The Incredible Shrinking GP / 12

privcap The Monthly Magazine of Privcap.com Digest/ February 2013

Special Report: The Incredible Shrinking GP / 12

In This Issue:

Fundraising with Bono / 4 What to Watch in 2013 / 7 KKR Looks to the Future / 16 Fired Up: Latin American Energy / 22 Lessons Learned: BlackRock & PE / 25 2 / Contents

In This Issue

Up Front Quotable Privcap LLC 04 A roundup of market intelligence shared on Privcap.com Snow’s Notes David Snow LP appetite for direct investing is good news for Co-founder and CEO 05 accomplished deal pros. By David Snow Gil Torren Co-founder and President The Big Question 07 The experts weigh in on news and topics that shape the Content private capital world Takeaway Matthew Malone Barry Miller, head of private equity for the New York City Editorial Director 09 Employee Retirement System (NYCERS) and a former GP, Emily Hebner on what he looks for in a GP Media Manager Deal Story: Dunkin’ Brands Design 10 Thomas H. Lee co-president Scott Sperling on the firm’s profitable exit from the iconic franchise Miguel Buckemeyer Deal Story: Egyptian Refining Company Art Director Karim Sadek of Citadel Capital talks about closing a deal Vasheena Doughty 11 amid recession and revolution Production

Contributors Features The Incredible Shrinking GP Tom Stein 12 A Privcap special report illustrating the consequences of smaller funds and lower fees Contacts KKR Looks to the Future Scott Nuttall, head of global capital and asset manage- Editorial 16 ment, reveals the thinking behind KKR’s expansion beyond David Snow / [email protected] PE and explains how to invest in a complex world (646) 233.4558 Matthew Malone / [email protected] The Healthcare Opportunity (646) 801.2337 19 Investing amid the uncertainty of the U.S. healthcare Sponsorships & Sales system Gill Torren / [email protected] Latin America’s High-Wattage Future (646) 233.4559 Two investing veterans give a tour of the Latin American For subscriptions, please call 855-PRIVCAP 22 energy opportunity—where it is, and how to profit from it or email [email protected] Lessons Learned: Blackrock & PE About Privcap Digest 25 Blackrock’s Russ Steenberg says private equity is a “simple” business at heart Privcap Digest is a monthly publication exclusively for Privcap Must See subscribers. It offers in-depth features and edited summaries Privcap’s upcoming programming schedule of the most recent and important thought-leadership from 26 Privcap.com. The Privcap editorial team has extensive experience reporting on the global alternative investment industry. From Our Sponsors Expert Q&A For inquiries about the Digest, please contact Matt Malone at Jennifer Cho of MVision Private Equity Advisers [email protected]. 27 Tammy Hill of McGladrey Copyright © 2013 by Privcap LLC Philip Bass of Ernst & Young All rights reserved. No part of this publication may be reproduced, distributed, or transmitted Interview transcripts in this issue have been edited for clarity and length. in any form or by any means, including photocopying, recording, or other electronic or mechani- cal methods, without the prior written permission of the Privcap LLC. For permission requests, contact Gill Torren at [email protected]. Privcap Digest / February 2013 / 2 Welcome to Privcap Digest

We hope you enjoy this complimentary copy of the debut issue of Privcap Digest—a monthly digital magazine created exclusively for private capital market professionals. Future issues of the Digest will be available only to Privcap subscribers—one of the many benefits of a Privcap.com subscription. Privcap, the premier channel for thought-leadership in private capital, is best known for its high-quality video programming. The Digest is a print distillation of the commentaries and conversations that Privcap delivers every month via online video. In addition to presenting over- views of thought-leadership from our website, the Digest will also deliver special reports on critical aspects of the private capital industry. You’ll find the first in this issue: “The Incredible Shrinking GP,” a case study in what happens to a GP when its current fund is smaller—and less profitable—than the last. Anyone seeking to prosper through the next cycle needs to understand firm microeconomics and the challenging reality of shrinking fee-based income. Market observers have long argued that GPs should use management fees to pay for peanut-butter-and-jelly sandwiches and save the caviar feast for carried interest. As this special report illustrates, fees of all kinds are indeed in shorter supply these days, forcing many firms to be as efficient as they expect their own portfolio companies to be. The Digest can be printed or read on your tablet or computer, reflecting our commitment to providing our content in every convenient format, allowing you to watch, listen to, or read Privcap’s exclusive market intelligence from top industry decision-makers on your own terms. I hope you enjoy our first edition—we’ve worked hard to elegantly present the best insights in private capital. We welcome your feedback on how we can make it even better.

Best regards,

David Snow Co-founder & CEO, Privcap [email protected]

Privcap Digest / February 2013 / 3 4 / Market Intelligence Quotable/ A roundup of market intelligence shared on Privcap.com

We found that when you bring a You often get asked the question You won’t be surprised to hear new CEO into a company, you lose by GPs, ‘What should we do to be that people would get their PPM at least six months as they get acquaint- able to raise money?’ Well, it’s ‘Make autographed.” ed with the people. They change out good returns.’” Kevin Albert, Pantheon Ventures, from people. And we found that that added an Frank Angella, Grove Street Advisors, from “Fundraising with Bono” ) Link element of risk to the investments.” “The New World of Private Equity” ) Link Carl Thoma, Thoma Bravo, from “The Changing Face of PE” ) Link

Private equity was a four-letter I know as an LP, I always hated The best place to be next year is word back in the late ‘90s, in terms when GPs went above my head, infrastructure, no question about of the energy space… If I walked into which is something that a lot of GPs do, it. California’s just going to fall into a CEO or CFO’s office and said ‘I’m a even unintentionally.” the water unless there are some major private equity guy,’ they’d show me the Sheryl Schwartz, Perseus, from “From LP to infrastructure projects.” door pretty quickly.” GP: Lessons Learned” ) Link Len Tannenbaum, Fifth Street Finance, from Dan Revers, Arclight, from “Energy’s Big “Outlook 2013: Where to Invest (and What to Moment” ) Link Avoid)” ) Link

Professionals from the following firms and organizations recently appeared on Privcap: On Camera TPG • The Carlyle Group • Pantheon Ventures • Vestar Capital Partners • Quaker Partners • RRE Ventures • Perseus • Actis Development Partners International • Hunstman Gay Global Capital • Saratoga Partners • MidOcean Partners • Grove Street Advisors

Privcap Digest / February 2013 / 4 5 / Commentary

Snow’s Notes

Up with PE People Even as the population of private equity firms shrinks, the demand for experienced direct investors will remain strong

recently spoke with a veteran fundraiser some major milestones have been met. Think of who shared some market intel that fits it as an “indentured” general partner. an important human-capital trend: ris- The sovereign wealth fund’s move reflects ing demand for individuals with proven a simple reality: Investors want more private skills as “direct” private equity investors, equity, but they want an improved version of it. even as the sprawling population of pri- They want more of what makes the asset class so vate equity firms is being culled. attractive and less of what makes it seem expen- Market According to my fundraising source, an un- sive and opaque. Some believe that the solution analysis by named sovereign wealth fund is currently looking lies in direct investing. Privcap CEO to hire a team of in-house investors and intends It’s an alluring premise. But direct investing David Snow to put a substantial amount of capital behind done right requires dedicated staff with high- them. The fund is seeking a more efficient way ly specialized skills. A typical LP spends most of to satisfy an increasingly common hunger among its time evaluating hundreds of GPs per year and the limited partner community—to make in- doesn’t also have the time, resources, and exper- vestments directly. By circumventing the general tise to quickly decide whether to commit $100 partner, the thinking goes, the LP can circumvent million in equity to, say, a German pet-food dis- the fees and carry that comes along with them. tributor. To put together its team, the fund has careful- Direct investing, in other words, is a full-time ly studied the individual track records of profes- job. That’s partly what created the GP-LP model in sionals within major private equity firms with an the first place. eye toward poaching the most talented. The fund What kind of experience does a sought-after is approaching them with the idea of creating its direct investment professional have? Serious, single-LP team—and adding additional induce- through-the-crucible, round-trip-deal experience. ments to seal the deal. Since many investment They have sourced and modeled deals, structured professionals are wary of a platform with a sin- financing, overseen operating progress, and most gle source of capital, this sovereign wealth fund importantly, consummated a profitable exit. is considering allowing its in-house GPs to raise The emerging indentured GP model means external capital after some time has passed and such talent will continue to be in high demand, even as many of the firms they’ve traditionally worked for fight to raise every penny. Investors want more private equity, A case in point: A recent LP survey conducted but they want an improved version by Probitas Partners found that exactly zero percent of respondents were considering reducing of it. They want more of what makes their allocation to private equity or exiting the the asset class so attractive and less asset class. But 54% said they were looking to “de- crease significantly” the number of GP relation- of what makes it seem expensive and ships they maintained. opaque. Some believe that the solution While the rising demand for talent is good news for anybody who has the talent demanded, lies in direct investing. it will make more acute a challenge that private equity firms have long faced—retaining the best . CONTINUES ON NEXT PAGE

