What is Private Equity

What is Private Equity ?

These are private investments made by private firms mostly (except couple of public trade companies such as KKR) who want to acquire other companies. Once they acquire them, they unlock the value and resell them to other buyers such as IPO or just any other buyer.

Structure of Private Equity is as follows:

"Private Equity" PE Firm owns a fund called "Private Equity Fund" and this fund owns the ultimate "PE Portfolio companies". Portfolio companies are the same companies that PE firm is trying to acquire using the PE Fund.

Life cycle of the PE fund is as follows:
PE firm raises and manages the investment made by investors by being the General Partner of the fund. Core investors are Limited Partners such that their liability is capped to the invested capital and they are not responsible for manager's activities.

A PE Firm acquires the new firm through 2 ways
1. Acquisition through Equity of Portfolio Companies
2. Acquisition through Debt of Portfolio Companies

• Type of investment under Equity Category are: "Venture Capital" and "Leverage Buyout (LBO)" 
• Type of investment under Debt Category are: "Mezzanine Financing" and "Distressed Debt"

GPs of the PE firms usually charge a money management fee (1-3.5%) on yearly basis (Fixed Fee) and an incentive fee (around 10-30%) of the realized profits during exit of the fund.

I will write more on 4 types of investment categories in another post another time.

Nitin

Counterparty Credit Risk

What is Counterparty Credit Risk

Counterparty Credit Risk is all about risk of dealing with banks. This risk primarily deals with an event under which a banking institution (aka counterparty) fails to meet its obligations to return the money that it borrowed from another bank (aka counterparty).

Banks usually need a lot of cash to do trading, to run their operations, payroll etc... due to their gigantic size. Since they don't have all the cash handy, they usually go to another bank and borrow. Under good economic conditions, banks usually have no problems in lending each other money but they want some sort of assets in the escrow account to make sure they get their money back. The asset that is put as a guarantee in escrow account is called "Collateral". Once the borrower bank returns the money back, the lending bank returns the collateral.

Now consider, economic conditions start worsening and banks still need money to run their operations. The same original banks are now reluctant to lend each other because they are doubting whether the other bank will be able to pay the money back. In case, the borrowing bank doesn't return money, lending bank might have a problem with its operations as well. To signal other bank about its creditworthiness during bad economic conditions, borrowing banks are willing to put even more collateral to get the money. However, even after more collateral deposits, banks are still unwilling to lend each other due to counterparty risk. The rationale here is banks usually put Bonds as a collateral to borrow money and lending banks are not willing to keep those bonds as collateral because they are not even sure whether they would be able to recover 100% of the lent money by selling those bonds in case counterparty defaults on its obligation. Also, under bad economic conditions prices usually fall and hence it makes it even more difficult to price those bonds accurately. Seeing so much volatility in markets, banks usually decline to lend regardless of collateral being posted.

As one can see, when banks stop lending each other because of the creditworthiness of the borrowing bank, it can cause huge liquidity crisis in the financial sector. In fact, this was the primary reason why two famous banks in America, "Lehman Brothers" and "Bear Stearns" collapsed as no other bank was willing to give them cash to keep them functioning. Finally, without much cash in hands to run the operations, banks were left with no choice but to file bankruptcy.

Finally, Remember that Banks are institutions who will give you the umbrella on a perfect sunny day and  would want it back on a Rainy day.

This is what counterparty risk is all about.

Nitin  

Discount Factor

Discount Factor

Another key term in Finance Theory is Discount Factor. This factor tells you how future values should be discounted to get back to Present Value. Simplest way to understand Discount Factor is how much money I need today to get some pre-determined amount that I need in future. Example - you have a series of liabilities such as tuition fee for your kid which might be fixed at the end of every year, say $30,000. So, you have 4 years of liabilities of $30,000 each at sometime in future and you want to know how much money do you need today to offset these liabilities. Discount factor is your answer to such a question.

Discount factor has 2 dimension attributes. One is time and second is Interest Rate. Based on interest rate, your discount factor changes. A simple logic is higher the interest rate that bank offers, the lower the deposit you need today.

Discount Factor is calculated as 1/(1+r)^n Where n is the number of years and r is the interest rate that bank is offering on fixed deposits for that duration.

Below screenshot shows how discount factor changes with maturity and interest rate.

