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2.1 - Group Activity - Task - 2023

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19 views2 pages

2.1 - Group Activity - Task - 2023

Uploaded by

Kamel Ramtan
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Group work SFI Master Class Private Equity

Private equity investments have unusual cash flow streams and different conventions to measure
performance when compared to other asset classes. The goal of this group work is to understand the
following items:

1) Performance measurement using value multiple and IRR


2) The J-curve
3) The importance of carried interest, i.e. the profit participation of the general partner
4) The impact of fees on performance

The attached excel spreadsheet contains a typical cash flow profile for a successful private equity
fund with a 2/20 structure, i.e. 2% of management fees per year and 20% carried interest. The
different items listed in the spreadsheet are:

Investments: Total cash used to purchase portfolio companies by the general


partner this period

Net asset value of portfolio, Total book value of all portfolio companies at the beginning of the
before distributions: period

Total distributions this period: The total dollar value from trade sales or IPOs of portfolio companies
realized in this period

Carried interest this period: The fraction of the total distributions to which the general partner is
entitled. General partners only receive distributions once the total
committed capital is returned to limited partners

Distributions to LPs this period: Total dollar amount of capital given back to investors this period

Cumulative distributions to The total dollar amount of capital given back to investors since
LPs, all periods: inception of the fund

Net asset value of portfolio Net asset value at the beginning of the period minus total
after distributions this period: distributions this period, also known as unrealized portfolio value

Management fees: The fees that need to be paid for the general management of the
fund. They are equal to 2% of the committed capital per year.

Questions:

1) The value multiple is the ratio of all distributed and unrealized investments, divided by the
money that the limited partners have already paid into the fund to date. For example, in
period 6, investors have given the general partners already $160 million for investments, plus
a total of $24 million in management fees. The fund has returned to investors $158 million to
date, and the value of unrealized investments (i.e., those investments that are not sold yet) is
equal to $107 million. Hence the value multiple is equal to (158 + 107) / (160+24) = 1.44. The
value multiple can be further split into realized value multiple and unrealized value multiple.
The realized value multiple is actual distributions / (cumulative investments + cumulative
management fees), and the unrealized value multiple is equal to unrealized portfolio value /
(cumulative investments + cumulative management fees).

a) Complete the table and calculate value multiple, realized value multiple, and unrealized
value multiple for all years (see cells G23-G25 for an example for year 6).
b) Market participants are somewhat skeptical about the unrealized value multiple. Can you
see why?
c) Value multiple is sometimes called “cash on cash”. Use the value multiple in year 10 to
explain what that means.

2) Now, let us calculate the most common metric for the performance of a PE fund, the fund’s
internal rate of return. To do so, we need the cash flow to investors in each year of the fund.
Cash flow to investors is equal to distributions (row 7 in Excel spreadsheet) minus new
investments (row 3) minus management fees (row 10). Until the fund is liquidated after 10
years, an interim IRR is calculated assuming that the fund's latest net asset value after
distributions this period (also known as unrealized portfolio value) is distributed as cash. The
excel spread sheet contains four examples for years 3, 4, 5 and 6 of the fund, in rows 31 to
34. The IRR excel function is called IKV in German and TRI in French, should you have local
versions of the software installed on your computer.

a) Complete the table and calculate an internal rate of return for each year of the fund’s
life.
b) Draw a 2D line figure of the IRRs from year 1-10.

3) Suppose the fund had 30% carry instead (the spreadsheet should update automatically if you
change the number in cell B15). What is the impact of a change in carry from 20% to 30% on
the IRR in year 10? Are you surprised, or does this match your expectations?

4) [Bonus question, if you have the time]. The excel spreadsheet can be expanded to make the
fee structure of a typical fund more realistic. In addition to the management fee, investors
typically also pay for legal and administrative costs to set up the fund (see “fund organization
expenses” in row 11). Use a cost of $1 million in cell B11. Second, a frequent additional cost
that is payable by investors is the so-called broken deal fee. The broken deal fee comprises
research costs, travel costs, professional fees, and other expenses incurred in deal-sourcing
activities related to specific investments that never materialize. Assume that the broken deal
fees in years 1 to 4 are 0.5% of the investments made in each year, and add them to row 12.
Include those fees in the calculation of cash flows and back out the new IRRs. Draw them in
the same figure as 2b). What do you conclude?

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