Private Equity Explained September 2007

watsonwyatt.
com
US | August 2007
private equity explained
4 What is private equity? Introducing the world of private equity. 13 Fund of funds or direct investment The route into private equity investment depends on the experience of the investor.
24 Private equity going forward 38 Distressed investing is the pace sustainable? Growing numbers of What does the future hold for investment managers are this asset class? raising specialised funds to invest in distressed companies.
Table of contents
Introduction What is private equity? Introducing the world of private equity. Building and maintaining an allocation Understanding the time and skill needed to maintain a private equity allocation. Fund of funds or direct fund investment? The route into private equity investment depends on the experience of the investor. Measuring private equity performance Trustees need to understand what they should measure, when and why. Fees, and other terms and conditions As private equity is the most expensive asset class in terms of fees paid to managers, this is a crucial area to understand. 3 4 8
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16
20
Private equity going forward is the pace sustainable? 24 What does the future hold for this asset class? The secondary market in private equity Why has this market emerged? What does it mean for potential investors? Co-investing in private equity Taking direct stakes in portfolio companies alongside other investors has both advantages and drawbacks. Distressed investing Growing numbers of investment managers are raising specialised funds to invest in distressed companies. How to manage conicts of interests Investors need to be aware of potential mineelds. Publicly listed vehicles Gaining a public listing benets private equity managers more than their investors. Glossary of terms The private equity team 31
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38
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52 53
For more information on any of the articles in Private equity explained, please contact one of the private equity team, page 53.
2 | Private equity explained
Introduction
Private equity has been hitting the headlines recently as a result of a spate of high prole transactions, managers raising ever larger funds and press comment about the proportion of the workforce that is now employed by private equity-backed companies. There has also been plenty of negative comment about the amount of leverage that is being used to nance these deals and concerns of a possible blow up. Against this background, we are seeing growing interest in the asset class as part of investors attempts to diversify their investment strategies and to gain exposure to different return drivers. But is now the right time to invest, how can an investor get the most out of their private equity programme and what should investors be aware of in developing exposure to this asset class? In this publication, we aim to address many of the concerns and issues that our clients have raised with us over the past 12 to 18 months. For some clients, coming to the asset class for the rst time, there is a need to understand the nature of the asset class and the mechanics of how to build and maintain a programme. For other investors, with existing private equity programmes that are focused on fund of funds (FoF) strategies, the issues might relate more to the pros and cons of a direct private equity strategy for at least part of their programme. Both types of investor are asking questions about the ow of money into private equity and the impact this could have on expected returns going forward. In later sections of the booklet we discuss some different parts of the private equity opportunity set, which might
have applications for some investors. The secondary market for private equity is now a very well-developed segment and arguably more efciently priced than it was 10 years or so ago. However, it still offers some advantages, particularly for clients building a programme from scratch and looking for some quick exposure to the asset class, and to prior vintage years and funds that are no longer open. Distressed or turnaround investing might also have a place in most private equity programmes, especially if the environment for private equity gets tougher. Finally, we cover some more specic issues for the private equity asset class including fees (they are high) and the potential conicts of interest that some managers might have, and how to ensure these conicts are managed. We also talk about how to determine whether a manager is doing a good job and how to benchmark this asset class. Private equity can be a highly rewarding asset class; some of the smartest asset managers around have migrated to this area and some of the most successful investors have large allocations to the private equity space. But it is a challenging asset class in terms of governance and investors need to be aware of all the issues if they are going to build a successful private equity programme.
rivate equity has been P hitting the headlines recently as a result of a spate of high prole transactions
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What is private equity?

Investing in private equity, once a minority pursuit for institutional investors, is becoming mainstream. The newspapers are full of bid rumours, countless conferences debate its inuence, and investors are allocating more and more capital. This article is written as a gentle introduction to a world where the inhabitants often seem to speak a different language.
Figure 1 | Main areas of private equity activities
Some denitions
Private equity embraces a broad range of disciplines and strategies. Media coverage tends to xate on the activities of the mega buyout rms, generally because they are buying/selling companies familiar to journalists. But there are a multitude of private equity activities out there Figure 1 highlights the main areas. We should emphasise, though, that private equity is not an area where tight denitions are helpful. Different rms will have hugely differentiated strategies that may not t neatly into the boxes below. Some private equity rms will focus on just one sector within the buyout arena, others will focus on rms in nancial distress. In venture capital, many rms will have an IT focus, others a healthcare bias. In the interests of keeping things simple, we will attempt loose denitions of the two main areas
n
Venture capital providing nance to companies that are forming or were recently formed, often with a new technology to exploit, but with little or no revenue/prots. Buyout the purchase of an established business with mature cashows.
Company size increases... risk reduces
Seed
Early stage
Late stage
Growth buyout
Mid-market
Large buyout
Mega buyout
Venture capital
Buyout
Figure 2 gives an indication of the amount of capital that has been allocated to buyout and venture over the past decade. What is clear is that the total capital employed has experienced fast growth over the past three years and that buyout activity has been driving the majority of the growth.
diversication the stampede into alternatives, as institutional investors have sought to diversify their public (quoted) equity risk, has included increased allocations to private equity return potential private equity, it is hoped, will outperform public markets.
Return potential
There are common arguments advanced as to why private-equity owned businesses might outperform their public counterparts
n
Why invest in private equity?

Private equity is not straightforward and some of the challenges are highlighted below. So why have investors allocated more and more money to this activity? It is conventional to offer two primary motives
leverage private equity rms usually have more debt and as such, are riskier than public companies long-term strategies it is said that private companies do not suffer quarterly shareholder scrutiny and are therefore free to pursue long-term strategic investments even if it temporarily reduces operating income alignment of interests most private-equity owned businesses are run by management who are highly incentivised to maximise shareholder returns the level of incentives is not always available to management of public companies activism private equity owners are able to inuence company strategy and management teams more easily than the generally disparate groups of public equity owners.
Diversication?
The diversication argument is, in our view, quite weak. Private equity is certainly equity and therefore a high correlation to public markets is a reasonable expectation. The accounting protocols in private equity may give some smoothing (no-one is valuing your companies every day) but the true economic values of privately held rms are driven largely by the same factors that inuence quoted equity. So in our opinion, the main reason for investing in this area is return.
Figure 2 | Capital allocated to buyout and venture over past decade

250
$204
200
$158
150 $ billion
$145
$106
100
$63
$91 $80 $78 $64 $43 $28 $17 $12 $17 $31 $81 $62 $58 $65 $43
50
$42
$33
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
Venture
Buyouts
Source: Goldman Sachs, Thomson Financial, Somerset Capital Limited, Prequin
There are valid points to each of these arguments and we would contend that private equity companies are likely to deliver better gross shareholder returns than public companies leverage alone could lead to this conclusion. However, the evidence for whether investors in aggregate can benet from these higher returns is very mixed. It seems safest to say that, after deducting private equity managers fees, the return to the average investor in private equity is likely to be similar to the return they would otherwise receive in public markets. So why get involved? The answer lies in Figure 3 overleaf.
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Figure 3 | Global private equity funds vintage year returns up to 30 June 2006
35 30 25 20 15 IRR 10 5 0 -5 -10 -15 1986 1987 1988 1989 1990 1991 1992 Vintage year Lower quartile to median
Source: VentureXpert
The challenges Managing cashows

Public equity investing is easy just pass the money across, and leave it there until (or hopefully just before) your manager goes off the rails. Private equity is different. Not only will the manager not take all your money at once, but he gives it back to you when hes nished with it. The investor therefore needs to manage cashows and keep making fresh commitments to new funds. This should not be too taxing for modestly resourced institutional investors, but the difference in cashow dynamics should be noted.
1993
1994
1995
1996
1997
1998
1999
Median to upper quartile
The graph indicates that, had you invested with the average (or median) manager, returns would have been at around the level achieved in public equities. However, if you had been able to invest only with managers achieving upper quartile returns, your outcome would have been between 10 15 per cent per year better. This brings us to our key thinking for investing in private equity.
Costs
Private equity rms charge fees that are high by most investors standards. This simply emphasises the fact that this area of investing is only worth it if you can access the truly excellent rms.
The J-curve
Returns in the early years of a private equity investment are likely to be poor. Management fees and expenses kick in from the start, while returns take years to feed through. Bad investments tend to go wrong before the good ones turn to prot, and losses get realised in the accounts quicker than prots.
f you can identify and access I the superior private equity rms, the potential returns are signicant. If you cant do both, dont invest
Illiquidity
Private equity funds are structured as limited partnerships where the investor is tied in, usually for 10 to 12 years. While it is possible to sell on your partnership interest to another party, the process for doing so is messy and you may not get a fair price. Private equity should be the domain of investors with long (in excess of 10 years) time horizons.
sold. So you actually care about the prices paid over that three to ve year period, not todays prices, and then the exit environment a few years later. Given these difculties, we advise against tactical timing of this market a successful private equity programme will be one where investments are made for the long term, over several market cycles.
Investors not prepared to spend the time developing those relationships can outsource the activity to one or more FoFs. This, of course, adds fees.
Summary
Private equity investment is not for everyone. To get this area of the market right the investor needs to:
n
What about current market conditions?

The press is full of articles raising alarm about the amount of money ooding into the hands of private equity rms. Surely this will push up prices and reduce future returns? In our view, trying to time investment in the private equity market is close to impossible. It is relatively easy to judge whether current prices being paid for companies by private equity rms are high or low in comparison to history but this doesnt help. Any commitments made today will be invested over the next three to ve years these investments will then take a few more years before being
Implementation
For the investor who has understood all the challenges, but cannot resist the prospect of upper quartile returns, the next question is, how do I get invested? There are two main options
n n n
have the time and expertise to identify the best funds or be prepared to pay someone else to do so on their behalf think very long-term endure peaks and troughs in performance.
difcult and expensive build a portfolio of private equity partnerships easy and very expensive delegate the activity to a fund of funds (FoF) or gatekeeper.
However, for those investors with the best governance, private equity represents an excellent opportunity to exploit the skill and insight of some of the best asset managers on the planet.
The choice comes down to a question of governance. Over time, smart, governance rich investors should be capable of building a suitably diversied portfolio of high quality relationships.
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Building and maintaining an allocation

The unique characteristics of private equity make it a more complicated asset class than traditional quoted equity or bonds. The illiquid nature of the investments and the depth of the due diligence required, mean that it takes time and skill to build and maintain a target allocation to private equity within a portfolio.
Gaining exposure
There are several ways for investors to gain exposure to private equity. The nal decision often depends on the investors governance capabilities. Few pension funds, for instance, have sufcient governance to set up an in-house team, and for many funds, an investment amounting to only 5 10 per cent of the overall portfolio does not warrant a line-up of direct private equity managers.
As a result, many pension funds decide that the most efcient way of gaining private equity exposure is via a fund of funds (FoF) manager. A FoF manager will research private equity managers and make commitments to between 20 and 30 in each fund. Investors in FoFs therefore benet from diversication across managers, without having to do the due diligence on the managers themselves. But the main benet of investing in a FoF is probably the access it provides to top quality private equity managers who are often over-subscribed. FoF managers spend a great deal of time building relationships with managers, and these relationships, and the access they provide, cannot be easily replicated by a new investor. In return, FoF managers charge an extra layer of fees on top of those demanded by their underlying managers.
Time lags in private equity

Money allocated to traditional asset classes, such as equities and bonds can be put to work in a matter of hours. But, because of the nature of the cash ows, private equity investments are not so straightforward. The typical time horizon for a private equity investment is about 12 years (see Figure 1). The underlying managers will draw down funds from the FoF manager only when they nd appropriate companies to invest in. Before this, the FoF manager must identify the underlying funds that are believed to be worthy of investment. This chain of events means that once they are committed to private equity, investors have little control over the pace of investment or disinvestment. In the early years of a private equity programme, cash ows are predominantly negative as the FoF manager calls money from investors to commit to the underlying managers and to
Figure 1 | The time lag between commitment and exit Stage 1:

n O nce the FoF manager receives a commitment from an investor, it must identify underlying direct managers that it believes are worthy of investment.
Investor
n I n addition, it must consider which of these managers are coming to market with a fund that is compatible with its own commitment cycle. n T ypical n T ypical
number of funds invested: 20 30. time frame for committing funds: three to ve years.
Fund of funds manager

Stage 1
Stage 2:
n O nce the direct manager receives a commitment from the FoF manager, it must identify underlying companies that it believes are worthy of investment, and accordingly, money is drawn down from the investor as and when these companies are identied. Once a company has been invested in, the direct manager must take measures that will add value to the company, for example, change of management, change of strategy or nancing. This is a time-consuming process, emphasising the long-term nature of the asset class. The typical holding period for a portfolio company is approximately three to ve years. Once value has been added over this period, an exit strategy is also required, which may add a further time lag to the process. n T ypical n T ypical
Direct private equity manager

