probitas partners private equity deskbook...

Private Equity Deskbook 2011

© 2011 Probitas Partners

Confidential & Trade Secret. © 2010 Probitas Partners. Do not circulate or publish.

Probitas Partners is a leading independent knowledge, innovation and solutions provider to private markets clients. It has three integrated global practices that include placement of alternative investment products, portfolio management and secondary fund advisory. These services are offered by a team of employee owners dedicated to leveraging the firm’s vast knowledge and technical resources to provide the best results for its clients.

On an ongoing basis, Probitas Partners offers research and investment tools on the alternative investment market as aids to its institutional investor and general partner clients. Probitas Partners compiles data from various trade and other sources and then vets and enhances that data via its team’s broad knowledge of the market. Unless otherwise noted, charts included in this white paper are from the Private Equity Deskbook 2011.

n. [from Latin probitas: good, proper, honest.] adherence to the highest principles, ideals and character.

probity ¯ ¯˘

Confidential & Trade Secret. © 2011 Probitas Partners. Do not circulate or publish. 1

C o n t e n t s

Market Trends ............................................................................... 2

The Global Economy: Where Do We Stand? ............................ 4

Fundraising Forecast and Dynamics ....................................... 6

Fundraising Dynamic for 2011 .................................................. 10

The Buyout Market: Investor Focus and Concerns .................................................... 12

Where Do We Go from Here? ...................................................... 16

Distressed Debt: Where Did the 100-Year Flood Go? ........................................... 19

Asia and the Emerging Markets: Searching for Growth ................................................................. 22

Europe: Beginning to Rebound ................................................... 26

Venture Capital: Armageddon or the Next New Thing? ...................................... 30

At the Margin: The Search for New Opportunities ........................................... 34

Secondary Market: Back on Track ............................................ 37

Forecasts for 2011 ......................................................................... 40

Confidential & Trade Secret. © 2011 Probitas Partners. Do not circulate or publish.2

M a r k e t Tr e n d sPrivate equity valuations and transaction activity in developed markets have rebounded

• Portfolios are rebounding from their spring 2009 lows, and public market indices are back to pre-Lehman collapse levels, if not their October 2007 highs

• However, fundamental economic issues — especially high unemployment and heavy government debt loads — continue to plague many developed markets; recent signs of GDP growth and unemployment moderation are the first early signs of real recovery

...Though private equity fundraising will continue to be sluggish

• The overhang of outstanding unfunded commitments continues to burden investors with large legacy portfolios, most of whom are triaging current relationships

Many investors are focusing on the growing economics of the emerging markets

• Investors are particularly interested in the BRIC countries of China, Brazil, and India, though Russia trails badly in investor interest

• The MIST countries (Mexico, Indonesia, South Korea, and Turkey) are now being touted as the next group of emerging market leaders

• Mega-buyout funds with global mandates are increasingly investing in the larger emerging markets

...Though there are concerns that these countries are overheating

• There are acknowledged concerns in China and Brazil, where their governments are taking steps to slow growth to control inflation

Distressed investment opportunities have been limited by the dramatic recovery in the capital markets

• High-yield bond issuance exploded as investors sought high returns, with much of that issuance used to refinance existing debt instead of supporting new transactions

• Bankruptcy rates have plunged from the historic highs of 2009 to near record lows


Buyout purchase price multiples rebounded more quickly than expected

• Average buyout purchase price multiples in the U.S. and Europe are already back to 2006 levels, increasing much more quickly than in past economic cycles

• While debt is more available than the past two years, leverage ratios remain constrained

The venture market is still undergoing significant secular challenges

• Median ten-year horizon returns for venture capital are now negative; even established venture capitalists are grappling with those issues while “zombie” funds raised at the last venture market peak of 2000 continue to die

• Many limited partners have given up on the sector; others are taking a contrarian approach, hoping that a decline in fundraising will translate into increasing future returns

Regulatory issues have become more settled

• The AIFM Directive and Dodd-Frank have become law in Europe and the U.S., though implementation details are still being worked out

• In Shanghai, details of a program to make RMB funds accessible to foreign investors is progressing

The wild cards: energy prices and Japan

• Turmoil in North Africa and the Middle East in 2011 resulted in a steep rise in oil prices even though the countries most affected are relatively small producers; further turmoil in key Gulf states could result in more significant rises with dramatic knock-on economic effects globally

• Besides the immediate death and destruction, the impacts of the earthquake, tsunami and subsequent nuclear incident in Japan are developing into much larger issues for Japan and its trading partners


Chart I Global Stock Performance: July 2007 to January 2011

Perc

enta

ge C

hang

e

60

40

20

0

-20

-40

-60

-80

Jul’0

7A

ug’0

7Se

p’07

Oct

’07

Nov

’07

Dec

’07

Jan’

08Fe

b’08

Mar

’08

Apr

’08

May

’08

Jun’

08Ju

l’08

Aug

’08

Sep’

08O

ct’0

8N

ov’0

8D

ec’0

8Ja

n’09

Feb’

09M

ar’0

9A

pr’0

9M

ay’0

9Ju

n’09

Aug

’09

Sep’

09O

ct’0

9N

ov’0

9D

ec’0

9Ja

n’10

Feb’

10M

ar’1

0A

pr’1

0M

ay’1

0Ju

n’10

Jul’1

0A

ug’1

0Se

p’10

Oct

’10

Nov

’10

Dec

’10

Jan’

11

Source: Yahoo! Finance

The Global Economy: Where Do We Stand?

2009 was the trough of the “Great Recession,“ the worst global economic crisis since the Great Depression. As summarized in Chart II, GDP shrank or stalled in almost every economy in the world, with only China, India and Indonesia barreling through strongly. As evidenced in Chart III, the rebound in GDP growth globally has been striking. During this market cycle, emerging markets in general have been growth leaders, with developed and emerging Europe lagging significantly along with Japan. Within Europe there are major differences, with Sweden and Poland forecast to grow at 4% or more in 2011, while many of the countries of Southern Europe remain weak.

