Jonathan Weil, CFA, is the managing director of Weil Capital Management (WCM). Weil has decided to reevaluate the asset backed security (ABS) positions in his investors' portfolios since a recent, and severe, credit problem in the subprime lending industry has had ripple effects on other fixed- income markets. Weil expects the interest rate term structure to remain flat, but shift upward as credit terms tighten. Weil has asked one of his analysts, Vanessa Ordon, to assist him in analyzing potential ABS investments, including some products he is unfamiliar with.Ordon provides an assessment of ABS backed by auto loans, credit card receivables, and closed end home equity loans. Ordon has assembled the following information on the collateral, credit enhancements, and prepayment risk associated with each type of ABS.Ordon has also assembled the following information on the structure of a closed end home equity loan (HEL) asset backed security. Ordon has presented the security to Weil as a potential investment opportunity, but Weil is concerned about its default and prepayment risks. The HEL ABS does not have a shifting interest mechanism.Ordon has also developed an assessment of mortgage backed securities (MBS). Ordon has assembled the following information related to a mortgage backed security.Weil has decided to invest in the MBS identified by Ordon, but wants to keep the interest rate sensitivity of the investment low while gaining a substantially large option adjusted spread at a cheap price. Weil is not concerned with credit risk in this case. Which of the MBS tranches is most likely to fulfill Weil's objectives?
Answer(s): B
Weil has stated several objectives for the MBS investment. He desires low interest rate sensitivity and a large option adjusted spread (OAS) for a cheap price. In order to have low interest rate sensitivity a tranche with a low effective duration should be chosen. A cheap price means that Weil wants the option cost of the purchased tranche to be low while the OAS is high. Option cost is defined as the z-spread minus the OAS and reflects the cost of the embedded prepayment option. Since the term structure of interest rates is flat, the z-spread and nominal spread are effectively the same. Thus, we can create the following table of OAS, option cost, and effective duration for the three choices given.PT5 has the best OAS per unit of option cost, but has the highest effective duration. Of the tranches with a low effective duration, ST1 has the highest ratio of OAS to option cost, indicating that if is the cheapest tranche in the duration range that Weil finds acceptable. (Study Session 15, LOS 57.e,h)
The New York-based Irwin Goldreich Schmidt (IGS) is a mid-sized private equity firm with $300 million capital raised from its investors. Amid a turbulent year, the firm has recently dropped its unsuccessful $100 million bid for a Norwegian media company and is now aggressively searching for new venture or buyout investments in the Eurozone. After several months of intense search IGS believes it identified two potential investments:1. Sverig, a rapidly expanding Swedish start-up construction company.2. L'Offre, a struggling French department store in existence since the late 19th Century.Following several rounds of successful negotiations, IGS makes a $20 million investment in Sverig and a $100 million leveraged buyout investment in L'Offre, committing to an additional $100 million for possible future capital drawdowns. It retains all of Sverig's managers but replaces L'Offre's management team with experienced IGS managers, many of whom are former company senior executives.IGS also sets up Sverig-L'Offre Private Equity Fund (SLPEF), a fund to manage both firms. The fund manager's compensation is set at 20% of profits net of fees. IGS also specifies that the manager's profits are calculated on the entire portfolio when portfolio value exceeds invested capital by 30%.Despite the market's recent turbulence, Sverig's original founders are extremely optimistic and believe the firm could be sold for $400 million in six years. To achieve this, they speculate the firm needs another capital infusion of $40 million in four years in addition to the $20 million capital investment today. Given the high risk of the firm, SLPEFs private equity investors decide that a discount rate of 40% for the first four years and 30% for the last two years is appropriate. The founders of Sverig want to hold 5 million shares.If total proceeds net of fees to SLPEF are worth $180 million upon exit in a year, the fund's general partner (GP) under the total return using invested capital method would receive a compensation of:
Invested capital in the fund was $20 million + $100 million = $120 million. Committed capital was $120 million + $100 million = $220 million. Since the fund was sold for $ 180 million, the fund earned a profit of $ 180 million - $ 120 million = $60 million.Under the total return using invested capital method, carried interest is paid to the GP only after the portfolio value exceeds invested capital (by 30% as specified by IGS). Since the $180 million exceeds ($120 million)(1.3) = $156 million, the GP is entitled to carried interest. Carried interest is calculated as:$180 million- $120 million = $60 million. 20% of $60 million is $12 million.(Study Session 13, LOS 47.h,i)
The New York-based Irwin Goldreich Schmidt (IGS) is a mid-sized private equity firm with $300 million capital raised from its investors. Amid a turbulent year, the firm has recently dropped its unsuccessful $100 million bid for a Norwegian media company and is now aggressively searching for new venture or buyout investments in the Eurozone. After several months of intense search IGS believes it identified two potential investments:1. Sverig, a rapidly expanding Swedish start-up construction company.2. L'Offre, a struggling French department store in existence since the late 19th Century.Following several rounds of successful negotiations, IGS makes a $20 million investment in Sverig and a $100 million leveraged buyout investment in L'Offre, committing to an additional $100 million for possible future capital drawdowns. It retains all of Sverig's managers but replaces L'Offre's management team with experienced IGS managers, many of whom are former company senior executives.IGS also sets up Sverig-L'Offre Private Equity Fund (SLPEF), a fund to manage both firms. The fund manager's compensation is set at 20% of profits net of fees. IGS also specifies that the manager's profits are calculated on the entire portfolio when portfolio value exceeds invested capital by 30%.Despite the market's recent turbulence, Sverig's original founders are extremely optimistic and believe the firm could be sold for $400 million in six years. To achieve this, they speculate the firm needs another capital infusion of $40 million in four years in addition to the $20 million capital investment today. Given the high risk of the firm, SLPEFs private equity investors decide that a discount rate of 40% for the first four years and 30% for the last two years is appropriate. The founders of Sverig want to hold 5 million shares.An appropriate equity valuation technique for Sveng and L'Offre, respectively, would be the: Sverig L'Offre
