The Secondary Market: A Panacea for the Illiquidity in ...€¦ · secondary market 1/ Source:...
Transcript of The Secondary Market: A Panacea for the Illiquidity in ...€¦ · secondary market 1/ Source:...
The Secondary Market: A Panacea for the Illiquidity in Private Equity Investments?
Peter Cornelius
October 23, 2014
For the exclusive use of attendees at the CFA Conference and may not be redistributed.
Trade Secret and Strictly Confidential
Important Legal Information • The views expressed herein are the personal views of Mr. Peter Cornelius of AlpInvest Partners (“AlpInvest”), which is
part of The Carlyle Group (“Carlyle”), and do not necessarily reflect the views of AlpInvest or Carlyle itself. The views expressed herein reflect the current views of Mr. Cornelius as of the date hereof and have been compiled and arrived at in good faith from sources believed to be reliable (but no representation or warranty, express or implied, is made as to their accuracy, completeness or correctness). None of Mr. Cornelius, AlpInvest or Carlyle undertakes to advise you of any changes in the views expressed herein.
• Under no circumstances should this document be construed as (and it should not be relied upon in any manner as) legal, tax, investment, accounting or other advice, or as an offer to sell or a solicitation of an offer to buy any securities of any investment product or any investment advisory service.
• This document has been prepared without regard to the circumstances and objectives of those who receive it. Investment concepts mentioned in this document may be unsuitable for investors depending on their specific investment objectives and financial position. Persons to whom this document has been made available are advised to independently evaluate particular investments and strategies, and are encouraged to seek the advice of financial and tax advisers.
• The value of and income from investments may vary because of changes in interest rates or foreign exchange rates, securities prices or market indexes, operational or financial conditions of companies, geopolitical or other factors. Tax considerations, margin requirements, commissions and other transaction costs may significantly affect the economic consequences of any transaction concepts referenced in this document.
• Past performance is not necessarily indicative of future performance. The price or value of investments to which the information contained herein relates may rise or fall. Estimates of future performances are based on assumptions that may not be realized, and differing facts from those assumptions may have a material impact on any indicated returns. Any trends or correlations shown herein may not continue.
• Alternatives investments, including secondary investments, are intended for sophisticated investors only. They may be speculative, provide limited liquidity, involve a high degree of risk, including the loss of capital, and may engage in the use of leverage.
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Trade Secret and Strictly Confidential
Agenda
• Private Equity as an Asset Class and Investment Risks
• The Evolving Role of the Secondary Market
• Conclusions: Implications for Risk Management
3
Trade Secret and Strictly Confidential
Agenda
• Private Equity as an Asset Class and Investment Risks
• The Evolving Role of the Secondary Market
• Conclusions: Implications for Risk Management
4
Trade Secret and Strictly Confidential
$2 $19 $87 $113
$716
$1,238
$2,776
$3,466
0
500
1,000
1,500
2,000
2,500
3,000
3,500
4,000
1980 1985 1990 1995 2000 2005 2010 2013
Private Equity Assets Under Management, US$ bn
Private Equity as an asset class has been growing rapidly, …
Source: McKinsey Global Institute, Preqin (as of 9/1/2014)
For illustrative purposes only.
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… with commitments to private equity funds having regained considerable momentum since the global financial crisis
0
100
200
300
400
500
600
700
800
900
0
50
100
150
200
250
300
350
400
450
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Buyouts VC Growth Capital
Mezzanine Distressed Other
Number of Funds
Com
mitm
ents
(US$
bn) N
umber of Funds Raised
Other includes balanced, special situations and turnaround funds. 2014 annualized. For illustrative purposes only.Source: Preqin (accessed 09/11/14)
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Trade Secret and Strictly Confidential
Private Equity has been subject to important innovations
The Stone Age 1974-1984
The Bronze Age1985-1990
The Silver Age1991-2001
The Golden Age 2002-2007
• Infant industry
• Small firms
• New technology of debt financing
• Small Deals
• Not important to the financial world
• More firms
• Wider investor base
• Debt financing more mainstream
• Junk bonds
• Public companies taken private
• Outsized Returns
• RJR Nabisco
• Multi-billion dollar funds
• Global investors and lenders
• Many new funds
• Public pension funds dominate investor base
• Overseas investments
• Talent drain from other financial companies
• Emergence of secondary market
• Dominant position in financial world
• 175 funds ≥ $1Bn1/
• Fortune 500 companies go private
• Accounts for large percentage of M&A activity (40% in 1H 2007) 2/
• A global business
• PE firms become large organizations
• PE firms going public
• Public/Government scrutiny
Post – GFC 2008 - today
• Terms and conditions; rebalancing GP/LP relations
• Co- and direct investments
• Managed accounts
• Access for retail investors
• GPs becoming alternative asset managers
• New regulations
• LPs’ increased focus on investment risk
• Environmental, Social & Corporate Governance.
