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Contents
Introduction
05
08
13
16
19
22
24
28
32
35
39
43
50
55
56
61
67
73
79
83
88
89
Notes
90
4 towerswatson.com
Introduction
A fresh approach
We begin by outlining a fresh approach to
private markets investing, which breaks down
asset class barriers and instead focuses on
the two primary reasons for making an illiquid
investment: return enhancement (alpha)
and diversification/capital protection (beta).
We advocate a holistic approach to illiquid
investments with a clear demarcation between
alpha and beta strategies. We also introduce
the concept of Adaptive Portfolio Management
which, compared with a traditional approach,
pursues a more thematic and flexible method of
constructing a private markets portfolio based on
the medium-term outlook for various sectors and
regions. The key features of this approach are
its adaptability to the rapidly-changing economic
environment and the prioritising of investment
strategies to optimise the risk-return profile of
long-term investments. In our view, the flexibility
of this approach is essential to achieve long-term
success in private markets investing.
6 towerswatson.com
Fees
We approach the issue of fees by disaggregating
total returns from the effects of beta, leverage
and management fees/carry by establishing a
framework for identifying true net alpha.
We also consider how to benchmark the
performance of private markets investments
a process which is notoriously challenging, but
extremely important given it both determines
success or failure and influences the remuneration
of individuals responsible for the investments.
Investment themes
One of the key tenets of Adaptive Portfolio
Management is a thematic approach to long-term
investing. We spend a substantial portion of this
publication exploring various investment themes
which may potentially be of interest to investors.
We consider the investment universe from a
strategic, global and regional perspective.
Strategy
In terms of strategy, we explore investors increased
interest in secondaries and co-investments and
outline our outlook for the future in these strategies.
We also discuss popular credit-related strategies
such as distressed debt and mezzanine. We assess
a number of broader macroeconomic themes that
could offer both potential return enhancement
and diversification, such as renewable energy,
agriculture, timber and natural resources.
Investment trends
We go on to explore the key investment trends
in the developed markets of the US and Europe,
which are arguably now creating more interesting
opportunities for investors than ever before. In
addition, private investments in emerging markets
have moved from the margins to the centre of
investors thinking. We focus on opportunities
in China, India and Brazil as well as the nascent
markets of Turkey and Africa. While all these
geographies provide interesting macro cases in
the longer term, finding skilful alpha generators
is far from straightforward. We encourage
caution and selectivity.
These articles serve as a useful starting point for
applying Adaptive Portfolio Management to private
markets programmes, which will enable investors
to position their private markets portfolios for
long-term success through a combination of
robust top-down and bottom-up selection
of investment opportunities.
Section one
8 towerswatson.com
10 towerswatson.com
Figure 01. Examples of alpha and beta portfolios using a thematic approach
Beta
Alpha
40%
30%
15%
5%
5%
5%
12 towerswatson.com
30%
20%
10%
10%
10%
10%
5%
5%
Identifying beta
It is challenging to disaggregate the underlying
market beta in private markets fund returns, but
it is clear that public market valuations have an
impact on prices and investors should not be
paying performance fees for performance driven
by broader market beta.
The method of identifying the beta proportion of
total returns depends on whether the analysis
is ex post (actual) or ex ante (forward-looking).
The latter simply requires the investor to make
an assumption for the rate of return on the index
that best reflects the underlying risk of a private
markets investment. For example, for a US private
equity fund, you might select the long-term
rate of return expected for the Russell 2000.
14 towerswatson.com
Cash flow
100%
80%
10
60%
40%
-10
20%
-20
-30
120%
0%
1
10
Year
Clawback
-20%
Gross alpha
Catch-up fee
Alpha
Beta
Total return
Tracking error
Total
volatility
20.0%
0%
20.0%
0.0%
0.0%
Return
Volatility
8.0%
0.0%
Expected fee
Expected
fee as a % of
alpha
4.78%
24%
Figure 03. Private markets fees adjusted for beta and leverage
Gross alpha
Cash flow
100%
80%
10
60%
40%
-10
20%
-20
-30
120%
0%
1
10
Year
Clawback
-20%
Gross alpha
Catch-up fee
Alpha
Beta
Total return
Tracking error
Total
volatility
9.3%
10.7%
20.0%
0.0%
0.0%
Return
Volatility
8.0%
0.0%
Expected fee
Expected
fee as a % of
alpha
4.78%
51%
Benchmarking critical to
assess performance
Here we outline the considerations for investors
when selecting benchmarks for their private
markets portfolios. By selecting the appropriate
benchmark, an investor is better able to assess
whether its specific goals have been met through
its private markets programme. It should be
noted that the availability of benchmarks differs
depending on the asset class and geography.
