Investments FINC 6399

| June 13, 2016

Question
Investments FINC 6399
Quiz 2

Note: All questions worth 3 points each, except as noted. Please complete using template provide in
BlackBoard. Questions also include the reading posted in BB Kaplan and Stromberg (2010).

1. The private equity model of ownership has the potential to improve returns due to
A. concentrated ownership.
B. all of these reasons.
C. stronger oversight and governance.
D. incentive based compensation for managers of portfolio companies.
E. highleverage, imposing greater discipline on the portfolio company’s management.

2. The prediction that the LBO or private equity form of ownership model would be the dominant form of
corporate organizational ownership
A. has come true.
B. has not come true.

3. The private equity industry has displayed
A. a steady upward trend in terms of its growth.
B. cycles of boom and bust due to availability of debt capital and market conditions.
C. cycles of boom and bust due to nonavailability of target companies.
D. a constant growth in terms of number of private equity firms listing themselves on public stock
exchanges.
E. absence of bankruptcy and failures in the past.

4. In a private equity structure, the limited partners (select all that apply)
A. provide most of the capital.
B. take an active role in the management of the private equity firm.
C. take an active role in the management of the portfolio companies.
D. can exit any time from their investment.
E. can sell their investment to general partners after providing the required notice period.

5. Usually, the life of a fund raised by a private equity firm is
A. unlimited.
B. ten years which can be extended by three years.
C. thirteen years.
D. five years.
E. anywhere between three years and thirty years.

6. When a private equity firm buys a portfolio company, the transaction is funded by
A. equity only.
B. equity and senior secured debt.
C. equity and a mix of senior secured and subordinate debt.
D. equity and junk bonds.
E. a mix of senior secured and subordinate debt only.

© 2015 Ray Sant PhD, CFA, CMA

7. A private equity firm has raised $1.5 billion as investment funds for a pool with terms of 2/20. This means
that the general partners of the private equity firm will be paid 2% per year in the form of management
fees, and will earn 20% of the increase in the value of the fund at the time of exit. If the expected life of
the fund is ten years and the net liquidation value of its equity holdings is $2.25 billion, what will be the
total fees earned by the general partners during the life of the fund? (6 points)
A. $300 million
B. $450 million
C. $150 million
D. $180 million
E. $750 million

8. US private equity activity until 2007 has
A. generally remained above 5% of the total value of the stock market.
B. generally remained between 1% and 3% of the total value of the stock market.
C. generally remained between 5 % and 10% of the total value of the stock market.
D. shown some periods of peak activity but generally remained below 1% of the total value of the stock
market.
E. been highly volatile and has consistently ranged between 1% and 3%.

9. Private equity firms
A. engage primarily in taking large public firms private with the help of debt.
B. have displayed resilience by buying mid size private firms when debt markets have undergone
turmoil.
C. only buy manufacturing and retail firms.
D. have never faced any situation where their portfolio companies have defaulted on debt obligations.
E. engage in shortterm market arbitrage.

10. Based on current research, exit data shows that the largest single category of buyers of private equity
portfolio companies
A. are companies in the same industry.
B. financial buyers.
C. public investors through IPOs.
D. investment banks.
E. hedge funds.

11. Research shows that median holding period for an investment in a portfolio company by a private equity
firm
A. is about six to seven years and has appeared to have lengthened over time.
B. is about two years and is shrinking.
C. is ten years.
D. is thirteen years.
E. varies anywhere from five to fifteen years.

12. In the private equity industry, a secondary buyout means
A. sale of a portfolio company to an investment bank.
B. listing of a portfolio company on a public stock exchange.
C. sale of a portfolio company to a strategic buyer.
D. repossession of a portfolio company by the lenders in the event of a default.
E. sale of a portfolio company to another private equity firm.
© 2015 Ray Sant PhD, CFA, CMA

13. Management ownership in a portfolio company belonging to a private equity firm
A. is typically less than that in public companies and averages around 5%.
B. is typically equal to that in public companies and averages around 15%.
C. is typically nonexistent.
D. is typically greater than that in public companies with median around 1516%.
E. is frowned upon by lenders and is barred by securities laws.

