THE PRIVATE EQUITYCFO & COODIGEST 2012

New ways of adding value to the firm,the fund and the portfolio company

Table of contents and sample extract

THE PRIVATE EQUITYCFO & COODIGEST 2012

Table of contents The limited partner’s quest for greater transparency InterviewwithErikHirsch,HamiltonLane

Investor relations in the age of public disclosure ByPatrickCurtin,JoePatellaroandMassimoZannella,CitiInvestorServicesand CitiPrivateEquityServices

What the US SEC registration means for fundraising and investor relations CharlesLerner,FiduciaryComplianceAssociatesLLCinterviewsRalphP.Money andRobertE.PhayJr.,CommonfundCapital,HowardJ.BeberandMichaelR. Suppappola,ProskauerRoseLLP.

Preparing for and surviving the US SEC audit ByJuliaCorelli,PepperHamilton

Conducting the US SEC annual review ByScottPomfret,HighfieldsCapitalManagement

Chief compliance officer roles and responsibilities ByDavidHarpestandDanielFaigus,PwC

Performance measurement: is it all about IRRs? ByAlistairHamilton,InflexionPrivateEquityPartnersLLP

Best practice in financial modelling for private equity CFOs ByE.BrookeWhitaker,SerasiCapital

Cost and cash management for private equity portfolio companies ByGaryMatthews,MorganStanleyPrivateEquityandDavidHanfland,ATKearney

Private equity accounting – the auditor’s perspective ByNatHarper,KPMGLLP

THEPRIVATEEQUITYCFO&COODIGEST2012

THE PRIVATE EQUITYCFO & COODIGEST 2012

Table of contents Using technology to manage the compliance function, gather data and report information to investors ByDavidMiller,eFront

Information technology: integration and operation effectiveness ByJamesCashinandDanielWheadon,RSMMcGaldrey,Inc.

Blackstone’s BXAccess: the next generation of limited partner reporting ByMatthewPedley,TheBlackstoneGroup

Comparative data on compensation for CFOs, COOs and private equity employees

Plus extensive journalistic coverage by Private Equity International’s and Private Equity Manager’s dedicated journalists

THEPRIVATEEQUITYCFO&COODIGEST2012

Conducting the US SEC annual review By Scott Pomfret, Highfields Capital Management

Rule 206(4)-7 under the Investment Advisers Act of 1940 (the Advisers Act) requiresadvisers registered or required to be registered with the Securities and ExchangeCommission (SEC) to ‘review, no less frequently than annually, the adequacy of policiesand procedures… and the effectiveness of their implementation.’ The purpose of thereview is to ensure that the policies and procedures that have been adopted are ‘ever-green’ (that is, they keep up with the changing regulatory and business environmentand changes to the adviser’s business). In the words of Gene Gohlke, former associatedirector of examinations at the SEC’s Office of Compliance Inspections andExaminations (OCIE), the goal of an annual review is ‘to determine if the firm’s compli-ance programme continues to reasonably and effectively prevent compliance issuesfrom happening, detect those compliance issues that do happen, and prompt correc-tion of the issues that do occur.’1 Although the SEC has not prescribed a specific time-line for newly registered advisers, advisers should generally conduct their first annualreview within a year of becoming registered with the SEC.

The SEC has not prescribed any particular form for the annual review. Instead, the SECand its staff have repeatedly stated that the investment adviser should tailor its reviewto its particular business risks. The annual review appropriate to a hedge fund adviseris therefore likely to be different in many respects from that of a private equity adviser.To account for such differences and to ensure that resources of the persons conduct-ing the annual review are appropriately deployed, every annual review should be pre-ceded and governed by an inventory (a risk inventory) of the firm’s particularcompliance risks, as described more fully below.