• Continued globalization, including investor base
• Continued growth in secondary market
1/ Source: Preqin (accessed 9/15/14).2/ Source: Dealogic (accessed 9/15/14).For illustrative purposes only.
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Trade Secret and Strictly Confidential
Primary Fund
Investments
Secondary Market
Co-Investments
Direct Investments
Fund-of-Funds
Listed Private Equity
Managed Account
Today, investors have several options to get exposure to the asset class
8For illustrative purposes only.
Trade Secret and Strictly Confidential
Typical life span of fund is 10 years, with possible extension of up to 2 years.
Investors serve as limited partners (LPs) in the fund, which is managed by private equity firm as general partner (GP).
GP charges management fees of around 1½% pa and participates in the profits (“carried interest”, normally 20%), subject to a hurdle rate).
Portfolio companies bought by the fund are typically held for 3 – 7 years.
Leveraged buyout and venture capital transactions represent the bulk of the private equity market.1/
While venture capital transactions generally involve little, if any, debt, buyouts tend to be substantially leveraged.2/
• 60% to 80% of purchase with debt• 20% to 40% with equity from private equity fund
However, the dominant way remains the limited partnership fund
91/ AlpInvest Research, based on data provided by Preqin for the period 2000 – H1 2014.2/ Source: S&P LCD Capital IQ (accessed 9/15/14)Source: S. Kaplan and P.Strömberg (2009), “Leveraged Buyouts and Private Equity,” Journal of Economic Perspectives, 23 (1), pp. 121-46.For illustrative purposes only.
Trade Secret and Strictly Confidential
In a limited partnership, the general partner serves as a financial intermediary
Corporate pension funds
Public Pension Funds
Insurance companies
Banks
Endowments
Foundations
Family Offices
Sovereign Wealth Funds
Investment advisors• Evaluate
• Manage funds of funds
Placement agents forpartnerships
Placement agents forissuers
• Advise issuers
Direct investments
Capital Supply Financial Intermediaries
Capital Demand
Limited Partnerships
• independent• captive
Other intermediaries
• Publicly listed investment companies
Venture Capital
• early stage• later stage
Middle-Market Private Companies
• Expansion (capex & acquisitions)
• Change in capitalstructure (financial restructuring and distress)
• change in ownership(retirement of owner, corporate spinoffs)
Public Companies• Management orLBO
• Financial distress
• Special situations
Cash flow
LP interest
Cash flow
Equity claim on intermediary
Cash flow,Corporate governance,consulting
Private equitysecurities
10
For illustrative purposes only. Source: P. Cornelius (2011), International Investments in Private Equity. Elsevier, 2011.
Trade Secret and Strictly Confidential
Private equity investors seek to harvest an illiquidity risk premium
Small cap equity Private equity Property Hedge funds High yield bonds High-gradecorporate bonds
Governmentbonds
Equity risk premia Liquidity risk premia Term risk premia Credit risk premia
World Economic Forum (2011). Most recent data available used. For illustrative purposes only.
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Trade Secret and Strictly Confidential
Reported returns suggest that the illiquidity risk premium is significant …
United States
Emerging Markets
Global
%
0
5
10
15
20
25
5 years 10 years 20 years
Buyouts S&P 500
0
5
10
15
20
5 years 10 years 20 years
Buyouts & Growth Capital MSCI World
0
5
10
15
20
5 years 10 years 15 years
Buyouts & VC MSCI EM
%%
End-to-End Pooled Returns (net-of-fees)%
Returns as of March 31, 2014Source: Cambridge Associates.For illustrative purposes only and should not be deemed an offer or recommendation to buy or sell any investment or to participate in any strategy. Past performance is not indicative of future results. Indices are unmanaged and it is not possible to invest directly in an index. Indices do not include any expenses or fees, which would lower performance.
