Private Equity: market, investment structures and perforamnce valuation

Question 1

What are the contractual structures of PE funds?

Answer 1

1. Limited partnerships (anglosaxon countries)
2. Closed-end mutual funds (Continental Europe)

Mostly a formal rather than substantial difference

Question 2

What is the structure of a limited partnership?

Answer 2

1. Limited partners purely provide funds
2. General partners provide management services and occassionaly funds

Question 3

What is the structure of a closed-end fund?

Answer 3

1. Investors purely provide funds
2. Management company provides management services and occassionaly funds.

Question 4

What is an SIF in Private Equity?

Answer 4

An SIF is a special investment fund, a vehicle through which investments are made in a PE environment.

Question 5

What is the lifecycle of Private Equity investments?

Answer 5

1. Fundraising period: It is the period dedicated to the collection of commitments from interested investors (up to T₀)
2. At time 0 the commited capital (non-binding) must be fully subscribed (becomes binding, although not necessarily provided in liquid form)
3. Investment Period: It is the period dedicated to the collection of funds from investors (usually when investments turn up). (From T₀ to 5 years)
4. Management and divestitutres: year 5 marks the final year to make further investments; usually the Authorities can allow the P.E. investor a grace period in order to better divest the assets in the portfolio (from 5 year mark to 10 year mark (might be slightly adjusted with grace period)).

Question 6

What is the compensation scheme in a PE fund?

Answer 6

The MCO or general partners in a LLP receive 2 forms of compensation:
- Fixed periodic fee = management fee (usually 2-2.5% on the commited capital, with early bird discount for earlier or larger commitment)
- Performance fee when the investments are liquidated = carried interest (with or without hurdle rate and catch up clause) usually 20-25%

Question 7

How is the management fee calculated?

Answer 7

• Management fee is a very lucrative source of revenue for management companies or general partners (it doesn’t depend on the performance of the investments)
  1. Lifetime fees = # of years of the fund * annual management fee
  2. Invested capital = commited capital - lifetime fees (it is the capital that can be invested in firms)
  3. Break even point (return on investment wise) = lifetime fees/invested capital

Question 8

What is carried interest?

Answer 8

• It is a component of the revenues of the MCO or GP that aims at incentivizing the search for the best possible opportunities (drawback: creates incentives to excessive risk-taking)
• There are three basic methods to set carried interest:
• Simple
• With hurdle rate
• With catch-up clause

Question 9

How is simple carried interest calculated?

Answer 9

CI (value) = (Total exit value - commited capital) * carried interest (percent)

commited capital = total capital commited in the beginning of fund

Question 10

What is the hurdle rate used in calculating carried interest?

Answer 10

• Sometimes the rules governing the PE investment require that the MCO or GP receive the carried interest only after having paid a minimum interest rate on the commited capital (hurdle rate).
• CI (value with hurdle rate) = (exit value - commited capital - commited capital * hurdle rate) * carried interest (percent)
• The hurdle takes priority over any other compensation. As can be seen from above the carried interest is calculated based on the profit already minus the hurdle rate

Question 11

What is the catuc-up clause in carried interest?

Answer 11

• The catch-up clause allows the GP/MCO - once the hurdle rate has been paid to the limited partners/investors - to get the additional liquidation flows until the GP/MCO reaches the simple CI value on the cumulative proceeds
• In other words, the GP/MCO doesn’t have to wait until the final investment has been liquidated for getting a part of the capital gains
• The catch-up clause doesn’t change the value of the CI as it was calculated with the simple formula. What changes is the timing.

Question 12

What are the usual measures of profitability of a PE investment?

Answer 12

1. IRR (realized and unrealized are different, the GP/MCO will seldom reinvest the proceeds rather than reinvest them)
2. Cash multiples (might be better)

Question 13

What is the formula for the total cash multiple (TVPI = total value to paid-in) in PE operations?

Answer 13

TVPI = (Total distributions to investors + Value of unreleased investments)/(invested capital + management fees)

Invested capital + management fees = commited capital

Question 14

What is the formula for the released cash multiple (DPI = distributions to paid-in) in PE operations?

Answer 14

DPI = (Total distributions to investors)/(invested capital + management fees)

Question 15

What is the formula for the unreleased cash multiple (RVPI = residual value to paid-in) in PE operations?

Answer 15

RVPI = (Value of unreleased investments)/(invested capital + management fees)