Despite the need for tailoring the approach to particular risks of the adviser’s business, thereare some issues that the SEC will expect every annual review to consider. For example:

• What was the nature and frequency of any of the compliance matters that aroseduring the period covered by the review? Does this data suggest that a change ineither is warranted? Examples of ‘compliance matters’ include violations of thecode of ethics or compliance manual, sanctions applied, complaints received, andlitigation, regulatory action or investigation commenced.

• How has the adviser’s business changed over the year since the last annual reviewwas conducted? Are there new business personnel, risks, products, issues, units oraffiliates that require a change to its policies and procedures?

1 Speech by Gene Gohlke, ‘Examiner oversight of ‘annual’ reviews conducted by advisers and funds’on April 7, 2006, available at http://www.sec.gov/info/cco/ann_review_oversight.htm.

Introduction

What formshould the

annual reviewtake?

1

Who shouldconduct the

annual review?

When does theannual review

take place?

• How does the adviser go about identifying conflicts? What new conflicts has theadviser identified during the period under review? What new measures, if any, areneeded to address the conflicts identified?

• What changes in the laws and regulations applicable to advisers have occurred dur-ing the period under review, or are expected to come into effect in the near future?

Most private fund advisers carry out the required annual review under the direction ofthe firm’s chief compliance officer. Based on a risk inventory, the chief compliance offi-cer creates the game plan for the review and oversees the performance of particulartests, reviews, inquiries, interviews and other tools necessary to carry out the review. Ina larger firm, the chief compliance officer and his or her staff may have sufficientresources to carry out the annual review without assistance from employees in the busi-ness units. However, in a firm of any size, the better practice is for the chief complianceofficer to set a plan and tone with the business unit employees carrying out much ofthe testing under the direction of compliance staff who then review the results. Thisapproach leverages compliance resources to allow a more comprehensive review andemphasises that compliance is the responsibility of everyone, not just designated com-pliance professionals. However, compliance must always ensure that the business unitemployee carrying out the review is independent (that is, business unit employeesshould not review their own work).

Some investment advisers hire third parties (primarily compliance consultants and lawfirms) to conduct annual reviews on their behalf. The third-party reviewer may not onlyhave the advantage of experience with a wide variety of advisers and approaches, butalso are often former SEC examiners. For an adviser with no or a small staff, an outsidereview provides a fresh look at the compliance programme. Typically, based on a riskinventory, the third-party reviewer works with the chief compliance officer to establishan agreed-on scope for the annual review. The reviewer’s findings are incorporatedinto a report to management.

From time to time, such reviews may consist of a full ‘mock SEC examination,’ in whichthe third party provides a document request and simulates the experience of a visit bySEC examiners. While this approach may be very comprehensive, it is also expensive.Therefore, other more limited or targeted reviews may be appropriate. For example,an adviser may conduct a mock review every four to five years, but have a more target-ed review in each of the other years.

The SEC has not prescribed any particular time for the annual review. Gohlke’s speechon the goal of an annual review describes a range of timing from ‘as compliance issuesarose’ to ‘rolling routine review by functional area’ to ‘work concentrated toward endof annual period.’

Notwithstanding its name, the annual review can be a culmination of ongoing com-pliance activity throughout the year, perhaps supplemented by additional year-end

Conducting the US SEC annual review

2

testing. Under this practice, the chief compliance officer’s game plan largely consistsof a 12-month compliance calendar that prompts particular tests, inquiries and otherassessment tools, on a frequency prompted by risk level. The results of these assess-ments are then documented to enable easy summary at the end of the period. Suchan approach spreads out the burden of the annual review (other than a final summa-ry of results) over the year, instead of creating spikes in demands on the compliancedepartment or others involved in the annual review. Where other business units aremobilised to undertake part of the review, the chief compliance officer should takecare to coordinate with the units’ ‘busy periods’ (such as audit season).

No matter when the annual review takes place, the SEC expects reviewers (whether in-house personnel or third parties) to use a range of assessment tools. These include:

• interviews of employees in key risk areas;• observation of key processes;• re-performance of key tasks or calculations;• exception reports;• transactional testing (focused on processes repeated on a daily or regular basis);• forensic testing (testing over time focused on trends and patterns not obvious from

pure transactional testing);• surveillance; and• third-party inquiry (for example, service providers).

