Building and Managing Your Private Equity Por1olio Hany Assaad Chief Por1olio & Risk Officer Avanz Capital 15th February 2013
The Landscape of PE in Emerging Markets Prospect for superior returns for investors with outperformance potential Comparatively lower entry valuations, greater impact on multiple expansion from organic growth, value creation drivers, exit opportunities Access to higher growth markets Attractive economic and demographic fundamentals, including higher GDP growth, younger populations and rising income levels Diversification beyond developed markets Wider choices of investments in companies than EM public markets Reliance on value creation and growing earnings to achieve target IRR than is the case in developed markets Value-added growth finance for companies Positive contribution to a country s economic growth Community benefits by improving environmental, social and governance standards Much less leveraged than PE in developed markets limited availability of debt financing particularly for acquisitions Buyout funds depend on leverage to generate investment returns by buying a company using a significant amount of debt but given limited debt in EMs there are few true buyout funds 2
The Landscape of PE in Emerging Markets (Con t) But: Majority control/buyout deals are the exception not the rule Most PE investments in EMs involve acquisition of minority/non-controlling stakes, so GPs can only influence change/improved corporate performance in more subtle/ cooperative ways Significant market inefficiencies exist in most EMs Limited transparency, sub-optimal governance standards, inconsistent protection of minority shareholders and fewer exit routes Fund manager differentiation to a great deal lies in their local knowledge and networks, and their ability to skillfully navigate EM business cultures Little bank debt available except for largest corporates Exit window can be volatile IPO opportunities in emerging markets appear and disappear quickly Less ability to rely on an increase in valuation multiple Shortage of both higher-level and mid-level management 3
The Landscape of PE in Emerging Markets (Con t) EMPEA surveys show accessing high-growth markets is the primary reason why 3/4 of investors grow their EM PE exposure Investors motivations for accelerating new commitments to EM PE for 2011/2012: 4
In Emerging Markets IRR is Driven by Growth & Efficiency Lever IRR Equity Cash Flow to Equity PE at Entry PE at Exit Margin Revenue Improvement: Growth p.a from 5% to x% Holding Period Years Leverage 25% 30% 55% 6 6 0% 5% Momentum 25% 75% 10% 6 14 0% 5% Growth 25% 75% 10% 6 6 20% 5% Efficiency 25% 75% 85% 6 6 0% 30% 5 5 5 5 Leverage & Momentum both have cyclical risk During major events, deals with these risks are caught in the same tide Growth & Efficiency have execution risk Emerging Market PE has: less cyclical risk and more execution risk than US and EU Private Equity and is more tied to Fund Manager skill 5
Diversification IFC s Private Equity Portfolio has outperformed comparable indices IFC has out-performed the Emerging Market Index with a much more geographically diversified exposure. Geographical diversification has proven to be an important factor for IFC s sustained performance and low volatility of returns 6
Myth Busters: Frequently Cited Risks with PE in Emerging Markets ü Minority positions are NOT too risky ü Smaller companies are NOT too risky ü Attractive exits ARE available ü A fund manager with the right skills CAN overcome first time fund & frontier risks 7
The IFC Experience: Minority Positions are NOT too Risky Minority positions (blue) have performed well in all forms of exit, indicating that the risks associated with minority positions can be managed effectively Median IRR Average IRR 50% 50% 40% 40% 30% 20% Majority Minority 30% 20% 10% 10% 0% IPO/LisPng Trade Sale MBO Structured Exit 0% IPO/LisPng Trade Sale MBO Structured Exit Sample: Exits of 61 majority positions and 251 minority positions from IFC invested funds 8
The IFC Experience: Smaller Companies are NOT too Risky Experience in deals as small as $2 million has been positive, suggesting that smaller companies are less risky than commonly perceived 70.00% 60.00% 50.00% 40.00% IRR by Investment Size * 35.00% 30.00% 25.00% Share of Write Offs by Investment Size ** 30.00% 20.00% 10.00% 0.00% - 10.00% - 20.00% $0-1m $1-2m $2-3m $3-4m $4-5m $5-6m $6-8m $8-10m $10-15m $15-20m $20-30m $30-40m $40-50m Sample: * 313 exits from IFC invested funds ** 323 exits from IFC invested funds + $50+ Median Mean 20.00% 15.00% 10.00% 5.00% 0.00% Investment Size $ million Low 9
The IFC Experience: Attractive Exits ARE Available Attractive exits are happening despite less developed capital markets, although access to an IPO improves returns Average holding period = 4.9 years Number of Exits * IRR on Exits ** 140 60 120 100 80 60 40 20 (percent) 50 40 30 20 10 Median Mean 0 IPO Trade sale MBO Structured Exit Write Off 0 IPO Trade sale MBO Structured Exit Sample: * 325 exits from IFC invested Funds ** 266 non-write-off exits 10
