Comparison of Members’ Experiences Investing in Public ... · This white paper explores the...

Comparison of Members’ Experiences Investing in Public versus Private Markets

Executive Summary

This white paper explores the experiences of International Forum of Sovereign Wealth Funds (IFSWF) members

investing in private markets. For the purposes of this study, we define private markets to include private equity,

real estate, and infrastructure investments. It seeks to answer the following questions:

What prompted members to move into private market investments?

What capabilities, governance, and other changes were required?

What lessons have members learned through this experience?

In considering these questions, we endeavor to present findings that are both descriptive, to enhance members’

understanding of private markets, and prescriptive, to empower SWFs to learn from one another’s experiences.

Our approach to this study was multifaceted and consisted of three distinct avenues of research. Specifically:

I. We conducted interviews with investment professionals at eight IFSWF member organizations to

document their experiences and identify lessons learned. These discussions provided us with a rich

understanding of the challenges and opportunities that SWFs face as they implement private market

investment programs. Despite the wide range of different investment objectives and disparate

geographic locations of these funds, a number of consistent themes emerged from these discussions.1

The complete list of the interview questions is provided in Appendix A. We treated these questions as a

rough roadmap for the conversations and did not insist that each SWF answer every question. Instead,

we allowed the discussions to evolve naturally, spending more time on the areas where each SWF had

specific insights to convey.

II. We spoke with one of the world’s foremost academic researchers in the private markets arena who has

also advised dozens of SWFs and other large institutions as they implement private market investment

programs. Specifically, the working group engaged in a detailed conversation with Professor Josh

1 In the interest of protecting each fund’s anonymity, we do not attribute quotes to specific SWFs or their investment teams. However, the list

of SWFs with which we spoke is provided in the Contributors section of this paper.

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Lerner, the Jacob H. Schiff Professor of Investment Banking at the Harvard Business School. Our

conversation with Professor Lerner served as a bridge between the insights we derived from our review

of academic research and the practical discussions with SWF investment professionals who manage

investment portfolios. An edited transcript of this discussion, which followed a question-and-answer style,

is presented in Appendix B.

III. We undertook an extensive review of the academic literature related to institutional participation in

private markets investments. The complete literature review is presented in Appendix C.

The main body of this paper — which synthesizes inputs from parts I, II, and II as outlined above — provides a

comprehensive outline of our key findings. At the highest level, these findings can be summarized as follows:

The primary motivation that SWFs cited for investing in private markets was the potential for these

assets to provide a return premium above that which is offered by public markets, particularly with many

stock and bond markets performing poorly in recent years. SWFs see this premium as being driven by

the illiquidity of private markets as well as a view that private markets are less efficient than public

markets, providing a greater opportunity for return. Some SWFs stated that they were well suited to bear

illiquidity risk due to their long investment horizon. However, even at SWFs where private markets

investments have performed well, internal debates continue as to whether the premium compensates

fully for the illiquidity and other risks associated with private markets investing. The funds cited a wide

array of risks, with liquidity risk, lack of transparency, and potential for loss of capital topping the list.

Each of the SWFs spoke at length about the capabilities and governance structures that they had

developed in order to launch a private markets program. One of the major themes that emerged from

these discussions was the importance of people. Each of the SWFs indicated that their commitment to

developing a qualified and talented team was a key ingredient to their success. “Human capability is the

most important part of a successful private markets investment program,” said one fund. Because many

SWFs are based in non-financial centers, attracting and retaining talent requires creative solutions.

Funds also spoke extensively about the need for enhanced governance and decision making

frameworks to balance the complexity of private markets (and the need for due diligence) with the

pressure to move decisively when opportunities arise.

Perhaps the most interesting, and useful, portion of the interviews was the discussion about lessons

learned. SWFs offered concrete advice on numerous aspects of private markets investing. The most

prominent suggestions were as follows:

o Start slow. “Go into the market step by step. It takes time to build up a good team with the

capability to manage private market investments, especially for direct investing.”

o Do your due diligence. “In the private markets you need to commit to understanding your

manager and the underlying investments that you have. You can’t sell tomorrow, so you must

understand the risks and consequences associated with your investments.”

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o Find creative ways to build and develop your team’s skills, and commitment, especially if

you are in a remote location. “There is an importance of ‘stickiness’ in having a team that is

around for an extended period of time. It has to do with what is required to create an

organization where people stick around.”

o Be sure to learn from your successes and failures. “The most successful investors tend to

have a process for institutionalized learning. They go through a structured process of periodic

self-examination. This isn’t just about looking at their aggregate returns, but looking at why they

chose funds that underperformed and why they passed on funds that ultimately did well.”

The views expressed herein are the views of the individuals and SWFs whom we interviewed and do not

necessarily reflect the views of the IFSWF or of State Street Corporation.

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Table of Contents

Executive Summary .................................................................................................................................................. 1

Contributors .............................................................................................................................................................. 5

About the International Forum of Sovereign Wealth Funds (IFSWF) ................................................................... 5

IFSWF Subcommittee 2 ........................................................................................................................................ 5

Acknowledgements ............................................................................................................................................... 6

Findings .................................................................................................................................................................... 7

1. What prompted members to move into private markets investments? ............................................................. 7

2. What capabilities, governance, and other changes were required? ............................................................... 15

3. What lessons have members learned through this experience? .................................................................... 25

Appendix ................................................................................................................................................................. 29

A. Interview Questions for IFSWF Members ...................................................................................................... 29

B. Transcript from Discussion with Professor Josh Lerner ................................................................................. 31

C. Full Literature Scan ........................................................................................................................................ 39

D. SWF Contributor Profiles ................................................................................................................................ 52

E. Legal Disclaimers ........................................................................................................................................... 62

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Contributors

About the International Forum of Sovereign Wealth Funds (IFSWF)

The International Forum of Sovereign Wealth Funds (IFSWF) is a global network of sovereign wealth funds

(SWFs) established in 2009 to enhance collaboration, promote a deeper understanding of SWF activity, and

raise the industry standard for best practice and governance.

IFSWF Subcommittee 2

Subcommittee 2 (SC2) is an integral part of the IFSWF and has been established to provide a consultative forum

that can effectively address and discuss matters relating to investment and risk for international sovereign wealth

funds. Every year, through the efforts of its members and its research partners, SC2 prepares research papers

on topics of interest to the SWFs. The topics are typically selected a year in advance by the members.

SC2’s scope includes: facilitating co-operation between SWFs in initiating, developing, and monitoring good

practices in investment and risk management; assisting in the development, review and distribution of investment

and risk management practices, procedures and policies; and monitoring developments in the fields of

investment and risk management.

Subcommittee 2 Members:

Italy CDP Equity (Lead)

Alaska (USA) Alaska Permanent Fund Corporation

Alberta (Canada) Alberta Finance

Australia Australian Government Future Fund

Korea Korea Investment Corporation

Kuwait Kuwait Investment Authority

Morocco Ithmar Capital

New Zealand New Zealand Superannuation Fund

Oman State General Reserve Fund

Palestine Palestine Investment Fund

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Acknowledgements

Research for this whitepaper was conducted by a working group within IFSWF Subcommittee 2 including the

Korea Investment Corporation (lead), Alaska Permanent Fund Corporation, State General Reserve Fund of

Oman and State Street, the IFSWF’s official research partner.

This paper was written by William Kinlaw, Senior Vice President of State Street, Kenneth Blay, Vice President of

State Street, Brett Moffat, Senior Manager at the Korea Investment Corporation, and Joohyung Song, Senior

Manager at the Korea Investment Corporation.

We would like to thank the following members for significant contributions to this work:

Abu Dhabi Investment Authority

Australian Government Future Fund

CDP Equity

New Zealand Superannuation Fund

State Oil Fund of Azerbaijan

We are also grateful to Professor Josh Lerner, the Jacob H. Schiff Professor of Investment Banking at the

Harvard Business School, for sharing his insights with us and helping us to distil actionable conclusions from the

academic literature.

Finally, we thank the IFSWF Secretariat for its invaluable support, assistance, and input as we undertook this

study, and Bayasgalan Rentsendorj, Senior Membership Manager at the IFSWF along with Roberto Marsella,

Head of Business Development at Cdp Equity S.p.A., for their tireless efforts in coordinating membership

participation in SC2 studies and work programmes.

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Findings

This section presents our comprehensive findings. Because our research was conducted largely through

conversations with SWFs and an academic expert, we rely heavily on direct quotes from these interactions as

opposed to extensive paraphrasing or quantification. This ensures that the key points are conveyed in the purest

possible form. However, for readability, we have collated the quotes into a narrative that follows the same outline

as our interview questions (which can be found in Appendix A): motivation, capabilities, and lessons learned.

Where clear patterns or themes emerged, we have also attempted to highlight those in the text.

1. What prompted members to move into private markets investments?

This section relates to the funds’ motivations to enter private markets as well as the risks and opportunities they

saw in private markets. The primary motivation cited was that private markets could provide a significant return

premium above that which is offered by public markets, particularly with many stock and bond markets

performing poorly in recent years. SWFs see this premium as being driven by the illiquidity of private markets as

well as a view that private markets are less efficient than public markets, providing a greater opportunity for

return. Some SWFs stated that, due to their long horizon (and in some cases, long-dated or nonexistent

liabilities) they were well suited to bear illiquidity risk. However, even within SWFs where private markets

investments have performed well, debates continue as to whether the premium compensates fully for the

illiquidity and other risks associated with private markets investing.

Other motivations cited for investing in private markets include:

Private markets offer access to specific exposures that cannot be accessed or are difficult to access in

public markets. For example, venture capital provides the opportunity to access new innovations in the

economy in a way that is deeper and richer than what is available in the public market. Moreover, the

public markets offer very limited opportunities for exposure to infrastructure and real estate. Real Estate

Investment Trusts (REITs) for example, are embryonic in Europe and still developing in Asia, said one

fund. Listed real estate and infrastructure companies also have structural issues that prevent them from

providing SWFs with pure exposure to the underlying assets.

Private markets investments are seen to introduce some beneficial diversification when combined with a

traditional public markets portfolio. However, there is a widely held view among SWFs that these

diversification benefits may be overstated (and risk may be understated) given that valuations of private

markets investments are not marked to market.

Investment manager performance is seen to be more persistent in certain private markets areas, such as

private equity, making it easier to select skilled managers.

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Despite these compelling arguments, most SWFs engaged in an extended period of deliberation and analysis

before launching their private markets programs. For the SWFs with whom we spoke, this process lasted for as

little as three months in one case, but was typically on the order of one to three years. Some funds solicited

advice from outside consultants and/or academics to help them evaluate the decision.

In many cases, as Exhibit 1 reveals, SWFs needed to overcome concerns from stakeholders before launching a

private markets investment program. Typically, stakeholders included boards, government bodies or elected

officials. In many cases they were also the subject of media coverage, which several SWFs described as

“mixed.” Specific concerns and questions raised by stakeholders included:

whether the SWF had the resources required to be successful in private markets,

how it would adapt its organizational structure,

how performance would be evaluated and what the benchmark would be,

whether these investments provided adequate compensation for their myriad and complex risks,

the degree of opacity in private markets, and

reputational risk.

To win support, SWFs worked to educate stakeholders on the prospective value of investing in private markets.

In many cases, real estate was seen as easier to explain than private equity and infrastructure. In certain

instances, SWFs needed to win local support from stakeholders in the country where the investment was

domiciled, particularly in the case of major real estate projects.

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Exhibit 1: Did you have to overcome concerns from stakeholders of your organization such as

government and/or media in order to invest in private markets?*

*Source: IFSWF

In the course of deciding whether to enter private markets, SWFs considered and developed plans to measure,

manage and mitigate a wide range of risks, including:

Concern that that investments would be too concentrated in particular sectors or geographies, which

some SWFs addressed by imposing guidelines for minimum and maximum allocations.

Concern about the degree of leverage risk, which some SWFs addressed by imposing explicit

limitations.

The risk of capital loss during specific economic scenarios, which SWFs analyzed by looking at

performance during specific environments such as high inflation or low growth. This risk can be difficult

to measure due to the fact that private markets holdings are not marked to market, and reported

valuations therefore reflect true fluctuations in value with a lag.

There is a widespread view that private markets investments have a greater degree of reputational, tax,

and regulatory risk. These were often evaluated and monitored by dedicated risk management teams.

Currency risk is sometimes a crucial concern, particularly for SWFs that are based in relatively small

countries and therefore invest substantial assets in overseas private markets.

Illiquidity risk, and how it would prevent them from meeting cash needs, maintaining the right portfolio

mix, or taking advantage of tactical opportunities. In the words of one SWF investor, “Investing in private

markets is like flying a plane. You cannot get out mid-flight, so you need to know very well the type of

plane you are boarding.”

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The risk of hiring a bad manager. In private markets, this risk is magnified due to the illiquid nature of

the investments and the difficulty of firing a manager mid-flight. “We run background checks on deals,

organizations and individuals,” said one SWF. Another produces a scorecard to evaluate each

manager’s people, process, and capabilities. This SWF monitors the scorecard over time, assigning

managers a green, orange, or red light. Another approach is to

have opportunities evaluated by two independent teams to provide

diversity of perspective. “Performance of private markets has been

very uneven. Endowments have historically done much better than

pensions and SWFs,” said Lerner. “There are several reasons for

this. First, there is a tendency for investors to jump in at the wrong

times… to invest at market peaks. In all private markets, this is the

worst possible strategy! These markets tend to exhibit a ‘boom-

bust’ dynamic with tremendous variation in performance across

vintage years. Second, in many cases, it also comes down to

manager selection. In all private markets there is huge disparity

between good managers and not-so-good managers. The returns to choosing good managers are really

quite high.”

“Key person” risk and turnover were a major concern, which this study covers in more detail later. In

some cases, this is mitigated by leveraging external providers. In others, SWFs implemented specific

plans to develop and retain key staff.

In addition to these risks, one drawback that was often considered was the relatively high fees that managers

charge in private markets. Many SWFs have begun to mitigate this concern by investing directly into private

investments or by co-investing alongside private equity firms. “This is a topic of enormous interest for LPs around

the world. And it is reasonable to see why,” said Lerner. “If you look at fund structures with ‘two and twenty’ type

compensation schemes, it is extremely generous. In many ways, it’s surprising that fees haven’t adjusted more

over the last several decades. You could even argue that compensation for private equity managers has gone

up, because the amount they manage has gone up so much and there are economies of scale in these funds. If

you have the same fee level, and assets go up, the amount of compensation per partner increases dramatically.

There are a variety of responses we’ve seen from LPs. One is shadow capital: separate accounts where LPs

commit more assets in exchange for more favorable economics. We’re also seeing more variability in funds in

terms of fees that LPs are paying, even versus five years ago. LPs are negotiating side letters, so that the price

that a given investor pays may be very different from the investor alongside of them. We’re also seeing a lot of

interest in direct investing. It is appealing and has potential for large cost savings. But if you look at the research,

it is clear that direct investing is considerably harder than first meets the eye.”

“Investing in private

markets is like flying a

plane. You cannot get out

mid-flight, so you need to

know very well the type of

plane you are boarding.”

