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Inside! The Privcap Liquid 100 p 13

NEW FRONTIERS IN CAPITAL FORMATION Is PE’s Future?/ 05 ‘Liquid Alternatives’: PE For The Masses/ 10 Tapping Defined Contribution Plans/ 23 The Story Behind The JOBS Act / 25

Privcap Special Report • Capital Formation | Q1 2014 / 1 On Privcap.c0m Videos in This Report

This special report includes the following new video On Camera programs. Watch them at Privcap.com Defined Contributions and IN THIS REPORT Transparency and liquidity are needed if private equity is to tap the IMAGE defined contribution opportunity, says Michael Riak of Pantheon WIDTH: 2.0887 IN Ventures. HEIGHT: 2.2907 IN DB to DC: Inevitable, and Soon The shift from defined benefit to defined contribution pension plans in the U.S. will be a rapid domino effect, with the first movers making the move within two to three years, George Pandaleon of Inland Institutional Capital Partners argues.

What’s a “Liquid Alternative”? Suzanne Donohoe, KKR A panel discussion with experts from Pantheon, KKR and Morgan Stanley on what a 40 Act Fund is, what’s driving the demand for liquid alternatives, and who’s buying them.

Big Challenge, Big Opportunity A panel discussion with experts from Pantheon, KKR, and Morgan Stanley on types of liquid alternatives, regulatory and technical challenges, and what the future holds.

COMING SOON on Privcap UPCOMING REPORTS KKR: LP Insights Suzanne Donohoe, who heads investor Q2 relations for KKR, describes the evolving needs of the firm’s institutional-investor Performance clients. Co-investment CFOs Navigate the Headwinds Scott Zimmerman of EY explains why pri- Energy vate equity firm CFOs are feeling bullish.

Privcap Special Report • Capital Formation | Q1 2014 / 2 On Privcap.com

In Case You Missed It... Must-see thought leadership from Privcap.com

ICYMI IMAGE WIDTH: 2.3933 IN HEIGHT: 1.3333 IN

Managing Music: KKR’s Investment How Bain Does Operating Partners Operating Rock Stars or Window in BMG Steven Barnes of describes Dressing? Philipp Freise of KKR shares details the evolution of the firm’s portfolio group, Kevin Kester of Siguler Guff describes his about its successful investment in which now has 70 operating executives approach to performing due diligence of a music-rights management business around the world. GP’s operational expertise. BMG.

Co-Investing: Selection Skills How PE Operating Partners Are The Realities of Raising Capital Are Paramount Paid, Hired Experts from Catalyst Investors, Blue Peter Cornelius of AlpInvest explains how How are private equity firms structuring Wolf Capital Partners and MVision talk the firm chooses its co-investment op- compensation for operating partners? A about what happens behind the scenes of portunities, and how those investments discussion with two executive search ex- a fundraising in 2014. have consistently outperformed the deals perts from Korn Ferry. it turned down.

About Privcap Special Reports Privcap Special Reports are exclusively for subscribers to Privcap, the definitive channel for thought leadership in private capital. Each month Privcap focuses on a critical theme and produces a “bundle” of thought leadership content in multiple formats—a digital report, video interviews and panel discussions, and audio programs. We capture the market intelligence of leading authorities, whose expertise forms the core of each report. Privcap Special Reports help market participants better understand opportunities and practices in private capital, as well as gain deep insights into the people with whom they may become long-term investment partners.

Privcap Special Report • Capital Formation | Q1 2014 / 3 PRIVCAP SPECIAL REPORTS

In This Issue 2 130 1 Commentary 4 05 Privcap CEO David Snow questions whether Berkshire Hathaway is the top model for PE.

DC’s Pension Evolution 07 U.S. pensions are making moves toward DC plans, and PE needs to be ready. By Ainslie Chandler.

Turning PE Liquid 10 A panel discussion on challenges of making PE a more 26 liquid asset class, and coming innovations. 25 23

The Privcap Liquid 100 13 A deep dive into the diverse business models of public and private entities inhabiting the PE space.

The Golden Ticket PRIVCAP SPECIAL REPORTS 20 Real estate PE managers look to woo investors with various investment models. By Christopher O’Dea. Privcap Media David Snow Co-founder and CEO Gill Torren Co-founder and President Public Sector: The Move To DC Matthew Malone Editorial Director 23 George Pandaleon of Inland Institutional Capital says Content DC plans could quickly gain favor in the public sector. Zoe Hughes Editor, PrivcapRE Ainslie Chandler Senior Journalist Fighting for JOBS Andrea Heisinger Associate Editor 25 Rep. David Schweikert tells how he helped shape the Kathleen O’Donnell Media Coordinator JOBS Act and how PE will be affected. Cameron Faulkner Media Coordinator Design From the Archives Cecilia Salama Design Coordinator 28 Related content from Privcap.com Contributors Christopher O’Dea From Our Sponsors Contacts 29 A look at impact capital in emerging markets, from our Editorial sponsors at EY. David Snow / [email protected] / 646.233.4558

Matthew Malone / [email protected] / 203.554.7261

Sponsorships & Sales Gill Torren / [email protected] / 646.233.4559

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Interviews in this report have been edited for length and clarity. Privcap Special Report • Capital Formation | Q1 2014 / 4 CAPITAL FORMATION / COMMENTARY Is Warren Buffett the Future? Why Berkshire Hathaway may be the ultimate model for big private equity firms

At a recent conference, TPG founder David Bonder- And yet, last year Berkshire Hathaway partnered man told an unsurprised audience that his firm with a Brazilian porn shop to sex up food gi- was “contemplating” going public, and added: “At ant . Buffett has taken pains to point out the end of the day, everybody will go public.” that while 3G Capital, the private equity firm led by Jorge Lemann, may eventually exit its stake in If Bonderman is right, what will the model for Heinz, Berkshire Hathaway is a forever owner of large private equity firms look like at the end of the company. the day? A lot like Berkshire Hathaway, the pub- licly traded investment behemoth whose value is The teaming of Berkshire’s balance sheet with 3G’s made up primarily by privately held companies. operational prowess offers an interesting view on the future of private equity, as well as highlights As the titans of private equity look for further the structural differences between the Berkshire growth, they are naturally moving toward the balance-sheet approach and the exit-driven private Market public markets, which offer access to permanent equity approach. Analysis by capital, huge pools of retail money and the pros- Privcap CEO pect of someday being free from the tyranny of Private equity’s history makes it difficult, but not fundraising and exits. impossible, to embrace a Buffett future. As Panthe- David Snow on Ventures’ Kevin Albert points out in a related Berkshire Hathaway as an alternative model for Privcap panel discussion, one must remember that private equity has been commented on before private equity should be defined by its core activi- by big-name GPs. In a 2009 BusinessWeek arti- ty, not by the mechanism used to accomplish that cle, Henry Kravis was quoted as saying that War- activity. The core activity of private equity is to in- ren Buffett “can make any kind of investment he vest in private companies and, hopefully, benefit as wants. . . and he never has to raise money.” Berk- the value of those companies grow. The process by shire Hathaway is “the perfect private equity mod- which that activity takes place has long been dom- el,” Kravis added. inated by limited partnerships, fundraising, capital calls, exits, distributions. But the mechanisms of The admiration is not mutual. For his part, Buf- the LP are certainly not the only way for investors fet regularly scoffs at private equity firms, and to participate in the growth of private companies. once described them as being analogous to “porn If you want to enjoy the growth of, say, the Burling- shops” that, ahem, buy paintings and “make the ton Northern Santa Fe railroad company, you may boobs a little bigger” and then sell them to “some simply buy shares in its owner, Berkshire Hatha- other guy. . . in a raincoat.” (Warren, that’s called a way. If you want liquidity, you don’t need to wait sponsor-to-sponsor transaction). for Buffett to sell Burlington and distribute your share of the proceeds. You only need to sell shares THE TEAMING OF BERKSHIRE’S BALANCE in Berkshire Hathaway. SHEET WITH 3G’S OPERATIONAL PROWESS The fact that Berkshire almost never sells assets is OFFERS AN INTERESTING FRAMEWORK its most important difference from a private equi- FOR THE FUTURE OF PRIVATE EQUITY. ty firm, which must eventually exit the collection “ Privcap“ Special Report • Capital Formation | Q1 2014 / 5 CAPITAL FORMATION / COMMENTARY

of portfolio companies it has acquired. The way an Although Buffett would disagree, private equity’s investor gets liquidity from a need to eventually exit isn’t necessarily a bad thing. is by waiting some 15 years to get all the principal If forces GPs to attempt to own companies during and profit back, or by entering into a complicated the “best years of their lives” and to work assidu- and time-consuming sale on the secondary mar- ously at improving the value during a defined pe- ket. Surely more and better options will be devel- riod of ownership. Each new fundraise forces a GP oped. team to prove its capabilities and allow investors to dig deeply into the track record and operations The growth of publicly-traded private equity will of the firm. have to be accompanied by greater systemization in the of private companies, including Blending the value-creation mandate and reg- daily valuations. As you will learn from the experts ular manager assessment of private equity with presented in this special report, market pioneers the permanent capital and liquidity of a Berk- are feverishly experimenting with new ways of shire Hathaway could be a winning combination cracking this toughest nut. The payoff for all this if structured correctly. Whatever Buffett, Lemann work will be better liquidity mechanisms, which and Kravis have in mind for the futures of their will in turn open a spigot of new capital for the as- respective firms, I’ll bet they’re all imagining re- set class. markably similar models./

Warren’s Forever Portfolio Estimated value of Berkshire Hathaway’s ownership stakes in public and private companies, in billions of dollars. The bulk of Berkshire Hathaway’s value comes from majority ownership stakes in companies like Burlington Northern Santa Fe, Heinz and MidAmerican Energy.