Benchmarking methods
Below we review the types of benchmarks
typically used, discuss the arguments for and
against their use and provide a view as to what
purposes these benchmarks can be applied.
16 towerswatson.com
18 towerswatson.com
How to select
the benchmark
We would argue that
there are two primary
considerations in selecting
a benchmark: which
implementation method has
the investor used to obtain
exposure and whose success
is being measured?
The implementation methods that we consider
are investing via funds of funds, investing directly
into private markets funds (direct funds) and
making direct investments (or co-investments) into
companies, assets or projects (collectively known
as direct investments).
We then consider whose success is being measured:
The private markets manager (defined as
General Partner or GP).
The group investing capital into private markets
after it has been decided to make a strategic
allocation to the asset class (a Limited Partner
or LP for fund investing and Internal direct team
for direct investments).
The group making the decision to invest
in private markets at the strategic asset
allocation level.
Recommended benchmarks
Fund of funds GP: We believe the benchmark
should be driven by funds of funds opportunity
set that is, the performance of all relevant
direct funds available during the years the
manager has to commit its capital. This analysis
should be net of fees in order to check that
the additional layer of fund of funds fees is
not so substantial that it is more than any
outperformance generated.
Investors private markets team: A fund of funds
benchmark is suitable given this is the investors
opportunity set. However, the team should
consider investing in direct funds if it cannot
find high-quality funds of funds, suggesting that
it could be subject to the same benchmark as
the fund of funds manager.
Strategic asset allocation group: We believe the
opportunity cost, or at least a fair representation
of the alternative use of capital, will typically be
an appropriate benchmark.
Recommended benchmarks
The answer is less straightforward than for funds
of funds:
Direct fund GP: First, the manager has to
demonstrate that it can invest the capital
more profitably than an investor could have done
passively in public markets. However, we would
urge caution over this benchmarking metric too
early in the life of a fund. Second, the manager
should show that it is able to outperform peers
(this may not be applicable to asset classes
where peer group indices are not available).
Third, it might be appropriate to consider a
direct (appraisal or transaction-based)
benchmark as an alternative route for
investment. This could be a portfolio of
buildings for a real estate investment.
Investors private markets team: both a fund
of funds and a direct funds benchmark could be
considered by an investor selecting direct funds.
We recommend the direct fund universe as it
is a more comprehensive representation of the
funds the investor could have chosen. For core
infrastructure and real estate assets, an absolute
return benchmark may be more appropriate.
Strategic asset allocation: similar to funds
of funds, the opportunity cost as a fair
representation of the alternative use of
capital should be used as a benchmark
since a private markets portfolio must
demonstrate it can provide a better
risk-adjusted return than any alternative
use of the capital.
20 towerswatson.com
Recommended benchmarks
The appropriate benchmark depends on the
investors mandate and applies to both the
internal direct team and to the strategic asset
allocation group:
For return-seeking strategies, a public market
benchmark plus a premium may be appropriate.
However, we prefer a long-term equity market
assumption if the investor is not subject to
the same need to generate liquidity as a
private equity manager acting on behalf of
third-party investors.
If risk considerations are an important factor
for the investor, we recommend the cost of
capital approach. It is more complicated and
therefore requires significant thought around an
investors mandate, but it will provide a better
reflection of whether the investor is meeting its
specific objectives.
For real estate, a suitable benchmark may be
either appraisal or transaction-based, which
may also be tailored (in conjunction with a
data provider such as the Investment Property
Databank) to match specific objectives.
Figure 04 opposite summarises our views on
the appropriate benchmark considering both the
implementation method and whose success is
being measured.
Despite
GP
LP
Internal direct
team
Strategic asset
allocation
Funds of funds
Direct funds
Direct investments
N/A
or
Appraisal/transactional indices
for real estate
N/A
or
Appraisal/transactional indices
for real estate
N/A
or
Appraisal/transactional indices
for real estate
N/A
22 towerswatson.com
Section two
Opportunities
in distressed assets
The aftermath of Lehman
Brothers collapse
Following Lehman Brothers collapse in September
2008, markets went through the most severe
liquidity withdrawal and repricing of risk ever
experienced in our lifetime. The following two
quarters saw corporate earnings fall significantly
as businesses cut expenditure due to the
heightened sense of uncertainty. This fed through
into further declines in public markets and
further decreased the availability of financing.
Fearing the crisis would lead to a depression,
governments globally provided significant fiscal
and monetary stimulus, leading to a rapid reflation
of public credit and equity markets. For managers
focused on distressed opportunities, this meant
that the opportunity to undertake restructuring or
distressed for control strategies passed rapidly.
Instead, markets witnessed record levels of high
yield refinancing as companies looked to extend
debt maturities and take advantage of yields that
were being depressed by government stimulus.