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Exhibit 2: What are some of the major risks that your fund saw in private market investments at the time

the decision was made to enter these markets?*

* Chart shows percentage of SWFs that explicitly identified each risk as a major consideration. Source: IFSWF.

After making the decision to invest in private markets, SWFs face the challenge of determining the appropriate

allocation. Funds took a wide variety of approaches, from very quantitative and structured to more subjective. On

the qualitative side, the predominant approach was to begin by defining clearly the objective of the fund. “We

have serious doubts about the ability to determine an ‘optimal’ allocation,” said one SWF investor. “It’s about your

objectives and what you are trying to achieve. If you are a pension fund with 45 years of inflows in front of you,

you don’t have a constraint on private assets except to ensure they deliver what you expect. If you have outflows

in progress, then you have a liquidity constraint, and you have to put a cap on private assets because you can’t

use them to pay the pension every month. Most important is to be clear about the objective of the fund.” For

SWFs that have the dual-objectives of long-horizon capital appreciation and fiscal stabilization, this is a balancing

act. “What we try to reconcile is our ability to withstand a market shock and the liquidity drains that it will impose

on us,” said another SWF. “We analyze that to work out the minimum level of liquidity and the maximum leve l of

illiquidity can be; this is the same question from a different angle. We watch this number on a weekly basis. We

perform that test very frequently.”

To estimate expected returns, SWFs often use a building block approach where they start with the risk-free rate

(which is currently very low in most developed economies) and then add in one or more risk premia. For

example, one SWF models private equity as an equity asset class with an added illiquidity premium. It expects

private equity to generate a two-to-three percent premium over public equity over a seven-to-10 year period with

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an appropriate level of risk. Another approach is to define a fixed hurdle rate of return as well as a benchmark

market index. “For infrastructure, we have a real return objective of 5.5 percent as well as a passive performance

benchmark of infrastructure stocks,” said one fund. “We would ideally like to beat both of these benchmarks. If

you’re going private you need to be earning a return premium relative to passive stock exposure.” A third fund set

a return hurdle that was linked to inflation: the benchmark is the inflation rate in the G7 countries plus a premium

of four percent.

To evaluate performance ex post, SWFs rely on a range of benchmarks. This entails, for example, evaluating

funds against pooled funds from different categories. A SWF’s North American buyout portfolio should be

evaluated against a universe of North American buyout funds. The SWF can also evaluate its entire portfolio

against the private markets portfolio of a universe of endowments or foundations. “It has to be tailored,” said one

SWF. “You can’t compare your venture capital performance to an overall private markets number and reach

meaningful conclusions.” Compared to public markets, where benchmarks are ubiquitous, there are few

benchmarks for private markets investments. Availability also varies across the various private markets: more

benchmarks are available for private equity than infrastructure, for example.

“There are relatively few benchmarks and there are big differences across the benchmarks,” said Lerner. “It is

hard to know why the differences exist and what is behind it. One approach that I recommend to SWFs and other

investors is to carefully evaluate your performance across multiple benchmarks. Instead of using one benchmark,

have a ‘big tent’ approach with multiple indicators of market activity. Drill down against each of these. One may

look better than the other, but looking at multiple benchmarks will give you the best overall sense of how well you

are doing.”

Many SWFs also make an effort to quantify the risk of private markets returns, and use this information to help

set the appropriate allocation. However, measuring the standard deviation of private market returns is a

complicated exercise. “After de-smoothing the returns to adjust for the lags in valuations, and after adjusting for

leverage, you can arrive at a much higher volatility than the smoothed returns would suggest. For U.S. real

estate, these adjustments can push the volatility into double digits,” according to one SWF. “Risk is trickier than

returns,” said another. “This is a challenge.” For private markets, most SWFs agreed that risk management is

largely a qualitative exercise. “We manage it through diversification, transaction structure, and governance, but

quantifying the risk using data analysis doesn’t seem to lead to meaningful conclusions,” said the same fund.

“We’re constantly thinking about risk, trying to manage it downwards using transparency, access, governance

control, and oversight to manage the risks.” Because of the lack of data, risk management can be a more manual

exercise than in public markets. One fund recalled sending an analyst around their offices with a spreadsheet to

capture the sector exposure of each of its private investments.

“Risk assessment in private markets is a topic that is complicated and where there are no easy answers,” said

Lerner. “It is also a very important topic to think about. There is a lot of research on private markets, what risk

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and return characteristics are, how they compare to public markets, and whether or not they outperform. The

thing that makes performance hard to analyze is understanding what the risk is. When you look at private

markets with no risk adjustment, you typically see outperformance. When it comes to risk adjusting, it gets quite

challenging. Specifically, in the context of private equity, funds tend to be conservative in terms of valuations and

mark the investment at cost for extended periods of time after the

deal is done. As a result, when you look at the correlation between

private and public markets, it often appears quite low. But you have to

wonder: is it really that low or does it just reflect the fact that private

equity investments aren’t marked to market? Is the low correlation

just reflecting the lag in valuation? The academic literature typically

makes adjustments to the valuations of returns on a quarterly basis

and tries to more accurately reflect what was going on in the portfolio.

The problem is that the estimates of risk and correlation (with public

markets) are very sensitive based on how you go about this process.

Some papers say the beta of private equity is about one and others

say it is as large as three. You see everything in between. When you

have wildly different estimates of risk, the risk-adjusted returns are

therefore highly variable as well. There is also the complication of

whether you make an adjustment for liquidity. These aren’t easy

investments to buy and sell. The literature shows that if you look

across the NASDAQ, the stocks that trade less frequently offer an

additional return, even if you adjust for their other characteristics. The truth is that we don’t really know yet how to

estimate return and risk for private markets. There is a lot of research on this question but it seems like we are at

the same stage that we were with public markets back in the mid-1960s, when Sharpe, Lintner, and their

colleagues published the CAPM. The notion of beta was out there, but it hadn’t yet been put to work by mutual

funds, hedge funds, and data services. It was an academic idea and the industry hadn’t worked out how to put it

into practice. A lot of tools developed by academics in recent years will be useful in answering this question

about risk and return, but they aren’t in a form yet where they are user-friendly for SWFs and other investors to

put into practice.”

Of course, once the target allocation to private markets is determined, the SWF must then identify opportunities

and begin to deploy capital. “Deploying money in the private markets takes time,” said one SWF. “Each year we

think through deployment pacing, distributions, and capital calls. Mean-variance analysis concludes that you

need much greater exposure to private markets, but in reality we are constrained by the need to not blunder in

blindly. If we decided tomorrow that we wanted to allocate 35% of the portfolio to private equity, which is where

some university endowments are, we couldn’t get there responsibly in two, three, or even five years. The biggest

challenge is deploying capital and keeping pace while the fund is growing.” A few SWFs also talked about the

“The truth is that we don’t

really know yet how to estimate

return and risk for private

markets. There is a lot of

research on this question but it

seems like we are at the same

stage that we were with public

markets back in the mid-1960s,

when Sharpe, Lintner, and their

colleagues published the

CAPM.”

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importance of deploying capital at a balanced pace to ensure the private equity portfolio was appropriately

diversified across vintage years.

While the various private market segments — defined herein to include private equity, real estate, and

infrastructure — share some similarities, they also have key differences. “Our sense is that they share some

characteristics, so in terms of organization, they can be under the same type of leadership,” said one fund. “But

we can identify different drivers for all of them, and they have different expected

return, risk, etc., so you may need to manage them separately.” The duration of the

segments can also differ, with infrastructure investments having a seven to 15 year

cycle and real estate being more like five to 10 years, according to one fund. “We

are puzzled by this move to go into real assets, as the combination of real estate

and infrastructure, in a single asset class. We tend to think that the risks, drivers,

the ways that the markets organize themselves, and the way you access them, are

all quite different. You have to be aware of those differences and nuances. You want to have participants in each

market rather than trying to bring them both into the same asset class.” Another difference between the different

segments is their cash yield and their ability to provide a hedge against inflation risk. Real estate and

infrastructure are seen more as fixed income replacements, with the potential to hedge against inflation risk over

longer periods. Some SWFs have increased their allocation to these segments as fixed income yields have fallen

to low or negative levels in some developed countries like Japan. Private equity is seen more as a return-

enhancing growth driver.

The decision to invest in private markets is perhaps most directly related to the SWF’s investment horizon and

liquidity needs. All else equal, liquidity is more of a concern for investors with shorter horizons and more

imminent cash needs, like stabilization funds. However, that doesn’t mean that SWFs with a purely long-horizon

objective are immune from liquidity risk. “Being long-term doesn’t mean you can buy anything,” said one fund.

“To benefit from being a long-term investor, you have to make sure that your assets will survive an economic

cycle. Investors who held commercial paper during the global financial crisis are still in court discussing the value

they will recover. Real estate firms with too much leverage have disappeared. You have to make sure that your

assets will survive a downturn which will inevitably come at some point.”

Another symptom of illiquidity is that it constrains an SWF’s ability to perform one of the most basic investment

functions: rebalancing its portfolio to its desired asset mix after price fluctuations distorts the allocation. “If you

are 70/30 and you can’t rebalance when 70 gets to 60, it’s harder to benefit from being a long-term investor. This

is not very well perceived by many investors. This is how we measure the cost of illiquidity in private assets. We

all know that rebalancing is a key component of the total return.” One fund defines liquidity categories, ranging

from A to D, and assigns a rating to each investment. Some SWFs that receive their funding from natural

resource exports have seen their liquidity provisions tested over the past year as energy prices have fallen. One

such fund said: “Our public portfolio is managed in a very prudent fashion with sufficient liquidity. We didn’t go

“Being long-term

doesn’t mean you

can buy anything.”

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overboard on direct investment. This has allowed us to manage the current liquidity situation as planned rather

than it becoming a crisis. Everything is going smoothly, there are no fire sales.”

2. What capabilities, governance, and other changes were required?

Each of the SWFs spoke at length about the capabilities and governance structures that they had developed in

order to launch a private markets investment program. One of the major themes that emerged from these

discussions was the importance of people. Each of the SWFs indicated that their commitment to developing a

qualified and talented team was a key ingredient to their success. “Human capability is the most important part of

a successful private markets investment program,” said one fund.

Because many SWFs are based in non-financial centers, attracting and retaining

talent can be very difficult. “Retention is a real challenge for us,” said one SWF.

“This is a unique place. People want to come for a few years, but they don’t want

to stay forever. It is often seen as a unique opportunity for people at a specific

point in their career. Turnover is always tough and expensive, but it is particularly

difficult to manage in private markets because these are long-term investments

with long-term relationships. The cost of turnover is higher in private markets than

in liquid markets.” Another fund said: “Our remoteness makes attracting the right

people quite difficult. Many investment professionals can be reluctant to leave

major financial sectors because it limits their ability to move around. This is

biggest challenge we face.” The SWFs employed a range of practices to hire,

develop, and retain strong teams including:

Developing local staff by cooperating closely with private equity firms, or even seconding employees to

develop expertise. One SWF, which invests directly in real estate but not yet private equity, explained:

“We are trying to learn as much as possible from partners in private markets. We go with funds where

specialized market knowledge is required. In real estate, we invest directly but only with prime

properties. There is no direct investment in private equity yet. We try to get practice that will help us in

the future to pick investments on our own. We cultivate in-house knowledge through cooperation with

our funds. Then we will play on our own. Right now, we’re in the cultivation phase. Our next step will be

to start doing co-investments in developed markets.” Another approach is to ask private equity

managers to allocate some budget for the SWF’s staff to attend training seminars and conferences.

Leveraging external consultants to supplement or complement in-house staff. One SWF explained: “We

have a panel of consultants that we tap for different kinds of expertise. As hard as it is to retain talent

internally, it is easy for us to hire consultants and advisors. This has resulted in a complicated situation

“Human capability is

the most important

part of a successful

private markets

investment

program.”

16


with lots of advisors and consultants. It works, but there are a lot of people at the table. We look for

industry specialists who can act as fiduciaries. We want alignment of interests, but we recognize that a

consultant never has the same commitment as someone who is internal. We wrestle with this balance

every day and all the time. You can outsource analytics. You can also retain consultants with local

expertise; we co-invested with a European company and worked with a firm that has offices in Europe.

But we would never outsource ultimate investment decision making or deal sourcing. These are core

things that need to happen internally. If you can’t make those decisions internally, then just commit to a

big fund, rather than direct investment. On the fund investing side, the same is true: the sourcing

element is important. We wouldn’t want to rely on a consultant to

pick funds – that needs to be done in house. The non-

discretionary consultants get paid the least and discretionary

managers get paid the most, so there is a natural migration of

talent. We want the best input at the lowest cost. We try to

structure compensation so we are aligned.” Other SWFs

leveraged outside consultants for manager due diligence.

Identifying staff with relationships. “When you’re looking for in-

house talent, you want people who have access to relationships

so you get the deal flow,” said an SWF.

Avoiding silos in the organizational structure so that different

types of specialists with different perspectives can offer insights

on each opportunity. It is also important that the team working the

deal from the bottom up can combine its perspectives with the

top-down view.

Building strong middle and back office teams in addition to a

strong front office. “It is not easy to monitor and analyze the total portfolio including traditional and

alternative investments together because their data schemes are different in terms of their timing and

frequency,” said one fund. Another fund had built up an internal legal team to address tax and other

issues associated with their private markets portfolio.

Building teams with a diverse set of skills, including “critical thinking and negotiation skills to deal with

managers, commercial skills to structure a mandate, and relationship management skills to engage with

managers and really understand what they are doing. You can’t just talk to the GP’s investor relations

people, you have to meet with the people who are doing the deals and understand the areas of value

add and also where they see risks. We spend quite a bit of time on this.”

Retaining staff by instilling them with a sense of purpose. “Many of our staff don’t do it for the money.

They could get paid more if they left for an outside company,” said one SWF. “So, are they rich or are

they dumb? Neither! There is a sense of national pride. We are doing something good for the country.

“Turnover is always tough

and expensive, but it is

particularly difficult to

manage in private markets

because these are long-term

investments with long-term

relationships. The cost of

turnover is higher in private

markets than in liquid

markets.”

17


People enjoy the challenge and the visibility. Plus, if they spend a few years here the get to understand

how these markets operate. There is nothing else quite like it in the country. So, we have to be

competitive, but not necessarily in terms of pay.” Professor Lerner had a similar perspective. “It is clearly

not all about the money,” he said. “When you look more generally, the data don’t support the notion that

the endowments that pay the most dollars have the best returns. It does seem to be about giving a

sense of mission, autonomy and importance of what they are doing. In US pension funds, the mentality

all too often is about controlling behavior more than creating an environment where people feel like

they’re doing something very important for the place that they’re representing. The worst case is a

relatively poor compensation scheme and an environment that doesn’t inspire people – then it can be a

real challenge to retain personnel.”

