Quarterly Report December 2013

PRIVATE EQUITY NAVIGATOR

Private equity analysis from Pevara &

INSEAD’s Global Private Equity Initiative

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INTRODUCING A NEW REFERENCE TOOL As a result of our research activities and engagement with industry players and students in the classroom, we regularly encounter requests for data on activity and performance in the private equity industry. In the absence of a standard index for this asset class, we suggest various sources, each with its own pros and cons. However, different sources work with different sets of data, making it difficult to compare performance without access to the underlying fund and transaction data. It is therefore in pursuit of the clarity that so often eludes practitioners, industry observers and academics that we are launching the quarterly INSEAD–Pevara Private Equity Navigator. What sets this report apart is the combination of independent academic leadership and a unique dataset derived entirely from cash flows reported by limited partners (LPs). The selection and interpretation of data is carried out by the Global Private Equity Initiative (GPEI) at INSEAD, while the data is provided by Pevara, the performance monitoring module of eFront, a leading financial analysis solution for alternative investments. Thanks to this joint initiative, we will provide a stream of unbiased observations on a quarterly basis. We will report and interpret key metrics, and illustrate the real life challenges of investing in private equity by tracking unique hypothetical LP portfolios based on actual underlying funds. The Private Equity Navigator is a reference tool for practitioners and academics, designed to stimulate further discussion and research, as well as to create enhanced transparency for this asset class, and thereby contribute to better allocation decisions. We hope you find it as thought-provoking as it is useful. As ever, we welcome your feedback and suggestions.

Claudia Zeisberger Michael Prahl

Affiliate Professor of Decision Sciences Executive Director and Head of

and Entrepreneurship and Family Enterprise, Research, GPEI

Academic Director, GPEI

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CONTENTS The Private Equity Navigator seeks to balance the presentation of raw data and minimal accompanying commentary with a more engaging (if less rigorous) approach to illustrate key concepts in private equity. Our findings are presented in three sections:

In section one, we present quarterly data for private equity activity levels, performance and variance. Derived from a large sample that is free from the reporting or self-selection biases so often encountered, these data points are fairly representative of the state of the industry. In addition to reporting on market developments in line with established industry standards (IRR), we use the (theoretically more sound) modified IRR (MIRR) method. By basing our calculations on more realistic assumptions about re-investment, cost of capital, as well as the timing of capital calls, our results are closer to the reality of institutional investors, and therefore allow for more meaningful discussion. In the second section we construct two portfolios resembling those of large institutional investors in private equity. These portfolios are hypothetical (even if they are aligned with actual global asset allocation trends), but the underlying funds are not; we will track their performance over time, while maintaining their anonymity. Our objective is to illustrate the interplay of private equity concepts from an investor perspective and provide insight into the development of funds invested over time. A special third section offers an opportunity to delve into niche topics of the industry. For this inaugural issue, we take a closer look at buyout performance in North America and Europe – by far the largest segments of the global private equity industry. Given the size of the buyout market, we differentiate between large-cap and mid-cap funds for much of our analysis.

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Industry Fundamentals – An Overview For anybody involved in private equity, be they a GP, LP, gatekeeper or service provider, certain sets of numbers are most illustrative of the health of the industry, and, by extension, its prospects. The two most relevant measures are (a) activity levels in the industry—how much capital is raised, how much invested, and how much distributed to investors; (b) performance—the kind of returns and variance among managers that investors are seeing. Consistently lower risk-adjusted returns than those made from allocations to other asset classes will obviously result in lower commitments to private equity over time.

ACTIVITY LEVELS A commonly used measure of activity levels in the PE industry is the total number or value of investments and divestments. In this report we use the sum of all capital called and all capital distributed by almost 2,300 funds, which serves as a more-than-adequate proxy for levels of activity in the industry and changes in the rate of activity. In this issue we consider private equity activity since 2005.

2005 2006 2007 2008 2009 2010 2011 2012

Calls ($bn) 82.24 141.80 216.91 207.33 96.89 154.25 161.59 126.37

Distributions ($bn) 107.00 113.72 138.86 63.70 31.68 106.34 176.44 190.38 From the data above, the impact of the global financial crisis on the private equity industry is clear. The total capital called by PE funds more than doubled between 2005 and 2007, to $216.9 billion. This figure declined sharply to just $96.9 billion in 2009, reflecting the uncertainty in the markets, the disappearance of debt capacity, PE firms’ focus on their existing portfolios, and a lack of enthusiasm among LPs about capital calls received during a period of constrained liquidity and temporary over-allocation to PE (for an explanation of the denominator effect, see Glossary). Distributions of capital by GPs, too, were at their lowest ebb in 2009, when only $31.7 billion was returned to investors, falling from $63.7 billion a year earlier and from $138.9 billion two years prior. However,

