Private Equity Investments and Value Creation

This assignment examines the validity of private equity as a valuable source for income generation and company growth. It requires students to discuss the various ways private equity investments can create value, considering factors like acquisition selection, pricing negotiations, management incentives, and operational improvements. Additionally, the assignment delves into the inherent risks associated with private equity and how investors mitigate them.

Case study
1

TABLE OF CONTENTS
Module Aims ..................................................................................................................................3
SECTION A.....................................................................................................................................5
SECTION B...................................................................................................................................25
SECTION C...................................................................................................................................33
2

MODULE AIMS
Question: 1. Provide an analytical framework for evaluating the strategic and financial impact of private equity and venture
capital in the modern economy?
Answer:
 PE and VC plays a major role in the modern economic conditions. With reference to Harvard Management Company
(HMC), its financial impact is it is gaining higher return on their private equity investment as during fiscal year 2015, its
PE return exceeded the benchmark of 10.8% by generating 11.8% return.
 On the other hand, investor can generate a better value on their VC by investing funds in companies in their early stage
of growing.
 Along with this, it PE and VC pathway also impact the business strategy as it assists investors to redesign their
governance structure and reduce friction among management, shareholders, controlling as well as non-controlling
shareholders. Through this, companies can align their managerial decisions by taking into consideration their
stakeholders interests and satisfy them.
 In PE, investors can add value by bringing operational and governance changes and exploit capital market inefficiencies
through buying undervalued assets and disposing off the over-valued assets.
Thus, from this analysis, it becomes clear that PE and VC pathway emphasize strategic, financial and operational
decisions and adds value for the growth equity investors.
Question: 2. Present a critical examination and analysis of the practical management and exit issues related to PE?
Answer:
 IPO, trade sale and secondary buyout etc. are the several exit strategies which HMC can use to exit from the private
equity but all the strategies has several issues.
3

 More importantly, in an secondary sale, tax issue can be arise. In this, buyers will try to get protect themselves from the
future tax demands of the taxation authorities by demanding certification, tax indemnities from the seller and preparing
an insurance policy as well.
 However, after the amendments in the finance act, it becomes very complex and tough for the buyer to obtain this
certificates.
Question: 3. Present the PE sand VC “life cycle”, from selection of targets, valuation techniques to exit strategies?
Answer: It is presented here as under:
According to this graph, it represents that formation, raising capital, operation and growth and exit are the stages of
private equity.
4

This chart presents that concept, start-up, growth and later stage are the 4 stages of venture capital funding.
Question: 4. Review and apply the key concepts and tools of corporate finance in the context of private equity industry?
Answer:
Key concepts and tools of corporate finance in the context of PE industry:s
 Corporate finance is an area which major deals with long-term financial sources. In context to private equity, there are
various tools available to the investor for taking better investment decisions such as Capital Assets Pricing Model and
Discounted Cash Flow Model (DCF).
 In the CAPM, investors can determined the cost of capital on their potential investments and by this, they can take take
decisions to invest funds at an affordable level of risk.
 DCF assist investors to estimate future cash flow and discount it at an appropriate rate of discount. With the help of this,
they can take viable decisions by the means of forecasting.
Question: 5. Build an appreciation of the valuation process in the private equity setting?
Answer: Accurate and prominent portfolio helps investment to take good decisions and also helps to attract more and more
investors. It plays a very important role because robust valuation process helps to reduce risk and ensure financial stability.
5

Question: 6. Assess the new phenomenon: Sovereign Wealth Funds and their role in the world economy?
Answer: Sovereign wealth funds is regarded as state owned money pool which is invested in different types of financial assets,
also known as budgetary surplus. It plays an important role in the foreign direct investment, government bonds and equity
investment as well.
SECTION A
Question: 1. Describe the main categories of Private Investing and comment on the extent to which these are used by Harvard?
Answer:
Introduction to private equity
Private equity is regarded as a finance source through which organizations can acquire funds by selling business equity to
the individual and institutions. In the corporate world, large number of companies meet their financial need by providing
ownership rights to the investors. In other words, it transfer the controlling power to the shareholders through which they can
take part in controlling regular business operations and decisions. It is an assets class which comprises both debt and equity
funds invested in privately held companies or organizations which are engaging in buyout of another companies. With regards to
HMC, it invest private equity by providing capital to invest in new technology, acquisition, expansion of working capital and
boost the balance sheet as well.
Types of Private equity funds or investment
There are different categories of private investing such as leveraged buyout, growth equity, venture capital, real estate
investment etc which are discussed here as under:
6

Leverage buyout (LBO) : It refers to acquisition of controlling stake which may be either alone or in partnership with
other PE firms. It is regarded as the collection of both long-term debt and equity capital by the PE firms and in the go-go year,
they use high level of debt while in the time of post-financial crisis, debt fund tends to decline to 50%.
7

Venture capital (VC): It mainly invest in start-up businesses which are operating in extensive growth sectors. In this,
capitalists do not make investment with the aim of getting regular cash flows like PE firms. Their strategies are to maximize
company's growth potential by expansion, introducing new customers and partners etc.
Growth equity funds: This are mainly invest in mature organizations which are looking for scale based benefits by
entering into new markets. Growth equity funds can be regarded as bridge between the private equity and venture capital.
Real-estate: In this, investors put their money to acquire ownership in real-estate properties. Detailed discussion of real-
estate are analyzed here as under:
Core Lower risk Lower return
Core-plus Moderate risk Moderate return
Value added Medium – high risk Medium – high return
Opportunistic High risk High return
Mezzanine financing: It consists of both debt and equity financing which are used by the organizations for their
expansion program. In this, companies use debt capital which provide rights to the lender to acquire an equity interest in the
company. Its most important advantage is it assist businesses to meet their capital need without transferring a lot of ownership
rights. However, on the other hand, lenders have greater risk because this financing are not collateralize such as bank loans.
Private equity business model:
8

