Wealth Management Research

21 September 2011

Private equity
Education Series: Risk & return analysis
This is the second part of an education series on private equity to foster understanding of the asset class. The first part (published on 15 July 2011) provided an insight into the global private equity industry, different investment strategies and the key players. In this paper, we look at the following aspects: What is the historical risk and return profile of private equity?
Stefan Brgger, strategist, UBS AG stefan.braegger@ubs.com

Is there an outperformance versus public equities? How do we correct for illiquidity, leverage and the non-quoted
nature of private equity?
Source: www.fotolia.de

How much do institutional investors allocate to private equity?

The last part will then conclude this series by looking at differences between investment strategies and by analyzing value creation (and destruction) in concrete private equity examples. Strong nerves required for equity market investors Investors in public equities have experienced a rough ride over the last ten years. An investor who put CHF 100 in the SMI on 1 January 2001 saw this shrink to less than CHF 80 as of 31 December 2010. During that time, the investor experienced a significant roller coaster ride, with his investment down to CHF 45 in March 2003 and up to CHF 117 in summer 2007. However, an investor who was able to time the market perfectly, investing at the bottom and selling at the peak, would have multiplied his investment by 2.6x. Fig. 1: Roller coaster ride for public equities Swiss Market Index (indexed to 100; Jan 2001)
120 110 100 90 80 70 60 50 40 Jan-01

Private Equity Education Series: - Part I: Introduction to Private Equity - Part II: Risk & return analysis - Part III: How private equity creates value (or not) Benefiting from turbulence via private equity - Introducing special situations investing - Bank deleverage - a buying opportunity?

Bottom: 45.3 Peak: 117.4

SMI indexed (Jan 01 = 100)

Jan-02

Jan-03

Jan-04

Jan-05

Jan-06

Jan-07

Jan-08

Jan-09

Jan-10

Source: Bloomberg, UBS WMR

This report has been prepared by UBS AG. Please see important disclaimers and disclosures that begin on page 7. Past performance is no indication of future performance. The market prices provided are closing prices on the respective principal stock exchange. This applies to all performance charts and tables in this publication.

Private equity

Return profile of private equity

Private Equity invests in private companies and there is no market price available. Hence, investors are not exposed to the daily volatility and overshooting of public markets. An investor in a private equity fund basically delegates the timing of the investment to the fund manager. A typical private equity fund has a 5-year investment period, during which companies can be acquired. To compare with our previous SMI example, a private equity fund would ideally have invested most of its capital in 2002/03 and sold in the subsequent market recovery. Interestingly, private equity funds raised in 2001-03 in Europe seemed to have done exactly that, showing a strong performance, as the managers bought during the downturn (Fig. 2). Table 1: Private equity return analysis
Key figures across asset classes Average Annual Return 5 years Citigroup World Gov Bonds Global Property Index GPR 250 S&P500 FTSE, CAC, DAX (equally weighted) CS/Tremont Hedge Fund Index U.S. Private Equity European Private Equity 7.5% 4.3% 8.5% 10.6% 4.2% 9.3% 17.8% 10 years 15 years 7.4% 11.1% 1.3% 1.3% 8.2% 7.0% 16.9% 6.0% 9.7% 6.6% 8.0% 8.6% 15.3% 20.2% Volatility (annualized) 5 years 8.8% 28.8% 19.6% 19.7% 10.1% 10.7% 21.9% 10 years 15 years 8.6% 22.2% 18.6% 22.0% 8.4% 10.9% 18.4% 7.9% 19.8%

Fig. 2: Private Equity with strong net returns in difficult times European funds raised between 1999 and 2004
35.0% 30.0% 27.6% 21.7% 18.6% 15.3% 15.0% 10.0% 5.0% 0.0% 1999 2000 2001 2002 2003 2004 Year when fund was raised (invested subsequently over 5 years) 29.5% 24.4%

Net performance

25.0% 20.0%

Source: Thomson One, UBS WMR

Fig. 3: Lower volatility - especially in equity bear markets

40% 30% 20%

21.7% 8.6% 14.6% 20.2%

Quarterly returns

18.1%

10% 0% -10% -20%

Source: Bloomberg, Thomson One, private equity returns are net of fees and carried interest, figures as of Dec 2010

