CAIA - 7 - Private Equity Market Structure

Question 1

The private equity market can be classified in 2 ways:

1. ___
2. ___

Answer 1

The private equity market can be classified in 2 ways:

1. Organized

2. Informal

Question 2

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

Answer 2

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

Question 3

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

Answer 3

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

Question 4

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

Answer 4

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

Question 5

There are three principal types of private equity funds:

1. ___ ___
2. ___
3. ___

Answer 5

There are three principal types of private equity funds:

1. Venture Capital

2. Buyout

2. Mezzanine

Question 6

___ ___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.

Answer 6

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.

Question 7

Venture capital falls into 2 stages:

1. ___ stage
2. ___stage

Answer 7

Venture capital falls into 2 stages:

1. Early stage
2. Expansion stage

Question 8

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

Answer 8

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.

Question 9

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

Answer 9

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

Question 10

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

Answer 10

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

Question 11

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

Answer 11

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

Question 12

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

Answer 12

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

Question 13

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

Answer 13

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

Question 14

___ ___ occur when current management acquires a company

Answer 14

Management buyouts occur when current management acquires a company

Question 15

___ ___occur when outsiders become the new management

Answer 15

Management buyins occur when outsiders become the new management

Question 16

___-___-___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.

Answer 16

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.

Question 17

___ 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.

Answer 17

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.

Question 18

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

Answer 18

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

Question 19

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

Answer 19

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

Question 20

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

Answer 20

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

Question 21

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

Answer 21

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

Question 22

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

Answer 22

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

Question 23

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

Answer 23

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

Question 24

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

Answer 24

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.

Question 25

___ fund managers often impose strict restrictions on the transferability of their funds’ interests.

Answer 25

VC fund managers often impose strict restrictions on the transferability of their funds’ interests.

Question 26

___ funds make a small number of large investments in established businesses.

Answer 26

Buyout funds make a small number of large investments in established businesses.

Question 27

Buyout managers are ___ involved in the portfolio companies than VC managers.

Answer 27

Buyout managers are more involved in the portfolio companies than VC managers.

Question 28

Buyout managers tend to have ___ failures, but their upside potential is ___.

Answer 28

Buyout managers tend to have few failures, but their upside potential is limited.

Question 29

___ transactions use mostly equity financing, and ___s gradually gain control of a company through a series of equity investments.

Answer 29

VC transactions use mostly equity financing, and VCs gradually gain control of a company through a series of equity investments.

Question 30

VC managers perform limited ___ due diligence due to the limited history of the companies. Instead, the perform extensive ___/___due diligence.

Answer 30

VC managers perform limited financial due diligence due to the limited history of the companies. Instead, the perform extensive sector/product due diligence.

Question 31

VC managers secure ___-___ ___ as part of successful exit strategies.

Answer 31

VC managers secure follow-on financing as part of successful exit strategies.

Question 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.

Answer 32

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.

Question 33

Buyout managers perform extensive ___ due diligence, and sometimes use ___ ___.

Answer 33

Buyout managers perform extensive financial due diligence, and sometimes use financial engineering.

Question 34

The key driver of a successful buyout transaction is being able to analyze a company’s ___ ___and extract ___ ___.

Answer 34

The key driver of a successful buyout transaction is being able to analyze a company’s balance sheet and extract operational efficiencies.

Question 35

Venture capitalists ___ ___to launch new or emerging companies, actively ___ and ___the portfolio companies in which they invest.

Answer 35

Venture capitalists support entrepreneurs to launch new or emerging companies, actively managing and developing the portfolio companies in which they invest.

Question 36

Buyout managers spend considerable time ___ ___and adjusting ___ ___, using their experience to ___ ___performing funds or to ___ ___of thriving funds. They improve ___ or hire ___ ___.

Answer 36

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.

Question 37

What are the 4 ways to invest in private equity:

1. ___ ___
2. ___ ___with ___-___
3. ___ ___
4. ___of ___

Answer 37

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

Question 38

LPs and GPs have a standard ___-___ relationship, which due to ___ of ___, may result in ___ ___ issues.

Answer 38

LPs and GPs have a standard principal-agent relationship, which due to asymmetry of information, may result in moral hazard issues.

