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

and the European Commission

Brussels, 25 February 2009

1

EVCA would like to express its gratitude to the following individuals and companies that contributed to this submission:

Brussels Task Force

- Jonathan Russell 3i, EVCA Chairman, Chairman Task Force

- Douwe Cosijn 3i

- Pierre de Fouquet Iris Capital

- Uli W. Fricke Triangle Venture Capital Group Management GmbH

- Dörte Höppner BVK

- Vincenzo Morelli TPG Capital LLP

- Anne Holm Rannaleet IK Investment Partners Limited

- Simon Walker BVCA

- Nickolas Reinhardt Fleishman-Hillard

- Javier Echarri EVCA

Representative Group

- Jonathan Russell 3i, EVCA Chairman

- Ole Steen Andersen Danfoss A/S, DVCA

- Kathryn Baker Reiten & Co Strategic Investments AS, NVCA

- Kurt Bjorklund Permira

- Gianpio Bracchi AIFI

- Craig Butcher Mid Europe Partners

- Rolf Christof Dienst Wellington Partners, BVK

- André-Xavier Cooreman Sofinim, BVA

- Pierre de Fouquet Iris Capital, AFIC

- Jean-Louis Delvaux Natixis Private Equity

- Uli W. Fricke Triangle Venture Capital Group Management GmbH

- Christian Frigast Axcel

- Jeremy Hand Lyceum Capital Ltd, BVCA

- Jaime Hernandez-Soto MCH Private Equity, ASCRI

- Bjorn Hoi Jensen EQT Partners A/S

- Johannes Huth Kohlberg Kravis Roberts & Co.

- Frederick Johansson SEB Merchant Banking, SVCA

- Vincenzo Morelli TPG Capital LLP

- Vincent Neate KPMG LLP

- Thomas U.W. Pütter Allianz Capital Partners GmbH

- Anne Holm Rannaleet IK Investment Partners Limited

- Norbert Reis The Carlyle Group

- Helmut Schühsler TVM Capital GmbH

- Patrick Sheehan Environmental Technologies Fund

- Marc St John CVC Capital Partners Limited

- Aris Wateler Parcom Capital BV, NVP

- Heikki Westerlund CapMan Invest A/S (CapMan Group), FVCA

PE/VC in the European Economy – An Industry Response to the European Parliament and the European Commission - February 2009

List of Contributors

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Technical Group PSC and Risk- Uli W. Fricke Triangle Venture Capital

Group Management GmbH,Chairwoman

- Anne Holm Rannaleet IK Investment PartnersLimited

- 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 García-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 Noël 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 - Maria Leander European Investment Fund- Matthias Lupp Clifford Chance- Robin Painter Proskauer Rose LLP- Jill Palmer 3i

- Bernard Peeters Tiberghien Advocaten- Georges Pinkham SJ Berwin LLP- Daniel Schmidt Proskauer Rose - Jutta Schneider Clifford Chance- Ulf Söderholm Andulf Advokat- Oliver Stahler Lenz & Staehelin- Jyrki Tahtinen Borenius & Kemppinen Ltd- Jacob Vinther Accura- David Widger A&L Goodbody- Simon Witney SJ Berwin LLP- Andreas Zahradnik 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 Rønne & Lundgren

Advokatfirma- Guy Geldhof BVA, Belgium- Natália Gömbös HVCA, Hungary- Iveta Griacova SLOVCA, Slovakia- Alenka Hren SLEVCA, Slovenia- Henrik Juul Hansen Rønne & Lundgren

Advokatfirma- Jörg Kirchner Latham & Watkins LLP- Georges Kourtis HVCA, Greece- Petra Kursova CVCA, Czech Republic- Jürgen 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 Rønne & Lundgren

Advokatfirma- Knut Traaseth NVCA, Norway- Advokatfirmaet Haavind AS- Advokatfirman Vinge KB- Roschier Attorneys Ltd- Plesner Svane Grønborg Law Firm- Advokatfirman Schjødt DA


List of Contributors

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Foreword 4

Executive Summary 5

1. Background 5

2. Private Equity: Part of the Economic Solution 5

3. Private Equity: Poses No Systemic Risk 6

4. Private Equity: Different to Other Funds, Particularly Hedge Funds 6

5. Proportionality of the Regulatory Framework 7

6. Actions Proposed by Private Equity 7

Introduction 9

Section I: Overview of the European Private Equity Industry 12

1. Private Equity Defined 12

2. Private Equity Investment Model 14

3. Private Equity – Distinct from Other Alternative Assets 19

Section II: Risk Analysis of the Private Equity Industry 22

1. Introduction 22

2. Specific Risks 23

3. Systemic Risk 32

4. Systemic Risk – Conclusions 34

Section III: Coverage of Law and Regulation, Contractual Agreements andIndustry Professional Standards with respect to EU Concerns regarding Private Equity 37

1. Introduction 37

2. Coverage of Law, Contractual Agreements and Industry Professional Standards 38

3. Recommendations relating to Section III 47

Conclusion and Recommendations 49

Annexes 53

1. Annex I: Detailed Risk Analysis of the Private Equity Industry 53

2. Annex II: Detailed Analysis – Coverage of Law and Regulation, Contractual Agreements

and Industry Professional Standards with respect to EU Concerns regarding Private Equity 99

Table of Contents

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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

Parliament’s Resolutions and support the European Commission in formulating possible EU policy outcomes.

This submission is the industry’s 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


Foreword

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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

Parliament’s Resolutions and support the European Commission in formulating possible EU policy outcomes. This report

provides the industry’s 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 company’s 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

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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.


Executive Summary

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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 industry’s 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.


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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.


Executive Summary

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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 Commission’s Recovery Programme).

Although private equity investments represent less than one percent of Europe’s 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 industry’s

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 EU’s 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 industry’s

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.


Introduction

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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.


Introduction

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

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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 industry’s 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 industry’s investment activities both now and in the future.


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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 company’s management team, and their industry contacts and credibility to promote the

company’s 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.


Section I: Overview of the European Private Equity Industry

(2) Stromberg, P., ‘The New Demography of Private Equity’, World Economic Forum, 2008.(3) 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


(4) S&P Leveraged Buyout Review, Q3 2008.(5) Net debt for the MSCI European 500 as reported by Bloomberg, January 2009.

Equity value (Euro Millions) Equity capital deployed (Euro Billions) Number of investments

Very large > 300 48.5 115

Large 150 - 300 38.7 193

Medium 15 - 150 76.4 1,664

Small <15 21.2 8,283

Source: EVCA/PEREP_Analytics

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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

company’s 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

fund’s 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 fund’s 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 world’s investments has come under the management of these long-

term 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) Gompers, Paul and Andrew Metrick, “Institutional Investors and Equity Prices”, Quarterly Journal of Economics, 116, 229-260, 2001.(7) Kaplan (Univ. Chicago) and Schoar (M.I.T.), Private Equity: Returns, Persistence and Capital Flows, November 2003.(8) 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).

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-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).(10) EVCA Yearbook, 2008.(11) Ibid.(12) Acharya (LBS/Stern), Hahn, Kehoe – Jan 2009, Corporate Governance and Value Creation – Evidence from Private Equity.

Figure 1: PE investments as % of GDP in 2007 (by country of portfolio company)

Source: EVCA/PEREP_Analytics

Swed

en

1.4%

1.2%

1.0%

0.8%

0.6%

0.4%

0.2%

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The

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The

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Denm

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Belg

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Fran

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and

Euro

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Norw

ay

Hung

ary

Germ

any

Switz

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Spai

n

Rom

ania

Aust

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Gree

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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 non-

executive director and draw on their firm’s 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) The Global Economic Impact of Private Equity Report 2008 – Large Sample Studies, World Economic Forum, mean holding period of 49 months for all exitedLBO transactions from 1970-2007.

