CAIA L2 - 7.4 - Access Through Private Structures Flashcards
List
7 Potential Advantages
of Listed Assets
and Unlisted Assets
7.4 - Access Through Private Structures
Listed Assets have…
1. > Liquidity They may be listed on multiple exchanges.
2. < Management fees Often lower than the combined AUM-based and performance-based fees of unlisted assets.
3. Simple diversification Listed assets can be bought in small increments, which eases the diversification process.
4. Better price transparency. Listed assets’ current values are continuously updated, which makes it easier to assess risk and return.
5. > Regulation. Investors shielded to a degree from undesirable management actions (e.g., fraud) because of upfront and subsequent continuous regulatory requirements.
6. > Financing. Being traded on public exchanges could allow for more sources of debt and secondary equity funding.
7. Taxes facilitated. Tax filings are facilitated because tax information is likely available more readily and on a timelier basis for listed securities.
Unlisted Assets have…
1. Illiquidity premium. Expected returns are increased by a risk premium for holding less liquid assets.
2. Manager incentives. Incentive-based fees may result in hiring managers with superior skills and investment opportunities.
3. Asset targeting. Investors can choose investment structures with risk and return characteristics that closely mirror their investment objectives.
4. Smoothed values. Reported prices will likely be smoothed because of the use of appraisals and quarterly NAVs.
5. Investor oversight. LPs have rights to terminate agreements that could mitigate the agency conflict with GPs.
6. Managerial flexibility. Without corporate hierarchies, GPs may have more operational flexibility.
7. Tax benefits. Carried interest is favorable for GPs in terms of lower tax rates in some countries. LPs can benefit from the reduced tax liability from the pass-through of expenses.
7.4 - Access Through Private Structures
Explain
Rational
of Investing in
High Fee Private Equity
7.4 - Access Through Private Structures
High fee attract superior managers
Their unique talents and abilities provide outstandingly high returns
Returns exceed the high performance-based fees
7.4 - Access Through Private Structures
Explain
ILPA guiding principles
with respect to:
* fund economics
* fund term and structure
* roles of key people
* fund governance
* financial disclosures
* notification and policy disclosures
7.4 - Access Through Private Structures
three ILPA guiding principleshelp with the potential manager-investor (principal-agent) conflict: (1) alignment of mutual interests; (2) governance; and (3) transparency:
Fund economics
* The waterfall structure. Investors should have full return of contributions and preferred returns prior to paying GPs. Also, it enhances the deal-by-deal model by requiring all fund fees and expenses to date (and not just a pro rata share of them) to be repaid prior to paying carried interest to GPs.
* Carried interest. computed on a net after-tax profit basis + hard hurdle (computed on profits only above the hurdle rate as opposed to a soft hurdle which is calculated on all profits above the hurdle rate). Preferred returns should be calculated only from the contribution to the distribution dates.
* Recycling distributions. Total distributions that may be recycled should have an agreed-upon limit. Recycling provisions permit a GP to recycle capital distributions for an investment exited generally within the past two years. Those funds are added back to the LP’s undrawn capital commitment and could be called again for additional investments.
* Clawbacks. Actual and potential clawbacks should be made known to LPs for every reporting period. They should include tax and repaid within two years of liability recognition. The period of clawback must go beyond the fund’s life, and LPs should be able to demand clawback directly from the GP.
* Management fees. Management fees should be limited to fair operating costs and wages with clear disclosure of the fees to the LPs.
* Additional fees over management fees. Fees should not be assessed to the fund’s portfolio firms.
* Reasonable expenses. Costs to establish the fund should be fair and commensurate with fund size. Expenses shared between the GP and the partnership include broken-deal expenses, cyber security, technology, and software upgrades. Expenses that can be allocated to the partnership include annual investor meetings, travel, external administration costs, audit costs, legal and litigation costs, interest expense, insurance, and regulatory expenses. The management fee should include consultant fees, placement agent fees, ESG-type costs, and unforeseen costs.
Fund term and structure
* GP commitments. The GP should make a significant, non-transferable equity investment to the fund. They should not be able to cherry pick their coinvestments.
* Fund term extensions. One-year extensions should be used requiring approval LPAC or LP approval. The GP has one year to liquidate the fund after fund’s termination date.
* Investing alongside the fund. Any investments made together the fund should use the same initiation date and termination date, and their performance results should be included with the fund’s results in computing distribution amounts.