The stock market indices highlighted in Chart I, further reflect this growth in GDP. While most of the developed market indices continue to perform below market highs set in 2007, all are off the market lows of late 2008 and 2009. The one stock market index

still showing significant weakness, however, is the Nikkei, which was performing 40% below its July 2007 value even before the earthquake and ensuing tsunami took place. The Brazilian and Indian indices, on the other hand, have been the clear market leaders, though they have weakened somewhat in the past few months.

The economic strength evidenced by these numbers sets the table for a stronger private equity investment market in 2011 for most sectors and geographies — with two large caveats. Oil prices have increased over 20% since the beginning of the year due to political turmoil in various countries in North Africa and the Middle East; continued high prices or a further surge from this point could have a significant impact on economic forecasts. Meanwhile, the global ramifications of the earthquake, tsunami and subsequent nuclear reactor incident in Japan are still developing, but are likely to create winners and losers in certain industries in Japan and amongst its trading partners globally.

Brazil (IBOVESPA) China (SSE Comp) India (BSE SENSEX)

U.S. (DJIA)) UK (FTSE 100) Germany (DAX) Japan (Nikkei 225)


Chart II GDP Growth in 2009 %YoY

Source: JP Morgan Global Data Watch (December 2010)

Russian Federation -7.9%

United States-2.6% China 9.1%

Australia 1.3%

Brazil-0.6%

Developed Europe-3.7%

New Zealand

-1.7%

India7.4%

Indonesia 4.5%

Japan -6.3%

Thailand -2.3%

Philippines0.9%

Emerging Europe-4.2%

Mexico-6.1%

Argentina-2.0%

Chile-1.5%

Venezuela-3.3%

South Africa -1.7%

≥4%2.0 to 3.9%0 to1.9%<0 to -3.9%≤-4%Unavailable

Canada-2.5%

Turkey-4.7%

Peru0.9%

Colombia0.8%

South Korea0.2%

Source: JP Morgan Global Data Watch (February 2011)

Russian Federation 4.5%

United States3.3%

China 9.6%

Australia 3.1%

Brazil4.5%

Developed Europe

2.6%

New Zealand

2.0%

India8.8%

Indonesia 5.4%

Japan 1.7%

Thailand 5.0%

Philippines5.3%

Emerging Europe

2.7%

Mexico4.5%

Argentina5.5%

Chile6.0%

Venezuela1.5%

South Africa3.1%

≥4%2.0 to 3.9%0 to1.9%<0 to -3.9%≤-4%Unavailable

Canada2.0%

Turkey4.3%

Peru6.5%

Colombia4.5%

South Korea4.2%

Chart III Forecast GDP Growth in 2011 %YoY


Fundraising Forecast and Dynamics

On a global basis the economy is rapidly improving, but the dynamics of private equity fundraising are subject to different forces keeping it largely flat. Many of the largest global investors in private equity are institutions based in the U.S. and Europe. Their portfolios, especially their alternative asset allocations, are still under stress from the financial crisis, with a large hangover of undrawn commitments from the boom

years that continues to limit their ability to make new commitments. This impact is most evident in the fundraising numbers for the U.S. and Europe shown in Charts IV and V.

The dramatic decline in fundraising for the U.S. and Europe in 2009 was matched by a poor 2010, with continued weakness in most sub-sectors of private equity. The mega- buyout sector, which had driven fundraising growth from 2005 through 2007, led the fundraising decline over the last two years.

Chart IV Commitments to U.S. Private Equity Partnerships by Sector

USD

in b

illio

ns

350

300

250

200

150

100

50

0

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Source: Private Equity AnalystNote: Does not include funds-of-funds

Buyouts/Corporate Finance MezzanineSecondaries/Other Venture Capital

13.3 19.529.8 31.5

50.1

90.7 100.0

160.5

107.0

58.848.0

91.4

152.2

236.4

297.0

236.5

87.5 80.0


Chart V Commitments to European Private Equity Partnerships

EUR

in b

illio

ns

75

60

45

30

15

0

2003 2004 2005 2006 2007 2008 2009 2010

Source: Probitas PartnersNote: “Corporate Finance” includes buyout, growth capital, mezzanine, secondaries, distressed debt, and turnaround funds

24.419.0

55.860.2 61.9

70.5

16.1 15.9

Corporate Finance Venture Capital


The story in emerging markets is somewhat different. Institutional investors looking for growth opportunities returned to the Asian and Latin American markets more quickly in 2010 as outlined in Charts VI and VII. The Latin American market actually reached an all-time fundraising high during 2010, driven by large closings for the pan-Latin American

funds Advent and Southern Cross, which closed on a combined $3.3 billion during the year. In Asia, fundraising nearly doubled during the year (though still well below record levels of 2007 and 2008) with the growing interest in renminbi-denominated funds in China providing significant impetus.

Chart VI Commitments to Asian Private Equity Partnerships

USD

in b

illio

ns

60

50

40

30

20

10

0

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Source: Asian Venture Capital JournalNote: 2010 total is a preliminary figure

2.0 2.35.3

6.7 5.6 5.9 7.4

16.217.9

13.2

6.5 7.3

13.4

26.6

41.2

50.9 50.2

14.9

29.0


Chart VII Commitments to Latin American Private Equity PartnershipsU

SD in

bill

ions

6

5

4

3

2

1

0

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Source: EMPEA, LAVCA

0.1

0.8 0.9

1.5

3.43.7

1.8

2.6

0.60.4 0.4

0.7

1.3

2.7

4.4 4.5

2.2

5.6


Fundraising Dynamic for 2011

Though fundraising remained weak in the developed markets last year, there was some evidence that the market was improving. Investors began to see more activity in their buyout and venture capital portfolios, with more capital being drawn down for new investments and cash being returned as exit markets or refinancing markets opened up. Given the normal five-year investment period for most funds, the overhang of undrawn commitments impacting investor allocations will increasingly be drawn or expire as we move through the year.

As investors re-engage, they will be increasingly focused on middle-market buyouts and growth capital in the U.S. and Europe, as well as Asian-focused country funds, as detailed in Chart VIII. Investors are not, however, investing blindly in these sectors. Given the problems over the past five years, investors are increasingly focusing on historical performance and intensive due diligence when evaluating investment opportunities. Additionally, most investors with limited allocations are actively triaging portfolios, deciding which fund managers not to back in the future to make room very selectively for new relationships. For new relationships, investors with established portfolios are looking for exposure to those sectors or geographies that are light or non-existent in their current portfolios in order

to increase diversification and generate alpha, or are seeking to upscale the quality of existing managers in established sectors and geographies.

