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CAIA - 7 - Private Equity Market Structure Flashcards

1
Q

The private equity market can be classified in 2 ways:

  1. ___
  2. ___
A

The private equity market can be classified in 2 ways:

1. Organized

2. Informal

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2
Q

The ___ PE market is dominated by funds, which serve as financial intermediaries to private companies and are professionally managed

A

The organized PE market is dominated by funds, which serve as financial intermediaries to private companies and are professionally managed

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3
Q

The ___ private equity market comprises angel capital; funding from family, friends and fools.

A

The informal private equity market comprises angel capital; funding from family, friends and fools.

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4
Q

___ investments are made in the informal private equity market than the organized private equity market.

A

More investments are made in the informal private equity market than the organized private equity market.

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5
Q

There are three principal types of private equity funds:

  1. ___ ___
  2. ___
  3. ___
A

There are three principal types of private equity funds:

1. Venture Capital

2. Buyout

2. Mezzanine

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6
Q

___ ___funds co-invest with entrepreneurs in their new or fast-growing companies that have a promising product, high potential for growth, and are typically in fast-growing technology sectors.

A

Venture capital funds co-invest with entrepreneurs in their new or fast-growing companies that have a promising product, high potential for growth, and are typically in fast-growing technology sectors.

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7
Q

Venture capital falls into 2 stages:

  1. ___ stage
  2. ___stage
A

Venture capital falls into 2 stages:

  1. Early stage
  2. Expansion stage
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8
Q

During the ___ stage, capital is provided to fund research, evaluate ideas, and develop new products. This stage takes place before a company is established.

A

During the seed stage, capital is provided to fund research, evaluate ideas, and develop new products. This stage takes place before a company is established.

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9
Q

During the ___-___stage, additional capital is provided to establish the company and begin product development and marketing

A

During the start-up stage, additional capital is provided to establish the company and begin product development and marketing

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10
Q

The ___ stage is characterized by established companies that need funds to increase growth by increasing production, developing markets, or providing additional working capital.

A

The expansion stage is characterized by established companies that need funds to increase growth by increasing production, developing markets, or providing additional working capital.

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11
Q

VC investmenst are not comparable to traditional financial investments in that they are still in the “___-___” stage.

A

VC investmenst are not comparable to traditional financial investments in that they are still in the “cash-burning” stage.

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12
Q

___ funds use financing to acquire established companies with tangible assets that need capital for changing ownership.

A

Buyout funds use financing to acquire established companies with tangible assets that need capital for changing ownership.

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13
Q

___ ___occur when debt is used to finance a private equity transaction.

A

Leveraged buyouts occur when debt is used to finance a private equity transaction.

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14
Q

___ ___ occur when current management acquires a company

A

Management buyouts occur when current management acquires a company

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15
Q

___ ___occur when outsiders become the new management

A

Management buyins occur when outsiders become the new management

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16
Q

___-___-___transactions occur when a public company becomes private when all its shares are purchased by a PE company and the public company is de-listed from the stock exchange.

A

Public-to-private transactions occur when a public company becomes private when all its shares are purchased by a PE company and the public company is de-listed from the stock exchange.

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17
Q

___ funds invest in established companies that generally cannot get capital from traditional financial markets to finance an expansion or for a transition. Instead, they acquire capital by issuing ___ ___ that has ___ attached or has rights to ___to ___ ___. ___ debt falls between equity and secured debt, provides a relatively stable cash flow, and generates lower returns than other types of private equity.

A

Mezzanine funds invest in established companies that generally cannot get capital from traditional financial markets to finance an expansion or for a transition. Instead, they acquire capital by issuing subordinated debt that has warrants attached or has rights to convert to common stock. Mezzanine debt falls between equity and secured debt, provides a relatively stable cash flow, and generates lower returns than other types of private equity.

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18
Q

___ strategies provide capital to help established companies recover profitability after undergoing difficulties.

A

Rescue strategies provide capital to help established companies recover profitability after undergoing difficulties.

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19
Q

___ ___, also called ___, acquire a company’s shares from another private equity company.

A

Replacement capital, also called secondaries, acquire a company’s shares from another private equity company.

