Learning Objectives Flashcards
1.1) Describe the structure of PE and VC firms and funds.
Structure of PE and VC firms and funds:
- Fund manager raises a fund
- Outside investors provide bulk of the $$
- Fund manager plays an active role in identifying the investment, negotiating the deal, and monitoring the investment
- Investments held for a limited # of years
- Fund manager gets a disproportionate share of the profits when the investments are harvested
1.2) What is the compensation structure of PE/VC firms and how do they affect their investment strategy.
a. Ability to achieve high returns
i. High powered incentives both for PE portfolio managers and for the operating managers of businesses in the portfolio
ii. Aggressive use of debt, which provides financing and tax advantages
iii. Determined focus on cash flow and margin improvement
iv. Freedom from restrictive public company regulations
b. Core of PE’s success:
i. Standard practice of buying businesses and then, after steering them through a transition of rapid performance improvement then selling them
c. Typical VC fund–2/20 fee structure: 2% of the fund is charged as a management fee each year, and the fund’s GPs and employees split 20% of the profits they generate
i. Profit sharing portion is usually referred to as “carried interest” or “carry fee”
ii. 2% management fee usually tapers off after a few years–used to cover salaries and other fees
iii. Funds increase over time because that means more management fees
d. How a Carry Fee works:
i. All exit proceeds are returned to LPs until their capital is paid back, then they get 80 cents on the dollar for future exits
ii. Future exits in the fund will be redistributed 80 (LPs)/ 20 (GPs)
1.3) Describe the major regulatory and income tax issues associated with PE and VC.
a. 1979: Dept of Labor changed the “prudent man” provision of ERISA to permit venture capital investing
b. This and some other regulatory changes made it clear that pension funds could invest in LP private equity funds
c. JOBS Act (2012): speeds IPOs of companies with less than $1 billion of annual revenue
d. Removed restrictions on how Wall Street analysts cover smaller companies
1.4) Understand the nature of investment rounds in venture capital.
a. Startups aim to get its operations up and running, proves worthiness of its model and products, steadily growing w/ investments. Customer base begins to grow and the business begins to expand its operations
b. Over time, the company has risen through the ranks of its competitors to become highly valued, opening the possibilities for an IPO
c. Startups raise capital through rounds of external funding–rounds provide outside investors the opportunity to invest cash in a growing company in exchange for equity, or partial ownership of that company
d. Pre-seed funders: refers to the period in which a company’s founders are first getting their operations off the ground. Most common pre-seed funders are the founders themselves, friends, family, VC firms, etc.
i. Also referred to as an angel investor
ii. Angel investors typically appreciate riskier ventures and expect an equity stake in the company in exchange for their investment
1.5) Describe the key features of hedge funds
a. Investment partnership
b. Fund manager (GP) and investors (LPs) pool their money together in a fund
c. LP’s contribute funding for the assets and GP manages it according to the fund’s strategy
d. Hedge Fund’s purpose is to maximize investor returns and eliminate risk
e. Hedge fund management team resembles traders more than classic investors
f. Only open to “accredited” or qualified investors
g. Wider investment latitude
i. Basically investment in anything (land, real estate, derivatives, currencies and other alternative assets)
h. Will often use leverage (borrowed money) to amplify their returns –which potentially exposes them to a much wider range of investment risks
i. Fee structure: instead of charging an expense ratio only, HFs can charge a performance fee (2/20)
j. 2/20: hedge fund’s manager receives 2% of assets and 20% of profits each year
k. Equity hedge fund: invests in attractive stocks while hedging against downturns in equity markets by shorting overvalued stocks or stock indices
l. Pershing Square:
i. High profile activist hedge fund run by Bill Ackman,
ii. Ackman invests in companies that he feels are undervalued with the goal of taking a more active role in the company to unlock value
m. Advantages of Hedge Funds
i. Investment strategies have the ability to generate positive returns in both rising and falling equity and bond markets
ii. Hedge funds in a balanced portfolio can reduce overall portfolio risk and volatility, and increase returns
2.1) describe the motivations for investing in PE and VC funds.
PE:
a. Return enhancement potential
b. PE managers are committed to deliver absolute returns and their incentivization structure of carried interest is highly geared towards achieving net cash returns to investors
c. Portfolio diversification improves risk and volatility characteristics
d. Access to legitimate inside information (as opposed to public markets where investors know less about the companies they are investing in)
e. PE managers are actively involved in deciding on the strategic direction of their companies
f. Valuation of the company in question: management, proven track record, market size, maturity level, growth prospects, and risk
g. Comparative tax benefits: the returns from PE are treated as taxable capital gain–these rates are lower than income tax
VC:
h. VCs want to make investments because every time they finish investing out of one fund, they can start the next
i. If a VC makes good investments, they’ll raise more funds and earn more carried interest
i. Most funds spend 2-4 years actively investing (funds lasting longer than 4 years would require raising too much LP capital and LPs would rather see results every few years before deciding whether to continue investing in a fund
2.2) Describe the process by which LPs select the funds in which they invest.
a. Certain amount of capital needed (accredited investors)
b. Industry-related fund
c. Does the GP have a track record?
d. Alignment of interest between LP and GP
e. When joining a fund, LPs accept liability for the money they invest in a fund and have no veto control over GP’s
2.3) Analyze the financial attractiveness of PE (buyout) transactions.