Roles of key people
* Identification and changes. Any material change in GP management should provide LPs the opportunity to reevaluate their investment commitments. LPs should be notified of any significant personnel changes [including key person(s)] within a reasonable time period.
* Time and attention. Key employees should dedicate their full professional effort to the fund. They may not serve as a GP for a competing (similar) fund within the firm during the same time period.
* Triggers and removal process. If suspension is activated by a key person or a for cause provision, then the GP should stop all use of fund assets. The LPs will vote on reinstating or removing the GP; any LP interests held by the GP are disallowed from the vote.
* GP removal. GP indemnification clauses should not exclude fiduciary responsibilities. A for cause removal of a GP requires a majority vote by the LPs.
Fund governance
* Fiduciary duty. Possible conflicts of interest for GPs need to be approved by the LPAC. In general, the GP should avoid any conflict of interest situations unless approved in writing by the LPAC.
* Investment management. The GP should consider time period and industry when diversifying and account for any LP requests for investment exclusions. The GP should include all suitable investments in the fund while under its management.
* Fund changes. LPs who do not vote should have no impact and should not be considered “no” votes. A super majority is recommended for LPA amendments and GP removal. A simple majority is recommended for suspensions and reinstatements.
* GP-led secondary transactions. Any such transactions should involve the LPAC early in the process. The GP should promote a transparent and fair process. They should also pay for a qualified advisor for bid solicitation purposes at the GP’s cost.
* Cross-fund investment. GPs should set a cap on investments that overlap multiple funds.
* Co-investment. Prior to investing, the GP should disclose all details of coinvesting plans with LPs, including the allocation process. The GP’s affiliates would be allowed to take part in coinvesting but restricted to the identical terms available to the LPs.
* LPAC best practices. LPAC’s mandate should be thoroughly articulated and coverage would include how to deal with conflicts of interest. There should be clear guidelines on the process of choosing LPAC members. Meetings should be held periodically with virtual access alternatives. A listing of LPAC members should be provided to the fund’s LPs whenever the list is updated. The fund should cover LPAC’s meeting participation costs. LPAC meetings should be conducted on a rotating chair basis.
* Auditor independence. The independence of the auditor should be paramount and should uphold the interests of the entire partnership.
Financial disclosures
* Fees and expenses. Fees charged to portfolio firms should be netted against management fees. Costs should be congruent with the LPA and side letters.
* Quarterly disclosures. On a quarterly basis, LPs should receive unaudited P&L reports, a summary of any material changes, a summary of any capital calls, a management commentary, and a detailing of quarterly valuation changes.
* Annual disclosures. On an annual basis, the GP should report on leverage, realization, and ESG risks at both the fund and portfolio firm levels. As well, it should report foreign exchange and concentration risks at the fund level and strategy and reputational risks at the portfolio firm level. Audited financial statements and annual reports should be presented within the first quarter following the end of the year.
* Capital calls and distributions. The ILPA Standardized Reporting format should be used for reporting capital calls and distributions.
* Subscription lines of credit. Subscription facility terms should be provided if requested and fund-level leverage should be reported quarterly and annually.
* Portfolio firm information. Valuations should be reported quarterly and any material information should be reported separately from fund-level information.
* Performance reporting. Performance should be shown both gross and net of carried interest. At fund termination, the LPs should receive a schedule of all the fund’s cash inflows and outflows.
* Fund marketing materials. Should include explanations for portfolio firm valuations that differ from audited statements and performance of prior funds on a gross and net basis. Pending or potential litigation should also be disclosed along with any political contributions by managers.
* Audit quality. The auditor must provide accurate (no fraud) reporting.
Notification and policy disclosures
* ESG policies. GPs should put in place an ESG policy.
* Other disclosures. In general, anything that is known and could substantially impact the fund should be made known to LPs.
7.4 - Access Through Private Structures
List
9 Issues
With
Side Letters
7.4 - Access Through Private Structures
- Most favored nation status means that no LP can be treated less favorably than the best negotiated rights for any LP. It is often a clause used in partnership agreements to prevent a side letter disadvantaging other LPs.
- Economic terms. LP to request certain (more favorable) economic terms with the GP than those covered in the LPA.
- Reporting. A side letter may mandate a GP to provide enhanced reporting (e.g., tax) to LPs. That could be a way for LPs to get more specific information on portfolio firms.
