Alternative Investments【Reading 46】Sample management, companies, 2012, efficient

jawz

The Austrian private equity firm RD primarily makes leveraged buyout investments as the firm’s management strongly believes that debt makes companies more efficient. The least likely explanation of management’s rationale is to:

A) transfer risk.

B) reduce the interest tax shield.

C) increase firm efficiency.

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A PE firm’s debt is frequently securitized and repackaged as collateralized debt or loan obligations, resulting in a transfer of risk to the debt buyer. Greater use of debt also requires disciplined and timely payment of interest, causing a PE firm’s portfolio companies to use free cash flow efficiently. Higher leverage generally increases the tax savings from the use of debt (the interest tax shield) increasing firm value in the meantime.

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burning0spear

The least likely factor affecting venture capital firm valuation is the:

A) bargaining power of the venture capital and private equity firms.

B) private equity firm’s initial investment.

C) probability of failure.

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The probability of failure is often factored in to adjust the discount rate (IRR) which could significantly affect firm valuation. The bargaining power between the two parties affects the final price paid for the venture capital firm. The private equity firm’s initial investment has no direct bearing on venture capital firm valuation.

burning0spear

A private equity investor is considering an investment in a venture capital firm, and is looking to calculate the firm’s terminal value. The investor determines that there is equal likelihood of the following:

• Expected firm earnings are $2.5 million with a P/E ratio of 8.
• Expected firm earnings are $3.0 million with a P/E ratio of 10.

The firm’s expected terminal value, and the analysis used by the investor, respectively, is:

Terminal value

Analysis

A) $25 million Scenario

B) $2.75 million Sensitivity

C) $50 million Scenario

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The investor is using scenario analysis to determine the venture capital firm’s terminal value. The terminal value under each scenario is calculated by multiplying the expected earnings by the P/E ratio:

Scenario 1: $2.5 million × 8 = $20 million
Scenario 2: $3.0 million × 10 = $30 million

The expected terminal value is then the weighted value under each scenario:

Expected terminal value = (0.50)($20 million + $30 million) = $25 million.

burning0spear

A private equity investor expects to realize a return on her venture capital investment in two years and expects to sell the firm for $30 million. She estimates that a discount rate of 30% is reasonable but expects that there is a 20% probability of failure in any given year. The post-money value of her investment today, adjusted for failure, is closest to:

A) $11.36.

B) $11.20.

C) $14.20.

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The investor must first adjust the discount rate for the probability of failure:

r* = (1 + r) / (1 − q) − 1, where r is the unadjusted discount rate, and q is the probability of failure.
r* = (1 + 0.30) / (1 − 0.20) − 1 = 0.625

To determine the post-money valuation, the projected future value must then be discounted at the adjusted discount rate:

POST = FV / (1 + r*)N = ($30 million) / (1.625)2 = $11.36 million

burning0spear

The founders of a small technology firm are seeking a $3 million venture capital investment from prospective investors. The founders project that their firm could be sold for $25 million in 4 years. The private equity investors deem a discount rate of 25% to be appropriate, but believe there is a 20% chance of failure in any year.

The adjusted pre-money valuation (PRE) of the technology firm is closest to (in millions):

A) $1.19.

B) $4.19.

C) $7.24.

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The general formula for determining the pre-money value (PRE) is to first discount the exit (sale) value at the appropriate discount rate to its present value. This value is called the post-money value (POST). The pre-money value is the post-money value less the investment (INV):

POST = FV / (1+r)N
PRE = POST − INV

This would yield a PRE value of $7.24 million when using the unadjusted discount rate of 25%. This rate, however, must be adjusted for the possibility of failure in any particular year. This is calculated as follows:

r* = (1 + r) / (1 − q) − 1, where r is the unadjusted discount rate and q is the probability of failure.

