Going Private: A Guide to Private Investments

Transcription

1 December 2016 WHITE PAPER Going Private: A Guide to Private Investments What Private Investments Can Bring to a Portfolio Nothing in life is to be feared, it is only to be understood. Now is the time to understand more, so that we may fear less. Marie Curie Private investments are often shrouded in mystery or stigmatized in the eyes of the unfamiliar investor. In this paper, we define the various forms of private alternative asset classes and distinguish them from their publicly available counterparts: stocks, bonds, and publicly traded real estate investment trusts (REITs). We then examine how each generates investment returns, why they are important/useful additions to portfolios, and how investors typically access such investments. At a time when the expected returns on traditional (that is, publicly traded) asset classes are below historical norms, it has become increasingly important to consider the role of private alternatives in investment portfolios. When carefully selected, we believe private investments have the potential to add incremental return in an otherwise low-return environment, in addition to improving the overall risk profile of portfolios through the diversification benefits offered by certain private investment strategies. Capturing the Price of Liquidity Private investments often involve tying up capital for extended periods, often 5 10 years or longer. In addition to not being able to draw upon this capital to fund current spending, there is also an investment cost to locking up capital for an extended period, including not being able to: divest if the manager underperforms; modify the allocation to adjust the risk profile of the portfolio in changing environments; and reallocate to other investment opportunities with better expected returns. (See our 2009 white paper The Science of Alternative Investments for a quantitative estimate and more detailed discussion of these costs.) To compensate for these costs, private investments must deliver, on average, an excess return over their liquid, publicly traded counterparts in order to be attractive to investors. This excess return is commonly referred to as the illiquidity premium. Of course, the actual return on any investment is impossible to know in advance, and not all private investments will deliver this excess return. Our research suggests this excess return has historically been basis points (bps) annualized. A study of large public pension funds conducted by Hamilton Lane, one of the world s largest allocators to private investments, supports this conclusion. Over the 10-year period ending June 2015, all but one of the pension funds in the study realized a premium in their private investments relative to their public equity allocations, with the vast majority seeing a premium of more than 300 bps. 1 In a separate study of Hamilton Lane s private equity database, the median private equity manager has typically generated a higher internal rate of return (IRR) than a comparable investment in global equities as measured by the MSCI World Index 2 1 Hamilton Lane study of annual reports of U.S. public defined benefit plans of $10 billion with 10 years of investments in private equity. Returns are for the most recent 10-year period as of June 30, Hamilton Lane Fund Investment Database; performance data through March 31, 2016, based on information in the database as of July 2016 as provided to PNC. The MSCI World Index performance is net reinvested dividends, and the benchmark is calculated as a Public Market Equivalent using the pooled cash flows.

2 (Chart 1). In essence, private investments are a way to get paid for giving up liquidity the investor does not need and is unlikely to use. That said, past performance is no guarantee of success. A key question to ask in evaluating investment opportunities is: Why does the potential to generate excess returns exist? There are several mechanisms through which a private investment manager can generate excess returns. Changing the Underlying Asset The most common method is by fundamentally changing the underlying asset in some way, ultimately making it more valuable. For example, consider a private equity strategy in which the manager purchases a controlling stake in a company. With this controlling stake, the private equity manager can work to improve a company s profitability by implementing various strategic initiatives that can help drive increased margins and accelerate growth, eventually selling the company at a significant profit. Capitalizing on a Market Inefficiency Another way to generate excess returns involves capitalizing on a market inefficiency. A private debt strategy specifically focused on providing growth capital to small businesses is a good example of this effect. Small businesses generally do not have access to public lending markets. Typically, they are either too small to issue a bond large enough to be traded or the loan itself may not be large enough for a bank to profitably conduct the necessary due diligence, likely resulting in a funding gap in this niche of the market. Private debt managers can step in to fill this gap by making loans with terms substantially more favorable to the borrower than is typical of larger firms that can readily access the public markets and commercial bank loans. Providing Capital to a Manager with a Particular Skill Set A third potential source for excess returns involves providing capital to a manager with a specific skill set or area of specialization who can earn fees utilizing that particular skill. Distressed credit is a Chart 1 Private Equity Internal Rate of Return versus MSCI World Public Market Equivalent /31/16 Source: Hamilton Lane Fund Investment Database. Performance as of 3/31/16 as recorded in the database in July Note: 2014 through 2016 vintages are too recent to have meaningful results at the time of writing. good example of this strategy. When a bond is likely to default, distressed credit managers can often purchase these bonds at a discount to fair value because of the managers specialized skill sets. Fixed income portfolio managers generally are not familiar with the details of the mechanics of the bankruptcy/reorganization process; their job is to conduct credit analysis explicitly to avoid purchasing credits on the verge of such bankruptcies. When faced with a defaulting bond, they are rationally willing to sell at a discount (to stem their losses) to someone who can avoid larger impairment of capital. This discount is essentially a fee paid to the distressed credit manager for managing the bankruptcy/reorganization process. The distressed credit manager can only execute on this strategy with a significant pool of capital. Investors can participate alongside a manager by providing this capital in exchange for a return based off of that effective fee. Financial Engineering Financial engineering is another potential source of return, but PNC intentionally tries to avoid managers employing such strategies. Many private investment strategies involve the use of leverage, 2

