Chapter 21 - Equity Types of Private Equity

Question 1

Describe differences between VS and LBOs.

Answer 1

In a LBO, all of the equity of a company is acquired and control is absolute. Many LBOs endeavour to find where they can add operating efficiencies and attempt to discover where they can expand product distribution. VC target higher internal rates of return than LBO firms.

Question 2

In VS, what is a ‘20-bagger’?

Answer 2

20x . A company that appreciates in value 20-fold compared to the cost of the VC investment.

Question 3

What is the range of management fees that is most likely to be charged by typical VC funds?

Answer 3

2.0 - 2.5 %

Question 4

A venture capital (VC) firm raises capital from outside investors; the capital is committed first and then invested in businesses. Typically, at which stage is the management fee assessed by the manager?

Answer 4

VC management fees are typically charged when committed

Question 5

At the very start of new ventures, entrepreneurs need funds to prepare business plans, evaluate the market potential, and assemble management teams. PE investors commonly provide financing for this stage. What term identifies this type of investing?

Answer 5

Angel investing

Question 6

LBO funds typically have less risk than VC funds. Provide three explanations for this differential.

Answer 6

1) LBOs purchase established public companies that are less risky than VC because they are considerably beyond their IPO stage. 2) LBO firms tend to be less specialized than VC firms and therefore LBOs tend to possess greater diversification than their VC counterparts. 3) Eventual exit strategy of an LBO is less likely to be a new IPO and is therefore less risky.

Question 7

Describe the J-Curve effect in the typical life cycle of a VC fund.

Answer 7

Losses in the early years due to write-offs and early expenses, followed by high returns in the later years as successful investments are exited and profits are realized.

Question 8

A manager of a VC fund raised $80m in committed capital. The management fee is set at 2%. To date, only $30m of the raised capital has been called and invested in start-ups. Calculate the annual management fee that the manager is collecting.

Answer 8

Annual management fee; $1.6m (2% x $80m)

Question 9

Assume a PE firm raises a $6b buyout fund and charges a management fee of 1.5%. Calculate the present value of the management fees to the PE firm assuming an 8 year life for the fund, no change in its value, and a 7% discount rate.

Answer 9

Annual fee for the life of the fund; $90m (1.5% x $6b). PV of management fees; $537.42m. Learn financial calculator quick input.

Question 10

XYZ potential LBO target; Equity (market) $350m, Debt (face value) $70m, current annual cash flow $75m. ABC fund offers $500m to purchase and pay off outstanding debt. ABC fund finances this $500m LBO issuing $450m in debt and $50m in equity. After the buyout, XYZ after tax cash flow is $90m p.a. Calculate the premium that ABY is offering XYZ shareholders.

Answer 10

[($500m-$70m)/$350m] -1 = 0.2286 or 22.86%. In dollars a premium of $80m

Question 11

XYZ potential LBO target; Equity (market) $350m, Debt (face value) $70m, current annual cash flow $75m. ABC fund offers $500m to purchase and pay off outstanding debt. ABC fund finances this $500m LBO issuing $450m in debt and $50m in equity. After the buyout, XYZ after tax cash flow is $90m p.a. Assuming XYZ does not pay dividends, cash flow directed to pay down debt, how many years would ABC fund have to wait for XYZ to be debt free? (Assumption 0% annual interest rate)

Answer 11

$450m/$90m = 5 years.

Question 12

XYZ potential LBO target; Equity (market) $350m, Debt (face value) $70m, current annual cash flow $75m. ABC fund offers $500m to purchase and pay off outstanding debt. ABC fund finances this $500m LBO issuing $450m in debt and $50m in equity. After the buyout, XYZ after tax cash flow is $90m p.a. After Yr 5, assume a forward looking long-term growth rate of 4% per year and a discount rate of 14%. Calculate the value of XYZ in 5 years using the Constant Dividend Growth Model.

Answer 12

$90m/(0.14-0.04)=$900m. This would be by the (in five years) the value of an unlevered firm.

Question 13

XYZ potential LBO target; Equity (market) $350m, Debt (face value) $70m, current annual cash flow $75m. ABC fund offers $500m to purchase and pay off outstanding debt. ABC fund finances this $500m LBO issuing $450m in debt and $50m in equity. After the buyout, XYZ after tax cash flow is $90m p.a. Calculate the annual total return on the investment for the LBO transaction.

Answer 13

($900m/$50m)^(1/5) - 1 = 0.7826 or 78.26%

Question 14

XYZ potential LBO target; Equity (market) $350m, Debt (face value) $70m, current annual cash flow $75m. ABC fund offers $500m to purchase and pay off outstanding debt. ABC fund finances this $500m LBO issuing $450m in debt and $50m in equity. After the buyout, XYZ after tax cash flow is $90m p.a. Assume discount rate changes at the end of Yr5 to 20%. Calculate the total annual return on the investment.

Answer 14

Projected value of company; $90m/(0.20-0.04)=$ 562.5m, and the 5yr rate of return becomes ($562.5m/$50m)^1/5 - 1 = 0.62 or 62.27%

Question 15

XYZ potential LBO target; Equity (market) $350m, Debt (face value) $70m, current annual cash flow $75m. ABC fund offers $500m to purchase and pay off outstanding debt. ABC fund finances this $500m LBO issuing $450m in debt and $50m in equity. After the buyout, XYZ after tax cash flow is $90m p.a. Assume discount rate changes to 15% and the growth rate at the end of year 5 is 3%. What is the total annual return on investment?

