FRESNO COUNTY EMPLOYEES’ RETIREMENT ASSOCIATION … · 2010. 1. 14. · 2012. 2013. 2014E. 2015E....
Transcript of FRESNO COUNTY EMPLOYEES’ RETIREMENT ASSOCIATION … · 2010. 1. 14. · 2012. 2013. 2014E. 2015E....
SEATTLE | 206.622.3700 LOS ANGELES | 310.297.1777 www.wurts.com
FRESNO COUNTY EMPLOYEES’ RETIREMENT ASSOCIATION
October 1, 2014
Private Credit Portfolio & Investment Recommendations
C O N T E N T S
Private Credit Review Tab I
Additional Fund Information Appendix I
Manager Write-Ups Appendix II
Private Equity Outlook Appendix III
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E X E C U T I V E S U M M A R Y
The Retirement Plan’s long time horizon and returntargets resulted in an 8% target to private credit in thenew strategic asset allocation.
FCERA recently committed $20 million to ColonyDistressed Credit Fund III. Given these investmentsare structured debt rather than real estate, Wurts &Associates recommends reclassifying both Colonyinvestments into the newly created private creditallocation.
After the re-classification of Colony, the currentprivate credit investments constitute 2.0% of PlanAssets as of June 30, 2014
The goal of this presentation is to review:
1) Current capacity
2) The current private markets environment
3) Funds we believe deserve strong consideration
Data as of 6/30/2014
26.6%
24.7%
2.2%2.0%
5.9%
25.9%
12.7%
Private Credit Exposure by Fund
Colony Capital Angelo GordonLonestar IV TCW Shop3TCW Shop4 KKROaktree IX
Market Value of Private Credit Assets: $80.6 Million
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C U R R E N T P R I V A T E C R E D I T E X P O S U R E
Vintage Manager Commitment Market Value Net IRR Investing/ Distributing Fund Focus
2014 Colony Distressed Credit III $20 Million - - Investing Distressed/Restructuring
2012 Oaktree Opportunities IX $15 Million $10.2 Million 14.6% Investing Distressed/Restructuring
2010 KKR Mezzanine Partners $30 Million $20.9 Million 11.3% Distributing Mezzanine Debt
2010 AGO $30 Million $19.9 Million 8.2% Distributing Distressed/Restructuring
2009 Colony Distressed Credit I $40 Million $21.4 Million 18.3% Distributing Distressed Debt
2002 Lone Star IV $20 Million $1.7 Million 30.7% Distributing Distressed & Equity Assets
2002 TCW Shop IV $15 Million $4.7 Million 6.9% Distributing Distressed/Restructuring
1998 TCW Shop III $15 Million $1.6 Million 3.4% Distributing Distressed/Restructuring
TOTAL $185 M $80.6 M
• The $80.6 million represents 2.0% of plan assets, 6.0% below the target allocation for Private Credit.
• The unfunded private credit allocation is currently invested in a BC U.S. Aggregate Bond Index Fund.
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R E C O M M I T M E N T C O N S I D E R A T I O N S
Source: Financial Analysts Journal
• Due to the illiquid nature of private investments, maintaining a stable allocation is challenging:
• The amount and timing of contributions and distributions are uncertain
• Distributions can often be re-called within the investment period
• The private equity NAV’s rarely reach the commitment amount
• To address this challenge:
• Total commitments should exceed the stated dollar target.
• By doing so, the investments will eventually reach the target suggested by the policy.
• Investing as opportunities present themselves, and using proven, experienced managers, is more important than hastily investing the necessary capital to reach the target allocation.
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P R I V A T E C R E D I T P R O J E C T I O N
Overall market conditions, total fund performance and the rate of return on existing commitments will allsignificantly influence private credit placements moving forward.
Using conservative assumptions, we have modeled:
A $60 million per year pace of contributions results in the 8% target being met in 2020 (see below)
A $100 million per year pace of contributions results in the 8% target being met in early 2018.
Assumptions:• A 1.5x multiple on committed capital is assumed for all investments. • All commitments are assumed to be fully called in the first three years of the life of the fund. • All new funds are assumed to begin distribution of assets over 4 years at an even pace 3 years after the last capital call.• All funds currently in distribution are assumed to evenly distribute assets over the remaining investment term (10 years from vintage year).• Total Plan Assets assume a 6.5% annualized return as described in FCERA’s 2013 Asset Allocation Study.
Fund Vintage Year
Total/New Commitments Called to date Estimated
MVSecond Half
2014 2015 2016 2017 2018 2019 2020
TCW Shop III 1998 $15,000,000 $15,000,000 $1,631,428 ($1,631,428)
TCW Shop IV 2002 $15,000,000 $22,661,307 $4,766,893 ($4,766,893)
Lone Star Fund IV 2002 $1,768,676 $19,045,199 $1,768,676 ($1,768,676)
Colony Distressed Credit I 2009 $40,000,000 $44,487,400 $21,421,400 ($2,313,511) ($4,127,304) ($4,127,304) ($4,127,304) ($4,127,304) ($4,127,304)
Angelo Gordon VII 2010 $30,000,000 $30,000,000 $19,912,093 ($1,792,088) ($3,261,601) ($3,261,601) ($3,261,601) ($3,261,601) ($3,261,601) ($3,261,601)
KKR Mezzanine Partners 2011 $30,000,000 $23,847,915 $20,904,241 ($1,612,613) ($2,976,423) ($2,976,423) ($2,976,423) ($2,976,423) ($2,976,423) ($2,976,423)
Oaktree Opportunities IX 2012 $15,000,000 $9,450,000 $10,222,811 $1,850,000 $3,700,000 ($4,500,000) ($4,500,000)
Colony 2014 $20,000,000 $0 $0 $6,666,667 $6,666,667 $6,666,667 ($7,500,000)
New Funds 2014 $30,000,000 $0 $0 $10,000,000 $10,000,000 $10,000,000 ($11,250,000)
New Funds 2015 $60,000,000 $0 $0 $20,000,000 $20,000,000 $20,000,000
New Funds 2016 $60,000,000 $0 $0 $20,000,000 $20,000,000 $20,000,000
New Funds 2017 $60,000,000 $0 $0 $20,000,000 $20,000,000 $20,000,000
New Funds 2018 $60,000,000 $0 $0 $20,000,000 $20,000,000 $20,000,000
New Funds 2019 $60,000,000 $0 $0 $20,000,000 $20,000,000
New Funds 2020 $60,000,000 $0 $0 $20,000,000
PE Balance $80,627,542 $91,709,203 $131,980,611 $193,373,733 $263,278,304 $338,775,241 $415,811,933 $482,888,864
% of Total Plan Assets 2% 2% 3% 4% 5% 6% 7% 8%
Total Plan Assets** $4,034,140,990 $4,296,360,154 $4,575,623,564 $4,873,039,096 $5,189,786,637 $5,527,122,768 $5,886,385,748 $6,269,000,822
Capital Calls / (Distributions)
5
2.73.9 4.8 5.2
8.611
0
2
4
6
8
10
12
10-yearTreasuries
InvestmentGrade Bonds
LeveragedLoans
High Yield Second Lien PE-backedMezzanine
Perc
ent
Domestic Fixed Income Yields (Estimated)(March 2014)
K E Y F I N D I N G S : P R I V A T E C R E D I T
US: High demand for financing and strong corporate balance sheets are
providing attractive premiums for private lending over public marketcredit, but default rates are low relative to history and likely to riseover time. The US economic recovery is five-years old; the averagebusiness cycle has lasted about six years since WWII.
Europe: Banks, under pressure to meet higher capital ratios, are reducing risk
by not only reducing their lending, but shifting their lending to larger,publically traded companies.
As Europe recovers, so does the demand for loans: midsizeEuropean businesses will need to raise 3.5 trillion euro in debtfunding over the next five years; in addition over 250 billion euros ofdebt will mature over the next five years.
Some EU nations are still in recession; European inflation is fallingand its money supply is falling, measures that hint at slowing growth.
Source: Source: Bloomberg, Credit Suisse, Barclays, S&P LCD
Source: PitchbookSource: Europe MFI
Charts and comments shown here can be found with additional commentary on pages 16 and 17 of the complete 2014 Private Equity Outlook.
3.03.54.04.55.05.56.06.5
Bank
Len
ding
, Ann
ual G
row
th R
ate
(Per
cent
)
European Bank Lending to Non-Financial CorporationsAnnual Growth Rates
Historically, European companies have relied on bank financing, but banks’ need todeliver is limiting their creation of new loans.
0
2
4
6
8
10
12
14
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014E 2015E
Perc
ent
European Leveraged Loan and High Yield Default Rates
Europe HY Default Rates Europe Levered Loan Default Rates
As the European economy recovers, default rates continue to come down. Its recovery is ayear old, suggesting default rates will remain low for some time.
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N E X T S T E P S
Wurts & Associates believes the following two strategies deserve strong consideration by theBoard:
GSO European Senior Debt Fund Established to take advantage of a secular shift in the European corporate lending environment. GSO will seek to fill this
void in the direct lending space caused by the decreasing amount of bank loans to non-financial corporations due to newregulations
Will invest primarily in privately originated secured loans in performing mid to large-sized European companies (EBITDA€50- €150 million or $65 - $193 million).
Expected to primarily make investments senior in the capital structure
CarVal; Credit Value Fund III CarVal has a long history of investing in European and EM countries. Teams are onsite around the world to perform due
diligence and analysis
Portfolios are constructed with a top down perspective and bottom-up fundamental analysis
Largest slices of the portfolio will be in Loan Portfolios and Corporate Securities followed by Structured Credit andShipping.
Can use up to 100% leverage at the individual deal level with a limit of 1:1 equity to debt on an aggregate fund level.
In addition we are currently underwriting several other GP opportunities which we expect todiscuss in early 2015.
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A P P E N D I X I
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A D D I T I O N A L F U N D I N F O R M A T I O N
GSO CarVal
Strategy Direct Lending Stressed/Distressed
Target Middle-Upper Market Middle Market
Investor Position Sole/Majority Minority / Influential
- 40-60%
100% 40-60%
- 5-15%
100% Unitranche/Senior 40-60% Corporates
40-60% Loan Portfolios
0-30% Structured Credit
0-10% Shipping
Real Estate? No Yes
Sectors
North America
Western Europe
Emerging Markets
Recommended
GSO – a direct lending strategy targeting a 11-13% IRR and a 1.5x multiple on invested capital.
