National Conference on Public Employee Retirement Systems

Why Secondaries Make Sense for Public Pension Funds

Jennifer Mink Senior Consultant | Senior Partner Investment Performance Services, LLC National Conference on Public Employee Retirement Systems What is Private Equity?

Asset class in which money is invested in privately‐held companies to fund growth or new technologies, make acquisitions, or restructure inefficient companies.

2 National Conference on Public Employee Retirement Systems Types of Private Equity Investments Financing for early stage, emerging or start‐up companies (often in technology and healthcare sectors)

Buyouts Acquisition of all or part of a company from its current shareholders; primarily mature businesses Distressed Investments in the debt of companies undergoing financial distress (i.e. bankruptcy) to restructure/revive the company Debt

Special Investments in a variety of event‐driven corporate activities Situations –spinoffs, mergers, acquisitions

3 National Conference on Public Employee Retirement Systems Public vs. Private Equity Public Equity Private Equity Information Availability Public; easily-obtained Limited access to information Higher fees; management + performance Fees Lower fees; only fee structure Liquidity Daily Illiquid Valuations Daily Quarterly Transparency Publicly-available pricing Limited pricing transparency Widely available; securities selected Few benchmarks; most are not publicly Benchmarks from benchmark index available and may not be relevant

Leverage Limited/none Utilizes financial leverage Ability to improve value / implement Value Creation Limited control over value creation change Investment Focus Quarterly-earnings focus Long-term value creation Absolute, given lack of appropriate Relative; outperform benchmark index Return Goals/Potential benchmarks; seeks substantial over a market cycle outperformance over public equity Volatility Similar to benchmark Higher than US public equity

4 National Conference on Public Employee Retirement Systems Private Equity Characteristics

Capital Investors commit an amount to be invested, which is “called” by the private equity managers and Commitment invested over time

Drawdown A fully funded commitment can take several years

Distributions Distributions (committed capital and gains) are made when investments are realized (sold; IPO); often later in the life cycle of the Fund

5 National Conference on Public Employee Retirement Systems Private Equity Characteristics

Blind Pool of Investors commit to a private equity fund before Assets knowing the underlying portfolio companies

Vintage Year The first year in which a private equity fund calls capital and can be a key driver of performance

Illiquidity Once capital is committed, investors cannot access their money until distributions are made ‐Private equity lifecycles are often 10 years or more

6 National Conference on Public Employee Retirement Systems Typical Timeline for Private Equity Investment

Note: For illustrative purposes only. Courtesy of Neuberger Berman 7 National Conference on Public Employee Retirement Systems J‐Curve Effect

Drawdowns Distributions Cumulative Cash Flow

For illustrative purposes only. Not indicative of any particular investment. Source: http://blog.dealmarket.com/j‐curve‐analysis‐could‐impact‐pe‐industry/ 8 National Conference on Public Employee Retirement Systems Potential Benefits of Private Equity

Large Opportunity Set

Attractive Returns

Low Correlation

Operational Value Add

9 National Conference on Public Employee Retirement Systems Large Opportunity Set

U.S. Listed Companies vs. Private Equity-owned Companies

10,000

7,948 8,000 6,247

6,000

4,000

1,518 3,580 2,000

0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

U.S. Listed Companies Private Equity‐Owned Companies

Source: Public from University of Chicago Center for Research in Security Prices as of December 31, 2018. Private from PitchBook: “2018 Annual US PE Breakdown.” 10 National Conference on Public Employee Retirement Systems Attractive Historical Returns

20 Year 15 Year 10 Year 5 Year

20% 20% 20% 20%

15% 15% 13.9% 15% 15% 12.4% 12.8% 11.1% 9.3% 10% 10% 8.2% 10% 8.6% 10% 6.2%

5% 5% 5% 5%

0% 0% 0% 0% MSCI World Global PE Index MSCI World Global PE Index MSCI World Global PE Index MSCI World Global PE Index - Pooled - Pooled - Pooled - Pooled

Source: Represents the investment horizon for Global Private Equity Index from Thomson Reuters as of September 30, 2018, which is the latest data available. Past performance is not indicative of future results. Please refer to the Endnotes for definitions of indices. Provided courtesy of Neuberger Berman.

