THE ALTERNATIVES BASKET Real Assets Real Estate Private Equity Hedge Funds Infrastructure Distressed Debt Alternatives: a spectrum of opportunities from low risk fixed income substitutes to high risk/high return equity substitutes Diversification properties stem from differentiated return drivers Many inherent non-investment risks
Annualized Return ALTERNATIVES SHIFT THE EFFICIENT FRONTIER 10.0% 9.5% with alternatives 9.0% 8.5% without alternatives 8.0% 7.5% 7.0% 6.5% 6.0% 0% 5% 10% 15% 20% Annualized Volatility Source: Morgan Stanley Using 15 years of data through 2015 2
GROWTH IN ASSETS UNDER MANAGEMENT BY ASSET CLASS 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 Other Private Equity Infrastructure Venture Capital Private Equity Real Estate Privaty Equity Buyouts Hedge Funds 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 H1 Fixed Income 39% Equities 35% Alternatives 26% Global AUM 2014 Source: Preqin, Hedge Fund Research 3
OVERVIEW OF KEY MACRO TRENDS AFFECTING THE ALTERNATIVE INVESTMENT ECOSYSTEM Direct impact on AI Secondary impact on AI The economic rise of non-oecd countries is: Increasing global trade Increasing share of non-oecd global GDP Creating large new pools of capital Technological Disruption Emerging Markets Soci al Syst em Sust ainab Monetary Policy Record levels of quantitative easing are: Reducing nominal returns for investors Increasing pension liabilities Driving asset prices to near record levels Aging in OECD countries is: Increasing pension liabilities Increasing funding gaps at pension funds Reduced access to defined benefit plans Macro trends are driving change in the alternative investment ecosystem Capital sources Increasing the supply of capital available to firms Increasing demand for alternative investments Business models Altering the competitive landscape for GPs Driving the creation of new GP-LP relationship models Investment opportunities Opening large new markets for firms to invest in Potentially larger deals 4
RETURN AND RISK EXPECTATIONS Return Expectations Risk* (Standard Deviation) Diversification Potential Real Estate 5-6% 12% Strong Private Equity 8-10% 22% Moderate Hedge Funds 4-5% 6% Variable Infrastructure 6 7% 12% Strong Global Equity 6 7% 17% n/a US Fixed Income 3.5 4% 4% n/a *alternatives volatility modified to reflect other aspects of risk
ALTERNATIVE INDEXES ARE INDEXES IN NAME ONLY Asset allocation decisions and performance evaluation are complicated by indexes which: Are derived from returns of active investment managers Are not fully representative of the universe Change in composition as sub-strategies move in and out of favor Obscure the true volatility of the asset class 6
RISK IN ALTERNATIVE INVESTMENTS IS A MULTI-DIMENSIONAL ISSUE Illiquidity Career risk Cyclicality of returns Tax Issues Leverage Fees Currency risk Public relations risk Lack of market pricing Transparency Peer group risk Surprise factors Basis risk Regulatory Risk Administrative complexity Credit risk
GOVERNANCE IS CRITICAL TO SUCCESS Taking the right risks is the proposed investment aligned with the objectives of the investment program? Documenting decisions for posterity is the rationale for investing in the alternative asset class clearly articulated in the fund s governing documents? Staffing do we have people with the required skills, knowledge and capacity? Are decision rights and responsibilities clearly spelled out and allocated to those who have the knowledge and capacity? Processes delegate as appropriate; balance influence with accountability. Establish a strong reporting framework to monitor the program s progress toward the agreed-upon goals and objectives.
