2025 CFA Level 1 IFT Review Notes (Sample)

LM03 Investments in Private Capital - Equity and Debt 2025 Level I Notes
LM03 Investments in Private Capital - Equity and Debt
1. Introduction ...........................................................................................................................................................2
2. Private Equity Investment Characteristics ................................................................................................2
3. Private Debt Investment Characteristics....................................................................................................6
4. Diversification Benefits of Private Capital .................................................................................................7
Summary......................................................................................................................................................................8
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Version 1.0
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1. Introduction
This learning module covers:
 Features and investment characteristics of private equity
 Features and investment characteristics of private debt
 Diversification benefits of private capital
2. Private Equity Investment Characteristics
Private capital is a broad term for funding provided to companies that is not sourced from
the public equity or debt markets.
Capital that is provided in the form of equity investments is called private equity, whereas
capital that is provided as a loan or other form of debt is called private debt.
Private Equity: Description
Private equity means investing in private companies or public companies with the intent to
take them private. The companies in which the private equity funds invests are called
portfolio companies because they will become part of the private equity fund portfolio.
The three main categories of private equity are:
 Leveraged buyouts: Borrowed funds are used to buy an established company.
 Venture capital: Refers to investments in companies that have not been established
yet.
 Growth capital: Refers to minority equity investments in mature companies that
require funds for growth or expansion, restructuring, entering a new territory, an
acquisition, etc.
Leveraged Buyouts
Leveraged buyout is an acquisition of an established public or private company with
borrowed funds. If the target company is a public company, then after the acquisition, the
company becomes private, i.e., the target company’s equity is no longer publicly traded.
The acquisition is significantly financed through debt, hence the name leveraged buyout.
LBOs capital structure consists of equity, bank debt, and high-yield bonds. The firm (GP) puts
in some money of its own, raises a certain amount from LPs, and a substantial amount of
money is borrowed in the form of debt to invest in companies.
For example, assume the GP invests in a target company that requires an investment of $100
million. In this, the GP invests $20 million of its money (equity), $70 million from bank debt,
and the remaining $10 million is raised by issuing high-yield bonds.
There are three changes that happen to a company as a result of a leveraged buyout:
 An increase in financial leverage.

 Change in management or the way the company is run.

 If the target company is previously public, after the LBO it becomes private.
Why LBO?
 To improve the company’s operations; to add value and eventually increase cash flows
and profits.
 Leverage will enhance potential returns once the restructuring/growth strategy is
complete and the company turns profitable. Debt is central to an LBO structure.
Buyouts are rarely done entirely using equity.
There are two types of LBOs:
 Management buyouts (MBO): Current management team purchases and runs the
company.
 Management buy-ins (MBI): Current management team is replaced and the acquirer
team runs the company.
Venture Capital
Venture capital firms invest in private companies (portfolio companies) with significant
growth potential. The time horizon is typically long-term. The distinction between VC and
LBO is that the latter invests in mature companies, whereas VC invests in growing
companies with a good business plan and strong prospects for future growth.
Other important points related to VCs are given below:
 Venture capitalists are actively involved in the companies they invest in.
 The rate of return expected depends on the stage the company is in when the
investment happens.
 VC investing can take place at various stages
Formative stage: Company is still being formed.
o Angel investing: Financing provided at the idea stage.
o Seed stage financing: Financing provided for product development and market
research.
o Early stage: Financing for companies moving towards operation, but before
commercial production and sales. Fund to initiate commercial production and
sales.
Later stage financing: For expansion after commercial production and sales but
before IPO.
Mezzanine stage: Preparing to go public.
The following exhibit shows the growth stages of a company and the types of financing it
may receive at each stage.

PIPE (Private Investment in public equity):

 A PIPE occurs when an institutional or accredited investor purchases stock from a
public company at a discount to the market price.
 PIPEs save companies time and money while raising funds because they have less
stringent regulatory requirements than public offerings.
 However, the lower cost of PIPE shares means less capital for the company, and their
issuance effectively dilutes the stake of current stockholders.
Private Equity Exit Strategies
The goal of private equity is to improve new or underperforming businesses and exit them at
high valuations. Typically, investments (target companies) are held for an average of 5 years.
The holding period may be longer or shorter.
The three common exit strategies are:
 Trade sale: Selling the company to a competitor or any strategic buyer. It can be done
through auction or private negotiation. For instance, if a PE firm (GP) invested in a
small generic pharma company, it may sell it to large pharma firm after a few years.
 IPO: Company goes public, i.e., it sells all or some of its shares to public investors.
 Special purpose acquisition company (SPAC): A SPAC is a shell company, often called a
“blank check” company, because it exists solely for the purpose of acquiring an
unspecified private company sometime in the future. SPACs raise capital through IPOs
and deposit the proceeds in a trust account. They have a finite time (e.g. 24 months) to
complete a deal; otherwise, the proceeds are returned back to the investors.
Exhibit 3 from the curriculum lists the pros and cons of these three strategies.