11 National Conference on Public Employee Retirement Systems Industry Expectations for Asset Class Returns 2012 2018 Difference Asset Class 10+ years 10+ years US Large Cap Equity 9.4% 6.1% ‐3.3% US Small/Mid Cap Equity 10.5% 6.6% ‐3.9% International (Developed) Equity 9.9% 6.7% ‐3.2% Emerging Markets Equity 12.6% 7.6% ‐5.0% Investment Grade Fixed Income (Core) 4.1% 3.4% ‐0.7% Future High Yield Bonds 7.4% 4.8% ‐2.6% expected returns Non‐US (Developed) Fixed Income 3.8% 2.2% ‐1.6% declined for all Non‐US Emerging Markets Fixed Income 7.2% 5.0% 2.2% asset Cash 2.8% 2.5% ‐0.3% classes! Real Estate 7.6% 5.9% ‐1.7% Hedge Funds 7.3% 4.9% ‐2.4% Infrastructure 8.3% 6.6% ‐1.7% Private Equity 12.9% 8.3% ‐4.6%

Source: Horizon Actuarial Study. Average assumptions of firms surveyed: 2012 includes 17 consulting firms; 2018 includes 34 consulting firms. National Conference on Public Employee Retirement Systems Operational Value Add Public Equity Private Equity

• Access to private • Only have public info information Buy Buy • Efficient market • Efficiencies result in valuation asymmetries

• Management alignment Hold • Limited to no ability to Hold • Focus on operational affect change improvements & enhance cash flows

• Multiple options for exit • No ability to “position” Sell company at sale Sell • Patient capital that can optimize exit timing

Source: Neuberger Berman. Note: For Illustrative purposes only. 13 National Conference on Public Employee Retirement Systems Implementation

Invest Directly in Private Equity Funds Invest in a Private Equity Fund‐of Funds

• Need to allocate to multiple private equity funds per year over a multi‐year period to build a diversified portfolio • Operational challenges ; requires significant • May offer broader diversification among managers and resources strategies –aims to deliver more consistent returns, less risk • Fees are charged at two levels

14 National Conference on Public Employee Retirement Systems Drawbacks of Private Equity

Because cash is invested at different points over time, Internal Rate of returns are calculated using the internal rate of return Return (IRR) –a measure of performance based on cash flows to and from the investor.

Underlying portfolio companies are typically exited via Exit an (IPO) or sale to another buyer. Market stress or a variety of economic factors could Strategy inhibit an exit.

15 National Conference on Public Employee Retirement Systems Drawbacks of Private Equity

Private equity investments usually seek to outperform Lack of public equities over a long period of time, and while Benchmarks there may be a few publicly‐available private equity benchmarks, they may not be truly representative of a particular private equity fund.

Much higher than public equity and generally include both an annual management fee and “”, an incentive fee representing the manager’s share of Fees the profits earned. Fees are also usually paid on committed, rather than invested, capital.

16 National Conference on Public Employee Retirement Systems Private Equity Allocation Options

Investment Type Description

Primary Fund structures formed to make investments in private Investment companies. Investor capital is called over time as the General Partner identifies investment opportunities within the stated mandate. (Direct Investments) Secondary Fund Limited Partnership structures formed to purchase interests in existing Private Investment Equity partnerships, often at a discount to the current Net Asset Value. Some Secondary Funds also participate in General Partner restructuring transactions.

Co-Investment Fund Investment funds structured to invest alongside General Partners of Primary Investment Funds in transaction where the General Partner needs additional capital to complete the transaction.

Fund-of-Funds Investment funds structured to allocate to underlying primary funds. Can also include allocations to secondary investments and co-investments.

17 National Conference on Public Employee Retirement Systems What is a Private Equity Secondary Investment?

Involves the purchase of an existing private equity fund interest from a limited partner (investor) that is seeking liquidity by selling their position to another investor

18 National Conference on Public Employee Retirement Systems A secondary investment involves the purchase of existing partneWhat is a Secondary Investment?rship interests in a private fund. Primary Fund Investment Secondary Investment In a primary fund investment, a fund investor In a secondary investment, an investor purchases an commits capital to a fund, typically before any interest in a fund in “mid‐life” from an existing investor for investments have been identified by the a negotiated price. The buyer now has exposure to the manager (“blind pool commitment”). existing portfolio of investments and is responsible for any remaining commitment to the fund.

“Blind pool” Seller Buyer Established portfolio Fund Fund Secondary Private Equity Fund investor Fund investor investor Any Company Company

commitment Private Equity Negotiated price remaining Fund commitment Company 1 Company 2   Company Company

Partnership Partnership interests Company 3 Company … interests Fund manager uses commitments Buyer has visibility into the to make investments in portfolio fund’s underlying companies over several years investments

19 Courtesy of GCM grosvenor National Conference on Public Employee Retirement Systems Private Equity Secondary Market Transaction Volume

Source: Preqin as of December 31, 2017. via Glouston Capital Partners 20 National Conference on Public Employee Retirement Systems Why do Private Equity Investors Sell their Holdings?

