Alternative Investments in a Changing World

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1 NORTHERN TRUST 2010 PROGRAM SOLUTIONS CONFERENCE Investment Solutions in an Uncertain World: WHAT S NEXT? Alternative Investments in a Changing World Andrew C Smith, CFA, Chief Investment Officer, NTGA Anthony Zanolla, CFA, Sr. Director Hedge Fund Investments Raj Vora, Vice President, Private Equity Kaz Sikora, CFA, Vice President, Global Manager Research 2010 Northern Trust Corporation northerntrust.com

2 Alternative Assets Hedge Funds Private Equity Real Estate Real Assets An extension of the traditional investments opportunity set A range of skill based strategies that complement traditional Beta oriented strategies Program Solutions Conference

3 Beta to Alpha Continuum Asset Location Versus Investment Strategy Alpha Active Return Alternative Beta Non linear investments Portfolio Concentration Segmented Market Absolute Return Long short Beta 130/30 Enhanced Index Index fund Active long only Program Solutions Conference Active Risk Source: Anson, 2009, Core Topics in Alternative Investments

4 What Are Trends For Institutional Investors? Institutional client surveys 1 show assets moving assets traditional asset classes to alternatives: Public plans are leading this trend followed by F&E. Corporate plans are adding to both fixed income and alternatives. Increased allocation to alternatives is coming primarily out of equities. Why? Institutional Investors have developed a more sophisticated understanding of investment risk, and more highly developed understanding of the beta to alpha continuum. Conclusion: Alternatives investments are being incorporated as less constrained, more actively managed, and less liquid extension of traditional equity and fixed income asset classes, not as a separate asset class. 1 JP Morgan Institutional Client survey, April Program Solutions Conference

5 Alternative Investments in the Current Market Environment The Catalyst = current market environment: Traditional fixed income outlook = low yields. Traditional equity outlook = low growth. Traditional Beta sources may not meet target return objectives. Alternative assets can offer higher returns from Alpha. Returns generated primarily by investment strategy not by market exposure. Incremental skill based returns above what the market offers. Alternative assets expand and diversify the investment opportunity set. Diversify sources of return and risk. Potential to reduce tail risk Program Solutions Conference

6 Alternative Investments Pro s and Con s Pros: Potential for increased returns from expanding the opportunity set: Alpha and/or exotic beta. Improved diversification and potential to mitigate tail risk. Cons: Typically private investments: Less transparency, more complexity, less regulation. High fees New risks to manage: Leverage Liquidity Counterparty Operational Fraud Reputational Program Solutions Conference

7 Outlook for Alternatives Hedge Funds: Registration requirements leading to improved transparency. Increased institutional uptake = trend towards lower fees. Additional regulation = increased attention to operational risks, conflicts. Private Equity: More transparency; FAS 157. Disappearance of weak and poorly resourced firms. Real Estate: Better segmentation of the market. Core/Value Add/Opportunistic = more choice. Growth of REITS = improved market liquidity, more sources of capital Program Solutions Conference

8 NORTHERN TRUST 2010 PROGRAM SOLUTIONS CONFERENCE Investment Solutions in an Uncertain World: WHAT S NEXT? Why Hedge Funds? Anthony Zanolla CFA, Sr. Director Hedge Fund Investments 2010 Northern Trust Corporation northerntrust.com

9 Why Hedge Funds? Hedge funds private placement status provides them far more flexibility in the investment decision making process and the securities they can employ versus traditional asset managers Wider investment mandate using broad array of securities, including derivatives, commodities, private investments Selling securities short (rather than being underweight versus a benchmark) allows the manager to profit from sell decisions and reduce risk in the portfolio Buying securities on margin (leverage) allows the fund to leverage its research and skill while reducing risk Hedge Funds low correlation with traditional assets makes it an attractive addition to an overall asset allocation. Aligns the interests of the manager, his team and investors Incentive fee incentivises manager and staff Manager co-investment - Manager eats his own cooking Program Solutions Conference