50
100
150
200
US$ billion
250
300
1996
59
1997
108
1998
130
1999
84
2000
34
2001
79
2002
57
2003
131
2004
138
2005
96
2006
...markets
witnessed
record levels of high yield
refinancing as companies
looked to extend debt
maturities and take
advantage of yields that
were being depressed by
government stimulus.
24 towerswatson.com
147
2007
136
2008
43
2009
148
2010
264
1H2011
164
2H2011
57
Source: Sifma (Securities Industry and Financial Markets Association)
26 towerswatson.com
250
200
196
174
150
156
115
100
80
92
50
0
2011
2012
2013
2014
Source: Dealogic
Real estate
Real estate financing has been a key issue
in the wake of the financial crisis and the
consequence falls in real estate values in Europe
and the United States. It is estimated that there
will be US$2 trillion to US$2.5 trillion in maturing
commercial real estate loans between 2011
and 2018 in the US. The European real estate
financing opportunity also appears vast, with an
estimated 400 billion to 600 billion of debt
needing to be refinanced in 2011 to 2013.
Banks in both Europe and the US are under
pressure from regulators to shrink their balance
sheets, increase the capital held against riskier
real estate loans and reduce the proportion of
non-performing loans on their books. This will
reduce the availability of new debt financing and
may also lead to asset disposals. This may create
opportunities for new lenders to provide financing
at attractive levels. However, we note that senior
debt remains available for high-quality assets let
to good tenants. This may restrict the opportunity
to more junior lending, which is not treated
favourably by new regulation.
A fund manager with strong sourcing, structuring
and operational capabilities could complement
and diversify an investors existing real estate
portfolio. The risk remains, however, that the
commercial real estate markets in the US and
Europe may fall further as macroeconomic
fundamentals remain weak.
2015
2016
Year
...investors
28 towerswatson.com
50
40
45
35
43
40
39
35
41
34
33
30
32
29
27
25
30
25
30
20
23
20
15
10
10
5
0
15
Aggregate commitments
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Year
3.3
3.8
10%
8%
6%
2%
5.7
5.2
5.0
4.8
5.5
6.3
5.6
5.1
4.0
4.0
4.1
4%
4.4
5.5
4.5
4.3
4.5
4.6
4.3
4.5
3.3
2.9
3.7
2.1
2.2
2.5
2.9
0.7
0%
5.3
4.4
4.9
4.9
5.4
1.0
1.6
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Jan-Sep
Year
One
US$ billions
597
500
400
300
306
200
219
176 174
147
100
0
15
25
22
49
81
72
46
72
79
180
60
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Source: ICG, S&P
In
terms of new opportunities, there is typically
a reliance on robust private equity activity, but
capital structure refinancing may also be a driver.
30 towerswatson.com
Year
40
35
40
38
42
30
20
18
19
2003
2004
22
10
0
2005
2006
2007
2008
2009
Source: Preqin
2010
Sep
2011
Year
Investing in renewable
energy infrastructure
Renewable energy infrastructure has become a fertile
ground for investment, as managers are attracted by the
strong yield and diversifying risk profile associated with
these assets. With the market for these assets continuing to
evolve, opportunities exist for investors with access to the
appropriate skill sets to generate significant returns.
What is renewable
energy infrastructure?
Renewable energy refers to the production of
energy by renewable sources.7 The sources of
generation techniques that usually fall within the
renewables category include hydro, wind, solar,
solar thermal, geothermal, biomass and waste.
Renewable energy is set to become an
increasingly important part of the suite of
energy generation techniques globally.
32 towerswatson.com
Trillion kilowatt/hours
2015
2020
2025
2030
2035
Year
Energy security
Geopolitically, renewables have a significant
advantage over traditional sources of fuel as they
are not dependent on foreign importation of raw
materials. Natural resources are often sourced
from areas that are geopolitically volatile: this
includes oil from North Africa and the Middle East,
and oil and natural gas from Russia. Investment
in renewable energy reduces the dependence on
these input resources.
State pledges
Lastly, there are a number of policies agreed
by developed nations that require them to build
renewable energy generation capability. In Europe,
the 20/20 legislation requires 20% of Europes
energy to be sourced from renewable sources
by 2020. The combined targets of the EU in
2009 were at 11.6% (latest data available).
Given that these factors are more prevalent in
Europe than elsewhere and that many European
countries have a developed regulatory regime,
we believe Europe offers the best opportunities
in renewables. In addition, Europes subsidies for
renewables are largely paid by utilities, with the
cost of these then passed onto the end consumer.
However, it remains to be seen what will happen if,
as a result of the shale gas revolution in the US,
Europe starts to import gas not required in the US.
