PE Investing - Terms for Midterm

Affirmative Covenant

Covenants that are applicable at specified periodic times when compliance with them is required to be tested. They are ongoing tests of creditworthiness.

What do creditors of a holding company do to protect themselves?

Creditors of a holding company commonly secure their debts through a lien on the shares of subsidiaries held by the holding company. But this will not resolve the structural subordination issue. (see other cards for common ways of addressing structural subordination for creditors of a holding company).

Offering Documents

Disclosures required by the SEC for securities that are to be sold to the American public. This includes a prospectus that describes the issuer, the security, the risks and the offering process. Note: Securities must either be registered with the SEC or satisfy an SEC registration exception in order to be sold.

inferred causality from regression to the mean

"causal explanations will be evoked when regression is detected but they will be wrong because the truth is that regression to the mean has an explanation but does not have a cause."

mechanics of carried interest

(1) all returns allocated to LP until they have recouped all of their invested capital (2) all remaining returns are allocated to the LPs until the LPs have recouped all of the fees and expenses they they have borne (3) all remaining returns flow to Lps until they have also earned a defined hurdle rate (8%) on their invested capital, fees, and expenses (4) all remaining returns are allocated to the sponsor until the combined rate of return on combination of invested capital, fees, and expenses is 10% (Catch Up) (5) any remaining returns on capital plus fees and expenses in excess of 10% componded are divided 80% to LPs and 20% to sponsors

fox traits

(1) constant incremental forecast updating (2) constant learning (3) constant testing (4) willingness to recognize errors

advantages to limited partnership

(1) latitude to define fiduciary duties of LPs and GPs (2) GPs act for partnership and have unlimited liability (3) LPs have no authority to govern the daily operations and liability is limited to amount of their investment (4) LPs have right to remove GPs (5) income is divisible and is pass through (6) LP lives match finite term of investments

sponsor revenue sources

(1) management fees (2) carried interest (3) transaction fees (4) monitoring fees (5) operating partner and other service fees and expenses

transaction fees

(1) transaction fees from portfolio company or add on acquisitions (typically 1% of asset value of target) (2) termination and reverse termination fees

Which 4 concerns do covenants deal with?

1) Housekeeping: Ensuring the basic functional integrity of the borrower 2) Monitoring: measuring the creditworthiness of the borrower for early warning signs of risk to the debt. 3) Restricting uses of cash: constraining where cash generated by the business can flow. 4) Ensuring seniority and security: limiting other debts that can be incurred or secured by the assets.

Two standards for determining if an entity's results must be consolidated

1) Ownership of a majority voting interest in an entity 2) Variable Interest Entity (VIE) Test: a company will have to consolidate the results of a VIE if it has "the power to direct the activities of a VIE that most significantly impact the VIE's economic performance and the obligation to absorb losses of the VIE that could potentially be significant to the VIE or the right to receive benefits from the VIE that could potentially be significant to the VIE"

Highly Confident Letter

Drexel pioneered the fee-generating issuance of highly confident letters in the 1980's. These were legally non-binding expressions of confidence in viability of a proposed financing.

operating cash flow

EBIT + Depreciation - Taxes

Term Debt

Bank debt loaned for a number of years

Which type of covenants will management teams want to have?

Incurrence tests, as these are within management's control - a borrower is only exposed to the risk of a breach if it undertakes an action triggering a test. Affirmative covenants may also capture the impact of events beyond a management's control.

Syndicated loans

Loans originated by banks and then syndicated by them among other banks and institutions

Material Adverse Change (MAC)

Many loan agreements include a catch-all agreement that there has been no MAC in the condition or prospects of the borrower.

Negative Covenant

Negative covenants involving incurrence tests apply only upon the occurrence of defined events. If the test is met, the event can proceed. If not, the action is prohibited.

Consolidating Statement

Presents the results of individual entities that are to be consolidated (arithmetically combined), adjusted by off-setting credits and debits for intercompany transactions and other period adjustments among them

Trustees

The Trust Indenture Act of 1939 requires the appointment of an independent, qualified trustee to act on the behalf of the holders of publicly issued bonds. Bond trustees are usually Institutions. It is their duty to enforce the provisions of bond indentures

Headroom

The difference between a ratio derived from a company's base business plan and the ratio incorporated in a test. The normal range of headroom relative to the base case projections in syndicated loans will vary as a function of market conditions from 15-30%. Borrowers will seek to provide leeway around their projections to accommodate the inevitable volatility of business.

