Private Equity Summary PDF

Summary Private Equity Session 1 -- Introduction ========================= Ein Bild, das Text, Screenshot, Schrift enthält. Automatisch generierte Beschreibung What is private equity ---------------------- - Investors are really involved - Often buy assets to help a company to grow -\> vent...

Summary Private Equity Session 1 -- Introduction ========================= Ein Bild, das Text, Screenshot, Schrift enthält. Automatisch generierte Beschreibung What is private equity ---------------------- - Investors are really involved - Often buy assets to help a company to grow -\> venture capital - Bigger risk than listed investments -\> bigger return  Growth of private assets under management ----------------------------------------- Grwoth was constantly pushed and especially in 2021/22/... because the stock market overall didn't perform very well. So alternative investments got intresting. In PE there is still potenzial to grow. PE is correlated with public markets, because it's still equity! Interest rates are important, because they influence the cost of financincing for PE firm and the valuation of the potential investment. - Low intrest rates are good for private equity investors, because the financing costs decrease. But because of the low discount rate for the valuation of a potential investment, the target companies are more costly. - High intrest rates are bad for private equity investors, because the financing costs increase. But the higher discount rate for the valuation of a potential company is reduced. - In General: low interest rates benefit PE firm by lowering financing costs, boosting valuations and enhancing exit opportunities. Ein Bild, das Text, Diagramm, Reihe, Schrift enthält. Automatisch generierte Beschreibung  Ein Bild, das Text, Schrift, Diagramm, Reihe enthält. Automatisch generierte Beschreibung Private markets --------------- Often «private equity» is used as an umbrella term for private markets. Private markets firms do: - Private equity (venture capital, growth equity, buyout)s - Private dept (Leveraged loans, mezzanine dept, distressed dept) - Real assets (Real estates, commodities, infrastructure,...)\ This are often investments in more risky projects (ex. Wind park development,...)  Current mood ------------ Ein Bild, das Text, Diagramm, Reihe, Screenshot enthält. Automatisch generierte Beschreibung PE investors ------------  Private equity definitions -------------------------- Ein Bild, das Text, Schrift, Screenshot, Zahl enthält. Automatisch generierte Beschreibung Private dept definitions ------------------------ - **Leveraged loans**: very risky loans for firms with a low credit rating. Therefore they pay high interest rates for a high return. This loans are created to provide capital to finance an acquisition, refinancing or to provide working capital. - **Mezzanine dept**: contains equity-like and dept-like features. - **Distressed dept**: purchasing the dept of troubled companies. This companies have already defaulted on their dept or are seeking bankruptcy protection. Requires a long-term horizon of the PE investor. Venture capital (VC) -------------------- - For fancy new ideas - Risky, illiquid, backed by unproven ideas. Normally banks or others are unwilling to provide venture capital because its too risky. Investments in firms that are in an early growth stage. The are attempting to grow into large firms but haven't yet established substantial revenues (-\> mostly start-ups). Cash flows are expected to be negative for several years. Venture capitalists invest their own capital and the capital of their investors. - Are active investors -\> as advisor, director of the board,... - Establish financial goals, implement incentive plans,... - Provide access to consultants, accountants, lawyers, investment bankers,... - Usually have the right to hire and fire key managers **VC Securities and goals used** Securities: - Private held stock - Preferred stock (stocks with special terms) - Equity linked securities VC investors must be prepared to invest for the long run investment horizon (5-10 years). They mostly have the goal, to exit by going public with a high multiple of the invested capital. **Investment structures:** - Convertible preferred equity -\> to provide higher priority than common stock for the VC investor. - Convertible notes -\> allow conversion upon a occurrence of an event - Debentures - Warrants -\> stock rights for the VC investors **Option-like payout of VC** - Investing in a start-up company is similar to purchase a call option. - **Stages of VC investing**  **Angel investing**: - is the earliest stage in VC. - The investors often are friends and families (and fools) or wealthy individuals that invest in start ups. - At this stage there is no business plan, management, production,... - The investment is mostly very informal (no placement memorandum, subscription agreement,...) - Typically rather small investments from \$50'000 -- 500'000 - Money is used to flash out a business plan with which new investors can be catched **Seed capital:** - First stage where institutional investors come in - Business plan is completed and presented - Financing is provided to complete the product development and begin initial marketing - Prototype is produced and sent to potential customers (beta testing) - Typically investments from \$1 Mio -- 5 Mio - Very little if any revenue has been generated **Early stage = first-stage = start-up stage** - Now the start-up has a viable product that has been tests, but the commercial viability is not yet established. - Used to built commercial scale manufacturing services. A management team is established. - Typically investment from \$2 Mio - Started generating revenue. - Goal is to achieve market penetration. Additional distribution channels. Reaching break even point **Late stage = expansion = second stage** - When first profitable quarter is reached. Company and its products are demonstrating commercial viability. - Company cannot yet sustain its own growth with the operating cash flow. - Receivable will be collected to establish a self-sustaining force. **Mezzanine venture capital = IPO-financing (not always!)** - Is the last stage before a start-up goes public (via IPO) or is sold to a strategic buyer (via buyout). - A second-generation product should be produced - Mezzanine financing should keep the company from running out of cash until the strategic sale. - Company has an established track record. ### Valuation of VC - Valuation of VC is very challenging, because the estimation of future CF is verry uncertain. There are numerous methods to estimate realistic CF. - A popular expression is enterprise value = total value of the company = total equity value + outstanding dept -- cash on the balance sheet.\ The enterprise value does not include the asset valuation. - VC assets are commonly valued based on EBITDA and EBITDA multiple. - Popular method of modeling is to discount the estimated future enterprise value with a quite high required rate of return. - Target is a high IRR **Calculation of VC** Ein Bild, das Text, Schrift, weiß, Screenshot enthält. Automatisch generierte Beschreibung IRR = investors required rate of return T = number of years estimated before exit  **Compound option** - is the right but no obligation to pay additional money at some point int the future. This can be viewed like buying a call option. - The options expiration date is the point, when either additional capital has to be invested or the project is abandonded or sold. - Keys for successful VC investing can be explained by the compounded option: - Identifying underpriced option by locating potentially valuable projects for which substantial information regarding likely profitability can be obtained prior to commitment of substantial capital - Abandoning worthless out-of-money options when they are expiring by ignoring sunk costs and judiciously assessing likely outcomes for success based on the objective analysis of new information **Growth equity = growth capital = expansion capital** - Are investments after the VC stage and prior the buyout or IPO. It's the final financing before the exit via IPO. - There is no clear differentiation between financing for the later stages of VC and growth equity. The following stages in VC (expansion stage, late stage, mezzanine stage,...) can overlap with growth equity. - **Calculation of growth equity value**  Annual revenue = estimates sales revenues T = years Revenue multiple = EV/R anticipated at time T Ein Bild, das Text, Screenshot, Schrift enthält. Automatisch generierte Beschreibung Leveraged Buyouts (LBOs) ------------------------ LBO distinguished from traditional investments by: 1. LBO buys control of the assets or the firm 2. LBO uses substantial leverage 3. Resulting leveraged firm is not immediately publicly traded - When a firm gets completely delisted from the stock exchange its called "public-to-private (P2P)" - Control of the new company is in the hands of the buyout firm. Usually there are no public shares left outstanding. - Suitable for established firms with tangible assets. They are normally not cash-burning, which allows the use of dept to finance a part of the transaction -\> leveraged buyouts - Goal is to unlock hidden value by: - Maximizing the borrowing capacity of a company's balance sheet - Taking advantage of the tax benefits of using dept financing - Exploiting existing but underfunded