2023 CFA© Program Curriculum Level I Volume 5 Private Equity
2023 CFA© Program Curriculum Level I Volume 5 Private Equity
LEARNING MODULE
3
Private Capital, Real Estate, Infrastructure,
Natural Resources, and Hedge Funds
LEARNING OUTCOME
Mastery The candidate should be able to:
SUMMARY—PRIVATE CAPITAL
1
explain investment characteristics of private equity
explain investment characteristics of private debt
Source: Exhibit from “McKinsey’s Private Markets Annual Review,” April 2021, McKinsey & Company,
www.mckinsey.com. Copyright © 2021 McKinsey & Company. All rights reserved. Reprinted by
permission. McKinsey continues to update this article annually here: www.mckinsey.com/industries/
private-equity-and-principal-investors/our-insights/mckinseys-private-markets-annual-review.
Leveraged Buyouts
Leveraged buyouts (LBOs), or highly leveraged transactions, arise when private
equity firms establish buyout funds (or LBO funds) to acquire public companies or
established private companies, with a significant percentage of the purchase price
financed through debt. The target company’s assets typically serve as collateral for the
debt, and the target company’s cash flows are expected to be sufficient to service the
debt. The debt becomes part of the target company’s capital structure after the buyout
occurs. After the transaction, the target company becomes or remains a privately
owned company. LBOs are sometimes called “going-private” transactions because
after the acquisition of a publicly traded company, the target company’s equity is
substantially no longer publicly traded. (When the target company is private, it is not
a going-private transaction.) The LBO may also be of a specific type. In management
buyouts (MBOs), the current management team participates in the acquisition, and
in management buy-ins (MBIs), the current management team is replaced with the
acquiring team involved in managing the company. LBO managers seek to add value
by improving company operations, boosting revenue, and ultimately increasing prof-
its and cash flows. Cash-flow growth, in order of contribution, comes from organic
revenue growth, cost reductions and restructuring, acquisitions, and then all other
sources. The financial returns in this category, however, depend greatly on the use of
leverage. If debt financing is unavailable or costly, LBOs are less likely to take place.
Venture Capital
Venture capital (VC) entails investing in or providing financing to private companies
with high growth potential. Typically these are start-ups or young companies, but
venture capital can be injected at various stages, ranging from concept creation for a
company to the point of a company’s IPO (initial public offering) launch or its acqui-
sition by another company. The required investment return varies with the company’s
stage of development. Investors in early-stage companies demand higher expected
returns relative to later-stage investors because the earlier the stage of development,
the higher the risk.
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432 Learning Module 3 Private Capital, Real Estate, Infrastructure, Natural Resources, and Hedge Funds
Venture capitalists, like all private equity managers, are active investors directly
involved with their portfolio companies. VC funds typically invest in companies and
receive an equity interest but may also provide financing in the form of debt (com-
monly, convertible debt).
Formative-stage financing is for a company still being formed. Its steps are as follows:
a. Pre-seed capital, or angel investing, is capital provided at the idea stage.
Funds may be used to develop a business plan and to assess market poten-
tial. The amount of financing here is typically small and sourced from indi-
viduals, often friends and family, rather than from VC funds.
Company
Start Up Business More Established Business Mature Business
Maturity
-Pre-seed/Angel Also known as “growth equity” -Management Buyout (MBO)
-Seed stage, Early stage -Stage between VC and Maturity -Management Buy-in (MBI)
-Later stage (expansion) VC -Primary Capital -High leverage
-Mezzanine VC -Secondary Capital
Source: Private Equity Primer, “What Is Private Equity?” (12 February 2016). www.pe-primer.com/
dealsherpapress/2016/2/12/bbcati52gcwdzrl34pts0x2tl783do (accessed 18 June 2020).
KNOWLEDGE CHECK
1. Identify two of the three stages of the private equity continuum and the
company growth stage each finances.
Solution
The stages of the entire PE continuum and their associated growth stage
financing are as follows:
Exit Strategies
Private equity firms seek to improve new or underperforming businesses and then exit
them at higher valuations, buying and holding companies for an average of five years.
Holding time, however, can range from less than six months to more than 10 years.
Before deciding on an exit strategy, private equity managers assess the dynamics of
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434 Learning Module 3 Private Capital, Real Estate, Infrastructure, Natural Resources, and Hedge Funds
the industry in which the portfolio company competes, the overall economic cycle,
interest rates, and company performance. Three common exit strategies are trade
sales, IPOs, and SPACs.
■ Trade sale. This refers to the sale of a company to a strategic buyer, such
as a competitor. A trade sale can be conducted by auction or by private
negotiation.
Advantages of a trade sale include
d. future upside potential (because the private equity firm may remain a
large shareholder).
Disadvantages include
b. spread between the announced and true equity value because of the
dilution,
KNOWLEDGE CHECK
1. Trade sale
2. IPO
3. SPAC
4. Recapitalization
5. Secondary sales
6. Write-off/liquidation
Direct Lending
Private debt investors get involved in direct lending by providing capital directly to
borrowers and subsequently receiving interest, the original principal, and possibly
other payments in exchange for their investment. As with typical bank loans, pay-
ments are usually received on a fixed schedule. The debt itself typically is senior and
secured and has covenants in place to protect the lender/investor. It is provided by a