CFM Private Equity & Venture Capital 2 — Questions and Answers
Question 1: In a leveraged buyout (LBO), which financial metric is most critical to assess a target company's ability to service acquisition debt?
- Price-to-earnings ratio
- EBITDA margin (Correct answer)
- Debt-to-EBITDA ratio
- Return on equity
Correct answer: EBITDA margin
EBITDA margin reflects operating cash flow generation, which determines the company's capacity to service LBO debt obligations.
Question 2: A venture capital firm uses a '10x return' target for individual investments. If the portfolio has a 90% failure rate, the fund can still achieve positive returns primarily because of:
- Management fee income offsetting losses
- The power law distribution where a few winners generate outsized returns (Correct answer)
- Diversification across all investments performing equally
- Government grants available to VC-backed companies
Correct answer: The power law distribution where a few winners generate outsized returns
VC portfolios follow a power law where one or two breakout investments can return multiples of the entire fund, compensating for the many failures.
Question 3: What is a 'drag-along' provision in a private equity shareholder agreement?
- A clause requiring minority shareholders to sell their shares if majority shareholders approve a sale (Correct answer)
- A provision allowing investors to increase their ownership stake
- A requirement that the company must conduct an IPO within five years
- A fee charged when a fund is liquidated
Correct answer: A clause requiring minority shareholders to sell their shares if majority shareholders approve a sale
Drag-along rights allow majority shareholders to compel minority shareholders to join a sale transaction on the same terms.
Question 4: Which stage of private equity investment typically carries the highest risk but also the highest potential return?
- Buyout
- Growth equity
- Seed/angel stage (Correct answer)
- Mezzanine financing
Correct answer: Seed/angel stage
Seed/angel stage investments carry the highest risk due to unproven business models, but offer the greatest upside if the company succeeds.
Question 5: In private equity fund accounting, the 'J-curve effect' refers to:
- Increasing management fees as the fund matures
- Initial negative returns due to fees and early losses before investments mature (Correct answer)
- The upward trend in valuation as portfolio companies grow
- The shape of carried interest distributions over time
Correct answer: Initial negative returns due to fees and early losses before investments mature
The J-curve describes how PE funds typically show negative returns in early years due to fees and write-downs before generating positive returns as investments mature.
Question 6: A PE firm acquires a company at 6x EBITDA and exits at 9x EBITDA. If EBITDA grows 50% during the holding period, what is the primary driver of the 'multiple expansion' component of returns?
- The 50% EBITDA growth itself
- The 3x increase in the exit multiple compared to entry (Correct answer)
- Debt reduction during the holding period
- Management fee income during ownership
Correct answer: The 3x increase in the exit multiple compared to entry
Multiple expansion specifically refers to the increase in the valuation multiple (from 6x to 9x), independent of EBITDA growth.
Question 7: What does 'anti-dilution protection' in a venture capital term sheet protect against?
- Loss of board representation when new investors join
- Reduction in an investor's ownership percentage when new shares are issued at a lower valuation (Correct answer)
- Management team receiving excessive stock options
- Debt covenants being violated by the portfolio company
Correct answer: Reduction in an investor's ownership percentage when new shares are issued at a lower valuation
Anti-dilution provisions protect early investors from dilution when later financing rounds occur at lower valuations (down rounds).
CFM Private Equity & Venture Capital 2
In a leveraged buyout (LBO), which financial metric is most critical to assess a target company's ability to service acquisition debt?