Understanding the J-Curve: A Primer on Interim Performance of Private Equity Investments

Transcription

1 Strategic Research December Understanding the J-Curve: A Primer on Interim Performance of Private Equity Investments DANIEL MURPHY Vice President Private Equity Group daniel.murphy@gs.com (1) 55- Executive Summary Private equity provides a number of benefits to investors, such as access to the private economy, attractive potential returns and diversification. But investing in private equity also exposes investors to the so-called J-Curve, a less attractive aspect of the asset class. The J-Curve is an industry term that derives from the graphical pattern exhibited by some key metrics used to gauge the performance of private equity investments. Specifically, the J-Curve commonly refers to attributes such as negative cash flows for several years after commitments are made, poor apparent performance early in the life of an investment, and valuations held at, or near, cost for investments that may be several years old. In this paper, we outline the main factors driving the J-Curve, and provide a framework for investors to assess its impact on apparent fund performance. It is important to keep in mind that the J-Curve Effect is not an indicator of the overall performance of a private equity investment, but rather an attribute of the investment at a certain point in its life cycle. In our view, understanding the mechanics behind the J-Curve allows investors to better manage their expectations regarding private equity investments. We begin our analysis by modeling J-Curves for three commonly tracked private equity investment measures: Cumulative Net Cash Flow (CNCF), Interim Internal Rate of Return (IRR) and Interim Return on Investment (ROI). 1 While the specific attributes of the J-Curve (e.g., minimums, curvature, etc.) differ for each metric, they often share many similar traits, providing enough consistency to validate our efforts. Our model of a typical private equity fund projects that: CNCF reaches a minimum around year five of the fund. In other words, total contributions are expected to be greater than total distributions until the fifth year of the investment. The Interim IRR may be between -5% and +1% three years into the investment, even for a fund that will eventually have a 15% net annual return. The ROI is expected to be between 9% and 13% after three years, even for a fund that will eventually have a total return of twice the overall contributed capital. At first glance, these statistics may surprise many investors, given that most private equity investments are likely to be profitable at the end of their lifecycle. The discrepancies between final and interim return numbers are due to the combined effects of management fee structures, the cash flow pattern of private equity investments and the valuation practices of the General Partners (GP) of private equity partnerships. Although the J-Curve Effect can not be completely eliminated, our research suggests that it can be mitigated. We discuss how investors concerned about the interim performance of their portfolios can utilize several methods to minimize the negative impact of the J-Curve, such as adopting steady annual commitment programs and investing in specialized funds that experience shorter investment cycles, such as secondary, mezzanine and distressed funds. 1 CNCF is the sum of all cash flows to and from an investment. The Interim IRR and ROI are the performance metrics calculated part-way into a fund s life, and are the performance measures most often associated with private equity investments. See Appendix A for detailed definitions of these measures.

2 What is the J-Curve? Investments in private equity boast a wide range of features that set them apart from their public counterparts relatively limited liquidity, negative cash flows in the early years of the investment, valuation constraints and management fees based on committed capital, among others. These features inherent to the asset class impact the management of investors cash flows as well as the timing of when the potential returns in private equity funds can be harvested. These impacts are usually measured by the J-Curve, an industry term that derives from the graphical pattern exhibited by key metrics used to gauge the performance of private equity investments. In our research, we modeled a typical private equity fund and studied the J-Curves for three commonly tracked private equity investment metrics: Cumulative Net Cash Flow (CNCF), Interim Internal Rate of Return (IRR) and Interim Return on Investment (ROI). The result of this analysis is shown in Exhibit 1. The chart of CNCF is the one that most closely follows the shape of the letter J, declining in the early years of the fund before increasing and turning positive. Although not as visually clear as the CNCF chart, the IRR and ROI charts are also often referred to as J-Curves. Exhibit 1 Private equity investments show specific cash flow and return attributes known as the J-Curve % of committed capital Cumulative Net Cash Flow - Percent Internal Rate of Return For illustrative purposes only. Simulated performance results do not reflect actual trading and have inherent limitations. Please see additional disclosures. Source: Goldman Sachs Asset Management (GSAM) % of contributed capital Return on Investment Since private equity funds draw down capital over the course of several years and make investments that often last four years or longer, most cash flows are negative in the first few years after a commitment is made, causing the initial decline in the CNCF curve. In addition, it is not unusual for GPs to take several years to find a sufficient number of attractive opportunities in which to invest all of their capital. Also, GPs will often make subsequent investments in the companies in their portfolio to help them expand. In order to adjust for the fact that contributions to private equity investments are conducted in a staggered fashion, the ROI charts in this paper show the evolution over time of return on investment as a percentage of the contributed capital. Goldman Sachs Asset Management

