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FRESNO COUNTY EMPLOYEES’ RETIREMENT ASSOCIATION

October 1, 2014

Private Credit Portfolio & Investment Recommendations

C O N T E N T S

Private Credit Review Tab I

Additional Fund Information Appendix I

Manager Write-Ups Appendix II

Private Equity Outlook Appendix III

1

E X E C U T I V E S U M M A R Y

The Retirement Plan’s long time horizon and returntargets resulted in an 8% target to private credit in thenew strategic asset allocation.

FCERA recently committed $20 million to ColonyDistressed Credit Fund III. Given these investmentsare structured debt rather than real estate, Wurts &Associates recommends reclassifying both Colonyinvestments into the newly created private creditallocation.

After the re-classification of Colony, the currentprivate credit investments constitute 2.0% of PlanAssets as of June 30, 2014

The goal of this presentation is to review:

1) Current capacity

2) The current private markets environment

3) Funds we believe deserve strong consideration

Data as of 6/30/2014

26.6%

24.7%

2.2%2.0%

5.9%

25.9%

12.7%

Private Credit Exposure by Fund

Colony Capital Angelo GordonLonestar IV TCW Shop3TCW Shop4 KKROaktree IX

Market Value of Private Credit Assets: $80.6 Million

2

C U R R E N T P R I V A T E C R E D I T E X P O S U R E

Vintage Manager Commitment Market Value Net IRR Investing/ Distributing Fund Focus

2014 Colony Distressed Credit III $20 Million - - Investing Distressed/Restructuring

2012 Oaktree Opportunities IX $15 Million $10.2 Million 14.6% Investing Distressed/Restructuring

2010 KKR Mezzanine Partners $30 Million $20.9 Million 11.3% Distributing Mezzanine Debt

2010 AGO $30 Million $19.9 Million 8.2% Distributing Distressed/Restructuring

2009 Colony Distressed Credit I $40 Million $21.4 Million 18.3% Distributing Distressed Debt

2002 Lone Star IV $20 Million $1.7 Million 30.7% Distributing Distressed & Equity Assets

2002 TCW Shop IV $15 Million $4.7 Million 6.9% Distributing Distressed/Restructuring

1998 TCW Shop III $15 Million $1.6 Million 3.4% Distributing Distressed/Restructuring

TOTAL $185 M $80.6 M

• The $80.6 million represents 2.0% of plan assets, 6.0% below the target allocation for Private Credit.

• The unfunded private credit allocation is currently invested in a BC U.S. Aggregate Bond Index Fund.

3

R E C O M M I T M E N T C O N S I D E R A T I O N S

Source: Financial Analysts Journal

• Due to the illiquid nature of private investments, maintaining a stable allocation is challenging:

• The amount and timing of contributions and distributions are uncertain

• Distributions can often be re-called within the investment period

• The private equity NAV’s rarely reach the commitment amount

• To address this challenge:

• Total commitments should exceed the stated dollar target.

• By doing so, the investments will eventually reach the target suggested by the policy.

• Investing as opportunities present themselves, and using proven, experienced managers, is more important than hastily investing the necessary capital to reach the target allocation.

4

P R I V A T E C R E D I T P R O J E C T I O N

Overall market conditions, total fund performance and the rate of return on existing commitments will allsignificantly influence private credit placements moving forward.

Using conservative assumptions, we have modeled:

A $60 million per year pace of contributions results in the 8% target being met in 2020 (see below)

A $100 million per year pace of contributions results in the 8% target being met in early 2018.

Assumptions:• A 1.5x multiple on committed capital is assumed for all investments. • All commitments are assumed to be fully called in the first three years of the life of the fund. • All new funds are assumed to begin distribution of assets over 4 years at an even pace 3 years after the last capital call.• All funds currently in distribution are assumed to evenly distribute assets over the remaining investment term (10 years from vintage year).• Total Plan Assets assume a 6.5% annualized return as described in FCERA’s 2013 Asset Allocation Study.

Fund Vintage Year

Total/New Commitments Called to date Estimated

MVSecond Half

2014 2015 2016 2017 2018 2019 2020

TCW Shop III 1998 $15,000,000 $15,000,000 $1,631,428 ($1,631,428)

TCW Shop IV 2002 $15,000,000 $22,661,307 $4,766,893 ($4,766,893)

Lone Star Fund IV 2002 $1,768,676 $19,045,199 $1,768,676 ($1,768,676)

Colony Distressed Credit I 2009 $40,000,000 $44,487,400 $21,421,400 ($2,313,511) ($4,127,304) ($4,127,304) ($4,127,304) ($4,127,304) ($4,127,304)

Angelo Gordon VII 2010 $30,000,000 $30,000,000 $19,912,093 ($1,792,088) ($3,261,601) ($3,261,601) ($3,261,601) ($3,261,601) ($3,261,601) ($3,261,601)

KKR Mezzanine Partners 2011 $30,000,000 $23,847,915 $20,904,241 ($1,612,613) ($2,976,423) ($2,976,423) ($2,976,423) ($2,976,423) ($2,976,423) ($2,976,423)

Oaktree Opportunities IX 2012 $15,000,000 $9,450,000 $10,222,811 $1,850,000 $3,700,000 ($4,500,000) ($4,500,000)

Colony 2014 $20,000,000 $0 $0 $6,666,667 $6,666,667 $6,666,667 ($7,500,000)

New Funds 2014 $30,000,000 $0 $0 $10,000,000 $10,000,000 $10,000,000 ($11,250,000)

New Funds 2015 $60,000,000 $0 $0 $20,000,000 $20,000,000 $20,000,000

New Funds 2016 $60,000,000 $0 $0 $20,000,000 $20,000,000 $20,000,000

New Funds 2017 $60,000,000 $0 $0 $20,000,000 $20,000,000 $20,000,000

New Funds 2018 $60,000,000 $0 $0 $20,000,000 $20,000,000 $20,000,000

New Funds 2019 $60,000,000 $0 $0 $20,000,000 $20,000,000

New Funds 2020 $60,000,000 $0 $0 $20,000,000

PE Balance $80,627,542 $91,709,203 $131,980,611 $193,373,733 $263,278,304 $338,775,241 $415,811,933 $482,888,864

% of Total Plan Assets 2% 2% 3% 4% 5% 6% 7% 8%

Total Plan Assets** $4,034,140,990 $4,296,360,154 $4,575,623,564 $4,873,039,096 $5,189,786,637 $5,527,122,768 $5,886,385,748 $6,269,000,822

Capital Calls / (Distributions)

5

2.73.9 4.8 5.2

8.611

0

2

4

6

8

10

12

10-yearTreasuries

InvestmentGrade Bonds

LeveragedLoans

High Yield Second Lien PE-backedMezzanine

Perc

ent

Domestic Fixed Income Yields (Estimated)(March 2014)

K E Y F I N D I N G S : P R I V A T E C R E D I T

US: High demand for financing and strong corporate balance sheets are

providing attractive premiums for private lending over public marketcredit, but default rates are low relative to history and likely to riseover time. The US economic recovery is five-years old; the averagebusiness cycle has lasted about six years since WWII.

Europe: Banks, under pressure to meet higher capital ratios, are reducing risk

by not only reducing their lending, but shifting their lending to larger,publically traded companies.

As Europe recovers, so does the demand for loans: midsizeEuropean businesses will need to raise 3.5 trillion euro in debtfunding over the next five years; in addition over 250 billion euros ofdebt will mature over the next five years.

Some EU nations are still in recession; European inflation is fallingand its money supply is falling, measures that hint at slowing growth.

Source: Source: Bloomberg, Credit Suisse, Barclays, S&P LCD

Source: PitchbookSource: Europe MFI

Charts and comments shown here can be found with additional commentary on pages 16 and 17 of the complete 2014 Private Equity Outlook.

3.03.54.04.55.05.56.06.5

Bank

Len

ding

, Ann

ual G

row

th R

ate

(Per

cent

)

European Bank Lending to Non-Financial CorporationsAnnual Growth Rates

Historically, European companies have relied on bank financing, but banks’ need todeliver is limiting their creation of new loans.

0

2

4

6

8

10

12

14

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014E 2015E

Perc

ent

European Leveraged Loan and High Yield Default Rates

Europe HY Default Rates Europe Levered Loan Default Rates

As the European economy recovers, default rates continue to come down. Its recovery is ayear old, suggesting default rates will remain low for some time.

6

N E X T S T E P S

Wurts & Associates believes the following two strategies deserve strong consideration by theBoard:

GSO European Senior Debt Fund Established to take advantage of a secular shift in the European corporate lending environment. GSO will seek to fill this

void in the direct lending space caused by the decreasing amount of bank loans to non-financial corporations due to newregulations

Will invest primarily in privately originated secured loans in performing mid to large-sized European companies (EBITDA€50- €150 million or $65 - $193 million).

Expected to primarily make investments senior in the capital structure

CarVal; Credit Value Fund III CarVal has a long history of investing in European and EM countries. Teams are onsite around the world to perform due

diligence and analysis

Portfolios are constructed with a top down perspective and bottom-up fundamental analysis

Largest slices of the portfolio will be in Loan Portfolios and Corporate Securities followed by Structured Credit andShipping.

Can use up to 100% leverage at the individual deal level with a limit of 1:1 equity to debt on an aggregate fund level.

In addition we are currently underwriting several other GP opportunities which we expect todiscuss in early 2015.

7

A P P E N D I X I

8

A D D I T I O N A L F U N D I N F O R M A T I O N

GSO CarVal

Strategy Direct Lending Stressed/Distressed

Target Middle-Upper Market Middle Market

Investor Position Sole/Majority Minority / Influential

- 40-60%

100% 40-60%

- 5-15%

100% Unitranche/Senior 40-60% Corporates

40-60% Loan Portfolios

0-30% Structured Credit

0-10% Shipping

Real Estate? No Yes

Sectors

North America

Western Europe

Emerging Markets

Recommended

GSO – a direct lending strategy targeting a 11-13% IRR and a 1.5x multiple on invested capital.

CarVal - a distressed strategy targeting a mid teens IRR and 2.0x multiple on invested capital

Estimated Final Close for Each Fund:

GSO: 1Q 2015

CarVal: April 2015

9

A D D I T I O N A L F U N D I N F O R M A T I O N

GSO CarVal

European Senior Debt Fund CVI Credit Value Fund III

Style Unitranche/Senior Stressed/Distressed

Current AUMTarget $2 billion ($500 million from COF II + $1.5

billion in raises)Target $2 billion

Firm Founded 2005 (acquired by Blackstone in 2008) 1987 (owned by Cargill)

Firm AUM $64 billion $10 billion

Headquarters New York Minneapolis

Geographic Focus Europe 50/40/10 - US/Europe/EM

Investment Period 3 years 3 years

Term 6 years + 2 extension options 6 years + 2 one-year extension options

Target IRR 11-13% Net (with 1:1 leverage) 13-17% net

Target Multiple 1.5x 2.0xLaunched First close end of August 2014 First close September 2014

Estimated Final Close Q1 2015 April 2015

Minimum Investment $7 Million $10 million

Types of Investments

Fund will invest in privately originated loans secured loans in performing mid/large

European companies. Will have quarterly distributions targeting 6-8% annually. Majority of underlying loans will be floating rate. 75% will be Unitranche, 25% will be Senior Debt.

Sees four major themes: QE, Commodity Supercycle, Europe healing/post-crisis

reform(bank sales), and opportunistic play on shipping. Will invest primarily corporate

securities, structured credit, liquidations and opportunistic dislocations. Will focus on

complex deals avoided by most other managers and piece out valuable parts. 25-50% will be

loans, 5-10% will be structured, 30-50% corporate debt and shipping 5-10%.

