Investing in Private Markets

Investing in private markets
The right strategy, the right geography,

the right manager
Investing in private markets

The right strategy, the right geography, the right manager
Many
investors would be surprised

to learn that a significant share of the
global economy is in private ownership:
as an example, a quarter of the US
economy by capital and 98% of it by
the number of companies is controlled
by private capital.
Contents
Introduction
05
Towards better risk-adjusted portfolios

Section one Why private markets?
08
How to identify alpha in private markets
13
Private markets benchmarking:

lateral thinking required
16
How to select the benchmark
19
Section two Global private markets:

opportunities in macro themes
22
Opportunities in distressed assets
24
Are mezzanine funds about to

make a comeback?
28
Investing in renewable energy infrastructure
32
Agriculture a strong investment base case
35
Timberland a good diversifier

but how do investors gain exposure?
39
Natural resources strong long-term potential
43
Investing in secondaries cyclical opportunities 47

Co-investments building trust, reducing fees
50
Section three Investment themes in

regional private markets

55
Europe are the lamps going out?
56
Private markets in the US
61
Private markets in China
67
Brazil is investors attention justified?
73
79
India unrivalled macro trends

The hottest ex-Asia frontier markets
Section four How we can help
83
88
Why partner with us?
89
Notes
90
4 towerswatson.com
Introduction
Towards better risk-adjusted portfolios

This new publication is designed to share some
of the key insights from the extensive and
ongoing research Towers Watson conducts
into private markets. We have a global team
of 40 investment professionals whose job is to
continuously identify investment products,
managers and themes in private markets that
could enhance the portfolios of a broad
variety of institutional investors.
One of our core beliefs is that institutional portfolios with an allocation
to private markets can achieve better risk-adjusted returns in the
long term than portfolios invested exclusively in traditional asset
classes. In our experience, many long-term investors tend not to take
full advantage of the duration of their capital and have sub-optimal
allocations to private markets. One of the key reasons for this is
the complexity of private markets investing: our role, and one of the
purposes of this publication, is to make it easier for our clients to
navigate private markets issues and position the illiquid parts of their
portfolios for long-term success.
Investing in private markets 5
A fresh approach
We begin by outlining a fresh approach to
private markets investing, which breaks down
asset class barriers and instead focuses on
the two primary reasons for making an illiquid
investment: return enhancement (alpha)
and diversification/capital protection (beta).
We advocate a holistic approach to illiquid
investments with a clear demarcation between
alpha and beta strategies. We also introduce
the concept of Adaptive Portfolio Management
which, compared with a traditional approach,
pursues a more thematic and flexible method of
constructing a private markets portfolio based on
the medium-term outlook for various sectors and
regions. The key features of this approach are
its adaptability to the rapidly-changing economic
environment and the prioritising of investment
strategies to optimise the risk-return profile of
long-term investments. In our view, the flexibility
of this approach is essential to achieve long-term
success in private markets investing.
6 towerswatson.com
Fees
We approach the issue of fees by disaggregating
total returns from the effects of beta, leverage
and management fees/carry by establishing a
framework for identifying true net alpha.
We also consider how to benchmark the
performance of private markets investments
a process which is notoriously challenging, but
extremely important given it both determines
success or failure and influences the remuneration
of individuals responsible for the investments.
Investment themes
One of the key tenets of Adaptive Portfolio
Management is a thematic approach to long-term
investing. We spend a substantial portion of this
publication exploring various investment themes
which may potentially be of interest to investors.
We consider the investment universe from a
strategic, global and regional perspective.
The variety and number of investment themes

within private markets are enormous and it is not
possible to do them all justice in one publication.
We have identified a selection which, in our view,
are particularly interesting and topical, regardless
of whether we believe they have a positive or
negative outlook.
Strategy
In terms of strategy, we explore investors increased
interest in secondaries and co-investments and
outline our outlook for the future in these strategies.
We also discuss popular credit-related strategies
such as distressed debt and mezzanine. We assess
a number of broader macroeconomic themes that
could offer both potential return enhancement
and diversification, such as renewable energy,
agriculture, timber and natural resources.
Investment trends
We go on to explore the key investment trends
in the developed markets of the US and Europe,
which are arguably now creating more interesting
opportunities for investors than ever before. In
addition, private investments in emerging markets
have moved from the margins to the centre of
investors thinking. We focus on opportunities
in China, India and Brazil as well as the nascent
markets of Turkey and Africa. While all these
geographies provide interesting macro cases in
the longer term, finding skilful alpha generators
is far from straightforward. We encourage
caution and selectivity.
These articles serve as a useful starting point for
applying Adaptive Portfolio Management to private
markets programmes, which will enable investors
to position their private markets portfolios for
long-term success through a combination of
robust top-down and bottom-up selection
of investment opportunities.
Section one
Why private markets?

Private markets is an umbrella term
encapsulating a variety of illiquid
investments that is, investments that
cannot be sold at short notice and
require a long-term investment horizon
and patient capital. A significant share
of the global economy is in private
ownership: as an example, a quarter
of the US economy by capital and 98%
of it by the number of companies is
controlled by private capital (as opposed
to being listed or state-owned).1 Most
small businesses are privately-owned
and most innovation is funded by
private capital.
Despite this huge economic representation, the role of private
markets in some large institutional portfolios remains limited.
In many instances, there are logical reasons why this is the
case for instance, regulatory requirements and liabilities requiring
short-term cash distributions. More often than not, however,
long-term investors tend not to take full advantage of their capital
duration and either ignore private markets altogether, preferring
the simplicity of liquid markets, or have sub-optimal allocations
to private markets.
8 towerswatson.com
01 Why private markets?
The main reasons why we believe private markets

deserve greater attention are:
Taking a holistic approach to

private markets allocations
Private markets provide investors with exposure

to unique market segments that are difficult to
access through listed vehicles for example,
small and mid-sized companies and new
ventures. Opportunities in publicly-listed
markets are particularly limited in emerging
economies where certain assets may not
exist in a publicly-listed form.
Investing in private markets provides additional
diversification. Many of the assets benefit from
low correlation with public stocks or bonds, for
example core real estate and infrastructure.
The range of tools for value creation is more
diverse. While public markets investing is mostly
based on insights about the future prospects of
a certain market segment, company or asset in
relation to its current pricing, there are additional
tools available in private markets. These
primarily stem from an active ownership model,
whereby shareholders representing private
capital help to drive future growth by providing
valuable strategic and operational input, creating
better governance structures, attracting better
management talent, aligning interests and
streamlining decision making. In addition,
a long-term horizon allows companies and
fund managers to better withstand periods
of volatility when market prices might lose
connection with fundamental value.
Investors in private markets (especially in
alpha-seeking strategies) should expect higher
returns compared with public markets. For a
variety of regulatory and other reasons, far less
capital is employed in long-term investments than
in short-term, liquid instruments. Consequently,
there is a meaningful premium paid for illiquidity.
There is often a price discrepancy between
valuations for publicly-listed and privately-owned
assets. In emerging markets, significant price
differentials are routine, giving flexible investors
an ongoing opportunity for valuation arbitrage.
Noticeable discrepancies can also occur in
developed markets, especially during times
of market turmoil when markets place an
unreasonable premium on liquidity.
In deciding how to invest in private markets, many

institutional investors follow a traditional asset
class model where illiquidity is spread across
different asset classes, such as private equity,
real estate, infrastructure, real assets and
hedge funds. The main reason for creating asset
classes stems from a desire to group together
assets expected to perform a similar role in the
portfolio. Our preference is to consider all illiquid
investments holistically, in which case investors
need to answer two main questions:
In summary, we believe that institutional portfolios

with an allocation to private markets are in a
position to achieve better risk-adjusted returns in
the long term than portfolios invested exclusively
in a traditional mix of public stocks and bonds.
10 towerswatson.com
How much illiquidity am I able to accept

over time?
How much of my allocation to illiquid assets
should be via return-seeking strategies and how
much via diversifying and defensive alternatives?
There are a number of advantages associated
with a holistic approach:
Taking a holistic view of the overall illiquid
exposure, including unfunded commitments
and the duration of funded ones, is a more
efficient way to manage liquidity over time
than considering this issue in separate silos.
Fewer funds and manager relationships are
necessary to provide sensible diversification
as vintage year and manager exposures are
managed across all illiquid investments rather
than separately within funds focused on
individual asset classes.
It enables a clear understanding of whether an
investment is made for return enhancement
or diversification purposes. For example,
infrastructure and real estate should have
a clear demarcation so their role in the
overall portfolio does not become blurred
or, worse, misunderstood.
Optimising fees and expenses through
better differentiation of strategies.
For example, in the past some investors
have overpaid for unnecessary manager
activism in core infrastructure.
Less overlap between asset classes.
For example, some private equity managers
invest in debt or real estate assets.
Ability to capture investments that tend
to fall between the cracks of traditional
asset class categories. Examples include
mezzanine, distressed debt and energy funds.
Constructing holistic private

markets portfolios
When constructing private markets portfolios,
we draw a distinction between alpha (skill-focused
return-seeking investment strategies) and beta
(diversifying/defensive investment strategies).
The split between alpha and beta allocations
depends on the investors risk appetite and
investment beliefs.
Beta simple, passive investments

do not exist in private markets
Unlike in public markets, there are no simple
passive options in private markets. Even strategies
that target market returns need an element of
skill. As a result, we define them as smart beta
compared with the bulk beta of investable
benchmarks of equities or bonds. Smart beta
targets returns from illiquid and off-market
portfolios that have attractive risk return
trade-offs. These strategies are supported by
underlying market returns and other systematic
factors that, by virtue of their risk exposures,
carry return premia relative to lower risk portfolios.
A range of smart beta strategies exist: the key
ones are core real estate and core infrastructure,
implemented through illiquid funds, co-investments
or direct deals. Other long-term smart beta
investments include agriculture, timber, natural
resources and sustainable investing among others.
The main characteristic of the smart beta portfolio
is its diversifying and defensive nature. These
investments are also often expected to generate
current cash yield. Considering the illiquid nature
of smart beta investments, it is also important that
they generate returns in excess of what investors
could access through the listed passive option,
bulk beta. Despite the element of skill, smart beta
should be priced closer to bulk beta rather than
alpha investments.
Alpha manager skill is key

Private markets alpha encompasses those
investment strategies that use manager skill
as the primary driver of investment returns.
The range of value creation tools for alpha
generation is much wider in private markets
than in listed markets and it is natural that
investors turn to private markets in search of
superior manager skill and higher returns.
As with beta, the alpha portfolio is constructed

from various return drivers. However, while
sensible diversification principles must be
applied, the availability of highly skilled managers
takes priority. If there is no adequate skill in an
apparently attractive theme, an investor would
be better off gaining exposure through a cheaper,
more liquid alternative. Identifying a pool of highly
skilled, managers who are able to navigate a
constantly evolving market environment through
portfolio positioning is a key component of a
successful alpha portfolio in private markets.
Moving with the times:

Adaptive Portfolio Management
Once the broad differentiation between alpha and
beta has been established, investors face the
challenge of constructing portfolios of individual
investments. Amid global economic uncertainty,
portfolio construction needs to be more robust
than ever before. We believe investors should
adopt a framework for alpha and beta in private
markets that has core investment beliefs at its
heart and targets a variety of return drivers. The
key ingredients of this portfolio management
framework are:
Clear definition of beliefs about the investment
world that subsequently drives exposures to
investment risk.
Well-conceived investment strategy customised
to specific investment objectives.
Thematic approach to positioning the portfolio
over time to benefit from medium-term market
developments and, potentially, shorter-term
market dislocations.
Strong understanding of the key return
drivers and risks in different underlying private
markets strategies.
Careful long-term planning of new commitments
to effectively manage liquidity.
Well-aligned and cost-effective
implementation model.
Our experience has shown that strategy allocation
and timing decisions can add as much value over
time as good manager selection. The nature of
private markets allows investors to take long-term
views, explore macro themes and position their
portfolios to benefit from tomorrows trends.
We recommend developing a thematic approach
to alpha and beta portfolio construction based
on the medium-term outlook for financial markets
and various sectors and regions.
Adaptive Portfolio Management focuses on key

return drivers and the appropriate diversification of
exposures to mitigate risk. It outlines a range of
investment themes with a positive medium-term
outlook based on an investors beliefs and
provides broad guidelines around the appropriate
composition of the private markets programme.
It also guides investors on execution in terms of
the number and nature of the investments (whether
it is via funds, co-investments or direct holdings).
We live in a rapidly-changing world and the ability
to ensure portfolio management is adaptive
is essential. Our preferred approach has less
formality than a pre-determined asset allocation,
with correspondingly more focus on regularly
changing the priority of investment initiatives and
commitments to optimise the risk-return profile.
The critical success factors for Adaptive Portfolio
Management are as follows:
Creating and prioritising an inventory
of investment themes with a positive
medium-term outlook based on investment
beliefs and conviction.
Frequently re-evaluating allocations based
on the changing economic environment rather
than over annual planning cycles.
Responding to emerging opportunities rather
than sticking to the plan.
Optimising the holistic portfolio approach
rather than protecting asset class allocations.
Proactively managing J-curve effects and
non-performing assets in the tail ends of
funds through the secondary market.
Figure 01 illustrates how alpha and beta

portfolios may look over time using a thematic
approach to investing and diversifying across
various return drivers.
Conclusion have a long-term outlook,

but be flexible
Private markets is a complex area of investment
which rewards investors via improved long-term,
risk-adjusted returns relative to traditional assets.
We believe that a holistic approach to portfolio
construction is optimal for building and managing
exposure to private markets. The breadth of the
opportunity set across private markets offers
asset classes that provide both diversification
and capital protection (beta), as well as a pool
of high-quality managers that have historically
demonstrated an ability to deliver returns in excess
of traditional equity markets (alpha). The Adaptive
Portfolio Management approach ensures that
investors are constantly re-evaluating attractive
investment themes and focusing on actively
managing their exposures rather than following
rigid asset class guidelines. In our view, this
flexibility is necessary to achieve appropriate
long-term returns in private markets.
Figure 01. Examples of alpha and beta portfolios using a thematic approach
Beta
Alpha
40%
30%
15%
5%
5%
5%
12 towerswatson.com
Core real estate

Core infrastructure
Credit
PPP
Agriculture
Timber
30%
20%
10%
10%
10%
10%
5%
5%
Growth equity and buyouts

Opportunistic real estate
Opportunistic infrastructure
Distressed debt
Energy
Emerging wealth
Healthcare
Technology
How to identify alpha

in private markets
There is a need to disaggregate the beta
and leverage from private market funds
returns in order to understand the true level
of outperformance, or alpha, that has been
generated and shared between the manager
and the investor.
It is important to understand these issues
because it is common practice for limited
partnerships in private markets to charge
performance fees based on exceeding a
certain return level. To understand whether a
manager has truly earned performance fees,
it is necessary to know what proportion of
performance has been driven by the effects of
leverage and beta and what proportion by alpha.
Identifying beta
It is challenging to disaggregate the underlying
market beta in private markets fund returns, but
it is clear that public market valuations have an
impact on prices and investors should not be
paying performance fees for performance driven
by broader market beta.
The method of identifying the beta proportion of
total returns depends on whether the analysis
is ex post (actual) or ex ante (forward-looking).
The latter simply requires the investor to make
an assumption for the rate of return on the index
that best reflects the underlying risk of a private
markets investment. For example, for a US private
equity fund, you might select the long-term
rate of return expected for the Russell 2000.
A further adjustment can be made if you believe

that the manager invests in lower or higher beta
companies and industries than the index.
If the analysis is ex post the returns have
already been generated investors in limited
partnerships have to adjust their calculations
for irregular cash flows. The primary method
used for making this adjustment is the Public
Market Equivalent (PME) approach, which is a
money-weighted return that would have been
achieved by replicating a private markets funds
cash flows with a public markets index. We will
not attempt to cover the shortfalls of this here,
but its simplicity makes it appealing (even if it
should be used in conjunction with other forms
of performance analysis).
The impact of leverage on returns

It is widely perceived that private markets
practitioners employ levels of leverage in excess
of those of publicly traded companies, amplifying
the return on equity. Clearly, there is some skill
in optimising the capital structure, but this alone
does not merit premium fees. It should also be
recognised that increasing leverage amplifies
risk, and the greater the risk the manager takes
the more likely it is to generate performance
fees, which is an asymmetric trade-off between
the manager and the investor since there are
no negative performance fees. Of course, if the
asymmetry is too great, it may impact the fund
managers ability to raise future funds.
On an ex ante basis, measuring leverage can be as

simple as making a reasonable estimate as to the
level of leverage the manager is likely to deploy in
the average capital structure and comparing it to
the average capital structure for the proxy index.
The same simple adjustment can be used for ex
post analysis, but to more accurately approximate
the level of leverage used requires the following
information about a managers portfolio:
The capital and time-weighted capital
structures to assess the level of leverage.
An assumption for the cost of debt.
The average tax rate saving on the
interest payments.
These assumptions may underplay the complexity
of capital structures, but using an average of entry
and exit total debt seems a reasonable starting
point. The analysis should also factor in that the
underlying benchmark that represents the beta will
also contain leverage.
Calculating ex post alpha

Beware of paying for beta. If a managers gross
IRR (internal rate of return) is 34% and the net
IRR is 27%, the level of net performance is, on
the face of it, extremely impressive. However, if
it was produced during a period of strong equity
markets and these same cash flows in the public
index would have produced a return of 24%, then
outperformance was just 3% net of fees, and yet
performance fees would have been paid on all
returns above zero.
In this example, the actual level of alpha
generated by the manager is 34% minus 24%, or
10% before fees. However, just 3% of this goes to
the end investor, or 33.3% of the alpha produced.
This seems an unfair split of alpha given the
relative levels of capital at risk in most private
markets partnerships.
Beware of leverage too. Let us assume:
The capital-weighted average capital structure
in the managers portfolio utilises 60% debt
and 40% equity.
The average capital structure of the index is
40% debt and 60% equity.
The average cost of debt is 7% and, for
simplicity, only bank debt is used.
We ignore the tax benefits associated with
using additional debt.
Whereas adjusting for beta suggested that
the manager outperformed the index by
10% net of fees, adjusting for leverage would
mean the manager has produced a 24% return,
which is exactly in line with the market
returns. Despite this, the manager would
have generated performance fees on the
full 34% gross return generated.2
14 towerswatson.com
While this analysis is simplified and relies on a

lot of assumptions, it does show that investors in
private markets need to be wary of how beta and
leverage contribute to performance.
Calculating ex ante alpha

We need to be able to ascertain on a
forward-looking basis whether sufficient
alpha is generated to justify a given fee level.
We use the following assumptions:
The manager will generate a gross IRR of 20%.
We believe the market that best proxies the
managers strategy will return 8%.
The manager utilises greater leverage than
the market, assumed to be the same as in the
example above and with the same cost of debt.
Cash flow assumptions are required to reflect
the unknown nature of drawdowns and the
subsequent distributions. We assume a steady
pace of drawdown over five to six years and a
ten-year fund life.
A preferred return of 8% subject to 100% GP
(General Partner) catch-up
All performance fees are paid after the full return
of an investors capital and preferred return.
Management fees of 1.75% on commitments
for five years, 1.5% on invested capital for a
further five years, performance fees of 20%
and no additional fees (such as transaction
or monitoring fees).
For now we have ignored volatility of returns.
If, firstly, we ignore leverage and beta, our
proprietary cash flow model would assume that
the outperformance generated was shared as
shown in Figure 02.
This shows that under the assumption of absolute
return (any return above zero) the manager has
taken just 24% of the outperformance generated
in fees. However, factoring in beta and leverage,
the same cash flows and gross returns predict that
alpha and beta will be shared in the proportions as
shown in Figure 03.
The alpha split in this scenario is now being
shared roughly 50:50 between the manager and
investor, a significantly less attractive return for
the investor.
If we add volatility to the returns, the manager
would also benefit from an option premium as the
greater the risk the manager takes the more likely
it is to generate performance fees. If we assume
that both the alpha and beta have a volatility of
approximately 25% not unreasonable given the
variance of returns in private equity the manager
would accrue an option premium of approximately
6%, increasing its share of alpha to 57%.
Conclusion evaluation of beta and leverage is critical

From the investors viewpoint, it is important to recognise the levels of beta
and leverage that contribute to a private markets managers returns. Adjusting
for these can make a dramatic difference to an investors evaluation of how
a manager has performed, both on a standalone basis and relative to peers.
Additionally, we believe that these factors need to be taken into consideration
thinking about fees, particularly about how any alpha, or outperformance, is split
between the investor and the manager.
Figure 02. Private markets fees no beta and leverage adjustment

Gross alpha
Cash flow
Central assumption cash flow chart

40
30
20
100%
80%
10
60%
40%
-10
20%
-20
-30
Gross alpha fee breakdown
120%
0%
1
Drawdown Gross distribution

Base fee
Performance fee
10
Year
Clawback
-20%
Gross alpha
Catch-up fee
Expected total fee Management fee

Performance fee Net alpha
Return assumption and expected fees (per annum)

Expected leveraged manager returns and risk
(includes 1x relative leverage)
Expected fee benchmark
Alpha
Beta
Total return
Tracking error
Total
volatility
20.0%
0%
20.0%
0.0%
0.0%
Return
Volatility
8.0%
0.0%
Expected fee
Expected
fee as a % of
alpha
4.78%
24%
Figure 03. Private markets fees adjusted for beta and leverage
Gross alpha
Cash flow
Central assumption cash flow chart

40
30
20
100%
80%
10
60%
40%
-10
20%
-20
-30
Gross alpha fee breakdown
120%
0%
1
Drawdown Gross distribution

Base fee
Performance fee
10
Year
Clawback
-20%
Gross alpha
Catch-up fee
Expected total fee Management fee

Performance fee Net alpha
Return assumption and expected fees (per annum)

Expected leveraged manager returns and risk
(includes 1.5x relative leverage)
Expected fee benchmark
Alpha
Beta
Total return
Tracking error
Total
volatility
9.3%
10.7%
20.0%
0.0%
0.0%
Return
Volatility
8.0%
0.0%
Expected fee
Expected
fee as a % of
alpha
4.78%
51%
Private markets benchmarking:

lateral thinking required
Benchmarking critical to
assess performance
Here we outline the considerations for investors
when selecting benchmarks for their private
markets portfolios. By selecting the appropriate
benchmark, an investor is better able to assess
whether its specific goals have been met through
its private markets programme. It should be
noted that the availability of benchmarks differs
depending on the asset class and geography.
Benchmarking methods
Below we review the types of benchmarks
typically used, discuss the arguments for and
against their use and provide a view as to what
purposes these benchmarks can be applied.
Public market indices