In 2009 and 2010 a large number of fund managers delayed returning to market to avoid launching funds into a difficult fundraising environment and with less compelling realizations records. Many of them are now faced with the investment periods of previous funds coming to an end and simply cannot delay coming back to market any longer. For these fund managers, the primary deal market has begun to thaw, however, and opportunities for investment (and realizations or recapitalizations)are increasing.

Global fundraising is likely to increase modestly in 2011, with certain sectors stronger than others. The key trend for 2011 will be many more fund managers returning to the market competing for a constrained pool of available capital commitments. The result will be a self-selection of the best fund managers (or those with the greatest momentum in fundraising) winning quicker closes, and those with less compelling propositions or an inability to garner demonstrable support from their existing limited partners to create scarcity languishing with protracted or smaller than targeted fundraises.


Chart VIII Private Equity Sectors of Interest“During 2011, I plan to focus most of my attention on investing in the following sectors: (choose no more than five)”

U.S. middle-market buyouts ($500 MM–$2.5 B)

Growth capital funds

U.S. small-market buyouts (<$500 MM)

European middle-market buyouts (country-focused)

Asian country-focused funds

Distressed debt funds

European middle-market buyouts (Pan-European)

Pan-Asian funds

Energy funds

Restructuring funds

Mezzanine/credit-focused funds

U.S. venture capital

Infrastructure funds

Secondary funds

Emerging markets (ex-Asia)

Cleantech/green-focused funds

Other niche sectors

U.S. large buyouts ($2.5–$5 B)

Fund-of-funds

Mega-buyout funds (>$5 B)

Timber funds

European/Israeli venture capital

Percentage of Respondents (%)

Source: Probitas Partners’ Private Equity Institutional Investor Trends Survey for 2011

0 10 20 30 40 50

46

8

39

37

25

17

13

11

9

5

4

2

9

13

15

18

19

19

22

27

30

33


Chart X Average European LBO Purchase Price/Adjusted EBITDA Multiples

Mul

tiple

of E

BITD

A

12x

10x

8x

6x

4x

2x

0

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

Source: Standard & Poor’s LCDNote: For middle-market LBOs, data from 2009 not statistically significant

The Buyout Market: Investor Focus and Concerns

Leveraged buyouts are the dominant form of private equity investing in North America and Europe. As previously noted in our survey, middle-market buyouts in those markets are a major target for investors in 2011. One of the reasons for that attraction is historical trends: during past recessions, prices paid by fund managers declined significantly and usually stayed at those lower levels for several years. This holds true for the

U.S. and Europe during the 2000 recession, as demonstrated in Charts IX and X. That has not been the case in the current recovery, however. 2010 saw a steep rise in purchase price multiples, especially at the larger end of the market where both in the U.S. and Europe they ended the year higher than they were in 2006. The trend for small and middle-market buyouts is less certain simply because in 2009, as activity declined, Standard & Poor’s was unable to track enough of these transactions to generate statistically significant data.

Chart IX Average U.S. LBO Purchase Price/Adjusted EBITDA Multiples

Mul

tiple

of E

BITD

A

12x

10x

8x

6x

4x

2x

0

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

Source: Standard & Poor’s LCDNote: For middle-market LBOs, data from 2009 not statistically significant

Large LBOs (>$500 MM)Middle-Market LBOs (<$250 MM)

Middle-Market LBOs (<$250 MM) Large LBOs (>$500 MM)


The drop in deal flow in 2009 can be attributed not only to market volatility, but also to the decline in the availability of debt. The loan markets, as illustrated in Charts XI and XII, that support buyouts surged from 2004 through 2007 in the U.S., peaking in the summer of 2007 as a liquidity crisis began in advance of the recession. The European markets followed a roughly similar pattern. The driving force behind this was the growth of the mega-buyout market, which generated

loans of size and scope that were attractive for CLO vehicles. The collapse of that market resulted in the drying up of the dominant source of debt available to support buyouts. The rebound in these loans only began in 2010 and, though considerably below its peak years, the rebound has continued on into 2011. At the larger end of the market, there has also been a surge of activity in high-yield bonds (this will be discussed later in the section covering distressed debt).

Chart XI U.S. Leveraged Sponsored Loan Volume

USD

in b

illio

ns

350

300

250

200

150

100

50

0

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Source: Standard & Poor’s LCD

Large Middle-Market

67.484.4 84.5

60.5 61.5

114.7

58.4

145.1

234.1

293.4

120.3

24.432.6 32.6

Chart XII European Buyout Loan Volume

USD

in b

illio

ns

200

175

150

125

100

75

50

25

0

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Source: Standard & Poor’s LCDNote: Reflects total sources of funding of initial and secondary buyouts by a private equity firm — excludes recaps, refinancing, etc.

Funded Sr. and 2nd Lien Bank Debt Other Sources

13.3 19.7 25.038.7

110.0

164.5152.3

69.3

9.1

47.2 53.739.4

31.5


Average debt multiples for corporate leveraged buyouts have largely tracked the overall availability of debt in the market. As Charts XIII and XIV show, the amount of debt applied to individual buyout transactions

rebounded in 2010 (and continues to do so in 2011) but remains significantly off 2007 market peak levels, a pattern unlike that demonstrated for purchase price multiples.

Chart XIII Average Debt Multiples of U.S. Corporate LBO Loans

Deb

t/EB

ITD

A

7x

6x

5x

4x

3x

2x

1x

0

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010


Large LBOs (Issuers with EBITDA <$50 MM)

Middle-Market LBOs(Issuers with EBITDA <$50 MM)

Chart XIV Average Debt Multiples of European Corporate LBO Loans

Deb

t/EB

ITD

A

7x

6x

5x

4x

3x

2x

1x

0

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010


6.12

4.814.39

4.17 4.16 4.254.61

5.235.50

5.17

3.954.36


With deal volumes increasing, purchase price multiples rising, and debt still constrained, an additional factor in the purchase equation must be examined: the amount of equity required to buy companies. For buyouts, as detailed in Chart XV, the amount of equity as a percentage of the purchase price in both the U.S. and Europe hit new highs in 2009, and although that percentage declined slightly in

the U.S. in 2010, it actually increased further in Europe. Companies purchased with a higher percentage of equity should present less risky investments, all things being equal; however, for those fund managers whose historical performance was heavily driven by financial leverage, the higher use of equity could spell lower returns for investors.

