Earn-outs

The major due diligence factors that are likely to affect the value of a property include:

operating expenses; structural integrity; environmental issues; leases and lease history; lien, ownership, and property tax history; and compliance with relevant regulations and laws

Conditional prepayment rate

The prepayment rate assumed for a pool based on the characteristics of the pool and the economic environment.

How does each approach value a firm?

(1) Income approach

(2) Asset-based approach

(3) Market approach

(1) PV of future income/discounted CF 

(2) Assets minus liabilities

(3) Uses price-multiples from sales of comparable assets

Paid-in capital (PIC) (formula + definition)

Management fee?

PIC = Committed Capital - Capital Drawn Down

Mgmt Fee = (PIC)*(%Fee)

-% of committed capital utilized by the GP

 -cumulative sum of amount of capital drawn down

Residual value to paid-in capital

is the value of the investor’s holding in the fund as a ratio of cumulative invested capital

A high RVPI to DPI ratio indicates

that the fund has not distributed a large portion of profits and may indicate difficulty realizing profits from its investments. In this case it would take longer for the investor to receive distributions from the fund (low cash flows to date). 

Convenience yield

The return from the non-monetary benefits of holding the asset underlying a futures contract

Gross income multiplier technique (formula)

Gross income multiplier = (Sales Price/Gross income)

GI = Rev - COGS

Components of return in a leveraged buyout (LBO) investment (3)

LBO components of performance

(1) Return on preference shares/earnings growth

(2) Increase in the price multiple on exit

(3) Reduction in debt claims

The private equity firm Purcell & Hyams (P&H) is considering a $17 million investment in Eizak Biotech. Eizak’s owners firmly believe that with P&H’s investment they could develop their “wonder” drug and sell the firm in six years for $120 million. Given the project’s risk, P&H believes a discount rate of 30% is reasonable.

The pre-money valuation (PRE) and P&H’s fractional ownership, respectively, are closest to (in millions):

Step 1: The exit value must first be discounted at the appropriate discount rate to its present value to arrive at the post-money (POST) valuation (all dollar figures in millions): 

POST = ($120) / (1.30)⁶ = $24.86 million. 

Step 2: The pre-money valuation is Eizak’s current value without P&H’s investment: 

PRE = $24.86 million − $17 million = $7.86 million. 

Step 3: P&H’s fractional ownership is the value of its investment as a fraction of Eizak’s POST valuation: 

f = INV / POST = $17 / $24.86 = 0.68. 

A hedge fund with a fixed-income arbitrage strategy is most likely to suffer a loss when (3 things):

And what does FI arbitrage usually involve?

Fixed-income arbitrage generally involves buying high-yielding (low quality) bonds while selling low-yielding (high quality) bonds. Leverage can be used in place of selling high quality bonds.

This strategy can suffer great losses when

(1) credit spreads widen quickly

(2) when leverage becomes more expensive

(3) when the markets for low-quality debt become less liquid.

The capitalization rate (C) is (definition and formula):

the rate of return that equity investors require on similar-risk real estate investments (r) net of the expected constant growth rate of net operating income (g). That is, C = r - g

It is difficult to apply traditional portfolio analysis to hedge funds because (3):

(1) it is difficult to develop accurate expected returns

(2) hedge fund correlation, beta exposures, and volatility can change over time

(3) standard deviation is not a complete measure of hedge fund risk due to higher moment risks such as skewness and kurtosis. This is due to non-normal distribution of hedge fund returns.

Distribution waterfall (def)

identifies the profit allocation between LPs and GPs and specifies when GPs can receive carried interest

A ratchet enables: (+def):

a ratchet enables the management team to increase its equity allocation depending on the company’s actual performance and the return achieved by the private equity firm.

refers to the equity allocation between shareholders and management

Carried interest (def + formula)

Formula = when total return based on excess of NAV (before distrib.) above committed capital

is the GP’s share in fund profits

=(NAV - committed capital) * (CI %)

=(CI%)*(change in NAV before distribution)

Pre-money valuation (PRE) formula

PRE = POST − INV

The pre-money valuation (PRE) is simply the venture capital firm’s post-money valuation (POST) less the capital investment (INV)

Ownership proportion = INV/POST

The ownership proportion is the investor’s fractional ownership of the firm value after the capital infusion: 

Hurdle rate of (ex. 10%) means investment IRR must exceed 10% for carried interest to be paid

IRR -> Input N, PV = Initial investment, FV = sell price, CPT I/Y (this must exceed hurdle rate)