A public market index is one of the most
common benchmarks applied in private
markets. However, there are a number of
issues related to these benchmarks:
Public market performance is not directly
linked to value drivers in private markets
investments. This is particularly true with
respect to real estate and infrastructure.
Public market indices have a significantly
shorter investment horizon and are
substantially more volatile over the short term.
The differences between the performance
methodologies for public equities, which
have typically time-weighted returns, versus
private investments, which mostly have
money-weighted returns.
16 towerswatson.com
The J-curve effect.3

The discrepancy in volatility and returns
between core infrastructure assets with
stable inflation-linked cash flows and listed
infrastructure indices (with significant exposure
to volatile energy generation stocks).
The commonly-used public real estate
benchmarks (FTSE EPRA/NAREIT Global
and Global ex US Indices) have significantly
different characteristics from privately-held
real estate assets.
Nevertheless, there are valid reasons why
many investors use public equity indices as a
benchmark for private markets investments:
Private markets investments are often funded
out of listed equities or are expected to
achieve a return in excess of public equities.
Therefore, public market performance serves
as a measure of the opportunity cost.
Public markets provide a comparison as to how
specific private markets assets are performing
against comparable listed peers.
While in the short-term the link between public
markets and private markets performance
is weak, in the long run a return-seeking
private markets investment should generate
a premium above long-term equity returns to
compensate for the challenges associated
with investing in them and the illiquidity. Public
real estate indices, for example, tend to
behave more like direct real estate over
the medium to long term.4
A variation on public market benchmarks

seen in real estate is appraisal-based or
transaction-based benchmarks, which use
information about private asset valuations or
transactions to create an index. While these
benchmarks cannot be replicated and rely on
reported valuations of assets that contribute
to the index (as opposed to the market as a
whole), given the considerable number of assets
and transactions covered, they do provide a
meaningful measure of performance. These
do suffer, however, from time lags and are
affected by the frequency of transactions.
For the reasons outlined above, we believe that
public market indices are not always appropriate
as a short-term measure of performance for a
private markets portfolio. However, as a longterm measure of performance we believe public
market benchmarks can be appropriate.
Peer group indices

Another popular method of private markets
benchmarking is to compare performance
against the peer group. However, there are
also a number of issues at play here:
Peer group indices are not generally investable.
Peer group indices often include gaps in
data, are self-reporting and suffer from
survivorship biases.
Self-reporting means that the valuation
methodologies between managers may not
be consistent, although this is less true for
managers that use established valuation
and reporting standards.
For smaller and less mature assets (for

example, infrastructure or emerging markets),
there is insufficient data to construct a
diversified peer group return stream.
The length of time an index has been in
existence is often an issue. Some real
estate indices, for example, have only
existed for a few years.
Despite the issues noted above, peer
group indices are commonly used for the
reasons below:
They are measurable and updated on a
reasonably frequent basis.
Peer groups can be created across a host of
different investment styles (buyouts versus
venture capital versus distressed in private
equity) and geographies, so a comparison can
be made to common return drivers.
The peer group constituents are also subject
to J-curve effects, meaning comparisons can
be made over all timeframes, though we would
not recommend placing too much emphasis on
peer group indices which are less than four or
five years old.
A number of private markets assets do not
have sufficient information to construct
appropriate peer groups. This is particularly
true of infrastructure, which is an immature
asset class and for real estate, where indices
are either unavailable or not well developed in
many geographies.
Where available, we believe that peer group

indices are useful as both a short and longterm benchmark for measuring the success
of a direct fund manager or a fund of funds.
Clearly, it is more reliable the more mature
the peer group constituents are.
Absolute return benchmarks

Absolute return benchmarks in private
markets have tended to focus on a
reasonable long-term expectation for the
level of returns expected from public equity
markets. For more return-seeking strategies,
a premium will often be added to an agreed
absolute return measure to reflect the
expected alpha. Again, this presents a
number of issues:
We do not think absolute return benchmarks

are appropriate as a short-term measure,
but for more mature portfolios they may be
useful. They can have value in assessing the
internal direct teams performance and also
potentially at a strategic asset allocation
level. They are rarely suitable, however,
as a standalone measure, particularly over
shorter periods.
Absolute return benchmarks are not

investable and do not represent the true
opportunity cost of capital.
There is limited consensus as to the level
of long-term returns to expect from public
equity markets, particularly if you want to
make the returns more granular and relevant
to a specific asset class or sub sector.
They ignore both historic and prevailing
market returns.
They do not take account of prevailing
market conditions specific to the asset
class in question.
A variation on absolute return targets is

the cost of capital approach which can
be an appropriate benchmark for direct
investments.5 In the private markets context,
cost of capital is often used as a discount
rate in estimating potential value creation
of new investment opportunities, using the
discounted cash flow valuation method.
The cost of capital approach is an attempt
to take into account individual investment
characteristics with a view to determining
whether an investment is more or less
attractive in comparison to other available
investment opportunities.
The case for absolute return benchmarks is:

Given the idiosyncratic nature of private
assets and the volatility of public equity
markets, a long-term proxy of the returns
expected from equity markets provides a
sensible performance comparator that is
not influenced by equity market volatility.
18 towerswatson.com
Where investors make direct investments

on their own behalf and have a specific
return target, absolute return metrics
are appropriate.
Absolute return benchmarks can provide
a meaningful measure of performance
against an investors specific requirements.
The cost of capital approach has four

main components:
Real risk-free rate of return.
Expected inflation.
Various risk premia (such as marketability,
leverage, diversification and control).
Equity risk.
How to select
the benchmark
We would argue that
there are two primary
considerations in selecting
a benchmark: which
implementation method has
the investor used to obtain
exposure and whose success
is being measured?
The implementation methods that we consider
are investing via funds of funds, investing directly
into private markets funds (direct funds) and
making direct investments (or co-investments) into
companies, assets or projects (collectively known
as direct investments).
We then consider whose success is being measured:
The private markets manager (defined as
General Partner or GP).
The group investing capital into private markets
after it has been decided to make a strategic
allocation to the asset class (a Limited Partner
or LP for fund investing and Internal direct team
for direct investments).
The group making the decision to invest
in private markets at the strategic asset
allocation level.
Investing via funds of funds

When investing via funds of funds, the critical
elements that are being measured are:
The investors ability to perform due diligence
and select high-quality fund of funds managers.
The fund of funds managers due diligence and
manager selection capabilities and portfolio
construction success.
The fund of funds managers ability to overweight
and underweight vintage years depending on the
attractiveness of the market.
Recommended benchmarks
Fund of funds GP: We believe the benchmark
should be driven by funds of funds opportunity
set that is, the performance of all relevant
direct funds available during the years the
manager has to commit its capital. This analysis
should be net of fees in order to check that
the additional layer of fund of funds fees is
not so substantial that it is more than any
outperformance generated.
Investors private markets team: A fund of funds
benchmark is suitable given this is the investors
opportunity set. However, the team should
consider investing in direct funds if it cannot
find high-quality funds of funds, suggesting that
it could be subject to the same benchmark as
the fund of funds manager.
Strategic asset allocation group: We believe the
opportunity cost, or at least a fair representation
of the alternative use of capital, will typically be
an appropriate benchmark.
Investing via direct funds
Investing via direct investments
When investing via direct funds, the critical

elements being measured are:
Direct investing by an internal investment manager

is becoming increasingly common among larger
global LPs. The critical elements are:
The investors fund due diligence and

manager selection capabilities as well as
portfolio construction.
The managers ability to access, select and make
high-quality investments compared to peers.
The managers portfolio construction capabilities.
The managers ability to add value and manage
risks to justify the additional fees associated
with investing in private markets rather than
investing into public equities.
The answer is less straightforward than for funds
of funds:
Direct fund GP: First, the manager has to
demonstrate that it can invest the capital
more profitably than an investor could have done
passively in public markets. However, we would
urge caution over this benchmarking metric too
early in the life of a fund. Second, the manager
should show that it is able to outperform peers
(this may not be applicable to asset classes
where peer group indices are not available).
Third, it might be appropriate to consider a
direct (appraisal or transaction-based)
benchmark as an alternative route for
investment. This could be a portfolio of
buildings for a real estate investment.
Investors private markets team: both a fund
of funds and a direct funds benchmark could be
considered by an investor selecting direct funds.
We recommend the direct fund universe as it
is a more comprehensive representation of the
funds the investor could have chosen. For core
infrastructure and real estate assets, an absolute
return benchmark may be more appropriate.
Strategic asset allocation: similar to funds
of funds, the opportunity cost as a fair
representation of the alternative use of
capital should be used as a benchmark
since a private markets portfolio must
demonstrate it can provide a better
risk-adjusted return than any alternative
use of the capital.
20 towerswatson.com
The investors ability to access, select and make

high-quality investments and add value to them
(where appropriate).
The investors portfolio construction capabilities.
The investors ability to select investments that
fit with the profile of the stated mandate if there
is a specific risk and return framework in mind.
The appropriate benchmark depends on the
investors mandate and applies to both the
internal direct team and to the strategic asset
allocation group:
For return-seeking strategies, a public market
benchmark plus a premium may be appropriate.
However, we prefer a long-term equity market
assumption if the investor is not subject to
the same need to generate liquidity as a
private equity manager acting on behalf of
third-party investors.
If risk considerations are an important factor
for the investor, we recommend the cost of
capital approach. It is more complicated and
therefore requires significant thought around an
investors mandate, but it will provide a better
reflection of whether the investor is meeting its
specific objectives.
For real estate, a suitable benchmark may be
either appraisal or transaction-based, which
may also be tailored (in conjunction with a
data provider such as the Investment Property
Databank) to match specific objectives.
Figure 04 opposite summarises our views on
the appropriate benchmark considering both the
implementation method and whose success is
being measured.
Despite
much academic literature

on the subject, there remains
no universally accepted method
of benchmark construction in
private markets.
Conclusion private markets

benchmarks are multi-dimensional
Despite much academic literature on the subject,
there remains no universally accepted method
of benchmark construction in private markets. In
this section, we have considered the most widely
recognised, such as public market, peer group and
appraisal-based comparisons, and have attempted
to consider both the implementation method and
the purpose of the benchmark in formulating best
practices. Bearing all this in mind, we recommend
investors consider the following when selecting
their desired benchmark:
Selecting the benchmark according to the

implementation method, as the purpose of
different routes may vary.
Taking into account the purpose, motivations and
roles of those being benchmarked. This ensures
that the choice of benchmark both matches their
goals and does not misalign interests.
Using both short-term and long-term measures.
This is particularly important when benchmarking
analysis is used as a basis for compensation,
since applying a single benchmark can create
a misalignment of interests.
Figure 04. Summary of appropriate benchmarks
GP
LP
Internal direct
team
Strategic asset
allocation
Funds of funds
Direct funds
Direct investments
Direct funds peer group

and
Public equity
(once sufficiently mature)
or
Absolute return + X%
or
Appraisal/transactional indices
for real estate
N/A
or
for real estate
Fund of funds peer group

or

or
Absolute real return + X%
or
Appraisal/transactional indices for
real estate
N/A
or
for real estate
N/A
or
for real estate
Long-term equity assumption + X%

or
or
The cost of capital approach
or
for real estate
N/A

or
Absolute return + X%

or
or
The cost of capital approach
22 towerswatson.com
Section two
Global private markets:

opportunities in macro themes
Executive summary
In this section, we assess the private markets
strategies that are currently the subject of most
interest by investors, as well as some that are
less well-known and less discussed strategies.
Distressed credit. With the need for banks to
reduce the size of their balance sheets, we believe
that significant opportunities exist in distressed
strategies. But, given the macroeconomic
headwinds, investors should not have too much
capital focused on strategies that are reliant on
economic recovery. Investors should consider
supplementing existing allocations to distressed
with a multi-strategy manager focused on illiquid
distressed credit.
Mezzanine funds. Mezzanine investing appears
to offer a defensive strategy with a recurring
income stream and equity upside. However, fee
structures are unjustifiably high for the limited
value-add, the spread over high-yield bonds may
not be sufficiently high to justify the higher fees
or the illiquidity and private equity deal activity
may remain muted.
Renewable energy. We believe that investments
into the operational phase of renewable projects
will generate attractive yields. For now, given
the relative immaturity of the industry, there
may be a shorter-term opportunity to generate
higher returns in the development and
construction stages.
Agriculture. The market fundamentals for
agriculture appear strong. The ability of supply
growth to keep pace with demand is weakening
and the result has been a shift in prices.
Investing in agriculture via private equity funds
gives the most direct exposure to agriculture

and an investor can benefit from strong market
fundamentals as well as inflation hedging.
Timberland. The lower expected returns from
timberland relative to other private equity
investments may not justify the fee drag. In
addition, the outlook for timber demand remains
uncertain given the link to US housing starts.
We maintain a neutral stance on timberland,
but it is an asset class worth keeping an eye on.
Natural resources. Our research suggests that
investment in natural resources has strong
tailwinds. In US energy, there are a number of
high-quality private markets managers who have
demonstrated an ability to produce tangible alpha.
The combination of attractive macroeconomic
tailwinds and a pool of high-quality managers
to navigate the ever-changing investment
landscape is attractive.
Secondaries. Since the second half of 2009,
private equity secondary prices have increased
twice as fast as the public markets. However,
demand has been mostly driven by unspent
capital raised by secondary funds during the
market boom and may not be sustainable.
Co-investments. Given the double layer of fees,
the potential conflicts of interest and the evidence
of ill-discipline in capital deployment, we are not
convinced that dedicated co-investment funds
offer an attractive net of fees value proposition.
Conversely, we believe that participating in
selected, direct co-investment deals is the right
approach for certain large investors. But there
must be a long-term commitment given the time
and resources needed to evaluate opportunities.
02 Global private markets: opportunities in macro themes
Opportunities
in distressed assets
The aftermath of Lehman
Brothers collapse
Following Lehman Brothers collapse in September
2008, markets went through the most severe
liquidity withdrawal and repricing of risk ever
experienced in our lifetime. The following two
quarters saw corporate earnings fall significantly
as businesses cut expenditure due to the
heightened sense of uncertainty. This fed through
into further declines in public markets and
further decreased the availability of financing.
Fearing the crisis would lead to a depression,
governments globally provided significant fiscal
and monetary stimulus, leading to a rapid reflation
of public credit and equity markets. For managers
focused on distressed opportunities, this meant
that the opportunity to undertake restructuring or
distressed for control strategies passed rapidly.
Instead, markets witnessed record levels of high
yield refinancing as companies looked to extend
debt maturities and take advantage of yields that
were being depressed by government stimulus.
Figure 05. US high yield issuance

0
50
100
150
200
US$ billion
250
300
1996
59
1997
108
1998
130
1999
84
2000
34
2001
79
2002
57
2003
131
2004
138
2005
96
2006
...markets
witnessed
record levels of high yield
refinancing as companies
looked to extend debt
maturities and take
advantage of yields that
were being depressed by
government stimulus.
24 towerswatson.com
147
2007
136
2008
43
2009
148
2010
264
1H2011
164
2H2011
57
Source: Sifma (Securities Industry and Financial Markets Association)
Figure 06. Historical option adjusted spreads: February 2002-12

25%
20%
15%
10%
5%
0%
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Year
European high yield Global high yield US high yield master II
Source: BOA Merril Lynch
Significant central bank stimulus

means spreads remain much tighter
than at the depth of the crisis
Credit issuance again deteriorated in the
second half of 2011 due to fears about the
macroeconomic environment and the health of
the financial sector in Europe. The banking crisis
in Europe has developed into a sovereign debt
crisis and with so much uncertainty surrounding
the future of the euro there had been signs of a
liquidity crisis similar to that experienced following
Lehman Brothers collapse.
However, despite these developments, public
markets did not reprice to anywhere near the same
extent as in Q4 2008 and Q1 2009 (see above).
Additionally, fearing another liquidity crisis central
banks have provided significant liquidity to markets
in the first quarter of 2012, bringing spreads down
to similar levels seen in 2010 and early 2011.
The most attractive distressed

credit opportunities
While pricing remains less attractive than it was
at the trough of the crisis, we believe the weak
macro-environment is likely to drive significant
opportunities for activist distressed credit
investors. We highlight four broad areas that we
believe will drive the most attractive opportunities.
Banking asset disposals

Approximately US$2 trillion in banking asset sales
have been announced to date, with expectations
this figure will increase over the next five years as

banks in the developed world look to shrink their
balance sheets in the face of increasingly stringent
regulation. Europe appears larger in terms of
opportunity than the US, due to the sovereign debt
crisis in the European periphery, though activity
in Europe remains muted. This is probably due to
many banks inability to book losses, suggesting
that the cleansing process will be protracted.
However, the US should not be ignored as there
have been a significant number of bank failures,
and there remains a significant book of assets
still within the FDIC (Federal Deposit Insurance
Corporation) (approximately 844 problem
institutions and US$339 billion in assets as
at 30 September 2011).6 We therefore expect
banking asset disposals to be a multi-year
opportunity on both sides of the Atlantic.
The breadth of the potential opportunity is
significant, spanning non-performing loans,
non-core business lines, non-core asset
divestitures and banks returning to their home
markets (particularly in Europe). We believe that
one of the most attractive opportunities for
investors in the current environment is finding a
manager that is able to source, price and work out
complex and illiquid loan pools where discounts
are substantially greater than the public auctions
of non-performing loans that are reported in the
financial press. There appears to be a significant
premium available, driven by the broader markets
aversion to illiquidity and complexity.
Many businesses owned by private equity firms

remain over-levered from the height of the credit
boom, and weakening macro fundamentals make
it less likely their portfolio companies will match
predicted growth based on peak 2007 earnings.
Some lenders will seek new capital, or take full
control of some of these companies in order to
reduce their financial burdens and reposition
them for a weaker macro-environment.
In the developed world, the US is likely to offer
more opportunity as the leveraged loans market
is much larger, but returns there may be offset by
the level of competition. Europe is more difficult
to predict as a lower proportion of leveraged
buyout (LBO) debt is publicly-traded. Additionally,
operating on a pan-European basis is difficult and
the path to economic recovery is less clear than
in the US.
However, it is hard to envisage a scenario other
than increasing rates of default from current
lows, and a case can be made for distressed
opportunities far out-stripping the supply of
capital. We therefore recommend that investors
consider investing in private equity managers
with a strong skill-set in undertaking financial
restructurings and, just as importantly, in helping
companies restructure their operations.
Reduced availability of credit

As banks in the developed world look to shrink
their assets, it follows that credit availability will
decrease. This is expected to be particularly acute
in Europe as further regulation looms. Additionally,
the size of the shadow banking sector such
as hedge funds and CLOs (collateralised loan
obligation) has also fallen significantly just
as re-investment periods for many existing
structured credit vehicles are reaching an end.
In this environment, strategies such as mezzanine
and direct lending should become more attractive.
While absolute yields in these strategies have
not risen hugely, they do offer an attractive
spread over government bonds compared with
the pre-2009 period. The strategy also offers
considerable asset coverage, long non-call
periods and equity participation.
However, we believe that the private-equity level
fees charged in the mezzanine and direct lending
space make it prohibitive on a stand-alone basis
given limited manager skill beyond credit selection
and origination. Mezzanine issuance is also likely
to stay muted as deal activity in the private equity
market remains slow and direct lendings focus
on smaller companies means it is exposed to
macroeconomic headwinds.
26 towerswatson.com
Figure 07. Estimated leveraged buyout debt maturities

US$ billion
The leveraged buyout maturity wall
250
200
196
174
150
156
115
100
80
92
50
0
2011
2012
2013
2014
Source: Dealogic
As such, we would only recommend these

strategies as part of a broader credit
offering, particularly as rescue financing and
recapitalisation might be opportunistically
employed within real estate and corporate
investment strategies.
Real estate
Real estate financing has been a key issue
in the wake of the financial crisis and the
consequence falls in real estate values in Europe
and the United States. It is estimated that there
will be US$2 trillion to US$2.5 trillion in maturing
commercial real estate loans between 2011
and 2018 in the US. The European real estate
financing opportunity also appears vast, with an
estimated 400 billion to 600 billion of debt
needing to be refinanced in 2011 to 2013.
Banks in both Europe and the US are under
pressure from regulators to shrink their balance
sheets, increase the capital held against riskier
real estate loans and reduce the proportion of
non-performing loans on their books. This will
reduce the availability of new debt financing and
may also lead to asset disposals. This may create
opportunities for new lenders to provide financing
at attractive levels. However, we note that senior
debt remains available for high-quality assets let
to good tenants. This may restrict the opportunity
to more junior lending, which is not treated
favourably by new regulation.
A fund manager with strong sourcing, structuring
and operational capabilities could complement
and diversify an investors existing real estate
portfolio. The risk remains, however, that the
commercial real estate markets in the US and
Europe may fall further as macroeconomic
fundamentals remain weak.
2015
2016
Year
Taking a multi-strategy distressed

credit approach
With a broad array of potential opportunities
created by the ongoing financial and sovereign
crises, there are benefits to allocating capital to a
multi-strategy distressed credit manager.
The primary benefits of a multi-strategy
approach are:
A multi-strategy distressed credit manager
provides access to a broad range of
distressed/stressed credit instruments
and can dynamically allocate to them as the
cycle unfolds.
It remains unclear when banks will sell certain
types of assets so it is helpful to have access
to a large opportunity set.
The strategy is not predicated on a cyclical
recovery and/or reflation of risk assets,
whereas corporate and real estate control and
restructuring focused opportunities rely on this
to some extent.
Broad aversion to illiquidity and complexity
increases the target returns for this strategy.
This approach does come with risks. For example,
finding a manager that has a high-quality offering
across a broad range of distressed strategies
is difficult, as is timing the optimal point
of entry. Fund managers should have the
following characteristics:
Proven access to deal flow.