Chart XV Equity Contribution to Buyouts at Purchase

Perc

enta

ge (%

)

50

45

40

35

30

25

20

15

10

5

0

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010


Large LBOs (>$500 MM)Middle-Market LBOs (<$250 MM)


Where Do We Go from Here?

As we began to exit the recession in 2009 and 2010, many institutional investors felt that 2010 and 2011 vintage buyout funds would be exceptionally strong performers. In the U.S. specifically (where there is more historical data), there has been a pattern of strong vintage years for buyout funds coming off of a recession or a financial crisis, as highlighted in Chart XVI.

In this cycle, however, that historical pattern is at risk. In the past, purchase price multiples declined significantly during periods of recession or financial crises and recovered slowly. (As previously shown in Charts IX and X, this trend occurred during the Asian and Russian crises as well as during the recession of the early 2000s.) During such post-recessionary periods, fund managers were able to buy companies inexpensively with the wind at their backs. The steep rise in

purchase price multiples over the last year, especially at the large end of the market, combined with lower levels of leverage and a less clear fundamental economic recovery, make that typical pattern much more difficult to replicate this cycle.

What makes this cycle different for private equity and buyouts in particular? One of the major factors is the overhang of committed but undrawn capital. Chart XVIII provides a rough estimate of the total overhang time, with the total for the buyout sector rising from just under $200 billion at the beginning of 2004 to over $400 billion at the end of 2010. The fundraising boom from 2005 through the first half of 2008 dramatically increased commitments to private equity in advance of the financial crisis. As the crisis dramatically slowed the pace of investment, as detailed in Chart XVIII, undrawn commitments began to rise.

Black Monday Market Crash

U.S. Recession

Asian Currency & Russian Financial Crises

U.S. Recession

Periods of Financial StressTop Quartile Returns

Chart XVI Historical Returns for U.S. Buyouts

Top

Qua

rtile

IRRs

(%)

40

35

30

25

20

15

10

5

0

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

Source: Thomson Venture Economics; Probitas Partners


Chart XVII Private Equity Deal Volume

USD

in b

illio

ns900

800

700

600

500

400

300

200

100

0

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Source: Thomson Venture EconomicsNote: As of February 2011; Deal volume includes both equity and debt

101.354.4 46.2 66.0

141.2185.6

434.6

773.7

344.9

261.6

Chart XVIII Capital Overhang — Undrawn Private Equity Commitments

USD

in b

illio

ns

900

800

700

600

500

400

300

200

100

0

Dec

’03

Dec

’04

Dec

’05

Dec

’06

Dec

’07

Dec

’08

Dec

’09

Dec

’10

Source: Preqin

332 317

410

699

751 743

676

578

Buyout Total Other Private Equity


Not immediately obvious from these charts are the deadlines that many fund managers are operating under for capital deployment and the potential effects of these deadlines. Most buyout funds have a five-year investment period, after which new investments cannot be made and unfunded commitments are extinguished. Those 2006 and 2007 vintage funds that have significant undrawn capital are under pressure to put that capital to work before those investment periods come to an end. Many have begun to negotiate investment period extensions of up to a year with their investors to relieve some of the pressure, but the urgency to put capital to work may be one factor driving up prices much earlier in this market cycle.

At this point, there is no “free lunch.” Simply investing in middle-market buyout funds in the U.S. or Europe will not yield substantial sector-driven returns. The driver of returns, as it almost always has been, is manager selection. Managers with strong operational expertise that can drive and create value in portfolio companies have always been strong performers. Fund managers with that relevant experience, investment discipline, and a truly value-added approach are likely to outperform this cycle as well.


Distressed Debt: Where Did the 100-Year Flood Go?

Going into 2009, the sector most favored in Probitas Partners’ annual investor survey was distressed debt, with turnaround/restructuring funds also an area of significant interest. The lack of leverage for buyouts, that began to develop in the summer of 2007, was widely thought to herald the beginning of the next distressed cycle even before AIG and Lehman Brothers appeared on investors’ radar screens. In 2007 and early 2008, many investors aggressively committed capital to these strategies in anticipation of what many thought was going to be an opportunity of historic proportion.

Two years on, it is obvious that the flood of opportunity did not develop in the way that fund managers or investors expected. The

bottom fell out of the market in September of 2008 and continued to decline through the spring of 2009. Many fund managers who deployed significant capital early in 2008 at what they thought were attractive prices found themselves scrambling by year-end to shore up those investments instead of making new ones at much lower prices. Not until after the nadir in the spring of 2009 did markets begin to rally sharply.

Charts XIX and XX illustrate these points. Distressed debt fundraising collapsed in 2009 as investors absorbed the negative news they were getting from fund managers in which they had recently made bets. Though corporate defaults remained high during that time, they peaked at levels actually much lower than anticipated. In 2010, defaults rapidly began to retreat, ending the year below long-term default averages.

Chart XIX Global Distressed Debt and Turnaround Fundraising

USD

in b

illio

ns

60

50

40

30

20

10

0

2003 2004 2005 2006 2007 2008 2009 2010

Source: Probitas Partners

Distressed Turnaround

5.26.9 8.7

15.3

29.4

5.8

18.5

45.8

0.11.0

1.62.1

4.64.0

9.6

5.6


During late 2009 and early 2010 a number of distressed debt fund managers began to argue that the opportunity in this cycle had not yet passed them by and that the wall of upcoming debt refinancing in 2012, 2013, and 2014 still presented interesting deal flow. Charts XXI and XXII demonstrate, however, what happens when the “wall of debt” meets the “wave of liquidity.”