Stage 2
Underlying company
number of companies invested: 10 30. time frame for committing funds: three to ve years.
n T ypical time frame remaining invested in underlying companies: three to ve years.
ue to the nature of private equity investing, the amount committed will not be immediately invested in the asset class. D The typical time horizon for a private equity investment is approximately 12 years. pay fees. Although the investments are typically held at cost, performance for the rst few years tends to be negative as management fees are generally paid on commitments and not invested amounts. This negative performance culminates in the J-curve effect (see Figure 2)1. Figure 2 is based on a 50 million commitment in year 1 and highlights the negative cash ow that is likely in the rst few years of a FoF private equity programme assuming a FoF manager makes no allocation to either co-investments or secondary investments, both of which can speed up the pace of investment. A 10 per cent return assumption has been used in all of the graphs.
1
Figure 2 | Negative cashflow in the early years

30 20 10 millions 0 -10 -20 -30 -40 Year 1 Year 2 Year3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Year 11 Year 12
Drawdown
Distributions
Cumulative cash flow

Source: Watson Wyatt estimates
Modelling of this kind is helpful in the planning stages, but it should be treated only as a guide. We advise investors to have enough exibility to adapt their commitment schedule if appropriate.
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Committed does not mean invested

One of the problems with the time lag between committing money and exiting investments is that investors can struggle to reach a target allocation to the asset class. Before the nal commitments are called, cash will typically begin to ow back to the investor via distributions. This will net out some of the initial commitment and so reduce the amount invested (the investors exposure to private equity).
As a consequence, even at the peak of a lifecycle, only about 75 per cent of a private equity commitment is expected to be invested. Figure 3 shows that, despite a 50 million commitment in year 1, the maximum invested in year 6 is only 38 million.
How to reach a target allocation

There are two ways for an investor to overcome this netting effect, and reach a target exposure to the asset class
n n
overcommit to private equity make a number of smaller commitments after the initial commitment.
Investors who want to reach their target allocation as quickly as possible should increase their initial commitment to private equity. For example, an investor who targets a 30 million allocation to the asset class could commit a one-off 40 million (see Figure 4). According to our model, by year 6, the investor would have achieved its target exposure. The drawback of this strategy is that it exposes the investor to manager and vintage year concentration. Figure 4 shows the cash ows we would expect to see in the above example. Another way of reaching a target allocation is to make a number of smaller commitments to private equity over time. Although this will take a little more time, it results in a more diversied portfolio in terms of fund managers and also of vintage years, ensuring that there is less concentration of economic and investment cycles. For example, in order to meet the same target exposure of 30 million, an investor could commit 17.5 million in years 1, 3 and 5 (see Figure 5).
Figure 3 | Commitment versus investment

60 50 40 millions 30 20 10 0 -10 -20 Year 1 Year 2 Year3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Year 11 Year 12 Target
Drawdown
Distributions
Net annual cashflow
Amount invested
Maintaining the allocation

Building up a target allocation is not the end of the story. Investors must also face the fact that distributions will force down their private equity exposure, and so a small number of commitments to private equity will not be enough to sustain their exposure in the long term. In order to do this, they will require an ongoing commitment strategy. Figure 6 shows the impact of an initial commitment of 25 million followed by bi-annual commitments of 15 million.
nvestors who want to reach their target I allocation as quickly as possible should increase their initial commitment to private equity
Figure 4 | Overcommitting to reach a target allocation

35 30 25 20 millions 15 10 5 0 -5 -10 Year 1 Year 2 Year3 Distributions Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Year 11 Year 12 Drawdown Target
This commitment schedule should ensure that a 30 million target xposure is reached sometime in year 6, and will be maintained subsequently. This is just one of several different schedules that could satisfy a 30 million target based on our ssumptions. Alternatively, two 40 million commitments in year 1 and year 6, followed by 15 million bi-annual commitments starting in year 9, would push the investment up to its 30 million target in year 5 and hold it thereafter. How investors choose to reach their target private equity exposure will clearly depend on many factors, such as actual cash ows, availability of funds, prevailing market conditions and whether the investor prefers getting money invested as soon as possible, or diversifying across managers and vintage years. Making sure that an allocation to private equity is achieved and maintained subsequently is not an exact science. This means that investors commitment schedules should be exible enough to evolve over time. Clearly, building and maintaining a target allocation to private equity is not a straightforward process. A commitment to private equity will take several years to be invested, and achieving a target exposure requires thoughtful advance planning. There is no easy way around this obstacle.
Net annual cashflow
Amount invested
Figure 5 | Making smaller commitments to reach a target allocation

35 30 25 20 millions 15 10 5 0 -5 -10 Year 1 Year 2 Year3 Distributions Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Year 11 Year 12
Drawdown
Net annual cashflow
Amount invested
Target
Figure 6 | Maintaining a target allocation over time

35 30 25 20 millions 15 10 5 0 -5 -10 -15 Year 1 Year 2 Year3 Distributions Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Year 11 Year 12
Drawdown
Net annual cashflow
Amount invested
Target
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Fund of funds or direct fund investment?

The route into private equity investment depends on the experience of the investor.
Investors who are considering an allocation to private equity face a common dilemma: should they invest through a diversied fund of funds (FoF), directly into private equity funds, or in a combination of the two? Unfortunately, there is no simple answer to this question because the optimal composition of a private equity portfolio is unique to every investor. However, there are various advantages and drawbacks to each choice that investors can take into account when making the decision, such as fees, expected levels of risk and return, and access to best-in-class managers. In this section, we outline some of the most important factors, with the aim of helping investors decide what may be the most suitable option for them.
teams, industries and vintage years, even if only small amounts of capital are allocated. They also help investors to acquire useful market knowledge and expertise. FoFs have in-depth research capabilities that allow them to carry out detailed due diligence on direct funds and their managers, as well as ongoing monitoring, reporting and administration. By doing this, they are able to select the best fund teams and build robust portfolios that reect market trends. Another advantage of FoFs, which has gained signicance as demand has grown, is their ability to access top private equity funds that are oversubscribed. In some segments of the private equity market, heavy demand can make it difcult for investors to gain exposure to the best management teams. Top tier US venture capital rms are a perfect example of this. FoFs nurture their relationships with managers in order to secure future capacity, and so they are sometimes able to gain access where other investors may be turned away. Although FoFs are appropriate for rst time private equity investors, experience in the asset class usually increases the motivation to go direct.
First time investors

FoFs are a convenient way to make rst time allocations to private equity. They offer immediate diversication across different types of direct private equity funds, management
oFs have in-depth research F capabilities that allow them to carry out detailed due diligence on direct funds and their managers
The main reason is that investing in FoFs comes with a hefty price tag. The fees charged by direct private equity fund managers are already high, with an average management fee of 2 per cent and a performance fee of 20 per cent. A FoF manager will add 0.5 to 1 per cent in management fees on top of this, and may also charge a performance fee of up to 10 per cent. These funds are based on commitments rather than on invested amounts and, as a result, FoF investors may end up giving up as much as 3.5 per cent of the annual returns from their private equity allocations to their own fees (see page 20).
invested in private equity and exacerbates the J-curve in which initial returns are strongly negative as the impact of fees (charged on commitments) heavily outweigh any returns generated.
Those with more experience

Most investors allocate only a small portion of their overall portfolios to private equity, often as a return enhancer rather than a risk diversier. This means that they are seeking a different trade-off between risk-taking and prot-seeking from private equity than from other asset classes, and so less diversication is needed. In fact, over-diversication might undermine the reason for investing in private equity in the rst place. For these reasons, we believe that investors who have some experience of investing in private equity through FoFs should consider allocating money directly to funds in order to develop their private equity programmes. By doing this, they are likely to enhance their returns from the asset class (mainly because of lower fees) with an insignicant increase in risk at the total portfolio level. Developments in the private equity market now make it easier for large, governance-rich institutional investors to start allocating directly to private equity funds. As the industry has matured, long-standing managers have gradually become institutional quality rms. Over the years, they have had successes and failures and gained experience of making deals in various phases of a market cycle. As they grow and raise further funds, they hire more qualied people, expand their resources and rene their processes.
Developments in the private equity market now make it easier for large, governance-rich institutional investors to start allocating directly to private equity funds
The second factor to consider is over-diversication. A direct fund normally gives investors diversication across 15 to 20 underlying companies. A FoF that invests in 15 to 20 underlying funds offers diversication across 300 to 400 underlying companies. This level of diversication makes FoFs a relatively safe bet for investors with limited experience of private equity. However, more sophisticated investors may not require this degree of risk reduction. Finally, a FoF approach can extend the time that it takes to get money
The result is additional stability and resilience, and the ability to identify opportunities even in adverse market conditions. Making a decision to invest with long-established players is probably less risky now than it used to be (notwithstanding where we might be in the private equity cycle).
appearing between large, globally diversied players and specialist niche managers. The emergence of these niche players gives investors more exibility to choose FoFs that specialise in sectors of the private equity market that complement the large buyout managers. Specialist FoFs could be used in such areas as US venture capital, where it is difcult to gain direct access to good funds, or in mid- or small-cap buyouts, where returns are very dependent on selecting the right manager and where access and due diligence can be more challenging than in the larger buyout area. Some investors may also want to consider smaller allocations to other niche private equity strategies to make their programmes more balanced. Investing in a secondary fund, for instance, would be a reasonable move. Because secondary fund managers invest in more mature private equity holdings, they are likely to produce positive returns sooner than traditional private equity funds (see page 31).
The initial capital drawdown period before cash distributions start to be returned to investors is comparatively long in private equity, and investing in a secondary fund could shorten the wait. However, the potential returns from a secondary investment are probably lower than from traditional funds. Another example might be to commit to a distressed investing manager (see page 38). To sum up, we believe that investors with limited experience of private equity will gain signicant benets from investing in large, globally diversied FoFs. However, investors with private equity allocations of more than 75 million (and who are not governance-constrained) may want to consider direct investing for at least part of their programme. This is likely to add signicantly to overall return without increasing risk at the total portfolio level.
How many managers?

What would be our suggested portfolio composition for large investors who want to consider expanding their private equity programmes? We suggest allocating up to a half of an overall private equity programme to large well-established buyout rms. Most of the funds managed by such rms are biased either towards the US or Europe in the location of their deals. Between two and four managers covering both Europe and the US are a reasonable number for this part of the portfolio. The remaining half of the portfolio can be allocated to specialist FoF managers. Recently, FoFs have begun to polarise, with a clear distinction
Measuring private equity performance

A major challenge of private equity investing is the lack of a single, widely-accepted benchmark against which to measure performance. However, a number of valid benchmarks and monitoring procedures do exist.
These different yardsticks are intended to assess different aspects of performance, so it is important for trustees and investment committees to understand what they should measure, when, and why. In our view, a balanced scorecard approach that includes qualitative as well as quantitative measures is the best way to assess private equity performance, particularly in the early years.
in the public or quoted equity markets. This fundamental goal should always be kept in mind when measuring the programmes success. Measuring private equity performance is a complex business. The key difculty arises from the cashow dynamics of private equity, where the amount of money committed is not invested on day one. This has led to the internal rate of return (IRR) being used as the principal performance measure for private equity, because it is a money-weighted measure compared to more conventional time-weighted returns used in public markets. This means that the IRR of a private equity programme cannot be meaningfully compared with public market indices. To resolve this issue, it is conventional to calculate a public market equivalent (PME) IRR. This is simply the IRR that the investor would have achieved had the cashows that were paid to, and received from, the private equity programme been invested in the public markets (see Figure 1). Note that the calculations for the two programmes we are comparing (IRR and PME IRR) require details of the actual cashows paid to and received from all of the portfolios private equity managers. Good record-keeping is therefore essential.
Secondary measures
As well as monitoring performance against public markets, private equity investors will want to understand the factors driving their private equity returns. To do this, we recommend setting out the total programmes IRR and multiple of capital (MoC) by individual vintage year. MoC measures the proceeds an investor receives from the sales of investments, plus the valuation of investments still in the portfolio, as a multiple of the investments original cost.
Benchmarks for the private equity programme Primary measure

Institutions invest in private equity with the expectation that the additional risk and fees associated with the asset class will be rewarded with higher returns than are available
Figure 1 | Comparing private and public equity returns

12 10 8 IRR 6 4 2 0 XYZ Private equity portfolio Passive FTSE all-share Passive FTSE all world Fees
To be meaningful, the gures used should be at least three years after the vintage year of the fund. They can then be measured against peer group comparators (See Figure 2a and 2b). Again, the calculations necessary to support this analysis require individual cashow data for the whole programme.
Figure 2a | Comparing returns by individual vintage year

20 15 10 5 IRR 0 -5 -10 -15 1998
Lower quartile to median
Benchmarking individual managers

The success or failure of the investors private equity managers can be assessed very simply by reviewing
n
IRRs are they above 10 per cent? MoCs are they above 1.5 per cent.
n
2001 Vintage year
Median to upper quartile Total scheme net of fees Total scheme gross of fees
2002
2003
Figure 2b | Comparing returns by individual vintage year

1.8
The managers themselves have compensation structures that are based on absolute returns, and it makes sense to account for these in the overall performance assessment. However, we encourage a broader review that covers
n
1.6
1.4 MoC
1.2
Performance measures on an absolute basis versus appropriate peer groups. A broad assessment of investment activity. Is capital being deployed in line with expectations, and are distributions occurring at the pace anticipated? A qualitative assessment of organisation and process issues.
1.0
0.8
0.6 1998 Lower quartile to median 2001 Vintage year Median to upper quartile Total scheme net of fees
2002
2003
Figure 3 | Assessing performance using a balanced scorecard approach Management measures

n Well n Succession n This n XYZ
established private equity rm with a strong track record of performance. issues continue to be monitored and managed well. is supported by a number of recent promotions. has continued to remain disciplined in its fundraising during a period where some managers have raised excessively large funds. interests demonstrated by signicant commitment to funds from XYZ professionals. raised a potential weakness of limited nancial backing.
Performance measures
n The
net IRR as at 31 December 2005 is 17.4 per cent which is a very strong return relative to similar 2001 vintage year direct funds. to date (including those not yet realised) have made an average prot of 28 per cent. 4a and 4b show the funds performance against a composite benchmark. The industry performance is based on 2001 vintage year funds with a 70:30 split between total US and total European direct private equity funds.
n Investments n Figures
Sensible sliding fee structure and additional alignment of
XYZ is committed to remaining independent, although this
Quantitative measures
Process measures
n n n
XYZ has a clear and disciplined approach and its due

diligence is thorough.
Financial measures
n
Investment activity gathered pace over the year,
XYZ has established relationships across the private

equity universe which ensures good deal ow.
XYZ has demonstrated strong sell disciplines by
with 32 per cent of the client As commitment drawn down as at 31 December 2005. This is an increase from 18 per cent at the end of 2004, but remains behind projections. during 2005. As at 31 December 2005, distributions totalled $8.8 million. expectations with European exposure at the higher level of the projected range. value of client As investments is $40.3 million as at 31 December 2005.
deciding against recommitting to several large funds after identifying areas of concern. a diverse spread of commitments in fund IV. Industrials (35 per cent) and technology (18 per cent) make up the largest percentage of commitments in the fund. experience and coverage for a global fund. To date, 17.5 per cent of commitments are to European funds.
Client A received its rst distributions from fund IV
Broad coverage of sectors in fund research as proven by
Splits by discipline and geography are in line with
There is a relative lack of breadth and depth of European
35 commitments have been made to date and the
Figure 5 | Investment history

80 60 $ millions 40 20 0 1998 Drawdowns 1999 40 30 20 10 0
2000
2001
2002
2003
2004
2005
Investments
Number or investments
Figure 4a | Internal rate of return

20 15 10 5 0 -5 -10 -15 2001 vintage year
Figure 4b | Multiple of capital
1.4 1.2 MoC 1.0 0.8 0.6 2001 vintage year XYZ Lower quartile to median Median to upper quartile XYZ
IRR
Lower quartile to median
Median to upper quartile
In our view, balanced reporting will seek to capture these points within a balanced scorecard framework (see Figure 3).
Setting an appropriate peer group

The appropriate peer group for a particular manager will depend on its
n n
broadly reects the managers underlying activities. We also recommend selecting the most appropriate sector peer group, for example
n
vintage year strategy.

n
for a global diversied FoF that focuses on all areas of the private equity market, we would use an all private equity universe for a venture capital-only FoF, we would use an all venture universe.
For direct manager relationships, this judgement is fairly simple. For example, a European buyout fund raised in 2006 can be measured against the European buyout universe (for example, from the Venture Economics database). For FoF/secondaries managers, the right peer group is less obvious, as these structures are usually (but not always) spread over a number of vintage years. One possible approach here is to create a blend of vintage year IRRs that
In conclusion, effective monitoring of a private equity programme is crucial if investors are to appreciate the progress of the programme against its objectives. The processes for such monitoring are less straightforward than in public markets, but good record-keeping and a balanced approach to measurement, particularly in the early years of a fund, will make the process manageable for the majority of investors.
Fees, and other terms and conditions

Private equity is the most expensive asset class in the asset management universe in terms of fees paid to fund managers. In theory, superior returns should compensate investors for the higher management costs.
The terms and conditions managers agree with their investors dene the relationship, and vary widely. The various provisions are all interrelated and inuence each other. They are also affected by the managers reputation, and investors demand, as well as the overall supply of capital in the market. Terms and conditions are a result of negotiations and a series of compromises on individual provisions. The complexity of the structures and some of the language can be daunting to rst time private equity investors. In this section, we offer a quick guided tour to help them through the maze.
Management fees
Management fees cover the running costs of a private equity fund. A lot of the fee goes towards paying key personnel. However, managers should not be making signicant prots on the fees. The level of the management fee usually reects the skill required to carry out the investment strategy. So, venture capital funds command the highest fees because they require a depth of operational expertise, while mezzanine funds command the lowest fees because they require pure nancial structuring skills. During the investment period, the management fee is typically charged as a percentage of capital committed rather than invested. This is done to avoid giving managers an incentive to go for volume instead of quality at the beginning of the fund cycle. On completion of the investment period, the management fee is typically charged on the basis of either invested capital or a step-down structure where fees are calculated as a percentage of the previous years fee. Managers argue that this step-down structure gives them stability in planning their resources. However, it also tends to result in a higher level of fees. Investors can protect themselves with a clause allowing for a fee adjustment if fees end up bearing no relation to underlying investment activity. The size of the fund at the nal closing is a key factor in setting the management fee. Managers typically base their budgets on the fee income they will derive from the minimum target size of the fund. However, if the fund closes with far more money than its initial target, the managers income will be drastically increased, and a corresponding adjustment to the percentage rate for calculating the management fee will be justied.
Some investors like budgeted management fees, where a funds management fee is based on its operating budget. The downside of this approach is that investors may unwittingly squeeze the fee below the level that allows the manager to attract the most qualied people. Investors should also consider whether a manager is running a number of funds at the same time. In this case, investors may ask for management fee reductions or exclusivity provisions to address the issue of fees overlapping among funds of different vintage years.
There are two main ways

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Carried interest
The main incentive for private equity managers is not the management fee, but participation in the performance of a fund. This is called carried interest. Typically, investors should receive back their entire capital and an accrued hurdle return prior to any carried interest entitlement by the funds managers. Because carried interest is the managers key incentive, debate swirls around what should trigger its distribution to the manager.
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Carry distribution based on repayment of full contributed capital. This mechanism works ne as long as there are no abnormal cash ow patterns. If, for instance, a very protable exit occurs early in the funds life, the manager can be entitled to carried interest while investors still have substantial amounts of their committed capital at risk. Investors main protection mechanisms are clawback obligations (investors have to bear managers credit risk) or escrow accounts (there is an issue of unused liquidity for both investors and fund managers). Carry distribution based on repayment of full committed capital. In this case, the balance is in favour of investors, who may benet from overdistribution if the manager does not draw down the full amount of the committed capital. To avoid this, investors and managers can agree to a continuous rebalancing of
distributions between them, or equalisation drawdowns, using undrawn commitments to balance distributions to investors and manager according to the agreed prot split.
How fees affect performance

In general, direct fund fees impact investors returns by 540-1,180 basis points, while FoF fees impact returns by an additional 75-370 basis points, depending on gross investment returns and the fee structure (see Figures 1a and 1b).
Other terms and conditions

On top of the basic fee structure, managers can accept or impose other terms and conditions that can shift the balance of their relationship with investors. Two of the most common are the preferred return or hurdle rate, which ensures that managers
Figure 1a | How fees affect returns: direct fund investment

VC and LBO fund net returns Annual management fee Carried interest 20% 1.50% 25% 30% 20% 2.00% 25% 30% 20% 2.50% 25% 30%
Gross IRR 20% 30% 40% 14.6% 23.7% 32.9% 13.8% 22.7% 31.7% 13.0% 21.6% 30.3% 13.5% 22.7% 31.9% 12.8% 21.7% 30.7% 11.9% 20.6% 29.3% 12.4% 21.6% 30.9% 11.6% 20.6% 29.6% 10.8% 19.5% 28.2%
Source: PiperJaffray, Private Equity Partners update, June 2005
Figure 1b | How fees affect returns: direct fund investment (the net IRR assumes a 2 per cent
management fee and 20 per cent carried interest at the direct fund level)
FoF net returns Annual management fee Carried interest 0% 0.25% 5% 10% 0% 0.50% 5% 10% 0% 0.75% 5% 10% 0% 1.00% 5% 10%
Gross IRR 20% 30% 40%
Net IRR 13.5% 22.7% 31.9% 13.2% 22.3% 31.5% 12.6% 21.5% 30.5% 11.9% 20.7% 29.5% 12.8% 21.9% 31.1% 12.2% 21.1% 30.1% 11.6% 20.3% 29.1% 12.4% 21.5% 30.7% 11.8% 20.7% 29.7% 11.2% 19.9% 28.7% 12.0% 21.1% 30.3% 11.4% 20.3% 29.3% 10.8% 19.5% 28.2%
Source: PiperJaffray, Private Equity Partners update, June 2005
are compensated only for overperformance. This is based either on the IRR or the multiple earned on the investment. The catch-up mechanism allows the manager to receive its agreed share of prots after investors have received their return. There may also be detailed terms and conditions relating to other charges. How much due diligence the manager outsources is important, for instance. The manager may charge due diligence costs only for specic expertise, such as legal advice, nancial audits or specic industry expertise. Then there is broken deal expense which species the terms on which the fund can be charged for costs incurred on deals that did not materialise. Other terms relate to set-up costs, and fee offset. To guard against excessive risk taking, investors usually require a manager to have a signicant portion of its own wealth in the fund. Typically, 1 per cent of the funds capital is standard, but it depends on the net worth of the management team.
There are also provisions made for key person risk. If one of the named key persons departs, investors can suspend activities in the fund until a replacement is found, or they may even terminate the fund. Of course, in certain circumstances, investors may want to remove the general partner. In private equity, it is difcult to prove a just cause for removal because the business is so subjective. A without-cause or good leaver termination clause enables investors to stop funding the partnership with a majority vote (usually 75 per cent of partners).
We like the management fee to be phased in during the rst two years of the funds life. We like carried interest to be charged after the limited partners achieve their preferred rate of return. We also prefer the same level of carried interest to be levied on primary investments, secondary investments and direct fund investments so that the incentives are equal for all types of activity. This is not usually the case (see Figure 2).
Fund of funds fees

We analysed the various fee structures offered by FoF managers, and came to some conclusions about our preferred fee structure. In our view, this type of structure best serves to align the interests of investors and FoF managers
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Note that recent fee data is available for only 23 FoF managers, which means that our analysis is limited by a small sample size. The management fees charged by our sample are so widely dispersed that proper analysis is difcult. But the major trends are clear
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We like the management fee to be charged initially on capital committed by limited partners, and on capital invested into underlying partnerships on completion of the funds investment period.
Most managers try to encourage larger commitments by scaling down the management fee. The highest fee in our sample is 1.35 per cent on the rst $10 million committed. The lowest is 0.5 per cent on commitments exceeding $150 million. One third of the managers charge a at management fee rate over a funds life. Half the managers use a step-down structure starting on average from year 8 (the range is year 5 to 10). Then, two thirds of the managersapply a 10 per cent annual discount while one third apply a 25 per cent discount. Only one sixth of the managers tie the management fee to invested capital. Most charge the management fee on committed
o guard against excessive risk taking, T investors usually require a manager to have a signicant portion of his own wealth in the fund
capital initially and on invested capital on the completion of the investment period. Only one manager charges the management fee on invested capital from the beginning of the funds life.
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Figure 2 | Levels of carried interest on different types of fund of funds investments

Primary investment
No carry, 11 5% carry, 11 3.5% carry, 1
Only three managers phase in their management fees over the rst two years of the funds life. The discount is either 25 per cent or 10 per cent in each of these years. Most managers use a hurdle rate of 8 per cent. Only one sets a multiple-based hurdle rate at 2x investors capital.
To conclude, the terms and conditions applied in private equity investing dene the relationship between investors and managers. They differ hugely from one manager to another. From the investors perspective, the best terms and conditions structure is the one geared towards creating the best incentives for a manager to outperform. The combination of a lean management fee (but one that is sufcient to cover a managers xed costs) and a carried interest for outperformance is the best Mechanism to align the interests of investors and managers.
Direct investment
20% carry, 6 15% carry, 4 10% carry, 2
Secondary investment
15% carry, 1 12.5% carry, 1 10% carry, 7
Private equity going forward is the pace sustainable?

Over the last couple of years, private equity has turned from a cottage industry practiced by a few smart players with small amounts of money into a phenomena that regularly grabs press headlines with news of ever larger deals. Recordbreaking fund volumes have been raised on the back of record performance. Investors are naturally starting to ask whether this exuberance is sustainable, and what they can expect from the industry going forward.
1
In our view, private equity is likely to play a much more signicant role in the economy over the long term. In the short term, however, returns will probably suffer a correction. To understand why we hold these views, we need to look at the story behind the numbers. Like other emerging asset classes, private equity has evolved through cycles of wild enthusiasm followed by total despair. The industry started shaping up as a separate asset class in the late 1970s and since then has grown at a compound annual rate of 18.5 per cent1 (see Figure 1). Growth has accelerated over the past two years.
Behind the success story

Private equity owes its success to many different factors. Investors are pouring money into the asset class for several key reasons Recent performance. Fuelled by low purchase multiples in 2002-03 and low interest rates in subsequent years, buyout managers have delivered spectacular returns against a background of decreasing return expectations from other asset classes (see Figures 2a and 2b). Accommodative credit markets. Boosted by the low interest rate environment, credit markets have also enjoyed high levels of liquidity following the entry of hedge funds and structured product managers into lending activities. The growth of credit derivatives has allowed private equity managers to deliver good results despite increasing purchase multiples. Changing focus of institutional investors. Institutions have turned to higher risk/higher return asset classes in order to diversify away from traditional equities and xed income.
Citigroup. Private Equity: The Way Forward Michael Klein.
Figure 1 | Growth in private equity since 1992

1,000
$920
This has led to spectacular growth in alternative assets, including private equity. Need to maintain target allocations. Good returns have led private equity managers to distribute a lot of cash back to investors, making it difcult for them to maintain target allocations. This means that they need to commit ever increasing amounts to maintain their target exposure to private equity.
900 800 700 600 $ billion 500 400 300 200 100 0 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
$111 $126 $149 $170 $189 $250 $352 $457 $612 $682 $696 $708 $754
$860
2005
2006
Source: Merrill Lynch, Somerset Capital Limited, Watson Wyatt estimates
Figure 2a | Twenty years of private equity returns

50 40 30 20 IRR 10 0 -10 -20
1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
Hunger for funds. It may be surprising given the volume of funds raised, but private equity managers investing activity has kept up with and sometimes even outpaced their fundraising activity. As a result, they can easily justify more frequent and larger funds. As a result of all these factors, the private equity industry has grown very quickly over the past three to four years. Investors naturally want to know whether the industry is overheated, like the dot com market in 2000, or if it is a new investment paradigm that they would be foolish to miss. The answer lies somewhere in between.
Vintage years Lower quartile to median Median to upper quartile
Figure 2b | Twenty years of private equity returns

80
Factors in favour of private equity Buyouts versus venture capital

In the early days, private equity was synonymous with venture capital, but today the market is dominated by leveraged buyouts. The distinction between the two sectors is important as the recent hype in returns and activity relates mainly to buyouts. During the internet hype of 2000, 60 per cent of global private equity funds were raised by venture capital managers. By 2006, venture capitals share in global private equity
60
40
IRR
20
-20
-40
1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
Vintage years Lower quartile to median Median to upper quartile
Figure 3 | Average global deal size

1,000 900 800 700 $ millions 600 500 400 300 200 100 0 1998 1999 2000 2001 2002 2003 2004 2005 $403 $367 $351 $389 $540 $716 $706
Potential for bigger deals

The average size of private equity deals has been steadily increasing. With their increased purchasing power, managers can now target large capitalisation companies. We see market opportunities in this segment absorbing a signicant share of capital raised (see Figure 3).
$877
Benets of private equity ownership

In recent years, private equity has become more accepted as a value-added ownership model. More companies are now opening their doors to private equity managers in recognition of the following benets
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Source: Goldman Sachs, Thomson Financial, Somerset Capital Limited, Prequin
enture capital focuses on small V innovative companies and start-ups, which can absorb only a limited amount of capital
fundraising had fallen to less than 20 per cent, while buyout managers accounted for 80 per cent. Venture capital focuses on small innovative companies and start-ups, which can absorb only a limited amount of capital. In contrast, a buyout target can be any mature company with stable cash ows and some potential for additional value creation. This means that the universe of buyout opportunities is far larger than the universe of venture capital Opportunities, and is able to absorb far more capital.
model now applies to other areas such as distressed investing (see page 38), which makes the asset class more diverse and resilient to external pressures.
The change of ownership brings a breath of fresh air to businesses that are often stale and tired. New ideas are tabled; a sense of urgency helps make things happen; expectations are high. Acquired companies demonstrate positive trends after they go private. The median company in the Citigroup study experienced rapid growth in revenues; capital expenditure rose; EBITDA margins increased, while the share of selling, general, and administrative expenses decreased after the buyout2. Private equity companies can employ compensation strategies that align the interests of management and owners. Private equity managers typically require key management to contribute equity and/or cash to ensure that they have signicant wealth at stake after the buyout. Another advantage is that compensation arrangements can be kept quiet, which is an advantage in light of the criticism heaped on highly paid CEOs of public companies.
Geographical expansion
The private equity market has started to push out its geographical boundaries quite aggressively. The US still accounts for more than 60 per cent of private equity assets but the last couple of years have seen increasing activity in Europe, and more recently, Asia and other emerging markets. Although risky, these markets have expanded the private equity universe and offer the benet of different market cycles and industry segments.
Diversity within private equity

Apart from venture capital and buyouts, the private equity
2
Citigroup Global Capital Markets. The Private Equity Revolution: Are You Ready? November 6, 2006.
Private equity compensation structures help attract and retain talent, while quickly weeding out underperformers.
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Without public market scrutiny, private companies can implement longer-term strategies without worrying about how the share price will react to quarterly results. Companies can be managed for cash returns to shareholders rather than earnings per share. Private equity owners can employ more efcient capital structures and lower the cost of capital for their portfolio companies. Private equity owners are a small group of people whose interests are, to a large extent, aligned. This makes decision-making much faster and more efcient than public ownership.
of all existing venture capital and buyout funds, including the effect of leverage, still represents less than 2 per cent of global enterprise value3. Private equity investment as a percentage of GDP stands at 0.40 per cent in the US and 0.14 per cent in Asia4. These low levels of penetration suggest that private equity still has a lot of room for growth.
four years to three in some cases even one to two years and the pool of uninvested private equity capital has been shrinking. However, despite the good news, there are causes for concern.
Factors against private equity Pushing price boundaries

Some prices have become totally disconnected from fundamental valuations. Supported by a strong global economy, private equity managers are testing the upper limits of purchase multiples in their deals (see Figure 5). The historic highs have already been broken and the sky now seems to be the limit. The current environment of rising public markets is better for selling companies than for buying them.
No capital overhang
The recent fundraising spree does not seem to have resulted in large amounts of uninvested money sitting around (see Figures 4a and 4b). Private equity managers have been so successful in putting funds to work that there is little or no capital overhang. Todays buyout funds are being deployed more rapidly than ever before. The average gap between funds has declined from more than
Institutional quality investment

The staggering volume of funds raised has not led to a big increase in private equity managers. It is tough for managers without track records to raise rst-time funds, so most of the money is being raised by well-established managers. Over the years, having learned from their successes and failures, most of these have become institutional quality rms. As they grow and raise subsequent funds, they hire more qualied people, expand their resources, and rene their processes. This momentum gives established managers resilience to withstand market cycles and identify opportunities even in adverse conditions.
Figure 4a | Levels of uninvested capital

100% 80%
60%
40%
20% 0% 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Drawn commitments
Undrawn commitments
Source: BVCA, Capital Dynamics
Figure 4b | Levels of uninvested capital

100% 80%
60%
40%
Market penetration
Despite the euphoria about private equity, its role in the global economy is still tiny. The purchasing power
3 4
20% 0% 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Drawn commitments
Undrawn commitments
Source: BVCA, Capital Dynamics
Pantheon Ventures Limited, Capital IQ, Watson Wyatts estimates. SCM, IMF 2005, Venture Economics, Incisive Media, Centre for Asia Private Equity Research.
Many private equity managers are now forecasting in their nancial models that purchase multiples may be higher than exit multiples in the hope that they can compensate for this gap and earn their target returns through operational improvements and de-leveraging.
Excessive and complex leverage

While private equity thrives in a relaxed lending environment, the downside is that borrowers become overly relaxed too. Private equity companies are taking on record levels of debt (see Figure 6) and easy credit has led to leverage structures that are incomprehensible. Any signicant hiccup in the economy is likely to cause major problems for a few privately nanced and over-leveraged companies. Compounding this threat is the fact that ownership of credit risks has become unclear. In the past, debt in private equity deals was mostly owned by banks. Now, private equity leverage often involves numerous
debt layers provided by different lenders. Banks are actively transferring their credit risks to hedge and credit funds in the form of structured instruments such as CDOs and CLOs. If a leveraged company gets into trouble, the divergent interests of numerous lenders are likely to cause further problems.
Diminishing equity share

Easy credit and abundant liquidity mean that lenders require less equity to be contributed into deals (see Figure 7). Private equity managers have taken advantage of this, and equity contributions in leveraged buyouts have been consistently declining over the last four years, which in turn increases bankruptcy risks for the underlying companies.
Are resources too stretched?

The private equity investment universe has expanded enormously to include more companies and much larger ones willing to consider private equity ownership. However, the more deals done, the higher the chance that some will go badly wrong. Private equity managers are stretching their resources and hiring new people to process the deal pipeline. This increases the risk that a lack of time and resources will result in a lapse of due diligence. Managers need a very strong investment discipline to avoid being carried away by such strong deal ow. Investors need to stick to a similar discipline. Only the best of breed private equity managers deserve investors money, and the only way to enjoy the benets of their performance is to make consistent commitments across the market cycle.
Figure 5 | EBITDA purchase multiples

10.0x 8.3x 8.0x 7.7x 7.3x 7.6x 7.1x 7.0x 6.8x 8.6x
Debt/EBITDA multiples
6.0x
4.0x
2.0x
0.0x 1999
Source: Citygroup, S&P
2000
2001
2002
2003
2004
2005
2006
Figure 6 | Rising debt in privately financed companies

8x
6x
6.0x
6.2x
Debt/EBITDA multiples
4.7x 4.2x 4x 4.1x 4.0x
4.6x
4.8x
prefer to nance large acquisitions in other ways. Nonetheless, about 70 per cent5 of the enterprise value of large buyouts (above $1 billion) were done by consortia last year. This increases the risk to private equity managers if external conditions become less favourable.
Resistance of public shareholders

2x
0x
1998
1999
2000
2001
2002
2003
2004
2005
Figure 7 | Equity contribution in leveraged buyouts

40% 38.6% 38% 37.4% 37.6%
37.3%
36%
35.9%
35.9%
34%
33.7%
33.7%
Public company shareholders often chase high growth and ignore steady but unspectacular performers, especially in the large cap sector. Private equity managers have moved to exploit the chronic undervaluation that often results. However, public shareholders have woken up to the realisation that these companies must contain hidden value if private equity rms are happy to pay a 30 per cent premium and still expect to earn 20 per cent a year. We are likely to see more battles where public shareholders resist a private equity acquisition. This will push up prices and decrease available investment opportunities.
32%
Fee drag is everyone getting rich except the investors?

1999 2000 2001 2002 2003 2004 2005 2006
30%
We often hear that there are so many good managers around that it would be a pity to miss them. As a result, investors throw more money into private equity than they had planned. This argument is not good enough. Only a really poor manager would fail to show good results in the current favourable environment. The test will come when conditions change.
deals where a number of private equity managers get together to nance a single deal. Most managers are not fond of this clubbing phenomena but lack the capital to nance large deals on their own. The problem with club deals is that managers often have different expectations of a portfolio company and so their interests are rarely perfectly aligned. There are examples of club deals that have gone off track in the past, and the managers involved
Fees are another factor likely to have negative impact on the private equity industry. The level of fees has so far been incredibly sticky. No matter how large the fund $100 million or $1 billion the manager is still likely to charge the magic 2 per cent management fee and 20 per cent carried interest. Successful managers may get away with 25-30 per cent carried interest. Good performance should be rewarded, and high fees allow managers to attract talented individuals and keep them motivated. But although a high performance fee can be justied, the management
The growth of club deals

Another threat to private equity is the recent proliferation of club
5
Source: Keyhaven Capital, Incisive Media.
fee on a multi-billion fund may provide managers with signicant opportunities for personal enrichment at investors expense. This management fee also creates a signicant drag on performance that could become serious if the cycle turns (for further analysis see page 20).
All the factors in favour of private equity suggest that its role in the economy will become more signicant in the long term. However, the factors against private equity all point to a correction in the short term. It is very likely that some buyout deals will go off track, and investors may lose money. Even in the best of economic times, private equity is about high returns, which go hand in hand with high risks. The single most important factor for private equity investors is to choose the right managers those most able to deliver returns even when markets turn sour. It is impossible for investors to time their entry into private equity. A commitment made today will not be drawn down fully for a number of years, and no-one can predict what lies ahead. Our best advice is to stay disciplined, hire only best of breed managers, and ensure that private equity allocations remain consistent year on year.
Timing the exit

The nite life of private equity partnerships is another structural deciency. Although private equity is perceived to be a long-term deep-value strategy, managers incentives are tied in with the moment of exit when a company is sold, prot on a deal xed, and the manager gets a performance fee. As a result, private equity managers strategies are geared towards achieving an exit in three to ve years, which is not always in the interests of investors or the underlying business (see also page 44). The recent environment has been excellent for successful exits. The public markets have been accommodative; strategic buyers have demonstrated interest; credit markets have allowed quick recapitalisations. If this changes, managers may struggle to nd exit opportunities, especially for the recent mega transactions.
What investors should do

Investors want to know if private equity will continue to outperform, and if so, should they hurry not to miss an opportunity? Or should they wait to see if the industry has reached the bubble stage, in which case those involved most recently will suffer the worst damage.
ven in the best of economic E times, private equity is about high returns, which go hand in hand with high risks
The secondary market in private equity

Long lock-up periods have dissuaded many would-be investors from committing their assets to private equity. But the emergence of a secondary market in private equity (known as secondaries) puts this asset class within reach of investors who want to enjoy the rewards of unquoted equity with a shorter maturity period.
Why has this market emerged?
Historically, investing in private equity has been perceived as difcult. In the absence of a public market (a stock exchange), investors commit assets to an investment manager (known as a general partner or GP), who invests in underlying businesses with the intention of realising a prot. Investors receive their return via an IPO, a trade sale, management buyout,
merger or recapitalisation. However, there may be many years between investment and distribution of proceeds. A secondary market for private equity assets can evolve in any sophisticated market where there are large pools of capital to be redeployed. Secondaries enable new investors to buy positions in private equity funds, or portfolios of companies, from existing investors who want an early exit. The supply of these secondary opportunities has grown for several reasons
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New capital adequacy requirements have forced banks and other nancial institutions to reduce their private equity exposures. Once wealthy US investors who built up private equity portfolios during the technology bubble are now unable to meet their commitments. They are being forced to sell their private equity portfolios. Some US pension funds are looking to trim their exposure to private equity because it now forms a large proportion of their total assets, partly because of private equitys outperformance. Other institutions might be looking to sell off a tail of private equity investments left over from prior commitments, or are looking to reduce the number of GPs with whom they invest. Large companies that have built up portfolios of associated private companies are looking to dispose of these non-core activities.
The supply of secondary private equity is met by demand from investors looking for entry to the asset class. They often have the opportunity to recoup their investment relatively quickly because they are investing at quite a mature stage, when the quality of the underlying assets has been revealed, risks tend to have been exposed, and capital is pretty much fully committed.
at least $6.5 billion was raised in secondary funds in 2004, suggesting signicant levels of activity ahead. With few notable exceptions, secrecy tends to surround secondary trades. Often this is because one or more parties do not want word to get out that they are selling their stakes to raise cash. Because the secondary market is so far relatively small and undeveloped, those in the know have, in the past, been able to achieve signicant discounts. There are currently about 12 leading secondary investors. The number of potential buyers has also increased as private equity FoFs and institutional investors increase allocations to secondaries. As the market attracts more players, the additional liquidity will bring potentially smaller discounts and lower returns. Nonetheless, the secondary market is still an attractive investment for those who wish to gain access to prior years funds.
How to invest in secondaries

The primary private equity market can be difcult to inltrate. There are two ways, a specialist secondaries fund or a generalist FoF. Most FoF providers set a maximum allocation to secondaries of approximately 25 per cent. But over time, as the secondary market becomes more competitive, and more specialist players move in, FoF may nd fewer opportunities in secondaries. The successful deals may ultimately be taken by specialist secondary vehicles, currently available via FoF managers or dedicated secondaries players. As the market has become more competitive, specialist secondaries managers have moved away from acquiring interests in funds towards synthetic secondaries whereby a GP is created (either by acquiring a portfolio of private equity holdings and installing a new GP or by nding a team to spin-out with the assets and form a new business). These deals require greater resources to effect, but can be more protable than simply acquiring existing interests in established funds. This means that, even for those investors with wellestablished private equity programmes, exposure to secondaries could be of interest as part of a diversied private equity strategy.
Secondaries facts and gures

Private equity is already a $1 trillion market. So far, only about 3 per cent of primary partnerships are traded on the secondary market, and growth seems set to continue as banks divest their holdings and beleaguered investors seek to raise cash. Between $6 billion and $8 billion of assets hit the secondary market in 2003, and
s the market has become more A competitive, specialist secondaries managers have moved away form acquiring interests in funds towards synthetic secondaries
Secondaries: the upside

Investors in secondaries can expect similar benets to investors in private equity including returns that are potentially superior relative to quoted markets. However, secondaries provide additional benets
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In particular, the multiples of capital invested are likely to be lower than for primary investments. There are some challenges that principally belong to primary private equity investment which are also worth considering. To sum up, there are many good reasons for investing in secondaries. Making secondaries part of a private equity programme reduces some of the risks and long lock-up periods traditionally associated with private equity. It opens up opportunities such as access to managers and funds that are typically invitation only. What is more, an allocation to secondaries can also accelerate an investors allocation to private equity and provide access to a more mature portfolio, leading to earlier distributions. However, going forward, the returns in terms of multiples of capital committed are likely to be lower than for primary investments.
They can sometimes be purchased at discounts to valuation, given the illiquid nature of limited partnership investments. As valuations are already conservatively estimated, secondaries can potentially provide higher returns than primary private equity investments. They can provide access to vintage years, managers and funds that have since closed to new business. Purchasers can build up more mature portfolios of holdings and accelerate the recycling of cashow. This can reduce the impact of the J-curve and can be an ideal way for new investors to gain exposure to this asset class. Exposure to different types of private equity (for example, synthetic secondaries).
Secondaries: the downside

Like all other investments, secondaries come with risks that are normally measured in terms of volatility of returns. A well-diversied portfolio that incorporates other asset classes can help to mitigate these risks. As the secondaries market matures and discounts disappear, returns may fall relative to primary investments.
aking secondaries part of a private M equity programme reduces some of the risks and long lock-up periods traditionally associated with private equity
Co-investing in private equity

Taking direct stakes in portfolio companies alongside other investors has both advantages and drawbacks.
Co-investment occurs when two parties invest alongside each other in a company. In private equity, this often happens when a general partner (GP) invites other parties (often their own limited partners or LPs) to invest their own money directly in an underlying
company. The GP may do this because the deal requires more equity than the GP is comfortable with, given the size of its fund. A GP may consider that its fund will be too concentrated in one portfolio company or industry if it supplies all the equity required to do the deal. Most private equity funds limit investment in a single portfolio company to 20 per cent of fund assets. If deals are larger, GPs may have no option but to engage with co-investors in order to complete the transaction. The GP negotiates and nalises the deal as normal with the vendor, then shares some of the equity requirement with a select group of investors and/or partners, who take a minority equity stake in the deal. The larger size of these deals means that co-investment opportunities tend to arise in the buyout market rather than in venture capital. The process is illustrated below for the $1 billion ABC fund VI, which has a 20 per cent limit on any individual investment and is looking to acquire the XYZ company.
XYZ company Equity required for acquisition = $400 million
ABC fund VI (fund size: $1 billion) Equity invested = $200 million Invite partners to co-invest Co-investment partners Equity invested = $200 million
Given the 20 per cent cap on a single investment, ABC fund VI is unable to provide the total $400 million equity required to purchase XYZ company. In order to complete the deal, it may decide to invest $200 million from the fund, and offer the remaining $200 million to third parties. Club deals have recently become a feature in the market. Club deals occur when a company is acquired by two or more private equity participants of roughly equal strength in terms of equity participation and input to the companys strategic direction. The chief reason for doing such deals is for a number of groups to share equity participation. One group may be unable to commit a large proportion of its capital to one underlying company, or the sponsor may want to diversify its fund. Club deals may themselves generate co-investment opportunities for smaller investors. However, a key distinction is that while the large players involved in a club deal tend to be active participants in the deal, co-investors tend to be passive investors.
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fees (the industry standard is 1.5 2 per cent) and carried interest (the industry standard is 20 per cent). A co-investor who is also invested in the sponsoring GPs fund will get a higher return on capital for the same underlying company or companies via the coinvestment. Timely exposure to the asset class. There is always a time lag before private equity investors see returns from their investment. Co-investing directly into portfolio
companies speeds up the process compared with investing via FoF. This is especially relevant for rst time investors who are looking to reach a target allocation as soon as possible.
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Enhance reputation in the market place. Participating in co-investments can improve investors credibility and reputation with private equity managers. This may subsequently help investors gain access to oversubscribed funds.
articipating in co-investments P can improve investors credibility and reputation with private equity managers
Co-investing: the benets

As well as allowing GPs to do deals that would otherwise be beyond their grasp, co-investing gives investors access to the networks and expertise of their co-investors. But GPs offer more potential benets to encourage third parties to take part in their deals
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Exposure to private equity investments without paying fees or carry. When offering a co-investment opportunity to investors or third parties, GPs usually waive management
Co-investing: the drawbacks

Although co-investment has compelling advantages, there are also drawbacks
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Adverse selection risk. Will the investor really get access to the best deals through co-investment?
Co-investment funds
Given current market conditions, and the ever-increasing size of private equity deals, co-investment vehicles are becoming more widespread. Co-investment funds are typically managed by FoF managers. These managers are able to leverage their GP relationships and their own expertise in analysing deals to offer funds dedicated to coinvestments. This approach allows investors who lack the expertise to evaluate specic co-investment opportunities to benet from co-investing. Investors in co-investment funds also have the comfort of knowing that the deals have been subjected to a double layer of due diligence from the sponsoring GP and the manager of the co-investment vehicle. The managers will also pay attention to portfolio construction, and ensure that their funds are properly diversied across industries, geographies, sponsoring GPs and styles. However, access to these benets comes at a cost. There is a signicant spread of fees for co-investment funds, with the standard management fee ranging between 0.25 and 1.5 per cent and carried interest between 10 and 20 per cent. There is also a wide variation in the quality of product on offer, and as with any investment vehicle, the value proposition must be considered on a net of fees basis.
Due diligence effort. Assuming the investor is not willing to rely on the due diligence of the sponsoring GP, a substantial amount of work is required by highly skilled investment professionals to ensure the opportunity is worthwhile. Taking part in co-investments is not advisable for the vast majority of private equity investors who do not have these resources readily available in-house. Over-concentration in specic company/geography/sector. If the investor also has money in the sponsoring GPs fund, a direct co-investment leads to a double exposure to the underlying company, as well as to its region or industry. If the investment fails, this could have an adverse impact on the investors private equity return.
iven current market conditions, and G the ever-increasing size of private equity deals, co-investment vehicles are becoming more widespread
Reputational risk. While investors can benet from increased credibility within the GP community if they partake in deals, the converse is also true. Unsuccessful deals could lead to a tarnished reputation.
It may help to explain how co-investment fund managers operate. Some will take small bitesizes of $10 million to $20 million out of larger deals and simply piggy-back on the due diligence and expertise of the GP. Other co-investment managers, who are often part of larger organisations (investment banks, for instance), have far more to offer. They may write cheques of up to $500 million for individual deals and then share this equity within their organisation, with the co-investment fund taking perhaps $100 million. These managers in large organisations are likely to have a greater impact on the deal, and will be called upon by GPs far more than the piggy-back type of manager. This means that they will be able to cherry pick from a larger number of potential deals than a manager who is only willing and able to write smaller equity cheques. As a result, these teams will have more experience and expertise in successfully analysing co-investment opportunities. Their funds also tend to be more expensive, which raises the question of why an investor would commit to a co-investment vehicle rather than a direct fund. Co-investment managers argue that they provide diversication across a number of GPs and a double layer of due diligence on deals. In addition, those managers with exceptional dealsourcing capabilities are well-placed to select the deals they consider most appealing on a risk versus return basis.
means that manager selection is critical. The same factors apply as in appointing a traditional FoF manager, but there are additional criteria that potential investors should analyse when evaluating a co-investment fund
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private equity allocation. They prefer to appoint one globally diversied FoF manager to cover the entire universe of private equity funds. Furthermore, allocating to a co-investment fund is probably inconsistent with their strategy. Co-investment funds are more likely to attract rst time private equity investors who want to implement a FoF strategy at rst, but who are willing to consider a more direct approach over the medium term. The co-investment fund can serve as an introduction to direct investing. It will also bring a faster payback than a FoF investment in the early years of the investors private equity programme. To sum up, we believe that co-investment opportunities can play a positive role in some investors private equity programmes. Investors benet from avoiding the GP fees and carried interest on company investments, and their money will be invested quicker than by allocating to a standard FoF. However, we do not advise co-investment for the majority of private equity investors who lack the expertise to analyse these opportunities.
appropriate skill-set to conduct thorough due diligence at company level willing to rely on more than just the sponsoring GPs due diligence strong capability to analyse the sponsoring GPs ability to create value in portfolio companies ability to source high quality deals from high quality GPs ability to be considered a value-added partner by GPs beyond nancing capabilities ability to have an impact on company despite minority interest.
Co-investment funds in a private equity programme

Although a strong case exists for using a high quality co-investment manager, it is less clear how this type of fund can be efciently incorporated into a private equity programme. Co-investment funds are unlikely to appeal to those investors who prefer to appoint managers for mid to large buyouts, and FoFs for access and deal selection in the venture capital and small buyout markets. Co-investment funds are usually dominated by larger buyout deals, so these investors will probably already have exposure to the same companies, or at least to this part of the market. Other investors have neither the governance nor the appetite to appoint several managers for their
Selecting a manager
The wide spread of returns from private equity co-investment funds
Distressed investing
The high level of debt nance raised by public and private companies has been causing controversy lately, not only because of the economic impact of the debt burden, but because of the potential investment opportunities it creates.
Figure 1 | Distressed investment strategies
Active/control
n Take
Growing numbers of investment managers including private equity managers are raising specialised funds to invest in distressed companies. They aim to invest at less than fair value, hoping to reap large rewards from a turnaround in the companys fortunes.
What is distressed investing?