Significant levels of investment and asset
management resource.
An activist approach where required and access
to high-quality specialist servicing groups in each
geography the manager operates in.
Proof of concept, that is experience in previous
distressed cycles and evidence of being able to
rotate through distressed opportunities.
Conclusion timing is everything

With the impact of the financial crisis still ongoing
and regulatory pressures likely to exacerbate the
need for banks to reduce the size of their balance
sheets, we believe that significant opportunities
exist for investors considering distressed strategies.
The challenge is to decide which are most attractive
and time the optimal point of entry, since the
opportunity is likely to be protracted and there
could be little clarity as to which types of assets
will be sold and when. Given the macroeconomic
headwinds, investors should not have too much
capital focused on distressed strategies that are
overly reliant on economic recovery and the reflation
of risk assets. We believe that investors should
consider supplementing existing allocations to
distressed with a multi-strategy manager focused
on illiquid distressed credit.
The ability to invest across the globe in

a broad range of credit instruments.
...investors
should consider supplementing existing

allocations to distressed with a multi-strategy
manager focused on illiquid distressed credit.
Are mezzanine funds

about to make a comeback?
28 towerswatson.com
The banking sector is in the process of

deleveraging which is likely to take many
years and the shadow banking system
(hedge funds, CLOs and so on) is struggling
to raise new capital for structured
products, meaning that buyout managers
are challenged by a shortage of debt.
Additionally, there is the pending leveraged
buyout maturity wall in 2013-16, whereby
a significant level of new financing will be
required. So is this a good time to invest
in mezzanine funds?
50
40
45
35
43
40
39
35
41
34
33
30
32
29
27
25
30
25
30
20
23
20
15
10
10
5
0
15
Aggregate commitments
The decade leading up to the height

of the boom in 2007 saw the private
equity market grow dramatically.
Leveraged buyouts made increasing
use of subordinated forms of debt such as
mezzanine, which enjoyed similarly dramatic
growth, culminating with over US$35 billion
being raised in 2007. However, since the
beginning of the global financial crisis,
fundraising has been much more
challenging (see Figure 08).
Figure 08. Annual mezzanine fundraising

Funds raised
Overview buyout firms seek

new debt channels
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Number of funds raised Aggregate commitments (US$ billion)
Year
Source: Thompson One
Figure 09. All-in mezzanine yield

16%
14%
12%
3.3
3.8
10%
Favourable market dynamics
8%
One of the greatest attractions of investing

in mezzanine in the current market is
that the terms an investor can achieve
have improved markedly compared with
the height of the boom. For example,
new mezzanine loans currently yield
approximately 12%, which is slightly lower
than during the buyout boom, but the
spread over cash has risen (see Figure 09).
Mezzanine lenders are also enjoying better
bargaining power in financing negotiations
in terms of prepayment penalties and
call protection. In addition, warrants have
reappeared in deals and equity purchases
remain an option, meaning there is
potential upside beyond the cash yield.
This package of yield, warrants and equity
appears to offer an attractive total reward
profile for investors.
6%
2%
5.7
5.2
5.0
4.8
5.5
6.3
5.6
5.1
4.0
4.0
4.1
4%
4.4
5.5
4.5
4.3
4.5
4.6
4.3
4.5
3.3
2.9
3.7
2.1
2.2
2.5
2.9
0.7
0%
5.3
4.4
4.9
4.9
5.4
1.0
1.6
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Jan-Sep
3-month EURIBOR Cash pay PIK
Year
Source: Standard & Poors
One
of the greatest attractions of investing in

mezzanine in the current market is that the terms
an investor can achieve have improved markedly
compared with the height of the boom.
Also, many of the transactions that are completed

today are capitalised more conservatively and
senior lenders have put in more restrictive
covenants. This should provide mezzanine
investors with greater security as they can usually
tag along on certain senior lender terms.
In terms of new opportunities, there is typically
a reliance on robust private equity activity, but
capital structure refinancing may also be a driver.
As we have mentioned before, the private equity
boom has created a large LBO maturity wall which
will hit in 2013-16. As companies seek to refinance
debt, senior lenders will likely offer debt levels
at a lower multiple of earnings than previously
(corporate earnings are likely to be lower too)
as they look to deleverage. A further constraint
on financing is the deleveraging of the shadow
banking system with hedge funds and CLOs
becoming significantly smaller participants in the
leveraged loans market than during the boom years
due to the limited availability of bank credit lines.
With previously buoyant high-yield markets also
faltering in the second half of 2011, there is likely
to be an increasing and urgent need for alternative
sources of capital.
Beware significant risks and challenges

While the qualitative case for an increase in the
need for mezzanine capital is strong, investors
need to be aware that mezzanine activities have
historically demonstrated a strong correlation with
deal activity. Deal activity did start to pick up in the
first half of 2011, but the deterioration in investor
confidence due to the European sovereign debt
crisis saw activity again become muted (see
Figure 10). With private equity fundraising still
difficult and a reasonable chance that deal flow
will remain low, the demand for mezzanine may
also remain muted.
There is also significant capital overhang in the
mezzanine market, with estimates of over US$40
billion as at the end of September 2011, which
implies capital already exists to meet any increase
in demand (see Figure 11). However, this dry
powder should decrease over the coming three
years as maturities fall due.
Another potential risk with mezzanine investing is
that being in the middle of the capital structure
means more risk in a default. Investors should
ensure they allocate to managers that have the
experience and skills to participate successfully in
restructuring plans and can show low loss ratios.
US$ billions
Figure 10. Aggregate US private equity deal volume

600
597
500
400
300
306
200
219
176 174
147
100
0
15
25
22
49
81
72
46
72
79
180
60
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Source: ICG, S&P
In
terms of new opportunities, there is typically
a reliance on robust private equity activity, but
capital structure refinancing may also be a driver.
30 towerswatson.com
Year
Dry powder (US$ billions)
Figure 11. Mezzanine market dry powder

50
46
42
40
35
40
38
42
30
20
18
19
2003
2004
22
10
0
2005
2006
2007
2008
2009
Source: Preqin
Our biggest concern with mezzanine managers,

however, is that they are not usually well positioned
to add operational value to portfolio companies.
They add value through credit evaluation and deal
origination fees. Expected returns are lower than
private equity and any value achieved through
the warrants or equity component is out of the
mezzanine managers hands. We therefore
believe it is difficult to justify a private equity like
fee of 1.5% to 2% on commitments, plus a 20%
performance fee over an 8% preferred return.
Taking the performance fee in isolation, charging
a fee as high as 20% over a preferred return is
impossible to justify given that the GP catch-up
reduces the actual hurdle over which a
performance fee is paid to 0%. The cash yield
generated is not dissimilar to that of high yield
markets and a high yield manager typically charges
a fee of 0.6% to 0.7% on invested capital with no
performance fee.
To reinforce the point, if we assume that a
mezzanine manager is able to achieve a gross
return of 13% and we assume a beta of 7% in
global high yield markets, a fee of 1.5% based on
the commitment amount and performance fees
as outlined above will result in approximately
67% of the alpha being paid away. Therefore the
mezzanine manager will have achieved a net
return of just 9%, only 2% more than liquid high
yield markets, which is arguably too little to justify
the additional risk and lack of liquidity. There is
therefore significant reliance on equity upside and
leverage, over which the mezzanine manager has
little control.
2010
Sep
2011
Year
Conclusion not suitable as

standalone strategy
In the wake of recent market uncertainty and
volatility, mezzanine investing appears to offer
private equity investors a defensive strategy with
a recurring income stream and equity upside.
Additionally, market dynamics for mezzanine are
potentially positive given the expectation of a debt
capital demand and a supply mismatch. However,
we would be cautious deploying capital into this
strategy for the following reasons:
Fee structures are unjustifiably high for the
limited value-add and manager skills required.
The spread over high yield, ignoring the potential
equity upside (which the mezzanine has limited
control over) may not be sufficiently high to
justify the higher fees or the illiquidity.
Private equity deal activity may remain muted
given the weak global economic outlook.
Based on the above, we would not recommend
mezzanine as a standalone investment strategy
unless there is a significant change in the fee
structure, notably a reduction in fees being
charged on invested capital and a true hurdle that
reflects the yield that can be achieved in high yield
markets. However, mezzanine may be interesting
if approached opportunistically, for example via
a multi-strategy credit manager with a broader
mandate which allows it to make a relative value
judgement against other credit investments.
Investing in renewable
energy infrastructure
Renewable energy infrastructure has become a fertile
ground for investment, as managers are attracted by the
strong yield and diversifying risk profile associated with
these assets. With the market for these assets continuing to
evolve, opportunities exist for investors with access to the
appropriate skill sets to generate significant returns.
What is renewable
energy infrastructure?
Renewable energy refers to the production of
energy by renewable sources.7 The sources of
generation techniques that usually fall within the
renewables category include hydro, wind, solar,
solar thermal, geothermal, biomass and waste.
Renewable energy is set to become an
increasingly important part of the suite of
energy generation techniques globally.
32 towerswatson.com
Figure 12 shows that renewable energy is

not expected to be the dominant source of
electricity generation in the next 20 years but
it will become increasingly important within
the overall energy mix. While hydroelectricity
in OECD countries remains a largely tapped
resource, significant growth in non-hydro
renewable generation is expected between
now and 2035. In fact, between 2008 and
2020 it is anticipated that electricity generated
through this source will increase by 8.2% a
year, with much of this growth coming from
wind and solar. This will create significant
investment opportunities.
Trillion kilowatt/hours
Figure 12. OECD net electricity generation by energy source, 2008-2035

4.0
3.5
3.0
2.5
2.0
1.5
1.0
0.5
0.0
2008
2015
2020
2025
2030
Liquids Natural gas Coal Nuclear Hydro-electic Non-hydro renewables
2035
Year
Source: International Energy Outlook 2011, US Energy Information Administration
Why invest in renewable

energy infrastructure?
There are a number of factors that combine to
make renewables attractive, especially from an
infrastructure perspective. Unlike some electricity
generation facilities, which use commodities as
the inputs to generate electricity and then sell on
to a competitive grid (often leading to volatility in
input prices and revenues), most renewables have
very low input costs and priority of dispatch is
often at a set price. This means that the cash flow
profile is relatively stable, with variations being
based largely on the amount of resource available
(that is, how much wind or sun).
One of the frequently raised concerns about
renewable energy is that it is dependent on state
support. It is correct that the attractive risk-return
dynamic enjoyed by renewable energy today is
assisted by the legislated support provided to
it by many developed nations. We believe there
is momentum from governments to continue
supporting renewables for a number of economic,
geopolitical and policy reasons, such as:
Energy security
Geopolitically, renewables have a significant
advantage over traditional sources of fuel as they
are not dependent on foreign importation of raw
materials. Natural resources are often sourced
from areas that are geopolitically volatile: this
includes oil from North Africa and the Middle East,
and oil and natural gas from Russia. Investment
in renewable energy reduces the dependence on
these input resources.
Inefficiency of existing network

The transmission capacity of most industrialised
nations has suffered from underinvestment,
meaning networks struggle to handle the increased
demand. The smaller renewable energy generation
facilities are easier for the grid to handle than larger
traditional methods, as smaller loads can be placed
into different sectors of the grid.
One of the criticisms levelled at renewable

energy is it is weather-dependent; however,
this is also a benefit, as it acts as a balance to
other technologies. The best example of this is
photovoltaic solar technology that can be deployed
in grid-congested areas and produces the most
power at the time of peak demand. However,
other renewables are continuous, such as biomass
which is a base load technology. A combination
of base load and peaking technologies is beneficial
to an efficient grid.
Cost of renewables is falling

The comparison of costs across technologies is
often difficult. However, it has become clear that
some renewables (particularly wind, hydro and
biomass) are becoming cost competitive with
overall grid prices in many jurisdictions.
State pledges
Lastly, there are a number of policies agreed
by developed nations that require them to build
renewable energy generation capability. In Europe,
the 20/20 legislation requires 20% of Europes
energy to be sourced from renewable sources
by 2020. The combined targets of the EU in
2009 were at 11.6% (latest data available).
Given that these factors are more prevalent in
Europe than elsewhere and that many European
countries have a developed regulatory regime,
we believe Europe offers the best opportunities
in renewables. In addition, Europes subsidies for
renewables are largely paid by utilities, with the
cost of these then passed onto the end consumer.
However, it remains to be seen what will happen if,
as a result of the shale gas revolution in the US,
Europe starts to import gas not required in the US.
The investment risks
How to invest choose your stage
There are a number of investment risks associated

with renewable energy:
There are a number of stages in the lifecycle of

a renewable project, all of which can be invested
in. The key stages are listed below, moving from
the highest risk (and highest return) phases to
the lowest:
Regulatory risk there are a number of strategic

reasons why it is important for renewables to
become a larger part of electricity generation
capacity, but shorter-term considerations may
mean that policymakers act in a manner that
is counter to this goal. This risk was realised
in Spain when the government retroactively
changed tariffs. While the Spanish move resulted
from a poorly-structured and overly-generous
tariff, it does highlight the risk. While we are
comfortable that the broad regulatory position
for renewables continues to be well supported,
we do recognise that this may change quickly,
particularly in periods of fiscal austerity.
Financial risk these assets are strongly cash
flow generative, with low operating costs. As
a result, the capital structure can support a
significant amount of debt. This means that debt
percentages can be upward of 70% of enterprise
value, creating some financial risk.
Resource risk put simply, this is the risk that
the wind blows or the sun shines less than
expected. The resource risks in these assets
are measured as statistical probabilities. The
usual basis for valuing these assets are a P50
and a P90 reflecting the median outcome and
the 90th percentile outcome, respectively, with
financing often using the 90th percentile figure.
Counterparty risk most of the risks associated
with construction, operation, maintenance
and off-take are passed onto contractors
and operators.
Substitution risk while a mix of energy sources
is considered prudent energy policy, we note that
technology and the market constantly develop
and could move in a way that makes current
energy production techniques uneconomical.
34 towerswatson.com
Development at this stage the required

approvals and planning are undertaken. This
is the highest risk (and highest return) part of
the project, requiring not only getting planning
permission, but also arranging the capital
structure of the project and understanding
the equipment requirements. Significant
development in Europe is undertaken by local
investors, particularly those with significant
amounts of land, such as owners of disused
industrial estates and farmers. Given the lack
of institutional skill within this group, we see
certain parts of this phase as highly attractive
for skill-based strategies in private markets.
Construction construction of most renewable
technology is relatively straightforward, using
proven technology and methods. However, grid
connection continues to be a risk and may lead
to delays and timing issues for cash flows.
Operation this is the phase when the asset
starts to operate and generate yield.
Consolidation in this phase a number of
projects are brought together to add scale to
the business. This is important, as it can aid in
reducing the cost of financing and operations as
well as improve exit opportunities.
Conclusion operational phase

attractive in longer term
Given some positive tailwinds, sophisticated
investors with large private markets programmes
may benefit from the inclusion of renewable energy
in their broader portfolios. Over time, we believe
that investments into the operational phase of
renewable projects will generate attractive current
yield. For now, given the relative immaturity of
the industry, there may be a shorter term
opportunity to generate higher overall returns
through investments in the development and
construction stages assuming good managers
can be found.
Agriculture
a strong investment base case
We
not only need to grow an extra one billion
tonnes of cereals a year by 2050 but do so from
a diminishing resource base of land and water in
many of the worlds regions, and in an environment
increasingly threatened by global warming and
climate change.
Jacques Diouf
Ex-Director General, Food and Agriculture Organization of the United Nations
Market fundamentals indicate that there is a

potential for further, long-term growth in this
market. Demand for agricultural commodities is
increasing, driven by population and economic
growth in emerging markets, coupled with a
decrease in arable land.
In this section, we review the market fundamentals
of the agricultural sector, discuss its investment
characteristics and ways of accessing investments
in agriculture.
Demand for agricultural commodities

is increasing
The global population has grown significantly over
the past decades and, according to World Bank
data, it is expected to reach 10.9 billion by 2050
(according to 2010 estimates). In the coming
years, population growth is expected to be
driven by developing countries and internal food
production in some of these countries may
not meet growing demand.
Economic growth in emerging markets also results
in growing demand for agricultural products. Rising
per capita incomes and urbanisation are resulting
in greater consumption of food and shifts in dietary
patterns in these countries. As GDP and incomes
grow, people consume more overall and consume
higher value foods. Urbanisation is also closely
linked to economic growth and rising incomes.
Urbanisation usually leads to a higher per capita
income and an increase in living standards.
This results in increasing caloric intake.
Supply in agriculture is a function of acreage
and yield and it can only increase through an
increase in one or both of these factors.
Figure 14 shows the supply of wheat globally.
Wheat is one of the key staples of human
diets, with human consumption accounting for
approximately 80% of total wheat usage.8
36 towerswatson.com
Billions
One type of alternative asset that has been

growing in popularity with investors is agriculture.
As traditional asset classes suffered in 2007
and 2008, agricultural commodity prices rose on
the back of strong fundamentals. This caused
investors to look at agriculture as an asset class,
which on closer inspection also provided the added
benefit of diversification.
Figure 13. Global population

12
10
8
6
4
2
0
1950 1960 1970 1980 1990 2000 2010 2020 2030 2040 2050
Year
More developed regions Less developed regions Least developed countries

Source: UN Secretariat, June 2011
Figure 14. Global wheat production versus global

wheat consumption
Million metric tons
The case for agriculture
700
680
660
640
620
600
580
560
2007/08
2008/09
2009/10
2010/11
Wheat production Wheat consumption

Source: United States Department of Agriculture, December 2011
2011/12
Year
Figure 14 also shows that global wheat

consumption has grown significantly over the
past few years. Production still meets demand,
however this may change if consumption continues
growing at the same rate. While it is probable
that increased supply will be needed over coming
years, in the last decade, the ability to increase
yield and acreage has become more difficult.
The amount of high-quality arable land available
is under pressure due to:
Increasing urbanisation
Degradation of land
Climate change.
The big question is: how much potential agricultural
land remains unused? At present some 1.5 billion
hectares of land is used for arable and permanent
crops, which is approximately 11% of the worlds
surface area. However, much of this land is in
practice unavailable or locked up in other valuable
uses. Of the remaining 89%, about half is covered
by forests, 12% is in protected areas, 3% is taken
up by human settlements and infrastructure, and
the remainder have characteristics that make
agriculture production difficult and less efficient.9
Agriculture: low correlation

and inflation hedge
Investing in agricultural assets provides a number
of benefits to investors. Agricultural assets are real
assets: they are tangible, have low correlation with
other asset classes and are therefore less
impacted by economic shocks. They also offer a
hedge against inflation. Total returns from farmland
have shown positive correlation with inflation:
in the US, between 1991 and 2008, correlation
between the total returns from farmland and the
CPI (Consumer Prices Index) was above 0.9. In
addition, United States Department of Agriculture
figures suggest that during the high-inflation
periods of 1944-1947 and 1975-1981 farmland
returns exceeded US CPI by 2% and 6.6%
respectively.10 Moreover, agriculture has resilience
across economic cycles. Population-driven demand
for grains remains the base case for agricultural
commodities. People need to eat regardless of
what is happening in the financial markets.
Due to the limited amount of available arable land,

the increased demand for agricultural crops will
need to be met by increasing yields. According to
the FAO, by 2030 average crop yields will need to
increase from the current level of 1.1 tons of grain
per acre to 1.5 tons in order to meet projected
demand. However, global yield growth has
stagnated due to climate change, water scarcity
and the deteriorating quality of arable land.
In
the coming years, population growth is
expected to be driven by developing countries
and internal food production in some of these
countries may not meet growing demand.
How to access agriculture

investment strategies
While agricultural futures and public equities offer
routes to access the theme, the purest form of
exposure to agriculture is through investment in
real agricultural assets. This exposure can be
achieved by:
Owning farmland: provides an investor with
exposure to changes in the value of land.
Operating a farming business: generates
returns through the production and sale of
agricultural commodities.
The strategy can be implemented via a
private equity-style fund, which has the
following advantages:
Is highly focused in the assets selected
across different geographies, sub-sectors
and businesses.
Access to experienced and high-quality
farm management teams who can drive
operational efficiencies.
Exposure to movements in commodity prices,
land values, operating efficiencies and
improvements in productivity.
There are some disadvantages:
Illiquidity.
Private-equity type fee structure, with
management fees of 1.5%-2%, plus carry.
A small universe of fund managers
specialising in agriculture.
38 towerswatson.com
Conclusion a worthy alternative

Volatility in financial markets has caused
investors to look for alternative investments
that have strong fundamentals, lower risks and
more stable returns than traditional investments.
One alternative is agriculture.
The market fundamentals for agriculture appear
strong. The ability of supply growth to keep pace
with demand is weakening and the result has been
a shift in prices: the prices of many agricultural
commodities are currently above historical levels.
Our research suggests that the gap between supply
and demand will develop and then continue to grow
and this will create further upward pricing pressure.
There are a number of ways of accessing
agricultural investments: investing in agricultural
futures, equities or exchange traded funds and
via private equity funds. Investing in agriculture
via private equity funds gives the most direct
exposure to agriculture and an investor can
benefit from strong market fundamentals
as well as inflation hedging.
Timberland a good diversifier

but how do investors gain exposure?
A small part of the investment universe
The worlds total forested area in 2010 was estimated to be
just over 4 billion hectares, corresponding to an average of
0.6 hectares of forest per capita.11 However, it is unevenly
distributed. The five most forest-rich countries (Russia,
Brazil, Canada, the US and China) account for more than
half the total forest area (53%), while 64 countries with a
combined population of two billion people have forests on
no more than 10% of their land area.
Figure 15. Institutional timberland investments by region

90%
80%
70%
60%
50%
An inefficient market
40%
Timberland is an inefficient market

(supply/demand imbalances, varied sophistication
of buyers and sellers) which creates attractive
investment opportunities. There are several
attractive investment characteristics of timberland
investments, including low or negative correlation
to other asset classes and a positive correlation
with inflation as seen in Figure 16.
30%
20%
10%
0%
Global commercial timberland value is around

US$300 billion and institutional timberland is
around US$50 billion, which is less than 1% of the
global institutional investment universe.12 The US
dominates the institutional timberland investment
market accounting for approximately 80% of the
universe as seen in Figure 15.
USA
South America
Oceania
Other
2006 2009
Source: RMK Timber Group presentation, 2010
Figure 16. Correlation of US timberland returns with other asset classes (1987-2009)
-0.5
US Commodity Index
US CPI Inflation
US Commercial Real Estate
US Direct Energy
US Small Stocks
International Equities
30-day US Treasury Bills
S&P 500
S&P Forests Products Index
US Long-term Corporate Bonds
Source: HTRG Research, 2010
40 towerswatson.com
-0.4
-0.3
-0.2
-0.1
0.0
0.1
0.2
0.3
0.4
0.5
As a result, timberland can be considered a portfolio

diversifier, tending to move counter-cyclically to
stocks and bonds and relatively independently of the
real estate sector. Some investors have questioned
if timberland is just a proxy to real estate, so we
examined rolling annual returns of the NCREIF
Property Index and the FTSE EPRA NAREIT US Index
and compared them to the NCREIF Timberland Index
and found that timberland has low correlation with
both private and public real estate. However, there
is a positive correlation between housing starts
and timberland, which we discuss later.
How can investors invest in timber?

