STRATEGIC ASSET ALLOCATION FOR INSTITUTIONAL PORTFOLIOS WITH PRIVATE EQUITY

Transcription

1 UNIVERZA V MARIBORU EKONOMSKO-POSLOVNA FAKULTETA MARIBOR BACHELOR THESIS STRATEGIC ASSET ALLOCATION FOR INSTITUTIONAL PORTFOLIOS WITH PRIVATE EQUITY March 2017 Manuel Wedra

2 UNIVERZA V MARIBORU EKONOMSKO-POSLOVNA FAKULTETA MARIBOR DELO DIPLOMSKEGA PROJEKTA STRATEŠKA DODELITEV SREDSTEV ZA INSTITUCIONALNE PORTFELJE Z ZASEBNIM KAPITALOM BACHELOR THESIS STRATEGIC ASSET ALLOCATION FOR INSTITUTIONAL PORTFOLIOS WITH PRIVATE EQUITY Kandidat: Manuel Wedra Študijski program: Ekonomske in poslovne vede Študijska usmeritev: Finance in Bančništvo Mentor: Prof. Dr. Franjo Mlinarič Jezikovno pregledala: Melanija Kožar Študijsko leto: 2016/2017 Basel, March 2017

3 Abstract The aim of this thesis is to present and explore the impact of private equity investments (later PE) on institutional investment portfolios. Especially to understand and comprehensively present the history and the trends in public and PE funds (U.S and non-u.s). Consequently, I will present the characteristics of main portfolio theories, which are followed by institutional investors. The investment market is getting more and more uncertain. This can be especially fatal for institutional investors including banks, insurance companies, investment advisors, pension, mutual and hedge funds. The largest decrease of holdings in public equity was between 2000 and Therefore, the Institutional investors replace public equity with private equity, venture capital, hedge funds, real estate, commercial loans and financial derivate. Due to the financial crisis in 2008, where the S&P 500 declined by 36.55%, the fluctuations in the financial markets have been significant. It is therefore necessary to reduce the overall volatility of the portfolio and the correlation between different investment classes. A reduction in portfolio volatility can be achieved through diversification. There are different possibilities to approach the equity investments in private firms. Direct investments, co-investments, alongside specialized investors, indirect investments through limited partnership (later LP), and indirect investments through fund of funds. According to academic literature, small or even big investors such as institutional investors tend to invest in PE through funds, which gives a much better spread of your committed capital and therefore minimized risk in comparison to direct investments. When dealing with direct investment, it is required to invest in a fund management team, which has a highly intensive relationship and due diligence skills to select the appropriate PE investment. Usually, the institutional investors have insufficient resources to build up a management team for monitoring portfolios of private firms. From a PE backed company perspective, fund managers do not only provide capital, but also offer management support, take an active role, where they contribute their skills, network, and experience. Besides the opportunity to get exposure to PE with Limited Partnership (later LP), it is also possible to invest in exchange-traded PE companies or LPE. These PE investments can be done either directly, indirectly or through the capital of their customers. Investments are conducted in the same way as Limited Partnerships, through various investment horizons (venture, buyout and growth) and financing styles (equity, mezzanine and debt). These exchange-traded PE companies offer the investor an immediate, liquid exposure to the PE investment class. The problem with investing in unlisted PE funds is the minimum required capital to participate in the PE investment class, which is usually too high for smaller or individual investors. It is also difficult to determine the price, which is determined on an illiquid and non-transparent secondary market. While the LPE is traded on an organized exchange market, that is liquid, has transparent market prices available and the possibility to get access to the investment class even for smaller institutional or individual investors with a minimum initial investment volume. Another advantage is the capability to rebalance their PE allocation in a flexible way. From analytic perspective, it is also much easier to compare LPE to other public traded asset classes using common standard analysing tools.

4 Due to the lack of agreement regarding historical return of the PE asset class, it is hard to assess, which are to observe, and which not. Most of the research papers focus on unlisted PE Research in unlisted PE suffers from a lack of reliable and meaningful data, such as market prices. Instead, there are only cash flows of traditional or unlisted PE funds available. Without having market prices available, calculations of main characteristics such as risk, return and correlation is challenging. It is required to have a very good knowledge of these parameters for integrating PE into the framework of modern portfolio theory and well structures investment management processes. The goal of the thesis is to observe and assess the impact of private equity investments when used within conventional investment portfolios consisting of stocks and bonds. We plan to test the following hypothesis: The addition of private equity investments to traditional investment portfolios reduces volatility and improve the risk-return profile. The aim is to establish a simple Markowitz optimization model solving for the portion of private equity investments in conventional investment portfolios. Thus, we will search for an optimal risk-return profile in order to maximize the Sharpe ratio. In the analysis with the efficient frontier, the portfolios with the additional asset class PE have a clear improvement of the risk, and return characteristics. Over the standard deviation range from 3.28% to 11.90%, the average improvement in return in the optimization framework is 0.48%. For big institutional, smaller or even individual investors, the LPE gives a liquid, transparent and immediate exposure to PE. In the environment of low interest rate, the PE mode is working well. If these kind conditions will continue in 2017, the asset class will continue to contribute a high absolute return and portfolio diversification.

5 Povzetek Namen tega diplomskega dela je predstaviti in raziskati vpliv dodajanja naložb zasebnega kapitala k institucionalnim portfeljem. Namen je tudi celovita predstavitev zgodovine in trendov običajnih investicijskih razredov zasebnega kapitala. Predstavljene bodo tudi različne možnosti investiranja v zasebni kapital ter prednosti in slabosti investiranja v tako imenovane kotirane razrede zasebnega kapitala. Omenjene bodo pa tudi glavne teorije portfelja, katerim sledijo institucionalni investitorji. Investicijski trg je vse bolj neprevidljiv. To je lahko še posebej nevarno za institucionalne vlagatelje, vključno z bankami, zavarovalnicami, investicijskimi svetovalci ter pokojninskimi, vzajemnimi in hedge skladi. Do največjega upada javnega trga kapitala je prišlo med letoma 2000 in Zato poskušajo Institucionalni vlagatelji nadomestiti investicije v tradicionalne investicijske razrede z investicijam v alternativne investicijske razrede, kot so zasebni kapital, tvegani kapital, hedge skladi, nepremičnine, poslovna posojila in finančni derivati. Zaradi finančne krize v letu 2008 so bila nihanja tradicionalnih investicijskih razredov še posebej visoka, S&P 500 indeks se je zmanjšal za kar 36,55 %. Zaradi visokih nihanj je treba zmanjšati splošno volatilnost portfelja in korelacijo med različnimi naložbenimi razredi. Zmanjšanje volatilnosti portfelja je mogoče doseči z diverzifikacijo. Investiranje v zasebni kapital je možno na različne načine: neposredno investiranje, co-investiranje, posredno investiranje preko vlagateljev in posredno investiranje v sklade skladov. Veliki institucionalni vlagatelji se običajno odločijo za neposredne investicije. Za tovrstni pristop k zasebnemu kapitalu je potreben dokaj visok vložek v vodstveni tim, ki ve, kako sklad deluje, ima dobre vodstvene sposobnosti in skrbno izbere najbolj primerne investicije. Srednje veliki in manjši vlagatelji težje investirajo velike denarne zneske, zato je neposredno investiranje zanje skoraj da neizvedljivo. Za takšne vlagatelje je zatorej bolj priporočljivo investiranje v sklade. Investiranje v PE sklade omogoča višjo stopnjo diverzifikacije, sklad pa upravlja za to specializiran vodstven tim. Podjetju, ki ga podpirajo skladi zasebnega kapitala, upravljavci sklada zagotovijo kapital, prav tako pa tudi ponudijo podporo pri vodenju, in sicer prevzamejo aktivno vlogo ter prispevajo svoje znanje, veščine in izkušnje. Poleg skladov zasebnega kapitala s komanditno družbo, ki ne kotirajo na borzi, je prav tako mogoče investirati v investicijske sklade podjetij zasebnega kapitala, ki so kotirani na borzi (kasneje LPE). Te investicije zasebnega kapitala so izvedene neposredno, posredno ali pa prek kapitala njihovih strank. Naložbe so izvedene na enak način kot komanditne družbe, in sicer prek različnih investicijskih vidikov (tvegana naložba, odkup in rast) in finančnih stilov (lastniški kapital, mezanine kapital in dolg). Ti LPE ponujajo vlagatelju takojšnjo tekočo izpostavljenost naložbenemu razredu zasebnega kapitala. Težava pri investiranju v sklade zasebnega kapitala, ki niso kotirani, je dokaj visok minimalni vložek, zahtevan za sodelovanje v naložbenem razredu zasebnega kapitala. Zahtevan minimalni znesek je običajno previsok za manjše in individualne vlagatelje. Prav tako je težko določiti ceno, ki je določena na nelikvidnem in netransparentnem sekundarnem trgu. Na drugi strani pa se s z LPE trguje na organiziranem deviznem trgu, ki je likviden in ima dostopne transparentne cene trga ter možnost pridobiti dostop do naložbenega razreda za manjše institucionalne ali individualne investitorje z začetno minimalno naložbeno vrednostjo. Naslednja prednost je zmožnost ponovne razporeditve zasebnega kapitala na fleksibilen način. Z analitičnega vidika je prav tako veliko lažje primerjati LPE z drugimi javnimi investicijskimi razredi, kjer lahko uporabimo standardna analitična orodja.