     Discount Factor 2-D Ladder

Now, to answer the original question on how much money you need to have 30,000 in future can be calculated as follows:
Let's say you need to have 30K in year 7, 8, 9, and 10 and the corresponding interest rates that bank offers are 7%, 8%, 9%, and 10%. Now you need to look at the intersection of maturity and interest rate to determine the correct discount factor for multiplication.
Discount factors that match maturity and interest rates are: 0.6227, 0.5403, 0.4604, 0.3855. Now to find total needs today, you just simply multiply each discount factor with the $30,000 that you need.
7 Yr = 18,681, 8 Yr = 16,209, 9 Yr = $13,812, and 10 Yr = $11,565.

So, altogether you would need a total of $60,267.00 today to offset your future liabilities of $120,000.
This is all about power of compounding where money keeps on making money. :)

-Nitin  

TVM - Time Value Of Money

Time Value of Money

One of the most fundamental concepts in Finance Theory is Time Value of Money. This concept is so crucial that without understanding and applying it correctly, none of the financial models be able to produce reliable outcome.

So, what is time value of money (TVM)?
This concept describes that money at two different time points is not same since money earns interest over that time period (money earns money). Let's say 1 year interest rate on fixed deposits on US Dollar is 10%. So, it's same as having $100 today vs $110 a year from now.

The reason why this concept is so important to us as an investor is we need to make an investment decision. Should we invest today or should we wait a year from now when we have 10% more money in hand? It's not that easy to answer but using some assumptions, a decision can be made.

Example: you have $100,000 today and you want to buy a house. The house costs $200,000. You have a choice of putting 100K down today and finance 50% or buy the house in a year from now with 55% down payment assuming nothing else has changed which usually doesn't happen. (House price can go up or down, inflation can skyrocket or etc... etc...)

In finance, value of money today is known as "Present Value" and value of money in future is called "Future Value". The interest income is called "Carrying Benefits" or plain "Interest Income" or "Time Value of Money"

Another one of the most important terms that is used in TVM is called "Discount Factor".

In above example as you might notice, that you give $100 today to receive $110 in a year can also be expressed as you give $90.91 today to receive $100 in a year from now. (They are same things)

Discount factor is calculated as PV/FV

In above example, 100/110 = 0.9091. In finance, we say it as 1 Year Discount factor at 10% is 0.9091.
To better use this information, the question can be asked as how much money do I need to deposit today in the bank to receive $525 in a year from now. You simply multiply your future value with the discount factor to get the answer. So, in this case you multiply 525 * 0.9091 = $477.27. In other words, you deposit $477.27 today and the bank will give you $525 in a year from now.

-Nitin

What Does Inflation Hedge mean?

What is Inflation Hedge? 

You ever heard in the media that Gold is inflation hedged instrument? I am sure many of us have heard this expression many times over CNBC, CNN Money etc.... So, what does Inflation Hedge mean?

In the last couple of posts, I have been mentioning that inflation is nothing more than measuring strength of the currency buying power. If currency gets weaker, we say inflation is higher since our buying power has deteriorated. So, how do we hedge ourselves against it.

It's really not that difficult and a it's very simple logic. It's just investment media make it sound so fancy and complicated such that local public get lost in financial terms. So, back to basics of Inflation - If the currency is getting weaker, people would have to pay a higher price for the same product in future as they pay for it today. So, why not hold something today that people would want to buy tomorrow such that you can collect a higher economic value in future. So, if you can own a lot of things today that people would want to buy tomorrow then you can only get richer in nominal terms in future.

Again back to economics, you have limited supply of cash inflow so you must use it wisely. Once cash is spent, you would have to wait for new cash which might take one month if you get paid monthly or who knows how your cash flow situation is. So, any asset that you think will be in demand in future can be bought with the money in hand today and you will be inflation hedged.

Also, when you buy an asset today, you need to consider following things as well:
1. Does buying the asset today has additional costs attached with it to store? In finance, we call it carrying cost. Hence, buy an asset that will have almost no storage costs.
2. You shouldn't buy an asset that may not be in demand in future because you wouldn't be able to charge more in future and hence will have negative return on your invested amount. This is called diminishing time value of money.

So, considering about principles, you wouldn't want to buy a lot of coke or pepsi bottles, or even gallon of gasoline, or anything that has a lot of storage overhead. So, what should one buy to hedge against inflation?

Some of the following assets are treated one of the best inflation hedged instruments.
1. Real Estate. (No storage is needed here)
2. Precious Metals such as Gold or Silver Bars (You can store them in the drawer, if needed)
3. Long term Futures Call Options on Oil Contracts. (Financial contracts carry counterparty credit risks)
4. DO NOT hold cash currency because that is the first one which loses value during inflation

Key note is: These instruments must stay in demand in future, else you might lose value of your invested capital. For example, if all of a sudden Gold demand dies out due to a cheaper substitutes availability in future, Gold price might fall down higher than inflation. Example holding a gold bar which lost 25% in its value due to demand evaporation while inflation was only 2%. You would lose 23% of your investment in such case.