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20
Q

Buyout funds use mostly ___ financing, so they tend to perform well when the ___of ___is less expensive.

A

Buyout funds use mostly debt financing, so they tend to perform well when the cost of debt is less expensive.

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21
Q

VC funds use ___ ___ ___as the most profitable exit route, so they tend to have a strong correlation with ___-___indices.

A

VC funds use public stock markets as the most profitable exit route, so they tend to have a strong correlation with small-cap indices.

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22
Q

Compared to VC funds, historical returns of buyout funds have been more ___.

A

Compared to VC funds, historical returns of buyout funds have been more stable.

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23
Q

___ funds invest small amounts of capital in a large number of new businesses.

A

VC funds invest small amounts of capital in a large number of new businesses.

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24
Q

___ fund companies have intermediate stages of completion, typically distinguished by meeting milestones or rounds of financing. Therefore, ___ funds are inherently long-term investments.

A

VC fund companies have intermediate stages of completion, typically distinguished by meeting milestones or rounds of financing. Therefore, VC funds are inherently long-term investments.

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25
\_\_\_ fund managers often impose strict restrictions on the transferability of their funds' interests.
**VC** fund managers often impose strict restrictions on the transferability of their funds' interests.
26
\_\_\_ funds make a small number of large investments in established businesses.
**Buyout** funds make a small number of large investments in established businesses.
27
Buyout managers are ___ involved in the portfolio companies than VC managers.
Buyout managers are **more** involved in the portfolio companies than VC managers.
28
Buyout managers tend to have ___ failures, but their upside potential is \_\_\_.
Buyout managers tend to have **few** failures, but their upside potential is **limited**.
29
\_\_\_ transactions use mostly equity financing, and \_\_\_s gradually gain control of a company through a series of equity investments.
**VC** transactions use mostly equity financing, and **VCs** gradually gain control of a company through a series of equity investments.
30
VC managers perform limited ___ due diligence due to the limited history of the companies. Instead, the perform extensive \_\_\_/\_\_\_due diligence.
VC managers perform limited **financial** due diligence due to the limited history of the companies. Instead, the perform extensive **sector**/**product** due diligence.
31
VC managers secure \_\_\_-\_\_\_ ___ as part of successful exit strategies.
VC managers secure **follow**-**on financing** as part of successful exit strategies.
32
Buyout transactions tend to use ___ and ___ \_\_\_ to buy companies. The \_\_\_of the acquired company are used as \_\_\_for the debt, and the debt is repaid using ___ \_\_\_ generated by the company.
Buyout transactions tend to use **equity** and **debt financing** to buy companies. The **assets** of the acquired company are used as **collateral** for the debt, and the debt is repaid using **cash flows** generated by the company.
33
Buyout managers perform extensive ___ due diligence, and sometimes use ___ \_\_\_.
Buyout managers perform extensive **financial** due diligence, and sometimes use **financial engineering**.
34
The key driver of a successful buyout transaction is being able to analyze a company's ___ \_\_\_and extract ___ \_\_\_.
The key driver of a successful buyout transaction is being able to analyze a company's **balance sheet** and extract **operational efficiencies**.
35
Venture capitalists ___ \_\_\_to launch new or emerging companies, actively ___ and \_\_\_the portfolio companies in which they invest.
Venture capitalists **support** **entrepreneurs** to launch new or emerging companies, actively **managing** and **developing** the portfolio companies in which they invest.
36
Buyout managers spend considerable time ___ \_\_\_and adjusting ___ \_\_\_, using their experience to ___ \_\_\_performing funds or to ___ \_\_\_of thriving funds. They improve ___ or hire ___ \_\_\_.
Buyout managers spend considerable time **analyzing investments** and adjusting **business models**, using their experience to **boost poorly** performing funds or to **increase profits** of thriving funds. They improve **strategies** or hire **new managers**.
37