Fund Level Leverage 1:1 Leverage on $2bn equity Deal Specific, none at Fund level

Target Company Size Middle-Upper European Companies Middle-Upper market

Team Size

3 co-PMs supported by 12-person European Alternative Investments team. Additional support provided by 12 European Credit

investment professionals.

10 senior investment professionals + 44 supporting analysts/associates

Reccomended

10

A D D I T I O N A L F U N D I N F O R M A T I O N

GSO CarVal

European Senior Debt Fund CVI Credit Value Fund III

GP Commitments 2% 1%

Management Fee 1.5% on invested capital 1.5% on invested capital

Preferred Return 7% 8%

Carried Interest15% with 80/20 catchup for GP/LP. GP does not

receive carry until LP receives 75% of committed capital

20% after 8% preferred with 100% catch-up, subject to 20% holdback thereafter

Track RecordEuropean Loans (2008): 10.1% Net IRRCapital Opportunities II (2012): 24.2%

Capital Solutions II (2013): 17.6%

Credit Value Fund I (2010): 23.5% Net IRRCredit Value Fund II (2013): 27.1%

Paul Eapen, Portfolio ManagerMr. Eapen is a Joint Portfolio Manager of the Fund and is focused on the origination and

management of private credit investments in Europe, including distressed, rescue,

refinancing and LBO acquisition financing.Mike Whitman, Portfolio Manager

Mr. Whitman joined GSO in 2006. He is the Head of the European Business of GSO and a Joint

Portfolio Manager of the Fund, of GSO’s mezzanine funds, the GSO Capital

Opportunities Funds I & II, and of the GSO Special Situations Fund.

Alan Kerr, Portfolio ManagerMr. Kerr is a Joint Portfolio Manager of the Fund

and primary Portfolio Manager for European CLOs and Commingled Funds. He is jointly

responsible for managing the European activities of GSO’s Customized Credit Strategies

Unit (“CCS”). Michael Ryan, Managing Director

Mr. Ryan joined GSO in 2012 as part of the Harbourmaster acquisition. He is a Managing Director within GSO Debt Funds Management Europe and is involved in all aspects of credit

origination, investment selection and monitoring of GSO’s European collateralized

debt obligation portfolio.

Key Team Members

James Ganley, Deputy CIO & Senior Managing Director

Mr. Ganley is responsible for overseeing CarVal's credit funds and investments globally. Has the authority to invest up to $25 million in deals without formal Investment committee

approval.Greg Belonogoff, Senior MD

Responsible for leading the firm's London office, as well as managing individual Corporate

Securities Investments globally. Has the authority to invest up to $25 million in deals

without formal Investment committee approval.

Geraldo Bernaldez, Senior MDLeads all investments in emerging markets and

the global corporate securities business. Has the authority to invest up to $25 million in deals

without formal Investment committee approval.

Seth Cohen, Senior MD/Deputy CIOHe is responsible for managing investments in

global loan portfolios. Has the authority to invest up to $25 million in deals without formal

Investment committee approval.

11

A P P E N D I X I I

12

 

 

Manager Evaluation: GSO Capital Partners LP

European Senior Debt Fund LP

Last Updated: July 2014

Strategy Background

Asset Class:  Direct Lending Firm Inception:  2005 Firm Assets:  $64.2 Billion Strategy Assets:  $500 Million Targeted Fund Size:  $2 Billion First Close:   August 2014 Final Close (estimated):  1Q 2015 GP Commitment:  2.0% Min. Commitment:  $7 Million Fund Term:   6 years + 2 one‐year ext. Investment Period:  3 years Management Fee:  1.5% on invested capital 

GP Carried Interest: 15% after LPs receive 75% of original capital 

Preferred Return:  7% 

Firm Background and History

GSO  was  established  in  2005  by  Messrs.  Bennett Goodman,  “Tripp”  Smith  and  Douglas  Ostrover  (the “Founders”).    Prior  to  starting  GSO,  the  Founders  were senior  executives  of  Credit  Suisse  First  Boston  (“CSFB”) where  they  were  responsible  for  building  and managing the Helios Credit Opportunities Fund, a diversified strategic portfolio  of  leveraged  finance  assets.  In December  2004, the  Founders  resigned  from  CSFB  to  form  GSO;  CSFB agreed to transfer the management of Helios to GSO along with substantially all the team managing the portfolio.    In  2005, GSO  acquired  the  Collateralized  Loan Obligation (CLO)  business  from  RBC  Capital  Partners,  a  division  of Royal  Bank  of  Canada,  and  established  its  own  funds, including  GSO  Special  Situations  Fund,  GSO  Mezzanine Fund, GSO Capital Opportunities  Fund,  and GSO  Liquidity Partners.  In  2006,  GSO  opened  offices  in  Houston  and London.  The  Houston  office  is  primarily  focused  on  the direct sourcing of private investments in the energy sector, while  the  London office  concentrates on European direct origination  for mezzanine and  rescue  financing as well as public market trading and research.  

On  March  3,  2008,  the  Blackstone  Group  acquired  a controlling stake  in GSO.   GSO principals  reinvested 100% of  the  after  tax  proceeds  from  the  transaction  into GSO managed  funds.  In December 2011, Blackstone purchased the remaining economic interest in GSO.  GSO continues to operate under the GSO brand with the same management team and investment process.  Since 2010, GSO made several strategic acquisitions of CLO assets  in  US  and  Europe,  including  a  2012  purchase  of Harbourmaster Capital, a  leading European  loan manager. The  acquisition made  GSO  one  of  the  largest  leveraged loan investors in Europe where they currently monitor over 300  companies  and  have  reviewed  over  400  private situations in the last four years. GSO’s European corporate debt portfolio comes  in at over €8.5 billion  ($12.0 billion) in AUM and  is  invested  in approximately 190  companies. This  platform  is  supported  by  a  team  of  32  investment professionals in London and Dublin.  GSO  and  its  subsidiaries  have  assembled  a  team  of  over 250 employees in New York, Houston, London and Dublin; of  those,  105  represent  investment  professionals.  GSO operates  through  two  primary  business  segments: Alternative  Investment  Funds  ($30.0  billion  AUM  across Mezzanine  and  Capital  Solutions  Funds,  an  event‐driven hedge  fund  and  a  small‐cap  direct  lending  BDC)  and Customized Credit Strategies–Long Only ($30.2 billion AUM primarily dedicated to CLOs and separate accounts).  

Strategy Background

GSO  has  established  the  European  Senior Debt  Fund  to take  advantage  of  a  secular  shift  in  the  European corporate  lending  environment.    Banks  and  other traditional  suppliers  of  credit must  shrink  their  balance sheets to comply with upcoming regulatory requirements set  forth by Basel  III and Asset Quality Reviews  (“AQR”). GSO will  seek  to  fill  the  void  in  the direct  lending  space caused by  the decreasing amount of bank  loans  to non‐financial  corporations  and  limited  capacity  for  CLO managers to refinance after low issuance. 

The Fund will invest in privately originated secured loans in performing  mid‐  and  large‐sized  European  companies, defined by GSO as those with EBITDA of €50‐€150 million. Its two primary approaches to  investing are: (i) originating direct  capital  infusions utilizing  a wide network of banks, financial  sponsors  and  corporate  contacts;  and  (ii) accumulating  publicly‐traded  securities  by  purchasing “hung”  bridge  commitments  from  investment  banks, anchoring  difficult  syndications  or  investing  in  select distressed  secondary market  securities.   GSO will be able to provide significant capital investments of €250 million or more  and  focuses  on  consensual  deals  alongside incumbent stakeholders.  

The Fund is expected to primarily make investments senior in  the  capital  structure  and  typically  secured. Most  loans will  be  floating  rate  instruments  and  the  majority  of returns  are  expected  to  come  from  current  income.  The Fund plans to  invest at  least 75%  in unitranche debt, with the  remainder of  the portfolio  comprised of  senior debt.  Investments are expected  to be  sized at 5% of  fund‐level commitments while  senior debt positions are  targeted  to be  2‐3%  positions,  for  a  total  of  25‐30  investments  over the life of the fund. 

 

The investment objective of the Fund is to target a net IRR of  approximately  11%‐13%  and  a  multiple‐on‐invested‐capital  (MOIC)  of  approximately  1.5x.  A majority  of  the portfolio  will  consist  of  debt  investments,  which  are typically structured with cash coupons of 10%‐13%, a total yield‐to‐maturity  in  the  mid‐teens,  call  premiums  and strong covenant protections.   There will be up to 1:1 non‐mark‐to‐market, term leverage at the Fund level.   GSO will seek to build a diversified portfolio across a wide array  of  issuers  and  industries  in  Europe.    The  only  fund previously  raised  by  GSO  constrained  to  Europe  is  the Blackstone/GSO  European  Senior  Loan  Fund,  which launched  in  2008.  Excluding  its  Special  Situations  funds, GSO  has  originated  over  €2.5  billion  of  private  loans  in Europe over the last three years.  

Key Investment Professionals

The Investment Team consists of three Portfolio Managers supported  by  twelve  investment  professionals  from Analyst  to Managing Director. Another  twelve  investment professionals  within  the  European  Customized  Credit Strategies group provide additional support.   Alan Kerr, PM, Senior Managing Director Mr.  Kerr  is  a  Joint  Portfolio  Manager  of  the  Fund  and primary  Portfolio  Manager  for  European  CLOs  and Commingled Funds. He  is  jointly responsible for managing the  European  activities  of  GSO’s  Customized  Credit Strategies Unit  (“CCS”). Mr. Kerr  is  a member of  the CCS Europe  Investment  and  Management  Committees.  He joined  GSO  in  2012  as  part  of  the  Harbourmaster acquisition, where  he  had  been  since  2000  and was  co‐head of  the  firm. Mr. Kerr  is a Chartered Accountant and received an honours Commerce Degree and a Master’s  in Accountancy from University College Dublin.    Michael Whitman, PM, Senior Managing Director Mr. Whitman  joined GSO  in 2006. He  is  the Head of  the European Business of GSO and a Joint Portfolio Manager of the  Fund,  of  GSO’s  mezzanine  funds,  the  GSO  Capital Opportunities  Funds  I  &  II,  and  of  the  GSO  Special Situations Fund. Prior to joining GSO in 2006, Mr. Whitman was  a  Managing  Director  with  Citigroup  Private  Equity. Prior  to  joining  Citigroup  Private  Equity,  Mr.  Whitman worked  in  Salomon  Smith  Barney’s  High  Yield  Capital Markets  business  from  1996  through  2000.  From  1994 through  1996,  Mr.  Whitman  was  a  corporate  finance analyst at Salomon Brothers. Mr. Whitman received a B.A. in History from the University of Notre Dame.   Paulo Eapen, PM, Managing Director Mr. Eapen  is a  Joint Portfolio Manager of the Fund and  is focused  on  the  origination  and  management  of  private credit  investments  in Europe,  including distressed, rescue, refinancing and LBO acquisition  financing. Prior  to  joining GSO  in  2007,  Mr.  Eapen  was  a  founding  member  of Citigroup  Private  Equity  London  where  he  focused  on private equity and mezzanine debt principal  investments. He began his career as an  investment banker  focusing on M&A  and  Utilities  at  Salomon  Smith  Barney. Mr.  Eapen received a B.A.  in Economic and Political Science from the University of Pennsylvania.  Michael Ryan, Managing Director Mr.  Ryan  joined  GSO  in  2012  as  part  of  the Harbourmaster  acquisition.  He  is  a  Managing  Director within  GSO  Debt  Funds  Management  Europe  and  is 

Individual Asset Components  Contribution to IRR 

Unitranche Coupons (75%):  8%‐10% 

Senior Debt Coupons (25%):  6%‐8% 

Upfront Fees/OID:  0.5% 

Call Premiums:  0.5% 

Total Unlevered Returns:  8.5%‐10.5% 

Expected Leverage (1:1):  5.5%‐6.5% 

Blended Gross IRR:  14%‐17% 

Blended Net IRR:  11%‐13% 

involved  in  all  aspects  of  credit  origination,  investment selection and monitoring of GSO’s European collateralized debt obligation portfolio. Prior to  joining Harbourmaster, he worked  for Hypo Real Estate Bank and KPMG  in  their Transaction  and  Financial  Services  groups. Mr. Ryan  is  a qualified  Chartered Accountant  and  received  a Master’s degree in Business & Accounting and an honors degree in Accounting & Finance, both from Dublin City University.   

