The Secondary Market: A Panacea for the I lliquidity in Private - - PowerPoint PPT Presentation

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The Secondary Market: A Panacea for the I lliquidity in Private Equity I nvestm ents?

Peter Cornelius October 23, 2014

For the exclusive use of attendees at the CFA Conference and m ay not be redistributed.

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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. 2

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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

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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

4

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Trade Secret and Strictly Confidential

$2 $19 $87 $113 $716 $1,238 $2,776 $3,466 500 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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Trade Secret and Strictly Confidential

… with commitments to private equity funds having regained considerable momentum since the global financial crisis

100 200 300 400 500 600 700 800 900 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 Commitments (US$bn) Number 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
• ther 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

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For illustrative purposes only.

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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

9

1/ 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.

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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 for partnerships Placement agents for issuers

• 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 capital

structure (financial restructuring and distress)

• change in ownership

(retirement of owner, corporate spinoffs)

Public Companies

• Management or

LBO

• Financial distress
• Special situations

Cash flow LP interest Cash flow Equity claim on intermediary Cash flow, Corporate governance, consulting Private equity securities

10

For illustrative purposes only. Source: P. Cornelius (2011), International Investments in Private Equity. Elsevier, 2011.

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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-grade corporate bonds Government bonds

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

%

5 10 15 20 25

5 years 10 years 20 years

Buyouts S&P 500 5 10 15 20

5 years 10 years 20 years

Buyouts & Growth Capital MSCI World 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, 2014 Source: 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.

5 10 15 20

5 years 10 years 15 years

Buyouts MSCI Europe

Europe

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Trade Secret and Strictly Confidential

... 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

Public Market Equivalent (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.

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Trade Secret and Strictly Confidential

… reflecting the characteristics of the underlying investments

Short-term bonds Long-term bonds Public equity Corporate bonds Commodities Hedge funds CDOs Buyout funds Real Estate VC funds Public equity - Strategic Direct buyouts Oil & gas Timber Direct VC Infrastructure

Less Liquid More Liquid 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

• f 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

• f AlpInvest or Carlyle itself.

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Trade Secret and Strictly Confidential

Standard cash flow models work well in normal times … 1 2 3 4 5 6 7 8 9 10 11 12 Investment Period Divestment Period Extension period Life Time of a Private Equity Fund (Years) Net Cash flow

Contributions Distributions

17

For illustrative purposes only.

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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

363 350 461 665 834 896 878 810 838 785 890 973

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

298 377 407 402 409 563 806 1,011 1,075 1,067 993 1,007 941 1,046 418 374 360 465 554 675 898 1,265 1,204 1,413 1,783 2,029 2,332 2,420 716 751 767 867 963 1,238 1,704 2,276 2,279 2,480 2,776 3,036 3,273 3,466

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.

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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 2014 YTD

Drawn Unfunded

Distressed

0% 20% 40% 60% 80% 100%

2006 2007 2008 2009 2010 2011 2012 2013 2014 YTD

Drawn Unfunded 0% 20% 40% 60% 80% 100%

2006 2007 2008 2009 2010 2011 2012 2013 2014 YTD

Drawn Unfunded 0% 20% 40% 60% 80% 100%

2006 2007 2008 2009 2010 2011 2012 2013 2014 YTD

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 payouts Direct 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 payout Focus 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.

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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%

23

Source: Yale Investments Office and Harvard Management Company, Annual Reports (various issues). For illustrative purposes only.

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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

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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

• n 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

.

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For illustrative purposes only.

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Trade Secret and Strictly Confidential

Secondary Market Structure

Banks Insurance firms Pension funds Endowments Foundations Sovereign Wealth Funds Secondary funds Funds of funds Insurance firms Pension funds Endowments Foundations Sovereign Wealth Funds Specialized Secondary Advisors General Placement agents General Partners

Sellers Intermediaries Buyers

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For illustrative purposes only.

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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.

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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 Returns Secondary Investing

Returns (%) Years 1 2 3 4 5 6 7 8 9 10 Entry Point

28

For illustrative purposes only.

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Trade Secret and Strictly Confidential

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.

Commitments to Secondary Funds USD bn)

Trend line

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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% 50 100 150 200 250 300 350 400 450 500

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 YTD

Primary Secondaries Share of Secondary Funds (rhs)

30 USD bn

Source: Preqin, as of 9/15/14. For illustrative purposes only.

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Trade Secret and Strictly Confidential

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 billion

For illustrative purposes only. There is no assurance this trend will continue.

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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 & Listed Vehicles 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

• r 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.

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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 2008 H1 2008 H2 2009 H1 2009 H2 2010 H1 2010 H2 2011 H1 2011 H2 2012 H1 2012 H2 2013 H1 2013 H2

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.

Portfolio Rebalancing Distress/ Liquidity needs Regulatory pressures GP restructuring

Portfolio rebalancing Portfolio rebalancing Fire sales Basel III, CAD IV, Solvency II

Mid-life/tail end restructuring

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Trade Secret and Strictly Confidential

50% 60% 70% 80% 90% 100% 110% 120% 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.

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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

37

Source: Cornelius et al. (2013). Mastering Illiquidity. Wiley. Chapter 6. For illustrative purposes.

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Trade Secret and Strictly Confidential

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.

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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%

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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.

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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.

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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

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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
• rganizations 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
• perating metrics & valuations of

unrealized companies

• Take view on potential returns to

compare 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 to managers

Active Monitoring

• Dedicate deal leaders to

manage investments throughout the life. Investment Committee 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

45

For illustrative purposes only.

SLIDE 46

Trade Secret and Strictly Confidential

Further reading

46

SLIDE 47

Trade Secret and Strictly Confidential

Thank you!

47