An increasingly aligned asset classPrivate equity

www.pwc.com/sovereignwealthfunds

May 2015

1 Preqin https://www.preqin.com/docs/reports/2015-Preqin-Global-Private-Equity-&-Venture-Capital-Report-Sample-Pages.pdf

In a context of sluggish growth and scarce liquidity in the global markets, private equity continues to shine and record high levels of activity. Fundraising has remained strong with over $500bn raised in 2014 by c. 1,000 funds1, given the Limited Partners (LPs) overall satisfaction with distribution and returns. Total assets under management of the industry have peaked at $3.8tn, a third of which is dry powder.

More importantly, the value of buyout deals came back to 2007 levels to $332bn globally. The industries with the highest activity were financial services, healthcare, commodities and consumer and retail – slightly different to what was observed for venture capital deals, where over 70% of the businesses acquired were related to telecoms, internet and other IT activities.

Though private equity activity continues to be centered in the US (both buyout and venture capital) and in Europe (mostly buyout), emerging economies in Latin America, Africa and Asia have a huge potential, despite their sometimes unwelcoming legislative and taxative regimes and disappointing funds’ performance. Global investors have recognized the opportunity and have not stopped from pouring capital and increasing the weight of their portfolios into developing markets.

2 Financial Times http://www.ft.com/cms/s/0/c9e24148-6a6a-11e4-bfb4-00144feabdc0.html#axzz3QLgQRtK5

3 WSJ http://www.wsj.com/articles/blackstone-carlyle-may-consider-takeover-deals-outside-their-existing-funds-1412592776

4 Bain & Company http://www.bain.com/Images/BAIN_REPORT_Global_Private_Equity_Report_2013.pdf

Sovereign investors, including sovereign wealth and pension funds, keep rising in both size and number, and are now the largest group of LPs. As these funds grow and mature, they allocate a greater proportion to alternative assets including private equity across all industries and sub sectors. Though strategic allocation is still biased towards developed markets, high-quality assets are becoming scarce and pricey, and new options are being considered.

These funds are increasingly sophisticated, with greater internal capabilities and in-house experts in every asset class, industry and geography. This has allowed them to transition from the more traditional LP-GP relationship to an early stage of co-investing alongside private equity. Other investors have not only entered into the funds but also acquired stakes in the general partnerships of some of the top-tier private equity firms.

Although alignment, in terms of horizon and risk-return profile remains the key issue in the relationship between sovereign investors and private equities, the liquidity of the former has made them attractive co-investors for which the latter are willing to adapt their offer. In November 2014, CVC announced the launch of a new $4bn fund dedicated to SWFs, with a lifespan of 15 years and a targeted IRR of 12%-14%2. Earlier that month, Blackstone and Carlyle had announced they would consider takeover deals outside their existing funds if that meant a larger alignment3.

This increasing collaboration has had an impact in the Investor Relations (IR) department of the major private equity houses. KKR is said to have now over 50 people fully dedicated to IR4, who need not only to deal with fundraising and asset management, but also to understand and originate co-investment opportunities.

Sovereign investors

The new co-investment model

The strategy of sovereign investors has shifted from fund investment to a new direct investment and co-investment model. For new fund commitments, a large number of LPs now ask for co-investment rights, which are usually granted. And while some SWFs consider co-investments separately, others include them as part of their broader private equity fund allocation5.

The LP has several reasons to co-invest. First, it gains control over the transaction and gives direct exposure to its investment executives, while reducing fees to half. Second, the liquidity provided early on in the transaction mitigates the J-curve effect associated to private equity deals and may help to outperform the returns of traditional fund investing.

The GP however faces conflicting views about this new trend. On one hand, it can use the capital to target larger deals or stakes, and thus benefits from offering high quality

co-investment opportunities to LPs. On the other hand, it is tempted to keep these highest quality deals in traditional fund structures in order to maximize management and transaction fees.

The co-investment model is in its early stage, and most players are still seeking to tap and maximize its potential. In November of 2014, the Korea Investment Corporation (KIC) hosted in Seoul the first Co-investment Roundtable of Sovereign and Pension Funds (CROSAPF) with thirty of the top tier global investors – twelve of them entered into a non-binding MoU to facilitate deals and co-investment opportunities. A session solely focused on private equity opportunities was chaired by Providence Equity Partners, whose investors include the Kuwait Investment Authority (KIA) and the Government of Singapore Investment Corporation (GIC).