Also, inflation hedge doesn't mean that you will always be richer in future in nominal terms than what you are today. There are many other types of risks that can eventually evaporate your wealth.

-Nitin 

Inflation - How do we measure it?

Inflation - How do we measure it?

In the last post, I described that inflation is nothing more than the strength of the currency. In the previous post, I used a cross currency reference of Australian Dollar and US Dollar to describe the relative purchasing power of Australians vs Americans. In this post, I will describe the relative strength of currency between two time periods at the national level.

In order for one to measure the strength of the currency in the domestic land between two time points, following parameters are needed:

a) Starting time point (usually denoted as t0 and often referred as reference point)
b) Future time point (any time in future, when inflation needs to be measured)
c) An Underlying(s) whose price needs to be measured usually called commodity basket or just basket.

Now, in order for us to measure the strength of the currency, we should take a good sample of products that  can help represent the inflation accurately.

Let's say a regular consumer has a dependency on following products

1. A gallon of Milk
2. A gallon of Gasoline
3. A 2 Litre bottle of Coke
4. A 32 inch television

I am taking a very small sample to get the point across but you can imagine that governments must consider all sorts of products that can accurately represent the domestic economy such as price of chicken, train ticket to New York City from Boston and so on.

Now, the above 4 products called the basket and their price is called Basket price. Imagine, our reference point is 2012 and hence we need the price of this basket on Jan 1, 2012 and Jan 1, 2013.

For simplicity, I am assuming uniform weights of these commodities in the economy and assuming that these 4 products accurately represent the economy.

Item             Jan 1, 2012             Jan 1, 2013
Milk             $5.00                      $4.50
Gasoline       $2.75                      $3.20
Coke            $2.00                      $3.50
TV               $100.00                  $101.00
===============================
Basket          $109.75                  $112.20
Price
===============================
So, the basket is 2.23% more expensive on Jan 1, 2013 when compared against same products on Jan 1, 2012. This will be known as yearly inflation.

Basket price is also known as Price index. In United States, it's called CPI (Consumer Price Index) where Index means the basket price of a bunch of commodities that US Govt uses as a reference basket to accurately represent health of economy.

Governments don't like higher inflation because it makes their currency weaker on a relative scale basis and hence they would intervene at various levels to control the relative strength of the currency.
Governments control inflation due to following 2 simple facts:

1. When currency becomes very expensive, exports takes a beating because the currency becomes very expensive for outsiders.
2. When currency gets cheaper, importers take a huge beating and these prices need to pushed down to the end consumer and consumers don't like to pay higher prices.

That's it for tonight.
Nitin 

Inflation - What is it?

Inflation - What is it?

So, what is inflation? what role does it play in our daily life. Did you ever wonder why a bottle of Coke that used to cost $1.20 now costs $2.25 or for that matter any other price. Usually products such as commodities offer the same functional value yet their economic value changes. For example, a bottle of coke still serves as a bottle of coke yet you have to pay a much higher price today. This is exactly what Inflation is all about. It's not the price of the underlying asset is increasing, it's because the buying power of your currency has gotten weaker and hence you must pay more of the weaker currency to buy exactly the same product.

Below example illustrates this concept a little better. I am using a cross currency example to illustrate it better.

Let's say an Australian Company charges AUD 100 for 1 gram of Gold. Also, in the foreign exchange market USD to AUD exchange rate is 1:1. Hence, for an American buyer, he needs to pay 100 US Dollars to buy the very same amount of 1 gram of gold.

Scenario 1: Let's imagine due to some government policies, USD has weakened against AUD and new exchange rate is: USD/AUD = 0.50 which means in 1 US Dollar now you get only 50 Australian Cents. This means US Dollar or anyone who is holding US Dollar in the pocket now has less buying power compared to when the exchange rate was 1:1. For the same American buyer to buy the very same 1 gram of gold, he now has to spend 200 USD. This is called Inflation where the buying power of the currency becomes weaker and everything priced in that currency must have a higher price when compared with old price.


Scenario 2: Let's imagine due to some government policies, USD has strengthened against AUD and new exchange rate is: USD/AUD = 2.0 which means in 1 US Dollar now you get you 2 Australian Dollars. This means US Dollar or anyone who is holding US Dollar in the pocket now can enjoy life with better life style. For the same American buyer to buy the very same 1 gram of gold, he now has to spend 50 USD only. This is scenario is Inflationary for Australians where the buying power of Australians now have weakened down against US Dollar.

Nitin