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distributions bounced back strongly, more than tripling to $106.34 billion in 2010. A lot more capital has since been returned to investors – $176.4 billion in 2011 and $190.4 billion in 2012 – a rare display of distributions exceeding capital calls. In recent months the investment pace has slowed markedly. In the first three quarters of 2013, the amount of capital called by funds in the database stood at $54.1 billion, around $33.8 billion less than in the first nine months of 2012 ($17.4 billion in Q3 2013 vs. $28.8 billion in Q3 2012). On the distribution side, the buoyant trend continues, with $170.1 billion in capital returned over the first nine months of 2013, an increase of $48 billion over the same period last year. It looks as if 2013 is on track to become the strongest year ever in terms of capital returned to LPs. Overall, the balance between capital calls and distributions suggest that we are seeing a prolonged sellers’ market, fuelled by the liquidity in the financial system. Accordingly, PE firms are finding it easier to refinance, recapitalise and exit their funds’ portfolio companies than to deploy freshly raised funds in a disciplined way, taking into account what is still considerable uncertainty. PERFORMANCE Private equity performance has always been a topic of intense scrutiny and interest for those in the financial industry. Traditionally the private equity industry uses IRRs and multiples to measure its success. Below we compare three different ways in which annual performance1 can be measured. First, IRR, the conventional but theoretically unsound performance measure of the industry.2 Second, the Pevara Index which calculates IRRs using the Modified Dietz Method (see Glossary), which improves slightly on the IRR by accounting for the timing of cash flows within a period. And third, the modified internal rate of return (MIRR) which assumes more realistic re-investment opportunities for investors. While there are several ways to address the structural shortcomings of IRR (including computing Public Market Equivalents), we prefer to use MIRR, given the ease of implementation and the closeness in intuition to currently used measures.3 MIRR is also comparable to the annual (buy and hold) returns used in public equity indices.

1 All net returns after fees and carried interest 2 The two main issues with IRR are the re-investment hypothesis on intermediary distributions and the cost of uncalled capital. In the case of intermediary distributions, IRR equals the effective rate of return only if the intermediary dividends are reinvested at the IRR rate. In effect this leads to early reported high IRRs inflating fund returns by assuming unrealistic high reinvestment rates, and early low IRRs punishing managers by assuming that investors can only find low-yielding reinvestment opportunities. As an additional consequence, the use of simple IRRs overstates the variance of performance between managers and the volatility for the asset class as a total. In addition, there are costs of holding capital. When the standard IRR is being used, there is no difference between calling capital late or early, as the IRR is only calculated over the investment period. Yet the interest of the investor, once committed, is for capital to be called early, but only for investments that are projected to deliver above the minimum accepted rate of return. For a practitioner-oriented review of issues surrounding IRR, refer to Phalippou (2008) “The hazards of using IRR to measure performance: The case of private equity”. 3 This report uses a discount rate for capital calls of 12% with a 10-year horizon, and equally assumes that proceeds will be reinvested at a rate of 12%. This is a fair estimate since it is in keeping with the 10-year return from the Russell 2000 from 2003-2012, which stands at 11.93%, and given the normal life span of a fund of 10 years. In any case, slight variations of the discount rate by a few percentage points have a negligible impact on the MIRR results.

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IRR vs Annual Pevara Index Returns vs MIRR

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 CAGR

IRR 14.54% -12.59% -7.42% 14.36% 19.84% 26.49% 26.46% 19.39% -24.40% 10.58% 18.54% 8.23% 12.19% 8.59%

Pevara 13.06% -13.06% -7.61% 14.14% 19.88% 26.56% 26.48% 20.04% -22.77% 10.07% 18.48% 8.35% 12.22% 8.60%

MIRR 14.54% -11.36% -6.31% 13.98% 16.70% 25.57% 24.82% 19.10% -21.61% 9.89% 17.44% 7.70% 11.79% 8.47% At first glance, all measures seem to produce remarkably close returns for the industry as a whole. Over a prolonged period (CAGR of 13 years) they are virtually undistinguishable. However, such uniformity masks major differences on an individual fund level and differences in distributions of funds (variance). The latter can be seen by comparing MIRR and the other two measures: MIRR generally shows less extreme performance in strong years (lower as in 2004) and weak years (higher as in 2008). When comparing the PE industry’s 13-year MIRR performance with the S&P 500 Total Return (ignoring some of the frictions in re-investing in an illiquid asset class vs. the most liquid stock market index), even the average performance for the asset class looks strong, with 8.47% annual return versus 1.66% for the S&P 500 over the same period. If one takes a 10-year horizon (conveniently starting after the 2001/2002 dip in both private and public equity markets),4 then the PE industry’s MIRR and S&P 500 Total Returns amount to 11.70% and 7.10% respectively. This premium over public market returns holds for comparisons with more globally diversified indices (e.g. 10y MSCI World IMI total net returns are 8.03%), but depending on the period chosen becomes less pronounced or non-existent for small-cap indices such as the Russell 2000 (annual of 11.75% for 10y from 2003-2012).

4 By choosing the horizon, one implicitly decides whether to include 1 or 2 cycles/crises in the data.

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For a more granular performance of the industry, we depict quarterly MIRRs including the first three quarters of 2013.

