ACFI333 - Private Capital

What is private capital?

Funding provided to companies not sourced from public markets or traditional institutional providers (e.g. governments or banks).

What is private equity?

Private capital funding sourced from outside public markets via non-traditional sources — injected at various stages of business development.

What is private debt?

Capital extended to companies through a loan or other form of debt, sourced privately rather than from public markets or banks.

What are the two forms of investment in private equity?

(1) Direct investment via a private equity fund. (2) Indirect investment via a fund-of-funds vehicle with stakes in other PE funds.

What is the primary driver of returns in private equity?

Capital gains — typically the largest component of PE returns, alongside dividend cash flows and exit proceeds.

What is a Leveraged Buyout (LBO)?

A PE firm acquires a public or private company using a significant percentage of debt financing. The target's assets serve as collateral; its cash flows service the debt.

Why are LBOs called 'going private' transactions?

After acquisition, the target company's equity is no longer publicly traded — it is taken off the public market.

What is the difference between an MBO and an MBI?

MBO (Management Buyout): current management participates in the acquisition. MBI (Management Buy-in): current management is replaced by the acquiring team.

What is venture capital?

Investing in or providing financing to private companies with high growth potential — typically start-ups or young companies. VC funds are active investors.

What financial instrument is commonly used in VC-backed start-ups?

Convertible preferred shares — with a predetermined conversion date/price — used to raise capital from VC funds.

List the four stages of venture capital financing in order.

(1) Pre-seed / angel investing → (2) Seed capital → (3) Early-stage / start-up financing → (4) Later-stage / expansion VC (pre-IPO).

At which VC stage do funds first typically invest?

Seed stage — supporting product development and marketing efforts, including market research.

What happens at the later-stage (expansion VC) phase?

Financing follows commercial production and sales but is still pre-IPO. Often involves management ceding control of the company to the VC fund.

What is mezzanine-stage financing?

Bridge financing between private and public company status. Defined by timing (pre-IPO) rather than method — prepares a firm for public listing or sale.

What is growth equity / growth capital?

Minority equity investing — a PE firm takes a less-than-controlling interest in a mature company seeking capital, without displacing management.

What is a PIPE transaction?

Private Investment in Public Equity — a private offering of newly issued or existing shares to select investors, allowing faster and cheaper capital raising than public equity issuance. Can dilute existing shareholders.

What are the two main exit strategies for PE firms?

(1) Trade Sale — direct or auction sale to a strategic buyer. (2) Public Listing — via an IPO, SPAC, or direct listing.

What are three advantages of a trade sale exit?

(1) Immediate cash exit. (2) Higher price from synergy-seeking strategic buyers. (3) Fast and simple execution with streamlined transaction costs.

What are three disadvantages of an IPO exit?

High transaction costs, long lead time, stock market volatility creating value uncertainty, onerous disclosure, potential lockup period, mainly suitable for large/fast-growing firms.

What is a SPAC and how does it work as an exit?

A Special Purpose Acquisition Company formed by sponsors that raises capital via its own IPO to acquire a private company within a predetermined period.

What is a recapitalization exit strategy?

The PE firm introduces or increases leverage and pays itself a dividend from the new capital structure. Not a true exit — the PE firm maintains control but extracts capital.

What is a secondary sale?

Sale of the portfolio company to another private equity firm or group of financial buyers.

What is a 'vintage year' in private equity?

The year in which a PE fund makes its first investment. Fund performance critically depends on the vintage year.

Why is private equity riskier than public equity?

Due to illiquidity risk (no public market to exit), leverage risk (high debt in LBOs), and performance index biases (survivorship bias, backfill bias).

What are the four main categories of private debt?

(1) Direct Lending. (2) Mezzanine Loans. (3) Venture Debt. (4) Distressed Debt.

What is direct lending?

Investors provide capital directly to borrowers and receive fixed-schedule interest payments plus principal repayment. Senior & secured with covenants. Provided at higher rates to firms lacking bank access.

What is a leveraged loan in the context of direct lending?

A private debt fund borrows money to finance a loan, then extends it to a borrower, profiting from the interest rate differential.

What is mezzanine debt and where does it sit in the capital structure?

Subordinated (junior) to senior secured debt but senior to equity. Higher risk and higher interest rate due to junior ranking and unsecured status. May include warrants or conversion rights.

better than equity, worse than secured debt. High risk, high interest

What is venture debt?

Debt financing for start-up or early-stage VC-backed companies, provided as credit lines or term loans. May include warrants/conversion rights to compensate for high default risk and lack of collateral.

What is distressed debt investing?

Buying the debt of mature companies in financial difficulty (defaulted or near-default). Investors use specialized knowledge to assess default probability and recovery rates. Turnaround investors may take active management roles.

What diversification benefits do private capital investments offer?

Moderate diversification benefits when added to a public stock/bond portfolio, due to less-than-perfect correlation with public markets. Venture capital shows the lowest correlations (~0.65).

What is the common diversification strategy within private equity?

Investing in funds with different vintage years — spreading exposure across economic cycles to reduce vintage year concentration risk.

J curve Phases

Phase 1 — Capital Commitment: Fund identifies investments. Fees and expenses are immediately charged but assets generate little or no income yet. Returns are negative.

Phase 2 — Capital Deployment: Managers invest the capital. Cash outflows exceed inflows. Management fees continue to reduce returns. Still in negative territory.

Phase 3 — Capital Distribution: Investments mature, assets appreciate, income exceeds costs. Capital gains are realised on exit. Returns accelerate positively.

The J-shape: negative early, inflecting positive as exits generate distributions. This is why IRR (which accounts for timing) is superior to MOIC (which doesn't) for evaluating PE.

Performance measurement - IRR vs MOIC

MOIC=Total invested capitalRealized value+Unrealized value​

vs

ⁿ∑_t=0NCF_t/(1+IRR)^T=0, Accounts for both magnitude and timing of all cash flows. Preferred measure for PE.

Vintage year

the year a fund makes its first investment. Returns vary significantly by vintage year because the macroeconomic entry conditions matter enormously. Diversifying across vintage years reduces this concentration risk.

Capital structure seniority (top to bottom)

Senior secured debt → Mezzanine debt → Equity

Higher seniority = lower risk = lower return. Lower seniority = higher risk = higher return.

Which is riskier PE or public equity

PE is riskier than public equity primarily due to two factors: illiquidity risk (capital locked up for years with no exit) and leverage risk (LBOs use substantial debt which amplifies both gains and losses).

vintage year diversification

investing in funds from different years to avoid concentration in a single macroeconomic entry point.

COMMON TRAPS

Trap 1 — Mezzanine-stage financing vs mezzanine debt. Mezzanine-stage financing is a PE equity strategy defined by where the company is in its lifecycle. Mezzanine debt is a private debt instrument defined by its position in the capital structure (between senior debt and equity). The exam will use both in the same question. They are completely unrelated beyond the shared name.

Trap 2 — MBO vs MBI. MBO = current management buys the company. MBI = new external management team is brought in to run the acquisition. Students confuse them under pressure.

Trap 3 — Recapitalisation is not a true exit. The PE firm extracts cash but retains control. It's a partial liquidity event, not an exit.

Trap 4 — MOIC ignores timing, IRR doesn't. A high MOIC with a long holding period can mean poor IRR. A modest MOIC returned quickly can mean excellent IRR.

Trap 5 — Vintage year matters. Funds launched at different times face different market entry prices and economic conditions. This is why PE performance is not directly comparable across funds without controlling for vintage year.