3 Furthermore, private equity investments do not typically have a significant current income component. Thus, most cash received from an investment comes only when the investment is sold. Since the duration of private equity investments is typically between three and seven years, it may be six or seven years before a fund experiences significant distributions. This slow rate of distributions, combined with the time it takes GPs to fully invest their funds, means that investors will often be called upon to fund their capital commitments for several years before any eventual profits are returned to them. However, as the fund becomes fully invested, and early investments mature and are realized, positive cash flows begin to dominate, shifting the curve upward around year six. Eventually, if the fund is profitable, CNCF becomes positive (in other words, all of the capital contributions have been returned to investors), and by year the fund has been fully liquidated. The J-Curves for IRR and ROI, as illustrated in Exhibit 1, have somewhat different shapes. They both start out quite low and gradually increase to their final value over several years. In the early stages of the fund s life, performance appears poor, even though the returns on the underlying investments may be quite attractive. That s because the IRR and ROI curves are largely determined by the valuation practices of the GPs as well as the management fee structure typically seen in private equity partnerships (the CNCF curve, on the other hand, is determined by the investment activity and the time it takes to liquidate the fund s investments). Thus, while the ultimate values of IRR and ROI at the end of a fund s life represent the performance of the fund s underlying investments, the IRR and ROI curves are actually more representative of and more influenced by the fund s management structure. For example, in the first few years of a fund s life, only a fraction of the total commitment is drawn down and invested in portfolio companies. Management fees, however, are typically charged annually as a percentage of the total commitment amount. Thus, the capital drawn for management fees in the first few years of the fund s life is a larger fraction of the total capital drawn than in the later years of the fund. This translates into a larger impact of management fees on the performance of the fund in the early years than in the later years. Additionally, private equity investments are often held at cost for some time after their initial purchase, regardless of whether real changes in value have taken place. This is because private equity investments, by definition, do not have a public price. Without the price discovery that a public market affords, it is difficult to assess how much a third party would pay for a given company at a particular point in time. Many GPs choose to hold their investments at cost until a significant third-party transaction has occurred. 3 In venture capital funds, for example, this transaction may be a new round of funding, in which case an accurate or at least market-based value may be obtained on a somewhat regular basis. However, for many leveraged buyout investments, the only transaction that takes place following the initial acquisition is the final sale of the company. This can mean that the GP valuation may significantly under/overstate the true economic value of the investment in the period between the acquisition and the sale of the investment. 3 In September, the US Financial Accounting Standards Board (FASB) through its Statement of Financial Accounting Standards (SFAS) No. 157 updated and clarified existing rules on the use of fair market value (FMV) in generally accepted accounting principles. It also provided additional guidance on how to calculate FMV. While its impact on the overall industry remains unclear, we believe that the SFAS No. 157 will likely change the valuation practices of some GPs. Goldman Sachs Asset Management 3

4 What Influences the Shape of the J-Curve? Many factors contribute to the shape of the J-Curves of a private equity investment. For the purposes of this paper, we will highlight four of the most important issues affecting J-Curves. They are: returns, accounting methodology, drawdown rate and duration. We will also examine the J-Curves for funds of funds. Due to their nature and structure, funds of funds which are designed to provide diversified exposure to private equity tend to exhibit a unique set of J-Curves. Returns The returns on the underlying investments in a private equity fund are often assumed to have a strong impact on the shape of the J-Curve in the first few years of the fund. However, as shown in Exhibit, different returns do not actually lead to significantly different J-Curves until four or five years into a fund. This is because the CNCF is only affected by drawdowns in the early years of a fund s life, and the IRR is dominated by the effect of management fees. Differences in return are only observable when enough time has elapsed for investments to be held at some value other than cost, which may not occur until the first realization or later. This illustrates a point that most long-time investors in private equity have come to realize: Apparent returns in the early years of a private equity fund are often a poor indicator of the actual performance of the underlying investments. Exhibit Different returns do not meaningfully alter the J-Curve in the early stages of the fund Cumulative Net Cash Flow Internal Rate of Return 3% Gross IRR 3 15 % Gross IRR 5 % Gross IRR - % Gross IRR For illustrative purposes only. Simulated performance results do not reflect actual trading and have inherent limitations. Please see additional disclosures. % of committed capital Percent 3% Gross IRR % Gross IRR % Gross IRR % Gross IRR Accounting Methodology The GP s valuation methodology is a factor that affects the IRR and ROI curves, but not the CNCF curve. Exhibit 3 illustrates the modeled difference in IRR and ROI between two hypothetical GPs, one who holds investments at cost until realized, and another who marks the portfolio to market on a quarterly basis. We also modeled a hybrid view, in which we approximate the fund s net asset value (NAV) by assuming that some investments are held at cost and some are marked to their fair market value (FMV). These differences in accounting may make it difficult to compare the performance of two funds until late in their life cycle, as they may have identical economic performance early on (while their investments are mostly unrealized) and yet report vastly different NAVs. This uncertainty in the valuation of private equity investments is both boon and bane to private equity. Boon because the inefficiencies caused by the difficulty in assigning values to private unlisted investments allows talented managers to generate excess returns; and bane because investors are often forced to accept (and report) poor returns for several years after making a commitment. It is an unfortunate fact of investing in private equity that investors typically appear to lose money in the early years of a commitment before reaping gains. Goldman Sachs Asset Management