34 towerswatson.com
Agriculture
a strong investment base case
We
not only need to grow an extra one billion
tonnes of cereals a year by 2050 but do so from
a diminishing resource base of land and water in
many of the worlds regions, and in an environment
increasingly threatened by global warming and
climate change.
Jacques Diouf
Ex-Director General, Food and Agriculture Organization of the United Nations
36 towerswatson.com
Billions
1950 1960 1970 1980 1990 2000 2010 2020 2030 2040 2050
Year
700
680
660
640
620
600
580
560
2007/08
2008/09
2009/10
2010/11
2011/12
Year
In
the coming years, population growth is
expected to be driven by developing countries
and internal food production in some of these
countries may not meet growing demand.
Investing in private markets 37
38 towerswatson.com
An inefficient market
40%
30%
20%
10%
0%
USA
South America
Oceania
Other
2006 2009
Source: RMK Timber Group presentation, 2010
Figure 16. Correlation of US timberland returns with other asset classes (1987-2009)
-0.5
US Commodity Index
US CPI Inflation
US Commercial Real Estate
US Direct Energy
US Small Stocks
International Equities
30-day US Treasury Bills
S&P 500
S&P Forests Products Index
US Long-term Corporate Bonds
Source: HTRG Research, 2010
40 towerswatson.com
-0.4
-0.3
-0.2
-0.1
0.0
0.1
0.2
0.3
0.4
0.5
...timberland
can be considered a
portfolio diversifier, tending to move
counter-cyclically to stocks and bonds
and relatively independently of the
real estate sector.
3000
45
2500
40
35
2000
30
25
1500
20
1000
15
10
500
5
0
1987
1990
1993
1996
1999
2002
2005
2008
0
2011
42 towerswatson.com
Natural resources
strong long-term potential
900
800
700
600
500
400
300
200
100
0
1990
2000
2008
2015
2020
Non-OECD OECD
2025
2030
2035
Year
At the same time, supply has increased. Five years ago with spot
gas prices moving above US$13/MMBtu (British thermal unit), there
were worries that the US would have to import liquefied natural gas
from countries like Russia. However, US production of natural gas has
accelerated with shale gas moving from less than 1% of domestic supply
five years ago to about 30% now. Today, the pricing for natural gas is
below US$3/MMbtu and in 2009 US passed Russia to become the
worlds largest producer of natural gas. Government officials are now
thinking of allowing more natural gas exports given how much is available
via new drilling techniques (called fracking) which have created more
initial reserves than anticipated.
Mining follows a similar story to energy with global economic and
population growth in developing countries creating increasing need
for coal in power generation and for iron ore, metallurgical coal and
manganese in the steel industry.
Coal is one of the most demanded resources in the world. For example,
coal use in the US totalled 22 quadrillion Btu in 2008 and accounts for
around 50% of total US power generation. The percentage is expected
to steadily decline with the rise of natural gas and of environmental
concerns but countries like China are picking up the excess supply.
According to EIA, the growth in demand for coal will mostly come from
developing countries, especially in Asia (see Figure 19).
Significant demand growth is expected for key steel industry inputs,
such as iron ore, metallurgical coal and manganese, from developing
countries. China and Indias growing economies and rapidly rising
standards of living have resulted in a surge of urbanisation and the
need for more steel.
Quadrillion Btu
Rest of world
44 towerswatson.com
Year
Outperformance by private
markets managers
Industry
performance
data and Towers Watson
research show that over
the most recent five and
ten-year periods, natural
resource managers have
created about 10% and
20% IRRs, respectively.
...investors
should be aware of
the exposure they may have
to similar assets in their public
equity portfolios and consider
their natural resources
exposure holistically.
Conclusion a good investment
if structured well
Our research suggests that investment in natural
resources has strong tailwinds. In US energy,
there are a number of high-quality private markets
managers who have demonstrated an ability
to produce tangible alpha. The combination
of attractive macroeconomic tailwinds and
a pool of high-quality managers to navigate
the ever-changing investment landscape are
attractive. The mining market offers a similar
macroeconomic dynamic, but a less compelling
manager opportunity set. Non-US investors must
be cognisant of potential tax implications from
FIRPTA and ECI taxes. In addition, we emphasise
that investors should be aware of the exposure
they may have to similar assets in their public
equity portfolios and consider their natural
resources exposure holistically. Manager selection
is particularly critical in such a specialised
strategy. Investors also need to be comfortable
with potential ESG issues in these businesses.
Investing in secondaries
cyclical opportunities
2011 saw the largest volume of secondary transactions
ever closed in private equity, with estimates at around
US$30 billion. With secondary managers currently
looking to raise US$30 billion of capital, we expect
activity to continue. In addition, the last few years have
seen a significant increase in the level of interest in
secondary transactions in real estate, following the global
financial crisis. However, fundraising for dedicated real
estate secondary vehicles dropped off in 2011, having
reached a peak of US$1.7 billion in 2010.16 In this section,
we will examine the secondaries market overall and assess
whether it is currently attractive for institutional investors.