-30% 1994

1996

1998

2000

2002

2004
US Private Equity

2006

2008

2010

S&P 500

A comparison of historical performance Let's have a look at key return and volatility figures of private equity, and compare them with bonds, real estate, public equities and hedge funds. We will thereby look at different time horizons (Table 1). The figures suggest that private equity has historically outperformed public equity markets at a comparably lower volatility over different time horizons. Especially in past bear markets, private equity showed a lower volatility than public markets, bringing stability to a diversified portfolio (Fig. 3). Ultimately, private equity is exposed to equity risks and portfolio firms are also affected by the developments in the global economy. Hence, private equity returns are positively correlated with public markets. In the United States, broad private equity shows a relatively high correlation of 0.7 with the S&P500 index. Interestingly, private equity in Europe is less correlated with public markets, having a low correlation factor of 0.34. However, this correlation has increased to 0.5 since 2000 with the maturing of the industry (Table 2).

Source: Bloomberg, Thomson One

Table 2: Correlation of private equity with other asset classes

Key figures across asset classes Correlation to U.S. Private Equity -0.16 0.39 0.71 0.70 0.51 1.00 0.43 Correlation to EU Private Equity 0.15 0.34 0.38 0.34 0.32 0.43 1.00

Citigroup World Gov Bonds Global Property Index GPR 250 S&P500 FTSE, CAC, DAX (equally weighted) CS/Tremont Hedge Fund Index U.S. Private Equity European Markets Private Equity

Source: Thomson One, Bloomberg, quarterly figures between 1994 and 2010

Wealth Management Research 21 September 2011

Private equity

Adding private equity to a portfolio

We use the above historical return figures between 1994 and 2010 to create a diversified portfolio, and look at the risk / return profiles. First, we build a portfolio comprising only bonds and equity. We construct an equally weighted portfolio by investing 1/3 in bonds, 1/3 in the S&P500 and 1/3 in a public market index in Europe (equally weighted between FTSE, CAC, DAX). This portfolio generated an annual return of 7.0% with a volatility of 12.1%. Using different weightings, we can construct several optimal portfolios with different risk / return profiles (Fig. 4). Now, we add alternative assets (private equity, real estate, hedge funds) to the diversified portfolio. We again first construct a theoretical portfolio with equal weightings (1/7). This portfolio generates an annual return of 10.8% with a volatility of 11%. Hence, this portfolio achieved a higher return (10.8% vs. 7.0%) with a lower volatility (11% vs. 12.1%) than the equally weighted portfolio comprised of bonds and equities only (Fig. 5). Hence, the addition of private equity (and other alternative assets) with different return characteristics and correlations improves the risk / return profile of the portfolio which only includes bonds and equities. An investor hence achieved historically a higher overall return with a portfolio including an allocation to alternative assets, with the same expected volatility.

Fig. 4: Optimal portfolios (bonds / equity only)

10.0%

9.0%

Return

8.0%
Equally weighted bond/equity portfolio 100% bonds

100% S&P 500

7.0%

100% Europe

6.0%

5.0% 0.0%

5.0%

10.0%

15.0% Risk (volatility)

20.0%

25.0%

30.0%

Optimal portfolio (only bonds and equity)

Source: Bloomberg, UBS WMR

Fig. 5: Optimal portfolio (incl. private equity, hedge funds, real estate)
20.0%
Bonds/equity and nontraditional asset classes

15.0%

Addition of alternative asset classes to portfolio Equally weighted bond/equity/ non-traditional portfolio Bonds/equity only

Return

10.0%

5.0%

Equally weighted < bond/equity portfolio

What's t he allocation to privat e equit y by inst itut ional investors?

Allocation by institutional investors to private equity varies significantly, subject to the differing investment objectives, asset liability duration, risk appetite and liquidity requirements. Family offices have the largest average private equity allocation with an average long-term target of 27% of their total assets, followed by foundations / endowments which target a 12% allocation. Public and private pension funds however have a significantly lower allocation to private equity, and the same applies for insurance firms.

