8.3 Investments in Private capital: Equity and Debt

Question 1

The largest source of returns for private equity investors

Answer 1

capital appreciation

–> which may take the form of price appreciation or free cash flows generated by portfolio companies’ operations.

Question 2

The primary approaches to private equity investing

Answer 2

leveraged buyouts

venture capital,

growth capital.

Question 3

Leveraged buyout (LBO) deals

Answer 3

structured to acquire publicly traded companies and operate them under private ownership

The intention of LBO investors is to add value by making changes to a company’s operations and capital structure.

These transactions are described as leveraged because they are financed with a high proportion of debt.

This debt becomes part of the newly private company’s capital structure and its assets are often pledged as collateral.

Because the companies that are targeted by PE firms typically have well-established operations, their cash flows are expected to be sufficient to support higher levels of debt.

Question 4

management buyout (MBO)

Answer 4

used to describe a leveraged buyout in which the target company’s current management team participates in the acquisition

Question 5

management buy-in (MBI)

Answer 5

a deal in which the company’s current leaders are replaced by management team that has been selected by the acquiring firm

Question 6

Venture capital (VC) firms

Answer 6

seek to take equity positions in companies with high growth potential

These companies are generally young, ranging from the smallest of start-ups to companies that are approaching the initial public offering (IPO) stage.

All else equal, venture capital investors expect higher rates of return when providing funds to companies at earlier stages in their development due to the greater risk of failure.

Because portfolio companies have often not yet started generating sales or operating cash flows, most VC investments take the form of equity, although debt capital (usually convertible debt) may be provided as well.

Question 7

describe the VC firms’ sources of capital. investors, and typical investment amounts at the Pre-seed stage

Answer 7

sources of capital: mostly individuals

Investors:
–> Founders
–> Family and friends
–> Angel investors

Typical investment: USD $5K - $500K

Question 8

describe the VC firms’ sources of capital. investors, and typical investment amounts at the seed stage

Answer 8

sources of capital: funds

Investors:
–> Seed funds
–> Angel investors

Typical investment: USD $25K - $5M

Question 9

describe the VC firms’ sources of capital. investors, and typical investment amounts at the early/later stage

Answer 9

sources of capital:
–> Institutional Investors
–> Family offices
–> Strategic Investors

Investors:
–> VC Funds
–> Coporate venture funds
–> Private equity investors
–> Strategic investors

Typical investment: USD $5M or more

Question 10

Pre-seed capital, or angel investing

Answer 10

used to support activities such as the development of a business plan.

These investments are relatively small and typically come from angel investors (e.g., friends and family) rather than VC firms.

Question 11

Seed-stage financing, or seed capital

Answer 11

supports pre-production activities such as product development and market research.

VC firms are generally unwilling to invest in companies before they have reached this stage.

Question 12

Early-stage financing, also known as early-stage VC or start-up financing

Answer 12

typically funds the initial phase of commercial production and sales.

Question 13

Later-stage financing, also known as expansion VC

Answer 13

provided after a company has started generating revenue, but before it is ready to go public through an IPO.

The funds provided at this stage are typically used to expand operations, improve products, and/or launch major marketing campaigns.

Because portfolio companies are generating sales, investors are more willing to provide debt capital at this stage. Indeed, the higher priority claims of debt securities (including convertible instruments) offer greater protection than common equity in the event of a subsequent bankruptcy.

It is at this point when founders and managers usually sell majority control of their company to VC investors.

Question 14

Mezzanine-stage financing, also known as mezzanine VC

Answer 14

prepares a company for its IPO.

This type of capital is provided after a company has started commercial production and is used to bridge the gap in advance of an IPO.

The term mezzanine financing refers to the issuance of hybrid securities, such as convertible debt and convertible preferred shares.

While mezzanine financing instruments may be used at this stage, investors are more likely to provide equity or short-term debt.

