1. Essential Terms of Fund Formation
July 19-20, 2005
Moderator: Robert M. Friedman, Dechert LLP
Panelist: John Aiello, VP & General Counsel Private Equity Group, Goldman Sachs & Co.
Materials have been abridged from laws, court decisions, and administrative rulings and should not be considered as legal opinions on specific facts or as a substitute for legal counsel.

2. 2005 Private Equity Strategic Financial Management Conference
I. Offering Process
2005 Private Equity Strategic Financial Management Conference

3. Private Offering – Not Registered Under Securities Act of 1933
No general solicitation or general advertising
Concern regarding interviews, seminar talks
Websites; password protection
Safe Harbor exemption under Regulation D for offers and sales only to “Accredited Investors”
Institutions with $5 million in total assets not formed for the purpose
Individuals with $1 million net worth (or joint with spouse) or income above $200,000 ($300,000 with spouse) for past 2 years and expectation of same for current year
Entity owned solely by Accredited Investors
2005 Private Equity Strategic Financial Management Conference

4. Private Offering – Not Registered Under Securities Act of 1933
Safe harbor exemption under Regulation S for offers and sales only to non-U.S. persons
Offers not made to persons in the United States
Buyer is outside the United States or seller reasonably believes him to be
No directed selling efforts in the United States
Offering materials to advise purchasers that interests may not be offered or sold in U.S. or to U.S. persons without registration or exemption
Regulation D and Regulation S may be relied on for concurrent sales to different groups
2005 Private Equity Strategic Financial Management Conference

5. Investment Company Act of 1940
Private Investment Funds exempt from registration as “investment company” pursuant to one of the following exceptions:
3(c)(1) Fund – no more than 100 partners
3(c)(7) Fund – limited to Qualified Purchasers
Institutions with $25 million in investments
Individuals with $5 million in investments
Parallel 3(c)(1) and 3(c)(7) Funds
2005 Private Equity Strategic Financial Management Conference

6. Investment Company Act of 1940
Non-U.S. Funds – only count U.S. persons toward 100 partner limit and only U.S. persons need be Qualified Purchasers. U.S. Funds count all partners (including non- U.S. persons) for purposes of Sections 3(c)(1) and 3(c)(7)
Knowledgeable Employees – do not count toward 100 partner limit and need not be Qualified Purchasers
Issue in granting carried interest with requirement for capital contribution to persons who are not qualified purchasers or knowledgeable employees
2005 Private Equity Strategic Financial Management Conference

7. Investment Advisers Act of 1940
Registration required if 15 or more clients
Each partnership counts as one client
Issue regarding how to treat parallel funds
Qualified clients
Net worth (together with spouse) in excess of $1.5 million
$750,000 under management with the advisor
2005 Private Equity Strategic Financial Management Conference

8. 2005 Private Equity Strategic Financial Management Conference
ERISA Considerations
Venture Capital Operating Company
First investment legal opinion
Issues regarding calling capital prior to first long-term investment
Direct payment to General Partner
Escrow
Don’t call capital until first investment is ready to be made
2005 Private Equity Strategic Financial Management Conference

9. Private Placement Memorandum
Description of investment program
What differentiates management group from others
Special expertise or focus
Investment objective/management capacity tied to projected size of Fund
Deal sourcing
Investment Team
Cohesiveness
Responsibility for track record
2005 Private Equity Strategic Financial Management Conference

10. Private Placement Memorandum
Track Record
State assumptions clearly regarding historical performance and projections of future results; how are unrealized investments valued (e.g., values of public securities in portfolio; subsidiaries not subject to limitations on sale)?
Descriptions range from good faith judgment of GP to detailed valuation methodology
Reporting of IRR performance – net or gross of fees and expenses, carried interest, organization costs?
Past performance is no guarantee of future results
Reporting Selected Investments – cross-reference to chart reporting entire Fund performance
2005 Private Equity Strategic Financial Management Conference

