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VOLUME IV: ISSUE XIV

SEPTEMBER 2013

THE DECLINE OF PRIVATE EQUITY MEGAFUNDS


By Teddy Xiong
Private equity has long been considered a desirable exit opportunity for practitioners in finance and a source for investors to earn aggressive investment returns. By pooling funds from large institutional investors, private equity firms are given a mandate to identify and buy out attractive businesses, manage and improve their operations over a medium-term time horizon, and ultimately cash out of the company to earn their investors an attractive internal rate of return. However, recent years of underperformance by megafunds relative to their smaller competitors and even the market have begun to frustrate some investors, many of whom are now looking to scale back their asset commitments to private equity as the general industry prepares itself for a potential shakeout. Underperformance of Megafunds Many investors view private equity as an absolute return strategy. To compensate for the riskier investments, they expect double-digit returns. However, since the mid-2000s, the largest players in the private equity space have typically lagged behind their smaller peers. Funds launched in 2006 that manage $3.5 billion or more only averaged a 4.1% annual return as of last fall, compared to 14.1% returns for funds managing less than $300 million and 9.7% for funds managing $1 billion to $3.5 billion. The industry median during this time horizon was 7.6%. As the graphic on page 3 indicates, these larger funds have also underperformed over one-year, five-year, and ten-year time horizons. Among the underperformers are some of the most prominent names within the private equity space. Blackstones $21.7 billion fund from 2006 had a 2% net annualized IRR as of last December; TPGs $18.9 billion fund from 2008 and $15.4 billion fund from 2006 earned returns of 2.5% and -4.9% annually as of last June; and KKRs $17.6 billion fund from 2006 earned 6.9% annually as of last September. Causes of Underperformance According to industry analysts, one of the key components of the underperformance has been the type of deals executed by these megafunds. Rather than buy out existing private firms, where the private equity company can often pay a discount due to liquidity concerns, these megafunds often take large public companies private, foregoing the typical liquidity discount and even paying a premium to the market at times. Additionally, while leverage ratios have come down to more manageable levels since 2007, the large amounts of absolute debt that the megafunds had to take on in order to finance their larger deals created a significant drag on company operations. Following the financial crisis, less capital has been available, especially bank debt, forcing funds to put up equity stakes in their deals as high as 40%. This has made middle market investments much more attractive in the past five years due to lower absolute capital requirements and an attractive high-yield market, giving smaller private equity firms an advantage. Meanwhile, firms have been increasingly pressured to invest the capital they already have, despite the decrease in the industry median return over the past few years. Over a quarter of the money raised from 2006 to 2008 has been returned to investors, and 14% of the $702 billion raised is yet-to-be invested dry powder that firms must invest or return to investors by the end of 2013 a record amount. Once they did invest, private equity firms struggled to cash out of their investments. Initial public offerings have slumped considerably since the recession, making sales to rival private equity firms an increasingly common exit strategy. These private-to-private deals lacked the payoffs of IPOs and sales to strategic buyers, and they accounted for roughly one-third of exit transactions in 2012, the highest since 2006. Investors Pulling Out Pension funds have long represented a core clientele for private equity firms, especially given todays low interest environment where making returns to meet growing pension obligations has proven increasingly difficult.

Continued on Page 3, PE Megafunds M&ABOOM Charles Bagley


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CURReNCY lOCKdOwN? Karan Parekh


Page 2

CRISIS IN CYPRUS JeonKang


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INSIDE THIS ISSUE

WHARTON UNDERGRADUATE FINANCE CLUB

SEPTEMBER 2013
pacity until it reached this goal. A response from other nations could inevitably lead to a cyclical problem. With nations constantly devaluing their currency in response to similar actions of others, situations of hyperinflation would develop, benefitting no one. However, many nations nonetheless responded to Japan in a manner suggesting tit-for-tat action. Francois Hollande called for the European Union to fix the value of the Euro at a mid-term exchange rate due to its recent rise. The European Central Bank, however, appeared to have other plans, with President Mario Draghi leaving the door open for additional monetary policy actions in order to further address the strength of the Euro. Even outside the Eurozone, South Korean President Park Guen-hye stated she would take preemptive action to help Korean companies avoid making losses, referring to currency action. The Federal Reserve of the United States has maintained monetary policies since the start of the recession to weaken the United States, slashing interest rates. The G-20, which represents the 20 largest economies of the world, addressed these rising currency war concerns in February. Largely ignoring Japans recent actions, the G-20 issued an empty, unenforceable declaration vowing to combat the recession with means other than currency. However, without enforcement, currency wars are a lingering worry for the worlds economies as they struggle to climb forward. China has already voiced some of these concerns, reminding G20 nations of their declaration and suggesting that developing nations would face the majority of the damage in any currency policy. It remains to be seen how effective this currency lockdown will be.