Process

GSO’s credit strategies incorporate a fundamentally‐driven investment  philosophy  based  on  thorough  credit underwriting  and  rigorous  financial  analysis.    The  Fund’s primary  focus  is  on  sourcing  privately  secured  loans  to healthy  European  companies  with  EBITDA  from  €50  to €150 million.   

The  team  sees  a  significant  amount  of  proprietary  deal flow by working closely with European banks and also from the  internal  Leveraged  Loan  group  as  well  as  the mezzanine  and hedge  fund  groups.    It  also has  access  to other  Blackstone  resources,  including  its  Advisory  and Restructuring businesses.   This  scale enables  the  Fund  to identify  opportunities  early  and  select  investments  that offer  the most  attractive  risk‐adjusted  return  profile  but which may not fit the mandates of other GSO products.  

Fund investments can be divided into two main strategies, unitranche debt and senior debt.   Potential deals typically include: (i) refinancing to companies facing significant debt maturities;  (ii)  financing  to  companies who  cannot access the  capital  markets  due  to  size,  new  bank  capital regulations  or  other  unique  reasons  (iii)  sponsor acquisition  financing;  or  (iv)  consolidation  of  debt  from existing fatigued lender groups.   

Unitranche Debt Transaction teams partner with companies to tailor a debt instrument  that  addresses  all  of  or  the majority  of  their financing needs in a single debt package. The Fund seeks to directly originate secured debt  investments  that minimize downside  risk  and protect  capital.  The  investments often yield  equity‐like  returns,  while  maintaining  capital structure seniority given the size and customization of the financing  structures. These debt  investments are  typically structured  with  coupons  of  8%‐10%,  a  total  yield‐to‐maturity in the low‐teens percentage range, call premiums, strong  covenant  protections  and  security  pledges  of company  assets.  The  average  leverage  multiple  for unitranche investments will be 4x‐5x EBITDA and positions sizes of €150‐€200 million.  

Senior Debt The  Fund  will  also  extend  senior  debt  commitments  as opportunities arise to target specific financing needs within the  capital  structure.  GSO  may  collaborate  with  “club” lenders,  providing  large  anchor  positions  which  solidify offerings  and  help  fill  remaining  capital  needs.  The  team will  target 6%‐8% cash coupons with an average  leverage multiple of 2x‐4x EBITA and mandatory amortization.  Investment Underwriting and Monitoring Each senior  investment professional  is responsible  for  the analysis, diligence structuring and monitoring of five to ten Fund  investments  from  inception  to  realization. A  typical deal  team  consists  of  four  investment  professionals, comprised  of  a  portfolio  manager,  managing  director, principal or vice president and associate and / or analyst.   The due diligence process often lasts up to six months and includes  a  thorough  business  review  of  the  industry, competitive  landscape,  products,  customers,  returns  on capital,  depth  of  management  team,  extensive  financial analysis  and  consultation  with  outside  advisors  and industry  experts.  Much  of  this  work  is  continually maintained by  the Leveraged Loan and CLO credit  teams.  The  deal  team  spends  time with management,  tours  the company’s  facilities  and  conducts  customer  and  supplier calls. This initial assessment is followed by extensive credit analysis,  including  asset  valuation,  financial  analysis,  cash flow and scenario analysis, legal and accounting review.   

The  Investment Committee  reviews deals  in parallel with the  diligence  and  relies  on  a  consensus‐driven  approach among  the  senior  investment  professionals:  Bennett Goodman, Tripp Smith, Doug Ostrover, Alan Kerr, Michael Whitman and Paulo Eapen.  

GSO seeks to structure individual investments that balance downside  protection  with  significant  current  income  in addition  to  upfront  fees  of  2%‐4%.  Current  income  is primarily in the form of cash coupons, two to four years of call  protection  premiums,  maintenance/incurrence covenants  and  security  pledges  of  assets.  Following  an investment,  the  same  deal  team  actively  monitors  and manages  all  transactions  through  realization.  The  Fund expects to hold most loans until maturity with the majority of returns coming from income.  

Risk Management

The  team  has  significant  experience  and  competitive advantage across  the  firm’s $64.2 billion diversified credit platform.    GSO’s  long‐term  track  record  speaks  to  their ability  to  leverage  the  team’s capital structuring expertise 

to  provide  unique  financing  solutions  that  meet companies’ unique objectives.   In  line  with  their  objective  to  anticipate  avoid  risks  if possible,  each  potential  investment  undergoes  rigorous credit analysis. Each  transaction  is  individually  structured, depending on the financing problem each company faces. As a result, each investment varies in terms of size of cash coupon,  degree  of  collateral  protection  and  structural seniority, tenor, and covenants. In an attempt to minimize risk the portfolio will limit any single investment to 15% of total commitments to avoid excessive concentration risk. A maximum of 20% of the portfolio can be  invested outside of Europe.   GSO has established a number of reporting and monitoring tools  for  portfolio  companies.  Custom  reports  for  each investment  contribute  to  the  internal monthly  valuations completed by GSO. These monthly valuations are approved by  the Valuation Committee, which does not  include any investment  professionals.  On  a  quarterly  basis,  GSO engages  an  independent  valuation  firm  to  support  the internal  valuations,  which  are  then  presented  to  the Blackstone  Valuation  Committee.  Deloitte  is  responsible for providing annual valuations.  Should  an  investment  become  stressed,  the  team  has internal  expertise  for  restructuring  and  other  workout scenarios.   The  team  is  able  to pull  from  across  the GSO platform,  including  legal  professionals  and  executive management talent should the need to assume control of a  portfolio  company  arise.    This  depth  and  breadth  of expertise is a key advantage of investing with GSO.  

Risk Factors and Potential Red Flags

At the Fund  level,  if, after the Investment Period, three of the six Key Men are unable to perform their functions for the  firm  for  90  days  out  of  the  year  then  the  Limited Partners can choose  to  liquidate  the  fund with a majority vote. During the  Investment Period Key Men must devote substantially all of their business time to the affairs of the management company. The Key Men named in the official Fund  documents  include  founders  Bennett  Goodman, Tripp  Smith  and  Douglas  Ostrover,  and  the  portfolio managers  of  the  Fund  Alan  Kerr, Michael Whitman  and Paulo Eapen.   GSO will use up to 100% leverage at the Fund level, giving the team a target of $4 billion to invest. While the use of leverage  can  enhance positive  returns,  the  amplification of  negative  returns  is  a  serious  risk  should  the  Fund 

experience  losses. Given  the  conservative  approach  and experience  of  the  team we  believe  that  this  amount  of leverage  is  acceptable;  however,  investors who wish  to avoid  leverage for UBTI or other considerations will have the option to invest in an unlevered sleeve.  The  success  of  the  Funds'  activities may  be  affected  by general economic and market conditions, such as interest rates,  availability  of  credit,  inflation  rates,  economic uncertainty,  changes  in  laws  and  national  and international  political  circumstances.    The  regulatory environment  for  banking  across  Europe  is  in  flux  and could materially  impact  the  Fund’s  ability  to  source  and invest  in opportunities, but  this changing dynamic of  the market  structure  also  creates  the  opportunity  for investors  in the Fund.   We believe GSO has the scale and depth of talent and organizational resources to capitalize on the opportunity set.  

Performance

GSO  has  a  history  in  European  senior  loans  (via  the Harbourmaster group) of 64  investments since 2008 with an  average  net  IRR  of  10%.    Business  Development Companies  created  by  the  firm  in  2009,  2011  and  2012 vintages  have  net  IRR’s  of  17%,  19%  and  11%, respectively.   The team has originated over €2.5 billion across a number of transactions in senior, junior and unitranche debt since September  2010  similar  to  the  Fund’s  mandate.    A summary  of  these  transactions  are  provided  below;  the team has also identified a pipeline of over €1 billion.  

Recommendation

Wurts  &  Associates  recommends  the  European  Senior Debt Fund as an attractive opportunity  for  investors who wish to capitalize on our view that European private credit markets  offer  a  unique  chance  to  take  advantage  of structural  reforms  and  a  recovering  economy.    GSO  is  a well‐known  and  well‐regarded  participant  in  the  private credit space and have maintained a significant presence in the  European market  specifically  since  the  early  2000’s. This  established  and  experienced  team  has  significant resources  for  sourcing  and  structuring  deals  in  the marketplace. The team’s track record in private credit and the broader firm’s support structure provides comfort that they have  the  commitment and  resources  to execute  the strategy with strong results.      

                        *All dollar amounts in millions COF: Capital Opportunities Funds CSF: Capital Solutions Funds SMA: Separately Managed Account 

GSO European Team

Representative TransactionsStrategy Security Type Closed Committed Leverage EBITDA Coupon Gross MOIC Gross IRR

Ring/Helios COF II2nd Lien & Junior

DebtApr-14 $208.1 5.5x € 37.8 11.0% NM NM

KP1 CSF II Unitranche Mar-14 $276.0 5.5x € 36.1 E+8.75% 1.0x NM

Safetykleen COF II Junior Debt Dec-13 $162.6 5.8x £90.6 L+11.0% 1.0x 14.3%

Morris Homes CSF II Unitranche Jun-13 $273.0 8.2x £32.5 L+8.5% 1.3x 39.6%

Welcome Break CSF IJunior Debt &

Anchor Senior DebtJan-13 $197.5 7.0x £67.2 13.5% 1.3x 29.6%

Perstorp CSF I Anchor 2nd Lien Nov-12 $132.9 4.8x $227.0 11.0% 1.3x 25.4%

Giant Cement CSF IUnitranche (1st

Out)Jul-12 $146.3 23% LTV $5.5 10.0% 1.2x 11.5%

Giant Cement CSF IUnitranche (2nd

Out)Jul-12 $273.0 66% LTV $5.5 10.0% 1.4x 20.8%

EMI Music Publishing CSF I & COF IIJunior Debt &

Anchor Senior DebtJun-12 $390.6 5.2x $286.1 12.5% 1.4x 22.8%

Miller Homes CSF I Equity Feb-12 $178.7 45% LTV £78.2 N/A 2.1x 42.8%

Coditel COF I Junior Debt Dec-11 $113.4 5.7x € 54.1 13.8% 1.4x 19.2%

Almatis CSF I, COF I, SMA Unitranche Sep-10 $353.3 4.5x € 113.3 13.0% 1.5x 16.2%

 

 

Manager Evaluation: CarVal Investors, LLC

CVI Credit Value Fund III, L.P.

