Articles PE

Question 1

What can be found out comparing IRRs of Global Private Equity and the MSCI ACWI by Vintage Year?

Answer 1

Private equity returns have been higher than the MSCI for every single vintage year.

Question 2

MSCI ACWI

Answer 2

The MSCI ACWI is a market capitalization weighted index designed to provide a broad measure of equity-market performance throughout the world. The MSCI ACWI is maintained by Morgan Stanley Capital International (MSCI) and is comprised of stocks from 23 developed countries and 24 emerging markets.

Question 3

What is the largest part of global private equity?

Answer 3

U.S. buyout funds

Question 4

How have U.S. buyout funds performed?

Answer 4

• they have outperformed the S&P 500 by a fairly wide margin.

Question 5

What is an appropriate benchmark to use for buyout find investments?

Answer 5

• The S&P 500.

- Assume that the market risk inherent in a portfolio of buyout funds is equivalent to having a beta of 1.2

Question 6

How are the expected returns for buyout funds going to be?

Answer 6

• expected to be lower than the past (buyout earnings yields are relatively low today)
• buyout fundraising has been substantial over the last five year and the higher fundraising has been associated with lower subsequent returns
• probably buyout firms will now be still able to outperform the S&P 500, they have been able to do so the last 25 years.

Question 7

Have buyout funds historically outperformed public market indices?

Answer 7

Yes, even more recently. The remains true even after making reasonable adjustments for leverage (beta).

Question 8

What is the relation of a fund’s track record to capital flows into individual GPs and the overall GP survival?

Answer 8

• fund flows are positively related to past performance

Question 9

What happens in boom times of the PE industry?

Answer 9

• new partnerships are more likely to be started in periods after the industry has performed especially well.
• funds that were started boom times, however, are less likely to raise follow-on funds.

Question 10

Which factors make it difficult for new funds to compete with existing funds and what explains the heterogeneity in performance of the existing funds?

Answer 10

• many practitioners assert that private equity investors have proprietary access to particular transactions. (Better GPs may be able to invest in better investments)
• Good GPs provide better management or advisory input
• better VCs get better deal terms (e.g. lower valuations) when negotiating with startups because the startup accepts these terms for getting superior management, advisory, or repetitional inputs.

Question 11

TVPI

Answer 11

cumulative total value to paid-in capital

Question 12

DPI

Answer 12

distributed total value to paid-in capital

Question 13

When does performance of PE increase in the cross-section?

Answer 13

• performance increases with the GP’s experience and decreases with funds size (concave relation to size)
• GP’s track record is positively related to the GP’s ability to attract capital into new funds.

Question 14

Would a successful GP chose to grow the fund?

Answer 14

• not necessarily because GPs might not easily scale up investments by putting more money in any particular deal or investing in more companies because other inputs such as time and advice are more important.
• could be difficult to hire partners of the same quality as the existing partners
• number of good startups in the economy is limited at each point in time.

Question 15

PIPOs

Answer 15

private IPO transactions

Question 16

What do managers do so that a company becomes a unicorn? (Unicorn is good for the company for PR reasons etc.)

Answer 16

At some companies managers manipulate the market valuation by acquiescing (hinnehmen) to complicated and onerous (mühsam) financing conditions from VC firms that enable them to attract a sufficient amount of new capital.

Question 17

How is the value of a start-up boosted?

Answer 17

In exchange for receiving terms that eliminate much of their downside risk, the participants in this new funding round may be wiling to accept higher valuations than would be justified by the fundamental economic activity of the firm.

Question 18

What are the disadvantages of complex financing terms?

Answer 18

• complications for the firm to raise additional capital in further rounds
• potential investors in subsequent funding rounds will pressure the firm to offer them similar or even more favorable terms than those provided to earlier investors.

Question 19

What is the advantage of complex financing terms?

Answer 19

• most cost-effective way for the firm to raise capital as long as the value of the new venture continues to increase

Question 20

What is a ratchet? = Anti-Dilution Provision

Answer 20

• adjusts the conversion ratio from preferred stock to common stock and provides additional share to the investor if certain pricing benchmarks in the IPO are not achieved.
• protect investors against share price declines that occur during subsequent fundraising rounds or an IPO

Question 21

What is a drawback of a ratchet for the venture?

