The European Lawyer's Private Equity Book, UK Chapter

1. MARKET OVERVIEW

   1.1 Types of investors

   Investors in private equity funds targeting UK investments comprise in the main pension funds, funds of funds, banks, insurance companies, government agencies, private individuals and family offices. During 2009, according to the British Private Equity and Venture Capital Association (BVCA), a total of £2.9 billion was raised by UK private equity funds (including venture capital funds) for investment in the UK and overseas. This sum was contributed to by those sectors in the following proportions: pension funds (18 per cent), insurance companies (10 per cent), corporate investors (14 per cent), banks (seven per cent), funds of funds (18 per cent), government agencies (six per cent), academic institutions (two per cent), private individuals (four per cent), sovereign wealth funds (six per cent) with the remainder (15 per cent) coming from a variety of other sources. According to the BVCA, £2.9 billion was invested during 2009 by private equity funds into UK companies, of which £296 million comprised venture capital investment.

   1.2 Types of investments

   Private equity funds will invest in businesses at almost any stage in their lifecycle and divide into a number of distinct types focusing on businesses at different stages in their development. At the smaller end of the scale, start up and seed financings will often be undertaken by private equity investors who specialise in venture capital, although recently there have been several multi-million pound start ups which have been backed by firms often more associated with more traditional leveraged buyouts. Moving up the scale of investment size, it is commonplace to divide the UK buyout market into three tiers, being the upper, mid- and lower market, the mid-range stretching from between £50 million to £500 million with the other two tiers falling on either side respectively. Private equity investors will typically seek to position themselves in a particular market, and while many will operate in two tiers, few will be active in all three. In addition, many private equity investors will focus their activities on particular industry sectors, such as healthcare, retail or heavy industry.

   During a business' early stages, private equity financing (seed and start-up and, in certain circumstances, growth capital as well) will typically be unleveraged as banks and other institutions will usually be unwilling to lend where there are few or no assets in the business over which security can be taken. Equally, where a private equity investor takes a minority stake in the business, this will usually be unleveraged as, without control, the private equity investor will be unable to require the business to grant security over the underlying assets.

   Once a business has developed to a point where it has a material asset base and some certainty as to the extent of future revenues and cashflow, private equity investment will typically be seen more favourably by lenders provided the company is able and willing to grant security over those assets, revenues and cash. However, at the time of writing, the effects of the credit crunch are still being felt in the UK and banks remain generally cautious over lending to finance private equity investments.

2. FUNDS

   2.1 Fund structures

   The most commonly used vehicle for a private equity fund is a limited partnership, constituted and governed by a limited partnership agreement to which all investors must adhere. Typically, an English limited partnership is used although there are circumstances in which a Scottish limited partnership is preferred. Scottish limited partnerships have separate legal personality, whereas English limited partnerships do not. A limited partnership structure is beneficial as it provides investors with limited liability (as they each subscribe to the fund as a 'limited partner') and is also a tax transparent vehicle, meaning that income and gains are taxed in the hands of the investors and there is no tax at the level of the partnership. This structure also enables the fund managers to receive their management fees and performance fees in a tax efficient manner.

   Limited partnerships are typically closed-ended, meaning that investors are locked in and cannot withdraw their interests in the fund (usually for five to 10 years). Limited partnerships will have a 'general partner', who is liable for the debts and obligations of the partnership and is responsible for the management of the partnership under law. In practice, however, such management duties are usually delegated to a separate manager entity. Limited partners must not take part in the day-to-day management of the fund (or they jeopardise their limited liability status) and they invest in the fund by committing to provide a certain amount of money. This is not usually contributed in full at the outset but in separate tranches during the investment period at such times as the general partner may request.

   Offshore fund structures are also used to avoid tax leakage at the level of the manager. Such offshore funds are commonly incorporated in the Channel Islands or the Cayman Islands, typically as offshore limited partnerships. The manager of an offshore fund will often be established offshore as well to avoid tax leakage.

   2.2 Regulation of fund raising and fund managers

   Private equity funds are typically unregulated collective investment schemes and therefore the fund vehicle itself will not be subject to authorisation by the Financial Services Authority (FSA). However, where carried out in the UK the fund must be established and operated, and its portfolio managed, by an authorised person. Operating a collective investment scheme is a regulated activity under the Financial Services and Markets Act 2000 (FSMA) which requires FSA authorisation, along with dealing in investments, advising on investments and arranging deals in investments, and the manager of the fund will therefore typically be authorised and regulated by the FSA. As a separate regime from that applicable to regulated activities under the FSMA, a fund cannot be marketed to potential investors in the UK (or outside the UK, if such communications may be 'capable of having an effect in the UK') by an unauthorised person, unless an exemption is...