After coming back significantly late in 2009, investors searching for yield drove the issuance of high-yield bonds to an all-time high in 2010. The vast majority of these new bonds, however, were not issued in support of new buyout transactions, but instead for

refinancing of outstanding bond issues, many of which were originally issued to support buyouts. The result has been a considerable push back of the wall of debt refinancing to 2014 and beyond, providing increased room for companies to maneuver while, in many cases, also dropping their interest rate obligations.

Though the market is faced with difficulties that may stress companies and create opportunities for distressed debt funds, it is fair to say that the mountain of opportunity that investors anticipated from this cycle simply did not materialize.

Chart XX Annual U.S. Corporate Bond Default Rates

Def

ault

Rate

(%)

16

14

12

10

8

6

4

2

0

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

Source: Altman, NYU Stern; Moody’s


Chart XXII Refinancing the Wall of Debt

USD

in b

illio

ns

450

400

350

300

250

200

150

100

50

0

2011 2012 2013 2014 2015 2016 2017

Source: Credit Suisse

As of Year End 2008 As of Year End 2010

Chart XXI High-Yield Corporate Bond Issuance

USD

in b

illio

ns300

250

200

150

100

50

0

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Source: Thomson Reuters

58.7

107.9

129.6

84.3

57.2

131.1

96.3

146.6136.0

34.3

77.8

137.9

43.0

147.8

263.2

48

122

70

172 164

314 304

394

229

186

261

107

186

66


Asia and the Emerging Markets: Searching for Growth

While the private equity markets in North America and Europe have experienced difficulties over the last three years dealing with falling or stagnating economies, many private equity investors looking for growth opportunities have turned to the emerging markets, especially in Asia. The following are several reasons for this:

• Long-termGDPgrowth: Goldman Sachs first introduced the concept of the BRICs to highlight the growing importance of certain emerging market economies. Table I depicts current GDP rankings along with the long-term forecast for the fifteen largest economies in the world. Though official 2010 numbers are not available for all countries, during the year, China overtook Japan as the second largest economy in the world.

• Economic performance over the lastcycle: In previous global economic down cycles, emerging market economies have typically been more negatively impacted than developed countries. This last cycle was quite different, with China, India, and Indonesia, for example, maintaining strong GDP growth through the downturn.

• The MIST joining the BRICs: At the beginning of 2011, the economist who coined the acronym BRICs created another one covering the next group of rising stars. MIST includes the countries of Mexico, Indonesia, South Korea, and Turkey. Interestingly, Mexico and South Korea were originally considered as possible inclusions in what would later become the BRICs, especially South Korea given its advanced GDP per capita ranking.

Table I GDP Rankings of BRICs and the MIST vs. Other Countries

Rank 2000 2009 2050 (fcst) 2050 GDP per capita (fcst)

1 U.S. U.S. China U.S.

2 Japan Japan U.S. South Korea

3 Germany China India UK

4 UK Germany Brazil Russia

5 France France Mexico Canada

6 China UK Russia France

7 Italy Italy Indonesia Germany

8 Canada Brazil Japan Japan

9 Brazil Spain UK Mexico

10 Mexico Canada Germany Italy

11 Spain Russia Nigeria Brazil

12 South Korea India France China

13 India Mexico South Korea Turkey

14 Australia Australia Turkey Vietnam

15 Netherlands South Korea Vietnam Iran

Legend BRIC MIST G7

Source: Actual: World Bank; Forecast: Goldman Sachs, “The N-11, More Than an Acronym,” 2007Note: India ranks 17th on the 2050 forecast of GDP per capita


Chart XXIIV MIST Stock Indices vs. S&P 500

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Chart XXIII BRIC Stock Indices vs. S&P 500

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• StronginterestinAsia: Four of the eight BRIC and MIST countries are in Asia, with China clearly the largest factor in these markets.

The public equity markets of the BRIC and MIST economies exhibited strong performance over the last cycle, a reflection of their continued GDP growth. Charts XXIII and XXIV highlight the performance of the core stock market indices in the BRIC and MIST countries compared to the S&P 500 (as a proxy for the developed markets) since the beginning of 2007. Over that period no stock market escaped the impact

of the financial crisis, but only the Russian index underperformed the S&P 500 while Brazil and Indonesia have been significant outperformers. A number of these markets began to turn down in early 2011, even before the turmoil in North Africa and the Middle East began, driven mainly by concerns that continued strong GDP growth in those countries would continue to drive increased inflation. A continued rise in oil prices would have mixed results on these economies, with those countries with significant oil reserves benefiting while others would be negatively impacted.

S&P 500 (U.S.) BOVESPA (Sao Paulo) SSE Composite (Shanghai)

BSE SENSEX (Mumbai) RTSI (Moscow)

S&P 500 (U.S.) ISE National 100 (Turkey) KOSPI Composite (South Korea)

JKSE (Indonesia) BMV IPC (Mexico)


Some private equity markets in emerging economies are much more developed than others, and the dynamics of investing greatly differ from the public markets. As Chart XXV demonstrates, China, Brazil, and India dominate current private equity interest in emerging markets, with Southeast Asia and Latin America following close behind. Of note, three of the top four geographies in the emerging markets are in Asia. Before the financial crisis, interest in Central Europe was much stronger than indicated in Probitas Partners’ recent survey, as those economies

were hurt badly in the downturn. Some of those economies, like Poland for example, are now rebounding strongly. Russia has never been a particularly strong contender for private equity interest and has always trailed its BRIC counterparts due to concerns regarding property rights and political risk. Additionally, Russia’s commodity wealth makes it more volatile: across this last market cycle, the fall in energy prices in 2008 severely hurt the country’s public stock markets, though the current oil price shocks are giving it a lift.

