CAIA - 7 - Private Equity Market Structure Flashcards

1
Q

The private equity market can be classified in 2 ways:

  1. ___
  2. ___
A

The private equity market can be classified in 2 ways:

1. Organized

2. Informal

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2
Q

The ___ PE market is dominated by funds, which serve as financial intermediaries to private companies and are professionally managed

A

The organized PE market is dominated by funds, which serve as financial intermediaries to private companies and are professionally managed

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3
Q

The ___ private equity market comprises angel capital; funding from family, friends and fools.

A

The informal private equity market comprises angel capital; funding from family, friends and fools.

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4
Q

___ investments are made in the informal private equity market than the organized private equity market.

A

More investments are made in the informal private equity market than the organized private equity market.

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5
Q

There are three principal types of private equity funds:

  1. ___ ___
  2. ___
  3. ___
A

There are three principal types of private equity funds:

1. Venture Capital

2. Buyout

2. Mezzanine

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6
Q

___ ___funds co-invest with entrepreneurs in their new or fast-growing companies that have a promising product, high potential for growth, and are typically in fast-growing technology sectors.

A

Venture capital funds co-invest with entrepreneurs in their new or fast-growing companies that have a promising product, high potential for growth, and are typically in fast-growing technology sectors.

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7
Q

Venture capital falls into 2 stages:

  1. ___ stage
  2. ___stage
A

Venture capital falls into 2 stages:

  1. Early stage
  2. Expansion stage
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8
Q

During the ___ stage, capital is provided to fund research, evaluate ideas, and develop new products. This stage takes place before a company is established.

A

During the seed stage, capital is provided to fund research, evaluate ideas, and develop new products. This stage takes place before a company is established.

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9
Q

During the ___-___stage, additional capital is provided to establish the company and begin product development and marketing

A

During the start-up stage, additional capital is provided to establish the company and begin product development and marketing

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10
Q

The ___ stage is characterized by established companies that need funds to increase growth by increasing production, developing markets, or providing additional working capital.

A

The expansion stage is characterized by established companies that need funds to increase growth by increasing production, developing markets, or providing additional working capital.

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11
Q

VC investmenst are not comparable to traditional financial investments in that they are still in the “___-___” stage.

A

VC investmenst are not comparable to traditional financial investments in that they are still in the “cash-burning” stage.

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12
Q

___ funds use financing to acquire established companies with tangible assets that need capital for changing ownership.

A

Buyout funds use financing to acquire established companies with tangible assets that need capital for changing ownership.

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13
Q

___ ___occur when debt is used to finance a private equity transaction.

A

Leveraged buyouts occur when debt is used to finance a private equity transaction.

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14
Q

___ ___ occur when current management acquires a company

A

Management buyouts occur when current management acquires a company

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15
Q

___ ___occur when outsiders become the new management

A

Management buyins occur when outsiders become the new management

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16
Q

___-___-___transactions occur when a public company becomes private when all its shares are purchased by a PE company and the public company is de-listed from the stock exchange.

A

Public-to-private transactions occur when a public company becomes private when all its shares are purchased by a PE company and the public company is de-listed from the stock exchange.

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17
Q

___ funds invest in established companies that generally cannot get capital from traditional financial markets to finance an expansion or for a transition. Instead, they acquire capital by issuing ___ ___ that has ___ attached or has rights to ___to ___ ___. ___ debt falls between equity and secured debt, provides a relatively stable cash flow, and generates lower returns than other types of private equity.

A

Mezzanine funds invest in established companies that generally cannot get capital from traditional financial markets to finance an expansion or for a transition. Instead, they acquire capital by issuing subordinated debt that has warrants attached or has rights to convert to common stock. Mezzanine debt falls between equity and secured debt, provides a relatively stable cash flow, and generates lower returns than other types of private equity.

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18
Q

___ strategies provide capital to help established companies recover profitability after undergoing difficulties.

A

Rescue strategies provide capital to help established companies recover profitability after undergoing difficulties.

