Perspectives 2015: What Really Matters To Private Equity Lps

perspectives 2015
What really matters to private equity LPs

Cheap debt everywhere
The return of volatility
Picking managers the right way
Why more regulation is a certainty
Tools for resource-constrained LPs
The future of fair value
How (not) to pay operating partners
How to manage co-investment
And much more...
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p e r spe ct i v e s 2015
It was the best of times

A PEI SUPPLEMENT
DECEMBER 2014/JANUARY 2015
PHILIP BOREL
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Oh, the vagaries of life as a limited partner.

Whatever mood youre in at a given point in
time will to a large degree depend on how
your investment portfolio is performing.When
markets are buoyant and distributions are flowing, you have every reason to be cheerful. Or at
least thats how you might be feeling - until you
start thinking about the future, and about how
much longer the good times can possibly last.
As 2014 draws to a close, most LPs are likely
going to tell you that theres a funny smell to
stuff right now. Lets be clear: few have ever
seen a better year in private equity. According
to estimates, total cashflows from the underlying fund investments back to the investor base
have exceeded $200 billion far more capital
than has ever been returned in a single year
in the history of the asset class. Time to crack
open the champagne, surely.
However, $200 billion in distributions is
also a reminder that markets are once again
in a frenzied state of feeding. Record-breaking
realisations have been possible because equity
and debt markets are back at their peaks, pushing asset prices and deal multiples higher and
higher.The system is awash with cash, investors
hunger for yield is rampant, and so from a
limited partner point of view, one big challenge for next year will be to reinvest this years
gains into a fully valued and hyper-competitive
market place.
Against this backdrop, it comes as no surprise that our recent survey of global private
equity investors for this, the 2015 edition of

LP Perspectives, produced a clear winner in
the most-dreaded-macro-influencer-for-thecoming-year category: cheap debt driving
prices up (see p. 6).
A year ago, this dubious honour had gone
to Concerns over the fate of the Eurozone,
but although no one in their right mind would
suggest that nowadays Europe is no longer a
worry, it is nevertheless clear that at this point
private equity investors are primarily preoccupied with valuations, leverage and credit risk.
Readers of last years edition of this supplement may remember that this heady mix had
already scored highly in our LP survey then,
but today, 12 months on, it seems a concern
like no other.
Theres no knowing if 2015 will bring the
correction that many believe is now overdue,
and it is equally impossible to predict what
might trigger it. But with Perspectives, now in
its third year. we do gain some insight into the
kinds of things limited partners are currently
trying to guard against through careful forward thinking. Its a wide range of issues, some
industry-specific, others pertaining to investors in all asset classes. For this volume, Private
Equity International journalists have analysed
and written about some of them; others were
addressed by leading market practitioners.
We hope you will find the result a stimulating read, and one that leaves you with a sense
that for private equity, these really are the best
of times. Heres to hoping they will last.
Happy reading,
Philip Borel
e: philip.b@peimedia.com
CONTENTS
privat e equit y int ernat io na l
PERSPECTIVES 2015
1
Editors Letter
The survey: Future fears

What are the issues keeping private
equity investors awake at night?
MACRO/ STRUCTURAL
6

Introduction: Feeling frothy

Which macro issues concern LPs most?
10 Toughening times

What should investors expect in 2015?
14 High Watermark

Will high leverage lending levels
continue into 2015?
16 Keynote interview:
Goldman Sachs Asset Management

Christopher Kojima and Michael
Brandmeyer on looking beyond an
organisations narrative
18 No end in sight

Tax and regulatory challenges in Europe
set to continue into the New Year
20 Keynote interview: McGladrey

The SECs proposed new parameters for
accredited investors might reduce the
private capital markets access to investors
PORTFOLIO MANAGEMENT
22 Introduction: Performance pressure

Which portfolio management issues are
worrying LPs?
24 Keynote interview: Landmark Partners

Analytical tools can help resourceconstrained LPs understand and manage
their portfolio more systematically
NEW YORK
16 West 46th Street, 4th Floor
New York NY 10036-4503
+1 212 633 1919
Fax: +1 212 633 2904
26 The future of fair value

Fund managers are continuing to
develop their approach to fair value
estimates
Pacific Equity Partners

Tim Sims on the challenge of finding
the right business model for persistently
high returns
FEES, TERMS & CARRY
44 Investor demand is the key to change

The rise of impact investing
28 Introduction: Value for money

Fee and expense-related issues that LPs
care about the most
30 When value-add goes wrong

GPs are exercising restraint when
appointing operating specialists to
portfolio company boards
48 Data room: Holding fast

IMF forecasts lacklustre growth for
2014/2015
Debevoise & Plimpton

Geoffrey Kittredge on transparency
around investment costs
34 Everyone wants some

How do GPs handle increased demand
for preferential co-investment rights?
GP-RELATED ISSUES
36 Introduction: Clear and distinctive

The issues that are top of LPs lists when
looking at GPs
Asante Capital

Warren Hibbert on what LPs look for
in a GP
40 When crude is down

With caution for even lower oil
prices, the focus for US PE firms is
now on buying
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THE SURVEY
SURVEY: OVERVIEW
PERSPECTIVES 2015:
THE RESPONDENTS
Future fears
TYPE OF LP
n Public pension fund
n Corporate pension fund
n Fund of funds manager
What are the issues keeping private equity investors

awake at night? Our Research & Analytics division
surveyed a broad range of LPs around the world to
establish which issues are top of their agenda as they look
ahead to 2015
n Endowment/foundation
n Sovereign wealth fund
n Insurance company
n Financial institution
n Family office
n Other
ASSETS UNDER MANAGEMENT

n $1 to $1bn
n $1bn to $10bn
What are the issues that institutional

limited partners really care about at the
moment? After a year when interest rates
have remained at historic lows, credit
markets have been buoyant to the point of
frothiness, volatility has become the norm in
stock markets, and the global economy has
struggled to get out of first gear, what are
the macro issues that are causing investors
to lose sleep? And as bumper levels of exit
activity have pushed private equity distributions to record levels giving the private
equity fundraising market a welcome boost
in the process how has this affected the
way LPs manage their portfolios and negotiate with managers?
These are the kind of questions were
looking to answer with Perspectives 2015,
our third annual study of the issues that
really matter to LPs. Our starting point, of
course, was to talk to LPs directly initially
through an online survey and subsequently
through a series of telephone interviews,
all conducted by our in-house Research &
Analytics team. You can find a breakdown
of the respondent set in the charts on the
right side of the page: theyre drawn from
a broad range of institutions right across
the globe, with assets under management
ranging from tens of millions to hundreds
of billions.
We asked LPs to rank their key concerns

in four separate categories: macro issues,
portfolio management issues; fees and
terms; and GP-related issues.We then went
back to a selection of our respondents and
asked them to provide some colour about
why they made the choices they made, and
how theyre trying to deal with some of the
risks they highlighted.
The picture that emerges does show
some important distinctions between different geographies. Perhaps not surprisingly,
for example, the current credit market
frothiness is more of a concern for North
American and European investors than it
is for Asian LPs who are more worried
about China and the IPO window.
But it also shows how much common
ground private equity LPs have. Whoever
they are and wherever theyre based, theyre
all thinking about understanding return drivers, and dealing with new regulation, and
understanding how GPs operate, and so on.
In the following pages, we bring you the
results of our research interspersed with
a series of essays on some of the key themes
highlighted. One conclusion is abundantly
clear: investors are going to ever greater
lengths to manage their risk and exposure.
In this increasingly volatile world, they cant
afford not to. n
n $10bn to $25bn
n $25bn to $50bn
n $50bn +
REGION
n North America
n Europe
n Asia
n Rest of World
EXPOSURE TO PRIVATE EQUITY

n 1% 5%
n 6% 10%
n 11% 15%
n 16% 24%
n 25% +
ALLOCATION PLAN IN NEXT TWO YEARS

n Higher
n Lower
n Equal
n Invest
opportunistically
Source: PEI Research & Analytics
Pioneered The Market

Pioneered
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Leading ItsNow
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Leading Its Evolution
Landmark pioneered the secondary market in 1990 with the rst

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arket
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Landmark specondary
ioneered m
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ith the rst
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Since etquity
hen L andmark
real estate
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ver
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and real estate funds and partnerships.
Private Equity and Real Estate Secondary Investing

Private Equity and Real Estate Secondary Investing
Headquarters
Simsbury, CT
10 MillHeadquarters
Pond Lane
Simsbury,
CT
Simsbury,
CT 06070
10 Mill
Pond Lane
(860)
651-9760
Simsbury, CT 06070
(860) 651-9760
New York, NY
Boston, MA
681 Fifth Avenue, 14th Floor
265 Franklin Street
NewNY
York,
NY
MA
Boston,Boston,
MA 02110
New York,
10022
681(212)
Fifth858-9760
Avenue, 14th Floor
265 556-3910
Franklin Street
(617)
Boston, MA 02110
New York, NY 10022
(617) 556-3910
www.landmarkpartners.com(212) 858-9760
www.landmarkpartners.com
London, UK
52 Jermyn Street
London,
UK
London, SW1Y
6LX England
Street
+44 52
20 Jermyn
7343 4450
London, SW1Y 6LX England
+44 20 7343 4450
MACRO/STRUCTURAL
MACRO
Feeling frothy
We asked investors to rank the following macro issues in
order of significance to their private equity portfolios as
they looked ahead to 2015:
The fate of the Eurozone

The slowdown in China
Over-investment in emerging markets
The LBO refinancing wall
Challenges posed by the switch to DC
pension plans
The performance of PE-backed IPOs
Negative public perceptions of private
equity
Tax or regulatory challenges
Cheap debt pushing up prices
The impact of enforcement actions
Asian LPs were most

worried about the slowdown
in China and the performance
of private equity backed IPOs,
followed by over-investment in
emerging markets
European investors were
most worried about cheap debt
pushing up prices, followed by
tax/regulatory challenges and
the fate of the Eurozone
US respondents were most
worried about cheap debt
pushing up prices, the fate
of the Eurozone and tax/
regulatory challenges
Terrorism; geopolitical conflict; the threat

of a global pandemic; signs of softening in
the US economy; renewed nervousness
about the Eurozone its no wonder that
global markets have been skittish in the
latter part of 2014.
But for private equity investors, our
survey clearly shows that one issue is preoccupying them above all others as we head
towards 2015: the extent to which cheap
debt is pushing up prices across the industry. Around 70 percent of the LPs polled put
this among their top three macro-level concerns, with more than half of all respondents citing it as their principal worry.
With the backdrop of cheap debt,
we are seeing that debt/EBITDA levels
are creeping up, covenants are becoming
looser, and consequently prices are becoming higher, says George Anson, managing
director of HarbourVest in London. Interest rates are low, so the level of cheap debt
is not excessive at the moment. [But] it
becomes an issue if interest rates rise to
five percent and debt holders cannot meet
their obligations.
MACRO/STRUCTURAL ISSUES THAT MOST CONCERN INVESTORS

%
Cheap debt
pushing up prices
1st choice
The fate of
the Eurozone
Tax or regulatory
challenges
2nd choice
The performance
of PE-backed IPOs
The slowdown
in China
3rd choice
The LBO
refinancing wall
Negative public
perceptions of
private equity
Over-investment
in emerging
markets
Challenges posed
by the switch to DC
pension plans
The impact of
enforcement
actions
At the Cutting Edge

in Private Equity
The Debevoise Private Equity Group

continues to lead the field, in an industry
it has helped shape for decades.
By any measure, the Debevoise Private Equity Group is one of the most
respected in the field, in the U.S. and throughout the world. It brings a
collaborative, multidisciplinary approach to deal after dealan approach that
that addresses each facet and each issue with sharp focus, specialized technology
and deep industry expertise. With consistently high rankings from Chambers
Global, Chambers USA, Legal 500 and PEI year after year, the group has been a
recognized leader for more than 30 years.
The Private Equity practice includes specialized groups expert in fund formation
and investment management, buyouts and other equity and debt investments,
finance, securities and capital markets, tax, and management compensation and
employee benefits. Each group approaches its work with a distinctive private
equity focus. And the practice as a whole also draws on the firms industry
specialists to deliver efficient, commercial, cutting-edge results.
The practices scope and focus make it extraordinarily market wise. A
proprietary database assembled over decades of sponsor-side and buy-side fund
formation work allows Debevoise lawyers to track fund terms and investors
records and requirements. And a constantly updated global survey of securities
and investment management laws that affect private equity funds in over 60
jurisdictions keeps Debevoise funds lawyers on top of the global regulatory
environment.
Key contacts
Erica Berthou
Partner, New York
eberthou@debevoise.com
+1 212 909 6134
Michael P. Harrell
Partner, New York
mpharrell@debevoise.com
+1 212 909 6349
David Innes
Partner, London
dinnes@debevoise.com
+44 20 7786 3003
Geoffrey Kittredge
Partner, London
gkittredge@debevoise.com
+44 20 7786 9025
Andrew M. Ostrognai
Partner, Hong Kong
amostrognai@debevoise.com
+852 2160 9852
Kevin M. Schmidt
Partner, New York
kmschmidt@debevoise.com
+1 212 909 6178
MACRO/STRUCTURAL
HOW SIGNIFICANT AN ISSUE IS CHEAP

DEBT PUSHING PRICES (by region)
%
North America
respondents
Europe
respondents
Asia
respondents
HOW SIGNIFICANT AN ISSUE IS THE FATE

OF THE EUROZONE (by region)
%
North America
respondents
Europe
respondents
Asia
respondents
HOW SIGNIFICANT AN ISSUE ARE TAX AND

REGULATORY CHALLENGES (by region)
%
North America
respondents
1st choice
Europe
respondents
2nd choice
Asia
respondents
3rd choice
But while some LPs suggested this

prospect was driving them to increase their
exposure to real assets rather than private
equity, most were more sanguine about the
likely medium-term impact of this credit
frothiness. There is too much cheap debt
available at the moment, but it should be a
greater worry for lenders rather than the
borrowers, said Tom Eriksson, founding
partner at Swiss group Aeris Capital.
Still, few would dispute that its having
a clear short term impact. As John Gripton, managing director and head of global
investment management at Capital Dynamics, put it: There is nothing wrong in the
use of debt if a GP can make sure that the
levered company can service it in the long
run. However, the level of debt is clearly
driving prices and valuations higher.
Thats a trend that could be bad news
for performance across the next cycle
although on the flipside, as several investors
also pointed out, the current environment
remains extremely conducive to selling businesses, which should be good for returns.
The fate of the Eurozone is still a hot
topic as far as private equity is concerned.
Last year, it was the most commonly-cited
worry, with more than 60 percent of LPs
counting it as one of their top three concerns; this year the total was slightly lower
(about 50 percent), but investors remain
worried that the underlying structural
problems still havent gone away, and that
the fiscal and monetary constraints necessary to ensure the survival of the Eurozone
in its present form will inhibit growth for
years to come. There is no growth in the
Eurozone and the threat of deflation is
looming this makes it awkward, said Hans
van Swaay, a partner at Lyrique.
One interesting aspect of this category

was that Asia investors tended to have
a slightly different perspective. As youd
expect, since leverage is typically used less in
Asian deals, theyre less bothered about the
credit markets; instead they were more concerned about local issues like the economy
in China and the after-market performance
of private equity-backed IPOs.
Generally speaking, the slowdown in
China seems to be less of an issue for Western investors compared with 12 months ago:
almost half cited it as one of their top three
concerns last year, while this year it was only
cited by about a quarter of European LPs and
a fifth of North American LPs. That chimes
with the fundraising numbers for the AsiaPacific region in 2014: at press time, about
$34 billion had been committed to Asiafocused funds, according to PEIs Research &
Analytics division, about the same amount as
for all Europe-focused funds. Some investors
clearly feel that after a couple of problematic years, Asian markets are starting to look
attractive again although many remain cautious of emerging markets (to say the least),
particularly in light of how currency issues
can play havoc with returns.
One issue that does tend to vex investors
everywhere in equal measure, of course, is
tax and regulation. European LPs having
seen their region produce some of the most
pernicious new rules of recent years were
predictably most worried about this. AIFMD
is raising issues, Gripton admits. The level
of bureaucracy is a knee jerk reaction. But
its also on the radar for investors in Asia a
region where some governments have been
known to change the rules or shift the locus
of regulation with very little warning. Hopefully therell be no more of that in 2015. n
OPERATING PARTNERS
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15-16 April 2015 | Institute of Directors | London
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2014 speakers included:

