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2011 Outlook: Private Equity

Private Equity team In the aftermath of dislocations resulting from the financial crisis, 2010 proved to be
a strong year for private equity investors, as the economy gradually improved, capital
markets rebounded and portfolio companies aggressively cut costs, conserved cash
and reduced debt. In our opinion, the outlook for 2011 remains favorable, given that
deal prices are relatively moderate while portfolio managers are seeking to add value
through operational and strategic improvements, rather than relying predominantly
on financial engineering. In the following pages, we provide a detailed view of the
private equity market and expectations for the coming year.

• Transactions are likely to be prudently leveraged, with operational improvements and
top-line growth driving returns.

• New deal activity in the buyout market should be robust and monetizations of existing
investments should markedly increase via IPOs, recapitalizations and M&A transactions.

• There is an active secondary market for partnership interests in private equity funds
and discounts available are below historical averages.

• Distressed and turnaround managers should continue to find attractive opportunities

among smaller, less liquid credits and complex situations.

• Although some “home runs” are attracting attention, most venture capitalists are likely
to focus on funding capital-efficient business models at reasonable valuations.

• Limited partners will continue to seek — and are expected to obtain — better alignment
of interests and more investor-friendly terms from managers.

As a result of the financial crisis, for the latter part of 2008 and all of 2009, very few new
private equity transactions were completed and portfolio company monetization activity
was minimal. However, the operating performance of existing private-equity portfolio
companies was better than generally expected and investment returns were superior to
public equity benchmarks. Although some of this outperformance can be attributed
to the resistance of some private equity firms to reducing the valuations of portfolio
companies that were affected by deteriorating economic conditions, we believe the
majority of the outperformance was the result of effective cost cutting, cash conservation
and debt reduction. Also, in some of the most troubled situations, private equity firms
were very effective in restructuring weak balance sheets and proactively negotiating with
creditors to address looming financial problems.

2011 Outlook: Private Equity

As the economy has improved, As the economy has improved, there has been an increasing level of monetization activity
there has been an increasing via sales, IPOs and leveraged recapitalizations of portfolio companies. We expect this trend
level of monetization activity to continue during 2011. Last year also saw an increase in new investment activity as the
via sales, IPOs and leveraged financing markets improved and the valuation gap between buyers and sellers narrowed. In
recapitalizations of portfolio our opinion, transactions are now being completed at reasonable valuation multiples based
companies. We expect this on depressed earnings that are expected to grow as the economy continues to improve.
trend to continue during 2011. Additionally, transactions completed in 2010 were less dependent on financial leverage and
more focused on earnings growth. We expect transactions in 2011 to be prudently leveraged,
with operational improvements and top-line growth driving returns.
During 2011, we expect the buyout market to be robust. New deal activity should remain
strong and we anticipate an increasing level of realizations of existing investments. The
financial crisis reminded investors that while private equity can provide strong returns, it is
a generally illiquid asset class with a long duration. During 2011, we believe that investors
will be rewarded for their patience as profitable returns will be generated via IPOs, portfolio
company sales and dividend recapitalizations.
For investors seeking to increase or reduce their private-equity exposure, there is an active
secondary market for partnership interests. The bid/ask “chasm” that prevailed during the
crisis has narrowed considerably. Improved earnings visibility combined with reasonable
transaction pricing provide the opportunity for attractive returns.
While there is currently limited opportunity in large liquid credits, distressed and turnaround
managers are finding attractive opportunities among smaller, less liquid credits and more
complex situations. Looking forward, we believe the mountain of non-investment grade
loans and high-yield bonds maturing over the next five years will present an outstanding
investment opportunity for managers who rely on independent credit analysis and who
have the ability to navigate complex restructurings in and out of bankruptcy court.
Within venture capital, certain high-profile companies including Facebook, Groupon, and
Twitter are achieving extraordinary valuations and are expected to go public shortly. While
these companies are receiving the majority of the media attention, they are not reflective
of the core strategies generally being pursued. Rather than trying to rely on “home runs,”
venture capitalists are currently funding capital efficient business models at reasonable
valuations with an eye towards exiting via a sale to cash-rich corporate acquirers.
In a challenging fundraising environment, investors in private equity funds have been
pushing for better alignment of interests with portfolio managers as well as more investor
friendly terms. While we do not believe that high quality private equity managers will
reduce their typical management fees (of 1.5%-2.0%) and 20% carried interest above a
hurdle rate (typically 8%), we do believe that private equity investors will receive more
favorable treatment. We see greater sharing of transaction, monitoring and other fees,
an overall improvement in terms protecting investors (e.g., “key-man” provisions) and
enhanced reporting, communication and transparency.