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19
Q

___ ___, also called ___, acquire a company’s shares from another private equity company.

A

Replacement capital, also called secondaries, acquire a company’s shares from another private equity company.

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20
Q

Buyout funds use mostly ___ financing, so they tend to perform well when the ___of ___is less expensive.

A

Buyout funds use mostly debt financing, so they tend to perform well when the cost of debt is less expensive.

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21
Q

VC funds use ___ ___ ___as the most profitable exit route, so they tend to have a strong correlation with ___-___indices.

A

VC funds use public stock markets as the most profitable exit route, so they tend to have a strong correlation with small-cap indices.

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22
Q

Compared to VC funds, historical returns of buyout funds have been more ___.

A

Compared to VC funds, historical returns of buyout funds have been more stable.

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23
Q

___ funds invest small amounts of capital in a large number of new businesses.

A

VC funds invest small amounts of capital in a large number of new businesses.

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24
Q

___ fund companies have intermediate stages of completion, typically distinguished by meeting milestones or rounds of financing. Therefore, ___ funds are inherently long-term investments.

A

VC fund companies have intermediate stages of completion, typically distinguished by meeting milestones or rounds of financing. Therefore, VC funds are inherently long-term investments.

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25
Q

___ fund managers often impose strict restrictions on the transferability of their funds’ interests.

A

VC fund managers often impose strict restrictions on the transferability of their funds’ interests.

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26
Q

___ funds make a small number of large investments in established businesses.

A

Buyout funds make a small number of large investments in established businesses.

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27
Q

Buyout managers are ___ involved in the portfolio companies than VC managers.

A

Buyout managers are more involved in the portfolio companies than VC managers.

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28
Q

Buyout managers tend to have ___ failures, but their upside potential is ___.

A

Buyout managers tend to have few failures, but their upside potential is limited.

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29
Q

___ transactions use mostly equity financing, and ___s gradually gain control of a company through a series of equity investments.

A

VC transactions use mostly equity financing, and VCs gradually gain control of a company through a series of equity investments.

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30
Q

VC managers perform limited ___ due diligence due to the limited history of the companies. Instead, the perform extensive ___/___due diligence.

A

VC managers perform limited financial due diligence due to the limited history of the companies. Instead, the perform extensive sector/product due diligence.

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31
Q

VC managers secure ___-___ ___ as part of successful exit strategies.

A

VC managers secure follow-on financing as part of successful exit strategies.

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32
Q

Buyout transactions tend to use ___ and ___ ___ to buy companies. The ___of the acquired company are used as ___for the debt, and the debt is repaid using ___ ___ generated by the company.

A

Buyout transactions tend to use equity and debt financing to buy companies. The assets of the acquired company are used as collateral for the debt, and the debt is repaid using cash flows generated by the company.

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33
Q

Buyout managers perform extensive ___ due diligence, and sometimes use ___ ___.

A

Buyout managers perform extensive financial due diligence, and sometimes use financial engineering.

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34
Q

The key driver of a successful buyout transaction is being able to analyze a company’s ___ ___and extract ___ ___.

A

The key driver of a successful buyout transaction is being able to analyze a company’s balance sheet and extract operational efficiencies.

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35
Q

Venture capitalists ___ ___to launch new or emerging companies, actively ___ and ___the portfolio companies in which they invest.

A

Venture capitalists support entrepreneurs to launch new or emerging companies, actively managing and developing the portfolio companies in which they invest.

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36
Q

Buyout managers spend considerable time ___ ___and adjusting ___ ___, using their experience to ___ ___performing funds or to ___ ___of thriving funds. They improve ___ or hire ___ ___.

A

Buyout managers spend considerable time analyzing investments and adjusting business models, using their experience to boost poorly performing funds or to increase profits of thriving funds. They improve strategies or hire new managers.

