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Private Equity > Lecture 4 > Flashcards

Lecture 4 Flashcards

1
Q

What is the historically annualized VC return index ?

A

Superior of those of public stock market indices but individual investment outcomes vary greatly.

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2
Q

What are the key distinctions between two kinds of risks ?

A

• Beta risk = market risk = non-diversifiable risk = systematic risk

• Idiosyncratic risk = diversifiable risk = firm-specific risk = residual risk
o Can be removed by diversification

→ investors only rewarded for systematic risk

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3
Q

What is the VC method of valuation ?

A

• Deciding allocation of committed capital in VC funds requires investment analysis of private firms to identify opportunities

• Most common approach used in VC industry = VC method
o Essentially variant fo DCF and Comparables analysis

• Key idea : estimate value of company in successful exit then discount at very high rate

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4
Q

What are the VC main elements ?

A
  • Successful exit valuation
  • Target multiple of money
  • Expected retention percentage
  • Investment recommendation
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5
Q

How to estimate the VC cost of capital ?

A

Use historical aggregate VC industry return data and estimate equation :
R(VC) - Rf = α + β(RM - Rf) + e
Where α = unexpected portion of return = skills of portfolio managers.

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6
Q

What is another relevant issue solved by PSM for VC ?

A

Investors may require premium for illiquid investments

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7
Q

What is the Pastor-Stambaugh Model ?

A
  • Same model as FAMA-FRENCH but includes illiquidity risk

* More sensitive return on asset is to liquidity factor, higher premium investors will demand

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8
Q

What is the issue concerning aggregate VC industry price index ?

A

Are updated based on reported valuations of private portfolio companies.

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9
Q

What is the third adjustment ?

A
  • Aggregate VC industry price index based on most recent round of financing → stale prices
  • Include values from past periods in regression
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10
Q

How is the Exist Valuation performed ?

A

• Successful exit valuation : estimate of value of company at IPO or buyout year
o Estimate of valuation conditional on success

  • Valuation taken at exit date (no discounting)
  • Focus on successful events = bulk of money for VC comes from
  • Not include only cases of staggering success
  • Key distinction between absolute valuation (discounted CF analysis and relative valuation (comps analysis)
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11
Q

What is the target multiple-of-money ?

A

• VC funds often target firms yielding exit valuations at least a multiple of dollar investment
→ Multiple called target multiple of money

  • Reason VC funds require multiple → successful exits need to compensate for failures + account for time value of money
  • PV of exit = exit valuation x p/(1+r(vc)^T where p = probability of exit

• Target multiple M & target return TR linked to cost of capital and p via : p/(1+r(VC)^T = 1/M + 1/(1+TR)^T
where T = # yrs firm remains private

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12
Q

What is the expected retention ?

A

Expected percentage of shares all current owners will own at exit date

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13
Q

How to estimate retention ?

A
  • Start with # shares VC own after round of financing
  • Include all founder’s shares
  • Include all options
  • Add # shares issued in subsequent rounds
  • Add # shares necessary at successful exit given past experience
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14
Q

What is an investment recommendation ?

A

Comparison of costs and benefits of given investment

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15
Q

What does investment recommendation involve ?

A

Partial valuation exercise

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16
Q

What does the partial valuation exercise show ?

A

How much of PV given valuation LPs expected to capture

17
Q

Why recommendation rather than decision of investment ?

A

Uncertainties in valuation of private firms.

18
Q

What is the Standard VC method steps ?

A
  1. Required investment today ? ($I)
  2. Exit valuation of comapny ? ($ exit valuation)
  3. Target multiple-of-money on investment ? (M)
  4. Expected retention percentage ?
  5. Total valuation for company today ?
    → total valuation = $ exit valuation x retention/M
  6. Proposed ownership percentage ?
  7. Estimate partial valuation for investment
    → partial valuation = proposed % x total valuation
  8. Investment recommendation : comapre partial valuation to $I
  9. Estimate LP cost for investment
    → LP cost = $I (committed capital / invesmtent capital)
  10. Expeced GP% fo investment ?
    → GP% = carry% x (GVM x investment capital - carry basis)/(GVM x Investment capital)
  11. LP valuation from investment ?
    → LP valuation = (1 - GP%) x partial valuation
  12. Investment recommendation : compare LP valuation to LP cost
19
Q

2 Ways to value firm conditional on successful exit ?

A
  • Input market’s opinion given investment at exit date = comparables method
  • Make projections of CF of firm from year exit until infinity and discount them to present (DCF approach)
20
Q

How is the discount rate estimated ?

A

From industry avg or comparable companies

21
Q

What does the discount rate refer to ?

A

Cost of capital of financed firm ≠ cost of capital of VC

22
Q

What is the discount rate used for ?

A

Compute value of firm in the date of exit

23
Q

How to estimate cash flows on exit date ?

A
  • Revenue forecasted for avg success case
  • Other accounting ratios estimated using comparable companies or rule of thumb estimates
  • Not estimate CFs from valuation ratios
  • Point of DCF analysis = form own opinion about potential investment
24
Q

What does Forecasting CFS need to take into account after exit date ?

A

Growth trajectory over lifetime of firm

25
Q

What do pioneering firms exhibit ?

A

Spectacular growth in early years

26
Q

What happens to growth ?

A

Slows over time = Not easy to generate spectacular ideas perpetually

27
Q

What happens to new invested capital ?

A

Fetches lower returns

28
Q

What do costs for larger firms lead to ?

A

Decreasing returns to scale

29
Q

What happens to success ?

A

Gets imitated by new competitors leading to declining margins

30
Q

What happens to growth in the long term ?

A

Stabilize at low levels

31
Q

Why does quantity of investment increases the return on each new invested dollar declines ?

A

Decreasing returns to scale

32
Q

What happens during rapid growth period ?

A
  • Last for 5-7 years
  • Avg revenue growth set to 75th percentile of growth for new IPO firms in same industry
  • Margins, tax rates, cost of capital : change in equal increments across years so that exit values reach graduation values in graduation year
33
Q

What happens on graduation date ?

A
  • Stable growth rate = expected inflation
  • Return on new capital = cost of capital
  • Return on old capital = industry average
  • Operating margin = industry avg
  • Cost of capital = industry average cost of capital
34
Q

What are the steps of using comps for cost fo capital ?

A
  1. Identify set of comparable companies
  2. Estimate performance-evaluation regression for each of these companies
  3. Compute unlevered betas
  4. Compute avg of unlevered betas
  5. Use corresponding cost of capital formula to estimate cost of capital

Private Equity (10 decks)

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