Is it just me or the answer below is incorrect regarding Carried interest for 2008? In 2008, the carried interest is shown as 46.3 but i could not derive that figure from my own calculation: carried interest = 0.25 (NAV after distribution 2007 + additional capital draw down in 2008 + operating result 2008 - management fee 2008 - total committed capital) = 0.25*(714.8 - 500) = 53.7 ! How come the answer got 46.3 ?? Zolan Athos and Katie Brie co-manage one of the funds of The Ceskel Group, a large private equity firm based in Canada. The fund, established in 2004, has total assets of $500 million and invests primarily in real estate firms ranging from new ventures to leveraged buyouts of larger, established companies. The fund will reopen to outside investors next year and is looking to raise an additional $250 million to make strategic investments over the next two years, after which the fund will be closed to new capital. In one of the meetings with potential investors, Athos and Brie discuss their recommendations for investment and acquisition opportunities. When questioned by an investor on exit strategies and terminal value projections, Brie makes the following statements:
Statement 1:
One possible exit route is through an IPO. An IPO generally offers a higher potential exit value than a management buyout or liquidation.
Statement 2:
We favor IPOs since they are appropriate for firms of any size, regardless of their growth prospects or lack of operating history.
Athos adds the following comments on terminal value projections:
Statement 3:
For venture capital projects, estimating terminal value with certainty is difficult given the relatively young age of these firms. To calculate the investor’s future wealth, however, one valuation technique is the IRR method.
Statement 4:
To project the terminal value for leveraged buyout (LBO) investments, we often use the free cash flow method or sales or earnings multiples approach.
Following their meeting with the investors, Athos and Brie meet privately to assess the fund’s recent performance. Athos and Brie charge 1.5% to manage the fund, and carried interest of 25% is paid based on the total return method using committed capital. The fund’s investors committed to a total of 500 million in capital over ten years. A scaled-down version of the firm’s statistics for the last five years is given in the following table (in millions):
Capital Operatin Mgt Fee NAV Before dis Carried distribution NAV after dis.
Call down results interest
2004 200 -40 3.0 157 0 0 157
2005 100 -70 4.5 182.5 0 0 182.5
2006 100 100 6 376.5 0 70 306.5
2007 50 180 6.8 529.8 7.4 100 422.3
2008 50 250 7.5 714.8 46.3 150 518.5
Finally Athos and Brie discuss two potential acquisition targets. The first is a venture capital firm with a projected discount rate of 20%. Athos and Brie, however, believe that this projection is highly optimistic given current market conditions, and speculate that in any given year there is a 30% chance of company failure. The second acquisition would be an investment in a leveraged buyout company. The company’s asset beta is estimated at 0.90 and the company uses 1/3 debt and 2/3 equity financing.
With regard to Statement 1 and 2, respectively, on an exit strategy through an IPO, Brie is:
Statement 1
Statement 2
A)
Incorrect
Correct
B)
Incorrect
Incorrect
C)
Correct
Incorrect
Your answer: C was correct!
An IPO traditionally offers the highest exit value due to higher liquidity and better access to capital. IPOs, however, are generally quite costly to implement and less flexible, and are most appropriate for firms with a high growth potential and considerable operating history. (Study Session 13, LOS 47.e)
With regard to Statement 3 and 4 on terminal value projections of the venture capital and LBO investments, respectively, Athos is:
A)
incorrect on Statement 3 since the IRR method is useful in obtaining present value projections but cannot be used as a tool to compute the future expected wealth of a venture capital investor.
B)
incorrect on Statement 4 since the free cash flow method and the sales or earnings multiples are not useful for investments financed to a large extent by debt.
C)
correct on both statements.
Your answer: C was correct!
Statement 3 is correct. One way to visualize the IRR method is to think of the venture capital method using NPV in reverse. With the IRR method, the investor’s present investment is compounded at the IRR rate over t (number of years to exit) to arrive at the investor’s expected future wealth.
Statement 4 is also correct. Private equity firms frequently use the free cash flow or a sales or earnings multiple approach to project terminal values. Debt (both junior and senior) is factored into these calculations.
Based on information in the table above, management fees and carried interest, respectively, in 2007 will be closest to (in $ millions):
Management Fee
Carried Interest
A)
$0.75
$8.90
B)
$6.80
$7.45
C)
$3.50
$8.30
Your answer: A was incorrect. The correct answer was B) $6.80 $7.45
For answers to questions 3-5, refer to the following table: