HF & PE

Activist funds need to devote more time and resources to investments compared to most other fund strategies. What added risk does this produce for activist funds?

- Funds are going to have more than one strategy. However with shareholder activist strategy, it takes a ton of time and effort away from other ventures. This limits the funds ability to diversify. - If the investment goes south it is expensive to divest, unlike other investments that have friendlier exits. There are a lot of sunk cost in this strategy, is a huge commitment

Explain the importance of hedge funds to investment banks, including revenue, types of business, and which investment banking division is most relevant. In addition, with which investment banking areas do hedge funds principally complete?

- HF are the single most important commission based clients of trading divisions of banks. - Banks usually have large exposure to credit risk in relation to cash loans to HFs. - Banks are usually the counter-party to the derivative contracts. - Types: Trading securities, clearing and custody, securities lending, financing (margin loans), reporting tools, and customized technology. - HF usually compete with the wealth management divisions of banks - Trading divison

Why is there a secondary market for private equity funds, but not hedge funds?

- HF is open ended as investors can exit at NAV. PE is closed ended so investors are committed for the life of the fund. Secondary is given to liquidate funds.

Describe how overall risk is determined in an equity long/short investing strategy

- HF manager needs to determine weather they are trying to maximize return (increase leverage and concentration) or minimize risk (diversifying lower leverage, and hedge volatility) - Goal is to shift the principal risk to market and manager risk

How is the commitment and redemption of capital different in private equity compared to hedge funds?

- HF managers receive performance fee annually. PE partners only receive fee when investments are monetized usually 3-7 years. Contracts can be signed to lock up money for 10-12 years, distributions can be paid out when investments are monetized.

What is a difference between the organizational structure of private equity funds and hedge funds?

- HF: Investors have no direct say over investments - PE: Investors become LP and have LPA

. Describe scenarios whereby distressed / restructuring hedge fund strategies could produce poor results.

- Liquidation value is lower than expected - Additional debt is raised, making more claim on assets - Time period for monetization is longer than expected - Firm liquidates and share become worth nothing

What are some of the major market events in the last three decades that have raised the issue of systemic risk?

- Long term capital management failed and had to be bailed out by 14 banks and the FED. - Amaranth advisers failed in 06. - Financial Cris in 07

What were the principal perceived benefits for the PE consortium's acquisition of TXU?

- Low beta industry, Historical solid returns - Large cash generation 800m in annual dividends, selling 20% interest in sub would generate 1B. - Historical solid returns and plan to eliminate near term capex in coal plants and ramp up nuclear

Annex funds attempt to address which of the principal risks outlined in Blackstone's IPO prospectus (Exhibit 20.10)?

The new investments and funds risk - (portfolio companies and exiting investments)

Generally speaking, in which two hedge fund strategies would you expect to see more volatile returns?

Equity based and macro because they are impacted more by movements in the market

Provide two examples: one of a publicly traded company that would be a good LBO target, and one that would not be an ideal candidate. Explain your choices.

GOOD: - Solid cash flow to pay off debt (Div recap) - Low equity, and competent management - Low Capex - Quality Assets (room for growth) - Target has low leverage, efficent debt, and assets that can be used for leverage. BAD: - Companies that don't have the above characteristics.High tech firms, biotech and service industries as value is with employees.

What timing mismatch issue exists for activist hedge fund investment strategy?

HF activities / need about a year to become profitable. With shareholder activism, it usually needs 3-4. Many investors aren't patient enough for this and you will be forced to pull out so you need to make sure that you have money committed for a few years and not just one. Long term investment.

Merger arbitrage is considered a market-neutral strategy. Under what conditions would this no longer be the case?

If the market is particularly down on a certain sector, and the sector happens to be the target or the acquirer or both involved in the merger arbitrage. An overall economic downturn would reduce merger arbitrage benefits.

What aspect of Harrah's business makes it not a good buyout target?

Large Capex purchases, returns on this purchase were highly depending on operating improvements and reduction in CAPEX.

Where doe the name hedge fund come from

- 1949 Alfred W. Jones created a fund that shorted assets to hedge other assets purchased by an investment portfolio. - His fund neutralized the effect of changes in the general market by buying assets that were expected to increase and selling short assets that were expected to fall

. Based on HCA buyout Exhibits in Chapter 19, calculate the value of the financial sponsors' equity stake in HCA, based on FASB 157's fair value determination requirements. Assume HCA's EBITDA dropped by 20% from its LTM EBITDA at the time of the transaction, no debt has been paid down, and valuation multiples have decreased to 6.5x.

- 28% and their equity has been wiped out. Their EV is lower than the $27B in debt is unpaid.

What is a possible negative consequence of investing during private equity boom cycles?

- A bust will follow, reducing the market cap of the portfolio which reduces the return on investment. - companies will exit at lower multiples as debt markets will be more expensive and require the buyer to user more equity lowering deal size

Describe a margin loan

- A margin loan is when HF buy a security using a bank loan. Typically is around 20%. - Example of 20% margin on $10 - Bank will have HF post securities as collateral on the loan.

Describe a total return swap (sometimes called an equity swap) and the benefits of this strategy for a hedge fund.

- A total return swap is where an investment bank will purchase shares for another company - Client pays for shares, plus a flat fee to the investment bank. - The bank holds the shares and passes dividends and or price increases to the client - Way for for companies to get exposure to other companies without having to file a 13d so that other companies can't catch on to what you are doing and drive a bidding war

. How has the perception of hedge funds changed since the financial crisis?

- AUm dropped by 25% to 1.4T by end of 2008 - Difficult cause investors wanted to pull out including fund to funds - Despite hard times HFs fell by 19% where the S&P fell by 38% - Due to people pulling out it made it hard to market themselves as an absolute return fund and had to focus on diversification. - Perceived as relative value funds. - Due to their investment in hedging tools they can minimize losses and attract diversified beta

Assuming same size and profitability, which fund would you expect to have more in tax liabilities: Active Trading or Activist Investing?

- Activist, key word is liabilites

What does an LBO analysis include, what does it solve for and what question is answered by the analysis?

- An LBO anaysis includes a cash flow projection which helps evaluate how much debt can be used. - Terminal value: what the company can be purchased for on exit typically the multiple of purchased EBITDA - PV: PV of all cash flows and terminal value - Find IRR, what is the highest price you can pay to reach target IRR

. What is the benefit of a hedge fund like Citadel expanding into the hedge fund services business such as market making and fund administration?

- As a HF themselves. Citadel would know how to service the Hf better than the banks would. Especially regaring reporting / admin services. I banks largest clients are PE firms and HF so it benefits them to simply do it themselves without a bank.

Discuss the dangers of asset/liability mismatch. what are some strategies HF can employ to mitigate this risk

- Assets are the HFS investment/ securities. Liabilities represent the value of their fund attributed to investors. - 20% of HFs investment are illiquid and hard to price. - This creates mismatch when an investor attempt to withdraw their money at the end of lockups - When HFs struggle investors may want to withdraw their money making the situation worse. To mitigate this HFs use lock-ups and gates. Lock up is a year to two years where investors can't withdraw funds. Gates limit the amount of withdrawals during a quarter or semi-n annual period after the lock up has expired.

Describe two types of direct leverage employed by hedge funds?

- Bank borrowings: Taking out margin loans from banks (Buying securities on margin - Banks protect themselves by requiring the hedge fund to deposit an agreed amount of securities as collateral - Repossession agreements: used to finance debt security purchases. - One party agreeing to sell a security to another party for a given price and then buying it back later at a higher price

From the perspective of existing LPs in a private equity fund, what are the benefits and considerations of annex funds?

- Benefit Terms are more favorable - If the LP does not invest in an annex fund, their shares will be diluted and new investors can invest in the portfolio companies at a lower price than original Lps. - If LPS don't invest than portfolio companies may not be able to exit which delays returns and incentivizes LPS to invest in the funds.

Describe the benefits and challenges of club transactions.

- Benefits: Spreading economic risk, sharing expertise, pooling of relationships with financing sources, reduce cost per firm, reduction in competition. - Challenges: Increase LP exposure who are invested in multipel clubs, determining firm rules, hiring advisors, Agreeing on price, agreeing on co-investors, Exit strategy

. Describe the benefits and risks of an equity buyout compared to a leveraged buyout.

- Benefits: enable PE to invest without change of control clause causing target to repay debt doesn't trigger refund fees. - Risks include that they carry greater risk than becasue the PE firm has to invest more of their capital upfront. Lose tax shield benefits.

