CAIA L2 - 1.5 - Demystifying Illiquid Assets: Expected Returns For Private Equity

Question 1

List

4 factor tilts of private equity
(relative to public equities)

1.5 - Demystifying Illiquid Assets

Answer 1

• Equity risk tilt
  (more debt = more beta)
• Illiquidity premium
  (lockup for 5-10 years)
• Size tilt
  (buyout targets small caps => bench should be small caps)
• Value tilt
  (buyout targets lower multiples companies)

1.5 - Demystifying Illiquid Assets

Question 2

List

3 factors
that explain the
decline in PE performance

1.5 - Demystifying Illiquid Assets

Answer 2

1. Richening of PE
   (attracted capital after good performance; High level of dry powder; more PE firms VS 2006)
2. Lessening leverage
   (Leverage 300%-400% in 1980s fallen to 100%-200% today, after financial crisis - changes in regulation )
3. Competition for deals

1.5 - Demystifying Illiquid Assets

Question 3

List

4 Levers
that PE use
to increase returns

1.5 - Demystifying Illiquid Assets

Answer 3

1. Deal selection
2. Operational improvements
3. Timing (entry and exit)
4. Leverage

1.5 - Demystifying Illiquid Assets

Question 4

Formula

Expected Real Return
of Private Equity
and Public Equities
(Yield-based approach)

1.5 - Demystifying Illiquid Assets

Answer 4

Expected Real Return of Private Equity
ER = ( y’u’ + g’u’ ) + [ (D/E) * (r’u’ - k’d’) ] + m - f

y’u’ = Dividend yield
g’u’ = real earnings per share growth rate
(D/E) = leverage (Debt to Equity)
unlevered ER => r’u’ = y’u’ + g’u’
m = multiple expansion
f = PE fees
‘–
Expected Real Return of Public Equities
ER = ( y’pub’ + g’pub’ ) + m’pub’ - f’pub’
m’pub’ = ~0
f’pub’ = ~10 bps

1.5 - Demystifying Illiquid Assets