11. Private Placement Memorandum
Risk factors
Disclosure of conflicts of interest
Disclosure of claims against key persons or GP for breaches of fiduciary duties or mismanagement of assets
Use of confidential information in PPM
Fiduciary responsibility to portfolio companies whose information is disclosed
2005 Private Equity Strategic Financial Management Conference

12. Private Placement Memorandum
Executive Summary – qualified in entirety by more detailed summary of terms and by Limited Partnership Agreement
Size of offering
Minimum subscription
Investor qualifications
Term
GP capital commitment
GP carried interest
Distribution methodology
Management fee
Cap on organizational expenses
Specific business strategy
Special conflict of interest concerns
2005 Private Equity Strategic Financial Management Conference

13. 2005 Private Equity Strategic Financial Management Conference
II. Deal Terms
2005 Private Equity Strategic Financial Management Conference

14. 2005 Private Equity Strategic Financial Management Conference
Distribution Waterfall – What Amount Must Be Distributed to Limited Partners Before General Partner Receives Carried Interest?
Deal by Deal (allows for earliest distribution of carried interest)
Return of capital invested in realized deals
Return of capital permanently written off
Return of amounts written down by GP (consider permitting future write – ups, but not above cost, to reduce the amount required to be returned to LPs)
Return of proportionate amount of expenses and management fees
Preferred return on capital distributed to LPs
2005 Private Equity Strategic Financial Management Conference

15. 2005 Private Equity Strategic Financial Management Conference
Distribution Waterfall – What Amount Must Be Distributed to Limited Partners Before General Partner Receives Carried Interest?
Total Return (more dollars distributed earlier to LPs)
More typical in European Funds and Fund of Funds
Return of all contributed capital and preferred return on all contributed capital
Return of all committed capital and preferred return on all contributed capital (need to cover circumstance in which all committed capital is not called)
Preferred Return on some funds ceases to accrue once committed capital has been returned
2005 Private Equity Strategic Financial Management Conference

16. Issues to Consider Regarding Timing of Carried Interest Distributions
Distributions to GP of carried interest earlier in the term of a Fund increases potential for GP clawback
Delaying distributions to GP causes partners of GP to delay rewards of successful performance; time value of money (Note, however, that holdback requirements effectively may limit actual cash benefit of early distributions to receipt only of tax payment1 and an incremental additional amount)
1. Clawbacks are typically net of taxes (as carried interest recipients do not keep those amounts) and clawback guarantees cover only net awards actually distributed to carry recipients
2005 Private Equity Strategic Financial Management Conference

17. Issues to Consider Regarding Timing of Carried Interest Distributions
Distribution in kind
Delayed GP distributions may result in GP not participating in early distributions in kind
Delaying distributions to GP and accelerating distributions to LPs reduces amount of preferred return due to Limited Partners and increases IRR of Fund
2005 Private Equity Strategic Financial Management Conference

18. GP Clawback/Managing Carried Interest
Neither Fund Limited Partners nor Partners of GP want to chase carry recipients for excess distributions
Several or Joint Liability – Guarantee of Carried Interest recipients
Escrow Account – portion of carry distributions put into escrow account to secure clawback obligation
What percentage of distributions is placed in escrow?
25% / 30% / 50%
Who controls escrow account?
Limits on securities into which escrow account be invested – only secure investments which tend to produce low return
When can escrow be broken and further distributions made to carry recipients?
2005 Private Equity Strategic Financial Management Conference

19. GP Clawback/Managing Carried Interest
Periodic or Annual True-up
GP clawback is due on termination of Fund
LPs may require escrowed money be put back into Partnership based on amount GP would have to return if Partnership terminated at true-up date
Requirement for carry recipients to go out-of-pocket pre-termination of Partnership (GP may prefer this as it may obviate requirement to chase people)
2005 Private Equity Strategic Financial Management Conference

20. GP Clawback/Managing Carried Interest
Breaking Escrow
Multiple of committed capital returned to LPs (115%-125%)
Net Asset Value Test – take account of all distributions and unrealized appreciation to determine if carried interest may be distributed out of escrow to GP
2005 Private Equity Strategic Financial Management Conference

