PE/VC Investing from the Perspective of Large Long-term Investors

从大型长期投资者的角度来看私募股权与创业投资

Second Annual China VC/PE CFO Conference2 September 2011

SUNG Cheng Chih 宋诚之

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Characteristics & Examples of

Large Long-term Investors

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Common Characteristics

• Captive relationship with legal asset owner

• Large community of ultimate stakeholders with formal governance structure

• Low cash outflows relative to fund size

• Investment policy driven by explicit, actuarial or proxy liabilities

• Generally with real risk/return orientation

• Diversified portfolio across multiple countries & asset classes, both public & private

• Selective active engagement with investee companies

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Leading Large Long-term Investors• Sovereign Funds:

ADIA, CIC, GIC, KIA, NBIM, Temasek

• Central Banks:

DNB, HKMA, MAS, SAFE, SNB

• Pension Funds:

APG, CPPIB, GM, NCSSF, OTTP, PGGM, QIC

• Endowments:

Harvard, MIT, Stanford, Yale

• Foundations:

Hewlett, Wellcome Trust

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Underlying Investment Beliefs

• Risk is a scarce resource that needs to be allocated efficiently

• Asset allocation drives total investment risk

• Long investment horizon confers advantages

• Scale is a double-edged sword

• Diversification across asset classes, geography, sectors, issuers & agents works

• Alphas are for real, but hard to find or sustain

• Willingness to forego liquidity is rewarded

• Cost can be managed, less so for risk, and least for return

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Asset Allocation Process &

Role of PE & VC Investments

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Asset Allocation Practices of LT Funds• Portfolio construction of most institutional

investors is centered on asset allocation which accounts for over 90% of total risk & return

• Asset allocation seeks to harness risk premia embedded in & diversification across asset classes to meet return targets & risk constraints

• Key constructs include asset class definitions, allocation targets, proxy & rebalancing rules

• Model usually based on equilibrium assumption with many variants: liability-hedging, liquidity cycle, value-driven, multi-factor, risk-parity, tail risk-hedging & de-risking mechanism etc

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Role of PE/VC Funds in Asset Allocation• Case for PE & VC investments rests on

equity risk premium, leverage & illiquidity premuim

• Mixed evidence for value-creation through strategic guidance & management know-how

• Some investors also see benefits from embedded leverage & smoothing effect on returns

• Diversification argument has weakened due to introduction of fair value accounting

• Most investors expect 3 to 5% return premium for PE & VC investments over public equities with commensurate increase in risk

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Modeling PE & VC Investments

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Search for Common Return Drivers

• Traditional allocation models make simplistic, static assumptions on volatility of PE and correlation with public markets

• However observed volatility & correlation have risen & become more unstable in recent years

• Investors are now keen to understand common risk/return drivers for both publicly & privately traded assets through quantitative models

• Such models generally try to decompose return of private asset into systematic publicly traded component and specific private component

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Alternative Private Asset Risk Models • Risk/return of private assets can be

modeled by publicly traded assets in multiple ways:

a) equity of individual listed firms (proxies)

b) equity and bond indicesc) fundamental (e.g. Barra-type) factors

• For example, under b), return Ri of i-th private asset can be decomposed as

Ri - rf = ∑j βij(Mj - rf) + Ai

Ai = ∑k θik Nk + Si

where Mj = return of j-th equity or bond index, Nk = return of k-th non-public factor, Si = specific return of i-th asset & rf = risk-free rate

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Uses of Private Asset Risk Model

• Private asset risk models generally work better at aggregate level than for individual assets

• Models shed light on both drivers for PE & VC investments and linkages with public markets

• Integrated risk models give holistic view of total portfolio risk and allow risk budgeting & stress testing tools to cover private assets

• Such models also provide fairer basis for evaluating value-added from manager skills

• But gap between theoretical MTM-based risk models and observed PE/VC valuation remains hard to bridge

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Modeling Commitments & Draw-downs• Investors traditionally used rules-of-

thumb to manage pace of commitment versus fixed allocation targets based on market value

• Recent crisis highlighted multi-faceted liquidity risks such as inability to rebalance or to meet capital calls

• Yale Model provides deterministic baseline forecasts of capital contributions, fund distributions & NAV based on historical data

• More recent efforts employ stochastic models to estimate statistical dispersions of cash flows & NAV with emphasis on distress scenarios

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Selection of PE & VC Funds

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Key Evaluation Criteria

• Track record

• Portfolio composition

• Succession plan, turnover and depth of team

• Reference checks

• Fund terms

• LP list

• Investment strategy and value-add

• Risk/return profile

• Disclosure and portfolio information

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ILPA Private Equity Principles

• ALIGNMENT OF INTEREST: carry/waterfall; fees & expenses; term of fund; GP fee income offset; GP commitment

• GOVERNANCE: investment team; investment strategy; fiduciary duty; changes to fund; role of LPAC

• TRANSPARENCY: management & other fees; capital calls & distribution notices; disclosure on GP; risk management; financial information; LP information

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Concluding Remarks

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Emerging Trends & Implications for GP• BAD NEWS: Among large long-term

investors, there is a gradual but persistent shift away from fund & co-investments towards in-house direct investments

• GOOD NEWS: Geographically, allocation to emerging markets is rising steadily for both public & private investments

• RISING BAR: Investors are raising demands for portfolio look-through & greater disclosure

• UNDECIDED: Meanwhile, debate lingers on the true value-add from PE & VC investments over (leveraged) public equities

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Long-term Differentiation Strategy

• For far-sighted GPs looking to build sustainable businesses, the fostering of open, trusting & mutually beneficial relationships with large long-term LP investors is key.

• To this end, good understanding of evolving LP thinking on asset allocation, risk, liquidity & valuation issues can offer GPs a distinct edge

• Furthermore, GPs who are pro-active in providing more data & valuation transparency and willing to help GPs solve their problems will stand out above the crowd in the new world of co-opetition

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Q & A