Important highlights
 This model presents that at the initial stage, firms raise funds through different sources for potential investment.
 Thereafter, companies identify different types of available investment opportunities and negotiate deal accordingly. This stage
mainly comprises deal selection, due diligence, financing and structuring as well.
 After this, PE firms take decisions to enlarge their operational results and business position.
 At the last stage, private equity firms valued their investment in order to ensure liquidity.
Private Equity Fund Structure:
9

According to the presented graph, it can be seen that investment team comprises fund manager and general partner, also
called PE firm which raise money and manage portfolio. General partner invest less percentage approximately 1 – 5% whereas
the rest of the money are invested by the outside investors such as assets management companies, trusts, pension funds and other
kind of limited partners.
10

Private Equity's investment dealing process:
According to the
diagram, it can be seen that sources lead, underwrite, due diligence, negotiating and raising of capital are the stages covered in
the investment process of private equity.
HMC's investment process:
11

 With regards to HMC, at the first stage, its investment team are engaging in more cross assets class discussion and
collaboration. Its board are highly committing to develop a strong investment portfolio by the comparison of various
investment opportunity available to the company.
 Secondly, Its CEO is encouraging their portfolio managers to be creative in identifying new investment platform which
will deliver maximum benefit to the company. It keep in mind the flexibility and reduction in management fees while
taking investment decisions.
 Harvard University owes $37.6 billion endowment assets. Therefore, deep market experience, analytical study,
determining alternative investment opportunities etc. is also of great importance for portfolio creation. University has
very risky portfolio with a greater beta value but still, it is managed effectively by analysis of the market environment.
12

1) As per the graph, investment manager also negotiate the agreements to take benefits of maximum return.
2) In the negotiation process, they initial estimate the buying price and working capital.
3) Thereafter, they decide structure of the private equity by identifying debt, equity, seller-financing etc.
4) After this, risk is mitigated by environmental liability, tax liability contingencies etc.
5) In the end, negotiation agreements are prepared such as management employment agreement and non-compete
agreements.
13

 In the end, it is operating with both the investment partners and peer institutional investors across the globe. It also meet
with internal as well as external managers of several investment institutions to obtain their advice for the better portfolio
decisions.
Deal financing:
As discussed earlier, that PE includes both debt and equity financing while finalize the deal which are discussed here as
under:
Debt financing: In this, funds can be invested in long-term debt capital through Mezzanine. It deliver rights to the
lenders to acquire equity ownership rights in the company. Henceforth, companies does not need to provide any collateral
14

securities to them which is an advantage of it.
Equity financing: PE fund and fund-less sponsor are the types of equity financing. It is a process through which investor
can raise money through sale of shares. In other words, if funds are acquired by the sale of ownership rights than it is known as
equity financing.
Hybrid investment model of HMC
 Harvard University is a private research university which was established in the year 1636. Harvard management
company (HMC)'s CEO Stephen Blyth follows hybrid investment model in which both the internal and external
management teams are focuses on specific area of investment.
 The main goal of this is to encourage an integrated investment approach in order to generate sufficient income to meet
University's operational budget need.
 Blyth's investment policy is not highly committed to invest huge money in illiquid assets.
 According to its endowment report for the fiscal year 2015, its total return and value reported to 5.8% and $37.6 billion
while the performance of each assets class are outlined below:
Important highlights
15

 From the above chart, it can be seen that HMC generated high return of 11.8% on
its private equity than the set benchmark of 10.8%. Moreover, the rate of return on
total public equity, natural resources and real estate are higher to 2.9%, 3.5% and
19.4% respectively.
 It represent more challenging conditions in the financial market. In 2015, its
endowment return is reported to 5.8% which is comparatively lower than previous
year's return of 15.4%.
 Foreign and emerging market stock generated loss due to which University's total
return came down to 5.8%.
 HMC's overall performance is good as it exceeded the benchmark of 3.9% and
reach to 5.8%. Assets allocation model to portfolio creation is the main reason
behind this occurrence.
 The proportion of private equity is around 1/6th of the entire portfolio which yielded
11.8% return. However, the VC is the main key driver of the portfolio return as it
VC investment returned 29.6% during fiscal year 2015. It is specially performed
outstanding in technology sector.
16

Summary:
 This chart reflects the growth of HMC's endowment annualized return from 1975 to 2015.
 According to this, it shows a continuous growing trend but still, the rate of increasing is fluctuating.
 As per the chart, annualized return for HMC endowment is 12.2% whilst for US stock or bond portfolio, it is 9.3% only.
17

Summary:
 This chart demonstrates return during the period of 1, 5, 10 and 20 year.
 In the time period of 1, 10 and 20 year, HMC's endowments depicts highest return of 5.8%, 7.6% and 11.8% as compare
to other.
 On the other hand, in 10 year, the return on portfolio benchmark, global portfolio and US portfolio are 6%, 5.4%, 6.8%
whereas in 20 year, this are 8.8%, 6.1% and 7.9% respectively.
 However, during the period of 5 year, US stock/bond portfolio indicates greatest return to 11.7% while, HMC
endowment have return only 10.5%.
18