Commitment Letter

The first document exchanged between sponsors and institutions intending to lead the provision of a particular loan. PE sponsors will seek commitment letters from their banks to ensure the availability of funding and to enhance their credibility as a bidder with targets. Sophisticated institutions will will also issue commitment letters indicating their intention to to participate in a loan. Investment Banks will issue commitment concerning their intention to underwrite a debt offering to the public or to sell debt to sophisticated institutions other than through a public offering.

Representations and Warranties

They define characteristics, or the quality of information describing the characteristics, of a business or asset on which a counterparty is entitled to rely. Know deviations from general representation & warranties are spelled out in "exception lists". E.g. a borrower may represent that all of its operations are properly licensed but then make an exception concerning one license known to have lapsed. The length of time after a closing that representations and warranties and other commitments made in a purchase agreement will remain a basis for post-closing claims and performance will be negotiated - this is referred to as "survival". Investors will prefer longer survival periods and issuers shorter ones.

regret avoidance

accepting misery in company

representative bias

acting on a sample size that is too small

scenario bias

adding scenario details (more dimensions and complexity) to make its more persuasive, but less likely to come true

Framing bias

allowing the depiction of data rather than its actual content to affect how a decision is made

short-term viability assessments

assessment of a target's ability to remain in business as a going concern; checks in operating results results, operating losses, negative cash flows, quick ratios less than one (current assets/current liabilities), and impending debt amortization obligations that exceed recent free cash flows from operations, or financial performance that fails to satisfy commitments made in loans and other contractual agreements

animal spirits

associated with intuition which is commonly associate with system 1 thinking (judgement heu

recognized returns

calculated based on marks * reflect potential returns and are used heavily in marketing of Lp interests for performance of portfolio

unlevered free operating cash flow

cash generated by the ongoing operations of a business before addressing how it is capitalized

myopic loss aversion

cause of short term selling without reference to long-term opportunity

monitoring fees

charge to portfolio companies for annual oversight fees; in some cases are credited against management fees; established as obligations of target until the latter 5-10 years after closing of buyout or after change of control

long shot bias

choosing based on potential return but without regard to the probability of the outcome desired

anchoring

consciously or unconsciously framing the analysis of a question based on an irrelevant suggested point of reference

whole product offerings

constellation of tangible and intangible product attributes that do a job for a customer; i.e. the whole experience of opening an iPhone box

forecast

created to understand the dynamics of macroeconomic environments, strategic market conditions, and technological environments in which targets and PCs will have to competel what target and PCs will become; and how other investors will perceive their value in the future when investments in them might be sold and in turn how those investors are likely to perceive the futur ebehaviors of the buyers to whom they plan to sell *cash flow valutions, discount rates, terminal value estimates, etc

value propositions

describe how a product is expected to solve a problem; they are a concept, not a thing

loss aversion

disproportionate aversion to loss -- a basic pillar of prospect theory and probably a Darwinian instict; Kahneman calls it one of the most significant contribution to psychology to behavioral economics;

basic economic units

dividing revenues, costs of goods, selling and marketing expenses, EBIT, and operating assets by the number of units of product sold in each period or or capacity available

owners' earnings

equals funds from operations less the average annual capital expenditures necessary to sustain a company's competitiveness

EV/EBITDA

equals the sum of the value attributed to the common stock plus all debt less cash balances, all divided by EBITDA

triage

exercises based on most readily available data that test for plausibly satisfactory returns; start with management cases, then default source of equity analyst forecasts, and if not then crude etrapolations of historical results will be used

hindsight bias

explaining events after the fact in a manner that obscures learning

home bias

favoring the locally familiar rather than the foreign solely because of its proximity (as opposed to greater level of understanding that its proximity might enable)

operating partner and other service fees

fees for services of sponsor operating partners who were former industry executives that are retained by PE firms to assist with their portfolios

management fees

fees to cover the costs of operating a fund to screen, make, oversee, and realize returns on investments * fixed percentage of committed capital (sometimes reduced by capital invested in positions that are sold during this time) * percentage is 1.5-2.0% of fund committed capital

performance

for PE funds, this is generally based on realized returns, volatility, and contribution to overall portfolio diversification; issue is that accurate assessment of PE returns can be manipulated

gambley's fallacy

ignoring the independence of events and rationally defined probability distributions

mental accounting

imposing artifical distinctions on fungible assets to rationalize the adoption of alternate risk profiles

doubling down

increasing exposure in response to losses in confirmation of a prior decision and not based on additional information or balanced analysis

immitigated risks

information gaps that present potential sources of PE investment risk and uncertainty; sponsors must decide if the price, terms, and return potential of an opportunity warrant accepting these risks and the steps they have or plan to take to mitigate them

iterative triangulation

involved reaching a conclusion based on comparisons of different sets of scenarios as they evolve over sycles of refinement

capital commitment

money which an investor has agreed to contribute to an investment fund; these are binding upfront notices from the fund when they are called; managers rely on these to ensure they have adequate resources to fund their acquisition pipeline and administrative expenses.

