Learning Module 4: Private Equity Investments

Learning Module 4 Private Equity Investments Leveraged Loan Covenants To protect investors, leveraged loans often carry covenants that may require or restrict certain actions. For instance, the covenants may require the company (1) to maintain specified financial ratios, (2) within certain limits, to submit information regularly so that the bank can monitor performance, or (3) to operate within certain parameters. The covenants may restrict the company from further borrowing (in other words, no additional bonds can be issued and no additional funds can be borrowed from banks or other sources), or they may impose limits on paying dividends or even making certain operating decisions. Similarly, bond terms may include covenants intended to protect the bondholders. One of the key differences between leveraged loans and high-yield bonds, however, is that leveraged loans are generally senior secured debt whereas the bonds are unsecured in the case of bankruptcy. Even given covenants on the bonds, the bonds issued to finance an LBO are usually high-yield bonds that receive low-quality ratings and must offer high coupons to attract investors because of the amount of leverage used. EXAMPLE 1 Calculation of Carried Interest Suppose that a LBO fund has committed capital of US$100 million, carried interest of 20%, and a hurdle rate of 8%. The fund called 75% of its commitments from investors at the beginning of Year 1, which was invested at the beginning of Year 1 in target company A for $40 million and target company B for $35 million. Suppose that at the end of Year 2, a profit of $5 million has been realized by the GP upon exit of the investment in company A, and the value of the investment in company B has remained unchanged. Suppose also that the GP is entitled to carried interest on a deal-by-deal basis; that is, the IRR used to calculate carried interest is calculated for each investment upon exit. A theoretical carried interest of $1 million (20% of $5 million) could be granted to the GP, but the IRR upon exit of investment in company A is only 6.1%. Unless the IRR exceeds the hurdle rate, no carried interest may be paid to the GP. EXAMPLE 2 Distribution Waterfalls Suppose a private equity fund has committed capital of £300 million and a car- ried interest of 20%. After a first investment of £30 million, the fund exits the investment nine months later with a £15 million profit. Under the deal-by-deal method, the GP would be entitled to 20% of the profit-that is, £3 million. In the first alternative for calculating carried interest under the total return method, the LPs are entitled to the entire proceeds of the sale-that is, £45 million-and the GP is entitled to nothing (yet). Under the second alternative, the exit value of £45 million exceeds the invested value of £30 million by more than 20%. The GP would thus be entitled to £3 million. Continuing this example with a clawback provision with an annual true-up, suppose that the deal-by-deal method applies and that a second investment of £25 million is concluded with a loss of £5 million one year later. At the annual true-up, the GP would have to pay back £1 million to LPs. In practice, an escrow account is used to regulate these fluctuations until termination of the fund. EXAMPLE 3 Calculating and Interpreting Private Equity Fund Performance Suppose that a private equity fund has a DPI of 0.07 and an RVPI of 0.62 after five years. The IRR is -17%. The fund follows a venture capital strategy in high technology and has a vintage year of 2006 and a term of 10 years. A DPI of 7% indicates that few successful exits were made. An RVPI of 62% points to an extended J-curve effect for the fund, as TVPI amounts to 69% at the midlife of the fund. A vintage year of 2006 hints that the fund was started before the 2007 global financial crisis and that the routes to exit for portfolio companies have been dramatically changed. During the financial crisis, the investment portfolio probably suffered a number of complete write-offs. LPs should thus consider the state of the portfolio and examine the number of write-offs and other signals of ailing companies. The risk of not recovering the invested amount at termination of the fund is significant. The GP's compliance with valuation policies should also be closely monitored by LPs in order to ensure that the GP's expectations are not excessive given the state of the portfolio.