Library/CFA (Chartered Financial Analyst)/JuiceNotes 2024: Alternative Investments - CFA Level I/Investments in Private Capital: Equity and Debt

Investments in Private Capital: Equity and Debt

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Private Equity Categories and Characteristics5 min

This section defines the main types of private equity strategies. Leveraged Buyouts (LBOs) focus on established companies and use debt to finance acquisitions. Within LBOs, Management Buyouts (MBOs) involve current management, while Management Buyins (MBIs) bring in new external management. Venture Capital (VC) focuses on early-stage companies, with managers often sitting on boards. Developmental Capital involves minority stakes in growing firms or restructuring efforts, including PIPEs. Distressed Investing targets mature companies in financial trouble, where investors, sometimes called vulture investors, actively help reorganize the company.

Key Points

LBOs use leverage to buy established companies.
MBOs involve existing management; MBIs involve external management.
VC funds invest in early-stage companies and often hold board seats.
Developmental capital is minority equity investing.
Distressed investing targets debt of financially troubled mature companies.

Venture Capital Investment Stages5 min

Venture capital investment occurs in distinct stages. The Formative Stage is the earliest period and includes Angel investing (idea stage, often individual investors), Seed stage (product development/market research), and Early stage (initial commercial production/sales). Following this is the Later Stage, where funds support expansion and marketing. Finally, Mezzanine-stage financing prepares a firm for an Initial Public Offering (IPO), often utilizing debt or preferred stock with equity conversion features.

Key Points

Formative Stage: Angel, Seed, and Early phases.
Angel investing is the 'idea' stage.
Seed stage funds product development.
Early stage funds initial commercial production.
Later stage funds expansion.
Mezzanine financing bridges the gap to an IPO.

Fund Structure, Fees, and Exit Strategies6 min

PE funds are generally Limited Partnerships. Investors provide 'committed capital' which is drawn down over a 3-5 year period. Management fees are calculated based on committed capital, not invested capital. Incentive fees reward performance but are subject to clawback provisions to protect investors from overpayment if future losses occur. Exit strategies are critical for realizing returns and include Trade Sales (strategic buyers), IPOs, Secondary Sales (financial buyers), and Liquidation. Recapitalization is a partial liquidity event but not a full exit.

Key Points

Funds are Limited Partnerships; capital is drawn down over time.
Management fees are based on committed capital.
Clawback provisions require returning incentive fees if total profits underperform.
Trade sales involve strategic buyers; Secondary sales involve financial buyers.
Recapitalization is not a definitive exit.

Valuation, Risk, and Due Diligence5 min

Valuing private equity is challenging. The Market/Comparables approach uses multiples (e.g., EBITDA). The DCF approach uses dividend or free cash flow models. The Asset-based approach looks at liquidation or fair market values. Risks include high leverage sensitivity to interest rates and higher volatility compared to public indices. Due diligence focuses heavily on the General Partner's track record, operating experience, and the specific valuation and fee structures employed.

Key Points

Valuation methods: Market/Comparables, DCF, Asset-based.
PE returns often show higher standard deviation than equity indices.
Correlation with traditional investments is typically low.
Due diligence must account for leverage and manager skill.
Interest rate changes impact LBOs significantly due to leverage.

Questions

Question 1

Which of the following best describes a Management Buyout (MBO)?

Investments in Private Capital: Equity and Debt

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