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CAIA > 4.2 PE Funds > Flashcards

4.2 PE Funds Flashcards

1
Q

Date of first PE and VC Fund

A

PE - 1946

VC - 1958

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2
Q

PE Funds lifetime

A

7-10 years with provision to extend 2-3 yrs

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3
Q

GPs role in PE funds?

A

The GP’s role involves sourcing investment opportunities for the fund, reviewing business plans, and performing due diligence on the potential investments.

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4
Q

3 levels of PE investment

A

Top, middle, bottom

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5
Q

PE Firms structure

A

PE firm creates 2 LLC (one is the GP, other is the investment advisor)

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6
Q

PE investment schedule

A

10-30 companies are identified, in the first 3-5 years about 2-6 companies per year are evaluated and purchased

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7
Q

PE support in Buyouts

A

1-4 people from PE firm sit at the board of directors, frequent business support is provided

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8
Q

Fund of Funds definition? How are they classified?

A

Pooled Investment (fund) in other funds, such as mutual/PE etc

Partially blind pools or Informed pools investments

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9
Q

Blind pool investment definition

A

Investment in a fund without the underlying portfolio companies known

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10
Q

What is undrawn commitment? AKA?

A

Not used committed capital, AKA: Dry Powder

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11
Q

Why Institutional investors invest in FOFs?

A

1) direct PE investing can be problematic due tue: lack of knowledge, incentives, employees may leave for better pay

2) allows to stay focused on core business

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12
Q

When PE firms fund companies what risks do they take?

A

Entrepreneurial, Credit, Leverage

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13
Q

Liabilities of PE firm parties?

A

LP - have limited liabilities

GPs - do not have limited liabilities

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14
Q

PE FUNDS’ FIVE PRIMARY FUNCTIONS

A

1) Pool investor capital to invest in private companies.

2) Screen and select companies with high expected returns.

3) Finance companies for product development, growth, acquisitions, or buyouts/ buy-ins.

4) Monitor and coach portfolio companies. By dedicating PE fund personnel, the PE firm can have more control and value creation of the portfolio company.

5) Source exit opportunities for portfolio companies.

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15
Q

4 forms of investment in PE

A

1) PE fund - The PE fund investment program (institutional PE investor) invests direct, fund that invests in portfolio companies.

2) PE FoF - Institutional investors buy LP units of a PE FoF, which buys units of PE funds invest in portfolio companies.

3) PE fund with co-investment - Institutional investors invest in a PE fund and, at the invitation of the fund’s GP, make a direct investment in a portfolio company.

4) Direct investment in PE - Institutional investors invest directly in a portfolio company with no intermediation. This is similar to a co-investment except without the PE fund manager.

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16
Q

Why institutional investors use intermediation in investment?

A

1) due to lack of expertise
2) lack of access to private companies

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17
Q

5 stages of development of a limited partnership

A

1) fundraising stage - capital committed, not collected (capital is collected on a just in time basis), 6-12 months duration,

2) Sourcing investment - locating investments, after fund is closed, first 3-5 years

3) Investing stage - 3-5 years, how much and how to invest

4) Operations and Management - after all of the funds gave been invested, funds begin to generate profits

5) Windup and liquidation - profits distributed, incentive fees to GP is paid

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18
Q

Duration of a Limited Partnership, limitations for GPs?

A

Long term investment, at least 10 yrs

Funds are locked up, each time GPs need to raise capital for a new fund, new PE fundraising cycle begins

GPs not permitted to follow on funds until other funds have been closed or all of the funds invested

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19
Q

Vintage year

A

First year when committed funds are drawn to invest in companies

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20
Q

3 possible outcomes in the Windup and Liquidation stage

A

Company is:

1) sold to a strategic/financial buyer

2) IPO

3) liquidated (bankrupted)

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21
Q

Reinvestment provision

A

Right to reinvest funds and not distribute earnings ASAP to investors

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22
Q

In kind distributions

A

Distributions to investors via publicly tradable securities of portfolio companies

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23
Q

3 periods of a fund’s life cycle

A

1) Investment Period

2) Value creation period

3) Harvest Period

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24
Q

Other observed J curves in PE?