14. Empirical research based on 1980s data shows that, in general, after a company has been acquired by a
private equity firm, and "operational engineering" has been implemented
A. operating margin increases 510%.
B. cash flow to sales remains constant.
C. operating margin increases by 10 20% and cash flow to sales increases by 40%.
D. operating margin increases by 40% and cash flow to sales increases by 1020%.
E. operating margin and cash flow to sales increase by about 10%.

15. Based on global studies of private equity portfolio companies, it may be concluded that
A. gains in value possibly arise from hardtovalue tax savings.
B. operational efficiencies.
C. higher productivity and better wage management.
D. reduction of agency costs.
E. all of these reasons.

16. More recent empirical evidence suggests that despite modest improvements in financial performance of
portfolio companies, private equity firms generate high investment returns for themselves because of
A. trading on inside information.
B. paying a lower price when buying a portfolio company.
C. selfdealing.
D. raising equity cheaply.
E. cutting labor aggressively.

17. A private equity firm has raised $1.5 billion as investment funds for a pool with terms of 2/20. This means
that the general partners of the private equity firm will be paid 2% per year in the form of management
fees, and will earn 20% of the increase in the value of the fund at the time of exit. If the expected life of
the fund is ten years and the net liquidation value of its equity holdings is $2.25 billion, what will be the
minimum total amount available for investment in portfolio companies? (6 points)
A. $1.5 billion
B. $1.2 billion
C. $1.8 billion
D. $750 million
E. $1.05 billion

18. Kaplan and Stromberg (2010) present evidence that
A. limited partners in private equity firms earn net returns equal to the return on the S&P 500.
B. private equity firms’ investment returns, gross of management and performance fees, lag those on
S&P 500.
C. while limited partners earn net returns exceeding those on S&P 500, portfolio firms underperform
S&P 500.
D. gains, if any, from private equity investing accrue to the limited partners.
E. gains, if any, from private equity investing accrue to the general partners.
© 2015 Ray Sant PhD, CFA, CMA

19. Empirical research show that
A. private equity market activity in the U.S. is driven by yield on junk bonds relative to EBITDA yields
(based on enterprise value).
B. leveraged buyout capital structures are most strongly related to prevailing debt market conditions at
the time of the buyout.
C. the amount of leverage available seems to affect the amount that the private equity bids to acquire a
portfolio company.
D. debt used in a given leveraged buyout transaction may be driven more by the conditions in the credit
markets than by the relative benefits of leverage for the firm.
E. All of the above.

20. Empirical research seems to suggest that
A. private equity fund returns tend to decline when more capital is committed to this asset class.
B. capital commitments to private equity tend to increase when realized returns increase.
C. private equity fund returns tend to increase when more capital is committed to this asset class.
D. both A and B.
E. both B and C.

21. Private equity includes all of the following except
A. venture capital firms.
B. leveraged buyout transactions.
C. management buyout transactions.
D. hedge funds.
E. mezzanine funding.

22. In a typical LBO transaction, debt is used to
A. increase operating margins of a portfolio company.
B. increase cash flow discipline on part of the management of the portfolio company.
C. increase the return on equity so long as the return on assets exceeds the cost of borrowing.
D. increase the return on assets of the firm.
E. B and C above.

23. If a portfolio company does not perform according to private equity fund’s expectations,
A. its CEO or management may not be replaced since they hold a significant stake.
B. the portfolio company is sold to another private equity firm.
C. the lenders call in their debt to reduce their risk exposure.
D. its CEO or management is likely to be replaced quickly.
E. B, C and D are true.

24. Companies that are acquired by private equity firms, must have
A. leverageable balance sheet and low capital expenditure requirements.
B. experienced loss making quarters prior to being acquired.
C. must have skipped dividends to their preferred stock holders.
D. leverageable balance sheet, low capital expenditure requirements, and quality physical assets.
E. all of the above.

© 2015 Ray Sant PhD, CFA, CMA

25. A financial sponsor does all of the following, except
A. identifies and selects the takeover target.
B. negotiates the purchase price or makes a bid.
C. controls the board and appoints the management of the acquired company.
D. provides debt financing.
E. provides equity financing.

