2: Private Equity

Question 0

Bailey’s criteria for an appropriate investment benchmark

Answer 0

Unambiguous
Investible
Measurable
Specified in advance
Appropriate (for what is being measured)

Question 1

RPVI (residual value to paid in ratio)

Answer 1

Measures how much of investor’s capital is still tied up in the fund.
RPVI = NAV / paid-in capital

Question 2

TOPSCAN framework

Answer 2

Team building
Operations
Perspective
Skill building
Customer development
Analysis
Network

Question 3

Key performance drivers for PE

Answer 3

Selection of fund manager
Management of diversification
Management of capital commitments

Question 4

What are the resources that VCs should assess in terms of their value proposition?

Answer 4

• Brand resources
• Cash resources
• In house expertise
• Network resources

Question 5

Benefits of FoF investing (4)

Answer 5

Diversification and intermediation
Resources and information
Selection skills and expertise
Incentives, oversight and agreements

Question 6

Hurt money

Answer 6

GP’s contribution

Question 7

Type 1 conflict

Answer 7

Conflict between firm’s and client’s interests. Mitigated by aligning interests

Question 8

Type 2 conflict

Answer 8

Firm favors one client to detriment of another. Worse than type 1

Question 9

Steps of PE investment process (6)

Answer 9

Portfolio objectives 
Portfolio design 
Liquidity management (over commit) 
Fund selection 
Monitoring
Actions and implementation

Question 10

Bottom up

Answer 10

Find best manager

Drawback: can result in unbalanced/risky portfolio

Question 11

Top down

Answer 11

Focus on sector or strategy

Drawback: strict allocations may be impractical to attain

Question 12

Advantages of core satellite

Answer 12

Diversification
Customization
Target risks
Focus on satellite portfolios

Question 13

Effects of diversification

Answer 13

Lowers risk, return, skew and kurtosis

20-30 funds diversifies 80% of SD; 5 funds diversify 80% of K

Question 14

Market timing

Answer 14

Predict vintage years that will perform well

Issues: PE markets over react to news

Question 15

Cost averaging

Answer 15

Invest consistently in each fund type each vintage year (ie vintage year diversification)

Question 16

Fund manager selection process

Answer 16

Wish list
Deal sourcing
DD
Decision and commitment

Question 17

Drawback of IIRR

Answer 17

Assumes distributions reinvested at IIRR. Solution is to use modified IRR as it assumes a different investment rate and accounts for cost of capital

Question 18

Drawbacks of paid in ratios

Answer 18

Ignore TVM and requires estimates of NAV

Question 19

Potential actions for poorly performing funds

Answer 19

Do not commit to follow on funds
Negotiate for change
Petition for lower management fees
Threaten action against or terminate managers
Investor default

Question 20

Pro for using NAV

Answer 20

Investors prefer valuation based on current (not future) information

Question 21

Cons for NAV

Answer 21

Private funds cannot be divided up into underlying portfolio companies
Aggregate NAV does not reflect economic value

Question 22

NAV does not reflect economic value. why?

Answer 22

It doesn't account for:
Undrawn commitments 
Value add provided by managers
Future fund expenses 
Capital constraints

Question 23

Shortcomings of CAPM

Answer 23

Assumes the following:
No transaction costs
Fully informed buyers and sellers
Tradable assets 
Markets always in equilibrium

Question 24

4 methods of estimating PE betas

Answer 24

1: Estimation based on quoted comps
2: Relative risk measures
3: bottom up beta
4: beta based on data corrected for staleness and smoothing (not recommended)

Question 25

Why is bottom up beta better than simple regression

Answer 25

1: averaging regression betas reduces noise
2: estimates reflect current fund
3: leveraged betas calculated using current leverage

Drawbacks: difficult to find quoted comps and assumptions needed for future cash flows

Question 26

Sources of funding/liquidity for PE investors

Answer 26

1: follow on funding
2: liquidity lines
3: maturing treasury investments
4: realizations of other investments
5: sell off LP shares
6: distributions from PE fund
7: LP default

Question 27

Estimation (CF projections)

Answer 27

Short term (3-6m)
Based on current market conditions
Data gathering and analysis

Question 28

Forecasting (CF)

Answer 28

Medium term (1-2y)
Based on specific market environment 
Quantitative (ie regression) modeling

Question 29

Scenarios (CF)

Answer 29

Long term (2+yrs)
Based on uncertain market environment

Question 30

Automatic conversion

Answer 30

Pref stock automatically converted (based on trigger price) to common stock at IPO, if IPO price is high enough
Higher automatic conversion hurdles better for investors

Question 31

Bad leaver clause

Answer 31

• enables removal of GP with a simple majority vote (for cause)
• suspends investments until replacement is found
• in extreme situations, fund can be liquidated

Sidey: In contrast to good leaver clauses, bad leaver clauses provide no entitlement to carried interest, but provide a vesting schedule so that part of the carried interest remains available as an incentive for the new manager

Question 33

Good leaver clause

Answer 33

• “without cause” removal; allows LPs with a qualified majority (a vote of more than 75%) to stop funding a partnership
• enables LP to end a failing partnership and is especially important for funds that do not have a track record
• sometimes provide compensation in the form of management fees for a period of time

Question 34

Traditional asset allocation techniques should not be used in private equity markets because:

Answer 34

1. there are issues with private equity data (such as scarcity of data and exposure to survivorship bias),
2. non-normality of private equity data, and
3. the implicit correlation that exists between private equity data and public equity data.