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Private EquityEmerging From the Crisis

June 30, 2010

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Todays presenters

z Mark Calnan, Senior Member Private Equity Research

z Sanjay Mansukhani, Senior Member Private Equity Research


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Todays discussion

z Secondaries

z Distressed investing

z Asia

z Key Takeaways


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Private equity secondariesWill the market breakout of its holding pattern?


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Private equity secondaries

z Holding pattern causes: z Buyer-seller dislocationz LP liquidity crisis abated?z Divergence between available assets from sellers and buyers preferences

z Reasons to be cautious

z Secondary market outlook

z Conclusions


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Holding pattern causes

z In 2008, amid the market turmoil following the Lehman Brothers bankruptcy, estimates of available secondary purchasing power were in the neighborhood of $40bn. Estimates for the potential supply of opportunities from secondary sellers was in the neighborhood of $140bn.1

z Today, approximately 13% of LPs are considering selling fund interests on the secondary market in the next 24 months. 63% of the LPs considering secondary sales indicate that liquidity is their top motivation for selling their interests. 2

z The number of potential secondary buyers is also high.

z Despite the market dislocation throughout 2008 and 2009, the anticipated uptick in secondary market deal activity never materialized in 2009. Source: 1- Pantheon, Take Note: Secondaries, 2009; 2- Prequin Research, Private Equity Secondaries: The Market in 2010, 2010.


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Buyer-seller dislocation

Average High Bid for Secondary Transactions (As a % of NAV)

Source: Cogent Partners

72%

88% 92%

108% 104%

84%

60%

40%

72%

0%

20%

40%

60%

80%

100%

120%

2003 2004 2005 2006 2007 1H08 2H08 1H09 2H09


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LP illiquidity crisis (temporarily?) averted

Cashflow to limited partners ($bns)

Source: VentureXpert

$43

$74$62

$24

$56 $61 $52 $58

$21$13$13 $11

-$3-$16

-$40

-$11

$51 $56

-$60

-$40

-$20

$0

$20

$40

$60

$80

$100

2004 2005 2006 2007 2008 2009

Drawdown Distributions Net Cashflow to LPs


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Divergence between available assets for sale by sellers and buyer preferences

Interest level of secondary buyers by fund type

Source: Probitas Partners, Second Thoughts Newsletter, Volume 1, Number 1, 2009

0%20%40%60%80%

100%

Mega BO MM BO/ largeBO

Small BO/Grow th

VC Mezz DistressedDebt

FoF GeneralPortfolio

Interest No Interest


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Reasons to be cautious

z The headline estimated levels of secondary supply do not tell the entire story

z The headline level of secondary market demand understates marketnuances

Source: Cogent Partners, Secondary Pricing Analysis, Interim Update, 2009


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Secondary market outlook

z We gave clients clear direction in 2009 to be very selective in appointing secondary managers and not to overweight the strategydespite much market hype.

z For clients with existing exposure, we were disappointed with the lack of activity from traditional secondary players, who were seemingly paralyzed.


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Secondary market outlook (continued)

z If liquidity concerns do not heighten in the near-term, buyers will continue to be forced to increase bids to deploy their capital in order to meet sellers expectations. This, combined with increasing demand for secondary deals potentially bidding away some of the value on acquisition, explains why the 'beta' in secondary investing is not currently compelling in our view.

z However, with capital calls in private equity starting to increase, and GPs struggling to generate distributions for old funds, we would expect to see both an increase in secondary sales and the volume of structured transactions.


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Conclusions

z Despite the cautions and concerns noted in this section, we believe an appealing strategy for some investors will be to participate in secondary transactions either directly or through their FOF managers who treat secondaries as an opportunistic bucket and do not have a different fee schedule than that for primary commitments


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Private equity distressed investingNavigating the private equity opportunity in distressed investing


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Navigating the opportunity

z Recent perspective

z Differentiating active vs. passive-the PE focus

z How did distressed managers fare during the crisis?

z Have investors missed the optimal point of entry?

z Short term headwinds but some medium term tailwinds

z Issues to consider in the near term

z Our thoughts

z Conclusions


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Recent perspective

z The thematic rationale for distressed investing began to materialize as the US subprime mortgage market began unwinding in 2007. The crisis peaked following the collapse of Lehman Brothers which took even the most experienced distressed investors by surprise.

z Corporate borrowers suddenly found debt markets virtually shut which led to aggressive re-pricing of risk across all financial markets.

z By early 2009, debt-laden capital structures of many companies, significant turmoil among traditional debt buyers (hedge funds and CLOs), and a virtual absence of DIP financing led to opportunities to acquire senior debt with equity-like expected return profiles.

z For PE managers with a traditional focus on financially and operationally distressed companies, the expectation was for the richest opportunity set ever seen.