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Senior Director
Portfolio Support,
APS Advisory
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MACRO/STRUCTURAL
KEYNOTE INTERVIEW: CINVEN
10
THE MACRO PERSPECTIVE
Toughening times
After another volatile year in the global economy in 2014,
what should private equity investors expect for 2015?
Vicky Meek reports
While 2014 may have started on an optimistic note, with stock market rallies in many
markets and a greater confidence in some
advanced economies (yes, even including
Europe), the year ended on a more subdued
note.The good news, according to the IMFs
October 2014 World Economic Outlook,
is that despite setbacks, an uneven global
recovery continues.The bad news, however
is that growth projections for 2015 were
revised downwards to 3.8% (from 3.9% in
April 2014s Outlook). Fittingly, in a world
where volatility has now become a fact of
life, the October report was entitled Legacies, Clouds, Uncertainties.
Geopolitical concerns, following the
events in Ukraine and the rising tensions in
the Middle East, plus third-quarter market
jitters were some of the causes for the IMFs
downward revision. More long-term issues
centred around stagnation in some OECD

economies and the lowering growth rates
of emerging markets.
AMERICA DEFIANT
Yet piercing through some of this gloom

is the US economy. The rest of the world
currently appears to be pinning its hopes
on continued recovery there, as its own
prospects are so tied up with what happens in America. US GDP growth, which
registered an encouraging 3.5 percent in
Q3 2014 (economists had largely expected
just 3 percent), is anticipated to continue,
with US unemployment figures continuing
to decline. GDP is now 8 percent higher
than its level of 2008, says Julian Jessop,
chief global economist at Capital Economics. We remain positive about a strong
recovery there.
The US economy appears to be defying

all predictions and that is improving confidence levels, adds George Anson, managing director at HarbourVest Partners. It
certainly feels like a much better place to
invest than it did five years ago.
The UK is also showing some albeit
more subdued signs of recovery, with several quarters of positive growth. Indeed,
the UKs Office for National Statistics latest
figures suggest that UK GDP in Q3 2014
was 3.4 percent higher than the pre-crisis
downturn peak of Q1 2008. Yet there are
some risks, with slowing or limited growth
in many other countries and the uncertainty
of a general election this year.
To some, the UKs recovery does indeed
look fragile. Many of the UKs fundamentals look similar to those in the US, albeit
that the recovery started later, says Giles
Gale, global inflation and derivatives analyst at RBS. The issue is that the UK has a
much greater exposure to the global trade
cycle than the US and so the strength of
sterling will have a greater drag on inflation than the US. In addition, its major
trading partner is the Eurozone, which
is looking weak on a number of fronts,
including inflation.
G20 leaders: concerns about growth, geopolitics
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MACRO/STRUCTURAL
12
The scale
of Europes
problems
requires action
in a number of areas and,
unlike the US, it does not
have a unitary front
THE WORLD IS FLAT

%
40
Inflation, average consumer prices (%)
VALUE VS GROWTH IN EUROPE
Peter McKellar, chief investment officer at

SL Capital Partners, agrees. Although the
UK continues to see good growth prospects, it is hampered by a weakening Continental Europe, he warns.
Europe is certainly still struggling to find
growth with Q3 2014 GDP growth at just
0.2 percent and growth is moderating
many emerging markets. Its leading some
economists to talk of a dichotomy. There
is a clear divergence in trends between the
US/UK and Continental Europe/Japan,
says Jessop. This gulf is likely to widen as
the prospect of deflation looms large around
the Eurozone and Japan.
Our survey shows that the Eurozone
worries have reduced in importance for
LPs as Europes policymakers have made
it clear that they will do all they can to
keep the currency together, in addition
to announcing QE-style asset purchases.
Anson is one of those more positive about
the region, largely because of the private
equity and corporate capability in Europe.
The lack of growth in Europe is not a
major concern, he says. The region has
never been a growth story its more
about value. European GDP has historically
grown by only around 2 percent a year, but
weve been able to get very good returns,
based on funds investments in good companies, rather than taking country bets.
Nevertheless, some LPs believe the
problems in large parts of Europe remain
very real. One of the issues that we see as
35
30
25
20
15
10
5
World
0
1980 1985 1990 1995 2000 2005 2010 2015
Source: IMF, October 2014
problematic in some European countries

is an unwillingness to grasp structural and
economic reform, says McKellar. While
some of the peripheral economies have
taken big strides towards structural reform
and rebalancing the mix of their economies, there remain some question marks
about the strength of local banks. From a
corporate perspective, for many of these
companies, it will be a long, slow climb.
He adds: Not only should we talk about
QE, but also about the transmission mechanisms, ie, the banks. Its difficult to see how
QE alone will increase the supply of money
without support from the banks.
Its partly why he, among other LPs, invest
mainly in the stronger areas of the region.
We remain focused on the Northern part of
Europe the Nordics, Germany and the UK
as we have for the last 10 years, says McKellar. These are the most liberal and open
markets and have the best labour policies. In
addition, from a private equity perspective,
these markets are populated by managers
that have the ability to undertake the right
deals and focus on added value.
DEFLATIONARY THREATS
Yet Europe clearly does not operate in isolation

from what happens elsewhere.The slowdown
in China as the government seeks to make
the transition from an investment-led to a

consumer-led economy may be happening to
a greater degree than officials had anticipated.
Chinas GDP growth slowed to 7.3% in Q3
2014, the lowest rate since the recession.While
this is clearly a good rate by global standards,
it was lower than many had expected, causing
some to question what happens next.
Any further slowdown in China would be
strongly deflationary, says Gale. If that were
to happen, its likely to push the global economy back two to three years, may prompt
further rounds of QE and cause a lockdown
of close to zero interest rates for some time.
It could even spark another systemic shock,
most likely in the Eurozone, where deflation is
becoming embedded and a number of countries are seeing the rise of alternative parties
more opposed to structural reforms. Market
patience may wear thin. I dont think it will
take much for it to turn tail.
In addition, a more general slowdown
in the growth of many emerging markets
will affect Europes prospects, adds EY chief
economist, UK & Ireland, Mark Gregory.
We remain uncertain about Europes prospects, he says. The scale of its problems
requires action in a number of areas and,
unlike the US, it does not have a unitary
front. The European strategy is based on
exporting its way out of growth, but this is
at a time when export markets are slowing.
Clearly, for Asian investors, the slowdown in China looms large in their list of
concerns, with good reason. The Chinese
slowdown is one of the main reasons for
the underperformance of many emerging
markets, with Asia in particular, but others
also, affected, says Jessop.
The impact is starting to be felt more
widely, with Chinas commodity trading
partners bearing the brunt. The effect of a
Chinese slowdown is already being reflected
in the numbers of some economies, such as
Australia, Brazil and Chile and Peru, which
13
are exporters of commodities to China,

says Brian Lim, partner at Pantheon. Indeed,
Brazil slipped into recession for the first
time in five years in Q2 2014.
But what of the prospect of interest rate
rises in the US (and possibly the UK)? After
last years infamous taper tantrum following the Federal Reserves announcement
of a scaling back of QE, which saw capital
flight away from emerging markets and into
the US, what effect might rising rates have?
Some believe the effect will be relatively
benign. I think weve seen the worst of
any effects of tightening monetary policy,
says Jessop. Anyone who was likely to have
panicked has done so already. The interest
rate rise in the US which we expect to
happen between March and June 2015 has
been well trailed.
Capital has been flowing back to emerging markets following the taper tantrum,
says Gale, with a particular emphasis on
hard currency allocations. So the end of QE
has not been a major issue and it is particularly helpful that the FOMC has reduced
purchases gradually.
Yet many believe there will be some
effect as yield-seeking investors turn their
attention back to the US. Its a matter of
Photo by: Landov
Yellen: all eyes on Fed chair. When will she raise?
when rather than if the Federal Reserve

raises interest rates in the US, says Lim.
The effect of this on emerging markets
will largely depend on when it happens and
the quantum, but its fair to expect some
capital flow away from them.
Gregory agrees. I think youll see some
recalibration of risk-seeking, he says. Any
rate rises will make the US and the UK
more attractive money will move towards
what are perceived to be safer havens.
EMERGING MARKET OPTIMISM
Yet it seems unlikely that a wholesale shift

will happen, with investors displaying a little
more discrimination this time around. If
you roll back the clock to 2013 and the
taper tantrum that stemmed from the Fed
announcement, there was an initial indiscriminate capital flight from emerging markets towards the US. That caused a lot of
difficulty for the fragile five in particular
Indonesia, India, South Africa,Turkey and
Brazil which are reliant on external capital flows. The Indian Rupee saw significant
depreciation.Yet he adds that some of these
countries most notably India are now
in better shape; it has reduced its current
account deficit from around 5-6 percent
of GDP to 1.7 percent today and inflation
is high but trending down. India shouldnt
suffer as much from capital flight in the
event of a US interest rate rise, whereas the
situation in South Africa and Turkey may be
more concerning, says Lim.
Indeed, Lim is highly optimistic about the
prospects for emerging markets as some of
the heat has now been removed from the
market. The slowdown in China and a fall in
the headline GDP growth of many emerging
markets is actually having a positive effect
on some emerging markets, he says. Investor enthusiasm may have cooled and private
equity fundraising in emerging markets is
now harder, but that is more of a welcome
The slowdown
in China is
actually having
a positive
effect on some emerging
markets
correction than a problem. He points to
lower valuations in many markets relative
to the multiples seen in 2010 to 2011, particularly in China. So the opportunities are
there, says Lim, along with the continued
attractions of market scale, young and growing populations, rising GDP per capita and
changing consumption patterns. If you look
long term, as most private equity investors
do, many emerging markets are now more
attractive than they have been for some time.
Its perhaps this, more moderated
growth, coupled with brighter prospects
for the US and the UK that are behind the
results of EYs October 2014 Capital Confidence Barometer. Nearly all (98 percent)
corporate executives across the globe, interviewed in the midst of the market volatility
seen in Q3 2014, felt that the prospects for
the global economy were either improving or stable, up from 89 percent a year
earlier.This is leading 77 percent to expect
strong corporate growth earnings for 2015,
up from just 43 percent in October 2013.
While its clear that large risks still remain
in the global economy, with destabilising
forces such as geopolitical issues and the
prospect of deflation in a number of regions
occupying the minds of many an economist
and policymaker, there is reason to be optimistic for 2015. Investors and companies
alike have become more adept at managing
many of these risks over the last few years,
and while a few legacies may remain for some
time to come, it may be that some of the
clouds and uncertainties start to lift. n
MACRO/STRUCTURAL
14
US CREDIT MARKETS
High watermark
Leverage lending levels hit record highs in the third
and fourth quarters of 2014, a trend that seems unlikely
to hold in 2015, writes Bailey McCann
Apart from a bit of market turbulence in the highest since 2007, according to data
October, 2014 was a record year for private
from S&P Capital IQ. The same S&P data
equity and more specifically the availability of shows that cov-lite loans as part of the
leverage, which drove purchase price multi- overall packages were more common than
ples higher and higher. Deal flow was heavy, in 2006 and 2007. All major buyout deals
competition for assets steep, and cov-lite or of 2014 included cov-lite terms.
Going into next year, market particicov-free deals became common once again.
By July, cov-lite deal volumes stood
pants expect things to hold steady owing to
at $83 billion across 82 transactions, an the resiliency of the US economy. But when
increase of 41 percent from the same
it comes to financing acquisitions, private
period in 2013, which totalled $59.4 bil- equity investors are now considerably more
lion spread over 68 deals, according to Dea- cautious about the current state of play than
logic. The 2014 numbers were the highest they were a year ago.
year-to-date ever recorded. Through to
The same is true for US regulators, who
the end of Q3, credit markets maintained tend to get twitchy when leverage to earnings
their buoyancy and helped finance a flurry ratios go beyond 6x. In November, they came
of highly geared buyouts.
down hard on the banks following an audit
The average leverage ratio for LBOS report about the recent ramp-up in both levthis year was 6.8x earnings before EBIDTA erage multiples and leveraged lending volumes.
US LEVERAGED LOAN ISSUANCE
$bn
25
Three federal agencies had harsh words for

Wall Street, citing familiar concerns around
systemic risk and softening lending terms.
The review [] found serious deficiencies in underwriting standards and risk management of leveraged loans, said examiners
from the Federal Reserve, the Office of the
Comptroller of the Currency and the Federal Deposit Insurance Corporation. Lenders
were given guidance for higher-quality loans
to be arranged on tighter terms.
Just before the audit was published,
credit investors had started making for
the exits, spurred into making redemptions by frothy-looking deal flow and growing market volatility. As of late November,
markets were in the 18th consecutive
week of leveraged lending outflows. Data
from Lipper and S&P Capital IQ shows
net redemptions of $17.9 billion over that
period. October accounted for the third
largest leveraged loan fund outflow in
history, and the highest since $1.3 billion
was withdrawn in the week ended Aug. 31,
2011. The data suggests that even though
flows have rebounded a bit since October,
the overall trend is downward. Q3 is looking like the high watermark for the loan
market, with sources predicting reasonably
flat levels of activity until the projected US
interest rate rise around mid-2015.
20
PRIVATE CAPITAL TO THE FORE

15
10
15/08 22/08 29/08 05/09 12/09 19/09 26/09 03/10 10/10 17/10 24/10 31/10 07/11 14/11 21/11
Source: S&P Capital IQ/LCD
In the meantime, the regulatory campaign

being mounted on the banks alone is unlikely
to take as much steam out of the leveraged
lending market as those who see systemic risk
would like to see. Because behind the banks,
private capital is quietly lining up to meet
demand from investors. Private lending first
started to increase in the wake of Dodd-Frank,
MACRO/STRUCTURAL
15
but now that the regulators are leaning on

the bulge bracket houses more heavily, private
credit has really come into its own.
Driving the trend is investor appetite
(or as some would have it, desperation), for
returns. The demand for debt is coming
from business, but also from investors who
are still hunting for yield, says Theodore
Koenig, president and chief executive of
Monroe Capital, a provider of financing to
the US middle market. More and more the
highly levered transactions are not getting
done in the banking system, in part because
of regulatory scrutiny. So if they are going to
get done, its going to be with private capital.
For how much longer this trend will
continue is an interesting question. I think
what youre seeing is that were nearing the
end of the cycle, suggests Don Ingham, a
director and portfolio manager at New
York-based Tenth Avenue Holdings.
For the time being, however, there is still
plenty of opportunity for private debt funds
to fill the gap that has been left behind by
the traditional providers. Ever-looser financing terms are fueling a deal market that is
highly competitive and also fast-moving, and
dominated by equity sponsors that are highly
motivated to invest. Many private equity
groups are willing to pay high multiples to
put capital to work and beat the competition,
but inevitably, using leverage more aggressively also means taking more risk.
Some predict that going forward, private
equity buyers are soon going to find it more
difficult to live with the consequences of the
financing decisions they make at the moment.
Private equity is going to be a harder business
in 2015, Koenig says. It is going to have to
find ways to add value, youre not going to see
multiple expansion. Its going to be tuck-ins,
Inflation is
tame, at least
for now. When
rates do go up, the
impact on long-duration
bond prices is going to
be violent
acquisitions firms are going to have to look
for ways to cover those multiples.
This also means that the broader economic context is likely to play an increasingly important role, with interest rates
and global GDP trends moving into sharper
focus. Inflation is still tame, says David
Golub, president of Golub Capital, and
although the US economy is performing
relatively, he sees little by way of pressure
for the Fed to raise interest rates.
However, when rates do go up, the
impact on long-duration bond prices is
going to be violent, Golub predicts.
GP DISCIPLINE
It goes without saying that when the hike

comes, private equity sponsors will be feeling the repercussions too. Sources predict
that any interest rate increases will have the
biggest impact on the large and mega-cap
deal segment, where financing terms have
been the most aggressive.
Says Koenig at mid-market focused
Monroe: Interest rates [are going to]
impact financing especially at the upper end
of the market, [but] arent going to hit the
middle market that hard. For us it will be
less about leverage and more about defaults.
Were going to be looking at performance.
Weve had very few defaults in recent years

so we are going to be watching that metric.
Limited partners in private equity funds,
meanwhile, are keeping their fingers crossed
that fund managers deploying capital into the
current environment will remain disciplined
instead of chasing deals at all costs. Fund
investors take comfort from seeing managers factoring multiple contractions into their
stress-testing models before they make a deal,
and investing at a measured pace instead of
going after a rapid succession of quick and
pricey purchases while the market is hot.
Above all, LPs depend upon GPs that can
use leverage wisely and in moderation.According to recent research from Cambridge Associates, the investment consultant, this will be
easier for firms with a differentiated strategy
and specialist knowledge in a certain sector.
Generalist funds on the other hand will find
it harder to evaluate credit risk and to build
long-term sustainable financing structures.
In an increasingly competitive private
equity environment, a managers ability to
demonstrate deep expertise in a focused
field is a key differentiator, says Andrea
Auerbach, a managing director at Cambridge and global head of the firms private investment research. Investors building private equity portfolios should keep
them in mind as one arrow in their quiver
of investment return generation.
The worry for LPs is that for GPs to
stay disciplined will become more difficult
the more pressure they face to invest their
equity capital. We see managers in the US
that dont seem to have much memory of
what went wrong last time, says an investment manager at a prominent family office.
Those would be the kinds of manager investors should handle with care. n
KEYNOTE INTERVIEW: GOLDMAN SACHS ASSET MANAGEMENT
16
MANAGER SELECTION
Key men
Private equity managers
have got better at telling a
compelling marketing story,
say Christopher Kojima
and Michael Brandmeyer
at Goldman Sachs Asset
Management, but investors
need to look past the
narrative to the organisation
and people behind it
Kojima: LPs big data challenge
Brandmeyer: unpacking the GP story
As an industry, private equity is steadily TAKING APART PERFORMANCE