(14) Bloom, Nicholas, et al, ‘Do Private Equity-owned Firms have Better Management Practices?’, The Global Economic Impact of Private Equity Report 2009.(15) Anuradha Gurung and Josh Lerner, ‘Private Equity, Jobs and Productivity’, The Global Economic Impact of Private Equity Report 2009.(16) Jensen, M. C., ‘Eclipse of the public Corporation’, Harvard Business Review, 1989 (Revised 1997).(17) 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 equity-

induced “dynamic” stays with the portfolio company for some time.


(18) Davis, Steven et al, ‘Private equity and employment’, The Global Economic Impact of Private Equity Report 2008.(19) Acharya (LBS/Stern), Hahn, Kehoe, ‘Corporate Governance and Value Creation – Evidence from Private Equity’, 2009.(20) Source: BVK 2009. More information available at http://www.bvkap.de.(21) Anuradha Gurung and Josh Lerner, ‘Private Equity, Jobs and Productivity’, The Global Economic Impact of Private Equity Report 2009.(22) Cao (Boston) and Lerner (Harvard), ‘The Performance of Reverse Leveraged Buyouts’, October 2006.(23) 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

company’s 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 fund’s 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 1.0–2.5% (depending on fund

size) of the funds committed – designed to pay running costs and base salaries.



(24) Alemany and Marti, ‘Unbiased estimation of economic impact of venture capital backed firms’, March 2005.(25) Achleitner and Klockner, ‘Employment contribution of Private Equity and Venture Capital in Europe’, EVCA, November 2005.(26) 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) The Global Economic Impact of Private Equity Report 2008 – Large Sample Studies – World Economic Forum.(28) EVCA/PEREP_Analytics. Deals over EUR 300 million equity value.(29) 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 industry’s future will be to find new ways to invest committed money at their disposal which

deploy private equity’s 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 Equity’s 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 Fund’s 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 Investor’s 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 Fund’s 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.


Section II: Risk Analysis of the Private Equity Industry

23

The Manager’s 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 Fund’s 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 Fund’s 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 Fund’s 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 Fund’s 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 Fund’s 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 Fund’s 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 Fund’s and its Manager’s 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 Investor’s 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 Investor’s 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 Fund’s

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 Manager’s 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 Fund’s or the Manager’s 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 Fund’s 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 Manager’s 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 Fund’s life, the fee is calculated on

the total amount of Investors’ Commitments – not the value of the Fund’s assets. In the latter half, it is calculated at

the cost of the Fund’s residual investments. Therefore, the Manager’s 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 Manager’s 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 Fund’s Commitments. The Manager therefore is exposed to risk in the valuation of

the Fund’s Portfolio Companies in the same way as the Investors – see above.

A Manager’s 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 Manager’s principal Credit Risk is its direct exposure to the Fund and indirect exposure to Investors in respect of

payment of the Manager’s fee. The failure of one Investor to meet its Commitment to the Fund is unlikely to have a

significant impact on the Manager’s 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 Manager’s fee in the latter part of the Fund when it is calculated on

the Fund’s 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 Fund’s 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 Fund’s

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 Manager’s 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 Manager’s 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.


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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 Manager’s 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 Lender’s 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 Fund’s 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 Group’s 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 company’s 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 Company’s board, there could be a conflict

of interest between the interests of the Fund as a shareholder and the individual’s 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 jurisdiction’s 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 section’s 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 Fund’s 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 Group’s 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 authority’s

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 Manager’s 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 Fund’s 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 company’s 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 Fund’s

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 Manager’s ability to raise future funds.


32

As discussed above, alignment of interests between the Private Equity Fund and the Portfolio Group’s 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.



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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 Fund’s 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 Company’s 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 Group’s 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.


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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 Fund’s 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/BarclaysPrivate 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 Firm’s 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 Fund’s 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.



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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 self-

regulation 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;


Section III: Coverage of Law and Regulation, ContractualAgreements and Industry Professional Standards withrespect to EU Concerns regarding Private Equity

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 Parliament’s 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 fund’s portfolio

composition (41).


(33) Such regulatory framework can be observed for: Denmark, France, Finland, Germany, Italy, The Netherlands, Norway, Sweden, Spain, The United Kingdom.(34) Denmark, Finland, Germany, The Netherlands, Norway, Sweden.(35) France, Italy, Spain, The United Kingdom.(36) Denmark, Finland, Germany, The Netherlands, Norway, Sweden, The United Kingdom.(37) Denmark, France, Finland, Germany, Italy, The Netherlands, Norway, Spain, Sweden, The United Kingdom.(38) France, Italy, The United Kingdom.(39) Germany.(40) E.g.: The United Kingdom.(41) France, Italy.

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• 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) Denmark, France, Finland, Germany, Italy, The Netherlands, Norway, Sweden, The United Kingdom.(43) Denmark, France, Finland, Germany, Italy, The Netherlands, Norway, Spain, Sweden, The United Kingdom.(44) Denmark, Finland, Germany, The Netherlands, Norway, Sweden, The United Kingdom.(45) France, Italy, Spain, The United Kingdom.(46) Denmark, France, Finland, Germany, Italy, The Netherlands, Norway, Spain, Sweden, The United Kingdom.

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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 company’s

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) Denmark, France, Finland, Germany, Italy, The Netherlands, Norway, Spain, Sweden, The United Kingdom.(48) Denmark, Finland, Germany, Norway, Sweden.(49) Denmark, France, Finland, Germany, Italy, The Netherlands, Norway, Spain, Sweden, The United Kingdom.

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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 anti-

avoidance 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) Denmark, France, Finland, Germany, Italy, The Netherlands, Norway, Spain, Sweden.(51) For further details, please see “Restricting Interest Deductions on Corporate Tax Systems: Its Impact on Investment Decisions and Capital Markets” by

Christoph Kaserer, Technische Universität München, March 2008. Downloadable at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1130718(52) Denmark, Finland, Germany, The Netherlands, Norway, Sweden, The United Kingdom.(53) France, Italy, Spain, The United Kingdom.(54) Denmark, France, Finland, Germany, Italy, The Netherlands, Norway, Spain, Sweden, The United Kingdom.(55) Denmark, France, Finland, Germany, Italy, The Netherlands, Norway, Sweden, The United Kingdom.(56) Finland, Germany, The Netherlands, Norway, Sweden, The United Kingdom.

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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) Denmark, Finland, Germany, Norway, Sweden, Spain.(58) France, Italy, Spain, The United Kingdom.(59) Germany, The Netherlands.(60) Denmark, Finland, Germany, The Netherlands, Norway, Sweden.(61) Denmark, Finland, Germany, Norway, Sweden, The United Kingdom.(62) Spain, France.

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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 Union’s 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 fund’s ability to make further

investments in case of substantial changes within the private equity firm.


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 Union’s 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).



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• 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:


- 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


- Trade associations that have adopted the EVCA Guidelines (74); and

- Trade associations that have no guidelines (75).


(63) 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. (64) Denmark, Finland, Germany, Norway, Sweden.(65) France, Italy, The Netherlands, Spain, The United Kingdom.(66) This situation is not observed for the main markets but for Austria and Greece.(67) 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. (68) Denmark, Finland, France, Germany, Italy, Norway, The Netherlands, Sweden, The United Kingdom.(69) Spain.(70) Denmark, Finland, France, Germany, Italy, Norway, The Netherlands, Spain, Sweden, The United Kingdom.(71) This situation is not observed for the main markets but for Greece and the Southeastern Association.(72) Denmark, Finland, Germany, Norway, The Netherlands, Sweden, The United Kingdom.(73) France, Italy, Spain.(74) Germany, The Netherlands.(75) Denmark, Finland, France, Italy, Norway, Spain, Sweden, The United Kingdom.

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• 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 Déontologie).

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) Finland, Germany, The Netherlands.(77) France.(78) Denmark, Italy, Norway, Spain, Sweden, The United Kingdom.(79) 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.


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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.



49

Before turning specifically to the Recommendations, it is worth reiterating the points raised in the private equity and

venture capital industry’s 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 well-

functioning 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.


