Private EquityFund Services

PRIVATE EQUITY UPDATEEdition 4

London | Luxembourg | Jersey | Guernsey | www.ipes.com

The growth of the Private Equity world has generated a parallel growth in the Due Diligence industry.

Most Private Equity deals are conducted in auction formats where the basic rule is “Caveat Victim” – or simply believe what you are shown at your own peril.

Generally buyers are given an Information Memorandum describing the business and its numbers. Sadly these are often written by people with a profound interest in maximising the price of the business so the skill base of people like Alastair Campbell, Andy Coulson or Josef Goebbels is frequently echoed in these marginally non-fiction works. Extreme sceptism is entirely appropriate – especially when looking at the apparently glorious future of the business that is being sold.

In the past it was frequently possible to cover at least some of the risks of buying a business by getting effective warranties from sellers as to the financial, legal and tax position of the business. Nowadays effective such cover is rare as Private Equity firms cannot really provide such warranties and warranties are simply not available if you are buying a public company. Even where warranties are available they will not fully cover all risks and will rarely extend to covering commercial risks – a sensible buyer will seek other ways to minimise his risks and to spot any opportunities in the target.

So “Due Diligence” – an odd phrase which extends back to concepts of propriety and order long gone from an Investment Bank led sales process. The buyer needs to check accounting, current performance, legal issues, regulatory issues, HR issues, IT systems, property matters, taxation, competition, strategy, financing and more. The list is long but everything you do not check is a risk of looking stupid later.

Sometimes Due Diligence reveals that businesses have upsides the current owners failed to spot or implement – a cost-cutting merger or a new market perhaps. So it is not all about downside.

But it is mostly about finding problems – weak trading since the last numbers supplied, unmentioned regulatory reviews, big environmental issues and the like.

How do you find these issues?Well in most auction processes you are provided with a dataroom, normally nowadays electronic and carefully monitored by the seller and his agents. They will know what you have, and have not, looked at which can help them in managing the information flow to you.

Datarooms are potentially very useful if carefully prepared and indexed but this is by no means always the case. They can be a dump of readily available papers of little or no reasonable interest to an acquirer; they can be so vast as to be uneconomic to search; they

Due Diligence - Not What It Was!by Jon MoultonClear and

present danger?

In the Hunt for Red October, we learned that Russian submarine captains sometimes turn around suddenly to see if anyone is behind them. It is called the “Crazy Ivan”.

This skilled seafaring manoeuvre helps the Captain to assess the risks and then either tackle sneaky opposing forces or proceed ahead with greater understanding of the theatre.

On the subject of successful turnarounds, in this edition we present a piece by captain of industry Jon Moulton of Better Capital providing a warning into the clear dangers of due diligence vs. dodgy diligence in his inimitable, acerbic style.

There is also a clear and present danger in the markets today – from rising inflation at 3.7% in the UK and 2.4% in the Eurozone and the resulting pressure on interest rates; the rise in the VIX or Fear Index to May 2010 levels; to our era of fiscal austerity; and the repressed indicators of a Chinese property and debt bubble.

However, the markets continue to show dogged resilience to accept higher inflation, absorb public sector cuts and react moderately to external shocks including Egypt’s boiling cauldron.

Whether you believe that market volatility is too low, too great or just right, this edition speaks to your view. In addition to Jon Moulton’s piece on due diligence to avoid a bad buy, Francois Scheepers of Validus Risk Management discusses means of reducing volatility in part by hedging FX risk, and for those who believe that the market risks are just right for business as usual, our own Nigel Strachan presents an update on the funds market in Jersey.

Finally, in this, our first newsletter of 2011, I would like to take the opportunity to look ahead, and wish all our clients and friends, every success in the coming year.

Justin Partington, Commercial Director, Ipes

Improving Financial Risk Management in a Post-Crisis Environmentby Francois Scheepers & Kevin Lester

Executive SummaryHeightened levels of volatility in the financial markets have prompted Private Equity managers to review how they manage, monitor and report financial risks within their funds and portfolio companies. In addition, pressure from investors and stakeholders to ensure that financial risk management systems and controls are sufficient to manage risks effectively in the current market environment continues to increase. As such, the establishment of a robust financial risk management framework can be a key source of differentiation for Private Equity managers.

