Private Investments - A Potential Alternative to Frothy Public Markets January 22, 2018
Session Aims Review the context for why and the degree to which leading practitioners allocate to private markets Examine the current environment for private investments Compare practices and experiences with allocating to private investments Discuss the key considerations when allocating to private investments 1
Anemic Return Expectations A low expected return environment is motivating a search for alpha 8% 6% 6.5% Long-term Historical U.S. Equity Return Annual Return Over 7 Years 4% 2% 0% -2% -0.5% -0.6% -0.9% 2.9% -1.0% 0.7% 0.2% 0.0% -4% -3.9% -2.9% -2.7% -6% U.S. Large U.S. Small U.S. High Quality Intl Large Intl Small EM U.S. Bonds Intl Bonds Hedged Emerging Debt U.S. Inflation Linked Bonds U.S. Cash Source: GMO Note: The chart represents real return for several asset classes and not GMO or Makena Performance. Actual results may differ materially from those anticipated in forward-looking statements. 2
What are the Prospects for a Real Return of 5%? Return Matrix for 65% Equity / 35% Fixed Income Portfolios Equity Market Returns 2.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0% 0.0% 1.3% 2.0% 2.6% 3.3% 3.9% 4.6% 5.2% 5.9% Fixed Income Returns 1.0% 1.7% 2.3% 3.0% 3.6% 4.3% 4.9% 5.6% 6.2% 2.0% 2.0% 2.7% 3.3% 4.0% 4.6% 5.3% 5.9% 6.6% 3.0% 2.4% 3.0% 3.7% 4.3% 5.0% 5.6% 6.3% 6.9% 4.0% 2.7% 3.4% 4.0% 4.7% 5.3% 6.0% 6.6% 7.3% Consensus return range for equities and fixed income 3
Private Equity Outperforms Public Equity A measure of the illiquidity premium and potential trends 5 Year Ann. 10 Year Ann. 15 Year Ann. Private Equity Burgiss Private Equity (Pooled Mean) 12.9% 9.2% 11.0% Public Benchmarks ACWI 9.4% 3.6% 5.9% Outperformance 3.5% 5.6% 5.1% The private equity portfolios of the largest endowments have historically performed better than the private equity benchmark mean Calendar year returns from 1991-2016. Past performance is no guarantee of future results. Comparison to the benchmarks is for illustrative purposes only. 4
Private Markets Offer an Attractive Opportunity Set Private companies outnumber public companies and exhibit more inefficiencies 25,000 # of Companies 20,000 15,000 10,000 5,000 0 389 19,379 384 9,830 536 6,288 # of Companies % of Total Private 40,457 93% Public 3,073 7% Total 43,530 100% 449 827 2,350 2,087 $50-100M $100-200M $200-500M $500M-1B $1-5B $5B+ Annual Revenue 488 523 Public Private SOURCE: CAPITAL IQ DATABASE AS OF 12/31/2016. DATA INCLUDES U.S COMPANIES ONLY. 5
Lower Purchase Prices in Private Equity As public markets continue to appreciate, pricing in the private markets remains attractive on a relative basis Enterprise Value / LTM EBITDA: Private Equity vs. SP 500 14.0x 12.0x 10.0x 11.7x 11.7x 11.8x 12.2x 11.7x Debt/EBITDA US Private Equity SP 500 11.0x 10.9x 9.1x 8.8x 8.8x 8.9x 8.3x 9.9x 10.5x 11.8x 12.8x 12.6x 8.0x 6.0x 6.4x 6.6x 7.1x 7.3x 8.4x 8.4x 9.7x 9.1x 7.7x 8.5x 8.8x 8.7x 8.8x 9.7x 10.3x 10.0x 10.3x 4.0x 2.0x 3.5x 3.9x 4.1x 4.6x 5.0x 5.1x 6.1x 4.8x 3.7x 4.6x 4.9x 5.1x 5.3x 5.7x 5.6x 5.5x 5.8x 0.0x 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 1H 2017 Sources: SP Capital IQ Leveraged Buyout Review 2Q17; Bloomberg 6
Better Fundamentals in Private Equity Consistently Lower Purchase Price Multiples Higher Growth Companies Conservatively Portfolio Valued Leverage Companies Less Portfolio Leverage Source: Bloomberg, as of 12/31/2016. Data set includes 595 portfolio companies and represents approx. 58% of PE NAV or 76% of PE buyout NAV. Statistics are based on manager survey response. Makena reached out to a representative manager sample set to generate these statistics. Not all managers were included due to several factors. This is presented for illustrative purposes only and no meaningful conclusions about PE s future performance should be drawn. Overall portfolio leverage includes Venture Capital and credit funds 7
The Spectrum of Private Investments Natural Resources Real Estate Buyout Venture Capital Role in the Portfolio Provides strong diversification, some inflation protection through contract terms Provides diversification, potential inflation protection, and returns with cash flow Driver of returns and portfolio diversification through a differentiated source of equity alpha Driver of returns, portfolio octane Increasing Risk/Return 8