Privcap Digest / February 2013 / 5 6 / Commentary

“While the rising demand for talent is ship. Talent retention will be even more difficult good news for anybody who has the with two trends at work—the rising value of direct-investment talent generally, and the talent demanded, it will make more increasing sophistication by which industry acute a challenge that private equity participants are able to evaluate individual track records. As investors and advisers dig deeper into firms have long faced—retaining the fund track records, they are unearthing valuable best people.” insights into who did what, putting the value- creation heroes in play. Ultimately, a key barrier to the growth of the people. Here’s one unpleasant scenario for an private equity asset class is talent. Before a greater existing GP: The LP that decided not to invest percentage of the world’s private companies are in your next fund has decided instead to launch owned or backed by private capital, we will need a $1 billion direct-investment program that needs more people who can profitably do these deals. to be staffed, and it wants to poach three of your The acquisition and management of a private deal professionals to staff it. The offer may be company is a difficult process—and the number irresistible, since staying put means they might of people who can do it successfully are few rela- not have another fund to manage. tive to the growing demand for their skills among Economically rational founders have long dissatisfied, yield-starved LPs. ■ attempted to pay themselves the most money while making the economics for the rest of the L Follow David Snow on Twitter @SnowsNotes team just attractive enough that they don’t jump

Privcap Digest / February 2013 / 6 7 / Market Intelligence The Big Question/ Taking the pulse of private capital—one answer at a time

This Month’s Question: As you assess the environment for your specific investment strategy, what indicators or statistics are you most focused on today? Why? And what are your expectations for those metrics for 2013?

The Experts

David Wachter Founding Partner, W Capital Partners

Mark Patterson Chairman, MatlinPatterson Global Advisors

Christopher Meyn Partner, Gavea Investimentos Wachter Meyn

Kevin Crosby Managing Director, ArcLight Capital Partners, LLC

Patterson Crosby

. CONTINUES ON NEXT PAGE

Privcap Digest / February 2013 / 7 8 / Market Intelligence

over the last three years, when most sane observ- Wachter 1 ers felt acquiring more land was an indication of dementia. In Direct Secondaries, DPI Matters Meyn 3 We closely track distributions to paid-in capital (DPI), the hold period for PE investments, and the number of funds reaching maturity. Industry- Brazil Regains Confidence wide, the median DPI for seven-year-old funds “We see an has fallen from 1.07x five years ago to 0.30x to- increase in At Gavea, we closely follow data that helps day—meaning that in 2007, the median PE fund credit growth us better understand Brazil’s macroeconomy, had returned capital in excess of LP contributions driven by including GDP growth, consumer activity, the by year seven; today it’s less then a third of called healthier banks IPO pipeline, and the local private equity exit capital. Current PE investments have, on aver- and expanded pipeline. On the macro side, we see accelerating age, been held more than five years. Lastly, the public credit, as GDP growth, showing that confidence is slowly number of funds that are reaching end of life is well as leading recovering and producing increases in invest- growing, with over 3,000 funds approaching year indicators that ment. We see an increase in credit growth driven 12 in the next three years. While LPs have been show moderate by healthier banks and expanded public credit, supporting their managers’ objective of maximiz- reductions in as well as leading indicators that show moderate

ing exits, at some point funds will need to reach delinquencies” reductions in delinquencies. We also follow same- the finish line. My expectation heading into 2013 Christopher◯ Meyn store retail sales, given the slowdown at major is that DPI will steady itself at current levels as retailers from 2010 to 2011. The statistics point to GPs focus on ways to at least offset capital calls a slow recovery. with exits. However, GPs won’t be able to lock in The improved macro conditions may fuel a net IRR and clear hurdle rates without material strong IPO market in 2013, which shows the po- cash distributions. Eventually, DPI must rise to tential to double or triple the activity of 2012. All raise subsequent funds. eyes are on the potential listing of BB Seguridade, which would be the biggest Brazilian IPO since Banco Santander Brasil in 2009. Patterson 2 ◯ U.S. Housing Emerges from Distress Crosby 4

Given current low European, Asian, and U.S. de- Keeping an Eye on Commodities fault rates during this booming financing market, which accepts all comers like a homeless shelter, As we assess the environment for energy infra- we’re much more focused on maximizing the structure, the most important statistics/indica- value of large investments made around 2009— tors are the prices and production levels of major housing among them. In that industry, the most “GPs won’t be energy commodities (crude, natural gas, electric- import metrics are family formation, employ- able to lock in ity, etc.). While heavily intertwined with the en- ment growth, the health of the mortgage market, net IRR and ergy markets, these commodity benchmarks serve and interest rates. All the metrics are moving in clear hurdle as important indicators of future infrastructure the right direction, so we’re optimistic. What I rates without investment. In the past few years, U.S. crude oil find most compelling is that the single-family material cash production and investment in supporting infra- U.S. new-home build tally is still at a fraction of distributions” structure has increased rapidly. Looking forward the 1.5 million units reached during the last peak David Wachter to 2013, we expect commodity levels that will sup- before 2007. port strong growth in the U.S. production of both We have about 20% ($1B) invested in the home- crude oil and natural gas. Likewise, we expect sig- builder and real estate “rebound” sectors, includ- nificant growth in the demand for capital aimed ing multi-family apartments. So we also look at at building critical supporting infrastructure such our land “runway”—not the land available to in- as pipelines, storage terminals, and processing vest at today’s prices, but the amount we acquired facilities. ■

Privcap Digest / February 2013 / 8 9 / Takeaway

By Tom Stein Click to watch this video at privcap.com How to Make Nice with NYCERS The pension fund’s PE chief on the value of good people—and good relationships Ps embarking on a new fundraise will find the field of limited partners more limited than it’s been in years. Those accustomed to calling the shots now must work hard to accommodate limited partners— and they must work especially hard when doing business with powerful LPs like Barry Miller, who handles $16 billion in PE commitments for the New York City Public Employees’ Retirement System, the largest municipal public employee retirement system in the U.S. Miller is now in the process of trimming the NYCERS roster of GP relationships in an effort to build a more focused portfolio and generate bet- they executed on the strategy they outlined when ter returns. NYCERS recently took to the secondary they first met with the LP. markets and sold $1 billion worth of PE holdings. But while it’s downsizing relationships, NYCERS The realization. It’s not so much the amount of is increasing its commitment to the asset class. money an LP gets back, Miller says, whether it’s a Miller says he looks at three fundamentals when partial realization or a full realization. “The real considering a new fund. story is IRR and multiple, because that’s what people are marking off of. When you talk to people, The team. “Turnover is not a good thing,” says everybody is top quartile. It’s one of the most amaz- Miller, who prior to taking his current position was ing things—you’ve got an industry which is all top cofounder and managing partner at Nottingham quartile.” So LPs like NYCERS are looking for con- Capital Management. When he considers a fund sistency: firms that were not only top performers now as an LP, he wants to see a senior team that’s this year but last year and years before that. What’s been together for a long time. “And when you look more, not only are they pinpointing the best people at the depth and breadth, you want to have people and the best funds, LPs are tightening focus on the who are ones, twos and threes.” asset classes that give the best return. The return. Investing is the easy part for GPs. “What And yet numbers are not the whole story. Miller you need to be good at is distributing money and sits down with GPs all the time and says he often selling companies,” Miller says. And to extend and meets managers with great track records who can't deepen a relationship, GPs must also show that raise money, while he meets other managers with so-so track records who have no problem pulling NYCERS Snapshot investment. The distinguishing factor is how a GP treats his LPs. “One of the challenges that some GPs have is they Covered employees: >300,000 get a little complacent with regard to their LPs,” he says. “Fundraising is not once every three or four Contributions, 2010: $800M years. Fundraising is nonstop... It doesn’t matter if you’re the best investor in the world—if you have no Assets: +$100B money to invest, nothing’s gonna happen.” ■

