CVCA_Institutional_Presentation_Treasury

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CVCA_Institutional_Presentation_Treasury

  1. 1. Private Equity Why Canadian Institutional Investors Should Participate in Global Private Equity “ Finding the Key” Report Implementation
  2. 2. The “Finding the Key” Report <ul><li>The “Finding the Key – Canadian Institutional Investors and Private Equity” research report was commissioned by the federal government and six provincial governments to assess the current attitudes of institutional investors towards Canadian private equity. </li></ul><ul><li>The research was conducted by Macdonald & Associates and based on interviews of almost 100 institutional investors in Canada and the US, </li></ul><ul><li>Key findings of the report were that there are barriers to private equity entry and sustained activity, especially for pension plans with under $5 billion in assets. Barriers noted include: </li></ul><ul><ul><ul><li>Attitudes and limited knowledge base about private equity among trustees and Canadian consultants </li></ul></ul></ul><ul><ul><ul><li>Internal staffing requirements and investment oversight difficulties </li></ul></ul></ul><ul><ul><ul><li>Lack of supporting infrastructure such as fund of funds, gatekeepers, advisors and consultants </li></ul></ul></ul><ul><ul><ul><li>Market entry costs </li></ul></ul></ul><ul><ul><ul><li>Limited access to reliable performance data, specifically for the Canadian market </li></ul></ul></ul>
  3. 3. Private Equity Investment by US and Canadian Pension Funds by Size Large differences exist between the US and Canada for private equity investment by institutional investors with under $5 billion in assets -$500 Million Source: Greenwich Associates, 2003 * Includes available data for endowments/foundations, corporate and public sector pension funds 0.1% 0.1% 0.5% 3.2% $501 Million - $1 Billion $1-5 Billion +$5 Billion Fund Size CANADA (CDN$) 1.5% 1.5% 2.6% 3.4% -$500 Million $501 Million - $1 Billion $1-5 Billion +$5 Billion Fund Size UNITED STATES (US$) % Total Assets
  4. 4. Report Recommendations and Presentation Objectives <ul><li>Recommendations </li></ul><ul><li>The Finding the Key report concluded that the CVCA should: </li></ul><ul><li>Increase communication and </li></ul><ul><li>education on private equity </li></ul><ul><li>through closer relationships with </li></ul><ul><li>PIAC and other industry </li></ul><ul><li>associations </li></ul><ul><li>Address means of overcoming </li></ul><ul><li>barriers and strengthening </li></ul><ul><li>available infrastructure to support </li></ul><ul><li>cost effective entry into the private </li></ul><ul><li>equity asset class </li></ul><ul><li>Increasing education about the Canadian private equity market was also recommended and will form the second phase of the project </li></ul><ul><li>Presentation Objectives </li></ul><ul><li>Provide an overview of private equity and reasons why the asset class should be considered as part of an institutional investment portfolio </li></ul><ul><li>Address potential risks and implementation issues related to private equity investments </li></ul><ul><li>Review alternative methods for establishing a private equity portfolio - from fund of fund to direct investing </li></ul>
  5. 5. Overview of the Institutional Committee (1) <ul><li>The Institutional Committee of the Canadian Venture Capital Association (“CVCA”) was set up to suggest how to implement the recommendations from the “Finding the Key” report. </li></ul>Natalie Townsend–CVCA Director Janet Rabovsky–Watson Wyatt David Rogers–OMERS Rosemary Zigrossi–Ontario Teachers Stuart Waugh-TD Capital Robert Palter–McKinsey Kirk Falconer–Macdonald and Associates Mark Weisdorf-MW Associates Brian Stewart-Consultant Sam Duboc–EdgeStone Institutional Investors Fund of Funds, Gatekeepers & Consultants General Partners & Service Providers Advisory Committee Core Committee
  6. 6. Overview of the Institutional Committee (2) Institutional Investors Alberta Treasury - Dan Kanashiro BCIMC - Neil Muth CAAT - Denis Larose CBC Pension - Debra Alves CDP - Pierre Fortier CPP – Tom Tutsch Industrial Alliance - Richard Legault McGill - John Limeburner NBIMC - John Sinclair PSP - Derek Murphy STM - Denis Giroux University of Alberta - Ron Ritter University of Ottawa - Barb Miazga Via Rail - Chris Caswell Fund of Funds, Gatekeepers & Consultants Adams Street - John Gray BDC - Brian Elder Cambridge - Andrea O’Toole-Auerbach Harbourvest - Brooks Zug James P. Marshall - David Kaposi Kensington - Tom Kennedy Pacific Corporate Group - Mike Russell Pantheon - Helen Steers Paul Capital - Ann Watson WestAM - Tom Thompson General Partners and Service Providers Goodmans - Rick Nathan Goodman and Carr-Murray Perelman Gowlings - Nicholas Dietrich Greenstone - Livia Mahler GTI - Bernard Hamel McLean Watson - John Eckert Penfund – John Bradlow PRIVEQ - Brad Ashley Advisory Committee
  7. 7. Presentation Background and Objectives <ul><li>Presentation Objectives </li></ul><ul><li>Provide an overview of private equity and reasons why the asset class should be considered as part of an institutional investment portfolio </li></ul><ul><li>Address potential risks and implementation issues related to private equity investments </li></ul><ul><li>Review alternative methods for establishing a private equity portfolio - from fund of fund to direct investing </li></ul><ul><li>Recommendations </li></ul><ul><li>The Finding the Key report concluded that the CVCA should: </li></ul><ul><li>Increase communication and </li></ul><ul><li>education on private equity </li></ul><ul><li>through closer relationships with </li></ul><ul><li>PIAC and other industry </li></ul><ul><li>associations </li></ul><ul><li>Address means of overcoming </li></ul><ul><li>barriers and strengthening </li></ul><ul><li>available infrastructure to support </li></ul><ul><li>cost effective entry into the private </li></ul><ul><li>equity asset class </li></ul><ul><li>Increasing education about the Canadian private equity market was also recommended and will form the second phase of the project </li></ul>