getting more and more competitive. Not Michael Brandmeyer, Co-Chief Operating
only in executing deals, where managers Officer of AIMS and co-head of the private
have long competed for deal flow and pric- equity investment team, breaks down a maning, but now also in fundraising as many agers performance and capabilities into three
investors seek to trim the number of rela- pieces historical performance, current NAV,
tionships they manage at the same time as
and potential new transactions going forward.
more GPs are coming back to market on the We try to unpackage the managers story into
heels of strong distributions. For investors
its component parts. Historical performance
looking to source leading talent, separat- is often the most straightforward you can
ing true skill from a well-crafted market- rely on the mathematical return attribuing story can be a daunting task, especially tion to help inform your conclusions, but
when considering the myriad risk factors
its important to place the analysis in context.
bombarding the market.
There will be times when the enviThe Alternative Investments & Manager ronment is accommodating, when credit
Selection (AIMS) Group of Goldman Sachs markets are aggressively lending to privateAsset Management is tasked with exactly equity backed companies, when publicthat. AIMS is the open architecture plat- market multiples expand, when the broader
form within Goldman Sachs, managing over economy serves as a tailwind. There will
also be times when everything is difficult,
$150 billion in client assets invested across
private equity funds, hedge funds, real estate when the credit markets contract, when
managers, public equity strategies and fixed the broader economy shrinks along with
top-line revenue growth, when raw-input
income strategies.With eight global offices
and more than 300 employees, the AIMS pressures on margins persist, and when
acquirers and IPO markets shun what
team sorts through potential investments
and managers across the alternatives spec- exiting GPs have to offer. How managers
trum and has developed a framework for differentiate themselves in these conditions
manager selection that moves beyond the
is what were really looking to understand.
story and takes a more clinical view.
20 years ago, there were fewer manag- READING THE CURRENT BOOK
ers, each with fewer funds, often presenting Recognising that the current NAV of a portfolio may not always be the best or only indiprospective LPs with just a handful of case
studies, says Christopher Kojima, Global cator of its potential future value, the AIMS
Head of AIMS. Today, LPs are confronted team looks to multiple sources of informawith an expanded menu of managers, each tion to evaluate the unrealised investments in
presenting volumes of data, all generally a GPs prior funds. When we look at current
packaged in an engrossing narrative. So NAV, Brandmeyer continues, were able to
there is much more storytelling in todays
use our knowledge about whats happening
fundraising. This is the big data challenge
elsewhere in the market.We can triangulate
for LPs how to dissect the story, resist on values based on secondary market pricing,
the narrative, and instead approach each what the GP is saying, and what we see in
fund as objectively as possible.
our own portfolios to better judge whether
KEYNOTE INTERVIEW: GOLDMAN SACHS ASSET MANAGEMENT
17
we think prospects are dim or bright, and

also how ambitious a GPs view on their
unrealised book is.
The AIMS team also looks to the current
state of a GPs portfolio to better understand
potential future behaviour. For some GPs
with struggling legacy investments, the only
hope for any performance-based economics
may lie in swinging for the fences, taking
unusual risks in the hopes of an unusual
payoff, Kojima describes. We need to recognise that were not just investing in the
firm of today, but making a commitment to
the firm of tomorrow. We have to understand how that evolution is likely to take place,
what factors are driving returns, and whether
significant changes are on the horizon.
individual, and an organisation, successful.

Brandmeyer also notes that diligence often
focuses on how a firm is organised, the level
of collaboration amongst the team, and how
the culture reinforces the key investment
philosophy. We want to find out if the team
is incentivised appropriately, if there is an
alignment of interests, if there is a culture
of leadership, and how they are cultivating the next generation of talent. Kojima
adds, As a firm grows and matures, how
its leaders are thinking about building for
the future can become more important. Do
they care deeply about the incentives for
future leaders? Are they humble about their
own role? If we start asking these questions
and are met with defensive behaviour, thats
typically a comment on the leader.
NO X-FACTOR
While detailed analysis of a GPs track

record provides useful context, the AIMS
team digs deeper in seeking to identify the
traits that they believe are likely to lead
to future success, and mitigate the potential for failure. In the wide dispersion of
manager performance, our goal is both to
avoid the left tail and to pursue the right
tail, says Kojima. These twin goals require
different analytical tools. Avoiding the bad
is analogous to a medical diagnostic, ensuring the basic health of the organisation, its
infrastructure, its operations. But pursuing
the great is more analogous to flying a plane
you need to rely on judgment, be mindful of the surrounding weather, and reach
your destination with the assistance of some
insightful, objective instrumentation.
We dont really believe in the idea of an
X-factor, an undefinable quality that makes
someone a superior investor, Brandmeyer
continues. Our approach is to be systematic and identify the qualities that make an
CHECKS AND BALANCES
One of the most important factors in the

AIMS process is a system of checks and
balances which encourage debate and promote consistent standards across managers. As Brandmeyer notes, for every matter
brought before our Investment Committee,
an independent devils advocate role is formally assigned to challenge the hypothesis
of the diligence team.This promotes a fluid
debate and intense examination of how the
manager is likely to perform across multiple
scenarios.
In addition to the regular investment
evaluation, AIMS also has a separate operational due diligence process that examines
each managers infrastructure, legal terms,
control environment, and risk management
protocols. This analysis, performed by a
multi-disciplinary team that draws from
Goldman Sachs legal, controllers, compliance, tax, and accounting teams, is distinct
from the investment due diligence process
20 years
ago, there
were fewer
managers, each with
fewer funds, often
presenting prospective
LPs with just a handful
of case studies. Today,
LPs are confronted with
an expanded menu
of managers, each
presenting volumes
of data, all generally
packaged in an
engrossing narrative
Chris Kojima
and reports to an independent Operational

Controls Committee.This committee holds
veto power over the entire process, and
often works with the investment team to
help managers strengthen their operations.
Ultimately, manager selection is about
developing conviction in our views, says
Brandmeyer. But at the same time we need
to inoculate ourselves against listening too
closely to the narrative or getting caught
up in a persona, and really focus on the data.
Our framework was designed to allow us
to evaluate the different factors independently, leveraging the platform expertise
of Goldman as an organisation, and instill
the discipline that is necessary to seek out
the best managers. n
MACRO/STRUCTURAL
18
EUROPE AND REGULATION
No end in sight
Tax and regulatory challenges in Europe were some
of the most significant issues preoccupying GPs and
investors in 2014. Unfortunately that trend looks set to
continue as we head into 2015.
By Thomas Duffell
Over the past 12 months the European
private equity industry has arguably experienced greater change to the regulatory
and tax landscape than ever before. Much
to the chagrin of GPs and investors alike,
the theme of more regulatory change looks
set to continue unabated in 2015.
Take for instance the unavoidable panEuropean marketing regulation the Alternative Investment Fund Managers Directive (AIFMD). The directive requires fund
managers to provide greater disclosure
to both regulators and investors, appoint
a custodian to safeguard the funds assets,
and tweak their organisations internal
structures regarding valuation and risk
management in exchange for a marketing
passport. The passport permits AIFMDauthorised GPs to market in all European
countries without having to comply with
each countrys individual marketing rules.
On 22 July 2014, three years after the
AIFMD became a legally binding act, all
European private equity fund managers with assets under management of
more than 500 million needed to have
filed their AIFMD registration with their
national regulators. The July date marked
the end of the directives transitional
period which allowed fund managers to
delay their AIFMD compliance by an extra
Photo by: J Lohan
EU: holding the key to private equitys

regulatory burden
year which the vast majority of GPs took

advantage of.
But, registration was only the first of
many AIFMD hurdles that GPs face. As
of 31 January 2015, managers will begin
sending their Annex IV reporting, but
most GPs say theyre not ready to do it, a
recent survey by Cordium, a compliance
consultancy, revealed. More than half (57
percent) of the 27 EU-based fund managers surveyed said theyve yet to begin their
reporting preparations. One reason for this
is the lack of clarity surrounding how to
file the reports.
Recently I was reaching out to regulators to try and find out for clients how
to file the Annex IV report, Sally Gibson,
international counsel at law firm Debevoise
& Plimpton, said at the BVCA Summit in
October. Do GPs need a password and
login for an online platform. Is the report
sent via email? If so, what is the email
address?
The AIFMD is not just a GP concern
either.The directive currently only permits
European GPs to benefit from the marketing passport, all other non-EU GPs must
continue to use each countrys individual
national private placement regime. The
problem is that many countries, such as
Germany and France, have added extra
rules to these marketing routes, which have
put off some non-EU fund managers, to
the point where some have said they have
given up on marketing in Europe for the
time being. The regulatory disparity got so
bad that private equity lobby group, the
European Private Equity & Venture Capital
Association (EVCA), formally complained
to the European Commission about France
requiring GPs marketing in the country to
hire a local bank or administrator as part of
their implementation of the AIFMD.
Non-EU GPs, and European investors
wanting access to the best fund managers,
hoped that 2015 would spell the end of
the patchwork regulatory regime caused
by the differing private placement regimes.
The directive calls for the European regulator, the European Securities and Markets
Authority (ESMA), to offer guidance to
the European Commission on whether or
not to extend the marketing passport to
MACRO/STRUCTURAL
19
non-EU fund managers in July next year.

In a speech at the EFAMA Investment
Management Forum in November, ESMA
chairman Steven Maijoor said that the regulator was currently gathering data from
individual European regulators on how well
the passport and the national private placement regimes are functioning.
This information will be crucial in helping us make our assessment of the current
arrangements and, subsequently, whether
we feel that the passport can be extended to
entities outside the EU, said Maijoor, who
added that any decision to extend the passport will not be a blanket acceptance of all
non-EU jurisdictions, and ESMA will not
simply say yes, there should be a passport
for everyone. Rather, ESMA will distinguish between the various non-EU jurisdictions and take into account their efforts to
get to a regulatory standard equivalent to
the AIFMD.
But, speaking under the condition
of anonymity, one senior European policymaker involved in writing the text of
AIFMD said he suspected EU officials might
introduce additional hurdles for non-EU
countries seeking equivalence so as to avoid
granting them passports for pan-EU distribution of funds in 2015.
UNDER NEW MANAGEMENT
However, it is actually quite hard for anyone

to speculate on what direction the EU will
take in 2015, as there were a few surprises on
the back of the European Parliamentary election results, which saw a boost to more Eurosceptic parties. Pierre Moscovici, the former
French Finance Minister, was appointed
Commissioner for Economic and Financial
Affairs,Taxation and Customs and will be in
charge of the key role of supervising national
budgets, and also now takes responsibility for
the Financial Transaction Tax (FTT).
If implemented as first drafted, the tax

would hit transactions by private equity
fund managers when purchasing or selling
shares, bonds or options in portfolio companies. However, many countries, including
the UK, vehemently opposed the notion
so 11 countries decided to breakaway and
invoked an enhanced cooperation a
term describing nine or more EU member
states deciding to move ahead with an initiative proposed by the Commission once
it proves too difficult to reach unanimous
agreement in all member states.
But, because only 11 of the 28 EU
members signed on to the controversial tax,
many have criticised the legality of the tax.
In fact a leaked European Council memo
said it would be discriminatory and likely
to lead to distortion of competition to the
detriment of non-participating member
states. At the time of going to press some
countries, led by France, were pushing for
a limited tax that would only hit shares and
a limited number of credit-default swaps,
which can be used to bet on the default
of a company and country. However, tax
experts say they do not expect a breakthrough anytime soon.
Further private equity tax worries to
watch out for in 2015 include the Organisation for Economic Co-operation and Developments (OECD) base erosion and profit
shifting (BEPS) project.
BEPS is set to act as the blueprint for
how the G20 group of rich nations will
tackle tax avoidance and the private funds
community had been concerned that the
OECDs proposals may prevent GPs from
domiciling funds and holding vehicles in
certain jurisdictions, like Luxembourg or
the Netherlands, which feature extensive
networks of double tax treaties.The target
of the OECDs proposals is double nontaxation and it regards so-called treaty
ESMA will not

simply say yes,
there should be
a passport for everyone
shopping as a key issue. Put simply, the

OECD wants to stop companies and other
financial firms from using special purpose
vehicles to bridge the gap between two
countries which do not have a double tax
treaty in place.
Private funds use these structures for
practical reasons, not for tax avoidance
purposes. For instance, a fund which has
investors from, and invests in, a wide range
of countries saves itself a compliance headache by channeling investments through a
central treaty-eligible structure.
The positive news for fund managers is
that the OECD recognises that investment
funds are a specific situation and do not
want them to be adversely affected by the
rules, says Brenda Coleman, tax partner
at law firm Ropes & Gray.
A separate working group has been
formed to review the impact on investment
funds. This should provide some comfort
although it is disappointing that such policy
considerations will not be finalized until
September 2015, creating uncertainty for
investment funds and their investors, adds
Coleman.
So, while 2014 was a year when the
industry needed to keep a watching brief
of the ever greater regulatory challenges,
2015 will see the trend continue as the
most concerning regulations are still in
development.Yet, whether or not GPs and
LPs will feel their force in 2015 as is all
too common for the industrys liking is
still uncertain. n
KEYNOTE INTERVIEW: McGLADREY
20
ACCREDITED INVESTORS
Up in the air
Only a year after lifting the
ban on general solicitation,
the SEC proposed new
parameters for accredited
investors. This proposal
might reduce the private
capital markets access
to investors, thereby
negatively impacting the
US investment industry
and the middle market as
a whole, says McGladrey
partner John Hague
Hague: significant costs
Last year, the US Securities and Exchange

Commission (SEC) lifted the ban on general
solicitation, giving private equity managers the okay to publicly market their funds
to accredited investors. So when the SEC
revealed plans to rework the definition of
what makes an accredited investor in
October, the industry stood at full attention.
As part of a review of the definition,
the SECs Investor Advisory Committee
(IAC) proposed several recommendations
of how to redefine the term in order to
better protect vulnerable investors without
constraining the pool of capital available for
private offerings. For investor protection
purposes, GPs are not able to solicit commitments from investors who do not meet
the accredited investor definition.
For industry expert John Hague, this
move to establish new parameters for
accredited investors is an industry gamechanger. As a partner in the Chicago office
at professional services firm McGladrey,
Hague focuses on audit and regulatory
consulting services for investment firms.
During his more than 30 years of accounting and compliance experience, Hague witnessed the first change to the accredited
investor definition in 1982 when the SEC set
the current income thresholds for wealthy
investors and chose to exclude the value of
a primary residence from net worth limits.
The latest proposal however, will have a much
more significant impact, he says.
The intent is to raise the bar so that
anybody thats solicited by a fund adviser
has the wherewithalboth from a financial
standpoint and from a market savvy standpointto make intelligent decisions about
alternative investments, explains Hague.
THE RECOMMENDATIONS
Currently, an accredited investor is defined

as someone who is worth $1 million (not
including his or her house), who earns
$200,000 a year, or has a household income
of $300,000.These financial thresholds represent an imperfect proxy for sophistication, access to information, and ability to
withstand losses, according to a report by
the IAC.
One recommendation by the committee entails adjusting the financial requirements for inflation. The adjustment would
bring the income thresholds to just under
$500,000, or $740,000 per household, and
the net worth requirement to nearly $2.5
million.
Although this option may be the simplest solution, raising the financial limits
would shrink the investor pool for managers
and restrict investment opportunities for
potentially competent investors that currently qualify but would not be able to meet
the new thresholds, notes Hague.
This may actually reduce the population
of potential investors because there may
be some investors that think they have the
savvy but dont meet the new definition,
Hague comments. There may be people
who would be very frustrated to be precluded from those types of investment
opportunities.
Fortunately, the IAC document questions whether raising these thresholds
would be the most effective solution. The
committee favors alternative approaches,
such as enabling individuals to qualify based
on their financial sophistication, including
professional credentials, like the Series 7
securities license and the CFA designation,
KEYNOTE INTERVIEW: McGLADREY

accredited investors to be a much more

costly and time consuming process, adding
to the already exhaustive compliance burdens they already face.
Given the current fast paced fundraising
environment, the increased time frame for
verifying accredited investors might have
a negative effect on smaller advisers, adds
Hague.
Its going to take a lot more time for
those GPs to solicit money and its a very
competitive environment out there, he notes.
Between raising the standards both quantitaROLE REVERSAL
tively and qualitatively and then the additional
Changing the accredited investor definition cost to be compliant with SEC rules, the cost
beyond just a financial cap would mean that for a small investment adviser to meet all
the process to verify an individuals investor those criteria is significant and might actually
status would become much more compli- curtail the growth of new funds.
cated for managers. However, the fact that
Indeed, the SEC is aware of this possiGPs would essentially be conducting their ble issue, and may step in to help with the
own due diligence on investors might be verification process. The IAC report also
seen as a plus by the LP community over- strongly encourages that the SEC develop
all, notes Hague, as it shows that the GP an approach to third-party verification of
is carefully considering where its capital accredited investors in order to reduce the
comes from.
burden on issuers to verify accredited invesInvestors might not be attuned to this tor status themselves.
request for information and due diligence
when theyre used to it being one hun- SLOW-GOING SOLICITATION
dred percent the other way around, but The proposed redefinition of accredited
it will allow for discussions and interac- investors goes hand in hand with the SECs
tions between the GPs and LPs to become
lift of the general solicitation ban as part
more transparent, he says. This will be of the Jumpstart Our Business Startups
beneficial to all partiesboth GPs and LPs, (JOBS) Act last year. Rule 506(c) of Reguthe marketplace and the current regulatory lation D ended a decades old ban keeping
private issuers from publicly advertising
environment.
This increase in due diligence, however, their funds. However, private issuers who
decide to brave the public airwaves must
may also become a significant burden from
a managers perspective, depending on the take reasonable steps to ensure that only
resources that a firm has at its disposal. A accredited investors can purchase their
smaller adviser will likely find verifying securities.
and their investment experience.The committee also proposed developing a test to
qualify as an accredited investor.
In the report, the IAC notes that finding
a way to measure these aspects of financial
sophistication would be much more challenging than the straightforward income
and asset requirements currently in place.
If the SEC decides to continue basing qualifications solely on financial thresholds, the
IAC suggests limiting investments in private
offerings to a percentage of assets or income.
21
Some investors
may think they
have the savvy
but dont meet the new
definition
While some argue that the new marketing rule is groundbreaking, others are waiting to see how elements like the accredited
investor definition play out. The change to
this investor base will be crucial once it is
finalised by the SEC, but this will likely take
some time, notes Hague.
With so many elements up in the air,
most fund managers still are not comfortable mass marketing their funds, and
although some firms like ff Venture Capital and 500 Startups have led the charge
into the public eye, Hague has yet to see
an increase in advertising take hold across
the industry.
We havent seen a lot of investment
managers take advantage of the ban because
theyre fearful of bringing on investors who
are not accredited, even under the old rules,
he notes.
It remains to be seen what changes, if any,
are ultimately made to the accredited investor definition, and whether those changes
would restrict the availability of capital or
increase the pool. The SEC is still in the
process of taking comments on the issue
and has not given any indication of when a
proposed rule may be forthcoming. Until
then, both investors and fund sponsors will
lie in wait. n
22
Performance pressure
We asked investors to rank the following portfolio
management issues in order of significance to their
private equity portfolios as they look ahead to 2015:
Establishing reliable performance metrics and benchmarks