Last Updated: July 2014

 

Strategy Background

Asset Class:  Multi‐Strategy Credit Firm Inception:  1987 (subsidiary of Cargill) Firm Assets:  $10 Billion Strategy Assets:  $3.3 Billion Targeted Fund Size:  $2 Billion First Close:   September 2014 Final Close (est.):  April 2015 GP Commitment:  1.0% Min. Commitment:  $10 Million Fund Term:   6 years + 2 one‐year extension Investment Period:  3 years Management Fee:  1.5% on invested capital GP Carried Interest:  20% over preferred Preferred Return  8% Target Return:  13‐17% (net)    

Firm Background and History

CarVal  Investors  (“the Firm”) was established  in 1987 by Cargill,  one  of  the  largest  agricultural  and  industrial service providers  in  the world,  to  serve  as  a proprietary financial trading arm. During the 1990’s CarVal expanded its  investment  operations  throughout  Europe  and  Asia and  in 2006 became an  independent subsidiary. CarVal  is headquartered  in  Minneapolis  and  has  over  180 employees,  70  of  which  are  investment  professionals, with  offices  in  London,  Luxembourg,  New  York,  Paris, Shanghai  and  Singapore.  They  are  led  by  President  and Chief Investment Officer John Brice, who transferred from Cargill in 1998 and became President in 2008.   CarVal  manages  approximately  $10  billion  across  four funds (three closed‐end and one open‐end) and separate accounts.  The  Firm  has  built  its  platform  around opportunistic  credit  and has  invested $73 billion  in over 4,800  transaction  in  70  countries.  The  Firm managed  a separate  account  for  Cargill  until  2007,  at  which  point they  began  liquidating  the  portfolio  and  launched  the Global  Value  Fund,  their  first  fund  open  to  outside investors, with $5.4 billion of initial commitments.  

CarVal  opened  their  London  office  in  1993  and  their Singapore office  in 1997. With 40 employees  in  London, CarVal offers a large on‐location presence in the European market. Their global reach is bolstered by the relationship and information advantages provided by their connection with Cargill, which employs more than 140,000 people  in 65 countries and generates $130 billion annual revenue.   By  agreement,  management  fees  are  split  50/50  and incentive  fees  90/10  between  CarVal  and  Cargill, respectively.  Cargill  has  no  influence  over  CarVal’s investment process or decision making; however, CarVal team members  often  use  Cargill  to  source,  evaluate  or partner if a prospective deal involves an industry in which Cargill operates, such as shipping.  

Strategy Background

The  first  Credit  Value  Fund  (“CVF”)  was  launched  in September of 2010. All Credit Value Funds follow a similar mandate and philosophy as the original Global Value Fund with the exception that the latter funds will not make any direct  real  estate  investments.  Four  primary  investment strategies  form  CarVal’s  core  investment  approach: Corporate  Securities,  Loan  Portfolios,  Liquidations  and Structured Credit.  Each  strategy plays  a different  role  in the  portfolio  but  all  usually  connect  to  one  of  the  four investment themes noted below which the team believes will  drive  continued  dislocation  and  generate opportunities going forward.  Post‐Crisis Banking Reform The  team  believes  that  extensive  re‐regulation  of  the financial  sector  in  the  United  States  and  Europe  will create  a  shift  in  the  global  lending  market.  The  team believes this regulatory scrutiny creates capital “vacuums” in  the  re‐performing  loan  market,  specifically  in  areas affected  by  mortgage  reform.  As  a  result,  CarVal  is actively  acquiring  non‐performing  loan  pools  sold  by banks  looking  to  improve  their  capital  efficiency  and quality measures (largely as a result of Basel III and Dodd Frank regulations).  

 The Stabilization of Europe In  a  similar  and  related  theme,  banks  are  selling more “non‐core  assets”  into  the market  place  as  the  risks  of Eurozone  breakup  and  financial  crisis  both  abate.    The banks  are more  eager  now  to  deleverage  their  balance sheets  of  corporate  loans,  commercial  real  estate  and other asset backed securities.  As the economy continues to  recover,  the  team  expects  the  deleveraging  to continue, estimating  that another $3  trillion  in  sales will come over the next few years.  The Fund will initially focus on  countries  further along  in  their  recovery,  such as  the United Kingdom, Ireland, and the northern regions. CarVal will  opportunistically  consider  Southern  Europe  as conditions  improve  and  more  attractive  risk/return opportunities present themselves.  The End of the Commodity Super Cycle Weak  commodity  prices  have  been  a  headwind  for Emerging Markets, specifically in Asia and South America, as well  as  less developed  areas  in  Eastern  Europe.    The team  now  sees  increasing  opportunities  in  the  shipping industry, which could comprise up to 10% of the portfolio.   In  support  of  this  theme,  the  relationship  with  Cargill provides a substantial information flow advantage, as well as deal sourcing, asset utilization and due diligence for the shipping  industry.  Cargill’s  business  engages  over  500 vessels at any given time and has been willing to guaranty market  rate use of  specific  tanker  investments made by CarVal. These contracts provide an immediate return and banks are much more willing to finance these investments knowing Cargill has already leased the vessels.  QE Tapering As  the  Federal  Reserve  and  other  developed  market central banks withdraw  stimulus  from  the bond market, the team will look to capitalize on the fear of rising rates. While  the  strategy  does  not  need  interest  rates  to  rise, the  team  will  position  the  portfolio  for  increased volatility.  They  believe  increased  volatility  will  lead  to attractive entry points into European financials, municipal bonds and other corporate credit opportunities.  CarVal  expects  these  themes  to  drive  the  majority  of activity during  the  first half of  the  investment period. As time  passes  the  team  believes  that  corporate  distress, restructuring  and  liquidations  and/or bankruptcies  could play  a  larger  role. CarVal will  seek  to diversify  the  Fund across  investment  strategy  and  geography  in  the following ways:  

 

  The  team  believes  they  can  achieve  a  2x  Multiple  on Invested Capital (“MOIC”) and a 15% net return to limited partners. The Fund’s  investment period will overlap with the  previous  fund,  CVF  II,  until  June  2016.  During  this period investments will be allocated on a pro‐rata basis to each fund.   

Key Investment Professionals

CarVal  employs  a  hierarchy  of  discretionary  decision making  ability  in  their  investment  team  structure. Managing Directors may approve up to $25 million trades and  Senior  Managing  Directors  have  the  authority  to execute $50 million trades. Investments are seldom made without frequent dialogue amongst the team beforehand. This  structure  is  designed  to  enable  the  team  to  act quickly  when  time‐sensitive  opportunities  present themselves  and  to  initiate  toe‐hold  positions  to  gain access to information on private holdings.  John Brice, President and Chief Investment Officer Mr.  Brice  serves  as  the  President  and  Chief  Investment Officer of the Firm, a position he has held since 2008. He is  the  chairman  of  the  investment  committee  and  is ultimately  responsible  for  all  portfolios  and  global operations.  Prior  to  joining  CarVal  in  1998,  Mr.  Brice worked  on  the  European  equity  arbitrage  desk  for  the Global  Capital  Markets  group  at  Cargill.  He  began  his career  in  the  Asset  Management  division  of  Friends Provident, a large UK life assurance company. He received a  Bachelor’s  degree  in  Economics  and  Accounting  from the  University  of  Wales  and  is  a  qualified  chartered accountant.   

50‐60%

30‐40%5‐10%

Targeted Portfolio Weight

North America

Europe

Emerging Markets

30‐50%

25‐50%

0‐10%

10%

Corporate Securities

Loan Portfolios

Structured Credit

Shipping/Liquidations

James Ganley, Deputy CIO, Senior Managing Director Mr. Ganley serves as Deputy Chief  Investment Officer  to Mr.  Brice  and  is  responsible  for  Corporate  Securities  in North  America.  He  is  a  member  of  the  Investment Committee and also  focuses on  Liquidation  investments. Prior  to  joining  CarVal  in  2009,  Mr.  Ganley  was  a managing  director  in  the  Special  Situations  group  at Goldman  Sachs  in  Europe  focusing  on  distressed  credit, high  yield  credit  and  event‐driven  investing. Mr. Ganley received  a  Bachelor  of  Science  degree  in  Finance  and Accountancy  from Villanova University and an MBA  from the University of Chicago.   Gerardo Bernaldez, Senior Manager Director Mr.  Bernaldez  is  responsible  for  Corporate  Securities investing on a global basis. He also manages all of CarVal’s Emerging Markets  investments  in  addition  to  serving on the  Investment  Committee.  Prior  to  joining  CarVal  in 1995, he worked at Cargill as a controller  in the Financial Markets Group  in Mexico  and Venezuela. Mr. Bernaldez received  a  Business  Administration  degree  from  the Universidad  de Belgrano,  in Argentina  and  is  a  Certified Public Accountant.  Seth Cohen, Senior Managing Director Mr.  Cohen  joined  CarVal  in  2009  and  leads  the  Loan Portfolio division. He is responsible for managing all global loan  portfolio  and  structured  credit  investments  and serves  on  the  Investment  Committee.  Prior  to  joining CarVal, Mr. Cohen was responsible for structured finance origination, analysis and execution at Garrison Investment Group.  He  was  also  previously  CEO  of  Franklin  Credit Management  Corporation  and  co‐head  of  the  financial services  group  at  Silver  Point  Capital.  He  received  a Bachelor’s degree  in Political Science from the University of Michigan and a J.D. from NYU School of Law.   Jody Gunderson, Senior Managing Director Ms.  Gunderson  manages  investments  in  global  loan portfolios  at  CarVal,  including  RMBS  and  CMBS investments.  She  serves  on  the  Investment  Committee and  focuses on consumer,  residential and small business loan  portfolios.  Prior  to  joining  CarVal  in  1994,  Ms. Gunderson  was  a  manager  in  the  financial  services division  of  PriceWaterhouseCoopers  working  with investment  fund  and  commercial  banking  clients.  She received  a  Bachelor’s  degree  in  Business  from  the University  of  Minnesota  and  is  a  Certified  Public Accountant (inactive).   

Potential  investments  above  $50  million  in  size  are discussed  at  the  Investment  Committee, which  includes the  investment professionals detailed  in the table below. The  only  other  senior  investment  team  member  with investment  making  authority  is  Greg  Belonogoff,  who leads  the  London  office  operations  and  focuses  on Corporate Securities investing.   

Investment Committee  Role 

John Brice*  President & CIO 

James Ganley*  Deputy CIO, Senior MD 

Gerardo Bernaldez*  Senior Managing Director 

Seth Cohen*  Senior Managing Director 

Jody Gunderson*  Senior Managing Director 

Joe Graf  Senior Managing Director 

Lucas Detor  Senior Managing Director 

Peter Vorbrich*  CFO 

David Fry  Managing Director of Risk 

Matthew Bogart  Chief Legal/Compliance 

*Indicates a “Key Principal” named in official fund documents 

 

 

Process

CarVal  has  a  long  history  of  investing  in  European  and Emerging Market  countries, with  local  teams performing due diligence and analysis for the last 20 years. This global presence  is  further  enhanced  by  the  close  relationship with Cargill and  its operations  in 44 emerging  countries. The history and experience of the firm, combined with the network  Cargill  provides,  are  key  features  of  CarVal’s sourcing ability and crucial to the success of the Fund.  The  team  constructs  portfolios  with  a  top‐down perspective  combined  with  bottom‐up  fundamental analysis.  The  Fund  has  a  broadly  defined  investment mandate  for  asset  class  and  geographic  regions,  giving flexibility  to  opportunistically  act  as  relative  risk  and returns evolve and new investments are discovered.   The  team  evaluates  potential  investments  relative  to current holdings in terms of volatility, risk profile, liquidity and income production. Investment professionals conduct extensive quantitative and qualitative analysis to form an opinion from a legal and a financial perspective. They seek out  complex  situations  and  believe  one  of  their  core competencies  is  the  ability  to  deconstruct  and  extract value  from  complicated  deals.    In many  cases,  they will have  developed  specific  experience  that  allows  them  to more  accurately  price  pooled  investment  opportunities that other “pure specialists” cannot value correctly. 

