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LOS f: Explain the risks and costs of investing in private equity. fficeffice" />

Q1. 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)      Market risk                    Distribution waterfall

B)      Capital risk                   Carried interest

C)      Market risk                    Carried interest

Correct answer is A)

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.

 

Q2. 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 correct.

B)   only one is correct.

C)   both are incorrect.

Correct answer is C)       

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.

 

Q3. 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.

Correct answer is C)         

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.