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Subject 5. Private Capital PDF Download

Private equity firms generally buy companies, repair them, enhance them, and sell them on. By definition, these private equity acquisitions and investments are illiquid and are longer term in nature. Consequently, the capital is raised through private partnerships which are managed by entities known as private equity firms.

Private Equity Structure and Fees

A private equity firm is typically made up of limited partners (LPs) and one general partner (GP). The LPs are the outside investors who provide the capital. They are called limited partners in the sense that their liability extends only to the capital they contribute.

GPs are the professional investors who manage the private equity firm and deploy the pool of capital. They are responsible for all parts of the investment cycle including deal sourcing and origination, investment decision-making and transaction structuring, portfolio management (the act of overseeing the investments that they have made) and exit strategies.

The GP charges a management fee based on the LPs' committed capital. Generally, after the LPs have recovered 100% of their invested capital, the remaining proceeds are split between the LPs and the GP with 80% going to LPs and 20% to the GP.

The clawback provision gives the LPs the right to reclaim a portion of the GP's carried interest in the event that losses from later investments cause the GP to withhold too much carried interest.

Private Equity Strategies

Private equity investors have four main investment strategies.

The leveraged buyout (LBO) is a strategy of equity investment whereby a company is acquired from the current shareholders, typically with the use of financial leverage.

A buyout fund seeks companies that are undervalued with high predictable cash flow, low leverage and operating inefficiencies. If it can improve the business, it can sell the company or its parts, or it can pay itself a nice dividend or pay down some company debt to deleverage.

In a management buyout (MBO), the current management team is involved in the acquisition. Not only is a far larger share of executive pay tied to the performance of the business, but top managers may also be required to put a major chunk of their own money into the deal and have an ownership mentality rather than a corporate mentality. Management can focus on getting the company right without having to worry about shareholders.

Venture capital is financing for privately held companies, typically in the form of equity and/or long-term debt. It becomes available when financing from banks and public debt or equity markets is either unavailable or inappropriate.

Venture capital investing is done in many stages from seed through mezzanine. These stages can be characterized by where they occur in the development of the venture itself.

  • Formative-stage financing includes angel investing, seed-stage investing and early stage financing. The capital is used from the idea stage, to product development, and pre-commercial production stage.
  • Later-stage financing is capital provided after commercial manufacturing and sales have begun but before any initial public offering.
  • Mezzanine (bridge) financing is capital provided to prepare for the step of going public and represents the bridge between the expanding company and the IPO.

Growth capital (minority equity investments) earns profits from funding business growth or restructuring.

Distressed investing. A distressed opportunity typically arises when a company, unable to meet all its debts, files for Chapter 11 (reorganization) or Chapter 7 (liquidation) bankruptcy. Investors who understand the true risks and values involved can scoop up these securities or claims at discounted prices, seeing the glow beneath the tarnish.

Exit Strategies

Every private equity investment starts with the end in mind: no fund will support a private equity company without a clear exit plan. Common exit strategies include trade sale, IPO, recapitalization, secondary sales, and write off or liquidation.

Other Considerations

Risk and return:

  • Higher long-term return opportunities than traditional investments.
  • Performance maybe overstated due to various biases.
  • Riskier than common stocks.
  • Can add diversity to a portfolio of traditional investments.

Valuation approaches: market or comparable, discounted cash flow (DCF), and asset based.

Private Debt

Private debt refers to various forms of debt provided by investors to private entities. There are four categories.

Direct lending provides funds to borrowers that lack favorable alternatives to traditional bank lenders. The rates are normally higher, and the number of borrowers is usually very small. A leveraged loan is a type of loan that is extended to companies or individuals that already have considerable amounts of debt or poor credit history.

Mezzanine debt is the middle layer of capital that falls between secured senior debt and equity.

  • junior ranking;
  • unsecured;
  • equity participation.

Mezzanine debt can be used as a financing source for corporate expansion projects, acquisitions, recapitalizations, management buy-outs (MBO) and leveraged buy-outs (LBO).

Venture debt is a type of loan designed specifically for early-stage, high-growth companies with venture capital backing. Instead of collateral, the lenders are compensated with the company's warrants on common equity for the high-risk nature of the debt instruments. The vast majority of venture-backed companies raise venture debt at some point in their lives from specialized banks such as Silicon Valley Bank.

Distressed debt refers to the securities of an issuer which has either defaulted, is under bankruptcy protection, or is in financial distress and moving toward the aforementioned situations in the near future. Why? The greater the level of risk you assume, the higher the potential return. Investors purchase these bonds at a steep discount of their face value in the anticipation that the company will successfully emerge from bankruptcy as a viable enterprise.

Private debt also includes specialized strategies, such as CLOs, unitranche debt, real estate debt, and infrastructure debt.

Investing in private debt is riskier than investing in traditional bonds. It can certainly add diversity to a traditional portfolio because it has less than perfect correlation with those investments.

Learning Outcome Statements

e. explain investment characteristics of private capital;

CFA® 2022 Level I Curriculum, Volume 5, Module 47

User Contributed Comments 1

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Rohule event-driven could be distressed investment?
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I passed! I did not get a chance to tell you before the exam - but your site was excellent. I will definitely take it next year for Level II.
Tamara Schultz

Tamara Schultz

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