Question: 2. What is the role of Limited Liability Partnerships (LLPs) in the organization and structure of the Private Equity
Market? Describe How LLPs facilitate the process of intermediation in the Private Equity market? How are the challenges of
information asymmetry that is characteristic of private equity investing addressed. Comment on the role of the General partners.
Answer:
Meaning of LLP
 When two or more people own a general partnership they share open liability for the debt and financial obligation of the
business is known as LLP.
 In general partnership, all the partners owes unlimited liability whereas the common structure of LLP is that partners
liability is limited for their financial obligations.
Role of LLP in the private equity:
 LLP plays an important role in the structure of private equity, it is because, PE funds follows a framework which take
into account the partners fund, investment horizon, managerial fees and other factors mentioned in the limited
partnership agreement (LPA).
 LLP can also be seen as a different opportunity for the investors from the private equity, in which, fund can be provided
in the form of LBO, Mezzanine, distressed debt, loans etc.
Role of general partners:
By registering with state agency general partner, firm can create a limited liability partnership. They contribute capital to
the firm but not participate in regular management of business. General partner can be litigate for any amount of money the
business build on and can end up using own personal assets to pay debt.
Question 3: How has the HMC endowment fund approached asset allocation? What are their main objectives and constraints to
investing in private equity?
Answer:
19

Approach of HMC's assets allocation and its objective
Asset allocation is the most fundamental strategy for investment decision it is also like challenging task for firm. The
goal of Harvard University endowment is to take strategic investment decision as an institutional investor. In this approach
assets class return, risk and correlation exception serve as the basis for optimization, and has high certainty in its input. For
assets allocation, investor like to follow a tried and true formula for minimizing the risk.
Harvard Management Company's investment model, FIFAA
With reference to HMC, it follows Flexible Indeterminate Factor Based Asset Allocation, shortened to FIFAA which
comprises 4 steps, described below:
1) Selection of appropriate factors: HMC's management team select mainly five essential factors that are US treasury, high
yield credit, inflation, currency and world equity to analyse risk and return on bond and equity, also known as reference
portfolio.
2) Measuring assets class exposure to factors: In this step, HMC identify that how an assets class will be related to the
selected factors. Flexibility is an attractive feature of FIFAA, which helps University to implement factor exposure to the
investment opportunities. In this, management use both empirical and market-informed approaches in order to assure
accurate forecasting.
20

3) Choosing factor exposure: This step is about selection of appropriate factor exposure which is based on both risk -return
portfolio. Management team chose factor by taking into consideration decrease in equity exposure, minimizing inflation
exposure, enhance dollar value and increase bond and high yield exposure. It is the main basis of HMC's strategic assets
allocation to fulfill the long term objectives.
4) Creating an assets class portfolio: This step involves creation of portfolio by deciding ranges for twelve or more assets
class. The most important point regarding portfolio creation is that it needs to satisfy or optimize all the five previously
discussed factors. The goal of the HMC's assets allocation process is to brings continuous improvements in multi-assets
class and mean-variance approach. HMC's 2016 assets allocation are analyzed here as under:
21

 According to this table, it can be seen that the ranges provides the flexibility to
the company to carry out an investment in variety of alternatives available to
HMC.
 The basis of HMC's assets allocation is to maximize return at given risk factor
so that University can acquire high yield on their investment by minimizing risk
involved.
 Presented table reflects that maximum range has been allocated to private
equity as it is between 13% to 23%. It indicates that University assigned high
weight to P/E asset class as compare to other.
 US equity ranges between 6%-16%, foreign equity 6%-11%, emerging market
equity 4%-17%, absolute return 11%-21%, natural resources and commodities
6%-16%, real estate 10%-17% and domestic bonds ranges from 5%-9%.
 On the contrary to this, zero level of minimum range has been decided for high
yield, foreign bonds and inflation-linked bonds.
22

Question: 4. Drawing evidence from the 2013 Harvard Endowment report, discuss the role of Private Equity investments in
institutional portfolios. Explain the main risks that could be faced by Private Equity investors and comment on how these can be
managed?
Answer:
Role of private equity in institutional portfolio:
 The role of private equity in the institutional portfolio is increasing day by day. Henceforth, it is important for an
investor to actively manage their asset allocation and deliver better return in future.
 Looking at the present volatile market era, many of the financial institutions are struggling because of weakened balance
sheet and high exposure to equity funding.
 Moreover, bailout and stimulus packages in the nations did not boosted the market to provide adequate funds to the
institutions. As a result, there is only one real source available to them which is debt or equity to meet their financial
need.
Private Equity's risk and its management by HMC:
 There are different type of risk involved in private equity. One of the most important risk is it is very difficult for the
investor to gain access to top-tier manager. Moreover, information asymmetry is a risk for the investor which can lead to
take harmful decisions.
 Furthermore, dispersion risk is also a challenge which indicates that there is a huge difference in the median return and
top-quartile return for the PE firms. Besides this, they cannot compare the actual performance until the entire portfolio
companies are sold.
 Apart from this, they also bear basic investment risk which is regarding identifying, selecting and investing in the
company. Thus, it becomes clear that private equity involved funding, liquidity, market and capital risk for the investors.
23

