Private Equity and Venture Capital: by Professor Stefano Caselli

MODULE 2
PRIVATE EQUITY AND

VENTURE CAPITAL
By Professor Stefano Caselli
Università Bocconi and SDA Bocconi
Content 1
1. Private Equity Investors: The Map to Investigate
2. Closed-End Funds in Europe: An Overview
3. Closed-End Funds in Europe: Lifetime of a Fund
4. Management Fees and Carried Interest
5. Investment Firms and Banks in Europe
6. Limited Partnerships in the US
7. The SBIC Experience in the US
8. Funds and VCT in the UK
9. Taxation around the World
10. New Solutions: SPACs, Private Debt Funds, Venture Philanthropy, and Crowd Funding
11. Calculating Returns (Exercise)

1
Introduction
In the previous module we have seen:
• When a company needs the intervention of PE
• The deals a PEI can undertake to provide the financial aid a company needs
We need to explore the world of the investors.
In this module we will discover:

• Who can be a PEI
• How an investor works
• How the regulation works for PE
• The remuneration of PE
3
1
The Formats
Regardless where the deal occurs, there are two formats, each having its regulation
and players:
1.The European Union format: This format is regulated by a Directive of the

European Union.
2.The Anglo-Saxon format: This format is regulated by US and UK laws.
Using one of the two formats does not

necessarily mean that the deal occurs in the
area of the format.
The European format has been adapted and is now used in, Brazil, and Russia, and
others; whereas the Anglo-Saxon format is also used in India and Australia.
4
1
The European Union Format
In the European Union, there are two Directives regulating PE activity and, at the
same time, they regulate the entire financial system in the European Union:
• The Banking Directive
• The Financial Services Directive
Behind these directives lies the idea that the financial system in Europe has to be
managed with stability, for this reason, before a financial institution becomes active,
there must be an approval by both the local and central authorities.
5
1
Within this framework, there are three players that can be a PEI:
1. Banks
– In Europe they are universal and they
– can provide any kind of financial service
Regulated by the banking
directive
2. Investment Firms
3. Closed-End Funds Regulated by both:

– They have an ad hoc structure and they are - the financial services directive
- the new AIFM (Alternative
– The most suitable player that can be a PE investor Investment Fund Managers)
directive
6
1
The Anglo-Saxon Format
The main difference between the two formats is the idea that each has of PE.
In the Anglo-Saxon world, PE is not a financial service (as it is in Europe), rather it is
an entrepreneurial activity.
This idea means that when talking about PE in the Anglo-Saxon world, the regulatory
framework is made up of:
Common law
+
Ad hoc fiscal rules
+
Special regulations for the PE world
In the end, in the Anglo-Saxon format, there is no supervisor.
7
1
The Formats
The taxonomy of the formats must be clear and must be applied as follows:
Local players (i.e. the perimeter of the investment is within the country of origin of
the PEI itself: a US PEI investing in the US only is a local player) must apply the legal
framework of the country of origin of the investor.
Global players (i.e. the perimeter of the investment is outside the country of origin of
the PEI itself) can opt for one format or the other one according to the needs of their
portfolio.
8
Content 2
1. Private Equity Investors: the Map to Investigate

9. Taxation Around the World

10. New Solutions: SPACs, Private Debt Funds, Venture Philanthropy, and Crowd Funding

2
As anticipated (module 2 clip 1), PE in Europe is a financial activity regulated within
the financial system legal framework and there are three vehicles that can be a PEI in
Europe:
1. Banks
– In Europe they are universal and they
– can provide any kind of financial service Regulated by the banking directive
2. Investment Firms
3. Closed-End Funds Regulated by both:

– They have an ad hoc structure and they are - the financial services directive
– The most suitable player that can be a PE investor - the new AIFM (Alternative Investment
Fund Managers) directive
In this clip, the attention is focused on closed-end funds.
10
Banks Closed-End Funds Investment Firms 2
Closed-End Funds
An investment made through closed-end funds consider a two-level system involving two
different institutions:
• Asset Management Company (AMC)
• Closed-End Fund
The AMC is a financial institution.