There are several different ways:
Direct forestry investments: Investors with access
to sufficient capital and appropriate expert advice
can invest in direct physical forestry. Commercial
timber plantations are complex operations that
require skills, knowledge and expertise to maximise
returns while keeping risk at a minimum. They are
also a very capital intensive way to invest in timber
and may not be cost-efficient. Additionally, it
requires the active involvement of an investor
in strategy implementation.
Timber ETFs: In November 2007, the
Claymore/Clear Global Timber Index ETF
(exchange traded fund) (Ticker code: CUT)
became the first American Timber ETF available
to investors. One year later, it was joined by the
iShares S&P Global Timber & Forestry Index Fund
ETF (WOOD), which has been trading in Europe
since October 2007. There are now other ETFs
available too. However, timber ETFs are broadly
focused on forestry/paper stocks, which lack most
of the benefits associated with timber investing.
In addition, the correlation between CUT and the
NCREIF Timberland Index over the last three years
was -0.4, providing further evidence that ETFs do
not necessarily provide exposure to timber.
Timber REITs: One way for smaller investors

to participate in timber investments is through
listed Real Estate Investment Trusts (REITs).
The REIT acquires and manages timber investment
properties. There are three major timber REITs:
Plum Creek Timber (PCL), Rayonier (RYN) and
Potlatch (PCH). Plum Creek was the first timber
firm to become a REIT and its eight million acres
of American forests makes it the countrys largest
non-government owner of timberland. None of
these REITs are pure-play timber firms, however.
Timber-related sales of Potlatch made up less
than 39% of revenues in 2010.13 Timber REITs
derived some of their timberland revenue from
real estate rather timber harvesting. They may
also prematurely harvest timber or sell trees at
deflated prices in order to subsidise mills.
Timber private equity funds: Investors can
access non-listed timber by investing through
segregated accounts or pooled vehicles known
as Timberland Investment Management
Organisations (TIMOs) which are typically
closed-end limited partnership vehicles.
There are advantages and disadvantages of
investing in timberland via closed-end funds:
Advantages: the investor has more exposure
to direct timberland returns and lower
volatility compared to timber REITs. Minimum
investments start at US$1 million, so it is less
capital intensive than direct exposure.
Disadvantages: the universe of such funds
investing in timberland is quite small.
The fee structures are similar to broader
private equity funds (1.5% to 2% annual
management fees and 20% performance
fee over an 8% preferred return), despite
the expected return for timberland funds
being much lower. In addition investments in
private equity funds are illiquid.
...timberland
can be considered a
portfolio diversifier, tending to move
counter-cyclically to stocks and bonds
and relatively independently of the
real estate sector.
Figure 17. Timberland appraisal prices firm in the face of falling

lumber prices
US$ per ton
50
3000
45
2500
40
35
2000
30
25
1500
20
1000
15
10
500
5
0
1987
1990
1993
1996
1999
2002
2005
2008
0
2011
US housing starts (seasonally adjusted 000s)

NCREIF timberland price per acre (US$, nominal)
Pine sawtimber (US$ per ton RHS)
Source: NCREIF, Datastream, Bloomberg, Towers Watson, 2011
Current market trends and outlook

Appraisal prices for timberland continue to remain firm (see Figure 17 with
the NCREIF data) which, set against declining timber prices over the past
few years, means timberland valuations appear to be pricing in a future
strengthening of timber prices. In our view, this may be difficult to justify.
The outlook for timber demand is uncertain given weak US housing
prospects, a key consumer of timber. On the supply side, restrictive factors
such as the black-beetle infestation in British Columbia or Russian export
taxes are likely to be offset by increased harvesting of timber stored on
the stump. Unlike other products, such as agricultural crops or some
consumer goods, timber does not perish quickly if it is not consumed.
Conclusion keep a watching brief

The global institutional timberland universe is modest in size relative to
traditional asset classes and is dominated by the US market. Timberland
has some attractive investment characteristics, particularly a low or
negative correlation to traditional asset classes and a positive correlation
with inflation. One can access timberland in different ways: direct forestry
investments, timber ETFs, timber REITs and timber private equity funds.
There is little evidence that listed alternatives for timber exposure offer the
desired investment characteristics. Investing through closed-end private
equity style funds may make sense. However, the private equity type
fee structure has a significant impact on returns to investors. The lower
expected returns from timberland relative to private equity investments
in other assets may not justify this fee drag. In addition, the outlook for
timber demand remains uncertain given the link to US housing starts.
For these reasons, we maintain a neutral stance on timberland, but it is
certainly an asset class worth keeping an eye on.
42 towerswatson.com
Natural resources
strong long-term potential
We explore some of the trends in energy and

mining along with the risks and some concerns
we have. We conclude with our views on the
overall investment opportunity in this sector.
Macro trends are compelling

According to the Energy Information Agencys
(EIA) estimates, world energy consumption
will increase by 53% between 2009 and 2035.
The capital required to meet the projected
energy demand for the next 25 years will be
around US$30 trillion according to IHS Herold,
an energy research firm. The International
Energy Agency (IEA) believes 5,900 additional
gigawatts of power is required globally by
2020, which is around six times the current
US capacity.
Figure 18. Energy demand growth set to continue

Quadrillion Btu
In our publication Private equity emerging

from the crisis, June 2010, we outlined our
positive view on power generation and how the
unfulfilled demand for it could lead to good
investment opportunities. Here we broaden the
topic to include natural resources, which we
define as energy (exploration and production of
oil and gas) and mining (coal and metals).
900
800
700
600
500
400
300
200
100
0
1990
2000
2008
2015
2020
Non-OECD OECD
2025
2030
2035
Year
Source: Energy Information Agency, 2011 Outlook 14
Figure 18 shows the growth in energy demand.

The non-OECD bar is a rough approximation for
developing countries needs, showing that the
increase in demand will predominantly come
from these areas. Non-OECD countries will
account for 90% of population growth, 70%
of the increase in economic output and 90%
of the expected energy demand growth in the
next two decades.15
At the same time, supply has increased. Five years ago with spot
gas prices moving above US$13/MMBtu (British thermal unit), there
were worries that the US would have to import liquefied natural gas
from countries like Russia. However, US production of natural gas has
accelerated with shale gas moving from less than 1% of domestic supply
five years ago to about 30% now. Today, the pricing for natural gas is
below US$3/MMbtu and in 2009 US passed Russia to become the
worlds largest producer of natural gas. Government officials are now
thinking of allowing more natural gas exports given how much is available
via new drilling techniques (called fracking) which have created more
initial reserves than anticipated.
Mining follows a similar story to energy with global economic and
population growth in developing countries creating increasing need
for coal in power generation and for iron ore, metallurgical coal and
manganese in the steel industry.
Coal is one of the most demanded resources in the world. For example,
coal use in the US totalled 22 quadrillion Btu in 2008 and accounts for
around 50% of total US power generation. The percentage is expected
to steadily decline with the rise of natural gas and of environmental
concerns but countries like China are picking up the excess supply.
According to EIA, the growth in demand for coal will mostly come from
developing countries, especially in Asia (see Figure 19).
Significant demand growth is expected for key steel industry inputs,
such as iron ore, metallurgical coal and manganese, from developing
countries. China and Indias growing economies and rapidly rising
standards of living have resulted in a surge of urbanisation and the
need for more steel.
Quadrillion Btu
Figure 19. World coal consumption

160
140
120
100
80
60
40
20
0
1990 1995 2000 2005 2010 2015 2020 2025 2030 2035
Non-OECD Asia OECD
Rest of world
Source: Energy Information Agency, 2011 Outlook
44 towerswatson.com
Year
Outperformance by private
markets managers
Industry
performance
data and Towers Watson
research show that over
the most recent five and
ten-year periods, natural
resource managers have
created about 10% and
20% IRRs, respectively.
Most investors have exposure to the likes of

Exxon, Shell, BP and Rio Tinto in their listed
equity portfolios which arguably provides them
with the diversification and inflation linkage
benefits associated with natural resources.
As such, investors have to be convinced they
can find managers that can provide alpha by
investing in this sector through private markets.
To date, it appears (gross of taxes) that some
top managers can indeed provide this alpha.
Industry performance data and Towers Watson
research show that over the most recent five
and ten-year periods, natural resource managers
have created about 10% and 20% IRRs,
respectively. When compared to the total return
from the MSCI world energy index (GDWUENR),
private markets managers have outperformed by
about 1,000 basis points over both the five and
ten-year time periods. Caveats apply, of course: on
the duration, the sensitivity of dates used and the
fact we have not accounted for leverage (though
levels of leverage used in private markets investing
in natural resources are not dissimilar to those
used by listed companies in this sector). But even
if one includes those factors, private markets
managers focused on natural resources have
demonstrated an ability to generate alpha.
Key risks and strategy concerns

Volatility. Along with risks that are inherent in
natural resources (geological, political, permitting
and construction), there is also price volatility.
This volatility is partially offset by the fact that
in private markets investments are made and
exited over approximately 10 years (a funds
typical life) and by tools that can manage this
risk, such as hedging commodity exposure or
investing in stages of exploration, production and
services that are not tied to commodity pricing.
An investor can take comfort that, over the long
term, investing in a finite resource with growing
demand should increase prices barring any
significant change in substitutions.
Taxes. As we discussed in our 2010 publication
on power generation, for non-US investors seeking
US energy and mining exposure, FIRPTA (Foreign
Investment Real Property Tax Act) is a stumbling
block. Alongside the ECI (Effectively Connected
Income) tax on foreign investors, the total tax
bill may account for at least a third of potential
investment returns. In private markets, most
managers focusing on natural resources are
US-based and prefer to invest in their home
market, so the issue is very significant.
The environment. While oil and gas exploration

and production and mining have, as industries,
done a reasonable job of considering the
environment, accidents occur from time to time,
ranging from oil spills to mine collapses. In
addition, investors have to accept that burning
fossil fuels and mining the land will always have
an environmental impact. More recently, the
increase in natural gas exploration has resulted
in a public debate over the safety of fracking.
By putting capital into this sector, investors
must be aware of their ESG (environmental,
social, governance) policies.
Ownership and control. Most managers partner
with an operator who actually conducts the work.
Private markets managers provide growth equity
capital in increments once a well, for example,
has been proven to be productive. This incremental
investing helps mitigate risk. However, the
manager is reliant on the operator to drill
producing wells and the investor is dependent on
the manager to identify good operators. Ideally,
an investor would want the manager to have
more of an active role or more control over the
management of its underlying businesses, but
managers are limited in their ability to provide
advice on how, for example, to make drilling and
mining more efficient. Moreover, while there are
a number of energy managers, there are fewer
mining-specific managers and only a handful of
managers that have the experience to invest
in both sectors. This makes manager selection
harder, especially for investors with a relatively
small private markets programme.
46 towerswatson.com
...investors
should be aware of
the exposure they may have
to similar assets in their public
equity portfolios and consider
their natural resources
exposure holistically.
Conclusion a good investment
if structured well
Our research suggests that investment in natural
resources has strong tailwinds. In US energy,
there are a number of high-quality private markets
managers who have demonstrated an ability
to produce tangible alpha. The combination
of attractive macroeconomic tailwinds and
a pool of high-quality managers to navigate
the ever-changing investment landscape are
attractive. The mining market offers a similar
macroeconomic dynamic, but a less compelling
manager opportunity set. Non-US investors must
be cognisant of potential tax implications from
FIRPTA and ECI taxes. In addition, we emphasise
that investors should be aware of the exposure
they may have to similar assets in their public
equity portfolios and consider their natural
resources exposure holistically. Manager selection
is particularly critical in such a specialised
strategy. Investors also need to be comfortable
with potential ESG issues in these businesses.
Investing in secondaries
cyclical opportunities
2011 saw the largest volume of secondary transactions
ever closed in private equity, with estimates at around
US$30 billion. With secondary managers currently
looking to raise US$30 billion of capital, we expect
activity to continue. In addition, the last few years have
seen a significant increase in the level of interest in
secondary transactions in real estate, following the global
financial crisis. However, fundraising for dedicated real
estate secondary vehicles dropped off in 2011, having
reached a peak of US$1.7 billion in 2010.16 In this section,
we will examine the secondaries market overall and assess
whether it is currently attractive for institutional investors.
Why secondaries?
Private equity secondary fund investors can
expect similar benefits to investors in traditional
private equity funds. In particular, returns
are potentially superior to those from public
markets: a significant factor that can lead to these
outsized returns is the funds potential to acquire
high-quality assets at discounts to net asset
value (NAV). Additionally, secondary funds mitigate
the J-Curve effect since they possess more
mature portfolios that are likely to return capital
more quickly than a traditional private equity fund,
as well as provide investors with an identifiable
portfolio and vintage year diversification.
Real estate investors can also access investments
through the secondary market. For closed-end
funds, the benefits are similar to those found
in private equity. For open-end funds, the
main benefits are the ability to access and exit
the underlying portfolios in periods of limited
liquidity and, depending on market conditions,
the potential to increase returns through
acquisitions at attractive prices relative to
the underlying assets.
Despite this lack of deal activity, secondary

managers raised bigger funds. In fact, more money
was raised by secondary funds in 2009 and 2010
than in the whole of the first half of the decade,
according to Preqin. This led to more deal activity.
While US$8 billion was deployed for secondary
private equity transactions in 2009, some
US$30 billion was deployed for these transactions
in 2011 with projections of up to US$40 billion in
secondary transactions in 2012.19 As secondary
transaction volume has increased and the supply
and demand spread has narrowed, prices have
risen. For private equity, the 35-40% discount
decreased to 10-15% in the second half of 2011.
In real estate, anecdotal evidence also points
to significant changes in the discounts available
on secondary transactions, with core high-quality
portfolios even trading at a premium in some cases.
The dedicated secondary fund universe is much
smaller for real estate, with not a single fund
raised in 2008 and just five raised between 2009
and 2011. In fact, real estate secondary funds
raised US$3.3 billion between 2007 and 2011,
compared with US$420 billion raised in private
equity real estate strategies in the same period.
Financial crisis bolstered

secondaries market
Pricing likely to remain stable
In late 2008, amid the market turmoil following

the Lehman Brothers bankruptcy, there was a
significant buyer-seller dislocation across private
markets, as investors sought liquidity through
redemptions (where possible) or secondary market
transactions. For private equity, estimates of
available secondary demand were approximately
US$40 billion, while estimates of secondary
supply were in the order of US$140 billion.17 This
excess supply can be, in part, explained by liquidity
concerns from LPs combined with LP overexposure
to the private equity market following the crash
of public markets (known as the denominator
effect). Buyers of secondary interests were
cautious and private equity secondaries were
priced at a 35-40% discount in 2009.18 In real
estate, high levels of redemption requests on
open-end funds led to the deferral of payments,
while closed-end fund investors experienced many
of the same liquidity issues as those in private
equity vehicles. Throughout late 2008 and 2009,
there was a dramatic reduction in deal activity as
buyers and sellers failed to find a market clearing
price. With the benefit of hindsight, it appears
that many potential buyers were too greedy in
the prices they were willing to pay and missed
out on this trough in pricing relative to NAV.
Figure 20. Average high bids in secondary auctions

% of net asset value
Pricing in 2011 was a story of two halves

in the first half of 2011, secondary pricing
steadily rose on expectations that the economy
was stabilising, while the turbulence in the credit
environment in the second half of 2011 led to a
softening in pricing to the end of the year (see
Figure 20). Without any further macroeconomic
shocks, secondary pricing is unlikely to drift too
far from its current level in 2012. We expect the
discount for larger transactions to be minimal
as larger secondary funds will compete on these
deals more aggressively.
120%
110%
100%
90%
80%
70%
60%
50%
2003 2004 2005 2006 2007 2008 2009
Source: Cogent
48 towerswatson.com
H1
H2
H1
H2
2010 2010 2011 2011
Year
Caution: inappropriate fee drag

A challenge for investors in secondary funds is to factor in the high
fees charged by secondary managers. Fees charged in the investment
period are typically 1-1.5% on committed capital. These fees represent
a second layer of fees on top of the fees charged by the underlying fund
managers. Figure 21 shows that the fees charged by secondary managers
significantly outweigh the fees charged by underlying managers in the
latter years of a secondary funds life. Given the responsibility lies with
the direct manager to actively own the business and manage the exit
process, this fee distribution represents an inappropriate drag on fees
for the secondary fund investor. It is worth noting that some real estate
products are available at lower fee levels, although these are not typically
wholly focused on secondary investments and may also, in some cases,
invest in lower returning, core opportunities.
Figure 21. Distribution of manager fees paid by an investor in a

secondary fund between underlying manager and secondary manager
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
1
10
11
12
Year
Secondary fund management fees Secondary fund performance fee

Underlying management fee Underlying performance fee
Source: Towers Watson
Direct investment experienced investors only

For some experienced investors, investing directly in secondary
transactions rather than through specialised secondary funds is a
potential channel for achieving many of the benefits of secondary
investing without incurring the double layer of fees and without the
pressure to deploy a level of capital demanded by the secondary
fund model. This is our preferred route for sophisticated investors.
For those investors, participating in secondary transactions tactically
when opportunities present themselves at certain points in the cycle
could be an appealing alternative to strategically committing capital
to secondary funds on an ongoing basis.
Conclusion: how attractive are current opportunities?

Pricing discipline will play an increasingly important role in driving returns
in the secondary market. Secondary prices contain nowhere near the
premiums paid during the boom of 2006-07. However, the concern is
that since the second half of 2009 private equity secondary prices have
increased twice faster than the public markets. Secondary market pricing
has often been reflective of overall market sentiment. However, in recent
years, demand has been driven by unspent capital raised by secondary
funds during the boom and has painted an overly optimistic picture.
This despite an economic future that is anything but certain. We do
not therefore view the current secondary opportunity as compelling.
Co-investments
building trust, reducing fees
In its simplest form, a co-investment is a minority

investment made directly into an operating
company alongside a fund manager. It is typically
a passive, non-controlling investment, as the
manager will exercise control and perform
monitoring functions on a co-investors behalf.
Managers seek co-investors for several reasons.
The most important of these is that co-investments
allow a manager to make larger investments
without dedicating too much of the funds capital
to a single transaction or sharing the deal with
competing firms in a club deal syndicate.
Through this process, managers are also able
to strengthen relationships with large, often
influential, investors.
Typically, co-investors are existing investors
(Limited Partners or LPs) in an already established
fund. However, co-investments are made outside
the fund so co-investors rarely pay management
fees or carried interest on an individual investment.
Considering the relatively high level of fees charged
by private markets managers, gaining exposure to
transactions with no management fee and carry
is a significant benefit. In addition to fee savings,
there are a host of potential advantages to the
co-investment model:
Speed of capital deployment relative to fund
investing, capital can be deployed more quickly
thereby increasing exposure to private markets
in a more timely fashion.
50 towerswatson.com
Tactical portfolio management if an investor

has a particularly positive view on a theme or
sector, co-investing in selected transactions
will allow the investor to gain relevant exposure
in a timely manner.
Strategic portfolio management if an investor
has a preference for a certain risk-return profile,
it can select deals that are better suited to this
preference (for example, levels of leverage, cash
generative nature of a business and so on).
If structured appropriately, co-investments may
also give an investor an opportunity to retain
the ownership of an attractive business when
the fund exits. Co-investing can therefore be a
useful portfolio management tool.
Access to deals where an investor has a very
large amount of capital that it seeks to deploy
to private markets, traditional fund investing
may not provide sufficient access. Co-investing
provides an additional channel to access deals
outside of traditional fund investing.
Increased exposure to, and strengthening of
relationships with, preferred managers where
an investor would like to commit more money to
a manager but cannot due to fund size limits,
co-investment allows the investor to increase
exposure to that manager by investing in its
deals directly. Traditionally, managers prefer to
have an existing investor as a co-investor rather
than invite competitors into a deal. This results
in a symbiotic relationship that is beneficial to
both parties.
These benefits have led to co-investment

programmes becoming increasingly popular with
larger institutional investors such as large pension
plans and sovereign wealth funds, whose scale
has allowed them to develop more sophisticated
in-house capabilities and governance structures
than many other private markets investors.
However, while there are clearly benefits to
co-investing, there are also a number of drawbacks:
Due diligence effort assuming the investor
is not willing to rely exclusively on the due
diligence of the sponsoring manager, a
substantial amount of work is required by
skilled investment professionals to ensure
the opportunity is sufficiently compelling.
Building the resources for a co-investment
programme can be costly and complex.
Adverse selection risk will the investor really get
access to the best deals through co-investment?
Often transactions that are offered to co-investors
are those that are too large or too risky to go
exclusively into the managers fund. These deals
are therefore not always the most attractive
from a risk-return perspective, emphasising
the criticality of deal selection.
Level of control and interest alignment
each party in a co-investment will have
different preferences around issues such
as risk tolerance, time horizons and so on.
For example, while a sponsoring manager might
want to sell a business in the near term to return
cash to investors and facilitate new fundraising,
co-investors might want to stay in the investment
over the long term to benefit from ongoing
cash yield.
Reputational risk while investors can benefit
from increased credibility within the manager
community if they partake in deals, an association
with unsuccessful, high-profile deals could lead
to a tarnished reputation.
Over-concentration in a specific
company/geography/sector if the investor
also has money in the sponsoring managers
fund, a co-investment leads to a double
exposure to the underlying manager and
company, as well as to its region or industry.
Investors might build this exposure deliberately
(for example, if they find a particular industry
compelling), but the concentration risk should
be considered carefully.
Co-investment deals versus