Wrigley, 6.8 Dow, 3 Bank of America, 10.9

Heinz, 12.3

GS & GE, 1.7

Burlington Santa Fe, 61.5 Other Stock, 15.2

Todd & Ted, 12

AmEx, 11.3

MidAmerican, 28.5 IBM, 13

Coca-Cola, 16 Marmon, 12.6

Iscar, 10 Wells Fargo, 19.1

Lubrizol, 10

Fixed Securities, 10.1 McLane, 3.9

Other Businesses, 19.6 , 35 Finance, 6.8

Sources: Berkshire Hathaway, Seeking Privcap Special Report • Capital Formation | Q1 2014 / 6 CAPITAL FORMATION / DEFINED BENEFIT PE’s Battle

for PensionInsider | November 2013 Dollars Defined contribution plans are rapidly replacing defined benefit plans as the U.S.In pension hybrid plans, the bene offit ischoice defined as an. account If private new to theequity 2013 Fortune 100. To control for annual balance (a lump sum) rather than an annuity. Benefits list turnover, we analyze the evolution of retirement wants to capitalize on thetypically transition, accrue more evenly itover must a worker’s career quickly offerings evolve. since 1998 among those companies in the (though hybrid designs can vary accruals by age, 2013 Fortune 100 (Figure 2). service or a combination of the two). When hybrid More sponsors of active DB plans joined the Fortune plan participants leave their employer, they may often By Ainslie Chandler 100 this year, replacing companies offering only a DC take their lump sum account balance with them plan to new salaried hires. All three companies new “ Among today’s Fortune 100, (either right away or at some point in the future). to this year’s Fortune 100 are DB plan sponsors. 93 companies offer only Hybrid plan participants have the option of converting hen Boeing’s unionized staff in Se- soon beginOnly to onefollow DB plan their sponsor corporate fell off the list;counterparts thus, list their account balances into life annuities, but most account-based retirement turnover resulted in a net gain of two open DB plans. attle approveddo not. Indeed, changes many traditional last DByear plans nowin offergreater numbers. plans to new salaried hires.” that wouldlump sum spell distributions an end at retirement, to their which are often Tracking the same Fortune 100 companies over time defined-benefitthe most popular pensionoption. plan, you For a host of(i.e., regulatory comparing Figure and 2 totechnical Figure 1) softens reasons, the arc the of the trend away from DB plans somewhat, with both In 1985, 89 Fortune 100 companies offered a could almost hear the murmurs rippling through private equitythe decline world in DBhas plans yet and to theattract rise in DC-onlymuch mon- traditional DB plan to newly hired salaried the private equity world. ey from theapproaches defined slightly contribution less pronounced. market. It’s an employees. Almost 30 years later, the pattern has completely flipped. Among today’s Fortune 100,enormous Ourmissed earlier analysesopportunity: found that a newrecent list members McKinsey Yet another major private93 companies employer offer only was account-based backing retirementstudy estimatedwere less that likely $4to havetrillion ever offered is currently a DB plan. invest For - away from the DB planplans system, to new salaried a major hires. source of ed in definedexample, contribution 29 of the companies plans. in today’sThat Fortune is expected the PE sector’s funding, and toward defined-con- to continue100 rising, offered perhaps only a DC plan at ato highernew hires rate,back in with a The evolution of today’s Fortune 100 1998, while 10 companies in the 1999 Fortune 100 tribution plans such asplans: 401(k)s. 1998 – 2013 2009 McKinseysponsored analysis only a DC showing plan. that the average American family faced a 37 percent shortfall in Some of the changes in the reported retirement This difference is mostly attributable to shifts in the Government employersofferings have arise been from slower annual turnoverto make in the Fortuneassets for retirement.sector makeup of the Fortune 100 over the last 20 to the switch to DC plans,100 butlist, rewithflecting many mergers, states spin-offs, in new or rapidly 30 years. For example, 30 years ago, most Fortune financial trouble andgrowing faced businesses, with huge and bankruptcies. unfunded Historically, The secular 100 shift companies toward were in ,DC plans, and that the sector huge seven to eight companies are new to the Fortune typically offered traditional pension plans to new pension liabilities, there is a feeling that they will amount of money involved, means one thing for 100 list in any given year, and three companies are salaried hires. Over time, however, these manufacturing

Figure 2a. Sponsorship trends for 2013 Fortune 100 companies, 1998 – 2013

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Today Total DB plans 71 71 71 70 70 69 67 64 57 50 46 42 41 35 32 30 Traditional plans 66 59 58 54 46 40 38 36 33 29 23 21 18 13 9 7 Hybrid plans 5 12 13 16 24 29 29 28 24 21 23 21 23 22 23 23 DC plan only 29 29 29 30 30 31 33 36 43 50 54 58 59 65 68 70

Figure 2b. Sponsorship trends for 2013 Fortune 100 companies, 1998 – 2013 80

70

60

50 Total DB plans Traditional plans 40 Hybrid plans 30 DC plan only

20

10

0 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Today

Note: Sponsorship shown as plan type offered to salaried new hires at year-end. In Figure 2a, the “Today” column reflects plan changes that took effect between January 1, 2013, and June 30, 2013. Trend data are shown for the 2013 Fortune 100 companies and capture changes to retirement plans since 1998. Privcap Special Report • Capital Formation | Q1 2014 / 7 Source: Towers Watson

2 towerswatson.com/research/insider CAPITAL FORMATION / DEFINED BENEFIT

private equity managers: figure out how to get Professional services firm Towers Watson’s sen- their hands on it, or risk their own future. ior retirement consultant Alan Glickstein says the pension shift is not a new trend, but accelerated as The Economic Imperative plan sponsors aimed to shift the responsibility and By 2013, Boeing was in a serious bind; at $68 billion, risk of retirement savings to individual employees. its pension liabilities exceeded the company’s $56 billion capitalization. Between 1998 and 2013, the number of companies featured on 2013’s Fortune 100 list offering tradi- The unionized workers fought the change-who tional or hybrid defined benefit plans to new hires wants to trade in a sure thing for a gamble?-but ca- fell from 71 to 30, Towers Watson reports. In the pitulated after the aeronautical giant threatened meantime, the number offering a defined contri- to move production of one of its products to a dif- bution plan rose from 29 to 70. ferent location. In early March 2014, Boeing Glickstein says the move away from private equity announced its non-union employees would also be would be slow, with 40-45-year time frames before shifted on to a DC plan. the now-frozen DB plans are actually closed.