Why secondaries?
Private equity secondary fund investors can
expect similar benefits to investors in traditional
private equity funds. In particular, returns
are potentially superior to those from public
markets: a significant factor that can lead to these
outsized returns is the funds potential to acquire
high-quality assets at discounts to net asset
value (NAV). Additionally, secondary funds mitigate
the J-Curve effect since they possess more
mature portfolios that are likely to return capital
more quickly than a traditional private equity fund,
as well as provide investors with an identifiable
portfolio and vintage year diversification.
Real estate investors can also access investments
through the secondary market. For closed-end
funds, the benefits are similar to those found
in private equity. For open-end funds, the
main benefits are the ability to access and exit
the underlying portfolios in periods of limited
liquidity and, depending on market conditions,
the potential to increase returns through
acquisitions at attractive prices relative to
the underlying assets.
120%
110%
100%
90%
80%
70%
60%
50%
2003 2004 2005 2006 2007 2008 2009
Source: Cogent
48 towerswatson.com
H1
H2
H1
H2
2010 2010 2011 2011
Year
10
11
12
Year
Co-investments
building trust, reducing fees
50 towerswatson.com
Co-investment funds
Across private markets (but particularly in private
equity), co-investment funds are becoming more
widespread. They are typically managed by fund
of funds managers who are able to leverage their
manager relationships and their own expertise
in analysing deals, to offer a fund comprised
exclusively of co-investments. This allows those
investors that do not have the expertise to
evaluate specific co-investment opportunities,
Returns from
co-investment programmes
Towers Watson has reviewed co-investment
returns data from multiple private equity fund
of funds managers and summarised them in
Figure 22. This shows the co-investment
managers returns (realised and unrealised)
against Thomson One benchmarks (top quartile
and median).
The co-investors ability to cherry pick transactions
that they believe will perform better than the
market has led to similar or better performance
in all vintage years with the exception of 2000.
This supports the view that a carefully constructed
co-investment programme can be additive to
overall net returns.
We must emphasise that the co-investment returns
are a gross return while the Thomson One figures
are shown net to capture the fact that direct
co-investors will not be paying fees. However,
if the route to these deals is via co-investment
funds, an additional fee drag must be considered.
Multiple of cost
Figure 22. Comparative returns between co-investment deals and overall private equity market
3.5x
3.2
3.0x
2.5x
2.5
2.0x
2.1
1.8
1.5x
2.1
2.0
1.6
2.0
1.7
1.7
1.8
1.7
1.3
1.2
1.0x
0.5x
1.7
1.5
1.5
1.1
1.3
1.3
1.2 1.2
1.0
1.0
1.0
1.0
1.1
1.0
1.1
1.0
1.1
1.0
0.7
0.0x
2000
2001
2002
2003
2004
2005
52 towerswatson.com
2006
2007
2008
2009
2010
Year
2500
3.5x
3.2x
3.0x
2000
1,963
2.5x
2.5x
2.0x
1500
2.0x
1.7x
1.5x
1.8x
1.2x
1000
1.5x
1.0x
823
0.7x
193
123
157
210
1.0x
520
471
302
1.1x
1.0x
591
500
Multiple of cost
0.5x
101
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
0.0x
Year
...if
investors are keen to build a
co-investment programme, they should
do so on an opportunistic basis.
As can be seen from Figure 23, which shows the median
co-investment return versus the capital deployed in each vintage
year, co-investment activities picked up significantly in the peak
years of the private equity market. Broadly speaking, these
have been the least attractive vintage years from a performance
perspective. The inverse relationship between performance and
co-investment capital deployment supports our hypothesis that
pressure to deploy capital can lead to co-investment capital being
allocated at an unattractive point in the cycle.
There are two interesting conclusions to draw from our analysis:
co-investors have tended to pick deals that have performed better
than the market, but they have also deployed most capital in the
least attractive vintage years. In our view, if investors are keen
to build a co-investment programme, they should do so on an
opportunistic basis.
54 towerswatson.com
Section t hree
Investment themes in
Europe
are the lamps going out?
A tough call
Despite being the longest serving British Foreign
Secretary, Sir Edward Grey is well known for a
single quote: The lamps are going out all over
Europe, we shall not see them lit again in our
lifetime. It was August 1914, and the conflict
that would come to be known as the Great War
was about to envelop Europe in darkness for the
following four years.