It can host many funds at the same time (they can be both closed and open-end) and it can
manage financial services as defined by the Financial Services Act (i.e., personal management
of savings, dealing, brokerage, advisory).
The closed-end fund is a separate entity that invests money for a pool of investors.
AMC
When referring to closed-end funds,
Closed-End Fund
there are three players to consider:
Investors
11
Closed-End Funds: Players
Financial institution approved and supervised by the local

AMC authority, whose task it is to manage the fund.
The AMC shares some characteristics with a consulting

company. In fact, it is not a financial institution but a cluster
of people advising.
Closed-end
Funds There are AMCs owned by banks, private individuals
(boutiques of PE), and the government.
There are no constraints in terms of shareholders, except for

Investors the commitment the AMC must own in every fund, which must
be equal to 2%.
12
A fund is a separated amount of money, given by the

AMC investors, managed by the Asset Management Company.
This amount of money can be used to invest into financial

assets or in other assets such as real estate, gold, etc.
Closed-end
A fund can be open end or closed end, where the distinction
Funds is driven by two parameters:
• The maturity (fixed or not)
• The amount of money to invest (fixed or not).
These funds can never use debt
Investors
Closed end funds have a fixed
maturity and a fixed amount of
money to invest.
13
Investors put money in the funds and from the moment when
AMC they do that, they automatically lose any right to have a
tailor-made investment. Their investment will be managed by
the AMC together with the other money belonging to the fund.
When they invest, they receive a certificate with the value
they invested in the fund.
Closed-end Typically investors are:
Funds - High net worth individuals
- Banks
- Insurance companies
- Pension funds
Investors - Corporations
- Governments
14
Closed-End Funds: Rules for the AMC
The existence of this “double level” is necessary to analyze the (very few) rules both for the
asset management company and for the closed-end fund - the same all over Europe.
The choice of a short albeit well-organized

system responds to the need to better
regulate a country-specific financial system.
For the AMC, the set of rules concerns:
Minimum requirements to operate

The rules are verified by
the country supervisor,
Governance rules checking over the whole
life of the AMC
Management rules
15
Banks Closed-End funds Investment Firms 2
Closed-End Funds: Rules for the Fund
For closed-end funds, the set of rules concerns three items:
General rules
Internal code of activity
Investment policy
16
Content 3
2. Closed-End Funds in Europe: an Overview

9. Taxation around the World

10. New Solutions: SPAC, Private Debt Fund, Venture Philanthropy, and Crowd Funding

Closed-End Fund
In the previous clip, closed-end funds were presented, together with the relative
regulatory frameworks and the players they interact with over their life (i.e. the investors
and the AMC).
The goal of this clip is to understand how those funds work.
All the rules concerning the functioning of a closed-end fund are stated in the set of rules
called internal code of activity (see module2, clip2), approved by the authority.
18
Closed-End Funds in Europe
Closed-end funds are the most important vehicle in Europe for PE.
Their length is fixed, meaning that the investors can invest in the beginning and
divest in the end of the fund.
The liquidity is no problem for the investors nor the AMC. For this reason closed-end
funds are the perfect tool to undertake a PE investment.
Typically, the average size of a fund is €100-300 million and this amount is divided
into tickets an investor can buy. Each ticket typically has a value of €1 million.
For instance, if the amount of money of the fund is €100 million, and each ticket is
worth €1 million, the fund needs (as a maximum) 100 investors.
19
Closed-End Fund: Lifetime of a Fund
When presenting the lifetime of a closed-end fund, some milestones must be set. In
its lifetime the following moments are the most important:
• Time 0
• Time 3
• Time N – 0.5 (where N is the end of the fund)
• Time N+3
-1.5 0 3 N – 0.5 N N+3
Fundraising Draw down period Getting to time N Extra time
20
Banks Closed-End funds Investment Firms 3
Closed-End Fund
Fundraising
Before launching any activity, the AMC needs the approval by the
-1.5 0
authority, where the approval depends on three criteria:
Fundraising
• The size of the fund
• The value of every ticket
• The investment target.
Once the approval is granted, the AMC has as a maximum 18 months
to collect the all of its money.
Generally, 4-5 months is the average time taken by an AMC to collect
the whole capital that will be invested. As a matter of fact, if the AMC
does not collect money before the time allowed, they usually stop
beforehand, otherwise they would lose their reputation.
In fact, 50% of the funds all over Europe do not manage to get to time
0.
21
Closed-End Fund
Draw Down Period
At time 0, the fundraising phase comes to an end.
0 3
In this period the AMC has the possibility ask the investors to deposit
Draw Down Period
a percentage of their commitment (e.g. 10%).
The time is set at 3 years, because collecting all the capital from the
investors will take much more time than it does in capital markets.
In the time going from time 0 and the third year, the closed-end fund
has to cash in all the money previously subscribed by the investors,
who can also deposit their investment with installments.
22
Closed-End Fund
Getting to Time N
3 N – 0.5 N
Getting to Time N
At time 3, the investors have to have entirely injected all the money equivalent to
their tickets. So, after the three years, the AMC keeps on investing until the end of
the fund. In fact, some investing activity can have already taken place before Time
3 but, not using the entire amount.
The length of the fund can be defined by the AMC, as long as it is shorter than 30
years. Usually, 90% of the funds have a maturity of 10 years. As a matter of fact, for
an AMC, 10 years is a maturity long enough to make two investments:
1. Year 0 - 3: first investment
2. Year 3 - 5: exit from the first investment
3. Year 5 - 7: second investment
4. Year 7 - 10: exit from the second investment
23
Closed-End Fund
Extra Time
N N+3 After the end of the closed-end fund there is the possibility to use
up to three year of extra time.
Extra Time As was presented in the first week, PE tends to have low liquidity,
and as such sometimes an AMC does not have the whole liquidity
it would need to pay off the investors right away.
When the fund finally comes to an end, the AMC valuates the fund
and spreads this value among all the investors coherently with the
amount of tickets bought by each investor in the beginning of the
fund.
24
Content 4
2. Closed-End Funds in Europe: an Overview

