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Which of the following terms correctly describes the risk to a private equity firm in long-term interest and exchange rates, and the provision that specifies the method of profit distribution between the limited partners (LPs) and general partner (GP), respectively?

Market risk

Distribution waterfall

Capital risk

Carried interest

Market risk

Carried interest

Market risk describes the risk of how changes in interest rate, exchange rate and other macroeconomic factors affect private equity investments.

The method of profit distribution between the LPs and GP is called distribution waterfall.

Carried interest is the GP’s share of fund profits. Capital risk refers to the risk of capital depletion in a private equity fund and the risk of obtaining additional financing.

An analyst makes the following statements on the risk and costs of private equity investments:

Statement 1:	Committed capital is the initial capital in a private equity fund to obtain first round financing. As committed capital is used up, investors are required to make additional commitments to finance firm projects and expansion.
Statement 2:	The J-Curve refers to the risk pattern in a private equity investment over time. Risk in private equity investments initially typically declines as more capital is drawn down but increases closer to exit since exit timing and values are difficult to predict.

With respect to the analyst’s statements:

Both statements are incorrect. Committed capital refers to the amount of funds investors committed to over the life of the private equity fund. Funds from committed capital are drawn down over time as the firm needs more capital. If the firm needs financing beyond investors’ committed capital, it would have to look for additional sources of funds.

The J-Curve refers to a pattern in private equity investment return, not risk. The return on investments usually declines initially, then increases as exit nears.

An implicit cost in private equity of additional financing or issuing stock options to management is called:

Management and performance cost is the explicit cost of manager compensation as a percentage of committed capital and annual fund performance. Capital costs are not discussed as a cost in private equity.

Dilution is the implicit cost of reduced investor value when firms take on additional financing or when stock options are granted (and exercised) by management.

A)	short-term macro changes only.

B)	both short-term and long-term macro changes.

C)	long-term macro changes only.

Private equity investments are affected to a large degree by long-term macro- factors such as interest rate and exchange rate fluctuations and various market risks. Short-term macro-factors and short-term fluctuations are less relevant as the investor’s time horizon typically exceeds 10 years.

Private equity values have declined significantly over the last year. Which of the following risk factors is the least likely reason for the decline?

Market risk is the risk of long-term changes in interest rates, exchange rates and economic risk. Certainly all of these have been factors in the less than spectacular private equity returns recently. Investment-specific risk is probably the most important source of risk in recent times, as many private equity investments suffered significant losses as a result of the subprime mortgage and real estate meltdown. Tax risk is the risk of tax changes over time, which has not been a significant factor in private equity valuations recently.