  8. 8. What is Private Equity? <ul><li>Long term equity and subordinated debt investments in non-publicly traded companies across different stages of development from venture to buyout </li></ul><ul><ul><li>Venture </li></ul></ul><ul><ul><ul><li>Equity for early stage and later stage growth companies, usually in technology or biotech businesses, to further develop the product or service, the management and sales team and to secure customer sales </li></ul></ul></ul><ul><ul><li>Buyouts and Expansion </li></ul></ul><ul><ul><ul><li>Equity and quasi equity for more established companies for growth, expansion or ownership change, including leveraged and management buyouts. May require strategic refocusing, management team augmentation and governance changes </li></ul></ul></ul><ul><ul><li>Mezzanine Debt </li></ul></ul><ul><ul><ul><li>Subordinated debt for established companies with strong and stable cash flows </li></ul></ul></ul><ul><ul><li>Other </li></ul></ul><ul><ul><ul><li>Specialized strategies such as distressed, special situations, turnarounds , secondaries and infrastructure </li></ul></ul></ul>
  9. 9. Characteristics of Private Equity <ul><li>Far more active than public equity investing </li></ul><ul><ul><li>Inefficient market </li></ul></ul><ul><ul><ul><li>Private equity managers develop and act on informational advantage </li></ul></ul></ul><ul><ul><ul><li>Investment opportunities must be actively sourced and require a high degree of due diligence, customization and structuring </li></ul></ul></ul><ul><ul><ul><li>Valuation and structure of private equity investments is determined through negotiation versus being set by an efficient public market </li></ul></ul></ul><ul><ul><li>Requires active involvement and governance </li></ul></ul><ul><ul><ul><li>Equity stakes are typically control or significant influence positions with rights outlined in a shareholders’ agreement </li></ul></ul></ul><ul><ul><ul><li>Private equity managers typically sit on the Boards of portfolio companies and are expected to contribute to company development by utilizing their experience and contacts to provide expertise in strategic, operational, capital structure, financial, management and compensation issues </li></ul></ul></ul><ul><ul><li>Long term investment horizon </li></ul></ul><ul><ul><ul><li>Portfolio company investments are typically held for between 5 - 7 years and the majority of the returns are earned upon sale towards the end of a Fund’s life </li></ul></ul></ul>
  10. 10. Why Consider Private Equity? <ul><li>Return Enhancement </li></ul><ul><ul><li>Other asset classes are not presently providing sufficient returns to meet long term funding targets </li></ul></ul><ul><ul><li>Produces high rates of return, with superior long term out-performance for top quartile managers relative to public benchmarks </li></ul></ul><ul><ul><li>Most pension plan consultants suggest that private equity returns should exceed returns from a public stock market portfolio by 300–500 basis points </li></ul></ul><ul><ul><li>Persistency of performance among top quartile managers increases the likelihood of success in building a high performing private equity portfolio </li></ul></ul><ul><ul><li>Structural, governance and informational advantages increase the private equity manager’s ability to consistently earn high returns </li></ul></ul><ul><li>Diversification Benefits </li></ul><ul><ul><li>Provides access to a broader range of investment opportunities than those available in the public markets </li></ul></ul><ul><ul><li>Provides access to active managers that can add value to portfolio companies through active, hands-on management in a manner not available to public investments </li></ul></ul><ul><ul><li>Provides portfolio risk diversification but the magnitude is difficult to measure accurately because the differences in public market and private equity data streams, which by necessity include interim valuations </li></ul></ul>
  11. 11. Private Equity Performance Disclosed for Canadian Pension Plans <ul><li>Ontario Teachers </li></ul><ul><ul><li>&quot;Teachers' Private Capital outperformed its benchmark by 13.1% in 2004 with a one-year rate of return of 27.6% to add $460 million in value.“ </li></ul></ul><ul><ul><li>&quot;Over the past four years, private equity delivered a rate of return of 16.0%..” </li></ul></ul><ul><li>Caisse </li></ul><ul><ul><li>Private Equity generated 20.5% in 2004 and the “Private Equity group made significant contributions to the Caisse’s 2004 results” </li></ul></ul><ul><li>OMERS </li></ul><ul><ul><li>The return on total investment income for the private equity was 12.5% compared with a negative 13.8% return in 2003 </li></ul></ul><ul><li>HOOPP </li></ul><ul><ul><li>Private equity and special situations generated 21.2% returns for 2004 and 8.9% for 2003 </li></ul></ul>
  12. 12. How to Evaluate Private Equity Returns <ul><li>Private equity returns are presented as internal rates of returns (IRRs) based on interim valuations until the investment is realized. </li></ul><ul><li>Public equity benchmarks such as the S&P and Nasdaq are reported on a time-weighted basis which makes comparison difficult, and potentially not meaningful </li></ul><ul><li>Private equity returns are not meaningful until a fund is in the mature phase, typically beyond 3-5 years when the realization process for initial investments begins </li></ul><ul><li>Because of the lack of ready benchmarks, multiple comparators are often used for short and long term measurement </li></ul><ul><ul><li>Short term (0-5 years) </li></ul></ul><ul><ul><ul><li>Mainly qualitative </li></ul></ul></ul><ul><ul><ul><li>Annual review of manager to ensure comfort level </li></ul></ul></ul><ul><ul><ul><li>Annual review of policy execution: adherence to stated strategy and objectives, investment pace, diversification, underlying performance of portfolio companies </li></ul></ul></ul><ul><ul><ul><li>Ongoing discussions with other LPs </li></ul></ul></ul><ul><ul><li>Longer term (5-12+ years) </li></ul></ul><ul><ul><ul><li>Vintage year performance comparisons (e.g first quartile in Thomson Venture Economics) </li></ul></ul></ul><ul><ul><ul><li>Relative return target (e.g. listed index + 300 to 500 basis points) </li></ul></ul></ul><ul><ul><ul><li>Absolute return target (e.g. 12% net) </li></ul></ul></ul><ul><ul><ul><li>Modeling portfolio cash flows in order to create a public market equivalent index for better comparison to public indices (an opportunity cost benchmark – see Appendix III) </li></ul></ul></ul>
