Introduction to Private Equity

Question 1

1. What option position most resembles the payouts of private equity investments?

Answer 1

• Long a call option

Question 2

2. Fill in the blanks of the following sentence using the terms private equity fund, private equity firm and underlying business enterprises: A 1 serves as the general partner to a _2 that invests its money in 3 .

Answer 2

• Private equity firm
• Private equity fund
• Underlying business enterprises

Question 3

3. What type or types of securities does a venture capitalist purchase in establishing a position in an underlying business venture?

Answer 3

• Privately held stock or equity-linked securities (i.e., preferred stocks or debt securities that can be converted into equity)

Question 4

4. What is the term that best describes the grouping of market participants into clienteles that focus their activities within specific areas of the market rather than operating throughout an entire market?

Answer 4

• Market segmentation

Question 5

5. What is an equity kicker and how does it serve the interests of a venture capitalist?

Answer 5

• An equity kicker is an option to acquire some type of equity participation in the firm, such as options to buy shares of common stock that is packaged with a debt financing transaction. The equity kicker portion provides the venture capitalist with an interest in the upside of the company, while the debt component provides a steady payment stream.

Question 6

6. What is the primary difference between a positive covenant and a negative covenant?

Answer 6

• Negative covenants are promises by the debtor not to engage in particular activities, such as paying dividends or issuing new debt. Positive covenants are promises to do particular things, such as maintaining a specified cash level.

Question 7

7. What does it mean when a loan is termed a syndicated loan?

Answer 7

• Syndicated loans mean that a group of entities, often investment banks, is underwriting a loan or loans.

Question 8

8. Discuss the following statement: empirical evidence indicates that investors in listed BDCs are subject to greater return volatility and enjoy less diversification benefits than investors in private equity that is not publicly traded.

Answer 8

• Since private equity lacks liquid market price data, such empirical evidence is likely formed by comparing liquid market prices with illiquid pricing data. Analysis of prices for private equity based on illiquid trading data or professional judgment can be argued to understate risk. Returns based on illiquid trading data or professional judgment are likely smoothed and therefore analysis based on those data should be expected to underestimate true return volatilities and correlations.

Question 9

9. What is the primary difference between a traditional PIPE and a toxic PIPE?

Answer 9

• Traditional PIPEs allow investors to buy common stock at a fixed price. A toxic PIPE is a PIPE with adjustable conversion terms that can generate high levels of shareholder dilution in the event of deteriorating prices in the firm’s common stock.

Question 10

10. Describe two major differences between typical hedge fund fees and typical private equity fund fees related to clawbacks and hurdle rates.

Answer 10

• Hedge funds usually have no provisions for the clawback of management or incentive fees. Private equity funds typically have clawback provisions requiring the return of fees on prior profits when subsequent losses are experienced.
• Hedge funds rarely have a preferred rate (hurdle rate) of return (e.g., 6%) that must be exceeded before the hedge fund manager can collect an incentive fee. Most private equity funds have a hurdle rate.