5 It is also worth noting that the FMV line decreases in the last few years of the fund this is due to the fact that we have assumed that while the GP marks investments to FMV, he or she does not make an allowance for carried interest on the unrealized investments. This practice also varies by fund, and a GP that does include an allowance for carried interest will not show this decline. Exhibit 3 A GP s valuation methodology plays a key role in determining the IRR and ROI curves Internal Rate of Return Return on Investment Held at FMV Held at FMV Percent NAV* Held at Cost % of contributed capital NAV* Held at Cost - *Approximate For illustrative purposes only. Simulated performance results do not reflect actual trading and have inherent limitations. Please see additional disclosures. Drawdown Rate The drawdown rate of a private equity fund (or how quickly capital is called by a GP) will influence the behavior of all of the analyzed J-Curves. Exhibit, for example, shows the effects of different drawdown rates on the CNCF and IRR curves. Assuming the fund s underlying investments have the same return and duration characteristics, a faster drawdown rate will make the CNCF curve steeper and deeper, but it will also reduce the time until all capital is returned, and thus shorten the J-Curve. The IRR J-Curve, however, will rise more quickly, since the additional invested capital lessens the impact of management fees early in the life of the fund, and, as a result, helps the fund move into positive territory more quickly. The opposite effects are true for slower drawdown rates the CNCF curve is longer and the IRR curve is deeper. As expected, all lines converge at the end of the fund s life. Exhibit The drawdown rate influences the behavior of the J-Curve Cumulative Net Cash Flow Internal Rate of Return % of ccommitted capital 5-5 % Drawdown Rate % Drawdown Rate 3% Drawdown Rate Percent % Drawdown Rate 3% Drawdown Rate % Drawdown Rate - For illustrative purposes only. Simulated performance results do not reflect actual trading and have inherent limitations. Please see additional disclosures. - Goldman Sachs Asset Management 5

6 Duration Duration, or the length of time an investment is held by the GP, is a parameter that has a significant effect on all of the J-Curves of a private equity fund. As a rule of thumb, assuming investments are sold for the same amount of money, the longer the duration, the lengthier the CNCF curve and the flatter the IRR curve. We illustrate this effect in Exhibit 5. Exhibit 5 Duration is another important factor affecting private equity J-Curves Cumulative Net Cash Flow Internal Rate of Return % of committed capital Duration 5- Duration 7- Duration For illustrative purposes only. Simulated performance results do not reflect actual trading and have inherent limitations. Please see additional disclosures. Percent Duration 7- Duration 5- Duration Since the IRR of an investment combines both its ROI and its duration, a fund whose underlying investments are realized quickly may be mistakenly identified as a better performer than a fund with longer-duration investments. Exhibit illustrates this phenomenon. In our example, Fund A holds its investments for an average of two years and generates 15% annual returns before fees and carry, while Fund B holds its investments for seven years on average and generates % annual returns before fees and carry. In the first three years of the funds lives, their J-Curves are nearly identical. However, after four years have elapsed, Fund A appears to be outperforming, since it has realized most of its investments while Fund B is still mostly unrealized (and largely held at cost). But after year five, Fund B s IRR curve improves, and the fund ultimately returns much more capital, and has a higher final IRR, than Fund A. This example illustrates one of the reasons why it is important not to put too much weight on the early performance of a private equity fund. Exhibit Investors should not put much weight on the early performance of a private equity fund % of committed capital Cumulative Net Cash Flow Fund A Fund B Internal Rate of Return For illustrative purposes only. Simulated performance results do not reflect actual trading and have inherent limitations. Please see additional disclosures. Percent Fund A Fund B Goldman Sachs Asset Management