  13. 13. J-curve Phenomenon <ul><li>Private equity funds typically experience declines in value in the early years of their development as Fund’s value an investment at cost until another round of financing, an acquisition or IPO occurs, while fees and write offs are recognized immediately </li></ul><ul><li>The chart below illustrates a typical J-curve for typical private equity Fund. The J-curve for venture capital is typically longer than for buyout. The 1999/2000 vintage funds are experiencing extended J-curves in excess of 5 years whereas 2001 vintage funds are already returning capital. (see Appendices V and VI for vintage year returns) </li></ul>Source: Thomson Venture Economics/NVCA It is important to consider the short term, negative impact of the J-curve when assessing private equity performance. Illustrative
  14. 14. North American and European Private Equity Performance For All Funds S&P/TSX Composite (US$) On a vintage year basis, private equity has delivered strong long-term returns, with sustained out-performance from top quartile managers * I ncluding recently formed funds which have not drawn down 100% of capital commitments, have not completed their investment periods and are experiencing the J-curve effect. Note on Vintage Year Returns: Vintage year returns are an internal rate of return calculation based on the year of fund formation and first drawdown of capital. Vintage year performance is an effective method for comparing individual funds as it reflects the definite life cycle to a group of funds formed in the same vintage year. Notes: 1. Private Equity returns are shown net of fees and expenses. 2. Public Equity returns are gross total returns, which assumes dividends are re-invested in the index 3. Canadian and European monthly total returns have been converted to US$ and converted values are then calculated as annualized total returns. Return figures are therefore affected by Source: Thomson Venture Economics, Bloomberg; private equity returns are calculated as annual compounded internal rates of return (&quot;IRRs&quot;), while those for the public market indices are not; Direct comparisons may therefore not be meaningful (As of December 31, 2004) Vintage Year Vintage Year Private Equity (Pooled Average) * 1999-2003 1994-2003 1989-2003 1984-2003 All Funds (0.2)% 9.4% 12.7% 13.6% Venture Capital (9.1) 19.9 23.3 16.9 Buyout 5.4 6.1 8.8 11.8 Private Equity - Top Quartile Cut-off * All Funds 3.5% 13.2% 16.1% 15.9% Venture Capital (1.4) 14.7 19.0 16.2 Buyout 7.7 11.3 15.0 16.2 Public Equity - Total Returns in US$ 5 yr 10 yr 15 yr 20 yr S&P 500 Gross TR (2.3)% 12.1% 10.9% 13.2% 7.9 11.7 7.9 10.2 Nasdaq Composite (11.6) 11.3 11.0 11.5 Russell 2000 TR 6.6 11.5 11.1 11.5 HSBC Smaller European (US$) 6.9 11.3 8.4 12.0 2 S&P/TSX Composite (C$) 3.6 10.1 8.2 9.7 foreign exchange fluctuations over the period 1 1 Nasdaq Composite Index - Total Returns available since September 30, 2003, price return values used prior to September 30, 2003 2 Inception for HSBC Smaller European Index is December 31, 1985 .
  15. 15. North American and European Private Equity Performance For Mature Funds For mature funds, private equity’s strong long term performance is evident across strategies and investment styles (As of December 31, 2004) Vintage Year Vintage Year Private Equity (Pooled Average) * 1999-2003 1994-1998 1989-1998 1984-1998 All Funds (0.2)% 14.9% 17.3% 16.1% Venture Capital (9.1) 43.6 32.0 20.1 Buyout 5.4 6.6 9.8 13.1 Private Equity - Top Quartile Cut-off * All Funds 3.5% 23.5% 23.3% 20.3% Venture Capital (1.4) 48.9 38.1 22.6 Buyout 7.7 14.3 18.4 18.7 Public Equity - Total Returns in US$ 5 yr 10 yr 15 yr 20 yr S&P 500 Gross TR (2.3)% 12.1% 10.9% 13.2% S&P/TSX Composite (US$) 7.9 11.7 7.9 10.2 Nasdaq Composite 1 (11.6) 11.3 11.0 11.5 Russell 2000 TR 6.6 11.5 11.1 11.5 HSBC Smaller European (US$) 6.9 11.3 8.4 12.0 2 * Includes immature funds that have not yet completed their investment period and may have significant amounts of capital yet to be drawn. 1 Nasdaq Composite Index - Total Returns available since September 30, 2003, price return values used prior to September 30, 2003 2 Inception for HSBC Smaller European Index is December 31, 1985. Developing Funds * Mature Funds Note: To estimate the potential impact of the J-curve and fund maturity on vintage year returns, we removed funds raised in the last 5 years (developing funds) The intention is to approximate the performance of mature funds, which, on average, should have drawn all their capital commitments and completed their investment cycle . Notes: 1. Private Equity returns are shown net of fees and expenses. 2. Public Equity returns are gross total returns, which assumes dividends are re-invested in the index 3. Canadian and European monthly total returns have been converted to US$ and converted values are then calculated as annualized total returns. Return figures are therefore affected by Source: Thomson Venture Economics, Bloomberg; private equity returns are calculated as annual compounded internal rates of return (&quot;IRRs&quot;), while those for the public market indices are not; Direct comparisons may therefore not be meaningful foreign exchange fluctuations over the period S&P/TSX Composite (C$) 3.6 10.1 8.2 9.7