What are the 4 ways to invest in private equity: 1. ___ \_\_\_ 2. ___ \_\_\_with \_\_\_-\_\_\_ 3. ___ \_\_\_ 4. \_\_\_of \_\_\_
What are the 4 ways to invest in private equity: 1. **PE Fund** 2. **PE** **Fund** with **Co**-**investment** 3. **Direct Investment** 4. **Fund** of **Funds**
38
LPs and GPs have a standard \_\_\_-\_\_\_ relationship, which due to ___ of \_\_\_, may result in ___ \_\_\_ issues.
LPs and GPs have a standard **principal**-**agent** relationship, which due to **asymmetry** of **information**, may result in **moral** **hazard** issues.
39
LP funds are structured to offer ___ \_\_\_, ___ \_\_\_and \_\_\_.
LP funds are structured to offer **reduced taxation**, **limited liability** and **transparency**.
40
PE funds perform several key functions 1. ___ \_\_\_ ___ to invest in private companies 2. \_\_\_and \_\_\_companies with high expected returns 3. ___ \_\_\_ for product development, growth, acquisitions, or buyouts/buyins. 4. \_\_\_and \_\_\_portfolio companies 5. Determine ___ \_\_\_ for portfolio companies
PE funds perform several key functions 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/buyins. 4. **Monitor** and **coach** portfolio companies 5. Determine **exit strategies** for portfolio companies
41
Private equity funds typically have a contractually limited life of \_\_\_-\_\_\_ years, often with a provision to extend another \_\_\_-\_\_\_ years.
Private equity funds typically have a contractually limited life of **7-10** years, often with a provision to extend another **2-3** years.
42
Each fund has a ___ \_\_\_, which is the calendar year in which the first drawdown of capital is made.
Each fund has a **vintage year**, which is the calendar year in which the first drawdown of capital is made.
43
Funds are generally \_\_\_-\_\_\_in that they distribute proceeds from realizations, interest payments, and dividends.
Funds are generally **self**-**liquidating** in that they distribute proceeds from realizations, interest payments, and dividends.
44
When portfolio companies securities are publicly tradable, \_\_\_-\_\_\_distributions may also be made in the form of the tradable securities.
When portfolio companies securities are publicly tradable, **in**-**kind** distributions may also be made in the form of the tradable securities.
45
GPs receive ___ \_\_\_, which is a fraction of the fund's profits.
GPs receive **carried interest**, which is a fraction of the fund's profits.
46
After the hurdle rate is met, GPs typically receive ___ or \_\_\_of the distributions until their carried interest split is reached. This is referred to as a \_\_\_-\_\_\_.
After the hurdle rate is met, GPs typically receive **all** or **most** of the distributions until their carried interest split is reached. This is referred to as a **catch**-**up**.
47
GPs are typically prohibited from starting follow-on funds before the end of the current fund's ___ \_\_\_or until a ___ \_\_\_ of the current fund has been invested.
GPs are typically prohibited from starting follow-on funds before the end of the current fund's **investment period** or until a **large portion** of the current fund has been invested.
48
Private equity fund of funds typically manage the following activity: 1. ___ \_\_\_in newly formed limited partnerships, which require evaluation of the fund manager's skill 2. \_\_\_-\_\_\_with the fund investment, which require investment expertise 3. ___ \_\_\_in existing funds or portfolio of direct investments, which require both evaluation of fund manager skill and investment expertise.
Private equity fund of funds typically manage the following activity: 1. **Primary investments** in newly formed limited partnerships, which require evaluation of the fund manager's skill 2. **Co**-**investments** with the fund investment, which require investment expertise 3. **Secondary** **investments** in existing funds or portfolio of direct investments, which require both evaluation of fund manager skill and investment expertise.
49
An investment in a PE fund may considered a \_\_\_-\_\_\_investment, since the underlying portfolio companies are unknown before investors commit capital to the fund.
An investment in a PE fund may considered a **blind**-**pool** investment, since the underlying portfolio companies are unknown before investors commit capital to the fund.
50
There are two costs associated with investing in a FoF 1. ___ \_\_\_of fees 2. Loss of \_\_\_and \_\_\_
There are two costs associated with investing in a FoF 1. **Double layer** of fees 2. Loss of **information** and **control**
51
There are 4 main ways fund of funds add value: 1. D\_\_\_ and \_\_\_ 2. R\_\_\_and \_\_\_ 3. S\_\_\_skills and \_\_\_ 4. I\_\_\_and \_\_\_