V=

Rental income (if full occupancy) + other income = Potential Gross Income (PGI)

- (PGI * Vacancy%)

=Effective Gross Income (EGI)

- Operating Expense - Property Management Fee

=Net Operating Income (NOI)

(divide by cap rate)

The returns of many hedge fund strategies – including merger arbitrage trades – are (re: distribution):

Highly kurtotic and negatively skewed

not normally distributed

Calculate Price/Square Foot

Calculate adjustments, sum them for total % adjustment

Price/SqFt*(1+Adj%) = Adj. Sales/Sq Ft

Average #s and multiply (subject sq.ft.*Adj$)

Funds from Operations (FFO) / Shares Outstanding

=FFO/share x Sector Average P/FFO multiple

=NAV/share

Total Property Value = 

PV of term rent + PV of incremental rent

Estimated cash NOI / assumed cap rate

=Estimated value of operating real estate

+ cash & accounts receivable

- debt and other liabilities

=NAV

NAV / shares oustanding = NAV/share

FFO - non-cash rents - recurring maintenance-type cpaital expenses = AFFO

AFFO / shares outstanding = AFFO/share

(AFFO/share) x property subsector average P/AFFO multiple = NAV/share

Committed capital refers to:

the amount of funds investors committed to over the life of the private equity fund

The J-Curve refers to:

a pattern in private equity investment return, not risk. The return on investments usually declines initially, then increases as exit nears. 

The three sources of value-added a private equity firm provides over public firms are:

(1) reengineering the portfolio firms

(2) obtaining debt on favourable terms (cheap credit)

(3) aligning the interests between private equity owners (the limited partners) and portfolio managers

MV = NOI / (r - g)

=NOI / C

C = capitalization rate

A CDO is a/an ______ that is collateralized by ______ comprising (3 categories):

an asset-backed security (ABS) that is collateralized by a pool of debt obligations

comprising:

(1) below investment grade corporate bonds

(2) corporate loans advanced by commercial banks

(3) bond issues in emerging markets

Cumulative Distributions paid to LPs / Cumulative invested capital

Net of management fees and carried interest; also called cash-on-cash return

Appropriate methods for valuing:

(1) Buyout

(2) Venture capital investment

Buyout -- Discounted cash flow

VC -- Pre-money valuation

Delta’s distributed to paid-in capital (DPI) ratio of 2.0 indicates that investors in the fund realized a profit of $2.0 for every dollar invested and that this profit has already been paid out

Distribution waterfall

The method of profit distribution between the LPs and GP

r* = [(1 + d) / (1 - f)] - 1

d = discount rate for firm

f = probability of failure in any one year

Private equity firms can use ________ to estimate terminal value in (2 types of) investments. 

Scenario analysis

venture capital and LBO investments

Private equity key drivers of return:

(1) Buyout

(2) Venture Capital

(3) LBO?

(1) Increase of multiple at exit; decrease in debt

(2) Pre-money valuation, the investment, subsequent equity dilution

(1) IPO

(2) Secondary market sales

(3) Management buyout (MBO)

(4) Liquidation

Measures LPs unrealized return:

(LP's holding in the fund) / Cumulative invested capital

Net of management fees and carried interest

DPI + RVPI 

Net of management fees and carried interest

Measures LPs realized and unrealized return

(1) NAV before distribution (formula)

(2) NAV after distribution (formula)

(1) Prior year NAV after distrib. + Cap. called down - Mgmt. Fees + Op. Result

(2) NAV before distributions - Carried Interest - Distributions

=Cumulative distributions / PIC =

LP's realized return

=NAV after distributions / PIC = 

LPs unrealized return

Fraction (f) of the firm that a venture capital investor must own as a result of new investment:

(1) NPV method

(2) IRR method

(1) New investment / PV of entire firm value at exit

(2) FV of new investment at exit / FV entire firm value at exit

(1) Selection bias: Better performers more likely to report

(2) Backfill bias: Inclusion of strong historical performance of those funds that choose to initiate reporting

(3) Survivorship bias: Historical data of deceased funds is purged

Distribution characteristics of HF returns:

(1) Normality of returns; effect

(2) In presence of (1), skewness is (pos/neg) and kurtosis is (low/high); and what combination preferred?

(1) Non-normal; this makes SD an inadequate measure of risk

(2) HF returns are NEGATIVELY skewed and have HIGH kurtosis. Positive skew and low kurtosis preferred