private equity 2nd partial Flashcards
lifecycle of the PE fund
-fundraising period: before the fund starts you look for capital commitments, once i reach a target amount i can close the fund and initiate true operations (usually 2-3 years)
-investment period: period in which you make capital calls (draw commitments) and invest your money, usually lasts 5 years.
-management and divesture period (harvesting): value creation and exits, this is the period in which you liquidate your portfolio, lasts usually 5 years + 3 which can be granted to ensure positive market and exit conditions.
how are GPs compensated during the life of the fund?
-recurring: management fee % calculated on the total committed capital or invested capital (during harvesting). Usually ranges around 2% annually.
-Una-tantum: Carried interest around 20% of the total capital gain minus initial commitments and hurdle rate.
is the management fee always fixed at 2%? what might affect it?
can be discounted for early birds (people subscribing first pay a lower annual management fee on their commitment) and large tickets (large commitments pay lower fee).
Additionally, if there’s high demand in the market for PE assets GPs might decide to increase the management fee.
how is invested capital computed?
(capital commitment-lifetime fees) where lifetime fees are recurring annual fees multiplied by the life of the fund.
what are the 3 bases on which one might calculate carried interest?
-simple carried interest: you compute carried interest once you return funds in excess of the initial committed capital
-with hurdle rate: you compute carried interest once you return funds in excess of the initial committed capital and hurdle rate which is calculated as a flat 8% (usually) on the initial capital commitment
-with hurdle and catch-up clause: you compute carried interest on the total capital gain excluding hurdle rate, you then pay principal and hurdle rate, all distributions in excess go to the GP until the carried interest is paid, if a portion remains unpaid this is carried forward to the next year.
what’s the difference between European model and US model to compute Capital gain?
European calculates capital gain on a portfolio basis, you consider capital gain only once you’ve given back the initial commitment (more common)
US computes capital gain on a deal by deal basis, you might receive carried interest when you liquidate a single investment at a surplus even if you have not returned the entire principal (common in distress debt funds)
how can hurdle rate be calculated?
usually either as a flat share of the initial committed capital or as a granted IRR considering capital calls and liquidations.
what are the drawbacks of the IRR measure of performance?
1) reinvestment assumptions
2) differences in interpretation between realized and unrealized IRR
how do you compute TVPI (total value to paid in) at time x? how about DPI (distribution to paid in) ? what are they?
(distributions to LPs from 0-x + Value of unreleased portfolio x) / (sum of fees up to x + invested capital from 0-x). DPI only considers actual distributions at numerator. they are both MOMMs.
what’s the relationship between DPI and TVPI?
TVPI= DPI + RVPI (residual value to paid in)
do you need WACC when discounting CFs in the PE method?
No, you don’t care about objective valuation of the company, you discount at the target IRR as that is what you have to grant your investors.
why is multiple round financing the norm?
because it greatly reduces dilution and uncertainty.
what is the retention ratio? what is it used for?
final required stake at exit/(1-stakes of other investors at YOUR exit) it is used to compute the amount you should initially require taking into account the dilution you will suffer in further rounds.
what are tag and drag along clauses?
clauses that allow (tag along) or force (drag along) minority shareholders to participate in an exit under the same conditions negotiated by the majority.
why do PE funds invest in preferred shares?
because this offers protection in case of downside. if the company is sold at a low valuation as all proceeds are first distributed to preferred shareholders.
what are the 2 types of preferred shares used? what are their features?
convertible (CPS): allows the investor the option to convert their preferred shares into common in case of exit event, this right will only be exercised if the proceeds from the sale are high enough and justify giving up the down side protection of PS.
redeemable (RPS): allows the same level of protection against downside, if the sale value is higher than the initial PE investment the fund can redeem the shares and participate in the upside (in excess of the initial investment) proportionally to their stake. this option favors PE investors.
the difference between the 2 is participation in the upside.
what is a replacement/LBO
a PE deal involving a merger/acquisition with extremely high leverage involved.
what is mezzanine capital?
is a subordinated debt that involves an equity kicker (warrants) that allows holders to purchase shares at a strike price. NB the debt is not convertible, the warrants are added on top of the debt. the warrant can be against new or secondary shares. is considered an intermediate instrument in between equity and debt.
what are the phases of an LBO?
1) creation of the Bid company, an SPV that gathers all the capital needed for the purchase following the capital structure designed for the deal (equity, debt and mezz)
2) acquisition: you purchase the shares of the target company, these shares represent the collateral for the debt holders in the transaction (pledge of shares)
3) the companies are merged together in a single entity, this is done because otherwise, debt holders in the HoldCo would be structurally subordinated to debt holders in the OpCo (as HoldCo only generates cashflows in the form of dividends from OpCo)
what is the usual treatment for debt holders in the OpCo?
they are usually refinanced by the new creditors as their debt was negotiated in a less leveraged environment. are probably not interested in participating in the new leveraged vehicle.
what happens to debt holders in the OpCo when interest rates are high? (such as the current time)
the portable capital structure doctrine is applied. instead of totally replacing the old (and usually cheap) credit line with a new and much more expensive one, the HoldCo simply negotiates and adjusts terms in order to maintain old lenders within the new capital structure.
what are sources of value in an LBO?
-growth: usually the most important source, consists of growing the ebitda through increased sales and improved efficiency
-arbitrage: changes in multiples and market conditions during the holding period (buy low sell high)
-deleverage: repayment of debt in the capital structure with organic cash flow results in appreciation of equity.