The person coordinating the annual review (for brevity’s sake, this chapter assumes achief compliance officer) should consider the following steps:

• Step 1. Assess any compliance and regulatory developments that became effectiveduring the review period.

• Step 2. Conduct or update a risk inventory.• Step 3. Review the results of the prior year’s annual review (if any) and any compli-

ance matters that have arisen since.• Step 4. Review any prior deficiency letter and the state of implementation of any

corrective action taken in response.• Step 5. Create a game plan for the review, including deciding the areas of focus,

the specific assessment tools for each such area to be reviewed, the sample sizesand frequency of each test, the approximate timeline, and an estimate and identifi-cation of the resources needed.

• Step 6. Oversee the review and adjust the game plan as needed.• Step 7. Address any compliance issues identified.• Step 8. Assess adequacy of current policies and procedures in light of review

results and develop recommendations.• Step 9. Share findings and recommendations with senior management.• Step 10. Implement necessary changes as approved by management.

3

What assessmenttools inform arobust annual

review?

What stepsshould adviserstake to conduct

the annual review?

Conducting the US SEC annual review

Performance measurement: is it all about IRRs? By Alistair Hamilton, Inflexion Private Equity Partners LLP

Although all private equity professionals would agree that the internal rate of return(IRR) is a very important performance-measurement tool, it would be wrong to consid-er IRRs as all-encompassing when measuring performance. This chapter is structuredinto three distinct sections: firstly, it describes how the performance of an individualprivate equity fund is typically measured; secondly, how a fund manager is appraised;and finally it explains the basics of investee-company performance measurement. I willargue that there is no single, all-powerful tool for measuring performance in privateequity. A range of approaches and metrics is required, as is a strong understanding ofthe basis of preparation.

As a private equity professional with a mid-market fund manager, I have drawn a num-ber of examples from this industry subsector. While all firms will measure performancein their own way, there are strong parallels between firms in different parts of the indus-try. No doubt performance-measurement tools will continue to develop as the indus-try matures, but the fundamental performance metrics, being the level of absolutereturn on capital invested, and the speed that this return is realised, will remain of cen-tral importance.

The performance measurement of individual private equity funds is a very importantbuilding block in the overall performance appraisal of fund managers, which makesstarting the analysis at the fund level a logical introduction to the wider debate.

The principal metrics used in performance assessment could be viewed as a mysterious-sounding set of acronyms – IRR, PIC, DPI, RVPI and TVPI – without suitable definitionsand explanation. None of these metrics are individually complicated, but the basis onwhich they are calculated needs to be properly understood to benchmark fairly.

This chapter discusses:

• How the performance of individual private equity funds are measured

• How the performance of a fund manager is measured

• How the performance of individual investee companies of a private equity fundis measured

1

Performancemeasurement ofindividual funds

Internal rate of return (IRR)

The IRR is the discount rate that makes the net present value of cash flow from a par-ticular source equal to zero. Presenting a simple example using a single investmentrather than a whole fund, if the investment was acquired for £100 and sold two yearslater for £121 then those cash flows have an IRR of 10 percent, being £100 multipliedby 110 percent, and then multiplied by 110 percent again. If the investment was soldfor the same £121 after only six months the IRR would be 47 percent, and if it were soldafter, say, ten years then the IRR would be 2 percent.

As you can no doubt imagine, this is a very important tool to use in benchmarking onefund against another, as all the fund cash inflows and outflows can be analysed and sum-marised in one individual and easy-to-understand statistic. What makes it even moreappealing is that the calculation can be done in basic spreadsheet applications using oneof the pre-programmed functions (the XIRR function is best to use in Microsoft Excel).

It is not necessarily the case that the fund with the highest IRR is the best; it dependson many factors and also the basis of preparation.