 Therefore, HMC use different methods to manage their risk and reach targets. Value at risk, liquidity adjusted value at
risk, cash flow at risk and sensitivity analysis etc. are the several types which are used by them in their risk management
framework.
 Furthermore, diversification, monitoring etc. are also used by the HMC's investment team to minimize their risk and
maximize return.
Harvard Management Company's 2013 Endowment report
Important highlights:
24

 According to the table, it can be seen that on 30th June, 2013, HMC's endowment valued
at $32.7 billion which was increased by $2 billion or by 6.5% from the endowment
value of $30.7 billion in 2012.
 During fiscal year 2013, HMC's endowment assets returned 11.3% while in the
historical year, it showed negative return. Henceforth, it can be stated that it was a better
improvement as it shows growth in return.
 Public equity assets delivered favorable return of 16.3% which is higher than benchmark
of 14.5%. On the other hand, fixed income and real-estate returned 3.3% and 7.0%
respectively.
 HMC's overall endowment was 11.3% which exceeded the benchmark by 2.2% as it was
9.1%.
 While, on the basis of internal comparative study, it has been noticed that HMC return
for 2012 was negative to 0.05% which rose up to 11.3% in 2015 which is an evidence
of good improvements.
Question: 5. Describe the main risks inherent in Private Equity Investments and comment on how these are managed by
Harvard Endowment?
Answer:
Inherent risk and its management by Harvard
 Risk management plays an inevitable role in designing a successful portfolio. With reference to HMC, its Chief
Investment Officer (CIO) manage its endowment investment portfolio by integrating risk management strategy with its
portfolio creation or investment strategy.
25

 It identify risk in the PE and manage it by taking appropriate actions on a timely basis. CIO adjust the inflation rate to
fulfill the current and potential requirement of the university in an effective manner.
 Moreover, risk adjusted assets allocation and long-term partnership with the managers assure its operational success.
Further, in order to eliminate risk, its portfolio is created by making mean-variance analysis.
 HMC's investment committee and board member are minimizing multiple form of risk such as market, leverage,
illiquidity and counter party risk by continuous monitoring and controlling.
 HMC's management board pay focus on measuring its investment risk so as to establish effective control over it.
Moreover, its risk tolerance factor is also a main factor in the portfolio designing.
 HMC works with the University to identify and measure different risk parameters and thereby generate adequate return
at an acceptable level of risk. It enable company to meet the return expectation of the University on its universally
diversified investment. portfolio.
 ESG Integration, Active ownership and Collaboration are also the main factors which are taken into account by its
portfolio strategy's Managing Director. In this, ESG integration comprises monitoring, evaluation, due diligence and
assets management whereas collaboration depicts that HMC works with universal investors in order to assure sustainable
investment strategies.
Question: 6. Discuss the role of due diligence in private equity investing and comment on how this may be implemented by the
Harvard University Endowment fund?
Answer:
Role of due diligence in private equity
 Role of due diligence in private equity firm is understood as a second or third derivative between existing management
and the new owners. Quality of information also refines between shareholder and company by using this approach.
26

 However, appropriate time is allocated for selection of right kind of private equity through which rate of return can be
increased.
 Furthermore, due diligence also teach among experienced management team within boundaries of operation with focus
upon leveraged balance sheet. They reallocate the company constrained operation to a larger facility to give the
opportunity to grow.
 It internally shows that employees are responsible for overseeing operational due diligence also had other responsibility.
It also helps to disclosure in a privately owned enterprises it may be of poor quality, influenced by tax and other.
Private Equity Investment due diligence
Due diligence is regarded as a process of minimizing risk comprising in the portfolio. It is important for HMC to
perform significant due diligence while deciding their investment portfolio, particularly private equity investment, analyzed
below:
27

Harvard University's due
diligence mainly includes top-down approach and internal managerial analysis.
Top down approach: In this approach, investment team mainly focuses on evaluating macro conditions such as external
market analysis to take better quality of investment decisions. It comprises criteria of potential investment in different assets
class group, review of fund's track records and risk mitigation tools and techniques. For instance, analysis of Earning before
interest, tax, depreciation and amortization helps investors to analyze determine the risk and return profile so that they can take
qualitative decisions.
28

Manager specific analysis: In this approach, managers examine historical financial records and allocate resources to
gain maximum return. In this, fund analysts consider different segments and industrial sectors to analyze risk/return and make
better portfolio decisions.
HMC's PE due diligence process
 HMC's initial due diligence starts with screening process, in which, investment management team analyze historical
financial track records, their business strategy and analysis of management team as well.
 After this, at the qualification phase, Harvard University review internal financial statements, operational structure and
projections also.
 Thereafter, it will be passed to the next stage, in which, investment board review assets allocation for the portfolio
creation. Qualified investment opportunity will be approved through a formal mechanism.
 Managers regularly monitor the investment progress so as to create an optimum portfolio by maximizing return at an
acceptable level of risk.
Challenge in due diligence
 One of the most important challenge is that it is very complex for the investors to obtain precise and prominent
information about the market. It is because, in the present era, market is highly volatile. Therefore, it becomes very tough
for an investors to estimate authentic information hence, incorrect information may lead to harmful decisions and
decline return as well.
 Volatile external market conditions makes it difficult for the investors to forecast future trend and identify an accurate
amount of future cash flows on potential investment. Thus, wrongful projection may lead to take worst quality of
investment decisions and may lead to failure.
 The projection is also dependent upon the expertise and top quality professionals who have great experience in the PE
investment. Therefore, lack of experienced investment team is also a challenge for HMC.
29