In hindsight, what were some of the errors committed by the buyout group for TXU?

- Betting on the price of a commodity - TXU was highly exposed to cyclical prices. - Investors assumed taht natural gas prices would rise and electricity rates in Texas were pegged to the gas prices. However, the gas price plunged as hydraulic fracturing of shale rock increased which pushed down electric rates. TXU tried to extend debt repayments, but due to large amounts of debt coming they ran out of cash

. What are the five principal financing sources for an LBO transaction?

- Cash - Equity - HY bonds - Mezzaine Debt - Syndicated Loans

. Describe the key characteristics and benefits of hedge funds

- Characteristics: Flexibility in investments, leveraging to increase returns, minimal regulation, somewhat illiquid, only qualified investors, and performance fees. - Benefits: Low correlation with market, focus on marketable securities, structural advantages (performance based comp), investment flexibility, (long and short), attractive risk adjusted returns, low volatility, and capital preservation.

What are similarities and differences in the compensation structure for private equity funds and hedge funds?

- Comp structure - Performance fee is realized differently HF is when NPV is realized, PE is when the investment is monetized. PE also receives transaction fees, and consulting fees

. What are the three ways to create returns through an LBO transaction?

- Deleverage - Increase CF by improving margins - Increase EBITDA multiple

When a private equity fund teams up with management for a potential buyout, why would they want to avoid having early disclosure of the transaction?

- Don't want to trigger defense or poison pills. Don't want to increase competition from other firms

What type of concessions were private equity firms able to get from investment banks during 2006 and the first half of 2007 that normally would not be possible?

- During these years loan default rates were very low and PE firms were able to access covenant lite loans and PIK toggles. - Covenants are less restrictive and don't require maintenance of certain financial ratios. - Often these firms would add more equity and call it EBITDA - PIk toggle gives borrowers the option on how to pay out accrued interest

Precious metals such as gold and silver experienced significant gains during the financial crisi as investors purchased tangible assets that have more perceived value stability. You notice that a gold/ silver precious metals closed end fund is trading at a historically high premium relative to its net assets value, what trade might you employ to take advantage of the situation. (Assuming you believe the worst is over)

- Employ a global macro based strategy, as you believe there is movement to come in the price of gold and silver and precious materials.Make a levered bet on that price assumption.

ABC and DEF operate in the same industry and you have just attended a trade show where they have unveiled their new product lines which are coming out this month. ABC's offering looks like a winner whereas you have serious doubts about DEF's new products. ABC and DEF both trade at $50 per share. ABC 1 year $50 calls trade at $3 and DEF 1 year $50 calls trade at $4. ABC 1 year $50 puts trade at $3.50 and DEF 1 year $50 puts trade at $3.50. Interest rates are 2%. Neither ABC nor DEF pay dividends nor are expected to pay dividends in the coming years. As a long/short hedge fund investor, what options trade should you execute in this scenario?

- Execute a call option on the ABC offering, anticipating that the stock price will go up, and execute a put option on the DEF offering, as you anticipate that the stock will likely not succeed.

Describe the three main areas where private equity investments may bring value to corporations.

- Financial Engineering: Add value by improving company's capital structure by reducing cost of capital - Operational Engineering: Improve companies through formal and informal consulting services to improve production processes, marketing, increase working capital - Governance: Create value by improving incentives and create monitoring processes that focus on improvements in CF through cost reduction and increase revs

Which of the three private equity value propositions for corporations has become most problematic in recent years?

- Financial engineering: Leverage ratios are stricter, interest rates are higher

What are some forseen consequences resulting from the proliferation of HFS

- HFS engage in shareholder activism taht can have various negative effects on the longevity of the business. - HFs create systemic risk with their investment strategies. - Some feel that new products used by HFs has led to unanticipated risks resulting in increase concern for regulators. - HFs enable banks to originate more loans and take the risk off their balance sheet allowing consumers and banks to access more capital - The increased in leverage can cause systematic risk like in 2008

What are some positive consequences resulting from proliferation of HFS

- HFS have significant impact on global capital markets. - Account for large amounts of trading - Increases liquidity in the marekts and increases financial options - Reduce pricing inefficiencies - Augmented the growth of credit derivatives - Large buyers in asset backed securities, CDOS allowing banks to originate more loans. - HFs are users of new products developed by Investment banks - Increase in quantitative trading