Need Liquidity Secondary market provides liquidity to investors in private equity, allowing them to sell Rebalance Portfolio private equity investments prior to the contractual maturity of those investments Seek New GP Relationships

Realize Gains

Manage Administrative Burden Need Liquidity Highly coveted funds may trade above NAV

21 National Conference on Public Employee Retirement Systems Who is Selling? BROAD SELLER MOTIVATIONS

Secondary Activity by Sellers Distressed Seller Regulatory Other Pressure 3% 100% 3% 4% 90% 80% 70% 60% 50% 40% GP 30% Liquidity Solution 20% Active 24% 10% Portfolio 0% Management 2015 2016 2017 66%

Public Pension / SWF General Partner Fund‐of‐Fund

Endowment & Foundation Corporate Pension Financial Institution

Other

Source: Greenhill & Co. as of December 31, 2017 Source: Private Capital Advisory as of December 31, 2017

Above charts provided by Glouston Capital Partners 22 National Conference on Public Employee Retirement Systems Evolving Secondary Market Landscape

% of GP led transactions continue to grow* Transactions by Year

9% 6% 7% 4%

13% 23% 24% 28%

78% 71% 69% 68%

2015 2016 2017 2018

LP Positions GPLiquidity Solutions Directs

* Source: Evercore Private Capital Advisory, 2015 Secondary Market Survey Results, January 2016; 2016 Secondary Market Survey Results, January 2017; 2017 Secondary Market Survey Results, January 2018; 2018 Secondary Market Survey Results, January 2019. Courtesy of GCM Grosvenor. 23 National Conference on Public Employee Retirement Systems GP Led Transactions Typically involve private equity funds that are approaching, or have exceeded, the end of the fund’s stated life but still have assets remaining in the fund.

The are often structured to provide liquidity to LPs while allowing the GPs additional time to maximize portfolio company values.

Tender offer for LP Interests: GP facilitates offers from one Examples: or more buyers for all or portion of fund’s LP interests

Fund Recap: Sale of all or significant portion of the fund’s assets into a new special purpose vehicle to me managed by the GP

24 National Conference on Public Employee Retirement Systems Who is Buying?

Source: Setter Capital Volume Report 25 National Conference on Public Employee Retirement Systems Why Do Investors Buy on the Secondary Market? Mitigated “J”‐curve

Due to the earlier distribution of capital back to investors from investing in more mature private equity funds, secondary investments are able to help mitigate the J-curve associated with primary fund investments.

Source: Hamilton Lane 26 National Conference on Public Employee Retirement Systems Why Do Investors Buy on the Secondary Market?

Secondary fund interests are often purchased at a substantial discount to Buying at a discount net asset value (NAV); although some can trade at NAV or even at a premium to NAV

Secondary market buyers are purchasing a fund in which the portfolio companies Known pool of assets are known and the risks of those companies can be evaluated before purchasing the interest

27 National Conference on Public Employee Retirement Systems Why Do Investors Buy on the Secondary Market?

Broader Diversification Investments can be made based on vintage year, strategy type, asset class, industry, geographic region

Vintage Year IRRs

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Upper Quartile 13% 16% 19% 17% 20% 19% 17% 20% 18% 14%

Median 8% 10% 14% 10% 13% 13% 11% 14% 8% ‐2%

Lower Quartile 4% 5% 9% 7% 8% 8% 7% 8% ‐4% ‐23%

Significant dispersion exists among vintage years and the top‐performing and bottom‐performing managers.

28 National Conference on Public Employee Retirement Systems Why Do Investors Buy on the Secondary Market?

A potentially more predictable outcome than a primary fund investment, though Predictability the potential for significant outsized returns may be reduced along with the generally lower risk

29 National Conference on Public Employee Retirement Systems Gross Internal Rate of Return

Primary Fund Secondary Fund 25% 25%

20% 20%

15% 15%

10% 10%

5% 5%

0% 0%

-5% -5%

-10% -10% Year Year Year Year Year Year Year Year Year Year Year Year 2 4 6 8 10 12 2 4 6 8 10 12

FN: Note: The J-curve illustrated above is for illustrative purposes only and does not represent the J-curve of any specific private equity fund. There is no guarantee that the return profile of primary investments will resemble the above graph or that they will deliver all, or any, of the above benefits. Actual performance may vary. Note, net returns will be lower. Courtesy of Neuberger Berman. 30 National Conference on Public Employee Retirement Systems Distributed to Paid‐In

Primary Fund Secondary Fund 2.5x 2.5x

2.0x 2.0x

1.5x 1.5x

1.0x 1.0x

0.5x 0.5x

Year Year Year Year Year Year Year Year Year Year Year Year 2 4 6 8 10 12 2 4 6 8 10 12