The funds also noted that the type of expertise required differs depending on the fund’s investment strategy. An

increasing number of SWFs are investing directly, or alongside GPs, as well as in traditional funds. Overall,

SWFs expressed strong interest in launching or expanding direct investment programs. They cited a range of

prospective benefits to direct investing or co-investing, including lower costs (no fees), the ability to tailor deal

structures to better align with the funds specific objectives and requirements. “There are two key benefits [to

investing directly],” said Lerner. “One is to save money. Two and twenty is a hefty bite. If you can be a solo

investor without a private equity group or do co-investing with no fees (or with a substantially lower fees than

fund investing), that is one benefit. You also control the timing of investment decisions: when to sell and when

not to. You can hold the investment for 20 years if you want to. You’re not married to a private equity group, with

its own priorities and structure. The appeal is easy to see. The real question is whether performance is good

enough that one ends up ahead of the curve.”

Of course, direct investing requires a much larger in-house capability. “Whether you are investing through funds

or going direct, there is an important difference in terms of the expertise you need. One is in terms of managers

and funds and the other is expertise in actual selection and management of the assets. These are distinct skills.

We do it both ways; we tend to invest directly in real estate and infrastructure but invest in private equity through

funds.” Exhibit 3 shows the percentage of SWFs that invested directly, indirectly, or both ways.

18


Exhibit 3: Do you invest in private markets directly, indirectly through funds, or both?*

*Source: IFSWF

“For indirect investing, in order to be able to select the best GPs for our managed assets, it is essential to have a

deep knowledge of global GPs and the leading managers in each sector,” said another SWF. “For direct

investing, we need expertise in analyzing the sectors and regions with local professionals. Deal sourcing and

execution capabilities are important and operational expertise with sector specialists is important to facilitate a

successful exit.” A number of SWFs identified private equity as the asset class in which it is most difficult for an

SWF to invest directly. “In public markets, if you want to invest in U.S. equities, you don’t need an active team,

you can do it passively,” said one SWF. “In private equity it is much more difficult. It is possible to obtain more or

less the benchmark return in real estate but it is much more difficult to obtain the median return of private equity

funds, let alone top quartile. We haven’t been able to build the resources to invest directly in private equity.”

As for the performance of direct investing versus fund investing, the results are inconclusive. “To study this

question, Lily Fang, Victoria Ivashina, and I looked at seven large institutions across the world: pensions,

endowments, and SWFs who had all been doing private equity for a decade or more,” said Lerner. “They shared

data on their direct deals with us. We put all data in blender, to keep the institutions anonymous, and looked at

the performance of these investments. What we found is that by and large they did reasonably well, but not

better than funds, even after the fee savings were taken into account. If they had invested in the average private

equity fund, their net performance would have been pretty much the same. In terms of our conclusions, there

were a couple of surprises and a couple things that weren’t so surprising. It was less surprising that there was a

big difference between venture capital and private equity. Direct investors did poorly in venture capital. This

space is hard to play in. There are multiple financing rounds, and our institutions were typically investing in later

19


rounds with much higher valuations. It’s hard to pull off. With private equity it is more straightforward: everyone is

investing at the same time. These deals turned out to be more successful. The biggest surprise we found, which

has since been corroborated by others, was that co-investments did quite poorly when compared to solo

investments. When these funds were investing alone, they did better than they did when investing alongside the

private equity groups. We thought it would go the other way. The institutions in our sample tended to co-invest in

large deals done at peaks in the market – venture capital in 1999 and buyout in 2007, for example. Few of these

turned out to be successful. Interestingly, when it came to solo deals, the ones most successful were, for

example, a Canadian fund investing in a Canadian deal, not necessarily a Canadian fund investing in Chinese

deal. They did well investing in their back yard. Of course, if you don’t have a large backyard, and you want to do

a lot of direct investing, the strategy is difficult to scale. There is a challenge as to how much can you expand and

have the same success.”

Another major theme was the additional layer of governance complexity that is required within an SWF to invest

in private markets. “One big difference from public markets is that in public markets, the investor isn’t managing

the assets,” said one SWF. “In private markets, you’re not only investing in the asset. You are often structuring it,

financing it, leveraging it, and in some cases actually managing it.” The funds employ a variety of different

decision governance frameworks, and in many cases, these had evolved significantly over time to empower staff

with greater decision rights. For one fund, the CEO has approval to authorize investments if the amount is less

than $500 million, whereas larger investments require board approval. Oftentimes, an investment committee

comprised of senior staff must approve investment decisions over a certain threshold, while deals that exceed a

larger threshold must go to the board. “Every deal from every team gets put before a forum that includes all asset

classes and our strategy group. We debate the merits of every opportunity relative to other things we can do,”

explained one fund. In many cases, empowering the investment committee to approve large private deals

required expanding its membership. “Our internal governance structure is crucial,” said another. “We had an

investment committee throughout but when we entered private markets, we needed to expand that investment

committee with members who have suitable experience to look at transactions and make decisions.”

Another fund employs a “buddy system” where the investment team works closely with the investment analysis

team to evaluate opportunities. “You need strong subject matter expertise as well as analytical skills to evaluate

risks associated with an investment. You need to be able to articulate why we should add a risk to the portfolio

and present this argument to the investment committee” it said.

The SWFs underscored the difficulty of striking the right balance between speed and rigor. One the one hand, it

is important to take a rigorous, analytical, and comprehensive review of investment opportunities. On the other

hand, if the process is too slow, the SWF will miss out on opportunities. “The governance needs to be quick but

also analytical enough to respond to the needs,” said one fund. Another said: “The speed of decision making is a

key factor for a successful private markets program. We introduced a separate process for direct investing and to

20


shorten the process for GP co-investment or re-up opportunities.” Exhibit 4 shows that half of the funds we

interviewed had faced, and had to overcome, challenges due to the speed of their decision making process.

Exhibit 4: Have you needed to overcome challenges due to the speed of your decision making process?*

*Source: IFSWF

A few SWFs felt that time pressures associated with private investment opportunities were often exaggerated.

“We’re always told that we have two days to get rich. But it is never true. We usually evaluate deals for a couple

of months. Sometimes on the last point in a negotiation, you have to decide quite fast. If someone is asking for

sizeable sum in a complex transaction, and giving two days, that is not the normal approach. We always have

time to follow our own governance.” Another said “If we don’t have time to do our due diligence, we do not invest

no matter how promising it sounds. We analyze everything in detail and come to the investment committee with a

recommendation to invest or not.” Other funds were comfortable moving quickly for the right opportunity. “Our

approval process was so long that we missed out on opportunities or got in too late. We’ve worked on improving

our efficiency. We’re constantly looking to make quicker decisions where we have confidence. The stronger our

confidence, the happier we are to move quickly.” For the most part, SWFs stated that decisions to invest in funds

could be made much more quickly than direct investment decisions.

Interestingly, despite widespread discussion in the global investment industry on the notion of sustainable

investing — often referred to as Environmental, Social, and Governance (ESG) considerations — few SWFs

imposed explicit sustainability objectives or constraints. However, these considerations often arose as a

byproduct of other considerations, including the SWFs’ natural interactions with recipient countries, management

21


of reputational risk, or impact on investment performance. One SWF explained: “We have always conveyed to

recipient countries what we are doing and shared our views. We visited all of our major recipient countries during

the global financial crisis of 2008 and 2009 to tell our story: who we are, what are our objectives, how we invest,

and how we make decisions. We don’t publish a number, but we are very clear if the government of a country

wants to know how much we have invested there.” On the topic of specific social or environmental objectives, the

fund expressed some practical concerns. “This is a complex issue. If tobacco is bad, which it is, then

governments should ban it. It’s not a good approach to remove it from investment portfolios. In fact, tobacco is

the best performing sector in the market. We are concerned, but we have difficulties in seeing how we can

incorporate these objectives into our guidelines in a way that is not ‘soft.’ We do incorporate clearly our

reputational risk, and we refuse certain investments for this reason. But environmental and social issues are

difficult to incorporate into our guidelines because they are very difficult to assess. Is a wind farm really

consuming less carbon if you include what has been used for constructing the wind farm, transporting it for

hundreds of miles, using steel and massive quantity of energy?” SWFs did stress the importance of performing

due diligence on managers and ensuring they were working with ethical and responsible partners. Some SWFs

consider sustainability purely through the lens of investment returns. “We are about return. To the extent that,

over the long term, there are environmental issues or sustainability issues that will impact those returns, we have

to make sure that is factored in. We don’t require that a certain minimum amount be invested in environmental

buildings. But if a building doesn’t have the right credentials, is that priced in? We think about that carefully.” A

number of SWFs said that they consider sustainability issues insofar as they could represent reputational risks

for sponsoring governments.

22


Exhibit 5: Does your fund have specific objectives around the sustainability of its private market

investments and/or strategies to ensure a welcome reception from recipient countries?*

*Source: IFSWF

Most SWFs had expanded their risk management capabilities to support their private markets investment

activities. The main points from our risk management discussions are as follows:

Most SWFs have centralized risk management functions. Oftentimes, this team was not solely

responsible for risk management and worked in cooperation with investment teams who also

incorporated risk considerations into their decisions. In some cases, the investment teams were seen as

the first line of defense in managing risk, with the central risk function as the second line. In some SWFs,

the investment and risk (and compliance) teams must make joint presentations to the investment

committee regarding new opportunities.

In many cases, a stated purpose of the central risk function was to draw connections across teams and

asset classes. “The central function is looking more across the whole portfolio for hot spots,

concentration, and correlation,” said one fund. “Each investment group also has its own internal risk

team to assess risk. The Chief Risk Officer sits with the risk team from each investment department,

public and private, to make sure that there is good communication across teams and with the central risk

function. The central function also has people dedicated to each group who spend part of their time

sitting within that group.”

Whereas risk management in public markets is mostly driven by fluctuations in price, risk management in

private markets is more complex and requires multidisciplinary input. “With direct investments, if we buy

23


a sea port, the legal and risk factors will be far beyond what specialized investment professionals can

identify. There are so many risks!”

Perhaps the most common shared attribute among the eight SWFs with whom we spoke was a commitment to

cooperation with other SWFs. As shown in Exhibit 6, every one of the eight funds stated that it had cooperated to

some degree with other SWFs or institutional investors in private markets.2

Exhibit 6: Have you cooperated with other large institutional investors in private markets?*

*Source: IFSWF

This inter-SWF cooperation took on a wide variety of forms. At a basic level, SWFs see cooperation as a way to

improve performance and manage risk. “By collaborating with like-minded institutional investors – pooling

resources, sharing expertise and transaction expenses, and exploiting local networks – we can potentially

mitigate risks and improve returns,” said one SWF. “In these situations, if there is one group where the deal is in

their backyard with an information advantage and an ability to provide value-added services, and the other

institutions aren’t local, the insiders can increase the probability that the deal with be successful,” exp lained

Lerner. “There have been a variety of efforts trying to encourage communication between SWFs and other large

institutional investors. There have been a few deals done together. One challenge is that these institutions often

2 It is possible that this unanimous result is subject to selection bias insofar as SWFs that are interested in cooperation were more likely to

agree to speak with us for this project.

24


find it hard to move quickly. Private equity fund managers, on the other hand, can move fast. Sometimes with

multiple SWFs, considering a deal at the same time, it can be a very drawn-out process.”

In some cases, cooperation meant investing alongside one another in deals. “We are never alone,” said one

fund. “We don’t want to be alone. We are much more comfortable taking 20 percent of a transaction than taking

more of it. In most cases we find ourselves in a consortium where you have other SWFs like us. We work

together. We know each other. We have regular contact.”

In other cases, it meant simply “picking up the phone” occasionally to compare notes. “We like to know what

peers are invested in a certain fund. If we see something that concerns us and want more information, it’s great

to have other investors you can call up to share views and compare ideas. There is lots of value in that in terms

of understanding the risks,” said one fund. Comparing notes can also help

SWFs improve internal best practices or validate their approach for

stakeholders.

SWFs stressed the importance of alignment of goals when partnering with

one another. “At the end of the day, we each have our own objectives and

they are not the same. Some SWFs will have cash outflows to manage so

their appetite for risk will not be the same. What you look at for in a

particular investment may be different. Your counterpart may see it more as

an equity investment, and might be willing to bid more. We have partners

with whom we are comfortable working but also comfortable being

competitors at certain times.” Another said: “We have learned that although

we may share a long-term horizon with our partner, our investment strategy

or capability may differ widely. Finding a truly aligned partner can be difficult.”

Some SWFs were deliberate and strategic in their management of partnerships. “To achieve successful

outcomes, you have to understand the motivations of your partner. You have to be a good partner,” said one

such fund. “We are very careful about making sure that we remain one. It is important to take the views of other

partners and deal with them up front and define a clear objective as to what everyone is trying to achieve. Once

we are invested in an illiquid asset we work hard to make sure we are a good partner, which means not pushing

our needs to the detriment of our partner’s. If our partner has an issue or needs to think about something, or has

to execute, we will do our best to facilitate that to the extent that we can. It is important for both partners to

communicate their positions in a timely way and, to the extent that we sense that interests are diverging, we will

try to make sure that that doesn’t persist for the long term.” For example, the fund explained that if its partner

wanted to exit an investment, and this did not run counter to its own best interests, that it would consider doing

so if market conditions allowed.

“We have learned that

although we may share a

long-term horizon with our

partner, our investment

strategy or capability may

differ widely. Finding a

truly aligned partner can

be difficult.”

25


To make partnerships successful, SWFs stressed the importance of understanding fully the partner’s objectives

(for example, whether purely financial or development focused), and communicating at the outset of an

investment the timeframe, division of duties/costs, and division of fees.

3. What lessons have members learned through this experience?

This segment typically comprised only the last five to 10 minutes of the discussions. We asked each SWF what

advice it would provide, in very practical terms, to another SWF that was just launching its private markets

investment program or considering doing so. We summarize below the responses to these questions, which we

have consolidated and paraphrased for concision and clarity.

Establish your strategy based on the expertise that you are confident that you can build in house.

“Determine what expertise you require and build a team. If a fund wants to go into private assets with

one or two full-time employees to follow private equity, hedge funds, and real estate, the program is

unlikely to deliver, no matter how good that person is. Establish resourcing and internal infrastructure

before you even think about investing!”

Start slow. “Go into the market step by step. It takes time to build up a good team with the capability to

manage private market investments, especially for direct investing. For us, it made sense to invest in

fund of funds for the first few years. You pay high fees which is not attractive, and returns aren’t great,

but it gives you access to the market. You’re in it and you’re starting to learn. Then you can understand

how those markets behave and inform how your fund is going to build the program. You have to go in

with that mindset and be willing to stick it out through long periods and be consistent in your deployment.

You can’t slam on the brakes in bad times and then accelerate in good times.” Said Professor Lerner:

“When we look at the performance of limited partner investors, we see a strong temporal trend. The

longer you’ve had a private equity program, the better your returns. Private markets are not an area

where you can just go from 0 to 60 miles per hour overnight. You have to look at it as a longer run kind of

process.”

Private markets are local markets. “Local knowledge is essential, so have a presence on the ground.

Be close to deal creation, identification, and sourcing. Where it makes sense, consider joint ventures to

tap the local presence of other investors. If you bring a generalized view that is not consistent with a

particular market, you will not succeed. You have to be flexible about how you actually integrate your

program and ensure it reflects differences in different markets. The US, European and Asian markets are

quite different. Flexibility is essential.”

