CAIA Chapter 21

Question 1

What two roles do PE firms play in a partnership and how do carried interest and management fees line up with those two roles?

Answer 1

General Partner: 20% of distributions as incentive fee

Investment Advisor: 1.5 - 2-5% management fee of commited or invested capital

Question 2

Describe the five stages of the life cycle of a VC fund

Answer 2

1) Fundraising: securing capital commitments from LPs

2) Investment Period: deploying committed capital into portfolio companies (3-5 years)

3) Monitoring: actively managing and adding value to portfolio companies

4) Exits: selling portfolio companies via IPOs, mergers or acquisitions

5) Liquidation: distributing proceeds to LPs and closing the fund

Question 3

What are the three phases in the LP-GP relationship?

Answer 3

1) Entry and Establish: GPs build a track record to attract LP commitments

2) Build and Harvest: LPs maintain loyalty as GPs grow and succeed

3) Decline or Transition: LPs may lose trust or shift allocations if GP performance declines or market dynamics change

Question 4

Describe bad-leaver and good-leaver clauses in PE partnerships

Answer 4

Good-Leaver clause: applies when a partner departs due to retirement, illness, or mutual agreement -> retains certain rights to carried interest and equity stakes

Bad-Leaver clause: activates if a partner exits under unfavorable circumstances (misconduct, breach of contract) -> rights to carried interest and other benefits are forfeited or reduced

Question 5

What is a Club Deal?

Answer 5

• a collaborative investment by multiple PE firms to acquire a company
• this approach mitigates risk and pools resources, especially for large transactions, but can lead to coordination challenges

Question 6

Discuss the following statement: empirical evidence indicates that investors in listed BDCs are subject to greater return volatility and enjoy less diversification benefits than investors in PE that is not publicly traded

Answer 6

• listed BDCs are publicly traded, subjecting them to greater market volatility and correlation with broader equity markets
• unlike private PE, listed BDCs provide less diversification as their valuations fluctuate with public markets rather than reflecting underlying asset fundamentals
• BDC investors also face lower returns due to public market inefficiencies compared to the illiquidity premium enjoyed by private PE investors

Question 7

Why can PE fund of funds suit new investors?

Answer 7

• it provides diversification across multiple funds, reducing risk
• grants access to established PE managers
• mitigates the need for extensive due diligence expertise

Question 8

What is the difference between a traditional PIPE and toxic PIPE?

Answer 8

Traditional PIPE: involves private placement of equity or equity-linked securities at a negotiated discount, often used for growth funding

Toxic PIPE: includes features (adjustable conversion ratios) that can lead to shareholder dilution and stock price depreciation, often favoring the PIPE investor at the expense of existing shareholders

Question 9

Name 6 differences between typical PE and Hedge Fund fees

Answer 9

1) Fee Basis:
- PE fees are based on committed or invested capita
- HF fees are based on assets under management

2) Carried Interest:
- PE typically 20% of profits above a preferred return (hurdle rate)
- HF 20% of all profits with no hurdle rate

3) Management Fees:
- PE 1.5-2.5%, decreasing after investment period
- HF typically 2% of AUM throughout

4) Clawback Provisions:
- PE GPs return excessive carried interest if the fund underperforms
- HF no clawback provisions

5) Performance Measurement:
- PE focus on IRR and multiple on invested capital
- HF emphasize annualized returns

6) Investment Horizon:
- PE long-term (7-10 years)
- HF short-term, with frequent liquidity events

Question 10

What are PE management fees and its purpose?

Answer 10

• annual charges paid by LPs to GPs to cover operational costs of managing a PE fund
• typically 1.5-2.5% of either committed capital (during funds investment period 3-5 years) or invested capital (after investment period)
• independent of fund performance

Question 11

What is carried interest and its purpose?

Answer 11

• share of profits GPs earn from fund’s investments (performance-based)
• typically at 20% of profits after hurdle rate (typically 8%)
• clawback provisions require GPs to return excess carried interest if fund’s performance under hurdle rate

Question 12

What are BDCs and key features?

Answer 12

• support growth and development of small to mid-sized companies
• provide private-equitiy-like capital with the liquidity of a publicly traded entity
• closed-end investment funds listed on public exchange

Question 13

What is a PIPE?

Answer 13

a form of financing in which institutional or accredited investors purchase securities (stock or convertible instruments) directly from a publicly traded company at a discounted price -> provides the company with quick access to capital without public offering -> when in need of liquidity