  16. 16. Persistence of Returns <ul><li>Stephen Kaplan and Antoinette Schoar of the University of Chicago completed a study on 2004 which found that over a 17 year period performance persists strongly across private equity funds </li></ul><ul><ul><li>GPs whose funds outperform the industry on one fund are likely to outperform in a successor fund; GPs who underperform are likely to repeat this performance as well </li></ul></ul><ul><ul><li>Findings are markedly different from the results for mutual funds, where persistence has been difficult to detect and, when detected, tends to be driven by persistent underperformance rather than out-performance </li></ul></ul><ul><ul><li>If there were survivorship or selection biases in the sample of funds, actual persistence would likely be greater than the persistence measured </li></ul></ul><ul><li>Investors must consider whether there has been any turnover of professionals or change in strategy since the previous fund </li></ul>Persistency of performance among top quartile managers increases the likelihood of success in building a high performing private equity portfolio
  17. 17. Why Private Equity Managers Produce High Returns Over the Long Term (1) <ul><li>Access to more information </li></ul><ul><ul><li>Opportunity to conduct lengthy and exhaustive due diligence </li></ul></ul><ul><ul><li>Ability to access detailed information about the company and during the life of the investment, typically through Board representation and internal reporting </li></ul></ul><ul><li>Market inefficiency </li></ul><ul><ul><li>Opportunity to utilize informational advantages and illiquidity to purchase private companies at more favourable valuations relative to public companies </li></ul></ul><ul><ul><li>Illiquidity discounts typically narrow as private companies grow toward a public liquidity event or strategic sale </li></ul></ul><ul><ul><li>Ability to structure security holder arrangements on more attractive and investor friendly terms than available in public equity investing </li></ul></ul>Structural, governance and informational advantages increase the private equity manager’s ability to consistently earn high returns
  18. 18. <ul><li>Active, value-added involvement and governance </li></ul><ul><ul><li>Bring value-added expertise by utilizing their contacts and providing experience on strategic, operational, financial, management and compensation issues </li></ul></ul><ul><ul><li>Can implement corrective action quickly if performance is off plan </li></ul></ul><ul><ul><li>Ability to control the manner and timing of exiting the investment to maximize shareholder value </li></ul></ul><ul><li>Strategic focus and alignment of interests over a long term horizon </li></ul><ul><ul><li>Can assist and provide clear direction to the management team on strategic focus and priorities </li></ul></ul><ul><ul><li>Can align compensation towards achievement of the strategy </li></ul></ul><ul><ul><li>Management can take a long term approach to implementing strategy since pressure to meet quarterly “street” expectations is removed </li></ul></ul>Why Private Equity Managers Produce High Returns Over the Long Term (2) Structural, governance and informational advantages increase the private equity manager’s ability to consistently earn high returns
  19. 19. Private Equity Diversification Opportunity Public 20,261 Private 151,345 171,606 Companies in the US Revenues $10 million and above Source: Dun & Bradstreet’s Market Identifiers Database, January 2002. Courtesy Abbott Capital 88% 12 % Public 7,424 Private 22,696 Revenues $100 million and above 67 % 33 % Private equity investing provides access to a broader range of investment opportunities than available in the public markets
  20. 20. Diversification within Private Equity Asset Classes <ul><li>The following sub sectors of private equity funds have different risk profiles, return expectations, investment opportunities and overall market conditions : </li></ul><ul><li>Offers opportunity to diversify within a private equity portfolio based on the overall assessment of the attractiveness of investment opportunities (growth prospects, valuation etc.) and the amount of capital available for investment. </li></ul>North America, Europe, Asia and Latin America Geography - Value - Growth - Media & Communications - Biotech - Information Technology - Communications Specialization Other - Mezzanine - Turnaround - Infrastructure Buyout - Small Market - Mid Market - Large Buyout Venture - Seed Stage - Early Stage - Later Stage Style
  21. 21. Benefits of Diversification 30.0% 1.0% 0.0% 42.0% 30.0% 1.0% 0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0% 35.0% 40.0% 45.0% Direct Investment in Single Private Company Investment in Single Private Equity Fund Investment in Private Equity Fund of Funds Note: Data contains about 5,000 direct investments, 300 funds and 50,000 simulated fund of funds Source: Weidig and Mathonet report, &quot;The Risk Profiles of Private Equity&quot;, January 2004, Courtesy TD Capital # of Portfolio Company Investments: 1 6 - 12 (Buyout) 20 - 40 (Venture ) 400 - 1200 Risk of Total Loss Risk of Some Loss A diversified private equity portfolio can significantly reduces volatility and risk of loss
  22. 22. Depth and Growth of the US Private Equity Industry (1) Private equity investing has grow n substantially into an established industry offering depth and diversity of investment strategies and fund managers Source: Thomson Venture Economics $722.0 $95.5 $4.4 Capital Under Management ($B) $51.3 $12.9 $2.3 Total Funds Raised ($B) 250 157 58 Number of Funds Raised in Year 15,598 6,734 1,553 Number of Professionals 2,977 1,136 157 Number of Funds 1,544 630 112 Number of Firms 2003 1990 1980