Privcap Digest / February 2013 / 9 10 / Deal Story

Click to watch this video at privcap.com Thomas H. Lee Partners ⬌ Dunkin’ Brands As told by Scott Sperling, Co-president, Thomas H. Lee Partners

The Details

Target company Massachusetts-based Dunkin’ Brands is best known for its Dunkin’ Donuts and Baskin-Robbins chain restaurants Seller Pernod Ricard Deal close date

Deal value at purchase

Exit $2.425B IPO and secondary offerings 2011-2012

The Story Scott Sperling sat down with Privcap in September to discuss the firm’s successful investment in Dunkin’ Brands, parent of the iconic Dunkin’ Donuts and Baskin Robbins food chains. In his telling, Dunkin’ Brands was unlike most other franchise businesses—its franchisees were actually happy. Yet the business was undermanaged as part of a large French conglomerate, and THL and its co-investors felt they could make a stand-alone Dunkin’ more profitable. Upon acquisition, they extracted value by expanding the company’s Need☕ a Refill? domestic and international footprint and product offerings. It was an unmitigated success: The company’s Dunkin’ Donuts cash flow nearly doubled, and its private equity owners exited through a successful IPO and secondary stock offerings. Watch the full story here ). sells more than 1.5B “We spent a lot of time working on expanding geograph- cups of hot & iced ically and making the store level more profitable. That coffee globally profitability would then allow us to ramp up the expan- every year. sion even more. The net result was obviously an incred- ibly successful investment for us.” –Scott Sperling

Privcap Digest / February 2013 / 10 11 / Deal Story

Click to watch this video at privcap.com Citadel Capital ⬌ Egyptian Refining Company As told by Karim Sadek, Managing Director, Citadel Capital

The Details

The company ERG is a greenfield refinery being built in cooperation with the Egyptian government

Close date

Co-investors Egyptian General Petroleum Corporation, Qatar Petroleum International

Deal value $3.7B Transaction type Greenfield

The Story As Karim Sadek recently told Privcap, things go wrong in most private equity deals, but Citadel ↓50% Capital’s plan to build a refinery in Egypt set a new standard for complexity. The financial crisis and Arab Spring occurred just as Citadel was completing major financing agreements. Only after many Diesel Imports months of negotiations—some with a government whose leadership was uncertain—Citadel = completed the financing on the $3.7B deal in June of 2012. Watch the full story here ). $300 There was a lot of waste happening, which was permis- Million “ Savings sible—I won’t say acceptable—when a barrel of crude was at $4 or $5 a gallon, but not when it’s at $100. The value you’re leaving on the table is too much.” –Karim Sadek

Privcap Digest / February 2013 / 11 12 / Special Report

By David Snow and Matthew Malone Illustrations by Raul Arias The Incredible Shrinking GP

Using the saga of a fictitious private equity firm we’ll call Destiny Equity Partners, Privcap charts the franchise impact of a smaller follow-on fund with smaller fees. It is a story that will ring true for many GPs who now must operate in leaner, meaner conditions

Privcap Digest / February 2013 / 12 13 / Special Report

hat happens to your firm’s finances when your next fund is a smaller fund and the fees aren’t as GP friendly? Let’s find out. It’s a math exer- cise worth undertaking because, many, many firms across the private equity market are facing exactly this reality. Let’s pretend there is a firm called Destiny Equity Partners. If we compare the fee revenues generated by Destiny at its peak in 2006 versus its diminished fund and fee position in 2013, we see a firm that is forced to promulgate its business with a rough- ly 37 percent reduction in fee income—and steadily declining. Like many successful buyout firms, Destiny’s life began in the 1990s with the close of its debut fund at an impressive $400 million in committed capital. Notwithstanding the “two and twenty” shorthand for alternative-investment fund economics, Destiny’s limited partners agreed to a 1.85 percent management fee, designed to support the operations of the new firm. And in truth, the $7.4 million in annual revenue that is not spent on firm resources and salaries tends to go in the partners’ pockets—it’s not a bad way of life. Further generating wealth creation for Destiny’s founding partners are transaction fees—each new deal done provides the opportunity for Destiny to charge its portfolio companies investment-bank-style fees on top of the management fees already charged to the LPs. The GPs share 50 percent of these “deal fees” with the LPs. Fast-forward to 2006, and things have never been better for Destiny Equity Part- ners (see 2006 “Snapshot” table). The private equity industry has grown tremendously with unprecedented inflows of institutional capital, allowing Destiny, with its solid . CONTINUES ON NEXT PAGE 2006 Destiny Equity Partners Snapshot

Capital Snapshot TERMS & CONDITIONS (Same for Funds I, II, III, IV) Fund Amount Raised Remaining Invested Capital • Carried interest 20% I (1994) $400M $50M (Year 13) • Management fee on committed capital (first 5 years) 1.85% II (1997) $900M $200M (Year 10) • Management fee on remaining invested capital III (2001) $2B $1.5B (Year 6) (starting year 6) 1.5% • Management fee on invested capital during extension IV (2005) $5B N/A (Year 2) period (starting year 13—negotiated for Fund I) 0.5% • Transaction fee sharing 50/50 Fee Sources Fund Remaining Invested Capital Management Fee Transaction Fee Revenue I $50M (Year 13) $50M x .5% de minimis $.25M II $200M (Year 10) $200M x 1.5% de minimis $3M

III $1.5B (Year 6) $1.5B x 1.5% de minimis $22.5M Fund Committed Capital Management Fee Transaction Fee Revenue $15M ($1B deal equity x 3%, IV $5B (Year 2) $5B x 1.85% less 50% LP share) $107.5M

Total Revenue for 2006 $133.25M

Privcap Digest / February 2013 / 13 14 / Special Report

investment track record, to raise a $5 billion fund the prior year. This is its third follow-on fund to have been much bigger than the previous effort. Given the fervor that LPs have to commit capital to the asset class, Destiny has been able to maintain its economic fee terms—the management fee holds steady at 1.85 percent of committed capital, and deal fees are shared on a 50/50 basis. After a period of five years, the management fee drops to 1.5 percent and is now calculated based on the amount of equity invested in deals that have yet been exited. By 2006, the firm has grown its roster of employees to 70 and has added many new partners as capital under management has grown.