CURRENCY LOCkDOWN?
By Karan Parekh
In January of 2013, Japanese Prime Minister Shinzo Abe stated that Japan would be open to buying large quantities of government bonds and jumpstarting the economy with inflationary measures. These comments led to a firestorm of debate and controversy regarding the recent international currency markets. With many global economies, particularly those in Europe and East Asia still struggling to rise out of an economic downturn, lowering the currency value would be a temporary fix that could potentially start a worldwide currency war, with nations attempting to gain a competitive edge. Currency plays an important role in economic strength. A weaker currency entices foreign investment, increases exports, and supports domestic industries through a (relatively) cheaper cost of production. Nations with stronger currencies will naturally look to those with weaker countries, as their currencies will have more bang for the buck. With many central banking systems printing currency during the economic downturn to facilitate these effects, countries not doing so are disadvantaged in attempting to boost their own economies. Japan recently took public action and followed through with inflationary measures. The Prime Minister referenced other nations, stating central banks around the world are printing money America is the prime example. Citing a need to defend against the rise of the yen, Japan looks to devalue its own currency and achieve a goal of 2 percent currency. In comments made in January, Japan stated that it would purchase assets and government bonds with unlimited ca-

SPAIN, IRELAND, ITALY, GREECE AND NOW...CYPRUS


By Jeon Kang
The Situation ATM lines are getting longer as Cypriots run to their banks to withdraw as much as cash as possible. Credit cards are shunned as major retailers announce that they accept cash payments only. Supermarkets are bursting with people grabbing food and basic necessities, a scene resembling a pre-war period. The Eurozone is again in shambles as Cyprus follows Spain, Ireland, Italy, Portugal, and Greece, despite the continued efforts to quell the crises. Considered one of the worlds largest tax havens in proportion to its size, Cyprus large banking sector (7.5 times the island nations economy) will be hit hard due to the EUs proposed 47.5 percent tax to be levied on uninsured funds over 100,000 in Cypriot banks. Nicosia, the home of the Cypriot government, opposed levying the tax only on the large account holders over worries about damaging the countrys reputation amongst wealthy international capital holders. The European Central Bank (ECB) announced on March 19th that it would cut the emergency funding to the Cypriot banks, which has been the lifeline to their distressed operations. The ECBs report could lead to Cyprus potential ouster from the Eurozone, bringing about significant loss of asset value anda vicious circle of devaluation and hyperinflation, according to a statement by The Bank of Cyprus, the nations largest financial institution. The European Union is requesting 5.8 billion from the island in return for the 10 billion (approximately $13 billion) bailout. Naturally, the plan was met with harsh opposition from Cypriots, forcing their congress to quickly reject the original plan. However, without a viable alternative, Nicosia turned to Moscow, whose financiers currently loan out $30 to $40 billion to Cypriot banks. CNN reports that this amount accounts for 20 percent of the [Cypriot] banks capital base. Michalis Sarris, the Finance Minister of Cyprus, however, returned with his head down from Moscow after talks with the Prime Minister Dmitry Medvedev. Although Mr. Medvedev claims that he has not completely shut the door, it is very unlikely that Russia will extend its hand before the European Union sorts out a deal with Cyprus. Now in hotter water, Sarris has announced that the original tax levy plan needs to be reconsidered more seriously. It is suspected that the island nations hefty investments in Greece and their outrageous losses have plunged the economy and the banking sector into crisis.

Continued on Page 4, Cyprus


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SEPTEMBER 2013

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CAN WE TRUST THE M&A BOOM?


By Charles Bagley
Wall Street dealmakers rang in the New Year right, as some of the biggest names in corporate America have apparently generated a frenzy of merger and acquisition activities in the past quarter. In February, we learned of the $11 billion deal between American Airlines and US Airways, which came on the heels of the announcement of the $28 billion joint acquisition of HG Heinz by Berkshire Hathaway and PE firm 3G. Of course, the deal between OfficeMax and Office Depot was noteworthy as well, and both firms will together hold approximately 30% of the office supply market, still outpaced slightly by Staples, with Wal-Mart and Amazon.com close behind. To put it in perspective, in the same time period it took for $85 billion of M&A activity in 2012, there has been $219 billion this year. Indeed, we are on course to having the biggest year in M&A activity since 2000. Furthermore, the largest M&A deals of 2012 occurred at the very end of the year. If we include that activity, we can see that these deals are really part of longer-lasting trend of M&A activity. While these deals obviously have a great effect on acquired firms (and the investment bankers that helped make it happen), does this large uptick in M&A activity signify anything about the health of the US economy? M&A activity tends to be cyclical, spurred by changes in credit availability, government regulation, and periods of private sector innovation. For example, the era of consolidation in the banking industry in the late 1990s was spurred by the passing of the Gramm-Leach-Bliley Act. Perhaps the most important factors, however, are fundamental economic conditions and their effects on the stock market. Mergers in particular are typically financed with shares of the companies involved, so high stock values can lead to more activity. But the stock market has been doing well for quite some time now, right? After all, the S&P 500 has more than doubled since 2009. So why didnt we see this uptick in activity earlier? The answer is that heavy quantitative easing from the Federal Reserve has left us with artificially high stock prices. The Fed has kept interest rates extremely low for a long time, and because of this we see higher stock prices. In other words, central bank stimulus makes the stock market a less reliable indicator of the economic health of the nation. more in terms of ego than business (Carl Icahns buyout of Dell comes to mind), we can discern increased confidence from large corporations, which is important for the real economy around us.