CarVal - a distressed strategy targeting a mid teens IRR and 2.0x multiple on invested capital
Estimated Final Close for Each Fund:
GSO: 1Q 2015
CarVal: April 2015
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A D D I T I O N A L F U N D I N F O R M A T I O N
GSO CarVal
European Senior Debt Fund CVI Credit Value Fund III
Style Unitranche/Senior Stressed/Distressed
Current AUMTarget $2 billion ($500 million from COF II + $1.5
billion in raises)Target $2 billion
Firm Founded 2005 (acquired by Blackstone in 2008) 1987 (owned by Cargill)
Firm AUM $64 billion $10 billion
Headquarters New York Minneapolis
Geographic Focus Europe 50/40/10 - US/Europe/EM
Investment Period 3 years 3 years
Term 6 years + 2 extension options 6 years + 2 one-year extension options
Target IRR 11-13% Net (with 1:1 leverage) 13-17% net
Target Multiple 1.5x 2.0xLaunched First close end of August 2014 First close September 2014
Estimated Final Close Q1 2015 April 2015
Minimum Investment $7 Million $10 million
Types of Investments
Fund will invest in privately originated loans secured loans in performing mid/large
European companies. Will have quarterly distributions targeting 6-8% annually. Majority of underlying loans will be floating rate. 75% will be Unitranche, 25% will be Senior Debt.
Sees four major themes: QE, Commodity Supercycle, Europe healing/post-crisis
reform(bank sales), and opportunistic play on shipping. Will invest primarily corporate
securities, structured credit, liquidations and opportunistic dislocations. Will focus on
complex deals avoided by most other managers and piece out valuable parts. 25-50% will be
loans, 5-10% will be structured, 30-50% corporate debt and shipping 5-10%.
Fund Level Leverage 1:1 Leverage on $2bn equity Deal Specific, none at Fund level
Target Company Size Middle-Upper European Companies Middle-Upper market
Team Size
3 co-PMs supported by 12-person European Alternative Investments team. Additional support provided by 12 European Credit
investment professionals.
10 senior investment professionals + 44 supporting analysts/associates
Reccomended
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A D D I T I O N A L F U N D I N F O R M A T I O N
GSO CarVal
European Senior Debt Fund CVI Credit Value Fund III
GP Commitments 2% 1%
Management Fee 1.5% on invested capital 1.5% on invested capital
Preferred Return 7% 8%
Carried Interest15% with 80/20 catchup for GP/LP. GP does not
receive carry until LP receives 75% of committed capital
20% after 8% preferred with 100% catch-up, subject to 20% holdback thereafter
Track RecordEuropean Loans (2008): 10.1% Net IRRCapital Opportunities II (2012): 24.2%
Capital Solutions II (2013): 17.6%
Credit Value Fund I (2010): 23.5% Net IRRCredit Value Fund II (2013): 27.1%
Paul Eapen, Portfolio ManagerMr. Eapen is a Joint Portfolio Manager of the Fund and is focused on the origination and
management of private credit investments in Europe, including distressed, rescue,
refinancing and LBO acquisition financing.Mike Whitman, Portfolio Manager
Mr. Whitman joined GSO in 2006. He is the Head of the European Business of GSO and a Joint
Portfolio Manager of the Fund, of GSO’s mezzanine funds, the GSO Capital
Opportunities Funds I & II, and of the GSO Special Situations Fund.
Alan Kerr, Portfolio ManagerMr. Kerr is a Joint Portfolio Manager of the Fund
and primary Portfolio Manager for European CLOs and Commingled Funds. He is jointly
responsible for managing the European activities of GSO’s Customized Credit Strategies
Unit (“CCS”). Michael Ryan, Managing Director
Mr. Ryan joined GSO in 2012 as part of the Harbourmaster acquisition. He is a Managing Director within GSO Debt Funds Management Europe and is involved in all aspects of credit
origination, investment selection and monitoring of GSO’s European collateralized
debt obligation portfolio.
Key Team Members
James Ganley, Deputy CIO & Senior Managing Director
Mr. Ganley is responsible for overseeing CarVal's credit funds and investments globally. Has the authority to invest up to $25 million in deals without formal Investment committee
approval.Greg Belonogoff, Senior MD
Responsible for leading the firm's London office, as well as managing individual Corporate
Securities Investments globally. Has the authority to invest up to $25 million in deals
without formal Investment committee approval.
Geraldo Bernaldez, Senior MDLeads all investments in emerging markets and
the global corporate securities business. Has the authority to invest up to $25 million in deals
without formal Investment committee approval.
Seth Cohen, Senior MD/Deputy CIOHe is responsible for managing investments in
global loan portfolios. Has the authority to invest up to $25 million in deals without formal
Investment committee approval.
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A P P E N D I X I I
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Manager Evaluation: GSO Capital Partners LP
European Senior Debt Fund LP
Last Updated: July 2014
Strategy Background
Asset Class: Direct Lending Firm Inception: 2005 Firm Assets: $64.2 Billion Strategy Assets: $500 Million Targeted Fund Size: $2 Billion First Close: August 2014 Final Close (estimated): 1Q 2015 GP Commitment: 2.0% Min. Commitment: $7 Million Fund Term: 6 years + 2 one‐year ext. Investment Period: 3 years Management Fee: 1.5% on invested capital
GP Carried Interest: 15% after LPs receive 75% of original capital
Preferred Return: 7%
Firm Background and History
GSO was established in 2005 by Messrs. Bennett Goodman, “Tripp” Smith and Douglas Ostrover (the “Founders”). Prior to starting GSO, the Founders were senior executives of Credit Suisse First Boston (“CSFB”) where they were responsible for building and managing the Helios Credit Opportunities Fund, a diversified strategic portfolio of leveraged finance assets. In December 2004, the Founders resigned from CSFB to form GSO; CSFB agreed to transfer the management of Helios to GSO along with substantially all the team managing the portfolio. In 2005, GSO acquired the Collateralized Loan Obligation (CLO) business from RBC Capital Partners, a division of Royal Bank of Canada, and established its own funds, including GSO Special Situations Fund, GSO Mezzanine Fund, GSO Capital Opportunities Fund, and GSO Liquidity Partners. In 2006, GSO opened offices in Houston and London. The Houston office is primarily focused on the direct sourcing of private investments in the energy sector, while the London office concentrates on European direct origination for mezzanine and rescue financing as well as public market trading and research.
On March 3, 2008, the Blackstone Group acquired a controlling stake in GSO. GSO principals reinvested 100% of the after tax proceeds from the transaction into GSO managed funds. In December 2011, Blackstone purchased the remaining economic interest in GSO. GSO continues to operate under the GSO brand with the same management team and investment process. Since 2010, GSO made several strategic acquisitions of CLO assets in US and Europe, including a 2012 purchase of Harbourmaster Capital, a leading European loan manager. The acquisition made GSO one of the largest leveraged loan investors in Europe where they currently monitor over 300 companies and have reviewed over 400 private situations in the last four years. GSO’s European corporate debt portfolio comes in at over €8.5 billion ($12.0 billion) in AUM and is invested in approximately 190 companies. This platform is supported by a team of 32 investment professionals in London and Dublin. GSO and its subsidiaries have assembled a team of over 250 employees in New York, Houston, London and Dublin; of those, 105 represent investment professionals. GSO operates through two primary business segments: Alternative Investment Funds ($30.0 billion AUM across Mezzanine and Capital Solutions Funds, an event‐driven hedge fund and a small‐cap direct lending BDC) and Customized Credit Strategies–Long Only ($30.2 billion AUM primarily dedicated to CLOs and separate accounts).
Strategy Background
GSO has established the European Senior Debt Fund to take advantage of a secular shift in the European corporate lending environment. Banks and other traditional suppliers of credit must shrink their balance sheets to comply with upcoming regulatory requirements set forth by Basel III and Asset Quality Reviews (“AQR”). GSO will seek to fill the void in the direct lending space caused by the decreasing amount of bank loans to non‐financial corporations and limited capacity for CLO managers to refinance after low issuance.
The Fund will invest in privately originated secured loans in performing mid‐ and large‐sized European companies, defined by GSO as those with EBITDA of €50‐€150 million. Its two primary approaches to investing are: (i) originating direct capital infusions utilizing a wide network of banks, financial sponsors and corporate contacts; and (ii) accumulating publicly‐traded securities by purchasing “hung” bridge commitments from investment banks, anchoring difficult syndications or investing in select distressed secondary market securities. GSO will be able to provide significant capital investments of €250 million or more and focuses on consensual deals alongside incumbent stakeholders.
The Fund is expected to primarily make investments senior in the capital structure and typically secured. Most loans will be floating rate instruments and the majority of returns are expected to come from current income. The Fund plans to invest at least 75% in unitranche debt, with the remainder of the portfolio comprised of senior debt. Investments are expected to be sized at 5% of fund‐level commitments while senior debt positions are targeted to be 2‐3% positions, for a total of 25‐30 investments over the life of the fund.
The investment objective of the Fund is to target a net IRR of approximately 11%‐13% and a multiple‐on‐invested‐capital (MOIC) of approximately 1.5x. A majority of the portfolio will consist of debt investments, which are typically structured with cash coupons of 10%‐13%, a total yield‐to‐maturity in the mid‐teens, call premiums and strong covenant protections. There will be up to 1:1 non‐mark‐to‐market, term leverage at the Fund level. GSO will seek to build a diversified portfolio across a wide array of issuers and industries in Europe. The only fund previously raised by GSO constrained to Europe is the Blackstone/GSO European Senior Loan Fund, which launched in 2008. Excluding its Special Situations funds, GSO has originated over €2.5 billion of private loans in Europe over the last three years.
Key Investment Professionals
The Investment Team consists of three Portfolio Managers supported by twelve investment professionals from Analyst to Managing Director. Another twelve investment professionals within the European Customized Credit Strategies group provide additional support. Alan Kerr, PM, Senior Managing Director Mr. Kerr is a Joint Portfolio Manager of the Fund and primary Portfolio Manager for European CLOs and Commingled Funds. He is jointly responsible for managing the European activities of GSO’s Customized Credit Strategies Unit (“CCS”). Mr. Kerr is a member of the CCS Europe Investment and Management Committees. He joined GSO in 2012 as part of the Harbourmaster acquisition, where he had been since 2000 and was co‐head of the firm. Mr. Kerr is a Chartered Accountant and received an honours Commerce Degree and a Master’s in Accountancy from University College Dublin. Michael Whitman, PM, Senior Managing Director Mr. Whitman joined GSO in 2006. He is the Head of the European Business of GSO and a Joint Portfolio Manager of the Fund, of GSO’s mezzanine funds, the GSO Capital Opportunities Funds I & II, and of the GSO Special Situations Fund. Prior to joining GSO in 2006, Mr. Whitman was a Managing Director with Citigroup Private Equity. Prior to joining Citigroup Private Equity, Mr. Whitman worked in Salomon Smith Barney’s High Yield Capital Markets business from 1996 through 2000. From 1994 through 1996, Mr. Whitman was a corporate finance analyst at Salomon Brothers. Mr. Whitman received a B.A. in History from the University of Notre Dame. Paulo Eapen, PM, Managing Director Mr. Eapen is a Joint Portfolio Manager of the Fund and is focused on the origination and management of private credit investments in Europe, including distressed, rescue, refinancing and LBO acquisition financing. Prior to joining GSO in 2007, Mr. Eapen was a founding member of Citigroup Private Equity London where he focused on private equity and mezzanine debt principal investments. He began his career as an investment banker focusing on M&A and Utilities at Salomon Smith Barney. Mr. Eapen received a B.A. in Economic and Political Science from the University of Pennsylvania. Michael Ryan, Managing Director Mr. Ryan joined GSO in 2012 as part of the Harbourmaster acquisition. He is a Managing Director within GSO Debt Funds Management Europe and is
Individual Asset Components Contribution to IRR
Unitranche Coupons (75%): 8%‐10%
Senior Debt Coupons (25%): 6%‐8%
Upfront Fees/OID: 0.5%
Call Premiums: 0.5%
Total Unlevered Returns: 8.5%‐10.5%
Expected Leverage (1:1): 5.5%‐6.5%
Blended Gross IRR: 14%‐17%
Blended Net IRR: 11%‐13%
involved in all aspects of credit origination, investment selection and monitoring of GSO’s European collateralized debt obligation portfolio. Prior to joining Harbourmaster, he worked for Hypo Real Estate Bank and KPMG in their Transaction and Financial Services groups. Mr. Ryan is a qualified Chartered Accountant and received a Master’s degree in Business & Accounting and an honors degree in Accounting & Finance, both from Dublin City University.