Endowment Asset Allocation Practices Larger Institutions Allocate More to Alternative Private Asset Classes 100% 90% Fixed Income / Cash, 22% Fixed Income / Cash, 19% Fixed Income / Cash, 17% Fixed Income / Cash, 10% 80% Absolute Return, 18% 70% 60% 50% 40% Absolute Return, 13% Alt. Asset Classes Natural Resources, 2% Natural Resources, 4% Real Estate, 2% Real Estate, 3% Private Equity, 5% Private Equity, 7% Long/Short Equity, 5% Absolute Return, 15% Absolute Return, 19% Long/Short Equity, 6% Natural Resources, 5% Real Estate, 3% Private Equity, 10% Long/Short Equity, 8% Natural Resources, 8% Real Estate, 7% Private Equity, 19% 30% Long/Short Equity, 8% 20% Listed Equity, 51% Listed Equity, 46% Listed Equity, 38% Listed Equity, 30% 10% 0% Institution Size: Source: NACUBO 2016 $51M to $100M $101M to $500M $501M to $1B Great than $1B 9
Full Transparency..What Our Institutions Do Asset Allocation Practices at Makena and the College of William Mary 100% Fixed Income / Cash, 7% Fixed Income / Cash, 8% 90% 80% Absolute Return, 18% Absolute Return, 16% 70% Natural Resources, 8% Natural Resources, 5% Real Estate, 5% 60% Real Estate, 12% Private Equity, 17% 50% 40% Private Equity, 20% Long/Short Equity, 17% 30% Long/Short Equity, 11% 20% Listed Equity, 33% 10% Listed Equity, 24% 0% Makena College of William Mary 10
Key questions to ask when considering private investments Illiquid allocations can reward patient investors but should be made judiciously with sufficient care and buy-in by trustees and staff involved What are the return expectations of trustees and staff? Is there conviction in active management? Is there tolerance for illiquidity among the decision-makers? Do the decision-makers have a sufficiently long time horizon for long-lived commitments? Are they ready for the negative cash flows and near-term performance drag, the j-curve? Is the organization positioned to identify and access top-tier managers around the globe? Can the organization take on illiquidity? What does the IPS say? Are there debt convenants? Does the staff understand the administrative requirements associated with private investments managing cash flows, reporting delays, tax audit implications? 11
Private Equity vs. Public Equity in Differing Market Cycles Private equity has outperformed public equities in all cases except for strong bull markets Burgiss Private Equity vs. SP 500 Over Past 25 Years. Calendar year returns from 1990-2016. Past performance is no guarantee of future results. Comparison to the benchmarks is for illustrative purposes only. As of 12/31/16. 12
The Evolution of a Private Equity Portfolio The build-out of a private equity portfolio takes 6-8 years and typically commences with negative cash flows and negative results, the so called j-curve Net CF Rolling 3 Year PE Returns 40% 20% 30% Net Cash Flows as a % of PE 20% 10% 0% -10% -20% -20% -14% -8% -3% 7% 11% 10% 9% 10.7% 10% 0% -10% Rolling 3 Year PE Returns -30% -40% 2008 2009 2010 2011 2012 2013 2014 2015 2016-20% NAV is a simple average of the quarterly NAV throughout the year. Historical cash flows adjusted for current portfolio ownership. As of 12/31/2016 13
Vast Difference in Return Dispersion Across Asset Classes Manager selection and access is of paramount importance in private asset classes Private Asset Classes Source: Cambridge Associates. 14
Private Equity Fundraising Trends Capital overhang is concentrated in large-cap private equity --- small and middle market space remains less competitive and the build up of dry powder in large-cap space represents a significant selling/exit opportunity As of: 09/30/2017 Cumulative U.S. Private Equity Fundraising ($B) Funds Less than $1B Funds Greater than $1B Cumulative U.S. Private Equity Overhang ($B) Funds Less than $1B Funds Greater than $1B $400 $379 $500 $465 $473 $475 $503 $300 $291 $263 $286 $262 $262 $268 $400 $387 $397 $375 $363 $407 $417 $200 $100 $200 $281 $184 $176 $135 $105 $49 $149 $152 $90 $97 $215 $184 $198 $185 $300 $200 $100 $286 $228 $321 $391 $391 $314 $294 $276 $316 $336 $406 $433 $0 $91 $98 $79 $56 $59 $71 $78 $83 $41 $55 $64 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 $0 $58 $66 $74 $82 $83 $81 $87 $91 $81 $69 $70 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Source: Pitchbook, Cambridge Associates 15
Key Takeaways Institutional understanding, buy-in, and patience are essential The illiquidity premium persists but may have compressed over the years Manager selection and access is crucial to long-term success Portfolio construction takes time and vintage diversification is an essential aspect of risk management Administration and monitoring requirements are important to consider 16
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