2011 Outlook: Private Equity

Over the course of 2010, Over the course of 2010, buyout activity accelerated meaningfully and we believe that
buyout activity accelerated transaction activity should remain strong in 2011, both in terms of new transactions
meaningfully and we believe and existing portfolio company realizations, especially with respect to small and mid-
that transaction activity should market companies, which are particularly attractive candidates for strategic acquirers
remain strong in 2011, both seeking growth and entry into new markets. Despite widespread predictions to the
in terms of new transactions contrary, at the height of the credit crisis, relatively few private equity backed companies
and existing portfolio company defaulted on their debt and declared bankruptcy. During the downturn, private equity
realizations, especially with firms aggressively managed their companies with a focus on cutting costs, preserving cash
respect to small and mid- and maintaining financial flexibility. More recently, sponsors have capitalized on much
market companies, which improved credit market conditions to refinance debt, extend maturities and take advantage
are particularly attractive
of lower interest rates.
candidates for strategic
Figure 1: Total U.S. Sponsored Debt and buyout Volume by Year 1,2
acquirers seeking growth and
entry into new markets. $450 $434

Total U.S. Leveraged Buyout Debt Volume
Total U.S. Leveraged Buyout Volume $316
USD in Billions


$250 $233


$150 $130
$163 $111
$100 $94
$57 $92
$53 $47
$50 $29 $33 $40 $66 $77
$42 $20 $22 $13 $47
$38 $28 $32
$21 $25 $12 $14 $6
’96 ‘97
’97 ‘98
’98 ‘99
’99 ‘00
’00 ‘01
’01 ‘02
’02 ‘03
’03 ‘04
’04 ‘05
’05 ‘06
’06 ‘07
’07 ‘08
’08 ‘09
’09 ‘10

Source: S&P LCD.

Leveraged buyout volume includes the total sources (loans, secured debt, unsecured debt, sub debt, and equity) involved in
leverage buyouts
Debt volume on this page includes the Total Sources (loans, secured debt, unsecured debt and sub debt) involved in leveraged buyouts

Although debt volumes have not recovered to pre-crisis levels, increased availability of
senior bank credit and healthy high-yield bond markets are funding new buyouts as well
as providing funding for dividend recapitalizations (see Figure 1).
Looking forward to 2011, we believe new transaction valuations should be reasonable
and in line with long-term historical averages. However, private equity managers will
need to maintain their pricing discipline as recent rises in public market valuations and
greater availability of credit have begun to drive transaction multiples somewhat higher.
Transactions will be financed with lower leverage levels and corresponding greater equity
contributions than deals consummated before the financial crisis. Financial engineering
will be deemphasized, and private equity firms will place an increasing focus on operational
improvements and top-line growth, both organically and via acquisitions. As transactions
require higher equity contribution percentages and as “club deals” (whereby multiple
sponsors share leadership of a transaction) have fallen out of favor, we expect private equity
firms to seek an increasing amount of co-investor capital to complete their transactions.
Relative to large cap transactions, we believe that small and mid cap buyouts will offer
the benefits of lower purchase multiples, more rapidly growing earnings streams and
provide a greater opportunity for private equity managers to add value via strategic and
operational initiatives.

2011 Outlook: Private Equity

Private equity firms will continue to utilize the credit markets to improve existing
capital structures, primarily by extending the maturities of existing debt and refinancing
at relatively low interest rates.
Monetization activity should meaningfully accelerate in 2011. We anticipate a high level
of private equity backed IPOs as companies seek to deleverage their balance sheets and
gradually provide liquidity to fund investors. Cash-rich strategic acquirers seeking growth
should provide an attractive means for private equity firms to exit existing investments.
Geographically, we expect more transactions completed in emerging markets, primarily
Asia and increasingly in South America.
Large capitalization transactions will start to recover, but “mega-cap” buyout transactions
in excess of $10 billion will be rare.
Finally, investor terms, communication and reporting will continue to improve and
significant investors have an opportunity to achieve increasingly favorable treatment.

2010 saw the highest level of 2010 saw the highest level of activity ever in the secondary market and we believe the market
activity ever in the secondary will remain robust throughout 2011. During 2009, divergent valuation expectations between
market and we believe the buyers and sellers limited the number of completed transactions. Pricing has increased since
market will remain robust the depths of the financial crisis, driven by stabilization in underlying portfolio company
throughout 2011. performance and confidence in portfolio valuations and, as a result, transaction volume
has increased substantially. In 2010, financial institutions were active sellers of secondary
interests, largely driven by new accounting rules (ASC 820) and regulatory changes (Dodd-
Frank, Basel III) that make holding interests in private equity funds less attractive. We
believe this trend will continue in 2011. Some endowments and pension plans continue to
selectively sell off some of their private equity interests as a combination of losses in their
public portfolios and lower-than-projected distributions from their private equity firms
have left them over-allocated to private equity.
In addition to the ability to invest at a discount to net asset value, secondary funds provide
diversification across multiple vintages, industries, manager strategies and geographies.
Secondary investment portfolios are generally well seasoned, providing visibility into
underlying portfolio company performance and investors can expect a more muted
“j-curve” than conventional private equity funds, generating faster returns of capital relative
to capital calls.