Process
GSO’s credit strategies incorporate a fundamentally‐driven investment philosophy based on thorough credit underwriting and rigorous financial analysis. The Fund’s primary focus is on sourcing privately secured loans to healthy European companies with EBITDA from €50 to €150 million.
The team sees a significant amount of proprietary deal flow by working closely with European banks and also from the internal Leveraged Loan group as well as the mezzanine and hedge fund groups. It also has access to other Blackstone resources, including its Advisory and Restructuring businesses. This scale enables the Fund to identify opportunities early and select investments that offer the most attractive risk‐adjusted return profile but which may not fit the mandates of other GSO products.
Fund investments can be divided into two main strategies, unitranche debt and senior debt. Potential deals typically include: (i) refinancing to companies facing significant debt maturities; (ii) financing to companies who cannot access the capital markets due to size, new bank capital regulations or other unique reasons (iii) sponsor acquisition financing; or (iv) consolidation of debt from existing fatigued lender groups.
Unitranche Debt Transaction teams partner with companies to tailor a debt instrument that addresses all of or the majority of their financing needs in a single debt package. The Fund seeks to directly originate secured debt investments that minimize downside risk and protect capital. The investments often yield equity‐like returns, while maintaining capital structure seniority given the size and customization of the financing structures. These debt investments are typically structured with coupons of 8%‐10%, a total yield‐to‐maturity in the low‐teens percentage range, call premiums, strong covenant protections and security pledges of company assets. The average leverage multiple for unitranche investments will be 4x‐5x EBITDA and positions sizes of €150‐€200 million.
Senior Debt The Fund will also extend senior debt commitments as opportunities arise to target specific financing needs within the capital structure. GSO may collaborate with “club” lenders, providing large anchor positions which solidify offerings and help fill remaining capital needs. The team will target 6%‐8% cash coupons with an average leverage multiple of 2x‐4x EBITA and mandatory amortization. Investment Underwriting and Monitoring Each senior investment professional is responsible for the analysis, diligence structuring and monitoring of five to ten Fund investments from inception to realization. A typical deal team consists of four investment professionals, comprised of a portfolio manager, managing director, principal or vice president and associate and / or analyst. The due diligence process often lasts up to six months and includes a thorough business review of the industry, competitive landscape, products, customers, returns on capital, depth of management team, extensive financial analysis and consultation with outside advisors and industry experts. Much of this work is continually maintained by the Leveraged Loan and CLO credit teams. The deal team spends time with management, tours the company’s facilities and conducts customer and supplier calls. This initial assessment is followed by extensive credit analysis, including asset valuation, financial analysis, cash flow and scenario analysis, legal and accounting review.
The Investment Committee reviews deals in parallel with the diligence and relies on a consensus‐driven approach among the senior investment professionals: Bennett Goodman, Tripp Smith, Doug Ostrover, Alan Kerr, Michael Whitman and Paulo Eapen.
GSO seeks to structure individual investments that balance downside protection with significant current income in addition to upfront fees of 2%‐4%. Current income is primarily in the form of cash coupons, two to four years of call protection premiums, maintenance/incurrence covenants and security pledges of assets. Following an investment, the same deal team actively monitors and manages all transactions through realization. The Fund expects to hold most loans until maturity with the majority of returns coming from income.
Risk Management
The team has significant experience and competitive advantage across the firm’s $64.2 billion diversified credit platform. GSO’s long‐term track record speaks to their ability to leverage the team’s capital structuring expertise
to provide unique financing solutions that meet companies’ unique objectives. In line with their objective to anticipate avoid risks if possible, each potential investment undergoes rigorous credit analysis. Each transaction is individually structured, depending on the financing problem each company faces. As a result, each investment varies in terms of size of cash coupon, degree of collateral protection and structural seniority, tenor, and covenants. In an attempt to minimize risk the portfolio will limit any single investment to 15% of total commitments to avoid excessive concentration risk. A maximum of 20% of the portfolio can be invested outside of Europe. GSO has established a number of reporting and monitoring tools for portfolio companies. Custom reports for each investment contribute to the internal monthly valuations completed by GSO. These monthly valuations are approved by the Valuation Committee, which does not include any investment professionals. On a quarterly basis, GSO engages an independent valuation firm to support the internal valuations, which are then presented to the Blackstone Valuation Committee. Deloitte is responsible for providing annual valuations. Should an investment become stressed, the team has internal expertise for restructuring and other workout scenarios. The team is able to pull from across the GSO platform, including legal professionals and executive management talent should the need to assume control of a portfolio company arise. This depth and breadth of expertise is a key advantage of investing with GSO.
Risk Factors and Potential Red Flags
At the Fund level, if, after the Investment Period, three of the six Key Men are unable to perform their functions for the firm for 90 days out of the year then the Limited Partners can choose to liquidate the fund with a majority vote. During the Investment Period Key Men must devote substantially all of their business time to the affairs of the management company. The Key Men named in the official Fund documents include founders Bennett Goodman, Tripp Smith and Douglas Ostrover, and the portfolio managers of the Fund Alan Kerr, Michael Whitman and Paulo Eapen. GSO will use up to 100% leverage at the Fund level, giving the team a target of $4 billion to invest. While the use of leverage can enhance positive returns, the amplification of negative returns is a serious risk should the Fund
experience losses. Given the conservative approach and experience of the team we believe that this amount of leverage is acceptable; however, investors who wish to avoid leverage for UBTI or other considerations will have the option to invest in an unlevered sleeve. The success of the Funds' activities may be affected by general economic and market conditions, such as interest rates, availability of credit, inflation rates, economic uncertainty, changes in laws and national and international political circumstances. The regulatory environment for banking across Europe is in flux and could materially impact the Fund’s ability to source and invest in opportunities, but this changing dynamic of the market structure also creates the opportunity for investors in the Fund. We believe GSO has the scale and depth of talent and organizational resources to capitalize on the opportunity set.
Performance
GSO has a history in European senior loans (via the Harbourmaster group) of 64 investments since 2008 with an average net IRR of 10%. Business Development Companies created by the firm in 2009, 2011 and 2012 vintages have net IRR’s of 17%, 19% and 11%, respectively. The team has originated over €2.5 billion across a number of transactions in senior, junior and unitranche debt since September 2010 similar to the Fund’s mandate. A summary of these transactions are provided below; the team has also identified a pipeline of over €1 billion.
Recommendation
Wurts & Associates recommends the European Senior Debt Fund as an attractive opportunity for investors who wish to capitalize on our view that European private credit markets offer a unique chance to take advantage of structural reforms and a recovering economy. GSO is a well‐known and well‐regarded participant in the private credit space and have maintained a significant presence in the European market specifically since the early 2000’s. This established and experienced team has significant resources for sourcing and structuring deals in the marketplace. The team’s track record in private credit and the broader firm’s support structure provides comfort that they have the commitment and resources to execute the strategy with strong results.
*All dollar amounts in millions COF: Capital Opportunities Funds CSF: Capital Solutions Funds SMA: Separately Managed Account
GSO European Team
Representative TransactionsStrategy Security Type Closed Committed Leverage EBITDA Coupon Gross MOIC Gross IRR
Ring/Helios COF II2nd Lien & Junior
DebtApr-14 $208.1 5.5x € 37.8 11.0% NM NM
KP1 CSF II Unitranche Mar-14 $276.0 5.5x € 36.1 E+8.75% 1.0x NM
Safetykleen COF II Junior Debt Dec-13 $162.6 5.8x £90.6 L+11.0% 1.0x 14.3%
Morris Homes CSF II Unitranche Jun-13 $273.0 8.2x £32.5 L+8.5% 1.3x 39.6%
Welcome Break CSF IJunior Debt &
Anchor Senior DebtJan-13 $197.5 7.0x £67.2 13.5% 1.3x 29.6%
Perstorp CSF I Anchor 2nd Lien Nov-12 $132.9 4.8x $227.0 11.0% 1.3x 25.4%
Giant Cement CSF IUnitranche (1st
Out)Jul-12 $146.3 23% LTV $5.5 10.0% 1.2x 11.5%
Giant Cement CSF IUnitranche (2nd
Out)Jul-12 $273.0 66% LTV $5.5 10.0% 1.4x 20.8%
EMI Music Publishing CSF I & COF IIJunior Debt &
Anchor Senior DebtJun-12 $390.6 5.2x $286.1 12.5% 1.4x 22.8%
Miller Homes CSF I Equity Feb-12 $178.7 45% LTV £78.2 N/A 2.1x 42.8%
Coditel COF I Junior Debt Dec-11 $113.4 5.7x € 54.1 13.8% 1.4x 19.2%
Almatis CSF I, COF I, SMA Unitranche Sep-10 $353.3 4.5x € 113.3 13.0% 1.5x 16.2%
Manager Evaluation: CarVal Investors, LLC
CVI Credit Value Fund III, L.P.