7 Funds of Funds Funds of funds select and invest in a portfolio of private equity funds on behalf of their investors. Since a fund of funds invests in multiple underlying funds over a period of time, it will have a unique J-Curve that is different from the J-Curves of its underlying investments. Exhibit 7 shows an example of this curve for a fund of funds that commits an equal amount of capital to different partnerships over the course of 15 months. The CNCF curve for a fund of funds has a wider spread, and is slightly shallower than that of a single partnership. A fund of funds also has a longer lifespan than a single partnership since it must remain active until its last underlying partnership is fully liquidated. The IRR curve is also more spread out, and it remains negative longer, partially due to the timing spread of the underlying commitments, and partially due to the additional layer of management fees charged by the fund of funds. The J-Curve for a fund of funds is typically more predictable and stable than that of a single fund investment since differences in returns, drawdown rates and durations are averaged out across several partnerships. The number of underlying funds, and their diversified nature, smoothes out the J-Curve. Exhibit 7 Funds of funds tend to have a unique set of J-Curves % of committed capital Cumulative Net Cash Flow Single Fund Fund of Funds 1 Percent Internal Rate of Return Single Fund Fund of Funds For illustrative purposes only. Simulated performance results do not reflect actual trading and have inherent limitations. Please see additional disclosures. 1 % of contributed capital Single Fund Return on Investment Fund of Funds 1 How to Mitigate the J-Curve Many investors concerned about the interim performance of their portfolios wonder about mitigating the private equity J-Curve. Unfortunately, there is no guaranteed way to lessen the drawdown of capital or to improve the seemingly low returns in the early years of a private equity commitment. But there are strategies that often help to improve the profile of the curves in the early years. One method that may reduce the volatility of the J-Curve, and thus its likely extreme values, is to follow a disciplined approach to making annual commitments to private equity. Steady annual commitments will create a portfolio that is diversified in vintage years and will, over time, incorporate funds at all stages of the private equity life cycle. As an illustration, Exhibit (next page) compares two private equity investment programs for a hypothetical investor targeting $ million of invested capital. The fast commitment program seeks large initial commitments of capital early in the life of the investment. The steady commitment program, however, seeks a more balanced disbursement of capital over time. To further illustrate the point, we also charted the evolution of the J-Curve for just the amount of capital committed in the first year of each program in our example, $ million (fast) and $3 million (steady). Goldman Sachs Asset Management 7

8 Exhibit Steady commitments can mitigate the J-Curve of a private equity program 1 Cumulative Net Cash Flow $ Millions - Capital Committed in the First of Fast Program Capital Committed in the First of Steady Program Fast Commitment Program Steady Commitment Program - -1 For illustrative purposes only. Simulated performance results do not reflect actual trading and have inherent limitations. Please see additional disclosures. 1 While the J-Curve still exists in the early years of either program, its magnitude is mitigated under the steady commitment program. More importantly, the fraction of the J-Curve that is attributable to the first-year commitments is significantly reduced in the steady plan. In our illustration, we assumed that the monies committed in the first year of the fast program performed well, thus allowing for the fast plan to outperform the steady program in the long run. However, had the performance of the first-year commitments turned out to be poor, this situation could have easily been reversed. In this light, we believe that adopting a steady program moderates the investor s exposure to a large commitment of funds made in a single year, thereby lessening the potential damage to the portfolio and to the final performance of the private equity investment if those funds turn out to underperform or to have a particularly deep J-Curve. Another method that may help mitigate the J-Curve is to make commitments to specialized funds that experience shorter investment life cycles or that are able to mark their commitments to market more easily. Secondary private equity funds, mezzanine funds and distressed funds are good examples of such strategies. Secondary private equity funds purchase partnership interests from other Limited Partners (LP) in funds that are typically several years old. Since the secondary fund is purchasing the LP s interest well into the fund s J-Curve, it experiences a higher velocity of cash flows (capital is drawn down more quickly to acquire these mature assets and then distributed more quickly as these assets are generally held for a shorter period of time before being sold). The pattern often leads to shorter J-Curves than primary partnerships. Mezzanine funds invest in securities that are junior to a company s senior debt, but sit above the equity, thus being somewhat safer than a pure equity investment while offering higher returns than the debt (sometimes through equity-conversion features). Mezzanine investments typically pay regular cash coupons, which can help provide additional positive cash flow early in the fund s life cycle and lessen the impact of CNCF J-Curve. The IRR and ROI J-Curves are also mitigated by these coupons, as they provide a guaranteed return stream even in the absence of re-valuation of the underlying securities. Goldman Sachs Asset Management

9 Meanwhile, distressed funds may incorporate trading strategies that involve purchasing the public debt and equity of companies considered to be in financial distress. Since they are associated with public companies, these securities tend to be more easily valued as the investment matures. Additionally, our research has shown that distressed funds tend to put a significant amount of their capital to work quickly when the economy enters a distressed cycle, thereby reducing the ratio of management fees to invested capital and raising the IRR and ROI J-Curves. Distressed managers also will often target holding periods somewhat shorter than typical leveraged buyout or venture capital managers, thus providing earlier distribution of proceeds to investors. Conclusion Private equity is a long-term investment whose performance is difficult to assess in the early years of a fund s life. Due to the asset class s specific attributes such as negative cash flows in the early years of the investment, valuation constraints and limited liquidity investors are forced to cope with the J-Curve. Our research shows that private equity investors should expect to contribute capital to a fund for a period of five to six years before receiving significant distributions, and they should expect to see potentially negative interim IRRs and ROIs below cost for several years following the fund s close. It s important to note, however, that these values do not necessarily indicate poor performance of the fund s underlying investments. Our research also illustrates that many factors influence the profile of the J-Curves, including the private equity fund s strategy, the economic environment and the pace at which capital is committed to a private equity program, among others. Investors should be aware of these different factors when they are comparing the performance of funds, particularly a fund s early performance. In addition, our studies indicate that investors may be able to mitigate the impact of the J-Curve on their investments by using some specific investment strategies, such as setting up steady diversified annual commitments to private equity, and/or investing in funds with abbreviated J-Curves, such as secondary, mezzanine and distressed funds. Goldman Sachs Asset Management 9