9. Taxation Around the World


The Economic Mechanism of an AMC
In closed-end funds there is an interaction between the investors and the AMC.
Investors will be paid, and a gain or loss will be generated at the end of the fund
(i.e. either at time 10 or at time 13 (see module2 clip3)).
What about the managers of the funds?

The goal of this clip is to understand how the AMC is remunerated over the fund’s
lifetime.
26
The Economic Mechanism of an AMC
Over the life of the investment, the AMC receives two different kinds of
remunerations:
1. Management fees
2. Carried interest
Please note: the rules that will be

presented are also valid for fund
managers operating in the US as long as
they operate in PE deals.
27
1. Management Fees
Management fees correspond to the amount of money an AMC receives every year
from closed-end funds.
Closed-end funds are the vehicles generating:

• Revenues, in the form of capital gains
• Dividends coming from the companies in which the investment is made
• Losses, in case the deal is not successful
The management fees is a fixed percentage of money calculated on the value of the
closed-end fund in the beginning of the fund itself.
For instance, in the case of a closed-end fund being worth €100 million bearing
management fees at 2%, every year the AMC receives €2 million from the fund.
28
1. Management Fees
The management fees must be precisely calculated for they have to cover:
• Operating costs
• Remuneration of the advisor helping the AMC in the consulting activity
• Remuneration of the technical committee
The percentage of the management fees is in fact computed with the capital
budgeting approach. That means that it is computed replying to the question: “Is the
amount enough to properly cover all expenses?”
The reply is in fact not in the percentage per se, rather it stands in the absolute value
of these fees.
29
1. Management Fees
In case an AMC belongs to a bank, all the above-listed costs will be easily covered.
On the contrary, if the AMC is an independent entity, covering all the above-listed
expenses can be very tough.
For instance, in venture capital, AMCs are owned by professionals and not by financial
institutions, because they need a workforce who can fully be devoted to the venture-
backed company.
30
2. Carried Interest
The second source of remuneration for the AMC is made up of the carried interest.
Maximizing the carried interest is the

ultimate goal and desire of an AMC.
It is computed only at the end of the closed-end fund’s life cycle.
CARRIED INTEREST = % x (Final IRR – Hurdle IRR)
IRR: it is a discount rate that equals

the investments with the present
values of the future returns of such
investments.
31
2. Carried Interest
The carried interest is the spread between the final IRR and a hurdle (a.k.a. threshold) IRR
multiplied by a fixed percentage.
Usually, the fixed percentage ranges between 25-30%; the hurdle rate ranges between 7-8%.
This means that, at the end of the fund, the AMC will receive a carried interest if and only
if the final IRR is larger than 7-8%..
The carried interest formula is also called “the waterfall mechanism.”

This mechanism can be used either with or without catch-up, where the choice to calculate
IRR one way or the other is up to the AMC and must be agreed in the Internal Code of
Activity.
• Without catch-up: The carried interest is computed on the difference between the final
IRR and the hurdle rate.
• With catch-up: The carried interest is directly computed on the final IRR.
32
Content 5

9. Understanding Taxation Around the World


5
PE Players in Europe
As anticipated in clip 1 of this module, PE in Europe is a financial activity regulated
within the financial system’s legal framework and there are players players that can
be a PE investor in Europe:
1. Banks
2. Closed-end funds
3. Investment firms
In this clip, the attention is focused on the other two players of the European format.
34
PE Players in Europe: Banks
In Europe, banks are universal: They can undertake any kind of financial activity
except for the following ones:
• Collective asset management activity

