabletodownloadfrom©JohnGilliganandMikeWright2010Allrightsreserved.Disseminationofthecontentsofthisreportisencouraged.Pleasegivefullacknowledgementofthesourcewhenreproducingextractsinotherpublishedworks.NoresponsibilityforanypersonactingorrefrainingtoactasaresultofanymaterialinthisdocumentcanbeacceptedbytheauthorsortheICAEW.ISBN978-1-84152-830-4PRIVATEEQUITYDEMYSTIFIEDAnexplanatoryguideSecondeditionJohnGilliganandMikeWrightContentsiiiContentsPagePrefacetothesecondeditionviAcknowledgementsviiiAbouttheauthorsixListoffigures,tablesandfindingsxExecutiveSummary11.Theprivateequitymarket151.1Anintroductiontotheprivateequitymarket161.2Whatisprivateequity?161.3AbriefhistoryofprivateequityintheUK161.4Howbigistheprivateequitymarket?181.5Howsignificantarelargerdealsintheprivateequitymarket?201.6WhathavebeenthebiggestUKdeals?211.7Whathavebeenthebiggestdealsintheworld?221.8Whatarethelargestprivateequityfundsintheworld?221.9Howsignificantarepublictoprivatetransactionsintheprivateequitymarket?231.10Whatistherationaleforapublictoprivatetransaction?231.11Towhatextentdoprivateequitydealsinvolvebuy-outsofdistressedfirms?242Whoaretheparticipantsinaprivateequitytransaction?272.1Introduction282.1.1Who’swho?282.2Theprivateequityfund292.2.1Whatisaprivateequityfund?292.2.2Howareprivateequityfundsstructured?292.2.3Whatdoprivateequityfundmanagersdo?302.2.4Howdoesaprivateequityfunddifferfromaquotedequityfund?312.2.5Howdoesaprivateequityfunddifferfromagroupofcompanies?322.2.6Whatarehedgefundsandhowdotheydifferfromprivateequityfunds?332.2.7Emergingandconvergingalternativeassetinvestors352.2.8Wheredoprivateequityfundmanagersoperate?362.2.9WhyareEuropeanprivateequityfundsbasedpredominantlyintheUK?372.2.10HowareUKprivateequityfundmanagersrewarded?392.2.11Management/advisoryfee392.2.12Carriedinterest402.2.13Otherfees402.2.14BroadprinciplesofUKfundtaxation402.2.15Taxationofcarriedinterest412.2.16Whatwastaperreliefandhowdiditaffecttheincentivesofprivateequityfundmanagers?412.2.17Non-UKdomiciledpersons422.2.18Competitionforfundsbyprivateequitymanagers422.2.19Canaprivateequityfundoraprivateequitymanagerfail?432.3Investorsinprivateequityfunds452.3.1Whoaretheinvestorsinprivateequityfunds?452.3.2Areinstitutionslong-terminvestorsinprivateequityfunds?462.3.3Whataretheaveragereturnsoftheprivateequitymarketforinvestors?472.3.4Whydoprivateequityfundsvalueunrealisedinvestments?482.3.5Howdoprivateequityfundsvalueunrealisedinvestments?482.3.6Understandingprivateequityportfoliovaluationmovements502.3.7Valuationoflimitedpartnerholdings:theJcurve502.3.8Whatistherangeofreturnsforinvestors?522.3.9Howcanindividualinvestorsinvestinprivateequityfunds?532.4Banks542.4.1Whatroledobanksplayinprivateequity?542.4.2Whatisleveragedlending?542.4.3Howdidthebankingmarketchange?542.4.4Whydidthebankingmarketchan