0
5
10
15
20
5 years 10 years 15 years
Buyouts MSCI Europe
Europe
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... with U.S. buyout funds having outperformed the S&P500 in 20 of 25 vintage years between 1984 and 2008
0.0
0.5
1.0
1.5
2.0
2.5
1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008
Source: Harris, Jenkinson, Kaplan (2013), based on Burgiss data.For illustrative purposes only and should not be deemed an offer or recommendation to buy or sell any investment or to participate in any strategy. Past performance is not indicative of future results. There is no assurance that this trend will continue.
Note: A PME of greater than 1 indicates outperformance by private equity, a PME of smaller than 1 indicates underperformance; public market returns measured by the S&P 500
Publ
ic M
arke
t Equ
ival
ent (
PME)
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Trade Secret and Strictly Confidential
• Liquidity risk: – Investors are unable to rebalance their portfolios continuously. Their actual
portfolios deviate almost always from their target allocations. 1/
– Investments in private equity funds (funded or unfunded) cannot easily be liquidated in periods where liquidity is needed.
• Commitment risk:– Future drawdowns are unknown in terms of their amounts and timing.
Failing to honor commitments has serious consequences for LPs.– Nor do investors know the volume and timing of future distributions,
aggravating the design of commitment strategies.
To be able to reap potentially higher returns requires accepting specific risks …
1/ See A. Ang and M. Sorensen (2012), “Risks, Returns, and Optimal Holdings of Private Equity. A Survey of Existing Approaches.” Quarterly Journal of Finance. For illustrative purposes only. The views and opinions provided herein are subject to change based on market and economic conditions. 14
Trade Secret and Strictly Confidential
… reflecting the characteristics of the underlying investments
Short-term bondsLong-term bonds
Public equity
Corporate bondsCommodities
Hedge funds CDOs
Buyout fundsReal Estate
VC funds
Public equity - Strategic
Direct buyoutsOil & gas
Timber
Direct VCInfrastructure
Less
Liq
uid
Mor
e Li
quid
Shorter-Term Longer-Term
Source: World Economic Forum (2011). Most recent data available used. For illustrative purposes only.
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Trade Secret and Strictly Confidential
• Why investors want to be compensated for liquidity risk (e.g. Acharya & Pedersen, 2005; Chien & Lustig, 2009; Huh & Subrahmanyam, 2009; Ang, Papanikolaou & Westerfield, 2011)
• Empirical literature: (e.g. Pastor & Stambaugh, 2003)
• PE liquidity risk:– Ang & Sorensen (2012)– Franzoni, Novak & Phalippou (2012) find a liquidity risk premium of 3% pa– Sorensen, Wang & Yang (2014) find that α > 2.06% pa is needed to
compensate investors for liquidity risk (in leveraged buyouts; α > 3.08% without leverage)
• “Although it is natural to benchmark private equity returns against public markets, investing in a portfolio of private equity funds across vintage years inevitably involves uncertainties and potential costs related to the long-term commitment of capital, uncertainty of cash flows and the liquidity of holdings that differ from those in public markets. While the average out-performance of private equity we find is large, further research is required to calibrate the extent of the premia investors require to bear these risks.” Harris, Jenkinson & Kaplan (JoF, forthcoming),
Liquidity risk is attracting increased interest, but there is little research on commitment risk
For illustrative purposes only. Past performance is not indicative of future results. The views and opinions provided herein are those of the authors cited and do not necessarily reflect the views of AlpInvest or Carlyle itself.
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Trade Secret and Strictly Confidential
Standard cash flow models work well in normal times …
0 1 2 3 4 5 6 7 8 9 10 11 12
Investment Period Divestment Period Extensionperiod
Life Time of a Private Equity Fund (Years)
Net Cash flowContributions
Distributions
17
For illustrative purposes only.
Trade Secret and Strictly Confidential
… but may collapse in periods of financial stress
U.S. Buyouts and Venture Capital (US$bn)
-$70
-$20
$30
$80
$130
$180
2005 2006 2007 2008 2009 2010 2011 2012 2013
Capital Called Distributions
Net Distributions
Global ex U.S. Developed Markets Buyouts and Venture Capital (US$bn)
-$40
-$20
$0
$20
$40
$60
$80
2005 2006 2007 2008 2009 2010 2011 2012 2013
Capital Called Distributions
Net Distributions
Source: Cambridge Associates (June 2014).For illustrative purposes only.