PE Megafunds, Story continued from front page


However, the recent underperformance of the largest private equity funds has prompted some pensions to reevaluate their asset allocation strategies. Some pension funds are demanding lower management fees, especially as more private equity firms are buying from other private equity firms. These private-to-private transactions are presumed to have limited upside as the first private equity owner likely already made high initial returns from the company. Worse, if a pension fund owns both the buying and selling firms, it greatly drags down its own payouts. In response to the decreased returns, the State of Wisconsin Investment Board sold $1 billion in private equity funds, while the Employees Retirement System of Texas announced that it planned to reduce its private equity allocations by $100 million in the next fiscal year. The Washington state pension fund reduced its investment in KKR from $1.5 billion in 2006 to $500 million for its latest fund, while Oregon reduced its commitment from $1.3 billion to $525 million. Other pension funds have announced secondary offerings of their private equity investments or have turned more towards middle market firms that are more likely to generate a high return. As a result, with nearly 260 funds trying to raise a combined $219 billion, many private equity firms have found raising capital to be much more difficult. Considering the other tailwinds in the industry, private equity is primed to experience a potential shakeout, with traditionally weaker firms surging forward.

e are on course to having the biggest year in M&A activity.

There is a glimmer of hope, however. Given that these recent deals were not ill advised, we know that most Boards of Directors would not permit expensive acquisitions and mergers if they were not confident about long-term growth. Furthermore, corporate profits havent taken a huge beating in this down economy, meaning that companies will have to start spending money to grow. We can only hope this will help our national economy recover. Thus, even though these deals are sometimes talked about
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WHARTON UNDERGRADUATE FINANCE CLUB Cyprus, Story continued from page 2


The Moves As of now, as the Finnish European Affairs Minister Alexander Stubb claims, Nicosias only option is to accept the 10 billion bailout deal from the European Union. On March 22nd, Cypriot lawmakers decided that Laiki Bank (Popular Bank of Cyprus), Cyprus most troubled and the second largest bank, would need to transfer its non-distressed accounts to the Bank of Cyprus. Laiki Banks problematic assets will be broken into pieces and restructured into what is called a bad bank. Then the accounts without problems will be subject to 47.5 percent tax levy according to the EUs bailout plan. Additionally, the Cypriot lawmakers have decided to sell Greek operations of Cyprus three largest banks to Piraeus Bank, a Greek financial institution, to protect the Greeks from the hefty price tag of the bailout plan and to dilute the burdens on Cypriot banks. The legislators also voted to nationalize pension funds, create sovereign wealth funds, and harshly restrict movement of capital to act as recovery and prevention measures. The decision to nationalize pension funds, however, was met with criticism from the Germans, whose political and financial influences steer (read: dictate) the decisions made by the EU. Currently, Nicosia is busy drafting revised plans that its Finance Minister will be presenting to the Eurozone Finance Ministers in Brussels. Moodys recently revised its credit rating on deposits in Cypriot banks to Caa3, just two grades away from the bottom of its junk rating.

SEPTEMBER 2013
The Prospects The European Union, European Central Bank, International Monetary Bank, and Cyprus have settled on a deal. The newly drafted contract eliminates the previous tax levy plan from large account holders (from depositors who have more than 100,000 in their accounts, which has instigated protest in Moscow, as wealthy Russian businessmen are the major Cypriot bank account holders. The newly framed action replaces the tax with monetary losses on bondholders and depositors but the amount to be drawn is still in the dark. European leaders insisted that this new action be executed immediately to ensure Cyprus stay in the Eurozone and restoration of its fragile economy. It is puzzling how this remedy will pan out although credit cards are accepted again, anxious Cypriots are still running to their banks to stock up on cash, even though the banks only allow a 300 withdrawal. It looks like the 10 billion bailout that the European Union promised Cyprus will be deposited in early May. Angry Cypriots have fretted over the opacity of the Brussels deal-making process. Despite the stopgap measure, Cypriot leaders have little time to do much reevaluation because its economy depends on an oversized financial sector that supports the nations 860,000 people, and it has a reputation as a haven for the worlds black money. Cures are bound to run out as they are heavily and rapidly distributed measures of prevention are direly needed in Cyprus and Europe.

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