Private Equity

CFA Level III
#1

How detail we need to know the private equity for L3?

I understand all the termminologies here but if get the question like

To support the initial marketing, it’s belong to start-up or first-stage financing I may have no idea…

Please advise.

#2

Not sure, but I suspect if they do ask a question on PE, it’ll be more to do with diversification benefits to the portfolio, the liquidity (or lack of), the time frame for investment, a minimum investment is typically large and not suitable for a individual with a ‘small’ investable asset base and a fee structure with a high water mark.

#3

I thought it’s L2 question? What’s additional information we need to learn vs. L2?

#4

You need to distinguish between PE and VC in terms of characterstics (Investment vehichles, benchmarks, Biases, diversfication effect, Liquidity, risk/return profile versus 50% Bond 50% Equity) requires long-term commitment and lack of liquidity…

You need to Explain the typical structure of a private equity fund, including the compensation to the fund’s sponsor (general partner) and typical timelines

Discuss the issues that must be addressed in formulating a private equity investment strategy (What you need to do before investing in PE)?

#5

^ Thanks! That’s L3!

#6

Hope my answer is correct.

You need to distinguish between PE and VC in terms of characterstics (Investment vehichles, benchmarks, Biases, diversfication effect, Liquidity, risk/return profile versus 50% Bond 50% Equity) requires long-term commitment and lack of liquidity…

PE Investment Characteristics

· Illiquidity

· Long-term commitments

· Higher risk than seasoned public equity investment

· High expected IRR required

Roles in the Portfolio

· Diversification

· Yield Enhancement

VC

· Private, nonexchange-traded equity investments.

· Through limited partnerships.

· Due to illiquidity and high risk, relatively high returns are expected.

· Private company eventually converts into publicly owned company.

· Have Capacity issues i.e. limited investment opportunities

· Requires distinct knowledge and experience

Buyout

· Publicly owned company is converted into private.

· Buyout funds constitute a large portion of private equity fund relative to VC funds in terms of AUM or size of capital commitments.

Benchmark

i. Cambridge association and Thomson Venture Economics

ii. Custom benchmarks

Biases: Infrequent pricing process creates problems for index construction as a result of stale values.

You need to Explain the typical structure of a private equity fund, including the compensation to the fund’s sponsor (general partner) and typical timelines

Structure

Direct Investment

· Structured as convertible preferred stock rather than common stock.

· Preferred stock is senior to common stocks both in terms of its profit share and liquidation value.

· Shares issued in later rounds of financing are senior to previously issued preferred stocks (all else constant).

· Events i.e. buyouts or acquisition of the common equity at a favorable price triggers the conversion of preferred stocks into common stocks.

Indirect Investment:

· Structured as limited partnerships or limited liability companies (LLCs).

· Have an expected life of 7-10 years with 1-5 years extension option.

· Commitment/offering period defines how committed funds will be requested over time.

· Investment in private equity is mostly done via private equity funds.

Compensation of the Fund Manager:

Management fee + Incentive fee

· Management fee is usually a % of committed funds(not the amount actually invested). It ranges 1.5 –2.5% and decreases over a period of time to reflect lower work load in later years of partnership.

· Incentive fee (a.k.a carried interest): It is the share of the private equity fund’s profit earned by manager after the fund has returned the outside investor’s capital (i.e.profits that represent a return >hurdle rate or preferred rate). It is expressed as % of total profits of a fund i.e. 20%.

Discuss the issues that must be addressed in formulating a private equity investment strategy (What you need to do before investing in PE)?

  1. Evaluation of prospects for market success (Market, management capabilities…)

  2. Operational Review (Infrastructure)

  3. Financial/ legal review (Financial statement, potential for dilution of interested…)