There is no easy way to dene distressed investing. It can take many forms, ranging from trading the nancial instruments of bankrupt or struggling companies, to gaining control of these companies and actively turning them around. The strategy originated in the early 1990s, on the back of soaring business failures after the heady economic expansion of the 1980s. Historically, distressed investing was associated with investing in distressed debt, which is generally dened as bank debt, private placements
Active/non-control
n Generally
Passive
n Trading
control of company through equity/debt swap and run company
do not take control but signicant stake in senior debt and active participation in restructuring process period: one to two years
in undervalued distressed securities structure arbitrage/long-short/value period: 6 months to one year
n Restructure
n Inuence
n Trading/buy-hold/capital
n Holding
period: three to four years
n Holding
n Holding
n Target
return: 20-25% per annum
n Target
n Target
or public debt of companies that have defaulted on their obligations, led for bankruptcy, or are in such nancial distress that their debt is trading at more than 1,000 basis points above comparable Government bonds. Today, the denition of distressed investing is much wider. There are three major strategies practised by distressed investors (see Figure 1). Some focus on one of the strategies; others take a more opportunistic approach and enter any distressed situation they consider attractive.
$ billion
Figure 2 | Size of the defaulted and distressed debt market

1000 900 800 700 600 500 400 300 200 100 0
1998
Face value
1999
Market value
2000
2001
2002
2003
2004
2005
How large is the market?

The size of the distressed opportunity is tricky to estimate, because it involves not only distressed debt, but other types of nancial instruments. The total of defaulted and distressed public and private debt was estimated at more than $700 billion (face value) and $530 billion (market value) at the end of 2005 (see Figure 2). However, it is impossible to estimate the consolidated value of companies in distress whose debt is not in the defaulted category. It may be more relevant for institutional investors to estimate manager capacity. About 125 distressed managers currently run between $125-150 billion of assets. These numbers are rapidly growing.
Source: Professor Edward Altman (NYU Salomon Centre); PCG Asset Management
Figure 3 | The high yield default rate

$3,000 14.00% 12.00% 10.00% 8.00% $ billion 6.00% $1,000 4.00% 2.00% $0 1998 1999 High yield bonds 2000 Leveraged loans 2001 HY default rate
Source: CSFB Research; PCG Asset Management
$2,000
0.00% 2002 2003 2004 2005
These are
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Timing the turn

Distressed investors thrive in troughs of the credit cycle when debt is trading cheap and more companies are in distress. Investors are watching the sector with heightened interest because several macroeconomic indicators suggest a turn in the cycle, which would create a surge in distressed investing opportunities.
record issuance of low-grade high yield debt and second lien loans (from under $1 billion in 2000 to about $19 billion in 2005) record level of dividend renancing (from $4 billion in 2000 to more than $40 billion in 2005) historically very low levels of defaults (see Figure 3)
decline of lending standards driven by the rise of the second-lien loan market and hedge funds as a new type of a creditor increasing EBITDA purchase price and debt multiples in buyout and strategic acquisition transactions increasing level of debt and reducing equity requirements in private equity transactions.
But predicting the next turn in the cycle is almost impossible because markets are constantly evolving. Despite regular predictions of an imminent downturn since 2002, default rates have continued to fall, reaching 1.88 per cent at the end of 2005, and market commentators have become much more cautious in their forecasts. Overheating in the credit market also needs to be offset against other factors that might be negative for distressed investors, such as the amount of capital poised to pour into the sector. However, a few managers are sufciently skilled and experienced to identify and exploit distressed opportunities at any stage of the market cycle. These managers can be an interesting addition to the portfolios of sophisticated investors who want to
diversify across strategies and investment styles. They have shown themselves able to earn sustainable returns throughout the credit cycle and abnormal returns when the cycle turns down.
freedom to take non-controlling stakes in companies, and to invest in publicly listed companies. Some global players engage in all types of distressed investment strategies. As private equity moves away from nancial engineering towards an investment approach aimed at creating value, more private equity rms are seeking deals involving under-managed companies and operational restructuring. As the borderline between a company being under-managed and being distressed is rather blurred, pure private equity players and distressed investors often nd themselves competing for deals. This obviously increases both the competition for distressed investments and the correlation between the two investment strategies. Recently, these players have been joined by FoF managers specialising in distressed debt investing. These funds offer diversication across distressed investment styles and managers as well as access to the best managers. Since the number of distressed managers is very limited, and even fewer are consistently credible performers, these funds are often oversubscribed and access is difcult.
The managers
The main players in the distressed sector are private equity rms and hedge funds. Traditionally, hedge funds have been at the passive end, trading distressed securities, while private equity managers have been involved in hands-on restructuring of companies. Private equity managers who specialised in distressed investing used to be known as turnaround investors. They take a majority stake in a distressed company by purchasing equity or mezzanine capital, and use their position to inuence management and engineer a turnaround.
istressed investors tend to ourish D when the credit cycle turns down and companies struggle
But the lines have blurred between the two types of managers in recent years. Hedge funds, attracted by the high level of returns, have extended their lock-in periods and become more active in the private market. With the explosion of second-lien nancing over the past four years, the bulk of leveraged loan transactions involve debt from hedge funds who use their loan portfolios as a way to access information on future distressed plays. At the same time, many private equity rms have given themselves the
What makes a good distressed manager?

Distressed investors tend to ourish when the credit cycle turns down and companies struggle. But they often have difculty deploying capital against a background of healthy economic growth. In these conditions, managers have been known to return capital to their investors or waive the management fee on uncommitted capital.
However, there will always be companies in difculty whatever the economy is doing. Managers who are able to take control and have the turnaround skills are best positioned to earn reasonable returns throughout the cycle. Investing in distressed situations requires a very specialised combination of skills and experience. Managers must be familiar with both the bankruptcy process and with fundamental credit analysis in order to price distressed securities. They must also be able to accommodate the disparate interests of a wide variety of stakeholders. If they are taking control of a company, managers must also have deep operational expertise and the ability to enforce change. The key characteristic of a good distressed manager is a strong contrarian viewpoint and a willingness to get actively involved in situations and transactions that typical investors would avoid. Distressed managers are concerned not with the short-term payment of interest and debt service, but rather with the ability of the company to execute a viable business plan. From this perspective, they are true value investors.
Intuitively, it makes sense that distressed investing should be a diversier to other asset classes and strategies, because it offers exposure to opportunities that are not covered by more conventional managers. The downside is that investors are exposed to the risk of downgrades, defaults and bankruptcies, and the possibility
that the company will fail to rise from the ashes. We can use the performance of defaulted debt as a proxy for distressed investing, but investors should bear in mind that distressed debt is only one element of distressed investing, though it is a very signicant one (see Figure 4a and 4b).
Figure 4a | Defaulted debt returns versus the S&P500 and HY bonds

Comparison of returns (as a percentage)
Altman-NYU Salomon centre defaulted securities index S&P 500 Citigroup high yield bond market index
1996 1997 1998 1999 2000 2001 2002 2003 2004
15.6 0.4 -17.6 4.5 -15.8 15.5 -0.5 49.3 15.1 7.4 20.1 5.8
23.0 34.4 28.6 21.0 -9.1 -11.9 -22.1 28.7 10.9 11.5 20.7 9.6
11.3 13.2 3.6 1.7 -5.7 5.4 -1.5 30.6 10.8 7.7 10.6 7.3
Arithmetic average Standard deviation Compounded average
Source: Professor Edward Altman, NYU Salomon Centre, S&P, Citigroup
Figure 4b | Default debt as a diversifier

50%
Risk and return

Any conclusions about the risk-return prole of distressed investing as a stand-alone strategy are bound to be incomplete. This is not surprising considering that the distressed investing universe is not clearly dened, and returns generated by distressed investors over the last decade are not readily available.
30%
10%
-10%
-30% 1996 1997 1998 1999 2000 2001 S&P 500 index 2002 2003 2004 Altman-NYU salomon centre defaulted securities index Citigroup high yield bond market index
Our analysis shows that the average returns from defaulted debt over nine years lagged behind common stocks and high yield bonds; however, the defaulted securities index outperformed the two other indices in four out of nine years. Apart from performance, one of the main reasons to invest in the distressed sector is to benet from its low return correlation with most other major asset classes (see Figure 5).
Event risk
The major risk of distressed investing is event risk. Companies become distressed for good reasons. Distressed managers hope to clean the companys balance sheet through bankruptcy and use their expertise to turn the business around. However, they may not always be successful. The second major risk is the lack of liquidity. Workout and turnaround situations do not come good overnight.
Figure 5 | Defaulted debt as a diversifier

Correlation of monthly returns January 1987 to December 2004 (as a percentage)
Altman defaulted bond index S&P 500 index Citigroup high yield bond market index 10 year T-bond
Altman default bond index S&P 500 index Citygroup high yield bond index 10 year T-bond
1.0
28.8 1.0
61.4 50.1 1.0
-19.1 3.9 10.6 1.0
The correlation between defaulted bonds and the S&P 500 is weak because holders of defaulted bonds usually exchange their debt for the equity of the company emerging from bankruptcy (unless they sell the debt just before it emerges). Distressed managers who take controlling stakes in companies, and invest in equity and equity-related securities, will have a higher correlation with stock markets.
It may be several years before a troubled company can be turned around and appreciate in value. To sum up, returns from distressed investing vary signicantly and are determined not only by the stage of the credit cycle but also by the managers ability to assess risks and identify the best opportunities. Only a few managers have shown themselves able to sustain returns throughout the ups and downs of a credit cycle. These managers might be attractive to larger institutions who have the appropriate governance and want to diversify across strategies and investment styles.
How to manage conflicts of interest

Conicts of interest in the nancial markets have hit the headlines all too frequently in recent years. The fallout from the US mutual fund trading scandal in particular has set alarm bells ringing in other asset classes. The result is that investors are far more aware of potential mineelds such as favoured treatment of certain client types, and how fund managers remuneration can provoke biased behaviours.
Could there be a repeat performance in the private equity sector? Certainly, investors need to keep their eyes open and ask the right questions in order to understand who they are doing business with, and how these organisations and individuals might be motivated.
Conicts within a large group

In an ideal world, the private equity team operates autonomously. It makes decisions independently; it hires and res its own staff; it remunerates them and sets the overall business strategy. In practice, this does not always happen. Some private equity teams operate within larger organisations that may interfere, and whose business objectives and time horizons may conict with those of the private equity team. Business pressures, or regulatory changes, could even change the parents commitment to the asset class. When investing with a team that is part of a larger group, investors need to verify how much autonomy the team is allowed, and how private equity ts into the parents business plan.
What to ask
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What are the parents objectives for the private equity business and how have these changed over time? How does the long time horizon of private equity t with the business objectives of the parent? What control does the private equity team have over hiring, ring and remuneration policy? Are there contractual arrangements between the parent and private equity team to protect third party investors in the event of a strategy change by the parent? How dependent is the private equity team on captive money? What is the parents attitude to external investors?
How are management fees and carried interest split between the team and the parent? Does this split align everyones interests? Does the parent commit to the private equity funds?
How are placement agency fees treated if funds are placed with the internal fund of funds (FoF) group? Who on the investment committee takes decisions on deals? Are all members from the private equity team? What is the managers policy on disclosure of conicts among investors and/or investments? Is there an independent body to resolve such conicts? How are members of the private equity team rewarded? How far are their interests aligned with those of investors? Do they invest their own money in the funds?
When group interests drive deals

Investors in private equity want to be sure that investments are made on the nancial merits of a deal. However, sometimes decision-making may be inuenced by the broader interests of the larger group or parent, rather than to protect the interests of the investors in the fund. For instance, a certain deal might generate fees for the corporate nance division, or a portfolio company may need additional nancial support. It is important to nd out how the private equity team deals with internal pressures to implement deals that benet the wider group.
n an illiquid market like private equity I that has lumpy payoffs, it is critical that all clients are dealt with fairly when deals are allocated
What to ask
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What proportion of deal ow comes via the group? Does the group provide debt nance or advisory services to portfolio companies? To what extent does the private equity team co-invest with the groups proprietary investment team? To what extent does the private equity team use the leveraged nance team as a source of co-investment deals? To what extent are exits arranged with the group?
Many private equity FoF managers also run direct private equity portfolios, or there may be a team that invests directly within a larger group. This presents an immediate conict of interest as the group will clearly earn higher fees if its FoF manager invests in an afliated fund. In these circumstances, investors should ask about the FoF managers policy on investing in associated direct funds, and how the manager ensures that such an investment is made on its own merits.
When parallel funds compete for deals

