Publicly traded private equity vehicles: A different kind of model By Adam Goldman, Red Rocks Capital LLC. Accessing private equity: an overview

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1 Publicly traded private equity vehicles: A different kind of model By Adam Goldman, Red Rocks Capital LLC Accessing private equity: an overview Over the past several decades, investors in private equity have typically accessed the asset class through a limited partnership interest. In doing this, investors have faced a number of significant challenges: Access to the asset class as a whole is limited. Not everyone can invest in private equity due to the qualified investor rules. Access to the best private equity managers within the asset class is difficult, and in some cases practically impossible. Unless you are a large institutional investor with an ongoing commitment to the asset class, the best private equity managers are quite selective in who they allow to invest with them. Large capital commitments to the asset class are required. High investment minimums make it difficult for all but the wealthiest individuals or family offices to play alongside large institutional investors. Development of a long-term relationship with the best private equity managers. This takes time and along with it comes the implicit expectation that the investor will invest in multiple fund offerings from the manager over time. Unpredictable drawdown schedules are normal. While the investment cycle of a traditional limited partnership may have an invest-up period of 3-5 years, when and how much the private equity fund calls at any given time is less than predictable. The J-curve effect can skew the value of an investor s long term objective to the asset class in the early part of a private equity fund commitment. Manager selection takes time and effort, and is costly. Significant research and due diligence is required to choose the right private equity fund(s) in which to invest now and in the future. Diversification within the asset class is not a simple exercise. Without intensive manager research as to style, strategy, geography, industry, stage of investment and vintage year diversification, an investor is making a bet instead of effectively managing their risk. Transparency continues to be a bigger and bigger expectation. Most limited partnerships are blind pools of capital with limited transparency. Valuation methodologies are non-standard, making it difficult to compare one private equity manager/fund to another. Issues revolve around timing (quarterly, semi-annual, yearly), stated metrics (if any) and the consistency of their application (from quarter to quarter and year to year) in reports. Private equity limited partnership interests are very illiquid.

2 While a limited partnership interest may have been the means by which investors have accessed private equity in the past, today there are over 200 private equity vehicles that trade on recognised financial exchanges throughout the world giving investors access to the asset class on a fully liquid basis, mitigating a number of the above mentioned challenges. This form of private equity is commonly referred to as listed private equity. What is listed private equity? Listed private equity companies are publicly traded vehicles that invest capital in privately held businesses. The model and structure can be similar to those of traditional limited partnership-based private equity funds, except that listed private equity companies are publicly traded in the open market. Hence, listed private equity is a different approach to accessing the same asset class: Listed private equity is an ownership interest in a set of investments that are traded in the open market on recognised financial exchanges every day. These ownership interests are no different than what a limited partner (LP) in a traditional private equity partnership might hold; investments in a set of private businesses with the objective of maximising total return at the end of an investment period. Listed private equity vehicles are structured as common equity (or shares), units in investment trusts or units in publicly traded limited partnership interests. Listed private equity vehicles typically take the form of direct private equity investments, fund of fund private equity investments (both primary and secondary fund interests, along with their future funding commitments) or an interest in the management company that oversees various investment funds/business units. Listed private equity vehicles can also be some combination of the above, or a hybrid. Listed private equity is a permanent pool of capital. Once raised, the capital of a listed private equity vehicle is recycled from one deal to the next. This represents a significant difference in the business model for a private equity manager. In most traditional limited partnership-based funds the LPs capital is called and invested once in a deal or business, although under special circumstances, especially in the distressed sector, a certain degree of capital recycling is allowed for a limited period of time. When that business achieves liquidity, the LPs receive their capital back from that deal, the investment basis along with any gains or losses. In a listed private equity vehicle, when an investment achieves liquidity, the listed private equity vehicle receives the proceeds from the liquidity event (basis plus any gains or losses). The manager of the listed private equity vehicle then decides what to do with that capital. They can reinvest it in another deal, retain it as cash for future deal or send it back to the shareholders of the listed private equity vehicle in the form of a dividend. The decision is solely the fund manager s. More often than not, the manager of the listed private equity vehicle retains the majority of the capital to reinvest in the next set of deals. Investors can purchase shares in a listed private equity vehicle at any point in time, thereby giving them the flexibility to invest when they see fit, not necessarily when the private equity firm is raising a fund or calling down a commitment.

