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REPORT TO ASRS                                                                                 !!!!!!      The Arizona Sta...
Table&of&Contents                            ! Introduction*.................................................................
IntroductionThe Arizona State Retirement System (ASRS), is a $28 billion public pension fund that investsup to $4.2 billio...
Three-part AnalysisPART I. Arizona State Retirement System’s Investment PortfolioWe recommend that ASRS not only continue ...
Clara University argues that these traditional factors include elements that do not relate toliquidity and therefore produ...
Emerging Market Debt                                                   4.00%Opportunistic Debt                            ...
1.2 An Efficient Investment Frontier for ASRSThis section assesses how the inclusion of PE affects the risk and return of ...
Similarly, the efficient frontier with PE has a higher expected return for the same amount ofrisk. If standard deviation i...
returns, this new frontier favors PE over all other asset classes. For instance, to achieve astandard deviation of less th...
Hidden FeesIn addition to management fees and carried interest, there are hidden fees that GPs receive,which can increase ...
the 2000s.” Venture capital fund sizes have increased from $77 million to $191 million to $358million. Their research indi...
Despite critics’ claims that PE returns do not justify the negative characteristics, data supportsthe opposite conclusion....
returns’ dependence on it, layering vintage years is also a way to maximize returns from the bestperforming years while li...
correlation and diversification—while it offers few identifiable advantages for hedging ingeneral and none for the ASRS po...
PART II. Accounting Issues in Private EquitySection two will discuss the accounting rules that impact PE and how certain r...
• Level 2: Here are assets or funds with moderate principal or secondary markets, such as  restricted stocks, some convert...
Total                                                                  4.00%                3.00%INVESTMENT IN INFLATION L...
previous method, this method requires the person who evaluates to make significant  subjective judgments.• Industry Valuat...
Subjectivity and uncertaintyPart of the objectives of SFAS 157 for PE is to help LPs and GPs assess differences in assetva...
government entities use FASB pronouncements in absence of an applicable GASBpronouncement.    Both FASB and GASB standards...
statements or footnotes of income statement as directors remuneration or compensation fordirectors. This is the same in No...
2.3 The structure of entities and incentive compensationThis section discusses the structure of entities and incentive com...
If stock based compensation is paid as stocks, it is possible for investors to compare the twoinvestments because the valu...
ending bailouts, protect consumers from abusive financial services practices, and for otherpurposes (HR 4173).Implications...
purpose of the Volcker rule is to prevent any conflict of interest with the LPs and preventexposure to risk.Delaware Uncor...
PART III. Private Equity In PracticeThis section outlines the current trends in private equity, including typical allocati...
in North America, fundraising levels for these vehicles are significantly higher in terms ofaggregate value when compared ...
Charts 2.1.3 and 2.1.4 show the most popular areas, by both fund types and geographicallocations, in which LPs seek to inv...
Appetite for Emerging MarketsAs is reflected in the chart above, a “substantial 72% of LPs will invest or consider investi...
NORTH                     SOUTHTYPE                                    EUROPE                  AUSTRALIA        ASIA      ...
National Social Security                             $151,751            2.4%               $3,622               9.3%Fund ...
Hence, the assertion that PE professionals are capitalist pigs who prefer gutting companies togrowing them is unsubstantia...
Investment in Private Equity justification
Investment in Private Equity justification
Investment in Private Equity justification
Investment in Private Equity justification
Investment in Private Equity justification
Investment in Private Equity justification
Investment in Private Equity justification
Investment in Private Equity justification
Investment in Private Equity justification
Investment in Private Equity justification
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Investment in Private Equity justification


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Assessed whether continued investment in private equity is justifiable
and to identify conditions under which investment in private equity would
contribute positively to returns given the portfolio’s specific

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  1. 1. REPORT TO ASRS !!!!!! The Arizona State Retirement System (ASRS) is a $28 billion public pension fund that invests up to $4.2 billion in alternative asset classes, including private equity and venture capital. ASRS has asked Thunderbird to provide recommendations regarding its strategic asset allocations, specifically to private equity. The purpose of this paper is toassess whether ASRS’ continued investment in private equity is justifiable and to identify conditions under which investment in private equity would contribute positively to ASRS’ returns given the portfolio’s specific constraints. Djoudie Etoundi Essomba Fikremariam Gurja Kazuki Hida Daniel Martin Karan Shah Dhinesh Kumar Shanmugam Kathryn Spada Lacey Yoder
  2. 2. Table&of&Contents ! Introduction*......................................................................................................................................................................................................*2! Three0part*Analysis*........................................................................................................................................................................................*3! PART%I.%Arizona%State%Retirement%System’s%Investment%Portfolio!......................................................................!3! 1.1 Contribution of PE to the ASRS portfolio!......................................................................................................................!3! 1.2 An Efficient Investment Frontier for ASRS!..................................................................................................................!6! . 1.3 Costs of PE!................................................................................................................................................................................!8! 1.4 Risk Management!.................................................................................................................................................................!11! 1.5 Conclusion!...............................................................................................................................................................................!13! PART%II.%Accounting%Issues%in%Private%Equity!................................................................................................................!14! 2.1 Influence of valuation rules!...............................................................................................................................................!14! 2.3 The structure of entities and incentive compensation!...............................................................................................!21! 2.4 Dodd-Frank Act!.....................................................................................................................................................................!22! 2.5 Conclusions!.............................................................................................................................................................................!24! PART%III.%Private%Equity%In%Practice!....................................................................................................................................!25! 3.1 Trends in Private Equity!.....................................................................................................................................................!25! 3.2 Trends in Private Equity investing for large-scale investments!............................................................................!28! 3.3 Social Responsibility!...........................................................................................................................................................!30! 3.4 Conclusions!.............................................................................................................................................................................!31! Conclusions*and*Recommendations*.....................................................................................................................................................*32! Appendix*..........................................................................................................................................................................................................*33! PAGE 1 OF 42
  3. 3. IntroductionThe Arizona State Retirement System (ASRS), is a $28 billion public pension fund that investsup to $4.2 billion in alternative asset classes, including private equity (PE) and venturecapital. ASRS has asked Thunderbird to provide recommendations regarding its strategic assetallocations, specifically to PE. The purpose of this paper is to assess whether or not ASRS’continued investment in PE is justifiable and to identify conditions under which PE wouldcontribute positively to ASRS’ returns given the portfolio’s specific constraints.Questions Under ConsiderationASRS submitted a list of questions and requested an analysis of the following characteristicsassociated with PE: liquidity, marketability, fee structure, risk-return ratios, legal and regulatoryframework, current and future trends, main players, investment strategies, and socialresponsibility. This paper will utilize these characteristics in order to answer the followingquestions:First, what is the rationale for investing in PE as it relates to ASRS? • How does PE interact with other elements in ASRS’ portfolio? • Is there an efficient frontier that includes PE and what is it? • How are PE fees established? • Are those fees justified or excessive? • How does illiquidity influence investment framework from investment to returns? • How is risk in PE managed? • What are the frameworks to manage risk?Second, what is the impact of accounting rules on PE? • How do valuation rules affect returns and what potential problems are thus raised? • Are the GASB rules on reporting for alternatives well-conceived?Third, what are the trends in PE, including considerations of social responsibility? • What are the main trends in PE investment by government pensions systems, endowments, and sovereign wealth funds? • Is PE socially responsible? PAGE 2 OF 42