Do your due diligence. “In the private markets you need to commit to understanding your manager and

the underlying investments that you have. You can’t sell tomorrow, so you must understand the risks and

consequences associated with your investments. Spend a lot of time on due diligence. Do it up front, and

26


then stay glued to the company you’re invested in. This is the best risk control there is in private markets!

You need good relationships with management and other investors. We have an entire team who just

follow the existing investments. With public market investments, you often don't want to appear too close

to management. In private markets, it's the opposite.” Professor Lerner expanded on this concept. “You

really need to build relationships and understand the lay of the land,” he said. “Too often we see

investors taking shortcuts, investing with fund-of-funds or investing in the biggest name-brand funds.

These aren’t necessarily bad decisions, but there is no real substitute for building a variety of

relationships, digging in to understand different market segments, and developing that experience. This

process isn’t easy, but it rewards those who spend time developing relationships, visiting groups, and

understanding them.”

Avoid working in silos and establish a strong governance and decision-making framework. “The

more diversity in information sources that lead to decision, the better it is! For example, you need a

framework to compare private markets opportunities with public market opportunities. Sometimes the

public markets are a better way to access particular risk premium. You have to understand relative

prices, risk-adjusted pricing, across the largest opportunity set you can. It’s very hard to do.” Added

Professor Lerner: “Governance is important. When you interview private markets investors and talk to

CIOs about what made them successful, certainly governance is one of the points they emphasize. The

successful investment committees seem to be willing to largely delegate decisions about which funds to

select to the staff. What they are doing is providing broader insights into market trends and strategic

input, without micromanaging the staff about individual investment decisions. On the other hand, when

you look at some of the pensions for public employees, where you have non-investment professionals

involved in making detailed decisions, it is not a formula that leads to great results. The best approach is

to hire qualified people and give them the leeway to make investment decisions.”

When it comes to picking a manager, emphasize quality over quantity. “By allocating more capital

to fewer managers, you will realize more efficiency in monitoring your investments. By awarding larger

mandates, you also gain leverage in negotiations with managers. Negotiate lower fees, deeper access,

and the option to commit more capital (or dial down commitments) in the future. There are also some

patterns in the performance data that can aid in manager selection,” said one fund. “If you look across

private equity funds, the very smallest funds do poorly,” said Lerner. “But once you get above a threshold

there is relatively little difference in performance due to the size of the funds. That said, when you look at

the largest deals being done by a particular fund, whether the fund is big or small, they tend to do worse

than a fund’s typical-sized deal. When a fund does a very large transaction, for example a middle market

group reaching into low-mega space, things don’t turn out very well. Why is this? With larger deals, it

may be that you have a situation where the deal takes on momentum of its own and becomes a runaway

train, and is harder to stop. With a smaller deal, when questions are raised, it might be easier for people

to halt the deal. There is also the fact that most large deals tend to be done around market peaks and we

27


know that market peaks tend to be the worst time to invest.” He added: “Rapid growth seems to be

associated with a deterioration of performance. Private equity firms that increase fund size very rapidly

seem to suffer in terms of their returns going forward. The thinking is that partners end up trying to do too

much and that ends up cutting into their performance. Finally, there is lots of evidence to suggest that

specialization is a good thing in private markets. If you look at health care, technology, or financial

services sectors, the funds that are specialists tend to do better than the funds that are generalists.

There seems to be a considerable benefit to really knowing the area in which you are investing. Those

are three types of characteristics of successful funds.”

Cultivate a long-term investment horizon. “We have interviewed some of the most successful long-run

investors and asked them what made them so successful in terms of investing in private markets,” said

Lerner. “One thing that is important is to cultivate a long-term time frame. This can be done, for example,

in the way that information is measured and reported as well as in the financial incentives that are

offered to staff. Most successful private markets investors have had continuity of staff; in many cases

you see a successful team that has stuck together for multiple years. This helps a lot in terms of making

subjective investment decisions, as well as being effective in getting access to the most desirable funds.”

Find creative ways to build and develop your team’s skills, and commitment, especially if you are

in a remote location. “It is a challenge,” said Lerner. “One approach we often see at SWFs is building

groups composed of ex pats who come in for a couple of years and then leave. Even if they’re terrific

people, this strategy doesn’t engender the continuity that these funds need. One thing that is important

for SWFs, and this is true regardless of location, is the need to build up internal capability. You want to

find young people who are willing to stay and invest time, rather than someone who will parachute in for

a couple of years before retiring.” One fund suggested “seconding” employees to private institutions to

build their skillsets. “This has proven effective in developing the in-house expertise that we need.” Lerner

explained that there is an “importance of ‘stickiness’ in having a team that is around for an extended

period of time. This raises a couple of issues which are clearly difficult for all institutional investors

whether they are SWFs, endowments, or pension funds. It has to do with what is required to create an

organization where people remain. It is partly to do with compensation. In the US pension system, for

example, professionals are investing billions of dollars but often being paid only 50,000 or 60,000 USD

per year. Eventually, they often get impatient and leave. But it also has to do with imbuing the

organization with a sense of mission. The mission shouldn’t be just about making money – it should be

about trying to address broader goals. Having that successful feeling of mission seems to be a very

important ingredient for success.”

Be sure to learn from your successes and failures. “The most successful investors also tend to have

a process for institutionalized learning,” said Lerner. “They go through a structured process of periodic

self-examination. This isn’t just about looking at their aggregate returns, but looking at why they chose

funds that underperformed and why they passed on funds that ultimately did well. They try to identify the

28


features of successful teams and figure out how to incorporate those learnings into subsequent

investment decisions.” He added: “This is done in a variety of ways. There isn’t one magic formula. You

see some groups implementing a process where they sit down every year and evaluate the performance

of a given asset class. They may rotate through private markets, from one to the other. This could be just

the staff or also include members of the investment committee as well. In some cases, that group goes

back to the original investment memoranda and asks themselves some questions. What did we get

right? What did we get wrong? This isn’t done in the spirit of apportioning blame. It is more about how

they can learn from their experiences. One of the things that everyone would agree is that investing in

private markets is not a purely analytical process. Aspects of it are highly subjective. To succeed, you

need to incorporate hard information, but there is also a lot of soft information that needs to be

processed and examined. Hopefully that gives you a few clues.”

29


Appendix

This Appendix includes the interview questions we asked the member organizations with whom we spoke, a full

listing of academic papers from our literature review, and brief profiles for each of the organizations we

interviewed.

A. Interview Questions for IFSWF Members

To guide our discussions with each of the eight SWFs that we interviewed, the working group prepared a list of

interview questions. The interview questions are presented below for reference.

Section I: Descriptive information

What are your total assets under management?

In which private market segments does your fund have the ability to invest?

o Private equity?

o Real estate?

o Infrastructure?

For how long has your fund been invested in each segment?

What is your fund’s overall allocation (%) to private market investments? Do you plan to increase or

decrease your allocation in the future?

What is your current overall allocation (%) to each market and are you under or overweight relative to

your policy target, if applicable?

Do you invest in these markets directly, indirectly though funds, or both? If both, do you differentiate

between direct and indirect in regards to investment sub-strategy (i.e. direct core RE and indirect

opportunistic RE)? If indirectly, are the funds single strategy, multi-objective funds or both?

How many investment professionals do you have in your organization? Is there a clear division between

public markets vs private markets personnel? And if so, how many investment professionals work in

private market investments? Do you also divide teams/personnel by direct vs indirect investment?

Section II: What prompted the decision to enter private markets?

What was the motivation for your fund to invest in private markets as opposed to (or in addition to) public

markets?

For how long did you evaluate private market investment before starting to invest?

Did you have to overcome concerns from stakeholders of your organization such as government, and/or

media? And if so, how?

30


What are some of the major opportunities and risks that your fund saw in private market investments at

the time the decision was made? Does the institution still hold those views?

How did your fund determine the appropriate overall allocation to private market investments? Are there

any upper bound constraints imposed on individual or total private market investments?

How do you evaluate the risks and benefits that each private market segment (private equity, real estate,

infrastructure) brings to your portfolio? What is the role of each segment in your portfolio (i.e. real return,

growth driver etc.)? How do you define success?

How does the decision to invest in private markets relate to the fund’s investment horizon and liquidity

needs?

Section III: What capabilities, governance, and other changes were required?

What capabilities and governance structures are required to invest in private market?

Of these, which did your fund build in-house and which does it source externally? How was the “build vs.

buy” decision made and what were the advantages and disadvantages associated with each approach?

To the extent that your fund has built capabilities and/or structures internally, what have been the

challenges? What capabilities have been built?

Does your fund have specific objectives around the sustainability of its private market investments and/or

strategies to ensure a welcome reception from recipient countries?

What differences have you discovered within private markets, i.e. between RE, PE and Infrastructure?

Please elaborate.

Did investing in private markets result in a significant increase to the headcount? And if so, what was the

approximate split between front and back office?

Have you found it difficult to attract and/or retain qualified professionals? Did you need to adjust your

compensation level and human resources policies? Is the compensation private sector equivalent? And

if not, what other benefits do you provide to your employees?

Do you have separate risk management team dedicated to private market investment risk?

Have you cooperated with other large institutional investors in private markets? If yes, why and what

have you learned from that experience?

Are economies of scale are important in private market investment? And if so, what is the AUM

threshold (total and/or by segment) to benefit from economies of scale?

How do you structure your decision making process for fund and direct investing respectively? Have you

needed to overcome challenges due to the speed of your decision making process?

Section IV: What lessons have members learned through this experience?

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What are the most important lessons that your fund has learned regarding investment in private

markets? What has worked best and what is the biggest area for improvement?

What advice would you give to other members who are considering investing in private markets or who

are considering changes to their private markets investment function?

B. Transcript from Discussion with Professor Josh Lerner

Below, we present a summary of this discussion, which followed a question-and-answer style. Both the questions

and answers have been edited for clarity.

Q: It is a well-documented trend that SWFs and other institutional investors are increasing their investments in

private markets, particularly private equity. What is driving this trend and what risks do you see for these

investors?

JL: It is natural for these institutions to want to go into private markets, which have historically offered attractive

returns, to build their savings, especially in light of the lower returns in many stock and bond markets in recent

years. But experiences have differed across funds. Performance of private markets has been very uneven.

Endowments have historically done much better than pensions and SWFs. There are several reasons for this.

First, there is a tendency for investors to jump in at the wrong times, to invest at market peaks. In all private

markets, this is the worst possible strategy! These markets tend to exhibit a ‘boom-bust’ dynamic with

tremendous variation in performance across vintage years. Second, in many cases, it also comes down to

manager selection. In all private markets there is huge disparity between good managers and not-so-good

managers. The returns to choosing good managers are really quite high.

Q: Are there any common factors you have observed among the most successful private markets investors?

JL: We have interviewed some of the most successful long-run investors and asked them what made them so

successful in terms of investing in private markets. One thing that is important is to cultivate a long-term time

frame. This can be done, for example, in the way that information is measured and reported as well as in the

financial incentives that are offered to staff. Most successful private markets investors have had continuity of

staff; in many cases you see a successful team that has stuck together for multiple years. This helps a lot in

terms of making subjective investment decisions, as well as being effective in getting access to the most

desirable funds. The most successful investors also tend to have a process for institutionalized learning. They go

through a structured process of periodic self-examination. This isn’t just about looking at their aggregate returns,

but looking at why they chose funds that underperformed and why they passed on funds that ultimately did well.

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They try to identify the features of successful teams and figure out how to incorporate those learnings into

subsequent investment decisions.

Q: What are the best practices for building a private markets investment capability at an SWF? What are

minimum resources required and how does one identify an attractive investment manager or opportunity?

JL: First of all, don’t try to do it overnight! When we look at the performance of limited partner investors, we see a

strong temporal trend. The longer you’ve had a private equity program, the better your returns. Private markets

are not an area where you can just go from zero to 60 miles per hour overnight. You have to look at it as a longer

run kind of process. Second, you really need to build relationships and understand the lay of the land. Too often

we see investors taking shortcuts, investing with fund-of-funds or investing in the biggest name-brand funds.

These aren’t necessarily bad decisions, but there is no real substitute for building a variety of relationships,

digging in to understand different market segments, and developing that experience. This process isn’t easy, but

it rewards those who spend time developing relationships, visiting groups, and understanding them. The final

thing has to do with the importance of ‘stickiness’ in having a team that is around for an extended period of time.

This raises a couple of issues which are clearly difficult for all institutional investors whether they are SWFs,

endowments, or pension funds. It has to do with what is required to create an organization where people remain.

It is partly to do with compensation. In the US pension system, for example, professionals are investing billions of

dollars but often being paid only 50,000 or 60,000 USD per year. Eventually, they often get impatient and leave.

But it also has to do with imbuing the organization with a sense of mission. The mission shouldn’t be just about

making money – it should be about trying to address broader goals. Having that successful feeling of mission

seems to be a very important ingredient for success.

Q: One of the challenges that SWFs frequently cite in building strong teams is location. They’re often not based

in financial centers. Is that an important factor?

JL: It is a challenge. One approach we often see at SWFs is building groups composed of ex pats who come in

for a couple of years and then leave. Even if they’re terrific people, this strategy doesn’t engender the continuity

that these funds need. One thing that is important for SWFs, and this is true regardless of location, is the need to

build up internal capability. You want to find young people who are willing to stay and invest time, rather than

someone who will parachute in for a couple of years before retiring.

Q: With respect to the importance of continuity of the staff, for many SWFs, compensation is a challenge. Media

scrutiny and government constraints make it very difficult to be competitive. We need another incentive to attract

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people or sometimes we need to outsource. In light of these constraints for internal staff, sometimes it is easier to

incentivize asset managers or outside companies. In a public entity, is the best strategy to raise internal comp or

pursue other opportunities externally? Which is most efficient? How should we strike the right balance?

JL: It is certainly an issue that many institutions have faced. Consider the comparison between Harvard’s

endowment and Yale’s. Harvard had more in-house capabilities and paid higher salaries. As a result, it has been

criticized for it by alumni and some others. But when you look at how much they are paying, even paying

someone within an endowment several million a year to manage money is cheaper than paying an external

manager to run the same fund. Fees to managers are invisible in a sense, because returns are reported on a net

basis. Compensating staff appropriately is worthwhile. I realize it is politically difficult. We were just talking to a

large pension fund. The people in charge of the private equity group, which has several billion in investments,

indicated that their total annual travel budget for the group was $20,000 per year. This just seems crazy to me. If

they spent $1 million on travel and got their performance up by 1 basis point it would be worth it many times over.

But it was a political decision that the governor’s office made. They didn’t want employees going on “junkets” so

they set a low travel budget. This highlights some of the challenges in this area.

Q: I fully understand and agree with your arguments. But in an environment with media scrutiny, extensive

disclosures, etc., people are reluctant to join a public organization. Within that environment, in practice, I’m not

sure compensation is the best approach. Are there more innovative ways to get access to that kind of talent?

JL: It is clearly not all about the money. When you look more generally, the data don’t support the notion that the

endowments that pay the most dollars have the best returns. It does seem to be about giving a sense of mission,

autonomy and importance of what they are doing. In US pension funds, the mentality all too often is about

controlling behavior more than creating an environment where people feel like they’re doing something very

important for the place that they’re representing. The worst case is a relatively poor compensation scheme and

an environment that doesn’t inspire people – then it can be a real challenge to retain personnel.