The DCF method and relative value approach would be less appropriate for Sverig. Given that Sverig is a startup venture capital firm, it would be difficult to assess its future cash flows and there are likely few comparables to benchmark against. Given that L'Offre has been in existence for over a century, it likely has relatively stable and predictable cash flows. Several comparables would also likely exist in the same industry. This would make either the DCF method or relative value approach an appropriate valuation technique. (Study Session 13, LOS 47.i)
The New York-based Irwin Goldreich Schmidt (IGS) is a mid-sized private equity firm with $300 million capital raised from its investors. Amid a turbulent year, the firm has recently dropped its unsuccessful $100 million bid for a Norwegian media company and is now aggressively searching for new venture or buyout investments in the Eurozone. After several months of intense search IGS believes it identified two potential investments:1. Sverig, a rapidly expanding Swedish start-up construction company.2. L'Offre, a struggling French department store in existence since the late 19th Century.Following several rounds of successful negotiations, IGS makes a $20 million investment in Sverig and a $100 million leveraged buyout investment in L'Offre, committing to an additional $100 million for possible future capital drawdowns. It retains all of Sverig's managers but replaces L'Offre's management team with experienced IGS managers, many of whom are former company senior executives.IGS also sets up Sverig-L'Offre Private Equity Fund (SLPEF), a fund to manage both firms. The fund manager's compensation is set at 20% of profits net of fees. IGS also specifies that the manager's profits are calculated on the entire portfolio when portfolio value exceeds invested capital by 30%.Despite the market's recent turbulence, Sverig's original founders are extremely optimistic and believe the firm could be sold for $400 million in six years. To achieve this, they speculate the firm needs another capital infusion of $40 million in four years in addition to the $20 million capital investment today. Given the high risk of the firm, SLPEFs private equity investors decide that a discount rate of 40% for the first four years and 30% for the last two years is appropriate. The founders of Sverig want to hold 5 million shares.A common risk factor faced by both IGS investors and the managers of the private equity firms is:
Answer(s): A
Market risk is the uncertainty in long-term macroeconomic factors, such as changes in interest rates and foreign exchange rates. If these changes adversely affect the private equity fund firms, both the fund's investors (limited partners) and the firms' managers could see their equity stake and investment declining. Agency risk refers to the possibility that the private equity firms' managers may place short-term and personal interests ahead of the interests of the firm and of private equity investors. This risk is only borne by the investors. (Study Session 13, LOS 47.g)
The New York-based Irwin Goldreich Schmidt (IGS) is a mid-sized private equity firm with $300 million capital raised from its investors. Amid a turbulent year, the firm has recently dropped its unsuccessful $100 million bid for a Norwegian media company and is now aggressively searching for new venture or buyout investments in the Eurozone. After several months of intense search IGS believes it identified two potential investments:1. Sverig, a rapidly expanding Swedish start-up construction company.2. L'Offre, a struggling French department store in existence since the late 19th Century.Following several rounds of successful negotiations, IGS makes a $20 million investment in Sverig and a $100 million leveraged buyout investment in L'Offre, committing to an additional $100 million for possible future capital drawdowns. It retains all of Sverig's managers but replaces L'Offre's management team with experienced IGS managers, many of whom are former company senior executives.IGS also sets up Sverig-L'Offre Private Equity Fund (SLPEF), a fund to manage both firms. The fund manager's compensation is set at 20% of profits net of fees. IGS also specifies that the manager's profits are calculated on the entire portfolio when portfolio value exceeds invested capital by 30%.Despite the market's recent turbulence, Sverig's original founders are extremely optimistic and believe the firm could be sold for $400 million in six years. To achieve this, they speculate the firm needs another capital infusion of $40 million in four years in addition to the $20 million capital investment today. Given the high risk of the firm, SLPEFs private equity investors decide that a discount rate of 40% for the first four years and 30% for the last two years is appropriate. The founders of Sverig want to hold 5 million shares.SLPEF's general partner's (GP's) share of fund profits, and management's right to buy an equity stake in the private equity firms, respectively, are called:Profits to the GP Management's right to buy an equity stake
Answer(s): C
The GP's share in profits is referred to as carried interest and is generally set at 20% of net profits after fees. A tag-along, drag-along clause would give management the right to buy an equity stake upon sale by the private equity owners.Ratchet specifies the equity allocation between the limited partners (LPs) and management. Distribution waterfall specifies how profits will flow to the LPs and also the conditions under which the GP may receive carried interest. (Study Session 13, LOS 47.b)
Post your Comments and Discuss CFA CFA-Level-II exam prep with other Community members:
Our website is free, but we have to fight against AI bots and content theft. We're sorry for the inconvenience caused by these security measures. You can access the rest of the CFA-Level-II content, but please register or login to continue.