Conclusions and Recommendations

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

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The European private equity and venture capital industry has taken the European Parliament´s 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 Commission´s 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 industry’s 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) 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.

(82) Downloadable at: http://www.america.gov/st/texttrans-english/2008/November/20081117173241xjsnommis0.4479639.html

Conclusions and Recommendations

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 EconomyAn Industry Response to the European Parliament and the European Commission

Annex I: Detailed Risk Analysisof the Private Equity Industry

Introduction 57

Section I: Discussion of “Risk” & Definitions 59

Section II: Private Equity – Structure & Operations 61

Section III: Risk Analysis of Private Equity Participants and Stakeholders 65

1. The Fund 65

2. The Investors 71

3. The Manager 74

4. The Lenders 80

5. The Portfolio Group 83

6. Civil Society 87

Section IV: Systemic Risk 91

1. Introduction 91

2. Private equity and its relationship with systemic liquidity risk 92

3. Receipt of finance 92

4. Provider of finance 93

5. Private equity and the systemic transmission of stress between market participants 95

6. Systemic risks – Conclusions 96

Table of Contents 55


56

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 firm’s 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.

Introduction


57

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.)

58

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 participant’s 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.

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 Fund’s 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 Fund’s 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 investor’s

or lender’s capital and threaten its viability and its ability to meet its own obligations. Other credit risks include

(i) issuer risk – where an issuer’s 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.

Section I: Discussion of “Risk” & Definitions


59

Section I: Discussion of “Risk” & Definitions


- Fiduciary/Agency Risk and Conflicts of Interest: Risks arising when a person’s 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 person’s 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 entity’s 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 Firm’s 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.à.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.

60

Section II: Private Equity – Structure & Operations


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 Fund’s 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 Investor’s “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 Investor’s maximum liability for the Fund’s 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 Fund’s 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 Fund’s profits for acting as General Partner. This payment is funded

either by drawing down some of the Investors’ Commitments or out of the Fund’s 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.

61



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 Company’s 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.

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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 Fund’s

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 Company’s employees

to manage the business and drive forward the agreed strategy.

16. The Fund’s 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.

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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 Fund’s 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 short-

term 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 Investor’s 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 Manager’s fee is not based on asset values and it usually only receives its Carried Interest once

the Fund’s 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 Fund’s assets.

64

Section III: Risk Analysis of Private Equity Participantsand Stakeholders


1. The Fund

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:

- 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.

1.2. These risks are faced by any investor in a private company and are not unique to the Private Equity industry.

1.3. The Fund’s investments are generally in shares in private companies for which there is no market. Therefore the

value of a Fund’s 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 Fund’s 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 Fund’s 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 target’s 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.

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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

Manager’s 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 Fund’s 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 Fund’s 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).

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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 Investor’s

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.

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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 drawn-

down in advance, arranging bridge financing and ensuring that the bridge lenders’ contractual commitment to

provide finance matches the acquiring company’s 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 Fund’s interest in its investments – see

sections 3.18 to 3.23. The Fund’s 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.

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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 Fund’s 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 Fund’s and its Manager’s 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 case-

by-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.

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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 Fund’s 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 Fund’s 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 Fund’s and its Manager’s 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.

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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 jurisdiction’s 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 Fund’s 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 Investor’s 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

Investor’s risk.

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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 Fund’s 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.


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.

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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 Investor’s 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 Manager’s business is disrupted due to the Group Risks that it faces

(see sections 3.30 and 3.31). This may affect the Manager’s ability to perform effectively, at least for a period

of time, which may affect the Fund’s performance, and therefore the Investor.

Market Abuse Risk

2.16. Investors are generally not given unpublished price sensitive information in relation to the Fund’s or the

Manager’s 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.

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2.20. Investors usually negotiate the right to receive regular and detailed financial information on the Fund’s

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.


2.23. Potential Investors located in a jurisdiction which imposes disproportionate requirements on Managers when

promoting a Fund’s 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 Manager’s 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 Manager’s 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 Fund’s assets. The Manager’s income therefore has little exposure to

fluctuations in the market value of the Fund’s assets or liabilities.

3.3. For many Private Equity Funds, the management fee reduces or is calculated based on the Fund’s 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.

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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 Fund’s Portfolio Companies.

3.7. A Manager’s ability to raise a new Fund will often be dependent on the strength of the fund raising market and

the performance of the Manager’s 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 Manager’s 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 Fund’s 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 Manager’s 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 Manager’s 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.

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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 Fund’s 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 Fund’s 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 Investor’s 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 Fund’s 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 Manager’s 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)

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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 Manager’s 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 Fund’s investments in Portfolio Groups

are bespoke commercial transactions. The Manager heavily negotiates the acquisition and investment

documentation in order to safeguard the Fund’s 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.


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 Manager’s principal expenses are

its employment and property costs which again tend to be predictable and largely within the Manager’s

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.

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Risk management

3.27. This can be managed by stress-testing a Manager’s 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 Fund’s 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 Manager’s 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 Manager’s 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).

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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.

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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.


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.

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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 Lender’s 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 other’s 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.

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Risk management

4.12. In relation to the Portfolio Group’s 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 Lender’s 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.


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.


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 Lender’s 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.

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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.


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 Fund’s 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

Fund’s 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.

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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.


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.

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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 Fund’s 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 company’s liability. This is

a usual requirement of secured bank facilities and is not specific to Private Equity.

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5.16. The Portfolio Group’s 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 Company’s 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.


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.

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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 inter-

relationships 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 section’s 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 Fund’s 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.

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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 Group’s 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.

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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 Fund’s 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 company’s 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 Manager’s 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.

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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.

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Section IV: Systemic Risk


1. Introduction

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.

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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.

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Private Equity Fund Lenders

Provision ofEquity Finance

Provision ofDebt Finance

Portfolio Group


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

the providers of debt finance.

The Manager, together with the Portfolio

Group’s 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.

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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 borrower’s ability to service its debt. The Private Equity Fund’s equity risk exposure can increase if

the Portfolio Group’s 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 Group’s 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-à-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 management’s 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.

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5. Private equity and the systemic transmission of stress betweenmarket 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 Manager’s consent). This trading of secondary interests never affects the Fund’s

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.

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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. Systemic risks – Conclusions

6.1. 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.

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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 Fund’s 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 Firm’s 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.

97

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 Fund’s 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 thePrivate Equity sector. It published both a Discussion Paper and a Feedback Statement which contained an extensive risk analysis, those papers are downloadableat 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 wererisks 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 bothas between the Fund Manager and Investors, and as between Investors. The FSA paper notes that the principal mechanism for dealing with these conflicts isthe agreed contractual arrangements with Investors. The paper also highlights potential conflicts which may arise where a Private Equity Firm is part of a largergroup, where other entities may provide services either to Portfolio Companies or to the Fund in connection with transactions. However none of the issuesidentified were considered to be likely to raise global systemic issues.


Private Equity and Venture Capital in the European EconomyAn Industry Response to the European Parliament and the European Commission

Annex II: Detailed AnalysisCoverage of Law and Regulation, Contractual Agreements

and Industry Professional Standards with respect toEU Concerns regarding Private Equity

Introduction 103

Part I: Detailed Analysis by Country of Law and Regulation, Contractual Agreementsand Industry Professional Standards with respect to Private Equity 105

1. Denmark 105

- Law and regulation 105

- Contractual agreements between parties and related entities 111

- Industry professional standards 113

2. Finland 117




3. France 125




4. Germany 139




5. Italy 153




6. The Netherlands 167




7. Norway 185




8. Spain 195




9. Sweden 209




10. The United Kingdom 217




Table of Contents 101

102

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 231

Part III: Articulation of EVCA Industry Professional Standards with the EU Concernsin respect of Private Equity 237

1. Scope, Coverage and Enforcement of EVCA Industry Professional Standards 237

2. Detailed analysis of the coverage of the EVCA Industry Professional Standards as regards the EU Concerns

in respect of private equity 239

Conclusion and Recommendations 249

Annexes 251

1. European legal regime relating to “asset stripping” and further potential risks relating

to private equity transactions 251

2. Restrictions in Scandinavian legislation on asset stripping from limited liability companies 281

3. Professional Standards and their Application on European Private Equity Funds 291


Table of Contents

Introduction

Law and Regulation

Private Equity:Mutually Reinforcing

Framework

Professional Standards(Self Regulation)

Contractual Agreements

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


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.