6 Zaradi predvsem visokih odstopanj rezultatov raziskovalnih člankov, je predvsem težko ugotoviti, kateri rezultati so realni. Večina člankov obravnava nekotirane investicije zasebnega kapitala. Raziskave nekotiranega investicijskega razreda zasebnega kapitala so predvsem zahtevne zaradi pomanjkanja zanesljivih in pomembnih podatkov, kot so tržne cene. Pri nekotiranih finančnih skladih zasebnega kapitala imamo na voljo le denarne tokove. Brez tržnih cen so izračuni, kot so tveganje, donosnost in korelacija med investicijskimi razred precej zahtevni. Zaradi tega je potrebno obširno poznavanje parametrov za integracijo investicijskega razreda zasebnega kapitala v sodobne teorije portfelja in tudi dobro znanje strukture procesov upravljanja naložb. Cilj naloge je opazovati in oceniti vpliv dodatnih naložb zasebnega kapitala v portfelje, ki so sestavljeni iz običajnih investicijskih razredov, kot so delnice in obveznice. Preveriti želim naslednjo hipotezo:»dodatek naložbe zasebnega kapitala v tradicionalne naložbene portfelje zmanjšuje volatilnost portfeljev in izboljšuje profil tveganj in donosa«. Z enostavnim modelom optimizacije Markowitz bom določil optimalno porazdelitev deležev sredstev v investicijskem portfelju in posledično optimalni profil tveganja in donosa. V analizi meje učinkovitosti ima portfelj z investicijskim razredom zasebnega kapitala jasno izboljšanje tveganja in značilnosti donosnosti. Za standardni odklon od 3,28 % do 11,90 %, znaša povprečno izboljšanje donosnosti v okviru optimizacije 0,48 %. Za velike institucionalne, manjše ali celo individualne vlagatelje omogoča LPE likvidno, transparentno in takojšnjo izpostavljenost zasebnemu kapitalu. V okolju z nizko stopnjo obresti PE metoda zelo dobro deluje. Če se bodo ti pogoji nadaljevali v letu 2017, bo skupina naložb še naprej prispevala k visoki absolutni donosnosti in diverzifikaciji portfelja.

7 Table of Contents 1 Introduction Description of the problem The purpose and objectives of the research Overview of Private Equity Difference Between Private and Public Equity companies Structure of Private Equity Investments Private Equity Investments Cash Flow profile of Private Equity Fund Investments: J-C Investment Management process Investment Styles Financing Styles Organizational structure of Private Equity investments Unlisted PE Funds (Limited Partnership) Listed Private Equity capital companies Listed Private Equity Fund of Funds Listed PE Fund Managers Unlisted against Listed PE Performance measurements of Private Equity Performance measurements of Unlisted Private Equity Funds The Internal Rate of Return (IRR) Value to Paid-in Capital Multiples Public Market Equivalent Performance measurements of listed Private Equity Funds Compounded returns Standard deviation Sharpe Ratio Interim conclusion for Private Equity overview Modern Portfolio Theory and the role of Listed Private Equity Risk and expected return Quantification of risk Correlation coefficient and covariance Systematic and non-systematic risk Models of Modern Portfolio Theory Mean-Variance Optimization The Efficient Frontier The Capital Asset Pricing Model Interim conclusion of Portfolio Theory and the role of Listed Private Equity Trends in Private Equity Performance Overview Performance Net Internal rate of returns (IRRs) Allocations to Alternatives PE Funds Largest Buyout Deals and Exits in Venture Capital Outlook for Optimization of portfolios... 42

8 5.1 Asset Class Index Proxies Historical Analysis Conclusion Literature List of Figures Figure 1: Approaches to equity investments in private firms Figure 2: J Curve of the cumulative cash flow Figure 3: Private Euqity Investment Process Figure 4: The organisation form Limited Partnership Figure 5: The organisation form Listed Private Equity capital companies Figure 6: The organisation form Listed PE Fund of Funds Figure 7: The organisation form Listed PE Fund Manager Figure 8: Systematic and Non-Systematic risk Figure 9: Efficient Frontier Figure 10: Private Capital Assets under Management Figure 11: PE Performance Median Net and Quartile Net IRRs Figure 12: Allocations to Alternative Investments Figure 13: Global PE Fundraising Figure 14: Largest PE Backed Buyout deals in Figure 15: Number and Aggregate Value of Venture Capital Deals of Venture Capitals Deals Globally Figure 16: Number of Venture Capital Deals by Region Figure 17: Cummulative Index Returns Figure 18: Historical Efficient Frontiers with and without PE Table List of Tables Table 1: Differences between Investment types Table 2: Comparison between LPFs and LPE Table 3: Asset Class Index Table 4: Risk-Return performance Table 5: Historical Correlation Matrix List of Abbreviations AUM Assets under Management CAGR Compound annual growth rate CAPM Capital Asset Pricing Model DPI Distribution to Paid in Capital Multiple GP General Partner IRR Internal Rate of Return LP Limited Partnership LPE Listed Private Equity LPF Limited Partnership Funds MIRR Modified Internal Rate of Return NPV Net Present Value PE Private Equity PME Public Market Equivalent RVPI Residual Value to Paid-in Capital Multiple TVPI Total Value to Paid-in Multiple

9 1 Introduction Investors generally base their asset allocation decisions on portfolio theory. This briefly states that diversification reduce its risks for given level of return or increase return for a given level of risk. Consequently, a risky individual asset can even reduce the overall risk of the portfolio with the same return on investment. Nonfinancial aspects play a minor role in the decision to invest in PE (later PE). However, the PE asset class is also associated with specific risks and associated disadvantages, which must be take into consideration when entering. In recent years, a worldwide increase in correlation among classical asset categories (stocks and bonds) has emerged. This fact naturally has an increasing influence on the asset selection strategy (professional asset assessment). Especially institutional investors and wealthy private individuals, who want to diversify their funds well, must take this fact into account. There are alternative investment strategies exhibiting low correlation with classical investments and are therefore suited to improve the risk-return profile of a portfolio. Various investigations have shown that PE has a very low correlation with various stock indices. These favourable properties stimulate investors to use PE investments in order to diversify their portfolios efficiently. 1.1 Description of the problem The investment market has become increasingly volatile. This can be especially fatal for institutional investors including banks, insurance companies, investment advisors, pension, mutual and hedge funds but also wealthy individuals. The largest decrease of holdings in public equity was between 2000 and The average decrease was 14.47%. Institutional investors replaced public equity with PE, venture capital, hedge funds, real estate, commercial loans and financial derivate. Alternative investments increased from 9% to 15% in this period. Due to the financial crisis in 2008 when the S&P 500 declined by 36.55% the fluctuations in the financial markets have been significant. It is therefore necessary to reduce the overall volatility of the portfolio and the correlation between different investment classes. A reduction in portfolio volatility is possible to achieve through diversification. According to the Preqin report, the allocation of institutional investments to PE was 6.6% in The following research papers reports different PE returns. For example, Chen, Baierl and Kaplan (2002) report an annual compounded return of 13.4% between 1960 and Compared returns of 12.2% and 14.5% for U.S. blue chip and small cap stocks over the same period with an annual standard deviation of 115.6%, and a correlation with public equities of 0.04, which leads to an allocation range of 2% to 9%. Swenson [2000] reports the historical ( ) correlation between the Yale PE portfolio and U.S. equity at.3. Yambao, Davis, and Sebastian [2007] estimate the expected return of PE at 13.6%, with a standard deviation of 30.7%, and a correlation with public equity of.9. Kaplan and Schoar (2005) report that the performance of PE funds is close to that of the S&P 500 Index, net of fees. Phalippou and Gottschalg (2006) found that Kapan and Schoar s (2005) performance findings are optimistic. Phalippou and Gottschalg (2006) report a substantial underperformance of -3.83% per year compared to the S&P 500. Assuming a typical fee structure, gross of fees these funds outperform by 2.96% per year. Harris, Jenkinson, and Kaplan (2013) report that buyout fund performance consistently outperformed the S&P 500 by an average of 20% to 27% over a fund s life (10 years) and more than 3% annually. 9 P a g e

10 After some introduction of different research papers, we can observe the lack of agreement regarding the historical returns of the PE asset class. This is the main reason why relatively little asset allocation guidance around PE can be derived from the literature. PE has become more popular among investors due to the fact, that the asset class has outperformed conventional equity investments in the last few decades. 1.2 The purpose and objectives of the research My first aim is to understand and comprehensively present the history and the trends in public and PE funds (U.S and non-u.s). Consequently, I will present the characteristics of main portfolio theories, followed by PE, institutional and individual investors. The goal of the thesis is to observe and assess the impact of PE investments when used within conventional investment portfolios consisting of stocks and bonds. I plan to test the following hypothesis: The addition of PE investments to traditional investment portfolios reduces portfolio s volatility and improves the risk return profile. My aim is to establish a simple optimization model using the Markowitz mean variance framework and solving for the portion of PE investments in conventional investment portfolios. Thus, I will search for an optimal risk-return profile in order to maximize the Sharpe ratio. 2 Overview of Private Equity PE is capital which is not publicly traded on a stock exchange. It consists funds and investors who directly invest in private companies, or are engaged in buyouts of public companies, resulting in the delisting of public equity. The expression PE can be used as an asset class or an investment strategy. Differentiate this two expressions can be confusing and creates challenges for the traditional approach to asset allocation. The decision how to allocate assets should base on the risk and return characteristics of the asset class. In reality, the most PE decisions are based on the risk and return characters of the available PE vehicles. (Ibbotson, 2007, P. 7) The risk return relationship between the asset class and the investment vehicle are not clearly defined. The standard deviation of the asset class PE is not equal to the standard deviation of the PE funds returns, because funds have a high level of idiosyncratic (investment specific) risk. An example shows us that the universe of large cap U.S. mutual funds, where the standard deviation of their return is quite similar to the one of the S&P 500, which is the main purpose of mutual funds to create portfolios with similar characteristic of the benchmark. The average standard deviation of PE funds returns is higher than the standard deviation of the PE asset class due to the concentrated nature of PE funds. This anomaly of wide dispersion of return among PE funds is documented in Lerner, Shoar, and Wongsuwai (2007). 10 P a g e

