burning0spear

Dr. Jason Bruno is a qualified investor in the US who is considering a $10 million investment in a private equity fund. Upon reading the fund’s prospectus, Dr. Bruno encounters several contract terms and expressions with which he is unfamiliar. In particular, he would like to know the meaning of ratchet and distributed paid-in capital (DPI). The most appropriate answer by the fund’s manager to Dr. Bruno would be that ratchet and DPI, respectively, is:

Ratchet

DPI

A) The general partner’s share of fund profits The general partner’s realized return

B) The allocation of equity between shareholders and management The limited partner’s realized return from the fund

C) The year the fund was set up Dividends paid out as a fraction of paid-in capital

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Ratchet is a contract term that specifies the allocation of equity between management and shareholders.

DPI, or distributed to paid-in capital, is the cumulative distributions paid out from the fund as a fraction of cumulative invested capital. DPI measures the limited partners’ realized return from the fund.

Note: The GP’s share of fund profits is called carried interest. The year the fund was set up is called the vintage. There should be no distinction between realized and unrealized return for the GP. Also, there is no term for dividends over paid-in capital as dividends are seldom paid out from a private equity fund.

burning0spear

A private equity fund pays a management fee of 3% of PIC and carried interest of 20% to the general partner using the total return method based on committed capital. In 2008 the fund has drawn down 80% of its committed capital of $250 million, and has a net asset value (NAV) before distributions of $260 million. The 2008 management fee and carried interest paid, respectively, is (in millions):

Management fee:

Carried interest:

A) 7.5 50.0

B) 6.0 2.0

C) 7.8 2.0

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(All dollar figures are in millions)
Management fee is paid annually on paid-in capital (PIC), which is just cumulative capital drawn down. 2008 management fee is thus 3% of $200, or $6.0.

Carried interest is the profit distributed to the general partner. The fund specifies a total return method based on committed capital and is calculated as the excess of NAV before distributions above committed capital. The 2008 carried interest paid out is then 20% of ($260 − $250) = $2.0.

burning0spear

Which of the following pairs correctly identifies the fees paid to agents for raising funds for the private equity firm, and the fees paid to the general partner (GP) for investment banking services, respectively?

Fees to agents

Fees to GP

A) Transaction fees Administrative costs

B) Placement fees Transaction fees

C) Administrative costs Placement fees

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Placement fees are upfront fees paid to agents for raising funds for the private equity firm. These fees typically are in the 2% range or paid as trailers.
Transaction fees are paid to the GP for investment banking services in the event of a merger or acquisition. Transaction fees are usually split with the limited partners and deducted from management fees.
Administrative costs are various annual costs including custodian fees, fees to transfer agents and accounting costs.

burning0spear

The Nishan private equity fund was established five years ago and currently has a paid-in capital of $300 million and total committed capital of $500 million. The fund paid its first distribution three years ago of $50 million, $100 million the year after and $200 million last year. The fund’s distributed to paid-in capital (DPI) multiple is closest to:

A) 0.67.

B) 0.70.

C) 1.17.

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The DPI multiple is calculated as the cumulative distributions paid by the private equity fund divided by the paid-in capital (the portion of committed capital drawn down).

Nishan’s current DPI is: ($50 + $100 + $200) / $300 = 1.17

burning0spear

A private equity firm makes a $10 million investment in a portfolio company and calculates that the firm’s outside investors should hold 1,000,000 shares at a price of $15.00 per share using the IRR approach. The founders of a portfolio company currently hold 300,000 shares. The appropriate post-money (POST) valuation is:

A) $19.5 million.

B) $15 million.

C) $13 million.

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Since we have no information on exit value or the IRR rate, but the share price and number shares held by each party is given, the post-money valuation (POST) is calculated as:

POST = shares price x total number of shares = $15 × (1,000,000 + 300,000) = $19.5 million.

burning0spear

A private equity investor makes a $5 million investment in a venture capital firm today. The investor expects to sell the firm in four years. He believes there are three equally possible scenarios at termination:

• expected earnings will be $20 million, and the expected P/E will be 10.
• expected earnings will be $7 million, and the expected P/E will be 6.
• expected earnings will be zero if the firm fails.

The investor believes an IRR of 25% is appropriate. The expected terminal value and the investor’s pre-money valuation, respectively, are closest to (in $ million):

Expected terminal value

Pre-money valuation

A) $80.67 $33.04

B) $9.00 $3.69

C) $80.67 $28.04

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The terminal value under each scenario is the expected earnings multiplied by the P/E ratio. The expected terminal value is the weighted average of the three scenarios (all in $ million):
Scenario 1: Terminal value = $20 × 10 = $200
Scenario 2: Terminal value = $7 × 6 = $42
Scenario 3: terminal value = $0
Expected terminal value = ($200 + $42 + $0) / 3 = $80.67
The expected terminal value is then discounted at the IRR rate to arrive at the post-money (POST) valuation:
POST = FV / (1 + r)N = $80.67 / (1 + 0.25)4 = $33.04
The pre-money (PRE) valuation is the post-money valuation less the investor’s initial investment:
PRE = POST − INV = $33.04 − $5.0 = $28.04

burning0spear

The Milat Private Equity Fund (Milat) makes a $35 million investment in a promising venture capital firm. Milat expects the venture capital firm could be sold in four years for $150 million and determines that the appropriate IRR rate is 40%. The founders of the venture capital firm currently hold 1 million shares. Milat’s fractional ownership in the firm and the appropriate share price, respectively, is closest to:

Fractional ownership

Share price

A) 23.33% $115.00

B) 89.64% $4.05

C) 89.64% $3.63

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The calculation requires four steps:Step 1: Calculate the expected future value of Milat’s $35 million investment in four years using an IRR rate of 40%:

W = ($35 million) × (1.40)4 = $134.46 million

Step 2: Milat’s fractional ownership of the venture capital firm is the future expected wealth divided by the exit value:

f = $134.46 million / $150 million = 0.8964, or 89.64%

Step 3: Calculate the number of shares required by Milat (Spe) for its fractional ownership of 89.64%:

Spe = 1,000,000 [0.8964 / (1 – 0.8964)] = 8,652,510

Step 4: The share price is the value of Milat’s initial investment divided by the number of shares Milat requires:

P = INV1 / Spe = $35 million / 8,652,510 = $4.05

(Note that both the NPV and IRR approach will yield the same answers.)

burning0spear

The primary difference between the venture capital method using the IRR and NPV approach is that:

A) the IRR method does not use exit values.

B) the NPV approach does not require fractional ownership calculations.

C) the IRR approach starts by calculating the investor’s expected future wealth.

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The IRR approach in venture capital firm valuations can be thought of as a reverse NPV calculation, where the IRR rate is used to first calculate the investor’s expected future wealth.

Both the IRR and NPV approach use exit values and fractional ownership calculations.

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.

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