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CFA Level 2 - Corporate FinancePages
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2023
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CFA Level 2 - Corporate Finance Session 13-Reading 49 Investing in Commodities-LOS f (Practice Questions, Sample Questions) 1. Which of the following is the least likely disadvantage in calculating the net asset value (NAV) for a private equity fund? A) Only capital commitments already drawn down are included in theNAV calculation.B) NAV may be difficult to calculate since firm values are not known withcertainty prior to exit. C) The limited partners use a third party to calculate the NAV of aprivate equity fund (Explanation: NAV is usually calculated by the fund’s general partner, which could result in a subjective and inflatedNAV. Limited partners, however, often use third party valuations to arriveat an objective and up-to-date NAV. This scenario thus describes acountermeasure to an issue in calculating NAV rather than adisadvantage itself. The other two answers are both disadvantages incalculating NAV ) 2. The Dragonhill Group manages a $250 million private equity fund. Investors committed to a total of $300 million over the term of the fundand specified carried interest of 20% and a hurdle rate of 10%. Carriedinterest is distributed on a deal-by-deal basis. 60% of the $250 millionhas been invested at the beginning of year 1 in Deutsch Co. (Deutsch),with the remaining 40% invested in Reiner Ltd (Reiner). Both firms are sold at the end of the third year, realizing a $45 millionprofit for Deutsch and a $35 million profit for Reiner. The carried interest paid to the fund’s general partner after Deutsch andReiner, respectively, is:
Deutsch Reiner A) $0 $7 million B) $9 million $0C) $9 million $7 million (Explanation: (A) Since carried interest is paid on a deal-by-deal basis, profits are not netted. Also, carried interest is only paid if theinvestment’s IRR at least meets the hurdle rate of 10%. (All figures are in $ million):The initial allocation between the firms was:Deutsch: (0.60)($250) = $150Reiner: (0.40)($250) = $100 The IRRs for the two firms are:IRRDeutsch: PV = -$150; FV = $195, N = 3; CPT I/Y → IRR = 9.14%.IRRReiner: PV = -$100; FV = $135; N = 3; CPT I/Y → IRR = 10.52%. Since the return on Deutsch fell short of the 10% hurdle rate, the generalpartner only receives profits after Reiner. The profit is 20% of $35 million,or $7 million ) 3. Based on information in the table above, management fees and carried interest, respectively, in 2007 will be closest to (in $ millions):Management Fee Carried Interest A) $6.80 $7.45 B) $0.75 $8.90C) $3.50 $8.30 (Explanation: (A) 2007 management fees are calculated as 1.50% of paid-in capital. 2007 paid-in capital is $200 + $100 + $100 + $50 = $450.Management fees are 1.50% of $450, or $6.75.
Carried interest is the general partner’s share of fund profits. It iscalculated based on the total return (NAV before distributions) methodusing committed capital. Total capital commitment by investors is $500million. In 2007 NAV before distributions was $529.8, exceedingcommitted capital for the first time. Carried interest is 25% of NAV before distributions less committedcapital, or (0.25)($529.8 ? $500) = $7.45 ) 4. Carried interest to the fund’s partners will first be paid out in: A) 2006. B) 2007. (Explanation: Carried interest is paid to the general partners based on the total return method using committed capital. Carriedinterest will thus be only paid when total return (as measured by NAVbefore distributions) exceeds the committed capital of $500 million. Thefirst year that carried interest would be paid is 2007 ) C) 2008 5. The fund’s distributed to paid in capital (DPI) and residual value to paid in capital (RVPI) multiples, respectively, for 2008 will be closest to:DPI RVPI A) 0.30 1.43B) 3.00 1.43 C) 0.64 1.04 (Explanation: (C) DPI measures the limited partners’ (LPs’) realized return in the fund. DPI is calculated as the cumulative distributionsdivided by the paid-in capital. Cumulative distributions for 2008 were$150 + $100 + $70 = $320. Paid-in capital in 2008 was $200 + $100 +$100 + $50 + $50 = $500.
The ratio of cumulative distributions to paid-in capital is $320/$500 =0.64 RVPI measures the LPs’ unrealized return in the fund. It is calculated bydividing the NAV after distributions by the paid-in capital. NAV afterdistributions in 2008 was $518.5. The ratio of NAV after distributions to paid-in capital is $518.5/$500 =1.037 ) 6. The pair of terms that correctly identifies the method of profit distribution between limited partners (LPs) and general partners (GPs),and the allocation of equity between shareholders and management of aportfolio company, respectively, is: Method of profit distribution Equity allocation A) Distribution waterfall Ratchet (Explanation: Distribution waterfall identifies the profit allocation between LPs and GPs and specifies whenGPs can receive carried interest. Ratchet refers to the equity allocationbetween shareholders and management. Carried interest is the GP’sshare in fund profits ) B) Ratchet Carried interestC) Carried interest Distribution waterfall 7. The party in a private equity fund that has unlimited liability for the firm’s debts, and this party’s share in fund profits, respectively, is referredto as: Unlimited liability Share in fund profits A) Limited partner Distribution waterfall
B) General partner Carried interest (Explanation: Limited partners’ liability does not extend beyond their capital investment, whereasgeneral partners (the fund managers) have unlimited liability for thefirm’s debt. The general partner’s share in fund profits is referred to ascarried interest. Management fees are paid annually as a percentage ofcapital (NAV, paid-in-capital, or committed capital) and are not tied tofund profits ) C) Manager Management fees 8. RDO is a private equity fund with $50 million in committed capital and an investment in three portfolio companies totalling $30 million. The fundearned a healthy profit of $5 million after its first year on the sale of oneof the companies but suffered a $2 million loss after its second year onthe sale of the second company. The fund pays carried interest of 20%on a total return basis using committed capital and also has a clawbackprovision. The clawback the general partner must pay at the end of the secondyear is: A) $0. B) $400,000.C) $600,000 (Explanation: (A) A clawback provision in a private equity prospectus requires the general partner to repay part of previously distributed profitsif the fund subsequently underperforms. Since carried interest is paid on a total return basis using committedcapital, the general partner of RDO would only receive interest when theportfolio value exceeds committed capital ($50 million). First-year profitis $5 million, bringing the portfolio value to $35 million, therefore nocarried interest is paid. Since no profit was distributed to the generalpartner in the first year, a clawback does not apply in the second year )
CFA Level 2 - Corporate Finance Session 13 - Reading 49 Investing in Commodities-LOS f
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