A

1) cash flow

2) Net Asset Value

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25
Q

Undrawn capital commitment

A

Commitment to provide capital in the future, not asked for as of yet

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26
Q

Commitment risk? AKA?

A

Risk that the LP will not be able to provide the capital commitment to the GP

AKA, funding risk

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27
Q

4 key risks of PE

A

1) market risk - market uncertainty

2) liquidity risk - limited possibilities for selling

3) commitment / funding risk

4) realization risk - risk of not generating returns in time for exit

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28
Q

What does Realization risk depend on?

A

1) Managers’ ability to create value and retrieve cash from their portfolio companies.

2) Level of equity markets and IPO activity at the time of exit.

3) Company-specific risks.

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29
Q

4 ways of mitigating PE Risks

A

1) market risk - diversified PE portfolio

2) Liquidity risk - adequate resources to hold the investment until maturity

3) commitment/funding risk - capital call is capped at original commitment amount

4) realization risk - diversified portfolio

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30
Q

Successful GPs of PE funds can oversee

A

Multiple funds over time

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31
Q

GPs look for which qualities in LPs?

A
  • financially dependable
  • knowledgeable
  • have long-term industry expertise
  • are familiar with the PE business
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32
Q

New LPs usually have access to what quality GPs? Why?

A

Inexperienced or in decline

Because of lack of relationships with successful GPs

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33
Q

Benefits of a good LP - GP relationship

A

1) Looking for and due diligence of quality funds is costly

2) LPs may be provided co-investment opportunities

3) Top managers have an established, loyal investor base, which may eliminate the need to find investors, which may eliminate the need to find investors and, thus, does not take away from their managing existing investments.

4) LPs indicate whether they intend to participate in follow-on funds and, if not, they typically refer other investors from their network to the fund. This information enables better planning, and predictable closings result in more efficient use of capital.

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34
Q

3 phases of a GP-LP Relationship?

A
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35
Q

Subscription Line of Credit (SLOC) for PE funds?

A

Liquidity management tool, for interim financing (2-3 yr term)

Secured by unfunded capital commitments

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36
Q

Global size of SLOCs?

A

300b globally

200b in the US, 65b in Europe, 30-35b in Asia

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37
Q

4 benefits to GPs and LPs when SLOCs are used

A

1) improved transaction certainty

2) better cash flow management

3) reduced administrative burden

4) enhanced IRR, reduced Multiple

38
Q

Albertus and Denes (2020) findings in relation to SLOCs?

A

SLOCs distort performance measures sensitive to cash flow timing (e.g., IRR), and SLOCs are used more by poorly-performing funds.

39
Q

Why lenders provide SLOCs?

A

1) Secured - SLOCs are secured by the unfunded capital commitments of the LPs, who are typically investment-grade institutional investors with considerable financial strength.

2) Diversification - more diverse base supporting repayment than typical corporate credit.

3) Fee-earning opportunity - Lenders have multiple fee streams (e.g., upfront fees, drawn and undrawn fees, and loan margin).

40
Q

Fees of PE Funds

A

1) management fees (1.5-2.5% based on size). During invest period based on committed capital, after invest period based on invested capital. Collected as soon as the capital is committed

2) Incentive fees / carried interest - 20% of profits. Recently calculated on fund as a whole basis

3) other fees

41
Q

Capital call

A

Calling on committed capital for an investment opportunity

42
Q

Clawback escrow agreement

A

Portion of GPs incentive fees are held until the fund is liquidated

43
Q

How is GPs catch up amount determined?

A

The amount that LPs got as preferred return (hurdle) * split rate

Example: 8m LPs got as preferred return (hurdle), the profit split is 80/20 =>

8% hurdle = 8m

20/80 profit share, catch up amount = 8m * 20/80 = 2m

44
Q

2 potential perverse incentives from PE hurdle rates

A

1) excessive risk taking - to increase GPs payout

2) gaming timing of realizations

45
Q

How to reduce exessive risk taking by GPs?

