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Why Private Equity Secondaries Make Sense for Public Pension Funds National Conference on Public Employee Retirement Systems Why Private Equity 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 Venture Capital 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; management fee 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 initial public offering (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 “carried interest”, 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 Limited Partnership 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
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