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Trade Secret and Strictly Confidential
363 350
461
665
834896 878
810 838785
890973
0
200
400
600
800
1,000
1,200
Buyouts Venture Capital Growth Capital Distressed PE Mezzanine Other
Dry Powder in USD bn; excludes real estate private equity funds
Managing commitment risk effectively is critical in light of the increase in unfunded commitments to almost USD 1 trillion …
For illustrative purposes only.Source: Preqin (accessed 9/11/14)
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Trade Secret and Strictly Confidential
298 377 407 402 409563
8061,011 1,075 1,067 993 1,007 941 1,046418 374 360 465 554
675
898
1,265 1,2041,413
1,7832,029
2,3322,420
716 751 767867
963
1,238
1,704
2,276 2,279
2,480
2,776
3,036
3,273
3,466
0
500
1,000
1,500
2,000
2,500
3,000
3,500
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Unrealized Value
Dry Powder
… representing 30% of private equity assets under management 1/
1/ Includes corporate private equity (including secondary funds and funds of funds, real estate private equity, infrastructure and energy).With commitments to corporate private equity funds representing around 67% of inflows to all private equity funds, corporate private equity is likely to represent the bulk of AUM managed by global private equity firms.
Source: Preqin Annual Report (January 2014)
Global Private Equity Assets under Management (End-of-Period, USD bn)
For illustrative purposes only. There is no assurance that this trend will continue.20
Trade Secret and Strictly Confidential
Today’s unfunded commitments reflect investments over the past 5 – 6 years
Venture Capital
Mezzanine
Buyouts
Drawdowns in Percent of Capital Raised, By Vintage Year
Source: Preqin (accessed 9/11/14).For illustrative purposes only.
0%
20%
40%
60%
80%
100%
2006 2007 2008 2009 2010 2011 2012 2013 2014YTD
Drawn Unfunded
Distressed
0%
20%
40%
60%
80%
100%
2006 2007 2008 2009 2010 2011 2012 2013 2014YTD
Drawn Unfunded
0%
20%
40%
60%
80%
100%
2006 2007 2008 2009 2010 2011 2012 2013 2014YTD
Drawn Unfunded
0%
20%
40%
60%
80%
100%
2006 2007 2008 2009 2010 2011 2012 2013 2014YTD
Drawn Unfunded
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Trade Secret and Strictly Confidential
Family offices and endowments are particularly exposed to liquidity risk and commitment risk
Institution Constraints Liability profile Risk appetite
Allocation to
illiquid assets
Life insurers Liability structure, regulation, accounting
Fixed payments with average duration of 7 – 15 years
Regulatory and accounting pressures reduce the risk a life insurer is willing and able to take
2‐4%
Defined benefit pension funds
Liability structure, regulation,accounting
Fixed payments with average duration of 12 – 15 years
Regulatory and accounting pressures reduce the risk a pension fund plan sponsor is willing and able to take
8–20%
Sovereign wealth funds
Potential for short‐term public pressure to influence decisions
Minimal yearly payoutsDirect and indirect influence from public opinion/policy makers
10‐20%
Endowments/Foundations
Significant yearly payout requirements
Yearly payouts are required for beneficiaries but are proportional to the assets
Despite some pressure from the trustees to meet yearly budget targets, willing to accept short‐term volatility of illiquid assets
15‐30%
Family offices Family conservatism Minimal yearly payoutFocus on wealth preservation but willing to accept short‐term mark‐to‐market losses
25‐50%
Source: WEF (2011); Preqin (as of 9/15/14). Most recent data available used.
22
For illustrative purposes only.
Trade Secret and Strictly Confidential
Today, some endowments are even more exposed than they were during the financial crisis
Yale Investments Office Harvard Management Company
2008 2013 2008 2013
Absolute Returns 25% 18% 18% 15%
Domestic Equity 10% 6% 12% 11%
Foreign Equity 15% 10% 22% 22%
Fixed Income 4% 5% 15% 9%
Private Equity 20% 32% 11% 16%
Real Assets 29% 28% 26% 25%
Cash -4% 2% -5% 0%
23Source: Yale Investments Office and Harvard Management Company, Annual Reports (various issues).For illustrative purposes only.