11 2.1 Difference Between Private and Public Equity companies The public equity asset class is formed by the public companies. Investor can get a position in public equity asset class by purchasing shares of publicly traded companies or shares of investment vehicles, such as mutual funds, that purchase the public shares. (Ibbotson, 2007, P. 7) Investments in public equity funds involve more than 1000 public companies, while PE funds are more concentrated on a low size portfolio of 15 private companies more or less. Because of the structure of the PE market, investors feel the company specific risk, which they can t diversify. Investments in PE are a mixture of systematic risk exposure to PE asset class and private company specific risk. (Ibbotson, 2007, P. 8) PE have in many aspects different characteristics to public equity. If is a company goal to go public, they first need an underwriter, which could be an investment bank. They are responsible to give support in the process of the initial public offering (later IPO). This support involves handling the sale, distributing securities, determining the amount IPO will raise and estimating how much the bank will be paid in fees and profit. The bank sets the price of the stock and takes the responsibility to find buyers. When the company goes public, the executive has to intervene when the stock price slides to low. In such cases the executive need to buy back shares, change accounting depreciations methods, sell products with high discounts to realize revenue in earlier periods to boost listed income. Such interventions could increase the stock price in the short term but can make damage in the long run. (Greg McFarlane, Investopedia, 2015) Companies, who want to stay private are not looking for short term investors. They watch out for long term oriented investors, with a certain level of experience in the market and which are able to handle up with losses. Usually the PE investors are institutions such as banks, pension funds and wealthy individuals. PE Investors have long horizon investments in mind and they do not care about daily fluctuating stock prices. The main goal is increasing profitability and market shares. For privately held companies it gives much more freedom and less liability for directors and officers (Greg McFarlane, Investopedia, 2015) PE firms and investors are philosophically not opposed to public equity. In many cases, PE investments are in the intention that the company someday will go public. It could also go in the other direction and go from public to private where is actually the trend going. In recent years more company have delisted than actually gone public. They are examples like Dell Computers whose buyout was complete in October 2013 or the H.J. Heinz whose was delisted in June (Greg McFarlane, Investopedia, 2015) For companies, which are looking for an Increase in capital, the dilemma whether to go public or stay private is hard to solve. If the company has a high tolerance for regulation and the demands of impatient analysts, there are more chances for the company to attempt an IPO. According to Google s research, successful IPOs have created more instant millionaires than any other mechanism in history. For Companies which prefer a minimum of interference while implementing and which can find investors with a wide time horizon and have plenty of patience, PE is the right financial mechanism. (Greg McFarlane, Investopedia, P a g e

12 Institutional Investors 2.2 Structure of Private Equity Investments PE is an asset class defined as any investment in the equity capital of a company, which is not publicly quoted on a stock exchange. This simplified description covers the most important characteristics of the asset class. These kinds of investments in unquoted companies, leave out a number of developments in the PE industry. (Fenn, Liang, and Prowse 1998). In the following subchapters I will present how PE is structured from different point of views. Which kind of PE investments exist, how a PE fund investment life cycle looks like, what is the procedure of an investment management team when investing in PE, which investment, financial styles are known and the different organisational forms in which PE deals are carried out Private Equity Investments The focus of the PE industry are investments made by funds and funds of funds. It is important to know that direct investment constitutes an appropriate alternative to indirect investments through funds. The main advantage of direct allocation is to enrich high return without paying management fees, usually 1 to 2 percentage and 20 percentage of the returns. The central question is if the institutional investors have enough profound expertise to make right decisions of investments (The Oxford Handbook of PE Kasper Meisner Nielsen, 2012). There are different possibilities to approach the equity investments in private firms. As seen in figure 1, there are direct investments, co-investments, alongside specialized investors, indirect investments through limited partnership (later LP), and indirect investments through fund of funds. In Figure 1 the differences are listed. Institutional investors can allocate the capital through fund of funds (1), which then invest usually in 10 to 20 funds. The investor can also invest directly to the fund, which invest in different private firms (2). Co-investment occurs when institutional investor invests in a fund and parallel in the private firm, the same private firm the fund invests. (3). It is also possible to invest directly, in which institutional investors take a direct equity interest in the private firm (4). (The Oxford Handbook of PE, Kasper Meisner Nielsen, 2012, p. 38) Figure 1: Approaches to equity investments in private firms Private firms Funds/Partnerships Private Firms 1) Fund-of Funds Funds/Partnerships Private Firms Funds/Partnerships Private Firms 2) Funds/Partnerships Private Firms 3) Funds/Partnerships Private firms 4) Private Firms. Source: The Oxford Handbook of PE, Kasper Meisner Nielsen, 2012, p P a g e

13 Table 1 shows the main differences between indirect investments, which are made through funds or fund of funds, and with direct investments, where institutional investors make the investment decision. Table 1: Differences between Investment types Investment Style Advantage Disadvantage Fund of funds (1) Funds (2) Co-investments (3) Diversification in both levels Underlying fund managers take positions on the board and help professionalize and restructure the firm. Diversification, fund managers take positions on the board and help professionalize and restructure the firm. Reduces fees while benefiting from fund managers interaction with management. Need for staff or advisors to select the fund of fund. Substantial fees on both levels ( fee-on-fees ). Need for staff or advisors to select the funds. Substantial fees Little direct influence and control over investments. Large exposure to a single investment. Direct (4) Full control over investments. Requires very substantial funds to achieve an adequate spread of investments Cost and commitment: need for substantial permanent specialist Source: The Oxford Handbook of PE, Kasper Meisner Nielsen, 2012, p. 39 Table 1 represents the advantages and disadvantages of different types of investments in private firms. In general, direct investments give institutional investors ownership and control over investments, but also require much stronger in-house resources. This kind of resources are managers which have a profound expertise in the industry of the portfolio company, in other words they have to acquiring, managing, and divesting assets. These activities are called transaction costs which are usually fixed and therefore require relatively large investment programs. On the other side, indirect investments can start with a much lower investments and reach a higher diversification, but have little or no control over the assets, and substantial fees need to be paid to the managing partners. For most small and medium sized institutional investors, direct investments might not be the best choice, but could be more realistic for larger institutional investors like pension funds. (The Oxford Handbook of PE, Kasper Meisner Nielsen, 2012, p. 39). 13 P a g e

14 The academic literature argues that direct investments are a priori inappropriate for institutional investors. For example, Lerner et al. (2007) argue that the bulk of institutional investment in PE is done through funds because institutions lack the intensive relationship and due diligence skills needed to directly select the appropriate PE investments. Moreover, institutional investors appear to have insufficient resources to intensively monitor a portfolio of private firms. Whereas these obstacles are likely to limit direct investments by institutions, this claim might not be universally true. In particular, direct investments by institutions might be absent only in high-tech, high-growth firms that attract venture capital literature, because investments in such firms require more information and expertise than investments in an average private firm (Nielsen, 2008). Instead, for majority of private firms, institutional investors might be an appropriate direct source of financing, a role that, to my knowledge, is unexplored by the literature. (The Oxford Handbook of PE, Kasper Meisner Nielsen, 2012, p. 40) In this paper I will focus on investments made by funds, which are closed-end vehicles with a limited lifetime of ten to twelve years. Fund investors are usually institutions such as pension funds, endowments or banks and wealthy individuals (Fenn et al. 1998, p. 45), who commit a certain amount of capital to the fund. This capital is then invested by fund managers during the first five years after fund closing and is returned in the subsequent five to eight years (Kaplan and Strömberg 2009, p. 123). Investments are made in individual companies for a typical holding period of three to five years (Kaplan and Strömberg 2009, p. 129). Funds provided by the transaction to the investee company can be used for a variety of entrepreneurial purposes: PE is used to finance growth for start-ups, for established companies, as replacement capital when the ownership structure changes, to realize succession plans (Grabenwarter and Weidig 2005, p. 3) and as distressed investment for turnaround financing (Böttger 2007, p. 278). 14 P a g e

15 CUMULATIVE CASH FLOW Cash Flow profile of Private Equity Fund Investments: J-C The cash flow profile shows, how the invested capital in PE funds flows in the range of 10 years. Usually, in the first 5 years the funds get capital from the investors, which is called capital calls, so there are just capital payments to selected fund without any receiving return. After the funds are closed, they are not allowed to accept capital from the investors anymore. The investors stars to receive returns after the first exits of the investments. Under normal circumstances the capital inflow of the investors is amortized in 7 to 8 years. (Mostowfi, Meier, 2013, P. 179) Figure 2: J Curve of the cumulative cash flow 60.00% 40.00% J curve: Cash flow profile 20.00% 0.00% % % % % Net cash flow of investors Cumulative cash flow Source: Mostowfi, Meier, 2013 Figure 2 represents an investment of a PE Fund, which includes a cumulative and a net cash flow. In the literature it is also called a J-form cash. The J-curve shows that the investments in PE are illiquid. PE Funds investor have to be aware, that they will start to receive the first returns five years after the closing and after around 7 to 8 years the invested capital will be amortized. Because of the illiquidity and the high required volume to participate in investing in PE funds, the investors expect a minimum return of 15 to 20%. 15 P a g e

16 2.2.3 Investment Management process The investment process, which includes all activities in which PE firms are engaged to recognize potential companies to invest into, can be split in two main stages. As seen in Figure 3, it splits into a pre-investment stage, which includes the selecting and structuring of investments, and a postinvestment stage, which includes monitoring and exiting from deals. Figure 3: Private Euqity Investment Process Preinvestment Preinvestment stage stage Preinvestment stage Selecting Structuring Postinvestment Postinvestment stage stage Postinvestment stage Monitoring Exiting Source: (Fenn et al. 1998, p. 2) For most PE firms it is usuall to have a deal generation strategy that focuses on a certain industry, geographical region, size bracket, stage of development, and other characteristics, which depends on the specialization of the management team. (Wright and Robbie 1998, p. 536) The first stage, which we ilustrate as selecting, contains the investment screening and evaluation, followed by a structured and standardized process (Kaplan and Strömberg 2001, p. 428). PE firms look for promising investments alligned with the key investment criterias, usually they reject nine out of ten business plans that do not align with these standards. (Fenn et al. 1998, p.30). After they accept a non-binding offer by the selling party, the process of structuring the deal starts. It usually begins with the due diligence stage. After the target company fills out all of the requirements of the due diligence process, the partners start negotiating the agreements of the investments. These agreements include the purchase price, the financial instruments to be used in governance aspects relating to the investments, the proportion of the owenrship that will be transfered to the fund and the extent of control the PE firm will exercise over the investee company (Fenn et al. 1998, p. 31). After the investment has been closed, the PE fund starts to monitor. The monitoring process is to be in an active role on their boards. They help with the industry expertise, broad experience and valuable 16 P a g e