co-investment funds
Co-investment deals
A small number of large pension plans and
sovereign wealth funds have developed in-house
capabilities to co-invest with managers directly,
rather than via co-investment funds. In some
cases, co-investors will be involved throughout
various stages of the transactions development,
but in most instances co-investors will take a
passive approach. In other words, they are invited
into a transaction and have minimal involvement in
the mechanics of it.
A co-investment is typically made through a vehicle
structured by the fund manager sponsoring the
transaction. The direct co-investment deal approach
is appropriate for investors who strongly believe
that the investment in question is likely to generate
returns that are greater than the average portfolio
return.20 In theory, this should be more achievable
given the avoidance of fees usually paid away to
the fund manager.
This approach has a natural role in the core
infrastructure space because investors are not
necessarily seeking outsized returns; rather
co-investments are a mechanism to get exposure
to good quality, inflation-protected underlying
assets providing long-term cash flows at lower cost
than traditional fund investing. Given the scale of
the underlying assets in many core infrastructure
projects, potential concerns over managers
willingness to share attractive deal flow with
investors are mitigated by the fact that
co-investing is often necessary to get such
transactions completed. By bringing in direct
co-investors who can write large cheques in a
reasonable timeframe, infrastructure managers are
better placed to win larger transactions without
having to share the equity with competitor funds.
Co-investment funds
Across private markets (but particularly in private
equity), co-investment funds are becoming more
widespread. They are typically managed by fund
of funds managers who are able to leverage their
manager relationships and their own expertise
in analysing deals, to offer a fund comprised
exclusively of co-investments. This allows those
investors that do not have the expertise to
evaluate specific co-investment opportunities,
to share the benefits of co-investments. In

addition, investors in co-investment vehicles have
peace of mind in that these deals are subject to a
double layer of due diligence by the sponsoring
manager and the manager of the co-investment
fund. Co-investment funds also ensure there
is appropriate diversification across industries,
geographies, sponsoring managers and styles.
While investing in co-investment funds overcomes
the need for significant due diligence by the
investor, the approach is not without its challenges.
The outsourcing of due diligence comes at a cost
(typically a 1% management fee and 10% carried
interest), so effectively the direct manager fee and
carry is replaced with a fee and carry (albeit lower)
to the (largely passive) fund of funds manager.
Given it is the direct manager rather than the
co-investor that is doing the vast majority of work
(the deal creation, structuring, adding value,
then exiting), we have a philosophical aversion
to this transfer of fee and carry streams. Further,
it remains to be seen how direct managers will
react over time to the potential conflict of interest
resulting from funds of funds competing with them
for investor commitments while repackaging the
direct managers deal flow into their own product.
Perhaps most significant, however, is the pressure
to deploy capital that a fund vehicle creates. While
direct co-investors are able to approach the
co-investment deal market selectively, funds of
funds, which have raised co-investment capital,
are under pressure to deploy the capital raised,
irrespective of market conditions.
Returns from
co-investment programmes
Towers Watson has reviewed co-investment
returns data from multiple private equity fund
of funds managers and summarised them in
Figure 22. This shows the co-investment
managers returns (realised and unrealised)
against Thomson One benchmarks (top quartile
and median).
The co-investors ability to cherry pick transactions
that they believe will perform better than the
market has led to similar or better performance
in all vintage years with the exception of 2000.
This supports the view that a carefully constructed
co-investment programme can be additive to
overall net returns.
We must emphasise that the co-investment returns
are a gross return while the Thomson One figures
are shown net to capture the fact that direct
co-investors will not be paying fees. However,
if the route to these deals is via co-investment
funds, an additional fee drag must be considered.
Multiple of cost
Figure 22. Comparative returns between co-investment deals and overall private equity market
3.5x
3.2
3.0x
2.5x
2.5
2.0x
2.1
1.8
1.5x
2.1
2.0
1.6
2.0
1.7
1.7
1.8
1.7
1.3
1.2
1.0x
0.5x
1.7
1.5
1.5
1.1
1.3
1.3
1.2 1.2
1.0
1.0
1.0
1.0
1.1
1.0
1.1
1.0
1.1
1.0
0.7
0.0x
2000
2001
2002
2003
2004
2005
Co-investment All buyouts top quartile All buyouts median

Source: Thomson One, managers, Towers Watson
52 towerswatson.com
2006
2007
2008
2009
2010
Year
2500
3.5x
3.2x
3.0x
2000
1,963
2.5x
2.5x
2.0x
1500
2.0x
1.7x
1.5x
1.8x
1.2x
1000
1.5x
1.0x
823
0.7x
193
123
157
210
1.0x
520
471
302
1.1x
1.0x
591
500
Multiple of cost
Amount of capital deployed (US$ million)
Figure 23. Invested capital by year of investment

and associated median returns
0.5x
101
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Source: Thomson One, managers, Towers Watson
0.0x
Year
...if
investors are keen to build a
co-investment programme, they should
do so on an opportunistic basis.
As can be seen from Figure 23, which shows the median
co-investment return versus the capital deployed in each vintage
year, co-investment activities picked up significantly in the peak
years of the private equity market. Broadly speaking, these
have been the least attractive vintage years from a performance
perspective. The inverse relationship between performance and
co-investment capital deployment supports our hypothesis that
pressure to deploy capital can lead to co-investment capital being
allocated at an unattractive point in the cycle.
There are two interesting conclusions to draw from our analysis:
co-investors have tended to pick deals that have performed better
than the market, but they have also deployed most capital in the
least attractive vintage years. In our view, if investors are keen
to build a co-investment programme, they should do so on an
opportunistic basis.
Conclusion full commitment essential

for direct co-investment
Given the double fee layer, the potential conflicts of interest and
the evidence of ill-discipline in capital deployment, we are not
convinced that co-investment funds offer investors an attractive net
of fees value proposition. Conversely, we believe that participating
in selected, direct co-investment deals is the right approach
for certain large investors. But there needs to be a long-term
commitment to this approach given the time and resources needed
to evaluate opportunities and the discipline required in capital
deployment. However, the effort can be justified given the return
potential, both from the prospective alpha of picking a managers
best transactions and the savings on fees and carry paid to
underlying managers.
54 towerswatson.com
Section t hree
Investment themes in
regional private markets

Private markets can be a diversifying tool in a portfolio.
To further enhance diversification, private markets
strategies should be spread geographically. Here we
examine the potential rewards and challenges
of investing in various parts of the world.
Europe. Plain vanilla strategies relying on
leverage are to be considered with caution,
while strategies able to take advantage of
distress and demonstrate the ability to turn
around assets and add operational and strategic
value will generate attractive returns. We believe
the Nordics have some attractive tailwinds,
particularly in private equity and real estate,
while the UK market boasts a pool of high-quality
private equity managers.
The US remains the largest private equity market
globally and offers investors an extremely diverse
fund universe that focuses on different regions,
strategies and asset size. Specific areas of
interest include:
Healthcare, which has suffered from
huge underinvestment.
The drive to improve operating efficiency, for
which technology will play a significant role.
Real estate. Commercial real estate is
attractive in the US as well as value-add
and opportunistic investments.
Infrastructure. The American Society of Civil
Engineers estimates the five-year investment
requirement at US$2.2 trillion.
China. Private markets investments should
provide an attractive way to benefit from
increased domestic consumption of goods and
services, greater demand for transportation
and rising urbanisation. However, the risks
include a manager universe that is much
less developed than in the US and Europe, a
regulatory environment that is fast-evolving and
restrictions on foreign capital in certain parts of
the economy.
Brazil looks attractive, particularly as the

growth prospects of Europe and the US look
weak. Many of the macro risks in Brazil have
improved. However, the private equity and, to a
lesser degree, real estate markets appear to be
overheated. Pricing in private equity is soaring
and in real estate there is oversupply of homes.
We are more bullish on infrastructure investing,
which needs to increase to match growth levels.
India. There are positive longer-term
macro-themes, but also implementation
difficulties which make allocating capital to
India challenging. India has an ambitious plan
to build up its infrastructure and real estate in
order to support further growth, but political
red tape, corruption and information asymmetries
are negative factors and investors need to
ensure that their local partners are fully
aligned with them.
Sub-Saharan Africa and Turkey. These are two
of the hottest private equity markets under the
frontier markets (ex-Asia) banner. However, while
there are good opportunities available, our view
is that the private equity risks outweigh potential
returns right now and there could be better
opportunities from a risk-reward perspective in
other more liquid strategies.
03 Investment themes on regional private markets
Europe
are the lamps going out?
A tough call
Despite being the longest serving British Foreign
Secretary, Sir Edward Grey is well known for a
single quote: The lamps are going out all over
Europe, we shall not see them lit again in our
lifetime. It was August 1914, and the conflict
that would come to be known as the Great War
was about to envelop Europe in darkness for the
following four years.
Parallels can, of course, be drawn between the
above and todays investment environment in
Europe should investors pull their capital out
of Europe on the basis that fighting against
a headwind of economic Armageddon is an
56 towerswatson.com
impossibility or does this environment provide a

tailwind for high-quality managers operating in
certain niches? Time will tell but, encouragingly,
Sir Edward was ultimately proved wrong the
lamps were lit again within his lifetime.
Faced with seemingly endless macroeconomic
uncertainty, private markets managers operating
in Europe face a tough challenge to steer
existing portfolios through the uncertainty while
simultaneously identifying new opportunities to put
capital successfully to work. In this section, we
review the private markets opportunity set across
Europe and identify areas that we believe are well
positioned to benefit despite (or because of) the
ongoing turmoil and those to avoid.
Differing country dynamics

Europe possesses a variety of cultural, legal,
environmental and economic conditions that
provide for a variety of different opportunities
and risks. The private markets landscape in each
European country is unique and some select
European markets are explored briefly below.
In the UK, the quality and experience of private
markets firms are strong, with a number of private
equity and real estate managers in particular
demonstrating long-term and successful track
records. The country was an early adopter of the
infrastructure privatisation model, which has been
culturally accepted, meaning that much of its
infrastructure is held in private hands. For these
reasons, private markets are very competitive,
with a large number of experienced intermediaries
ranging from bulge bracket and boutique
investment banks to a variety of real estate agents
helping to price test practically every transaction.
In France, the private equity market is laser-focused
on the mid-market and it is common for a business
to be bought and sold between private equity firms
two to three times (or more). Infrastructure is a
developing industry in France, where the country
has been a slower adopter of private infrastructure.
However, this is now changing and projects are
developing in social infrastructure while privatisation
of the state-owned regional airports is mooted.
In Germany, there has been a historic reticence to
sell infrastructure and real estate assets to foreign
investors. In private equity, while there should
be good opportunities among the Mittelstand
(family-owned small and mid-sized businesses),
the industry has a poor reputation with business
owners. As regards real estate, a combination of

regulated German valuation practices that artificially
smooth valuations and the financial crisis has led
to some real estate assets held by funds to be
overstated relative to their true market value. This
has led to a wave of redemption requests and many
German open-end funds closing as a result; it is
estimated that German open-ended funds with a
combined value of 30 billion have been closed due
to redemptions.
Slow fundraising may signal

future outperformance
Europe is an important region for global private
markets investment on the basis of its size and
appetite from investors. For example, European
real estate is the largest collective real estate
market (at US$4.2 trillion) in the world, followed
by North America at US$3.7 trillion and Asia Pacific
at US$3.4 trillion.
The volume of private markets transactions has
reflected the accessibility to the debt markets in
recent years. In 2010, debt markets provided a
more benign market for deals, with vendor and
purchaser expectations merging. However, the
renewed instability in Europe has put an end to
this increased deal optimism in the near term.
Real estate has followed a similar path (see
Figure 24) to private equity with the exception
that transaction volumes remained robust through
the second half of 2011. Despite the increase
in activity in recent quarters, Figure 24 starkly
demonstrates the difference between current
transaction volumes and deal activity at the
peak of the market in 2007.
billion
Figure 24. European real estate transaction volumes

90
80
70
60
50
40
30
20
10
0
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3
2007
2008
2009
2010
2011
Source: Real Capital Analytics (Q1 2007 to Q3 2011)
Year
Fundraising has seen a similar pattern, with brief

periods of respite in a challenging environment
in recent years. In 2009 and 2010, European
private equity managers raised just 18 billion and
20 billion, respectively, compared with 112 billion
in 2006. It seems most private equity managers
are waiting until the eleventh hour to come back to
market, which might lead to a deluge of fundraising.
This, of course, will increase the likelihood that the
industry will consolidate (albeit slowly) as there is
only so much capital limited partners are willing
to commit in any given year and, combined with
tight investor purse strings, competition for capital
will be fierce. We see any consolidation that takes
place as a positive development for the market as
the removal of unskilled and aggressive market
participants would lead to less competition and
lower purchase price multiples.
Infrastructure and real estate fundraising is
similar. In real estate, funds that have launched
successfully in the period since 2008 have
predominantly been at the core end of the asset
class spectrum (lower risk, lower return). This
supports the view that investors are principally
seeking secure income and capital preservation.
For example, 2009-11 saw 21 core funds and just
six value-add/opportunistic funds successfully
close. We see this more challenging fundraising
backdrop as a positive indicator of future real
estate and infrastructure fund performance.
Pockets of opportunity
While merger and acquisition (M&A) activity has
slowed down, there are pockets where transactions
are occurring. Tight debt markets have made the
mega and even upper mid-market transactions
difficult for all but the most secure of assets,
and only in the smaller lower-mid market areas
have many private markets managers been
consistently completing deals. For private equity
funds, we would expect to see increased deal flow
58 towerswatson.com
in corporate orphans (non-core businesses spun

off by parent companies) and private family-run
businesses. The buy and build strategy is popular,
as are turnarounds, though the latter requires
a differentiated skillset, particularly given the
challenging economic environment. Accordingly,
finding skilled turnaround managers is particularly
important in this environment given the rarity
value of this skill set.
The most compelling European private equity
market is, in our view, the Nordic region. This is
based on the transparency of the market (private
company detailed financials are publicly disclosed),
the availability of proven company management
teams and the prevalence of high-quality private
equity firms with a deeply ingrained operational
investment approach. However, our concern is
that investor appetite for the region has led to
a significant amount of competing capital being
raised in recent years. Also questions on tax have
been raised by government officials.
Given the continued challenges facing European
financial institutions, capital is scarce and lending
criteria are tight. We expect lending against secure
assets in both infrastructure and real estate to
continue to be favoured by banks. Given that the
origins of the current turmoil are liquidity-related, it
is perhaps unsurprising that two traditional owners
of real assets, banks and construction firms, are
both willing sellers of assets at the moment. These
opportunities are particularly abundant in Southern
Europe, with Spanish construction companies
being large holders of infrastructure and real
estate assets.
However, it is not just the economic situation that
is driving opportunities: increasing European
regulation also offers a number of opportunities,
particularly in infrastructure. First, the commitment
of the European Union to increase its renewable
energy usage to 20% by 2020 has resulted in
development opportunities and is also creating a
new stock of infrastructure that can be held by

core infrastructure funds focused on mature assets.
Second, the EU has legislated the unbundling
of energy assets in Europe, meaning that many
integrated utilities are looking to dismantle
their integrated operations. This has created
an opportunity for core infrastructure managers
to purchase stable midstream transmission
or pipeline assets, which can provide good
risk-adjusted returns.
In real estate, we continue to see attractive
opportunities at the core end of the market. In the
UK, super-secure income streams (such as ground
leases) and long-term well-let properties (such
as long-lease strategies), both display attractive
characteristics, including some explicit inflation
linkage. Such strategies have become increasingly
attractive for pension funds when index-linked
bond real yields have been driven into negative
territory. In continental Europe, core balanced-style
funds tend to be much younger and hence have
less diversification in terms of assets held than
their UK counterparts. This is changing though
as international diversification is embraced by
investors. In the Nordic region, an area that has
performed relatively well over the last few years,
there are established core (and to an extent,
long-lease) products. These are becoming
increasingly attractive given the deterioration
in southern Europe.
We also see opportunities in the tier of property
below core. Good secondary real estate,
as we term it, consists of properties that are
fundamentally attractive, but need some asset
management attention to convert them into prime
properties. Currently, we believe these assets
represent good value although considerable care
should be taken with sourcing stock that has high
re-lettability value. There may be potential to
enhance both rental and capital values in a period
when rental growth is likely to remain depressed.
Real estate debt (including mezzanine) is also
of interest given the maturing of pre-crisis debt,
the partial withdrawal of debt by banks and
increasingly tight lending standards. As lending
continues to be constrained in the light of the
pending Basel III requirements and a difficult
economic environment, opportunities will be seized
by managers able to structure and price debt after
thorough analysis of the underlying real estate.
At the opportunistic end of the spectrum, there has

been limited fundraising and deployment activity
in recent years, which might lead to an attractive
supply-demand equation for skilful managers.
Manager ability versus

challenging markets
It is worth emphasising that Europe has a
high-quality private markets manager talent pool
that has demonstrated an ability to generate
alpha through various cycles. For example, vintage
year returns from top-quartile European buyout
managers from 1997-2006 (including more
recent vintage years skews the data since funds
are still investing) show an average net internal
rate of return of 10.7% a good return given the
economic challenges throughout the period. We
are also encouraged by the deep pool of managers
willing and able to take an operational approach
to helping underlying businesses and assets as
opposed to simply using financial engineering to
drive returns. Track record attribution supports the
success of this approach.
Cyclical and secular risks

One of the most prevalent near-term risks for
investment in European private markets is liquidity.
Increasingly scarce and more expensive funding
will be a concern for private markets funds that
have significant capital to refinance. According to
Dealogic, the amount of private equity debt that
requires refinancing between now and 2016, is
around US$420 billion. The extend and pretend
mentality that has been prevalent over the last few
years cannot continue indefinitely. The scale of
the problem can be seen in a UK real estate paper
published by De Montfort University in May 2011,
suggesting there is around 290 billion of debt
secured on UK commercial property of which around
110 billion is due to mature in 2011-13.
There are further economic risks. There remains
the likelihood of extended, anaemic growth in
certain areas of Europe, driven by the liquidity
squeeze and government austerity measures.
More economically-sensitive private markets
strategies such as plain vanilla highly-leveraged
buyouts in cyclical industries would struggle in
such an environment. However, turnaround or real
estate debt strategies should be provided with an
increased supply of opportunities.
Looking beyond the cyclical issues, a secular

change brought about by regulation threatens to
make debt more expensive for longer-term and
illiquid assets. The proposed Basel III regulations,
which increase the capital requirements for banks
lending to private assets, could have a profoundly
negative impact on the way that private markets
assets are financed (particularly in the project
finance markets).
Conclusion skilled and well-resourced

managers to benefit from dislocation
The well-known economic challenges across
Europe have had a significant effect on private
markets investing, with uncertainty and lack
of liquidity leading to reduced fundraising and
M&A activity. While there is not the same level
of paralysis seen immediately after the Lehman
crisis, it still remains a slow market, with investors
decidedly (and understandably) cautious.
However, we believe in the merits of global
diversification, and as such institutional investors
across the world should not ignore the European
private markets. But strategy selection, as ever,
will be crucial. Plain vanilla strategies relying
heavily on leverage are to be considered with
caution, while strategies able to take advantage
of any distress and demonstrate an ability to
turn round businesses and assets and add
genuine operational and strategic value by driving
profitability and/or asset efficiency will generate
60 towerswatson.com
attractive returns, in our view. From a regional

perspective, flexibility is key to navigate these
turbulent economic conditions, so we believe
a high-quality threshold is necessary for
geographically-targeted managers. We believe
the Nordics have some attractive tailwinds,
particularly in private equity and real estate,
while the UK market boasts a pool of high-quality
private equity managers with deep track records
and a potentially attractive dynamic for core real
estate (for example, the existence of long and
upward-only leases). Core infrastructure assets,
if sensibly sourced and structured, will also
provide attractive risk-adjusted returns.
Given that private markets returns are
characterised by a significant spread between
the best and worst performing funds, manager
selection will be critical in building a successful
programme that is able to navigate, and indeed
take advantage of, the current opportunities in
Europe. To use another war metaphor, Baron
Rothschild once famously said: The time to buy
is when theres blood in the streets. He was
referring to a young Napoleon rampaging through
Europe, but we believe this crisis presents similar
opportunities. While there remain questions about
the macroeconomic future of Europe, at a company
or asset level the current market dislocations
provide an attractive entry point for well-resourced
and differentiated private markets managers to
buy high-quality businesses or assets.
Private markets
in the US
Positive trends to trump the negative?

