Chapter 20 - Introduction to Private Equity

Question 1

What term is most accurately associated with the year in which a particular private equity fund commences operations?

Answer 1

Vintage year

Question 2

Describe the evolution of the private equity market in recent decades.

Answer 2

A few decades ago the supply of PE capital came typically through a limited number of large PE firms. Competition has increased with more PE firms being able to compete. Further, in the past few years, HF managers have been bidding for operating assets in open competition with PE firms.

Question 3

Describe venture capital (VC)

Answer 3

Represents senior equity stakes in firms that are still privately held and are illiquid. VC often take active roles in providing managerial guidance. Investors in VC must be prepared to invest for the long run.

Question 4

What was the key factor contributing to the growth in leveraged buyouts (LBOs) during the 1980s?

Answer 4

Financing of LBOs using bonds originally issued with low credit ratings.

Question 5

What type of PE represents a hybrid of debt and equity that is typically designed as an intermediate-debt bond plus an equity kicker?

Answer 5

Mezzanine financing

Question 6

What are story credits?

Answer 6

Private debt issues with credit risk based on unusual circumstances that involve special aspects (they have a ‘story’) and are senior secured financings of companies possessing good credit.

Question 7

Describe the type of firms that distressed debt investing targets.

Answer 7

Companies that have already defaulted on their debt, or may be about to default. These companies may be seeking bankruptcy protection.

Question 8

What factors caused the distressed debt market to grow considerably in the first decade of the new millennium?

Answer 8

Many more types of commercial loans were available for resale. The issuance of covenant-light loans (cov-lite) increased. Many more banks managed their assets from a larger portfolio perspective, as opposed to an account level basis during this period, and the volume of very low-quality debt as a percentage of total high-yield bond issuance grew significantly.

Question 9

What are common differences between typical HF fees and typical PE fund fees?

Answer 9

PE fund fees tend to be collected at the termination of deals, whereas HF fund incentive fees are front-loaded. PE fund incentive fees tend to be collected at the time of events such as exits, whereas HF incentive fees are collected on a regular basis. PE funds, but not HF, typically have claw back provisions requiring the return of fees on prior profits when subsequent losses are experienced.

Question 10

Keyword ‘Charge-off loans’

Answer 10

Loans of a financial institution or other lender that have been sold to investors and written off the books of the lender at a loss.

Question 11

Keyword ‘Conversion price’

Answer 11

Price per share at which the convertible security can be exchanged into shares of common stock, expressed in terms of the principal value of the convertible security.

Question 12

Keyword ‘Conversion ratio’

Answer 12

Number of shares of common stock into which each convertible security can be exchanged. Conversion ratio and the conversion price are inversely relates measures of the same concept.

Question 13

Keyword ‘Covenants’

Answer 13

Promises made by a debtor to the creditor that strengthen the perceived credit quality of the obligation. Loan covenants may be required by creditors to protect their interest, or they may be offered by debtors to negotiate better terms.

Question 14

Keyword ‘Cov-lite loans’

Answer 14

Loans that place minimal restrictions on the debtor in terms of loan covenants.

Question 15

Keyword ‘Distressed debt investing’

Answer 15

Practice of purchasing the debt of troubled companies is therefore subject to substantial risk.

Question 16

Keyword ‘Equity kicker’

Answer 16

Option for some type of equity participation in the firm, such as options to buy shares of common stock. Equity kicker portion provides the investor with an interest in the upside of the company, while the debt component provides a steady payment stream.

Question 17

Keyword ‘Haircut’

Answer 17

Difference between the market value of an asset used as loan collateral and the amount of the loan.

Question 18

Keyword ‘Incurrence covenants’

Answer 18

Typically require a borrower to take or not take a specific action once a specified event occurs (e.g. EBITDA/debt ratio)

Question 19

Keyword ‘Junk bonds’

Answer 19

Subordinated debt (also referred to as high-yield or speculative-grade debt).

Question 20

Keyword ‘Leveraged buyouts (LBOs)’

Answer 20

Transaction to take publicly traded company private.