Trade Secret and Strictly Confidential
Agenda
• Private Equity as an Asset Class and Investment Risks
• The Evolving Role of the Secondary Market
• Conclusions: Implications for Risk Management
24
Trade Secret and Strictly Confidential
What are secondary transactions?• Secondary transactions refer to the buying and selling of pre-existing limited
partnership interests in private equity funds (and similar vehicles focusing for example on real estate).
• These interests include both commitments that have already been drawn down by the GP and unfunded commitments.
– The transfer of investor commitments between LPs in the secondary market should not be confused with secondary buyouts where, for example, a deal is exited by a fund or sponsor selling the underlying portfolio company to another fund!
• Transactions are usually initiated by sellers. However, it is not uncommon for buy-side LPs to pro-actively source deals.
• Transactions involving individual funds or small portfolios are usually negotiated bilaterally.
• Intermediated auctions are common for larger and more complex transactions.
• A secondary transaction requires the consent of the GP.
25For illustrative purposes only.
Trade Secret and Strictly Confidential
Secondary Market Structure
BanksInsurance firmsPension fundsEndowmentsFoundations
Sovereign Wealth Funds
Secondary fundsFunds of fundsInsurance firmsPension fundsEndowmentsFoundations
Sovereign Wealth Funds
Specialized SecondaryAdvisors
General Placement
agents
General Partners
Sellers Intermediaries Buyers
26For illustrative purposes only.
Trade Secret and Strictly Confidential
What motivates sellers and buyers in the secondary market?
Sellers and their Motivations
• Liquidity needs• Dissatisfaction• Returns• Regulation• Asset allocation• Strategy• Active portfolio management• Change of group strategy
Buyers and their Motivations
• Discount• Repayment speed• Visibility versus “blind pools”• Portfolio diversification• ‘Invitation’-only funds• J-curve• Commitment pace and exposure• Investment pace
Source: Cornelius et al. (2013). Mastering Illiquidity. Wiley (Chapter 6). For illustrative purposes only. 27
Trade Secret and Strictly Confidential
Key characteristics of secondaries investing
Mix of funded assets and unfunded capital:- Funded assets (50-70%): existing portfolio
companies- Unfunded capital (30-50%): remaining undrawn
commitments to the underlying funds acquired
Asset visibility:- Funds are already invested in portfolio companies- Generally, have 2-5 years of performance data per
portfolio company
Shorter duration:- Early cash proceeds from funded assets- Less fee “drag”- Earlier full exit from a fund
Smoothens the J-Curve:- Lower risk of early book losses compared to a
primary program- Higher IRR- Less capital at work
The J-Curve of Private Equity ReturnsSecondary Investing
Retu
rns
(%)
Years
1 2 3 4 5 6 7 8 9 10
Entry Point
28For illustrative purposes only.
Trade Secret and Strictly Confidential
0
5
10
15
20
25
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
YTD
Capital Raised by Secondary Funds (USD bn)
The demand for LP stakes has risen appreciably …
Sources: Preqin, Thomson (as of 9/15/14)For illustrative purposes only. There is no assurance this trend will continue.
Com
mitm
ents
to S
econ
dary
Fun
ds U
SD b
n)
Trend line
29
Trade Secret and Strictly Confidential
… with commitments to secondary funds accounting for around 8% of total commitments to private equity partnerships
0%
2%
4%
6%
8%
10%
12%
14%
0
50
100
150
200
250
300
350
400
450
500
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014YTD
Primary Secondaries Share of Secondary Funds (rhs)30
USD bn
Source: Preqin, as of 9/15/14.For illustrative purposes only.
Trade Secret and Strictly Confidential
0
5
10
15
20
25
30
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Transaction Volume in the Secondary Market (USD bn)
Market volume has grown significantly as supply has also increased
Source: UBS (as of 3/15/14)
Trend line
USD
bill
ion
For illustrative purposes only. There is no assurance this trend will continue.
31
Trade Secret and Strictly Confidential
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
2008 2009 2010 2011 2012 2013
Other
Asset Managers & ListedVehicles
Endowments, Foundations &Family Offices
Pension Funds (Public &Corporate)
Financial Institutions (Banks& Insurers)
Who are the sellers?
Source: UBS (2013)For illustrative purposes only.