Because Boeing will slowly whittle down its de- Not all of that shift is negative, Glickstein says. fined benefit liabilities as those under the old plan As labor mobility continues to increase, DC plans, retire and, ultimately, die, the impact on private which are portable, make more sense for many equity will be spread over several decades. That Americans. Such accounts are always accessible, makes it no less significant. According to a recent and investments and performance are more trans- article in Pensions & Investments, Boeing allocated parent. approximately $4 billion, or five percent, to private equity in 2013. Insider | NovemberGeorge 2013 Pandaleon, president at Inland Institution- al Capital Partners, said he thought the impact on Behind the Scenes PE could be felt much sooner, particularly as more state pensions moved to a DC or hybrid DC/DB plan. companies have been replaced by high-tech companies, Figure 3. Plan types offered by Fortune 100 companies today most of which never offered DB retirement plans. He points to cities like Detroit, which is under sig- nificant financial pressure, as potentially leading Back in 1998, 29 of 2013 Fortune 100 companies the way for other states to adopt DC plans. offered only a DC plan to new hires versus 70 of those ■ 6 Final average pay plan + DC plan Challenges—and Opportunities same companies today. Between year-end 2012 and ■ 1 Career average pay plan + DC plan Pantheon Ventures Global Head of Business De- June 2013, two more companies stopped offering DB ■ 22 Cash balance plan + DC plan velopment Kevin Albert recently told Privcap that, plans (one traditional DB plan and one hybrid plan) to ■ 1 Other hybrid plan + DC plan aside from figuring out how to tap the DC market, new salaried hires, opting for a DC-only approach ■ 70 DC plan only private equity is looking at a variety of markets to instead. Over the same period, one company converted fill the funding gap left by the decline of DB plans. its traditional DB plan formula to a hybrid formula. “We’re looking at listed markets, open-end mar- Of the 30 Fortune 100 companies that offer a DB Source: Towers Watson kets, defined contribution markets, and high net plan to new hires today, almost three-quarters of them Figure 4. Most recent change to retirement program since 1998 worth investors,” Albert says, noting that out of offer a cash balance plan, as shown in Figure 3. those, DC and high net worth individuals would be At 6%, final average pay plans — a traditional design their focus. — are the second most prevalent offering. ■ 21 Hybrid conversion ■ “Those categories of investors have very different Companies followed different paths to their current 18 Closed pension ■ 22 Froze pension needs and preferences. Some of them are legal or retirement programs. Figure 4 depicts the most regulatory needs for liquidity; some just prefer not ■ 1 Terminated pension recent plan action by current Fortune 100 companies to be locked up in something for 10 to 15 years.” ■ (Figures 2a and 2b serve as points of comparison). 29 Remained DC only ■ 9 No changes to DB pension He says the change would likely lead to significant When a DB plan is frozen, some or all benefits stop (7 traditional, 2 hybrid) innovation. accruing for some or all participants. For example, Source: Towers Watson the plan might stop accruing benefits linked to Pantheon’s Michael Riak says the PE sector faced service but continue those linked to pay. Benefits significant challenges in coming years, if it was might stop accruing for all participants younger than compared with 66 in 1998 (thus controlling for list “ Almost 10% of companies 50 or those with 15 or fewer years of service. turnover). Only 11 companies on the 1985 Fortune have made Privcapno changes Special to Report • Capital Formation | Q1 2014 / 8 100 list did not offer a traditional DB plan. After a pension plan has been closed, benefits their plans since 1998.” continue to accrue for participants but no one else So far in 2013, two companies have stopped offering can join the plan. Since 1998, 22 companies froze DB plans to new (salaried) hires, shifting to an their pension plans (six closed their plan to new hires all-DC retirement environment, while one company earlier and then froze accruals later), while 18 closed converted its traditional DB plan to a hybrid plan. them. One company terminated its plan, meaning that all benefits were frozen and then settled via These changes — both recent and over time — annuity purchases and/or lump sum payments. signal a large-scale redistribution of corporate Meanwhile, 21 other companies converted their resources for retirement. Employers are spreading traditional DB plan to a hybrid plan. Almost 10% of their retirement dollars more evenly across the companies have made no changes to their plans workforce, rather than concentrating benefits on since 1998. older and longer-tenured workers. Traditional DB plans offer employers greater control over workforce Conclusion retirement patterns. Account-based plans give employees more responsibility for retirement saving The shift away from traditional DB pension plans and planning, and retirement timing depends more continues, as companies adopt account-based DB heavily on economic and other factors than on the plans or move to a DC-only environment. Seventy of retirement timeline encouraged by the plan. today’s Fortune 100 companies provide only DC plans to new hires. Looking at the evolution of 2013 For comments or questions, contact Fortune 100 companies since 1998, only seven of Brendan McFarland at +1 703 258 7560, them offer a traditional DB plan to new hires today [email protected].

Towers Watson is a leading global professional services company that helps organizations improve performance through effective people, financial and risk management. With 14,000 associates around the world, we offer solutions in the areas of benefit programs, talent and reward programs, and risk and Copyright © 2012 Towers Watson. All rights reserved. capital management. towerswatson.com CAPITAL FORMATION / DEFINED BENEFIT

to secure significant defined contribution alloca- The last hurdle is getting DC investors comfortable tions. with a “new” form of investment.

The largest issue is liquidity. “People like to go on “Even plan sponsors we’ve spoken to who have and see how their balance is doing on a daily ba- been doing this for years still have to be educated sis,” Riak says. That requires daily valuation, a cost- on…this type of portfolio,” he says. ly, complicated-and, some would argue, irrele- vant-exercise for a private equity portfolio filled Such education is essential if average investors with investments held and nurtured over the long become more responsible for their own retire- term.” ment investing. Without access to the private eq- uity asset class, they could miss out on a signifi- Private equity also needs to grapple with issues re- cant source of long-term returns. lated to capital calls, Riak says. With the existing GP-LP structure, limited partners hand over mon- Says Riak: “Just a few basis points of alpha really ey when the general partner identifies an oppor- can make a difference.”/ tunity. With permanent capital from public mar- kets, GPs will be sitting on those piles of cash from the get-go, and will face increasing pressure to put money to work quickly , or risk hampering returns.

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Privcap Special Report • Capital Formation | Q1 2014 / 9 CAPITAL FORMATION / EXPERT PANEL

Click to watch this video at privcap.com Turning PE Liquid Transforming private equity into a more liquid asset class is a challenging task, say panelists from Pantheon, KKR, and Morgan Stanley. However, innovations and moves to address vehicle complexity are expected to help.

Kevin Albert Suzanne Donohoe Paul Weisenfeld Global Head of Business Development Global Head Director of Funds Pantheon Ventures Client and Partner Group - KKR Morgan Stanley Wealth Management

Albert is global head of business de- Donohoe is global head of KKR’s Client Weisenfeld is director of funds at Mor- velopment at Pantheon Ventures. He and Partner Group and a Risk Commit- gan Stanley Wealth Management. The worked at Lynch for 24 years as tee member. The former partner and former for Citi- managing director and global head of head of Asset Man- group’s Global Wealth Management in- the Private Equity Placement Group. agement International at the Goldman vestment products also served as COO Albert was managing director of Eleva- Sachs Group, where she was North for GWM Alternative Investments and tion Partners at the firm’s inception. He American head of client businesses and director of alternative investments at received a B.A. and an M.B.A. from the co-head of the EMEA business, holds a Smith Barney. Weisenfeld holds a B.S. University of California, Los Angeles. B.A. from Georgetown University and from Cornell University and a J.D. from an M.B.A. from the Wharton School. the Benjamin N. Cardozo School of Law.

Privcap Privcap We’re talking about a term we’re hearing Paul, can you talk about your program and more about recently—liquid alternatives. where liquid alternatives come in? All three of you approach this growing field from a different perspective. Kevin, can you Weisenfeld talk about what you’re working on? I’m responsible for the distribution of mutual funds and ETFs at Morgan Stanley. We make Albert available about 5,000 mutual funds and The decline of defined benefit plans is un- about 1,000 or 1,100 ETFs. One of the big- questionable in the corporate market and gest areas today is liquid alternatives. That’s looks to be starting to happen in the public public mutual funds and even ETFs. We eval- plan market globally. That has implications uate five to 10 different open-end mutual for private equity’s ability to fund itself going funds in the liquid alternative space at any forward and all of us are looking at different given time, and we talk to at least one asset markets: listed, open-end, defined contribu- manager every other day about liquid alter- tion, high-net worth investors. Those cate- natives. It’s a common topic. gories of investors have different needs and preferences. That’s going to give rise to an Albert amazing amount of innovation. Paul, when you use the term liquid alterna- Privcap Special Report • Capital Formation | Q1 2014 / 10 CAPITAL FORMATION / EXPERT PANEL tives, do you include private equity and brick tried to find a way to meet the liquidity pa- and mortar real estate? rameters of a 40 Act mutual fund.

Weisenfeld Weisenfeld Many of us are beholden to what Morning- There’s a disconnect between the product star would categorize as liquid alternatives. proliferation and demand. We’ve seen a tre- Even Morningstar would tell you it’s chang- mendous amount of flows into the long/ ing on a regular basis. fixed-income mutual fund space, which lends itself to daily liquid products. Privcap Paul, why are you getting more inquiries Privcap about liquid alternatives? Do people know We’re largely talking about 40 Act mutual what it means? funds. Suzanne, can you define that term and talk about, for KKR, what kinds of un- Weisenfeld derlying activities and assets are in the first More and more, advisors and clients batch of products created? understand what it is. At our firm, about two- thirds of our financial advisors are trained in Donohoe alternative investments. We have an interest When people refer to the 40 Act, they’re typ- in that space because, historically, the lion’s ically thinking of the 1940 Act rules, which share of our clients participating in alterna- effectively created a registration framework tives did so with private products. The num- for the sale of products to all types of inves- ber of liquid alternatives has increased in the tors. There are some structural limitations last several years and so has the flow into the on what’s permitted as the underlier in a 40 space. Act format.

Privcap Weisenfeld Is it the liquidity driving demand, or the fea- We’ve seen those products for some time. tures of the underlying asset class that the What it will take to make those strategies advisors see as being beneficial to the portfo- successful is for someone to prove there is an lios of their clients? illiquidity premium in returns.

Weisenfeld Albert Both apply. The appeal of liquid alternatives The question is whether there’s inherent- is you have to plan less, and you’re more flex- ly a premium for liquidity, or is there only ible. There’s no question the greater avail- a premium for being a patient investor and ability of daily liquid mutual funds has also staying while the magic is happening at the driven demand. From an advisor’s perspec- company level? tive, there’s a big difference. Weisenfeld It’s a great question. If I were a portfolio Privcap manager and didn’t have to worry about be- Suzanne, it sounds like there’s a need for ing liquid every day, I’d be more patient as innovation given the changing appetites of an investor. There’s clearly an opportunity investors who haven’t participated in invest- for an illiquidity premium, and one of our ment classes like this. Is that what’s driving challenges is educating financial advisors the change? and clients about what it is.