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Part I


Detailed Analysis by Country of Law and Regulation,Contractual Agreements and Industry Professional Standardswith respect to Private Equity

1. Denmark

1.1. 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.


1.2.1.1. 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.

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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.

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(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 Danishpublic limited liability companies (with the necessary adjustments). However, a limited partnership company is not a separate tax entity as public limitedliability 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) limitedpartner(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 thecompany contributing with a specific amount of capital to the company which is divided into shares.


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.

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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 company’s 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 company’s 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-company’s decision.

108


• 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 company’s financial

situation is sound at all times in the context of the company’s 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.

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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 auditor-

reviewed 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 Group’s 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.

110


- 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

arm’s length principle). Furthermore, documentation showing that the arm’s length principle has been

complied with must be prepared.


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



Usually, there are no additional requirements, as investors are typically relying on the rules

presented under 1.2.1 above.


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.

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Part I


1.3.2. Contractual disclosure and monitoring

1.3.2.1. Contractual disclosure and explanation of investment strategies and risks to investors


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 fund’s 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-à-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 fund’s 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 fund’s 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.


See 1.2.2.4 above. Typically contractual documents do not extend these disclosure obligations.


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.


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.

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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.


1.3.5.1. 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 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.



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.


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.


The DVCA’s 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.

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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:

- Operational and financial developments

- Corporate governance

- Financial and other risks

- Employee matters.

1.4.2.2. Private equity funds

The disclosure obligations comprise inter alia disclosure of the following information on the fund’s

website:

- A description of the fund’s history and origin

- A description of the fund’s 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 company’s 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 fund’s companies stating:

i Geographical location

ii Industrial sector

iii 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 fund’s 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:

114


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.



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-à-vis employees containing Q&A’s on issues that workers

reasonably can be expected to want answers to.


There are no specific self-regulation rules.




There are no specific self-regulation rules in this respect.


There are no specific self-regulation rules in this respect.


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.

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Part I


1.4.7. Other professional standards

- The DVCA’s 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) The minimum capital requirement of DKK 125,000 for private limited liability companies is removed.

(ii) 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) Full voting rights on all shares even if the entire subscription amount has not been paid in.

(iv) Shareholders’ register publicly available in relation to ownership and voting rights exceeding 5%.

(v) 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.

(vi) 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) 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.

(xi) 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.

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2. Finland

2.1. 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.



Management companies of Finnish private equity funds (i.e. closed-end funds) are generally limited


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.


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.


2.2.2.1. 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.

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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


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”).


See 2.2.2.2.


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).


• 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.


The Act on Preventing and Clearing Money Laundering and Funding of Terrorism (2008/503)

transposes the Third Money Laundering Directive into Finnish law.



Finland (like the other Nordic countries) has implemented the EU Transfer of Undertakings Directive.

118


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.


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.


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 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.

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Part I



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.



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.


Shareholders may generally not directly affect the remuneration of the company’s 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.




There are usually no additional requirements.


Fund size is usually subject to negotiations (and documentation may provide for a minimum and

a maximum size).




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).


120







in the fund as and when the fund’s underlying investments are realised is usually very evident in fund


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 fund’s

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.


See paragraph 2.2.2.4 above. Typically a fund’s contractual documents do not extend these

disclosure obligations.



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.


There are typically no additional contractual provisions.


There are typically no additional contractual provisions. Please see paragraph 2.2.3 above.




addition to the legal rules restricting this set out in paragraph 2.2.4.1 above.


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.

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Part I







documented in great detail. The arrangements are, however, confidential to the parties and do not

form part of any notification to any regulatory authority.


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.


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


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.


The recommendations on transparency apply to all members of the FVCA making majority or

minority investments in portfolio companies.

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There are no specific self-regulation rules in this respect. Please see paragraph 2.2.3 above.


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)



2.4.6.1. Transparency of compensation structure



- 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)).

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3. France

3.1. Introduction

The national industry body is the French Private Equity and Venture Capital Association, Association Française 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 à Risques (FCPR),

- The Fonds Commun de Placement dans l’Innovation (FCPI) and the Fonds d’Investissement de Proximité (FIP),

which are specific FCPRs, reserved to individual shareholders who will be entitled to a tax reduction,

- The Société de Capital-Risque (SCR)

The FCPR is a joint ownership of financial instruments and deposits (copropriété d’instruments et de depots). An FCPR is

not a legal entity (i.e. it does not have a personnalité 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 (société de gestion de

portefeuille) of the FCPR which is its sole legal representative.

An FCPR is formed by a management company and a custodian (dépositaire). 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 société par actions (e.g. a French société anonyme or a French société 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 Autorité des Marchés 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:

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• 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 agréé)

that must be approved by the AMF from those reserved for qualified investors (FCPR allégé).

The FCPR allégé 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 mobilières, 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;


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(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 company’s 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 allégés or as a subscriber either in an FCPR not advertised or marketed to the public or

in an FCPR allégé or in an unlisted société 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.



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.


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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 agréés (approved FCPR) and FCPRs allégés

(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


1 single OPCVM (UCIT)


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 allégés, 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 allégés 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 allégés are not

important, it is very common to provide further restrictions in by-laws.


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 client’s 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.”


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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.


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 agrée) or to the control of the AMF (FCPR allégé).

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.


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 fund’s 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 Fund’s 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.


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 company’s 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

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.


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.


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.


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The AMF requires that the management company appoints a person (generally a manager) in order

to be the contact of the TRACFIN.



Under French law, the employer must inform the comité d’entreprise (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 comité d’entreprise,

at least once a year, of the investment strategies.


No specific regulation.


No specific regulation.

3.2.4. Limits on ‘asset stripping’ and capital depletion


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 fund’s 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 fund’s 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.


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.

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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.”


• 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 company’s 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 company’s 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 company’s 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.


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133

If the company’s 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.


• Articles of association of the management company (and its code of ethics).

• The by-laws (règlement) 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 allégé or FCPR contractuel), the management company has to file the by-laws

with the AMF within one month.




3.3.1.3. At the level of the funds – investment vehicle (‘exposure’ risk)

As stated above, legal restrictions applicable to FCPRs allégés are not very restrictive. Therefore it

is common that by-laws of FCPR allégés provide additional rules.




FCPRs and moreover FCPRs reserved to qualified investors issue a document called a Règlement

(LPA) and a private placement memorandum which contain detailed disclosure of the fund’s

investment strategy and related risks.


FCPRs are typically closed-end funds. Their règlement 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 fund’s 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


There is usually additional information in the private placement memorandum.


There are typically additional contractual provisions. In FCPRs allégés, there is usually a specific

committee (with the main investors) that deals with these kinds of issues. Moreover, specific rules

are generally granted in Règlements.







There may be additional contractual provisions.




Under most règlements, 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




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.



As well as being disclosed in the fund’s 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 Règlement 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.


There may be a remuneration committee.


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3.4. Industry professional standards and investor relations (governed by self regulation / professional

standards)

AFIC’s 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 Française de Gestion Financière)

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


Code of ethics of management companiesauthorised to invest private equity

AFIC’s code of ethics of their officers and employees

Objective of the standards • Transparency • Conflicts of interest

• Equal treatment • Exercise of shareholder rights

• Fairness • Relations with investors

• Harmonisation of practices

Clarity • Made of “guiding principles” • Clear and precise provisions

Enforcement and monitoring • AFIC’s compliance committee • By the AMF

(elected members + previous chairmen • By investors since these rules figure

of the AFIC) in the by-laws of the fund

• Penalties such as warning disqualification

Coverage • All members of the AFIC • Management companies authorised by the AMF

(companies and their employees) to invest private equity (officers and employees)

136


There are no additional rules.