A

Require personal committed capital (usually 1%)

Some require it to be 1/4 or 1/2 of GPs personal net worth

46
Q

Key person provision in PEs?

A

Allows to suspend or divest until replacement is found or to eliminate the fund

47
Q

Bad leaver clause?

A

With a simple majority vote to remove GP or to liquidate the fund

48
Q

Good leaver clause? AKA?

A

LPs with a qualified majority (75%+) can stop funding the partnership.

Sometime provides compensation to LPs

AKA: without clause

49
Q

4 covenants on VC fund management

A

1) size - no single huge investment, diversification

2) use of debt - restricted

3) co-investing - with prior or future funds may be restricted

4) distribution of profits - LPs generally want to receive profits as they are realized, whereas fund managers would prefer to see less money distributed so that the fees they receive are based on larger funds.

50
Q

4 covenants on Activities of GP

A

1) private investments of GPs in companies that are being invested in by the VC fund

2) Sale of GP’s interest in the fund to a third party is usually limited

3) future fundraising and outside interests - restricted so that GPs focus on existing funds

4) investment focus - required to invest in areas where GPs have the most expertise

51
Q

Key to higher VC Funds return? Why?

A

Access to performing VC funds and their GPs.

Because usually the best performing GPs continue to perform

52
Q

Key to PE risk reduction?

A

Diversification vintage year (especially), geography and industry

53
Q

For what VC’s 3 main risks are they compensated? How much?

A

1) Business Risk

2) Liquidity risk

3) Lack of diversification

4-8% over public equities

54
Q

Key differences between VCs and buyout fund managers?

A

1) VCs launch new or emerging companies, whereas buyout managers leverage the assets of an established company.

2) Venture capitalists back entrepreneurs, whereas buyout managers deal with experienced managers.

3) Venture capitalists are typically active in the companies in which they invest by being involved in the companies’ day-to-day management or sitting on their board of directors.

55
Q

Types of LBO funds?

A

LBO funds are categorized according to the size of the portfolio companies in which they invest:

1) small-cap companies (i.e., $100 million to $1 billion in sales revenue)

2) mid-cap companies (i.e., $1 billion to $5 billion in sales revenue)

3) large-cap companies (i.e., $5 billion and above).

56
Q

Number of LPs in LBO?

A

20-50

57
Q

LBO funds lifetime

A

10 yrs with provision to extend 1-2 years

During the first 5 years the deals are sourced and reviewed

58
Q

Why do LPs prefer not to pay management fees in the fund’s extended life?

A

So that the GPs have an incentive to close the fund more quickly

59
Q

LBO Funds fees

A

1) Annual management fees - 1.25% to 3%, collected before any profits are earned.

2) Incentive fees (or carried interest) - 20% to 30% of total profits

3) Transaction fees - for arranging the LBO, of up to 1% of the selling price charged to the company being taken private.
• For instance, KKR earned $75 million for arranging the buyout of RJR Nabisco.
• Some LBO firms keep these fees for themselves, some give 25% to 75% of the fees to the LPs, and some include the fees as part of the profits to be distributed among the GP and the LPs.

4) Break-up fees - if the deal fails to go through.

5) Divestiture fees - for selling a division after the buyout has been completed.

6) Directors’ fees - for the LBO firm’s managing partners to sit on the company’s board of directors after the buyout has occurred.

60
Q

Two forms of agency costs

A

1) Cost to better align management’s goals and shareholders’ value-creation goal (monitoring and compensation)

2) Erosion of shareholder value from agency conflicts that are too costly to resolve efficiently (adverse effect on shareholders of managers not acting in the shareholders’ best interests)

61
Q

2 recent developments in LBOs?

A

1) transforming into an auction market

2) club deals

62
Q

Pros and cons of Club Deals

A

Pros:
1) They enable LBO firms to participate in buying companies that they could not purchase on their own.
2) They enable PE firms to pool resources to carry out costly due diligence.
3) They enable PE firms to get a second opinion about the value of a potential acquisition from another firm in the club.

Cons:
1) less individual bidders
2) responsibilities of the parties is not clear

63
Q

Why LBOs are less risky than VC funds?

A

1) LBOs purchase more established companies

2) LBO funds are more diversified

3) IPO exit is more likely for an LBO

64
Q

Business Development Companies (BDCs) characteristics?

A
  • pass through
  • 70% of assets in small firms
  • provide substantial managerial assistance
  • 90% of income to shareholders
  • moderate leverage
  • facilitate liquid investment in illiquid assets
  • close end funds
65
Q

BDC market?

A
  • 40 publicly traded companies
  • 10b in market cap
  • 90% invest in small cap businesses
66
Q

BDS usually traded at a discount or premium to their NAV, what is the formula for that

A
67
Q

Rank mean return, volatility of BIZD (tracks BDCs), SPY and IWM (russell 2000) and the correlation of BIZD with the other 2

A
68
Q

PIPE Definition

A

Private Investment in Public Equity.

Purchasing securities directly from a public company in a private transaction

69
Q

Typical issuers of PIPE

A

Less than 500m market cap

Seeking 10-75m in equity

70
Q

4 SECURITIES ISSUED THROUGH PIPES

A

1) Privately placed common stock (issued at a discount, where the discount on the PIPE’s issue price is greater for more illiquid securities)

2) Registered common stock (investors acquire stock at a discount to the public market price)

3) Convertible preferred stock or convertible debt (often with an agreement to register the equity securities within the next six months)

4) Equity line of credit (ELC) - contractual agreement that enables investors to purchase a formula-based quantity of stock at set intervals of time.

71
Q

PIPEs provide 4 advantages to issuing firms. What are the greatest?

A

1) Quick way to raise capital

2) Cheap way to raise capital

3) Less time-consuming than issuing public stock offering

4) simple offering memorandum

Numbers 1 and 2 are considered the greatest advantages.

72
Q

2 general classes of PIPEs?

A

1) Traditional PIPEs - preferred stock or debt with a fixed conversion price or conversion ratio.

2) Structured PIPEs (floating convertibles) - floating conversion price that changes based on market common stock price

73
Q

Conversion price in PIPEs formula

A
74
Q

Issue with Structured PIPEs? Why do they occur?

A

Can result in TOXIC PIPEs = when the decreasing prices of stocks result in high conversions and dilution of the ownership

They occur because the investors buy these convertible securities and then short they stock => company has to convert private securities into common stock at lower price

75
Q

3 Reasons why PE investors sell stakes in the secondary market?

A

1) To raise cash for funding requirements.
•For instance, a pension fund may need cash to pay retirement benefits or to meet capital calls.

2) To reduce an investment portfolio’s risk.
•During the global financial crisis, many large investors strategically adjusted their portfolios’ risk profiles.

3) To rebalance their portfolios (a form of active portfolio management).
• Investors may need to reduce certain asset class allocations, which would result in a partial liquidation of an asset class.

76
Q

Issues with PE investors selling their PE stake in the secondary market

A
  1. The PE investor may need to get the GP’s permission (sign on) to complete the exchange.
  2. GPs may not invite the LPs to participate in future PE funds that they sponsor, since GPs are typically averse to LPs selling their limited partnership interests to third parties.
77
Q

4 advantages from a buyer’s perspective to a secondary purchase of PE limited partnerships

A

1) Exposure to a portfolio of companies with a vintage year different from the buyer’s portfolio, thus facilitating vintage-year diversification.

2) Investment in a portfolio closer to harvesting profits than a new PE fund.

3) A way of gaining exposure to future funds sponsored by the GP.

4) A form of opportunistic buying (particularly when limited partnership interests are trading at substantial discounts), where the buyer sees greater potential for cash flows from the secondary portfolio than from current primary investments.