Question 15

Growth capital, also known as growth equity or minority equity investing

Answer 15

funds a company’s expansion during the period when it no longer requires VC investments but before it is mature enough to be considered as a potential LBO target.

Companies typically seek growth capital to expand or restructure their operations.

If a company has not yet gone public, its managers may initiate a round of growth financing to monetize some of their shares while retaining control.

Question 16

private investments in public equities (PIPE)

Answer 16

A company that has already gone public through an IPO can raise growth capital by issuing a private investments in public equities (PIPE)

These securities may be sold to existing or new stockholders at an agreed fixed price but they may only be marketed to sophisticated investors, such as mutual funds or endowments.

Lower disclosure requirements reduce transaction costs and allow the firm to raise capital more quickly compared to issuing exchange-traded shares.

PIPE transactions are often used to raise capital during periods of market turmoil or company-specific distress, when a company’s share price is significantly below management’s valuation.

Question 17

The disadvantage of PIPE issues, including convertible debt and convertible preferred stock

Answer 17

is that they are dilutive, which can lead to conflicts between new and existing shareholders.

Question 18

The two main exit strategies used by private equity investors

Answer 18

trade sales and public listing

Question 19

a trade sale

Answer 19

the portfolio company is sold to a strategic buyer, which is typically a competitor within the same industry.

Question 20

Trade sales offer the following advantages:

Answer 20

Cash is received immediately

Strategic buyers typically offer higher valuations due to synergies

Execution is relatively fast and simple

Transaction costs and disclosure requirements are lower compared to an IPO

Question 21

The disadvantage of a trade sale include:

Answer 21

The pool of potential buyers is limited

Managers may object out of concern for losing their jobs if the company is acquired by a competitor

Employees may prefer to monetize their shares through an IPO, which may produce a higher valuation

Question 22

An initial public offering (IPO)

Answer 22

another exit strategy that a private equity firm can use to sell some (but not necessarily all) of its position in a portfolio company

Question 23

main advantages of an IPO exit strategy:

Answer 23

The potential for a higher sale price than could be realized from other exit strategies

Managers will be supportive because they will retain their jobs

A successful IPO will generate good publicity for the private equity firm

Continued exposure to upside potential if some shares are retained

Question 24

disadvantages of an IPO exit strategy:

Answer 24

Long lead times

High transaction costs

High disclosure requirements

Exposure to market volatility, including the tendency for investors to focus on short-term performance

A lockup period provision can require a private equity firm to hold its shares for a minimum amount of time after the IPO

IPOs are best suited for larger companies with high growth potential

Question 25

a direct listing

Answer 25

results in a company’s shares being listed on a public exchange

However, an underwriter is not required to execute this strategy because no new capital is raised.

This is a faster, less costly alternative to an IPO for companies that are not in need of new capital and would like the benefits of having publicly-traded shares.

Question 26

A special purpose acquisition company (SPAC)

Answer 26

a shell company that raises cash through an IPO with the intention of buying a private company and taking it public.

If a suitable target is not acquired within a specific period (typically 24 months), the shell company dissolves and the capital that was raised in the IPO gets returned to investors

Question 27

The advantages of the SPAC exit strategy include:

Answer 27

The extended deal period can be used to build investor confidence through public disclosures

A fixed valuation and less volatile share pricing

Highly flexible transaction structure

Access to high profile sponsors and their networks of investors

Question 28

The disadvantages of the SPAC exit strategy include:

Answer 28

The cost of capital can be increased by sponsor dilution, warrants, and other fees

Dilution will result in a spread between the announced price and the true equity valuation

Exposure to deal risk due to the possibility that the transaction will not be completed

Capital risk exposure from the prospect of investor redemptions

Shareholder overhang and churn may occur after the transaction closes

Question 29

Three additional exit strategies

Answer 29

recapitalizations

secondary sales

liquidations.

Question 30

recapitalizations

Answer 30

executed by having the portfolio company take on additional debt and redistributing part of the proceeds as dividend payments to shareholders.

