PE79300 - Guidance for specific trade sectors: Private equity and venture capital: The investment cycle

Following the creation of the PEH, the typical investment cycle has three distinct phases, as follows.

Phase 1 - Establishment of the fund and investment

This first phase of the cycle normally takes about nine months. In this period the fund manager will obtain Financial Conduct Authority (FCA) authorisation, set up the fund and look for potential investors. To facilitate this a prospectus may be drawn up detailing the type of investments the fund is looking to make, the life span of the fund, the exit strategy, the return the investors can expect and the charges that will be made. The prospectus is sent to a target audience of potential investors, for example pension schemes, banks, insurance companies or high net worth individuals. Another way of generating interest in a fund is through private equity fairs.

The fund manager is obliged to perform checks on the investors for anti-money laundering purposes. The fund will not necessarily receive all the promised investment straight away, but there will be a commitment from the investors to provide the monies at an appropriate time.

Once there are sufficient funds, the manager will look to make investments. The type of investment will depend on the strategy detailed in the prospectus, for example there are funds that specialise in start-ups, others in a particular area such as renewable energy, pharmaceuticals, retail or manufacturing. For investment into existing businesses the fund manager is looking for a business that is not performing at its maximum, where there is an opportunity to improve performance and therefore value.

When a prospective target is found the fund manager will engage due diligence services, often performed by an external adviser, and which will normally be supplied to BidCo – see below. This service will be a comprehensive check of the target to establish its assets and liabilities and evaluate its commercial potential. If the target is found to meet the fund’s criteria, the PEH will make the investment through the purchase of the investee’s share capital, normally with a controlling interest in the investee company.

BidCo

Where the structure includes a BidCo, it will have been incorporated by the PEH during this first phase with the purpose of acquiring the investee company, and this action often takes place after the PEH has begun commissioning the various services required to achieve the acquisition (for example: due diligence). However, we would expect the parties to arrange their affairs in order that these services are made to BidCo after it acquires the investee company, for example by ensuring that BidCo is named in letters of engagement, or that such services are novated to them in such documents. Whether BidCo can recover input tax incurred on these taxed inputs will depend on its own partial exemption status post-acquisition.

What matters for VAT purposes is whether the arrangements put in place mean that the supplies are properly made to BidCo. You should consult guidance at VATSC11500 (direction of supply) if you have any concerns.

Phase 2 - Building the investment

The middle and longest phase is that where the fund manager is building value in their investment. This can be done a number of ways, for example through the provision of advice to the investee company on products, sales, restructuring, new strategies and re-capitalisation. To do this the PEH may provide the advice itself, or through the appointment of a non-executive director (NED). The NED may be an employee of the PEH, or an independent specialist appointed by the PEH.

Phase 3 - Realisation of investment, or the exit phase

The final period, of possibly six months, comes at the end of the determined lifespan of the fund. In this period the fund manager is looking to sell the equity stake taken in the investee company for a profit. The disposal of equity may be to a counterparty located anywhere in the world or sold to a follow-on fund established by the fund manager.

If exit is by means of the sales of the investee company’s shares, the place of supply of these sales will determine their VAT liability and whether there is a right to deduct related input tax – see pe34000.

The disposal is normally by means of the sale of the investee company’s shares but may also be via a further private equity arrangement, a trade sale or an Initial Public Offering (IPO).

Once the fund has divested itself of all its investments it will make a return to the investees, normally on a pro rata basis as a proportion of their investment.

If the investment was by means of a loan, the investee company would have repaid, or would repay the balance of the sum loaned. (Loan debts may be repayable for an equivalent value (possibly including accrued interest) by way of shares issued by the investee company under a Convertible Loan Note arrangement. Conversion to equity occurs at the maturity date of the Note which may be between 30 days or several years from the commencement of the loan.)

When all the investments have been sold and distributions made the fund will usually be closed down.