opportunities **Types of LBOs** - Management buy-in (MBI): new management teams take control of the new company. Old management leaves. - Management buyout (MBO): current management buys the company - Buy-in management buyout: combination of MBI and MBO. New management teams is a combination of old and new managers (is mostly the case) - Secondary buyout (SBO): ownership change among private equity firm. PE firm sells to another PE firm. **Mechanics and Valuation of LBOs**  +-----------------------------------+-----------------------------------+ | Operational value drivers | Multiple expansion | | | | | Ein Bild, das Text, Screenshot, |  | | | | | | Reasons for multiple expansion: | | | | | | - - - | +-----------------------------------+-----------------------------------+ Ein Bild, das Text, Screenshot, Zahl, Schrift enthält. Automatisch generierte Beschreibung **Valuation creation in LBOs** - Efficiency buyouts - Entrepreneurship stimulators - Overstuffed corporation - Buy-and-build strategy - Turnaround strategy  Ein Bild, das Text, Screenshot, Diagramm, Schrift enthält. Automatisch generierte Beschreibung ### M&A Process - The exit in PE is always more difficult than the investment in PE. - there are two possibilities for a M&A process: - Dual Track: simultaneous preparation of possible initial public offering (IPO) and a possible private sale (M&A Track) - Trippe Track: simultaneous preparation of possible initial public offering (IPO) and a possible private sale (M&A Track) as well as a possible refinancing (Refinancing-Track)  Tripple Tack Ein Bild, das Text, Screenshot, Schrift enthält. Automatisch generierte Beschreibung Reading notes: CAIA chapter 20 -- private equity assets ------------------------------------------------------- ### PE terms and background The term private equity is sometimes also used including private credit/dept. PE is a long term investment process. It requires: - Patience - Due diligence - Hands-on monitoring PE provides the capital investment and working capital that are used to held private companies to grow and succeed. Risks are great but potential revenues are even greater. There are three types of assets underlying PE: - Venture capital (VC) -\> nascent, start-up companies - Growth equity -\> companies that are too large and established to be considered VC but too small to be publicly traded for buyouts - Buyouts -\> established, mature companies **Private securities** Are legally considered as fixed-income securities. The risk characteristics resemble the risk exposure of equity positions. - Mezzanine dept:\ Contains equity-like and debt-like features. It appears as dept on the issuers balance sheet. Is typically constructed as an intermediate-term bond. Includes an equity kicker that allows to participate in some type of equity in the firm. - Distressed dept:\ purchasing the dept of troubled companies that may have already defaulted. The investor is taking a substantial risk, which requires special expertise. The investor needs the ability to accept the lack of liquidity. Often there is no trading market. - Leveraged loans:\ Are issued by firms with substantial dept. Typically leveraged loans have high intrest rates and low credit ratings (also under investment grade). They should provide the borrower with capital to finance an acquisition, refinancing or as working capital. ### 3 Forms of pre-IPO PE investing It's a key investment strategy to invest in firm that grow into publicly traded corporations. - Venture capital to initial public offering:\ early financing for young firm with high potential growth that do not have sufficient track record to attract capital from traditional sources (like public market or lending institutions). VC of \$5 Mio, Company value \$10 -\$100 Mio - Growth equity to IPO\ Investment of \$25 Mio, company value \$25 - \$50 Mio. - Buyout to IPO\ often also buying a public company and taking it private. **8 major distinctions**  ### Venture Capital (VC) VC focuses on equity or equity like claims of firms that are in an early stage of growth. They are attempting to grow into large firms but have not yet established substantial and reliable revenues. VC financing is through their own capital and capital of their investors. They take an active role through advisory, board member,... they monitor the progress and implement incentive plans to establish financial goals. They often have the right to hire and fire key managers including the original entrepreneur. CF from VC investments are typically expected to be negative for several years. Traditional investors are not willing to invest in a company, that will not provide any positive CF in the short run. VC is risky, illiquid and backed by unproven ideas. **Securities and goals in VC** VC securities are the privately held stock, preferred stock or equity-linked securities. They are striving to become larger and to go public. The investment horizon is around 5 -- 10 years. VC exits are typically focusing on going public. VC investments can be very successful (Google, Microsoft, Genentech,...). But VC investments can be difficult to assess. The view big wins, which gains a multiple of the invested capital, need to compensate for many failures. The investment structure of VC capitalists mostly includes: - Convertible preferred equity (they provide higher priority than common stocks) - Convertible notes - Debentures that provide for the conversion of the principal amount - Option of VC (warrants) Investing in a start-up company is similar to the purchase of a call option. The price of the option is the capital that the venture capitalist invests in the start-up company. If the company fails, the venture capitalist forfeits the option premium. However if the start-up is successful the VC shares in all of the upside, like a call option. **Stages of VC** A key characteristic of VC investing is the stage of the financing. - [Angel investing]:\ Is the earliest stage in VC where the first cash is funded of an entrepreneurial idea. They often come from F&F (Friends and Family). And wealthy individuals who invest in start-ups. There is no formal business plan, management team,... there is just the idea of the entrepreneur. Smaller investment are made (\$50'000 -- \$500'000) which are used to develop a prototype, assess market potential, etc. - [Seed capital stage]:\ Typically the first stage where institutional investors commit their capital. A business plan is completed and presented. Prototype is developed and testing begins by sending it to potential customers for free (beta testing). Raises \$1 Mio - \$5 Mio). - [First-stage, start-up stage, early-stage of VC]:\ When the firm has a viable product that can be sold but the commercial viability has not been established. Is used to build out commercial-scale manufacturing. Goal is to achieve market penetration, and a break-even point. Investments from \$2 Mio. - [Second or later stages of VC]:\ Begins when the start-up has generated his first profits and commercial viability is reached. The operating CF also doesn't sustain its own growth yet. - [Mezzanine VC]:\ last funding stage before a company goes public or is sold to a strategic buyer. This financing keeps the company from running out of cash until the IPO. At this stage, the company has an established track record. **J-Curve for PE Projects** Ein Bild, das Text, Diagramm, Reihe, Schrift enthält. Automatisch generierte Beschreibung **Valuation of VC companies** Valuation of VC is challenging because the estimation of future CF are highly uncertain. A popular expression of VC worth is the enterprise value. The enterprise value is the total value of a company which adds the equity value to its outstanding debt minus the cash on the balance sheet. Assets are commonly valued based on EBITDA and EBITDA-multiples. A method of modeling the (unknown) future value ist to discount the projected enterprise value wiht a very high required rate of return.  The most important document for VC investors to decide if they want to invest or not is the business plan of the entrepreneur. The business plan should cover: - Clearly state the business strategy - Identify the niche - Describing the needed resources (personnel and assets) - Must be comprehensive, coherent and internally consistent. **VC as compound option** A compound option is an option on an option. It allows its owner the right but not the obligation to pay additional money at some point in the future to obtain an option. Money invested in different stages of a VC can be viewed as purchase of a call option investing in the next stage of the venture. It is the ability to defer investment decisions until uncertainty has diminished that gives these options their primary value, not the time value of money. Keys to successful VC investing: - Identifying underpriced options - Abandoning worthless out-of-money options when they are expiring by ignoring sunk costs Growth equity ------------- Growth equity overlaps with late VC stages. Growth equity investments occur after the VC firm has established. It is after the VC stage and prior to a buyout or IPO. In growth equity investments the investors normally do not involve in the ongoing management. Qualitative characteristics of growth equity are: - Growth equity securities: have a minority position in terms of control but a relatively high position in terms of liquidation -\> convertible preferred equity or dept - Source of growth: increase of the value comes