Last Updated: July 2014
Strategy Background
Asset Class: Multi‐Strategy Credit Firm Inception: 1987 (subsidiary of Cargill) Firm Assets: $10 Billion Strategy Assets: $3.3 Billion Targeted Fund Size: $2 Billion First Close: September 2014 Final Close (est.): April 2015 GP Commitment: 1.0% Min. Commitment: $10 Million Fund Term: 6 years + 2 one‐year extension Investment Period: 3 years Management Fee: 1.5% on invested capital GP Carried Interest: 20% over preferred Preferred Return 8% Target Return: 13‐17% (net)
Firm Background and History
CarVal Investors (“the Firm”) was established in 1987 by Cargill, one of the largest agricultural and industrial service providers in the world, to serve as a proprietary financial trading arm. During the 1990’s CarVal expanded its investment operations throughout Europe and Asia and in 2006 became an independent subsidiary. CarVal is headquartered in Minneapolis and has over 180 employees, 70 of which are investment professionals, with offices in London, Luxembourg, New York, Paris, Shanghai and Singapore. They are led by President and Chief Investment Officer John Brice, who transferred from Cargill in 1998 and became President in 2008. CarVal manages approximately $10 billion across four funds (three closed‐end and one open‐end) and separate accounts. The Firm has built its platform around opportunistic credit and has invested $73 billion in over 4,800 transaction in 70 countries. The Firm managed a separate account for Cargill until 2007, at which point they began liquidating the portfolio and launched the Global Value Fund, their first fund open to outside investors, with $5.4 billion of initial commitments.
CarVal opened their London office in 1993 and their Singapore office in 1997. With 40 employees in London, CarVal offers a large on‐location presence in the European market. Their global reach is bolstered by the relationship and information advantages provided by their connection with Cargill, which employs more than 140,000 people in 65 countries and generates $130 billion annual revenue. By agreement, management fees are split 50/50 and incentive fees 90/10 between CarVal and Cargill, respectively. Cargill has no influence over CarVal’s investment process or decision making; however, CarVal team members often use Cargill to source, evaluate or partner if a prospective deal involves an industry in which Cargill operates, such as shipping.
Strategy Background
The first Credit Value Fund (“CVF”) was launched in September of 2010. All Credit Value Funds follow a similar mandate and philosophy as the original Global Value Fund with the exception that the latter funds will not make any direct real estate investments. Four primary investment strategies form CarVal’s core investment approach: Corporate Securities, Loan Portfolios, Liquidations and Structured Credit. Each strategy plays a different role in the portfolio but all usually connect to one of the four investment themes noted below which the team believes will drive continued dislocation and generate opportunities going forward. Post‐Crisis Banking Reform The team believes that extensive re‐regulation of the financial sector in the United States and Europe will create a shift in the global lending market. The team believes this regulatory scrutiny creates capital “vacuums” in the re‐performing loan market, specifically in areas affected by mortgage reform. As a result, CarVal is actively acquiring non‐performing loan pools sold by banks looking to improve their capital efficiency and quality measures (largely as a result of Basel III and Dodd Frank regulations).
The Stabilization of Europe In a similar and related theme, banks are selling more “non‐core assets” into the market place as the risks of Eurozone breakup and financial crisis both abate. The banks are more eager now to deleverage their balance sheets of corporate loans, commercial real estate and other asset backed securities. As the economy continues to recover, the team expects the deleveraging to continue, estimating that another $3 trillion in sales will come over the next few years. The Fund will initially focus on countries further along in their recovery, such as the United Kingdom, Ireland, and the northern regions. CarVal will opportunistically consider Southern Europe as conditions improve and more attractive risk/return opportunities present themselves. The End of the Commodity Super Cycle Weak commodity prices have been a headwind for Emerging Markets, specifically in Asia and South America, as well as less developed areas in Eastern Europe. The team now sees increasing opportunities in the shipping industry, which could comprise up to 10% of the portfolio. In support of this theme, the relationship with Cargill provides a substantial information flow advantage, as well as deal sourcing, asset utilization and due diligence for the shipping industry. Cargill’s business engages over 500 vessels at any given time and has been willing to guaranty market rate use of specific tanker investments made by CarVal. These contracts provide an immediate return and banks are much more willing to finance these investments knowing Cargill has already leased the vessels. QE Tapering As the Federal Reserve and other developed market central banks withdraw stimulus from the bond market, the team will look to capitalize on the fear of rising rates. While the strategy does not need interest rates to rise, the team will position the portfolio for increased volatility. They believe increased volatility will lead to attractive entry points into European financials, municipal bonds and other corporate credit opportunities. CarVal expects these themes to drive the majority of activity during the first half of the investment period. As time passes the team believes that corporate distress, restructuring and liquidations and/or bankruptcies could play a larger role. CarVal will seek to diversify the Fund across investment strategy and geography in the following ways:
The team believes they can achieve a 2x Multiple on Invested Capital (“MOIC”) and a 15% net return to limited partners. The Fund’s investment period will overlap with the previous fund, CVF II, until June 2016. During this period investments will be allocated on a pro‐rata basis to each fund.
Key Investment Professionals
CarVal employs a hierarchy of discretionary decision making ability in their investment team structure. Managing Directors may approve up to $25 million trades and Senior Managing Directors have the authority to execute $50 million trades. Investments are seldom made without frequent dialogue amongst the team beforehand. This structure is designed to enable the team to act quickly when time‐sensitive opportunities present themselves and to initiate toe‐hold positions to gain access to information on private holdings. John Brice, President and Chief Investment Officer Mr. Brice serves as the President and Chief Investment Officer of the Firm, a position he has held since 2008. He is the chairman of the investment committee and is ultimately responsible for all portfolios and global operations. Prior to joining CarVal in 1998, Mr. Brice worked on the European equity arbitrage desk for the Global Capital Markets group at Cargill. He began his career in the Asset Management division of Friends Provident, a large UK life assurance company. He received a Bachelor’s degree in Economics and Accounting from the University of Wales and is a qualified chartered accountant.
50‐60%
30‐40%5‐10%
Targeted Portfolio Weight
North America
Europe
Emerging Markets
30‐50%
25‐50%
0‐10%
10%
Corporate Securities
Loan Portfolios
Structured Credit
Shipping/Liquidations
James Ganley, Deputy CIO, Senior Managing Director Mr. Ganley serves as Deputy Chief Investment Officer to Mr. Brice and is responsible for Corporate Securities in North America. He is a member of the Investment Committee and also focuses on Liquidation investments. Prior to joining CarVal in 2009, Mr. Ganley was a managing director in the Special Situations group at Goldman Sachs in Europe focusing on distressed credit, high yield credit and event‐driven investing. Mr. Ganley received a Bachelor of Science degree in Finance and Accountancy from Villanova University and an MBA from the University of Chicago. Gerardo Bernaldez, Senior Manager Director Mr. Bernaldez is responsible for Corporate Securities investing on a global basis. He also manages all of CarVal’s Emerging Markets investments in addition to serving on the Investment Committee. Prior to joining CarVal in 1995, he worked at Cargill as a controller in the Financial Markets Group in Mexico and Venezuela. Mr. Bernaldez received a Business Administration degree from the Universidad de Belgrano, in Argentina and is a Certified Public Accountant. Seth Cohen, Senior Managing Director Mr. Cohen joined CarVal in 2009 and leads the Loan Portfolio division. He is responsible for managing all global loan portfolio and structured credit investments and serves on the Investment Committee. Prior to joining CarVal, Mr. Cohen was responsible for structured finance origination, analysis and execution at Garrison Investment Group. He was also previously CEO of Franklin Credit Management Corporation and co‐head of the financial services group at Silver Point Capital. He received a Bachelor’s degree in Political Science from the University of Michigan and a J.D. from NYU School of Law. Jody Gunderson, Senior Managing Director Ms. Gunderson manages investments in global loan portfolios at CarVal, including RMBS and CMBS investments. She serves on the Investment Committee and focuses on consumer, residential and small business loan portfolios. Prior to joining CarVal in 1994, Ms. Gunderson was a manager in the financial services division of PriceWaterhouseCoopers working with investment fund and commercial banking clients. She received a Bachelor’s degree in Business from the University of Minnesota and is a Certified Public Accountant (inactive).
Potential investments above $50 million in size are discussed at the Investment Committee, which includes the investment professionals detailed in the table below. The only other senior investment team member with investment making authority is Greg Belonogoff, who leads the London office operations and focuses on Corporate Securities investing.
Investment Committee Role
John Brice* President & CIO
James Ganley* Deputy CIO, Senior MD
Gerardo Bernaldez* Senior Managing Director
Seth Cohen* Senior Managing Director
Jody Gunderson* Senior Managing Director
Joe Graf Senior Managing Director
Lucas Detor Senior Managing Director
Peter Vorbrich* CFO
David Fry Managing Director of Risk
Matthew Bogart Chief Legal/Compliance
*Indicates a “Key Principal” named in official fund documents
Process
CarVal has a long history of investing in European and Emerging Market countries, with local teams performing due diligence and analysis for the last 20 years. This global presence is further enhanced by the close relationship with Cargill and its operations in 44 emerging countries. The history and experience of the firm, combined with the network Cargill provides, are key features of CarVal’s sourcing ability and crucial to the success of the Fund. The team constructs portfolios with a top‐down perspective combined with bottom‐up fundamental analysis. The Fund has a broadly defined investment mandate for asset class and geographic regions, giving flexibility to opportunistically act as relative risk and returns evolve and new investments are discovered. The team evaluates potential investments relative to current holdings in terms of volatility, risk profile, liquidity and income production. Investment professionals conduct extensive quantitative and qualitative analysis to form an opinion from a legal and a financial perspective. They seek out complex situations and believe one of their core competencies is the ability to deconstruct and extract value from complicated deals. In many cases, they will have developed specific experience that allows them to more accurately price pooled investment opportunities that other “pure specialists” cannot value correctly.
Of the four investment strategies, Loan Portfolios and Corporate Securities will be the largest allocations, followed by Shipping/Opportunistic (to potentially be replaced by Liquidations and traditional distressed situations later) and Structured Credit. Loan Portfolios The Fund will invest in whole loan portfolios backed by consumer credit, RMBS, small business loans, CRE and auto/student unsecured debt. The team opportunistically purchases loans secured by commercial real estate. If necessary, CarVal can take direct control of the underlying real estate and has experience in arranging external management teams to manage the property. One competitive advantage CarVal believes they enjoy over competitors is their ability to choose a servicer to manager their loan portfolios. They will often break up the loans into specialized portions that match up with an individual servicer’s best ability. Corporate Securities CarVal follows a similar sourcing and due diligence process for its corporate securities investing. Potential investments include, but are not limited to, corporate bonds, bank debt, credit default swaps, and equities. To a lesser extent, the Fund may invest in high yield loans or DIP (debtor‐in‐possession) financing of companies in distress or bankruptcy. Rather than buying for control, CarVal looks to assist or influence the restructuring, bankruptcy or recapitalization process. CarVal emphasizes their avoidance of “crowded” trades in which most large distressed funds, such as Oaktree, Cerberus or Fortress, are currently investing in heavily. Instead, the team tries to identify unique situations that require specific experience or bespoke financing solutions in which they have a successful track record. Liquidations Claims against bankrupt or liquidating companies require more hands‐on management and support than other strategies. Although it will play a lesser role within the portfolio, CarVal has built out internal legal and operational teams dedicated to handle these investments. Given the generally positive or stable market environments in place throughout the U.S. and Europe, CarVal believes Liquidations will play a minor role until the business cycle matures or market stress develops. Structured Credit The team will focus its structured credit efforts on asset‐backed securities, primarily RMBS, and CLOs. CarVal is
able to leverage its experience investing in the underlying securities across multiple investment teams to give it a competitive advantage over others. CarVal prefers to look at the most complex securities and break out valuable aspects to multiple servicers. The complexity allows them to bid near the highest price but still achieve return targets. Favoring a more conservative approach with regard to structured products, the team looks to add value outside of the security itself. CarVal acquired its own servicer in Portugal to take advantage of the supply/demand imbalance in the European servicing market. In addition to restructuring or collecting against individual loans within the security, the team actively trades the securities. Special Opportunities CarVal’s current focus on the shipping industry falls under the Special Opportunities category. Historically, any investment that does not fit within the other categories has been deemed a special opportunity. Previous investments have included aviation leasing and part‐outs, other miscellaneous vessels, and oil and gas related assets.