market capitalization/revenues

multiple is referred to in discussions of early stage and growth companies that have yet to generate any EBITDA or net income

system 1 thinking

part of the brain to act when it is confronted with new information; associated with intuition and what are called judgement heuristics -- problem solving shortcuts

possibility effect

people are willing to pay a premium to completely mitigate a risk; that is they would pay more than the arithmetical marginal benefit of moving from 95% to 100%; attributable to tendency to overweight small risks and improbably outcomes and susceptibility to vivid images, concrete representation, and explicit reminders

P/E

price per common share divided by fully diluted earnings per share

PEG

price per share divided by analyst's estimates of earnings per share growth

change of control multiples

prices paid for companies similar to the one being assessed when changing control of ownership

realized returns

proceeds (usually in the form of cash but sometimes including marketable, and less frequently, illiquid securities) received from sale of a portfolio position or as a dividend or other form of tangible income * carrid interest is based on this

fundraising

process by which PE fund raises money from families of funds and large institutional investors

CAPE ratio

ratio of price to cyclically adjusted earnings

realized gains

realized returns in excess of the cost (including attributed expenses) of a position

model specification

refers to (i) the variables a model includes and (ii) the functional relationships into which those variable sare put also refers to (i) factors (actions or exogeneous forces, independent or interdependent) that combine to cause an outcome of interest and (ii) the variables, constants, formulas, and relationships involving those variables and constants, that describes the factors

carried interest

refers to portion of returns on investments paid as an incentive to the sponsor; returns may be realized through dividends, interest, repayment of capital, or capital gains * defined as a set division of returns between LPs and sponsors; usually sponsor takes 20% of the profits from realized gains

system 2 thinking

reflective, rational analysis that is supposed to occur; relied on system 1 for information it process and is susceptible to any biases imposed by System 1 on information retrieval, prioritization, and screening

restrictions on fund borrowing

restrict sponsors ability to use leverage for transctions and short term financing; now, most funds use subscription line financing which are lines of credit with banks that draw capital secured by ability of funds to call capital from their limited partners

claw-back provisions

truing up of carry at the end of the life of a fund that require sponsors to disgorge carry previously paid to them that, in retrospect, should not have been

management cases

used by sponsors to understand how well a management teamunderstands their business and to signal how the management team will likely argue for the value of their company in an investment negotiation

best comparables

used to model out the performance ratios of their most and least successful comparators under the best and worst macroeconomic circumstances

coherence bias

validating a hypothesis based on the coherence of an underlying story rather than on statistically valid data

mark

value attributed to the unrealized portion of an investment * necessary for tracking the embedded performance of a portfolio * regualted by fair value (mark to market) accounting and oversight standards

availability or attention bias

weighing the importance of information by the frequency at which it is encountered rather than its substance

exclusivity

when investment professionals in a fund pledge to commit to work exclusively for the benefit of the that fund within the scope of its mandate until they are permiteed by the terms of the LP agreement to raise another fund

model specification risk

when sponsor financial models run the risk of emulating the form of historical financial statements and are not sufficient to explain value creation; factors unaccounted for in historical financial statements are central to financial value creation

commitment period

time with which partnerships can make more commitments to new portfolio investments; it is usually in the first 5 years of PE limited partnership's life

Suppose that Holdco & its creditors wish Holdco senior debt to have a senior claim to the assets and cash flow of the subsidiaries that is pari passu with the claim of any senior unsecured debt of the subsidiaries. What are the commonly used ways to achieve this?

