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MSIN0227 Private Equity and Venture Capital
Sample Examination Solution


Examination length: THREE (3) hours
There are THREE (3) compulsory questions to the examination paper. Question 1 is worth
SEVENTY (70) marks, Question 2 is worth SIXTY (60) marks, and Question 3 is worth
SEVENTY (70) marks.
In completing this paper, you should answer ALLTHREE (3) QUESTIONS.
Your submission should be typewritten in PDF and be as one document.
You are advised to allocate your time between the three questions in proportion to the
marks available.
Module Leader and Examiner: Dr. George G. Namur













TURN OVER
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ALL tasks/requirements (Question 1, Question 2, and Question 3) should be responded
to.

Question 1 [70 marks]

As one of the General Partners (GP) at Plaisio Capital, a private equity firm, you are in
charge of three (3) LBO funds Shroeder Opportunity I, Shroeder Opportunity II, and
Shroeder Opportunity III.
Parts A, B, and C immediately below are independent but related to the context of
Plaisio Capital.

Part A
You have identified Barnaby Technology, a publicly traded software as a service (SaaS)
company as a potential investment for Shroeder Opportunity III (the Fund). The Fund would
take Barnaby Technology private, improve its operations, reduce any redundancies, then
exit after three years. Barnaby Technology has no debt currently.
An analyst developed the following forecasts regarding this investment:

Year 1 Year 2 Year 3
$m $m $m
Cash flows 105.00 120.00 130.00
The Fund wishes to pay $800 million for Barnaby Technology consisting of $250 million
equity and $550 million 10% debt. The $250 million equity investment is contributed as
follows:
• $170 million in the form of 12.5% PIK preferred equity from the Fund
• $72 million as common shares from the Fund
• $8 million as sweet equity common shares from the management of Barnaby
Technology
The Fund will use all free cash flows generated by Barnaby Technology to service the debt.
The Fund estimates that it will be able to sell the company in 3 years for $1.00 billion.

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Tasks

1. [Total 20 marks]
Required:
Calculate the MoM and the IRR for the Fund and for the management of Barnaby
Technology. Show your detailed workings.
[20 marks]
The proceeds available to shareholders are the ending equity. To compute the value of
ending equity, we need to compute the remaining value of the debt.
Year 1
$m
Year 2
$m
Year 3
$m
Debt at beginning of year 550.00 500.00 430.00
Interest 55.00 50.00 43.00
Cash flow 105.00 120.00 130.00
Debt at end of year 500.00 430.00 343.00

The value of the equity is:
= $1,000 − $343 = $657
The payoff to the preferred shares is equal to principal plus interest, or:
= $170 × (1 + 12.5%)3 = $242.05
Proceeds available to common shareholders is equal to $657m minus $242.05 or
$414.95. The Fund owns 90%, while management owns the remaining 10%.
The Fund common equity is worth:
90% × $414.95 = $373.46
Management common equity is worth:
10% × $414.95 = $41.50
The Fund’s MoM is equal to:
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$242.05 + $373.46
$170 + $72
= 2.54
The Fund’s IRR is equal to:
= (
$242.05 + $373.46
$170 + $72
)
1
3⁄
− 1 = . %
Management’s MoM is equal to:
$41.50
$8
= 5.19
Management’s IRR is equal to:
= (
$41.50
$8
)
1
3⁄
− 1 = . %

Part B
Shroeder Opportunity I, with a committed capital of $650 million, is well into its divestment
stage. Over the last seven years, it has made the following investments and exits
(investments made in Years 1, 2 3, and 4 were exited in Years 4, 5, 6, and 7, respectively).

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7
$m $m $m $m $m $m $m
Invested 150 77 230 50 - - -
Realized - - - 285 120 410 110

The management fee is 2%, applied to committed capital the first three years, and to
invested capital after that. The carried interest is 20%, using a deal-by-deal waterfall
approach.

