PE/VC Investing from the Perspective of Large Long-term Investors 从大型长期投资者的角度来看 私募股权与创业投资

1. PE/VC Investing from the Perspective of Large Long-term Investors从大型长期投资者的角度来看私募股权与创业投资 Second Annual China VC/PE CFO Conference 2 September 2011 SUNG Cheng Chih宋诚之

2. Characteristics & Examples of Large Long-term Investors

3. Common Characteristics • Captive relationship with legal asset owner • Large community of ultimate stakeholders with formal governance structure • Low cash outflows relative to fund size • Investment policy driven by explicit, actuarial or proxy liabilities • Generally with realrisk/return orientation • Diversified portfolio across multiple countries & asset classes, both public & private • Selective active engagement with investee companies

4. Leading Large Long-term Investors • Sovereign Funds: • ADIA, CIC, GIC, KIA, NBIM, Temasek • Central Banks: • DNB, HKMA, MAS, SAFE, SNB • Pension Funds: • APG, CPPIB, GM, NCSSF, OTTP, PGGM, QIC • Endowments: • Harvard, MIT, Stanford, Yale • Foundations: • Hewlett, WellcomeTrust

5. Underlying Investment Beliefs • Risk is a scarce resource that needs to be allocated efficiently • Asset allocation drives total investment risk • Long investment horizon confers advantages • Scale is a double-edged sword • Diversification across asset classes, geography, sectors, issuers & agents works • Alphas are for real, but hard to find or sustain • Willingness to forego liquidity is rewarded • Cost can be managed, less so for risk, and least for return

6. Asset Allocation Process & Role of PE & VC Investments

7. Asset Allocation Practices of LT Funds • Portfolio construction of most institutional investors is centered on asset allocation which accounts for over 90% of total risk & return • Asset allocation seeks to harness risk premia embedded in & diversification across asset classes to meet return targets & risk constraints • Key constructs include asset class definitions, allocation targets, proxy & rebalancing rules • Model usually based on equilibrium assumption with many variants:liability-hedging, liquidity cycle, value-driven, multi-factor, risk-parity, tail risk-hedging & de-risking mechanism etc

8. Role of PE/VC Funds in Asset Allocation • Case for PE & VC investments rests on equity risk premium, leverage & illiquidity premuim • Mixed evidence for value-creation through strategic guidance & management know-how • Some investors also see benefits from embedded leverage & smoothing effect on returns • Diversification argument has weakened due to introduction of fair value accounting • Most investors expect 3 to 5% return premium for PE & VC investments over public equities with commensurate increase in risk

9. Modeling PE & VC Investments

10. Search for Common Return Drivers • Traditional allocation models make simplistic, static assumptions on volatility of PE and correlation with public markets • However observed volatility & correlation have risen & become more unstable in recent years • Investors are now keen to understand common risk/return drivers for both publicly & privately traded assets through quantitative models • Such models generally try to decompose return of private asset into systematic publicly traded component and specific private component

11. Alternative Private Asset Risk Models • Risk/return of private assets can be modeled by publicly traded assets in multiple ways: • a) equity of individual listed firms (proxies) • b) equity and bond indices • c) fundamental (e.g. Barra-type) factors • For example, under b), return Riof i-th private asset can be decomposed as • Ri - rf= ∑jβij(Mj- rf) + Ai • Ai= ∑kθikNk+ Si • where Mj = return of j-th equity or bond index, Nk= return of k-th non-public factor, Si = specific return of i-th asset & rf = risk-free rate

12. Uses of Private Asset Risk Model • Private asset risk models generally work better at aggregate level than for individual assets • Models shed light on both drivers for PE & VC investments and linkages with public markets • Integrated risk models give holistic view of total portfolio risk and allow risk budgeting & stress testing tools to cover private assets • Such models also provide fairer basis for evaluating value-added from manager skills • But gap between theoretical MTM-based risk models and observed PE/VC valuation remains hard to bridge

13. Modeling Commitments & Draw-downs • Investors traditionally used rules-of-thumb to manage pace of commitment versus fixed allocation targets based on market value • Recent crisis highlighted multi-faceted liquidity risks such as inability to rebalance or to meet capital calls • Yale Model provides deterministic baseline forecasts of capital contributions, fund distributions &NAV based on historical data • More recent efforts employ stochastic models to estimate statistical dispersions of cash flows &NAV with emphasis on distress scenarios

14. Selection of PE & VC Funds

15. Key Evaluation Criteria • Track record • Portfolio composition • Succession plan, turnover and depth of team • Reference checks • Fund terms • LP list • Investment strategy and value-add • Risk/return profile • Disclosure and portfolio information

16. ILPA Private Equity Principles • ALIGNMENT OF INTEREST: carry/waterfall; fees & expenses; term of fund; GP fee income offset; GP commitment • GOVERNANCE: investment team; investment strategy; fiduciary duty; changes to fund; role of LPAC • TRANSPARENCY: management & other fees; capital calls & distribution notices; disclosure on GP; risk management; financial information; LP information

17. Concluding Remarks

18. Emerging Trends & Implications for GP • BAD NEWS: Among large long-term investors, there is a gradual but persistent shift away from fund & co-investments towards in-house direct investments • GOOD NEWS: Geographically, allocation to emerging markets is rising steadily for both public & private investments • RISING BAR: Investors are raising demands for portfolio look-through & greater disclosure • UNDECIDED: Meanwhile, debate lingers on the true value-add from PE & VC investments over (leveraged) public equities

19. Long-term Differentiation Strategy • For far-sighted GPs looking to build sustainable businesses, the fostering of open, trusting & mutually beneficial relationships with large long-term LP investors is key. • To this end, good understanding of evolving LP thinking on asset allocation, risk, liquidity & valuation issues can offer GPs a distinct edge • Furthermore, GPs who are pro-active in providing more data & valuation transparency and willing to help GPs solve their problems will stand out above the crowd in the new world of co-opetition

20. Q & A