In fact, this is not a true exit strategy because the private equity firm retains its shares and control over the company.

This is a complementary approach that is often used to monetize a position and improve the investment’s internal rate of return before selling shares at a later date through an IPO or a trade sale.

Question 31

A secondary sale strategy

Answer 31

involves selling a position to another private equity firm or group of investors.

This exit strategy has become more common as the private equity market has grown.

Question 32

A liquidation strategy, also known as a write-off

Answer 32

used when an investment does not work out as expected.

Underperforming companies, or some of their assets, are sold for the purpose of salvaging any value.

Question 33

Private debt

Answer 33

refers to the various forms of lending to private entities.

Question 34

The four main categories of private debt

Answer 34

direct lending

mezzanine loans

venture debts

distressed debt

Question 35

direct private debt investment

Answer 35

the investor makes a loan directly to a specific operating company

Question 36

indirect private debt investment

Answer 36

the investor takes an intermediated path, purchasing an interest in a fund that pools contributions typically on behalf of multiple participants to buy into the debt from a set of operating companie

Question 37

Venture Debt

Answer 37

provides funding to complement the existing equity financing of start-up or early-stage companies.

It often takes the form of a line of credit or term loan. Venture debt allows shareholders to retain ownership and control of the company.

To compensate investors for the increased risk of default and the lack of collateral, venture debt includes features such as the right to purchase equity in the borrowing company under certain circumstances.

Question 38

Direct Lending

Answer 38

Direct lending transactions involve a private debt firm providing capital directly to the borrower using funds raised that have been raised from investors looking for higher-yielding debt.

The loan is typically senior and secured, with covenants in place to protect investors.

It differs from traditional debt instruments as the loan is provided by a small number of investors and cannot be publicly traded.

Question 39

Leveraged loans

Answer 39

commonly used in direct lending to enhance the return on the loan portfolio of a private debt firm.

This form of private debt investing carries additional risk because loans are made with borrowed funds.

Question 40

Mezzanine debt

Answer 40

subordinate to senior secured debt but senior to equity.

To compensate for its junior ranking and the fact that it is usually unsecured, mezzanine debt offers higher yields and usually comes with warrants or conversion rights.

The capital provided by mezzanine debt is often used to finance LBOs, recapitalization, and corporate acquisitions.

Question 41

Distressed debt

Answer 41

financing provided to mature companies that are facing financial distress

Debt issued by firms in these circumstances is often priced closed to the expected recovery rate.

Turnaround investors buy debt at a fraction of its par value and seek to directly increase its value by becoming involved in the management of the reorganized company.

This type of investing requires specialist knowledge of the bankruptcy process, which can be complex, lengthy, and capital intensive.

Question 42

Unitranche debt

Answer 42

a combination of different tranches of secured and unsecured debt into a single loan

Its priority ranking falls between those of senior and subordinated debt.

The interest rate on this type of debt will fall between the rates of return that investors require on secured and unsecured debt.

Question 43

Specialty loans

Answer 43

debt extended to borrowers in specific situations, such as to finance the legal fees and expenses in a litigation.

Question 44

Real estate debt

Answer 44

loans provided for real estate financing collateralized by a specified real estate asset or property.

Question 45

Infrastructure debt

Answer 45

used to finance the construction, operation, and maintenance of infrastructure assets.

Question 46

Collateralized loan obligations (CLOs)

Answer 46

created by pooling loans offered to multiple corporations in various industries and dividing the pool into tranches of debt and equity that differ in seniority and security.

More senior tranches of the CLO are sold to investors who are more risk-averse.

Question 47

Vintage year effects

Answer 47

especially important to consider when comparing different investments in private equity and venture capital

Question 48

rank the different types of debt/investments based on the most risk averse to riskiest (proportional with eexpected returns)

Answer 48

1. infrastructure debt
2. Senior real Estate Debt
3. Senior Direct Lending
4. Unitranche Debt
5. Debt Mezzanine
6. Pivate equity / Co-investments