Q: The long-term nature of private markets investments means they require more comprehensive governance.

How do SWFs deal with that and what are issues that need to be addressed?

JL: Governance is important. When you interview private markets investors and talk to CIOs about what made

them successful, certainly governance is one of the points they emphasize. The successful investment

committees seem to be willing to largely delegate decisions about which funds to select to the staff. What they

are doing is providing broader insights into market trends and strategic input, without micromanaging the staff

about individual investment decisions. On the other hand, when you look at some of the pensions for public

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employees, where you have non-investment professionals involved in making detailed decisions, it is not a

formula that leads to great results. The best approach is to hire qualified people and give them the leeway to

make investment decisions.

Q: Another hot topic is fees and the high costs of retaining private equity managers.

JL: This is a topic of enormous interest for LPs around the world. And it is reasonable to see why. If you look at

fund structures with ‘two and twenty’ type compensation schemes, it is extremely generous. In many ways, it’s

surprising that fees haven’t adjusted more over the last several decades. You could even argue that

compensation for private equity managers has gone up, because the amount they manage has gone up so much

and there are economies of scale in these funds. If you have the same fee level, and assets go up, the amount of

compensation per partner increases dramatically. There are a variety of responses we’ve seen from LPs. One is

shadow capital; separate accounts where LPs commit more assets in exchange for more favorable economics.

We’re also seeing more variability in funds in terms of fees that LPs are paying, even versus five years ago. LPs

are negotiating side letters, so that the price that a given investor pays may be very different from the investor

alongside of them. We’re also seeing a lot of interest in direct investing. It is appealing and has potential for large

cost savings. But if you look at the research, it is clear that direct investing considerably harder than first meets

the eye.

Q: That’s a great segue to the topic of direct versus indirect investing. What are the key considerations an SWF

should take into account when thinking about launching a direct investment program? What are the benefits of

direct investing?

JL: There are two key benefits. One is to save money. Two and twenty is a hefty bite. If you can be a solo

investor without a private equity group or do co-investing with no fees (or with a substantially lower fees than

fund investing), that is one benefit. You also control the timing of investment decisions: when to sell and when

not to. You can hold the investment for 20 years if you want to. You’re not married to a private equity group, with

its own priorities and structure. The appeal is easy to see. The real question is whether performance is good

enough that one ends up ahead of the curve.

Q: Considering challenges of attracting staff, which we’ve already discussed at length, can SWFs expect to make

investments of high enough quality to keep pace with fund investments?

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JL: To study this question, Lily Fang, Victoria Ivashina, and I looked at seven large institutions across the world:

pensions, endowments, and SWFs who had all been doing private equity for a decade or more. They shared

data on their direct deals with us. We put all data in blender, to keep the institutions anonymous, and looked at

what the performance looked like for these investments. What we found is that by and large they did reasonably

well, but not better than funds, even after the fee savings were taken into account. If they had invested in the

average private equity fund, their net performance would have been pretty much the same. In terms of our

conclusions, there were a couple of surprises and a couple things that weren’t so surprising. It was less

surprising that there was a big difference between venture capital and private equity. Direct investors did poorly

in venture capital. This space is hard to play in. There are multiple financing rounds, and our institutions were

typically investing in later rounds with much higher valuations. It’s hard to pull off. With private equity it is more

straightforward: everyone is investing at the same time. These deals turned out to be more successful. The

biggest surprise we found, which has since been corroborated by others, was that co-investments did quite

poorly when compared to solo investments. When these funds were investing alone, they did better than they did

when investing alongside the private equity groups. We thought it would go the other way. The institutions in our

sample tended to co-invest in large deals done at peaks in the market – venture capital in 1999 and buyout in

2007, for example. Few of these turned out to be successful. Interestingly, when it came to solo deals, the ones

most successful were, for example, a Canadian fund investing in a Canadian deal, not necessarily a Canadian

fund investing in Chinese deal. They did well investing in their back yard. Of course, if you don’t have a large

backyard, and you want to do a lot of direct investing, the strategy is difficult to scale. There is a challenge as to

how much can you expand and have the same success.

Q: This notion that local knowledge is important came up in many of our discussions with other SWFs. But, as

you point out, some SWFs live in local markets that are very shallow in terms of their private equity opportunities.

So they have to go abroad if they want to invest in this market. How can they overcome this challenge?

JL: One area with increased interest is club deals, not between multiple private equity groups but between

multiple SWFs. In these situations, if there is one group where the deal is in their backyard with an information

advantage and an ability to provide value-added services, and the other institutions aren’t local, the insiders can

increase the probability that the deal with be successful. There have been a variety of efforts trying to encourage

communication between SWFs and other large institutional investors. There have been a few deals done

together. One challenge is that these institutions often find it hard to move quickly. Private equity fund managers,

on the other hand, can move fast. Sometimes with multiple SWFs, considering a deal at the same time, it can be

a very drawn-out process.

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Q: Is there a particular asset level or threshold that makes direct investing preferable to indirect investing?

JL: I don’t think there is a magic number. There is a number below which it doesn’t make sense to direct invest.

If it’s less than a couple of billion dollars, it is hard to make a persuasive case that direct investing makes a lot of

sense. There could be exceptions, for example, a family office investing in an industry where the founders have

private knowledge. But for most small organizations, it doesn’t make sense. Beyond that, it is hard to say. It has

less to do with asset levels and more to do with the things we talked about early on: the skill set of the investment

staff and how experienced are they in this area. It’s also to do with having a governance process that supports

this kind of activity. It’s less a matter of dollars and cents and more about the decision making process within the

organization.

Q: When it comes to selecting private equity managers, we’ve heard two arguments. One is that there are

benefits to making large investments. The other is that you want to stay small. What does the research say on

this question?

JL: If you look across private equity funds, the very smallest funds do poorly. But once you get above a threshold

there is relatively little difference in performance due to the size of the funds. That said, when you look at the

largest deals being done by a particular fund, whether the fund is big or small, they tend to do worse than a

fund’s typical-sized deal. When a fund does a very large transaction, for example a middle market group

reaching into low-mega space, things don’t turn out very well. Why is this? With larger deals, it may be that you

have a situation where the deal takes on momentum of its own and becomes a runaway train, and is harder to

stop. With a smaller deal, when questions are raised, it might be easier for people to halt the deal. There is also

the fact that most large deals tend to be done around market peaks and we know that market peaks tend to be

the worst time to invest.

Q: We’d also like to talk about private markets investments in a total portfolio context, alongside public markets

investments. Given the limited track record for private markets, how should SWFs approach the process of

establishing return and risk expectations?

JL: This is a topic that is complicated and where there are no easy answers. It is also a very important topic to

think about. There is a lot of research on private markets, what risk and return characteristics are, how they

compare to public markets, and whether or not they outperform. The thing that makes performance hard to

analyze is understanding what the risk is. When you look at private markets with no risk adjustment, you typically

see outperformance. When it comes to risk adjusting, it gets quite challenging. Specifically, in the context of

private equity, funds tend to be conservative in terms of valuations and mark the investment at cost for extended

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periods of time after the deal is done. As a result, when you look at the correlation between private and public

markets, it often appears quite low. But you have to wonder: is it really that low or does it just reflect the fact that

private equity investments aren’t marked to market? Is the low correlation just reflecting the lag in valuation? The

academic literature typically makes adjustments to the valuations of returns on a quarterly basis and tries to more

accurately reflect what was going on in the portfolio. The problem is that the estimates of risk and correlation

(with public markets) are very sensitive based on how you go about this process. Some papers say beta of

private equity is about one and others say it is as large as three. You see everything in between. When you have

wildly different estimates of risk, the risk-adjusted returns are therefore highly variable as well. There is also the

complication of whether you make an adjustment for liquidity. These aren’t easy investments to buy and sell. The

literature shows that if you look across the NASDAQ, the stocks that trade less frequently offer an additional

return, even if you adjust for their other characteristics. The truth is that we don’t really know yet how to estimate

return and risk for private markets. There is a lot of research on this question but it seems like we are at the

same stage that we were with public markets back in the mid-1960s, when Sharpe, Lintner, and their colleagues

published the CAPM. The notion of beta was out there, but it hadn’t yet been put to work by mutual funds, hedge

funds, and data services. It was an academic idea and the industry hadn’t worked out how to put it into practice.

A lot of tools developed by academics in recent years will be useful in answering this question about risk and

return, but they aren’t in a form yet where they are user-friendly for SWFs and other investors to put into practice.

Q: Another practical issue for SWFs is the issue of identifying investment managers. Are there any manager

characteristics that have been shown to be reliable predictors of skill?

JL: The first ting to note is that there is huge variation across managers. If you look at interquartile range of

manager performance — that is, the difference between the 75th and the 25th percentile manager — for public

funds, it is around 3 percent, whereas with private equity it is closer to 15 percent. For venture capital, it is even

larger at 20 percent. There is enormous variation in performance across managers. If you can chose top-quartile

managers you do very well, even if private markets as a whole don’t do spectacularly. The returns to manager

selection are quite large. So, how do you pick good managers? If I knew that answer to that question, I would be

a billionaire myself! You can point to some patterns in the data. For one, performance is sticky. If a manager

performed well in past, they are likely to perform well in the future. This is where private equity and real estate

are different from public markets. With mutual funds, there is almost no persistence in manager performance

from quarter to quarter. Even among hedge funds, where there are rocket scientists and secret formulas, there is

remarkably little persistence in over longer time frames. That’s one pattern, though research by Steve Kaplan

and co-authors suggests that persistence may be weakening over time. Another pattern has to do with the size of

the funds. Not so much that large or mid-size funds do poorly, but rather that rapid growth seems to be

associated with a deterioration of performance. Private equity firms that increase fund size very rapidly seem to

suffer in terms of their returns going forward. The thinking is that partners end up trying to do too much and that

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ends up cutting into their performance. Finally, there is lots of evidence to suggest that specialization is a good

thing in private markets. If you look at health care, technology, or financial services sectors, the funds that are

specialists tend to do better than the funds that are generalists. There seems to be a considerable benefit to

really knowing the area in which you are investing. Those are three types of characteristics of successful funds.

Q: Does that last point about specialization work against fund of funds?

JL: It does suggest that rather than a one-size-fits-all fund, you want to look at the specialist firms. Find someone

who is doing real estate in India or Scandinavian corporate finance.

Q: Continuing on the topic of manager performance, one of the key challenges is how to benchmark managers.

There are few benchmarks and they have limitations. Can you provide any insights in how to evaluate private

markets investments over time when you don’t necessarily have the best benchmarks available?

JL: This is certainly a challenge. Part of it is that there are relatively few benchmarks and there are big

differences across the benchmarks. It is hard to know why the differences exist and what is behind it. One

approach that I recommend to SWFs and other investors is to carefully evaluate your performance across

multiple benchmarks. Instead of using one benchmark, have a “big tent” approach with multiple indicators of

market activity. Drill down against each of these. One may look better than the other, but looking at multiple

benchmarks will give you the best overall sense of how well you are doing.

Q: Earlier, you suggested that one characteristic of successful private equity investors is a commitment to

institutionalized learning. What sort of processes have you observed? How was this implemented?

JL: This is done in a variety of ways. There isn’t one magic formula. You see some groups implementing a

process where they sit down every year and evaluate the performance of a given asset class. They may rotate

through private markets, from one to the other. This could be just the staff or also include members of the

investment committee as well. In some cases, that group goes back to the original investment memoranda and

asks themselves some questions. What did we get right? What did we get wrong? This isn’t done in the spirit of

apportioning blame. It is more about how they can learn from their experiences. One of the things that everyone

would agree is that investing in private markets is not a purely analytical process. Aspects of it are highly

subjective. To succeed, you need to incorporate hard information, but there is also a lot of soft information that

needs to be processed and examined. Hopefully that gives you a few clues.

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Q: We have focused on private markets in this discussion. Obviously, public markets also comprise a big part of

any SWF portfolio. What are the best approaches for evaluating private markets opportunities in the context of

the broader portfolio?

JL: Institutions have a variety of approaches. We have done a series of case studies on one institution that has

an extremely analytic approach where they use a large matrix, based on industry and country, to determine how

much equity they will invest in each cell. When one of their private markets fund invests in a company in a

particular country, they sell the corresponding amount of public equity from that cell to keep the total exposure to

that country/industry in balance. That’s an extreme form. Other groups have targets in terms of allocations to

keep things in balance.

C. Full Literature Scan

In this section we shed light on the issues related to private markets investing and insights presented in both

academia and financial industry. This section was excerpted from State Street’s The Bridge report from Q3,

2016.3

We begin with private equity, which has received the majority of the attention from researchers, but we also

present a brief review of the literature related to infrastructure and real estate. Private equity typically refers to

investing in illiquid, unregistered equity holdings. Principal investors in private equity funds are institutional

investors such as pension funds, SWFs, university endowments, insurance companies, and banks, though

wealthy individuals also invest in these funds. Moreover, there are different styles of private equity investing,

including venture capital, real estate, growth or development capital, mezzanine financing, leveraged buyouts

(LBOs), distressed private equity, and fund-of-funds. Investments in private equity have been a hot topic for both

academic and financial industry professionals.

History

LBOs can be traced back to the 1960s, while PE firms got their start with KKR in 1976.4 In 1979, Houdaille

Industries became the first successful LBO of a large public company, which generated interest in the process

and other PE funds sprung up to take advantage. The 1980s saw a boom in LBOs, spurred by the development

of a liquid high-yield debt market. This boom led to a political backlash against the highly leveraged buyouts and

3 For more information visit https://www.uat-ssgx.com/portal/public/#/idealab

4 Seretakis, A. (2013). A Comparative Examination of Private Equity in the United States and Europe: Accounting for the Past and Predicting

the Future of European Private Equity. Fordham Journal of Corporate and Financial Law, (18.3)

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– along with a tightening credit market and the collapse of the high-yield debt market – this in turn caused the

end of the LBO surge.

During most of the 1990s there was a lull in LBO activity. After the passage of the Sarbanes-Oxley Act in the

U.S., which increased operating costs for publicly traded companies, private equity investing began to grow

again in 1997. The period of 2003-2007 is often referred to as the “golden age” of private equity. During this

period a number of multi-billion dollar deals were struck as private equity funds switched from buying middle

market companies to larger public-to-private transactions in an attempt to deploy the large funds raised during

this time. The excess credit supply supported the shift to these more expensive, lower yield transactions. The

pattern was strikingly similar to the experience during the first private equity wave in the 1980s.