3 A listed private equity company may also offer traditional limited partnership-based funds that they manage alongside the listed private equity vehicle. In this instance, the private equity company is investing both the listed private equity vehicle s capital along with the limited partnership-based fund s capital in the same deals or businesses, at the same time, on the same terms, thereby leveraging the deal flow, due diligence and ongoing work of the private equity managers for the benefit of both vehicles. Listed private equity vehicles can be structured to focus on senior loans, mezzanine debt or secured/unsecured debt investments. In some cases, a private equity manager may have a listed private equity vehicle that focuses on the debt side of the capital structure along with a traditional limited partnership-based fund(s) that invests in the equity side of a deal. The listed private equity vehicle may invest in the senior loan, mezzanine debt or secured/unsecured debt in a deal while the traditional limited partnership-based fund(s) invests in the equity side of the same deal. By purchasing a share or unit in a listed private equity vehicle, an investor gains direct exposure to the asset class, instantaneously, with a fairly well-defined portfolio of existing private investments. The vehicle comes with daily liquidity (it trades on a recognised financial exchange, not through the secondary market) and strikes a daily valuation (the price at which a buyer and seller are willing to consummate a transaction for that security on that given day). The investor also gains portfolio-level transparency, thereby seeing what businesses the private equity manager has invested in, how those businesses are doing, what the cost basis of those investments are, what valuation methodology is being used, how those investments are valued from quarter to quarter (write-ups and write-downs), and when a liquidity event occurs, how the investment performed. Because listed private equity vehicles typically have a fairly well-defined portfolio of existing private investments that are diverse and reasonably well seasoned, the investor is able to minimise the J-curve effect. Also, because listed private equity vehicles are continuously making investments, with no pre-set investment or liquidation period, vintage year risk tends to be dampened (Figure 1). Figure 1: Comparison of private equity vehicles

4 Not all listed private equity vehicles are structured the same While there are many variations on the listed private equity model, the vehicles can be broken down into four general categories: 1. Direct listed private equity investment companies 2. Listed private equity fund of funds 3. Listed private equity management companies 4. Hybrids Direct listed private equity investment companies Direct listed private equity investment companies, such as Ratos AB (STO:RATO B), make direct investments in private businesses solely from their balance sheet, or side by side with the private equity limited partnership(s) that the private equity manager also manages, such as HgCapital Trust plc (LON:HGT). An investor in a direct listed private equity investment company knows exactly what they own, right down to each of the businesses that the listed private equity vehicle holds along with how they re being valued. These are the most transparent listed private equity vehicles. They are fairly straightforward to analyse and hence to understand. Listed private equity fund of funds This contrasts with listed private equity fund of funds vehicles that commit capital to other nonlisted private equity funds, both on a primary and secondary fund basis. These non-listed private equity funds are typically managed by an outside private equity manager that makes direct private equity investments. The commitment by the listed private equity fund of funds vehicle into the non-listed private equity fund comes in the form of a limited partnership interest. An example of this type of listed private equity vehicle would be Conversus Capital LP (AMS: CCAP). As with any commitment to a limited partnership interest, it is important to understand how much capital has already been called/invested versus how much can be expected to be called in the future and when. This, coupled with how much current net cash a listed private equity fund of funds has on its balance sheet plus any debt or credit facility they may have, will give the investor a very good sense as to how levered the vehicle is. It is not uncommon to see a listed private equity fund of funds with unfunded commitments equaling or exceeding 100 percent of their actual invested capital. In most cases, the listed private equity fund of funds will have a sizeable credit facility in place, giving them the flexibility to meet future capital calls without having to rely upon liquidity events from existing holdings if they are not in a net cash position. Some investors look favourably upon this over a commitment strategy along with the inherent leverage. Other investors see it differently, as will be discussed later. The most significant benefit that a listed private equity fund of funds offers is the broad diversification that an investor gains through the purchase of a single vehicle. A fund of funds investor is essentially turning over all of the research and ongoing due diligence to a private equity fund of funds manager who decides which private equity funds to commit to and how to manage those ongoing commitments. They are also gaining access to a set of private equity funds that typically would not be available to them due to pre-existing relationships that the fund of funds manager enjoys, and the ability to circumvent the high minimums required to invest in certain private equity funds. The biggest drawbacks of this type of vehicle include an additional layer of fees (fees on fees) and the general lack of transparency of each of the individual private equity funds in which the listed private equity fund of funds has invested in and how they are valued.