SECTION B
Question: 1. Barcelona’s Venture Fund is evaluating a $5 million investment in Cayman Industries. The fund manager has
calculated a cost of equity of 17% and estimates that if Cayman survives for four years, the payoff from selling the stake in
Cayman will be $30 million. The fund manager has estimated the following failure probabilities for Cayman Industries:
Year 1 2 3 4
Probability of Failure 30% 20% 15% 10%
What is the net present value of the potential investment in Cayman Industries?
Answer: According to the scenario, Barcelona’s venture fund is desire to make investment of $5m dollar in Cayman Industries.
The fund manager determined that cost of equity is 17% and also forecast that if the company survives for 4 years, then payoff
from selling the stake in the Cayman will be around $30m. The finance manager predicted that the possibility of project failure
are 30%, 20%, 15% and 10% respectively. Now, Barcelona is intended to assess the viability of this proposal which can be done
through identifying the net present value of the project. NPV indicates the net return which Barcelona can generate by investing
money into Cayman Industries. It is considered as the best technique as it take into account the time value of money and provide
more realistic results about the project return. In the corporate budgeting, NPV method use cost of equity as a discounting rate to
find out the future value of estimated return. Thereafter, total of future value is subtracted from the initial investment to find out
the net project return, called NPV. According to the selection criteria of this rule, if the project indicates favorable or positive
return than investor can accept it. However, in the case of two alternative, potential capitalists has to select such proposal which
yield greater return in the future period. As per the scenario, net present value is calculated here as under:
Probability of project's success
Year Failure probability Success probability (1-failure probability)
1 0.30 0.7
30

2 0.20 0.8
3 0.15 0.85
4 0.10 0.9
Total probability of project's success = 0.70*0.80*0.85*0.90 = 42.84%
Total probability of project's success = 1- 42.84% = 57.16%
According to this, if Cayman survives for a time period of 4 year, than expected NPV will be computed as under:
Money obtain at the end of 4th year by selling the stake in Cayman = $30,000,000
Cost of equity (ke) = (1+17%) ^4 = 1.874
= $30,000,000/1.874
= $16,009,501
Expected NPV of venture capital = ∑ (Period cash flow/ (1+r) ^t) - Initial investment
(0.4284*$16,009,501)+ (0.5716*$5,000,000)
= ($6,858,470 - $2,858,000)
= $4,000,470
Taking into account the results, it can be seen that if the Cayman operates successfully during the projected period of 4
years, than Barcelona can generate positive NPV worth $4,000,470 on his potential investment of $5m. Henceforth, it can be
said that he should accept the project and invest money into the Cayman Industries.
Question: 2. A venture capital Fund Manager is considering investing $2,500,000 in a new project. The projected cash flow
from the project is $12,000,000 at the end of five years if the project is successful at the end of the 5-year period. The cost of
equity for the investor is 15%, and following extensive due diligence on the project the manager has established that there is a
possibility that the project may not survive the 5-year period. The due diligence process has also revealed that there is a
31

possibility that the project can fail in any given year over the five years. The estimated probability of failure in any given year is
presented in the table below;
Estimated Probability of Failure
Year 1 2 3 4 5
Probability of Failure 0.20 0.20 0.17 0.15 0.15
Further research by an analyst at the Fund Management firm has revealed that there is an investment bank that is familiar with
the venture and is willing to insure against failure for a fee of $1,000,000. The Fund Management firm has approached you to
express an opinion on the following;
1. Proceed without the insurance contract
2. Proceed with the insurance contract
If you become aware that the investment bank has priced risk on the insurance contract correctly, comment on any additional
due diligence information you would recommend the Fund Manager to seek before engaging on the investment.
Answer:
32

According to the diagram, it can be seen that venture capital industry has four main players that are business
organization, venture capitalists, investment bankers and investors who demand for high return. Every investment carries risk
with it and venture capital is a long-term investment henceforth, it is obvious that risk is always associated with it. Capitalists
can protect themselves from the risk by co-investing with other firms. With regards to the current scenario, investor desires to
invest $2,500,000 in the venture capital at a project life of 5 year and at the end of project life, it has been estimated that he will
33

obtain $12,000,000. The cost of equity or discounting rate is 15% and the due diligence process revealed that there is also a
probability of project failure hence, the NPV calculations is done below:
1. Proceed without the insurance contract
Year Failure probability
Success probability (1-failure
probability)
1 0.2 0.8
2 0.2 0.8
3 0.17 0.83
4 0.15 0.85
5 0.15 0.85
Total probability of project's success = 0.80*0.80*0.83*0.85*0.85= 38.38%
Total probability of project's success = 1- 38.38% = 61.62%
Money obtain at the end of 5h year by selling the stake = $12,000,000
Cost of equity (ke) = (1+15%) ^5 = 2.011
= $12,000,000/2.011
= $5,966,121
Expected NPV of venture capital = ∑ (Period cash flow/ (1+r) ^t) - Initial investment
(0.3838*$5,966,121+ (0.6162*$2,500,000)
= ($2,289,749 - $1,540,520)
= $749,229
2. Proceed with an insurance contract
Current scenario stated that an investor is willing to insure against project failure at a fee of $1m. By this, capitalists can
assure smooth running of the project and remove the risk of its failure. Here, the expected project's NPV will be as under:
34