3 essentially borrowing at a low interest rate to invest in higher-returning assets. This, of course, can also significantly increase the risks of the investment. Our preference is to find managers whose excess returns come from a clear and consistent ability to improve assets, identify market inefficiencies that can only be accessed through an illiquid vehicle, or leverage a specialized skill set to effectively collect a fee. Our due diligence process is focused on differentiating between managers with these skills and those who simply rely on leverage or other financial engineering to generate their returns. The Main Strategies: Private Equity, Debt, and Real Estate Similar to their publicly traded counterparts, private investments span a range of asset classes, each with distinct risks, expected returns, and drivers of those returns. In this section, we discuss the most common strategies used across private equity, private debt, and private real estate, as well as provide brief descriptions of how each strategy seeks to add value and generate investment returns. This list is far from exhaustive as there are a broad range of specialized strategies, but most of the private investments PNC clients will come across will likely fit into one of the categories discussed here. Private Equity Not surprisingly, this category focuses on purchases of equity stakes or ownership in companies. There are a wide variety of strategies under the umbrella term of private equity, but the two categories that seem to draw the most investor and media attention are large-scale leveraged buyouts (LBOs) and venture capital. There is a broad range of strategies within each of these categories, and many of these opportunities can look quite different from what is typically seen in the business section headlines. Leveraged Buyout LBO funds come in a wide range of flavors, typically defined by size of investment, geography, and industry focus. The most well-known form of LBO is the so-called take private transaction. Here, an LBO fund (or in the largest transactions, a group of LBO funds together) offers to purchase all outstanding shares of a public company at a premium to the current trading price, effectively turning the publicly traded company into a privately held business. The purchase is often executed with a substantial amount of debt, hence the leverage component in the term leveraged buyout. Once the purchase is complete, the fund manager implements fundamental changes in the operations of the company with the aim of improving margins and revenue growth. Sometimes, fund managers will combine acquisitions of similar companies to create a larger, more efficient enterprise (that is, to achieve economies of scale). After several years when the operational improvements have been made and some of the debt has been paid down, the fund will hold a new initial public offering (IPO) for shares of the transformed company. Alternatively, the fund might sell to a larger corporation in a strategic transaction. In either case, the goal is to generate a substantial premium versus the original purchase price. The key theme across all LBO strategies is managers seeking to positively effect change in the companies they purchase. While that is the most widely recognized version of the LBO story, it is not representative of the majority of transactions. Private equity funds frequently purchase companies from other private holders (that is, either other funds or the owners of closely held companies) or from corporations seeking a strategic sale of a division. The key theme across all LBO strategies is managers seeking to positively effect change in the companies they purchase, either through influence as a large minority shareholder or through direct control as a majority owner of the company. In large transactions, the LBO manager often acts like a consultant (although with much more power to effect change) looking to find efficiencies in large 3