17 contacts to implement value creation plan that aims to increase the operational and financial performance of the portfolio companies. (Kaplan and Strömberg 2009, p ). The second part of the post-investment stage contains the exit strategy, which could be an initial public offering (IPO, a full or partial sale or a secondary buyout). (Wright and Robbie 1998, p. 549) Investment Styles PE investments can be broadly subdivided into venture capital, growth or expansion capital, and buyout financing, when these investment styles are ordered by the maturity of the typical portfolio company. Venture Capital The European PE and Venture Capital Association (EVCA) defines venture capital as professional equity co-invested with the entrepreneur to fund an early-stage (seed and start-up) or expansion venture. At the time of the initial investment, most of a venture capital funds portfolio companies are pre-revenue or pre-profit, but have an innovative product that is to be developed to market-readiness, using the venture capitalist s funding, network and management advice. The enterprise value of the portfolio companies of a venture capital fund is therefore typically small. Venture Capital funds almost always take minority stakes in their portfolio companies and almost never use debt transactions. Their target companies typically operate in high-growth industries, such as Information Technologies, Telecommunications, Health Care including Biotechnology and Medical Devices, or Semiconductors. (Huss et al, 2013, p. 9-10) Buyout Capital In contrast, a buyout investment is a transaction financed by a mix of debt and equity, in which a business, a business unit or a company is acquired with help of a financial investor from current shareholders. According the EVCA s definition, buyout funds typically acquire majority stakes of their portfolio companies, which are mostly mature, established enterprises that are profitable or at least generate substantial operating cash flow. The enterprise value of a typical buyout target company is therefore medium to large and can sometimes reach a multi-billion dollar volume. Buyout funds typically make extensive use of debt to finance their transactions and prefer investments in industries with largely predictable cash flows. (Huss et al, 2013, p.10) Growth or Expansion Capital The definition of expansion or growth capital is more ambitious, since there is a considerable overlap with the definitions of (later stage) venture capital or buyout investments. Growth capital usually refers to minority stakes in mature companies and is used to finance a wide range of growth opportunities, such as increasing production capacity, opening new markets or developing new products. Growth capital may also be used to finance strategic acquisition or a change of ownership. (Huss et all, 2013, p ) Financing Styles PE deals could be financed by equity, mezzanine capital or debt. Calling mezzanine a financing style is often confusing. In contrast to other existing methodologies, we define mezzanine capital as any capital between equity and debt e.g. subordinated debt, convertible debt or loans with equity kickers. We observe that most of the mezzanine capital provided is within a buyout deal. However, a small proportion of mezzanine capital is also provided in venture and growth deals. This leads us to the conclusion to define mezzanine capital as a financing style instead of an investment type. (Bergmann, Christophers, Huss, Zimmermann, 2009, p. 6) 17 P a g e

18 2.2.6 Organizational structure of Private Equity investments PE investments are clearly distinguished from investments in exchange-traded securities due to their illiquid character. Because of the higher level of complexity, a management team is usually involved, which carries out the investments in the name of the investor. It is therefore necessary to choose a specific form of organization, in which the investor and the management team are located. (Christophers, 2012, p.16) It is also important to know that partners of PE firms are called General Partners (later GP) of a fund. They collect capital commitments from investors, also known as Limited Partners (later LP). In the following subchapter I will introduce the different Organizational structure more in detail Unlisted PE Funds (Limited Partnership) The most important organizational form in which PE deals are carried out is that of the Limited Partnership. Figure 4 shows a simplified representation of an unlisted PE fund organizational structure. The investor, in this case the Limited Partner, commits a commitment over a certain amount for a certain period of time. As a rule, this period is from 8 to 10 years. He receives a share in the Limited Partnership. The management of the Limited Partnership is called "General Partner" in this case. In the first phase of the Limited Partnership (depending on the chosen investment and financing style), the General Partner makes investments in Private Equity (deals). He calls the capital necessary for the deals in the context of capital calls from the limited partner. If successful exits occurs after a certain period of time, the proceedings received minus the Management Fee and the Carried interest will be repaid to the Limited Partners. If all private investments are sold or depreciated by exits that have been exhausted, and the entire capital less fees is repaid to the Limited Partners, the Limited Partnership will be terminated. This is a construction with a limited duration. (Christophers, 2012, p.16) Figure 4: The organisation form Limited Partnership Limited Partnership Balance sheet Deal 1 Dela 2. Deal X Management-Fee Performance-Fee General Partner (Manager) Investment professionals Limited Partenrship Share Limited Partner (Investor) Source: (Christophers, 2012) During the Partnership, the Limited Partner is informed about his value of share via a net asset value report (later NAV). Limited Partnerships are in general not traded on the stock exchange, due to the fact that they are actually an illiquid investment. However, in recent decades, a secondary market has been developed, on which limited partnership agreements can be traded. If the limited partner decides to sell the shares, depending on the market situation, a significant markdown on the NAV has to be accepted. (Christophers, 2012, p.17, 77) 18 P a g e

19 Listed Private Equity capital companies A further possibility to obtain exposure to PE and the most important form of organization for a LPE is that of a direct-investing LPE, as seen in Figure 5. It directly provides the capital for PE deals. This can be either equity or mezzanine capital. (Christophers, 2012, p.17, p.78) Figure 5: The organisation form Listed Private Equity capital companies Limited Partnership Balance sheet Deal 1 Dela 2. Deal X Stocks Management- and Performance-Fee Management Management-Fee Performance-Fee Intern Extern Additional fund management Yes No LPE Investor Source: (Christophers, 2012) The LPE carry out PE investments with the capital made available by LPE-Investors (shareholders). The commitment is expressed by the purchase of a stock. In this way, the investor receives a share in an LPE company, which has the purpose to do PE investments. This type of commitment (stock) is possible to sell at any time (depending on liquidity on the stock exchange). In case of exits, the available capital (net of salaries, management and performance fees) is not necessarily distributed to the shareholders in form of dividends or share buybacks. Rather, investment is reinvested in new deals; this liquidity is called permanent capital. The duration of a direct LPE is basically unlimited, which is a big advantage, if we compare it to Limited Partnerships. The direct LPE companies are required to publish annual financial statements, which is, compared to Limited Partnerships, a transparency advantage. A further significant difference to LP is that the internally managed direct LPE companies, which beside of managing the LPE Company, additionally manage the capital of LP investors. In this case, a LPE investor, is not only involved in the further development of the deals, but also participates in management and performance fees that generate the management of the LPE Company. (Christophers, 2012, p.17-20, 78) 19 P a g e

20 Listed Private Equity Fund of Funds Another possibility to invest in the PE class via the stock exchange is an indirectly investing LPE company, like shown in figure 6, which is called the LPE Fund of Funds. This organizational form shares the essential characteristics with a direct LPE company. (Christophers, 2012, p. 20) Figure 6: The organisation form Listed PE Fund of Funds LPE-Fund of Funds Balance sheet Limited Partnership I Management Management-Fee Performance-Fee Additional fund management Yes Limited Partnership II. Limited Partnership X Management- and Performance-Fee Intern Extern No Stocks LPE Investor Source: (Christophers, 2012) However, an LPE Fund of Funds does not invest directly in PE deals, but in Limited Partnerships. This gives the investor a liquid exposure to a portfolio of Limited Partnerships that is actively managed by the internal or external management of the LPE company. (Christophers, 2012, p. 20) 20 P a g e

21 Listed PE Fund Managers The type of PE investment is a listed fund management company whose main activity is the management of Limited Partnerships. The LPE investor does not have any direct exposure to private incentives in this form of organization, at least not primarily. He also participates in the management and performance fees which the LPE makes a special position for this group of companies and should not be compared directly to the organizational forms presented. (Christophers, 2012, p. 21) Figure 7: The organisation form Listed PE Fund Manager Limited Partnership I Deal 1 Deal 2. Deal X Listed Fund management company Limited Partnership II Management-Fee Performance-Fee General Partner Limited Partnership III Stocks Limited Partnerhip IV Source: (Christophers, 2012) LPE Investor The main activity of LPE Fund Management is the management of Limited Partnership. The LPE Investor participates in the income of the management and performance fees that the LPE company generates through the management of Limited Partnerships. (Christophers, 2012, p. 21) Unlisted against Listed PE The investor, who wants to make an exposure to PE with a commitment to the management team, has basically two options buying a Limited Partnerships share or buying a stock of a LPE company. LPE and Limited Partnerships have some common characteristics. In most cases, an investment in PE is boosted by a management team that transacts deals in the name of the investor. The characteristics of the deals (investment styles, financing styles, cash flow profile, etc.) of LPE and Limited Partnerships are not different. It is rather the organizational form that involves differences between LPE and Limited Partnerships. (Christophers, 2012, p ) The LPE companies are investing directly, indirectly or through the capital of their customers. Investments are conducted in the same way as Limited Partnerships, through various investment horizons (venture, buyout and growth) and financing styles (equity, mezzanine and debt). In Table 2 I will make a comparison and contrasts between these two vehicles. 21 P a g e

22 Table 2: Comparison between LPFs and LPE Limited Partnership Funds (LPFs) Generally have fixed life of 10 years Can be difficult to sell and determine the value on the secondary market (illiquid and non-transparency) Fees typically 1,5-2% of commitments and 20% carry High minimum size of investment and investors need to invest in a wide range of direct funds to diversify properly Active Management of drawdowns/ exposure required Sometimes offer co-investment opportunities Investors can sometimes participate on advisory boards Investors can change managers, but usually have few others powers Initially invest at asset value Realization proceeds are returned to investors Direct funds tend to be focused Source: (The Oxford Handbook of PE, Brown & Kraeussl, 2012, p ) Listed PE (LPE) Unlimited life Shares can be sold in the stock market and the prices are determined with the market prices. (liquid and transparent) Fess usually lower than LPs, shareholders often own management company No minimum size and diversification can be achieved with a smaller number of holdings Easy to rebalance portfolio PE exposure No co-investment opportunities Shareholders not able to participate in the management of the company Shareholder democracy Can often buy at a discount Realization proceeds usually reinvested, although some listed funds return capital. There can be cash drag pending reinvestment. Usually well diversified by deal type and vintage A shareholder of an LPE company usually participates in the same deals as the Limited Partnerships. The shareholder has the advantage that he receives immediate exposure to the PE investment class and participates, as the Limited Partner, in the exits. The shareholders are, however, only partially participating in these successful exits in the form of quarterly dividends, but also in the revenues. While the investor of the Limited Partnership must always pay a management- and performance fee, the shareholder of the LPE company, also known as General Partner, is involved in the revenue generated by the management of the partnership. Additionally, the shareholder also participates in new deals, which gives to the investor an immediate, permanent and diversified exposure to the asset class. (Bergmann, Christophers, Huss, Zimmermann, 2009, p. 10) Both types of investors have an additional report to NAV to determine the value of their holdings. It is possible to determine the price on the secondary market for Limited partnership shares, and for LPE on the stock exchange. The disadvantage of the secondary market is that it is illiquid and nontransparent. The presence of market makers and brokers means that the LPE stock can be sold at any time, which gives the opportunity to gain access to the investment class even for smaller institutional investors with a minimum initial investment volume. (Christophers, 2012, p ) 22 P a g e