Of  the  four  investment  strategies,  Loan  Portfolios  and Corporate  Securities  will  be  the  largest  allocations, followed  by  Shipping/Opportunistic  (to  potentially  be replaced  by  Liquidations  and  traditional  distressed situations later) and Structured Credit.  Loan Portfolios The  Fund will  invest  in whole  loan  portfolios  backed  by consumer  credit,  RMBS,  small  business  loans,  CRE  and auto/student unsecured debt. The team opportunistically purchases  loans  secured  by  commercial  real  estate.  If necessary, CarVal can take direct control of the underlying real  estate  and  has  experience  in  arranging  external management  teams  to  manage  the  property.  One competitive  advantage  CarVal  believes  they  enjoy  over competitors  is  their  ability  to  choose  a  servicer  to manager  their  loan  portfolios.  They will  often  break  up the  loans  into specialized portions that match up with an individual servicer’s best ability.  Corporate Securities CarVal  follows  a  similar  sourcing  and  due  diligence process  for  its  corporate  securities  investing.  Potential investments  include,  but  are  not  limited  to,  corporate bonds, bank debt, credit default swaps, and equities. To a lesser extent,  the Fund may  invest  in high yield  loans or DIP  (debtor‐in‐possession)  financing  of  companies  in distress  or  bankruptcy.  Rather  than  buying  for  control, CarVal  looks  to  assist  or  influence  the  restructuring, bankruptcy or recapitalization process.    CarVal emphasizes their avoidance of “crowded” trades in which  most  large  distressed  funds,  such  as  Oaktree, Cerberus  or  Fortress,  are  currently  investing  in  heavily. Instead,  the  team  tries  to  identify unique  situations  that require specific experience or bespoke financing solutions in which they have a successful track record.  Liquidations Claims against bankrupt or  liquidating companies require more  hands‐on  management  and  support  than  other strategies.  Although  it will  play  a  lesser  role within  the portfolio,  CarVal  has  built  out  internal  legal  and operational teams dedicated to handle these investments. Given  the  generally  positive  or  stable  market environments  in  place  throughout  the U.S.  and  Europe, CarVal  believes  Liquidations will  play  a minor  role  until the business cycle matures or market stress develops.  Structured Credit The team will focus  its structured credit efforts on asset‐backed  securities,  primarily  RMBS,  and  CLOs.  CarVal  is 

able to leverage its experience investing in the underlying securities  across multiple  investment  teams  to  give  it  a competitive advantage over others. CarVal prefers to look at  the most  complex  securities  and  break  out  valuable aspects to multiple servicers. The complexity allows them to  bid  near  the  highest  price  but  still  achieve  return targets.   Favoring  a  more  conservative  approach  with  regard  to structured products, the team  looks to add value outside of  the  security  itself. CarVal acquired  its own  servicer  in Portugal  to  take  advantage  of  the  supply/demand imbalance  in  the European servicing market.    In addition to  restructuring  or  collecting  against  individual  loans within  the  security,  the  team  actively  trades  the securities.   Special Opportunities CarVal’s current focus on the shipping industry falls under the  Special  Opportunities  category.  Historically,  any investment  that does not  fit within  the other  categories has  been  deemed  a  special  opportunity.  Previous investments have included aviation leasing and part‐outs, other  miscellaneous  vessels,  and  oil  and  gas  related assets.   

Risk Management

CarVal  has  been  investing with  the  same  approach  and philosophy  for  over  25  years  and  has  built  out  a wide‐reaching  network  of  offices,  relationships  and underwriting  capabilities.  The  long‐term  track  record  of the  Cargill  managed  account  points  to  their  skill  and ability  to execute on a  large  scale across developed and emerging markets.   To  promote  portfolio  diversification,  the  Fund may  not invest more  than  15%  of  total  commitments  in  a  single issuer  and must  limit  investments  in  emerging markets (China, Hong Kong, Latin America and South America)  to 30%.  The  Fund will not be dependent on  any one  asset class or region to achieve expected returns.   CarVal  continues  to  actively manage  securities  once  an investment  is made.  If any  security approaches  their  fair value estimate  they will exit  the position and  reinvest  in securities with more attractive risk/return prospects. The team  expects  to  recycle  capital  during  the  investment period  and  has  a  three‐year harvesting period, with  the intent  of  driving  more  return  earlier  in  the  life  of  the Fund.  

CarVal  is backed by one of the  largest private companies in  the  world  and  is  structured  to  pursue  a  global investment  opportunity  set. More  than  100  employees are  dedicated  to  legal,  operational  and  administrative duties to support the investment teams in each office.   

Risk Factors and Potential Red Flags

Fund  documents  name  six  key  persons,  the majority  of whom must devote substantially all of their business time to CarVal and management of the Fund. Limited Partners will  have  the  power  to  suspend  Fund  operations  or approve new key personnel should the situation arise.  CarVal will use up to 100% leverage at the individual deal level, with a  limit of 1:1 equity  to debt on an aggregate fund  level  basis.    In  many  cases,  aggressively  priced financing  is provided by the seller of the assets who wish to obtain a higher optical price while meeting regulatory capital hurdles.   While  the use of  leverage  can  enhance positive returns, the amplification of negative returns is a potential  risk of  any  losses. Given  the diversified,  value‐focused  approach  and  the deep  experience of  the  team we believe that this amount of leverage is reasonable.  

Funds  II  and  III will  have  briefly  overlapping  investment periods  (about nine months) until  June 2016. Both  funds employ  identical mandates and will allocate  investments on a pro rata basis. This potentially prevents either Fund from taking full‐sized positions if the security in demand is limited.  However,  we  believe  that  CarVal  has  the resources and appropriate mandate to source a sufficient amount  of  opportunities  and  identify  securities  able  to accommodate capital from both funds.  

Performance

From  inception  in  1989  to  2007,  when  it  ceased investment  activities,  the  Cargill  Managed  Account completed  1,563  deals  and  invested  more  than  $10.7 billion. Total return on investment reached $4.1 billion for gross  and  net  realized  IRR’s  of  26.6%  and  21.3%, respectively. The S&P 500 returned 11.7% over the same time period.   

The Global Value Fund was launched in 2007 and split into two distinct portfolios when additional capital was raised in  mid‐2008,  creating  Global  Value  Fund  II.  Since inception, Global Value  Fund  I has  a 6.0% net  IRR while Global  Value  Fund  II,  with  a  different  asset  mix  at inception  that  included  less  real  estate  and  more corporate  securities,  has  a  16.9%  net  IRR.  Investment periods for both portfolios ended in February 2011.  Credit Value Fund  I,  launched  in October 2010, posted a net 2013 return of 25.3%, giving  it a 22.5% net  IRR since inception.  The  S&P 500  returned 14.8%  annualized over the  same  time period. Credit Value  Fund  II,  launched  in November 2012, returned 24.1% net of  fees  in 2013 and has  provided  investors  with  a  29.1%  net  IRR  since inception.  This  compares  favorably  to  the  S&P 500 over the same period, which gained 27.4% annualized during a tremendous market rally.   Within  the  Credit  Value  Funds,  CarVal  has  had  the greatest success  investing  in Corporate Credit, with gross since inception IRRs of 39.6% and 71.1% for Funds I and II, respectively. Structured Credit and Liquidations have also performed  well,  with  returns  between  20‐40%  within both asset classes for each fund since inception.  Loan Portfolios have  generated  gross  IRRs of 24.7%  and 5.6% for Funds I and II, respectively. Although they did not fare as well as the other asset classes, Loan Portfolios are cornerstone  investments within  the  Fund  that  generate consistent  cash  flow  and  small  capital  gains  over  time; they are not expected to generate extreme returns given their relatively low risk.  

Recommendation

Wurts &  Associates  believes  CarVal’s  third  Credit  Value Fund  is  a  compelling  option  for  investors  looking  for  a balance  of  conservative,  stable  cash  flow  assets  and potential for outsized returns from calculated investments in riskier, more complex opportunities. CarVal has a long‐term track record of successful alternative  investing with a consistent approach and philosophy. Their platform is of institutional  quality  and  has  supported  Cargill’s  private investment  mandate  since  1989.  Looking  forward,  we concur  with  their  investment  themes  for  the  next  few years and are confident  in  the  team’s ability  to build on the success of prior funds and deliver strong returns with Credit Value Fund III.    

 

 

CarVal

Asset Class WeightingCVF II CVF I GVF II GVF I

Corporate Credit 23.3% 18.9% 30.0% 31.4%

Liquidations 41.4% 47.3% 40.6% 19.3%

Loan Portfolios 22.7% 20.7% 10.3% 17.2%

Special Opportunities 0.0% 0.0% 5.7% 10.8%

Structured Credit 12.7% 13.1% 5.9% 4.2%

Real Estate N/A N/A 7.6% 17.2%

CarVal

European Track Record2013 2012 2011 2010 2009 2008 2007 2006

Gross Return 33.2% 28.5% 21.4% 33.9% 45.3% 23.5% 21.1% 53.3%

Average Equity Capital Employed $2,998  $2,890  $3,117  $1,843  $1,175  $1,245  $1,273  $501 

CarVal

Prior Funds Summary

Investment

Period Open

Investment

Period Close

Invested

CapitalTotal Value Net IRR

Credit Value Fund II Nov‐12 Jul ‐16 $1,739.4 $1,923.7 29.1%

Credit Value Fund Oct‐10 Jun‐13 $812.7 $1,338.3 22.5%

Global Value Fund II May‐08 Feb‐11 $1,897.1 $3,524.8 16.9%

Global Value Fund Jan‐07 Feb‐11 $5,554.6 $7,489.4 6.0%

Cargill Managed Account 1989 2006 $10,756.4 $14,860.7 26.3%

*All values in millions

CarVal

Gross Returns by Asset ClassCVF II CVF I GVF II GVF I

Corporate Credit 71.1% 39.6% 25.7% 15.7%

Liquidations 29.1% 26.0% 29.3% 28.3%

Loan Portfolios 5.6% 24.7% 17.7% 3.6%

Special Opportunities 0.0% 0.0% 2.0% ‐0.3%

Structured Credit 20.4% 39.6% 26.8% 19.6%

Real Estate N/A N/A 21.5% ‐7.8%

A P P E N D I X I I I

13

SEATTLE | 206.622.3700 LOS ANGELES | 310.297.1777 www.wurts.com

PRIVATE EQUITY OUTLOOK

June 2014

T A B L E O F C O N T E N T S

1

Executive Summary Page 2

Buyout Page 7

Venture Capital & Growth Page 11

Secondary Market Page 13

Private Credit Page 15

Recommendations Page 18

Market Environment Page 20

E X E C U T I V E S U M M A R Y : S T R A T E G Y R E C O M M E N D A T I O N S

2

Outlook:  Neutral Market dynamics improving, but the majority of capital is allocated to larger funds

Venture/Growth

Outlook:  Neutral Rising asset values, growing dry powder and rising transaction prices limit expected returns

Secondary Markets

Outlook:  Negative (US Large/Emerging markets)/ Neutral (U.S. Middle Market, Europe) New commitments face higher than average purchase prices which reduces expected returns U.S. middle market, European buyout more attractive than U.S. large and mega deals or Emerging

Markets

Buyout

For those with a strategic allocation requirement, select opportunities include

Opportunities to participate in the apparent dislocation in European markets, including direct lending Smaller, niche sectors or companies that are overlooked by mega‐funds Special vehicles, timely opportunities and other unique offerings

Skilled GPs have delivered attractive returns in most market environments through superior companyselection and ability to lead portfolio companies to greater than market driven growth

Manager Selection

Private Credit Outlook:  Neutral (U.S.)/ Positive (Europe) Premiums for direct lending appear more attractive in Europe than in the U.S

E X E C U T I V E S U M M A R Y : M A R K E T E N V I R O N M E N T

3

Neutral In a period of slow expected economic growth it will be more difficult for companies to grow EBITDA. 

