CHAPTER 3: INVESTMENTS IN PRIVATE CAPITAL (EQUITY & DEBT)

Question 1

Private Equity Investment Characteristics

Answer 1

Private Capital: Funding for companies outside public markets.

Types:
- Private Equity: use equity
- Private Debt: Loans or other debt instruments.

Private equity means investing in private companies or public companies with the
intent to take them private.

The companies in which the private equity funds invests are called portfolio companies because they will become part of the private equity fund portfolio.

Question 2

The three main categories of private equity are:

Answer 2

From youngest to oldest:

1. Venture capital: Refers to investments in companies that have not been established yet.
2. Growth capital: Refers to minority equity investments in mature companies that require funds for growth or expansion, restructuring, entering a new territory, an acquisition, etc.
3. Leveraged buyouts: Borrowed funds are used to buy an established company. Mature.

Question 3

Leveraged Buyouts

Answer 3

Leveraged buyout is an acquisition of an established public or private company with borrowed funds.

If the target company is a public company, then after the acquisition, the company becomes private, i.e., the target company’s equity is no longer publicly traded.

eg: Hilton Blackstone (purchased for 26B out of which 74% was debt)

The acquisition is significantly financed through debt, hence the name leveraged buyout.

LBOs capital structure consists of equity, bank debt, and high-yield bonds.

The firm (GP) puts in some money of its own, raises a certain amount from LPs, and a substantial amount of money is borrowed in the form of debt to invest in companies

Eg:

assume the GP invests in a target company that requires an investment of $100 million.

In this, the GP invests $20 million of its money (equity), $70 million from bank debt, and the remaining $10 million is raised by issuing high yield bonds.

Question 4

There are three changes that happen to a company as a result of a leveraged buyout:

Answer 4

1. Increase in financial leverage.
2. Change in management or the way the company is run. Not the case in Management BuyOut when the old management stays (eg: Dell)
3. If the target company is previously public, after the LBO it becomes private.

Question 5

WHY LBO?

Answer 5

1. To improve the company’s operations; to add value and eventually increase cash flows and profits.
2. Leverage will enhance potential returns once the restructuring/growth strategy is complete and the company turns profitable. Debt is central to an LBO structure. Buyouts are rarely done entirely using equity.

Question 6

2 TYPES OF MANAGEMENT LBO’s

Answer 6

Management buyouts (MBO): Current management team purchases and runs the company. eg: Dell

Management buy-ins (MBI): Current management team is replaced and the acquirer team runs the company. eg: Blackstone-Hilton

Question 7

VENTURE CAPITAL

Answer 7

Venture capital firms invest in private companies (portfolio companies) with significant growth potential.

• Time Horizon: typically long-term.
• Actively involved in invested companies.
• Rate of return depends on company’s stage when investment happens

The distinction between VC and LBO is that the latter invests in mature companies, whereas VC invests in growing companies with a good business plan and strong prospects for future growth.

Question 8

VC investing can take place at various stages

1. FORMATIVE: Angel, Seed & Early Stage
2. LATER STAGE
3. MEZZANINE STAGE

Answer 8

1. Formative stage: Company is still being formed.

• Angel investing: Financing provided at the idea stage.
• Seed stage financing: Financing provided for product development and market research.
• Early stage: Financing for companies moving towards operation, but before commercial production and sales. Fund to initiate commercial production and sales.

2. Later stage financing: For expansion after commercial production and sales but before IPO.
3. Mezzanine stage: Preparing to go public. Debt+Equity Subordinated Debt

Question 9

Growth stages of a company and the types of
financing it may receive at each stage

Answer 9

VC: STARTUP BUSINESS: Preseed/angel, Seed, Early stage, Later stage (expansion) VC or Mezzanine VC

Growth Capital: More established business: also called ‘Growth Equity’: stage between VC & maturity: primary capital

LBO: Mature: MBO, MBI, High Leverage, Secondary Capital

Question 10

PIPE: Private Investment in Public Equity

Answer 10

Institutional or accredited investor purchases stock from a public company at a discount.

Advantages:
Saves time and money compared to public offerings.
Less stringent regulatory requirements.

Disadvantages:
Shares sold at a discount reduce capital raised.
Dilutes current stockholders’ ownership stake.

Question 11

PRIVATE EQUITY: EXIT STRATEGIES

Answer 11

Objective: Improve new or underperforming businesses and achieve high valuations upon exit.

Average Holding Period: Typically around 5 years.

Variability: Holding periods can vary, being either longer or shorter based on market conditions and strategic goals.

Question 12

PRIVATE EQUITY: EXIT STRATEGIES

Answer 12

1. IPO (Initial Public Offering): Company goes public by selling shares to public investors. BEST EXIT. BEST PRICE. High transaction costs.
2. Trade Sale:

Selling the company to a competitor or strategic buyer.
Can be through auction or private negotiation.
Eg: A PE firm may sell a small generic pharma company to a large pharma firm.