5 Listed private equity management companies The most complicated and least transparent listed private equity vehicle is one where the shareholder owns a piece of the management company. An example of this type of listed private equity vehicle would be The Blackstone Group LP (NYSE:BX). When an investor purchases a unit, or share, in Blackstone, they are buying a piece of the management company that oversees, and potentially benefits economically from, all of Blackstone s activities. In the case of Blackstone, the management company invests as a LP from its own balance sheet in each of the Blackstone funds, receives fee income from each of the Blackstone funds that they manage, and has the ability to earn a performance fee, or carry, as the general partner (GP) in each of those funds. Currently, Blackstone has fee earning assets in excess of $100 billion; these assets generate substantial, consistent fee income for Blackstone, and its shareholders, regardless of how the investments fare in the short term. The more assets that a company such as Blackstone manages, the more fee income they generate. Assets under management, and the corresponding fee income that those assets produce, can therefore be a big, if not the biggest, driver of value in a listed private equity management company vehicle in some cases bigger than the underlying private equity investments themselves. However, not all of the assets that some listed private equity management companies manage are private equity. In fact, in the case of Blackstone private equity makes up about 26 percent of the total assets in The remaining portions of the assets are in Blackstone real estate funds, hedge fund of funds and Blackstone s captive hedge fund (GSO Capital Partners). In addition, Blackstone receives fee income from its mergers and acquisition/restructuring/financial advisory business along with its private equity fund placement group (Park Hill). The key takeaway: an investor may not be getting pure private equity exposure, depending on which listed private equity management company vehicle they are choosing. Beyond the purity issue, another important element to keep in mind is that an investor is always one level removed from the direct private equity investments that most other listed private equity vehicles offer. This is not necessarily a bad thing; it is just a different model. And lastly, the biggest drawback of the listed private equity management company is the lack of transparency. It is rare that an investor will know, understand and be able to value all of the underlying businesses that a listed private equity management company owns through the various partnerships that it manages and how the mix between private equity and other asset classes might change in the future. Hybrids While there are three primary types of listed private equity vehicles, there is also a fourth, albeit less common vehicle: hybrids. Hybrids are just that, a mix between one type of listed private vehicle and another. One type of hybrid combines the direct listed private equity investment company with the listed private equity fund of funds. Examples of this would be Graphite Enterprise Trust (LON: GPE) or AP Alternative Assets LP (AMS: AAA). In the case of Graphite, the direct listed private equity company has committed capital to Graphite-managed funds in addition to other outside, non-graphite-managed private equity funds. Coupled with this are direct private equity investments in individual businesses that may also be in those funds, or not as the case may be.