From the chart we can discern five broad phases in the financial markets since the year 2000. The turn of the century coincided with the end of the tech boom, with PE returns peaking in the first quarter of 2000 (11.59%). The next phase saw markets plummeting, with a series of negative or zero returns for the industry before they gradually rebounded. The third phase, extending from the middle of 2003 till late 2007—a golden era for investing—saw strong returns in private equity as well as in many other asset classes. Quarterly returns for private equity turned marginal in Q3 in 2007 (0.86%), and negative in Q4 2007 (-1.26%). The ensuing market crash had severe repercussions for the PE industry, as asset values plummeted and returns turned negative. Yet this correction produced only five quarters of negative returns for the industry and a strong rebound followed. Since then, markets have seen a gradual stabilisation in what is an on-going period of moderate returns, which, while steady, are lower than those of the golden age. Average quarterly returns in 2012 reached only 2.86%, marginally higher than the average quarterly return of 1.92% recorded in 2011. The average quarterly MIRR for the first half year of 2013 stood at 3.21%, slightly above the 2.745% recorded for the first two quarters of the previous year. In the first two quarters of 2013, the MIRR stood at 3.73% and 2.69% respectively.

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VARIANCE In this inaugural issue we present variance in performance by PE funds by vintage year. This reflects the business cycles discussed in the earlier section but breaks down industry returns by managers grouped into quartiles. The chart below represents the range of returns by vintage year for all funds in the Pevara Index5 between 2005 and 2009.6 Upper and lower ranges for all quarters are shown, as well as arithmetic and pooled means.7

Benchmark IRR Quartiles by Vintage Year

Arithmetic Mean Pooled Mean Median

2005 6.50% 7.62% 6.47%

2006 4.93% 4.72% 5.37%

2007 4.67% 7.02% 6.53%

2008 6.48% 9.55% 6.31%

2009 3.08% 8.39% 2.95%

5 In this section we use the Pevara Index, allowing for easy extraction of volatility measures from the database. 6 We do not include funds from younger vintages as they are still in their investment period, hence preliminary returns are likely to change substantially. 7 The arithmetic mean is calculated as the average of the IRRs of each of the PE funds as single entities without consideration of fund size. The pooled mean, on the other hand, is calculated as the average of the IRRs of private equity funds on a dollar-weighted basis.

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A number of observations can be made from the data. First upper and lower boundaries as well as average performance per vintage fluctuate significantly. Funds of the 2006 vintage have the lowest pooled mean of 4.72%. Funds of subsequent vintages up to 2009 provided better returns on average, with funds of the 2009 vintage recording pooled returns of 8.39%. This variance between vintages shows the importance of diversification by fund date. By investing across multiple years, investors gain exposure to various points of the industry cycle, in the process reducing volatility in their portfolios. Second, there is a significant difference between arithmetic (“average”) returns and pooled returns, in particular for vintages 2007-2009. Pooled mean returns are significantly higher (as much as five percentage points in 2009), which is explained by a stronger-than-average showing of larger PE funds in these vintages. The historic loss ratio from investing in PE funds is lower than often perceived. Broadly speaking, in most vintages only the bottom quartile funds deliver negative performance over the lifetime of their investment, while three quarters show (often strongly) positive returns. This means that a portfolio diversified across several funds is highly likely to show positive returns. Yet variance in performance between managers of the same vintage (and therefore the need for diversification between managers) is significant. Using the industry practice of grouping funds into quartiles, those in the 2007 vintage display the greatest range in IRR performance, ranging from 21.22% at the top end of the first quartile to -16.17% at the bottom end of the fourth quartile. Funds of the 2006 vintage are more homogeneous, ranging from 19.08% at the top to -11.61% at the bottom. The table below shows the variance in performance between funds in each vintage measured by standard deviation. The calculation of the standard deviation is based on the arithmetic mean of the IRRs of all private equity funds in a particular sample. The lower the standard deviation for a particular year, the closer the funds to the arithmetic mean.

Standard Deviation ArithmeticMean One standard deviation Two standard deviations

2005 10.99% 6.50% (4.49%) to 17.49% (15.48%) to 28.48%

2006 10.04% 4.93% (5.11%) to 14.97% (15.15%) to 25.01%

2007 12.19% 4.67% (7.52%) to 16.96% (19.71%) to 29.05%

2008 11.06% 6.48% (4.58%) to 17.54% (15.64%) to 28.60%

2009 13.45% 3.08% (10.37%) to 16.53% (23.82%) to 29.98%

Benchmark IRR Dispersion on Standard Deviation by Vintage Year

The standard deviation in percentage points of returns lies between 10% and 13.5%. If we look at the still relatively immature vintage of 2009, standard deviation is 13.5%, while the arithmetic mean IRR stands at 3.1%. Applying the empirical rule,8 68% of the funds currently have an IRR of between -10.4% and 16.5% (within one standard deviation of the mean), and 95% have an IRR of between -23.8% and 30% (within two standard deviations of the mean). As some of these vintages mature, we would expect to see a reduction in performance variance.

8 It needs to be stated that this is a conscious oversimplification as private equity returns do not follow a bell-shaped distribution (normal distribution).

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MODEL PORTFOLIO The figures in the previous section paint a somewhat abstract picture, which requires some context to be useful. To make them more intuitive, we construct several hypothetical portfolios for limited partners. We start with two “model” portfolios representing a typical LP with a balance of commitments across strategies and geographies. The portfolios consist of actual underlying private equity funds, very much like those assembled by an “average” institutional LP (with a total PE commitment of $1 billion).9 This unique approach offers insight into the capital allocation, capital call and capital distribution processes in the PE industry. How we constructed the Portfolios:

9 In practice, the process would probably be reversed, with investors establishing an “optimal” target allocation to PE and managing its commitments to achieve this target through over-commitment.