A History of Private Equity Returns

There is debate over the history of returns for private equity investors driven by the lack of data that

characterizes the industry. Despite this, there have been efforts to examine returns objectively using what data is

available. Harris, Jenkinson, and Kaplan (2016)5 use private equity fund-level cash flow data to measure

performance. The data comes from Burgiss and includes histories of almost 6,000 funds with a total

capitalization of almost $4 trillion as of June 2014. The dataset consists of the complete transactional and

valuation histories between limited partners and their primary fund investments. In other words, the dataset

includes cash flows from limited partners (LPs) to general partners (GPs), and vice versa, for all private equity

investments. The data is sourced from 300 institutional investors with $740 billion in committed capital. The

authors measure performance using the public market equivalent (PME) method.6

The authors find that the PME for private equity funds is 1.18 across all funds, ignoring vintage, through each of

the three decades the data covers. A PME of greater than 1.0 means the private equity funds outperformed the

public market. A PME of 1.0 would mean returns for the public and private markets are equal and a PME of less

than 1.0 would mean the public market outperformed the private market. The authors also show PME results for

different vintages across LBOs and VCs through the 1984-2010. Based on their findings, it seems that private

equity has outperformed the public market in general during these vintage years. The average PME during the

period is 1.20 for buyout funds and 1.35 for venture capital funds. The authors also calculate the direct alpha for

each fund to get a measure of excess returns over and above the S&P 500. The excess return for these funds

fell somewhere between 3.16% and 4.72%. So, private equity funds outperformed public markets by about 20%

over the life of the fund, or by about 3% per year.

5 Jenkinson, T., Harris, R., and Kaplan, S. (2016). How Do Private Equity Investments Perform Compared to Public Equity? Journal of

Investment Management, (14.3):1-24. 6 PME directly compares an investment in a private equity fund with an equivalently-timed investment in the relevant public market,

discounting (or investing) all cash distributions and residual value to the fund at the public market total return and dividing this value by the value of all cash contributions discounted (or invested) at the public market total return. In other words, the PME provides a net of fees, market-adjusted multiple of invested capital. The authors use the S&P 500 to proxy for the public market, as well as other benchmark indices such as growth and size-related indices to test the sensitivity of PME to the benchmark used.

41


It is worth highlighting that the authors also find that post-2005 vintages have delivered a return that is roughly

equal to that of the public market. These funds are not fully realized, though, and their eventual performance will

depend on how the funds’ perform going forward.

Measuring Risk and Return

Measuring risk and returns for private equity is a difficult task due to data limitations and the fact that returns are

not normally distributed and/or are artificially smooth due to the fact that funds are valued using backward-

looking appraisals. Therefore, the standard measures of risk (variance or standard deviation) are not practical for

assessing private equity.

Researchers have traditionally emphasized the importance of manager selection in generating strong private

equity returns. Lerner and Schoar (2007)7, for example, suggest that investors’ private equity returns are driven

mainly by manager selection.

Research over the last ten years or so suggests that private equity may share common risk factors with publicly

traded assets. Kothari, Danilov, and Swamy (2013)8 explore the concept of a risk-reward efficient frontier to

private equity portfolio management. The concept stems from modern portfolio theory, which states that optimal

diversification can improve return for a given level of portfolio risk and that there exists an efficient frontier of risky

portfolios. To define an efficient frontier, however, the authors first tackle the problem of measuring risk. Private

equity is characterized by low transaction volume, high illiquidity, and a highly leptokurtic, non-normal return

distribution. Therefore, the standard deviation of private equity returns is difficult to estimate accurately and does

not provide a complete or precise measure of risk. As a result, the authors use the product developed by

Alternative Asset Risk Management (AARM) called AARM-Insight™. This product uses the following seven

factors to estimate risk from the perspective of private equity LPs: Market Risk, Manager Risk, Performance Risk,

Personnel and Operations Risk, Diversification Risk, Cash Risk and Pricing (Deal) Risk. This framework is one

example of a holistic approach to estimate risk in private equity investments.

Measuring private equity returns also presents challenges. The authors choose to use multiple-of-capital (MOC)

as their measure of returns. (Harris, Jenkinson, and Kaplan (2016)9 chose PME over MOC and IRR because

they felt the most relevant measure of PE performance was how it performed against the public market and were

primarily concerned with the performance against the public market). Here, Kothari, Danilov, and Swamy

7Lerner J., Schoar, A., and Wong, W. (2007). Smart Institutions, Foolish Choices? The Limited Partner

performance puzzle. Journal of Finance, (62.2):731-764. 8Kothari, S. P., Danilov, K., and Swamy, G. M. (2013). Generating Superior Performance in Private Equity: A New Investment Methodology.

Journal of Investment Management, (11.3). 9Jenkinson, T., Harris, R., and Kaplan, S. (2016). How Do Private Equity Investments Perform Compared to Public Equity? Journal of

Investment Management, (14.3):1-24.

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(2013)10

are concerned with finding the optimal reward-risk portfolio and so the performance of PE over the

private market is less of a concern. However, the methodology deployed here could be recreated using PME to

vet the results and to alleviate concerns with actual PE portfolio performance relative to other assets.

With these measure in hand, the authors turn to the question of whether or not PE portfolio returns are driven by

factors similar to traditional asset classes, which have been shown to be influenced by value, growth, and market

cap11

, as well as things like industry focus and geographic exposure. Mirroring these common factors, the

researchers identified similar risk-type factors to assess private equity performance. These factors include

Strategy/ Product, Fund Size, Vintage, Industry Focus, and Geographic Exposure. Other risk-type factors exist

but the authors choose these for their simplicity and similarity to the factors commonly used for traditional asset

classes. The Strategy/Product spectrum is meant to mirror the distinction between value and growth style

spectrum seen in traditional equities. Fund Size is a direct match for market cap. Ultimately, an optimal reward-

risk portfolio is measured by estimating a “diversification Risk Score” using exposure to the five risk factors

mentioned above for each portfolio for the first year of the test window. In each subsequent year they eliminate

any new fund investments which do not decrease risk according to their measure, or increase the expected

return while maintaining risk. They use expected returns at the time of the decision to eliminate hindsight bias. At

the end of the window, returns generated by this approach are compared to the actual returns and optimal

portfolio is constructed.

Kinlaw, Kritzman and Mao (2015)12

also look at the drivers of private equity performance. The authors use data

from 2,400 private equity funds to decompose the excess returns into asset class alpha and illiquidity premium.

They show that private equity managers possess skill in generating alpha by anticipating the relative

performance of economic sectors. Moreover, investors can capture this alpha by using liquid assets (e.g. sector

ETFs) in order to match the PE funds’ sector weights and, thus, avoid the drawback of illiquidity. This excess

return decomposition has the following effect on the optimal portfolio composition: private equity becomes less

attractive compared to liquid asset classes due to the smaller premium as a compensation for liquidity.

Private Equity Styles

There are different types of PE investing, which we refer to as strategies here. These are venture capital (VC),

real estate, growth capital, mezzanine financing, leveraged buyouts (LBOs), distressed PE, and fund of funds.

10Kothari, S. P., Danilov, K., and Swamy, G. M. (2013). Generating Superior Performance in Private Equity: A New Investment Methodology.

Journal of Investment Management, (11.3). 11

See Sharpe, W. F. (1992). Asset Allocation: Management Style and Performance Measurement. The Journal of Portfolio Management, (18.2):7-19.; and Fama, E. F., and French, K. R. (1993). Common Risk Factors in the Returns on Stocks and Bonds. Journal of Financial Economics, (33.1):3-56. 12

Kinlaw, W., Kritzman, M., and Mao, J. (2015). The Components of Private Equity Performance: Implications for Portfolio Choice. The Journal of Alternative Investments, (18.2):25-38.

43


VC funds provide capital to startups and early stage companies. This capital is used to grow the young firm,

increasing the value of the share of the firm owned by the PE fund. VC funds also create economic growth and

create jobs. The difficulty with VC investing is obviously the vetting of potential investments. With little information

about how the company runs itself and, often times, the fact that startups are bringing new products to the

market, it means that VC knowledge and experience are crucial based on the amount of risk they are taking. This

is exactly what Hege, Palomino, and Schwienbacher (2003)13

showed when they compared the VC market in the

US with the market in Europe. Europe’s VC market was still young at the time and the authors found that this

younger market failed to protect its own interests and generally did a worse job of vetting projects. Experience

and industry knowledge appear to be the most important components of VC success.

Private equity real estate fund investments are often differentiated by risk class: core, value-added, or

opportunistic. Core investments are generally investments in stable properties with little leverage and income

coming from existing rent collection. Value-added investments take existing assets and try to improve them

through releasing, repositioning, or redeveloping. This may also require greater leverage than core investing.

Finally, opportunistic investing typically focuses more on land and development, distressed properties or

properties in emerging markets. This often requires more leverage than core or value-added strategies. These

strategies go from least to most risky, from a focus on present income to a greater focus on future income, and

from least to most leveraged.

Risk seems to be the single greatest driver of performance in this market. Alcock et al. (2013)14

examine the

long- and short-term impact of leverage on the performance of PE real estate funds using a sample of 169 global

PE real estate funds from 2001 to 2011. Using annual cash flows and end-of-year NAV estimates along with

fixed effect models the authors find that fund performance is nearly proportional to the return on the underlying

real estate market. In other words, fund managers essentially track their target market. The authors also provide

evidence that leverage cannot be used as a long-term strategy to improve performance, though it may be used in

the short-term. Lastly, the authors show that core investing outperformed the other strategies during the financial

crisis, while opportunistic funds outperformed prior to that time.

Fisher and Hartzell (2016)15

use fund cash flow data from Burgiss to assess the role which class plays in

predicting differences in performance. The data covers value-added and opportunistic real estate PE funds

raised between 1980 and 2013. The authors find that average IRRs, equity multiples, and alternative market

equivalent measures are indistinguishable between classes over the entire period. However, this result is driven

13 Hege, U., Palomino, F., and Schwienbacher, A. (2003). Determinants of Venture Capital Performance: Europe and the United States. LSE

Ricafe Working Paper 1. 14

Alcock, J., Baum, A., Colley, N., and Steiner, E. (2013). The Role of Financial Leverage in the Performance of Private Equity Real Estate Funds." The Journal of Private Equity, (17.1): 80-91. 15

Fisher, L. M., and Hartzell. D. J. (2016). Class Differences in Real Estate Private Equity Fund Performance. The Journal of Real Estate Finance and Economics (52.4):327-346.

44


by the fact that value-added and opportunistic funds outperform core strategies pre-recession, but underperform

in the 2004-2008 period. Moreover, investment in development activities is negatively correlated with returns.

LBOs are perhaps the most well-known type of PE. In an LBO a PE firm will take control of an existing company

using a small amount of equity and a large amount of debt. Subcategories of LBOs are management buyouts,

management buy-ins, and institutional buyouts. Management buyouts involve an incumbent manager partnering

with a PE firm to privatize the company. In a management buy-in, an outside management team partners with a

PE firm to bid on the company. In an institutional buyout the PE firm buys the company and provides

management with equity as part of its remuneration package. In a public-to-private transaction, 60% to 70% of

the purchase is typically funded by debt16

. This amount was easy to come by in the years leading up to the crisis,

which contributed to the boom and eventual bust of investment.

Value can be created with an LBO through a number of sources, including corporate governance engineering,

operational engineering, tax savings, and wealth expropriation from other stakeholders. Corporate governance

engineering refers to the fact that after an LBO management typically holds a significant ownership stake in the

company, which eliminates the agency problem typical for public companies where there is no direct connection

between owners and managers. Operational engineering simply refers to the use of industry and operating

expertise to improve performance. Tax savings are generated by the debt used in an LBO through the tax

deductibility of interest. Wealth expropriation from other stakeholders refers to the potential for increasing value

by firing workers or the fact that pre-buyout bondholders may hold downgraded bonds due to the increased level

of debt created by the buyout. These wealth expropriation arguments are not supported by the evidence.17

Funds of funds (FOFs) invest in the direct strategies listed above. Due to the illiquid nature of PE, the cost of

finding investments and monitoring performance, and the difficulty of scaling PE investments, FOFs are an

attractive path into the market. They provide lower cost services along with diversification and specialized

investment skill to investors looking for PE exposure. So, how do FOFs perform relative to the public market and

relative to investing directly in one of the PE strategies?

Harris, Jenkinson, Kaplan, and Stucke (2015)18

find answers to these questions. They use fund-level, timed cash

flows and fund valuations for FOFs and direct investments from Burgiss through year 2012. They compare FOF

performance to public market performance using PME. They also compare FOF performance to direct investing

by matching an FOF’s actual PME with a distribution of synthetic FOF PMEs. The synthetic FOFs are created by

choosing portfolios of randomly selected direct funds drawn from a set of all direct funds matching the FOF by

16 Seretakis, A. (2013). A Comparative Examination of Private Equity in the United States and Europe: Accounting for the Past and Predicting

the Future of European Private Equity. Fordham Journal of Corporate and Financial Law, (18.3) 17

Seretakis, A. (2013). A Comparative Examination of Private Equity in the United States and Europe: Accounting for the Past and Predicting the Future of European Private Equity. Fordham Journal of Corporate and Financial Law, (18.3) 18

Harris, R. S., Jenkinson T., Kaplan, S. N., and Stucke, R. (2015). Financial Intermediation in Private Equity: How Well Do Funds of Funds Perform? Available at SSRN 2620582

45


vintage year and investment focus (buyout or VC). The authors find that FOFs offer returns above those from

investing in the public market. However, FOFs have lower returns than portfolios of direct funds. This is

especially true for FOFs focusing on buyouts, while FOFs focusing on VC perform roughly equally to a randomly

chosen synthetic FOF. It may still be beneficial to invest in an FOF, though, given the limited access provided to

directly investing in one of these strategies. The FOF opens the door to a number of investors and provides

manager selection skills to uninformed investors.

Other private equity investment styles include:

Growth capital, or development capital, involves providing capital to existing companies to fund

expansion of the firm.

Mezzanine financing provides funds to LBOs in the form of subordinated debt. This debt includes equity

participation in the form of warrants to subscribe for shares in the borrower. It can bridge the gap

between low-risk debt obtained through traditional methods and high-risk equity investment.

Distressed PE refers to the purchasing of debt of troubled firms at a discount rate. Then, using their

rights as debtholders, the PE fund will promote a restructuring of the company.

Real Estate

Recent real estate literature has focused on understanding the risk characteristics of real estate, the implications

for investors of an evolving real estate market, and approaches for improving performance. Lizieri (2013)19

uses

a regime-based filtering process to correct for appraisal effects and shows that the relationship between real

estate and other financial assets is time varying and that, despite a perceived failure of private real estate as a

diversifier in mixed asset portfolios during the global financial crisis of 2008-9, there continues to be significant

benefits from including commercial real estate in portfolios. Clayton (2011)20

, et al. discuss how increased

transparency, the availability of market information, and greater integration with the broader capital markets has

led to markets that react more quickly and exhibit greater volatility. They argue that risk management for real

estate investment has become increasingly important.

Furthering insights on real estate performance and risk, Stefek and Suryanarayanan (2012)21

demonstrate a

strong link between public and private real estate in the UK market by correcting for appraisal smoothing and for

the lead–lag relationship between public and private returns. They highlight the fact that the risk presented by

19 Lizieri, C. (2013). After the Fall: Real Estate in the Mixed-Asset Portfolio in the Aftermath of the Global Financial Crisis. The Journal of

Portfolio Management, (39.5):43-59. 20

Clayton, J., Fabozzi, F., Giliberto, S., Gordon, J., Hudson-Wilson,S., Hughes, W., Liang, Y., MacKinnon, G., and Mansour, A. (2011). The

Changing Face of Real Estate Investment Management. The Journal of Portfolio Management, (37.5):12-23. 21

Stefek, D., Suryanarayanan, R., (2011). Private and Public Real Estate: What is the Link? The Journal of Alternative Investments,

(14.3):66-75.

