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1 Confidential and Proprietary
JULY 2009
Confidential and Proprietary
PRESENTATION PREPARED FOR
CFA Hawaii Institutional Investor Conference
2 Confidential and Proprietary
AGENDA
Introduction
Private Equity Market Then and Now Secondary Investing Outlook and Activity
Hedge Fund Market The Case for Hedge Funds Process Breakdown Key Trends
©2009 Pathway Capital Management, LLC
NOTE: The information contained in this presentation is proprietary and confidential in nature and must not be disclosed to any third party except to the extent required under applicable law or as expressly permitted pursuant to a written agreement with Pathway Capital Management, LLC.
3 Confidential and Proprietary
PRIVATE EQUITY MARKET
Private equity was...
“Blackstone IPO—Sign of the Times?” Ninth largest U.S. IPO of all time
Wall Street Journal, March 23, 2007
“The New Kings of Capitalism” “In two decades, private-equity firms have moved from the outer
fringe to the center of the capitalist system”The Economist, November 27, 2004
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“Going Private” “Hotshot executives are fleeing the scrutiny
of public companies for the mad money of the private equity boom”Business Week, February 27, 2006
“Unprecedented Heights” “PE Deal Volume and Funds Raised On Course to Hit New Highs” Buyouts magazine, July 10, 2007
THEN: 2003–2007
4 Confidential and Proprietary
The 2003–2007 time period was marked by extraordinary capital activity and the prominence of the private equity industry.
PRIVATE EQUITY MARKETTHEN: 2003–2007
Economic Drivers Low cost of capital Attractively priced assets (2002–2004)
Flexible Financing: Cov-Lite, PIK
GP Activity Record LBO volume & debt issuance
Robust fundraising Strong portfolio performance
Private Equity Themes The Club Deal Public-to-Private Transactions The Mega Deal
Private Equity Investor Mindset Increased target allocations to private equity
Easy money to be made in buyouts High confidence in superior return potential
5 Confidential and Proprietary
The credit crisis has dramatically altered the private equity landscape.
PRIVATE EQUITY MARKETNOW: 2009-
Economic Drivers Challenging credit markets Larger equity contributions Purchase price multiples declining
GP Activity Preservation of value & operational initiatives
Debt exchange offers and debt buybacks
Slower fundraising process
Private Equity Themes Secondaries & distressed strategies “in favor”
Flight to quality Greater alignment of interests
Private Equity Investor Mindset
Investors dealing with liquidity issues
Investors over-allocated to PE
Deal activity is slow
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6 Confidential and Proprietary
Yesterday
PRIVATE EQUITY MARKET
Secondary Market TimingThere has been record fundraising over the past few years to capture the anticipated expansion of investment opportunities resulting from “liquidity” sellers.
What Happened Transaction volume has not matched expectations due to valuation difficulties and
disparities.
This sector is not immune to financial market difficulty—2008 quarter-over-quarter secondary pricing declines were in nearly perfect correlation with the S&P.
Bid/ask spreads have narrowed as a result of low transaction activity.
A number of prominent dedicated secondary funds that were early movers into the market have been burned and are now extremely cautious.
Sellers are unhappy with bid pricing and have become wary. Some have aborted portfolio sales—Harvard Management, Columbia University.
Underwriting rates have risen substantially—from the low teens in 2007 to the 20% range in the second half of 2008—reflecting the riskiness of this market.
Important Considerations Deep discounts on assets will persist until audited financials are released for 2008.
Further declines may occur as FMV is reconciled by the GPs.
Secondary investing is not a “gimme” as promoted. The basic premise of shortening return horizons and gaining higher near-term IRRs has been shaken, if not discredited.
Better to focus on GP quality and selectively target specific opportunities in the primary or secondary markets.
SECONDARY INVESTING
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PRIVATE EQUITY MARKET
Secondary Market Private Equity Funds RaisedMore than $70 billion raised since 2004
NOTE: Based on data from Private Equity Intelligence, Thomson Financial VentureXpert, and UBS Investment Bank estimates.aLexington Capital Partners IV Closed commitments of $2.5 billion in 2006 and $1.3 billion in 2007.bRepresents the closed commitments in 2008.