10 Deciphering Hedge Fund Terminology Leverage: Long Exposure: Short Exposure: Additional investment exposure achieved through margin or borrowing. Manager A with $100 in assets, who borrows to buy $150 of securities would be leveraged 150% or 1.5x. Knowing the level of leverage is essential, but alone it does not provide a complete picture of the particular strategy. Aggregate amount of long positions. Aggregate amount of short positions. Net Exposure: Defined as longs - shorts. If Manager A (above) has $100 long and $50 short (using leverage), then their net directional market exposure is 50%. The significance of net exposure is that it is a rough measure of directional market risk in the portfolio. Gross Exposure: The total of the long and short positions. In our example, a manager who was $100 long and $50 short would have a gross exposure of 150%. This is significant as it represents the absolute level of investment exposure Program Solutions Conference

11 Shorting, Leverage and Reducing Risk Using leverage to add short exposure can lead to more consistent, attractive risk adjusted returns Example: Investor A has $100 of Northern Trust s stock. He has a favorable outlook on the company, but is cautious on the market. He decides to hedge his position, eliminating the market risk. On Jan 1, 2008 he does the following: Buys $100 of NTRS Sells Short $100 of S&P 500 His Gross exposure is 200% (i.e., 2X leverage) His Net market exposure is 0% How does he do in 2008? For illustrative purposes only Program Solutions Conference

12 Shorting, Leverage and Reducing Risk The strategy works! He makes 6.2% while both the market and NTRS are down significantly For illustrative purposes only Program Solutions Conference

13 The Hedge Fund Universe Is Comprised of Many Different Strategies With Numerous Alpha Opportunities Equity Strategies Corporate Restructuring Strategies Convergence Strategies Opportunistic Strategies Hedged Equity Distressed Fixed Income Arb Emerging Markets Merger Arb Convert Arb Global Macro Equity Market Neutral Activist Investors Event Driven Fixed Income Yield Alt CTA Short Sellers Regulation D Relative Value Arb Program Solutions Conference

14 Manager Selection - Dispersion Within Single Strategies Despite factors that contribute broadly to a strategy s performance, each fund is unique in its talent and approach, leading to a wide range of results Average Strategy Returns (data as of December 31, 2009) 2008 Average Strategy Returns (data as of December 31, 2008) Source: CSFB Program Solutions Conference

15 Real World Example: The Equity Market Conundrum After experiencing 2008, client A is apprehensive to move from cash back into equities Bond yields are too low to support income needs and philanthropic goals Potential Solution: Take 30% of equity allocation and allocate to Equity Long / Short Decreases volatility Reduces magnitude of drawdowns Increases overall return with lower risk over a market cycle Program Solutions Conference

16 Adding Alpha Through Hedge Funds $5,000 S&P 500 Index vs. 70% S&P 500 / 30% HFRI Equity Hedge Mix January 1995 March 2010 $4,500 $4, % $3,500 $3, % $2,500 $2,000 $1,500 $1,000 $500 $0 S&P 500 DRI 70/30 SPX/HFRI Hedged Equity Mix Source: HFR and Pertrac. All internally developed data and other third party sources are believed to be reliable. Northern Trust Global advisors, Inc. has not sought to independently verify information obtained from public and third party sources and makes no representations or warranties as to accuracy, completeness or reliability of such information Program Solutions Conference

17 Adding Alpha Through Hedge Funds And Manager Selection S&P 500 Index vs. S&P 500 with 30% HFRI Equity Hedge vs. S&P 500 with 30% Bluefin May 2007 March 2010 $1,200 $1, % -10.0% $ % $600 $400 $200 $0 spx/bluefin 70/30 mix 70/30 SPX/HFRI Hedged Equity Mix S&P 500 w/ dividends Source: HFR and Pertrac. All internally developed data and other third party sources are believed to be reliable. Northern Trust Global advisors, Inc. has not sought to independently verify information obtained from public and third party sources and makes no representations or warranties as to accuracy, completeness or reliability of such information Program Solutions Conference

18 NORTHERN TRUST 2010 PROGRAM SOLUTIONS CONFERENCE Investment Solutions in an Uncertain World: WHAT S NEXT? Why Private Equity? Taking Advantage in Today s Environment Raj N. Vora Vice President, Northern Trust Private Equity Investment Team 2010 Northern Trust Corporation northerntrust.com

