En Route to Financial Health? Three Business Drivers to Consider - - PDF document

4/23/2020 1

En Route to Financial Health? Three Business Drivers to Consider During COVID-19

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4/23/2020 2

Nicholas J. Wallace, CPA, CGMA

Director, BKD CPAs & Advisors

Jonathan Swanson, CAIA

Institutional Consultant, Graystone Consulting

Today’s Presenters

“You Cannot Fix What You Will Not Face”

– James Baldwin

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“I Cannot Change the Direction of the Wind, but I Can Adjust My Sails to Reach My Destination”

– Jimmy Dean

› “A sustainable business model is one in which colleges streamline their academic offerings based on mission (What are we good at?), market (What do students want and need?), and margin (How can we generate net revenue for reinvestment?)” › An analysis by the education consulting firm rpk GROUP consistently shows that two-thirds of an institution’s undergraduates major in no more than 12 programs

Source: Rick Staisloff, Chronicle of Higher Education, March 31, 2020

Regional Public Universities

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Prepare for a specific job or career Increase financial opportunities Stay competitive in today's job market Strengthen critical thinking and writing skills Growth in leadership skills Discover who you are Learn about academic interest Learn how to make a difference in the world Develop moral character Encourage spiritual growth

7.0% 14.0% 22.0% 25.0% 27.0% 30.0% 36.0% 48.0% 55.0% 69.0% 7.0% 14.0% 22.0% 23.0% 26.0% 31.0% 36.0% 51.0% 56.0% 70.0% 0.0% 20.0% 40.0% 60.0% 80.0%

Encourage spiritual growth Develop moral character Learn how to make a difference in the world Learn about academic interest Discover who you are Growth in leadership skills Strengthen critical thinking and writing skills Stay competitive in today's job market Increase financial opportunities Prepare for a specific job or career

Purpose for Going to College

Self-Identified Christians All U.S. Adults

Purpose for Going to College

For Faith-Based Schools, Which Is Rated Highest? As summarized from data on the National Center for Education Statistics website

What Programs Are Growing?

Source: As summarized from data at the National Center for Education Statistics website

8

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Have You Stress Tested Your Institution Lately?

What is your next step to preventing an unpleasant set of conditions?

• Major program cuts & layoffs
• Major reductions of services for students
• Closure of portions of the operation

How long will your reserves last?

Massachusetts Law Passed in November 2019

Requirement for All Colleges

• 1. Notification of the State Board

regarding the existence of the risk of imminent closure

• 2. Annual assessment of the risk of

imminent closure based on an annual financial screening

• 3. Fines, suspended funds & degree

granting authority

• 4. Required training for campus

governing board members

State of Massachusetts Act to Support Improved Financial Stability in Higher Education (H4099)

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So Where Is Your Institution?

Source: Current State of Financial Health for Private Masters and BACC Institutions, Attain Oct. 2018 P. 4

‐4 ‐3 ‐2 ‐1 1 2 3 4 5 6 7 8 9 10

MODIFIED SCALE FOR CHARTING CFI PERFORMANCE

Critically Unhealthy Surviving Thriving Barely Surviving

‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐

The Teaching Institution Economic Model

› Three distinct centers of operational activity that generate economic return

• Academic core
• Auxiliaries (food service, housing, bookstores & coffee shops, parking, health

systems, real estate development, sports)

• Philanthropy & capital (giving, investment return, financing)

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Academic Programs Auxiliary Enterprises Capital Management & Philanthropy

Instruction Tuition & Fees $ 41,655,470 Less Institutional Aid $ (15,495,387) -37% Government Appropriations Instruction $ (18,449,103) -44% Margin $ 7,710,980 19% Margin Funding Academic Support $ (2,633,608) Student Services $ (9,809,024) Institutional Support $ (5,529,902) Net Margin $ (10,261,554) -25% Auxiliary Enterprises Sales & Services $ 6,293,136 Auxiliary Service Expense $ (6,993,619)

• 111%

$ (700,483) $ (700,483)

