Friday 4 October 2019

CFA Institute Investment Foundations Program: Chapter 12 – Alternative Investments (Part II)



In a previous article, we introduced the CFA Institute Investment Foundation Program (Read more here).  It is a free program designed for anyone who wants to enter or advance within the investment management industry, including IT, operations, accounting, administration, and marketing.  Candidates who successfully pass the online exam earn the CFA Institute Investment Foundations Certificate.

There are total of 20 Chapters in 7 modules, covering all the essential topics in finance, economics, ethics and regulations.  This series of articles will highlight the core knowledge of each chapter.

Chapter 12 provides an overview of alternative investments. The learning outcome of chapter 12 is as follows:

·       Describe advantages and limitations of alternative investments;
·       Describe private equity investments;
·       Describe real estate investments;
·       Describe commodity investments.

Private equity encompasses several strategies that may help provide money to companies at different stages of their development. The most widely used strategies are venture capital, growth equity, buyouts, and distressed. Another private equity investment strategy, which is unrelated to the stage of a company’s development, is called secondaries.

Venture Capital
Venture capital is a private equity investment strategy that consists of financing the early stage of companies that have an innovative business idea. Venture capitalists frequently invest in “start-up” companies that exist merely as an idea or a business plan. The company may have only a few employees, have little or no revenue, and still be developing its product or business model. Entrepreneurs are often looking not only for capital to start their business but also for advice and expertise about how to establish and run their company.

Venture capital is considered the riskiest type of private equity investment strategy because many more companies fail than succeed. It can take many years before a company becomes successful, and most venture capital–funded companies have years of unprofitable activity before they reach the point of making money. So, venture capital investing requires patience. However, those companies that do succeed tend to greatly reward their investors.

Growth Equity
Growth equity is a private equity investment strategy that usually focuses on financing companies with proven business models, good customer bases, and positive cash flows or profits. These companies often have opportunities to grow by adding new production facilities or by making acquisitions, but they do not generate sufficient cash flows from their operations to support their growth plans. By providing additional money in return for equity of the company, growth equity investors help these companies expand and become more established.

Some growth equity investors specialise in helping companies prepare for an initial public offering. These investors provide additional money at a later stage of a company’s development than venture capitalists or early-stage growth equity investors.

Buyouts
Buyouts are a private equity investment strategy that consists of financing established companies that require money to restructure and facilitate a change of ownership. Buyout transactions sometimes involve making a publicly traded company private. For example, such companies as UK-based Alliance Boots or US-based Hertz and Hilton Hotels were once public companies, but they underwent buyouts and are now privately-owned companies.

Buyouts for which the financing of the transaction involves a high proportion of debt are often called leveraged buyouts (LBOs)—recall from the Debt Securities chapter that financial leverage refers to the proportion of debt relative to equity in a company’s capital structure. Because the high level of debt implies high interest payments and principal repayments, companies that undergo an LBO must be able to generate strong and sustainable cash flows. So, they are often well-established companies with good competitive positioning in their industry. Buyout investors often target companies that have recently underperformed but that offer opportunities to grow revenues and margins.

Distressed
When companies encounter financial troubles, they may be at risk of not being able to make full and timely payments of interest and/or principal. This risk, which is known as credit or default risk, was discussed in the Debt Securities chapter. Distressed investing focuses on purchasing the debt of troubled companies that may have defaulted or are on the brink of defaulting. Frequently, investments are made at a significant discount to par value—that is, the amount owed to the lenders at maturity. For example, an investor who purchases the debt of a troubled company may only offer the existing lenders 20% or 30% of the amount they are owed. If the company can survive and prosper, the value of its debt will increase and the investor will realise significant value. Distressed investing does not typically involve a cash flow to the company.

Secondaries
Another strategy that does not involve a cash flow to the company is secondaries. Secondaries are not based on a company’s stage of development. This strategy involves buying or selling existing private equity investments. As discussed more thoroughly in the next section, private equity investments are usually organised in funds managed by partnerships. The life of a private equity fund is typically about 10 years, but it can be longer. It includes three or four years of investing followed by five to seven years of developing the investments and returning capital to those who invested in the private equity fund. Some private equity partnerships may not be able or willing to hold on to all of their investments, which could be venture capital, growth equity, buyouts, or distressed. So, a partnership may want to sell one or several of its investments to another private equity partnership in what is known as the secondary market. The purchases and sales between private equity partnerships are secondary transactions.

A private equity partnership usually includes two types of partners:

·       The general partner is typically a private equity firm that sets up the partnership. It is responsible for raising capital, finding suitable investments, and making decisions. General partners have unlimited personal liability for all the debts of the partnership—that is, general partners could lose more than their investment in the partnership because if necessary, their personal assets could be used to pay the partnership’s debts.
·       Limited partners are investors who contribute capital to the partnership. They are not involved in the selection and management of the investments. Limited partners have limited personal liability—that is, limited partners cannot lose more than the amount of capital they contributed to the partnership.

The private equity firm makes money through two mechanisms:

·       management fees, which are the fees that limited partners must pay general partners to compensate them for managing the private equity investments. Management fees are typically set as a percentage of the amount the limited partners have committed rather than the amount that has been invested. Additionally, limited partners must pay management fees even if an investment is underperforming and must continue paying management fees even if an investment has failed.
·       carried interest, which is a share of the profit on a private equity investment. It is a form of incentive fee that general partners deduct before distributing to the limited partners the profit made on investments. Carried interest is designed to ensure that general partners’ interests are aligned with limited partners’ interests.

Investments in private equity partnerships tend to be illiquid. That is, once the limited partners have committed capital to the partnership, it is difficult, if not impossible, for them to exit the investment before the end of the commitment term.




Which type of private equity strategy is most likely used to finance a start-up company?
 
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