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37
Q

What are the 4 ways to invest in private equity:

  1. ___ ___
  2. ___ ___with ___-___
  3. ___ ___
  4. ___of ___
A

What are the 4 ways to invest in private equity:

  1. PE Fund
  2. PE Fund with Co-investment
  3. Direct Investment
  4. Fund of Funds
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38
Q

LPs and GPs have a standard ___-___ relationship, which due to ___ of ___, may result in ___ ___ issues.

A

LPs and GPs have a standard principal-agent relationship, which due to asymmetry of information, may result in moral hazard issues.

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39
Q

LP funds are structured to offer ___ ___, ___ ___and ___.

A

LP funds are structured to offer reduced taxation, limited liability and transparency.

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40
Q

PE funds perform several key functions

  1. ___ ___ ___ to invest in private companies
  2. ___and ___companies with high expected returns
  3. ___ ___ for product development, growth, acquisitions, or buyouts/buyins.
  4. ___and ___portfolio companies
  5. Determine ___ ___ for portfolio companies
A

PE funds perform several key functions

  1. Pool investor capital to invest in private companies
  2. Screen and select companies with high expected returns
  3. Finance companies for product development, growth, acquisitions, or buyouts/buyins.
  4. Monitor and coach portfolio companies
  5. Determine exit strategies for portfolio companies
41
Q

Private equity funds typically have a contractually limited life of ___-___ years, often with a provision to extend another ___-___ years.

A

Private equity funds typically have a contractually limited life of 7-10 years, often with a provision to extend another 2-3 years.

42
Q

Each fund has a ___ ___, which is the calendar year in which the first drawdown of capital is made.

A

Each fund has a vintage year, which is the calendar year in which the first drawdown of capital is made.

43
Q

Funds are generally ___-___in that they distribute proceeds from realizations, interest payments, and dividends.

A

Funds are generally self-liquidating in that they distribute proceeds from realizations, interest payments, and dividends.

44
Q

When portfolio companies securities are publicly tradable, ___-___distributions may also be made in the form of the tradable securities.

A

When portfolio companies securities are publicly tradable, in-kind distributions may also be made in the form of the tradable securities.

45
Q

GPs receive ___ ___, which is a fraction of the fund’s profits.

A

GPs receive carried interest, which is a fraction of the fund’s profits.

46
Q

After the hurdle rate is met, GPs typically receive ___ or ___of the distributions until their carried interest split is reached. This is referred to as a ___-___.

A

After the hurdle rate is met, GPs typically receive all or most of the distributions until their carried interest split is reached. This is referred to as a catch-up.

47
Q

GPs are typically prohibited from starting follow-on funds before the end of the current fund’s ___ ___or until a ___ ___ of the current fund has been invested.

A

GPs are typically prohibited from starting follow-on funds before the end of the current fund’s investment period or until a large portion of the current fund has been invested.

48
Q

Private equity fund of funds typically manage the following activity:

  1. ___ ___in newly formed limited partnerships, which require evaluation of the fund manager’s skill
  2. ___-___with the fund investment, which require investment expertise
  3. ___ ___in existing funds or portfolio of direct investments, which require both evaluation of fund manager skill and investment expertise.
A

Private equity fund of funds typically manage the following activity:

  1. Primary investments in newly formed limited partnerships, which require evaluation of the fund manager’s skill
  2. Co-investments with the fund investment, which require investment expertise
  3. Secondary investments in existing funds or portfolio of direct investments, which require both evaluation of fund manager skill and investment expertise.
49
Q

An investment in a PE fund may considered a ___-___investment, since the underlying portfolio companies are unknown before investors commit capital to the fund.

A

An investment in a PE fund may considered a blind-pool investment, since the underlying portfolio companies are unknown before investors commit capital to the fund.

50
Q

There are two costs associated with investing in a FoF

  1. ___ ___of fees
  2. Loss of ___and ___
A

There are two costs associated with investing in a FoF

  1. Double layer of fees
  2. Loss of information and control
51
Q

There are 4 main ways fund of funds add value:

  1. D___ and ___
  2. R___and ___
  3. S___skills and ___
  4. I___and ___
A

There are 4 main ways fund of funds add value:

  1. Diversification and intermediation
  2. Resources and information
  3. Selection skills and expertise
  4. Incentives and oversight
52
Q

New fundraising typically occurs every ___-___ years.