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Recent perspective (continued)

Distressed fundraising ($bns)

Source: VentureXpert

$8.4 $8.6 $7.0

$14.2

$32.0$35.8

$17.6

$0

$5

$10

$15

$20

$25

$30

$35

$40

2003 2004 2005 2006 2007 2008 2009


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Active vs. passive

z How can an investor get exposure to distressed investing?

z It is important for an investor to differentiate between alpha and betain distressed investing and not to pay alpha fees for what are essentially beta strategies.


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How did distressed managers fare during the crisis?

z Contrary to expectations, few private equity managers were able to close distressed transactions. In our view, there are four key reasons for this outlined below:z Sellers were unwilling to accept deep discount bids on companies that had

the strength to survive the recessionz There was a lack of clarity on future earnings power; in turn, this made truly

distressed companies either a) too risky to invest in or b) when a bid was offered, it discounted economic uncertainty to the point where the bid was unsatisfactory to the seller

z Problems in existing portfolios of distressed private equity firms took a disproportionate amount of the investment professionals time

z Loose lending practices and flexible covenant packages secured in the bull market (2006 and 2007) removed a traditional catalyst to transact.


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Have investors missed the optimal point of entry?

Leveraged loan monthly amendments

Source: Morgan Stanley AIP, Popular Myths in Distressed Private Equity Investing, 2010

Moodys high yield historical rates and projections through 2010


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Short term headwinds, but some medium term tailwinds

US unemployment rate through May 2010 (%) Upcoming high yield & leveraged loan maturities ($bns)

Sources: Bureau of Labor Statistics (left); JP Morgan, Cerberus (right)

0

2

4

6

8

10

12

Jan, 2007 Jul, 2007 Jan, 2008 Jul, 2008 Jan, 2009 Jul, 2009 Jan, 2010

$17

$74$116

$224

$378

$214$186

$133

$57

$0

$50

$100

$150

$200

$250

$300

$350

$400

2010 2011 2012 2013 2014 2015 2016 2017 2018

Leveraged Loans High Yield Bonds


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Issues to consider in the near term

z The sheer volume of capital chasing private equity distressed strategies has been largely silent since the financial crisis started.

z Distressed strategies also must account for future government actions and adjust for the impact of future public policy initiatives and regulatory actions.


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Our thoughts

z The distressed story of 2009 was very much driven by credit beta with a strong recovery across credit markets.

z We expect distressed opportunities to be more idiosyncratic as highly levered companies struggle to refinance existing debt which will open the door for skilled active distressed managers.


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Conclusions

z It may be a good time for investors to consider exposure to experienced distressed-for-control managers.

z However, investors must be cognizant that the opportunity set has already narrowed following the rebound in credit markets and defaults are expected to fall further.

z As such, the focus should be on managers and funds that have strong sourcing capabilities away from the relatively well-intermediated restructuring opportunities.


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Private equity in AsiaCapturing the emerging wealth theme via Asian Private Equity


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Private equity in Asia

z Rationale for Asian private equity (PE)

z Why now?

z Issues to consider

z Summary of strategy considerations when investing in Asia private equity

z Conclusions


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Rationale for Asian private equity

z Favorable macro themes:z Improved Regulatory Environmentz Growth Trendsz Strong Sustained Growth Projectionsz Strong Exit Environment

z Private equity firms are well positioned to participate in the regions long-term growth trend.