78
Q

6 Fee differences between hedge funds and PE funds?

A

1) Hedge funds have front-load incentive fees (i.e., fees are paid when shares are purchased), whereas PE fund fees are typically collected at the end of deals

2) Hedge fund incentive fees are based on changes in net asset value (whether gains are realized or unrealized), whereas those of PE funds are based on realized values of exited positions.

3) Hedge funds’ incentive fees are collected regularly (quarterly or semiannually), whereas PE fund incentive fees tend to be collected at the time of events such as exits.

4) Hedge funds’ incentive fees can be collected before a return of investor capital, whereas PE funds do not distribute incentive fees until the original investor capital has been repaid.

5) Hedge funds typically have no clawback provisions for management or incentive fees, whereas PE funds typically have clawbacks requiring fees on prior profits to be returned to investors if losses subsequently occur

6) Hedge funds rarely have preferred rates (or hurdle rates) that must be exceeded before fund managers can collect incentive fees. In contrast, most PE funds have hurdle rates.

79
Q

Governance issues of Publicly Traded PE firms

A

Drury (2013)
1) Tend to be organized as limited partnerships and LLCs (rather than as corporations), which may reduce personal liability for managers to LPs.

2) Managers retain control as opposed to other shareholders.

3) Listed PE firms’ structures tend to reduce or waive management’s fiduciary duties

4) Listed PE firms tend to exclude typical corporate controls by shareholders through the Board of Directors and opt out of stock exchanges’ governance rules.

80
Q

Long hold buyout funds characteristics

A

15-20 yrs

Accounted for 4.4% of buyout and growth capital raised by funds over 1b since 2015

81
Q

Long-hold PE funds improve which shortcomings of traditional PE funds?

A

1) forced to sell because the fund life expires

2) GPs raising a new fund may need to sell strong performers prematurely to display a verifiable track record or to provide distributions to existing LPs for reinvestment.

3) GPs may be incentivized to exit good assets in a short time period so they can post a high IRR and secure their carry.

82
Q

Which SBO transactions tend to outperform?

A

Transactions between firms with complementary skills

83
Q

Outperformance of long hold funds is based on what?

A
  • deferring capital gains
  • eliminating transaction fees
  • keeping the fund fully invested
84
Q

2 main types of long hold PE funds?

A

1) Core buyout funds - portfolio companies with lower risk and return

2) Long-hold buyout funds - risk/ return profiles and fees in line with traditional buyout funds.
• long-hold funds may re-evaluate the incentive fee after several years or may replace it with stock options for listed PE firms.

85
Q

Investments not suitable for long hold strategy

A
  • distressed
  • turnaround
  • cyclical
  • businesses that can be disrupted by new tech
86
Q

Pros of long hold funds?

A

1) Lower transaction costs

2) Fully invested capital over longer periods and with less time waiting to be reinvested

3) Deferred taxation of capital gains

4) Greater flexibility on exit timing

87
Q

Cons of long hold funds?

A

1) increase illiquidity

2) lower IRRs (even though higher after tax and fee returns on multiple)

3) issues incentivizing investment professionals (fees are paid later, key person risk also possible)

4) limited scope for value add (companies invested in are usually mature businesses with limited growth potential)

88
Q

What is hurt money?

A

Money contributed by the GP

89
Q

3 stages of a PE fund manager - investor life cycle?

A

1) entry & establish

2) build and harvest

3) decline, exit, transition

90
Q

Which GP’s LLP receives the incentive fee and the management fee?

A

Incentive fee - GP

Management fee - Investment adviser

91
Q

In which 3 ways can VCs use their profits?

A

1) make cash distributions

2) make in kind distributions

3) reinvest profits in new opportunities

92
Q

Impact of SLOCs on the J-curve?

A

1) The J-Curve may be inverted.

2) Interim IRRs in early years may be higher than the lifetime IRR.

3) Interim IRRs converge downward to the lifetime IRR.

CAIA (14 decks)

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