Question 39

LP funds are structured to offer ___ ___, ___ ___and ___.

Answer 39

LP funds are structured to offer reduced taxation, limited liability and transparency.

Question 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

Answer 40

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

Question 41

Private equity funds typically have a contractually limited life of ___-___ years, often with a provision to extend another ___-___ years.

Answer 41

Private equity funds typically have a contractually limited life of 7-10 years, often with a provision to extend another 2-3 years.

Question 42

Each fund has a ___ ___, which is the calendar year in which the first drawdown of capital is made.

Answer 42

Each fund has a vintage year, which is the calendar year in which the first drawdown of capital is made.

Question 43

Funds are generally ___-___in that they distribute proceeds from realizations, interest payments, and dividends.

Answer 43

Funds are generally self-liquidating in that they distribute proceeds from realizations, interest payments, and dividends.

Question 44

When portfolio companies securities are publicly tradable, ___-___distributions may also be made in the form of the tradable securities.

Answer 44

When portfolio companies securities are publicly tradable, in-kind distributions may also be made in the form of the tradable securities.

Question 45

GPs receive ___ ___, which is a fraction of the fund’s profits.

Answer 45

GPs receive carried interest, which is a fraction of the fund’s profits.

Question 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 ___-___.

Answer 46

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.

Question 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.

Answer 47

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.

Question 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.

Answer 48

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.

Question 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.

Answer 49

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.

Question 50

There are two costs associated with investing in a FoF

1. ___ ___of fees
2. Loss of ___and ___

Answer 50

There are two costs associated with investing in a FoF

1. Double layer of fees
2. Loss of information and control

Question 51

There are 4 main ways fund of funds add value:

1. D___ and ___
2. R___and ___
3. S___skills and ___
4. I___and ___

Answer 51

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

Question 52

New fundraising typically occurs every ___-___ years.

Answer 52

New fundraising typically occurs every 3-5 years.

Question 53

The 3 phases of the GP-LP relationship’s life cycle are:

1. ___ and ___
2. ___ and ___
3. ___, ___or ___

Answer 53

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

Question 54

Empirical evidence supports the hypothesis that new fund managers have a ___ mortality rate than established or institutional quality managers.

Answer 54

Empirical evidence supports the hypothesis that new fund managers have a higher mortality rate than established or institutional quality managers.

Question 55

First time managers, understanding the importance of innovation for fundraising, often pursue ___ investment strategies.

Answer 55

First time managers, understanding the importance of innovation for fundraising, often pursue specialized investment strategies.

Question 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.

Answer 56

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.

Question 57

A PE fund’s ___ ___ ___ defines its legal framework and terms and conditions.

Answer 57

A PE fund’s limited partnership agreement defines its legal framework and terms and conditions.

Question 58

The limited partnership agreement (LPA) has two main clauses:

1. ___ ___ clauses
2. ___ ___ clauses

Answer 58

The limited partnership agreement (LPA) has two main clauses:

1. Investor protection clauses
2. Economic terms clauses

Question 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.

Answer 59

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.

Question 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.

Answer 60

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.

Question 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.

Answer 61

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.

Question 62

LPAs are undergoing some ___, as evidenced by the increased use of the private equity principles developed by the Institutional Limited Partners Association (ILPA).

Answer 62

LPAs are undergoing some standardization, as evidenced by the increased use of the private equity principles developed by the Institutional Limited Partners Association (ILPA).

Question 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.

Answer 63

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.

Question 64

The ___ ___ ___ responsibilities are defined in the LPA and include addressing conflicts of interest, reviews of valuation procedures and other LPA agreements.

Answer 64

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.

Question 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.

Answer 65

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.

Question 66

GPs ___ generally make investment decisions without LPs participation.

Answer 66

GPs should generally make investment decisions without LPs participation.

Question 67

Many funds are required to disclose information according to guidelines provided by ___ ___.

Answer 67

Many funds are required to disclose information according to guidelines provided by PE associations.

Question 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.

Answer 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 fee-offset clause that mandates other fees be fully or partly set off against management fees.

Question 69

Fees based on invested capital may provide managers an incentive to pursue ___ rather than ___.