Risk Management
CarVal has been investing with the same approach and philosophy for over 25 years and has built out a wide‐reaching network of offices, relationships and underwriting capabilities. The long‐term track record of the Cargill managed account points to their skill and ability to execute on a large scale across developed and emerging markets. To promote portfolio diversification, the Fund may not invest more than 15% of total commitments in a single issuer and must limit investments in emerging markets (China, Hong Kong, Latin America and South America) to 30%. The Fund will not be dependent on any one asset class or region to achieve expected returns. CarVal continues to actively manage securities once an investment is made. If any security approaches their fair value estimate they will exit the position and reinvest in securities with more attractive risk/return prospects. The team expects to recycle capital during the investment period and has a three‐year harvesting period, with the intent of driving more return earlier in the life of the Fund.
CarVal is backed by one of the largest private companies in the world and is structured to pursue a global investment opportunity set. More than 100 employees are dedicated to legal, operational and administrative duties to support the investment teams in each office.
Risk Factors and Potential Red Flags
Fund documents name six key persons, the majority of whom must devote substantially all of their business time to CarVal and management of the Fund. Limited Partners will have the power to suspend Fund operations or approve new key personnel should the situation arise. CarVal will use up to 100% leverage at the individual deal level, with a limit of 1:1 equity to debt on an aggregate fund level basis. In many cases, aggressively priced financing is provided by the seller of the assets who wish to obtain a higher optical price while meeting regulatory capital hurdles. While the use of leverage can enhance positive returns, the amplification of negative returns is a potential risk of any losses. Given the diversified, value‐focused approach and the deep experience of the team we believe that this amount of leverage is reasonable.
Funds II and III will have briefly overlapping investment periods (about nine months) until June 2016. Both funds employ identical mandates and will allocate investments on a pro rata basis. This potentially prevents either Fund from taking full‐sized positions if the security in demand is limited. However, we believe that CarVal has the resources and appropriate mandate to source a sufficient amount of opportunities and identify securities able to accommodate capital from both funds.
Performance
From inception in 1989 to 2007, when it ceased investment activities, the Cargill Managed Account completed 1,563 deals and invested more than $10.7 billion. Total return on investment reached $4.1 billion for gross and net realized IRR’s of 26.6% and 21.3%, respectively. The S&P 500 returned 11.7% over the same time period.
The Global Value Fund was launched in 2007 and split into two distinct portfolios when additional capital was raised in mid‐2008, creating Global Value Fund II. Since inception, Global Value Fund I has a 6.0% net IRR while Global Value Fund II, with a different asset mix at inception that included less real estate and more corporate securities, has a 16.9% net IRR. Investment periods for both portfolios ended in February 2011. Credit Value Fund I, launched in October 2010, posted a net 2013 return of 25.3%, giving it a 22.5% net IRR since inception. The S&P 500 returned 14.8% annualized over the same time period. Credit Value Fund II, launched in November 2012, returned 24.1% net of fees in 2013 and has provided investors with a 29.1% net IRR since inception. This compares favorably to the S&P 500 over the same period, which gained 27.4% annualized during a tremendous market rally. Within the Credit Value Funds, CarVal has had the greatest success investing in Corporate Credit, with gross since inception IRRs of 39.6% and 71.1% for Funds I and II, respectively. Structured Credit and Liquidations have also performed well, with returns between 20‐40% within both asset classes for each fund since inception. Loan Portfolios have generated gross IRRs of 24.7% and 5.6% for Funds I and II, respectively. Although they did not fare as well as the other asset classes, Loan Portfolios are cornerstone investments within the Fund that generate consistent cash flow and small capital gains over time; they are not expected to generate extreme returns given their relatively low risk.
Recommendation
Wurts & Associates believes CarVal’s third Credit Value Fund is a compelling option for investors looking for a balance of conservative, stable cash flow assets and potential for outsized returns from calculated investments in riskier, more complex opportunities. CarVal has a long‐term track record of successful alternative investing with a consistent approach and philosophy. Their platform is of institutional quality and has supported Cargill’s private investment mandate since 1989. Looking forward, we concur with their investment themes for the next few years and are confident in the team’s ability to build on the success of prior funds and deliver strong returns with Credit Value Fund III.
CarVal
Asset Class WeightingCVF II CVF I GVF II GVF I
Corporate Credit 23.3% 18.9% 30.0% 31.4%
Liquidations 41.4% 47.3% 40.6% 19.3%
Loan Portfolios 22.7% 20.7% 10.3% 17.2%
Special Opportunities 0.0% 0.0% 5.7% 10.8%
Structured Credit 12.7% 13.1% 5.9% 4.2%
Real Estate N/A N/A 7.6% 17.2%
CarVal
European Track Record2013 2012 2011 2010 2009 2008 2007 2006
Gross Return 33.2% 28.5% 21.4% 33.9% 45.3% 23.5% 21.1% 53.3%
Average Equity Capital Employed $2,998 $2,890 $3,117 $1,843 $1,175 $1,245 $1,273 $501
CarVal
Prior Funds Summary
Investment
Period Open
Investment
Period Close
Invested
CapitalTotal Value Net IRR
Credit Value Fund II Nov‐12 Jul ‐16 $1,739.4 $1,923.7 29.1%
Credit Value Fund Oct‐10 Jun‐13 $812.7 $1,338.3 22.5%
Global Value Fund II May‐08 Feb‐11 $1,897.1 $3,524.8 16.9%
Global Value Fund Jan‐07 Feb‐11 $5,554.6 $7,489.4 6.0%
Cargill Managed Account 1989 2006 $10,756.4 $14,860.7 26.3%
*All values in millions
CarVal
Gross Returns by Asset ClassCVF II CVF I GVF II GVF I
Corporate Credit 71.1% 39.6% 25.7% 15.7%
Liquidations 29.1% 26.0% 29.3% 28.3%
Loan Portfolios 5.6% 24.7% 17.7% 3.6%
Special Opportunities 0.0% 0.0% 2.0% ‐0.3%
Structured Credit 20.4% 39.6% 26.8% 19.6%
Real Estate N/A N/A 21.5% ‐7.8%
A P P E N D I X I I I
13
SEATTLE | 206.622.3700 LOS ANGELES | 310.297.1777 www.wurts.com
PRIVATE EQUITY OUTLOOK
June 2014
T A B L E O F C O N T E N T S
1
Executive Summary Page 2
Buyout Page 7
Venture Capital & Growth Page 11
Secondary Market Page 13
Private Credit Page 15
Recommendations Page 18
Market Environment Page 20
E X E C U T I V E S U M M A R Y : S T R A T E G Y R E C O M M E N D A T I O N S
2
Outlook: Neutral Market dynamics improving, but the majority of capital is allocated to larger funds
Venture/Growth
Outlook: Neutral Rising asset values, growing dry powder and rising transaction prices limit expected returns
Secondary Markets
Outlook: Negative (US Large/Emerging markets)/ Neutral (U.S. Middle Market, Europe) New commitments face higher than average purchase prices which reduces expected returns U.S. middle market, European buyout more attractive than U.S. large and mega deals or Emerging
Markets
Buyout
For those with a strategic allocation requirement, select opportunities include
Opportunities to participate in the apparent dislocation in European markets, including direct lending Smaller, niche sectors or companies that are overlooked by mega‐funds Special vehicles, timely opportunities and other unique offerings
Skilled GPs have delivered attractive returns in most market environments through superior companyselection and ability to lead portfolio companies to greater than market driven growth
Manager Selection
Private Credit Outlook: Neutral (U.S.)/ Positive (Europe) Premiums for direct lending appear more attractive in Europe than in the U.S
E X E C U T I V E S U M M A R Y : M A R K E T E N V I R O N M E N T
3
Neutral In a period of slow expected economic growth it will be more difficult for companies to grow EBITDA.
Five years into the US economic recovery, it is likely that growth will slow sometime in the next five years,hurting EBITDA growth, while growth in Europe and the emerging markets should improve over that period.
Facing sIow growth, General Partners must find other ways to grow portfolio company revenues andearnings to support exit values. “ Buy and Build” strategies reflect an attempt by General Partners to createvalue by “bolting” portfolio companies onto one another.
EBITDAGrowth
Neutral/Unattractive While it is impossible to know what the exit environment will be in 7 to 10 years, the possibility of longer
holding periods for portfolio companies, and the expected large number of portfolio companies needing exists (based on record levels of buyouts taking place today) are headwinds to attractive exit prices.
Exit Environment
Unattractive Purchase price multiples are near historical highs, driven in part by easy access to inexpensive credit.
Rising distributions have been a tailwind to increased fund raising, leading to record amounts of drypowder that has negative implications for future purchase price multiples, expected IRRs and thecomposition of future private investments.
Valuation
Today’s environment for new commitments to private equity is not broadly favorable for generatingattractive long‐term expected returns, and is characterized by headwinds to new investments that havenegative implications for future performance.
O V E R V I E W : M A R K E T E N V I R O N M E N T
4
2013 was a good year for distributions, but 2005 to 2008 vintage funds have yet to return all of theirinvestors’ capital.
Evaluated as a whole, private equity returns have been average for some time, but skilled managershave delivered attractive risk‐adjusted returns over time.
1.79x 1.47x 1.32x 1.24x 0.78x 0.52x 0.48x 0.46x 0.25x 0.16x 0.09x
0.20x0.36x
0.39x 0.49x
0.64x0.75x 0.81x 0.88x
0.97x 0.98x 0.98x
2.00x1.85x
1.72x 1.71x
1.43x1.28x 1.29x 1.35x
1.22x 1.15x 1.07x
0.00x
0.50x
1.00x
1.50x
2.00x
2.50x
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Global Average PE Fund Return Multiples By Vintage Year
DPI RVPI TVPI
While investors in early vintage funds (pre-2004) have been made whole (theirDPI: Distributions to-Paid-in-Capital are greater than one) they still havesignificant amounts of unrealized value (RVPI: Remaining Value to Paid-in).
