Free CFA Level III: Private Markets Private Equity Practice Questions

A is correct. Leverage in an LBO reduces the amount of equity the PE firm must invest, allowing the same fund to make more investments. It also amplifies equity returns: if the company's assets generate returns above the cost of debt, the excess accrues entirely to equity holders. Combined with the tax shield from interest deductions, leverage is a fundamental tool in buyout value creation.

B is incorrect. While interest deductions provide tax benefits, the primary purpose of leverage is return amplification, not tax minimization. Excessive leverage purely for tax purposes would increase financial risk to unacceptable levels.

C is incorrect. Leverage does not eliminate business risk. It amplifies both upside and downside outcomes for equity holders. If the business underperforms, leverage increases the risk of financial distress or bankruptcy. Lenders bear credit risk, but equity holders bear the amplified business risk.

B is correct. Growth equity investments typically involve minority (non-controlling) stakes in companies with strong revenue growth and proven business models. Little or no leverage is used because the company's value proposition is revenue growth, not financial engineering. Buyouts, by contrast, involve controlling stakes with substantial leverage, targeting more mature companies where operational improvements and financial optimization drive returns.

A is incorrect. Growth equity targets companies with high revenue growth, not declining revenues. Buyouts do not specifically target high-growth companies; they target companies with stable, predictable cash flows that can support leverage.

C is incorrect. Holding periods are broadly similar (3-7 years for growth equity, 3-7 years for buyouts). The distinction is in ownership percentage, leverage usage, and the source of value creation, not holding period duration.

B is correct. Exit EV = 9 x 100 = 900 million. Remaining debt = 400 - 150 = 250 million. Exit equity = 900 - 250 = 650 million.

Equity multiple = 650 / 200 = 3.25x over 4 years.

IRR: $(1 + r)^4 = 3.25$. $1 + r = 3.25^{0.25} \approx 1.343$. $r \approx 34.3\%$.

This is closest to 36% (the slight difference may be due to interim cash flows not captured in the simplified calculation). The return is driven by: EBITDA growth (75 to 100, +33%), multiple expansion (8x to 9x, +12.5%), and leverage (150 million debt paydown).

A is incorrect. 28% would imply $1.28^4 = 2.68$x, or exit equity of approximately 536 million, well below the 650 million calculated.

C is incorrect. 42% would imply $1.42^4 = 4.07$x, or exit equity of approximately 814 million, which exceeds the calculated 650 million.