Donohoe Privcap At the core, what’s driving this change is the Liquid alternatives take underlying assets low-rate environment we’re operating in, that haven’t traditionally been made avail- and a sense that’s not going to persist for- able to certain investors and make them ever. People need more return to provide for available. Paul, what are the challenges in their retirement. On the demand side, peo- taking illiquid investment classes like pri- ple have gotten more open minded about the vate equity and putting them in a liquid for- sources of return for their portfolios. On the mat? supply side, you have more managers who’ve Privcap Special Report • Capital Formation | Q1 2014 / 11 CAPITAL FORMATION/ EXPERT PANEL

Weisenfeld Privcap What makes people anxious is a mismatch Haven’t variations of these types of products between liquidity of the underlying invest- been tried in prior cycles? ments and the vehicle itself. If clients are requesting that their money come back and Weisenfeld the fund sponsor can’t deliver, there are We’ve seen a variety of products. Seven, problems. There are regulatory requirements eight, nine years ago, we saw a number of on how much can be liquid, but an investor 130-30 funds [go long 130 percent, short up doesn’t want to risk not getting their money to 30 percent]. That was an area we heard a back. lot about for 18 months, and it never gath- ered a tremendous amount of assets. Privcap Kevin, why is there not yet a private equity Privcap mutual fund? There was a demand problem?

Albert Donohoe They’re illiquid investments that haven’t A lot of it had to do with the environment. been valued on a frequent basis, so there’s no The 130-30 products were coming at a time fair value to enable them to change hands. when the equity market was running hard The innovation that will allow more liquid- and people had the choice between hedged ity in private equity for the investor is more equity exposure or full exposure. It was more frequent daily valuations. Algorithms have complexity than they had appetite for. been developed, extensively tested, proven to be accurate, and applied to existing portfoli- Weisenfeld os. It will require working with regulators to Investment performance was a big issue. relieve some restrictions on the use of mu- If you can’t deliver what clients want, they tual fund vehicles to deliver private equity to won’t buy it. The shift toward defined-con- individuals. It all comes back to the ability to tribution plans having daily liquidity is the create a daily fair value. appeal.

Weisenfeld Donohoe It’s one thing to make a product available There will be innovation as managers figure that can create liquidity, and an institution- out ways to diversify. It will be most success- al or sophisticated investor can understand ful for managers who can bring their high- its complexity. The challenge of the 40 Act est-octane strategy and not have to change structure is that it’s available to all investors, it much to deliver a return for clients. and it’s important they understand the vehi- cle’s complexity. Albert Five or 10 years ago, managers could raise all Privcap of their capital in the traditional market and Kevin, can you give more detail about how weren’t looking at alternatives. Valuation daily liquidity would be achieved, who would technology, and being able to strike accurate provide that, and what the hurdles are? daily valuations, is going to make a differ- ence in the ability to do this in a high-quality Albert way./ Through the use of the PE secondary market, it’s possible to create a liquid vehicle that can be traded daily on the New York Stock Ex- change at or above net asset value. Many of these vehicles have been tried in Europe, but they tend to not be structured with good gov- ernance or pay a dividend, which has been a successful indicator of a closed-end fund ve- hicle trading at a premium in the U.S. That’s going to be the daily liquidity.

Privcap Special Report • Capital Formation | Q1 2014 / 12 Private Equity, Public Markets How does private equity tap the ever-evolving pool of potential investors, particularly those new to the asset class? Through innovation. Here, Privcap examines one popular approach: ‘liquid’ private equity, and catalogs the 100 biggest players in the game.

Privcap Special Report • Capital Formation | Q1 2014 / 13 CAPITAL FORMATION / DATA Accessing “Alternative” Private Equity

n recent years, the options for finding “al- The GFC interrupted the plans of other PE firms, ternative” ways to access private equity have including megafirms Carlyle and KKR, which were multiplied rapidly. Of this ever-expanding contemplating taking their management compa- universe, Privcap has examined a set of more nies public. After Blackstone’s share price initially than 150 publicly-traded and other nontraditional spluttered from its $31-per-share IPO price to the private equity entities, with more than US$300 bil- mid-single digits in early 2009, both GPs and LPs lion of aggregate market capitalization. From this were wary of the financial and strategic merits of data, we have created a league table of the Top 100 publicly-listed management companies. Publicly-Listed PE Vehicles by Market Capitaliza- tion, starting on page 16. Current Day As the public markets inched, and then sped, their From this data set, we also highlight some interest- way to recover from the late 2000s to the present ing trends and delve further into five examples of day, we have witnessed a growing group of U.S.-list- enterprising private equity firms that are utilizing ed PE management companies, plus a revival of these alternative structures. BDCs. KKR’s public listing in 2011 marked the quiet reemergence of management company IPOs. More Historical Recap recently, the IPOs of the Carlyle and Apollo man- Prior to the 2000s, the nontraditional private equi- agement companies were met with greater pub- ty diaspora was dominated by publicly-listed con- lic market enthusiasm and greater LP acceptance glomerates and European institutions, including of the shifting tides—and return expectations—for Safeguard Scientifics in the U.S. and the U.K.-head- mega- firms in a low-interest-rate environ- quartered Group and Intermediate Capital. From ment. the end of the 1990s to the early 2000s, we also saw the pioneers of business development companies In this yield-scarce environment, LPs have been in- such as American Capital, Gladstone Capital, and creasingly accepting of traditional PE shops apply- MVC Capital begin their rise in the U.S. ing their equity investment prowess to credit se- lection. As a direct consequence, BDCs have once Shift to the mid-2000s, and the industry was met again risen in popularity. Notable examples include with the first major wave of BDCs, as well as the Carlyle GMS Finance, New Mountain Finance Cor- pioneers of U.S.-listed PE management compa- poration (managed by Steven Klinsky’s firm), Garri- nies. The credit market bubble preceding The Great son Capital, and TCP Capital Corporation (managed Recession spurred more traditional private equi- by credit/special situations investor Tennenbaum ty firms to find ways to participate in capturing Capital Partners). the upside of a frothy credit market. Established and emerging PE shops such as Apollo, Kelso & Private equity firms have also pursued a broader Company (jointly with BlackRock), Ares, and KKR base of investors by creating fund vehicles that are launched BDCs and other publicly-listed fund vehi- open to noninstitutional investors, with a big-pic- cles. Blackstone and Fortress’ management compa- ture aspiration of accessing the 401(k) market. Ex- ny IPOs were closely watched by competitors and amples include the CPG (“Central Park Group”) LPs alike to see how the public markets perceived Carlyle Private Equity Fund, as well as Panthe- the PE business model, as well as what the impact on Ventures’ target-date fund program, which are of a public listing would be on GP-LP alignment of both reportedly still attempting to raise capital; interest. Swiss fund-of-funds Partners Group also Blackstone and Partners Group are also said to be ventured forth with the IPO of its management developing mutual funds and 401(k)-friendly of- company in 2006, soon followed by the listings of ferings. However, the process has proven challeng- its permanent capital vehicles Princess Private Eq- ing, with KKR closing down its efforts to raise two uity Holding and Partners Group Global Opportu- funds for individual investors in February of this nities. year./

Privcap Special Report • Capital Formation | Q1 2014 / 14 CAPITAL FORMATION / DATA

Public Vehicle Snapshots: Business Development Companies A comparison of three notable business development companies shows how terms have progressed toward investors’ favor in recent years.

Fund Name Solar Capital New Mountain Finance Corporation TCP Capital Corporation Fund Structure Business development company Business development company Business development company Publicly Listed? Yes; NASDAQ: SLRC Yes; NYSE: NMFC Yes; NASDAQ: TCPC Status IPO on Feb. 9, 2010 IPO on May 25, 2011 IPO on April 4, 2012 Market Cap Approx. $970 million Approx. $650 million Approx. $530 million IPO Share Price $18.50 $13.75 $14.75

Current Share Price $22.00 $15.01 $17.59 (2/14/2014) Dividend Yield 7.27% 9.06% 8.19% Term Perpetual Perpetual Perpetual Fund Strategy Invests in leveraged middle-market • to U.S. middle-market businesses with •Debt of U.S. private middle-market companies in the form of: $20 million– $200 million of EBITDA companies with enterprise values of $100 •Senior secured loans •Unlevered yields of 10-15% million to $1.5 billion •Mezzanine loans •5-10-year maturities •$10 million to $35 million investment size •Equity securities •$10 million to $50 million investment size Strategy: •Credit •Non-control equity •Value Fund Economics •Annual : 2.0% of gross •Annual management fee: 1.75% of gross assets •Annual management fee: 1.5% of total assets (including borrowings less cash) (less borrowings and cash) assets (including borrowings less cash) •Incentive fee: •Incentive fee: •Incentive fee: -20.0% of pre-incentive fee net investment -20.0% of pre-incentive fee net investment -20.0% of ordinary income income income, subject to hurdle and catch-up -20.0% of realized capital gains -20.0% of realized capital gains -20.0% of realized capital gains •Hurdle rate: •Hurdle rate: •Hurdle rate: -8.0% annualized -7.0% annualized -10.0% annualized (but not compounded) •Other annual expenses: •Other annual expenses: •Other annual expenses: -Approx. 0.86% interest expenses -Approx. 1.8% interest expenses -Approx. 1.0% interest expenses -Approx. 0.60% “other expenses” -Approx. 1.0% “other expenses” -Approx. 1.0% “other expenses”

Public Vehicle Snapshots: CPG Carlyle and HarbourVest have taken two divergent strategies for making funds-of-funds accessible to more investors.