- Confidentiality. LPs may need to report specific information to their own investors or to regulatory authorities, for example. A side letter may be needed to negotiate favorable amendments to the GPs confidentiality clauses. A use of name clause could be added to limit the disclosure of the identity of LPs to preserve anonymity as long as it is permissible by regulatory authorities.
- Excuse rights. Excuse rights enable an LP to not make certain investments because of: (1) jurisdictional laws; (2) LP internal constraints; or (3) religious constraints.
- Coinvestments. Side letters could be used to initiate coinvesting agreement terms.
- ESG. A side letter may be used to get the GP to invest in sync with the ESG principles of at least one LP. That could create problems for the GP if divergent ESG requests are demanded by multiple LPs.
- Transfer of interests. A side letter may establish the rules under which a LP can transfer their rights of ownership in the main fund to another party.
- Credit facilities. Enforcement of capital calls by the GP can be reinforced with a side letter; the capital calls may impact the GP’s ability to access financing.
7.4 - Access Through Private Structures
Define and explain
overcommitment strategy
7.4 - Access Through Private Structures
promise to invest more capital than an investor has on hand at a given moment
overcommitment ratio = total commitments / resources available for commitments
= 125% and 140% appear to be reasonable
Objective: minimize opp cost of idle capital and cost of lost deals/losses with forced asset selling
LPs will bear commitment risk (Funding risk), which is the risk of defaulting
2007–2009 financial crisis was a good example of why proper managing of funding risk is crucial.
7.4 - Access Through Private Structures
List
Advantages
of secondary market PE purchases
7.4 - Access Through Private Structures
- The possible discount on the purchase
- Faster capital tied up - A shorter amount of time for capital to be tied up and for payment of management fees
- Enhanced diversification potential
New Stigma of secondary market
* Position reallocation possibility in the normal course of portfolio management.
* Faster PE exposures
* Greater diversification in vintage years for LPs
* Secondary = High IRRs / low TVPI (total value to paid-in) ratios => because of a shorter investment horizon
* Most favorable stretch of the J-curve
* There is increased experience of both buyers and sellers, leading to more successful secondary transactions.
7.4 - Access Through Private Structures
Define
Market for
synthetic secondaries
7.4 - Access Through Private Structures
possibility of negotiation of
bundles of portfolio firms
in secondary markets
(between GPs)
7.4 - Access Through Private Structures
Quote
The size
of the
secondary market
7.4 - Access Through Private Structures
2011 = $25 b
2018 = $74 b
(discounts were ~40%. Now ~10%)
7.4 - Access Through Private Structures
Identify
PE buyer
and
PE seller
motivations
(for transacting in secondary markets)
7.4 - Access Through Private Structures
PE buyer motivations for transacting in secondary markets
1. Discounts. LPs sometimes become desperate to sell their stake in a PE fund due to an inability to make upcoming capital calls, thereby attempting to avoid the negative mark of default. Discounts are correlated with seller desperation, and buyers with enough liquidity to take over those futures capital calls may interested in buying at deep discounts if they can be found.
2. Portfolio visibility. When a private equity fund is early in its life cycle, it is essentially a blind pool of capital because investors are not aware of how their funds will specifically be invested later. However, in secondary markets, most of the investment in portfolio firms has already occurred. Such transparency is helpful for secondary market buyers in performing due diligence and assessing the performance of the investments in the portfolio firms.
PE seller motivations for transacting in secondary markets
1. Need for liquidity
2. Restructuring portfolio (poor/outstanding asset performance, denominator effect)
7.4 - Access Through Private Structures
Formula
Discount value
of
Secondary Private Equity Stakes
7.4 - Access Through Private Structures
P0=∑ [CF’t’ / (1+IRR’buyer’)’t’ ]
discount’t’ = (NAV’t’−P’t’) / NAV’t’
For example,
an investment has projected net cash flows at the end of each year of $1.5 million for six more years. An investor has a required rate of return of 20%, which translates into an estimated present value of $4.988 million using the formula. Note that the value can also be found using the CF key on a financial calculator (CF0 = 0; CF1 = 1.5; FO1 = 6; I = 20; NPV = 4.988). The next step is to find the discount, which can be expressed as:
Assuming the fund has a NAV of $5.6 million, then the discount is computed as 10.92% [=($5.600 – $4.988) / $5.600].
7.4 - Access Through Private Structures