Chart XXV Most Attractive Emerging Markets“I find the most attractive emerging markets to be: (choose no more than two)”

China

Brazil

India

Southeast Asia

Pan-Latin America

Central Europe

Turkey

Vietnam

Russia

Korea

Eastern Europe

Mexico

Africa

Middle East

Global emerging markets funds

Do not invest in emerging markets

Other



0 5 10 15 20 25 30 35 40 45

30

11

15

6

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1

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Table II Largest China-Focused Funds

Fund Manager Type Size (MM)

Size (MM USD)

Vintage Year

Bohai Industrial Investment Fund BOCI Private Equity Buyout/Growth CNY 20,000 2,563 2006

Hopu USD Master Fund IHopu Investment

ManagementBuyout/Growth USD 2,000 2,000 2008

CDH China Fund IIICDH China

Management Company

Buyout/Growth USD 1,600 1,600 2007

Yunfeng Fund Yunfeng Capital Growth/Venture CNY 10,000 1,512 2010

CDH China Fund IVCDH China

Management Company

Buyout/Growth USD 1,458 1,458 2010

Source: Probitas PartnersNote: Currency transaction at value at time of close

Over the last several years China has been the leading country of interest for private equity investors in both the emerging markets in general and in Asia specifically. Besides its strong economic growth, another factor is driving its private equity market — the rise of funds denominated in renminbi (RMB). In most emerging markets, private equity funds are denominated in dollars or euros and not the local currency, in large part to cater to the desires of foreign investors, who dominated the limited partner base for most funds. RMB denominated funds, which until recently have been restricted to local investors due to currency regulations, have expanded rapidly over the last two years as more Chinese investors seek private equity exposure and as structures are created to allow foreign investors entry into these funds. Because the Chinese currency is

not freely convertible, RMB funds have distinct advantages in executing deals in the Chinese market.

As is noted in Table II, two of the five largest China-focused funds ever raised are denominated in local currency. There are at least seven local funds currently in the market targeting CNY 10,000 million or more.

Given the local advantages associated with these vehicles, there are several U.S.-based fund managers looking to raise substantially-sized RMB funds. These funds are, however, a mixed blessing, as they actually compete with their sister funds denominated in dollars, providing a potential conflict of interest directly affecting those limited partners who can only invest in the dollar denominated funds.


Europe: Beginning to Rebound

Buyouts are the dominant form of private equity investment in Europe. While the dynamics of European buyouts have already been covered in detail in a previous section of this report, this section covers other topics of interest in European private equity.

Charts XXVI and XXVII cover fundraising trends for corporate finance funds based upon geographic focus. The majority of these funds are buyout focused, but also include growth capital, mezzanine and distressed debt funds. Capital raised for Pan-European funds, the largest and best known funds, drove the expansion of the market from 2005 through 2008 and in most instances were and continue to be focused on very large buyouts. Regionally-focused funds (targeting

defined regions such as Scandinavia or Central Europe) and funds focused on individual countries tend to be smaller vehicles, usually with a middle-market focus. Many of the Pan-European funds focused now on mega-buyouts began life as country-focused or regional middle-market funds that grew with success, while other successful middle-market firms opted to focus on their main area of expertise and have remained smaller. Some mega-buyout funds based in Europe have also begun to invest globally (as a number of their U.S. counterparts do).

The “other” category on these two charts is also country-focused, but includes funds focused on Russia, Cyprus, Greece, and Turkey. These are treated separately as they are considered to be outside the mainstream of the Western European market.

Chart XXVI Commitments to European Corporate Finance Partnerships

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2003 2004 2005 2006 2007 2008 2009 2010

Source: Probitas PartnersNote: “Other” includes commitments to funds with a geographical focus on Russia, Cyprus, Greece, and Turkey

22.918.0

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Pan-European Country-FocusedRegionally-Focused Other


Chart XXVII Number of European Corporate Finance Funds Raised

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As previously noted in Chart VIII, depicting sectors of most interest from our annual investor survey, country-focused middle- market buyout funds are the sector of most interest to investors targeting Europe. Chart XXVIII provides a more detailed look at which European countries and regions are of most interest to investors. Though the top three

geographies remained the same (although in a different order) between our 2010 and 2011 surveys, there has been a noticeable shift away from Southern Europe, in general, to Northern Europe, where interest was already strong.

Chart XXVIII Most Attractive European Markets“For European country/regionally-focused funds, I find the most attractive markets to be: (choose no more than three)”

Nordic Region

Germany

United Kingdom

France

Pan-European funds

Benelux

Central Europe

Eastern Europe

Italy

Spain

Europe via fund-of-funds

Do not invest in Europe

Other



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The venture capital sector, which has always been weaker in Europe than in the U.S., developed much later, prohibiting most funds from taking part in the benefits produced by the surging technology market of the 1990s prior to the bursting of the Internet Bubble. Among both global and international investors, interest in European

venture capital remains low and is reflected in the fundraising numbers laid out in Chart XXIX. The distribution of venture fundraising between sectors is roughly similar to that in the U.S., with cleantech being small, though increasing, and most new fund managers coming to market pursuing specialized strategies.

Chart XXIX Commitments to European Venture Capital Partnerships

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Life Sciences CleantechTechnology Diversified


Venture Capital: Armageddon or the Next New Thing?

The U.S. venture capital market, as the largest, deepest and longest lived, sets patterns for much of the market globally.

As detailed in Chart XXX below, fundraising was down slightly in 2010 from the previous year. Unlike private equity, long-term fundraising trends for venture capital have not been driven by the financial crisis, they reflect, instead, longer-term secular trends experienced by the sector. The Internet Bubble of the late 1990s drove returns and fundraising to unsustainable highs the

venture capital market has not been able to reach since. Many limited partners are frustrated with the entire sector and have begun to give up on new investments.

The reason for this lack of confidence is illustrated in Table III. It shows that as the high returns from the late 1990s have rolled off, indexed ten-year venture capital returns have turned negative. That is not to say that a few investors with portfolios concentrated in a very few top performing funds have not made money, but it does verify that for many investors the frequently heard complaint “I have not made any money in venture in ten years” is literally true.