• Insurance activity
• Non financial activities
However banks can hold equities of AMCs, insurance companies, and non financial
firms.
35
When a bank wants to directly invest in the private equity of a company (whether it
be listed or non), not only does it have to follow very strict constraints and rules
but it is necessary for the bank to set aside a lot of regulatory capital, due to the
strict regulation constraints imposed on banks by Basel II and III.
This means that the capital gain obtained through the investment can be
counterweighted by the regulatory capital it has to set aside.
36
For the reasons mentioned above, it is very rare that a bank invests directly and
become a PEI.
Banks usually invest in closed-end funds to ultimately participate to some PE
activities.
Banks only directly invest if there needs to be an urgent intervention to save a

company in a certain industry or area or if the venture-backed company is of
particular importance.
37
PE Players in Europe: Investment Firms
Investment firms can undertake the same activity as banks with the exception of
collecting money through deposits.
According to the regulation they comply to, there are two kinds of investment firms.
38
Type 1 Investment firms
They do not have any specific constraints to manage their activities and the
supervision impact is quite soft.
They do not undergo any regulatory capital rules.
Type 2 Investment firms

They face the same constraints set for banks and for them the supervision impact is
hard. In this case, all investments undertaken by the firm entail a regulatory capital
as if they were banks.
In Europe, the most widespread

kind of firm is the second type.
39
The balance sheet of an investment firm.
Debt
Private
Equity Cash
Investments
A-Shareholders
Equity
B-Shareholders
Collected through
Debt and Equity
40
The role of the two kinds of shareholders is necessary to replicate, in the
investment firm, the relation existing between an AMC and the investors within
closed-end funds.
As a matter of fact:
• A-shareholders: act as an AMC. They are remunerated with the management fees
and with a yearly carried interest (it is computed every year because the
investment firm does not come to and end, unlike the closed-end fund).
• B-shareholders: act purely as investors and cannot influence the management of
the investment. They are remunerated with the difference between the profits
and the carried interest given to A-shareholders.
41
There may be at least two main reasons to use investment firms to invest PE:
• Investors may want to leverage (closed-end funds cannot use debt).

• A small group of investors may want to create a captive vehicle and they do not
want to comply to very strict regulations. Such is the example of the so-called
“family offices,” a group of family members who want to invest their own money.
42
Content 6



6
PE Players in the Anglo-Saxon World
With this clip, we will start looking at the Anglo-Saxon world. We will see the
mechanisms according to which PE works in the US.
Looking at the Anglo-Saxon markets, it’s can be noted that investments in PE are not
regulated by a regulation framework, rather they are market-related.
This derives from the Anglo-Saxon idea that the market discipline is more powerful
and important than a financial authority regulation.
44
6
PE Players in the US
The US financial market is driven by common law and great importance is covered
both by the local courts’ work and by the federal court’s work.
Some federal acts have created a general framework for the financial system. This
framework is not based on financial institutions but on relevant financial activities.
The pillars are represented by:
• Discipline on stock exchange and securities
• Corporate governance rules
• Discipline for insurance and pension funds
• General rules for banks
45
VCF SBIC Banks Corporate Venture Business Angels 6
PE Players in the US
In the US system, there is evidence of:
1. Venture Capital Funds (VCFs or simply, funds) The two institutional

2. Small Business Investment Companies (SBICs) vehicles in the US market
3. Banks
4. Corporate Venture
5. Business Angels
46
Venture Capital Funds
Venture capital funds are the most popular PE instruments in the US. Regardless of
the name, they can operate in every PE deal.
The legal entity supporting a VCF is called the limited partnership (LP).
An LP is one of the typical structures to create a company in the US, whereas
common organizational forms are: sole proprietorship, partnership, limited-liability
partnership, limited partnership, S-corporation and C-corporation.
That means PE investment is considered a business activity and not a financial

activity as it is in Europe.
47
An LP is the legal entity with the mandatory presence of two different groups of
shareholders:
LP
Debt
Assets
Limited
Equity Partners
General
Partners
The Limited Partners (LPs) must own 99% of the equity of the LP, whereas the
General Partners (GPs) must own 1% of it. This is set by US law.
48
Limited Partners are solely investors. They do not manage the company and are
limitedly liable to the extent of their investment.
General Partners are the managers of the company and they are fully liable for the
LP liabilities. This means that in the worst-case scenario they lose everything.
COMPARISON WITH EUROPE
LPs are like the investors in closed-end funds.

GPs are like the AMCs in closed-end funds.
Even though the holding stake is different
49
What does being “fully liable” mean?
It means that the GPs are responsible for the liabilities.