Understanding and influencing drivers
of returns
Pricing (and marks) in the secondary
market
Investment period extension requests
Fundraising extension requests
The level of unfunded commitments
Shortening the J-curve
Dealing with valuation/compliance
issues
Dealing with tail-end funds
Allocation to listed private equity
Asian LPs were most worried

about understanding drivers of
return, followed by establishing
better performance metrics and
shortening the J-curve
European investors were most
worried about understanding drivers of return, followed
by establishing better performance metrics and shortening
the J-curve
US respondents were most worried about understanding drivers of return, followed by shortening the J-curve and establishing better performance metrics
When it comes to portfolio management,

theres one issue that appears to be outstripping all others for private equity investors around the globe: understanding and
influencing drivers of returns was by some
distance the biggest concern for the respondents to our survey.Thats a subtle but noticeable change from last year, when the vote
was much more evenly spread. Although it
also polled highest, fewer than half of our
respondents voted this as one of their top
three concerns 12 months ago; this year the
equivalent figure was almost 90 percent,
with around two-thirds describing it as their
single most important portfolio management
issue (with LPs in all three regions seemingly
attaching a similar level of importance to it).
Indeed, the primacy of this issue highlights that investors are increasingly preoccupied with performance measuring it,
understanding it, and attempting to replicate
it. Further evidence of this can be seen in
the second most popular choice, establishing reliable performance metrics and benchmarks, which again was much more widely
cited than last year across all three regions.
In these volatile and uncertain times, its
PORTFOLIO ISSUES THAT MOST CONCERN INVESTORS

%
Understanding and
influencing drivers
of returns
1st choice
Establishing
reliable
performance
metrics and
benchmarks
Shortening the
J-curve
2nd choice
Dealing with
valuation/
compliance issues
The level of
unfunded
commitments
3rd choice
Pricing (and marks)

in the secondary
market
Dealing with
tail-end funds
Investment period
Fundraising
Allocation to listed
extension requests extension requests
private equity
23
no wonder than investors are struggling to a target allocation, said Mark Hedges, chief
try and impose some analytical order but investment officer at Nationwide Pension
clearly its easier said than done. Perfor- Fund. He added that the level of undrawn
commitments was currently an important
mance reporting methods tend to vary so
much between different managers that for portfolio management issue for his fund.
The third most-cited concern for invesa large LP with a diversified portfolio and
an extensive list of GP relationships, its
tors was finding ways to shorten the J-curve
increasingly difficult to compare different and it was particularly significantly for Asian
funds against each other with any degree
investors, more than a quarter of whom cited
of reliability. The extent of this inconsist- it as their biggest worry in this category.This
ency which has reportedly (/hopefully) is hardly surprising in a region where GPs
have struggled to exit investments in the
attracted the attention of the US Securities
& Exchange Commission in recent months, last couple of years, particularly in China
as part of their new oversight of the indus- with the almost total shut-down of the IPO
try is why so many GPs can claim to be window.When investors first started putting
top-quartile while keeping a straight face. money into Asian private equity, the short
A related problem to this concerns valu- holding periods and abundant public market
ation, which (in conjunction with other liquidity meant J-curves were shorter than is
compliance-related complications) also put standard for the asset class so the effect of
in a strong showing in this years survey this has been all the more marked.
it actually made the top three in Europe,
That said, J-curves were almost as big
although not globally. Investors tend to have
an issue for North American and European
two problems here, from a portfolio manage- investors. Many LPs had to stop committing
ment perspective: studies suggest that most to new funds in the wake of the financial
GPs under-value their assets for most of the
crisis; which means that five years or so later,
fund cycle, and then over-state them when they now have a big hole in their portfolios
they start marketing a new fund. For mar- where they should have a bunch of funds
keting purposes, some private equity fund that are starting to deliver returns. So its
managers use very aggressive valuation meth- no surprise that so many are turning to secods, which we cannot agree with, admits ondaries in particular as a way of shortening
Tom Eriksson of Aeris Capital. All told, this the J-curve on new investments.
is clearly another example of an area where
The only trouble is that many think its
regulation is making life more complicated. too expensive to be buying at the moment.
Elsewhere, LPs also pointed out that At the moment the secondary market is
while the recent surfeit of distributions very competitive in general terms, said
might seem like an unmitigated boon, it does Gonzalo Eguiagaray, a New York-based
actually make life difficult at a time when
associate at Arcano Capital. [But] I believe
some managers are struggling to put money that there will be good opportunities for
to work via new deals. The timing of draw- investing in the early secondary market in
the future, [i.e.] funds that are less than
downs and distributions is unpredictable, and
the combination makes it difficult to stick to 50 percent invested. n
HOW SIGNIFICANT IS UNDERSTANDING

RETURN DRIVERS (by region)
%
North America
respondents
Europe
respondents
Asia
respondents
HOW SIGNIFICANT IS ESTABLISHING

BETTER BENCHMARKS (by region)
%
North America
respondents
Europe
respondents
Asia
respondents
HOW SIGNIFICANT IS SHORTENING

THE J-CURVE (by region)
%
North America
respondents
1st choice
Europe
respondents
2nd choice
Asia
respondents
3rd choice
KEYNOTE INTERVIEW: LANDMARK PARTNERS
24
SECONDARIES
Thought Partner
Analytical tools can help
resource-constrained LPs
understand and manage
their portfolio in a much
more systematic way, says
Landmarks Barry Miller
Barry Miller, Landmark Partners
For limited partners, the challenges of run- systematic approach to portfolio managening a large and diverse private equity port- ment.
This allows Landmark to act as a
folio have not become any easier in 2014.
The story today is a simple one, says thought partner in the industry, he sugBarry Miller, a partner at specialist second- gests. If you look at the staffing for most
institutional investors, they simply dont
ary manager Landmark Partners. Investors
are looking to write larger cheques to fewer have the bandwidth to manage such large
managers because the work required to
and often over-diversified portfolios. QRG
invest $10 million is not really any differ- was developed to offer investors better
ent from the work required to invest $100 access to education, research and market
million. Each investment requires a similar intelligence that can assist in their thought
amount of work in terms of monitoring, process when evaluating investments.
managing the relationship and handling
capital calls and distributions. So if investors PRICE VS VALUE
can reduce the number of manager relation- Pricing is always a topic of conversation
ships, it arguably makes them better and
among buyers, sellers and holders of private
more efficient portfolio managers.
equity. Evidence suggests that good assets
However, distributions have been so have been trading at par or even at a prestrong in the last couple of years (with most mium to net asset value during 2014.
GPs taking a sell everything that isnt nailed
But focusing too heavily on the headline
down approach, to quote Apollos Leon price misses the point, Miller argues.
Black) that doing this while maintaining
If you look at pricing today, there is a
target allocations has been easier said than misconception that everyones paying par
done. As a result, many portfolios are still that everyones paying up for assets. Secondas unwieldy as ever making it difficult for ary buyers price assets off of several metrics,
resource-strapped institutions to manage
including quarterly NAVs at the pricing date
them properly.
and closing date. Thats the starting point
Landmark attempts to provide LPs
for how we price, but its just a snapshot; a
with a solution to this problem via its point in time. A price of 95 cents [on the
Quantitative Research Group (QRG), a
dollar] in March may not be the same as
seven-person in-house research team led 95 cents in September. And if I pay you 95
by Principal Barry Griffiths and supported
cents today, thats very different from paying
by Landmarks affiliation with several lead- you 95 cents in two years.
ing research academics.
We look to buy high-quality assets that
We give LPs tools that can help them will give us strong risk-adjusted returns,
analyse their overall portfolio, explains
and you can do secondary deals in many
Miller. From publishing white papers to
different ways. Instead of looking at the
utilising diagnostic tools, our goal is to
discount to NAV, the important figure to
help LPs better understand their private
look at is the discount to intrinsic value.
investments so that they can take a more Put simply: we dont want to pay more than
KEYNOTE INTERVIEW: LANDMARK PARTNERS
25
what the asset is worth today which may

be a discount or a premium to where its
held. (He adds that there can be inconsistencies in the way underlying managers
calculate their NAVs, so comparing one
fund to another is not always an apples to
apples comparison).
Has the widespread eagerness among
LPs to reduce their number of GP relationships made them more reluctant to
consider complex solutions like deferred
payments? According to Miller, it depends
on why theyre selling.
In some cases, people sell because they
want to relieve the administrative burden of
having too many funds, and they use the secondary market to do that. Other investors
are selling because they are exiting the asset
class, or taking a different strategy. In addition, some investors may no longer want
PRIVATE EQUITY SECONDARY
TRANSACTION VOLUME
$bn
$33.0
Secondary Volume
$18.5
2H
2014E
$22.5
$24.5
$25.0
$26.0
$14.5
1H
2014A
2010
2011
2012
2013
2014
2014 volume has been driven by strong nominal pricing, large portfolio trades and GP restructurings
2014 is on pace to be the largest year in secondary
market history, but public market performance impact
on Q4 volume could be significant
Sources: Preqin, Setter Capital, Cogent Partners & Landmark
Partners
to have a programme thats purely focused

on fund commitments, and want to build
up a portfolio of co-investments. By reducing the number of funds in their portfolio,
investors free up capital and no longer have
the same administrative burden, allowing
them to focus on their new strategy.
There is a
misconception
that everyones
paying par that
everyones paying
up for assets
A GOOD IMBALANCE
Miller believes the current level of distributions has been a benefit to secondary
managers.
Weve seen huge levels of distributions
for private equity in the last few years, and
thats a great thing. But the challenge then
becomes: where do you put the money?
With the private equity model, the money
gets drawn down over five years or so. And
thats why in the last 12 months, weve seen
an enormous amount of capital flow into
secondary funds because people want to
put capital to work, and secondary funds
have shorter duration and higher-velocity
cash flows.
And given the current strength of the
primary market, he sees no sign of this
trend tailing off in the coming months.
Everybody expects interest rates to rise,
but there is uncertainty about when this
will occur. So in the meantime, interest
rates are fuelling an incredibly robust leveraged finance market with debt widely available and that has boosted deal volume. In
addition, in the last few months, weve seen
enormous amounts of volatility in the stock
markets and for private equity investors,
that should mean enormous amounts of
opportunity. I think that if we continue to
see this volatility, well continue to see a lot
of capital being deployed by private equity.
Recently in the US, there has been a lot

of negative coverage about public pensions
use of alternatives. But Miller believes that
such institutions will have no choice but to
maintain their allocations.
These stories will come and go, but ultimately, its about how individual allocations
work for individual pension funds. Some
will have a hard time scaling in certain asset
classes, some will have access problems
But if you look at their actuarial returns,
which are normally somewhere between
six and eight percent, the only way to cover
that is via alternative assets.
In the secondary market, transaction
levels have been robust Landmark reckons there were will be about $30 billion
of deals completed in 2014, about 20 percent higher than last year. And according
to Miller, there is still a favourable supply/
demand mismatch.
The good news is that the definition of
secondaries continues to evolve, so volumes
keep rising. And there are plenty of transactions out there. In fact, we think that the
supply of deals still exceeds the level of dry
powder.Thats a good imbalance, which we
think will continue to grow. n
26
VALUATION
The future of fair value

Fund managers are continuing to develop their approach
to fair value estimates, driven by increased pressure from
regulators and limited partners. Third-party validation can
help, but the managers input will continue to be vital,
write David Larsen and Warren Hirschhorn
The future of fair value is now more interwoven with the future of the alternative
assets industry than ever before. Back in
2009, the concept of rigorously estimating
on a regular basis the fair value of underlying investments of a fund was a practice
actively implemented by only the largest
funds and those that were publicly traded.
In the five years that have ensued, we have
witnessed an explosion of both large and
mid-market funds availing themselves of
third-party valuation services.
Further, a number of limited partners
are scrubbing their alternative portfolios
more thoroughly to ensure that using net
asset value (NAV) as their fair value estimate is supportable. The venture capital
market is finding itself under increasing
pressure to expand documentation, and in
some cases, to use mathematical models to
estimate value.
The world of alternative assets has seen
much turmoil during and subsequent to the
financial crisis. For a period of time, assets
under management started to decline, only
to turnaround and increase to more than
$2 trillion (the approximate figure under
management at time of writing). The line
between private equity and hedge funds,
venture capital and growth equity continues
to blur, with a number of fund managers
A process in
which the
portfolio
manager, who clearly
knows the investment
better than anyone
else, has sufficient but
not absolute input into
the valuation process is
becoming best practice
currently managing over $100 billion. Some

of the largest managers now run a supermarket, with private equity, hedge funds,
venture capital, fund of funds, placement
agent services, investment banking and
other financial services all under the same
umbrella.
These developments continue to stretch
management and they require the use of
consultants to assist in the compliance issues
that arise out of these complex operations.
While no crystal ball can accurately predict the future, we believe the following areas
will continue to see increased focus from
participants in the alternative asset sector:
Robustness of processes and value conclusions

Timeliness of reported values
Independence
Regulations and requirements
THE ROBUSTNESS OF PROCESSES
Funds have continued to make significant

progress in terms of the process via which
they value their holdings. Improved rigour
has in large part been caused by the registration process undertaken since 2011 by
the US Securities & Exchange Commission
of fund managers with over $150 million in
assets under management.The registration
process and subsequent inspections by the
SEC have raised scrutiny of the valuation
process to a very high level.
Regulatory inspections include a review
of a funds written valuation policies and procedures, as well as verification that these policies and procedures have been followed by
the fund.The SEC has sanctioned and fined
numerous funds over valuation deviations
from their written valuation procedures.
Non-US funds also continue to improve
their fair value estimation process.With the
implementation of AIFMD, inspections
similar to those performed by the SEC are
expected to occur in Europe.
TIMELINESS OF REPORTED VALUES
As funds continue to grow, and as more and

more become publicly-listed entities, investors and shareholders will require fair value
conclusions to be supplied by funds on an
ever tighter timeframe. This puts an enormous strain on the funds internal valuation
processes, and increases the likelihood of
error. For public companies, it is the rule to
have a third-party valuation partner. For the
27
PREVENTING OVER-REACHING
multitude of funds that remain private, regulation is now a given and LPs need for more
timely information is ever increasing. Therefore, a valuation process that can stand up to
regulatory scrutiny while meeting the time
demands of investors increasingly requires the
assistance of a qualified third-party expert.
Further, as LPs realise that they cannot
blindly accept NAVs as reported by funds
as their fair value estimate, pressure will
increase to have quarterly NAV reported on a
much more timely basis (possibly within days
rather than the current standard of months).
HOW INDEPENDENT?
The concept of independence is one that

every fund has dealt with, and one that will
continue to be a challenge. It is a given that
auditors are independent. Some believe that
independence with respect to valuations
could be preferable. However, a party totally
independent of the manager would likely not
improve fair value estimates, as the necessary
knowledge and background available from
deal teams is critical in estimating fair value.
As funds continue to add assets and asset
classes, their ability to internally evaluate
the fair value of each asset becomes more
difficult. A process in which the portfolio
manager, who clearly knows the investment better than anyone else, has sufficient
but not absolute input into the valuation
process is becoming best practice.