A

New fundraising typically occurs every 3-5 years.

53
Q

The 3 phases of the GP-LP relationship’s life cycle are:

  1. ___ and ___
  2. ___ and ___
  3. ___, ___or ___
A

The 3 phases of the GP-LP relationship’s life cycle are:

  1. Entry and establish
  2. Build and harvest
  3. Decline, exit or spinout
54
Q

Empirical evidence supports the hypothesis that new fund managers have a ___ mortality rate than established or institutional quality managers.

A

Empirical evidence supports the hypothesis that new fund managers have a higher mortality rate than established or institutional quality managers.

55
Q

First time managers, understanding the importance of innovation for fundraising, often pursue ___ investment strategies.

A

First time managers, understanding the importance of innovation for fundraising, often pursue specialized investment strategies.

56
Q

Evidence supports a ___ degree of continuity in investors of successive funds, and the ___ of ___investors to identify funds that will perform poorly in subsequent funds.

A

Evidence supports a high degree of continuity in investors of successive funds, and the ability of sophisticated investors to identify funds that will perform poorly in subsequent funds.

57
Q

A PE fund’s ___ ___ ___ defines its legal framework and terms and conditions.

A

A PE fund’s limited partnership agreement defines its legal framework and terms and conditions.

58
Q

The limited partnership agreement (LPA) has two main clauses:

  1. ___ ___ clauses
  2. ___ ___ clauses
A

The limited partnership agreement (LPA) has two main clauses:

  1. Investor protection clauses
  2. Economic terms clauses
59
Q

___ ___ takes place before a transaction has been completed and refers to decisions made by one party causing undesirable parties to be attracted to the transaction.

A

Adverse selection takes place before a transaction has been completed and refers to decisions made by one party causing undesirable parties to be attracted to the transaction.

60
Q

___ ___takes place after a transaction has been completed and refers to one party’s behavior changing to the detriment of another party as a result of a contract’s incentives.

A

Moral hazard takes place after a transaction has been completed and refers to one party’s behavior changing to the detriment of another party as a result of a contract’s incentives.

61
Q

The ___- ___ ___ describes situations in which two parties do not cooperate with each other for fear that they might give the other party more bargaining power and, thus, reduce their own profits.

A

The hold-up problem describes situations in which two parties do not cooperate with each other for fear that they might give the other party more bargaining power and, thus, reduce their own profits.

62
Q

LPAs are undergoing some ___, as evidenced by the increased use of the private equity principles developed by the Institutional Limited Partners Association (ILPA).

A

LPAs are undergoing some standardization, as evidenced by the increased use of the private equity principles developed by the Institutional Limited Partners Association (ILPA).

63
Q

Despite the value of LPA covenants and advisory boards, the success of the limited partnership structure depends on reducing ___-___issues by ensuring proper alignment of managers’ and investors’ interests.

A

Despite the value of LPA covenants and advisory boards, the success of the limited partnership structure depends on reducing principal-agent issues by ensuring proper alignment of managers’ and investors’ interests.

64
Q

The ___ ___ ___ responsibilities are defined in the LPA and include addressing conflicts of interest, reviews of valuation procedures and other LPA agreements.

A

The LP Advisory Committee’s responsibilities are defined in the LPA and include addressing conflicts of interest, reviews of valuation procedures and other LPA agreements.

65
Q

___ majorities are needed for decisions such as extending the investment period or the fund’s duration, and ___ majorities are needed for decisions such as removing the GP without cause.

A

Simple majorities are needed for decisions such as extending the investment period or the fund’s duration, and qualified majorities are needed for decisions such as removing the GP without cause.

66
Q

GPs ___ generally make investment decisions without LPs participation.

A

GPs should generally make investment decisions without LPs participation.

67
Q

Many funds are required to disclose information according to guidelines provided by ___ ___.