2011 Outlook: Private Equity

While competition has increased and discounts have rebounded from the lows seen
during the financial crisis, we believe prices are still attractive relative to historical levels
(see Figure 2). Pricing levels, combined with momentum in underlying portfolio company
performance and near-term monetization activity should help generate attractive returns
for secondary investors during 2011.

Figure 2 : Average High Bid Price as % of Reported Net Asset Value

Historical Benchmarks (2004 – 2010)

108% 104%
100% 94%
86% 85%


2004 2005 2006 2007 2008 2009 2010

Sources: Cogent Secondary Market Trends and Analysis and UBS Private Equity Secondary Market Review.

The financial crisis and the The financial crisis and the resulting credit market dislocation in late 2008 and through
resulting credit market much of 2009 provided distressed investors with an excellent opportunity to achieve outsized
dislocation in late 2008 returns. During this period, exceptional bargains were available in massive quantity and the
and through much of 2009 supply of distressed opportunities far outstripped demand. Those investors equipped with
provided distressed investors the right skill set, available capital and conviction benefitted greatly.
with an excellent opportunity
The size of the leveraged loan and high yield bond market has nearly doubled since the last
to achieve outsized returns.
distressed cycle in 2002. Even though refinancings, debt amendments and maturity extensions
have reduced balance sheet strains, over $1 trillion of non-investment grade debt will mature
in the U.S. and Europe over the next five years. As this occurs, we believe ample opportunities
should present themselves, as interest rates are likely to increase and a large number of
companies carry highly leveraged balance sheets (see Figure 3).

Figure 3 : Refinancing Overhang : Non-Investment Grade Maturities

by Year 1,2
USD in Billions

$300 $292
$200 $176
$100 $74

2011 2012 2013 2014 2015 2016 2017

Sources: Credit Suisse Leveraged Finance Strategy Update: September 1, 2010.

The sum of maturities for HY from 2010 to 2017 does not comprise the total market because a number of HY loans issued in
2010 may have maturities extending beyond 8 years.
Institutional U.S. and Western Europe Leveraged Loan Market data includes non-investment grade fully drawn institutional term
loans (TLb’s, TLc’s, TLd’s, delayed-draw and other tranches held by institutional investors).

2011 Outlook: Private Equity

While larger companies have been able to mitigate their capital structure issues by
accessing the public markets, smaller companies have faced more challenging capital
market conditions resulting in significantly higher default rates (see Figure 4). We expect
this trend to continue, and while we believe there are currently limited opportunities in
the large liquid distressed markets, there should be an attractive universe of opportunities
among small and mid-market credits.

Figure 4 : Default Rates on Leveraged Loans


Percentage of Loans Outstanding

Mid-cap Default Rate
Large-cap Default Rate





May-08 Aug-08 Nov-08 Feb-09 May-09 Aug-09 Nov-09 Feb-10 May-10 Aug-10 Nov-10

Source: S&P LCD.

Note: Weighted by Dollar. Mid-cap is defined as institutional loan issuers with EBITDA of less than $50 million at the time of issuance.

The competitive environment for distressed managers is favorable as regulatory issues are
constraining the participation of financial institutions and hedge funds have a decreased
appetite for less liquid securities.
During 2011, we expect that firms will utilize a combination of strategies including
restructurings, turnarounds and distressed debt purchases. Investors will pursue
opportunities at all levels of the capital structure including bank debt, bonds, preferred
stock and non-traditional instruments such as unsecured trade claims. Managers with
the ability to navigate complex restructurings, both in and out of bankruptcy court, will
have a distinct advantage. Similar to buyout firms, distressed managers will also place an
increased emphasis on driving returns from implementing operational improvements at
restructured companies.

