Private Equity Overview June 10, 2010 State Universities Retirement System Rob Parkinson, Associate
Agenda Asset Class Overview Market Update SURS Private Equity Portfolio
Asset Class Overview
Benefits of Private Equity Investing in private equity offers an investor the opportunity to generate higher absolute returns while improving portfolio diversification Investment Horizon: Through long-term investing in Private Equity, investors can take advantage of market cycles and are less subject to the pressures associated with investments in public securities Impact of superior returns: Investors with only a small allocation to Private Equity can considerably impact the overall returns of their portfolio Access: Institutional investors have access to a portion of the investable universe usually not available to the everyday investor
Asset Class Size Total Investable Capital Market December 31, 2009 $104.6 Trillion All Other Stocks 18.6% Cash Equivalents 4.0% Emerging Market Debt 3.4% Emerging Market Stocks 2.6% U.S. Stocks 14.8% Private Capital 1.0% U.S. Real Estate 4.7% U.S. Bonds 27.1% Non-U.S. Bonds 22.7% High Yield Bonds 1.2% Source: UBS Global Asset Management, Venture Economics, EnnisKnupp
Private Equity Strategies Venture Capital Seed An entrepreneur has a new idea or product, but no established organization or structure. Investors tend to provide a few hundred thousand dollars and perhaps some office space to an entrepreneur who needs to develop a business plan. Early Stage The organization has been formed and has employees and products are in the developmental stage. Early-stage investors back companies when they have a completed business plan, at least part of a management team in place, and perhaps a working prototype. Later Stage An established infrastructure is in place and the company has a viable product that is market-ready and generating revenues. Later-stage investors typically provide financing for expansion of a company that is producing, shipping, and increasing its sales volume.
Private Equity Strategies Buyouts (AKA: Corporate Finance) A fund investment strategy involving the acquisition of a product or business, from either a public or private company, typically utilizing both debt and equity. Mezzanine Financing A fund investment strategy involving subordinated debt (the level of financing senior to equity and below senior debt). Distressed Strategy A fund investment strategy involving investment in equity or debt of companies that are unable to service existing debt, often including companies in, or preparing to enter bankruptcy.
Private Equity Risk/Return Spectrum 40 30 Rate of Return (%) 20 10 Mega Buyout Large Buyout Mezzanine Medium Buyout Small Buyout Distressed Debt/ Turnaround Late Stage Venture Capital Early Venture Capital Seed Venture Capital 0-10 Lower Risk Higher Source: Thomson Venture Economics
Risks of Private Equity Investing Liquidity Vintage Year Geographic Portfolio Risks Sector Industry Investment Type
How to Mitigate Risk in PE Portfolios Concentration Risk: Limit no more than 15% of allocation to one firm and no more than 10% to any one fund. Geographic Risk: Allocate 25% or more, not to exceed 35% of entire portfolio to non-u.s. investments. Sector Risk: Allocate no more than 50% of the portfolio to any one sub sector. Industry Risk: No more than 15% in any one industry. Skill: Hiring a fund or adviser to select top performing funds Benchmarking: Peer benchmark of Venture Economics or Preqin are good indicators of relative performance. Time & Reporting: Back office and investment management services can typically be outsourced at a relatively low cost to the investor.