Answer 69

Fees based on invested capital may provide managers an incentive to pursue volume rather than quality.

Question 70

Buyout funds typically give their investors an ___% preferred return; while venture capitalists ___ offer a preferred return.

Answer 70

Buyout funds typically give their investors an 8% preferred return; while venture capitalists rarely offer a preferred return.

Question 71

GPs typically base the preferred return on the ___.

Answer 71

GPs typically base the preferred return on the IRR.

Question 72

A carried interest of ___% is considered to align manager and investor interests appropriately.

Answer 72

A carried interest of 20% is considered to align manager and investor interests appropriately.

Question 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.

Answer 73

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.

Question 74

One way to reduce eradicate or excessive risk in private equity funds is to require managers to ___ in the ___.

Answer 74

One way to reduce eradicate or excessive risk in private equity funds is to require managers to invest in the fund.

Question 75

The GPs share in a PE fund is generally around ___% of committed capital.

Answer 75

The GPs share in a PE fund is generally around 1% of committed capital.

Question 76

The GP’s contribution is referred to as ___ ___.

Answer 76

The GP’s contribution is referred to as hurt money.

Question 77

___-___clauses may be used in anticipation of senior fund managers retiring.

Answer 77

Key-person clauses may be used in anticipation of senior fund managers retiring.

Question 78

The ___ ___clause enables the removal the GP and suspends investments until a replacement can be found.

Answer 78

The bad leaver clause enables the removal the GP and suspends investments until a replacement can be found.

Question 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 ___ ___.

Answer 79

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.

Question 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 ___ ___.

Answer 80

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.

Question 81

PE funds distribute exit proceeds according to a ___ ___ that divides the proceeds between the GPs and LPs in terms of amount and timing.

Answer 81

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.

Question 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.

Answer 82

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.

Question 83

Some agreements have ___% catch-ups and some have ___ catch ups.

Answer 83

Some agreements have 100% catch-ups and some have 50/50 catch ups.

Question 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 ___ ___ .

Answer 84

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.

Question 85

Fund managers often have to put some of their carried-interest proceeds in an ___ ___, which can be used to cover any clawbacks.

Answer 85

Fund managers often have to put some of their carried-interest proceeds in an escrow account, which can be used to cover any clawbacks.

Question 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.

Answer 86

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.

Question 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.

Answer 87

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.

Question 88

Clawbacks (can/cannot) exist for LPs

Answer 88

Clawbacks can exist for LPs

Question 89

For co-investments, LPs are only charged ___ fees with no ___ ___ . However, some LPs pay ___ as a way of incentivizing GPs

Answer 89

For co-investments, LPs are only charged transaction fees with no offset provision. However, some LPs pay promote as a way of incentivizing GPs

Question 90

In terms of their risk-reward profile, ___-___fall between PE fund investments and direct investments.

Answer 90

In terms of their risk-reward profile, co-investments fall between PE fund investments and direct investments.

Question 91

Evidence indicates that co-investments significantly ___ direct investments.

Answer 91

Evidence indicates that co-investments significantly underperform direct investments.

Question 92

The underperformance of co-investments may be due to ___ ___or may be reflective of an ___problem.

Answer 92

The underperformance of co-investments may be due to higher risk or may be reflective of an agency problem.

Question 93

Investments that perform far below expectations are referred to as ___.

Answer 93

Investments that perform far below expectations are referred to as lemons.

Question 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 ___ ___.

Answer 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 real options.

Question 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

Answer 95

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

Question 96

By targeting investments, LPs can reduce ___ ___.

Answer 96

By targeting investments, LPs can reduce style drift.

Question 97

Co-investments do not ___ a fund’s shares, so they enhance downside protection, particularly for investments in ___ ___.

Answer 97

Co-investments do not dilute a fund’s shares, so they enhance downside protection, particularly for investments in small funds.

Question 98

Co-investments are difficult and present a number of disadvantages for LPs:

1. ___ portfolios
2. Higher ___risk
3. ___of ___
4. ___among parties

Answer 98

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

Question 99

Portfolio strategies typically allocate ___-___% to co-investments.

Answer 99

Portfolio strategies typically allocate 10-20% to co-investments.