0%5%10%15%20%25%30%35%40%45%
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
PE vs. VC Top Decile & Quartile IRRs by Vintage
VC Top Quartile VC Top Decile PE Top Quartile PE Top Decile
During most vintage years since 2001, top quartile buyout managers haveoutperformed top quartile venture capital funds.
Source: Pitchbook Source: Pitchbook
O V E R V I E W : M A R K E T E N V I R O N M E N T
5
‐
20
40
60
80
100
120
140
160
2006 2007 2008 2009 2010 2011 2012 2013
Billion
s $
US PE Dry Powder By Fund Type and Vintage
Buyout PE Growth Co‐Investment Restructuring Mezzanine Energy Other
The majority of dry powder in US focused funds is held by buyout funds ($400b),and the majority of that in recent vintage funds with several years left in theirinvestment periods.
‐
50
100
150
200
250
300
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Billion
s $
PE Fund Raising by Fund Size
Under $100M $100M‐$250M $250M‐$500M $500M‐$1B $1B‐$5B $5B+
Source: Pitchbook Source: Pitchbook
2013 fund raising not only saw its best year since 2008, but the return of “mega”funds. Nearly half of committed capital went to funds that raised more than $5billion.
Positive net‐cash flows to limited partners helped fund raising, but 2013 also saw the return of“mega” funds‐those that closed with more than $5 billion of committed capital.
Dry powder continues to grow and has negative implications for purchase price multiples, expectedIRRs and the composition of future private investments.
O V E R V I E W : M A R K E T E N V I R O N M E N T
6
Leveraged buyouts continue to drop as a share of total private equity deals, reflecting a change in howgeneral partners believe they can best create value. Sponsor‐to‐sponsor transactions (“DirectSecondaries”), “buy and build” strategies and taking minority positions in growth/expansion deals havegrown in importance.
The growth in sponsor‐owned portfolio companies is leading to rising holding periods for portfoliocompanies, and has negative implications for returns to future investments in private equity.
Buyouts represent a declining portion of private equity deals as GPs see greateropportunity to add value through add-ons and in the growth/expansion stage ofventure.
0%
20%
40%
60%
80%
100%
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014Q1
US Private Equity Investments by Deal Type
Buyout/LBO Add‐on Recap
PE Growth/Expansion PIPE Platform Creation
4.23.8 3.7 3.5
3.9 3.9
4.7 4.95.3
6
0
1
2
3
4
5
6
7
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Years
Private Equity Median Hold Period
2012 and 2013 were good years for portfolio liquidations and distributions tolimited partners, but holding periods continue to rise.
Source: Pitchbook Source: Pitchbook
B U Y O U T
7
G L O B A L B U Y O U T : U . S .
8
Rising stock prices, aging dry powder and inexpensive debt continues to drivepurchase price multiples to higher levels. Smaller LBOs face less competition andrequire greater equity and less leverage, helping hold down prices.
The use of debt to finance LBOs fell dramatically following the financial crisis.As credit markets have opened up, the use of debt has increased to pre-crisislevels.
.x
2.x
4.x
6.x
8.x
10.x
12.x
1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q
2012 2013
EV/EBITDA Purchase Price Multiples by Deal Size
$0‐$25M $25M‐$250M $250M+Source: Pitchbook Source: Pitchbook
Rising public equity markets, growing dry powder and easy access to credit drove U.S. buyout purchaseprice multiples higher, creating headwinds to future performance
Buyout deals completed at today’s purchase price multiples face a number of headwinds to expected performance:
In a period of slow expected economic growth it will be more difficult for companies to grow EBITDA, forcing general partnersto hold portfolio companies longer in order to generate enough earnings to justify the necessary sale prices. This brings IRRsdown.
Five years into the US economic recovery, it is likely that growth will slow sometime in the next five years, challenging EBITDAgrowth. The increased use of leverage to finance deals is a drag on performance in a weakening economic environment.
Growth in the number and value of portfolio companies needing liquidation will increase the supply of companies beingauctioned, a headwind to exit prices.
Outlook: Large (Negative); Small/Mid (Neutral): Fund raising and dry powder will keep purchase price multiples high for large deals.Prices and leverage are more attractive for Small/Mid size deals, but trends seem to support higher prices ahead.
61%62% 63%
60%
54%56% 55%
62%
65%
45%
50%
55%
60%
65%
70%
2005 2006 2007 2008 2009 2010 2011 2012 2013
Median Debt‐to‐Equity Ratio by Year
G L O B A L B U Y O U T : E U R O P E
9
6.8 6.97.7
8.87.8 7.7 7.6 7.9 7.57.6
8.3 8.89.7 9.7
8.9 9.2 8.8 9.3 8.7
4
6
8
10
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
European Private Equity EV/EBITDA Purchase Price Multiples
<250m Euros All
Source: LCD European Leveraged Buyout ReviewSource: Preqin
Investors’ growing confidence in European reforms and economic growth has led torecord levels of dry powder as fund raising appears ahead of deal-making.
Purchase price multiples for smaller deals are generally more attractive, reflectingless competition and more difficulty in obtaining financing.
Growing confidence in economic reform and recovery is leading to renewed activity and opportunityin European leveraged buyouts, but slow growth may limit returns
A review of 2013 fund raising, deal flow, exit activity and purchase price multiples reveals a return to more normalized levels ofactivity. This appears to reflect investors’ growing confidence in the effects of economic reforms and recovery on earnings andvaluations.
Purchase price multiples have nearly recovered to pre‐crisis levels, but reflect: cyclically‐low/depressed EBITDA: as EBITDA recovers with growth, price multiples will decline. a limited supply of available companies as sellers seek to avoid selling at depressed EBITDA levels and buyers seek only high
quality, low risk assets.
Outlook: Neutral Europe’s economy has turned, but investor sentiment appears ahead of fundamentals as reflected by rising dry powder. Slow
growth will limit returns. European recovery is expected to be uneven and slow, favoring northern over southern Europe. Successful General Partners
will be those that recognize these risks and identify high quality, global companies with limited exposure to on‐going risks. While economic growth is slower, European buyouts are more attractive than U.S. given their valuations are lower and based
on cyclically depressed EBITDA.
272 241 245 221264 277
0
50
100
150
200
250
300
2009 2010 2011 2012 2013 2014Q1
Billion
s $
European‐focused Dry Powder
0
G L O B A L B U Y O U T : E M E R G I N G M A R K E T S
10
Emerging markets remain an attractive long‐term opportunity, but over the next year the dynamics and fundamentals associated with private equity investing are poor
As a whole, emerging markets private equity investing is characterized by: A decade of successful fund‐raising that has led to significant dry powder, placing upward pressure on purchase price multiples. A weak exit environment (including the closure of the Chinese IPO market) has increased holding periods and hurting exit prices. Poor performance on the part of general partners in managing and creating value in their portfolio companies. Macroeconomic conditions (weak economic growth, market and exchange rate volatility), that negatively impacts company
competitiveness, revenue and earnings growth.
Outlook: Neutral Demographic trends favor a growing allocation to emerging markets, but in the next year private equity faces many of the same
headwinds that developed markets struggle with: an overhang of capital, slowing growth and challenging exits, and managerschallenged to create value.
For those with capital to put to work, manager selection, skillful country selection and access to attractive deal flow matters;managers are looking to a new set of countries today including Mexico and South East Asia.
For all of its potential, less than half of private equity investors find any region withinemerging markets attractive investments today.
Emerging market deal flow declined from 2009 until 2012 before starting to grow.Dry powder, measured in terms of years-of-investment has begun to rise again.
149 166 193 185 176 257 377 436 479 480 425 388 356 3990
1
2
3
4
5
6
0
100
200
300
400
500
600
2000 2002 2004 2006 2008 2010 2012
Years of In
vestmen
t
Dry Pow
der, billion
s $
Emerging Markets Dry Powder
Dry Powder Years of Investments
Source: PreqinSource: Bain Capital
7% 7% 7%12% 14%
26% 26%33%
38%
50%
0%
10%
20%
30%
40%
50%
60%
Other MiddleEast
Russia India EasternEurope
Brazil China Africa SouthAmerica
Asia
Regions within Emerging Markets Limited Partners feel Present the Best Opportunities (Preqin Survey)
V E N T U R E C A P I T A L & G R O W T H
11
V E N T U R E A N D G R O W T H C A P I T A L
12
The changing dynamics of the venture capital industry as well as innovation in technology is altering the ways inwhich limited partners should approach venture and growth capital
Trends in Venture Capital The difficulty in returning investors’ capital has led to less capital raised and a rationalization of the industry; the number of active
venture capital (VC) funds is half that of 2000.
Successful VC firms are capturing a larger proportion of limited partners’ capital, leading to bigger funds; in 2012 over 50% of the$21 billion raised went to 11 of the 182 VC funds raised.
Developments in IT (the growth of open source software, the “cloud” and leverageable distribution platforms) have reduced theamount of seed and early stage capital needed to see a company through to its growth stage. As a result, smaller funds takingsmaller positions are better positioned to exploit these opportunities than larger funds.
The intersection of these trends suggests that smaller funds are more likely to outperform, and thus many limited partners in largerfunds will be disappointed. The evidence of fund performance by size tends to confirm this hypothesis.
Outlook: Neutral. The supply/demand dynamics of VC is improving, but the majority of capital allocated to larger funds suggests thatthe average limited partner will underperform, making manager selection critical.
$(40)
$(20)
$‐
$20
$40
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Billion
s $
US Venture Capital Funds Annualized Cash Flows by Year
Contributions ($B) Distributions ($B) Net Cash Flow ($B)
Source: Pitchbook
Distributions continue to exceed new commitments, leading to a net outflow ofassets, letting the asset class downsize to a sustainable level given opportunities.
Small Venture Capital funds have outperformed the large end of the market.
Source: StepStone
2.6 3.44.5
2.0 2.1 1.62.3 2.4
6.1
0.8 1.8 0.80
2
4
6
8
Pre 1990 1990‐1994 1995‐1998 1999‐2001 2002‐2004 2005+
Multip
les
Performance by Fund Size and Vintage Year
<$250m >$250m
S E C O N D A R Y M A R K E T S
13
S E C O N D A R Y M A R K E T S
14
40
60
80
100
120
2007 2008 2009 2010 2011 2012 2013H1 2013H2
Discoun
t/Prem
ium to
NAV
, Percent
Secondary Pricing
Buyout Venture All Strategies
Transaction volume continues to rise, but so does fund raising. Existing dry powderof $24.5b is about one-year of volume, while 2013 fund raising has created another$33b of dry powder yet to be called.