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We have selected funds for two different portfolios that we will “manage” going forward. For each of them we have picked 20 funds equally spread across five vintage years from 2008 to 2012 (which started investing predominantly post-global financial crisis). The funds apply a mix of strategies including buyout, growth, distressed, venture and mezzanine. To get a wider range of geographical exposure, the funds were picked from North America, Europe, Asia and Latin America. In order for the portfolios to differ from the market (that is, as represented by the Pevara Index), we attribute some selection skill to the hypothetical LP. For the initial portfolio selection, we apply “perfect hindsight” avoiding bottom quartile funds (as of today). Instead the funds are randomly picked in equal parts from each of the other three quartiles. We rationalise this with better selection processes, more thorough due diligence and risk avoidance, as exhibited by professional institutional investors. However, this advantage will partly disappear as selected funds may slip in performance1, and as we reshuffle/add new funds to the portfolio.1 Both model portfolios comprise a gross allocation to private equity of $1 billion committed to 20 private equity funds. The dollar allocation to strategies and geographies in Portfolio 1 is in line with the overall relevant ~2,300 private equity funds present in the Pevara database. For Portfolio 2 we add another dimension of variance by over-allocating (relative to the index) to emerging markets (mainly Asia) and growth capital funds. The portfolio construction is depicted below: Portfolio 1:

Strategy: Buyouts 75%; Growth 6%; Venture 7%; Others (Distressed & Mezzanine) 12% Geography: North America 63.5%; Europe 28%; Asia 5.5%; Other Emerging Markets 3%

Portfolio 2:

Strategy: Buyouts 54%; Growth 21%; Venture 11%; Others (Distressed & Mezzanine) 14% Geography: North America 41%; Europe 34%; Asia 19%; Other Emerging Markets 6%

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J-CURVE AND CASH FLOWS Below we depict the cash flows associated with the portfolios: drawdowns (capital called), distributions, and the resulting net cash positions (J-Curve).

Drawdowns for Portfolio 1 started in Q2 2008, while the first meaningful distributions occurred four years later in Q2 2012. The $1bn allocation is now drawn down to $492m or 49%, the net result of capital calls and distributions, the latter amounting to about 10% of invested capital. We observe broadly the same initial drawdown pattern for Portfolio 2. However, distributions started a little earlier, and became sizable and growing from Q2 2012. With distributions reaching 16% of invested capital, the net drawdown now stands at $469m, which is already less than the current low point in the curve from two quarters earlier ($485m).

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Both portfolios show how hard it is to get the targeted net exposure to private equity right. If Portfolio 2 has indeed already reached its inflexion point in the J-curve, then over-commitment to the asset class versus actually invested capital would be roughly 100%. At the same time even the eight funds in our two portfolios from 2008 vintage (and therefore outside a funds typical investment period) are only on average 80% called further illustrating the challenges in timing cash outflows. This raises questions about liquidity management in order to service the capital calls but also to deploy the capital returned to investors (either back into private equity funds or other asset classes). Investors are advised to simulate different cash flow scenarios (specifically taking market cycles and external shocks like those during the recent financial crisis into account) and include risk buffers. If private equity is seen in the context of a wider investment strategy, fluctuations in the PE portfolio’s Net Asset Value (NAV) or overall portfolio’s NAV make it much harder to reach and maintain a target allocation, with the portion of the portfolio allocated to private equity constantly over- or undershooting.

PORTFOLIO SUMMARY

Portfolio 1Figures in Millions

Fund Vintage Strategy Geography Committed Called Remaining Distributed NAV TVPI IRR MIRR Quartile

Fund 1 2008 Bu you t US 90.00 (82.54) 7.46 5.36 102.85 1.31x 11.53% 11.75% 2n d

Fund 2 2009 Bu you t US 90.00 (74.13) 15.87 15.13 88.52 1.40x 16.78% 14.70% 2n d

Fund 3 2010 Bu you t US 90.00 (52.72) 37.28 1.64 61.43 1.20x 12.58% 12.26% 2n d

Fund 4 2010 Bu you t US 90.00 (47.24) 42.76 13.01 49.78 1.33x 23.12% 17.50% 1s t

Fund 5 2011 Bu you t US 90.00 (23.87) 66.13 1.28 25.46 1.12x 9.06% 10.53% 1s t

Fund 6 2012 Bu you t US 90.00 (25.02) 64.98 0.00 23.16 0.93x (15.64%) 2.15%

Fund 7 2008 Bu you t W . Eu rop e 70.00 (36.58) 33.42 2.85 42.24 1.23x 7.52% 9.42% 2n d

Fund 8 2009 Bu you t W . Eu rop e 70.00 (40.38) 29.62 0.55 41.71 1.05x 3.04% 8.15% 2n d

Fund 9 2011 Bu you t W . Eu rop e 70.00 (29.71) 40.29 0.01 26.45 0.89x (11.05%) (0.38%) 3rd

Fund 10 2008 VC R.o.W 10.00 (9.50) 0.50 1.83 8.30 1.07x 1.96% 5.42% 3rd

Fund 11 2008 VC US 15.00 (11.35) 3.65 2.04 11.77 1.22x 7.76% 9.81% 3rd

Fund 12 2008 VC W . Eu rop e 15.00 (13.29) 1.71 3.71 11.18 1.12x 4.79% 8.47% 2n d