Expected NPV = ($12,000,000/2.011) – (2,500,000+ 1,000,000)
= $5,966,121 – ($3,500,000)
= $2,466,121
3. Comment on additional due diligence to recommend the fund manager to seek before engaging on the investment
Apart from the insurance, there are different types of due diligence available to the fund manager while making any
investment. It includes screening, business and legal due diligence as well.
Screening due diligence: In this process, capitalists can review and evaluate various investment opportunities over its
project life with a predetermined criteria. It helps investor to to minimize risk and take better investment decisions.
Business due diligence: After identifying the opportunity, deal can be assigned to the junior and senior management
team to determine the project viability. It is a specific process, in which, managers review the investment project, market
potential and the business model as well to take better decisions.
Legal due diligence: Venture capitalists can recruit lawyers, advisers etc. to make right selection among all the
alternatives available to him.
Question: 3. Explain the stages in venture capital investing, venture capital investment characteristics, and challenges to venture
capital valuation and performance measurement?
Answer:
Process
Venture capitalists invest their money in the businesses and fulfill the financial requirement of the corporations. Its
process is discussed below:
Seed-stage: In the inaugural stage, capitalists provide money to the entrepreneurs of their product development, build an
efficient management team, business plan and conducting an extensive market research as well. Further, they also provide funds
to an entity to bear the cost of expansion such as sales and distribution, recruiting people and marketing as well.
35

Early stage: Companies which are ready to start their operations in the market, but still, they are not ready for
commercial manufacturing prevail in this stage. It involves both start-up and first stage, in which start-up investing support
product development and initial marketing whereas first stage is regarded as providing capital for the commercial production
and carrying out sales operations.
Formative stage: It is the combination of both the seed and early stage in which investor provide money for different
objectives which are discussed previously.
Later stage: In this, money is provided after starting the manufacturing process but still, before the IPO. This stage helps
to meet the financial need for plant expansion, bringing improvements in products, expanding the operations and Mezzanine
(bridge between IPO and expansion) as well.
Balanced stage: It is the last stage which includes collection of funds from seeds to Mezzanine. In this, money can be
used for varied purpose like mergers and acquisition, reduction in price to enhance competitive strength, taking a step towards
IPO etc.
Characteristic of venture capital funding:
 Illiquidity is one of the basic feature of VC funding which indicates that it is not easy for an investor to convert
investment to the cash.
 It is a type of long-term investment which ranges between 3 to 5 years but still, the possibility of return is very large.
 It is very difficult for identify the market value of VC because of the reason, that such kind of assets are not traded at an
active marketplace.
 It contains less historical risk because of unavailability of an active market.
 Lack of information is also a characteristic of venture capital. The reason behind this is sometimes, an entrepreneur may
be new hence, in such case, little information will be available to the investor.
36

 Vintage cycle indicates that start-up business volume is greatly dependent upon economic environment which provide
both opportunities and risk as well.
Challenges to valuation and performance measurement:
 Requirement of a skilled, experienced and talented management team is a major challenge in the venture capital funding.
 High payback period of the invested capital is also a challenge for the capitalists.
 Capitalists invest money in new businesses hence, the risk of uncertainty and business failure is also a difficulty for
them.
 Lack of complete information about the market size, company's competitors, market share, potential consumers, pricing
details etc. arisen a problem in taking viable decisions.
 Financial considerations such as ROCE, initial project cost, internal rate of return (IRR), mortgage loans etc. also
influenced the investment decisions to a major extent.
Question: 4. Explain alternative exit routes in private equity and their impact on value?
Answer:
Private Equity's exit strategies:
The ultimate goal of the private equity investor is to obtain good return on their investment. Exit process plays an
important role in the investor’s decisions that whether they should invest fund or not in a particular organization. There are
following ways available to the Harvard University as an exit routes from private equity, examined below:
Initial public offerings (IPO): It is the very common way by which HMC can issue their own shares in the market and
sale equity to the public. By listing the shares on a recognized stock exchange, companies are entitled to go to the public for
fund collection. But still, its disadvantage is it is very expensive and time consuming process. Along with this, if an investor is
looking for full exit than future public investor can view such exit as a lack of confidence which impact value adversely.
37

