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Private Equity Fund distribution waterfalls

EMILIO ESCARTIN, OBE
By EMILIO ESCARTIN, OBE
2 weeks ago
The key concepts relating to private equity (PE) and venture capital (VC) for Shariah compliant fund distributions are: performance fee, returns (profits) and examples.

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  1. IFN SECTOR CORRESPONDENT Private equity fund distribution waterfalls PRIVATE EQUITY & VENTURE CAPITAL By Dr Emilio Escartin The key concepts relating to private equity (PE) and venture capital (VC) for Shariah compliant fund distributions are: performance fee, returns (profits) and examples. Calculation of proϐits in performance fee Hedge funds generally invest in marketable securities for which market quotations are readily available. As a result, most hedge funds define and calculate profits and losses by reference to both realized and unrealized gains and losses with respect to the investments. Manager) receives distribution out of profits to cover the management fee and will be responsible for paying the fee to the team out of the GP profit share. Before profits arise, the GP will be entitled to ‘borrow’ the amount required out of drawings from the limited partners (investors in the fund) against their commitments, to be repaid out of the profit share in due course. Organizational and/ or formation expenses of a fund will frequently be paid by the fund itself up to a specified limit, with any excess for the account of the GP or set off against the management fee. VC and PE generally invest in illiquid securities. As a result, most VC and PE funds calculate profits and losses by reference to only realized gains and losses. An exception to this model relates to distributions of securities in-kind. In such cases, the calculation of profits and losses does include the unrealized gains and losses with respect to such securities. With regards to management fees and organizational expenses, the issue is whether profits should take into account amounts attributable to management fees and organizational expenses. The following are principles/standards that touch on this: - – – © ILPA Principles: The best practices are that such fees and expenses should be included in full in determining the profits attributable to the realized investments as quickly as possible (as opposed to pro rata as discussed below). US Market Standard: Include such fees/expenses in the calculations of profits but reduce the profits on the realized investment by only a portion of the total amount of the management fees and organizational expenses corresponding to the portion of the total capital contributions attributable to the realized investment. UK Market Standard: The general partner (also known as GP or The – European Market Standard: The manner in which profits are calculated, allocated and distributed varies depending on the European jurisdictions and the particular vehicle utilized in that jurisdiction. Performance fee — timing issues • Issue generally: Whether the performance fee is calculated on a deal-by-deal basis or on an aggregate basis and, if the latter, whether that is based upon the total unreturned capital contributions made by the investors on realized and unrealized investments or just realized investments (and unrealized investments that have been written down for financial reporting purposes). • US and UK Model: Deal-by-deal basis by reference to realized investments. • European Model (increasingly being accepted in the US and the UK): An aggregate basis based upon unreturned capital contributions on realized and unrealized investments. 22 • ILPA Principles: Restrict calculations of the performance fee until the investors have recovered 100% of their capital contributions on realized and unrealized investments. VC and PE generally invest in illiquid securities. As a result, most VC and PE funds calculate proϔits and losses by reference to only realized gains and losses • US Market Trend: Most US VC and LBO funds assume that all unrealized investments will generate proceeds equal to their book/carrying value. As a result, they calculate the performance fee based upon an aggregate approach but only with respect to realized investments (and unrealized investments that are written down). As a result, the US market trend is NOT to return all capital contributions on unrealized investments unless such unrealized investments have been written down for financial reporting purposes. Dr Emilio Escartin is the professor of Islamic finance at the IE Business School. He can be contacted at eescartin@faculty.ie.edu. 2nd October 2019