  4. 4. Three-part AnalysisPART I. Arizona State Retirement System’s Investment PortfolioWe recommend that ASRS not only continue to invest in PE, but also that it will benefit fromincreasing its investments in PE. Even though PE is strongly illiquid compared to other options,the PE asset class as an investment strategy provides greater returns for the ASRS portfolio andreduces risk by increasing overall diversification by sector, geography, and stage. PE alsoreduces the portfolio’s correlation with its asset invested in public equity markets. A survey ofUS state retirement funds indicates that ASRS’ PE allocation is below the norm. An increase inPE investments would position ASRS nearer the country’s average. The fees associated with PEfunds can negatively impact PE returns when too high. However, with proper due diligence andsustained oversight of General Partners (GPs), fees and costs can be contained and high returnspreserved.1.1 Contribution of PE to the ASRS portfolioCritics of PE advise against investing in the asset class due to its illiquidity, high costs, and highrisk. This section analyzes the arguments and research in regards to these issues, highlighting therationale for investing in PE. This section also includes a discussion of an efficient frontier theASRS’s portfolio with and without PE. Despite negative characteristics that PE criticsemphasize, recent studies have found that a portfolio that includes PE optimizes the risk-returnratio compared to investments in public equity. Finally, this section will also providerecommendations on liquidity and risk management strategies.Liquidity RiskA key factor that restricts investment in PE is liquidity risk. Generally investors expect a greaterreward the longer assets are committed to an investment, known as liquidity risk premium. Theperiod of illiquidity for PE is usually ten years. To address ASRS’ liquidity needs we began bymeasuring the current level of liquidity in the portfolio and compared it to three other USretirement pension funds. An analysis of liquidity measurement methodologies, ourmethodology, and a table that applies our methodology to the ASRS portfolio are below.Liquidity Measurement MethodologyLiquidity measurement methodology has been a subject of discussion for over 100 years. Despitecontinuous research and debate, the common understanding of liquidity can be attributed to CarlMenger (1892). Menger assess liquidity based on three characteristics: an established market,tightness, and depth. In recent years, industry experts have proposed methods to define andmeasure liquidity; however, there is no universally accepted process. While most argue that asystematic method for measuring liquidity is important in the market, there is not yet apredominant method. Anson (2010) states that liquidity risk arises from investing in an asset that“cannot be sold in a timely manner” unless it is sold at a large discount. He further argues thatliquidity risk is the mismatch between the holding period of an asset and the time interval overwhich liquidity is needed. In their measure of liquidity, most methods include observable factors such as trading time,tightness, depth, and resilience (Zimmerman, et al, 2004). A recent report published by Santa PAGE 3 OF 42
  5. 5. Clara University argues that these traditional factors include elements that do not relate toliquidity and therefore produce measurements that are “incorrectly diluted” (Chacko, Das, andFan, 2012). Chacki, Das, and Fan recommend using an index-based measurement that analyzes aportfolio which is long Exchange Traded Funds (ETF) and short the underlying securities. Incompletely efficient markets the difference in yield would be zero; in imperfect markets, thedifference in yield is attributed to the lack of liquidity. Although this approach would result in a less diluted liquidity measurement, it is not feasibleto apply this method to the ASRS portfolio. Therefore, we have used Menger’s definition, usingthree of the most commonly accepted, measureable factors for each asset class within ASRS’portfolio: presence of an established market, tightness, and depth. Tightness is the market’sability to match supply and demand at a low cost and is measured by the bid-ask spread. Depth isthe market’s ability to absorb a large amount of activity without being reflected in the price.(Committee on the Global Financial Systems, 2001) Using these three factors, we classified each of the asset classes into three levels, level 1assets being most liquid and level 3 assets being least liquid (see Table 1.1.1). We thencalculated a weighted score for ASRS’ portfolio (see Table 1.1.2). According to theseclassifications ASRS’ portfolio has a liquidity score of 2.45 out of 3.00, which indicates that theportfolio is relatively liquid. In comparison, the Teacher Retirement System of Texas portfolioscores 2.39, Public Employees’ Retirement Association of Colorado scores 2.67 and PublicEmployees’ Retirement System of Mississippi scores 2.82 (see Exhibit 1 in Appendix).Table 1.1.1 Liquidity Asset Classification for ASRS’ Portfolio LEVEL 1 LEVEL 2 LEVEL 3ASRS ASSET CLASSES HIGHLY LIQUID SOMEWHAT LIQUID HIGHLY ILLIQUIDINVESTMENT IN US EQUITYLarge Cap Equities 23.00%Mid Cap Equities 5.00%Small Cap Equities 5.00%TOTAL 33.00%INVESTMENT IN NON-US EQUITYIntl Developed Large Cap Equities 14.00%Intl Developed Small Cap Equities 3.00%Emerging Intl Equities 6.00%TOTAL 23.00%INVESTMENT IN ALTERNATIVE ASSETSPE 7.00%Opportunistic Equity 0.00%Equity Long-ShortTOTAL 7.00%INVESTMENT IN US FIXED INCOMECore Bonds 13.00%High-Yield Bonds 5.00%TOTAL 13.00% 5.00%INVESTMENT IN OTHER FIXED INCOME PAGE 4 OF 42
  6. 6. Emerging Market Debt 4.00%Opportunistic Debt 0.00%Private Debt 3.00%TOTAL 4.00% 3.00%INVESTMENT IN INFLATION LINKED ASSETSCommodities 4.00%Real Estate 8.00%InfrastructureFarmland and TimberOpportunistic Inflation-Linked AssetsTOTAL 4.00% 8.00%TOTAL PERCENTAGE 73.00% 4.00% 18.00%Table 1.1.2 Liquidity Score LIQUIDITY LEVEL WEIGHT WEIGHTED SCORE Level 1 – Highly Liquid 3 points 0.73*3 = 2.19 Level 2 – Somewhat Liquid 2 points 0.04*2 = 0.08 Level 3 – Highly Illiquid 1 point 0.18*1 = 0.18 TOTAL WEIGHTED SCORE 2.45The ASRS portfolio is relatively liquid compared to other pension funds. However, ASRS candecrease the risk associated with liquidity. Some studies have shown that the diversificationgains expected by PE investors may not materialize because PE is “significantly exposed to thesame liquidity risk factors as public equity” (Netspar, 2011). Therefore, institutional investorssuch as ASRS should adopt strategies to manage liquidity. We recommend that ASRS ladder itsPE investments by investing in funds in a way that allows ASRS to receive cash returns atstaggered time intervals. When laddering, ASRS should manage the GPs cash returndistributions so that the timing and amounts received serve the needs of the organization. PE investments function as limited partnerships, with a GP managing the contributions of theLP in a fund for seven to ten years on average. Most often the lifecycle of the fund begins withan investing period in the first two to four years, followed by a maturing and realization periodwhen the fund starts to earn returns, ending with a liquidation period of the fund’s assets, whichis when returns are maximized and assets converted into cash. Most managing partners raise anew fund within three to four years, thus diversifying investments by the year of formation, thevintage year. This time diversification is the means by which a fund overcomes the timeilliquidity inherent in this asset class: layering the vintage years across several years allows theGPs to limit exposure to a specific time period while spreading the periods of initial returns, thusproducing continuous returns for LPs from various funds in spite of the immobilized nature ofthe assets. Given the cyclical nature of the economic environment, layering vintage years is alsoa way to maximize returns from best performing years while limiting the impact of the lessperforming ones. PAGE 5 OF 42
  7. 7. 1.2 An Efficient Investment Frontier for ASRSThis section assesses how the inclusion of PE affects the risk and return of the overall portfolio.PE is both an asset class and a strategy, which poses challenges when integrating it into aninvestment portfolio. As an asset class, PE investments are managed most efficiently by using abasket of all privately held companies, weighted according to their inherent value. However PEis also a choice in favor of the skill-based strategy of a specific PE fund. Most of the time, thisstrategy relies on leveraged buyouts and/or venture capital investments. The fragmentedstructure of the private equity market is such that private equity investors cannot fully-diversify away from private company specific risk; thus, all private equity investmentsare a mixture of systematic risk exposure to the private equity asset class and to privatecompany specific risk (Ibbotson Associates, 2007). We incorporated ASRS’ portfolio and allocation1 in the various asset classes and constructedan efficient frontier analysis, both with and without PE. The optimization inputs were theexpected returns, the standard deviation, and correlation between the different asset classes. Theoptimization result for ASRS’ portfolio with and without PE is shown in Chart 1.2.1.Chart 1.2.1 ASRS’ Efficient Frontier With and Without PEThe red line represents the portfolio’s efficient frontier without PE. In this particular case theexpected return is 9.1% with a standard deviation of 15.8%. The standard deviation indicates therisk of the portfolio for a certain expected return. The gray line represents the efficient frontierwith PE. The 9.1% expected return can be achieved with 13.4% standard deviation. Thisindicates that a portfolio that includes PE has the same expected returns with a lower degree ofrisk. Therefore, holding returns constant, the standard deviation of the portfolio is lower whenPE is included.1 In order to understand the current combination of expected return and risk for the ASRS portfolio, we would needto obtain exact allocation percentage of all asset classes. This assessment uses aggregated asset classes. PAGE 6 OF 42
  8. 8. Similarly, the efficient frontier with PE has a higher expected return for the same amount ofrisk. If standard deviation is fixed at 15.36% for both without PE and with PE, the portfoliowithout PE yields an expected return of 9.04%, while the portfolio with PE yields an expectedreturn of 9.53%, which is a 49 bases point advantage. Therefore, though PE may have a higherstandard deviation as an isolated asset class, it actually reduces risk for a given expected returnwhen considered in a portfolio. However, based on the findings of a recent study, the standard deviation and expected returnfor PE reported by ASRS is too conservative. The study assessed PE performance compared tothe S&P 500 and found that the standard deviation of both asset classes is overstated (see Table1.2.1).Table 1.2.1 Risk-Return Analysis of PE & S&P500 (2000-2011) CAPITAL WEIGHTED UNWEIGHTED S&P 500 S&P TRAverage (annualized) 6.3724% 4.1041% 1.3215% 3.2319%Standard Deviation 5.00505% 4.2311% 9.33% 9.34764%Coefficient of Variation 3.14169% 1.0260% 28.23% 11.57%Source: Gary Gibbons, Ph.D. and Olga Kugatkina, Ph.D., unpublished research (2013)This study includes data from the two recent recessions of the last decade. Despite the financialcrisis in early 2000s and in 2008, investments in private equity have proven to be less risky andearned more return than the public markets. However, it is still important to consider theliquidity implications of investing in private equity, which is discussed in the liquidity risksection. Based on new data from Gibbons’ study regarding the standard deviation and expectedreturns of private and public equity, ASRS’ portfolio can be optimized according to Chart 1.2.2.Chart 1.2.2 ASRS’ Efficient Frontier Based on New Return and Risk DataWhen the volatility for PE, Large Cap Equities, and small/mid cap equities are changed, the newefficient frontier is drastically different. Due to PE’s low standard deviation and high expected PAGE 7 OF 42
