LOS e: Explain the role of exit routes in private equity and how it affects value.

Q1. 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.

Q2. 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)   Liquidation, secondary market sale, IPO.

C)   Management buyout, liquidation, IPO.

Q3. Christina Wagner is a CFA level 2 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 be liquidated in the absence of prospective buyers through the sale of the firm’s assets.

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

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

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Q1. 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.

Correct answer is A)

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.

Q2. 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)   Liquidation, secondary market sale, IPO.

C)   Management buyout, liquidation, IPO.

Correct answer is B)

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.

Q3. Christina Wagner is a CFA level 2 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 be liquidated in the absence of prospective buyers through the sale of the firm’s assets.

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

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

Correct answer is C)         

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.