Full liability is something that is not stated in the rules of the closed-end funds
(Note: remember that closed-end funds can not leverage). The fact that a fund can
leverage makes it a hedge fund, entailing a higher risk-return combination than the
one in Europe.
The functioning of a fund is regulated by a Limited Partnership Agreement and it is
made by GPs and LPs, where the content is very similar to the one of the internal
code of activity, except for the parts referring to debt policy.
The only difference with the fact that in Europe, it is a code, therefore in case of a
legal battle they go before a Supervisor. On the contrary in the US it is a contract,
then they go before a Court.
50
In addition the GPs want to protect themselves due to the full liability. This is why
GPs usually is a management company and it operates via a Limited Liability
Partnership (LLP) working just like an AMC in Europe.
GPs want to be protected, but the LPs do not want them to be too safe. This is why
the assets of the LLP will be a collateral of the debt of the VCF.
51
LP
LLP
Debt
Debt
Cash
Assets General
Equity
Partners (100%)
Equity
99%
Limited Partners Investment 1

Investment 2
Investment n
52
Limited partners are typically banks, insurance, pensions funds, private investors,
etc.
The great success of limited partnership is due both to the simple scheme of
functioning and to the tax transparency.
The US government decided to have a tax law with specific reference to PE. This
entails that if in any US State there is a PE investment, taxes = 0% provided that:
• The fundraising lasts 1 year
• The maturity is 10 years
• The maximum extra-time is 2 years
In all other cases, investors pay taxes.
These benefits can be enjoyed if you do not operate in the US, as long as the VCF is
in the US.
53
Content 7



PE Players in the Anglo-Saxon World
With this clip, we continue the overview over the US players within PE with
particular attention on SBICs and some final considerations made concerning
corporate ventures, business angels and banks.
55
SBIC
SBICs were created through the Small Business Investment Company Act of 1958.
They are considered the beginning of the PE development in the US because they
were created to stimulate the VC market.
It is a legal entity, in which one of the two shareholders must be a US Public Admin,
while the other shareholder can be any kind of shareholder (it is usually a bank,
corporation, or individual).
Debt
Assets Shareholder 1
(50%) Sharing stands
Equity for a joint
venture
Shareholder 2
(50%)
56
SBIC: Duties and Rights
The Public Admin that holds 50% of the equity of the company is a pure investor: it
cannot manage the company. On the contrary, the non-public admin investor has the
duty and the right to manage the investments and the whole company.
Both shareholders receive a management fee, but the profit distribution (calculated
with the carried interest approach) is asymmetric: the US PA will get the
remuneration up to a threshold stated in the SBIC Agreement, whereas the extra
profit generated through the investments belongs to the other shareholder. Losses
are equally distributed.
57
SBIC: Duties and Rights
33% of debt can be borrowed from the Federal Reserve System at a very low and
fixed rate which is set yearly.
Capital gains and other revenues are free from tax and the taxation starts with the
distribution of earnings. This kind of “free-from-tax” vehicle can not be
implemented in the European Union because within the European Union there is a
rule of “non-State aids” even if both in Europe and in Asia the introduction of a
similar mechanism is a highly discussed topic.
This mechanism is very popular in the US, because with a partner belonging to the
Public Administration, some investors feel they can invest even in riskier deals.
SBICs are considered among the best models of PPPs (Public-Private Partnerships).
58
Other US Players
Banks
Also in the US, banks can invest in PE although like in Europe they have many
constraints, therefore it is very rare that they directly invest in PE. They usually act
as either GPs or LPs in VCFs.
Corporate Ventures
They are not proper legal entities, rather they are a division or a department of a
corporation which wants to invest in venture capital. The only aim of the CV is to run
seed and start-up financing.
The investment is done to promote R&D, outputs, patents and unlike in VCFs, the aim
is not to generate IRR but to enhance the value for the corporation.
59
Other US Players
Business Angels
They are PE investors without any professional skills. Example of such could be
foundations, universities, and individuals.
They can also be high net worth individuals, charities, and foundations, and in this
case can benefit of the QSBS rule (Qualified Small Business Stock). This means that if
they invest in PE and, at the end of the investment, the capital gain is immediately
invested in another private company under the form of PE, taxes are not paid. This
is a huge incentive for PE investments.
They are mostly active in venture capital, mostly with seed and start-up financings.
60
Content 8
8. Funds and VCTs in the UK


8
Players in the Anglo-Saxon World
After having seen how the PE market works in the US, we shift focus to the UK
whose mechanisms are more similar to the US rather than to the rest of Europe.
As with the US, the UK financial market is driven by common law and great
importance is played by the courts.
However, it is possible to use the schemes designed through EU Banking and

Financial Services Act: that means we find out a great variety of
solutions/typologies of equity investors.
62
VCF VCT Banks Business Angeles Local PPP 8
PE Players in the UK
In the UK system, there is evidence of:
1. Venture capital funds (VCF)

