Private Equity & Private Debt: Core Concepts for CAIA Level 1

Dimitri Dangeros, CFA, CAIA
3 days ago
4 min read

Private Equity & Private Debt: Core Concepts for CAIA Level I

In the CAIA Level I curriculum, Private Equity (PE) and Private Debt (PD) together form a vital segment of the alternative investments landscape. While their combined weight is smaller than core areas like Ethics or Introduction to Alternative Investments, mastery of these topics is essential for success—both on the exam and in real-world investment practice.

Private Equity: An Overview CAIA Level 1 Private Equity & Private Debt

Private equity involves investing directly in private companies or taking public companies private, with the aim of generating returns through growth, operational improvements, and strategic exits. CAIA Level 1 Private Equity & Private Debt

Key Characteristics

Illiquidity: PE investments are typically locked up for several years.
Active Management: PE firms take an active role in governance and strategic decision-making.
Long-Term Horizon: Value creation often takes 5–10 years, depending on the strategy.

Primary Strategies

Venture Capital (VC)
- Early-stage financing for startups with high growth potential.
- Focus on innovation, scalability, and market disruption.
- High risk but potentially high return.
Growth Equity
- Capital for more mature companies looking to expand without ceding control.
- Lower risk than VC but still offers strong growth potential.
Buyouts (Leveraged Buyouts – LBOs)
- Acquiring controlling stakes in established companies, often using significant leverage.
- Goal: Improve operations, increase cash flows, and exit profitably.
Distressed Investing
- Acquiring underperforming companies at a discount with a plan to restructure.

Fund Structure

Typically limited partnerships:
- General Partner (GP): Manages the fund, makes investment decisions, earns management fees + carried interest (performance-based profit share).
- Limited Partners (LPs): Provide capital, have limited liability, and receive returns net of fees.

Valuation Methods

Discounted Cash Flow (DCF)
Comparable Company Analysis (CCA)
Precedent Transactions
For VC: use of the venture capital method and first Chicago method.

Private Debt: An Overview

Private debt refers to non-bank lending where investors provide debt capital directly to companies without intermediaries like public bond markets.

Key Characteristics

Customized Structures: Terms can be tailored to borrower needs.
Higher Yields: Investors earn a premium for illiquidity and credit risk.
Collateralized or Unsecured: Varies by deal type.

Primary Strategies

Direct Lending
- Loans directly to middle-market companies.
- Often senior secured loans with covenants to protect lenders.
Mezzanine Financing
- Hybrid of debt and equity—subordinated to senior debt but senior to equity.
- Often includes equity warrants for upside participation.
Distressed Debt
- Purchasing debt of companies in financial trouble, aiming for restructuring gains.
Special Situations
- Opportunistic lending in complex or transitional scenarios.

Risk Considerations

Credit Risk: Probability of borrower default.
Liquidity Risk: Difficulty selling positions before maturity.
Covenant Risk: Looser covenants can increase exposure to losses.

Return Drivers

Interest income
Fees (origination, arrangement)
Potential equity upside in mezzanine deals

PE vs. PD – Core Distinctions

Feature	Private Equity	Private Debt
Role in Capital Structure	Equity (ownership)	Debt (lending)
Return Source	Capital gains at exit	Interest income + fees
Risk Profile	Higher volatility, dependent on exit	Lower volatility, credit risk
Liquidity	Illiquid (5–10 years)	Illiquid (3–7 years)
Control	Often active operational involvement	Limited operational involvement

Exam-Relevant Concepts for CAIA Level I

Fund Economics
- Know how management fees and carried interest affect net returns to LPs.
- Example: Carried interest usually 20% over a “hurdle rate” of 8%.
Performance Measurement
- PE: Internal Rate of Return (IRR), Multiple on Invested Capital (MOIC)
- PD: Yield to Maturity (YTM), cash-on-cash returns, default-adjusted returns
Risk & Due Diligence
- PE: Market, operational, financing, and exit risk
- PD: Creditworthiness, industry cyclicality, collateral value
Valuation Nuances
- PE often values at fair market value quarterly, but illiquidity makes this challenging.
- PD valuations depend heavily on credit quality and market rates.

Study Tips for 2025 Candidates

Link Theory to Practice: Relate CAIA concepts to real-world deals in the news.
Use Case Studies: Analyze an LBO example and a direct lending transaction to compare mechanics.
Memorize Key Formulas: Especially IRR, MOIC, and basic credit metrics like interest coverage ratio.
Understand J-Curve Effects: Especially for PE funds—negative returns in early years before value creation is realized.

Final Takeaway

In the CAIA Level I exam, Private Equity and Private Debt test your ability to differentiate between ownership and lending strategies in private markets, understand their unique risk-return profiles, and apply valuation and performance measurement techniques.

While their combined weight may not dominate the exam, their complexity and real-world relevance mean they can be score-boosters if mastered thoroughly. Approach them with both conceptual clarity and practical insight, and they’ll strengthen your overall exam performance.

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