The relationship matrix between sovereign investors and private equities is growing and increasingly complex. A sample of these interactions is included in the table below:

PE SWF/PF

ADIA ADIC AIMCo bcIMC CIC CPPib Future Fund GIC KIA QIA Temasek

3i Group LP, Co LP LP LP H, LP, Co LP LP Co

Advent International LP, Co LP LP LP Co Co LP, Co LP

Apax Partners LP LP LP H, LP LP H, LP, Co H, LP

Apollo Management H, LP LP LP Co LP LP LP

Bain Capital LP Co

BC Partners LP LP LP Co LP LP

Blackstone Group LP LP H, LP, Co LP, Co LP, Co LP Co

Carlyle Group LP LP LP LP Co LP LP Co LP Co

Cinven LP LP LP LP

CVC Capital Partners LP LP LP Co H, LP, Co H, LP

KKR LP, Co LP LP, Co Co

Onex Partners LP LP

Permira LP Co

TPG Capital LP, Co LP LP LP Co LP LP, Co H, LP Co

Warburg Pincus LP, Co Co Co

Source: Sovereign Wealth Center H: Stake in PE firm LP: Limited Partner

Co: Co-Investor

5 Preqin https://www.preqin.com/docs/reports/Preqin_Private_Equity_Co-Investor_Report.pdf

Venture capital – a rejuvenated relationship

Hedge funds – the big loser

Venture capital (VC) is nothing new for sovereign investors. As early as 1988, Singaporean fund Temasek established Vertex Ventures, and has since deployed over $1.2bn in 350 start-ups, some of which have gone public or been acquired by large corporations. Its neighbor GIC has been investing in ventures since the early 2000s, sometimes in conjunction with Chinese or American funds. In the Middle East, some examples also exist – KIA’s subsidiary NTEC has helped grow over 40 technology businesses since 20026.

In the current context, the incubation of start-ups seems to gain momentum. Due to the increasing competition over the same opportunities and premiums for high-quality assets, global investors are forced to consider new options. In the private equity space, this translates to contemplating secondaries, private debt, non-performing loans, mezzanine and venture capital.

Long-term horizons and great financial muscle – in paper, these funds are great candidates to invest in technological start-ups. Timing seems opportune to diversify away from oil & gas and financial services, and towards healthcare, clean energy, e-retail and other internet-related businesses.

This trend applies to the whole spectrum of sovereign investors. In 2013, the Canadian Pension Fund AIMCo, the New Zealand Superannuation Fund and the Abu Dhabi Investment Authority (ADIA) created the Innovation Alliance to collaborate with VC Kleiner Perkins – in line with the co-investment trend, and have injected capital into two growth capital opportunities on both coasts of the US. The Abu Dhabi Investment Council (ADIC) is also developing its VC footprint, and has used Sequoia Capital to invest in Whatsapp and MongoDB in the past few months.

This has translated into a larger physical presence in the Bay Area: At the end of 2013, Khazanah chose San Francisco as the location of its first office outside Asia, and last year Temasek’s Vertex hired an executive from Facebook to launch a subsidiary in Silicon Valley. Other funds may soon follow the footsteps of the two as well as of Singaporean GIC, the first one to settle in the area.

Though hedge funds are often put in the same basket as private equity, they are a very different asset class that invests in public markets, uses derivatives and borrows at the fund level. Today, this sort of funds manages assets worth $2.8tn, with a very different risk-return profile.

Since the start of the financial crisis, the industry has suffered a reversal of fortune and some of its top executives have been accused of wrongdoings and underperformance. But the biggest blow may have been in September of last year, when public pension fund CalPERS announced it would terminate its $4.5bn hedge fund portfolio to ‘reduce complexity and costs’.

North American pension funds, including Alaska, CPPib and Teachers, have traditionally dedicated ambitious investment programs to alternative asset classes. However, over the last years, the performance of the hedge funds has not justified their high fee structures, and this may lead sovereign investors to move away from direct hedge funds and fund-of-funds, towards more liquid alternative investments with lower fees.

6 NTEC website http://www.ntec.com.kw/#investments

Outlook

The buyout industry continues to be dominated by corporates and private equities. From 2009 to 2013, only 15% of the buyout deals over $1bn involved an institutional investor, either as LP or as a direct investor. Only a handful of sovereign investors have the capabilities and appetite needed to compete directly with private equity firms for buyouts on a standalone basis.

However, in the current market conditions, sovereigns are very valuable partners, and private equities have started to appreciate the importance of aligning interests and governance with them. The accumulated dry capital, the new co-investment model and the rejuvenation of the venture capital are signs of the increasing relationship between both groups of investors.

Sovereign investors will continue to boost their allocation to private equity and buy stakes of buyout and venture capital funds, but more as an active long-term stakeholder and partner than as a purely passive investor. Most partnerships will include co-investment rights, and as a result of a continuous and more open collaboration, investment ‘clubs’ will arise.

The traditional LP-GP relationship between sovereign investors and private equities is over – both groups of funds have evolved and are now partners, and co-investors.

Diego Lopez d.lopez@ae.pwc.com

This publication has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication, and, to the extent permitted by law, PwC does not accept or assume any liability, responsibility or duty of care for any consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.

© 2015 PwC. All rights reserved. PwC refers to the PwC network and/or one or more of its member firms, each of which is a separate legal entity. Please see www.pwc.com/structure for further details.

150428-222729-GN-OS