23 The approach of the NPV price is a central concept for both forms of access. In certain market periods, it is possible to acquire a share of a limited partnership as well as a share in an LPE company under the NAV. In this case, it is an acquisition which is called discount. If the investor purchases the share above the booking value, it is called a premium. The difference is that the LPE Investor is often able to buy at a major discount whereas investments in Limited Partnerships are initially invested at a premium. (Christophers, 2012, p ) (Bergmann, Christophers, Huss, Zimmermann, 2009, p. 11) A significant difference also shows the LPE investments an access to a diversified portfolio of PE investments, while a Limited Partnership provides access to certain investment years (vintage) (Christophers, 2012, p ) The main advantages of LPE are liquidity, transparency of market prices, a longer-term approach and flexible investment policy, lower fees, ease of monitoring, and the opportunity to buy at discount. The main disadvantages are less efficient cash management, and less choice. The main advantage of LPFs are their efficient use of cash, and occasional co-investment right. The main disadvantages are poor liquidity, more administration managing commitments, less diversification, high minimum commitments, and higher fees. (The Oxford Handbook of PE, Brown & Kraeussl, 2012, p ) 2.3 Performance measurements of Private Equity It has already been mentioned that a PE investment can be undertaken directly, indirectly via a PE fund or with a stock of a Listed PE company which will be explained later. Therefore, risk-return characteristics of PE can basically be defined from two different perspectives, either if we assess the return distribution of a company s specific investment or if we assess the return distribution of an investment in a PE fund. As far as risk management issues are concerned, the first perspective is especially relevant from the viewpoint of a general partner, as he is supposed to make congruent decisions with respect to the allocation of a capital to portfolio firms. The second perspective is relevant for a private or institutional investor who considers acting as a limited partner, i.e. to invest money in a PE fund. When talking about return distributions, one should make clear as to what kind of return processes he is referring to: returns generated at the level of a single portfolio company or returns generated at the level of a PE fund. (EVCA, 2004, p. 36) As already mentioned, in this study I am focussing on return distribution at the fund level. From an economic point of view, the most important characteristic of PE investments are the missing or highly imperfect secondary markets. As a consequence, for any single fund investment there are only a few points in time for which transaction prices can be observed: When limited partners pay in their capital and then the investment is liquidated. Usually, such transactions do not happen very frequently. As a consequence, no intermediate series of historical returns is available and, hence, estimating the performance of a PE fund becomes a difficult issue. It is well known that there are at least two solutions in this regard. The first is to estimate a PE fund s return on the basis of net asset values (NAV). This is the approach followed in the first part of this study, where an exposition of the methodological problems arising in this context can also be found. The basic problem is that net asset values are subject to valuation biases and, hence, returns estimated on this basis will be biased as well. (EVCA, 2004, p. 37) 23 P a g e

24 The idea of the approach followed in this chapter is to circumvent these problems by inferring the PE funds return only on the basis of its cash flow history. In this way, one could presume that an unbiased return estimation would be possible. However, even under this approach, serious methodological problems could arise. They are discussed in the following section. (EVCA, 2004, p. 37) Performance measurements of Unlisted Private Equity Funds Cash flow data, which is used in traditional literature of PE with the focus on limited partnerships, presents some challenges regarding risk and return measurements. The classical performance measures, which are used for public equity calculation, are not applicable for such kind of investment, because there is a lack of transparency and no market prices available. The following performance measures are mainly used for such kind of unlisted PE investments. The Internal Rate of Return (IRR), the modified IRR (MIRR),the Total Value to Paid-in Multiple (TVPI), The Money Multiple (TVPI) and the Public Market Equivalent (PME). (Christophers, 2012, p. 55) The Internal Rate of Return (IRR) In order to determine the realized average return, the internal rate of return of net cash flow from the investor view is determined by the difference between the inflows of the investors from the fund (cash inflows) and the investments in the fund (cash outflows). (Mostowfi, Meier, 2013, p. 211) The Net Cash Flow to Investors is calculated by the formula: NPV= T CV t t=1 (1+r ) t The IRR therefore corresponds to the calculation rate r*, in which the net present value of the net cash flows is zero. After the fund is fully liquidated, the calculated yield represents the final realized return on investors. (Mostowfi, Meier, 2013, p. 211) An IRR calculated in this way can only be assured as a yield calculation, if the fund is either completely liquidated, as is the case with our example fund, or at least a large part of the investment has already been sold. Otherwise, a return expressed as interim IRR is calculated instead of IRRs, which also takes into account the current net asset value of the fund, NAV T : (Mostowfi, Meier, 2013, p. 211) NPV= T CV t t=1 (1+r ) t = 0 + NAV t (1+r ) T = 0 The NAV t represents the value of the not yet sold investments by the fund. Such a calculation of the interim IRRs r* answers the question as to how high the investor's return would be, if the current net asset value could be fully distributed at the time of the calculation. This figure therefore represents only an estimate of the expected actual yield, after the sale of the investments still held in the portfolio could lead to exit revenues in the future, the net present value of which corresponds to NAV t. (Mostowfi, Meier, 2013, p. 211) 24 P a g e

25 Phalippou (2008) mentioned four weaknesses. First, the use of the IRR provides an incentive for PE managers to influence the timing of the cash flows of a deal. In practice, it is often the case that PE houses pay off a high cash dividend a few months after a buyout, leading to a high, early positive cash flow. Due to the reinvestment assumption at the IRR, this cash flow is very weighted, in other words, it leads to a higher IRR. Secondly, Phalippou argues that the IRR leads to an overestimation of the return on capital differences between individual funds, which in turn is related to the implicit reinvestment assumption. Third, the use of simple arithmetic meanings in the IRR leads to an overestimation of the results. As a fourth point, Phalippou calls the problem, that the sensitivity of the IRR to the timing of cash flows leads PE managers to have an incentive to influence this timing to the detriment of the investors, if they can derive an advantage from the form of a kickback. (Phalippou, 2008) The Modified Internal Rate of Return (IRR), which is used, for example, by Franzoni (2011), is a modification of the IRR. The main difference to the IRR is that for positive cash flows a reinvestment rate is set up, whereas for negative flows a financing rate. It is possible to use for example the S&P 500 or the DAX, as the reinvestment rate. As an example of a financing the risk-free interest rate isused. (Christophers, 2012, p. 56) n FV(Positive Cash Flows, costo f capital) MIRR = 1 PV(Initial Outlays, Financing Cost) Given the variables, the formula is: MIRR = ( FVCF(c) 1 PVCF(fc) ) n 1 Where n is the number of equal periods at the end of which the cash flows occur (not the number of cash flows), PV is the present value (at the beginning of the first period), FV is the future value (at the end of the last period, or in other way: FVCF (c) = the future value of positive cash flows at the cost of capital for the company PVCF (fc) = the present value of negative cash flows at the financing cost of the company n = number of periods (Investopedia) Value to Paid-in Capital Multiples In addition to the IRR, the most popular key figure for more mature PE Funds is the ratio of the cumulative cash inflows to the cumulative cash outflows of the investors. This indicator is called the "Distribution to Paid-In Capital Multiple (DPI). (Mostowfi, Meier, 2013, p. 212) DPI T T i=0 T i=0 CIF T COF T The DPI is an easy-to-calculate and interpretable measure that considers exclusively invested and actually distributed cash flows. If the value is more than one, the investment has already been amortized by the realized cash flows. For example, if the value is approximately three, the cash flows that have been distributed, represent a triple capitulation. The major weakness of this ratio is that cash flows generated at different times are added together without interest or discounting, and consequently the time value of the money becomes negligible. 25 P a g e

26 For Funds, which are not fully liquidate, is considered the DPI in relation to the net asset value of not distributed participations (NAV t ) to the accumulate Cash Inflows, called Residual Value to Paid-in Capital Multiple (RVPI): (Mostowfi, Meier, 2013, p ) RVPI T = NAV T T COF T This key figure represents an estimate of expected cash flows in the future (based on today's valuation of the investment) in relation to the invested capital. Adding the two key figures together, it presents the Total Value to Paid-in-Multiple (TVPI). This can be interpreted as an estimate for future DPI at the time of the complete liquidation of the PE Fund (Mostowfi, Meier, 2013, p. 213) RVPI T = T i=0 i=0 CIF T + NAV T T COF T i=0 If the fund is fully liquidated, the RVPI assumes the value zero, and the TVPI is equal to the DPI. DPI = TVPI Public Market Equivalent The weakness of the mentioned Value to Paid-in Multiples, where the monetary value is neglect, the Public Market Equivalent (PME) figure tries to solve that problem. This key figure assumes that the alternative investment in PE Funds is exclusively from a financial investment on the stock market. This figure, which is similar to the DPI, was originally introduced by Kaplan and Schoar (2005) for the purpose of a performance comparison between PE funds and the public equity market. The PME is calculated as the ratio of the accumulated cash inflow to the discounted cash outflows, accrued to the same point in time at the end of the period (Mostowfi, Meier, 2013, p. 214) T RVPI T = i=0 CIF T j=t+1(1 + r j ) T COF T T (1 + r j ) i=0 T j=t+1 The r j represents the returns of a stock market index (benchmark) in the periods t + 1 to T. The PME shows, how the investor's assets would have developed when investing in a portfolio of PE funds in relation to an investment in the public equity market, if the return flows from the fund, CIF T, had been invested directly in the public equity market. A PME greater than one indicates that the PE funds have developed better than the stock index. It is assumed that investments in the considered PE funds are subject to the same risks as the investment in the equity market. However, the interpretation of the calculated PME is, in our example, relative to the fact that there is no risk equivalency between investing in the considered PE Fund and an investment in the highly diversified and liquid MSCI World Index. The production of such a risk equivalent for individual funds is in fact not possible, due to the problem of risk measurement for individual PE funds described before. This is sometimes the reason, why the PME should only be used to assess the performance of larger portfolios of PE funds, where at least the risks specific to individual funds are largely eliminated by diversification. (Mostowfi, Meier, 2013, p ) 26 P a g e