In an illiquid market like private equity that has lumpy payoffs, it is critical that all clients are dealt with fairly when deals are allocated. To avoid conicts altogether, a private equity manager should ideally have just one fund open at any time. In real life, most managers launch new funds before earlier ones are fully committed. They also run parallel funds for clients who have different regulatory or investment requirements. This means that they may run separate accounts, or have multiple funds open that appear to follow different strategies, but could in practice compete for exposure to a deal. Worse, it may suit a manager to favour a particular client or vehicle (for example, a captive) with particularly lucrative deals. How can the investor be sure that deals are allocated fairly?
What to ask
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Does the manager run separate accounts as well as pooled vehicles? How large and numerous are these accounts and how long have they been established? What is the managers policy on launching new funds before previous funds are committed? Does the manager run money for the parent or other afliates? How does the manager ensure fair play between these and external clients? What is the managers policy on allocating deals across portfolios and how is this policed? Is there an advisory group to deal with the conicts? Who sits on the advisory group?
When FoF managers invest directly

Many FoF managers have some exibility to invest in secondaries and directly, for instance in co-investments presented to them by underlying managers. Here, the carry (or share of any prots) is typically higher than it is from a fund investment, reecting the greater due diligence required. This presents potential conicts of interest because managers may be tempted to do more of these deals in order to enjoy higher fees. They may also be tempted to select underlying funds for their co-investment opportunities rather than on overall merit. What is more, many FoF managers lack the skill and resources to evaluate direct investment opportunities, and a co-investment may arise because a deal is unattractive.
Investors need to nd out the extent of these deals, and the managers policy towards them.
What to ask
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How do the fees work? Who participates in the management fee and the carry? What expenses are charged to the fund, and are they reasonable? Are transaction-related fees and advisory board fees returned to investors or do they benet the private equity rm or its parent?
What to ask
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Do you invest directly within your FoF? What about secondaries? If you invest, what is the maximum exposure permitted? How high an allocation have you had in the past? How do you evaluate the merits of the deal? Do you co-invest with groups where you are not a limited partner (LP)? If so, where do you source these deals from and how is due diligence carried out? What is your fee arrangement for direct investments and for secondaries? Does the FoF team or a separate direct investment team participate in the carry? What proportion of co-investment opportunities presented to you do you accept? And how do you conduct due diligence?
It is important for investors and managers to acknowledge that these conicts exist, and should be avoided as far as possible. Conicts that cannot be avoided should be managed appropriately and disclosed clearly to minimise nancial loss and disappointment. By asking the right questions, investors will be far better equipped to invest wisely in private equity. We hope that their awareness will speed up the adoption of best practice principles by market participants.
When consultants run funds

As the investment consulting industry has developed, several consultants have developed FoF businesses. A potential conict of interest arises when consultants offer advice to clients on the suitability of an asset class, but also earn fees from selling a fund that invests in the asset class. Competing fund providers may also be reluctant to discuss their processes in research meetings in case they are leaked to a competitor during a manager selection exercise.
What to ask
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Fees and favours

Fee arrangements in private equity are potentially highly lucrative for the managers. Fees may reward certain behaviours, not all of which are in line with investors best interests. Such behaviours may include favouring certain clients over others, investing more in co-investments and secondaries than is appropriate, and charging expenses to the fund for travel, legal fees and other advisory services. Investors clearly need to dig into the details of fee arrangements before investing.
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If the consultant offers a private equity FoF, do they typically avoid giving strategic advice in this area? How effective are the Chinese walls between the consulting and multi-manager funds businesses? Does the latter have full access to the manager research output?
Conclusions
Conicts of interest are a fact of life. Some, like the mutual funds controversy in the US, may not be illegal, but they are detrimental to non-privileged investors. The private equity industry is no different.
Publicly listed vehicles

Gaining a public listing benets private equity managers more than their investors.
The allure of going public is not new to private equity managers. As long ago as the 1970s, venture capital rms were using public markets as a means of raising evergreen capital that never has to be repaid. Some of the largest private equity rms today have come to the same conclusion. The benets of not having to go cap in hand to institutional clients every two years to raise capital outweighs the drawbacks of being exposed to market factors not normally associated with private equity. With exchanges across the globe competing for listings, we expect this trend to continue (the FSA is currently considering new rules that make it easier for private equity rms to list in London). Many listed rms run both listed and unlisted funds. This leads us to ask whether publicly listed vehicles provide any benets for managers as well as for investors over the usual method of investing in private equity via a limited partnership. And if there are advantages for the manager, can these bias their behaviour?
How and where they list

A private equity rm can list publicly as either a quoted public company or an investment trust. Because of the tax benets, most private equity rms list as investment trusts; in the US these are known as BDVs (business development vehicles) and in the UK known as PEITs (private equity investment trusts). Investors should be aware that the regulatory differences between the two can be considerable (which may explain why global private equity giant KKR decided against listing in London or New York and chose Amsterdam instead). These investment trusts can comprise direct investments (such as KKRs fund), fund of funds investments, or both. It is important to understand why a private equity rm might choose a public listing, because some of the benets conferred may not be in the best interests of investors.
How listing benets managers

The most transparent benet to listing is evergreen capital. An investment in a listed vehicle, unlike in a partnership, has no xed lifespan and therefore is not distributed back to the investor when an investment is sold. This is the Holy Grail for private equity and hedge funds alike as the proceeds from the sale of assets are retained for re-investment, allowing the manager to re-invest continually. Current market conditions make this a very good time to raise capital, with investors clamouring for high yielding assets in a low interest rate environment.
Is this opportunistic? Quite possibly, but this is not in itself at odds with the interests of institutional clients who are concerned with long-term capital appreciation. Perhaps even more attractive to the manager is that evergreen capital brings with it a recurring stream of manager fees. There is no set fee structure, and so each fund should be judged on its individual terms, but one common structure is to charge fees on the entire net or gross asset value of the fund, including un-invested cash. The managers can argue that this is fair for several reasons. Firstly, investors often buy into an existing
Why investors should be wary

Investors may be uncomfortable with some aspects of fee charging, particularly the recurring stream of fees, because these may affect a managers incentives. The net and gross asset values on which fees are based are generally calculated twice a year, and the values of unrealised investments will only be estimates. This could potentially tempt the manager to choose a sub-optimal exit strategy. For example, the manager could, hold an underperforming investment longer than would otherwise be prudent and value it at cost.
portfolio investments and indirect investments into funds. But why should investors pay high fees for a manager to hold cash? In this environment, managers may be forced to make a tough decision; do they return cash to investors, losing the fees they would have generated, while publicly announcing to the market that they are unable to identify appropriate opportunities, or do they invest in sub-optimal investments? At a time when competition for private equity investments, and hence multiples, are increasing because of huge capital inows, investors must be aware of the inherent conict of interest. This conict may arise even when fees are not charged on cash, as investors will expect their money to be put to work. Similar conicts may arise in partnership investing, where fees are charged on money committed, rather than invested. However, there are important differences. When committing to a partnership vehicle, investors can keep undrawn capital in return-seeking assets, such as quoted equities. Also, partnership vehicles do not enjoy the benets of evergreen capital and guaranteed recurring fees. This should incentivise their managers to raise funds of a suitable size at a suitable time if they do not want to risk having their caps hanging empty.
Evergreen capital may also affect the managers incentives in adverse conditions where attractive investment opportunities are lacking
pool of investments. Secondly, the pool of capital needs to be continually put to work; managers therefore spend their time and resources continually searching for new opportunities and working on existing ones. As long as the manager has the resources to keep the process going indenitely, and is fully dedicated to the publicly-listed vehicle, this fee structure may seem reasonable.
In addition, charging performance fees based on net/gross asset values increases the incentive to isrepresent an assets true value. Evergreen capital may also affect the managers incentives in adverse conditions where attractive investment opportunities are lacking. Logic dictates that it is preferable to hold cash if the expected returns from an investment are less than cash plus an appropriate risk premium. This applies to direct
Who should invest?

Taking all these points into account, we believe that public vehicles offer no benets to large institutional investors who have the resources to invest in private equity via partnerships. For these investors, the potential conicts of interest outweigh the main advantage of listed vehicles, which is their liquidity.
However, investors with limited governance capabilities who are looking to build a private equity portfolio in a short time frame may nd listed vehicles a useful entry point. Their liquidity provides clear benets to these investors. They are able to gain immediate access to the asset class without the governance required for a partnership investment. Secondly, far smaller commitments are required, allowing investors to dip their toes in before making a decision. Thirdly, investors are often buying into a ready pool of investments. Those who do not like the fund, and do not think the fees are justied, can simply sell.
Share price versus asset value

However, listed vehicles do have another signicant drawback. Their share prices can suffer lumpy price movements due to their infrequently recalculated asset values, as well as to periods of market volatility. This means that investors will need to decide whether the current share price represents good value. Investment trusts generally trade at a discount to net asset value. In the well-developed listed private equity sector in the UK, however, some of the better known funds trade at a large premium to underlying net asset value (NAV) (see Figure 1). Candover, which also manages private equity investments for third parties, has seen its share price rise by a startling 105.7 per cent over the past three years and is trading at a 36.1 per cent premium to net asset value. Also performing extremely well is 3i, the UKs oldest and largest listed private equity rm, which has seen its share price rise by 71.2 per cent over the past three years and is trading at a premium of 24.8 per cent to NAV. This may reect investors belief that the NAVs of these companies are undervalued. However, the optimism surrounding private equity and the huge capital inows it is experiencing may also be signicant factors. We are not concluding that private equity investment trusts do not represent good value, but investors must be aware that the very best managers are currently trading at big premiums. Another drawback to consider is listed vehicles closer correlation with public equity markets. Correlations between public and
Figure 1 | Selected UK listed private equity vehicles: size, and premium or discount of share price to NAV
1200 4531.6 40 35 1000 30 Premium/discount to net asset value 25 800 Market cap (M) 20 15 600 10 400 5 0 200 -5 -10 0 3i Candover Electra HG capital private equity Graphite enterprise SVG capital Pantheon F&C private equity Standard life -15
Market cap direct Market cap FOF Source: Financial Times, Trustnet
Premium to net asset value Discount to net asset value
private equity returns are generally considered to be fairly close in any case, but listed vehicles are more closely correlated with public markets than are partnerships. This is because investors returns are dictated by share price, which is subject to market sentiment, whereas returns from private equity partnerships are based on underlying asset values. Investors therefore run the risk that the premium or discount to NAV at which they enter and exit may vary considerably. The industry is actively looking to smooth out these share price uctuations but investors need to be aware that this is an investor-driven issue. Managers fees are calculated on asset values, not share price. In conclusion, we have specic concerns about listed private equity vehicles.
The large size of the funds being raised, and the corresponding fees, could cause a potential conict of interest between managers and their clients if good investments become scarcer. The pressures on partnerships are similar, but they are amplied in the case of publicly listed vehicles. As a result, we believe that investors who have the governance capability should continue to invest through partnership vehicles rather than public markets. However, the liquidity benets of publicly listed vehicles may attract investors who lack the governance, or are not yet comfortable with partnership investing. These investors may nd listed vehicles an acceptable rst step towards building a private equity portfolio, although they should be well aware of the risks they are taking.
Glossary of terms
Carried interest (Carry) A prot sharing arrangement designed to allow the private equity manager or general partner
to participate in a successful fund or investment.
Commitments Investors will allocate a specic amount of money to the private equity manager. This is the commitment,
which the private equity manager will request as and when it is needed for investment opportunities. The commitment sets the maximum level of investment that the investor may place into the market, although it is unlikely that the commitment will be totally invested at any one point in time. Rather, it is likely that 50-75 per cent of the commitment will be invested at the peak of the fund investment. n investor may be given an opportunity to actively become involved in a co-investment opportunity, A whereby it can invest alongside the general partner directly into a portfolio company. Direct funds are run by private equity managers that select and invest into private, or unquoted companies. By contrast, FoF will invest in a range of direct funds, and possibly a number of direct investments. invest in the debt, equity, or trade claims of companies either already in default, under bankruptcy protection, or in distress and apparently heading toward such a condition. to the underlying investors.
Co-investments Direct funds
Distressed investing There is no universally accepted denition of distressed investing. Distressed investors typically Distribution As private equity managers sell their investments and receive cash, they will then pass this on
Drawdown The private equity manager will call upon investors to provide monies for investment in underlying
companies from the initial commitment. Each request for money is referred to as a draw-down.
Due diligence Prior to a private equity manager investing in a company, the manager conducts a series of investigations
in order to determine how successful that company is likely to be. This level of investigation may include an external nancial audit of the company, an assessment of the business, interviews with the management, references from clients, competitors and previous employers, and in some cases private detective investigations of the senior management of the company. FoF managers will conduct similar investigations into the direct funds in which they invest. allow investors to gain a diversied portfolio of funds, invested in different geographical areas and over a spread of stages of investment. Funds of funds is expressed as FoFs within this publication.
Fund of funds (FoF) A number of managers specialise in the selection of private equity managers. They provide vehicles which Internal rate of return (IRR) This is a measure of the performance of a private equity investment. It is based on the initial investment
cost and the nal investment proceeds over the period of investment. The internal rate of return for a fund is based on the cashows into and out of the fund, as experienced by an investor. to termination). The common practice of paying the management fee and start-up costs out of the rst drawdown does not produce an equivalent book value. As a result, a private equity fund will initially show a negative return. When the rst realisations are made, the fund returns start to rise quite steeply. partnership is created with a prescribed term to dissolution. The private equity manager, or the general partner, will usually have the option to extend the life of the partnership by two separate one year periods.
J-curve The curve realised by plotting the returns generated by a private equity fund against time (from inception
Limited partnership This is the most common means of providing a pooled vehicle for private equity investment. A limited Multiple of capital (MOC)
his is another measure of performance for a private equity investment in addition to the IRR. It measures T the multiple of capital that the private equity manager returns relative to the capital invested. underlying investors.
Realisation When an investment is sold the proceeds are realised and subsequently distributed to the Secondaries
A secondary investment is an investment into an existing private equity partnership (with the direct manager continuing as the manager) or into a portfolio of company investments where a new direct manager is appointed to manage the companies (known as synthetic secondaries). Also known as private companies, or private equity.
Unquoted Generic term used to refer to all companies that are not listed on a recognised stock exchange. Venture economics An organisation that specialises in the collection of data on private equity investments in the United States. Vintage year This refers to the year in which the private equity fund was raised. Most performance measurers use vintage
year to segregate different funds for comparison purposes.
The private equity team
The UK team
Mark Calnan (UK)