A

Many funds are required to disclose information according to guidelines provided by PE associations.

68
Q

Low management fees may lead to managers looking for additional compensation. To offset these incentives or offset doubling management service payments, LPAs typically include a ___-___clause that mandates other fees be fully or partly set off against management fees.

A

Low management fees may lead to managers looking for additional compensation. To offset these incentives or offset doubling management service payments, LPAs typically include a fee-offset clause that mandates other fees be fully or partly set off against management fees.

69
Q

Fees based on invested capital may provide managers an incentive to pursue ___ rather than ___.

A

Fees based on invested capital may provide managers an incentive to pursue volume rather than quality.

70
Q

Buyout funds typically give their investors an ___% preferred return; while venture capitalists ___ offer a preferred return.

A

Buyout funds typically give their investors an 8% preferred return; while venture capitalists rarely offer a preferred return.

71
Q

GPs typically base the preferred return on the ___.

A

GPs typically base the preferred return on the IRR.

72
Q

A carried interest of ___% is considered to align manager and investor interests appropriately.

A

A carried interest of 20% is considered to align manager and investor interests appropriately.

73
Q

Carried interest can be calculated on a fund-as-a-whole or deal-by-deal basis. LPs prefer the ___ approach, since it better aligns interests.

A

Carried interest can be calculated on a fund-as-a-whole or deal-by-deal basis. LPs prefer the fund-as-a-whole approach, since it better aligns interests.

74
Q

One way to reduce eradicate or excessive risk in private equity funds is to require managers to ___ in the ___.

A

One way to reduce eradicate or excessive risk in private equity funds is to require managers to invest in the fund.

75
Q

The GPs share in a PE fund is generally around ___% of committed capital.

A

The GPs share in a PE fund is generally around 1% of committed capital.

76
Q

The GP’s contribution is referred to as ___ ___.

A

The GP’s contribution is referred to as hurt money.

77
Q

___-___clauses may be used in anticipation of senior fund managers retiring.

A

Key-person clauses may be used in anticipation of senior fund managers retiring.

78
Q

The ___ ___clause enables the removal the GP and suspends investments until a replacement can be found.

A

The bad leaver clause enables the removal the GP and suspends investments until a replacement can be found.

79
Q

A ___ ___clause enables LPS with a ___majority to stop funding the partnership. This provision enables LPs to end a failing partnership and is especially important for funds that do not have a ___ ___.

A

A good leaver clause enables LPS with a qualified majority to stop funding the partnership. This provision enables LPs to end a failing partnership and is especially important for funds that do not have a track record.

80
Q

___ leaver clauses sometimes provide compensation. In contrast, ___leaver clauses provide no compensation or entitlement to carried interest, but provide a ___ ___so that part of the carried interest remains as incentive for the ___ ___.

A

Good leaver clauses sometimes provide compensation. In contrast, bad leaver clauses provide no compensation or entitlement to carried interest, but provide a vesting schedule so that part of the carried interest remains as incentive for the new manager.

81
Q

PE funds distribute exit proceeds according to a ___ ___ that divides the proceeds between the GPs and LPs in terms of amount and timing.

A

PE funds distribute exit proceeds according to a distribution waterfall that divides the proceeds between the GPs and LPs in terms of amount and timing.

82
Q

A distribution of a fund generally begins with the LPs being repaid all ___ ___and then receiving the preferred return. After this, GPs get ___or ___of the distributions until their ___ ___ split is reached. This is referred to as a ___ ___ interest period.

A

A distribution of a fund generally begins with the LPs being repaid all drawn capital and then receiving the preferred return. After this, GPs get all or most of the distributions until their carried interest split is reached. This is referred to as a catch up interest period.

83
Q

Some agreements have ___% catch-ups and some have ___ catch ups.

A

Some agreements have 100% catch-ups and some have 50/50 catch ups.

84
Q

An accepted agreement is for GPs to take a ___ ___ of early distributions until ___ capital is repaid, and distribute any excess to ___ or put it in an ___ ___ .