26. Limited partners in a private equity fund
A. have lock up periods that are medium term and extend up to five years.
B. do not have lock up periods.
C. have lock up periods that extend up to ten to twelve years.
D. have highly liquid securities.
E. have to register with the SEC in the U.S.

27. "Carried interest" for general partners means the latter
A. get annual management fees.
B. get a share, generally 20 percent, of the profits.
B. have to invest their personal money at least equal to the investment by general partners.
C. have to guarantee the loans taken out by the portfolio companies.
D. have to carry insurance to protect the losses to limited partners.

28. Invested capital in a private equity fund equals
A. contributed capital minus life time management fees paid to the fund.
B. contributed capital plus lifetime management fees paid to the fund.
C. contributed capital minus cost basis of exited investments.
D. net contributed capital minus cost basis of exited investments.
E. market value of all portfolio companies.

29. Deal and monitoring fees
A. are fees charged to the limited partners.
B. are fees paid to investment bankers.
C. are paid to the government regulators.
D. charged to portfolio companies by the fund and split with limited partners.
E. are deducted from the price paid to the selling shareholders of the target company.

30. A private equity firm improves the net income margin of a portfolio company to 105 percent of its
original margin, and doubles its financial leverage from thirty percent of total assets to sixty percent of
total assets. All else being equal, if the original ROE of the portfolio company was eleven percent, the
new ROE will be (6 points)
A. 15%
B. 20%
C. 25%
D. 11%
E. 22%

© 2015 Ray Sant PhD, CFA, CMA

31. The average equity contribution as a percentage of total acquisition price in LBO deals
A. has remained the same over the years.
B. has declined over the years.
C. has increased over the years.
D. has been under ten percent since the 1980s.
E. has been above thirty percent since the 1980s.

32. Over the period, 2004 to 2011, leverage multiples as measured by total debt to EBITDA
A. have remained constant.
B. peaked in 2009.
C. were greater for larger deals (EBITDA greater than $50 million) than smaller deals (EBITDA under $50
million).
D. were lower for larger deals (EBITDA greater than $50 million) than smaller deals (EBITDA under $50
million).
E. Both B and C are true.

33. After the debt crisis of 2007,
A. senior debt as a proportion of total debt was greater for larger deals (EBITDA greater than $50
million) than smaller deals (EBITDA under $50 million).
B. senior debt as a proportion of total debt was lower for larger deals (EBITDA greater than $50 million)
than smaller deals (EBITDA under $50 million).
C. senior debt as a proportion of total debt was about the same for larger deals (EBITDA greater than
$50 million) and smaller deals (EBITDA under $50 million).
D. access to senior debt was completely shutoff for private equity companies.
E. the spread over LIBOR went down on debt available to private equity industry.

34. Data from a survey in 2011 shows that the biggest number of contributors to private equity funds as
limited partners were asset management firms with
A. AUM between $20 and $50 billion.
B. AUM greater than $50 billion.
C. AUM between $5 and $10 billion.
D. AUM between $10 and $20 billion.
E. AUM under $5 billion.

35. Based on available research it may be concluded that private equity portfolio firms
A. were able to borrow funds for LBOs at more favorable covenants than most other entities.
B. experienced lower default rates on average than other corporate borrowers.
C. were able to leverage up more during periods of low cost debt.
D. were subject to strong governance policies.
E. all of the above.

36. In an LBO transaction, stub equity
A. refers to equity held by the management of a portfolio company.
B. refers to equity held by a public shareholder, most likely to be a large shareholder or founder.
C. may be used to facilitate the transaction by overcoming opposition to the deal.
D. both B and C above are true.
E. A, B and C above are true.

© 2015 Ray Sant PhD, CFA, CMA

37. Which of the following statements is FALSE?
A. Presence of stub equity increase disclosure and reporting burden of a portfolio company to SEC.
B. Rollover equity refers to equity offered to management in the postLBO company.
C. A controlling shareholder is defined as someone who owns 50 percent or more of a target company
prior to its takeover.
D. Teaming up with a company’s management to acquire a company usually triggers takeover defense
mechanisms and issues of fairdealing.
E. In practice, stub equity is limited to thirty percent or less of the equity of a portfolio company after
the LBO transaction.