While debt markets have been accommodating to larger and more seasoned issuers, the
public and 144A bond markets have been significantly less receptive to funding smaller
buyouts and portfolio company financing activities. As a consequence, private equity firms
While debt markets have have been utilizing an increasing amount of private mezzanine capital in their transactions.
been accommodating to In the current market, yields typically range between 10% and 13%, significantly in excess
larger and more seasoned of public high yield bonds. In addition, mezzanine instruments frequently contain some
issuers, the public and 144A equity participation in the form of stock warrants. Equity participation can increase overall
bond markets have been mezzanine returns by approximately 300 to 500 basis points. Realization of proceeds from
significantly less receptive to mezzanine funds is typically faster than traditional equity-oriented funds as the debt is typically
funding smaller buyouts refinanced within a two- to three-year period. Because mezzanine investments have a more
and portfolio company limited upside than equity-oriented investments, managers must construct appropriately
financing activities. diversified portfolios. With a portfolio that does not have sufficient diversification a single bad
investment can result in substandard returns at the aggregate fund level.

2011 Outlook: Private Equity

The mezzanine market is prone to cyclicality and during the later stages of credit cycles
conventional funding sources such as banks and bond markets become more willing to
finance smaller and riskier credits. As this occurs, mezzanine investors risk getting crowded
out of the market and fund managers may lower hurdle rates.
We are currently in the middle stage of the mezzanine cycle and, with the increased emphasis
on liquidity among conventional fixed-income sources, we believe that for the next two
years there will be attractive opportunities for experienced mezzanine managers.


The venture capital industry continues to evolve and rationalize its size and depth in the
short and medium term. Through the first three quarters of 2010, U.S. venture capital
fundraising was at its lowest run rate since 2003.
The venture capital industry
continues to evolve and Figure 5 : Annual Commitments to Venture Capital Funds
rationalize its size and depth
$90 $85.5
in the short and medium
term. Reduced fundraising in $70
USD in Billions

2010 resulted in a slower rate $60

of capital deployment relative $50
$42.5 $40.1
to the prior two years. This $40
$28.7 $31.2 $28.6
trend should continue
$20 $19.0 $18.9
into 2011. $10.4 $13.5
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 1Q–3Q

Source: Dow Jones VentureSource.

Reduced fundraising in 2010 resulted in a slower rate of capital deployment relative to the
prior two years. This trend should continue into 2011. It follows that median valuations
across all stages of investment should remain at attractive levels relative to those seen
over the past 10 years. Certain innovative business category leaders will continue to be
exceptions to these moderate valuation levels. In this select category, companies such
as Facebook, Zynga, Twitter and Groupon attracted a great deal of publicity during the
year, but these are outliers in an industry where the philosophy of relying on “home run”
investments to drive a fund’s returns is no longer viable. Cash-laden corporate acquirers
have been aggressively pursuing early-stage companies at reasonable valuations and there
was a steady level of strategic acquisitions of venture-backed companies in 2010. As a result
of this trend, small seed and early stage funds focusing on capital-efficient business models
are able to underwrite their funds to attractive returns based on M&A exits of product
stage companies.
Growth equity continues to be an undersupplied source of capital relative to many other
types of private equity, despite the favorable supply of target companies. The lack of stable
bank financing for small businesses will continue to drive better-than-normal growth
equity opportunities. As debt financing remains expensive and difficult to secure, slower
economic growth also encourages these companies to seek outside capital to spur growth
and gain the professional insights and guidance offered by leading growth equity funds.
The operational value-add that institutional growth equity firms provide has become

2011 Outlook: Private Equity

an increasingly desirable function. In terms of exits, as businesses strive for revenue and
earnings growth in the current economic environment, one avenue to pursue will be the
acquisition of growth businesses—this is a trend we expect to see more of if economic
growth remains sluggish.

After experiencing a tumultuous period during the financial crisis, the private
equity markets have improved markedly. New transaction levels are healthy and cash
We expect 2011 to be distributions from existing investments are increasing. Valuations and leverage ratios
a robust year for private have moderated to more reasonable levels. Private equity firms are de-emphasizing
equity. Macroeconomic financial engineering and are instead focusing on driving returns by adding value
trends are improving, credit operationally and strategically. The secondary market is active, with an ample universe
markets are healthy, the of sellers and reasonable purchase discounts are available. For distressed managers, the
M&A environment is strong ability to achieve attractive returns by purchasing large, liquid securities has largely
and public equity markets passed but, for firms with creativity and the expertise to navigate complex restructurings,
are increasingly receptive ample opportunities remain. While headline-grabbing investments such as Facebook
to private equity backed are achieving stratospheric valuations, more conventional venture capital investments
companies. with proven business models and profitable operations offer clear paths to profitable
monetization via sales to corporate acquirers.
We expect 2011 to be a robust year for private equity. Macroeconomic trends are
improving, credit markets are healthy, the M&A environment is strong and public equity
markets are increasingly receptive to private equity backed companies.

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