Answer 21

• because the ratchet provides a return guarantee the ratchet moves some investors which have a ratchet to want the venture to sell less than the anticipated IPO value

Question 22

Primary documents that determine the structure of VC investments?

Answer 22

term sheet and the definitive agreements.

Question 23

term sheets

Answer 23

non-binding agreements between the investors and the company that mark the formalization of negotiations.
- provide an outline of the major terms that will be incorporated into the definitive agreements

Question 24

definitive agreements

Answer 24

final contracts that govern the terms and conditions that legally bind the company and the investors in a VC transaction
- specification of the securities

Question 25

Who are common stockholders?

Answer 25

• residual claimants in the sense that their claims on the company’s cash flows are subordinated to government claims, taxes, pensions and other regulated employee claims, accounts payable, debt payments, and preferred stock
• not used by VC because downside risk of acquisition offer to venture which is below price they invested

Question 26

what is preferred stock?

Answer 26

provides an ownership position in the company that is senior in priority to common stock holders

Question 27

redeemable preferred stock

Answer 27

= straight preferred stock

• FV (initial investment) that must be repaid upon maturity
• usually provides a dividend payment in cash or PIK shares of preferred stock (in growth stages, venture-backed companies rarely pay cash dividends, which are instead accrued and paid out upon the successful completion of a liquidation event
• not convertible into common stock –> no participation in any increases in company value –> VS rarely commit their capital using preferred security

Question 28

convertible preferred stock

Answer 28

• can be exchanged for common stock –> protection from downside risk and upside potential in the firm
• usually carries a mandatory conversion provision that becomes effective if the company completes a successful IPO exceeding the minimum price

Question 29

participating convertible preferred stock (PCPS)

Answer 29

• gives investors a preference payment and a payout tied to their percentage of net proceeds
• preference payment = FV of preferred stock + dividends that accrued –> PCPS converts into common stock –» (FV of sec + ownership% in firm *(acquisition offer-preference payment)
• mandatory conversion upon the completion of a successful IPO

Question 30

What harm can the rights of preferred shareholders create?

Answer 30

• transfer wealth, but also destroy wealth by:
• delaying future fundraising
• causing distractions for management
• diminishing managers’ incentives to remain with the firm (waterfall analysis could lead management finding out that they will not get good compensation)
• -> loss of key management can destroy firm value

Question 31

Contracting terms for VC used in practice?

Answer 31

• many firms provide VCs with liquidation preferences over common stocks
• some IPO protection terms
• almost none full ratchet, many weighted average protection

Question 32

What can be done to not destroy value?

Answer 32

• caps on preference payments to VCs
• eliminate preference payments upon the achievement of certain operating objectives
• amendments after the fact (after the waterfall analysis)
• -> bonus plan (carve out) to provide financial incentive for management or regreenings for all the employees
• -> enlargement of the option pool combined with the issuance of new options

Question 33

Which VCs are especially active?

Answer 33

• VCs with partners that have prior business experience are more active recruiting managers and directors, helping with fundraising and interacting more frequently with their portfolio companies.
• independent VC firms are also more active than captive VC like banks, corporate or government owned firms.

Question 34

Four measures of activism

Answer 34

• recruiting the management team
• assembling the company’s board of directors
• provides assistance with obtaining additional financing
• how often it interacts with a portfolio company

Question 35

Is there a relationship btw. investor activism and the success of portfolio companies?

Answer 35

Yes there is a positive relationship

Question 36

Which funds are likely to outperform the industry in the future?

Answer 36

Those which have done so in the past. Funds are positively related to past performance.

• This is because private equity investors have proprietary access to particular transactions (Better GPs are able to invest in better investments).
• GPs provide advisory inputs and some GPs are better than others in doing so
• better VCs get better deal terms (e.g. lower valuation) when negotiating with startups. A startup would be wiling to accept these terms if some investors provide superior management, advisory or reputational inputs.

Question 37

When are new partnerships likely to be started?

Answer 37

In periods after the industry has performed especially ell. But funds and partnerships that are raised in boom times are less likely to raise follow-on funds suggesting that these funds perform poorly.

Question 38

How is performance linked to find size?

Answer 38

It is concave. Decreasing returns to scale.

Question 39

Why are some gains in operating CF greater for some VC firms?

Answer 39

because they replace the CEO soon after the buyout.

- larger the debt the more tax benefits, reduction in agency costs