4 companies that have become bloated or need a new strategic direction. In smaller companies, the LBO manager may simply be professionalizing a family-run business (that is, improving the business by implementing more formalized processes and procedures). Bringing in new, experienced managers can often: lead to dramatic improvements in the supply chain; expand the customer base; optimize pricing; and increase the scale of operations through strategic acquisitions. These changes can drive significant growth in margins over time, and the increased scale can also open the company up to larger buyers willing to pay a higher valuation for a more mature, professional company than they might otherwise have found for the original family business. Larger LBO funds tend to purchase companies at higher valuations (that is, the purchase price is usually a higher multiple of current earnings) and use higher levels of leverage than smaller funds that focus on smaller transactions. On the other hand, larger funds also tend to execute more transactions per fund, yielding a more diversified overall portfolio. The net effect has historically been that the relatively lower risk from greater diversification has outweighed the relatively higher risk associated with greater leverage. Additionally, larger funds tend to have less dispersion in returns while smaller funds have a greater potential opportunity to outperform larger ones depending on the stage of the economic cycle. This is, of course, a generalization based on averages, and the return expectations and risk profiles of specific funds and managers will vary. A common critique of LBO funds is they are merely applying financial engineering techniques and yielding returns that are not substantially different from simply leveraging publicly traded equities. This critique is a valid one, in our view, which is why PNC s due diligence team focuses on how managers generate returns and strongly favors managers who clearly demonstrate adding value by changing the companies they own. We believe managers who add value are likely to generate higher returns with less risk over time than either public equity markets or private investment managers who primarily rely on financial engineering to generate returns. Venture/Growth Capital Venture capital and growth capital funds focus on providing capital to rapidly growing companies. Excess returns come from a combination of identifying companies with high growth potential and, for the best-performing managers, providing resources to help those companies achieve their maximum growth potential. Typically these investments do not include the use of leverage, and fund managers do not have majority control of the companies in which they invest. Venture capital funds focus on earlier-stage companies (startups) and more mature companies whose revenue growth may be constrained for some reason. Growth capital is more typically focused on growth opportunities for companies that already have healthy revenue streams and/or profitability. Some venture capital firms will use an IPO as an exit strategy, but the more common exit is via a sale to another private equity firm that focuses on companies later in the development lifecycle or to a corporation in a strategic transaction. Growth capital funds use these same exit strategies but may also sell their stakes back to the company itself. Returns in venture capital can be significant. However, success is rare, and returns for venture capital funds tend to be highly dependent on a few home runs. Thus, investing in venture capital funds can be a risky endeavor, with some funds delivering extraordinary returns while many others may be subpar at best. Another key challenge is the best venture capital returns historically have been concentrated in a small number of exceptional firms. These firms have developed a competitive advantage in the marketplace that helps perpetuate their top-tier status. Owners of startups will often seek out capital providers who they believe can act as strong 4

5 partners to help drive growth in their companies. In exchange, they are often willing to sell at a discount to venture capital fund managers who have strong track records of helping launch successful companies. These managers tend to have limited capacity and only accept commitments from longtime investors. The combination of returns being concentrated in a small number of top-tier managers, the high dispersion in returns among managers and vintages of the same manager, and the difficulty accessing the best funds makes successfully investing in venture capital extremely challenging for new investors. As a result, PNC would generally not recommend investing in a single venture capital fund. That said, venture capital can be a part of a highly diversified program of private equity provided that investors have access to top-tier funds. Growth capital tends to be relatively lower risk because the funds are investing at a later stage of the development lifecycle, but these funds are not likely to deliver the same eye-popping returns in venture capital. However, it is usually easier for investors to access strong growth capital funds. Private Debt The investable opportunity set in private debt spans the universe of fixed income from investmentgrade to high-yield corporate issues, as well as asset-backed securities, leases, mortgages, and so forth. The risk and return profiles of each strategy depend largely on the underlying assets. As such, different types of investors tend to gravitate toward investing in different strategies of the private debt market given their rather unique/distinctive risk tolerances and return expectations. Based on our knowledge of our client base and the market (that is, what types of investors generally invest in each strategy), most PNC clients would generally access private debt investments via small market lending, mezzanine debt, or distressed credit since these are typically the three areas with the greatest return potential. Small Market Lending This strategy is primarily focused on issuing loans on favorable terms due to a market inefficiency. Companies seeking these loans are typically looking for capital to help fund future growth in some way. They do not want to forfeit significant equity ownership, but small firms are rather limited in their ability to raise capital. The loans are too small to make up a bond that can be traded in a market, and banks are often unwilling to underwrite these loans because there is not enough profit potential to justify the complex but necessary due diligence. Banks often provide these companies with loans backed by assets or receivables (that is, amounts owed to a business, regarded as assets), but growth-oriented loans require underwriting the firm s business, which is a much more complex task than simply underwriting an asset-backed loan. The combination of returns being concentrated in a small number of top-tier managers, the high dispersion in returns among managers and vintages of the same manager, and the difficulty accessing the best funds makes successfully investing in venture capital extremely challenging for new investors. Private debt managers fill this gap in the marketplace, and because the market is inherently inefficient, the loans from private debt managers often come with more favorable terms for the borrowers. While a similar bank loan might price at a spread of bps over LIBOR, the loans from a private debt manager can often have cash coupons of greater than 10%, an additional pay-inkind coupon, warrants in the equity of the company, and an upfront 2% closing fee. The loans can vary between senior secured debt and mezzanine debt (that is, lower in the capital structure than bank loans), which will typically be backed by claims on specific assets. Private debt funds focused on small market lending often incorporate the use of leverage, which brings the risk and return profile of these funds closer to that of private equity. 5

