CAIA Chapter 20 Flashcards
Introduction to Private Equity
What are the three major forms of private debt?
Mezzanine Debt: a hybrid of debt and equity, often with equity-like features such as warrants or options
Distressed Debt: Involves investing in obligations of financially troubled companies, with the potential for significant returns if the company recovers
Leveraged Loans: Senior debt issued by firms with high leverage or poor credit, often used for acquisitions or refinancing
List major contrasts between venture capital, growth equity, and buyouts with respect to asset size, investor control, time horizon, and investment risk
Venture Capital:
- asset size: USD 10 million
- investor control: team approach, shared
- time horizon: 5-10 years
- investment risk: very high
Growth Equity:
- asset size: USD 100 million
- investor control: limited control
- time horizon: 3-7 years
- investment risk: moderately high
Buyouts:
- asset size: USD 100 million
- investor control: total control
- time horizon: 3-5 years
- investment risk: moderate
Identify three major methods of executing an exit from VC
Initial Public Offering (IPO): taking the company public to sell shares in the market
Acquisition or Buyout: selling the company to a strategic buyer or another private equity firm
Leveraged Recapitalization: Refinancing the company with debt to pay dividends to investors
What differentiates the angel investing stage of VC from the seed stage of venture capital financing?
Angel Investing:
- earliest stage where friends, family, walthy individuals invest based on raw idea
- typically informal, with minimal business development
- financing ranges from USD 50’000-500’000
Seed Stage:
- first institutional funding stage where a prototype or business plan exists
- investors include venture capital firms
- financing ranges from USD 1million-5million, used to develop products and conduct initial market testing
What is a compound option and how do compound options relate to VC?
- option on an option, giving the holder the right to make sequential investments as milestones are met
- each stage of VC funding is akin to purchasing a call option on the next stage of investment -> this approach minimizes risk by allowing investment decisions to be delayed until uncertainty is reduced
What is a springing board remedy?
a remedy in growth equity or private equity contracts where investors gain the right to designate a majority of the defaulting company’s board of directors if certain redemption obligations are unmet
What is the difference between a management buy-in (MBI) and Management buyout (MBO) LBO?
Management buy-in: external management team takes over the company, replacig the existing management
Management buyout: existing management team acquires the company, retaining control
Describe the evolution of the buyout market
- initially focused on distressed assets and underperforming businesses
- transitioned to using sophisticated financial engineering and operational improvements
- expanded to include secondary buyouts, where one private equity firm sells a company to another
What are the two primary conflicts of interest that emanate from the potentially lucrative compensation schemes offered to exiting management teams in a management buy-in?
Misaligned Objectives: incumbent management may prioritize personal compensation over long-term company value
Valuation Manipulation: management may inflate the company’s value or overstate performance metrics to secure lucrative exit terms
List the five general categories of LBOs that can create value
1) operational improvements: increasing efficiency and profitability
2) financial engineering: optimizing the capital structure with leverage
3) growth strategies: expanding markets, products, or geographies
4) divestitures: selling off underperforming or non-core business units
5) tax benefits: utilizing debt to lower tax liabilities through interest deductions
What are the four substantial risks of private equity?
1) Market Risk:
- influenced by broader economic conditions, which can impact valuations and exit opportunities
2) Liquidity Risk:
- PE investments are illiquid, with capital typically locked in for the fund’s life cycle (7-10 years)
- limited secondary markets for selling stakes
3) Funding Risk:
- LPs are obligated to fulfill capital commitments over the fund’s investment period, if portfolio performance declines, meeting these obligations can strain LP resources
4) Realization Risk:
- ability to successfully exit investments is uncertain and dependent on market conditions
- suboptimal exits or delayed liquidity events can reduce overall returns