Real Estate / Real Assets
THE REAL ESTATE/REAL ASSETS Income-Producing Commercial Property Investments - Office - Industrial - Retail - Apartments Indirect Real Estate Investments (REITs, REOCs) Timber Agriculture Energy/Commodities
Return COMMERCIAL REAL ESTATE INVESTMENT SPECTRUM Low Risk Fixed Income Substitute to High Risk Equity Alternative Security of Income Growth-Oriented Opportunistic Distressed sellers globally Income Triple-net leased Investment-grade CMBS Mortgage Loans Core Fully-leased multi-tenant property Core diserfied Publicly traded REITs Value-Added Property leasing strategies Property repositioning strategies Recapitalization Publicly traded REITs Private partnerships Recovery capital Growth capital Emerging property sectors New company foundation Land development Risk
PRIVATE VS PUBLIC REAL ESTATE INVESTMENT Defining a Role for Real Estate Securities (REITs, REOCs) Real estate securities are securities first, real estate second - Higher volatility than private core real estate - Higher correlation to public markets However, real estate securities can complement a private real estate portfolio: - Assist in maintaining a fully invested real estate allocation - Facilitate tactical or strategic shifts in the overall real estate allocation - Allow short term tilts in property type or geographic concentration
REAL ESTATE RISKS Lack of liquidity Long lead time for new development Changing demographics Obsolescence Environmental issues Cost and availability of capital Leverage Unexpected inflation 13
Growth TIMBER INVESTMENTS Older than 20 years Physical growth < 2% per year Chief by-product is lumber used in housing Liquidity is significantly higher Prices are more volatile. 10 to 20 years old Physical growth of 8 10% per year Sold for dimensional lumber, paper and plywood Liquidity is significantly enhanced at this stage due to the greater range of end-uses and more efficient harvestability. Young trees; < 10 years old Physical growth of 10 15% per year Limited liquidity (too small for economical harvesting) Price volatility is low AGE Emerging Growth Established Growth Mature PULPWOOD CHIP-N-SAW SAWTIMBER Source: Evergreen Timber
Private Equity
Revenues PRIVATE EQUITY Long term equity investments in non-publicly traded companies Venture Capital Private Equity MBO IPO 4th Round Seed/First Stage 2nd Round 3rd Round Stage Start-Up Expansion Pre-IPO Public Buyout Principal Risks Product Development Market Development Managing Growth Market Price & Debt Service SECONDARIES
THE PRIVATE EQUITY PYRAMID Plan Sponsor Gatekeeper Discretionary Separate Account or Fund-of-Funds IWP V (Early Stage Venture) SV VI (Late Stage Venture) BC VII (Mezzanine) CEP II (Buyout) Company 1 Company 2 Company 4 Company 5 Company 7 Company 8 Company 11 Company 12 Company 3 Company 6 Company 9 Company 13
LIFE CYCLE OF A PRIVATE EQUITY FUND 18
PRIVATE EQUITY CAPITAL-RAISING TRENDS Global PE Capital Raised (by Fund Type) 800 600 400 200 0 93 207 349 538 666 681 318 299 352 405 547 555 2003 04 05 06 07 08 09 10 11 12 13 14 15 527 Total Value CAGR (10-15) 12% Notes: Includes funds with final close and represents year funds held their final close; distressed PE includes distressed debt, special situation and turnaround funds; other includes PIPE and hybrid funds Source: Bain and Company CAGR (14-15) -5% Other 18% 70% Mezzanine 21% 118% FoFunds 2% 14% Nat.Res 26% 44% Distressed 5% -5% Secondaries 11% -32% Growth -2% -30% Infrastruct. 1% -16% Venture 13% -2% Real Estate 17% -2% Buyout 16% -11% 19
ACQUISITION VALUATIONS CONTINUE TO CLIMB 12 10 8.9 9.6 8.8 10.3 10 10.3 11.3 12 10 8 6 3.9 4.1 3.7 3.9 4.3 4.5 5.8 8 6 4 2 5 5.5 5.1 6.3 5.7 5.8 5.5 4 2 0 2010 2011 2012 2013 2014 2015 2016 Debt/EBITDA Equity/EBITDA Valuation/EBITDA 0 20
US PRIVATE EQUITY AND VENTURE CAPITAL INDEX RETURNS Periods Ended June 30, 2016 USD Terms Percent (%) QTR YTD 1 YR 3 YR 5 YR 10 YR 15 YR 20 YR 25 YR CA US Private Equity 4.0 4.2 3.0 11.8 11.7 10.7 11.3 12.5 13.3 Nasdaq Constructed mpme -0.2-2.7-1.8 15.3 13.8 10.4 8.8 8.9 9.7 Russell 2000 mpme 3.8 2.2-6.9 8.1 9.1 7.5 8.0 8.1 8.7 S&P 500 mpme 2.5 3.8 3.8 12.3 12.6 8.3 7.3 7.7 8.2 CA US Venture Capital 0.7-2.6-1.4 18.1 13.2 10.2 5.3 26.1 25.8 Ex-US Developed Mkts Private Equity & Venture Capital Index 1.29 5.79 7.01 10.56 7.19 8.77 12.92 13.19 13.19 MSCI World Ex-US Index (net) -1.05-2.98-9.84 1.88 1.23 1.63 4.47 4.16 5.27 Sources: Cambridge Associates LLC, Frank Russell Company, Standard & Poor s, and Thompson Reuters Datastream 21
DISPERSION IN MANAGER RETURNS 920 bps 235 bps 22