15 Year Returns As of 6/30/2009 25% 20% 19.3% 16.3% 15% 13.8% 10% 9.4% 6.9% 6.6% 6.5% 5% 3.5% 3.3% 2.5% 0% Non-U.S. Buyouts (Venture Econ.) U.S. Venture Capital (Venture Econ.) U.S. Buyouts (Venture Econ.) Real Estate (NCREIF) Large Caps (S&P 500) Bonds (Barclays Capital AGG) Small Caps (Russell 2000) Int'l Equities (EAFE) Treasury Bills Inflation Source: Thomson Venture Economics, Bloomberg
Typical Institutional Allocations to Private Equity 12% 11.5% 10% 10.2% % of Total Fund Assets 8% 6% 4% 5.3% 4.4% 4.4% 3.7% 2.8% 4.4% 6.6% 7.8% 8.4% 8.4% 2% 0% Corporate Defined Benefit Plans Public Defined Benefit Plans Endowments & Foundations Source: Greenwich Associates 2009 Survey 2006 2007 2008 2009
Characteristics of Successful Investors We believe six elements are essential in determining private equity allocation: - Access and skill - Risk tolerance - Internal resources for supervision - Board support - Liquidity requirement - Asset size
Market Update
Private Equity Market Overview 30 25 20 15 10 5 0 Global 1Q10 Fundraising (by Sector) 24 16 $13.0 $11.0 7 6 $3.8 $2.0 3 $3.1 Buy out Distressed Fund of Funds Secondaries Venture General Partners Fundraising. US private equity firms raised $50.4 billion in the first quarter of 2010. This is down 68% from the $76.0 billion raised during the same period in 2009. Portfolio Performance. General Partners continue to emphasize margin improvement and operating efficiency over revenue expansion in their portfolio companies. Many General Partners are starting to experience an increase in quality of deal flow. Liquidity. Global M&A activity was up 43% from the previous quarter. In addition, IPO markets have become more receptive to new offerings as over a dozen private equity backed companies went public in the first quarter of 2010. No. of Funds Aggregate Capital Raised ($B) Source: Preqin Capital Raised (USD $Bil) Global 1Q10 Fundraising (by Geography) $20.0 $18.0 $0.9 $16.0 $14.0 $5.3 $0.3 $0.7 $12.0 $2.7 $10.0 $2.4 $8.0 $1.2 $1.0 $3.3 $7.0 $2.2 $6.0 $4.0 $2.8 $2.0 $4.8 $3.1 $3.1 $0.0 North America Europe Asia/ ROW Note: Fundraising only includes funds that held a final close Fund of Funds Other Secondaries Distressed Buyout Venture Capital Limited Partners New Commitments. Many Limited Partners are more selective with new fund commitments. As a result, many fundraising efforts have been put on hold or delayed significantly. Fundraising. Currently, there are 736 North American-focused funds targeting $332.3 billion in commitments, while $152.1 billion is being sought by 388 European-focused funds. Valuations. NAVs have begun to rebound as public market comparable valuations have increased from year-ago levels. Sources: Thomson Reuters, Preqin
Buyouts/ Corporate Finance Value ($mil) Buyout M&A Deal Volume and Value $350,000 1,600 $300,000 1,400 $250,000 1,200 1,000 $200,000 800 $150,000 600 $100,000 400 $50,000 200 $0 0 1Q02 1Q03 1Q04 1Q05 1Q06 1Q07 1Q08 1Q09 1Q10 Number of Deals Current Environment Slower Deal Pace. LBO deal volume picked up in Q1 2010 with sponsors closing 147 deals, a 22% increase over the prior quarter. Difficult Operating Environment. Though portfolio companies continue to view the current environment as difficult, there have been fewer defaults among sponsor-backed companies. Exit/liquidity. Exit options are starting to emerge as strategics focus on acquisitions and markets become more receptive to IPOs. There were 65 exits, totaling $13.0 billion, from buyout funds in Q1 2010. 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 6% 11% 16% 17% 50% Value Sources: Preqin Number of Deals Number and Aggregate Value of Buyout Deals by Value (Q1 2010) Number of Deals 29% 33% 23% 10% 6% Aggregate Deal Value $1b or More $500-999m $250-499m $100-249m Less than $100m Fundraising. Buyout funds raised $13.0 billion in the first quarter of 2010. Limited Partner Considerations Leverage. Announced deals are utilizing more leverage than deals in the past 18 months. Banks have started to lend to larger more conservative transactions. Focus on Strategy. Operational value-add is required for managers to be successful. Financial engineering is more difficult in the current environment. Attractive Sectors. Lower and middle-market deals, growth equity, and de novo strategies utilizing little-to-no debt are appealing opportunities in this market environment. Sources: Thomson Reuters, Preqin