10 Appendix A Below are the definitions and assumptions used to build the illustrative examples in this white paper. Let: C t be the contributions made by an investor at time t D t be the distributions received by an investor at time t V t be the reported valuation of remaining investments at time t The Cumulative Net Cash Flow CNCF τ of a private equity investment at time τ is defined to be: (1) This is simply the sum total of all cash flows experienced by the investor through time τ, with contributions defined to be negative and distributions positive. The Interim Internal Rate of Return IRR τ of a private equity investment is the discount rate that sets the net present value of the investment to zero. For an investment at time τ, this is mathematically defined as the solution to the equation: () The Interim Return on Investment ROI τ is another measure of the performance of an investment that divides the total proceeds and value of the investment by its cost. This metric is calculated as: (3) As can be seen from equations and 3 above, both the Interim IRR and ROI incorporate the reported valuation V τ. Since this value is dependent on the valuation practices of GPs and may not reflect the true market value of investments, and since in the early years of a fund the unrealized valuation may be a significant fraction of the total value of the investment, both the Interim IRR and ROI may not reflect the actual performance of a private equity investment. For a fund that has been fully realized at or before time T, the final IRR IRR T and final ROI ROI T are similarly defined as solving: () (5) These values represent the true performance of the fund, but are only available after the fund has liquidated all investments. Goldman Sachs Asset Management

11 Appendix B The projected cash flows and values used to create the examples in this paper are calculated using an implementation of the cash-flow model described in the paper Illiquid Alternative Asset Fund Modeling by Dean Takahashi and Seth Alexander of the Yale University Investments Office, published in the Journal of Portfolio Management (Winter ). This model has parameters for the rate at which cash is drawn down, the rate of distribution ( bow ) and the gross internal rate of return (IRR) of the fund. We have augmented this model to include projections of invested value, management fees, and carried interest; and we utilize a formulation that calibrates the bow parameter described in the article to yield a desired average duration of investments. For our base case projection in Exhibit 1, we project quarterly cash flows and values for a fund with a lifespan of years, meaning that all investments are fully liquidated years after the close of the fund. We assume that 3% of investable commitments are drawn in the first two years, followed by annual drawdowns of % of remaining investable capital. The bow parameter is calculated such that the cash flows generated imply an average investment duration of five years, and gross returns (before management fees and carried interest) are % annually. Management fees are assumed to be 1.75% of commitments per year for five years, then 75% of the previous year s fees thereafter. Carried interest is assumed to be % of profits after investors have received a return of capital. To estimate NAV, we use a weighted average of invested value and fair market value (FMV), where the weight on FMV is a linearly increasing function of the age of the fund. Unless otherwise noted, all IRR and ROI J-curves are calculated using this estimate of NAV. For the exhibits shown in this paper, the following parameter sets were used (all other parameters are the same as described above): Lifespan Initial Drawdown Rate Average Duration Gross IRR Exhibit (years) (% of investable capital) (years) (percent) ,,, , 3, , 5, 7 (Fund A) 3 (Fund A) 15 (Fund A) (Fund B) 7 (Fund B) (Fund B) In Exhibit 7, we construct a fund of funds that is composed of identical partnerships projected using the same parameters as those used in Exhibit 1, but with a gross IRR of.5%. It is assumed that the fund makes equal-sized commitments to each of these partnerships, evenly spaced over a period of 15 months. The fund of funds itself charges management fees of 1% per year for five years, after which fees are calculated as 75% of the previous year s fees. Carry is calculated as 5% of profits from investments, payable after an % preferred return has been achieved by the investors in the fund. The single fund shown in the example uses the same parameters as Exhibit 1. In Exhibit, we assume equal quarterly commitments are made to identical funds each year, where each fund is projected using the same parameters as those used in Exhibit 1. The annual commitments of each program are illustrated in the table below: Steady Commitments ($mn) Faster Commitments ($mn) Goldman Sachs Asset Management 11