Parallels can, of course, be drawn between the
above and todays investment environment in
Europe should investors pull their capital out
of Europe on the basis that fighting against
a headwind of economic Armageddon is an
56 towerswatson.com
billion
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3
2007
2008
2009
2010
2011
Year
Pockets of opportunity
While merger and acquisition (M&A) activity has
slowed down, there are pockets where transactions
are occurring. Tight debt markets have made the
mega and even upper mid-market transactions
difficult for all but the most secure of assets,
and only in the smaller lower-mid market areas
have many private markets managers been
consistently completing deals. For private equity
funds, we would expect to see increased deal flow
58 towerswatson.com
60 towerswatson.com
Private markets
in the US
While
US private equity is
not immune to global macro
factors, and fundraising remains
challenged, we believe there are
significant areas of opportunity
that investors could focus on in
the near to medium term.
62 towerswatson.com
Finding opportunities in a
low-growth environment
64 towerswatson.com
US infrastructure in need of
private investment
Ageing infrastructure in the United States is less
discussed in the investment community than it
should be. Heavy investments were made decades
ago and have facilitated economic development
ever since. However, experts, including the World
Banks chief economist Justin Lin, largely agree
there has been significant under-investment over
time, meaning the US now requires large capital
investment to both upgrade existing assets and
finance new developments. The consequences
of not doing so are clear: infrastructure-related
failures include the Minneapolis I-35W bridge
collapse, the levees breach in New Orleans and
the Northeast electricity blackout.
The American Society of Civil Engineers grades US
infrastructure as a D.21 The breakdown provides a
pretty dire picture for those looking for a quick fix,
such as targeting areas which have Cs and Ds
across the board. While the Societys estimated
five-year investment requirement may look like
overkill at US$2.2 trillion (primarily due to the
fact that the estimate looks at repair cost of
all existing assets), it may not be too far off
if the US wants to keep up with economic and
population growth.22 Take New York City; in 2010,
the comptrollers office stated that 40% of the
roads and bridges were substandard or obsolete,
despite the state having already allocated
US$63 billion to transportation infrastructure
over the past decade.
66 towerswatson.com
Private markets
in China
68 towerswatson.com
number of local funds as well as increasing dollardenominated fund sizes appear to be leading to
heightened competition for private equity deals,
culminating in higher transaction prices and more
modest return expectations.
It also remains difficult to both close and exit a
deal. Many governmental agencies are involved
in approving investments and differing policies
may be applied at the local and national levels.
Exits by public offering on Chinas domestic
stock exchanges also remain tightly controlled
by government regulators who pursue policies
that are not always transparent to investors.
Furthermore, the private equity industry in China
is quite young, meaning it lacks the history and
depth of track records of private equity teams
operating in developed markets. Manager selection
is therefore likely to be more critical in this market
than in developed markets.
70 towerswatson.com
After
a round of home
purchase restrictions and
loan tightening measures
instigated by the central
government in 2010 and
2011 to cool the property
market, property prices
have started falling and
transaction volumes of
residential units have
slowed or stopped in
some towns and cities.
Infrastructure domestic-only
investment policy
Chinas infrastructure market is dominated by
state-owned enterprises. Although relatively young
compared with infrastructure firms in developed
markets, these companies have grown rapidly in
tandem with Chinas economy. They have also
benefited from the governments mistrust of
72 towerswatson.com
Brazil
is investors attention justified?
Historically, private markets investing was dominated by
developed markets like the US and Europe. Over recent years,
this trend has started to change with emerging markets
namely three of the BRIC countries (Brazil, India and China)
starting to move to centre stage.
While China has gained much of the attention,
Brazil has become popular too, as demonstrated
by the record amount of private equity capital
raised in the country. In this section, we will
explore whether Brazils rise in the affections
of private markets investors is warranted.
74 towerswatson.com
In
contrast to US or European
institutional real estate investment,
residential assets are the main focus
in Brazil and commercial real estate
investment is less established.
76 towerswatson.com
...one
With respect to office space, one manager believes that the future rental growth
rates in Sao Paulos office market may decline as the market is becoming saturated,
which could lead to increasing vacancy rates.
As with real estate in other regions, regulatory and permit risks are significant.
Managers also typically depend on local developers to act as joint venture partners.
The local developer will be responsible for obtaining permits and approvals and
will put in a higher percentage of equity capital, thereby aligning its interest with
investors. Although this structure provides access to local knowledge and expertise,
it can introduce another layer of costs and managers will need to have appropriate
controls and monitoring systems.
Brazilian infrastructure
Out of the three main private markets, Brazilian infrastructure is probably the asset
class that has received the least amount of attention from institutional investors.
Ironically enough, we think there are probably the most opportunities in it because
of chronic underinvestment by the government.
Risks:
confusing regulation, inexperienced managers
In emerging markets infrastructure, the biggest
risks are sovereign risk, the likelihood of the
counterparty to honour contractual arrangements
and the ability to enforce contractual agreements
through the rule of law. Brazils sovereign credit
rating has improved significantly over recent years.