FX and interest rate market conditionsIncreased levels of volatility in the foreign exchange market can have a substantial impact on fund returns and portfolio company valuations, as demonstrated in the top right hand chart.

In addition, although interest rates have remained at near record lows throughout the past two years (please see bottom right hand chart), it is feasible that rate hikes are likely towards the end of 2011 as global GDP growth returns and inflation pressures build. Bank of England figures show that UK inflation accelerated to an eight-month high of 3.7% in December, the 13th consecutive month

Source: Preqin

can omit difficult materials or issues or can be unhelpfully provided in foreign languages or obscure computer file formats. Stuff is usually added continuously throughout a transaction making monitoring essential. Nonetheless it is usually worth a good look at a dataroom.

Information will also be provided in management presentations and possibly site visits will be arranged. On all but the smallest of transactions these will be rehearsed and choreographed – again though useful information can be obtained by attending these and especially by questioning where a failure to answer on the spot will quite often lead to an area of real concern.

Note however – in the absence of warranties or verification work – all the information is potentially wrong or incomplete.

Traditionally buyers sent in accountants to verify the financial information of the target. This has largely ceased as sellers disliked the time and intrusiveness of these verification exercises, and given the numerous buyers around for most businesses since the growth of Private Equity; the sellers started providing their own accountants’ reports – Vendor Due Diligence (“VDD”) – and buyers had to rely on that.

VDD is obviously a dodgy concept – the accountants really work for the seller so the emphasis of the report is likely to be on the optimistic side. It also gives the accountants the opportunity to minimise risk to themselves with what are remarkable limitations. Mostly these VDD reports start with a preface saying you can only sue the accountants for a small sum of money, in any case they have only repeated what the company told them and have not verified anything and have not conducted an audit.

In practice VDD means you – the buyer – ends up paying a considerable multiple of an audit fee to a firm of accountants instructed by the seller for what is reported speech in PowerPoint. It is not surprising that VDD is widely believed to actually stand for Very Dodgy Data.

Sellers will often allow some verification of information by the buyer and the buyer should normally insist on this especially where warranties are not adequate. Due Diligence is not all financial work, similar considerations apply to other forms of Due Diligence.

What is the due level of Due Diligence?This is often a tough question to answer – in practice it is a trade off of perceived risk; the cost and time of the checking; the competitive position of the buyer versus other potential buyers; the integrity of the seller and the protection from contractual warranties.

But neglect Due Diligence at your peril .....

Jon Moulton Chairman, Better Capital LLP

T +44 (0) 20 7440 0840

Better Capital Fund focuses on the provision of investment capital for the acquisition and operational turnaround of underperforming businesses.

Jon is a Chartered Accountant, a CF and Fellow of the Institute for

Turnaround Professionals and he previously worked with Citicorp Venture Capital in New York and London, Permira and Apax. He is a trustee of the UK Stem Cell Foundation and an active angel investor. He is non-executive Chairman of FinnCap, the stockbroker. He has recently been appointed a member of the Advisory Board for the £1.4bn UK Regional Growth Fund.

Francois Scheepers, CFA Director, Validus Risk Management

T +44 (0) 1753 290029 francois.scheepers@validusrm.com

Francois specialises in derivatives and structured products with particular expertise in designing risk

management solutions for the Private Equity sector. Francois is a member of the CFA Society of the UK and a member of the Professional Risk Manager’s International Association (PRMIA).

Kevin Lester Director, Validus Risk Management

T +44 (0) 1753 290029 kevin.lester@validusrm.com

Kevin is a Director at Validus Risk Management. Previously Head of Risk Management for Europe, the Middle East and Africa (FX and Commodities)

at Alcan (now Rio Tinto), Kevin has several years of corporate treasury experience with Dow Chemical and Avery Dennison. He is a member of the Professional Risk Manager’s International Association (PRMIA).

Ipes NewsIpes boosts senior team with hat trick of new hires

Ipes has strengthened its local leadership teams with the appointment of Andrew Whittaker and Nigel Strachan as Managing Directors in London and Jersey respectively.