6 Mezzanine Debt Mezzanine debt funds are similar to small market lending funds, but they may also lend to larger borrowers. These loans typically fall in the middle of the capital structure above common and preferred equity ownership but below senior secured notes. These loans offer a higher coupon than the senior debt due to the higher level of risk. An important component of the mezzanine debt universe is what is known as sponsored debt (that is, debt issued by companies owned by LBOs), and this is the debt that provides the leverage in an LBO. As with most investment strategies, there are advantages and disadvantages to investing in sponsored debt. On the plus side, there is an active, experienced, and highly incentivized manager working to improve the issuing company. Mezzanine debt funds often build strong working relationships with LBO firms (the sponsors). As a result, debt managers tend to develop an added level of comfort when making the loans because they can scrutinize the sponsor s track record and know sponsors will want to be able to raise debt again for future deals. On the minus side, the companies issuing this debt are often more highly levered than nonsponsored peers. Like small market lending-focused funds, mezzanine debt funds also tend to use some leverage to increase the risk and return expectations closer to that of private equity. Distressed Credit Distressed credit managers have the potential to generate excess returns due to their specialized skill sets. These managers seek to acquire large positions in debt that is likely to undergo default or some other form of restructuring. They add significant value by driving the reorganization and/or bankruptcy process. They will typically join the creditors committee and be active participants in the negotiations and litigation that adjudicate the claims of various stakeholders. Distressed credit funds may invest in and benefit from reorganizations by receiving: equity in the reorganized company, and/or cash proceeds as assets are sold off in a liquidation. The liquidity of the debt instruments owned by distressed credit managers can vary, and as a result this strategy is pursued in private debt structures and in hedge funds with quarterly or annual liquidity terms. While we have listed this strategy under the private debt category because that is what the fund acquires, this debt can be considered at least partially equity-like due to the possibility of a debt-to-equity conversion during the reorganization process. As a result, leverage is not generally necessary in this strategy to deliver returns similar to private equity. Private Real Estate The investment case for private real estate differs somewhat from the other two categories of private investments. In the private equity category, the objective is to find a manager who can capitalize on taking control of a company to effect significant positive change that is not possible as a minority shareholder in a publicly traded company. Units of publicly traded REITs, however, are already an economic interest in a portfolio of real estate assets controlled by an active real estate management team. Publicly traded REITs and their private real estate counterparts share the same objective (that is, to make improvements in the assets they own). A key benefit of investing in private real estate is purer access to the real estate return stream. Publicly traded REITs are constituents of equity indexes, and thus their returns are somewhat contaminated by the supply and demand pressures that affect broad equity market valuations. Whenever investors buy or sell broad market indexes (that is, by trading index-based exchange-traded funds), publicly traded REITs will increase or decrease in price accordingly. This can result in changes in the implied valuations of the underlying real estate assets that may not be truly reflective of direct transactions in the relevant private real estate market. When looking at the performance of private real estate funds compared to publicly traded REITs, one might conclude that private real estate exhibits lower volatility than the publicly traded counterpart. We believe this effect is largely a result of statistical 6

7 smoothing techniques in reported data series, and the true underlying risk is actually comparable in both public and private versions of real estate. However, our research also indicates the returns of publicly traded REITs do not fully explain the returns of private real estate even after taking out this smoothing effect. (See our February 2012 white paper Brothers from Another Mother: Public and Private Real Estate for a quantitative assessment of the relationship between publicly traded REITs and private real estate.) Thus, private real estate may still provide a diversification benefit compared to publicly traded REITs, which we believe makes private real estate potentially additive to portfolios. Private real estate comes in many forms and can include both the equity and the debt of properties. The broad categories of private real estate include: residential, including investing in homes; commercial, investing in businesses; mortgage-backed securities (MBS), investing in the income and principal return streams of a pool (or pools) of mortgages, in both residential and commercial markets; timberland, investing in land; and farmland, enabling natural resources to generate a positive return over time. Further, private real estate can be accessed through several strategies. Core real estate funds hold well-performing properties managed to generate rental income as the primary source of returns. Opportunistic real estate funds aim to purchase properties that require some improvements, for example, renovations, upgrades, expansions, or simply better leasing arrangements. These funds are similar to LBO firms in that they aim to drive returns by effecting positive change in the underlying assets. There are also private real estate funds that primarily invest in mortgages and still others that invest in distressed assets. In the case of distressed real estate, the fund purchases distressed debt backed by real estate assets with the expectation of ultimately taking possession of the property and subsequently selling it as the exit strategy. Opportunistic and distressed real estate funds tend to exhibit higher risk profiles and generate higher returns on par with private equity. Core real estate and mortgage-based funds tend to have risk and return profiles closer to that of private debt. Building a Portfolio A core component of any portfolio construction process is strong diversification this is equally important in the world of private investments. In private investments, it is important to diversify not only across asset classes, managers, strategies, and geographies but also through time. Typically, a private investment fund has a limited initial investment period followed by a multiyear so-called harvesting period during which the manager executes its investment strategies with the portfolio of assets gathered and eventually sells them to generate profits and make distributions back to investors. Thus, allocations to private investments in any given year will only be invested over a limited period, even though the capital will be tied up for much longer. It is important not to overallocate (that is, commit an entire private investment allocation to a group of managers in a single year). Such an allocation would leave the portfolio overexposed to investments made over too short a horizon. For example, it would have been a poor choice to build a private investment portfolio solely of funds starting in 2006 all of the investments would have been made right before the financial crisis of Instead, we recommend making commitments over an extended horizon, and investors should plan on a ramp-up period of up to 10 years. In the same example, an investor who spread out his or her commitments from 2005 through 2015 would still have made some investments during the ill-fated period but also would have been able to buy assets at attractive prices from As a matter of practice, investors tend to make commitments to multiple funds from the same 7

