An Introduction to Investing 2020

David B. Perkins, CAIA Thomas P. Riegert, CFA Overview of Private Equity

introduction

Private equity continues to play a significant role in portfolio management for larger investors. It is widely used by institutional and ultra-high net worth investors with a desire for enhanced returns and increased diversification. Limited historical data and a lack of widespread adoption of the investment strategy have led to an incomplete understanding about private equity in the broader marketplace. As the private equity industry evolves, we believe there will be more opportunities for a broader range of investors to participate in high quality private equity investments.

In this paper we will first go through a broad overview of private equity and private equity strategies, review the historical returns at a high level, take a deep look into how private equity managers make money, discuss the typical profile of private equity investors, talk about the various ways investors can access private equity, and look into the mechanics of private equity investing including fund structures, lifecycle and fees. We will explore some of the challenges of gaining and maintaining a private equity target allocation. Finally, we share the story of the Johnsons and how they turned IRR into ROR through a private equity program.

an introduction to private equity investing / hatteras investment partners 2 private equity defined

Ask 25 investment professionals to define private equity and In exchange for this illiquidity (often referred to as you will get pretty close to 25 different answers. Our working “liquidity risk”), private equity investments have the definition of private equity for the purposes of this paper is potential to earn significantly higher returns than publicly an equity-oriented investment in non-public securities made traded, liquid securities. This is frequently referred to through a negotiated private process. We should further as the “illiquidity premium.” clarify two critical points: Although the private equity industry is relatively new to the • First, the negotiated process is private, meaning the details broader investment community, its practice is hundreds of of the negotiations between the buyer and seller are not years old. Queen Isabella of Spain sold her jewelry to finance publicly disclosed. Christopher Columbus’s voyage across the Atlantic Ocean in • Second, most private equity transactions target return for whatever riches he could find in the New World.1 equity-oriented securities. The vast majority of private In June of 2008, a syndicate of investors, equity transactions involve companies that are not guided by Bain Capital Ventures, and publicly traded. Greylock Partners, led a $53 million equity investment in the business-related social networking site LinkedIn, resulting in Private equity funds make direct investments in companies a $1 billion valuation for the company.2 Following a May 2011 often referred to as portfolio companies. A typical private IPO, LinkedIn garnered a market capitalization of $10 billion.3 equity fund may invest in eight to 12 portfolio companies, Since performance metrics are private, we do not know how while some funds may invest in as many as 20 to 30, much Bain, Sequoia and Greylock earned on their investment throughout its life cycle. In some cases, the private equity in LinkedIn. However, it is reasonable to assume the results manager will only make two to three investments per year, were spectacular. While both preceding examples are extreme yet in others, the manager will make as many as eight to cases, the means and desired ends were the same: high-risk 10 investments each year. The pace of investment is driven investments in search of outsized returns. by a number of factors, including the manager’s investment philosophy, sub-strategy, and the general market environment at the time.

Typically, the private equity firm will hold investments for three to five years and exit opportunities via strategic sales, public markets, or restructuring. Thus, private equity transactions often require an investor’s capital to be “locked-up” for an extended period. As a result, private equity investments are often referred to as “illiquid,” or without a readily accessible market for buying and selling them.

1 Handbook of Alternative Investments, Second Edition; Anson, Mark J.P. 2006 2 Guynn, Jessica (June 17, 2008). “LinkedIn networks way to $53-million investment.” The Los Angeles Times. http://www.latimes.com/ business/ la-fi-linkedin18-2008jun18,0,6631759.story. Retrieved April 11, 2012 3 http://finance.yahoo.com/q?s=LNKD. Retrieved April 11, 2012.

an introduction to private equity investing / hatteras investment partners 3 Private Equity Strategies In practice, the term “private equity” generically refers to five distinct strategies for investing: 1) venture capital, 2) , 3) , 4) special situations, and 5) private debt. In some instances, private investments in real estate, infrastructure, energy, and natural resource assets are also generically considered to be part of the asset class.

For the purposes of this paper, we will focus on the five equity manager assumes a different role after the distinct strategies, referring to them henceforth as private investment is made, depending on the sub-strategy equity “sub-strategies.” Each sub-strategy offers different being pursued. risk-and-return characteristics. In addition, the private

private equity sub-strategies

Sub Strategy Risk and Return Parameters Role of the Private Equity Expected Duration Use of Different Securities Manager After Investment of Investment within the

Venture Capital (VC) Greatest Return Potential Very active; often VC investors Average hold is 5–7 years Equity-preferred or are former entrepreneurs and common stock High Risk senior level managers who work Tends to be long for early stage closely with the company on all companies, with multiple rounds elements of business formation of financing expected for most and expansion investments Minority ownership

Growth Capital High Returns Degree of involvement varies Average hold is 3–5 years Equity-preferred or by situation, impacted by common stock Moderate to High Risk involvement of other private equity investors and the sophistication of the company’s management Minority ownership

Buyouts High Returns Emphasis on financial Average hold is 3–5 years Equity-preferred or structuring, efficiency and common stock Moderate to High Risk motivating/retaining strong Potential for early return management teams of some capital via financing events Majority ownership

Special Situations High Returns Unusual and complex Average hold is 3–5 years Equity or debt transactions Moderate to High Risk Restructuring and repositioning Typically seek majority can happen within 1 to 2 years ownership leading to shorter holds

Private Debt Moderate Returns Little active management Average hold is 3–5 years High yielding debt, with upside potential from warrants Moderate Risk Emphasis on financing structure Some capital returned early from cash coupon payments Ease of use Minority ownership, if any

Source: Hatteras Investment Partners

an introduction to private equity investing / hatteras investment partners 4 1 Handbook of Alternative Investments, Second Edition; Anson, Mark J.P. 2006 ii Guynn, Jessica (June 17, 2008). “LinkedIn networks way to $53-million investment.” The Los Angeles Times. http://www.latimes.com/ business/ la-fi-linkedin18-2008jun18,0,6631759.story. Retrieved April 11, 2012 http://finance.yahoo.com/q?s=LNKD. Retrieved April 11, 2012 Weidig, Tom and Pierre-Yves Mathonet, The Risk Profiles of Private Equity: Private equity is a risky asset, but private equity investments are not necessarily so, January 2004

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