There are 4 main ways fund of funds add value: 1. **Diversification** and **intermediation** 2. **Resources** and **information** 3. **Selection** skills and **expertise** 4. **Incentives** and **oversight**
52
New fundraising typically occurs every \_\_\_-\_\_\_ years.
New fundraising typically occurs every 3-5 years.
53
The 3 phases of the GP-LP relationship's life cycle are: 1. ___ and \_\_\_ 2. ___ and \_\_\_ 3. \_\_\_, \_\_\_or \_\_\_
The 3 phases of the GP-LP relationship's life cycle are: 1. **Entry** and **establish** 2. **Build** and **harvest** 3. **Decline**, **exit** or **spinout**
54
Empirical evidence supports the hypothesis that new fund managers have a ___ mortality rate than established or institutional quality managers.
Empirical evidence supports the hypothesis that new fund managers have a **higher** mortality rate than established or institutional quality managers.
55
First time managers, understanding the importance of innovation for fundraising, often pursue ___ investment strategies.
First time managers, understanding the importance of innovation for fundraising, often pursue **specialized** investment strategies.
56
Evidence supports a ___ degree of continuity in investors of successive funds, and the ___ of \_\_\_investors to identify funds that will perform poorly in subsequent funds.
Evidence supports a **high** degree of continuity in investors of successive funds, and the **ability** of **sophisticated** investors to identify funds that will perform poorly in subsequent funds.
57
A PE fund's ___ \_\_\_ ___ defines its legal framework and terms and conditions.
A PE fund's **limited partnership agreement** defines its legal framework and terms and conditions.
58
The limited partnership agreement (LPA) has two main clauses: 1. ___ \_\_\_ clauses 2. ___ \_\_\_ clauses
The limited partnership agreement (LPA) has two main clauses: 1. **Investor protection** clauses 2. **Economic terms** clauses
59
\_\_\_ ___ takes place before a transaction has been completed and refers to decisions made by one party causing undesirable parties to be attracted to the transaction.
**Adverse selection** takes place before a transaction has been completed and refers to decisions made by one party causing undesirable parties to be attracted to the transaction.
60
\_\_\_ \_\_\_takes place after a transaction has been completed and refers to one party's behavior changing to the detriment of another party as a result of a contract's incentives.
**Moral hazard** takes place after a transaction has been completed and refers to one party's behavior changing to the detriment of another party as a result of a contract's incentives.
61
The \_\_\_- ___ \_\_\_ describes situations in which two parties do not cooperate with each other for fear that they might give the other party more bargaining power and, thus, reduce their own profits.
The **hold**-**up** **problem** describes situations in which two parties do not cooperate with each other for fear that they might give the other party more bargaining power and, thus, reduce their own profits.
62
LPAs are undergoing some \_\_\_, as evidenced by the increased use of the private equity principles developed by the Institutional Limited Partners Association (ILPA).
LPAs are undergoing some **standardization**, as evidenced by the increased use of the private equity principles developed by the Institutional Limited Partners Association (ILPA).
63
Despite the value of LPA covenants and advisory boards, the success of the limited partnership structure depends on reducing \_\_\_-\_\_\_issues by ensuring proper alignment of managers' and investors' interests.
Despite the value of LPA covenants and advisory boards, the success of the limited partnership structure depends on reducing **principal**-**agent** issues by ensuring proper alignment of managers' and investors' interests.
64
The ___ \_\_\_ ___ responsibilities are defined in the LPA and include addressing conflicts of interest, reviews of valuation procedures and other LPA agreements.
The **LP Advisory Committee's** responsibilities are defined in the LPA and include addressing conflicts of interest, reviews of valuation procedures and other LPA agreements.
65
\_\_\_ majorities are needed for decisions such as extending the investment period or the fund's duration, and ___ majorities are needed for decisions such as removing the GP without cause.
**Simple** majorities are needed for decisions such as extending the investment period or the fund's duration, and **qualified** majorities are needed for decisions such as removing the GP without cause.
66
GPs ___ generally make investment decisions without LPs participation.
GPs **should** generally make investment decisions without LPs participation.
67