46


real estate changes over longer horizons and that the correlation between private and public returns increases as

the investment horizon increases.

With regards to improving real estate performance, Esrig, Hudgins, and Cerreta (2011)22

show that large assets

have historically outperformed other properties in the NCREIF database on both an absolute and a risk-adjusted

basis when “large” investments are defined in a way that aligns with the perceptions of institutional investors.

Finally, Andonov, Kok, and Eichholtz (2013)23

show that, as with both private equity and infrastructure

investments, disintermediation through the internal management of real estate assets tends to lower costs and,

consequently, improve performance.

Infrastructure

Infrastructure has seen increasing interest from institutional investors due to its low correlation with other portfolio

assets as well as its potential inflation hedging characteristics. However, a limited return history makes it difficult

to measure the risk and performance characteristics of infrastructure. Researchers have attempted to use

different methods to extend available history to extract additional insights about the performance of infrastructure.

Bianchi, Bornholt, Drew, and Howard (2014)24

reconstruct U.S. listed infrastructure index returns by mapping

monthly performance to systematic and industry risk factors from 1927 through 2010 and find that recent

infrastructure returns may understate long-term tail risk. Bahçeci and Weisdorf (2014)25

use 27 years of EBITDA

data (1986-2012) for 229 mature infrastructure assets across six sub-sectors in the United States and Western

Europe to provide important insights into the investment performance of unlisted infrastructure. Their results

show that infrastructure cash flow has a low correlation to those of real estate and equities along with materially

lower volatility. They also found that infrastructure provided diversification benefits during the past three

recessions by providing cash flows that outpaced CPI inflation and GDP growth. Kaserer and Rothballer (2012)26

further our understanding of the asset class by confirming the low volatility and correlation characteristics of

infrastructure but point out that despite of diversification benefits idiosyncratic risks remain an important

consideration.

22 Esrig, D., Hudgins, M., and Cerreta, L., (2011). Revisiting the Impact of Large Assets on Real Estate Portfolio Returns. The Journal of


Andonov, A., Kok, N., and Eichholtz, P., (2013). A Global Perspective on Pension Fund Investments in Real Estate. The Journal of


Bianchi, R., Bornholt, G., Drew, M., and Howard, M., (2014). Long-Term U.S. Infrastructure Returns and Portfolio Selection. The Journal

of Banking and Finance. (42.0):314-325. 25

Bahçeci and Weisdorf (2014). The Investment Characteristics of OECD Infrastructure: A Cash-Flow Analysis. The Rotman International

Journal of Pension Management, (7.1):32-36. 26

Kaserer, C., and Rothballer, C., (2012). The Risk Profile of Infrastructure Investments: Challenging Conventional Wisdom. The Journal of

Structured Finance, (18.2):95-109.

47


Other research in this area focuses on the challenges of investing in private infrastructure including

benchmarking and the constraints that stem from the time-inconsistency and principal-agent problems embedded

in the third-party fund management model. Bachher, Orr, and Settel (2012)27

address the challenges of

benchmarking infrastructure investments by providing a broad overview of available infrastructure benchmarks

and discuss their shortcomings. They point out that identifying a single correct benchmark for the asset class is

not feasible because investors have differing goals for infrastructure investments. Extending their benchmarking

analysis using the Bailey criteria, a generally accepted framework for assessing benchmark quality, they find that

that all available benchmarks are flawed and that investors must choose the benchmark with the most “tolerable

imperfections.” Toward providing guidance on selecting an appropriate infrastructure benchmark they present

general principles of benchmark selection for unlisted assets. Clark, Monk, Orr, and Scott (2011)28

address the

time-inconsistency and principal-agent problems that have led many institutional investors to establish in-house

investment teams to invest in infrastructure directly. They offer insights into how these investors can establish

internal programs, the challenges of direct investment programs, and suggestions for overcoming those

challenges.

Additional Private Equity Papers

Raising Funds on Performance: Are Private Equity Returns Too Good to be True?29

Investments in private equity are typically structured as ten-year limited partnerships in which fund managers act

as general partners (GPs) and investors act as limited partners (LPs). LPs face two types of problems associated

with asymmetry of information: first, LPs are concerned with identifying good quality GPs before committing

capital in the first place, and second, they might be concerned that GPs would not work hard enough to maximize

value once capital has been committed. Thus, with LPs relying on performance signals to determine the GP’s

quality, low-quality GPs without convincing track records would have an incentive to signal strong current

performance. In such a case, LPs are not only faced with hidden actions ex-post, if effort is unobservable, but

potentially with hidden action ex-ante through low-quality GPs’ incentive of manipulating net asset values

(NAVs). The latter is focus of this paper.

Indeed, private equity reported NAVs have come under increasing scrutiny in recent years. Industry observers

and academics have called for regulatory changes to the private equity industry, raising concerns that NAVs are

27 Bachher, J., Orr, R., and Settel, D., (2012). Benchmarks for Unlisted Infrastructure. CFA Institute, (2012.1).

28 Clark, G., Monk, A., Orr, R., and Scott, (2011). The New Era of Infrastructure Investing. Pensions: An International Journal, (17.2):103-111.

29 Huether, “Raising Funds on Performance: Are Private Equity Returns Too Good to Be True?”, European Finance Association, Annual

Meeting, 2016, https://www.conftool.com/efa2016/index.php/EFA2016-1102-FIIE-04-Huether-Raising_Funds_on_Performance.pdf?page=downloadPaper&filename=EFA2016-1102-FIIE-04-Huether-Raising_Funds_on_Performance.pdf&form_id=1102&form_version=final

https://www.conftool.com/efa2016/index.php/EFA2016-1102-FIIE-04-Huether-Raising_Funds_on_Performance.pdf?page=downloadPaper&filename=EFA2016-1102-FIIE-04-Huether-Raising_Funds_on_Performance.pdf&form_id=1102&form_version=final



48


inflated for funds of GPs who are looking to raise a follow-on fund. Before private equity funds are liquidated,

their returns rely heavily on reports of interim, unrealized performance of their investments. While these NAVs

are subjective estimates of fund performance in privately held deals, private equity funds often also hold shares

in publicly traded stocks as part of their portfolios. Just as with their private investments, private equity funds take

activist roles in these companies. In contrast to endogenous portfolio company exits, returns of investments in

publicly traded stocks are observable and provide a simple empirical benchmark for private equity fund returns—

and it is this benchmark that Huether relies on to examine whether agency problems between GP and LPs

impact reported fund performance.

This benchmark helps shed new light on the fact that GPs' new fundraising events seem to coincide with

estimates of strong current fund performance. This pattern is consistent with two hypotheses: either GPs

manipulate NAVs around fundraising events to attract LPs, or they time fundraising events to strong performance

in order to overcome hidden information about their own quality. Both hypotheses are consistent with the

conjecture that GPs strive to signal high quality to attract potential LPs for a follow-on fund, but the implications

for the industry hinge critically on GPs' nature of marketing.

Using quarterly cash flow and valuation data on 2,776 portfolio company investments by 138 U.S. buyout funds,

Huether finds—in contrast to industry perceptions—that fund managers do indeed time fundraising with strong

current fund performance instead of manipulating interim performance estimates. There is no systematic bias

between private equity fund performance based on stock investments versus fund performance based on

privately held deals. Cumulative portfolio excess returns in stock investments—as well as in privately held

deals—peak around fundraising events. These results support the hypothesis that GPs time fundraising to true

estimates of strong performance.

In summary, this paper differentiates between observable and unobservable returns to show that both types of

fund returns peak around new funding events. This finding is directly at odds with the widely held view that GPs

manipulate NAVs to lure unsophisticated potential investors into a new fund. Evidence actually suggests that

GPs with potentially noisy quality signals indeed time fundraising with strong current fund performance. They

accelerate investments in publicly traded stocks to show observable higher fund returns compared to peers,

delay write-offs and seem to generate returns more quickly in privately held companies.

The Levered Returns of Leveraged Buyouts: The Impact of Competition30

Private equity deal returns are driven by both the value added by private equity ownership (including potential

benefits from additional leverage) and the price that can be negotiated with the sellers. Previous research

suggests that the price paid by private equity firms to acquire a portfolio company is positively related to the

30 Braun, Crain and Gerl, “The Levered Returns to Leveraged Buyouts: The Impact of Competition”, Financial Management Association,

Annual Meeting, 2016, http://www.fma.org/Vegas/Papers/PE_Leverage_Competition_Braun_Crain_Gerl_2015_October.pdf

http://www.fma.org/Vegas/Papers/PE_Leverage_Competition_Braun_Crain_Gerl_2015_October.pdf

49


amount of debt used to finance the purchase. This suggests sellers of the target firm are better off when more

debt is available to finance the deal, but tells us little about the value captured by private equity. It could be that

high levels of debt correspond to the largest increases in the value of the target firm—through tax savings, for

example. Sellers may capture a portion of this increase through higher deal prices, but the return to the private

equity sponsor may be higher as well. Alternatively, the increase in deal price may come at the expense of

private equity sponsors—with the returns to private equity sponsors expected to decline with leverage. This

paper investigates specifically how the performance of private equity buyout deals is related to the level of

competition—and hence the amount of debt used to finance their purchase.

Using a large data sample of 3,198 deals with information on both deal performance and leverage, Braun et al.

examine the relationship between the realized returns to individual buyout investments and the amount of debt

used to finance the deal. The authors find a strong negative relationship between returns and Debt / EBITDA.

More specifically, one additional turn of Debt / EBITDA corresponds to a nearly 2% decrease in the expected

Internal Rate of Return (IRR) to the deal’s private equity sponsor. This relationship holds after controlling for deal

characteristics (e.g., industry, region, etc.) that may be related to systematic risk. The relationship also holds in

the cross-section, which suggests that it is not likely to be driven by time-varying changes in discount rates or

other macro factors that may drive investment returns.

Rather than causing lower returns, it seems more plausible that the negative relationship between Debt / EBITDA

and returns is an equilibrium outcome of the deal process— particularly the competitive environment surrounding

the deal. A portion of the data sample, 947 deals, contains information on whether the target firm was purchased

through an investment bank (IB) auction or sourced from “proprietary” deal flow. The authors find that the

negative relationship between Debt / EBITDA and returns only holds for auctions. Indeed, for deals sourced

through auctions, one additional turn of Debt / EBITDA corresponds to a nearly 5% lower IRR. There is no

evidence of this relationship in proprietary deals.

Additionally, for both IBs and PE funds, small deals produce less benefit (e.g., fees and potential gains) while

requiring similar costs (marketing and due diligence) than larger deals. As a result, small deals are less likely to

be sold through an auction—and hence less likely to receive interest from a large number of potential investors.

Consistent with the ex-ante intuition about the effects of competition, Braun et al. estimate that the relation

between Debt / EBITDA and returns in large deals is twice as strong as that for small deals.

The authors also examine how a fund’s flow of new deals varies with credit market conditions and proxies for firm

reputation. Their results show that deal flow of funds with lower performance is particularly sensitive to credit

spreads. These results also hold for the sub-sample of auction deals. Poorly performing funds win more auctions,

particularly when credit spreads—and expected returns—are low. In contrast, there is little evidence that interim

performance is related to the rate with which funds complete proprietary deals. This suggests that credit

50


conditions predominantly affect poorly performing funds when they face competition from other buyers who may

have better access to capital.

In summary, this paper provides further evidence on the role of leverage in private equity transactions. A

common refrain in the private equity industry is that fund managers always seek as much leverage as possible in

financing each deal to improve returns and increase the value of the portfolio company. Seeking the maximum

leverage possible may instead be necessary to bid aggressively and compete for a deal.

The Liquidity Cost of Private Equity Investments: Evidence from Secondary Market Transactions31

An important cost of investing in private equity (PE) is illiquidity. To alleviate it, a secondary market has

developed in which investors can buy and sell limited partner (LP) stakes in PE funds. More specifically, the

buyer pays cash to the seller and assumes the obligation to participate in all future investments and pay all future

management fees. In return, the buyer receives the right to all eventual distributions from exits of the fund’s

current investments. This paper attempts to understand in greater depth the ways in which secondary markets

alleviate illiquidity costs.

Nadault et al. begin by examining the discounts or premiums relative to Net Asset Value (NAV) at which

transactions occur. To the extent NAVs are unbiased, discounts from NAV can be interpreted as discounts from

fundamental underlying value—and therefore as a measure of the premium buyers receive for providing liquidity

to sellers in the secondary market. On average, transactions occur at a substantial discount of 14% to NAV for all

types of funds transacted on the secondary market, including buyout funds, venture capital funds, real estate

funds, and funds of funds.

Nevertheless, because NAVs in PE funds are not necessarily a market-based estimate of the fund’s underlying

value, and because the literature suggests that NAVs are sometimes manipulated, the authors construct an

alternative measure of the cost of secondary sales. Using data on the cash flow distributions of the funds, they

calculate the annualized returns to investors who buy and sell the funds. Despite the discounts to NAV they

accept, sellers potentially could outperform buyers by this measure if they are able to systematically sell funds

whose future prospects are poor. This could occur if existing LPs have valuable soft information (as opposed to

the hard information provided to potential buyers as part of a due diligence process) that potential buyers do not.

However, the data suggest that the buyers in these transactions substantially outperform sellers, again

suggesting that transaction prices occur at a discount to the funds’ underlying values. Weighting trades by

transaction size, buyers earn an annualized IRR of 17.8%, compared to an annualized IRR of 4.2% for sellers.

The differences are even larger if trades are equally weighted, with an IRR of 27.4% for buyers and 0% for

sellers.

31Nadauld, Sensoy, Vorkink and Weisbach, “The Liquidity Cost of Private Equity Investments: Evidence from Secondary Market

Transactions”, Western Finance Association, Annual Meeting, 2016, https://westernfinance-portal.org/viewpaper.php?n=444332

https://westernfinance-portal.org/viewpaper.php?n=444332

51


Another measure of the cost of exiting a PE investment through the secondary market is the difference between

the return an investor receives if they exit and the return they would receive if they held the fund for the duration

of its life. This measure is arguably the most salient from the perspective of an LP weighing potential

commitments to PE funds at inception. By this measure, too, sellers incur substantial costs by accessing the

secondary market, earning an annualized return of 4.2% compared to 10.1% if the fund were held to completion.

It is tempting to interpret these return differences as additional estimates of the liquidity premium earned by

buyers. However, this interpretation is confounded by the possibility of changing expected returns over a fund’s

life. If expected returns on the fund’s assets increase as the fund ages, buyers would earn higher returns than

sellers and sellers’ realized returns would be less than hold-to-maturity fund returns even in the absence of any

liquidity premium for transacting. To disentangle these effects, Nadault et al. calculate what the return differences

would have been had the transactions occurred at NAV rather than at the actual observed price. They then

estimate the liquidity premium as the difference between the two, resulting in 4.0% per year.