Five years into the US economic recovery, it is likely that growth will slow sometime in the next five years,hurting EBITDA growth, while growth in Europe and the emerging markets should improve over that period.

Facing sIow growth, General Partners must find other ways to grow portfolio company revenues andearnings to support exit values. “ Buy and Build” strategies reflect an attempt by General Partners to createvalue by “bolting” portfolio companies onto one another.

EBITDAGrowth

Neutral/Unattractive While it is impossible to know what the exit environment will be in 7 to 10 years,  the possibility of longer 

holding periods for portfolio companies, and the expected large number of portfolio companies needing exists (based on record levels of  buyouts taking place today) are headwinds to attractive exit prices.

Exit Environment

Unattractive Purchase price multiples are near historical highs, driven in part by easy access to inexpensive credit.

Rising distributions have been a tailwind to increased fund raising, leading to record amounts of drypowder that has negative implications for future purchase price multiples, expected IRRs and thecomposition of future private investments.

Valuation

Today’s environment for new commitments to private equity is not broadly favorable for generatingattractive long‐term expected returns, and is characterized by headwinds to new investments that havenegative implications for future performance.

O V E R V I E W : M A R K E T E N V I R O N M E N T

4

2013 was a good year for distributions, but 2005 to 2008 vintage funds have yet to return all of theirinvestors’ capital.

Evaluated as a whole, private equity returns have been average for some time, but skilled managershave delivered attractive risk‐adjusted returns over time.

1.79x 1.47x 1.32x 1.24x 0.78x 0.52x 0.48x 0.46x 0.25x 0.16x 0.09x

0.20x0.36x

0.39x 0.49x

0.64x0.75x 0.81x 0.88x

0.97x 0.98x 0.98x

2.00x1.85x

1.72x 1.71x

1.43x1.28x 1.29x 1.35x

1.22x 1.15x 1.07x

0.00x

0.50x

1.00x

1.50x

2.00x

2.50x

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Global Average PE Fund Return Multiples By Vintage Year

DPI RVPI TVPI

While investors in early vintage funds (pre-2004) have been made whole (theirDPI: Distributions to-Paid-in-Capital are greater than one) they still havesignificant amounts of unrealized value (RVPI: Remaining Value to Paid-in).

0%5%10%15%20%25%30%35%40%45%

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

PE vs. VC Top Decile & Quartile IRRs by Vintage

VC Top Quartile VC Top Decile PE Top Quartile PE Top Decile

During most vintage years since 2001, top quartile buyout managers haveoutperformed top quartile venture capital funds.

Source: Pitchbook Source: Pitchbook

O V E R V I E W : M A R K E T E N V I R O N M E N T

5

 ‐

 20

 40

 60

 80

 100

 120

 140

 160

2006 2007 2008 2009 2010 2011 2012 2013

Billion

s $

US PE Dry Powder By Fund Type and Vintage

Buyout PE Growth Co‐Investment Restructuring Mezzanine Energy Other

The majority of dry powder in US focused funds is held by buyout funds ($400b),and the majority of that in recent vintage funds with several years left in theirinvestment periods.

 ‐

 50

 100

 150

 200

 250

 300

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Billion

s $

PE Fund Raising by Fund Size 

Under $100M $100M‐$250M $250M‐$500M $500M‐$1B $1B‐$5B $5B+

Source: Pitchbook Source: Pitchbook

2013 fund raising not only saw its best year since 2008, but the return of “mega”funds. Nearly half of committed capital went to funds that raised more than $5billion.

Positive net‐cash flows to limited partners helped fund raising, but 2013 also saw the return of“mega” funds‐those that closed with more than $5 billion of committed capital.

Dry powder continues to grow and has negative implications for purchase price multiples, expectedIRRs and the composition of future private investments.

O V E R V I E W : M A R K E T E N V I R O N M E N T

6

Leveraged buyouts continue to drop as a share of total private equity deals, reflecting a change in howgeneral partners believe they can best create value. Sponsor‐to‐sponsor transactions (“DirectSecondaries”), “buy and build” strategies and taking minority positions in growth/expansion deals havegrown in importance.

The growth in sponsor‐owned portfolio companies is leading to rising holding periods for portfoliocompanies, and has negative implications for returns to future investments in private equity.

Buyouts represent a declining portion of private equity deals as GPs see greateropportunity to add value through add-ons and in the growth/expansion stage ofventure.

0%

20%

40%

60%

80%

100%

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014Q1

US Private Equity Investments by Deal Type

Buyout/LBO Add‐on Recap

PE Growth/Expansion PIPE Platform Creation

4.23.8 3.7 3.5

3.9 3.9

4.7 4.95.3

6

0

1

2

3

4

5

6

7

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Years

Private Equity Median Hold Period

2012 and 2013 were good years for portfolio liquidations and distributions tolimited partners, but holding periods continue to rise.

Source: Pitchbook Source: Pitchbook

B U Y O U T

7

G L O B A L B U Y O U T : U . S .

8

Rising stock prices, aging dry powder and inexpensive debt continues to drivepurchase price multiples to higher levels. Smaller LBOs face less competition andrequire greater equity and less leverage, helping hold down prices.

The use of debt to finance LBOs fell dramatically following the financial crisis.As credit markets have opened up, the use of debt has increased to pre-crisislevels.

.x

2.x

4.x

6.x

8.x

10.x

12.x

1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q

2012 2013

EV/EBITDA Purchase Price Multiples by Deal Size

$0‐$25M $25M‐$250M $250M+Source: Pitchbook Source: Pitchbook

Rising public equity markets, growing dry powder and easy access to credit drove U.S. buyout purchaseprice multiples higher, creating headwinds to future performance

Buyout deals completed at today’s purchase price multiples face a number of headwinds to expected performance:

In a period of slow expected economic growth it will be more difficult for companies to grow EBITDA, forcing general partnersto hold portfolio companies longer in order to generate enough earnings to justify the necessary sale prices. This brings IRRsdown.

Five years into the US economic recovery, it is likely that growth will slow sometime in the next five years, challenging EBITDAgrowth. The increased use of leverage to finance deals is a drag on performance in a weakening economic environment.

Growth in the number and value of portfolio companies needing liquidation will increase the supply of companies beingauctioned, a headwind to exit prices.

Outlook: Large (Negative); Small/Mid (Neutral): Fund raising and dry powder will keep purchase price multiples high for large deals.Prices and leverage are more attractive for Small/Mid size deals, but trends seem to support higher prices ahead.

61%62% 63%

60%

54%56% 55%

62%

65%

45%

50%

55%

60%

65%

70%

2005 2006 2007 2008 2009 2010 2011 2012 2013

Median Debt‐to‐Equity Ratio by Year

G L O B A L B U Y O U T : E U R O P E

9

6.8 6.97.7

8.87.8 7.7 7.6 7.9 7.57.6

8.3 8.89.7 9.7

8.9 9.2 8.8 9.3 8.7

4

6

8

10

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

European Private Equity EV/EBITDA Purchase Price Multiples

<250m Euros All

Source: LCD European Leveraged Buyout ReviewSource: Preqin

Investors’ growing confidence in European reforms and economic growth has led torecord levels of dry powder as fund raising appears ahead of deal-making.

Purchase price multiples for smaller deals are generally more attractive, reflectingless competition and more difficulty in obtaining financing.

Growing confidence in economic reform and recovery is leading to renewed activity and opportunityin European leveraged buyouts, but slow growth may limit returns

A review of 2013 fund raising, deal flow, exit activity and purchase price multiples reveals a return to more normalized levels ofactivity. This appears to reflect investors’ growing confidence in the effects of economic reforms and recovery on earnings andvaluations.

Purchase price multiples have nearly recovered to pre‐crisis levels, but reflect: cyclically‐low/depressed EBITDA: as EBITDA recovers with growth, price multiples will decline. a limited supply of available companies as sellers seek to avoid selling at depressed EBITDA levels and buyers seek only high

quality, low risk assets.

Outlook: Neutral Europe’s economy has turned, but investor sentiment appears ahead of fundamentals as reflected by rising dry powder. Slow

growth will limit returns. European recovery is expected to be uneven and slow, favoring northern over southern Europe. Successful General Partners

will be those that recognize these risks and identify high quality, global companies with limited exposure to on‐going risks. While economic growth is slower, European buyouts are more attractive than U.S. given their valuations are lower and based

on cyclically depressed EBITDA.

272 241 245 221264 277

0

50

100

150

200

250

300

2009 2010 2011 2012 2013 2014Q1

Billion

s $

European‐focused Dry Powder

0

G L O B A L B U Y O U T : E M E R G I N G M A R K E T S

10

Emerging markets remain an attractive long‐term opportunity,  but over the next year the dynamics and fundamentals associated with private equity investing are poor

As a whole, emerging markets private equity investing is characterized by: A decade of successful fund‐raising that has led to significant dry powder, placing upward pressure on purchase price multiples. A weak exit environment (including the closure of the Chinese IPO market) has increased holding periods and hurting exit prices. Poor performance on the part of general partners in managing and creating value in their portfolio companies. Macroeconomic conditions (weak economic growth, market and exchange rate volatility), that negatively impacts company

competitiveness, revenue and earnings growth.

Outlook: Neutral Demographic trends favor a growing allocation to emerging markets, but in the next year private equity faces many of the same

headwinds that developed markets struggle with: an overhang of capital, slowing growth and challenging exits, and managerschallenged to create value.

For those with capital to put to work, manager selection, skillful country selection and access to attractive deal flow matters;managers are looking to a new set of countries today including Mexico and South East Asia.

For all of its potential, less than half of private equity investors find any region withinemerging markets attractive investments today.

Emerging market deal flow declined from 2009 until 2012 before starting to grow.Dry powder, measured in terms of years-of-investment has begun to rise again.

149 166 193 185 176 257 377 436 479 480 425 388 356 3990

1

2

3

4

5

6

0

100

200

300

400

500

600

2000 2002 2004 2006 2008 2010 2012

Years of In

vestmen

t

Dry Pow

der, billion

s $

Emerging Markets Dry Powder

Dry Powder Years of Investments

Source: PreqinSource: Bain Capital

7% 7% 7%12% 14%

26% 26%33%

38%

50%

0%

10%

20%

30%

40%

50%

60%

Other MiddleEast

Russia India EasternEurope

Brazil China Africa SouthAmerica

Asia

Regions within Emerging Markets Limited Partners feel Present the Best Opportunities (Preqin Survey)

V E N T U R E C A P I T A L & G R O W T H

11

V E N T U R E A N D G R O W T H C A P I T A L

12

The changing dynamics of the venture capital industry as well as innovation in technology is altering the ways inwhich limited partners should approach venture and growth capital

Trends in Venture Capital The difficulty in returning investors’ capital has led to less capital raised and a rationalization of the industry; the number of active

venture capital (VC) funds is half that of 2000.

Successful VC firms are capturing a larger proportion of limited partners’ capital, leading to bigger funds; in 2012 over 50% of the$21 billion raised went to 11 of the 182 VC funds raised.

Developments in IT (the growth of open source software, the “cloud” and leverageable distribution platforms) have reduced theamount of seed and early stage capital needed to see a company through to its growth stage. As a result, smaller funds takingsmaller positions are better positioned to exploit these opportunities than larger funds.