  9. 9. returns, this new frontier favors PE over all other asset classes. For instance, to achieve astandard deviation of less than 5%, the portfolio will be nearly 100% allocated to PE. However,due to the illiquidity and advantages of diversification we do not recommend investing 100% inPE. Therefore, the allocation percentages should be defined in such a way that maximizes thereturn within the institution’s accepted level of risk for each asset class. For example, accordingto the ASRS asset allocation table, PE should be between 5 and 9%. If all asset classes’allocation percentages are set, these constraints would be applied to the output during theoptimization process. These constraints, according to the investment policies of ASRSmanagement, would help to obtain institutionally acceptable efficient frontier recommendations.However, it is important to note that adding PE to the portfolio contributes positively to theoverall ASRS portfolio. Even in a constrained basis, PE increases the expected return anddecreases risk.1.3 Costs of PESome critics point to the high fees associated with PE as support for their argument that it is notan attractive or financially rewarding asset class. GPs have been severely scrutinized for thesehigh fees. The fixed portion fee charged by GPs, in particular, has become a substantialpercentage of overall compensation, spurring accusations that PE does not yield LPs enoughreturn to compensate for the fees. In addition to standard fees, there are some hidden fees thatadd to the overall cost of PE. This section provides an overview of the various types of fixed andhidden fees.Types of Fees in PEAt the inception of a fund, GPs and LPs sign a contract that specifies compensation. There aretwo types of standard fees: management fee and carried interest. The standard management fee is2% of the total committed funds. Recently, there has been increased pressure to reduce thisamount, but the only changes that have been made are in Asia. In addition to a management fee, GPs receive carried interest, usually 20% of profits. Thecarried interest is viewed as an incentive mechanism or a reward for good performance. Therationale behind this incentive is that PE locks up a GP’s assets for ten years or more; therefore,LPs must motivate or incentivize GPs to facilitate high returns. Academic literature debates the effect that carried interest has on the overall performance ofthe fund. According to a report from Duke University, “the terms of management contractsprovide insufficient incentives, and, as such, allow PE GPs to charge excessive fees for theperformance they deliver” (Robinson and Berk). Another report by PE International rebukes thisargument, stating, “management contracts reflect agency considerations and the productivity ofmanagerial skills” (April 2012). Experts claim that funds with higher compensation packagestake on more systemic risk to earn back fees. Others conclude that these fund managers add morevalue rather than taking on more risk. Various reports indicate that as a GP increases its fees, IRRs decrease. Due to numerousmanagement fees many investors favor smaller funds that yield a higher IRR. “Carried interest ishigher in larger funds, while management fees are lower. These findings imply that the elasticityof GP compensation to performance is higher in larger funds” (Robinson and Berk). Critics ofhigh fees argue that if fees are reduced, the alpha would increase dramatically. A more recentreport by Gibbons and Kugatkina purports the previous claims and concludes that a fund’s sizehas no correlation to the level of return. PAGE 8 OF 42
  10. 10. Hidden FeesIn addition to management fees and carried interest, there are hidden fees that GPs receive,which can increase the cost of PE as an alternative investment. A personal interview with ErikSebusch of UPS Investments revealed several different types of hidden fees. In the event thateither party decides to dissolve the contract before its contracted date, the GP usually will refundsome of the fees, though 12% of funds do not refund anything. Out of the funds that do refundsomething, one-third refund all of the transaction fees, one-third refund 50% of the transactions,and one-third refund some amount in between. Typically, all funds refund 80% of the monitoringfees. Phallipou indicates that if hidden fees are included in the total cost of PE, they total 50 to80% of the total committed funds (2009), though this amount is not verified by other sources.Table 1.2.2 outlines some PE fees.Table 1.2.2 PE Fees FEE AMOUNT (RANGE) COMMENTS STANDARD FEES Some countries and firms are applying pressure to Management 2% reduce this amount Incentive mechanism that is considered a reward for Carried Interest 20% good performance QUANTIFIABLE HIDDEN FEES Organizational Expenses: Paid at beginning of Fund Set-Up $1M commitment Expenses related to the purchase, holding and sale of Portfolio Expenses 50% portfolio companies Director Fee’s 100% OTHER “HIDDEN FEES” AMOUNT VARIES • Marketing Budget • Restructuring • Deal Fee • Fund Expenses (Legal, travel budget, • Break Up Fee annual meetings, entertainment, etc.) • Wind down These particular fees are not mentioned in academic literature; therefore, we are unable to quantify or analyze their effect on the overall cost of PE.Are these high costs justified?Critics of PE point to the high fees, illiquidity, and lack of marketability as justification forlabeling PE as an inferior asset class. Countless reports have been published to identify whetheror not the level of PE return justifies its negative traits. There is a lack of agreement amongscholars as to whether or not there is consistent data to support the claim that PE has consistentlyoutperformed the S&P 500, thereby introducing less volatility and higher returns than the publicmarkets. This section will briefly discuss a few of these reports. Harris, Jenkinson, and Kaplan (2012) reviewed 1,400 US PE funds (buyout and venturecapital) from 1980 to 2008. Their research indicates that although buyout funds havesignificantly outperformed public markets during this time period, there is a negative correlationbetween the buyout funds’ performance and the aggregate commitment to the fund. Harris,Jenkinson, and Kaplan analyzed the relation of the fund size to performance. Buyout fund sizeshave increased from “$390 million in the 1980s to $782 million in the 1990s to $1.4 billion in PAGE 9 OF 42
  11. 11. the 2000s.” Venture capital fund sizes have increased from $77 million to $191 million to $358million. Their research indicates that smaller funds outperform larger funds. Robinson and Sensoy (2011) analyzed quarterly cash flow data for 837 buyout and venturecapital funds from 1984 to 2010. Their findings imply that “high PE fundraising forecasts bothlow PE cash flows and low market returns, suggesting a positive correlation between PE net cashflows and public equity valuations.” This conclusion is supported in other reports. PE returns areconsistently higher than public equity markets. Higson and Stucke (2012) surveyed over 4,000 PE and venture capital funds from 1980 to2010. Their research shows that “liquidated funds from 1980 to 2000 have delivered excessreturns of about 450 basis points per year. Adding partially liquidated funds up to 2005, excessreturns rise to over 800 basis points.” Only 60% of these funds net of fees and 70% at the grosslevel outperformed the S&P 500. During the 1980s funds yielded IRRs of 25% or above but the1990s showed significantly lower returns in the single digits. Funds that fully liquidated duringthe economic boom at the end of the 1990s once again showed IRRs of 25%. According toHigson and Stucke, “the evident inverse correlation between the performance cycles and equityand debt capital market cycles, and with the business cycle suggests that wider economic factorshave a significant impact.” Robinson and Sensoy support this conclusion. Despite theseeconomic cycles, US buyout funds have consistently outperformed the S&P 500 almost everyyear since 1980. The average IRR for 1980 to 2000 is 544 basis points higher than the S&P 500and this number rises to 809 basis points in 2010. The average for 1980 to 2010 is 468 basispoints higher than the S&P 500.i A more recent, unpublished study by Gibbons and Kugatkina (2013) analyzes data fromPrequin that accounts for 70% of all worldwide funds. The report assesses the performance of5500 funds from 1600 fund managers from March 2001 through December 2011. Gibbons andKugatkina’s research contradicts many of the previous reports that favored capital weightedresults and indicates that smaller funds actually may not perform better than larger funds. Theaverage return for an un-weighted fund was 4.10% compared to 6.37% return for a capitalweighted fund. Whereas many reports only analyze buyout or venture funds, the Prequin dataencompasses nine different fund types.Chart 1.3.1 Risk-Adjusted Returns, Net of Fees Cumm Return S&P 500 Over Time (IRR to data Point) Cumm Return Over Time Capital 1.2 Weighted Cumm Return S&P 500 TR Over Time 1 (IRR to data Point) Cumm Return Over Time Unweighted 0.8 0.6 0.4 0.2 0 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 -0.2 -0.4 -0.6Source: Gary Gibbons, Ph.D. and Olga Kugatkina, Ph.D., unpublished research (2013) PAGE 10 OF 42