The discount rate adjusted for failure is then:

r* = (1 + 0.25) / (1 − 0.20) − 1 = 0.5625 or 56.25%

The pre value is then calculated as:

POST* = $25 / (1.5625)4 = $4.19 million.
PRE* = $4.19 − $3.0 = $1.19 million.

burning0spear

A private equity investor calculates a discount rate of 40% for valuing a company. The investor, however, believes that there is a 20% chance that the company will fail in any one year. The most appropriate adjusted discount rate the investor should use is:

A) 75.0%.

B) 48.0%.

C) 50.0%.

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The discount rate adjusted for the probability of failure is calculated as follows:

r* = (1 + 0.40) / (1 − 0.20) − 1 = 0.75 or 75%

burning0spear

The private equity firm Purcell & Hyams (P&H) is considering a $17 million investment in Eizak Biotech. Eizak’s owners firmly believe that with P&H’s investment they could develop their “wonder” drug and sell the firm in six years for $120 million. Given the project’s risk, P&H believes a discount rate of 30% is reasonable.
The pre-money valuation (PRE) and P&H’s fractional ownership, respectively, are closest to (in millions):

PRE

Fractional ownership

A) $24.86 0.68

B) $7.86 0.68

C) $7.86 0.14

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Step 1: The exit value must first be discounted at the appropriate discount rate to its present value to arrive at the post-money (POST) valuation (all dollar figures in millions):

POST = ($120) / (1.30)6 = $24.86 million.

Step 2: The pre-money valuation is Eizak’s current value without P&H’s investment:

PRE = $24.86 million − $17 million = $7.86 million.

Step 3: P&H’s fractional ownership is the value of its investment as a fraction of Eizak’s POST valuation:

f = INV / POST = $17 / $24.86 = 0.68.

burning0spear

A private equity firm makes a $10 million investment in a portfolio company. The founders of a portfolio company currently hold 300,000 shares and the pre-money valuation is $6 million. The number of shares to be held by the private equity firm, and the appropriate share price, respectively, are closest to:

Number of shares

Share price

A) 500,000 $32.00

B) 500,000 $20.00

C) 480,000 $20.83

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The answer requires four steps:

Step 1: Calculate the post-money (POST) valuation, which is simply the pre-money (PRE) valuation plus the investment:

POST = PRE + INV = $6 million + $10 million = $16 million

Step 2: Calculate the private equity firm’s fractional ownership in the portfolio company:

f = INV / POST = $10 million / $16 million = 0.625

Step 3: If the founders currently hold 300,000 shares, the number of shares to be held by the private equity firm to have 62.5% ownership is:

Number of shares = 300,000 [0.625 / (1-0.625)] = 500,000

Step 4: Given the private equity firm’s $10 million investment and 500,000 shares, the share price is calculated as:

P = $10 million / 500,000 = $20.00

burning0spear

The private equity firm Purcell & Hyams (P&H) is considering a $17 million investment in Eizak Biotech, of which $10 million is invested today and $7 million in four years. Eizak’s owners firmly believe that with P&H’s investment they could develop their “wonder” drug and sell the firm in six years for $120 million. Given the project’s risk, P&H believes a discount rate of 50% is appropriate for the first four years, and 30% for the last two years. The fractional ownership for first-round investors would be closest to:

A) 0.71.

B) 0.79.

C) 0.27.

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The calculation requires four steps (all figures in millions except for fractional data): Step 1: The terminal value must first be discounted to the time of the second-round financing to arrive at the post-money (POST2) valuation:

POST2 = ($120 million) / (1.30)2 = $71.01 million

Step 2: The pre-money valuation (PRE2) at the second round of financing is:

PRE2 = $71.01 million − $7 million = $64.01 million.

Step 3: The PRE2 valuation then has to be discounted back at the appropriate discount rate to the time of the first-round financing to arrive at the post-money (POST1) valuation:

POST1 = ($64.01 million) / (1.50)4 = $12.64 million

Step 4: The fractional ownership (f1) for first-round investors is:

f1 = INV1 / POST1 = $10 million / $12.64 million = 0.79.