The intersection of these trends suggests that smaller funds are more likely to outperform, and thus many limited partners in largerfunds will be disappointed. The evidence of fund performance by size tends to confirm this hypothesis.

Outlook: Neutral. The supply/demand dynamics of VC is improving, but the majority of capital allocated to larger funds suggests thatthe average limited partner will underperform, making manager selection critical.

 $(40)

 $(20)

 $‐

 $20

 $40

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Billion

s $

US Venture Capital Funds Annualized Cash Flows by Year

Contributions ($B) Distributions ($B) Net Cash Flow ($B)

Source: Pitchbook

Distributions continue to exceed new commitments, leading to a net outflow ofassets, letting the asset class downsize to a sustainable level given opportunities.

Small Venture Capital funds have outperformed the large end of the market.

Source: StepStone

2.6 3.44.5

2.0 2.1 1.62.3 2.4

6.1

0.8 1.8 0.80

2

4

6

8

Pre 1990 1990‐1994 1995‐1998 1999‐2001 2002‐2004 2005+

Multip

les

Performance by Fund Size and Vintage Year

<$250m >$250m

S E C O N D A R Y M A R K E T S

13

S E C O N D A R Y M A R K E T S

14

40

60

80

100

120

2007 2008 2009 2010 2011 2012 2013H1 2013H2

Discoun

t/Prem

ium to

 NAV

, Percent

Secondary Pricing

Buyout Venture All Strategies

Transaction volume continues to rise, but so does fund raising. Existing dry powderof $24.5b is about one-year of volume, while 2013 fund raising has created another$33b of dry powder yet to be called.

Venture capital portfolios trade more cheaply than buyout portfolios, reflectinggreater uncertainty about expected IRRs, and making the points that portfoliosselling at large discounts to NAV are not necessarily attractive.

Secondary market offerings continue to rise, but rising public equity markets have driven up seller’s expectations,hurting expected returns

Supply continues to grow, the result of regulatory driven selling and the recent attractiveness of “fund restructuring” opportunities.

Over $125 billion of funds coming to the end of their life are not in a position to provide liquidity (zombie funds). With visibility to the underlying portfolio companies, secondary buyers are restructuring these portfolios, providing liquidity to

LPs and giving GPs additional time to realize value.

Secondary pricing has climbed, in part due to higher seller expectations following rising public equities.

Buyers suggest that these prices can be misleading, pointing to the rise in “structured transactions”. Buyers will pay par in astructured transaction for assets about to be written up in value and with payment to be deferred, effectively reducing thepurchase price to below par.

Outlook: Neutral. Regulatory driven selling will increase the supply of secondary portfolios, but the write‐up of NAV due to risingequity markets, rising transaction prices and growing dry powder should limit returns compared to recent history.

0

10

20

30

40

50

60

0

5

10

15

20

25

30

2005 2006 2007 2008 2009 2010 2011 2012 2013

Dry Pow

der (Billion

s $)

Capital R

aised, Transactio

n Vo

lume 

(Billions $)

Capital Raised versus Transaction Volume

Capital Raised ($Billions) Transaction Volume Dry Powder

Source: Preqin Source: Cogent

P R I V A T E C R E D I T

15

P R I V A T E C R E D I T : U . S .

16

2.7 3.1 2.82.1 2.4 2.7 2.4

3.4 3.0 2.8 2.6

3.9 4.1 4.3 4.44.8

4.3

3.43.7

4.2 4.34.8

0

1

2

3

4

5

6

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Multip

les

Company Ability to Service Debt

Average Coverage Ratio (EBITDA‐CAPEX)/Interest Average Total Debt to EBITDA

Source: Standard & Poor’s LCD

2.7 3.9 4.8 5.28.6

11

0

2

4

6

8

10

12

10‐yearTreasuries

InvestmentGrade Bonds

LeveragedLoans

High Yield Second Lien PE‐backedMezzanine

Percen

t

Fixed Income Yields(March 2014)

The ability of companies to service their debt remains high, but is less attractive than inthe last couple of years. As credit markets ease, companies have taken on more debt,reducing their interest coverage.

The premium for investing in private credit strategies above public credit remainshigh relative to history.

Source: Bloomberg, Credit Suisse, Barclays, S&P LCD

Returns to U.S. focused private lending appear attractive but risks are likely to rise as the economic recoverymatures

Understanding the role of private credit (first & second lien loans, mezzanine debt) is important to understanding its relativeattractiveness. It is most often used by middle market companies to finance growth, leveraged buyouts, and refinance existing debt.

Private equity sponsors have (1) large pools of dry powder that need to be put to work; and (2) a need to refinance and recapitalizetheir large portfolio of companies in order to provide liquidity to limited partners. The large demand for private debt is being rewarded with attractive premiums relative to public market credit.

Risk to private lending appears low today; default rates are low and companies as a whole are well prepared to service debt.

Outlook: Neutral. High demand for financing and strong corporate balance sheets are providing attractive premiums for privatelending over public market credit, but default rates are low relative to history and likely to rise over time. Prospective investors mustconsider that the US economic recovery is five‐years old; the average business cycle has lasted about six years since WWII.

P R I V A T E C R E D I T : E U R O P E

17

02468101214

Percen

t

European Leveraged Loan and High Yield Default Rates

Europe HY Default Rates Europe Levered Loan Default Rates

As the European economy recovers, default rates continue to come down. Itsrecovery is a year old, suggesting default rates will remain low for some time.

Historically, European companies have relied on bank financing, but banks’ need todelever is limiting their creation of new loans.

Declining bank lending to companies and a slowly recovering economy is creating an opportunity for direct lendingstrategies focused on Europe

An opportunity exists for direct lenders because European banks, the traditional suppliers of debt, are constrained while demand forloans is recovering.

Banks, under pressure to meet higher capital ratios, are reducing risk by not only reducing their lending, but shifting theirlending to larger, publically traded companies.

As Europe recovers, so does the demand for loans: midsize European businesses will need to raise 3.5 trillion euro in debtfunding over the next five years; in addition over 250 billion euros of debt will mature over the next five years.

There are risks to lending in Europe. While Europe’s recession has technically ended, no one expects its economy to recoveryquickly, and in fact there are threats to its recovery. Some EU nations are still in recession; European inflation is falling and itsmoney supply is falling, measures that hint at slowing growth.

Outlook: Positive. With declining access to bank credit for smaller borrowers, pricing appears most favorable for non‐traditionallenders to small and lower middle‐market companies.

3.03.54.04.55.05.56.06.5

Bank

 Len

ding, A

nnual G

rowth 

Rate (P

ercent)

European Bank Lending to Non‐Financial CorporationsAnnual Growth Rates

Source: Europe MFI Source: Credit Suisse

R E C O M M E N D A T I O N S

18

R E C O M M E N D A T I O N S

19

U.S. Buyout European BuyoutEmerging Markets

Buyout Secondary Market Venture Private Credit

Pricing Conditions

Prices for large and middle‐market LBOs are high relative to their history, though more attractive for middle market deals than than for large deals.

Purchase price multiples are  high, but in part because earnings are cyclically depressed. As growthand earnings recover, purchases over the next several years  will appear more attractive.

Conditions remain similar to a year ago.  Strong fundraising relative to opportunity set is leading to large capital overhang and rich pricing.

Strong equity markets and increased distributions to LPs have pushed purchase prices up. General Partners suggest that “structured” transactions that delay payment to sellers effectively reduces the purchase price.

Fundraising appears to have settled at a more sustainable level. Decreasing commitments and improved industry dynamics are producing more favorable pricing.

The premium for investing in private credit over public credit is wide relative to historical averages, in both the U.S. and Europe, but the risks associatedwith these premiums are different and changing.

Macro Environment (Beta)

Conditions are similar to a year ago.  Rising public equity markets, inexpensive financing and dry powder is putting upward pressure on price multiples.  Slowerthan average economic growth will contribute to longer holding periods,  effectively reducing expected returns.

European recovery is expected to be uneven and slow, favoring northern over southern Europe. 

Over the intermediate‐term, faster economic growth is a tailwind to value creation, but in the near termmarkets are recognizing differences in macroconditions across countries  that have implications for expected returns.  In the near‐term, private equity faces  the same headwinds that developed markets struggle with: an overhang of capital, slowing growth and challenging exits. 

Fundraising and strongpublic equity markets have in the short‐run made the market less attractive, but changing market dynamics (regulatory driven selling) will, in the medium‐term, favor buyers of secondary portfolios..

Developments in information technology have reduced the amount of seed and early stage capital needed to see a company through to its growth stage.   As a result, smaller funds taking smaller positions are better positioned to exploit these opportunities than larger funds.. 

Its relative attractiveness  varies with where credit is in its market cycle.  Five years into its recovery, U.S. credit markets are late in their cycle, while European credit cycle is in its earlier stages.  In addition, European banks,   are under pressure to raise capital ratios, leading them to lending to companies.

Manager Environment

High purchase prices and low economic growth means manager driven value creation will be key to strong returns; favoring small and middle‐market deals where managers have more levers to create value and exit options

A bifurcated economic recovery suggests that successful General Partners will be those that identify high quality, global companies with limited exposure to on‐going European risks.

Successful managers will be those that recognizedifferences in country risk and that are skillful  in country selection and company selection. Managers are looking to a new set of countries today including Mexico and South East Asia.

As the market matures, LP interests will be more efficiently priced. Managers with access to proprietary deal flow and strong underwriting efforts will outperform.

.

Managers that have demonstrated earlier success are raising larger funds at a time when small allocations are needed by technology firms.

The absolute returns to private credit appear attractive, but today, as the credit cycle reachesits top, the risk return profile  is less attractive. With many “new” managers raising funds, the challenge for investors is to identify managers with the skill set and experience to implement the strategy in a manner that reflects the desired risk‐return profile they seek.

Outlook Negative (Large)Neutral (Mid‐market) Neutral Neutral Neutral Neutral Neutral (U.S.)/Positive (Europe)

M A R K E T E N V I R O N M E N T

20

M A R K E T E N V I R O N M E N T : R E T U R N S

21

0.83x 0.75x 0.65x 0.32x 0.70x 0.33x 0.29x 0.25x 0.14x 0.09x 0.11x

0.38x0.37x 0.47x

0.75x

0.92x

0.84x 0.98x 1.01x 1.17x1.01x 1.04x

1.22x1.11x 1.12x 1.06x

1.62x

1.15x1.27x 1.26x 1.31x

1.09x 1.14x

0.00x0.20x0.40x0.60x0.80x1.00x1.20x1.40x1.60x1.80x

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Global Average Venture Capital by Vintage Year

DPI RVPI TVPI

1.79x 1.47x 1.32x 1.24x 0.78x 0.52x 0.48x 0.46x 0.25x 0.16x 0.09x

0.20x0.36x

0.39x 0.49x

0.64x0.75x 0.81x 0.88x

0.97x 0.98x 0.98x

2.00x1.85x

1.72x 1.71x

1.43x1.28x 1.29x 1.35x

1.22x 1.15x 1.07x

0.00x

0.50x

1.00x

1.50x

2.00x

2.50x

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Global Average PE Fund Return Multiples By Vintage Year

DPI RVPI TVPI

While investors in early vintage funds (pre-2004) have been made whole (their DPI:Distributions to-Paid-in-Capital are greater than one) they still have significant amountsof unrealized value (RVPI: Remaining Value to Paid-in).

As a group, no vintage year funds since 2001 have yet to make limited partnerswhole. All DPI’s are less then one. Potential returns, as measured by TVPI (realizedand unrealized value) are also low across all vintages.