0.0% 0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

Risk (volatility)

Source: Bloomberg, UBS WMR

Fig. 6: Allocations vary widely Long-term asset allocation (% of assets) to private equity
30% 25% 20% 15% 10% 5% 0% Family offices Foundations Endowments Public pension funds Private pension funds Insurance companies 12.4% 12.0% 6.7% 5.9% 3.2% 27.1%

Source: Preqin (2010), UBS WMR

Wealth Management Research 21 September 2011

Private equity

Accounting for the special characteristics ofprivateequity

The above results suggest that private equity has historically outperformed public markets with a relatively lower volatility. However, several specific characteristics of private equity need to be taken into consideration when interpreting these results. Multi-year investment horizon: Investors in private equity need to have a long time horizon. A typical fund has a finite life, usually 10 years, with the possibility to extend the fund by another 1 to 2 years to sell all assets. During these 10+ years, the fund manager typically first sources transactions in order to build a diversified portfolio of private companies, then takes an active approach to build further value in the portfolio and eventually exits the companies again. This long-time horizon allows the manager to pick the right timing to invest and gives him flexibility when to sell. Hence, an investment in private equity is traditionally characterized by illiquidity and cannot be easily sold. Investors thus expect an illiquidity premium over public equities. Timing of cash flows: In contrast to mutual funds, where a manager can fully invest the money by buying shares instantly, a private equity manager must develop a deal pipeline, find investment opportunities, enter discussions with the seller, and eventually close a transaction. Given this longer investment horizon, there is less pressure to invest, and often the contractual agreement between investors and the fund manager foresees that only a certain amount (usually 20-25%) of the fund can be invested in a single year. As such, a private equity fund usually has an investment period of five years. Investors in private equity make a capital commitment at closing of the fund. This capital is then drawn down by the fund manager to make investments and cover the fund expenses. Therefore, an investor will only reach a significant investment level after several years. Normally, after 4 to 6 years, the fund manager will start to generate liquidity for investors. These returns are generated by exit events, typically through an IPO or a sale to a strategic / financial buyer. Hence, while a private equity fund has a 10+ years lifetime, the actual net cash flows for the investors have a shorter duration and tend to be positive after 5 to 7 years. This pattern is generally referred to as "J-curve" (Fig. 8). As a conclusion, an investor in private equity tends to have a positive net cash flow position after 5 to 7 years despite the investment horizon of 10+ years. Furthermore, the actual net investment level as a percentage of the original commitment can vary and tends not to reach 100%. Therefore, investors need to address this by an active investment level steering to achieve their required net investment level. Furthermore, comparing private equity returns with long-term buy-and-hold returns from public markets needs to take into consideration the active timing of cash flows by private equity managers.

Fig. 7: Special characteristics of private equity

Multi-year investment horizon Not fully invested at beginning No available price for valuation Limitation of benchmark Different risk profile due to leverage Illiquidit y premium Invest ment horizon of 10+ years Commit ment Invest ment Capit al calls over 5 years Private, non-quot ed f irms Only quart erly valuat ions Dat a limit at ions Non adequat e benchmarks Use of debt in f inancing acquisit ions

Source: UBS WMR

Fig. 8: The famous J-Curve Illustrative cash flow profile for a private equity investor
200 150 Investment period: Commitments are drawn as needed (years 1-5) Realization period: Distributions to investors occur as investments are exited (years 4-10), can occur before entire commitment is drawn

Investor's cash flows

100 50 0 (50) (100)

Cash flows to investors: Net cash position to investor (- capital calls + distributions) Year 1 Year 2 Year 3 Year 4 Year 5
Capital calls

Year 6 Year 7
Distributions

Year 8 Year 9 Year 10

Source: UBS WMR

The J-Curve in realit y

The J-Curve can vary significantly between vintage year, investment strategy and fund manager. Fig 9 shows the real cash flow patterns for a selection of different European buyout managers for vintage years 2000, 2003 and 2007. The most mature funds (2000 vintage) have returned a significant amount of capital to investors at the end of their fund life and there is already a positive net cash flow position after approx. 5 years. The more recent funds (vintage 2003, 2008) are still in the J-curve and only a few funds have already achieved a positive net cash flow position for investors. The recent impact of the financial crisis has impacted the realization figures and prolonged the J-curve. Interestingly, most funds raised in 2007 in this sample went into the crisis with less than 50% invested, providing them with shooting power for the economic recovery. Although all funds with a 2000 / 2003 vintage in the sample achieved an investment level of at least 90% of commitments, investors' actual net investment level (taking into consideration early distributions) ranged between 17% and 85% of the original commitment. Hence, the actual net investment level for an investor can vary significantly per vintage year and depends on the exit environment, but never reached 100% of the original commitment.