Andrew Whittaker will be responsible for growing the UK based business, with a particular focus on building the outsourcing practice. He has extensive experience of onshore / offshore vehicles, open and closed and traditional and alternative funds. Prior to joining Ipes Andrew was Managing Director for Capita Financial Group’s Specialist Fund Services division. He also serves on the AIC Technical Committee and AREF Regulatory Committee.

Nigel Strachan joins Ipes from Kleinwort Benson, where he was Head of New Business for Corporate Clients in Jersey. A Chartered Accountant, Nigel has more than 12 years experience in the funds industry with specific expertise in offshore structuring and the administration of Private Equity and Mezzanine funds. Nigel is also Chairman of the Jersey Funds Association.

In Luxembourg, Christophe Ponticello has been appointed as a Client Director. He has more than eight years of experience in the investment funds industry and will work closely with Managing Director, Simon Henin to drive the operational functioning of the office. Christophe joins Ipes from Caceis, where he headed the accounting and reporting team for Real Estate and Private Equity funds SIF/SICAR and unregulated entities (Soparfi).

where annual price growth has exceeded the 2.0% inflation target. The longer term risk is therefore that interest rates rise, resulting in an increase in the cost of capital and consequently lower fund returns.

Risk management frameworkA successful risk management solution begins with a clear understanding of the size and nature of the financial risk exposures faced by the fund, either directly or indirectly via portfolio companies.

Financial risks can impact Private Equity funds in a number of ways, including:

• Realvalueoffuturecommitments;• Costandsubsequentvaluationofassetswithinthefunds;• Valueoffuturedistributionstoinvestors.

Financial risk can also affect portfolio companies in several ways and understanding the relationships between these risks and other business factors can be a challenge.

Risk management objectives and strategy designOnce a manager clearly understands the magnitude and nature of the risks faced, it is important to determine risk management objectives to drive the hedging strategy. These could include:

• Protectingaspecificbudget/accountingrate;• Minimisingtheprobabilityofbreachingdebtcovenants;• Reducingtheimpactthatvolatilityhasoncashflows.

Implementation of a hedging strategyThere are several tools, broadly divisible into ‘internal’ and ‘external’, with which to mitigate and manage financial risk.

Internal risk management tools include:

• Theredenominationofoutstandingdebtintoanothercurrency;• Modificationofaportfoliocompany’scapitalstructure;• Direct changes to the portfolio company’s customer pricing mechanisms.

External tools typically involve the use of derivative instruments transacted externally with a financial counterparty. When executing a hedge it is important to consider credit spreads, dealing costs, hedge documentation (ISDA) and to ensure that the hedging strategy is transacted at competitive prices.

Risk reporting and performance managementSince the financial crisis, the requirement for transparency and control has increased significantly. A well-functioning risk monitoring process is indispensable for a Private Equity manager to keep track of the impact of financial risk on the fund itself, and the portfolio companies within it. Such a process also facilitates communication with investors and other stakeholders which, in a post-crisis environment, is rapidly becoming a source of competitive advantage.

Looking aheadIt is clear that financial risk will continue to pose a challenge to Private Equity managers in the future. The changes brought about by the financial crisis have altered the landscape in which Private Equity managers operate and a structured approach to risk management is therefore essential to manage these risks effectively.

Taking action now will certainly give the forward-looking Private Equity manager a strong position from which to manage any subsequent bouts of financial market volatility and could provide a tangible source of competitive advantage.

www.ipes.com Ipes is regulated in the provision of fund administration services, for more details please see our website.

In reflecting on 2010, I am sure you will agree it has certainly been a tough year for the industry as a whole. Looking back over the past twelve months, it seems that there have been three key distinct areas that have affected the global funds industry:

• Alackofleverage;• Alackliquidity;and• Alackofclaritywithregardstointernationalregulation.

Against this backdrop, Jersey’s funds industry remained strong. Indeed, third quarter statistics released by the Jersey Financial Services Commission showed that the net asset value of Private Equity funds administered in Jersey grew by 9.8%.