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 AFIC’s 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 (règlement) 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.


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 company’s governing

bodies, open dialogue with employee representatives at the time of entry into the capital of the company and

of their investment exit”.







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.


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• Principes directeurs devant régir les ‘Plans d’Investissement des managers et salariés’ des opérations

de Capital Transmission en France (2007)

This contains recommendations regarding the way to associate managers with the value issued by LBO

transactions.

• AFIC’s 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 Française 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.


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138


4. Germany

4.1 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 Förderung 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).

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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 (Unternehmens -

beteiligungs gesellschaften) 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 Förderung 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.

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PEFs must generally comply with the Act on the Prevention of Money Laundering (Geldwäschegesetz – 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).



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.


4.2.2.1. 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.

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The annual accounts must be prepared and signed by all members of the PEF’s 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

PEF’s 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


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 fund’s 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 Landesbehörde), 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.

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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.


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.


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 company’s 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.


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.

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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 company’s 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 company’s business

and trade secrets are not endangered.


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.



The managing directors of a German GmbH or the members of the executive board of a German

AG or SE (société européenne) 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 AG’s shareholders basing his decisions solely on the best interest of

the company.

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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

money’s worth, is significantly less than the value, in money or money’s 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 company’s creditors or a surety

or guarantor for any of the company’s 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).

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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 company’s 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.


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 (Geschäftsführung) 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.

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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.


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).

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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.



On the level of the PE fund manager there is typically not any additional capital requirement.


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.



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 fund’s 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 fund’s 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.

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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 fund’s 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 fund’s ability to make investments if the management

team is subject to significant changes or if there is a change of control.


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).


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.


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.


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.


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).

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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.


There are no additional rules mentioned in any professional standard.


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 firm’s

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.


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 firm’s 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.

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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.


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.


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 BVK’s Large Buyout group.


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.


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.


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.

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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.

152


5. Italy

5.1. 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 Società 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.


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 Società 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.

153

(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 fund’s units or, if appointed to do so by the SGR, make the calculation itself;(c) verify that in transactions involving a fund’s 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 directorsand 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.

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 fund’s 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).

154

(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) themajority of its capital has to be held by universities, research centres, university and bank foundations, public territorial authorities, university consortiumparticipated 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 startup companies or companies specialized in R&D or high tech focused.



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%.


5.2.2.1. 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 società 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.

155

(87) Italian Civil Code and Legislative Decree No. 58/1998.(88) Article 37 of the Legislative Decree No. 58/1998 as enacted by the Ministerial Decree No. 228 of 24 May 1999.

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


According to the definition of article 1, paragraph 1 of the Legislative Decree No. 58/1998, “closed-

end fund” means mutual fund in which the right to redeem units may be exercised by participants

only at predetermined maturities.

156

(89) The provision refers to a regulation of the Minister for the Economy and Finance.


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.


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.

157

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.


All the investors of the Fondo Chiuso are registered in the register of the Fondo Chiuso.


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.


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.


5.2.3.1. 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.


See above under point 5.2.3.1.

158

(90) Italian Civil Code, Bankruptcy Law.



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.”



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 company’s 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 company’s 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.

159

(91) 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”).

(92) 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 becalculated 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 orinvestment service, that shall not be payable through or imposed by the intermediary; (d) the payment methods.

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.



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).

160

(93) According to article 73 of the Consob regulation No. 16190/2007, in relation to the provision of collective asset management services, asset managementcompanies 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 followingconditions 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 saidamount 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 managementservice 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 exchangecommissions, compulsory withdrawals or legal expense, and which, by nature, cannot enter into conflict with the company’s duty to act in an honest, fairand 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 tofees, commissions or non-monetary services in summary format, providing further details on request from the investor.


Moreover, incentives may be received by the SGR at the conditions provided by law only (93).


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


5.3.1.1. 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.

161

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.



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 fund’s

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 fund’s 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.


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.


Further to earlier remarks above, typically contractual documents do not extend these disclosure

obligations.


See section 5.2.3 above.

162



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).


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).



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.


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.

163

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.

164


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.



There are no additional rules beyond the extensive legal/regulatory rules set out in paragraph 5.2.1

above.


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.


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.


No additional rules result beyond the provisions under paragraphs 5.2.2, 5.3.2 and 5.4.2.

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Part I



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.






No specific information seems to be given in the Manual of Procedures and in the Code of Conduct.


No additional rules result beyond the provisions under paragraph 5.2.3.1.






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.


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.


No additional rules result beyond the provisions under this paragraph 5.4.

166

(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 managedinvestment company.


6. The Netherlands

6.1. 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).

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Part I168


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 Financiële 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.



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.


6.2.2.1. 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) See footnote 94.(96) This regime equally applies for partnerships of which all liable partners are foreign joint stock companies.

Part I170

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 PEF’s 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 PEF’s 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 PEF’s investment manager (and depositary, if applicable).

- Simplified prospectus (financiële 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 manager’s registration document and

prospectus of the PEF managed by it, the investment manager’s 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 manager’s 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 manager’s 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).


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.


Part I172


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

company’s 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 arm’s 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.


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



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”)


Part I174

- 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

enterprise’s 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”)


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.


investee companies. In practice it is often a matter of negotiations what information is shared.


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.



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).


Part I176

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

money’s worth, is significantly less than the value, in money or money’s 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 company’s creditors or a surety or guarantor for

any of the company’s 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).


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 target’s 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 company’s 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



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 thanEUR 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 financialyear 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 amountsto 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 employeesduring the financial year is less than 250.

Part I178

- 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 company’s 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 year’s 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.


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).




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).


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


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.


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 fund’s 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 PEF’s investment period if the key executives of the management team

leave or the management team is subject to extensive changes.






Given the extensive legal rules referred to in paragraph 6.2.3 above, typically no further rules are

implemented.


There are generally no additional contractual provisions.


Please see 6.2.3.3 above.





(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.

Part I180


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.



As well as being disclosed in the fund’s 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.


As remuneration systems are previously negotiated and laid down in the fund documentation, there

is a minimum level of alteration. General, a PEF’s 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


The NVP Code does not provide for additional best practices or requirements in this respect.




181


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) Policy rule on key principles for assessing the risk management for alternative investments issued by DNB on August 2007 (Beleidsregel beoordelingrisicobeheer van alternatieve beleggingen).

(100) EVCA Governing Principles, ed. March 2003; EVCA Corporate Governance Guidelines, ed. June 2005; International Private Equity and Venture CapitalValuation Guidelines, ed. June 2005 and EVCA reporting Guidelines, ed. June 2006.

(101) 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 sixmonths after the transaction.

(102) 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.

(103) See footnote 102.

Part I182

(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 non-

disclosure obligation in this matter.

(x) The responsibility for transparency about the portfolio company vis-à-vis the public is primarily that of the

portfolio company’s 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 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.


183


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.



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.


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.


There are no additional rules beyond the legal rules set out in paragraph 6.2.4 above.


The level of leverage is sustainable for the target company.

The level of leverage is according to NVP’s best practices to be included in the strategic plan the PEF is

required to make with the portfolio companies.


There are no additional rules beyond the rules set in paragraph 6.2.6 above.


- 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.


Part I


184


7. Norway

7.1. 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 association’s code of ethics.

Members must work to achieve the association’s objects, and observe its statutes as well as decisions taken

under these. Members can be suspended and⁄or 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:


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.

185

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.



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 customer’s 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

year’s fixed costs.


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 Brønnøysund 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

Brønnøysund Registers and are publicly available.


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

Brønnøysund Registers) as well as financial statements of limited partnerships in which the general

partner is a limited liability company.