Venture capital portfolios trade more cheaply than buyout portfolios, reflectinggreater uncertainty about expected IRRs, and making the points that portfoliosselling at large discounts to NAV are not necessarily attractive.
Secondary market offerings continue to rise, but rising public equity markets have driven up seller’s expectations,hurting expected returns
Supply continues to grow, the result of regulatory driven selling and the recent attractiveness of “fund restructuring” opportunities.
Over $125 billion of funds coming to the end of their life are not in a position to provide liquidity (zombie funds). With visibility to the underlying portfolio companies, secondary buyers are restructuring these portfolios, providing liquidity to
LPs and giving GPs additional time to realize value.
Secondary pricing has climbed, in part due to higher seller expectations following rising public equities.
Buyers suggest that these prices can be misleading, pointing to the rise in “structured transactions”. Buyers will pay par in astructured transaction for assets about to be written up in value and with payment to be deferred, effectively reducing thepurchase price to below par.
Outlook: Neutral. Regulatory driven selling will increase the supply of secondary portfolios, but the write‐up of NAV due to risingequity markets, rising transaction prices and growing dry powder should limit returns compared to recent history.
0
10
20
30
40
50
60
0
5
10
15
20
25
30
2005 2006 2007 2008 2009 2010 2011 2012 2013
Dry Pow
der (Billion
s $)
Capital R
aised, Transactio
n Vo
lume
(Billions $)
Capital Raised versus Transaction Volume
Capital Raised ($Billions) Transaction Volume Dry Powder
Source: Preqin Source: Cogent
P R I V A T E C R E D I T
15
P R I V A T E C R E D I T : U . S .
16
2.7 3.1 2.82.1 2.4 2.7 2.4
3.4 3.0 2.8 2.6
3.9 4.1 4.3 4.44.8
4.3
3.43.7
4.2 4.34.8
0
1
2
3
4
5
6
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Multip
les
Company Ability to Service Debt
Average Coverage Ratio (EBITDA‐CAPEX)/Interest Average Total Debt to EBITDA
Source: Standard & Poor’s LCD
2.7 3.9 4.8 5.28.6
11
0
2
4
6
8
10
12
10‐yearTreasuries
InvestmentGrade Bonds
LeveragedLoans
High Yield Second Lien PE‐backedMezzanine
Percen
t
Fixed Income Yields(March 2014)
The ability of companies to service their debt remains high, but is less attractive than inthe last couple of years. As credit markets ease, companies have taken on more debt,reducing their interest coverage.
The premium for investing in private credit strategies above public credit remainshigh relative to history.
Source: Bloomberg, Credit Suisse, Barclays, S&P LCD
Returns to U.S. focused private lending appear attractive but risks are likely to rise as the economic recoverymatures
Understanding the role of private credit (first & second lien loans, mezzanine debt) is important to understanding its relativeattractiveness. It is most often used by middle market companies to finance growth, leveraged buyouts, and refinance existing debt.
Private equity sponsors have (1) large pools of dry powder that need to be put to work; and (2) a need to refinance and recapitalizetheir large portfolio of companies in order to provide liquidity to limited partners. The large demand for private debt is being rewarded with attractive premiums relative to public market credit.
Risk to private lending appears low today; default rates are low and companies as a whole are well prepared to service debt.
Outlook: Neutral. High demand for financing and strong corporate balance sheets are providing attractive premiums for privatelending over public market credit, but default rates are low relative to history and likely to rise over time. Prospective investors mustconsider that the US economic recovery is five‐years old; the average business cycle has lasted about six years since WWII.
P R I V A T E C R E D I T : E U R O P E
17
02468101214
Percen
t
European Leveraged Loan and High Yield Default Rates
Europe HY Default Rates Europe Levered Loan Default Rates
As the European economy recovers, default rates continue to come down. Itsrecovery is a year old, suggesting default rates will remain low for some time.
Historically, European companies have relied on bank financing, but banks’ need todelever is limiting their creation of new loans.
Declining bank lending to companies and a slowly recovering economy is creating an opportunity for direct lendingstrategies focused on Europe
An opportunity exists for direct lenders because European banks, the traditional suppliers of debt, are constrained while demand forloans is recovering.
Banks, under pressure to meet higher capital ratios, are reducing risk by not only reducing their lending, but shifting theirlending to larger, publically traded companies.
As Europe recovers, so does the demand for loans: midsize European businesses will need to raise 3.5 trillion euro in debtfunding over the next five years; in addition over 250 billion euros of debt will mature over the next five years.
There are risks to lending in Europe. While Europe’s recession has technically ended, no one expects its economy to recoveryquickly, and in fact there are threats to its recovery. Some EU nations are still in recession; European inflation is falling and itsmoney supply is falling, measures that hint at slowing growth.
Outlook: Positive. With declining access to bank credit for smaller borrowers, pricing appears most favorable for non‐traditionallenders to small and lower middle‐market companies.
3.03.54.04.55.05.56.06.5
Bank
Len
ding, A
nnual G
rowth
Rate (P
ercent)
European Bank Lending to Non‐Financial CorporationsAnnual Growth Rates
Source: Europe MFI Source: Credit Suisse
R E C O M M E N D A T I O N S
18
R E C O M M E N D A T I O N S
19
U.S. Buyout European BuyoutEmerging Markets
Buyout Secondary Market Venture Private Credit
Pricing Conditions
Prices for large and middle‐market LBOs are high relative to their history, though more attractive for middle market deals than than for large deals.
Purchase price multiples are high, but in part because earnings are cyclically depressed. As growthand earnings recover, purchases over the next several years will appear more attractive.
Conditions remain similar to a year ago. Strong fundraising relative to opportunity set is leading to large capital overhang and rich pricing.
Strong equity markets and increased distributions to LPs have pushed purchase prices up. General Partners suggest that “structured” transactions that delay payment to sellers effectively reduces the purchase price.
Fundraising appears to have settled at a more sustainable level. Decreasing commitments and improved industry dynamics are producing more favorable pricing.
The premium for investing in private credit over public credit is wide relative to historical averages, in both the U.S. and Europe, but the risks associatedwith these premiums are different and changing.
Macro Environment (Beta)
Conditions are similar to a year ago. Rising public equity markets, inexpensive financing and dry powder is putting upward pressure on price multiples. Slowerthan average economic growth will contribute to longer holding periods, effectively reducing expected returns.
European recovery is expected to be uneven and slow, favoring northern over southern Europe.
Over the intermediate‐term, faster economic growth is a tailwind to value creation, but in the near termmarkets are recognizing differences in macroconditions across countries that have implications for expected returns. In the near‐term, private equity faces the same headwinds that developed markets struggle with: an overhang of capital, slowing growth and challenging exits.
Fundraising and strongpublic equity markets have in the short‐run made the market less attractive, but changing market dynamics (regulatory driven selling) will, in the medium‐term, favor buyers of secondary portfolios..
Developments in information technology have reduced the amount of seed and early stage capital needed to see a company through to its growth stage. As a result, smaller funds taking smaller positions are better positioned to exploit these opportunities than larger funds..
Its relative attractiveness varies with where credit is in its market cycle. Five years into its recovery, U.S. credit markets are late in their cycle, while European credit cycle is in its earlier stages. In addition, European banks, are under pressure to raise capital ratios, leading them to lending to companies.
Manager Environment
High purchase prices and low economic growth means manager driven value creation will be key to strong returns; favoring small and middle‐market deals where managers have more levers to create value and exit options
A bifurcated economic recovery suggests that successful General Partners will be those that identify high quality, global companies with limited exposure to on‐going European risks.
Successful managers will be those that recognizedifferences in country risk and that are skillful in country selection and company selection. Managers are looking to a new set of countries today including Mexico and South East Asia.
As the market matures, LP interests will be more efficiently priced. Managers with access to proprietary deal flow and strong underwriting efforts will outperform.
.
Managers that have demonstrated earlier success are raising larger funds at a time when small allocations are needed by technology firms.
The absolute returns to private credit appear attractive, but today, as the credit cycle reachesits top, the risk return profile is less attractive. With many “new” managers raising funds, the challenge for investors is to identify managers with the skill set and experience to implement the strategy in a manner that reflects the desired risk‐return profile they seek.
Outlook Negative (Large)Neutral (Mid‐market) Neutral Neutral Neutral Neutral Neutral (U.S.)/Positive (Europe)
M A R K E T E N V I R O N M E N T
20
M A R K E T E N V I R O N M E N T : R E T U R N S
21
0.83x 0.75x 0.65x 0.32x 0.70x 0.33x 0.29x 0.25x 0.14x 0.09x 0.11x
0.38x0.37x 0.47x
0.75x
0.92x
0.84x 0.98x 1.01x 1.17x1.01x 1.04x
1.22x1.11x 1.12x 1.06x
1.62x
1.15x1.27x 1.26x 1.31x
1.09x 1.14x
0.00x0.20x0.40x0.60x0.80x1.00x1.20x1.40x1.60x1.80x
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Global Average Venture Capital by Vintage Year
DPI RVPI TVPI
1.79x 1.47x 1.32x 1.24x 0.78x 0.52x 0.48x 0.46x 0.25x 0.16x 0.09x
0.20x0.36x
0.39x 0.49x
0.64x0.75x 0.81x 0.88x
0.97x 0.98x 0.98x
2.00x1.85x
1.72x 1.71x
1.43x1.28x 1.29x 1.35x
1.22x 1.15x 1.07x
0.00x
0.50x
1.00x
1.50x
2.00x
2.50x
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Global Average PE Fund Return Multiples By Vintage Year
DPI RVPI TVPI
While investors in early vintage funds (pre-2004) have been made whole (their DPI:Distributions to-Paid-in-Capital are greater than one) they still have significant amountsof unrealized value (RVPI: Remaining Value to Paid-in).
As a group, no vintage year funds since 2001 have yet to make limited partnerswhole. All DPI’s are less then one. Potential returns, as measured by TVPI (realizedand unrealized value) are also low across all vintages.
2013 was a good year for distributions, but 2005 to 2008 vintage funds have yet to return all of theirinvestors’ capital
Funds raised during the years leading up to the Great Financial Crisis paid high prices for portfolio companies that lost value duringthe downturn. As a group, these funds have struggled to return capital.
Many are starting to see a recovery in the value of their portfolio companies but as their life‐spans are winding down, limitedpartners are seeking liquidity and the funds’ ability to generate “carry” for their general partners is limited. These have becomeknown as “zombie funds”.
Zombie funds have become targets of secondary funds. The secondary funds provide liquidity to limited partners while creatingnew economics for general partners to actively manage the portfolios to their conclusion.
Source: Pitchbook Source: Pitchbook
M A R K E T E N V I R O N M E N T : R E T U R N S
22
During most vintage years since 2001, top quartile buyout managers haveoutperformed top quartile venture capital funds.
