Library/CFA (Chartered Financial Analyst)/Alternative Investments — CFA Program Curriculum (Level I, Volume 8, 2026)/Learning Module 3 Investments in Private Capital: Equity and Debt

Learning Module 3 Investments in Private Capital: Equity and Debt

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Overview and definitions5 min

Private capital is financing provided outside public markets and comprises private equity and private debt. Private equity strategies include venture capital (pre-seed to later-stage financing, convertible preferred, convertible debt), growth equity (minority investments in mature firms), and leveraged buyouts (LBOs) where debt finance becomes part of the target's capital structure. LBOs can be management buyouts (MBO) or management buy-ins (MBI). Private equity funds typically deploy capital over a 5-year investment period and harvest over a longer fund life; the fund's vintage year is important for realized returns. Exit strategies for private equity include trade sales (to strategic buyers), public listings (IPOs, direct listings), SPAC mergers, recapitalizations, secondary sales to other sponsors, and write-offs/liquidations. Trade sales offer speed and synergies; IPOs can deliver highest prices but with costs, disclosure, and market volatility; SPACs offer valuation pre-agreement and speed but potential dilution and regulatory attention. Private equity returns derive from ownership control, operational improvement, and leverage. Valuation is complex: Level 1-3 hierarchy applies; many private assets are Level 3 (unobservable inputs) and require independent model validation to reduce conflicts. Performance measures: IRR (time-sensitive, uses financing and reinvestment rate assumptions) and MOIC (money multiple, ignores timing). Leverage magnifies gains and losses; leveraged return rL = r + (Vb/Vc)(r - rb). Private debt includes direct lending, mezzanine, venture debt, distressed and unitranche loans. Venture debt complements equity in early companies, often with warrants. Mezzanine sits junior to senior debt and may include equity kickers. Distressed debt involves DIP financing and restructuring. Private debt often pays higher yields but carries illiquidity and credit risks. Fees in private capital often include management and performance/incentive fees; structures may have hurdles (soft/hard), catch-ups, and high-water marks, affecting investor returns. Fee calculation order matters (independent vs net-of-management), and clawbacks can require returning previously accrued incentive fees if later losses occur. Fund structures vary: open-end REITs/public funds for real estate vs closed-end private funds; funds-of-funds provide diversified access but introduce double fees. Hedge funds, infrastructure, real assets, commodities and natural resources have different roles in a diversified portfolio. Private capital offers moderate diversification benefits when combined with public stocks and bonds, but correlations vary by sub-asset and vintage. Common risks include illiquidity, valuation opacity, concentration, leverage, manager conflicts, fees, and timing/vintage risk. Investors should pursue vintage diversification, require transparent valuation/fee terms, and conduct due diligence on governance, alignment, and cash-flow timing to appropriately price and hold private capital investments.

Key Points

Private capital comprises private equity and private debt; vintage year matters.
Private equity strategies: VC, growth, LBO; exits: trade sale, IPO, SPAC, recap, secondary.
Private debt strategies: direct lending, mezzanine, venture debt, distressed, unitranche.
Valuation uses Level 1-3 hierarchy; Level 3 assets require independent model testing.
Performance metrics: IRR (timing sensitive) and MOIC (ignores timing).
Fees can be complex: management, performance, hurdles, catch-up, high-water marks, clawbacks.
Leverage magnifies returns and losses; careful monitoring is needed.
Vintage diversification reduces timing risk; do due diligence on governance and valuation.

Private equity specifics: stages, exits, and returns5 min

Private equity invests across the corporate life cycle: seed, start-up, growth, maturity, and decline. Venture capital covers pre-seed, seed, early, later, and mezzanine stages and uses convertible preferred, convertible debt, and common equity. Growth equity takes minority stakes in mature companies. LBOs buy controlling stakes, often using significant debt; management buyouts and buy-ins are variations. Exit routes include trade sales (to strategic buyers with potential synergies), IPOs (highest potential price but costly and volatile), SPACs (speed and fixed valuation but dilution and regulatory risk), recapitalizations (partial exits via dividend recap), secondary sales, and write-offs. Returns stem from operational improvements, strategic changes, and leverage. Measuring returns uses IRR (sensitive to cash flow timing and reinvestment assumptions) and MOIC (money multiple). MOIC is simple but ignores timing; IRR requires reinvestment and finance-rate assumptions. Equity ownership provides control and potential for outsized returns but raises illiquidity and valuation challenges. Private equity funds commonly have a 10-12 year lifespan with a 5-year investment period and 5-7 year harvesting period. Fees and carry structures (20% typical carry) and waterfall styles (deal-by-deal vs whole-of-fund) change LP/GP outcomes. Selection bias in reported returns and mark-to-model valuation smoothing can overstate performance if not adjusted.