8 manager pursuing the same strategy each commitment is to a fund from a different year, referred to as a vintage. There is one more important element to consider in building a private investment portfolio. For each private investment asset class, there are generally three approaches to building a portfolio: primary commitments, secondaries, and co-investments. Each structure has its benefits and drawbacks. We believe incorporating a mix of all three approaches will yield a well-diversified strategy across vintages and strategies for most client portfolios. Primary Commitments Primary commitments are the most common way to access a private investment fund. A primary commitment involves investing at the outset or creation of a private investment vehicle (that is, investors commit a portion of their capital to the manager during the early stages of the fund s investment process). Accessing private investments through primary commitments provides not only access to a greater array of investment opportunities but also more control over the overall private investment portfolio, since most managers and opportunities are not available any other way. The drawbacks are straightforward: investors have to wait for capital to be called, there is no transparency into the fund s portfolio, and the duration of the overall investment is longer than investing via secondaries and co-investments. Nevertheless, the ability to access a broader array of investment opportunities results in most private investments being accessed via primary commitments. Secondaries Secondaries are purchases of existing interests in funds that are already operating. Secondary purchasers are providing liquidity to other investors who may have unforeseen liquidity needs or changes in their strategic outlook that require exiting the private investment. This allows the secondary buyer to buy the interest at a discount to fair value there is a cost for liquidity. Other benefits of this method include: the ability to more rapidly increase vintage diversification by purchasing older funds; greater transparency into the underlying portfolio at the time of investment; and faster drawdowns of capital and earlier distributions because the fund is typically already several years into its lifecycle. Secondary investments are typically executed via a fund of funds specializing in secondary purchases. Investors commit capital to the secondary fund manager, and the process from there is similar to other private investments. The secondary manager collects its own fee in addition to the fees paid to managers of the underlying funds. However, this additional layer of fees is often mitigated by the discounted purchase price of the fund interests. For each private investment asset class, there are generally three approaches to building a portfolio: primary commitments, secondaries, and co-investments. Co-Investments Co-investments come about when a private investment manager has a large investment opportunity that requires more capital than the manager can allocate from an existing fund. Typically, managers seek existing fund investors to provide or allocate additional capital solely for this opportunity. One of the key benefits of this approach is co-investors do not typically pay extra management fees or additional carried interest on such an investment. The investment manager takes the capital without incremental fees because this extra capital enables the manager to make an attractive investment for the overall fund that might not otherwise be possible. However, this arrangement can lead to outsized exposure to a single investment for the co-investor. Large institutions and independent family offices often seek to develop a diversified portfolio of coinvestments as a way to mitigate the overall fees in their private investment portfolios. 8