($ billions)
SECONDARY INVESTING
8 Confidential and Proprietary
PRIVATE EQUITY MARKET
Rise of “Mega-Deals”
Highest Amount of Capital Raised by Private Equity Funds
Private Equity Garnered Larger Share of Overall M&A Markets
Record-Setting Deal Volume
Secondary Pricing—% of NAVPricing trends are dramatically lower as a result of the credit crunch and the decline in public markets. There remains a large disparity between buyer and seller expectations.
SOURCE: Cogent Partners.
SECONDARY INVESTING
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Yesterday
PRIVATE EQUITY MARKET
Private equity has entered into a new investment cycle, characterized by more-rational capital structures, lower purchase prices, and a greater reliance on operational management skills than on financial engineering. Established and proven general partners that have been through difficult economic cycles are best-positioned to thrive in the prospective market environment.
This period will serve to differentiate the highest-quality managers to a greater degree than in the recent past. Median-performing GPs will find fundraising market place very difficult.
Buyouts: The best buyout managers are adapting to the changed environment to take advantage of attractive opportunities made available by the current financial and economic dislocation. Greater focus on smaller transactions, growth equity investments, and build-up opportunities Structured equity investments Restructuring opportunities Discounted leveraged loans
Venture Capital: Technological refinement and innovation will continue to drive investment opportunities, but large disparity in performance among venture capital managers warrants continued emphasis on selectivity.
Attractive investment opportunities are beginning to emerge. Experienced managers with “dry powder” to invest will be well positioned to take advantage of changing market conditions. However, until the credit markets re-open, investment pace will be carefully managed.
Outlook
OUTLOOK & ACTIVITY
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PRIVATE EQUITY MARKET
Buyout Performance in Post-Recessionary YearsU.S. buyout funds have historically shown superior performance in the two years following a U.S. recession.
aVenture Economics Final December 31, 2008, return benchmarks.bBureau of Economic Analysis.
OUTLOOK & ACTIVITY
11 Confidential and Proprietary
PRIVATE EQUITY MARKETDistressed
Debt
General partners are focused on managing their existing investments and in accessing emerging areas of opportunities.
Existing Portfolio Investment Opportunities Operational Initiatives
Apply cost-cutting measures Evaluate capital expenditure plans Refocus on core businesses vs. new initiatives
Balance Sheet Adjustments Debt exchange offers Debt buybacks Covenant amendments/equity cures Debt refinancing/credit facility extensions/creative financing (fee deferrals, annex funds, lower LP co-investment thresholds) Evaluate Existing Portfolio Companies Critically
Which companies have the greatest chance of success? Rank portfolio company financing needs by priority
Operational Initiatives Conserve cash, reduce non-essential expenses, reduce headcount
Focus on reaching cash flow breakeven rather than growth
Bar Has Been Raised for New and Follow-on Investments
Lower Purchase Prices Late-stage companies at early-stage prices Opportunistic cram-down financings
Sectors of Interest/Emerging Sectors & Geographic Regions
Pharmaceuticals (drug pipeline needs driving industry consolidation), clean technology, China/India, cloud computing
Heavily Discounted Leveraged Loans & Bonds Equity-like returns for senior/secured positions
Opportunistic Add-on Acquisitions Lower Purchase Prices
Average purchase price multiple in 2H08 was 8.8x Ebitda vs. 9.7x Ebitda in 2007. Multiples are expected to decrease further.
More-rational capital structures -lower leverage, higher equity contribution rates
Restructuring/Distressed Investments > Rescue Capital Structured Equity (PIPEs, Preferred Equity Investments)
Relative Value Analysis of Existing Portfolio Sell existing investments to reinvest in more-attractive opportunities
Invest/Recycle Interest Income in More-Attractively Priced Opportunities
Add to Existing Positions on the Way Down If Confident in Underwriting Case
Gain control of restructuring process/reorganized equity
Opportunity Set Has Increased Significantly in Past 12 Months
4.1% default rate in 2008, representing $430 billion in par value
65% of high-yield bond market trading at >1,000 bps over U.S. Treasuries >$300 billion in par value
Severe Dislocation in Leveraged Loan Market Forced selling by CLOs and hedge funds have driven yields in loan market to unprecedented levels
Equity-like returns for senior/secured positions
Venture
Capital
Acquisitions
OUTLOOK & ACTIVITY
12 Confidential and Proprietary
HEDGE FUND MARKET
Reasons Why Institutions Will Increase Their Commitments to Hedge Funds in the Coming Years
Diversification Opportunistic and diversified allocation, practiced by the best and brightest, make hedge
funds attractive on a risk-adjusted basis.