There are many factors that may contribute to
a positive investment environment for private
markets funds in the US in the near to mediumterm. With predictions for a slightly faster growth
rate in 2012 (general consensus of around 2.5%),
corporations many with strong profits and flush
with cash may be encouraged to hire and become
increasingly acquisitive. Furthermore, sectors
such as technology, healthcare and energy are
expected to continue to grow. Consumer spending
has been stronger than expected, US employers
added 1.8 million jobs to their payrolls in 2011, the
unemployment rate fell, the number of Americans
filing initial unemployment claims continues to
decline and inflation apparently remains in check.
At the same time, major economic uncertainties
often delay business and investment decisions.
The weak global macroeconomic environment
makes the US economy susceptible to event
shocks. While declining, the US unemployment

rate remains high by historic standards and
negative job trends are likely to continue in finance,
government and construction. Home foreclosures
and mortgage delinquencies remain high and home
prices continue to decline. A divided Congress
and a potentially bitter presidential race suggest
that little may get done in Washington in 2012,
increasing market uncertainty. Fiscal deficits at
federal and state levels remain a concern and
Americas financial system, while less precarious
than that of Europe, is not strong. In addition,
any significant increase in crude oil prices, which
accounts for nearly 70% of US economic activity,
may erode consumer confidence.
On balance, while the macroeconomic picture
remains mixed and potentially troubling, there
are sufficient positive trends to present private
markets investors with interesting opportunities.
The challenge is finding and implementing them.
Finding opportunities in a challenged

private equity market
The US remains the largest private equity market
globally and offers investors an extremely diverse
fund universe that focuses on different regions,
strategies and asset size. While US private equity
is not immune to global macro factors, and
fundraising remains challenged, we believe there
are significant areas of opportunity that investors
could focus on in the near to medium term.
Risks: longer holding periods and

over-deployment of capital
Fundraising remains challenging, with private equity
funds raising approximately the same amount
of capital in 2011 as in 2010 (approximately
US$90 billion), significantly down from the peak
in 2007 when over US$300 billion was raised.
Market sentiment did improve briefly, with activity
significantly picking up in the second half of 2010
and the first half of 2011, but sentiment changed
rapidly in the second half of 2011 as Europes
woes continued, which led to reduced deal activity
as credit availability deteriorated.
While
US private equity is
not immune to global macro
factors, and fundraising remains
challenged, we believe there are
significant areas of opportunity
that investors could focus on in
the near to medium term.
62 towerswatson.com
Despite this, 2011 saw greater deal activity

than 2010, with US private equity funds deploying
US$180 billion in 2011, the highest amount
since 2008. This, in conjunction with poor
fundraising and higher equity contributions
generally being required in transactions, has
led to callable reserves (dry powder) declining
slightly to around US$50 billion at the end of
2011. There still remains a significant amount
of capital to deploy, though with many of these
US funds raised in the peak years, the total
amount of dry powder may fall significantly
over the next two to three years as investment
periods end and can no longer be extended.
This need to deploy capital prior to investment

periods ending (in order to generate fees on it
after the end of the investment period) may explain
one of our primary concerns in the current US
buyout market that purchase price multiples have
become elevated and are around the peak levels
seen in 2007 (approximately 9.3 times EBIDTA
on average). It may also explain why the spread
of entry multiples between larger and smaller
deals, at over 10 times EBIDTA for deals over
US$250 million enterprise value (EV) versus six
times EBIDTA for deals below US$250 million EV,
is at its widest since 2000, as most of the capital
overhang resides with the largest private equity
funds. A further point potentially increasing pricing
pressure is that global firms are focusing most
of their attention on the US given the uncertainty
in Europe.
suggest that a US private equity portfolio should

be comprised solely of specialist investments.
However, the bar for generalist firms has risen and
firms should be able to demonstrate meaningful
evolution in how they identify opportunities in a
more competitive and lower-growth landscape.
The following themes represent a sample of the
areas we believe to be interesting in the near to
medium term:
Following the crisis of 2008, many private equity

managers in the US were forced to address
difficulties in their existing portfolio companies,
ensuring that these businesses had access to
sufficient debt capital and improving their efficiency
in areas such as logistics and lean manufacturing.
Amid slower growth, volatile markets, the sovereign
crisis in Europe, a potential hard landing in China
and commodity inflation, these factors alone are
unlikely to drive meaningful earnings growth in the
near to medium term.
Healthcare spending in the US is coming under

increasing scrutiny due to an ageing population
and strained state and federal budgets.
Business models predicated on increased
utilisation and cost reduction are most likely to
benefit from these trends. Other opportunities
related to the broader theme of an ageing
population include care home provision and
changing consumption patterns.
There is a drive to improve operating efficiency,
for which technology will play a significant
role. This includes cloud computing, software
as a service (SaaS) and managing big data
(using technology to acquire, manage and
analyse the ever-expanding amount of data
that businesses and governments collect).
Related to this are opportunities in online
security and technology infrastructure.
US businesses selling specialised products,
particularly those with strong branding and
precision engineering, are likely to benefit from
increased wealth in the emerging world. It is also
likely that emerging market businesses, with
increased capital to spend, will look to expand
their presence in the US through acquisitions.
There continue to be opportunities resulting
from the financial crisis. These include:
purchasing distressed financial assets,
such as non-performing loans; purchasing
non-core assets from financial institutions;
gaining exposure to distressed industries
at what appear to be cyclical lows, such as
those related to real estate. However, as not
all areas of distress are likely to see activity
return to pre-crisis levels in the near to medium
term, caution and downside protection are
essential in executing these strategies.
We believe the private equity firms best placed to

succeed should either have deep knowledge of one
(or a select group) of industries or possess the
functional and strategic expertise to help portfolio
companies increase top-line growth (or both).
Managers should, in general, be more focused
on identifying attractive themes and be able to
draw upon their knowledge of the opportunities
and threats in emerging markets. This is not to
These themes form the basis of our proposition

to build a private equity portfolio comprised
of managers that are willing and have the
resources to take on corporate transformation,
product innovation, international marketing, sales
force effectiveness and geographic expansion.
These initiatives are key to driving earnings through
topline growth in a slow-growth world and thus
delivering alpha to investors.
Some firms are increasing holding periods. Where

holding companies and portfolios are under water,
the general partners (GPs) have a low probability
of earning carried interest, incentivising them to
hold on to portfolio companies in the hope that
markets rebound to pre-crisis levels. An indication
of GPs holding an excessive number of companies
is evidenced in the increased median holding
period from purchase to exit, which climbed from
a low of 3.6 years in 2007 to 4.8 years at the end
of September 2011. With public markets volatile
and an uncertain macroeconomic environment, the
exit environment may not improve for some time,
further increasing the average holding period.
Finding opportunities in a
low-growth environment
Real estate improving performance

In 2012, US commercial real estate as well as
new and recent value-add and opportunistic
investments should provide attractive yields
and returns relative to risk-free rates. Except for
apartments, new construction is limited and market
fundamentals are stable or improving. Apartment
rents continue to rise, certain office markets such
as the San Francisco Bay Area have seen rent
growth, business and luxury hotels experienced
improved performance driven in part by increasing
room rates, and high-end malls exhibit strong
occupancy. The recovery may not be robust,
but the cycle does appear to have bottomed.
Constraints on fundraising and debt

Global private equity real estate fundraising for
2011 appears to be at its lowest level since
2003, with a roughly 80% decrease from the
peak fundraising activities in 2007, according
to Preqin. There are currently 449 funds being
marketed, seeking US$154 billion in capital
commitments. In addition, US$86 billion of
dry powder is available to invest in US real
estate. Realistically, many funds will not reach
their targets or will not be raised at all.
Despite this, transaction volumes and the
sales pipeline early in 2011 were strong, with
property offerings at the highest level since
2008 as owners tried to take advantage of solid
demand, particularly for stabilised offices and
apartments. Deal flow, however, could be limited
in the future due to uncertainty in pricing, a more
stringent lending environment and debt capital
being in short supply, as hundreds of billions of
troubled mortgages reach their terms and require
refinancing. Activity in the Commercial Mortgage
Backed Securities markets remains muted too.
Additionally, maturing mortgage debt is mounting
with more than US$1.5 trillion coming due between
now and 2015. Lenders have been playing pretend
and extend as they lengthen loans to buy time
rather than pursue foreclosures and take
mark-to-market losses. According to Trepp,
approximately US$250-300 billion of maturing
loans were rolled over each year in 2009 and
64 towerswatson.com
2010. Other lenders plan to foreclose and

dispose. The gamesmanship is likely to continue
for a few more years, but borrowers who overpaid
for properties and compounded the issue by
overleveraging will rarely recoup any of their equity.
Prime market firm, but secondary

market softens
Investing in property is currently a tale of two
markets. In primary markets, pricing for well-leased
properties and trophy assets with credit-worthy
tenants and reliable cash flow approaches or
exceeds its prior peak in most top metropolitan
areas across all property types. Unless the
European sovereign debt and banking crisis
escalates, attractive financing should remain
available. Conversely, secondary and tertiary
markets, where pricing had looked more attractive
and capital had begun to flow, have seen a pullback
in interest due to investor risk aversion, the lower
availability of financing and less liquidity at exit.
Investors had begun migrating to these markets
to capture higher yields, but the weaker economic
outlook, greater uncertainties, and recent capital
markets turmoil may curtail these capital flows.
Occupancy rates look to have recovered in
apartments and are improving slowly in industrial
and office, with retail occupancy stable. Rents
have recovered in multi-family, have stabilised
or improved in some office markets, but remain
near cyclical lows in other office locations as well
as industrial and most retail properties, and may
not recover to prior peaks until 2016. Industrial
properties have shown positive net absorption and
retail is generally bifurcated with necessity and
high-end retailers doing well, while others face
pressure. Hotel RevPAR (Revenue Per Available
Room) has not recovered to peak numbers, but
performance has been strengthening and is
strongest in luxury and upscale properties.
Conversely, projections for a robust recovery
in commercial real estate were scaled back in
the latter half of 2011 and near-term demand
growth is expected to be tepid at best. The weak
development pipeline across nearly all segments
and markets should, however, lead to a recovery
in the medium term.
A range of strategies offer promise

So what does all this mean in terms of
opportunities? Core spreads remain attractive
relative to fixed income alternatives, especially if
properties can be acquired in markets such as
gateway cities where income growth and the
potential for capital appreciation exist. Other core
markets, however, look fully priced as they benefited
from the yield trade (fund managers reported a 7.9%
discount rate based on an unlevered 10-year return
projection from growth and income as of Q3 2011)
and cap rate compression. It is uncertain whether
underlying NOI growth will compensate for limited
future cap rate growth.
With many existing apartment assets priced
at sub-5% cap rates and IRRs below 7%,
development provides better risk-adjusted returns
in many markets. Projects started early in the
cycle will enjoy lower construction costs and
stronger leasing activity. With the supply pipeline
building, the discipline to sell assets in markets
without meaningful supply constraints is critical.
Conservative investors should focus on apartment
transactions in infill and well-located areas.
Central business district (CBD) office repositioning
in strong markets is also potentially interesting,
particularly medical office buildings and targeted
transactions near major healthcare centres. While
a solid near-term recovery in office markets is
unlikely, the outlook is more favourable two to three
years out. Contrarian investors may find attractive
opportunities in non-trophy offices in technology
centres (such as Seattle, San Francisco, Austin
and Portland).
Grocery-anchored retail with strong tenants may
also provide opportunities, although leverage
levels are high based on current valuations.
As valuations and bank balance sheets recover
and lenders are less inclined to extend underwater
loans, recapitalisations will provide investment
opportunities too. Low interest rates provide
significant spreads for mezzanine and preferred
equity investors, who can do deals with motivated
borrowers, participate in future upside and may
also have control over strategy and realisations.
Purchasing debt at a discount to get to the
equity may be todays best arbitrage opportunity.
Increasing prospects also exist for providers of
high-yield debt gap financing based on current
property valuations, where positions in the 60-80%
portion of the adjusted value capital stack can
generate high returns and also provide a measure
of risk protection through the junior equity tranche.
Finally, we discuss US REITs, which hold some

of the best real estate assets. While proceeds
from earlier stock sales were used mainly to
restructure balance sheets and reduce debt,
proceeds from recent sales, combined with strong
access to capital during the first half of 2011,
will permit them to continue to acquire property
which is financed at low interest rates. However,
REITs potential for growth may be diminished
due to the limited availability of high-quality
product. While dividend yields are high in relation
to Treasuries and other bond products, pricing at
the end of 2011 appears full in relation to asset
values. An investors best approach may be to
buy and hold the best companies through market
ups and downs, collecting the dividends and
opportunistically purchasing more on the dips.
US infrastructure in need of
private investment
Ageing infrastructure in the United States is less
discussed in the investment community than it
should be. Heavy investments were made decades
ago and have facilitated economic development
ever since. However, experts, including the World
Banks chief economist Justin Lin, largely agree
there has been significant under-investment over
time, meaning the US now requires large capital
investment to both upgrade existing assets and
finance new developments. The consequences
of not doing so are clear: infrastructure-related
failures include the Minneapolis I-35W bridge
collapse, the levees breach in New Orleans and
the Northeast electricity blackout.
The American Society of Civil Engineers grades US
infrastructure as a D.21 The breakdown provides a
pretty dire picture for those looking for a quick fix,
such as targeting areas which have Cs and Ds
across the board. While the Societys estimated
five-year investment requirement may look like
overkill at US$2.2 trillion (primarily due to the
fact that the estimate looks at repair cost of
all existing assets), it may not be too far off
if the US wants to keep up with economic and
population growth.22 Take New York City; in 2010,
the comptrollers office stated that 40% of the
roads and bridges were substandard or obsolete,
despite the state having already allocated
US$63 billion to transportation infrastructure
over the past decade.
Lack of clear leadership

impeding renewal
Public sector officials surveyed in a 2009
KPMG study saw a lack of funding as a principal
issue even after President Obama had made
infrastructure investment one of his administrations
top three win the future initiatives.23 More recently,
the National Infrastructure Development Bank Act
of 2011 demonstrated a renewed effort by the
government to advance President Obamas initiative,
but with the banks expected capitalisation at only
US$25 billion and the banks shelf life of just 15
years, it represents too little to address the issue.24
Why is it so difficult for the government to do
anything about infrastructure? Well, public
resistance to higher taxes or user fees fuels
a partisan debate over the federal and state
governments borrowings. For example, Congress
has long refused to raise federal gasoline tax or
allow states to collect higher tolls on interstate
highways, which cuts off potential sources of
funding for repair and maintenance projects and
alternative transportation modes. Projects such as
a regional high-speed passenger rail system, a new
electric grid tied to energy-saving technologies,
and a GPS-guided traffic control system for aviation
are being delayed, cut back, or even shelved.
Managers are also focusing on emerging

opportunities, such as shale gas extraction.
Environmental services, including renewable
energy and waste management, have also been
gaining traction, with the increased corporate
focus on environmental stewardship and the
long-term nature of these energy contracts
supporting cash flow.
Some argue, however, that the area of most urgent
need is water infrastructure. The American Society
of Civil Engineers has produced a rating of D-
for both drinking and waste water but it has received
little attention from policymakers, with only
US$10 billion of the total US$787 billion stimulus
programme allotted to drinking and wastewater
projects.27 This compares to projections by the
Environmental Protection Agency that some
US$334 billion is needed for investments over
the next 20 years just to ensure the provision
of safe water.28
The problem facing US infrastructure is too large

for any single entity to deal with and requires a
very long-term horizon. Some of the medium term
developments needed in the US infrastructure
space are:
We have also seen positive sentiment toward PPP

investment structures, and while these have been
concentrated in transport assets in the past, the
Long Beach Courthouse project represents the first
social PPP project in the US. Some states have
shown increasing interest in seeking private capital
for PPP projects, including California, Colorado,
Arizona, Texas, Georgia, Florida, Illinois, Michigan,
New York, Virginia and Ohio. With the majority of
funds focused on investing in traditional brownfield
assets and energy-related investments, there is
still a large financing gap for new developments
across all other areas of US infrastructure.
The development of a national infrastructure

plan like other developed nations.
Prioritisation of repairs and maintenance for
high-impact assets.
E xpansion of funding sources through initiatives
such as public-private partnerships (PPP).25
To address the lack of government funds, the US

is exploring the creation of an infrastructure bank
and how to foster deeper collaboration between the
public and private sector. Investors should continue
to monitor these developments as they may throw
up some interesting investment opportunities.
Opportunities for private capital
Conclusion deep market, deep skills
The US infrastructure fund universe is small

relative to the size of the country and the economy,
with US$89.6 billion raised by 65 funds from 2000
to 2011 for North America-focused strategies.26
But we see fund managers increasingly interested
in infrastructure investing, with the biggest focus
being energy infrastructure, such as pipelines,
storage and other midstream activities.
Despite the US facing some significant

challenges, not least in fundraising and an
uncertain macroeconomic environment, we
believe there are a number of opportunities
that warrant private markets investors attention.
The US is still the single deepest market, with
the broadest set of highly-skilled private markets
managers. However, it is more important than
ever for investors to focus on strategies or
markets benefiting from attractive trends and
on managers that have the skills necessary to
operate in a challenging market environment.
66 towerswatson.com
Private markets
in China
Despite the prospect of a potential hard landing for the

Chinese economy, the fundamental drivers that pushed
China into the spotlight of international investors
remain largely intact, including a strong trend towards
urbanisation and an expanding middle class, both of
which are likely to drive domestic consumption.
Furthermore, the Chinese government has demonstrated its commitment
and ability to adjust its policies armed with the worlds largest fiscal
surplus to promote stable economic growth. This has led to China
becoming a key destination for private markets capital within Asia, both
in terms of funds raised and investments made, a development that we
believe is likely to continue.
Dynamic but immature private markets

Private equity investment in China has a relatively
short history. Although some China-focused private
equity funds emerged in the 1990s, there were few
opportunities to invest private capital in an economy
that remained state-dominated. A step-change
in the Chinese private equity industry occurred
in the middle of the last decade, with increased
government support for the sector coinciding with
an abundance of liquidity globally and the increased
attention of international investors attracted by
news of successful exits and attractive returns.
Private equity activity has accelerated since then
and over US$28 billion was invested in 2011,
more than in any other Asian country. The number
of fund managers operating in China is now
estimated at over 1,000 and this is expected to
increase with the participation of non-traditional
investors in the private equity space, including
domestic insurance companies, which are seeing
their restrictions loosened.
There are, however, real risks. The Chinese
regulatory environment for private equity investment
is rapidly evolving. Most notably, policies have
been promulgated to support the development of
local RMB (Renminbi currency) funds, which some
would argue have been to the detriment of offshore
investors. Foreign investors are often frustrated
by Chinas foreign exchange control regime and
by the countrys continued restriction on foreign
investment in certain industries. The increased
68 towerswatson.com
number of local funds as well as increasing dollardenominated fund sizes appear to be leading to
heightened competition for private equity deals,
culminating in higher transaction prices and more
modest return expectations.
It also remains difficult to both close and exit a
deal. Many governmental agencies are involved
in approving investments and differing policies
may be applied at the local and national levels.
Exits by public offering on Chinas domestic
stock exchanges also remain tightly controlled
by government regulators who pursue policies
that are not always transparent to investors.
Furthermore, the private equity industry in China
is quite young, meaning it lacks the history and
depth of track records of private equity teams
operating in developed markets. Manager selection
is therefore likely to be more critical in this market
than in developed markets.
Private equity the optimal way to play

emerging wealth theme
Despite these risks, there is a significant breadth
of opportunities due to the pace of development
in China, including in agriculture, healthcare,
consumption, improving efficiency in the supply
chain and a move towards higher-end manufacturing
to serve a growing domestic consumer market.
These opportunities all form part of the emerging
wealth theme that we believe is most interesting
to investors in the region. As public markets in
China are not deep and tend to be biased

towards industries such as financial institutions
and capital goods, private equity provides an
attractive way to access the sectors that are
most likely to benefit from this emerging wealth
trend. There are two strategies in particular that
we believe investors should consider, namely
State-Owned Enterprise (SOE) restructuring and
growth capital.
SOE restructuring has been one of the main
strategies driving the domestic private equity
industry in recent years. This is unsurprising since
Chinese SOEs operate in a wide range of industries
and are estimated to account for 60% of national
revenue.29 SOEs vary tremendously in terms of
profitability, providing plenty of opportunity for cost
efficiency improvements and strategies to drive
topline growth. There is also government support
for bringing in external expertise, although deals
are often dominated by domestic players with
existing relationships with government officials.
We are seeing more non-domestic private equity
firms team up with local governments in the hope
of accessing more of these opportunities, which
makes sense as global firms are often better
placed to assist SOEs in expanding abroad and
meeting global standards.
Aside from SOEs, there are thousands of
established private businesses that are either
having difficulty obtaining financing and therefore
require capital, or would like external expertise to
help them expand, restructure and/or meet global
best practices. This presents a large opportunity

set for private equity firms willing to provide growth
capital. These businesses tend to be at the earlier
stage of their lifecycle and are often operating in
fragmented industries, providing opportunities for
investors to benefit from increased consumption
and industry consolidation.
The downside of these strategies, however, is that
they almost always involve taking minority stakes,
not least because foreign ownership cannot exceed
25% of total equity for a company to be treated as
domestic for listing purposes, which is often the
ultimate goal of the fund (all dollar-denominated
funds are considered to be foreign owners). In
addition, private equity firms are usually dealing
with first generation entrepreneurs who are often
not willing to cede control at a time of rapid growth.
Minority control is not ideal for a private equity firm
that is likely to have strong views on how to grow
the business.
To mitigate the risks, we believe investors should
focus on managers that are able to structure a
transaction with downside protection, in particular
using enforceable negative control rights.
Managers must also demonstrate meaningful
evolution in how they source transactions and help
portfolio companies grow. It is unlikely that the
returns generated in the mid-2000s will be easily
replicable. Therefore, the most successful private
equity firms will be those that meet global best
practice standards.
Real estate Chinese slowdown

well planned
In the short to medium term, we believe that Chinas
real estate market is likely to face some challenges.
After a round of home purchase restrictions and
loan tightening measures instigated by the central
government in 2010 and 2011 to cool the property
market, property prices have started falling and
transaction volumes of residential units have slowed or
stopped in some towns and cities. Some of the hardest
hit are new homeowners who, after placing a deposit
on a yet-to-be-completed development, have seen the
prices offered by the developers to new buyers reduced
by up to 20%. This reduces the resale value of their
homes overnight. The fallout also affects brokers and
agents, who have suffered numerous redundancies as
home sales have slowed.
Other market participants that have been impacted
include development companies and local
governments. Property developers are starting to feel
liquidity pressures and in order to manage cash flows,
are looking to slow down projects and reduce land
holdings on their books. Some small to medium-size
developers are facing the prospect of bankruptcy as
loans fall through and financing becomes sparse.
But the least talked-about impact is on local
government revenues: in some municipalities land
sales have contributed about one-third of revenues.
This slowdown in China has been a conscious choice
by the central government. Therefore, tightening
policies can easily be removed. The governments
intention is not to damp Chinas longer-term
economic growth, but rather to control the risks
of an out-of-control property market. So far, the
government has remained steadfast, but many
commentators believe that recent actions suggest
some easing of the measures in 2012.
70 towerswatson.com
After
a round of home
purchase restrictions and
loan tightening measures
instigated by the central
government in 2010 and
2011 to cool the property
market, property prices
have started falling and
transaction volumes of
residential units have
slowed or stopped in
some towns and cities.
Repricing is positive for new capital

While the short-term outlook is potentially
troubled, the medium to long-term outlook is more
promising. Apart from the strong urbanisation and
wealth factors which will continue to apply upward
pressure on the market, the government can
stimulate the property market when it judges that
it has re-priced adequately.
non-Chinese investors, with foreign investors only

allowed to enter the Chinese market if domestic
companies do not have the technical expertise
and even then generally only through minority
stakes in joint ventures with domestic companies.
These very high barriers to entry for foreign
investors mean that Chinese companies
have been able to reap the full benefits of the
governments economic stimulus package so far.
In addition, insurance companies and local