  23. 23. Depth and Growth of the US Private Equity Industry (2) <ul><li>Tougher environment for generating high absolute private equity returns as increased competition makes it more difficult to find undervalued companies or proprietary deal flow </li></ul><ul><li>Relative out-performance versus public markets is still expected with increased focus on manager selection and taking a tactical approach </li></ul><ul><ul><li>Focusing on private equity sub asset classes and/or markets which are less capitalized yet still capable of generating high returns </li></ul></ul><ul><ul><li>Selecting private equity managers which have shown discipline through previous market cycles and an ability to substantially build the value of investee companies </li></ul></ul><ul><ul><li>Considering the impact of partnership dynamics such as increasing age and net worth of the private equity managers on the ability to continue to out-perform public market alternatives </li></ul></ul>While achieving historical absolute returns may be challenging in the future, relative out-performance to public markets is still expected
  24. 24. Global Private Equity Funds Raised vs. Invested The historical capital overhang is dissipating as investment activity has outpaced fund raising activity
  25. 25. Presentation Background and Objectives <ul><li>Presentation Objectives </li></ul><ul><li>Provide an overview of private equity and reasons why the asset class should be considered as part of an institutional investment portfolio </li></ul><ul><li>Address potential risks and implementation issues related to private equity investments </li></ul><ul><li>Review alternative methods for establishing a private equity portfolio - from fund of fund to direct investing </li></ul><ul><li>Recommendations </li></ul><ul><li>The Finding the Key report concluded that the CVCA should: </li></ul><ul><li>Increase communication and </li></ul><ul><li>education on private equity </li></ul><ul><li>through closer relationships with </li></ul><ul><li>PIAC and other industry </li></ul><ul><li>associations </li></ul><ul><li>Address means of overcoming </li></ul><ul><li>barriers and strengthening </li></ul><ul><li>available infrastructure to support </li></ul><ul><li>cost effective entry into the private </li></ul><ul><li>equity asset class </li></ul><ul><li>Increasing education about the Canadian private equity market was also recommended and will form the second phase of the project </li></ul>
  26. 26. Perceived Risks of Private Equity (1) <ul><ul><li>Experienced staff or a Consultant, Fund of Funds, or Gatekeeper (collectively “Advisor”) can provide expertise to undertake manager selection to diversify manager-specific risk and to access persistent top quartile managers </li></ul></ul><ul><ul><li>Access to top quartile funds is important as the spread between median and top quartile returns is very large </li></ul></ul><ul><ul><li>Difficult to obtain access to all top quartile funds specifically for venture and mid market buyout funds </li></ul></ul>Sub-optimal Investment Selection <ul><ul><li>Most pension funds have adequate liquidity (~90%) from quoted bond and equity portfolios </li></ul></ul><ul><ul><li>The secondary market for fund investments has been growing rapidly offering increased liquidity and comfort around competitive pricing </li></ul></ul><ul><ul><li>Fund investments are long term investments which should be held to maturity. If liquidity is required before maturity, there will be transaction costs. </li></ul></ul>Limited Liquidity Mitigation Issue
  27. 27. Perceived Risks of Private Equity (2) <ul><ul><li>Robust practices have been developed for measuring and monitoring through all phases of a fund’s life </li></ul></ul><ul><ul><li>Benchmarks including both absolute and relative return targets are utilized </li></ul></ul><ul><ul><li>Industry groups are developing more standard reporting and valuation guidelines that should be compared to a fund’s policy. </li></ul></ul><ul><ul><li>Must rely on appraisal pricing to assess performance in the early years </li></ul></ul><ul><ul><li>Benchmarking difficult as private equity returns are reported using IRRs with appraisal pricing </li></ul></ul>Difficult to Measure and Monitor <ul><ul><li>Investment strategy should provide consistent exposure to funds at different points of economic and capital markets cycle </li></ul></ul><ul><ul><li>Difficult to time the market as the fund life extends over ten years. Thus, most plans invest consistently through the cycles </li></ul></ul><ul><ul><ul><li>Like many other investment alternatives, private equity returns are cyclical </li></ul></ul></ul><ul><ul><ul><li>At the start of a private equity program, returns can be more highly dependent on vintage year performance </li></ul></ul></ul>Vintage Year Performance Mitigation Issue
  28. 28. Unique Implementation Issues (1) <ul><ul><li>During the fund life, realizations will be distributed and provide cash returns with most of the capital being drawn and returned in the 6 to 8 year time frame for an average diversified portfolio </li></ul></ul><ul><ul><li>Pension plans, endowments and foundations have long term liabilities and investment horizons which are beyond board tenures and fit well against private equity cash flows </li></ul></ul><ul><ul><li>Distributions from lower performing managers are utilized to rebalance portfolio towards top quartile managers over time </li></ul></ul><ul><ul><li>Must recognize that success can only be measured over long periods as fund life is typically 10–14 year </li></ul></ul><ul><ul><li>May create hesitation to commit among board members as the time frame may be beyond their tenure </li></ul></ul><ul><ul><li>Typically, it is very difficult to replace a fund manager as a super majority of investors is required to effect the change </li></ul></ul>Long-term Commitment to Managers <ul><ul><li>Experienced staff or an Advisor can provide required expertise and access to high performance funds </li></ul></ul><ul><ul><li>External management through an Advisor offers a cost effective and practical solution for building an initial private equity portfolio. As the experience base grows, investors often undertake internal fund selection and may consider co-investment and direct investment depending on internal resources </li></ul></ul><ul><ul><li>Require experienced professionals to build a high performing portfolio and manage risks effectively </li></ul></ul><ul><ul><li>Staffing and size constraints for some institutional investors may make building a private equity portfolio seem impractical or cost ineffective </li></ul></ul>Staffing Requirements Mitigation Issue
