Where would you invest in the capital structure?

Orchid's picture
Rank: Senior Chimp | 16

I hear this question asked all the time and I would just like to know how you guys would answer this question? How do you go about answering this question? Also could be for hedge fund interviews or private equity intervies.

Thanks
Orchid

Comments (17)

Mar 28, 2011

Tailor your answer to the person/team asking. If you're at a mezz shop, don't say control equity or senior debt. Say subordinated debt w/ warrants or minority equity participation.

Then, mention the pros of the section of the capital structure you picked. Keeping with the mezz example, you'd say something like: sub debt has the benefit of high interest rates, and whose returns are more likely to occur relative to equity expectations. Additionally, warrants and/or minority equity slices allow you to participate in any potential upside. Then, mention the cons of the other sections. Mezz is more interesting than senior debt, because there's no upside potential, and rates are low in the name of security. It's more interesting than control equity, because of the inherent risk and responsibility that comes with ownership.

Just gotta bullshit something to give the interviewer the impression that you understand what they invest in, and why it might be attractive to somebody.

    • 1
Mar 27, 2011

That is a great question. I gotta agree with TVBB on this but do not discredit knowing the nature of investing across all levels of the capital structure.

My take is that you focus on the shop you're working at's style and say that you would consider looking at other levels on the capital structure as well for the whatever reason (and since you'd be dealing with debt, you can create a nice little portfolio with mitigated risks and good duration exposure) you think are fit.

They are asking for your opinion so I would give it to them with a slant towards their flavor of investing.

Mar 28, 2011

If they don't provide it with the question, I would consider asking him or her for some more information on the type of investment (stage of investment, growth profile, industry, capital raise), as this will enable you to get more detailed with your pros and cons.

Mar 28, 2011
<span class=keyword_link><a href=/wall-street-mentors-finance-mock-interviews rel=nofollow>Wall Street Mentors</a></span>:

If they don't provide it with the question, I would consider asking him or her for some more information on the type of investment (stage of investment, growth profile, industry, capital raise), as this will enable you to get more detailed with your pros and cons.

exactly.

The critical thing for this question is to understand the risk vs. return dynamics of what you're investing in... that will, to a large degree, help you choose where to invest within the capital structure.

Mar 28, 2011

great question....segues nicely into capital structure arbitrage ideas if you really want to show off knowledge all across the capital structure too

Mar 28, 2011

I like the totally arbitrary/buzzword tags for the original post...

hahaha

    • 1
Mar 28, 2011

these are great responses keep them coming

Mar 28, 2011

This is a terrible question.

You invest wherever the alpha is. And that varies dramatically from opportunity to opportunity.

Jan 25, 2013
HFAnalyst:

This is a terrible question.

You invest wherever the alpha is. And that varies dramatically from opportunity to opportunity.

I think it is a terrible question because of the variance of investment focuses. For instance, if you are a high yield HF, that's where you should answer. You wouldn't say, I think common equity is the best place to find alpha, otherwise, what good are you to the HY fund?

However, if its a diversified group, I would answer with a place you feel there is the most alpha.

Mar 28, 2011

a lot of times in hedge fund interviews, this question will be given in the context of a specific opportunity. e.g., you'll be talking about a specific company with debt and/or mezz and equity securities outstanding and you'll be asked which part of the capital structure you think is most attractive from a risk/return perspective for that specific company.

You can't just say one part of the capital structure, e.g. Mezz, is inherently more attractive than debt (low yield) or equity (higher risk). That doesn't make any sense - it's a trade-off between risk and yield.

Mar 29, 2011
bankbank:

a lot of times in hedge fund interviews, this question will be given in the context of a specific opportunity. e.g., you'll be talking about a specific company with debt and/or mezz and equity securities outstanding and you'll be asked which part of the capital structure you think is most attractive from a risk/return perspective for that specific company.

You can't just say one part of the capital structure, e.g. Mezz, is inherently more attractive than debt (low yield) or equity (higher risk). That doesn't make any sense - it's a trade-off between risk and yield.

I agree with this. Of course the question makes no real sense for a typical private equity fund but is way more interesting if the shop you interview at invests across the capital structure. Then come specific cases, for example based on specific deals where, based on the risk/profile of the sector/company you would have to make suggestions as to which part of the capital structure offers the best investment thesis. I actually like to ask this question when I interview candidates and focus it on the mezz part:"does the investment look more attractive for the mezzanine or for the equity holders?". Which forces you to go deeper in the upside/downside analysis.

Mar 28, 2011

I would probably just ask what the investment objectives are and give some general ideas about cap structure--for instance, it's usually easier/cheaper to raise debt than equity, or if you're doing an LBO then you want to make sure the cash flows from the investment will be able to pay off the large amount of debt you would use.

Metal. Music. Life. www.headofmetal.com

Mar 28, 2011

rare gold coins or native american arrowheads. That's where they want to be.

Jan 25, 2013

How about if they give you a case with an IM...how would you determine where in the capital structure to invest?

Jan 25, 2013

Mezz is a shitty asset I reckon only insurance companies have any real justification for owning it.

'Mezz, not even once'.

Jan 28, 2013
samoanboy:

Mezz is a shitty asset I reckon only insurance companies have any real justification for owning it.

'Mezz, not even once'.

I agree with this. As a general rule, unless you've got some equity tail or conversion rights then Mezz tends to be too much risk for too little return.

Jan 27, 2013
Comment
    • 1