Level 1 CFA® Exam:
Private Equity Investments & Depository Receipts
Just like public equity securities, private equity securities are securities issued by entities generally to finance their planned expenditures. However, private equity securities are usually issued via non-public offerings and are usually targeted at investors who have considerable knowledge in finance, that is institutional investors. Instruments issued privately are not listed on exchanges, so their quoted prices are not established in the market. Private equity securities are also illiquid.
We distinguish among a few private equity investments:
- venture capital,
- leveraged buyout, and
- private investments in public equity.
Such investments provide capital for start-ups, which use it for expansion. Venture capital investments are very risky. Entities serving this way as capital generators are usually family members, friends, or certain institutions like private equity funds. An investment typically ends with conducting an initial public offering or through the sale of shares to some other entity, most often a sector investor.
Private Investment in Public Equity
Another type of private equity investment is private investment in public equity. Thanks to those investments it is possible to obtain funds for planned expenditures. This way investors acquire some shares of the company.
Such investment requires a detailed analysis of the company's financial health and its expansion plans. Often, when there is a strong need to obtain capital, it is possible to purchase shares at a discount, that is below the market price. Over the last few decades the private equity market has grown considerably but compared to the public equity market it is still small.
Global expansion has triggered the growth of huge global markets. This translated into the growth in primary and secondary financial markets. Now it is easier to raise capital and invest funds anywhere in the world. Investors can further diversify their portfolios and change the level of risk and returns.
A financial market offers a lot of opportunities to invest in financial instruments issued in foreign markets. Of course, the easiest investment opportunity is investing directly in instruments quoted in these markets. However, it has its drawbacks.
You should remember that such transactions together with dividend payments are usually done in the currency of an issuing company. Because of the characteristics of a particular market, an investor should know local settlement regulations which may be different from the procedures in his domestic market. He may also have some difficulties in acquiring market information.
Note that direct investing also includes investing in depository receipts and global registered shares. Trade in such securities is conducted in an investor's domestic market in his currency. This way the risks and drawbacks we've just mentioned are partially eliminated.
Depository Receipts: Introduction
A depository receipt, DR for short, is a security that represents ownership of another security that is traded in a non-domestic equity market. The security whose ownership is represented by a depository receipt is deposited in a depository bank. Then, a depository bank issues a depository receipt.
A depository receipt may represent one or more securities. The proportion is expressed as a ratio of the number of depository receipts to the number of underlying assets. The price of a depository receipt depends on the same factors as those which affect an asset.
A depository bank plays a few important roles as it is not only a custodian but also a registrar and a transfer agent.
How are depository receipts created?
- A depository bank buys shares of a company on the stock exchange where the company's shares are traded (the company's country market) and deposits them.
- A depository bank issues a depository receipt (a security) on the foreign exchange (foreign from the perspective of the company).
Example: A company is located in France and listed on the Paris Stock Exchange. A depository bank buys shares of this company. The depository bank issues a depository receipt in Borsa Italiana that represents e.g. 2 shares of the company. This way the company gets exposure to Italian investors.
Sponsored DR vs Unsponsored DR
Global Depository Receipts vs American Depository Receipts
We distinguish between two main types of depository receipts: global depository receipts (GDRs) and American depository receipts (ADRs).
Global depository receipts are issued outside the US and are subject to the legal regulations of a country other than the US. An example of a GDR issuance was the issuance conducted by a Polish oil refiner PKN Orlen whose assets were issued in 1999 on the London Stock Exchange. 1 GDR granted rights to 2 shares of PKN Orlen.
American depository receipts are issued in the US and are subject to American regulations. ADRs are the oldest and currently the most often traded depository receipts. An example of an ADR issuance was the issuance conducted by the said PKN Orlen in 2001 in the OTC market in the US. As in the case of GDRs issued in the London Stock Exchange, 1 ADR granted rights of 2 shares of PKN Orlen.
Level 1 CFA Exam Takeaways: Private Equity Investments & Depository Receiptsstar content check off when done
- Private equity investments include venture capital, leveraged buyout, and private investment in public equity.
- Private placements are mainly targeted at institutional investors who have considerable knowledge and experience.
- Venture capital investments provide capital for start-ups, which use it for expansion.
- In case of leveraged buyout all shares of a publicly-traded company are bought out of the market.
- When we talk about investing in non-domestic markets, apart from direct investing there is also investing in depository receipts among which we distinguish: GDRs and ADRs.
A depository receipt, DR for short, is a security that represents ownership of another security that is traded in a non-domestic equity market.
- Global depository receipts are issued outside the US and are subject to the legal regulations of a country other than the US.
- American depository receipts are issued in the US and are subject to American regulations.