  29. 29. Unique Implementation Issues (2) <ul><ul><li>Venture Fund Access for Public Fund </li></ul></ul>Managed through staying in touch with marketplace and can be assisted by an Advisor <ul><ul><li>Top quartile fund and fund of funds may not be available when investors’ want to invest </li></ul></ul><ul><ul><li>While Canadian law presents less risk regarding disclosure, the perception still exists </li></ul></ul><ul><ul><li>Fund of funds aggregation of results addresses venture fund FOIA concerns </li></ul></ul><ul><ul><li>Some top quartile venture funds are excluding public pension plan as investors because of fears regarding potential performance disclosure under the Freedom of Information Act (FOIA) </li></ul></ul>Product Availability <ul><ul><li>J-curve impact only felt on a small percentage of the capital drawn by a fund in years 1-3 (typically less than 50% of the total commitment) </li></ul></ul><ul><ul><li>Building the portfolio over different vintage years will alleviate this issue as portfolio matures </li></ul></ul><ul><ul><li>Allocate part of the portfolio to later stage buyouts, mezzanine debt and secondaries </li></ul></ul><ul><ul><li>Short-term results are negatively impacted by the J-curve </li></ul></ul>The J-curve Mitigation Issue
  30. 30. Unique Implementation Issues (3) <ul><ul><li>While not enacted as law yet, the most recent budget removed the 30% foreign content restriction for Canadian pension plans </li></ul></ul><ul><ul><li>Previous QLP structuring problems will no longer be an issue </li></ul></ul><ul><ul><li>Pension plans now have full flexibility in structuring their investment portfolios and will likely move towards measuring performance against relevant global benchmarks </li></ul></ul><ul><ul><li>Previous to the recent budget, investments in non-Canadian funds and many Canadian funds that could not be structured effectively as Qualified Limited Partnerships (QLP’s) were considered foreign content </li></ul></ul><ul><ul><li>Foreign Content </li></ul></ul><ul><ul><li>Funds typically covenant not to have ECI or FIRPTA but in the event this type of income is earned inadvertently a blocker corporation should be set up to isolate tax reporting </li></ul></ul><ul><ul><li>Canadian tax exempt investors can become inadvertently subject to US income tax on distributions received which constitute effectively connected income (ECI) or certain real estate related income (FIRPTA) </li></ul></ul>Potential US Tax Issues Mitigation Issue
  31. 31. Unique Implementation Issues (4) <ul><ul><li>To maintain a target allocation to private equity it is necessary to make ongoing fund commitments </li></ul></ul><ul><ul><li>Amount of net invested capital in a private equity fund declines rapidly after year five </li></ul></ul><ul><ul><li>Increasing standardization of contracts, valuation methodology and performance reporting </li></ul></ul><ul><ul><li>External expertise available to assist investors </li></ul></ul><ul><ul><li>Complex contracts and lack of common performance reporting standards </li></ul></ul><ul><ul><li>Contractual Documentation </li></ul></ul><ul><ul><li>To achieve a target allocation, it is necessary to make fund commitments in excess of the target investment amount (over-commit) to the asset class </li></ul></ul><ul><ul><li>Due to the timing of distributions and drawdowns, net invested capital usually peaks at far less than the target allocation, thus the target allocation is rarely reached with single fund commitment </li></ul></ul>Difficulty Maintaining Target Allocation Mitigation Issue
  32. 32. Maintaining a Private Equity Allocation <ul><li>To achieve a target allocation, it is necessary to over-commit to the asset class </li></ul>Amount of Total Portfolio in Private Equity Due to the timing of distributions and drawdowns, net invested capital peaks at approximately 60% of committed capital in year 5 in this example <ul><li>Assumes one-time commitment of 10% of portfolio to a private equity Fund of Funds </li></ul><ul><li>10% target allocation is never reached with single fund commitment </li></ul><ul><li>Amount of net invested capital in Private Equity declines rapidly after year five </li></ul><ul><li>An ongoing program (committing approximately 1.0x allocation every 2 years) is required to achieve and maintain a target allocation to private equity </li></ul>Source: Journal of Wealth Management Courtesy TD Capital Year Percentage of Portfolio in Private Equity 0 0 1 2 3 4 5 6 7 8 9 10 11 12 1% 2% 3% 4% 5% 6% Illustrative
  33. 33. Private Equity Fees <ul><li>Management fee of 1.5% to 2.5% on the total capital committed, often reduced after 5 years </li></ul><ul><li>All distributions go to the investor until cumulative distributions represent a repayment of all capital commitments including management fees plus, typically, an 8% compound annual rate of return. </li></ul><ul><li>Performance based compensation in the form of a carried interest, typically 20% is paid to the GP thereafter (subject to GP catch up provisions if they exist) </li></ul><ul><li>Cost of building an experienced, internal investment team to source, evaluate, monitor and manage direct equity investments in private companies is high </li></ul>Fees are higher than quoted equities but net return from private equity tends to be higher over the long term