Fund Name CPG Carlyle Private Equity Fund, LLC HarbourVest Global Private Equity Limited TCP Capital Corporation Fund Structure 1940 Act investment company; closed-end Guernsey-incorporated company management investment company Business development company

Publicly Listed? No AMS: HVPE Yes; NASDAQ: TCPC IPO on April 4, 2012 Status Raising IPO on Dec. 6, 2007; active Approx. $530 million Market Cap N/A Approx. $828 million $14.75 IPO Share Price N/A $10.00 $17.59 Current Share Price N/A $10.20 (2/14/2014) 8.19% Dividend Yield N/A N/A Perpetual Term Perpetual Perpetual •Debt of U.S. private middle-market Fund Strategy •>80% of assets to be invested in multiple •Majority of investments made in HarbourVest- companies with enterprise values of $100 Carlyle-managed investment funds: managed private equity funds of funds; underlying million to $1.5 billion -Primaries (20.0-90.0%) investments include: -Secondaries (10.0-60.0%) -Primaries (46.0% actual) •$10 million to $35 million investment size -Co-invests (0.0-20.0%) -Secondaries (40.0% actual) •Diversification -Directs (14.0% actual) -Geography -

Fund Economics •Annual management fee: 1.20% of NAV •Fees charged by HarbourVest on underlying invest- ments: •Annual management fee: 1.5% of total •Annual placement agent fee: 0.60% of NAV assets (including borrowings less cash) -Annual management fee: •Acqquired fund fees and expenses: approx. 1.33% •Incentive fee: annually (based on 1.0-1.75% annual manage- Primaries: 0.85% Secondaries: 0.85–1.15% -20% of ordinary income ment fees and 20.0% carry charged by underly- -20% of realized capital gains ing fund investments) Directs: 0.85–2.25% •Hurdle rate: •Other annual expenses: approx. 0.55% -Performance fee: Primaries: 0% -8% annualized Secondaries: 10.0–12.5% •Other annual expenses: Directs: 10..0–20.0% -Approx. 0.86% interest expenses •No incremental fees to HarbourVest except for -Approx. 0.6% “other expenses” Parallel Investments that co-invest alongside Harbour- Vest’s FoF vehicles Privcap Special Report • Capital Formation | Q1 2014 / 15 10

CAPITAL FORMATION / DATA

The Privcap The biggest listed private equity Liquid 100 vehicles, by market capitalization. Rank Firm/Fund Symbol Market Cap Current Country Category USD Bn* Yield** 1 Brookfield Asset Management Inc. BAM.A 24.2 1.6% Canada PE fund manager 2 Blackstone Group LP, The BX 17.9 4.2% USA PE fund manager 3 Leucadia National Corp. LUK 10.3 0.9% USA Direct PE 4 Fosun International Ltd. 656 7.3 1.9% China Direct PE 5 KKR & Co. KKR 6.9 5.8% US PE fund manager 6 Wendel SA MF 6.7 1.7% France Direct PE 7 Imperial Innovations Group PLC IVO 6.6 0.0% UK Direct PE 8 3i Group PLC III 6.4 2.0% UK PE fund manager 9 Partners Group Holding AG PGHN 6.4 2.8% Switzerland PE fund of funds 10 Onex Corp. OCX 6.0 0.1% Canada PE fund manager 11 Melrose Industries PLC MRO 5.5 0.0% UK Direct PE 12 IAC/InterActiveCorp. IACI 5.5 1.5% USA Direct PE 13 Ares Capital Corp. ARCC 5.4 8.3% USA Direct private mezzanine 14 Eurazeo SA RF 5.1 2.1% France Direct PE 15 LLC APO 4.6 1.9% USA PE fund manager 16 American Capital Ltd. ACAS 4.4 0.0% USA Direct private mezzanine 17 Fortress Investment Group LLC FIG 4.0 3.0% USA PE fund manager 18 Ackermans & van Haaren NV ACKB 3.7 1.5% Belgium Direct PE 19 Prospect Capital Corp. PSEC 3.5 11.8% USA Direct private mezzanine 20 Ratos AB B RATO B 3.1 4.8% Sweden Direct PE 21 Intermediate Capital Group ICP 2.9 4.7% UK PE fund manager 22 KKR Financial Holdings LLC KFN 2.5 7.3% USA Direct PE 23 AP Alternative Assets LP AAA 2.4 0.0% Netherlands PE fund of funds 24 Jafco Co Ltd. 8595 2.4 0.5% Direct PE 25 Brait SE BAT 2.3 0.0% South Africa PE fund manager 26 Apollo Investment Corp. AINV 2.0 9.1% USA Direct private mezzanine 27 3i Infrastructure PLC 3IN 2.0 5.1% UK Direct PE 28 Carlyle Group LP/The CG 1.8 1.8% USA PE fund manager 29 SVG Capital PLC SVI 1.7 0.0% UK PE fund of funds 30 Electra PLC ELTA 1.4 0.0% UK PE fund manager 31 Main Street Capital Corp. MAIN 1.4 5.8% USA Direct private mezzanine 32 Fifth Street Finance Corp. FSC 1.3 10.5% USA Direct private mezzanine 33 Aurelius AG AR4 1.3 4.7% Germany Direct PE 34 IP Group PLC IPO 1.2 0.0% UK Direct PE 35 GIMV NV GIMB 1.2 5.0% Belgium PE fund of funds 36 Aberdeen Development Capital PLC AVC 1.2 0.0% UK Direct PE

Privcap Special Report • Capital Formation | Q1 2014 / 16 CAPITAL FORMATION / DATA The Privcap Liquid 100 HIGHLIGHTS

Top 5 Management Companies Rank Constituent Market Cap USD Bn* Country 1 Brookfield Asset Management Inc. 24.2 Canada 2 Blackstone Group LP, The 17.9 USA 3 KKR & Co. 6.9 US 4 3i Group PLC 6.4 UK 5 Onex Corp. 6.0 Canada

Top 5 Fund of Funds Rank Constituent Market Cap USD Bn* Country 1 Partners Group Holding AG 6.4 Switzerland 2 AP Alternative Assets LP 2.4 Netherlands 3 SVG Capital PLC 1.7 UK 4 GIMV NV 1.2 Belgium 5 Pantheon International Participations PLC 1.2 UK

Top 5 Business Development Corporations Rank Constituent Market Cap USD Bn* Country 1 Ares Capital Corp. 5.4 USA 2 American Capital Ltd. 4.4 USA 3 Prospect Capital Corp. 3.5 USA 4 Apollo Investment Corp. 2.0 USA 5 Main Street Capital Corp. 1.4 USA

Top 5, By Dividend Yield Rank Constituent Current Yield** Country 1 Castle Private Equity AG 16.7 Switzerland 2 k1 Ventures Ltd. 16.7 3 KCAP Financial, Inc. 12.5 USA 4 Prospect Capital Corp. 11.8 USA 5 TICC Capital Corp. 11.3 USA

Privcap Special Report • Capital Formation | Q1 2014 / 17 CAPITAL FORMATION / DATA The Privcap Liquid 100

Rank Firm/Fund Symbol Market Cap Current Country Category USD Bn* Yield** 37 Pantheon International PIN 1.2 0.0% UK PE fund of funds Participations PLC 38 Schouw & Co. SCHO 1.1 2.1% Denmark Direct PE 39 Hercules Technology Growth HTGC 1.0 7.7% USA Direct private Inc. 40 Solar Capital Ltd. SLRC 1.0 7.3% USA Direct private mezzanine 41 Compass Diversified Holdings CODI 0.9 8.1% USA Direct PE 42 HarbourVest Global Private HVPE 0.8 0.0% Netherlands PE fund of funds Equity Ltd. 43 Golub Capital BDC Inc. GBDC 0.8 6.9% USA Direct private mezzanine 44 Triangle Capital Corp. TCAP 0.8 7.7% USA Direct private mezzanine 45 ICG Group Inc. ICGE 0.8 0.0% USA Direct PE 46 PennantPark Investment PNNT 0.8 9.9% USA Direct private mezzanine Corp. 47 HBM Healthcare Investments AG HBMN 0.7 1.5% Switzerland Direct PE 48 Alaris Royalty Corp. AD 0.7 5.2% Canada Direct PE 49 BlackRock Kelso Capital Corp. BKCC 0.7 11.1% USA Direct private mezzanine 50 Graphite Enterprise Trust PLC GPE 0.7 0.9% UK PE fund of funds 51 HgCapital Trust PLC/Fund HGT 0.7 2.1% UK Direct PE 52 New Mountain Finance Corp. NMFC 0.7 9.2% USA Direct private mezzanine 53 Medley Capital Corp. MCC 0.6 10.6% USA Direct private mezzanine 54 VinaCapital Vietnam Opportunity VOF 0.6 0.0% Vietnam Direct PE Fund Ltd. 55 PICO Holdings Inc. PICO 0.6 0.0% USA Direct PE 56 TICC Capital Corp. TICC 0.5 11.3% USA Direct private mezzanine 57 Altamir LTA 0.5 3.8% France Direct PE 58 TCP Capital Corp. TCPC 0.5 8.4% USA Direct private mezzanine 59 Standard Life European Private SEP 0.5 2.5% UK PE fund of funds Equity Trust PLC 60 THL Credit Inc. TCRD 0.5 8.8% USA Direct private mezzanine 61 Capital Southwest Corp. CSWC 0.5 0.6% USA Direct PE 62 NB Private Equity Partners Ltd. NBPE 0.5 4.2% Netherlands PE fund of funds 63 Castle Private Equity AG CPEN 0.5 16.7% Switzerland PE fund of funds 64 JZ Capital Partners Ltd. JZCP 0.5 9.0% UK Direct private mezzanine 65 DeA Capital S.p.A. DEA 0.5 0.0% Italy Direct PE 66 Safeguard Scientifics Inc. SFE 0.4 0.0% USA Direct PE 67 Better Capital PCC Ltd. BCAP 0.4 0.0% UK Direct PE 68 Symphony International Holdings Ltd. SIHL 0.4 0.0% UK Direct PE 69 Oakley Capital Investments Ltd. OCL 0.4 0.0% UK PE fund of funds