Additionally, transaction discounts to NAV and the difference between buyer and seller returns tend to be larger

when the economy is doing poorly and there is less capital available to purchase the stakes. They also tend to be

larger when there are fewer bidders, for smaller funds, for younger funds, and for smaller stakes in funds.

In summary, Nadault et al. show that the cost of obtaining liquidity through secondary sales is indeed high; most

transactions occur at a substantial discount to NAV. Buyers in this market dramatically outperform sellers as the

former tend to be strategic investors with greater flexibility to provide liquidity to sellers, who are willing to pay a

price to exit their position because of cash flow requirements.

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D. SWF Contributor Profiles

Below, we list a short profile for each of the eight SWFs that we interviewed over the course of our research.

Abu Dhabi Investment Authority (ADIA)

United Arab Emirates

Since 1976, the Abu Dhabi Investment Authority has been prudently investing funds on behalf of the Government

of Abu Dhabi with a focus on long-term value creation.

ADIA’s mission is to sustain the long-term prosperity of Abu Dhabi by prudently growing capital through a

disciplined investment process and committed people who reflect ADIA’s cultural values.

Investments

ADIA manages a diversified global investment portfolio across more than two dozen asset classes and sub-

categories. We invest directly in global financial markets, alongside trusted partners and through a network of

carefully selected external managers.

With a long tradition of prudent investing, ADIA’s decisions are based solely on its economic objectives of

delivering sustained long-term financial returns.

ADIA has a disciplined investment process that aims to generate stable returns over the long term within

established risk parameters.

The Strategy Unit plays a central role in the investment process, with responsibility for developing, maintaining

and periodically reviewing ADIA’s policy portfolio mix of more than two dozen asset classes and sub-categories.

It also identifies medium-term tactical opportunities for generating returns in excess of those achieved by the

long-term policy portfolio while maintaining ADIA’s target risk profile.

In accordance with ADIA’s prudent governance structure, the Strategy Unit’s recommendations are evaluated by

the Strategy Committee, before being submitted to the Investment Committee and ultimately the Managing

Director. Once approved, funds are allocated to the respective investment departments, which are responsible

for implementation in line with their mandates, benchmarks and guidelines.

53


Relationship with the Government of Abu Dhabi and Source of Funds

ADIA is a public institution established by the Government of the Emirate of Abu Dhabi in 1976 as an

independent investment institution.

ADIA carries out its investment activities independently and without reference to the Government of the Emirate

of Abu Dhabi.

ADIA has no visibility on either the spending requirements of the Government of the Emirate of Abu Dhabi or the

activities of other Abu Dhabi-owned investment entities. ADIA’s assets are not classified as international

reserves.

Under the UAE Constitution, the natural resources and wealth of the Emirate of Abu Dhabi are the public

property of Abu Dhabi. The Government of the Emirate of Abu Dhabi provides ADIA with funds that are allocated

for investment and surplus to its budgetary requirements and its other funding commitments.

ADIA is required to invest and reinvest these funds and make available to the Government of the Emirate of Abu

Dhabi, as needed, the financial resources to secure and maintain the future prosperity of the Emirate. In practice,

such withdrawals have occurred infrequently.

Governance

ADIA has robust governance standards with clearly defined roles and responsibilities that ensure accountability.

Management of ADIA is vested in ADIA’s Board of Directors, which comprises a Chairman, a Managing Director

and Board members who are appointed by a decree of the Ruler of the Emirate of Abu Dhabi.

The Board has primary responsibility for the discharge of ADIA’s activities and meets periodically for the

establishment and review of ADIA’s overall strategy but does not involve itself in investment or operational

decisions.

ADIA’s Managing Director has sole responsibility for the implementation of ADIA’s strategy and administering its

affairs, including all decisions related to investments. Investment decisions are based solely on economic

objectives in order to deliver sustained long-term financial returns.

Risk Management

In keeping with our prudent culture, risk management is embedded in all of ADIA’s investment and related

activities, from asset allocation to investments in individual asset classes and ultimately to trade execution.

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ADIA’s risk management framework is holistic in nature, having been designed to comprehensively identify and

analyse all types of risks across asset classes and ensure that any potential issues are managed efficiently and

effectively.

The Managing Director has ultimate responsibility for ADIA’s risk management, with assistance and advice from

several committees and departments, including the Investment Services Department, Strategy Unit, Evaluation

and Follow-Up Division, Internal Audit Department, and Legal Division.

For further information, please go to www.adia.ae

Alaska Permanent Fund Corporation (APFC)

United States of America

The Alaska Permanent Fund was created by the people of Alaska in 1976 as a way to save a portion of the

state’s oil revenues for the needs of future generations. It uses oil royalties to make investments in bonds,

stocks, real estate, infrastructure, and private entities. The returns on these investments are used to grow and

finance the Fund. Additionally, since 1983, the Alaska Permanent Fund Dividend Division has distributed a

portion of the earnings to Alaskans annually in the form of a dividend. The Fund is currently worth more than US

$54 billion.

In 1980, the Alaska State Legislature created the Alaska Permanent Fund Corporation to manage the

investments of the Permanent Fund outside of the State Treasury. The investments are guided by a six-member

board of trustees, appointed by the Governor, but once appointed the four public board members can only be

removed for cause.

The Trustees have maintained a conservative asset mix over the years. The current asset allocation consists of 6

asset classes categorized by the following Investment Objectives and Liquidity Characteristics:

Tradeable Growth – (1) Public Equities

Tradeable Income – (2) Bonds, Real Estate Investment Trusts, Infrastructure Securities

Illiquid Growth – (3) Private Equity & Special Growth, (4) Absolute Return Funds

Illiquid Income – (5) Real Estate, (6) Infrastructure & Special Income

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Target allocation ranges and return criteria, including benchmarks were established for each of these asset

classes. Investments into each of the six asset classes is led by a dedicated investment team whose

performance benchmarks are tailored to achieve best-in-class investment performance.

The Permanent Fund is divided into two parts: Principal (nonspendable) and Earnings Reserve (spendable), both

of which are fully invested in the same pool of assets. The Alaska Constitution articulates that the Principal shall

only be used for income-producing investments. The Earnings Reserve account, established in Alaska Statutes,

may be spent through appropriations approved by the Legislature.

In a state with primarily non-renewable resources, the Permanent Fund generates renewable revenue. In most

years since its creation, the Fund has been the second-largest producer of state revenue, trailing only taxes and

royalty payments generated by the oil and gas industry. The Permanent Fund is a progressive concept that

provides a source of renewable revenue for Alaska; when oil and gas revenues are diminishing, the Fund is still

growing. The Fund’s successful adaptation to the varied global economic climates fortifies its significance to the

State’s future.

Korea Investment Corporation (KIC)

Korea

Introduction

The Korea Investment Corporation (KIC) was established in 2005 to manage public funds entrusted by the

government and Bank of Korea through investing in a variety of international financial assets. Our net asset

value was USD 91.8 billion as of the end of 2015.

Mission

Our mission is to preserve and enhance the international purchasing power of sovereign assets by consistently

generating returns that exceed inflation levels, and to contribute to the development of the domestic finance

industry.

Governance

KIC’s Steering Committee, as its highest governing body, ensures autonomy and independent operation. It has

nine members, including the chairman, six professionals from the private sector, the CEO of KIC, and

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representatives of institutions that have entrusted KIC with assets exceeding one trillion won, namely the Minister

of Strategy and Finance and Governor of the Bank of Korea.

KIC reports its business activities to the National Assembly, in accordance with the National Assembly Act and

the Act on the Inspection and Investigation of State Administration. We are subject to annual inspections

conducted by the National Assembly.

Investment Policy & Objectives

KIC’s investment objective is to generate consistent and sustainable returns in line with and in excess of relevant

benchmarks, within appropriate levels of risk. We aim to increase returns while (1) minimizing the risks from

individual markets and assets through portfolio diversification; and (2) exercising flexibility to seize investment

opportunities.

According to the KIC Act, under which we were founded, KIC can invest in asset classes including public

equities, bonds, commodities, private equity, real estate, and hedge funds. Decisions related to strategic asset

allocation are subject to deliberation by the Steering Committee. Investment management agreements signed by

KIC and its sponsors specify eligible asset classes and benchmark targets, serving as the basis for our risk

management and performance evaluation.

Future Fund

Australia

The Future Fund is Australia’s sovereign wealth fund. It invests for the benefit of future generations of

Australians.

The Future Fund was established in 2006 to accumulate financial assets to offset the Australian Government’s

unfunded superannuation liability from 2020. This was particularly important in view of the pressure that

Australia’s aging population is likely to place on Commonwealth finances into the future.

Since then the organization has taken on management of additional public asset funds, including the

DisabilityCare Australia Fund, the Medical Research Future Fund and two Nation-building Funds.

Our role is to generate high, risk adjusted returns over the long-term. Every dollar that we make is a dollar that

adds to Australia’s wealth and contributes to its future.

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We operate independently from Government and tailor the management of each fund to its unique investment

mandate.

The Future Fund is valued at AUD123 billion (30 June 2016) and has generated a return of 7.7% per annum over

10 years.

Adding in the other public asset funds the organization invests nearly A$140 billion on behalf of the Australian

Government.

State General Reserve Fund

Oman

About

State General Reserve Fund (SGRF) was established in 1980 by a Royal Decree 1/80. It endeavors to achieve

long term sustainable returns on the revenues generated from the oil and gas, and that are surplus to the state's

budgetary requirements

On behalf of the Government of Oman, SGRF manages the reserves placed in its care to achieve best possible

long term returns with acceptable risks, through investing in a diversified portfolio of asset classes in more than

25 countries worldwide.

SGRF is regulated and supervised by the Financial Affairs and Energy Resources Council (FAERC).

Missions

To execute on and enhance the following:

Maximize returns while prudently managing its risk profile

Invest strategically with long term time horizon for Oman’s future generations

Leverage global relationships to facilitate investments and build Oman’s Economy

Attract global investments and experiences through global relations net

Develop its current platform into Human Resource Center of Excellence

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Communicate and engage with community regarding SGRF's role in the future of Oman

Play a local investment leadership role and facilitate global best practices

Governance

SGRF has a juristic personality and an independent financial status. It is regulated and supervised by the

Financial Affairs and Energy Resources Council (FAERC).

SGRF has a Board of Directors which is responsible for the overall portfolio performance and the implementation

of the policies and regulations as set by FAERC.

SGRF has a robust governance framework with clearly defined policies, process and procedures.The

Management of SGRF is empowered by the Board to manage the Fund's investments and operational activities.

SGRF has a number of committees to assist and support the Board and the Executive President in the decision

making process.

CDP Equity SpA

Italy

CDP Equity started in 2011 as Fondo Strategico Italiano and is an institutional investor acquiring mainly minority

holdings in companies of “significant national interest”, which are balanced economically, financially and balance

sheet wise. Investee companies need to have adequate profitability and development prospects that are suitable

for generating value for investors.

Companies, which operate in the following sectors, are considered to be of “significant national interest” (as

established by the decree of the Minister for the Economy and Finance dated 2 July 2014):

defense;

security;

infrastructures;

transportation;

communications;

energy;

insurance and financial brokerage;

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hi-tech research and innovation;

public services;

tourism and hospitality;

food and food distribution; and

management of cultural and artistic heritage.

CDP Equity's majority shareholder is Cassa depositi e prestiti Group Spa, which is controlled by the Italian

Ministry of Economy and Finance, and is active in supporting the economy and the infrastructural development.

Bank of Italy is the minority shareholder.

In accordance with its long-term horizon and its investment objective, CDP Equity participates in the corporate

governance of its portfolio companies entering into agreements with the other shareholders of the investee

companies with the aim of:

ensuring an adequate level of representation and active governance;

ensuring a constant information flow;

identifying options for the development of the company;

developing an exit plan, at market conditions, with a focus toward the listing of the company.

CDP Equity is open to joint-investments with other primary industrial and financial partners that show interest in

individual transactions. The selection of such partners is performed on the basis of the contribution that the

partners can bring to the development and the governance of the company.

CDP Equity has agreements with a number of other sovereign wealth funds, such as The Kuwait Investment

Authority, Qatar Investment Authority, Korea Investment Corporation, The Russian Direct Investment Fund and

China Investment Corporation.

New Zealand Superannuation Fund

New Zealand

Mission, purpose and mandate

The New Zealand Superannuation Fund is a Government savings vehicle that is designed to help pre-fund the

rising cost of universal retirement benefits in New Zealand. The Fund, which began investing in 2003, is

managed by an Auckland-based Crown entity, the Guardians of New Zealand Superannuation.

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The Guardians, which has operational independence regarding its investment decisions, invests money the New

Zealand Government contributes to the Fund. In this way, the Fund adds to Crown wealth, improves the ability of

future Governments to pay for superannuation and, ultimately, reduces the tax burden of the cost of

superannuation on future.

The Guardians' mission is to: "Maximise the Fund’s return over the long term, without undue risk, so as to reduce

future New Zealanders' tax burden."

The Guardians' legislative mandate is to: invest the Fund on a prudent, commercial basis and, in doing so,

manage and administer the Fund in a manner consistent with:

best-practice portfolio management;

maximising return without undue risk to the Fund as a whole; and

avoiding prejudice to New Zealand’s reputation as a responsible member of the world community.

Investment approach

The Fund has a long investment horizon: withdrawals are not scheduled until 2030/31 and the NZ Treasury

estimates that it will keep growing until the 2080s. The Fund’s highly diversified global investment portfolio is

therefore heavily growth-oriented. The Guardians uses a Reference Portfolio to benchmark the value being

added through active investment strategies.

The Reference Portfolio, which is capable of meeting the Fund’s objectives over time, is a shadow or notional

portfolio of passive, low-cost, listed investments suited to the Fund’s long-term investment horizon and risk

profile. It has an 80:20 split between growth and fixed-income investments and its foreign currency exposures

are 100% hedged to the New Zealand dollar.

The Guardians' aim, as an active investor, is to add more value after all costs to the Fund than the reference

approach would do, using strategies based on the Fund’s natural advantages as a long-term, sovereign investor

with low liquidity requirements.

Further information about how the Guardians invest the Fund, the Reference Portfolio approach and monthly

updates on Fund performance, are available onwww.nzsuperfund.co.nz. The website also includes copies of the

Guardians’ investment policies and Annual Reports.

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State Oil Fund of the Republic of Azerbaijan (SOFAZ)

Azerbaijan

The State Oil Fund of the Republic of Azerbaijan (SOFAZ), established in December 1999 by the Presidential

Decree is a legal entity and an extra-budgetary institution. The Fund is a mechanism whereby energy-related

earnings are accumulated and efficiently managed. The cornerstone of the philosophy behind the SOFAZ is to

ensure intergenerational equality with regard to benefit from the country's oil wealth, whilst improving the

economic well-being of the population today and safeguarding the economic security of future generations. For

more information about SOFAZ, please visit http://www.oilfund.az/.

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E. Legal Disclaimers

The material presented is for informational purposes only. The views expressed in this material are subject to

change based on market and other conditions and factors, moreover, they do not necessarily represent the

official views of State Street Global ExchangeSM and/or State Street Corporation and its affiliates.

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