27 2.3.2 Performance measurements of listed Private Equity Funds With Listed PE, we have market prices available, so we can use common performance measurements, as described in the literature. Often the calculation includes the basis of monthly returns, the annualized geometric average return, which indicates the returns of a buy and hold Investor. In addition, the risk is calculated as an annualized standard deviation of (usually) monthly returns (volatility). The Sharpe Ratio combines both concepts and describes the quotient of the additional yield of the geometric average return over the risk-free interest rate and volatility. Another risk-adjusted performance measure is the CAPM which I more used for forward looking asset allocation analyses Compounded returns The compounded annual return, also called a compound annual growth rate (later CAGR), is the rate of return on your investment, taking into consideration the compounding effect of the investment for each year. This is a much more accurate measure of performance than the average annual return. The average year-on-year growth rate of an investment over a number of years. While investments usually do not grow at a constant rate, the compound annual return smoothed out returns by assuming constant growth. This makes accounting for the investment tidier. It is calculated as: 1 ( Ending Value CAGR = ( Beginning Value ) # of years ) 1 The calculation divides an investment at the end of the period in question by its value at the beginning of that period, raise to the power of one, divided by the period length, and subtract one from the subsequent result. (Investopedia) Standard deviation Standard deviation is a measure of the dispersion of a set of data from its mean. If the data points are further from the mean, there is higher deviation (volatility) within the data set. Standard deviation is calculated as the square root of variance by determining the variation between each data point relative to the mean. The standard deviation applies to the annual rate of the return of an investment to measure the investments volatility. Standard deviation is a statistical measurement that sheds light on historical volatility. The formula for standard deviation (SD) is the following: x x 2 SD = n 1 Where means sum of, x is each value in the data set, x is the mean of all values data set, and n is the number of values in the data set. (Financial dictionary) 27 P a g e

28 Sharpe Ratio One of the most referenced risks of return measures used in finance is called the Sharpe Ratio. The Sharpe ratio is the average return earned in excess of the risk-free rate per unit of volatility or total risk. In other words, the ratio describes, how much excess return you are receiving for the extra volatility that you have been enduring for holding a riskier asset. The literature teaches us to always be properly compensated for the additional risk taken for not holding a risk-free asset. Generally, the greater the value of the Sharpe ratio, the more attractive the risk-adjusted return. (Investopedia Staff, 2014) The Sharpe Ratio formula will give us a better understanding of this ratio: S(x) = (r x R f ) SD (x) Where x is the investment, r x the average rate of return of x, R f the best available rate of return of a risk-free security and the Standard deviation (SD) of r x. Therefore, for this calculation we only need the asset return, the risk-free return, and the standard deviation. The Sharpe Ration is typically used, when a new asset or asset class is added to the portfolio for comparing the change in an overall riskreturn profile. (Investopedia Staff, 2014) Interim conclusion for Private Equity overview There are different possibilities to approach the equity investments in private firms. Direct investments, co-investments, alongside specialized investors, indirect investments through limited partnership (later LP), and indirect investments through fund of funds. According to academic literature, small or even big investors such as institutional investors tend to invest in PE through funds, which gives a way better spread of your committed capital and therefore minimized risk in comparison with direct investments. When dealing with direct investment, it is required to invest in a fund management team which has a high intensive relationship and due diligence skills to select the appropriate PE investment. Usually, the institutional investors have insufficient resources to build up a management team for monitoring portfolios of private firms. The main advantages of investing in Funds are that it is possible to invest smaller investments, have higher degree of diversification, and are controlled by a specialized fund management staff. For large institutional investors, such as pension funds, it might be realistic to invest directly, as they are prepared to invest in a professional staff, but for small and medium size investors direct investment might not be achievable. Besides the opportunity to get exposure to PE with Limited Partnership (later LP), it is also possible to invest in exchange-traded PE companies or LPE. These PE investments can be done either directly, indirectly or through the capital of their customers. Investments are conducted in the same way as Limited Partnerships, through various investment horizons (venture, buyout and growth) and financing silence (equity, mezzanine and debt). These exchange-traded PE companies offer the investor an immediate, liquid exposure to the PE investment class. 28 P a g e

29 The main differences of investing in Listed Private equities are that the investment in LPFs are fixed for 10 years and get first returns after 5 years after the closing and about 6 to 8 years amortised. It is possible to sell the shares on the secondary market, which is illiquid and non-transparent and usually forces the shareholder to sell the share for a premium, which means over the NAV. If the investment in LPE has no fixed life time, it means that it can be bought or sold at any time on the stock exchange which is liquid and transparent and gives the investor an immediate, permanent and diversified exposure to the asset class. The main advantages of LPE are liquidity, transparency of market prices, a longer-term approach and flexible investment policy, lower fees, ease of monitoring, and the opportunity to buy at discount. The main disadvantages are less efficient cash management, and fewer choices. The main advantages of LPFs are their efficient use of cash, and occasional co-investment right. The main disadvantages are poor liquidity, more administration managing commitments and cash flows, less diversification, high minimum commitments, and higher fees. (The Oxford Handbook of PE, Brown & Kraeussl, 2012, p ) If we observe it from the investor s point of view, the LPE also has advantages in performance measurements compared to the LPF. While in LPF it is just possible to analyse the cash flows of the LP Funds and determine the returns, which are often hard to compare with the public equity stocks and bonds. To fill this issue, the LPE stocks have the same characteristics as a normal publicly traded stock. LPE has market prices available, which makes the comparison with other stocks and bonds much easier. It gives us the risk, return, and correlation characteristics which are the key ingredients for asset allocation decision. In this study, I will focus on LPE (listed PE) which provides exposure to thousands of PE companies. As mentioned before, the LPE has many common characteristics to those of the LPF. LPE offers a much easier way to compare the returns with each other and make the right asset allocation decisions. 29 P a g e

30 3 Modern Portfolio Theory and the role of Listed Private Equity The financial portfolio theory argues a positive relationship between risk and return of an investment. That means, the higher the risk, the higher the return can be realized and contrariwise the same. (Hull, 2012) 3.1 Risk and expected return The composition between risk and return in portfolios of financial investments are a composition between risk and expected return, the statistical definition of the expected value of a variable is applied. The expected value of a variable is its average or mean value. The expression expected return means in this case a weighted average of possible return, where the weight applied to a particular return equals the probability of that return occurring. The possible return and their probabilities can either be estimated from historical data or assessed subjectively (Hull, 2012). The formula is the following: N E(R inv ) = P i It means, that the expected returns of a portfolio are calculated by the weighted average of the expected return of the individual investments in that portfolio (Sharpe, 2000). The weight applied to each investment matches the investment share of the total portfolio. The formula of the expected return of a portfolio is the following: N i=1 R i E(R p ) = w i E(R i ) i= Quantification of risk Risk of investments is often quantified by the standard deviation of return over a given period of time, which is often one year (Hull, 2012). For a one year investment with an expected return of E(R) the formula of the standard deviation is: σ = E(R 2) [E(R)] 2 The standard deviation of return of a portfolio depends on the standard deviations of return of its associated investments, their correlation coefficients and each investments allocation of the total portfolio. The standard deviation of return of a portfolio of N investment, σ p, can be calculated by the following formula: N N σ = w i w j ρ ij σ i σ j i=1 j=1 where w i and w j are the weight of invested in each investment, σ i and σ j the standard deviation of return of each investment and ρ ij the correlation coefficient between investment i and j. 30 P a g e

31 3.1.2 Correlation coefficient and covariance The correlation represents the relation between the two variables of investment or financial assets. It measures the linear relationship between them. That means, that a correlation coefficient of zero means a no linear relation or independence in the movement of value between the two variable. A coefficient of 1 means that the value follows perfectly of the two variances, so they are dependent to each other. That means, if one variable increases, the other will increase appropriately. When the two variables (investments) have a perfect positive correlation, the portfolio will not be diversified. The coefficient -1 would represent a perfect negative linear relation and an opposite valuation of the variables. That means, if the value of one variable increases, the value of the other variable will decrease with the same amount. This leads to a high diversification and consequently a low exposure, which means a loss on one of the variables is likely to be offset by a gain on the other. (Hull, 2012) The following formula shows the correlation coefficient, which is defined as: ρ = E(V 1V 2 ) E(V 1 )E(V 2 ) σ v1 σ v2 = cov(v 1,V 2 ) σ v1 σ v2 Where the cov(v 1, V 2 ) is the covariance, which represents a fundamental variable of mathematical quantifications of the movements between two variables and the σ v1 σ v2 the standard deviation of the two variables Systematic and non-systematic risk Systematic risk, more known as market risk, is the uncertainty of the entire market or market segment. Systematic risk consists of the daily fluctuations in an asset price which is referred to as volatility. Volatility, which is one of the main measurements, shows the risk. It refers to the behaviour of the investment. Non-systematic risk or specific risk, diversifiable risk or residual risk, shows the uncertainty of a specific asset or investment. Figure 8: Systematic and Non-Systematic risk Total risk of the portfolio Non-systematik risk Systematic risk Number of investments of the portfolio Systematic risk has all the assets and investments, therefore this kind of risk is not possible to diversify in a portfolio. In figure 8 it is shown, how it is possible to minimize the non-systematic risk with diversification. The non-systematic risk decreases with the number of investments in the portfolio. It is also shown, that we cannot diversify the systematic risk away. This risk is equally faced by all of the portfolio s components. 31 P a g e