  12. 12. Despite critics’ claims that PE returns do not justify the negative characteristics, data supportsthe opposite conclusion. PE risk-adjusted returns, net of fees, are consistently higher than thoseof public markets.1.4 Risk ManagementThere are three mainstream ways to mitigate risk in terms of investment strategies: Correlation,Diversification and Hedging. Private Equity offers opportunities to strongly reinforce the twoformer, while it offers almost no advantage for the latter.CorrelationAs a separate asset class, Private Equity can enhance the risk profile of the ASRS portfoliothanks to a lower correlation with the public equity markets and asset classes. This is an issuewhere arguments are still ongoing over the proper methodology to be used. A number ofstructural factors may influence positively or negatively PE’s correlation to public equity:infrequent valuations and the tendencies to report investment values close to initial costs until thetime of exit may contribute to making this correlation lower than it actually is. Alternatively, onecan infer from the PE asset class’s dependence on many of the same systematic and economicrisks as public equity, that the two are very closely correlated. Marthendal (2010), based onanalysis of listed Private Equity with public equity stock markets indexes, brings intriguing andsubtle conclusions: Private Equity seems to have little to no correlation with bond indices,whereas with stock market indices there is a low correlation, of 0.35 on average (Cohen, 1988).This indicates that PE has a strong diversification potential. Although further simulations fromMarthendal with different asset allocation models fail to yield a decisive conclusion on PrivateEquity’s contribution to an overall portfolio, Gibbons (2012) puts PE’s correlation to the S&P5000 in a range between 0.62 and 0.72 over the period 2001-2011. This PE correlation rate,coupled with a lower volatility over the period aforementioned, produces a risk/return profilewhich makes Private Equity particularly attractive as an asset class to diversify into for theASRS portfolio.DiversificationSince Private Equity is also a strategy, it can also contribute positively to diversification. Fourmain levers can be employed.1. Time DiversificationThe first lever is time diversification: Private equity investments function as limited partnershipswith a GP managing the contributions of the LP immobilized in the fund for a specific duration,of seven to ten years on average. Most often the lifecycle of the fund is divided around aninvesting period, during the first two to four years, followed by a maturing and realization periodwhen the fund starts to actually earn returns; until the time of liquidation of the fund’s assets,when returns are maximized and assets converted into cash. Most managing partners raise a newfund within 3 to 4 years, diversifying their investments by the year of formation. Hence, time diversification is the means by which a fund overcomes the time illiquidityinherent in this asset class: layering the vintage years across several years allows the GPs to limitexposure to a specific time period while spreading the periods of initial returns, thus producingcontinuous returns for their LPs from various funds in spite of the immobilized nature of theassets. What’s more, given the cyclical nature of the economic environment and Private Equity PAGE 11 OF 42
  13. 13. returns’ dependence on it, layering vintage years is also a way to maximize returns from the bestperforming years while limiting the impact of the less performing ones.2. Strategy diversificationThe second lever relate to various mixes of PE strategies: a GP will use a mix of strategies withlow correlation to each other to reduce exposure to risk and increase returns, such as mixingVenture Capital and Buy-out funds for example. Different PE strategies will also yield differingsectorial exposures: Venture Capital portfolios because of their focus on growth investing tend tobe exposed to technology industries including information technology, communications,healthcare and biotechnology. Buy-out funds on the other hand are more diversified across majorindustries such as consumer/retail, communications/media, industrial, energy and others.3. Stage DiversificationStage investment can also be calibrated both in Venture Capital and Buy-out funds: for venturecapital this is achieved through targeting companies at early stage, late stage, diversified Ventureand growth equity funds. Buy-out funds use fund size as a proxy to differentiate between stages:less than $250 million for small buy-outs, $250 to $500 million for mid-market, $500 million to$1 billion for large buy-outs, and over $1 billion for the mega buy-outs. However, the scale ofthese buy-outs has grown in recent years.4. Geographic DiversificationGeographic diversification can be pursued either through region-focused funds or at the portfoliocompany level by assessing the underlying exposure of the fund. Various funds specialize onNorth America, Europe (EU), Emerging Markets (EM), or Frontier Markets. The evidence of thelast 30 years however points to higher returns in US focused funds than EU ones, and it must benoted that returns from EM focused funds have risen although with a very high volatility.HedgingWhile hedging is a classic risk control for portfolio managers, private equity provides almost norisk control through hedging. Hedging is a method of coverage, where one investment is used tooffset losses from another investment. One of the most ancient and basic forms of Hedging waswheat farmers’ futures contracts, which provided coverage against the potential wheat pricefluctuations by guaranteeing the selling price of the commodity. What’s more, the future contractitself had a value whose fluctuation might offset that of wheat prices. Hence, the overall hedgingmethod here was to long the futures contract and to short the actual wheat. These basic levershold over with today’s financial markets and translate into various hedging strategies: some relyon low correlation with public equity (market neutral) or strong correlation with them (marketdirectional); others leverage risk to generate excess revenues with increased volatility (returnenhancers), or offer positive excess returns while reducing risk (risk reducers) (Gregory Connorand Leo Lasarte). PE, given its very nature as an asset class with strong illiquidity, thus offersfew advantages in most of these strategies, except with the market neutral ones based on lowercorrelation. Private equity, however, may hedge slightly in down markets because it has a Beta that isless than 1 (Gibbons 2013). It should also be noted that there seems to be a convergence betweenPE and hedging: many hedge funds use investment in PE funds or funds of funds as part of amarket neutral strategy or betting on a specific corporate or industry event. Hence, with regard tothe chosen risk management strategy of the ASRS portfolio, we can conclude that PE cancontribute positively and strongly to two of the established methods of risk management— PAGE 12 OF 42
  14. 14. correlation and diversification—while it offers few identifiable advantages for hedging ingeneral and none for the ASRS portfolio specifically.1.5 ConclusionDespite the high fees and risk associated with PE the ASRS portfolio will achieve lower risk andhigher returns overall. The efficient frontier illustrates that by including PE in the portfolio thatASRS can achieve higher levels of return for the same level of risk or reduce overall risk andreceive the same level of returns. In addition, PE funds invest in a variety of industries,geographies, and company growth stages, which increases the total portfolio’s diversificationwhich ultimately results in lower risk. Currently the ASRS portfolio has a below averageliquidity rating (2.45 out of 3.00). PE is one of the most illiquid assets but the ASRS canmaintain the same level of PE investment and increase its liquidity by laddering the various PEfund investments and matching expected future cash flows with the ASRS’s liquidity needs.Therefore, since PE contributes to diversification, lower risk and higher returns, the ASRSshould continue to allocate to PE and complete an optimization of all the asset classes to achievethe highest return possible for the accepted amount of risk. PAGE 13 OF 42
  15. 15. PART II. Accounting Issues in Private EquitySection two will discuss the accounting rules that impact PE and how certain rules result in otherassets appearing to perform better than PE. For example, the valuation rules may require theASRS to disclose management fees, which will cause PE to appear as a less rewardinginvestment. It is crucial for ASRS to understand the valuation rules and methods in order toguarantee the accuracy of its returns and to manage its fee payments. This section discussesseveral valuation rules and methods, reporting rules, and fiduciary duties, which force GPs tofairly value and disclose fees and returns. In addition we will address valuation, FASB, GASB,and Dodd-Frank as it relates to the ASRS’s needs.2.1 Influence of valuation rulesTo address the question, “How do valuation rules affect returns and is this a problem?” it isimportant to assess valuation rules for PE, valuation methods, and their impact on PEinvestments in practice. One way can increase the value of the assets in a PE fund is to valuethem unfairly: LPs get will more returns, but they might not be real, whereas LPs have to paymore management fees to GPs. The fairly regulated valuation rules are needed, andunderstanding the valuation rules and methods is important for ASRS investment decision.2.1.1 Valuation Rules on PEThe Financial Accounting Standards Board (FASB), the regulator of financial accountingpractices, has defined the fair value of an asset or liability. ASRS must comply with its regulator.This section outlines the valuation methods for assets or liabilities invested in PE funds, as wellas an asset allocation table in accordance with SFAS (Statement of Financial AccountingStandards) 157 (est. 2006) valuation guidelines categorizing ASRS assets. SFAS is theaccounting standards issued by FASB.FASB Fair Value MeasurementFASB stipulates accounting and financial reporting standards for activities and transactions ofconsumer and non-governmental entities. SFAS 157 establishes guidelines to measure the fairvalue of investments and to disclose investments and transactions in financial statements. According to SFAS 157, “the fair value is the price that would be received by selling an assetin an orderly transaction between the market participants at the measurement date” (SFAS No.157, paragraph 5). The fair value definition was changed in 2006 and now requires the “exitprice” to be recorded. Inclusion of an exit approach maximizes the use of objective inputs in thevaluation of an asset. Assets are classified and valued periodically to adjust the fair value tocurrent market conditions, then disclosed in financial statements per FASB standards. SFAS 157defines three asset classes:• Level 1: These are assets or funds that have easy access to an active principal market such as the stock market. An active market is defined by the combination of a high average trading volume, a high frequency of observable transaction, and a low bid-ask spread. Level 1 assets are valued based on the market quoted prices of the asset. PAGE 14 OF 42
