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MSIN0227 Private Equity and Venture Capital
Sample Examination Solution
Examination length: THREE (3) hours
There are THREE (3) compulsory questions to the examination paper. Question 1 is worth
SEVENTY (70) marks, Question 2 is worth SIXTY (60) marks, and Question 3 is worth
SEVENTY (70) marks.
In completing this paper, you should answer ALLTHREE (3) QUESTIONS.
Your submission should be typewritten in PDF and be as one document.
You are advised to allocate your time between the three questions in proportion to the
marks available.
TURN OVER
Page 2 of 15
ALL tasks/requirements (Question 1, Question 2, and Question 3) should be responded
to.
Question 1 [70 marks]
As one of the General Partners (GP) at Plaisio Capital, a private equity firm, you are in
charge of three (3) LBO funds Shroeder Opportunity I, Shroeder Opportunity II, and
Shroeder Opportunity III.
Parts A, B, and C immediately below are independent but related to the context of
Plaisio Capital.
Part A
You have identified Barnaby Technology, a publicly traded software as a service (SaaS)
company as a potential investment for Shroeder Opportunity III (the Fund). The Fund would
take Barnaby Technology private, improve its operations, reduce any redundancies, then
exit after three years. Barnaby Technology has no debt currently.
An analyst developed the following forecasts regarding this investment:
Year 1 Year 2 Year 3
$m $m $m
Cash flows 105.00 120.00 130.00
The Fund wishes to pay $800 million for Barnaby Technology consisting of $250 million
equity and $550 million 10% debt. The $250 million equity investment is contributed as
follows:
• $170 million in the form of 12.5% PIK preferred equity from the Fund
• $72 million as common shares from the Fund
• $8 million as sweet equity common shares from the management of Barnaby
Technology
The Fund will use all free cash flows generated by Barnaby Technology to service the debt.
The Fund estimates that it will be able to sell the company in 3 years for $1.00 billion.
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Tasks
1. [Total 20 marks]
Required:
Calculate the MoM and the IRR for the Fund and for the management of Barnaby
Technology. Show your detailed workings.
[20 marks]
The proceeds available to shareholders are the ending equity. To compute the value of
ending equity, we need to compute the remaining value of the debt.
Year 1
$m
Year 2
$m
Year 3
$m
Debt at beginning of year 550.00 500.00 430.00
Interest 55.00 50.00 43.00
Cash flow 105.00 120.00 130.00
Debt at end of year 500.00 430.00 343.00
The value of the equity is:
= $1,000 − $343 = $657
The payoff to the preferred shares is equal to principal plus interest, or:
= $170 × (1 + 12.5%)3 = $242.05
Proceeds available to common shareholders is equal to $657m minus $242.05 or
$414.95. The Fund owns 90%, while management owns the remaining 10%.
The Fund common equity is worth:
90% × $414.95 = $373.46
Management common equity is worth:
10% × $414.95 = $41.50
The Fund’s MoM is equal to:
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$242.05 + $373.46
$170 + $72
= 2.54
The Fund’s IRR is equal to:
= (
$242.05 + $373.46
$170 + $72
)
1
3⁄
− 1 = . %
Management’s MoM is equal to:
$41.50
$8
= 5.19
Management’s IRR is equal to:
= (
$41.50
$8
)
1
3⁄
− 1 = . %
Part B
Shroeder Opportunity I, with a committed capital of $650 million, is well into its divestment
stage. Over the last seven years, it has made the following investments and exits
(investments made in Years 1, 2 3, and 4 were exited in Years 4, 5, 6, and 7, respectively).
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7
$m $m $m $m $m $m $m
Invested 150 77 230 50 - - -
Realized - - - 285 120 410 110
The management fee is 2%, applied to committed capital the first three years, and to
invested capital after that. The carried interest is 20%, using a deal-by-deal waterfall
approach.
2. [Total 20 marks]
Required:
Calculate the net IRR for Shroeder Opportunity I. Show your detailed workings.
[20 marks]
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Year Invested Realized Net to GPs
Invested
Capital
Management
Fee Carry Net to LPs
1 150 0 -150 150 13 -163
2 77 0 -77 227 13 -90
3 230 0 -230 457 13 -243
4 50 285 235 357 7.14 27 200.86
5 120 120 280 5.6 8.6 105.8
6 410 410 50 1 36 373
7 110 110 0 0 12 98
IRR = 14.62%
Part C
3. [Total 30 marks]
Required:
In the context of a leveraged buyout deal, briefly explain how a private equity team goes
about structuring the deal, namely deciding on leverage (how much debt versus equity),
equity components (preferred versus common), and the breakdown of the debt
components between the different types of debt.
The decision about leverage involves a trade-off between leverage and the
corresponding cost of debt. If the management of the PE firm expects a deal to be
profitable, then they would want to leverage it up as much as possible.
However, the higher the leverage, the higher the effective cost of debt (weighted
average of all tranches of debt), which can also negatively impact the IRR of the deal.
However, higher leverage also has a disciplining effect on management of the target
company.
Also, the higher the debt component, the higher the price paid (the fund can hit the
same IRR by paying more for the target if they use more leverage), since the benefit of
leverage accrues to a large extent to the seller (current owners of target company).
On the equity side, a fund would want a large chunk of their equity contribution to be in
the form of preferred shares, to give itself priority over the shares held by the
management of the investee (those are common).
Nevertheless, they want a portion of their contribution to be in the form of common
shares. The portion of their equity in the form of common shares is determined largely
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by how much sweet equity ownership they wish for the management of the portfolio
company to have.
Therefore, the breakdown of their equity contribution flows from the leverage decision
shown above. Once the total amount of equity is determined (based on cost of debt,
price, and target leverage), the breakdown of the equity part flows.
In terms of debt, the private equity fund would want to rely as much as possible on
senior, secured debt since it has the lowest cost, but the size of that tranche depends on
the target company’s asset base and ability to generate free cash flows.
What cannot be raised in the form of senior debt will be raised in the form of junior debt.
To minimize the effect cost of debt, the private equity fund will likely use equity kickers
(adding a convertibility option or a warrant) to mezzanine loans sold in the private
market.
They will also resort to junk bonds sold to the public. How much they sell depends on
market conditions and participants’ appetite.
They may also resort to vendor financing (vendor debt or earn-outs).
Earn-outs have the advantage of tying that portion of the price to management
performance in which case it is an attractive option for the private equity fund.
Finally, they can fill any debt gaps by providing a shareholder loan.
Even when the interest on that loan is not tax deductible. This tranche has the
advantage of having a larger portion of the fund’s contribution take precedence over
management’s equity.