A Secondary sale is not a trade sale. Trade sale is to another company in same industry. Secondary sale is to another PE firm.

3. Special Purpose Acquisition Company (SPAC): Reverse IPO

A shell company formed to acquire a private company in the future.
Process: Raises capital through IPO, deposits proceeds in a trust.
Timeline: Has a set period (e.g., 24 months) to complete an acquisition; otherwise, funds are returned to investors.

Question 13

Other Exit Strategies in Private Equity:

Answer 13

1. Recapitalization:

PE firm increases or introduces leverage to the portfolio company and pays itself a dividend.

Nature: Not a complete exit as PE firm retains control, but allows extraction of capital.

2. Secondary Sale:

Scenario: VC firm specializing in early-stage companies sells portfolio company to another PE firm focusing on later-stage companies.

3. Write Off/Liquidation:
   Worst-case scenario where investment doesn’t succeed.
   Action: VC firm sells assets or writes off investment to focus on other projects.

Question 13

Risk–Return from Private Equity Investments

Answer 13

Benefits of Private Equity:

• Access to Private Companies
• Ability to Actively Manage and Improve Portfolio Companies
• Ease of Using Leverage

Considerations:
- Higher Return Opportunities
- Higher Illiquidity Risks
- Higher Leverage Risks

Question 13

PRIVATE DEBT

Answer 13

Private debt refers to various forms of debt provided by investors to private entities.

Question 14

Key private debt categories include:

1. Direct lending
2. Mezzanine debt
3. Venture debt
4. Distressed debt
5. Unitranche debt

Answer 14

RISK (X) VS RETURN (Y) GRAPH:

SLOPE: safest (secured) to riskiest (unsecured)

INFRA DEBT
SENIOR REAL ESTATE DEBT
SENIOR DIRECT LENDING
UNITRANCHE DEBT: different tranches combined to one
MEZZANINE DEBT: almost similar to equity
PRIVATE EQUITY CO-INVESTMENTS

Question 15

DIRECT LENDING

Answer 15

Providing debt capital directly to entities that need capital and cannot obtain it from traditional bank lenders.

Process and Features:

1. Higher Interest Rates: Debt provided at rates higher than traditional banks.
2. Returns: Lenders receive interest, original principal, and possibly other payments.
3. Leveraged Loans: Often includes leveraged loans where debt is provided with additional leverage.
4. Financing Structure: Private debt firms borrow money to finance loans extended to borrowers.
5. Return Enhancement: Leverage used to amplify returns on the loan portfolio.

Question 16

MEZZANINE DEBT

Answer 16

Private credit positioned between senior secured debt and equity in the borrower’s capital structure.

Characteristics:

Subordination: Ranks below senior secured debt but above equity.

Risk and Return: Higher risk prompts investors to seek higher interest rates and potential equity options.

Question 16

VENTURE DEBT

Answer 16

Debt financing offered to start-up or early-stage companies, often with minimal or negative cash flow.

Purpose and Benefits:

1. Access to Funds: Provides funding without significant dilution of shareholder ownership.
2. Risk Management: Includes features to compensate for higher risk, similar to mezzanine debt.

Question 16

DISTRESSED DEBT

Answer 16

Involves purchasing debt of mature companies experiencing financial distress, potentially including bankruptcy proceedings.

Investment Strategy:
- Opportunity: Investors target companies facing temporary cash-flow issues but with viable business plans.
- Active Management: Often involves active participation in company management to facilitate turnaround efforts.

Question 16

UNITRANCHE DEBT

Answer 16

Hybrid loan structure combining various tranches of secured and unsecured debt into a single loan with a blended interest rate.

Key Features:

• Structure: Integrates secured and unsecured debt tranches.
• Interest Rate: Typically falls between rates for secured and unsecured debt.

Question 17

Risk-Return of Private Debt:

Answer 17

• Arrangement: Can be structured directly from an investor or through a fund throughout the corporate lifecycle.
• Returns: Investors receive interest payments and principal repayment at term end, often with debt secured and protected by covenants.
• Comparative Return: Offers potentially higher returns compared to traditional bonds.
• Risk Profile: Higher returns are typically associated with elevated risk levels.

Question 18

Diversification Benefits of Private Capital:

Answer 18

Illiquidity Risk:
- Private capital investments are less liquid compared to public investments, which may reduce short-term volatility but require longer holding periods.

Concentration Risk:
- Investments in private equity and debt often involve concentrated positions in fewer assets, potentially increasing risk due to dependence on individual companies’ performance.