2. [Total 20 marks]
Required:
Calculate the net IRR for Shroeder Opportunity I. Show your detailed workings.
[20 marks]

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Year Invested Realized Net to GPs
Invested
Capital
Management
Fee Carry Net to LPs
1 150 0 -150 150 13 -163
2 77 0 -77 227 13 -90
3 230 0 -230 457 13 -243
4 50 285 235 357 7.14 27 200.86
5 120 120 280 5.6 8.6 105.8
6 410 410 50 1 36 373
7 110 110 0 0 12 98

IRR = 14.62%

Part C
3. [Total 30 marks]
Required:
In the context of a leveraged buyout deal, briefly explain how a private equity team goes
about structuring the deal, namely deciding on leverage (how much debt versus equity),
equity components (preferred versus common), and the breakdown of the debt
components between the different types of debt.
The decision about leverage involves a trade-off between leverage and the
corresponding cost of debt. If the management of the PE firm expects a deal to be
profitable, then they would want to leverage it up as much as possible.
However, the higher the leverage, the higher the effective cost of debt (weighted
average of all tranches of debt), which can also negatively impact the IRR of the deal.
However, higher leverage also has a disciplining effect on management of the target
company.
Also, the higher the debt component, the higher the price paid (the fund can hit the
same IRR by paying more for the target if they use more leverage), since the benefit of
leverage accrues to a large extent to the seller (current owners of target company).
On the equity side, a fund would want a large chunk of their equity contribution to be in
the form of preferred shares, to give itself priority over the shares held by the
management of the investee (those are common).
Nevertheless, they want a portion of their contribution to be in the form of common
shares. The portion of their equity in the form of common shares is determined largely
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by how much sweet equity ownership they wish for the management of the portfolio
company to have.
Therefore, the breakdown of their equity contribution flows from the leverage decision
shown above. Once the total amount of equity is determined (based on cost of debt,
price, and target leverage), the breakdown of the equity part flows.
In terms of debt, the private equity fund would want to rely as much as possible on
senior, secured debt since it has the lowest cost, but the size of that tranche depends on
the target company’s asset base and ability to generate free cash flows.
What cannot be raised in the form of senior debt will be raised in the form of junior debt.
To minimize the effect cost of debt, the private equity fund will likely use equity kickers
(adding a convertibility option or a warrant) to mezzanine loans sold in the private
market.
They will also resort to junk bonds sold to the public. How much they sell depends on
market conditions and participants’ appetite.
They may also resort to vendor financing (vendor debt or earn-outs).
Earn-outs have the advantage of tying that portion of the price to management
performance in which case it is an attractive option for the private equity fund.
Finally, they can fill any debt gaps by providing a shareholder loan.
Even when the interest on that loan is not tax deductible. This tranche has the
advantage of having a larger portion of the fund’s contribution take precedence over
management’s equity.


END OF QUESTION ONE

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Question 2 [60 marks]

Cloud Nine Technologies is a startup cloud technology company in need of financing.
Starting with a cash balance of $0, the company projects the following cash balances:

End of Year 1 End of Year 2 End of Year 3 End of Year 4 End of Year 5
$(1,600,000) $(2,700,000) $(4,600,000) $(2,600,000) $1,200,000

Based on its own projections, the company recognized that it needed to raise a total of $4.6
million. It also thought that it was more prudent to leave itself with some safety cushion, so
it decided to raise a total of $5 million. As they do not need the entire amount immediately,
the founders of Cloud Nine Technologies will seek to raise $3 million now, and another $2
million in two years.
The founders expect their company to be sold in four years for $25 million.
Following networking with other entrepreneurs in the same space, they have identified two
venture capital firms who would be interested in investing: Ashcroft Ventures for the first
round ($3 million), and Kingston Partners for the second round ($2 million). This fact is known
from the onset by all three parties concerned (Cloud Nine Technologies, Ashcroft Ventures,
and Kingston Partners).
The risk aversion of both VC firms implies an annual risk-adjusted discount rate of 20
percent. Suppose both VC firms believe that Cloud Nine Technologies might falter (with no
value left), and that the probability of that event happening is 20 percent each year.
The entrepreneurs also decided that whatever valuation they would get, they wanted to
own 1 million shares of Cloud Nine Technologies after their first round of financing.