2. Venture capital trusts (VCT)
3. Banks
4. Business Angels
5. Local PPPs
63
UK VCFs are not built under the European scheme of closed-end funds but are legal
entity operating like LPs like in the US.
As a matter of fact the UK and the US aim to attract the same investors, also in
terms of investors’ risk-return profile.
As in the US, limited partners generally are private investors, banks, pension and
insurance funds, and corporate investors; and they are allowed to leverage.
A UK fund must have a set maturity of 10 years.
64
Venture Capital Trust: The General Definition
Venture Capital Trusts (VCTs) were introduced in 1997 and have had a great success
in the UK market. Started in the UK but nowadays it has become a sort of format,
and there is evidence of this tool in India and in Australia.
They are based on the concept of the UK Trust.
A trust is a very old British institution (there is evidence of the first trusts in the 11th
and 12th century) and it is an entity, not a company. The trust was born in the first
place for succession issues, as a matter of fact through this mechanism the owner
(called the settlor) does not have to manage the assets, for a third player will do it
(the trustee) and that is fully liable. In case the VCT has a maturity, at the end of
the VCT the owner gets back the assets belonging to the trust.
65
Venture Capital Trust: Application in PE
In terms of PE, trusts want to combine retail investors with PE activity (unlike with
closed-end funds). GPs create a trust with a term (the VCF term) and they set a
portion of their assets in the trust which they use as a collateral to show the LPs the
commitment in the management of the fund.
Investors become the settlers, whereas a management company becomes the

trustee. The trust does not own any assets, rather it just has the cash injected by
the investors used to make VC investment.
66
TRUST
Debt
Cash
Investors Investors (99%)
(Settler) Equity
Management
Company (1%)
Investment 1
Management Company Investment 2
(Trustee)
Investment n
67
Every time investors invest in trust, they receive a certificate listed in the stock
exchange; this ensures to investors a high level of liquidity.
The trust is like “an empty box” that does not publish any financial reporting.
The investors trust the reputation

of the trustee.
A trust can invest in listed securities, but at least 70% of the cash collected among
the retail investors must be used to invest in non-listed companies.
In the end, fiscal incentive are granted to the investors.
68
The Other UK Players
Local PPPs
They are not as popular as they are in the US within SBICs. They operate at a local
level and they do not have to comply to certain rules, rather they have to comply to
local laws.
Business Angels
See the US’s case.
Banks
See the US’s case.
69
Content 9


9
Taxation within PE
After having seen the key elements of the different vehicles through which an
investor can invest in PE, it is time to understand how the taxation works for these
investments.
To see how taxation works within PE, provided that taxation differs in every
country, two are the perspectives:
• Players involved into taxation in PE
• Areas of impact on taxation
Not every combination player-area of impact is relevant from the fiscal point of
view. We will focus only on those combinations which are.
71
9
Taxation within PE
Venture-backed
Vehicles Investors
Company
Relevant for personal
Taxation on capital Relevant to increase Not relevant
taxation profile (final net
gains NAV and IRR
IRR)
Taxation on Relevant to increase Relevant only for gains
Not relevant
dividends NAV and IRR given trough earnings
Relevant to reduce company

Incentive to startup Not relevant Not relevant
tax rate
Incentive to R&D Relevant to reduce company
Not relevant Not relevant
investment tax rate
Comparative Relevant to compose capital

Not relevant Not relevant
incentive D vs. E structure within net WACC
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9
Taxation on Capital Gains
For the taxation on capital gains, there are two
relevant players: the vehicles and the investors.
Taxation on Capital Gains for the VEHICLES
Three standards may be applied:

a) Participation Exemption (PEX): It is a mechanism identifying a threshold in the taxation.
When some conditions occur, the tax burden on the vehicle is lower than the general
taxation in the country.
b) Flat tax: It works like the PEX, only without any conditions. The tax rate is lower that the
tax rate in the country (like for Close-end Funds in Europe for which the tax rate is 20%).
c) Tax Transparency: This is a special case of flat tax making the tax rate equal to 0%. Plus
this entails that losses can be deducted as if they were costs. Regardless of the tax
transparency on the vehicle, the investors have to pay taxes in their home country (this is
the case of VCF both in the US and in the UK and of SBICs).
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9
Taxation on Capital Gains
Taxation on Capital Gains for the INVESTORS
In this case, the tax burden derives from a mix of the fact that an investor is either
a domestic or a foreign investor (with respect to the vehicle) and if the investor is a
legal entity or a private individual. You will have 4 different combinations as
reported in the matrix below, whose content will differ by country.
Domestic Foreign
Private
individual
Legal
Entity
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9
Taxation on Dividends
For the taxation on capital gains, there are two
relevant players: the vehicles and the investors.
Taxation on Dividends
In this case, the rules that are applied to investors and to vehicles concerning the
taxation on dividends are the same as in the case of capital gains.
Although, one very important difference between this case and the previous one
stands in the fact that dividends are not the primary goal of the PE activity, the
generation of capital gain is.
75
9
Incentives to R&D and Startups
Concerning the fiscal incentives to undertake R&D
activities and to invest in startup, there exists
three mechanisms, relevant only to VBCs.
Three incentives (from the least to the most sophisticated):