Answer 15

Projected value of company; $90m/(0.15-0.03)=$750m, and the 5yr rate of return becomes ($750m/$50m)^1/5 -1 = 0.7188 or &1.88%

Question 16

XYZ potential LBO target; Equity (market) $350m, Debt (face value) $70m, current annual cash flow $75m. ABC fund offers $500m to purchase and pay off outstanding debt. ABC fund finances this $500m LBO issuing $450m in debt and $50m in equity. After the buyout, XYZ after tax cash flow is $90m p.a. Assume discount rate is 14% and growth rate 4%, but now the investment requires six years to exit. Calculate the total annual return on the investment.

Answer 16

Projected value of company; $90m/(0.14-0.04) = $900m, and the 6yr rate of return becomes ($900m/$50m)^(1/6) -1 = 0.6189 or 61.89%

Question 17

Keyword ‘20-bagger’

Answer 17

(VC) 20x . A company that appreciates in value 20-fold compared to the cost of the VC investment.

Question 18

Keyword ‘Angel investing’

Answer 18

(VC) Friends & Family

Question 19

Keyword ‘Auction process’

Answer 19

(LBO) When a parent company decides to sell a subsidiary in an LBO format, it almost always hires an investment banker to establish an auction process of bidding among several PE firms, with the deal going to the highest bidder. This competitive bidding process can often result in less upside for the PE investor, but it reflects the maturation of the PE industry.

Question 20

Keyword ‘Business plan’

Answer 20

Should clearly state the business strategy, identify the niche that the new company will fill, and describe the resources needed to fill that niche, including the expenses, personnel, and assets. It must be comprehensive, coherent, and internally consistent. Two key objectives; 1) Secure financing from a VC 2)Serve as an internal game plan for the development of the start-up company

Question 21

Keyword ‘Buy and build’

Answer 21

(LBO) LBO value creation strategy involves combining several operating companies or divisions through additional buyouts.

Question 22

Keyword ‘Buyout to buyout’

Answer 22

(LBO) Increasingly in the PE industry, a firm sells one of its portfolio companies to another buyout firm (also known as secondary buyouts).

Question 23

Keyword ‘Capital calls’

Answer 23

Options for the managers to demand, according to the subscription agreement, that the investors contribute additional capital. The potential for the manager to earn inventive fees on capital from capital calls may give the manager an inventive to call for capital, even when investment opportunities are not of the highest quality.

Question 24

Keyword ‘Clawback provision’

Answer 24

Covenant that allows the limited partners to receive back (or claw back) previously paid incentive fees.

Question 25

Keyword ‘Club deal’

Answer 25

(LBO) Two or more LBO firms work together to share costs, present a business plan, and contribute capital to the deal.

Question 26

Keyword ‘Committed capital’

Answer 26

Cash investment that has been promised by an investor but not yet delivered to the fund.

Question 27

Keyword ‘Compound option’

Answer 27

(VC) Option on an option. A compound option allows its owner the right, but not the obligation, to pay additional money at some point in the future to obtain an option.

Question 28

Keyword ‘Conglomerates’

Answer 28

Have many different divisions or subsidiaries, often operating in completely different industries.

Question 29

Keyword ‘Efficiency buyouts’

Answer 29

(LBO) LBO’s that improve operating efficiency.

Question 30

Keyword ‘Entrepreneurship’

Answer 30

LBO can also create value by helping to free management to concentrate on innovations.

Question 31

Keyword ‘Escrow agreement’

Answer 31

Portion of the manager’s incentive fees are held in a segregated account until the entire fund is liquidated. This ensures that the fund manager does not walk away with incentive fees unless the limited partners earn a profit.

Question 32

Keyword ‘Exit plan’

Answer 32

Describes how VC can liquidate their investment in the start-up company to realize a gain for themselves and their investors.

Question 33

Keyword ‘First or early stage venture capital’

Answer 33

(VC) Start-up company should now have a viable product that has been beta tested. Revenues are being generated.

Question 34

Keyword ‘Gearing’

Answer 34

Increasing risk through leverage (additional debt).

Question 35

Keyword ‘Limited liability’

Answer 35

Protection of an investor from losses that exceed their investment. The limited partners are not responsible for liabilities beyond a total loss of their investment, even if the partnership has further losses and unmet liabilities due to the use of leverage or from lawsuits.

Question 36

Keyword ‘Mezzanine stage’

Answer 36

Last stage before a start-up company goes public or is sold to a strategic buyer.

Question 37

Keyword ‘Second or late-stage/expansion venture capital’

Answer 37

(VC) Start-up company may just be at the point of breaking even. Commercial viability is now established.

Question 38

Keyword ‘Seed capital’

Answer 38

(VC) First stage where VC firms invest their capital. At this stage, a business plan is completed and presented.

Question 39

Keyword ‘Turnaround strategies’

Answer 39

(LBO) Unlike traditional buyout firms that look for successful, mature companies with low debt-to-equity ratios and stable management, turnaround LBO funds look for underperforming companies with excessive leverage and poor management.