Bottom quartile PE (Buyout) funds have consistently outperformed bottom quartileventure capital funds.
Evaluated as a whole, private equity returns have been average for some time, but skilled managers have delivered attractive risk-adjusted returns over time.
Academic research suggests there is persistence in general partner performance over time, and thus manager selection matters. Areview of performance by quartile reveals double digit differences in performance between the top and bottom quartile funds in bothbuyout and venture capital.
A review of fund performance by quartile reveals that: Bottom quartile buyout funds have consistently delivered superior absolute performance relative to bottom quartile venture
capital funds. Top quartile buyout funds have generally outperformed top quartile venture funds.
These results raise a question about the role of venture capital in a client’s portfolio in the absence of skill in fund selection; shouldlimited partners ignore venture and invest only in buyout?
-15%
-10%
-5%
0%
5%
10%
15%
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
PE vs. VC Bottom Quartile IRRs by Vintage
PE Bottom Quartile VC Bottom Quartile
Source: Pitchbook Source: Pitchbook
0%
10%
20%
30%
40%
50%
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
PE vs. VC Top Decile & Quartile IRRs by Vintage
VC Top Quartile VC Top Decile
PE Top Quartile PE Top Decile
M A R K E T E N V I R O N M E N T : F U N D R A I S I N G
23
The increase in fund raising was driven by an increase in commitments to buyoutfunds as well as to energy and mezzanine focused funds.
2013 fund raising not only saw its best year since 2008, but the return of “mega”funds. Nearly half of committed capital went to funds that raised more than $5billion.
Source: Pitchbook
Positive net-cash flows to limited partners helped fund raising in 2013, but it also saw the return of“mega” funds-those that closed with more than $5 billion of committed capital
After four years of weak fund raising, the amount of capital raised and the number of funds closed reached post‐financial crisis highs.
The primary explanation for a recovery in fund raising is an increase in distributions to limited partners, giving them new capital tocommit to private equity. Other explanations include an under allocation to private equity relative to investors’ policy statements giventhe outperformance of public market equities since 2009.
The increase in fund raising was accompanied by a rise in the proportion of assets committed to “mega” funds (those with more than$5b of committed capital). One explanation is that limited partners are reducing the number of managers they invest with to those thathave been the most successful in the past.
One implication of more capital being allocated to mega funds is the likelihood of more “larger” deals being done than in the last fiveyears.
‐
50
100
150
200
250
300
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Billion
s $
PE Fund Raising by Fund Size
Under $100M $100M‐$250M $250M‐$500M $500M‐$1B $1B‐$5B $5B+
Source: Pitchbook
‐
50
100
150
200
250
300
'04 '05 '06 '07 '08 '09 '10 '11 '12 '13
Billion
s $
US Fund Raising by Strategy
Buyout PE Growth Co‐Investment Restructuring Mezzanine Energy Other
M A R K E T E N V I R O N M E N T : D E A L F L O W
24
Buyouts represent a declining portion of private equity deals as GPs see greateropportunity to add value through add-ons and in the growth/expansion stage of venture.
Within US buyout, acquisition of private companies remains the biggest portion ofdeals. Sponsor-to-sponsor transactions have stabilized with recovery of the IPOmarket.
Source: PitchbookSource: Pitchbook
Changes in the make-up of completed private equity transactions suggests General Partners are finding new ways to generate value for their limited partners
PE‐acquisition of privately held companies continues to dominate deal making. Sponsor‐to‐sponsor transactions which grewsignificantly following the financial crisis have stabilized as sponsors turn to a recovering IPO market for better exit values.
Leveraged buyouts continue to drop as a share of total private equity deals, reflecting a change in how general partners believethey can best create value.
“Buy and build” strategies and taking minority positions in growth/expansion deals have grown in importance.
An increase in capital allocated to growth/expansion deals reflect a change in the nature of venture capital funding. Early roundfunding needs to develop new technology have got smaller but more capital is necessary to see those companies to profitability.
0%
20%
40%
60%
80%
100%
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
US Buyout Deals by Source
Private‐to‐Sponsor Sponsor‐to‐Sponsor
Carve‐Out Public to Private
0%
20%
40%
60%
80%
100%
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014Q1
US Private Equity Investments by Deal Type
Buyout/LBO Add‐on Recap
PE Growth/Expansion PIPE Platform Creation
M A R K E T E N V I R O N M E N T : D E A L F L O W
25
The share of deals under a billion dollars has risen in importance as GPs engage inbuy and build strategies within buyout, and minority growth/expansion deals.
Add-on deals continue to grow in importance as GPs seek to create value throughbuy and build strategies.
680 867 1107 799 508 725 881 883 838 245
10561300 1476
1047
575
882904 967
757
171
39% 40% 43% 43%47% 45%
49% 48%53%
59%
0%
10%
20%
30%
40%
50%
60%
70%
0
500
1000
1500
2000
2500
3000
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014*
Buyouts: Add‐ons vs Non Add‐ons
Add‐on Non Add‐on Add‐On % of Buyout
0%
20%
40%
60%
80%
100%
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014Q1
Investments by Deal Size
Under $25M $25M‐$250M $100M‐$500M
$500M‐$1B $1B‐$2.5B $2.5B+
The changing economics of private equity deals is forcing General Partners to look for new ways to createvalue, leading to changes in the composition of completed private equity deals
The share of smaller deals, specifically under a billion dollars, has grown the last couple of years, reflecting changing privateequity economics.
The increase in capital raised, dry powder waiting to be put to work, and recovery in public equity markets has put upwardpressure on purchase price multiples. In an environment of slow economic growth, General Partners must find other ways togrow portfolio company revenues and earnings to support exit values.
“Add‐ons” , typically smaller deals, reflect an attempt by General Partners to create value by “bolting” portfolio companies ontoone another in “buy and build” strategies. They believe that synergies arising from putting companies together will createvalue.
Source: Pitchbook Source: Pitchbook
M A R K E T E N V I R O N M E N T : D R Y P O W D E R
26
‐
20
40
60
80
100
120
140
160
2006 2007 2008 2009 2010 2011 2012 2013
Billion
s $
US PE Dry Powder By Fund Type and Vintage
Buyout PE Growth Co‐Investment Restructuring Mezzanine Energy Other
The majority of dry powder in US focused funds is held by buyout funds($400b), and the majority of that in recent vintage funds with several years leftin their investment periods.
The majority of US dry powder dedicated to buyout is held by funds with greater than$1 billion, The limited number of mega buyout deals in which to put capital to worksuggests General Partners will seek out new investment strategies.
Source: PitchbookSource: Pitchbook
Growth in dry powder has negative implications for purchase price multiples, expected IRRs and the composition of future private investments
In the competition between fund raising and new deal flow, fund raising continues to win. The result is a rise in the dry powderGeneral Partners have to put to work.
A more granular look reveals that General Partners are sitting on nearly a trillion dollar in global dry powder, over $600 billion of itdedicated to US‐focused funds and over $400 billion of that dedicated to US buyout funds (nearly 5‐years of deal flow).
A legitimate concern is that General Partners, anxious to put that capital to work before their investment period ends, will bid uppurchase price multiples. Others suggest that the composition of dry powder makes its potential impact on purchase pricemultiples less serious. Specifically, that within the pool of buy‐out focused dry powder, only approximately $100 billion is in fundswhose investment period is nearing an end. More than half of dry powder has been raised in the last two years.
Three‐quarters of the dry powder is held by funds with more than a billion dollars. As there are generally not enough large buyoutdeals to put this much dry powder to work, it is likely these larger funds will seek out other types of transactions including add‐onsand minority growth expansion deals.
‐
20
40
60
80
100
120
140
160
2006 2007 2008 2009 2010 2011 2012 2013
Billion
s $
PE Capital Dry Powder by Fund Size
Under 50M $50M‐$100M $100M‐$250M $250M‐$500M $500M‐$1B $1B+
M A R K E T E N V I R O N M E N T : E X I T S
27
$‐
$50
$100
$150
$200
$250
‐ 100 200 300 400 500 600 700 800 900
Value of Exits, B
illions
Num
ber o
f Exits
PE Exit Flow by Type and Value
Corporate Acquisition IPO Secondary Buyout Capital Exited ($B)
After two strong years of exit activity, 2014 is off to a slower start. A recovery in exit price multiples has rewarded partners in earlier vintage fundsbut those high prices are an impediment to returns for new buyers.
Source: Pitchbook Source: Pitchbook
Rising public equity markets, lots of dry powder and aging sponsor-owned companies contributed toa strong exit market
Corporate acquisitions continue to provide the majority of exits for private equity owned companies, but 2013 saw a small declinein its overall contribution to exits, the result of a recovery in the IPO market.
With general partners holding lots of dry powder on one hand and an aging portfolio of companies on the other, the growth insecondary buyout (also known as sponsor‐to‐sponsor transactions) exits is not surprising. They have grown from 25% of all exits in2009 to 39% in 2013; and the average median secondary buyout size has increased from $150m in 2011 to $379m in 2013.
The increase in 2012 and 2013 exits has reduced the ratio of new privately held companies‐to ‐exits, but it is still greater than one,meaning the number of privately held companies continues to grow.
The combination of high purchase price multiple in a low growth environment and lots of companies needing to be sold will lead tolonger holding periods for companies, hurting expected returns.
7.1
7.5
6.7
8.6
9.2
8.1 8.1 8.1
7.3
8.9
6.0
6.5
7.0
7.5
8.0
8.5
9.0
9.5
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Median Valuation/EBITDA At Exit
M A R K E T E N V I R O N M E N T : P R I V A T E E Q U I T Y E X P O S U R E
28
9631238
1704
2275 22792480
27763036
32733466
0
500
1000
1500
2000
2500
3000
3500
4000
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Billion
s $
Private Equity Exposure
Source: Pitchbook
The value of private equity controlled companies now exceeds the market cap ofthe Russell 2000.
2012 and 2013 were good years for portfolio liquidations and distributions tolimited partners, buy holding periods continued to rise.
The growth in sponsor owned portfolio companies has negative implications for returns to futureinvestments in private equity
Ten years ago, private equity firms controlled nearly 2300 companies worth about $960 billion. Today, private equity controls over7000 companies worth nearly $3.5 trillion.
The rate at which private equity sponsors are acquiring portfolio companies is faster than the rate at which they are beingliquidated. Historically, private equity owned portfolio companies are held for around four years before they are turned over andliquidity provided to limited partners. Today, the average holding period exceeds 6‐years.
Rising holding periods in the absence of above average revenue and earnings growth, leads to smaller distributions (TVPI) andlowering realized IRRs.
Source: Pitchbook
4.23.8 3.7 3.5
3.9 3.9
4.7 4.95.3
6.0
0
1
2
3
4
5
6
7
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Years
Private Equity Median Hold Period