Many funds are required to disclose information according to guidelines provided by ___ \_\_\_.
Many funds are required to disclose information according to guidelines provided by **PE associations**.
68
Low management fees may lead to managers looking for additional compensation. To offset these incentives or offset doubling management service payments, LPAs typically include a \_\_\_-\_\_\_clause that mandates other fees be fully or partly set off against management fees.
Low management fees may lead to managers looking for additional compensation. To offset these incentives or offset doubling management service payments, LPAs typically include a **fee**-**offset** clause that mandates other fees be fully or partly set off against management fees.
69
Fees based on invested capital may provide managers an incentive to pursue ___ rather than \_\_\_.
Fees based on invested capital may provide managers an incentive to pursue **volume** rather than **quality**.
70
Buyout funds typically give their investors an \_\_\_% preferred return; while venture capitalists ___ offer a preferred return.
Buyout funds typically give their investors an **8**% preferred return; while venture capitalists **rarely** offer a preferred return.
71
GPs typically base the preferred return on the \_\_\_.
GPs typically base the preferred return on the **IRR**.
72
A carried interest of \_\_\_% is considered to align manager and investor interests appropriately.
A carried interest of **20**% is considered to align manager and investor interests appropriately.
73
Carried interest can be calculated on a fund-as-a-whole or deal-by-deal basis. LPs prefer the ___ approach, since it better aligns interests.
Carried interest can be calculated on a fund-as-a-whole or deal-by-deal basis. LPs prefer the **fund-as-a-whole** approach, since it better aligns interests.
74
One way to reduce eradicate or excessive risk in private equity funds is to require managers to ___ in the \_\_\_.
One way to reduce eradicate or excessive risk in private equity funds is to require managers to **invest** in the **fund**.
75
The GPs share in a PE fund is generally around \_\_\_% of committed capital.
The GPs share in a PE fund is generally around **1**% of committed capital.
76
The GP's contribution is referred to as ___ \_\_\_.
The GP's contribution is referred to as **hurt money**.
77
\_\_\_-\_\_\_clauses may be used in anticipation of senior fund managers retiring.
**Key-person** clauses may be used in anticipation of senior fund managers retiring.
78
The ___ \_\_\_clause enables the removal the GP and suspends investments until a replacement can be found.
The **bad leaver** clause enables the removal the GP and suspends investments until a replacement can be found.
79
A ___ \_\_\_clause enables LPS with a \_\_\_majority to stop funding the partnership. This provision enables LPs to end a failing partnership and is especially important for funds that do not have a ___ \_\_\_.
A **good leaver** clause enables LPS with a **qualified** majority to stop funding the partnership. This provision enables LPs to end a failing partnership and is especially important for funds that do not have a **track record**.
80
\_\_\_ leaver clauses sometimes provide compensation. In contrast, \_\_\_leaver clauses provide no compensation or entitlement to carried interest, but provide a ___ \_\_\_so that part of the carried interest remains as incentive for the ___ \_\_\_.
**Good** leaver clauses sometimes provide compensation. In contrast, **bad** leaver clauses provide no compensation or entitlement to carried interest, but provide a **vesting schedule** so that part of the carried interest remains as incentive for the **new manager**.
81
PE funds distribute exit proceeds according to a ___ \_\_\_ that divides the proceeds between the GPs and LPs in terms of amount and timing.
PE funds distribute exit proceeds according to a **distribution waterfall** that divides the proceeds between the GPs and LPs in terms of amount and timing.
82
A distribution of a fund generally begins with the LPs being repaid all ___ \_\_\_and then receiving the preferred return. After this, GPs get \_\_\_or \_\_\_of the distributions until their ___ \_\_\_ split is reached. This is referred to as a ___ \_\_\_ interest period.
A distribution of a fund generally begins with the LPs being repaid all **drawn capital** and then receiving the preferred return. After this, GPs get **all** or **most** of the distributions until their **carried interest** split is reached. This is referred to as a **catch up** interest period.
83
Some agreements have \_\_\_% catch-ups and some have ___ catch ups.
Some agreements have **100**% catch-ups and some have **50**/**50** catch ups.