from growth in the firm revenue and profitability. In VC investments the value increase comes from the increased probability of a successful launch. - Cashflow: They have no or little interest payments and moderate inflow from revenues Growth equity investors should require a notification and consent about major changes like derivation from the budget, changes in business plans, key transactions,... **Redemption rights as key deal characteristic** Redemption rights grand powers to the investors to redeem their position in the company by specifying the triggers and actions that demark the remedies available to the investors. Principal considerations in redemption rights: - Redemption triggers: Time, performance and violations of convenants. - Redemption value: When the redemption is triggered, the investor has a right to the prenegotiated redemption value. - Sources of funds: investors often obtain contractual requirememts of the efforts - Default remedies: include springing board remedies and forced sales **Valuation of Growth equity** Similar to VC valuations, most of the value emanates from the uncertain potential for large growth and a favorable exit. The "Times revenue method" values an enterprise as the product of its projected annual revenue and a multiple derived from analysis of the value of similar firms. Buyouts and leveraged buyouts ----------------------------- Buyout is a generic term that denotes a change of ownership. The capital (dept and equity) is used to acquire an entire existing company from its current shareholders and to operate the company as an independent organization (opposed to an acquisition). The distinction between buyouts can be made on the purpose of the buyout and the management team that will operate the target firm. Buyouts are often executed in lieu of an IPO exit. **Types of PE buyouts and resulting management** - Management buy-in (MBI): Buyout is led by an outside management team. Control of the new company is taken over by the new (outside) management team. The old management team leaves. - Manegement buyout (MBO): when the current management acquires the company. - Buy-in management buyout: hybrid between an MBI and MBO. New management team is a combination of new managers and incumbent managers. Secondary buyouts (SBO) is when a PE firm sells a private company to another PE firm. Its an ownership change among PE firms. **PE strategies base on their purpose** This strategies do not realy fit into the ones above. - Rescue capital (turnaround capital) - Replacement capital (secondary purchase capital) ### Buyouts of private companies Buyouts are distinguished from mergers by the extent to which the firm that is bought out is intended to function as a stand-alone business rather than to fold into the organization of the purchaser. **Buyout objectives** - IRR target of buyouts are lower than in VC, but still quite high. - Its an alternative from an IPO - Buyouts must have a value-creating purpose - Capital structure optimization - Operational efficiency optimization ### Leveraged buyouts (LBO) A buyout is described as an LBO when after the buyout the dept-to-equity ratio is much greater than before the acquisition. LBOs are distinguishd from traditional investments by three aspects: - LBO buys out control of the assets or the firm - LBO uses substantial leverage - The resulting leveraged firm is not immediately publicly traded LBOs distinguish from M&A because they fold the structure and operations of the target firm into to acquiring firm. Public-to-private (P2P): when a public company is bought entirely and delisted from the stock exchange. LBOs have leverage possibilities, when a company has dept potential. Having more dept can also have tax benefits. **Key economic and agency issues of buyouts** - Are buyout markets segmented and informationally inefficient?\ Segmentation can lead to informational market inefficiency - Are management buyouts a violation of fiduciary duties?\ conflict of interest between the shareholder and managers - Are managers perversely incentivized with regard to management buyins?\ The outcome of a manager of a MBI can vary tremendously depending on the compensation he will get upon their departure. **General category of LBOs that create value** - Efficiency buyouts\ LBOs to improve operating efficiency. - Entrepreneurship stimulators\ help to concentrate on innovations - Overstuffed corporation\ LBO is used to dismantle inefficient conglomerates and shut down inefficient operations - Buy-and-build strategy\ different companies aligned with the initial LBO are acquired in a portfolio of the investor. - Turnaround strategy Benefits of a LBO to targets - Use of leverage where interest payments are tax deductible - Less secutiny form public equity investors and regulators - Freedom from a distracted (and potentially distracting) corporate parent - Potential of company management to become substantial equity holders and thereby benefit directly from building the business **Valuation of an LBO** Look page 661 -- 662 **LBO exit strategies** The following strategies can be applied, when the estimated value is exited. They can also be combined. - Sale to a strategic buyer - Initial public offering (IPO) - Another LBO\ refinanced by the current owners using another LBO deal in which new dept is reintroduced. - Straight refinancing\ taking on new dept - Buyout-to-buyout deal\ =secondary buyouts Merchant banking ---------------- Is the practice whereby financial institutions purchase nonfinancial companies to merge them or acquire other financial institutions. They buy and sell nonfinancial companies for the profits they can generate. Dynamics of PE opportunities (in VC and growth equity) ------------------------------------------------------ - Winner-take-all market:\ tendency that only a few market participants are rewarded with massive profits with only a marginally better product or service than the competitors. Being second in the market can led to losses and bankruptcy - Longer time horizons to exit:\ average time for an IPO increased. That leds to illiquidity in VC and increases the importance of growth equity investments. - Potential reasons for declining number of IPO in US: - Concerns over increasing regulations - Pressure from shareholders regarding short-term stock price performance - Delistings - Competition between private and public ownership structures Session 2 -- private equity funds =================================  Investing in the securities of the companies. Typically, PE funds consist of more or less 10 companies. A limited partnership is a legal shell. Sometimes LPs have the restriction, that they cannot invest more than 10% in one company. That's why most PE funds have 10 companies in it. **GP:** is the Manager -\> is responsible for the management of the fund. Generally the GP is fully liable (like Kollektivgesellschaft). The GP doesn't need to repay the money when the fund is not performing. **LP**: Do not have liability. They give the money to the GP to manage the invested money. They have no obligations (like shareholders). They don't have a lot of obligations, but neither right to be active in the companies. ### PE Fund / PE Funds PE firms serve as GP for PE funds! Most PE firms manage a lot of PE funds. They can be structured differently (ex. Geograficaly,...) PE firms have two "roles" - GP -\> is always an entity. Gets the incentive fee or performance fee. Is the ultimate power. When you have a lawsuit you have to legally go for the GP. - Investment advisor -\> advises different funds for the PE firm. Is mostly a separate entity (ex. Partnersgroup advisors AG). Receives a management fee. The investment advisor agreement regulates all the tasks of the investment advisor. (ex. Which area to invest,...). The high of the management fee is a big part, of the agreement. Normally the Investment advisor is owned by the GP. ### PE Investors They give the money and are therefore key. Almost 80% of invested money in PE is institutional money (Pension fund, insurance company,...). State funds are big PE investors (CalPERS like AHV). PE would like to work with private investors. Example CPP -\> Canada Pension Plan (Biggest Canadian investment fund) 1/3 of their assets are invested in PE.  