38. When it comes to secondary markets for private equity investments,
A. any limited partner can sell his or her share easily at a fair price.
B. it has been found that transactions are few and in general have fetched up to forty percent less than
their original net asset value.
C. efforts are being made to create a publicly traded stock exchange devoted to private equity.
D. individual investors can participate and buy smaller stakes than what is available through direct
placement.
E. they represent a large proportion of the total invested funds by limited partners in the private equity
industry .

39. Based on recent research reports, it can be said that
A. private equity investments have consistently underperformed broader stock market indexes since
the debt crisis.
B. private equity investments have consistently outperformed broader stock market indexes since the
debt crisis.
C. private equity investments have performed about as well as the broader stock market indexes since
the debt crisis.
D. private equity investments have shown a mixed performance in comparison with the broader stock
market indexes since the debt crisis.
E. private equity investments cannot be compared to broader stock market indexes due to their non
tradeable nature.

40. Based on available data, it can be claimed that
A. acquisition and debt multiples (x EBITDA) were at historic lows just prior to the debt crisis.
B. acquisition and debt multiples (x EBITDA) held steady at historic averages just prior to the debt crisis.
C. acquisition and debt multiples (x EBITDA) were at a historic peak just prior to the debt crisis.
D. acquisition and debt multiples (x EBITDA) are unrelated to availability of debt capital to finance LBO
deals.
E. acquisition and debt multiples (x EBITDA) only reflect future operational efficiency gains from
portfolio companies.

41. Based on published data, it can be concluded that the debt crisis of 2007 led to a
A. sharp reduction in the size of an average LBO deal.
B. led to a sharp increase in the share of equity required to complete an LBO transaction.
C. led to a significant drop in LBO debt multiples (x EBITDA).
D. led to a large reduction in the number of LBO deals.
E. all of the above.

© 2015 Ray Sant PhD, CFA, CMA

42. When acquiring a portfolio company, the private equity fund’s emphasis is on all of the following except
A. improving free cash flow to the enterprise in order to service its debt obligations.
B. cost cutting and improving margins.
C. increasing capital expenditures.
D. relying on debt to finance the acquisition.
E. improving incentives for the management to perform at their best.

43. Free cash flow to the firm can be defined as
A. net operating profit, plus depreciation and amortization, plus changes in net working capital as
measured by accruals and deferrals, minus capital expenditures, and plus sales of assets both
tangible and intangible.
B. net income, plus depreciation and amortization, plus changes in net working capital as measured by
accruals and deferrals, minus capital expenditures, and plus sales of assets both tangible and
intangible.
C. net operating profit, plus depreciation and amortization, plus changes in net working capital as
measured by accruals and deferrals, minus capital expenditures, plus sales of assets both tangible
and intangible, and minus debt service payments.
D. net income plus depreciation and amortization.
E. net income, plus depreciation and amortization, plus changes in net working capital as measured by
accruals and deferrals.

44. free cash flow to shareholders of a firm can be defined as
A. net operating profit, plus depreciation and amortization, plus changes in net working capital as
measured by accruals and deferrals, minus capital expenditures, and plus sales of assets both
tangible and intangible.
B. net income, plus depreciation and amortization, plus changes in net working capital as measured by
accruals and deferrals, minus capital expenditures, and plus sales of assets both tangible and
intangible, and minus debt principal payments
C. net operating profit, plus depreciation and amortization, plus changes in net working capital as
measured by accruals and deferrals, minus capital expenditures, plus sales of assets both tangible
and intangible, and minus debt principal payments.
D. net income plus depreciation and amortization.
E. net income, plus depreciation and amortization, plus changes in net working capital as measured by
accruals and deferrals.