19 Private Equity Sector Overview The private equity asset class encompasses several different sectors Venture Capital Investments in young, early stage companies that generally do not have positive cash flow (or even revenues) but are expected to grow quickly. Buyout Purchase of stock or assets of a company, generally involving leverage and controlling interest by the private equity firm. Company is generally cash flow positive. PRIVATE EQUITY: Investing in companies that are not listed on a public exchange Distressed Debt Investments in under-performing or bankrupt companies. Focus may be on improving operations (i.e. cash flow) or balance sheet. May take the form of an equity or debt investment. Mezzanine Debt Investments take the form of both debt and equity. Provides a current interest return with equity participation. Generally made in buyout transactions, but increasingly popular in venture capital. Secondaries Acquisitions of interests in private equity funds following their final close and typically at a discount. Note: Within sectors funds may emphasize particular industries and/or geographic regions. For informational purposes only and not intended as an offer or recommendation of any investment product or security described herein Program Solutions Conference

20 Why Private Equity as an Asset Class? Private equity has outperformed public equity indices over the 3, 5, 10, 15 and 20 year time horizons. As of 3/31/10 1 Year 3 Year 5 Year 10 Year 15 Year 20 Year S&P % -4.2% 1.0% -0.7% 7.8% 8.7% DJIA 46.9% -1.5% 3.3% 2.3% 9.0% 9.8% NASDAQ 56.9% -0.3% 3.7% -6.3% 7.4% 8.9% Private Equity 22.4% 1.3% 10.4% 7.2% 12.0% 12.3% Source: Cambridge Associates as of 3/31/10 Why? Exposes a portfolio to a whole new set of firms, talent, and companies Private equity funds participate in a more inefficient deal market Unlike public equity managers, private equity fund managers generally have control of the entities in which they invest The term structure of funds allows firms to build companies for the long term without fear of redemptions - focus is on a five year plan as opposed to quarterly plan A sense of urgency, accountability, and discipline, allow for efficient decision-making and focuses companies on value enhancing projects Economic alignment of interest among investors, fund managers, and management teams Private equity can be tax-efficient for taxable investors (There may also be some estate planning benefits) Program Solutions Conference

21 Top-Tier Manager Selection Is Central To Success Wide range of returns for private equity means fund selection is key. 25% 20% Cumulative Internal Rates of Return for Mature Private Equity Funds Performance Percentile Comparison 19.6% 15% 10% 9.4% 5% 1.3% 0% -5% -10% Lower Quartile (75th percentile) Median (50th percentile) Upper Quartile (25th percentile) Source: Thompson Financial Venture Economics, All Private Equity Funds data, latest available information from Venture Economics with data as of December 31, Private Equity data is based on cumulative internal rates of return for private equity funds in Venture Economics database. Data here is for funds that started operations between 1982 and 1997 and are near or have reached full maturity. The dataset includes over 1,000 private equity funds. More recent funds are not included as they are less seasoned and their performance is limited. Note: Private Equity returns are net of underlying manager fees and carried interest. Past performance does not guarantee future results Program Solutions Conference

22 Why Private Equity Now? Recession vintage years in particular have historically provided the opportunity for outsized returns in private equity. Why? Significantly reduced liquidity in the market leads to lower purchase prices for private equity firms Cash flow has stabilized and earnings visibility has increased Liquidity is returning to the market Buyout Fund Returns by Vintage Year Net IRR (% ) 1991 Recession 2001 Downturn GDP Growth (% ) Return Drivers: BUY (Entry Valuation) 40% 30% 6.0% 4.0% BUILD (Grow the Company) 20% 2.0% SELL (Exit Valuation) 10% 0.0% 0% NM Upper Quartile Return for Vintage Real GDP Growth (2.0% ) Source: Venture Economics, Bureau of Economic Analysis. Note: Past performance does not guarantee future results Program Solutions Conference