Destiny Equity Partners Snapshot 2013 The firm’s new fund is notably smaller than the last one, and the economic terms have tightened in favor of the LPs

Capital Snapshot TERMS & CONDITIONS (Funds I, II, III, IV extensions & revisions included) Fund Amount Raised Remaining Invested Capital • Carried interest 20% I (1994) $400M Closed • Management fee on remaining invested capital for Fund IV (unchanged terms—fund is in year 9) 1.5% II (1997) $900M Closed • Management fee on remaining invested capital for Fund III (2001) $2B $800M (Year 13) III (revised extension terms—fund now in year 13) 0.5% Fund V: IV (2005) $5B $2.5B (Year 9) • Management fee on committed capital (first 5 years) 1.5% V (2012) $3B N/A (Year 2) • Management fee on remaining invested capital (starting year 6) 1.25% • Transaction fee sharing: 100% to LPs Fee Sources Fund Remaining Invested Capital Management Fee Transaction Fee Revenue III $800M (Year 13) $800M x 0.2% de minimis $1.6M IV $2.5B (Year 9) $2.5B x 1.5% de minimis $37.5M Fund Commited Capital Management Fee Transaction Fee Revenue V $3B (Year 2) $3B x 1.5% $0 (100% to LPs) $45M

Total Revenue for 2013 $84.1M

Excluding carried interest payments (which go directly to the personal accounts of those in the “carry pool” and not toward the operations of the firm), the firm in 2006 generates $133.25 million from management and deal fees across four active funds, or nearly $2 million per employee. Times are good, and the founding partners wonder aloud how much they should plan on raising for the next fund—$7 billion? $9 billion? Then Came 2013 The world did not continue on an upward trajectory for Destiny Equity Partners. It turns out that 2006 was a year marked by irrational exuberance in all markets affect- ing private equity—fundraising, debt, M&A. . CONTINUES ON NEXT PAGE Privcap Digest / February 2013 / 14 15 / Special Report

Destiny Equity Partners Revenues, 2006 vs 2013 2006 Revenue $133.25 M 2013 Revenue $84.1 M ↓37%

After hitting the fundraising trail in 2010 with The reduction in investment talent is not sim- Notes: higher hopes, Destiny ends up closing on $3 billion ply a function of the greed of top partners—since 1. For the sake of simplicity, we do not account for any in commitments for Fund V in 2012. The partners 2006 it has become much more expensive to be a management-company revenue derived from car- feel fortunate to have secured capital, but they rec- private capital firm. Destiny has had to become a ried interest and assume ognize that their business is going to look and oper- Registered Investment Advisor with the SEC, and this goes entirely to the personal accounts of those ate differently. Not only is the firm’s base of capital it spends some $1 million per year on compliance in the carry pool. smaller with the new fund, but the terms and con- expenses. 2. We assume that the ditions agreed to by the limited partners reflect a In addition, its limited partners demand a much key economic terms and conditions are the same changed environment in which the investors have higher level of service, requiring Destiny to bulk up for Funds I, II, III, and IV, greater negotiating power. The management fee on its investor-relations staff, back office, and other although in reality there more likely would have committed capital has dropped to 1.5 percent, and support services. been variance across the deal fees go entirely to the LPs. The new environment has now actually made vintages. 3. Management fee income At the very least, Destiny is drawing fees on it more difficult for Destiny to retain the talent in our example is charged remaining invested capital from Fund IV, now in for which it has already budgeted because of the on total committed capital during the first five years its ninth year. The good news is that the intermit- characteristics of the carried-interest “distribution and then moves to total tent years have been horrible for exits, and there waterfall.” The firm’s first through third funds have remaining invested capital during the subsequent is still much invested capital to charge a fee against. “American-style” waterfalls that tend to pay out years. The bad news is that with each new year this num- carry earlier in the fund’s life. This has been a nice 4. We assume a need to ber will decline and with it the overall fee base for feature, especially for junior investment profession- negotiate a fund extension at the end of year 12. the firm—they’d better raise a bigger next fund or als who are allocated points of carry and get to enjoy 5. We assume that the bulk of things will start to get ugly! the fruits of the firm’s success while still relatively deal fees come upon initial investments, with the Destiny has been able to agree to a fund-life young. GP charging a 3 percent extension with its limited partners for the long- For Fund IV, Destiny has been compelled to fee for each equity check. Subsequent deal fees like in-the-tooth Fund III, now in its 13th year. But the adopt a “European-style” waterfall, which does not monitoring, board, and extension only gives Destiny a 0.2 percent manage- begin to pay carry to the GP team until all commit- exit fees are de minimis (although some firms ment fee on the remaining invested capital in the ted capital has been returned to the LPs. This means charge hefty fees for termi- fund. The message from LPs is, “Hurry up and liqui- that everyone allocated carry in that fund will like- nating monitoring fees). 6. For the sake of simplicity, date that portfolio.” ly have to wait years—perhaps as long as eight to we assume all funds close ten years—before beginning to see the big bucks (if and begin the management Impact Analysis there are indeed any to be had). It leaves the non- fee “clock” on Jan. 1 of the Having gone from fee revenue of $133.25 million in year in which they reach founding professionals more vulnerable to being final closes. 2006, Destiny in 2013 expects revenue of $84.1 mil- poached by bigger, wealthier firms that can promise 7. In reality, standard lion, representing a 37 percent decline. What im- terms vary between fund a faster track to wealth creation. pact will this decline have on the franchise? sizes—with larger funds It is surely nothing to sneeze at that Destiny typically charging smaller First and most importantly, there isn’t as much, management fees. In the Equity has a brand-new $3 billion fund to put to or any, management fee and deal fee income “left venture capital market, work in a recovering economy, which is a better management fees tend to over” for the partners to pocket. The fee stream be higher. situation than many fund-challenged market par- more closely matches the essential expenses of the 8. These revenue figures are ticipants. But the business is a different business, pre-tax, although we will firm, and in fact the firm has had to recalibrate its forcing the top partners to be as rigorous in map- note that possible tax expenditures to reflect the new revenue. changes will likely further ping out their own operations as they require of affect firm operations. In 2006, Destiny had 70 employees with $1.9 their portfolio companies. The founding partners million in revenue per employee. If all 70 employ- Special thanks to Kelly can be forgiven for occasionally lapsing into nos- Deponte of Probitas Partners ees stayed on board through 2013, that revenue- talgia for the middle of the prior decade. And don’t and Earl Macomber of Noson per-employee figure would drop to $1.2 million. Lawen Partners for their ex- mention taxes. ■ pert guidance on this article The firm decides to close one of its three offices and let a number of partners and supporting professionals go.

Privcap Digest / February 2013 / 15 16 / Keynote

Click to watch this video at privcap.com KKR Looks to the Future Scott Nuttall opens up about missed opportunities and the firm’s expansion beyond private equity

When you go build relationships with management teams, they don’t think of you as just a private equity person. You’re building trust. They like you. They call. And they say, you know, “I need help with this.” And what happened in our business is that we started to get a lot of those phone calls, especially in the ’01 to ’03 period, when companies needed capital. They just didn’t necessarily need it in “private equity” form. And so by building these relationships, our deal teams started to source very interesting risk/ reward opportunities. And a lot of them didn’t fit in a private equity fund. So these calls would come in. They’d say, “Well, can you help us with this?” We’d look at it and say, “It’s a great risk/reward. We'd love to make that investment. But it doesn't fit.” And so frustration builds up over time. And we started to track it and literally built a spreadsheet of all the things we could have done if we had the ability to say yes to those situations that we found interesting. And then we tracked who made the investment and how they did. And frankly, it was a very depressing spreadsheet. Bio So we said, well, that’s kind of dumb. We’re investors. We don’t have to think of ourselves as Scott Nuttall joined KKR in 1996 and is head of KKR’s Global Capital and Asset just doing this one thing. We know companies. We Management Group, which includes KKR Asset Management, KKR Capital know industries. Let’s find a way to say yes and be Markets, and KKR’s Client and Partner Group. He is currently a member of the relevant. boards of directors of First Data Corporation and KKR Financial Holdings. That’s what led us to say, “Okay, maybe we should think about doing other things.” And so that’s how the evolution started. Frankly, that spreadsheet had Privcap: What prompted KKR to expand beyond a number of investments that were largely struc- private equity? tured credit investments. So we started with credit. Nuttall: In the year 2000, we told our teams, don’t We wanted to be relevant to those opportunities chase auctions. Go out and build relationships with that were on that spreadsheet. And that’s how we management teams in the industries that you started the expansion of the firm. The same thing cover. And have a set of themes that you think will happened in energy and infrastructure. It’s just play out over the subsequent five to 20 years. been a continuation of that theme as we’ve evolved the firm. . CONTINUES ON NEXT PAGE Privcap Digest / February 2013 / 16 17 / Keynote