9 That said, the institution or family office will need to have sophisticated resources and capabilities to assess each investment, and most investors in private investments do not have the ability to execute co-investments on their own. A more common solution is to work with a fund of funds manager who creates a co-investment fund that builds a portfolio of co-investments. These coinvestment funds have similar structures to other private investments, though the fees are generally substantially lower. The Illiquidity Effect It is also important to consider the overall amount of a portfolio to commit to private investments. This will, of course, differ for each client depending on specific circumstances, investment objectives, liquidity needs, and risk tolerance. Your PNC investment advisor will work closely with you to determine an appropriate allocation. In general, however, PNC does not subscribe to the so-called Yale Model, where allocations to private equity and other alternative investments can easily exceed 50% of a total portfolio because of the inherent illiquidity effect of private investments in portfolios. When some assets in a portfolio are illiquid, the sequence and timing of events matter as they relate to asset allocation targets through time; that is, portfolio outcomes become path-dependent. For example, two scenarios in which the longer-term average annual return on equities is, say, 8% will not result in identical annual portfolio performance unless the sequence of returns is also precisely the same. As a result, we have performed an extensive simulation analysis based on explicitly modeling the structural characteristics that make private investments illiquid, including capital commitments, drawdowns, and distribution processes. In many of our simulations, significant deviations from asset allocation targets tend not to be a problem since portfolios do not often meaningfully deviate from their expected long-term growth paths. Even without timely portfolio rebalancing, the relative portfolio weightings do not drift too far from their targeted allocations. The problems start to arise in scenarios where the sequence of asset returns is such that the portfolio becomes significantly misaligned with the allocations most consistent with achieving long-run objectives (that is, when a portfolio s value declines sharply and becomes overconcentrated in illiquid assets). When divergences from the norm are large or persistent, a large allocation to illiquid assets may have significant, adverse consequences on a portfolio. Based on our analysis, we have concluded that a combined targeted allocation of 20 30% to private investments strikes an appropriate balance between their underlying attractive investment characteristics (relatively high return potential and solid contribution to overall portfolio diversification) and the drawbacks associated with illiquidity. Given that typical minimum commitments often exceed $1 million, even portfolios in excess of $100 million in total assets may struggle to build fully diversified private investment portfolios when investing directly with private investment funds without taking on undue liquidity risk. Thus, PNC would suggest investing primarily through a fund of funds structure that permits access to a broadly diversified portfolio across asset classes, managers, strategies, vintages, and structures. What to Expect When Making a Private Investment The strategies outlined above are usually offered through private investment vehicles. Traditionally, the common structure is a partnership, with the manager referred to as the general partner (GP) and the investors as limited partners (LPs). The general partner is usually a limited liability company or partnership that manages the fund and the underlying investments; the limited partners each own a fractional interest but are not involved in the operations of the partnership. 3 3 Technically, many institutional and other tax-preferred investors invest in offshore funds that are structured as corporations. Nevertheless, the phrases general partner and limited partners are frequently used in connection with these offshore vehicles even when they are not actually partnerships. 9

10 Once established, a private equity fund generally has a fixed lifespan of approximately years. However, investors committed capital (the amount they have agreed to invest) is not invested in the fund for its entire lifespan. As the GP identifies investment opportunities, LPs are required to contribute a portion of their committed capital. Most funds have defined investment periods lasting between three and five years during which the GP is permitted to allocate capital to new investments. A smaller amount of capital can sometimes be called after the investment period to cover expenses. Consequently, LPs make investments over time and may not reach a fully committed position for many years, if at all. Under certain difficult or competitive investing conditions, a fund s GP may be less likely to call for the fully committed amount of capital if additional investments are likely to only be dilutive to returns. When the partnership exits an investment, the GP typically distributes the proceeds to the LPs. Certain strategies may generate and throw off cash flows leading to distributions prior to formal investment exits. Examples of such strategies include coupons from loans in private debt, dividends from companies in a private equity fund, and rents in private real estate. Distributions often begin before the GP has made all intended capital calls. Chart 2 Capital Calls and Distributions for a $1 Million Commitment to a Model Private Equity Fund These capital call and distribution features have important effects on the liquidity of the private investment and on the relationship between how much capital is committed to private investments and how much is actually invested at any given time. According to our research, for the typical private equity fund an LP will likely have a maximum net out-of-pocket cash flow of less than 70% of the original commitment. Typically, the full commitment is returned to the LP by year seven or eight of the partnership, with distributions in the remaining years accounting for the profits of the investment. Thus, the LP s actual exposure in a private equity fund will vary over time. An LP who commits $1 million to a partnership will generally have less than $1 million exposed to the investment at any given time. The exposure ramps up in years one through five, with capital called by the GP, and then winds down over the next several years as investments are exited. Though the partnership may not wind down fully for years after it begins, LPs typically have exposure of less than one-third of their original commitment by the end of year 10 and usually have received all of their initial capital back in the form of distributions by year eight. These numbers will vary by strategy and vintage, but they are reasonable rules of thumb. (See Charts 2 and 3 for an illustrative example of the cash flow pattern for a private equity Chart 3 Cumulative Cash Flows for a $1 Million Commitment to a Model Private Equity Fund Source: PNC Source: PNC 10