Table III U.S. Venture Capital Time Horizon Returns

For the Period Ending Quarter 1-Year 3-Year 5-Year 10-Year 15-Year 20-Year

September 30, 2010 3.7 8.2 -2.1 4.3 -4.6 36.9 25.6

June 30, 2010 0.4 6.4 -2.6 4.3 -4.1 38.1 24.3

September 30, 2009 2.1 -12.7 1.2 4.6 8.5 36.4 23.0

Source: NVCA

Chart XXX Commitments to U.S. Venture Capital

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Table IV Survey Respondents Targeting Venture Capital and Comparative Rankings vs. Other Sectors

2007 2008 2009 2010 2011*

U.S. Venture Capital% of Respondents 34% 29% 13% 16% 17%

Category Rank 3rd 4th 8th 8th 12th

European Venture Capital% of Respondents 5% 5% 2% <1% 2%

Category Rank Last Last Last Last Last

Source: Probitas PartnersNote: *The 2011 survey included four additional categories compared to previous years; three out of four of these ranked ahead of U.S. Venture Capital

The effect of this issue shows up in Probitas Partners’ annual investor surveys, as detailed in Table IV. Though European venture capital has never fared well in our survey, the decline of limited partner interest in venture capital funds over the last five years is striking, going from a core holding in 2007 to a middle-of-

the-pack also-ran in 2011. Additionally, as illustrated in Chart XXXI, when asked in which sectors of venture capital limited partners are most interested, 33% of respondents said they did not invest in venture capital at all.


Chart XXXI Most Attractive Venture Capital Sectors“I find the most attractive U.S. venture capital sector or strategies to be: (choose all that apply)”

Early stage

Late stage

Multi-stage

Mid-stage

Technology funds

Seed stage

Life science funds

Cleantech funds

Funds focused on multiple sectors

Focus solely on historic returns

Do not invest in venture capital

Other



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Are there any rays of sunshine in this gloomy picture?

• The contrarian bet: scarce capitaldrives higher returns. Even after the dramatic fall from the heights of vintage year 2000 fundraising, there remained too much capital in the sector and too many marginal fund managers. As other limited partners leave the sector and fundraising is rationalized at a lower level, contrarian investors are betting that overall returns will begin to rebound.

• TheNextNewThing: SocialMedia. In the 1980s, personal computers were the “Next New Thing,” a title that was passed to the Internet in the 1990s. These were not simply products, but galvanizing concepts. As a result, a large number of successful companies were built developing and servicing these sectors. Over the past decade, nanotechnology and clean technology were touted as transformative concepts that had the opportunity to drive the sector, but neither has yet led to mammoth returns. Over the last couple of years, however, social media has come to the fore, and secondary market valuations of Facebook, Twitter, LinkedIn, and Groupon have begun to rivet investor interest.

There are caveats to these rays of sunshine. Along with the concept of scarce capital comes the issue of what a sustainable level of fundraising might be in the venture capital

sector — and whether the sector is scalable enough to be an “investment class” or a perennial niche sector. As far as social media is concerned, the trials of MySpace, one of the early leaders in the space, demonstrate that not every company in the sector is guaranteed long-term success. It calls into question how many large companies the sector can support and, given current capital efficiency, how much investment capital the sector can absorb in developing companies.

The social media revolution has also focused attention on secondary markets in private equity. None of these companies are publicly traded, and it is uncertain as to whether all of them desire it in the future. A secondary market for shares of these companies has sprung up, enabling certain stock holders to gain liquidity and allowing other parties to gain access to the companies allowing them to claim that they, too, own a piece. These transactions, or course, do not show up in the usual IPO or M&A statistics. The prices of small lot purchases recently quoted in the market certainly do not represent a clearing price for large amounts of stock and seem to be driven more by “eyeballs on the screen” analysis as opposed to company profitability reports — a scenario seen at the height of the Internet Bubble.

The most recent secondary activity has attracted the attention of the SEC, which has begun an investigation into whether these companies need to be registered or the secondary activity regulated.


At the Margin: The Search for New Opportunities

Though inflation currently remains low in the developed markets, there is increasing uneasiness that inflation may increase as a result of the stimulus programs many governments implemented in response to the financial crisis, especially if these programs are continued too long. A number of investors are beginning to explore investment opportunities in sectors such as timber, commodities, mining, royalties and agricultural land to hedge against this potential increase and develop specific allocations for inflation-linked or inflation-hedged assets.

Within the private equity world historically, there have been relatively few fund vehicles that specifically target these sectors. Timber has been the most active in the past, but has been an area that many institutional investors addressed through separate accounts, which are much more difficult to track, as opposed to multi-party funds. Just over $1.4 billion was raised for timber funds in 2010 by seven funds, while private equity fundraising for the other sectors was more scattered. Further, large-scale investment opportunities in developed markets remain elusive as

most of the largest holders of timber stands (paper and forestry companies) migrated those assets off balance sheets over the past decade. Thus, gaining portfolios of scale remains difficult. Increasingly, opportunities in developing markets, especially in large scale plantation efforts or in harvesting vast holdings in markets like Brazil, are gaining attention — the constraint in many of these markets being the development of infrastructure.

There has also been increased interest in infrastructure investing over the last five years, as detailed in Chart XXXII below, driven in part because many of the underlying contracts are structured to provide long-term inflation protection. Though a number of investors invest in the sector through specific infrastructure or inflation-linked allocations, others invest through private equity allocations. Core infrastructure assets are typically long-lived, and a number of investors are interested in the sector to better match the lives of their assets and liabilities while providing a current income component. It is notable that fundraising for this sector (which is dominated by funds focused on the developed markets) rebounded significantly in 2010, while other areas of private equity remained flat.

Chart XXXII Global Infrastructure Fundraising

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Energy funds are another sector of renewed interest, especially in light of the turmoil in North Africa and the Middle East and the probability that Japan will likely need to increase imports of liquid natural gas. Chart XXXIII tracks fundraising for the three major types of energy-focused funds, defined below, over the last eight years:

• Private Equity Vehicles: Funds pursuing buyout or growth capital strategies, buying either midstream or upstream assets in the energy sector. Most of these funds are focused on generating returns through capital gains, and very few are focused on exploration and production.

• Cleantech/GreenEnergyFunds: Venture capital or growth funds focused on clean technology or renewable energy, most often investing in young companies without a history of profitability or revenue. Again, these funds are focused on capital gains and have the highest risk/return profile.

• Energy Infrastructure Funds: A subset of infrastructure funds, these funds most often look to buy established, cash-flowing assets (such as natural gas distribution lines or wind farms) or take

on some small development risk but only with established technology. These funds have a lower risk/return profile than the other two, and their returns often have a strong current income focus.

As a niche sector that includes a few very large funds (First Reserve XII, the largest energy fund, raised $8.8 billion), energy annual fundraising totals can swing not only based upon shifts in commodity prices and investor interest but also whether or not one of the major established players is in the market in any particular year. The very different risk/return profiles of these funds also mean that investors are selective — an investor with an allocation to energy infrastructure funds may not have an allocation to cleantech funds and vice versa.