• 11%

Capital Management & Philanthropy Investment Income $ 1,180,482 Private Gifts – Nonoperational Private Gifts – Operational $ 2,833,180 Endowment Gifts Interest Rate Gain on SWAP Change in Value – Split Interest Gifts Interest on Operating Funds Other Income $ 622,619 $ 4,636,281 Interest Cost Allocated Fundraising Expense $ (94,201) Loan Cancellation Allocated $ 4,542,080

Net Loss – $6,419,957

Revenue Cost & Margin Analysis

Private School #1 – Small School

Enrollment 2,502 (’17) Endowment $13,129,960 Grad School: Yes Academic Programs Auxiliary Enterprises Capital Management & Philanthropy

Revenue Cost & Margin Analysis

Private School #2 – Larger School

Enrollment 5,204 (’18) Endowment $432,000,000, Grad School: Yes

Instruction Tuition and Fees 138,416,775 $ Less Institutional Aid (63,334,552) $ Government Grants 5,294,081 $ 80,376,304 $ Instruction Delivery Cost (46,484,926) $ Margin 33,891,378 $ 42% Margin Funding: Academic Support (12,950,532) $ Student Services (29,831,393) $ Institutional Support (25,760,969) $ Public Service, Research and Media (2,949,489) $ Net Margin (37,601,005) $ ‐47% Auxiliary Enterprises Sales and Services 20,829,788 $ Auxiliary Service Expense (21,279,025) $ Net Gain (Loss) (449,237) $ ‐2% Capital Management and Philanthropy Investment Income 20,728,073 $ Private Gifts ‐ Operational 7,374,855 $ Private Gifts ‐ Non‐Operational 42,010,456 $ Change in Value Split Interests 1,991,138 $ Other Income 6,505,989 $ Fundraising Expense (4,182,072) $ Endowment & Plant contributions 8,195,347 $ Net Return 82,623,786 $

Change in Net Assets $44,573,544

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Academic Programs Auxiliary Enterprises Capital Management & Philanthropy

Revenue Cost & Margin Analysis

Public School #1 (Large Public)

Enrollment (’18) 44,474 Endowment $3.3B Grad School: Yes

Instruction Tuition and Fees 1,037,216,000 $ Less Institutional Aid (145,279,000) $ Government & Other Grants and Contracts 405,179,000 $ 1,297,116,000 $ Instruction Delivery Cost (1,351,618,000) $ Margin (54,502,000) $ ‐4% State Appropriations 398,143,000 $ Margin Funding: Academic Support (213,981,000) $ Student Services (47,874,000) $ Institutional Support (279,731,000) $ Public Service, Research and Media (146,278,000) $ Net Margin (344,223,000) $ ‐27% Auxiliary Enterprises Sales and Services 377,393,000 $ Auxiliary Service Expense (231,617,000) $ Net Gain (Loss) 145,776,000 $ 39% Capital Management and Philanthropy Investment Income 125,711,000 $ Private Gifts ‐ Operational 91,659,000 $ Private Gifts ‐ Non‐Operational Change in Value Split Interests Other Income 88,027,000 $ Fundraising& Interest Expense (29,687,000) $ Endowment & Plant contributions 96,515,000 $ Net Return 372,225,000 $

Net Income $173,778,000

(13% of Net tuition & grants)

Academic Programs Auxiliary Enterprises Capital Management & Philanthropy

Revenue Cost & Margin Analysis

Public School #2 Small Public

Enrollment 9,454 (’18) Endowment $51,849,060 Grad School: Yes

Instruction Tuition and Fees 111,630,154 $ Less Institutional Aid (42,834,365) $ Government & Other Grants and Contracts 28,794,657 $ 97,590,446 $ Instruction Delivery Cost (107,416,840) $ Margin (9,826,394) $ ‐10% State Appropriations 45,344,100 $ Margin Funding: Academic Support (9,953,325) $ Student Services (16,563,970) $ Institutional Support (19,094,877) $ Public Service, Research and Media (6,570,379) $ Net Margin (16,664,845) $ ‐17% Auxiliary Enterprises Sales and Services 44,233,077 $ Auxiliary Service Expense (27,014,680) $ Net Gain (Loss) 17,218,397 $ 39% Capital Management and Philanthropy Investment Income 3,191,632 $ Private Gifts ‐ Operational 1,369,510 $ Private Gifts ‐ Non‐Operational 403,899 $ Change in Value Split Interests Insurance recovery 4,040,459 $ Fundraising& Interest Expense (1,829,489) $ Endowment & Plant contributions 8,553 $ State capital Contribution 4,378,656 $ Net Return 11,563,220 $