Fig. 9: Real J-curve for European buyout funds

Net cash f low (100 = t ot al commit ment )

200% 150% 100% 50% 0% -50% -100% 2000

2001

2002

2003 2000 vint age

2004

2005

2006

2007

2008

2003 vint age

2007 vint age

Source: Preqin, UBS WMR

Wealth Management Research 21 September 2011

Private equity

Valuation methodology: In contrast to public markets, where the value of a company is readily available and new information is instantly priced in, there is typically no public market for a privately held company. Instead, private equity companies are only valued on a quarterly basis. However, the same portfolio company held by several private equity managers can at times be valued differently. In the first year of a private equity fund, an investment is often carried at cost and only changed subsequently to reflect the operational developments, the general economic environment and public market comparables. Interim private equity returns shown for private equity funds or the industry as a whole should therefore always be viewed with some caution. However, the final performance of private equity is not impacted by this valuation methodology as the return reflects actual cash distributions to investors. Overall, this smoothing of valuations reduces the actual volatility of private equity. Benchmark selection: Given the non-public nature of private equity, there are certain data limitations, as private equity firms are not required to report their performance. Several benchmark providers like Cambridge Associates, Thomson Reuters, Preqin or State Street exist. However, benchmarks do not fully reflect the entire universe of private equity and can be subject to a survivorship bias. Preqin for example covers over 5300 funds, which amounts to some 70% of all private equity funds raised. Furthermore, historical private equity return databases are relatively short (roughly 25 years), in comparison to the histories of stocks and bonds which span multiple decades (well over 70 years). Use of leverage: Private equity funds can make use of external debt to acquire a company. Leverage is mainly used in buyouts, which traditionally involve the acquisition of stable companies with predictable cash flows, low capex requirements and limited working capital. In contrast, companies at an early stage of their development which require significant resources to grow (venture, growth capital), are usually acquired without or with very limited financial leverage. At the same time, public companies listed on a stock market have mostly also financial debt on their balance sheets. Hence, in order to compare the performance of private equity with public markets, the different degrees of leverage (and hence risk) must be taken into consideration. A comparison (Fig. 11) of the financial leverage of public companies listed on the S&P 500 with the historical debt levels of leveraged buyout transactions in the US, however, shows that average long-term historical debt levels have been very similar (4.2x S&P 500 vs. 4.1x for US LBOs), reflecting the overall availability of debt in the broad economy for borrowers. Hence, the higher private equity returns compared to public markets are not necessarily a result of a higher risk due to higher leverage vs. publicly listed companies.

Exhibit : List ed privat e equit y is a w eak proxy benchmark Occasionally, investors also use a listed private equity index (e.g. LPX) as a proxy benchmark for private equity returns. However, there is a limited universe of liquid stocks (hence increasing volatility), the index tends to overweight certain countries (mainly UK, US) and is not representative of a diversified private equity portfolio. Furthermore it also includes diversified asset management companies (Blackstone, KKR, Apollo) which are active in many different fields outside of private equity investing, (e.g. hedge funds, public equities, real estate, M&A advisory), exhibit different return drivers to a private equity portfolio and are hence a weak proxy for private equity returns. Historically, the LPX 50 has been closely correlated with global equity markets, but experienced a higher volatility (mainly during internet bubble in the late 90s driven by venture capital and during the recent financial crisis in 2008/09). Hence, we see a listed private equity index as a weak proxy to compare private equity with public market returns.