FN: Note: The J-curve illustrated above is for illustrative purposes only and does not represent the J-curve of any specific private equity fund. There is no guarantee that the return profile of primary investments will resemble the above graph or that they will deliver all, or any, of the above benefits. Actual performance may vary. Note, net returns will be lower. Courtesy of Neuberger Berman. 31 National Conference on Public Employee Retirement Systems Private Equity Secondary Considerations

Secondary market transaction volume has doubled in Crowded the last 5 years. Although deal supplies remain strong, Market finding attractive opportunities in a segment that could be increasingly crowded may present a challenge.$74

$58 Transaction volume has grown substantially $ billions $42 $40 $37 $28 $23 $25 $25

Source: Greenhill Cogent, Secondary Market Trends & Outlook, Ja2010 2011 2012 2013nuary 2019. “All Strategies” incl 2014 2015udes , venture, real est 2016 2017ate, mezzanine/distressed, fund‐ 2018 of‐funds and energy/infrastructure strategies. Courtesy of GCM Grosvenor. 32 National Conference on Public Employee Retirement Systems Private Equity Secondary Considerations

Increasing Following a decline from a 9% premium to NAV in 2006 to an average discount of 37% in 2009; Pricing competition for deals has driven the average discount to 5% in 2017.

Pricing has tightened, but still a “discount” market1 Average secondary pricing, % of NAV 100% 97% Buyout

90% 92% All Strategies

Smaller deals 83% Venture trade at larger 80% discounts 70%

60% 2010 2011 2012 2013 2014 2015 2016 2017 2018 Source: Greenhill Cogent, Secondary Market Trends & Outlook, January 2019. “All Strategies” includes buyout, venture, real estate, mezzanine/distressed, fund‐of‐funds and energy/infrastructure strategies. Courtesy of GCM Grosvenor. 33 National Conference on Public Employee Retirement Systems

Pricing Factors • Fund age Factors That Can Influence Fund PricingSecondary Market Pricing by Age1 • Underlying companies As a % of NAV, 2010 to August 2015 – Quality 100% – Volatility – Upside potential (carrying values) – Overall cash flow duration 95% • Manager 92.1% 92.1% – Quality/franchise risks 90.5% 90.5% 89.5% – Familiarity 90%

• Activity subsequent to reference date 86.2% – Valuation adjustments (IPOs, Exits, Public market movements) 85% 83.4% 82.2% – Cash activity 81.9% 81.6% – Pro‐forma discount/premium 80% • Visibility – Carrying values/exit assumptions

75% 6 7 8 9 10 11 12 13 14 15 1 Greenhill Cogent complete transactions since 2010. Excludes pricing points received more than six months after the transaction recordYears date. Years Years Years Years Years Years Years Years Years Source: Greenhill Cogent ‐ Secondary Sale Rationale, August 2015. Courtesy of GCM Grosvenor 34 National Conference on Public Employee Retirement Systems Private Equity Secondary Considerations

Older Secondary investments only provide Vintages exposure to previous vintage years not future vintages

Volatility in public equities has the potential to Public Markets increase the number of distressed sellers of Influence partnerships, which may be good for pricing…but also has the potential to reduce valuations of underlying portfolio companies

35 National Conference on Public Employee Retirement Systems Private Equity Secondary Considerations

Some secondary funds utilize leverage to potentially enhance reruns….however, this can Leverage increase the risk of the fund if investments do not perform as expected

36 Key Takeaways • Utilize managers whose primary business is private equity • Deep research teams • Access to a breadth of deals • Strong track records across vintage years

• Reduce risk by diversifying across funds, strategies, and vintage years

• Diversify portfolio allocation by utilizing primary and secondary investments;

• Cash flow needs should be analyzed before considering a commitment to private equity National Conference on Public Employee Retirement Systems

Questions?

Thank you! Jennifer Mink Senior Consultant | Senior Partner Investment Performance Services, LLC jmink@ips‐net.com

38 National Conference on Public Employee Retirement Systems Index Disclosure

Cambridge Associates Global Private Equity Index: Based on data compiled from 2,450 private equity funds, including fully liquidated partnerships, formed between 1993 and 2016. Internal rates of returns are net of fees, expenses and carried interest. CA research shows that most funds take at least six years to settle into their final quartile ranking, and previous to this settling they typically rank in 2‐3 other quartiles; therefore fund or benchmark performance metrics from more recent vintage years may be less meaningful. Benchmarks with “—” have an insufficient number of funds in the vintage year sample to produce a meaningful return.

39