How do you respond to concerns that, as a public And so we look to capitalize on that in a couple company, KKR risks misalignment between the of different ways. Firstly, we said, let’s aggregate interest of the firm, its limited partners, and its some shale plays and then sell it to those guys. shareholders? So we did two deals, East Resources and Hilcorp. We helped them scale. And then we sold East Nuttall: We became public in a very unconven- Resources to Shell and Hilcorp to Marathon. And tional fashion. We had created a closed-end fund so that was one way to do it—actually create the in Europe. We raised $5 billion. That $5 billion was product they want to buy and scale. invested in our private equity funds and coinvested The other way we looked at it was actually in our private equity deals. And we merged KKR giving them cash to go invest in shale. Let’s buy into that closed-end fund—didn’t sell any stock. their conventional oil and gas fields and develop Nobody sold any shares. And then we moved that those fields better than they are. So we created combined company from the Euronext Amsterdam the business—it’s called KKR Natural Resources— Exchange to the New York Stock Exchange. to go buy that. There’s very few participants in So it’s kind of a roundabout way to become pub- that space, so we’ve been able to make some very lic. But critically, for us, nobody sold any stock. We interesting investments there. So that’s a couple actually locked people up for longer than, frankly, different ways we’ve been playing that theme. the vesting on their carry. So we used it as a way to Infrastructure’s yet another one. There’s tril- lock people in. lions of dollars of need in the infrastructure space. Now we’re our own largest investor. We have All you have to do is to fly from the Beijing Airport $6.5 billion of permanent capital. We hold more of to JFK and you can see we’ve got some work to do. our investments than anyone else. And as we seek And so what we found is that there’s not a lot of to grow the firm, it gives us capital to seed growth. capital formed around that opportunity either. But it also allows us to sit down with investors and And the original way infrastructure funds were say, “We’re actually more aligned with you than ever getting invested didn’t work out so well. We saw before, because we gave up some of the manage- a new way to do it—more operationally focused. ment fees and carry—30% of that—to be more like a So we created an infrastructure business and are limited partner.” quite busy. Because if you think about the pres- Timeline: KKR Moves Beyond PE sure on federal, state, and local budgets, they just don’t have the capital to do it. So it’s moving 2004 Credit (asset management) 2009 Energy (dedicated/non-PE) much more to a private model. 2006 Capital Markets 2011 Real Estate (dedicated) Brazil is unquestionably “hot” right now, yet KKR 2008 Infrastructure 2012 Third-Party Capital Markets has treaded rather lightly there. Why?

Nuttall: We’ve tried to be very measured in our KKR recently amassed more than $4 billion to approach. As we sought to figure out what to invest in energy and infrastructure. Where do do in South America, we’ve been sending teams you see opportunity? down and looking at transactions in Brazil and Nuttall: The overarching way that we think about other parts of South America for quite a while the world right now is there’s a lot of supply and now. demand imbalances. And there’s a significant But we’ve tried to be very disciplined about it. need for capital in both energy and infrastructure If you hire a bunch of strangers and put them in a that is not really being met by traditional pools market and say “Go for it,” that tends not to work of capital. And we find that imbalance pretty that well, in our experience. So that’s not some- interesting. thing we’re going to do. Take, for example, oil and gas. Unconventional What we’ve done thus far is brought on board a shale plays have become of great interest to the senior adviser named Enrique Morales, who was conventional players. They need about a trillion the former head of the Central Bank of Brazil. He’s dollars to actually develop the shale plays. They joined us to help build out that effort. And one of do not have a trillion dollars. What they have is a our colleagues who was in New York with us here large portfolio of conventional oil and gas assets. has also moved down. And we’re creating an of- We looked at this imbalance, and it was very clear: fice in São Paulo. Companies that had access to the shale plays were We’ve got teams from all around the world trading at a two- or three-point EBITDA multiple going down and looking at transactions. And at premium to those that did not. some point we’ll hire a local team as well, when CONTINUES ON NEXT PAGE Privcap Digest / February 2013 / 17 18 / Keynote

we find someone that fits culturally and we think will help us build the business we want. In which of KKR business lines do you expect to see the most growth?

Nuttall: As you look at KKR today, we have one scale business, which is our private equity business. We have about a 4% market share in a trillion-dollar market. We’re the biggest player in that business. And we have more opportunities to grow it. But we’re a big player there. Everything else we’ve talked about, whether it’s credit, real estate, en- “We built a spreadsheet of all the things ergy, infrastructure, hedge funds—all the differ- we could have done if we had the ability ent businesses that we’ve now entered—we are relatively new and relatively small. to say yes to those situations that we In addition, the end markets are much larger. found interesting. And then we tracked So if you aggregate the end markets of those new areas, it’s over $5 trillion relative to the $1 trillion who made the investment and how in PE. So we see lots of opportunities for growth, they did. And frankly, it was a very frankly, in all of these newer efforts. I think you’re going to see a higher percentage of growth out of depressing spreadsheet.” Names the newer efforts, given that they’re still getting to scale. sleep at night, knowing that I’m generating at least an 8% return from I think energy and infrastructure will continue something that I’m doing.” And so we’re finding a lot of interest in to grow. We’ve gone from no assets to $4 billion yielding products globally. in two years. I think we can keep scaling that. What does the performance of your portfolio companies tell you Our credit business is $16 billion. But given the about where we are in the economic cycle? size of the credit markets, we’ve got lots of room for growth. Real estate is a start-up. Our hedge Nuttall: Let’s break it down. In the U.S., I’d say we’re doing a bit bet- fund is a start-up. So there are lots of places we ter than bouncing on the bottom. We can’t seem to put together, as see opportunities to grow the firm—in North an economy, a sustained period of decent performance. It’s just good America but also in Europe and Asia. month, bad month, good month, bad month. Our companies have And unless you have expertise in the local mar- actually performed quite well, but it’s because we’ve been very disci- kets, then it’s quite difficult to do. plined around the expense side. The challenge is revenue growth. So you’ve just got to stay opera- Which asset classes or regions do you expect to tionally disciplined. You’ve got to consolidate and take market share in present the most opportunities? times like this. Nuttall: If I had to pinpoint areas where I see But it’s also a good time to put money to work. We did $26 billion more aggressive growth opportunities, Asia would worth of transactions last year just in private equity, and the vast be one. We’ve now got a footprint in Asia. I think majority was in North America. So when you have a long-term holding the firm at large is very focused on how we’re period like we do in private equity, this is a good time to plant seeds. At going to continue to build out in that market, some point, the economy will feel better than it does now—multiples both in private equity and in other asset classes. will keep going up. And there will be an attractive opportunity to exit. I think our hedge fund effort—we’re seeing Europe is weak. We think the GDP forecasts are too optimistic. lots of capital rotate into those types of vehicles. But our portfolio is today, happily, largely focused in northern Europe, There’s a real interest in liquid alternatives. And which has been somewhat less exposed to the ills of the continent. So I think anything that’s got liquidity to it is going our overall European portfolio has been performing well—probably bet- to be pretty attractive to institutional and retail ter than we would have expected. investors. So I think you’ll see more growth out of Asia is slowing down a little bit. But I think some of the anxiety is a liquid alternatives for us and others. bit overdone. If China grows at 7% instead of 8.5%, there’s going to be all And then, as we look at the world today, people sorts of anxiety about that. But honestly, last I checked, 7% is probably want yield. People are saying, “I don’t want to lose a bit better than what we’re seeing in the U.S. and Europe. And even in my money. I’d like to book a current return that places like India that are having their own sets of issues, we’re seeing is attractive and has some upside. But I want to growth. So, on a relative basis, Asia’s still very attractive. ■