Table 3: Return / volatility comparison between MSCI World and LPX 50

Key figures across asset classes MSCI World LPX 50 (listed private equity) 2.7% 1.9% Average Return 5 years 10 years 2.5% 3.9% 15 years 5.6% 12.7% 5 years 21.9% 40.0% Volatility 10 years 20.1% 33.5% 15 years 18.9% 36.9%

Source: Bloomberg, UBS WMR

Fig. 10: Listed private equity follows stock markets closely Correlation between LPX 50 and MSCI World
100% 80%
Correlation: 5 years: 0.87 10 years: 0.86 15 years: 0.79

Quarterly returns

60% 40% 20% 0% -20% -40% -60%

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009
4.5 4.2

MSCI World

LPX 50

Source: Bloomberg, UBS WMR

Fig. 11: Similar debt levels at private equity and public firms in the US Comparison of financial leverage for public and private equity LBOs
6.0
5.7 4.9 5.0 4.9 4.0 3.7 3.7 3.7 3.2 3.7 3.3 4.8 4.7 4.7 4.7 4.9 4.5 3.7 3.0 3.5 2.9 4.1

S&P 500 US LBOs

Net debt / EBITDA 2.0 4.0

4.3 3.8 4.0

4.5

0.0

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

Source: Bloomberg, S&P, UBS WMR

Wealth Management Research 21 September 2011

Average

2010

Private equity

Return comparison - revisited

The above mentioned specific characteristics of private equity must be taken into consideration when comparing the performance of private equity with public equities [Note]. Based on an analysis of over 700 mature private equity buyout funds between 1980 and 2003 in the US and Europe, private equity has outperformed public equity markets, even adjusting for the different timing of cash flows, sector mix and different leverage. The overall figures show that private equity has outperformed public markets (Fig. 12). However, the alpha (0.8% p.a.) generated by an average buyout fund in the sample seems relatively small given the illiquidity which investors have to face in private equity. Looking at a sub-sample of the top performing buyout funds (25% quartile) in Fig. 13, these funds show a higher absolute performance and a significant alpha (5.1%) compared to public markets with the same risk profile. Therefore, adjusting for the (active) timing of cash flow, sector mix and leverage, figures suggest that the average private equity industry has slightly outperformed public markets. However, the best private equity managers have historically achieved a considerable outperformance versus equity markets. Conclusion Adding alternative assets can improve the risk / return profile of an investor's portfolio. Fig. 12: Small outperformance of overall private equity industry Return comparison adjusted for special characteristics of PE
8.0% 6.1% 6.0%

0.8% 0.1% 0.7% -0.1%

7.6%

Return

4.0%

2.0%

0.0% Public equity Adjusted for timing Adjusted for of cash flows different sector mix Adjusted for different leverage Alpha Private Equity

Source: Gottschalg, Bain Capital, UBS WMR

Fig. 13: Significant outperformance of top private equity funds

16.0% 14.0% 12.0%
0.7% 5.1%
13.6%

Return

10.0% 8.0% 6.0% 4.0% 2.0% 0.0% Public equity

6.7%

0.2%

0.9%

Investors in private equity need to be aware of special characteristics,

including a multi-year investment horizon, illiquidity, lower volatility helped by quarterly valuations and the use of leverage.

Adjusted for timing of cash flows

Adjusted for Adjusted for different sector different leverage mix

Alpha

Private Equity

Source: Gottschalg, Bain Capital, UBS WMR

Accounting for these factors, the overall private equity industry has
slightly outperformed public markets, compensating investors with an illiquidity premium.

However, the selection of the top performing private equity funds resulted in significant alpha for investors.

Note: The return figures are based on a HEC Paris study published by Oliver Gottschalg (2010), composing a sample of over 700 mature buyout funds based in the US and Europe with at least seven years of cash flows available with vintage years between 1980 and 2003. This makes sure that return figures are mainly built on actual cash realizations, and less on unrealized net asset values. All figures are shown net of fees, expenses and carried interest. Public markets are based on MSCI World, Nasdaq and Eurostoxx sector indices. The investment timing of private equity is corrected by comparing private equity returns with the hypothetical returns earned by a public market portfolio with the same cash flow pattern. This public market portfolio is a public index (e.g., S&P 500), and every time the private equity fund makes a draw-down, an equal amount of shares of the index are purchased. Likewise, whenever there is a positive distribution from the private equity, an equivalent amount of the public index is sold.

Wealth Management Research 21 September 2011

Private equity

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Wealth Management Research 21 September 2011