The IFC Experience: 1st Time Fund & Frontier Risks A Fund Manager With the Right Skills CAN Overcome 1 st Time Fund & FronZer Risks IFC s experience is that the differentiating factor in fund quality is the Manager s skill set, not 1 st time fund risk or a frontier focus IRR as of March 2009 (simple average %) Development Impact Score Highly Suc = 3 HighlyUn S = -1 1st Time Funds % IDA % (< $1000 GDP per capita) Average Deal Quality Score Max = 1 Min = 0 Top 10% 46.6% 2.10 53% 27% 0.97 Bottom 10% -38.3% 0.14 53% 13% 0.17 Sample: 150 Funds in IFC portfolio, excluding those in the J-curve The Same More Top 10% in the Frontier 11
Private equity vs. Public Equities in Emerging Markets ü Public markets tend to be small, with higher valuations and more volatile, with less choice in EMs ü Private equity provides more exposure to consumer growth in EMs than public markets 12
Type of Funds Listed Equity Venture Capital Private Equity Small Business Property Development/Real Estate Distressed Assets Debt Stock market listed companies Early stage companies, risky, 1-2 home runs Later state privately held companies; growth expansion Require different structuring as growth and exit are difficult Development and re- development in sectors such as residenpal & housing; commercial & warehousing; office & buildings; mixed- use Acquiring Non- Performing Loans (NPL) Funds invespng in debt (Bonds, corporate and sovereign) 13
Ways to Invest in Private Equity Investors have a choice of ways to invest in private equity such as: Funds investments investing in one or more PE funds directly. A one fund strategy is difficult to implement. A multifund strategy is suited for an investor who will allocate a large amount over a number of years. This strategy is best suited for a large program of investments over several years ($100 million and more per year) Fund of funds Investment in one or more fund of funds. Best suited for smaller size allocations but to diversify in several funds Used by large investors with limitations on minimum investment size ($50 million and greater) to invest in medium-sized funds Secondaries Purchasing existing LP interests in funds reduce risk and duration Co-investments Invest along-side funds in companies Directs Invest directly in companies. Will need scale, capacity and capabilities to successfully invest in multiple companies across geographies 14
Portfolio Construction Strategy Establish three year strategy Set out and define general allocation guidelines for PE Set target commitments per year based on availability of adequate investment opportunities Type and number of funds Ways to invest Select your investment space Not all investment spaces are equally attractive Growth capital, mid-cap, buyout, venture capital, SMEs Diversification is important Geographical, industry sectors, type & size of funds, fund managers/teams Match your strategy to your capabilities and resources Staff size, skills and location, investment consultants, networks 15
Portfolio Construction Implementation Maintain discipline Strategy, approach Select the most attractive funds from a pool of target funds Rigorous selection process Due diligence and closing 16
Managing Your Portfolio Establish an annual portfolio monitoring cycle Quarterly review of Fund Managers reports Valuation Advisory Committee oversight Benchmark portfolio and performance assessment Overall portfolio Individual managers Monitor portfolio exposure Regular and consistent reporting by fund manager crucial Early identification of issues and problems Regular monitoring Early warning signals Watch-list Take early action to resolve issues Build capacity in portfolio monitoring team to deal with issues when they arise Coalesce with other investors and empower the largest and most capable investor to lead Active participation in Advisory Committee (directly or indirectly) 17
Investors Risk Management Options Risk Category DescripZon MiZgaZon Economic risks PE is a non- regulated industry Non- regulated product Exposure to systemic external economic or financial cycles Largely self- regulated by contracts with investors Investors and Fund Managers believe that product regulapon is impracpcal due to unique characterispcs of each PE fund raised and different market characterispcs DiversificaPon by geography, industries and vintage year DiversificaPon by Fund Manager Fund life and structure Investors perform extensive due diligence on Fund Manager and Fund prior to making an allocapon Appropriate choice of jurisdicpon Well structured and detailed agreements Investors require significant reporpng and governance structures Important role of advisory commijee It is important that Investors carefully evaluate each PE product Different products for different markets? 18
Investors Risk Management Options (Cont d) Risk Category DescripZon MiZgaZon Fund Manager Issues of alignment of interests with Fund Manager, transparency, actual capabilipes Liquidity Very limited tradability of assets, long holding period, individual investors need for liquidity cannot be accommodated by the Fund Currency Typically foreign currency denominated draw- downs and distribupons, while investments are made in local currencies Clearly defined pre/post investment due diligence and checks InsPtuPonal allocapon to PE is generally small in the por1olio, and liquidity to meet capital calls is manageable Many insptuponal investors can afford to invest in assets with a longer term liquidity profile to match their future cash needs Can be mipgated by invespng across vintage years Fund life Liquidity events & exit strategies Emergence of secondaries market IdenPfy currency issues early on Diversify investments Secure projected drawdown plans and plan accordingly. FM ability to structure individual transacpons. 19