Net Income $12,116,772

(12% of Net Tuition & Grants)

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Healey’s Rule (Law) of Holes, First Law of Holes Denis Healey, a U.K. Member of Parliament & former Chancellor of the Exchequer, famously commented “Follow the rule of holes; if you are in one, stop digging” There is a corollary to Healey’s law, variously expressed as “When your opponent is in a hole and digging, for god’s sake don’t stop him” or alternately “Why would you want to take away his shovel?”

Financial & Operational Characteristics of Stress

• 14 financial characteristics

Academic & Leadership Stress

• 8 academic & leadership indicators

Building Awareness

The First Step Toward Solution – Creating a Sense of Urgency

14

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Example Financial Stress Dashboard

Example College 2018 2017 2016

Overall tuition discount rate of less than 50% Yes Yes Yes GAAP-based change in unrestricted net assets 4% or more

• f operating revenue

No No No Long-term debt equaling less than 50% of annual operating revenue No No No Debt service (principal & interest) not to exceed 5% of

• perating revenue

Yes Yes Yes Total salary & benefit costs not to exceed 65% of total

• perating revenue

Yes Yes Yes Total salary & benefit costs not to exceed 90% of net tuition revenue Yes Yes Yes Student to faculty ratio of 15 to 1 or greater No No No

Strategy for the Path Forward

• 1. Fix the academic core – Discover the details of academic

financial margins & markets

• 2. Find alternative revenue – Make full use of all resources
• 3. Facilitate cost reduction – Set targets & unleash faculty &

staff creativity to suggest direction & goals

• 4. Model the effectiveness of the decisions for three to five

years out

Steps to Regain or Retain Financial Stability

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Recognize: The Emotional Path of Change

Exploration Resistance Commitment Denial

Shock Nostalgia Hope Testing Excitement Detachment Turmoil

Time

Study Searching Focus

• 1. Start with urgency (everyone needs to see it, not just leadership)
• 2. Assigned to a small group (motivated & skilled team)
• 3. Who develop a change strategy & vision
• 4. & communicate that effectively creating buy-in
• 5. Then empower teams to act to solve problems to
• 6. Produce short-term wins initially, then
• 7. Stay at it to seal the new behaviors that lead to
• 8. Changing the culture

Successful Financial Stability Processes

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› How do I fix the academic core?

• Academic margin review to prune poor performers that are not

mission critical & supply existing & potential programs that can drive margin with additional funding

• Academic program markets analysis to rank existing programs &

research potential new programs taking advantage of your specific marketplace

• Scenario-based modeling to project the impact of reductions &

additions of programs & the facility changes that might be required

Right Place, Right Time, Right Program

MARGIN MODELING MARKETS

MISSION

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Characteristics of an effective academic programs review

• 1. Great data (at both the student & the program level)
• 2. Great visualization (a picture is worth a thousand words)
• 3. A sense of urgency (people willing to make change happen)
• 4. Leadership buy-in (leaders clearing the path for change)
• 5. Great modeling of the resulting efforts (a clear picture of the path

forward)

Right Place, Right Time, Right Program

Margin Modeling Markets

MISSION

Margin Analysis Tools

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Margin Modeling Markets

MISSION

Margin Analysis Tools

Margin Modeling Markets

MISSION

Margin Analysis Tools

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Student Demand Competitive Environment Employment Degree Fit