Sources: 1- IMF, World Economic Outlook Update, January 2010; 2- Dealogic


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A maturing, but still underserved, private equity market

2008 Funds raised by region ($bns) Private equity penetration ratio

Sources: Asian Venture Capital Journal, Private Equity Analyst/ VentureXpert (left); Goldman Sachs Global Economics Analyst, Volume 7 Issue 1 (right)

$42.7

$256.9

$0

$50

$100

$150

$200

$250

$300

All Asia US

China India Aust. Japan Korea SE Asia Other Asia US

0.37%

0.72%0.58%

0.09%0.27%

0.03%

0.30%

1.80%

China India Aust. Japan Korea SE Asia All Asia US


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Stable national balance sheets

Public debt % of GDP External debt % of GDP Debt coverage ratio %

Source: World Bank


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Stable financial institutions

Loan to deposit ratios

Source: National Banks and Monetary Authorities; Probitas Partners, The Asian Private Equity Market in the Global Crisis, 2009

0%

20%

40%

60%

80%

100%

120%

140%

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1996 2008


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Issues to consider

z Business & Currency: Asia remains a collection of culturally and economically diverse countries, often with divergent forces driving economies. As such, investors must factor in business and currency risks which are often expensive (or impossible) to hedge.

z Geopolitics: Political relationships between China, North Korea, Japan, and Chinas tensions with Tibet and Taiwan all give investors reason for pause. Tensions between India and Pakistan could lead to further social, political, and economic events that could destabilize the region.

z Regulation: Despite recent progress on the regulatory front, several jurisdictions have yet to develop a proper framework to deal with contracts, tax, and ownership rights. Moreover, governance standards- both at the business and government level- lag behind the developed world.

z Experience: While there are a handful of managers that came out the other end of the 1997 Asian Financial Crisis, the depth of experienced managers is relatively thin. The majority of market participants have limited track records and have yet to develop a proven, sustainable competitive edge. Successful early-movers have also rapidly grown assets under management which could lead to dilution of skill or negative shifts in core investment strategy.


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Summary of strategy considerations when investing in Asia private equity

z Why invest in Asian private equity now?z Improving regulatory environment e.g. introduction of partnership laws

z Stronger expected long term growth relative to the rest of the world

z Improving exit markets

z Low leverage

z Early mover in selected sectors

z Low private equity penetration

z The main risks are include:z Heterogeneous investment environment leads to unique challenges

Business and currency

Lack of hedging instruments

z Geopolitical risks

z Regulatory uncertainty tax, governance and private ownership

z Lack of relevant experience leads to manager selection risks


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Conclusions

z Short and medium term outlookz Just a few years ago, experienced private equity firms tended to avoid higher risk

investments in emerging markets like Asia.

z Since the global financial crisis, it has become much more difficult to avoid the growth prospects in Asia as macroeconomic tailwinds blow in the region as deal sourcing and financing is scarce in the more developed world.

z As a result, we expect Asia to play a more prominent role in private equity portfolios and the trend seems to be self-reinforcing.

z Closing thoughts on Asiaz Consistent with other fast-growing, relatively inefficient markets, Asia will inevitably see

its fair share of ups-and-downs.

z However, given the strength of underlying fundamentals, we are confident that talented investment managers are well positioned to deliver outsized returns in Asia.


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Key takeaways


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Key takeaways

z Selectivity is the key across all private equity strategiesz Secondaries: It may be appropriate for some investors to participate in secondary

transactions either directly or through their FOF managers who treat secondaries as an flexible allocation to take advantage of opportunities arising from breaks in the holding pattern

z Distressed: While the opportunity set in distressed private equity has begun to narrow, the medium term global economic outlook remains cloudy presenting opportunities for select turnaround managers with an opportunity to achieve alpha through active management

z Asia: The private equity market is underpenetrated, quite heterogeneous and more inefficient than markets in the U.S and Europe. If LPs believe in the compelling secular fundamentals of the region, especially in the case of China and India they have the opportunity to deploy capital through an increasingly mature subset of private equity managers, some of whom have been crisis tested.


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Contact details

z Mark Calnanz 21 Tothill Street, Westminster, London, SW1H 9LL, England

z +44 20 7598 2819z [email protected]

z Sanjay Mansukhaniz Suite 300, Four Landmark Square, Stamford, CT 06901-2502z +1 203 977 6230z [email protected]


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Disclaimer

z The information included in this presentation is general information only and should not be relied upon without further review by the appropriate professional advisors. Towers Watson is not a law firm or accounting firm, and we are not providing legal, accounting or tax services or advice. Some of the information included in this presentation might involve the application of law; accordingly, we strongly recommend that audience members consult with and involve their legal counsel and other professional advisors as appropriate to ensure that they are fully advised concerning such matters. Additionally, material developments may occur subsequent to this presentation rendering it incomplete and inaccurate. Towers Watson assumes no obligation to advise you of any such developments or to update the presentation to reflect such developments.

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