Investors Risk Management Options (Cont d) Risk Category DescripZon MiZgaZon ConcentraPon A PE fund will typically invest in less than 20 companies over its life (typically 12 to 15) Investors can spread their PE allocapon amongst several PE funds, or invest in a FoF With FoF can achieve a por1olio of 200-300 companies with small capital commitment ValuaPon Consistency of por1olio valuapon Apply InternaPonal PE valuapon guidelines Agree with Fund Manager on valuapon methodologies and Pming Value por1olio quarterly and annually Focus on quality and frequency Pipeline Contract enforcement Ability to build pipeline of funds and execute Weak enforcement of contracts is a common feature in many emerging countries Must have good sources and network to establish a deal pipeline Ability to select fund managers and funds Ability to close on investments Can be parpally mipgated through selecpon of fund managers with the right skills to operate locally 20
Investors Risk Management Options (Cont d) Risk Category DescripZon MiZgaZon ReputaPonal risk Ability to exit Crucial for Investors to avoid reputaponal risk, even by associapon Exits is where money is made in PE. Ability of Fund Manager to exit is a crucial component Due diligence and integrity checks on Fund Manager but also on other Investors Manage environment & social risks (need robust system) Timely and accurate reporpng Deal with conflict of interest issues early on through Advisory Commijee Proven track record of ability to exit through different methods, e.g.: IPO, trade sale, sale to another financial investor/fund, buy- back Demonstrated abilipes of Fund Manager as early in the fund life as possible Discipline on Pming of exits 21
Issues That Can Arise Key person event Slow deal flow and limited pipeline Strategy drift External factors E&S risks Governance issues and conflict of interest 22
Reporting to Investors and Disclosure Ensure necessary reports are made available to Investors in a timely manner Standardized reports International Private Equity & Venture Capital Investor Reporting Guidelines ILPA Quarterly Reporting Standards Quarterly reports Quarterly financial statements Portfolio review Valuation report (by Fund Manager) Annual report Annual audited financial statements Valuation report confirmed by auditors Annual environmental and social report Summary portfolio update letter Management discussion of key drivers of activity and performance Summary of capital activity (cash flows) Transactions closed or pending Including portfolio company defaults, LPA breaches, etc. Consistent with ILPA Principles V 2.0, a discussion of any material changes in risk factors 23
Valuation of PE Investments Funds invest in unlisted companies there are no quoted prices Concept of realized and unrealized fair value applied Most EM funds today apply the International Private Equity and Venture Capital Valuation Guidelines (http://www.privateequityvaluation.com) - latest edition: August 2010 Agree with the Advisory Committee on valuation methodologies to follow Unrealized valuations are determined using models: DFC Multiples Comparators Recent similar transactions in market Must consider many factors both quantitative and qualitative The fair value of each investment should be assessed at each reporting date: Quarterly valuations by fund managers Annual independent fund audits Independent valuation experts 24
Advisory Committee and its Role Task DuZes/ power Purpose/scope DuZes Profile of people Fiduciary duty Expenses Advisory Committee A committee of investors that does not represent the fund manager Powers and duties must be specified in the Fund s legal documents Typically represents investors and advises manager Provides advice on the strategic direction of the Fund and its progress Duties are not deemed managerial mostly focused on well defined governance issues Depending on the jurisdiction, activities that are not deemed management e.g. conflict resolution, review valuations, fund s progress Reviews conflicts of interest events such as key-person situations Reviews audited financial statements Reviews and approves valuation policies, and valuations assigned to portfolio companies Notifies manager of any material breach of its obligation, and approves waivers under the legal documents e.g. investment limits, extension of investment period Savvy and knowledgeable investors, professional, regional knowledge is useful, strong business judgment, knowledge of various sectors, global perspective of PE industry and multi-sectors AC members do not have fiduciary duty to the fund or investors but must act honestly and in good faith Out-of-pocket expenses should be borne by the fund Jurisdiction of Fund does matter: Liabilities and duties of investors on an AC depend on where a fund is incorporated 25
Benefits A clear strategy and a well structured portfolio can lead to: Higher sustained returns, higher than public markets Less volatility Better management of the effects of J-curves Better matching of cash needs with long term liabilities Recycling of investments (10-year horizon) 26
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