11 investment. Note that this is only an illustration and is not necessarily indicative of any individual investment.) Another important consideration is when to expect the investment to start generating returns. GPs tend to value investments at cost for several quarters after the initial investment is made. Because the GP is also taking fees as the portfolio is invested, an LP will usually see a loss in the early stages of a private investment. As improvements are made in the assets and valuations increase, the LP begins to see a recovery in returns turning into a profit over the first few years of the investment. This early loss is usually just a so-called paper loss in that it simply reflects how the GP is valuing the assets combined with the impact of fees rather than a true loss of value in the investments. The overall effect is called the J-curve because a chart of the return on investment over time looks like the letter J (see Chart 4 for an illustration based on the cash flow model shown in Charts 2 and 3, page 10). Note that the early loss shown in Chart 4 is larger than one would typically experience because this private equity model fund started investing in 2006 right before the 2008 financial crisis, which exacerbated the normal J-curve effect. It is also often difficult to fully assess performance before a significant investment exits. Recalling that Chart 4 J-Curve: Internal Rate of Return Over Time for a Model Private Equity Fund an important component of many private investment strategies is the manager s ability to bring positive change to an asset, the valuations of the investments will not fully reflect that potential while the changes are being implemented. Thus, we expect private investment funds that appear to be underperforming during the first five years or longer can still become strong investments when the fund ultimately completes its lifecycle. However, it is common for GPs to value fund assets conservatively. GPs often tell the PNC due diligence team they routinely sell assets at a 20% or larger premium to where they were valued on the fund s books. Of course, this means GPs are undervaluing fund assets during the course of the fund as a way to avoid embarrassing writedowns. This is not a material concern, however, since the actual cash flows associated with the initial investment and final exit are what matter for judging investment performance intermediate estimates of the portfolio are merely for accounting purposes. They do not affect fees, and unlike traditional investments or even limited partnership hedge funds, LPs do not have the ability to redeem their investments at the valuation recorded on the partnership fund's books. LPs receive cash once the investment is sold, making that sale the only valuation basis that counts. How the General Partners Get Their Yachts: The Fees The old adage Where are the investors yachts? reinforces the common perception that investment managers often seem to be the only ones reaping the rewards. GPs are indeed well compensated, but PNC always conducts analysis on a net-of-fees basis. The strategies we recommend in the private investment universe are often only accessible through these relatively more expensive private partnerships. There simply is no cheap index-based alternative. The main fees come in two pieces: management fees and incentive fees. Source: PNC 11

12 Management Fee The management fee is a basic percentage of partnership assets the GP is managing. Depending on the fund, this will typically be charged on either LP committed capital or invested capital (or some combination of the two) over the life of the fund. The management fee generally ranges between 1.5% and 2.5%, depending on the strategy. Incentive Fee or Carried Interest The incentive fee, also referred to as carried interest, is based on realized investment gains of the partnership. As an example, if the fee is 20% of realized gains and the profit is $100, the fee would be $20. This is often subject to a predefined hurdle rate, which would specify that the incentive fee only kicks in after the LP has reached a specified return on its initial investment. This fee typically ranges from 15-20% while the hurdle rate is often set near 8%. How this fee is charged varies by fund. Some funds charge the incentive fee on an investment-byinvestment basis while others charge based on overall fund performance. Another important variation is how the hurdle rate is calculated. In some cases it is a simple return on invested capital while in other funds it is based off of the IRR of the fund to any given date. Distribution Waterfall The incentive fee is usually captured by reserving a portion of distributions for the GP. The rules that govern how distributions are shared comprise the so-called distribution waterfall. The typical waterfall is defined by four phases: recovery, hurdle, catchup, and carried interest. In the recovery phase, while the original capital has not been fully returned to the LPs, the whole distributed amount is allocated to them. In the hurdle phase, the return on capital continues to be distributed exclusively to the LPs until they reach a return equal to the preferred return, otherwise known as the hurdle rate. For most funds, this return of capital and the hurdle rate incorporates all management fees (that is, LPs receive all of their invested capital plus all management fees plus the hurdle rate before any incentive fee is paid). In the catchup phase, GPs receive an elevated percentage (possibly all) of the Chart 5 Distribution Waterfall Below is an illustration of a distribution waterfall for a private investment fund with a 20% carried interest after an 8% preferred return. In this case, the preferred return and carried interest are calculated on a fund level and simple return basis (as opposed to a deal-by-deal and/or IRR basis). LP GP Source: PNC 12

