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.

jawz

Contrary to most public companies, the magnitude that debt is typically utilized in private equity (PE) firms and the way this debt is quoted, respectively, is:

Debt is utilized:

Debt is quoted:

A) less heavily as a multiple of sales

B) more heavily as a multiple of EBITDA

C) more heavily as a multiple of equity

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PE firms typically use higher leverage than most public companies do, especially in leveraged buyout investments. Debt is usually quoted as a multiple of EBITDA, while public firm debt is usually quoted as a multiple of equity (debt-to-equity ratio).

jawz

The Jefferson Group is a large private equity firm managing a multi-billion dollar portfolio. Which of the following is the least likely source of value-added the Jefferson Group would provide to its portfolio companies than a public firm would?

A) Aligning the interests between private equity owners and limited partners.

B) Reengineering the portfolio companies.

C) Obtaining cheap credit.

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The three sources of value-added a private equity firm provides over public firms are: reengineering the portfolio firms, obtaining debt on favourable terms (cheap credit), and aligning the interests between private equity owners (the limited partners) and portfolio managers.

jawz

Pauler Investment Co. (“Pauler”) just proposed to make a sizeable investment in Bada Cork, a recently established Hungarian producer of synthetic wine bottle corks with a patented new technology. Pauler is looking to make further strategic acquisitions in small venture capital companies in the food and beverage industry and has set up a fund to manage the portfolio companies. It has also brought onboard Kristina Sandorf as portfolio manager. Upon receiving her contract, Sandorf complains to a friend of the contract terms proposed by Pauler. In particular, she grumbles that an earn-out clause is inserted, which she believes would give Pauler priority on the earnings and dividends of companies in the portfolio ahead of herself.

In her description of earn-outs, Sandorf is:

A) correct.

B) incorrect, because earn-outs refer to tying the acquisition price paid by Pauler for the portfolio companies to the companies’ future performance.

C) incorrect, because earn-outs refer to Pauler having priority over Bada’s assets in case of bankruptcy or liquidation.

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Earn-outs are typically used in venture capital investments where the acquisition price paid for portfolio companies by private equity firms is tied to the companies’ future performance.

jawz

In a private conversation with his best friend, Harry Veeslay, CFA, makes the following statements:

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Statement 1:	Private equity (PE) firms generally focus on short-term results. For example, they frequently use restructuring of acquired companies in an effort to quickly divest them for a profit.
Statement 2:	PE firms also want to ensure that the interests of portfolio company managers and of limited partners are aligned. For example, they frequently tie manager compensation to firm performance and include tag-along, drag-along clauses to give management a stake in the firm under certain trigger events.

With regard to Veeslay's statements:

A) only one is correct.

B) both are correct.

C) both are incorrect.

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Statement 1 is incorrect. PE firms tend to have a long-term, rather than short-term focus in their investment strategies, which often exceeds 10 years. Restructuring is generally a lengthy process and requires a long-term perspective.

Statement 2 is correct with regard to both manager compensation and the use of tag-along, drag-along clauses.

jawz

Norah Cyly is the recently appointed manager of a private equity fund that invests exclusively in venture capital investments in online fashion and media advertising companies. In a discussion with the fund’s assistant portfolio manager, Cyly makes the following statements on control mechanisms and exit routes:

Statement 1:	Earn-outs are mainly used in venture capital investments. They relate the acquisition price paid by the limited partners to the future performance of the portfolio companies.
Statement 2:	It is generally difficult to value venture capital investments using the portfolio companies’ cash flows or EBIT or EBITDA growth, since both cash flows and earnings are difficult to predict with certainty.

With respect to her statements, Cyly is:

A) correct on Statement 1 only.

B) correct on both statements.

C) correct on Statement 2 only.

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Both of Cyly’s statements are correct. Her description of earn-outs as a control mechanism is accurate. Her comment on cash flows and earnings growth is also correct, given most venture capital firms’ lack of stable cash flow and earnings patterns. This type of valuation is better suited for leveraged buyout investments.

jawz

Private equity firms can maintain control over portfolio companies in a variety of ways. Which of the following contract terms would least likely achieve this goal?

A) Tag-along, drag-along clauses.

B) Priority in claims.

C) Board representation.

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A tag-along, drag-along clause is less a control mechanism for private equity firms and more a tool to tie portfolio manager interests to the portfolio companies. The clause gives portfolio managers the right to obtain an equity stake in the portfolio companies should the private equity firm decide to dispose of its holding.

Priority in claims and board representation are both effective tools that give PE firms greater control over portfolio companies. Priority in claims allows the PE firm to receive distributions before all other owners. Should the portfolio company experience a major event (bankruptcy, restructuring, IPO, etc.), the private equity firm can gain control of the company through board representation.

jawz

Analysts Jordan Green and Noelle Lafonte are discussing terminal value estimation in venture capital and buyout investments.
Lafonte states: “Private equity firms often use scenario analysis in both venture capital and buyout investments to estimate terminal value.”
Green adds: “Private equity firms only use the multiple of net income approach in leveraged buyout (LBO), but not in venture capital investments to estimate terminal value.”With respect to their statements:

A) Lafonte is correct but Green is incorrect.

B) Green is correct but Lafonte is incorrect.

C) Neither Lafonte nor Green is incorrect.

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Lafonte’s statement is correct. Private equity firms can use scenario analysis to estimate terminal value in both venture capital and LBO investments. Under scenario analysis, terminal values are calculated under multiple scenarios using different assumptions.
Green’s statement is incorrect. Private equity firms often use a relative value approach to estimate terminal value in both venture capital and LBO investments. Under the multiple of net income approach, terminal year net income is multiplied by the P/E ratio to project terminal equity value.

jawz

The most appropriate pairing for valuing a buyout and a venture capital investment, respectively, is:

Buyout

Venture capital

A) Relative value approach Discounted cash flow

B) Pre-money valuation Relative value approach

C) Discounted cash flow Pre-money valuation

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Buyout investments have predictable cash flows and there are typically several comparable firms in the industry. Both the discounted cash flow and relative value approach are thus reasonable valuation techniques for buyout firms.

Venture capital firms, on the other hand, have less stable cash flows and few industry comparables given their young age and position in the business life cycle. Pre- and post-money valuation techniques are frequently used valuations for these firms.

burning0spear

A private equity investor is considering making an investment in a venture capital firm. The investor values the firm at $1.5 million following a $300,000 capital investment by the investor. The venture capital firm’s pre-money (PRE) valuation and the investor’s proportional ownership, respectively, are:

PRE valuation

Ownership proportion

A) $1.5 million 25%

B) $1.5 million 20%

C) $1.2 million 20%

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The pre-money valuation (PRE) is simply the venture capital firm’s post-money valuation (POST) less the capital investment (INV):

PRE = POST − INV = $1.5 million − $300,000 = $1.2 million.

The ownership proportion is the investor’s fractional ownership of the firm value after the capital infusion:

Ownership proportion = INV/POST = $300,000 / $1.5 million = 0.20 or 20%.