Academic Program BI Platform

Margin Modeling Markets

MISSION

Student Demand Competitive Environment Employment Degree Fit

Academic Program BI Platform

Applications Inquiries Market Research BLS Data Burning Glass American Community Survey – Census IPEDS Internal Research

Margin Modeling Markets

MISSION

Program Outcomes Connected to Work Requirements (CIP to SOC Crosswalks)

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Program Ranking Report

Margin Modeling Markets

MISSION

Program Scoring Details

Margin Modeling Markets

MISSION

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Seeing the Financial Impact

• n Major Financial

Areas Such as “Assets” by Scenario Selected & by Projection Year Is Valuable

Margin Modeling Markets

MISSION

Scenario-Based Modeling Example

Margin Modeling Markets

MISSION

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› Once you have data & a team identified, you may find the guidance based on the book Leading Change by Dr. John Kotter from Harvard Business School helpful › Reengineering the University: How to be Mission Centered, Market Smart and Margin Conscious, William F. Massy, 2016, Johns Hopkins › Resource Management for Colleges and Universities, William F. Massy, 2020 (to be released June 2020)

Resources for the Path Forward

William F. Massy writes that resource allocation in colleges and universities needs to become more responsive to academic mission, marketplace realities, and the requirements of financial sustainability. “Such improvement is needed,” he asserts, “because few institutions currently have the evidence, know-how, and cultural capacity to take advantage

• f modern information systems and models”

Resources for the Path Forward

Source: Resource Management for Colleges and Universities. To be released June, 2020

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bkd.com | @BKDNFP @BKDHigherEd

The information contained in these slides is presented by professionals for your information only & is not to be considered as legal advice. Applying specific information to your situation requires careful consideration of facts & circumstances. Consult your BKD advisor or legal counsel before acting on any matters covered

Nick Wallace | nwallace@bkd.com

Capital & Philanthropy

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• Purpose of Endowment Accumulation
• Allocations & Return Forecasts
• Philanthropy
• The Bear Has Arrived
• Attractive Investment Themes

Agenda

Purpose of Endowment Accumulation

Understand Your ‘Why’

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“The Trustees of endowed institutions are the guardians

• f

the future against the claims of the present. Their task is to preserve equity among generations.”

– James Tobin

Endowment Purpose Maintain Independence Create Margin

• f Excellence

Provide Stability

Purpose of Endowment Accumulation

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1. Maintain/grow long-term purchasing power to fund in the future the same level of activities that it currently supports  Drives intergenerational equity  Requires fiduciaries to seek returns that preserve the value of assets + inflation  New gifts should increase AUM – NOT offset inflation erosion  This tenant requires an equity bias 2. Provide current

• perating

support to the institution

Grow Purchasing Power Support Operations High Risk/High Return Low Risk/Low Return Accepts Volatility Accepts Muted Returns Long Term Goal Near-Term Goal Future Generations Present Generation Volatility Time Horizon Key Issue/Conflict The high risk/high return policy best suited for purchasing power preservation conflicts with… … the low risk/low return approach more likely to produce a stable payout to the operating budget

Balancing the Conflict

 Attempts to resolve the tension between the two conflicting goals on the prior page  Instills financial discipline  While some are complicated, most spending policies are a specified rate applied to a percentage of a moving average  i.e. 5% of a trailing three-year ending market value  Smoothing effect helps enhance the stability of your annual spend, but it spreads the pain over a longer time period

Primary Tool: Spending Policy

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Key Considerations 1) The percentage of your operating budget funded by your endowment payout 2) Trends in the institution’s net tuition revenue & expenses 3) Expected level of gifts & the reliability of those gifts 4) The amount & cost of any debt that you may have 5) Expected capital expenditures 6) Your investment committee’s comfort with risk & illiquidity

Endowment Risk Factors

‒ Multi-variant total enterprise stress testing model built in VBA-Excel & Python Proprietary Application

Endowment Stress Testing

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60% Public Equity 40% Fixed Income 100% Fixed Income

Probability of Maintaining Purchasing Power (%) Probability of a Disruptive Drop in Spending (%)

You want to be here! You DO NOT want to be here!