Fund 13 2012 VC W . Eu rop e 15.00 (2.18) 12.83 0.00 2.31 1.06x 10.27% 11.22%

Fund 14 2012 Bu you t As ia/P acific 15.00 (2.58) 12.42 0.03 2.42 0.95x (5.40%) 2.35%

Fund 15 2012 Late/Exp an s ion R.o.W 20.00 (7.46) 12.54 0.00 8.11 1.09x 11.57% 11.79%

Fund 16 2010 Late/Exp an s ion As ia/P acific 20.00 (8.44) 11.56 0.96 6.70 0.91x (4.66%) (0.16%) 3rd

Fund 17 2012 Op p ortu n is tic As ia/P acific 20.00 (9.42) 10.58 0.00 10.85 1.15x 29.01% 17.99%

Fund 18 2009 Dis tres s ed US 40.00 (35.79) 4.21 4.57 51.80 1.58x 19.08% 16.58% 1s t

Fund 19 2012 Mezzan in e Cap ita l US 40.00 (17.38) 22.62 0.00 19.00 1.09x 8.24% 8.07%

Fund 20 2011 Dis tres s ed W . Eu rop e 40.00 (16.00) 24.00 0.02 17.03 1.07x 4.50% 6.23% 2n d

All 1,000 .00 (545 .57 ) 454 .43 53 .00 611.07 1.22x 11.11% 11.67% Overall, Portfolio 1 stands at a Total Value to Paid-in Capital [TVPI = Cumulative Distributions + Period NAV divided by paid in capital] of 1.22x. This means that about 22% value or $118m over the investment cost has been created (or at least has been accounted, as actual cash returns account for $53m or just under 10% of investment cost). This leads to a current portfolio IRR of 11.1% and an MIRR of 11.7%. Again the almost identical return number for the portfolio obscures the moderating effect the realistic re-investment assumptions have on individual outlier funds, e.g. funds 6 or 17.

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Portfolio 1 shows significant more activity in the US funds than in their European counterparts, both with respect to drawdowns and early distributions. They also show the strongest TVPIs. Overall there are only four funds with a TVPI below one, reflecting our “selection” skill in not picking funds from the fourth quartile.

Portfolio 2Figures in Millions

Fund Vintage Strategy Geography Committed Called Remaining Distributed NAV TVPI IRR MIRR Quartile

Fund 21 2008 Bu you t US 90.00 (77.55) 12.45 8.25 93.09 1.31x 7.69% 8.78% 2n d

Fund 22 2010 Bu you t US 90.00 (47.24) 42.76 13.01 49.78 1.33x 23.12% 17.50% 1s t

Fund 23 2012 Bu you t US 90.00 (31.48) 58.52 0.06 36.32 1.16x 15.17% 15.25%

Fund 24 2008 Bu you t W . Eu rop e 70.00 (44.53) 25.47 6.76 44.24 1.15x 5.67% 8.90% 2n d

Fund 25 2009 Bu you t W . Eu rop e 70.00 (57.63) 12.37 10.62 50.25 1.06x 2.36% 6.56% 2n d

Fund 26 2009 Bu you t As ia/P acific 60.00 (51.26) 8.74 0.04 47.72 0.93x (3.74%) 4.39% 3rd

Fund 27 2010 VC US 30.00 (17.40) 12.60 0.04 23.93 1.38x 24.24% 18.44% 1s t

Fund 28 2011 VC US 30.00 (8.10) 21.90 1.80 6.76 1.06x 6.91% 9.89% 2n d

Fund 29 2009 Late/Exp an s ion US 30.00 (27.21) 2.79 12.19 35.26 1.74x 24.99% 19.37% 1s t

Fund 30 2011 VC R.o.W 20.00 (6.10) 13.90 0.00 5.15 0.84x (13.47%) (0.91%) 3rd

Fund 31 2012 Bu you t W . Eu rop e 70.00 (16.28) 53.73 0.00 17.09 1.05x 6.76% 8.37%

Fund 32 2011 Bu you t R.o.W 40.00 (13.71) 26.29 0.01 11.64 0.85x (13.59%) 0.22% 4th

Fund 33 2011 Late/Exp an s ion As ia/P acific 30.00 (16.58) 13.42 1.15 15.31 0.99x (0.47%) 1.99% 1s t

Fund 34 2010 Late/Exp an s ion As ia/P acific 30.00 (11.69) 18.31 0.09 11.58 1.00x (0.05%) 3.59% 2n d

Fund 35 2009 Late/Exp an s ion As ia/P acific 30.00 (28.76) 1.24 9.56 36.70 1.61x 20.06% 16.42%

Fund 36 2011 Late/Exp an s ion W . Eu rop e 40.00 (8.49) 31.51 0.00 8.49 1.00x 0.00% 5.85% 2n d

Fund 37 2008 Late/Exp an s ion W . Eu rop e 40.00 (33.24) 6.76 2.14 26.74 0.87x (5.02%) 2.52% 3rd

Fund 38 2010 Dis tres s ed Deb t US 50.00 (26.07) 23.93 11.43 26.47 1.45x 16.47% 15.12% 1s t