Enhancing the valuation process by
involving a third party that does not have any
skin in the game allows for a detailed review
of each investment, including deal team
input, but without any value bias towards
the upside or downside. As a result, LPs can
place greater reliance on valuation processes
that include critical deal team input and are
enhanced through independent validation.
REGULATION AND REQUIREMENTS
The two largest regulatory impacts on the

industry in recent times have been from the
Dodd-Frank Act in the US and the AIFMD
in Europe. Regulation imposes far-reaching
rules that will have a profound impact on
the way funds operate, particularly in terms
of how they communicate and interact with
investors and other stakeholders.
A major impact of AIFMD is the requirement for independent valuations.The Directive allows valuations to be performed either
internally or externally. Whether performing the valuation internally or engaging an
external valuer, the Directive makes it clear
that the fund must take steps to ensure that
the valuation is functionally independent
from portfolio management.
There continues to be much discussion
around the valuation requirements and
application of the new AIFMD rules.
Over time the hope is that the regulators

and industry participants will focus on
pragmatically estimating fair value with
sufficient rigour while including independence in the process. It would be unfortunate
if independence were to trump expertise,
or the perceived precision provided by
mathematical models was to trump market
participants assumptions and judgement.
Such risks exist. The best way to prevent
over-reaching by regulators, including auditors, is to have a robust process where managements judgement is validated and the
results are clearly documented.
The future of fair value can be summed
up as: it is not what you thought it was,
and there is a risk that it will be misinterpreted going forward. What originally
was thought to be a straightforward concept continues to be a hotly debated topic
within the accounting, regulatory and fund
world. Even within the same organisation,
we see different groups using the rules
differently.
Nonetheless, fair value, while imperfect,
continues to be the best basis to meet the
multitude of analysis and reporting needs
for which it is used. n
David L. Larsen is a managing director
and a leader of Duff & Phelps Alternative Asset
Advisory practice, based in San Francisco, while
Warren Hirschhorn is the Vice Chairman of
Duff & Phelps, based in NewYork.
Cover_PEV2 17/07/2014 15:47 Page 1
PRIVATE EQUITY
VALUATION
The definitive guide to valuing investments fairly
By
Duff & Phelps
This is an exclusive extract from

Private Equity
Valuation, which
was edited by
Duff & Phelps and
published by PEI
Media in 2014.
FEES, TERMS AND CARRY
28
FEES & TERMS
Value for money

We asked investors to rank the following fee and
expense-related issues in order of significance to their
private equity portfolios as they looked ahead to 2015:
Preferential terms for larger investors

Waterfall arrangements
Structuring separate account arrangements
Current level of management fees
Current level of carried interest
Paying fees to zombie funds
Guarantees around future compliance
liabilities
Division of expenses between LPs and
GPs
Asian LPs were most worried about the current level

of management fees, followed
by waterfall arrangements and
expense allocation
most worried about the current level of management fees,
followed by expense allocation
and paying fees to zombie funds
worried about the current level
of management fees, followed
by waterfall arrangements and
expense allocation
This year, for the second time, we asked investors to specify the main pressure points in
their negotiations with GPs; once again, as it
was last year, the current level of management
fees was the most commonly cited concern,
with almost three-quarters of respondents
placing it in their top three. European investors were particularly hot on this: around half
stated that it was their single most important
issue when negotiating with GPs.
The 2-and-20 fee level is expensive, and
[our] trustees are certainly concerned with
the average fee level for private equity funds,
says Nationwide chief investment officer
Mark Hedges.
On the other hand, Hedges also said
that Nationwides trustees had never actually blocked a fund investment solely on
the basis of fees. And this serves to highlight a sentiment shared by many of the
respondents to our survey: the fee structure
is not necessarily a problem as long as the
performance is there to back it up.
As HarbourVests George Anson puts it:
The question should not be about whether
2-and-20 is expensive, but rather about
whether these managers can deliver above
TERMS AND CONDITIONS THAT MOST CONCERN INVESTORS

%
Current level of
management fees
1st choice
Division of expenses
between LPs and GPs
2nd choice
Waterfall
arrangements
Paying fees to zombie

funds
3rd choice
Current level of
carried interest
Structuring separate
account arrangements
Preferential terms for

larger investors
Guarantees around
future compliance
liabilities
29
average returns in the long term. If they specify every eventuality in the original LPA
significantly outperform, the fees are not and the vaguer the language, the more
expensive.
room there could be for chicanery. For now,
Im fairly soft on fees, agrees Lyriques
all investors can do is be extra careful when
Hans van Swaay. 1-2.5 percent and 20-30 they sign up to a new fund. Events in the
percent is fine if they do a good job but US have raised the profile of the allocation
it becomes upsetting when managers are of expenses and this is now a bigger issue for
charging these fees and are doing nothing, LPs, says Capital Dynamics John Gripton.
such as with zombie funds.
The recent scandal of the allocation of
Interestingly, the second most com- fund manager expenses should be a wakemonly cited concern was around the allo- up call to the industry, as investors naturally
cation of fees and expenses, an issue that are becoming more probing and demandwasnt even on a lot of peoples radar this
ing, adds Anson.
time last year. Whats changed, of course,
Although the three regions were equally
is the intervention of the SEC: since the vehement about headline fees being the
US regulators chief inspector Andrew most significant issue here, there were
Bowden suggested at PEIs Private Fund
some other interesting variances between
Compliance Forum earlier this year that them. For instance, waterfall arrangements
more than half of the firms examined by were the third most-cited concern globally,
his team had shown some material failing but it seems to be much less of an issue for
in the way they treated fees and expenses, European investors: barely a third chose
GPs have been fielding lots of calls from this as one of their top three issues, comworried LPs wanting to know whether they pared with more than 60 percent of North
had anything to be worried about.
American LPs. This is presumably a good
In general terms, the answer to this ques- reflection of the fact that waterfall agreetion is surely yes. As the recent survey by ments globally are increasingly going along
our sister magazine pfm revealed (see p. 30 the lines of the European model rather
for a snippet), there is relatively little con- than the US model because thats what
sistency or in some cases clarity about investors want.
the way different managers choose to split
It was also noticeable that preferential
expenses between the GP, the fund and its terms for larger investors a hot topic
LPs. And in fairness, thats largely because
last year, cited by more than 60 percent
there are all sorts of grey areas where the
of respondents appears to have dropped
line in the sand is far from obvious. For off the agenda to some extent in developed
instance, even if the GP foots the bills for markets (only one in five European investhe annual investor meeting, who should tors mentioned it all, for example). But its
pay for LPs from far-flung destinations to
clearly still a live issue in Asia, where 45
be there? Who should pay for portfolio percent included it among their top three
company CEOs to attend?
issues. Given the relative preponderance of
Whats more, there are so many poten- sovereign wealth funds in the region, thats
tial variables that its incredibly difficult to
not wholly surprising. n
HOW SIGNIFICANT AN ISSUE ARE

CURRENT FEE LEVELS (by region)
%
North America
respondents
Europe
respondents
Asia
respondents
HOW SIGNIFICANT AN ISSUE IS SPLITTING

EXPENSES BETWEEN LPs, GPs (by region)
%
North America
respondents
Europe
respondents
Asia
respondents
HOW SIGNIFICANT AN ISSUE ARE

WATERFALL ARRANGEMENTS (by region)
%
North America
respondents
1st choice
Europe
respondents
2nd choice
Asia
respondents
3rd choice
30
MANAGER COMPENSATION
When value-add goes wrong

Nervous that the SEC may strip them of management
fees, GPs are exercising restraint when appointing
operating specialists to portfolio company boards,
writes Nicholas Donato
Too much regulation can have an interesting

impact on industry practice.
As the US Securities and Exchange Commission (SEC) scans the industry for bogus
fees and expenses, theyve taken issue with
operating partners on portfolio company
boards who draw lucrative directors fees.
The regulatory clampdown comes
at a time when operating partners, or
at least the use of operating consultants,
has become a staple of the private equity
industry. Especially in the current economic
environment, with the global economy still
struggling to get out of first gear, the value
of operating partners has been undeniable.
But a trend as big as this is bound to catch
the attention of regulators; and its not
entirely clear (in all instances) how operators can be used without leaving the firms
compliance team feeling nervous.
For the uninitiated, first a bit of background:The SEC reasons that management
fees are already funding the firm, and the
firm should be paying partners for their
work so why are GPs double-dipping by
having portfolio companies pay a second
salary?
The bottom line is GPs are meant to
monitor and improve portfolio companies.
So the SEC says you cant just send one of
your people down there to take a board seat,
be paid a directors fee, and save yourself
his or her remuneration at the management
company, explains Julia Corelli, who cochairs the fund services practice at law firm
Pepper Hamilton.
Accordingly GPs typically either dont
allow portfolio companies to pay their partners directors fees, or they offset any remuneration paid to their people for serving as
directors against the annual management

fee.
However, this same logic is being applied
to operating partners that take a portfolio
company board seat but who arent really
employees or partners of the firm. Often
private equity firms will have operating
specialists on retainer, meaning theyre on
call for feedback and advice when needed.
These retainer fees may only be as little as
a couple thousand dollars per month, but
sometimes it can be enough for the SEC
to consider them working members of the
management firm.The problem arises when
one of these operating specialists take a
board seat at one of the firms portfolio
companies (perhaps they felt it was a really
great investment) and begin drawing sixfigure fees or possibly more.
What happens then is that operating specialists fee income or salary might have to be
offset against the management fee, says Anne
Anquillare, co-founder and chief executive of
PEF Services, a fund administrator. Were
talking about potentially millions of dollars
in lost fees here because a $5,000 a month
or so retainer fee for their services brought
them under the firm umbrella.
FREE EQUITY
SPLIT OPINION
Q: Assume an operating partner
on retainer with your firm joins a
portfolio company as an independent director. Would you offset the
operating partners cash director fee
against the funds management fee?
Q: If you answered yes, if the firm

ceases to pay them the retainer
would you offset the operating
partners cash directors fee against
the funds management fee?
Q: Would you offset any equity

options that the portfolio company
grants to this operating partner (for
services as an independent portfolio company director) against the
fund management fee?
No
No
No
Yes
Yes
Yes
Q: If you answered yes, what is the

amount of the offset?
Net cash received

from the option
shares at exit from
the investment
Value at time of
exercise
Value at time of
grant
Source: Fees and Expenses 2014: A pfm benchmarking survey
31
INDIRECT PAYMENTS
Q: If the portfolio company pays consulting fees to the operating partners
company and the operating partner owns 25 percent of the consulting
firm, would you offset the consulting fees paid to the consulting business
against the management fee?
%
Q: Would knowing what the consulting firm actually pays the operating
partner make any difference to you?
Total
Less
than
$1bn
$1bn
to
$2bn
$2bn
to
$5bn
More Buyout Growth Debt

than
equity
$5bn
Real Other
Asset
Total
Not at all
No
Yes, in the amount of 25% of the fees
Yes
Less
than
$1bn
$1bn
to
$2bn
$2bn
to
$5bn
More Buyout Growth Debt

than
equity
$5bn
Real Other
Asset
Yes, in total
One of the SECs concerns is that these

value-add experts or sector specialists on
retainer are being portrayed to investors
as full-time members of the management
firm, when in reality they have a much more
limited scope.The title operating partner
can in itself be confusing to LPs, who may
mistakenly invest in a fund under the belief
that the firm has certain staff dedicated to
operational value-add.
In fact, operating partners who are
portrayed as employees of the management
firm but who are actually compensated by
the fund or portfolio company is one of
the most common deficiencies cited during
presence exams, SEC chief inspector Drew
Bowden said at the PEI Private Fund Compliance Forum in NewYork earlier this year.
Bowden specified that exam staff find
these types of professionals often work
exclusively for the manager from an onsite
office; they invest in the managers funds on
the same terms as other employees; and
they can even appear on the firms website
and fundraising materials as full members
of the team. So theres a bit of a dilemma for
GPs here. It seems unfair that an operating

specialist called a few times a month results
in such a loss of management fees. But in
light of all the recent SEC rumblings, the
safe bet is to offset their director fees.
JUST THE FACTS
To find out which of these less-than-ideal

options GPs are actually pursuing, PEI sister
title pfm, in partnership with Pepper Hamilton and PEF Services, polled over 100
CFOs/CCOs about their current fee and
expense policies.
On the question of offsetting the operating partners cash director fee against the
funds management fee, the results show a
nearly even split in response, indicating the
level of uncertainty around the issue. Take
away that retainer fee, however, and more
GPs are (as one would predict) fine with
leaving management fees alone.
From there, we tweaked the scenario to
test what kinds of factors might result in
GPs landing one way or the other on the
issue. For example, if the operating specialist on retainer also happened to own a slice
of the consultancy firm the GP entered into

contract with as well, that might bring the
operating partner more under the firms
umbrella, such that an offset would seem
more appropriate.
In a worst case scenario, what this
could mean is that private equity firms
abandon this type of value-add strategy
in order to preserve management fees.
But Corelli says the more likely scenario
going forward is that more PPMs and
other fund documents will discuss operating specialists in more detail and better
clarify the terms of the relationship with
the management firm.
Indeed, its a changed world since SEC
registration became a requirement for many
firms back in 2012. And now that investors and regulators have jointly pushed a
spotlight on fees and expenses, future fee
and expense benchmarking exercises may
reveal that more of a standard is developing.
But how that standard evolves alongside the growing use of operating partners
remains to be seen.
Stay tuned. n
KEYNOTE INTERVIEW: DEBEVOISE & PLIMPTON
32
FUND ECONOMICS
Fair on fees
As a result of the fee
debate earlier this year,
GPs are becoming
more transparent about
investment costs
which is good for all
parties, says Debevoises
Geoffrey Kittredge
Kittredge: disclosure and follow-through critical
used to support the business for a number

When the SECs Andrew Bowden made
of years during the life of the fund, most
his now-infamous Spreading Sunshine
importantly during the investment period
in Private Equity speech at PEIs Private
Fund Compliance Forum in New York in of the fund.
May, he firmly catapulted the issue of fees
and expenses into the limelight.
BALANCING ACT
By far, the most common observation GPs are sensitive to concern among LPs that
our examiners have made when examin- high management fees will discourage GPs
ing private equity firms has to do with the
from working as hard on investors behalf
advisers collection of fees and allocation
as they should.
Investors are very, very conscious these
of expenses, Bowden said. When we have
examined how fees and expenses are han- days about perceptions of a misalignment of
dled by advisers to private equity funds, we
interests on the management fee, Kittredge
have identified what we believe are viola- says. The theory is if the management fee
tions of law or material weaknesses in con- is too high, then the team is, at least from
trols over 50 percent of the time.
the investors perspective, not sufficiently
Cue LPs examining where their money motivated on the carried interest side.
is being spent, and US GPs putting their
However, Kittredge doesnt think this
houses in order in case the regulator comes theory deserves much credence; after all,
the promise of 20 percent carry is much
knocking.
more enticing than the significantly lower
According to London-based Debevoise
& Plimpton partner Geoffrey Kittredge, level of income that comes from the mandisclosure and follow-through are the key agement fee.
Investment professionals are in this
issues, both in the US and Europe. Regulaasset class in order to generate superior
tors are likely to look at whether firms are
returns and earn the rewards of those
adequately disclosing to investors how fees
and expenses are handled, whether they returns through the carried interest strucfollow through on the promises made to ture, and not through the management fee
investors, and, to a certain degree, whether structure.
That is not to say that fee structures
the agreed-upon terms are reasonable.
Greater transparency is something GPs
are not very carefully crafted for each fund,
can act upon immediately, and, for the most Kittredge says. European GPs are generally not required to register with the SEC,
part, thats exactly what theyre doing.
I think theres more transparency and for the most part are not currently in
around fee discussions. GPs are providing danger of a surprise inspection, although
a lot more information these days to their European regulators are likely to be paying
investors about what they are doing with
close attention to the SECs activities.
the management fee, Kittredge says.
Its inevitable that the regulators do
GPs understand that theres a lot of compare notes and identify areas of focus
sensitivity on this, and theyre providing that they share in common, Kittredge said.
information about how those fees are It could very well be that the FCA and the
KEYNOTE INTERVIEW: DEBEVOISE & PLIMPTON
33
SEC do look at some of the same issues

when theyre conducting their respective
visits.
Appropriate disclosure, therefore, is
paramount, even as both GPs and LPs push
to negotiate the best deal for themselves.
Investors care about how much management fee they are paying in the fund that
they are going to be investing in and are
looking to keep those fees as lean and mean
as possible, Kittredge says.
Investors are
very, very
conscious these
days about perceptions
of a misalignment
of interests on the
management fee
Although GPs are not necessarily obliged

to disclose the exact amount of the discount offered to each investor, LPs can
be protected from paying a rate which is
out of step with other investors through
Most Favoured Nation (MFN) clauses.This
roughly means that, where a commitmentbased MFN clause is in place with particular
investors, those investors are offered the
same arrangements and fees as are available to any other investors with the same
commitment or less.
BEYOND THE HEADLINES
As LPs are becoming increasingly aware, the

headline fee rate is rarely the full story. A
number of fund managers offer a range of
discounts to prospective investors to persuade them to commit. These include socalled early-bird discounts, where investors
are offered a reduction in the management
fee if they commit early, for example at the
first close, and discounts based on the size
of the investors commitment.
GPs also offer co-investment opportunities, which can have the effect of blending
down an investors overall management
fee rate on the amount of capital theyre
investing.
I dont think, generally speaking, the
so-called headline rates are radically different from the fees actually being paid,
Kittredge says. The GP is not going out
with a fee thats artificially high. If they did,
theyd be turning off prospective investors at
the outset, and thats really not the message
that GPs want to convey.
The discounts offered, therefore, are
usually fairly modest. Many GPs shy away
from early-bird discounts, Kittredge says,
because they can be a slippery slope;
later investors who were not in discussion
with the GP before the first close can start

demanding to also receive a discount, which
puts the GP in an awkward position regarding those who committed at the first close.
A discount based on commitment size
is much more prevalent, according to
Kittredge, and broadly accepted by the
investor community. Whether it is based
on a predetermined threshold or negotiated
on an individual basis, the GP will usually
let other investors know that fee reductions
are being considered.
Best practice would suggest the fund
manager make clear to all investors there
may be discounts or fee breaks on the
management fee, and that they are tied to
the size of the investors commitment. At a
minimum, investors are then all on notice
that those types of arrangements are out
there and are part of the fund, and that
theres authority with the documentation
for those arrangements to be negotiated.
If investors are interested, they can talk to
the GP about it, Kittredge says. Thats one
approach that can keep the details of the
negotiations relatively confidential, whilst
still communicating effectively with all
investors.
ON THE BORDERLINE
Management fees may, therefore, be welldefined ahead of time, as long as GPs and
investors are on the same page. Expenses
can be more ambiguous. Some outlays, such
as due diligence expenses, legal fees and
broken deal expenses, can easily be set
out in the LPA. However, some are not so
clear-cut.
Should GPs pay to wine and dine target-company CEOs or should that be a
fund expense? At the annual LP meeting,
should the GP, the fund or the LP itself
pay for travel and accommodation? What
about meals or rounds of golf? Although
it can be tempting to ask management
firms to break down every single expense,
Kittredge advises keeping such outlays in
perspective.
In the big picture these are modest
amounts and are on the borderline, and I
think most general partners and managers
make reasonable judgements about these,
acting with good faith, Kittredge says. Its
really more about GPs and managers being
clear with their investors about how those
situations are handled so that there are no
surprises. n
34
CO-INVESTMENT
Everyone wants some