Capital Preservation and Risk Reduction Hedge funds are best-equipped to manage risk through hedged portfolio management.
Structural Change Regulatory developments, institutional preferences, and economic reality will result in
more-attractive terms, more control, and transparency for investors.
Industry Contraction The bigger get better (and bigger); the bad go away. Fewer participants means less
efficient markets and, therefore, better opportunities to generate alpha.
The Environment Requires Expertise Markets of change are best exploited by employing the expertise and execution
capabilities offered by select, sector-specialist hedge fund managers.
THE CASE FOR HEDGE FUNDS
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HEDGE FUND MARKETTHE CASE FOR HEDGE FUNDS
Long-Term, Risk-Adjusted PerformanceThere are a number of compelling reasons why allocations to hedge funds make sense. The first is long-term performance.
Sharpe Ratio
SOURCE: PAAMCO and Bloomberg.
14 Confidential and Proprietary
Long/Short vs. Long-Only PerformanceHedged portfolio management consistently outperforms long-only, and does so with substantially lower risk.
HEDGE FUND MARKET
SOURCE: PAAMCO and Bloomberg.
Through December 31, 2008, long/short equity portfolios had a standard deviation of 6.5%; the S&P 500 had 14.5%.
THE CASE FOR HEDGE FUNDS
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HEDGE FUND MARKET
Process Breakdown: What Ever Happened to Due Diligence?Funds of Funds Invested with Madoff
PROCESS BREAKDOWN
Grosvenor Capital Management LLC, Arden Asset Management Inc., and EIM Management (USA) had investments with Madoff but redeemed funds over the past few years.
Investor Description Amount of Exposure Comment
Austin Capital Management
Fund of Funds Based in Austin, Texas
$10,000,000 The exposure is about 7.5% of assets.
Bramdean Alternatives An Asset Manager $31,200,000 The exposure is about 9.5% of assets.
Fairfield Greenwich Advisors
An Investment Management Firm
$7,500,000,000 More than half of Fairfield Greenwich's $14.1 billion in assets under management, or about $7.5 billion, was connected to Madoff.
Man Group PLC A UK Hedge Fund $360,000,000 Invested in funds directly and indirectly subadvised by Madoff Securities; Madoff acted as broker-dealer for these funds. Madoff investment represents 1.5% of the company's funds under management for its RMF fund-of-funds business and 0.5% of funds under management for Man Group itself, according to a Dec. 15 disclosure. Man Group is considering taking legal action to recover some of its investments.
Maxam Capital Management
A Fund of Funds Based in Darien, Connecticut
$280,000,000 The fund reported a combined loss of $280 million on funds the firm had invested in.
Meridian Capital Partners
Fund of Funds Based in Albany, NY
$100,000,000 NA
Tremont Group Holdings An Asset Management Firm
$3,300,000,000 The investment firm is owned by OppenheimerFunds and Massachusetts Mutual Life Insurance Co. Tremont's Rye Investment Management business had $3.1 billion invested, and its Fund-of-Funds Group invested another $200 million. The loss is more than half of all assets overseen by Tremont.
Union Bancaire Privée Swiss Bank $700,000,000 Half of UBP's 22 funds of funds put at least some of their money into Madoff-related investment vehicles, including one run by J. Ezra Merkin. The principal fund, Dinvest Total Return, had about 3% of its more than $1 billion of assets in Madoff-related funds. One fund of funds had as much as 6.9% of assets in Madoff-related funds. The bank had most recently met with Madoff Nov. 25 as part of an ongoing vetting process.
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HEDGE FUND MARKET
Key Industry Trends
Concentration of Assets Investors will commit capital only to those managers viewed as having sustainable businesses.
Investors in the Driver’s Seat Investors focus increasingly on transparency and risk-management. Scrutiny on liquidity terms and management fees.
Traditional Assumptions are Insufficient Realistic investment objectives with flexible and opportunistic allocations.
Institutionalization of the Industry Asset Base More stable asset base and more-mature operating platforms.
KEY TRENDS