6 Another type of hybrid combines the direct listed private equity investment company with the management company model. Examples of this would be KKR & Co. LP (NYSE:KKR) and Deutsche Beteiligungs AG. (ETR: DBA) In the case of KKR, when an investor owns a unit, or share, in KKR they get exposure to the direct private equity investments that KKR makes in various businesses, either directly or through KKR funds, along with ownership in a piece of the management company that has a financial interest in all of the KKR funds interest (fee income, LP interests and GP carry) along with other fee generating businesses that KKR owns (capital markets, advisory). Obviously hybrids can be quite complex to understand and are less than fully transparent. They also may shift their focus between balance sheet investing (direct private equity investing or fund of funds investing) and the management company depending on their own particular circumstances or outlook. Drawbacks The advantages of listed private equity vehicles are numerous. However, they are not without their drawbacks. Managing Cash Because listed private equity vehicles are perpetual or permanent capital vehicles, their capital is generally fixed to the number of outstanding units, or shares, at the time they go public. Unlike a traditional limited partnership, where the LP is committing to fund a series of future capital calls, a listed private equity vehicle must effectively manage their capital at all times. They do not have the flexibility of calling capital, or issuing new shares at a moment s notice, when they want to make an investment. They have to plan where and how they will get the necessary capital to fund an investment. There are several ways that they can do this: Holding significant cash: this provides the greatest flexibility for new or follow-on investments but creates cash drag on performance. Cash on the balance sheet of a listed private equity vehicle historically has earned substantially lower returns than the portfolio of private investments. Holding minimal cash: this does away with the issue of cash drag but creates the risk of not having sufficient liquid resources to fund new or follow-on investments in direct private equity investments or capital calls from LP commitments in the listed private equity fund of funds vehicles. Companies that employ this strategy have to either sell assets or tap into a pre-existing credit facility for their capital needs. Expanding on the concept of cash drag, many listed private equity vehicles tend to over-commit in their investments, especially the fund of funds vehicles, thereby making more investment or LP commitments than they have available cash to fund with. This is known as an over- commitment strategy and is done under the assumption that the listed private equity vehicle can effectively manage future cash calls with realisations from existing investments or expected inflows from existing LP interests in mature fund investments, with credit arrangements serving as an interim cushion. It works well in a rising equity market where liquidity is robust and realisations are occurring on a frequent basis. It does not work so well when equity valuations are in free fall mode and/or liquidity is at a premium, as witnessed in 2008 and parts of The simple conclusion: understanding how leverage is employed in a listed private equity vehicle is critical to determining how the vehicle will perform under various conditions or assumptions.

7 Premiums & Discounts Another drawback of listed private equity vehicles is that they trade at premiums/discounts to stated manager or GP valuations. Because they are liquid, and trade daily on recognised financial exchanges, the public sets the value of these vehicles on any given day. There are times when these vehicles have traded at premiums to their stated value. There are also times when these vehicles have traded at discounts to the stated value. Most recently, these discounts have been extreme. Figure 2: Listed private equity companies: Premiums/Discounts It should be noted that prior to June 2008 while listed private equity vehicles traded in a band of between 15 percent premiums to 25 percent discounts to stated manager or GP valuations, the majority of the time they have traded at a discount (see Figure 2). In the second half of 2008, everything changed. With the implosion of the financial markets and the liquidity crisis, listed private equity vehicles traded at historically wide discounts. As the financial markets healed in 2009, listed private equity vehicles closed their discounts but have yet to achieve levels that are considered typical. IPOs Examining discounts/premiums from a somewhat different perspective, when a direct or fund of funds listed private equity vehicle goes public via an IPO, it typically does so based on the stated manager or GP valuation of the private investments or funds that the vehicle holds plus any net cash/debt. In the case of the listed private equity management company vehicle, these are typically valued on some combination of the balance sheet assets (direct investments and/or fund investments), the value of the fee income that will be earned from each of the funds the manager oversees, along with the ability to earn a performance fee, or carry, as the GP in each of those funds. Since the beginning of 2007, ~24 listed private equity vehicles have gone public via an IPO. Of these, only 8 were trading above their IPO price (including any dividends or distributions made to shareholders since that time) as of 6/30/2010: clearly not a very rewarding experience for the recent listed private equity investor who purchased shares at the IPO. One possible conclusion is that these vehicles are flawed. Another is that these vehicles may very well be a victim of