Rising activity levelsThe Private Equity funds sector has shown considerable resilience in difficult market conditions, with the value of assets under management remaining stable and at high levels. There is still a significant amount of capital to be invested from the last vintage of funds raised in 2006 (Preqin data suggests that dry powder in European funds collectively totals $235bn1) so activity levels should be high in 2011.

There are also encouraging signs of recovery in the availability of leverage integral for the completion of the deals in the LBO market. A recent Preqin report2 highlighted that almost half of all deals announced globally in 2010 were leveraged buyout deals. Similarly, research from Ernst & Young showed that by Q4 in 2010 the value of European buyouts totalled €48.2bn, with a fourth quarter value of €14.7bn – the highest since Q3 20083. These results, combined with better economic indicators, indicate it should be a strong year for deal activity and a better year for fundraising.

A positive outlook on regulationWhilst the spotlight has shone on offshore centres in recent months, Jersey has emerged as one of the strongest. The latest Global Financial Centres Index ranked Jersey 22nd, the highest out of all the offshore jurisdictions. The report also noted that both Jersey and Guernsey are “close to achieving the wider global awareness that would move them up to the profile of Global Specialists. Both these centres are working to change perceptions and to ‘rise above’ the status of offshore specialist centres by being seen as more diversified”4. In 2009, Jersey was also recognised by the IMF as being in the ‘top division’ of international finance centres and is classed as being compliant or largely compliant with 44 of the 49 general FATF recommendations.

The agreed compromise text for the EU AIFM Directive, meanwhile, is also positive for Jersey, and other reputable offshore centres, and provides greater certainty for fund professionals wishing to market to investors in the EU. Private placement regimes of EU member states are to continue at least to 2018 and Jersey is well placed to comply with the requirements to obtain a ‘passport’ within the EU for its funds when introduced in 2015.

The recent appointment of Steve Williams, the current British Ambassador to Bulgaria, as Director of European Affairs at the Channel Islands’ Brussels Office (a joint initiative with Guernsey) should further strengthen the islands’ position in the EU.

A View from Jersey by Nigel Strachan

Nigel Strachan Managing Director, Ipes Jersey

T +44 (0) 1534 712501 nigel.strachan@ipes.com

Nigel is Managing Director for Ipes in Jersey and is responsible for the overall management and development of the Jersey operation. A Chartered Accountant, Nigel has more than 12 years experience in the funds

industry with specific expertise in offshore structuring and the administration of Private Equity and Mezzanine funds. Nigel is a member of the Institute of Chartered Accountants of England and Wales, the Chartered Securities Institute and is Chairman of the Jersey Funds Association.

1 Preqin data as at February 20112 Preqin research report – 2010 private equity backed deals, January 20113 Has private equity come out of the slump, Sachin Date - Head of Private Equity EMEA, January 20114 The Global Financial Centres Index 8, September 20105 States of Jersey, Tax Information Exchange Agreements, 12 October 2010

Also of note from a regulatory perspective are new and recent developments in legislation relating to the establishment of funds in Jersey. Following the successful introduction of Unregulated Fund Classes in 2008, more than 120 such schemes have been set up, with promoters benefiting from the flexibility and expedience the regime offers in situations where additional regulatory oversight is not required.

New separate and incorporated limited partnerships are also set to be introduced early this year, and these will provide yet further choice for fund managers.

Looking aheadJersey has been proactive in adapting to meet the changing requirements of the industry. In particular, it is seeing success in establishing itself as a centre for specialist funds business, such as mezzanine finance and funds trading in secondary deals for senior debt.

The jurisdiction is also active internationally. As at October 2010 Jersey had signed TIEAs with 16 countries and a further 14 are in the pipeline5. It is also reaching out to emerging economies such as China – where its funds are recognised on the Hong Kong Stock Exchange, India and Russia.

Both in my capacity as Chairman of the JFA, and as a funds industry participant, I believe that Jersey has much to offer investors, fund promoters and managers. Through industry collaboration, maintaining a commitment to innovation, high standards of supervision and responsible and proportionate regulation Jersey is ready for ‘business as usual’ during 2011.