Private Equity

Question 1

What is Private Equity?

Answer 1

It encompasses 4 different strategies in the market for private investing:

1. Venture Capital, equity financing for start up companies; ownership in equity claims
2. Buyouts purchase and conversion of established companies into private companies ownership in equity claims
3. Mezzanine Financing, combination of private debt and private equity financing ownership in debt claims
4. Distressed debt financing, investing in established trouble companies ownership in debt claims

VBMD

Question 2

What is the call option view of private equity?

Answer 2

Ir reflects its frequent losses and sporadic gains, in particular venture capital

Question 3

What are the 2 primary types of private equity investments and what is the main difference?

• What is Venture capital?
• What is Buyour?

Answer 3

• VC and Buyout

VC is equity financing provided by professionals in young, rapidly growing companies

PE Buyouts involve the purchase of a public company by a private comapny

They are 2 extremes of EQUITY TYPES Hedge Funds,

In investment strategies, VC rely on new technology or innovation, Buyouts identify where operating efficiencies can be improved or product distributions can be expanded

Question 4

What is meant by the following:

1. Vintage year
2. Burn rate
3. Equity Kickers

Answer 4

1. Year in which private equity fund beigns operations
2. The rate at which start up companies use up thier cash
3. Equity kickers are offers of equity positions (for instance, stock options) in deals involving loans. They are given to lenders as inducement to lend money to the company and are often used in mezzanine financing.

Question 5

What is meant by merchant banking?

Answer 5

Practice of buying non financial companies by financial institutions

Question 6

What are the 2 main types of PE investments that involve ownership in debt claims.

Describe each

Answer 6

• Mezzanine debt and Distressed debt

Mezzanine debt begins as a risky debt claim,

Distressed debt is debt whose credit worthiness has deteriorated

Question 7

What is meant by:

• Charge off loans
• Incurrence covenants
• Maintenance covenanants

Answer 7

• Charge off loans: Loans that have been written off as bad
• Incrrence covenant: If a borrower is to maintain a limit of 5 times EBITDA loan, if debt falls above the 5 times because EBITDA went down, borrower is not in violation
• Maintenance covenants: in the case above, the rule is srictly enforced

Question 8

Leveraged loans

Answer 8

Bank loans can be classified into 2 broad categories:

1. Made to companies with investment grade credit ratings (i.e. BBB by S&P or Baa by Moody’s and above)
2. Leveraged loans, syndicated loans made to companies with non-investment grade credit ratings (i.e. BB and Ba, and below)

Syndicated loan is a loan underwritten by a group of entities

Question 9

Business development companies (BDC)

Answer 9

Publicly traded closed end funds that invest in the equty of small, private companies

Question 10

What are BDCS, SPY and IWM

Answer 10

They are ETF’s

• TracksUS BDC sector,
• Tracks S&P 500 and
• Tracks Russel 2000

Question 11

What are the recent changes in private equity markets

Answer 11

1. Increased activity in secondary markets through BDCs)
2. PIPE (Private Investment in Public Entity)
3. Transition of hedge funds into PE

PIPEs are generally

Question 12

What is Equity line of credit? (ELC)

Answer 12

Relates to PIPE, contractual agreement that enables investors to purchase a formula based quantity of stock at set intervals of time

Question 13

What are the 2 general classes of PIPEs: traditional and structured

Answer 13

1. Traditional PIPEs, invovles purchasing preferred stock or debt with a fixed price or conversion ratio;
2. Structured PIPEs have floating conversion price. This can result in toxic PIPE or death spiral

Question 14

Contrast PE funds and Hedge Funds

Answer 14

Deal terms and fee structures are more attractive for hedge fund managers

Question 15

What is the difference in equity stake of the investment in VC and buyout

Answer 15

VC: Minority, but substantial

Buyout: Control of company

Question 16

What are VC funds?

Answer 16

They are PE funds that pool investors’ capital to fund start up companies. Most funds are structured as limited partnerships, the venture capitalist is the GP.

The fund investors are typically limited partners.

Question 17

What are the 2 types of VC fees?

Answer 17

1. Management fee, usually 2 to 2.5%, they are based on the committed capital;
2. Incentive fee < usually 20%. they usually have clawhack provisions

Question 18

Related to VC, what is a capital call?

Answer 18

The VC manager can demand for investors to contribute capital if he deems there is an investment opportunity

Question 19

What is the J-curve?

Answer 19

J-curve follows the life stages of VC fund’s portfolio of companies.

It starts with Fundraising (capital commitment)and ends with Windup and liquidation

Question 20

What are the 5 discrete stages of VC financing?

Answer 20

1. Angel investing (F,F &f), $50-$500k;
2. Seed capital, about $1-$5 million
3. First or early stage ventur capital, generally more than $2M. Manufacturing has begun
4. Second-or late stage/ expansion venture capital, $5-$25m of financing is provided
5. Mezzanine venture capital

Question 21

What is a compound option?