Venture Capital $35,000 $30,000 $25,000 $20,000 $15,000 $10,000 $5,000 $0 Venture Capital Deal Volume ($MM) $8,022 $5,836 $6,334 $5,846 $5,753 $7,791 $7,071 $5,493 $6,580 $4,939 $5,841 $5,177 $4,737 $7,077 $7,377 $7,359 $5,100 $6,121 $6,293 $4,837 $4,142 $4,211 $5,212 $5,036 $6,343 $7,450 $7,745 $3,364 $4,727 2003 2004 2005 2006 2007 2008 2009 2010 Quarter 1 Quarter 2 Quarter 3 Quarter 4 Venture Capital Industry Focus Bus. Service Consumer 2% 3% Telecom Financial 3% Services 5% Current Environment Investment Pace. Venture capitalists invested $4.7 billion in the first quarter of 2010 down 6% from the previous quarter. Investment was up versus the first quarter of 2009. Exit Environment. 9 VC-backed IPOs in 1Q 2010 vs.12 VC-backed IPOs in all of 2009. Represents best quarterly total for venture-backed IPOs since 4Q 2007. Fundraising has slowed. US venture capital firms raised $3.6 billion in the first quarter of 2010 from 32 funds. This level marks a 31% decline, by dollar commitments, compared to the first quarter of 2009 and 44% decline by number of funds. Industry Focus. Healthcare and technology continue to attract the bulk of venture capital investment. Limited Partner Considerations Valuations. Entrepreneurs valuation expectations and venture capital buyer expectations have seemingly converged, which may increase deal activity. Technology 33% Healthcare 29% Investment Strategies. Funds that invest in capital-efficient businesses are better able to weather the crisis as these companies require less capital and spend it more slowly. Industrial/ Energy Media and 14% Entertainment 7% Slower Deployment of Capital. In preparation for potentially longer holding periods, funds maintain additional capital reserves for portfolio companies. Sources: Thomson Reuters, National Venture Capital Association
Distressed High-Yield Issuance ($ in billions) Basis Points 200 180 160 140 120 100 80 60 40 20 0 3000 2500 2000 1500 1000 500 0 Jan-94 Jan-95 Jan-96 High-Yield Loan Volume vs. Default Rates 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 YTD Jan-97 High-Yield Issuance ($ in billions) Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 BB B CCC Jan-04 Jan-05 Default Rates U.S. High Yield Corporate Bonds by Quality Jan-06 Jan-07 Jan-08 2010 Current Environment Timing the Market Opportunity. Covenant-lite terms have delayed triggering events until financial default occurs. Restructuring situations should start to emerge over the next 24 months as debt needs to be refinanced. Bankruptcies. There were just nine bankruptcies of buyout-backed companies in the first quarter of 2010 vs. 27 bankruptcies during the first quarter of 2009. 1 Default Rate. The 1Q 2010 default rate was 0.134% on $1.6 billion of defaults, the smallest quarterly default rate since the third quarter of 2007. The trailing 12-month default rate decreased to 7.3%, down from 10.8% as of year end 2009. 2 Limited Partner Considerations Cyclical Investment Strategies. Mezzanine and distressed debt opportunities become increasingly attractive during economic downturns and wide credit spread environments. Attractive Investment Opportunities. Refinancing needs for struggling companies provide opportunity for buyers to strengthen balance sheets. Credit Spreads: Distressed investors realized significant gains through debt positions that traded up in late 2009. The tightening of credit spreads have reduced the attractiveness on acquiring debt in struggling companies. 1 Dow Jones LBO Wire 2 New York University Salomon Center, First-Quarter 2010 Review Source: New York University Salomon Center Jan-09 14% 12% 10% 8% 6% 4% 2% 0% Jan-10 Default Rate
Mezzanine Debt Median Net IRR 25% 20% 15% 10% 5% 0% Mezzanine Performance and Credit Spreads 900 800 700 600 500 400 300 200 100 0 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Year Median Net IRR of Vintage Year US High-Yield Option-Adjusted Spreads Over Treasuries Spread over Treasuries (bps) Current Environment Refinancing Needs. About $1.1 trillion in leveraged loans and high yield bonds are expected to mature from 2010-2014. While a portion will be lost or converted to equity in restructurings, refinancing needs have been estimated at $700.0 billion over this timeframe. Bank Capacity Constraints. Banks invested $1.5 trillion in leveraged loans between 2004 and 2008. Assuming leveraged loans comprise the historical average percentage of bank assets, banks will have only $300.0 billion to invest in leveraged loans over the next five years. Dry Powder. Buyout firms raised around $700.0 billion in equity capital between 2006 and 2008, while mezzanine firms raised less than $100.0 billion. If the