12 Glossary of Terms Alternative Investments: Broadly, investments in assets or funds whose returns are generated through something other than long positions in public equity or debt. Generally includes private equity, real estate and hedge funds. Buyouts: Investments made to acquire majority or control positions in businesses purchased from or spun out of public or private companies, or purchased from existing management/shareholders of public equity in going private transactions, private equity funds or other investors seeking liquidity for their privately held investments. Buyouts are generally achieved with both equity and debt. Examples of various types of buyouts include: small, middle market, large cap and growth. Capital Call/Drawdown: Occurs when a private equity fund manager (typically acting through the General Partner (GP) of the partnership) asks an investor (typically, a Limited Partner (LP) of the partnership) to fund a portion of his or her capital commitment in order to make a current investment, or to fund management fees or expenses. Usually, an LP will agree in advance to a capital commitment, and over time the GP will make a series of capital calls to the LP as opportunities arise or the capital is otherwise needed. Capital Commitment: The total out-of-pocket amount of capital an investor commits to invest over the life of a fund. This commitment is generally set forth on an investor s subscription agreement during fundraising, and is accepted by the GP as part of the closing of the fund. Carried Interest: Also known as carry or promote. A performance bonus for the GP based on profits generated by the fund. Typically, a fund must return a portion of the capital contributed by LPs plus any preferred return before the GP can share in the profits of the fund. The GP will then receive a percentage of the profits of the fund (typically % to 5%). For tax purposes, both carried interest and profit distributions to LPs are typically categorized as a capital gain rather than ordinary income. Catch-Up: A clause in the agreement between the GP and the LPs of a private equity fund. Once the LPs have received a certain portion of their expected return, often up to the level of the preferred return, the GP is entitled to receive a majority of the profits (typically 5% to %) until the GP reaches the carried interest split previously agreed. Clawback: A clause in the agreement between the GP and the LPs of a private equity fund obligating the GP to return distributions to the LPs to the extent the GP received excess carry distributions, or if the LPs did not receive their preferred return. This can sometimes happen if carry is paid on a deal-by-deal basis, and if the carry paid for early, profitable investments is offset by significant losses from later investments in a portfolio. The clawback is often calculated on an after-tax basis, so the GP will not be obligated to return distributions in excess of the tax it was obligated to pay in respect of the carry distributions. Distressed/Turn-Around Securities: The equity or debt instruments of troubled or bankrupt companies. Distribution: When an investment by a private equity fund is fully or partially realized (resulting from the sale, liquidation, disposition, recapitalization, IPO, or other means of realization of one or more portfolio companies in which a GP has chosen to invest) the proceeds of the realization(s) are distributed to the investors. These proceeds may consist of cash or, to a lesser extent, securities. Distribution Waterfall: The order and priority in which a private equity fund distributes capital and profits to LPs and the GP. The GP, for example, may return all capital contributed by the LPs before taking carried interest, or take carry on a deal-by-deal basis. Most funds offer a priority return of realized invested capital, rather than all contributed capital. LPs are protected from portfolio losses subsequent to distribution of carry to a GP through the clawback. Goldman Sachs Asset Management 1

13 General Partner (GP): A class of partner in a partnership. The GP makes the decisions on behalf of the partnership and retains liability for the actions of the partnership. In the private equity industry, the GP is solely responsible for the management and operations of the investment fund while the LPs are passive investors, typically consisting of institutions and high net worth individuals. The GP earns a percentage of profits. Internal Rate of Return (IRR): The compound interest rate at which a certain amount of capital today would have to accrete to grow to a specific value at a specific time in the future. This is the most common standard by which GPs and LPs measure the performance of their private equity portfolios and portfolio companies over the life of the investment. IRRs are calculated on either a net (i.e., including fees and carry) or gross (i.e., not including fees and carry) basis. Leveraged Buyout (LBO): The purchase of a company or a business unit of a company by an outside investor using mostly borrowed capital. Limited Partner (LP): A passive investor in a limited partnership. The GP is liable for the actions of the partnership while the LPs are generally protected from legal actions and any losses beyond their original investment. The LPs receive income, capital gains and tax benefits. Limited Partnership: A legal entity composed of a GP and various LPs. The GP manages the investments and is liable for the actions of the partnership while the LPs are generally protected from legal actions and any losses beyond their original investment. The GP receives a percentage of profits, while the LPs receive income, capital gains and tax benefits. Management Fee: A fee paid to the investment manager for its services, typically as a percentage of aggregate capital commitments. Management fees in a private equity fund typically range from 1.5% to.5% of commitments during the fund s investment period, and then step down to the same or a lower percentage based on the fund s invested capital remaining in investments. Venture capital funds tend to have higher management fees than traditional private equity funds. Management Fee Stepdown: Provides for a reduction of the management fee once the majority of the fund is invested (i.e., the investment period has expired) and much of the intensive work and costs required to build a portfolio of companies has been completed. The management fee stepdown typically occurs in a reduction of the base of the management fee from commitments to invested capital. Mezzanine Financing: Financing provided by a bank or specialized investment fund to invest in a debt instrument of lower credit quality relative to the senior debt in a company but ranking senior to any equity claims. The instrument may include equity features, such as warrants. Preferred Return: Also known as the hurdle rate. Preferred returns are typically found in buyout funds. After the cost basis of an investment is returned to the LPs, they will also receive additional proceeds from the investment equal to a stated percentage, often %. Once the preferred return is paid, then the GP will be entitled to its carried interest on all profits realized from the investment. Present Value: The sum of money which, if invested now at a given rate of compound interest, will accumulate exactly to a specified amount at a specified future date. Private Equity: The Goldman Sachs Private Equity Group defines private equity as anything not publicly traded, anywhere in the world, except real estate. Goldman Sachs Asset Management 13