  16. 16. • Level 2: Here are assets or funds with moderate principal or secondary markets, such as restricted stocks, some convertible bonds, and private investment in public equity. Level 2 assets are valued by comparing the market-quoted prices of the similar assets. Typically, Level 2 valuation also uses inputs other than quoted market prices.• Level 3: These are assets or funds that have limited marketability due to lack of access to a primary market; PE is ranked among them. The main characteristics of Level 3 assets are high illiquidity, no readily available market data, and a large bid-ask spread. Valuation of Level 3 assets typically involves multiple valuation methods: since theydo not have an active market to take “observable” inputs such as market data the fair value measurement for Level 3 uses internal valuation methodologies. Usually an independent third party valuation expert values the assets and/or the funds using internal data.Fair Value Asset ClassificationThe following table was derived from assumptions and broad generalizations of assetclassification using the data provided in ASRS’ strategic asset allocation policy schematic.Table 2.1.a FASB Fair Value Asset ClassificationASRS ASSET CLASSES LEVEL 1 LEVEL 2 LEVEL 3INVESTMENT IN US EQUITYCashLarge Cap Equities 23.00%Mid Cap Equities 5.00%Small Cap Equities 5.00%Total 33.00%INVESTMENT IN NON-US EQUITYInt’l Developed Large Cap Equities 14.00%Intl Developed Small Cap Equities 3.00%Emerging Intl Equities 6.00%Total 23.00%INVESTMENT IN ALTERNATIVE ASSETSPE 7.00%Opportunistic Equity 0.00%Equity Long-ShortTotal 7.00%INVESTMENT IN US FIXED INCOMECore Bonds 13.00%High-Yield Bonds 5.00%Total 13.00% 5.00%INVESTMENT IN OTHER FIXED INCOMEEmerging Markets Debt 4.00%Opportunistic Debt 0.00%Private Debt (Credit Opportunities) 3.00% PAGE 15 OF 42
  17. 17. Total 4.00% 3.00%INVESTMENT IN INFLATION LINKED ASSETSCommodities 4.00%Real Estate 8.00%InfrastructureFarmland & TimberOpportunistic Inflation-Linked AssetsTotal 4.00% 8.00%TOTAL PERCENTAGE 73.00% 9.00% 18.00% Source Rothstein Kass, 2010Based on fair value classification, 73% of assets are classified as Level 1, 9% as Level 2, and18% as Level 3. All PE assets are classified as Level 3 assets.Valuation Methodology for PE investmentGPs use several different methodologies to value PE assets. The fund manager and the personwho evaluates make certain assumptions on the factors influencing the value of an asset andselect the valuation methodology that is most appropriate and objective for the specificinvestment. Typically a third party valuation firm is used to value assets under management. SFAS 157 defines Level 3 as follows: Level 3 inputs are unobservable inputs for the asset or liability, that is, inputs that reflect the reporting entity’s own assumptions about the assumptions market participants would use in pricing the asset or liability (including assumptions about risk) developed based on the best information available in the circumstances.Some methodologies used for valuing Level 3 assets are as follows (IPEV Board, 2010):• Price of Recent Investment: The basis of fair value is the cost of a recent investment in the asset. This methodology is appropriate only for limited time period investments. The appropriateness of the valuation diminishes in time. This methodology is commonly used for start-up or early stage investments.• Multiples: A business is valued by applying earnings multiples (such as P/E) to the earnings of the business. This method is applicable for investments in established businesses with a steady stream of earnings. An specific multiple should be used for the business being valued.• Net Asset Value: This methodology uses the value of a net asset to derive the value of the business. This method is used for valuating companies which do not have high returns on assets. NAV calculates the fair value of the fund’s interest of the underlying asset. The fair value of the fund’s interest is the summation of the estimated fair value of the investment as if realized on the reporting date. After the investment is realized, the proceeds, which are equal to the NAV, are given to the investors.• Discounted Cash Flows (DCF) or Earnings (of underlying business): The value of a business is derived by calculating the present value of expected future cash flows of the underlying business. A DCF valuation requires a detailed cash flow forecast, terminal value and risk- adjusted discount rate. All of these inputs require subjective assumptions.• Discounted Cash Flows (DCF) (from the investment): The value of a business is derived by calculating the present value of expected future cash flows from the investment. Similar to the PAGE 16 OF 42
  18. 18. previous method, this method requires the person who evaluates to make significant subjective judgments.• Industry Valuations Benchmarks: The value of the business is derived using industry specific benchmarks such as “price per subscriber”. This is considered a reliable method to estimate the fair value of the business if applicable.Regardless of which valuation methodology is used, the person who evaluates must includeappropriate risk adjustments. A fair value measurement includes a risk premium reflecting theamount market participants would demand in compensation to the risk associated with the cashflows of the underlying business.International Financial Reporting Standards (IFRS)The US does not yet require compliance with International Financial Reporting Standards(IFRS)but is considering adopting it as a reporting standard. Additionally, if ASRS holds assetswhich invest in emerging markets it must be IFRS compliant. There are a few differencesbetween IFRS and GAAP standards that have little to no effect on PE valuation. The US has discussed adopting the IFRS. Many expected the U.S. to adopt IFRS in 2014 or2015, but the SEC has stated that it is content with US GAAP. The adoption is currentlyexpected to happen in 2017 or later. Thus, if ASRS does not hold any international assets, it isnot necessary to make any accounting or reporting adjustments at this point in time. In the eventthe US adopts IFRS, the ASRS would be required to make several adjustments to its accountingand reporting procedures. This time horizon should be monitored. Many PE funds invest in emerging markets. If ASRS considers investments in funds focusedon emerging markets, such as China, it must be IFRS compliant. The biggest difference betweenthe US GAAP and IFRS is that the IFRS does not determine details of certain accountingmethods for each transaction. This difference does not have a significant impact on PE valuation.Under IFRS, managers have the authority to decide appropriate accounting methods for theirtransactions. This, in turn, allows the asset manager to choose the valuation methodologyappropriate for the particular asset. This level of discretion results in an increased level of subjectivity in PE valuations. LPsshould be prepared for variable valuation rules and subjectivity, although several US regulationsmight settle this issue. Additionally, changing from GAAP to IFRS will result in several changes on financialstatements. Under IFRS, a fund cannot record off-balance sheet financing, such as securitization.There is also a significant difference in the regulations for consolidating accounting. US GAAPallows funds to extract some of their investing equities, but IFRS requires funds to include themajority of the investment in their consolidation accounting. Thus, total assets would be larger ifa fund is IFRS compliant than if the asset is US GAAP compliant.2.1.2 Influence of Valuation Rules on ReturnsThough valuation rules intend to provide objectivity in the valuation process, subjective inputsare still needed for valuation of PE assets. This section reflects on the subjectivity, uncertainty,and variations in returns of PE due to valuation rules. It is mandated that private equities disclosethe values and valuation procedures for PE funds. Investors can compare the values of similarassets among the different PE funds. They also can compare the values of PE funds and the otherpotential investment options. Auditors might value PE assets conservatively, which might lowerthe periodic payments to LPs. PAGE 17 OF 42
  19. 19. Subjectivity and uncertaintyPart of the objectives of SFAS 157 for PE is to help LPs and GPs assess differences in assetvalues if PE firms reallocate assets to different asset classes. To see this, the valuation of Level 3assets is important because it cannot be done objectively. Investors are concerned about the highdegree of uncertainty and subjectivity, so they long for more accurate and transparentinformation in the assets in PE funds. As mentioned, fair valuation of Level 3 assets is difficult because of the lack of a marketcomparison. Valuation of Level 3 assets relies on fund managers’ estimates and assumptions.Even if GPs calculated the value of some asset higher or lower, the value is not certain until theassets are sold. Although GPs have fiduciary duties, GPs will tend to favor the interests of thrfirm over those of investors. This is reflected in how PE firms are setup in Delaware to waivetheir fiduciary duties (see Section 2.3 Delaware Uncorporate Law, for detail).Change in ReturnsSFAS 157 requests PE firms to report the fair value of the assets under management in standardformat. With the SEC’s additional reporting requirement, LPs can access detailed information onPE firms as well as comparisons with other firms and other asset classes. Accurate informationabout the investment returns on PE investments is readily available. This can be used by LPs forselecting GPs for the future investments. The more developed PE firms are equipped to providemore accurate and reliable information to LPs. Larger firms have better processes to reportperiodic asset valuations. When GPs select the appropriate valuation methodology, each investment should beconsidered individually so that GPs can value each investment properly. However, similarinvestments should be valued with the same methodology. Though subjective inputs are used forvaluation, the fair value assessment guidelines insist on maximizing objective inputs. Volatilityin the estimated value of an asset is expected. GPs could arrive at a higher valuation by usinginappropriate methodology or assumptions. Under SFAS 157, both GPs and auditors havegeneral concepts to calculate the values of the assets. GPs must comply with the rules andauditors can check the accuracy of GPs’ calculation according to the rules. However, the actual returns LPs will get would not change because the actual returns arecalculated by actual transactional prices. Even if the values of the assets were properlydetermined and LPs thought the asset allocation was favorable, the actual returns might be lowerthan LPs’ expectation if the actual deal price is lower than the valuation.2.2 GASB rules on reportingThis section addresses the question, “Are the GASB rules on reporting for alternatives well-conceived?” PE funds have to disclose management fees whereas some other asset classes arenot required to do so. This section first shows the overview of GASB rules. The later partsdiscuss reporting criteria and discussion about the fairness of different reporting rules amongseveral asset classes, as well as perceptions for the reporting rules.Overview of GASB RulesThe Government Accounting Standards Board (GASB) provides the accounting and financialreporting standards for activities and transactions of state and local governmental entities. Allother businesses follow FASB standards for accounting and reporting. State and local PAGE 18 OF 42