Fund 39 2012 Bu you t As ia/P acific 40.00 (8.40) 31.60 0.00 9.75 1.16x 16.70% 15.79%

Fund 40 2011 Dis tres s ed W . Eu rop e 50.00 (33.26) 16.74 14.06 19.27 1.00x 0.36% 7.66% 3rd

All 1,000 .00 (564 .97 ) 435 .03 91.22 575 .56 1.18x 8 .21% 10 .73% The TVPI for Portfolio 2 currently amounts to 1.18x, slightly lower than Portfolio 1. This means that about 18% value (or $102m over the investment cost) has been booked. The proportion of actual cash realisations at $91m or 16% is, however, significantly higher than in Portfolio 1. The portfolio’s IRR stands at 8.2%, while the MIRR is at a somewhat higher 10.7%. Investment and distribution activity is more evenly spread across geographies and investment strategies than in Portfolio 1. Yet a full six out of 20 funds are currently showing a TVPI below one, which in part reflects the immaturity of some of these funds (although two are from 2008 and 2009 vintages).

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COMPARISON OF PORTFOLIOS We now compare the portfolios with each other by looking at their constituent funds’ performance by vintage (and overall). We also compare them with the wider universe of funds in the Pevara database for these vintages, and for this reason we use IRR as the measure of performance. The returns from 2008 vintage funds in Portfolio 1, for instance, have been compared with the returns generated from 2008 funds in Portfolio 2, and with the pooled mean IRR delivered so far by 2008 vintage funds in the broader database (representing the market). The chart shows that funds from Portfolio 1 comfortably outperform ‘All’ funds in the broader Pevara Group for most vintages. This is not surprising given that we have designed Portfolio 1 to mirror market allocation while using selection skill to avoid bottom quartile funds. However, the blind selection methodology means that, even with that advantage, Portfolio 1 may underperform the broader market (including the fourth quartile) in a specific year, as demonstrated here in 2010. In contrast, the performance of funds from Portfolio 2 is much more inconsistent. All vintages but one (2010) under-perform against funds from Portfolio 1 and Pevara All funds. Considering Portfolio 2 has the same selection advantage (no bottom quartile funds) over the Pevara All Funds Group, this suggests that in this case geographical and strategic allocation decisions trump manager selection. However, bear in mind that the IRR is an imperfect measure of the performance of the portfolios at this point, as funds in the portfolios are still young and largely in their investment phase. We will therefore continue to observe how the portfolios mature and perform over time in the hope that readers will gain practical insight into decisions around portfolio construction, liquidity and return, and demystify some of the inner workings of private equity.

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EUR NA EUR NA

Pooled Mean 1.87x 1.73x 1.34x 1.35x

Top 5% 3.65x 3.50x 2.47x 2.12x

Upper Quartile 2.26x 2.26x 1.47x 1.73x

Median 1.67x 1.64x 1.18x 1.36x

Lower Quartile 1.38x 1.15x 0.93x 1.11x

Bottom 5% 1.06x 0.53x 0.68x 0.75x

Pre-2001 Vintages Vintages 2001 & after

SPECIAL COMMENTARY European vs North American Buyout Funds Each issue of the Private Equity Navigator features a specific topic for more in-depth treatment. We start with the largest pools of money in the industry – buyout funds in North America and Europe – comparing their aggregate performance across different parameters. For most of this analysis we use a data sample of 435 funds in Europe and 645 in North America, but we consider a smaller selection when comparing large-cap with mid-cap performance. 1. TVPI comparison by quartiles Given the influence of market cycles on the industry, we split European and North American funds into vintages pre- (373) and post- (707) 2001. For both European and North American buy-out funds, performance has deteriorated for the later vintages. For vintages pre-2001, the pooled mean TVPI for European and North American buyout funds was 1.87x and 1.73x respectively, considerably higher than for post-2001 vintages, at 1.34x and 1.35x respectively. Pre-2001 funds have on aggregate performed well, with European funds slightly ahead, particularly with respect to the bottom quartile and bottom 5%. For buyout funds of the 2001 vintage and later, European buy-out funds show a much wider dispersion than their North American counterparts. TVPI standard deviation for North American buyout funds stood at 49.58%, compared with 55.37% for European funds. European buyout funds are more likely to have done either extremely well or very poorly – that is, they are characterised by greater performance volatility.

2. RVPI comparison by quartiles The residual value to paid in capital (RVPI, see Glossary) for buyout funds of vintages 2001 and later is currently slightly higher for North American buyout funds (0.71x) than for European funds (0.67x). This means that the latter distributed a larger proportion of returns to investors. The differences across the various quartiles are minor, but North American buyout funds consistently have a higher residual value to paid-in capital – in other words they are sitting on portfolios that are higher in value than their European counterparts.

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3. Comparison of pooled mean IRRs In recent years there has been little to choose between European and North American buyout funds when using annual IRR as the measure of performance. While their returns differed until 2007, since then they have moved in lockstep. However, this year the first three quarters have shown some divergence with the annualised return, hitherto standing at 8.56% for North American buyout funds and 5.03% for European buyout funds.

