burning0spear

The relevant measure of cash flows for the limited partners (LPs), and the LPs’ realized return from investment in the private equity fund, respectively, is:

Return metric

LPs’ realized return

A) Net IRR Distributed to paid-in capital

B) Gross IRR Residual value to paid-in capital

C) Paid-in capital Net IRR

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Net IRR measures the cash flows between the fund and the limited partners and is therefore the relevant return metric for the LPs. Distributed to paid-in capital (DPI) measures the LPs’ realized return from investment in the fund. It is calculated as the cumulative distributions already paid to the LPs over the cumulative invested capital.

Gross IRR measures the cash flows between the fund and the portfolio companies. Residual value to paid-in capital (RVPI) measures the LPs’ unrealized return from the fund. Paid-in capital measures the percent of capital used by the general partner.

burning0spear

An investor in a private equity fund realizes that the residual value to paid-in capital (RVPI) is fairly large relative to the paid-in capital (PIC). The most appropriate conclusion drawn by the investor would be that:

A) the fund successfully earned profits from its investments.

B) there were significant cash flows from the fund to the investor.

C) it will take longer for the investor to realize a return from the fund.

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Paid-in capital measures the ratio of capital drawn down as a fraction of total committed capital. Residual value to paid-in capital is the value of the investor’s holding in the fund as a ratio of cumulative invested capital.

A high RVPI to DPI ratio indicates that the fund is having difficulty realizing profits from its investments. In this case it would take longer for the investor to receive distributions from the fund (low cash flows to date).

burning0spear

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:

A) both are incorrect.

B) both are correct.

C) only one is correct.

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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.

burning0spear

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

A) management and performance cost.

B) capital cost.

C) dilution cost.

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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.

burning0spear

The most relevant market risk to a private equity investor is:

A) short-term macro changes only.

B) long-term macro changes only.

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

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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.

burning0spear

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?

Risk in long-term rates

Profit distribution

A) Capital risk Carried interest

B) Market risk Carried interest

C) Market risk Distribution waterfall

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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.

burning0spear

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

A) Tax risk.

B) Investment-specific risk.

C) Market risk.

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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.

burning0spear

Which of the following is the least likely disadvantage in calculating the net asset value (NAV) for a private equity fund?

A) Only capital commitments already drawn down are included in the NAV calculation.

B) NAV may be difficult to calculate since firm values are not known with certainty prior to exit.

C) The limited partners use a third party to calculate the NAV of a private equity fund.

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NAV is usually calculated by the fund’s general partner, which could result in a subjective and inflated NAV. Limited partners, however, often use third party valuations to arrive at an objective and up-to-date NAV. This scenario thus describes a countermeasure to an issue in calculating NAV rather than a disadvantage itself.

The other two answers are both disadvantages in calculating NAV.

burning0spear

The Dragonhill Group manages a $250 million private equity fund. Investors committed to a total of $300 million over the term of the fund and specified carried interest of 20% and a hurdle rate of 10%. Carried interest is distributed on a deal-by-deal basis. 60% of the $250 million has been invested at the beginning of year 1 in Deutsch Co. (Deutsch), with the remaining 40% invested in Reiner Ltd (Reiner).
Both firms are sold at the end of the third year, realizing a $45 million profit for Deutsch and a $35 million profit for Reiner.
The carried interest paid to the fund’s general partner after Deutsch and Reiner, respectively, is:

Deutsch

Reiner

A) $0 $7 million

B) $9 million $0

C) $9 million $7 million

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Since carried interest is paid on a deal-by-deal basis, profits are not netted. Also, carried interest is only paid if the investment’s IRR at least meets the hurdle rate of 10%.

(All figures are in $ million):
The initial allocation between the firms was:
Deutsch: (0.60)($250) = $150
Reiner: (0.40)($250) = $100

The IRRs for the two firms are:
IRRDeutsch: PV = -$150; FV = $195, N = 3; CPT I/Y → IRR = 9.14%.
IRRReiner: PV = -$100; FV = $135; N = 3; CPT I/Y → IRR = 10.52%.

Since the return on Deutsch fell short of the 10% hurdle rate, the general partner only receives profits after Reiner. The profit is 20% of $35 million, or $7 million.

burning0spear

The party in a private equity fund that has unlimited liability for the firm’s debts, and this party’s share in fund profits, respectively, is referred to as:

Unlimited liability

Share in fund profits

A) General partner Carried interest

B) Limited partner Distribution waterfall

C) Manager Management fees

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Limited partners’ liability does not extend beyond their capital investment, whereas general partners (the fund managers) have unlimited liability for the firm’s debt. The general partner’s share in fund profits is referred to as carried interest. Management fees are paid annually as a percentage of capital (NAV, paid-in-capital, or committed capital) and are not tied to fund profits.