21. GP Clawback/Managing Carried Interest
What does clawback protect?
GP not receiving in excess of 20% of profits
LP receiving preferred return
Clawback obligation net of taxes
Net of tax liabilities due on sale of securities distributed in kind
2005 Private Equity Strategic Financial Management Conference

22. 2005 Private Equity Strategic Financial Management Conference
Management Fees
Percentage of committed capital during Investment Period
Step Down of Base (and sometimes percentage) after
Investment Period
Formation of a Successor Fund
Key person event
“Tail” if LPs vote to terminate Investment Period early
2005 Private Equity Strategic Financial Management Conference

23. No Fault and For Cause Terminations
Percentage to trigger
GP Removal or Fund Termination
“Cause” definition
Felony conviction of key principal
Gross negligence
Material breach of LPA
Bankruptcy of GP
“Key person” event
Treatment of GP carry
2005 Private Equity Strategic Financial Management Conference

24. Investment Limitations
Diversification
Limits on investment in single issuer
Limits on investment in single industry
Geographical Focus – limits on investment outside specified geographic focus of Fund
Leverage – limits on borrowing and guarantees
Public Securities – limits on investments in securities of Public Companies (Do negotiated investments count?)
Investments in Other Funds – concern on multiple layers of fees
2005 Private Equity Strategic Financial Management Conference

25. Reinvestment of Capital
Objective that at least 100% of capital commitments be invested in portfolio companies at least once (possibly not the case on account of management fees and expenses); some funds permit reinvestment in excess of 100% of capital
Generally reinvest only returns of capital but not profits
Ability to recall distributions for reinvestment
Reinvestment only during Investment Period
2005 Private Equity Strategic Financial Management Conference

26. Reinvestment of Capital
Separate provision for reinvestment of “quick turns” on investments and for loans and bridge investments ( months)
Effect of reinvestment may be to delay further the receipt of carried interest by GP; effect is also to free more LP dollars at risk if recycling dollars that could have been LP carried interest
Reinvestment may result in increased base for management fee calculation after the Investment Period
2005 Private Equity Strategic Financial Management Conference

27. Vesting in Carried Interest
Important item for LP due diligence: How is carry allocated among management team and what are vesting provisions? (ties to key person provisions)
Keep carried interest participants focused on the Fund during its entire term
Reserve to reward superior performance
Reserve for replacement Partners of GP and new hires
2005 Private Equity Strategic Financial Management Conference

28. Vesting in Carried Interest
Pace of vesting – ratably over Investment Period; over term of Fund; something in between
Deal by deal vesting
Percentage determined for each deal; allows for economic benefits to be granted in each case to persons who contributed most to a deal
No sharing in deals done before person becomes a carry recipient or after withdrawal
2005 Private Equity Strategic Financial Management Conference

29. Vesting in Carried Interest
Fixed percentage
Over life of Fund
Determined annually
Discretion to change during year in respect of unfunded investments
Cliff to start vesting
Accelerated vesting
Senior professionals
Participants in fundraising
Long-term employees
Active Participant when deal is realized
2005 Private Equity Strategic Financial Management Conference

30. Vesting in Carried Interest
Delayed vesting – vest in a percentage of carried interest only at termination of Fund
Distribution Holdback – whether or not an escrow is required by Fund, the General Partner may determine to withhold a portion of distributions as a reserve to fund clawback
Extra vesting – termination on death; disability; termination without cause; good reason termination
2005 Private Equity Strategic Financial Management Conference

31. Vesting in Carried Interest
Post withdrawal – only retain interest in deals done prior to withdrawal
Institutional Goal – departing partners may not do better based only on deals in which they have an interest than they would have based on entire portfolio
Forfeiture – termination for cause; violate non-compete with Fund
Loss Allocations – if carry participants have interests in different deals, need to determine how to allocate subsequent losses on other deals
2005 Private Equity Strategic Financial Management Conference