13 profits until they have shared in the profits at the percentage set by the incentive fee. In the carried interest phase, profits will be distributed based on the incentive fee, meaning that the GP will receive a percentage of distributions set by the incentive fee and LPs receive the remainder (see Chart 5, page 12, for an example). In addition to these fees, there will also be expenses borne by the partnership. Legitimate expenses include fund creation costs (largely legal fees for setting up the partnership), audit fees, administrator fees, and banking costs. Generally these fees are fairly small as a percentage of the partnership s assets. Unfortunately, many GPs also charge various consulting, investment banking, and monitoring fees against the underlying assets. We believe GPs are already paid for their work via the management fee and, therefore, view these additional charges as excessive or unreasonable. Our due diligence team aims to avoid GPs that charge excessive expenses unless they are justified for a highly specialized strategy that is particularly attractive. Measuring Performance and Comparing to Traditional Asset Classes Evaluating the performance of private investment funds is more difficult than evaluating that of traditional investments, chiefly because there is no straightforward notion of compounded annual return for private investments. For traditional investments, we generally consider the value of a fully invested portfolio, including reinvested dividends or interest payments, at an end date and compare this to an initial investment that takes place on a single date, which leads to a straightforward calculation of an annualized return. GPs, however, call capital from LPs over time and distribute proceeds that cannot be reinvested in the fund. As a result, there is no directly comparable analysis possible for this type of investment. Thus, it is necessary to evaluate several metrics when assessing the performance of private funds. These metrics include the IRR net of fees (net IRR), the ratio of distributions to paid-in capital, the ratio of residual value to paid-in capital, and the sum of these last two, which represents the total value of the investment divided by the capital invested (net multiple). We recommend investors consider these metrics in combination to assess the performance of a fund. Ultimately, LPs are generally most concerned with overall wealth creation; hence, they consider the net multiple a key metric. However, the timing of cash flows matters. Doubling one s money in 20 years is not an impressive result, but doubling one s money in three years is extraordinary. Thus, LPs also consider net IRR to account for the timing of capital calls and distributions. Net IRR on its own can also be problematic. In particular, early cash flows can boost net IRR, but since these distributions cannot be reinvested in the fund and there may not be attractive alternative investments, these early distributions may reduce overall wealth creation and result in a lower net multiple. Thus, using these metrics in tandem gives a stronger sense of overall fund performance. Net IRR is the internal rate of return net of fees, which is found by determining a constant interest rate that would make all discounted cash flows including the initial investment and net asset value of the fund equal to zero. Ratio of distributions to paid-in capital is simply fund distributions divided by capital invested, that is, the capital called by the GP. Ratio of residual value to paid-in capital is the value of the fund s investments divided by capital invested. Net multiple is the sum of distributions and residual value, divided by capital invested. Public Market Equivalent (PME) is the net IRR that would have been achieved if the investments had been made in a public equity portfolio (for example, the S&P 500) instead of the private investment. 13

14 As noted earlier, the structure of private equity investments makes it difficult to compare returns between private investments and their publicly traded counterparts. Investment professionals have created a number of ways to deal with this problem, the most common being the Public Market Equivalent (PME). To calculate the PME, the LP imagines a portfolio that is invested in a public market such as the S&P 500 instead of the private equity fund. In this calculation, every time there is a capital call from the private equity fund, the LP would invest that amount of capital in the public market. Whenever the private equity fund makes a distribution, the LP would sell that amount of the public market investment. Then, the LP would calculate a net IRR of these public market investments, which is the PME, and compare this with the net IRR of the fund. Setting aside some technical issues with this approach, this does provide a good measure of whether a private equity fund outperformed a corresponding public market. However, this metric shares the problems discussed above about net IRR in that it is not a compound annual return. Our approach essentially considers the impact of a private equity investment on a portfolio that otherwise comprises the corresponding public market. Since most investors have an intuitive feel for compound annual returns rather than net IRR, we also consider another method for comparing private equity funds with the corresponding public markets. Our approach essentially considers the impact of a private equity investment on a portfolio that otherwise comprises the corresponding public market. As an illustration, we consider a hypothetical private equity fund for which the S&P 500 is the relevant public market. Thus, we compare a portfolio that incorporates the S&P 500 and the private equity fund with a portfolio that is simply invested in the S&P 500. For the portfolio that incorporates the private equity fund, we start with a portfolio of the S&P 500 in an amount that will be sufficient to fund Chart 6 Comparison of Portfolio Value over Time for a Public Equity Portfolio versus a Portfolio Including a Model Private Equity Fund Source: PNC the private equity fund s capital calls. Then, whenever the private equity fund calls capital, we simply sell some of our stock portfolio to fund the private equity investment. Whenever we receive a distribution from the private equity fund, we reinvest that distribution in the S&P 500. Chart 6 shows the value of this portfolio over time compared with the value of a comparable portfolio that was invested solely in the S&P 500. In this illustration, the portfolio that incorporated the private equity fund did outperform the purely traditional portfolio, but not by nearly as much as a naïve comparison of the private equity fund s net IRR and the S&P 500 s compounded return. As of third-quarter 2016, the public-only portfolio yielded a compound annual return of 5.8%. The portfolio that incorporated the private equity fund yielded a compound annual return of 7.9% over the same period. Thus, this hypothetical private equity fund did add some value over this period, but not nearly what one might assume comparing a 13.5% net IRR for the private equity fund with a 5.8% compound annual return for the S&P 500. The reason for this disparity is simply the timing of capital calls and distributions. This private equity fund invested much of its capital after the 2008 stock market drawdown, investing during a period of strong public market performance. We believe 14