23 Value Proposition of a Fund-of-Funds Structure The appeal of private equity lies in its potential for three main goals for investors: performance enhancement, diversification, and downside protection Limited Partners Investor 1 Investor 2 Investor 3 Key Advantages Access to top-tier, oversubscribed fund managers Extensive resources and network Fund-of- Funds Private Equity Program Specialized, experienced managers Multiple Fund Investments per Strategy Buyouts Venture Capital Distressed Debt Disciplined investment process and ongoing portfolio monitoring Exposure to Hundreds of Portfolio Company Investments A B C A B C A B C Diversification and overall risk reduction Flexibility / customization Reporting efficiency and administrative ease Program Solutions Conference

24 Illustrative Private Equity Cash Flow Summary Committed Capital Does Not Equal Funded Capital Distributions often begin before all capital is drawn An estimated maximum of 65% of commitment is funded at any time Payback occurs between years 7 and 8 in this example $ (000s) For illustrative purposes only $ (000s) 5,000 10,000 4,000 8,000 3,000 2,000 1,000 0 Maximum Net Funded Capital ($6,500,000) 6,000 4,000 2,000 0 Net Gains (1,000) (2,000) (2,000) (4,000) (3,000) (4,000) Breakeven Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Year 11 (6,000) (8,000) Contributions (left scale) Distributions (left scale) Cumulative Cash Flow Note: The data above reflects hypothetical cash flows and an initial investment of $10.0 million. Actual results may differ substantially. The hypothetical cash flows are assumed to be net of all fees, expenses and carried interest Program Solutions Conference

25 NORTHERN TRUST 2010 PROGRAM SOLUTIONS CONFERENCE Investment Solutions in an Uncertain World: WHAT S NEXT? Investing in Real Estate Kaz Sikora Vice President, Senior Investment Analyst 2010 Northern Trust Corporation northerntrust.com

26 Why Invest In Real Estate Income is a significant component of total return The annual income return for private real estate has averaged 7.7% since % 10.0% 5.0% 0.0% -5.0% -10.0% -15.0% -20.0% -25.0% NCREIF Property Index (NPI) Income & Appreciation Average Annual Income return 7.7% Income Appreciation * Source: NCREIF The dividend yield for global real estate securities has averaged 4.5% since % 9.0% 8.0% 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% Average Yield 4.5% (1) FTSE EPRA/NAREIT Developed Real Estate Index. Prior to January 2005, yields were for the S&P Developed Property Index Program Solutions Conference

27 Why Invest In Real Estate Real Estate as an Inflation Hedge Multi-year lease contracts can adjust to increases in CPI Shorter-term leases adjust to keep pace with inflation Apartment leases - typically one year in duration Hotels - rental rates change daily The strongest correlation was observed in high-inflation periods Program Solutions Conference

28 Why Invest In Real Estate Real Estate as a diversification tool Returns from private real estate are largely uncorrelated to stocks and bonds Returns from public real estate also offer diversification benefits Source: Bloomberg Program Solutions Conference

29 Why Invest In Real Estate Active Management (Public Real Estate) Active management has added value over the global REIT index over time * Source: Evestment Alliance Program Solutions Conference

30 Why Invest In Real Estate Active Management (Private Real Estate) Managers may add value by: Investing at or below replacement cost Exploiting opportunities throughout the capital structure during periods of dislocation Focusing on strategies that have significant growth in yield Secondary focus on out of favor or inefficient market segments Invest in operators with access to attractive properties and the ability to execute value add Managers that understand the complexity and risk as well as real estate value Program Solutions Conference

31 Program Solutions Conference Questions and Answers

32 Important Information NOT A SOLICITATION. No information provided herein shall constitute, or be construed as, an offer to sell or a solicitation of an offer to acquire any security, investment product or service, nor shall any such security, product or service be offered or sold in any jurisdiction where such offer or solicitation is prohibited by law or regulation. This material is provided for informational purposes only and does not constitute a recommendation of any investment strategy or product described herein. Opinions expressed are those of the presenter(s) and subject to change without notice. Past performance is no guarantee of future results. Index performance returns do not reflect any management fees, transaction costs or expenses. It is not possible to invest directly in any index. There are risks involved in investing including possible loss of principal. There is no guarantee that the investment objectives of any fund or strategy will be met. Risk controls and models do not promise any level of performance or guarantee against loss of principal Program Solutions Conference