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Tasks

1. [Total 10 marks]
Required:
Calculate the percentage of shares in Cloud Nine Technologies that Kingston Partners
will acquire upon the second round of financing in two years. Show your detailed
workings and carry percentage ownership to two decimals places.
[10 marks]
The adjusted discount rate is equal to:
∗ =
(1 + r)
(1 − h)
− 1
∗ =
(1 + 20%)
(1 − 20%)
− 1 = 50% = IRR
The post-money value of Cloud Nine Technologies at the time of the second round of
financing, i.e. in two years is:
2 =
$25,000,000
(1 + 50%)2
= $11,111,111
As Kingston Partners is investing $2 million during the second round of financing, the
percentage ownership is equal to:
% ℎ =
$2,000,000
$11,111,111
= 18.00%
The remaining 82% will be shared between the founders and Ashcroft Ventures.

2. [Total 11 marks]
Required:
In relation to the first round of financing:
(i) Calculate percentage ownership of Cloud Nine Technologies by Ashcroft Ventures
upon investing the $3 million. Show your workings and carry percentage ownership
to two decimals places.
[5 marks]
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(ii) Calculate the total number of shares issued. Show your detailed workings.
[3 marks]
(iii) Calculate the price of one share. Show your detailed workings.
[3 marks]
(i) For the first-round investment, Ashcroft Ventures can then expect the company
to be worth $9,111,111 at the time of the second round, i.e., in two years’ time.
The post-money valuation at the time of the first round is computed as:

$9,111,111
(1.5%2
= $4,049,383
As Ashcroft Ventures is investing $3 million, the percentage ownership it will
require is equal to:
$3,000,000
$4,049,383
= 74.09%

(ii) The company founders wish to own 1 million shares which corresponds to a
value of:
$4,049,383 − $3,000,000 = $1,049,383
Total number of shares is then equal to:
$4,049,383
$1,049,383
× 1,000,000 = 3,858,824 ℎ
(iii) The post-money value of Cloud Nine Technologies at the first round of financing
is equal to $4,938,272, through 3,858.823 shares. The price of one share is
therefore equal to:
$4,049,383
3,858,824
= $1.05
3. [Total 10 marks]
Required:
In relation to the second round of financing:
(i) Calculate number of new shares issued. Show your detailed workings.
[5 marks]

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(ii) Calculate the price of one share. Show your detailed workings.
[5 marks]
(i) At second round, the 3,858,824 shares will now only represent the 82% combined
stake of Cloud Nine Technologies and Ashcroft Ventures. The number of new
shares issued is Kingston Partners’ 18%, hence:
ℎ =
0.18
0.82
× 3,858,824 = 847,059
(ii) The 847,059 shares are worth $2 million. The price of one share is therefore:
$2,000,000
847,059
= $2.36

4. [Total 9 marks]
Required:
Calculate the wealth (dollar value of stake) of each of Cloud Nine Technologies founders,
Ashcroft Ventures, and Kingston Partners at exit in four years. Show your detailed
workings.
[9 marks]
The value of the firm in four years is equal to $25 million.
The percentage stake of Kingston Partners is 18%, so the dollar value of its stake
equals
0.18 × $25,000,000 = $4,500,000
The percentage stake of Ashcroft Ventures is 82% of 74.09%, or 60.75% so the dollar
value of its stake equals
0.6075 × $25,000,000 = $15,187,500
The value of the founders’ stake is equal to:
$25,000,000 − $4,500,000 − $15,187,500 = $5,312,500




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Task 5 below is independent from Tasks 1 through 4 immediately above.