REITs have not meaningfully entered the real
estate market. Given the scale of potential
investment from these investors as evidenced
in more mature real estate markets it is a fair
expectation that the impact on Chinas market
will be similarly positive. Chinese insurers alone
could create demand for over five times the current
total investable real estate stock. Similarly, the
benefit of REITs can be seen from the impact on
the Japanese market after the entry of JREITs in
2000. These are strong drivers over which the
government has control.
There are, however, likely to be significant

opportunities for investors as infrastructure
development remains one of the three key focus
areas of Chinas latest five-year economic plan.
China continues to place significant emphasis
on the development of transportation and energy
infrastructure, which is designed to gradually
move the economy away from a reliance on
manufacturing for export and towards production
for local demand. This is an important development
as it encourages domestic consumption,
develops the service sector and shifts production
towards more value-added manufacturing.
The recent tightening measures have resulted

in the retreat of many speculators. A lot of
companies whose core business is not real estate
are now exiting or selling down their property
exposure. Speculators who were buying second
and third homes in order to flip them at higher
prices have been restricted through changing
bank lending policies. In some cities, banks do
not offer mortgages at all to third home buyers.
For developers looking to build land holdings
to sell on or develop in conjunction with other
parties, the lack of financing has made this
strategy unviable, leaving land auctions less
competitive. These factors should improve
the pricing significantly for new capital.
The exit of some of these speculative players has
provided a more level playing field for participants
with stronger ties to real estate and with longer
investment horizons. It is also likely that investors
will see increased opportunities to acquire assets
from distressed vendors at attractive prices over the
next year as financing constraints fully feed through.
Infrastructure domestic-only
investment policy
Chinas infrastructure market is dominated by
state-owned enterprises. Although relatively young
compared with infrastructure firms in developed
markets, these companies have grown rapidly in
tandem with Chinas economy. They have also
benefited from the governments mistrust of
The case for infrastructure in China

China has large latent demand for transport
and energy which means that demand exceeds
supply in most areas. Given Chinas position
as the worlds biggest creditor, the chances of
achieving the broad objectives of the five-year plan
appear high. From an infrastructure investors
perspective, China is perfectly capable of funding
its large-scale infrastructure requirements on
its own. So the main opportunities for investors
are likely to be via provincial and municipal
governments that have infrastructure development
requirements in excess of their available funding.
As with private equity, however, certain segments
of the market are not accessible to foreign capital.
It is therefore important that an investor picks
their market segments carefully.
The electricity power generation and transmission
sectors are largely dominated by state-owned
companies and there will be little opportunity
for foreign investors to enter this sector over the
medium to long term. However, as part of the
current five-year plan, China intends to reduce
energy consumption and develop cleaner energy
sources. It is anticipated that nuclear power
and hydro will play a large role in this. Other
forms of renewable energy such as solar and
hydro-generation are also expected to receive
a significant boost and may represent the best
opportunities for foreign investment.
In the transportation segment, ports and

passenger rail are dominated by large
state-owned domestic companies with little
opportunity for foreign investors to participate.
Additionally, toll roads are dominated by
large domestic toll road companies. However,
freight rail is gradually opening up and could
be incorporated as part of an overall logistics
strategy. Airports are, in our view, the most
attractive area for foreign investors interested in
a burgeoning transport market. Air transportation
currently accounts for just 1% of domestic
passenger transportation in China and has been
growing at double-digit rates. The international
airports of Shanghai and Beijing will remain
in public hands, but provincial governments
are tasked with developing 100 or more new
airports and upgrading 67 existing airports
to cater for the expansion of regional and
international travel. While high-speed rail will
provide competition on major routes, significant
opportunities remain in the rest of the country
and are open to foreign investment.
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Improvements in urban infrastructure are also

expected given the significant number of people
that are expected to migrate to the big cities over
the next five years. However, it is unclear what
role foreign investors can play in this. Finally,
the telecommunications sector is dominated by
state-owned companies and there is no prospect
of breaking the states grip on this sector.
Conclusion get to know the risks

Private markets investments should provide an
attractive way to benefit from trends such as
increased domestic consumption of goods and
services, greater demand for transportation and
rising urbanisation. The risks include a manager
universe that is much less developed than in the
US and Europe, but potentially as competitive, a
regulatory environment that is fast evolving and
restrictions on foreign capital in certain parts of
the economy. Despite this, if investors devote
the time and resources to get comfortable
with these risks, China should provide plenty
of attractive opportunities for private markets
capital. Manager selection, as ever, is critical.
Brazil
is investors attention justified?
Historically, private markets investing was dominated by
developed markets like the US and Europe. Over recent years,
this trend has started to change with emerging markets
namely three of the BRIC countries (Brazil, India and China)
starting to move to centre stage.
While China has gained much of the attention,
Brazil has become popular too, as demonstrated
by the record amount of private equity capital
raised in the country. In this section, we will
explore whether Brazils rise in the affections
of private markets investors is warranted.
since a high percentage of its economic growth

is driven by internal consumption. However, 2011
GDP growth results show that Brazil is not totally
insulated from external events. Brazils GDP fell
from 7.5% in 2010 to 2.7% in 2011. Expectations
for 2012 are only 3.4%.31
Strong growth starting to slow
Record fundraising in 2011
The favourable macro trends in Brazil are familiar

to most investors but lets drill down to some of the
catalysts over the last decade. Former Presidents
Lula da Silva and Fernando Henrique Cardoso paved
the way towards modernising Brazil, where inflation
has been lowered to a stable rate of around 6.5%
and a larger consumer class has been created with
an additional 29 million people. It has changed from
being a net debtor nation to a creditor one with
US$350 billion in foreign reserves, while achieving
a 3.3% public sector surplus.30 Brazil is now rated
as investment grade by all the major credit rating
agencies. Further growth is likely considering that
61% of its population is under 35 and mostly lives
in cities.
Private equity in Brazil is still a relatively nascent

asset class, although the market has been growing
rapidly in line with economic expansion and investor
appetite. Part of the reason for the historical slow
growth of the asset class was restrictions on local
public pension funds from investing in illiquid
securities. In addition, high interest rates in the
1990s meant that many large pension funds only
had to invest in Brazilian treasuries to get their
required rates of return. However, in the mid-2000s
the government encouraged public pension funds
to invest in higher-risk asset classes in order to
inject more capital into the private sector. The
decrease in nominal interest rates also forced
pension funds to look for higher returns outside
bonds and gave private equity managers access to
less expensive debt for deals.
Like some other emerging markets, the country

is somewhat insulated from global recession,
The market has been dominated by local players

with only opportunistic investing from larger
international players. However, over the last
few years that has changed, with local firms
raising much larger funds and global firms
(Carlyle, Blackstone, 3i and Warburg Pincus to
name a few) opening offices or partnering with
local firms. As a result, 2011 was a record year
of fundraising for Brazilian-based funds with
successive closings over a billion dollars.
For example, Gavea raised US$1.8 billion for
its fourth fund making it the largest fund ever
raised in Brazil, and BTG Pactual, Patria and
Vinci also raised funds above US$1 billion.
Why Brazilian private equity?

Brazilian private equity attracts investors on the
basis of strong consumer growth prospects as
well as the wider growth story. The Brazilian
middle class has grown from 38% of the
population in 2003 to 51% in 2009.32 Moreover,
private equity is in a great position to tap into
this middle class consumer growth theme as the
public market is skewed towards commodities.
Currency, debt and regulatory risks

While we applaud the successful fundraisings
by Brazil private equity managers, the volumes
have become risks in themselves and are
perhaps evidence of overheating. Some funds
have raised large amounts of capital with
little or no track record. The ability to access
top-quality companies at attractive purchase
multiples is likely to decline, especially as private
equity managers increase their target deal size.
74 towerswatson.com
Although there are buyout deals with enterprise

values greater than US$300 million, typical deal
sizes have been mostly below US$100 million
so far.
Given the historic high levels of interest rates,
leverage is not something that Brazilian private
equity managers could freely tap. The state
development bank, BNDES, provides financing for
projects and large businesses, but its investment
goals do not fit those of typical private equity
investments. Therefore, there is a ceiling to
the size of businesses private equity firms can
buy. This makes Brazil more of a growth equity
market rather than a leveraged buyout one.
This means private equity managers will usually
not have control and in an emerging market
with the accompanying risks, that lack of
control is not ideal.33
Another key risk is currency, as the Brazilian
Real is volatile and some market observers
say it is currently overvalued. The Brazilian real
appreciated by more than 50% between 2005
and 2010 in real terms but depreciated by 19%
between July and September 2011. Inflation is
a further risk: while government officials have
curbed it of late, it still remains high at 6.5%,
above the governments target rate of 4.5%.
Brazils judiciary system is slow and tax evasion
is pervasive amid a convoluted tax structure, in
which there are 19 types of different taxes.34
There is also a tax which applies to foreign
investors that was lowered from 6% to 2% in
January 2011 and then to 0% in December
2011. While a 0% base rate is great for foreign
investors, government decisions can be volatile.
In
contrast to US or European
institutional real estate investment,
residential assets are the main focus
in Brazil and commercial real estate
investment is less established.
Brazilian real estate

Like private equity, Brazil has emerged as a
favourite real estate destination, although the size
of the institutional closed-end real estate market
is smaller than private equity. Many real estate
managers are convinced that now is the time
to invest because the market fundamentals as
well as Brazils secular economic factors are well
aligned to generate good returns.
Real estate still lags private equity

In contrast to US or European institutional real
estate investment, residential assets are the
main focus in Brazil and commercial real estate
investment is less established. Many managers
do, however, have the capability to invest across
real estate types, including industrials, retail and
hospitality assets. The majority of institutional
investment activity has been concentrated in Sao
Paulo and Rio de Janeiro, since these two cities
produce around 45% of the countrys GDP. However,
as pricing in those areas has increased, some
real estate funds are looking to second-tier cities
for opportunities. Leverage is relatively common
for residential investment due to the existence of
government-led project financing schemes. However,
the majority of other real estate investments are
carried out with little or no leverage due to the high
cost of financing.
As with private equity, Brazilian real estate has
historically seen under-investment. The market
has developed with the creation of Brazilian REITs
in the 1990s and the entry of foreign investors in
the 2000s. Between 2005 and 2007 a market for
permanent capital was created with the successful
listing of a dozen local real estate developers. Local
pension schemes remain underweight real estate
relative to the governments target, so they are likely
to seek to increase their commitments and may
also, in time, look to own assets directly, providing
a potential exit route for real estate managers.
Private equity has been key to the development of
this market, with many of the real estate managers
coming from that asset class. Real estate

developers have also launched funds. The number
of funds raised increased significantly in 2011,
although less significantly than in private equity.
According to Preqin, Latin American-focused real
estate fundraising trebled in 2005-07 from
US$1 billion to US$3 billion, before dipping
during the global financial crisis. In 2011, five
Brazil-focused funds raised US$2.3 billion.
During the first three quarters of 2011, Latin
American-focused funds represented 7.9% of
global real estate market share, compared with
just 2% in 2010. The largest private real estate
fund raised in Brazil in 2011 was Prosperitass
US$750 million fund.
Commercial real estate starts to

challenge residential dominance
The residential market exhibits favourable
characteristics for developers. This includes a
pre-sale process which allows the developer to sell
before investing large amounts of capital and to
cancel the project if the pre-sale target is not met.
The developer can then use the buyer payments
from the pre-sale process to fund project costs,
which essentially provides construction financing.
Additionally, the buyer assumes the inflation risk
as prices are adjusted using the construction
inflation index.
The total volume of mortgage loans in Brazil is low
at 5% of GDP, compared with 67% in the US and 9%
in China, meaning the market is less leveraged and
there is room for potential growth.35 Furthermore,
mortgages are not provided for second homes. In
addition, the housing financing market has grown
rapidly from R$6 billion in 2004 to R$80 billion
in 2010.36 The government has introduced a
R$7.6 billion programme called Minha Casa,
Minha Vida (My House, My Life), which subsidises
home purchases for lower-income families. Another
favourable factor is that land value is still a smaller
percentage of overall development cost at around
15% for residential properties compared with more
than 50% in some Asian countries.
The growing number of middle class citizens who

aspire towards home ownership has increased
demand, while supply shortages have been
exacerbated by the lack of affordable housing.
Brazils young population will continue to add to this
growing demand for housing. Currently the official
undersupply figure stands at seven million units.37
These favourable trends also apply outside the
residential sector. Real estate fund managers
note that there is a shortage of good quality office
space needed to support the growing economy.
This is exacerbated by the fact that some older
buildings are in poor condition and will require
capital for refurbishment. Many buildings are
strata titled (owned fractionally, floor-by-floor)
which is a barrier to redeveloping old buildings.
Current vacancy rates in Sao Paulo stand at just
4.2% and in Rio de Janeiro at 3%.38
Although one of the last sectors to receive
attention from institutional real estate investors,
industrial investment is growing and dedicated
funds are starting to appear. The thesis is that
large, multinational corporations based in Brazil
as well as local businesses looking to expand
their footprint are creating demand for grade-A
warehouses. Historically, large corporations and
multinationals have owned their industrial sites
directly, but more recently many industrial quarters
have been converted to other uses and are no
longer suitable.
Retail is another theme benefiting from the
tailwind of the growing middle classes. In addition,
there is significant appetite for hotel development
as Brazil prepares for the Olympics and World Cup.
The government estimates US$556 million will
need to be invested in hotels.39
Growing risks of market saturation

Many of the risks mentioned in the private equity
section also apply to real estate investing, including
macroeconomic risks. However, one specific risk
for Brazilian real estate investors is the changing
market environment and the large inflow of capital.
This is starting to have an impact on pricing, making
the typical return target of over 20% IRR harder to
achieve. Many of the low-cost housing developers
are operating at very low margins with a focus on
volumes. These margins are being pushed down
even further by high levels of wage inflation and
rising production costs. These low-cost developers
suffered during the last global financial crisis and
there is no guarantee that they will not be hurt
again if there is further global economic weakness.
The high-end and mid-income segments of the
real estate market are becoming saturated and
anecdotal evidence is that the sales prices of
homes have risen faster than income, which may
not be sustainable over the long term.
76 towerswatson.com
...one
specific risk for Brazilian

real estate investors is the changing
market environment and the large
inflow of capital. This is starting to
have an impact on pricing, making
the typical return target of over
20% IRR harder to achieve.
With respect to office space, one manager believes that the future rental growth
rates in Sao Paulos office market may decline as the market is becoming saturated,
which could lead to increasing vacancy rates.
As with real estate in other regions, regulatory and permit risks are significant.
Managers also typically depend on local developers to act as joint venture partners.
The local developer will be responsible for obtaining permits and approvals and
will put in a higher percentage of equity capital, thereby aligning its interest with
investors. Although this structure provides access to local knowledge and expertise,
it can introduce another layer of costs and managers will need to have appropriate
controls and monitoring systems.
Brazilian infrastructure
Out of the three main private markets, Brazilian infrastructure is probably the asset
class that has received the least amount of attention from institutional investors.
Ironically enough, we think there are probably the most opportunities in it because
of chronic underinvestment by the government.
Slow development to date

The lack of attention to Brazilian infrastructure is due to a number of factors.
First, infrastructure investment requires a sound sovereign credit rating and
regulatory environment, which was absent during the financial and political turmoil
that consumed the region in the 1980s and 1990s. Second, infrastructure is a
relatively nascent asset class.
Third, the focus has been narrow until recently. Of the limited number of private
infrastructure investments which have taken place to date in Brazil, the majority have
been in the energy sector. This has blurred the distinction between private equity and
infrastructure, a process that has further been demonstrated by the recent raising of
infrastructure funds by private equity specialists. In 2011, Patria raised a US$1.2
billion fund in partnership with Promon SA, while BTG Pactual is raising a US$1.5 billion
infrastructure fund. Although Patria and BTG Pactuals funds are targeting
infrastructure, such as water, sewage, transport and logistics, their track
records have largely been in energy.
Government committed to improving infrastructure

Brazil has historically under-invested in energy, roads, water and sewage systems.
Its dependence on hydro-energy (80% of its energy is produced by hydropower)
meant that the drought in 2001-02 led to an energy shortage crisis during
Fernando Henrique Cardosos presidency and may have contributed to his eventual
replacement by Lula da Silva. The political will for infrastructure investment may have
been strengthened as a result.
Energy shortage is a huge issue in Latin America generally and is becoming more
acute amid a surge in demand due to the rising middle classes in the region. Conduit
Partners, a local infrastructure manager, estimates that the price of electricity in
Latin America is 2-3 times that of the US. In Brazil, Petrobras (the Brazilian national
oil company) has plans to increase capital expenditure and this is also increasing the
need for private capital in the oil and gas sector. Renewable energy is another area
receiving substantial investment; the constant and strong trans-Atlantic trade winds
blowing along the north/north east coastline of Brazil mean wind is a credible source
of alternative energy.
Anyone who has visited Sao Paulo will realise the need for better transport systems
in this fast-growing city. Brazil will need to improve its roads and airports before the
World Cup in 2014 and the Olympic Games in 2016. As recently as 2009, Brazils
airport system was ranked 101st in quality out of 133 countries.40 If the country
wishes to increase its competitiveness in the world, it will need to improve the
transport links between its regions in order to decrease shipping costs. In addition,
the water and sewage systems in the country are in dire need of improvement amid
rapid urbanisation. In 2010, only 42% of the country had access to a sewage system
and only 32% to treated water.41
The Brazilian government is very much aware of

the infrastructure problems facing the country and
has introduced an accelerated growth programme,
known as PAC, to provide capital for infrastructure
projects as well as mortgage lending. Between
2011 and 2014, around R$959 billion is projected
to be invested in PAC 2. The increase in the number
of infrastructure projects means additional financing
from private banks is needed, as the Brazilian
public banks, like BNDES and Banco do Brasil, are
currently the only providers of long-term capital in
the country. Private banks have shorter lending
periods of five years and charge higher interest
rates so are not suited to infrastructure investment.
Risks:
confusing regulation, inexperienced managers
In emerging markets infrastructure, the biggest
risks are sovereign risk, the likelihood of the
counterparty to honour contractual arrangements
and the ability to enforce contractual agreements
through the rule of law. Brazils sovereign credit
rating has improved significantly over recent years.
However, the regulations for certain infrastructure
sub-sectors in Brazil have been confusing and have
deterred institutional investment. There are also
multiple layers of bureaucracy (federal, state and
municipal) which infrastructure managers must
navigate. Strict environmental regulations can
also be a barrier to new developments.
Other risks include principal-agent risk (given that
managers will use local developers), construction
and permitting risk (with greenfield projects) and
selection risk given a universe of managers with
mostly energy investing experience.
78 towerswatson.com
Conclusion infrastructure offers

best opportunities
Over recent years, Brazils attractiveness as a
destination for foreign capital has become evident
across all asset classes. Private equity paved the
way, but real estate and now infrastructure investing
are gaining traction. On a relative value basis,
Brazil looks attractive, particularly as the growth
prospects of Europe and the US look weak. Many
of the macro risks in Brazil have improved. However,
in line with this de-risking, the private equity and, to
a lesser degree, the real estate markets appear to
be overheated. Pricing in private equity is soaring
and in real estate there is oversupply of homes
which people either cannot afford or on which
managers cannot make good returns (such as
residential real estate). Both effects will inevitably
have a negative impact on returns.
In addition, the domestic consumption story has
recently seen a slowdown, showing that Brazil is
not immune to global economic cycles. Brazil made
a V-shaped recovery during 2008-09, but it is not
clear where the economy is heading now, especially
when there is so much more capital to deploy.
Our current stance on Brazilian private equity and
real estate is cautious. We are more bullish on
infrastructure, as this is an area which has been
significantly underinvested and which needs to
increase to match general growth levels.
India
unrivalled macro trends
India is currently the fourth-largest economy in
the world and is predicted to overtake Japan as the
third-largest by 2020. This GDP growth provides a
favourable backdrop for private markets investing.
It supports greater consumption of local goods and
services that benefit private equity. In real estate, GDP
growth has a positive correlation with rental growth.
In infrastructure, the increase in economic activity
has led to the expansion of industry and commerce,
fuelling the demand for more urban infrastructure,
energy and transportation.
In addition, domestic consumption makes up over

55% of Indias GDP. Countries with high reliance
on domestic consumption tend to be a lot more
resilient to global downturns. This strengthens
the case for India as a defensive investment.
In terms of demographics, India is unusual
among large global economies. Whereas most
other countries are struggling with an ageing and
declining working population, Indias is growing
fast. More importantly, the number of people
expected to join the workforce over the next
few decades is some 270 million. To put it in
perspective, this increase is over four times the
total population of the UK and over six times its
working population. As the working population
in India grows and more jobs are created, it is
expected that businesses will demand more office
space. Disposable income will rise as a result of
increases in salaries, meaning Indians will spend
more on clothes, food and beverages thereby
creating investment opportunities for local private
equity (especially growth equity) and retail real
estate investors.
Since 1990, Indias urban population has grown
by over 50% and the urbanisation rate is expected
to reach 40% by 2030. This puts pressure on
the demand for housing. In the top seven Indian
cities, the demand for new homes has grown
to around 1.2 million units per year and this is
expected to increase.
80 towerswatson.com
Not only does India have a growing workforce,

but it also has a relatively deep talent pool. Many
businessmen are Western-educated and speak
English. Further, India is home to some of the
worlds wealthiest entrepreneurs and there exists a
strong entrepreneurial spirit leading to the creation
of new ventures and the expansion of existing
businesses. This, in turn, provides opportunities
for private capital.
The Indian government is paying more attention
to infrastructure. Considerable progress has been
made in the last decade with the development of
telecommunications infrastructure to serve the
IT outsourcing industry. Infrastructure investment
as a percentage of GDP increased from 5% in
2003 to 7% in 2009. Around 30% of the total
investment has come from the private sector.42
Still, most infrastructure remains inadequate with
more roads, airports, ports, railways, water and
electricity supply needed across the country.
According to estimates in the governments
five-year plan, demanded infrastructure investment
will be around US$1 trillion by 2017, rivalling that of
Chinas. The government expects the private sector
to make up 50% of this amount. This level of
capital requirement does not, however, necessarily
equate to attractive investment opportunities.
Risks are strong counter-balance

to positive macro factors
The Indian market has become increasingly
competitive. In private equity, for example,
estimates of the capital waiting to be invested are
put at US$20 billion, which would be enough to
fund all new investments for the next two years if
the investment pace of 2010 were sustained. In
addition to this level of dry powder, there are also
an increasing number of smaller firms entering
the market. During the previous decade, most
private equity firms in India were captive arms of
banks and other multinationals (ICICI and Kotak, to
name two). Over the last few years, the market has
seen the emergence of a number of spin-offs and
independent firms. This competitive environment
for new investments has driven up pricing to
double-digit multiples (enterprise value/EBITDA).
Another challenge facing private equity investors

in India is the flip side of Indias strong
entrepreneurial culture: business founders are
often unwilling to sell their businesses and private
capital is seen as an expensive and restrictive
form of financing. Entrepreneurs often prefer
alternative forms of capital which have less
stringent governance requirements. Coupled with
restrictions on the amount of debt investors can
use, this has led to minority investments being
far more common than buyouts that lead to full
control. In 2010, almost 60% of deals involved
minority positions. Even among the 25 biggest
deals, almost 80% were purchases of minority
interests. This unavoidably leads to heightened
risks for investors given the lack of control and
governance rights. Over 50% of businesses seek
IPOs rather than buyout financing.
5,000
4,500
4,000
25
22
19
20
3,500
16
3,000
2,500
15
13
4,294
2,000
4,272
10
2,993
1,500
2,421
1,000
500
0
Number of funds
US$ millions
Figure 25. Private equity funds raised
2007
2008
2009
2010
Value of total funds raised Number of funds raised by year
0
Year
Source: VCCEdge
7,000
120
108
6,000
5,000
100
87
80
Number of exits
Value US$ millions
Figure 26. Private equity exits 2008-10
4,000
4,589
2,000
37
6,210
40
4,062
2,565
1,000
0
60
51
3,000
2007
2008
2009
Private equity exits value Private equity exits number
20
2010
0
Year
Bain & Company

Another criticism of the market is the lack of realised track records.