The returns are measured real -\> inflation included It's the real money we get out of the investment. They have very high returns -\> investment was very worth it. They invest directly in companies -- no longer in the PE funds. Because of that they don't have to pay the fees, which is also a reason for their outperformance. Swiss pension funds have max. 5% in PE. ### Primary functions of PE ### Forms of PE funds intermediation  There are 4 ways to invest in PE: - Most direct way: Invest directly in companies -\> you don't need a fund - Most indirect way: Invest in fund-of-funds -\> investor invests in a fund-of-fund, fund-of-fund invests in the fund, fund invests in the companies - Invest directly in the fund. - Invest in funds and do co-investments. Co-investments means, that an investor that is already invested in the funds, also invests directly in the company by buying shares. For the Co-investor this is a good opportunity to be invested and save the fees. Because we are invested directly (partly) and don't need to pay fees to the PE fund. Exposure stays the same. Rule of thumb 90% in the fund 10%co-investment. Pension funds or other institutional cannot afford to have an "inhouse PE" because they cant pay the high salaries. ### Life cycle of a Venture Capital Fund In most funds money is committed and not collected. The committed capital will be drawn, when the fund will invest it. When the fund is asking for the committed investment, it has to be payed in short time. The investment is sourced in different ways. Mostly through personal network. VC funds lose money in the beginning. Because they need to pay salaries, lawyers, consultants,... **J-Curve**  - Typically in the first couple of years CF are negative - After that, IRR goes up. Which doesn't mean that CF also go up! A venture fund has a more extreme J-Curve. Because the company buyed is already having negative CF on top to the costs of the PE. A secondary fund has a quite flat J-Curve. ### Risks of PE The big difference from public to private equity is the liquidity risk. A share of a bad performing company you can sell it. It would be a bad price but I will be able to sell it. In PE nobody would buy the share. In PE there is no way, to get the money out of the investment. In theory the liquidity risk is why PE should get a bigger return. ### GP-LP relationship life cycle model  - Its very hard to raise an own fund for the first time. - When funding, you need to differentiate from existing funds. (f.e. raising a fund for the worldwide hotel sector). - From time to time also very good and known fund managers don't perform. Often 2-3 good funds and then it goes down. ### PE Management fees and carried interest Sometimes there is an agreement, that fees are paid when they are over the hurdle rate. There are always discussions about what other fees come on top. F.e. a salary to be in the board, etc. And also the management of the company can provide a lot of consultants etc. without anyone knowing. The fund manager always has a lot of fees that will be charged (f.ex. transaction fees, divestiture fee,...) to the portfolio company. The regulators f.e. FINMA) are only responsible for public equities, that's why they didn't do anything about this hidden fees. The SECA got aware of this untransparent accountants. Important when investing in PE: 1. Always ask for a listing of all fees 2. Ask for "most favorite nation clause" That side letter guarantees, that you get the best of all other investors. **Catsh-up clause**  - In hurdle zone we don't get any fees - I go form hurdle zone in catch-up zone, when The catch-up can get very expensive for the investor. Always be aware of it. Application 21.4.3A typical exam question! ### Leverage buyout (LBO) funds VC funds and LBO funds have a lot of similarity. But also differences. Clubdeals and Co-investments are a little bit difficult to distinguish. Reading notes: CAIA chapter 21 -- private equity funds ------------------------------------------------------ PE funds are unregistered investment vehicles. Investors or limited partners (LP's) pool money in this funds to invest in privately held companies under the management of general partners (GP's). Fund management companies (PE firms) set up these funds and typically serve as the GP's. ### Organizational structure of PE funds Each PE fund is managed by a GP which is typically the PE firm that raised the capital for the fund. They source investment opportunities, reviews business plans, do the due-diligence and usually take a seat on the board of directors. PE funds have a contractually limited life of 7-10 years with sometimes options for an extension of 2-3 years. They are structured as LP's. PE investments have 3 layers, therefore it can be unclear, for what the term PE investment is used: - Private equity management - Private equity investment fund - Private equity underlying investment The PE fund serves as intermediate between the underlying business enterprises and the investors in PE funds. ### PE firms - Lager PE firms serve as fund managers - Therefore as GP's - That attract institutions s LP's The goal is, to realize all investments before or at the liquidation of the fund. When successful, multiple PE funds can be launched through time. usually, the PE firms invest also their own capital and sometime the fully own the underlying business enterprise. They obtain additional capital through forming limited partnerships which attract LP's. Usually, the partnership units are not publicly traded. PE firms mostly have a dual role: - PE firm creates a PE fund that purchases PE securities ### Private equity investments by institutional investors Most institutional outsource their PE fund investments. They pool assets with other investors. PE fund of funds are the most common type of institutional investment programs. **PE funds of funds** are organized by specialist asset managers and pool capital from a group of investors to invest in diversified portfolios of PE funds. They can be specialized in specific sectors, geographics, etc. They primarily invest in newly formed LPs. Because investors don't know the underlying portfolio companies when investing, the skills and trust in the fund management team is key. Investors can commit a specified amount of money to the fund. The amount committed but not yet called is called an «undrawn commitment» or «dry powder». ### PE funds as intermediaries PE funds serve as financial intermediaries by facilitating investment in PE. There are several motivations to use PE funds as intermediaries: - Risk\ PE funds mostly step in, when traditional lenders (ex. Banks) are not willing to lend to an entrepreneur. Because there is a substantial risk. PE investors take advantage of the inefficiencies in financial markets while satisfying the needs of the borrowers. The risk is minimized by the limited liability. This is a protection oft he investors, that the losses cannot exceed their investment (-\> limited partnership). The GP hat no limited liability! - Efficient incentives\ Sometimes managers do not have proper incentives to maximize shareholders value. PE seeks in, to align the interests of managers and shareholders to achieve higher returns. **Primary functions of PE fund:** 1. Pooling investors capital for investing in private companies 2. Screening, evaluating and selecting potential companies with expected high-return opportunities 3. Financing companies to develop new products and technologies, foster their growth and development, make acquisitions or allow for a buyout or a buyin by experienced managers 4. Controlling, coaching and monitoring portfolio companies 5. Sourcing exit opportunities for portfolio companies ### Forms of PE fund intermediation Ein Bild, das Text, Diagramm, Quittung, Reihe enthält. Automatisch generierte Beschreibung ### Life cycle of a venture capital fund (VC fund) A VC fund is a longterm investment. Normally capital is locked up for minimum 10 years. A VC fund goes through 5 staged of development: 1. **Fundraising**\ the VC firm raises capital form outside investors. Capital is committed not collected yet! The commitments are drawn down when needed f.ex. to make investments, pay costs or pay the management fees. PE funds do not retain large pools of uninvested capital. 2. **Sourcing investments**\ locating possible investments by reading business plans, due-diligence, etc. 3. **Investing stage**\ VC fund manager determines how much capital to commit to each start-up company. He makes capital calls to the investors in the fund to draw the committed capital of the LPs. This is called the "vintage year". 4. **Operations and management\ **Manager has to improve the portfolio companies. F. ex. establish distribution channels, prototype products, generate great sales. Ideally positioning the Start-up for an eventual public offering or sale strategy. 5. **Windup and liquidation**\ The fund is in his harvesting stage. Profits are distributed to the LPs and the GP fund. The portfolio companies face three possible outcomes to generate the realization: - - - **Fund J-Curve** Illustration of the early losses and later likely profitability ot a VC.  ### Substantial risk of PE PE has specific characteristics that are not shared by other asset classes. 1. Market risk\ is the economic uncertainty of the asset value. Listed values are valued by market prices, illiquid assets by present value of their future cash flows. 2. Liquidity risk\ secondary market is relatively small and inefficient. Prices often are discounted. 3. Commitment or funding risk\ When the fund manager calls for the committed capital, LPs have to provide it within a fixed short notice period. When they cannot meet their obligations they default on their payments and lose a substantial portion or all of their partnership. 4. Realization risk\ Long term risk of not recovering the value of their invested capital at realization. Mostly because of 2 factors: - - ### LP and GP relationship life cycle Mostly over time GPs oversee multiple funds. Satisfied investors will seek to invest in the new funds when the GPs is successful. Because of information in PE markets are incomplete and asymmetric, there is the problem of moral hazard and conflict of interest. Between LPs and GPs. - GPs want financially strong, dependable, knowledgeable and longterm LPs. - LPs should be familiar with the PE business. - Adverse selection -\> Poor quality GPs will cour inexperienced LPs. Because of poor results, both will eventually exit the market. - To maintain continuous investment in new portfolio companies, GPs need to raise new fund as soon, as the capital from their latest active fund is fully invested. This will be around all 5 years. - Investors should have good fund managers on hold. So they don't need to find and check new fund managers. - Lack verifiable track record it's very difficult to new fund managers to establish in the market. There are a lot of entry barriers to enter into the PE market.  ### PE fund feed and terms The compensation structures between public and PE governance are very different. PE managers get a fee from 1.5% (large funds) to 2.5% (smaller funds) of the committed capital (not the invested capital!). In VC funds normally the fund manager can call for a "capital call". Which will provide him with more capital to invest and therefore more management fees. This can lead to a wrong incentive for the fund manager. GPs earn a wide variety of fees from their portfolio companies including director fees, buyout fees, etc. The main upside incentive for GPs is the carried interest, normally around 20% of the realized profit of the fund. **Clawback provision** Is a covenant that allows the LPs to receive back the payed incentive fees. They are returned when at the end or the liquidation of the venture fund the LPs get returns below the annualized preferred return. This is an ensurement, that the fund manager doesn't walk away with incentive fees unless LPs earn a profit. Clawbacks can also exist for LPs. It's triggered when at the end of a fund the GPs has received less than their share of the fund profits. Such clawback is relevant when a portion of the committed capital has not been drawn and the LPs have received full repayment of their commitment plus hurdle before the GP has access to his carry. **Carried interest und hurdle rate** Ein Bild, das Text, Reihe, Diagramm, Schrift enthält. Automatisch generierte Beschreibung  The mechanism for carried interest payment is not standardized. They can be compounded quarterly, annually, etc. **Perverse incentives from fees** - High hurdle rates can cause excessive risk taking.\ Fund Managers can get unmotivated if it becomes unlikely that they will receive carried interest. Therefore, they will take desperate risks to earn the incentive fees. - Time issue with hurdle rates.\ A dilemma whether to realize an investment over a short period to optimize the IRR or to hold the investment to optimize the long-term multiple. In the limited partnership agreement investors can see it there is potential for substantial conflicts of interest between the GP and LP. **GPs contribution to initial PE fund investment** Excessive risk taking can be reduced if fund managers have a significant personal investment in the fund. A standard contribution is about 1% up to 25% or more, depending on the wealth of the fund manager. This is also called "hurt money". It should be contributed in cash and not through the waiver of management fees. **Key-person provision** PE is a people business. When people of the fund management are unable to carry out their duties, this can have a substantial adverse effect. The "key-personnel clause" allows LPs to take specific actions if named key persons depart the team. **Termination and divorce** The "bad-leaver clause" gives the LPs the possibility to vote for a new fund manager, if the excysting one does not exceed. But this is a high legal risk, because its highly subjective and very difficult to prove wrongdoing. The "good-leaver clause" enables investors to ask for additional funding of the partnership through voting. This clause provides a clear framework for shutting down a non working partnership. When any of these clauses are exercised, this means a big reputation problem for the fund manager. Because the market consists of small number of players. GPs tend to agree on a fund restructuring to prevent a forced removal. **Other covenants** - Partnership's funding - Distribution of cash - Operation of the fund - Investment practice - Etc. ### Key determinants of VC fund risks and returns VC funds contains different risks. The key issues are: - **access as key to enhanced returns:** for investors its key to have access to the top-tier VC fund managers. - **Diversifying venture capital risk:** invest in PE funds with different vintage years, industry and geography - **Required risk premiums for VC:** the risk premium includes business risk, liquidity risk and idiosyncratic risk. ### Distinction of VC and Buyout Managers +-----------------------------------+-----------------------------------+ | **VC** | **Buyout** | | | | | - Launch new or emerging | - Focus on leveraging an | | companies | established company's assets | | | | | - Back entrepreneurs | - Deal with experienced | | | managers | | - Active role | | +-----------------------------------+-----------------------------------+ Leveraged buyout funds (LBO) ---------------------------- LBO funds classify themselves in three classes (small-capitalization, mid-capitalization and large capitalization). LBO are structured as limited partnerships and runned by a general partner. The number of LPs in a fund is not fixed and can vary a lot. The lifetime is typically 10 years with provisions to extend for several years. LBO firms have different sources to earn money: - Annual management fees (1.25 -- 3% of investors capital) - Incentive fees (20 -- 30% of the funds profits) - Carried interest (20 -- 30% of the funds profits) - Charging fees for operations (1% of selling price) - Operating fees (f.ex. when someone is member of the board) The management fees of the funds can get very high and untransparent. Nowadays when a company decides to sell subsidiary in an LBO format, they normally hire an investment banker to establish an auction process. This means, that several PE firms are bidding, and the highest bid get the LBO. Because of the big demand, LBO firms can also work together in form of a **club deal** to share costs, present a business plan and contribute capital to the deal. Club deals have pros and cons. They tend to increase the number of potential buyers because they enable firm that could not individually bid on a target. ### Buyout risks relative to venture capital risks LBO funds have less risk than VC funds because: - Normally LBO funds buy established and mature companies that are potentially undervalued. - VC funds face the substantial business risks associated with start-up companies. - LBO funds tend to be less specialized than VC funds but are also greater diversified. - An eventual IPO is more likely for an LBO than for a VC deal. PE liquid alternatives ---------------------- - **Business development companies (BDCs):** are public traded funds with underlaying assets typically consisting of equity or equity-like positions in small private companies. - **Business development companies as closed-end funds**: transforms ownership of underlying fund assets into shares. The close-end structure facilitates the liquid ownership of illiquid pools of assets much better than an open-end structure would. The difference is that closed-end funds do not regularly create new shares or redeem old shares. - **Extending closed-end fund pricing to illiquid alternatives**: Data have shown, that BDCs do not provide a greater diversification than listed equities. The performance is highly correlated with equities of similar capitalization size. PE funds of funds ----------------- Are private fund structures with underlying assets composed of private PE funds. Fund of funds are often less efficient than single GP because they have to layers of management and incentive fees. The double fee is the main disadvantage of this structure. But these costs have to be compared with the inhouse costs if the investment would be directly into the fund. Successful investing in PE requires a lot of skills and knowledge: - Wide-reaching network - Well-trained investment judgment - Ability to assemble balanced portfolios Funds of funds can be used as a first step into PE investments. Funds of funds can really add value in specialized investments like technologies, emerging market,... Private investments in public equity (PIPE) ------------------------------------------- Are privately issued equity or equity-linked securities that are placed outside of a public offering. They are exempt from registration and are used as vehicles for publicly traded companies to issue additional equity shares. Shares of publicly traded companies are sold directly to investors. These shares normally cannot be traded in the secondary market for a specified period of time. Securities of PIPEs for the investor: - Privately placed common stock (the greates the illiquidity, the greater the discount on the PIPE issue price) - Registered common stock (stocks can be bought with a discount to the market price) - Convertible preferred share4s or convertible debt - Equity line of credit (ELC is an agreement that a defined quantity of stock can be sold at intervals of time) Advantages for PIPE issuers: - Company can quickly rise capital without long registration processes - Can be a cheap way to rise capital from friendly investors - Management can stay focused on the operations of the business +-----------------------+-----------------------+-----------------------+ | **Traditional PIPE** | **Structured PIPE** | **Toxic PIPE** | | | | | | - Investors can buy | - Include more | - Has adjustable | | common tick at a | exotic securities | conversion terms | | fixed price | like floating | (mostly | | | rate convertible | downwards) | | - Fixed conversion | preferred stock, | | | price | convertible | - Are structured | | | resets and common | PIPEs | | | stock resets. | | | | | | | | - Floating | | | | conversion price | | +-----------------------+-----------------------+-----------------------+ PE secondary markets and structures ----------------------------------- ### Secondary market for PE partnerships The lack of registration and public trading makes the purchase and sale of a LP less liquid than listed stocks or other registered securities. When investors want to liquidate their investment before the exit, they need to access the secondary market. The main reasons why investors need to sell their part of the portfolio are: - Raise cash for funding requirements - Trim the risk of the investment portfolio - Rebalance of the portfolio Besides the unfavorable price, the GPs permission to sell the own part may be necessary. GPs don't like it, when the LPs sell their parts to third parties. Therefore, they maybe wont invite the LP for a next funding. Advantages for a buyer in the secondary market: - Gain exposure to a portfolio with a different vintage year - Being closer to the harvesting profits - May gaining access to future funds - Greater potential for cash flows ### Difference between PE and Hedge funds There are blurry lines between hedge funds and PE firms. They differ mostly in their fee structure. Generally said, the deal terms for a hedge fund are much more favorable to managers than are those for PE fund managers. Session 3 -- private credit and distressed debt =============================================== Ein Bild, das Text, Screenshot, Schrift, Zahl enthält. Automatisch generierte Beschreibung Loans / Bonds -------------  - The issuer is asking for assets, normally cash - Its very risky, the investor has the knowledge that the issuer can go bankrupt. It can be, that the corporate goes bankrupt, but they can still provide the assets. - SSL -\> senior secured loans. 1^st^ and 2^nd^ can be seen as mortgages. The first will be payed back before the 2^nd^. - High yield bonds are typically unsecured. They will get their money back, when the loans are payed back. And then in the bonds there is again a scale. - Inbetween the high yield bonds and the stock investments, there are mezzanine investments. Difference between SSLs and high yield bonds Ein Bild, das Text, Schrift, Zahl, Screenshot enthält. Automatisch generierte Beschreibung - 2^nd^ lien loans are typically longer than 1^st^ lien loans. - You can't prepay high yield loans. You buy them when they are issued.  Ein Bild, das Text, Screenshot, Schrift, Zahl enthält. Automatisch generierte Beschreibung Rating spectrum leveraged loans / high yield --------------------------------------------  - Leveraged loans and distressed dept is normally always under investment grade. - When bonds are very leveraged, they can get trash even when they are issued from a solid corporate. Ein Bild, das Text, Screenshot, Zahl, Schrift enthält. Automatisch generierte Beschreibung The rating is based primarily on the EBITA / EBITDA. **Rating process** - Process is the same for all rating agencies - Always important to distinguish between the issuer rating and the issue rating! - Different issues from one issuer can have different ratings.  Ein Bild, das Text, Screenshot, Visitenkarte, Schrift enthält. Automatisch generierte Beschreibung - The countries of issue are a very important rating aspect as well as the market. - They always compare to similar companies and their ratings. **Default rates: investment grade vs. speculative grade** It depends how much coupon an investor gets. Even if a corporate got bankrupt but the investor got a lot of coupon, this could be a good investment.  Covenants --------- Ein Bild, das Text, Schrift, Screenshot, Dokument enthält. Automatisch generierte Beschreibung  - A lot of loans are covenant lite issued. This means they are covenants but very light. - Lite covenants are rather bad for banks. Because they cannot really influence the outcome of the investment. But it also to say, that a lot of banks don't want to be active anyway because they don't have the resources/knowhow. Capital structure ----------------- - business can be risky or not. The question is, how is that business financed. - The riskiness of the financing depends on how much dept they have. - Equity is always the riskiest part and has therefore the highest return.  Distressed dept and bankruptcy process -------------------------------------- Ein Bild, das Text, Schrift, Screenshot, Dokument enthält. Automatisch generierte Beschreibung When for example a mortgage taker can't pay the mortgage, in Switzerland the bank sells the house, takes interest and what is left is for the owner of the house. In US the equity will also be taken from the bank in a case of default. **Private dept**  Ein Bild, das Text, Schrift, Screenshot, Dokument enthält. Automatisch generierte Beschreibung **How are loans issued?**  - "normal" loans are typically issued by banks. You just go to a bank and ask for it. - Very big loans can't be provided by banks because they can afford a big exposure to one client. That's why primary and secondary loan market exist. Big issuers are: +-----------------------------------+-----------------------------------+ | - Bank of America (BofA) | - BNP Paribas | | | | | - JP Morgan | - Citi | | | | | - Wells Fargo | -... | +-----------------------------------+-----------------------------------+ Big investment banks (Morgan Stanley, Goldman Sachs,...) are getting smaller in loan investments. Because for the loan business banks have to hold securities in cash, which can get expensive. **Direct lending** Ein Bild, das Text, Schrift, Screenshot enthält. Automatisch generierte Beschreibung - Money is lended directly without involving a bank -\> non banks (mostly funds) lend to PE - They are specialized companies (they are also called "shadow banks") +-----------------------------------+-----------------------------------+ | Market US | parallel, Reihe enthält. | | | Automatisch generierte | | - Non-refi-issuance are new | Beschreibung | | issued | | | | | | - There are different in the | | | spread depending on the | | | rating grade. They fluctuate | | | depending on the market | | | situation (inflation,...) | | +-----------------------------------+-----------------------------------+ Mezzanine dept -------------- - Mezzanine dept is in between of PE and private dept - The main reason is to substitute equity with mezzanine to have lower costs. - This calculation is ignoring taxes. On the dept side you can detract taxes. - In the real word this doesn't hold. Because mezzanine is more expensive than equity finance because the risk is higher. PE is not following the capital structure theory.  CLOs (Collateralized loans obligation) -------------------------------------- Is a capital structure of the capital structure. Ein Bild, das Text, Software, Website, Webseite enthält. Automatisch generierte Beschreibung - In the US the CLOs take over 70% of the market, that's why they get important. - In AAA also Insurances, banks, etc. invest. In the lower grated only hedge funds and asset managers - A CLO is a "mini bank" taking leveraged loans How it works: - The fund buys a lot of different loans in different grades. - AAA never fails in CLOs -- they can be seen secured because there is a very unlikely possibility to lose them.  Reading notes: CAIA chapter 22 -- private credit and distressed debt -------------------------------------------------------------------- - Private credit: leveraged loans & direct lending - Private equity: mezzanine & distressed dept (because of the equity like risks) **Dry powder**: investments that are pledged to private debt investment firms that have not yet been lent out to a borrower or capital that has been committed but not yet called or invested. ### Types of fund private credit vehicles Private credit is very illiquid. These investments can be accesses through funds containing mostly liquid assets such as open-end mutual funds. Private credit investments can be made through closed-end vehicles like hedge funds, private equity funds, business development companies (BDCs). - **Interval funds**: are semi-liquid, semi-illiquid closed-end funds. They don't trade on secondary market. But offer the opportunity for investors to redeem or exit their investments regularly. - **Drawdown funds**: type of PE fund. The investor commitments are called as needed. - **Funds with loan** **to own objective**: when the investor focuses on the value of the asset and the value of the company that could be reposed. PE funds can underwrite dept with a loan-to-own objective. - **Fulcrum securities and reorganization**: A fulcrum security is the most senior-dept security. It's the security that is most likely to be repaid with equity when in the reorganized firm. ### Fixed income analysis A lot of capital invested in private credit and distressed debt is invested in unrated dept or dept that is rated below investment grade. To understand this lower-quality credits it important to understand the risk and rewards of this dept. **Three key differences between bonds and loans** Bonds are underwritten by banks and sold to external investors. They earn a coupon. Loans are privately traded dept instruments. After a bank has made the loan, they can decide to retain the loan on its balance sheet or sell it to other investors. Differences: - Liquidity: bonds