As the demand from investors for preferential
co-investment rights continues to rocket, GPs are being
pushed to institute sophisticated processes that respond
to requests fairly and openly. By Claire Coe Smith
Driven by LPs wanting to build stronger

relationships with fewer managers, and
with the added benefit of deal-by-deal
investment selection and often zero carry
and fees, co-investment opportunities have
become a real attraction during fundraisings. Managers also benefit from the availability of a friendly capital source, providing
an alternative to debt and making larger
deals feasible.
But the challenge of sharing out coinvestment opportunities in a way that
keeps investors onside without alienating
those that lose out is becoming a tricky
issue for fundraisers. And advisers predict
it becoming even more of a feature in 2015.
Andrew Bentley, a partner at global
placement agents Campbell Lutyens, says:
Co-investments have been important to
Once you start

debating the
issue you are
actually better off not
having any kind of hard
legal rights
LPs for a long time, but we see interest

continuing to strengthen as the number of
LPs asking for preferential co-investment
rights continues to rise. That presents an
issue for GPs during fundraisings, because
the more LPs that ask, the more difficult
it is to manage priorities. How to handle
co-investment requests is almost always a
key aspect of a fundraising strategy.
SHALL WE PUT IT IN WRITING?
Glover: dichotomy of approach
Two models of managing the demand have

emerged in the last few years, essentially
separating those managers who take a prescriptive view on how opportunities will be
distributed, and those who have continued
to approach the issue on a more ad hoc basis.
There are different ways of addressing it,
from being silent on it in fund documentation at one end of the spectrum, says Bentley,
to having a highly-evolved co-investment club
on the other.The latter drives certainty and
transparency for LPs by setting out rights

to opportunities upfront. Deciding which
route to go down depends on the number
of LPs involved, and the types of deals and
opportunities for co-investment that they
are particularly interested in.
Jason Glover, a fundraising partner at
the law firm Simpson Thacher & Bartlett in
London, sees the same dichotomy of approach.
He says: Investors like to see something in
writing about their access to these opportunities.The more sophisticated GPs try to avoid
that, on the grounds that if you allow investors to co-invest on some sort of formulaic
basis normally pro rata to the size of their
commitment to the fund and everybody
potentially gets that right, then you can end
up with a situation where a co-investment is
offered to tens of investors and the amount
of the co-investment is almost meaningless,
and doesnt justify the time necessary to carry
out due diligence and so on.
One option is to offer co-investment
rights only to the largest investors in a fund,
but that in turn raises the question of where
to draw the line.
Michael Halford, head of the investment
funds team in the UK at King & Wood
Mallesons, says: The problem you get into,
with a typical fund of 20-plus investors, is
that if you offer a co-investment opportunity to one investor, you have to justify why
you are not offering it to others. Therefore,
once you start debating the issue you are
actually better off not having any kind of
hard legal rights to co-investments.
Where managers are keen to formalise
arrangements, there is a growing trend
towards firms setting up parallel co-investment fund pools alongside the main fund,
such that investors who want access to coinvestments can make allocations to both the
35
main fund and to a non-discretionary coinvestment pool. That second fund remains
under the control of the private equity firm,
and is typically fee-free and carry-free.
Glover says: That is a developing area
of fundraising structuring, and can present
a win-win for the investors and the private
equity house. It means that when theres a
surplus of equity that the fund cant take
up, rather than the fund underwriting
that surplus and carrying the risk of being
unable to syndicate, it has a second pool
of capital that it controls and which can
co-invest alongside the fund.That removes
syndication risk for the fund and provides
a mechanism to make the co-investment
process less elongated.
INVESTORS NEGOTIATE HARD
In a more traditional co-investment scenario, the manager ordinarily underwrites

the larger equity cheque, and then seeks to
syndicate it to its investors. At that point a
specific co-investment vehicle is set up for
the one deal. Given that some investors will
be better equipped than others to undertake
the diligence on such opportunities, that process can add significant time pressures to
transactions, as well as risk for the manager.
Halford says: We have seen bespoke
vehicles being set up and there is continuing interest in those. One of the reasons is
that what you often see otherwise is that
when co-investments are executed, a specific co-investment vehicle is set up thats
not very different to the fund vehicle. Until
recently, because those were no-fee, nocarry vehicles, just for the co-investment,
investors used to take quite a light approach
to reviewing the terms.
But thats changed, he says: Now investors are actually treating those vehicles a
Halford: investors are negotiating hard
bit like a mini-fund, and negotiating terms

quite hard. That triggers a demand on the
part of the manager to hardwire all that
from the beginning into a separate coinvestment fund.
PLAYING TO LPS STRENGTHS
However much investors may request coinvestment rights, the fact remains that
the actual number who are in a position to
execute on opportunities to tight timescales
when they arise will be a subset of those
interested. So whatever structure a GP puts
in place, the key to keeping investors happy
will often be knowing what each one is looking for from co-investment opportunities.
We recommend to clients that no formal
co-investment arrangement is entered into,
says Glover. Instead, at the time of admission of an investor to the fund, you establish
their appetite for co-investment upfront,
including the geographies, sectors and
types of deals that they might be interested
in, and seek to direct a disproportionate
amount of those targeted opportunities to
that investor.
If a co-investment opportunity arises

in Germany, for example, a German pension fund may be best placed, and have the
most appetite, to come into the deal as a
co-investor.
In the tight fundraising environment
of the last few years, larger LPs have been
able to secure promises of co-investment
opportunities as part of a suite of incentives to sign up to fundraisings. Preferred
co-investments rights have been offered as
first close incentives, but now that so many
LPs are asking for them, there are signs of a
shift back to clearly demonstrating an equal
footing amongst the LPs in a partnership.
Private equity firms are under more
scrutiny than before in this regard. Nigel
van Zyl, a funds partner with the law firm
Proskauer, says: Theres been a significant
increase in the appetite for co-investments
from LPs, and a number of the global funds
have set up dedicated co-investment teams
to manage the allocation of the opportunities. Theres a lot of focus on what GPs
are doing about co-investment during the
fundraising. So we see a lot of diligence
from LPs on how many co-investment
opportunities there have been in the past,
how those decisions have been made by
the GPs, and looking for reassurance that
no investor has been granted preferential
rights over others.
Americas Securities and Exchange Commission has also weighed in, highlighting
its own concerns about a lack of clearly
defined procedures for co-investment allocation, and unclear policies on allocating
fees and expenses to co-investment vehicles.
All of which puts more pressure on GPs to
be mindful of the promises they make at
fundraising time. Failing to keep them will
do damage to the franchise. n
GP-RELATED ISSUES
36
GP-RELATED
Clear and distinctive

We asked investors to rank the following GP-related issues
in order of significance to their private equity portfolios as
they looked ahead to 2015:
Team stability/retention strategy
Quality and quantity of GP communication
Adherence to ESG principles
Proven operational expertise
Length of investment period
Clarity of strategy
Competitive management fee
Level of GP commitment
Preferential terms for early investors
Preferential terms for larger investors
Level of carried interest
Asian LPs were most worried about clarity of strategy

and team stability (equally),
followed by the GP commitment level
most worried about clarity
of strategy and team stability
(equally), followed by proven
operational expertise
worried about clarity of strategy, followed by team stability
and then proven operational
expertise
As youd expect, the limited partners

responding to our survey had some pretty
strong views across the board on what
theyre looking for in their GP relationships
as we head towards 2015.
But this year, one issue jumped out above
all others for LPs of every stripe: the importance of a clear and comprehensible strategy.
Now that fundraising has roared back to its
highest run rate since the crisis, the market
is looking pretty crowded again in many
regions especially as there are relatively
few good deals going begging. As a result,
LPs are desperately looking for managers
with an edge; groups with a strategy thats
clear and distinctive enough to give them
a competitive advantage.
Tom Eriksson of Aeris speaks for many
LPs when he says: The clarity of the investment strategy is one of the key parts of our
due diligence on GPs.
Nationwides Mark Hedges agrees: The
most important side to our due diligence
involves understanding the managers
philosophy and how they intend to make
money! We need to be able to trust them
to deliver on their promises of returns.
GP-RELATED ISSUES THAT MOST CONCERN INVESTORS

%
Clarity of strategy
1st choice
Team stability/
retention
strategy
Proven
operational
expertise
2nd choice
Level of GP
commitment
Competitive
management fee
Quality and
quantity of GP
communication
3rd choice
Adherence to
ESG principles
Level of carried
interest
Length of
investment
period
Preferential
terms for early
investors
Preferential
terms for larger
investors
GP-RELATED ISSUES
37
How do GPs get this across? You need to

convince me that your strategy is the best,
explains HarbourVests George Anson. What
is your unique selling point? Track record is
important but that is [just] what gets you in
the door. From then on, you must convince
me why we should invest with you.
LPs and GP alike concur that the due
diligence process for new investments today
is much more intensive than it has ever been
before: as well as analysing a managers track
record in minute deal, most investors these
days want to meet their investment team,
chat to their portfolio company CEOs,
establish their views on ESG (environmental, social and governance issues), quiz them
on their value-add capability and check
their anti-fraud and disaster recovery policies. Business recovery plans are important,
insists Anson. You have to know that GPs
have back-up plans in place.
Our results show that team stability and
retention remains an important issue for
investors: more than 70 percent of respondents said it was one of their top three concerns when assessing a GP. Indeed, in Asia,
it was cited as often as clarity of overall
strategy. When it comes to their fund managers, LPs still seem to fear change even
though various studies have now shown that
some turnover of staff can actually be good
for investment returns.
The third most common concern cited
by almost 70 percent of all LP respondents
was over proven operational expertise.
Most firms are pretty good now at talking
the talk on value creation: they have to be,
because they know that LPs now expect
it as a matter of course. So for the latter,
the challenge becomes trying to identify
which firms can also walk the walk to

cut through the rhetoric and identify how
much of the value created on a particular
deal was due to the GP, and how much was
due to other factors (like good luck, market
timing, exceptional management teams, and
so on). That means looking for repeated
examples where the firms approach has
delivered tangible results.
There was also a clear feeling among
respondents that GPs communication still
leaves a lot to be desired. As Lyriques Hans
van Swaay puts it: GPs listen to you when
you are an investor during the fundraising
process, but communication weakens after
the fundraising process.
Reporting continues to be a major bone
of contention. With so little consensus
around best reporting practice, LPs find
themselves struggling to assimilate a huge
range of different data sets, almost all of
which are presented to them in a slightly
different way. Reporting is primitive, too
segmented, and too diverse, van Swaay
says. The industry should have a platform
whereby definitions and procedures are
standardised. Of course, agreeing on and
establishing such a platform will be easier
said than done.
That said, some LPs were quick to point
out how far the industry has come in a
relatively short space of time. GP reporting and communication has improved a
lot since 2008, both on a fund level and a
company level, by both developed and developing managers. In fact the small managers
tend to provide at least the same quantity,
if not better, reports as larger managers.
So some clear progress, definitely but
still more work to do. n
HOW SIGNIFICANT AN ISSUE IS CLARITY

OF STRATEGY (by region)
%
North America
respondents
Europe
respondents
Asia
respondents
HOW SIGNIFICANT AN ISSUE IS TEAM

STABILITY/RETENTION STRATEGY (by region)
%
North America
respondents
Europe
respondents
Asia
respondents
HOW SIGNIFICANT AN ISSUE IS PROVEN

OPERATIONAL EXPERTISE (by region)
%
North America
respondents
1st choice
Europe
respondents
2nd choice
Asia
respondents
3rd choice
KEYNOTE INTERVIEW: ASANTE CAPITAL
38
FINDING WINNERS
How to find the right fund

GPs that can guarantee
consistently outsized
returns have become
harder and harder for
many investors to find or
access. The tried and true
practices of scrutinising a
team and its track record
remain the most important
factors when assessing
managers, says Asantes
Warren Hibbert
Hibbert: maiden funds driven, focused and

highly motivated
There was a time when fundraising was a

relatively easy job for the majority of private
equity fund managers. During the pre-crisis
boom era, most reasonably performing GPs
could simply send out PPMs, have a few
meetings and commitments would soon
follow private equity, as an asset class,
seemed to be enjoying unstoppable growth
and success.
There was a feeling that nothing could
go wrong and then it all went horrifically
wrong beyond anyones worst nightmares,
recalls Warren Hibbert, founding partner
of placement agent Asante Capital Group.
As is typical, GPs bought at the top of the
market and LPs too believed the party
wouldnt end. Theres no question that lessons have been learned by all participants
GPs and LPs alike. In the aftermath, the
industry has been left with a universe
of gun-shy, sceptical and risk averse LPs
charged with funding what is an illiquid,
risk-on industry which has led to further
polarisation of the market as the brandname mega-cap groups attract capital at an
exponential rate relative to their broader
mid and lower mid-market peer set.
Since then, investors have upped their
level of due diligence significantly, he confirms. More than ever, LPs are determined
to back the right GPs. But what is the best
way of doing that? When all is said and
done, the two fundamental areas that we
and LPs spend time on are the track-record
and the team and the strength of the relationship between the two, says Hibbert.
On the one hand, this is very straight
forward, he says: you start with the track
record. One of the first things an LP would

do when considering a manager is to go
through their previous results. How well have
they performed? How consistently have they
performed? What have they done to generate performance and is that sustainable in
a market that continues to become more
efficient? And finally, is it the same team that
has delivered these results? On the other
hand it becomes considerably more complex
as LPs dont have enough time or bandwidth
to assess every team member and visit every
portfolio company to form a clear assessment
on every fund they review.
So while asking the above questions is a
good starting point, finding binary answers
wont necessarily provide enough insight to
make the right choice of manager. Fundamentally the answers are derived using retrospective data points in trying to assess future
outcomes.Take first-time funds, for instance.
Many LPs say they would categorically never
consider a first-time manager and will be
quite nervous to commit to them. But they
can often be a great bet, says Hibbert.
The good thing about maiden funds is
that they wont have any legacy issues or
investments to deal with; they are driven,
focused and very motivated. After all, its
do-or-die for them and hence they tend
to also appreciate the symbiotic nature of
the GP-LP partnership.
A STELLAR STRATEGY
Understanding and assessing a GPs particular strategy is vital. In an ever more

competitive fundraising environment, GPs
are keen to commit to funds that have a
KEYNOTE INTERVIEW: ASANTE CAPITAL
39
focused strategy and rightly so, says Hibbert. Everyone is looking to differentiate
themselves, whether it is by having a specialist operating team or by targeting a specific
sector or sectors where they can generate
significant alpha.
Sector funds particularly in the healthcare, financial services or energy sectors
can work well and appeal to many LPs,
but the pressure for sector-focused GPs is
always much higher, Hibbert says. Theres
more portfolio risk associated with investing in just one sector primarily because it is
less diversified and hence, specialist teams
need to show that they can generate a better
return than their generalist peers across
similar assets. If the generalists are beating
you on performance then theres no point
being a sector-focused firm.
While strategy is clearly important,
the quality of the team and level of performance still trump everything else, he adds.
LPs want a diversified portfolio of funds.
They therefore like to back funds in different regions and sectors, but if you are an
amazing team generating consistent returns,
within reason, it doesnt matter what kind
of investments you make or where you
make them, he says. If theres a team that
has delivered a return of 6x across each of
the last four funds and happens to be based
on the moon, LPs will make every and any
exception to ensure theyre in that fund.
If theres a
team that has
delivered a
return of 6x across each
of the last four funds and
happens to be based on
the moon, LPs will make
every and any exception
to ensure theyre in
that fund
plays perhaps the biggest role in persuading

