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2023 Curriculum CFA Program Level II Alternative Investments


Private equity’s shift from a niche activity to a critical component of the financial system is evident from investors’ financial commitment: around $2.8 trillion globally as of mid-2018. And that’s just the equity portion. The use of debt means transaction value is often two or three times the actual equity raised. Blackstone, Carlyle, and KKR are household names and publicly traded companies of significant size. Private equity funds may account for 15%–18% of the value of all mergers and acquisitions, and the market capitalization of Alibaba, Amazon, Facebook, and Google has raised the profile of venture capital investing.

We take two approaches to illuminate our subject: In Section 2 the perspective is primarily that of the private equity firm evaluating potential investments. Valuing acquisitions is particularly complex; except for public-to-private transactions, there will be no market prices to refer to, and the challenges are considerable. In Section 3 we take the perspective of an outside investor investing in a fund sponsored by the private equity firm.

Definitions of private equity differ, but here we include the entire asset class of equity investments that are not quoted on stock markets. Private equity stretches from venture capital (VC)—working with early-stage companies that may be without revenues but that possess good ideas or technology—to growth equity, providing capital to expand established private businesses often by taking a minority interest, all the way to large buyouts (leveraged buyouts, or LBOs), in which the private equity firm buys the entire company. When the target is publicly traded, the private equity fund performs a public-to-private transaction, removing the target from the stock market. But buyout transactions usually involve private companies and very often a particular division of an existing company.

Some exclude venture capital from the private equity universe because of the higher risk profile of backing new companies as opposed to mature ones. For this reading, we refer simply to venture capital and buyouts as the two main forms of private equity.

Many classifications of private equity are available. Classifications proposed by the European and Private Equity Venture Capital Association (EVCA) are displayed in Exhibit 1.

Exhibit 1. Classification of Private Equity in Terms of Stage and Type of Financing of Portfolio Companies
Broad Category Subcategory Brief Description
Venture capital Seed stage Financing provided to research business ideas, develop prototype products, or conduct market research
Start-up stage Financing to recently created companies with well-articulated business and marketing plans
Later (expansion) stage Financing to companies that have started their selling effort and may already be covering costs: Financing may serve to expand production capacity, product development, or provide working capital.
Replacement capital Financing provided to purchase shares from other existing venture capital investors or to reduce financial leverage.
Growth Expansion capital Financing to established and mature companies in exchange for equity, often a minority stake, to expand into new markets and/or improve operations
Buyout Acquisition capital Financing in the form of debt, equity, or quasi-equity provided to a company to acquire another company
Leveraged buyout Financing provided by an LBO firm to acquire a company
Management buyout Financing provided to the management to acquire a company, specific product line, or division (carve-out)
Special situations Mezzanine finance Financing generally provided in the form of subordinated debt and an equity kicker (warrants, equity, etc.) frequently in the context of LBO transactions
Distressed/turnaround Financing of companies in need of restructuring or facing financial distress
One-time opportunities Financing in relation to changing industry trends and new government regulations
Other Other forms of private equity financing are also possible—for example, activist investing, funds of funds, and secondaries.

Private equity funds may also be classified geographically, by sector, or both. Certain specialists target real asset classes, such as real estate, infrastructure, energy, and timber, or they seek out emerging or niche sectors, such as agribusiness or royalties in pharmaceuticals, music, film, or TV.

US private equity enjoyed a far larger market size historically than private equity in other regions, with few restrictions on hostile takeovers. Buyouts subsequently expanded to Europe and then Asia as friendly deals became commonplace. In broad terms, around four-fifths of the money has been flowing into buyout, growth, and other types of private equity in both the United States and Europe, with buyout amounts far exceeding other types. The sheer scale of buyouts means that an individual deal can absorb billions of dollars in capital. Buyout funds have benefited from increased allocations given their ability to absorb far higher capital amounts and to deliver historically higher-than-average returns.

Venture capital deals, in contrast, tend to drip, providing small amounts of feed money. Still, advances in technology and communications are causing the number of venture capital funds and the availability of start-up capital to grow. Investor attention started to shift to China in 2015, an especially active year for raising capital. VC funds targeting Asia had more than US$200 billion in 2017, up from US$50 billion in 2010.

Most private equity money comes from institutional investors, such as pension funds, sovereign wealth funds, endowments, and insurance companies, although many family offices and high-net-worth individuals also invest directly or through fund-of-funds intermediaries. Venture capital investors include government agencies and corporations seeking to promote regional investment or gain insight into, and possibly control of, emerging businesses and technologies.

Private equity investment is characterized by a buy-to-sell orientation: Investors typically expect their money to be returned, with a handsome profit, within 10 years of committing their funds. The economic incentives of the funds are aligned with this goal.

Learning Outcomes

The member should be able to:

  1. explain sources of value creation in private equity;

  2. explain how private equity firms align their interests with those of the managers of portfolio companies;

  3. distinguish between the characteristics of buyout and venture capital investments;

  4. interpret LBO model and VC method output;

  5. explain alternative exit routes in private equity and their impact on value;

  6. explain risks and costs of investing in private equity;

  7. explain private equity fund structures, terms, due diligence, and valuation in the context of an analysis of private equity fund returns;

  8. interpret and compare financial performance of private equity funds from the perspective of an investor;

  9. calculate management fees, carried interest, net asset value, distributed to paid in (DPI), residual value to paid in (RVPI), and total value to paid in (TVPI) of a private equity fund.


  • Private equity funds seek to add value by various means, including optimizing financial structures, incentivizing management, and creating operational improvements.

  • Private equity can be thought of as an alternative system of governance for corporations: Rather than ownership and control being separated as in most publicly quoted companies, private equity concentrates ownership and control. Many view the combination of ownership and control as a fundamental source of the returns earned by the best private equity funds.

  • A critical role for the GP is valuation of potential investments. But because these investments are usually privately owned, valuation encounters many challenges.

  • Valuation techniques differ according to the nature of the investment. Early-stage ventures require very different techniques than leveraged buyouts. Private equity professionals tend to use multiple techniques when performing a valuation, and they explore many different scenarios for the future development of the business.

  • In buyouts, the availability of debt financing can have a big impact on the scale of private equity activity, and it seems to impact valuations observed in the market.

  • Because private equity funds are incentivized to acquire, add value, and then exit within the lifetime of the fund, they are considered buy-to-sell investors. Planning the exit route for the investment is a critical role for the GP, and a well-timed and well-executed investment can be a significant source of realized value.

  • In addition to the problems encountered by the private equity funds in valuing potential portfolio investments, challenges exist in valuing the investment portfolio on an ongoing basis. This is because the investments have no easily observed market value and there is a large element of judgment involved in valuing each of the portfolio companies prior to their sale by the fund.

  • The two main metrics for measuring the ongoing and ultimate performance of private equity funds are IRR and multiples. Comparisons of PE returns across funds and with other assets are demanding because it is important to control for the timing of cash flows, differences in risk and portfolio composition, and vintage-year effects.

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