Privcap Special Report • Capital Formation | Q1 2014 / 18 CAPITAL FORMATION / DATA The Privcap Liquid 100

Rank Firm/Fund Symbol Market Cap Current Country Category USD Bn* Yield** 70 Bure Equity AB BURE 0.3 1.8% Sweden Direct PE 71 MVC Capital Inc. MVC 0.3 3.8% USA Direct PE 72 MCG Capital Corp. MCGC 0.3 11.2% USA Direct private mezzanine 73 k1 Ventures Ltd. K01 0.3 16.7% Singapore Direct PE 74 Kayne Anderson Energy KED 0.3 6.9% USA Direct private mezzanine Development Co. 75 East Capital Explorer AB ECEX 0.3 0.0% Sweden PE fund of funds 76 GP Investments Ltd. GPIV33 0.3 0.0% Brazil Direct PE 77 Fidus Investment Corp. FDUS 0.3 7.5% USA Direct private mezzanine 78 KCAP Financial, Inc. KCAP 0.3 12.5% USA Direct private mezzanine 79 F&C Private Equity Trust PLC FPEO 0.2 5.5% UK PE fund of funds 80 GSV Capital Corp. GSVC 0.2 0.0% USA Direct PE

81 Garrison Capital Inc. GARS 0.2 9.7% USA Direct private mezzanine 82 LMS Capital PLC LMS 0.2 0.0% UK Direct private equity 83 Aberdeen Private Equity Fund Ltd. APEF 0.2 0.0% UK Private equity fund of funds 84 Firsthand Technology Value Fund Inc. SVVC 0.2 0.0% USA Direct private equity 85 PennantPark Floating Rate Capital Ltd. PFLT 0.2 7.7% USA Direct private mezzanine 86 Solar Senior Capital Ltd. SUNS 0.2 7.8% USA Direct private mezzanine 87 Gladstone Investment Corp. GAIN 0.2 9.2% USA Direct private mezzanine 88 Gladstone Capital Corp. GLAD 0.2 8.6% USA Direct private mezzanine 89 J.P. Morgan Private Equity Ltd. JPEL 0.2 0.0% UK Private equity fund of funds 90 Private Equity Holding AG PEHN 0.2 3.8% Switzerland Private equity fund of funds 91 China Merchants China Direct Invest- 133 0.2 3.8% Hongkong Direct private equity ments Ltd. 92 Allied Capital Corp. AFC 0.2 7.1% USA Direct private mezzanine 93 CapMan PLC CPMBV 0.2 3.6% Finland Private equity fund manager 94 PLC CDI 0.2 0.0% UK Direct private equity 95 Dinamia Capital Privado SCR SA DIN 0.2 0.0% Spain Direct private equity 96 Unternehmens Invest AG UIV 0.2 1.5% Austria Direct private equity 97 NGP Capital Resources Co. NGPC 0.2 8.5% USA Direct private mezzanine 98 Dunedin Enterprise Investment Trust DNE 0.1 1.6% UK Direct private equity PLC 99 Scandinavian Private Equity A/S SPEAS 0.1 0.0% Denmark Private equity fund of funds 100 Henderson Diversified Income Ltd HDIV 0.1 1.3% UK Direct private mezzanine

About The Privcap Liquid 100 Privcap compiled the publicly-listed entities included in the S&P Listed PE Index, the RedRocks GLPE Index, the LPEQ members, and the LPX. Top 100 list based on largest market cap as of Feb. 13, 2014. Source: Google Finance, Morningstar, Bloomberg, Reuters, company websites, as of Feb. 13, 2014, and converted to USD as of the same date

Privcap Special Report • Capital Formation | Q1 2014 / 19 CAPITAL FORMATION / REAL ESTATE

The Golden Ticket Real estate private equity managers are experimenting and innovating with investment models in order to capture the attention – and cash – of retail investors. By Christopher O’Dea

After all, strong retail demand for real estate in 2013 pushed inflows to non-traded equity real estate Investment Trusts to a record level of $18.7 billion, double the amount raised in 2012. But non-traded REITS primarily tap retail assets through independent broker-dealers, a limited channel where high sales commissions and limited liquid- ity for investors’ holdings pose obstacles to reach- ing a broader retail market.

Most retail assets are held in accounts that are part of defined-contribution (DC) retirement plans. The opportunity is compelling. Assets in DC plans topped $5.1 trillion at the end of 2012, according to the Investment Company Institute, the trade group for mutual-fund companies. More than half – $2.9 trillion – was allocated to mutual funds, and real estate managers will have to find some way to provide investors with access to their expertise through this mainstream – and much more highly regulated – vehicle.

For the past 30 years, private commercial real estate managers have “thrived,” managing assets from public plans and insurance companies, says George Pandaleon, president of Inland Institutional Capital Partners. Pandaleon believes eal estate private equity managers are defined-contribution assets are likely to grow often innovative, supplying private substantially in the coming years and predicts capital in often-unique structures that that a switch from defined benefit to defined get deals done and buildings built. But contribution in the public sector could occur the next few years may present challenges that much sooner – and faster – than many real estate test the industry’s creativity – and its appetite managers expect. “Defined-contribution plans are for change. going to be where the growth is,” he says. While the industry is still experimenting, he suggests One area in focus is their sources of capital. that asset-allocation vehicles such as target-date Managers need to attract capital from a wider funds could enable commercial real estate (CRE) range of sources, in particular from retail investors. managers to tap meaningful retail flows. That might not sound like much of a challenge.

Privcap Special Report • Capital Formation | Q1 2014 / 20 CAPITAL FORMATION / REAL ESTATE

Even a small shift toward DC plans in the public dated in 2013, the fund received intensive industry sector could result in large new cash flows. The scrutiny as a pioneering effort “to address 100 largest public plans in the U.S. had assets of well-known shortcomings associated with $2.6 trillion in 2013, according to pension consult- traditional non-listed REITs, principally, lack of ant Milliman, Inc. But those plans face liabilities liquidity, the rigidities implicit in a closed-end, of $3.77 trillion ($2.2 trillion for retirees and inac- finite-life, fixed price investment, and high tive plan members not yet collecting benefits and fees,” according to Clarion letters filed with the $1.6 trillion for plan members who are still work- Securities and Exchange Commission. ing). That leaves the plans with only 27 percent of the assets needed to cover the accrued liability for To control costs, CPPT charged a management fee active plan members. In states such as Illinois, un- of 0.9 percent and a performance fee of 25 percent derfunding of public pension plans has forced leg- of gains that only applied after the manager, CPT islators to introduce 401(k)-style DC options for Advisors LLC, a unit of ING Clarion Partners LLC, new and some active workers. delivered a 6 percent minimum return. The maximum sales charge of 3 percent was Pandaleon says CRE managers who can tap DC significantly below the prevailing rate for assets will hold a “golden ticket.” That will require non-traded real estate vehicles at the time. Despite innovation in product development and personnel. the modest cost structure, the fund achieved little What’s needed, he says, is a product that can meet traction and reported only $13 million in net offering the need for the daily liquidity and daily pricing that proceeds in its March 31, 2013, SEC filing. The fund is required in the 401(k) world. The next question was liquidated in June 2013. Clarion Partners LLC, is “how to get into the 401(k) option list.” the successor entity to ING Clarion, declined to comment for this article. As a long-duration asset often involving private-market transactions, real estate does not Perhaps the best illustration of the challenges readily lend itself to a daily-liquidity model. It’s facing CRE managers is the correspondence a marketing dilemma, and CRE managers are in between CPPT and the SEC in early 2012, when the early stages of experimenting with solutions. the fund asked the SEC for permission to shift its So far, no structure has emerged that meets the redemption policy toward the “net redemption” requirements of the major retail channels, DC policy used in retail mutual funds that offer plans, and fee-only financial advisers. But it’s investors the ability to redeem their entire position not for lack of effort on the part of private CRE at NAV on any business day. Redemptions in CPPT managers, and the size of the retail opportunity were originally subject to a quarterly limit of means the industry will continue to try. 5 percent of the prior quarter-end net asset value. In 2012 the fund asked to revise its policy to set the Approaches to date have clustered around three 5 percent limit based on net redemptions in order broad product-development strategies aimed at to improve liquidity for investors. Redemption different parts of the retail-distribution spectrum. caps can prevent some investors from selling Those include hybrid funds that adjust sales loads their positions if they try to redeem after the limit and tweak other features of non-traded REITs is reached. If not changed to a net basis, CPPT in an effort to spur sales to a wider range of said, the cap “could limit redemptions in a quarter commission-driven advisers; mutual-fund despite the Company receiving a net capital inflow approaches in which non-traded funds adopt for the quarter, which is at odds with the objectives pricing and other features usually found in of a perpetual life, non-listed REIT and does not registered fund vehicles in an effort to appeal to advance the investor protection goals” of the SEC. financial advisers who don’t sell commission products; and institutional approaches that seek to The rationale for the change highlighted the deliver the performance of commingled real estate dilemma inherent in delivering the benefits of funds to defined-contribution plans. real estate investments to retail customers. Fund managers must hold cash to pay shareholders Each approach has its merits, but tension remains who redeem their holdings, but idle cash can hurt between the retail channel’s need for liquidity and performance. CPPT said the change to net the inherent long-term nature of real estate. The redemption was “designed to provide greater most ambitious approach was Clarion Property Part- liquidity to the Company’s stockholders without ners Trust, Inc. (CPPT). Launched in 2011 and liqui- requiring the Company to allocate a greater portion