186


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

Brønnøysund Registers.

7.2.2.2. (Mandatory) disclosure and explanation of investment strategies and risks to investors


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.


See 7.2.2.2.


According to the Companies Act, private limited liability companies need to have a shareholders’

register giving overview of the owners of the company’s 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 Brønnøysund Registers, in which the information is publicly available

(also through online databases).

187

Part I



• 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.


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.



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 undertaking’s 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 company’s board of directors.

For information on collective agreements, see 7.3.3 below.

188



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.


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.



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 company’s

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 company’s 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 company’s 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.

189

Part I



The level of leverage has an impact on the tax deductibility of the investor’s 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.



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.


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.




There are usually no additional requirements, because investors are happy to rely on the legal rules

referred to in paragraph 7.2.1 above.


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.



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 fund’s

investment strategy and related risks.


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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.



7.2.3 above.




There are typically no additional contractual provisions between investors and private equity firms

in this regard. Please see paragraph 7.2.3 above.

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The level of leverage is sustainable for the target company













See 7.2.6.2.


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.





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.

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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 NVCA’s 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 NVCA’s 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.


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.


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.







There are no specific self-regulation rules in this respect. Please see paragraph 7.2.3 above.


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 public’s 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.

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(104) The International Private Equity and Venture Capital Valuation Guidelines were developed by the Association Française 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 toreflect the need for greater comparability across the industry and for consistency with IFRS and US GAAP accounting principles. Valuation guidelines areused by the private equity and venture capital industry for valuing private equity investments and provide a framework for fund managers and investors tomonitor 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.

Part I



Please see 7.4.4 above.




- 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))

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(105) In Spain, public to private transactions are permitted. (106) 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.


8. Spain

8.1. 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” (régimen

simplificado) or “Common Regime ECR” (regimen común).

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

Inversión 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 (Comisión Nacional del Mercado de Valores or CNMV).

The national industry body is ASCRI (Asociación Española de Entidades de Capital Riesgo) with 106 members of

which 28 are also members of EVCA.

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• 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 (Comisión de Prevención 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 Comisión Nacional del Mercado de Valores, sobre normas

contables, cuentas anuales y estados de información reservada de las entidades de capital-riesgo).


(Circular 7/2008, de 26 de noviembre, de la Comisión Nacional del Mercado de Valores, sobre normas

contables, cuentas anuales y estados de información reservada de las Empresas de Servicios de

Inversión, Sociedades Gestoras de Instituciones de Inversión Colectiva y Sociedades Gestoras de

Entidades de Capital-Riesgo).


(Circular 5/2000, de 19 de septiembre, de la Comisión Nacional del Mercado de Valores, sobre normas

contables y modelos de estados financieros reservados y públicos 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 Inversión

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 Anónimas, 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 Anónima 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).

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- Law 19/1993 on measures against money laundering (Ley 19/1993, de 28 diciembre sobre determinadas

medidas de prevención 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 régimen jurídico de las empresas de servicios de

inversión y de las demás entidades que prestan servicios de inversión y por el que se modifica

parcialmente el Reglamento de la Ley 35/2003, de 4 de noviembre, de Instituciones de Inversión

Colectiva, aprobado por el Real Decreto 1309/2005, de 4 de noviembre).


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.


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 ECR’s 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.

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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.


8.2.2.1. 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.

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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 ECR’s 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).


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 Gestión) 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.


• 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 fund’s 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).

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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.


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.

200

(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 anadministrative 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 tothe fact that the Transferor breached the information obligation. The consequence of such judgement was that the affected employees which had beentransferred to the Transferee, had the option to return to their jobs with their former employer (the Transferor).


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.


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.


8.2.3.1. 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 Worker’s 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);

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- 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.


Under Spanish Law there are no statutory obligations regarding disclosure of investment strategies

and risk to investee companies.

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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.


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 company’s 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 company’s

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 company’s 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 company’s creditors may bring a claim against the directors where such claim has not been brought by

the company or its shareholders, whenever the company’s 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.

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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 company’s 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 judge’s 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 Gestión) 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.



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.


Under Spanish Law, there is a presumption that members of the board of directors are not

remunerated unless expressly provided for in the company’s 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.

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Applicable rules vary depending on whether the company is a public limited company (Sociedad

Anónima 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 company’s

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 company’s 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 director’s and manager’s 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.


8.3.1. Introduction

SGECRs are governed by several contractual agreements which generally include the company’s Articles of

Association and a shareholders’ agreement.

FCRs are governed by Management Regulations (Reglamento de gestión 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 fund’s standard provisions (fees,

investor protection measures etc.).

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(108) Spanish private equity funds do not always issue a PPM and when issued they are often drafted in English and addressed to international institutionalinvestors.

Part I


SCRs are governed by the company’s Articles of Association which include the main terms and conditions of

the SCR and which shall be authorised by the CNMV similarly to the FCR’s 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 fund’s 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.


8.3.2.1. At the level of management companies

There are no additional requirements, further to the legal rules referred to in part 1 above.



8.3.2.3. 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.




Pursuant to the Spanish Private Equity Law, a summary of the fund’s 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 fund’s 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.


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.

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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 fund’s 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.


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.



These are compulsory statutory obligations and cannot be waived by the parties. In that sense,

please see section 8.2.3 above.




In Spain, there are typically no additional contractual provisions other than those provided in the Law.


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.


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.



As well as being disclosed in the fund’s 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.

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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.


In Spain, the remuneration of directors and managers is not usually disclosed in any contractual

documents between the management company and private equity entity’s 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.


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).

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9. Sweden

9.1. 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.


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.

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Management and advisory companies of Swedish private equity funds are generally limited


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.


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.


9.2.2.1. 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.



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”).


See 9.2.2.1 and 9.2.2.2.


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.

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The partners of Swedish limited partnerships are noted in the Swedish Companies Register which

information is publicly available (also through online databases).


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.


The Third Money Laundering Directive has been transposed into Swedish law.



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 employee’s

trade union regarding a transfer of business from one employer to another, a termination due

to redundancy, or matters which specifically relates to the employee’s 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 company’s 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

employer’s 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.



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.

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Part I



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.



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 company’s 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.


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).

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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 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.







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.



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 fund’s investment strategy and

related risks.


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Part I























9.2.3 above.




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.










214










See 9.2.6.2.


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.


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.



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.


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.

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Part I



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.


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.







Please see 9.2.3.3 above. There are no specific self-regulation rules in this respect.


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

public’s 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.




- The SVCA’s 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)).

216


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:


• 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 firm’s senior managers; (ii) risk management and the annual risk report; (iii) the finance officer’s and

the compliance officer’s respective roles; (iv) audit and IT systems; (v) business continuity management and

(viii) requirements with regard to record keeping.

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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 Exchange’s 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


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 firm’s 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 manager’s 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 manager’s 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 ¼ of its annual fixed overheads.

The private equity firm’s 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.

218



Apart from a requirement that the amount of capital contributed to a UK limited partnership must

be registered at the Company’s 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 FSA’s

supervisory relationship with an individual firm depends on how much of a risk it considers that firm

could pose to the FSA’s 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 FSA’s 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 firm’s compliance manual, including the firm’s 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.

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Part I




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 firm’s 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.


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 firm’s activities, processes and systems, and where

appropriate, set the level of risk tolerated by the firm.


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.


• 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 company’s 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.

220


The FSA will be keen to see that conflicts policies and management are dealt with effectively in

the firm’s compliance manual and that senior management is fully engaged with this to ensure

such policies are being upheld.


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 firm’s 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


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 employment-

related 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)

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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 company’s 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 company’s

shareholders an opinion on the offer which must include the effects of implementation of the offer

on employment, the offeror’s strategic plans for the offeree company and their likely repercussions

on employment and the locations of the offeree company’s 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.)


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).


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.