LPs that interests are indeed aligned, says
Hibbert.
An agreement between an LP and a GP
is like a marriage contract, so for LPs it is
fundamentally a question of whether this is
a group of individuals they know and trust
to do what they say they will do.
Looking at the ownership and carry/
compensation structure is important
which can of course differ depending on
the firm. LPs can get comfortable with
the founders owning most of the firm if
there is evidence that the rest of the team
are aligned relative to their future input,
as reflected in the carry distribution. he
A HAPPY MARRIAGE
says. LPs will inevitably be concerned about
The need for alignment of interests is a whether the key team members are aligned.
common refrain from investors, and assess- LPs dont like team turnover as a rule. In
some instances team turnover is justified,
ing a funds team structure and dynamics
particularly when a new PE house is starting off and there can be a phase of upgrading the team, but at the end of the day LPs
want to see the core team aligned and those
current and future rain-makers retained
and motivated to perform.
Looking at the GP commitment can be
another method of sussing out the better
performing GPs, says Hibbert. GPs with a
higher commitment are typically hungrier
to make it work and confident in their ability to do so. They dont have an attitude of,
Well, lets give this a shot. No, they are very
determined to succeed. LPs know this and
love it therefore when GPs are investing
a material chunk of their personal wealth
in a fund.
Since the 2008 financial crisis, GP
commitment levels have increased, he says.
Many GPs used to try and get away with one
percent, but very few funds we raise have
a GP commitment of less than 3 percent.
One of the groups we worked with recently
has an ambition to eventually be the largest
LP in their funds through reinvesting carry
earned. From an LPs perspective, this is a
fantastic philosophy because it is the ultimate alignment.
These are just a few of the key factors
investors focus on during the manager
selection process. But there is unfortunately no secret recipe for finding the
best fund manager, says Hibbert.Why not?
Because, at the end of the day, there are
very few GPs that are close to perfection
largely because the model is predicated
upon the strengths and weaknesses of
human beings. n
GP-RELATED ISSUES
40
US OIL & GAS
When crude is down

With caution for even lower oil prices, the focus for
US private equity firms is now on buying, writes
Gregory DL Morris
As private equity investors and fund managers look ahead to 2015 and beyond, many
in the oil and gas sector believe that a propitious window is opening for the sector.
In the US, domestic production is surging
as a result of unconventional development
technology and methods of extracting
vast quantities of hydrocarbons that were
known but previously not economically
recoverable. That bonanza, plus geopolitical drives to boost production globally have
meant that oil prices have declined sharply.
At the same time, vast capital requirements
remain both upstream for exploration and
production, as well as for the midstream
gathering, processing and transport.
I just got off the phone with an LP who
called me to talk about the price of oil, says
Frost Cochran, managing director of Post
Oak Equity Capital. Far from being concerned about the lower price, he was asking
about how many great openings there were
in the sector as a result. Our LPs definitely
see the current lower price trend as a
buying window.
It bears noting that while the absolute
price of oil has declined about 20 percent
in the two months to mid-November most
investors were calculating values for deals
or holdings at just about the current price.
I dont know any fund that underwrites
long-term oil prices of more than $80 to
$85 a barrel, says Cochran.
So the current real price is in the zip
code of what we were planning for anyway.
If oil goes to $60 a barrel, that will be a big
BOTTOM OF THE BARREL
End of day Commodity Futures

Price Quotes for Crude Oil,
West Texas Intermediate
$ per Barrel
01
14
02
14
03
14
04
14
05
14
06
14
07
14
08
14
09
14
10
14
Source: Nasdaq
problem and you will see most PE firms

lock up at that level. But right now PE guys
are not changing their behaviour, unless it
is to move on more buying opportunities.
TOUGH DECISIONS BELOW $80
The 20 percent price drop, notes Danny

Weingeist, Managing Partner with Kayne
Anderson Energy Funds, does two things.
First, it makes wells that were very economic less so, and makes marginal wells
uneconomical. A well generating a 60 percent return could go to 30 percent, but
the producer is still going to drill that well.
The challenge comes, he explains, for the
less attractive wells, and particularly for
the publicly-traded companies with stated
growth plans. The public companies still

use money forward economics: they have
already spent money to lease the acreage
and the infrastructure is in place, so the
question becomes whether to drill or not.
At $80 per barrel, they probably still drill,
but if prices drop further, they may face a
tougher decision.
The second, less immediate effect of lower
oil prices is on lease bonuses for acreage,
Weingeist says. For firms that may have to
reduce their holdings to concentrate more
on core development, that can be a problem,
but lower acreage prices are better for both
companies and investors that have cash and
are in a position to accumulate acreage.
Looking more closely at asset disposals,
whether those are for acreage or for more
developed assets, Weingeist notes that the
first round of such divestitures is usually
driven by negative net cash flow where
capex exceeds cash flow. When that happens, companies will usually raise equity
and/or debt, or sell non-core assets. If oil
prices continue to decline, to below $70
per barrel, you may start to see the another
reason to sell: leverage.
For Kayne Anderson, the change in oil
prices represents a significant pivot point.
Oil had been trading in a fairly narrow band
around $100 a barrel for a considerable
time for such a global commodity with
heavy geopolitical influences. Currently,
prompt trades are re running about $80
per barrel. Selling into strength,Weingeist
says his firm returned approximately $1.5
billion to its investors over the past year. At
$80 per barrel oil, the next two to three
years may be a much better time to acquire
assets.
Kayne Anderson is in the process right
now of raising a $1.5 billion fund to buy
GP-RELATED ISSUES
big assets, including those that are much

more developed than it previously would
have considered. The initial focus will be
natural gas, a sector that has mostly been
out of favor for quite some time.
REPLUMBING NORTH AMERICA
Another significant development in the

energy sector is not so much a change of
direction but an acceleration of privateequity investment in the midstreamgathering, processing, and transportation. For
more than a decade the midstream has been
dominated by master limited partnerships
(MLPs).The largest are well-known names
such as Williams and Enterprise, but there
are many mid-cap and smaller MLPs also.
At the outset, the financial and operating
structure of MLPs suited the midstream,
but now that the vast resources of the
unconventional boom are being quantified, the massive infrastructure that will
be necessary to take those molecules to
market is well beyond the capacity of the
MLPs. The replumbing of North America
will have to be done through the equity
markets, public and private.
MLPs have two challenges, explains
Cochran at Post Oak, first is their risk
capital is scarce because they have high
distributions. They just dont have the billions necessary up front. They cannot be
dilutive to their coverage ratio.
The second challenge is human resources.
MLPs often have very small head office staffs.
Everyone at an MLP is responsible for cashflow, Cochran. Operating personnel in the
field support that cashflow, but people managing construction projects are not bringing in revenue. So the limitations on MLPs
are not just capital but people. That is why
private equity is particularly well suited to
41
energy, upstream and mid.There is a single

If oil prices go to
entry and a single exit. I think the MLPs are
below $70 per
finding the evolving role of private equity
in the midstream very exciting.
barrel, you may
Given this level of enthusiasm, it might start to see the another
seem that there ought to be more transreason to sell: leverage
actions in the midstream than there have
been. Indeed there are, says Cochran, but
in the deal flow and the newsfeeds they are
overshadowed by the upstream deals. We
are in the sector, and lots of other people
are as well. Midstream investment is hap- a barrel. A year or two out was in the low
pening, you just dont hear about it as much. $80s. So now the curve is essentially flat.
The investment banker confirms that
The deal flow is about 6:1 upstream to mid.
To be sure, not every voice is yet a full when people ran their sensitivities, no ones
on bull for the energy sector. Volatility has price deck was $100, so in that sense not a
been very high for oil, and I dont know that lot has changed, at least on paper. But you
it is going to be much lower by the start of definitely notice that the decline in prices
2015, so the near-term outlook is unclear, has taken a lot of enthusiasm out.
He is also circumspect about the much
says the managing director of an investment
bank that advises private equity in energy. heralded capital needs for oil and gas. To
be sure, hundreds of billions will need to
While the changes have been precipitous, he
notes that all we are really seeing is the end be invested upstream and mid, but no one
of a steeply backward-dated price curve. It has to write a check for the whole thing
was only ever the near month that was $100 tomorrow.
The consensus among investors, managers, and advisors is that opportunities
abound in North American oil and gas for
2015 and the following few years.The heady
rush days are over where operators were
content to pay $12,000 an acre for leases and
$12 million a well, and investors were happy
to back them at those levels. And while the
headlines are featuring the word slump for
oil prices, private equity is reading that word
to be sale, as in discount prices for decent
goods. Bearing in mind the risk that further
erosion in oil prices would put serious pressure on profitability for many operations, the
current levels of pricing, capex, and operations are broadly considered a solid chance
to buy into softness. n
Weingeist: marginal wells become uneconomical
KEYNOTE INTERVIEW: PACIFIC EQUITY PARTNERS
42
PERFORMANCE
The importance of persistent returns

The best GPs will be
defined by persistently
high returns; the challenge
is to find the right business
model to achieve this
outcome in the markets in
which you compete, Pacific
Equity Partners founder
Tim Sims argues
Sims: LPs have a clear way of testing for

persistency
The Global Financial Crisis of 20082009

put hard questions to the business community. Private equity was no exception.
In particular, it showed that returns from
private equity are far from inevitable. In
response LPs have had to become smarter
and more discriminating about where they
place their money within the asset class, and
this has had a profoundly negative impact
on many GPs.
Inevitably there has been a critical focus
on what it takes to succeed in an environment where in many markets around the
world the level of competition and capital
has increased by an order of magnitude.
The unsurprising secret is for GPs to
demonstrate high returns consistently.
Persistent high returns are the goal
of both LPs and GPs and it is a crucial
thing to select for in private equity in particular, where the range between the best
performers and the worst is very large,
Tim Sims, managing director at Pacific
Equity Partners (PEP), explains.
Because of that, it is very important to
make good selections and the objective of
good selection is to select people who make
high returns, and persistently so. The reason
for that obviously is that both parties invest
in the relationship it is quite a costly exercise to select a GP and once you select a
GP, if they provide superior returns that are
persistent, that is very, very positive. If it is
indeed achievable, it becomes the ultimate
goal of good investors.
The importance of providing good
returns consistently is becoming more
evident as competition for investor support increases globally. The ratio of funds
in market to closed funds is markedly worse
today than it was in 2008, Sims adds. Today,
there are 3.3x the number of funds on the

road versus closed funds that figure was
just 2.1x in 2008 and had been reasonably
consistent at around 2x since 2005, according to data sourced by Bain & Company.
The level of competitiveness in many
markets around the world is intense, Sims
says, citing GrantThornton data that shows in
North America, 40 percent of GPs surveyed
believe that prices are going up, with only
50 percent believing they will stay the same.
In the Asia Pacific region, dry powder
levels continue to rise. There was $138 billion of uninvested equity capital in Asia Pacific
at the end of 2013 a 52 percent increase
from the $91 billion left at the end of 2009,
according to the Bain research.
RARE QUALITY
Unfortunately, the world today is not an easy

place to generate stable returns. Not only
are persistently high returns key, but theyre
being sought in a challenging environment
in many markets, Sims believes.
While all firms are striving to produce
high quartile funds, there are very few GPs
globally that have been able to consistently
deliver in the top-quartile over the course
of a few funds.
According to Bain, there is a 35 percent probability that a manager of one
top-quartile fund will follow this success
with another top-quartile vehicle, and a 65
percent probability that the GP will return
with a first- or second-quartile fund.
To my mind those numbers are surprisingly low, comments Sims. It suggests that
statistically, a high level of performance consistency is a rare quality.
And as GPs scramble for investor commitments, LPs are making it even harder
KEYNOTE INTERVIEW: PACIFIC EQUITY PARTNERS
43
honing their own skills and expertise when

it comes to fund investing.
The best LPs [are] asking very probing
questions about the way in which GPs go
about assembling their investments and what
their track records are. The market is learning, [although] it is still not universal that LPs
have a clear way of testing for persistency.
What the most sophisticated LPs are
doing is making it their business to understand in detail what the investment model
is that is being pursued by the GP and what
the competitive circumstances are. This
often yields a much better predictor for
future results than historical outcomes,
where high performance is not always
repeated. This is particularly true when it
comes to pulling apart the impact of the
global crisis on the GP model.
THE RIGHT COMBINATION
A repeatable model to generate returns

may not be easy but it isnt impossible,
insists Sims, whose firm takes a systematic
approach to investing.
Looking at the firms that have consistently superior results, they overwhelmingly
have certain characteristics in common.
They tend to be middle market players,
focused on careful asset selection and performance change. Those might seem to be
clich or trite observations, but they are
really important.
The fundamentals such as market segment and asset selection cannot be ignored,
but GPs must have the ability to change
performance fully developed if they are
to pay market price and still produce high
returns. Sims explains that the point of
differentiation for a persistently high performance player is what they actually do to
add value this is what makes them capable

of systematically and frequently extracting
high returns from businesses that they have
just paid a competitive market price for.
The critical points of difference come in
the area of asset selection for persistent
players, they need to know what theyre
looking for that gives them a repeating
opportunity for high returns. So there
needs to be a very clear sense of what the
source of value-add is.
PEP itself, he explains, chooses businesses that are under-achieving their full
potential, and hones its internal skills to
make operational changes in those businesses. We look to take on the underperformance risk in these businesses Sims says.
In companies that are focused on the
practical process of adding value, it is very
likely returns will come from increasing revenue through product innovation,
pricing and product differentiation; or
improved efficiency, which shows up in
margin expansion.
If you look at our experience over the last
16 years, over 80 percent of the value weve
been able to add has come from these areas.
There is an 85 percent probability that the
business will return between 2 and 3x the
money.With experience, in a learning culture,
these probabilities improve He adds.
SUNNY DOWN UNDER
Globally, competition for assets is fierce, and

economies are subject to ever-increasing
volatility. But Sims argues that happily for
PEP, the current environment in Australia
for private equity is one of the best around.
Australia and New Zealand are quite
fortunate on a number of key dimensions.
They are far away, and relatively isolated
Statistically,
a high level of
performance
consistency is a rare
quality
from a number of other financial centres. It

is a significantly sized market, and one that
has unique taxation and business structures
that make it quite difficult for outside investors to invest from a distance. The track
record on this front is quite telling to date,
as a matter of fact, it has been difficult to
get good returns out of this market whilst
investing from a remote location.
Sims explains that more traditional and
stable market conditions have helped PEP
secure sensible prices in the Australian and
New Zealand mid-market.
What that means is the middle market
here has persistently, and for a long period
of time, had a good supply of competition,
a relatively well-managed supply of capital
in the context of quite a traditional, creditbased bank lending structure, and as a result,
buy-in multiples in the mid-market have
tended to be more modest than in other
markets.
And while LPs lose sleep over volatility
in Europe or emerging markets, Australia
offers itself as a reliable alternative for their
private equity allocations, he says: The primary drivers for growth in Australia and
New Zealand are secure and sound. So one
would expect, as has happened historically,
that Australian stability and growth are at a
premium to many economies in other parts
of the world. n
GP-RELATED ISSUES
44
IMPACT INVESTING
Investor demand is the key to change