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Trade Secret and Strictly Confidential
The emergence of the secondary market has been hailed as the advent of liquidity in an otherwise illiquid asset class
Are Secondaries Discounts Really a Bargain?- Private Equity News, September 16, 2013
Secondary Deals Slow, But GPs Continue to Raise Big Funds- Wall Street Journal, September 5, 2013
Buyout fund sell-offs fuel secondary market- Financial News, July 31, 2013
A buoyant private equity secondary market- FTSE Global Markets, June 10, 2013
Secondary Market for Private Equity Heats Up- Institutional Investor, Feb 5, 2013
Nearly 100% of LPs Expect Secondary Market Activity to Match or Beat 2012 Levels- PE Hub, March 21, 2013
Rise of the non-traditional buyer- PEI, July/August 2013
Secondary Volume Hit $15B in First Half- LBO Wire, September 16, 2013
Secondary Market Volume Higher Than Previously Assumed- Deal Market, September 26, 2013
For illustrative purposes only and should not be deemed as an offer or recommendation to buy or sell any investment or participate in any strategy.
33
Trade Secret and Strictly Confidential
0%
1%
1%
2%
2%
3%
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Transaction Volume in % of private equity assets (NAV, plus unfunded commitments)
But the secondary market is still in “adolescence” and has a long way to go before it is mature
Source: UBS (2013).For illustrative purposes only.
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Trade Secret and Strictly Confidential
30%
40%
50%
60%
70%
80%
90%
100%
110%
2003 2004 2005 2006 2007 2008H1
2008H2
2009H1
2009H2
2010H1
2010H2
2011H1
2011H2
2012H1
2012H2
2013H1
2013H2
Average high bids in secondary market as a percentage of NAV
During the global financial crisis (“GFC”), the number of sellers jumped, but there were few buyers, resulting in a collapse of secondary prices …
Source: Cogent Partners (as of Q1 2014). Most recent data available used. For illustrative purposes only.
PortfolioRebalancing
Distress/Liquidity needs
Regulatory pressures
GP restructuring
Portfolio rebalancing Portfolio rebalancing
Fire sales
Basel III, CAD IV, Solvency II
Mid-life/tail end restructuring
35
Trade Secret and Strictly Confidential
50%
60%
70%
80%
90%
100%
110%
120%
0
5
10
15
20
25
30
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Volume (US$bn), lhs Price (Discount/Premum to NAV), rhs
Transaction volume in the secondary market and first-bid offer prices
… as well as volumes
Source: UBS, Cogent Partners, Q1 2014.For illustrative purposes only.
36
Trade Secret and Strictly Confidential
The price dynamics during the GFC reveal the particular characteristics of how buyers and sellers form their price expectations
• Key issue is the deviation of the price a buyer offers from the fund’s NAV provided by the GP.
• A transaction at a discount creates a loss on the seller’s books.
• Losses may be particularly painful for private equity investors as their compensation tends to be tied more closely to performance.
• Sellers tend to employ lower discount rates than potential buyers, who usually have an informational disadvantage and therefore require a higher risk premium.
• The discrepancy may be particularly large if the seller is a pension fund, which for actuarial reasons uses a low target rate of return.
• Determining the offer price for a stake in a private equity fund requires pricing each underlying portfolio company as a function of a set of key variables (EBITDA, cash position, debt, exit multiples etc).
• Valuing VC stakes tends to be even more challenging as many companies have no revenues.
• Valuing unfunded commitments is usually based on a GP’s track record and governance factors.
• Given these uncertainties, buyers typically work with different scenarios and require significant risk premiums.
• The required risk premiums vary over time, reflecting macro and market uncertainties.
The Seller’s Perspective The Buyer’s Perspective
37Source: Cornelius et al. (2013). Mastering Illiquidity. Wiley. Chapter 6.For illustrative purposes.
Trade Secret and Strictly Confidential
0
20
40
60
80
100
120
140
160
180
200
Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13
Buyout Average Fund of Funds Average Venture Average
Listed Private Equity Share Prices (December 2004 = 100)
Similarly, the share price of listed private equity, which tends to follow the NAVs of the underlying portfolio companies, fell sharply
Source: Preqin (as of 9/15/14).For illustrative purposes only.
38
Trade Secret and Strictly Confidential
During the GFC, many investors suffered substantial losses …
$0
$5
$10
$15
$20
$25
$30
$35
$40
1997 2001 2005 2009 2013
Source: Yale Investments Office; Harvard Management Company, Annual Reports (various issues).For illustrative purposes only.