Privcap Special Report • Capital Formation | Q1 2014 / 21 CAPITAL FORMATION / REAL ESTATE of its portfolio to cash, cash equivalents and other investors about potential illiquidity, PREI last year liquid assets that typically produce a lower return retained the -based Real Estate Research than investments in the Company’s targeted assets.” Corporation to determine the daily value of PRREF’s direct real estate investments and to ensure that Another approach is being tried by The Blackstone the process is transparent, consistent, and accurate. Group, Inc., which in January filed with the SEC for permission to market a non-traded CRE vehicle, the PREI notes that DC plans can access its direct CRE Blackstone Real Estate Income Fund II. Blackstone expertise through asset-allocation strategies such declined to comment while the fund is in a quiet as target-date funds. Prudential’s strategy seems period. Blackstone’s structure appears aimed at to be paying off. The fact sheet for PRREF shows intermediary firms and fee-only financial advisers; assets of $468 million on September 30, 2013, instead of a sales commission, the fund will pay an although it does not indicate whether that is all ongoing 12(b)-1 fee of 25 basis points, a flat annual from DC clients. And the Callan Glidepath 2020, marketing fee that is included as an operational a target-date fund designed for employee benefit expense in a traditional mutual fund’s expense plans and managed by the investment consulting ratio. The fund will have a 1.5 percent expense ratio firm, had a 12 percent allocation to PRREF on and a 15 percent performance fee. While a marketing December 31, 2013 – the fund’s second-largest fee of just 0.25 percent seems razor thin in the allocation to a single manager of any strategy./ non-traded REIT world, it shows the cost-sensitive nature of the retail channel.

One of the largest institutional real estate mangers, Prudential Real Estate Invest- ment Management (PREI), has been pursu- ing the DC channel for about 5 years. Pru- dential is investing strategically in its effort. In 2011 it hired David Skinner, JP Morgan’s head of defined contribution investment-only institutional sales, to spearhead its DC push. PREI’s website prominently features a video, “Commercial Real Estate in Your DC Plan” (http:// www3.prudential.com/prei/main/us_inv_dc_ about.shtml), and Skinner was instrumental in launching the defined-contribution Real Estate Council (DCREC) during 2013. The group aims to persuade plan sponsors and consultants to add commercial real estate as a DC investment option.

On the investment front, PREI invests 75 percent of DC assets through a separate account in its institutional commingled funds to achieve exposure to the CRE asset class. To provide liquidity, PREI holds up to 25 percent publicly traded REITs and cash. That might cause concern in the DC world; in its video, PREI notes that REITs are not a good substitute for direct commercial real estate investments since REITs tend to track the equity market and trade like small-cap stocks, but does not address why assets with small-cap-equity characteristics are suitable as a cash equivalent. PREI did not provide a contact for this article. PREI clearly states that the ability to make daily withdrawals from its Prudential Retirement Real Estate Fund (PRREF) is not guaranteed, and redemptions could be delayed if the fund does not have sufficient cash available. While cautioning

Privcap Special Report • Capital Formation | Q1 2014 / 22 CAPITAL FORMATION / FUNDRAISING

Click to watch this video at privcap.com Public Sector: The Move to Defined Contributions The shift from defined-benefit to defined-contribution plans in the public sector will occur with a rapid domino effect, George Pandaleon of Inland Institutional Capital Partners predicts.

effect. Illinois may be one of the first ones, because they have the biggest problem.

Privcap How quickly could we start seeing these changes?

Pandaleon It could start in the next two to three years. Once there’s a consensus that this is the direction to go in, as it has in corporate America, there could be reductions in available capital to private-equity real estate over the next five to 10 years.

Privcap What impact will it have on the GPs raising private-equity real estate funds?

Pandaleon George Pandaleon, Inland Institutional Capital During the Baby Boomer generation, most of these funds were getting a lot of new capital Privcap contributions from employees. Those Will the shift from defined-benefit to de- employees are retiring, and we’ve seen a shift fined-contribution plans in the public sector toward cash-flow-oriented investments, be a long evolution? which have some liquidity. That trend is likely to continue. George Pandaleon, Inland Institutional Capital That’s a common perspective, but I think it will happen faster. The funds may still Privcap be there, but they’re going to be managed We’ve seen some GPs, some real estate differently. Once some corporate plans determine managers, trying to tap retail investors. What they no longer want to have defined benefits, do they need to consider when doing this? they will freeze the plan. Pandaleon They make precise determinations of what There are a number of regulatory hurdles. You the future runoff of that fund is going to be need daily pricing and liquidity if you want and invest in interest-bearing securities. to tackle 401(k) programs. Liquidity is the Once one or two of the big states or municipal challenging piece. You need to hold back a plans goes in this direction, it’s a domino fair amount of cash, or have a large corporate

Privcap Special Report • Capital Formation | Q1 2014 / 23 CAPITAL FORMATION / FUNDRAISING balance sheet as a backstop. Most investment issues with actuarial rates of return and managers aren’t capitalized enough to underfunded status. They’re going to focus backstop, so it’ll have to be held inside the on delivering capital back to the fund. The primary appeal to an institutional pension beneficiaries. investor is that 6 percent dividend. When [you have to hold cash] and that lowers Privcap it to a 3.5 or 4 percent dividend, [they’ll] start What is the appetite among defined to wonder why they’re investing in real estate. contribution plans for real-estate?

Privcap Pandaleon Is crowdsourcing a way of opening retail That’s proving to be difficult. One of the -rea investors to an institutional market? sons is that the people making decisions about your investment opportunities are not Pandaleon investment people. They’re HR people with The implications of the JOBS Act, which is an an attorney reminding them what their lia- opening toward modern methods of marketing bilities are./ securities, is a potential game changer.

The syndication business that used to be a primary way of financing real estate has gotten bigger and smaller over the years, but now it’s booming. The JOBS Act could allow for significant growth in that market.

Privcap What do opportunistic GPs contemplating the next potential fundraise need to be mindful of when they look at future capital raising?

Pandaleon The big change that’s going to affect them is already happening. There are five to 10 fund managers raising more than 80 percent of the capital in the more opportunistic space. The other 500 to 700 of them look the same. They would all dispute this, but they’re closed- end opportunistic asset allocators.

There will be continuing focus on opportunistic investments, but it’s not going to be the massive flows that we’ve seen over the last 20 years. Many of these pension funds have

BIO

Prior to joining Inland, George Pandaleon was affiliated with Grubb & Ellis, where he was executive managing director of its Institutional Investment Group. He has also been a partner with CMD Realty Investors, where he was responsible for portfolio and asset management for their national portfolio of investment properties. He has also held senior positions at Allstate Insurance and LaSalle Partners.

Privcap Special Report • Capital Formation | Q1 2014 / 24 CAPITAL FORMATION / JOBS ACT Fighting for JOBS PE capital formation should be made easier for startup businesses by the JOBS Act. U.S. Rep. David Schweikert and attorney Scott Gluck tell Privcap about the act’s bi-partisan support, a coming battle with the SEC, and letting some sunshine into PE deals.

Privcap The way the JOBS Act was conceived and came to fruition is a complex story. Can you summarize the factors that allowed it to be signed into law?

Schweikert If you have only been in Congress one term and you are sort of stupid, you can make things happen. Two-thirds of the bills in the JOBS Act are mine, and I had a couple of simple bills on Regulation A. I could not get anyone to take an interest. I kept visiting [Rep.] Barney Frank’s (D-MA) staff, and I con- vinced them the bills were not a Republican plot. We made changes, and Barney Frank gave his blessing. We had this cascade of individual bills that we packaged into one; the SEC should have done some of it on its own, but was never going to. Rep. David Schweikert (R-AZ) Privcap What was the selling point to get the support of Barney Frank and the Democrats? Was access to capital a key benefit that dovetailed with their agenda?

Schweikert New York is the capital center, represented by some of the most liberal members of Congress. They are often the most hostile, unless someone has said to them, “This isn’t an evil plot.” We were able to break down partisan barriers.