What differences between the HF industry and the mutual fund industry led to the creation of fund of hedge funds, but not fund of mutual funds

- HFs are limited in the type of investor they accept. - Unless you are a pension fund, endowment, or high net worth individual, you cannot directly invest in a HF. This is where a fund of fund provides the opportunity to invest in the HF industry. - The Mutual fund industry is open to the public and is not limited to accredited investors therefore a fund to fund approach is not needed for mutual funds

Discuss why HF may or may not welcome investments of funds to funds

- HFs welcome the investment of FoF because it gives them a new source of cash and the investment amount if typically large - HFs may not welcome FoF because they worry that FoFs take short term view and are quick to withdraw money if performance delcines

What were the principal risks faced by the PE consortium when they made their bid to acquire HCA?

- HICA operated in a difficult industry and expeienced poor stock performance - Financing: Capital markets appetiti for 27b of new debt - Target IRR difficult to achieve if margins contract 1-2% - Difficulty getting SH approval due to low 18% premium

Discuss whether or not the tax rates applicable to private equity firms should be changed?

- Historically carried interst has been taxed on Long term cap gains. Many feel this should be changed and should be ordinary income and taxed around 39%. They are able to pay lower taxes on their incomes than public investment firms

. Under historical U.S. laws, when did a fund (and its advisors) need to register with the SEC? What is the regulatory requirement under the Dodd-Frank Act?

- Historically, HFs would not be required to register with the SEC through private advisor exempt. (Until they had 15 clients) - Banks who are Hfs counter-parties in trading and lending are highly regulated and caused indirect regulation to HFs. - Under Dodd frank, HFs who manage above 150m are required to register with the SEC. This requires maintaining extensive records about their investment and business practices, provided info to the SEC, and hire a chief compliance officer, and be subject to SEC examinations and inspections

How have limited partners utilized the secondary market to participate in private equity?

- Historically, secondary markets have been developed as an opportunity to liquidate funds because they either need cash or no longer believe in the GPS. - Now the market has become more common as 60% of LPS have bought and sold on this market. If offers lPs an opportunity to use uninvested capital to increase exposure to PE, it also helps diversify across several funds.

Suppose Company A submits a corporate governance proposal to destagger its board. Under current regulations, would brokers be permitted to vote their customers' shares without voting instructions?

- In 2009, SEC took away broker discretionary voting. - Before 2009, brokers could vote for their clients if the clients didn't specifically instruct them how to vote (People didn't have time to express how to vote) Leading to the broker voting for the incumbent managers and since brokers cant do that it gives activists more power as brokers cant offer the same support

Why do you think more companies don't recapitalize their balance sheets by adding more debt in order to replicate the returns achieved by private equity fund portfolio companies? Do investment banks ever recommend a leveraged recapitalization of public companies? Why or why not?

- Increased the risk for the company by adding more debt. Employees are at risk of losing their jobs and communities are at risk by possible bankruptcy of the company, therefore they wouldn't receive tax payments. - Thre would be less motivation behind it since the dividend would be going to share holders and not PE firm. - Also, It takes focus away from strategic path of the firm in order to generate short term cash gains to pay back the recap. Investment banks probably do recommend recapt to public companies for share buy back, fight unwanted takeover, diversify

. In the U.S., what provisions have private equity funds historically relied on to avoid registration with the SEC? How has the Dodd-Frank Act changed regulation of private equity funds?

- Investment Advisers: 14 funds - Investment Company act: <100 benefical owners; not public but if they have over $150m AUM they have to register with the SEC. Managers who manage more than $25m must register with the SEC. Are required to keep books, and records and anti-money laundering requirements.

Cumulative voting is the practice of allowing shareholders to cast all of their votes for a single nominee for the board of directors when the company has multiple openings on its board. Does this practice help or hinder activists?

- It is beneficial to activists since they can pool their votes toward one director candidate. - By throwing all their votes at one person, they can get that person on board to start implementing their value increasing the the agenda

Which type of company makes an easier target for an activist investor and why: a company that has adopted a majority voting standard, or a company with a plurality voting standard?

- Majority voting standard - Companies have moved away from plurality voting because if one person votes they decide what happens. You need X amounts of vote to keep your spot on the board. - This makes it easier for activists to get rid of directors, its a lot easier to say no to a director than win a popularity contest. Once they get rid of the director its easier to bring in the one the activist wants.