14 Secondary Market: A market for the sale of existing private equity investments prior to their stated maturity. Traditionally, the secondary market has been focused on partnership interests in private equity funds. More recently a market has developed for portfolios of direct private equity investments as well. Private equity investors may choose to sell their interests for a variety of reasons: They may want to raise cash, change their asset allocation, shift their private equity investment strategy, reduce their number of private equity managers, recycle capital into preferred managers, or they may be in distress and cannot meet their obligation to invest more capital according to a capital commitment schedule. Certain investment companies specialize in providing liquidity to these investors, acquiring partnership interests or portfolios of directs as secondaries. Valuations: Traditionally, private equity funds have carried their assets at cost until an investment is realized or until some type of financing event occurs (such as additional investment, merger, sale, realization or an upround of financing for a venture capital fund). Venture Capital: A private equity asset class that seeks to build businesses through equity investments in young private companies. Many venture capitalists also seek to provide management, industry or technical expertise to add value to the company or their investment. Liquidity typically is realized through an IPO or the sale of the company. The three major classes of venture capital investing are early, middle and late stage, referring to the level of development of the companies. Vintage : The year in which a private equity fund has its final closing. Goldman Sachs Asset Management 1

15 Goldman Sachs Asset Management Publications Following are additional research papers examining a range of investment topics. The Future of Defined-Benefit Plans: Using LDI Policy to Adapt to New US Pension Regulation (NOVEMBER ) US pension rules are in the midst of an overhaul that will significantly impact the financial results of defined-benefit pension plans. We believe that the adoption of liability-driven investing (LDI) policies will become critical for pension management under the new regulatory environment. In this paper, we show that LDI strategies can help plan sponsors cope with the new regulation by potentially lowering the volatility of the pension surplus (or deficit), while possibly improving the portfolio s risk-adjusted return. These strategies can also decrease the likelihood that sponsors will have to make forced pension contributions. Additionally, in the long run, we anticipate pension plans using LDI to have a healthier funded status than the ones using traditional portfolio construction strategies. Designing Efficient Return-Generating Portfolios: Tilting Away from Equilibrium toward Alpha and Exotic Beta (OCTOBER ) Institutional investing is changing, and we believe investors can add value to their portfolios by increasing exposures to skill-based strategies (alpha) as well as asset classes that are chronically mispriced (exotic beta). This paper provides a framework through which investors can use equilibrium-theory-based models to build portfolios with an optimal combination of alpha, exotic beta and market beta. It also illustrates how investors can use leverage to enhance potential returns. Reserve Management in an Equilibrium Framework (AUGUST ) In this paper, we provide an investing framework for central banks to reconcile their need to maintain adequate liquidity levels while generating higher return on assets. By allocating reserves more efficiently, central banks can designate a portion of their assets to a liquidity portfolio and still have considerable latitude to invest in a return-generating portfolio. We show that the allocation between these two portfolios can be determined through a model that tests a range of factors frequently watched as signals of potential reserve losses. Liability-Driven Investment Policy: Managing to the True Benchmark (JUNE ) In this paper, we develop a general framework that investors can use to better formulate liability-driven investment policies across different types of investment organizations and regulatory frameworks. We discuss how portfolio efficiency changes when investors treat liabilities as their true benchmark, and how they can further improve efficiency by relaxing constraints on alpha portability and increasing exposures to active strategies. Emerging Markets Equity: Structural Opportunities for Investors (MARCH ) This paper highlights the important role that emerging markets equity can play in institutional portfolios. It also includes a series of observations about emerging markets equity returns and how these observations are consistent with extraordinary returns from exposure to the asset class. Further, it presents the diversification benefits of emerging markets equity and offers an alternative interpretation of contagion and changes in correlation, as well as ideas regarding optimal portfolio structure and the practical aspects of increasing exposure to actively managed emerging markets equity. Are Constraints Eating Your Alpha? (AUGUST 5) Is the hedge fund manager who outperforms the traditional manager better at forecasting stock returns, or is he or she just facing fewer material constraints? Constraints exist for a reason and serve an important role ensuring underlying risk control of portfolios. But not all constraints are created equal. This paper explores ways to help fiduciaries reach the next level in setting constraints and potentially improve performance for traditional investment managers. It includes information on what to watch for and what you can do when investment guidelines become out of date. Public and Private Real Estate: Yesterday, Today and Tomorrow (MAY 5) In this paper, we discuss the landscape of real estate investing and analyze the differences between the public and private markets. We find that the differences are not statistically meaningful. Therefore, investors should choose their implementation approach based on the specific characteristics of each structure. Given the advantages of public real estate liquidity, diversification and flexibility we believe it should be a substantial component of a real estate allocation. Active Risk Budgeting in Action: Assessing Risk and Return in Private Equity (APRIL 5) Since private equity investments are not regularly traded and are limited by poor data quality, a basic investing framework may not be applied to this asset class. However, we believe private equity can be naturally decomposed the same way as other investments. This paper provides a framework that puts private equity returns and allocations on equal footing with other investments. By using our assumptions on residual volatility and information ratios, our analysis shows that investors can potentially achieve higher expected returns by including private equity in a traditional portfolio of global equity and global fixed income. Understanding Variations in Risk of Multi- Strategy Portfolios (OCTOBER ) In this paper, we tackle the real-life decisions faced by pension fund managers and private wealth investors, among others. By breaking variations in risk into asset class weights, volatilities and correlations deviating from the risk budget, we provide a framework for investors to better understand their portfolios, manage risk more optimally and improve the investment process. This paper also provides guidance on when and how to rebalance portfolios back to strategic weights. Active Risk Budgeting In Action: Understanding Hedge Fund Performance (MAY ) This paper develops a framework for analyzing hedge fund performance across a variety of strategies including tactical trading, equity market neutral, equity long/short, event driven, convertible arbitrage and fixed income arbitrage. Please contact your relationship manager to obtain a copy of any of these research papers.