45. A private equity firm requires a minimum return of fifteen percent on its equity investment. It expects to
improve the EBITDA of a portfolio firm by fifteen percent over five years compared to $65 million today.
If the projected fiveyear exit value multiple is 7X (of EBITDA) and debt pay down will amount to $125
million over the five year period, what is the maximum amount the firm should bid for the portfolio
company assuming it will leverage the acquisition value today with seventyfive percent debt? (9 points)
A. $260 million
B. $348 million
C. $517 million
D. $694 million
E. $792 million

© 2015 Ray Sant PhD, CFA, CMA

46. A private equity firm will finance the acquisition of a portfolio company with sixtyfive percent debt and
the rest with equity. The company will generate enough cash flow to pay down debt principal by $875
million annually. Its minimum annual return requirement is twenty percent. If the exit EBITDA in three
years is expected to be $950 million with a 6.5X valuation multiple, should the company be acquired if
selling shareholders are asking an enterprise value of $5.5 billion? (9 points)
A. Yes, the PE firm will earn an annualized return of 25.5%.
B. No, the PE firm will earn an annualized return of 14.6%.
C. No, the PE firm will earn an annualized return of 19.7%.
D. Yes, the PE firm will earn an annualized return of 31.5%.
E. Yes, the PE firm will earn an annualized return of 28.3%.

47. A portfolio company is projected to have an EBITDA of $175 million in the third year. It will have $650
million in debt outstanding in debt at the beginning of the year, carrying an interest rate of 5.5%. capital
expenditures will amount to twentyfive percent of EBITDA and net working capital will increase by $12
million. How much cash will be available to the portfolio company to pay down its outstanding debt if it is
in the thirty percent tax bracket? Assume depreciation of $32 million for the year. (6 points)
A. $60.50 million
B. $51.33 million
C. $75.00 million
D. $48.75 million
E. $68.28 million

48. In order to increase its rate of return on an investment in a portfolio company, a private equity fund can
(select all that apply)
A. increase operating cash flows.
B. reduce capital expenditures.
C. increase operating margins.
D. reduce acquisition multiple.
E. increase leverage without increasing risk.

49. Private equity (financial) buyers compete for the same companies with strategic buyers. Which of the
following statements is TRUE?
A. Strategic buyers take advantage of lower cost of capital whereas financial buyers rely on operational
and strategic synergies.
B. Strategic buyers improve corporate governance of acquired companies whereas financial buyers
primarily benefit from cutting costs.
C. Strategic buyers employ financial engineering techniques whereas financial buyers apply operational
engineering techniques to improve performance of acquired companies.
D. Strategic buyers rely on operational and strategic synergies whereas financial buyers rely on lower
cost of capital due to greater leverage in order to justify premium paid for acquiring a target
company.
E. Strategic buyers use leverage to gain value in an acquisition whereas financial buyers use
operational, financial and governance efficiencies to extract value form an acquired company.

© 2015 Ray Sant PhD, CFA, CMA

50. Threat of an acquisition by a private equity may make an inefficiently managed company
A. increase its financial leverage.
B. attempt to find a whiteknight.
C. erect takeover defenses.
D. sell unproductive assets.
E. do all of the above.

51. Historically, an overwhelming percentage of merger and acquisition transactions have involved a(n)
A. corporate seller and a financial sponsor buyer.
B. financial sponsor seller and a corporate buyer.
C. corporate seller and a corporate buyer.
D. financial sponsor seller and a financial sponsor buyer.
E. investment bank as a buyer and financial sponsor as a seller.

52. Instead of doing an IPO, a private company’s owners may prefer to sell the company to a private equity
firm due to
A. ease and speed of transaction.
B. potential for stub equity with improved governance and operational efficiencies.
C. elimination of public reporting burden and associated costs.
D. support in the form of managerial expertise and internal consulting services.
E. all of the above reasons.

53. In theory, the private equity model seems like a perfect solution for value maximization challenge due to
the corporate governance problem in a publicly traded firm where equity is dispersed. Why has it not
become the dominant model of ownership?
A. Due to a lack of depth of management expertise.
B. Due to a lack of availability of good executives who could serve on corporate boards of acquired
companies.
C. Due to regulatory hurdles.
D. Due to necessity for high levels of leverage to make it work, which requires it to be virtually an error
free operation.
E. Du…

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