Click icon to add a picture Asset allocation and Private Equity –

an institutional perspective

Argentum Private Equity Conference

Elias Korosis5 September 2012

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“I cannot conceive how different Nations could agree to put an Imaginary Value upon any thing, especially upon Silver, by which all other Goods are valued; Or that any one Country would receive that as a Value, which was not valuable equal to what it was given for; Or how that Imaginary Value could have been kept up.”

PE Asset Allocation Research: a ‘renaissance’ level of understanding?

5 September 2012

John Law on the value of silver (1705), from Money and Trade Considered

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A quick journey through portfolio design history

5 September 2012

Source: Citi Prime Finance

Contemporary (2000s)Traditional

Passive

Active

Passive

Active

No fixed allocationDiscretionary investment in

Hedge Funds, Private Equity, Infrastructure or Commodities

Equity

Bonds/Fixed Income

Opportunistic

Passive

Active

Passive

Active

Hedge Funds

Private Equity

Infrastructure and Real Assets

Equity

Bonds/Fixed Income

Alternatives

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Portfolio design – the future?

(ATP example)

5 September 2012

Source: ATP (www.atp.dk ), Citi Prime Finance

Hedging portfolioIs designed to hedge ATP’s pension liabilities as efficiently as possible to offset changes in interest rates. The portfolio mainly comprises of interest-rate swaps and long-dated bonds

Investment portfolioIs required to generate an absolute return that is sufficient to ensure growth in our reserves so that we may preserve the long-term purchasing power of pensions

Beta portfolioThe beta portfolio, totalling DKK309.0bn, is used primarily to assume market risks. Investments are distributed among five risk classes. Over time, this type of investment generates higher returns than risk-free investments because investors charge a premium for assuming investment risks. The return is seen as compensation to investors for accepting risk and is known as “beta”

Alpha portfolioThe alpha portfolio, totalling DKK7.6bn, is actively invested, e.g. through the purchase and sale of invidividual equities that are expected to show the greatest rise or fall over a given time horizon. The return achieved by active asset management is known as “alpha”. The return on the alpha portfolio is independent of financial market ups or downs

Passive

Active Long only

Directional Hedge Funds

Corporate Private Equity

Macro Funds

Volatility and Tail Risk Funds

Commodities

Market neutral Funds

Arbitrage related strategies

Relative value strategies

Infrastructure

Real Estate

Other (i.e. Timber)

Equity risk

Inflation / Stable Value

Absolute Return

Real Assets

(Citi PF illustration)

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High-level portfolio design framework

5 September 2012

Process Key issues to consider

1. First, define your portfolio goals and tolerance regarding falling short of these goals

Time horizon and loss tolerance Determine hedging vs. return-seeking allocations in

the overall portfolio If ‘hedging’-oriented, how to catch up if underfunded?

2. Second, what split of alpha and beta? Expectations on individual asset classes and how they move together

Beliefs around beta (reliability), skills and confidence in alpha

3. Third, how to construct your beta portfolio? Capital vs. risk allocation Active vs. passive implementation Economic environment linkages

4. Fourth, how to construct and benchmark your alpha portfolio?

Sources of alpha Access Manager diversification

5. Fifth, implement, monitor and evaluate performance versus expectations, adjust and repeat

Portfolio benchmarking Risk controls Identifying embedded betas

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Discussion of the role of private equity in an institutional portfolio – Key considerations

5 September 2012

Select research issues / challenges

Understanding and quantifying the value creation in PE: Revenue growth, margin growth, multiple expansion, debt paydown

Understanding and quantifying risk

Understanding risk-return properties at the sub-asset class level (sector, region, stage etc)

Understanding correlation properties at the sub-asset class level and relationship with economic environments

Analytical rigour in manager selection

Cash flow modelling / forecasting

Market structure evolution (e.g. co-investment model)

Appropriate regulatory treatment

Proposed benefits

High absolute returns: Equity risk premium, illiquidity premium, PE value creation (incl. leverage)

Strong risk-return relationship (Sharpe ratio improvement ?)

Imperfect (if material) correlation with public equities

Risks and costs

Large dispersion of performance

Cash flow timing risks

Fees

Regulation

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Source: West Midland Pension Fund (http://www.wmpfonline.com)

Private Equity in sample institutional portfolios (contemporary example)

5 September 2012

March 2011 benchmark %

31 March 2011 %

UK equities 14.0 11.6

Global equities 6.0 5.3

Overseas equities 30.0 30.6

North America 8.0 9.0

Europe (ex UK) 11.0 9.0

Japan 2.0 2.0

Pacific Basin (ex Japan) 3.5 3.5

Emerging markets 5.5 7.1

Private equity 10.0 10.8

Total equities 60.0 58.3

UK gilts and other fixed interest 4.7 4.6

Index-linked gilts 4.7 5.6

Non-government bonds 4.6 4.7

Cash 1.0 1.5

Total fixed interest 15.0 16.4

Property 9.0 8.7

Absolute return strategies 8.0 7.7

Commodities 2.7 2.9

Emerging market debt 2.7 3.1

Infrastructure 2.6 2.9

Total complementary 25.0 25.3

Total 100.0 100.0

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Private Equity in sample institutional portfolios (risk-aligned)

5 September 2012

Source: Calpers (http://www.calpers.ca.gov), ATP (www.atp.dk )

The beta portfolio is divided into five risk classesIn the beta portfolio we systematically assume market risks by investing in a number of different assets assigned to different risk classes. We anticipate that this approach will ultimately yield higher returns than risk-free investments, since investors require a premium for assuming those risks that are not readily diversified

We allocate the assets in the beta portfolio between five risk classes with very different risk profiles in order to ensure that the return is as stable and as independent of economic conditions as possible

The five risk classes are

Interest rates, which focuses on bonds subject to interest-rate sensitivity. For example, this includes government and mortgage bonds

Credit, which focuses on the creditworthiness of the issuers. For example, this risk class includes low-rated government and corporate bonds

Equities, which focuses on corporate earnings. Examples of assets in this risk class would be listed equities, private equities and venture capital

Inflation, which focuses on general price trends. This would include index-linked bonds, real, estate and infrastructure assets

Commodities, which focuses on oil-price developments. This risk class primarily includes oil-indexed bonds

Asset class

Actual investment

($bn)

Actual investment

(%)

Interim strategic

target (%)

Growth $153.0bn 65.0% 64.0%

Public equity $120.0bn 51.0% 50.0%

Private equity $33.0bn 14.0% 14.0%

Income $40.4bn 17.0% 17.0%

Liquidity $8.0bn 3.0% 4.0%

Real assets $21.8bn 9.0% 11.0%

Real estate $18.9bn 8.0% 9.0%

Forestland/ infrastructure $2.9bn 1.0% 2.0%

Inflation $7.5bn 3.0% 4.0%

Absolute return strategy $5.2bn 2.0% n/a

Total fund* $236.0bn 100.0% 100.0%

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Fin

5 September 2012

Source: Lyrique Private Equity