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.
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