  34. 34. Private Equity Allocation Targets Strategic (Targeted) Allocation to Private Equity by Type of Organization, 1995-2003 (North America) (%) Source Goldman Sachs International & Russell Investment Group Alternative Investing Report 2003 North American institutional investors have generally been increasing their target allocations to private equity Public Pension Funds Corporate Pension Funds Endowments/Foundations
  35. 35. Canadian corporate pension plans and endowments have less invested in private equity than US plans Private Equity Investment by US and Canadian Pension Funds 3.3% Pension Funds (Corporate) 3.1% Pension Funds (Public Sector) 8.0% Endowments and Foundations 1.0% Endowments and Foundations Canada 1.3% Pension Funds (Corporate) Source: Greenwich Associates, 2003 2.8% Pension Funds (Public Sector) United States % Total Assets
  36. 36. Presentation Background and Objectives <ul><li>Presentation Objectives </li></ul><ul><li>Provide an overview of private equity and reasons why the asset class should be considered as part of an institutional investment portfolio </li></ul><ul><li>Address potential risks and implementation issues related to private equity investments </li></ul><ul><li>Review alternative methods for establishing a private equity portfolio - from fund of fund to direct investing </li></ul><ul><li>Recommendations </li></ul><ul><li>The Finding the Key report concluded that the CVCA should: </li></ul><ul><li>Increase communication and </li></ul><ul><li>education on private equity </li></ul><ul><li>through closer relationships with </li></ul><ul><li>PIAC and other industry </li></ul><ul><li>associations </li></ul><ul><li>Address means of overcoming </li></ul><ul><li>barriers and strengthening </li></ul><ul><li>available infrastructure to support </li></ul><ul><li>cost effective entry into the private </li></ul><ul><li>equity asset class </li></ul><ul><li>Increasing education about the Canadian private equity market was also recommended and will form the second phase of the project </li></ul>
  37. 37. Ways to Invest In Private Equity Fund of Funds Non-Discretionary Advisor Internal Direct Investments Internal Fund Selection Degree of Plan Sponsor Involvement Lower Higher Internal Resources Required Lower Higher External Fees Higher Lower
  38. 38. Evolution of Private Equity Investment by Institutional Investors <ul><li>Lack of interest and/or restrictions concerning alternative investments </li></ul><ul><li>No dedicated Private Equity staff </li></ul>Stage II: Fund of Funds and Limited Fund Investments <ul><li>Investments in Fund of Funds </li></ul><ul><li>Investments in Private Equity Funds with the assistance of an Advisor </li></ul><ul><li>Small staff </li></ul>Stage III: Full Fund Investment Program Stage IV: Full Fund Investment Program with a Direct Co-Investment Program Stage V: In-house Private Equity Investment Group <ul><li>Investments in Private Equity Funds with or without the assistance of an Advisor </li></ul><ul><li>Investments in Fund of Funds for specific geographies or sub asset classes </li></ul><ul><li>Small dedicated Private Equity Fund investment staff </li></ul><ul><li>Investments in Private Equity Funds </li></ul><ul><li>Co-investments generated through Fund Investments </li></ul><ul><li>Investments in Fund of Funds requiring external expertise </li></ul><ul><li>Medium-sized dedicated Private Equity investment staff </li></ul><ul><li>Active direct investments, co-investments and Fund Investments </li></ul><ul><li>Investments in Fund of Funds requiring external expertise </li></ul><ul><li>Specialization (eg. industry, venture vs. LBO, etc.) </li></ul><ul><li>Dedicated large Private Equity staff </li></ul>Stage I: No Private Equity Investments
  39. 39. Why a Fund of Funds or Advisor? <ul><li>Access to top tier private equity managers because of institutional scale and resources, historical relationships and market presence </li></ul><ul><li>Access to an experienced investment team and disciplined process for private equity manager due diligence, selection and portfolio construction </li></ul><ul><li>Benefits of scale are passed on to the investor </li></ul><ul><ul><li>Investors can build a portfolio of 20-30 managers without having to commit over US$100-200 million required to build the portfolio directly (assuming US$5-10 minimum per fund) </li></ul></ul><ul><ul><li>Enables private equity investing to be practical and cost effective for smaller institutional investors </li></ul></ul><ul><li>Eases administrative burden </li></ul><ul><ul><li>negotiation of agreements </li></ul></ul><ul><ul><li>consolidation of cash flows </li></ul></ul><ul><ul><li>consolidated reporting </li></ul></ul><ul><ul><ul><li>tracking of cash commitments, drawdowns and distributions </li></ul></ul></ul><ul><ul><ul><li>performance reporting </li></ul></ul></ul><ul><ul><li>liquidation of in-kind distributions </li></ul></ul>
  40. 40. Fund of Fund Fees <ul><li>Management fee in the range of 75-100 basis points on the total capital committed, often reduced after 5 years </li></ul><ul><li>All distributions go to the investor until cumulative distributions represent a repayment of all capital commitments including management fees plus, typically, an 8% compound annual rate of return </li></ul><ul><li>Performance based compensation in the form of a carried interest is typically paid to the GP thereafter. The carried interest varies depending on the type of investment </li></ul><ul><ul><li>Primary Fund Investments: 0%-5% Carried Interest </li></ul></ul><ul><ul><li>Secondary Fund Investments: 5%-10% Carried Interest </li></ul></ul><ul><ul><li>Direct Co-Investments (if any): 10%-15% Carried Interest </li></ul></ul><ul><li>These fees are in addition to the fees paid to the private equity fund manager </li></ul>Despite additional fees, Fund of Funds offer a cost effective solution for smaller pension funds. For larger pension funds with in-house private equity teams, the incremental fees must be weighed against the other benefits gained.