Mark joined Watson Wyatt in August 2004 as an investment analyst and has been a member of the Private Equity ASK since then. Mark graduated from Leeds University with an MA in Economics and a BA in Business Economics, and he is currently a Level II candidate in the CFA programme. Email: mark.calnan@watsonwyatt.com Tel: +44 (0) 207 598 2819
Ed Francis (UK)
Ed Francis has been a key member of the Private Equity ASK for the past four years and is also a senior investment consultant. Eds experience in consulting to institutional investors on a broad range of issues is vital in effectively communicating our private equity ideas to our clients. Ed graduated from Hull University in 1992 with a BSc in Economics and Economic history and has worked in the pensions and investment eld since graduating. He joined Watson Wyatt in 2001 from PriceWaterhouseCoopers and is an Associate of the Pensions Management Institute. Email: ed.francis@watsonwyatt.com Tel: +44 (0) 1737 284802
Sanjay Mansukhani (US)

Sanjay heads the Private Equity team and is based in the Stamford, Connecticut ofce. Sanjays deep knowledge and extensive contacts within the private equity industry are key factors in Watson Wyatts direct research programme. Prior to joining Watson Wyatt early in 2005, Sanjay spent over 7 years with Evaluation Associates in Norwalk, Connecticut, where he served most recently as director of alternative investments. In that capacity he led the rms private equity and real estate investment consulting practice and was a member of the fund of hedge funds manager research team. Before joining Evaluation Associates, Sanjay worked for CP Inc. (Ambuja House) in Calcutta, India as a business development manager, at Holland Capital Management (Chicago) as an equity research analyst and as a portfolio analyst for DeMarche Associates in Kansas City. He has a Bachelors degree from the University of Calcutta, and an MBA in Finance from Pittsburg State University. Email: sanjay.mansukhani@watsonwyatt.com Tel: +1 203 977 6320
Gregg Disdale (UK)

Gregg joined Watson Wyatt in the graduate intake of 2006 as an investment analyst after two years at BNP Paribas, London, where he was a Business IT consultant specialising in derivatives. Gregg is focused on manager research in alternatives, more specically private equity, real estate, and hedge funds. Gregg has an MSc in Economics and Finance from the Warwick Business School. Email: gregg.disdale@watsonwyatt.com Tel: +44 (0) 1737 274605
Luba Nikulina (UK)

Luba joined Watson Wyatt in September 2005 as an investment consultant focusing exclusively on private equity manager research. She has seven years of experience in direct private equity investments in Eastern Europe. She worked as an investment manager in a major investment rm in Russia and was responsible for identifying investment opportunities, executing due diligence and managing portfolio companies. Luba has played an important role in driving forward Watson Wyatts direct private equity research, leveraging her hands-on experience and taking full advantage of her extensive industry contacts. Luba is well known in the industry and regularly writes private equity papers published in the specialist press. Luba received an MS in Finance from the Finance Academy in Russia and an MBA from the London Business School. Luba is also a Level II candidate in the CFA programme. Email: luba.nikulina@watsonwyatt.com Tel: +44 (0) 207 227 2107
Martin Potgieter (UK)

Martin joined Watson Wyatt in January 2003. He has been a member of the private equity research team since January 2005. Prior to researching private equity, he was responsible for researching European equities. Before joining the rm, Martin worked for seven years as pension actuary for a major rm of pension and employee benets consultants in South Africa. Martin graduated from the University of Pretoria with an Honours degree in Actuarial Science. He qualied as a Fellow of the Institute of Actuaries in 2001 and is a past member of the AIDS committee of the Actuarial Society of South Africa. Martin is also a Level III candidate in the CFA programme. Email: martin.potgieter@watsonwyatt.com Tel: +44 (0) 1737 274204
Stuart Sergeant (UK)

Stuart is responsible for all private equity monitoring and manager selection reporting. In addition to his reporting responsibilities, Stuart provides key support into the teams due diligence process with performance and attribution analytics. Stuart is also responsible for the maintenance of Watson Wyatts private equity databases. Stuart graduated from Warwick University with a BSc in Mathematics with Business Studies, and is currently studying for the Investment Management Certicate. Email: stuart.sergeant@watsonwyatt.com Tel: +44 (0) 1737 274357
Jane Welsh (UK)

Jane is the Head of the European Private Equity team and is a senior investment consultant, having specialised in investment consulting since 1984. She has three years private equity experience at Watson Wyatt but researched some direct private equity rms prior to joining Watson Wyatt in 1992. Prior to Watson Wyatt, Jane worked for eight years with Frank Russell in a manager research role, covering UK-based and international investment managers. While at Frank Russell, Jane worked with UK and non-UK nancial institutions to help them select and monitor their investment managers. Prior to Frank Russell, Jane worked in the nancial services area of the London Business School advising pension funds and investment managers on risk analysis of portfolios. In addition to an MA in Politics, Philosophy and Economics from The Queens College, Oxford, Jane earned an MSc in Economics (now known as an MBA) from London Business School in 1986. Email: jane.welsh@watsonwyatt.com Tel: +44 (0) 1737 284852
Janet Rabovsky (Canada)

In 2002, Janet transferred from Watson Wyatts London ofce where she was primarily involved in the development and delivery of a delegated investment consulting service, and where she engaged in private equity research and client consulting. Janets experience in researching private equity managers, both direct and FoF, is a great resource for the team. From 1998 to 2001, Janet was with BMO Mutual Funds, the mutual fund company of the Bank of Montreal, in Toronto, Canada. In her capacity as Director, Investments, she was responsible for the development and performance of 47 mutual funds and 14 investment portfolios, as well as the selection and monitoring of investment managers for these funds. Email: janet.rabovsky@watsonwyatt.com Tel: +1 416 813 4523
Sandi Orleow (Australia)

Sandi is a senior investment consultant in the Sydney Ofce. She joined Watson Wyatt in May 2004. Prior to joining Watson Wyatt, Sandi headed the Consulting Division of Brockhouse Cooper, South Africa (a specialist manager search and structure consultant). Prior to this she worked in the multi-manager environment involved in product development, manager selection and implementation. Sandi shares her research responsibilities between Australian and Asian private equity funds and Australian equity products. Sandi is a chartered accountant by training and has a B Com and B Acc degree from the University of Witwatersrand (South Africa). She is also a CFA Charterholder. Email: sandi.orleow@watsonwyatt.com Tel: +612 9253 3113
Watson Wyatt Investment Consulting Thinking Ahead

This article is written by members of our Thinking Ahead Group (TAG), who sit within the Investment Practice at Watson Wyatt. Their role is to identify and develop new investment thinking and opportunities not naturally covered under mainstream research. They seek to encourage new ways of seeing the investment environment in ways that add value to our clients. The information contained in this article does not constitute legal, accounting, tax, consulting or other professional advice. Before making any decision or taking any action relating to the issues addressed in this article, please engage a qualied professional adviser. Watson Wyatt Investment Consulting, a division of Watson Wyatt, is focused on creating nancial value for institutional investors through independent, best-in-class investment advice. We are specialist investment professionals who provide coordinated investment strategy advice based on expertise in risk assessment, strategic asset allocation and investment manager selection. Watson Wyatt Investment Consulting provides investment advice to some of the worlds largest pension funds and institutional investors, and has more than 300 associates in Europe, the Americas and Asia. In the United States, investment advisory and investment consulting services are provided by Watson Wyatt Investment Consulting, Inc., which is a subsidiary of Watson Wyatt & Company. Watson Wyatt Investment Consulting, Inc., is a registered investment adviser with the Securities and Exchange Commission. Watson Wyatt (NYSE: WW) is a leading global human capital and nancial management consulting rm. The rm specializes in employee benets, investment consulting, human capital strategies, technology solutions, and insurance and nancial services and has 6,700 associates in 31 countries. The rm is located on the Web at watsonwyatt.com.
Watson Wyatt Worldwide

Watson Wyatt is the trusted business partner to the worlds leading organizations on people and nancial issues. Our client relationships, many spanning decades, dene who we are. They are shaped by a deep understanding of our clients needs, a collaborative working style and a rm-wide commitment to service excellence. Our consultants bring fresh thinking to client issues, along with the experience and research to know what really works. They deliver practical, evidence-based solutions that are tailored to your organizations culture and goals. With 6,700 associates in 31 countries, our global services include:
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Private Equity Explained September 2007

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Private Equity Explained September 2007

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private equity explained

2 | Private equity explained

What is private equity?

Company size increases... risk reduces

4 | Private equity explained

Why invest in private equity?

Figure 2 | Capital allocated to buyout and venture over past decade

Source: Goldman Sachs, Thomson Financial, Somerset Capital Limited, Prequin

The challenges Managing cashows

Median to upper quartile

6 | Private equity explained

What about current market conditions?

Building and maintaining an allocation

Time lags in private equity

8 | Private equity explained

Figure 1 | The time lag between commitment and exit Stage 1:

Fund of funds manager

Direct private equity manager

n T   ypical time frame remaining invested in underlying companies: three to ve years.

Figure 2 | Negative cashflow in the early years

Cumulative cash flow

Committed does not mean invested

How to reach a target allocation

Figure 3 | Commitment versus investment

Net annual cashflow

Maintaining the allocation

10 | Private equity explained

Figure 4 | Overcommitting to reach a target allocation

Net annual cashflow

Figure 5 | Making smaller commitments to reach a target allocation

Net annual cashflow

Source: Watson Wyatt estimates

Figure 6 | Maintaining a target allocation over time

Net annual cashflow

Source: Watson Wyatt estimates

12 | Private equity explained

Fund of funds or direct fund investment?

First time investors

Those with more experience

14 | Private equity explained

How many managers?

Measuring private equity performance

Benchmarks for the private equity programme Primary measure

16 | Private equity explained

Figure 1 | Comparing private and public equity returns

Source: Watson Wyatt estimates

Figure 2a | Comparing returns by individual vintage year

Benchmarking individual managers

Figure 2b | Comparing returns by individual vintage year

Figure 3 | Assessing performance using a balanced scorecard approach Management measures

 Sensible sliding fee structure and additional alignment of

 XYZ is committed to remaining independent, although this

 XYZ has a clear and disciplined approach and its due

 Investment activity gathered pace over the year,

 XYZ has established relationships across the private

 XYZ has demonstrated strong sell disciplines by

 Client A received its rst distributions from fund IV

 Broad coverage of sectors in fund research as proven by

 Splits by discipline and geography are in line with

 There is a relative lack of breadth and depth of European

 35 commitments have been made to date and the

Figure 5 | Investment history

n T ypical time frame remaining invested in underlying companies: three to ve years.

Sensible sliding fee structure and additional alignment of

XYZ is committed to remaining independent, although this

XYZ has a clear and disciplined approach and its due

Investment activity gathered pace over the year,

XYZ has established relationships across the private

XYZ has demonstrated strong sell disciplines by

Client A received its rst distributions from fund IV

Broad coverage of sectors in fund research as proven by

Splits by discipline and geography are in line with

There is a relative lack of breadth and depth of European

35 commitments have been made to date and the