However, the regulations for certain infrastructure
sub-sectors in Brazil have been confusing and have
deterred institutional investment. There are also
multiple layers of bureaucracy (federal, state and
municipal) which infrastructure managers must
navigate. Strict environmental regulations can
also be a barrier to new developments.
Other risks include principal-agent risk (given that
managers will use local developers), construction
and permitting risk (with greenfield projects) and
selection risk given a universe of managers with
mostly energy investing experience.
78 towerswatson.com
India
unrivalled macro trends
India is currently the fourth-largest economy in
the world and is predicted to overtake Japan as the
third-largest by 2020. This GDP growth provides a
favourable backdrop for private markets investing.
It supports greater consumption of local goods and
services that benefit private equity. In real estate, GDP
growth has a positive correlation with rental growth.
In infrastructure, the increase in economic activity
has led to the expansion of industry and commerce,
fuelling the demand for more urban infrastructure,
energy and transportation.
80 towerswatson.com
5,000
4,500
4,000
25
22
19
20
3,500
16
3,000
2,500
15
13
4,294
2,000
4,272
10
2,993
1,500
2,421
1,000
500
0
Number of funds
US$ millions
2007
2008
2009
2010
0
Year
Source: VCCEdge
7,000
120
108
6,000
5,000
100
87
80
Number of exits
4,000
4,589
2,000
37
6,210
40
4,062
2,565
1,000
0
60
51
3,000
2007
2008
2009
20
2010
0
Year
82 towerswatson.com
Turkey
Turkey has the sixth-largest GDP in the European
Union and the 17th largest in the world however
its economy is about the size of the state of
Washington in the US. It has undergone aggressive
privatisation, reducing state involvement in basic
industries, banking, transport and communications
and helping GDP to double from 2003 to 2010.
After suffering from a financial crisis in 2001,
it implemented significant reforms as part of a
US$45 billion IMF bailout. The reforms ushered
in an era of strong growth, averaging more than
6% annually until 2008, and helped reduce
inflation to single digits. In addition, the public
sector debt-to-GDP ratio fell below 45%.47 It also
has a young population (median age of 29), which
is growing at 1.5% a year.
The economy, however, continues to be burdened
by a high current account deficit due to its reliance
on imported energy, and unemployment is close
to 11%. Currency volatility is another concern and
its largest trading partner is Europe, which takes
40% of Turkeys exports, but whose own growth
prospects are poor.
Despite these concerns, it is widely accepted that
the Turkish economy has positive tailwinds which
has in turn led to an increase in Turkish private
equity activity. Most deals are in the consumer
and business services sectors. There is little
leverage although banks have been more
accommodating recently by providing senior
credit packages. Most private equity managers
take minority positions in companies.
84 towerswatson.com
Turkey
The Turkish private equity market has become
increasingly competitive in the last 18 months
as investors look for alternative destinations for
their capital outside of mainland Europe. In the
large cap space, most deals are sourced through
investment banks, and the managers in this
market tend to be global or pan-European with
one or two locals on the team. Those who have
been active include BC Partners, which completed
a partial exit of Migros, a local retailer, and TPG,
which sold Mey Icki, a local distiller, to Diageo in
2011. In the mid-cap space, there are the likes
of Mid-Europa, Abraaj and local firms Actera and
Turkven (which has migrated into the space after
recently raising much larger funds). We expect
competition to increase in the mid-cap sector
due to this dynamic. In the small-cap space
(funds sub-350 million), where a large proportion
of Turkish companies reside, the most number of
managers, including Private Equity, NBGI and
Mediterra, compete.
Private
86 towerswatson.com
Turkey
2010 GDP
US$1.1 trillion
US$1.1 trillion
5.0%
9.0%
Population
840 million
74 million
Private Equity as a
percentage of GDP
>0.2%
>0.2%
50
>20
Source: CIA World Factbook, RMB FICC Research Where to invest in Africa
Strategy implementation:
manager skill is critical
Sub-Saharan Africa
As with most emerging markets, opportunities
tend to be focused on the rise of the consumer
with many deals being a play on disposable
income and the expanding middle class.
Infrastructure was the strategy du jour as a result
of the World Cup, but governments appear to be
less supportive of the sector at the moment.
The quality of managers is mixed, though there
are some standouts who have been in the market
almost 20 years. Our view is that in this market
investors need country diversification to mitigate
political risk so we believe the best opportunities
are with managers who can execute a pan-African
strategy. However, as mentioned before, private
equity managers need locals in each office, which
does not always make commercial sense given the
size of each individual market. In addition, there
is a question mark over how much private equity
talent exists to populate these local offices.