  41. 41. Conclusions <ul><li>Private equity is an important part of an institutional portfolio, offering return enhancement and diversification benefits versus traditional asset classes </li></ul><ul><li>Risk and implementation issues unique to private equity can be addressed by experienced internal resources or by engaging a Consultant, Fund of Funds, or Gatekeeper (collectively “Advisor”) </li></ul><ul><li>There is a significant opportunity for Canadian institutional investors, especially those with assets under $5 billion, to increase participation in private equity either directly or through an Advisor </li></ul><ul><li>Investment industry professionals should work together to increase communication and education about private equity among managers, trustees/directors, and consultants and to address perceived barriers to entry into the asset class for Canadian investors </li></ul>
  42. 42. Private Equity Appendices Appendix I: Canadian and US Contributors to the “Finding the Key” Report Appendix II: List of Advisory Board Members for the “Finding the Key” Report Appendix III: Private Equity Performance Measurement and Benchmarking Studies Appendix IV: Building a Private Equity Portfolio Structure Appendix V: US Venture Funds Annualized Net Cumulative IRR by Vintage Year Appendix VI: US Buyout Funds Annualized Net Cumulative IRR by Vintage Year
  43. 43. Contributors to “Finding the Key” Report (1) <ul><li>Canada </li></ul>Gestion Aequilibrium Greystone Managed Investments Hospital Employees Pension Plan of Manitoba Hydro One Pension Plan Hydro-Quebec Pension Plan Imperial Oil Pension Plan Industrial Alliance Insurance and Financial Services IWA Forest Industry Pension Plan Jefferson Partners La Capital Life Insurance Lucie and Andre Chagnon Foundation Manitoba Civil Service Superannuation Board Maritime Life Assurance Company McLean Watson Capital Mercer Investment Consulting Montreal Transit Pension Plan Montreal Urban Community Police Pension Association New Brunswick Investment Management Corporation Nortel Networks Pension Plan Nova Scotia Hospitals Pension Plan Alberta Revenue Alberta Teachers Retirement Fund Board Alcan Pension Plan Bank of Montreal Pension Plan BDC Venture Capital Group BIMCOR British Columbia Investment Management Corporation Canadian National Railways Pension Plan City of Winnipeg Pension Plan Colleges of Arts and Applied Technology Pension Plan Canada Life Assurance Company Canada Post Pension Plan CBC Pension Plan CDP Capital CPP Investment Board DaimlerChrysler Canada Pension Plan Domtar Pension Plan EdgeStone Capital Fund-of-Funds Fonds Eterna Frank Russell Canada General Motors of Canada Pension Plan
  44. 44. Contributors to “Finding the Key” Report (2) <ul><li>Canada - continued </li></ul>United States Abbott Capital Management LLC BellSouth Pension California Public Employees Retirement System California State Teachers Retirement System Cambridge Associates LLC Colorado Public Employees Retirement System Credit Suisse First Boston Flag Venture Partners Florida State Board of Administration Grove Street Advisors Harbourvest Partners LLC Harvard Endowment Fund MIT Endowment Fund Massachusetts Pension Reserves Investment Management Oregon Public Employees Retirement Fund Pennsylvania State Employees Retirement System RBC Capital Partners (U.S.) State of Wisconsin Investment Board Teacher Retirement System of Texas Verizon Investment Management Corporation Nova Scotia Public Service Pension Plan Ontario Pension Board Ontario Teachers Pension Plan Ontario Municipal Employees Retirement System Pension Investment Association of Canada Petro-Canada Pension Plan Province of Newfoundland Pension Plan PSP Investment Board Regimes de rentes du Mouvement Desjardin Reseau de capital de risque du Canada Shell Canada Pension Plan Sun Life Assurance Company TD Capital Private Equity Investors Telus Corporation Pension Plan Towers Perrin University of British Columbia Faculty Pension Plan University of Laval Pension Plan University of Montreal Pension Plan University of Quebec Pension Plan University of Toronto Asset Management Corporation Ventures West Management
  45. 45. Advisory Board Members for “Finding the Key” Report Project Team Wayne Clendenning – Research Consultant Kirk Falconer – Macdonald & Associates Kathy Jeramez-Larson – Macdonald & Associates Mark Nelson – Ontario Ministry of Economic Development Trade Beverley Morden – Research Consultant Lucien Biron - PriceWaterhouseCoopers Advisory Board Mark Belfrey – Prince Edward Island Business Development John Eckert – McLean Watson Capital Inc. Brian Elder – Business Development Bank of Canada Marc Leduc – Quebec Ministry of Economic and Regional Development Robin Louis – Ventures West Management Inc. Mary Macdonald – Macdonald & Associates Limited Claude Miron – InVivo Ventures David Rogers – Ontario Municipal Employees Retirement System John Sinclair – New Brunswick Investment Management Corp. Christine Soucy – Industry Canada Annie Thabet – Celtis Canada Peter Webber – Industry Canada Doug Welwood – Ontario Ministry of Economic Development and Trade Rosemary Zigrossi – Ontario Teachers’ Pension Plan Board
  46. 46. Private Equity Performance Measurement and Benchmarking Studies <ul><li>&quot;A Method for Comparing Private Market Internal Rates of Return to Public Market Index Returns&quot;,  Austin M. Long and Craig J. Nickels, ( www.alignmentcapital.com /publications/ Index Comparison Method), August 1995. </li></ul><ul><li>&quot;Benchmarking and Performance Measurement&quot;, Mark Weisdorf and Janet Rabovsky, extracted from the Research Guide, 'Private Equity Due Diligence: Investment Selection in an Inefficient Asset Class', to be published in 2005 by Private Equity International and Probitas Partners. </li></ul><ul><li>&quot;Private Equity Benchmarking with PME+&quot;, Christophe Rouvinex, Venture Capital Journal, August 2003. </li></ul><ul><li>  </li></ul><ul><li>&quot;Benchmarking the Returns to Venture&quot;, Woodward and Hall, Working Paper 10202, National Bureau of Economic Research, www.nber.org(wpaper/w10202 ), December 2003. </li></ul><ul><li>  </li></ul>
  47. 47. Building a Private Equity Portfolio Structure <ul><li>Portfolio structure decisions must address style, sector, geographic and vintage year diversification </li></ul><ul><li>The primary style decision is the relative weighting of venture and buyouts </li></ul><ul><ul><li>Additional considerations include: </li></ul></ul><ul><ul><ul><li>Mezzanine debt </li></ul></ul></ul><ul><ul><ul><li>Distressed </li></ul></ul></ul><ul><ul><ul><li>Venture stage </li></ul></ul></ul><ul><ul><ul><li>Secondary purchases </li></ul></ul></ul><ul><li>The sector decision involves expertise and experience across a number of different industries </li></ul><ul><li>The geographic decision focuses on the relative weights of North America, Europe and other geographic regions </li></ul><ul><li>The vintage year decision should address building the portfolio over time with relatively level commitments but not timing market entry beyond tactical relative weightings </li></ul><ul><li>Plans make a strategic allocation first which increases as their comfort level with private equity increases </li></ul><ul><ul><li>Allocations of smaller than 5% will not provide meaningful diversification benefits or positive impacts on overall portfolio returns </li></ul></ul>
  48. 48. US Venture Funds Annualized Net Cumulative IRR by Vintage Year As of 03/31/2004 Source: Thomson Venture Economics
  49. 49. US Buyout Funds Annualized Net Cumulative IRR by Vintage Year As of 03/31/2004 Source: Thomson Venture Economics

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