  20. 20. government entities use FASB pronouncements in absence of an applicable GASBpronouncement. Both FASB and GASB standards follow GAAP and provide standards that are important toorganizations. There has been confusion between FASB and GASB standards for decades. Thedifference between FASB and GASB is significant in the format and form of financialstatements, accounting of transactions such as investments, and the footnote disclosures. Thedifference is primarily due to differing purposes of each standard. GASB intends to provideaccountability since its transactions involve taxpayers’ money. On other hand, FASB intends tohelp management and investors make financial decisions. Some organizations are uncertain of which standard to follow. Because of the differences instandards and the complexity of the business activities of governmental organizations, diligenceis required to aptly apply the various standards. GASB has the jurisdiction over FASB forgovernmental entities and entities for which the government appoints and controls a majority ofthe board, or of which the net asset reverts to the government if dissolved.Disclosure in PEOne of the most important objectives of accounting standards is the ability to compare one reportwith another. If ASRS increases the amount it invests in PE it will be required to disclose thecorresponding increase in management fees. Since other asset classes are not required to disclosetheir management fees, PE will appear to be a more expensive investment. This section discussesthis comparison issue and outlines the PE disclosing requirement in financial reporting andcompares its requirements to those of other asset classes.Disclosure ElementsThe disclosure elements for PE and venture capital cannot be generalized because of theconfidentiality and uniqueness of each fund. For instance, investors in some funds needinvestors’ capital allocation, while investors in other funds don’t disclose individuals’information. However, some general information is disclosed regardless of the type of fund.Some principal disclosure elements are:• Fund information, including fund overview, executive summary, and fund status;• Investor information, including cash flow, net IRR calculation, capital accounts, capital call notices, and distribution notices;• Fees, carried interest and related party transaction information, including management fees and and carried interest;• Investment portfolio information, including current portfolio summary, realized portfolio summary, portfolio company detail, and movement in fair value of the portfolio.Frequency of disclosure can differ for each element, as well. For instance, general fundinformation, such as fund overview, does not necessarily need to be updated frequently. On theother hand, capital call notice and distribution notices should be updated for each transaction.Comparison with other asset classes about management feesManagement fees are disclosed in venture capital too. A venture capital fund has to issueinvestor reports like a PE fund. The U.S. equities, which currently consist 33% of ASRS’sinvestment, report their management fee in their financial reports. All companies have to reporttheir financial statements with footnotes. Management fees would be included in income PAGE 19 OF 42
  21. 21. statements or footnotes of income statement as directors remuneration or compensation fordirectors. This is the same in Non-US equities, which currently consist 23% of ASRS’sinvestment. Evaluating management fees for fixed income, such as bonds, is difficult. Bonds are issued tohelp governments’ or companies’ finance. Management fees for bonds cannot be calculatedseparately. Thus, management fees for fixed income, which consists 25% of ASRS’s investment,are not disclosed. Management fees for investment in commodities and real estates can begrasped. Investors have to pay transaction fees for these investments. These transaction fees canbe regarded as management fees although they are not frequently reported.Perception of GASB RulesThis section introduces perception of GASB rules from LPs, GPs, and other stakeholders of PE.Other stakeholders include auditors, stakeholders of LPs, potential LPs, and consultants for LPs.LPs General valuation rules are helpful for LPs as they have to use accurate information on theirinvestment for their reporting purpose. Also, LPs can determine their investment strategyaccording to the result of PE investments. Accounting standards are made to protect investorsfrom a lack of transparency so that investors can make rational decisions. The investors are LPsin the case of PE, and the objectives of GASB are to provide enough appropriate information toLPs. In other words, the rules should be well-understood by LPs.GPs The general rules for asset valuation might have a negative impact on the GPs’ operationsbecause they no longer are able to evaluate their assets subjectively. GPs were able to value theirinvestment assets with their own methods. They were able to set the value of their assets higherusing only their own rationale. However, concrete valuation rules keep GPs from valuing theassets in PE funds by themselves. When GPs cannot increasethe values of the assets arbitrarily,LPs may come to think the funds are not doing well, resulting in possible loss of current/futureinvestors. GPs would keep their fiduciary duties because of GASB.Other stakeholdersAuditors Auditors of PE funds are tasked with judging the accuracy of the valuation of assets intheir investments. With the general valuation rules, the possibility of conflict between GPs andauditors will decrease because both of them will have universal rules. Such rules will helpauditors calculate the appropriate values of the assets in PE funds.Stakeholders of LPs The stakeholders of LPs, the Arizona state employees in the ASRS case,can see the returnson LPs’ investment returns without the subjective judgment of the GPs. Thebenefit to LP stakeholders is similar to that of LPs themselves.Potential LPs and consultants If investors could remove subjectivity from PE asset valuationthey could properly estimate the results of PE investment. The general valuation rules enablereporting to investors to be in a standard structure so comparison among several PE funds ismade easier. The general valuing rules also help consultants for LPs. Consultants can provideproper advice to LPs when they want to make decisions for PE investments with appropriatelycalculated returns of PE funds. This increases the efficiency and accuracy of consulting. PAGE 20 OF 42
  22. 22. 2.3 The structure of entities and incentive compensationThis section discusses the structure of entities and incentive compensation being implicitly orexplicitly stated. ASRS, as a pension fund, cannot compensate with its stocks. Therefore, ASRShas to pay management fees in cash. On the other hand, an LLC , such as Goldman Sachs cancompensate with its stocks or in cash. This might make a difference in financial statementsbetween ASRS and other investment organizations.Accounting Matching PrincipleThe first subject in this section is whether a stock based compensation system violates theaccounting matching principle for recording revenue and expenses. Stock based compensationcreates the difference in accounting principle between an investment bank like Goldman Sachsand a pension fund like ASRS which invests in private equity. Stock based compensation is essentially the same compensation system as the manager feespaid by cash in the sense that both of them are “paid” to managers. The value of stock basedcompensation at the time of payment must be the same value as what would be paid in cash.However, these two methods have different impacts on financial statements. If a private equityfund pays management fees in cash, that reduces assets, and expenses are booked on an incomestatement. On the other hand, if a company like Goldman Sachs pays management fees as stockbased compensation, it affects shareholder’s equity. The expense is still booked on an incomestatement. If this company chooses stock option, the expense would be lower at the payment daysince the amount of compensation is calculated as the value of the right to purchase stocks in thefuture; the price of stock option is lower than the stock-purchasing price. Although, the totalvalue of the compensation is the market price of the stock. Stock based compensation does not violate the matching principle for the recording ofrevenue and expenses when management fees are paid as stock. However, when the managementfees are paid as stock option, the matching principle might be affected since the amount ofexpenses is typically lower than the actual value of stock option even though the expense ofstock option is equally booked over the stock option term. Also, the change in the price of thestock is not recorded. Thus, stock based compensation, if paid as stock option, would make it difficult to simplycompare management fees. As ASRS is not a company but a pension fund, it cannot paymanagement fees with stocks. A company such as Goldman Sachs, on the other hand, hasoptions. It can enjoy the benefits of stock based compensation.The Advantages and Comparison of Compensation SystemsThe second discussion in this section is what the advantages of stock based compensation overmanagement fees paid by cash are, and vice versa. Also, discussion about the possibility ofcomparison of them follows. The advantage of stock based compensation is that a company can save cash whilemotivating managers. Also, when using a stock option, a company can lower the expenses at thepayment date and get cash for common stock later. A company can also confuse investors sothey do not see high management fees as expense. On the other hand, the advantages of cash payment for management fees are that a companycan retain some indices such as EPS (Earning per Share) and eliminate the risk of selling stock atan undervalued price. Also, it is easy for investors to see the actual expenses for managementfees, so paying in cash is better in terms of financial transparency. PAGE 21 OF 42