. What is the impact of highly leveraged deals on the portfolio companies' ability to compete in their industries?

- Makes it harder for them to compete because of the high interest payments

How have the investment profiles of hedge funds changed in recent years as hedge funds have tried to differentiate themselves from traditional fund managers?

- More access to leverage and arbitrage strategies. In their search for Alpha HF are shifting from public to more private based transactions. This is demanding for longer lock up periods, some managers are reducing the typical 2/20 fee scheudle

What type of management is generally needed to run a portfolio company owned by a private equity firm (describe the characteristics of these managers)?

- Motivated and Competent. Able to work with high amounts of leverage meaning small window for error. - Need to be able to align interest with PE firm, need to increase CF by reducing costs and increasing growth

The performance disparity between established managers and new managers was especially sizable in 2008. Describe what may have attributed to this.

- Newer managers especially after the 08 crisis were not as haunted with memories of losing during the time and were more likely to take on risk. It seems that new managers have less of a reputation defend and can take on riks to make a big splash to build reputation.

What were the World Economic Forum's principal conclusions regarding private equity firms?

- PE firms do more than apply financial engineering to target companies. PE back firms are well managed and controlled. - Have good operational management practices such as lean management, continuous improvement and implementation of performance documentation. Better at growing productivity

. Why would a proposal to eliminate the tax benefits of carried interest (performance fees) have a greater impact on the private equity industry?

- PE firms hold their investments longer than HF. so their gains usually are long term cap gains, which has tax advantages. - Usually PE carry is taxed at 15% compared to its income tax of 39%

Describe the benefits of the private-equity ownership model versus public ownership and family-ownership.

- Public: Gives companies access to more capital. Credibility with suppliers, customers, and banks. Disadvantage: shorterminism, investors have limited influence within the deision making process of a company. FAmily Owned: are not regulated and avoid public scrutiny. Owners have direct say in governance. Disadvantage: Funding options are limited to banks and debt financing. - PE: Is the hybrid of the two models. Pe incetivizes managers in ways that public markets can't. Companies can focus on long term. Managers co-invest to align incentives. Disadvantage: Leverage is not sustainable and hurts competitive advantage

What are the primary exit strategies considered by private equity firms?

- Sell to strategic buyer - Sell to an LBO backed company - Sell to PE firm - Dividend Recap - IPO

Which two core hedge fund activities can either create incremental risk or act as a risk mitigator?

- Short selling and derivaties - Short selling has unlimited potential loss, but can be hedge against a long position. - Derivatives have risks that are hard to analyzed and value. But can mitigate when properly used

Describe Side Pockets

- Side pockets are used by HF to house illiquid or hard-to-value assets. - New investors don't participate and old investors withdraw they still owe side pockets - Mgmt fees are charged on book value not market value for assets. - One an asset is put in the side pocket only investors at the time will be able to participate on returns

. What is a benefit of having a financial buyer versus a strategic buyer in an M&A transaction?

- Strategic buyer helps with operational engineering though synergies and allows higher purchase. - Financial buyers: improve the company using all three operational, financial, and governance. - Use debt to detemine valuation analysis

Explain the advantages of private equity funds partnering with strategic buyers.

- Strategic buyers provide deal sourcing, sector expertise, and capital. For investment in regulated industries, a strategic buyer may provide comfort to regulators that the target company will be impacted by.

Based on the description of the ideal buyout target in the beginning of the section titled Corporate Rationale for Private Equity Transaction, which of the companies described in the section "Private Equity Portfolio Companies Purchased During 2006-2007" were the most suitable buyout targets?

- Strong CF, leveragable BS, Low capital expenditures, High quality assets, and can sale assets.

Why is it especially important to adjust hedge fund return data for survivorship bias

- Survivorship bias is the fact that unsuccessful funds that have folded are note included in most HF databases. - The numbers are skewed positively for only well performing HF. - EX 900 firms failed during 07/08 crisis and removing their data skews the historic numbers

Since private equity firms seek to minimize their equity contribution in a deal in order to maximize returns, the amount of debt used to finance transactions should (wishing away financial risk) be the maximum amount of leverage for the company that debt providers will accept. Why then, are these companies allowed to take on even more debt for leveraged recapitalizations?