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

EUR 32.17% -3.46% 0.35% 8.57% 24.75% 43.44% 41.79% 26.80% -26.34% 7.59% 21.43% 9.41% 12.22% 5.03%

NA 3.77% -9.00% -6.22% 17.96% 24.29% 26.38% 23.30% 20.35% -25.38% 8.83% 19.15% 9.82% 13.43% 8.46% The years 2005 and 2006 were particularly good years for the buyout industry, with European funds recording IRRs of 43.44% and 41.79% respectively, and North American funds recording returns of 26.38% and 23.3% in those two years. Not surprisingly, the year after returns plummeted to -26.34% in Europe in and to -25.38% in North America.

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4. Comparison across mid-cap buyout funds Here we compare the return performance of 163 mid-cap buyout funds in Europe and 131 North American funds for the 2001 vintage and after. The IRR performance of European funds has been marginally better than their North American counterparts – entirely due to the strong performance of the top 5% mid-cap buyout funds in Europe – while North American buyout funds have better IRRs across all other quartiles. Indeed the arithmetic mean for NA funds stands at 9.44%, while the mean for European mid-cap funds is only 6.51%. The big difference between the European mean and pooled mean (about 5%) indicates that larger European mid-cap buyout funds played a key role in lifting overall performance in terms of the pooled (dollar-weighted) mean. The standard deviations for European and North American mid-cap buyout funds from the mean IRR were 15.24%, and 10.32% respectively.

5. Comparison across large-cap and mega-cap buyout funds In the large-cap and mega-cap segment (defined in the Glossary), data from 58 European funds and 93 North American funds of post-2001 vintages again show a higher pooled mean IRR for European funds. Once more, European buyout funds that are in the top 5% outperform their North American counterparts, while in all other quartiles and in particular in the bottom 5%, North American large-cap and mega-cap buyout funds register higher returns. The standard deviation for European large and mega buyout funds stood at 12.96%, higher than the 9.75% recorded for comparable North American funds. Looking at the segments by size and geography, the most attractive place over the last 12 years (in hindsight) for a diversified investor would have been North American mid-market buyout funds. With the mid-market segment posting significant higher returns than the large-cap space, its low variance (compared to the European mid-market funds) made it a much safer bet for investors. While European buy-out funds during this period delivered marginally better returns to investors than their North American counterparts, they saw a much wider dispersion, and this trend was driven entirely by the top 5%.

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APPENDIX 1 - METHODOLOGY The Pevara database contains information on fund cash flows contributed by LPs representing net-to-LP performance (after management fees and carried interest have been paid by the LP). As a result, there is no reporting or self-selection bias in Pevara data since GPs regularly report their fund statistics to investors. Valuations collected from LPs represent quarter-end (semi-annual in some cases) fair market valuations as reported on capital accounts by the fund managers. Pevara grosses up cash flows received from LPs to represent the value of the entire fund based on the fund’s total size. The report is published within two months of quarter end and a few weeks after LPs reported their data to Pevara. For performance calculations, capital calls are represented as negative values and distributions are represented as positive values. Cash flows are pooled for sample sets by summing the cash flows and valuations on the days they occur for all funds in the sample. Pevara uses IRR to show performance of a single fund investment or a group of funds. Since inception, IRR is used unless a time period for the IRR is specifically stated (see Glossary). Index calculations within Pevara show the periodic return of a sample of funds calculated using the Modified Dietz Method (see Glossary). The Pevara Index analytics from the Benchmark Analysis library plot quarterly Modified Dietz returns for the selected sample. For the MIRR, this report uses a discount rate for capital calls of 12% with a 10-year horizon, and also assumes that intermediary proceeds in the form of dividends are reinvested at a rate of 12%, rather than being reinvested at the IRR rate, which is unrealistic. This is in keeping with the 10-year return from the Russell 2000 (2003-2012), which stands at 11.93%, and also takes into account the fact that a private equity fund’s life span is about 10 years. These MIRR calculations are performed on a quarterly basis and help us showcase differences in returns depending on the method used to determine performance.

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APPENDIX 2 - GLOSSARY

i. LP: Limited partner – refers to an investor in a private equity fund. These are usually institutional investors or high-net-worth individuals. Their liability in the partnership is limited to the extent of the capital invested by them in a private equity fund.

ii. GP: General partner – refers to the private equity fund manager. The general partner is liable for the actions of the partnership, and retains a percentage of the profits (known as carried interest) and charges the LPs a management fee.

iii. Capital commitment: An LP’s obligation to provide a fixed amount of capital to a private equity fund at the time it is investing.

iv. Capital deployment: That part of the capital committed to a private equity fund that is drawn down as and when the GP makes investments.

v. Sum of capital calls: Capital calls are also known as drawdowns or paid-in capital. When a GP requests more capital from an LP committed to the fund for making an investment, it is referred to as a capital call. The sum of capital calls is simply an aggregation of capital called by all the private equity funds in a selected sample.

vi. Sum of distributions: When PE funds exit investments, they retain their carried interest and the rest of the profits are distributed to the LPs in the fund, referred to as distributions. The sum of distributions hence refers to the total money returned to LPs by GPs in a particular timeframe after they have exited investments

vii. IRR: This is a measure of performance that refers to the dollar-weighted internal rate of return exclusive of the management fees and the carried interest that the GP retains. It is the annualised discount rate that when applied to each cash flow and the ending market value will equate to a net present value (NPV) of zero. The IRR function is calculated as:

where CF represents the cash flows of the fund(s) including the terminal NAV for active funds as of date for the calculation and r represents the IRR. IRRs are de-annualised for periods of less than 1 year based on the number of days between the first and last cash flow.