  23. 23. If stock based compensation is paid as stocks, it is possible for investors to compare the twoinvestments because the value of the stocks should be the same as the amount that would be paidas cash. The difference is, as written above, whether it causes decrease in assets, or it is just achange in shareholders’ equity. However, when stock based compensation is paid as stockoption, it is harder to compare because the given value of stock option is usually less than theactual value of stocks that the stock option holder can purchase.FASB Stance on the Balance Sheet EffectThe third discussion explores the reason FASB allows the deferral and primarily balance sheeteffects. Stock based compensation is a favorable way to motivate GPs: holding some shares ofthe fund and adding value to it will benefit the GPs through the rise of the stock price. Thiscompensation method is globally admitted by accounting standards. Thus, a company likeGoldman Sachs can pay management fees as stock based compensation. When stock based compensation is paid as stock option, the actual benefits the receivers gainare unknown until the receivers exercise the stock option. Therefore, a company cannotrecognize the full amount of compensation at the time of payment. This is the reason FASBallows the deferral accounting method. The difference on the balance sheet occurs because the resource of payment is differentbetween cash payment and stock based compensation. Cash payment is from cash in currentassets in balance sheet. Stock based compensation, on the other hand, is from shareholders’equity. Thus, the difference is not caused by the timing issue on recognition although the certainamount of time till the exercise is part of the reason of the difference.The Significance of GAAPThe fourth and final discussion in this section considers whether GAAP would create a disparitybetween accounting for investments, and what is the intent of creating that difference. GAAPshould create a disparity between different accounting methods.The purpose of the payment is the same between cash payment and stock based compensation,but the accounting procedure is different. GAAP would set different accounting rules fordifferent accounting procedures. Managers cannot say which method is better because both methods have pros and cons forthem. Stock based compensation can lead managers to huge benefit if managers succeed inadding value to the company, but it is not certain; value-adding does not always increase theprice of the stock. On the other hand, cash payment can fix the benefit managers get. Managerscannot enhance their benefits, but they do not have to take a risk to get them. Stock based compensation has a lot of benefit for payers and payees, and it makes financialstatements look better if it is used wisely. However, it also has negative factors; it might worsenfinancial statements and some financial indices in the future. Thus, different accounting methodsshould be distinguished. That reflects the essence of the transactions, and it helps investors to seewhat is happening in the company.2.4 Dodd-Frank ActThe Dodd-Frank Wall Street Reform and Consumer Protection Act was enacted to promote thefinancial stability of the United States by improving accountability and transparency in thefinancial system, to end the ‘‘too big to fail,’’ problem and protect the American taxpayer by PAGE 22 OF 42
  24. 24. ending bailouts, protect consumers from abusive financial services practices, and for otherpurposes (HR 4173).Implications of Dodd-Frank Act on PEDodd-Frank Act has made significant changes to the regulation of the financial sector thatdirectly or indirectly affects PE firms.Registration RequirementDodd-Frank eliminated the “private investment advisor” exemption for Investment advisors. Inpast, the Investment advisor was exempt from registration with the SEC under the Advisers Actif he or she had fewer than 15 clients and did not serve in a registered investment company.Many Investment advisors used this exemption to avoid complying to many SEC requirementsassociated with registration including the fiduciary duties, the periodic examination and therestrictions on fees. However, the Dodd-Frank Act provides some new exemptions such as theForeign Private Adviser Exemption, the Certain Private Fund and Mid-Size Private FundAdvisers Exemption, the Venture Capital Fund advisers Exemption and the Exemption forAdvisers to family officesDefinition of “Accredited Investor” and “Qualified Client”To become an “Accredited Investor,” the investor should have a net asset worth of more than $1million or an individual income exceeding $200,000 over the past two years. A “QualifiedClient” is one that has at least $750,000 worth of assets under management or a net worth of $1.5million. These changes will reduce the number of investors especially in the smaller funds.Minimum Assets requirementInvestment advisers who manage funds of less than $100 million in assets should register withthe state regulatory bodies. This would allow the SEC to focus on larger funds. If alreadyregistered, the smaller funds will be forced to withdraw their registration from the SEC.Registration and reporting obligation with every state regulatory body in whose jurisdiction thefund operates, could become more costly than being under the SEC. This will make it harder forsmaller funds to operate.Accounting and Reporting requirementGPs are under scrutiny from the SEC on the reporting and record keeping requirements. Privatefunds are required to comply with several accounting and reporting practices such as 1) assetsunder management, 2) leverage, 3) counterparty credit risk exposure, 4) valuation practices offunds, 5) asset types held, 6) trading practices, and 7) any other information deemed necessaryby the SEC. The additional requirements increase the cost of accounting, which is usually passedon to LPs. Dodd Frank Act does not clearly define fiduciary duties for the PE fund managers. The SECdoes not provide clear guidance on where the fiduciary duty of the fund manager applies – to thepooled fund or to the individual investors in the pooled fund.Volcker RuleThe Volcker rule is a special section of the Dodd-Frank Act which limits banking institutionsfrom investing or sponsoring and from partnership or ownership of interest in PE funds. The PAGE 23 OF 42
  25. 25. purpose of the Volcker rule is to prevent any conflict of interest with the LPs and preventexposure to risk.Delaware Uncorporate LawThe State of Delaware has laws which exempt financial institutions from certain federalregulations. The LP and LLC acts of Delaware give firms the option to opt out of the fiduciaryduties. The law was intended to limit regulations and provide flexibility to partnership firmsthrough the contractual agreements. Delaware law could be used by fund managers to relinquishtheir fiduciary duties to the fund under management. The LPs should be more comprehensive inpreparing the contractual agreement and should spend time thinking about the financialenvironment in the future. Any forgotten element in the contract could be exploited by the GPs.2.5 ConclusionsStandards and guidelines are there to protect investors’ interests and prevent firms frommanipulating their books. However, accounting in the PE business is still very subjective. Theregulations are always playing catching up with the highly evolving nature of PE in today’sworld. Investors should be aware of the risk involved in PE in terms of the possibly misleadingaccounting and reporting. There are no concrete rules or incentives for the fund manager to workcompletely in the interest of the investors. A fund manager will aim to maximize his profits,whether by creating value on the investment or manipulating the value of the assets, somethinginvestors should constantly monitor. Even if the asset manager is honest in all his activities, he has to choose from a number ofmethodologies to value the asset under management. Since there are many subjective inputsinvolved in the valuation of PE assets, the value is bound to be inaccurate in many cases. It alsodepends on how robust the valuation process is and whether all environmental factors and riskadjustment have been included. Fair value guidelines are trying to bring more objectivity tovaluation. Until the subjectivity is eliminated, the valuation methodologies will have an impacton the value of the assets, which in turn will affect the returns on investment. FASB reporting requirements and other regulations such as the Dodd-Frank Act has madeinformation, especially the management fees in ASRS’s portfolio, including PE, readily availablethrough the SEC. ASRS can compare the management fees among its investment options. FASBand GASB also help the stakeholders of PE in other ways, such as valuation rules and reportingstandards. In terms of the compensation system, ASRS, as a pension fund, has limited options. SinceASRS cannot opt for stock based compensation, it cannot enjoy its benefits. Consequently,ASRS does not have to deal with downside of stock based compensation, such as lowering EPSindex. PAGE 24 OF 42
  26. 26. PART III. Private Equity In PracticeThis section outlines the current trends in private equity, including typical allocation percentagesfor pension funds, sovereign wealth funds (SWFs), foundations, and endowments. These trendsinclude amount allocated to PE, portfolio percentages allocated to PE, and growing trend toinvest in emerging markets. The purpose of analyzing the trends in private equity is tounderstand how and where other portfolios are investing. The following sections breakdown theinvestor attitudes of LPs, their geographical areas of interest, and private equity allocationpercentage trends amongst fund types. Finally, this section compares ASRS’s portfolio allocationto pensions funds, endowments, foundations, and SWFs to assess its positioning among thesetrends.3.1 Trends in Private EquityIn general, aggregate investment commitments to PE bottomed out following the 2008 globalfinancial crisis. However, aggregate PE investment is on the upswing, especially for PE fundsinvesting outside North American and Europe. PE investing in Europe has taken a downturn,likely due to this growing trend to invest in emerging Asian economies, as well as economicinstability in Europe. The emerging Asian economics are growing at significantly higher ratesthan the US or European economies. Chart 3.1.1 shows aggregate investment commitments to PE from 2003 to 2011. “Asia andRest of World” has seen increasing annual investment since 2009, whereas North America andEurope have seen decreasing annual investment. Thus, the post-2008 PE investment trend hasbeen to direct investment dollars away from Western countries and toward high growth rateAsian economies.Chart 3.1.1 Aggregate Commitments to PE from 2003 to 2011, by Geographic Focus (Preqin)Towards the end of 2011, the differences in quarterly fundraising levels among funds withdifferent geographic focuses narrowed. Due to the larger number of funds focused on investing PAGE 25 OF 42
  27. 27. in North America, fundraising levels for these vehicles are significantly higher in terms ofaggregate value when compared to other territories. However, by Q3 2011, the total capitalraised by funds in each region was the closest it’s ever been, with $28B raised for NorthAmerica, $12.8B for Europe, and $13.2B for Asia (see Chart 2.1.2).Chart 2.1.2 Quarterly Private Equity Fundraising by Primary Geographical Focus (Preqin)Aggregate commitments for funds in Asia in Q1 2011 grew compared to Europe by the largestmargin to date, raising $7.7B more than Europe funds. For all of 2011, Asia and Europe fundsaccounted for almost the same amount of aggregate capital raised, with 187 funds garnering$59.6B in Asia and 150 funds attracting $59.5B in Europe (see Chart 3.1.1). Fundraising forAsia private equity funds has been more resilient throughout the 2008 global financial crisis.From 2009 to 2010, institutional investors began aggressively investing in Asia as they perceivedthe emerging Asian economies to be more attractive for PE investment than the traditionalmainstays of PE investment regions in the US and Europe. While investment dollars did notincrease by a substantial amount in 2011, the investment level remained constant.Investor AttitudesRecently, Preqin published a report that analyzed the percentages of 100 LPs who would investin PE in the various regions of the world. 34% of investors felt that North America was still thebest place for PE investment. 27% of these investors said Asia, while a slightly less 26% of theinvestors said Europe. 31% of the investors were geographically indifferent. A pension fund from the United Kingdom said, “There are interesting opportunities in allregions so [we] cannot name one region” (Preqin). Not surprisingly, 24% of LPs said they wouldinvest elsewhere away from Europe. As long as there is political and financial uncertaintyconcerning the current fiscal crisis, investors will shy away from Europe and continue the trendto invest in the emerging Asian economies. This is not to belittle the true economic strength ofemerging Asian economies, for such economies would be an attractive investment regionregardless of the financial situation in Europe. PAGE 26 OF 42
