Download Overview of Public Markets` Investment Process

PE/VC Investing from the Perspective
of Large Long-term Investors
从大型长期投资者的角度来看
私募股权与创业投资
Second Annual China VC/PE CFO Conference
2 September 2011
SUNG Cheng Chih 宋诚之
Characteristics & Examples of
Large Long-term Investors
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Common Characteristics
• Captive relationship with legal asset owner
• Large community of ultimate stakeholders with
formal governance structure
• Low cash outflows relative to fund size
• Investment policy driven by explicit, actuarial
or proxy liabilities
• Generally with real risk/return orientation
• Diversified portfolio across multiple countries &
asset classes, both public & private
• Selective active engagement with investee
companies
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Leading Large Long-term Investors
• Sovereign Funds:
ADIA, CIC, GIC, KIA, NBIM, Temasek
• Central Banks:
DNB, HKMA, MAS, SAFE, SNB
• Pension Funds:
APG, CPPIB, GM, NCSSF, OTTP, PGGM, QIC
• Endowments:
Harvard, MIT, Stanford, Yale
• Foundations:
Hewlett, Wellcome Trust
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Underlying Investment Beliefs
• Risk is a scarce resource that needs to be
allocated efficiently
• Asset allocation drives total investment risk
• Long investment horizon confers advantages
• Scale is a double-edged sword
• Diversification across asset classes, geography,
sectors, issuers & agents works
• Alphas are for real, but hard to find or sustain
• Willingness to forego liquidity is rewarded
• Cost can be managed, less so for risk, and least
for return
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Asset Allocation Process &
Role of PE & VC Investments
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Asset Allocation Practices of LT Funds
• Portfolio construction of most institutional
investors is centered on asset allocation which
accounts for over 90% of total risk & return
• Asset allocation seeks to harness risk premia
embedded in & diversification across asset
classes to meet return targets & risk constraints
• Key constructs include asset class definitions,
allocation targets, proxy & rebalancing rules
• Model usually based on equilibrium assumption
with many variants: liability-hedging, liquidity
cycle, value-driven, multi-factor, risk-parity, tail
risk-hedging & de-risking mechanism etc
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Role of PE/VC Funds in Asset Allocation
• Case for PE & VC investments rests on equity risk
premium, leverage & illiquidity premuim
• Mixed evidence for value-creation through
strategic guidance & management know-how
• Some investors also see benefits from embedded
leverage & smoothing effect on returns
• Diversification argument has weakened due to
introduction of fair value accounting
• Most investors expect 3 to 5% return premium
for PE & VC investments over public equities with
commensurate increase in risk
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Modeling PE & VC Investments
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Search for Common Return Drivers
• Traditional allocation models make simplistic,
static assumptions on volatility of PE and
correlation with public markets
• However observed volatility & correlation have
risen & become more unstable in recent years
• Investors are now keen to understand common
risk/return drivers for both publicly & privately
traded assets through quantitative models
• Such models generally try to decompose return
of private asset into systematic publicly traded
component and specific private component
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Alternative Private Asset Risk Models
• Risk/return of private assets can be modeled
by publicly traded assets in multiple ways:
a) equity of individual listed firms (proxies)
b) equity and bond indices
c) fundamental (e.g. Barra-type) factors
• For example, under b), return Ri of i-th private
asset can be decomposed as
Ri - rf = ∑j βij(Mj - rf) + Ai
Ai = ∑k θik Nk + Si
where Mj = return of j-th equity or bond index,
Nk = return of k-th non-public factor, Si =
specific return of i-th asset & rf = risk-free rate
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Uses of Private Asset Risk Model
• Private asset risk models generally work better
at aggregate level than for individual assets
• Models shed light on both drivers for PE & VC
investments and linkages with public markets
• Integrated risk models give holistic view of
total portfolio risk and allow risk budgeting &
stress testing tools to cover private assets
• Such models also provide fairer basis for
evaluating value-added from manager skills
• But gap between theoretical MTM-based risk
models and observed PE/VC valuation remains
hard to bridge
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Modeling Commitments & Draw-downs
• Investors traditionally used rules-of-thumb to
manage pace of commitment versus fixed
allocation targets based on market value
• Recent crisis highlighted multi-faceted liquidity
risks such as inability to rebalance or to meet
capital calls
• Yale Model provides deterministic baseline
forecasts of capital contributions, fund
distributions & NAV based on historical data
• More recent efforts employ stochastic models
to estimate statistical dispersions of cash flows
& NAV with emphasis on distress scenarios
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Selection of PE & VC Funds
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Key Evaluation Criteria
• Track record
• Portfolio composition
• Succession plan, turnover and depth of team
• Reference checks
• Fund terms
• LP list
• Investment strategy and value-add
• Risk/return profile
• Disclosure and portfolio information
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ILPA Private Equity Principles
• ALIGNMENT OF INTEREST: carry/waterfall;
fees & expenses; term of fund; GP fee income
offset; GP commitment
• GOVERNANCE: investment team; investment
strategy; fiduciary duty; changes to fund; role
of LPAC
• TRANSPARENCY: management & other fees;
capital calls & distribution notices; disclosure
on GP; risk management; financial information;
LP information
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Concluding Remarks
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Emerging Trends & Implications for GP
• BAD NEWS: Among large long-term investors,
there is a gradual but persistent shift away
from fund & co-investments towards in-house
direct investments
• GOOD NEWS: Geographically, allocation to
emerging markets is rising steadily for both
public & private investments
• RISING BAR: Investors are raising demands for
portfolio look-through & greater disclosure
• UNDECIDED: Meanwhile, debate lingers on the
true value-add from PE & VC investments over
(leveraged) public equities
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Long-term Differentiation Strategy
• For far-sighted GPs looking to build sustainable
businesses, the fostering of open, trusting &
mutually beneficial relationships with large
long-term LP investors is key.
• To this end, good understanding of evolving LP
thinking on asset allocation, risk, liquidity &
valuation issues can offer GPs a distinct edge
• Furthermore, GPs who are pro-active in
providing more data & valuation transparency
and willing to help GPs solve their problems
will stand out above the crowd in the new
world of co-opetition
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Q&A
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