Reading 48: Private Equity Valuation- LOS a～ Q1-3

equity, private, possible, creation, class

LOS a: Explain the possible sources of value creation in private equity. fficeffice" />

Q1. 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) Reengineering the portfolio companies.

B) Obtaining cheap credit.

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

Correct answer is C)

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.

Q2. 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

Correct answer is B)

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).

Q3. 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.

Correct answer is B)

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.