Uncertainties and Risk Management:
- Private investments face greater uncertainties related to underlying businesses and limited hedging options, influencing risk management strategies.

Performance Differential:
- Private capital exhibits distinct risk-return profiles compared to public counterparts, reflecting differences in market dynamics and investment characteristics.

Question 18

VINTAGE YEAR IN PRIVATE CAPITAL

Answer 18

Refers to the year in which a private capital fund is launched.

INVEST in diff funds from diff parts of the biz cycle eg: one during covid (niveshaay) then persistence AIF now

Impact on Performance:
- The economic and valuation environment during the fund’s launch can significantly influence its performance throughout its lifespan.

Risk Mitigation Strategy:
- Diversification across fund vintage years helps mitigate risks associated with launching a fund during unfavourable economic cycles.

Importance:
- Understanding the vintage year helps investors assess potential performance and risks associated with a private capital fund.

Question 19

Investments in private capital funds can add a moderate diversification benefit to a
portfolio of publicly traded stocks and bonds.

Answer 19

Investments in private capital funds can add a moderate diversification benefit to a
portfolio of publicly traded stocks and bonds.

Question 20

LO. Explain features of private debt and its investment characteristics.

Answer 20

Private debt refers to various forms of debt provided by investors to private entities.

Key private debt categories include: direct lending, mezzanine debt, venture debt, and distressed debt

Question 21

Summary

LO. Explain features of private equity and its investment characteristics.

Answer 21

Private equity means investing in private companies or public companies with the intent to take them private. The three main categories of private equity are: leveraged buyouts, venture capital, and growth capital. The main exit strategies are: trade sale, IPO, and SPAC.

Question 22

LO. Describe the diversification benefits that private capital can provide.

Answer 22

A fundamental timing characteristic for private capital is its vintage year (year of launch).

The valuation and economic environment at the fund’s inception can have a significant impact on realized results over the fund’s lifespan.

Investments in private capital funds can add a moderate diversification benefit to a portfolio of publicly traded stocks and bonds.

Question 23

Which of the following types of private debt is subordinated to senior secured debt but is senior to equity?

A Direct lending
B Venture debt
C Mezzanine debt

Answer 23

C is correct. Mezzanine debt refers to private credit that is subordinated to senior secured debt but is senior to equity in the borrower’s capital structure. Because of the higher risk, investors commonly demand a higher interest rate and may also require options for equity participation.

Other private debt strategies include:

Direct lending: Debt capital is provided at higher interest rates, directly to entities that require capital, but are unable to get capital from traditional bank lenders. Lenders subsequently receive interest, the original principal, and possibly other payments in exchange for their investment.

Venture debt: Debt funding provided to start-up or early-stage companies that may be generating little or negative cash flow. Entrepreneurs may seek venture debt as a way to access funds without further diluting shareholder ownership in their companies. Similar to mezzanine debt, venture debt may contain additional feature that compensate investors for the increased risk.

Distressed debt: Refers to buying debt of mature companies with financial difficulty such a bankruptcy proceeding. Investors seek companies with a temporary cash-flow problem but a good business plan. They may also get actively involved in the management of the company and help turn it around.

Question 24

Which of the following is least likely a feature of private debt?

A The return on private debt changes with the benchmark interest rate environment.
B It always provides lower return as compared to traditional bonds.
C It can be arranged on a direct or indirect basis.

Answer 24

B is correct.

Private debt investments can provide a higher return as compared to traditional bonds.

However, this higher return is often connected to higher levels of risk.

Question 25

Private equity funds whose vintage year occurs in the contracting phase of the business cycle tend to earn excess returns by investing in companies that are:

A mature.
B early stage.
C distressed.

Answer 25

A is correct.

The valuation and economic environment in the vintage year can have a significant impact on realized results over the fund’s lifespan.

Funds seeded during the contracting phase tend to do best with distressed companies.

Question 26

Statement 1: Private debt and equity are similar to their public counterparts in terms of risks and performance.

Statement 2: The performance of private equity funds is primarily determined by the vintage year and the coinciding phase of the business cycle.

Which of the above statements is not correct?

A. Statement 1
B. Statement 2
C. Both

Answer 26

A.

A is correct. Statement 1 is not correct. Due to illiquidity and concentration risk, as well as the often-greater uncertainties of both their underlying businesses and the means to hedge away their risks, private debt and equity differ from their public counterparts in terms of risks and performance.

Question 28

Which of the following categories of private capital is most likely to offer the highest returns?

A Unitranche debt
B Private equity
C Infrastructure debt

Answer 28

B.

B is correct. Investments in private capital vary in terms of risk and return across the corporate capital structure hierarchy.

Typically, private equity, as the riskiest alternative, offers the highest returns. Private debt returns declining on a continuum down to the safest, most secured form of debt i.e., infrastructure debt.