LM10 Financial Reporting Quality 2025 Level I Notes
LM10 Financial Reporting Quality
1&2. Introduction & Conceptual Overview ....................................................................................................2

3 – 5. Quality Spectrum of Financial Reports ................................................................................................2
6. Differentiate between Conservative and Aggressive Accounting .....................................................3
7. Context for Assessing Financial Reporting Quality ................................................................................3
8. Mechanisms that Discipline Financial Reporting Quality ....................................................................4
9. Detection of Financial Reporting Quality Issues: Introduction & Presentation Choices .........6
10 - 12. Accounting Choices and Estimates and Their Effects ................................................................7
13. Warning Signs ................................................................................................................................................. 11
Summary................................................................................................................................................................... 14
Version 1.0

1&2. Introduction & Conceptual Overview

There are two main interrelated concepts that will be discussed in detail in this reading:
financial reporting quality and earnings quality.
Financial reporting quality: High-quality financial reporting provides information that is
useful to analysts in assessing a company’s performance and prospects. They contain
information that is relevant, complete, neutral, and free from error.
High-quality reporting helps in making the right decision as it depicts the true economic
reality of a company for the reporting period. Low-quality financial reporting contains
inaccurate, misleading, or incomplete information.
Earnings quality: High-quality earnings result from activities that a company will likely be
able to sustain in the future and provide a sufficient return on the company’s investment. If
the return on investment is greater than the cost of funds, then it indicates high earnings
quality.
Sustainability is the key here. For example, assume a company uses accrual-based earnings
in a quarter. It has high accounts receivable and as a result reports high earnings, which is
not sustainable in the following quarters. This implies earnings quality is low.
3 – 5. Quality Spectrum of Financial Reports
Combining the two aspects – financial reporting quality and earnings quality, we get a
spectrum spanning from highest to lowest. Let us now look at the characteristics of
reporting/earnings quality as we move down along the spectrum as shown in the exhibit
below.
1. Reporting is GAAP compliant and decision useful. The earnings are also sustainable
and adequate.
2. Reporting is GAAP compliant and decision useful. However, earnings quality is low,

i.e., the earnings are not sustainable or adequate.

3. Reporting is GAAP compliant, but the reporting choices and estimates used while
preparing the reports are biased.
4. Reporting is GAAP compliant, but the amount of earnings is actively managed. The
intent is to increase/decrease/smooth reported earnings.
5. Reporting is not GAAP compliant, although the reports are based on the company’s
actual economic activities.
6. Reporting is not GAAP compliant and the reports contain numbers that are fictitious.
Non-GAAP reporting of financial metrics which is not in compliance with generally accepted
accounting principles such as US GAAP and IFRS includes both financial metrics and
operating metrics. Non-GAAP earnings are sometimes referred to as underlying earnings,
adjusted earnings, recurring earnings, or core earnings.
6. Differentiate between Conservative and Aggressive Accounting
The choice of accounting methods used can distort the economic reality. Unbiased financial
reporting is the ideal, but investors may prefer conservative accounting choices as a positive
surprise is acceptable. Whereas the management may prefer aggressive accounting choices.
Aggressive accounting: It refers to biased accounting choices that aim to improve the
reported earnings or financial position in the period under review.
Conservative accounting: It refers to biased accounting choices that aim to decrease the
reported earnings or financial position in the reporting period.
Some managers use aggressive accounting when earnings are below targets and
conservative accounting when earnings are above targets, to artificially smooth earnings.
When a company makes conservative choices, it implies that:
 revenue is recognized only when earned and when collections are reasonably certain.
 expenses/losses are recognized when probable.
 earnings will be understated in the current period.
7. Context for Assessing Financial Reporting Quality
Motivations
Managers may be motivated to issue financial reports that are not high quality in order to:
 mask poor performance.
 boost the stock price.
 increase personal compensation.
 avoid violation of debt covenants.

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Conditions Conducive to Issuing Low-Quality Financial Reports

The three conditions conducive for issuing low-quality financial reports are presented
below:
Opportunity: It can be the result of weak internal controls, ineffective board of directors, and
accounting standards that allow a range of choices.
Motivation: It can result from pressure to meet some criteria for some personal reasons.
Rationalization: It can result from justifying a wrong choice as seen in Enron’s case. Enron’s
CFO sought board approvals, legal and accounting opinions for misstated financial
statements.
8. Mechanisms that Discipline Financial Reporting Quality
Market Regulatory Authorities
Regulators in every country can play a key role in enforcing financial reporting quality.
Examples of regulatory authorities include:
 the SEC (Securities Exchange Commission).
 SEBI (Securities and Exchange Board of India).
 Securities and Futures Commission in Hong Kong.
These regulatory authorities are members of an international organization called the
International Organization of Securities Commissions (IOSCO), comprising 120 regulatory
authorities and 80 securities market participants like the stock exchanges.
The actual regulation, however, is enforced through each individual regulatory authority in a
country. The features of any regulatory regime such as the SEC that affect financial reporting
quality include the following:
 Registration requirements: Publicly traded companies must register securities before
offering securities for sale to the public. A registration document (often known as a
prospectus in an Initial Public Offering) contains current financial statements, future
prospects of the company, and securities being offered.
 Disclosure requirements: Publicly traded companies are required to make public
periodic reports such as financial statements.
 Auditing requirements: The financial statements must be audited by an independent
auditor that states the statements conform to the accounting standards.