  28. 28. Charts 2.1.3 and 2.1.4 show the most popular areas, by both fund types and geographicallocations, in which LPs seek to invest. The funds LPs are predicted to prefer for the months June2012 through June 2013 are small to mid-market buyout funds as well as venture capital funds.The geographical location preferences are primarily Asia, South America, and Africa. This datareflects the same 100 LPs chosen by Preqin for its report.Chart 2.1.3 Investor AttitudesChart 2.1.4 Attractive Countries and Regions for PE PAGE 27 OF 42
  29. 29. Appetite for Emerging MarketsAs is reflected in the chart above, a “substantial 72% of LPs will invest or consider investing inemerging markets. Furthermore, 95% of these expect to increase their exposure to these regionsover the next 12 months, and none plan to reduce their exposure in the long term” (Preqin).3.2 Trends in Private Equity investing for large-scale investmentsThe next section assesses investment trends by LP type—government pension plans,endowments, and sovereivn wealth funds (SWFs)—in order to compare target PE allocations ofthe general LP population with that of ASRS. Each of the LP categories in Table 3.2.1 includesthe five investor types with the highest target allocation to PE. Most funds allocate higherpercentages of their portfolios to private equity than does ASRS. Details about each of theselected investor types can be found in Exhibit 2.Table 3.2.1 Asset Allocation by investor Type TYPE TARGET ALLOCATION TO PE Endowments 30% - 43% Public Pension Funds 20% - 25% Sovereign Funds 08% - 10% ASRS 05% - 09%In Table 3.2.2, the average percentage of deals by investment strategy is provided for the samegive funds with the highest allocations as Table 3.2.1. Most notably, ASRS has a lowerpercentage allocated to add-on (stock issuances done by any mean other than an IPO) and ahigher percentage allocated to growth capital relative to other LPs. Details on the exact numberof funds in each investor type in each strategy can be found in Exhibit 2.Table 3.2.2 Asset Allocation by Investment Strategy GROWTH PUBLIC - RESTRUC-TYPE ADD-ON BUYOUT MERGER PIPE RECAP CAPITAL PRIVATE TURING Endowments 64.93% 12.08% 3.50% 5.69% 0.42% 11.58% 1.80% 0.00% Public Pension Funds 53.60% 23.73% 6.07% 3.13% 2.49% 7.65% 2.62% 0.62% Sovereign Funds 49.4% 25.1% 8.8% 3.5% 1.4% 9.2% 2.4% 0.2% ASRS 38% 28% 12% 5% 4% 7% 5% 2%The same five investor types are again compared in Table 3.2.3, based on their geographicpreferences in in PE investment. ASRS is more North America-focused than the other investorsrepresented in this table. Furthermore, ASRS is steering away from Europe, which may be aprudent strategy, given not only the continent’s stagnating growth but also the steep drop in itsPE activity, both fundraising and incesting. ASRS has similar investments in South America,Australia, Asia, and Africa as the main investor types. LPs.Table 3.2.3 Asset Allocation by Geographic Region PAGE 28 OF 42
  30. 30. NORTH SOUTHTYPE EUROPE AUSTRALIA ASIA AFRICA AMERICA AMERICAEndowments 69.98% 22.27% 3.38% 3.98% 0.40% 0.00%Public Pension Funds 65.05% 24.83% 1.16% 1.09% 7.33% 0.54%Sovereign Funds 63.1% 30.6% 1.0% 1.1% 3.5% 0.8%ASRS 75% 18% 1% 1% 6% 0%Next, ASRS’ portfolio is compared to funds with fund sizes closest to its own of $28 billion.Exhibit 2 shows that the target allocation of private equity for Endowment Funds is in the rangeof 12% to 23%. This is substantially lower than ASRS’s target allocation of 5% to 9% to PE.Exhibit 2 shows us that pension funds with assets closest to $27 billion have PE allocationsranging from 3.5% to 25% with the average being above 12%. SWFs with fund sizes close to$27 billion typically invest 4% to 10% of their portfolio in PE. This is closer to ASRS’ allocationpercentage. Finally, the ASRS portfolio is compared to SWFs. The four SWFs listed in China to date areChina Investment Corporation (CIC), National Social Security Fund (NSSF), StateAdministration of Foreign Exchange (SAFE), and Hong Kong Monetary Authority (HKMA).Out of the four, SAFE is the largest fund by assets under management (AUM). It has about$589.5 billion million AUM, 5% of which is allocated to alternatives. Its only known PEinvestment is in the TPG Partners VI buyout fund for $2.500 billion. The exposure assumed inthis deal is almost all buyout and add-on and US focused. The second biggest SWF in China by AUM is the CIC, which manages roughly $482.167billion AUM in assets. Its current allocation to PE is $11.138 billion, or 2.3% of its total AUM.Starting in the third quarter 2012, CIC plans to forgo liquidity issues to pursue higher returns toboost the overall performance of its investment portfolio. The CIC is very diversified, investingwith over 15 firms in primarily add-on and buyout deal types. The CIC is most heavily investedin Asia, with the US coming in at a distant second. The third biggest SWF in China by AUM is the HKMA. It currently has $408.340 billionAUM. By the end of 2011, 11.5% of its portfolio had been allocated to alternatives including PEand real estate. The smallest SWF in China by AUM is the NSSF, which has $151.751 million AUM. Itscurrent allocation to PE is 2.4%, but its target allocation is 9.3%. Its plan is to allocate a total of$4.807 billion to PE by the end of 2012 and $8.012 billion million by the end of 2015. Eventhough this SWF is partnered with many foreign GPs, it has a strong preference for growth fundsfocused on China (see Table 3.2.3).Table 3.2.4 Sovereign Wealth Funds in China FUNDS UNDER CURRENT CURRENT TARGETINVESTOR MGMT ALLOCATION TO ALLOCATION TO PE ALLOCATION TO (MILLIONS) PE (MILLIONS) PEState Administration of $589,500 5% $29,475 -Foreign ExchangeChina Investment $482,167 2.3% $11,138 -CorporationHong Kong Monetary $408,340 - - -Authority PAGE 29 OF 42
  31. 31. National Social Security $151,751 2.4% $3,622 9.3%Fund - China Currently, the only two SWFs listed in Singapore are Government of Singapore InvestmentCorporation (GIC) and Temasek Holdings. The larger of the two funds by AUM is TemasekHoldings. As the sole shareholder of Singapore’s Ministry of Finance, Temasek seeks tomaximize the value of its investee companies. Temasek’s investment strategy is primarily basedon buyouts and add-ons with a heavy focus emphasis on Asia Pacific, Australia, and the US. Nofigures are available concerning current or target allocations to PE. The other fund, GIC has $247.500 billion in AUM, 27% of which is allocated to alternativeinvestment vehicles such as private equity. GIC’s mission is “to invest the country’s foreignreserves so as to earn reasonable returns within acceptable risk limits over the long term”( It has 400 known partnerships and typically invests between $50-$600 million witheach. Its strategy is to focus on emerging economies like China, India, and South America due toslowing growth in developed economies. As of March 2012, GIC had 11% of its portfolioallocated to PE and infrastructure investments. Its principal PE investments types are add-onsand buyouts.Table 3.2.5 Sovereign Wealth Funds in Singapore FUNDS UNDER CURRENT CURRENT TARGETINVESTOR MGMT ALLOCATION TO ALLOCATION TO PE ALLOCATION TO (MILLIONS) PE (MILLIONS) PETemasek Holdings 248,175 - - -Gov’t of Singapore 247,500 27 66,825 -Investment Corporation3.3 Social ResponsibilityMany critics of PE have labeled it the quintessential capitalistic industry that is only interested inachieving the highest rates of return on investment possible, regardless of the resulting socialimpacts. The main criticism is that private equity executives live by the “greed is good” mottobecause all they do is gut companies and destroy jobs. However, A study by Mercer LLC, aglobal consulting firm, defines PE as the leader in investment strategies by environmental, social,and environmental (ESG) standards.Chart 3.3.1 outlines the distribution of the ESG ratings among asset classes, with ESG1 being thehighest rating and ESG4 being the lowest. PE resulted in the highest proportion of highly ratedESG strategies, whereas hedge funds and fixed income placed at the lowest end of the spectrum.In order to receive an ESG1 rating, “the investment team must have demonstrated market-leading capabilities in integrating ESG factors and active ownership in some or all of thefollowing processes: generation of investment ideas, construction of portfolios, implementationof active ownership practices, and demonstration of the degree of firm-wide commitment to ESGissues” (Mercer, February 2012). To have been placed at the top of the list, PE strategies haveincorporated transparency and improvement of ESG performance metrics within their portfolios.The more an investment type has ESG3 and ESG4, the worse off they are in terms being inadherence with ESG standards. PAGE 30 OF 42
  32. 32. Hence, the assertion that PE professionals are capitalist pigs who prefer gutting companies togrowing them is unsubstantiated. Not only does PE lead the combined ESG1/ESG2 category, itis on the lower end of the ESG4 category. That is an encouraging statistic for investors whowonder if investing in PE is an act of social irresponsibility.Table 3.3.1 ESG Ratings for All Investment TypesTYPE ESG1 ESG2 ESG3 ESG4Equity 2.3% 6.8% 43.6% 47.2%Fixed Income 1.1% 2.7% 18.1% 78.1%Property 3.7% 15.9% 51.1% 29.4%Infrastructure 0.0% 18.1% 50.0% 31.9%Private Equity 1.6% 24.4% 31.5% 42.5%Hedge Funds 0.5% 1.9% 17.2% 80.4%Other 1.2% 12.7% 16.7% 69.3% Source: Mercer, February 20123.4 ConclusionsTrends in PE investment have shifted dramatically post-2008. First of all, aggregatecommitments to PE plummeted in 2008 and 2009 after the financial crisis. As they did begin torecover, investments in PE are shifting in geography from North American and Europe to Asiaand other emerging markets. In 2011 PE investment in Asia surpassed that of Europe. Compared to other pension funds, endowment, foundations and SWFs, ASRS’ portfolioallocated less to PE, less to add-ons and more to capital growth, and less to emerging markets.Given its liquidity requirements, this is understandable. However, if ASRS employed a ladderingstrategy to achieve required liquidity as discussed in Part I, it could increase its allocation to PEand emerging markets, which would likely achieve greater returns with the same risk. PE has also proven to be the most socially responsible asset class in a field of over 5,000investment strategies via a report done by a renowned global consulting firm. Hence, not only isprivate equity a great way to diversify your portfolio and achieve greater returns with essentiallythe same risk as other assets, it is a leader in socially responsible investing at the same time. PAGE 31 OF 42