84
An accepted agreement is for GPs to take a ___ \_\_\_ of early distributions until ___ capital is repaid, and distribute any excess to ___ or put it in an ___ \_\_\_ .
An accepted agreement is for GPs to take a **lower percentage** of early distributions until **contributed** capital is repaid, and distribute any excess to **LPs** or put it in an **escrow account**.
85
Fund managers often have to put some of their carried-interest proceeds in an ___ \_\_\_, which can be used to cover any clawbacks.
Fund managers often have to put some of their carried-interest proceeds in an **escrow** **account**, which can be used to cover any clawbacks.
86
A ___ provision requires GPs to return proceeds to LPs if, at the end of the fund's life, LPs have received less than they were supposed to. As a show of goodwill, some GPs return projected ___ funds to LPs before the ___ of the fund's term.
A **clawback** provision requires GPs to return proceeds to LPs if, at the end of the fund's life, LPs have received less than they were supposed to. As a show of goodwill, some GPs return projected **clawback** funds to LPs before the **end** of the fund's term.
87
Clawbacks tend to be stricter for ___ management teams and teams with \_\_\_historical performance. Buyout funds tend to have clawbacks \_\_\_often than venture capital funds because buyouts typically have \_\_\_realizations.
Clawbacks tend to be stricter for **new** management teams and teams with **poor** historical performance. Buyout funds tend to have clawbacks **more** often than venture capital funds because buyouts typically have **earlier** realizations.
88
Clawbacks (can/cannot) exist for LPs
Clawbacks **can** exist for LPs
89
For co-investments, LPs are only charged ___ fees with no ___ \_\_\_ . However, some LPs pay ___ as a way of incentivizing GPs
For co-investments, LPs are only charged **transaction** fees with no **offset provision**. However, some LPs pay **promote** as a way of incentivizing GPs
90
In terms of their risk-reward profile, \_\_\_-\_\_\_fall between PE fund investments and direct investments.
In terms of their risk-reward profile, **co**-**investments** fall between PE fund investments and direct investments.
91
Evidence indicates that co-investments significantly ___ direct investments.
Evidence indicates that co-investments significantly **underperform** direct investments.
92
The underperformance of co-investments may be due to ___ \_\_\_or may be reflective of an \_\_\_problem.
The underperformance of co-investments may be due to **higher risk** or may be reflective of an **agency** problem.
93
Investments that perform far below expectations are referred to as \_\_\_.
Investments that perform far below expectations are referred to as **lemons**.
94
In theory, co-investing maximizes a fund investment's upside by reducing costs and increasing exposure to portfolio companies selected for their potential upside. Thus, co-investing has characteristics of ___ \_\_\_.
In theory, co-investing maximizes a fund investment's upside by reducing costs and increasing exposure to portfolio companies selected for their potential upside. Thus, co-investing has characteristics of **real options**.
95
Besides reducing fees, co-investing has the following benefits: 1. ___ investments 2. Better management of ___ \_\_\_ 3. Mitigating \_\_\_ 4. Double level of ___ \_\_\_ 5. Improved \_\_\_ 6. ___ \_\_\_ with invitation-only funds 7. Reducing ___ effect
Besides reducing fees, co-investing has the following benefits: 1. **Targeted** investments 2. Better management of **portfolio diversification** 3. Mitigating **dilution** 4. Double level of **investment review** 5. Improved **monitoring** 6. **Forming relationships** with invitation-only funds 7. Reducing **J-curve** effect
96
By targeting investments, LPs can reduce ___ \_\_\_.
By targeting investments, LPs can reduce **style drift**.
97
Co-investments do not ___ a fund's shares, so they enhance downside protection, particularly for investments in ___ \_\_\_.
Co-investments do not **dilute** a fund's shares, so they enhance downside protection, particularly for investments in **small funds**.
98
Co-investments are difficult and present a number of disadvantages for LPs: 1. ___ portfolios 2. Higher \_\_\_risk 3. \_\_\_of \_\_\_ 4. \_\_\_among parties
Co-investments are difficult and present a number of disadvantages for LPs: 1. **Unbalanced** portfolios 2. Higher **fiduciary** risk 3. **Conflicts** of **interest** 4. **Disputes** among parties
99
Portfolio strategies typically allocate \_\_\_-\_\_\_% to co-investments.
Portfolio strategies typically allocate **10**-**20**% to co-investments.

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