2013 was a good year for distributions, but 2005 to 2008 vintage funds have yet to return all of theirinvestors’ capital

Funds raised during the years leading up to the Great Financial Crisis paid high prices for portfolio companies that lost value duringthe downturn. As a group, these funds have struggled to return capital.

Many are starting to see a recovery in the value of their portfolio companies but as their life‐spans are winding down, limitedpartners are seeking liquidity and the funds’ ability to generate “carry” for their general partners is limited. These have becomeknown as “zombie funds”.

Zombie funds have become targets of secondary funds. The secondary funds provide liquidity to limited partners while creatingnew economics for general partners to actively manage the portfolios to their conclusion.

Source: Pitchbook Source: Pitchbook

M A R K E T E N V I R O N M E N T : R E T U R N S

22

During most vintage years since 2001, top quartile buyout managers haveoutperformed top quartile venture capital funds.

Bottom quartile PE (Buyout) funds have consistently outperformed bottom quartileventure capital funds.

Evaluated as a whole, private equity returns have been average for some time, but skilled managers have delivered attractive risk-adjusted returns over time.

Academic research suggests there is persistence in general partner performance over time, and thus manager selection matters. Areview of performance by quartile reveals double digit differences in performance between the top and bottom quartile funds in bothbuyout and venture capital.

A review of fund performance by quartile reveals that: Bottom quartile buyout funds have consistently delivered superior absolute performance relative to bottom quartile venture 

capital funds.   Top quartile buyout funds have generally outperformed top quartile venture funds.

These results raise a question about the role of venture capital in a client’s portfolio in the absence of skill in fund selection; shouldlimited partners ignore venture and invest only in buyout?

-15%

-10%

-5%

0%

5%

10%

15%

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

PE vs. VC Bottom Quartile IRRs by Vintage

PE Bottom Quartile VC Bottom Quartile

Source: Pitchbook Source: Pitchbook

0%

10%

20%

30%

40%

50%

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

PE vs. VC Top Decile & Quartile IRRs by Vintage

VC Top Quartile VC Top Decile

PE Top Quartile PE Top Decile

M A R K E T E N V I R O N M E N T : F U N D R A I S I N G

23

The increase in fund raising was driven by an increase in commitments to buyoutfunds as well as to energy and mezzanine focused funds.

2013 fund raising not only saw its best year since 2008, but the return of “mega”funds. Nearly half of committed capital went to funds that raised more than $5billion.

Source: Pitchbook

Positive net-cash flows to limited partners helped fund raising in 2013, but it also saw the return of“mega” funds-those that closed with more than $5 billion of committed capital

After four years of weak fund raising, the amount of capital raised and the number of funds closed reached post‐financial crisis highs.

The primary explanation for a recovery in fund raising is an increase in distributions to limited partners, giving them new capital tocommit to private equity. Other explanations include an under allocation to private equity relative to investors’ policy statements giventhe outperformance of public market equities since 2009.

The increase in fund raising was accompanied by a rise in the proportion of assets committed to “mega” funds (those with more than$5b of committed capital). One explanation is that limited partners are reducing the number of managers they invest with to those thathave been the most successful in the past.

One implication of more capital being allocated to mega funds is the likelihood of more “larger” deals being done than in the last fiveyears.

 ‐

 50

 100

 150

 200

 250

 300

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Billion

s $

PE Fund Raising by Fund Size 

Under $100M $100M‐$250M $250M‐$500M $500M‐$1B $1B‐$5B $5B+

Source: Pitchbook

 ‐

 50

 100

 150

 200

 250

 300

'04 '05 '06 '07 '08 '09 '10 '11 '12 '13

Billion

s $

US Fund Raising by Strategy

Buyout PE Growth Co‐Investment Restructuring Mezzanine Energy Other

M A R K E T E N V I R O N M E N T : D E A L F L O W

24

Buyouts represent a declining portion of private equity deals as GPs see greateropportunity to add value through add-ons and in the growth/expansion stage of venture.

Within US buyout, acquisition of private companies remains the biggest portion ofdeals. Sponsor-to-sponsor transactions have stabilized with recovery of the IPOmarket.

Source: PitchbookSource: Pitchbook

Changes in the make-up of completed private equity transactions suggests General Partners are finding new ways to generate value for their limited partners

PE‐acquisition of privately held companies continues to dominate deal making. Sponsor‐to‐sponsor transactions which grewsignificantly following the financial crisis have stabilized as sponsors turn to a recovering IPO market for better exit values.

Leveraged buyouts continue to drop as a share of total private equity deals, reflecting a change in how general partners believethey can best create value.

“Buy and build” strategies and taking minority positions in growth/expansion deals have grown in importance.

An increase in capital allocated to growth/expansion deals reflect a change in the nature of venture capital funding. Early roundfunding needs to develop new technology have got smaller but more capital is necessary to see those companies to profitability.

0%

20%

40%

60%

80%

100%

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

US Buyout Deals by Source

Private‐to‐Sponsor Sponsor‐to‐Sponsor

Carve‐Out Public to Private

0%

20%

40%

60%

80%

100%

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014Q1

US Private Equity Investments by Deal Type

Buyout/LBO Add‐on Recap

PE Growth/Expansion PIPE Platform Creation

M A R K E T E N V I R O N M E N T : D E A L F L O W

25

The share of deals under a billion dollars has risen in importance as GPs engage inbuy and build strategies within buyout, and minority growth/expansion deals.

Add-on deals continue to grow in importance as GPs seek to create value throughbuy and build strategies.

680 867 1107 799 508 725 881 883 838 245

10561300 1476

1047

575

882904 967

757

171

39% 40% 43% 43%47% 45%

49% 48%53%

59%

0%

10%

20%

30%

40%

50%

60%

70%

0

500

1000

1500

2000

2500

3000

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014*

Buyouts:  Add‐ons vs Non Add‐ons

Add‐on Non Add‐on Add‐On % of Buyout

0%

20%

40%

60%

80%

100%

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014Q1

Investments by Deal Size

Under $25M $25M‐$250M $100M‐$500M

$500M‐$1B $1B‐$2.5B $2.5B+

The changing economics of private equity deals is forcing General Partners to look for new ways to createvalue, leading to changes in the composition of completed private equity deals

The share of smaller deals, specifically under a billion dollars, has grown the last couple of years, reflecting changing privateequity economics.

The increase in capital raised, dry powder waiting to be put to work, and recovery in public equity markets has put upwardpressure on purchase price multiples. In an environment of slow economic growth, General Partners must find other ways togrow portfolio company revenues and earnings to support exit values.

“Add‐ons” , typically smaller deals, reflect an attempt by General Partners to create value by “bolting” portfolio companies ontoone another in “buy and build” strategies. They believe that synergies arising from putting companies together will createvalue.

Source: Pitchbook Source: Pitchbook

M A R K E T E N V I R O N M E N T : D R Y P O W D E R

26

 ‐

 20

 40

 60

 80

 100

 120

 140

 160

2006 2007 2008 2009 2010 2011 2012 2013

Billion

s $

US PE Dry Powder By Fund Type and Vintage

Buyout PE Growth Co‐Investment Restructuring Mezzanine Energy Other

The majority of dry powder in US focused funds is held by buyout funds($400b), and the majority of that in recent vintage funds with several years leftin their investment periods.

The majority of US dry powder dedicated to buyout is held by funds with greater than$1 billion, The limited number of mega buyout deals in which to put capital to worksuggests General Partners will seek out new investment strategies.

Source: PitchbookSource: Pitchbook

Growth in dry powder has negative implications for purchase price multiples, expected IRRs and the composition of future private investments

In the competition between fund raising and new deal flow, fund raising continues to win. The result is a rise in the dry powderGeneral Partners have to put to work.

A more granular look reveals that General Partners are sitting on nearly a trillion dollar in global dry powder, over $600 billion of itdedicated to US‐focused funds and over $400 billion of that dedicated to US buyout funds (nearly 5‐years of deal flow).

A legitimate concern is that General Partners, anxious to put that capital to work before their investment period ends, will bid uppurchase price multiples. Others suggest that the composition of dry powder makes its potential impact on purchase pricemultiples less serious. Specifically, that within the pool of buy‐out focused dry powder, only approximately $100 billion is in fundswhose investment period is nearing an end. More than half of dry powder has been raised in the last two years.

Three‐quarters of the dry powder is held by funds with more than a billion dollars. As there are generally not enough large buyoutdeals to put this much dry powder to work, it is likely these larger funds will seek out other types of transactions including add‐onsand minority growth expansion deals.

 ‐

 20

 40

 60

 80

 100

 120

 140

 160

2006 2007 2008 2009 2010 2011 2012 2013

Billion

s $

PE Capital Dry Powder by Fund Size

Under 50M $50M‐$100M $100M‐$250M $250M‐$500M $500M‐$1B $1B+

M A R K E T E N V I R O N M E N T : E X I T S

27

 $‐

 $50

 $100

 $150

 $200

 $250

 ‐ 100 200 300 400 500 600 700 800 900

Value of Exits, B

illions

Num

ber o

f Exits

PE Exit Flow by Type and Value

Corporate Acquisition IPO Secondary Buyout Capital Exited ($B)

After two strong years of exit activity, 2014 is off to a slower start. A recovery in exit price multiples has rewarded partners in earlier vintage fundsbut those high prices are an impediment to returns for new buyers.

Source: Pitchbook Source: Pitchbook

Rising public equity markets, lots of dry powder and aging sponsor-owned companies contributed toa strong exit market

Corporate acquisitions continue to provide the majority of exits for private equity owned companies, but 2013 saw a small declinein its overall contribution to exits, the result of a recovery in the IPO market.

With general partners holding lots of dry powder on one hand and an aging portfolio of companies on the other, the growth insecondary buyout (also known as sponsor‐to‐sponsor transactions) exits is not surprising. They have grown from 25% of all exits in2009 to 39% in 2013; and the average median secondary buyout size has increased from $150m in 2011 to $379m in 2013.

The increase in 2012 and 2013 exits has reduced the ratio of new privately held companies‐to ‐exits, but it is still greater than one,meaning the number of privately held companies continues to grow.

The combination of high purchase price multiple in a low growth environment and lots of companies needing to be sold will lead tolonger holding periods for companies, hurting expected returns.

7.1

7.5

6.7

8.6

9.2

8.1 8.1 8.1

7.3

8.9

6.0

6.5

7.0

7.5

8.0

8.5

9.0

9.5

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Median Valuation/EBITDA At Exit

M A R K E T E N V I R O N M E N T : P R I V A T E E Q U I T Y E X P O S U R E

28

9631238

1704

2275 22792480

27763036

32733466

0

500

1000

1500

2000

2500

3000

3500

4000

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Billion

s $

Private Equity Exposure

Source: Pitchbook

The value of private equity controlled companies now exceeds the market cap ofthe Russell 2000.

2012 and 2013 were good years for portfolio liquidations and distributions tolimited partners, buy holding periods continued to rise.

The growth in sponsor owned portfolio companies has negative implications for returns to futureinvestments in private equity

Ten years ago, private equity firms controlled nearly 2300 companies worth about $960 billion. Today, private equity controls over7000 companies worth nearly $3.5 trillion.

The rate at which private equity sponsors are acquiring portfolio companies is faster than the rate at which they are beingliquidated. Historically, private equity owned portfolio companies are held for around four years before they are turned over andliquidity provided to limited partners. Today, the average holding period exceeds 6‐years.

Rising holding periods in the absence of above average revenue and earnings growth, leads to smaller distributions (TVPI) andlowering realized IRRs.

Source: Pitchbook

4.23.8 3.7 3.5

3.9 3.9

4.7 4.95.3

6.0

0

1

2

3

4

5

6

7

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Years

Private Equity Median Hold Period