The performance of Indian infrastructure funds, for example, is lower
than investors could have expected for the additional country-specific
risk they take. According to Preqin, no Indian infrastructure fund has
achieved a return greater than 1.7 times invested capital (although
the relative immaturity of the dataset should be noted).43
There are few institutional managers with reliable track records in
real estate in India. In addition, the nature of development projects
means that real estate fund managers often need to identify a
reliable joint venture or operating partner to help them source and
develop assets. Often managers will seek downside protection in
the form of a guaranteed return in exchange for foregoing some
of the upside. In the past, investors in Indian real estate also
encountered very long holding periods for real estate investments,
which have been a drag on returns. In other emerging markets,
building construction can be completed in less than three years;
however, it generally takes longer in India due to low labour
efficiency, approval processes and the climate.
The availability of credit can be a hindrance too. There is considerable
dependence on bank credit and project finance, especially for
infrastructure and real estate investing, and it is not clear whether
this will be widely available in the near term. Almost 40% of new
domestic bank lending has been going to infrastructure investments
and, with the new single-sector and single-borrower exposure limits
placed upon banks, refinancing could become an issue in the
medium term.
As is often the case in developing markets, when a significant amount
of domestic capital is competing for an investment, foreign investors
are often precluded from investing. This has been the case in Indian
real estate and infrastructure, but the dynamic is slowly changing as
local firms are increasingly looking to foreign investors for capital and
are making improvements in transparency and risk sharing to attract
such capital.
High inflation is another macro risk for development projects in
real estate and infrastructure as well as growth equity investing in
India. Input costs can vary greatly from the initial underwriting and
margins may be eroded if a suitable buffer for increasing costs is
not maintained.
Other challenges for private markets investors include the continuing
social unrest in parts of India, regulatory hurdles, political red tape
and corruption. This latter is a significant barrier as, for example,
permitting and construction delays on large greenfield projects
could lead to a disastrous outcome for investors.
Conclusion significant implementation challenges

Despite the positive longer-term macro themes, we believe there are
a number of implementation difficulties which make allocating capital
to India challenging in the near term. Although a variety of sectors
have demonstrated impressive growth and India has an ambitious
plan to build up its infrastructure and real estate in order to support
further growth, investors should exercise caution, in our view. Political
red tape and corruption concerns plus information asymmetries are
factors that can significantly impact returns in private markets and
investors need to ensure that their partners are aligned with them in
order to minimise risks.
82 towerswatson.com
The hottest ex-Asia

frontier markets
Focus on sub-Saharan Africa and Turkey
Right now, there appear to be two hot private equity markets falling
under the frontier markets (ex-Asia) banner: Turkey and, to a lesser extent,
sub-Saharan Africa (SSA).44 Central and Eastern Europe (CEE) has also been
considered a hot market in recent years and Western European managers
do cover it opportunistically. However, our view of the CEE market is that, in
general, it offers Western European-type returns with emerging market risk
and volatility not an attractive trade-off. As such, this section will focus
on Turkey and SSA and provides some thoughts on potential next steps for
private equity investors.
Young populations, fast growth

Sub-Saharan Africa
The region has grown at 5.6% a year in the last
decade and boasts six of the 10 fastest-growing
economies in the world. Despite that, inflation has
fallen from around 60% to single digits in most
countries. The continent overall is the second
most-populous in the world and in SSA alone there
are 840 million people. With 40% of the population
under the age of 15, it has attractive long-term
demographics. A middle class is emerging along
with a rise in urbanisation. When talking about
private equity in Africa, most investors focus on
South Africa (which makes up about 50% of the
market); however, Kenya, Nigeria and Ghana are
seeing more activity too.45
Little or no leverage is used in deals outside
South Africa. Most transactions are done in
infrastructure (the recent World Cup was a boost
to this sector), followed by financials, energy,
business services and technology.46 Private
equity managers usually take minority positions
in businesses as management does not want to
relinquish control and is not accustomed to private
equity as an ownership form.
Turkey
Turkey has the sixth-largest GDP in the European
Union and the 17th largest in the world however
its economy is about the size of the state of
Washington in the US. It has undergone aggressive
privatisation, reducing state involvement in basic
industries, banking, transport and communications
and helping GDP to double from 2003 to 2010.
After suffering from a financial crisis in 2001,
it implemented significant reforms as part of a
US$45 billion IMF bailout. The reforms ushered
in an era of strong growth, averaging more than
6% annually until 2008, and helped reduce
inflation to single digits. In addition, the public
sector debt-to-GDP ratio fell below 45%.47 It also
has a young population (median age of 29), which
is growing at 1.5% a year.
The economy, however, continues to be burdened
by a high current account deficit due to its reliance
on imported energy, and unemployment is close
to 11%. Currency volatility is another concern and
its largest trading partner is Europe, which takes
40% of Turkeys exports, but whose own growth
prospects are poor.
Despite these concerns, it is widely accepted that
the Turkish economy has positive tailwinds which
has in turn led to an increase in Turkish private
equity activity. Most deals are in the consumer
and business services sectors. There is little
leverage although banks have been more
accommodating recently by providing senior
credit packages. Most private equity managers
take minority positions in companies.
84 towerswatson.com
Sub-Saharan Africa: a small market

for private equity
The estimated number of deals varies depending
on the data provider, but according to the Emerging
Markets Private Equity Association, there were
50 deals in 2010, worth US$0.6 billion.48
Even at the height of the market in 2007, just
US$3.4 billion was invested so this is a small
market in the context of the global private equity
opportunity set. SSA managers have raised around
US$8 billion-US$10 billion since 2000. Given
the relatively small deal sizes (usually around
US$50 million based on enterprise value),
there is a natural limitation to fund sizes.49
In South Africa, deals can be larger, however.
SSA is still very under-penetrated in terms
of total private equity capital invested as a
percentage of GDP at around 0.1-0.2%. The
largest fund raised to date was US$900 million.
Turkey: lack of deal flow

Despite the media hype around Turkish private
equity, one of the biggest concerns about the
market is the lack of deals. Since 2003, only 110
private equity deals have been completed. Thirty
of those were completed by three local firms
(Turkven, Actera and Private Equity) and just
12 of the 110 were for businesses with enterprise
values of over 100 million. Roughly US$10 billion
has been raised since 2003.50
Competition strong in both regions

Sub-Saharan Africa
In South Africa, competition is strong with some of
the longest-tenured managers like Brait and Ethos
competing for leveraged buyout and growth equity
deals. Overall, there are about 50 private equity
firms operating in the region. Elsewhere in SSA,
competition is less intense for what are mostly
minority stakes in growth companies. Anecdotally,
in South Africa, entry pricing has doubled from

around 4.0-5.0x (enterprise value to EBITDA) in
2004-05 to 8.0-9.0x in 2010. Other parts of Africa
are seeing an increase in pricing as well. However,
on a relative basis, entry multiples are lower
than valuations paid in booming Asian emerging
markets such as China and India, which are usually
in the double digits.
In the past, development finance institutions played
a role in providing capital to target businesses,
but this capital is being slowly replaced by
institutional investors. Some South African
managers have begun to expand their remit to
take advantage of lower competition in places like
Kenya and Nigeria, but have had mixed success
to date, arguably due to the lack of sufficient
local resources. In order to develop a successful
pan-African model, we believe a manager needs
local offices staffed with local personnel.
Turkey
The Turkish private equity market has become
increasingly competitive in the last 18 months
as investors look for alternative destinations for
their capital outside of mainland Europe. In the
large cap space, most deals are sourced through
investment banks, and the managers in this
market tend to be global or pan-European with
one or two locals on the team. Those who have
been active include BC Partners, which completed
a partial exit of Migros, a local retailer, and TPG,
which sold Mey Icki, a local distiller, to Diageo in
2011. In the mid-cap space, there are the likes
of Mid-Europa, Abraaj and local firms Actera and
Turkven (which has migrated into the space after
recently raising much larger funds). We expect
competition to increase in the mid-cap sector
due to this dynamic. In the small-cap space
(funds sub-350 million), where a large proportion
of Turkish companies reside, the most number of
managers, including Private Equity, NBGI and
Mediterra, compete.
Private
equity is still carving out a role within the

financial markets of these frontier economies and,
combined with so few deals having been done, the
media will inevitably pick up on one or two poor
transactions or those that have caused job losses.
This creates potential reputation risk.
Opportunities and risks

The primary reason for investing in emerging
private equity markets such as SSA and Turkey is
to access outsized returns. Like China and India,
SSA and Turkey are exhibiting significant growth
in their consumer classes and private equity can
access that emerging wealth more easily than
other asset classes. Retail, healthcare, financial
services and technology are all benefiting from
increased purchasing power. In addition, a public to
private valuation arbitrage has existed historically
which private equity managers are taking
advantage of at the moment. Lastly, businesses
are in need of professionalisation and private
equity firms are uniquely placed to help with this
and to expand these businesses internationally.
Given their frontier market status, investing in
these regions obviously carries higher risk. For
us, the largest risk pertains to the fact that the
most investments in businesses are minority
positions, so private equity managers have
limited control over management. In a market
86 towerswatson.com
where you are looking to reduce risks (political,

the enforceability of contract law and fraud),
not having the safety net of control over a
business is a considerable obstacle. In addition,
because there are sometimes multiple sets of
accounts (one for tax purposes and one for the
owner) or in some cases no accounts at all,
company due diligence is incredibly difficult.
Private equity is still carving out a role within the
financial markets of these frontier economies and,
combined with so few deals having been done,
the media will inevitably pick up on one or two
poor transactions or those that have caused job
losses. The creates potential reputation risk.
Despite the attractive economic fundamentals,
current valuations in SSA and Turkey are
high based on historical measures which, all
other things being equal, will make it more
challenging to drive good future returns.
Finally, exit markets are not as developed and
management talent pools are not as deep,
though both have improved in the last decade.
Figure 26. Sub-Saharan and Turkey economic growth

SSA
Turkey
2010 GDP
US$1.1 trillion
US$1.1 trillion
2010 GDP Growth
5.0%
9.0%
Population
840 million
74 million
Private Equity as a
percentage of GDP
>0.2%
>0.2%
Number of PE deals in 2010
50
>20
Source: CIA World Factbook, RMB FICC Research Where to invest in Africa
Strategy implementation:
manager skill is critical
Sub-Saharan Africa
As with most emerging markets, opportunities
tend to be focused on the rise of the consumer
with many deals being a play on disposable
income and the expanding middle class.
Infrastructure was the strategy du jour as a result
of the World Cup, but governments appear to be
less supportive of the sector at the moment.
The quality of managers is mixed, though there
are some standouts who have been in the market
almost 20 years. Our view is that in this market
investors need country diversification to mitigate
political risk so we believe the best opportunities
are with managers who can execute a pan-African
strategy. However, as mentioned before, private
equity managers need locals in each office, which
does not always make commercial sense given the
size of each individual market. In addition, there
is a question mark over how much private equity
talent exists to populate these local offices.
Turkey
In Turkey, a handful of high-quality managers have
raised capital recently, although even the most
experienced managers operating in the market have
only been doing so for about 10 years. That said,
with privatisations and second and third-generation
family business owners looking to diversify their
wealth or potentially expand their businesses
internationally, we expect private equity to play
a larger role. Sectors that are popular include
ones buoyed by increasing consumer spend such
as education and healthcare. Two of the more
successful exits have been in retail (Migros) and
alcohol (Mey Icki).
Conclusion: implementation
risks are high
Despite the attractive economic fundamentals,
our view is that investors should continue to
monitor SSA and Turkey, but be cautious about
making any allocations at this stage. While we
believe there are good opportunities available,
our view is that the private equity risks outweigh
potential returns right now and that there could be
better opportunities from a risk-reward perspective
in other more liquid strategies.
Section four
How we can help
Our Delegated Investment Service for

private markets portfolios offers:
A refreshingly holistic approach to private markets, by thinking about the
portfolio as one block of investments. This allows more robust, cross-asset class
comparisons, which leads to a compelling balance between attractive underlying
market betas and best-in-class manager skill.
A thematic angle to portfolio construction by leveraging other specialist
groups within Towers Watson (for example, Asset Research, Global Investment
Committee) to position client portfolios to benefit from attractive global
investment themes that are best played in a private context.
Bespoke construction of a portfolio of best-in-class investments in private equity,
real estate, infrastructure and distressed assets. Our high-conviction portfolios
are constructed to achieve a broad spread of exposure across a mix of asset
classes and return drivers.
Integration with a funds wider investment strategy. We can proactively amend
the structure of the private markets portfolio as the total funds exposures,
requirements and investment objectives change over time. This ensures
efficiency of a funds risk management processes as it avoids managing risks
in asset class silos.
Active negotiations with managers, ensuring that fees are appropriately
structured and offer an attractive net-of-fees value proposition.
Commitment strategy planning via our proprietary Private Markets Pro style
cash flow modelling tool, which ensures that our clients liquidity needs
are well-managed.
Comprehensive reporting which provides detailed performance and risk
attribution, as well as in-depth qualitative research on each of the managers
on the portfolio.
Full implementation, transition management, investment manager agreement
negotiation and provision/signing of all legal documentation. Our service can be
delivered by means of an investment management agreement with you, or under
a power of attorney if desired.
Unrestricted access to our private markets researchers.
88 towerswatson.com
Why partner with us?

We have one of the worlds largest independent
manager research teams, including 40
private markets specialists with experience
spanning direct transactions, fund investing,
management consulting, accounting, banking
and investment consulting.
Our private markets group is able to leverage
the extensive asset class and macro research
resources across our global investment
business, which generates ideas, promotes
debate and enhances the depth and rigour of
our private markets investment judgements.
Our advice is tailored to ensure clients
existing portfolio exposures are considered
and hence we take an integrated approach
to risk management.
We are capacity aware and selective.
Our portfolios invest with a small number
of high-quality managers. We often take a
contrarian approach and proactively avoid
deploying capital in all areas of the market.
Our consulting heritage means we are committed
to a long-term partnership with our clients.
We invest heavily in our specialist quantitative
team whose sole focus is on developing
and maintaining our proprietary quantitative
analysis tools.
Further information
If you would like to discuss any of the areas
covered in more detail, please get in touch with
the consultant who normally advises you at
Towers Watson, or:
Luba Nikulina
Head of Private Markets
+44 20 7227 2559
luba.nikulina@towerswatson.com
Mark Calnan
Head of Private Equity
+44 20 7598 2819
mark.calnan@towerswatson.com
Gregg Disdale
Head of Distressed Investing
+44 20 7227 2558
gregg.disdale@towerswatson.com
Duncan Hale
Head of Infrastructure
+44 20 7227 2993
duncan.hale@towerswatson.com
Paul Jayasingha
Head of Real Estate
+44 1737 284824
paul.jayasingha@towerswatson.com
Notes:
22 http://www.infrastructurereportcard.org/
1 Commonfund Capital, Inc. 2009 Chicago Advisory Committee Meeting
23 The changing face of infrastructure, KPMG
2 To calculate the leverage adjusted return, we used the following calculation. The
managers return on equity multiplier is (100/40=) 2.5. The markets return on equity
multiplier is (100/60=) 1.67. To adjust the managers return to the same leverage level
to that employed in public markets requires first dividing the gross return by (2.5/1.67=)
1.5. The savings implied from a lower debt load then need to be added, and here they
are approximately ((0.6-0.4) x7%=) 1.4%. Therefore the managers gross IRR adjusted
for leverage is ((34%/1.5)+1.4%=) 24%
24 http://www.opencongress.org/bill/112-h402/text
3 The J-curve is used to illustrate the historical tendency of private markets funds to
deliver negative returns in early years due to management fees, transaction costs,
construction and, to a lesser extent, under-performing investments that are identified
early and written down
25 Infrastructure 2011 A Strategic Priority Urban Land Institute and Ernst & Young
26 Source: Preqin
27 http://www.infrastructurereportcard.org/ and http://www.reuters.com/
article/2009/05/08/us-infrastructure-summit-water-idUSTRE5473IG20090508
28 http://www.opencongress.org/bill/112-h402/text
29 National Bureau of Statistics of China (NBS) 2009 dataset
30 Banco Central do Brasil, October 2011
31 Banco Central do Brasil, November 2011
4 Do REITs Behave Like Property or Equity?, Watson Wyatt Limited. May 2009
32 Ministry of Finance, from INSEAD PwC Brazil PE Report 2011, p17
5 Pratt, S. and Grabowski, R. (2008). Cost of Capital: Applications and Examples.

New Jersey: Wiley 3rd edition
33 T he other risks we name below are not just for Brazilian private equity but account for
infrastructure and real estate (especially closed-end funds) too. To avoid repetition,
we have just included them in the private equity section
6 FDIC, Quarterly banking profile, http://www2.fdic.gov/qbp/2011sep/qbp.pdf

7 Renewable energy is a sub-set of the broader clean technology category which
encompasses such segments as venture capital investing in new technologies.
Ultimately, we do not find the risk return profile in the broader clean-tech area
as compelling as the infrastructure approach which has little new technology risk
and a more stable return profile
34 INSEAD PwC Brazil PE Report 2011, p14
8 Food and Agriculture Organisation of United Nations, Agribusiness Handbook, 2007
37 J P, Colliers, IRR Viewpoint, CBRE. From GTIS Brazil Fund II presentation, September 2011
9 Food and Agriculture Organisation of United Nations, World Agriculture:

Towards 2015/2030, Summary report
38 SDI Tellus Real Estate FIP II presentation, June 2011
10 S teward, M., 30 June 2009, Seed capital, Investment & Pensions Europe Magazine,
www.ipe.com/articles/print.php?id=32104
11 F ood and Agriculture Organisation (FAO) of United Nations, FAO Forestry paper:
Global Forest Resource Assessment, 2010
12 US Timberland Investment Management Organisation Timberland Investment Resources,
2011. FLAG Capital Management, 2011
13 Potlatch 10-K filing data 2010
35 JPMorgan, Banco Central, CBIC. From GTIS Brazil Fund II presentation, September 2011
36 A BECIP (Brazilian Association of Home loans and Savings Banks).
From Brookfield presentation, October 2011
39 G overnment estimates. From Brazil 101, The 2011 Country Handbook, JPMorgan,
April 2011, page 22
40 World Economic Forum 2009 Survey
41 Brazil Infrastructure, Special Report, Financial Times, 6 May 2010
42 Hem Securities, Industry Research Report on Indian Infrastructure Sector,
September 2011
43 Preqin (Private Equity Intelligence)
14 The British thermal unit (Btu) is a traditional unit of energy equal to about 1055 Joules,
the amount of energy to heat one pound of water
44 Sub-Saharan Africa is made up of over 46 countries of which South Africa, Nigeria,

Angola, Sudan, Ethiopia, Kenya, Ghana, Tanzania, Cameroon and Uganda are
the 10 largest
15 We emphasise that these are projections and these growth rates might prove
to be aggressive in the case of a prolonged global recession
45 Emerging Markets Private Equity Association
16 According to Preqin (Private Equity Intelligence)

17 Source: SEI
18 Source: UBS
19 Source: Paul Capital
20 Greenberger, 2007
21 http://www.infrastructurereportcard.org/
90 towerswatson.com
46 Ibid
47 CIA World Factbook
48 Emerging Markets Private Equity Association
49 UBS, Investing in sub-Saharan Africa, November 2011
50 As quoted in Private Equity International, September 2011 issue, page 76
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Investing in Private Markets

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Investing in private markets

The right strategy, the right geography,

Investing in private markets

investors would be surprised

Towards better risk-adjusted portfolios

How to identify alpha in private markets

Private markets benchmarking:

How to select the benchmark

Section two Global private markets:

Opportunities in distressed assets

Are mezzanine funds about to

Investing in renewable energy infrastructure

Agriculture a strong investment base case

Timberland a good diversifier

Natural resources strong long-term potential

Investing in secondaries cyclical opportunities 47

Section three Investment themes in

Europe are the lamps going out?

Private markets in the US

Private markets in China

Brazil is investors attention justified?

India unrivalled macro trends

Why partner with us?

Towards better risk-adjusted portfolios

Investing in private markets 5

The variety and number of investment themes

Investing in private markets 7

Why private markets?

Investing in private markets 9

01 Why private markets?

The main reasons why we believe private markets

Taking a holistic approach to

Private markets provide investors with exposure

In deciding how to invest in private markets, many

In summary, we believe that institutional portfolios

How much illiquidity am I able to accept

Constructing holistic private

Beta simple, passive investments

Alpha manager skill is key

As with beta, the alpha portfolio is constructed

Moving with the times:

Investing in private markets 11

01 Why private markets?

Adaptive Portfolio Management focuses on key

Figure 01 illustrates how alpha and beta

Conclusion have a long-term outlook,

Core real estate

Growth equity and buyouts

How to identify alpha

A further adjustment can be made if you believe

The impact of leverage on returns

Investing in private markets 13

01 Why private markets?

On an ex ante basis, measuring leverage can be as

Calculating ex post alpha

While this analysis is simplified and relies on a

Calculating ex ante alpha

Conclusion evaluation of beta and leverage is critical

Figure 02. Private markets fees no beta and leverage adjustment

Central assumption cash flow chart

Gross alpha fee breakdown

Drawdown Gross distribution

Expected total fee Management fee

Return assumption and expected fees (per annum)