A

An accepted agreement is for GPs to take a lower percentage of early distributions until contributed capital is repaid, and distribute any excess to LPs or put it in an escrow account.

85
Q

Fund managers often have to put some of their carried-interest proceeds in an ___ ___, which can be used to cover any clawbacks.

A

Fund managers often have to put some of their carried-interest proceeds in an escrow account, which can be used to cover any clawbacks.

86
Q

A ___ provision requires GPs to return proceeds to LPs if, at the end of the fund’s life, LPs have received less than they were supposed to. As a show of goodwill, some GPs return projected ___ funds to LPs before the ___ of the fund’s term.

A

A clawback provision requires GPs to return proceeds to LPs if, at the end of the fund’s life, LPs have received less than they were supposed to. As a show of goodwill, some GPs return projected clawback funds to LPs before the end of the fund’s term.

87
Q

Clawbacks tend to be stricter for ___ management teams and teams with ___historical performance. Buyout funds tend to have clawbacks ___often than venture capital funds because buyouts typically have ___realizations.

A

Clawbacks tend to be stricter for new management teams and teams with poor historical performance. Buyout funds tend to have clawbacks more often than venture capital funds because buyouts typically have earlier realizations.

88
Q

Clawbacks (can/cannot) exist for LPs

A

Clawbacks can exist for LPs

89
Q

For co-investments, LPs are only charged ___ fees with no ___ ___ . However, some LPs pay ___ as a way of incentivizing GPs

A

For co-investments, LPs are only charged transaction fees with no offset provision. However, some LPs pay promote as a way of incentivizing GPs

90
Q

In terms of their risk-reward profile, ___-___fall between PE fund investments and direct investments.

A

In terms of their risk-reward profile, co-investments fall between PE fund investments and direct investments.

91
Q

Evidence indicates that co-investments significantly ___ direct investments.

A

Evidence indicates that co-investments significantly underperform direct investments.

92
Q

The underperformance of co-investments may be due to ___ ___or may be reflective of an ___problem.

A

The underperformance of co-investments may be due to higher risk or may be reflective of an agency problem.

93
Q

Investments that perform far below expectations are referred to as ___.

A

Investments that perform far below expectations are referred to as lemons.

94
Q

In theory, co-investing maximizes a fund investment’s upside by reducing costs and increasing exposure to portfolio companies selected for their potential upside. Thus, co-investing has characteristics of ___ ___.

A

In theory, co-investing maximizes a fund investment’s upside by reducing costs and increasing exposure to portfolio companies selected for their potential upside. Thus, co-investing has characteristics of real options.

95
Q

Besides reducing fees, co-investing has the following benefits:

  1. ___ investments
  2. Better management of ___ ___
  3. Mitigating ___
  4. Double level of ___ ___
  5. Improved ___
  6. ___ ___ with invitation-only funds
  7. Reducing ___ effect
A

Besides reducing fees, co-investing has the following benefits:

  1. Targeted investments
  2. Better management of portfolio diversification
  3. Mitigating dilution
  4. Double level of investment review
  5. Improved monitoring
  6. Forming relationships with invitation-only funds
  7. Reducing J-curve effect
96
Q

By targeting investments, LPs can reduce ___ ___.

A

By targeting investments, LPs can reduce style drift.

97
Q

Co-investments do not ___ a fund’s shares, so they enhance downside protection, particularly for investments in ___ ___.

A

Co-investments do not dilute a fund’s shares, so they enhance downside protection, particularly for investments in small funds.

98
Q

Co-investments are difficult and present a number of disadvantages for LPs:

  1. ___ portfolios
  2. Higher ___risk
  3. ___of ___
  4. ___among parties
A

Co-investments are difficult and present a number of disadvantages for LPs:

  1. Unbalanced portfolios
  2. Higher fiduciary risk
  3. Conflicts of interest
  4. Disputes among parties
99
Q

Portfolio strategies typically allocate ___-___% to co-investments.

A

Portfolio strategies typically allocate 10-20% to co-investments.