are publicly traded dept securities with relatively high liquidity. Loans are more illiquid and have therefore an illiquidity premium. - Default risk: Loans are typically the most senior dept instrument in capital structure. Bonds are typically more junior, they might have a higher recovery rate than bonds. - Interest rate risk: bonds mostly are fixed-rate and non callable. Loans are likely to have a floating rate and callable. **Implications of floating rates vs. fixed rates on interest rate risk** Fixed rate dept declines in value when interest rates rise. This risk is measured by the duration. The Duration for a simple fixed-rate bond is the average time to receive the cash flows of a bond. With rising interest rates the value of a fixed-rate coupon falls because the present value of the cash flow is diminished. Newly issued dept must be issued at higher yields when market interest rates rise. **Implication of floating rates vs. fixed rates on duration** Floating rate coupons reset periodically to new market interest rates level. So, they minimize the interest rate risk. Floating-rate note prices are less volatile and have lower durations and have therefore a lower price risk relative to changes in interest rates than fixed-rate notes. When interest rates rise, notes with shorter durations will decline less in value and notes with longer durations. When interest rates fall, notes with longer duration rise more in value than notes with shorter duration. **Implication of compounding conventions on modified duration** Modified duration in an intrest rate risk measure that adjusts the duration for descrete compounding in order to reflect the differing effects of various compounding conventions on measuring intrest rate risk. m = number of compounding periods per year y = states annual yield or intrest rate (y/m) = periodic non-annualized rate ### Credit risk analysis and the bankruptcy process Most private credit markets are below investment grade. That's why it is important for investors to understand how to value these loans and also what to do in a bankruptcy case. **Credit ratings, yields and financial ratios** Moody's, S&P, Fitch and others are paid by borrowers to assign ratings to bond issues and large loans. Dept rates as investment grade is expected to have low default rates and therefore low credit spreads. A lot of private credit market is not rated by credit rating agencies. Investors should study the balance sheet and the income statement of the borrower to assign a suitable credit spread.  **Credit spreads and credit risk** Credit spreads depend on the default probability, expected loss and various risk premiums. Credit spread is the excess of the yield on a debt security with credit risk relative to the yield on a debt security of similar maturity but no credit risk. There are big differences between the yields of investment grade dept and non-investment grade dept. Non-investment grade dept is also called high-yield, speculative or junk bonds. It's very difficult to estimate a yield curve for long-term-high-yield dept. And investors often don't want to have a long maturity, because the risk is too high. **Covenants** Covenants are promises from the debtor to the creditor that strengthen the perceived credit quality of the obligation. Covenants can be required by the creditor to get more protection or they can be offered by the debtor to get better conditions. "Covenant-lite loans" are loans with minimal restrictions on the debtor concerning loan covenants. The contract between the borrower and the lender with all terms is called "indenture". They include: - Interest rate - Maturity date - Face value - Schedule of payments - Covenants - **Affirmative covenants**: are requirements that a minimum income is asked for the intrest payments - **Negative covenants:** are prohibitions. For example to prevent that companies increase their dept load. - **Incurrence covenants:** force the borrower to take or not take a specific action when a specified event occurs. For example he must maintain a limit of total debt of five times the EBITDA. - **Maintenance covenants:** are stricter than incurrence covenants. For example, the EBITDA has to pass the test each quarter. This allows the lenders to step in in an early stage to reprice risk. Covenants increase the security of a loan. When a borrower fails to maintain the covenants, they can be technical default on the loan. Covenants can control risk for lenders through: 1. Preservation of collateral: lenders can control risk by limiting the size of the loan relative to the value of the firm. 2. Approximation of excess cash flow: Lenders are protected when the use of corporate cash is limited. Often, they require, that the value of the asset sales is payed out to dept holders rather than equity holders. 3. Control of business risk: lenders have interest in limiting the types and sized of investments, merges and dept that the firm can undertake. Because the have a bigger downside risk than the upside potential 4. Performance requirements: maybe capital expenditures need to be limited in order to maintain the requested financial ratios (negative covenants) 5. Reporting requirements: Company has to report to the lenders (affirmative covenant) ### Capital structure and priority The capital structure or also called capital stack is the mix of equity and dept in a firm. The riskier the capital structure, f.e equity has a higher expected return than safer parts as first-lien dept which should have a lower expected return. Typically loans and secured borrowings have highest credit quality and priority in the case of a bankruptcy and therefore the lowest potential return. The capital structure can change over time. F.ex. when dept issue are paid to equity holders through dividend or stock buybacks. ### Recovery rates When a firm defaults, they may not be able to pay their principal and interest rates as scheduled or to comply with the covenants. Firms are in default, because their assets and cash flows are not sufficient to pay the liabilities. So, lenders should be concerned about: - **Recovery rate**: is the portion of the face value of the dept, that is paid back form the assets in a bankruptcy case. When it's a good firm with a bad balance sheet, a reorganization bankruptcy can make sense. It this case, the firm can renegotiate any and liabilities (contracts, lease, pensions, dept issues). First-lien term loans and secured bonds have the highest recovery rate. Subordinated dept is often cancelled and converted into an equity stake. ### Distressed dept and the bankruptcy process Many distressed dept investors invest while the borrowing company is in the throes of bankruptcy or when bankruptcy is expected. That's why, distressed investors should be well aware about the bankruptcy procedure. With a plan of reorganization and the vote of all creditors, the bankruptcy can be emerged. There are numerous variations and contingencies of the process: - Classification of claims - Prepacked bankruptcy filing - Blocking position - The cramdown - Absolut priority - Debtor-in-possession financing Leveraged Loans --------------- Are another asset class of fixed income securities where PE firms invest. They are also called senior loans or syndicated loans. Leveraged loans are syndicated bank loans to non-investment-grade borrowers. Syndicated refers to a group of entities, that engange in other financial activities, often investment banks. A loan is considered leveraged if: 1. Borrower has outstanding dept that is rated under BBB 2. Loan bears a coupon that is in excess of 125 to 200 basis points over the LIBOR A leveraged loan for an unrated firm, should have a similar credit spread as bank loans of non-investment grade credit ratings. Many non-investment grade corporation have high-yield bonds and leveraged loans outstanding. The secondary market of leveraged loans gets bigger. Commercial banks often disinvest their balance sheet by divesting the loans into a secondary market. Many loans will never be fully payed back to the lender. However, leveraged loans typically have high priority in corporate reorganizations and therefore a high recovery rate. Direct lending -------------- Also called marked-absent lending, shadow banking or nonbank lending. When investors extend credit to borrowers outside of the traditional banking system. The borrowers get credits from loans originated by PE, private credit and hedge fund lenders. Mostly the borrowers do not have access to fund through bank loans. So they pay higher interest rates for direct lending. Direct lending typically focuses on credit analysis, asset-based lending and sometimes also unsecured lending. Mezzanine dept -------------- Mezzanine dept is defined differently depending on the investor. Mezzanine dept is often viewed as an equity investment in the company. Mezzanine dept becomes equity-like when an equity kicker is attached to the dept. This means, an equity warrants to purchase a stock with a strike price under \$0.01. A warrant is a call option issued by a corporation for its own stock. The higher the coupon rate, the fewer warrant need to be issued. Structural view of corporate dept:  Mezzainen financing does not necessarily involve control of the company, in contrast to an LBO. Mezzanine is an appropriate financing source for those companies, that have reliable cash flows. In contrast to VC investments which do not have sufficient cash flow to support their dept. Mezzanine financing has lower returns than other forms of PE investment. This reflects a lower risk profile. The typical exit strategy for mezzanine dept occurs, when the underlying company goes public or obtains capital through a large equity issuance. ### Mezzanine dept advantage Normal financing mezzanine financing Ein Bild, das Text, Screenshot, Schrift, Reihe enthält. Automatisch generierte Beschreibung - Mezzanine financing lowers the capital costs of a firm, because it reduces the equity part. - Mezzanine dept works because of the inefficiencies and imperfections in the capital market for the size of companies, that tend to use mezzanine financing. - Mezzanine financing is generally used by middle-market companies for amount bellow \$400 Mio. These firms often do not have access to the large public dept markets which are relatively efficiently priced. - Mezzanine dept is highly negotiated, which makes it very illiquid.  ### Basic transaction of mezzanine financing - Mezzanine financing for a Management buyout (MBO) - Mezzanine financing for growth and expansion - Mezzanine financing for an acquisition - Mezzanine financing to recapitalize a company - Mezzanine financing in commercial real estate - Mezzanine financing in a leveraged buyout - Mezzanine financing as bridge financing ### Major mezzanine investors - Mezzanine funds - Insurance companies - Traditional senior lenders - Traditional venture capital firms ### Characteristics of mezzanine dept - Board representation - Restrictions on the borrower - Flexibility - Negotiations with senior creditors - Subordination - Acceleration - Assignment - Takeout provisions Distressed dept --------------- Is dept that has deteriorated in quality since issued: - the market price is less than half of its principal value. - Or the yield is 1'000 or more basis point over the riskless rate - Or has a credit rating of CCC or lower Distressed dept investors are usually interested in purchasing cheap dept, convert them into stock, turn the company around and reap the rewards of appreciation. This is very risky because the underlaying company is already distressed. Distressed investors spot tired companies and identify their weaknesses. They bring fresh approaches to the table to get the company back on the right path. The distressed dept market is also an inefficient market, which makes it an attractive market for investors. Investors use distressed dept to gain an equity investment stake in a company. Or it can simply be an investment in an undervalued security. ### Expected default losses on distressed dept - Default rate: annual portion of debt issues that defaults paying the principal and interest rates as scheduled. - Loan loss rate: annual default rate multiplied by the losses on the dept thaht aren't recovered through bankruptcy Goal of a distressed investor:  ### Distressed dept investment strategies - Active approach with the intention to obtain control of the company. Is the riskiest and most time consuming investment and therefore promises higher returns. - Active role in bankruptcy and reorganization process but not in taking control of the company. - Passive or opportunistic investors. Don't want to convert their dept into equity. ### Risk of distressed dept investing Main risk is the business risk. A troubled company can ultimately prove to be worthless and unable to pay off its creditors. Credit risks and other fixed-income-based views of riks are less relevant because the firm has already shown the lack of creditworthiness. Investments in distressed dept is always a longterm investment. Because it can take several years to turnaround a company. Session 4 -- Performance ======================== - Performance is the most important topic because when investing in an asset class we want returns Ein Bild, das Text, Schrift, Zahl, Screenshot enthält. Automatisch generierte Beschreibung Performance in PE depends on: - Expertise of the fund manager - Market conditions - Overall economy - The future is important and not the past years like in other performance measurements IRR --- - Calculates the annual growth rate of an investment over a specific period. - Time value is important for the IRR calculation. - The later you get the money back, the lower is the IRR - MOIC = multiple of invested capital  - A 20% IRR does not mean that we make 20% per year! - The IRR has to been seen with the investment multiple. - A specific problem of the IRR in PE is, that it doesn't take into account the commitment period - IRR are still very important because the carry is based on the IRR. - Be careful with the amounts of reinvestments. A rolling portfolio never gets the money back. Performance studies ------------------- The study shows the global IRR of PE and compares it to IRR of other assets. - PE IRR are outperforming IRR of public equity of 3 -- 5%. But you must take into account the commitment period. And it takes more time to invest in PE than in public markets. Ein Bild, das Reihe, Diagramm, Schrift, Text enthält. Automatisch generierte Beschreibung - To compare PE, you have to be aware what you are comparing. - When looking at the performance of PE funds the fund needs to be at least 5 years old. Because younger funds normally didn't make an investment and for sure no returns yet. During Corona there was a big boom in PE and public market. Up to 30% gain (light blue bare). Since then, performance isn't going very well.  **IRR performance per strategy** Ein Bild, das Diagramm, Reihe, Text enthält. Automatisch generierte Beschreibung  ### Listed private equity Because PE is so illiquid, investors invented listed private equity. These are funds that are listed, they invest in PE. The investment in the trust can be traded. Example the HgCapital Trust Listed PE vs. public market  Most PE firms are listed. LPX50 is an index about all listed PE funds. Why PE is not performing since the last 3 years? - High returns are bad for PE. PE does not work when interests are high - PE is depending on interest rates. - Low returns because of higher interest rates Drivers of performance: - Dept - Interest rates - Internal growth - Multiples ### Choosing the right fund There is a likelihood that a new fund of the same fund managers will not perform as good as the old funds. Ein Bild, das Text, Screenshot, Zahl, Schrift enthält. Automatisch generierte Beschreibung  Raised money now will be invested over years. That means, it also must be PE investment opportunities. Otherwise, the collected capital will sum up. Reading notes -- Phalippou,... ------------------------------- **Summary from ChatGPT** The document titled \"The Hazards of Using IRR to Measure Performance: The Case of Private Equity\" by Ludovic Phalippou examines the challenges and limitations of using the Internal Rate of Return (IRR) as a performance measure, particularly in the context of private equity investments. Here\'s a summary of the key points: **Key Issues with IRR:** 1. Misleading Performance Measure: a. IRR assumes that intermediate cash flows are reinvested at the same IRR, which is unrealistic and often inflates actual performance. b. This reinvestment assumption exaggerates the dispersion of fund performance, creating a false impression of wide variability. 2. Aggregation Problems: c. The average IRR across multiple funds can misrepresent the actual performance of combined cash flows, leading to biases. d. Duration negatively correlates with performance, making average IRRs upwardly biased. 3. Gaming Incentives: e. IRR incentivizes fund managers to time cash flows strategically (e.g., early exits) to inflate reported IRRs. f. Intermediary dividends or cash flows can be manipulated to boost IRR, even if it leads to value destruction. 4. Distorted Comparisons: g. IRR cannot be directly compared with time-varying benchmarks (like stock indices) because of differences in investment patterns over time 5. Computational and Ranking Issues: h. IRR involves iterative computation that can result in multiple solutions or fail to converge. i. It often ranks projects suboptimally compared to Net Present Value (NPV), especially in cases of scale or timing differences. **Proposed Solution: Modified IRR (MIRR)** Phalippou advocates for using MIRR as an alternative: - MIRR assumes that cash flows are reinvested at a predetermined hurdle rate (e.g., 8% or the S&P 500 average return), providing a more realistic measure of performance. - MIRR addresses the gaming incentives by aligning manager and investor objectives and is uniquely defined without computational ambiguities. - IMIRR (Isolated MIRR) can also be used for individual investments, while MIRR is better suited for entire funds. **Recommendations for Reporting:** 1. Report MIRR for the whole fund and IMIRR for individual investments to standardize performance metrics. 2. Use consistent assumptions about reinvestment rates and fund durations to prevent gaming. 3. Avoid pooling funds or artificially grouping cash flows to inflate IRR. 4. Show performance net of fees and based on actual cash flow timings, not announcement dates. **Conclusion:** While IRR is widely used in private equity and other investment contexts, its shortcomings make it an unreliable measure of performance. By adopting MIRR, investors and fund managers can achieve better alignment of incentives and a more accurate assessment of returns. The paper encourages debate and further research to refine performance measurement standards.