Question 21

Keyword ‘Leveraged loans’

Answer 21

Syndicated bank loans to non-investment grade borrowers.

Question 22

Keyword ‘Maintenance covenants’

Answer 22

Stricter than incurrence covenants in that they require a standard be regularly met to avoid default (e.g. EBITDA/debt)

Question 23

Keyword ‘Management buyouts’

Answer 23

LBOs led by the target firm’s current management.

Question 24

Keyword ‘Merchant banking’

Answer 24

Practice whereby financial institutions purchase nonfinancial companies as opposed to acquiring or merging with other banks (allows the bank to build relationships to generate ancillary business from investment banking activities).

Question 25

Keyword ‘Mezzanine debt’

Answer 25

Viewed as a form of PE due to its high risk and because it often comes with potential equity participation, although it appears as debt on an issuer’s balance sheet. Mezzanine because it is inserted into a company’s capital structure between the floor of equity and the ceiling of senior secured debt.

Question 26

Keyword ‘Middle market’

Answer 26

Companies that are not as large as those companies that have ready access to the financial markets but are larger than companies seeking VC. Market capitalization in the range of $200m to $2b.

Question 27

Keyword ‘Negative covenants’

Answer 27

Promises by the debtor not to engage in particular activities, such as paying dividends or issuing new debt.

Question 28

Keyword ‘Positive covenants’

Answer 28

Promises to do particular things, such as maintaining a specified cash level.

Question 29

Keyword ‘Private Equity firms’

Answer 29

Invest in PE and manage PE funds (serve as general partners)

Question 30

Keyword ‘Private Equity funds’

Answer 30

Investment vehicles created to hold portfolios of private equity securities (usually organized as limited partnerships and last perhaps 10 years)

Question 31

Keyword ‘Private investments in public equity (PIPE)’

Answer 31

Transactions are privately issues equity or equity-linked securities that are placed outside of a public offering and are exempt from registration.

Question 32

Keyword ‘Prudent person standard’

Answer 32

Requirement that specifies levels of care that should be exercised in particular decision-making roles, such as investment decisions made by a fiduciary. Prudent man rules were established to ensure competent investment decision making with regard to the large and growing pension assets and liabilities of corporations. Limited VC investments.

Question 33

Keyword ‘Segmentation’

Answer 33

Idea that there are limited numbers of participants who focus on specific aspects and activities of a market, rather than varying their range of activities more broadly throughout all available opportunities.

Question 34

Keyword ‘Story credit’

Answer 34

Debt with credit risk based on unusual circumstances. Story credits are private debt issues that involve special aspects, such as corporate reorganisations, that distinguish their analysis from more traditional circumstances.

Question 35

Keyword ‘Structured PIPEs’

Answer 35

More exotic securities, like floating-rate convertible preferred stock, convertible resets, and common stock resets. These have a floating conversion price, which can change depending on the price of the publicly traded common stock.

Question 36

Keyword ‘Syndicated’

Answer 36

Group of entities, often investment banks, in underwriting a security offering, or more generally, jointly engaging in other financial activities.

Question 37

Keyword ‘Toxic PIPE’s’

Answer 37

PIPE with adjustable conversion term that can generate high levels of shareholder dilution in the event of deteriorating prices in the firm’s common stock.

Question 38

Keyword ‘Traditional PIPEs’

Answer 38

Investors can buy common stock at a fixed price (initiated using convertible preferred stock or debt with a fixed price at which the securities can be converted into common stock).

Question 39

Keyword ‘Underlying business enterprises’

Answer 39

Private equity investment targets; often owned directly by individuals or families without investment from PE funds or PE firms (ownership is through private equity securities)

Question 40

Keyword ‘Venture Capital’

Answer 40

Begins as financing for young firms with high potential growth that do not have a sufficient track record to attract investment capital from traditional sources like public markets or lending institutions. VC represents senior equity takes in firms that are still privately held and illiquid).

Question 41

Keyword ‘Vintage year’

Answer 41

Year a particular PE fund commences operations.