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10.2.4.Asset stripping and capital depletion


The main protections within the UK company law against so-called “asset stripping” and other

misuse of a director’s 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 company’s employees;

- the need to foster the company’s business relationships with suppliers, customers and others;

- the impact of the company’s 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 company’s property, and the extent

of the director’s 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 company’s creditors or a surety or guarantor for any of the company’s 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 company’s capital. A dividend declared in excess of

a company’s distributable profits is unlawful and a reduction of share capital should not affect the

creditors of a company adversely.

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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

arm’s 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


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 FSA’s Prospectus Rules require disclosure of fees payable to service

providers (which would include any investment manager or adviser) and their method of calculation.


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.

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10.3.2.Contractual disclosure and monitoring



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 fund’s investment strategy and related risks.


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 fund’s underlying investments are realised will be clearly

disclosed to investors in the PPM.





change of control. Investors typically have extensive downside protections which are heavily negotiated.




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10.3.3.Information and consultation of employees


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.







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





As well as being disclosed in the fund’s 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




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.

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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.



10.4.2.Industry imposed disclosure and related monitoring


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.


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.

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The Walker Guidelines operate on a ‘comply or explain’ basis, with any non-compliance to be

explained on the company’s 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 year’s accounts and to address them in the

meantime by including the information on the company’s 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 firm’s membership of the BVCA.


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 UK’s 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.

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10.4.3.Information and consultation of workers


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 company’s 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.


According to the Walker Guidelines, a portfolio company’s 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.


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.


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)





10.4.6.2. Transparency of manager’s remuneration systems


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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.

230

231

Private Equity Funds and Contractual Relationships withtheir Investors – Governance, Reporting and Transparency

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 investor’s “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.


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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 firm’s 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.


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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 fund’s 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-à-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

Although the security of investor funding is critical to the private equity firm’s ability to make genuinely long-

term 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 fund’s 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 fund’s 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 company’s 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 Fund’s 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.


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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 company’s 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.


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237


Articulation of EVCA Industry Professional Standardswith the EU Concerns in respect of Private Equity

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 industry’s 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, EVCA’s 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, EVCA’s 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).

Part III

(109) http://www.evca.eu/uploadedFiles/Home/Toolbox/Industry_Standards/evca_code_of_conduct_08.pdf(110) http://www.evca.eu/uploadedFiles/Home/Toolbox/Industry_Standards/evca_governing_principles.pdf(111) http://www.evca.eu/uploadedFiles/Home/Toolbox/Industry_Standards/evca_reporting_guidelines_2006.pdf(112) http://www.evca.eu/uploadedFiles/Home/Toolbox/Industry_Standards/evca_international_valuation_guidelines.pdf or http://www.privateequityvaluation.com(113) http://www.privateequityvaluation.com

238

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-à-vis their investors.


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2. Detailed analysis of the coverage of the EVCA Industry ProfessionalStandards 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 one’s actions would stand up to the scrutiny of a

third party. An alternative test is to judge one’s 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

• 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.”


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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

- “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 fund’s 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

EVCA’s 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

EVCA’s 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.”


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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 carefully-

considered 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

EVCA’s 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 investor’s identity cannot be verified.


244

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.”


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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, EVCA’s 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

EVCA’s 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 EVCA’s Code of Conduct’s sixth principle is to do no harm to the industry and this implies operations that would

include asset stripping or abuse of employees.


246

2.5. Limits on leverage

The EVCA’s Code of Conduct’s 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

EVCA’s 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 company’s 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.”


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Tab

le 3

:E

VC

A In

dus

try

Pro

fess

iona

l Sta

ndar

ds

EVCA

Cod

e of

EVCA

Cor

pora

teEV

CA R

epor

ting

Cond

uct

Gove

rnan

ce G

uide

lines

EVCA

Gov

erni

ng

Guid

elin

es (D

iscl

osur

eIn

tern

atio

nal V

alua

tion

EU L

evel

con

cern

s w

ith re

spec

t to

Priv

ate

Equi

ty(c

f IOS

CO; 2

008)

(cf

OECD

; 200

5)

Prin

cipl

es (2

003)

to in

vest

ors;

200

6)Gu

idel

ines

(200

6)

I. Ca

pita

l req

uire

men

ts

At th

e le

vel o

f man

agem

ent c

ompa

nies

(‘op

erat

iona

l ris

k’)

3(1

5)

At th

e le

vel o

f the

fund

s –

inve

stm

ent v

ehic

le (‘

expo

sure

’ ris

k)

II. In

crea

sed

disc

losu

re a

nd m

onito

ring

(Man

dato

ry) D

iscl

osur

e an

d ex

plan

atio

n of

inve

stm

ent s

trate

gies

and

risks

to in

vest

ors

(sop

hist

icat

ed a

nd re

tail)

3(3

)3

(1,2

,3,7

,12)

3 (1

,2,3

,5)

Disc

losu

re a

nd e

xpla

natio

n of

inve

stm

ent s

trate

gies

and

risk

s to

regu

lato

rs3

(3)

Cont

ract

ual c

laus

es c

over

ing

lock

-up

perio

ds, c

ance

llatio

n an

d te

rmin

atio

n3

(3)

3(3

,10,

11,1

4,15

)3

(5)

Prev

entio

n of

mon

ey la

unde

ring

3(1

)3

(2)

3 (4

,16)

Regi

ster

and

iden

tify

shar

ehol

ders

3 (6

)

Adop

t prin

cipl

es b

ased

val

uatio

n m

easu

res

for i

lliqui

d as

sets

3 (1

3)3

(4)

3(1

)

Man

agem

ent a

nd d

iscl

osur

e of

con

flict

s of

inte

rest

3 (6

,8,9

,10,

3(1

,2)

3 (1

,8)

11,1

3,14

,16)

III. In

form

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248

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(1) 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

EVCA Governing Principles(1) 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 Manager’s internal organisation, 10.3 Financial resources(16) Section 10.4 Procedures and organisation

EVCA Reporting Guidelines (1) 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

International Valuation Guidelines(1) IPEV are the internationally adopted and highly respected global set of principles for valuing illiquid assets


Part III

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.


Conclusion and Recommendations

(116) Downloadable at: http://www.america.gov/st/texttrans-english/2008/November/20081117173241xjsnommis0.4479639.html

250

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.


Conclusion and Recommendations

1. Annex 1: European legal regime relating to “asset stripping” andfurther potential risks relating to private equity transactions

1.1. Introduction

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 Société Anonyme (SA) (France), Gesellschaft mit beschränkter Haftung (GmbH), Aktiengesellschaft (AG) (Germany),

Società per azioni (SpA), Società a responsabilità limitata (Srl) (Italy), Sociedad Anónima (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 investor’s 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.

251


Annexes

252

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 company’s 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

Annexes

• 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 company’s

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 company’s 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.

253

Submission paper on the private equity industry to the European Commission and the European Parliament - February 2009

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 société 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 Holzmüller/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 company’s 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.

254

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 shareholder’s

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 company’s object may require a resolution of the

general shareholders meeting in the cases where such actions imply a change of the company’s

object. In this event rules regarding amendment of the company’s 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 company’s object. Therefore, in the event a

disposal of key operating or essential assets implying a change of the company’s 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 company’s 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.


255

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 company’s 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 company’s

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 société

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.

256


• 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 beschränkter Haftung) the courts have

developed detailed rules prohibiting that a majority shareholder intentionally destroys the

existence of the company (existenzgefährdender 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 subsidiary’s 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 company’s

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 subsidiary’s 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 company’s actions or (ii) that the damages have been entirely eliminated by a

transaction directed to such purpose.

Should a parent company instruct the subsidiary’s 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 subsidiary’s 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 subsidiary’s 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 company’s, quotaholders’ and third parties’ rights.

257

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 Anónimas 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 company’s 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.

258


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 société 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 company’s best interest;

and (iii) among others, preserve the value of company’s assets in order to protect the rights of

the creditors and other stakeholders.