• Criteria for good LBO candidates:
a. Strong market position and sustainable competitive advantage: high barriers to entry, high switching costs, etc
b. Multiple avenues of growth
c. Stable, recurring cash flows: due to the reliance on high leverage, PE firms must find companies with stable CFs in order to have sufficient cash flow to service all debt requirements (relatively immune to economic downturns)
d. Low CapEx requirements: provide management more flexibility in terms of how it can allocate the company’s capital and run its operations
i. Capital-intensive businesses will typically generate lower valuations from PE firms since there is less available capital (after interest expense), and there is increased financial risk in the deal
e. Favorable industry trends
i. Companies need to be well-positioned to benefit from attractive industry trends, since it results in above market growth and provides strong equity return potential
f. Strong management team
g. Multiple areas to create value: good LBO target candidate will also have multiple areas where a PE firm can create additional value (i.e selling underperforming assets, increasing efficiency of operations, pricing optimization, org structure, etc)
[Confirm this is fully encompassing answer ]
3.1) describe the legal and ethical issues associated with going private transactions.
a. PE is essentially about asset stripping and profiteering, with PE investors, partners and managers taking unfair advantage of tax breaks and regulatory loopholes to make unseemly amounts of money from dubious commercial practices (others defend private equity as a generally superior way of managing business)
3.2) create a set of financial projections to evaluate a buyout.
*** Follow up
4.1) evaluate the attractiveness of a potential VC investment.
- Attractiveness of a potential VC investment
a. Market conditions, strategy, technology, product/service, customer adoption, competition, deal terms, valuation, ability to add value, fit with the fund, and the quality of the management team
b. Valuation tools: cash-on-cash return, MOIC, and IRR
c. Deal structure: make sure that the entrepreneur does will while providing the VCs with leverage if the entrepreneur does not perform
d. Exits: VC returns are driven by deal sourcing/selection and by value-added activities
i. IPO and M&A
4.3) Understand the challenges of creating entrepreneurial ecosystems
a. Ecosystem refers to the elements–individuals, organizations or institutions, outside the individual entrepreneur, that are conducive to, or inhibitive or, the choice of a person to become an entrepreneur
b. Organizations and individuals representing these elements are referred to as entrepreneurship stakeholders
c. Stakeholders are any entity that has an interest, actually or potentially, in there being more entrepreneurship in a certain area (ie gov’t, universities, private sector, family businesses, investors, etc)
d. EX: Silicon Valley
- Reading: “How to Start an Entrepreneurial Revolution”
a. Article describes the environment in which entrepreneurship tends to thrive. Proposes that entrepreneurs are most successful when they have access to the human, financial and professional resources they need and operate in which government policies encourage and safeguard entrepreneurs (an ecosystem)
b. Healthy ecosystem is described as:
i. Tailored around its own unique environment
ii. Operates in an environment with reduced bureaucratic obstacles in which government policies support the unique needs of entrepreneurs and tolerate failed ventures
iii. Actively encourages and invites investors to participate in planning new business ventures
iv. Supported by entrepreneurship stakeholders
c. Why do governments want to encourage the development of entrepreneurial ecosystems?
i. Governments around the world are recognizing that entrepreneurship can transform their economies
d. What are some of the key differences and similarities among entrepreneurial ecosystems in different parts of the world?
i. Access to resources, $$
ii. Views of entrepreneurship
4.3) Understand the challenges of creating entrepreneurial ecosystems
a. Ecosystem refers to the elements–individuals, organizations or institutions, outside the individual entrepreneur, that are conducive to, or inhibitive or, the choice of a person to become an entrepreneur
b. Organizations and individuals representing these elements are referred to as entrepreneurship stakeholders
c. Stakeholders are any entity that has an interest, actually or potentially, in there being more entrepreneurship in a certain area (ie gov’t, universities, private sector, family businesses, investors, etc)
d. EX: Silicon Valley
- Reading: “How to Start an Entrepreneurial Revolution”
a. Article describes the environment in which entrepreneurship tends to thrive. Proposes that entrepreneurs are most successful when they have access to the human, financial and professional resources they need and operate in which government policies encourage and safeguard entrepreneurs (an ecosystem)
b. Healthy ecosystem is described as:
i. Tailored around its own unique environment
ii. Operates in an environment with reduced bureaucratic obstacles in which government policies support the unique needs of entrepreneurs and tolerate failed ventures
iii. Actively encourages and invites investors to participate in planning new business ventures
iv. Supported by entrepreneurship stakeholders
c. Why do governments want to encourage the development of entrepreneurial ecosystems?
i. Governments around the world are recognizing that entrepreneurship can transform their economies
d. What are some of the key differences and similarities among entrepreneurial ecosystems in different parts of the world?
i. Access to resources, $$
ii. Views of entrepreneurship
5.1) describe impact investing.
a. Investment strategy that is meant to generate financial return and a social/environmental impact
b. Use money and capital for a good cause
c. Investing in non-profits or clean technology enterprises
d. How it works:
i. Goal is to reduce negative effects of business activity on the social environment (could be considered an extension of philanthropy)
5.2) calculate the impact of an investment.
a. Social Return on Investment (SROI)-not typically reflected in financial statements
b. How effectively does a company use its capital and other resources to create value for the community
c. SROI= (Social Impact Value/Initial Investment)/(Initial Investment X 100%)
d. Needed to measure SROI
i. Inputs, or resources investments in your activity
ii. Outputs, or the direct and tangible products from the activity
iii. Outcomes, or the changes to people resulting from the activity
iv. Impact, or the outcome less an estimate of what would have happened anyway