8 circumstance is widely considered to be the top of the private equity market during the past decade. Had these vehicles gone public in 2000 or 2001, the results would most likely have been very different: of the ~47 listed private equity vehicles that went public via an IPO between 2000 and 2007, only 8 were trading below their IPO price (including any dividends or distributions made to shareholders since that time) at the end of While discounts to stated manager or GP valuations can be a drawback for some, they can also represent an opportunity for astute investors who understand the underlying value and growth potential in a particular private equity portfolio. Looked at from the perspective of a long-term commitment to the asset class, discounts alone should not be an impediment to ownership. What drives pricing? The biggest driver of a listed private equity vehicle s price has historically been the underlying performance of the private investments (write-ups, write-downs and realizations) that make up the portfolio. Recently, liquidity has been a bigger driver. Investors who needed liquidity in 2008 sold what they could (liquid vehicles), not necessarily what they wanted (illiquid vehicles), because it was liquid. Put another way, the liquidity feature of listed private equity worked against the vehicle as investors were able to quickly exit the asset class, even if it meant selling at historically wide discounts to stated manager or GP valuations. The complexity, transparency and leverage of many listed private equity vehicles didn t help matters as newer investors to these vehicles struggled to understand what exactly they owned and the associated risks associated. The adage, sell first and ask questions later comes to mind. Under more normal circumstances, listed private equity vehicles have tended to track the pricing in the secondary market for LP interests reasonably well. Why? Because listed private equity vehicles have a fairly well-defined portfolio of existing private investments, some of which are mature, avoiding most, if not all, of the J-curve. These are not blind pools of undrawn capital commitments. Hence, they tend to mimic secondary market pricing for similar more mature assets (see Figure 3). Figure3: Secondary LP pricing vs. LPE discounts The recent discount to secondary LP pricing, along with the historically wide discount to stated GP or manager valuations has attracted traditional secondary private equity buyers. When listed private equity company SVG Capital plc completed a 171 million rights offering in December 2008, Coller Capital, a traditional secondary LP buyer, purchased upwards of 19 percent of SVG Capital plc via the rights offering.

9 Investors are taking notice of listed private equity vehicles that offer an alternative means of accessing similar or nearly identical assets to those of traditional LP-based private equity funds, particularly when those vehicles trade at a significant discount. Conclusion At its core, private equity is a long-term commitment. To reap the benefits that the asset class has to offer, investors must do their homework, choose the right fund managers, understand the strategy and structure of the funds they are committing to, and build a diversified portfolio of investments if they expect to be appropriately rewarded. It takes many years to invest, build and realise value in a portfolio of private investments. Whether it is in a traditional limited partnership format or in a listed private equity vehicle, the expectation is the same: strong overall investment performance from a well diversified portfolio of top private equity funds. Listed private equity vehicles have delivered on this expectation and are well positioned to continue to do so in the future. This article was first published in The Definitive Guide to Private Equity Investment Fund Due Diligence (Second Edition) by PEI Media in 2010 Adam Goldman serves as a founder and managing director of Red Rocks Capital, the premier US listed private equity fund manager. Prior to forming Red Rocks Capital in 2003, he was a general partner and managing director in four separate venture funds with Centennial Ventures, managing over $1 billion. Adam has served on the boards of more than one dozen private and public companies. He is a past president and chairman of the board of the Colorado Venture Capital Association. In addition, Adam sat on the Governor s Science and Technology Commission for the State of Colorado, and is currently a board member of Energy Outreach Colorado. Adam has a B.A. degree from Northwestern University and a M.M. from the J.L. Kellogg School of Management at Northwestern University. He has over 25 years of investment experience in alternatives, public and private equity.