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.

2


Agenda

• Private Equity as an Asset Class and Investment Risks

• The Evolving Role of the Secondary Market

• Conclusions: Implications for Risk Management

3


Agenda




4


$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.

5


… 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)

6


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.

7


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.


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.


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.


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.

11


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


Buyouts & Growth Capital MSCI World

0

5

10

15

20


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


Buyouts MSCI Europe

Europe

12


... 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)

13


• 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


… 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.

15


• 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.

16


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



… 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.

18


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)

19


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


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

21


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



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.


Agenda




24


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.



Secondary Market Structure

BanksInsurance firmsPension fundsEndowmentsFoundations


Secondary fundsFunds of fundsInsurance firmsPension fundsEndowmentsFoundations


Specialized SecondaryAdvisors

General Placement

agents

General Partners

Sellers Intermediaries Buyers



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


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



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


… 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.


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


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.

32


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


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.

34


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


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


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.


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


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


… 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


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


41


Agenda




42


• 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.

43


• 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.

44


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

45


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