a) Mark Down: The tax rate is reduced to incentivize these investments without
any parameter of investment (e.g.: in the first three years of a startup, the
company does not have to pay taxes.). The risk is that such a mechanism can
create vicious cycles.
b) Shadow Costs: The company can use some debt expenses to generate tax
benefits.
c) Tax Credit: This is a tax voucher that the company can use in other fiscal years.
76
9
Taxation and Incentives to D/E Ratio
Concerning the fiscal incentives to the D/E ratio,
there are two mechanisms relevant to the VBCs
only.
Two incentives
a) Thin Cap: There is a limit for the company to use interest rate paid on debt to
reduce the fiscal burden.
b) DIT: Double Income Taxation gives tax incentives if the company collects money
trough equity.
77
Content 10
10. New Solutions: SPAC, Private Debt Fund, Venture Philanthropy,

and Crowd Funding
10
New Trends in PE
Innovation in the instruments and mechanisms of financing is very important in PE.
As a matter of fact, the market signals and trends stimulate new solutions in the
way of doing PE.
Nowadays, there is the definition of 4 new solutions:
1) Private Debt funds

2) Crowd Funding
3) Venture Philanthropy
4) Special Purpose Acquisition Companies (SPACs)
79
10
1. Private Debt Funds
Vehicles used in private debt are the same as in private equity (investment firms,
closed-end funds,…). The only difference is that the investment is made in private
debt.
This new instrument is becoming more and more popular lately for two reasons:
1) In Europe there is an increasing tendency among companies to collect debt.
Companies do not want to do so anymore with banks but through the market.
For the companies listed this is easy: they issue bonds on the market. However
in Europe most companies are not listed SMEs.
2) PE already knows how to deal with the fundraising when the company is a
private one.
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10
2. Crowd Funding
Crowd funding has become very important and widespread nowadays. It is a brand
new and digital way of collecting money.
Different players can launch their own financial needs and make a call on the
internet to collect money through their platform.
PE and VC can be done through crowd funding: for companies who are in the very
early stages of their life, they launch a call on the market to raise money.
Because this is a very recent approach, we can not say with certainty whether this
tool works or not for startups.
81
10
3. Venture Philanthropy
When PE vehicles invest only in businesses generating a string social impact, this is
called Venture Philanthropy.
In these cases, the mechanisms are the same as in the other forms of PE except for
the fact that both investors and the management company accept to get a lower
level off profits in terms of capital gains, carried interest, and management fees.
82
10
4. SPACs
SPACs were born around ten years ago in the US and the idea was so successful that
they started to operate in Europe 3-4 years ago.
They basically are an “empty shell” a form of an SPV.
20% of the SPV vehicle is held by the promoter, the company is listed in the Stock
Exchange so that they can collect the other 80% of the equity.
The SPAC can collect money only to do one investment: to buy another company.
If the SPAC succeeds, it will merge with the target company, otherwise the investors
will get their money back as this is a “one-shot vehicle.”
83
Content 11
11.Calculating Returns (Exercise)

11
Introduction
This exercise aims at understanding, in practice, how the calculation of carried
interest and of management fees work for a closed-end fund managed by an AMC.
The exercise will be done following these steps:
1) Presentation of the inputs
2) Investment: presentation on the cash flows deriving from the investment and in
the divestment phases
3) Computation of the IRR
In doing the exercise, we have to remember the formula used in module2 clip4 to
calculate the Carried interest:
85
11
Inputs
INPUT
Management Fee 2%
Hurdle Rate 8%
The committed capital is
the size of the closed- Carried Interest 30%
end fund. Committed Capital (min.) 400
Percentage Managers (GPs) 2%
The percentage is fixed OUTPUT

by law. Committed Capital 400
Capital at the End ?
86
11
Investment
To apply the carried interest formula and to compute the remuneration of the managers, we need
to calculate the development of the investment of the closed-end fund.
Investment period Divestment period extra

Draw-downs
Years 1 2 3 4 5 6 7 8 9 10 11 Total
(+) Draw-downs 100 200 100 0 0 0 0 0 0 0 400

(-) Investment 80 190 130 180 310 360 100 200 50 0 1600
(+) Divestment 0 0 40 200 320 370 100 250 500 600 700 3080
(-) Management 8 8 8 8 8 8 8 8 8 8 8 88
fee
Cash 12 14 16 28 30 32 24 66 508 1100 1792
2% x 400 Final amount of the

closed-end fund
(starting from 400)
Note that in the 10th and 11th year no investment
is planned. The focus is on the exit. Maturity
87
11
Case 1: Global IRR
We have to understand how to split the total amount of the closed-end fund. The
formula can be applied in two ways even if the formula is the same: in the first way,
the carried interest is computed on a global level (global IRR approach) whereas in
the second way, the carried interest is computed on a yearly basis (yearly IRR
approach).
STEPS
Fund Global IRR 348% a) The global IRR of the fund:
Net Global IRR 340% (Final Amount – Committed Capital)