IRRs can be presented in a range of different ways and funds can be operated in differ-ent manners, which can lead to materially different IRR results. The European PrivateEquity and Venture Capital Association (EVCA) Reporting Guidelines recommend astandard method for calculation, but there are many variations on this best practice,examples of which are cited below.

Fund borrowing facilities, also known as capital-call Some, but by no means all funds operate a capital-call facility. These are facilities set upwith a bank that lends money to the fund so that investments can be purchased withoutdrawing down cash from investors. Typically a bank will lend money to a fund for up toa year and at this point the loan from the bank is repaid via a capital call to investors.

As you can imagine, the fact that the investors might be putting their money into thefund a year later than the investment is made leads to a higher IRR result despite themoney multiple, being the total returned cash divided by total cost, remaining thesame. The IRR of the investment of £100 that I mentioned previously from an investor’sperspective is 10 percent if it invested its money for two years, but it is 21 percent if theuse of the borrowing facility results in the investor only investing its money for the sec-ond of the two years.

There is of course a cost to setting up and operating a capital-call facility (that is, thebank arrangement fees and interest) and so in reality the actual IRR would be margin-ally lower than the 21 percent quoted above.

An important point is that when appraising the performance of a fund it is important tomake sure the appraiser understands whether a fund has been operated with or with-out a capital-call facility. Clearly the manager of the fund with a capital-call facility thatreturned an IRR of 21 percent is not more than twice as good as the manager that didnot deploy a capital-call facility and that returned a 10 percent IRR.

Performance measurement: is it all about IRRs?

2

Basis of preparation of the IRR calculations IRRs can be presented in a number of different ways that give different results. The maindifference in presentation is whether the cash flows are presented before or after adeduction for operating expenses and carried interest. A return quoted on the cash flowsbetween the fund and the investee company before these deductions, which is definedby EVCA’s Reporting Guidelines as the ‘gross return on all investments’, just considersthe pre-tax investment-specific cash flows, and can give a materially higher result than ona post-deductions basis. The main expenses that net down the result are the priority prof-it share (PPS) and carried interest, which is typically 20 percent of profits.

By way of an example, assuming a 2 percent per annum PPS (paid every six months inadvance) and a 20 percent carried interest on profits, the gross IRR (that is, pre-deduc-tions) of the investment bought for £100 and sold for £121 after two years is simply the10 percent described earlier. However, as shown below, the post-deductions return is6 percent. An illustration of the timing and quantum of cash flows is shown in Table 1.

Also, it is important to understandwhether the IRR being quoted is that ofthe cash flows between the fund and theinvestors, or the cash flows between thefund and the investee companies. Youmight think that there would be very lit-tle difference between the two alterna-tives, however sometimes there can bea material difference between them.

As an example, a capital call could bemade on January 1 for the £100 invest-ment but, if there were unforeseendelays in the due diligence processthen the investment might not bemade for another three months. TheIRR of the cash flows between theinvestors and the fund, (ignoring PPS,carry and similar items), would be 10percent if the investment was sold andthe proceeds distributed to investorsafter a total of two years after the draw-down. However, due to the three-month delay between the drawdownfrom investors and the actual invest-ment date there is a shorter time peri-od between the actual acquisition ofthe investee and the realisation.Therefore, the IRR between the fundand the investee would be higher

Performance measurement: is it all about IRRs?

3

Table 1: Gross vs. net IRR illustration

Gross Net

Jan 1, 2010 -100 -100

Jan 1, 2010 – -1

June 30, 2010 – -1

Jan 1, 2011 – -1

June 30, 2011 – -1

Dec 31, 2011 – -4.2

Dec 31, 2011 121 121

IRR 10% 6%

Table 2: IRR between the investors andthe fund versus fund and the investee

Investorsand the

fund

Fund and the

investee

Jan 1, 2010 -100 –

Mar 31, 2010 – -100

Dec 31, 2011 121 121

IRR 10.0% 11.5%