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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-à-vis the

company, the shareholders or the company’s 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” “Acción 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” “Acción

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)


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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 company’s

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 company’s 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: Société Anonyme (SA) (France), Gesellschaft mit beschränkter

Haftung (GmbH), Aktiengesellschaft (AG) (Germany), Società per azioni (SpA), Società a responsabilità

limitata (Srl) (Italy), Sociedad Anónima (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 (écarts de réévaluation). It has to be noted that the

distributable reserves include the capital premium and the special reserves of long-term

capital gain.

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Please note that no distribution is allowed, if, as result of such distribution, the shareholder’s

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 (Aktiengesellschaft-

AG), 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 beschränkter 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 Anónimas), 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.

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Payment of interim dividends (see Art. 216 of the Ley de Sociedades Anónimas) 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 company’s 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 company’s 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.

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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 société 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 company’s 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 company’s 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).

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- Spain

Art. 217 the Ley de Sociedades Anónimas 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-à-vis the company’s 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 company’s 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.

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(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 onregulated markets or highly distributes among the public.


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 société 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 shareholder’s 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.

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• Spain

Pursuant to Art. 75 et seq. of the Ley de Sociedades anónimas a company (Sociedad Anónima)

may purchase its own shares on the basis of an authorization of the shareholder’s 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 Anónimas,

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 company’s 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 company’s 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).

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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

company’s creditors.

A capital reduction requires the company’s managing directors to publish three times an

announcement that the shareholders have passed a resolution to reduce the company’s

nominal share capital by a ¾ majority (Sec. 58 para. 1, 53 para. 2 German Limited Liability

Companies Act (GmbHG)) or a ¾ 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 company’s 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 company’s 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.

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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

company’s creditors and shareholders.

A capital decrease requires in the case of a Sociedad Anónima that the company’s directors

publish an announcement in a newspaper and in the Commercial Registry Official Gazette. In

this event rules regarding amendment of the company’s by-laws should be followed, Art. 164.3

of the Ley de Sociedades Anónimas 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.

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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 company’s 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.

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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 company’s

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 company’s 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 borrower’s 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 (sociétés

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 société 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).

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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 company’s 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 monétaire et financier) or a member of a regulated market.

If the directors, the chairman of the board and the managing director of a société anonyme

purchase the company’s 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 company’s 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 société 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 company’s 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

(Sozietà per azioni-Spa). It is worth noting that they also apply to limited liability partnerships

(società 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.

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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

anónimas) are contained in Art. 81 of the Royal Legislative Decree 1564/1989, of 22 December

relating to Sociedades anónimas (“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.

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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 Monétaire 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 subsidiary’s share capital.

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Pursuant to Art. L. 571-3 of the French Monetary and Financial Code (Code Monétaire 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 Monétaire et financier) and Art. L. 131-38 and

L. 131-39 of the French Criminal Code (Code Pénal), 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 company’s 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 company’s “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 société 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 beschränkter Haftung-

GmbHG) 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.

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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 beschränkter 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 beschränkter 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 subsidiary’s interest. Otherwise the subsidiary’s 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 (attività 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 company’s actions or (ii) that the damages have

been entirely eliminated by a transaction directed to such purpose.

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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.

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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 holder’s 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 (Autorité des Marchés 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.

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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 n°3). 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).

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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 Authority’s (“FSA”) Disclosure Rules and Transparency Rules

(“DTR”), a person reaching a holding of 3% or more of a listed company’s 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.

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2. Annex 2: Restrictions in Scandinavian legislation on asset strippingfrom limited liability companies

2.1. Introduction

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) Roschier Attorneys Ltd. in respect of Finland;

(ii) Plesner Svane Grønborg Law Firm in respect of Denmark; and

(iii) Advokatfirmaet Schjødt 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 company’s 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

company’s operations.

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If a divestment would not be deemed to be within the ordinary course of the company’s 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 company’s 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 company’s 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

company’s 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

company’s 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. beloppsspärren) and “the prudence rule” (Sw. försiktighetsprincipen). 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

company’s 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 company’s solidity (and other financial key ratios), liquidity and financial position in other

respects.

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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 board’s 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 company’s 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 company’s 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.

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2.3.2 Finland


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

company’s 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

Director’s competence.

There is no explicit rule in the Finnish Companies Act’s (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.


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).

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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.


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-à-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.

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2.3.3. Norway


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

company’s operations.

If a divestment would not be deemed to be within the ordinary course of the company’s 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 company’s 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).


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.

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2.3.4. Denmark


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 company’s 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.


Under Danish corporate law, we have identified the following rules which apply to Danish limited

companies and which protect a company’s capital or (directly or indirectly) may prevent asset

stripping:

(i) the board of directors is obliged to ensure that the company’s 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;

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(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 company’s 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 company’s 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 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. Årsredovisningslag (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 director’s 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.

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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 auditor’s 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

period’s similar item by showing the last accounting period’s item. The information in the notes to accounts

and annual report does not need to be compared to last accounting period’s 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 company’s registered annual accounts are public information and available in the

Finnish Trade Register.

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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).

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3. Annex 3: Professional Standards and their Application on European PrivateEquity 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 pool’s 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 EVCA’s

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.

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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 xAustriaBelgium x**CroatiaCzech Republic xDenmark x*Finland x*France xGermany x*GreeceHungary xIreland xItaly xThe Netherlands xNorway x*Poland x*Portugal xRussia xSlovakia xSoutheastern AssociationSpain xSweden x*Switzerland xThe United Kingdom xTotal 8 11

* Modeled on EVCA’s 1983 Code of Conduct.** Code of Conduct under development, will be based on EVCA’s.

Annexes


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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-à-vis their investors.

Table 5


Europe xAustriaBelgium CroatiaCzech RepublicDenmark xFinland xFrance xGermany xGreeceHungary xIreland xItaly xThe Netherlands xNorway x*PolandPortugal xRussia xSlovakiaSoutheastern AssociationSpainSweden x**SwitzerlandThe United Kingdom x***Total 13 1

* Endorsed by the NVCA although not compulsory for members.** Code of Conduct refers to “Industry Standards” in terms of reporting to investors.

*** BVCA reporting guidelines dated 2005 (in line with outdated EVCA reporting guidelines). Walker guidelines recommend EVCA reporting guidelines.


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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


Table 6

Supra or national association by country/region IPEV/EVCA Own national standard

Europe xAustria x Belgium xCroatiaCzech Republic xDenmark xFinland xFrance xGermany xGreeceHungary xIreland xItaly xThe Netherlands xNorway xPoland xPortugal xRussia xSlovakia xSoutheastern AssociationSpain xSweden xSwitzerland xThe United Kingdom xTotal 21 0

Annexes


294

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


EuropeAustria

Belgium

Croatia

Czech Republic

Denmark x

Finland*

France

Germany x

Greece

Hungary

Ireland

Italy

The Netherlands**

Norway*

Poland

Portugal

Russia

Slovakia

Southeastern Association

Spain

Sweden x

Switzerland

The United Kingdom x

Total 0 4

* Working on transparency guidelines.** Transparency covered in NVP Code of Conduct.


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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


Table 8


Europe x

Austria

Belgium

Croatia

Czech Republic

Denmark

Finland

France

Germany x

Greece

Hungary x

Ireland

Italy

The Netherlands x

Norway

Poland

Portugal x

Russia x

Slovakia

Southeastern Association

Spain

Sweden

Switzerland

The United Kingdom

Total 6 0

Annexes


296

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


Europe xAustriaBelgium CroatiaCzech RepublicDenmarkFinland x*France xGermany xGreeceHungary xIrelandItalyThe Netherlands xNorwayPolandPortugalRussia xSlovakiaSoutheastern AssociationSpainSwedenSwitzerlandThe United KingdomTotal 6 1

* A national code exists for listed companies, expected over time to also be adopted by privately held companies; well developed company law with cleardivision of responsibilities between owners, boards and management.


297


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EVCA February 2009Bastion 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: [email protected] web: www.evca.eu

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