5. [Total 20 marks]

Context:
Consider a startup company that has raised seed capital from a VC fund a couple years
ago that is now trying to raise ‘Series A’ down round financing from another VC fund.
Required:
Briefly explain a down round in this context and critically discuss the impact that such a
financing situation would have on all parties involved
[20 marks]
1) Founders/entrepreneurs and any employee shareholders: they are affected
negatively on two accounts. First, they will be further diluted just because new
capital is being injected (Series A). Furthermore, a down round means that the
value of their stake has been marked down (a share is worth less, even without
dilution). Therefore, they are doubly negatively affected.
2) Seed capital VC: they are affected, but the negative impact is mitigated by the
anti-dilution clause. This clause will protect the seed capital VC firm as far as
their preferred shares are concerned. Their conversion price will be adjusted
downwards to reflect the new, lower valuation of the company. Their common
shares, however, are not protected, and their value will fall
3) Series A capital VC: they are not affected in terms of valuation as they are
investing at a lower valuation. This can be an advantage if the drop in valuation is
temporary. Ut can be a negative if the fortunes and prospects of the investee
have changed to the worse.


END OF QUESTION TWO

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Question 3 [70 marks]

As an analyst at Bianca Management, a private equity real estate fund, you were tasked
with valuing a 12-year old industrial property as potential investment.
The appraiser feels that it has an effective age of 15 years based on its current condition.
For example, there are cracks in the foundation that are not feasible to repair. In other words,
it would cost more to try to repair these problems than the value that would be created in the
property. The appraiser believes that it has a 60-year remaining economic life.
The building was constructed using a greater ceiling height than users require in the current
market.
It would cost $27 million to reproduce the building with the same ceiling height but $25 million
to construct a replacement property with the same utility but a normal ceiling height.
The higher ceiling results in increased heating and air conditioning costs of $50,000 per year.
A cap rate that would be used to value the property would be 10 percent.
The building was designed to include a cafeteria that is no longer functional. This area can
be converted to usable space at a conversion cost of $25,000, and it is believed that the
value of the property would increase by at least this amount.
The roof needs to be replaced at a cost of $250,000, and other necessary repairs amount to
$50,000. The costs of these repairs will increase the value of the building by at least their
$300,000 cost.
The road providing access to the property is a two-lane road, whereas newer industrial
properties are accessible by four-lane roads. This has a negative impact on rents (locational
obsolescence), which is estimated to reduce NOI by $100,000 per year.
The land on which the property sits was appraised at $5 million.

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Tasks

1. [Total 40 marks]
Required:
Using the cost approach, estimate the value of this property. Show your detailed
workings.
[40 marks]
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Preliminary Calculations:

Replacement cost (built to current standards) $25,000,000

Physical depreciation
Roof $250,000
Other $50,000
Total curable physical depreciation $300,000 $300,000

Replacement cost after curable physical
depreciation $24,700,000

Ratio of effective age to total economic life 20%
Incurable physical depreciation $4,940,000

Curable functional obsolescence
Conversion of cafeteria $25,000

Incurable functional obsolescence
Extra HVAC costs ($50,000 @ 10%) $500,000

Incurable functional obsolescence ($100,000 @
10%) $1,000,000

Depreciated cost $18,235,000

Land value $5,000,000

Estimated value from cost approach $23,235,000

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Task 2 below is independent from Task 1 immediately above.

2. [Total 30 marks]
Required:
Briefly but clearly explain the DCF method of valuing private real estate property and
highlight four assumptions that need to be made in conducting a DCF analysis in that
context.
[30 marks]
Under this method, the value of a property is estimated by projecting income beyond the
first year (as opposed to the Direct Capitalization Method, where only the first year NOI
is needed) and then discounting the income stream, using an appropriate discount rate.
The DCF method starts with projecting income from current leases
Assumptions needed for this approach include:
• Lease renewal assumptions: related to rent renewals, what rental rate it will be
renewed at, whether there will be any vacant days as the owner looks for a new
tenant, and how much money would need to be spent on tenant improvements
(to fix up the tenant space).
• Operating expense assumptions: whether fixed or variable) include property
taxes, insurance, maintenance, management, marketing, and utilities.
• Capital expenditure assumptions: related to renovations or installation of new
heating equipment for example. As these expenditures are lumpy, the appraiser
needs to assume an average annual amount of capital expenditure to be
deducted from NOI to arrive at cash flows.
• Vacancy assumptions: related to how long a space is likely to be vacant until it is
rented out, since cash flow projections are impacted by vacancy periods.

END OF QUESTION THREE

END OF PAPER