Committed Capital
Carried Interest 102%
For Managers (GPs) 408 a) Net global IRR:
For Investors (LPs) 1384 Global IRR – Hurdle Rate
b) Carried Interest:
Net Global IRR * Carried Interest
88
11
Case 1: Global IRR
We have to understand how to split the total amount of the closed-end fund. The
formula can be applied in two ways even if the formula is the same: in the first way,
the carried interest is computed on a global level (global IRR approach) whereas in
the second way, the carried interest is computed on a yearly basis (yearly IRR
approach).
Fund Global IRR 348% d) The remuneration for the managers:
Net Global IRR 340% Carried Interest * Committed Capital
Carried Interest 102% e) The remuneration for the investors:

For Managers (GPs) 408 Total Amount – Managers’ Remuneration
For Investors (LPs) 1384
Remember that managers invested 2% of the committed

capital, whereas investors invested 98% of it.
89
11
Case 2: Yearly IRR
We are approaching the yearly way to compute IRR.
STEPS
a) The IRR of an investment planning to invest € 400 million in time 1 and receiving
€1,792 million euros is equal to 16.2%.
b) Net yearly IRR:

Fund Yearly IRR – Hurdle Rate
Fund Yearly IRR 16.2%
Net Global IRR 8.2% c) Carried Interest:
Carried Interest 2.45% Net Yearly IRR * Carried Interest
For Managers (GPs) 122.2335 d) The remuneration for the managers:

For Investors (LPs) 1669.766 Carried Interest * Committed Capital
e) The remuneration for the investors:

Total Amount – Managers’ Remuneration
90
11
Final Considerations
Note that in both cases we have used the formulas without catch up.
This means that the carried interest is calculated on the difference between the
final IRR and the hurdle rate.
It is possible, on the contrary, to calculate the same results also with catch up and
this means that the carried interest is calculated not on the difference but on the
IRR of the fund.
91

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MODULE 2

PRIVATE EQUITY AND

3. Closed-End Funds in Europe: Lifetime of a Fund

4. Management Fees and Carried Interest

5. Investment Firms and Banks in Europe

6. Limited Partnerships in the US

7. The SBIC Experience in the US

8. Funds and VCT in the UK

9. Taxation around the World

11. Calculating Returns (Exercise)

We need to explore the world of the investors.

In this module we will discover:

1.The European Union format: This format is regulated by a Directive of the

Using one of the two formats does not

3. Closed-End Funds Regulated by both:

In the end, in the Anglo-Saxon format, there is no supervisor.

2. Closed-End Funds in Europe: An Overview

4. Management Fees and Carried Interest

5. Investment Firms and Banks in Europe

6. Limited Partnerships in the US

7. The SBIC Experience in the US

8. Funds and VCT in the UK

9. Taxation Around the World

11. Calculating Returns (Exercise)

3. Closed-End Funds Regulated by both:

In this clip, the attention is focused on closed-end funds.

The AMC is a financial institution.

Financial institution approved and supervised by the local

The AMC shares some characteristics with a consulting

There are no constraints in terms of shareholders, except for

A fund is a separated amount of money, given by the

This amount of money can be used to invest into financial

The choice of a short albeit well-organized

For the AMC, the set of rules concerns:

Minimum requirements to operate

Internal code of activity

2. Closed-End Funds in Europe: an Overview

3. Closed-End Funds in Europe: Lifetime of a Fund

5. Investment Firms and Banks in Europe

6. Limited Partnerships in the US

7. The SBIC Experience in the US

8. Funds and VCT in the UK

9. Taxation around the World

11. Calculating Returns (Exercise)

-1.5 0 3 N – 0.5 N N+3

Fundraising Draw down period Getting to time N Extra time

2. Closed-End Funds in Europe: an Overview

3. Closed-End Funds in Europe: Lifetime of a Fund

4. Management Fees and Carried Interest

6. Limited Partnerships in the US

7. The SBIC Experience in the US

8. Funds and VCT in the UK

9. Taxation Around the World

11. Calculating Returns (Exercise)

What about the managers of the funds?

Please note: the rules that will be

Closed-end funds are the vehicles generating:

Maximizing the carried interest is the

It is computed only at the end of the closed-end fund’s life cycle.

CARRIED INTEREST = % x (Final IRR – Hurdle IRR)

IRR: it is a discount rate that equals

The carried interest formula is also called “the waterfall mechanism.”

2. Closed-End Funds in Europe: An Overview