32. Departing Partners of GP
In anticipation of Partners of GP departing prior to termination of Fund, the GP Agreement should address some or all of the following:
Restrictive Covenants
Non-compete (time limits; geographical and industry-specific limitations; enforceability)
Non-solicitation of Fund Limited Partners
Non-solicitation of employees or portfolio company management
Confidentiality and proprietary nature of track record
2005 Private Equity Strategic Financial Management Conference

33. Departing Partners of GP
Non-disparagement
Releases
Cooperation in connection with Fund matters
Separation Agreements – often covers the above matters as well as economic agreement upon departure
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34. 2005 Private Equity Strategic Financial Management Conference
Conflicts of Interest
General Duty of Loyalty to Limited Partners under Delaware law to act in their best interests
Hard to demonstrate, so best to have agreed upon practices in conflict situations
Investing in portfolio companies in which a principal of Fund holds an interest
Passive or active investment
Size of investment
Investing in portfolio companies in which affiliates have made investments at different levels of capital structure
2005 Private Equity Strategic Financial Management Conference

35. 2005 Private Equity Strategic Financial Management Conference
Conflicts of Interest
Follow-on investments in portfolio companies in which a prior fund has made an investment
Limit to a percentage of committed capital
Require Board of Advisor approval
Require third party investor to take a minimum percentage of the deal
Independent Appraisal
2005 Private Equity Strategic Financial Management Conference

36. 2005 Private Equity Strategic Financial Management Conference
Conflicts of Interest
Fund Manager earning fees on account of portfolio investments
Management fee offset (50% / 80% 100%)
Possibly treat fees differently – Transaction fees; Monitoring fees; Breakup fees; Directors’ fees
How to treat broken deal expenses
Affiliates’ arms-length services
2005 Private Equity Strategic Financial Management Conference

37. 2005 Private Equity Strategic Financial Management Conference
Co-investment
No “cherry picking” by GP and its affiliates
Annual Fixed Percentage for GP co-investment in all deals
LP first look at co-investments
Permitted to show co-investments exclusively to certain parties that provide some strategic importance to the Fund
2005 Private Equity Strategic Financial Management Conference

38. 2005 Private Equity Strategic Financial Management Conference
Side Letters
MFN Clauses – Who gets benefits of side letters?
All Limited Partners
Similarly situated Limited Partners
Only those Limited Partners who committed capital equal to or greater than recipient of side letter
Disclosure of side letters
2005 Private Equity Strategic Financial Management Conference

39. 2005 Private Equity Strategic Financial Management Conference
Key Person Provision
Trigger – withdrawal; failure to play an active role in management (consider expertise expressed in investment decisions and general advice versus active sourcing and management of investments)
Determining who is a key person
Few individuals and loss of any one triggers key person event
Is the PE firm viewed as an institution?
2005 Private Equity Strategic Financial Management Conference

40. 2005 Private Equity Strategic Financial Management Conference
Key Person Provision
Balancing desire for larger group to avoid key person trigger against giving leverage as a key person to non- senior members
2005 Private Equity Strategic Financial Management Conference

41. 2005 Private Equity Strategic Financial Management Conference
Key Person Provision
Consequences of key person event
Termination of Fund unless specified percentage of LPs vote to continue
Suspension of investment period unless specified percentage of LPs vote to continue
Removal of GP
No consequences unless LPs vote to terminate Fund or suspend investment period
2005 Private Equity Strategic Financial Management Conference

42. 2005 Private Equity Strategic Financial Management Conference
Key Person Provision
Consider eliminating key person concept after Investment Period
GP right to designate new key persons
Who determines: percentage of LPs or Advisory Board?
Related Point – restriction on principal’s right to transfer interests in GP
2005 Private Equity Strategic Financial Management Conference

43. General Partner Internal Issues
Division of carried interest
Division of management fee
Often management fee is paid to a separate company owned by senior members of management team
Division of clawback liabilities
2005 Private Equity Strategic Financial Management Conference

44. General Partner Internal Issues
Vesting
Decision making process
Investments
Internal governance
Carried interest allocation
2005 Private Equity Strategic Financial Management Conference