Privcap Digest / February 2013 / 18 19 / Sector Focus

Click to watch this video at privcap.com The Healthcare Opportunity It’s widely accepted that healthcare spending will be an ever-growing part of the U.S. economy, but that consensus is of little comfort to those hoping to profit from it. That’s because the size of the opportunity is matched by its complexity. Few industries are as susceptible to the whim and wisdom of policymakers, the central planners who not only approve medica- tions but, in many cases, decide who gets covered, for how much, and by whom. We spoke with three experts in the healthcare space—Tammy Hill of McGladrey, Sherrill Neff of Quaker Partners, and Jim Elrod of Vestar Capital Partners—to help cut through the regulatory fog and provide practical solutions to the challenge facing private equity investors. Key Findings

➊ Management and execution are critical in an uncertain healthcare environment ➋ Reimbursement and “government” risks are hard to measure—and fatal if miscalculated ➌ Some healthcare sectors should be avoided altogether ➍ Companies that provide cost-saving care and products are best bets ➎ Regularly update due diligence to reflect the changing environment

Finding 1 they’re going to build out the team to realize the opportunity is much more important than it used to be because of the changing landscape. To have Management and execution are confidence that this person has the vision to do critical in today’s uncertain healthcare that is really important these days.” environment Private equity firms don’t want to buy a company and watch the management team retire to a The healthcare industry is volatile. Technology is beach somewhere. They need the team to stay on, constantly and rapidly evolving, and government execute the plan, and drive success. efforts at reform have injected additional uncer- “That’s absolutely true in the deals we see,” said tainty into the market. In this environment, high- Tammy Hill of McGladrey. “Most of the entrepre- ly skilled management teams are critical. neurs in the healthcare sector, as opposed to an “It used to be an old saw,” said James Elrod older industry like manufacturing, these are rela- of Vestar Capital Partners. “Give me an ‘A’ man- tively young entrepreneurs, and our clients aren’t agement team and a ‘C’ business any day. We all interested in seeing them go away. Part of the in- used to pay lip service to it, but it’s really true. To vestment they’re making is in the management hear the CEO’s or the entrepreneur’s plan on how team, the top level of management.” . CONTINUES ON NEXT PAGE Privcap Digest / February 2013 / 19 20 / Sector Focus

“Most of what we see are one-off deals where the buyers are pursuing smaller niche players who are geographically concentrated. It’s not a situation where the deal flow is coming from big investment banks and they’re bringing it to a lot of buyers. It’s people going after the players because of the expertise they have and the operating partners that they team up with.”–Tammy Hill

“Our experience has been that you’re pushed Finding 2 into the consulting world, maybe with former administrators, et cetera, to give you a sense of what it was like when they were there,” he said. Reimbursement and “government” “But it’s a new game, and I’m not sure that any- risks are hard to measure and fatal if body’s crystal ball, in terms of the next two or miscalculated three years on the federal level, is going to be worth a lot.” Healthcare investing has always involved uncertainty around reimbursement, regulation, and other “government” risks—politicians do- Finding 3 ing things that are hard to foresee. All the participants agreed that government risk is now at an all-time high, not only because the White House Some healthcare sectors should be is pushing through reform but because the gov- avoided altogether ernment is such a dominant force in healthcare regulation and payment. All three participants said there are some sectors “Almost all the products that come through our of healthcare where the risks make investment companies have to deal with the Food and Drug unwise. Elrod said capital-intensive services in Administration,” said Sherrill Neff of Quaker Part- the target zone for reimbursement cutbacks don’t ners. “And for the past five years, since the Vioxx look good for the next three to five years, even if blowup, the entire attention of the agency has they’re services that are in demand. been shifted to the safety end of the pendulum.” “Nursing homes would be an example,” he not- Once a product is approved, a company has to ed. “Very much a needed service, but the reim- figure out the reimbursement end of the equa- bursement focus that they’ve experienced recent- tion—and here again, the government plays a ly and the cost of admission—where you’re kind heavyweight role. Neff pointed out that the feder- of a genius if you have 93% occupancy and strug- al government now provides 45 cents out of every gling if you have 89% occupancy—means it’s just healthcare dollar spent—and predicts that spend- not an equation where it makes sense.” ing is very difficult. Neff said there are areas of therapeutics his firm . CONTINUES ON NEXT PAGE

Privcap Digest / February 2013 / 20 21 / Sector Focus

By the Numbers The value of healthcare private equity deals doubled, from approximately $15 billion in 2010 to about $30 billion in 2011, despite a nearly 10% decline in the number of deals. Source: Bain and Company, Global Healthcare Private Equity Report, 2012

“absolutely avoids,” including large-market drugs overall cost and get more people on appropriate that require extensive patient-safety data and clin- treatment,” Neff said. “That’s typical of a theme ical trials, and “me too” products like stents. that we’re trying to address.” Tammy Hill said clients of McGladrey are steering clear of companies whose profits depend on long treatments that historically have not had Finding 5 good outcomes. “It’s more about the innovation “The problem and how can you improve the outcomes, how Regularly update due diligence to we face today is can you get people out of the hospital.” reflect the changing environment that the public market is an on- again, off-again Finding 4 Due diligence is a vital step prior to any invest- experience and ment. But the areas of concern change over time. pretty unreliable What was diligence a few years ago could be neg- Companies that provide cost-saving in terms of ligence today. In an industry shifting as quickly care and products are best bets when the gates as healthcare, private equity partners must con- are going to be stantly update their list of red flags. open. That has The most urgent issue in U.S. healthcare is cost. Elrod said Vestar now pays particularly close driven more This logically makes companies with products attention to organizational details. “One of the transactions and services that cut costs attractive investments. items we look at is not whether the entrepreneur into the hands of “One of the themes that we’re quite focused on as or the CEO has simply a vision for where the busi- private equity.” investors right now is how to tackle significant ness could go but whether they’ve got the organi- problems in medical care or medical delivery with zational chart plotted out on what they need to do —Jim Elrod solutions that are both cost-effective and result in to make the investment thesis come to fruition.” better quality,” Neff said. Hill said several high-profile cases of payment He gave an example, a recent Quaker Partners fraud in the past decade have forced much closer investment called NovaSom. The company sells scrutiny of reimbursement, especially govern- an in-home device for diagnosing sleep apnea, a ment reimbursement. “In a situation where the condition that affects some 28 million Americans up-front diligence would start to point out poten- and is linked to a wide range of very expensive, tial problems on the billing or the collection side, very serious medical conditions, from cancer to it would most likely be a deal killer.” heart disease. Neff agreed that reimbursement must be an People who suspect they suffer from sleep ap- area of concern in any healthcare investment. He nea have traditionally checked into a clinic run by said Quaker Partners has walked away from sev- a hospital to spend the night hooked up to an ar- eral seemingly attractive deals recently because ray of electrodes and sensors. It’s uncomfortable the reimbursement now enjoyed by those compa- and expensive—anywhere from $1,500 to $3,000 nies was “too good to be true.” per night—preventing more patients from get- “In one case, since we turned down the deal, ting tested. other people invested, and it has in fact proved NovaSom appeals to payers because it cuts out the way we suspected it would.” costs and helps more people get diagnosed for He agreed that GPs these days must be able sleep apnea before the disorder leads to more to find companies that create value and, just as serious and expensive conditions. NovaSom important, dodge those deals that will destroy appeals to patients because they don’t have value. “We make all our partners take dancing to spend the night in a hospital bed. “We can lessons.”■ put into patients’ hands something that’s less costly for the payers—and they can significantly increase their volume without increasing their

Privcap Digest / February 2013 / 21 22 / Deep Dive

Click to watch this video at privcap.com Fired Up Russell Deakin of Rio Bravo Investimentos and Scott Swensen of Conduit Capital discuss the profits and perils of Latin American energy investing