Harvard Management Company: Endowment Size US$bn
$0
$5
$10
$15
$20
$25
1997 2001 2005 2009 2013
Yale Investments Office: Endowment Size US$bn
∆ 2008/09: -29% ∆ 2008/09: -30%
39
Trade Secret and Strictly Confidential
… as they became increasingly desperate for liquidity
Forbes, 26 February 2009
“Desperate for cash, Harvard Management went to outside money managers begging for a return of money it had expected to keep parked away for a long time. It tried to sell off illiquid stakes in private equity partnerships but couldn’t get a decent price. It unloaded two-thirds of a $2.9 billion stock portfolio into a falling market. And now, in the last phase of the cash-raising panic, the university is borrowing money, much like a homeowner who takes out a second mortgage in order to pay off credit card bills. Since December Harvard has raised $2.5 billion by selling IOUs in the bond market. Roughly a third of these Harvard bonds are tax exempt and carry interest rates of 3.2% to 5.8%. The rest are taxable, with rates of 5% to 6.5%.”
For illustrative purposes only. 40
Trade Secret and Strictly Confidential
But what’s the alternative? (especially in a period of extremely low interest rates)
Financial Times, 11 October 2009
“ There have been some articles that have criticized the Yale model and my role in managing the endowment. And I think that’s odd. … What is the alternative? Aside from the heroic impossible alternative of being 100 percent in treasury bills?”
David Swensen, Yale Investments Office
For illustrative purposes only.
41
Trade Secret and Strictly Confidential
Agenda
• Private Equity as an Asset Class and Investment Risks
• The Evolving Role of the Secondary Market
• Conclusions: Implications for Risk Management
42
Trade Secret and Strictly Confidential
• The secondary market represents a major innovation, with features that are of interest to both sellers and buyers, e.g.
– Portfolio management– J-curve mitigation– Faster exposure to private equity– Potentially attractive risk-adjusted returns
• Given these features, it is anticipated that the secondary market will continue to grow.
• But it is not a risk management tool.• Nor is the secondary market an appropriate mechanism to determine the fair
market value of assets held by limited partnership funds.
The secondary market should not be considered as a risk management tool
For illustrative purposes only. The views and opinions provided herein are subject to change based on market and economic conditions and may not necessarily come to pass.
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Trade Secret and Strictly Confidential
• Over-Commitment ratios (“OCR”):
–
– 1
&
– 2
, &
– Over-commitment strategies of OCR > 120% would seem increasingly imprudent, given LPs’ experience during the GFC.
Instead of relying on the secondary market, LPs should carefully monitor their commitment risk on the basis of various funding tests
Source: Cornelius, Diller, Guennoc, Meyer (2013).For illustrative purposes only.
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Trade Secret and Strictly Confidential
Risk Management
Sector Expertise
Investment teams dedicated by sector
Proprietary database of funds & underlying companies
Independent Market & Sector Research
Proprietary market research & allocation strategies
Sector views from dedicated teams
Engagement with industry leading organizations including ILPA
Prudent Portfolio Construction
Prudent approach to portfolio construction through investment selection & diversification
Proprietary asset allocation & risk management research
Integrated portfolio construction process within both diligence and global Investment Committee process
Independent Underwriting
Review underlying company operating metrics & valuations of unrealized companies
Take view on potential returns tocompare with GP view
Utilize outside experts to validate GP assumptions
J-Curve Mitigation Strategies
Complement portfolio with shorter duration strategies to lower illiquidity risk
Develop complementary portfolios to fill exposure gaps to minimize vintage year risk
Portfolio Value-Add
Utilize industry network to add value to GPs
Active board participation; including taking lead advisory board member roles
Independent diligence review & strategic introductions tomanagers
Active Monitoring
Dedicate deal leaders to manage investments throughout the life. InvestmentCommittee oversight of the process
Instill comprehensive regular investment review process
Re-underwriting of investments within the reviews
Legal Review / Framework
Access to internal legal experts to negotiate terms & improve alignment of interests
Access to internal experts to understand regulatory & tax considerations of investment structure
Develop relationships with LPs to compare notes on market terms
Risk / Return Benchmarking
Multi-stage investment process with input from IC throughout the process
Internal & external databases to assess risk / return
Managing commitment risks should be part of an holistic risk management approach
Funding Tests
Ensuring that capital calls can always be met
Optimizing commitment strategies
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For illustrative purposes only.
Trade Secret and Strictly Confidential
Further reading
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Trade Secret and Strictly Confidential
Thank you!
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