50% Public Equity 20% Fixed Income 10% Private Equity 10% Real Assets 10% Absolute Return 100% Public Equity 70% Public Equity 30% Fixed Income

Policy Allocation Drivers

Your Policy Allocation Should Be Crafted to Meet YOUR Needs

Return Forecasts & NACUBO Allocations

4/23/2020 25

Low Return Forecasts Put Distribution Rates & Philanthropy on Hot Seat

Capital Market Return Forecasts

Medium Term Nominal Forecasts

GMO Morgan Stanley JP Morgan BlackRock Callan Northern Trust Expected Return Average (Ex GMO) 25-Year Historical Average % Decrease

US Equity (S&P 500)

• 2.7%

4.8% 5.6% 4.5% 7.0% 5.7% 5.5% 8.3%

• 33.5%

Developed International Equity (MSCI EAFE) 1.4% 6.9% 7.2% 8.4% 7.0% 6.0% 7.1% 4.6% 55.4% Emerging Markets Equity (MSCI EM Index) 5.7% 7.7% 9.2% 5.2% 7.3% 6.1% 7.1% 9.0%

• 21.1%

US Core Fixed Income (BC US Aggregate Index) 0.2% 1.5% 3.1% 1.3% 2.8% 3.0% 2.3% 4.2%

• 44.0%

High Yield Bonds (BC US High Yield Index)

• 2.8%

5.2% 4.0% 4.7% 4.8% 4.3% 6.6%

• 34.7%

Private Equity (Cambridge Associates)

• 9.0%

8.8% 13.0% 8.5% 7.7% 9.4% 14.0%

• 32.9%

Hedge Funds (HFRI Fund Weighted Composite Index)

• 4.7%

4.5% 4.9% 5.0% 3.7% 4.6% 7.3%

• 37.5%

70/30 Portfolio

• 1.8%

3.8% 4.9% 3.5% 5.7% 4.9% 4.6% 6.6%

• 31.3%

Inflation 2.2% 2.0% 2.0% 2.0% 2.0% 2.2% 2.0% 2.2%

• 7.7%

Real Return

• 4.0%

1.8% 2.9% 1.5% 3.7% 2.7% 2.5% 4.4%

• 43.1%

Forecast Range (Years) 7 7 10 5 10 5 Forecast Date Dec 2019 Mar 2020 Jan 2020 Dec 2019 Jan 2020 Dec 2019

Sources: CMA reports from each respective firm; asset class performance and inflation data sourced from Bloomberg

‒ Largest endowments have ~50% less exposure to public equities than smallest endowments ‒ Largest endowments have de minimus exposure to fixed income ‒ Largest endowments have 14x more private equity & 5x more hedge fund exposure than the smallest endowments ‒ Smallest endowments have a heavy US home country equity bias (75/25 US/Non-US)

US Equities Non-US Equities Fixed Income1 Public Real Assets2 Hedge Funds Private Equity3 Private Credit Private Real Estate Cash & Equivalents $25mm & Under 48% 14% 26% 2% 4% 2% 1% 1% 4% $25-50mm 41% 17% 23% 2% 7% 3% 1% 2% 4% $50-100mm 37% 19% 22% 2% 10% 6% 1% 2% 2% $100-250mm 34% 21% 17% 3% 11% 9% 1% 3% 3% $250-500mm 26% 21% 13% 2% 16% 14% 1% 5% 3% $500mm-1bn 24% 21% 12% 3% 17% 17% 2% 3% 3% $1bn+ 15% 17% 7% 2% 21% 28% 1% 7% 3%

NACUBO Size Cohort4 Asset Class

NACUBO Allocation Data

Allocations Vary Based On Endowment Size

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$25mm & Under $25- 50mm $50-100mm $100- 250mm $250- 500mm $500mm- 1bn $1bn+ 7-Year Return Forecasts1 4.3% 4.5% 4.8% 5.1% 5.5% 5.6% 6.2%