Russell Deakin Scott Swensen

Bios Privcap: What’s driving the ability to make Russell Deakin is a Managing Director of Rio Bravo money as a private equity investor in Brazil’s Investimentos, an independent asset management firm. energy scene today? With a total AUM of USD 2.5 billion, the firm specializes Russell Deakin, Rio Bravo Investimentos: Macro in Brazilian assets and long-term investment strategies. economics and demographics. First, it has a $2.2 The firm has approximately 90 professionals based in trillion economy, so we have scale. And in the last São Paulo, Rio de Janeiro, Recife, and Miami. decade, of the 200 million people in Brazil, 75 mil- Scott Swensen is the Chairman of Conduit Capital Part- lion have moved from the lower class to middle ners, which he founded in 2003. He has a long career class, or even middle class to upper class. That’s in private equity investing and global finance, and has obviously generating more energy consumption spent the last 18 years as lead investment manager of and more demand. the Latin Power Funds. Brazil has about 113 gigawatts of installed capacity. So it’s the third-largest market in North Ameri- ca, behind the U.S. and Canada. But even looking at “There’s a need of about $130 billion of conservative estimates over the next eight or nine investment just to meet the minimum years, there’s a need of about $130 billion of investment just to meet the minimum energy capacity energy capacity for the country to grow for the country to grow at a sustainable rate. There’s at a sustainable rate.” a great foreseen, forecasted shortage, and that needs to be financed. So that creates a lot of opportunity. Russell Deakin, Rio Bravo Investimentos And we have very high yields in Brazil. We can do purchasing contracts that give a nominal yield of 18%, and then total returns much better than that. We’re looking at nominal rates of high 20% to low 30. It’s one thing to identify an opportunity in Brazil, and quite another to deploy the capital. What do institutional investors need to understand about . CONTINUES ON NEXT PAGE

Privcap Digest / February 2013 / 22 23 / Deep Dive

Total Primary Energy Consumption on a risk/reward basis, it’s very intriguing. You have that protection on the downside, but because it’s a in Brazil (2010) new, developing market, you still have very attrac- Source: EIA, International Energy Statistics tive private equity-like returns. If that’s true, why don’t you have more competition?

Swensen: We do, but it’s on the larger deals. The global strategic power companies are all over Latin America. And Brazil’s probably the only 29% market where the majority of power is domesti- Hydroelectricity cally owned. Most of the other countries have 39% sold their utilities out. If you’re an AES or a Duke Oil & Other Energy, the thought of spending three years to Liquids 1% build a $50 million hydroelectric plant just doesn’t Nuclear 3% work with their cost structure. While there’s a lot of activity at our lower lev Coal 7% 21% el, it’s us and some local players. The global funds Other that have tried to go into our business have not Renewables succeeded. And so we think we’re in a really Natural unique position. Gas How about you, Russell? What does the competitive landscape look like for your firm? the private equity opportunity in Latin American energy to be successful? Deakin: There is competition on the large scale, there’s no question. Even more so in Brazil, be- Scott Swensen, Conduit Capital: The great misper- cause Brazil’s more attractive in terms of inter- ception among investors is that this is a highly national investors coming and looking at it and regulated business. Once you sign a power contract, having scale. For the large companies, scale is whether it’s with a municipality, a distribution important. company, or an industrial—whatever rate of return For example, on a hydro, we’re going to invest you’re able to make, you keep. In the 19 years we’ve in 161 megawatts. That’s attractive for a larger been doing this, we never once have had to show player. But one of the projects we’re doing is only financials to a government agency. It’s an unregu- three. That’s not of any interest to the larger player. lated business. People don’t understand that. And on wind projects, we’re doing 524 megawatts; Russell, what are some things that institutional 524 megawatts is one of the biggest wind projects investors would be surprised to learn about the in all of Brazil. But again, individually, they’re quite ability to make money doing what you do? small. We also have relationships with the financial Deakin: One thing people don’t realize is that 85% companies, such as the Brazilian Development of the country’s energy is clean energy, primarily Bank. If you have outstanding relationships with hydro. That’s a very high percentage. them over the last 20 years, it certainly helps speed So clean energy is actually mainstream energy. up the process. And one of the biggest differences in Brazil is that And lastly is the auction process. The auctions are energy is unsubsidized. So it’s viable. typically twice a year, and they are “live.” It’s a very The other aspect is in terms of the perception of sophisticated process, a reverse Dutch auction. And the risk/reward—I can go into a contract, have a 20- you have to have all your financing, all your techni- year purchasing power agreement, and be locked cal analysis, in place, because if there are competing into a 17% or 18% nominal yield. In the contracts, you offers that are very close, you have to adjust quite actually lock in a real yield above inflation. quickly in real time. Even in the United States, over a 20-year con- And unless you have expertise in the local mar- tract, inflation is going to eat away at your real kets, then it’s quite difficult to do. return. In Brazil, you have that protection. And so . CONTINUES ON NEXT PAGE

Privcap Digest / February 2013 / 23 24 / Deep Dive

“Where we don’t see competition is at the smaller size. While there’s a lot of activity at our lower level, it’s us and some local players. The global funds that have tried to go into our business have not succeeded.” Scott Swensen, Conduit Capital

As you go across Latin America, how are you very competitive plant, we go home. We will not sourcing the assets and opportunities that rely on a pile of paper if the economics don’t sup- you invest in? port it. After that, we always insist on getting inflation Swensen: The most important source of deals for adjustments. us are local partners on the ground. And typically, they have done the up-front development. Russell, what are some of the risks that you So they’ve spent $1 million to $3 million. They spend the most time with before you do a deal? have a site. They have an environmental impact Deakin: Well, our fund, as you know, is focused on statement that’s approved. They have a potential Brazil. But Brazil itself is a very large country. It’s off-taker. larger than the continental United States. And so So for us, the most critical is aligning ourselves land cost varies tremendously. Land in São Paulo, with those technically qualified, competent de- for instance, isn’t viable at this point. velopers. And we have a number of them in many So we need to geographically diversify our countries. investment. What are the more common risks that you Which countries have you avoided altogether, analyze for your deals? And how do you decide either because a deal never came up or you just whether they’ll be a factor? absolutely will not go there? Swensen: We want to invest in a plant that is Swensen: We’re avoiding what we would call the very economically competitive in its host market. Chavez axis—Venezuela, Ecuador, Bolivia, Argen- And so one of the first things we do is we hire an tina, Nicaragua, and Belize. If you’ve got a risk engineering firm to model the plant, whether it’s of expropriation or of adverse price caps, it can existing or a new build. absolutely destroy your investment. ■ We look out 15 years and ask: Where is this plant going to rank in the cost of power in that country? If we don’t find that this is going to be a

Privcap Digest / February 2013 / 24 25/ Insight

Click to watch this video at privcap.com Back to Basics

What are some other lessons you’ve learned? Steenberg: Private equity has been and will continue to be a people business. It’s about relationships. It’s about contacts. It’s about being able to do business with people. The other thing we look for in each of our investments—whether it’s a general partner team that we’re looking at or management teams when we’re doing co-investment—is passion for the business. It’s those individuals with passion that we want to find and put money to work with. Investors are changing their assumptions about Russ Steenberg, the head of BlackRock how their portfolios should perform. What does Private Equity Partners, says PE investing is a that mean for private equity? “simple” business—requiring perfect execution Steenberg: You can pick any 20-year time period you want and private equity performs ten to 500 basis points better on average than the public markets. Now, if you’re with the right people who Privcap: You’ve been an LP with AT&T Investment Managers. You have the right capabilities and the right skill set, were at Merrill Lynch and Fenway Partners. What are some of the you should be able to do better than the average lessons you’ve learned? return. So private equity becomes a very attractive asset class compared to the public markets today, Russ Steenberg: Everyone wants to make this business very complicated. given the environment we’re in. If we’re in a long And at the end of the day, I’m not sure that it is. What I’ve learned—and deleveraging cycle, as many people say we are, Joe Rice at Clayton, Dubilier & Rice told me this a long time ago—he said, we’re in the mid-innings or early innings of that “Russ, this is a business of cycles. It always has been and it always will ten-year cycle. The expectations over the next be.” And that was in the late ’80s. I’ve seen nothing since then that would 10-year cycle would be, hopefully, for an improv- change my view. Knowing how to play the cycle becomes a very important ing economic environment worldwide. Which skill set that private equity people need to have. So when the cycle is hot, means the money that’s going in the ground you can sell into it. That’s how you make a lot of money. And when the today will have a cycle to sell into, where you can cycle is not hot, if you have capital, it normally is a good time to put it to also get multiple arbitrage off of increasing cash work—so when the cycle turns, you can sell those assets and make a lot flow and as a result make a whole lot of money. of money. Again, it’s not a complicated business in that sense. You’ve said that BlackRock itself is a private equity success story. What do you mean by that?