32 3.2 Models of Modern Portfolio Theory The Modern Portfolio Theory (later MPT) definition was first presented by Harr Markowitz in his paper Portfolio Selection in 1952, for which he later received a Nobel Prize in economics (Markowitz, 1952). It was based on a book on this topic in In the book he mentioned the problem with the portfolio as a choice of the mean and variance of a portfolio of assets. He introduced the concept of maximizing expected return given constant variance, and minimizing variance given expected return. In the book he wanted mainly to express that assets should not be selected only on characteristics that were unique to the security. It is not enough only to look at the expected risk and return of a stock. He declared, that with a portfolio, which includes more than one stock, it is possible to reduce the volatility and gain benefits of diversification of the whole portfolio Mean-Variance Optimization The mean-variance analysis, which is a known financial optimization technique, has a crucial role for the financial decision makers. The quadratic programming method determines the optimal portfolio in consideration of the risk and return. Estimation of the expected return and the covariance for the financial assets has a significant importance in quantitative portfolio management. (Gökgöz, 2009) The mean-variance optimization developed by Markowitz helps to determine the optimal portfolio weights. The optimization framework determines the optimal portfolio weights, which helps the investor to choose rational investment opportunities. These optimal portfolio weights have a significant effect on the performance of the portfolio. (Markowitz, 1959). The mean-variance portfolio theory is based on the term of measuring the investment opportunities in expected return and variance of asset return. Mean-variance analysis is based on the following questions: First question is, whether the investor wants a minimum on risk, so they prefer less risk to more for the same level of expected return, and the second question is, whether the investors need to only know the expected return, variances and the covariance of returns to determine optimal portfolios, and the last one is, whether there exist any transaction costs or taxes limitations. (DeFusco et al., 2007) (Gökgöz, 2009) Mean-variance analysis is considered as a positive and a normative tool. On this basis, for the positive tool approach, this technique supports the hypotheses regarding how the financial markets and investors behave. The Capital Asset Pricing Model (later CAPM) is the most positive outcome of a tool, which was the result of a mean-variance analysis investigation of the framework for developing suggestions on how investors should behave. However, the efficient portfolios of the financial assets in mean-variance analysis are regarded as a prosperous application of a normative tool for optimization models. The mean-variance analysis supports the decision making of a financial engineer. (Gökgöz, 2009). 32 P a g e

33 Expected return The Efficient Frontier Applying the principles of the risk-return relationship and the concept of correlation, developed a mathematical procedure that produces a set of theoretically best portfolios. This translated into the portfolios that have the highest expected return for any given equal risk, or the portfolios that have the lowest expected risk for any given equal. The main purpose of the Modern Portfolio Theory (later MPT) is to optimize the relationship between risk and return with construction of the portfolios of assets, determined by their risks, return and covariance or correlations with other asset. Therefore, the main goal is to construct optimal allocated portfolios to maximize expected return based on a given level of market risk. MPT develops a framework, where any expected return is composed of carious future outcomes and are thereby risky. As the theoretically best portfolio features the optimal riskreturn relationship possible, it is also called the efficient portfolio. No other portfolio has a higher return at the same risk level (Markowitz 1959). Oppositely, a portfolio is inefficient if it is possible to achieve a higher expected return with no greater risk, or to reduce risk with the same level of expected return. (Markowitz, 1959, 1991) The MPT seeks for optimization of the relationship between risks an expected return, which is illustrated on the efficient frontier in Figure 9. The efficient frontier represents the optimal combination of these two key figures. Each dot represents a portfolio. The dots that are closest to the Efficient Frontier line are the portfolios that are expected to show the best performance with the smallest risk. Figure 9: Efficient Frontier Efficient Fronter Individual portfolios Risk/Volatility (Standard deviation) Due to this fact, the frontier represents the limit of how far the northwest of it is possible to construct portfolios given available assets. There is no possible investment that dominates a point on the efficient frontier, in the sense that it has both a higher expected return and a lower standard deviation of return. The area below (or southeast of) the efficient frontier represents the set of all investments that are possible. For any point in this area that is not on the efficient frontier, there is a point on the efficient frontier that has a higher expected return and lower standard deviation of return. 33 P a g e

34 3.2.3 The Capital Asset Pricing Model The Capital Asset Pricing Model (later CAPM) helps investors decide on the expected return required for an individual investment, when that investment is to be added to a well-diversified portfolio. Because of the latter, any non-systematic risk is almost completely diversified away and investors should therefore not be concerned about it and not require extra return above the risk free rate for bearing non-systematic risk. E(R) = R f + β(e(r M ) R f) The CAPM shows that the excess expected return over the risk free rate required on an investment is β, and it is an indicator of the extent to which the investment contributes to the risk of the market portfolio, i.e. it is a measure of the systematic risk of the investment. A beta below 1 represents an investment that is less risky than the market portfolio and hence requires an excess expected return less than that of the market portfolio. A beta above 1 represents an investment that is more risky than the market portfolio, and the required return is therefore larger than that of the market portfolio. An investment with a beta of 1 has the same risk as the market portfolio and though requires the same excess return. 3.3 Interim conclusion of Portfolio Theory and the role of Listed Private Equity LPE provides an alternative way to approach the PE asset class. Although this niche in the PE sector is relatively small, it offers a variety of features that make it attractive for both investors and researchers alike. Investors benefit from easy access to the asset class, with almost no restriction. There are no minimum investments or other requirements, such as a proven track record as an investor, to participate in a listed fund. The fact that it is possible to acquire or to sell listed PE in an organized market significantly enhances liquidity and lowers transaction costs. This makes listed PE particularly suitable for institutions that are too small to commit to a selection of traditional funds or do not want to spend a high amount of resources to a specialized PE investment team. Another advantage is an immediate exposure to an existing portfolio of unquoted companies of listed PE. The capability to rebalance their PE allocation in a flexible way is enticing for all types of investors. From a research perspective, enhanced transparency and the availability of daily market prices are the conspicuous advantages of listed PE. Research in traditional PE suffers from a lack of reliable and meaningful data, like market prices. Instead there are just cash flows of traditional or unlisted PE funds available. Without having market prices available, calculations of main characteristics such as risk, return and correlation is challenging. It is required to have a very good knowledge of these parameters for integrating PE into the framework of modern portfolio theory and well structures investment management processes. As the LPE is on a public stock exchange, a listed PE portfolio of funds is daily priced in an organized market. The possibility of employing a time series of market returns enable the application of standard tools in financial research. The results so attained are easy to compare to other asset classes. The key characteristics that make the risk return profile of PE unique are shared between listed and unlisted funds. Listed and unlisted funds operate in the same way, follow the same investment style, provide the same capital and manage their portfolio in the same way. Besides providing capital, the PE fund manager offers management support and take an active role in their portfolio companies, where they contribute their skills, network, and experience. 34 P a g e

35 4 Trends in Private Equity In 2016 the PE industry continues growing. The trends direction is clearly optimistic, which confirms also the total high of assets under management of 2.46tn 2.49tn $ as of June 2016 of all time. There are some concerns about continuing this trend of strong increase. The increase might not be so steep, however, it is clear that the industry has a good position and will remain strong in (Preqin report, Christopher Elvin, 2017). The last three years to June 2016 the PE industry had a 16.4% of annualized return. The strong performance is also visible in the exceeded distributions over capital calls of 257bn $, which was distributed in the first half of 2016 in comparison with 129bn $ in capital calls. Consequently, the net cash flow of 128bn $ was paid out to LPs. The trend of exceeding capital distributions over capital calls has started 6 years ago and the last three years have shown a remarkable net cash flow over 100bn $. (Preqin report, Christopher Elvin, 2017). In 2016, 57% of institutional investors have portfolio PE in their investment. After a survey, carried out by Preqin, 95% of the investors were satisfied with PE investments and have exceeded their expectations in the past year. 49% of LPs are planning to invest the same amount of capital and 40% a higher amount in the next 12 months than they did in Performance Overview Figure 10 highlights the Private Capital Assets under Management (later AUM), defined as uncalled capital commitments (later dry powder) and unrealized value from December 2000 to June The total of portfolio assets has grown 4.9% between December 2014 and June 2015 with 4.2tn $. Dry powder has increased for 7% from 1.25tn $ to 1.34tn $. The total unrealized portfolio value has increased 3% from 2.71tn $ to 2.82tn $ between December 2014 and June Although the capital distribution back to LPs has increased in recent years, the aggregate unrealized value still grows, as GPs invest more capital to work. Since 2000, the PE capital industry has increased 5 times in terms of AUM. In the last six months total unrealized value has grown for 3.8%, despite the real estate portfolio funds decreased by 3%. Figure 10: Private Capital Assets under Management Private Capital Assets under Management Dry Powder Unrealized Value (bn$) Source: Preqin PE Report, P a g e

36 Performance Net Internal rate of returns (IRRs) Figure 11 shows the median and quartile boundaries of Net IRR of All PE strategies and all regions. The spread of top and bottom quartile net IRR had a high in 1993, which was 31.9%. The average spread from 1992 to 2013 was 18.4%. In 2016 the spread was quite under the average with 13.3 %. Figure 11: PE Performance Median Net and Quartile Net IRRs 50 Median Net and Quartile Net IRRs - All PE Top Quartile Net IRR (%) Median Net IRR (%) Bottom Quartile Net IRR (%) Source: Preqin PE Report, 2017 Consequently, it is significant to choose the right funds, which have had a high performance in the past. The high spread between the net IRR is the answer to how important it is to have a high potential PE management team, which has a profound expertise in the industry of the portfolio company. 36 P a g e

37 4.3 Allocations to Alternatives Interests in PE have grown in the last decade, as seen in Figure 12 the average allocations to alternative investments and real assets for defined pension plants from 1998 to The Unlisted real estate asset class has increased in allocation from 2.90% in 1998 to 4.46% in Figure 12: Allocations to Alternative Investments 25 Allocation to Alternative Investments Unlisted Real Estate Other Hedge Funds Private Equity Source: CEM Benchmarking 2016 The highest increase in alternatives has the asset class PE and hedge funds. Over the period of 16 years, Hedge Funds have increased from 1.46% in 1998 to 8.36% in PE has an asset allocation of 1.97 in 1998 and has grown up to 5.93% in 2014, which is a 300% increase. 37 P a g e

38 PE Funds In 2016, 830 PE funds closed and raised an aggregate capital of 347bn $. In Preqin s report they expect to exceed the capital raised in 2014, which was 348bn $. As shown in Figure 13, the capital calls in 2016 will reach a high since the global financial crises. Figure 13: Global PE Fundraising Global PE Fundraising Year of Final Close Aggregate Capital Raised ($bn) Numer of Funds Closed Source: Preqin PE Report, 2017 In 2016, the PE Industry had 57% of all private capital raised, in 2015 it was 52%. The continuing of high net distributions increased the demand, which has caused LPs to reinvest capital back into PE in order to maintain their allocations. (Preqin Report, 2017) 38 P a g e