In 2015 it will become clearer that impact investing
is a fast-growing part of the financial sector, writes
Shelley Morrison
The arrival of social impact investing in the

financial mainstream, and private equity in
particular, has been announced so often you
might be forgiven for thinking the recording
is stuck on auto-repeat. Investment styles
driven by traditional financial metrics seem
to be as dominant as ever they were. Has
anything changed? The answer is: a lot has
changed, and a lot more will change in 2015.
You just have to know where to look.
The biggest change that will be visible
in 2015 is a change in the pattern of investor demand. The fact that there is a huge
amount of Millennial capital in the investment pipeline as much as $41 trillion
over the next 40 years, according to the
World Economic Forum is well known.
It is also well understood that a lot of that
inherited wealth is likely to flow into some
kind of impact investing investment that
looks for positive social impact as part or
even all of the return on investment. But
the Millennial shift is a long-term shift.
What is less well understood is that there
are also shorter-term factors at work that
are going to push impact investing closer
to the financial centre-stage more quickly.
Demand is the key to change. We know
there is still no shortage of demand for what
private equity has always done best, which
is transforming businesses for profit. So
why would the industry need to add social
impact investing to its product mix?
That is not a minority viewpoint. If conventional money managers still see impact
investing as at best a niche, private equity
is already taking it beyond the niche. Many
general partners recognise that reputation is probably the single biggest barrier
to growth in the industry, and that social
impact is likely to be part of the solution in
their own portfolios. According to Michele
Giddens of Bridges Ventures, which invests
growth capital in companies making a positive social impact: There were some early
movers [in private equity] who backed
Bridges; but now we see increasing interest
in impactful investing. Some of the worlds
largest firms are asking us how to achieve
and measure social impact.
LPS MEAN BUSINESS
Giddens: governments everywhere have big

financing problems
One reason is because impact investing

answers one of the biggest problems private equity faces the problem of reputation. Businesses are just not as keen as they
should be to enter private equity deals.
Deal flow is certainly down, said Garry
Wilson of private equity house Endless at
the recent annual summit of the British
Venture Capital Association (BVCA). Why
is it down? Well, we certainly still have a
reputational issue. And the reputation we
have is one of the things that is depressing
the deal flow.
Demand from the managers of funds is one

part of the impact investing story, but it is
probably not the most important part. In
the end, it will be demand from the providers of capital that counts.
The shape of that demand has been
changing for some time, but one of the
many effects of the global financial crisis
was to draw a line under some old assumptions about how investment should be managed. Hands-off investing where private
capital simply lets fund managers do their
mysterious thing is out of fashion for the
very good reason that it turned out not to
protect capital, let alone produce returns.
Classic investment styles and themes
are out of fashion too, for the same reason.
Todays investors tend to want to know a lot
more about the assets they invest in, and they
want to exert more strategic influence on the
companies they back, through direct investing,
GP-RELATED ISSUES GP ISSUES
45
co-investing, or through activist managers

who share their value set. Impact investing
is tailor-made for this emerging approach.
There has been a change in attitudes
to asset classes too a change that downgrades the whole idea of investment defined
by asset class. Equities, private debt and sovereign bonds have all proved disappointing
over the last ten years, and today there is
no traditional asset class that offers decent
returns. Todays and tomorrows investors
are going to want strategies that arent stifled by asset-selection dogmas, strategies
which find return in unexpected places.
Social impact is certain to be part of
those strategies. One good reason for that
is that governments cannot afford for things
to be otherwise.Take Europe: the overhang
of debt is set to grow exponentially if the
governments of the near-stagnant Eurozone
cannot find creative ways of financing their
social needs. In the UK, the debt is already
with us, and the government recognises that
co-investing to achieve social targets is not
only desirable, but also a survival strategy.
Europe is not alone: this is a global issue.
Governments everywhere have big financing
problems, Giddens of BridgesVentures told
the recent BVCA summit in London. They
cant afford welfare, they cant afford the transition to the green economy.They have to look
beyond their own resources that is why we
have already seen the UK for example introduce a social impact tax break for investors.
Tax incentives and returns on defined
targets through social impact bonds are
going to be part of the policy mix that will
support impact investing. But in the future
it may not be called impact investing any
more it may just be investing. Plenty of
the things that look like impact investing

today happen to point in the direction the
economy is moving anyway. Sustainable
products, housing, health and social care
for ageing societies, renewable energy, and
education these are all things that society
needs and in some cases is still learning
how to pay for. One way or another society
will have to make investing in these sectors
attractive, and it may well turn out that
many of the investors who back businesses
in these sectors would be surprised to learn
they are social impact investors.
INCREMENTAL BUT FUNDAMENTAL
But there will be more self-described social

investors too, and they certainly wont all
be concerned individuals. Institutions will
also come out of the closet. People used to
think venture capital would never produce
Photo by: Landov
Cohen: in the beginning, investors didnt

believe in venture or private equity either
Some of the
largest private
equity firms are
asking us how to manage
social impact investing
a return, says Sir Ronald Cohen, Chairman of the G8 Social Impact Investment
Taskforce. Pension funds wouldnt invest
in venture capital or private equity. But all
that changed, and it will happen in impact
investing too. In the US some foundations
are already saying that they want 100 percent allocations to impact investing.
Total impact investing strategies are some
way off in Europe. More to the point, they
are probably not the characteristic pattern
for the future anyway. Social impact investing
will not be the dominant mode of investing,
either this year or in the foreseeable future.
But in 2015 it will become clearer that
impact investing is one fast-growing part
of the fabric of the financial sector.
Many of the most important changes in
the way the world works arrive not as sudden
revolutions, but by incremental change, and
often by stealth.That is the pattern that social
impact investment is following. The changes
that we will continue to see in 2015 are
gradual, and sometimes unexpected but
they are fundamental changes all the same. n
Shelley Morrison is a Director in the RBS
Financial Institutions team, which provides banking solutions to the fund and wider asset management sector from offices in the UK, Jersey,
Guernsey, the Isle of Man, Luxembourg and Dublin.
GP-RELATED ISSUES
46
ESG IN AFRICA
Enhancing financial returns

African managers using ESG are reinforcing the notion
that incorporating ESG should not be regarded as
secondary or compliance-driven, but rather as good
business practice, writes James Brice
Nairobi, Kenya: investing in the demographic dividend a must
How GPs view ESG in emerging markets

such as Africa is starting to change, for the
better. Until now, private equity groups have
adopted one of two approaches: one is the
impact investor, who has raised money off
the back of a promise to maximise social
impact, while preserving investors capital
(7 to 8 percent returns). The other is the
commercial investor, who promises to do
no harm while maximising financial returns
for themselves and their investors (usually
targeting 25 to 40 percent return on equity).
The limitation with these approaches is
twofold: one, the GP is following the ESG
philosophy of the LP without applying the
creative rigour necessary to extract maximum commercial value from ESG. As a result,
ESG projects remain undercapitalised, inadequately measured and usually allocated to
junior staff. As long as they are doing the
minimum to keep their LPs happy and to
secure the next fund, most GPs prefer to

stick to the commercials.When it comes to
conferences, its easy to pull out numbers of
jobs created or taxes paid to provide a sufficient good-feel factor for most stakeholders.
The second limitation is that neither
investment is building truly sustainable and
competitive investee businesses. Not harming
the environment; not limiting human rights;
not killing workers, and not breaking the
law might save an investor some downside
pain, but it hardly shifts the needle on the
companys P&L. Progressive companies in
Europe and the US have learnt from five
decades of sustainability theory that appropriate adoption of ESG results in a new level
of strategic competitiveness. African SMEs
should be benefitting from leapfrogging this
learning curve. And private equity fund managers, with their teams of ivy-league MBAs,
are well positioned to facilitate this.
A NEW APPROACH TO CAPITALISING

ON ESG
What has begun to emerge, however, is

a hybrid approach wherein significant
enhancements to exit valuations can be
achieved by incorporating ESG improvements into the financial investment thesis.
These investors are taking the initiative
themselves and going beyond the minimum
requirements of their LPs by embracing
ESG opportunities strategically to enhance
their financial returns. In other words, they
are going beyond just keeping the LPs happy
enough to secure their next fund rather
they are creatively exploring new ways to
capitalise on Africas low hanging ESG fruit.
In emerging markets such as Africa,
listed and unlisted companies are coming
off such a low ESG base that any investment
into ESG has a ring-fenced ROI of three to
four times that of the commercial returns.
Research performed by EBS over 12 years
in Africa has consistently demonstrated
that ESG projects generally have a payback
period of less than 18 months.This rule-ofthumb has held true, even in the relatively
capital intensive energy conversion projects
in South Africa where the electricity cost is
roughly half that of the rest of Africa.
Instead of simply complying with gender
equality to fulfil an investor or moral duty,
companies such as Safaricom are mining
critical market intelligence from their
female employees and women-focused CSR
projects to sustain their 85 percent market
share, despite rampant competition.
Mining and agricultural companies are
going beyond the International Labour
Organisation (ILO) standards with regard
to worker housing. Instead, they are building mixed-used commercial and residential
GP-RELATED ISSUES
47
complexes. Housing allowances are beginning to finance staff assets which are resellable on termination of employment, significantly lowering staff turnover, but also
ensuring better maintenance of the housing
assets and enhancing worker productivity.
ISP funds are winning licenses for their
fibre optic cables on the back of research
which shows that a 10 percent increase in
bandwidth results in a 1.2 percent increase
in GDP.
Of 35 first-time
managers in
Kenya, all are
looking for money from
the same pool of DFIs,
all of whom rate ESG
as important
OTHER BENEFITS IN GETTING

ESG RIGHT
Investing in ESG earlier in the due diligence

process allows GPs to be better informed
about the political, financial and socio-economic challenges in Africa earlier in the
investment cycle. Too many GPs conduct
the ESG DD too late in the process to affect
valuations, and usually only once the legal,
tax and financial DDs have given the allclear. This often leaves the ESG team with
limited time in which complete their work
before going to the Investment Committee.
In land deals, for example, too often
the onus for the clearing of settlers from
the land is placed on the seller, who has
little interest in forcibly evicting settlers
according to UN Human Rights standards.
In Zambia, Nigeria, and many other countries, an eviction order can be secured in
two weeks from a magistrates court without any requirements for consultation or
compensation, to enable a seller to sell the
land unencumbered. These cases would
make interesting headlines back in Europe
or wherever the funds being used to purchase this land originated. Getting ESG
right means that the costs of relocation
and compensation can be factored into the
purchase price of the land, and lowered

by as much as 80 percent but only if ESG
expertise is brought on board early enough.
As more GPs compete to raise money,
transparency on investment screening criteria becomes an important differentiator. Of
35 first-time managers in Kenya, for example,
all are looking for money from the same pool
of DFIs, all of whom rate ESG as important as financial performance. GPs who are
better able to differentiate their management
approach for example by implementing an
ESG management system before going on a
roadshow, rather than promising to do so
once the fund is closed are received more
favourably by investors.
Some investors, particularly those in
the US, are late-starters in attempting to
understand these markets. Carlyle closed
its first African deal in 2012 and KKR a few
months ago. China and India are already
well established in Africa and have been
actively investing on the continent for more
than 50 years. Numerous surveys are being
conducted by Chinese state departments to
gauge African sentiment towards Chinese
companies, products and people.
Africas emerging middle class is the
largest, but most under-researched middle

class market in the world. Terms such as
middle class need to be understood in an
African context. South Africas middle class
is classified as household breadwinners who
earn $350 (R4,000) a month. This translates into $11 a day, which is uncomfortably
close to the United Nations poverty line
of $1.25. This demographic dividend, the
vital ingredient to Africa boasting six out
of 10 of the highest growth economies in
the world, lacks any tertiary education or
assets, takes monthly short-term credit to
make ends meet at interest rates in excess of
60 percent, and is highly vulnerable to inflation.Youth unemployment is at 65 percent.
And thats in South Africa. Further north, the
situation is not much better.
EVERYONE LIKES A GOOD STORY
Making astronomical returns in Africa

comes with a moral imperative to do so
responsibly.The reputational risk associated
with getting this wrong is something that
is top of mind for most developmental LPs.
These are delicate markets which cannot
be viewed from afar. Too many fund managers, their advisors and associations all
with a dedicated African focus have no
offices on the continent and operate from
the comfort of London.
Those who want to invest in African
countries need to invest in understanding
the markets which will drive this growth. At
this stage in Africas development, therefore,
ESG is a non-negotiable critical success
factor for any PE manager. n
James Bryce is CEO of EBS, a specialist ESG
consultancy to the financial services sector based
in Randburg, South Africa.
DATA ROOM
48
Holding fast
IMF forecasts lacklustre
growth for 2014/2015
Macroeconomic growth may not be the be-all
and end-all for private equity, but a robust
economic climate definitely doesnt hurt.
While figures from the International Monetary Fund (IMF) suggest a modest increase
in growth rates in 2015, the predictions may
not be quite what economists had hoped for.
Emerging markets have not had as good a
year as anticipated.The current growth forecast for 2014, released in October, is 4.4 percent, down from 4.7 percent in 2013.This is
expected to pick up to 5 percent in 2015. In
some regions, geopolitical issues clearly took
a toll. In July 2013 the IMF predicted growth
of 3.6 percent in the CIS region in 2014; the
current projection for 2014 is 0.8 percent,
creeping up to 1.6 percent in 2015. Russias
economy is expected to grow 0.5 percent in
2015, up from 0.2 percent this year.
Advanced economies paint a slightly
brighter picture, with anticipated cumulative growth of 2.3 percent in 2015, up
from 1.8 percent currently forecasted for
2014. Projected growth for the UK this year
is 3.2 percent, up from 1.7 percent in 2013.
However, this is expected to slow to 2.7 percent in 2015. US growth held steady from
2013 to 2014, posting 2.2 percent each
year. Its economic recovery is expected to
continue into 2015, expanding 3.1 percent.
The Eurozone is expected to see cumulative growth of 1.3 percent in 2015, up from
0.8 percent in 2014. However, the IMF warns
the probability of the Eurozone re-entering a
recession in the next six months is 38 percent.
Given the IMF has repeatedly revised
down its projections over the last four years,
even these fairly conservative growth figures could prove too optimistic.
Private equity may have its work cut out. n
PREDICTED YEAR-ON-YEAR GDP GROWTH IN 2014/2015 (%)

PREDICTIONS
2012
2013
2014
WORLD OUTPUT 1/
3.4
3.3
3.3
2015
3.8
Advanced Economies
1.2
1.4
1.8
2.3
United States
2.3
2.2
2.2
3.1
Euro Area
-0.7
0.4
0.8
1.3
Germany
0.9
0.5
1.4
1.5
France
0.3
0.3
0.4
1.0
Italy
-2.4
-1.9
0.2
0.8
Spain
-1.6
1.2
1.3
1.7
Japan
1.5
1.5
0.9
0.8
United Kingdom
0.3
1.7
3.2
2.7
Canada
1.7
2.0
2.3
2.4
Other Advanced
Economies 2/
2.0
2.3
2.9
3.1
Emerging Market and

Developing Economies 3/
5.1
4.7
4.4
5.0
Commonwealth
of Independent States
3.4
2.2
0.8
1.6
Russia
3.4
1.3
0.2
0.5
Excluding Russia
3.6
4.2
2.0
4.0
6.7
6.6
6.5
6.6
China
7.7
7.7
7.4
7.1
India 4/
4.7
5.0
5.6
6.4
ASEAN-5 5/
6.2
5.2
4.7
5.4
Emerging and Developing

Europe
1.4
2.8
2.7
2.9
Latin America
and the Caribbean
2.9
2.7
1.3
2.2
Brazil
1.0
2.5
0.3
1.4
Mexico
4.0
1.1
2.4
3.5
4.8
2.5
2.7
3.9
4.4
5.1
5.1
5.8
2.5
1.9
1.4
2.3
European Union
-0.3
0.2
1.4
1.8
Middle East and North Africa
4.8
2.3
2.6
3.8
Emerging and Developing

Asia
Middle East, North Africa,

Afghanistan, and Pakistan
Sub-Saharan Africa
South Africa
Memorandum
Note: Real effective exchange rates are assumed to remain constant at the levels prevailing during July 30August 27, 2014. When
economies are not listed alphabetically, they are ordered on the basis of economic size. The aggregated quarterly data are
seasonally adjusted.
1 The quarterly estimates and projections account for 90 percent of the world purchasing-power-parity weights.
2 Excludes the G7 (Canada, France, Germany, Italy, Japan, United Kingdom, United States) and euro area countries.
3 The quarterly estimates and projections account for approximately 80 percent of the emerging market and developing
economies.
4 For India, data and forecasts are presented on a fiscal year basis and output growth is based on GDP at market prices.
Corresponding growth rates for GDP at factor cost are 4.5, 4.7, 5.6, and 6.4 percent for 2012/13, 2013/14, 2014/15, and
2015/16, respectively.
5 Indonesia, Malaysia, Philippines, Thailand, Vietnam.
Source: The International Monetary Fund
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perspectives 2015

What really matters to private equity LPs

Partnering with Best-of-Breed Managers Across the Globe

It was the best of times

Oh, the vagaries of life as a limited partner.

equity investors for this, the 2015 edition of

privat e equit y int ernat io na l

The survey: Future fears

Introduction: Feeling frothy

26 The future of fair value

FEES, TERMS & CARRY

44 Investor demand is the key to change

28 Introduction: Value for money

48 Data room: Holding fast

Private Equity International is published

46 Enhancing financial returns

PRINTED BY: Hobbs the Printers Ltd

no responsibility for the accuracy of

Power comes from being understood.

privat e equit y int ernat io na l

What are the issues keeping private equity investors

ASSETS UNDER MANAGEMENT

What are the issues that institutional

We asked LPs to rank their key concerns

EXPOSURE TO PRIVATE EQUITY

ALLOCATION PLAN IN NEXT TWO YEARS

Source: PEI Research & Analytics

Pioneered The Market

Landmark pioneered the secondary market in 1990 with the rst

Private Equity and Real Estate Secondary Investing

privat e equit y int ernat io na l

The fate of the Eurozone

Asian LPs were most

Terrorism; geopolitical conflict; the threat

MACRO/STRUCTURAL ISSUES THAT MOST CONCERN INVESTORS

At the Cutting Edge

The Debevoise Private Equity Group

privat e equit y int ernat io na l

HOW SIGNIFICANT AN ISSUE IS CHEAP

HOW SIGNIFICANT AN ISSUE IS THE FATE

HOW SIGNIFICANT AN ISSUE ARE TAX AND

But while some LPs suggested this

One interesting aspect of this category

2014 speakers included:

+44 (0)20 7566 5445

privat e equit y int ernat io na l

THE MACRO PERSPECTIVE

centred around stagnation in some OECD

Yet piercing through some of this gloom

The US economy appears to be defying

G20 leaders: concerns about growth, geopolitics

Photo by: Landov

Free sample content available

Highly practical, incisive

Full of unique and compelling

TO SEE THEM ALL, VISIT OUR BOOKSTORE:

THE WORLD IS FLAT

Inflation, average consumer prices (%)

VALUE VS GROWTH IN EUROPE

Peter McKellar, chief investment officer at

privat e equit y int ernat io na l

Source: IMF, October 2014