Secondary buyout: This is regarded as the process in which HMC can sell their entire stake in the organization to
another financial sponsor. It may be done due to different reasons such as requirement of excessive capital and changing
economic climate etc. Moreover, if the investor believes that new PE firm can add more value to the portfolio than they can also
use this way as their exit route.
Trade sale: In this method, University can sale their entire shares to a trade buyer. It provides an advantage of complete
and immediate exit. Moreover, it is considered as more efficient process because it do not involve high regulatory restrictions
which is applied in IPO. On the other side, it can lead to arise risk and difficulties. For instance, if the buyer is competitor of the
firm than it will lead to disclose confidential business information in the process of negotiation.
SECTION C
Question: 1. XYZ Corporation has just paid a dividend of £0.50 per share and the Board has announced that the dividend can be
expected to grow at the rate of 15% a year for the next 3years. Beyond that, the expected growth rate will decline to 4% a year
forever. The costof equity for XYZ Corporation is 12.5%. XYZ Corporation’s current tax rate is 21% and the company currently
has no debt in its capital structure. It has however become the target for a leveraged buyout transaction financed with 20%
Private Equity Investment and 80% debt. The Private Equity firm seeking to complete the suggested transaction has approached
you and you are required to provide clarification to the General Partners and address the following specific questions;
1. What is the current fair value of XYZ Corporation if the company has 500 million shares outstanding?
2. Outline the key requirements that you believe are vital for a successful investment in XYZ Corporation using the
suggested Private Equity Investing approach.
1. If the deal price per share is the fair value plus 10% premium, what is the required market value of Equity and Debt
in the revised capital structure of XYZ Corporation after the transaction?
2. If the Private Equity firm wishes to maintain a weighted average cost of capital of 12.5% after the transaction, what is
the implied cost of debt if the company’s tax rate is expected to remain unchanged? Explain the factors that may
affect the cost of debt for XYZ Corporation.
Assuming that XYZ Corporation can be sold after 5 years for £25 per share, if the cost of debt is 15.8% per annum over
5 years, what is the annual percentage return to equity investors?
3.
0 1 2 3 4 5 6 7
Dividend 0.5 0.575 0.66125 0.7604 0.7908 0.8224 0.855389 0.8896
38

38 55 89 04
growth 15% 15% 15% 4% 4% 4% 4%
ke 12.50%
DF
0.8888
89 0.790123
0.7023
32
0.6242
95
0.5549
29 0.49327
0.4384
62
PV of
Dividends
0.5111
11 0.522469
0.5340
8
TV
9.3041
76
PV Y1-3 1.567659808
PV of TV 6.534620512
8.10228032
Shares 500 million
V0
£
4,051 million
Purchase
Price
£
4,456.25
Equity
£
891 million
Purchase price*
19%
Debt
£
3,565 million
Purchase price*
80%
39

kd 15.8% =12.5%/(1-21%)
0 1 2 3 4 5
Starting
Debt
£
3,565 £ 3,723
£
3,858
£
3,960
£
4,059
Dividend
-£
288 -£ 331
-£
380
-£
395
-£
411 Dividend *500
Interest
£
564 £ 589
£
610
£
627
£
642
Starting debt* cost
of debt
Tax Shield
-£
118 -£ 124
-£
128
-£
132
-£
135
D
£
3,565
£
3,723 £ 3,858
£
3,960
£
4,059
£
4,156 Interest *21%
Value Y5
£
30
per
share
£
15,000 Value of share*500
-£
4,156
PE Return
£
10,844
Investment
£
891 Equity
Return 12.16754618 PE return/Investment
CAGR 65% Retrun^(1/5-1)
Answer: 1.
40

Current fair value of shares is 899 million which means that considering dividend and its growth rate as well as cost of equity or
required rate of return shares must be valued at mentioned price. In order to compute fair value of shares Gordon growth model
is used in under which formula S/(K-G) is applied.
Answer: 2. There are number of factors that needs to be considered for making successful investment in XYZ under private
equity approach. First of all investment must be made in various stages or money must be provided to the firm in different
phases. This is because business growth rate will be different in different time period. Hence, it is very important to make
projections of cash inflow in different stages and accordingly investment must be made. In order to make investment
successfully in XYZ it is very important to understand business model of the mentioned firm. Along with this it is also very
important to understand industry to which firm belong. Broad understanding of these two things will help private equity firm in
estimating growth rate. On that basis answer of question whether investment must be made in XYZ can be identified easily. By
doing all these things investment can be made in proper way in XYZ.
Answer: 3.
The revised value of equity is deducted from entire capital amount which is 891 million. Now the required market value of debt
is 3565 million.
Answer: 4.
Cost of debt for XYZ is 15.8% after deduction of current tax rate. In the calculation 80% of purchase price is computed.
Some of the factors that may affect cost of debt are interest rate that can be changed by the central bank. If loan is taken at
flexible interest rate then with hike in central bank interest rate cost of debt will also increase.
Annual percentage return to shareholders is negative which is 65%.
Question: 2. Some private equity market participants hold the view that the key to successful private equity investing lies in the
Private Equity Firm being able to evaluate the following questions early and correctly;
1. What are we really buying?
41

2. What is the target’s stand-alone value?
3. Where are the synergies – and how can these be realised?
4. What is our walk-away price?
Discuss this view in the context of a Leveraged Buyout transaction and explain the relevance of these questions to the due
diligence process and the success of the transaction.
Answer: All these questions have relevance to due diligence process and success of transaction. This is because if PE firm will
know that what they really are buying which means business they will be able to determine whether investment in specific
business will be profitable on the basis of evaluation of economic environment. It is also necessary to determine target stand
alone value of project for success of transaction. This is because enterprise value reflects the business size that may happen of
the firm in future time period. On the basis of calculation PE can identify the fair value of shares and on that basis it can
determine net profit on share per unit which it will received when shares will be sold in future according to agreement. Hence, it
is very important to get answer of question which is “What is our walk-away price?”. If firm will know where are the synergies
then it will be able to determine areas that will act as USP of the firm. Hence, these questions have relevance to the success of
transactions and due diligence process. Leveraged buyout transaction means one is acquiring other company asset and keeping it
as collateral security with the bank from which loan is obtained which is used to buy asset. So other bank will fund such kind of
heavy requirement when PE firm will be able to prove that firm in which they are going to invest is profitable. Hence, evaluation
of these questions is important.
Question: 3. Goodheim Corporation is considering a major change in its capital structure. Presently the firm has a beta of 1.5
and the market value of debt and equity is £2 and £4 million, respectively. The corporate tax rate is 28%, the 3-months UK gilt
is 2.5% and the market risk premium is stated at 5.5%.The firm considers a change in terms of its capital structure and is
exploring 3 separate options:
42