- The new debt increases returns for PE firms as it is paid out as a divident to them and reduces their exposure to the investment. Justified by the lenders earn more interest and fees need to be paid out

Why are general partners typically only allowed to make investments in new companies during the first five years of a fund's life?

- The typical fund lasts 10 years, and the final five years is reserved for add-on investment and exiting existing portfolio companies

. If Company A owns Company B's stock (which is currently trading at $30) and A purchases a two year put on B's stock with a strike price of $25 and sells a two year call on B stock with a strike price of $34, what is this equity derivative structure called? What are its benefits and disadvantages?

- This is called an equity collar. - The purchase and sale of the call/put cancel each other out. The cost comes to 0 - It provides the option to go either route in the event of a stock price increase/decrease. It is used to lock in accrued earnings. It also doesn't draw attention as purchasing shares straight up as its a derivative and you don't have to file a 13d - Keeps options discrete, and has a cash settlement clause where you can elect to not purchase the shares and take the cash equivalent instead. - Caps upside returns substantially.

What are the key credit statistics in an LBO financing?

- Total Debt / EBITDA (3-6) - Senior Bank Debt / EBITDA (2-3) - EBITDA / Interest Coverage >2x - EBITDA - CAPEX / Interest Coverage >1.6x - BAnk Debt Payoff (6-8yrs) - Equity Contribution (20-35%)

Describe what is meant by a "13D letter"

- When a person/company acquires more than 5% of a publicly traded company, they have to file a 13D within 10 days. - Basically informs the public/ target of the purchase. - This is worrisome to the company as it can signal a hostile takeover has begun. - Usually the letter contains analysis about how poor the management team has been, and why the strategy should change to apply pressure on CEO and board to step down

. When is merger arbitrage an attractive investment strategy? What are the downside risks of this strategy?

- When the market price inherently underestimates probability of the merger being consummated. - When acquisition premium is large and when the competitive bidding situation leads to dramatic target price increase. - Downside: deal falls thru, loss on long position and short position), acquisition is completed after acquirer reduces price, or if there is a significant delay in closing the transaction.

. What's the benefit of staggering the election of board of directors?

- With Staggering, a hostile takeover is less likely. Only a portion of the positions are put to vote each time. That way, if a company is looking to perform a hostile takeover, they can't just do it in one swift election/ proxy fight. They'd have to wind 2-3 over a long amoutn of time before the whole takeover is complete. By slowing it down, there is a better chance at fighting the takeover and loss of control

What are some measurable benefits from private equity ownership of corporations?

- Wordl Economic Forums: PE owned firms are managed better, have better management practice scores, good at operational management, more productive, and productivity grows faster. - Share gains with more employees in terms of higher wages, offer financial engineering benefits. - Strong operational management, governance

MNO makes a tender offer for PRS at 1.5 MNO shares per PRS share. MNO was trading at $40 per share prior to announcement and fell to $38 on announcement. PRS was trading at $40 per share prior to announcement and is now trading at $50. If you are pursuing a merger arbitrage strategy, what is the position you would set up to create potential investment value? What derivative transaction could you use to mitigate your risk?

- You would short MNO and buy shares of PRS, ultimately realizing the difference between the two as the arbitrage of the sale occurs

After initially finding success in M&A advisory businesses, what issues have arisen for private equity firms in this arena?

- conflict of interest concerns have risen over the ownership by the firms of many portfolio companies made M&A advising more problematic.

During the Financial Crisis, the yield curve flattens and the yield on the 30 yr treasury bond reached a new low. As a HF manager suppose you think the market has overreacted and will eventually correct itself, leading to a steepening in the yield curve. What trades might you execute in a long/short strategy to take advantage?

- execute a long/short equity trade, and take a short position in a 1 or 2 year T bond, and a long position in the 30YR treasury bond. This way you take advantage of the current market situation and mitigage risk by targeting common securities.

Why were LBO funds so successful from 2002 through July 2007? Describe what has happened since then

- from 02 - 07 Cost of debt was low compared to cost of equity. This means PE firms can borrow more money and secure favorable terms (mispriced) resulting in firms to do additional deals and larger deals. - Credit is light and expensive and corporate earnings are weaker charecterized by debt defaults and bankruptcies.