39 E L E C T R O N I C S G A M I N G H E A L T H C A R E R E T A I L IT C H E M I C A L S L E I S U R E C O N S U M E R P R O D U C T S S O F T W A R E P H A R M A C E U T I C A L S M E D I A DEAL SIZE (MN$) Largest Buyout Deals and Exits in 2016 In the following Figure 14, we can see the largest PE backed buyout deals in 2016 split into Industry and Investment Type. The highest deal of mn $ was a public to private of Hilton Worldwide, invested by Blackstone Group and acquired by HNA Group, which is in the Leisure sector. Figure 14: Largest PE Backed Buyout deals in 2016 LARGEST PE-BACKED BUYOUT DEALS IN Buyout Public to Private Merger Add-on Source: Preqin PE Report, 2017 The leading investment style is still buyout with mn $. The first place of the largest PE backed buyout deals in 2016, selected by industry was the Leisure sector. 39 P a g e

40 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 No. of Deals Aggregate Deal Value (bn$) 4.6 Venture Capital In the year 2016, a total of venture capital deals with a total value of 134bn $ were announced. As seen in Figure 15, in year 2016 there was the lowest level since The aggregate deal value was in 2016 still the second highest since The key findings from Preqin were that the rise in value was driven by a high number of more than 1bn $ transactions, including six of the top 10 largest deals in the whole period from 2007 to High valuations have seen an average deal size rise nearly 2.5 times since 2013 for transactions in later stages. In 2016 Q2 was the second highest aggregate deal value of any single quarter at 42bn $. Figure 15: Number and Aggregate Value of Venture Capital Deals of Venture Capitals Deals Globally Number and Aggregate Value of Venture Capital Deals Globally No. Of Deals Aggregate Deal Value (bn$) Source: Preqin PE Report, had a drop of 13% in the number of financings from It is also important to note that 2015 was a record year for venture capital deal activity with financings, and aggregate deal value was only 6% lower in 2016 than in P a g e

41 No. of Deals A shift in venture capital activities from North America to Greater China were seen in 2015, 2016, as seen in Figure 16. North America had venture capital financings in 2016, which was a quite high decrease of 32% compared to 2015 with financings. In 2016 there was a continuation of the shift in venture capital activity from North America to Greater China, as shown in Figure 16. The number of financings in North America in 2016 was 3.793, which was considerably lower than the previous year with financings. Consequently, there was a decline of the amount of the financings in North America to 61bn in 2016, which suffered a 15% decrease. Figure 16: Number of Venture Capital Deals by Region Number of Venture Capital Deals by Region Nort America Europe Greater China India Israel Other Source: Preqin PE Report, Outlook for 2017 The year 2016 was a record year for PE funds with a total of funds with an aggregate value of 620bn $. For emerging markets and first time managers, this will bring challenges in competing for investor s capital in an increasingly demanding investor s community. LPs are still liquid because of continuing and maintaining of distributions. A high amount of assets to PE was invested before the global financial crisis, which has yet to be realized, therefore the market should continue with the trend in 2017, where the values of exits will continue to raise. While fund managers had a record high of capital available after a survey by Preqins research team, they indicate that many are looking to increase the amount of capital over the next 12 months. In the low interest rate period, which we had in 2016 and which will apparently continue in 2017, the PE model is working well. The asset class will continue to contribute high absolute return and portfolio diversification. 41 P a g e

42 5 Optimization of portfolios The risk, return, and correlation characteristic of an asset class are the key ingredients for asset allocation decision. This section addresses the question of how the listed PE affects the diversification of an international bond and equity portfolio from the perspective of a U.S.-currency-based investor. 5.1 Asset Class Index Proxies I have chosen six asset classes, which two of them represent the PE asset class. European bonds, U.S. bonds, European equity, U.S. equity, PE Europe and PE America. The Benchmark used in the empirical study are Citigroup European Government Bonds Index, Citigroup U.S. Government Bonds Index, The MSCI Europe and the S&P 500. For the PE asset class, I used the LPX Europe and LPX America. On the efficient frontier I simulate two opportunity sets, one with and one without the PE asset class. The database includes market prices with dividends from the 2 nd of January 2013 to the 30 th of December European Bonds The EGBI consists of the EMU-participating countries that meet the WGBI which measures the performance of fixed-rate, local currency, investment grade and sovereign bonds. Current EMUparticipating countries include: Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Latvia, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, and Spain. Among these markets, only those that satisfy the WGBI criteria for market inclusion are included in the EGBI, namely: Austria, Belgium, Finland, France, Germany, Ireland, Italy, the Netherlands, and Spain. (Citigroup Index Guide) U.S. Bonds This index includes fixed rate of US Treasury bonds with USD 5 billion public amount outstanding and greater than one year to maturity. The index excludes Federal Reserve purchases, inflation-indexed securities and STRIPS. (Citigroup Index Guide) European equity The MSCI Europe Index is part of the Modern Index Strategy and represents the performance of large and mid-cap equities across 15 developed countries in Europe. The index has a number of sub-indexes which cover various sub-regions market segments/sizes, sectors and cover approximately 85% of the free float-adjusted market capitalization in each country. (MSCI official website). U.S. equity The S&P 500 is widely regarded as the best single gauge of large-cap U.S. equities. There is over USD 7.8 trillion benchmarked to the index, with index assets comprising approximately USD 2.2 trillion of this total. The index includes 500 leading companies and captures approximately 80% coverage of available market capitalization. (S&P Dow Jones Indices) 42 P a g e

43 Listed PE Index (LPX) The LPX Index is a very well-known and the first provider of LPE and developed as the benchmark index for the PE asset class. The index has been established in 2004, which contains global indices (LPX composite, LPX50 and LPX Major Markets), style indices (LPX buyout, LPX venture, LPX direct, LPX indirect and LPX mezzanine) and regional indices(lpx Europe, LPX UK and LPX America). The basis for the LPX indices is a database of more than 300 PE companies listed worldwide. To be a part of the index it is required to have more than 50% of net assets in private companies. The following liquidity characteristics has to be fulfilled. Minimum market value of 20 to 150mil $, minimum daily trading volume relative to market capitalization of 0.06 to 0.10%, a minimum trade continuity of 75 to 90% and a maximum bid-ask spread from 1.5 to 4%. Europe PE The LPX Europe represents the most traded LPE companies and covers all the PE companies listed in Europe which fulfil certain liquidity criteria. The index is characterised by a high degree of diversification across investment styles such as buyout and venture. LPX Group publishes a monthly newsletter that contains the most important characteristics of the LPX Europe. U.S. Private Equity The LPX America represents the most actively traded LPE companies covered by LPX Group that are listed n North America and fulfil certain liquidity criteria. The index is well diversified across PE investment styles such as venture, buyout and growth. As shown in Figure 17 has the MSCI Europe a decrease of 1%, the S&P 500 an increase of 53%, the European Government Bond Index an 4% decrease, U.S. Government Bond Index an increase of 4%, the LPX Europe, which represents the PE Asset class an increase of 54% and the LPX America an increase of 28% in the period from the 2 nd January 2013 to the 30 th of December 2016 for Figure 17: Cummulative Index Returns 2, Cumulative Index Returns 2, , , Jan 02, 2013 Jan 02, 2014 Jan 02, 2015 Jan 02, 2016 MSCI Eruope S&P 500 EGBI USGB LPX Europe LPX America 43 P a g e

44 5.2 Historical Analysis In my historical analysis, I will create a strategic asset allocation setting which will include two opportunity sets. The first set will include just the traditional asset classes without PE. The second include PE asset classes. I will use a number of historical performance statistics. The historical returns, standard deviations (risk), and correlations for the asset classes. These statistics form a set of historical capital market assumptions that drive the Markowitz mean-variance optimization framework, so I can determine the best possible combination of asset classes in our portfolio, which maximize the return for a given level of risk. To build the efficient frontier I used the market prices with dividends to calculate the main characteristics like historical annualized returns, standard deviations (risk), and correlations. After defining the covariance matrix, I built with the help of a framework the efficient frontier. The Asset classes and the asset class indexes, which I used in this study are listed in Table 3 Table 3: Asset Class Index Asset Classes Asset Class Index European Bonds Citigroup European Government Bond Index (EGBI) U.S. Bonds Citigroup U.S. Treasury Bond Index (USGBI) European Equity MSCI Europe U.S. Equity S&P 500 European PE LPX Europe U.S. PE LPX America As seen in Table 4 has the Portfolio with the asset class PE outperformed over the portfolio without PE. Over the standard deviation range from 3.28% to 11.90%, the average improvement in return in the optimization framework is 0.48%. Table 4: Risk-Return performance Portfolio without Private Equity Portfolio with Private equity Return St. deviation (risk) Return St. deviation (risk) % 11.87% 10.80% 11.90% 10.80% 10.70% 10.00% 10.83% 10.00% 9.73% 9.00% 9.50% 9.00% 8.53% 8.00% 8.19% 8.00% 7.35% 7.00% 6.92% 7.00% 6.20% 6.00% 5.70% 6.00% 5.12% 5.00% 4.56% 5.00% 4.13% 4.00% 3.62% 4.00% 3.34% 3.00% 3.02% 3.00% 2.91% 2.00% 2.91% 2.00% 2.90% 1.00% 3.28% 1.00% 3.28% 44 P a g e

45 Table 5 presents the correlation matrix which shows the relationship between the asset classes. We can see that LPX Europe and MSCI Europe, also the LPX America and the S&P 500 have a high positive correlation. A high negative correlation is notable on USGB and the S&P 500. High positive and high negative correlations are not ideal for portfolio diversification. If the purpose is to diversify a portfolio, the correlations should be close to 0, which means that they are not related to each other and perfectly diversified. In this example, the EGBI and the S&P 500 have almost no correlation, which is the perfect way to diversify a portfolio. Table 5: Historical Correlation Matrix MSCI Europe S&P 500 EGBI USGBI LPX Europe LPX America MSCI Europe S&P EGBI USGBI LPX Europe LPX America Figure 18 represents the efficient frontiers of the defined opportunity sets, the blue line represents optimal allocated portfolios without the asset classes PE, and the green line represent the optimal allocated portfolios with PE. As seen in Figure 18, the portfolios with the asset class PE improve the risk and return characteristics of the efficient frontier. Figure 18: Historical Efficient Frontiers with and without PE. 45 P a g e