Turkey
In Turkey, a handful of high-quality managers have
raised capital recently, although even the most
experienced managers operating in the market have
only been doing so for about 10 years. That said,
with privatisations and second and third-generation
family business owners looking to diversify their
wealth or potentially expand their businesses
internationally, we expect private equity to play
a larger role. Sectors that are popular include
ones buoyed by increasing consumer spend such
as education and healthcare. Two of the more
successful exits have been in retail (Migros) and
alcohol (Mey Icki).
Conclusion: implementation
risks are high
Despite the attractive economic fundamentals,
our view is that investors should continue to
monitor SSA and Turkey, but be cautious about
making any allocations at this stage. While we
believe there are good opportunities available,
our view is that the private equity risks outweigh
potential returns right now and that there could be
better opportunities from a risk-reward perspective
in other more liquid strategies.
Section four
How we can help
88 towerswatson.com
Further information
If you would like to discuss any of the areas
covered in more detail, please get in touch with
the consultant who normally advises you at
Towers Watson, or:
Luba Nikulina
Head of Private Markets
+44 20 7227 2559
luba.nikulina@towerswatson.com
Mark Calnan
Head of Private Equity
+44 20 7598 2819
mark.calnan@towerswatson.com
Gregg Disdale
Head of Distressed Investing
+44 20 7227 2558
gregg.disdale@towerswatson.com
Duncan Hale
Head of Infrastructure
+44 20 7227 2993
duncan.hale@towerswatson.com
Paul Jayasingha
Head of Real Estate
+44 1737 284824
paul.jayasingha@towerswatson.com
Notes:
22 http://www.infrastructurereportcard.org/
2 To calculate the leverage adjusted return, we used the following calculation. The
managers return on equity multiplier is (100/40=) 2.5. The markets return on equity
multiplier is (100/60=) 1.67. To adjust the managers return to the same leverage level
to that employed in public markets requires first dividing the gross return by (2.5/1.67=)
1.5. The savings implied from a lower debt load then need to be added, and here they
are approximately ((0.6-0.4) x7%=) 1.4%. Therefore the managers gross IRR adjusted
for leverage is ((34%/1.5)+1.4%=) 24%
24 http://www.opencongress.org/bill/112-h402/text
3 The J-curve is used to illustrate the historical tendency of private markets funds to
deliver negative returns in early years due to management fees, transaction costs,
construction and, to a lesser extent, under-performing investments that are identified
early and written down
25 Infrastructure 2011 A Strategic Priority Urban Land Institute and Ernst & Young
26 Source: Preqin
27 http://www.infrastructurereportcard.org/ and http://www.reuters.com/
article/2009/05/08/us-infrastructure-summit-water-idUSTRE5473IG20090508
28 http://www.opencongress.org/bill/112-h402/text
29 National Bureau of Statistics of China (NBS) 2009 dataset
30 Banco Central do Brasil, October 2011
31 Banco Central do Brasil, November 2011
4 Do REITs Behave Like Property or Equity?, Watson Wyatt Limited. May 2009
33 T he other risks we name below are not just for Brazilian private equity but account for
infrastructure and real estate (especially closed-end funds) too. To avoid repetition,
we have just included them in the private equity section
37 J P, Colliers, IRR Viewpoint, CBRE. From GTIS Brazil Fund II presentation, September 2011
10 S teward, M., 30 June 2009, Seed capital, Investment & Pensions Europe Magazine,
www.ipe.com/articles/print.php?id=32104
11 F ood and Agriculture Organisation (FAO) of United Nations, FAO Forestry paper:
Global Forest Resource Assessment, 2010
12 US Timberland Investment Management Organisation Timberland Investment Resources,
2011. FLAG Capital Management, 2011
13 Potlatch 10-K filing data 2010
35 JPMorgan, Banco Central, CBIC. From GTIS Brazil Fund II presentation, September 2011
36 A BECIP (Brazilian Association of Home loans and Savings Banks).
From Brookfield presentation, October 2011
39 G overnment estimates. From Brazil 101, The 2011 Country Handbook, JPMorgan,
April 2011, page 22
40 World Economic Forum 2009 Survey
41 Brazil Infrastructure, Special Report, Financial Times, 6 May 2010
42 Hem Securities, Industry Research Report on Indian Infrastructure Sector,
September 2011
43 Preqin (Private Equity Intelligence)
14 The British thermal unit (Btu) is a traditional unit of energy equal to about 1055 Joules,
the amount of energy to heat one pound of water
15 We emphasise that these are projections and these growth rates might prove
to be aggressive in the case of a prolonged global recession
90 towerswatson.com
46 Ibid
47 CIA World Factbook
48 Emerging Markets Private Equity Association
49 UBS, Investing in sub-Saharan Africa, November 2011
50 As quoted in Private Equity International, September 2011 issue, page 76
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