. Discuss "multiple expansion" in the context of value creation for private equity investments made following a financial crisis

- increasing exit multiple over entry multiple - Can be difficult following financial crisis but focus on improving operating value with companies that the firm knows well similar to ones in their portfolio. Buy and add on strategy to accelerate growth that may have low multiples.

Although HF are less regulated than mutual funds, what type of indirect regulation affects the hedge fund industry?

- the indirect regulation that impacts HFs is through the investment bank hedge funds engage with to execute trades. - Investment banks are highly regulated by the SEC and since banks do so much business with HF, their regulation impacts the HF industry

. Are private equity firms financial buyers or strategic buyers and why? Which type of buyer should generally be able to pay more in an M&A auction and why? Why might that not always be the case?

-Financial buyers because they do not extract synergies. - Strategic buyers can pay a higher price because they can realize synergies. - Sometimes financial buyers can out perform strategic by being more aggressive in CF assumptions and exit strategies as well as leverage ratio, management and favorable debt terms

What are two of the key checks and balances in place to help manage the incremental risks associated with the hedge fund industry?

1. Banks to employ more conservative lending strategies. 2. HFS to become less leveraged and more diversified. 3. EXtra: regulators to apply good judgement in efforts to increase regulation, but too much regulation can impact liquidity.

What are the 3 key benefits touted by fund of funds. Do you think that fund of funds usually achieves these benefits. Why or why not?

1. Investors may not qualify to invest in HFs. (lack of money or accredited investor) 2. Diversification: Funds of funds provide further diversification sine they invests in 10 or more HFs 3. Due Diligence: Strong due diligence process that enables them to weed out poor performing HFs and invest in top performers. - I think FoF don't provide the touted benefit because they have performed worse or the same as HF indexes. - Also, benie madoff scandal highlighted the flaws in teh ability of FoF to pick the best managers. Those who can't invest in HF it opens the door though

Unlike most mutual funds, why are hedge funds able to charge performance fees on top of management fees?

1. Provide diversification beyond long investments 2. Able to achieve higher returns with less risk 3. Seek absolute returns, or returns that aren't correlated with the market 4. Bring top talent with their high salaries 5. Use broader range of strategies and execute complex trades 6. Use leverage to boost returns 7. Provide higher returns than public market and are less volatile

In the legal battle between CSX, TCI and 3G, the SEC and the Federal Court judge that presided over the lawsuit held differing views of the case. Which had a more rules-based approach and which had a more principles-based approach?

1. SEC ruled on the case that they were not doing anything illegal. Since the derivative swaps ton't provide a vote to cast they didn't have to disclose their position. - From legal translation they didn't do anything wrong. But the federal court saw it differently. - Said although the law wasn't violated it was abused and was a sneaky work around. Ruled it was a violation. - The SEC used the rules based approach, while the federal court used the principal based approach.

Suppose a hedge fund manager buys $15 million of ABC shares on 20% margin. The maximum allowable leverage ratio is 4.0x. The next day, unexpected negative news about ABC is released and its stock closes down 7%. One day later, the hedge fund's prime broker notifies the manager that leverage ratios now need to come down to 3.0x. What percentage of the original balance of ABC shares is left in the investment fund at the end of the day after selling shares to comply with the new leverage requirement? (assume the fund's sales of ABC stock does not further depress its share price)

52%

Classifying some of the largest hedge funds as Tier 1 financial holding companies would subject these funds to requirements regarding capital, liquidity, and risk management. The rationale for this is that a large hedge fund, on its own, could pose systemic risk to the financial system. Discuss the merits of this argument.

Agreed, HF already perform many investment banking functions such as M&A advice, IB advice, and invest in PE. HF, PE, and I banks are starting to provide all 3 services. I think merits for this is to provide diversified soures of income in a way that is easy to transition to because the skills to do this are already there

What are some ways to neutralize market risk in an equity long/short transaction?

By hedging or diversifying across various regions or industries. This is similar to any investing strategy of neutralizing risk

Calculate the expected return for the following cash merger arbitrage transaction: Offer per Target share is $30.25. Target's share price just prior to the announcement is $20.00, and $28.50 immediately following the announcement. The deal is expected to close with a 95% certainty. The deal is expected to close in four months.

ER = (C*G - L(100%-C)/ Y*P 18.75%

What is the formula for determining cash flow available for debt service?

CF from operations - CAPEX