average buyout includes $1 of mezzanine for every $2 of equity, the shortfall is meaningful. Maturities (USD$ Bil) $450 $400 $350 $300 $250 $200 $150 $100 $50 $0 $17 $33 $44 $101 $66 $72 Loan Maturity Expectation $173 $94 $279 $45 $136 $136 $122 $109 $26 Bank Loans High Yield Bonds $1 $1 $167 2010 2011 2012 2013 2014 2015 2016 2017 2018 and beyond Limited Partner Considerations Fundamental Risk Compression. Mezzanine capital is most at risk when the enterprise value of a company declines below the company s total outstanding debt. With senior lenders providing less capital to new transactions, borrowers are less encumbered by higher priority debt than mezzanine thus decreasing the largest risk of mezzanine investments. Asymmetric Returns. Mezzanine investments are currently generating coupon payments between 15-17% with equity participation adding to the return. Total expected gross returns for 2009 mezzanine investments are approximately 20-23%. Sources: Morgan Stanley, Thomson Reuters / Venture Economics, Preqin Private Equity Intelligence, JP Morgan
Secondaries $ (in billions) 120% 100% 80% 60% 40% 20% 0% 25 20 20 15 15 12 10 10 9 8 7 5 0 2003 2004 2005 2006 2007 2008 2009 Source: Private Equity Analyst, Probitas Partners Transaction Volume (USD $B) Secondary Bid Spreads (Buyout LP Interests) Median High Median Low 2007 1H '08 2H '08 1H '09 Q3 '09 Q4 '09 Current Environment Fundraising. During 1Q 2010, secondary funds collected $3.1 billion vs. the $3.8 billion collected in 1Q 2009. Pricing. The bid-ask spread between buyers and sellers was very wide in 2009. Pricing was the main driver behind the low number of closed transactions. Performance. Due to the rebound in the public markets over 2009 many secondary transactions received an immediate increase in value after closing due to mark to market valuations. Strong Deal Flow. In 2010, deal flow will likely be originated from financial institutions, particularly banks, versus the high net worth's and family offices activity in 2009. Limited Partner Considerations Valuations. With discounts narrowing, we would expect to see additional secondary activity in 2010. Diversification. Secondary funds remain a option for investors who are seeking additional vintage year and private equity subsector exposure. Strategy. Seasoned secondary strategies will exhibit additional transparency versus other secondary strategies. Source: Probitas Partners
Summary of Opportunities Overweight Neutral Underweight Small-Market Corporate Finance Middle-Market Large Mega Seed / Early Stage Venture Capital Growth/Expansion Late Stage Multi-Stage Mezzanine Distressed Debt Secondaries Special Situations Royalty Clean Technology Energy Infrastructure Sector Focused
SURS Private Equity Portfolio
Private Equity SURS Exposure As of 12/31/2009 Current Policy Allocation Average Public Fund Allocation to Private Equity 1 Current Portfolio Market Value Current Dollar Amount as a Percent of Total Fund Total Commitments Over the Life of the Program 2 Total Assets Drawn by the Investment Managers 3 6.0% 7.8% $1.1 billion 8.0% $2.3 billion $1.7 billion 1 Per Greenwich Associates 2009 Survey, Public Fund Dollar-Weighted Asset Mix 2 Total Commitments represents assets committed to private equity since 1990. 3 Total Assets Drawn represents assets invested by the managers since 1990.
Performance as of 12/31/2009 1 Private Equity SURS Long Term Record Account Vintage Year Since Inception IRR Venture Economics Median IRR Venture Economics Top Quartile IRR Adams Street Sep Account 1990 29.0% 10.3% 19.3% Adams Street Global Secondary 2008 10.9% 0.8% 1.0% Adams Street Non-U.S. 1998 14.2% 1.0% 1.5% Muller and Monroe Illinois PE FoF 2004-15.1% 1.9% 11.5% Pantheon Ventures Separate Account 2002 8.5% 1.4% 12.1% Pantheon Europe III FoF 2002 17.0% 1.0% 1.5% Pantheon Global Second II FoF 2004 7.2% 0.9% 1.0% Progress 1995-3.2% 10.0% 32.2% 1 Performance is on a quarter lag. Performance for ASP 2009, ASP 2008, ASP 2007 Global Opportunities, Pantheon Europe VI, Pantheon USA 8, and Muller & Monroe MPEFF is not yet meaningful.
SURS Experience The nature of private equity dictates that assets be committed several years before they are actually invested. It is rare that 100% of assets committed are actually invested at any given point of time. Therefore, over-commitment is required to reach and maintain the policy target. Commitments have been made over several years instead of in a single year to allow vintage year diversification. SURS performance history has been favorable.