Dramatic swings in energy prices also affect these funds in different ways. A steep increase in the price of oil, for example, might increase the value of the current holdings of a private equity fund while making it more difficult to make new investments at reasonable prices. Sustained higher oil prices could make cleantech investments, meant as oil substitutes, more attractive — but higher oil prices driven by political considerations could rapidly reverse and eliminate that advantage.

Chart XXXIII Capital Raised for Energy-Focused Funds

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Private Equity InfrastructureCleantech


One last sector worth discussion is mezzanine and credit-focused funds. Mezzanine funds, that invest in subordinated debt, often with equity warrants attached, have been a long time feature of the private equity market, as seen in Chart XXXIV. These funds, however, have always been a niche sector considered by some investors to be a fixed income investment and not a true private equity opportunity. Fundraising for the sector, like the energy sector, can be dramatically impacted by large fund closings in any particular year. For example, GS Mezzanine Partners V, a $13 billion fund, which closed in 2008, had substantial effect on the final total for that year, the highest on record.

Though mezzanine funds have been a feature of the market for a long time,

since the financial crisis there have been a number of credit-focused funds launched whose fundraising totals are included in the totals below. These funds generally focus on senior instead of subordinated debt, and at least earlier in the crisis, also purchased performing debt in the secondary market. Many of these vehicles are levered at the fund level to enhance returns, something rarely done with mezzanine funds. At the larger end of the debt market, though the resurgence of high-yield bonds has provided competition for both mezzanine and credit funds, middle-market bank loans have not yet rebounded, leaving more scope for these vehicles to generate strong returns.

Chart XXXIV Global Mezzanine Fundraising

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Secondary Market: Back on Track

Fundraising for secondary funds hit an all-time high in 2009 on the back of investor anticipation of a strong market for secondaries caused by the financial crisis. As Charts XXXV and XXXVI make clear, however, transaction volume fell in 2009, as the steep discounts to NAV that were triggered by

the financial crisis led potential sellers to hold back from selling due to sticker shock. As we moved through 2010 and discounts decreased, secondary specialists began to concentrate on investing rather than fundraising. While the amount of capital raised for the sector dramatically decreased during the year, secondary activity soared, setting a new record.

Chart XXXV Secondary Pricing for Buyout and Venture over the Current

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02007 1H’08 2H’08 Q3’09 Q4’09 Q1’10 Q2’10 Q3’10 Q4’10

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Buyout Venture


Although not included in Chart XXXVI, there is substantial additional capital targeting secondaries beyond what has been raised by secondary specialists. Probitas Partners estimates that secondary specialists currently have $20 billion to $25 billion in dry powder, while an equal amount of dry powder is available in the secondary allocations of primary funds-of-funds and targeted programs of certain large limited partners.

As far as deal flow is concerned, the market has continued to be strong in 2011. Secondary changes in banking regulations in the U.S. and in insurance company regulation in Europe have increased deal flow while these institutions seek to adapt. At the same time, a number of institutions, such as pension plans and endowments, are still finding

themselves over-allocated to private equity or have the need to rebalance their portfolio exposures and are turning to the secondary market to address these issues. In addition, a number of fund managers sponsored by financial institutions are looking to spinout and become independent, often through recapitalizations or stapled secondaries.

As investors and fund managers continue to utilize the secondary market to work out some of those issues, secondary specialists will continue to raise funds to take advantage of these investment opportunities. Currently, there are twenty-five secondary funds in the market looking to raise nearly $20 billion in new commitments. Some well-known secondary specialists currently in the market include Coller, Lexington, and AXA.


Chart XXXVI Secondary Market Transaction Volume and Capital Raised by Secondary Fund Specialists

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Capital Raised Transaction Volume

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F o r e c a s t f o r 2 0 1 1Private equity fundraising in the developed economies will continue to be sluggish

• The overhang of outstanding unfunded commitments remains a drag on many investors’ allocations and many investors will continue to triage current relationships

• The market will remain extremely competitive with a large number of fund managers who delayed fundraising in 2009 and 2010 coming to market in 2011

Many investors will focus on the growing economics of the emerging markets

• Fundraising for Asia and Latin America rebounded significantly in 2010 and is on track to continue strong in 2011

• The MIST countries (Mexico, Indonesia, South Korea, and Turkey) are likely to be the next group of emerging market targets after the BRICs

Limited partners, focused on middle-market buyouts, will grow increasingly concerned that purchase price multiples are rebounding more quickly than hoped

• Average buyout purchase price multiples in the U.S. and Europe are already back to 2006 levels, increasing much more quickly than in past economic cycles

Strains in the high-yield bond market will make it more difficult to refinance transactions or execute dividend recaps

• At this point it is difficult to know whether the early signs of stress are more related to the current turmoil in MENA and Japan or whether it will have longer-term implications over the year

• Though the high-yield market appears to be slowing, the record amounts already raised in late 2009 and throughout 2010 have already pushed out the wall of debt that many buyout portfolio companies were facing, limiting damage to buyout portfolios while reducing opportunities for distressed debt funds


The venture market will continue to suffer from significant long-term problems but secondary market valuations of social media companies will offer hope for the “Next New Thing”

• Median ten-year horizon returns for venture capital are now negative and will create fundamental issues for venture capitalists and an increasing number of “zombie” funds raised at the last venture market peak of 2000

• Certain limited partners will take heart at huge secondary market valuations of social media investments such as Facebook, Twitter, LinkedIn and Groupon and continue to invest in venture as contrarians

Wild cards for the year: energy prices and Japan

• Political turmoil in North Africa and the Middle East in 2011 has resulted in a steep rise in oil prices; further turmoil in key Gulf states could result in more significant rises with dramatic knock-on economic effects

• Besides the immediate death and destruction, the impacts of the earthquake, tsunami and subsequent nuclear incident in Japan will continue to develop into more serious issues for Japan and its trading partners

Probitas Funds Group, LLC Probitas Funds Group, LLC PFG-UK Ltd. Probitas Hong Kong Limited

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