Towers-Watson - PPT - Private Equity Emerging From The Crisis

2010 Towers Watson. All rights reserved.
Private Equity
Emerging From the Crisis
June 30, 2010
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2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
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Todays presenters
Mark Calnan, Senior Member Private Equity Research
Sanjay Mansukhani, Senior Member Private Equity Research
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Todays discussion
Secondaries
Distressed investing
Asia
Key Takeaways
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Private equity secondaries
Will the market breakout of its holding pattern?
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Private equity secondaries
Holding pattern causes:
Buyer-seller dislocation
LP liquidity crisis abated?
Divergence between available assets from sellers and buyers preferences
Reasons to be cautious
Secondary market outlook
Conclusions
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Holding pattern causes
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
$140bn.1
Today, approximately 13% of LPs are considering selling fund interests
on the secondary market in the next 24 months. 63% of the LPs
considering secondary sales indicate that liquidity is their top motivation
for selling their interests. 2
The number of potential secondary buyers is also high.
Despite the market dislocation throughout 2008 and 2009, the
anticipated uptick in secondary market deal activity never materialized
in 2009.
Source: 1- Pantheon, Take Note: Secondaries, 2009; 2- Prequin Research, Private Equity Secondaries: The Market in 2010, 2010.
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Buyer-seller dislocation
Average High Bid for Secondary Transactions (As a % of NAV)
Source: Cogent Partners
72%
88%
92%
108%
104%
84%
60%
40%
72%
0%
20%
40%
60%
80%
100%
120%
2003 2004 2005 2006 2007 1H08 2H08 1H09 2H09
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LP illiquidity crisis (temporarily?) averted
Cashflow to limited partners ($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/ large
BO
Small BO/
Growth
VC Mezz Distressed
Debt
FoF General
Portfolio
Interest No Interest
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Reasons to be cautious
The headline estimated levels of secondary supply do not tell the entire
story
The headline level of secondary market demand understates market
nuances
Source: Cogent Partners, Secondary Pricing Analysis, Interim Update, 2009
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Secondary market outlook
We gave clients clear direction in 2009 to be very selective in
appointing secondary managers and not to overweight the strategy
despite much market hype.
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)
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.
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
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 investing
Navigating the private equity opportunity in distressed investing
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Navigating the opportunity
Recent perspective
Differentiating active vs. passive-the PE focus
How did distressed managers fare during the crisis?
Have investors missed the optimal point of entry?
Short term headwinds but some medium term tailwinds
Issues to consider in the near term
Our thoughts
Conclusions
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Recent perspective
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.
Corporate borrowers suddenly found debt markets virtually shut which
led to aggressive re-pricing of risk across all financial markets.
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.
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
$40
2003 2004 2005 2006 2007 2008 2009
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Active vs. passive
How can an investor get exposure to distressed investing?
It is important for an investor to differentiate between alpha and beta
in distressed investing and not to pay alpha fees for what are
essentially beta strategies.
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How did distressed managers fare during the crisis?
Contrary to expectations, few private equity managers were able to
close distressed transactions. In our view, there are four key reasons
for this outlined below:
Sellers were unwilling to accept deep discount bids on companies that had
the strength to survive the recession
There was a lack of clarity on future earnings power; in turn, this made truly
distressed companies either a) too risky to invest in or b) when a bid was
offered, it discounted economic uncertainty to the point where the bid was
unsatisfactory to the seller
Problems in existing portfolios of distressed private equity firms took a
disproportionate amount of the investment professionals time
Loose lending practices and flexible covenant packages secured in the bull
market (2006 and 2007) removed a traditional catalyst to transact.
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Have investors missed the optimal point of entry?
Leveraged loan monthly amendments
Source: Morgan Stanley AIP, Popular Myths in Distressed Private Equity Investing, 2010
Moodys high yield historical rates and projections
through 2010
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Short term headwinds, but some medium term tailwinds
US unemployment rate through May 2010 (%)
Upcoming high yield & leveraged loan maturities ($bns)
Sources: Bureau of Labor Statistics (left); JP Morgan, Cerberus (right)
0
2
4
6
8
10
12
J an, 2007 J ul, 2007 J an, 2008 J ul, 2008 J an, 2009 J ul, 2009 J an, 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
The sheer volume of capital chasing private equity distressed strategies
has been largely silent since the financial crisis started.
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
The distressed story of 2009 was very much driven by credit beta with a
strong recovery across credit markets.
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
It may be a good time for investors to consider exposure to experienced
distressed-for-control managers.
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.
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 Asia
Capturing the emerging wealth theme via Asian Private Equity
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Private equity in Asia
Rationale for Asian private equity (PE)
Why now?
Issues to consider
Summary of strategy considerations when investing in Asia private
equity
Conclusions
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Rationale for Asian private equity
Favorable macro themes:
Improved Regulatory Environment
Growth Trends
Strong Sustained Growth Projections
Strong Exit Environment
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. J apan 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. J apan 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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Issues to consider
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.
Geopolitics: Political relationships between China, North Korea, J apan, 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.
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.
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
Why invest in Asian private equity now?
Improving regulatory environment e.g. introduction of partnership laws
Stronger expected long term growth relative to the rest of the world
Improving exit markets
Low leverage
Early mover in selected sectors
Low private equity penetration
The main risks are include:
Heterogeneous investment environment leads to unique challenges
Business and currency
Lack of hedging instruments
Geopolitical risks
Regulatory uncertainty tax, governance and private ownership
Lack of relevant experience leads to manager selection risks
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Conclusions
Short and medium term outlook
J ust a few years ago, experienced private equity firms tended to avoid higher risk
investments in emerging markets like Asia.
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.
As a result, we expect Asia to play a more prominent role in private equity portfolios
and the trend seems to be self-reinforcing.
Closing thoughts on Asia
Consistent with other fast-growing, relatively inefficient markets, Asia will inevitably see
its fair share of ups-and-downs.
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
Selectivity is the key across all private equity strategies
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
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
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
Mark Calnan
21 Tothill Street, Westminster, London, SW1H 9LL, England
+44 20 7598 2819
mark.calnan@towerswatson.com
Sanjay Mansukhani
Suite 300, Four Landmark Square, Stamford, CT 06901-2502
+1 203 977 6230
sanjay.mansukhani@towerswatson.com
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Disclaimer
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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