LM14 Credit Risk 2025 Level I Notes
LM14 Credit Risk
1. Introduction ...........................................................................................................................................................2
2. Sources of Credit Risk ........................................................................................................................................2
3. Credit Rating Agencies and Credit Ratings ................................................................................................5
4. Factors Impacting Yield Spreads ...................................................................................................................7
Summary......................................................................................................................................................................9
Version 1.0

1. Introduction
This learning module covers:
 Credit risk and its components – probability of default and loss given default
 Role of credit ratings in debt markets
 Factors that influence the level and volatility of yield spreads
2. Sources of Credit Risk
Credit risk is the risk that the borrower will fail to make principal and/or interest payments
on time.
Traditionally, many analysts assessed creditworthiness using what are known as the "Cs of
credit analysis," as illustrated in Exhibit 1:
The five bottom-up factors that are applicable to an individual borrower are:
 ‘Capacity’ refers to the ability of the borrower to make its debt payments on time.
 ‘Capital’ refers to other company resources available that reduce reliance on debt.
 ‘Character’ refers to the quality of the management and the willingness to pay debt.
 ‘Covenants’ refers to the terms and conditions of the debt agreement that the issuer

must comply with.

 ‘Collateral’ refers to the quality and value of the assets pledged against the debt.
The remaining three factors are general top-down factors that apply to all borrowers:
 ‘Conditions’ refers to general economic, competitive, and business environment faced
by all borrowers that may impact their ability to service or refinance debt.
 ‘Country’ refers to the geopolitical environment as well as the legal and political
system faced by all issuers in a jurisdiction.
 ‘Currency’ refers to cash flows affected by exchange rate changes, such as
import/export or borrowings in foreign currency.
Sources of Credit Risk
Exhibit 3 from the curriculum shows the main borrower types, their primary sources of
repayment and credit risk.
As shown in the exhibit, many factors can affect the primary and secondary sources of
repayment for different fixed-income issuers.
Measuring Credit Risk
Credit risk has two components:
 Probability of default (POD): The likelihood that an issuer fails to make full and timely
payments of principal and interest.
 Loss given default (LGD): How severe is the loss incurred by the investor? What

portion of the bond’s value (including interest) is not paid by the issuer? A default
leads to various severity of losses; for instance, the loss may be total, or the
bondholders may recover some value.
We combine both the components into a single term called the ‘expected loss’.
Expected Loss = POD x LGD
The loss given default depends on:
 Exposure at default (EAD): The size of the investor’s claim at the time of default.
 Recovery rate (RR): Represents the percentage of an outstanding debt claim recovered
when an issuer defaults. A related term is loss severity (1-RR) which represents the
unrecovered portion of the claim.
LGD = EE x (1 - RR)
Exhibit 4 from the curriculum illustrates these concepts:
One way to interpret a fixed-income security's expected loss for a given period is to compare
it to the compensation an investor expects for taking on a borrower's credit risk over that
period, which is the credit spread. We can say that an investor is fairly compensated if the
expected loss is equal to the credit spread for a given period.
Credit Spread ≈ POD × LGD
Example:
(This is based on Question Set – Q#4 from the curriculum.)
A bond investor analyzing a company’s unsecured debt estimates a POD of 2% and an LGD of
80%. The observed actual credit spread for this bond is 200 bps per year. Is the investor
fairly compensated/ less than fairly compensated/more than fairly compensated for

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LM03 Investments in Private Capital - Equity and Debt 2025 Level I Notes

LM03 Investments in Private Capital - Equity and Debt

© IFT. All rights reserved 1

© IFT. All rights reserved 2

 Change in management or the way the company is run.

© IFT. All rights reserved 3

PIPE (Private Investment in public equity):

© IFT. All rights reserved 4

LM10 Financial Reporting Quality

1&2. Introduction & Conceptual Overview ....................................................................................................2

© IFT. All rights reserved 1

1&2. Introduction & Conceptual Overview

© IFT. All rights reserved 2

i.e., the earnings are not sustainable or adequate.

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3. CAIA (Chartered Alternative Investment Analyst)

B. Accounting & Auditing Exams contact email johnway168@yahoo.com

1. CPA (Certified Public Accountant)

11. Best Forex/Trading Mastery Courses

Have a good day!

Conditions Conducive to Issuing Low-Quality Financial Reports

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LM14 Credit Risk

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must comply with.

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