1) Restricted Subsidiaries: Assuming there are no debts at the subsidiaries at the time the Holdco Senior Debt is issued, Holdco and its subsidiaries can agree not too incur any subsidiary debt until the Holdco Senior Debt is fully repaid Note that this is not a perfect solution as trade creditors would still have priority over the equity interest of Holdco in the subsidiaries. 2) Guarantees Some or all of the subsidiaries can guarantee, in whole or in part, the performance of Holdco's debt and commit their guarantees to rank as a senior obligation of each subsidiary. In this case, Holdco Senior Debt would rank pari passu with other senior claims of the subsidiaries. 3) Springing Liens and Negative Pledges The Holdco Senior Debt could be granted a first (senior) lien on the assets of some or all of the subsidiaries. In some cases, to reduce costs for the borrower, creditors agree to a "springing lien/collateral release" that gives them the right to impose a perfected lien on assets as a function of the debtor's creditworthiness. In such a case, the creditor would logically also require an undertaking by the debtor not voluntarily to grant any other liens on those assets (a negative pledge) 4) Cross-defaults As a complement to each of the above solutions, lenders of Holdco Senior Debt will also often seek a cross default right. A cross default enables a Holdco Senior Debt holder to deem the insolvency, or any other agreed default under a debt instrument of a specified subsidiary, to constitute an event of default of Holdco. Alone, a cross default will not affect the priority of the Holdco debt relative to debts at the subsidiary level, but it will permit the Holdco creditors to accelerate their access to what equity value Holdco may have in the subsidiaries.

What does the rule of thumb headroom range imply the leeway is in terms of credit rating?

The 15-30% range implies that the loan market generally tolerates covenant ratio latitude of ~ a half step of credit rating exposure relative to business plan projections.

Money default

A breach of payment of interest or principal ; (other types of covenant breaches are "non-money defaults")

Benefit of incurring debt at holding company (for a sponsor)

A creditor of a holding company will have recourse only to the equity interests in the subsidiaries that are owned by the holding company. This makes the creditor to the holding company structurally subordinate to the creditors of the subsidiaries (even subordinated subsidiary lenders).

Cure Period

A defined period of time that debtors may have in which to correct (cure) a breach before a creditor can declare an event of default.

term of PE fund

these are usually 10-12 years in anticipated lives and the investments should be realized and the proceeds distributed to the partners within that time

Revolver

Senior secured sources of essential capital for seasonal and growing businesses

Waterfall

Sequential partitioning of free cash flow into multiple streams

Covenants

Tests that monitor and constrain borrower behavior. If failed, they cam empower lenders to intervene to protect the security and priority values of their claims. If a covenant is breached, creditors may have a basis for declaring an event of default that, in turn, entitles them to demand the immediate repayment (acceleration) of their principal and any accrued but unpaid interest.

netting

this is when you net the losses against gains when calculating carry

Consolidated Statement

What companies typically report. They combine the results of the various entities of which a reporting company is comprised to present, in one place, what is supposed to be a fair and economically meaningful representation of the reporting company's combined assets, liabilities and operating results

capital call

When a private equity fund manager requests than an investor in the fund provide additional capital. Usually a limited partner will agree to a maximum investment amount and the general partner will make a series of these over time to the limited partner as opportunities arise to finance startups and buyouts and to pay fees

co-investment rights

rights to co-invest with funds to which they committed capital; hope is to take advantage of investment acumen of funds, increase PE asset exposure, and reduce fee burden

sponsor and expert cases

scenarios that a sponsor builds based on their best available data; can be from their own independent research and bring to new targets what they have learned from others

confirmation bias

selecting information to reinforce a preexisting perception

Fechner's law

some subjective assesssments are proportionate to the log of the stimulus

fox v hedgehog

someone who knows many things versus someone who knows one big thing; Tetlock argued that best forecasters were one of these because the were pragmatic and were to draw on analytical tools to solve problems through adaptive thinking

limited partnership

structure of a financial sponsor entity; limited partner (or LP) is a third party investor in a private equity fund. Private equity firms raise private funds in general partnerships where they manage the capital as the general partner.

disposition effect

tendency to take gains and defer realization of losses

mandates

terms that may distinguish the stage or condition of the intended portfolio companies (i.e. late stage, growth, venture, or distressed), the industry in which they operate (i.e. energy, biotechnology, social media, etc), their source (i.e. the deal flow of a particular organization or institution), their geographic focus (i.e. the US, EU, China, emerging markets, or a particular state from which substantial LP funding comes), or social mission * other terms are prohibition on pursuing offers opposed by a target's board of directors (hostile offers)

cash flow

the difference between cash coming in and cash going out of a business

General partners

these are the sponsors that are established as corporations to act on behalf of the PE limited partnerships

equity analyst cases

these are used if target is public and are based substantially on management guidance and may be biased by an institution's eagerness to sell financial services to a target company