PRIVATE EQUITY RISKS Limited liquidity The J-curve Returns can be highly dependent on entry point Lack of transparency Constant struggle to reach allocation target Timing: Opportunity vs. Process Sub-optimal investment selection Overhang of uninvested capital could lead to disappointing returns
Indicative Equity-Risk Premium (bps) INFRASTRUCTURE INVESTMENTS The Indicative Risk Premium and Timeline Varies by Project Phase 1,000 900 800 700 600 500 400 300 200 100 0 Development Construction Transition Operation Source: McKinsey Duration of Project Phases, Years 24
INFRASTRUCTURE RISKS Failure to complete a new project Extended delays and / or cost overruns Regulatory risk Political risk Deteriorating economics if government subsidies are withdrawn Environmental issues Displacement by a new technology Changes in commodity prices which limit a project s viability 25
Hedge Funds
HEDGE FUND STRATEGIES Directional Non-Directional Equity Long/Short Domestic International Emerging Markets Sector Specialists Dedicated Short Sellers Event Driven Distressed Merger Arbitrage Strategic/Activist Trade Claims Other Macro Option Volatility Trading Catastrophe Bonds Relative Value Fixed Income Arbitrage Capital Structure Arb Convertible Arbitrage Equity Market Neutral Pairs Trading Commodity Arbitrage
SHIFTING STRATEGY COMPOSITION 1990 2010 2015 37 10 14 30 26 28 26 39 20 24 19 27 Source: Hedge Fund Research 28
ANALYZING RISK AND RETURN A TWO DIMENSIONAL FRAMEWORK Hedge Fund Sub-Strategy Average Correlations to S&P 500 Index, Aug 2008 to Mar 2016 Aggregate 0.78 Managed Futures 0.01 Global Macro 0.43 Fixed Income Arb 0.58 Convert Arb 0.56 Event Driven 0.76 Market Neutral 0.60 Source: Morningstar Equity L/S 0.85 Source: CreditSuisse Dow Jones Hedge Fund Indexes
THE NON-QUANTIFIABLE RISKS Derivatives Integral Leverage Correlation to S&P Complexity Equity Strategies Equity hedge Low No Low Moderate Short selling Low No Low High neg Emerging markets Low No Low Moderate Event Driven Strategies Merger arb Moderate Yes Moderate Moderate Distressed secs Moderate No Low Moderate Event-driven Moderate No Low Moderate Relative Value Strategies Fixed income arb High Yes High Low Market neutral High No Moderate Moderate Convertible arb Moderate Yes Moderate Low Macro investing Moderate/High Yes Moderate Low
Implementation and Monitoring
BUILD OR BUY Non-Discretionary Consulting Relationship Discretionary Gatekeeper Fund of Funds Governance Capacity Required high moderate moderate Flexibility to customize moderate high high investment guidelines /low Access to superior partnerships moderate moderate/high high Diversification moderate moderate high Advisor accountability moderate high high Liquidity ability to terminate advisor moderate moderate low Fees and costs moderate high high
HIGH COST OF IMPLEMENTING AN ALTERNATIVE INVESTMENT PROGRAM Acquisition Fees Investment Management Base Fees 50 bps Real Estate Private Equity Hedge Funds 6% - 8% of net income or 50 to 75 bps on assets Due diligence costs Transaction fees 1.5% to 2% of committed capital 1% to 2% of assets Gatekeeper Fee n/a 0.75% to 1.4% 0.75% to 1.5% Incentive Fees (on profits) Hurdle rate Other Fees and Expenses 10% to 20% Typically payable only on profits above a hurdle rate Property/asset management fees Underlying manager: 20% Gatekeeper: 0% to 10% Profit distributions subject to clawback Underlying manager: 15% to 20% Gatekeeper: 0% to 10% Subject to highwater mark. Some subject to a hurdle rate. Myriad costs may or may not be passed through to the LPs. Read documents carefully
PERFORMANCE EVALUATION REQUIRES FLEXIBILITY Returns are presented as internal rates of return, and are not easily rolled up into total fund reporting which uses time-weighted returns Reporting is lagged, further complicating the reporting of total fund performance Benchmarks are ambiguous - there is no universally accepted market benchmark - you need to make sure you are comparing apples to apples - the universe of comparators is limited Many of the standard performance measures assume normal distributions of return
ALTERNATIVE INVESTMENT PERFORMANCE EVALUATION Many Alternative Investment Performance Measures which one to use? Private Equity (IRR) - Vintage year quartile rankings - MOIC Multiple of invested capital - PME public market equivalent Real Estate (IRR and TWR) - Cash on cash Hedge Funds (IRR) - Up-capture/down-capture - Max drawdown/drawdown duration - Sortino - Omega 35
ALTERNATIVE INVESTMENTS ARE YOU READY TO TAKE THE PLUNGE? 36