And I’m going to take some personal credit on this for my willingness to spend time with [Rep.] Maxine Waters (D-CA)—and particularly her staff—and say, “Look, this is OK.” I think she ultimately voted against it, but she didn’t block it. You have to be tenacious and honest that this is about Scott Gluck, Venable LLP

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buddy has a Ph.D. in electrical engineering Jumpstart Our Business Startups Act and doesn’t have a million bucks in the (H.R. 3606) Facts bank, but a deal happens to be for a company specializing in that space. If he’s truly an • Signed into law on April 5, 2012. expert, why shouldn’t he be allowed to invest? • Reopens capital markets to “emerging growth” com- panies with total annual gross revenue of less than Gluck $1 billion. … As you probably know, the GAO came • Companies can raise up to $1 million yearly from indi- out with a report by now, maybe five or six vidual investors. months ago, talking about how the threshold limits for the definition of accredited investor • Increases the number of shareholders a company can haven’t been increased in a long time. There have before being required to register its common stock are even some proposals to retroactively with the SEC to 500 unaccredited or 2,000 total share- holders. index the threshold limits for inflation. That would dramatically reduce the amount • Title II repeals prohibitions against general solicitation of people who meet the qualification of or advertising for private placements as long as offers or accredited investor. sales of securities are made to accredited investors. • Title III deals with and provides a new Privcap exemption from the requirement to register public of- A world where it’s easier for capital to connect ferings with the SEC for certain types of small offerings. with projects or businesses or funds—that’s It allows Internet “funding portals” registered with the good for the formation of funds and for SEC, similar to Kickstarter. A condition of this exemp- innovation, but it does increase the risk of tion is a yearly limit on the amount each person may invest in offerings of this type, depending on net worth fraud. What do you think the appropriate or yearly income. protection should be, if any, to guard against, or at least discourage, the fraud that would • Limit for securities offered exempted under Regula- naturally creep into a more open system? tion A from $5 million to $50 million, allowing for larger fundraisings. Schweikert One of the great failings in the SEC’s rule set for equity crowdfunding is, “How do I use the next generation of capital formation, sunshine? How do I use that crowdsourcing which is tough because, for a lot of these folks, of information?” it doesn’t play to their base. Here’s your intermediary hosting the Privcap crowdfunding platform, and here’s Mary’s You’re saying that, specifically, private Bakeshop. She wants to raise a equity—not the broader private markets— quarter-million dollars, and there’s a is where you see an appetite on at least one blog where people are talking about her side of Capitol Hill to further define, seek cupcakes, or saying it’s in a horrible further clarity, seek further disclosure? neighborhood. I’m a powerful believer that filing another piece of paper that almost Schweikert no one reads is not modern regulation. We were trying to find a more egalitarian way Having something instantaneous, easily to access information. You have a country accessible and digestible—particularly for with 318 million people and we have, what, the lower-market investor—that’s where about 600,000 who are qualified investors? regulation has to be more about sunshine and access to information, rather than creating I’m passionate about broadening that another series of forms to file. But the definition [of a qualified investor], because innovation is electronic filing. How many of we’re locking out so much of our society you use Yelp or these sorts of things to choose from being able to take incremental risk and a restaurant? participate in investments that they have high knowledge of, because they haven’t met Privcap the definitions the SEC produces. Say my Sure. All the time.

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Schweikert private equity, as well as the PE firms, wonder You’re going to trust that to make a financial if their lives are going to get better or more decision on what you’re going to stick in your difficult in the future. tummy. We’ve already experienced this. How do we pull that into other activities around us? Schweikert There is a tug-of-war. I watch the House Privcap Committee on , and you If you look at the way private equity and any have one side fixated on no one losing private-fund industry has evolved, it is highly money and the other fixated on access confidential. Is the JOBS Act going to give way and capital availability. to a more open way of exchanging information? We were hearing noise about private equity Schweikert from regulators. There is a coming battle The [private and public approaches] will coexist with the SEC over what should be disclosed and until one starts to demonstrate that its cost registered, how deep that registration should of raising funds is more efficient. I used to go, and who gets to play. Some of us are trying represent a wealthy man in Scottsdale; my job to create an environment that says, “If you’re was as much to keep stupid deals away from not playing with government-insured money, him as to keep people from knowing what not taking money from the general public, he was investing in. Often, when he would ultimately, what do we care? It’s your jump into a deal, we had snipers who would risk capital. t is your job to build a rate of try to raise our price or screw with us. That return for your investors. It is not our job to world will exist, it will be uncomfortable for babysit you.” certain dealmakers to talk, and I would like to fix some of the liability issues. It is healthier Also, be prepared to have to fight through the for the economy to have many opportunities, fungible definition of who and what a private discussions, fights, and debates over where to placement deal is, what private equity is and park your money. what it’s investing in, and what falls into a space of disclosure. Privcap Scott, what will be the battlegrounds where Privcap the outcome could be different, based on how You mentioned a coming battle. Will the things break? ultimate outcome be more pain for the capital-formation world and bringing Gluck regulations in line with technology and In private equity, funds with more than $150 society? How do you think it will break? million generally have to be registered under the Investment Advisors Act, which was never Schweikert intended to apply to PE fund managers. No one will like the first part of my answer; They are subject to a host of regulations, it is the worst of both worlds. Those in the like keeping track of their employees’ capital-raise or dealmaking business are personal trades, even though the funds thinking, “Give me a bad rule, but dammit, invest in privately held companies. It is just give me the rule.” expense with virtually no benefit of reducing insider trading. We desperately need capital formation, and some of the “paint all the financial industries The SEC has given favorable guidance with with a broad brush of being evil” from 2008 is respect to things like the custody rule, but it fading. Something like equity crowdfunding might take some sort of legislative fix. Unless takes a year and a half or two years for the SEC you get a Senate more conducive to easing to produce a set of rules; they end up being regulatory burdens on private-equity funds, overly cautious and bureaucratic. Waiting is it will be difficult to implement changes. the problem. I hope it does not stop folks from putting a deal together./ Privcap Institutional investors who commit capital to

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From the Archives Explore Privcap’s vault of recent videos forecasting 2014’s critical trends

MIDDLE MARKET VC & Deal Stories: Reinventing Frozen Food and Candy Growth Equity Is the New Black With panelists from McGladrey, Vestar Capital, and With Brian Rich of Catalyst Investors Brynwood Partners ‘No Trade-offs’ Between Impact and Profit The Carve-Out Specialists With Jean Philippe de Schrevel of Bamboo Finance With OpenGate Capital’s Joshua Adams CVCA’s Entrepreneurial Drive Small Companies, Big Profits With Richard Remillard of Canada’s and With Satya Ponnuru from MacColl Partners Private Equity Association Affordable Care Act: The Middle Market Impact Why Venture IRRs Will Rise Again With Pam Hendrickson of The Riverside Company With experts from Atlas Venture, NextView, and Top Tier Where Have All the Good Deals Gone? Capital With Scott Budoff of Saw Mill Capital

PORTFOLIO OPERATIONS Carve-Outs: Plan of Action With experts from Grant Thornton, Sun Capital, and Blue Wolf Preparing for an “Intense” Sale Process With Philippe Leroy of EY Property in Poland: The Eastern European Opportunity With Jeffrey Lefleur of W. P. Carey Why 100-Day Plans Are Critical With Ed Kleinguetl of Grant Thornton SECTORS & STRATEGIES Healthy Returns With Mike Liang of Baird Capital Gen. Petraeus of KKR: Global Opportunities, Risks With General David Petraeus and Vance Serchuk of KKR Global Institute Transportation: Big PE Opportunity, Few Players With Reginald Jones of Greenbriar Equity Group Healthcare Royalty Investing With Todd Davis of Healthcare Royalty Partners LP Focus: EDC’s Foreign Mission WIth Paul Day of Export Development Canada Pine Brook’s Capital-Intensive Opportunities With Michael McMahon of Pine Brook

Privcap Special Report • Capital Formation | Q1 2014 / 28 SPONSORED CONTENT

Please contact Jon Shepard at [email protected] • www.ey.com Click to watch this video at privcap.com

Expert Q&A With Jon Shepard Director, Enterprise Growth Services, EY

WHAT IS EY’S ENTERPRISE GROWTH the time they’re on the program. We then charge fees SERVICES PROGRAM? that recover the remainder of their salary. Enterprise Growth Services is a non-profit program within EY. We send people to emerging markets to work WHAT IS THE SMALLEST BUSINESS YOUR PROGRAM with job-creating small businesses. And we help those WOULD WORK WITH? businesses overcome barriers to growth and exploit op- This is not for a guy with a fruit stand. They need to be portunities for growth. We send experienced EY people big enough to absorb some professional consulting help. for a long enough duration to help them do that. So, we The smallest business we would work with is probably 20 might send a team of two to help a small business per- or 30 employees. But we also set a cap on the maximum manently improve its working capital management and size of business we will work with, which is well below that might take two or three months. In some cases, we the level at which we would expect an organization to will send a larger team to work with a business for up to work with EY on a normal commercial basis. six months if it needs fundamental rewiring in terms of the way it manages its core operations and finances.

DO YOUR ENTREPRENEUR CLIENTS PAY FOR THESE SERVICES? The program works on a not-for-profit, but also not-for-loss basis. So, we drive our costs down, and then we charge low fees to recover them. EY doesn’t make any profit. We don’t recover any overhead or indirect costs. And the people we send from our European offices take 50 percent salary cuts for

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