burning0spear

Which of the following statements most accurately describes the components of returns on a leveraged buyout (LBO) investment:

A) The return on common shares, the increase in the price multiple on exit, and the equity held by management.

B) The return on preference shares, the increase in the price multiple on exit, and the reduction in debt claims.

C) The interest earned on debt financing, the return on common shares and the return on preference shares.

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The components of a private equity firm’s returns are the return on preference shares, the increased price multiple and the reduction in debt claims. The private equity firm should see an increase in the price multiples as the operational efficiencies of the LBO firm improve. The second component is the value of the interest-bearing preference shares. The third component is the reduction in debt over the time period to exit.

burning0spear

A private equity firm is guaranteed to receive 80% of the residual value of a leveraged buyout investment, with the remaining 20% owing to management. The initial investment is $500 million, and the deal is financed with 70% debt and 30% equity. The projected multiple is 2.0. The equity component consists of:

• $120 million preference shares.
• $25 million private equity firm equity.
• $5 million management equity.

At exit in 5 years the value of debt is $150 million and the value of preference shares is $300 million. The payoff multiple for the private equity firm and for management, respectively, is closest to:

Private equity

Management

A) 5.10 22.0

B) 3.03 11.0

C) 6.34 46.0

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The calculations at exit are as follows (all in million $):

• The exit value will be $500 × 2.0 (the specified multiple) = $1,000.
• Outstanding debt is $150.
• Preference shares are worth $300.
• Private equity firm’s value: 80% of the residual exit value:
  (0.80)($1,000 − $150 − $300) = $440.
• Management’s value: 20% of the residual exit value:
  (0.20)($1,000 − $150 − $300) = $110.

Total initial investment by the private equity firm is $145, and by management $5.

Total payoff to the private equity (PE) firm at exit is $440 + $300 = $740.
Payoff multiple for the PE firm is $740 / $145 = 5.10.

Total payoff to management at exit is $110.
Payoff multiple to management is $110 / $5 = 22.0.

burning0spear

Which of the following statements is the least appropriate?

A) Leverage in a leveraged buyout investment can be advantageous as debt amortization can magnify investor returns.

B) Leverage in a leveraged buyout investment can be disadvantageous as debt increases risk to the investor if the firm cannot meet its interest obligation.

C) Debt amortization in a leveraged buyout investment increases risk to the investor as it is a burden on the firm’s cash flow.

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As the amortization of debt reduces investor risk (less debt outstanding) and the reduced claim by debtholders can actually magnify investor returns.

burning0spear

Christina Wagner is a CFA level II candidate currently studying about hedge funds, private equity and commodity futures. One of her friends is fascinated by what Wagner is learning and asks several questions on the topic. In particular, she is curious to know what exit options are available to a promising young venture capital (VC) firm if it is having difficulty attracting buyers due to poor market conditions. What should be Wagner’s most appropriate response?

A) The VC firm should consider the acquisition of another firm and sell the merged entity once capital market conditions have improved.

B) The VC firm should be liquidated in the absence of prospective buyers through the sale of the firm’s assets.

C) Since an initial public offering is not feasible, the VC firm should be sold to another firm through a buyout or secondary market sale.

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Liquidation occurs when a firm becomes insolvent or bankrupt, cannot function as an independent entity, and there are very few or no interested buyers. Liquidation results in low exit values. Selling the VC firm through a buyout or secondary market sale is also less feasible since these transactions require significant debt financing which the young VC firm may be unable to support.

In poor market conditions it may be feasible for the VC firm to make a strategic acquisition through a merger and sell the merged entity once market conditions have stabilized.

burning0spear

Which of the following lists correctly identifies exit routes in private equity, arranged from lowest to the highest exit values?

A) Initial public offering (IPO), management buyout, secondary market sale.

B) Management buyout, liquidation, IPO.

C) Liquidation, secondary market sale, IPO.

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Liquidation is a sale of last resort for bankrupt or insolvent firms and generally results in low exit values. The value realized on the sale to management in a management buyout typically varies, but lags behind values from a secondary market sale or an IPO.

A secondary market sale is analogous to a private sale of the firm to another firm. Secondary market sales use large amounts of debt financing and could result in the second highest valuation after an IPO. An IPO is a sale of the entire firm or part of the firm (e.g. a division) to the public. As a result of the increased post-IPO liquidity, transparency and access to capital, the private equity firm can realize the highest exit value of a firm through the IPO process.

burning0spear

The primary advantage of an initial public offering (IPO) as an exit route in private equity is that it:

A) offers the highest exit value potential.

B) is more cost-efficient and flexible than alternative exit routes.

C) is appropriate for firms regardless of firm size and operating history.

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A private equity firm can generally realize the highest exit value for a portfolio company through an IPO, as the post-IPO firm offers greater liquidity (it is continuously traded on an open exchange) and access to capital. IPOs, however, are costly to implement and involve a complex process that ranges from dealing with underwriters, gauging market interest and complying with various regulatory requirements. IPOs are also most appropriate for large firms with a stable operating history.

burning0spear

The pair of terms that correctly identifies the method of profit distribution between limited partners (LPs) and general partners (GPs), and the allocation of equity between shareholders and management of a portfolio company, respectively, is:

Method of profit distribution

Equity allocation

A) Ratchet Carried interest

B) Distribution waterfall Ratchet

C) Carried interest Distribution waterfall

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Distribution waterfall identifies the profit allocation between LPs and GPs and specifies when GPs can receive carried interest. Ratchet refers to the equity allocation between shareholders and management. Carried interest is the GP’s share in fund profits.

burning0spear

RDO is a private equity fund with $50 million in committed capital and an investment in three portfolio companies totalling $30 million. The fund earned a healthy profit of $5 million after its first year on the sale of one of the companies but suffered a $2 million loss after its second year on the sale of the second company. The fund pays carried interest of 20% on a total return basis using committed capital and also has a clawback provision.

The clawback the general partner must pay at the end of the second year is:

A) $0.

B) $400,000.

C) $600,000.

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A clawback provision in a private equity prospectus requires the general partner to repay part of previously distributed profits if the fund subsequently underperforms.

Since carried interest is paid on a total return basis using committed capital, the general partner of RDO would only receive interest when the portfolio value exceeds committed capital ($50 million). First-year profit is $5 million, bringing the portfolio value to $35 million, therefore no carried interest is paid. Since no profit was distributed to the general partner in the first year, a clawback does not apply in the second year.

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.

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.