“Private equity has been and will continue Steenberg: Most people don’t understand that to be a people business” BlackRock’s origins were as a private equity company. Today it’s the largest publicly traded asset manager in the world. But more important than being the largest is we are a pure fiduciary, and we only manage clients’ money. So the interest and the alignment with our clients is as pure as you can find in the world today, just like you want in the private equity world. ■ Privcap Digest / February 2013 / 25 26 / Calendar Must See / Upcoming programs on Privcap.com

Calendar February 4, 2013

Cordiant’s Emerging World View A conversation with David Creighton of Cordiant Capital

Technology M&A and the Private Equity Opportunity A conversation with Jeffrey Liu of Ernst & Young

February 11, 2013

Carlyle’s Next Generation A conversation with Glenn Youngkin

New Rule No. 3—The Fund As You Know It Will Not Be Your Next Fund Part three in the ‘New Rules of Private Equity Fundraising’ series

Alternative Finance for the Middle Market A conversation with Jim Hunt of THL Credit

IPOs and the New VC Exit Reality A conversation with Jim Robinson of RRE Ventures

February 18, 2013

ESG Success Stories TPG and Carlyle

Why CIOs Like Private Equity A conversation with Russell Steenberg of BlackRock Private Equity Partners

Evolving LP Attitudes Toward Emerging Markets A conversation with Adiba Ighodaro of Actis

The Energy “Revolution” A conversation with Marc Lipschultz of KKR

Investable Africa A conversation with Runa Alam of Development Partners International

Making It in the Middle Market A conversation with Marc Utay of Clarion Capital

February 25, 2013

ESG Case Studies and Cautionary Tales Three experts discuss ESG in the emerging markets

Private Equity Meets Venture Capital A conversation with David Hellier of Bertram Capital

PE Investing—The Lower-Middle Market A conversation with Kirk Griswold of Argosy Capital

LLR Partners: Evolution of Middle Market Investing A conversation with Mitchell Hollin of LLR Partners

Privcap Digest / February 2013 / 26 27 / From Our Sponsors

Click to watch this Expert Q&A/ video at privcap.com with Jennifer Cho Rinehart, Managing Partner, MVision Private Equity Advisors

ing at. But I think—if you can align all of those elements, and that you can show that the opportunity’s an exciting one, so it’s not just another plain vanilla middle-market buyout fund, but there’s something about the way they buy or what they buy that’s differentiated—I think there is a whole universe of investors that can get very excited about that. I think the converse is true as well. There’s a whole universe of investors, no matter how good the experience or track record or strategy is, [who] will never do a first-time fund. So part of the knowledge that we bring to the table is that historical knowledge of which investors would be more inclined.

What level of due diligence does MVision perform on its own potential GP clients? Jennifer Cho Rinehart, Managing Partner, MVision Private Equity Advisers So we would run the GP through our own due diligence process, which is very similar to that of your traditional LP. And I think we’re email: [email protected] Web: www.mvision.com going through the strategy, making sure everything is internally consistent, spending time with Snapshot Almost half of MVision’s clients have been first- the entire team, and really understanding where time funds. Why? potential weaknesses may be. Education: When we were starting out, I think that we So let’s not hope and pretend these issues Bachelor of Arts were looking for high-return opportunities, won't arise during the fundraising. Let’s be very in Ethics, Politics & and whether it was an existing fund or a new cognizant about it, and try to be offensive in the Economics, fund, we were indifferent. We thought we knew way we handle those issues, and build it into Yale University which investors we could bring on board to those maybe our materials, our marketing, the PPM, Experience: types of opportunities. as opposed to being caught on the back foot as Private Equity Group, I think as we’ve been growing our business you’re fundraising. ■ investment banking in the U.S., those types of opportunities happen division, Merrill Lynch to be a little bit more prevalent. You see the next Expertise: generation of leaders coming through in the Manages and over- private equity firms. There’s a natural inflection sees global fund- point. So we’ve seen a lot of opportunities on raisings, evaluates that front. general partners in North America, What kinds of questions do LPs tend to have and maintains LP about first-time funds? relationships with I think they’re looking for seasoned teams. the endowment, Experienced teams that have been executing foundation, pension, on a strategy for a long period of time. They want and insurance to see that that type of strategy is something that community they can repeat outside of that parent company or the platform that they were previously invest-

Privcap Digest / February 2013 / 27 28 / From Our Sponsors

Click to watch this Expert Q&A/ video at privcap.com with Tammy Hill, Managing Partner, Transaction Advisory Services, McGladrey

Tammy Hill, Managing Partner, Transaction Advisory Services, McGladrey

email: [email protected] Web: www.mcgladrey.com

What challenges do private equity firms face Snapshot How does McGladrey support private equity investing in the many sub-industries within the investments in the healthcare sector? healthcare sector? Expertise: We have a consulting practice and also audit There are so many regulatory issues and Financial due and tax, with a fairly good-size number of other factors that affect those industries that diligence on mergers people within McGladrey that specialize in and private equity groups are looking everywhere they and acquisitions literally spend 100% of their time in the health- can to, number one, confirm their investment Education: care area. These professionals exclusively serve thesis, but also, in many cases, help them, once BS, Accounting, with healthcare sectors such as classic hospitals and they’ve done acquisitions: how to grow, how to be highest distinction, physician practices, and also some of the one-off more cost-effective, looking for the right add-on Indiana University sectors like ambulatory surgical centers, equip- acquisitions—all of the things that are going to ment and service providers, and other kinds of make that investment successful. providers.■

Privcap Digest / February 2013 / 28 29 / From Our Sponsors

Click to watch this Expert Q&A/ video at privcap.com Ernst & Young’s Philip Bass on the growth of emerging markets private equity

Why are the largest private equity firms expanding into the emerging markets? When you take a look at the mature markets, the developed markets, you’re really looking at reduced GDP growth across the landscape. When private equity firms are looking at their portfolio and their investment strategy, they’re looking to diversify. That’s where the rapidly growth markets come in. Markets like Brazil, China, India, with higher GDP growth, really become much more attractive.

How does Ernst & Young help connect private equity firms with opportunities in the emerging markets? We have resources around the globe. So as different funds set up offices, we can intro- Philip Bass, Global Private Equity Markets Leader, Ernst & Young duce them. We can help them set up the office. We can introduce them to our local contacts, our local team, and really help them get started. So it email: [email protected] Web: www.ey.com/privateequity will be a much easier transition than it is. One of the keys to private equity is having resources on the ground. If you’re going to invest Ernst & Young’s new Global Private Equity Snapshot in Brazil, you have to be in Brazil. It’s connecting Watch report finds that GPs have been very them with our local resources, helping them get entrepreneurial in adapting to new opportuni- Experience: started, helping them develop their investment ties. Can you elaborate? E&Y's Global Private strategy, and then moving forward together. In putting together the PE Watch this year, Equity Market Leader we took a look at private equity behavior over Recent Work: Over the next 10 years, what is your prediction the last 12 months and looked at what was A study of PE exits for the magnitude of the impact that emerging happening in today’s market. One of the things in Latin America markets will have on the private equity indus- we noticed was that PE firms were behaving try? much like the clients that they were investing Emerging markets will continue to be an in—very entrepreneurial, adapting to the envi- increasingly big part of the overall portfolio ronment, adapting their operating model to the for private equity. I think we’ll continue to see current system. investment again, the attraction and the GDP So we talk about companies diversifying, going growth, the rising middle class in many cases. ■ public, diversifying into different businesses, diversifying into different markets, so really a com- pletely different ball game.

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