16 Alternative Investments such as hedge funds are subject to less regulation than other types of pooled investment vehicles such as mutual funds, may make speculative investments, may be illiquid and can involve a significant use of leverage, making them substantially riskier than the other investments. An Alternative Investment Fund may incur high fees and expenses which would offset trading profits. Alternative Investment Funds are not required to provide periodic pricing or valuation information to investors. The Manager of an Alternative Investment Fund has total investment discretion over the investments of the Fund and the use of a single advisor applying generally similar trading programs could mean a lack of diversification, and consequentially, higher risk. Investors may have limited rights with respect to their investments, including limited voting rights and participation in the management of the Fund. Alternative Investments by their nature, involve a substantial degree of risk, including the risk of total loss of an investor's capital. Fund performance can be volatile. There may be conflicts of interest between the Alternative Investment Fund and other service providers, including the investment manager and sponsor of the Alternative Investment. Similarly, interests in an Alternative Investment are highly illiquid and generally are not transferable without the consent of the sponsor, and applicable securities and tax laws will limit transfers. There may be conflicts of interest relating to the Alternative Investment and its service providers, including Goldman Sachs and its affiliates, who are engaged in businesses and have interests other than that of managing, distributing and otherwise providing services to the Alternative Investment. These activities and interests include potential multiple advisory, transactional and financial and other interests in securities and instruments that may be purchased or sold by the Alternative Investment, or in other investment vehicles that may purchase or sell such securities and instruments. These are considerations of which investors in the Alternative Investment should be aware. Additional information relating to these conflicts is set forth in the offering materials for the Alternative Investment. Opinions expressed are current opinions as of the date appearing in this material only. No part of this material may, without GSAM s prior written consent, be (i) copied, photocopied or duplicated in any form, by any means, or (ii) distributed to any person that is not an employee, officer, director, or authorized agent of the recipient. This material is provided for educational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell securities. These examples are for illustrative purposes only and are not actual results. If any assumptions used do not prove to be true, results may vary substantially. Simulated performance is hypothetical and may not take into account material economic and market factors that would impact the adviser s decision-making. Simulated results are achieved by retroactively applying a model with the benefit of hindsight. The results reflect the reinvestment of dividends and other earnings, but do not reflect fees, transaction costs, and other expenses, which would reduce returns. Actual results will vary. This presentation has been communicated in the United Kingdom by Goldman Sachs Asset Management International which is authorized and regulated by the Financial Services Authority (FSA). This presentation has been issued or approved for use in or from Hong Kong by Goldman Sachs (Asia) L.L.C. This presentation has been issued or approved for use in or from Singapore by Goldman Sachs (Singapore) Pte. (Company Number: 1915W). With specific regard to the distribution of this document in Asia ex-japan, please note that this material can only be provided, upon review and approval by GSAM AEJ Compliance, to GSAM's third party distributors (for their internal use only), prospects in Hong Kong and Singapore and existing clients in the referenced strategy in the Asia ex-japan region. This presentation has been communicated in Canada by GSAM LP, which is registered as a non-resident adviser under securities legislation in certain provinces of Canada and as a non-resident commodity trading manager under the commodity futures legislation of Ontario. In other provinces, GSAM LP conducts its activities under exemptions from the adviser registration requirements. In certain provinces GSAM LP is not registered to provide investment advisory or portfolio management services in respect of exchange-traded futures or options contracts and is not offering to provide such investment advisory or portfolio management services in such provinces by delivery of this material. Copyright Goldman, Sachs & Co. All Rights Reserved. (-7) RP_JCURVE/1-