1 Annualized compunded return estimates per Morgan Stanley Capital Market Assumptions

NACUBO Size Cohort

‒ Return drivers for larger endowments include: (1) private equity, (2) growth equity, (3) venture capital, (4) non-US equities, (5) private real estate & (6) manager selection alpha ‒ Median PE returns are better than no PE returns ‒ Essential to model your institutions illiquidity tolerance via Total Enterprise Endowment Management model

NACUBO Cohort Return Forecasts

Return Projections Based on Endowment Size Cohort

Philanthropy

4/23/2020 27

Endowment Return Philanthropy

Dual-Pronged Approach

Cohesive Endowment Growth Economic Crisis Action Plan

I. Make plans to extend any active campaigns II. Redirect development resources to immediate student needs like emergency funds through grants & scholarships

• III. Keep your annual fund up & running & include phonathons since your

prospects are tied to their homes

• IV. Pivot major giving resources to planned giving efforts
• V. Increase alumni contact that does not have an ask attached
• VI. Stay ahead of the curve by offering innovative charitable vehicles

Recession Strategy Tool Kit

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‒ DAFs are the fastest growing & most active type of giving vehicle in philanthropy

Source: National Philanthropic Trust 2017 Annual Report

Contributions to Donor-Advised Funds as % of Total Giving

Donor-Advised Funds

Rapid Growth Is Only Accelerating

The Bear Has Arrived

COVID-19 & Oil Market Collapse

4/23/2020 29

“There are decades when nothing happens, and there are weeks where decades happen”

 One of the greatest pandemics to reach our shores since the Spanish Flu over 100 years ago  The greatest economic contraction since the Great Depression, which ended 80 years ago  The greatest oil price decline in the OPEC era (& possibly ever)  The greatest Central Bank/Government intervention of all time

What Have the Last Six Weeks Given Us?

Besides an Ulcer Dual Economic Shocks

How Did It Happen?

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Current Bear Market – Fastest in History Long Treasuries

• vs. S&P

500

Long-Term Treasuries (Vanguard) S&P 500

‒ Correlations across effectively all asset classes spiked to one in the third week of March ‒ Safe haven assets like long-term government bonds & other high- quality fixed income ceased working to hedge to risk assets

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Past 25%+ SPX Declines & Recoveries

V Bottoms Are Rare

Characteristics of a Bear

4/23/2020 32

• 1. Yield Curve Inversion. Some strategists understated last year’s curve

inversion suggesting this time was different. This time was not different

• 2. WeWork. Sorry, but the business of taking on long-term leases for top dollar

as liabilities & then expecting to be profitable by leasing the space out in the short-term was never a full cycle strategy

• 3. Covenant-lite

leveraged bank lending. No financial reporting, no restrictions…no problem? That is, until credit tightens, or the rating agencies downgrade the leveraged loan space pre-empting the distribution of loans into the now voided space of CLO underwriting This Time Was NOT Different

Signs of Excess

• 4. Unicorns with operating losses. Okay, so who now wants to pay for

those operating losses hoping that these “bad pennies” can be profitably passed off to the IPO market?

• 5. Retail commercial space. There’s too much of it.
• 6. Massive share repurchases, financialization of the economy, & re-

leveraging of the Fortune 500. EPS accretes in the good times while fallen angels proliferate in the bad

• 7. The relentless expansion of private equity. PE drove over 60% of LBO

deals to leverage beyond 6x, in many cases justified with EBITDA add- backs This Time Was NOT Different

More Signs of Excess

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Surge in Temporary Layoffs

How Temporary?

Source: Morgan Stanley Research

Where to from Here?

When Will the Economy Rebound? How Strong Will It Be?