viii. Pooled Mean: The IRR for the pooled cash flows of the selected sample ix. Median: the IRR of the fund(s) representing the 50th percentile of the individual IRRs from the

selected sample x. Top (upper/first) Quartile IRR: The IRR of the fund(s) representing the 75th percentile of the

individual IRRs from the selected sample xi. Bottom (lower/third) Quartile IRR: The IRR of the fund(s) representing the 25th percentile of

the individual IRRs from the selected sample xii. Arithmetic mean: A simple average of the individual fund IRRs from the selected fund sample

xiii. Modified IRR: MIRR is a more accurate measure of private equity performance as it assumes that positive cash flows to LPs are reinvested at the cost of capital, and also accounts for the cost of uncalled capital, unlike the standard IRR.

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xiv. Modified Dietz Method: A quarterly Modified Dietz Method return is calculated as:

Where: EMV = Ending Market Value BMV = Beginning Market Values CF = Cash Flows during the period

Where: CD = the number of calendar days during the return period being calculated

Only quarters for which the Beginning and Ending Market Values are greater than zero (0) are included

in the index calculations.

xv. Performance Multiples: These can be calculated for individual funds or pooled samples of funds. They include:

PICC: Paid-in to Committed Capital = Cumulative Calls/ Sum of Commitments DPI: Distributed to Paid-in Capital = Cumulative Distributions/ Cumulative Calls DCC: Distributed to Committed Capital = Cumulative Distributions/ Committed Capital RVPI: Residual Value to Paid-in Capital = Period NAV/ Cumulative Calls TVPI: Total Value to Paid-in Capital = [Cumulative Distributions + Period NAV]/

Cumulative Calls xvi. Vintage year: This refers to the year the private equity fund was formed and the first

drawdown of capital was made xvii. Denominator effect: This refers to an asset allocation problem due to an allocation lag caused

by a collapse in the public equity markets. Institutional investors have a mandate to invest up to a certain part of their portfolio in the private equity class. As the public equity markets collapsed, the overall value of the total portfolio (the denominator) of the institutional investors shrank. While the value of the public equities allocation plummeted, the same did not happen with private equity because private equity performance is reported with a lag of one quarter or more. This meant investors were over-allocated to the private equity asset class and hence had to sell off part of their PE portfolio commitments.

xviii. Large- and mega-cap buyout funds: These refer to buyout funds typically larger than $2.5 billion in size, typically targeting companies with an enterprise value of ~$750 million or more.

xix. Mid-cap buyout funds: These refer to buyout funds with a typical size of $1 billion, targeting companies with an enterprise value of ~$300 million.

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ABOUT US PEVARA Pevara, a division of alternative investments software provider eFront, is a private equity portfolio analysis solution incorporating reliable private equity benchmarks and advanced analytics. It enables investors to monitor their portfolio’s performance, benchmark fund investments and evaluate new investment opportunities. eFront is a leading software provider of end-to-end solutions dedicated to the financial industry, with recognised expertise in alternative investments and risk management. Pevara’s data is obtained from actual LP cash flows, as opposed to surveys or relying on the Freedom of Information Act to source data. LPs who wish to contribute data to the Pevara Private Equity Index do so by sending an email to data@pevara.com, after which a Pevara data specialist will discuss the process with them. INSEAD GLOBAL PRIVATE EQUITY INITIATIVE The Global Private Equity Initiative (GPEI) drives teaching, research and events in the area of private equity and related alternative investments at INSEAD, one of the world’s leading business schools (www.insead.edu). It was launched in 2009 to combine the rigour and reach of the school’s research capabilities with the talents of global professionals in the private equity industry. Through its research, the GPEI aims to enhance the productivity of the capital deployed in this asset class and to facilitate the exchange of ideas and best practice among general and limited partners.

INSEAD's global presence – with campuses in France, Singapore and the UAE – offer a unique advantage in conducting research into established markets for private equity, while at the same time exploring new frontiers in emerging markets to arrive at a truly global perspective on this asset class. The GPEI also focuses attention on newer areas shaping the industry, such as impact investing, growth equity, infrastructure PE, and the needs of various groups of LPs like family offices and sovereign wealth funds. The GPEI looks to partner with stakeholders in the private equity industry to collaborate on research ideas and projects. Its core supporters are:

CONTACT US

PEVARA Brookmount House 62-65 Chandos Place London WC2N 4HG United Kingdom www.pevara.com info@pevara.com & data@pevara.com(Data contribution requests)

INSEAD – GPEI INSEAD Asia Campus 1 Ayer Rajah Avenue Singapore 138676 Tel: +65 6799 5388 Fax: +65 6799 5399 www.insead.edu/gpei gpei-private.equity@insead.edu

This report is authored by Michael Prahl, Executive Director and Head of Research at the GPEI, and Siddharth Poddar, Research Associate, under the supervision of Claudia Zeisberger, Academic Director of the GPEI, Professor of Decision Sciences and Entrepreneurship and Family Enterprises. We thank Rishi Kotecha from Pevara and Hazel Hamelin, senior editor at INSEAD for their invaluable support.