Answer 21

Option on an option.

The option holder has the option of committing additional capital

Question 22

What are the return characterestics of VC investments?

What are the risks of VC investments?

Answer 22

Return: They are similar to out-of-the money call options (i.e. manly losses and few instances of large profits), this the retruns are right skewed

Risks:

• Business
• Liquidity
• Lack of diversification

Question 23

What are the 2 keys to successful VC investing?

Answer 23

1. Accessing top-tier VC managers (for persistent returns)
2. Vintage year diversification, VCs tend to follow a cycle of boom and bust, hence the need to diversify across funds with different vintage.

Question 24

What is meant by LBO?

What are the 3 different ways in which LBOs differ from publicly traded equity?

Answer 24

LBO transforms a publicly traded company into a highly leveraged private firm

1. LBOs take control of company. Traditional equity investments are passive
2. LBO’s siginificant leverage
3. LBOs are not publicly traded

Question 25

What are the subcategories of LBOs

Answer 25

1. **MBO**: LBO led by the current management 2. **MBI**: LBO led by outside management team which replaces the current management 3. **Buy-in management buyout**: Combination of new and incumbent managers 4. **Secondary buyout**: PE form selling a privae company to another PE firm

Question 26

What is the average life time of a PE Fund? How many companies does PE funds typically invest in?

Answer 26

10 years with provision to increase it by 1-2 years 10-30 portfolio companies

Question 27

What are the 5 general categories of LBOs and how do they create value?

Answer 27

1. Efficiency buyout: Improve operating inefficiencies 2. Entreprneurship: Focus on innovations 3. Dismantling conglomerates: breakup inefficient conglomerates 4. Buy and build straegies: Opposite of dismantling conglomerates 5. ***Turnaround strategy: pursue poorly managed underperform companies with extremely _high leverage._*** merging with another company is not a typical LBO strategy

Question 28

What are auction and club deals?

Answer 28

They are the result of influx of capital into private equity Auction is among several private equity firms Club deals are several LBO firms working "in clubs' with the same target company

Question 29

What are the 5 LBO funds exit strategies?

Answer 29

1. Sale to strategic buyer: the most common strategy 2. IPO 3. Another LBO 4. Straight refinancing 5. PE firm sells one of its portfolio companies to another buyout firm. One-third of pe deals are buyout to buyout

Question 30

Give 3 reasons why LBO funds are less risky than VC funds?

Answer 30

1. VC funds are subject to significant risks of start up companies 2. LBO firms are less specialized and hence more diversified 3. Exit strategy usng an IPO is more likely to succeed for an LBO because its traget firm was initially public.

Question 31

What are the typical management and incentive fee structure of an LBO firm?

Answer 31

management fee of 1.25% to 3% and incentive fee of 20% to 30%

Question 32

what is mezzanine debt?

Answer 32

Mezzanine debt is an * unsecured, * medium-term, (4-6) years * highly illiquid debt instrument * has lower priority than leveraged loans, * does not involve amortization, * does not require credit ratings to be issued, * and has a fixed coupon rate higher than the coupon rate on senior debt.

Question 33

What is chapter 11 Bankruptcy procedure?

Answer 33

The company files a reorganization plan and seeks approval of the plan from its creditors and the courts.

Question 34

Give the risk spectrum of private equity strategies

Answer 34

The risk spectrum of private equity strategies, from least to most risky, is * mezzanine debt, * distressed debt, * LBOs, and * **venture capital.**

Question 35

What is the general purpose of mezzanine financing?

Answer 35

To fill a gap in company's capital structure

Question 36

What is the the annual compounded return for an LBO?

Answer 36

The rate that equates the compounded initial equity investment to the amount of total cash flow after all debt has been repaid

Question 37

What is compound option?

Answer 37

Like real estate development, venture capital can be described as a compound option (i.e., a string of real options), where the option holder delays committing additional capital until new information is received. The value of the option comes from being able to defer decisions until there is less uncertainty about the investment.

Question 38

What is a story credit?

Answer 38

**A story credit** *_is a private debt issue_* of good credit and senior secured standing that involves a special circumstance (e.g., a corporate reorganization) that has an interesting story to sell it. Story credits are associated with mezzanine debt in that mezzanine debt provides financing for those who fall in between the junk bond market and story credits (i.e., they can do better than junk bonds but cannot issue story credits). *Mezzanine debt is not able to issue story credits.*

Question 39

Relaed to the characteristics of mezzanine debt, what is meant by * Blanket subordination * Spring subordination * Takeout provisions

Answer 39

* Blanket subordination, prevents payment of principal and interest to mezzanine debt investors have been fullh paid off until completely; * Spring subordination: Allows INTEREST payments to ne made to mezzanine debt investors while senior debt is outstanding, but subordination "springs up" to stop such payments in the event that the issuer defaults on the senior debt or a covenant is violated. * Takeout provisions: give md investors the right to purchse the senior debt after after a certain portion of it has been repaid