1. Issue £1 million in new stock and repurchase half of its outstanding debt. This will make it a AAA rated firm (AAA
rated debt is yielding 6% in the market place).
2. Issue £1 million in new debt and buy back stock. This will drop its rating to A-. (A- rated debt is yielding 8% in the
market place).
3. Issue £3 million in new debt and buy back stock. This will drop its rating to CCC(CCC rated debt is yielding 10% in
the market place).
From a cost of capital standpoint, which of the three options would you pick, or would you stay at your current capital
structure?
Now 1 2
D 2 1 3
E 4 5 3
EV 6 6 6
Enterprise
value=Debt+equity
Beta(g) 1.5 1.26 1.90
Beta*(1+debt/equity)*(1-
28%)
Beta
(u) 1.10
ke 10.8% 9.4% 12.9% 2.5%+Beta(g)*5.5%
Kd 7.0% 6.0% 8%
WACC 8.8% 8.5864215686274500% 9.3%
Ke*E/EV+Kd*(1-28%)*D/EV
43

Answer: From cost of capital stand point first option is selected for Goodheim Corporation. Value of WACC is 8.5% in first
option and in second option it is 9.3%. If second alternative will be implement then debt proportion will be equal to equity.
Moreover, value of beta is already high which means that in case of turmoil in economy share price will decline at sharp rate
which will create negative image of firm share among the investors. Hence, it will be better to issue shares and repurchase half
of outstanding debt. This will bring balance in the capital structure.
Question: 5. A new company to be created through a leveraged buyout transaction would issue, 10 million shares with a par
value of $20.The proposed purchase price is $550 million. In addition the new company would refinance $60 million worth of
long-term lease obligations. Fees are expected to run at 5% of the purchase price. Expected new Capex and restructuring costs
are estimated at 8% up front.
On-going Capex will be 7% of EBIT. The tax rate is 28%. The company expects to have EBIT of $80 million in the 12 months
prior to purchase. This is predicted to grow at 7% for the first 3 years and 4% thereafter.Discussions with banks suggest that for
this kind of business it might be difficult to a syndicate acquisition loan unless EBIT interest coverage is at least 1.6.
At this level, the cost of funds would be quite high (see table).
The managers, who would run the company, have managed to raise 5 million among themselves to invest in the company. The
remainder must be raised by the private equity firm, whose partners generally look for an exit plan after 5 years and a return of
25%. Similar companies have been able to go public at a multiple of 9x EBITDA-Net Debt, but this group is hoping for more.
Current long term government bond rate is 4.00%
a. What is the company's debt capacity, and how much additional financing is needed? b. What forms of financing could fill the
funding gap?
c. What kind of rate of return can the engineers expect to make if the If EBIT interest coverage ratio is:
predictions work out?
44

Answer:
EBIT 80000000
Shares 10000000
Par value 20
Total value 200000000
Proposed purchase price 550000000
Refinance of lease 60000000
Fees 5.00%
Amount of fees 27500000
Estimated CAPEX 5.00%
Value of CAPEX 27500000
Ongoing CAPEX 7.00%
EBIT 80000000
Amount 5600000
CAPEX 7.00%
CAPEX 4.00%
CAPEX
45

Curren long term bond rate 4.00%
Return (Standard) 25.00%
Total value 200000000
Proposed purchase price 550000000
Finance need 350000000
Firm need to finance 350000000 to fund acquisition of the firm. This fund can be raised from banks and business friends. It is
possible that banks deny from allotting loan. Hence, firm can form a syndicate and by doing so it can raise debt equal to
350000000.
46

Question: 6. Private Equity investments represent an excellent source of value creation. Discuss the validity of this statement
and explain risks and the sources of value creation in private equity.
Answer: Private equity is the great source of income which assists investors to increase overall rate of return. Here, investors get
benefit through investing money into profitable companies. Private equity investment facilitates to enhance operating efficiency
of corporation as well as greater revenue generation for investors. For this purpose, seven alternatives are considered by fund
investors in order to create value of sources. Under this, first alternative is acquisition selection criteria where focus is laid on
identification of appropriate companies. It will be effective for business to seek for operating improvement. The second
alternative is of acquisition pricing negotiation under which stock with lowest price are purchased for lesser risk. This in turn
helpful to reduce risk to a great extent and ensure higher rate of return of investors. Apart from this, third alternative reflects
about incentives for management. However, this alternative basically focuses upon acquisition financing & structuring.
Furthermore, fourth alternative reflects that superior value based management of acquired companies must be considered after
the acquisition. This in turn investors can make out best value of invested funds. Moreover, this is the effective method through
which investors can come to know that which alternative will be effective for investment purpose.
Furthermore, corporations can invest in the private equity investment for making long term plan. This will be effective
for public sector corporations to attract more buyers and offer good rate of return among private equity firms. Here, performance
of corporation must be linked to pay. As the private equity portfolio organization tend to invest in performance of their business.
In this regard, long term objectives are set by corporation for getting higher rate of return.
47

48