Key Points

VC stages vary from pre-seed to later-stage; instruments include convertible preferred and debt.
LBOs rely on leverage and operational change; MBO and MBI are governance variants.
Exit choice impacts timing and proceeds: trade sale, IPO, SPAC, recap, secondary, liquidation.
IRR vs MOIC tradeoff: timing sensitivity versus simplicity.
Fund lifecycles and vintage-year timing significantly affect returns.
Fees, carry and waterfall design materially change investor net returns.

Private debt specifics and debt structures5 min

Private debt includes direct lending (senior secured loans, leveraged loans), mezzanine debt (junior to senior secured debt, often with warrants/conversion features), venture debt (loan-like financing for early-stage firms often with warrants), distressed debt (DIP financing, restructuring, buying credit at distress), unitranche (blended single-credit facility combining senior and subordinated tranches), and specialized loans (litigation finance). Risk/return varies: senior direct lending is lowest risk among private debt, mezzanine is higher return/higher risk; distressed and venture debt are higher risk. Debt investors earn interest (spread over reference rates like LIBOR or SOFR) and principal. Private debt is illiquid and requires specialized due diligence on covenants, collateral, recovery expectations, and borrower stage. Financing terms, covenant protections, LTV ratios in real-estate lending, and amortization schedules play critical roles in risk management. DIP financing supports companies in bankruptcy and is typically high-priced but senior and protective. Asset-backed debt and mortgage securitization (CMBS, MBS) are alternate financing routes.

Key Points

Direct lending, mezzanine, venture debt, distressed, and unitranche are core private debt types.
Interest often quoted as reference rate plus spread; covenants and collateral determine risk.
Distressed and DIP financing can offer high returns but require restructuring expertise.
Recovery, LTV, and debt ranking are central to loss estimation and risk management.

Fees, incentive structures and fee calculations5 min

Fee structures in private capital include management fees (percent of AUM) and performance/incentive fees (carried interest). Variations include founders shares, either/or fees (choose management or incentive), hurdle rates (soft vs hard), catch-up provisions, high-water marks, gates, lockups, notice periods, redemption fees, and clawbacks. Fee calculation sequence matters: incentive fee calculated independently or net of management fee changes GP payout and investor net returns. Hard hurdle only pays carry on returns above hurdle; soft hurdle pays carry on all returns if hurdle surpassed. Catch-ups allow GP to capture a portion of returns until a contractual share is reached. High-water marks ensure GPs only earn performance fees above prior peaks. Clawbacks require GPs to repay previously accrued fees if subsequent losses eliminate earned profit. Examples illustrate that fee ordering and hurdle/high-water mark choice can change investor returns by meaningful percentage points.

Key Points

Common fee structures: management fee plus carried interest; typical 2% and 20% but negotiable.
Hurdles, catch-ups and high-water marks materially affect the allocation of returns.
Clawbacks protect LPs over the fund life, requiring GP repayment if net profits fall.
Fee calc order (independent vs net-of-management) changes investor net return.

Valuation and reporting challenges5 min

Alternative assets often lack tradeable market prices and rely on fair-value estimates. The fair-value hierarchy defines Level 1 (quoted prices), Level 2 (observable inputs), and Level 3 (unobservable inputs). Many private equity, real estate, and longer-lived assets are Level 3 and valued using discounted cash flows, comparables, or models with manager assumptions. Level 3 valuations require benchmark testing, independent review, and consistent governance because of concerns about smoothing, overstating returns, and understatement of volatility. Interim accounting marks can produce illusory stability and mask true correlations. Investors should demand independent valuation policies, clear model assumptions, sensitivity analysis, and transparency to mitigate the risk of optimistic or self-serving valuations.

Key Points

Use the fair value Level 1-3 framework; Level 3 requires robust model governance.
Interim marks can smooth volatility; demand independent testing and transparent methods.
Illiquid assets may anchor to cost until realized; this can misrepresent current risk/return.

Diversification and portfolio implications5 min

Private capital can diversify portfolios: private equity historically shows higher expected returns with more risk and lower correlation to public markets (but correlations vary and depend on vintage, marking and liquidity). Private debt provides higher yields than public fixed income but less liquidity. Investors should consider vintage diversification to mitigate timing risk across fund lives. Allocation decisions should reflect liquidity needs, expected holding periods, and governance. Fees reduce net returns; funds of funds can lower due-diligence burdens but add fee layers. Illiquid private investments can reduce apparent volatility in appraisal-based indexes; investors should stress-test portfolios for liquidity events when valuations move sharply and when forced sales can lock in losses. Private capital complements public stocks and bonds but requires operational expertise and appropriate governance and side-letter terms to align manager-investor incentives.

Key Points

Private capital adds diversification but requires vintage-year diversification.
Fee layering (e.g., funds-of-funds) reduces net returns though improves access.
Liquidity mismatches can lead to forced sales and realized losses under stress.

Questions

Question 1

Which of the following best describes 'private capital' as used in this chapter?

Learning Module 3 Investments in Private Capital: Equity and Debt

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