4/23/2020 34

2000–2003 Bear Market

Dead Cat Bounces Recovery Supported by Record Stimulus

4/23/2020 35

Importance of Portfolio Rebalancing

Attractive Investment Themes

Never Let a Good Crisis Go to Waste

4/23/2020 36

• Bull markets are unique in that the leaders in one expansion are almost

never the leaders in the next

• 2000s: emerging markets & commodities
• 2010s: technology, technology, technology (FANGS)
• 2020s: ?
• Difficult to predict what investors will fall in love with in a bull market
• Crises, however, tend to be more alike
• A recent academic study found that standard models for predicting returns

in equity markets are 8x as predictive during recessions as during expansions Slugging Percentage More Important Than Batting Average

Opportunistic Crisis Investing Hardest Hit Become Best Performers

4/23/2020 37

Current Investment Themes

• Small Cap Value
• Distressed-for-Control Strategies
• Private Equity Secondaries
• Energy Public Equity

Source: Bloomberg

Small Cap Value

4/23/2020 38

Date Small Cap Growth Small Cap Value Large Cap Growth Large Cap Value 1/31/1970 41% 44% 33% 33% 3/31/1974 35% 35% 14% 30% 3/31/1982 102% 91% 67% 55% 10/31/1987 17% 30% 18% 25% 3/31/2001

• 28%

14%

• 20%
• 28%

9/30/2008 37% 31% 32% 19% Average 34% 41% 24% 23%

12M Returns Starting 3 Months from a 20% Decline in the S&P 500

Date Small Cap Growth Small Cap Value Large Cap Growth Large Cap Value 1/31/1970 61% 50% 55% 44% 3/31/1974 53% 75% 22% 73% 3/31/1982 45% 100% 44% 66% 10/31/1987 21% 32% 39% 41% 3/31/2001

• 24%

11%

• 19%
• 31%

9/30/2008 78% 66% 52% 29% Average 39% 56% 32% 37%

24M Returns Starting 3 Months from a 20% Decline in the S&P 500

Small Cap Value Distressed Debt

Default Rates Will Increase – Creating Opportunities

4/23/2020 39

Overleveraged & Under-Protected

Distressed Debt

Number of Distressed Bonds Traded

• Increased from ~100 to 750+ in literally 30 days
• Surpasses 2009 GFC high water mark

Source: Bloomberg

Distressed Debt

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‒ Restructuring Discussions Begin ‒ Creditors Engage Debtor ‒ Judicial Filings or Ad Hoc Process

Value Time

‒ Financial Stress ‒ Deteriorating Credit Ratios ‒ Cash Flow Pressures ‒ Bank Covenant Defaults ‒ Reluctant Financial Sellers ‒ Impending Payment Default ‒ Vender Nervousness ‒ Widening Bid-Offer Spreads ‒ Par Investors Sell to Vultures ‒ Payment Other Defaults ‒ Restructuring Terms Reached (Judicial or Negotiated) ‒ Reorganization Implemented ‒ Operational Focus ‒ High Yield Buyers Start Buying Restructured Debt ‒ Return to the Financing Market

Investment Opportunity Monetization Opportunity

‒ Financial Conditions Stabilized ‒ Secondary Trading Market Becomes Active

Distressed Debt

Lifecycle of a Distressed Opportunity What Are PE Secondaries Transactions?

Private Equity Secondaries

4/23/2020 41

Highest Median Net IRRs

Private Equity Secondaries

Highest Median Net IRRs

Private Equity Secondaries

Next Move is Down

4/23/2020 42

Discounts Are Widening

Private Equity Secondaries

• Starting to see early signs of investors defaulting on their PE commitments

which has created opportunities in secondary markets

• Discounts were 5-15% in January & are now around 40-60% due to

portfolios being marked to current environment & uncertainty around the duration of the economic shutdown

• There has been a shift from courting sellers that wanted to sell, to courting

sellers that need to sell (i.e. investors that could default & don’t have other liquidity options are the ones that can stomach big discounts) Nothing Works at $10 Crude Oil

Energy Public Equity

• Super contango means future

prices are much higher than current oil prices

• The decrease in demand from

COVID-19 dwarfs the supply glut in size & impact to the price

• Demand will slowly come back
• Nothing is profitable at $10 oil

4/23/2020 43

Thanks!

Jonathan Swanson Graystone Consulting Institutional Consultant jonathan.swanson@msgraystone.com (515) 224-5544

Questions?

4/23/2020 44

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